Chapter 2
Financial
Statement
Analysis
Learning Objectives









Explain basic financial statements and reports
Explain the nature and need of financial analysis.
Explain the meaning of financial ratio analysis.
Develop skills in using different types of financial
ratios.
Make classified assessment of firm’s financial
performance by using Du-Pont identity.
Use comparative ratios and benchmarking for
comparative financial analysis.
Describe the uses and limitations of financial ratios.
Use common size statements in financial analysis.
Use percentage change analysis and trend analysis in
analysis of financial statements of a firm.
Financial Statements and
Reports

Corporation prepares various types of reports.

The Annual Report is one of the basic documents to be
issued publicly by corporations.

Annual
report
basically
contains
two
types
of
information.

First section includes a descriptive report of firm’s operation during
past
year. It
also presents
new
developments,
if
any,
the
corporation is going to pursue.

Second section of annual report presents four basic financial
statements—the
income
statement,
the
balance
sheet,
the
statement of stockholders’ equity, and the statement of cash flow.

The financial statements contain the basic financial
information
such
as
revenues,
expenses,
assets,
liabilities and cash flows of the corporation during a
specified period.

The balance sheet and the income statement are basic
financial statements.

The income statement summarizes the revenues and
expenditures of a firm during an accounting year

The balance sheet summarizes the balance of the firm’s
assets, liabilities, and shareholders’ claim outstanding
on balance sheet preparation date.

Financial
statements
provide
an
input
to
shareholders,
creditors and other investors to form expectations about the
required return and risk associated with the corporation’s
financial affairs.

Understanding financial statements is, therefore, important for
shareholders, creditors, other investors and for the firm’s
management.
Role of Financial Statements
1. Financial statements are useful in reporting.
2. Financial statements are useful in business
decision making.
3. Financial statements are useful in forecasting.
4. Other uses.
Nature and Need of
Financial Analysis

The process of analyzing relative strengths and weaknesses of
a firm’s financial position.

Various stakeholders involve in financial analysis to ensure
that their interests are being served.

Financial
analysis
corporation’s
is
financial
essential
to
statement
is
understand
conveying
what
the
about
its
financial performance.


Financial statement analysis involves two types of comparison:

Compare a firm’s performance with that of other firms in the same industry;

Evaluate trends in the firm’s financial position over time.
Financial
managers
can
identify
deficiencies
in
financial
performance of the firm and take actions to improve the
performance.
Financial Ratio Analysis

Financial ratios are important tools of financial analysis.

The quantitative relationship between two or more sets of
financial data derived from income statement and balance
sheet.

They furnish information about strengths and weaknesses of
various aspects of a firm's performance.

For example, Unilever Nepal Limited’s income statement for
the year ended mid-July 2017 (Table 2.2) shows net income of
Rs 965.229 million.

We compare the net income against some other data, such as,
assets, or equity, or sales, or so on, to derive meaningful
conclusion about firm’s profitability.
Table 2.1
Unilever Nepal Limited: Balance Sheet as of mid-July (in ‘000)
ASSETS
Net fixed assets
Current Assets:
Inventories
Accounts receivable
Short-term investments
Cash and cash equivalents
Bank balance other than CCE
Total Current Assets
Total Assets
EQUITY AND LIABILITIES
Equity:
Share Capital
Retained earnings
Total Common Equity
Long-term debt
Current Liabilities:
Accounts payables
Accruals
Notes payables
Total Current Liabilities
Total Liabilities
Total Equity and Liabilities
2017
2016
Rs 581,814
Rs 489,845
Rs 620,026
680,278
1,160,494
241,737
37,480
Rs 2,740,015
Rs 3,321,829
2017
Rs 674,691
297,066
1,036,772
517,566
30,501
Rs 2,556,596
Rs 3,046,441
2016
Rs 92,070
1,982,201
Rs 2,074,271
Rs 12,949
Rs 92,070
1,956,919
Rs 2,048,989
Rs 10,870
Rs 1,019,448
160,332
54,829
Rs 1,234,609
Rs 1,247,557
Rs 3,321,829
Rs 902,020
43,664
40,898
Rs 986,582
Rs 997,452
Rs 3,046,441
Table 2.2
Unilever Nepal Limited: Income Statement for the year ended midJuly (in ‘000)
Sales revenue
Less: Cost of goods sold except
depreciation
Depreciation and amortization
Other operating expenses
Net operating income
Add: Other income
Earnings before interest and tax
Less: Interest expenses
Earnings before tax
Less : Taxes
Net income
2017
Rs 4,442,375
2016
Rs 3,946,476
2,283,003
32,987
1,483,299
Rs 643,086
626,332
Rs 1,269,418
8,724
Rs 1,260,694
295,465
Rs 965,229
2,006,171
26,434
1,012,699
Rs 901,172
512,725
Rs 1,413,897
6,417
Rs 1,407,480
285,802
Rs 1,121,678
Types of Financial Ratios

