FINANCIAL STATEMENT ANALYSIS 1

Presented to the Faculty of College of Business Administration

University of the Cordilleras

In Partial Fulfillment of the Requirements of the Course ADM B003:

Managerial Accounting and Control I

Submitted by:

Gonzales, Shane Kaye Joi

Hallig, Triken

Jiang, Cunmin

Luy, Hazel

Submitted to:

Jasmin May P. Baniaga, CPA,CMA,MBA

 Objectives & General Approach to Financial Statement Analysis

Reported by: Gonzales, Shane Kaye Joi

Financial Statement Analysis

Financial Statement Analysis involves careful selection of data from financial statements

in order to assess and evaluate the firm’s past performance, its present condition, and

future business potentials.

Financial statement analysis is the process of analyzing a company's financial

statements for decision-making purposes. External stakeholders use it to understand the

overall health of an organization as well as to evaluate financial performance and

business value. Internal constituents use it as a monitoring tool for managing the finances.

The financial statements of a company record important financial data on every aspect

of a business’s activities. As such they can be evaluated on the basis of past, current, and

projected performance.

In general, financial statements are centered on generally accepted accounting

principles (GAAP) in the U.S. These principles require a company to create and maintain

three main financial statements: the balance sheet, the income statement, and the cash

flow statement. Public companies have stricter standards for financial statement

reporting. Public companies must follow GAAP standards which requires accrual

accounting. Private companies have greater flexibility in their financial statement

preparation and also have the option to use either accrual or cash accounting.
Objectives of Financial Statement Analysis

The primary purpose of Financial Statement Analysis is to evaluate and forecast the

company’s financial health. Interested parties, such as the managers, investors, and

creditors, can identify the company’s financial strengths and weaknesses and know

about the:

1. Profitability of the business firm

2. Firm’s ability to meet its obligations

3. Safety of the investment in the business

4. Effectiveness of management in running the firm

Types of Financial Statement Analysis

Most often, analysts will use three main techniques for analyzing a company's financial

statements.

1. Horizontal Analysis

Involves comparing historical data. Usually, the purpose of horizontal analysis is to

detect growth trends across different time periods.

2. Vertical Analysis

Compares items on a financial statement in relation to each other. For instance,

an expense item could be expressed as a percentage of company sales.

3. Ratio Analysis

A central part of fundamental equity analysis, compares line-item data. P/E ratios,

earnings per share, or dividend yield are examples of ratio analysis.

a. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debts as they

become due, using the company's current or quick assets. Liquidity ratios include

the current ratio, quick ratio, and working capital ratio.

b. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt

levels with its assets, equity, and earnings, to evaluate the likelihood of a company

staying afloat over the long haul, by paying off its long-term debt as well as the

interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-

assets ratios, and interest coverage ratios.

c. Profitability Ratios

These ratios convey how well a company can generate profits from its operations.

Profit margin, return on assets, return on equity, return on capital employed, and

gross margin ratios are all examples of profitability ratios.

d. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company

uses its assets and liabilities to generate sales and maximize profits. Key efficiency

ratios include: turnover ratio, inventory turnover, and days' sales in inventory.

e. Coverage Ratios

Coverage ratios measure a company's ability to make the interest payments and

other obligations associated with its debts. Examples include the times interest

earned ratio and the debt-service coverage ratio.

f. Market Prospect Ratios

 These are the most commonly used ratios in fundamental analysis. They include

dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio.

Investors use these metrics to predict earnings and future performance.

Analyzing Financial Statements

The financial statements of a company record important financial data on every aspect

of a business’s activities. As such they can be evaluated on the basis of past, current, and

projected performance.

In general, financial statements are centered on generally accepted accounting

principles (GAAP) in the U.S. These principles require a company to create and maintain

three main financial statements: the balance sheet, the income statement, and the cash

flow statement. Public companies have stricter standards for financial statement

reporting. Public companies must follow GAAP standards which requires accrual

accounting.

Private companies have greater flexibility in their financial statement preparation and

also have the option to use either accrual or cash accounting.

Several techniques are commonly used as part of financial statement analysis. Three of

the most important techniques include horizontal analysis, vertical analysis, and ratio

analysis. Horizontal analysis compares data horizontally, by analyzing values of line items

across two or more years. Vertical analysis looks at the vertical affects line items have on

other parts of the business and also the business’s proportions. Ratio analysis uses

important ratio metrics to calculate statistical relationships.

Financial Statements

As mentioned, there are three main financial statements that every company creates

and monitors: the balance sheet, income statement, and cash flow statement.

Companies use these financial statements to manage the operations of their business

and also to provide reporting transparency to their stakeholders. All three statements are

interconnected and create different views of a company’s activities and performance.

Balance Sheet

The balance sheet is a report of a company's financial worth in terms of book value. It is

broken into three parts to include a company’s assets, liabilities, and shareholders' equity.

Short-term assets such as cash and accounts receivable can tell a lot about a company’s

operational efficiency. Liabilities include its expense arrangements and the debt capital

it is paying off. Shareholder’s equity includes details on equity capital investments and

retained earnings from periodic net income. The balance sheet must balance with assets

minus liabilities equaling shareholder’s equity. The resulting shareholder’s equity is

considered a company’s book value. This value is an important performance metric that

increases or decreases with the financial activities of a company.

