Financial statement analysis

Balance sheet walk demonstrates financial statement analysis using the relationship of the key financial statements, the income statement, cash flow and
balance sheet.

We show the financial statement links

Most business people tend to look at each of the financial statements in turn. Our contribution is to show that all three key financial statements are linked.

The income statement shows the potential cash flows. The cash flow statement shows the real cash flows. The balance sheet shows the cash owing or
payable.

Income statement
The income statement (or profit and loss) shows revenue, cost of sales, expenses, interest and tax, but does not show the cash flow for a business.

Balance sheet
The balance sheet shows the assets and liabilities for the business. On the balance sheet we can see the cash balance at the start and end of the period.
However, the details of all the cash flows cannot be gleaned from the balance sheet.

Cash flow
The cash flow statement shows the cash flows for the business. Here we see the operating cash flows, financing cash flows and investing cash flows.

The income statement, cash flow and balance sheet above are not independent of each other. Financial statements links demonstrates how they work
together. This understanding helps with financial statement analysis.

Financial Statement Links

Where is the relationship between the key financial statements? Take a look at this example.

1. The income statement shows revenue of 500,000.

2. The cash flow statement shows the cash received from customers is 375,000.
3. The balance sheet shows under assets the difference, i.e. accounts receivables is 125,000.
 

 The key financial statement flow

All three financial statements are linked.

Income statement Cash Flow statement Balance sheet

500,000 375,000 125,000

Note: The income statement = cash flow statement + balance sheet. In the example above: 500,000 = 375,000 + 125,000

 
 Commentary on the financial statement links:
Income statement
Maximum cash flows:
Here is a key fact about the Income
statement- the accounts listed
represent the maximum cash flows  
possible for the business from the
sales and expenses incurred during the
period. (Taxes also play a part, but
lets keep it simple for now).
The Income statement shows the
sales, costs of sales and expenses
incurred during the period (for
example, during the last financial
year).
The Income statement and cash
flows
The cash flows are not revealed in the
income statement. The profit shown
on the Income statement is the book
profit earned, but the profit will
usually not have all been received in
cash. Some of the sales made will
have been paid for, but not all. Some
customers will owe you money. Also,
some of the expenses your firm has
incurred may not have been paid for
yet.
Tip: A cash flow analysis can be based on the balance sheet. Strategic Focus financial analysis softwareproduces this cash flow report automatically.
Balance sheet formats
Traditional vs Financial analysis balance sheet formats
Most financial statements reflect a balance sheet format consistent with the following formula:
  Cash Flow  
statement
The financial link:
The Income statement
shows the maximum cash
flows possible for the  
business. TheCash Flow
statementshows the actual
cash flows received and
paid by the business.
The Cash Flow statement
  shows the actual cash  
flows for the business.
The cash flows
   
The Cash Flow statement
shows the cash flows from
operations (cash received
from customers, cash paid
to suppliers and staff),
from financing activities
and investing activities
Balance sheet
The financial link:
The Income statement shows
the maximum cash flows
possible for the business. The
Cash Flow statement shows
the actual cash flows received
and paid by the business.
TheBalance sheet shows the
cash that was not collected or
the cash that is owing but not
yet paid.
The Balance sheet shows the
assets and liabilities of the
business. Usually this will be
stated for both the start and
end of the period (for
example, at the start and end
of the financial year).
The Balance sheet reveals
some cash flows
The balance sheet does show
some cash flow information.
For example, if the opening
accounts receivables (or
debtors) is 100,000 and the
closing accounts receivables
is 125,000, then the cash
flows from accounts
receivables could be:
Cash collected from opening
accounts receivable: 100,000
(assuming all customers
paid).
Cash not collected from sales
made during the period:
125,000.
Traditional balance sheet
EQUITY = (current assets - current liabilities) + (non-current assets - non-current liabilities).

The debt financing components of the traditional balance sheet are included in current liabilities and non-current liabilities.

Financial analysis balance sheet

Financial analysis demands a change in the balance sheet format by separating all funding components from operating components. The following balance
sheet format needs to be considered:

EQUITY + DEBT = (current assets - current liabilities) + non-current assets.

