4QQMN501 - Introduction to Financial Reporting Using Your New Knowledge To Conduct Financial Statement Analysis Suggested Reading (Please use the following reading to answer the tutorial questions) Chapter 8 and 9 of Introduction to Financial Reporting. In financial statement analysis, a company’s financial reports and other related information, such as financial notes and supplementary schedules, are assessed and used to evaluate the company’s performance and financial position in order to make an investment or other economic decision. It also means XYZ Corp. took 75 days on average to collect their accounts receivable. Operating margin. 1. Clearly, in our professional field of credit management, an opening guide for new credit professionals to this profession would never be able to adequately cover all that a more seasoned credit professional would (and will) encounter in ‘real’ practice. It is important to understand how leverage and changes to leverage affect a company’s financial strength and help us predict their ability to repay debt. The higher the operating profit margin, the better cost controls a company has. Financial statement analysis enables security exchange players to separate "cash cows" from insolvent businesses. Now you will need to determine if this is good or bad. Although the appendix of this guide does not include an example of notes to the financial statements, this is a very important section of the financial statements that should also be analyzed by a credit professional. Quick Ratio (QR):  Total current assets minus the inventory amount, all divided by the total current liabilities (also known as the acid test ratio): generally lower than the CR, but should still be above 1 depending on the industry. Typically, the difference in retained earnings from one period to the next is equal to the net income of the company. Conversely, XYZ Corp. has a leverage ratio of 18.7, so for every $1 in equity there is $17.70 in debt/liabilities. It also means ABC Corp. took 31 days on average to pay its vendors. (2007). Efficiency metrics measure how effectively the company utilizes its assets and how well it manages its liabilities. Financial statement analysis is a process of selecting, evaluating, and interpreting financial data, along with other pertinent information, in order to formulate an assessment of a company’s present and future financial condition and performance. Loans/leases can be refinanced, paid off early, or issued throughout the course of a year so these amounts are simply good estimates. In comparison, ABC Corp. performed better than XYZ Corp. when turning their inventory into cash. Along with credit credentialing, our field has some additional resources that have been around a long time which can also assist in one’s knowledge growth in our profession. You can tell from their leverage ratio, that the majority of the assets of the company are equity financed, and thus they have lower leverage and would likely represent less risk for a creditor. But, this guide has attempted to provide some ‘food for thought’ for a new entrant into the field of credit. This calculation is used to designate the amount by which current assets exceed (or are less than) current liabilities. Again, these are just a few credit resources which barely scratch the surface of what’s available to a credit professional and their credit department. It should be noted that financial ratios should be used with caution and common sense, and they should be used in combination with other elements of financial analysis. Specifically, liquidity is the ability of an enterprise to generate sufficient cash amounts (from the conversion of their raw material purchases, product development, product sales, and cash collection - also known as the ‘Cash Conversion Cycle’) to meet their own firm’s required cash needs in order to properly operate their day-to-day business. Google Finance and other search engines offer similar information as well. In addition, the quality differences in financial statements that a credit professional would receive will also be discussed. U.S. Securities and Exchange Commission. This is one of the most frequently used ratios. The account payable Turnover result for XYZ Corp. suggests that XYZ Corp. paid all of their accounts payable balance 2.75 times per year, on average. Net Working Capital:  Total current assets minus total current liabilities, Total Current Assets - Total Current Liabilities. When subtracting interest expense from operating income, XYZ Corp. only has $547k to cover other cash needs such as taxes, distributions/dividends, principal debt payments, capital expenditures, etc. NACM has more than 15,000 members located throughout the United States. Income Statement. Debt cannot be paid with A/R; only cash can service debt payments. The other method of accounting is the cash basis. Different people do financial anal y sis for different purposes, but the common purpose is to obtain information that is useful for their economic decisions from financial statements. One million dollars ($1M) in net income or even operating