# Financial statement analysis ACCG 1001 Week 11

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Learning objectives
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. Discuss the need for financial statement analysis and identify the
tools of financial statement analysis.
Explain and apply horizontal analysis.
Explain and apply vertical analysis.
Calculate ratios and describe their purpose and use in analysing the
liquidity, solvency and profitability of a business. Both calculation and
interpretation are important.
Comparative analysis
Understand the limitations of financial statement analysis.
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•Financial statement analysis is necessary because: Financial statement analysis is necessary because:

•information expressed in monetary terms is of limited use information expressed in monetary terms is of limited use on its own; comparison is key. on its own; comparison is key.

•it reveals relationships between financial statement items it reveals relationships between financial statement items and help to identify trends in financial data.and help to identify trends in financial data.

•it enables assessment of past performance and can be used it enables assessment of past performance and can be used to forecast performance.to forecast performance.
The need for financial statement analysis
The need for financial statement analysis
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•General purpose financial reports (GPFR) are the main source of General purpose financial reports (GPFR) are the main source of financial information about an entity to primary and other financial information about an entity to primary and other users. users.

•Investors and other resources providers are the major user Investors and other resources providers are the major user group, and base their economic decisions on these reports.group, and base their economic decisions on these reports.
Methods of financial statement analysis
Methods of financial statement analysis
Basic tools/techniques for analysing financial statements are:
Basic tools/techniques for analysing financial statements are:
Horizontal analysis
Horizontal analysis: : evaluates a series of financial data over time.evaluates a series of financial data over time.
Vertical analysis
Vertical analysis: : evaluates financial items in relation to a base evaluates financial items in relation to a base amount.amount.
Ratio analysis
Ratio analysis: : eevaluates a comprehensive range of financial valuates a comprehensive range of financial relationships representing different aspects of an entity’s activities.relationships representing different aspects of an entity’s activities.
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Horizontal analysis
Horizontal analysis

•Used to evaluate a series of financial statement data Used to evaluate a series of financial statement data over a period of timeover a period of time..

•Analyses increases or decreases that have occurred from a particular Analyses increases or decreases that have occurred from a particular base yearbase year..

•One year is selected as the base year and then increases or decreases are based One year is selected as the base year and then increases or decreases are based on the formula:on the formula:
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Change from 2015 to 2016:
Change from 2015 to 2016:
(77,542
(77,542–74,390)/74,390 = 74,390)/74,390 =
3,153/74,390 = 4.2%
3,153/74,390 = 4.2%

•Figures are expressed as either in dollar Figures are expressed as either in dollar amounts or as percentages.amounts or as percentages.

•Percentages removes the effect of size, so Percentages removes the effect of size, so relative magnitude of change is revealed.relative magnitude of change is revealed.
Horizontal analysis example
Horizontal analysis example
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Vertical analysis
Vertical analysis
Evaluates financial statement data by expressing each item as a
Evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude.percentage of a base amount to indicate relative magnitude.
Provides insights that may not be apparent from individual items
Provides insights that may not be apparent from individual items presented in the financial statements.presented in the financial statements.
Calculated percentages can also be tracked over time to determine
Calculated percentages can also be tracked over time to determine patterns of change.patterns of change.
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Vertical analysis example
Vertical analysis example
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For example,
For example,
3,386/88,010 = 3.8%
3,386/88,010 = 3.8%
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In
In–class Quizclass Quiz
1.
1.Horizontal analysis is a technique for Horizontal analysis is a technique for evaluating a series of financial evaluating a series of financial statement data over a period of time:statement data over a period of time:
a.
a.that has been arranged from the highest number to that has been arranged from the highest number to the lowest number.the lowest number.
b.
b.that has been arranged from the lowest number to that has been arranged from the lowest number to the highest number.the highest number.
c.
c.to determine which items are in error.to determine which items are in error.
d.
d.to determine the amount and/or percentage to determine the amount and/or percentage increase or decrease that has taken place.increase or decrease that has taken place.
Ratio analysis
Ratio analysis
Expressing the relationship between two or more dollar amounts
Expressing the relationship between two or more dollar amounts in ratio or percentage form. in ratio or percentage form.
Three main types of ratios are:
Three main types of ratios are:

