 Hello and welcome to this session in which we would look at purpose and tools of financial statement analysis. This is part one of seven. In this series, I will take a look at financial statement analysis and I will break it down into separate component. And the reason is this, I want you to understand this topic piece by piece because although they are all interconnected, but learning each piece separately is important starting with purpose and tool and financial statements. Why do we prepare financial statement analysis? Well, simply put, to make better decision. That's the purpose of financial statement analysis. Who wants to make those better decision? By whom? Who wants to make those better decisions? Well, auditors could be external and internal auditors. Investors and creditors. Investors and creditors, they invest money in the company. They're very interested in knowing how well the company is doing. The auditors, they're interested in learning about the company in order to pinpoint red flags in order to pinpoint some unusual relationship between accounts. And this is what we call an auditing analytical procedures. So if you are listening to me and you are an auditing students, I'm going to be analyzing the financial statement as if you are an investor and as if you are an auditor. So I'm going to show you both pictures. And it's very important to see the numbers from how the investor or the creditor would look at them from a profitability perspective as well as the auditor. The auditor look at the numbers from a critical point of view, from a skepticism point of view. Also the board of directors, they would use financial statement analysis to evaluate management. Anyone interested in the company can use financial statement analysis. How do financial statement analysis help these users? It would help them learn about the company. And by doing so, you would reduce what's called information risk. So simply put, the more you learn, the more you know about something, the less is the risk. That's the assumption. So how do you do it? You're going to crunch the numbers in a way to give you more information. That information will pinpoint strength in the company. We'll pinpoint certain weaknesses. We'll pinpoint, for example, for the auditor, red flags, things that we have to look at more in details. And this is why we are talking about analytical procedures, why auditors use analytical procedures when they do financial statement analysis. Now, what tools do we use? Well, we have many tools. Let's take a look at the tools. We're going to have what's called horizontal analysis. What's horizontal analysis? Comparing the performance of the company over time. And don't worry, we would look at an example. We're going to look at a detailed example. But basically what we're looking at, we're looking at this is year one and this is year two. And we're looking horizontally, the difference between year one and year two. And the more years we have, obviously, the better off we are. So we are looking across time. Another method is called vertical analysis. Vertical analysis is different. Vertical analysis is vertically. Looking at the financial statements vertically. Choosing a number on the financial statement and comparing everything to that number. For example, on the balance sheet, we would compare everything to assets. On the income statement, we'll compare everything to revenues. Again, we're going to be working these examples. Another tool that we have is called common size financial statement. What is common size financial statements is changing of the figures relative and relative importance. What does that mean? It means we're going to be looking at the numbers, but all as a percentage. For example, we look at cash last year. What was cash relative to total assets last year as in form of percentage? And what is the cash total balance relative to this year? Well, for example, last year it was 3%. This year is 5%. And this year is 1%. So we would take a look at how important that number relative to the total assets of the company. This is what we mean by common size financial statements. And common size financial statements, the beauty of common size financial statements is you can use it to compare companies of different sizes. Why? Because you could have a multi-million or a multi-billion dollar company, which is a large company, and you could have a small company, a medium size company, multi-million dollar. Well, what's going to happen is you can compare the multi-million to the multi-million by changing older figures to percentages, because the percentages will factor the size out. So this is what we mean by common size. It means they all have the same size financial statements. So what I'm going to do in the next session, I will take a look at those three tools together. So this is going to be recording number two. Before we proceed, I would like to remind you whether you are an accounting student or a CPA candidate. Take a look at my website, farhatlectures.com. I am a useful addition, whether you are studying for your CPA exam or you are an accounting student. My motto is saving accounting students and CPA candidates one at a time. I provide you with lectures, resources that's going to help you understand the material better and do better in your accounting career. Your risk is one month of subscription. Your potential gain is passing the CPA exam, having a rewarding career. Don't shortchange yourself. My catalog include many accounting courses, intermediate, advanced, cost, governmental, tax, so on and so forth. CPA material is aligned with your Becker, Roger, Wiley and Gleam, and I give you access to all previously released AICPA questions, almost 1,500 previously released questions with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with other, connect with me on Instagram, Facebook, Twitter and Reddit. Other tools that we have include ratios. Now the ratios would include liquidity ratios, which is basically measuring the ability of the company to pay off at short term that basically in the short term can we meet our short term obligation. This is going to be recording number three. We're going to have activity ratios, which is will be recording number four, measure how efficiently and effectively assets are being used. So we're going to measure, for example, how account receivable, how companies manage managing their inventory. Five will be solvency ratio. Solvency ratio measuring the ability of the company to pay off long term debt. So notice we're going to have a short term debt ability and long term debt ability. Number six will be the profitability ratios comparing how profitable is the company relative to other companies relative to competitors. Seven, it's going to be the investor or market ratios measure the attractiveness of the company for potential investors. Simply put, we're going to try to determine whether this company is a good investment or not a good investment and how much we should pay for it. What's a fair price? And this is going to be an interesting, interesting ratio, interesting sets of ratios to look at. Now, bear in mind, I'm going to go, I'm going to be using the same data for the same company. So that's why you want to see those in order because it does not make any sense to look at one recording and not the others. As we are going through those financial statement analysis tools, I'm going to keep reminding you that you always have to have a standard to compare them to. What are some of the standards that you can compare your performance to? One is intercompany. Basically, compare yourself to yourself for the same accounting period. For example, you can compare your sales, Q1 year one to Q1 year two. So comparing quarter one to quarter one year to year on month to month. This way, you know exactly what's going on because the assumption is the conditions that existed in Q1 year one are the same that exists in Q1 year two. Versus you cannot compare Q1 to Q2 because you might have, it could be a seasonal company where in Q2 you really don't have sales. Let's assume you are a ski resort. Well, in Q2, the spring, you may not have as much work as Q1, which is January, February and March. So that's why it's very important to compare the same for the same time period. Or you can compare yourself to a competitor. You have to choose a good competitor and compare yourself to. Now that might be difficult. In classes in college, we always say compare PepsiCo to Coca-Cola. PepsiCo and Coca-Cola are two different companies. PepsiCo, there are so many different businesses that Coca-Cola is not into. So you have to compare the soda division to the soda divisions side by side. Also what's difficult is different companies use different accounting methods. For example, one company use FIFO, the other one use LIFO, one company use the straight line method. The other company use the double declining method. One company is very aggressive in their estimate. Another company are less aggressive, for example, when they estimate their warranties and their bad debt. So that's why comparing yourself to a competitor, it's not as straightforward as people think. Also, you can compare yourself to industry averages. And again, here we are dealing with averages and how do you provide those averages? Well, certain companies, they collect this data, for example, a company called IBS World, and they provide averages about the industry, whatever industry you are in, hospitality, software, real estate, so on and so forth. Also, there are certain guidelines that you can compare yourself to, especially if you are in a very specific industry. For example, the oil and gas industry will have certain guidelines. Maybe the hotel industries will have a certain guidelines that are different. Also, there are certain guidelines that are acceptable in general, such as current ratio of two is a good ratio. Again, those are very also general guidelines that may or may not apply to your industry. Now, I'm going to give you a peak look at what we're going to be looking at next. So this way, you'll have an idea what we're going to be dealing with in the next few sessions. So this is what we're going to be looking at two years of financial statements where we're going to be performing vertical, horizontal and explaining the numbers and explaining the importance of these figures and how do you use them in the real world. At the end of this session, I'm going to remind you again to take a look at farhatlectures.com to practice additional questions. This is how you learn the material, practice questions. If you're studying for your CPA, it's worth it. Study hard, good luck, and stay safe.