Financial

Statements
Analysis
Chapter 2
PROF MILIND SATHYE
Learning Objectives
1. explain the key financial statements (FS),
2. explain why lenders analyse FS,
3. describe the various methods of analysis of FS,
4. describe the techniques of analysis used in project finance,
5. explain the step-by-step approach to FS analysis,
6. describe the techniques of detecting window dressing of FS,
7. explain which of the financial ratios are preferred by loan officers, and
8. outline the limitations of FS analysis.
LO1: explain the key financial
statements (FS)
The analysis of financial statements plays a key role in assessing potential business loans.

Generally, financial statements consist of:

 Statement of financial performance. Also known as an income statement or a profit and

loss statement, the statement of financial performance compares a business’s revenues to its
expenses at a given time and determines whether a profit or a loss was made.

 Statement of financial position. Sometimes referred to as a balance sheet, the statement

of financial position compares a business’s assets, that is what it owns, to its liabilities, that is
what it owes, at a given time to determine the equity, that is what the business is worth.

 Statement of cash flows. Shows how the business uses cash.

LO2: explain why lenders analyse FS
Lenders analyse financial statements because they can help a lender determine
whether:

 the business has adequate liquidity so it can honour short-term obligations.

 the business is run efficiently.

 the business is run profitably.

 the proprietor’s stake in the business is high or if the business is carrying excessive
debt.
LO2: explain why lenders analyse FS
Analysis of financial statements helps provide answers to three key questions:

 Should the bank give the requested loan?

 If the loan is given, will it be repaid together with interest?

 What is the bank’s remedy if the assumptions of the loan turn out to be wrong?
Activity
Room for a case study here where students need to identify the best statement to use for
a situation and answer the questions in the previous slide. Could even do one of those
word maps where you connect the term (in this case the statement) to its definition.
LO3: describe the various methods
of analysis of FS
How is analysis done?

The analysis of financial statements falls into three broad categories:

 Cross-sectional techniques, such as ratio analysis and common-size statements.

 Time series techniques, such as identifying trends in ratios or other measures.

 A combination of the two.

LO3: describe the various methods
of analysis of FS
Cross-sectional techniques

Cross-sectional techniques focus on data from a single point in time rather than over a
period of time. The most important tool for this kind of analysis is ratios. Financial ratios
derived from the financial statements fall into four main categories:

 Liquidity ratios

 Efficiency ratios

 Profitability ratios

 Leverage ratios
LO3: describe the various methods
of analysis of FS
Liquidity ratios

Used to determine the ability of the firm to meet its short-term obligations.

 Current Ratio: Current assets / Current liabilities

 Quick Ratio: Quick assets / Current liabilities

Efficiency ratios

Used to determine how efficiently the firm has used its assets.

 Inventory turnover ratio: Net sales / Inventory

 Average collection period: Receivables / Average sales per day

LO3: describe the various methods
of analysis of FS
Profitability ratios

Used to assess the profitability of sales generated through operations.

 Gross Profit–Sales Ratio: Gross profits / Net sales

 Net Profit–Sales Ratio: Net profits / Net sales

Leverage ratios

Used to assess the proportions and manageability of debt carried by a firm.

 Debt–Equity Ratio: Debt / Equity

 Interest Coverage Ratio: Earnings before interest and taxes / Interest payable on loans

 Fixed Charges Coverage Ratio:

Activity
Case study or two where students get to practise using the ratios just covered on
previous slides.
LO3: describe the various methods of analysis of FS

Common-size statements

Common-size statements express relationships between the items (e.g., revenue, gross
profit, cost of goods sold, etc.) on the financial statements as a percentage. For
example, the following items could be expressed as a percentage of total assets in a
common-size statement:

 Accounts receivable

 Inventory

 Equity
Activity
Case study or two where students get to practise using a common-size statement.
LO3: describe the various methods
of analysis of FS
Time series techniques

Ratios can be evaluated to detect any improvements or deteriorations in a business’s

financial position over time.