In essence all funding is removed from the operating side of the equation. The net working capital is redefined by removing the cash on hand and at the
bank and the bank overdraft from the right hand side of the equation. The same principal would apply to all forms of funding. This means that the end
result would give rise to the following balance sheet format:
DEBT + EQUITY = WORKING CAPITAL + NON CURRENT ASSETS.

TOTAL CAPITAL EMPLOYED = TOTAL NET OPERATING ASSETS.

FINANCE = OPERATIONS.

The Financial analysis balance sheet reveals clearer information than the traditional balance sheet

Working capital
Working capital on the balance sheet
A balance sheet contains funding and operating items. Funding items includes equity and debt. Operating components include working capital and non-
current assets

Working capital consists of Current Assets and Current Liabilities. These are defined below.

Current Assets
Accounts receivable

This is money owed to the organization by customers. It appears on the balance sheet under current assets.

How is Accounts receivable linked to the income statement:

The balance sheet amount for Accounts receivable is related to the sales amount in the income statement / profit and loss. It is the amount of sales that have
not yet been paid for. It relates to credit sales only. (Cash sales would appear on the balance sheet under Cash at bank).

Accounts receivable days

The money owed to the organization by customers is expressed in days.

Inventory

This is the stock of goods available for resale, valued at the lower of cost or net realizable value.

How is Inventory linked to the income statement:

The balance sheet amount for inventory is related to the cost of sales amount in the income statement / profit and loss.

Inventory Days

The stock of goods available for resale is expressed in days.

Other inventory

This is inventory of consumables.

Inventory WIP

The stock of work in process valued at the lower of cost or net realizable value is shown here.

WIP Days

This is the work in process amount expressed in days. The balance sheet amount is valued at the lower of cost or net realizable value and is related to
the cost of sales amount on the profit and loss.

Other current assets

Current assets that are not included above are entered here.

Current Liabilities
Accounts payable

This is money owed by the organization to suppliers of inventory and other variable cost of sales. Accounts payable appears on the balance sheet under
current liabilities.

How is Accounts payable linked to the income statement:

The balance sheet amount for Accounts payable is related to the cost of sales amount and expenses amount in the income statement / profit and loss. It is
the amount of goods and services that have not yet been paid for.

Accounts payable days

This is the Accounts Payable amount expressed in days.

Income tax liability

Provision for tax is a liability. It is tax payable arising from the current years operations but not yet paid.Provision for tax is not a funding provision
because it is closely linked to the trading cycle. It is entered as part of working capital on the operations side of the balance sheet as “income tax liability”.

Accruals and Accruals as % of Fixed exp

Accruals are current liabilities and relate to fixed expenses which were incurred but not paid for in the period shown. They can be expressed as a
percentage of fixed expenses.

Other current liabilities

This is used for current liabilities that are not included above.

Bank and Cash at bank

Traditionally working capital includes cash at bank and bank overdraft. Financial analysis demands a change in the format so that the funding components
of the organization are separated out.

Working capital management

For a  company to have working capital the current assets must exceed the current liabilities. Working capital management is managing the use of current
assets and current liabilities to make the most of the business's short-term liquidity. There is a direct correlation between business performance and working
capital management.

Business Performance
Understand Business Performance
Why is information from the income statement and balance sheet useful as a comparison performance measure?

As a performance measure for comparing company performance, it is useful to know how much profit is generated for each $100 of capital invested in the
balance sheet.

Example: There are two businesses producing similar products and services. They both make the same profit, $1m per annum. Business A has $3m
invested in the balance sheet (in working capital, fixed and other assets). Business B has $2m invested in the balance sheet. Which is the better business?

When businesses are similar, then the more efficient business is usually the one that has the smaller balance sheet.
For each $100 invested in the balance sheet, Business A produces $33 profit. Business B produces $50 profit.

If one were comparing this performance measure, then Business B is the better performer.

On the other hand, if the purchase price for Business A were cheaper, then A could be a good investment, as the new owners will know that they can get
the balance sheet in order to improve the financial outcome.

All companies and businesses should be on top of their financials. There are software tools like Strategic Focus to help with performance measures
e.g. NOPAT, business performance and detailed financial analysis and to suggest areas that need to be improved.

