Chapter 12- Financial Statement Analysis

What is financial analysis?

Financial analysis =

• looking at a company’s financial statements

• judging its performance

• deciding how healthy it is

What are the five steps of the financial analysis process?

1. Determine Purpose/Context

2. Collect Information

3. Common-Size Analysis & Ratios

4. Analyze & Interpret

5. Conclusions & Recommendations

Why is understanding the context of financial analysis important?

• Context determines which tools are used.

• Tools (like trend or cross-sectional analysis) depend on what is being studied.

• The goal is to focus on the most relevant parts of company performance.

What are the common contexts for financial analysis?

1. Investment Decisions

2. Lending Decisions

3. Credit Applications

4. Acquisition Decisions

Why is knowledge of the business crucial in financial analysis?

Understanding the company’s operations, market, and strategies helps interpret ratios and financial data accurately.

Where is the primary source of information for financial analysis found?

The annual report, including financial statements, MD&A, and the auditor’s report.

What is retrospective analysis?

• Examines past financial data to assess performance

• often using trend or cross-sectional analysis

What is prospective analysis?

Forecast future performance based on current trends and data.

What is trend analysis?

Reviews financial performance over a period (3-10 years) to identify patterns and changes.

What is cross-sectional analysis?

Compares a company’s performance to others in the same industry to evaluate its competitive position.

What is common-size analysis?

Restates financial statements as percentages of a base amount (e.g., income as a percentage of total revenue).

What is ratio analysis?

• Evaluates liquidity

• profitability

• solvency

• equity

• by calculating ratios from financial statement items

What are the types of ratios used in financial analysis?

1. Liquidity Ratios

2. Activity Ratios

3. Solvency Ratios

4. Profitability Ratios

5. Equity Ratios

What is the formula for the current ratio?

Current Ratio = Current Assets / Current Liabilities

What is the formula for the quick ratio?

Quick Ratio = (Current Assets - Inventories) / Current Liabilities

What is the formula for the operating cash flow ratio?

Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

What are activity ratios and give examples?

• Activity ratios measure efficiency.

• Accounts Receivable Turnover

• Inventory Turnover

• Accounts Payable Turnover

What are solvency ratios and give examples?

• Solvency ratios measure long-term health.

• Debt to Equity Ratio

• Interest Coverage Ratio

What are profitability ratios and give examples?

• Profitability ratios measure earnings.

• Gross Margin

• Net Profit Margin

• ROA

What are equity ratios and give examples?

• Equity ratios assess shareholder value.

• Earnings Per Share (EPS)

• P/E Ratio

• Dividend Yield

What are the limitations of ratio analysis?

1. Differences in accounting policies

2. Definition variations

3. Seasonality

4. Window dressing (manipulation)

What are non-IFRS financial measures?

• Non-IFRS measures adjust IFRS data for better operational insight.

• Examples: Free Cash Flow, EBITDA.

What are examples of other financial and operational measures?

Other financial measures: Same-store sales, sales per square foot. Operational measures: Customer retention, churn rate.

Why should you be cautious when using non-IFRS measures?

1. No standard definitions 2. Not audited 3. Lack of comparability across companies.

What is the conceptual framework in financial analysis?

The framework ensures financial information is:

• comparable and verifiable

• helping analysts make reliable decisions

What are the regulatory guidelines for non-IFRS measures in Canada?

CSA guidelines ensure transparency in non-IFRS disclosures to reduce misleading reporting.

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Determine Purpose/Context → e.g., Investment, Lending, Acquisition\nCollect Information → sources: MD&A, Notes to Financial Statements, Annual Report\nPrepare Analysis → common-size statements (vertical) and horizontal analysis\nAnalyze & Interpret Results → include benchmarking against competitors\nConclusions & Recommendations → insights and actionable suggestions

How is horizontal analysis calculated and what is its purpose?

Dollar change = Current Year − Base Year\n% change = (Dollar change ÷ Base Year) × 100\nPurpose: Measures year-to-year changes in financial statement items

What is common-size analysis and provide examples?

• Converts financial statements into percentages to make comparisons easier

• Income Statement: expressed as a % of sales (revenue)

• Balance Sheet: expressed as a % of total assets

• Use: helps with benchmarking across industries and companies

What are key liquidity ratios and their formulas?

Current Ratio = Current Assets ÷ Current Liabilities\nQuick Ratio = (Current Assets − Inventories) ÷ Current Liabilities\nWorking Capital = Current Assets − Current Liabilities\nOperating Cash Flow Ratio = Operating Cash Flow ÷ Current Liabilities

What are key activity ratios and their formulas?

Accounts Receivable Turnover = Net Credit Sales ÷ Avg Accounts Receivable\nInventory Turnover = COGS ÷ Avg Inventory\nDays to Sell Inventory = 365 ÷ Inventory Turnover\nAccounts Payable Turnover = COGS ÷ Avg Accounts Payable

What are key solvency ratios and their formulas?

Debt-to-Equity = Total Debt ÷ Total Equity\nNet Debt to Total Capitalization = Net Debt ÷ (Net Debt + Equity)\nInterest Coverage = EBIT ÷ Interest Expense

What are key profitability ratios and their formulas?

Gross Margin = (Sales − COGS) ÷ Sales\nOperating Income % = Operating Income ÷ Total Revenue\nProfit Margin = Net Income ÷ Sales\nReturn on Assets (ROA) = Net Income ÷ Total Assets\nReturn on Equity (ROE) = Net Income ÷ Avg Shareholders’ Equity\nAsset Turnover = Net Sales ÷ Avg Total Assets

What are key equity ratios and their formulas?

Dividend Payout Ratio = Dividends ÷ Net Income\nEarnings Per Share (EPS) = Net Income ÷ Shares Outstanding\nPrice/Earnings (P/E) Ratio = Market Price ÷ EPS\nDividend Yield = Dividend per Share ÷ Share Price

What are non-IFRS measures, their variations, and operational metrics?

Non-IFRS Measures: Free Cash Flow, EBITDA\nVariations: EBITDAR, Adjusted EBITDA\nOperational Metrics: Subscriber counts, Units delivered/ordered\nCautions: Unaudited, biased, not comparable across companies

What is a quick way to remember financial ratio categories?

Liquidity → short-term survival\nActivity → efficiency\nSolvency → long-term risk\nProfitability → performance\nEquity → investor perspective