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Analysis of Financial Statements (Chapters 7, 8 & 9)

Balance Sheet

• Assets = Liabilities + Owners’ Equity (Shareholders’ equity)

Assets have economic value if they’re expected to bring future benefit

Liabilities are non-ownership claims (borrowings) to those assets.

Owners’ Equity represents the residual claim to the assets of the business.

▪ Comprises contributed capital plus earned capital.

▪ As inception of an enterprise, contributed capital is amount of cash plus
other assets owners put into a business.
▪ Earned capital, or Retained Earnings is the net increase in assets arising from
profitable performance of the enterprise.

The Profit and Loss Account (Income Statement)

• Income is the increase in OE arising from profitable activity

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• Income equals Revenue less Expenses

o Revenue is increase in net assets, i.e., sales

o Expenses are decreases in net assets required to generate revenue

• Income is not cash

o A key concept of the accounting model is accrual accounting.

o Accruals represent non-cash components of income (Example - credit sales)

• The Relation between the Balance Sheet and the Income Statement

o Owners’ Equity = Assets – Liabilities

o O/E (beg.) = A (beg.) – L (beg.)

o O/E (end) = A (end) – L (end)

o O/E (end) – O/E (beg.) = Earnings – Dividends + New Capital = [A (end) – A (beg.)] –
[L (end) - L (beg ) ]

o Change in O/E = Change in Assets – Change in Liabilities

• Sales, or Revenue means net turnover (income) of the period from services and goods
sold.

• Cost of goods sold means all the expenses that are straight in connection to the sold
consumables, products and services.

• Gross profit is the difference between the sales revenue and the cost of all goods/services
sold.

• Operating profit tells the business profitability that is the difference between business
revenues and expenses.

• Profit before tax is the surplus after deducting all the expenses (including finance) from all
the revenues. This gives the level of profit which is the basis for taxation.

• Profit for the period (net income) is the surplus which is available for retention or for the
distribution of dividend.

Statement of Cash Flows

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o Statement shows changes in CASH for a firm between two balance sheet dates

o Breaks down changes into three components:

Cash flow from Operations (CFO)

Cash flow from Investment Activities (CFI)
Cash flow from Financing Activities. (CFF)

o Financial analysts and others view CFO as the important component of cash, since
it’s what is viewed as the best measure to use to forecast a firm’s permanent cash
flow potential

Disclosure

o Footnote Disclosure - Required disclosures of accounting policy choices (e.g.,

depreciation policies), additional detail information of amounts recognized in the
financial statements (e.g., listing of all major debt obligations), and other
supplemental information (e.g., employee stock option information).

o Key Supplemental disclosures - Pension benefit obligations and pension assets,

Employee stock option information, Leasing obligations.

o Management Discussion and Analysis (MDA) – provides descriptive information

to help interpret the financial statements. Often contains forward-looking
information, such as description of market segments firm expects to develop in
the future.

Some limitations of the published financial accounts

Because published accounts are prepared in retrospect and in money terms, there are some
drawbacks to the amount and type of information that users are able to get from them.

For example:
• the accounts look backwards, usually over the past few years, so they are of limited value
to people who want to estimate future performance.

• most companies treat the legal requirements as the maximum disclosure requirement and
do not give much more information than that to outsiders, on grounds of confidentiality
and maintaining competitive advantage.

• some important assets that cannot be easily valued in money terms have to be left out
from balance sheet, for example customer goodwill, staff skill and employee loyalty;

• assets are generally recorded at historical (original) cost which, after a period of inflation,
can be quite out of touch with their current values. They are also depreciated.
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Financial Analysis

Objective: Assess the performance, efficiency, leverage of a firm in the context of its stated
goals and strategy.

Financial statements provide absolute amounts, but “good or bad” performance is relative.

Few key financial ratios generally helpful in financial analysis;

No standards for ratio definitions.

Financial ratio analysis helpful for analysing:

o Performance/Profitability
o Efficiency of utilisation of resources
o Liquidity
o Long-term solvency

Ratio analysis is about comparing one set of ratios against another - either time-series or
cross sectional.

The notes to the financial statements provide important information for ratio analysis.

Accounting ratios can be manipulated by appropriately timing the firm’s activities or

changing accounting methods.

