Financial Analysis Fundamentals
Hi, and welcome to Financial Analysis Module 1: Analyzing the income statement
In this session we will:
- Walk through the key components of the income statement
- Perform a vertical analysis of the income statement through ratios
- Perform a horizontal analysis of the income statement using past years’ history
- Prepare and train to be ready for a career as an analyst of other finance jobs
- And finally, discuss how to benchmark against other companies within an industry
- During this module, we will be using an example from the technology industry and one from the retail industry in order to demonstrate and practice our analytical skills.
- But first, let’s start with a general discussion about financial analysis.
Financial analysis includes a number of different steps in order to gain a complete picture regarding the performance of a company. The starting point is the financial statements – in particular, the balance sheet, income statement, and statement of cash flows.
Once we have the financial statements, we can perform trend and ratio analysis – for the income statement, this relates to the horizontal and vertical analysis that we’ll be covering throughout the module. We also use the balance sheet and statement of cash flows to undertake a cash flow analysis. These are covered in Modules 2 and 3 of this course.
Once we perform the analysis, we interpret the results.We interpret the results throughout each module. However, Module 4 of this course puts it all together, leading you through the pyramid of ratios and how it can be used to give you a solid overview of how a company is performing.
When using ratio analysis, there are two basic groups – performance ratios and financial leverage ratios.
- Performance ratios speak to how a company is doing – how profitable is it and how efficiently is it being run.
- Financial leverage ratios speak to the financial condition of the company – how liquid and how solvent it is.
For this module, we are only focusing on the performance ratios – and when analyzing the income statement, it is the profitability ratios that we pay attention to. Before we break out the calculators, let’s spend some time reviewing the components of the income statement. If you look at the components on your screen, you will see that each component has been color-coded. The colors help highlight how items are grouped and treated within the income statement.
- First, we start with sales –in the blue box. Sales revenues are the lifeblood of the company and play a key role in a significant number of ratios as you will see in just a few moments. In order to produce sales, we need to incur expenses. The first set of expenses relates to our cost of sales, or cost of goods sold – highlighted in the lavender boxes. Cost of goods sold relates to the direct labor and raw materials used in order to create the product or service that is being sold.
- One other item related to cost of goods sold relates to the depreciation of the equipment that is used in order to produce the product. For example, in a manufacturing company, any depreciation related to the manufacturing equipment would be allocated here.
- By subtracting the cost of goods sold from sales, we come up with our first significant item on the income statement – gross profit – the green box. Gross profit tells us what net revenue is before we take into account any other costs needed to keep the company running. If gross profit is a negative number, the company is in big trouble since it means that it costs more to produce the product or service than it can be sold for.
- After gross profit, you will see a series of red boxes. These boxes relate to the indirect expenses that are required to keep the company going.
- Research and development relates to new products or technologies required to keep up with or keep ahead of the competition.
- Marketing and sales relates to those costs that need to be incurred in order to get the product or service out to the customers.
- General and administrative are those costs that can’t be allocated anywhere else. Usually, finance and accounting, human resources, IT support, and the executive management of the company are allocated to this group of expenses.
- Also, amortization of intangible assets and any depreciation related to non-production equipment (like office furniture for example) would be allocated to this set of expenses.
- After subtracting all of these expenses, we come up with the next key item on the income statement – income from operations, or operating income. Operating income is used to pay the government, creditors, and ultimately the shareholders. And those are the next few boxes you will see.
- The first box relates to both interest income and expenses that the company has incurred. Interest income would arise when the company makes investments – for example, it may put any excess cash into a term or certificate of deposit, or a treasury bond.
- Interest income normally isn’t included in revenue because it’s not an operational item. That is, it wasn’t earned for any other reason than the company investing excess cash. If it were included in revenue, this could lead to making the wrong conclusion about a company’s actual performance, as weak sales could be propped up by interest income in the short term.
- Interest expense is paid on any debt that the company may have incurred in order to finance an acquisition, say for example a building, a piece of equipment, or maybe to purchase another business.
