Financial Analysis
1st Definition of Financial Analysis
means using Techniques to analyze Financial Data according to it’s relative importance in order to
evaluate the financial position of the company.
2nd Techniques of Financial Analysis:
1st Ratio Analysis
Financial Ratios are a relation between two related items which gives a meaningful information. They are
usually expressed in % or times per period.
1st we have to compute Financial Ratios by determining the relation between:
• Item in Balance sheet with Item in Balance Sheet.
• Item in Income Statement with Item in Income Statement.
• Item in Balance Sheet with Item in Income Statement.
2nd We have to Compare Financial Ratios with:
• Ratios of Previous Periods for the Same Company (Trend Analysis).
• Ratios of Current Period for another company.
• Ratios of Current Period for Industry (Industry Ratios).
Problems of Ratio Comparison:
Comparing Ratios with other companies has many problems because of:
1) Difference in Equations & Basis used by each company to compute ratios.
2) Difference in Fiscal Year Ends used by each company to prepare Financial Statements.
3) Difference in Accounting Methods used by each company.
Comparing between Different Size Companies is more difficult than Comparing between Equal Size
Companies especially when using Absolute Numbers.
Financial Analysis - Part (1) | 1
2nd Common Size Analysis
Under Common Size Analysis; It is better to use Percentages or Relatives (%) rather than absolute
numbers because using Percentages will help in comparing companies with different sizes.
Vertical Analysis vs. Horizontal Analysis in Financial Statement Analysis
Financial statement analysis is a fundamental tool for evaluating a company’s performance, financial
position, and trends over time. Among the most widely used techniques are Vertical Analysis and Horizontal
Analysis, both of which are often discussed within the broader framework of Common-Size Financial
Statements.
Common Size Analysis includes two types of Analysis; Vertical Analysis & Horizontal Analysis:
Vertical Analysis Horizontal Analysis
Under Vertical Analysis; Each amount is Horizontal analysis evaluates financial statement
compared with a base amount from the same items across multiple periods by measuring the
year: absolute and percentage change over time.
• Each Balance Sheet Item is presented as Under Horizontal Analysis; Each amount is
% of Total Assets. compared with a base amount from another year
(base year).
• Each Income Statement Item is
To identify growth patterns and trends
presented as % of Net Sales.
To detect financial improvement
To support forecasting and strategic decisions
To understand the structure of financial
statements
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EXAMPLE 1 on VERTICAL Analysis:
2012 2011
Net Sales 100,000 120,000
(-) COGS 65,000 70,000
Gross Profit (1) 35,000 50,000
(-) Operating Expenses 30,000 20,000
Operating Income before Tax (2) 5,000 30,000
(-) Income Tax 1,000 3,000
Net Income (3) 4,000 27,000
Required:
1) Prepare a Vertical Analysis of this statement for each year, using Sales as the base.
2) Comment briefly on the changes between the two years, based on the Vertical Analysis.
Solution
Net Sales is the Base Amount, So it should be 100%
2012 2011
Net Sales (Base = 100%) 100,000 100% 120,000 100%
(-) COGS 65,000 65% 70,000 58%
(65,000 / 100,000) (70,000 / 120,000)
Gross Profit (1) 35,000 35% 50,000 42%
(35,000 / 100,000) (50,000 / 120,000)
(-) Operating Expenses 30,000 30% 20,000 17%
(30,000 / 100,000) (20,000 / 120,000)
Operating Income before Tax (2) 5,000 5% 30,000 25%
(5,000 / 100,000) (30,000 / 120,000)
(-) Income Tax 1,000 1% 3,000 2.5%
(1,000 / 100,000) (3,000 / 120,000)
Net Income (3) 4,000 4% 27,000 22.5%
(4,000 / 100,000) (27,000 / 120,000)
From Vertical Analysis:
Gross Profit decreased from 42% to 35% because of Increase in COGS.
Operating Income decreased from 25% to 5% because of Increase in Operating Expenses.
