Lesson 10
Understanding and Using
Financial Statements
Task Team of
FUNDAMENTAL ACCOUNTING
School of Business,Sun Yat-sen University
2
?Demand and supply of financial analysis
?Basic analytical procedures
?Analysis methods
?Comprehensive analysis of financial ratios
?The limitations of financial analysis
Outline
3
What’s wrong with
accounting information?
4
Demand and supply of
financial analysis
Investors
Managers
Employees
Customers
auditors
Government/regulatory
agencies
Demand
Internal analysts
Intermediaries
Financial analysts
Bond rating agencies
Supply
5
Basic analytical procedures
Conclude
Contrive
analysis
scheme
Analyze
data
Determine
objective
Collect
data
6
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
7
Horizontal analysis
X Company
Comparative Balance Sheet
December 31,2004 and 2005
December
31 Increase or Decrease
2004 2005 Amount Percentage
Asset
Liabilities
and
Stockholders
Equity
- - - -
8
Comparing a company’s financial condition and
performance across time
Trend Analysis
Cash
0
200000000
400000000
600000000
800000000
1000000000
1999 2000 2001 2002 2003
Year
Cash
9
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;
10
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
11
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
12
Profitability analysis
Return on total
assets
Net income
Average total assets
Return on long-
term capital
Net income
Average long-term debt+average
owner’s equity
Return on net
assets
Net income
average stockholders’ equity
Operating margin
Gross income
Net sales
13
A compare of company
profitability
Return on net asset
0.00
0.05
0.10
0.15
0.20
0.25
1999 2000 2001 2002 2003
Company A
Company B
Return on total assets
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
1999 2000 2001 2002 2003
Company A
Company B
14
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
15
A compare of company
efficiency ratios
Accounts receivable
turnover
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
1999 2000 2001 2002 2003
Company A
Company B
Inventory turnover
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
1999 2000 2001 2002 2003
Company A
Company B
16
Liquidity analysis
Current ratio Current assets Current Liabilities
Quick ratio Quick assetsCurrent liabilities
Cash ratio Cash+ Short-term investmentCurrent liabilities
17
A compare of company
Liquidity ratios
1999 2000
2001
2002 2003
0.00
0.50
1.00
1.50
2.00
Current Ratio
Company A
Company B
1999
2000 2001
2002
2003
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
Quick Ratio
Company A
Company B
18
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
19
A compare of Long-term
debt-paying ability
1999
2000
2001
2002
2003
Company A
0.00
0.20
0.40
0.60
0.80
Debt-to-total assets
Company A
Company B
20
Market Strength
Earning per
share
Net income
shares of common stock
outstanding
Price-
earnings
ratio
Market price per share
Earnings per share
Dividend
yield
Dividend per share
Market price per share
21
A compare of market strength
P/E Ratio
0.00 10.00 20.00 30.00
1999
2000
2001
2002
2003
Company B
Company A
22
Dupond Analysis
Net income
Net Sales
ROE=Net Margin X Asset Turnover X Leverage Factor
Net income
owner’s equity
Sales
Assets
Assets
Owner’s equity
23
Dupon analysis for five firms
Firm Net Margin AssetTurnover 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%
24
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;
? ……
25
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;
26
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;
27
Standards of comparison for
financial statement analysis
Prior years’
results
Industry
averages
Internal
projections or
budget
May include inefficiencies or reflect
different operating policies than in effect in
the current year.
May not be representative or desirable for
this firm.
May not be available; may be based on
different or budgets operating policies than
in effect in the current year.
Standard of
comparison Potential problem
28
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;
29
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;
30
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
31
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?
The End of Lesson 10
Understanding and Using
Financial Statements
Task Team of
FUNDAMENTAL ACCOUNTING
School of Business,Sun Yat-sen University
2
?Demand and supply of financial analysis
?Basic analytical procedures
?Analysis methods
?Comprehensive analysis of financial ratios
?The limitations of financial analysis
Outline
3
What’s wrong with
accounting information?
4
Demand and supply of
financial analysis
Investors
Managers
Employees
Customers
auditors
Government/regulatory
agencies
Demand
Internal analysts
Intermediaries
Financial analysts
Bond rating agencies
Supply
5
Basic analytical procedures
Conclude
Contrive
analysis
scheme
Analyze
data
Determine
objective
Collect
data
6
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
7
Horizontal analysis
X Company
Comparative Balance Sheet
December 31,2004 and 2005
December
31 Increase or Decrease
2004 2005 Amount Percentage
Asset
Liabilities
and
Stockholders
Equity
- - - -
8
Comparing a company’s financial condition and
performance across time
Trend Analysis
Cash
0
200000000
400000000
600000000
800000000
1000000000
1999 2000 2001 2002 2003
Year
Cash
9
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;
10
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
11
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
12
Profitability analysis
Return on total
assets
Net income
Average total assets
Return on long-
term capital
Net income
Average long-term debt+average
owner’s equity
Return on net
assets
Net income
average stockholders’ equity
Operating margin
Gross income
Net sales
13
A compare of company
profitability
Return on net asset
0.00
0.05
0.10
0.15
0.20
0.25
1999 2000 2001 2002 2003
Company A
Company B
Return on total assets
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
1999 2000 2001 2002 2003
Company A
Company B
14
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
15
A compare of company
efficiency ratios
Accounts receivable
turnover
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
1999 2000 2001 2002 2003
Company A
Company B
Inventory turnover
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
1999 2000 2001 2002 2003
Company A
Company B
16
Liquidity analysis
Current ratio Current assets Current Liabilities
Quick ratio Quick assetsCurrent liabilities
Cash ratio Cash+ Short-term investmentCurrent liabilities
17
A compare of company
Liquidity ratios
1999 2000
2001
2002 2003
0.00
0.50
1.00
1.50
2.00
Current Ratio
Company A
Company B
1999
2000 2001
2002
2003
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
Quick Ratio
Company A
Company B
18
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
19
A compare of Long-term
debt-paying ability
1999
2000
2001
2002
2003
Company A
0.00
0.20
0.40
0.60
0.80
Debt-to-total assets
Company A
Company B
20
Market Strength
Earning per
share
Net income
shares of common stock
outstanding
Price-
earnings
ratio
Market price per share
Earnings per share
Dividend
yield
Dividend per share
Market price per share
21
A compare of market strength
P/E Ratio
0.00 10.00 20.00 30.00
1999
2000
2001
2002
2003
Company B
Company A
22
Dupond Analysis
Net income
Net Sales
ROE=Net Margin X Asset Turnover X Leverage Factor
Net income
owner’s equity
Sales
Assets
Assets
Owner’s equity
23
Dupon analysis for five firms
Firm Net Margin AssetTurnover 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%
24
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;
? ……
25
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;
26
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;
27
Standards of comparison for
financial statement analysis
Prior years’
results
Industry
averages
Internal
projections or
budget
May include inefficiencies or reflect
different operating policies than in effect in
the current year.
May not be representative or desirable for
this firm.
May not be available; may be based on
different or budgets operating policies than
in effect in the current year.
Standard of
comparison Potential problem
28
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;
29
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;
30
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
31
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?
The End of Lesson 10
