Chapter 13: Basics of Analysis

Building Blocks of Financial Statement Analysis Financial statement analysis relies on four core building blocks, each focusing on a different aspect of a company’s financial condition or performance: 1. Liquidity and Efficiency: o Liquidity: Measures a company's ability to meet its short-term obligations as they come due. Key ratios include the current ratio and quick (acid-test) ratio. o Efficiency: Evaluates how effectively a company uses its assets to generate revenue. Examples include inventory turnover and accounts receivable turnover. 2. Solvency: o Assesses a company’s capacity to meet its long-term obligations and sustain operations over time. It involves examining long-term debt ratios like the debt-to-equity ratio and interest coverage ratio. 3. Profitability: o Focuses on a company’s ability to generate profits and reward its investors. It includes measures like return on assets (ROA), return on equity (ROE), gross profit margin, and net profit margin. 4. Market Prospects: o Evaluates how well a company is positioned to meet investor expectations and maintain or increase its stock value. Ratios like price-to-earnings (P/E) and market-to-book are commonly used here. Standards for Comparisons in Financial Analysis When performing financial analysis, the results need to be compared against benchmarks or standards to assess the company’s performance. The common standards are: 1. Intracompany Comparison: o Analyzing the company's current performance against its own historical performance. For instance, comparing Apple’s current net income to its net income from previous years or assessing how its revenue has grown over time. 2. Competitor Comparison: o Comparing a company’s metrics with those of its direct competitors. For example, comparing the profit margin of Coca-Cola with that of PepsiCo gives insights into their competitive positioning. 3. Industry Comparison: o Using industry averages or statistics as a benchmark. This helps understand how a company like Intel performs relative to the broader semiconductor industry. 4. Guidelines (Rules of Thumb): o These are general benchmarks developed over time. For example, a current ratio of 2:1 or an acid-test ratio of 1:1 is often used as a basic standard of financial health. Purpose of Financial Statement Analysis Financial statement analysis serves different purposes for internal and external users: • • Internal Users (e.g., managers, officers, internal auditors): o Aim to use the analysis to improve company efficiency and operational effectiveness. External Users (e.g., shareholders, creditors, analysts): o Use the analysis to make informed investment or lending decisions. For example, shareholders assess profitability, while creditors focus on solvency and liquidity. o External auditors review financial statements to ensure fair presentation in compliance with accounting standards. Tools of Financial Statement Analysis Three primary tools are used in financial statement analysis: 1. Horizontal Analysis: o Also called trend analysis, it compares financial data over multiple periods to identify trends and growth patterns. It helps assess how certain financial items have changed over time. 2. Vertical Analysis: o Involves comparing financial statement items to a common base number within the same period. For example, each line item on the income statement is expressed as a percentage of total sales. 3. Ratio Analysis: o Calculates and interprets various financial ratios to assess liquidity, profitability, solvency, and efficiency. Ratios help identify relationships between different financial data points and provide insights into a company’s financial health. By understanding these building blocks, comparison standards, and analysis tools, users can assess a company's financial performance and condition, making more informed decisions.