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Introduction to financial statement analysis

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The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year. The dollar change is found by taking the dollar amount in the base year and subtracting that from the year of analysis. Using Banyan Goods as our example, if Banyan wanted to compare net sales in the current year year of analysis of? The percentage change is found by taking the dollar change, dividing by the base year amount, and then multiplying by This means Banyan Goods saw an increase of?

The same dollar change and percentage change calculations would be used for the income statement line items as well as the balance sheet line items. Figure shows the complete horizontal analysis of the income statement and balance sheet for Banyan Goods. Depending on their expectations, Banyan Goods could make decisions to alter operations to produce expected outcomes. It could possibly be that they are extending credit more readily than anticipated or not collecting as rapidly on outstanding accounts receivable.

The company will need to further examine this difference before deciding on a course of action. Another method of analysis Banyan might consider before making a decision is vertical analysis. Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement.

For example, a company may compare cash to total assets in the current year. This allows a company to see what percentage of cash the comparison line item makes up total assets the other line item during the period. This is different from horizontal analysis, which compares across years. Vertical analysis compares line items within a statement in the current year.

This can help a business to know how much of one item is contributing to overall operations. For example, a company may want to know how much inventory contributes to total assets. They can then use this information to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital investments.

The company will need to determine which line item they are comparing all items to within that statement and then calculate the percentage makeup. These percentages are considered common-size because they make businesses within industry comparable by taking out fluctuations for size.

It is typical for an income statement to use net sales or sales as the comparison line item. The formula to determine the common-size percentage is:. For example, if Banyan Goods set total assets as the base amount and wanted to see what percentage of total assets were made up of cash in the current year, the following calculation would occur.

Cash in the current year is? This may not be enough of a difference to make a change, but if they notice this deviates from industry standards, they may need to make adjustments, such as reducing the amount of cash on hand to reinvest in the business. Figure shows the common-size calculations on the comparative income statements and comparative balance sheets for Banyan Goods.

This could be due to many factors, and Banyan Goods will need to examine this further to see why this change has occurred. Financial ratios help both internal and external users of information make informed decisions about a company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal operations, among other things, based in part on the outcomes of ratio analysis.

The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity, solvency, efficiency, and profitability.

Note that while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions. You will learn more about ratios, industry standards, and ratio interpretation in advanced accounting courses. Liquidity ratios show the ability of the company to pay short-term obligations if they came due immediately with assets that can be quickly converted to cash. This is done by comparing current assets to current liabilities.

Lenders, for example, may consider the outcomes of liquidity ratios when deciding whether to extend a loan to a company. A company would like to be liquid enough to manage any currently due obligations but not too liquid where they may not be effectively investing in growth opportunities. Three common liquidity measurements are working capital, current ratio, and quick ratio.

Working capital measures the financial health of an organization in the short-term by finding the difference between current assets and current liabilities. A company will need enough current assets to cover current liabilities; otherwise, they may not be able to continue operations in the future.

Before a lender extends credit, they will review the working capital of the company to see if the company can meet their obligations. A larger difference signals that a company can cover their short-term debts and a lender may be more willing to extend the loan. On the other hand, too large of a difference may indicate that the company may not be correctly using their assets to grow the business. The formula for working capital is:. Using Banyan Goods, working capital is computed as follows for the current year:.

In this case, current assets were? Current assets were far greater than current liabilities for Banyan Goods and they would easily be able to cover short-term debt. The dollar value of the difference for working capital is limited given company size and scope. This ratio is the current ratio. Working capital expressed as a ratio is the current ratio. The current ratio considers the amount of current assets available to cover current liabilities.

The higher the current ratio, the more likely the company can cover its short-term debt. The formula for current ratio is:. A ratio means the company has twice as many current assets as current liabilities; typically, this would be plenty to cover obligations. This may be an acceptable ratio for Banyan Goods, but if it is too high, they may want to consider using those assets in a different way to grow the company.

The quick ratio, also known as the acid-test ratio, is similar to the current ratio except current assets are more narrowly defined as the most liquid assets, which exclude inventory and prepaid expenses. The conversion of inventory and prepaid expenses to cash can sometimes take more time than the liquidation of other current assets.

A company will want to know what they have on hand and can use quickly if an immediate obligation is due. The formula for the quick ratio is:. Solvency implies that a company can meet its long-term obligations and will likely stay in business in the future. To stay in business the company must generate more revenue than debt in the long-term. Meeting long-term obligations includes the ability to pay any interest incurred on long-term debt.

Two main solvency ratios are the debt-to-equity ratio and the times interest earned ratio. The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations running.

It is less risky and less costly to use equity sources for financing as compared to debt resources. This is mainly due to interest expense repayment that a loan carries as opposed to equity, which does not have this requirement.

Therefore, a company wants to know how much debt and equity contribute to its financing. Ideally, a company would prefer more equity than debt financing. The formula for the debt to equity ratio is:. The information needed to compute the debt-to-equity ratio for Banyan Goods in the current year can be found on the balance sheet. This means that for every? This would be a concern for Banyan Goods. This could be a red flag for potential investors that the company could be trending toward insolvency.

Banyan Goods might want to get the ratio below to improve their long-term business viability. This ability to pay is determined by the available earnings before interest and taxes EBIT are deducted. These earnings are considered the operating income.

Lenders will pay attention to this ratio before extending credit. The more times over a company can cover interest, the more likely a lender will extend long-term credit. The formula for times interest earned is:. The information needed to compute times interest earned for Banyan Goods in the current year can be found on the income statement.

