Financial Statement Analysis

Question 1

What to look out for when evaluating the performance of a firm?

Answer 1

1. Analyze the financial statements
2. Be aware of the limitations of financial figures
3. Be aware of the different accounting policies and methods in arriving at the financial figures
4. Be aware of the different business strategies in arriving at the financial figures
5. Be aware of the different business strategies in arriving at the financial figures
6. Consider non-financial performance measures.

Also consider economy-wide factors, industry-wide factors and firm specific factors.

Question 2

What are the 3 common methods of evaluating a firm’s financial performance?

Answer 2

1. Horizontal analysis
2. Vertical analysis
3. Financial ratio analysis.

Question 3

What is horizontal analysis?

Answer 3

• A type of trend analysis
• Compares a company’s financial condition and performance across time.
• Compares values with previous years.

Question 4

What is vertical analysis?

Answer 4

• Compares a company’s financial condition and performance to a base amount.
• This analysis is also known as a common-sized statement.
• This method makes it easy to compare companies of different sizes and also to evaluate how the composition of various items change over time.
• The base amount needs to be identified so that other information can be compared against it.

Question 5

How useful will it be when combining both the vertical and horizontal analysis?

Answer 5

• Users of the financial information can deduce these points from the Statement of Financial Position:
  1. Cash and cash eq

Question 6

What is Financial Ratio Analysis?

Answer 6

• It is the relationship between 2 or more numbers taken from a firm’s financial statements.
• It highlights important information for stakeholders even without them reading through the complete set of financial statements.

Question 7

What are the 5 major types of financial ratios? How to make sense of them?

Answer 7

1. Profitability
2. Liquidity
3. Solvency
4. Market Tests
5. Efficiency

• To make sense of these ratios, there must be bases of comparison.
• We can compare the ratios across periods, among competitors, with the industry average and with targets set.

Question 8

What are the differences between profitability and liquidity?

Answer 8

Profitability is the excess of income over expenses.

Liquidity is the amount of liquid assets, for example, cash, that an entity has.

A business can be profitable, but no liquid.

Question 9

Profitability ratios

Answer 9

Gives us an idea of a firm’s ability to generate earnings from its operations.

Question 10

Liquidity

Answer 10

Tells us of a firm’s ability to pay off its short-term liabilities.

Question 11

Solvency ratio

Answer 11

Tells us of a firm’s ability to meet its long-term debts.

Question 12

Market test ratio

Answer 12

Gives us an insight into the value of a company, and potential returns on investments for investors.

Question 13

Efficiency ratio

Answer 13

Typically used to analyze how well a company uses its assets and liabilities internally.

Can be used to calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory and machinery.

Question 14

How can a firm further evaluate the level of its efficiency?

Answer 14

A firm can also use its operating cycle to further evaluate the efficiency level of its operation.

• Usually, the shorter the operating cycle, the more efficient it is.

Question 15

When does financial ratio change?

Answer 15

It changes when business transactions occur.

Question 16

What is considered the most important profitability measure?

Answer 16

Return on equity.

This shows the return on shareholders’ investment.

Question 17

What is DuPont Analysis?

Answer 17

It is a powerful tool used for understanding how Return on Equity varies across time or different companies.

Return on Equity can be broken down into 3 ratios:
1. Leverage, a solvency ratio
-> What proportion of assets belong to shareholders?
2. Asset Turnover, an efficiency ratio
-> How much sale does company get from each asset dollar?
3. Net Profit Margin, a profitability ratio.
-> How much of each sales dollar does company keep?

Allows one to determine where the company is weak or strong and gives you a good idea of what areas of the business to further investigate.

!! It is still a broad tool and should not be a substitute for detailed analysis.