Application of

financial statement
analysis
Group-3
 Contents

01 02 03
Evaluation of Financial Forecasting of Earnings Assessment of Credit
Performance and Position and Cash flows Risk

04

Quality of Financial
Statements
Evaluation of Financial performance and position

● The overall performance and position of the company can be evaluated on a set
of criteria that includes profitability,liquidity, solvency, financial efficiency and
repayment capacity

● Each of these criteria measures a different aspect of financial performance and

position.
1. Liquidity Ratio:
Current ratio, Quick ratio, cash ratio

2. Solvency Ratio:
debt-equity ratio,total debt ratio, interest coverage ratio,debt-to-asset ratio

3. Profitability ratio:
Gross Profit Margin,Operating Profit Margin,Net Profit Margin,
Return on Assets (ROA),Return on Equity (ROE),Earnings Per Share (EPS)
4.Financial Efficiency Ratio:

● Asset Turnover Ratio

● Inventory Turnover Ratio
● Accounts Receivable Turnover Ratio
● Fixed Asset Turnover Ratio

5. Trend Analysis:
● Identify trends in Revenue, expenses, profits and cash flows over the
Years
 Forecasting of Earnings and Cash flows

● Forecasting Income Statement

● Forecasting Balance Sheet

● Forecasting Cash Flow Statement

 Forecasting Income Statement
Key steps to forecast the income statement:

1. Gather Historical Data

● Collect at least 2-3 years of historical income statement data to establish trends.
● Analyze any issues with the historical data, such as revenue segmentation or line
item classification.
2. Forecast Revenues
● Analyze historical revenue growth trends and make adjustments based on expected
changes in the business.
● Use either an aggregate growth rate approach or a more detailed price x volume
segment-level forecast.
3. Forecast Cost of Goods Sold (COGS)

● Tie COGS to the revenue forecast, using historical COGS margins as a guide.

4. Forecast Operating Expenses

● Forecast operating expenses like S&M, R&D and G&A as a percentage of revenue or
based on historical trends.

5. Forecast Depreciation and Amortization

● Use the straight-line method to forecast depreciation based on existing assets and
expected future capital expenditures.

6. Forecast Interest Expense and Income

● Tie interest expense to debt levels and interest rates, and interest income to cash
balances.
7. Forecast Taxes

● Typically straight-line the last historical year's effective tax rate.

8. Forecast Shares Outstanding and EPS

● Project shares outstanding and calculate earnings per share.

By following these steps to forecast the key income statement line items, you can
create an accurate income statement projection to integrate with the balance sheet
and cash flow forecasts
Ratios for Forecasting the Income Statement
1. Sales Growth Rate:
○ Used to project future revenue based on historical growth rates.
○ Formula: Sales Growth Rate=(Current Period Sales−Previous Period) /Previous Period
2. Gross Margin:
○ Used to estimate future gross profit.
○ Formula: Gross Margin=Gross Profit Sales Gross Margin/Sales Gross Profit
3. Operating Margin:
○ Helps forecast operating income.
○ Formula: Operating Margin=Operating IncomeSalesOperating Margin/SalesOperating
Income
4. Net Profit Margin:

○ Used to predict net income.

○ Formula: Net Profit Margin=Net Income Sales Net Profit Margin/Sales Net Income

5. EBITDA Margin:

○ Useful for estimating EBITDA (Earnings before Interest, Taxes, Depreciation, and
Amortization).
○ Formula: EBITDA Margin=EBITDA Sales EBITDA Margin/Sales EBITDA

6. Tax Rate:

○ Applied to forecast the tax expense.

○ Formula: Tax Rate=Tax Expense Pre-tax Income Tax Rate/Pre-tax IncomeTax Expense
 Forecasting balance sheet
1. Categorize Balance Sheet Items

First, categorize all items on the balance sheet into assets, liabilities, and equity.

Assets:

● Current Assets: Cash, accounts receivable, inventory, prepaid expenses, etc.

● Non-Current Assets: Property, plant, and equipment (PPE), intangible assets, long-term
investments, etc.

Liabilities:

● Current Liabilities: Accounts payable, short-term debt, accrued liabilities, etc.

● Non-Current Liabilities: Long-term debt, deferred tax liabilities, etc.

Equity:

● Common stock, retained earnings, additional paid-in capital, etc.

2. Include Balance Sheet Changes in the Relevant Cash Flow Category

Changes in balance sheet items need to be reflected in the cash flow statement to ensure that the cash
balance reconciles. Categorize these changes into operating, investing, or financing activities.

Operating Activities:

● Changes in working capital (e.g., accounts receivable, inventory, accounts payable).

Investing Activities:

● Purchases and sales of PPE, acquisitions of intangibles, etc.

