“How well am I doing?

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Financial Statement Analysis

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Financial Statement Analysis
Financial statement analysis is the process of analysing a company's financial statements for
decision-making purposes. External stakeholders use it to understand the overall health of an
organization as well as to evaluate financial performance and business value. Internal
constituents use it as a monitoring tool for managing the finances. The financial statements of
a company record important financial data on every aspect of a business’s activities. As such
they can be evaluated on the basis of past, current, and projected performance.
Several techniques are commonly used as part of financial statement analysis. Three of the
most important techniques include horizontal analysis, vertical analysis, and ratio analysis.
Horizontal analysis compares data horizontally, by analysing values of line items across two
or more years. Vertical analysis looks at the vertical affects line items have on other parts of
the business and also the business’s proportions. Ratio analysis uses important ratio metrics
to calculate statistical relationships.

Financial Statements
As mentioned, there are three main financial statements that every company creates and
monitors: the balance sheet, income statement, and cash flow statement. Companies use these
financial statements to manage the operations of their business and also to provide reporting
transparency to their stakeholders. All three statements are interconnected and create different
views of a company’s activities and performance.
Balance Sheet
The balance sheet is a report of a company's financial worth in terms of book value. It is
broken into three parts to include a company’s assets, liabilities, and shareholders' equity.
Short-term assets such as cash and accounts receivable can tell a lot about a company’s
operational efficiency. Liabilities include its expense arrangements and the debt capital it is
paying off. Shareholder’s equity includes details on equity capital investments and retained
earnings from periodic net income. The balance sheet must balance with assets minus
liabilities equalling shareholder’s equity. The resulting shareholder’s equity is considered a
company’s book value. This value is an important performance metric that increases or
decreases with the financial activities of a company.
Income Statement
The income statement breaks down the revenue a company earns against the expenses
involved in its business to provide a bottom line, net income profit or loss. The income
statement is broken into three parts which help to analyse business efficiency at three
different points. It begins with revenue and the direct costs associated with revenue to
identify gross profit. It then moves to operating profit which subtracts indirect expenses such
as marketing costs, general costs, and depreciation. Finally it ends with net profit which
deducts interest and taxes.

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Cash Flow Statement
The cash flow statement provides an overview of the company's cash flows from operating
activities, investing activities, and financing activities. Net income is carried over to the cash
flow statement where it is included as the top line item for operating activities. Like its title,
investing activities include cash flows involved with firm wide investments. The financing
activities section includes cash flow from both debt and equity financing. The bottom line
shows how much cash a company has available.
Financial Statement Analysis (Meaning)
1. Financial statement analysis is an analysis which highlights the important
relationships in the financial statements.
2. It focuses on evaluation of past operations as revealed by the analysis of basic statements.
3. Financial statement analysis embraces the methods used in assessing and interpreting the
result of past performance and current financial position as they relate to particular factors of
interest in investment decisions.
4. Financial statement analysis is an important means of assessing past performance
and in forecasting and planning future performance.
5. Financial statement analysis is a systematic and specialized arrangement of information
for the purpose of its interpretation.

The Interrelationship of the 4 Financial Statements

BALANCE SHEET
As of December 31, 20x1
(000)
Assets
Cash $ 100
Other Current Assets $ 1,300

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Long-term Investments $
3,000 Long-term Assets $
10,000 Income Statement

Intangible Assets $ 1,600 For the year ended December 31, 20x2

Total Assets $ 16,000 (000)

Liabilities and Owner's Equity Revenues $ 5,880

Current Liabilities $ 1,000 Expenses $ 4,795

Long-term Liabilities $ 4,950 Net Income $ 1,085
Joe Owner, Capital $ 10,050
Total Liabilities and Equity $
16,000 Statement of Changes in Owner's
Equity For the year ended December 31,
20x2
(000)
Joe Owner, capital, 1/1/x2 $ 10,050
Plus: Investments by owner $ -
Plus: Net Income $ 1,085
Less: Withdrawals by owner $ 200
Joe Owner, capital, 12/31/x2 $ 10,935

