Financial Statement Analysis Tools

Chapter 3: Financial Statement Analysis Tools

Objectives

  • Discuss and interpret the analysis tools of financial statements.
  • Apply several basic financial statement ratios and techniques.
  • Identify relevant analysis information beyond financial statements.
  • Explain equity or valuation analysis methods.
  • Analyze the ratio usage and cautions in using financial tools.

Financial Analysis Tools

  • Basic tools of financial analysis include:
    • Comparative financial statements
    • Horizontal Analysis
    • Trend Index Analysis
    • Common size financial statements
    • Ratio analysis:
    • Profitability analysis
    • Credit analysis
    • Equity analysis and evaluation

Comparative Financial Statement Analysis

  • Involves reviewing consecutive financial statements (balance sheets, income statements) over multiple periods to identify trends.
  • Key insights include:
    • Trend direction
    • Speed
    • Extent of change
Horizontal Analysis
  • Shows changes in financial data between years as both amounts and percentages.
  • Calculation:
    • Amount Change = Current Year - Base Year
Trend Index Analysis
  • Utilizes a base year (100%) to express multiple years' financial data.
  • Calculation:
    • Trend Index = (Current Year Amount * 100) / Base Year Amount

Common Size Analysis

  • Involves expressing items in financial statements as percentages of a total.

  • Useful for:

    • Understanding asset distribution (balance sheet)
    • Analyzing expense distribution over sales (income statement)

  • Types of Common Size Analysis:

    • Common size income statements
    • Common size balance sheets

Ratio Analysis

  • A method for assessing a company's strengths, weaknesses, and insights into performance.
  • Major classifications include:
    • Liquidity Ratios: Assess ability to cover short-term obligations.
    • Leverage Ratios: Indicate financial leverage and debt proportions.
    • Activity Ratios: Examine efficiency of assets conversion into sales.
    • Profitability Ratios: Measure earnings relative to costs over time.
Liquidity Ratios
  • Measure short-term debt-paying ability. Higher values indicate better safety margins.
    • Current Ratio:
    • Formula: Current Assets / Current Liabilities
    • Acid-Test Ratio:
    • Formula: (Cash + Accounts Receivable + Short-term Investments) / Current Liabilities
    • Working Capital:
    • Formula: Current Assets - Current Liabilities
    • Working Capital Turnover:
    • Formula: Sales / Working Capital
Leverage Ratios
  • Debt Ratio:
    • Indicates proportion of debt to assets. Formula: Total Debt / Total Assets
  • Debt/Equity Ratio:
    • Measures financial leverage. Formula: Long Term Debt / Shareholders’ Equity
Activity Ratios
  • Assess ability to turn accounts into cash or sales.
    • Inventory Turnover:
    • Formula: Cost of Goods Sold / Average Inventory
    • Receivables Turnover:
    • Formula: Sales / Average Accounts Receivable
Profitability Ratios
  • Measure ability to generate earnings relative to expenses.
    • Net Profit Margin:
    • Formula: Net Income / Revenue
    • Return on Assets (ROA):
    • Formula: Net Income / Total Assets
    • Return on Equity (ROE):
    • Formula: Net Income / Shareholders’ Equity

DuPont Analysis

  • Breaks down ROE into its components to identify sources of profitability.
    • Formula: Net Profit Margin x Total Asset Turnover x Financial Leverage

Valuation Analysis

  • Compare ratios over time or against industry averages. Important for trend analysis and benchmarking.

Cautions in Using Ratios

  • Ratios alone do not confirm problems.
  • Differences in company characteristics can lead to misinterpretation.
  • Ensure calculations align with industry standards and practices.
  • Financial statement audit is crucial for accurate analysis.