Financial Statement Analysis

These pages are designed for students in Intro. to Finance and other elementary Finance courses.
Financial Statement analysis involves using the output of the standard business information system found in all businesses to judge the performance and riskiness at an instance or over time. A business may have other information systems for managers but all business must conform with generally accepted standards with their accounting statements.

There are several steps in the use of Financial Statement Analysis:

Understanding the basic statements
Inherent problems with the system
Use of ratio analysis
Interpreting the analysis
Using the analysis
Basic Financial Statements
Income Statement
INCOME STATEMENT
for the year ending
December 31, 1996
 
Sales 5,011,766
Cost of goods sold  3,758,825
Gross Profit 1,252,942
Expenses: 
Selling 353,300
General and administrative 250,025
Depreciation 102,000
Miscellaneous 65,927
 
Net Profit 481,490

The Income Statement presents a picture of the activity of the firm for the last year and tries to give the reader an impression of whether or not there was an increase in wealth or the value of the firm. Since most of the values shown represent summaries of cash flows during the year there is much to be learned from this statement. Some expenses do not represent cash flows such as depreciation and some very large cash flows from financing and capital improvements are missing from the Income Statement. But it is a good place tostart analyzing the basic day to day operations of the firm. The statement of Cash flows described below is an attempt to provide the missing information.

Find the connection between the Income Statement and the balance sheet! Notice that the net income for the previous year explains the difference in retained earnings between years. Exceptions are shown in the Statement of Retained Earnings.

This connection clearly indicates that Retained Earnings is not a hoard of cash but really only a book entry reflecting cash reinvested in the business in other assets such as Accounts Receivable or Plant and Equipment.

Notice that there are two measure of profit shown, Gross Profit and Net Profit. Gross Profit gives an indication of the level of markup maintained. This can also be viewed as a measure of the amount of competition in the industry.

Balance Sheet
Balance Sheet
 12-31-93 12-31-94 12-31-95 12-31-96
ASSETS    
Cash 400000 250000 300000 175500
Accounts Receivable 1050000 1350000 1560500 1875250
Inventory 610000 789150 1060350 146890
Plant and Equipment 1240000 1260000 1100000 1155250
Total Assets 3300000 3649150 4020850 4662890
Liabilities & Capital    
Accruals 150000 75000 250000 275000
Accounts Payable 250000 350000 425000 560550
Notes Payable [current] 760000 800000 800000 800000
Mortgage Bonds 1000000 1000000 1000000 1000000
Preferred Stock 225000 225000 225000 225000
Common Stock 300000 300000 300000 300000
Retained Earnings 615000 899150 1020850 1502340
Total Lia. & capital 3300000 3649150 4020850 4662890

The Balance Sheet presents a summation of the entries made in the accounting system of a business over a long period of time. The titles on the statement refer to the account name in the bookkeeping system and may not accurately reflect what we might think of as "real" value today. The more short-lived an asset is or the more often it turns over, the more likely the statement value will reflect real value. The bookkeeping value for Plant and Equipment is especially inaccurate for old companies as amounts are added for the cost of equipment purchases and amounts are deducted for deprecation according to arbitrary methods. The balances shown for Preferred Stock and Common Stock and Retained Earnings bear no relationship to reality and should be used with caution. Equity market values should be used instead.

Balance Sheets are shown for several consecutive years to give an impression of the direction of growth and progress. No attempt is made by the company to account for the generally decreasing purchasing power of the currency over time!

Financial Statement Analysis should concentrate on evaluating the current assets and liabilities in proportion to the level of sales and profits shown in the income statement. Analysis or ratios using book values for Plant and Equipment or Equity Capital items should be used with caution and viewed with suspicion!

Statement of Retained Earnings

STATEMENT OF RETAINED EARNINGS
for the year ending
December 31, 1996
Balance of retained earnings, December 31, 1995  1,050,000
Add: 1996 Net Income  350,000
Less Dividends to stockholders 120,000
Less Loss on Abandoned Operations 100,000
Balance of retained earnings December 31, 1996 1,280,000

The Statement of Retained Earnings is straightforward and simple and shows the reconcilement of the Retained Earnings account as the result of a year's activities. It purports to show how much the stockholder's equity increased or decreased as a result of the year's activities.

Statement of Cash Flows
Although it may seem strange at first, Financial managers are always more concerned about cash flows than they are about profit. Profit is important in the long run for survival and growth but cash flow problems can be aggravated by the very conditions that lead to enhanced profitability. Running out of cash can cause default and bankruptcy and is a major headache for financial managers. The financial statements can give a view of where the money came from and where the money went throughout the past year.

A two stage process is necessary to analyze cash flows:

Source and use of cash statement
Statement of cash flows for the period.
The source and use of cash statement is prepared by looking at consecutive year balance sheets and the last year's income statement.