Income Statement

The income statement breaks down the revenue a company earns against the expenses

involved in its business to provide a bottom line, net income profit or loss. The income

statement is broken into three parts which help to analyze business efficiency at three

different points. It begins with revenue and the direct costs associated with revenue to

identify gross profit. It then moves to operating profit which subtracts indirect expenses
such as marketing costs, general costs, and depreciation. Finally it ends with net profit

which deducts interest and taxes.

Basic analysis of the income statement usually involves the calculation of gross profit

margin, operating profit margin, and net profit margin which each divide profit by

revenue. Profit margin helps to show where company costs are low or high at different

points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company's cash flows from

operating activities, investing activities, and financing activities. Net income is carried

over to the cash flow statement where it is included as the top line item for operating

activities. Like its title, investing activities include cash flows involved with firm wide

investments. The financing activities section includes cash flow from both debt and equity

financing. The bottom line shows how much cash a company has available.

Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and other valuation

statements to analyze the value of a company. Free cash flow statements arrive at a net

present value by discounting the free cash flow a company is estimated to generate

over time. Private companies may keep a valuation statement as they progress toward

potentially going public..

General Approach to Financial Statement Analysis

1. Evaluation of the environment (industry and economy as a whole) where the

company conducts business.

2. Analysis of the firm’s short-term solvency

3. Analysis of the company’s capital structure and long-term solvency

4. Evaluation of the management’s efficiency in running the business

5. Analysis of the firm’s profitability

 Steps in Financial Statement Analysis

Reported by: Hallig, Triken

Financial statement analysis, seeking to describe and explain:

• The demand and supply forces underlying the provision of financial statement

data.

• The properties of numbers derived from financial statements.

• The key aspect of decision that use financial statement information.

• The features of the environment in which these decisions are made.

Any financial statement is known to be used in three main steps for analysis.

1. Find out the relevant information from all the available data which helps in

decision making.

2. Organize the selected information to emphasize on the relationships that exist

between the crucial figures in a financial statement.

3. Draw conclusions, infer, and evaluate the processed information for results.

3 Major Process in Financial Statement Analysis

1. Reformulating Reported Financial Statements:

Reformulating reported financial statement is restating financial statement

in such a way that financial statements serve the purpose of analysis better

and allows to more efficiently and accurately interpret the performance of the

company. In case of income statement reformulation takes form of dividing

reported items into recurring and non-recurring items, separating earnings into
 core and transitory earnings. In case of balance sheet reformulation takes form

of breaking the balance sheet items into operating assets/liabilities and

financial asset/liabilities. For cash flow statements removing financing

activities(for example interest expense) from cash flow from operations etc.

2. Adjustments of Measurement Errors:

Adjustment of measurement errors is done to remove the noise present in

the input data to enhance the quality of the reported accounting numbers.

For example removing the R&D expenses from the income statement and

showing in the balance sheet.

3. Financial Ratio Analysis on the Basis of Reformulated and Adjusted Financial

Statements:

Conducting ratio analysis on the adjusted financial statements involves

calculating various ratios to derive insight about the performance of a

company.

Financial Statement Analysis Framework

Steps Explanation Output

Identify The this step guides further decisions Statement of the purpose

Purpose and about the approach, tools, data or objective of analysis

Context of The sources, and the format which the

Analysis final report will assume. It also

 defines the target audience, end A list (written or unwritten)

product, and timeframe. Further, it of specific questions to be

identifies the requisite resources answered by the analysis.

and resource constraints. After this,

the analyst should be able to Nature and content of

compile the specific questions report to be provided

which are to be answered by the Timetable and budgeted

analysis; resources for completion.

Collect Relevant the analyst gathers the necessary Organized financial

Data data to answer the specific statements.

questions that were compiled in

step 1. This may include obtaining Financial data tables.

information on the economy and

industry within which the company Completed questionnaires,

operates. Such data will allow a if applicable

better understanding of the

company’s business, financial

position, and financial

performance;

Process Data the analyst processes the data that Adjusted financial

was collected in step 2 using various statements,

tools of analysis. This may involve

computing financial ratios and Common-size statements.

 growth rates, creating charts,

preparing common-size financial Ratios and graphs.

statements, or performing statistical

analyses such as regression analysis; Forecasts.

Analyze / Interpret the analyst assesses the data that Analytical results.

The Processed was processed in step 3. The analyst

Data. should be able to interpret the

output of the analysis as well as use

it to support a conclusion or

recommendation;

Develop And the analyst should communicate Analytical report answering

Communicate the conclusion and questions posed in Phase 1.

Conclusions (E.G., recommendations derived from the

With An Analysis analysis in an appropriate format Recommendation

Report). that answers the questions that regarding the purpose of

were posed in step 1 the analysis, such as

whether to make an

investment or grant credit.

Follow up The analyst should perform periodic Updated report and

reviews to determine if the initial recommendations.

conclusions and recommendations

still hold. This may require a repeat

of all the previous steps periodically.