Liquidity ratios

Assets management ratios

Debt management ratios

Profitability ratios

Market value ratios
Liquidity Ratios





The ratios used to assess the short-term solvency
position of a firm.
Measure a firm's ability to pay its short-term
obligations out of current or liquid assets.
Two Measures of Liquidity are:
As a conventional rule, the current ratio of 2:1 and
quick ratio of 1:1 is employed as a standard of
comparison.
However, these are only quantitative measures
Problem Solving

Please solve Problem 2.1, 2.2 and
2.3 to illustrate and interpret
current and quick ratio
Asset Management Ratios

Asset management ratios are also known as
turnover ratios or activity ratios or efficiency
ratios.

The ratios measuring the effectiveness of firm’s
assets utilization.

If high amount of funds are tied up in certain
types of assets that could otherwise be employed
more productively elsewhere, the firm is not as
profitable as it should be.

Inventory Turnover ratio (ITOR) - measures how a firm's
investment in inventory is being used for generating sales. It is the test
of the liquidity of firm's investment in inventories.


A low inventory turnover ratio indicates that the firm is holding
excessive stock of inventory or is unable to turn it over into sales.
Receivable Turnover Ratio - The ratio that indicates the number of
times the firm collects its accounts receivable during the year.

A low receivable turnover ratio indicates that the firm is making
excessive investment in receivables or it is unable to make timely
collection of credit sales.

Days sales outstanding (DSO) - The average length of time in terms
of number of days that a firm must wait for receiving back cash after
making sale.


A higher average collection period indicates that customers are not
paying their bills in time.
Fixed Assets Turnover Ratio (FATOR) - The measurement of
effectiveness of firm's ability to make efficient utilization of fixed
assets.

A low fixed assets turnover ratio indicates that the firm is using its
fixed assets not as efficiently as other firm in the industry. It points
out that the firm needs to re-evaluate overall strategies, marketing
efforts and capital expenditure program.

Total assets turnover ratio (TATOR) - Measures the efficiency of
assets management in relation to all of the firm's assets.


Problem Solving
Please solve Problem 2.4 and 2.5 to illustrate and
interpret various types of asset management ratio
Debt Management Ratios

Also
known
as leverage
ratios, indicate
the
extent to which debt financing is being used by a
firm.

Measure of long-term solvency of a firm.

Used to analyze long-term solvency position from
two prospects:

first, how firm is using the borrowed funds to finance its
assets;

second, how far the firm is able to serve its debt in terms
of satisfying fixed interest charges.

Debt-asset ratio (DA)- Shows the proportion of total debt used
to finance total assets of a firm.

Total debt consists of long-term debt, notes payable and other
interest-bearing debt instruments.

Non-interest bearing liabilities are excluded from total debt.

Low debt-asset ratio provides a cushion of protection against
possible losses at the time of liquidation.

However, from the firm's management point of view, the firm
with low debt ratio is not able to take leverage advantages of
debt.


Debt-equity ratio (DE)- The relationship between debt capital
and equity capital, and reflects the relative claim of them on
the assets of the firm.
Total common equity includes paid up capital, share premium, and
any balance of undistributed profits net of fictitious assets.

Used to analyze financial risk both by creditors and the firm.

A high debt-equity ratio indicates higher contribution of creditors
towards total financing of the firm.

A high debt-equity ratio of a firm is riskier to creditors as the firm
may be unable to satisfy their claim.

Creditors may put unnecessary pressure and intervene into firm's
management with a high DE ratio.

Equity multiplier (EM)- Also known as the leverage factor,
measures the extent to which the total asset of a firm is
greater than the firm's common equity capital.

Market Debt Ratio - The debt ratio expressed in terms of
market value.

Market value of equity is the number of shares outstanding multiplied
by market price per share.