DuPont model
 The DuPont financial analysis model
The DuPont model separates finance from operations. It has three primary components:

Financial analysis using the DuPont model

 Profitability
 Activity
 ROCE - Return on capital employed.
 

The DuPont model financial components are discussed below.

   
Income Statement Balance sheet ROCE
Performance measure Performance measure Profitability x
is: Profitability
x is: Activity
= Activity

Commentary on the DuPont model financial components:

  ROCE - Return on capital

Profitability Activity
employed
Efficiency of the income Efficiency of the
statement balance sheet ROCE is a dynamic measurement which
integrates the activities of the profit and
   
loss and balance sheet in one calculation:
   

ROCE =PROFITABILITY x ACTIVITY 

PROFITABILITY % = ACTIVITY =
ROCE= (EBIT / SALES) x (SALES /
Earnings before interest and   SALES/TOTAL  
TNA) 
tax (EBIT) / SALES NET ASSETS
ROCE= EBIT / TNA

Profitability: This ROCE provides a measurement of the

measurement represents the
operating performance of a
business entity expressed as a
return on sales. It also
provides a measurement of
operational efficiency in the  
profit and loss account, void
of finance costs.
 
operational return on the investment in total
net assets (TNA). This is also the return on
Activity: This net assets (RONA) or the return on
measurement reflects investment (ROI) due to the equivalence
balance sheet concept derived from separating finance
efficiency in terms   from operations. ROCE would have to at
of the utilization of least equal the average weighted cost of
scarce resources. borrowing to avoid reverse leverage taking
place. This is the erosion of equity as a
result of too little EBIT being generated to
service the cost of borrowing.

Limitations of the DuPont model for financial analysis.

1. It is a short term measurement.

2. It is a before tax measurement.
3. Setting a target for a good ROCE is difficult.
 4. It does not link to the cost of capital.
5. It does not link to the time value of money.
6. It does not link to value.
 

Also see: Economic Value Added - EVA®.

Remember when doing your analysis that DuPont is a pre-tax performance analysis tool. It is beneficial to perform the analysis on both a pre-tax
and after-tax basis.  Strategic Focus  includes both

Economic Value Added

Economic Profit or Economic Value Added explained
Note: "Economic Value Added" (EVA®) is a registered trademark of Stern Stewart & Co.
One of the most useful performance measurements to account for the ways in which business value can be added or lost is Economic Value Added or EVA.
Another term for this metric is Economic Profit.

EVA subtracts the cost of capital from the net operating profits after tax (NOPAT) generated in the business. It is a measure of the residual income from
the income statement after accounting for the cost of the balance sheet.
Economic Value Added will increase if:

 New capital is invested and it earns more than the cost of capital.
 Capital is divested from the business if it does not cover the cost of capital.
 NOPAT increases without increasing the capital employed.
Economic Value Added is a performance measurement that links directly with the intrinsic value of the business.

The formula for EVA is:

 EVA=(r - c*) x Capital employed

 r = economic rate of return

 c* = cost of capital

Example:
Total capital employed = $2,000
c* = 10%
r = 12.5%
EVA = (12.5% - 10%) x 2,000
EVA= $50.00

Note that: 
r = economic rate of return on capital employed (also refrerred to as EcROCE%)

NOPAT / CAPITAL EMPLOYED= EcROCE%

EcROCE % = NOPAT % x Capital Turnover

 
Economic Value Added as a valuation methodology:

An overview
Many businesses have an objective to maximise shareholder wealth. While very few people would disagree that this is a good objective for any business,
how this objective should be achieved is much less certain.

Firstly, how will returns to shareholders be measured?

 Generally, returns are represented by returns to shareholders via dividends and increases in the value of the market price of their shares.

For many years, managers and shareholders have believed that growth in annual earnings per share and increases in return on equity were the best measures
for maximizing shareholder wealth. However, more recently there has been a growing awareness that these conventional accounting measures are not
reliably linked to increasing the value of the company’s shares. This occurs because earnings do not reflect changes in risk and inflation, nor do they take
account of the cost of additional capital invested to finance growth.