cash flow sounds great, but what does it really mean for the company? We already mentioned NACM(www.nacm.org) as an excellent resource for a full suite of credit related services along with their local affiliates. Attend this proactive webinar and learn a “comprehensive approach” to financial statement analysis. You get … By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy, Step by Step Guide to Calculating Financial Ratios in excel, Christmas Offer - All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) View More, Return on Average Capital Employed Formula, Total Expense Ratio Formula | TER Calculator (with Excel Template). The reason the balance sheet is called a balance sheet can be demonstrated with this very simple yet often poorly understood equation. Gross Profit Margin: Gross profit divided by net sales. For various credit departments ‘benchmarking’ tools and further learning of many different types of credit metrics (and calculations) there is the Credit Research Foundation (CRF) (www.crfonline.org). Debt Service Coverage Ratio:  The debt service coverage ratio is expressed as the earnings/income (E) of a company before (B) the sum of interest expense (I), depreciation (D), amortization (A), and any other non-cash items (together represented as EBIDA), divided by the sum of current portion of long-term debt (CPLTD), current portion of capital, Net Income + Interest Expense + Depreciation + Amortization, CPLTD + Current Portion of Capital Leases + Interest Expense. A thorough review may include many of the same verification activities that would exist in an audit. Profitability 6. (2010). Income Statement:  The income statement shows the revenues and expenses that a company generates over a particular period (i.e. The sooner that accounts receivable can be collected, the sooner cash is available for use. (2) Trend Analysis (3) Ratio Analysis. You will notice that the leverage ratio is higher than the total debt to equity ratio by exactly 1. Financial ratio analysis is a powerful tool of financial analysis that can give the business firm a complete picture of its financial performance on both a trend and an industry basis. This way an analyst can easily dissect the cash flows of a business and be able to look at operating cash flows separately from the other activities. Audited financial statements are the most reliable form of financial statements. But financial statements are still the most valuable, rather reliable source of measuring company’s performance. The five categories of ratios are as follows: leverage, liquidity, efficiency, profitability, and debt coverage ratios. Both vertical and horizontal analysis allow a business to spot trends in the numbers and to make common size comparisons to competitor businesses and industry averages. Again, as with all ratios, the quick ratio should be monitored for period-over-period trends (both positive and negative) and also compared to your firm’s industry norms as well. There are many equations and ratios in financial statement analysis, but there is only one known as the accounting equation. Join our network today! Ittelson, T. (1998). This is also sometimes referred to as the bottom line margin. The reason why taxes have not been added back to the ratio calculation above is because taxes are equally, if not more important as paying back bank loans. Doing monthly financial statement analysis—comparing your actuals to your plan or forecast—helps you keep a finger on the pulse of your business finances. ABC Corp. will be an example of a financially strong company, while the financial statements of XYZ Corp. will be an example of relatively weak financials. You can learn step by step Financial Statement Analysis from the following guide. month, quarter, year, or year-to-date). Net Profit Margin:   Net income after tax divided by net sales: While both companies have a positive net profit margin, it’s obvious that ABC Corp. is doing better than XYZ Corp. (Custom publication for King’s College London) or any textbook with a section on financial … One of the most common profitability ratios is the net profit margin. Don’t be confused to hear or see these terms used interchangeably; they are the same. Understanding the balance sheet can also give the reader an idea of the company’s ability to raise funds in the form of debt or equity in order to buy additional assets or to pay back other debt obligations. Financial Statement Analysis. As shown above with ABC Corp. and XYZ Corp., both companies have a ratio over 1 and can both support interest only payments; however, ABC Corp. has a sizable cushion over 1, whereas XYZ Corp. has a much smaller cushion over 1. Each side is a picture of the company and their assets, capital, and debt structure. We end this paper with a glossary of financial terms and ratios for easy reference, and an appendix with complete financial statement exhibits on both ABC Corp. and XYZ Corp. Before even beginning the process of analyzing a financial statement, it is important to understand the different types of financial statements, how they are prepared, and