It is not common to find the market value of debt. So, financial
analysts can use value of debt reported in the financial statements.

Liabilities-to-assets-ratio - Debt ratio expressed as the

ratio of total liabilities used by firm to its total assets.
Shows the extent to which firm’s assets are not financed by
equity.

The total liabilities include all interest –bearing and non-interest
bearing liabilities.

Interest Coverage Ratio - Indicates the extent to which the
firm is able to satisfy interest payments out of EBIT

EBITDA coverage ratio- evaluates the firm's debt serving
capacity out of all the cash flow available to service debt.


Problem Solving
Please solve Problem 2.6, 2.7, 2.8, and 2.9 to illustrate
and interpret various types of debt management ratios
Profitability Ratios

Profitability is the end result of a number of
corporate policies and decisions.

It measures how effectively the firm is being
operated and managed.

Owners and managers of a firm are interested to
know the profit earning capacity of the firm.

Following are the major ratios used to measure the
profitability of a firm:




Net profit margin -
The ratio between net income
available to common stockholders and sales of a firm. It
shows the firm’s ability to generate net income per rupee of
sales.
Higher net profit margin is desirable for a firm. It shows the
operating efficiency of generating net income per rupee of
sales.
Gross profit margin -
The ratio between gross profit and
sales of a firm and shows the firm’s efficiency to generate the
amount in gross profit per rupee of sales. It is calculated as:
Higher gross profit margin indicates that the firm’s cost of goods sold
is relatively lower

Operating profit margin (OPM) - The relationship between
operating profit (EBIT) and sales. It shows the pure operating
efficiency of a firm as it measures only the profits earned on
operation and ignores interests and taxes.

Basic Earning Power - The ratio of firm’s earnings before
interest and tax to total assets… Used to evaluate the firm’s
ability to generate profit before the payment of interest and
taxes out of the assets used.

Return on Assets (ROA) - Measures the overall effectiveness

of management in generating profit with its available assets.
The higher the firm's return on assets the better it is doing in
operation and vice versa.

Return on Common Equity (ROE) - Measures the return on

the owner's investment in the firm.
Higher ratio of return on equity is better for owner. It is
calculated as net income available to common stockholders
divided by common equity.
Market Value Ratios

The market value ratios are used to assess firm’s stock
price in relation to its earnings and book value of
shares.

Price-Earning Ratio (PE) – Represents the amount per
share that investors are willing to pay for each rupee of the
firm's earnings. The higher PE ratio indicates the greater
confidence of investor in the firm's future.

Market-to-book ratio - Measures the extent to which the
financial market has added value to the
management and efficiency over the time.



firm's
overall
Price-to -cash flow ratio- The ratio of market price per
share to cash flow per share.
Market price of a firm’s shares of stock largely depends on the
firm’s ability to generate cash flows.
Higher price to cash flow ratio shows better growth prospects
of a firm.
Problem Solving

Solve Chapter end Problem 2.10 to 2.15 to
illustrate and interpret several profitability
ratios and market value ratios

Also
solve
remaining
Integrated
Chapter
Problems covering all ratio calculations.
DuPont Equation

DuPont System - A system of financial analysis used
for
classified
assessment
of
firm's
financial
performance

Presents an integrated view on financial analysis,
planning and control process of a firm.

First propounded and used by DuPont Corporation.

More popular for making classified assessment of
financial performance of a firm.

Provides a summary of firm's profitability in terms of
return on assets (ROA) and return on equity (ROE).
Simple DuPont Equation

ROA = Profit margin x Assets turnover
Extended DuPont Equation





ROE = Profit margin x Assets turnover x Equity multiplier
The DuPont analysis looks at the three main components of
ROE

Profit margin

Total assets turnover

Financial leverage
Profit margin is a measure of the firm’s operating efficiency –
how well does it control costs
Total asset turnover is a measure of the firm’s asset use
efficiency – how well does it manage its assets
Equity multiplier is a measure of the firm’s financial leverage
Comparative Ratios and
Benchmarking

Financial
performance
analysis
by
using
financial
ratios
requires a comparison of ratios of the firm with similar other
firms in the industry or industry average.

Compare their financial ratios against other smaller and larger
firms in the same line of business.

This
technique
of
comparing
financial
ratios
is
called
‘benchmarking’ and the firms being used in comparison are
called ‘benchmark firm’.

