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TOPIC 5
FINANCIAL
STATEMENT
ANALYSIS
PART 1
BIZ201 - MODUL E 3.1
BI Z201 - MODULE 3.1
FINANCIAL
STATEMENT
ANALYSIS
FUNDAMENTAL ANALYSIS
Fundamental analysis refers to analysing many aspects of an entity to
assess the entity.
Fundamental analysis involves reviewing the state of the industry in
which the entity operates, as well as the entity’s financial statements, its
management and governance and its competitive positioning.
One aspect of fundamental analysis is financial analysis.
Financial analysis uses the reported financial numbers to form opinions
about the entity’s financial performance and position.
FINANCIAL ANALYSIS
A fundamental purpose of preparing financial statements is to provide
useful information to assist users in their decision making.
The financial data in these statements are expressed in monetary terms,
with corresponding figures for the comparative year provided.
To better understand the consequences of an entity’s operating, investing
and financing decisions, it is necessary to analyse the relationships between
the numbers in the financial statements, rather than relying on the absolute
values on one particular period or one particular statement.
Financial analysis uses the reported financial numbers to form opinions
about the entity’s financial performance and position.
It is essential in financial analysis to compare figures with:
the equivalent figures from previous years (rather than in one year’s
absolute terms)
other figures in the financial statements.
HORIZONTAL ANALYSIS
Horizontal analysis compares reported numbers in
different reporting periods to highlight magnitude and
significance of changes.
Dollar change is calculated by:
Current period’s number – Previous period’s number
Percentage change is calculated by:
Current period’s number – Previous period’s number
Previous period’s number
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X 100
TREND ANALYSIS
Tries to predict the future direction of various items on the basis
of the direction of the items in the past.
To calculate a trend, it is necessary to have at least three years of
data.
Trend analysis of a particular item involves expressing the item
in subsequent years, relative to a selected base year — which is
usually given a value of 100.
(
Current period’s number – Base period’s number
Base period’s number
)
x 100
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+ 100
VERTICAL ANALYSIS
Vertical analysis involves comparing the items in a financial
statement to an anchor item in the same financial statement:
revenue and expense items are expressed as a
percentage of sales or revenue
Every item
Total Sales or Revenue
X 100
A, L and equity items are expressed as a percentage of
total assets.
Every item
Total Assets
X 100
When expressed this way, the financial statements are often
referred to as common size statements.
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RATIO ANALYSIS
An expression of one item in the financial statements as another
item in the financial statements — one item is divided by
another to create the ratio.
The ratio comparison can be between two different statements.
But statement of profit or loss and statement of cash flows
involve flow items while statement of financial position reports
stock items.
BENCHMARKS
Ratios are of limited usefulness unless compared to relevant
benchmarks. Comparisons may be made:
to identify trends:
the entity’s ratios over time
assess the stability and/or directional changes
for intra-industry analysis:
the entity’s ratios with those of other entities in same
industry
uses ratios to compare their returns and risks
of industry averages:
an industry norm is a relevant benchmark to assess a
return and risk
for inter-industry analysis:
the entity’s ratios compared with those of entities
operating in different industries
differences in industry structures will affect the ratios
to arbitrary standards:
not possible to specify what a ratio should be
users operate on rules of thumb that serve as crude
points of initial assessment
Ratio analysis is a three-step process:
1. Calculate a meaningful ratio by expressing $ amount
of an item by $ amount of another item.
2. Compare the ratio with a benchmark.
3. Interpret the ratio and seek to explain why it differs:
from previous years
from comparative entities or
from industry averages.
RATIOS IN VARIOUS
CATEGORIES HELP USERS IN
THEIR DECISION MAKING
profitability ratios
efficiency ratios
liquidity ratios
capital structure ratios
market performance ratios
PROFITABILITY ANALYSIS
A measure of the profit relative to the resources available to
generate the profit.
Return on equity (ROE)
Captures profitability, efficiency and capital structure.
Upward trend is advantageous for entity.
But, a sustained high ROE attracts new competitors to industry
and eventually erodes excess ROE.
Profit
Average equity
X 100 = 𝑥𝑥 %
Return on assets (ROA)
Reflects the results of entity’s ability to:
convert sales revenue into profit
generate income from its asset investments.
Profit
Average total assets
X 100 = 𝑥𝑥 %
Gross profit margin
Measures gross profitability per dollar of sales revenue.
Gross Profit
Sales revenue
X 100 = 𝑥𝑥 %
Cash flow to sales ratio
Measures the cash flow generated from operating activities for each dollar of sales revenue.
Cash flow from operating activities
Sales revenue
X 100 = 𝑥𝑥 %
REFERENCES
Birt, J., Chalmers, K., Maloney, S., Brooks, A., Oliver, J., &
Bond, D. (2020). Accounting: Business reporting for
decision making. (7th ed.). John Wiley & Sons,
Incorporated.
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