Financial statement analysis Study Guide

📖 Core Concepts Financial Statement Analysis – systematic review of a firm’s financial statements to inform economic decisions about future earnings. Main Objectives – assess risk, performance, valuation, financial health, and future prospects. Typical Users – equity investors, creditors, government/public agencies, and internal managers. Key Financial Statements – Income Statement (revenues/expenses → profit), Balance Sheet (assets‑liabilities‑equity snapshot), Cash‑Flow Statement (operating, investing, financing cash), Notes to Accounts (disclosures), Statement of Changes in Equity (equity movements). Analytical Techniques – Horizontal analysis: compare line items across periods to spot trends. Vertical (common‑size) analysis: express each item as a % of a base (e.g., sales on the income statement, total assets on the balance sheet). Financial ratios: quick quantitative gauges grouped as liquidity, profitability, activity, and leverage. Advanced Valuation – DuPont decomposition of ROE, Dividend Discount Model (DDM). Recasting – adjust reported numbers (e.g., treat operating leases as capital leases) to improve valuation accuracy. --- 📌 Must Remember Current Ratio = $\dfrac{\text{Current Assets}}{\text{Current Liabilities}}$ – liquidity gauge. Gross Profit Ratio = $\dfrac{\text{Gross Profit}}{\text{Revenue}}$ – % of sales left after COGS. Debt‑to‑Equity Ratio = $\dfrac{\text{Long‑term Debt} + \text{Short‑term Debt} + \text{Leases}}{\text{Equity}}$ – leverage indicator. ROE (DuPont) = $\dfrac{\text{Net Income}}{\text{Equity}}$ = (Profit Margin) × (Asset Turnover) × (Equity Multiplier). DDM – value = $\displaystyle \sum{t=1}^{\infty}\frac{Dt}{(1+r)^t}$ where $Dt$ = dividend in period $t$, $r$ = required return. Horizontal analysis → look for rising/falling trends over multiple periods. Vertical analysis → each line item = % of base (sales for income statement, assets for balance sheet). --- 🔄 Key Processes Horizontal Analysis Gather the same line item for at least two periods. Compute % change: $\dfrac{\text{Current Period} - \text{Prior Period}}{\text{Prior Period}}\times100\%$. Interpret trend direction & magnitude. Vertical Analysis Choose a base (e.g., Revenue for income statement). Divide each line item by the base and express as a percentage. Compare percentages across firms or periods. Ratio Calculation Pull required figures from statements (e.g., Current Assets, Current Liabilities). Apply the formula; round to 2‑decimal places. Benchmark against industry averages. Recasting Example Identify operating lease commitments. Convert to a capital lease: add present value of lease payments to assets and corresponding liability. Re‑compute ratios (e.g., Debt‑to‑Equity) to see impact. DuPont Decomposition Compute Profit Margin = $\dfrac{\text{Net Income}}{\text{Revenue}}$. Compute Asset Turnover = $\dfrac{\text{Revenue}}{\text{Total Assets}}$. Compute Equity Multiplier = $\dfrac{\text{Total Assets}}{\text{Equity}}$. Multiply the three to get ROE. --- 🔍 Key Comparisons Equity Investors vs. Creditors – Investors care about earnings power & dividend growth; creditors focus on ability to meet interest & principal. Horizontal vs. Vertical Analysis – Horizontal = trend over time; Vertical = structure within a single period. Liquidity Ratios vs. Profitability Ratios – Liquidity gauges short‑term payment ability; profitability measures how efficiently earnings are generated. DuPont ROE vs. Simple ROE – DuPont breaks ROE into three drivers (margin, turnover, leverage); simple ROE is just Net Income/Equity. --- ⚠️ Common Misunderstandings Current Ratio > 1 always means “safe.” – It can be misleading if the firm holds non‑liquid current assets (e.g., inventory). Vertical analysis = “only for income statements.” – It also applies to balance sheets (each asset = % of total assets). Higher turnover = better. – Extremely high turnover may indicate overly aggressive credit policies or under‑investment in receivables. DDM works for all stocks. – It fails for firms that do not pay dividends or have irregular dividend policies. Recasting changes the “true” earnings. – It simply provides an alternative view for valuation; underlying cash flows may remain unchanged. --- 🧠 Mental Models / Intuition Financial statements as a “movie” vs. “snapshot.” – The balance sheet is a single frame; the income statement and cash flow statement are the motion leading to the next frame. Ratios as health vitals. – Current ratio = blood pressure (liquidity), ROE = heart rate (overall performance). DuPont as a three‑gear engine. – Profit margin = fuel efficiency, asset turnover = engine speed, equity multiplier = turbo boost (leverage). Recasting = “re‑photographing” a picture with better lighting – you see the same scene, but details become clearer for valuation. --- 🚩 Exceptions & Edge Cases Negative Equity – Debt‑to‑Equity ratio becomes undefined or flips sign; interpret with caution. Seasonal Businesses – Horizontal analysis over a single year may hide regular seasonal swings; use quarter‑over‑quarter comparisons. Zero Sales – Vertical analysis on the income statement cannot use sales as a base; use total revenue or another appropriate base. High‑Growth Firms with No Dividends – DDM yields zero value; use discounted cash flow (DCF) instead. --- 📍 When to Use Which Assess short‑term solvency → use Current Ratio (or Quick Ratio if inventory is questionable). Evaluate operating efficiency → start with Gross Profit Ratio, then Operating Margin. Diagnose ROE drivers → apply DuPont analysis. Value dividend‑paying stocks → use DDM; otherwise prefer DCF or multiples. Compare firms of different sizes → rely on vertical (common‑size) percentages rather than raw numbers. --- 👀 Patterns to Recognize Consistent upward trend in gross profit ratio → improving cost control. Sharp decline in current ratio after a large capital lease → likely recasting impact. High accounts‑receivable turnover + low days sales outstanding → efficient collection. Debt‑to‑Equity spikes coinciding with major asset acquisitions → leverage used for growth. --- 🗂️ Exam Traps Mix‑up numerator/denominator – e.g., writing Current Ratio = Current Liabilities ÷ Current Assets. Using total revenue instead of gross sales for vertical analysis of the income statement. Treating “accounts payable turnover” as a time‑in‑days figure (the correct conversion is Days Payable = 365 ÷ Turnover). Applying DDM to a firm with zero or erratic dividends – answer will be wrong. Ignoring lease recasting – may lead to understated debt and overstated liquidity ratios. ---