CHAPTER ONE

OVERVIEW OF FINANCIAL
STATEMENT ANALYSIS

Business Analysis
Financial statement analysis is part of business analysis. Business analysis is the evaluation of a
company’s prospects and risks for the purpose of making business decisions. These business
decisions extend to equity and debt valuation, credit risk assessment, earnings predictions, audit
testing, compensation negotiations, and countless other decisions. Business analysis aids in making
informed decisions by helping structure the decision task through an evaluation of a company’s
business environment, its strategies, and its financial position and performance.

For example, equity investors desire answers to the following types of questions before deciding to
buy, hold, or sell a firm’s stock:
 What are the firm’s future business prospects? Are the firm’s markets expected to grow?
What are the firm’s competitive strengths and weaknesses? What strategic initiatives has it
taken, or does it plan to take, in response to business opportunities and threats?
 What is the firm’s earnings potential? What is its recent earnings performance?
 How sustainable are current earnings? What are the “drivers” of the firm’s profitability?
 What estimates can be made about earnings growth?
 What is the firm’s current financial condition? What risks and rewards does the firm’s
financing structure portray? Are the firm’s earnings vulnerable to variability?
 Does it possess the financial strength to overcome a period of poor profitability?
 How does the firm compare with its competitors, both domestically and globally?
 What is a reasonable price for the firm’s stock?

Types of Business Analysis

a) Credit Analysis
a. Trade (or operating) creditors deliver goods or services to a company and expect
payment within a reasonable period, often determined by industry norms.
b. Nontrade creditors (or debtholders) provide financing to a company in return for a
promise, usually in writing, of repayment with interest (explicit or implicit) on
specific future dates.

Creditors and lenders desire answers to important questions before entering into lending
agreements with a company. Their questions include the following:
 What are the firm’s business plans and prospects? What are the firm’s needs for future
financing?
 What are the company’s likely sources for payment of interest and principal? How much
cushion does it have in its earnings and cash flows to pay interest and principal?
 What is the likelihood the company will be unable to meet its financial obligations?
How volatile are the company’s earnings and cash flows? Does it have the financial strength to pay
its commitments in a period of poor profitability?

Creditors bear the risk of default. Credit analysis is the evaluation of the creditworthiness of a
company. Accordingly, the main focus of credit analysis is on risk, not profitability.
Credit analysis focuses on downside risk instead of upside potential. This includes analysis of both:
 Liquidity, which is a company’s ability to raise cash in the short term to meet its obligations.
 Solvency, which is a company’s long run viability and ability to pay long-term obligations.
The tools of credit analysis and their criteria for evaluation vary with the term (maturity), type, and
purpose of the debt contract.

Source: Financial statement analysis, K. R. SUBRAMANYAM, University of Southern California 1

 CHAPTER ONE
OVERVIEW OF FINANCIAL
STATEMENT ANALYSIS
b) Equity Analysis

Equity investors provide funds to a company in return for the risks and rewards of ownership. Equity
investors are major providers of company financing. Equity financing, also called equity or share
capital, offers a cushion or safeguard for all other forms of financing that are senior to it.

Individuals who apply active investment strategies primarily use technical analysis, fundamental
analysis, or a combination.

• Technical analysis, or charting, searches for patterns in the price or volume history of a stock
to predict future price movements.

• Fundamental analysis, which is more widely accepted and applied, is the process of
determining the value of a company by analysing and interpreting key factors for the
economy, the industry, and the company.

