Financial Statement Analysis

Financial Statement Analysis
Mary Low
Waikato Management School
The University of Waikato
Mary Lo
Business Survival:
There are two key factors for business survival:
Profitability
Solvency
Profitability is important if the business is to
generate revenue (income) in excess of the
expenses incurred in operating that business.
The solvency of a business is important
because it looks at the ability of the business in
meeting its financial obligations.
Mary Lo

Financial Statement Analysis will help business
owners and other interested people to analyse
the data in financial statements to provide them
with better information about such key factors for
decision making and ultimate business survival.
Mary Lo

Purpose:
To use financial
organisations
statements
to
evaluate
an
Financial performance
Financial position.
To have a means of comparative analysis across time

in terms of:
Intracompany basis (within the company itself)
Intercompany basis (between companies)
Industry Averages (against that particular industrys averages)
To apply analytical tools and techniques to financial

statements to obtain useful information to aid decision
making.
Mary Lo

Financial statement analysis involves analysing the
information provided in the financial statements to:
Provide information about the organisations:
Past performance
Present condition
Future performance
Assess the organisations:
Earnings in terms of power, persistence, quality
and growth
Solvency
Mary Lo
Effective Financial Statement Analysis

To perform an effective financial statement
analysis, you need to be aware of the
organisations:
business strategy
objectives
annual report and other documents like articles about
the organisation in newspapers and business reviews.
These are called individual organisational factors.
Mary Lo
Effective Financial Statement Analysis

Requires that you:
Understand the nature of the industry in which
the organisation works. This is an industry factor.
Understand that the overall state of the economy
may also have an impact on the performance of
the organisation.
Financial statement analysis is more than just
crunching numbers; it involves obtaining a
broader picture of the organisation in order to
evaluate appropriately how that organisation is
performing
Mary Lo
Tools of Financial Statement Analysis:

The commonly used tools for financial statement
analysis are:
Financial Ratio Analysis
Comparative financial statements analysis:
Horizontal analysis/Trend analysis
Vertical analysis/Common size analysis/ Component
Percentages
Mary Lo
Financial Ratio Analysis

Financial ratio analysis involves calculating and analysing
ratios that use data from one, two or more financial
statements.
Ratio analysis also expresses relationships between
different financial statements.
Financial Ratios can be classified into 5 main categories:
Profitability Ratios
Liquidity or Short-Term Solvency ratios
Asset Management or Activity Ratios
Financial Structure or Capitalisation Ratios
Market Test Ratios
Mary Lo
3 elements of the profitability analysis:
Analysing on sales and trading margin
focus on gross profit
Analysing on the control of expenses

focus on net profit
Assessing the return on assets and return

on equity
Mary Lo
Gross Profit % = Gross Profit * 100

Net Sales
Net Profit % = Net Profit after tax * 100
Net Sales
Or in some cases, firms use the net profit before tax figure. Firms
have no control over tax expense as they would have over other
expenses.
Net Profit % = Net Profit before tax *100
Net Sales
Return on Assets =
Net Profit
Average Total Assets
Return on Equity =
Net Profit
Average Total Equity
* 100
*100
Mary Lo

Short-term funds management
Working capital management is important as it signals the firms ability
to meet short term debt obligations.
For example: Current ratio
The ideal benchmark for the current ratio is $2:$1 where there are two
dollars of current assets (CA) to cover $1 of current liabilities (CL).
The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL
represents liquidity riskiness as there is insufficient current assets to
cover $1 of current liabilities.
Mary Lo

Working Capital = Current assets Current Liabilities
Current Ratio =
Current Assets
Current Liabilities
Quick Ratio = Current Assets Inventory Prepayments

Current Liabilities Bank Overdraft
Mary Lo

Efficiency of asset usage
How well assets are used to generate revenues
(income) will impact on the overall profitability of the
business.
For example: Asset Turnover

This ratio represents the efficiency of asset
usage to generate sales revenue
Mary Lo

Asset Turnover =
Net Sales
Average Total Assets
Inventory Turnover =
Cost of Goods Sold

Average Ending Inventory
Average Collection Period = Average accounts Receivable

Average daily net credit sales*
* Average daily net credit sales = net credit sales / 365
Mary Lo

Long term funds management
Measures the riskiness of business in terms of debt
gearing.
For example: Debt/Equity
This ratio measures the relationship between debt and
equity. A ratio of 1 indicates that debt and equity funding
are equal (i.e. there is $1 of debt to $1 of equity) whereas
a ratio of 1.5 indicates that there is higher debt gearing in
the business (i.e. there is $1.5 of debt to $1 of equity). This
higher debt gearing is usually interpreted as bringing in
more financial risk for the business particularly if the
business has profitability or cash flow problems.
Mary Lo

Debt/Equity ratio = Debt / Equity
Debt/Total Assets ratio =
Equity ratio =
Debt
*100
Total Assets
Equity *100
Total Assets
Times Interest Earned = Earnings before Interest and Tax

Interest
Mary Lo
Market Test Ratios

Based on the share market's perception of the
company.
For example: Price/Earnings ratio
The higher the ratio, the higher the perceived
quality of the earnings by the share market.
Mary Lo
Market Test Ratios

Earnings per share =
Net Profit after tax

Number of issued ordinary shares
Dividends per share =
Dividends
Number of issued ordinary shares
Dividend payout ratio = Dividends per share *100

Earnings per share
Price Earnings ratio = Market price per share
Earnings per share
Mary Lo
Horizontal analysis/Trend analysis

Trend percentage
Line-by-line item analysis
Items are expressed as a percentage of a
base year
This is a time series analysis
For example, a line item could look at
increase in sales turnover over a period of
5 years to identify what the growth in sales
is over this period.
Mary Lo
Vertical analysis/Common size analysis/

