F

INANCIAL

S

TATEMENTS ANALYSIS

Financial Statement Analysis

Who analyzes financial statements?

– Internal users i.e., Management, Shareholders, Internal auditors, Budget Analyst, – External users • Examples?

• • Investors, creditors, regulatory agencies & … stock market analysts, Business analysts, Financial Analyst, Investment Analyst 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

Financial Statement Analysis

Information is available from – Published annual reports • • (1) (2) Financial statements Notes to financial statements • • (3) (4) Letters to stockholders Auditor’s report (Independent accountants) • (5) Management’s discussion and analysis – Reports filed with the government Taxation Department, SECP.

Financial Statement Analysis

Information is available from – Other sources • (1) Newspapers (e.g., The News) • (2) Periodicals (e.g. The Economist, Fortune) • (3) Financial information organizations • (4) Other business publications

Methods of Financial Statement Analysis

•

Horizontal Analysis

•

Vertical Analysis

•

Common-Size Statements

•

Trend Percentages

•

Ratio Analysis

Horizontal Analysis

Vertical Analysis

Common-Size Statements

Trend Percentages

Ratio Analysis

Horizontal Analysis Example

The management of ABC Company provides you with comparative balance sheets of the years ended December 31, 2009 and 2010. Management asks you to prepare a horizontal analysis on the information.

ABC CORPORATION Comparative Balance Sheets December 31, 2009 and 2010 2010 2009 Current assets: Assets Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ 12,000 60,000 80,000 3,000 155,000 $ 23,500 40,000 100,000 1,200 164,700 40,000 120,000 160,000 $ 315,000 40,000 85,000 125,000 $ 289,700 Increase (Decrease) Amount %

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Change = Current Year Figure – Base Year Figure Since we are measuring the amount of the change between 2010 and 2009, the dollar amounts for 2009 become the “base” year figures.

Horizontal Analysis Example

Calculating Change as a Percentage

Percentage Change = Dollar Change Base Year Figure × 100%

Horizontal Analysis Example

ABC CORPORATION Comparative Balance Sheets December 31, 2010 and 2009 2010 2009 Increase (Decrease) Amount % Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses $ 12,000 60,000 80,000 3,000 $ 23,500 40,000 100,000 1,200 $ (11,500) Total current assets Property and equipment: Land Buildings and equipment, net 155,000 $12,000 – $23,500 = $(11,500) 40,000 120,000 40,000 85,000 Total property and equipment Total assets 160,000 $ 315,000 125,000 $ 289,700

Horizontal Analysis Example

ABC CORPORATION Comparative Balance Sheets December 31, 2010 and 2009 2010 2009 Increase (Decrease) Amount % Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ 12,000 60,000 80,000 3,000 40,000 120,000 160,000 $ 315,000 $ 23,500 40,000 100,000 1,200 40,000 85,000 125,000 $ 289,700 $ (11,500) (48.9) ($11,500 ÷ $23,500) × 100% = 48.9%

Horizontal Analysis Example

ABC CORPORATION Comparative Balance Sheets December 31, 2010 and 2009 2010 2009 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ $ 12,000 60,000 80,000 3,000 155,000 40,000 120,000 160,000 315,000 $ 23,500 40,000 100,000 1,200 164,700 $ 40,000 85,000 125,000 289,700 Increase (Decrease) Amount $ (11,500) 20,000 (20,000) 1,800 (9,700) $ 35,000 35,000 25,300 % (48.9) 50.0

(20.0) 150.0

(5.9) 0.0

41.2

28.0

8.7

Horizontal Analysis Example

Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet.

ABC CORPORATION Comparative Balance Sheets December 31, 2010 and 2009 2010 2009 Increase (Decrease) Amount % Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable Total current liabilities Long-term liabilities: Bonds payable, 8% Total liabilities Stockholders' equity: Preferred stock Common stock Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 67,000 3,000 70,000 $ 44,000 6,000 50,000 $ 23,000 (3,000) 20,000 75,000 145,000 20,000 60,000 $ 10,000 90,000 80,000 170,000 315,000 80,000 130,000 20,000 60,000 $ 10,000 90,000 69,700 159,700 289,700 $ (5,000) 15,000 10,300 10,300 25,300 52.3

(50.0) 40.0

(6.3) 11.5

0.0

0.0

0.0

0.0

14.8

6.4

8.7

Horizontal Analysis Example

Now, let’s apply the procedures to the income statement.

