Financial Statement Analysis

Topic 7: 1 of 5
Financial Statement Analysis
LB5212: Accounting and Finance for Managers
Learning objectives
Know why we undertake financial statement

analysis
Understand the key sources of data for analysis
within the published financial report
Be able to carry out and interpret a vertical
analysis
Be able to carry out and interpret a horizontal
analysis
Be able to prepare and interpret a trend analysis
Introduction
Financial analysis adds further meaning to the reported

numbers, allowing users to make a better assessment of a firms
profitability
liquidity
efficiency
capital structure and
market performance
To conduct any analysis we require information. One public

source of information of companies are the financial statements.
Comparing Figures:
It is essential in financial analysis to compare figures with:
the equivalent figures from previous years
other figures in the financial statements
industry averages
Start your analysis with the

financial statements and
report
The users of financial reports can broadly be

categorised as:
Resource providers (e.g. creditors, lenders,
shareholders, employees)
Recipients of goods and services (i.e.
customers, debtors)
Parties performing an overview or regulatory
function (e.g. tax office, corporate regulator,
statistical bureau, ASIC)
Internal management - to assist in their
decision-making capacity
Why do we analyse
financial statements?
Why are we doing the analysis?

Answering this question guides the type of analysis
conducted and the type of information required
Whilst analyses of various forms assist in identifying the
good and the bad they do not offer solutions on
how to overcome problems, and they do not tell us how
the business got to the point we are observing.
Further contextual research is required to answer
these questions.
Analysis has no meaning in itself, it acquires meaning
when it is carried out and interpreted in the context of
the business, and its operating and strategic
environments
Context / Environment /
Industry
Initial
look
Types of
Revenues/expenses
Types of
Assets/Liabilities
Deeper
look
Vertical Analysis
Horizontal Analysis
Trend Analysis
Deeper
Again
Profitability
Liquidity
Capital Structure
Market Performance
Asset Efficiency
Financial statements
include all of the
following:
Income Statement
Balance Sheet
Statement of Cash Flows
Independent Auditors report
Directors Declaration
Notes to the Financial Statements
Independent Auditors
Report and Directors
Declaration
Independent Auditors Report
Audit conducted in accordance with Australian Auditing Standards
Opinion based on their audit process that the financial statements are in
accordance with:
The Corporations Act, including:
Giving a true and fair view of the companys performance and

position.
Compliance with Australian Accounting Standards and the

Corporations Regulations.
Other mandatory professional reporting requirements.

Directors Declaration
That the Financial Statements are in accordance with Corporations Act
including:
Giving a true and fair view of the companys performance and

position.
Compliance with AASBs and Corporations Regulations.
That there are reasonable grounds to believe the company will be

able to meet maturing debts as they fall due i.e. it was solvent at the
Notes to the statements
Look at the notes to company financials.

The notes provide a greater level of detail
and are required by the AASBs.
The level of detail would not be feasible
within the statements themselves, but this
detail is essential in facilitating meaningful
analysis and conclusions.
Seek meaningful context

and comparisons
Figures on their own are not very meaningful.
Identify the businesss nature, and understand

the operating environment and strategic context
of the business.
To make figures meaningful it is essential to

compare figures with:
the equivalent figures from previous years,
other figures in the financial statements,
industry figures, and
trends that occur over time.
Remember
A single number could mean

anything
Two figures gives us a
comparison
Three gives us a TREND!
insight)
(greater
Three main methods of

analysis
1.
Horizontal analysis and Trend analysis (short and

longer time series)
2.
Vertical (common size) analysis
3.
Ratio analysis
An expression of one item in the financial statements
relative to another item in the financial statements
The ratio comparison can be between two different
statements, or within one statement
1 Horizontal Analysis
Eves Enterprises
Income Statement for years ending 30 June
20X4
20X3
20X2
($ M)
($ M)
($ M)
Sales revenue
800
350
200
Less Cost of goods sold
352
147
80
Gross Profit
448
203
120
Less Expenses
217
142
103
Wages
90
70
60
Rent
22
16
10
Other expenses
20
12
Advertising
64
28
16
Depreciation expense
10
Administration expense
11
231
62
17
EBIT
LB5212: Accounting and Finance