• Intrinsic value is the value of a company (or its stock) determined through fundamental
analysis without reference to its market value (or stock price).

c) Other Uses of Business Analysis

 Managers. Analysis of financial statements can provide managers with clues to strategic
changes in operating, investing, and financing activities. Managers also analyze the
businesses and financial statements of competing companies to evaluate a competitor’s
profitability and risk. Such analysis allows for inter-firm comparisons, both to evaluate
relative strengths and weaknesses and to benchmark performance.
 Mergers, acquisitions, and divestitures. Business analysis is performed whenever a
company restructures its operations, through mergers, acquisitions, divestitures, and spin-
offs. Investment bankers need to identify potential targets and determine their values, and
security analysts need to determine whether and how much additional value is created by
the merger for both the acquiring and the target companies.
 Financial management. Managers must evaluate the impact of financing decisions and
dividend policy on company value. Business analysis helps assess the impact of financing
decisions on both future profitability and risk.
 Directors. As elected representatives of the shareholders, directors are responsible for
protecting the shareholders’ interests by vigilantly overseeing the company’s activities. Both
business analysis and financial statement analysis aid directors in fulfilling their oversight
responsibilities.
 Regulators. The Internal Revenue Service applies tools of financial statement analysis to
audit tax returns and check the reasonableness of reported amounts.
 Labor unions. Techniques of financial statement analysis are useful to labor unions in
collective bargaining negotiations.
 Customers. Analysis techniques are used to determine the profitability (or staying power) of
suppliers along with estimating the suppliers’ profits from their mutual transactions.

Components of Business Analysis

a) Business Environment and Strategy Analysis
Industry analysis is the usual first step since the prospects and structure of its industry largely drive
a company’s profitability. Industry analysis is often done using the framework proposed by Porter
(1980, 1985) or value chain analysis.
Strategy analysis is the evaluation of both a company’s business decisions and its success at
establishing a competitive advantage. This includes assessing a company’s expected strategic

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OVERVIEW OF FINANCIAL
STATEMENT ANALYSIS
responses to its business environment and the impact of these responses on its future success and
growth.
b) Accounting Analysis
Accounting analysis is a process of evaluating the extent to which a company’s accounting reflects
economic reality. This is done by studying a company’s transactions and events, assessing the effects
of its accounting policies on financial statements, and adjusting the statements to both better reflect
the underlying economics and make them more amenable to analysis.

While accounting principles are governed by standards, the complexity of business transactions and
events makes it impossible to adopt a uniform set of accounting rules for all companies and all time
periods.

Also there are users such as investors, creditors, and analysts; preparers such as corporations,
partnerships, and proprietorships; regulators such as the Securities and Exchange Commission and
the Financial Accounting Standards Board. These parties influence the accounting practices of the
businesses.

These accounting limitations affect the usefulness of financial statements and can yield at least two
problems in analysis.
a) Comparability problems arise when different companies adopt different accounting for
similar transactions or events.
b) Accounting distortions are deviations of accounting information from the underlying
economics. These distortions occur in at least three forms.
i. Managerial estimates can be subject to honest errors or omissions. This estimation error is
a major cause of accounting distortions.
ii. Managers might use their discretion in accounting to manipulate or window-dress financial
statements. This earnings management can cause accounting distortions.
iii. Accounting standards can give rise to accounting distortions from a failure to capture
economic reality. These three types of accounting distortions create accounting risk in
financial statement analysis.
c) Financial Analysis
Financial analysis is the use of financial statements to analyze a company’s financial position and
performance, and to assess future financial performance.

Financial analysis consists of three broad areas—profitability analysis, risk analysis, and analysis of
sources and uses of funds.

i. Profitability analysis is the evaluation of a company’s return on investment. It focuses on a

company’s sources and levels of profits and involves identifying and measuring the impact of
various profitability drivers.
ii. Risk analysis is the evaluation of a company’s ability to meet its commitments. Risk analysis
involves assessing the solvency and liquidity of a company along with its earnings variability.
iii. Analysis of cash flows is the evaluation of how a company is obtaining and deploying its
funds. This analysis provides insights into a company’s future financing implications.

d) Prospective Analysis
Prospective analysis is the forecasting of future payoffs—typically earnings, cash flows, or both. This
analysis draws on accounting analysis, financial analysis, and business environment and strategy
analysis. The output of prospective analysis is a set of expected future payoffs used to estimate
company value.