 Limitations of Financial Statement Analysis

Reported by: Jiang, Cunmin

Limitations of Financial Statement Analysis

Financial Analysis helps provide an assessment of the financial weaknesses and strengths

of a business enterprise. However, there are several limitations which include

incomparable financial statements across different companies. Several limitations

include the following:

1. Limitations of financial Statements

Financial statements do not provide a complete understanding of the problem. The

information provided in these statements is simply a rough estimate. Only when the

business is sold or liquidated can the true position be determined. During the life of the

company, however, the financial statements must be prepared for various accounting

periods, usually one year. To determine profitability and other factors, costs and incomes

must be allocated to different times.

The accountant's personal judgment will determine how expenses and incomes are

allocated. The statements are also inaccurate due to the presence of contingent assets

and liabilities. As a result, financial statements do not provide a complete picture.

2. Affected by Window-dressing

Because the financial accounts are expressed in monetary terms, they appear to provide

a holistic picture of the situation. The valuation of fixed assets on the balance sheet does

not reflect the value for which they can be sold or the money that will be needed to
replace them. The balance sheet is constructed under the assumption that the business

will continue to operate.

The worry is likely to persist in the future. As a result, fixed assets are valued at their original

cost less accumulated depreciation. Certain assets on the balance sheet, such as

preliminary expenses, goodwill, and the discount on the issue of shares, will not be

realized at the time of liquidation, despite the fact that they are included on the balance

sheet. Results of financial statement analysis can be misleading.

3. Different Accounting Policies

Two different companies/firms have a choice to choose different accounting methods

or policies that makes the comparison unreliable.

For example, in terms of inventory – LIFO (Last-In, First-out) vs FIFO (First-In, First-Out). In

terms of depreciation, one firm may adopt depreciation on original cost method and the

other may adopt the written-down value method. The results obtained from each

comparison may result as misleading from one another.

4. Difficulty in Forecasting

Historical costs or past events are used to create financial Statements. With the passage

of time for business, the value of assets changes and past events may not be of much

help in future forecasting. The financial statements are not produced in light of current

economic conditions.

The balance sheet loses its value as an index of present economic conditions. Similarly,

the profit shown on the income statement may not reflect the company's earning

capabilities. The increase in earnings could be attributed to a price increase or other

unusual circumstances, rather than a gain in efficiency. Financial statement analysis of

historical facts cannot give a complete picture for the future.

5. Lack of Qualitative Analysis

Certain elements have an impact on a company's financial situation and operating

outcomes, but they are not included in these financial statements because they cannot

be measured in monetary terms.

The company’s reputation, effectiveness, changes in management, employer-

employee relationship, capability to build new products, meeting customers satisfaction,

etc. These are some of the elements that is vital for the company’s financial situation

specially on the operating outcomes for the profitability of the company which are

sometimes being neglected because these are qualitative in nature.

6. Limited Use of Single Year’s Financial Statement Analysis

Financial statement data cannot be precise since the statements deal with issues that

cannot be described precisely. The information is gathered using standard processes that

have been used for many years. The data is developed using a variety of conventions,

postulates, personal judgments, and other methods. For example, Th company’s sales

increases by 10% comparing to last year’s sales of 8%. Compared to last year and the

present year, there is an increase of profit by 2% which is a positive indication for the profit

of the company. Nevertheless, due to changes in accounting policies, comparing the

two years of financial statements cannot still be commensurable.

 Horizontal Analysis of Comparative Statements(Increase & Decrease Method)

& Trend Percentage

Reported by: Luy, Hazel

Horizontal Analysis of Comparative Statements (increase/decrease method)

Horizontal analysis allows investors and analysts to see what has been driving a

company's financial performance over several years and to spot trends and growth

patterns. This type of analysis enables analysts to assess relative changes in different line

items over time and project them into the future. An analysis of the income statement,

balance sheet, and cash flow statement over time gives a complete picture of

operational results and reveals what is driving a company’s performance and whether it

is operating efficiently and profitably.

An item on a balance sheet or income statement has little meaning by itself.

Dollar and Percentage Changes on Statements. Horizontal analysis (also known as trend

analysis) involves analyzing financial data over time, such as computing year-to-year

dollar and percentage changes within a set of financial statements.

The dollar changes highlight the changes that are the most important economically; the

percentage changes highlight the changes that are the most unusual.

Example of Horizontal Analysis is shown below:

Trend percentages

Trend analysis calculates the percentage change for one account over a period of time

of two years or more.

Horizontal analysis can be even more useful when data from a number of years are used

to compute trend percentages. To compute trend percentages, a base year is selected

and the data for all years are stated as a percentage of that base year. Periods may be

measured in months, quarters, or years, depending on the circumstances. The goal is to

calculate and analyze the amount change and percent change from one period to the

next.

Example:

Note: Trend percentages are calculated as the current year divided by the base year

(2006). For example, the net sales 2010 trend percentage of 146 percent equals $35,119

(net sales for 2010) divided by $24,088 (net sales for the base year 2006).
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