CHAPTER 2

ANALYSIS OF
FINANCIAL STATEMENT
LEARNING OBJECTIVE

1. Calculate and interpret financial ratios.

2. Compare different company performances using financial ratios, historical financial
ratio trends, and industry ratios.
3. Know how to standardize financial statements for comparison purposes
4. Know how to compute and interpret important financial ratios
FINANCIAL STATEMENTS

Just like a doctor takes a look at a patient’s x-rays or cat-scan when

diagnosing health problems, a manager or analyst can take a look at a
firm’s primary financial statements i. e. the income statement and the
balance sheet, when trying to gauge the status or performance of a firm.
Income statement: periodic recording of the sources of revenue and
expenses of a firm,
Balance sheet: provides a point in time snapshot of the firm’s assets,
liabilities and owner’s equity.
 FINANCIAL ANALYSIS AND FINANCIAL RATIOS
• Various method can be used in measuring and evaluate the financial health of a business such as horizontal,
vertical analyses and ratio analysis

• Financial analysis is the use of financial statements to analyse a firm’s

financial position and its performance.
Questions:
• Does a firm have the resources to succeed and grow?
• Does it have adequate resources to invest in new projects?
• What are its sources of profitability?
• Did the earnings of the firm meet its forecast earnings?
• What are the sources of a firm’s future earnings power?
 FINANCIAL ANALYSIS

• Financial analyst uses the ratios to make two types of comparisons:

• Industry comparison (Benchmarking).. The ratios of a firm are compared with those of similar firms or with
industry averages or norms to determine how the company is faring relative to its competitors.
• Trend analysis. A firm’s present ratio is compared with its past and expected future ratios to determine whether the
company’s financial condition is improving or deteriorating over time.

• After completing the financial statement analysis, the firm’s financial analyst will consult with management
to discuss their plans and prospects, any problem areas identified in the analysis, and possible solutions.
 HORIZONTAL ANALYSIS @ TREND ANALYSIS

• Horizontal analysis is used to evaluate the trend in the accounts over the years.
• It is a financial statement analysis technique that shows changes in the amounts of corresponding
financial statement items over a period of time.
• Horizontal analysis is usually shown in comparative financial statements and companies often
show comparative financial data for 5 years in annual report.
• The earliest period is usually used as the base period and the items on the statements for all later
periods are compared with items on the statements of the base period.
• The changes are generally shown both in dollars and percentage.
 EXAMPLE

In fiscal years 2010 and 2009, Coca-Cola had the operating income shown
as follows. (Amounts are in millions).

Percentage Change
2010 2009 Dollar Change
%

Operating Income 8,449 8,231 218 2.65

EXAMPLE
ANALYSIS

The net sales increased by $4,129,000,000, or 13.3 percent. Cost of goods sold had a corresponding increase of
$1,605,000,000, or 14.5 percent.
The increase in net sales and related increase in cost of goods sold resulted in an increase in gross margin of
$2,524,000,000, or 12.7 percent.
The increase in selling and administrative expenses of $1,800,000,000, or 15.8 percent, outpaced the increase in net
sales, resulting in a relatively small increase in operating income of $218,000,000, or 2.6 percent.
The significant increase in other income (expenses), net of 555.6 percent relates to a one-time gain of
$4,978,000,000 resulting from Coca-Cola’s acquisition of Coca-Cola Enterprises, Inc., in 2010
Problem 1
1. Calculate the dollar change and percentage change using
horizontal analysis
2. Evaluate your findings
 VERTICAL ANALYSIS @ COMMON SIZE
ANALYSIS
• It helps a business to know how much of one item is contributing to overall operation.
• For example, a company may want to know how much inventory contributes to total assets.
• They can then use this information to make business decisions such as preparing the budget, cutting costs,
increasing revenues, or capital investments.
• Common size analysis is also an effective way of comparing two companies with different level of revenues
and assets.
• It helps us to compare companies on equal ground.
RATIO ANALYSIS

• Ratios also allow for better comparison through time or between companies.
• Horizontal and vertical analyses compare one figure to another within the same category.
• It is also essential to compare figures from different categories. This is accomplished through ratio analysis.
• There are various kind of ratios that an analyst can use, depending upon what he or she considers to be
important relationships.
Financial ratios are used by:
• Lenders in deciding whether or not to lend to a company.
• Credit-rating agencies in determining a firm’s credit worthiness.
• Investors (shareholders and bondholders) in deciding whether or not to invest in a company.
• Major suppliers in deciding to whether or not to extend credit to a company and/or in designing the specific
credit terms.
5 key areas of a firm’s performance can be analyzed using financial ratios:

