topic 8: financial statements analysis

TOPIC 8:

FINANCIAL STATEMENTSANALYSIS

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INTRODUCTION

Interpretation is when users evaluate financial information to make judgementsIt is the key to any in-depth understanding of an organisation’s performance.Basically, the users evaluate an organisation’s performance using the information from INCOME STATEMENT and BALANCE SHEET.The value of the analysis is depends on the value of the financial statements.

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TECHNIQUES (TYPES) OF ANALYSIS:…

1.Horizontal Analysis Comparing key figures in financial statement It evaluates a series of financial statement over a period of time.

2.Vertical Analysis It evaluates financial statement by expressing each item in a

financial statement as a percent of the base amount (key figure) Key-figure (such as sales in P&L and total assets on BS) are set to

100% Other items are then expressed as percentage of 100

3. Trend analysis Similar to horizontal analysis, except that the first set of account

in the series is given a base of 1004.Ratio Analysis

It expresses the relationship among selected items of financial statement data. 3

HORIZONTAL ANALYSISHORIZONTAL ANALYSISHORIZONTAL ANALYSISHORIZONTAL ANALYSIS

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What is horizontal analysis?

What is horizontal analysis?

It’s an analysis of the percentage increases and decreases of related items in comparative financial statements.

It’s an analysis of the percentage increases and decreases of related items in comparative financial statements.

HOME DEPOTCOMPARATIVE BALANCE SHEETS (IN

MILLIONS)FEBRUARY 3, 2009 AND JANUARY 28,

2008

AssetsCurrent assets $10,361 $ 7,777 $2,584 33.2%Property and equipment, net15,37513,068 2,307 17.7Other assets 658 540 118 21.9Total assets $26,394 $21,385 $5,009 23.4

LiabilitiesCurrent liabilities $ 6,501 $ 4,385 $2,116 48.3Long-term debt, excluding current installment 1,250 1,545 (295) (19.1)Other long-term liabilities 372 256 116 45.3Deferred income taxes 189 195 (6) (3.1)Total long-term liabilities$ 1,811$ 1,996$ (185) (9.3)Total liabilities $ 8,312 $ 6,381 $1,931 30.3 5

Increase (Decrease) Feb. 3, 2009 Jan. 28, 2008 Amount Percent

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The stockholders’ equity section is not displayed.The stockholders’ equity section is not displayed.The stockholders’ equity section is not displayed.The stockholders’ equity section is not displayed.

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HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2009 and January 28, 2008

AssetsCurrent assets $10,361 $ 7,777 $2,584 33.2%Property and equipment, net 15,375 13,068 2,307 17.7Other assets 658 540 118 21.9Total assets $26,394 $21,385 $5,009 23.4

LiabilitiesCurrent liabilities $ 6,501 $ 4,385 $2,116 48.3Long-term debt, excluding current installment 1,250 1,545 (295) (19.1)Other long-term liabilities 372 256 116 45.3Deferred income taxes 189 195 (6) (3.1)Total long-term liabilities $ 1,811 $ 1,996 $ (185) (9.3)Total liabilities $ 8,312 $ 6,381 $1,931 30.3


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Horizontal Analysis: Horizontal Analysis:

Difference $2,584

Base year $7,777= 33.2%

33.2%

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14-9

CondensedCondensed

33.2% AssetsCurrent assets $10,361 $ 7,777 $2,584 33.2%Property and equipment, net 15,375 13,068 2,307 17.7Other assets 658 540 118 21.9Total assets $26,394 $21,385 $5,009 23.4


17.733.2%


Difference $2,307

Base year $13,068= 17.7%

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14-10

CondensedCondensed

AssetsCurrent assets $10,361 $ 7,777 $2,584 33.2%Property and equipment, net 15,375 13,068 2,307 17.7Other assets 658 540 118 21.9Total assets $26,394 $21,385 $5,009 23.4


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HOME DEPOT INC. Income Statement (in millions)

