FA3
Lesson 10. Financial statement analysis
and cash flow
1. Ratio analysis
2. Cash flow statement
3. Horizontal and vertical analysis
1. Ratio analysis
Comparison of proportional relationship between
two different financial statement items. This
removes the effect of size differences between
companies, or for the same company over
time:
• Facilitates comparisons (inter-company and
temporal)
• Provide informed basis for decision-making
• Etc.
Problems with ratio analysis
• Ratios are only as good as the numbers in the
calculations
• Ratios are only meaningful if there is a clear
understanding RE: the relationship between
the numerator and denominator
• Ratios require a basis for comparison
(benchmarks)
• Ratios point out potential problem areas, but
usually do not give definitive answers
• Ratio results depend on accounting decisions
Types of ratios
a.
b.
c.
d.
Profitability ratios
Activity ratios
Solvency ratios
Liquidity ratios
a. Profitability ratios
General form = Income/Average Investment,
Where
Income = net income, EBIT, EBITDA, Income +
interest after tax, Net income – preferred
dividends, . . .
Investment = Shareholders’ equity, Assets,
Shareholders equity + long-term debt, . . .
The numerator and denominator must be
logically consistent.
“Average” investment?
Use average investment in profitability ratios so that
numerator and denominator are based on the same
time period. Income is earned throughout the period
(usually year), but investment is measured at one
point in time.
Ideally, average investment for the year=
(Investment, Jan 1 + Investment, Jan 2... +.. Dec 31)
365
Practically, the best possible measure is usually
Investment, Jan. 1 + Investment, Dec. 31
2
Leverage effect
ROE = Income/Average shareholders’ equity
ROA = Income + Interest expense after tax
Average assets
Int. exp. after tax = Int. exp. X (1 – tax rate)
ROE – ROA = Effect of leverage
This measures additional return to shareholders
generated by effective use of debt (borrowing
at a low rate to invest in high return projects)
Example: Safety Ltd. vs Leverage
Safety Leverage
Ltd.
Average assets (A)
Average liabilities (L)
Average equity (E)
Sales
Operating expenses
Interest expense (I)
Income tax [Rate (R)=33%]
Net income (NI)
Int. after tax [IAT=(1-R) X I]
ROA [(NI+IAT)/A]
ROE [NI/E]
ROE – ROA (leverage effect)
$200
$200
$100
70
10
$20
0
10%
10%
0
$200
150
50
$100
70
15
5
$10
$10
10%
20%
10%
Components of profitability ratios
Du Pont formula
ROA = operating margin X asset turnover,
where ROA = EBIT/average total assets,
Operating Margin = EBIT/Revenue, and
Asset turnover = Revenue/Average total assets.
Companies can earn high ROA by combining
high turnover and low margin, or by
combining low turnover and high margin.
b. Efficiency ratios
Asset turnover = Revenue/Average Assets
AR turnover = Credit sales/Average AR
Average collection period = 365/AR turnover
Inventory turnover = COGS/Average inventory
c. Solvency ratios
Debt-equity = Debt/Invested capital
Debt = liabilities, long-term debt, . . .
Invested cap. = total assets, shareholders’ eq., . . .
Times interest earned
= Net income + interest exp + income tax exp
Interest expense
d. Liquidity ratios
Current ratio = Current assets/Current liabilities
Quick ratio = Monetary current assets
Monetary current liabilities
Defensive-interval ratio =
Monetary current assets
Annual operating expenditures/365
2. Cash flow statement
EXAMPLE: A23-22
T-account approach (see Beechy and Conrod,
chapter 5 appendix, pp. 219 – 223)
3. Horizontal and vertical analysis
Horizontal analysis involves recasting financial
statements, using prior years’ data as a yardstick.
Items are presented as a percentage of the
equivalent item in the base (usually oldest) year.
Vertical (or common size) analysis involves
recasting each of the financial statement items as
a percentage of some base item in the same year.
The base is usually net sales for the income
statement and total assets for the balance sheet.
EXAMPLE: A23-3 – vertical and horizontal
analysis of A23-22 balance sheet