Financial Statement Analysis Notes

Financial Statement Analysis
  • Key Stakeholders: Managers, Shareholders, Investors, Creditors all utilize financial statements for decision-making.
  • Relying solely on financial statements provides limited context to the numbers.
Dimensions of Financial Statement Analysis
  1. Liquidity: Measures how easily a company can convert current assets into cash.
  2. Solvency: Assesses how easily a company can pay off long-term liabilities.
  3. Profitability: Evaluates how profitable a company is.
Analytical Methods for Financial Analysis
  • Analytical Methods: Techniques to interpret financial data, allowing for both internal (self) and external (other companies) comparisons.
  • Ratios: Enable comparison over time or against competitors.
Horizontal Analysis

  • Definition: Calculates changes in financial metrics over time (Trend Analysis).

  • Formulas:

    • $Change = New Year - Old Year
    • % Change = $Change / Old Year

  • Example: From 2023 to 2024:

    • Revenue: $250,000 vs. $200,000 → $Change: $50,000, %Change: 25% (Favorable)
    • Expenses: ($210,000) vs. ($180,000) → $Change: ($30,000), %Change: 17% (Unfavorable)
    • Net Income: $40,000 vs. $20,000 → $Change: $20,000, %Change: 100% (Overall Favorable)

  • Rule of Thumb:

    • Favorable: Increases in assets, equity, revenues.
    • Unfavorable: Increases in expenses, liabilities, or decreases in assets/equity.
Vertical Analysis

  • Definition: Standardizes figures on financial statements relative to a base figure, allowing for industry-wide comparisons.

  • Key Variables for Vertical Analysis:

    1. Balance Sheet: Divide by total assets.
    2. Income Statement: Divide by revenue.
    3. Cash Flow Statement: Focus on cash from operations.

  • Advantages:

    • Allows for apples-to-apples analysis across all industries.
Ratio Analysis
  • Purpose: Provides deeper context to financial items and enables both internal and external comparisons.
Liquidity Ratios
  • Analyzes the ability to cover current liabilities:

  1. Working Capital:

    • Formula: Current Assets - Current Liabilities.
    • Interpretation: Provides surplus assets available for further use.
    • Disadvantage: May vary significantly by industry.

  2. Current Ratio:

    • Formula: Current Assets / Current Liabilities.
    • Interpretation: Indicates how many times current liabilities can be covered by current assets.
    • Disadvantage: Not all current assets have the same liquidity.

  3. Quick Ratio (Acid Test Ratio):

    • Formula: (Current Assets - Inventory - Prepaids) / Current Liabilities.
    • Includes: Cash, Temporary Investments, Accounts Receivable (most liquid assets).
    • Excludes: Inventory and Prepaids.
    • Interpretation: Shows immediate ability to cover current liabilities with the most liquid assets.
Accounts Receivable Analysis
  • Accounts Receivable Turnover:
    • Formula: Sales / Average Accounts Receivable.
    • Interpretation: A higher ratio indicates effective collection practices.
    • No. Days Receivables:
      • Formula: 365 / Accounts Receivable Turnover.
Inventory Analysis
  • Inventory Turnover:
    • Formula: Cost of Goods Sold / Average Inventory.
    • Interpretation: Higher turnover means better ability to sell inventory quickly.
    • No. of Days Inventory:
      • Formula: 365 / Inventory Turnover.
Solvency Ratios
  1. Fixed Assets to Long Term Liabilities:
    • Formula: Fixed Assets / Long-Term Liabilities.
  2. Liabilities to Shareholder's Equity:
    • Formula: Total Liabilities / Total Stockholder's Equity.
    • Interpretation: Lower ratios indicate less risk.
  3. Times Interest Earned:
    • Formula: EBIT / Interest Expense.
    • Interpretation: Higher ratios suggest better ability to cover interest expenses.
Profitability Analysis
  1. Asset Turnover:
    • Formula: Sales / Average Total Assets.
  2. Return on Assets (ROA):
    • Formula: (Net Income + Interest Expense) / Average Total Assets.
  3. Return on Equity (ROE):
    • Formula: Net Income / Average Stockholder's Equity.
  4. Earnings per Share (EPS):
    • Formula: (Net Income - Preferred Dividends) / Number of Common Stocks Outstanding.
  5. Price to Earnings Ratio (P/E Ratio):
    • Formula: Market Price of Stocks / EPS.
  6. Dividends per Share:
    • Formula: Dividends / Number of Shares Outstanding.
  7. Dividend Yield:
    • Formula: Dividends per Share / Market Price per Share.
Annual Reports
  • Companies must publish Financial Reports Annually and Quarterly (10K).
  • Contain both Quantitative (Financial Statements) and Qualitative (MD&A) information.
  • Management Discussion and Analysis (MD&A):
    • Offers insights on performance, outlook, risks, and changes in accounting methods.
Compliance and Audits
  • Sarbanes Oxley Act (SOX): Requires management to assure the integrity of internal controls and audits.
  • Auditors must verify adherence to GAAP and assess financial statement fairness.
  • Opinions:
    • Unmodified Opinion (Clean Opinion): No significant issues detected.
    • Modified Opinion: Indicates potential problems with financial reporting.