Trend Analysis

Horizontal and Trend Analysis

The following table shows extracts from Burberry Plc’s financial statements for the year ending
31. March 2009

2009 2008 2007 2006 2005

£m £m £m £m £m
Revenue 1,205.5 995.4 850.3 742.9 715.5

Gross 665.8 617.7 521.3 446.1 424.2

profit

Loss/profit (16.1) 195.7 156.3 157.0 166.2

before tax
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This is just a small part of the information disclosed by Burberry Plc in its annual financial
statements. What does it tell us?

Annual percentage increases (decreases):

2009 2008 2007 2006 2005

% % % % %
Revenue 20,7% 17,1% 14,5% 3,8%

Gross 7,8% 18,5% 16,9% 5,2%

profit

Loss/profit (108,2%) 25,2% (0,4%) (5,5%)

before tax

A great deal depends upon the context of the financial information.

GAAP requires side-by-side comparison of the current and the preceding years in published
financial reports
Trend statements:
o Recast each statement item as a percentage of that item in a base year.
o Trend statements provide a clear indication of the growth and decline of each item
Collect data for competitor (industry) for comparison
o Sources: Moody’s, Standard & Poor, Financial analysts etc.

Some problems with Horizontal Analysis

Changes in the business

o Very rapid changes can take place in business. These may mean that figures are not
really comparable over a period of years. Also, new accounting rules and standards
may make a difference to the presentation of the figures.

Failure to take the effects of inflation into account. Let’s have a look at the following example:

A 5-year analysis of the sales of Trevor Fine Art Productions Limited shows the following
figures:
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Looking at the individual years we can see that there has been an increase each year. So tar, so
good, but if we take inflation into account the picture changes somewhat?

Common Size Financial Statements

Common size income statements
o Recast each statement item as a percentage of sales
o Common size IS reveal changes in sales, margins, profits
Common size balance sheets:
o Recast each statement item as a percentage of total assets
o Common size BS reveal changes in asset composition, and financing structure
Examples:
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Vertical and horizontal analysis:

Comparing businesses with each other

interested users will often need to make comparisons between businesses (especially the
relative size…)

or comparing the results and balance sheets of a business with industry averages.

Problems in Comparison:
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Differences in accounting policies (the principles of accounting applied in preparing the

financial statements):

o Despite a fairly extensive level of regulation, there are many areas in which a
business can make legitimate choices about the amounts at which items are stated,
and the way in which those items are presented.

Example:
Spanners Limited and Gasket Limited operate within the same business sector. A financial
analyst is examining the results of the companies on behalf of a client. Extracts from their
income statements show the fallowing information (together with vertical analysis
percentages):

The companies appear to be similar in size in that they generate similar levels of turnover, and
the percentage of grass profit to sales is close. It seems a fair conclusion, on the face of it, that
their performance is virtually identical.
However, the analyst finds out that the companies' policies on inclusion of costs in cost of sales
are not the same. Specifically, Spanners includes depreciation of vehicles within cost of sales,
whereas Gasket includes the same type of east within selling and distribution costs. Gasket's
vehicle depreciation is £28 977 for the year under review.

In order to compare like with like the analyst must make an adjustment to Gasket's cost of
sales:

Adjusted cost of sales =

Building this adjusted cost into the income statement analysis results in the following changes
(vertical analysis percentages are re-calculated far Gasket Limited):

Spanners Gasket
£ % £ %
Revenue 984742 100 1096880 100
Cost of sales 673938 68,4
Gross profit 310804 31,6
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Financial statement analysts have to be alert for this type of difference. As the example shows
application of different accounting policies can make a lot of difference. The example
illustrates the point in relation to cost classification but there are many other potential areas
of difference, including, for example, depreciation and amortization methods.

Differences in business activities

No two businesses are entirely alike. Comparison of two apparently similar businesses can lead
to incorrect conclusions, if the differences between the two are not fully appreciated.

Example:

A financial analyst is comparing the results of two companies for 2012 and 2011. Pool & Splash
Limited and Dive & Float Limited are both involved in swimming pool installation and
maintenance. Companies in the industry are generally performing well.

22,5% 19,4%

However, the picture changes when we are supplied with information about the breakdown
of revenue. Pool & Splash’s sales and maintenance contracts are in respect of domestic sales
only. Dive & Float, on the other hand, undertakes contract pool maintenance for local
authorities. A breakdown of the revenue figures shows the following:

The meaningful comparison would be:

Segment Analysis
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large companies usually operate in a range of different markets and conduct varying business
activities. Listed companies are required by international accounting standards to produce
additional information about the business segments in which they operate. This can be very
useful for the analyst in providing an insight into which segments of the business yield the
most revenue and which are most profitable.

