FS AnalysisMethod used by interested parties such as

investors, creditors, and management to evaluate the past, current, and projected conditions and performance of the firm.

The important thing to remember is: everyone who looks at your financial statements will conduct a financial statement analysis, in one form or another. That is why your statements need to be as accurate and truthful as possible.

You, as well as your business, will be judged according to your financial statements.

Users of Financial Statement Analysis There are a number of users of financial statement analysis. They

are: Creditors. Anyone who has lent funds to a company is interested

in its ability to pay back the debt, and so will focus on various cash flow measures.

Investors. Both current and prospective investors examine financial statements to learn about a company's ability to continue issuing dividends, or to generate cash flow, or to continue growing at its historical rate (depending upon their investment philisophies).

Management. The company controller prepares an ongoing analysis of the company's financial results, particularly in relation to a number of operational metrics that are not seen by outside entities (such as the cost per delivery, cost per distribution channel, profit by product, and so forth).

Regulatory authorities. If a company is publicly held, its financial statements are examined by the Securities and Exchange Commission to see if its statements conform to the various accounting standards and the rules of the SEC.

There are three major analyses you need to make.1. Actual vs. Planned Performance

You did considerable business planning before you started your business (and you likely updated it for the banks, investors, or suppliers), complete with pro forma financial statements (no matter how crude).

So, after your business is operating, you will need to compare your actual performance (from your current financial statements) against your planned performance (from your pro forma financial statements).

This financial statement analysis should be performed line item by line item. If you had fewer sales than planned … you should know or find out why. If any costs were greater than planned … again, you should know or find out why.

2. Trend Analysis

By comparing current financial statements to previous financial statements you can see which areas of your business have changed, and by how much.

Then you need to determine why the change occurred, whether positive or negative:

Are sales trending up?Are costs trending down (which ones aren’t)?Are profits trending up?Is your cash flow improving?

3. Industry Comparisons

This analysis is not only a comparison of your business’s performance to others in your industry, but also to standards set by your banker, your investor(s), your advisory group, or even yourself.

Methods of Financial Statement AnalysisThere are two key methods for analyzing

financial statements. i. The first method is the use of horizontal and

vertical analysis. Horizontal analysis is the comparison of financial

information over a series of reporting periods, while vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item.

Thus, horizontal analysis is the review of the results of multiple time periods, while vertical analysis is the review of the proportion of accounts to each other within a single period.

Horizontal Analysis of the Income StatementHorizontal analysis of the income statement is

usually in a two-year format, such as the one shown below, with a variance also shown that states the difference between the two years for each line item. An alternative format is to simply add as many years as will fit on the page, without showing a variance, so that you can see general changes by account over multiple years. A third format is to include a vertical analysis of each year in the report, so that each year shows expenses as a percentage of the total revenue in that year.

Horizontal Analysis of the Income Statement

  2011 2012 Variance

Sales $1,000,000

$1,500,000

$500,000

Cost of goods sold

400,000 600,000 (200,000)

Gross margin 600,000 900,000 300,000

       

Salaries and wages

250,000 375,000 (125,000)

Office rent 50,000 80,000 (30,000)

Supplies 10,000 20,000 (10,000)

Utilities 20,000 30,000 (10,000)

Other expenses 90,000 110,000 (20,000)

Total expenses 420,000 615,000 (195,000)

Net profit $180,000 $285,000 $105,000

Horizontal Analysis of the Balance SheetHorizontal analysis of the balance sheet is also

usually in a two-year format, such as the one shown below, with a variance showing the difference between the two years for each line item. An alternative format is to add as many years as will fit on the page, without showing a variance, so that you can see general changes by account over multiple years. A less-used format is to include a vertical analysis of each year in the report, so that each year shows each line item as a percentage of the total assets in that year.