Variability measures: Where trends are not detected, these may be used to determine
the variability over time. The below equation helps one detect variability:
Activity
Case study or two where students get to practise using the variability equation.
LO3: describe the various methods
of analysis of FS
Combining financial statement and non-financial statement information

Other non-financial information that may be incorporated into the analysis of a business
include:

 Changes in market share

 Market perceptions via share price

 Changes in key management

 Impact of macro-economic changes

Activity
An in-depth case study where students have to select which method of FS analysis is
best for the case and then use it properly.
LO4: describe the techniques of
analysis used in project finance
 Payback period. Determines how long it will take a project to recover the funds
invested into it, that is how long it will take to reach the break-even point.

 Accounting rate of return. Determines how much return investors can expect over
the lifetime of a project and is calculated as so: Average project revenue / Initial
investment

 Discounted cashflow techniques. Use estimated future cash flows to determine the
present value of a project. These techniques include:
◦ Net present value
◦ Internal rate of return
LO4: describe the techniques of
analysis used in project finance
Sensitivity analysis

Measures the impact of changes to key variables, such as the interest rate or prices of key inputs, and any
subsequent impact to the project’s viability.

Break-even analysis

The level of sales at which revenue equals expenses and net income is zero. This technique requires knowledge
of fixed and variable costs.

Margin of safety

The margin between the profitability of current operations and the break-even point.
LO4: describe the techniques of
analysis used in project finance
Cash break-even point

An equation that determines when a project will become profitable, that is generate
enough revenue to cover all expenses. It is calculated as follows:

Simulation

A computational approach where one variable is changed at a time to determine

sensitivities across numerous variables.
Activity
Case study or two that look at project finance and the methods of analysis in the previous
slides.
LO5: explain the step-by-step
approach to FS analysis
Step 1: Obtain relevant financial statements

Obtain the statements of financial performance, financial position and cash flows from over the past 3
years.

Step 2: Check for consistency

Verify the names on financial statements, signatures of partners, corporate seals, etc.

Step 3: Undertake preliminary scrutiny of financial statements

Examine the financial statements you have obtained for accuracy and key information.
LO5: explain the step-by-step
approach to FS analysis
Step 4: Collect data about industry and general economic trends
Focus on the strength of the economy and on the relevant industry.

Step 5: Comparison with industry averages

How does the firm’s financial ratios compare with those of competitors in the same
industry?
LO5: explain the step-by-step
approach to FS analysis
Step 6: Do supplementary analysis
Complete both a break-even analysis and a sensitivity analysis.

Step 7: Summarise main features

Provide an analytical overview outlining all the relevant data you have obtained.
Activity
Case study or two where students have to go through the step-by-step approach. Maybe
have the first be easy and then the second be a bit more challenging.
LO6: describe the techniques of
detecting window dressing of FS
The overwhelming accounting complexities in financial statements can lead to the
potential abuse of the notion of ‘true and fair’ via the manipulation of:
 the valuation of receivables, inventory, property, marketable securities and other
assets,
 liabilities, including off-balance sheet items, and
 changes to accounting method.
Activity
Case study where students have to identify any window dressing, fraud or errors in the
statements.
LO7: explain which of the financial
ratios are preferred by loan officers
The top ten ratios of importance in loan assessment are:
 Debt equity ratio  Net interest earned
 Current ratio  Net profit before tax
 Cash flow to long-term liabilities  Financial leverage
 Fixed charges coverage ratio  Inventory turnover in days
 Net profit after tax  Accounts receivables turnover in days
LO8: outline the limitations of FS
analysis
Financial statements analysis cannot substitute for sound judgement because of the
following issues:
 Problems with benchmarks. What benchmarks should be used for multi-industry
firms?
 Window dressing/creative accounting.
 Historical data. Accounting reports reveal only history, not the future.
 Qualitative aspects. Changes in management, the economy, etc.
Links to real world issues
Why is credit analysis so important?
https://ncert.nic.in/textbook/pdf/leac204.pdf

Storm Financial: A recent case of a lending debacle

http://www.abc.net.au/news/2016-08-26/storm-financial-former-directors-breach-law-j
ustice-finds/779036
6
Summary
In these slides, we discussed:
 Key financial statements
 Importance of analysis
 Techniques for project risk analysis
 Step-by-step approach and window dressing
 Financial ratios used by lenders
 Limitations