for Managers
What
can you
make of
these
figures
?
13
Horizontal Analysis
Compares reported numbers in the current period

with equivalent numbers for a preceding
period/s.
Frequently expressed as
a monetary value or
as a percentage
Essentially it looks at the change in monetary

value of an item from one year to the next.
The change in monetary values can also be

expressed as a % of the original i.e. the $ change
from 20X3 20X4 is expressed as a % of 20X3
figure to see what % change has taken place
for Managers
14
Horizontal analysis
Freds Enterprises - Income Statement for years ending 30 June
Where change % =
(Yr 2 Yr 1)/Yr 1 x
100
or
(2013-2012)/2012
Sales revenue
x 100
Horizontal Analysis
2014
2013
2012
2014
2013
Change
($ M)
($ M)
($ M)
($ M)
2013
2012
Change
2014
2013
Change
2013
2012
Change
($ M)
800
350
200
450
150
128.6
75.0
352
147
80
205
67
139.5
83.8
Gross Profit
448
203
120
245
83
120.7
69.2
Less Expenses
217
142
103
76
39
53.6
37.4
Wages
90
70
60
20
10
28.6
16.7
Rent
22
16
10
37.8
60.0
Other expenses
20
12
66.7
100.0
Advertising
64
28
16
36
12
128.6
75.0
10
25.0
33.3
11
50.0
50.0
231
62
17
169
45
275.1
261.8
EBIT
Horizontal Analysis
contd
Compare changes over the periods to see what changes

are occurring.
Ideally REVENUE should be increasing at a greater %

than the various expenses including COGS.
Look at the increase in Revenue, COGS and GP What do

you notice (all three are increasing year on year in $
terms - but which are increasing at a faster rate look
at the % change).
With increases in Revenue, you would expect some

increase in Expenses, depending on how much are fixed
or variable however, the rate of increase in expenses
must be less than the rate of increase in revenue,
otherwise profit will erode over time as more growth
occurs.
An example of a trend
TLS 5 year share price, Yahoo Finance 13/03/15
Compare this trend with others by

plotting them on the same chart.
Freds Enterprises - Income Statement for years ending 30 June
Vertical analysis
2014
2013
2012
2014
2013
2012
($ M)
($ M)
($ M)
Sales revenue
800
350
200
100.0
100.0
100.0
352
147
80
44.0
42.0
40.0
Gross Profit
448
203
120
56.0
58.0
60.0
Less Expenses
217
142
103
27.2
40.4
51.5
Wages
90
70
60
11.3
20.0
30.0
Rent
22
16
10
2.8
4.6
5.0
Other expenses
20
12
2.5
3.4
3.0
Advertising
64
28
16
8.0
8.0
8.0
10
1.3
2.3
3.0
11
1.4
2.1
2.5
231
62
17
28.8
17.6
8.5
EBIT
Vertical Analysis
Highlights changes of a single variable over time in the Income

Statement as a % of sales, in the Balance Sheet as a % of total
assets
Can be very useful to monitor variables of interest e.g. gross

profit, inventory levels, advertising expense
Also useful to look at the changes of expense items e.g. wages, to

see their proportion to the anchor figure such as sales. Ask how
much of each sales dollar is spent on wages and salaries costs?
Frequently used together with horizontal analysis as they

complement each other
Compare businesses in the same industry, but which differ in size

(common size analysis ) results are compared relative to their
own performance e.g. small retailer vs large retailer
Eves Enterprises - Income Statement for years ending 30 June
Vertical analysis
Where % =
Each item/ Sales Rev
20X4
20X3
20X2
20X4
20X3
20X2
($ M)
($ M)
($ M)
Sales revenue
800
350
200
100.0
100.0
100.0
352
147
80
44.0
42.0
40.0
Gross Profit
448
203
120
56.0
58.0
60.0
Less Expenses
217
142
103
27.2
40.4
51.5
Wages
90
70
60
11.3
20.0
30.0
Rent
22
16
10
2.8
4.6
5.0
Other expenses
20
12
2.5
3.4
3.0
Advertising
64
28
16
8.0
8.0
8.0
10
1.3
2.3
3.0
11
1.4
2.1
2.5
231
62
17
28.8
17.6
8.5
EBIT
LB5212: Accounting and Finance for

