Techniques of Financial Statement Analysis

Business

It is an interrelated system of financial resources movement that is activated by the management decisions.

Management                                                          

It is the art of asking significance questions. The process management is a series of economic choices that activates movement of financial resources connected with business.

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Financial Analysis

It is analytical as well as judgemental process that helps answers questions that have been properly posed and therefore it is a means to an end.

Questions to be asked in analysis: -

           Exact nature and scope of the issue to be analysed ( problem & its relative importance been clearly spelled out)

           Specific factors, relationships, and trends likely to help in analyzing the issue. Order of their importance, sequence be adhered.

           Reliability and availability of data.

           Level of preciseness in answering the question. Additional refinement worthful?

           Limitation inherent in the tools to be applied.

           Importance of qualitative judgment.

The basic task of financial analysis is to develop a reasonably consistent and meaningful set of data & relationships abstracted from the combined results of management decisions on the investment, operation, and financing for the purpose of judging the financial condition and outlook for the business in terms of economic performance and value.

Investment Decisions

Capital budgeting for committing existing or newly obtained funds to three main area: -

1)      working capital

2)      new facilities and equipment

3)      Major spending plans such as R&D and promotional program.

Operations

Key strategies and decisions involve the effective utilization of the funds invested in serving selected market and the task of setting appropriate pricing and service policies that are competitive in filling the customer’s needs. Basically it involves economic trade-offs. Operating leverage is proportion of fixed (period) cost committed to the operations.

Financing

There is two issues to be discussed, one is disposition of profit and secondly capital structure. Financial leverage is a prudent use of funds obtained from fixed cost debt obligations in financing investment opportunity with potential earning higher than cost of interest.

Financial Statement

1)      Balance Sheet: - it is called as statement of financial condition/position. It describes the categories and amount of funds employed by the business (i.e. the fund committed) and the offsetting liabilities incurred to lenders and owners (i.e. the funds obtained).

2)      Operating statement

3)      Funds flow statement

4)      Cash flow statement

5)      Change in ownership statement

Three different objectives of financial process: -

Financial Accounting	Financial Analysis	Managerial Economics
Profit Determination 1)      revenue recognition 2)      expense recognition 3)      cost allocation 4)      profit definition	Financial Information 1)      adjustment process 2)      trend analysis 3)      profit projection 4)      cash flow projection	Activity Economics 1)      task analysis 2)      economic allocation 3)      contribution analysis 4)      trade-off determination
Value Determination 1)      Historical Cost 2)      Conservatism 3)      Equity Determination 4)      Contingency Recognition	Comparative Data 1)      Industry Analysis 2)      Competitor Analysis 3)      Economic Conditions 4)      Adjustment Area	Resource Effectiveness 1)      Investment Base 2)      Capital Investment 3)      Capital Divestments 4)      Human Resources
Tax Determination 1)      Legal Data Rqmnt. 2)      Income, Expense Timing 3)      Tax Management Issues 4)      Statement Adj.	Market Analysis 1)      Share Price Pattern 2)      Market Trends 3)      Value Drivers 4)      Market Models	Shareholder Value 1)      Cash flow Pattern 2)      Cost of Capital 3)      Investor Expectation 4)      Risk-Reward Trade-offs

Assessment of Business Performance

Before any analysis is undertaken, we should clearly

Ø  Define the view point taken

Ø  Objectives of the analysis

Ø  Potential standards of comparison

The actual usefulness of any particular ratio is strictly governed by the specific objectives of the analysis.

There are lots of individuals and groups interested in the performance of a given business.

