Financial Statement Analysis

Need for comparative analysis

1. Intra-entity basis: compares an item/financial relationship within an entity in the current year
with the same item/relationship in one or more prior years.
Eg 1. Compare a companys cash balance at the end of current year with last years balance to
find the amount of the increase/decrease.
Eg 2. Compare percentage of cash to current assets at the end of the current year with the
percentage in one or more prior years.
- Useful in detecting changes in financial relationships and significant trends.
2. Industry averages: compares an item/financial relationship of an entity with industry averages
(or norms) published by financial ratings organisations.
Eg. Profit pf a major sporting goods supplier can be compared with the average profit of all
entities in the retail chain-store industry.
- Comparisons with industry averages provide info as to an entitys relative performance
within the industry.
3. Inter-entity basis: compares an item/financial relationship of one entity with the same
item/relationship in one or more competing entities. Comparisons are made on the basis of the
published financial statements of the individual entities.
- Useful in determining an entitys competitive position.
Horizontal analysis: evaluates a series of financial statement data over a period of time.
Ratio analysis: expresses the relationship among selected items of financial statements data.
Horizontal analysis
Used primarily in intra-entity comparisons:
1. Each of the basic financial statements is presented on a comparative basis for a min. of 2
years.
2. A summary of selected financial data is presented for a series of 5-10 years or more.
Also called trend analysis
Technique used for evaluating a series of financial statement data over a period of time.
Purpose is to determine the increase/decrease that has taken place this change may be expressed
as an amount/percentage.

Horizontal analysis of changes since base period:

Current year amountBase year amount

Change since base period=
Base year amount

Horizontal analysis of current year in relation to base year:

Current year amount
Current resultsrelation base period=
Base year amount

In the income statement, note that although the amount column is additive, the percentage column
isnt additive. A separate percentage has to be calculated for each item.

Ratio analysis
Used in all 3 types of comparisons.
Ratio: expresses the mathematical relationship between one quantity and another relationship is
expressed in terms of either a percentage/ratio/simple proportion.
Liquidity ratios: measures of short-term ability of the entity to pay its maturing obligations and to
meet unexpected needs for cash.
Solvency ratios: measures of the ability of the entity to survive over a long period of time.
Profitability ratios: measures of the profit or operating success of an entity for a given period of
time.
Comparisons (intra-entity, industry average, inter-entity) provide a benchmark against which
performance is assessed. If results from ratio analysis dont meet expectations, further investigation is
needed to understand the source of unexpected variation.

Liquidity ratios
I.e. how quickly an entity can convert its current assets into cash.
- Short-term creditors (eg. Bankers, suppliers) are particularly interested in assessing liquidity.
- Ratios that can be used to determine the entitys short-term debt-paying ability:
current ratio
acid-test ratio
receivables turnover
inventory turnover
creditors turnover

Current ratio
Current assets
Current ratio=
Current liabilities

Eg.
2011-Ratio of 2.96:1, 2010-Ratio of 3.1:1, Industry average-1.28:1, Competitors current ratio-2.19:1
For every dollar of current liabilities, the company has $2.96 of current assets. The companys current
ratio has decreased in the current year. But compared to the industry average of 1.28:1, and the
competitors current ratio, the company appears to be reasonably liquid.
*If an entity has very predictive cash flows and solid earnings, it can operate without working capital
current assets
(excess of current liabilities )

- Doesnt take into account the composition of the current assets.

eg. A satisfactory current ratio doesnt disclose the fact that a portion of the current assets may be tied
up in slow-moving inventory. A dollar of cash would ne more readily available to pay the bills than a
dollar of slow-moving inventory.
Acid-test ratio: measure of an entitys immediate short-term liquidity.
- An important complement to the current ratio.
- Cash, short-term investments and receivables are highly liquid compared w/ inventory and
prepaid expenses.
- Inventory may not be readily saleable + prepaid expenses may not be transferable to others.
 Thus, acid-test ratio measures immediate liquidity.
- Important for financial analysis when there are concerns about whether the entity is a going
concern.
Cash+ shortterm investments +receivables
Acid test ratio=
Current liab ilities
Eg.
2011- ratio of 1.0:1, 2010- ratio of 1.3:1, industry average- 0.33:1, competitors ratio-1.81:1

When compared with the industry avg of 0.33:1 and the competitors of 1.81:1, the companys
acid-test ratio seems adequate. However, a decreasing trend indicates deterioration in liquidity,
which might signal a future solvency risk.

