Chapter 7: Preparation and Integration

of Statement of Comprehensive
Income, Cash Flow Statements and
Statement of Financial Position
Chapter Content
1. Analysis of industry assumptions and their
rationale for revenues & costs, assets and
liabilities’ assumptions
a. Operating cost
b. Capex
c. Leverage
d. Modeling of historical ratios
e. Trends
2. Short listing assumptions and applying
adjustments
Introduction
• Financial Statement Analysis is a method of
reviewing and analyzing a company‘s financial
statements in order to gauge its past and
present performance or predict future
performance.
• This process of reviewing the financial
statements allows for better economic decision
making.
Components of Financial
Statements
• Consist of Income Statement, Balance Sheet, and
Cash Flow Statement.
• Building blocks that form the Financial Statements
and helps in understanding the financial health of
the business.
• Each component serves a purpose and helps in
understanding the financial affairs of the business.
Financial Statements and
Financial Analysis
Financial
Statements

Financial Income Balance Cash Flow

Statements Statement Sheet Statement

Types of Financial Horizontal Vertical Ratio

Analysis Analysis Analysis Analysis
Financial Statements

The Balance Sheet is a summary of the assets and liabilities and equity of a
business at a specific point of time. It also provides a picture of the financial
solvency and risk bearing ability of the business.

The Income Statement, or Profit and Loss statement, summarizes the revenue
and expenses for a specific time period (i.e. one quarter or one year) .

The Cash Flow Statement, is a financial statement that summarizes the amount of
cash and cash equivalents entering and leaving a company. It measures how well a
company manages its cash position i.e. how well the company generates cash to pay
its obligations and fund its operating expenses.
Financial Statement Structures
Income Statement Balance Sheet Cashflow Statement
Sales Assets Cash from Operating Activities
(-) Cost of Goods Sold
= Gross Profit Liabilities Cash from Investing Activities
Equity
(-) Expenses Cash from Financing Activities
= Operating Profit

(-) Interest
= EBT

(-) Taxes
= Net Profit
Types of Financial Analysis

Vertical Analysis Horizontal Analysis

• Vertical analysis is a financial • Horizontal analysis is one of the most
statement analysis where each important techniques to find out how
item in the financial statement is a company is doing financially.
shown in the percentage of the • It is used to evaluate trends year over
base figure. year (YoY) or quarter over quarter
(QoQ).
• It is simple to do and also called a
common size analysis. • A year-end balance sheet or income
statement wouldn’t be enough for
• E.g. all the items in the income you to judge how a company is doing.
statement can be stated as a • You need to look at a couple of years
percentage of gross sales. at least to be sure. Better yet, if you
• All the items in the balance sheet can see many years of balance sheets
can be stated as a percentage of and income statements and make a
the total assets. comparison among them.
Vertical Analysis
• In the vertical analysis of financial statements, the
percentage is calculated by using the formula:
Vertical Analysis for Income
Statement

(Net Profit/ Sales) x 100 = (17000/ 100000) x 100 =17%

To increase the effectiveness of vertical analysis, multiple year’s statements or reports can
be compared, and comparative analysis of statements can be done. This analysis makes it
easier to compare the financial statements of one company with another and across the
companies as one can see the relative proportion of accounts.
Vertical Analysis for Balance
Sheet

Percentage analysis of
balance sheet items on
the basis of a common
figure.
E.g. Each item is shown as
a percentage of total
assets.
Advantages and Disadvantages of
Vertical Analysis
Advantages Disadvantages
• One of the easiest methods of • It does not help to make a firm decision
financial analysis. as there is no standard percentage or
• Provides a comparable percentage ratio regarding the change in the
components of the income statement
which can be used to compare with or the balance sheet.
previous years.
• The accounting conventions are not
• Different organization statements can followed vigilantly in the vertical
be compared as the comparison is analysis.
made in percentage form.
• The liquidity of the organization cannot
• Can be used to understand the be measured precisely by using the
percentage share of individual items. analysis.
• Can be used to understand the • Quality analysis is not done by using
structural composition of various vertical analysis as there is no
components like cost, expenses, consistency in the ratio of the
assets, and liabilities. elements.
Horizontal Analysis
• First, we need to take the previous year as the base
year and the following year as the comparison year.
• E.g. let’s say we are comparing between 2015 and
2016; we will take 2015 as the base year and 2016
as the comparison year.
Horizontal Analysis
Horizontal Analysis in
Forecasting and Financial
Modelling
• Horizontal Analysis is very useful for Financial
Modeling and Forecasting.
• The approach is fairly simple.
• Step 1 – Perform the horizontal analysis on the historical
data.
• Step 2 – Based on the YoY or QoQ growth rates, you can
make an assumption about future growth rates.
Interpretation of Results
• From the income statements and balance sheets, a company may portray a
good hold on their financial affairs. But it’s your responsibility to check each
item and see if there is a difference. You may discover something about the
company which is hidden from potential investors.
• Companies can inflate profit or show an undervalued statement by
changing a few things here and there. But if you pay attention, you would
be able to discover what’s actually going on within the company.
• With such analysis, you would be able to understand how this company
may do and what they are trying to accomplish over the years – what’s their
recent purchase, sales, revenue, net income, fixed assets, current assets,
capital structure and every data mentioned in the balance sheet and
income statement.
• Unlike other techniques, this technique give investors an overall picture of
where a company stands in terms of financial matters, what they are trying
to do with the funds, and how profitable the company can be in the near
future.
Ratios
• Ratios are useful when comparing a company with the
competition on financial performance and
benchmarking the performance of the company.
• Ratios can measure a company's performance against
the performance of other companies.
• Most ratios will be calculated from information
provided by financial statements.
• Financial ratios can analyse trends and compare
financial status to other similar companies.
• They can also be used to monitor a company’s overall
financial status.
Financial Ratios Example
Financial Ratios