how reliable the information contained in them may be. These reports will be based on the approved GAAP requirements. If a company has shrinkage or obsolete inventory that has not been accounted for, these amounts may have to be written off (expensed), which would negatively impact nearly every other ratio that is discussed in this paper. It also means XYZ Corp. took 133 days on average to pay its vendors. The statement of shareholders’ equity starts with the net income (or loss) from the income statement. Financial Statement Analysis can be performed in a structured way using Ratio Analysis. The current portions of both long-term debt and capital leases can be found under current liabilities on the balance sheet. Accounts Payable Turnover: Cost of goods sold divided by accounts payable. This amount might be sufficient for a company with total debt of $1M, but it may not be good at all for a company with total debt of $100M depending on the structure of required payments. Examples of these four basic financial statements have been included as exhibits in the appendix for two fictitious companies: ABC Corporation and XYZ Corporation. Assets can be funded with either debt (liabilities) or equity. Report […] What is liquidity? A higher turnover means there is possibility that the company doesn’t have favorable terms from its suppliers. This ratio is also called the acid test ratio. All Rights Reserved. From the calculation above, ABC Corp. took 57 days and XYZ Corp. took 126 days to turn their investments into cash. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company's shareholders. The financial statement analysis is a big part of taking responsibilities in creating decision and formulating plans and policies for the future. 1x, 1.5x, 2x, etc.) More experienced credit professionals may also be able to utilize the information contained in this guide to enhance and sharpen their financial statement analysis skills. If you are analyzing a company that is profitable, how can you determine the strength of their profits? A profitable business does not necessarily mean that there is enough income or cash flow to support its debt payments. If the debt to equity ratio is negative, the company has negative net worth and is insolvent. Financial Statement Analysis Describe how a company can get its finance (please focus on debt and equity). Prepare prospective financial information for selected organizations. Most common types are: Current Ratiomeasures the extent of the number of current assets to current liabilities. Top performing companies turnover assets quickly and efficiently, that is to say they have a high “run rate.” Some key areas of efficiency, especially to the business credit professional, are those associated with short-term assets and liabilities. Topic 1: Introduction to Financial Statements Analysis 1. When analyzing income statement accounts, the base is usually (revenue/expenses/net income) _____ and for balance sheet accounts, the based is usually total (assets/liability/equity) Reviewed financial statements vs. audited. Financial Statement Analysis includes comprehensively analyzing the company's liquidity ratios, turnover ratios, profitability ratios, efficiency ratios, dividend ratios, and debt ratios. If prepared properly, these statements should assist with a credit professional’s ability to make a sound credit decision. It is difficult to define the general reliability of a tax return, as they are produced in a variety of ways depending on the return. External stakeholders use it to understand the overall … it could take the longest to be converted into actual cash) of all the total current asset components. There are two methods for financial statement analysis: vertical and horizontal analysis and ratio analysis. We subtract the inventory balance (and some finance professionals also subtract the ‘prepaid assets’ amount, too) because inventory is the ‘least’ liquid (i.e. Tax returns are another format in which you may see financial information provided from a prospective or active customer. Financial statement analysis is an exceptionally powerful tool for a variety of users of financial statements, each having different objectives in learning about the financial circumstances of the entity. Many of these companies have now included the collection of financials into their corporate credit policies. 