Chapter: 18

Financial Statement Analysis

● Basics Of Financial Statement Analysis

Analyzing financial statements involves evaluating three characteristics: a company’s liquidity,
profitability, and solvency.
✔ A short-term creditor, such as a bank, is primarily interested in liquidity—the ability of
the borrower to pay obligations when they come due. The liquidity of the borrower is
extremely important in evaluating the safety of a loan.
✔ A long-term creditor, such as a bondholder, looks to profitability and solvency
measures that indicate the company’s ability to survive over a long period of time. Long-
term creditors consider such measures as the amount of debt in the company’s capital
structure and its ability to meet interest payments.
✔ Similarly, stockholders look at the profitability and solvency of the company. They
want to assess the likelihood of dividends and the growth potential of the stock.
● Need for Comparative Analysis
Comparisons can be made on a number of different bases.
1. Intra-company basis: This basis compares an item or financial relationship within a company
in the current year with the same item or relationship in one or more prior years. Intracompany
comparisons are useful in detecting changes in financial relationships and significant trends.
2. Industry averages: This basis compares an item or financial relationship of a company with
industry averages (or norms) published by financial ratings. Comparisons with industry averages
provide information as to a company’s relative performance within the industry.
3. Inter-company basis: This basis compares an item or financial relationship of one company
with the same item or relationship in one or more competing companies. Analysts make these
comparisons on the basis of the published financial statements of the individual companies.
Intercompany comparisons are useful in determining a company’s competitive position.

● Tools of Analysis
Three commonly used tools are these:
• Horizontal / Trend analysis evaluates a series of financial statement data over a period of
time. Horizontal analysis is used primarily in intra-company comparisons
• Vertical / Common-Size analysis evaluates financial statement data by expressing each item
in a financial statement as a percent of a base amount. Vertical analysis is used in both intra- and
inter-company comparisons.
• Ratio analysis expresses the relationship among selected items of financial statement
[Link] analysis is used in all three types of comparisons

● Horizontal Analysis or Trend Analysis:

Horizontal analysis, also called Trend analysis, is a technique for evaluating a series of financial
statement data over a period of [Link] purpose is to determine the increase or decrease that has
taken place. This changemay be expressed as either an amount or a percentage. Horizontal
analysis is commonly applied to the balance sheet, income statement, and statement of retained
earnings.
✔ Advantage and Disadvantage of Horizontal Analysis and Vertical Analysis
Horizontal analysis of changes from period to period is relatively straightforward and is quite
useful. But complications can occur in making the computations. If an item has no value in a
base year or preceding year but does have a value in the next year, we cannot compute a
percentage change. Similarly, if a negative amountappears in the base or preceding period and a
positive amount exists the following year (or vice versa), no percentage change can be computed.
✔ Formula for horizontal analysis of changes since base period:

✔ Formula for horizontal analysis of current year in relation to base year:

 Figure 1 Horizontal Analysis of Balance sheet

Interpretation for Horizontal Analysis of Balance sheet:

The comparative balance sheets show that a number of significant changes have occurred in
Quality Department Store’s financial structure from 2012 to 2013:
• In the assets section, plant assets (net) increased $167,500, or 26.5%.
• In the liabilities section, current liabilities increased $41,500, or 13.7%.
• In the stockholders’ equity section, retained earnings increased $202,600, or 38.6%.
These changes suggest that the company expanded its asset base during 2013 and financed this
expansion primarily by retaining income rather than assuming additional long-term debt.
Interpretation for Horizontal
Analysis of Income Statement: Figure SEQ Figure \* ARABIC 2 Horizontal

Horizontal analysis of the income statements shows the following changes:

• Net sales increased $260,000, or 14.2% ($260,000 /$1,837,000).
• Cost of goods sold increased $141,000, or 12.4% ($141,000 /$1,140,000).
• Total operating expenses increased $37,000, or 11.6% ($37,000/ $320,000).
Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net
income, 26.5%. Quality’s profit trend appears favorable.
 Figure 3: Horizontal Analysis of Retained Earnings Statement

Interpretation- Horizontal Analysis of Retained Earnings Statement:

Analyzed horizontally, net income increased $55,300, or 26.5%, whereas dividends on the
common stock increased only $1,200, or 2%.We saw in the horizontal analysis of the balance
sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a
significant portion of net income to finance additional plant facilities.

