Financial Statement Analysis
Readings: Chapter 3
At the end of this unit students should be able to:
Explain why ratio analysis is usually the first step in the analysis of a company’s financial statements.
Explain the purpose of trend analysis.
Explain the purpose of comparative analysis (benchmarking)
Explain the purpose of common-size analysis.
List several limitations of ratio analysis.
Identify some of the qualitative factors that must be considered when evaluating a company’s financial performance
NOTE - These electronic notes are not detailed. The lecture for this topic will entail the working of ratios for the financial statements of a fictitious company (to be given in class or accessible from below).
Analyzing financial statements is a crucial and integral phrase of the process of evaluating the current or future position of a company. Pervasive throughout financial statement analysis is the use of ratios.
(Note- Using ratios that draw upon figures from the P&L as well as from the Balance Sheet can be misleading. This is because a 'flow' figure is placed with a 'year-end' figure. Category B has already accounted for this by the use of "Average figures".)
This form of analysis is important as it brings out the relative position of a company overtime i.e. whether things are improving or declining. (Note - When considering trends, one should always factor in the impact of inflation.
This involves comparing ratios of one company with similar ratios of another company in the same industry (Benchmarking) or with an industry average. Although two companies may be in the same industry, they may be of different sizes. Care must be taken to ensure that any effects caused by this inequity are appropriately adjusted for when making comparisons (e.g. a small grocery store in a neighbourhood versus an international giant).
1999 2000 2001 2002 Firm A 3.1 3.2 3.3 3.4 Firm B 3.3 3.2 3.3 3.2 Firm C 3.8 3.7 3.7 3.5 Firm D 3.6 3.5 3.3 3.2 Industry Average 3.5 3.4 3.4 3.3
Common Size Analysis
This involves constructing a common size balance sheet by dividing each asset and liability item by total assets and then expressing the result as a percentage. It also involves constructing a common size income statement by simply dividing each income statement item by sales. The resultant percentage statements can be compared with statements of larger or smaller firms, or those of the same firm over time.
Common-Size Balance Sheet - Year 2000
$ % $ % Cash 9000000 18 Accounts payable 12000000 24 Accounts Receivable 1000000 2 Notes Payable 5000000 10 Inventory 20000000 40 Accrued Expenses 3000000 6 Marketable Securities 8000000 16 Bonds Payable 20000000 40 Prepaid Expenses 1000000 2 Preferred Stock 1000000 2 Plant and Equipment 11000000 22 Common Stock 1000000 2 50000000 100 Share Premium 3000000 6 Retained Earnings 5000000 10
Common-Size Income Statement - Year 2000 $ % Sales 10000000 100 Cost of Goods Sales 4000000 40 Selling & Admin. Expenses 800000 8 Depreciation Expense 2000000 20 Interest Expense 1350000 13.5 Taxes 740000 7.4 Preference Dividends 110000 1.1 Ordinary Dividends 400000 4 Retained Profit 600000 6 100
Note - a combination of any two or all of the above types of analyses is the customary practice of good financial analysts. Another analysis could involve comparing the current performance of a company with budgets and goals set by the management.
The figures that are used are derived from financial statements which are vulnerable to window dressing.
Financial statements of supposedly similar companies may look totally different due to contrasting methods of accounting.
The impact of inflation (mentioned above at Trend analysis)
The impact of size (mentioned above at Comparative Analysis)
Seasonal factors can distort ratios
Comparing a company with an industry average can be misleading because many companies operate in more than one industry.
* - The above limitations support the fact that analysis of financial statements is more an art than a science. Interpreting the results of financial statements analysis requires a sound understanding of the company, the industry in which it operates and the general economic environment.
Qualitative factors to be considered in evaluating a company
nAre the company’s revenues tied to 1 key customer?
To what extent are the company’s revenues tied to 1 key product?
nTo what extent does the company rely on a single supplier?
What percentage of the company’s business is generated overseas?
nLegal and regulatory environment
Information about Financial Ratios
In the North America and Europe, a number of research databases exists with which a user can interact to obtain information about companies.
In Jamaica, sources include:
- Bank of Jamaica - http://www.boj.org.jm/home30.html
- Statistical Institute of Jamaica (STATIN) - http://www.statinja.com/
- The Jamaica Stock Exchange - http://www.jamstockex.com/
- Financial sections of newspapers
- Annual and interim reports of companies
- Web-sites of companies
- Stock brokers and other financial services companies
RIGHT CLICK BELOW AND CHOOSE "Save Target As..." (If using Internet Explorer) OR "Save Link As..."(If using Netscape) for the following Excel spreadsheet: (You will be prompted to save it to a destination of your choice)
|Note - If you are having trouble accessing these spreadsheets, please drop me an email as soon as possible. I will still carry enough copies to the lecture.|