S8 Financial Statement Analysis 1

Understanding Financial Statements

The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders and other creditors in
making decisions relating to providing resources to the entity.
Information in Annual Reports
 Primary financial statements (i.e., Balance Sheet, Income Statement, statement of
changes in equity, Statement of Cash Flows).
 Auditors’ opinion.
 Notes to financial statements.
 Management discussion and analysis.
 Operating segment information.
 Comparative data and Optional information (e.g., products, personnel, facilities).
Auditors
 CAs: Meet prescribed professional standards and COP.
 Express opinion on fairness of financial statements. Provide reasonable assurance that
financial statements do not contain any material misstatements.
 Select and perform audit procedures.
 Test checks of accounting system.
 Verify existence of assets.
 Verify accuracy of accounts receivable.
 Check bank balances and investments.
 Compliance with GAAP.
 Management, not auditors, have primary responsibility for financial statements.
Auditors’ Opinion
 Results of auditors’ examination and relates to financial statements and notes, not other
parts of annual report.
 Clean opinion: Financial statements materially conform with GAAP.
 Qualified opinion.
 Lack of consistency.
 Existence of a major uncertainty.
 Doubt as to ability to continue as a going concern.
 Disclaimer: Unable to express an opinion.
 Adverse opinion: Not a fair representation of situation.
Qualitative characteristics of useful financial information
If financial information is to be useful, it must be relevant and faithfully represent what it purports
to represent. The usefulness of financial information is enhanced if it is comparable, verifiable,
timely and understandable.
Inherent Limitations of Accounting
 Accounting reports show monetary information.
 Accounting reports are influenced by estimates of future events.
 S8 Financial Statement Analysis 2

Financial Statement Analysis

Quality of Earnings
 All that glitters isn’t gold” : Quality of earnings reefers to how well a reported
earnings communicates the firm’s true performance
 Firms that choose more conservative accounting principles often have higher
quality of earnings.
 Earnings Management
 Increasing Income
 Recording revenue too soon or of questionable quality
 Recording bogus revenue and shifting current exp to another period
 Failing to record / reduce liabilities
 Take a Big Bath
 Creating hidden reserves (Cookie Jar Reserves)
 Booking too many expenses during good times to avoid showing expenses
during bad times
 Income Smoothing

Financial Statement Analysis

 Financial ratios
 Enables inter-temporal and cross-sectional analysis
 Historical, present and future (pro forma) ratios
 Vertical analysis is used to denote a common-size analysis using only one reporting
period or one base financial statement, whereas horizontal analysis refers to an
analysis comparing a specific financial statement with prior or future time periods or
to a cross-sectional analysis of one company with another Common size financial
statements
 Common size income statement-expresses each income statement as a
percentage of net sales and common size balance sheet-expresses each item
on balance sheet as a percentage of total assets
 A horizontal analysis examines the increase or decrease in percentage terms of each
balance sheet item from the prior.
Principal value of financial analysis: Suggests questions not answers.
 Making comparisons
 Finding the appropriate standard is difficult.
 A high ratio may be good or bad. It can’t be viewed in isolation.
 Ratios mean different things to different groups (e.g., current ratio, ROI).
 Benchmarks for comparison: Usually, no “correct” values for ratios.
 Experience. A feel for what is right or reasonable.
 Budget. A target developed within the company. Factors to be considered:
 Historical standards. Prior period’s results adjusted for changes in accounting
methods.
 External benchmarks. Competitor, industry average, Median performance
 S8 Financial Statement Analysis 3

Statement of P/L of HERO MOTOCORP (in Rs. Cr.)

Mar-20 Mar-19 Common Sized Change %
Revenue 28,836 33,651 97.4 98.0 -4,814 -14%
Other Income 778 691 2.6 2.0 87 13%
Total Income 29,614 34,342 100.0 100.0 -4,727 -14%
Expenses
Cost Of Materials Consumed 19,697 23,318 66.5 67.9 -3,620 -16%
Employee Benefit Expenses 1,842 1,730 6.2 5.0 111 6%
Finance Costs 22 9 0.1 0.0 13 156%
Depreciation& A Expenses 818 602 2.8 1.8 216 36%
Other Expenses 3,339 3,672 11.3 10.7 -333 -9%
TOTAL EXPENSES 25,718 29,331 86.8 85.4 -3,613 -12%
Profit Bef. Ex, &Extra Items and Tax 3,896 5,011 13.2 14.6 -1,114 -22%
Exceptional Items 677 0 2.3 0.0 677
PBT 4,574 5,011 15.4 14.6 -437 -9%
TAX EXPENSES 940 1,626 3.2 4.7 -685 -42%
PAT 3,633 3,385 12.3 9.9 248 7%
Exercise 1
1. The three most common tools of financial analysis are:
A. Financial reporting, ratio analysis, vertical analysis.
B. Ratio analysis, horizontal analysis, financial reporting.
C. Horizontal analysis, vertical analysis, ratio analysis.
D. Trend analysis, financial reporting, ratio analysis.
E. Vertical analysis, political analysis, horizontal analysis.