Financing Activities:

● Issuance or repurchase of stock, issuance or repayment of debt, dividends paid, etc.

3. Perform BASE Analysis

BASE analysis is crucial for items that belong to more than one category, like PPE and intangible assets.

BASE Analysis Steps:

● Beginning balance
● Additions (e.g., purchases, new intangibles)
● Subtractions (e.g., depreciation, disposals)
● Ending balance

For example, for PPE:

● Beginning PPE balance

○ Additions (new equipment purchased
○ Subtractions (depreciation, disposals)
○ Ending PPE balance
4. Reconcile Net Cash Flow to the Balance Sheet Cash Balance

Ensure the net change in cash flow from the cash flow statement reconciles with the change in the
cash balance on the balance sheet. This involves:

● Starting with the beginning cash balance

● Adding/subtracting the net cash flow from the cash flow statement
● Ensuring the result matches the ending cash balance on the balance sheet
Ratios to Forecasting the Balance Sheet
1. Days Sales Outstanding (DSO):
○ Used to forecast accounts receivable.
○ Formula: DSO=(Accounts Receivable/Sales)×365
2. Inventory Turnover:
○ Helps project future inventory levels.
○ Formula: Inventory Turnover=Cost of Goods Sold/Average Inventory
3. Days Payable Outstanding (DPO):
○ Used to estimate accounts payable.
○ Formula: DPO=(Accounts Payable/Cost of Goods Sold)×365
4. Current Ratio:

○ Used to evaluate liquidity and forecast current assets and liabilities.

○ Formula: Current Ratio=Current Assets/Current Liabilities

5. Debt-to-Equity Ratio:

○ Helps in predicting the financing structure.

○ Formula: Debt-to-Equity Ratio=Total Debt/Total Equity

6. Capital Expenditure (CapEx) Ratio:

○ Used to forecast future investments in PPE.

○ Formula: CapEx Ratio=Capital Expenditures/Sales
 Forecasting Cash Flow Statement
Key Steps

1. Start with Net Income: Use the net income forecasted from the income
statement as the starting point for the cash flow statement.
2. Adjust for Non-Cash Items: Add back non-cash expenses such as
depreciation and amortization to net income since these do not affect cash.
3. Adjust for Changes in Working Capital: Analyze changes in working capital
items (accounts receivable, inventory, accounts payable, etc.). Increases in
current assets (like receivables or inventory) are cash outflows, while
increases in current liabilities (like payables) are cash inflows.
4. Forecast Cash Flows from Operating Activities: Combine net income, non-cash
adjustments, and changes in working capital to determine the net cash provided by
operating activities.

5. Forecast Cash Flows from Investing Activities: Include cash flows from capital
expenditures, purchases of investments, and proceeds from the sale of assets or
investments. Subtract capital expenditures and add any cash inflows from sales of assets.

6. Forecast Cash Flows from Financing Activities: Incorporate cash flows from borrowing,
repaying debt, issuing equity, or repurchasing shares. Include dividends paid and any
other financing-related cash movements.
7. Calculate Net Cash Flow: Sum the cash flows from operating, investing, and
financing activities to determine the net change in cash for the period.

8. Reconcile to Cash Balance: Add the net cash flow to the beginning cash balance to
arrive at the ending cash balance, ensuring consistency with the balance sheet.

By following these steps, you can accurately forecast the cash flow statement,
providing insight into the company's liquidity and cash management over the
forecast period.
Ratios to Forecasting the Cash Flow Statement
1. Operating Cash Flow (OCF) Margin:
○ Helps forecast cash generated from operations.
○ Formula: OCF Margin=Operating Cash Flow/Sales
2. Free Cash Flow (FCF) Margin:
○ Used to estimate the cash flow available after capital expenditures.
○ Formula: FCF Margin=Free Cash Flow/Sales
3. Cash Conversion Cycle (CCC):
○ Used to forecast the time required to convert inventory and receivables into cash.
○ Formula: CCC=DSO+Inventory Days−DPO
4. Interest Coverage Ratio:

○ Helps in forecasting the ability to pay interest on outstanding debt.

○ Formula: Interest Coverage Ratio=EBIT/Interest Expense

5. Dividend Payout Ratio:

○ Used to forecast dividends paid.

○ Formula: Dividend Payout Ratio=Dividends Paid/Net Income

6. Working Capital Turnover:

○ Helps in predicting the efficiency of using working capital.

