Basics of Financial Analysis

FEDFACM20101: Financial Analysis & Engineering

Source: Financial Reporting & Analysis

Gibson, 13th edition, CENGAGE Learning (Chapters 5)
Learning Outcomes
Understand:

• The meaning, need and scope of Financial Analysis

• The key methods used by financial analysts to:

• Evaluate the position of a firm
• Emphasize the relative importance of the data presented by a company

• The three main Financial Analysis techniques:

• Ratio Analysis
• Common-Size Analysis
• Year-to-Year Change Analysis

• Other techniques – Statistical regression, use of graphics

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Financial Analysis – scope and purpose
• Financial Analysis represents a rigorous approach to analyzing the economic and
accounting data surrounding a business and form an overall opinion about it

• The purpose is to provide a global assessment of the company’s current and future
financial position

Economic analysis Accounting analysis

Financial Analysis

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Economic and Accounting Analysis

Economic Analysis Accounting Analysis

• What is the vision of the company – its long- • What is the quality of the published financial
term goals?
statements of the company?
• What is the strategy of the management to
• Are they in line with the requirements of GAAP?
achieve these goals?
• What does the Audit Report say?
• What is the firm’s business environment?
• What do profitability, liquidity, solvency and
• How is its competitive scenario?
market ratios indicate?
• Does the firm face any imminent dangers such
as policy changes, regulatory issues etc.? • How is the cash position of the company?

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The motivation for Analysis
• Different stakeholders may be interested in the results of a financial analysis for different reasons:
• Current shareholders (is the company able to create value?)

• Future shareholders (should we buy its stocks?)

• Banks and other lenders (will we ever receive our money?)

• Rating agencies (what rating to assign to the company?)

• Executives (how are we placed vis-à-vis our competitors?)

• The purpose of a financial analysis is to assess the financial health of the company (the reporting objective),

and to help the executives managing the firm to make decisions (the managing objective).

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The need for Analysis
• Financial Statement analysis is a complex and often, subjective process

• It often requires the analyst to make judgements about the information presented by the firm

• Given the massive amount of financial accounting data presented by a company, it becomes important for the
analyst to assess the following:

• The relative importance or insignificance of an item reported

• Condensation and simplification of numerical information

• Identification of major changes in trends and relationships

• Unusual numbers or trends, relative to industry-peers

• This process is made much easier through the various financial analysis tools discussed in this chapter

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I. Ratio Analysis
• A Ratio is simply one number divided by another, expressed as a percentage, decimals or
times per year

• Given its ability to condense two or more numbers into a single number, it renders
simplicity to the analysis process
• Ratios can be computed using numbers from the Income Statement, Balance Sheet and
the Statement of Cash Flows, depending on the purpose of the ratio

• Please note that there is no exhaustive list of ratios or standard computations. Each
analyst uses his own.

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Ratio Analysis – pros and cons

Advantages Pitfalls
1. Brief and concise 1. A ratio is just a number. It does not explain the ‘why’
behind the numbers.
2. Easy to compute
2. Comparison with peers may be a tricky affair due to:
3. Ease of comparability across
• Difference in financial reporting styles
competitor firms and industry averages
• Difference in Accounting Standards
4. Ease in identification of trends over • Difference in fiscal year-ends
time 3. Unduly dependent on the quality of financial
information presented. If reporting is fraudulent,
5. Helps in forecasting ratios will be misleading too!
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Comparison using Ratio Analysis
• One of the primary advantages Ratio Analysis offers is the ease of comparability

• Comparison using Ratio Analysis usually takes the following two forms:

1. Intra-company comparison: This involves the comparison of the ratios of the same company over time. The purpose is
to identify trends and growth patterns.

Example: Return on Assets (ROA) for Pepsico increased from 15 to 16.4% from 2016 to 2017. This indicates increase in
profitability.

[Link]-company comparison: Also called cross-sectional comparison. This involves the comparison of the ratios of one
company to another, usually in the same industry. It helps in identifying the relative positioning of the firm vis-a-via the
industry.

