ANALYSIS OF FINANCIAL

STATEMENTS
 Financial Statement Analysis
• Learning Objectives:
After going through this lecture, you would be
able to have a better understanding of the
following concepts.
• Analysis of Financial Statements
• Key Financial Ratios
• Limitation of Financial Statements Analysis
• Market value added & Economic value added.
 Financial Markets
Capital Markets:
These are the markets for the long term debt & corporate
stocks. The maturity of debt should be more than one year
to qualify it as a capital market instrument.
• Stock Exchange:
A stock exchange is a place where the listed shares, Term
finance certificates (TFC) and national investment trust units
(NIT) are exchanged and traded between buyers and sellers.
• Long term bonds:
Long term government & corporate bonds are also traded in
capital markets.
 Financial Markets
Money Markets
Money market generally is a market where there is buying and selling
of short term liquid debt instruments. (Short term means one year or
less).Liquid means something which is easily en-cashable; an
instrument that can be easily exchanged for cash.
Short term Bonds
• Government of Pakistan: Federal Investment Bonds (FIB), Treasury-Bills
(TBills)
• Private Sector: Corporate Bonds, Debentures
• Call Money, Inter-bank short-term and overnight lending & borrowing
• Loans, Leases, Insurance policies, Certificate of Deposits (CD’s)
• Badlah (money lending against shares), Road-side money lenders
 Financial Markets
• Real Assets or Physical Asset Markets
• Cotton Exchange, Gold Market, Kapra (Cloth)
Market
• Property (land, house, apartment, warehouse)
• Property (land, house, apartment, warehouse)
• Computer hardware, Used Cars, Wheat, Sugar,
Vegetables, etc.
 Financial Statement Analysis
• A company’s financial statements need to be
studied for signs of financial strengths and
weaknesses and then compared to (or
benchmarked against) the industry.
• Before getting into the details of the financial
management techniques, we would briefly
revise some of the accounting concepts, which
are going to help us in comprehending those
analysis techniques.
 Basic Financial Statements:
• There are four basic financial statements that are
prepared by the financial accountants for the use
of the managers, creditors and investors of the
company. These statements are
a. Balance Sheet
b. P/L or Income Statement
c. Cash Flow Statement
d. Statement of Retained Earnings (or Shareholders’
Equity Statement)
 Basic Financial Statements:
• The concepts that we are going to discuss here in
reviewing financial accounting concepts are Fundamental
Accounting Equation and Double Entry Principle.
• Assets + Expense = Liabilities + Shareholders’ Equity +
Revenue (Note: Expense & Revenue are Temporary P/L
accounts – the others are Permanent Balance Sheet
Accounts)
• Left Hand Items increase when debited. Right Hand items
increase when credited.
• For every journal entry, the Sum of Debits = the Sum of
Credits
 Balance Sheet:
• The following facts about balance sheet are
also going to help us in understanding the
financial statements analysis process.
• – A balance sheet is a ‘static snapshot’ at one
point in time (therefore the consolidated data
available is vulnerable to inventory and cash
swings,
 Balance Sheet:
• i.e., if the balance sheet of a firm is showing low
inventory and high cash position at the year
ending when the balance sheet is prepared, the
company may buy excessive inventory against
cash the very next day. The balance sheet
prepared a day earlier would not report the new
transaction and the latest financial position of
the company would not be known to the analyst,
unless the company updates him on that.)
 Balance Sheet:

• Balance sheet items or accounts are

‘permanent accounts’ that continue to
accumulate from one accounting cycle to the
next.
 Balance Sheet:
• Balance sheet items are recorded on historical cost
basis, i.e., the balance sheet neglects any increase
in value of assets resulting from inflation and
reports assets and liabilities at their book value. It is
a big limitation for financial analysts, since a useful
analysis could only be made by considering the
assets and liabilities at their market value rather
than book value. Nevertheless, there are some
approaches by which we can solve this problem.
Constant rupee approach is one such remedy
 Balance Sheet:
• Constant Rupee Approach: In constant rupee
approach, two balance sheets of the same
company for different times are compared at a
specific time and inflationary adjustments are
made.
 Balance Sheet:
• Assets (Left Hand Side):
• Having revised certain concepts and
imitations of financial accounting process and
financial statements, we would now have a
brief overview of the items that appear on the
left-hand side of the balance sheet, known as
assets.
 Balance Sheet:
• – Assets are economic and business resources that
are used in generating revenue for the
organization: They can be tangible (inventory) or
intangible (patent, brand value, license). Some
assets are classified as current (cash, accounts
receivable) and others are fixed (machinery, land,
and building). There are also long-term assets
(property, loans given) and contingent assets, the
value of which can only be assessed in future (legal
claim pending, option).