•liquidityliquidity

•solvencysolvency

•profitability.profitability.
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Liquidity ratios
Liquidity ratios
Liquidity ratios
Liquidity ratios measure the measure the shortshort–termtermability of an entity to pay its debts and ability of an entity to pay its debts and meet unexpected needs for cash.meet unexpected needs for cash.
Current ratio:
Current ratio:
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Quick ratio:
Quick ratio:
Excludes inventory and prepaid assets
Excludes inventory and prepaid assets which are the least liquid current assets.which are the least liquid current assets.
Liquidity ratios
Liquidity ratios
Current cash debt coverage (not
Current cash debt coverage (not–examinable):examinable):

•Reflects the whole period not just a single point in time.Reflects the whole period not just a single point in time.

•Does not just use year end balances.Does not just use year end balances.

•Combines cash and accrual figures.Combines cash and accrual figures.
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Liquidity ratios
Liquidity ratios
Receivables turnover:
Receivables turnover:

•Measures the number ofMeasures the number oftimes times trade receivables are converted into cash trade receivables are converted into cash during the period.during the period.

•Indicates the effectiveness of credit collection policies.Indicates the effectiveness of credit collection policies.
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Average collection period:
Average collection period: cconvertsonvertsreceivables turnover figure into a receivables turnover figure into a measure of measure of daysdaysfor receivables collection.for receivables collection.
Liquidity ratios
Liquidity ratios
Inventory turnover:
Inventory turnover:
Reflects the effectiveness of inventory management.
Reflects the effectiveness of inventory management.
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Average days in inventory:
Average days in inventory:
Converts inventory turnover into a measure of days for inventory to be sold.
Converts inventory turnover into a measure of days for inventory to be sold.
Solvency ratios
Solvency ratios
Solvency ratios
Solvency ratios measure the ability of an entity to survive over a measure the ability of an entity to survive over a longlongperiod of period of time.time.
Debt to total assets ratio:
Debt to total assets ratio:
Indicates degree of leverage (percentage of total assets funded through debt).
Indicates degree of leverage (percentage of total assets funded through debt).
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Times interest earned:
Times interest earned:
Indicates entity’s ability to sustain debt by measuring its ability meet interest
Indicates entity’s ability to sustain debt by measuring its ability meet interest payments from operating profit.payments from operating profit.
Solvency ratios
Solvency ratios
Cash debt coverage (not
Cash debt coverage (not–examinable):examinable):

•Indicates entity’s ability to repay liabilities from cash generated from Indicates entity’s ability to repay liabilities from cash generated from operating activities, without having to liquidate assets used in operations.operating activities, without having to liquidate assets used in operations.

•Reflects the whole period, not just a single point in timeReflects the whole period, not just a single point in time..
Free cash flow (not
Free cash flow (not–examinable): examinable):
Indicates entity’s ability to pay dividends or expand operations.
Indicates entity’s ability to pay dividends or expand operations.
Provides an estimation of discretionary cash.
Provides an estimation of discretionary cash.
Combines cash and accrual figures.
Combines cash and accrual figures.
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In
In–class Quizclass Quiz
2.
ShortShort–term creditors are term creditors are usually most interested in usually most interested in assessing:assessing:
a.
a.solvency.solvency.
b.
b.liquidity.liquidity.
c.
c.marketability.marketability.
d.
d.profitability.profitability.
Profitability ratios
Profitability ratios
Profitability ratios
Profitability ratios measure the profit or operating success of measure the profit or operating success of an entity for a given period of time.an entity for a given period of time.
Size of entity’s profit affects its:
Size of entity’s profit affects its:

•Ability to obtain debt and equity financing.Ability to obtain debt and equity financing.

•Liquidity position.Liquidity position.

•Ability to grow.Ability to grow.
Profitability is often regarded as the ultimate test of
Profitability is often regarded as the ultimate test of management’s operating effectiveness.management’s operating effectiveness.
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Profitability ratios
Profitability ratios
Return on ordinary shareholders’ equity ratio:
Return on ordinary shareholders’ equity ratio:
Indicates earnings per dollar invested by the owners.
Indicates earnings per dollar invested by the owners.
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Return on assets:
Return on assets:
Measures overall profitability with respect to investment in assets.
Measures overall profitability with respect to investment in assets.
Profitability ratios
Profitability ratios
Profit margin:
Profit margin:
Measures percentage of each dollar of sales that results in profit:
Measures percentage of each dollar of sales that results in profit:

•High volume firms (e.g. supermarkets) generally experience low profit margins.High volume firms (e.g. supermarkets) generally experience low profit margins.

