Lesson 3 Financial Statement Analysis

LESSON 3 –
FINANCIAL STATEMENT
ANALYSIS
FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is the process of

analyzing a company’s financial statements for
decision-making purposes.
External stakeholders use it to understand the

overall health of an organization and to
evaluate financial performance and business
value.
Internal constituents use it as a monitoring tool

for managing the finances.
OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS
• To assess the overall performance of the business for a given period of time as a
basis for the owner or management in making present and future plans or decisions.
• The results of the analysis can thus be used to evaluate the performance of the
different managers.
• The analysis should be able to discover the strengths and weaknesses of the
business
• The analysis should be able to determine the LIQUIDITY, STABILITY, PROFITABILITY

AND EFFICIENCY of the business
ANALYZE VS. INTERPRET
• ANALYZE – the financial statement simply means to develop FINANCIAL RATIOS
• INTERPRET - means to explain the SIGNIFICANCE of the financial ratios developed.

Financial statement analysis is a critical tool for

assessing the financial health and performance
of companies.
It helps stakeholders make well-informed

decisions, whether they are considering
investments, extending credit, or managing a
business.
FINANCIAL STATEMENTS ANALYSIS
Here are the key components and steps involved in financial statement analysis:
1.Gather Financial Statements: Obtain the company's financial statements, including the balance
sheet, income statement, and cash flow statement. These documents provide a snapshot of the
company's financial position and performance over a specific period.
2.Study the Balance Sheet:

•Assess the company's assets, including current assets (e.g., cash, accounts receivable) and
long-term assets (e.g., property, plant, equipment).
•Examine liabilities, both current (e.g., accounts payable, short-term debt) and long-term (e.g.,
long-term debt, deferred taxes).
•Calculate and analyze key ratios like the current ratio (current assets/current liabilities) and
debt-to-equity ratio (total debt/shareholders' equity) to evaluate liquidity and leverage.
3.Analyze the Income Statement:

•Review revenue and sales figures to understand the company's revenue-generating activities.
•Examine the cost of goods sold (COGS) and operating expenses to assess cost
management.
•Calculate profitability ratios such as the gross profit margin (gross profit/revenue) and net
profit margin (net income/revenue).
•Look for trends and changes in revenue and expenses over multiple periods.
4.Evaluate the Cash Flow Statement:

•Analyze cash flow from operating activities to assess the company's ability to generate cash
from its core operations.
•Examine cash flow from investing activities (e.g., capital expenditures) and financing activities
(e.g., debt issuance, stock repurchases) to understand investment and financing decisions.
•Assess changes in cash and cash equivalents over time.
5.Calculate and Interpret Ratios:

•Use financial ratios to gain deeper insights into the company's financial health and
performance. Common ratios include:
•Return on Assets (ROA): Net income/total assets
•Return on Equity (ROE): Net income/shareholders' equity
•Earnings Per Share (EPS): Net income/number of outstanding shares
•Price-Earnings Ratio (P/E): Stock price/earnings per share
•Debt Ratio: Total debt/total assets
•Operating Cash Flow Ratio: Operating cash flow/total debt

6.Compare to Industry Benchmarks: Compare the company's financial ratios and performance metrics to
industry averages and competitors to identify strengths, weaknesses, and areas for improvement.
7.Assess Financial Health and Risk: Evaluate the company's financial health by considering factors such as
liquidity, solvency, profitability, and operational efficiency. Identify potential financial risks and vulnerabilities.
8.Identify Trends and Anomalies: Look for trends and anomalies in the financial statements. For example,
sudden spikes in debt levels, declining profit margins, or inconsistent cash flow patterns may warrant further
investigation.
9.Consider Non-Financial Factors: While financial statement analysis primarily focuses on numbers, it's
important to consider non-financial factors such as industry trends, competitive positioning, management
quality, and market conditions that may impact the company's financial performance.
10.Prepare a Report or Recommendation: Summarize your findings and provide recommendations or

conclusions based on the analysis. This report can be used by investors, creditors, or internal management to
make informed decisions.
FINACIAL STATEMENT ANALYSIS
FINANCIAL RATIO
• FINANCIAL RATIO - is the ratio of one item in

the financial statement to another item in the
same financial statement
KINDS OF FINANCIAL RATIOS
• INCOME STATEMENT RATIO – the ratio of one item in the Income Statement to
another item in the same Income Statement.
e.g. RETURN ON SALES = Net Income / Net Sales

the ratio of net income to net sales
• BALANCE SHEET RATIO – the ratio of

one item in the Balance Sheet to
another item in the same Balance Sheet.
e.g. CURRENT RATIO = Total Current