○ Formula: Working Capital Turnover=Sales/Average Working Capital
 3. Assessment of Credit Risk
● Evaluate a company’s ability to meet financial obligations and avoid
default
● Various financial ratios and metrics derived from the company's financial
statements
● Helps in credit decisions, investment evaluations, and risk management
● Essential for lenders, investors, and stakeholders to make informed
decisions
Key Metrics and Ratios for Credit Risk Assessment
❖ Liquidity Ratios
● Current Ratio
-Formula: Current Assets/Current Liabilities
-Indicates ability to cover short-term obligations
-A current ratio greater than 1 indicates a good liquidity position
● Quick Ratio
-Formula: Current Assets-Inventory/Current Liabilities
-measures the ability of a company to meet its short-term obligations with
its most liquid assets
Key Metrics and Ratios for Credit Risk Assessment
❖ Solvency Ratios
● Debt-to-Equity Ratio
-Formula: Total Debt/Shareholders’ Equity
-Measures the extent of company financing through debt versus equity
● Interest Coverage Ratio
-Formula: EBIT/Interest Expenses
-measures a company's ability to meet its interest obligations
-A higher ratio suggests better capability to cover interest payments
Key Metrics and Ratios for Credit Risk Assessment
❖ Cash Flow Analysis
● Operating Cash Flow
-Indicates cash generated from core business operations
-Positive cash flow suggests sufficient funds to cover debt repayments
● Free Cash Flow
-Formula: Operating Cash Flow-Capital Expenditure
-Measures available cash after investments for debt repayment and growth
Key Metrics and Ratios for Credit Risk Assessment
❖ Profitability Ratios
● Return on Assets (ROA)
-Formula: Net Income/Total Assets
-Indicates efficient use of assets to generate profits
● Return on Equity (ROE)
-Formula: Net Income/Shareholders’ Equity
-measures profitability relative to shareholders' equity
Key Metrics and Ratios for Credit Risk Assessment
❖ Altman Z-Score
-predicts bankruptcy risk using multiple financial ratios
-includes working capital, retained earnings, EBIT, market value of equity,
and sales to total assets
-Z-Score above 2.99 indicates a low risk of bankruptcy
 Example: Tesla, Inc.

● A current ratio of 1.7x indicates a solid ● The latest quick ratio of 1.0x
liquidity position, with sufficient indicates that Tesla has exactly
current assets to cover current enough liquid assets to cover its
liabilities current liabilities
● High current/quick ratios and
lower debt-to-equity ratio
indicate significant
improvement.
● Slight debt increase in 2023
needs attention despite positive
trends.
● Current, quick, and cash ratios
have decreased slightly over
the past three years.
● Tesla's strong asset conversion
capabilities make the liquidity
decline less concerning in the
short term.
● Profitability trending positive:
strong gross margin, operating
margin, and positive EBITDA.
● Recent dip in gross margin and
EBITDA, but net profit remains
stable, suggesting good cost
control.
● Overall, significant profitability
improvement and strong cash
flow generation.
● Recent fluctuations in profitability
metrics require monitoring.
 Example: Tesla, Inc.

● improvement with a ROA of 13.9%, ● improvement with an ROE of 24.3%,

indicates robust profitability and reflecting robust profitability and
excellent asset utilization excellent equity utilization
 Quality of Financial Statements
1. Accuracy and Consistency:
- Verify that the financial statements are accurate and consistent
over time.
- Consistent application of accounting policies and principles
ensures reliability and comparability of financial data.

2. Compliance with Standards:

- Ensure the financial statements comply with relevant
accounting standards (e.g., GAAP, IFRS).
 Quality of Financial Statements
3. Transparency and Disclosure:

- High-quality financial statements provide clear and

comprehensive notes and explanations

4. Audit and Assurance:

- Check if the financial statements have been audited by an

independent and reputable auditor.
 Quality of Financial Statements
5. Analytical Ratios and Metrics:

- Evaluate financial ratios and metrics (e.g., liquidity ratios,

profitability ratios, leverage ratios).
 Quiz
1. What ratio would you use to assess a company's short-term liquidity?
● a) Debt-to-equity ratio
● b) Current ratio
● c) Profit margin
● d) Return on assets
2. How do you forecast revenue for future periods?
● a) Based on historical growth rates and market analysis
● b) By estimating future expenses
● c) By projecting current liabilities
● d) Using last year's profit margin
1. Which tool helps decompose Return on Equity into profit margin, asset turnover, and financial leverage?
● a) DuPont Analysis
● b) Common Size Statements
● c) Altman Z-Score
● d) Trend Analysis
2. What is a key indicator of financial statement quality?
● a) Revenue growth
● b) Auditor's report
● c) Inventory turnover
● d) Debt repayment schedule
3. What does a high interest coverage ratio indicate?
● a) Poor ability to pay interest
● b) Strong ability to pay interest
● c) High levels of debt
● d) Low levels of equity
 QUIZ LINK

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Thank You