CHAPTER 2

FINANCIAL STATEMENT ANALYSIS

Suggested Reading(s)
Ehrhardt, M.C. Brigham, E. F. (2020), Financial Management: Theory and Practice,
16th Ed., South-Western Cengage Learning.
Introduction
◼ Financial analysis is a process of selecting, evaluating, and interpreting
financial data, along with other pertinent information, in order to
formulate an assessment of a company’s present and future financial
condition and performance.

◼ Refers to an assessment of the viability, stability, and profitability of a

business, sub-business, or project.

◼ Also known as analysis and interpretation of financial statements.

Need for FSA
◼ Used to identify the trends and relationships between financial statement
items.

◼ Both internal management and external users (such as analysts, creditors,

and investors) of the financial statements need to evaluate a company's
profitability, Efficiency, liquidity, and solvency.

◼ The nature of the analysis depends upon their [users] purpose or

requirement. Users make the necessary analysis and take the decision,
based on their assessment of the results obtained.
Cont’d…
External Uses of Financial Statement Analysis:

▪ Trade Creditors - Focus on the liquidity of the firm.

▪ Bondholders - the long-term cash flow of the firm.

▪ Shareholders - the profitability and long-term health.

Internal Uses of Financial Statement Analysis:

▪ Plan - Focus on assessing the current financial position and evaluating potential firm
opportunities.

▪ Control - Focus on return on investment for various assets and asset efficiency.

▪ Understand - Focus on understanding how suppliers of funds analyze the firm

Sources of Financial Statement Analysis

▪ Annual reports of a company usually contain:

1.Financial statements.
2.Notes to the financial statements.
3.A summary of accounting methods used.
4.Management discussion & analysis of the financial statements.
5.An auditor’s report.
6.Comparative financial data.
▪All these documents can be the source of financial statement analysis.
Financial reports
▪ Income statement- Provides a financial summary of the firm’s operating
results during a specified period.
▪ Statement of Financial Position-Summary statement of the firm’s
financial position at a given point in time.
– current assets-Short-term assets, expected to be converted into cash within 1 year or less.
– current liabilities- Short-term liabilities, expected to be paid within 1 year or less
– long-term debt- Debt for which payment is not due in the current year.
– Paid-in capital in excess of par- The amount of proceeds in excess of the par value received from
the original sale of common stock.
– retained earnings- The cumulative total of all earnings, net of dividends, that have been retained
and reinvested in the firm since its inception.
– statement of stockholders’ equity-Shows all equity account transactions that occurred during a
given year.
Cont’d…
▪ Statement of retained earnings-Reconciles the net income earned
during a given year, and any cash dividends paid, with the change in
retained earnings between the start and the end of that year. An
abbreviated form of the statement of stockholders’ equity.
▪ Statement of cash flows- Provides a summary of the firm’s operating,
investment, and financing cash flows and reconciles them with changes in
its cash and marketable securities during the period.
▪ Notes to the financial statements-Explanatory notes keyed to
relevant accounts in the statements; they provide detailed information on
the accounting policies, procedures, calculations, and transactions
underlying entries in the financial statements.
Basic Financial statement analysis
Need for Comparative Analysis
▪ Every item reported in a financial statement has significance.
▪ Various analytical techniques are used to evaluate the significance of
financial statement data.

Characteristics Comparison Tools of Analysis

Bases
• Liquidity • Intracompany • Horizontal
• Profitability • Industry • Vertical
• Solvency averages • Ratio
• Intercompany
Horizontal Analysis
▪ Horizontal analysis also called trend analysis is a technique for
evaluating a series of financial statement data over a period of time.
▪ Purpose is to determine the increase or decrease that has taken place.
▪ Commonly applied to the statement of financial position, income
statement, and retained earnings statement.
Statement of Financial Position (1 of 3)
Quality Department Store
Condensed Statements of Financial Position
December 31
Increase or (Decrease)
during 2020

2020 2019 Amount Percent

Assets
Intangible assets € 15,000 € 17,500 € (2,500) (14.3%)
Plant assets (net) 800,000 632,500 167,500 26.5%
Current Assets 1,020,000 945,000 75,000 7.9%

Total assets €1,835,000 €1,595,000 € 240,000 15.0%

Statement of Financial Position (2 of 3)
Quality Department Store
Condensed Statements of Financial Position
December 31
Increase or (Decrease)
during 2020
2020 2019 Amount Percent

Equity
Share capital—ordinary, €1 par € 275,400 € 270,000 € 5,400 2.0%
Retained earnings 727,600 525,000 202,600 38.6%
Total equity 1,003,000 795,000 208,000 26.2%

Liabilities
Non-current liabilities € 487,500 € 497,000 € (9,500) (1.9%)
Current liabilities 344,500 303,000 41,500 13.7%
Total liabilities 832,000 800,000 32,000 4.0%
Total equity and liabilities €1,835,000 €1,595,000 € 240,000 15.0%
Statement of Financial Position (3 of 3)
▪ In the assets section, plant assets (net) increased €167,500, or 26.5%.
▪ In the equity section, retained earnings increased €202,600, or 38.6%.
▪ In the liabilities section, current liabilities increased €41,500, or 13.7%.