2. The comparison of a company's financial condition and performance across time is known as:
A. Horizontal analysis. B. Vertical analysis.
C. Political analysis. D. Financial reporting. E. Investment analysis.

3. The comparison of a company's financial condition and performance to a base amount is known
as:
A. Financial reporting. B. Horizontal ratios.
C. Investment analysis. D. Risk analysis. E. Vertical analysis

4. Extraordinary items:
A. Are not reported on a corporate income statement.
B. Are included in income from operations.
C. Are unusual and infrequent.
D. Include changes in accounting principle.
E. Are disclosed before discontinued operations on the income statement.

5. Horizontal analysis:
A. Is a method used to evaluate changes in financial data across time.
B. Is also called vertical analysis.
 S8 Financial Statement Analysis 4

C. Is the presentation of financial ratios.

D. Is a tool used to evaluate financial statement items relative to industry statistics.
E. Evaluates financial data across industries.

Example 1
Comparative statements for Kool Corporation are shown below:
KOOL CORPORATION
Comparative Income Statement
For the Years Ended December 31
2014 2013 2012
Sales $14,800 $13,229 $13,994
Cost of goods sold 8,225 8,661 8,375
Gross profit 6,575 4,568 5,619
Operating expenses 3,664 3,576 3,487
Operating income $ 2,911 $ 992 $ 2,132
Calculate trend percentages for all income statement amounts shown and comment on the results.
Use 2012 as the base year.
Answer:
KOOL CORPORATION
Comparative Income Statement
For the Years Ended December 31
2014 2013 2012
Sales 105.7% 94.5% 100.0%
Cost of goods sold 98.2 103.4 100.0
Gross profit 117.0 81.3 100.0
Operating expenses 105.1 102.5 100.0
Operating income 136.5 46.5 100.0
Comment: During 2013, sales declined, cost of sales increased, and operating expenses increased,
causing income to be only 46.5% of 2012 income. However, during 2014, sales increased, cost of
sales decreased, and although operating expenses increased from 2012, 2014 operating income was
136.5% of 2012 income. 2013 was not a good year, but the company seemed to recover in 2014.
Example 2
Vertical Common-Size (Partial) Balance Sheet for a
Hypothetical Company
Period 1 Period 2
% of Total Assets % of Total Assets
Cash 25 15
Receivables 35 57
Inventory 35 20
Net Fixed assets 5 8
Total assets 100 100
 S8 Financial Statement Analysis 5

Example 3 Example 4
Total Income +20% In July 1996, Sunbeam, a US company, brought in new
Net income +25% management to turn the company around. In the following year,
Operating cashflow –10% 1997, using 1996 as the base, the following was observed based
Total assets +30% on reported numbers:
Revenue +19%
Inventory +58%
Receivables +38%

1. Overall performance & Profitability

 Return on Equity (ROE) =Net income/shareholders’ equity.
 Reflects return on funds invested by shareholders.
 Of interest to current and prospective shareholders.
 Return on invested capital (ROIC) = (net income + interest(1-tax rate))/ invested
capital
 Invested capital = capital employed = Interest bearing debt+ shareholders’
equity
 Return on funds entrusted to the firm for relatively long time.
 Return on assets (ROA)=(net income + interest*(1-tax rate))/ total assets.
Numerator Denominator
Overall performance.
Return on Invested Capital PAT +Int(1-T) Average (Debt + Equity)
ROE Net income Average total equity
Margin Ratios
Net Margin /Return on Sale PAT Revenue
Operating Margin Operating Profit Revenue
Gross Margin Gross Profit Revenue
EBITDA Margin EBITDA Revenue