Net sales ABC CORPORATION Comparative Income Statements For the Years Ended December 31, 2010 and 2009 Increase (Decrease) Cost of goods sold 2010 $ 520,000 360,000 2009 $ 480,000 315,000 Amount $ 40,000 45,000 % 8.3

14.3

Gross margin Operating expenses Net operating income Interest expense 160,000 128,600 31,400 6,400 165,000 126,000 39,000 7,000 (5,000) 2,600 (7,600) (600) (3.0) 2.1

(19.5) (8.6) Net income before taxes Less income taxes (30%) Net income 25,000 7,500 $ 17,500 32,000 9,600 $ 22,400 (7,000) (2,100) $ (4,900) (21.9) (21.9) (21.9)

Net sales ABC CORPORATION Comparative Income Statements For the Years Ended December 31, 2010 and 2009 Increase (Decrease) Cost of goods sold 2010 $ 520,000 360,000 2009 $ 480,000 315,000 Amount $ 40,000 45,000 % 8.3

14.3

Gross margin Operating expenses Net operating income 160,000 128,600 31,400 6,400 165,000 126,000 39,000 7,000 (5,000) 2,600 (7,600) (600) (3.0) 2.1

(19.5) (8.6) Net income before taxes income decreased by 21.9%.

Less income taxes (30%) Net income 25,000 7,500 $ 17,500 32,000 9,600 $ 22,400 (7,000) (2,100) $ (4,900) (21.9) (21.9) (21.9)

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). Net sales Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income 2010 $ 520,000 360,000 160,000 128,600 31,400 6,400 25,000 7,500 $ 17,500 2009 $ 480,000 315,000 165,000 126,000 39,000 7,000 32,000 9,600 $ 22,400 Increase (Decrease) Amount % $ 40,000 45,000 8.3

14.3

(5,000) 2,600 (7,600) (600) (3.0) 2.1

(19.5) (8.6) (7,000) (2,100) $ (4,900) (21.9) (21.9) (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

Cash Accts. Rec.

Inventory Land Equipment Accum. Depr.

Total Sample Company Balance Sheet (Assets) At December 31, 1999 and 1998 1999 1998 % of Total Assets 1999 1998 $ 120,000 101,000 110,000 $ 82,000 87,000 (17,000) 483,000 $ $ 30,000 100,000 82,000 90,000 100,000 (15,000) 387,000 17% 25% 18% 21% 23% -4% 100% 8% 26% 21% 23% 26% -4% 100%

Vertical Analysis Example

Cash Accts. Rec.

Inventory Land Equipment Sample Company Balance Sheet (Assets) At December 31, 1999 and 1998 1999 1998 % of Total Assets 1999 1998 $82,000 ÷ $483,000 = 17% rounded $30,000 Accum. Depr.

Total $ 82,000 120,000 101,000 110,000 (17,000) $ 483,000 $ 30,000 100,000 90,000 100,000 (15,000) $ 387,000 17% 25% 23% -4% 100% 8% 26% 21% 23% 26% -4% 100%

Vertical Analysis Example

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

Trend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.

Revenues Expenses Net income 1999 $ 2,405 2,033 $ 372 Wheeler, Inc.

Operating Data 1998 1997 $ 2,244 1,966 $ 278 $ 2,112 1,870 $ 242 1996 $ 1,991 1,803 $ 188 1995 $ 1,820 1,701 $ 119

Trend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.

Revenues Expenses Net income 1999 $ 2,405 2,033 $ 372 Wheeler, Inc.

Operating Data 1998 1997 $ 2,244 1,966 $ 278 $ 2,112 1,870 $ 242 1996 $ 1,991 1,803 $ 188 1995 $ 1,820 1,701 $ 119 $1,991 - $1,820 = $171

Trend Percentages Example

Using 1995 as the base year, we develop the following percentage relationships.

Revenues Expenses Net income 1999 132% 120% 313% Wheeler, Inc.

Operating Data 1998 1997 123% 116% 116% 110% 234% 203% 1996 109% 106% 158% 1995 100% 100% 100% $1,991 - $1,820 = $171 $171 ÷ $1,820 = 9% rounded

140 130 120 110 100 90 Sales Expenses 1995

Trend line for Sales

1996 1997

Years

1998 1999

Ratios

Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25) “Using ratios and percentages without considering the underlying leads to incorrect conclusions.”

Categories of Ratios

• • • • Liquidity Ratios Indicate a company’s short-term debt-paying ability Equity (Long-Term Solvency) 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

Important Considerations

• Need for comparable data – Data is provided by different companies.

– Must compare by industry 

Influence of external factors



General business conditions



Seasonal nature of business operations



Impact of inflation