For example, Standard Chartered Bank Nepal Limited may
benchmark
against
Himalayan
Limited and Everest Bank Limited.
Bank
Limited,
Nabil
Bank

In the process of benchmarking, some key financial
ratios are compared against those of benchmark firms,
which allow the management to compare different
aspects of financial performance on a firm-to-firm
basis.

In selecting benchmark firm, it should be noted that
comparative
ratios
of
the
benchmark
firm
have
consistent emphasis as that of own firm.

Besides, the ratios being used for comparison must
hold the same definition as that of benchmark firm.
Uses of Financial Ratios

Useful to various stakeholders.

Useful
in
vertical
and
horizontal
analysis.

Useful
in
internal
and
external
comparison.

Useful
in
evaluation
managerial
performance
Limitations of Ratio Analysis

Requires basis of comparison.

Differences in interpretation.

Difference in situation of two firms.

Change in price level.

Short-term changes.

No indication of the future
Common Size Statements

The financial statement that expresses all items in percentage terms of
some common standard item such as sales for income statement and
total assets for balance sheet.

Useful to compare when two firms have different size or the size of a
single firm changes over different point in time.

For example, if we compare the financial performance of Microsoft
Company of the USA against the financial performance of Mercantile
Computers of Nepal; a direct comparison is meaningless.

In case of common size balance sheet, all items are expressed as a
percentage of total assets.

For income statement, all items are expressed as a percentage of total
sales revenue.
Table 2.3 Common Size Balance Sheet of Unilever Nepal Limited
as of Mid-July
ASSETS
Net fixed assets
Current Assets:
Inventories
Accounts receivable
Short-term investments
Cash and cash equivalents
Bank balance other than CCE
Total Current Assets
Total Assets
EQUITY AND LIABILITIES
Equity:
Share Capital
Retained earnings
Total Common Equity
Long-term debt
Current Liabilities:
Accounts payables
Accruals
Notes payables
Total Current Liabilities
Total Liabilities
Total Equity and Liabilities
2017
17.5%
2016
16.1%
18.7%
20.5%
34.9%
7.3%
1.1%
82.5%
100.0%
2017
22.1%
9.8%
34.0%
17.0%
1.0%
83.9%
100.0%
2016
2.8%
59.7%
62.4%
0.4%
3.0%
64.2%
67.3%
0.4%
30.7%
4.8%
1.7%
37.2%
37.6%
100.0%
29.6%
1.4%
1.3%
32.4%
32.7%
100.0%
Table 2.4 Common Size Income Statement of Unilever
Nepal Limited as of Mid-July
Sales revenue
Less: Cost of goods sold except
depreciation
Depreciation and amortization
Other operating expenses
Net operating income
Add: Other income
Earnings before interest and tax
Less: Interest expenses
Earnings before tax
Less : Taxes
Net income
2017
100.0%
2016
100.0%
51.4%
0.7%
33.4%
14.5%
14.1%
28.6%
0.2%
28.4%
6.7%
21.7%
50.8%
0.7%
25.7%
22.8%
13.0%
35.8%
0.2%
35.7%
7.2%
28.4%
Percentage Change Analysis

Each item in balance sheet and income statement
are expressed as a percentage change against a
base year.

Consider Table 2.5, which shows the percentage
change in income statement figures of Unilever
Nepal Limited in the year 2017 as compared to
2016.
Table 2.5 Income Statement: Percentage Change
Analysis
Sales revenue
Cost of goods sold except depreciation
Depreciation and amortization
Other operating expenses
Net operating income
Other income
Earnings before interest and tax
Interest expenses
Earnings before tax
Taxes
Net income
Percentage Change in
2017
12.6%
13.8%
24.8%
46.5%
(28.6%)
22.2%
(10.2%)
36.0%
(10.4%)
3.4%
(13.9%)
Trend Analysis

A tool of financial analysis that indicates whether
the financial condition of a firm is likely to
improve or deteriorate.

By trend analysis, we look pattern of particular
financial ratios whether they are increasing or
decreasing over the years.

A financial ratio of the firm is plotted against that
of
industry
movement
average
is
to
confirmed
industry average.
identify
or
whether
contradicted
the
to
Figure 2.2: Trend Analysis of Profit Margin Ratio over
2012-2017
Profit Margin (%)
Firm
12%
Industry Average
10%
2012
2013
2014
2015
2016
2017
END