Financial statement analysis
Contents
The balance sheet 3
Assets 3
Liabilities 4
Shareholders’ equity 4
Inventories 5
Cost allocation problem of inventories 6
Amounts receivable 8
Non-current assets 8
Depreciation of non-current assets 9
Subsequent value changes of non-current assets 11
Accounting treatment of intangible assets 12
Liabilities 12
Debt with equity features 14
Leases 15
Deferred taxation 16
Leverage 18
The income statement 20
Revenue recognition 20
Revenue recognition for contracts with multiple goods and services 22
Revenue recognition for warranties 23
Expense recognition 23
Non-recurring items 23
Management discretion 24
Earnings per share 24
The cash flow statement 26
Cash flows 26
Direct vs indirect method 27
Analysis of the balance sheet 30
Liquidity ratios 31
Solvency ratios 31
Activity ratios 32
Analysis of the income statement 34
, Profitability ratios 34
Valuation ratios 36
Analysis of the cash flow statement 37
Cash flow ratios 37
Consolidation 39
Treatment of investments 39
Goodwill 39
Non-controlling interest 39
The equity method 40
The purchase method 41
Mid-year acquisition 42
Other financial statements 43
The statement of changes in owners’ equity 43
The notes 44
The management commentary 44
The auditor’s report 44
, The balance sheet
The balance sheet provides a snapshot of the company at a given point in time.
1. Its goal is to show the available resources and how they’re funded:
𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 = 𝑓𝑢𝑛𝑑𝑖𝑛𝑔
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝐸𝑞𝑢𝑖𝑡𝑦
2. It’s broken down into 3 categories:
a. Assets.
b. Liabilities.
c. Shareholders’ equity.
Assets
Assets are the resources owned by the company.
1. They should be recognised in the balance sheet only if:
a. It’s likely that future economic benefits will flow to the company.
b. And the item has a cost/value that can be measured reliably.
2. If the asset isn’t derived from a specific transaction, we write it off as an expense in
the income statement.
Current assets are expected to be liquidated within 1 year.
1. They’re kept for operating purposes:
a. Cash and equivalents.
b. Short-term receivables.
c. Inventory.
d. Short-term investments.
2. They’re valued at the lower of cost or market value.
Non-current assets aren’t expected to be liquidated within 1 year.
1. They represent the infrastructure from which the company operates:
a. PPE.
b. Long-term investments.
c. Patents.
i. Tangible and intangible assets must be recorded at cost, and then
depreciated/amortised over their useful economic life.
ii. Investments are held at market value.
2. Therefore, the book value of (in)tangible assets is the following:
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 = 𝑐𝑜𝑠𝑡 − 𝐷&𝐴
, Liabilities
Liabilities are obligations that a company owes to third parties, thus depend on future cash
outflows.
1. Current liabilities are due within 1 year:
a. Payables.
b. Accrued expenses.
c. Deferred income.
d. Short-term loans.
2. Non-current liabilities are long-term liabilities:
a. Long-term loans.
b. Bonds.
c. Deferred tax liabilities.
d. Lease obligations.
Working capital shows the ability of a company to meet liabilities as they fall due:
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
1. Positive working capital indicates that the company has enough current assets to cover
its current liabilities.
a. It also provides a buffer for unexpected expenses and growth opportunities.
2. However, a too high working capital might signal inefficiencies.
Shareholders’ equity
Equity is the residual ownership interest in a company after subtracting liabilities from assets.
1. It represents the shareholders’ claims on the company’s assets.
a. An increase in equity comes from contribution by the owners or profits of the
current year.
b. A decrease in equity comes from dividends or losses.
2. The formula to find equity is the following:
𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑐𝑎𝑙𝑙𝑒𝑑 𝑢𝑝 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠
a. Called up capital (or issued capital) is the share capital.
b. Reserves are the undistributed gains of the company.
i. The most common reserve is retained earnings, the total accumulated
profits of the company that haven’t been distributed as dividends.
