Task Team of FUNDAMENTAL ACCOUNTING School of Business Sun Yat-sen University Less Lesson 10 Understanding and Using Financial Statements Learning objectives 1. Describe the need and supply for financial statement analysis 2. Learn basic financial statement analytical procedures 3. Perform horizontal and vertical analysis on financial statement accounts and interpret the data 4. Calculate a number of ratios related to efficiency, solvency, liquidity, and profitability and explain the information supplied by each, individually and collectively Aware of the limitations of financial statement analysis Teaching hours Students major in accounting: 3 hours Other students Teaching contents The financial condition and the results of operation of business enterprise are of interest to many groups, including owners, managers, creditors, governmental employees, and prospective owners and creditors. The principal financial statements, toge supplementary statements and schedules, present much of the basic information needed to make sound economic decisions regarding business enterprises. In this lesson, the various ways in which financial statement data can be analyzed to assist in making these decisions will be discussed Demand and supply of financial analysis Demand of financial analysis Parties demanding financial statement information include Shareholders, investors and security analysts; Employees Lenders and other sup Customers, Government regulatory agencies These parties can also be grouped into internal versus external users. Internal users onsist of managers and employees while external users consist of the rest in the above list
Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Yat-sen University Lesson notes Lesson 10 Understanding and Using Financial Statements Learning objectives 1. Describe the need and supply for financial statement analysis. 2. Learn basic financial statement analytical procedures. 3. Perform horizontal and vertical analysis on financial statement accounts and interpret the data obtained. 4. Calculate a number of ratios related to efficiency, solvency, liquidity, and profitability and explain the information supplied by each, individually and collectively. 5. Aware of the limitations of financial statement analysis Teaching hours Students major in accounting: 3 hours Other students: 6 hours Teaching contents The financial condition and the results of operation of business enterprise are of interest to many groups , including owners, managers, creditors, governmental agencies, employees, and prospective owners and creditors. The principal financial statements, together with supplementary statements and schedules, present much of the basic information needed to make sound economic decisions regarding business enterprises. In this lesson, the various ways in which financial statement data can be analyzed to assist in making these decisions will be discussed. Demand and supply of financial analysis Demand of financial analysis Parties demanding financial statement information include: ⚫ Shareholders, investors and security analysts; ⚫ Managers; ⚫ Employees; ⚫ Lenders and other suppliers; ⚫ Customers; and ⚫ Government regulatory agencies These parties can also be grouped into internal versus external users. Internal users consist of managers and employees while external users consist of the rest in the above list
Task Team of FUNDAMENTAL ACCOUNTING School of Business Sun Yat-sen University Suppliers of Financial Statements analysis Business firms are the suppliers of the financial statements information. Limited liability quired by the act to prepare financial statements and disclose the audited financial statements to the public/shareholders. Listed companies are required by the regulations governing the operation of the stock market to disclose audited financial statement information. At the same time, some firms'internal analysts provide financial statement analy to help managers make decision. Outside intermediaries agencies, such as financial analysts, bond rating agencies, provide professional services to the external users of financial statement information Basic analytical procedures The analytical measures obtained from financial statements are usefully expressed as ratios or Analytical procedure may be used to compare the amount of specific items on a current statement with the corresponding amounts on earlier statements Analytical procedures are also widely used to show the relationship of individual items to each other and of individual items to totals on a single statement Techniques of Financial Statement Analysis Vertical analysis and horizontal analysis Vertical (or common size) analysis uses one item on each financial statement as a base amount and expresses other amounts as a percentage of the base. On the balance sheet, total assets are usually the base, while the income statement uses net sales. Financial statements based on ertical analysis allow for easy analysis between companies or between time periods of a company Formatting financial statements in this way reduces the bias that can occur whe analyzing companies of differing sizes. It also allows for the analysis of a company over various time periods, revealing, for example, what percentage of sales is cost of goods sold and how that value has changed over time Horizontal (or trend) analysis uses data from prior years as a yardstick. Usually, the lde is used as a base, line by line, and subsequent years are expressed as a percentage of the base. In essence, the analyst is looking for areas of deterioration or improvement from a prior period. Care must be taken with horizontal analysis because small changes in large items(such as
Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Yat-sen University Suppliers of Financial Statements analysis Business firms are the suppliers of the financial statements information. Limited liability companies are required by the company act to prepare financial statements and disclose the audited financial statements to the public/shareholders. Listed companies are required by the regulations governing the operation of the stock market to disclose audited financial statement information. At the same time, some firms’ internal analysts provide financial statement analysis to help managers make decision. Outside intermediaries agencies, such as financial analysts, bond rating agencies, provide professional services to the external users of financial statement information. Basic analytical procedures The analytical measures obtained from financial statements are usefully expressed as ratios or percentages. Analytical procedure may be used to compare the amount of specific items on a current statement with the corresponding amounts on earlier statements. Analytical procedures are also widely used to show the relationship of individual items to each other and of individual items to totals on a single statement. Techniques of Financial Statement Analysis Vertical analysis and horizontal analysis Vertical (or common size) analysis uses one item on each financial statement as a base amount and expresses other amounts as a percentage of the base. On the balance sheet, total assets are usually the base, while the income statement uses net sales. Financial statements based on vertical analysis allow for easy analysis between companies or between time periods of a company. Formatting financial statements in this way reduces the bias that can occur when analyzing companies of differing sizes. It also allows for the analysis of a company over various time periods, revealing, for example, what percentage of sales is cost of goods sold and how that value has changed over time. Horizontal (or trend) analysis uses data from prior years as a yardstick. Usually, the oldest year is used as a base, line by line, and subsequent years are expressed as a percentage of the base. In essence, the analyst is looking for areas of deterioration or improvement from a prior period. Care must be taken with horizontal analysis because small changes in large items (such as
Task Team of FUNDAMENTAL ACCOUNTING School of Business Sun Yat-sen University inventory or capital assets)are sometimes far more significant than large changes in small accounts(such as prepaid), which can be volatile Horizontal analysis on an income statement indicates sales trends and the behaviour of the various expense components over time. The trends in these percentages may reveal significant insights into the strategy and efficiency of the operation The profit margin on sales percentage(a ratio in its own right) is especially important due to the size of the cost of goods sold expense category and its vulnerability to operating inefficiencies and competitive forces. a slippage of 1%or 2%, or even. 1%, in gross profit can make a large difference to returns earnec Ratio analysis Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. Ratio analysis is very useful for users of financial statement information, for example They facilitate inter-company comparison They downplay the impact of size and allow evaluation over time or across entities without undue concern for the effects of size differenc They serve as benchmarks for targets such as financing ratios and debt burden They help provide an informed basis for making investment-related decisions by comparing an entity' s financial performance to another classifies ratios into five analytical groups, which are Profitability analysis ratios, which show how successful a company is in terms of generating returns or profits on the Investment that it has made in the business. If a business is Liquid and Efficient it should also be Profitable Main profitability analysis ratios Return on Sales or Profit Margin (%) The Profit Margin of a company determines its ability to withstand competition and adverse conditions like rising costs, falling prices or declining les in the future. The ratio measures the percentage of profits earned per dollar of sales and thus is a measure of efficiency of the company Return on Sales or Profit Margin=(Net Profit/Net Sales)x 100 Return on Assets: The Return on Assets of a company determines its ability to utilize Assets employed in the company efficiently and effectively to earn a good return The ratio measures the percentage of profits earned per dollar of Asset and thus is a measure of efficiency of
Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Yat-sen University inventory or capital assets) are sometimes far more significant than large changes in small accounts (such as prepaids), which can be volatile. Horizontal analysis on an income statement indicates sales trends and the behaviour of the various expense components over time. The trends in these percentages may reveal significant insights into the strategy and efficiency of the operation. The profit margin on sales percentage (a ratio in its own right) is especially important due to the size of the cost of goods sold expense category and its vulnerability to operating inefficiencies and competitive forces. A slippage of 1% or 2%, or even 0.1%, in gross profit can make a large difference to returns earned. Ratio analysis Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. Ratio analysis is very useful for users of financial statement information, for example: They facilitate inter-company comparison; They downplay the impact of size and allow evaluation over time or across entities without undue concern for the effects of size difference; They serve as benchmarks for targets such as financing ratios and debt burden; They help provide an informed basis for making investment-related decisions by comparing an entity’s financial performance to another. This lesson classifies ratios into five analytical groups, which are: Profitability analysis ratios, which show how successful a company is in terms of generating returns or profits on the Investment that it has made in the business. If a business is Liquid and Efficient it should also be Profitable. Main profitability analysis ratios: Return on Sales or Profit Margin (%): The Profit Margin of a company determines its ability to withstand competition and adverse conditions like rising costs, falling prices or declining sales in the future. The ratio measures the percentage of profits earned per dollar of sales and thus is a measure of efficiency of the company. The formula: Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100 Return on Assets: The Return on Assets of a company determines its ability to utilize the Assets employed in the company efficiently and effectively to earn a good return. The ratio measures the percentage of profits earned per dollar of Asset and thus is a measure of efficiency of
Task Team of FUNDAMENTAL ACCOUNTING School of Business Sun Yat-sen University the company in generating profits on its Assets Return on Assets =(Net Profit /Total Assets)x 100 Return on Equity or Net Worth: The Return on Equity of a company measures the ability of the management of the company to generate adequate returns for the capital invested by the owners of a company. Generally a return of 10% would be desirable to provide dividends to owners and have funds for future growth of the company Return on Equity or Net Worth=(Net Profit/Net Worth or Owners Equity) x 100 Net Worth or Owners Equity= Total Assets(minus) Total Liability Activity analysis(efficiency analysis)ratios, which are ratios that come off the the balance Sheet and the Income Statement and therefore incorporate one dynamic statement, the income statement and one static statement, the balance sheet. These ratios are important in measuring the efficiency of a company in either turning their inventory, sales, assets, accounts receivables payables. It also ties into the ability of a company to meet both its short term and long term Main activity analysis ratios and the formula DSO (Days Sales Outstanding): The Days Sales Outstanding ratio shows both the average time it takes to turn the receivables into cash and the age, in terms of days, of a company's accounts receivable. The ratio is regarded as a test of Efficiency for a company. The effectiveness with which it converts its receivables into cash. This ratio is of particular importance to credit and ollection associates The formula Regular DSo =(Total Accounts Receivables/Total Credit Sales)x Number of Days in the Inventory Turnover ratio: This ratio is obtained by dividing the Total Sales of a company by its Total Inventory. The ratio is regarded as a test of Efficiency and indicates the rapidity with which the company is able to move its merchandise The formula: Inventory Turnover Ratio= Net Sales/ It could also be calculated Inventory Turnover Ratio=Cost of Goods Sold/Inventory
Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Yat-sen University the company in generating profits on its Assets. The formula: Return on Assets = (Net Profit / Total Assets) x 100 Return on Equity or Net Worth: The Return on Equity of a company measures the ability of the management of the company to generate adequate returns for the capital invested by the owners of a company. Generally a return of 10% would be desirable to provide dividends to owners and have funds for future growth of the company The formula: Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100 Net Worth or Owners Equity = Total Assets (minus) Total Liability Activity analysis (efficiency analysis) ratios, which are ratios that come off the the Balance Sheet and the Income Statement and therefore incorporate one dynamic statement, the income statement and one static statement , the balance sheet. These ratios are important in measuring the efficiency of a company in either turning their inventory, sales, assets, accounts receivables or payables. It