Managers
20
Vertical Analysis
example contd
Sales is 100% (the base, or anchor point)
Over the 3 years the COGS as a % of sales has

increased from 40 44% resulting in a decreasing
ability of GP to cover operating costs
However, the proportion that total expenses makes up

of Sales has decreased from 51.5% 27.2% which
shows that relative to Sales expenses have been
controlled
Look at Advertising 5% for all three years and thus

the business is spending the same proportion on
Advertising
Now look at wages actually decreasing as a % of

sales as are all the
other expenses including
Depreciation
for Managers
21
Ratio analysis
Ratio analysis is as flexible and varied as are the

questions you ask of the data.
The only rule is to explore until you have
exhausted all avenues of analysis and data.
Ratios are illustrated throughout the course
material at relevant parts of topics.
Note the summary of ratio formulae in Table 10.1.
Topic 7: 2 of 5
Ratios - liquidity
Learning Objectives
Explain the Liquidity concept and be able to

describe and calculate the ratios that measure it
Understand the interrelationships between ratios
Appreciate the limitations of ratio analysis
Liquidity Ratios
The concept of liquidity relates to the ability of the

business to pay its obligations on time
Ideally the businesss operating cash flow will

enable it to meet its operating obligations each
day as a result, much of the liquidity analysis
focusses on cash and cash generating activities
Sometimes a major planned event may call for

extra funds such as would occur if a long term
loan matured and had to be repaid, or re-financed.
Liquidity Ratios
A) Current ratio
B) Quick or Acid test ratio
C) Cash ratio
D) Cash flow to sales ratio
E) Cash flow to Total debt
Liquidity is about cash

recall the operating cash
cycle
Purchase
of goods
on credit
Payment
to
suppliers
Creditors
Turnover
Sale of
goods on
credit
Cash
received
from debtors
Debtors
turnover
Inventory
turnover
Operating cash cycle

Inventory Turnover (days)
+ Debtors Turnover (days)
- Creditors Turnover (days)
= Operating Cash Cycle
A)
Current ratio
Current Assets
Current Liabilities
A businesss liquidity is its ability to meet its shortterm obligations

An arbitrary ratio of 1.5:1 is sometimes argued to
be considered a minimum, however this is a lazy
way of looking at the issue, because for some
business models 1.5 will be too high, and for others
it will be too low
DONT rely on rules of thumb in assessing the
meaning of ratios, assess them intellectually in the
context of the actual business
B)
Quick or Acid Test ratio

Current Assets less Inventory
Current Liabilities
An arbitrary benchmark ratio for the minimum

quick asset ratio is around $0.80 of current
assets, for every $1 of current liabilities however
this is a lazy way of looking at the issue,
because for some business models 1.5 will be too
high, and for others it will be too low
Again, dont rely on arbitrary rules, assess the
ratio in context
BEWARE!!
If a company
has anything
less than a 2:1
current ratio
they are in a
BAD place and
will be unable
to pay their
Wow!! Way to
debts!!! generalise!!
What is true for

one company
wont
necessarily be
true for
another
company.
USE YOUR
BRAIN
C)
Cash ratio
Cash + Marketable Securities (i.e. near cash)

Current Liabilities
A more stringent ratio looking at cash and near

cash in relation to current liabilities
Criticisms of these three

ratios
They are static ratios based on balance sheet

data we need to look at the firms liquidity
throughout the period.
Internal mangers do this via cash budgets
External users get financial reports when the

figures are already out of date i.e time lag from
closing date to distribution and at year end
D) Cashflow to Sales
ratio
Cashflow from operating activities
Sales
This indicates the ability of the firm to convert

Sales into Cash flow
Higher is better
E)
Cashflow to Debt ratio
Cashflow from operating activities