Example: ROA for Pepsico and Coca Cola for the year-ended 2017 is 16.4 and 18% respectively. This indicates that Coca
Cola is more profitable than Pepsico, using ROA as the metric for profitability.
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Comparison using Ratio Analysis (Cont’d)
• May also be interpreted in comparison with
 Industry ratios
 Predetermined standards

• Trend and variability of a ratio are important considerations

Comparisons: Trend Analysis
• A study of the financial history of a firm
• It reveals whether the ratio is
– Falling
– Rising
– Relatively constant
• Highlight
– Effective management
– Evidence of problems
Industry Variations
• Financial components vary by type of industry
• Merchandising
 Inventory is a principal asset
 Sales may be primarily for cash or on credit
• Service
 Inventory is low or nonexistent
• Manufacturing
 Large inventory holdings
 Substantial investment in plant assets
 Cost of sales often represents the major expense
Comparisons: Caution in Using Industry Averages

• Ratios are subject to variance from

– Differing data
– Inconsistent formula construction
– Optional (elective) accounting treatment
– Different fiscal year-ends
– Varying financial policies
– Inconsistent basis (before or after tax)
Types of Ratios
Category Purpose Examples

Profitability To assess the financial performance of the • Return on Assets (ROA)

company • Net Profit Margin
Liquidity To assess the ability of the company to meet its • Cash ratio
short-term payments in time • Current ratio
Solvency To assess the ability of the company to meet its • Interest Coverage ratio
long-term debt payments in time • Debt-Equity ratio
Efficiency/ Turnover To assess the efficiency with which the company • Working Capital turnover
uses its assets to generate revenue • Asset Turnover ratio
Valuation-based To measure market perception associated with the • Earnings Per Share (EPS)
company • Price-Earnings Ratio (P/E)
Cash-Flow based ratios To assess the efficiency of cash management of • Operating Cash flow to
the company Debt ratio
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Complexities and Context
• Use of average data from balance sheet
 Necessary when comparing with income statement data
 Does not
• Eliminate seasonal or cyclical variations
• Reflect changes that occur unevenly throughout the year

• Analysis must be performed and understood within the context of

 Native accounting principles
 Native business practices and culture
Descriptive Information
• Narrative data
 Annual report
 Trade periodicals
 Industry reviews
• Further explains the financial position of a firm
• Management Discussion and Analysis (MD&A) provides an overview of
the previous year and of future goals and new projects
II. Common-Size Analysis
• Used to express numbers in financial statements in terms of percentages, in relation to a single number chosen (called the
base). For instance, if cash is $40,000 and Total assets, $1 million, cash represents 4% of total assets.

• Can be of two types:

1. Vertical Common-Size Analysis: The purpose is to assess the relative importance of each item vis-à-vis the selected
base. Base is one item selected from the same year’s financial statement. Common bases include:
- Balance Sheet: Total Assets

- Income Statement: Total Sales revenue

- Cash Flow Statement: Total cash inflows or outflows

2. Horizontal Common-Size Analysis: The purpose is to assess changes across time for the same item. A base year is
selected and all items are expressed relative to the values in that base year.