Example:

Burberry plc is a fashion business. It publishes information about revenue from different
segments by business category and also by destination. This allows the analyst to see which
product categories are dominant in the business, and which are the company's most
important export markets.

What does this additional information tell us about Burberry's revenue for the 5-year period
covered by the figures?

We can see from the table that, relatively speaking, menswear and
licensing revenue have both declined in importance, while the contribution to total revenue of
womenswear has changed relatively little.

Both accessories and childrenswear have become relatively more important to the
company.

However, it should be emphasized that revenue in all categories has actually increased
(this is evident from the first table). What has changed is the relative contribution of the
different categories.
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We could extend the analysis by looking at the year-on-year increases or decreases in revenue
in the various categories

Financial Ratios

The ratio calculation will depend upon the availability and accuracy of basic accounting data.
Here we will examine only some of the ratios that can be calculated from published accounts,
which are related to performance, liquidity, efficiency and solvency of a company.

NOTE that there are several ways to calculate a certain ratio. That’s why companies usually
give the formulas used in their financial reports.

1. Performance ratios

GROSS profit MARGIN % = Gross profit

Net sales * 100

Gross profit is the difference between the sales price and the cost of goods sold.
Gross profit margin is a very simple idea and it tells us how much gross profit per €1 of turnover
our business is earning.

OPERATING Profit Margin % = Operating profit

Net sales * 100

Operating profit is known internationally as EBIT (earning before interest and taxes), and it
indicates the level of profits of the actual business operations, with which a company
must cover financial items and taxes.

NET PROFIT % = Net income

Net Sales * 100

The net profit to sales ratio focuses on profit, after all expenses of the business are deducted,
compared to sales. It indicates the profitability of each euro sold.
The net profit margin will be affected by two major considerations: the gross profit margin and the
size of expenses.
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RETURN ON EQUITY (ROE) = Net income

Average equity * 100

Shareholders’ equity = share capital + profit retained + profit for the period
AVERAGE: (Shareholders’ equity at the beginning of the year + Shareholders’ equity at the end of
the year) / 2

ROE measures how much (accounting) return a firm generates for its shareholders (shareholders’
perspective. Reasonable level is depending on the owners´ expectation, which in turn reflects the
risk level of their investment. A shareholder would also want to use this ratio to compare the
company’s performance with other investment opportunities.

Return on Assets
• Return on Assets (ROA) = EBIT / Av. Total Assets
EBIT – here is before tax
What is the benchmark?

RETURN ON CAPITAL EMPLOYED = Profit before finance costs and tax

(ROCE) Average of Long term capital * 100

Long term capital = shareholders’ equity + long-term debts

AVERAGE: (Long term capital at the beginning of the year + Long term capital at the end of the
year) / 2

The return on capital employed (ROCE) represents the return to the total investment generated
(include both shareholders and debt holders). Remember, the greater the return, the greater
degree of risk.

Is it high/low? Compare to the competitors? How can it be improved?

2. Liquidity ratios (Can the business meet its liabilities as they fall due?)

Liquidity ratios are designed to help the user take a view of the ability of the business to meet bills
as they fall due. So they could be used by anyone who is thinking of lending to a company, or
supplying it with goods etc.

But use these ratios by caution, since they are all calculated from the year end accounts and the
picture could well have changed if the ratio is being calculated at a date some time after that
balance sheet date.
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CURRENT RATIO = Current assets

Current liabilities

The current ratio indicates the amount of cover for the short-term liabilities: the number of times
current liabilities can be paid out of the current assets.

QUICK RATIO = Current assets less inventory

Current liabilities

The quick ratio shows how well short-term liabilities are covered by cash or near-cash assets. This
is a particularly useful secondary calculation if the business happens to be one where it can take
quite a long time to turn stocks into cash. It is less vital in an industry where you would expect very
quick turnover of stocks, for example a grocery store.

3. Efficiency Ratios

Efficiency ratios are used to examine the extent to which asset and liability items are well
managed and utilised.

INVENTORY TURNOVER = Cost of goods sold (Cost of sales)

Average Inventories

In period:

INVENTORY TURNOVER IN DAYS = Average Inventories

Cost of goods sold * 365

The inventory turnover measures and reflects on the ability of the firm to manufacture/hold
inventory efficiently. It is affected by the relations with suppliers and the production process and
types of business. Too much goods in stock means high storage costs, insurance costs and working
capital tied up. There may also be problems when we have too small quantities in stock. We may
not be able to fulfil customer orders in time.

