Internal and external users analyze financial statements to assess a company's performance and financial position. Internal users use it for planning, evaluating, and controlling operations, while external users assess past performance, current financial position, and future profitability and solvency. Methods for analyzing financial statements include horizontal analysis, vertical analysis, common-size statements, trend percentages, and ratio analysis. Ratio analysis specifically uses liquidity, equity, profitability, and market ratios to evaluate a company's financial health.

1. Analyzing
Financial
Statements
An overview of financial tools and techniques
By
Arpit amar

2. yzing Financial Statements
 Who analyzes financial statements?
Internal users (i.e., management)
External users
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors
 What do internal users use it for?
Planning, evaluating and controlling company operations
 What do external users use it for?
Assessing past performance and current financial position and making predictions
about the future profitability and solvency of the company as well as evaluating
the effectiveness of management

3. ds of Analyzing Financial Statement
 Horizontal Analysis
 Vertical Analysis
 Common-Size Statements
 Trend Percentages
 Ratio Analysis

4. ds of Analyzing Financial Statements
 Horizontal Analysis
Using comparative financial statements to calculate dollar or percentage changes
in a financial statement item from one period to the next
 Vertical Analysis
For a single financial statement, each item is expressed as a percentage of a
significant total, e.g., all income statement items are expressed as a percentage
of sales
 Common-Size Statements
Financial statements that show only percentages and no absolute dollar amounts
 Trend Percentages
Show changes over time in given financial statement items (can help evaluate
financial information of several years)
 Ratio Analysis
Expression of logical relationships between items in a financial statement of a
single period (e.g., percentage relationship between revenue and net income)

5. Horizontal Analysis
The management of Clover Company provides you with comparative
balance sheets of the years ended December 31, 1999 and 1998.
Management asks you to prepare a horizontal analysis on the
information.

6. Horizontal Analysis
Calculating Change in Dollar Amounts
Dollar Current Year Base Year
Change Figure Figure
Since we are measuring the amount of the change
between 1998 and 1999, the dollar amounts for 1998
become the “base” year figures'
–
Calculating Change as a Percentage
Percentage
Change = Dollar Change
Base Year Figure × 100%

7. Horizontal Analysis
$12,000 – $23,500 = $(11,500)

8. Horizontal Analysis
($11,500 ÷ $23,500) × 100% = 48.9%

9. Horizontal Analysis

10. Horizontal Analysis Let’s apply the same procedures to the
liability and stockholders’ equity sections of the
balance sheet.
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7

11. Horizontal Analysis
Now, let’s apply the procedures to the
income statement.
CLOVER CORPORATION Sales increased by 8.3%
Comparative Income Statements while net income decreased
For the Years Ended December 31, 1999 and 1998 by 21.9%.
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
There were increases in both cost of goods sold (14.3%) and
operating expenses (2.1%). These increased costs more than offset
the increase in sales, yielding an overall decrease in net income.

12. Vertical analysis
The management of Sample Company asks you to prepare a vertical
analysis for the comparative balance sheets of the company.
$82,000 ÷ $483,000 = 17% rounded
$30,000 ÷ $387,000 = 8% rounded

13. Vertical analysis
$76,000 ÷ $483,000 = 16% rounded

14. Trend Percentage
Wheeler, Inc. provides you with the following operating data and
asks that you prepare a trend analysis.
$1,991 - $1,820 = $171
Using 1995 as the base year, we develop the following percentage
relationships.
$171 ÷ $1,820 = 9% rounded

15. Trend Percentage
Trend line
for Sales

16. Ratio Analysis
Ratios can be expressed in three different ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)
CAUTION!
“Using ratios and percentages without considering the underlying
causes may be hazardous to your health!”
lead to incorrect conclusions.”

