CHAPTER 3

FINANCIAL STATEMENTS
ANALYSIS
INTRODUCTION

• Every business concern wants to know the various financial

aspects for effective decision making.

• The preparation of financial statement is required in order to

achieve the objectives of the firm as a whole.
MEANING OF FINANCIAL
STATEMENTS
• The term financial statement refers to an organized
collection of data on the basis of accounting principles and
conventions to disclose its financial information.
TYPES OF FINANCIAL STATEMENTS

Financial statements are broadly grouped in to two statements:

1. Income Statements (Profit and Loss

Account)
2. Balance Sheets
3. Statement of Retained Earnings
4. Statement of Changes in Financial
Position
INCOME STATEMENTS

 The term 'Income Statements' is also known as Profit and

Loss Account.
 This is the first stage of preparation of final accounts in
accounting cycle.
 The purpose of preparing Profit and Loss Accounts to
ascertain the Net Profit or Net Loss of a business concern
during the accounting period.
BALANCE SHEET

Balance Sheet is a statement of financial position of any

economic unit disclosing as at a given moment of time its
assets, at cost, depreciated cost, or other indicated value, its
liabilities and its ownership equities.

In other words, it is a statement which indicates the financial

position or soundness of a business concern at a specific
period of time.
STATEMENT OF RETAINED
EARNINGS:
• It is considered to be as the connecting link between the
Profit and Loss Account and Balance Sheet.
• The accumulated excess of earning over losses and
dividend is treated as Retained Earnings.
• The balance of retained earnings shown on the Profit and
Loss Accounts and it is transferred to liability side of the
balance sheet.
STATEMENT OF CHANGES IN
FINANCIAL POSITION
• Income Statements and Balance sheet do not disclose the
operational efficiency of the concern.
• In order to measure the operational efficiency of the concern
it is essential to identify the movement of working capital or
cash inflow or cash outflow of the business concern during
the particular period.
STATEMENT OF CHANGES IN
FINANCIAL POSITION(CONTD…)
• To highlight the changes of financial position of a
particular firm, the statement prepared may
emphasize of the following aspects:
• Fund Flow Statement is prepared to know the changes in the firm's working
capital.
• Cash Flow Statement is prepared to understand the changes in the firm's cash
position.

• Statement of Changes in Financial Position is

used for the changes in the firm's total financial
position.
NATURE OF FINANCIAL STATEMENTS
• Financial Statements are prepared on the basis of business transactions
recorded in the books of Original Entry or Subsidiary Books, Ledger,
and Trial Balance.
• Recording the transactions in the books of primary entry supported by
document proofs such as Vouchers, Invoice Note etc.
• According to the AICPA,
• "Financial Statement reflects a combination of recorded facts, accounting
conventions and personal judgments and conventions applied which affect
them materially."
NATURE OF FINANCIAL
STATEMENTS (CONTD..)
It is therefore, nature and accuracy of the data included in the
financial statements are influenced by the following factors:

(1) Recorded Facts.

(2) Generally Accepted Accounting
Principles.
(3) Personal Judgments.
(4) Accounting Conventions.
ANALYSIS AND INTERPRETATIONS
OF FINANCIAL STATEMENTS
MEANING OF ANALYSIS AND
INTERPRETATIONS
• The term "Analysis" refers to rearrangement of the data given in the
financial statements.

• In other words, simplification of data by methodical classification of

the data given in the financial statements.

• The term "interpretation" refers to "explaining the meaning and

significance of the data so simplified."

• Both analysis and interpretations are closely connected and inter

related. They are complementary to each other.
MEANING OF ANALYSIS AND
INTERPRETATIONS (CONTD…)

• They are a process of evaluating the relationship between component parts of a

financial statement to obtain a better understanding of a firm's position and
performance.

• The facts and figures in the financial statements can be transformed into
meaningful and useful figures through a process called "Analysis and
Interpretations."

• In other words, financial statement analysis and interpretation refer to the

process of establishing the meaningful relationship between the items of the two
financial statements with the objective of identifying the financial and
operational strengths and weaknesses.
FINANCIAL STATEMENT
ANALYSIS 625

Who analyzes financial statements?