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Limitations of financial statement analysis
1. Not a Substitute of Judgement
An analysis of financial statement cannot take place of sound judgement. It is only a means to
reach conclusions. Ultimately, the judgements are taken by an interested party or analyst on
his/ her intelligence and skill.
2. Based on Past Data
Only past data of accounting information is included in the financial statements, which are
analyzed. The future cannot be just like past. Hence, the analysis of financial statements
cannot provide a basis for future estimation, forecasting, budgeting and planning.
3. Problem in Comparability
The size of business concern is varying according to the volume of transactions. Hence, the
figures of different financial statements lose the characteristic of comparability.
4. Reliability of Figures
Sometimes, the contents of the financial statements are manipulated by window dressing. If
so, the analysis of financial statements results in misleading or meaningless.
5. Various methods of Accounting and Financing
The closing stock of raw material is valued at purchase cost. The closing stock of finished
goods is value at market price or cost price whichever is less. In general, the closing stock is
valued at cost price or market price which ever is less. It means that the closing stock of raw
material is valued at cost price or market price whichever is less. So; an analyst should keep
in view these points while making analysis and interpretation otherwise the results would be
misleading.
6. Change in Accounting Methods
There must be uniform accounting policies and methods for number of years. If there are
frequent changes, the figures of different periods will be different and incomparable. In such
a case, the analysis has no value and meaning.
7. Changes in the Value of Money
The purchasing power of money is reduced from one year to subsequent year due to inflation.
It creates problems in comparative study of financial statements of different years.
8. Limitations of the Tools Application for Analysis
There are different tools applied by an analyst for an analysis. Even though, the application of
a particular tool or technique is based on the skill and experience of the analyst. If an
unsuitable tool or technique is applied, certainly, the results are misleading.
9. No Assessment of Managerial Ability
The results of the analysis of financial statements should not be taken as an indication of
good or bad management. Hence, the managerial ability can not be assessed by analysis.

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10. Change of Business Condition
The conditions and circumstances of one firm can never be similar to another firm. Likewise,
the business condition and circumstances of one year to subsequent can never be similar.
Hence, it is very difficult for analysis and comparison of one firm with another

Statements in comparative and common-size form

Analytical techniques used to examine relationships among financial statement items:
1. Dollar and percentage changes on statements
2. Common-size statements
3. Ratios
Dollar and Percentage changes on statements
Comparing statements underscores movements and trends and may provide valuable clues
about what to expect in the future.
1. Horizontal Analysis
2. Trend Analysis
Horizontal Analysis
Horizontal analysis is the comparison of financial information of a company with historical
financial information of the same company over a number of reporting periods. It could also
be based on the ratios derived from the financial information over the same time span. The
main purpose is to see if the numbers are high or low in comparison to past records, which
may be used to investigate any causes for concern. This method of analysis is simply
grouping together all information, sorting them by time period: weeks, months or years. The
numbers in each period can also be shown as a percentage of the numbers expressed in
the baseline (earliest/starting) year. The amount given to the baseline year is usually 100%.
This analysis is also called dynamic analysis or trend analysis.

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 CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2004 2003 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700

Calculating change in Dollar amounts

Dollar change = current year figure – Base year figure (the dollar amounts for 2003 become
the “base” year figure)
Dollar Change = $12,000-$23,500 = $(11,500)
Calculating change as a percentage
Percentage change = Dollar change/Base Year Figure *100%
Percentage Change = ($11,500/$23,500)*100%

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After putting the results of all the changes in the balance sheet

CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2004 2003 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7

We could do this for the liabilities and stockholders’ equity, but now let’s look at the
income statement accounts

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2004 2003 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

Sales increased by 8.3% yet net income decreased by 21.9%

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There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%).
These increased costs more than offset the increase in sales, yielding an overall decrease in
net income.
Trend Percentages
Trend percentages state several years’ financial data in terms of a base year, which equals
100 percent. Trend Analysis is a statistical technique that tries to determine future movements
of a given variable by analyzing historical trends. In other words, it is a method that aims to
predict future behaviors by examining past ones.

Trend Analysis = Current year amount/Base year amount *100%

Example:
Look at the income information for Berry Products for the years 2000 through 2004. We will
do a trend analysis on these amounts to see what we can find about the company.
Berry Products
Income Information
For the Years Ended December 31

Year
Item 2004 2003 2002 2001 2000
Sales $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of goods sold 285,000 250,000 225,000 198,000 190,000
Gross margin 115,000 105,000 95,000 92,000 85,000

The base year is 2000, and its amounts will equal 100%
Year
Item 2004 2003 2002 2001 2000
Sales 105% 100%
Cost of goods sold 104% 100%
Gross margin 108% 100%

2001 Amount ÷ 2000 Amount × 100%

($290,000 ÷ $275,000) × 100% = 105%
($198,000 ÷ $190,000) × 100% = 104%
($ 92,000 ÷ $ 85,000) × 100% = 108%

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 Year
Item 2004 2003 2002 2001 2000
Sales 145% 129% 116% 105% 100%
Cost of goods sold 150% 132% 118% 104% 100%
Gross margin 135% 124% 112% 108% 100%

By analysing the trends for Berry products, we can see that cost of goods sold is increasing
faster than sales, which is slowing the increase in gross margin.
We can use the trend percentages to construct a graph so we can see the trend over
time.

