Financial Statement Analysis

Financial statements include : Income Statement or Profit and Loss A/C, Position S
tatement or Balance Sheet and A statement of changes in financial position or a c
ash flow statement These financial statements are the end product of accounting
process that starts with recording of monetary transactions and events and culmi
nates in the preparation of financial statements. Financial statements help in a
chieving the objectives of accounting. The main objective of accounting is to su
pply decision relevant information to various groups of users who are associated
with the firm.
Financial statements are the principal means of providing the information to the
se groups ± on which they base their decisions.
1.
Main financial statements :
Income statement : it is a report on the firm¶s operation over some past period. R
evenue from business operations and income from other sources is matched with th
e expenses required to generate the revenue. What is the net result over a perio
d of time. Position statement : it reports on the financial position on a partic
ular date. It shows the various assets on one side which tells us about the uses
of funds deployed in the business. They are matched with the liabilities on the
opposite side which tell us about the sources of funds deployed in the business
2.
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Financial statement analysis : means detailed and indepth study of the informati
on given in the financial statements so as to draw important conclusions
Need for financial statement analysis :
Financial statements are same for every user but the information requirements of
different users are different. During analysis every user can focus on the rela
tions in which he is interested. Financial statements provide information about
the past but users are more interested in the present and future projections. So
they need to analyze them. Absolute figures given in the financial statements a
re dumb. They do not convey much about the health of the firm. In order to make
the absolute numbers speak, we should study the inter relationship between numbe
rs.
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Users of Financial Analysis : These groups are the various stakeholders, who hav
e come to be associated with the firm over a period of time with the development
s in the field of trade and commerce.
Important groups are :
Proprietor ± shareholders Prospective investors Trade creditors Lenders Inves
analysts Management Employees, customers, government, society.
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Techniques of financial statement analysis
Horizontal analysis or comparative financial statement analysis : in this two ye
ar figures of financial statements are compared item by item taking one year as
the base. Absolute and percentage change over the base period are reported and a
nalyzed. Vertical analysis or common size statements : in this different figures
given in the financial statements are expressed as a percentage of some importa
nt aggregate (sales in case of income statement and assets, liabilities in case
of position statement). Ratios analysis : financial statements numbers are divid
ed by one another to study the underlying relationship. Ratio is one number divi
ded by another.
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Ratio Analysis A ratio is numeric or arithmetic relation
between two numbers. It is simply one number expressed in terms of another The t
wo numbers used in the ratio can both be taken from income statement or position
statement or one number from income statement and one number from position stat
ement.
Advantages of Ratio Analysis :
Ratio is always a pure number which is not affected by size. We can make meaning
ful comparison even among the firms of different sizes. Ratios can be used by in
terested groups to make projections about future profitability, solvency or liqu
idity. Ratios help to make a qualitative judgment about the firm¶s financial perfo
rmance
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Standard of Comparison : Ratios on its own do not convey much. For a meaningful
analysis we must make comparison of ratios. In ratio analysis , we make three ty
pes of comparisons :
Time series analysis : intra-firm comparison Cross section analysis : Inter-firm
comparison Comparison with industry averages
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Types of Financial Ratios
Liquidity ratios Solvency ratios Turnover ratios Profitability ratios Equity-rel
ated ratios
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Liquidity Ratios
Liquidity ratios measure a firm¶s ability to meet its current obligations.
Current assets Current ratio = Current liabilities Current assets ± Inventories Qu
ick ratio = Current liabilities Cash + Marketable securities Cash ratio = Curren
t liabilities
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Solvency ratios : these ratios measure the dependence of a firm on borrowed fund
s.
Debt ± Equity Ratio = Debt / Equity Where Debt = long term borrowings Equity = pro
prietor funds or net worth Debt To total capitalization = Debt /(Debt + Equity)
Where Debt + Equity = total long term funds Interest coverage ratio = EBIT / Ann
ual interest
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Turnover or activity ratios : these ratios measure the firm¶s efficiency in utiliz
ing its assets.
1. Inventory turnover ratio = cost of goods sold / average inventory Inventory c
onversion period = 365 days/inventory turnover ratio Accounts receivable turnove
r ratio = Net credit sales / Average account receivable Accounts receivable coll
ection period = 365 days/account receivable turnover ratio
2.
3.
4.
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5. Working capital turnover ratio = net sales / working capital 6. Fixed asset t
urnover ratio = net sales / fixed assets 7. Accounts payable turnover ratio = ne
t credit purchase/average a/c payable 8. Average payment period = 365 days/accou
nt payable turnover
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Profitability ratios : measure a firm¶s overall efficiency and effectiveness in ge
nerating profit.
Gross profit ratio Net profit ratio = Gross Profit / Net sales = Net Profit / Ne
t sales
Operating profit ratio = Operating profit / Net sales Operating ratio = COGS + o
perating exp./ Net sales All kinds of expense ratios ± Administration, financial e
tc ROI or Return on capital employed = net profit/ capital employed where capita
l employed = fixed asset + w/c
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ROI is a function of two variables ± dupont analysis
ROI = net profit ratio x investment turnover ratio = net profit/sales x sales/in
vestment As Investment = Fixed assets + Working capital Investment turnover can
be broken down into fixed asset turnover and working capital turnover. Working c
apital turnover can be broken down into turnover of individual current assets. N
et profit ratio can be broken down into various expense ratios and operating rat
io.
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Equity-related ratios : These ratios measure the shareholders¶ return and value
EPS = (profit after tax ± preference dividend) / no. of equity shares Dividend pay
out ratio = dividend per share/EPS Retention ratio = 1 ± Dividend payout ratio or
(EPS ± Dividend per share)/EPS Dividend yield ratio = dividend per share/market pr
ice per share P/E ratio = market price per share/earnings per share Earnings cap
italization ratio = EPS/Ke or cost of equity. Dividend capitalization = D/Ke Boo
k value per share = net worth/no of equity shares Earnings yield ratio = EPS/mar
ket value per share.
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Utility of Ratio Analysis
Assessment of the firm¶s financial conditions and capabilities. Diagnosis of the f
irm¶s problems, weaknesses and strengths. Credit analysis Security analysis Compar
ative analysis Time series analysis
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Cautions in Using Ratio Analysis Financial statements are based on historic data
. Company differences : different companies may be using different accounting po
licies. Price level : financial statements are prepared on the assumption of fix
ed monetary unit. Fixed assets are shown at historic cost. Possibility of window
dressing. Financial statements provide only financial information and ignore th
e qualitative aspects or non financial information.
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