Component Percentages
All items are expressed as a percentage of a
common base item within a financial statement
e.g. Financial Performance sales is the base
e.g. Financial Position total assets is the base
Important analysis for comparative purposes
Over time and
For different sized enterprises
Mary Lo
Limitations of Financial Statement Analysis

We must be careful with financial statement
analysis.
Strong financial statement analysis does not
necessarily mean that the organisation has a strong
financial future.
Financial statement analysis might look good but there
may be other factors that can cause an organisation to
collapse.
Mary Lo
Illustration: Financial statement analysis

The following financial statements of Walker Ltd
were prepared in accordance with New Zealand
GAAPs. Walker Ltd is a diversified enterprise
with its main interests in the manufacture and
retail of plastic products.
The financial statements of Walker Ltd need to be
analysed. An investor is considering purchasing
shares in the company. Relevant ratios need to
be selected and calculated and a report needs to
be written for the investor. The report should
evaluate the companys performance and
position
Mary Lo
Walker Ltd
Statement of Financial Position as at 31 March
Mary Lo
Walker Ltd
Statement of Financial Performance for year ended 31 March
Mary Lo
Walker Ltd
Statement of Cash Flows for the year ended 31 March
Mary Lo
Additional information:
Credit purchases for the year 2006 were $2,142,800.
General prospects for the major industries in which
Walker is involved look good with a forecast glut of oil set
to reduce the cost of production and world demand for
plastic remaining strong.
Benchmarks:
There are no exact benchmarks for Walker Ltd because it
is a diversified company. The following are average
indicators that relate to the plastic retailing and
manufacturing industries for the year 2006.
Gross profit margin

Net profit margin
Inventory turnover
Debt/equity ratio
Return on Assets
Return on Equity
25%
7%
6 times
0.6 : 1
12%
20%
Mary Lo
Relevant ratios
Important note: The calculations of the ratios in this illustration did not use averages for total assets, equity and
inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided.
Profitability
ratios:
Benchmarks
2005
2006
Gross Profit
Margin
Industry
25%
22%
22.7%
Net Profit
Margin
Industry
7%
7.1%
6.1%
Return on
Assets
12%
15.6%
15.5%
Return on
Equity
Industry
20%
32%
26%
Mary Lo
Asset
Management
ratios:
Benchmarks
2005
2006
Inventory
Turnover
Industry
6%
5.8 times
5.58 times
Asset Turnover
Not given
2.2
2.53
Mary Lo
Liquidity
ratios:
Benchmarks
2005
2006
Current Ratio
Ideal standard
2:1
Acceptable
standard
1:1
1.78:1
1.70:1
Quick Ratio
Ideal standard
2:1
Acceptable
standard
1:1
0.85:1
0.69:1
Days Payable
Standard
30 days
Credit
purchases not
available
49.19 days
Mary Lo
Financial
Structure
ratios:
Benchmarks
2005
2006
Debt/Equity
Industry
0.6:1
Standard
benchmark
1:1
1.05: 1
0.67:1
TIE
Standard
benchmark:
Between 3 and 5.
Below 3 risky.
Above 5 very
favourable
10.14 times
39.74 times
Mary Lo
Report
For the investor considering the purchase of shares in
the company, the return they will earn is the key financial
factor but an overall evaluation of the companys
performance and position is also important to get a
better picture of how well the company is actually doing.
ROE in 2006 is 26%. Whether or not this is attractive
depends on the perceived riskiness of this investment
and other alternatives available but this return is certainly
more attractive than current bank interest rates.
ROE has decreased by 4% but the companys ROE at
26% is still better than the industry average of 20%
Riskiness of business is being reduced by the significant
repayment of loan in 2006.
Mary Lo
Profitability
The NP% and ROA ratios show a small downward
trend in % over the 2 year period. ROE% ratio show a
more significant decrease but is still better than the
industry average.
Gross Profit Margin is slightly unfavourable at about
2.3% below the industry benchmark of 25%.
The horizontal analysis information show that Sales
have increased by 20%. However operating costs
have increased by 34%.
Asset Management
IT has gone down slightly from 5.8 to 5.58 times.
IT is still close to the industry benchmark of 6 times.
AT has increased showing more sales being
generated from asset usage
Mary Lo
Liquidity
Current ratios of 1.78:1 (2005) and 1.70: 1 are at
above acceptable levels but below ideal level.
Quick ratios appear more of a concern being below
acceptable levels in both years and even more so in
2006 (0.69:1).
Raises some concerns over the liquidity of the
business and inventory management (although IT
ratio only shows a slight decline in 2006).
Days Payable is a concern as there may be poor debt
payment management.
Mary Lo
Financial Structure
Although slightly higher than D/E industry benchmark
(0.67:1), business has become less risky due to the
significant repayment of loan in 2006.
TIE is extremely good for the business at 39.74 times
(well above 5 the standard benchmark).
Cash flow situation

Strong cash flow from operating activities (increased
from 160,600 to 185,000).
Spending under investing activities suggest more
growth.
Repayment of debt under financing activities imply
restructuring of business to have more equity funding
rather than debt funding.
Mary Lo
Recommendation
Given:
1) the strong forecast for the industry (ie general
prospects looking good and world demand for
plastic products remaining strong),
2) the sales growth in this business,
3) acceptable ratios as they are quite close to the
industry averages,
4) good cash flows from operating activities and
5) favourable ROE, although it has decreased, it
is still better than the industry average ROE.
=> it is recommended that the investor purchase shares
in the Walker Ltd company.
Mary Lo

Financial Statement Analysis

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