2. Efficiency and Investment utilization.

Numerator Denominator
Activity Ratios
Total asset turnover Revenue Average total assets
Fixed asset turnover Revenue Average net fixed assets
Working capital turnover Revenue Average working capital
Receivables turnover Revenue* Average receivables
Inventory turnover Cost of goods sold Average inventory
Payables turnover Purchases or Expense Average trade payables
Days of sales outstanding (DSO) Number of days in period Receivables turnover
Days Sales in Inventory (DSI) Number of days in period Inventory turnover
Days Payable Outstanding (DPO) Number of days in period Payables turnover
 S8 Financial Statement Analysis 6

 Cash conversion cycle=Receivables conversion period (i.e. days’ receivables) + inventory

conversion period (i.e. days’ inventory) - payment deferral period (i.e. days’ payables) =
operating cycle - payment deferral period.

3. Leverage and Financial condition.

1. Liquidity : Ability to meet current obligations.
 Working Capital = Current Assets-Current Liabilities
 Current Ratio= Current Assets/Current Liabilities
 Quick or Acid Test Ratio= (Current Assets-Inventory)/Current Liabilities
2. Solvency: Ability to meet interest costs and repayment schedules associated with long-
term debt.
 Debt/equity ratio = total liabilities/shareholders’ equity
 Alternatively, Debt/equity ratio = long-term liabilities/shareholders’ equity.
 Debt/capitalization ratio = long-term debt/total invested capital.
 Times interest earned = income before interest/interest expense
 Ratio of Cash generated by operations to total debt

4. Market ratios and Dividend

Numerator Denominator
Liquidity Ratios
Current ratio Current assets Current liabilities
Quick ratio Current assets-Inventory Current liabilities
Solvency Ratios
Debt Ratios
Debt-to-assets ratio Total debt Total assets
Debt-to-equity ratio Total debt Total shareholders’ equity
Coverage Ratios
Interest coverage / TIE EBIT Interest payments
Valuation Ratios & Related
EPS PAT No of Shares
P/E Price per share Earnings per share
P/B Price per share Book value per share
Dividend payout ratio Dividends Net income
Dividend Yield Dividends Price per share
 EPS: basic and diluted
o When a company has convertible securities, stock options outstanding, or other
financial instruments that can be converted to common shares, the calculation of
EPS becomes more complicated.
 S8 Financial Statement Analysis 7

Services

 Simultaneous production and consumption: There are no inventories or buffers (except

consulting WIP)
 Critical aspects of services are intangible: Intangible aspects are difficult to
quantify/measure
 Service usually consists of "substantive" and "peripheral" components. Completion of
peripheral components
 The value addition is mainly through human activities.
 Retaining human capital is vital.
 It is difficult to achieve economies of scale
 Accounting for training costs etc..
Financial Companies
Financial assets and liabilities should be considered as operating assets and liabilities
o Equity capital function as a cushion for economic risk
 Customers are liability holders.
o They prefer banks of high credit quality; but investors are less credit-sensitive,
provided they are compensated
 Opaqueness to customers and investors
o Detailed asset holdings are not publicly disclosed
o Relatively liquid balance sheet – assets can undergo substantial change in risk and
size within a short time
 They operate in highly competitive financial markets: Asset markets are less competitive?
 ROA =PAT/TA
 ROE=PAT/NW
 Operating efficiency is examined from three angles
o Net interest Margin (NIM) – difference between interest income and interest
expense as a percentage of total assets
o Spread – difference between interest rate on loans & advances and interest rate on
deposits
o Employee Cost
o Operating to staff expenses

Example 5
Use the financial data shown below to calculate the following ratios for the current year:
(a) Current ratio
(b) Acid-test ratio
(c) Accounts receivable turnover
(d) Days' sales uncollected
(e) Inventory turnover
 S8 Financial Statement Analysis 8

(f) Days' sales in inventory

Income statement data

Sales $650,000
Cost of goods sold 425,000
Income before taxes 78,000
Net income 54,600

Ending Balances Beginning Balances

Cash $ 19,500 $ 15,000
Accounts receivable (net) 65,000 60,000
Inventory 71,500 64,500
Plant and equipment (net) 195,000 183,900
Total assets $351,000 $323,400
Current liabilities $ 62,400 $ 52,700
Long-term notes payable 97,500 100,000