Assets / Total Current Liabilities
the ratio of total current assets to
total current liabilities
• INTER-STATEMENT RATIO – the ratio of one item in the Income Statement to another
item in the Balance Sheet.
e.g. ACCOUNTS RECEIVABLE TURNOVER = Net Credit Sales / Average Accounts

Receivable*
* The Balance Sheet item must be the average of the beginning and ending balances
• TREND RATIO – the ratio of

one item to the same item of
different periods
e.g. Ratio of sales this year to

the sales last year
RATIO ANALYSIS
USES OF THE RATIO ANALYSIS
• COMPARISONS
• One of the uses of ratio analysis is to compare a company’s financial performance to

similar firms in the industry to understand the company’s position in the market.
• Obtaining financial ratios, such as Price/Earnings, from known competitors and

comparing them to the company’s ratios can help management identify market gaps
and examine its competitive advantages, strengths, and weaknesses.
• The management can then use the information to formulate decisions that aim to
improve the company’s position in the market.
• TREND LINE
Companies can also use ratios to see if there is a trend in financial performance.
Established companies collect data from financial statements over a large number of
reporting periods.
The trend obtained can be used to predict the direction of future financial performance,
and also identify any expected financial turbulence that would not be possible to predict
using ratios for a single reporting period.
• OPERATIONAL EFFICIENCY
• The management of a company can also use financial ratio analysis to determine the
degree of efficiency in the management of assets and liabilities.
• Inefficient use of assets such as motor vehicles, land, and buildings results in
unnecessary expenses that ought to be eliminated.
• Financial ratios can also help to determine if the financial resources are over- or
under-utilized.
FINANCIAL RATIOS
FINANCIAL RATIOS
FINANCIAL RATIOS
FINANCIAL RATIOS
FINANCIAL RATIOS
FINANCIAL RATIOS

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LESSON 3 –

Financial statement analysis is the process of

External stakeholders use it to understand the

Internal constituents use it as a monitoring tool

• The analysis should be able to determine the LIQUIDITY, STABILITY, PROFITABILITY

• ANALYZE – the financial statement simply means to develop FINANCIAL RATIOS

• INTERPRET - means to explain the SIGNIFICANCE of the financial ratios developed.

Financial statement analysis is a critical tool for

It helps stakeholders make well-informed

2.Study the Balance Sheet:

3.Analyze the Income Statement:

4.Evaluate the Cash Flow Statement:

5.Calculate and Interpret Ratios:

•Return on Assets (ROA): Net income/total assets

•Return on Equity (ROE): Net income/shareholders' equity

•Earnings Per Share (EPS): Net income/number of outstanding shares

•Price-Earnings Ratio (P/E): Stock price/earnings per share

•Debt Ratio: Total debt/total assets

•Operating Cash Flow Ratio: Operating cash flow/total debt

10.Prepare a Report or Recommendation: Summarize your findings and provide recommendations or

• FINANCIAL RATIO - is the ratio of one item in

e.g. RETURN ON SALES = Net Income / Net Sales

• BALANCE SHEET RATIO – the ratio of

e.g. CURRENT RATIO = Total Current

e.g. ACCOUNTS RECEIVABLE TURNOVER = Net Credit Sales / Average Accounts

• TREND RATIO – the ratio of

e.g. Ratio of sales this year to

• One of the uses of ratio analysis is to compare a company’s financial performance to

• Obtaining financial ratios, such as Price/Earnings, from known competitors and

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