Lesson 2 Flashcards
is the process of analyzing
a company’s financial statements for decision-making
purposes.
Financial statement analysis
use it to understand the overall health of an organization as well as to evaluate
financial performance and business value.
External stakeholders
use it as a monitoring tool for managing the finances.
Internal constituents
Two Main Types of Financial Analysis
Fundamental analysis
and
Technical analysis
uses ratios and financial statement data to determine the intrinsic value of a security.
Fundamental analysis
uses statistical trends gathered from trading activity. It attempts to understand the market sentiment behind
price trends by looking for patterns and trends rather than analyzing a security’s fundamental attributes.
Technical analysis
Common Techniques Used in FS Analysis
Horizontal analysis
Vertical analysis
Ratio analysis
is used in financial statement analysis to compare historical data over a number of accounting periods. It predicts future performance.
Horizontal analysis
is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item.
Vertical analysis
is a quantitative method of gaining
insight into a company’s liquidity, operational
efficiency, and profitability.
Ratio analysis
Three(3) Main Financial Statements
Balance Sheet
Asset
Liabilities
Shareholders’ equity
is a report of a company’s financial worth in terms of book value.
Balance Sheet
is a resource with economic value that an
individual, corporation or country owns or controls
with the expectation that it will provide a future
benefit.
Asset
include its expense arrangements and the debt capital it is paying off.
Liabilities
is the amount of assets remaining in a business after all liabilities have been settled.
Shareholders’ equity
breaks down the revenue a company earns against the expenses involved in its business to provide a bottom line, net income profit or loss.
Income Statement
the _____________ is broken into three parts which
help to analyze business efficiency at three different
points.
Income Statement
three parts of Income Statement
- It begins with revenue and the direct costs
associated with revenue to identify gross profit. - It then moves to operating profit which subtracts
indirect expenses such as marketing costs, general
costs, and depreciation. - Finally, it ends with net profit which deducts
interest and taxes.
- It begins with revenue and the direct costs
associated with revenue to identify _______
gross profit.
- It then moves to _____________ which subtracts
indirect expenses such as marketing costs, general
costs, and depreciation.
operating profit
- Finally, it ends with __________ which deducts
interest and taxes.
net profit
3 profit that mentions inside Income Statement
gross profit.
operating profit
net profit
provides an overview of the
company’s cash flows from operating activities,
investing activities, and financing activities.
Cash Flow Statement
is carried over to the cash flow statement
where it is included as the top line item for operating
activities.
Net income
Investing activities include cash flows involved with
firmwide -___________
investments
The financing activities section includes cash flow
from both _________ and _____________-
debt and equity financing.
Statement of cash flow
operating activitives
investing activities
financing activities
refers to the combined term for means,
methods, and systems to deliver applicable data to aid in decision-making for the company’s management.
Financial Statement Analysis
There are two (2) main factors for a company to survive: in financial statement analysis
- Profitability
- Solvency
is when business can gain profit and it is vital to the company for the generation of revenues more than the operational expenses sustained by the company. As we all know, the primary objective of a business is to maximize its profits.
Profitability
occurs when a firm can meet its long-term debts and other financial obligations. The company’s ________ is equally significant since it considers its
capability to meet financial commitments.
Solvency
aids proprietors, stockholders, and other persons with business interests in analyzing information in financial statements to deliver relevant information on the
vital aspects for decision-making and eventual company’s existence.
Financial Statement Analysis (FSA)
To evaluate the financial condition and performance of the business.
Purpose of FSA (Financial Statement Analysis)
are profits (cumulative net income)
held by a company in reserve in order to invest in
future projects rather than distribute as dividends to
shareholders.
Retained earnings
It is used by analysts to understand how corporate
profits are utilized
Retained earnings
For example, businesses can use these earnings to
reinvest into the company for expansion through the
purchase of property, plant and equipment or to pay off its debts.
