Financial statement

analysis
• What Is 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 as well as to evaluate financial
performance and business value. Internal
constituents use it as a monitoring tool for
managing the finances.
• Analyzing Financial Statements
• The financial statements of a company record important financial data on
every aspect of a business’s activities. As such they can be evaluated on the
basis of past, current, and projected performance.
• In general, financial statements are centered around generally accepted
accounting principles (GAAP) in the U.S. These principles require a company
to create and maintain three main financial statements: the balance sheet,
the income statement, and the cash flow statement. Public companies have
stricter standards for financial statement reporting. Public companies must
follow GAAP standards which requires accrual accounting. Private
companies have greater flexibility in their financial statement preparation
and also have the option to use either accrual or cash accounting.
• Several techniques are commonly used as part of
financial statement analysis. Three of the most
important techniques include horizontal analysis,
vertical analysis, and ratio analysis. Horizontal
analysis compares data horizontally, by analyzing
values of line items across two or more years.
Vertical analysis looks at the vertical affects line
items have on other parts of the business and also
the business’s proportions. Ratio analysis uses
important ratio metrics to calculate statistical
relationships.
• Financial Statements
• As mentioned, there are three main financial
statements that every company creates and
monitors: the balance sheet, income statement,
and cash flow statement. Companies use these
financial statements to manage the operations of
their business and also to provide reporting
transparency to their stakeholders. All three
statements are interconnected and create different
views of a company’s activities and performance.
BALANCE SHEET

• The balance sheet is a report of a company's financial worth in

terms of book value. It is broken into three parts to include a
company’s assets, liabilities, and shareholders' equity. Short-term
assets such as cash and accounts receivable can tell a lot about a
company’s operational efficiency. Liabilities include its expense
arrangements and the debt capital it is paying off. Shareholder’s
equity includes details on equity capital investments and retained
earnings from periodic net income. The balance sheet must
balance with assets minus liabilities equaling shareholder’s
equity. The resulting shareholder’s equity is considered a
company’s book value. This value is an important performance
metric that increases or decreases with the financial activities of a
company.
INCOME STATEMENT
• The income statement breaks down the revenue a company earns
against the expenses involved in its business to provide a bottom line,
net income profit or loss. The income statement is broken into three
parts which help to analyze business efficiency at three different points.
It begins with revenue and the direct costs associated with revenue to
identify gross profit. It then moves to operating profit which subtracts
indirect expenses such as marketing costs, general costs, and
depreciation. Finally it ends with net profit which deducts interest and
taxes.
• Basic analysis of the income statement usually involves the calculation
of gross profit margin, operating profit margin, and net profit margin
which each divide profit by revenue. Profit margin helps to show where
company costs are low or high at different points of the operations.
CASH FLOW STATEMENT
• The cash flow statement provides an overview of the
company's cash flows from operating activities,
investing activities, and financing activities. Net
income is carried over to the cash flow statement
where it is included as the top line item for operating
activities. Like its title, investing activities include
cash flows involved with firmwide investments. The
financing activities section includes cash flow from
both debt and equity financing. The bottom line
shows how much cash a company has available.
Free Cash Flow and Other Valuation Statements

