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Financial Statement Analysis for
Business Decision-Making
Financial Statement Analysis
What is Financial Statement Analysis (FS Analysis)?
FS Analysis involves methods of calculating, analyzing, and interpreting the firm's financial status, financial performances, and financial activities through the use of financial ratios. It involves careful and thorough selection of data, primarily financial in nature, from the financial statements for the purpose of forecasting the financial health and soundness and capabilities of the firm. It also involves the comparisons and evaluation of financial data across companies from the same industries and other relevant companies.
Financial Ratio
A financial ratio is the relative value of an account or financial data that compare, relate, and interact with other accounts or financial data for the purposes of analyzing the financial statements of the firm. Financial ratios can be expressed in proportion, decimal, percentages, fraction, or times.
Interested Parties on the Analysis of Financial Statements
Shareholders/Owners : Both current and prospective shareholders are interested in the firm's current and future level of risk and return, particularly the distribution of dividends, and the changes in the value or price of their ownership or shares. Creditors : Creditors are interested primarily in the short-term liquidity and long-term solvency of the firm and its ability to make interest and principal payments when they become due. Management : Management shall monitor the firm's financial status, financial performances, and financial activities favorable both to the shareholders/owners and creditors.
Limitations and Cautions on Using Financial Statement
Analysis
Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. Comparing the ratios of a firm in one industry with those of a firm in another industry is difficult because industry peculiarities will cause the ratios to differ. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. However, if an analysis is concerned only with certain specific aspects of a firm's financial position, one or two ratios may suffice.
The ratios being compared should be calculated using financial statements dated at the same point in time during the year. If they are not, the effects of seasonality may produce erroneous conclusions and decisions. It is preferable to use audited financial statements for ratio analysis. If they have not been audited, the data in them may not reflect the firm's true financial condition. The financial data being compared should have been developed in the same way. The use of differing accounting treatments, such as accounting standards, can distort the results of ratio comparisons, regardless of whether cross-sectional or time-series analysis is used. Results can be distorted by inflation. Without adjustment, inflation tends to cause older firms (older assets) to appear more efficient and profitable than newer firms (newer assets). Data from the financial statements are year-end numbers and are based on historical costs. Predictions for the future may not be realized.
Types of Ratio Comparisons
Cross-Sectional Analysis : Comparison of different firms' financial ratios at the same point in time; involves comparing the firm's ratios to those of other firms in its industry or to industry averages. Benchmarking is a type of cross-sectional analysis in which the firm's ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate. Time Series Analysis : Evaluation of the firm's financial performance over time using financial ratio analysis. Interchangeably known as horizontal analysis, is a comparison of financial data for two or more years of the same firm to determine the increase or decrease from the previous years or vice versa. It is also considered a trend analysis that analyzes trends or changes of performances from one period to another. Vertical Analysis : Evaluation of the proportionality of each line item or account on a financial statement as a percentage of another item in a single reporting period. This analysis is also useful in comparing relative changes in accounts over time in a time series analysis. For the Statement of Financial Position, the Total Assets is primarily the base 100% for asset accounts, and the Total Liabilities and Shareholder's Equity for liabilities and equity accounts. For the Statement of Comprehensive Income, the Gross Sales is primarily the base 100%. This is also known as Common-Sized Balanced Sheet or Common-Sized Income Statement.
Categories of Financial Ratios
Liquidity Ratios Activity Ratios Debt Ratios (Leverage Ratios) Profitability Ratios Market Ratios
Inventory Turnover or Average Inventory / (COGS / 365) | Measures how many days of inventory the firm has on hand. It indicates the number of days to sell or consume the average inventory. The higher the average age of inventory, means the longer the inventory stays on hand. |
Financial Statement Analysis for Bartlett
Company
Liquidity Ratios
The shorter the trade payable turnover, the better, especially for perishable items or products that must be sold quickly. The trade payable turnover ratio measures the efficiency of the firm's payment of trade payables. It indicates the number of times the firm pays its trade payables in a given period. A higher trade payable turnover indicates more frequent payment of the firm's trade payables.
The average payment period, also known as the average age of accounts payable, measures the average number of days the firm pays its trade payables. This figure is meaningful only in relation to the average credit terms extended to the firm. The average age of payment must not go beyond the credit term, as that would mean the firm takes too long to pay its trade payables. The payment days must also not be too early compared to the credit term, in order to maximize the time value of money and payment of interest, if any.
Activity Ratios
The total asset turnover ratio measures the efficiency with which the firm uses its assets to generate sales. It indicates the number of times the firm generates sales from its assets. A higher total asset turnover indicates more efficient use of the firm's assets or total resources in generating sales.
The capital intensity ratio measures the efficiency of the firm in generating sales through the employment of its resources.
Leverage Ratios
The debt ratio measures the proportion of total assets financed by the firm's creditors. A higher debt ratio indicates a greater amount of other people's money being used to generate profits, and a greater degree of indebtedness and financial leverage.
The equity ratio indicates the proportion of assets provided by owners, reflecting the firm's financial strength and caution to creditors. Its relevance depends on the risk preferences of the firm.
The debt-to-equity ratio measures debt relative to the amounts of resources provided by the owners.