The first ratio tells how many times per one year the average stock is replaced. The second ratio is
maybe even more understandable. It tells how many days approximately an item of stock spends
in a warehouse.
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The average stock (inventory) is calculated either by dividing the sum of opening and closing stock
by two or if we have monthly figures of stock value, we can summarize them and divide by 12.

To make some conclusions from these ratios we can compare different years from a specific
business. Also we can compare two businesses within the same line.

DEBTORS TURNOVER = Sales

(Receivable Turnover) Av. trade receivables

DEBTORS TURNOVER IN DAYS = Average trade receivables

(Days of Receivables) sales * 365

The debtors turnover (Receivable turnover) ratio tells the number of days that our receivables
from debtors are open. How long does it take that we get our receivables paid? This ratio can be
given as a target to collectors who are in charge of getting early payments from customers. It is no
use calculating it from companies, whose sales are made in cash.
Average trade debtors (trade receivables) is calculated by dividing the sum opening trade debtors
and closing trade debtors by two.

CREDITORS TURNOVER = Purchases

(Trade payables turnover) Av. Trade payables

CREDITORS TURNOVER IN DAYS = Average trade payables

(Days of payables) Purchases * 365

The creditors turnover ratio (trade payables turnover) tells the number of days that our payables
remain unpaid. With creditors we mean trade creditors to our suppliers.
Average creditors number (Av. trade payables) is calculated either by dividing the sum of opening
trade creditors and closing trade creditors by two.
Purchases = C.O.G.S. + Ending Inventory –Beginning inventory

Analyzing Efficiency =>Turnovers and Days

Receivables turnover => Days of Receivables

Inventory turnover => Days of Inventory
Payables turnover => Days of Payables
Asset turnover = Sales / Av. Total Assets
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Cash Cycle = Days of Receivables + Days in Inventory – Days in Payables

4. Lending ratios (Solvency)

A gearing ratio expresses the relationship between two different types financing of a company: (a)
financing through equity i.e. ordinary shares, and (b) financing through long-term loans, i.e. debt.

There is more than one way of calculating gearing:

debt
equity

or debt
debt + equity

Gearing is a measure of a company’s leverage – how much financing it has in the form of debt as
compared with how much it has invested in the business.

A high level of debt capital relative to equity capital (i.e. a high level of gearing)
means that the company faces a relatively high interest charge.

Interest must be paid out of the store of available profits.

If the interest profit soaks up most of the available profit there will be very little left
over for the ordinary shareholders.

Therefore, an investment in a highly geared company is usually seen as relatively

risky for equity shareholders.

However, a great deal depends upon the level of profits generated.

Why are ordinary shareholders interested in Gearing?

Let’s have a look at an example:

Two companies, Basket Rabbitts plc and Telford Barron plc, have very similar operations and are of
very similar sizes. However, their financing varies: Basket Rabbitts plc is highly geared, and Telford
Barron plc is low geared, as follows:
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Let's look at the effects of the gearing at three different potential levels of profit before tax:

High level 12 000

Medium level 8 000

Low level 4 000

In all cases we assume a tax rate is 30%.

Interest cover Ratio

5. Investor ratios

EPS is an important statistic that gives an idea of what the business has actually achieved during
the year for the benefit of the shareholders..

If you buy one of those shares, what has been generated in the year that can be attributable to
you?

Earnings per share EPS = Profit available to equity shareholders

Av. number of issued equity shares

Earnings per share is generally considered to be the single most important variable in determining
a share's price.
It is also a major component used to calculate the price-to-earnings valuation ratio.
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Investors also need to be aware of earnings manipulation that will affect the quality of the
earnings number.
It is important not to rely on any one financial measure, but to use it in conjunction with
statement analysis and other measures.

Price/earnings ratio

This is a very important stock market ratio. It expresses the relationship between earnings per
share and the price of the share.

Only for listed companies

PE = Price per share

Earnings per share

What does it mean?

It is very useful for making comparisons with other listed companies, and especially, with
companies in the same industry sector. The P/E ratio is a measurement of the market’s perception
of a company’s shares.

Examples pf P/E ratios of companies on the London Stock Exchange

Company P/E

Clinton Cards 4,25

Marks & Spencer 11,45
Next 11,66
J Sainsbury 15,82
Tesco 15,75

Note: A sudden fluctuation in share price can result in a significant change to the P/E ratio so that
at any point in time, the P/E may not be representative of the general trend.