Lecture 15

Financial Statement
Analysis I
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 Bad debts

 Doubtful debts

 Provisions

 Contingent liabilities
Stakeholders
Why financial statement analysis
is important to managers
• Users of accounting information are interested in whether the
company is creating wealth and making profits, and whether it
is likely to survive and expand

• Managers are accountable to shareholders for the management

of risk and performance

• They therefore need to understand and explain the financial

performance and risk so that they can justify how they have
used the resources entrusted to them.
Users needs

• Different users of financial information are likely to have

different information needs, which will determine the ratios
that they find useful.
For example,
• Shareholders are interested in profitability, investment and
gearing ratios
• Lenders are interested in profitability and gearing ratios
• Suppliers are interested in liquidity ratios
Financial Statements
Financial Statements Are Designed for Analysis

Classified Comparative Consolidated

Financial Financial Financial
Statements Statements Statements

Items with certain Amounts from Information for the

characteristics are several years parent and subsidiary
grouped together. appear side by side. are presented.

Results Helps identify Presented as if

in standardized, significant the two companies
meaningful changes and are a single
subtotals. trends. business unit.
Financial Statement Analysis

• Interpret the financial statements. What do the

numbers tell us? What do they mean?
• Assess the company performance and diagnose its
problems
• Come up with solutions and recommendations
• Make informed decisions
Lecture outline

• The purpose of financial statement analysis

• Major categories of ratios used for analysing financial

statements

• Ratio calculation

• Ratio interpretation
Learning Outcomes

a. describe the roles of financial reporting and financial statement

analysis;
b. describe the roles of the statement of financial position,
statement of comprehensive income, statement of changes in
equity, and statement of cash flows in evaluating a company’s
performance and financial position;
c. describe the importance of financial statement notes and
supplementary information—including disclosures of
accounting policies, methods, and estimates—and
management’s commentary;
Learning Outcomes

d. describe the objective of audits of financial statements, the

types of audit reports, and the importance of effective internal
controls;
e. identify and describe information sources that analysts use in
financial statement analysis besides annual financial statements
and supplementary information;
f. describe the steps in the financial statement analysis
framework.
Tools of Analysis

Dollar &
Trend
Percentage
Percentages
Changes

Component
Percentages
Ratios
Dollar and Percentage Changes

Dollar Change:
Dollar Analysis Period Base Period
Change = Amount – Amount

Percentage Change:
Percent Base Period
Change = Dollar Change
÷ Amount

14-18
Dollar and Percentage Changes
Evaluating Percentage Changes in
Sales and Earnings

Sales and earnings In measuring quarterly

should increase at changes, compare to
more than the rate the same quarter in
of inflation. the previous year.

Percentages may be
misleading when the
base amount is small.

14-19
Dollar and Percentage Changes

14-20
 Evaluating Percentage Changes in Sales and Earnings

Computing the percentage changes in sales, gross

profit, and net income from one year to the next
provides insight into a company’s rate of growth.

In measuring the dollar or percentage change in

quarterly sales or earnings, it is customary to compare
the results of the current quarter with those of the
same quarter in the preceding year, in order to prevent
seasonal distortions.

14-21
Percentages Become Misleading When the Base Is Small

Percentage changes may create a misleading

impression when the dollar amount used as a base is
unusually small.
EXAMPLE:

Year 1 Income: $100,000

Year 2 Income: $10,000 (Possibly due to an
extraordinary transaction, like tornado losses)
Year 3 Income: $100,000
From Year 2 to Year 3: 900% increase in net income.

14-22
 Trend Percentages

Trend analysis is used to reveal patterns in

data covering successive periods.

Trend Analysis Period Amount

= × 100%
Percentages Base Period Amount

14-23
Trend Percentages

14-24
Component Percentages
Examine the relative size of each item in the financial
statements by computing component (or common
sized) percentages.
Component Analysis Amount
Percentage
= Base Amount × 100%

Financial Statement Base Amount

Balance Sheet Total Assets
Income Statement Revenues

14-25
Component Percentages

14-26
Quality of Earnings

Investors are interest in companies that

demonstrate an ability to earn income at a
growing rate each year. Stability of earnings
growth helps investors predict future prospects
for the company.

Financial analyst often speak of the “quality of

earnings” at one company being higher than
another company in the same industry.

