Lesson 10
Understanding and Using
Financial Statements
Task Team of
FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Outline
Demand and supply of financial analysis
Basic analytical procedures
Analysis methods
Comprehensive analysis of financial ratios
The limitations of financial analysis
2
What’s wrong with
accounting information?
3
Demand and supply of
financial analysis
Demand
Investors
Managers
Employees
Customers
auditors
Government/regulatory
agencies
Supply
Internal analysts
Intermediaries
Financial analysts
Bond rating agencies
4
Basic analytical procedures
Determine
objective
Contrive
analysis
scheme
Collect
data
Analyze
data
Conclude
5
Techniques of Financial
Statement Analysis
Horizontal analysis
 Comparative financial statements are presented
side by side
Trend analysis
Vertical analysis
 Common-size financial statement
Ratio analysis
6
Horizontal analysis
X Company
Comparative Balance Sheet
December 31, 2004 and 2005
December
Increase or Decrease
31
2004 2005 Amount
Percentage
Asset
-
-
-
-
Liabilities
and
Stockholders
Equity
7
Trend Analysis
Comparing a company’s financial condition and
performance across time
Cash
1000000000
800000000
600000000
Cash
400000000
200000000
0
1999
2000
2001
Year
2002
2003
8
Vertical analysis
Vertical analysis is used to show the
relationship of the component parts to the
total in a single statement
 In the vertical analysis of the balance sheet,
each asset or equity item is stated as a percent
of total assets;
 In the vertical analysis of the income statement,
each item is stated as a percent of net sales;
9
A example of vertical analysis
Year ended
2003
2002
2001
Net Sales
100.00
100.00
100.00
Less: Cost of goods sold
854.96
85.61
87.88
Gross profit on sales
15.01
14.39
11.40
Selling expenses
11.29
11.01
11.41
Administrative expenses
2.71
2.59
2.40
Interest expenses
0.20
0.15
-0.81
Total expenses
14.20
13.75
13.00
Income before taxes
0.81
0.64
1.40
Income taxes
0.02
0.03
0.06
Net income
0.89
0.61
1.34
10
Ratio Analysis
Financial ratio analysis is the calculation and comparison
of ratios which are derived from the information in a
company's financial statements
Profitability
analysis
Activity
analysis
Liquidity
analysis
Long-term
debt-paying
ability
analysis
Market
Strength
11
Profitability analysis
Return on total
assets
Return on longterm capital
Return on net
assets
Operating margin
Net income
Average total assets
Net income
Average long-term debt+average
owner’s equity
Net income
average stockholders’ equity
Gross income
Net sales
12
A compare of company
profitability
Return on net asset
Return on total assets
0.08
0.25
0.07
0.20
0.06
0.05
0.15
Company A
Company B
0.10
Company A
Company B
0.04
0.03
0.02
0.05
0.01
0.00
0.00
1999 2000 2001 2002 2003
1999 2000 2001 2002 2003
13
Activity analysis
Asset turnover
total revenue
average total assets
Accounts
receivable
turnover
Sales revenue
Average accounts receivable
Average collection
period of accounts
receivable
365(days)
Accounts receivable turnover
Inventory
turnover
Cost of goods sold
Average inventory
14
A compare of company
efficiency ratios
Accounts receivable
turnover
Inventory turnover
8.00
7.00
80.00
70.00
60.00
50.00
40.00
30.00
20.00
10.00
0.00
6.00
5.00
Company A
Company B
Company A
Company B
4.00
3.00
2.00
1.00
0.00
1999 2000 2001 2002 2003
1999 2000 2001 2002 2003
15
Liquidity analysis
Current ratio
Current assets
Current Liabilities
Quick ratio
Quick assets
Current liabilities
Cash ratio
Cash+ Short-term investment
Current liabilities
16
A compare of company
Liquidity ratios
Quick Ratio
Current Ratio
2003
2003
2002
2001
2000
0.00
1999
0.50
Company A
Company B
2002
Company A
Company B
2001
1.00
2000
1.50
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
1999
2.00
17
Long-term debt-paying ability
analysis
Debt-equity
ratio
Total liabilities
Total owner’s equity
Debt-to-total
asset
Total liabilities
Total Asset
Times
interest
earned
Net income +interest expense
+taxes
Interest expense
18
A compare of Long-term
debt-paying ability
Debt-to-total assets
0.80
0.60
Company A
0.40
2003
2002
2001
2000
0.00
Company B
1999
0.20
Company A
19
Market Strength
Earning per
share
Net income
shares of common stock
outstanding
Priceearnings
ratio
Market price per share
Earnings per share
Dividend
yield
Dividend per share
Market price per share
20
A compare of market strength
P/E Ratio
2003
Company B
2002
Company A
2001
2000
1999
0.00
10.00
20.00
30.00
21
Dupond Analysis
ROE=Net Margin X Asset Turnover X Leverage Factor
Assets
Owner’s equity
Net income
Net Sales
Net income
owner’s equity
Sales
Assets
22
Dupon analysis for five firms
Firm
Net
Asset
Margin Turnover
ROA
Leverage
Factor
ROE
A
8.36%
0.56
4.65%
2.43
11.31%
B
22.83%
0.12
2.80%
1.82
5.11%
C
3.87%
0.86
3.34%
1.96
6.52%
D
1.42%
1.36
1.94%
3.64
7.04%
E
4.24%
1.12
4.74%
1.32
6.25%
23
Why ratio analysis is useful?
 They facilitate inter-company comparison;
 They downplay the impact of size and allow evaluation
over time or across entities without undue concern for the
effects of size difference;
 They serve as benchmarks for targets such as financing
ratios and debt burden;
 They help provide an informed basis for making
investment-related decisions by comparing an entity’s
financial performance to another;
 ……
24
How is ratio analysis limited?
It is restricted to information reported in the
financial statements;
It is based on past performance.
Comparability is hampered when
accounting policies are not uniform across
an industry;
The past may not predict the future;
25
How is ratio analysis limited?
(cont)
Trends and relationships must be carefully
evaluated with reference to industry
norms, budgets, and strategic decisions;
Because of some potential problems in
standard, comparison must be careful;
26
Standards of comparison for
financial statement analysis
Standard of
comparison
Potential problem
Prior years’
results
May include inefficiencies or reflect
different operating policies than in effect in
the current year.
Industry
averages
May not be representative or desirable for
this firm.
Internal
projections or
budget
May not be available; may be based on
different or budgets operating policies than
in effect in the current year.
27
What should an analyst keep in
mind about financial analysis?
An overview of all ratios can provide
important information concerning the
strategic decisions of a company and the
nature of its business;
However, accounting information can only
provide so much data. An analyst must
proceed with caution;
28
Summary
Users of financial statements often gain a
clearer picture of the economic condition of
an entity by the analysis of accounting
information;
The analytical measures obtained from
financial statements are usually expressed
as ratios or percentages;
29
Summary
Financial analysis techniques work best
when they are used to confirm or refute
other information. When using analytical
tools to evaluate a company, the analyst
should keep in mind the limitations of
analysis
30
Discussion questions
 What is the advantage of using comparative
statements for financial analysis rather than
statements for a single date or period?
 What does an increase in the number of days’
sales in receivables ordinarily indicate about the
credit and collection policy of the firm?
 Why would the dividend yield differ significantly
from the rate earned on common stockholders’
equity?
31
The End of Lesson 10