5.5 Financial Statement Analysis

FINANCIAL STATEMENT
ANALYSIS
The Starting Point of an Investment Valuation
Topics
• Trend Analysis
• Common Size Analysis
• Financial Ratio Analysis
• Points to Note on:
– Ratio Analysis
– Financial Statements
– SME’s and Corporations
– Window Dressing
• Financial Warnings
• Practical Applications
• Homework
Source: Substantively from IFC Bank Training Center and MIT

Sloan School of Management Course #15.515 & #15.535.
2
Purpose of Financial Statement Analysis
• To be able to answer following questions:

– Does the enterprise perform well or not?
– Is the enterprise profitable?
– Does the enterprise operate efficiently?
– Will the enterprise be able to carry out its business plan?
– Will the enterprise be able to meet its future commitments?
• Using:
– Trend analysis
– Common size analysis
– Financial ratio analysis
– Capital structure / working capital analysis
– Cash flow analysis

3
Trend Analysis
• Called Horizontal analysis

• Very useful when combined with other analysis methods
• A process to study the volatility trend of items in financial
statements over a number of consecutive periods
 Profitability:  Debt raising/ debt coverage
- Gross profit capabilities:
- Net profit - Equity
- Profitability ratios - Short term/long term loan
 Productivity: - Fixed assets
- Revenue - Debt service ratios
- Receivables  Liquidity:
- Payables - Working capital
- Raw materials/Inventory - Cash
- Performance ratios - Payables
- Liquidity ratios
4
Common Size Analysis
• Also called Vertical analysis

• Is an effective method for comparing the performance of an enterprise over a
number of years in combination with horizontal analysis and ratios analysis
methods
• Provides information on economic characteristics of different industries and
different enterprises in one industry
• Each item is presented in the form of percentage of the total assets (Balance
Sheet) or Net revenue (P&L/Income Statement)
• Used in combination with different groups of ratios:
– Profitability ratios
• Gross profit margin
• Trading profit margin
• Net profit margin
– Direct costs (expense) ratios
• Cost of goods sold / Revenue
• Direct cost (expense)/Revenue
– Operating expense ratios
– Other revenues/expenses ratios
• Interest expenses/Revenue
5
Financial Ratio Analysis
• A tool to evaluate efficiency & performance of an enterprise

• An in-depth analysis thanks to the combination of data from all
financial reports
• Enables calculation of the appropriateness and feasibility of future
plans of an enterprise
• Ratios explanation is more important than ratios calculation
• To correctly conclude, the Analyst must compare ratios:
– Of several years
– Versus ratios of enterprises in the same industry
– Versus targets/goals which the enterprise has set at the beginning of the
period

6
Some Main Groups of Financial Ratios
• Profitability ratios:
– Measure the earning of an enterprise in relationship to its Revenue and
Investment capital
• Performance ratios:
– Evaluate the efficiency of assets management of an enterprise
• Liquidity ratios:
– Measure the ability to meet short term obligations from its cash
• Debt raising/Debt coverage ratios
– Examine the capital structure and ability to meet long term debt obligation
of an enterprise

7
Profitability Ratios: Return on Assets
•T he objective is to assess how successful a firm 's operating

perform ance as been (i.e., how successful ha s the firm been at
generating profits?).
• M easures a firm 's success in using assets to generate earnings,
independent of the financing of those a ssets (i.e., debt versus equity).
ROA = Net Income + (1 - Tax Rate)(Interest Exp)
Average Total Assets
The num erator is operating incom e after incom e taxes, excluding
any financing costs.

