In order to achieve a complete and effective financial analysis, both pure financial data and other data that can influence the behavior of securities, such as industry and outlook, must be considered in the light of the economic environment. There are three types of analysis discuss below:
1. Horizontal Analysis or Trend Analysis
Horizontal analysis compares each amount in current year with a base year amount (for a selected base year). For example, if sales were $20000 in year 2015 and $30000 in year 2018, then sales increased to 150% of the 2015 in 2018, actually an increase of 50% of total sales. Comparison is made within the same industry firms, For example, manufacturing firms will make comparison with Manufacturing firms etc.
It is very clear from the name “Trend analysis” that it studies the financial history (yearly) of a firm for the comparison purpose. We watch on the trend if it is increasing decreasing or is consistent, on annual bases. These are provided by the institutions established for this purpose. Financial analysis requires judgment on the part of the Analyst. Users of financial statements must be careful and not to place complete confidence in comparisons provided by the ratios, because ratios are fractions simply with a numerator and a denominator.
In order to get trend we have to calculate Absolute Change and percentage change by using Fixed and Chain Base method.
1.1 Absolute Change
Current Year – Base Year ………………………. Fixed Base Method
Current Year – Preceding Year…………………. Change Base Method
1.2 Percentage Change
Current Year / Base Year * 100 ………………….Fixed Base
Current Year / Preceding Year *100 …………….. Chain Base Method
Example of Financial Statement Analysis
Saifullah opened his Automobile Parts Store, Executive Auto Parts, in 2004, in mid-sized city located in Hazara region of N.W.F.P. (Pakistan). Having worked for an automobile dealership, first as a technician, and later as the parts department manager (after BS), for over 16 years, Saifullah had learned the many competitive automobile servicing business. He had developed many contacts with dealers and servicing technicians, which came in real handy when establishing his own business. Business had picked up significantly well over the years, and as a result, Saifullah had more than doubled his store size by third year of operations. The industry and local forecasts for the next few years were good and he was confident that his sales would keep growing at or above the recent level.
However, Saifullah had used up most of his available funds in expending the business and was well aware that future growth would have to be funded with external funds. What was worrying Saifullah was the fact that over the past two years, the store’s Net Income figures has been negative, and his cash flow situation had gotten petty week (Comparative Income Statement). He figured that he had better take a good look at his firm’s financial situation and try to improve it, if possible, before his suppliers found out. He knew full well that being shut out by suppliers would be disastrous!
Saifullah’s knowledge of Financial Decision Making, not unlike many small businessmen, was very limited. He had often entertained the thought of taking some financial management courses, but could never find the time. One day, at his weekend, he happened to mention his problem to Tamoor, his long time friend and partner. Tamoor had often given him good advice in the past and Saifullah was desperate for a solution. “I’m no finance expert, Saifullah,” said by Tamoor, but you might want to contact to Nosheen; she can be very insightful, you know. That‘s exactly what Tamoor said, within a week he was able to contact Nosheen, who was MBA Executive (2) student in Comsats Abbottabad. Saifullah explained exactly what his concerns were. “I’m going to have to raise funds for future growth, and given my recent profit situation, the prospects look pretty bleak. The commercial loan committee is going to want some pretty convincing arguments as to why they should grant me the loan. I had better put some concrete remedial measures in place. I was hoping that you can help sort things out, Nosheen,” said Saifullah.
Comparative Income Statement
Comparative Balance Sheet
Horizontal Analysis for Income Statement
Horizontal Analysis for Balance Sheet
2. Vertical Analysis or Common Size Analysis
Common-Size Balance Sheets: – Compute all accounts as a percent of Total Assets… 100/ Total Assets * Items
Common-Size Income Statements: – Compute all line items as a percent of Sales …. 100/Sales * Items
Vertical Analysis of Income Statement
Vertical Analysis of Balance Sheet
3. Ratio Analysis
- Measure relationships between resources and financial flows
- Ratios also allow for better comparison through time or between companies
- Following are different type of Ratios
3.1 Liquidity Ratios
Assess ability to cover current obligations
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = Quick Assets / Current Liabilities
- Cash Ratio = Cash Equivalent / Current Liabilities
3.2 Activity Ratios
Activity ratios are also called asset mananagement or turnover rations. Assess amount of activity relative to amount of resources used.
- Inventory Turnover = CGS / Average Inventory
- Inventory Turnover in Days = 365 / IT
- Receivable Turnover = Net Credit Sales / Avg. Receivables
- Receivable Turnover in Days = 365 / RT
- Fixed Assets Turnover = Net Sales / Net Fixed Assets
- Total Assets Turnover = Net Sales / Total Assets
- Creditor Turnover = Net Credit Purchase / Avg. Creditors
- Creditor Turnover in Days = 365 / CT
- Working Capital Turnover = Net Sales / Net Working Capital
3.3 Debt Management Leverage Ratios
Assess ability to cover long term debt obligations.
- Debt-to-Equity Ratio = Debt / Equity
- Debt-to-Total Assets = Debt / Total Assets
- Equity Ratio = Equity / Total Asset
- Interest Coverage Ratio = EBIT / Interest Expenses
3.4 Profitability Ratios
Assess profits relative to amount of resources used.
- Net Profit Margin = Net Profit / Net Sales
- Basic Earning Power = EBIT / Total Assets
- Return on Assets = Net Profit / Total Assets
- Gross Profit Margin = Gross Profit / Net Sales
- Earnings Per Share = Net Profit / No. of Share Outstanding
- Dividend per Share = Dividend / No. of Share Outstanding
- Return on Equity = Net Profit / Equity
- Expense Ratio = Expenses / Net Sales
3.5 Valuation/ Market Ratios
Assess market price relative to assets or earnings.
- Price / Earnings Ratio = Price Per Share / Earnings Per Share
- Market / Book Ratio = Market Price Per Share / Book Value Per Share
- Dividend Yield = Dividend Per Share / Market Price Per Share
- Dividend Payout Ratio = Dividend Per Share / Earning Per Share
Liquidity Ratios MCQs
Liquidity Ratios Problems
Activity Ratios MCQs
Activity Ratios Problems
Financial Management: Theory and Practice, Dr Eugene F Brigham & C Micheal Ehrhardt
Fundamentals of Financial Management: Concise Edition, Brigham Houston
The Economist Guide to Financial Management, John Tennet
Financial Management: Core Concepts, Raymond M Brooks