Horizontal Analysis of the Income Statement

  2011 2012 Variance

Cash $100,000 80,000 $(20,000)

Accounts receivable 350,000 525,000 175,000

Inventory 150,000 275,000 125,000

     Total current assets 600,000 880,000 280,000

       

Fixed assets 400,000 800,000 400,000

Total assets 1,000,000 1,680,000 680,000

       

Accounts payable 180,000 300,000 120,000

Accrued liabilities 70,000 120,000 50,000

     Total current liabilities 250,000 420,000 170,000

       

Notes payable 300,000 525,000 225,000

     Total liabilities 550,000 945,000 395,000

       

Capital stock 200,000 200,000 0

Retained earnings 250,000 535,000 285,000

     Total equity 450,000 735,000 285,000

       

Total liabilities and equity 1,000,000 1,680,000 680,000

Vertical AnalysisVertical analysis is the proportional analysis

of a financial statement, where each line item on a financial statement is listed as a percentage of another item. Typically, this means that every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets.

Vertical Analysis of the Income StatementThe most common use of vertical analysis in an

income statement is to show the various expense line items as a percentage of sales, though it can also be used to show the percentage of different revenue line items that make up total sales. 

The information provided by this income statement format is useful not only for spotting spikes in expenses, but also for determining which expenses are so small that they may not be worthy of much management attention.

Vertical Analysis of the Income Statement

  Totals Percent

Sales 1,000,000 100%

Cost of goods sold 400,000 40%

Gross margin 600,000 60%

     

Salaries and wages 250,000 25%

Office rent 50,000 5%

Supplies 10,000 1%

Utilities 20,000 2%

Other expenses 90,000 9%

Total expenses 420,000 42%

Net profit 180,000 18%

Vertical Analysis of the Balance Sheet

  Totals Percent

Cash $100,000 10%

Accounts receivable 350,000 35%

Inventory 150,000 15%

     Total current assets 600,000 60%

     

Fixed assets 400,000 40%

Total assets 1,000,000 100%

     

Accounts payable 180,000 18%

Accrued liabilities 70,000 7%

     Total current liabilities

250,000 25%

     

Notes payable 300,000 30%

     Total liabilities 550,000 55%

     

Capital stock 200,000 20%

Retained earnings 250,000 25%

     Total equity 450,000 45%

Total liabilities and equity

1,000,000 100%

RATIO ANALYSISii. The second method: Ratio analysis is the most

common form of financial analysis. It provides relative measures of the firm's conditions and performance.

horizontal analysis and vertical analysis are also popular forms.

Horizontal analysis is used to evaluate the trend in the accounts over the years, while vertical analysis, also called a common size financial statement , discloses the internal structure of the firm. 

Balance Sheet RatiosBalance Sheet ratios typically measure

the strength of your business, using the following formulas.

Current Ratio — This is one of the most widely used tests of financial strength, and is calculated by dividing Current Assets by Current Liabilities. This ratio is used to determine if your business is likely to be able to pay its bills. 

CURRENT RATIOTo calculate the current ratio, divide the total

of all current assets by the total of all current liabilities. The formula is:

Current assetsCurrent liabilities

Obviously, a minimum acceptable ratio would be 1:1; otherwise your company would not be expected to pay its bills on time. A ratio of 2:1 is much more acceptable, and the higher, the better.

QUICK RATIOThe quick ratio formula matches the most easily

liquidated portions of current assets with current liabilities. The intent of this ratio is to see if a business has sufficient assets that are immediately convertible to cash to pay its bills.

The key elements of current assets that are included in the quick ratio are cash, marketable securities, and accounts receivable. Inventory is not included in the quick ratio, since it can be quite difficult to sell off in the short term.

Because of the exclusion of inventory from the formula, the quick ratio is a better indicator than the current ratio of the ability of a company to pay its obligations.

QUICK RATIOTo calculate the quick ratio, summarize cash,

marketable securities and trade receivables, and divide by current liabilities. Do not include in the numerator any excessively old receivables that are not likely to be paid. The formula is:

Cash + Marketable securities + Accounts receivableCurrent liabilities

 Depending on your history for collecting receivables, a satisfactory ratio is 1:1.

WORKING CAPITALWorking Capital — Bankers especially,

watch this calculation very closely as it deals more with cash flow than just a simple ratio. Working Capital equals Current Assets minus Current Liabilities.

Quite often your banker will tie your loan approval amount to a minimum Working Capital requirement.