- Taxes need no explanation. When a company earns money, the government takes its share. However, efficient managers know how to minimize taxes paid to the government in order to maximize profits to the shareholders.
- And this leaves the final significant item on the income statement – net income. The income that’s left when all is said and done to be distributed to the shareholders of the company.
- So now that we’ve reviewed the income statement components, let’s get down to the analysis, starting with vertical analysis. Vertical analysis is ratio analysis that is performed by taking each component under sales and calculating it as a percentage of sales.
- We can take everything from cost of goods sold through to general and administrative expenses and divide them with sales revenues in order to come up with a percentage of sales. The significance of calculating these ratios is to give us an idea of what the contribution for each expense is to earning the sale. Put a different way, for every dollar of sale made, how much did it cost to earn that dollar?
Although we could calculate every ratio related to the income statement, for this course there are really only 3 key profitability ratios that we are most concerned about.
- The first is the gross profit margin percent. This ratio is calculated by taking gross profit, which is simply our sales less our cost of goods sold, or cost of sales, and dividing that number by sales. For every dollar sale made, how much of that dollar was spent producing the good or service that was sold?
- The second key profitability ratio is directly related to the second key item we looked at on the income statement. It’s the operating profit margin percent. The calculation of this ratio is taking income from operations – also known as EBIT or ‘income before interest and taxes’ – and dividing it by sales revenue. The importance of income from operations, or EBIT, was explained briefly earlier. As stated earlier, this is the income that’s left over to pay interest obligations on debt, pay taxes to government, and the remainder is what the shareholders earn for their ownership in the company.
- The last of the three key profitability ratios relates to the very last item on the income statement – net income, also known as net profit. The net profit margin percent is calculated by taking net income and once again dividing it by sales. The ratio ultimately tells us how much is earned for every dollar worth of sales revenue.
There are two more ratios that we need to cover before we crunch some numbers.
- The first is the tax ratio. The tax ratio is an efficiency ratio that demonstrates how well management is managing tax. It is calculated by taking the tax expense shown on the income statement and dividing it by earnings before tax, but after interest. By comparing the percentage to the effective tax rate, we can identify if management is effectively utilizing its assets to earn operating income or if assets are sitting as idle investments. A tax ratio that’s higher than the effective tax rate would indicate the latter, as investment income attracts a higher tax rate than operating income.
- The second and final ratio that we will look at is the interest cover ratio. This ratio is a solvency ratio that tells us whether the company will be able to cover what it owes in interest to its creditors in the short term. The interest cover ratio is calculated by taking EBIT, or operating income, and dividing it by the interest expense reflected on the income statement.
RIM Vertical Analysis Demonstration
Tesco Vertical Analysis Exercise
Now it’s your turn to calculate these ratios.
- Click on the link entitled “Tesco vertical analysis exercise” to open up Tesco’s income statement for 2010 along with a Word template for you to put in all of the ratios.
- Once you are finished, click on the “Tesco vertical analysis solution”. The solution provides the ratios and how they were calculated.
Horizontal analysis is the next step of financial analysis and is usually done after the vertical analysis is complete. Horizontal, or trend analysis, is performed by analyzing across months or years. Calculating the ratios is one thing, but in order to put them into context, they should be calculated for at least the past five years. By comparing historical trends, we are better able to understand how the company is performing and better predict how it may be expected to perform in the future.
By performing trend analysis, we can see whether there is consistent and continued growth – as demonstrated by a straight line rising up – or consistent and continued losses – the straight line going in the opposite direction.
- We can see whether a change in sales price or volumes through a strategic change has caused an increase or decrease in growth, demonstrated by a curved line extending either up or down.
- We can see whether growth has remained flat – demonstrated by a flat horizontal line. This type of line may be experienced in a mature industry that isn’t subject to market fluctuations.
- Or we can see whether there are market fluctuations or other factors causing a pattern of peaks and valleys over time – expressed through a line with an inconsistent pattern.
