Financial statement analysis uses accounting numbers to assess a company’s past performance and financial position and to forecast its future. Investors ask about firm value, creditors about the ability to repay, and managers about their position relative to competitors. This course covers how to read the financial statements learned in Principles of Accounting and Intermediate Accounting. For how the statements are prepared, see Principles of Accounting chapter 4.

1. The four stages of analysis

Palepu and Healy divide financial statement analysis into four stages.

The four stages of financial statement analysis
Stage	Question	Chapters in this course
Business strategy analysis	How does this industry make money, and what strategy does this company compete with?	Chapter 1
Accounting analysis	Do the numbers faithfully represent economic substance?	Chapter 6
Financial analysis	Assess performance and risk with ratios and cash flows	Chapters 2–5, 7
Prospective analysis	Forecast future earnings and cash flows to estimate value	Chapter 8

Calculating ratios without business analysis leads to misreading the numbers. An inventory turnover of 4 is high for a shipyard but dismally low for a convenience store.

2. FA’s financial statements

Throughout this course we analyze a fictional manufacturer, FA (unit: ₩100 million).

FA's statement of financial position
Item	End of 20X1	End of 20X2
Cash	40	50
Trade receivables	120	150
Inventories	160	200
Total current assets	320	400
Property, plant and equipment (net)	580	600
Total assets	900	1,000
Trade payables	100	120
Short-term borrowings	70	80
Total current liabilities	170	200
Long-term borrowings	280	300
Total liabilities	450	500
Total equity (including retained earnings of 300 at end of 20X2)	450	500

FA's income statement
Item	20X1	20X2
Revenue	1,000	1,200
Cost of sales	(720)	(840)
Gross profit	280	360
Selling and administrative expenses (including depreciation of 60 in 20X2)	(180)	(216)
Operating profit	100	144
Interest expense	(22)	(24)
Profit before tax	78	120
Income tax expense	(16)	(24)
Net profit	62	96

3. Common-size statements: vertical analysis

Dividing each income statement item by revenue, and each balance sheet item by total assets, allows comparison across companies or years of different size.

Common-size income statement

\text{Item percentage} = \frac{\text{Item amount}}{\text{Revenue}} \times 100\%

In 20X2 FA's cost of sales ratio is 70%, selling and administrative ratio 18%, operating margin 12% and net margin 8%. In 20X1 they were 72%, 18%, 10% and 6.2%.

A 2-percentage-point fall in the cost of sales ratio explains the improved operating margin; the selling and administrative ratio is unchanged at 18%. Whether it comes from lower raw material prices, price increases or a change in product mix is checked through business analysis and the notes.

On the balance sheet side, inventories make up 20% and receivables 15% of total assets at the end of 20X2. Liabilities are 50% of the total, the same as in 20X1.

4. Trend analysis: horizontal analysis

Trend analysis looks at the year-on-year change in the same item.

Growth in FA's key items (20X1 → 20X2)
Item	Growth
Revenue	+20.0%
Operating profit	+44.0%
Net profit	+54.8%
Trade receivables	+25.0%
Inventories	+25.0%
Total assets	+11.1%

Profit grew faster than revenue. This is operating leverage: with fixed costs steady, revenue growth greatly increases profit (Cost Accounting chapter 13). Meanwhile, receivables and inventories grew faster (25%) than revenue (20%). That may signal slower collections or piling-up inventory, to be checked with the turnover analysis of chapter 4.

Check your understanding

In FA’s 20X2 common-size income statement the operating margin is 12%. If in 20X3 revenue rises by 10%, the cost of sales ratio stays at 70% and selling and administrative expenses remain ₩21.6 billion, what are operating profit and the operating margin?

Revenue in 20X3 is ₩132 billion and gross profit $1{,}320 \times 30\% = 396$ (₩39.6 billion). Operating profit is $396 - 216 = 180$ (₩18 billion), an operating margin of about 13.6%. Because selling and administrative expenses are fixed, operating profit grows faster (25%) than revenue (10%).

References

Krishna Palepu, Paul Healy and Erik Peek, Business Analysis and Valuation: IFRS Edition, ch. 1
Stephen Penman, Financial Statement Analysis and Security Valuation, ch. 1–2
IASB, IAS 1 Presentation of Financial Statements

Financial Statement Analysis — The Framework: Business, Accounting and Financial Analysis and Common-Size Statements