Liquidity Ratios Leverage Ratios Profitability Ratios Activity Ratios Market Ratios

Current Ratio Debt Equity Ratio Gross Profit Margin Inventory Turnover Earnings per Share

Accounts
Debt Service Operating Profit
Acid-Test Ratio Receivables
Coverage Ratio Margin
Turnover

Interest Coverage Average Collection

Net Profit Margin
Ratio Period

Return on Equity

Return on Assets
Trends
• Trend analysis is an analysis of the performance of
the company by comparing its financial statements
to the market or analysis of the future on the basis
of past performance.
• Involves collecting information from multiple
periods and plotting the information on a horizontal
line with the objective of finding actionable
patterns.
Importance of Trend Analysis
• A trend represents the general direction the firm/ market is
heading during a specific period.
• Trends can be growing and/ or decreasing, relating to
bearish and bullish markets.
• Trend analysts try to find out a trend for a bull market run,
and make a profit until data shows a trend reversal, i.e. from
a bull to bear market. It is helpful for traders because
moving with trends, and not going against them, will make a
profit to an investor.
• While there is no specified minimum amount of time
required for a direction to be considered a trend, the longer
the direction is maintained, the more notable the trend.
Uses of Trend Analysis

Accounting Analysis Technical Analysis

• Revenue and expenses in the firm’s P&L • Trend lines can be created from historical
statement can be arranged on a horizontal stock prices, and this information can be
line for multiple periods with trends used to predict the future movement of
examined or for data inconsistencies. the stock price.
• E.g. a sudden spike in the expenses in a • The trend can be associated with a given
particular quarter followed by a sharp information. Cause and effect relationships
decline in the next period, is an indicator must be studied before concluding the
that expenses was booked twice in the first trend analysis.
quarter.
• Involves finding patterns that occur over
• Essential for examining financial statements time, like a cup and handle pattern, head
for inaccuracies, to see whether adjustment and shoulder pattern or reverse head and
should be made before the conclusion is shoulder pattern.
drawn from the financial statements.
• In technical analysis, it can be used in the
• Compares the overall growth of key financial foreign exchange market, stock market, or
statement line item over the years from the derivative market. With slight changes, the
base case i.e. can also be used for
same analysis can be used in all markets.
forecasting.
Examples
• Examining sales patterns to see if sales are
declining because of specific customers or products
or sales regions;
• Examining expenses report claims for proof of
fraudulent claims.
• Examining expense line items to find out if there
are any unusual expenditures in a reporting period
that require further investigation;
• Forecast revenue and expense line items into the
future for budgeting for estimating future results.
Types of Trends
Sideways/ Horizontal
Uptrend Downtrend
Trend
• An uptrend or bull • A downtrend or bear • A sideways/
market is when market is when horizontal trend
financial markets and financial markets and mean asset/ share
assets move in the asset prices move in prices are not
upward directions the downward moving in any
and keep increasing direction and prices direction; they are
prices of the stock or of the stock or the moving sideways, up
the assets or even assets or even the for some time, then
the size of the size of the economy down for some time.
economy over the keep on decreasing • The direction of the
period. over time. trend cannot be
decided.
Things to Ponder
• Trend analysis can be used to forecast future
performance of firms.
• However following blindly can turn out to be
dangerous if a proper analysis of the past event is
not done.
Any Questions
End of Chapter 7