•Low volume firms (e.g. white goods) have high profit margins.Low volume firms (e.g. white goods) have high profit margins.
.
.
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Asset turnover:
Asset turnover:
Asset turnovers vary considerably between industries.
Asset turnovers vary considerably between industries.
Return on assets:
Return on assets:
=profit margin x asset turnoverprofit margin x asset turnover
=profit after taxprofit after taxx x net sales net sales ..net salesnet salesaverage total assetsaverage total assets
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Relationship between profitability ratios
Relationship between profitability ratios
Profitability ratios
Profitability ratios
Gross profit rate:
Gross profit rate:
Indicates entity’s ability to maintain an adequate selling price above its costs.
Indicates entity’s ability to maintain an adequate selling price above its costs.
Ratio declines as industry becomes more competitive.
Ratio declines as industry becomes more competitive.
Operating expenses to sales ratio:
Operating expenses to sales ratio:
Measures costs incurred to support each dollar of sales.
Measures costs incurred to support each dollar of sales.
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Profitability ratios
Profitability ratios
Cash return on sales ratio (not examinable) :
Cash return on sales ratio (not examinable) :
Similar to net profit ratio. Uses cash numerator instead of accrual profit.
Similar to net profit ratio. Uses cash numerator instead of accrual profit.
Earnings per share (EPS) (not examinable) :
Earnings per share (EPS) (not examinable) :
Measures profit earned on each ordinary share.
Measures profit earned on each ordinary share.
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Profitability ratios
Profitability ratios
Price
Price–earnings ratio (not examinable):earnings ratio (not examinable):
Measures ratio of market price of each ordinary share to earnings per share.
Measures ratio of market price of each ordinary share to earnings per share.
Reflects investors’ assessments of an entity’s future earnings.
Reflects investors’ assessments of an entity’s future earnings.
Cash dividend payout rate (not examinable):
Cash dividend payout rate (not examinable):
Measures the percentage of profit distributed in the form of
Measures the percentage of profit distributed in the form ofcash cash dividends.dividends.
Entities with high growth rates generally have low payout ratios because they
Entities with high growth rates generally have low payout ratios because they reinvest most of their profit in the firm.reinvest most of their profit in the firm.
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BCG Ltd
BCG Ltd
Balance Sheet
Balance Sheet
30 June 2012
30 June 2012
2011
2011
2012
2012
Current Assets
Current Assets
Cash
Cash
\$ 0
\$ 0
\$ 0
\$ 0
Receivables (net)
Receivables (net)
820 000
820 000
1 240 000
1 240 000
Inventories
Inventories
1 240 000
1 240 000
1 600 000
1 600 000
Prepaid expenses
Prepaid expenses72 00072 00080 00080 000
\$ 2 132 000
\$ 2 132 000
\$ 2 920 000
\$ 2 920 000
Current liabilities
Current liabilities
Accounts payable
Accounts payable
\$ 520 000
\$ 520 000
\$ 1 200 000
\$ 1 200 000
Bank overdraft
Bank overdraft
180 000
180 000
760 000
760 000
Dividend payable
Dividend payable
260 000
260 000
260 000
260 000
Income tax payable
Income tax payable240 000240 000280 000280 000
\$1 200 000
\$1 200 000
\$ 2 500 000
\$ 2 500 000
Profit after tax was \$ 2.88M.
Profit after tax was \$ 2.88M.
Sales (all on account) were
Sales (all on account) were \$18.4M.\$18.4M.
Cost of sales (COS)
Cost of sales (COS)was was \$14.4M.\$14.4M.
Required:
Required:
Calculate the ratios on next slide
Calculate the ratios on next slide for 2012.for 2012.
Lecture exercise 1
Lecture exercise 1
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Lecture exercise 1 continued
Lecture exercise 1 continued
a) Current ratio
a) Current ratio
=Current assetsCurrent assets
Current liabilities
Current liabilities
= 2 920 000/ 2 500 000
= 2 920 000/ 2 500 000
= 1.2 : 1
= 1.2 : 1
b)
b)Quick ratioQuick ratio
= CA CA ––[inventory + prepaid expense][inventory + prepaid expense]
Current liabilities
Current liabilities
= 1 240 000/ 2 500 000
= 1 240 000/ 2 500 000
= 0.5 : 1
= 0.5 : 1
c) Receivables turnover
c) Receivables turnover
= Net credit sales/
= Net credit sales/ AvgAvgrec. bal.rec. bal.
= 18 400 000/[(820 000+1 240 000)/2]
= 18 400 000/[(820 000+1 240 000)/2]
= 17.9 times
= 17.9 times
d) Average collection period
d) Average collection period
= 365/ Receivables turnover
= 365/ Receivables turnover
= 365/ 17.9 times
= 365/ 17.9 times
= 20.4 days
= 20.4 days
e) Inventory turnover
e) Inventory turnover
= COS/ Average inventory balance
= COS/ Average inventory balance
= 14 400 000/[(1 240 000+1 600 000)/2]
= 14 400 000/[(1 240 000+1 600 000)/2]
= 10.1 times
= 10.1 times
f) Average days in inventory
f) Average days in inventory
= 365/ Inventory turnover
= 365/ Inventory turnover
= 365/ 10.1 times
= 365/ 10.1 times
= 36.1 days
= 36.1 days
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Lecture exercise 2
Lecture exercise 2
Ratio
Ratio
Transaction
Transaction
Impact on ratio?
Impact on ratio?
Current ratio
Current ratio
Purchased a
Purchased aPPE PPE using 100% using 100% mortgage financingmortgage financing
––
––——————
Return on ordinary
Return on ordinary shareholders’ equityshareholders’ equity
Issued ordinary shares
Issued ordinary shares