Changes suggest that the company expanded its asset base during 2020
and financed this expansion primarily by retaining income rather
than assuming additional long-term debt.
 Quality Department Store
Condensed Income Statements

Income Statement For the Years Ended December 31

Increase or (Decrease) during
2020 Overall, gross
profit and net
2020 2019 Amount Percent income were up
Sales revenue € 2,195,000 € 1,960,000 € 235,000 12.0% substantially.
Gross profit
Sales returns and allowances 98,000 123,000 (25,000) (20.3%)
increased
Net sales 2,097,000 1,837,000 260,000 14.2% 17.1%, and net
Cost of goods sold 1,281,000 1,140,000 141,000 12.4% income, 26.5%.
Quality’s profit
Gross profit 816,000 697,000 119,000 17.1%
trend appears
Selling expenses 253,000 211,500 41,500 19.6% favorable.
Administrative expenses 104,000 108,500 (4,500) (4.1%)

Total operating expenses 357,000 320,000 37,000 11.6%

Income from operations 459,000 377,000 82,000 21.8%

Other income and expense

Interest and dividends 9,000 11,000 (2,000) (18.2%)

Interest expense 36,000 40,500 (4,500) (11.1%)

Income before income taxes 432,000 347,500 84,500 24.3%

Income tax expense 168,200 139,000 29,200 21.0%

Net income € 263,800 € 208,500 € 55,300 26.5%

Retained Earnings Statement
Quality Department Store
Retained Earnings Statements
For the Years Ended December 31
Increase or (Decrease) during
2020
2020 2019 Amount Percent

Retained earnings, Jan. 1 € 525,000 € 376,500 € 148,500 39.4%

Add: Net income 263,800 208,500 55,300 26.5%
788,800 585,000 203,800
Deduct Dividends 61,200 60,000 1,200 2.0%
Retained Earnings, Dec. 31 € 727,600 €,525,000 € 202,600 38.6%

In the horizontal analysis of the statement of financial position the 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
▪ Vertical analysis, also called common-size analysis, is a technique
that expresses each financial statement item as a percent of a base
amount.

• On an income statement, we might say that selling expenses are 16%

of net sales.
• On a statement of financial position, we might say that current assets are
22% of total assets.
• Vertical analysis is commonly applied to the statement of financial
position and the income statement.
Statement of Financial Position (1 of 3)
Quality Department Store
Condensed Statements of Financial Position
December 31
2020 2019
Amount Percent Amount Percent

Assets
Intangible assets € 15,000 0.8% € 17,500 1.1%

Plant assets (net) 800,000 43.6% 632,500 39.7%

Current Assets 1,020,000 55.6% 945,000 59.2%

Total assets €1,835,000 100.0% €1,595,000 100.0%

Statement of Financial Position (2 of 3)
Quality Department Store
Condensed Statements of Financial Position
December 31
2020 2020
Amount Percent Amount Percent

Equity
Share capital—ordinary, €1 par € 275,400 15.0% € 270,000 16.9%
Retained earnings 727,600 39.7% 525,000 32.9%
Total equity 1,003,000 54.7% 795,000 49.8%

Liabilities
Non-current liabilities € 487,500 26.5% € 497,000 31.2%
Current liabilities 344,500 18.8% 303,000 19.0%
Total liabilities 832,000 45.3% 800,000 50.2%
Total equity and liabilities €1,835,000 100.0% €1,595,000 100.0%
Statement of Financial Position (3 of 3)
▪ In the assets section, current assets decreased from 59.2% of total assets
in 2019 to 55.6% in 2020.
▪ Plant assets (net) increased from 39.7% to 43.6% of total assets.
▪ Retained earnings increased from 32.9% to 39.7% of total equity and
liabilities.
▪ These results reinforce the earlier observations that Quality is
choosing to finance its growth through retention of earnings
rather than through issuing additional debt.
 Quality Department Store

