Lesson 3: Financial Statement Analysis for Finance Manager

Financial statement analysis highlights the connection, relation and

importance of accounting to financial management in particular and to finance
in general. It is however, important to bear in mind that financial analysis is
not an end in itself but rather an effort to understand and judge the
characteristics and performance of highly interrelated system of financial
relationship. It also involves careful selection of data from financial statement
in order to assess and evaluate the firm’s past performance, its present
condition, future business potentials.

OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

The primary purpose of FS analysis is to evaluate and forecast the
company’s financial health. Interested parties, such as the managers,
investors, and creditors can identify the company’s financial strength and
weaknesses and know about the:
1. Profitability of the business firm;
2. Firm’s ability to meet its obligations;
3. Safety in the investment in the business; and
4. Effectiveness of management in running the firm.

GENERAL APPROACH TO FINANCIAL STATEMENT ANALYSIS

1. Evaluation of the environment (industry and economy as a whole)
where the company conducts business
2. Analysis of the firm’s short-term solvency
3. Analysis of the company’s capital structure and long-term solvency
4. Evaluation of the management’s efficiency in running the business
5. Analysis of the firm’s profitability

PROBLEMS AND LIMITATIONS IN FINANCIAL STATEMENTS ANALYSIS

1. Comparison of financial date
a. Differences between companies – a ratio that is acceptable to one
company may not be acceptable to another when other factors are
considered
 b. Differences in accounting methods and estimates

Valuation problem - financial statements are based on historical costs and

therefore, do not reflect the current market value of the firm’s assets.

c. More so, the effects of price level changes must be considered.

d. The timing of transactions and use of averages in applying the
various techniques in FS analysis affect the results obtained.
2. The need to look beyond ratios
Ratios are not sufficient in themselves as basis for judgments about the
future. Other factors must be considered, such as:
a. Industry trends
b. Changes in technology
c. Changes in consumer tastes
d. Changes in economy as a whole
e. Changes that are taking place within the company itself

STEPS IN FINANCIAL STATEMENTS ANALYSIS

1. Establish the objectives of the analysis to be conducted.
2. Study the industry where the firm belongs.
3. Study the firm’s background and the quality of its management.
4. Evaluate the firm’s financial statements using the evaluation
techniques available.
5. Summarize the results of the studies and evaluation conducted.
6. Develop conclusions relevant to the established objectives.

TECHNIQUES USED IN FINANCIAL STATEMENTS ANALYSIS

1. Horizontal Analysis (trend ratios and percentage)
2. Vertical Analysis (common-sized statements)
3. Ratio analysis
4. Analysis of variation in gross profit and net income
5. Cash flow analysis

Horizontal Analysis
It involves comparison of figures shown in the financial statements of two
or more consecutive periods. The difference between the figures of the
two periods is calculated and the percentage change from one period to
the next is computed using the earlier period as the base.
Formula:

Vertical Analysis
The process of comparing figures in the financial statements of
a single period. It involves converting of figures in the statements to a
common base. This is accomplished by expressing all the figures in the
statements as percentages of an important item such as total assets (in
the balance sheet) or total or net sales (in the income statement). These
converted statements are called common-size statements or percentage
composition statements
Ratio Analysis
Ratios are calculated from the financial statements to provide users of
such statements with relevant information about the firm’s liquidity, use of
leverage, asset management, cost control, profitability, growth, and
valuation.
a. Liquidity Ratios – provides information about the firm’s ability to pay
its current obligations and continue operations
RATIO FORMULA SIGNIFICANCE
1. Current Ratio Test of short-term
or Working debt paying ability.
Capital Ratio or
Banker’s
Measures the firm’s
2. Acid Test or ability to pay its
Quick Ratio short-term debts
from its most liquid
*Quick Assets = Cash +
assets without
 Cash Equivalents + Net having to rely on
Receivables + Marketable inventory.
Securities
A more conservative
 Cash variation I Quick-
Ratio Ratio. It tests short-
term liquidity without
having to rely on
receivables and
inventory.
 Cash to Measures the
Current liquidity of current
Assets assets.
Ratio
 Cash Shows the
Flow significance of cash
Ratio flow for setting
current obligations
as they become due
Reflects the
3. Defensive percentage of near-
Interval cash items to the
daily operating cash
flow.
Shows the amount
4. Investment of current
Financing investment that was
“financed” by
depreciation and
increase in retained
earnings.
A Measure of
5. Liquidity Index liquidity of current
 assets stated in
*Non Cash Current Assets days. It shows the
are weighted by multiplying period-to-period
their balances by the changes in an
average days they are entity’s liquidity.
removed from conversion
to cash

b. Leverage Ratios
Measure the company’s use of debt to finance assets and operations
Financial Leverage (trading on the equity) – the use of debt to
finance assets and operations; it is advisable to trade on equity when
earnings from borrowed funds exceed the cost of borrowing.
 As leverage increases, the risk borne by creditors, as well as
the risk that firm may not be able to meet its maturing
obligations, increases.
 Since interest expense is tax deductible, leverage increases
the company’s return when it is profitable.
Solvency – the firm’s financial ability to pay long-term obligations
and survive in the long-term.