Tutorial for
Basic Financial Statement Analysis

by

Dr. Del Hawley, PhD
Senior Associate Dean and Associate Professor of Finance
The University of Mississippi School of Business Administration

• Never use only one ratio: One ratio by itself tells you nothing. Multiple ratios within each group (profitability, liquidity, efficiency, leverage) should be used to get the "big picture" of what is going on.
   
• Never use only one time point: Financial statements are cast in quarters and years, which are arbitrary time periods that do not necessarily correspond to actual business activity. It is only by comparing information over several periods that you can spot significant changes and trends that warrant further analysis. CHANGE is what you are looking for.
   
• Never use only one company: Knowing what is happening with other companies in the industry is essential to knowing what is happening in a particular company. In any time period, most of the changes that you will see in the financial statements and ratios are due to general economic and industry changes, not changes in the company itself so you need to know which changes are specific to the particular company you are analyzing and which are not.

Financial analysis is just good detective work. You are looking for clues in the data -- hints that something has changed -- so you can look deeper to find out why. It's the changes that tell you the most. There are also some standards and "rules of thumb" that you can apply, but they are of secondary importance to just analyzing the changes.

Financial statements provide only raw, undigested data in a relatively standard format. It's up to you, as the analyst, to digest the information so it can be used to learn something about the company. You need to know what the statements do and do not tell you; they are incomplete and imperfect, but they are the major source of the information you will have to use.

Before you start to analyze a company, get to know the industry in which the company operates. Read news articles and industry reports (see the resource page for some good sources) to get a good feel for what is happening in the industry, what has changed over the last few years, any major problems in the industry, what the major companies are, and what analysts are saying about the industry's future prospects.

Read news articles and other background information on the company. Look for information that will let you in on the company's recent successes and failures, its major products, its competition, and its future plans. Select at least one major competitor and read about that company as well so you have a basis for comparison.

Now you are ready to start looking at the company's financial data.

You need at least three years of financial statement data, but five years would be better. While there are many good sources on the resource page, the best ones are probably Mergent Online (because it makes it a snap to download the data into a spreadsheet) and Research Insight on the Web (RIWeb) because it is directly integrated into Excel as an add-in).

If you are using Mergent:

Look up the company you are analyzing and download the data into a spreadsheet. You might want to set the dropdown for the type of statement you want to ALL SECTIONS so you get everything on one page, then click on DOWNLOAD TO MS EXCEL to get it in your spreadsheet. In the resulting spreadsheet, you will need to adjust the column widths so you can see everything, and you might want to do some other basic formatting so the data is easier to read and get around in.

Do the same thing for at least one other company in the industry, preferably a major competitor. You will need this data as a basis for comparison.

See this example spreadsheet for instructions on downloading data from Mergent for Dell and Gatewaty.

If you are using RIWeb:

Read this tutorial on how to download data into your spreadsheet. Get data for at least two similar companies for at least three years.

The first step in the actual analysis should be to recast the statements in "common size" format. This allows you to see the numbers standardized across time so you can more easily spot changes and trends in the line items. To do this, follow these steps:

• In the income statement, divide each line item in a given year by SALES for that year. The result will be all amounts stated as a percent of  sales, and this will also provide the major PROFITABILITY RATIOS (gross profit margin, operating profit margin, net profit margin).
   
• In the balance sheet, divide each line item in a given year by TOTAL ASSETS for that year.
   
• Also in the balance sheet, divide all current assets and current liabilities by SALES for that year.

Do this for the main company and the competitor(s) you chose.

See the example spreadsheet for examples for common size statements for Dell and Gateway.

The percentage figures in the common size statements are your clues to spot changes and trends. Look at every item and look for significant changes, particularly those that persist and increase over time. A change can be significant without being huge. For a company with $10 Billion in sales and a gross profit margin of 40%, a 1% change to 41% equates to a $100 Million difference in profit.

