Financial Statement Analysis

INTRODUCTION AND ANALYSIS TECHNIQUES

Financial analysis involves appraising and communicating the position, performance and
prospects of a business based on given and prepared statements and ratios.

K
The ability to review, analyses and interpret a set of financial statements is a key skill for

.L
a financial accountant. Analysis may involve any or all of the following:

1. Vertical or horizontal trend analysis

G
2. Common size analysis
3. Ratio analysis

IN
VERTICAL OR HORIZONTAL TREND ANALYSIS

T
Trend analysis involves comparing financial statements. Vertical trend analysis is

N
comparing the financial statements of one company from one year to the next. Horizontal
analysis is comparing the financial statements of one company with those of an
U
equivalent company in the same period.
O

This type of analysis involving comparisons has drawbacks:

a. The financial results of one year may be skewed by a significant event, making
comparison with another year less meaningful. For this reason, it is more useful
C

to perform vertical analysis over an extended period rather than just two years.
C

b. An 'equivalent company', ie a company of a similar size in the same industry may

A

be difficult to find, and if one is found, its results for a particular year may, again,
be skewed by a particular event.
E

COMMON SIZE ANALYSIS

N

Common size analysis again involves comparison – either of the same company in
LI

different periods or different companies in the same period.

In this case, however, comparison is not of the 'raw' numbers presented in the financial
N

statements.
O

Instead, a common base figure is adopted and amounts are expressed as a percentage of
this base number. These percentages are then compared. A common base figure when
analysing the statement of profit or loss is revenue.
 2019 % of revenue 2018 % of revenue
Revenue 100,000 90,000
Cost of sales (35,000) 35% (30,000) 33%
Gross profit 65,000 60,000
Distribution costs (20,000) 20% (16,000) 18%

K
Administrative expenses (20,000) 15% (21,000) 23%
Operating profit 30,000 23,000

.L
Finance costs (5,000) 5% (3,000) 3%
Profit before tax 25,000 20,000

G
Tax (5,000) 5.3% (4,000) 4%
Retained profit 20,000 16,000

IN
As the revenue in the company has increased, it follows that costs might increase.
Common size analysis helps to identify whether costs have increased proportionately.

T
Questions that might be asked as a result of performing this analysis are as follows.

N
a. Why has cost of sales increased as a proportion of revenue? Have selling prices
reduced while cost per unit remains the same or have costs increased?
U
b. Why have distribution costs increased as a proportion of revenue? Have costs such
as petrol increased or are proportionately more items being distributed (this
O

would be the case if prices have decreased)?

c. There is a significant drop in the proportion of revenue spent on admin expenses.
C

Is there a one-off item of income in 20X9 or was there a one-off expense in 20X8
that has caused the change? (d) Finance costs as a proportion of revenue have
C

increased; the company appears to have borrowed money in the year. This has
been employed in the business and resulted in increased revenue.
A

RATIO ANALYSIS
E

Ratio analysis involves using amounts from the financial statements to produce a ratio
N

and comparing it with the same ratio for any of:

 The same company in a different year
LI

 A different company in the same year

 Industry averages
N

Ratios can be grouped into five categories:

O

 Profitability
 Long-term solvency
 Short-term liquidity
 Efficiency (working capital ratios)
 Shareholders' investment ratios
 For each of the categories of ratio, we will identify a number of standard measures or
ratios that are normally calculated and generally accepted as meaningful indicators.

It must be stressed, however, that each individual business must be considered

separately, and a ratio that is meaningful for a manufacturing company may be

K
completely meaningless for a financial institution. Try not to be too mechanical when
working out ratios and constantly think about what you are trying to achieve.

.L
It is also important to remember that ratio analysis on its own is not sufficient for
interpreting company accounts, and that there are other items of information that should

G
be looked at, for example:

IN
a. The content of any accompanying commentary on the financial statements and
other numerical information provided
b. The age and nature of the company's assets

T
c. Current and future developments in the company's markets, at home and

N
overseas, recent acquisitions or disposals of a subsidiary by the company
d. Unusual items separately disclosed in the financial statements
U
e. Any other noticeable features of the report and accounts, such as events after the
end of the reporting period, contingent liabilities, a qualified auditors' report, the
O

company's taxation position, and so on.

ILLUSTRATIVE FINANCIAL STATEMENTS

C
C

To illustrate the calculation of ratios, the following statement of financial position and
statement of profit or loss figures will be used. We are using a separate statement of profit
A

or loss for this example, as no items of other comprehensive income are involved.
E

Pacific co statement of profit or loss for the year ended 31 December 2021
Notes 2021 2020
N

Revenue 1 3,095,576 1,909,051

Operating profit 1 359,501 244,229
LI

Interest 2 (17,371) ( 19,127)

Profit before taxation 342,130 225,102
N

Income tax expense (74,200) (31,272)

Profit for the year 267,930 193,830
O

Earnings per share 12.8 9.3

 Pacific co statement of financial position as at 31 December 2021
Notes 2021 2020
Assets
Non-current assets
Property, plant and equipment 802,180 656,071

K
Current assets
Inventory 64,422 86,550

.L
Receivables 3 1,002,701 853,441
Cash at bank and in hand 1,327 68,363

G
1,068,450 1,008,354

IN
Total assets 1,870,630 1,664,425

Equity and liabilities

T
Equity
Stated capital 258,178 258,178
Retained earnings N 651,721
909,899
410,591
668,769
U
Non-current liabilities
10% loan stock 100,000 100,000
O

Current liabilities 4 860,731 895,656

C

Total equity and liabilities 1,870,630 1,664,425

C

Notes to the accounts

A
E

1. 2021 2020
Sales revenue and profit
N

Sales revenue 3,095,576 1,909,051

Cost of sales (2,402,609) (1,441,950)
LI

Gross profit 692,967 467,101

Administration expenses (333,386) (222,872)
Operating profit 359,581 244,229
N

Depreciation charged 151,107 120,147

O
 2. 2021 2020
Interest
Payable on bank overdrafts and other loans 8,115 11,909
Payable on loan stock 10,000 10,000
18,115 21,909
Receivable on short-term deposits (744) (2,782)

K
Net payable 17,371 19,127

.L
3. 2021 2020
Receivables

G
Amounts falling due within one year
Trade receivables 905,679 807,712

IN
Prepayments and accrued income 97,022 45,729
1,002,701 853,441

T
4. 2021 2020
Current liabilities
Trade payables
Accruals and deferred income
N 627,018
81,279
545,340
280,464
U
Corporate income taxes 108,000 37,200
Other taxes 44,434 32,652
O

860,731 895,656
C

5. 2021 2020
Dividends paid 20,000 10,000
C
A

LIMITATIONS OF FINANCIAL ANALYSIS

E

There are a number of limitations of financial analysis, some of which are related to the
N

limitations of historical cost financial statements.

LI

 Different Accounting policies and practices

 Calculation of ratios
 Historical financial statements
N

 Window dressing
 Related party transactions
O

 Seasonality