● Vertical Analysis or Common-size Analysis:

Vertical analysis, also called common-size analysis, is a technique that expresses each financial
statement item as a percent of a base amount. On a balance sheet we might say that current assets
are 22% of total assets— total assets being the base amount. Or on an income statement, we
might say that selling expenses are 16% of net sales—net sales being the base amount. Vertical
analysis is commonly applied to the balance sheet and income statement.
o Vertical analysis of balance sheets
Vertical analysis shows the relative size of each category in the balance sheet. It also can show
the percentage change in the individual asset, liability, and stockholders’ equity items.
EachItemonBalanceSheet
The formula for calculating these balance sheet percentages =
Total Asset
 Figure 4: Vertical Analysis of Balance Sheet

Interpretation for Vertical Analysis of Balance sheet:

Quality Department Store is choosing to finance its growth through retention of earnings rather
than through issuing additional debt.
o Vertical analysis of Income statements
Vertical analysis shows the relative size of each category in the income statement. It also can
show the percentage change in the individual revenues and expense.
EachItemonIncome Statement
The formula for calculating these income statement percentages =
Net Revenues

Interpretation for Vertical Analysis of Income Statement:

Quality Department Store appears to be a profitable enterprise that is becoming even more
successful.
o Intercompany income statement comparison (vertical analysis)
An associated benefit of vertical analysis is that it enables you to compare companies of different
sizes.
o Interpretation of Intercompany Income Statement
Macy’s net sales are 13,320 times greater than the net sales of relatively tiny Quality Department
Store. But vertical analysis eliminates this difference in size. The percentages show that
Quality’s and Macy’s gross profit rates were comparable at 38.9% and 40.1%, respectively.
However, the percentages related to income from operations were significantly different at
21.9% and 9.9%, respectively. This disparity can be attributed to Quality’s selling and
administrative expense percentage (17%) which is much lower than Macy’s (30.2%). Although
Macy’s earned net income more than 5,629 times larger than Quality’s, Macy’s net income as a
percentage of each sales dollar (5.3%) is only 42% of Quality’s (12.6%).

● Ratio Analysis
Ratio analysis expresses the relationship among selected items of financial statement data. A
ratio expresses the mathematical relationship between one quantity and [Link] relationship
is expressed in terms of either a percentage, a rate, or a simple [Link] relationship is
expressed in terms of either a percentage, a rate, or a simple proportion
Example:
⮚ Percentage: Current assets are 313% of current liabilities.
⮚ Rate: Current assets are 3.13 times of liabilities.
⮚ Proportion: The relationship of current assets to liabilities is 3.13:1.

● Financial ratio classifications

To analyze the primary financial statements, we can use ratios to evaluate liquidity, profitability,
and solvency.

⮚ Liquidity Ratios
Liquidity ratios measure the short-term ability of the company to pay its maturing obligations
and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are
particularly interested in assessing [Link] ratios we can use to determine the enterprise’s
short-term debt-paying ability are the current ratio, the acid-test ratio,
● Current Ratio
Current ratio is widely used measure for evaluating a company’s liquidity and short-term debt-
paying [Link] ratio is computed by dividing current assets by current liabilities. Sometimes
this ratio is referred to as the working capital ratio; working capital is current assets minus
current liabilities.
 Current Asset
The formula for calculating Current ratio =
Current Liabilities

Interpretation:
⮚ Higher than 1.5 means more liquidity for the company but indicates unprofitable
investment of current asset,
⮚ Lower than 1.5 indicates liquidity problem

$ 1020000
The formula for calculating Current ratio = = 2.96
$ 344500
 Current ratio = Current Asset / Current Liabilities
Quality Departmental Store
2013 2012
$ 1,020,000 $ 945000
=¿2.96:1 =3.12:1
$ 344500 $ 303000

Industry average Macy’s, Inc.

1.70:1 1.40:1

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current
assets.
● Acid-test /Quick Asset Ratio
Acid-test ratio is the ratio of quick asset(generally current asset less inventory) to current
liabilities. This ratio indicates a company’s ability to satisfy current liability with its most liquid
assets.

(Current Asset – Inventory )

The formula for calculating Acid test ratio/ quick asset ratio=
Current Liabilities

Interpretation: higher than 0.8 means more liquidity for the company but indicates unprofitable
investment of current asset; lower than 0.8 indicates liquidity problem.

$ (1020000−620000)
The formula for calculatingAcid test ratio/ quick asset ratio= =1.1
344500

⮚ Profitability Ratios
Profitability ratios measure the income or operating success of a company for a given period of
time. This ratio compares components of income with [Link] ratio includesReturned on
Earnings, returned on asset, gross profit margin and net profit margin.
● Net profit margin
 Net profit margin is the ratio of net profit to sales and indicates how much of each dollar of sales
is left after all expenses.
Net Profit
The formula for calculatingNet Profit Margin =
Sales

Interpretation:The higher the ratio, the better

$ 263800
The formula for calculatingNet Profit Margin = =12.6 %
$ 2097000

● Gross profit margin

Gross profit (sales minus cost of sales) as a percentage of sales is an indication of the
management ability to mark up its products over their cost.
Gross Profit
The formula for calculatingGross Profit Margin =
Sales