There are a number of other reasons why earnings fail to measure changes in the economic value of the business.

These are:

 Alternative accounting methods may be employed.

 Dividend policy is not considered.
 The time value of money is ignored.
The value of companies shares will only increase if management can earn a rate of return on new investments which is greater than the rate investors
expect to earn by investing in alternative, equally risky companies.

Since the concept of "maximizing shareholder wealth" was developed in the 1970’s, more and more enlightened managers are focusing on strategies which
maximise economic returns for shareholders, as measured by dividends plus the increase in the company’s share price.

One way of viewing the "shareholder value" approach is to value the business using Economic Value Added as a valuation methodology.

Market value added (MVA)

The market value of a business at a point in time is an approximation of the fair value of the business’s entire debt and equity capitalization . This can be
arrived at by taking the number of shares and multiplying by the share price and adding the book value of long and short term loans net of any cash
deposits.

Theoretically, market value at a point in time is equal to the total capital employed plus or minus the net present value of all future Economic Value
Addeds. Therefore, market value is maximized by maximizing the present value of future Economic Value Addeds.

Consequently, if we prepare a projection of annual Economic Value Added into the future and discount these projections to the present value, at the cost of
capital, we get an estimation of market value that management has added to or subtracted from the total capital employed in the business.

This present value of all future Economic Value Addeds is theoretically equal to market value added, MVA. Therefore the market value of a business is:
            Market value = MVA + capital employed.

Advantages of Market Value Added (MVA) / EVA as a performance measurement

 By forecasting Economic Value Added for each year it shows how much value will be added to the capital employed each year.
 It is the only method that can clearly connect capital budgeting and strategic investment decisions with a methodology for subsequent
evaluation of actual performance.
 By forecasting Economic Value Added amounts it automatically produces a series of targets for management to achieve in order to justify the
valuation.
 It can be readily communicated to and understood by operational management.
 Through the computation of Economic Value Added amounts Economic Value Added creates a meaningful performance measurement which
can be used to judge subsequent performance. (The cash flow performance of one business just cannot be compared with another).
 For a project to be favorably considered, market value added must be positive. On the other hand free cash flow may fluctuate from positive to
negative and back again over the life of the project.
 Economic Value Added focuses managements attention on the fundamental three ways to create value. These are:-
 Improve profits without making a further investment in additional capital.
 Only invest in projects where earnings exceed the cost of capital.
 Dis-invest from projects where the savings on the capital cost exceeds earnings foregone.
Discounting the benefits of these strategies in free cash flow terms makes them difficult to understand.

Because Economic Value Added is a powerful overall measurement of managements performance, it is an ideal method for setting corporate goals,
management incentives and the payment of performance bonuses.
 This cannot be achieved with cash flow. It links planning to performance.....and performance to value.

Conclusion

The creation of wealth can be achieved in the real world through the use of economic profit / economic value added as a performance measurement linking
strategy to value.

The managers of many well known international corporations have succeeded in substantially increasing the value of their business entities by using this
valuable tool.

The dynamics of using Economic Value Added and market value added have a very powerful application in every business entity, irrespective of size or
industry. The Economic Value Added methodology can be applied to create wealth for the owners of businesses from the size of the corner store to that of
the multi-national corporations. It is now up to us as business executives and advisers to assist owners with the implementation of business strategies which
are consistent with the principle of Economic Value Added. We are now able to use economic profit as a performance measurement which directly links
strategy to value and is therefore the key to wealth creation.

Strategic Focus  software helps business to assess the impact of new and existing strategies on the valuation of the business using Economic profit and Free
cash flow

NOPAT
Financial statement analysis using NOPAT
Profitability is the return on revenue before tax. NOPAT is the return on revenue after tax.

 NOPAT is an operating performance measure after taking account of taxation but before financing cost (i.e. interest is excluded).
 Compared to EBIT, NOPAT provides a more realistic performance measure of the actual cash yield generated from recurring business
activities.
 NOPAT is EBIT adjusted for the impact of taxation. The purpose of this is to arrive at taxation on operating income which is then deducted
from EBIT. Interest is totally excluded as the concept of separating finance from operations should be taken into account.
 The NOPAT % is the return on revenue.
  

