Financial Statements Analysis (Chapter 13)

Financial statements help users mainly investors, creditors, management of the company
to make better economic decisions.
Published financial statements are designed primarily to meet the needs of external
decision makers (Regulators), including present and potential owners (shareholders),
investment analysts, and creditors.
In considering an investment in stock, investors should evaluate the company’s future
income and growth on the basis of three factors:
1. Economy –Wide factors:
Often the overall health of the economy has a direct impact on the performance of an
individual business. Investors should consider data such as the unemployment rate,
general inflation rate, and the changes in interest rate
2. Industry factors:
Certain events can have a major impact on each company within an industry but may
have minor impact on other companies outside the industry.
3. Individual company factors:
To properly analyze a company, good analysts do not rely only on info. contained in
financial statements, they study a company’s strategy when evaluating its financial
stat., products quality, employees and customers satisfaction, and many other factors.
Financial statements analysis:
Analyzing financial statements data without a basis for comparison is impossible. For
example, if the company made $500,000 net income for the period ended 12/31/2018,
would you consider the company is successful? Not necessary, the company may have
reported net income for the period ended 12/31/2017 of $750,000. Also, the average net
income for the industry for the year ended 12/31/2018 is $690,000.
As you see from this simple example, financial results cannot be evaluated in isolation.
To properly analyze the information reported in financial statements, you must develop
appropriate comparisons.
1- Horizontal analysis or Trend analysis (time series analysis):
Information on a single company is compared over time.
One of the techniques of the horizontal analysis is the % of change:
If ABC corporation reported net sales for the year ended 12/31/2019 of $12,000,000 and
net sales for the year ended 12/31/2018 of $10,000,000
Then the % of change in net sales = (12,000,000 – 10,000,000) / 10,000,000 = 20%
That means sales for the company increases by 20% from last year sales.
How to evaluate:
Compare against % of change for the industry:
If industry sales increased by 26%, so the company’s increase in sales is lower than its
industry. (20% lower than 26%).
But if industry sales increased by 15%, so company’s sales increased by % higher than its
industry (20% is higher than 15%).
Also, company may compare its % of increase in sales against other individual
companies in the same industry. (ABC 20%, but X in the same industry 22% or 17%).
2- Vertical Analysis (Common size analysis, or Component) analysis:
Analysts often compute component analysis, which express each item on a financial
statement as a % of a single base number (the denominator) on the same statement.
The base number for the income statement is net sales for goods or operating revenue
for service. The base number for the balance sheet is total assets.
Let us now see component analysis for income statement items for ABC company for the
year ended 12/31/2019:
Amount in $ %
Net sales $20,000,000 100
Less: cost of sales (13,000,000) 65
Gross profit 7,000,000 35
Less: operating expenses (4,000,000) 20
Operating income 3,000,000 15
Less: interest expense (200,000) 1
Pretax income 2,800,000 14
Less: provision for income taxes (560,000) 2.8
Net income 2,240,000 11.2

Each % is calculated by dividing the item by net sales.