14-27
Quality of Assets and the Relative
Amount of Debt
While satisfactory earnings may be a
good indicator of a company’s ability to
pay its debts and dividends, we must also
consider the composition of assets, their
condition and liquidity, the timing of
repayment of liabilities, and the total
amount of debt outstanding

14-28
A Classified Balance Sheet
COMPUTER CITY
Asset Section: Classified Balance Sheet
December 31, 2019
Current assets:
Cash $ 30,000
Marketable Securities 11,000
Notes Receivable 5,000
Accounts Receivable 60,000
Inventory 70,000
Prepaid Expenses 4,000
Total current assets 180,000
Plant and equipment:
Land $ 151,000
Building $ 120,000
Less: Accumulated depreciation (9,000) 111,000
Equipment and Fixtures 45,000
Less: Accumulated depreciation (27,000) 18,000
Total plant and equipment 280,000
Other assets:
Land held as a future building site 170,000
Total assets $ 630,000

14-29
14-30
Ratios analysis
A ratio is a simple mathematical expression
of the relationship between one item and another.

Along with dollar and percentage changes,

trend percentages, and component percentages,
ratios can be used to compare:

Past performance to Other companies to

present performance. your company.

14-31
Ratios analysis

• An accounting ratio is calculated by dividing one number from a

set of financial statements by another number from the same
set of financial statements.
• Aids comparison between organisations of different:
– Size and
– Reporting currency
Most useful for comparing within same industry
– Comparison of one company over time (past performance and
planned performance)
Important to note

• Financial statement analysis is only as good as the underlying

data
• Different accounting methods used by companies can make
comparisons difficult
• There is no single correct way to compute many financial ratios.
• Ratios do not provide the answer, merely helps find the right
questions to ask (e.g. indicates areas for further
analysis/questioning)
 Financial ratio classification
Categories

Profitability Is the company creating wealth?

Financial gearing How risky is the company?

Liquidity Are liquid resources sufficient to meet maturing short

term obligations?

Efficiency Is the company using resources efficiently?

Investment What’s the return on shareholders’ investment?

Profitability
• The profitability ratios are concerned with how efficiently a firm
is generating profit from operations and how income and
expenses contribute to profitability

• The following ratios can be used to evaluate the profitability of

a company:

• Return on shareholders’ equity

• Return on capital employed
• Gross profit margin
 Measures of Profitability

An income statement can be prepared in either a

multiple-step or single-step format.

The single-step format

is simpler. The multiple-step
format provides more detailed
information.

14-36
 Income Statement (Multiple-Step)
Proper Heading

Gross Profit

Operating Expenses

Non-operating Items

Remember
to compute
EPS.
14-37
Return on shareholders’ equity（ROE）

• How much profit a company generates with the money

shareholders have invested (or how well managers use funds
invested by shareholders to generate profit)
Net Profit × 100
Shareholders’ equity
Year 20X0 Company A Company B
Net Profit 5,000 3,600
Shareholders Equity 20,000 12,000
ROE 25% 30%

•In long term, ROE should exceed cost of equity capital for the firm to be
regarded as a success.
Return on capital employed
• Indication of how well managers use total funds invested in the
company.
Operating profit × 100
Shareholders’ Equity + Non-current liabilities
A higher ROCE indicates more efficient use of capital.
ROCE should be higher than the company’s cost of capital; otherwise it
indicates that the company is not employing its capital effectively and is not
generating shareholder value.

Year 20X0 Company A Company B

Operating Profit 5,500 4,000
Shareholders Equity 20,000 12,000
Non-current liabilities 10,000 10,000
ROCE 18.3% 18.2%
Cost of Capital 20% 15%
 The ROCE for UK companies
18
Service
ROCE

companies
15
All non-financial
12 companies

Manufacturing
6
companies

2006 2007 2008 2009 2010 2011

Gross profit margin
• How much profit per £ sales is the company making?
Gross profit × 100
Sales revenue
• Measures the profitability of sales, after deducting direct cost of sales
• Reflect a firm’s market power and production efficiency
• Influenced by the price premium charged on the company’s products

Company A Company B
Units sold 500 500
Sale price per unit £10 £8
Sales Revenue £5,000 £4,000
Cost of Sales £3,500 £3,500
Gross Profit £1,500 £500
Gross Profit Margin % 30% 12.5%
Comparison of gross profit margin
across industries
High
Company Industry Year to Gross profit % Sale
Price
AstraZeneca Pharmaceuticals 31/12/12 81%

ASOS Online fashion 31/8/13 52%

Adidas Sports goods 31/12/12 48%

Daimler Motor vehicles 31/12/12 22%

Big
Morrison Supermarket 3/2/13 6.7% volume,
Economies
of scale
Comparison of gross profit margin
within the same industry

