Week 2: Financial statement analysis
Major objectives of financial statements analysis is to:
- Assess the firm’s current liquidity position
- Assess the firm’s past performance as an indicator of it’s future financial performance in
terms of profitability and growth
- Assess the firm’s operational efficiency. Gross, Operating, Net profit after tax.
- Predict potential bankruptcy and/or failure of the firm.(Stress analysis)
Annual reports
- Auditor’s report
- Director’s report
- Statement of Financial Performance (Comprehensive Income / Income statement)
- Statement of Financial Position (Balance sheet)
- Cash flow statement
Objectives & User of annual reports
Primary users
Equity Investors
- Return on capital invested
- Capital preservation & growth
Credit grantors
- Short-term: interest cover, repayment of amounts owing
- Long-term (Banks) – interest cover and capital preservation
Management
- Decision making
- Planning and control
Secondary users
Employees
- Job security, career prospects
- Wage & Salary negotiations
Acquisition and merger analysts
- Valuation of potential candidates
Auditors
- Analytical review
Other/SARS – Tax authorities
- Income fairly stated
,Approaches to FRA
Time series techniques
Comparative (Trend) financial statements:
Direct comparison of current statements to numerous prior year statements to detect/
identify trends in key variables
Index analysis: (Average of last 5 years)
- Like comparative method, but a base year is used to express values as percentages for
succinct comparisons
- Selecting a base year can be problematic. So it would be better to use previous years’
averages
Cross section techniques
1. Common size analysis
Statement of comprehensive income
, *Dividends based on profit after tax
2. Financial Ratios Analysis
Two or more line items from AFS that have a MEANINGFUL RELATIONSHIP and express it as
an relationship (A : B), % , days, times.
- Financial Ratios help identify and highlight areas of good or bad financial performance
and areas with significant changes (i.e. facilitating Management By Exception).
- Financial Ratio analysis highlights the important Financial characteristics of an enterprise
by comparing the Financial ratios for the enterprise in question against an Appropriate
Benchmark:
Ø Previous years' financial ratios (Trend analysis or Time series)
Ø Similar companies of similar size (E.g Boeing or airbus)
Ø Industry average standards,
Ø Average ratios of leading companies in the same industry (Can’t compare
Woolworths & pick n pay)
Ø Target (Budgeted) ratios
Procedure
1. Know the formula.
2. Calculate the financial ratio
3. Define the financial ratio. EXPLAIN WHAT INFORMATION IT CONVEYS.
4. Correct expression of financial ratios. You will be penalized.
5. Compare the calculated financial ratio to the given benchmark in question
Identify trends:
- Increases in ratios can either be good or bad.
- Decreases in ratios can either be good or bad.
- Identify the reasons (causes) why the financial ratio has increased or decreased and the
future financial implications.
6. Make any recommendations [Future Plan of Action (POA)] to improve the situation /
measurement.
Terminology and definitions
Debt equity
The more common definition of debt is: interest bearing liabilities. So the Debt to Equity
(D/E) ratio normally means:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑑𝑒𝑏𝑡
𝑥 100
𝐸𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 (𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠)
𝑥 100
𝐸𝑞𝑢𝑖𝑡𝑦
Major objectives of financial statements analysis is to:
- Assess the firm’s current liquidity position
- Assess the firm’s past performance as an indicator of it’s future financial performance in
terms of profitability and growth
- Assess the firm’s operational efficiency. Gross, Operating, Net profit after tax.
- Predict potential bankruptcy and/or failure of the firm.(Stress analysis)
Annual reports
- Auditor’s report
- Director’s report
- Statement of Financial Performance (Comprehensive Income / Income statement)
- Statement of Financial Position (Balance sheet)
- Cash flow statement
Objectives & User of annual reports
Primary users
Equity Investors
- Return on capital invested
- Capital preservation & growth
Credit grantors
- Short-term: interest cover, repayment of amounts owing
- Long-term (Banks) – interest cover and capital preservation
Management
- Decision making
- Planning and control
Secondary users
Employees
- Job security, career prospects
- Wage & Salary negotiations
Acquisition and merger analysts
- Valuation of potential candidates
Auditors
- Analytical review
Other/SARS – Tax authorities
- Income fairly stated
,Approaches to FRA
Time series techniques
Comparative (Trend) financial statements:
Direct comparison of current statements to numerous prior year statements to detect/
identify trends in key variables
Index analysis: (Average of last 5 years)
- Like comparative method, but a base year is used to express values as percentages for
succinct comparisons
- Selecting a base year can be problematic. So it would be better to use previous years’
averages
Cross section techniques
1. Common size analysis
Statement of comprehensive income
, *Dividends based on profit after tax
2. Financial Ratios Analysis
Two or more line items from AFS that have a MEANINGFUL RELATIONSHIP and express it as
an relationship (A : B), % , days, times.
- Financial Ratios help identify and highlight areas of good or bad financial performance
and areas with significant changes (i.e. facilitating Management By Exception).
- Financial Ratio analysis highlights the important Financial characteristics of an enterprise
by comparing the Financial ratios for the enterprise in question against an Appropriate
Benchmark:
Ø Previous years' financial ratios (Trend analysis or Time series)
Ø Similar companies of similar size (E.g Boeing or airbus)
Ø Industry average standards,
Ø Average ratios of leading companies in the same industry (Can’t compare
Woolworths & pick n pay)
Ø Target (Budgeted) ratios
Procedure
1. Know the formula.
2. Calculate the financial ratio
3. Define the financial ratio. EXPLAIN WHAT INFORMATION IT CONVEYS.
4. Correct expression of financial ratios. You will be penalized.
5. Compare the calculated financial ratio to the given benchmark in question
Identify trends:
- Increases in ratios can either be good or bad.
- Decreases in ratios can either be good or bad.
- Identify the reasons (causes) why the financial ratio has increased or decreased and the
future financial implications.
6. Make any recommendations [Future Plan of Action (POA)] to improve the situation /
measurement.
Terminology and definitions
Debt equity
The more common definition of debt is: interest bearing liabilities. So the Debt to Equity
(D/E) ratio normally means:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑑𝑒𝑏𝑡
𝑥 100
𝐸𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 (𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠)
𝑥 100
𝐸𝑞𝑢𝑖𝑡𝑦