Interpretation:the higher the ratio, the better

816000
The formula for calculatingGross Profit Margin = = 38.91%
2097000

● Return on Asset (ROA)

ROA is an overall measure of profitability. We compute this ratio by dividing net income by
average assets. This variation measures return on total asset after recognizing financing cost and
taxes.
Net Income
The formula for calculating ROA =
Average Total Asset

Interpretation:The higher the ratio, the better (compare with past years and/or similar
companies, analyze the trend.
263800
The formula for calculating ROA = = 15.4%
{(1595000+1835000)/2 }
● Return on Common Stockholder’s Equity (ROE)
ROE shows how many dollars of net income the company earned for each dollar invested by the
owners. ROE measures the return on ownership capital after taxes and interest payment.
ROE = Net Income/ Average Common Shareholders’ Equity
Interpretation: The higher the ratio, the better (compare with past years and/or similar
companies, analyze the trend)
ROE= 263800/ {(795000+1003000)/2} = 29.3%

● Return On Common Stockholders’ EquityWith Preferred Stock

When a company has preferred stock, we must deduct preferred dividend requirements from net
income to compute income available to common stockholders. Similarly, we deduct the par
value of preferred stock (or call price, if applicable) from total stockholders’ equity to determine
the amount of common stockholders’ equity used in this ratio.
ROE = (Net Income – Preferred Dividend)/ Average Common Shareholders’ Equity
⮚ Market Performance Ratio
Market performance ratio measures the performance related to shareholders expectations of
public limited companies and companies listed on stock exchanges. This ratio includes earnings
per share, price-earnings ratio and dividend payout ratio.
● Earnings Per Share (EPS)
EPS is the amount of income earned during a period per share of common stock. It is computed
using reported earnings and the average of common shares outstanding during the year.
EPS= (Net Income –Dividend on Preferred Stock)/ Weighted Average Number of Share
Outstanding
= $ (263,800 – 0)/ {(270000+275400)/2}
=$0.97
Interpretation:The higher, the better
● Price-Earnings Ratio
PER is the ratio of price per share of common stock to earnings per share of common stock. PER
reflects investors’ assessments of a company’s future earnings.
PER = Price per share/ Earnings per share
Interpretation:High PER indicates high expectation of the investors about the future of the
company and vice versa.
PER= 12/.97=12.4 times
● Dividend Payout Ratio
Dividend payout ratio is the return to shareholders measured in terms of the dividend paid during
the period
Dividend payout ratio = Dividend paid per share/ Earning per share
Interpretation: the higher,the better for the investors
⮚ Solvency Ratio:
Solvency ratio is used to measure the ability of a company to meet its long term debts. This ratio
generates insight into a company’s ability to meet long term debt payment schedule and also
includes Debt to Asset Ratio, Debt to equity, Debt ratio, Equity ratio, Interest coverage ratio.
● Debt To Total Assets Ratio/Debt Ratio
Debt ratio indicates the proportion of asset that are financed with debt (both long term and short
term)
Debt ratio: Total Debt/ Total Asset
Interpretation: 50%. (higher than this benchmark indicate higher dependence of debt. Too
much high may indicate financial risk.)
Debt ratio= 832000/183500 = 45.3%
● Debt to equity ratio:
Debt to equity ratio indicates the relative use of debt and equity as sources as capital to finance
the company’s asset
Debt to equity: Total Debt/ Shareholders’ Equity
Interpretation: 100% (higher than this benchmark indicate higher dependence of debt. Too
much high may indicate financial risk.)
Debt to Equity Ratio = 832000/1003000
= 82.95%
● Equity ratio:
Equity ratio: Shareholders’ Equity/ Total Asset
Interpretation: 50% (less than this benchmark figure indicates indicate higher dependence of
debt. Too low may indicates high financial risk.)
Equity ratio = 1003000/1835000
=54.65%
● Interest Coverage Ratio
Interest coverage ratio compares the earnings available to meet the interest obligations.
Interest coverage ratio: EBIT/ Interest
Interpretation:the higher the better. Less than 1 indicates bankruptcy in near future.
Cash Flow Statement Ratio:
✔ Free Cash Flow
In the statement of cash flows, cash provided by operating activities is intended to indicate the
cash-generating capability of the company. Analysts have noted, however, that cash provided by
operating activities fails to take into account that a company must invest in new fixed assets just
to maintain its current level of operations. Companies also must at least maintain dividends at
current levels to satisfy investors. The measurement of free cash flow provides additional insight
regarding a company’s cash-generating ability. Free cash flow describes the cash remaining from
operations after adjustment for capital expenditures and dividends
The formula for calculating Free Cash Flow=Net cash provided by operating activities – Capital
expenditure – Cash dividend