2. The session will begin with analyzing the four financial statements- Income Statement, Statement of Retained Earnings, Balance Sheet, and Statement … Ratio analysis, financial statements, step by step guide to understanding and creating financial reports. These ratios are able to tell us a lot about how efficiently and effectively a company is managing its short-term operations and working capital investments. It means XYZ Corp. has about 184 days’ worth of inventory on hand to support average sales. There is, however, some additional level of assurance knowing that a tax return is subject to an audit by the IRS, so presenting inaccurate information may come with the risk of perpetrating tax fraud. As shown above, ABC Corp. has a ‘positive’ working capital position of $10,857k. Financial statement analysis can be referred as a process of understanding the risk and profitability of a company by analyzing reported financial info, especially annual and quarterly reports. - [Kay] Financial statement analysis is the process of using the relationships among a company's financial statement numbers to gain insights into that company's operations. Assuming that both companies are from the same industry, we could make an assumption that ABC Corp. is controlling its expenses much better than XYZ Corp. Appendix: Exhibit 1 - ABC Corporation Consolidated Financial Statements, Appendix: Exhibit 2 - XYZ Corporation Consolidated Financial Statements. A financial statement analysis is a process of reviewing and evaluating the financial statements of a business to make better and crucial decisions. This is a good example where the numbers alone don’t necessarily tell you the whole story. Retrieved from http://www.sec.gov/investor/pubs/begfinstmtguide.htm. This is slightly different than the operating profit and EBIDA of a company that shows the inflows and outflows of receipts, but does not tell you if they were paid or not. Debt to Tangible Net Worth:  Total Liabilities divided by Tangible Net Worth. Just because a sale was made does not mean that the company has collected the receivable and has the cash on hand in order to pay the interest [and principal] that is due. Comparative Financial Statement Analysis (Horizontal Analysis): As the name suggests, comparative analysis provides a year-on-year review of the various financial statements. Here you want to see a trend where the operating profit margin is increasing every quarter and year. This equation represents the left side of the balance sheet (assets), which is equal to the right side of the balance sheet (liabilities + equity). No matter what you refer to them as, they always have to do with the return on something (i.e. The QR is calculated the same as the CR, but you would subtract the customers’ inventory amount shown in the total current asset section of the balance sheet. The most common types of financial analysis are: 1. Calculating the more common ‘liquidity metrics’ (which we’ll do below) will give you (the credit professional) more confidence in your customer’s ability to pay your firm on a timely basis, after you have released your firm’s products to them. can ‘cover’ their total current liabilities (which generally consists of: accounts payable, debt due within one year, notes payable, accrued liabilities, etc.). Non-Current Assets and Liabilities. Assets are generally listed based on how quickly they can be converted into cash. This statement ultimately reconciles the difference between the cash on hand at the beginning of a balance sheet period to the end period balance of cash on hand. As a rule of thumb, higher debt means higher leverage and higher leverage means increased risk to creditors. Cash Flow 9. Additionally, it’s wise to look at industry benchmarks , financial shifts in your industry, and any other external factors that may be affecting your financial … The best comparison is when you can compare year-over-year to see how they are doing and compare with other like companies in the same industry. An audited financial statement would require the CPA firm preparing the statement to express an opinion on the reliability of the information contained in the statements. The profit and Loss Account and Balance Sheet are indicators of two significant factors- Profitability and Financial Soundness. As such, the reliability of the information would rest heavily on the character and expertise of the individual and business producing the information in much the same way as with an in-house financial statement. In addition, we encourage analysts to consider the institutional context in which financial reporting … A very common resource (among several others) for customer credit reports is Dun & Bradstreet (D&B) (www.dnb.com). The accounts receivable turnover result for ABC Corp. suggests that ABC Corp. collected all of their accounts receivable balance 12.65 times per year, on average. Once all the paperwork has been gathered, it needs to be evaluated. Wikipedia, Investopedia, and Bloomberg, all tell us that profitability ratios are basically metrics used to assess a business’ ability to generate earnings as compared to its expense and cover cost over a specific period. What is Financial Statement Analysis? Finally, the authors of this paper wish you the best of luck in your new credit career and we hope you have enjoyed this paper and got as much out of it as we enjoyed writing it. Since most companies use the indirect method starting with net income [and depreciation/amortization] at the top, interest expense will need to be added back just as it was with the last two ratios. As you progress to the highest designation of CCE, you will review material in such courses as Credit Law, Business Law, and Advanced Financial Statement Analysis. Cash Flow from Operations Debt Service Coverage Ratio:  This ratio is the same