Income Statement Condensed Income Statements

For the Years Ended December 31
2020 2019
Amount Percent Amount Percent Quality
€ 2,195,000 104.7% € 1,960,000 106.7%
Department
Sales revenue
Store appears
Sales returns and allowances 98,000 4.7% 123,000 6.7%
to be a
Net sales 2,097,000 100.0% 1,837,000 100.0% profitable
Cost of goods sold 1,281,000 61.1% 1,140,000 62.1% business that
Gross profit 816,000 38.9% 697,000 37.9% is becoming
even more
Selling expenses 253,000 12.0% 211,500 11.5%
successful.
Administrative expenses 104,000 5.0% 108,500 5.9%

Total operating expenses 357,000 17.0% 320,000 17.4%

Income from operations 459,000 21.9% 377,000 20.5%

Other income and expense

Interest and dividends 9,000 0.4% 11,000 0.6%

Interest expense 36,000 1.7% 40,500 2.2%

Income before income taxes 432,000 20.6% 347,500 18.9%

Income tax expense 168,200 8.0% 139,000 7.5%

Net income € 263,800 12.6% € 208,500 11.4%

Income Statement
Condensed Income Statements
For the Year Ended December 31, 2020
(in thousands)
Quality Department Park Street
Store
Amount Percent Amount Percent Enables a
comparison of
Net sales € 2,097 100.0% €17,556,000 100.0%
companies of
Cost of goods sold 1,281 61.1% 10,646,000 60.6% different sizes.
Gross profit 816 38.9% 6,910,000 39.4%
Selling and administrative 357 17.0% 6,247,000 35.6%
expenses
Income from operations 459 21.9% 663,000 3.8%
Other income and expense
(including income taxes) 195 9.3% 412,000 2.4%
Net income € 264 12.6% € 251,000 1.4%
Ratio Analysis
▪ Ratio analysis expresses the relationship among selected items of
financial statement data.

Liquidity Ratios Profitability Ratios Solvency Ratios

Measure short-term Measure the Measure the ability
ability of the income or of the company to
company to pay its operating success survive over a long
maturing obligations
and to meet of a company for a period of time.
unexpected needs for given period of
cash. time.
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 liquidity.
▪ Ratios include the current ratio, the acid-test ratio, accounts receivable
turnover, and inventory turnover.
Current Ratio

Current Current Assets

=
Ratio Current Liabilities

Quality Department Store

2020 2019
€1,020,000 €945,000
= 2.96:1 = 3.12:1
€344,500 €303,000

Industry average Park Street

1.70:1 2.05:1

The 2020 ratio of 2.96:1 means that for every euro of current liabilities, Quality has
€2.96 of current assets.
Acid-Test Ratio (1 of 2)
Quality Department Store
Statement of Financial Position (partial)
2020 2019
Current assets
Prepaid expenses €50,000 €40,000
Inventory 620,000 500,000
Accounts receivable (net*) 230,000 180,000

Short-term investments 20,000 70,000

Cash 100,000 155,000
Total current assets €1,020,000 €945,000

*Allowance for doubtful accounts is €10,000 at the end of each year

Acid-Test Ratio (2 of 2)

▪ The acid-test ratio measures immediate liquidity.

Cash + Short-Term Investments +

Acid-Test Ratio = Receivables (net)
Current Liabilities

Quality Department Store

2020 2019
€100,000 + €20,000 + €155,000 + €70,000 +
€230,000 = 1.02:1 €180,000 = 1.34:1
€344,500 €303,000

Industry average Park Street

0.70:1 1.05:1
Accounts Receivable Turnover (1 of 2)
▪ Measures the number of times, on average, the company collects
receivables during the period.
Accounts Receivable Net Credit Sales
=
Turnover Average Net Accounts Receivable

Quality Department Store

2020 2019

€2,097,000 €1,837,000
€180,000 + = 10.2 times €200,000 + = 9.7 times
€230,000 €180,000
2 2

Industry average Park Street

46.4 times 37.2 times
Accounts Receivable Turnover (2 of 2)

€2,097,000 Accounts Receivable

Turnover
€180,000 + €230,000 ÷ = 10.2 times
2
A variant of the Accounts Receivable Turnover ratio is to convert it to an average
collection period in terms of days.

365 days ÷ 10.2 times = 35.78 days

Receivables are collected, on average, every 36 days.
Inventory Turnover (1 of 2)

▪ Measures the number of times, on average, inventory is sold during the

period.

Cost of Goods Sold

Inventory Turnover =
Average Inventory

Quality Department Store

2020 2019
€1,281,000 €1,140,000
€500,000 + = 2.3 times €450,000 + = 2.4 times
€620,000 €500,000
2 2

Industry average Park Street

4.3 times 3.1 times
Inventory Turnover (2 of 2)

€1,281,000 Inventory Turnover

€500,000 + €620,000 ÷ = 2.3 times
2

A variant of the Inventory Turnover ratio is the Days in Inventory.

