Eastern University, Sri Lanka

Faculty of Commerce and Management

Department of Commerce
DAF 2033 – Fundamentals of Corporate Finanace

Session 01 – Financial Statement Analysis

CHAPTER OVERVIEW

Financial statements are the primary means an outsider uses to evaluate a particular
company. Once completed, the results can be compared with other companies. There
are a variety of tools used to evaluate performance. In this chapter you are introduced
to some of these techniques. The learning objectives for the chapter are to:

1. Perform a horizontal analysis of comparative financial statements

2. Perform a vertical analysis of financial statements
3. Prepare common-size financial statements
4. Calculate the standard financial ratios used for decision-making
5. Measure economic value added by a company’s operations

CHAPTER REVIEW

Financial statement analysis is based on information taken from the annual report,
reports lodged with the ASIC, articles in the business press, and so on. The objective
of financial statement analysis is to provide information to creditors and investors to
help them 1) predict future returns and 2) assess the risk of those returns. Past
performance is often a good indicator of future performance. Three categories
of financial statement analysis are horizontal, vertical, and ratio analysis.

Objective 1 - Perform a horizontal analysis of comparative financial

statements.

The study of percentage changes in comparative statements is called horizontal

analysis. Horizontal analysis highlights changes over time. Calculating a percentage
change in comparative statements requires two steps: 1) calculate the dollar amount
of the change from the base period to the later period, and 2) divide the dollar amount
of the change by the base period amount.

The base period for horizontal analysis is the year prior to the year being considered.
Suppose there are three years of data. The change from Year 1 to Year 2 is:

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 Rs. YEAR 2 - Rs. YEAR 1
Rs. YEAR 1

and the change from Year 2 to Year 3 is:

Rs. YEAR 3 - Rs. YEAR 2

Rs. YEAR 2

Trend percentages are a form of horizontal analysis. They indicate the direction of
business activities by comparing numbers over a span of several years. Trend
percentages are calculated by selecting a base year and expressing the amount of
each item for each of the following years as a percentage of the base year’s amount.
That sounds complicated - what it means is you are taking, say, sales in year four and
divide it by sales in year one and that shows sales in the fourth year as a percentage
of sales of the first year.

Objective 2 - Perform a vertical analysis of financial statements.

Vertical analysis of a financial statement reveals the percentage of the total that each
statement item represents. Percentages on the comparative income statement are
calculated by dividing all amounts by net sales. Percentages on the comparative
statement of financial position are shown as either 1) a percentage of total assets or
2) a percentage of total liabilities and shareholders’ equity.

Vertical analysis of the income statement highlights changes in such items as

the gross profit percentage and net profit.

Vertical analysis of the statement of financial position shows the composition of

statement of financial position items. Trend analysis can be used to highlight year-to-
year percentage changes.

Objective 3 - Prepare common-size financial statements.

Common-size statements report amounts in percentages only. The common-size

statement is a form of vertical analysis. On a common-size income statement, each
item is expressed as a percentage of the net sales amount. In the statement
of financial position, the common-size is the total on each side of the accounting
equation. Note that common-size percentages are the same percentages shown on
financial statements using vertical analysis.

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Benchmarking is the practice of comparing a company to a standard set by
other companies. Benchmarking is used to compare a company’s results with the
average for their industry. In addition, common-size statements can be compared with
those of specific competitors within the industry.

Common-size percentages can be used to compare financial statements of different

companies or to compare one company’s financial statements to previous years or
industry averages.

Objective 4 - Calculate the standard financial ratios used for decision-making.

There are many, many different ratios used in financial analysis. Sometimes a ratio is
used alone but more frequently a group of ratios is calculated and used to analyse a
particular issue. The ratios discussed in this section are grouped as follows:

1. ratios that measure the company’s ability to pay current liabilities

2. ratios that measure the company’s ability to sell inventory and
collect
receivables
3. ratios that measure the company’s ability to pay long-term debt
4. ratios that measure the company’s profitability
5. ratios used to analyse the company’s shares as an investment

Rather than trying to ‘rote’ learn the ratios, think of what the name tells you about the
ratio. The name of the ratio is usually a good guide to the formula of the ratio. Then
think why we are calculating the ratio, many are common sense. If I told you I earned
Rs.100,000 on my investments, before you gave me your money to invest you would
want to know how much money I had invested. If it was Rs.200,000 I am an excellent
investor but if it was Rs.30 million, I am a very poor investor. How do you know? You
have just calculated ‘rate of return on total assets’.

1. Ratios that measure the company’s ability to pay current liabilities

Working capital is used to measure a business’s ability to meet its short-term

obligations with its current assets.

WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

The current ratio is used to measure the availability of sufficient current assets to
maintain normal business operations.

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 CURRENT RATIO = CURRENT ASSETS
CURRENT LIABILITIES

The acid-test (or quick) ratio measures the ability of a business to pay all of its
current liabilities if they came due immediately.

CASH + SHORT-TERM + NET CURRENT

ACID-TEST RATIO = INVESTMENTS
RECEIVABLES
CURRENT LIABILITIES

Study Tip: Inventory and prepaid expenses are not used to calculate the acid-test ratio.

2. Ratios that measure the company’s ability to sell inventory and collect
receivables

Inventory turnover is a measure of the number of times a company sells an average

level of inventory during a year.

