8/6/2019 Lecture - 1 - Analysis of Financial Statements
1/31
FADM 2
CA.N.Nabeel Ahmed
8/6/2019 Lecture - 1 - Analysis of Financial Statements
2/31
Relevance of Accounting Numbersy It helps in determining value ofthe Firm
y It helps in predicting bankruptcy ofthe Firm
y It helps in taking managerial decisionsy Pricing
y Make or buy
y Close or continue
y Analyze financial statements
8/6/2019 Lecture - 1 - Analysis of Financial Statements
3/31
Financial Statement Analysis -
Usersy The users of financial reports can broadly be
categorised as:y resource providers
e.g., creditors, lenders, shareholders, employees
y recipients of goods and servicesi.e., customers, debtors
y parties performing an overview or regulatory function
e.g., tax office, corporate regulator, statistical bureausy internal managementto assist in their decision making
duties
8/6/2019 Lecture - 1 - Analysis of Financial Statements
4/31
NATURE AND PURPOSE OF
FINANCIAL ANALYSISy Financial analysis involves expressing the reported numbers in relative
terms (percentages, ratios, comparison)
y Highlights the strengths and weaknesses of firms
y By evaluating an entitys financial past, users are in a better position toform an opinion as to the entitys future financial health
y Uses reported financial numbers to form opinions aboutthe entitysfinancial performance.
8/6/2019 Lecture - 1 - Analysis of Financial Statements
5/31
5
ANALYTICAL METHODS
y It is essential in financial analysis to compare figures with:
y the equivalent figures from previous years
y
other figures in the financial statements (competitors)
y Analytical methods include
y (A) Horizontal analysis
y
(B)Vert
ical analysisy (C)Ratio analysis
y (D)Trend analysis
y (E) Benchmarks
8/6/2019 Lecture - 1 - Analysis of Financial Statements
6/31
(A) Horizontal analysisy Compares reported numbers in different reporting periods
to highlightmagnitude and significance of changes
y
Dollar change is calculated by:
y Percentage change is calculated by:
(Current Year Number Previous Year number
) * 100Previous Year Number
Accounting number in current reporting period()Accounting number in previous reporting period
8/6/2019 Lecture - 1 - Analysis of Financial Statements
7/31
Example: Comparative Balance SheetDecember 31, 2009, and 2010
2010 2009 Amount Percent
Assets
Cash $1,200 $2,350 $(1,150) -48.90%
Accounts receivable 6,000 4,000 2000 50%
Inventory 8,000 10,000 -2000 -20.00%
Prepaid Expenses 300 120 180 150.00%
Land 4,000 4,000 0 0%
Building 12,000 8,500 3,500 41.20%
----------- ----------- ----------
Total assets 31,500 28,970 2,530 8.70%
====== ====== ====== ======
Liabilities and Stockholders' Equity
Accounts payables $5,800 $4,000 1800 45%
Accrued payables 900 400 500 125%Loan 300 600 -300 -50%
Bank Over Draft 7,500 8,000 -500 -6.30%
Total paid in capital 9,000 9,000 0 0%
Retained earnings 8,000 6,970 1,030 14.80%
---------- ---------- ---------- ---------
Total liabilities and
stockholders' equity $31,500 $28,970 $2,530 8.70%===== ====== ====== ======
8/6/2019 Lecture - 1 - Analysis of Financial Statements
8/31
ContyA horizontal analysis can be for
y Income Statement
y Balance Sheet
y Cash Flow statement
y Easyto identify which reported numbers have gone upor gone down in the period.
y Acts as a base for auditors to have enquiries on anysignificant changes in the period
8/6/2019 Lecture - 1 - Analysis of Financial Statements
9/31
9
2. Vertical analysisy Involves comparing the items in a financial statementto an
anchor item in the same financial statement:
INCOME STATEMENT
y
Revenue and expense items are expressed as a percentage ofsales or revenue
BALANCE SHEET
y A, L and Equity items are expressed as a percentage oftotalassets
y When expressed this way, the financial statements are oftenreferred to as common size statements
8/6/2019 Lecture - 1 - Analysis of Financial Statements
10/31
Company A
Particulars Amount %
Revenue 200,000 100
Cost of sales 50000 25
Gross profit 150000 75
Other income 10000 5
Sales and marketing -20000 -10
Occupancy -5000 -2.5
Admin expenses -15000 -7.5
Finance Cost -25000 -12.5
Profit 95000 47.5
8/6/2019 Lecture - 1 - Analysis of Financial Statements
11/31
Common Size Analysis
Company A Company B
Particulars Amount % Amounts %
Revenue 200,000 100 1,000,000 100
Cost of sales 50,000 25 400,000 40
Gross profit 150,000 75 600,000 60
Other income 10,000 5 50,000 5
Sales and marketing (20,000) -10 (150,000) -15
Occupancy (5,000) -2.5 (80,000) -8
Admin expenses (15,000) -7.5 (35,000) -3.5
Finance Cost (25,000) -12.5 (60,000) -6
Profit 95,000 47.5 325,000 32.5
8/6/2019 Lecture - 1 - Analysis of Financial Statements
12/31
8/6/2019 Lecture - 1 - Analysis of Financial Statements
13/31
13
Ratio analysisy Ratio analysis is a 3-step process
1. Calculate a meaningful ratio by expressing $ amt of an
item by $ amoun
tof ano
ther i
tem
2. Compare the ratio with a benchmark
3. Interpretthe ratio, seek to explain why it differsy from previous years
y from comparative entities or
y from industry averages
8/6/2019 Lecture - 1 - Analysis of Financial Statements
14/31
8/6/2019 Lecture - 1 - Analysis of Financial Statements
15/31
Ratio Analysis(1)Liquidity
(2)Turnover Ratios
(3)Profitability(4)Capital Structure
(5)Market Performance
8/6/2019 Lecture - 1 - Analysis of Financial Statements
16/31
16
1) LIQUIDITY ANALYSISy The survival ofthe entity depends on its abilityto pay
its debts when they fall due (its liquidity)
yAn entity must have sufficientworking capital tosatisfy its short-term requirements and obligations
y But excess working capital is undesirable because thefunds could be invested in other assets that wouldgenerate higher returns.