Total Debt
OR Cash = NP after tax + non-cash charges (e.g.
Depreciation)
This is a ratio that has successfully been used as
a predictor of corporate bankruptcy
Numerator = Profit plus add back non-cash
expenses. This amount is an indicator of the
firms ability to repay the debt from its operations
after meeting all costs
The greater the ratio the quicker the firm would
be able to repay the principal amount.
If ratio = 0.10 it means that the firm would take
10 years to repay the principal amount from
Exercise time
Questions 1 & 2, Week 7
35
Topic 7: 3 of 5
Ratios - efficiency
Learning Objectives
Explain the Asset Efficiency concept

and be able to describe and calculate the
ratios that measure it
Understand the interrelationships between

ratios
Efficiency Ratio and Net Working

Capital
We need to understand why mangers

want to control Net Working Capital
first..
You may need to go over last weeks materials again
Efficiency ratios
Asset efficiency relates to the ability of a firms

assets to generate income the more income
generated from assets, the greater is the
efficiency of that asset group
Efficiency (activity) ratios measure how efficiently

the available business resources have been used
Many of these ratios can also be viewed as an

indicator of managements ability or efficiency in
managing the underlying asset (e.g. inventory) or
liability (creditor)
Efficiency Ratios
A) Asset turnover
B) Days Inventory
C) Days Debtors
D) Days Creditors
A)
Asset turnover ratio

Sales (Revenue) * 100
Average total assets
[Where Av. total assets = opening assets + closing assets]

2
Measures a firms overall efficiency in generating sales per dollar

of investments in assets
Why use Average Total Assets? Static start and end of year
figures, so use the mid point provided the environment is
reasonably stable.
If you have only one balance sheet, then you cannot average, so
use the end of year figure
B1) Number of Days of

Inventory
Days to sell inventory =
Average Stock
Cost of average days sales
[Where: Cost of average days sales = COGS
p.a. / 365]
Average Stock = Average Stock * 365
COGS / 365
Cost of Goods Sold
Example: (142+166)/2 x 365 = 103days
544
B2) Inventory Turnover

Example: (142+166)/2 x 365 = 103days
544
Since Inventory held averages103 days, we must
order it
every (365 / 103) = 3.54 times per annum
Thus stock is turned over 3.54 times per year
Can also be calculated using:
COGS / Average Stock =
166)/2)
= 3.54 times
544 / ((142 +
B)
Inventory efficiency
Interpretation
Average period of time it takes for a firm to
sell its inventory will depend on industry
Notice that slower turnover, means

correspondingly higher number of days held
If average stock doesnt reflect stock levels,

e.g in the case of highly seasonal industries,
then adjust calculation appropriately but
this is more for internal users, since data are
not available for external users
If COGS not available we would have to use

Sales, but this mis-matches, because
Inventory is at Cost, and Sales are at markedup selling price.
C1) Number of Days of

Debtors
Days to collect debtors = Average Debtors
Average Days Sales
(ideally credit Sales, but this figure is not
available externally)
[Where: Average days (credit) sales = Sales /
365]
Average Trade Debtors * 365
Sales (credit if possible)
Example:
days
= ((45+55)/2) * 365) / 500 = 36.5
C2) Debtors Turnover

Example: = ((45+55)/2) * 365) / 500 = 36.5 days
Thus Debtors turn on average 365 / 36.5 = 10 times p.a.
or
Debtors (Accounts Receivable) Turnover
= Sales / Trade Debtors
= 500 / 50 = 10 times
C)
Debtors efficiency
If the average collection period increases over time (i.e.

the receivables turnover decreases), it means that the
level of average receivables is increasing at a faster
rate than the level of sales
This might be intended as a marketing strategy - increase

sales by relaxing credit terms OR might be inefficiency in
credit screening and collection policies
Whilst profit from sales may increase - there is the possibility of

greater bad debts plus costs of holding these accounts (you are
financing your customer)
It also has the potential to impact on the firms liquidity - may
need to obtain further operating financing. Need to balance your
receipts from debtors and your payments to creditors.
D) Number of Days of
Creditors
Accounts Payable Days
Trade creditors / Purchases (credit if possible)*365
60/500*365 = 43.8 days
or
365 / 8.33 = 43.8 days
Accounts Payable Turnover

Purchases (credit ideally) / Trade creditors (Average)
500 / 60 = 8.33 times
The operating cash cycle

Purchase of
goods on
credit
Sale of
goods on
credit
Payment
for goods
Credito
rs
Turnove
r
Stock turnover
Cash received
from debtors
Debtor
s
turnov
er
Operating cash cycle