The working capital ratio is the same as the current ratio

Inventory Turnover Ratio  The inventory turnover formula or stock

turnover ratio is defined as the rate at which inventory is used over a measurement period. This is an important measurement, for many businesses are burdened by an excessively large investment in inventory, which can consume their available cash. Inventory turnover is typically measured on a trend line or in comparison to the industry average to judge how well a company is performing in this area.

When there is a low rate of inventory turnover, this implies that a business may have a flawed purchasing system that bought too many goods, or that stocks were increased in anticipation of sales that did not occur. In both cases, there is a high risk of inventory aging, in which case it becomes obsolete and has little residual value.

When there is a high rate of inventory turnover, this implies that the purchasing function is tightly managed. However, it may mean that a business does not have the cash reserves to maintain normal inventory levels, and so is turning away prospective sales. The latter scenario is most likely when the amount of debt is unusually high and there are few cash reserves.

Inventory Turnover Ratio

Inventory Turnover FormulaTo calculate inventory turnover, divide the

ending inventory figure into the annualized cost of sales. If the ending inventory figure is not a representative number, then use an average figure instead. The formula is:

Annual cost of goods soldInventory 

Inventory Turnover PeriodYou can also divide the result of the inventory

turnover calculation into 365 days to arrive at days of inventory on hand, which may be a more understandable figure. Thus, a turnover rate of 4.0 becomes 91 days of inventory. This is known as the inventory turnover period.

Debt to Equity RatioLeverage Ratio — This is another of the analyses

used by bankers to determine if your business is credit worthy. It basically shows the extent your business relies on debt to keep operating.

This ratio is calculated by dividing Total Liabilities by Net Worth (total assets minus total liabilities). Obviously, the higher the ratio is, the more risky it becomes to extend credit to your business.

This is often the calculation a supplier to your business will make before extending credit to you.

The debt to equity ratio of a business is closely monitored by the lenders and creditors of the company, since it can provide early warning that an organization is so overwhelmed by debt that it is unable to meet its payment obligations. This is also a funding issue. For example, the owners of a business may not want to contribute any more cash to the company, so they acquire more debt to address the cash shortfall.

How to Calculate the Debt to Equity Ratio

To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should also include all leases. The formula is:

Long-term debt + Short-term debt + LeasesEquity

P&L Ratios Gross Profit Ratio —The gross profit ratio shows the

proportion of profits generated by the sale of products or services, before selling and administrative expenses. In essence, it reveals the ability of a business to create sellable products in a cost-effective manner. 

The gross margin ratio can be measured in two ways. One is to combine the costs of direct material, direct labor, and overhead, subtract them from sales, and divide the result by sales. This is the more comprehensive approach. The formula is:

Sales – (Direct materials + Direct Labor + Overhead)Sales

EBITDA — This analysis is of the "Earnings Before Interest, Taxes, Depreciation, and Amortization" (EBITDA). This ratio is calculated by dividing EBITDA by Net Sales, and indicates how well the business is actually "operating," without the inclusion of non-operating costs.

This ratio should be looked at as one of the most important ratios of your business operations.

Net Profit RatioNet Profit Ratio — The net profit percentage is the ratio

of after-tax profits to net sales. It reveals the remaining profit after all costs of production, administration, and financing have been deducted from sales, and income taxes recognized. As such, it is one of the best measures of the overall results of a firm, especially when combined with an evaluation of how well it is using its working capital. The measure is commonly reported on a trend line, to judge performance over time. It is also used to compare the results of a business with its competitors.

The formula for the net profit ratio is to divide net profit by net sales, and then multiply by 100. The formula is:

(Net profit / Net sales) x 100

Management RatiosReturn on Assets — This is calculated by

dividing Net Pre-tax Profit by Total Assets. This ratio is supposed to indicate how efficiently you are utilizing your assets. To me, this is a useless analysis for helping you run your business.

However, bankers and investors will always calculate this ratio if you don’t.

Return on Investment (ROI) — This ratio is supposed to tell you if you are investing your time, and money, properly, or should you just liquidate your business and put the money into a savings account.

This ratio is of considerable value to a banker or investor—they certainly want to know if they could make a better return on their money by investing or loaning it to someone other than you.

To calculate your Return on Investment, divide your Net Pre-tax Profit by your Net Worth (total assets minus total liabilities).