For example,
Operating expenses ratio= 4,000,000 / 20,000,000 = 20%
Profit margin = Net income / Net sales = 2,240,000 / 20,000,000 = 11.2 %
These percentages can be compared with the percentages of the company last year,
compared against average percentages for the industry for the current period. Also, can
be compared against percentages of another company in the same industry.
3- Ratio and Percentage analysis:
All financial analysts use ratio analysis or percentage analysis when they review
companies. The ratio analysis allows the comparison of companies of different sizes.
ABC reported net sales of $50,000,000 and operating income of $9,000,000
XYZ reported net sales of $10,000,000 and operating income of $2,400,000
By comparing the absolute value of operating income, it looks that Company ABC is
making higher net operating income.
When ratio analysis is used, we compute the operating income ratio for each of the two
companies and then we can compare.
Operating income % for ABC= $9,000,000 / $50,000,000 = 18%
Operating income % for XYZ = $2,400,000 / $10,000,000 = 24%
Now it shows that company XYZ has higher operating income for each one dollar of
sales than company ABC.
Tests of profitability:
As a rule, to calculate a ratio for items on the same statement you do not need an average.
For example, operating income ratio is operating income divided by net sales both
numbers are shown on income statement.
But to compute a ratio for a relationship between a number from income statement and a
number from balance sheet, the balance sheet number will be an average. The reason is
that income statement is reported for a particular period (for example a year) but the
balance sheet is reported at a point of time. This is why in order to analyze financial
statements; companies report income statement for the current year and the balance sheet
for the current and the previous year (which is considered the beginning balance sheet for
the current year).
Profitability can be tested with respect to:
a- One dollar of sales (operating revenue), this will be called profit margin ratio
b- One share of common stock, this will be called Earnings Per Share (EPS)
c- One dollar of total shareholders’ equity, this will be called Return on Equity (ROE)
d- One dollar invested in total assets, this is called, Return on Assets (ROA)
Financial statements Analysis Case:
The income statement and the comparative balance sheet for ABC Corporation are presented below
ABC Corporation
For the year ended 12/31/2019
Net sales $1,800,000
Less: cost of sales ($1,000,000)
Gross profit $800,000
Less operating expenses (550,000)
Operating Income $250,000
Less: Interest expense (20,000)
Income before taxes $230,000
Less: income tax expense (46,000)
Net income 184,000
Additional Information:
1- 70% of sales made on account
2- The credit period allowed to customers 30 days
3- The interest rate on bonds payable 10%
ABC Corporation, Balance Sheet at
12/31/2019 12/31/2018
Assets:
Current assets:
Cash 60,100 64,200
Short term investment 69,000 50,000
Accounts receivable (net) 117,800 102,800
Inventory 100,000 90,000
Other current assets 23,000 25,500
Total current assets 369,900 332,500
Total noncurrent assets 600,300 520,300
Total assets 970,200 852,800
Liabilities and SHE:
Current liabilities:
Accounts payable 160,000 145,400
Accrued expenses payable 43,500 42,000
Total current liabilities 203,500 187,400
Bonds payable (1/12025) 200,000 200,000
Total liabilities 403,500 387,400
SHE:
Common stock ($5 par) 300,000 300,000
Retained earnings 266,700 165,400
Total SHE 566,700 465,400
Total Liabilities and SHE 970,200 852,200
All these ratios will be covered using the case
a) Profit margin ratio:
As we mentioned earlier, the profit margin measures the percentage of profit for each
one dollar of net sales.
Profit Margin = Net income / Net sales
Profit margin for the year ended 12/31/2019 = $184,000 / 1,800,000 = 10.22%
So, profit for each one dollar of sales for the year ended 12/31/2019 is 10.22 cents.
Compare against last year, average industry, and other companies in the same industry.
While profit margin is good measure of operating efficiency, care must be used in
analyzing it because it doesn’t consider the resources (i.e., total investment) needed to
earn income.
b)Earnings per share (EPS):
The earnings per share is a measure of return on investment that is based on the
number of shares outstanding (shares held by shareholders).
Going back to the case:
EPS= Net income / Average number of outstanding shares
The number of shares of common stock at 12/31/2019 = $300,000 / $5 =60,000 shares.
Since common stock at 2/31/2018 ($300,000) is the same at 12/31/2019 that means
number of shares of common stock at 1/1/2019 is 60,000 shares.
Here you do not to calculate an average. It is none sense to calculate the average as:
(Number of shares at 1/1 beg. + number of shares at 12/31 end) / 2
(60,000 + 60,000) /2 = 60,000
So, you need to calculate the average number of outstanding shares of common stock,
if there is a change in the number of outstanding shares at the end of the period
compared to number of outstanding shares at the beginning of the period.
EPS For the year ended 12/31/2019 = $184,000 / 60,000 = $3.067
It means that profitability for each one share of outstanding common shares is $3.067.
EPS is probably the single most widely watched ratio.
Now let us assume the case was: 12/31/2019 12/31/2018
Common Stock ($5 par) $360,000 $300,000
It is clear that the company issued additional shares of common stock during the year.
Number of shares at 12/31/2019 = $360,000/ $5 = 72,000 shares
Number of shares at 1/1/2019 = $300,000 / $5 = 60,000 shares
Now, the average number of outstanding shares = (60,000 + 72,000)/2 = 66,000 shares
EPS= $184,000 / 66,000 shares = $2.79
 If the shares are issued at October 2019 (So it means 3 months stay)
Weighted average number of shares = 60,000 + (12,000/12 * 3) = 63,000
EPS = $184,000 / 63,000 = $2.92
c) Return on Equity (ROE):
ROE relates income earned to the investment made by owners. The investment by
owners represents their investment (common stock + additional paid-in capital) in
addition to portion of cumulative profit kept from distribution to shareholders i.e.,
retained earnings (-) Treasury Stock if any.
Therefore, ROE relates net income to average total shareholders’ equity.
So, it measures profitability per $1 of average total shareholders’ equity.
ROE = Net income / average total shareholders’ equity
Average total SHE = (total SHE beginning + total SHE end) / 2
= (465,400 + 566,700) / 2 = $516,050
So, ROE = $184,000 / 516,050 = 35.66%
Profitability for each $1 of SHE is 35.66 cents
d)Return on Assets (ROA):
This is one of the important ratios used to evaluate management’s ability to utilize
assets effectively because it is not affected by the way in which assets have been
financed as we know majority of liabilities result in interest expense (18,000) which is
subtracted before reaching net income. However, when interest expense is deducted
before computing pretax income, it leads to reduction in income tax expense (20%).
We will need the tax rate in our discussion. Because it is not given explicitly in the
case, we will use the available information.
Tax rate = income tax expense / pretax income
= 48,000 / 240,000
= 20%
Now assume that the company has no liabilities and having liabilities which is the case
we are covering: No Liabilities Having liabilities
( A = SHE) ( A = L + SHE)
Operating income $258,000 $258,000
Less interest expense (0) (18,000)
Pretax income $258,000 $240,000
Less: Income tax (20%) (51,600) (48,000)
Net income $206,400 $192,000
 The final effect of interest expense on income is $14,400 if assets are financed by L
and SHE instead of being Financed by SHE only.
That difference $14,400 is the interest expense net of taxes
Interest expense * (1- tax rate)
$18,000 * (1- 0.2) = $14,400
So, to calculate ROA by eliminating the effect of debt financing (Liabilities) on
income we add interest expense net of taxes to the net income calculated after
subtracting.
ROA = (net income + interest expense net of taxes) / Average total assets
Average total assets = (total assets at beginning + total assets end) / 2
Average total assets = (852,800 + 970,200) / 2 = $911,500
So, ROA = (184,000 + 14,400) / 911,500 = 21.94%
Note that interest expense net of taxes is added back to income in the numerator of the
ratio because the denominator (total assets) includes financial resources provided by
both shareholders’ (equity financing) and liabilities (debt financing).
So, profitability for each $1 of average total assets is 21.94 cents
ROE denominator (Total SHE)
ROA denominator (Total Assets (Liab. + SHE))
e) Financial Leverage Percentage (FL%)
FL% measures the advantage or disadvantage when a company’s ROE differs from a
company’s ROA. This occurs when there is debt financing.
So, FL% = ROE – ROA
= 35.66% - 21.94% = 13.72%
The meaning that FL% is positive is that the ROA is greater than the average interest
rate on debt financing. So, the money borrowed at interest rate is used to generate ROA
higher than the interest rate, the difference goes to the shareholders.
When FL% is positive, it means that there is an advantage of debt financing for
the shareholders.
f) Quality of income ratio
Relates net cash provided by operating activities (Cash flow based on cash basis) to net
income (Accrual basis), assume that net cash provided by operating activities for the
year ended 12/31/2019 is $110,000
QIR = 110,000 / 184,000 = $0.59
It means each $1 of net income is reflected by increase of 0.59 Cents in cash
If more than 1 this is happened cause unearned revenue.
Testing Liquidity:
Liquidity is short term-oriented measure. It refers to ability of the company to pay short
term liabilities (current liabilities) when they become due.
There are four measures of liquidity:
1. Current Ratio (CR):
Current ratio is a general measure of liquidity. It relates total current assets at a point of
time to total current liabilities at the same point of time.
CR = Total current assets / Total current liabilities
Going back to the case for the year ended 12/31/2019
CR = 369,900 / 203,500 = 1.82 times
So, it means that at 12/31/2019 current assets are 1.82 current liabilities. We can also
say that at 12/3/2019 each $1 of current liabilities is covered by $1.82 of current assets
The CR should be compared against last year for the same company and against
average industry current ratio for the current year.
2. Quick Ratio (QR):
The quick focuses on the relationship between quick assets defined as cash, short term
investment in securities, accounts receivable, and short-term notes receivable.
Quick Ratio = Quick assets / total current liabilities
Going back to the case at 12/31/2019:
QR = (60,100 + 69,000 + 117,800) / 203,500 = 1.21 times
The company has very good liquidity position because each $1 of current liabilities is
covered by $1.21 of quick assets.
When inventory represents high % of total current assets, there will be big difference
between CR and QR.
3. Accounts receivable Ratio (Turnover):
As we know accounts receivable result from selling goods or providing services on
account. In the case of merchandising company, the AR turnover means how many
times on average AR turned into credit sales (sales on account).
AR turnover = Net credit sales / Average Accounts receivable
Net credit sales = 1,800,000 * 70 % = $1,260,000
The 70% is given as additional information below the income statement.
Average Accounts receivable = (102,800 + 117,800) / 2 = 110,300
So, AR turnover = 1.260,000 / 110,300 = 11.42 times
So, on average accounts receivable turned into credit 11.42 times (Higher is better)
Once, AR turnover is measured, we can compute average collection days
 Average collection days = 365 / AR turnover
= 365 / 11.42 = 31.96 days

