Basics for the financial
analysis
Lecture for Corporate Finance
Ing. Tomáš Heryán, Ph.D.
Corporate Finance
FIU/BAFIK
Content of the presentation
• Introduction
• Balance Sheet
• Profit and Loss statement
• Financial Analysis (highlight the key variables)
• Users of the analysis
• Ratio analysis
• Profitability
• Liquidity
• Activity
• Indebtedness
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Introduction
Financial Statements represent a formal record of the financial activities of an entity. These
are written reports that quantify the financial strength, performance and liquidity of a
company. Financial Statements reflect the financial effects of business transactions and events
on the entity.
The objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an entity that is useful to a wide range of
users in making economic decisions.
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Financial
statement
Balanced
sheet
Profit and loss
statement
Cash flow
statement
Statement of
changes in
equity
Balance Sheet
Statement of Financial Position, also
known as the Balance Sheet, presents
the financial position of an entity at a
given date.
It is comprised of the following three
elements:
• Assets: Something a business owns
or controls.
• Liabilities: Something a business
owes to someone.
• Equity: What the business owes to
its owners.
Information resulting from the
balance sheet
About the property
situation
About financial sources
About the financial
situation
Balance Sheet – ASSETS
An asset is something that an entity owns or controls in order to derive economic benefits
from its use.
Assets must be classified in the balance sheet as current or non-current depending on the
duration over which the reporting entity expects to derive economic benefit from its use.
Assets are also classified in the statement of financial position on the basis of their nature:
• Tangible & intangible: Non-current assets with physical substance are classified as
property, plant and equipment whereas assets without any physical substance are
classified as intangible assets. Goodwill is a type of an intangible asset.
• Inventories balance includes goods that are held for sale in the ordinary course of the
business. Inventories may include raw materials, finished goods and works in
progress. Trade receivables include the amounts that are recoverable from customers
upon credit sales.
• Trade receivables are presented in the statement of financial position after the
deduction of allowance for bad debts.
• Cash and cash equivalents include cash in hand along with any short term investments
that are readily convertible into known amounts of cash.
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Balance Sheet – LIABILITIES
The company's financial structure is the corporate capital structure from which the company's
assets are financed. It is captured in balance sheet liabilities. Liabilities include:
• equity - equity, capital funds, profits/loss, past performance and current period economic
results,
• debt capital - reserves, long-term and short-term liabilities and bank loans and debt
• other liabilities - in which accruals and deferred income, exchange rate differences,
passive
The financial structure shows the structure of the increase in corporate capital from which the
increase in assets is funded.
In addition to the term financial structure, there is also the concept of a capital structure - it
captures the structure of corporate capital, from which fixed assets and a permanent part of the
current assets are financed. It is therefore a structure of long-term capital. Within the financial
structure, it is necessary to analyze especially the relationship between own and debt capital.
For an optimal financial structure, it considers a capital distribution that is linked to the
minimization of all the costs of its acquisition and is in line with the expected revenue and
profits and property structure of the enterprise.
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Profit & Loss statement
• Income Statement, also known as the
Profit and Loss Statement, reports the
company's financial performance in
terms of net profit or loss over a
specified period.
• The income statement is one of the
major financial statements used by
accountants and business owners.
• The profit and loss statement is
important because it shows the
profitability of a company during the
time interval specified in its heading.
Structure of profit and loss
statement
Revenues
Costs
Net profit or loss
Profit & Loss statement – REVENUES
Revenues from primary activities are often referred to as operating revenues. The primary activities of
a retailer are purchasing merchandise and selling the merchandise. The primary activities of a
manufacturer are producing the products and selling them. For retailers, manufacturers, wholesalers,
and distributors the revenues resulting from their primary activities are referred to as sales revenues or
sales. The primary activities of a company that provides services involve acquiring expertise and selling
that expertise to clients.
It's critical that you don't confuse revenues with receipts. Under the accrual basis of accounting, service
revenues and sales revenues are shown at the top of the income statement in the period they are earned
or delivered, not in the period when the cash is collected. Put simply, revenues occur when money is
earned, receipts occur when cash is received in form of income.
Revenues from secondary activities are often referred to as non-operating revenues. These are the
amounts a business earns outside of purchasing and selling goods and services. For example, when a
retail business earns interest on some of its idle cash, or earns rent from some vacant space, these
revenues result from an activity outside of buying and selling merchandise. As a result the revenues are
reported on the income statement separate from its primary activity of sales or service revenues.
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Profit & Loss statement – COSTS (maybe Expenses)
Costs involved in primary activities should be expenses that are incurred in order to earn normal
operating revenues. Under the accrual basis of accounting sales commissions expense should appear on
the income statement in the same period that the related sales are reported, regardless of when the
commission is actually paid. In the same way, the cost of goods sold is matched with the related sales
on the income statement, regardless of when the supplier of the merchandise is paid.