Retained earnings
To accomplish a useful financial statement analysis, one has to be mindful of the organization’s:
Objectives
Business plan
Yearly report and additional documentation such as write-ups in newspapers on the organization’s profile and corporate analyses.
To have an effective FSA, you are required to be attentive on the following:
Better understand the type of industry the organization belongs to, also termed as the industry factor. (ex.: telecom, agriculture, construction,
education, pharmaceutical, energy, etc.)
Profound knowledge that the overall economic condition may also affect the performance of the organization.
With financial statement analysis, it must be remembered that a robust financial statement analysis does not necessarily indicate an organization’s healthy financial future. Financial statement analysis sometimes appears complete. Nonetheless, further factors that may be present could trigger the downfall of an organization.
Limitations of Financial Statement Analysis
it must be remembered that a robust financial statement analysis does not necessarily indicate an organization’s healthy financial future.
Financial Statement Analysis (FSA)
sometimes appears complete. Nonetheless, further factors that may be present could trigger the downfall of an organization.
Financial Statement Analysis (FSA)
Limitations of Financial Statement Analysis \
BASAHA
- Financial analysis is only a Means
- It disregards Price Level Changes
- Financial Statements are Interim (short-term/temporary) Reports
- Must consider Accounting Models and Conventions
- The Pressure of Personal Judgments
- Financial Facts are only revealed
is a method of analysis and interpretation of
financial statements. It is the means of establishing and interpreting numerous ratios which are useful in decision- making.
Financial Ratio Analysis
is not an end in itself. It is only a mode of better understanding of financial strengths and weaknesses of a company.
Financial Ratio Analysis
includes computing and analyzing ratios using
data from one or more financial statements. It also conveys relationships between various financial statements.
Financial ratio analysis
Financial Ratios can be classified into four (4) main categories:
- Liquidity Ratio
- Leverage Ratio
- Profitability Ratio
- Efficiency Ratio
measures the ability of the
business to meet its short-term maturing
Liquidity Ratios
Quick Assets consist of cash, accounts receivable, and other current assets, excluding inventories
Liquidity Ratios
measures the degree to which
credit applicant has been funded by debt.
Leverage Ratio
measures management’s efficiency as presented in returns generated from sales and investments
Profitability Ratio
measures how competent and capable is the credit applicant in using its resources.
Efficiency Ratio
Beginning Inventory + New Purchases - Ending
Cost of Goods Sold (COGS)
Trend analysis/ Trend percentage
✓ Line-by-line item analysis
Items are expressed as a percentage of a base year
termed as a time series analysis.
✓ An example would be a line item that could look at growth in sales turnover over
five years to ascertain the increase in sales over such a period.
Horizontal analysis
Common size analysis/ Component Percentages
✓ All items are stated as a percentage of a common base item within a financial
statement
✓ Financial performance indicates sales as the base
✓ Financial position indicates total assets as the base
✓ Significant analysis for comparative purposes means over time and for several
sized businesses.
Vertical analysis
The Uses of Ratio Analysis
Uses of Ratio Analysis
Financial Statement Assessment – Ratios help review and assess financial statements more clearly, enabling better decision-making.
Decision-Making Tool – Businesses use ratios to formulate strategic financial decisions based on analysis.
Broad Applicability – Ratio analysis is not limited to financial managers; various individuals and groups use it to understand a firm’s financial position.
Financial Performance Evaluation – It helps in assessing a business’s financial health in terms of key indicators.
Determination of Financial Position – Ratios help determine profitability, liquidity, leverage, and other financial aspects of a business.
The uses, importance and
advantages of financial ratios
- Aids in assessing the performance movements over a long period.
- Assists in financial forecasting and planning.
- Helps a business to compare the financial results of competitors.
- Assists management in making decisions.
- Reveals company problems and weak areas alongside with the strength areas.
- Helps develop relationships between different financial statement
transactions. - Aids in making effective control of the business.
