Financial Statement Analysis Notes

Enabling Competencies and Learning Outcomes

• Enabling competencies include solving problems, making decisions, and communicating.
• Learning outcomes:
  • Explain the relation of financial statement analysis to competency areas.
  • Identify the three steps in financial statement analysis.
  • Describe the first step (assessing the situation).
  • Describe the second step (analyzing major issues).
  • Describe the third step (concluding and advising).
  • Apply the steps to a scenario.

11.1 Performing Financial Statement Analysis

• Financial statement analysis is used by CPAs in various roles:
  • Manager: to improve efficiency.
  • Governance: to assess performance.
  • Auditor: to determine the risk of misstatement.

11.2 Application

• Financial statement analysis relates to several competency areas:
  • Financial reporting: Used to interpret and explain financial results to stakeholders for investment, lending, and credit decisions. Lending covenants often use financial ratios.
  • Audit and assurance: Performed as part of analytical procedures throughout assurance engagements to identify items for further investigation.
  • Strategy and governance: Used during situational analysis to identify strengths, weaknesses, opportunities, and threats. Organizational objectives are stated in the form of ratios.
  • Management accounting: Used in performance measurement systems, creating incentives to achieve ratio targets. Ratios are also used to assist in planning, forecasting, and budgeting.
  • Finance: Provides information about financial health, short- and long-term financial strength, and the ability to use resources efficiently to generate profits and cash flow. Ratios are useful for capital structure and financing decisions.

11.3 Step 1: Assess the Situation

• The first step is to assess the situation by determining relevant ratios or trends.
• Approaches to financial statement analysis:
  • Horizontal trend
  • Vertical trend
  • Ratios
• Each approach compares current results to a benchmark like prior-period results, industry results, or budgeted expectations.
• Example: Expecting a 10% sales increase, the benchmark is prior-period sales plus 10%.

11.3.1 Horizontal Trend

• Compares financial information over time to identify significant changes.




• Calculates dollar and percentage changes compared to a benchmark (e.g., prior period).




• Dollar change: Current period value minus benchmark period value.




• Percentage change: (Dollar change / Benchmark period value).




• Example:

  
  
  
  
  • Company XYZ Income Statement
    

• Also known as a common-size trend, compares accounts with a single line item.
• Presents each item as a percentage of a base figure (e.g., total revenues for the income statement, total assets for the balance sheet).
• Allows for easy comparison of financial statement line items and identification of areas outside the benchmark.
• Example:
  • Company XYZ Income Statement
    | | Year 2 | Year 1 |
    | :---------- | :------ | :------ |
    | Sales | 100% | 100% |
    | Cost of Sales | 40% | 39% |
    | Gross Margin | 60% | 61% |
    | Other Expenses| 25% | 27% |
    | Net Income | 35% | 34% |
• Provides a quick snapshot of expenses relative to sales and identifies margin deterioration.
• Focus on items expected to change in relation to sales, such as cost of sales, bad debt expense, commissions, and advertising.

11.3.3 Ratios

• Compare financial information, reporting key performance indicators in a common format (percentage).
• Make information comparable to other periods, companies, and industry standards.
• Expressed as a decimal (e.g., 0.10) or percentage (e.g., 10%).
• Categories:
  • Liquidity ratios: Ability to meet short-term financial obligations.
  • Asset turnover ratios: Efficiency in utilizing assets.
  • Profitability ratios: How well assets are used and expenses are controlled to generate a return.
  • Debt service ratios: Ability to repay long-term debt.
• Allow for comparisons between:
  • Organizations
  • Industries
  • Time periods
  • External benchmarks
  • Responsibility centers
  • Actual or forecasted results and specified criteria
• Ratios help focus on key areas and identify areas for further analysis.
• Calculating key ratios can help identify what is occurring.

11.4 Step 2: Analyze Major Issue(s)

• Interpret the results of vertical/horizontal trends and ratio calculations.
• Consider how qualitative information ties into the calculations.
• Examples of case facts that may impact financial statements:
  • Economic slowdown
  • Expansion during the year
  • New competition
  • New product introduction
  • Discontinued operations
• Determine whether the results align with benchmarks.
• If an issue is identified (e.g., benchmark not met), discuss it by identifying the issue and explaining its potential impact.
• Incorporate the WHAT (result of analysis) + WHY (significance).

11.5 Step 3: Conclude and Advise

• Always provide a course of action with the analysis.
• Operational or governance role: Consider steps to improve the trend/ratio.
• Auditor role: Discuss accounts and assertions at risk of material misstatement and procedures to mitigate that risk.
• Financial Statement Analysis Setup:
  • Ratio/trend: Accounts receivable (AR) turnover decreased.
  • Analysis: AR turnover slower, higher risk of uncollectibility.
  • Conclusion:
    • Operations: Review credit and collection procedures.
    • Assurance/audit: Additional procedures focusing on the collectability of AR: Obtain an aged listing of AR. Inquire of management payment status for accounts older than 90 days. Vouch payments to bank statements for accounts received after year end. Inquire about the likelihood of collectability and inspect documented communication with the client for accounts not received.

11.6 Common Ratios

11.6.1 Liquidity Ratios

• Provide information about the ability to meet short-term financial obligations.
• Used by short-term creditors.