Terminology in equity can be confusing:
1. The authorised share capital is the maximum amount of shares a company can issue.
2. The issued capital represents the actual number of shares in issue.
3. The additional paid-in capital represents the share premium.
a. It’s the additional value that a company gets from shares:
𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 ∗ (𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 − 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒)
Contents
The balance sheet 3
Assets 3
Liabilities 4
Shareholders’ equity 4
Inventories 5
Cost allocation problem of inventories 6
Amounts receivable 8
Non-current assets 8
Depreciation of non-current assets 9
Subsequent value changes of non-current assets 11
Accounting treatment of intangible assets 12
Liabilities 12
Debt with equity features 14
Leases 15
Deferred taxation 16
Leverage 18
The income statement 20
Revenue recognition 20
Revenue recognition for contracts with multiple goods and services 22
Revenue recognition for warranties 23
Expense recognition 23
Non-recurring items 23
Management discretion 24
Earnings per share 24
The cash flow statement 26
Cash flows 26
Direct vs indirect method 27
Analysis of the balance sheet 30
Liquidity ratios 31
Solvency ratios 31
Activity ratios 32
Analysis of the income statement 34
, Profitability ratios 34
Valuation ratios 36
Analysis of the cash flow statement 37
Cash flow ratios 37
Consolidation 39
Treatment of investments 39
Goodwill 39
Non-controlling interest 39
The equity method 40
The purchase method 41
Mid-year acquisition 42
Other financial statements 43
The statement of changes in owners’ equity 43
The notes 44
The management commentary 44
The auditor’s report 44
, The balance sheet
The balance sheet provides a snapshot of the company at a given point in time.
1. Its goal is to show the available resources and how they’re funded:
𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 = 𝑓𝑢𝑛𝑑𝑖𝑛𝑔
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝐸𝑞𝑢𝑖𝑡𝑦
2. It’s broken down into 3 categories:
a. Assets.
b. Liabilities.
c. Shareholders’ equity.
Assets
Assets are the resources owned by the company.
1. They should be recognised in the balance sheet only if:
a. It’s likely that future economic benefits will flow to the company.
b. And the item has a cost/value that can be measured reliably.
2. If the asset isn’t derived from a specific transaction, we write it off as an expense in
the income statement.
Current assets are expected to be liquidated within 1 year.
1. They’re kept for operating purposes:
a. Cash and equivalents.
b. Short-term receivables.
c. Inventory.
d. Short-term investments.
2. They’re valued at the lower of cost or market value.
Non-current assets aren’t expected to be liquidated within 1 year.
1. They represent the infrastructure from which the company operates:
a. PPE.
b. Long-term investments.
c. Patents.
i. Tangible and intangible assets must be recorded at cost, and then
depreciated/amortised over their useful economic life.
ii. Investments are held at market value.
2. Therefore, the book value of (in)tangible assets is the following:
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 = 𝑐𝑜𝑠𝑡 − 𝐷&𝐴
, Liabilities
Liabilities are obligations that a company owes to third parties, thus depend on future cash
outflows.
1. Current liabilities are due within 1 year:
a. Payables.
b. Accrued expenses.
c. Deferred income.
d. Short-term loans.
2. Non-current liabilities are long-term liabilities:
a. Long-term loans.
b. Bonds.
c. Deferred tax liabilities.
d. Lease obligations.
Working capital shows the ability of a company to meet liabilities as they fall due:
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
1. Positive working capital indicates that the company has enough current assets to cover
its current liabilities.
a. It also provides a buffer for unexpected expenses and growth opportunities.
2. However, a too high working capital might signal inefficiencies.
Shareholders’ equity
Equity is the residual ownership interest in a company after subtracting liabilities from assets.
1. It represents the shareholders’ claims on the company’s assets.
a. An increase in equity comes from contribution by the owners or profits of the
current year.
b. A decrease in equity comes from dividends or losses.
2. The formula to find equity is the following:
𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑐𝑎𝑙𝑙𝑒𝑑 𝑢𝑝 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠
a. Called up capital (or issued capital) is the share capital.
b. Reserves are the undistributed gains of the company.
i. The most common reserve is retained earnings, the total accumulated
profits of the company that haven’t been distributed as dividends.
Terminology in equity can be confusing:
1. The authorised share capital is the maximum amount of shares a company can issue.
2. The issued capital represents the actual number of shares in issue.
3. The additional paid-in capital represents the share premium.
a. It’s the additional value that a company gets from shares:
𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 ∗ (𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 − 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒)