Answer:
(a) Current ratio: ($19,500 + $65,000 + $71,500) / $62,400 = 2.5
(b) Acid-test ratio: ($19,500 + $65,000) / $62,400 = 1.35
(c) Accounts receivable turnover: $650,000 / [($65,000 + $60,000) / 2] =10.4 times
(d) Days’ sales uncollected: ($65,000 / $650,000) x 365 = 36.5 days
(e) Inventory turnover: $425,000 / [($71,500 + $64,500) / 2] = 6.25 times
(f) Days’ sales in inventory: ($71,500 / $425,000) x 365 61.4 days

Example 6
Use the following information from the current year financial statements of a company to calculate
the ratios below:
(a) Current ratio.
(b) Accounts receivable turnover. (Assume the prior year's accounts receivable balance was
$100,000.)
(c) Days' sales uncollected.
(d) Inventory turnover. (Assume the prior year's inventory was $50,200.)
(e) Times interest earned ratio.
(f) Return on common stockholders' equity. (Assume the prior year's common stock balance was
$480,000 and the retained earnings balance was $128,000.)
(g) Earnings per share (assuming the corporation has a simple capital structure, with only common
stock outstanding).
(h) Price earnings ratio. (Assume the company's stock is selling for $26 per share.)
(i) Divided yield ratio. (Assume that the company paid $1.25 per share in cash dividends.)

Income statement data:

Sales (all on credit) $1,075,000
Cost of goods sold 575,000
Gross profit on sales 500,000
Operating expenses 305,000
Operating income 195,000
 S8 Financial Statement Analysis 9

Interest expense 20,400

Income before taxes 174,600
Income taxes 74,000
Net income $ 100,600

Balance sheet data:

Cash $ 38,400
Accounts receivable 120,000
Inventory 56,700
Prepaid Expenses 24,000
Total current assets 239,100
Total plant assets 708,900
Total assets $948,000

Accounts payable $ 91,200

Interest payable 4,800
Long-term liabilities 204,000
Total liabilities 300,000
Common stock, $10 par 480,000
Retained earnings 168,000
Total liabilities and equity $948,000

Answer:
(a) Total current assets $239,100
Total current liabilities $96,000
Current ratio = $239,100/$96,000 = 2.5 to 1
(b) Accounts receivable turnover = $1,075,000/[$120,000 + $100,000)/2] = 9.8 times
(c) Days' sales uncollected = ($120,000/$1,075,000) x 365 = 40.7 days
(d) Inventory turnover = $575,000/[($56,700 + $50,200)/2] = 10.7 times
(e) Times interest earned = $195,000/$20,400 = 9.6 times
(f) Beginning Ending
Common stock $480,000 $480,000
Retained earnings 128,000 168,000
Total equity $608,000 $648,000
Return on common stockholders' equity =
$100,600/[($608,000 + $648,000)/2] = 16%

(g) Number of shares of common stock = $480,000/$10 par = 48,000 shares

Earnings per share = $100,600/48,000 shares = $2.10
(h) Price earnings ratio = $26/$2.10 = 12.4
(i) Dividend yield ratio = $1.25/$26 = 4.8%
 S8 Financial Statement Analysis 10

Unidentified Industries
Try to match the five following types of companies with their corresponding balance sheets and financial
ratios as shown in sheet _industry.
1. Electric utility
2 Automobile manufacturer
3. Japanese trading company
4. Aerospace manufacturer
5. Supermarket Chain
In doing the exercise, consider the operating and competitive characteristics of the industry and their
implications for (1) the collection period; (2) inventory turnover; (3)the amount of plant and equipment; (4)
the profit margins and profitability; and (5) the appropriate financing structure. Then identify which one of
the five sets of balance sheets and financial ratios best match your expectations.
Unidentified Balance Sheet
A B C D E
Balance Sheet Percentages
Cash 7.60% 2.70% 1.40% 7.20% 12.70%
Receivables 31.7 4.7 2.9 60.3 11.5
Inventories 5.3 2.0 23.0 8.7 48.1
Other current assets 1.2 3.0 1.8 7.3 0.0
Property and equipment (net) 30.2 66.6 49.9 4.3 25.0
Other assets 24.0 21.0 21.0 12.2 2.7
Total assets 100.00% 100.00% 100.00% 100.00% 100.00%

