Financial statement analysis Learn to read and analyse your financial data

Who does financial statement analysis of your SME? Your banker - to determine your capability of paying back a loan or getting a loan in the first place. Your investor(s) - to determine if you have been performing according to plan, and/or whether your business is a good investment. Your suppliers - to determine your credit worthiness etc. everyone who looks at your financial statements will conduct a financial statement analysis, in one form or another.

Types of financial statement analysis Vertical and horizontal analysis (analysis of absolute indicators) Analysis using perfomance measures (ratios)

Vertical and horizontal analysis (analysis of absolute indicators) This method of analysis uses direct data involved in financial statements (Balance sheet and Income (Profit and loss) statement) – for assessing and following of financial situation of a given firm.

Vertical analysis Vertical analysis shows how do different parts of a financial statement relate to a total figure in the statement. We set the total figure at 100 percent and compute each part’s percentage of that total. On the balance sheet, the figure would be total assets or total liabilities and owner’s equity, and on the income statement, the figure would be total revenues or total sales.

The main advantage of vertical analysis is its independence of the possible yearly inflation, allowing the comparability of results of analysis from various years and even comparison of various companies. We can see the percentage of various items with respect to total revenue (in P&L statement) and with respect to total assets and liabilities.

Horizontal (trend) analysis By comparing current financial statements to previous or planned financial statements you can see which areas of your business have changed, and by how much. We compare line by line how much have certain items changed (by using index or percentage change) We can then ask ourselves why the change occurred, whether positive or negative: - Are sales going up/down ? - Are costs going up/down (which ones aren’t)? - Are profits going up/down?

Short example – vertical and horizontal analysis of Profit and loss (Income) statement

Short example – vertical and horizontal analysis of Balance sheet

How do we read the data? – example Profit and loss statement Total income (turnover) has increased in year 2014 by 15,3%, mainly due to growth in sales of products by 16,2%. – HORIZONTAL In the structure of income, 97,3% in 2013 and 98% in 2014 come from sales of products, of which sales on domestic market is predominant (88,2% in 2013 and 82,8% in 2014) – VERTICAL Operating costs have grown by 20,8% due to increase in costs of good sold by 21,7% (which represent the highest share in overall cost structure (32,7% in 2013 and 34,5% in 2014) – combination of VERTICAL and HORIZONTAL analysis THE SAME PRINCIPLE APPLIES FOR BALANCE SHEET!

Relative indicators Besides vertical/horizontal analysis, management and other interested parties (banks, investors, suppliers etc.) use for their analysis various financial indicators based on items from your financial reports. These indicators show if firm is safe to invest in (liquid, financialy stable and in debth) and to what extent is it successful (profitable).

Types of indicators liquidity ratios – ratios showing capability of firm to service its current (short-term) obligations; leverage ratios – ratios showing the extent to which firm is financed from other sources; acitivity ratios – ratios showing efficiency of firm in use of its own resources; profitability ratios – ratios measuring return on capital invested;

Liquidity ratios ratios that measure the ability of a firm to pay its short term debt obligations. They put in relation characteristic parts of the assets and liabilities of the firm – Balance sheet data They determine the maturity structure of business financing sources Main indicators: current ratio, quick ratio or acid test, cash ratio

Current ratio The current ratio indicates a firm's ability to meet short-term debt obligations. It measures whether or not a firm has enough resources to pay its debts over the next 12 months. Potential creditors use this ratio in determining whether or not to make short-term loans. The current ratio = Current (Short-term) Assets / Current (Short-term) Liabilities The higher the ratio, the more liquid the firm is. Commonly acceptable current ratio is 2 (short term assets are 2x the short term liabilities)

Quick ratio/Acid test measures the ability to meet short-term obligations using its most liquid assets Quick assets include those current assets that can be quickly converted to cash. Quick ratio is viewed as a sign of a firm's financial strength or weakness; it gives information about a firm’s short term liquidity. Quick ratio = (Cash and cash equivalents + Accounts receivable) / Current Liabilities It should be minimum 1, which means that current liabilities should not be larger than the sum of cash and receivables

Cash ratio ratio of a firm's cash and cash equivalent assets to its total liabilities is a refinement of quick ratio - the extent to which readily available funds can pay off current liabilities. Potential creditors use this ratio as a measure of a firm's liquidity and how easily it can service debt and cover short-term liabilities. Most conservative of the three liquidity ratios (current, quick and cash ratio). It only looks at the firm's most liquid short-term assets – cash and cash equivalents Cash ratio = Cash and cash equivalents / Current Liabilities It should not be less than 0.1. If it is 1 and larger, it means that the firm has enough cash to pay its current liabilities within 15 days. in practice (especially in large companies ) it is never 1 since it means that firm is not utilizing its cash in a good way. Companies should use extra cash to invest in business, and too much cash represents possibility for hostile takover. Bare in mind - in the crisis, cash is king!