To evaluate the company’s crediting and collection polices, compare the average
collection days against 1.5 (or 150%) of the credit period
Rule: Compare # days of collection against # of days allows for customers to pay

31.96 days Lower than 30 days * 1.5 = 45 days

So, the company has very good crediting and collection polices.
But if the average collection days is 75 days which exceed 45 days that means that the
company needs to have strong crediting and collection policies than the ones used now.
4. Inventory Ratio (Inventory turnover):
When inventory is sold, its cost is turned into cost of goods sold. When the inventory is
fast moving, it will be sold in short period of time as compared to the case of the
inventory is slow moving where it would be sold in long period of time.
Inventory turnover is very important to determine whether the inventory is slow
moving or fast moving. For sure each company prefers its inventory to be fast moving.
Inventory Turnover = Cost of Goods Sold / Average inventory

Going back to the case, Cost of goods sold on income statement $1,000,000
Average inventory = (90,000 + 100,000) / 2 = 95,000
So, Inventory turnover = $1,000,000 / $95,000 = 10.52 times (Higher is better)
It means on average inventory is sold 10.52 times during the year.

Now we can determine the average number of days to sell the inventory.
Avg. days to sell inventory= 365 / Inventory turnover
= 365 / 10.52 = 34.7 days

The 365 represent the number of days in a year.

Inventory for this company is considered fast moving because the inventory
turnover is high.