INVENTORY TURNOVER = COST OF GOODS SOLD

AVERAGE INVENTORY

AVERAGE INVENTORY = BEGINNING INVENTORY + ENDING INVENTORY

2

Accounts receivable turnover measures the ability of a company to collect cash

from its credit customers.
ACCOUNTS = NET CREDIT SALES
RECEIVABLE

TURNOVER AVERAGE NET ACCOUNTS RECEIVABLE

AVERAGE NET BEGINNING ENDING

ACCOUNTS = ACCOUNTS RECEIVABLE + ACCOUNTS
RECEIVABLE
RECEIVABLE 2

Days’ sales in receivables measures in sales days the value of accounts receivable;
it tells how many days’ sales remain uncollected (in accounts receivable).

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 ONE DAY’S = NET SALES
SALES
365

DAYS’ SALES IN
ACCOUNTS = AVERAGE NET ACCOUNTS RECEIVABLE
RECEIVABLE ONE DAY’S SALES

To calculate the ratio for the beginning of the year, substitute beginning net Accounts
Receivable for average net Accounts Receivable. To calculate the ratio for the end of
the year, substitute ending net Accounts Receivable for average net Accounts
Receivable.

3. Ratios that measure the company’s ability to pay long-term debt

The debt ratio measures the relationship between total liabilities and total assets.

DEBT RATIO = TOTAL LIABILITIES

TOTAL ASSETS

The times-interest-earned ratio measures the ability of a business to pay interest

expense.

TIMES- PROFITS BEFORE BOTH

INCOME
INTEREST- = TAX AND INTEREST EXPENSE
EARNED

RATIO INTEREST EXPENSE

Remember that profits before income tax and interest expense is what profits would
be if we paid no interest expenses and no tax.

4. Ratios that measure the company’s profitability

Rate of return on net sales measures the relationship between net profit and sales.

RATE OF RETURN = NET PROFIT

ON NET SALES NET SALES

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Rate of return on total assets measures the success a company has in using its
assets to earn a profit.

RATE OF NET PROFIT BEFORE BOTH INCOME

RETURN ON = TAX AND INTEREST EXPENSE
TOTAL AVERAGE TOTAL ASSETS
ASSETS

AVERAGE = BEGINNING TOTAL ASSETS + ENDING TOTAL

TOTAL ASSETS

ASSETS 2

The rate of return on ordinary shareholders’ equity shows the relationship between
net profit and the ordinary shareholders’ investment in the company.
RATE OF RETURN ON
ORDINARY = NET PROFIT - PREFERENCE DIVIDENDS
SHAREHOLDERS’
EQUITY AVERAGE ORDINARY SHAREHOLDERS’
EQUITY

AVERAGE
ORDINARY
SHAREHOLDERS’ = BEGINNING + ENDING ORDINARY SHAREHOLDERS’
EQUITY
EQUITY 2

Earnings per share (EPS) is the amount of net profit per share of the company’s
ordinary share.

EPS = NET PROFIT - PREFERENCE DIVIDENDS

NUMBER OF SHARES OF ORDINARY SHARE ISSUED

Study Tip: Remember, if the number of shares issued has changed during the year, the
denominator is changed to reflect the weighted average number of shares issued.

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5. Ratios used to analyse the company’s shares as an investment

The price/earnings (P/E) ratio is the ratio of the market price of an ordinary share to
the company’s EPS.

PRICE/EARNINGS = MARKET PRICE PER SHARE OF ORDINARY SHARE

RATIO EARNINGS PER SHARE

Dividend yield is the ratio of dividends per share to the share’s market price per
share.

DIVIDENDS YIELD ON = DIVIDENDS PER ORDINARY SHARE

ORDINARY SHARES MARKET PRICE PER ORDINARY SHARE

The formula for calculating book value per ordinary share is:

BOOK VALUE PER = TOTAL SHAREHOLDERS’ EQUITY - PREFERENCE

EQUITY
ORDINARY SHARE NUMBER OF ORDINARY SHARES ISSUED

Ratios should be 1) evaluated over a period of years, and 2) compared with industry
standards. For example the inventory turnover of a florist would be very different to that
of a bookshop. Ratios also contain all the limitations of the accounting
information on which they are based. Assets, especially land and buildings, recorded
at historical cost can distort return on assets. Ratios are based on past information but
are used to predict the future.

Objective 5 - Measure economic value added by a company’s operations.

Economic value added (EVA) is one measure many companies use to evaluate
whether the company has increased shareholder wealth from operations. The formula
for EVA is:

Net profit + interest expense - capital charge

Capital charge is bills payable plus loans payable plus long-term debt and
shareholders’ equity all times the cost of capital. The cost of capital is the weighted
average of the returns demanded by the company’s shareholders and lenders. Newer
companies, because of the added risk, have a higher cost of capital compared with
older, more established companies.

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The underlying assumption behind EVA is that returns to both shareholders and
lenders should be greater than the company’s capital charge. If the calculation results
in a positive value, the result indicates an increase in shareholder wealth. If negative,
shareholders may consider selling the share that could lower the price of the share.
Obviously, companies who use this measure strive to achieve a positive result.

Another way to analyse a company is to look for red flags that may signal financial
trouble:
Earnings problems
Decreased cash flow
Too much debt (high debt is not necessarily bad, but it does indicate
an increase in risk)
Inability to collect receivables
Build-up of inventory
Sales, inventory and receivables moving in different directions.

Annual reports contain a wealth of information beyond the financial statements and the
notes to the accounts, the chairperson’s and chief executive officer’s (CEO) reports
and the auditor’s report. The auditor’ report provides an independent opinion as to
the ‘truth and fairness’ of the financial statements.

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