financial reporting &

analysis

Professor:
Abla Talbi El Alami
fin 3307
1)financial analysis
steps
steps in financial statement analysis.

Phase
1. Articulate the Purpose and Context of the Analysis

2. Collect Data

3. Process Data

4. Analyze/Interpret the Processed Data

5. Develop and Communicate Conclusions and Recommendations

6. Follow-Up

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Articulate the Purpose and Context of the Analysis.

● Purpose of analysis: evaluate the historical performance of a company (trend and cross
sectional), prepare a forecast of future performance, value a company’s equity or debt
securities, prepare rating or recommendation
● Define the context
○ Intended audience
○ End product
○ Time frame
○ Resources and resource constraints
● Based on purpose and context, formulate questions to be answered

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Collect data, Process data, Analyze data.

● Collect data required to answer questions.

● Use analytical tools to process data:
○ Ratio analysis
○ Common-size financial statements
● Analyze data:
○ Use financial ratios to assess a company’s profitability, liquidity, leverage, and efficiency relative to
its own past (trend analysis) and relative to peer/benchmark companies.
○ Synthesize all available information to develop expectations about a company’s likely future
performance.
○ Develop forecasts and use as input to valuation.

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Develop and Communicate Conclusions and
Recommendations.
● Communicate the conclusion or recommendation in an appropriate format.
● Appropriate format will vary by analytical task, by institution, and/or by audience.
● An equity analyst’s report would typically include the following components:
○ Summary and investment conclusion
○ Earnings projections
○ Valuation
○ Business summary
○ Risk, industry, and competitive analysis
○ Historical performance
○ Forecasts

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follow up.

● If an equity investment is made or a credit rating is assigned, periodic review is required to

determine whether the original conclusions and recommendations are still valid.

● Follow-up may involve repeating all the previous steps in the process on a periodic basis.

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2) financial analysis
introductions.
Financial analysis is a process of selecting, evaluating, and interpreting financial data, along with
other pertinent information, in order to formulate an assessment of a company’s present and
future financial condition and performance.

Financial
Market Data Disclosures

Economic
Data

Financial Analysis

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common-size analysis.
● Common-size analysis is the restatement of financial statement information in a standardized
form.
○ Horizontal common-size analysis uses the amounts in accounts in a specified year as the
base, and subsequent years’ amounts are stated as a percentage of the base value.
■Useful when comparing growth of different accounts over time.
○ Vertical common-size analysis uses the aggregate value in a financial statement for a given
year as the base, and each account’s amount is restated as a percentage of the aggregate.
■Balance sheet: Aggregate amount is total assets.
■Income statement: Aggregate amount is revenues or sales.

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common-size analysis.
example.
Consider the CS Company, which reports the following financial information:

Year 2008 2009 2010 2011 2012 2013

Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40
Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65
Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57
Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29
Intangibles 400.00 402.00 404.01 406.03 408.06 410.10
Total assets $6,500.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54

1. Create the vertical common-size analysis for the CS Company’s assets.

2. Create the horizontal common-size analysis for CS Company’s assets, using 2008 as the base year.

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common-size analysis.
example - vertical common-size analysis.
Year 2008 2009 2010 2011 2012 2013
Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%

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common-size analysis.
example - horizontal common-size analysis.
Year 2008 2009 2010 2011 2012 2013
Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%
Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%
Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%
Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%
Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%
Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%

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financial ratio analysis.
● Financial ratio analysis is the use of relationships among financial statement accounts to gauge
the financial condition and performance of a company.
● We can classify ratios based on the type of information the ratio provides:

Activity Ratios Liquidity Ratios Solvency Ratios Profitability Ratios

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financial ratio analysis.
● Financial ratio analysis is the use of relationships among financial statement accounts to gauge
the financial condition and performance of a company.
● We can classify ratios based on the type of information the ratio provides:

Activity Ratios Liquidity Ratios Solvency Ratios Profitability Ratios

Ability to
Effectiveness in Ability to meet
manage
putting its asset short-term, Ability to satisfy
expenses to
investment to immediate debt obligations.
produce profits
use. obligations.
from sales. 15

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activity ratios.
● Turnover ratios reflect the number of times assets flow into and out of the company during the
period.
● A turnover is a gauge of the efficiency of putting assets to work.
● Ratios:

How many times inventory is created

and sold during the period. denominator is the
investment that is
How many times accounts receivable being put to work
are created and collected during the
period.