also ties into the ability of a company to meet both its short term and long term obligations. Main activity analysis ratios and the formula: DSO (Days Sales Outstanding): The Days Sales Outstanding ratio shows both the average time it takes to turn the receivables into cash and the age, in terms of days, of a company's accounts receivable. The ratio is regarded as a test of Efficiency for a company. The effectiveness with which it converts its receivables into cash. This ratio is of particular importance to credit and collection associates. The formula: Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in the period that is being analyzed Inventory Turnover ratio: This ratio is obtained by dividing the 'Total Sales' of a company by its 'Total Inventory'. The ratio is regarded as a test of Efficiency and indicates the rapidity with which the company is able to move its merchandise. The formula: Inventory Turnover Ratio = Net Sales / Inventory It could also be calculated as: Inventory Turnover Ratio = Cost of Goods Sold / Inventory
Task Team of FUNDAMENTAL ACCOUNTING School of Business Sun Yat-sen University Accounts Payable to Sales (%): This ratio is obtained by dividing the 'Accounts Payables of a company by its 'Annual Net Sales. This ratio gives you an indication as to how much of their suppliers money does this company use in order to fund its Sales. Higher the ratio means that the company is using its suppliers as a source of cheap financing. The working capital of such companies could be funded by their suppliers The formula Accounts Payables to Sales Ratio=[Accounts Payables /Net Sales ]x 100 iquidity analysis ratios, which help analyze a company' s ability to generate cash or other highly liquid assets in order to extinguish debt or allocate resources. These ratios are important in measuring the ability of a company to meet both its short term and long term obligations Main liquidity ratios and the formula: Current Ratio: This ratio is obtained by dividing the Total Current Assets of a company by Its Total Current Liabilities!. The ratio is regarded as a test of liquidity for a company. It expresses the working capital relationship of current assets available to meet the company s current The formula Current ratio Total Current Assets/ Total Current liabilities Quick Ratio: This ratio is obtained by dividing the Total Quick Assets of a company by Total Current Liabilities. Sometimes a company could be carrying heavy inventory as part of its current assets, which might be obsolete or slow moving. Thus eliminating inventory from current assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid test of liquidity for a company. It expresses the true working capitalrelationship of its cash, accounts receivables, prepaid and notes receivables available to meet the company's current Quick Ratio= Total Quick Assets/ Total Current Liabilities Quick Assets= Total Current Assets(minus) Inventory Long-term debt-paying ability analysis ratios, which measure the degree of protection of suppliers of long-term funds and can also aid in judging a firm's ability to raise additional debt and its capacity to pay its liabilities on time
Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Yat-sen University Accounts Payable to Sales (%): This ratio is obtained by dividing the 'Accounts Payables' of a company by its 'Annual Net Sales'. This ratio gives you an indication as to how much of their suppliers money does this company use in order to fund its Sales. Higher the ratio means that the company is using its suppliers as a source of cheap financing. The working capital of such companies could be funded by their suppliers. The formula: Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100 Liquidity analysis ratios, which help analyze a company's ability to generate cash or other highly liquid assets in order to extinguish debt or allocate resources. These ratios are important in measuring the ability of a company to meet both its short term and long term obligations. Main liquidity ratios and the formula: Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total Current Liabilities'. The ratio is regarded as a test of liquidity for a company. It expresses the 'working capital' relationship of current assets available to meet the company's current obligations. The formula: Current Ratio = Total Current Assets/ Total Current Liabilities Quick Ratio: This ratio is obtained by dividing the 'Total Quick Assets' of a company by its 'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as part of its current assets, which might be obsolete or slow moving. Thus eliminating inventory from current assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid test of liquidity for a company. It expresses the true 'working capital' relationship of its cash, accounts receivables, prepaids and notes receivables available to meet the company's current obligations. The formula: Quick Ratio = Total Quick Assets/ Total Current Liabilities Quick Assets = Total Current Assets (minus) Inventory Long-term debt-paying ability analysis ratios, which measure the degree of protection of suppliers of long-term funds and can also aid in judging a firm’s ability to raise additional debt and its capacity to pay its liabilities on time