Financial Statement Analysis: Understanding Ratios and Financial Performance, Study notes of Financial Statement Analysis

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Accounting for decision

making

Topic 3

Ratios & Financial Analysis

Goals for this Topic…

1. Understand the objectives of financial statement analysis;
2. Understand the various approaches to financial statement analysis;
3. Appreciate the value of analysing financial statements and ratios over time and in comparison with relevant industry and competitor benchmarks;
4. Analyse financial statements by considering overall performance, profitability, investment utilisation, solvency and liquidity, and dividend policy;
5. Calculate the ratios widely used in financial statement analysis; and,
6. Understand the limitations of financial ratio analysis.

Helps determine the extent to which the

organisation is:

• achieving its objectives;
• operating efficiently;
• capable of continuing to provide goods and services in the future; and
• using its resources in the manner that was intended.

In broad terms, financial statement

analysis…

...and in particular…

 How profitable is the business?

 What are its major sources of revenue (and

has revenue been increasing or decreasing)?

 What are the major expenses of this

business (and have expenses been increasing

or decreasing)?

Approaches to financial statement

analysis

What are we looking at?

 Trends over time  How we compare with similar organisations  How we relate to the industry

How?

 Overview of financial statements  “Horizontal” analysis  “Vertical” analysis  Financial ratio analysis

Overview of financial statements

 “Eyeball” the key financial statements:

 Balance Sheet  Income Statement  Cash Flow Statement

 What stands out?

 What are the trends?

 Are there any patterns?

For example, items from the Balance Sheet of XYZ Company for the past three years are as follows:

What’s the story?

2011 ($’000) 2012 ($’000) 2013 ($’000) Cash 100 120 150 Accounts Receivable 50 40 30 Inventory 60 80 100

Items from the Income Statement of XYZ Company for the past five years are as follows:

And again…

2009 2010 2011 2012 2013 $’000 $’000 $’000 $’000 $’ Sales 100 110 120 80 60 Cost of Goods Sold 30 40 45 47 50 Wages & Salaries 35 55 30 33 40

What is this telling us?

“Vertical” analysis

 A base item and a base amount is selected

and all other items are calculated as a

proportion of this base amount

 This can help us to consider the significance

of the various components of the balance

sheet or income statement.

What’s the story?

For example, items from the Balance Sheet of ABC Company for 2013 are as follows: $ % Total Assets 400 100 Cash 40 10 Accounts Receivable 80 20 Inventory 120 30 Plant & Equipment 160 40

Example of vertical analysis VERTIGO ENTERPRISES Income Statement $ % relative to income Total income 323 800 100 Expenses Cost of sales 140 000 43 Advertising expense 30 000 9 Insurance expense 15 000 5 Rent expense 24 000 7 Utilities expense 1 800 1 Depreciation 12 000 4 Wages and salaries 60 000 19 Interest expense 4 500 1 Total expenses 287 300 89 Net profit $36 500 11

Benchmarking & Industry Averages…

NHPPD Hospital A Hospital B Hospital C INDUSTRY Medical 3.2 2.2 1.9 2. Surgical 6.8 5.3 5.7 5. Maternity 2.6 1.4 2.1 1.

BUT…

Why use ratios?

Need to make comparisons:  against previous periods  across divisions  against the forecast  organisations in the same industry  organisations in a different industry

• Different analysts use different ratios or

define them differently

• Important to use and measure them

consistently

Which ratios?