For Periods Ended February 3, 2009 and January 28, 2008

Sales (net) $53,553 $45,738 $7,815Cost of merchandise sold 37,406 32,057 5,349 Gross profit $16,147 $13,681 $2,466 Selling and store operating exp. 10,280 8,655 1,625General and administrative exp. 935 835 100 Total operating expenses $11,215 $ 9,490 $1,725Income from operations $ 4,932 $ 4,191 $ 741Other income and expenses:

Interest and investment inc. 53 47 6 Interest expense (28) (21) (7)Income before income tax $ 4,957 $ 4,217 $ 740 Income taxes 1,913 1,636 277 Net income $ 3,044 $ 2,581 $ 463


Difference $7,815

Base year $45,738= 17.1%

17.1%

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Increase (Decrease) 2009 2008 Amount Percent

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Difference $5,349

Base year $32,057= 16.7

17.1%16.7

14-12


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17.1%16.7

14-13

18.018.812.018.217.7

12.833.317.516.917.9

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Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis

A percentage analysis can be used to show the relationship of

each component to a total within a single statement.

A percentage analysis can be used to show the relationship of

each component to a total within a single statement.

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The total, or 100% item, on the balance sheet is “total

assets.”

The total, or 100% item, on the balance sheet is “total

assets.”

Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis

The total, or 100% item, on the income statement is

“total sales.”

The total, or 100% item, on the income statement is

“total sales.”

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14-18

AssetsCurrent assets $10,361 $ 7,777Property and equipment, net 15,375 13,068Other assets 58 540Total assets $26,394 $21,385

LiabilitiesCurrent liabilities $ 6,501 $ 4,385Long-term liabilities 1,811 1,996Total liabilities $ 8,312 $ 6,381 Stockholders’ EquityCommon stock/paid-in capital $ 5,529 $ 4,926RE & accumulated comp. loss 12,553 10,078Total stockholders’ equity $18,082 $15,004Total liabilities and SE $26,394 $21,385

Total assets is 100.0%


100.0%


Feb. 3, 2009 Jan. 28, 2008 Amount Percent Amount Percent

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CondensedCondensed

15



14-19

CondensedCondensed



39.3%

100.0%

Vertical Analysis: Vertical Analysis:

Current assets $10,361

Total assets $26,394= 39.3%

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14-20

CondensedCondensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

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14-21

CondensedCondensed

39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%





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CondensedCondensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%

36.4%


Current assets $7,777

Total assets $21,385= 36.4%


14-22

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CondensedCondensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%

36.4%61.1

2.5


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20.5% 9.3 29.8%

23.0% 47.1 70.2%100.0%

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Sales (net) $53,553 100.0% $45,738 100.0%Cost of merchandise sold 37,406 32,057Gross profit $16,147 $13,681Selling and store operating exp. 10,280 8,655General and administrative exp. 935 835Total operating expenses $11,215 $ 9,490Income from operations $ 4,932 $ 4,191Other income and expenses:

Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217Income taxes 1,913 1,636Net income $ 3,044 $ 2,581

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Amount Percent Amount Percent

2009 2008

Net sales is 100.0%

Net sales is 100.0%

Net sales is 100.0%

Net sales is 100.0%

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14-25


2009 2008


Cost of Merchandise Sold $32,057

Net Sales $45,738

= 70.1%

2001

70.1

22




Cost of Merchandise Sold $37,406

Net Sales $53,553

= 69.9%

2002



14-26


2009 2008

69.9 70.1

23





14-27


2009 2008

69.9 29.9%

18.9% 1.8

20.7%9.2%

0.1 (0.1)

9.2% 3.6

5.6%

70.1

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14-28


2009 2008

70.1 30.1%

19.2% 1.7 20.9%

9.2%

0.1 (0.0)

9.3% 3.6

5.7%

29.9%18.9%

1.8 20.7%

9.2%

0.1 (0.1)

9.2% 3.6

5.6%

69.9

RATIO ANALYSIS

Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured.