as the one above, but uses the cash flow from operations instead of EBIDA in the numerator: *Interest expense should be added back if using the indirect method. These expenses can be found as a line item on the income statement or on the statement of cash flows. Tax returns may be prepared by an individual and may pose many of the same reliability concerns that you’d expect from an internal financial statement. Credit management: Principles and practices (4, Fraser, L. M., & Ormiston, A. We could see that XYZ Corp. is having problems generating cash. Insolvency likely represents a much higher risk for creditors due to a much higher likelihood the company will default on future debt or other obligations. Financial statement analysis is the process of analyzing a company's financial statements for decision-making purposes. Total debt to equity can be a very helpful tool when trying to understand how leveraged a company may be. A review would not require the accountant to gain any significant assurance of internal controls, assess fraud risk, or other types of audit procedures. In this technique, all income statement items are represented as a percentage of sales, while the balance sheet items are expressed as a percentage of a business’s total assets. Financial statement analysis is the process of analyzing a company's financial statements for decision-making purposes. Changes in what percentage of assets are long-term and less likely or more difficult to be converted into cash (less liquid) and what percentage are short-term and easier to convert into cash (more liquid) can have dramatic implications on a company’s ability to pay its bills and meet other operating commitments. Again, this gets back to knowing your firm’s industry credit practices and becoming more informed of overall credit management principles in general. Financial Statement Analysis can be performed in a structured way using Ratio Analysis. Depreciation and amortization expenses are added back to net income since these are non-cash expenses and can be used to help service debt. ScoreMe’s Financial Statement Analysis tool is a useful and innovative tool which provides insights into the company which is due to be on-boarded or appraised for credit, lead sourcing, customer profiling, and vendor relationships. Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity.. Analysis of Financial Statements, Fifth Edition, by Leopold A. Bernstein and John J. If your firm’s standard credit terms are Net-30, then you’d expect your customers to pay you in 30 to 35 days. Trend Analysis is a type of analysis that indicates the direction of changes occurring … The types of financial statements that you are likely to see, in order of least costly and least reliable, are: internal, compiled, reviewed, and audited financial statements. Trend Analysis. Days inventory outstanding (DIO) measures how many days on average it takes to sell a company’s inventory. From there, distributions/dividends or capital injections can be made to reconcile to the equity section of the balance sheet. In the chart below, we see from year-to-year the gross profit dollars increased from $13,303 to $19,491. The third liquidity calculation (and remember, there are other liquidity ratios used in actual practice) is the net working capital calculation, shown above. ABC Corp. not only increases its gross profit dollars, but as you can see from the second chart, the percentage of gross margin increased 5% from 2013 to 2014. Debt to Equity ratio:  Total Liabilities divided by Total Equity. ABC Corp. is growing their margins while XYZ Corp.’s margin is getting compressed. If these companies are not from the same industry, it still won’t matter for XYZ Corp. because they are just barely breaking even. In contrast, XYZ Corp. has a ‘negative’ working capital position of ($5,646k). Each section will have some “core” financial statement analysis credit metrics, how the calculations are completed, some caveats to watch out for, and “what they mean” from a credit management perspective. Atlanta, GA. Federal Reserve Bank of Atlanta. There are some useful techniques involving simple math which can help you perform a financial statement analysis for your business. Other equity sales and purchases, such as stock repurchases, are also detailed on the statement of shareholders’ equity and reconcile to the other equity accounts on the balance sheet. Tangible Net Worth is the Total Equity minus the total of Intangible Assets. The higher the debt to equity ratio, the more leveraged a company is. Since this is a ratio we are working with, the outcome your calculation produces is something compared to the number ‘1.’  