Compare the changes in your target company's statements to the competitors' statements to see whether the changes were likely to have been industry wide or specific to your target company. This is also a good way to see whether your target company weathered problems better or worse than others in the industry. For example, if your target company's operating profit margin fell from 20% to 18% over the last few years but the competitors fell from 21% to 16%, things were a lot better for the target company than for others in the industry. This points out that what appears to be bad (a decrease in profitability) might actually be good when compared to others in the industry (less decrease in profitability than others). That's why the industry/competitor comparison is so important.

An important area to watch in the common size balance sheet is the relationship between current assets (accounts receivable and inventory in particular) and current liabilities (accounts payable and short-term borrowing in particular) to sales. These are the "working capital" components of the balance sheet, and you would expect them to maintain about the same percentage relationship to sales over time. Increases and decreases in these items' relationship to sales can be important flags concerning good or bad things happening to the company. For example, an increase in accounts receivable to sales could mean that the company's customers are stretching their accounts, paying later on average, and thus putting pressure on the company's cash flow due to longer collection periods. An increase in payables to sales could be an indicator that the company is having trouble meeting its short-term obligations due to a cash shortage. Any change can be caused by a multitude of factors, so they should be viewed as CLUES about places to dig deeper in the information to determine the real cause of the change. Again, comparisons with competitors and industry averages are important elements of this part of the analysis. See this list of online resources for potential sources of industry average figures.

To understand ratio analysis, you have to think of things from the perspective of cash flow. Cash is the blood of the business. Literally. Your body's health -- indeed your life -- depends on blood, but more importantly it depends on what the blood is doing. It needs to move around under a certain pressure, it can't be sitting in one place very long, it can't be leaking out, it needs to be replenished on a more or less constant basis, you need a particular amount of it, etc. When you go to the doctor, the first thing she does is...  take your blood pressure. If you are sick, you get... a blood test. It's important stuff.

Cash in a business is just as important, and it has the same sorts of requirements. Most of the ratios (except profitability) are in some way measuring either a cash FLOW or a cash STOCK (with stock meaning a supply of cash). The income statement is the amount of change in certain aspects of the business over a time period (a quarter or a year) and the balance sheet is a snapshot of the company's major accounts at a point in time. Ratios help take the raw data that is supplied in these statements and recast it into something more useful -- something that shows rates of change in important items and relationships between important things. Many of the ratios are like miles per hour or miles per gallon figures for your car. Saying you drove five miles says something, but saying you drove five miles in five minutes provides a lot more information. You can give the same information by saying you drove 60 miles per hour for 5 miles. Saying your car used 3 gallons of gas says something, but saying it used three gallons to go 30 miles gives a lot more information. Saying you get ten miles per gallon says the same thing (although you might not want to admit that). That's what ratios do for you -- they take raw information and make it better information by combining items together.

As noted above, the main things to look for in ratios are significant changes and trends over time that depart from the norms of the industry during the same time. Improvement or deterioration of ratios relative to the industry tells you that something is happening in the company that warrants more investigation.

See the example spreadsheet for some key ratios for Dell and Gateway.

There are good summaries of the most common ratios listed on the resource page -- Investopedia, Ameritrade, and NetMBA. Use those sources to get familiar with the ratio definitions and purposes. Investopedia's tutorial on ratio analysis is a great one to work through. The Damodaran and BizStat sites are good sources for industry comparison data. Also be sure to read Dr. Damodaran's very excellent Primer on Financial Statements and these tutorials on financial analysis:

• http://www.va-interactive.com/inbusiness/editorial/finance/ibt/ratio_analysis.html
• http://www.bized.co.uk/compfact/ratios/index.htm
• http://www.investopedia.com/university/financialstatements/
• http://www.investopedia.com/university/fundamentalanalysis/

For the period of concern, compare the company's stock price movement to that of similar companies and to the S&P 500 stock index. Changes in the market price of the stock are objective external assessments of changes in the company's value, but many things change value that are not specific to the company -- like general economic factors, exchange rates, interest rates, etc. So, what you want to look for are changes that are different from the average stock or from other similar stocks. Those changes are clues that the average investor saw something as affecting the company's value that was specific to the company.

