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Five important sets of tools for

financial analysis
BBA 441(F)
1. Comparative financial statement analysis
Financial Statement Analysis 2. Common-size financial statement analysis
3. Ratio analysis
Week2: Analysis Tools
4. Cash flow analysis
Academic Year 2011/12
5. Valuation
Semester 1
Department of Management Studies
University of Peradeniya

Comparative financial statement Comparative financial statement

analysis analysis Cont.,
• Conduct by reviewing consecutive balance sheets, • Two techniques
income statements, or statements of cash flows from
period to period – Year-to-year change analysis
• Involves a review of changes in individual account – Index-number analysis
balances on a year-to-year basis
• Also called, horizontal analysis
• Reveals “trend”
– i.e., a comparison of statements over several periods can
reveal the direction, speed, and extent of a trend
– Also compares the trend in related items, e.g., 15%
increase in accounts receivable along with a sales increase
of only 5 percent calls for investigation

Year-to-year change analysis Year-to-year change analysis Cont.,

• Compares financial statements over relatively • Few rules to remember (Illustration 1.1)
short time periods – 2 to 3 years – When negative amount in the base and positive
• Performs with analysis of year-to-year changes amount in the next period (or vice versa), no
in individual accounts meaningful % can be calculated
– When there is no amount in the base period, no % can
• Short time period is manageable and
be computed
understandable
– When the base period amount is small, % change can
– Changes can present in Rs. and % terms
be calculated, but it should interpreted with caution
– E.g., 50% change from base amounts Rs. 1000 and
– When an item has a value in the base period and none
Rs. 100,000
in the next period, the decrease is 100%

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Year-to-year change analysis Cont., Index-number trend analysis

• Useful tool for long-term trend comparison
• Procedure
– Choose a base period (Year with normal business
conditions)
– Preselected index number is 100
– Current year index is calculated as follows
• Current year balance x 100
Base year balance
• E.g., cash balances Y1(12000); Y2(18000);
Y3(9000). Calculate indexes given base year, Y1.

Index-number trend analysis Cont., Index-number trend analysis Cont.,

• Do not analyse every item in financial statements,
i.e., focus only on significant items
• Due care must be given as changes can be due to
– Changes in the economic or industry factors
– Inconsistent applications of accounting policies* can
adjust in accounting analysis
– Price level changes
• Can convey insight into mangers’ philosophies,
policies, and motivations

Common-size financial statement Common-size financial statement

analysis analysis Cont.,
• Provides information on what proportion of a • Useful in understanding the internal makeup
group or subgroup is made up of a particular
account of financial statements
– Balance sheet: express total assets (or liabilities plus – e.g., Balance Sheet > sources of financing
equity) as 100% (distribution of financing across current and non
– Income statement: sales are set at 100% current liabilities and equity)
• Sum of individual accounts within groups is 100%, – composition of assets (current and non current
therefore, called common-size financial
statements assets)
• Also, called vertical analysis (up-down or down-
up)

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Common-size financial statement Common-size financial statement

analysis Cont., analysis Cont.,
• Temporal (time) comparisons
– Useful in revealing any proportionate changes in
accounts within groups of assets, liabilities,
expenses, and other categories
• Intercompany comparisons
– Useful for intercompany comparisons because
financial statements of different companies are
recast in common size format
• Key limitation: failure to reflect the relative sizes of the
companies under analysis

Common-size financial statement

Ratio analysis
analysis Cont.,
• The most popular and widely used tools of
financial analysis
• Ratio is a simple arithmetic operation, but
interpretation is more complex
• To be meaningful, a ratio must refer to an
economically important relation
– E.g., sales price and its cost; freight cost and
marketable securities balance

Ratio analysis Cont., Ratio analysis Cont.,

• More to remember • Factors affecting ratios
– Provide us insights into underlying conditions
– Starting points of analysis, not the end point
– Beyond the internal operating activities
– Identify areas requiring further investigation • Economic events, industry factors, management policies,
– Reveals important relations and accounting methods
• In uncovering conditions • Accounting analysis is undertaken
• Trends difficult to detect by inspecting the individual components
– More useful when they are future oriented – Make sure the numbers are appropriate
• Often adjust the factors affecting a ratio for their probable future • E.g., inventories value at LIFO; certain pension liabilities are
trend and magnitude often unrecorded (disclosure only) and influence ratios such
• Also must assess factors potentially influencing future ratios as debt to equity; when one ratio adjusts needs to adjust
– Usefulness depends on our skillful application and others also such as net income; reliability of accounting
interpretation and these are the most challenging aspects of numbers also depends on internal accounting controls
ratio analysis