Stock Turnover (days)
+ Debtors Turnover (days)
- Creditors Turnover (days)
= Operating Cash Cycle
Exercise time
Questions 3 - 5, Week 7
50
Topic 7: 4 of 5
Ratios - profitability
Learning Objectives
Explain the concept of Profitability and be able

to describe and calculate the ratios that
measure it
Profitability Ratios
Profit is not the same concept as profitability
Profit is measured in absolute $ terms at a POINT in time

Profitability refers to the firms performance throughout the
reporting period thus over a PERIOD of time
Profitability relates a businesss profit to the resources

(assets or equity) available to generate that profit and
the effectiveness in converting income into profit
Thus comparing one business with another may show

one generating lower profit ($ terms) but having greater
profitability meaning it uses its assets better
Assists to assess the businesss degree of success in

creating wealth for its owners
Profitability Ratios
A) Return on Equity (ROE)
B) Return on Assets (ROA)
C) Gross Profit margin
D) Net profit margin
E) Expense Ratios
A) Return on Equity
(ROE)
Profit available for distribution * 100
Average Equity
Generally stated as % (sometimes as a decimal)
Relates profit attributable to owners to their investment
Usual to exclude extraordinary items & Preference Dividend
Should show trend upwards over time
Will be compared with other investments
Reflects businesss profitability, efficiency and capital
structure
B) Return on Assets
(ROA)
EBIT * 100
Average Total Assets
Compares the businesss EBIT profits to the assets
available to generate them
Looks at the generation of profit i.e.
generate sales from the assets at its disposal
convert sales into profits (revenue less
expenses)
NOTE: EBIT = Earnings before interest and tax
C)
Gross Profit Margin

Gross Profit * 100
Sales or Revenue
Reflects the proportion of sales dollars that remains as gross

profit after accounting for the cost of the item sold (COGS)
Gross profit has to then be able to cover all operating

expenses and leave enough for a profit, and ultimately a
return to shareholders
Why are management interested in this ratio? It is a

strategically determined KPI should never be left to
chance, but should be determined as part of strategy, and
monitored continuously
C)
Gross Profit Margin
The following factors can lead to a change in the GP ratio

Increase in Avg Selling Prices - Volumes constant
Increase in volumes - Avg Selling Price constant
A decrease in the production / purchasing costs
Combination of above
Most of the details of these choices are only known

internally
REMEMBER: Gross Profit Margin is a KPI within a
business, and is set as part of their positioning strategy
relative to competitors
D) Net Profit Margin
EBIT * 100
Sales or Revenue
Indicates what percentage of sales dollars
remains as profits after all expenses, but before
interest and tax.
Why do we remove these from the calculation?
Due to variations in capital structures & taxation
allowances within an industry, inter-firm
comparisons are only meaningful if they use EBIT
i.e. before interest and tax is deducted
EBIT is a performance benchmark for most
business, it is close to the cash profit of a
business
NOTE: EBIT = Earnings before interest and tax
E)
Expense ratios
Expense
(choose whichever expense you are interested n)
Revenue
Profits are a function of revenue and expenses
This ratio looks at the proportion a particular expense or

category or total expenses consume out of each revenue
dollar
This ratio ties in very closely with efficiency i.e. minimise

expenses and maximise revenue to generate highest possible
profits
Used extensively in service orientated firms where there is no

COGS and hence no GP Margin e.g. Banks
Remember to also use vertical analysis when understanding

expenses
Exercise time
Questions 6 - 9, Week 7
61
Topic 7: 5 of 5
Ratios capital structure
Learning Objectives
Explain Capital Structure and describe and

calculate the ratios that measure it
Capital Structure or
Solvency Ratios
Shows how the business is financing its assets

Solvency/Gearing (leverage) ratios
help to assess the degree of financing provided by

owners versus outsiders
this relationship affects the level of business risk
Capital structure ratios or gearing ratios are useful when

assessing a firms long-term viability i.e. solvency
TA/TL
Businesses set specific Debt /Equity targets which they
maintain and need to keep in mind when issuing further
debt or equity
May also be used by financiers to control risk levels e.g.
bank covenants
Remember.
How we finance the business matters!!
Debt comes at a cost (interest) and must be paid back

in regular payment
If we fail to make these payments we may face
bankruptcy
Equity also comes at a cost however it is delayed