Net Income decreased from 22.5% to 4% because of decrease in Operating Income
Financial Analysis - Part (1) | 3
EXAMPLE 2 on VERTICAL Analysis:
Item Amount ($)
Total Assets 2,000,000
Current Assets 800,000
Non-Current Assets 1,200,000
Total Liabilities 1,100,000
Equity 900,000
Required:
1) Prepare a Vertical Analysis of this statement.
2) Comment briefly.
Solution
Item Amount ($) Percentage
Total Assets 2,000,000 100%
Current Assets 800,000 40%
Non-Current Assets 1,200,000 60%
Total Liabilities 1,100,000 55%
Equity 900,000 45%
The company is moderately leveraged
Assets are concentrated in long-term investments
Advantages and Limitations of Vertical Analysis
Advantages:
• Simple and intuitive
• Facilitates cross-company comparison
• Highlights cost and asset structure
Limitations:
• Does not show performance trends over time
• Sensitive to unusual base amounts
Financial Analysis - Part (1) | 4
EXAMPLE on HORIZONTAL Analysis:
2012 2011
Net Sales 95,000 120,000
(-) COGS 65,000 70,000
Gross Profit (1) 35,000 50,000
(-) Operating Expenses 30,000 20,000
Operating Income before Tax (2) 5,000 30,000
(-) Income Tax 1,000 3,000
Net Income (3) 4,000 27,000
Required:
1) Prepare a Horizontal Analysis of this statement for each year, using 2011 as the base year.
2) Comment briefly on the changes between the two years, based on the Horizontal Analysis.
Solution
2011 is the Base Year, So it should be 100%
2012 2011 (Base = 100%)
Net Sales 95,000 79% 120,000 100%
(95,000 / 120,000)
(-) COGS 65,000 92% 70,000 100%
(65,000 / 70,000)
Gross Profit (1) 35,000 70% 50,000 100%
(35,000 / 50,000)
(-) Operating Expenses 30,000 150% 20,000 100%
(30,000 / 20,000)
Operating Income before Tax (2) 5,000 17% 30,000 100%
(5,000 / 30,000)
(-) Income Tax 1,000 33% 3,000 100%
(1,000 / 3,000)
Net Income (3) 4,000 14% 27,000 100%
(4,000 / 27,000)
From Horizontal Analysis:
Gross Profit decreased by 30% because of Decrease in Sales.
Operating Income decreased by 83% because of Increase in Operating Expenses.
Net Income decreased by 86% because of decrease in Operating Income
Financial Analysis - Part (1) | 5
Advantages and Limitations of Horizontal Analysis
Advantages:
• Highlights trends and growth rates
• Useful for forecasting and planning
Limitations:
• Inflation may distort comparisons
• Requires consistent accounting policies
Integrated Example (Vertical + Horizontal)
A company may use vertical analysis to determine that operating expenses represent 30%
of sales, and horizontal analysis to observe that operating expenses increased by 20%
over three years.
Conclusion:
• Vertical analysis explains what the structure looks like
• Horizontal analysis explains how it changes over time
Financial Analysis - Part (1) | 6
Profitability Analysis
Profitability Analysis measures the ability of the company to use it’s Assets in order to generate Profit
(Net Income). The Profitability Analysis can be measured from Two Perspectives
Using Total Assets Using Operating
Here; we use Total Assets to measure ability of Assets
the company to generate Income.
Here; we use Operating Assets to measure
Total Assets are All resources that are used or
ability of the company to generate Income.
not used in operations.
Operating Assets are Resources that are used in
Net Income is Income generated after paying
operations.
Interest & Tax = EBIT - Interest & Tax
Operating Income is Income generated from
Operating = EBIT
Ratios: Ratios:
1) Return on Assets 1) Return on Operating Assets
2) Return on Sales (Net Profit Margin) 2) Operating Income Margin
3) Total Assets Turnover 3) Operating Assets Turnover
Financial Analysis - Part (1) | 7
Profitability Ratios
Using Total Assets Using Operating Assets
When computing these ratios; we depend on two main When computing these ratios; we depend on two main
items: items:
Total Assets = Current Assets + Long Term Assets Operating Assets = TA - (Investments +
Construction in Progress + Leased Assets to Others)
NI after Interest & Tax = EBIT - Interest & Tax
Operating Income = EBIT
1) Return on Assets (ROA):
Income After Interest & Tax
1) Return on Operating Assets:
= EBIT
Average Total Assets =
Average Operating Assets
It measures the ability of the company to generate Profit
(Net Income) by using each dollar of Assets. It measures the ability of the company to generate Profit
(EBIT) by using each dollar of Operating Assets.
