Chapter III
Financial Analysis
3.1 The Concept of Financial Analysis
Financial Analysis is the process of applying analytical tools to the
financial statements of companies to evaluate the financial condition and
financial performance of the companies.
3.2 The Objective of Financial Analysis
The objectives of financial analysis are to:
(1) Identify the strength and weakness of the company
(2) Provide information for financial decision making
3.3 Approaches to Financial Analysis
There are two approaches of financial analysis:
(1) Cross-sectional approach, and
(2) Time-series approach
Cross-sectional analysis involves the comparison of different firms’
financial statements at the same point in time.
Time-series analysis is usually applicable when a financial analyst
evaluates financial position and performance of a firm over time.
3.4 Who Performs Financial Analysis?
Parties that perform financial analysis include:
Accountants
Analysts and advisors
Bankers
Managers
Creditors
Investors
Owners
Competitors
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Government agencies
Tax authorities
Trade unions etc.
3.5 Sources Data and Requirements for Financial Analysis
Financial analysis requires:
(1) Financial Statements
(2) Standards of Comparison/Benchmark
Prior year, and
Industry average
3.6 Analytical Tools for Financial Analysis
The analysis tools include:
(1) Horizontal Analysis
(2) Vertical Analysis
(3) Ratios
(1) Horizontal analysis—which is analysis across time and analyzes
changes in accounts between years.
It is typically, done on both the income statement and balance sheet.
Horizontal analysis is looking for change.
The analysis is calculated both on the absolute and percentage
change in each account balances on financial statements. To calculate
the percentage change use the formula below:
Percentage Change=$ Current Year-$ Base Year
$ Base Year
Example,
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Horizontal Analysis—Balance Sheet/Statement of Financial Position
Account 2013 2012 $ Increase/ % Increase/
Decrease Decrease
Cash $ 130,000 $ 110,000 $20,000 18.18%
Accounts Receivable 130,000 120,000 10,000 8.33%
Inventory 225,000 215,000 10,000 4.65%
Prepaid Insurance 25,000 30,000 (5,000) (16.67%)
Horizontal Analysis—Income Statement/Profit and Loss Statement
Account 2013 2012 $ Increase/ % Increase/
Decrease Decrease
Total Revenue $ 60,868 60,952 -84 (0.14%)
Cost of goods sold 44,344 44,474 -130 (0.29%)
Gross Profit 16,524 16,478 46 0.29%
Operating Expense 14,387 14,020 367 2.62%
Net Profit 2,137 2,458 -321 (13.06%)
From the above analysis one can state that the profit of the company has
dropped. Then try to say something on what caused the drop in profit.
(2) Vertical Analysis—analysis within the same year (period) using some
benchmarks, i.e., for income statement total (net) Sales or Revenue
and for Balance Sheet the analyst uses total assets.
It is done down the page within one year.
It is calculated by dividing each account balance by a base
account.
Example,
Vertical Analysis—Balance Sheet/Statement of Financial Position
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Account 2013 % of base 2012 % of base
account account
Cash $ 130,000 9.74% $ 110,000 9.87%
Accounts Receivable 130,000 9.74% 120,000 10.76%
Inventory 225,000 16.85% 215,000 19.28%
Prepaid Insurance 25,000 1.87% 30,000 2.69%
Equipment 50,000 3.75% 25,000 2.24%
Machine 35,000 2.62% 15,000 1.35%
Building 240,000 17.98% 200,000 17.94
Land 500,000 37.45% 400,000 35.87%
Total Assets 1,335,000 100% 1,115,000 100%
Account Payable 20,000 1.5% 10,000 0.9%
Bonds Payable 45,000 3.37% 30,000 2.69
From the analysis it can be concluded land is the most important asset.
Vertical Analysis—Income Statement/Profit and Loss Statement
Account 2013 % of base 2012 % of base
account account
Total Revenue $ 60,868 100% 60,952 100%
Cost of goods sold 44,344 72.85% 44,474 72.97%
Gross Profit 16,524 27.15% 16,478 27.03%
Operating Expense 14,387 23.63 14,020 23%
Net Profit 2,137 3.51% 2,458 4.03%
Net profit is dropping due to high operating expense.
(3) Ratios Analysis results in some key indicators of a business. It make
calculations and compare with previous performance or benchmarks in
the industry. There are five different kinds of ratios.
(1) Liquidity Ratio—concerned with How well are we paying our
debt. That is, the company’s ability to pay its current debts
(current liabilities). It includes:
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Current Ratio
Quick Ratio
(2) Asset Management Ratio—concerned with how well are we
using the assets that are entrusted to us? How well are we
turning our inventory over? How well are we collecting our
accounts receivable? That is, it measures the efficiently with
which the firm uses its assists to produce sales. It includes:
Inventory Turnover Ratio
Age of Inventory Ratio
Asset Turnover Ratio
(3) Debt Management Ratio—concerned with how well are we
controlling our debt? That is, it is used to measure a company’s
ability to pay its long-term debt obligation. It includes:
Debt Ratio
Debt to Equity Ratio
Times Interest Earned
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