 Balance Sheet:
• Current Assets = Cash + Marketable Securities
+ Accounts Receivable + Pre-Paid Expenses +
Inventory
 Balance Sheet:
• The accounts receivable aging schedule is a
listing of the customers making up total
accounts receivable balance. Most businesses
prepare an accounts receivable aging schedule
at the end of each month. Analyzing your
accounts receivable aging schedule may help
you identify potential cash flow problems.
 Balance Sheet:
• Inventory value (at any instant in time) is a
very controversial figure which depends on
inventory valuation methodology (i.e. FIFO,
LIFO, Average Cost) and Depreciation Method
(i.e. Straight Line, Double Declining,
Accelerated). Companies have the flexibility
that they can use one methodology for
preparing the financial statements & the
different methodology for tax purposes.
 Balance Sheet:
• Liabilities (Right Hand Side):
• The right hand side of the balance sheet
represents liabilities.
• – Liabilities are sources which are use to
acquire the resources or liabilities are
obligations of two types:
1) Obligations to outside creditors and
2) Obligations to shareholders known as Equity.
 Balance Sheet:
Liabilities (Right Hand Side):
• Liabilities can be short term debts, long term
debt, equity, retained earnings, contingent,
unrealized gain on holding of marketable
securities
• – Current Liabilities = Account Payables + Short
Term Loans + Accrued Expenses
• – Net Working Capital = Current Assets –
Current Liabilities
 Balance Sheet:
Liabilities (Right Hand Side):
• – Total Equity = Common Equity + Paid In
Capital + Retained Earnings (Retained Earnings
is NOT cash always)
• – Total Equity represents the residual excess
value of Assets over Liabilities: Assets –
Liabilities = Equity = Net Worth
• – Only cash account represents real cash which
can be used to pay your bills!!
 Profit & Loss account or Income
Statement:
• – An income statement is a “flow statement” over a
period of time matching the operating cycle of the
business, which reports the income of the firm.
• – Generally, Revenue – Expense = Income
• – Right hand side receipts (revenues) are added. Left
hand side payments (expenses) are subtracted.
• – P/L Items or Accounts are ‘temporary’ accounts
that need to be closed at the end of the accounting
cycle.
 Profit & Loss account or Income
Statement:
• – Operating Revenue – Other Expenses +
Other Revenue = EBIT
• – EBIT – Financial Charges & Interest = EBT
Note: Leasing Treatment
• – EBT – Tax = Net Income
• – Net Income – Dividends = Retained Earnings
• – Net Income is NOT cash (it can’t pay for bills)
Profit & Loss account or Income
Statement:
 Cash Flow Statement:
• A cash flow statement shows the cash position of
the firm and the way cash has been acquired or
utilized in an accounting period.
• A cash flow statement separates the activities of the
firm into three categories, which are operating
activities, investing activities and financing activities.
• Operating Cash Flow Statement can be obtained by
using two approaches:
• 1) Direct
• 2) Indirect
 Cash Flow Statement:
• A cash flow statement can be derived from P/L or
Income Statement and two consecutive year
Balance Sheets.
• A cash flow statement is not prepared on accrual
basis but rather on cash basis: Actual cash receipts
and cash payments.
• The net income is obtained from the Income
Statement of a period of time matching the
operating cycle of the business. Generally:
• Revenue – Expense = Income
 Statement of Retained Earnings or
Shareholders’ Equity Statement
• Total Equity = Common Par Stock Issued + Paid
In Capital + Retained Earnings
• (Retained Earnings is the cumulative income
that is not given out as Dividend – it is NOT
cash)
 Statement of Retained Earnings or
Shareholders’ Equity Statement
• Total Equity = Common Par Stock Issued + Paid
In Capital + Retained Earnings
• (Retained Earnings is the cumulative income
that is not given out as Dividend – it is NOT
cash)
FINANCIAL RATIOS:
 LIQUIDITY & SOLVENCY RATIOS:
• Current Ratio: Current ratio is a ratio between current assets
and liabilities, which tells that for every dollar in current
liabilities, how many current assets do the company
possess. Since the current liabilities are usually paid out of
current assets, it makes sense to compare the two figures to
assess the liquidity of the firm. Liquidity implies the ease
with which the current liabilities can be paid off.
• Generally, the higher the ratio, the better it is considered,
but too high a ratio may imply less productive use of current
assets. A ratio of two to one (2:1) is considered ideal. =
Current Assets / Current Liabilities
 LIQUIDITY & SOLVENCY RATIOS:
• Quick/Acid Test ratio: Quick ratio is relatively a stringent
measure of liquidity. The ratio is obtained by subtracting
inventory from current assets and dividing the result by
current liabilities. Inventory is the least liquid of all current
assets. By subtracting inventory from current assets, we are
actually comparing more liquid assets with current liabilities.