If ROA = 40% this means that each dollar in Assets generates
0.40 dollar in Net Income. If ROA = 40% this means that each dollar in Operating
Assets generates 0.40 dollar in Operating Income.
2) Net Income Margin (ROS):
Income After Interest & Tax
2) Operating Income Margin:
= EBIT
Net Sales =
Net Sales
It measures the ability of the company to generate Profit
(Net Income) by using each dollar of Sales. It measures the ability of the company to generate Profit
(EBIT) by using each dollar of Sales.
If Margin = 40% this means that each dollar in Sales
generates 0.40 dollar in Net Income. If Margin = 40% this means that each dollar in Sales
generates 0.40 dollar in Operating Income.
3) Total Assets Turnover:
Net Sales
3) Operating Assets Turnover:
= Net Sales
Average Total Assets =
Average Operating Assets
It measures the ability of the company to use Total Assets to
generate Sales. It measures the ability of the company to use Operating
Assets to generate Sales.
Financial Analysis - Part (1) | 8
Comprehensive Problem
The following is balance sheet and income statement of ABC Company for year 2017:
Balance Sheet
Assets:
1st Current Assets:
Cash 145,000
Accounts Receivable, Net 120,000
Inventory 135,000
Total Current Assets 400,000
2nd Long Term Assets:
Property, Plant & Equipment 50,000
Leased Building to others 100,000
Long Term Investments 150,000
Intangible Assets 300,000
Total Long Term Assets 600,000
Total Assets 1,000,000
Liabilities:
Current Liabilities 150,000
Long Term Liabilities 250,000
Total Liabilities 400,000
Equity:
Preferred Stock 100,000
Common Stock 200,000
Additional Paid in Capital 50,000
Retained Earnings 250,000
Total Equity 600,000
Financial Analysis - Part (1) | 9
Income Statement
Net Sales (90% Credit Sales) 690,000
(-) COGS (90,000)
Gross Profit 600,000
(-) Selling & Administrative Expenses (100,000)
Operating Income (used with Operating Assets) 500,000
(-) Interest Expense (240,000)
(-) Tax Expense (60,000)
Net Income after Interest & Tax (used with Total Assets) 200,000
(±) Gain or Loss from Discontinued Operations 10,000
(±) Gain or Loss from Extraordinary Items (20,000)
Net Income before Equity Earnings & Minority Share in Earnings 190,000
(+) Equity Earnings in Unconsolidated Subsidiary 220,000
(-) Minority Share in Earnings of Consolidated Subsidiary (10,000)
Net Income 400,000
Required: Compute the following ratios:
1) Return on Assets
2) Return on Sales (Net Profit Margin)
3) Total Assets Turnover
4) Return on Operating Assets
5) Operating Income Margin
6) Operating Assets Turnover
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Solution
1) Return on Assets:
Income After Interest & Tax 200,000
=
Total Assets
=
1,000,000
= 20%
2) Net Income Margin:
Income After Interest & Tax 200,000
=
Net Sales
=
690,000
= 29%
3) Total Assets Turnover:
Net Sales 690,000
=
Total Assets
=
1,000,000
= 0.69 times
4) Return on Operating Assets:
Operating Income 500,000
=
Operating Assets
= = 67%
1,000,000 – 100,000 – 150,000
(All Assets except Leased Asset & Investments)
5) Operating Income Margin:
Operating Income 500,000
=
Net Sales
=
690,000
= 72%
6) Operating Assets Turnover:
Net Sales 690,000
=
Operating Assets
= = 0.92 times
1,000,000 – 100,000 – 150,000
(All Assets except Leased Asset & Investments)
Financial Analysis - Part (1) | 11