Source: Financial statement analysis, K. R. SUBRAMANYAM, University of Southern California 3

 CHAPTER ONE
OVERVIEW OF FINANCIAL
STATEMENT ANALYSIS
e) Valuation
Valuation is a main objective of many types of business analysis. Valuation refers to the process of
converting forecasts of future payoffs into an estimate of company value. To determine company
value, an analyst must select a valuation model and must also estimate the company’s cost of
capital.

Financial Statements—Basis of Analysis

Sources of Financial and other information

i. Balance Sheet
ii. Income Statement
iii. Statement of Changes in Shareholders’ Equity
iv. Statement of Cash Flows
v. Additional Information
a. Management’s Discussion and Analysis (MD&A).
b. Management Report
c. Auditor Report
d. Explanatory Notes
e. Supplementary Information
f. Proxy Statements

ANALYSIS TOOLS
1. Comparative financial statement analysis
Also called the horizontal analysis or Year-to-Year Change Analysis
Analysts conduct comparative financial statement analysis by reviewing consecutive
balance sheets, income statements, or statements of cash flows from period to period. This
usually involves a review of changes in individual account balances on a year-to-year or
multiyear basis. The most important information often revealed from comparative financial
statement analysis is trend.
Limitations:
 When a negative amount appears in the base and a positive amount in the next period
(or vice versa), we cannot compute a meaningful percentage change.
 When there is no amount for the base period, no percentage change is computable.
 When the base period amount is small, a percentage change can be computed but the
number must be interpreted with caution. This is because it can signal a large change
merely because of the small base amount used in computing the change.
 Also, when an item has a value in the base period and none in the next period, the
decrease is 100%.
2. Common-size financial statement analysis
In analysing a balance sheet, it is common to express total assets (or liabilities plus equity) as
100%. Then, accounts within these groupings are expressed as a percentage of their
respective total. In analysing an income statement, sales are often set at 100% with the
remaining income statement accounts expressed as a percentage of sales. Because the sum
of individual accounts within groups is 100%, this analysis is said to yield common-size
financial statements. This procedure also is called vertical analysis given the up-down (or
down-up) evaluation of accounts in common-size statements. Common-size financial
statement analysis is useful in understanding the internal makeup of financial statements.

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 CHAPTER ONE
OVERVIEW OF FINANCIAL
STATEMENT ANALYSIS
Common-size statements are especially useful for intercompany comparisons because
financial statements of different companies are recast in common-size format.
3. Ratio analysis
Ratio analysis is among the most popular and widely used tools of financial analysis. Yet its
role is often misunderstood and, consequently, its importance often overrated.
While computation of a ratio is a simple arithmetic operation, its interpretation is more
complex. To be meaningful, a ratio must refer to an economically important relation. For
example, there is a direct and crucial relation between an item’s sales price and its cost.
Accordingly, the ratio of cost of goods sold to sales is important.
Ratios are one of the starting points of analysis, not an end point.
In fact, they are usefully interpreted in comparison with (1) prior ratios, (2) predetermined
standards, and (3) ratios of competitors.
Some of the uses of the ratio analysis are:
I. Credit (Risk) Analysis
a) Liquidity. To evaluate the ability to meet short-term obligations.
b) Capital structure and solvency. To assess the ability to meet long-term obligations.
II. Profitability Analysis
a) Return on investment. To assess financial rewards to the suppliers of equity and debt
financing.
b) Operating performance. To evaluate profit margins from operating activities.
c) Asset utilization. To assess effectiveness and intensity of assets in generating sales, also
called turnover.
III. Valuation
To estimate the intrinsic value of a company (stock).
Some common ratios:
Liquidity

Current assets
Current ratio=
Current liabilities
Cash∧cash equivalents+ Marketable securities + Accounts receivable
Acid – test ratio=
Current liabilities
Average accounts receivable
Collection period=
Sales /360
Average inventory
Days ¿ sell inventory=
Cost of sales/360

Source: Financial statement analysis, K. R. SUBRAMANYAM, University of Southern California 5