Notes payable 38.40% 4.20% 4.60% 50.80% 0.90%

Accounts payable 5.5 3.0 20.0 15.2 21.5
Other current liabilities 1.5 4.7 12.7 5.7 27.4
Long-term debt 17.4 30.0 37.5 22.7 8.1
Other liabilities 26.5 22.9 9.8 1.3 8.1
Owners’ equity 10.7 35.2 15.4 4.3 34.0
Total liabilities and equity 100.00% 100.00% 100.00% 100.00% 100.00%
Selected Ratios
Net profits/net sales .04 .14 .02 .01 .05
Net profits/total assets .03 .05 .06 .01 .03
Net profits/owners’ equity .29 .14 .41 .13 .10
Net sales/total assets .78 .36 3.2 2.1 .67
Collection period (days) 149 48 3 106 63
Inventory turnover 11 10 10 23 1.1
Total liabilities/total assets .89 .65 .85 .96 .66
Long-term debt/owners equity 1.6 .85 2.4 5.3 .24
Quick ratio .9 .9 .2 .9 .5
 S8 Financial Statement Analysis 11

MC Questions
1. 1. A company has current assets in the amount of Rs.8,392, and current liabilities in the amount
of Rs.5,923. What is the company’s working capital?
A. Rs.14,315 B. Rs.13,685
C. Rs. 3,099 D. Rs. 2,469 E. Rs.5923

2. The average number of times a company's inventory is sold during an accounting period,
calculated by dividing cost of goods sold by the average inventory balance, is equal to the:
A. Accounts receivable turnover. B. Inventory turnover.
C. Days' sales uncollected. D. Current ratio.
E. Price earnings ratio.
3. A company had a market price of $37.50 per share, earnings per share of $1.25, and dividends per
share of $0.40. Its price-earnings ratio is equal to:
A. 3.1. B. 30.0.
C. 93.8. D. 32.0.
E. 3.3.

4. The Blake Company has a gross profit ratio of 38%, a net margin ratio of 4.5%, and net income
of Rs.12,600. What is Blake Company’s cost of goods sold?
a. Rs.106,400 b. Rs.173,600
c. Rs.272,175 d. Rs.280,000

5. Hampton Company had net sales in the amount of Rs.1,845,000 and a gross profit margin of
42%. If Hampton’s inventory turnover ratio is 4.5, what is the company’s average inventory?
a. Rs.172,200 b. Rs.237,800
c. Rs.410,000 d. Rs.1,607,200

6. A company has sales of $2,458,422, a gross profit ratio of 23%, a days’ sales in inventory ratio of
12.4, and total current assets of $539,600. What is the ending inventory for the year?

A. $46,013 B. $58,000
C. $64,310 D. $61,715
E. $55,951

7. A company has net sales in the amount of Rs.10,535 and cost of goods sold in the amount
of Rs.7,643. What is the company’s gross profit ratio?
a. 27.45% b. 37.84%
c. 72.55% d. 137.84%

8. A company that frequently collects cash from customers on its accounts would have a
a. high gross profit ratio
b. low earnings per share
c. low accounts receivable turnover ratio
d. high accounts receivable turnover ratio
 S8 Financial Statement Analysis 12

9. Gibson Company had the following information on its 2006 income statement:
Net Sales Rs.838,000
Cost of Goods Sold Rs.376,000
Operating Expenses Rs.194,000
Interest Expense Rs. 37,500
What is Gibson Company’s times interest earned (interest coverage) ratio?
a. 22.35 times b. 17.17 times
c. 12.32 times d. 7.15 times

10. A company that is leveraged is one that has

a. high earnings per share b. high equity financing
c. high debt financing d. a high dividend yield ratio

11. A company that builds airliners for major passenger airline companies would most likely have a
a. high current ratio b. high inventory turnover ratio
c. low inventory turnover ratio d. low debt to equity ratio

12. The relationship between credit sales and accounts receivable is known as
a. working capital b. cash flow adequacy ratio
c. accounts receivable turnover ratio d. profit margin ratio

13. If Hatch Company’s net sales are Rs.675,000, its gross profit is Rs.495,000, and its average
inventory is Rs.45,000, what is Hatch’s inventory turnover ratio for the period?
a. 4 b. 11
c. 15 d. 26

14. If Morris Company’s total assets are Rs.764,000, and its total liabilities are Rs.394,000, what is
Morris Company’s debt to equity ratio?
a. 0.516 b. 0.939
c. 1.065 d. 1.939