Financial Statement Analysis

Readings: Chapter 3

At the end of this unit students should be able to: 

1. Explain why ratio analysis is usually the first step in the analysis of a company’s financial statements.

2. Explain the purpose of trend analysis.

3. Explain the purpose of comparative analysis (benchmarking)

4. Explain the purpose of common-size analysis.

5. List several limitations of ratio analysis.

6. Identify some of the qualitative factors that must be considered when evaluating a company’s financial performance

7. List the five groups of ratios, specify which ratios belong in each group, and explain what information each group gives us about the firm’s financial position.
8. Compute the above ratios of a company and determine the company's strengths and weaknesses.

NOTE - These electronic notes are not detailed. The lecture for this topic will entail the working of ratios for the financial statements of a fictitious company (to be given in class or accessible from below).

• Use of Ratios

(Note- Using ratios that draw upon figures from the P&L as well as from the Balance Sheet can be misleading. This is because a 'flow' figure is placed with a 'year-end' figure. Category B has already accounted for this by the use of "Average figures".)

 

• Trend Analysis

This form of analysis is important as it brings out the relative position of a company overtime i.e. whether things are improving or declining. (Note - When considering trends, one should always factor in the impact of inflation.)

Illustration:

		Debtors Turnover
	1999	2000	2001	2002
Firm A	3.1	3.2	3.3	3.4
Firm B	3.3	3.2	3.3	3.2
Firm C	3.8	3.7	3.7	3.5
Firm D	3.6	3.5	3.3	3.2
Industry Average	3.5	3.4	3.4	3.3

 

• Comparative Analysis

This involves comparing ratios of one company with similar ratios of another company in the same industry (Benchmarking) or with an industry average. Although two companies may be in the same industry, they may be of different sizes. Care must be taken to ensure that any effects caused by this inequity are appropriately adjusted for when making comparisons (e.g. a small grocery store in a neighbourhood versus an international giant).

		Debtors Turnover
	1999	2000	2001	2002
Firm A	3.1	3.2	3.3	3.4
Firm B	3.3	3.2	3.3	3.2
Firm C	3.8	3.7	3.7	3.5
Firm D	3.6	3.5	3.3	3.2
Industry Average	3.5	3.4	3.4	3.3

• Common Size Analysis

This involves constructing a common size balance sheet by dividing each asset and liability item by total assets and then expressing the result as a percentage. It also involves constructing a common size income statement by simply dividing each income statement item by sales. The resultant percentage statements can be compared with statements of larger or smaller firms, or those of the same firm over time.

	Common-Size Balance Sheet - Year 2000
		$	%				$	%
Cash		9000000	18		Accounts payable		12000000	24
Accounts Receivable		1000000	2		Notes Payable		5000000	10
Inventory		20000000	40		Accrued Expenses		3000000	6
Marketable Securities		8000000	16		Bonds Payable		20000000	40
Prepaid Expenses		1000000	2		Preferred Stock		1000000	2
Plant and Equipment		11000000	22		Common Stock		1000000	2
		50000000	100		Share Premium		3000000	6
					Retained Earnings		5000000	10
							50000000	100
	Common-Size Income Statement - Year 2000
			$	%
Sales			10000000	100
Cost of Goods Sales			4000000	40
Selling & Admin. Expenses			800000	8
Depreciation Expense			2000000	20
Interest Expense			1350000	13.5
Taxes			740000	7.4
Preference Dividends			110000	1.1
Ordinary Dividends			400000	4
Retained Profit			600000	6
				100

 

Note - a combination of any two or all of the above types of analyses is the customary practice of good financial analysts. Another analysis could involve comparing the current performance of a company with budgets and goals set by the management.

 

• Limitations of Ratios

• Qualitative factors to be considered in evaluating a company

1. nAre the company’s revenues tied to 1 key customer?

2. To what extent are the company’s revenues tied to 1 key product?

3. nTo what extent does the company rely on a single supplier?

4. What percentage of the company’s business is generated overseas?

5. nCompetition

6. nFuture prospects

7. nLegal and regulatory environment

 

• Information about Financial Ratios

RIGHT CLICK BELOW AND CHOOSE "Save Target As..." (If using Internet Explorer) OR "Save Link As..."(If using Netscape) for the following Excel spreadsheet: (You will be prompted to save it to a destination of your choice)