8/6/2019 Lecture - 1 - Analysis of Financial Statements
17/31
Liquidity Ratiosy A group of ratios which helps to analyze the ability of the
company to pay off its short term liabilities.
y It Analyses the Current assets and Current Liabilities.y Ability to meet short term liability
y If CA > CL Shows that liquidity position is good
y Also throws a light on financing of Assets
y If CA>CLy Part ofCurrent assets are financed by Long term sources
y If CA
8/6/2019 Lecture - 1 - Analysis of Financial Statements
18/31
a. Current Ratioy Current ratio
y Current ratio (or working capital ratio) indicates $ of
current
asset
s per $ of current
liabilit
ies.
y We need to know :-
y Composition ofthe ratio
y Interpretation ofthe ratio
Current assets =x times
Current liabilities
Current ratio
an arbitrary ruleofthumb is that itshould be around
1.5 : 1
8/6/2019 Lecture - 1 - Analysis of Financial Statements
19/31
Exampley If Current ratio = 2:1
yWhat do you infer from it?y Current ratios is twice Current liability
y Current ratio is positive
y Can we say whether Current ratio is favorable orunfavorable?
y Unless Compared, cannot be interpreted.
8/6/2019 Lecture - 1 - Analysis of Financial Statements
20/31
Lets compare
A B C
CR 4:1 3:1 1:1
Recall :-
- Composition of CA and CL
Is it necessary for accounting policies to be same for each of the
three companies?
-Stock (FIFO , WA)
-Accounts Receivable ( Difference in Provision for Bad debts)
8/6/2019 Lecture - 1 - Analysis of Financial Statements
21/31
Limitations of Current RatioyFocus on Quantity rather than Quality
yCurrent Ratio is subjectto accountingassumptions:y Stock valuation,
y Provision for Doubtful debts
ySowindow dressing is possible .
8/6/2019 Lecture - 1 - Analysis of Financial Statements
22/31
Address the limitations of Window
Dressing
y (a) Current Ratio = CA / CL
y (b) Liquid Ratio
y = (CA- Stock) / CL
y (c )Absolute Cash ratioy = (CA Stock Debtors) / CL
8/6/2019 Lecture - 1 - Analysis of Financial Statements
23/31
2)Turnover Ratios
a. Debtors Days ( Accounts Receivable Days)
y Days debtors ratio indicates average period oftime itt
akest
o collect
t
he money from it
st
rade relat
ed account
sreceivable.
y In other words, No. Of days of sales, remaining as adebtor.
Average Debtors = x days
Sales revenue Per day
Days debtors
8/6/2019 Lecture - 1 - Analysis of Financial Statements
24/31
Exampley Sales Revenue per year = 7200
yAverage Debtors = 500
y Sales per day = 7200/365 = $20 per day
y Debtors days = 500/20 = 25 days
y DD : Is 25 days a good indication of Debtors days?
y Cannot conclude unless compared with Creditor days orcompanys policy for collection of Debtors
8/6/2019 Lecture - 1 - Analysis of Financial Statements
25/31
No stringent Nr & Dr for Debtors
Days
Average Debtors =x days
Sales revenue Per day
Days debtors
Average Debtors =x days
Credit Sales revenue Per day
Days debtors
8/6/2019 Lecture - 1 - Analysis of Financial Statements
26/31
Which company is doing better?A B
Debtor Days 50 150
Creditor Days 25 175
Credit policy for both company = 75 days!
Is it bad to have HUGE DEBTORS?
Ageing Analysis shows quantum ofgood quality Debtors!
8/6/2019 Lecture - 1 - Analysis of Financial Statements
27/31
b. Creditor Daysy Creditor days, shows the number of days purchases
which is standing as creditor.
Average Creditors =x days
Purchases per day
Creditors Days
8/6/2019 Lecture - 1 - Analysis of Financial Statements
28/31
c.Inventory Daysy Days inventory ratio indicates the average period oftime
ittakes to sell inventory .
y In other words, Number of days of sales in Inventory.
Average Inventory =x days
Cost of goods sold per day
Days inventory
Cost of goods sold = Sales - Profit
8/6/2019 Lecture - 1 - Analysis of Financial Statements
29/31
Putting it Together.
y Debtors Days + Inventory Days Creditors Days = Working capital Days
CurrentAssets
CurrentLiabilities
Cash Conversion Cycle
The cash conversion cycle attempts to measure theamount oftime each net input dollar is tied up in theproduction and sales process before it is converted intocash through sales to customers.
8/6/2019 Lecture - 1 - Analysis of Financial Statements
30/31
Example5. The following ratios have been calculated for Interport Pty LLc, a manufacturing
company.
2010 2009
Current Ratio------------- 2.5:1 1.3:1
Quick asset ratio--------- 1.3:1 0.7:1
Inventory Days----------- 130 90
Debtor Days-------------- 62 45
Creditor Days------------- 44 43
Profit Margin------------- 5% 7%
Comment on
Liquidity
Management Efficiency
Profitability
8/6/2019 Lecture - 1 - Analysis of Financial Statements
31/31
Summarizing Liquidity RatioLiquidity
Ratios
CurrentRatio
LiquidRatio
AbsoluteCash Ratio
Turn overRatios
DaysDebtors
CreditorDays
InventoryDays