1. Liquidity ratios: Can the company meet its obligations over the short term?
2. Solvency ratios: (also known as financial leverage ratios): Can the
company meet its obligations over the long term?
3. Asset management ratios: How efficiently is the company managing its
assets to generate sales?
4. Profitability ratios: How well has the company performed overall?
5. Market value ratios: How does the market (investors) view the company’s
financial prospects?
 Liquidity

Solvency/
Market
Leverage

Financial Ratio

Efficiency/
Profitability
asset mgt
INCOME
STATEMENT
BALANC
E SHEET
LIQUIDITY RATIO

• A liquid asset is one that can be converted quickly and routinely into cash at the
current market price.
• Liquidity measures the firm’s ability to pay its bills on time. It indicates the ease with
which non-cash assets can be converted to cash to meet the financial obligations.
• It attempt to measure a company ability to pay off short-term debt obligation
• 3 key liquidity ratios include: The current ratio, quick ratio, and cash ratio

• NWC = CA - CL
EXAMPLE

• Cogswell has better liquidity and short-

term solvency than Spacely,

• Spacely has only $1.02 in current assets

for every $1 in current liabilities.
Cogswell’s liquidity is higher than
Spacely, which has a current ratio of 1.06

• Current ratio - We can safely say that for

every RM 1 short term debt that Cogwell
Cola owed, it had RM 1.06 backing by
current asset.
• Quick Ratio – Cogswell is covering its
current liabilities 0.84 times without any
contribution from its inventory.
 INTERPRETING LIQUIDITY RATIO

• Current Ratio – higher better

• Current ratio compares a firm’s current assets to its current liabilities.

• Quick Ratio – higher better

• Quick ratio compares cash and current assets (minus inventory) that can be converted into cash during the
year with the liabilities that should be paid within the year
• >1 better
• QR<CR, firm depends on inventory

• Cash Ratio – higher better

• The cash ratio indicates the percentage of current liabilities covered by the current cash on hand.
 LEVERAGE RATIO

• Measure a company’s ability to meet its long-term debt obligations based on its overall debt level
and earnings capacity.
• Failure to meet its interest obligation could put a firm into bankruptcy

• Does the firm finance its assets by debt or equity or both?

• Debt to equity ratio = Total Debt/Owner’s Equity
• Cogswell Cola has relatively less debt
and a significantly greater ability to
cover its interest obligations by using
either its EBIT (times interest earned
ratio) or its net cash flow (cash
coverage ratio) than Spacely Spritzers.

• Leverage must be analyzed as a

combination of debt level and
coverage. If a firm is heavily leveraged
but has good interest coverage, it is
using the interest deductibility feature
of taxes to its benefit. Having a high
leverage with low coverage could put
the firm into a risk of bankruptcy.
LEVERAGE RATIO

• Debt Ratio – Lower better (Higher ratio = more risk )

• This ratio indicates the percentage of the firm’s assets that are financed by debt (implying that the balance is financed
by equity). A low percentage means that the company is less dependent on leverage.
• One way to look at the debt ratio is to see it as the amount in debtfor every dollar of assets.
• DR > 1 = lots of debt

• Times Interest Earned – Higher Better

• The times interest earned ratio reflects the number of times before-tax earnings cover interest expense
• is used to determine how easily a company can pay interest expenses on outstanding debt

• Cash Coverage Ratio – Higher better

• The cash coverage ratio indicates a company’s ability to generate cash from operations to meet its financial
obligations
ASSET MANAGEMENT RATIOS

• Measure how efficiently a firm is using its assets to generate revenues or how much
cash is being tied up in other assets such as receivables and inventory.
• Activity ratios are used to determine how quickly various accounts are converted into
sales or cash.
While Cogswell is more efficient at managing its inventory, Spacely seems to be doing a better
job of collecting its receivables and utilizing its total assets in generating revenues

• Inventory turnover –
• Cogswell sold and restocked the entire inventory about eight times during the year.
Spacely sold and restocked about five times.
• Days’ sales in inventory –
• Inventory was “on the shelf ” forty-three days at Cogswell and an average
of seventy-six days at Spacely before it sold.
 ASSET MANAGEMENT RATIOS
• Receivables turnover –
• The receivables turnover ratio is similar in orientation to inventory turnover. It measures the number of times per year the
company's collected payment on credit accounts. For Cogswell, it was about ten times, and for Spacely, it was about
eighteen times.

