Lec 4.2 Financial Statements Analysis
Lec 4.2 Financial Statements Analysis
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
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
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
Inventory for this company is considered fast moving because the inventory
turnover is high.