Introduction to Financial Analysis – ch.13
Accounting provides information for decision-making. Based on the data gathered,
informed decisions are made. We can use the figures for one year to compare with the
figures of another year, for example, for expenses, revenue, sales, liability and so on.
Why do we need to analyze?
We can analyze a company for internal and external purposes. For internal purposes we can
observe trends for these figures, which we can use to improve our business.
Users of Financial Analysis
We can observe trends from these figures, which we can use to improve our business.
External Users –
- Bankers and Large Creditors
Bankers and large creditors would analyze the company’s figures to determine their ability
to repay loans.
- Potential Investors
They want to see the trend in growth, income, and net worth, to determine if it’s a
- Labour Union
Labour unions examine the profit of the company and compare this with the salaries the
Ways of Analysing Figures
1. Analysis of Comparative Financial Statements – Page 659
This is done by comparing a company’s financial data for two or more years e.g. 1996 to
that of 1998. This would show a trend in profitability, growth, areas of improvements
Things to look for:
1 Items with unusual changes – analyse exceptions i.e. very high or very low
Then look closer to find out what could have caused these changes
Management uses this information to make vital changes to weak areas or if it was a
positive change then they are used to make the system even better by increasing the
2. Condensed Statement Analysis
This is a condensed statement analysis gives selected or key statement amounts as a
percentage of a base figure e.g. operating expense, net sales, net income, are given and a
comparative percentage is given beside it. E.g. 662 -663
A Horizontal Analysis is now shown on page 664
Vertical analysis is a method used to present the common-sized income statement. The
main items on the income statements or balance sheet are shown as a percentage of one
Common-sized income statement - shows only the percentage of the income statement so
that the dollar values are left out. Page 665
3. Trend Analysis
Trend analysis is done by careful examination of percentage changes on a condensed
financial statement. This would show the percentage changes of the main items so that the
analyst can get an understanding of what might have caused these changes. The analyst
may be carried out over a 10 years period. Using this information of the past the future can
A based year is used i.e. that year represents 100% as on Page 665. The figures of the
other years would fluctuate around this one-year – 2001, which is the base year.
Trend analysis is used:
1. To give trend analysis information of the company to users of the financial
2. To give a picture of a financial position and performance over a number of years
2 3. To analyze a company’s strengths and weaknesses, and based on this a forecast can
4. To gather as much information as possible from the analysis before making final
5. There may be External factors too, which may be causing poor performances e.g. a
slump in the economy.
Page 666 - 673
4. Ratio Analysis
The purposes of ratio analysis:
- For decision-making, so accurate, relevant, information is given.
- The figures are used to analyze a firm’s liquidity (i.e., how much cash is available
to pay debts), borrowing capacity and profitability.
- To give the above information to Users both internal and external to the company.
- Liquidity ratio tells or indicates how much fund the company has to pay off its
debts or current liabilities without having to borrow or sell assets.
- Bankers and creditors use this information to decide if they should lend the
company their money, and based on this, they can decide if the company will be
able to repay and how quickly.
- To achieve good results, the company must manage the current assets efficiently.
The ratios used to analyse liquidity are:
a) Working capital
Working capital = current assets – current liability
Working Capital shows the company’s ability to pay its short-term debts or current
liabilities. The sum remaining shows how much fund the company has after covering its
current liabilities so it gives the liquidity information. Prior to an investment decision, it’s
good to look at the working capital trends over a time period.
b) Current ratio
Current ratio = Total Current Assets / Total Current Liabilities
E.g., 2.6 : 1
3This is another way to determine if the company can repay its current debt. In the example
above, it means that the company has $2.60 worth of current asset for every $1 of current
liability. The company should be able to generate or get enough cash from its current assets
to cover its current liabilities.
The general rate is, 2: 1 is satisfactory and means that the company can pay its debts;
1: 1 is poor;
6: 1 is not necessarily good as this maybe due to poor management
allowing too much money to be tied up in inventory or n