• Days’ sales in receivables –

• Customers took an average of thirty-seven days at Cogswell and an average of twenty days at Spacely to collect for their
credit sales.

• Total asset turnover –

• The total asset turnover ratio relates sales to assets. We call this the management efficiency ratio because it indicates how
well a company uses assets to generate revenue.
 PROFITABILITY RATIOS

• Profitability ratios such as net profit margin, returns on assets, and return on equity, measure
a firm’s effectiveness in turning sales or assets into profits
• Ultimately, what we want to know is how well the company has performed overall—that is,
how the company has generated profits
• As far as profitability is
concerned, Cogswell is
outperforming Spacely by
about 3%.
PROFITABILITY RATIOS

• Profit Margin –
• It indicates the
profitability generated from revenue and hence is an important measure of
operating performance. It also provides clues to a company’s pricing, cost structure, and
production efficiency.
• Cogswell Cola is generating 13 cents of profit from every sales dollar, and Spacely Spritzers is generating 10 cents.

• ROA –
• This ratio indicates how profitable a company is relative to its total assets.
• The assets of Cogswell
Cola are generating 14 cents per investment dollar in profit, whereas
the assets of Spacely Spritzers are generating 11.5 cents per investment dollar.
• ROE –
• This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity.
• measures how much the shareholders earned for their investment in the company.
MARKET VALUE RATIOS

• Used to gauge how attractive or reasonable a firm’s current

price is relative to its earnings, growth rate, and book value.
MARKET VALUE RATIOS

• Potential investors and analysts often use these ratios as part of their valuation
analysis.
• Typically, if a firm has a high price to earnings and a high market to book value
ratio, it is an indication that investors have a good perception about the firm’s
performance.
• However, if these ratios are very high it could also mean that a firm is over-valued.
• With the price/earnings to growth ratio (PEG ratio), the lower it is, the more of a
bargain it seems to be trading at, vis-à-vis its growth expectation.
MARKET VALUE RATIOS

Ratio Cogswell Cola Spacely Spritzers

EPS 1.85 1.46

P/E 15.41 13.01

BVPS 5.19 4.54

P/B 5.49 4.17

The ratios seem to indicate that investors in both firms seem to have good
expectations about their performance and are therefore paying fairly high
prices relative to their earnings book values.
MARKET VALUE RATIOS

• EPS –
• Earnings per share indicates the amount of earnings for each common share held.

• Price to earning Ratio –

• The P/E ratio measures how cheaply valued a company's stock price is by comparing the current stock price to its (EPS)
• It measures the premium investors are willing to pay for shares of stock relative to the company’s earnings.

• Book value per share

• Book value per share is net assets available to common stockholders divided by shares outstanding, where net assets is
stockholders’ equity minus preferred stock
• (Total equity – preferred equity)/ total shares outstanding

• Market to book value –

• A valuation ratio used by investors which compares a stock's per-share price (market value) to its book value
• Provides investors a way to compare the market value, or what they are paying for each share, to a conservative measure
of the value of the firm.
QUESTION 1
Tri-mark Products Inc.
Balance Sheet as at year ended
31st December 2014 (‘000s)
Liabilities:
Current Assets Current Liabilities
Accounts
Cash $6,336 Payable $57,000
Accts.
Rec. $43,000 Short Term Debt $1,500
TOTAL Current
Inventory $42,000 Liabilities. $58,500
Other
Current $12,000 Long Term Debt $74,000
Total
Current $103,336 Other Liabilities $15,000
L- T Inv. $25,340 Total Liabilities $147,500
PP&E $225,000 Owner’s Equity
Goodwill $30,000 Common Stock $189,676
Other Retained
Assets $14,000 Earnings $60,500
Total OE $250,176
Total Total Liab. And
Assets $397,676 OE $397,676

• Re-state Tri-Mark Incorporated’s 2014 financial statements as common-size statements and

comment on them
ANSWER