The times interest earned ratio, also called the interest coverage ratio, measures the firm's ability to make contractual interest payments. It indicates how many times interest expense is covered by operating profit. A higher value indicates better ability to fulfill interest obligations.
The fixed-charge coverage ratio measures the firm's ability to meet all fixed payment obligations, such as loan interest and principal, lease payments, and preferred stock dividends. A higher value indicates lower risk to both lenders and owners.
Profitability Ratios
The gross profit margin measures the profit generated after consideration of costs of product sold. A higher gross profit margin may indicate lower relative cost of merchandise sold.
The operating profit margin measures the profit generated after consideration of operating costs, excluding interest, taxes, and preference share dividends, and other finance costs. A higher operating profit margin may indicate lower relative cost of operations.
The net profit margin measures the profit generated after consideration of all expenses, including interest, taxes, and preference share dividends. A higher net profit margin may indicate lower relative cost of production, operations, and other expenses.
Earnings per share (EPS) represents the number of dollars earned during the period on behalf of each outstanding share of ordinary share. A higher EPS is generally of interest to present or prospective shareholders and management, as it is considered an indicator of corporate success.
Return on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness and efficiency of management in generating profits with its available assets. A higher ROA indicates a higher return earned on the use of the firm's assets.
Return on equity (ROE) measures the return earned on the common stockholders' investment in the firm. A higher ROE indicates a higher return earned on every ordinary share investment in the firm.
Market Ratios
The price-to-earnings (P/E) ratio measures the relationship between the price of the ordinary shares in the open market and the profit earned on a per-share basis. A higher P/E ratio indicates greater investor confidence in the firm's future performance.
The market-to-book (M/B) ratio relates the market value of the firm's shares to their book value. A higher M/B ratio indicates that the firm is expected to earn high returns relative to its risk.
In 2012, the total asset turnover rose to a level considerably above the industry average, but it appears that the pre-2011 level of efficiency has not yet been achieved.
Debt
Bartlett Company's indebtedness increased over the 2010โ2012 period and is currently above the industry average. Although the increase in the debt ratio could be cause for alarm, the firm's ability to meet interest and fixed-payment obligations improved from 2011 to 2012, outperforming the industry. The firm's increased indebtedness in 2011 apparently caused deterioration in its ability to pay debts adequately, but the company's improved ability to pay debts in 2012 compensates for its increased degree of indebtedness.
Profitability
Bartlett's profitability relative to sales in 2012 was better than the average company in the industry, although it did not match the firm's 2010 performance. The gross profit margin was better in 2011 and 2012 than in 2010, but higher levels of operating and interest expenses in 2011 and 2012 appear to have caused the 2012 net profit margin to fall below that of
However, Bartlett Company's 2012 net profit margin is quite favorable when compared to the industry average. The firm's earnings per share, return on total assets, and return on common equity behaved much as its net profit margin did over the 2010โ2012 period.
Market
Investors have greater confidence in the firm in 2012 than in the prior 2 years, as reflected in the price/earnings (P/E) ratio of 11.1, which is below the industry average. The P/E ratio suggests that the firm's risk has declined but remains above that of the average firm in its industry. The firm's market/book (M/B) ratio has increased over the 2010โ period and in 2012 it exceeds the industry average, implying that investors are optimistic about the firm's future performance. The P/E and M/B ratios reflect the firm's increased profitability over the 2010โ2012 period, as investors expect to earn high future returns as compensation for the firm's above-average risk.
Summary
The firm appears to be growing and has recently undergone an expansion in assets, financed primarily through the use of debt. The 2011โ2012 period seems to reflect a phase of adjustment and recovery from the rapid growth in assets.
Bartlett's sales, profits, and other performance factors seem to be growing with the increase in the size of the operation, and the market response to these accomplishments appears to have been positive.
Use of Financial Ratios
The use of financial ratios is not conclusive and perfect, and has limitations. Careful and thorough selection of data and interpretation are necessary. Cross-sectional analysis, time-series analysis, and vertical analysis are useful in analyzing financial ratios.
Major Categories of Financial Ratios
The five major categories of financial ratios are:
Liquidity Ratios Activity Ratios Debt Ratios (Leverage Ratios) Profitability Ratios Market Ratios
Liquidity, activity, and debt ratios primarily measure risk, while profitability ratios measure return. Market ratios capture both risk and return.
Uses of Financial Statement Analysis
Financial statement analysis provides a wide variety of uses of accounting information, particularly for planning, controlling, and decision-making in business, not only to generate profit but primarily to maximize the owners' wealth.
Student/Learner Evaluation
The student/learner's performance in this module is evaluated as follows:
20% Attendance, Poll Questioning, and Oral Exercises 20% Portfolio Journal for work exercises 20% Formative Examination ASSIGNMENT/AGREEMENT
Further Reading
For further reading, the student/learner is advised to read the topic on Cash Flows, Financial Planning, and Budgeting in the book "Principles of Managerial Finance" by Gitman, L.J. and Zutter, C.J., 13th Edition, Prentice Hall. The student/learner should also review the Cash Flow Statements discussed in FAR 3 and the discussion of cash flows in financial accounting.
References
Cabrera, MEB. C. Management Advisory Services 2009 Edition. GIC Enterprises & Co., Inc.
