Financial Statement Analysis - Business Finance - ثاني ثانوي

Link to digeste 3.5 Financial Statement Analysis www.ren.edu.sa Key Terms Vertical analysis Horizontal analysis Activity ratios Leverage ratios Coverage ratios Ratio analysis Profitability ratios Liquidity ratios Time series analysis Cross-sectional analysis Vertical andylis A method for analyzing accounting data by reading down a single column in a financial statement and determining how each individual line items in the statement relates to anothai base figure in the report Accounting data are often used to analyze a firm's financial condition. Such analysis may be conducted by creditors to measure the safety of their loans. Investors also analyze financial statements to learn how well management is performing. The profitability of the firm may be perceived in the financial statements. In addition, management analyzes the data in financial statements to identify weaknesses in the firm, which, if corrected, may increase the firm's profitability and value. You can easily download financial statements for publicly traded companies from the Internet. However, once you have them, how do you go about analyzing a set of accounting documents? Typically, professionals will follow one of two common methods to analyze a company's financial statements: vertical and horizontal analysis, and ratio analysis. Vertical and horizontal analysis are two related, but different, techniques used to analyze financial statements. They each refer to the way in which a financial statement is read, and the comparisons that an analyst can draw from the reported values. Both types of analysis are critical to gaining an accurate understanding of the information provided in a financial statement. 3.5a Vertical Analysis Vertical analysis is the process of reading down a single column in a financial statement and determining how each individual line item in the statement relates to another base figure in the report. For example, in an income statement, each line item might be listed as a percentage of gross sales and line items on a balance sheet may be shown as a percentage of total assets (see Figure 3.9). L,102.」「yt 192 Business Finance

Hent Men's FIGURE 3.9 Vertical Analysis of Enancial Statuent Read down a single column in a financial statement and determine how each individual line item in the statement relates to the base figure 3.5b Horizontal Analysis Horizontal analysis, on the other hand, refers to the process of comparing current financial data to previous reporting periods. Horizontal analysis can either use absolute comparisons or percentage comparisons, where the numbers in each succeeding period are expressed as a percentage of the amount in the baseline year (see Figure 3.10). Reading a financial statement in this way shows how different financial metrics have changed over time. For example, have liabilities increased or decreased from Q1 to Q4? A method for evaluating accouiumy data by comparing current financial data to previous reporting periods new 1 It 2 Be 3 5 Compare the data of each item in different periods in relation to the base period, in this case Year 1 compared with Year 2 FIGURE 3.10 Horizontal Analysis of Emanual Statement 3.5c Ratio Analysis of Financial Statements Ratio analysis compares different line items from the financial statements, but neither reads them horizontally nor vertically. Instead, multiple line items may be combined and expressed as a ratio, the relationship between the two quantities-normally expressed as the quotient of one divided by the other. Ratio analysis The process of evaluating elements of a inancial report as they relate to other pièces of information in the same report وزارة التعليدر CHAPTER Analysis of Financial Statements 103

. FIGURE 3.11 Types of Ralio Analysis There are many different ratios which can help you gain insight into the health of a company. These ratios are generally broken into broad categories including: profitability ratios, liquidity ratios, and activity ratios, as illustrated in Figure 3.11. Liquility Activity refix Profitability ratios Leverage Ta Coverage retlos Operating Petworth T margin Profitability ratios Atim's ability to generate earnings relative to its revenue operating costs assets. ur equity over time Ly A company's ability to pay of? current debt obligations without securing external capital Activity ratios An indicator of hw well a company is using its resources to generate revenues and cash Leverage rates An indicator of the extent to which a firm's operations are funded by debt Coverage ratios The ability of the firm to service interest or vividend payments Profitability ratios assess a business's ability to generate earnings relative to its revenue, operating costs, assets, or equity over time. Some important profitability ratios include gross profit ratio, return on equity, break-even point, and return on net assets. Liquidity ratios provide perspective on a company's ability to pay off current debt obligations without needing to secure external capital. Liquidity is the ability to convert assets into cash quickly and is an important part of a company's ability to stay in business. Some important liquidity ratios include cash coverage ratio, current ratio, and liquidity index. Activity ratios indicate how well a company is using its resources to generate revenues and cash. Some important activity ratios include accounts payable turnover rate, accounts receivable turnover rate, inventory turnover rate, and working capital turnover rate. Laverage ratios show how dependent a company is on debt to maintain its operations. These ratios also assess the ability of the firm to meet its financial obligations. Some important leverage ratios include debt to equity ratio, debt service coverage ratio, and fixed charge coverage. Coverage ratios show the ability of the firm to service interest or dividend payments. An important coverage ratio is the times interest-earned ratio. 104 Business Finance

rities mar 3.5d Time Series and Cross-Sectional Analysis These ratios may be computed and interpreted from two viewpoints known as time series analysis and cross-sectional analysis, as follows: • In time series analysis or trend analysis the ratios are compiled for a period of years to perceive trends. • In cross-sectional analysis the ratios may be computed at the same time for several firms within an industry. Time series and cross-sectional analysis may be used together. Rarely will. all the ratios indicate the same general tendency. When taken as a group, the ratios should give you an indication of the direction in which the firm is moving and how it compares with other firms in its industry. Time sanelyse Evaluation of a firm financial performance over a penod of time Goxcommonal analys An evaluation of data about several Fims in the same industry at a point in time 99 How can time series and cross-sectional data help analysts understand a company's performance? واة التعليم 105

Pl F 196 Business Finance 3.5e The Value of Ratios as a Tool for Analysis Analysis of financial statements through ratios can be an invaluable tool for managers, investors, and creditors to establish how a firm is performing over time and relative to its competition. Some of the benefits of ratio analysis are as follows: Ratios can indicate trends, such as a deterioration in the firm's profitability, enabling management to take action to prevent or minimize future difficulties. • Ratios can be used to analyze performance of a firm compared to other companies within the same industry. (To make such comparisons, you must have access to industry averages or benchmarks, which can be sourced from Bloomberg, Thomson Reuters, or other data providers.) ■ By calculating their own ratios, financial analysts and creditors can choose the ratios most applicable to the intended use of the analysis, rather than relying on less relevant data provided by other sources. This final point is important. The following points highlight the challenges associated with ratio analysis when using data from published sources: Published industry averages may be based on the prior year's financial statements, reducing comparability of the data with current-year financial ratios. ⚫ The individual firm may not fit neatly into one of the industry categories. Large firms, such as Savola Group, have operations in a variety of related fields (for example, drinks and foods), which reduces the comparability of ratios for similar, but not identical, firms (for example, Al Jomaih Bottling Plants, which operates in the beverages sector). ⚫ Even if industry averages are presented for firms in comparable industries. the challenge of comparing firms of different sizes remains (for example, comparing the local grocery store with a large supermarket chain). Despite these challenges associated with its application, ratio analysis. remains a convenient way to analyze a firm's financial condition, particularly when combined with other financial analysis tools.

Why is it useful to be able to understan how well a company is performing? In the sections that follow, several ratios are discussed and illustrated. These ratios do not exhaust all the possible ratios. The purpose of this chapter is only to illustrate how ratios are compiled, interpreted, and used, employing the balance sheet as of the end of the 20X1 fiscal year (Figure 3.5), and income statement for the 20X1 fiscal year (Figure 3.7). You also need to be forewarned that a ratio can have more than one definition. The definition used by one analyst may differ from that used by another. You cannot assume that the analysis obtained from one source is comparable to that provided by an alternative source. Why is it useful to be able to understand how well a company is performing? وزارة التعليم CHAPTER Analysis of Financial Statements 107