Company Year to Gross profit %

Volkswagen 31/12/12 18%

BMW 31/12/12 20%

Daimler 31/12/12 22%

Toyota 31/3/13 16%

Renault 31/12/12 17%

Comparison of ROE and ROCE

Company Year to ROE ROCE

Volkswagen 31/12/12 30% 11%

BMW 31/12/12 18% 7%

Daimler 31/12/12 15% 7%

Toyota 31/3/13 9% 6%

Renault 31/12/12 7% 4%
Profitability ratios
Return on shareholders’ equity (ROE)

Net Profit × 100

Shareholders’ equity

Return on capital employed (ROCE)

Operating profit × 100

Shareholders’ Equity + Non-current liabilities

Gross profit margin

Gross profit × 100

Sales revenue
 Market Value Ratios (Investors’ Reactions)
• Notes: (1) Book Value Per Share = (Com Equity)/(# of Shares)
(2) Cash flow per share equals net income plus depreciation or
amortization divided by the number of shares outstanding.
Price Per Share
Price Earnings (P/E) Ratio =
Earnings Per Share
（市盈率）
Price Per Share
Price to Book Value =
Book Value Per Share
（市净率）
Price Per Share
Price to Cash Flow =
Cash Flow Per Share
（股价与现金流比率）
Price Per Share
Price to Sales =
Sales Per Share
（市销率）
 Market Value Ratios (Investors’ Reactions)

Market capitalization = Current stock price * Number of outstanding shares.

Total book value = Total assets – Total liabilities – Preferred stock – Intangible
assets
Market Value Ratios (Investors’ Reactions)
Financial Gearing
• The financial risk from having some proportion of capital in the
form of interest bearing liabilities or debt
• In the USA, this is called financial leverage.
• Important in assessing risk: when borrowing is heavy, it
increases the risk of the company becoming insolvent
• If a company is insolvent, it cannot meet its financial
commitments as they fall due in the long term
• When lenders see that a company is insolvent they usually
force it out of business, so as to limit their losses before its
financial situation becomes worse
Financial Gearing
 The effect of financial gearing
The word gearing is a metaphor,
Operating like a gear or lever, increases the
profit rewards and risks to shareholders.

Returns
to ordinary

shareholders

The two wheels are linked by the cogs, so a

small circular movement in the large wheel
leads to a relatively large circular
movement in the small wheel.
 Financial Gearing Ratios

1. Gearing ratio: Measures the contribution of long-term lenders

to the capital of the company.

Gearing Long-term (non-current) liabilities × 100

ratio Equity + Long-term (non-current) liabilities

Year 1 Year 2
Non-current liabilities 200 300
Equity 500 540
Gearing ratio 28.6% 35.7%
Financial Gearing Ratios
2. Interest cover ratio: Measures the amount of operating profit available to cover
interest payable.

Interest cover Operating profit

ratio Interest payable

Operating Profit 250

Interest payable 20
Interest cover ratio 12.5 times

If the ratio is low, there is higher risk to the lenders that interest payments will not be
met.
Gearing ratio
ASOS Daimler General Motors
Morrison Telefonica
31/08/13 31/12/12 31/12/04
3/2/13 31/12/12

37%
Interest
bearing Interest
liabilities bearing
Interest
liabilities
bearing
Equity 67% liabilities
75%
100 %
92%
Equity
63%
Equity
33% Equity
25%
8%
Effect of increasing gearing on ROE
Scenario 1 Scenario 2
Non-current liabilities 200 300
Equity 200 100
Gearing ratio 50% 75%
Net profit 25 20
ROE 12.5% 20%
In the second scenario, the company achieves a much
higher return to shareholders because of the effect of
gearing on ROE. Gearing can be used to increase return to
owners (especially when interest rates are low)
Profit attributable to sources of funds
Interest
bearing
liabilities

ROCE:
Operating profit
Capital employed
ROE:
Net profit Equity
Equity

Principle: Relate profit to capital used to generate that profit

Week 12 Test
• Date/time: Sunday 23th May at 19:00pm
• Duration: 50 minutes
• Location: check your timetable for information
• Please arrive to the exam room promptly. The invigilator has the right to not
admit you to the room if you are late.
• Leave your belongings near the entrance to the room.
• Bring your student ID, writing tools and calculator. The calculator will be
checked for any information stored in memory.
• You are allowed to bring a dictionary but it will be checked for annotation
(Electronic dictionaries are not permitted).
• Students are not permitted to have mobile phones in the exam venue.
Any brought in should be turned off and left in bags at the rear of the room,
or with the invigilator. Under no circumstances should they be taken to the
students desk, or left in pockets. It is an academic offence for a student to
have a mobile phone with them.
Week 12 Test

• Test topics will cover material from week 1 to week 8.

• The test will consist of two parts: part A and part B.

• You must answer all questions in part A. You make a choice of
two out of three questions from part B.