ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Financial Statement Analysis

What is financial statement analysis?

Tearing apart the financial statements and looking at the relationships

Financial Statement Analysis

Who analyzes financial statements?
Internal users (i.e., management) External users (emphasis of chapter)
Examples? Investors, creditors, regulatory agencies & stock market analysts and auditors

Financial Statement Analysis

What do internal users use it for?
Planning, evaluating and controlling company operations

What do external users use it for?

Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

Financial Statement Analysis

Information is available from
Published annual reports
(1) (2) (3) (4) (5) Financial statements Notes to financial statements Letters to stockholders Auditors report (Independent accountants) Managements discussion and analysis

Reports filed with the government

Tax Returns Filings with the regulators ( SEBI(India), SEC(US), MAS(Singapore) etc

Financial Statement Analysis

Information is available from
Other sources
(1) Newspapers (e.g., Economic Times, Financial Express(India), Wall Street Journal(US), Financial Times(UK)) (2) Periodicals (e.g. Capital Market, Fortune etc) (3) Financial information organizations such as: CRISIL, CARE, ICRA, Moodys, Standard & Poors, Dun & Bradstreet, Inc., and Robert Morris Associates, CRISIL. (4) Other business publications

Methods of Financial Statement Analysis

Horizontal Analysis Vertical Analysis Common-Size Statements Trend Percentages Ratio Analysis

Horizontal Analysis
Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next

Vertical Analysis
For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

Common-Size Statements
Financial statements that show only percentages and no absolute dollar amounts

Trend Percentages
Show changes over time in given financial statement items (can help evaluate financial information of several years)

Ratio Analysis
Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

Horizontal Analysis Example

The management of Amalgamated Company provides you with comparative balance sheets of the years ended March 31, 2009 and 2008. Management asks you to prepare a horizontal analysis on the information.

AMALGAMATED CORPORATION Comparative Balance Sheets March 31, 2009 and 2008

2009 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets 40,000 120,000 160,000 INR 12,000 60,000 80,000 3,000 155,000

2008

Inc A

INR 23,500 40,000 100,000 1,200 164,700 40,000 85,000 125,000

INR 315,000 INR 289,700

Horizontal Analysis Example

Calculating Change in Dollar Amounts
Dollar Change = Current Year Figure Base Year Figure

Horizontal Analysis Example

Calculating Change in INRmounts
Dollar Change = Current Year Figure Base Year Figure

Since we are measuring the amount of the change between 2008 and 2009, the INR amounts for 2008 become the base year figures.

Horizontal Analysis Example

Calculating Change as a Percentage
Percentage Change = Dollar Change Base Year Figure

100%

Horizontal Analysis Example

AMALGAMATED CORPORATION Comparative Balance Sheets March 31, 2009 and 2008 2009 Assets Current assets: Cash INR 12,000 INR 23,500 INR (11,500) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 INR12,000155,000 INR23,500 = 164,700 INR(11,500) Total current assets Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets INR 315,000 INR 289,700 2008 Increase (Decrease) Amount %

Horizontal Analysis Example

AMALGAMATED CORPORATION Comparative Balance Sheets March 31, 2009 and 2008 2009 Assets Current assets: Cash INR 12,000 INR 23,500 INR (11,500) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 (INR11,500 INR23,500) 100% = 48.9% Total current assets 155,000 164,700 Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets INR 315,000 INR 289,700 (48.9) 2008 Increase (Decrease) Amount %

Horizontal Analysis Example

AMALGAMATED CORPORATION Comparative Balance Sheets March 31, 2009 and 2008 2009 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets INR 12,000 INR 23,500 60,000 40,000 80,000 100,000 3,000 1,200 155,000 164,700 (INR 11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 INR 25,300 (48.9) 50.0 (20.0) 150.0 (5.9) 0.0 41.2 28.0 8.7 2008 Increase (Decrease) Amount %

40,000 40,000 120,000 85,000 160,000 125,000 INR 315,000 INR 289,700

Horizontal Analysis Example

Lets apply the same procedures to the liability and stockholders equity sections of the balance sheet.

AMALGAMATED CORPORATION Comparative Balance Sheets March 31, 2009 and 2008 2009 Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable Total current liabilities Long-term liabilities: Bonds payable, 8% Total liabilities Stockholders' equity: Preferred stock Common stock Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity 2008 Increase (Decrease) Amount %

INR 67,000 3,000 70,000 75,000 145,000 20,000 60,000 10,000 90,000 80,000 170,000 INR 315,000

INR 44,000 6,000 50,000 80,000 130,000 20,000 60,000 10,000 90,000 69,700 159,700 INR 289,700

INR 23,000 (3,000) 20,000 (5,000) 15,000 10,300 10,300 INR 25,300

52.3 (50.0) 40.0 (6.3) 11.5 0.0 0.0 0.0 0.0 14.8 6.4 8.7

Horizontal Analysis Example

Now, lets apply the procedures to the income statement.

AMALAGAMATED CORPORATION Comparative Income Statements For the Years Ended March 31, 2009 and 2008 Increase (Decrease) 2009 2008 Amount % Net sales INR 520,000 INR 480,000 INR 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 128,600 126,000 2,600 2.1 Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income INR 17,500 INR 22,400 (INR 4,900) (21.9)

AMALAGAMATED CORPORATION Comparative Income Statements For the Years Ended March 31, 2009 and 2008 Increase (Decrease) 2009 2008 Amount % Net sales INR 520,000 INR 480,000 INR 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 126,000 2.1 Sales increased by 8.3% 128,600 income decreased by 2,600 while net Net operating21.9%. income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income INR 17,500 INR 22,400 (INR 4,900) (21.9)

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

AMALAGAMATED CORPORATION Comparative Income Statements For the Years Ended March 31, 2009 and 2008 Increase (Decrease) 2009 2008 Amount % Net sales INR 520,000 INR 480,000 INR 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 128,600 126,000 2,600 2.1 Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income INR 17,500 INR 22,400 (INR 4,900) (21.9)