The Efficiency shows how well a company uses and manages their assets. Areas of importance with efficiency are management of sales, accounts receivable, and inventory. A company that is efficient typically will be able to generate revenues quickly using the assets it acquires. Accounts receivable turnover measures how many times in a period usually a year a company will collect cash from accounts receivable.

A higher number of times could mean cash is collected more quickly and that credit customers are of high quality. A higher number is usually preferable because the cash collected can be reinvested in the business at a quicker rate. A lower number of times could mean cash is collected slowly on these accounts and customers may not be properly qualified to accept the debt. The formula for accounts receivable turnover is:.

Many companies do not split credit and cash sales, in which case net sales would be used to compute accounts receivable turnover. Average accounts receivable is found by dividing the sum of beginning and ending accounts receivable balances found on the balance sheet. The beginning accounts receivable balance in the current year is taken from the ending accounts receivable balance in the prior year. An accounts receivable turnover of four times per year may be low for Banyan Goods.

Given this outcome, they may want to consider stricter credit lending practices to make sure credit customers are of a higher quality. They may also need to be more aggressive with collecting any outstanding accounts.

Total asset turnover measures the ability of a company to use their assets to generate revenues. It is different from the market value of equity stock market capitalization which is calculated as follows: number of shares outstanding multiplied by the current share price. The balance sheet is analyzed to obtain some key ratios that help explain the health of the firm at a given point in time. These metrics are as follows:.

The debt-equity ratio is also called a leverage ratio. It is calculated to assess the leverage, or gearing, of a firm to show how much it relies on debt to finance its activities. This ratio has pertinent implications for the financial health of the firm and the risk and return of its shares.

The variations in this ratio also show any value added by the management and its growth prospects. The enterprise value of a firm shows the underlying value of the business. The purpose of an income statement is to report the revenues and expenditures of a firm over a specific period of time. It was previously also called a profit and loss account. The general structure of the income statement with major components is as follows:.

The net income on the income statement, if positive, shows that the company has made a profit. If the net income is negative, it means the company incurred a loss. Earnings per share can be derived from knowing the total number of shares outstanding of the company:. Some useful metrics based on the information provided in the income statement and the balance sheet are as follows:. Net profit margin: This ratio calculates the amount of profit that the company has earned after taxes and all expenses have been deducted from net sales.

Return on Equity: This ratio is used to calculate company profit as a percentage of total equity. It assesses whether the stock is overvalued or undervalued. It is essentially a statement whereby the net income is adjusted for non-cash expenses and any changes to the net working capital. It also reflects changes in cash coming from, or being used by, investing and financing activities of the firm.

The structure and main components of the cash flow statement are as follows:. In order to measure how much cash is available to the company for investments without outside financing or money diverting from operations, it is useful to conduct a simple cash flow statement analysis. The free cash flow, as the name suggests, allows a company to be able to pay dividends, repay its debts, buy back its stock and also make new investments to facilitate future growth.

The excess cash produced by the company, free cash flow, is calculated as follows:. In order for the company to be doing extremely well, the cash from operating activities must be consistently greater than the net income earned by the company. Apart from the key financial statements, complete financial reporting statements also include the following:.

It serves as a preface to all the complete reporting statements in which the management talks about recent events, discloses essential information regarding expansion and future plans, and discusses significant developments in the business industry.

The business and operating review is a good place for the company to share any good news with the general public. It reconciles the opening balances of the equity accounts with the closing balances. These notes provide details and information that are left out of the main reporting documents. They are important for the sake of clarity on many points as they outline the accounting methodology used for recording certain transactions. The notes to the financial statements are essentially footnotes because if included in the main statements, they would obscure the important information, as they are generally quite elaborate and detailed.

The following notes are usually used to impart important disclosures for explaining the numbers on the financial statements:. Financial statement analysis is a brilliant tool to gauge the past performance of a company and predict future performance, but there are several issues that one should be aware of before using the financial statement analysis results blindly, as these issues can interfere with how the results are interpreted.

Some of the issues are:. This is a big issue for analysts because they can seemingly compare financial statement analyses between different companies on the basis of ratios used, but in reality it may not paint an accurate picture. The financial ratios of two different companies may be compared to see how they match up against each other, but each company may aggregate all their information different from each other in order to draw up their accounting statements.

This may lead to incorrect conclusions drawn about a company in relation to other companies in the industry. The change in accounts where financial information is stored may skew the results of the financial statement analysis, from one period to the next. For example, if a company records an expense in one period as cost of goods sold , while in another period, it is recorded as a selling and distribution expense, the analysis between those two periods would not be comparable.

Analysts do not take into account operational information of a company, as only financial information is analyzed and reviewed. There may be several indicators in operational information of the company which may be predictors of future performance, for example, the number of backlogged orders, any changes in licenses or warranty claims submitted to the company or even changes in the culture and work environment. Therefore, analysis of financial information may only relay half the story.

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Introduction to financial statement analysis Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin, which each divide profit by revenue. This ability to pay is determined by the available earnings before interest and taxes EBIT are deducted. These can be classified into internal and external users. Before a lender extends credit, they will review the working capital of the company to see if the company can meet their obligations. The income statement breaks down the revenue a company earns against the expenses involved in its business to provide a bottom line, meaning the net profit or loss. This affects the financial statement ratios. Overview of Financial Ratios Financial ratios help both internal and external users of information make informed decisions about a company.
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Analysing Financial Statements - Introduction - Part 1 #accounting #business

Financial Statement Analysis is. › financial-statement-analysis-introduction. Financial analysis is the process of examining a company's performance in the context of its industry and economic environment in order to arrive at a decision.