The income statements or profit and loss statements of merchandisers and manufacturers will use a
separate line for the cost of goods sold. The other costs involved in their primary activities will either be
grouped together as operating costs or subdivided into the categories "selling" and "administrative".
Costs from secondary activities should be referred to those non-operating expenses. For example,
interest expense is a non-operating expense because it involves the finance function of the business,
rather than the primary activities of buying/producing and selling.
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Types of costs (expenses)
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
• Costs independent of the quantity produced
Fixed costs
• Costs dependent on the quantity produced
Variable costs
• Costs that can not be assigned directly to a particular performance
• It is necessary to budget them in a certain way
Indirect costs
• The cost of the last produced unit
• An increase in the total cost of producing one extra product
Marginal costs
• The cost of sacrificing opportunities
Opportunity costs
Types of economic results
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Operating profit/loss
Profit or loss from financial operations
Profit or loss from ordinary activity
Extraordinary profit/loss
Profit/loss from current accounting period
Profit/loss before taxes
The weaknesses of financial statements
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Pitfalls of financial statements
Focusing on historical
accounts
Comparability with other
companies
Impact of inflation
Influence of nonmonetary
factors
Comparability of data
over time
Content of the presentation
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Financial analysis is a systematic analysis of the obtained data, which are contained mainly in the
financial statements, their items, aggregated data and analyze relationships and trends. Financial
analysis incorporate evaluation of corporate past, present and predicting the future financial conditions.
Objectively, it is to identify weaknesses in the company's financial health, which could in the future
lead to problems and strengths related to possible future appreciation of the assets of the company.
Evaluation of firm‘s history
Financial analysis
Investigation of perspectives
Financial planning
T I M E
Users of financial analysis and their interest
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Users of financial analysis
Management
Operating
analysis
Resources
management
Profitability
Creditors
Liquidity Indebtedness Debt services
Shareholders
Profitability Dividend policy
Ratio analysis
Ratios are widely used as a tool in the
interpretation of financial statements. The
ratios selected and the use of the resulting
information depend on the needs of the
person using the information.
In monitoring performance the expert
analysts and fund managers will use ratios
rather than absolute amounts.
Ratios show changes in relationships of
figures which start to create a story and start
to generate questions. They do not provide
answers.
Ratio analysis
Profitability
Liquidity
Activity
Indebtedness
Market ratios
Ratio analysis – PROFITABILITY
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Profitability is a measure of the ability of an enterprise to generate new resources, to make a profit
using the capital invested. Profit ratios with other variables to assess success in achieving business
goals. It is actually a form of expression of profit, which is the main criterion for the allocation of
capital.
Basic questions related to profitability evaluation:
• Does the company use its assets effectively?
The return on assets (ROA) responds to this question and the higher its value, the more effective the total use of
assets is.
• Do the company achieve adequate margins?
The answer is hidden in return on sales (ROS) and the higher the value, the stronger the company is in terms of
gaining one crown of revenue.
• What is the return on investment for shareholders?
We find the answer in return on equity (ROE) and once again the growth of the indicator will mean greater
efficiency for the shareholders.
• Is there sufficient control over operating costs?
Cost-effectiveness and high values indicate capital wastage and require a detailed cost analysis.
• How did the company manage to implement dividend policy?
We look for a response in earnings per share and the growth of this indicator signals a growth in earnings per
share.
Basic PROFITABILITY ratios
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
• Return on assets - it reflects the overall efficiency of the company, its earnings capacity, and also
the strength of production, regardless of the sources were business financed.
• Return on equity - an indicator by which investors can determine whether their capital is
reproduced at the appropriate rate consistent with the investment risk.
• Return on sales - it expresses the ability of an enterprise to achieve profit at a given revenue level,
as it can produce an effect of $ 1 in revenue.
• Return on costs - evaluate the return on the cost invested in the business.
ROA = profit /assets
ROE = net profit /equity
ROS = profit /revenues from sales
ROC = profit /costs
Ratio analysis – LIQUIDITY (liquid or illiquid company?)
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
LIQUIDITY reveals the ability of an enterprise to repay short-term liabilities as persistent, pay-ability
is one of the basic conditions for successful business existence.
Liquidity management means specific solutions that allow the concentration and management of
financial resources that are particularly suited to economically linked groups of companies.
The concept of liquidity is used in the following terms:
• the liquidity of certain components of assets - as an expression of the properties of the components
of the assets as quickly and without much loss of value can be converted into cash
• the liquidity of the company - as an expression of the ability of the company to pay its payment
obligations on time.
Basic LIQUIDITY ratios 1/2
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Cash ratio (L1) =
Cash + Short−term
investments
Current liabilities
Acid test (L2) =
Cash + Short−term
investments
+ Receivables
Current liabilities
Liquidity ratios have a general form of share of what can be paid for what needs to be paid.