• Companies and analysts also use free cash flow

statements and other valuation statements to
analyze the value of a company. Free cash flow
statements arrive at a net present value by
discounting the free cash flow a company is
estimated to generate over time. Private companies
may keep a valuation statement as they progress
toward potentially going public.
• KEY TAKEAWAYS
• Financial statement analysis is used by internal and
external stakeholders to evaluate business performance
and value.
• Financial accounting calls for all companies to create a
balance sheet, income statement, and cash flow
statement which form the basis for financial statement
analysis.
• Horizontal, vertical, and ratio analysis are three
techniques analysts use when analyzing financial
statements.
FINANCIAL PERFORMANCE
• Financial statements are maintained by companies
daily and used internally for business management.
In general both internal and external stakeholders
use the same corporate finance methodologies for
maintaining business activities and evaluating
overall financial performance.
• When doing comprehensive financial statement
analysis, analysts typically use multiple years of
data to facilitate horizontal analysis. Each financial
statement is also analyzed with vertical analysis to
understand how different categories of the
statement are influencing results. Finally ratio
analysis can be used to isolate some performance
metrics in each statement and also bring together
data points across statements collectively.
• Below is a breakdown of some of the most
common ratio metrics:
• Balance sheet: asset turnover, quick ratio,
receivables turnover, days to sales, debt to assets,
and debt to equity
• Income statement: gross profit margin, operating
profit margin, net profit margin, tax ratio efficiency,
and interest coverage
• Cash Flow: Cash and earnings before interest, taxes,
depreciation, and amortization (EBITDA). These
metrics may be shown on a per share basis.
• Comprehensive: Return on assets (ROA) and return
on equity (ROE). Also DuPont Analysis.
• What Is Return on Assets—ROA?
• Return on assets (ROA) is an indicator of how
profitable a company is relative to its total assets.
ROA gives a manager, investor, or analyst an idea as
to how efficient a company's management is at
using its assets to generate earnings. Return on
assets is displayed as a percentage.
• The Basics of Return on Assets—ROA
• Businesses (at least the ones that survive) are
ultimately about efficiency: squeezing the most out
of limited resources. Comparing profits to revenue
is a useful operational metric, but comparing them
to the resources a company used to earn them cuts
to the very feasibility of that company's’ existence.
Return on assets (ROA) is the simplest of such
corporate bang-for-the-buck measures.
• ROA is calculated by dividing a company’s net
income by total assets. As a formula, it would be
expressed as:
• Return\ on\ Assets = \frac{Net\ Income}{Total\
Assets}Return on Assets=
• Total Assets
• Net Income
•
• Higher ROA indicates more asset efficiency.
• For example, pretend Spartan Sam and Fancy Fran both
start hot dog stands. Sam spends $1,500 on a bare-bones
metal cart, while Fran spends $15,000 on a zombie
apocalypse-themed unit, complete with costume. Let's
assume that those were the only assets each deployed. If
over some given time period Sam had earned $150 and Fran
had earned $1,200, Fran would have the more valuable
business but Sam would have the more efficient one. Using
the above formula, we see Sam’s simplified ROA is
$150/$1,500 = 10%, while Fran’s simplified ROA is
$1,200/$15,000 = 8%.
• Return On Assets (ROA)
• The Significance of Return on Assets—ROA
• Return on assets (ROA), in basic terms, tells you what earnings
were generated from invested capital (assets). ROA for public
companies can vary substantially and will be highly dependent on
the industry. This is why when using ROA as a comparative
measure, it is best to compare it against a company's previous
ROA numbers or against a similar company's ROA.
• The ROA figure gives investors an idea of how effective the
company is in converting the money it invests into net income.
The higher the ROA number, the better, because the company is
earning more money on less investment.
• Remember total assets is also the sum of its total liabilities
and shareholder's equity. Both of these types of financing
are used to fund the operations of the company. Since a
company's assets are either funded by debt or equity, some
analysts and investors disregard the cost of acquiring the
asset by adding back interest expense in the formula for
ROA.
• In other words, the impact of taking more debt is negated
by adding back the cost of borrowing to the net income and
using the average assets in a given period as the
denominator. Interest expense is added because the net
income amount on the income statement excludes interest
expense.
• Assets—ROA
• ROA is most useful for comparing companies in the same
industry, as different industries use assets differently. For
example, the ROA for service-oriented firms, such as banks,
will be significantly higher than the ROA for capital intensive
companies, such as construction or utility companies.
• Let's evaluate the return on assets (ROA) for three companies
in the retail industry:
• Macy's (M)
• Kohl’s (KSS)
• Dillard's (DDS)
• Due to the increasing popularity of e-commerce,
brick and mortar retail companies have taken a hit in
the level of profits they generate using their available
assets. Still, every dollar that Macy's has invested in
assets generates 8.3 cents of net income. Macy's is
better at converting its investment into profits,
compared with Kohl’s and Dillard’s. One of
management's most important jobs is to make wise
choices in allocating its resources, and it appears
Macy’s management is more adept than its two
peers.
• Return on Assets—ROA vs Return on Equity—ROE
• Both ROA and return on equity (ROE) are measures
of how a company utilizes its resources. Essentially,
ROE only measures the return on a company’s
equity, leaving out the liabilities. Thus, ROA
accounts for a company’s debt and ROE does not.
The more leverage and debt a company takes on,
the higher ROE will be relative to ROA.
• Limitations of Return on Assets—ROA
• The biggest issue with return on assets (ROA) is that it can't be
used across industries. That’s because companies in one
industry—such as the technology industry—and another industry
like oil drillers will have different asset bases.
• Some analysts also feel that the basic ROA formula is limited in its
applications, being most suitable for banks. Bank balance sheets
better represent the real value of their assets and liabilities
because they’re carried at market value (via mark-to-market
accounting), or at least an estimate of market value, versus
historical cost. Both interest expense and interest income are
already factored in.
IMPORTANT
• The St. Louis Federal Reserve provides data on US
bank ROAs, which have generally hovered around
or just above 1% since 1984, the year collection
started.
• For non-financial companies, debt and equity capital is
strictly segregated, as are the returns to each: interest
expense is the return for debt providers; net income is
the return for equity investors. So the common ROA
formula jumbles things up by comparing returns to
equity investors (net income) with assets funded by
both debt and equity investors (total assets). Two
variations on this ROA formula fix this numerator-
denominator inconsistency by putting interest expense
(net of taxes) back into the numerator. So the formulas
would be:
• ROA variation 1: Net Income + [Interest Expense*(1-tax
rate)] / Total Assets
• ROA variation 2: Operating Income*(1-tax rate) / Total
Assets
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