17. Major Ratio Analysis Tools
 Liquidity Ratios
Indicate a company’s short-term debt-paying ability
 Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity financing in a
company
 Profitability Tests
Relate income to other variables
 Market Tests
Help assess relative merits of stocks in the marketplace

18. 1.Liquidity Ratios 4.Market Tests
Current (working capital) ratio Earnings yield on common stock
Acid-test (quick) ratio
Price-earnings ratio
Cash flow liquidity ratio
Payout ratio on common stock
Accounts receivable turnover
Dividend yield on common stock
Number of days’ sales in account receivable
Inventory turnover
Dividend yield on preferred stock
Total assets turnover Cash flow per share of common stock
2.Equity (Long-Term Solvency) Ratios
Equity (stockholders’ equity) ratio
Equity to debt
3.Profitability Tests
Return on operating assets
Net income to net sales (return on sales or “profit margin”)
Return on average common stockholders’ equity (ROE)
Cash flow margin
Earnings per share
Times interest earned
Times preferred dividends earned

19. Implementation of Ten main Ratio Analysis Tools
Now, let’s look at Norton Corporation’s 1999 and 1998 financial statements.

20. Calculating the liquidity ratios for Norton.
NORTON CORPORATION
1999
Cash $ 30,000
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000

21. 1.Working Capital
The excess of current assets over current liabilities.
12/31/99
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
* While this is not a ratio, it does give an indication of a company’s liquidity.
Working capital ratio
Current Current Assets
Ratio = Current Liabilities
Current $65,000
Ratio = = 1.55 : 1
$42,000
Measures the ability of the company to pay current debts as they become due.

22. 2.Acid –Test (Quick) Ratio
Acid-Test Quick Assets
Ratio = Current Liabilities
Quick assets are Cash, Marketable Securities, Accounts
Receivable (net) and current Notes Receivable.
Norton Corporation’s quick assets consist of cash of
$30,000 and accounts receivable of $20,000.
Acid-Test $50,000 = 1.19 : 1
Ratio = $42,000
3.Account Receivable Turnover
Accounts Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts $494,000 = 26.70 times
Receivable = ($17,000 + $20,000) ÷ 2
Turnover
This ratio measures how many times a company
converts its receivables into cash each year.

23. 4.Number of Day’s sales in account receivable
Days’ Sales 365 Days
in Accounts = Accounts Receivable Turnover
Receivables
Days’ Sales 365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables
Measures, on average, how many days it takes to
collect an account receivable.
5.Inventory Turnover
Inventory Cost of Goods Sold
Turnover = Average Inventory
Inventory $140,000
Turnover = ($10,000 + $12,000) ÷ 2 = 12.73 times
Measures the number of times inventory is sold and
replaced during the year.

24. Equity or Long Term Solvency ratios
Calculating the equity, or long-term solvency ratios of Norton Corporation.
NORTON CORPORATION NORTON CORPORATION
1999
1999
Common shares outstanding
Net operating income $ 84,000 Beginning of year 17,000
Net sales 494,000 End of year 27,400
Interest expense 7,300 Net income $ 53,690
Total stockholders' equity 234,390 Stockholders' equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390

25. 6.Equity Ratio
Equity Stockholders’ Equity
Ratio = Total Assets
Equity $234,390 = 67.7%
Ratio = $346,390
Measures the proportion of total assets provided by stockholders.
7.Net income to Sales Ratio
Net Income Net Income
to = Net Sales
Net Sales
Net Income
to $53,690
= = 10.9%
Net Sales $494,000
Measures the proportion of the sales dollar which is retained as profit.

26. 8.Return on Equity (ROE)
Return on Net Income
Stockholders’ = Average Common
Equity Stockholders’ Equity
Return on $53,690
Stockholders’ = ($180,000 + $234,390) ÷ 2 = 25.9%
Equity
Important measure of the income-producing ability of a company.
9.Earning per share(EPS)
Earnings Earnings Available to Common Stockholders
per Share = Weighted-Average Number of Shares Outstanding
Earnings $53,690
per Share = (17,000 + 27,400) ÷ 2 = $2.42
The financial press regularly publishes actual and forecasted EPS amounts.

27. 10.Price-Earning ratio
Price-Earnings = Market Price Per Share
Ratio EPS
Price-Earnings $20.00
Ratio = $ 2.42 = 8.3 : 1
Provides some measure of whether the stock is under or overpriced.

28. Important Consideration
Need for comparable data
Data is provided by Dun &
Bradstreet, Standard & Poor’s etc.
Must compare by industry
Is EPS comparable?
Influence of external factors
General business conditions
Seasonal nature of business operations
Impact of inflation
Thanks for reading