8
Return on Assets
D eco m po sition o f R O A : Insigh ts in to a firm 's p rofitab ility ca n b e

gaine d by de com posing R O A in to its co m pon en ts, profit m arg in a n d
asset turno ver.
RO A = Profit M argin X Assets Turnover
N e t In co m e + In t e r e st N e t In co m e + In t e r e st
Ex p e n se (n e t o f t ax e s) = Ex p e n se (n e t o f t ax e s) X Sale s
Avg T o t al A sse t s Sale s Avg T o t al Asse t s

9
Fixed Asset Turnover
M easures the relation betw ee n sales and the investm ent in

p roperty, p lant, a nd equipm ent.
H ow efficie ntly is the firm using its fixed assets to generate sales?
Fixed asset turnover = Sales

A verage fixed assets

10
Return on Common Equity (ROE)
R O E m easures the re turn to com m on shareholders after

accou nting fo r the cost of debt and (preferred) equity financing.
RO E = Net Incom e - Preferred Dividends

A verage Com m on Equity
Or
RO E = Net Incom e A vailable to Com m on
A verage Com m on Equity

11
Du Pont Analysis
• D is-aggreg a ting R O E (D u P o nt analysis)

R O E = N e t Incom e / S h areho ld ers’ eq uity
RO E = Profit m argin X Turnover X Leverage
P rofit m argin = N et Incom e / S ales

T urnover = S ales / A sse ts
Leverage = A sse ts / S hareholders equ ity

12
Short-Term Liquidity
• C om m only used m e asure of short-term debt paying ability:

Current Ratio = Current Assets
Current Liabilities
– Matches the amount of cash & other current assets that will
become cash within 1 year against obligations that come due
in the next year. Basic rule of thumb: Minimum ratio of 1.0.
A variation of the current ratio is the Quick Ratio (or “Acid

Test Ratio”):
Quick Ratio = Current Assets- Inventory
Current Liabilities
Why would we use this ratio?

13
Operating Cash Flow to Current Liabilities Ratio
• A no ther m ea sure a firm ’s short-term liquidity.
– The advan tage is tha t it is based on ca sh flo w

A F T E R th e fun ding needs for w orking capital (i.e.,
accou nts receivables an d inven tory) been m ad e.
O perating C ash F low
A verage C urrent Liabilities

14
Liquidity Ratios-Accounts Receivables Turnover Days
• Measures how many days it takes the business’ (trade

customer(s)) accounts receivable to pay
• An increasing number indicates that it is taking longer to receive
payment for items sold and that cash will be being absorbed in
this area
• It is always calculated against Sales, but note it is standard
practice only to include trade debtors i.e. ignore any other current
assets such as prepayments and other debtors
Account Receivable Turnover Days = Accounts Receivable X 365

Sales

15
Liquidity Ratios – Accounts Payable Turnover Days
• Measures how many days it takes the business to pay its own
trade creditors i.e. those businesses which have supplied goods
and services to our customer
• A rising number indicates that it is taking longer to pay – this will
free up cash but may be symptomatic of a problem – are they
slow to pay because they cannot afford to pay any quicker?
• It is standard practice only to include trade creditors i.e. ignore
any other creditors such as accruals, tax, etc
• It is normally calculated against Cost of Goods Sold because this
gives a more accurate representation of how long it is taking to
pay suppliers, but note that it can also be calculated against sales
Accounts Payable
Accounts Payable Turnover Days = x 365
Cost of Goods Sold

16
Liquidity Ratios – Inventory Turnover Days
• Measures how many days it takes items of inventory to be sold i.e.

a measure of how long goods sit on the customer’s shelves
• A rising number indicates that it is taking longer to sell items and
that cash will be being absorbed in this area
• It is normally calculated against Cost of Goods Sold because this
gives a more accurate representation of how long the stock takes
to move, but note that it can also be calculated against sales
Total Inventory
Stock Turnover Days = x 365
Cost of Goods Sold

17
Liquidity Ratios – Net Working Assets
• Net working Assets is the proper name given to the funding gap
between inventory, accounts receivable and accounts payable
• It is a measure of how much cash is absorbed in the key working
capital items of inventory, accounts receivable and accounts
payable
• It excludes non trade items – assumed generally to balance out
over time
• It is expressed a a percentage of sales and a rising percentage
indicates that more of the businesses cash is being absorbed in
working capital
• It can also be used for forecasting
Accounts receivable + Inventory – Accounts payable
Net Working Assets = x 100

18 Sales
Long-Term Solvency Ratios
• Measure firm’s ability to meet interest & principal payments on long-
term debt when they come due.
• The best indicator for assessing long-term solvency is the firm's ability
to generate earnings in long term.
Long-Term = Long-Term Debt