11.6.1.1 Current Ratio

• Formula: Current Assets / Current Liabilities
• Measures liquidity by comparing current assets to current liabilities.
• Determines whether short-term assets are sufficient to cover short-term liabilities.
• Higher ratio = better, but could indicate mismanagement of working capital.
• Low ratio may be acceptable for cash-based businesses with limited inventory.
• Typical values vary by organization and industry. Cyclical industries may strive for a higher current ratio.
• Assumes all current assets can be liquidated to meet current liabilities, which is unlikely.

11.6.1.2 Quick Ratio

• Formula: (Current Assets – Prepaid Expenses – Inventory) / Current Liabilities
• Refines the current ratio by comparing only the most liquid current assets with current liabilities.
• More conservative than the current ratio because it excludes inventory.
• A higher ratio means a more liquid current position.
• A high ratio might indicate excessive liquid assets.

11.6.2 Asset Turnover Ratios

• Measure a company’s efficiency in utilizing assets.

11.6.2.1 Receivables Turnover

• Formula: Credit Sales / Average Accounts Receivable
• Measures how quickly accounts receivable are collected.
• Higher rate = more efficiently receivables are collected.
• Reduces the risk of bad debts and converts working capital into cash.
• A high ratio may indicate overly tight credit policies, reducing sales.

11.6.2.2 Average Collection Period

• Formula: Average Accounts Receivable / (Credit Sales / 365)
• Measures the average number of days that credit sales remain in accounts receivable before collection.
• Assess the efficiency of receivables collections and the effectiveness of collection policies.
• Assess the risk of overdue receivables becoming uncollectible.

11.6.2.3 Inventory Turnover

• Formula: Cost of Goods Sold / Average Inventory
• Measures how quickly inventory is sold.
• Higher rate = more efficiently inventory is managed.
• Reduces the risk of obsolescence and converts working capital into cash.
• A high ratio may indicate a shortage of inventory, reducing sales.

11.6.2.4 Inventory Period

• Formula: Average Inventory / (Cost of Goods Sold / 365)
• Measures the number of days that goods remain in inventory before being sold.
• Assess inventory management efficiency and the risk of obsolescence.

11.6.3 Profitability Ratios

• Measure success in generating profits.

11.6.3.1 Gross Margin Percentage

• Formula: (Sales – Cost of Goods Sold) / Sales
• Measures the percentage of each sales dollar remaining after recovering the cost of goods sold.

11.6.3.2 Profit Margin

• Formula: Net Income / Sales
• Measures overall profitability after all expenses.

11.6.3.3 Return on Assets

• Formula: Net Income / Average Total Assets
• Measures how effectively assets are used to generate profits.

11.6.3.4 Return on Equity

• Formula: Net Income / Average Equity
• Measures the profits earned for each dollar invested in equity.

11.6.4 Debt Service Ratios

• Indicate a company’s long-term solvency.
• Measure the overall use of debt (leverage or financial stability ratios).

11.6.4.1 Debt Ratio

• Formula: Total Liabilities / Total Assets
• Compares total debt to total assets used to finance assets.
• Low ratio = less dependence on leverage.
• High ratio = more leveraged and financially risky.

11.6.4.2 Debt-to-Equity

• Formula: Total Liabilities / Equity
• Compares total liabilities to total equity.
• Measures the degree of leverage.
• Lower percentage = less leverage and a stronger equity position.

11.6.4.3 Debt Service Coverage

• Formula: Net Operating Income / (Principal + Interest Payments)
• Measures how much cash is available to pay debt.

11.6.4.4 Times-Interest-Earned Ratio

• Formula: EBIT / Interest Expense
• Measures the ability to pay interest expenses from income.
• Lower ratio = more income burdened by debt expense.

11.6.5 Other Ratios

11.6.5.1 Asset Turnover

• Formula: Sales / Average Total Assets
• Indicates how efficiently assets are utilized (efficiency or asset utilization ratios).

11.6.5.2 Asset Turnover in Days

• Formula: 365 / (Sales / Average Total Assets)
• Measures the average number of days it takes for the company to earn sales equal to the amount of assets that it has.

11.6.5.3 Accounts Payable Turnover

• Formula: Purchases / Average Accounts Payable
• Measures how quickly accounts payable are paid.
• A company does not want the turnover to be too high, as this may indicate poor cash management. However, if it is too low, it may indicate difficulty making payments.

11.6.5.4 Days Payable Outstanding

• Formula: Ending Accounts Payable / (Cost of Goods Sold / 365)
• Estimates the number of days it takes a company to pay its suppliers.
• A higher number of days could indicate difficulty making payments.

11.6.5.5 Price Earnings

• Formula: Market Price of Shares / Earnings Per Share
• Measures the current market price of a share relative to earnings per share.
• Indicates how much an investor needs to invest to receive one dollar of the company’s earnings.

11.6.5.6 Dividend Payout

• Formula: Yearly Dividend Per Share / Earnings Per Share OR Dividends / Net Income
• Measures the amount of income that translates to dividends in a year.
• Low ratio could indicate lacking funds generated from operations or poor financial health. Conversely, a high ratio may indicate a return of capital in excess of funds generated from operations, which could indicate financial difficulties.