The extent to which total assets create numerator is the

revenues during the period. result of that effort.
The efficiency of putting working
capital to work (WC= CA - CL)

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activity ratios.
example.
Consider the CS Company, which reports the following financial information:
Year 2008 2009 2010 2011 2012 2013
Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40
Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65
Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57
Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29
Intangibles 400.00 402.00 404.01 406.03 408.06 410.10
Total assets $6,500.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54

1. Assuming your revenue and CoS is as follows, calculate inventory turnover, receivable turnover, and total
assets turnover for the years 2009 and 2010?
Year 2008 2009 2010 2011 2012 2013
Revenue $1300.00 $1320.00 $1390.00 $1420,00 $1450,00 $1480,40
CoS 845.00 875.40 930.22 965.51 986.30 1,021.65

2. Assume the company’s current liabilities for the year 2008 are 2200, and for the year 2009 are 2100,
calculate the firm’s working capital turnover for both years.
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activity ratios considerations.
● Turnover ratios reflect the number of times assets flow into and out of the company during the
period.
● A turnover is a gauge of the efficiency of putting assets to work.
● Ratios:

how many times per period is inventory created and sold. If

converted into days (period days/RT) → the company created and
sold its inventory every x days per year

how many times per period are receivables collected. If converted

into days (period days/RT) → how many days on avg. do clients take
to pay (important to compare historically)

For every dollar in assets, the company generates x dollars in sales

→ the higher the better (i.e. company generates more sales in 1
dollar of assets)

For every dollar in WC, the company generates x dollars in sales.

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operating cycle components.
● The operating cycle is the length of time from when a company makes an investment in goods
and services to the time it collects cash from its accounts receivable.
● The net operating cycle is the length of time from when a company makes an investment in
goods and services, considering the company makes some of its purchases on credit, to the
time it collects cash from its accounts receivable.
● The length of the operating cycle and net operating cycle provides information on the
company’s need for liquidity: The longer the operating cycle, the greater the need for liquidity.

Number of Days of
Inventory Number of Days of Receivables

| | | |

Buy Inventory on Credit Pay Accounts Sell Inventory on Credit Collect Accounts
Payable Receivable

Number of Days of Payables Net Operating Cycle

Operating Cycle 19
operating cycle formulas.

Average time it takes

to create and sell
inventory.

Average time it takes

to collect on
accounts receivable.

Average time it takes

to pay suppliers.

total Cost of sales

/ Average accounts payable

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operating cycle formulas.

Time from investment in

inventory to collection of
accounts.

Time from investment in

inventory to collection of
accounts, considering the use
of trade credit in purchases.

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liquidity.
● Liquidity is the ability to satisfy the company’s short-term obligations using assets that can be
most readily converted into cash.
● Liquidity ratios:

Ability to satisfy current liabilities

using current assets.
if >1 company could pay
Ability to satisfy current liabilities Current Liabilities without
using the most liquid of current leveraging other types of
assets. assets (not included in
formula).
Ability to satisfy current liabilities
using only cash and cash equivalents.

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activity & liquidity ratios.
example.

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activity & liquidity ratios.
example.

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solvency analysis.
● A company’s business risk is determined, in
large part, from the company’s line of business. Risk
● Financial risk is the risk resulting from a
company’s choice of how to finance the
business using debt or equity. Business Risk Financial Risk
● We use solvency ratios to assess a company’s
financial risk.
● There are two types of solvency ratios: Sales Risk
component percentages and coverage ratios.
○ Component percentages involve comparing

the elements in the capital structure.

○ Coverage ratios measure the ability to meet
Operating Risk
interest and other fixed financing costs.

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solvency ratios.
Proportion of assets financed with debt. Increases and
decreases → greater or lesser reliance on debt in CS.
Component-Percentage
Solvency Ratios

Proportion of assets financed with long-term debt. -> x

dollar of LT debt for every dollar of asset

Debt financing relative to equity financing.

Reliance on debt financing. The smaller debt, the smaller

the ratio
Ability to satisfy interest obligations. The lower the ratio,
the more likely the to difficulty meet debt payments.
coverage ratios

Ability to satisfy interest and lease obligations.

Ability to satisfy interest obligations with cash flows.

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profitability.
● Margins and return ratios provide information on the profitability of a company and the
efficiency of the company.
● A margin is a portion of revenues that is a profit.
● A return is a comparison of a profit with the investment necessary to generate the profit.

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profitability ratios.
margins.
● Each margin ratio compares a measure of income with total revenues:

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profitability ratios.
returns.
● Return ratios compare a measure of profit with the investment that produces the profit:

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relationship between ratios.
example.

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relationship between ratios.
example.

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The DuPont formula.
Return on Equity

● The DuPont formula uses the relationship

among financial statement accounts to Net Profit Total Asset Financial
decompose a return into components. Margin Turnover Leverage
● Three-factor DuPont for the return on equity:
○ Total asset turnover
Operating Profit
○ Financial leverage Margin
○ Net profit margin
● Five-factor DuPont for the return on equity:
○ Total asset turnover
Effect of Non-
operating
○ Financial leverage
Items
○ Operating profit margin
○ Effect of nonoperating items
Tax
○ Tax effect
Effect
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The DuPont formula.
5-component model.