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Ratio analysis Cont., Ratio analysis Cont.,

• Ratio interpretation • Ratio analysis as applied to three important areas of FSA:
– Credit (Risk) Analysis
– Due care should be provided. E.g., reducing R&D • Liquidity: to evaluate the ability to meet short-term obligations
• Capital structure and solvency: to assess the ability to meet long-term
can improve operating expenses to sales in the obligations
short run only – Profitability Analysis
• Return on investment: to assess financial rewards to the suppliers of
– Similar to other techniques in financial analysis, equity and debt financing
• Operating performance: to evaluate profit margins from operating
ratios are not relevant in isolation activities
• Need to interpret in comparison with (1) prior ratios; • Assets utilization: to assess effectiveness and intensity of assets in
generating sales, also called turnover
(2) predetermined standards; (3) ratios of competitors – Valuation
• To estimate the intrinsic value of a company (stock)

Ratio analysis Cont., Ratio analysis Cont.,

Ratio analysis Cont., Ratio analysis Cont.,

• Credit analysis • Credit analysis Cont.,
– Liquidity – Capital structure and solvency
• Current ratio reflects CA available to satisfy CL • To assess long-term financing structure and credit risk
• Acid test ratio uses more liquid assets excluding – Debt-to-equity ratio
Inventories – Long-term debt-to-equity ratio
– Times interest earned
• The length of time needed for conversion of receivables
and inventories to cash
– Collection period, plus
– Days to sell inventory

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Ratio analysis Cont., Ratio analysis Cont.,

• Profitability analysis • Profitability analysis Cont.,
– Return on investment – Asset utilization
• Return on total assets • Cash turnover
• Return on common equity • Accounts receivable turnover
– Operating performance ratios • Sales to inventory
• Gross profit margin • Working capital turnover
• Operating profit margin • Fixed asset turnover
• Pretax profit margin • Total asset turnover
• Net profit margin

Ratio analysis Cont., Ratio analysis Cont.,

• Valuation • To sum up ratio analysis
– Market measures – Yields many valuable insights
• Price-to-earnings ratio – Enhanced by our adjustments to reported
• Earnings yield numbers prior to inclusion in the analyses
• Dividend yield • This is the goal of accounting analysis
• Dividend payout rate – Only one part of financial analysis
• Price-to-book

Cash flow analysis Valuation models

• Provides insights into how a company is obtaining • Valuation
– Estimating intrinsic value of a company or its stock
its financing and deploying its resources – an important outcome of many types of BA and FSA
• Uses • The basis of valuation is present value theory
– as a tool to evaluate the sources and uses of funds – Sum of all expected future payoffs from the security (debt
or equity) that are discounted to the present at an
– In cash flow forecasting and as part of liquidity appropriate discount rate
analysis – Uses time value of money
• Expected future payoffs of over the life of the security (Debts:
• Basic analysis can be done using cash flow principal and interest payments; Stocks: dividends and capital
appreciations)
statement • A discounted rate (Debt: prevailing interest rate or yeild to
maturity; Stocks: risk adjusted cost of capital or expected rate of
• detailed analysis is in week 8 return)

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Debt Valuation Equity Valuation

• A bond contract specifies its future payoffs along • The basis of equity valuation is same as debt
with investment horizon
valuation
• The value of a bond at time t is computed using
the following formula: • More complex as, with equity, investor has no
claim on predetermined payoffs (Debt has)
• Instead two main (uncertain) payoffs
• Where It+n is the interest payment in t+n, F is the
principal payment (usually the debt’s face value), – Dividend payments and capital appreciation
and r is the interest rate
• See illustration 1.5

Equity Valuation Week3 Discussion Questions

• Value of an equity security at time t, or Vt, equals the 1. Explain why financial statements are important to the
sum of the present values of all future expected decision making process in financial analysis. Also,
dividends identify and discuss some of their limitations for
analysis purposes.
2. Identify and discuss at least four categories of
financial analysis tools
• Where Dt+n is the dividend in period t+n, and k is the 3. What are the problems of valuing equity as the
cost of capital present value of future cash flows?
• This model is called the dividend discount model 4. Explain the practical obstacles of dividend discount
model in equity valuation. What are the alternative
• This formula is based on expected dividends rather valuation models available to minimize such
than actual dividends (as dividends are not specified) problems?

Week3 Discussion Questions

• Exercise 1-4 to 1-9
• Problem 1-5
• Case 1-3