• This ratio not only helps in gauging the solvency of the
company, it may also show if the inventories are piling up. A
desirable quick ratio can range from (0.8:1) to (1.5:1)
depending on the nature of the business. = (Current Assets –
Inventory) / Current Liabilities
 LIQUIDITY & SOLVENCY RATIOS:
• Average Collection Period: Also known as Days Sales
Outstanding, average collection period shows in how many
days the Accounts receivables of the company are converted
into cash. Most of the companies sell most of their
products/services on credit basis, hence it is critical for the
company to know in how much time these receivables could
be converted to cash in order to ensure liquidity at all times.
• Average collection period is calculated using the following
formula = Average Accounts Receivable /(Annual Sales/360)
Note: Average collection period is usually expressed in terms
of days. If you find a decimalized answer, you should round it
off to the next integer.
 PROFITABILITY RATIOS:
• The profitability ratios show the combine effects of
liquidity, asset management, and debt management on
operating result.
• Profit Margin (on sales): One of the most commonly used
ratios is profit margin on sales. This ratio tells the
percentage of profit for every dollar of revenue earned.
This ratio is usually expressed in terms of percentage and
the general rule is , the higher the ratio, the better it is.
Most of the companies compare this ratio to the previous
years’ ratios to assess if the company is better off.
• = [Net Income / Sales] X 100
 PROFITABILITY RATIOS:
• Return on Assets: Return on assets is another
profitability ratio, which shows the profitability of
the company against each dollar invested in total
assets. We can obtain this figure by simply by
dividing the net profit with total assets. Since the
assets are economic resources that are used to
earn profit, it is logical to assess if the assets have
been used efficiently enough to generate profits.
This ratio is also expressed in percentage terms. =
[Net Income / Total Assets] X 100
 PROFITABILITY RATIOS:
• Return on equity: Return on equity is of
special interest to the shareholders, since
equity represents the owners’ share in the
business. Return on equity can be obtained by
dividing the net income with the total equity.
This ratio shows that for each dollar in equity
how much profit is generated by the company.
= [Net Income/Common Equity]
 ASSET MANAGEMENT RATIOS
• These measures show how effectively the firm has been
managing its assets.
• Inventory Turnover: Inventory turnover shows the number of
times the inventories are replenished within one accounting
cycle. The ratio can be obtained by dividing the sales by
inventory. While the quick ratio measures the liquidity and
points out the inventory piling problem, the inventory
turnover confirms whether or not the major portion of the
current assets of the firm are tied up in inventory. This ratio is
also used in measuring the operating cycle and cash cycle of
the firm. A higher turnover is desirable as it reflects the
liquidity of the inventories. = Sales / inventories
 ASSET MANAGEMENT RATIOS
• Total Assets Turnover: An effective use of total assets
held by a company ensures greater revenue to the
firm. In order to measure how effectively a company
has used its total assets to generate revenues, we
compute the total assets turnover ratios, dividing the
sales by total assets.
• = Sales / Total Assets
• An increasing ratio over the years may show that with
an addition of assets, the company has been able to
generate incremental sales in greater proportion.
 DEBT (OR CAPITAL STRUCTURE) RATIOS:
• Debt-Assets: A commonly used ratio to measure the capital
structure of the firm is debt to assets ratio.
• Capital structure refers to the financing mix (proportion of
debt and equity) of a firm. The greater the proportion of debt
in the financing mix, the less willing creditors, and investors
would be to provide more finances to the company.
• In Pakistan, the debt to assets ratio is prescribed in prudential
regulations by the State Bank of Pakistan as a guideline for the
banks (creditors). A ratio greater than 0.66 to 1 is considered
alarming for the providers of funds.
= Total Debt / Total Assets
 DEBT (OR CAPITAL STRUCTURE) RATIOS:

• Debt-Equity: Another commonly used ratio,

debt to equity, explicitly shows the proportion
to debt to equity. A ratio of 60 to 40 is used for
new projects, i.e., for a project it is permitted
to raise its finances 60 percent from the debt
and 40 percent from equity. Debt to equity is
computed by the following formula.
• = Total Debt / Total Equity
 DEBT (OR CAPITAL STRUCTURE) RATIOS:
• Times-Interest-Earned: Times-interest-earned reflects the
ability of a company to pay its financial charges (interest). This
ratio is obtained by dividing the operating profit by the
interest charges.