• Internal users (i.e., management)
• External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors
FINANCIAL STATEMENT
ANALYSIS
• What do internal users use it for?
Planning, evaluating and controlling company operations

• What do external users use it for?

Assessing past performance and current financial
position and making predictions about the future
profitability and solvency of the company as well as
evaluating the effectiveness of management
 SOURCES OF
FINANCIAL STATEMENT ANALYSIS

Information is available from

• Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (Independent accountants)
(5) Management’s discussion and analysis
(6) Reports filed with the government
e.g., Form of Custom and Revenue Authority
 FINANCIAL STATEMENT ANALYSIS

Information is available from 627 628

• Other sources
(1) Newspapers
(2) Periodicals
(3) Financial information organizations such
as: Moody’s, Standard & Poor’s, Dun & Bradstreet,
Inc., and Robert Morris Associates
(4) Other business publications
 METHODS OF FINANCIAL STATEMENT
ANALYSIS
• Horizontal Analysis
• Vertical Analysis
• Common-Size Statements
• Trend Percentages
• Ratio Analysis
HORIZONTAL ANALYSIS
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
VERTICAL ANALYSIS
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
COMMON-SIZE STATEMENTS

Financial statements that show

only percentages and no
absolute dollar amounts
TREND PERCENTAGES

Show changes over time in a

given financial statement items
(can help evaluate financial
information of several years)
 RATIO ANALYSIS

Expression of logical relationships

between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)
 HORIZONTAL ANALYSIS EXAMPLE

The management of Clover Company provides you

with comparative balance sheets of the years ended
December 31, 1999 and 1998. Management asks
you to prepare a horizontal analysis on the
information.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Incre
1999 1998 Amo
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
 HORIZONTAL ANALYSIS EXAMPLE

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure
 HORIZONTAL ANALYSIS
EXAMPLE
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

Since we are measuring the amount of

the change between 1998 and 1999, the
dollar amounts for 1998 become the
“base” year figures.
 HORIZONTAL ANALYSIS
EXAMPLE
Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
 HORIZONTAL ANALYSIS EXAMPLE
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
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:
$12,000 – $23,500 = $(11,500)
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
 HORIZONTAL ANALYSIS
EXAMPLE CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
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:
($11,500 ÷ $23,500) × 100% = 48.9%
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
 HORIZONTAL ANALYSIS EXAMPLE
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 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
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 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)
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 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
Sales increased by 6,400 7,000
8.3% while net (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
income
Less income taxes (30%)
decreased
7,500
by 21.9%.
9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 There were increases in both cost of goods
sold (14.3%) and operating expenses (2.1%).
These increased costs
CLOVERmore than offset the
CORPORATION
increase inComparative
sales, yielding anStatements
Income overall
Fordecrease
the Years Ended
in netDecember
income. 31, 1999 and 1998
Increase (Decrease)
1999 1998 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)
 VERTICAL ANALYSIS EXAMPLE

The management of Sample Company asks you to

prepare a vertical analysis for the comparative
balance sheets of the company.
 VERTICAL ANALYSIS EXAMPLE
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
 VERTICAL ANALYSIS
EXAMPLE
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
$82,000 ÷ $483,000 = 17% rounded
Land 101,000 90,000 21% 23%
Equipment
$30,000110,000
÷ $387,000 100,000
= 8% rounded
23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
 VERTICAL ANALYSIS EXAMPLE`.

Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Acts. Payable $ 76,000 $ 60,000 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable 50,000
$76,000 ÷ $483,000 = 50,000 10%
16% rounded 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%
 TREND PERCENTAGES EXAMPLE

Wheeler, Inc. provides you with the following operating

data and asks you to prepare a trend analysis.

Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119
 TREND PERCENTAGES
EXAMPLE
Wheeler, Inc. provides you with the following operating
data and asks that you prepare a trend analysis.

Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

$1,991 - $1,820 = $171

 TREND PERCENTAGES EXAMPLE

Using 1995 as the base year, we develop the

following percentage relationships.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%

$1,991 - $1,820 = $171

$171 ÷ $1,820 = 9% rounded
 140
Trend line
130 for Sales
% of 100 Base

120

110

100

90
1995 1996 1997 1998 1999
Sales
Years
Expenses
FINANCIAL RATIOS

• Financial ratios are useful indicators of a firm’s performance

and financial situation.
• Most ratios can be calculated from information provided by
the financial statements.
• Financial ratios can be used to analyze trends and to
compare the firm’s financials to those of other firms.
• In some cases, ratio analysis can predict future bankruptcy.
CATEGORIES OF RATIOS

• Liquidity Ratios
Indicate a company’s short-term
debt-paying ability
• Asset management ratio
Indicate asset management/utilization efficiency and
effectiveness
• Financial Leverage Ratios
Show relationship between debt and equity financing in a
company
• Profitability Tests
Relate income to other variables
• Market Tests
Help assess relative merits of stocks in the marketplace
1. LIQUIDITY RATIOS

• Provide information about a firm’s ability to meet its short-

term financial obligations.

• They are of particular interest to those extending short-

term credit to the firm.

• Two frequently-used liquidity ratios are

• the current ratio (or working capital ratio) and
• the quick ratio.
I. CURRENT RATIO

• The current ratio is the ratio of current assets to current

liabilities:
II. QUICK RATIO

• The quick ratio is an alternative measure of liquidity that

does not include inventory in the current assets.
• The quick ratio is defined as follows:
• The quick ratio often is referred to as the acid test.
III. ASSET TURNOVER RATIOS

• They indicate of how efficiently the firm utilizes its assets.

• They sometimes are referred to as efficiency ratios, asset
utilization ratios, or asset management ratios.
• Two commonly used asset turnover ratios are
• Receivables turnover and
• Inventory turnover.
A. RECEIVABLES TURNOVER

• Receivables turnover is an indication of how quickly the

firm collects its accounts receivable and is defined as
follows:
Receivables turnover
B. INVENTORY TURNOVER

• It is the cost of goods sold in a time period divided by the

average inventory level during the period:
FINANCIAL LEVERAGE RATIOS

• They provide an indication of the long-term solvency of the

firm.
• Financial leverage ratios measure the extent to which the
firm is using long term debt.
• The following are the financial leverage ratios:
• Debt ratio
• Debt-equity ratio
I. DEBT RATIO

• The debit ratio is defined as total debt divided by total

assets:
DEBT-EQUITY RATIO

• The debt-to-equity ratio is total debt divided by

total equity:
PROFITABILITY RATIOS

• Profitability ratios offer several different measures of the

success of the firm at generating profits.
• Some of the profitability ratios are:
• Gross profit margin
• Return on Assets
• Return on Equity
I. GROSS-PROFIT MARGIN

• The gross profit margin is a measure of the gross profit

earned on sales.
• The gross profit margin considers the firm’s cost of goods
sold, but does not include other costs.
• It is defined as follows:
II. RETURN ON ASSETS

• Return on assets is a measure of how effectively the firm’s

assets are being used to generate profits.
• It is defined as:
III. RETURN ON EQUITY

• Return on equity is the bottom line measure for the

shareholders, measuring the profits earned for each dollar
invested in the firm’s stock.
• Return on equity is defined as follows:
USE AND LIMITATIONS OF
FINANCIAL RATIOS
Attention should be given to the following issues when using financial ratios:

• A reference point is needed. To be meaningful, most ratios must be

compared to historical values of the same firm, the firm’s forecasts, or
ratios of similar firms.
• Most ratios by themselves are not highly meaningful. They should be
viewed as indicators, with several of them combined to paint a picture
of the firm’s situation.
• Year-end values may not be representative. Certain account balances
that are used to calculate ratios may increase or decrease at the end of
the accounting period because of seasonal factors.
• Such changes may distort the value of the ratio. Average values
should be used when they are available.
• Ratios are subject to the limitations of accounting methods. Different
accounting choices may result in significantly different ratio values.
 “THE END”

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