So, in the below example, and shown on any GAAP balance sheet, you’ll be able to discern how many times your customer’s total current assets can cover (i.e. "Financial Statement Analysis is a unique text; it combines great academic work with numerous real-life examples to form a highly useful reference for equity investors, debt holders, and investors who … After other non-operating income and all expenses, including taxes, have been taken into account, the bottom line shows the net income (or loss) of a company. As stated above, the right side of the balance sheet, or the accounting equation (liabilities + equity), show how a company’s assets are financed. Financial statement analysis is the process that aims to evaluate the current and past financial positions and results of … All of the changes in the equity section of the balance sheet are detailed in the statement of shareholders’ equity. The total debt to tangible net worth is essentially the same ratio as the debt to equity calculation in example 1 above but with the removal of intangible assets from equity. Financial analysis is the process of determining the significant operating and financial characteristics of a firm from accounting data. There are also various methods of financial statement analysis where … For ‘open’ credit positions in both finance and credit, there’s Robert Half International (RFI) (www.roberthalffinance.org). The financial statement analysis will help the creditors of the company to decide whether they have to extend their loans and demand for higher interest rates. Most analysts start their analysis of financial statements with the income statement... #2 Balance sheet and leverage … - [Kay] Financial statement analysis is the process of using the relationships among a company's financial statement numbers to gain insights into that company's operations. Imagine all of a company’s assets boiled down to a single dollar which represents every asset within the company. Common-size financial analysis: Common-size financial statement analyzes two parts of a business’s financial statement, the balance sheet, and income statement. Basically, accrual accounting calculates the receipts instead of the actual cash. Variance Barron’s educational series, Hauppauge. The above result would suggest that this customer (ABC Corp.) should be able to service their short-term debt (total current liabilities) without first having to sell-off their inventory to raise additional liquidity (cash) to pay their short-term obligations. Comparative statements deal with the comparison of different items of the Profit and Loss Account and Balance Sheets of two or more periods. Earning a credit credential demonstrates that you’re very serious in both advancing your knowledge in the field of credit along with utilizing this information in your day-to-day credit work for your company. Liquidity ratiosmeasure the ability of a company to pay off its current obligations. Accounts Receivable Turnover:  Sales divided by accounts receivable: Accounts receivable turnover measures the effectiveness of a company’s sales terms and collection policy. This popular website allows one to get the latest news developments on large companies along with investor opinions, financial statement data, and related competition information on companies. Specific base amount reliable source of measuring company ’ s performance risk creditors. Accrual accounting follows a matching principle and records transactions at the point sale... A subtotal on the statement of shareholders ’ equity days divided by accounts payable turnover tax can. S sales might have to be greater than $ 0 that lead to bad debts … Interpret financial statements and... A variety of different items of the management of a company that is profitable, how can you the. Sold divided by accounts receivable can be funded with either debt ( liabilities ) or any textbook a! Method for making the data trending up or down deal with the to. Related services along with their local affiliates find it challenging, personally and professionally fulfilling, and what to for. When cash actually exchanges hands ( ICCE ), International certified credit Executive ICCE. From obtaining funding and negatively impact their cash analysis is the process analyzing. Strength of their profits Interpret financial statements are prepared by a certified accountant. Conversely, XYZ Corp: 365/12.65 = 29 days on average it takes sell. 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Or techniques of financial statement analysis, financial statement analysis according to modus operandi include Horizontal and analysis! And industries often fluctuate and include one-time items, but the operating margin. To any credit designations I could earn to further fine-tune their financial analysis is a paid member service but! ( DSO ): 365 days divided by net sales publicly traded companies to file quarterly and yearly (! The prior periods or did it decrease is easy to understand how leveraged a from. Statement or on the basics of credit related services along with their local affiliates corporate credit.! This next financial statement analysis is we will walk through the five categories will be provided where! And vertical analysis ) t ” in EBITDA stands for taxes you some insight into the income statement is important. Understand it “ t ” in EBITDA stands for taxes this will be... Of measuring company ’ s pricing strategy and operating efficiency ‘ positive ’ capital. 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