Debt Ratio Long-Term Debt + Shareholders’ Equity
Debt/Equity = Long-Term Debt

Ratio Shareholders’ Equity
Liabilities/Assets = Total Liabilities

Ratio Total Assets

19
Some Points To Note When Using the Ratio Analysis Method
• Ratio is a tool for financial analysis, they are indicators but do not directly
“diagnose” or “prescribed”
• The degree of reliability of ratios depends on the quality of the financial
statements
• Different accounting principles lead to different ratio calculation results
and comparison results
• The methods (formula) to calculate ratios must be consistent
• All positive and negative movements must be investigated
• Monitor the trend of performance and explain it
• Must analyze all groups of financial ratios to get a full picture of the
enterprises
• Compare with other enterprise to get a clearer picture, however must be
careful in choosing appropriate criteria for comparison
• Financial information in the past may not reflect future situation
20
Some Suggestions in Financial Statement Analysis
• Analysis is to clarify issues but not to complicate issues

• Must combine all different analysis methods
• Don’t talk about obvious issues; figures themselves talk
• Figures are objective; understanding them or not depends on
analyst’s ability to point out historical and future issues behind
them
• Do indicate the main trend of volatility
• Avoid covering up important “negative” issues, try to explain them
• In the analysis process, identify key RISK issues and put conditions
for investment to mitigate the risks
• Do not make subjective assumption: get information from target
to clarify problems

21
Limitations of Financial Statements
• Do not reflect all/true picture at time of statements preparation

• Do not reflect non-financial factors
• Do not account for time value of money
• Do not reflect the seasonal nature of business!
• Being effected by different accounting policies in:
– Inventory
– Depreciation
– Revenue/expense

22
Some Points to Note When Analyzing Small & Medium Enterprises
• Tendency to maneuver profit

• “cash leakage”
• Burden of bad quality assets
• Quality of business cycle ?
• Unstable source of capital
• Some serious “sickness”
– Negative net worth
– Excessive investment
– Big difference between cash flow and profit from operations
– Excessive borrowing
– Business is too diversified

23
Some Points to Note When Analyzing Large Corporate
• Read and study carefully the Auditor’s opinion

• Grasp main information from Board of Director’s Report and
Notes to the financial statements
• Understand the nature of enterprise’s main business
• Clarify the true picture behind figures
• Clarify the details behind figures
• Understand the main messages of the financial statements
– Quality of assets and stability of source of capital
– Leverage ratio
– External risks and internal control
– Cash management

24
How Enterprises “Window Dress” Financial Statements
• Evaluation of inventory at the end of the period?

• Does not book sales in cash
• Books higher salary
• Includes non-cash expenses to inflate equity
• Capitalizes expenses
• Depreciation policy?
• Personal expenses/mixed
• Undisclosed or remove non-performing loan out of balance sheet
• Change in accounting principles
• Inject capital and increase sales at the last minute
• Accelerate receivables collection, late in payment to suppliers, delay
assets purchase
• Inter company transactions
25
Financial Warning Signals
• Often change auditors and inconsistent accounting policies

• Too many qualified opinions in Auditor’s Report (in Auditor’s opinion
section)
• Late completion of financial reports
• Much different from internal financial report; projection reports
• Quick increase in borrowing, quick cash decrease
• Wide mismatch in maturities of assets and liabilities
• Prolonged time of receivables collection and loan repayment schedule !
• Increase in returned goods and increase in sales discount
• Decrease in raw materials consumption
• Decrease in gross profit margin and net profit margin from operations
• Income mainly generated from sub-business(es) or from unstable
sources