• Cash ratio (L1) - only the most liquid items in the balance sheet enter into cash ratio. Ability to
satisfy current liabilities using only cash and cash equivalents. In addition, in the case of cash ratio,
non-compliance with the prescribed values does not necessarily mean financial problems for the
company at all costs, because even in corporate conditions there is relatively frequent use of
spreadsheets, overdrafts or cash pooling, which may not be apparent from the balance sheet data.
Recommended value L1 … from 0,2 to 1
Recommended value L2 … from 1 to 1,5
• Acid test (or quick test (L2)) - ability to satisfy current liabilities using the most liquid of current
assets. The acid test takes a closer look at the liquid assets of the current ratio, omitting the stocks
(inventories). For many companies this ratio is less than 1:1 because it is unlikely that all creditors
will require payment at the same time.
Basic LIQUIDITY ratios 2/2
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Current ratio (L3) =
Current assets
Current liabilities
Net working capital = Current ratio − current liabilities
Recommended value L3 … from 1,5 to 2
• Net working capital - is current assets section, which is financed by long-term financial resources
and the company it may freely dispose of the implementation of their plans. The amount of net
working capital has a significant impact on the company's solvency. NWC required amount depends
largely on the length of the turnover cycle of money, but also to competition, market stability, fiscal
and customs regulations etc.
Current ratio (L3) - The current ratio indicates the extent to which short-term assets are available to
meet short-term liabilities. A current ratio of 2:1 is regarded, broadly speaking, as being a reasonable
order of magnitude. As with other ratios, there is no ‘best’ answer for any particular company and it is the
trend in this ratio which is more important.
The ACTIVITY ratios (in/solvent vs. i/liquid)
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
• Inventory holding period - tells us how long the current assets are tied in the form of inventory. In
general, a shorter inventory turnover time means the better situation. However, it is necessary to
remember the optimum stock size.
• Customer collection period measures the average period of credit allowed to credit customers. An
increase in this measure would indicate that a company is building up cash flow problems, although
an attempt to decrease the period of credit allowed might deter customers and cause them to seek a
competitor who gives a longer period of credit.
• The suppliers’ (trade creditors’) payment period measures the average period of credit taken
from suppliers of goods and services. An increase in this measure could indicate that the supplier
has allowed a longer period to pay.
Inventory holding period =
Average inventories (stock) held
Cost of sales
x 365
Customer collection period =
Trade receivables (trade debtors)
Credit sales (revenue)
x 365
Suppliers payment period =
Trade payables (trade creditors)
Credit sales (revenue)
x 365
Ratio analysis – INDEBTEDNESS
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
• Debt ratio - In general, the higher the value of this indicator, the higher the risk of creditors.
However, this indicator needs to be assessed in relation to the overall return of the company and
also to the structure of the debt capital. The high value of this indicator may be favorable from the
perspective of holders of ordinary shares if the enterprise is able to achieve a higher percentage of
return than the percentage of interest paid from debt capital. Creditors generally prefer the low
values of this indicator.
• Equity ratio - expresses the proportion in which the company's assets are funded by shareholders'
money. It is considered to be one of the most important ratios of indebtedness for assessing the
overall financial situation, but again its relevance to the profitability indicators is important.
• Debt/equity ratio It is the ratio of debt capital to the company's equity. A value above 1 means
higher use of debt capital, a value lower than 1 higher utilization of equity.
Debt ratio =
Debt
Totall assets
Equity ratio =
Equity
Totall assets
Debt/equity ratio =
Debt
Equity
Working with ratio analysis
Comments are conducted in 4 steps:
1. Comment change - growth or decline Items
2. Evaluation of the change - positive or negative in terms of corporate functioning
3. Justification of the assessment - answer to the question WHY?
4. Recommendations for further analysis or further functioning of the company
Presentation of results:
• Charts are important, but not dominant
• The graph is intended to facilitate the orientation of the problem
• Proper use of the chart type:
• Horizontal Analysis and Ratio Analysis - Column or Linear
• Vertical analysis - column stacked or pie
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Working with ratio analysis
• Financial conditions rarely give answers but help to ask the right questions.
• There is no international standard for financial ratios. A little thinking and
common sense have more value than blank formulas.
• Choose. Different ratios often say the same.
• To estimate the company's financial position, you need a reference point. It
is useful to compare the company's financial ratios with these ratios in
previous years and the relationships of other companies in the same field.
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Check questions
1. What is liquidity and why it is important for the company to monitor it.
2. What kinds of liquidity are we differentiating within the ratios?
3. Explain the terms solvency and liquidity.
4. What factors can influence the company when deciding on the way of financing
(e.g. when deciding between own and foreign sources of funding)?
5. Which activity indicators do you consider the most important in terms of business
operation and why?
Tomas Heryan, Ph.D.
Department of Finance and Accounting, SU SBA, Czechia,
http://fiu.cms.opf.slu.cz/en
Thank you for
your attention!
☺