We do not need to repay immediately
However shareholder expect
And increase in share value, and/or
Dividends
Equity comes with obligations attached to it
Capital Structure Ratios

A) Debt to equity
B) Debt ratio
C) Equity ratio
D) Interest cover
Capital Structure Ratios

(contd)
A) Debt to equity ratio:
Total Liabilities * 100
Total Equity
B) Debt ratio:
Total Liabilities * 100
Total Assets
C) Equity ratio:
Total Equity * 100
Note that the Debt ratio plus the Equity ratio must always add
toTotal
total ofAssets
1.00
These three ratios are alternative measures of the same thing
gearing
Example of Capital Structure

Ratios
Relate this discussion to

gearing concept
Notice the amount of the assets that are funded

by debt for this to be positive gearing the
ROA on those assets must be higher than the
cost of the debt
Since a large portion of the assets are funded by

debt (70%), the financial risk of the balance
sheet is relatively high
Debt providers might set a debt covenant that

prohibits the business from letting its debt ratio
exceed e.g. 75%. They put a ceiling on financial
D) Interest Coverage
Ratio
EBIT
Net Interest
This ratio measures financial risk i.e. the number of times

a firms existing EBIT covers the its net interest expense
Net interest is calculated as Interest Cost Interest
Income (if any)
As an arbitrary figure this ratio should preferably not be
below three times
If interest rates are high, then higher coverage is preferred
Exercise time
Questions 10 & 11, Week 7
71
Next Week
Assignments Due
One assignment per group
No Business cover sheet required you sign the plagiarism
declaration upon submitting
ONE file no separate excel files
Peer review forms due at the same time
These are anonymous
Only those people who complete this part as per the task
requirements will be awarded the relevant marks
Take it serisously
Wk 8: Cost Behaviour and CPV

analysis

Financial Statement Analysis

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Topic 7: 1 of 5

Financial Statement Analysis

LB5212: Accounting and Finance for Managers

Know why we undertake financial statement

Financial analysis adds further meaning to the reported

To conduct any analysis we require information. One public

Start your analysis with the

The users of financial reports can broadly be

Why are we doing the analysis?

Statement of Cash Flows

Independent Auditors report

Notes to the Financial Statements

Independent Auditors Report

Audit conducted in accordance with Australian Auditing Standards

The Corporations Act, including:

Giving a true and fair view of the companys performance and

Compliance with Australian Accounting Standards and the

Other mandatory professional reporting requirements.

Giving a true and fair view of the companys performance and

Compliance with AASBs and Corporations Regulations.

That there are reasonable grounds to believe the company will be

Notes to the statements

Look at the notes to company financials.

Seek meaningful context

Figures on their own are not very meaningful.

Identify the businesss nature, and understand

To make figures meaningful it is essential to

A single number could mean

Three main methods of

Horizontal analysis and Trend analysis (short and

Vertical (common size) analysis

Less Cost of goods sold

LB5212: Accounting and Finance

Compares reported numbers in the current period

Essentially it looks at the change in monetary

The change in monetary values can also be

Less Cost of goods sold

Compare changes over the periods to see what changes

Ideally REVENUE should be increasing at a greater %

Look at the increase in Revenue, COGS and GP What do

With increases in Revenue, you would expect some

TLS 5 year share price, Yahoo Finance 13/03/15

Compare this trend with others by

Freds Enterprises - Income Statement for years ending 30 June

Less Cost of goods sold

Highlights changes of a single variable over time in the Income

Can be very useful to monitor variables of interest e.g. gross

Also useful to look at the changes of expense items e.g. wages, to

Frequently used together with horizontal analysis as they

Compare businesses in the same industry, but which differ in size

Eves Enterprises - Income Statement for years ending 30 June

Less Cost of goods sold

LB5212: Accounting and Finance for

Sales is 100% (the base, or anchor point)

Over the 3 years the COGS as a % of sales has

However, the proportion that total expenses makes up

Look at Advertising 5% for all three years and thus

Now look at wages actually decreasing as a % of

Ratio analysis is as flexible and varied as are the

LB5212: Accounting and Finance for Managers

Explain the Liquidity concept and be able to

Understand the interrelationships between ratios