160

150

140
Percentage

130

120 Sales
COGS
110 GM
100
2000 2001 2002 2003 2004
Year

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Common-Size Statements
Common-size statements use percentages to express the relationship of individual
components to a total within a single period. This is also known as vertical analysis.
Example:
Let’s take another look at the information from the comparative income statements of Clover
Corporation for 2004 and 2003. This time we will prepare common-size statements.

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2004 2003 2004 2003
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400

Net sales is usually the base and is expressed as 100%

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 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2004 2003 2004 2003
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400

2004 Cost ÷ 2004 Sales × 100%

($360,000 ÷ $520,000) × 100% = 69.2%
2003 Cost ÷ 2003 Sales × 100%
( $315,000 ÷ $480,000 ) × 100% = 65.6%

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Gross Margin Percentage
Gross margin percentage = Gross margin/Sales
This measure indicates how much of each sales dollar is left after deducting the cost of goods
sold to cover expenses and a profit.

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2004 2003 2004 2003
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000 30.8 34.4
Operating expenses 128,600 126,000 24.8 26.2
Net operating income 31,400 39,000 6.0 8.2
Interest expense 6,400 7,000 1.2 1.5
Net income before taxes 25,000 32,000 4.8 6.7
Less income taxes (30%) 7,500 9,600 1.4 2.0
Net income $ 17,500 $ 22,400 3.4 4.7

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Norton Corporation’s 2004 and 2003 financial statements

NORTON CORPORATION
Balance Sheets
December 31

2004 2003
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets $ 346,390 $ 300,000

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 NORTON CORPORATION
Balance Sheets
December 31

2004 2003
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000

Total liabilities and stockholders' equity $ 346,390 $ 300,000

NORTON CORPORATION
Income Statements
For the Years Ended December 31

2004 2003
Net sales $ 494,000 $ 450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income $ 53,690 $ 46,200

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Now Ratios Calculation based on Norton Corporation’s statements
Earnings per Share
Earnings per share = (Net income – Preferred Dividends)/Average number of common shares
outstanding
Earnings per share = ($53,690-0)/{(17,000+27,400)/2}
= $2.42
Price-Earnings Ratio
This measure is often used by investors as a general guideline in gauging stock values.
Generally, the higher the price-earnings ratio, the more opportunity a company has for
growth.
Price-earnings ratio = Market price per share/Earnings per share
= $20.00/$2.42 =8.26 times
Dividend Payout Ratio
This ratio gauges the portion of current earnings being paid out in dividends. Investors
seeking current income would like this ratio to be large
Dividend payout ratio = dividends per share/ earnings per share
= $2.00/$2.42 =82.6%
Dividend Yield Ratio
This ratio identifies the return, in terms of cash dividends, on the current market price of the
stock.
Dividend Yield ratio = Dividends per share/ Market price per share
= $2.00/$20.00 =10.00%
Return on Total Assets
Return on total assets = Net income+ [Interest expense*(1- Tax Rate)] / Average total Assets
= $53,690 + [7,300*(1-.30)] / ($300,000+$346,390) /2
= 18.19%
Return on Common Stockholders’ Equity
Return on Common Stockholders’ Equity = (Net income – Preferred Dividends)/ Average
stockholders’ equity
= $53,690 – 0 / {($180,000 + $234,390) / 2}|
= 25.91%

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Book value per value
This ratio measures the amount that would be distributed to holders of each share of common
stock if all assets were sold at their balance sheet carrying amounts and if all creditors were
paid off.
Book value per share = common stakeholders’ equity / number of common shares
outstanding
= $234,390 / 27,400 = $8.55
Working Capital

December 31,
2004
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
Current Ratio = Current assets / Current liabilities
= $65,000/ $42,000 = 1.55:1
Accounts Receivable turnover = sales on account / average accounts receivable
= $500, 000/ {($17,000+$20,000)/2}
= 27.03times
Inventory turnover = cost of goods sold/ Average Inventory
= $140,000/ {($10,000+$12,000)/2} =12.73 times
Average sales period = 365 days/ 12.73 times = 28.67 days
Debt to equity Ratio = Total liabilities/ stockholders’ equity
= $112,000/ $234,390 = 0.48 to 1

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