FINANCIAL STATEMENT ANALYSIS (Part 1)

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. (analyze finance data)

There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.

TOOLS AND TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS:

Following are the most important tools and techniques of financial statement analysis:

1. Horizontal and Vertical Analysis
2. Ratios Analysis   

1: Trend Analysis / Horizontal Analysis in financial Statements

Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis.

Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form as has been done in the example below. Showing changes in dollar form helps the analyst focus on key factors t hat have affected profitability or financial position. Observe in the example that sales for 2002 were up $4 million over 2001, but that this increase in sales was more than negated by a $4.5 million increase in cost of goods sold. Showing changes between years in percentage form helps the analyst to gain perspective and to gain a feel for the significance of the changes that are taking place. For example a $1 million increase in sales is much more significant if the prior year's sales were $2 million than if the prior year's sales were $20 million. In the first situation, the increase would be 50% that is undoubtedly a significant increase for any firm. In the second situation, the increase would be 5% that is just a reflection of normal progress.

Example of Horizontal or Trend Analysis:

Balance Sheet:

Comparative Balance Sheet       December 31, 2002, and 2001      (dollars in thousands)
			Increase (Decrease)
	2002	2001	Amount	Percent
Assets
Current Assets:
Cash	$1,200	$2,350	$(1,150)*	(48.9)%
Accounts receivable	6,000	4,000	2000	50%
Inventory	8,000	10,000	(2000)	(20.0)%
Prepaid Expenses	300	120	180	150.0%
	----------	-----------	----------	----------
Total current assets	$15,500	$16,470	(970)	(5.9)%
	-----------	-----------	----------	---------
Property and equipment:
Land	4,000	4,000	0	0%
Building	12,000	8,500	3,500	41.2%
	-----------	-----------	----------
Total property and equipment	16,000	12,500	3,500	28%
	----------	-----------	----------	---------
Total assets	31,500	28,970	2,530	8.7%
	======	======	======	======
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payables	$5,800	$4,000	1800	45%
Accrued payables	900	400	500	125%
Notes payables	300	600	(300)	(50%)
	----------	----------	-----------	---------
Total current liabilities	7,000	5,000	2,000	40%
	----------	----------	----------	-----------
Long term liabilities:
Bonds payable 8%	7,500	8,000	(500)	(6.3)%
	----------	----------	----------	----------
Total long term liabilities	7,500	8,000	(500)	6.3%
	----------	----------	----------	----------
Total Liabilities	$14,500	13,000	1,500	(11.5)%
Stock holders equity:
Preferred stock, 100 par, 6%, $100 liquidation value	$2,000	$2,000	0	0%
Common stock, $12 par	6,000	6,000	0	0%
Additional paid in capital	1,000	1,000	0	0%
	----------	----------	---------	--------
Total paid in capital	9,000	9,000	0	0%
Retained earnings	8,000	6,970	1,030	14.8%
	----------	----------	----------	----------
Total stockholders' equity	17,000	15,970	1,030	6.4%
	----------	----------	----------	---------
Total liabilities and stockholders' equity	$31,500	$28,970	$2,530	8.7%
	=====	======	======	======

*Since we are measuring the change between 2001 and 2002, the dollar amounts for 2001 become the base figure for expressing these changes in percentage form. For example, cash decreased by figures $1,150 between 2001 and 2002. This decrease expressed in percentage form is computed as follows:

$1,150 ÷ $2,350 = 48.9%

Other percentage figures in this example are computed by the same formula.

Income Statement:

Comparative income statement and reconciliation of retained earnings For the year ended December 31, 2002, and 2001 (dollars in thousands)
			Increase (Decrease)
	2002	2001	Amount	Percent
Sales	$52,000	$48,000	$4,000	8.3%
Cost of goods sold	36,000	31,500	4,500	14.3%
	------------	------------	------------	-----------
Gross margin	16,000	16,500	(500)	(3.0)%
	------------	------------	------------	------------
Operating expenses:
Selling expenses	7,000	6,500	500	7.7%
Administrative expense	5,860	6,100	(240)	(3.9)%
	------------	------------	------------	------------
Total operating expenses	12,860	12,600	260	2.1%
	------------	------------	------------	------------
Net operating income	3,140	3,900	(760)	(19.5)%
Interest expense	640	700	(60)	(8.6)%
	------------	------------	------------	------------
Net income before taxes	2,500	3,200	(700)	(21.9)%
Less income taxes (30%)	750	960	(210)	(21.9)%
	------------	------------	------------	------------
Net income	1,750	2,240	$ (490)	21.9%
			======
Dividends to preferred stockholders, $6 per share (see balance sheet above)	120	120
	------------	------------
Net income remaining for common stockholders	1,630	2,120
Dividend to common stockholders, $1.20 per share	600	600
	------------	------------
Net income added to retained earnings	1,030	1,520
Retained earnings, beginning of year	6,970	5,450
	------------	------------
Retained earnings, end of year	$ 8,000	$ 6,970
	=======	=======