Definition of Accounting Ratios: The term "accounting ratios" is used to describe

significant relationship between figures shown on a balance sheet, in a profit and loss account, in a budgetary control system or in any other part of accounting organization. Accounting ratios thus shows the relationship between accounting data.

ADVANTAGES Simplifies financial statements: It simplifies the

comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of the business

Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios highlight the factors associated with with successful and unsuccessful firm. They also reveal strong firms and weak firms, overvalued and undervalued firms.

Helps in planning: It helps in planning and forecasting. Ratios can assist management, in its basic functions of forecasting. Planning, co-ordination, control and communications.

Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of the performance of different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future.

Help in investment decisions: It helps in investment decisions in the case of investors and lending decisions in the case of bankers etc.

TYPES OF RATIO ANALYSIS

1. Profitability Ratio2. Efficiency/activity/asset management Ratio3. Liquidity Ratio4. Solvency Ratio5. Cash flow6. Investment

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1. Profitability 1. Return on capital employed 2. Gross profit margin 3. Net profit margin 2. Liquidity 1. Current ratio 2. Quick ratio

3. Efficiency 1. Debtors turnover 2. Debtors collection period 3. Stock turnover ratio 4. Asset turnover ratio 5. Working capital turnover

ratio4. Solvency/financial

leverage management ratio

1. Debt to Equity ratio2.Debt ratio

CONTINUE………..

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5. Investment 1. Dividend yield 2. Earnings per share 3. Price/earnings ratio

PROFITABILITY RATIO

It measure the income or operating effectiveness of an organisation for a given period of time.

A low value of this ratio will affect the company ‘s ability to obtain debt, equity financing and the ability to grow or expand.

i Return on capital employed/Return on common equity• measures effective use of capital• It measures the profitability from the shareholder view

point. It shows how many ringgit of the net income were earned

for each ringgit invested by the owner.

= Profit or earning after tax x 100% Average capital employed

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CONTINUE…ii. Gross Profit Margin It measures the percentage of one ringgit of sales

that results in gross income.= Sales – Cost of Goods Sold x

100% Sales= Gross Profit x 100%

Salesiii. Net Profit Margin

It measures the percentage of one ringgit of sales that results in net income.= Profit or earning after tax x 100%

Sales 31

LIQUIDITY RATIO

It measure the short term ability of the organisation to pay debt and to meet unexpected need for cash.

i.Current Ratio To measure the ability of current asset that the

company have to pay back the short term debt.

= Current Asset Current Liability

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CONTINUE…

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ii. Quick Ratio

• It measures the company’s immediate short term liquidity.

= Current Asset – Stock – Prepayment

Current LiabilityThis ratio indicates whether current liabilities could be paid without having to sell the inventory

This ratio is useful for companies who cannot convert inventory into cash quickly if necessary.

CONTINUE…. This ratio indicates whether the business has enough short-

term assets to cover its short-term liabilities. A ratio above 1 indicates that working capital is positive

(Current assets exceed current liabilities) A ratio below 1 indicates that working capital is negative. Many large companies regularly operate with current ratio

closer to 1 and 2 Generally the higher the ratio, the greater the financial

stability and the lower the risk for both creditors and owners.

However, the ratio should not be too high because that may indicate that the business is not reinvesting in long-term assets to maintain future productivity.

High current ratio can actually indicate problems if inventories are getting larger than they should be or collections of receivables are slowing down. 34

EFFICIENCY RATIO

(i) Debtors turnover Measures how many times it takes customers to

pay debts= Credit sales

Average debtors

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CONTINUE…(ii) Debtors collection period Measures how long it takes customers to pay

= Average debtors x 365 days OR 365 days

Credit sales debtors turnover

This ratio indicates how many days it takes, on average to collect a day’s sale revenue.