Management	Owner	Lender
Operational Analysis 1)      Gross Margin 2)      Profit Margin 3)      Operating Expense Analysis 4)      Contribution Analysis 5)      Operating Leverage	Profitability 1)      Return to NW 2)       Return on common equity 3)      EPS 4)      CFPS 5)      Share Price Appreciation 6)      Total Shareholder return 7)      Shareholder value Analysis	Liquidity 1)      Current Ratio 2)      Acid Test 3)      Quick Sale Value 4)      Cash Flow Pattern
Resource Management 1)      Asset Turnover 2)      Working Capital Management 3)      Human Resource Effectiveness	Disposition of Earning 1)      DPS 2)      Dividend Yield 3)      Payout/Retention 4)      Dividend coverage	Financial Leverage 1)      Debt to Asset 2)      Debt to Capitalization 3)      Debt to Equity 4)      Risk-Reward trade-offs
Profitability 1)      Return on Assets 2)      Return before interest and tax 3)      Return on Current Value Basis	Market Indicators 1)      Price-Earning Ratio 2)      Market to Book Value 3)      Relative Price Movement 4)      Cash Flow Multiples	Debt Service 1)      interest coverage 2)      interest and Principal Coverage 3)      Cash Flow Analysis

Owner’s Point of View

I.        Profitability

 It means the return achieved through efforts of management on the funds invested by the owners.

a)     Return on Net worth – Net Profit / Net worth (Equity). As operations build-up shareholders equity during the year that hence the annual profit should be related to the mid-point of this build-up. Here the point to discuss is deferred tax. How should we treat deferred taxes? Two arrangement posed by analysts. Firstly we treat it as owner’s equity set aside against future higher tax levels. Secondly a form of long-term debt. Therefore there is no consensus amongst analyst about treatment of deferred tax; we do not include it in any of the ratio calculations.

b)     Return on Common Equity – this is more refined version of the calculation of return on owner’s investment, as it is based on earning accruing to the holders of common shares only. It is calculated as Net Profit to common / Avg. common equity. Net Profit – reduced by dividend paid to preference shareholder and by other obligations (like distribution to holder of minority interests). Net Worth reduced by the amount of preferred equity and any minority elements.

c)     Earning Per Share – Net profit to common / Avg. no. of shares outstanding. It can be of two types, Primary EPS; it uses avg. shares actually outstanding during the period. Secondly Fully Diluted EPS, all shares potentially in addition to actual shares outstanding, i.e. shares that would result from the conversion of preferred and Debt securities that are convertibles into common shares under various provision and shares from option by employees and others not yet exercised.  Quarterly or annual profitability do impact EPS. Changes in no. of outstanding shares may be because of fresh issue, stock split, dividend in shares, retirement of shares, retirement of shares, option exercised etc.

d)     Cash Flow Per Share – (Net profit to common + write-offs) / Avg. no. of shares outstanding. It is used as a rough measure of the company’s ability to pay cash dividends. CFPS ratio is an effort to simulate the operating funds flow on a per share basis. It is developed from on a net profit to which operating write-offs such as depreciation, amortization, and depletion have been added back. Adding back these book-entries restates the net profit in a form that approximates the funds generated by operations.

e)     Share Price Appreciation – Economic Value Addition is generation of more positive cash flows than outlays in the long run through the combined effect of investment, operation, and financing decisions.

f)      Total Shareholder Return – change in share price + cash dividend. The full economic benefit received by the shareholder is the sum of this stream of dividends and the change in the price of the stock.

g)     Share Holder Value Analysis

II.   Disposition of Earning

a)      Dividend per Share

b)      Dividend Yield – Annual Dividend per share / Avg. Mkt. Price per share. It can be average of 52 week high and low.

c)      Payout / Retention – Cash Dividend per Share / EPS

d)     Dividend Coverage – Degree to which dividends are covered by earning and cash flow.

III.            Market Indicators

a)     Price/Earning Ratio – market price per share / Earning per share. It is used to indicate how the stock market is judging the company’s earning performance and prospects. It is overall approximation of the market’s current judgment of company risk versus past and prospectus earning performance. The reverse of EPS formula is earning yield which relates EPS to market price.

b)     Market to Book Value Ratio - it is only be a beginning step in the appraisal of long term performance and outlook.

c)     Relative Price Movement