Analysis &
Interpretation of
Financial Statements
Financial Statement Analysis


The application of analytical tools and techniques to financial statement
data.

Allows users to focus on how numbers are related and how they have changed
over time
Objective of Financial StatementAnalysis

External users rely on general purpose financial statements

Make predictions about an organization as an aid in making decisions

Users highlight important trends or changes
Risk and Return


Users try to balance the risk of an investment with its expected return

Generally the greater the risk, the higher the return

Financial statement analysis is one source of information for assessing risk
and return
Sources of External Information

Sources of External Information

Public companies must publish an annual financial report

Government reports

SEC 10K, 10Q

Financial service information

Moody’s, Dow-Jones

Financial newspapers and periodicals

Wall Street Journa
Financial Analysis Tools

Horizontal analysis

Vertical analysis

Ratio analysis
Horizontal Analysis

Horizontal Analysis: Amounts and Percentages of Change

Amount of change = later year amount - Earlier year amount

Percentage change = Amount of change / Earlier year amount

Look for significant change
Horizontal Analysis: Trend Percentages

Horizontal Analysis: Trend Percentages

Set all amounts in base year at 100%

Compute percentages for a number of years

Divide each statement amount by respective amount in base year

Shows degree of increase or decrease in individual statement items

Used to explain changes in operating performance
Horizontal Analysis: Trend Percentages

Set all amounts in base year at 100%

Compute percentages for a number of years

Divide each statement amount by respective amount in base year

Shows degree of increase or decrease in individual statement items

Used to explain changes in operating performance
Vertical Analysis

Shows how each item in a financial statement compares to the total of that
statement

Balance sheet

Set both total assets and total equities at 100%

Income statement

Set net sales at 100%
Analysis

Days’ Sales in Receivables

How many days’ sales remain uncollected in accounts receivable

Net sales

Net sales per day =

365 days

Average net accounts receivable

Net sales per day

Inventory Turnover Cost of goods sold Average inventory

Number of times the company sells and replaces its inventory during the period

Holding inventory results in financing and storage costs

Cost of goods sold

Average inventory
Analysis

Debt Ratio Total liabilities Total assets

Shows amount of total assets creditors provide

Higher levels of debt financing means company has a higher risk of not meeting interest and principal
payments

Total liabilities

Total assets

Net income + Income tax expense

Times Interest Earned

Number of times the company earned interest expense with current income

Creditors want to know the firm’s ability to pay annual interest charges

Net income + Income tax expense

+ Interest expense

Interest expense
Analysis cont’d

Profitability Profit margin Total asset turnover

Return on total assets

Return on owners’ equity

Earning per share

Profit Margin Net income Net sales

Percentage each sales dollar contributes to net income

Net income

Net sales
Analysis Cont’d

Total Asset Turnover Net sales Average total assets

Measures the efficiency of the company is using its investment in assets to
generate sales

Net sales

Average total asset
Analysis Cont’d

Return on Total Assets Net income Average total assets

Measures the amount a company earns on each dollar of investment in assets

Net income

Average total assets

Return on Owners’ Equity

Measures the earnings in relation to the owners’ investment in the company

Net income - Preferred dividends

Average owner’s equity

Price/Earning (P/E) Ratio

Number of times earnings per share the stock is currently selling for in the market

Market price per share of common stock

Earnings per share

Dividend Yield Dividends per share Market price per share

Measure of dividend-paying performance of a company

Investors buy stock for two reasons

Receive cash dividends

Sell stock at a higher price

Dividends per share

Market price per shar
Limitations of Financial Analysis Tools

Historical nature of accounting information

Changing economic conditions

Comparisons with industry averages

Seasonal factors

Quality of reported income