365 days ÷ 2.3 times = every 159 days

Inventory turnover ratios vary considerable among industries.
 Profitability Ratios
▪ Measure the income or operating success of a company for a given period
of time.
▪ Income, or the lack of it, affects the company’s ability to obtain debt and
equity financing, liquidity position, and the ability to grow.
▪ Ratios include the profit margin, asset turnover, return on assets, return
on ordinary shareholders’ equity, earnings per share, price-earnings, and
payout ratio.
Profit Margin

▪ Measures the percentage of each dollar of sales that results in net

income.
Net Income
Profit Margin =
Net Sales

Quality Department Store

2020 2019
€263,800 €208,500
= 12.6% = 11.4%
€2,097,000 €1,837,000

Industry average Park Street

8.0% 1.4%
Asset Turnover
▪ Measures how efficiently a company uses its assets to generate
sales.
Net Sales
Asset Turnover =
Average Assets

Quality Department Store

2020 2019
€2,097,000 €1,837,000
€1,595,000 + = 1.2 times €1,446,000 + = 1.2 times
€1,835,000 €1,595,000
2 2

Industry average Park Street

1.4 times 1.4 times
Return on Assets

An overall measure of profitability.

Net Income
Return on Assets =
Average Assets

Quality Department Store

2020 2019
€263,800 €208,500
€1,595,000 + = 15.4% €1,446,000 + = 13.7%
€1,835,000 €1,595,000
2 2

Industry average Park Street

8.9% 2.4%
Return on Ordinary Shareholders’ Equity

Net Income − Preference Dividends

Return on Ordinary
= Average Ordinary Shareholders’
Shareholders’ Equity
Equity
Quality Department Store
2020 2019
€263,800 − €0 €208,500 − €0
€795,000 + = 29.3% €667,000 + €795,000 = 28.5%
€1,003,000 2
2

Industry average Park Street

18.3% 6.4%

Shows how many euros of net income the company earned for each euro invested by the
owners.
Earnings per Share (EPS)

Net Income − Preference Dividends

Earnings per Share = Weighted-Average Ordinary Shares
Outstanding
Quality Department Store
2020 2019
€263,800 − €0 €208,500 − €0
270,000 + 275,400 = €0.97 270,000 = €0.77
2

A measure of the net income earned on each ordinary share.

Price-Earnings Ratio

Price-Earnings Ratio = Market Price per Share

Earnings per Share

Quality Department Store

2020 2019
€12.00 €8.00
= 12.4 times = 10.4 times
€0.97 €0.77

Industry average Park Street

21.3 times 17.2 times

Reflects investors’ assessments of a company’s future

earnings.
Payout Ratio

Cash Dividends Declared on Ordinary

Payout Ratio = Shares
Net Income
Quality Department Store
2020 2019
€61,200 €60,000
= 23.2% = 28.8%
€263,800 €208,500

Industry average Park Street

16.1% 63.0%

Measures the percentage of earnings distributed in the form of

cash dividends.
Solvency Ratios
Solvency ratios measure the ability of a company to survive over a long
period of time.

▪ Debt to Total Assets and

▪ Times Interest Earned

are two ratios that provide information about debt-paying ability.

Debt to Assets Ratio

Debt to Assets Total Liabilities

=
Ratio
Total Assets

Quality Department Store

2020 2019
€832,000 €800,000
= 45.3% = 50.2%
€1,835,000 €1,595,000

Industry average Park Street

34.2% 62.0%

Measures the percentage of the total assets that creditors

provide.
Times Interest Earned

Net Income + Interest Expense + Income Tax

Times Interest Expense
=
Earned
Interest Expense
Quality Department Store
2020 2019
€263,800 + €36,000 + €208,500 + €40,500 +
€168,200 13 €139,000 9.6
= =
times times
€36,000 €40,500

Industry average Park Street

16.1 times 2.9 times

Provides an indication of the company’s ability to meet

interest payments as they come due.
Summary of Ratios (1 of 3)
Summary of Ratios (2 of 3)
Summary of Ratios (3 of 3)
Limitations of ratio analysis

▪ No underlying theory to identify correct ratios to use or appropriate

benchmarks.
▪ Benchmarking is difficult for diversified firms.
▪ Firms may use different accounting procedures.
▪ Firms may have different recording periods.
▪ One-off events can severely affect financial performance.
Chapter End