26
Questions From Investment Team
• Techniques of FS Analysis
– If we lack data to the desired level of details, which are the areas we should focus
most on?
– What constitutes a reasonable time horizon for analysis.
– How to link the analysis result of different ratios groups to make a full story of
financial position in a 3-year time frame?
– Data give conflicting signals for conclusion, how do we handle?
• Company and Industry Indicators
– What are the indicators to look at for different types of companies, different
industries, etc.?
– Things to pay attention to in FS analysis of different industries?
• Misleading Metrics
– How do we identify misleading metrics? What are the misuse of these metrics that
tend to occur?
– Recommendations for helping analysts see through the misdirection?
– Frequent tricks/ errors in Vietnamese financial statements?
27
General Steps For Analyzing Financial Statements
1. Have at least three years worth of statements,
– current year plus prior two
– Five years historical is ideal
2. Have a pencil in hand and a calculator nearby when reading
3. Start with the current financials first and then work back in history
4. Read the board compositions and the major shareholder list
5. Read the auditor’s opinion and highlight the number of discrepancies they’ve found
6. Start with the balance sheet and understand the line items with the largest amount first
7. Move on to the income statement and understand the line items with the largest amount first
8. Now review the cash flow statement, if there is one, highlight large amounts and negative cash flow
9. Go back to the balance sheet, income statement and cash flow statement, and carefully review all notes associated to
each line item
10. When reading the notes, refer back to the auditor’s opinion and associate each discrepancies with the notes to see if
you can understand the nature and cause of discrepancies, and write follow-up points for management
11. Read the auditor’s opinion for prior year and skim through the financial statements looking for inconsistencies in
accounting principles, change in auditors, or change in line items
12. Transpose the financial statements into excel format, including current year and historical years
13. Create separate spreadsheets for trend analysis, common-size analysis, and a key ratio analysis
14. Collect and summarize all key points to follow-up with management, specifically the CFO, accountant, and/or auditor
of the company, and send to company for response
15. Write down your financial analysis for the company and review with Hiep
16. Complete your valuation model for the company

28
APPENDIX

29
FINANCIAL RATIOS REFERENCE
• Profitability indicators
• Performance indicators (measuring management effectiveness)
• Liquidity indicators
• Indicators of debts and debt solvency
• Personal expenses/mixed
• Undisclosed or remove non-performing loan out of balance sheet
• Change in accounting principles
• Inject capital and increase sales at the last minute
• Accelerate receivables collection, late in payment to suppliers,
delay assets purchase
• Inter company transactions

30
PROFITABILITY INDICATORS
Gross profit margin Gross profit/Net sales

Showing the gross profit level on sales, resulting in price
adjustments or production cost management
Operating profit margin Net operating profit/Net sales
This indicator accurately determines the effectiveness of the

company’s performance. Show the all-cost management and
monitoring abilities by the company owner

31
Profit (before tax) margin Profit before tax/Net sales
Measuring the performance of the company, using profit before tax for easier
comparison with other companies in the same industry. (Attention: do not
include abnormal incomes)
Net profit margin Net profit/Net sales
Measuring the overall performance of the company. It also reflects the

company ability in total cost management

32
Return on Equity Net profit/Owner’s equity
Showing the net profit level on the total owner’s equity
Operating return on assets Net operating profit/Total assets
Showing the profitability on the total assets put into operations. Measuring the
effectiveness of the use of assets in the operating activities, not taking into
account other expenses and taxes

33
PERFORMANCE INDICATORS
Operating expenses ratio Operating expenses / Net

sales
Showing the effectiveness of operating cost
management (financial cost, sales cost, overhead cost)

34
LIQUIDITY INDICATORS
Current ratio Current assets/Current liabilities
Showing the ability to pay whats due from cash and ‘near’ cash during the
reporting period
Quick ratio Cash + Short term investments +

Receivables/Short term debts
This is a stricter liquidity indicator, showing the ability to pay all the debts due
from cash or ‘near’ cash

35
LIQUIDITY INDICATORS
Number of days the available Cash balance + Cash at bank /

cash can meet operations needs Average daily spending in cash
Showing the ability of the company to meet operations needs in
cash. Also showing the level of cash excess, which can be
invested elsewhere temporarily.

36
DEBT INDICATORS
Debt to asset ratio Total debts/Total assets
Equity to asset ratio Total equity / Total assets
Debt to equity ratio Total debt/Total equity
Bank loan to equity ratio Total borrowings/Total equity
Showing the level of owner’s commitments and level of external debts. If the company
relies mainly on its owner, shareholders or debtors, banks?. Too high level of debt can
make it difficult to consider new operating plans.