Receivables turnover
- Liquidity may be measured by how quickly certain assets can be converted to cash.
- Ratio used to assess the liquidity of the receivables.
- Measure no. of times, on avg, receivables are collected during the period.
Net credit sales
Receivables turnover=
Avg net receivables
- Unless seasonal factors are significant, avg receivables can be calculated from beginning and
ending balances of the receivables.
Eg.
Beginning balance of 2010 - $200000
Ending balance of 2010 - $180000
Ending balance of 2011 - $230000
Receivables turnover improved in 2011. Quicker turnover improves liquidity. Trend suggests
improved liquidity management (receivables are being converted to cash more quickly). Turnover of
9.8 times compares quite favourably with Toy Citys 1.4 times and is similar to the retail industry.
- Trend associated may provide insight into the likely collectability of debtors.
Deterioration in receivables turnover can be caused by an overall increase in the acc
receivables balance because one or more debtors havent paid their outstanding accs.
Companies w/ sound liquidity may have customers who are no longer solvent,
therefore unable to pay their accs.
If too many customers become insolvent, entity will face reduced liquidity can
create pressure on entitys ability to survive in the long term.
In some instances, low receivables turnover may be caused by a deliberate strategy to
encourage customers to take on more credit.
Eg. Some large retailers sell goods on 1-, 2-, 3-year interest-free terms. After interest-
free term, retailer hopes to earn a high interest rate on the unpaid amount.
This highlights the importance of not viewing a ratio in isolation.
Results from ratio analysis that suggest a problem are a signal to trigger further
investigation.
365
Average collection period termsof days=
Receivables turnover
Eg. Receivables turnover 10.2 times
365/10.2 = 36 days receivables are collected on avg every 36 days / about every 5 wks.
Average collection period frequently used to assess effectiveness of entitys credit + collection
policies.
- Gen rule collection period shouldnt greatly exceed the credit term period (time allowed for
payment)
Inventory turnover
- Measures no. of times on avg inventory is sold during the period.
COGS
Inventory turnover=
Avg inventory
Eg.
Inventory beginning balance of 2010 - $450000
Inventory turnover of 2010 2.4 times, inventory turnover of 2011 2.3 times, industry avg 6.7
times, competitors inventory turnover 4.6 times
Companys inventory turnover declined slightly in 2011. Turnover is 2.3 times is relatively low
compared w/ industry avg of 6.7 and competitors turnover of 4.6.
- Generally, the faster the inventory turnover, the less cash thats tied up in inventory and the less
chance of inventory obsolescence.
- Inventory turnover ratios vary considerably among the industries.
Eg. Supermarket chains tend to have a turnover of 10 times and an avg selling period of 37 days.
In contrast, jewellery stores tend to have an avg turnover of 1.3 times and an avg selling period of
281 days.
- Decline in inventory turnover might indicate that some inventory has become obsolete.
Eg. Inventory is damaged/no longer in fashion it may not be saleable.
Value of this inventory should be written down to its market/realisable value.
When theres obsolete inventory on hand, balance of inventory will increase over time.
Inventory turnover will slow as a consequence.
A company may have sound liquidity, but losses associated w/ damages/obsolete
inventory will reduce liquidity.
If an entity is facing financial stress, such losses would create further pressure on the
entitys ability to survive in the long term.
365
Average days sell inventory=
Inventory turnover
Eg. Companys 2011 inventory turnover of 365/2.3 times = 159 days
An avg selling time of 159 days is also relatively high compared w/ industry avg of 54.5 days
(365/6.7) and the competitors 79.3 days (365/4.6).
- Its desirable for an entity to turn over its inventory as quickly as possible.
- Offering reduced prices at saes time is for the purpose of moving inventory.
Cash/operating cyc avg debtors collection period +avg days sell inventory

Eg. Receivables turnover - 10.2, avg debtors collection period - 365/10.2 = 35.78 or 36 days.
Inventory turnover 2.3, avg days to sell inventory 365/2.3 = 158.69 or 159 days.
Cash/operating cycle = 195 days (36+159=195)
Therefore, from the date of inventory arrives in the warehouse, it takes, on avg, 195 days to convert
the inventory into cash.
Creditors turnover
- Measures time it takes to make payment following the credit purchase of inventory (ie. Speed of
cash outflows).
Net credit p urchases
Creditorsturnover=
Avg trade creditors ( acc payable )

Eg.
Beginning balance of 2010 - $150000, ending balance of 2010 - $170000
Creditors turnover of 2010 - 12.1, creditors turnover of 2011 - 11.2, industry avg -11.3 times,
competitors turnover - 10.1 times
Companys creditors turnover deteriorated in 2011 company took longer on avg to pay its trade
creditors.
- A decrease in creditors turnover (thus a longer payment period) can be interpreted as a
deterioration in liquidity.
- Such a trend might indicate the company is struggling to find the cash to pay its creditors.
The turnover of 11.2 times compares favourably with competitors 10.1 times and is similar to the
industry avg of 11.3 times.
- Trade creditors might be used as a cheap, short-term source of funding for the entity. Delaying
payment to suppliers is a potential source of costless credit (ie. No interest component).
- A decrease in creditors turnover might reflect either a deterioration in liquidity / entitys deliberate
effort to maximise its source of costless credit.
- Important to analyse other aspects of the entitys financial position and performance to distinguish
b/w these alternative explanations.
365
Average payment perioddays=
Creditors turnover

Eg. Creditors turnover of 11.2 365/11.2=32.58 or 33 days creditors are paid on avg every 33 days (
approx. 5 wks)

Solvency ratios
Debt to total assets ratio (D-A)
- Measures the percentage of total assets provided by creditors (incl. suppliers, banks and other
lenders).
- Indicates entitys degree of leverage
- Provides some indication of the entitys ability to withstand losses + continue to repay creditors.
- The higher the percentage of debt to total assets, the greater the risk that the entity may be unable
to meet its maturing obligations.
Totaldebts
Debt total assets=
Totalassets

Eg. Ratio of 2010 - 50.2%, ratio of 2011 45.3%, industry avg 40.1%, competitors ratio 76.1%
Ratio of 45.3% means that creditors have provided 45.3% of companys total assets. Companys
43.5% is above the industry avg of 40.1%.
It is considerably below the high 76.1% ratio of competitor.
- The lower the ratio, the more equity buffer there is available to the creditors.
- Thus, from the creditors POV, a low ratio of debt to total assets is usually desirable.
- Generally, entities w/ relatively stable earnings have high debt total assets ratios than cyclical
companies w/ wider fluctuating earnings (eg. Many mining, biotech or hi-tech companies.)