One of the best - free- sources for this information is Yahoo Finance. Use the new charting tool for a great view of the stock price movement. For example, type DELL in the input box at the top left of the front page and press GET QUOTES. On the resulting page, click on TRY OUR NEW CHARTS IN BETA just over the small chart on the right. If it asks permission to load an applet, say YES. When the chart loads, click on the "5y" button on the bottom of the chart to extend the view to 5 years. Note that you can move your cursor over the chart and get specific information for any date. At the top left of the chart, you should see three companies that are direct competitors. Click on Hewlett Packard to add it to the chart. Under the competitors, you should see the major stock indexes. Click on S&P 500 to add it to the chart. Now you have a great tool to compare Dell to the industry and to the market! To make it even better, click on the TIME RANGE button at the bottom left of the chart. Use you mouse to move the arrow handles in the pop-up window to the date range that you want to zoom in on. Now you have a way to magnify one particular time period while still comparing the company's stock movement to other companies in the industry and to the market.

As I said earlier, there is nothing scientific about any of this. When it comes down to it, you are just making an educated guess about what is going on in a company. The more analyses you do, the better your guesses will be. Just put on your Sherlock Holmes hat, grab your magnifying glass, and start looking for clues.

There are a few common mistakes that you should try to avoid, and some potential problems to look out for, such as the following:

Reality didn't read the textbook. That is, there are very few textbook problems that ever show up in reality. A very common problem format in a basic financial analysis textbook is to set up a sample income statement a balance sheet for a company, usually with only one year of data and some industry average numbers for that year, and have you calculate the common ratios. Then, using the lone year's industry comparison data, you are somehow supposed to say whether a particular ratio is "good" or "bad" relative to the industry average. This exercise is close to useless. There are many reasons why your company might have ratios that are not close the industry averages and yet the company is in fine shape, and one year of data is never enough to analyze. Always remember that the analysis just gives you clues about where you need to look for more information -- it is not the end of the job.

Cases are meant to leave you guessing, or there wouldn't be anything to discuss. If a case gave you all of the information you needed to get to a definitive answer, it would be textbook problem and not a case. In order to form the basis for a discussion, cases are meant to leave a lot of holes in the information and they do not have one right answer by design. (There are always lots of wrong answers -- things that are just stupid -- but always more than one right answer.) It is typical for a case to be short on industry comparison data, and possibly even short on the number of years of information you get. So, you just need to work with what you got, and if possible (and if you want to be viewed as a highly industrious and motivated student) go look for some of the information you are missing. Many magazines archive years and years of articles on their websites, and while you may not be able to find hard data for industry comparisons if the case took place more than a few years in the past, you can usually find a lot of other useful information about any company or industry at any time.

Industry averages can be misleading. Always use them with caution and remember that "average" is not necessarily "optimal". There can be lots of good reasons to be different than average, and lots of reasons why an industry average is not a good comparison for a particular company. For instance, there are some industries (software, for example) where the industry average is ONE COMPANY (Microsoft) simply because one company's size dwarfs the others in the industry. Comparing a small software company in a niche market to Microsoft won't be very useful. Another problem is when the company you are analyzing is in multiple industries. If you can't disaggregate the financial statements by industry classifications (not likely) then industry averages are not going to be very useful. In that case, you fall back on looking for changes and trends relative to the general economy.

Don't forget that financial statements are far from perfect. You need to know their limitations. There are many important factors that impact valuation heavily that are not included in the financial statements (the value of human capital, the value of reputation, the value of appreciated real property, and many others), and things that do not impact value that are included (book value of equity, for example). They are RAW DATA only, presented in a reasonably standardized form, but almost useless until they are refined and digested through the analysis process.