• Conceptually, the interest charges are to be paid from the
earnings before interest and taxes. A ratio of 4 to 1 shows that
the company covers the interest charges 4 times, which is
generally considered satisfactory by the management,
however, a ratio higher than that, may be more desirable. A
high timeinterest- earned ratio is a good sign, especially for
the creditors.
• = EBIT / Interest Charges
 Market Value Ratios:
Market value ratios relate the firm’s stock price to its
earnings & book value per share. These ratios give
management an indication of what equity investors think
of the company’s past performance & future prospects.
• Price Earning Ratio:
• It shows how much investors are willing to pay per rupee
of reported profits. This ratio reflects the optimism, or
lack thereof, investors have about the future
performance of the company.
• = Market Price per share / *Earnings per share
 Market Value Ratios:
• Market /Book Ratio:
• Market to book ratio gives an indication how
equity investors regard the company’s value. This
ratio is also used in case of mergers, acquisition
or in the event of bankruptcy of the firm.
= Market Price per share / Book Value per share
• *Earning Per Share (EPS):
= Net Income / Average Number of Common
Shares Outstanding
 Limitations of Financial Statement
Analysis:
• Ratios help us to compare different businesses
in the same industry and of a similar size.
• Despite the fact that ratios are a useful
analysis tool, there are certain limitations,
which are important for an analyst to
understand before applying this tool, in order
to make his analysis more meaningful.
 Limitations of Financial Statement
Analysis:
• FSA is generally an outdated (because of Historical
Cost Basis) post-mortem of what has already
happened. It is simply a common starting point for
comparison. Use Constant Rupee / Dollar analysis
to account for inflation.
• FSA is limited by the fact that financial statements
are “window dressed” by creative accountants.
Window dressing refers to the understatement or
overstatement of financial facts.
 Limitations of Financial Statement
Analysis:
• Different companies use different accounting
standards for Inventory, Depreciation, etc.
therefore comparing their financial ratios can be
misleading
• FSA just presents a few static snapshots of a
business’ financial health but not the complete
moving picture.
• It’s difficult to say based on Financial Ratios
whether a company is healthy or not because that
depends on the size and nature of the business.
 Limitations of Financial Statement
Analysis:
• Difference in Focus:
• Financial Statements are prepared by financial
accountants with a certain perspective,
however the financial managers—the end
users of these financial statements, have a
different focus to draw meaningful
conclusions out of these statements. These
differences are listed on the next slide.
 Limitations of Financial Statement
Analysis:
• Financial Accounting (FA) Focus:
• Use Historical Value (assets are booked at
original purchase price)
• Follow Accrual Principle (calculate Net Income
based on accrued expense and accrued
revenue)
• •How to most logically, clearly, and completely
represent the financial data.
 Limitations of Financial Statement
Analysis:
• Financial Management (FM) Focus:
• •Use Market Value (assets are valued at current
market price)
• Follow Incremental Cash Flows because an
Asset’s (and a Company’s) Value is determined
by the cash flows that it generates.
• How to pick the best assets and liabilities
portfolios in order to maximize shareholder
wealth.
 Limitations of Financial Statement
Analysis:
• FM Measures of Financial Health:
• The financial management measures that are
used for assessing the financial health of a
company primarily focus on the basic
objective of financial management, i.e., to
increase the wealth of the shareholders.
 M.V.A (Market Value Added):
• Given below are the two important measures
of financial health.
• M.V.A (Market Value Added):
• Market Value Added is a measure of wealth
added to the amount of equity capital provided
by the shareholders. It can be determined by
the following equation
• MVA (Rupees) = Market Value of Equity – Book
Value of Equity Capital
 M.V.A (Market Value Added):
• Following are the characteristics of MVA
• It is a cumulative measure, i.e., it is measured from
the inception of the company to date. Market Value
is based on market price of shares.
• It shows how much more (or less) value the
management has succeeded in adding (or reducing)
to the company in the eyes of the general public /
market.
• It is used for incentive compensation packages for
CEO’s and higher level management.
 E.V.A (Economic Value Added):
• Economic Value Added, on the other hand,
focuses on the managerial effectiveness in a
given year. It can be obtained by subtracting
the cost of total capital from the operating
profits of a company
• EVA (Rupees) = EBIT (or Operating Profit) –
Cost of Total Capital
 E.V.A (Economic Value Added):
• EVA has the following characteristics
• It is measured for any one year.
• It is relatively difficult to calculate because
Operating Profit depends on Depreciation
Method, Inventory Valuation, and Leasing
Treatment, etc. Also, a combined Cost of Total
Capital (Debt and Equity) is difficult to
compute.