Issues with Financial Statement Analysis

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  • 0:04 Issues with Financial…
  • 1:31 Comparing Ratios
  • 3:09 Inventory Valuation
  • 4:19 The Seasonal Factor
  • 5:33 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define financial statement ratios. You'll also learn some of the issues in analyzing financial statement ratios, as well as suggestions on how to make sure you're comparing apples to apples.

Issues with Financial Statement Analysis

Sue has been working as a financial analyst for one year. Her basic job responsibilities include reviewing her company's financial statements, calculating financial statement ratios, and completing an analysis.

A financial statement ratio is calculated by using two or more line items from a financial statement, performing a mathematical operation, and drawing a conclusion of the results. While Sue is pretty good at calculating the ratios, she needs help in making a solid analysis.

Sue enrolls in a financial statement analysis seminar. She's extremely impressed with the speaker, Bob. He has over 25 years' experience in finance and is a best-selling author of multiple financial analysis books.

At the first part of the seminar, they discuss various types of important ratios and their calculations. Sue is quite bored because she's an expert in calculations. Just as she's about to fall asleep, Bob says, 'After lunch, we will talk about the issues that affect financial statement analysis: comparison, inventory valuation, and seasonality.'

For the remainder of this lesson, we'll explore issues with financial statement analysis: comparison, inventory valuation, and seasonality, and discuss suggestions on how to make sure you're comparing apples to apples.

Comparing Ratios

After a light lunch, the seminar convenes and Bob says, 'How many people are uncomfortable with their analysis of financial ratios?' Everyone raises their hand. He then goes on to ask, 'How many people have calculated financial ratios and made an analysis without comparing it to something?' Sue looks around the room, while raising her hand.

Bob says, 'If you all have written an analysis on the ratios you calculated without comparing it to something, your analysis is wrong! You must compare your calculation to a prior period, industry average, or competitor to gain a true understanding of the ratio results.'

'Once you calculate the ratio, find the same ratio from last month, last year, or five years ago. How does it compare to those prior periods? Has it increased, decreased, or remained the same? Once you figure that out, you need to find out why. This may require you to do some digging. You may want to speak to department heads to find out what happened during that time period in the company.

You can also pull industry statistics and compare the ratio to what's happening in your industry. Ratio analysis for the technology industry will have different results than for the healthcare industry, so make sure you're reviewing industry-specific data.

Lastly, if you can find your competitor's ratios, you can compare your company's ratios against the competitor. Now, how many people know the issue in comparing inventory ratios to the industry or a competitor?' Bob looks around the room and sees no hands. He says, 'Good, that's what you're here to learn.'

Inventory Valuation

Bob asks, 'What are the two main types of inventory valuation methods?' Sue knows this one, so she raises her hand, 'LIFO and FIFO.' Bob says, 'That's correct, LIFO and FIFO. What do those acronyms represent?'

Once more, Sue knows, 'LIFO means inventory that's last in gets sold first, and FIFO means inventory that's first in gets sold first.' Bob replies, 'Excellent! Now why is this a problem in financial statement analysis?'

Companies who use LIFO but compare their ratios to a company who uses FIFO will appear to sell their inventory faster than a competitor, but their profitability may appear lower. Therefore, it's imperative that when comparing inventory ratios you make sure you understand their inventory valuation methods.

Sue notices that the participants' faces looked flushed. She can hear whispers of, 'I wished I had known this a long time ago.' Bob walks down from the stage and says, 'We're almost finished; we have one more topic: seasonal issues.'

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