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Analyzing Financial Statements

Now that you know how to read financial statements and understand what the different accounting terms mean, the next step is to analyze the financial statements. There are 2 common types of analysis. The horizontal analysis and the ratio analysis.

Horizontal Analysis

Horizontal analysis is the most straightforward method of analyzing financial statements. It is a quick method to separate companies with great investment opportunities from the rest. It is also useful to uncover problem areas for further investigations.

In the annual reports, the financial statements show the financial data for the current year and the year before. The figures are presented side by side for easier comparison between this year’s performance with last year’s performance.

Sales Revenue

The key in horizontal analysis is to analyze the % change of the company’s sales revenue with the % change in the other lines. For example, if sales increased by 15%, then product costs, operating costs, trade receivables and payables should be expected to increase by about 15%.

% change in Sales = 100 x [This year Sales − Last year Sales] / Last year Sales

Gross Profit (GP)

Has the gross profit changed in line with the change in sales revenue?

If the sales have increased but the gross profit has dropped, then something is seriously wrong. Has the company changed its pricing strategy? Has the product costs increased? Has the company written-off a lot of old and bad inventory? Has the company charged other costs such as research and development costs into cost of sales?

Sometimes the % change in Gross Profit is higher than the % change in Sales. If it is due to a change in pricing strategy, is it sustainable? Is the company moving from mass products to niche products therefore higher margin? Has the cost reduced because of efficiency? Were there one time expenses charged into the cost of sales last year and not this year?

% change in GP = 100 x [This year GP − Last year GP] / Last year GP

Earnings Before Interest & Tax (EBIT)

Is the % change in EBIT consistent with the change in Sales and Gross Profit?

Check the operating expenses to understand more about the % change in EBIT. Has the management reduced admin costs through management efficiency, down-sizing, or by off-loading non-critical processes (such as payroll) to a third party? Has the company suddenly increased or reduced its marketing and advertising spend? Why?

% change in EBIT = 100 x [This year EBIT − Last year EBIT] / Last year EBIT

Earnings Before Tax (EBT)

EBT is obtained after deducting for interest expense from EBIT. The interest expense is unlikely to move in line with sales. However, a simple year-on-year comparison may highlight other changes such as leasing charges and changes in borrowings.

These figures may tie in with the figures in the balance sheet such as the short-term and long-term borrowings.

Net Income

The net income is affected by all the line items above it. In addition, you also need to evaluate if the change in net income is affected by the tax rate. The company’s policy on deferred tax may be relevant as well.

% change in Net Income = 100 x [This year Net Income − Last year Net Income] / Last year Net Income

Dividend

Compare dividends with previous years. A reduction in dividend is a worrying sign and major companies usually try to avoid this. This is important especially for the elderly who invest in income stocks because they want to live on the dividend income and so the reliability of the expected cash flows from dividend is crucial.

Also, compare the dividend per share to see if it is consistent or increasing. A decreasing dividend per share is also a worrying sign.

In summary, when analyzing the financial statements, always ask yourself why and what could possibly cause the changes in the figures from last year to this year. Confirm this with other non-financial information such as press release, the outlook of the industry, consumer trends and so forth.

It is never advisable to make your investment decisions solely based on analyzing the financial statements because whatever is in the financial statements have already paseed. Past performance is not a guarantee that the company will produce the same performance in the future. Nevertheless, since nobody can predict the future with accuracy, perhaps this is why analysts look to the past as a guidance to predict the future.

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