Leverage ratios Ratios showing how much of companies activities are covered from own assets and how much from various debt. Predominantly calculated from Balance Sheet statement They influence SME’s credit rating - banks and investors can easily calculate the ability of the business to pay existing debt. Main indicators: Debt ratio, Debt to equity ratio, Equity ratio

Debt ratio ratio that indicates proportion between firm's debt and its total assets. It shows how much the firm relies on debt to finance assets. Debt ratio = Total Liabilities / Total Assets The higher the ratio, the greater the risk associated with the firm's performance – the firm will not be able to service its debts with the financial results achieved and will not it be able to cover interests on the debt. A low debt ratio indicates conservative financing with an opportunity to borrow in the future at no significant risk. If the ratio is less than 0.5, most of the firm's assets are financed through equity (desirable). If the ratio is greater than 0.5, most of the firm's assets are financed through debt.

Debt to equity ratio Debt-to-equity ratio = Total Liabilities / Equity Measuring the relative proportion of firm’s equity and debt used to finance firm’s assets. Also called financial leverage. key financial ratio used as a standard for judging a firm’s financial standing and as measurement of ability to repay obligations. If the ratio is increasing, firm is being financed by creditors rather than from its own financial sources which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios because their interests are better protected in the event of a business decline. high debt-to-equity ratios - firms may not be able to attract additional lending capital. Debt-to-equity ratio = Total Liabilities / Equity

Optimal debt-to-equity ratio is considered to be about 1, i. e Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, ratio is very industry specific - it depends on the proportion of current and non-current assets. For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable.

Equity ratio Also called - net worth to total assets ratio. It tells us how much of the asset is financed from own capital (equity) and how much from the creditors. Equity Ratio = owners equity / Total assets The value should be more than 0.5, meaning that for every 1 euro employed in the business, the contribution of owners is about 50 eurocents or more. The creditors’ contribution would then be 50 eurocents and less.

Activity ratios also called turnover ratios, how many time during the year certain assets are “turned over” in firm (speed of circulating the assets in business process) Most commonly used are turnover ratios on: total assets, short-term (current) assets and receivables Average collection period – calculated from turnover ratios calculated using the figures from Profit and Loss Statement and Balance Sheet Note: the items from the balance sheet can be used as average (beginning + end of year)/2 or as stated at the end of the year!

Generaly speaking, successful companies have high turnover ratios, i.e. the time in which the assets is held in firm is shorter. How do you know you are succesful? – compare yourself with other firms in the industry, or in relation to previous years.

Total assets turnover measure of how efficiently management is using the assets at its disposal to boost sales. The ratio helps to measure the productivity of a firm's assets. Asset turnover = total revenue (income) / total assets

Current assets turnover Ratio that tells us how many time during the year we “turn over” the current assets in order to gain as high revenue (income from sales) as possible Current asset turnover = total revenue (income) / current assets

Receivable turnover ratio Receivable turnover ratio indicates how many times, on average, account receivables are collected during a year It is an important indicator of a firm's financial and operational performance, used also to determine if a firm is having difficulties collecting sales made on credit. Receivable turnover ratio = income from sales / accounts receivables

Average collection period (Days sales outstanding) It tells us, on average, how many day it takes a firm to collect its accounts receivables, i.e. the average number of days required to convert receivables into cash. Average collection period (Days sales outstanding) = 365 / Receivables Turnover Ratio

Profitability ratios Types of financial ratios showing ability of firm to generate income in relation to cost in a given period. the larger the value in relation to the competitor or previous years means that firm is doing good job.

Main indicators: Net profit margin, Return on sales (ROS), Return on assets (ROA) and Return on equity (ROE) They are calculated combining data from Balance sheet and Profit and Loss statement

Net profit margin Most important profitability ratio It shows the amount of each sales euro left over after all expenses have been paid. Useful when comparing firms in similar industries. Higher net profit margin - firm is more efficient at converting sales into actual profit. Net profit margin = (Net profit/ Total revenue) x 100

Return on sales (ROS) also known as "operating profit margin“ ROS indicates how much profit firm makes after paying for variable costs of production such as wages, raw materials, etc. (but before interest and tax) – operating profit also known as EBIT (earnings before interests and taxes) Return on sales (operating margin)= (EBIT / Total revenue) X 100

ROS tells us how much operating profit is firm gaining for each euro of sale/revenue. For example, if ROS is 20%, it means that firm has EBIT of 0,2 euros for each 1 euro of revenue. The higher the productivity, i.e. production of larger amount of output with the same amount of input, profitability will be also higher.

Return on assets (ROA) shows the percentage of profit that a firm earns in relation to its overall resources (total assets). It measures the amount of profit made by a firm per euro of its assets. gives an indication of the capital intensity of the firm, which will depend on the industry. Capital-intensive industries (such as railroads and thermal power plant) - low return on assets due to huge assets required. Software and service companies - high ROA: their required assets are minimal. ROA = (Net profit / Total assets) X 100

Return on equity (ROE) The “mother of all ratios” It shows how much profit a firm earned in comparison to the total amount of owner equity found on the balance sheet. It measures how profitable a firm is for the owner of the investment, and how profitably a firm employs its equity. ROE = (Net profit / Owner's equity) X 100