FINANCIAL ANALYSIS IN
ENTERPRISES
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Lecture outline
 Financial statements- structure and
interpretation
Techniques of financial analysis
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Financial statement- definition
A financial statement is a formal record of
the financial activities of a company, person,
or other entity
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Financial statements as an element
of financial reporting
 The obligation of financial reporting creates
the necessity of financial statements
International rules concerning the structure of
financial statements
 International Accounting Standards Board
for the EU, Canada and Australia, Generally
Accepted Accounting Principles in the USA
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Why do companies publish
financial statements?
 The information about the financial
position and performance of the
company is essential to many users
 Owners and managers
 Investors/prospective investors
 Public finance entities
 Financial markets participants
 Employees
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The structure of financial
statements
Balance sheet (statements of financial
position)
Income statement (statement of
comprehensive income)
Statement of changes in equity
Cash flow statement
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Balance sheet
Assets
 Fixed assets
 Current assets
Liabilities
 Equity
 Borrowed capital
(interest payments)
 Other liabilities (no
interest payments)
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Income statement
All items of income and expense in a given
period
Sometimes called the statement of profit
and loss
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Income statement
 The statement should include
information about
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revenue,
finance cost
share of the profit or loss of associates
tax expense
profit or loss,
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Statement of changes in equity
The statement should include
 Total comprehensive income with distiction of the
amounts attributable to owners and non-controlling
interest
 For each component of equity, the effects of
restrospective application
 For each component of equity, the changes between
the amount at the beginning and the end of the period
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Cash flow statement
Cash flow- the movement of money into a
company and out of the company
The statements shows how changes in balance
sheet accounts and income affect cash
 The statements involves operating, investing,
and financing activities
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Cash flow statement-interpretation
 Useful in determining the short-term
ablity to meet the financial commitments of
a company
 Reflects a firm's liquidity
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The purpose of financial analysis
 To evaluate the performance and the
financial position of the company given the
strategy of the firm, the economic and
legal environment, the accounting
flexibility and prospects
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How is the financial analysis
performed?
 To evaluate the company’s performance
we need a benchmark
 Performance compared to past results
Performance compared to other
companies
Artificial benchmarks build on economic
experience
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Non-comparability of financial
statements
 Changes of the time span of the financial year
Different balance sheet dates
Changes in company structure
Accounting method changes and accounting
estimate changes
Differences in presentation
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Types of financial analysis
 Horizontal analysis
Common size analysis
Segmental analysis
Ratio analysis
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Horizontal analysis
Also called trend analysis
 Aimed at comparing the respective
positions of the financial statement with
previous statements
It usually covers a five year period
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Horizontal analysis
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Common size analysis
 Aimed at comparing the performance of
firms usually from the same industry
Size adjustment is needed- the positions
in the balance sheet are expressed
relatively to total assets, in the income
statement relatively to the amount of sales
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Segmental analysis
Aimed at reporting accounts on a breakdown of
the total revenue over the different business
segments
Segmental reporting data may be subject to
manipulation as the company may shift the data
between segments in order to show to desirable
result
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Ratio analysis
 The ratio analysis is aimed at answering
the following questions:
 Can the company meet its financial
commitments?
 How successful, profitable and efficient is the
company?
 Is the business a good investment for
shareholders?
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Profitability of the firm
 The ratio combines the result of a firm
with the investments made for the
generation of this result
Return on equity
ROE=Profit/Equity
Return on assets
ROA= (Profit before tax+ Interest)/ Total
assets
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Profitability of the firm (1)
Return on capital employed
ROCE=(Profit before tax + Long term
interest)/(Equity + Long term debt)
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Profitability of the firm (2)
 Which investment base should be taken into
account?
 From the beginning of the year?
An average equity base?
In practice the most common benchmark the
equity base at the end of the year
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Profitability of the firmbenchmarks
 Time series or competitor comparisons
 The proceeds from an investment in risk
free loans as benchmark
 This measure allows to see if the
owners would be better off selling the
company and placing the money in a
bank?
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Profitability of the firm-breakdown
analysis
To see the which components of the firms
activity played a role in shaping the profitability
one can break down the ROA measure
The components relate to sales results and
investment results
ROA=Profit/Total sales * Total sales/Assets
 Profit/Total sales- called profit margin reflects
operating decisions
 Total sales/Assets- called efficiency ratio reflects
investment decisions
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Liquidity and solvency
Useful especially for external stakeholders
Information about the financial status can
be obtained by analyzing the assets
available to the company to meet its
liabilities
Short, medium and long term analysis
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Liquidity (1)
 The subject of analysis are assets able to
meet short term liabilities
 The structure of working capital matters
Current ratio
CR=Current assets/Current liabilities
Acid test ratio
ATR=(Current assets-Inventory)/Current
liabilities
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Liquidity (2)
Current assets are supposed to be
converted into cash in the current
operating cycle
 The acid test ratio excludes inventory as
this is the least convertible part of current
assets
The benchmark for liquidity ratios depends
on the industry
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Solvency (1)
 To see if the company is able to meet its
long term liabilities one has to analyze the
capital structure
 Of crucial importance is most of all the
ratio of own and borrowed capital
 Debt/equity ratio- most popular
A high debt/equity ratio implies higher
financial risk due to higher interest
payments, pay-off deadlines etc.
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Solvency (2)
Depending on the focus of the analysis the
debt/equity ratio can be transformed
Debt/Equity+Debt
Long term debt/Equity
Or expressed relatively to assets
Debt/assets
Short term debt/ assets
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Solvency- benchmarks
 The debt equity ratio could be influenced
by national or institutional differences
 In bank based economies e.g. Germany,
France the debt/equity ratio will be higher
than in countries with shareholder
orientation e.g. UK
 Firms from similar countries should be
used as a benchmark
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Investment perspective (1)
 Is the company worth investing?
Investment decisions require specific
ratios besides liquidity, efficiency and
profitability
 Dividends performance, earnings per
share, price/ earnings ratio
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Investment perspective (2)
 Ratios for shareholders reported in financial
statements
Companies can try to influence share prices by
communicating to the market outside financial
statements
Companies can create their own ratios eg.”like
for like sales”, „profit before one-time”
expenditures
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Univariate and multivariate ratio
analysis
Univariate analysis- one ratio is
considered at a time, judgment is based
on the respective ratios calculated
Multivariate analysis- the respective ratios
are weighted and combined
A popular multivariate measure- the Zscore (Altman 1968)
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The z-score
Aimed at predicting company failure
 A risk measure
 Based on research in the US manufacturing sector
 Z-scores are sector specific-e.g.other weightings should
be applied for banks and manufacturing companies
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Z=0,012x1+0,014x2+0,033x3+0,006x4+0,999x5
X1-working capital/total assets
X2-retained earnings/total assets
X3-earnings before interest and tax/total assets
X4- market capitalization/book value of debt
X5-sales/total assets
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Source: Wikipedia
Financial analysis-remarks
The ratio analysis should be accompanied
by common size and trend analysis
These methods are complementary
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Example
 Compute and compare the liquidity and
solvency ratios for company A and B
 Company A finances it’s activity via bank
loans. The value of inventory is 200 the
value of financial assets 100, the value of
fixed assets is 2000. The value of the bank
loan is 1200 from which 500 is due in the
current operating cycle.
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Example
 Company B leases the production
infrastructure. The value of inventory is
200, the value of financial assets 100, the
value of fixed assets is 800, the value of
leased assets is 1200. The value of
current liabilities is 100.
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Literature
D. Alexander, A. Britton, A. Jorissen,
International Finacial Reporting and
Analysis, Cengage Learning, 2011
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