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A. Vertical Common-Size Analysis
Melcher Company
Income Statement
For the years ended December 31
2007 2006 2005
Sales revenue $100,000 100% $95,000 100% $91,000 100%
Cost of Goods Sold 65,000 65% 60,800 64% 56,420 62%
Gross Profit (A) 35,000 35% 34,200 36% 34,580 38%
Operating expenses:
Selling expenses 14,000 14% 11,400 12% 10,000 11%
General expenses 16,000 16% 15,200 16% 13,650 15%
Total operating expenses (B) 30,000 30% 26,600 28% 23,650 26%
Operating Income before Taxes (A – B) 5,000 5% 7,600 8% 10,930 12%
Income taxes 1,500 1.5% 2,280 2.4% 3,279 3.6%
Net Income $3,500 3.5% $5,320 5.6% $7,651 8.4%
Note that in this case, the base selected is Sales revenue (highlighted in red). The percentage of the base is always 100.
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B. Horizontal Common-Size Analysis
Melcher Company
Income Statement
For the years ended December 31
2007 2006 2005 2007 2006 2005
Sales revenue $100,000 $95,000 $91,000 109.9% 104.4% 100%
Cost of Goods Sold 65,000 60,800 56,420 115.2% 107.8% 100%
Gross Profit (A) 35,000 34,200 34,580 101.2% 98.9% 100%
Operating expenses:
Selling expenses 14,000 11,400 10,000 140% 114% 100%
General expenses 16,000 15,200 13,650 117.2% 111.4% 100%
Total operating expenses (B) 30,000 26,600 23,650 126.8% 112.5% 100%
Operating Income before Taxes (A – B) 5,000 7,600 10,930 45.7% 69.5% 100%
Income taxes 1,500 2,280 3,279 45.7% 69.5% 100%
Net Income $3,500 $5,320 $7,651 45.7% 69.5% 100%
Note that in this case, the base year selected is 2005 (highlighted in red). The percentage of the base is always 100.
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III. Year-to-year Change Analysis
• This approach helps the analyst compare financial statements over two different time periods
• It helps us understand how the value of an item has changed compared to last year, both in absolute
and in percentage terms.

• Use both absolute and percentages

• While very simple to perform, this analysis involves three key rules:
1. When an item has value in the base year and zero in the next period, the % decrease is simply,
100%.

2. A meaningful percent change cannot be computed when one number is positive and the other,
negative.

3. No computation of % is possible when there is no figure available for the base year. 20
Example
Item Year 1 Year 2 Change from year-to-year

Absolute Amount ($) Percentage

Advertising expense $20,000 - ? ?

Operating Income 6,000 (3,000) ? ?

Net Income (7,000) 8,000 ? ?

Other - 4,000 ? ?

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Example - Solution
Item Year 1 Year 2 Change from year-to-year

Absolute Amount ($) Percentage

Advertising expense $20,000 - $(20,000) (100%)

Operating Income 6,000 (3,000) (9,000) -

Net Income (7,000) 8,000 15,000 -

Other - 4,000 4,000 -

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Example - Solution
Item Year 1 Year 2 Change from year-to-year

Absolute Amount ($) Percentage

Advertising expense $20,000 - $(20,000) (100%)

Operating Income 6,000 (3,000) (9,000) -

Net Income (7,000) 8,000 15,000 -

Other - 4,000 4,000 -

Can you explain

why?
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Example - Solution
Item Year 1 Year 2 Change from year-to-year

Absolute Percentage
Amount ($)

Advertising expense $20,000 - $(20,000) (100%)

Operating Income 6,000 (3,000) (9,000) One number negative and the other
positive.
Net Income (7,000) 8,000 15,000 Same as above

Other - 4,000 4,000 No figure for base year

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Other Analysis techniques
• Some other techniques that may assist in analysis, in addition to those
already discussed, include:
• Graphics, diagrams, charts and other visual aids: These help in
understanding trends and patterns through visual aids such as pictures

• Statistical regression: This can be done with the help of statistical softwares
readily available. Regressions help to understand the statistical relationship
between two variables of interest, for instance sales and profitability.

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Use of graphics – Example 1
Operating Profit by Geographical Segment

22% 21%

19%
38%

North America Latin America Europe/South Pacific Greater Asia/Africa

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Example 2

Greater Asia/Africa 2007 2008

2009 2010

Europe/South Pacific
2011

Latin America

North America

0 200 400 600 800 1000 1200 1400 1600

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Example 3
Operating profit margin
30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%
20061 20062 20063 20064 20071 20072 20073 20074 20081 20082 20083 20084 20091 20092 20093 20094 20101 20102 20103 20104 20111 20112 20113 20114

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Statistical Regression
14.0

y = 0.1176x + 5.8177 12.0

R² = 0.2687

10.0

8.0
GDP Change

6.0

4.0

2.0

0.0
-40.0 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 40.0

-2.0

-4.0
Sales Growth

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Thank you!

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