Users of Financial Ratios
Bankers and Lenders
Investors
Employees
Customers
Suppliers
Government
Use profitability, liquidity and investment for the main
reason that they would like to know the ability of the borrowing business in interest payments and repayments of principal loan schedule on a regular
basis.
Bankers and Lenders
Use profitability and investment since they are more interested in profitability performance of business for the safety & security of their investment and prospective growth of their investment.
Investors
Use profitability, liquidity and performance they will be
concerned with job security, bonus, compensation and stability and liquidity of the organization for collective bargaining agreement.
Employees
Use liquidity they seek reassurance that the business can survive in the short term and continued its existence.
Customers
Use liquidity because they are more interested in learning the capability of the business to settle its short-term obligations as and when they
fall due.
Suppliers
Use profitability for the reason that government may use profit as a basis for taxation, grants and subsidies.
Government
Limitation of Financial Ratios
- Limited Use of a Single Ratio
- Lack of Adequate Standards
- Historical in nature
- Alteration of Accounting Policies and Procedures
- Window Dressing
- Business Environment
- Price Level Changes/Inflation
- Ratios are not alternatives
- Interpretation
- Operational change
usually, does not carry on much of a sense. A better interpretation involves a number
of ratios to be calculated which to create confusion to the analyst than assisting him to make any
meaningful conclusion.
- Limited Use of a Single Ratio
Sad to say, there are no well accepted standards or rules of thumb for all ratios which can be
accepted as models thus it provides interpretation of the ratios problematical
- Lack of Adequate Standards
All of the data used in ratio analysis is derived from actual historical results which means that not
the same results will carry forward into the future. Ratios from the past are not certainly true guides
of the future. However, the analyst can use ratio analysis on pro forma information and make
comparison of it to historical results for consistency.
- Historical in nature
Modification in accounting procedure by the company frequently creates misrepresentation in ratio
analysis. Different companies may have different policies for recording the same accounting
transaction. Meaning to say, comparing the ratio results of different companies may be like
comparing apples and grapes
- Alteration of Accounting Policies and Procedures
Businesses can simply window dress financial statements to present a healthier condition of its
financial and profitability position to external stakeholders. Therefore, the person analyzing the
financial statements has to be very careful in formulating a decision from ratios calculated from
these financial statements. However, there can be difficulty on the part of an outsider to have
knowledge about the window dressing used by the company.
- Window Dressing
A company need consider to put ratio analysis in the perspective of the business environment. An
example would be, when the business has 60 days of sales accounts receivables, it might be assessed
insignificant in a period of sales growing fast, but might be excellent during an economic contraction
when customers are in austere financial status and are not able to pay their credits.
- Business Environment
In the preparation of ratio analysis, changes in price levels are not taken into consideration and this
invalidate the _______________ of ratios. If the rate of inflation has changed in any of the periods under
review, this can mean that the numbers are not equivalent over periods.
- Price Level Changes/Inflation
Ratio analysis is simply a means of financial statements. Therefore, ratios will tend to be useless if
separated from the statements from which they are calculated.
- Ratios are not alternatives
There is difficult to ascertain the logic for the results of a ratio. For example, a current ratio of 2:1 might
exist to be excellent, until the analyst realizes that the business sold a substantial amount of its stock to
strengthen its cash position. Ratios can only provide only to analysts and not final conclusions. Hence,
these ratios need to be interpreted by experts and as mentioned earlier, there are no standard rules for
______________
- Interpretation
Business may amend its primary operational organization to the point that a ratio computed for the past several years and comparing it to the same ratio at present will generate a misleading conclusion.
Example, a company which implemented a limited analysis system, this might lead to a reduction of
investment in fixed assets, wherein a ratio analysis may assume that the company is allowing its fixed
asset base become too outdated.
- Operational change
as a diversity of limitations which can constrain its value. Nevertheless, the business must be aware of the limitations and make use of alternatives and supplementary processes to gather and interpret data, ratio analysis will still be useful.
Ratio analysis