The NOPAT equation is:

Revenue Less:expenses
Less: Operating tax
Gross
EBIT NOPAT
profit
Less: Cost of sales Plus: Other income Plus: Other income

i.e. Revenue - Cost of sales -> Gross profit - Expenses + Other income -> EBIT - Operating tax -> NOPAT

NOPAT $   Revenue   NOPAT %

Net operating profit after tax

(amount) / Total revenue on the income
statement = Net operating profit after
tax (%)

i.e NOPAT % = NOPAT $ / Revenue.

NOPAT is an after tax performance measure. EBIT is earnings before tax whereas NOPAT is earnings after tax. EBIT is the earnings amount used
in Dupont financial analysis.
Balance sheet analysis guide
Your quick and simple way to master financial statement analysis!

 You're just minutes away from the very best that financial analysis experts have to offer in this unique approach. 

Balance sheet analysis skills are easy to acquire with the

right information.
Pure step by step knowledge designed to enhance
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Increase revenue with informed decisions.

Here is an extract from the Balance Sheet Analysis Guide

Profitability
Profitability is a measurement of operational performance.

It is illustrated in the following diagram:

Profitability represents the operating performance of a business expressed as a return on sales after all costs have been covered except interest and tax.

The ratio for profitability is:

PROFITABILITY % = EBIT / REVENUE

EBIT is Earnings before interest and tax. A summarized form of the income statement is below, to show how to calculate EBIT. 
Note: You may be using another term for EBIT e.g. PBIT (Profit before Interest and Taxes).
From the profitability diagram above, it can be seen that this business has a profitability of 12.21%. For every $100.00 of revenue, the business makes a
profit of $12.21.

For any business the trend in profitability is important. If it goes down, then from the profitability diagram above it can be deduced that one or more of the
following may have occurred:

Revenue went down or expenses went up. 

The drivers of profitability are revenue (price and volume), cost of sales and expenses.

 
Drivers
“Drivers” – these are the key items that, if changed, will affect Profitability.

Knowing the drivers, you can implement strategies to improve Profitability:

Revenue may be able to be improved by selling more (sales volume increase) or increasing prices (sales price increase). The marketability potential of the
products or services of the business may need to be investigated to determine the potential revenue for the business. To improve profitability, the business
should improve revenue and try to get cost of sales and expenses down. To maximize profits management should allocate resources in the most efficient
way.

The Profitability measurement represents the operating performance of a business entity expressed as a return on sales. It provides a measure for comparing
how efficiently a business can create operating profits from sales
It also provides a measurement of operational efficiency in the profit and loss account, void of finance costs.

Profitability will vary across industries - it may be useful to obtain typical values for your industry so you can compare your results with others.

Not all the drivers of profitability are equally easy to implement

Example
Here is a table of each of the drivers or “Strategic actions” for profitability. To increase profitability from 12.21% to say 15%, calculate how much each
driver needs to be changed to achieve the desired profitability. These are shown below in order of the smallest change.
Notice that a price increase of only 3.28% is required to achieve the desired 15% profitability, whereas a sales volume increase (“more sales”) of 11.21% -
almost 4 times as much – is required to achieve the same target. The target can also be achieved by reducing costs of sales by about 5% or reducing
expenses by about 10%.

In practice, you may decide to implement a combination of the drivers to obtain the target. The drivers are useful in that they give you a starting point; they
are a list of actions that should be considered to improve performance.

The blue bars on the diagram above are a visual indicator as to how easy it is to implement each action – the longer the bar, the more difficult it is to
achieve. Every business will have a different set of numbers, and the order of ease to achieve will depend upon your own financials.

The above is the Profitability section of the "Balance Sheet Analysis Guide". The
 

full table of contents is shown below.

Balance Sheet Analysis Guide

 Table of Contents

Introduction to Balance sheet analysis

Balance sheet analysis

The balance sheet

The income statement is linked to the balance sheet

The cash flow statement is also used for financial analysis

Balance sheet format

Balance sheet format for financial analysis

Why do we separate finance from operations?