 CHAPTER ONE
OVERVIEW OF FINANCIAL
STATEMENT ANALYSIS
Capital Structure and Solvency

Total liabilities
Debt ¿ equity=
Shareholder ’ s equity
Income before income taxes∧interest expense
¿ interest earned =
Interest expense
Return on Investment

Earning before interest ∧Tax( EBIT )

Returnon assets=
Average Total Asset
Net income
Returnon equity=
Average shareholders ’ equity
Operating Performance

Sales−Cost of sales
Gross profit margin=
Sales
Net income
Net profit margin=
Sales
Asset Utilization

Cost of sales
Inventory turnover=
Average inventory
Sales
Total asset turnover=
Average total assets
Market Measures
Market price per share
Price ¿ earnings(P /E)=
Earnings per share(EPS)
Earnings per share
Earnings yield=
Market price per share

4. Cash flow analysis

Cash flow analysis is primarily used as a tool to evaluate the sources and uses of funds. Cash
flow analysis provides insights into how a company is obtaining its financing and deploying
its resources. It also is used in cash flow forecasting and as part of liquidity analysis.
5. Valuation
Valuation is an important outcome of many types of business and financial statement
analysis. Valuation normally refers to estimating the intrinsic value of a company or its stock.
The basis of valuation is present value theory. This theory states the value of a debt or
equity security (or for that matter, any asset) is equal to the sum of all expected future
payoffs from the security that are discounted to the present at an appropriate discount rate.
a) Debt Valuation
The value of a security is equal to the present value of its future payoffs discounted
at an appropriate rate.

Source: Financial statement analysis, K. R. SUBRAMANYAM, University of Southern California 6

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OVERVIEW OF FINANCIAL
STATEMENT ANALYSIS
b) Equity Valuation
 Dividend discount model.
Value of stock= present value of all future expected dividend
Limitations: infinite horizon
 Free cash flow to equity model
Value of stock= present value of all future expected free cash flows to
equity
Free cash flows to equity = cash flows from operations – capital expenditures + increases in debt.

Source: Financial statement analysis, K. R. SUBRAMANYAM, University of Southern California 7

 CHAPTER ONE
OVERVIEW OF FINANCIAL
STATEMENT ANALYSIS
GHT Holdings Limited
Statement of financial position
For the year ended 30 June 2024
Assets Amount BDT
Property, plant and equipment 7,40,00,000
Other long-term assets 1,20,00,000
Non-current assets 8,60,00,000
Inventories 2,60,00,000
Accounts receivables 1,50,00,000
Cash and cash equivalents 70,00,000
Current assets 4,80,00,000

Total assets 13,40,00,000

Equity and liabilities

Share capital 3,95,00,000
Retained earnings 2,35,00,000
Total equity 6,30,00,000
Long-term debt 5,00,00,000
Non-current liabilities 5,00,00,000
Trade and other payables 50,00,000
Short-term debt 1,60,00,000
Current liabilities 2,10,00,000
Total liabilities 7,10,00,000

Total equity and liabilities 13,40,00,000

GHT Holdings Limited

Statement of comprehensive Income
For the year ended 30 June 2022
Particulars Amount in BDT
Sales Revenue 24,00,00,000
Cost of Goods Sold 16,80,00,000
GROSS PROFIT 7,20,00,000
Selling and Admin Expenses
Salary 2,40,00,000
Rent 72,00,000
Utility 1,20,00,000
Bad Debt Provision 48,00,000
Depreciation -
Total S & A Expenses 4,80,00,000
OPERATING PROFIT 2,40,00,000
Interest Expense 96,00,000
Profit before tax 1,44,00,000
Tax 31,68,000
Profit after tax 1,12,32,000
Ordinary dividends 28,08,000.0
Retained earnings 84,24,000

Source: Financial statement analysis, K. R. SUBRAMANYAM, University of Southern California 8

 CHAPTER ONE
OVERVIEW OF FINANCIAL
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Source: Financial statement analysis, K. R. SUBRAMANYAM, University of Southern California 9