The quicker a business collects and bank the money, the better it is to the company

Large numbers of days is a negative signal, raising questions about the company’s policies of granting credit such as; Unstricted credit policies Longer credit limit Collection attempts is not very strength

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CONTINUE…

(iii) Stock turnover ratio measures how quickly stock moves through business This ratio means that the average length of time

that the stocks are held before being sold. = Cost of goods sold

Average stock

It can also be calculated in days= Average stock x 365 days OR 365 days

Cost of sales stock turnover

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CONTINUE…

(iv) Asset turnover ratio compares sales to total assets employed Measure how efficient the assets in

generating sales= Sales x 100%

Average total assets

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CONTINUE…

(v) Working capital turnover ratio = Cost of sales Net working capital*Working capital = current assets –current liabilities

measure the efficiency with which the working capital is being used by a firm.

A high ratio indicates efficient utilization of working capital and a low ratio indicates otherwise. But a very high working capital turnover ratio

may also mean lack of sufficient working capital which is not a good situation.

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SOLVENCY/FINANCIAL LEVERAGE MANAGEMENT RATIO

- This is to measure the ability of the company to survive over a long period of time

- The ability to pay interest as it comes due/mature

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CONTINUE…

(i) Debt to Equity ratio = Total liabilities

Total Equity Debt to equity ratio indicates the

proportionate claims of owners and the outsiders against the firms assets.

(ii) Debt ratio/debt to assets ratio

= Total liabilities Total Asset 41

INVESTMENT

(i) Dividend yield= dividend per share

market value per share to evaluate the relationship between dividends per

share paid and the market value of the shares helps as intending investor is knowing the effective

return he is going to get on the proposed investment.

(ii) Earning per share (EPS)= Profit after tax – preference dividend

No. of common shares Measures net income earned on each share of

common stock42

CONTINUE…

(iii) Price/earnings ratio = Market price per share of stock EPS

Measures the ratio of market price per share to earnings per share

helps the investor in deciding whether to buy or not to buy the shares of a particular company at a particular market price.

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Limitations of the Accounting Information1. Estimates

The financial statement contains numerous estimates. Ex. Provision for doubtful debt, depreciation and contingent loss.

2. CostThe traditional financial statements are based on historical cost, it is not adjusted for price-level change. Ex. Inflation affects the sales growth.

3. Alternative Accounting MethodA comparison may be misleading as different companies use different accounting method. Ex. FIFO and LIFO.

4. Diversification of firmsThis diversification of activities of companies limit the usefulness of financial analysis. (no specific industry).

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CONCLUSION

Ratio analysis is a good way to overview an organisation’s activities

Ratio analysis must be compared with past result or industry norms, not in isolation

Things to be taken into account in using ratio analysis: size of the organisation Method used in accounting treatment Same industry Same country

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INCOME STATEMENT FOR THE YEAR ENDED 31 DEC 2010

Sales 200Less: Cost of sales (100)Gross profits 100Less expenses

General 40Interest 10 (50)

Profit before tax 50Less: Taxation (15)Profits after tax 35Less: Dividends (15)Retained profits 20

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Exercise:

BALANCE SHEET AS AT 31 DEC 2010

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Fixed AssetsCurrent Assets Stock Debtors CashCurrent Liabilities Creditors Proposed dividends and taxNet Current assetsTotal assets less current liabilities

Financed by/ capital employed:

Long-term liabilities Loan Preference share capital (50m, $1)

Owners Equity Ordinary Share capital (150m.$1)Other reserves Retained Earning

$ m

604020

(50)(10)

$ m

120

(60)

7050

150

65

$ m275

60335

120

215335

ASSIGNMENT

Refer to the following website http://www.accountingformanagement.com/

financial_statement_analysis_accounting_ratios.htm

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topic 8: financial statements analysis

Documents

total liabilities

total longterm liabilities

total assets

liabilitiescurrent liabilities

assetscurrent assets

longterm debt

financial information

horizontal analysis