How is finance separated from operations?

  

Finance

Equity

Other finance
Debt

Balance sheet analysis

Profitability

EBIT

Drivers

Activity

Working capital analysis

Working capital:- AR (Accounts Receivable)/ Debtors days

What effect will a change in AR days have?

Working capital:- AP (Accounts Payable) / creditors days

What effect will a change in AP days have?

Working capital: - Inventory days

Examples>

ROCE - Return On Capital Employed

DuPont model

What is a good value for ROCE?

Other financial analysis based on ROCE

How to increase sales

Difference between a sales price change and a sales volume change

Goal seeking can be used to find strategies to improve ROCE.

Example

Strategies that can be considered to improve ROCE:

ROE – RETURN ON EQUITY

Debt to Equity mix

Cash flows

Operating Cash

FCF (Free cash flow)

Operating tax
 Net Cash flow

Cash flow statement

Marginal Cash

Sustainable growth

Dividends

Earnings per share

Cost of Capital

Cost of debt

Cost of equity

Conclusion

Balance sheet analysis guide comes complete with the knowledge you need to
…
1. Determine the financial strength and economic efficiency of a business.

2. Understand how short term management decisions effect long term value creation.

3. Understand the benefits of separating Funding and Operations on the Balance sheet.

4. Learn the role of DuPont model in financial analysis techniques.

5. Understand the role of ratios and cash flows in Balance sheet analysis.

6. See where how and why particular ratios are used.

7. See if the normal business operations are generating profits or incurring losses.

8. Learn how to determine efficiencies with ratios.

9. Discover how working capital management impacts on balance sheet performance.

10. See how the same techniques can be used to drive future strategic management decisions.

11. View the relationship of Operational cash, Free cash flow and Net cash.

12. Understand the effect of the Debt to Equity mix and leverage.

Opportunity cost explained

A dollar can be spent only once. So if you spend it on A it is no longer available to be spent on B
or C or D.
 

Opportunity cost - almost anything you decide to do has a cost

Option A Option B Option C Option D

Spend a Spend a Spend a Spend a

dollar on A. dollar on B. dollar on C. dollar on D.
You will get You will get You will get You will get
the benefits the benefits the benefits the benefits
that option A that option B that option C that option D
provides provides provides provides
(financial or (financial or (financial or (financial or
otherwise) otherwise) otherwise) otherwise)
 

Commentary on Opportunity cost

  Evaluate the  
Find the alternatives Decide
alternatives
Work out the
To make an benefits of
informed each
decision, list alternative. After completing
the alternatives The benefits the analysis, you
available for may be should be in a
consideration. financial or position to be able
There are non-financial. to make an
usually   These should   informed decision.
different be quantified Keep in mind that
methods so that a if you choose A,
available to reasonable the opportunity
accomplish a comparison cost is that you can
desired can be made of no longer choose B
outcome. the or C or D.
 
alternatives.
 

Alternatives   Evaluate   Decide:

If you are For a financial Several factors will

 goal, the return
is a key factor
in making the
decision. If
you invest in a
very high
return
investment,
usually the
influence your
risks will be
decision,including
higher. The
making an the financial return
opportunity
investment for and the possible
cost is clear -
a return, then erosion of the
one investment
there will capital invested
provides a high
usually be (due to the risk
return, but
several factors).
there is an
strategies that Of course,
associated big
can be sometimes the
risk. The
considered. benefits are non-
second
They will often financial (e.g.
investment
give different spend money on
pays a lower
returns (and schools or roads or
return, but also
have different hospitals). The
has a lower
risks). concept of
risk.
opportunity cost
Opportunity
still applies.
cost requires
you to weigh
up the benefits
of both. If you
choose one,
you loose the
opportunity to
invest in the
other.
 

Benefits and limitations of Opportunity cost analysis.

 There are few limitations - almost all decisions take into account an assessment of the opportunity cost, even if you do not do so consciously.
 Decision making can be improved by a rigorous assessment of the opportunity costs of any decisions.
 It re-enforces the concept of alternatives - most decisions will benefit by an opportunity cost analysis.
Opportunity costs analysis is recommended for informed decision making.