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The DuPont formula.
example.
Suppose that an analyst has noticed that the return on equity of the D
Company has declined from FY2012 to FY2013. Using the DuPont formula,
explain the source of this decline.
(millions) 2013 2012
Revenues $1,000 $900
Earnings before interest and taxes $400 $380
Interest expense $30 $30
Taxes $100 $90

Total assets $2,000 $2,000

Shareholders’ equity $1,250 $1,000

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The DuPont formula.
example.
2013 2012
Return on equity 0.20 0.22
Return on assets 0.13 0.11

Financial leverage 1.60 2.00

Total asset turnover 0.50 0.45
Net profit margin 0.25 0.24
Operating profit margin 0.40 0.42

Effect of nonoperating items 0.83 0.82

Tax effect 0.76 0.71

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other ratios.
● Earnings per share is net income, restated on a per share basis:

● "Earnings per share = " "Net income available to common shareholders" /"Number of
common shares outstanding"

● Basic earnings per share is net income after preferred dividends, divided by the average
number of common shares outstanding.
● Diluted earnings per share is net income minus preferred dividends, divided by the number of
shares outstanding considering all dilutive securities.
● Book value per share is book value of equity divided by number of shares.
● Price-to-earnings ratio (PE or P/E) is the ratio of the price per share of equity to the earnings
per share.
● If earnings are the last four quarters, it is the trailing P/E.

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other ratios.
● Measures of Dividend Payment:

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Shareholder ratios.
example.
Calculate the book value per share, P/E, dividends per share, dividend payout, and
plowback ratio based on the following financial information:
Book value of equity $100 million
Market value of equity $500 million
Net income $30 million
Dividends $12 million
Number of shares 100 million

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Shareholder ratios.
example.
There is $1 of equity, per the books, for every share of
Book value per share $1.00
stock.
The market price of the stock is 16.67 times earnings
P/E 16.67
per share.

Dividends per share $0.12 The dividends paid per share of stock.

The proportion of earnings paid out in the form of

Dividend payout ratio 40%
dividends.

Plowback ratio 60% The proportion of earnings retained by the company.

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effective use of ratio analysis.
● In addition to ratios, an analyst should describe the company (e.g., line of business, major
products, major suppliers), industry information, and major factors or influences.
● Effective use of ratios requires looking at ratios
○ Over time.
○ Compared with other companies in the same line of business.
○ In the context of major events in the company (for example, mergers or divestitures),
accounting changes, and changes in the company’s product mix.

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pro forma analysis.
● Estimate typical relation between revenues and sales-driven accounts.

● Estimate fixed burdens, such as interest and taxes.

● Forecast revenues.

● Estimate sales-driven accounts based on forecasted revenues.

● Estimate fixed burdens.

● Construct future period income statement and balance sheet.

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pro forma income statement.
Imaginaire Company Income Statement (in millions)
One Year
Year 0 Ahead
Sales revenues €1,000.0 €1,050.0 ⇦ Growth at 5%
Cost of goods sold 600.0 630.0 ⇦ 60% of revenues
Gross profit €400.0 €420.0 ⇦ Revenues less COGS
SG&A 100.0 105.0 ⇦ 10% of revenues
Operating income €300.0 €315.0 ⇦ Gross profit less operating exp.
Interest expense 32.0 33.6 ⇦ 8% of long-term debt
Earnings before taxes €268.0 €281.4 ⇦ Operating income less interest exp.
Taxes 93.8 98.5 ⇦ 35% of earnings before taxes
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Net income €174.2 €182.9 ⇦ Earnings before taxes less taxes
Dividends €87.1 €91.5 ⇦ Dividend payout ratio of 50%

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pro forma balance sheet.

Imaginaire Company Balance Sheet, End of Year (in millions)

One Year
Year 0 Ahead
Current assets €600.0 €630.0 ⇦ 60% of revenues
Net plant and equipment 1,000.0 1,050.0 ⇦ 100% of revenues
Total assets €1,600.0 €1,680.0

Current liabilities €250.0 €262.5 ⇦ 25% of revenues

Long-term debt 400.0 420.0 ⇦ Debt increased by €20 million to
maintain the same capital structure
Common stock and paid-in capital 25.0 25.0 ⇦ Assume no change
Treasury stock (44.0) ⇦ Repurchased shares
Retained earnings 925.0 1,016.5 ⇦ Retained earnings in Year 0, plus net
income, less dividends
Total liabilities and equity €1,600.0 €1,680.0
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summary.
➔ Financial ratio analysis and common-size analysis help gauge the financial performance and
condition of a company through an examination of relationships among these many financial items.
➔ A thorough financial analysis of a company requires examining its efficiency in putting its assets to
work, its liquidity position, its solvency, and its profitability.
➔ We can use the tools of common-size analysis and financial ratio analysis, including the DuPont
model, to help understand where a company has been.
➔ We then use relationships among financial statement accounts in pro forma analysis, forecasting
the company’s income statements and balance sheets for future periods, to see how the company’s
performance is likely to evolve.

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