Quick ratio
Quick ratio
Purchased inventory on credit
Purchased inventory on credit

Return on assets
Return on assets
Paid off accounts payable
Paid off accounts payable

––
––

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Comparative analysis/benchmark
Comparative analysis/benchmark
Types of useful comparative information:
Types of useful comparative information:
Intra
Intra–entity basisentity basis: : comparisons within a single entity (detects comparisons within a single entity (detects changes in financial relationships and trends).changes in financial relationships and trends).
Inter
Inter–entity basisentity basis: : bbetween other entities (indicates competitive etween other entities (indicates competitive position).position).
Industry averages
Industry averages: : between entities in the same industry between entities in the same industry (determines position relative to others).(determines position relative to others).
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Limitations of financial statement analysis
Limitations of financial statement analysis
Estimates:
Estimates:
Financial statements contain estimates, e.g., allowance for doubtful debts, depreciation
Financial statements contain estimates, e.g., allowance for doubtful debts, depreciation expense and costs of warranties. If estimates are inaccurate, the financial ratios and expense and costs of warranties. If estimates are inaccurate, the financial ratios and percentages will also be inaccurate.percentages will also be inaccurate.
Cost:
Cost:
Many items are carried at historic cost. This does not account for price
Many items are carried at historic cost. This does not account for price–level changes.level changes.
Alternative accounting methods:
Alternative accounting methods:
Differences in accounting policies for the similar financial activities are often allowed:
Differences in accounting policies for the similar financial activities are often allowed: e.g. methods of depreciation.e.g. methods of depreciation.
Atypical data:
Atypical data:
Some end
Some end–ofof–period data may not represent normal business conditions.period data may not represent normal business conditions.
Diversification:
Diversification:
Diversification within entities limits usefulness of financial statement analysis.
Diversification within entities limits usefulness of financial statement analysis. Segment data may provide more relevant and comparable information.Segment data may provide more relevant and comparable information. 30
Summary of the lecture
Summary of the lecture

•Understand the need for and the limitations of financial statement analysis.Understand the need for and the limitations of financial statement analysis.

•Apply the various analytical techniques.Apply the various analytical techniques.

•Compute ratios and interpret what they indicate about an entity’s liquidity, Compute ratios and interpret what they indicate about an entity’s liquidity, solvency and profitability.solvency and profitability.
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