37
GEARING RATIOS – LEVERAGE RATIO
• The leverage ratio measures how many times debt levels exceed
current Operating Profits
• Useful ratio linking two of the key things bankers are interested in
within one simple formula
• Can help with debt structuring and debt capacity e.g. typically a
3x leverage ratio (debt three times greater than PBIT) is used as a
rule of thumb for calculating the level of debt which could be
repaid in 5 years
Operating Profit
Leverage Ratio =
Total Debt

38
GEARING RATIOS – INTEREST COVER
• Interest cover is a measure of how many times the Operating

Profits of a business (i.e. Profits before interest and tax) can cover
the gross interest payments of the business
• It is therefore a measure of how comfortably debts are being
serviced by surplus profits
• A rule of thumb used in measuring this is that Interest cover
should normally be at least three times
• Like gearing it can be expressed as a net figure (in this instance net
of credit interest received on cash balance)
Operating Profit
Interest Cover =
Interest payable
39
40

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FINANCIAL STATEMENT

Source: Substantively from IFC Bank Training Center and MIT

• To be able to answer following questions:

Source: Substantively from IFC Bank Training Center and MIT

• Called Horizontal analysis

• Also called Vertical analysis

• A tool to evaluate efficiency & performance of an enterprise

Source: Substantively from IFC Bank Training Center and MIT

Source: Substantively from IFC Bank Training Center and MIT

•T he objective is to assess how successful a firm 's operating

Source: Substantively from IFC Bank Training Center and MIT

D eco m po sition o f R O A : Insigh ts in to a firm 's p rofitab ility ca n b e

RO A = Profit M argin X Assets Turnover

Source: Substantively from IFC Bank Training Center and MIT

M easures the relation betw ee n sales and the investm ent in

Fixed asset turnover = Sales

Source: Substantively from IFC Bank Training Center and MIT

R O E m easures the re turn to com m on shareholders after

RO E = Net Incom e - Preferred Dividends

RO E = Net Incom e A vailable to Com m on

A verage Com m on Equity

Source: Substantively from IFC Bank Training Center and MIT

• D is-aggreg a ting R O E (D u P o nt analysis)

RO E = Profit m argin X Turnover X Leverage

P rofit m argin = N et Incom e / S ales

Source: Substantively from IFC Bank Training Center and MIT

• C om m only used m e asure of short-term debt paying ability:

A variation of the current ratio is the Quick Ratio (or “Acid

Why would we use this ratio?

Source: Substantively from IFC Bank Training Center and MIT

• A no ther m ea sure a firm ’s short-term liquidity.

– The advan tage is tha t it is based on ca sh flo w

Source: Substantively from IFC Bank Training Center and MIT

• Measures how many days it takes the business’ (trade

Account Receivable Turnover Days = Accounts Receivable X 365

Source: Substantively from IFC Bank Training Center and MIT

Source: Substantively from IFC Bank Training Center and MIT

• Measures how many days it takes items of inventory to be sold i.e.

Source: Substantively from IFC Bank Training Center and MIT

Source: Substantively from IFC Bank Training Center and MIT

Long-Term = Long-Term Debt

Debt/Equity = Long-Term Debt

Liabilities/Assets = Total Liabilities

Source: Substantively from IFC Bank Training Center and MIT

• Analysis is to clarify issues but not to complicate issues

Source: Substantively from IFC Bank Training Center and MIT

• Do not reflect all/true picture at time of statements preparation

Source: Substantively from IFC Bank Training Center and MIT

• Tendency to maneuver profit

Source: Substantively from IFC Bank Training Center and MIT

• Read and study carefully the Auditor’s opinion

Source: Substantively from IFC Bank Training Center and MIT

• Evaluation of inventory at the end of the period?

• Often change auditors and inconsistent accounting policies

Source: Substantively from IFC Bank Training Center and MIT

Source: Substantively from IFC Bank Training Center and MIT

Source: Substantively from IFC Bank Training Center and MIT

Source: Substantively from IFC Bank Training Center and MIT

Gross profit margin Gross profit/Net sales

This indicator accurately determines the effectiveness of the

Source: Substantively from IFC Bank Training Center and MIT

Measuring the overall performance of the company. It also reflects the

Source: Substantively from IFC Bank Training Center and MIT