FINANCIAL STATEMENTS ANALYSIS

Financial Statement Analysis

Who analyzes financial statements?

– Internal users i.e., Management, Shareholders,

Internal auditors, Budget Analyst,

– External users• Examples?• Investors, creditors, regulatory agencies & …• stock market analysts, Business analysts,

Financial Analyst, Investment Analyst and • auditors

Financial Statement Analysis

• What do internal users use it for? Planning, evaluating and controlling company

operations

• What do external users use it for? Assessing past performance and current financial

position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

Financial Statement Analysis

Information is available from

– Published annual reports • (1) Financial statements• (2) Notes to financial statements• (3) Letters to stockholders• (4) Auditor’s report (Independent accountants)• (5) Management’s discussion and analysis

– Reports filed with the government Taxation Department, SECP.

Financial Statement Analysis

Information is available from

– Other sources• (1) Newspapers (e.g., The News)• (2) Periodicals (e.g. The Economist, Fortune)• (3) Financial information organizations• (4) Other business publications

Methods ofFinancial Statement Analysis

• Horizontal Analysis

• Vertical Analysis

• Common-Size Statements

• Trend Percentages

• Ratio Analysis

Horizontal Analysis

Vertical Analysis

Common-Size Statements

Trend Percentages

Ratio Analysis

Horizontal Analysis Example

The management of ABC Company provides you with comparative balance sheets of the years ended

December 31, 2009 and 2010. Management asks you to prepare a horizontal analysis horizontal analysis on the

information.

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Since we are measuring the amount of the change between 2010 and 2009, the dollar amounts for 2009 become the “base” year

figures.

DollarChange

Current YearFigure

Base YearFigure

= –

Horizontal Analysis Example

Calculating Change as a Percentage

PercentageChange

Dollar Change Base Year Figure 100%= ×

$12,000 – $23,500 = $(11,500)

Horizontal Analysis Example

($11,500 ÷ $23,500) × 100% = 48.9%

Horizontal Analysis Example

Horizontal Analysis Example

Let’s apply the sameprocedures to the

liability and stockholders’equity sections of the

balance sheet.

Horizontal Analysis Example

ABC CORPORATIONComparative Balance SheetsDecember 31, 2010 and 2009

Increase (Decrease)2010 2009 Amount %

Liabilities and Stockholders' EquityCurrent liabilities: Accounts payable 67,000$ 44,000$ 23,000$ 52.3 Notes payable 3,000 6,000 (3,000) (50.0) Total current liabilities 70,000 50,000 20,000 40.0Long-term liabilities: Bonds payable, 8% 75,000 80,000 (5,000) (6.3) Total liabilities 145,000 130,000 15,000 11.5Stockholders' equity: Preferred stock 20,000 20,000 - 0.0 Common stock 60,000 60,000 - 0.0 Additional paid-in capital 10,000 10,000 - 0.0 Total paid-in capital 90,000 90,000 - 0.0Retained earnings 80,000 69,700 10,300 14.8 Total stockholders' equity 170,000 159,700 10,300 6.4Total liabilities and stockholders' equity 315,000$ 289,700$ 25,300$ 8.7

Now, let’s apply the procedures to theincome statement.

Horizontal Analysis Example

ABC CORPORATIONComparative Income Statements

For the Years Ended December 31, 2010 and 2009Increase (Decrease)

2010 2009 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

ABC CORPORATIONComparative Income Statements

For the Years Ended December 31, 2010 and 2009Increase (Decrease)

2010 2009 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

Sales increased by 8.3% while net income decreased by 21.9%.

ABC CORPORATIONComparative Income Statements

For the Years Ended December 31, 2010 and 2009Increase (Decrease)

2010 2009 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the

increase in sales, yielding an overall decrease in net income.

Vertical Analysis Example

The management of Sample Company asks you to prepare a vertical analysis vertical analysis for the comparative

balance sheets of the company.

Vertical Analysis Example

Vertical Analysis Example

$82,000 ÷ $483,000 = 17% rounded$30,000 ÷ $387,000 = 8% rounded

Vertical Analysis Example

$76,000 ÷ $483,000 = 16% rounded

Trend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend

analysis.

Trend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend

analysis.

$1,991 - $1,820 = $171$1,991 - $1,820 = $171

Trend Percentages Example

Using 1995 as the base year, we develop the following percentage relationships.

$1,991 - $1,820 = $171$1,991 - $1,820 = $171$171 ÷ $1,820 = 9% rounded$171 ÷ $1,820 = 9% rounded

Trend linefor Sales

Ratios

Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25)

“Using ratios and percentages without considering the underlying leads to incorrect conclusions.”

Categories of Ratios

• Liquidity RatiosIndicate a company’s short-term debt-paying ability

• Equity (Long-Term Solvency) RatiosShow relationship between debt and equity financing in a company

• Profitability TestsRelate income to other variables

• Market TestsHelp assess relative merits of stocks in the marketplace

Important Considerations

• Need for comparable data– Data is provided by different companies.– Must compare by industry

Influence of external factors General business conditions Seasonal nature of business operations

Impact of inflation