Cash Sources and Uses During 1996
 12/31/96 12/31/95 Sources Uses
Cash 20 40 20 
Accounts Receivable 180 160  20
Inventory 270 200  70
Gross Plt & Equip 680 600  80
Accounts Payable 30 15 15 
Accruals 60 55 5 
Notes Payable 40 35 5 
Long Term Bonds 297 255 42 
Common Stock 130 130  
    
Net Income 62  62 
Depreciation 50  50 
Dividends 29   29
Totals   199 199

Notice that when comparing balance sheet accounts, increases in liabilities and decreases in assets are sources of funds and increases in assets and decreases in liabilities are uses of funds. Don't go further until you understand why this works out!

Notice that from the income statement we only need net income and depreciation. Depreciation is a source of funds because income is a source and the accountant subtracted depreciation to get net income. Depreciation is a non-cash expense so the accountant made a mistake, in a financial sense.

Statement of Cash Flows
The statement of cash flows merely takes the information gathered above in the sources and uses statement and uses them to reconcile the change in the cash account from the beginning of the year to the end of the year. Further, this statement classifies the cash flows according to operating activities, long term investing activities, and financing activities. It is like a quick replay of all of the financial manager's cash activities for the year.

Statement of Cash Flows for the Period Ending December 31, 1995
Cash Flows from Operating Activities
Net Income 62 
Depreciation 50 
Increase in Accounts payable 15 
Increase in accruals 5 
Increase in Accounts receivable (20) 
Increase in Inventory (70) 
Net cash flow from operations 42
Cash flows from long term investingactivities
Purchase of fixed assets (80)
Cash flows from financing activities
Increase in notes payable 5 
Increase in bonds 42 
Dividend payment (29) 
Net cash flow from financing 18
Net change in cash (20)
Cash at beginning of the year 40
Cash at the end of the year 20

You only really understand these Cash flow statements when you can look at each item in the cells and by observing whether it is positive or negative describe in words what must have happened in the business to cause it. If you cannot do this easily let me know and I will try to have your Accounting credits revoked!

Ratio Analysis
You may be able to discover facts and trends about the risk and profitability of a company and also something about the quality and efficiency of the management by examining the financial statements. This process is called ratio analysis and is not perfect nor does it give definitive answers but it can serve as an early warning or alarm system to alert owners, lenders and managers to general problems. It is very common in everyday use.

There are several steps to implementing and understanding ratio analysis:

Calculating Key ratios from the latest and earlier financial statements.
Gathering industry average ratios
Making the comparisons.
Making recommendations for action.

Calculating key financial ratios
There are four types of ratios:

Liquidity
Leverage
Efficiency
Profitability
Liquidity Ratios
These ratios are the most used. Both creditors and managers need to keep a close watch on the following measures. They predict the ability of the firm topay its bills on time.

Current Ratio

Quick or Acid test

Leverage Ratios
Debt ratio.

Debt to equity ratio

Efficiency Ratios
Average Collection period or number of days sales outstanding in receivables. 360 days is traditionally usedto measure average daily sales.

Inventory Turnover can be based on sales or cost of goods sold, both shown on the income statement. Industry average figures are often shown both ways.

Profitability Ratios
Owners Equity = Common stock = Preferred Stock + Retained Earnings. This number represents the rate of return earned on the book value of the owners investment.

The Price Earnings ratio is astock market oriented measure of profitability and stockholder's expectations.

Use of Financial Ratios
The use of financial ratios involves comparison of one company's values to that of a group of similar companies and the comparison of a company's ratios over time.

Commercial sources of industry data. Convenient printed forms of the data are available at the Weinberg Library Reference Desk. You will need to look upthe company's SIC [Standard Industrial Classification], also available at the same Reference Desk.

Dun @ Bradstreet
Robert Morris Associates
These industry averages are made by statistical surveys of companies. The data are stratified according to size of assets and sales in the RMA guide. Since the company you are studying will always have a value that is different from the industry average you will be faced with the question whether the deviation is significant. To help you answer this question the industry sources will also present upper and lower quartile values for each ratio. With this information you can judge whether you company is close to the average or really far away from it. It is not wrong to have an average that is different but it does indicate a need for an explanation.

Using the balance sheet data above and some industry averages:

RATIO ANALYSIS 1993 1994 1995 1996 IND LO IND AVG IND HI
Current Ratio 1.78 1.95 1.98 2.14 1.52 1.66 1.83
Quick Ratio 1.25 1.31 1.26 1.25 .98 1.30 1.61
Debt Ratio .65 .61 .62 .57 .33 .51 .61
InventoryTurnover 9.31 6.53  4.7 3.44 6.01 7.34 8.56
ACP 39 55 76 105 45 51 77

It should be quite clear from the above information that the company was close to the industry averages in 1993 but as time has passed it has clearly accumulated too much Inventory and Accounts receivable for the size of its business.

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