Horizontal analysis allows us to answer questions such as: “Are margins rising or falling?” or “Is performance improving or declining?“ And by using this analysis, we are able to pinpoint areas for further examination. For example, what is causing margins to rise or fall? Are the causes related to sales price fluctuations, to changes in volumes or changes in costs related to the production of the goods or services? Or, are margins being impacted by non-direct costs such as increases in research and development or marketing? By understanding the change in performance, we are better able to predict future performance or make changes to either capitalize on the company’s successes or react to declining performance.
RIM Horizontal Analysis Demonstration
Debrief of RIM Horizontal Analysis
Tesco Horizontal Analysis Exercise
It’s your turn to put theory into action again.
- Open the “Tesco Horizontal Analysis” link.
- Complete the vertical analysis for the remaining four years of income statements and look at the trends. What do the numbers tell you about the performance of the company?
- Once you’ve completed your analysis, click on the “Tesco horizontal analysis solution” link to see how you did.
Vertical and horizontal analysis performed on a company’s financial statements provides insight into how the company is performing in the context of itself. However, it is just as important to understand how the company is performing relative to others in the same industry.
There are different ways that a company can be benchmarked.
- The first is to compare two or more companies – the competitors – this means obtaining their financial statements and calculating the same ratios that were calculated for your company and then comparing them against each other. The risk associated with this benchmarking is that the competing companies may report income and expenses differently than your company. However, the benefit to calculating the ratios yourself is that if you perform horizontal analysis, you will be able to see the historical trends and compare those trends to your company’s performance.
- Another way to benchmark is to compare the company’s ratios to an industry average. The risk is similar to what was previously mentioned.
Different reporting methods may lead to differences in the ratios that may not really exist. Also, the ratios themselves may be calculated slightly different from how you have calculated them. However, once again by using horizontal analysis, you can compare the trends to determine how the company is performing relative to the industry.
In order to perform benchmarking, you need to find sources of information – either industry ratios that have already been calculated or competitors’ financial statements where you can calculate the ratios yourself. But where do you find this information? There is actually a surprising amount of readily available information at your fingertips. In fact, all you really need is a computer and an internet connection.
First, let’s consider where to find the financial statements for a competitor. If the companies are publicly traded, then all of their financial statements must be filed for regulatory purposes and those financial statements are available for public access.
- For example, for US companies or any company that is under regulation by the US Securities and Exchange Commission, EDGAR (http://www.sec.gov/edgar.shtml) contains all reports related to financial information for the company.
- For companies traded in Canada, then their filings can be found on SEDAR – the Canadian equivalent of EDGAR (http://www.sedar.com)
- Another excellent source of financial information is MSN Money. MSN Money provides up to 10 years of historical information and even calculates the ratios for you. In addition, it provides the ratios for industry averages as well. (http://moneycentral.msn.com)
- Google Finance is similar to MSN Money. It also provides a list of competitors with links to their financial information as well. (http://www.google.com/finance)
You should spend some time exploring these websites as they provide valuable information and if used in conjunction with each other, will provide you with more than enough for you to conduct a fairly thorough initial analysis. There are a couple of other places where financial information can be found.
- One area is to go directly to the competing companies’ websites. Often they post their annual report, which includes financial statements.
- The other is to obtain trade journals for the industry itself. For example, in the retail industry, a trade journal such as provides useful information.
So as you can see, there is no shortage of information out there and you can do a very thorough job of analyzing a company if you know where to start.
RIM Benchmarking Demonstration
TESCO Benchmarking Exercise
That concludes this session on Analyzing the income statement. As you have seen, financial analysis is important in understanding a company’s past performance as a predictor of its future success, and income statement analysis is just one step in the overall analysis, but one that provides a wealth of information. By using horizontal and vertical analysis both internal to the company, as well as in comparison to the industry as a whole, we are better able to assess how to improve or maximize performance if we are internal to the company, or how to make better investment and/or credit decisions if we are outside the company.