FINANCIAL STATEMENT ANALYSIS
Financial Statement analysis is the process of analyzing a company’s financial statements for decision making purposes and to understand the overall health of an organization.
1. Comparative Statement Analysis is an analysis of financial statement from period to period, also known as Horizontal analysis. Two techniques of comparative analysis are as follows:
- Year-to-Year change analysis: Comparing financial statements over relatively short time periods – two to three years to compute the changes that are easily manageable and understandable.
- Index-Number trend analysis: Analyzing data using index-number trend analysis requires choosing a base period, for all items with a pre-selected index number usually set to 100.
2. Common Size Statement Analysis is an analysis of financial statement in which figures reported are converted into percentage to some base, also known as Vertical analysis.
3. Ratio Analysis: Ratio Analysis is the process of determining and interpreting the numerical relationships based on financial statements.
A. Liquidity Ratios: A financial ratio that indicates whether a company’s assets will be sufficient to meet the company’s obligations when they become due.
a. Current Ratio: Measures the ability to repay current liabilities with current assets.
Current Ratio = Current Assets / Current Liabilities
b. Quick Ratio: Measures the availability of liquid current assets per current liabilities.
Quick Ratio = (Current Assets- Inventories-Prepaid Expenses)/Current Liabilities
c. Absolute Liquid Ratio/Cash Ratio: Measures the absolute liquidity of the business.
Cash Ratio = (Cash and Bank Balances +Marketable securities)/Current Liabilities
d. Defensive Interval Ratio: Indicates the number of days that a company can operate without needing to access non-current assets.
Defensive Interval Ratio = (Cash and Bank
Balance + Marketable Securities) /
{Operating Expenses/Number of days}
e. Cash Flow Coverage Ratio: Ability of a company to pay interest and principal amounts when they become due.
Cash Flow Coverage Ratio = Operating Cash Flow/ Total Debt
B. Profitability Ratios: Measures the overall efficiency or performance of a business.
a. Gross Profit Ratio: Reflects the effective standard performance of firm’s business
Gross Profit Ratio =( Gross Profit / Net Sales ) X 100
b. Operating Ratio: Firm’s ability to cover total operating expenses
Operating Ratio =( Operating Cost / Net Sales ) X 100
c. Operating Profit Ratio: Indicates the operational efficiency of the firm
Operating Ratio = ( Operating Profit / Net Sales ) X 100
d. Net Profit Ratio: Indicates the overall efficiency in operating the business.
Net Profit Ratio = (Net Profit / Net Sales ) X 100
e. Return on Investment Ratio: Measures a return on the owner’s or shareholder’s investment.
ROI Ratio = (Net Profit after Interest and tax / Shareholder’s investment ) X 100
f. Return on Capital Employed Ratio: Measures the profitability of the company.
ROCE =( Net Profit After taxes / Gross Capital Employed ) X 100
Gross Capital Employed = Fixed assets +Current Assets
Net Capital Employed = Total assets – Current Liabilities
g. Earnings per Share Ratio: Measures the earning capacity of the concern and helps in determining the price of the equity share in the market.
EPS Ratio =( Net Profit after tax – Preferred Dividend ) / No. of Equity Sharesh. Dividend Payout Ratio: Indicates the dividend policy adopted by the top management.
Dividend Payout Ratio = Equity Dividend / (Net Profit after
Tax – Preferred Dividend) X 100
i. Dividend Yield Ratio: Determines the dividend income from the investors’ point of view.
Dividend Yield Ratio= (Dividend per Share / Market Value per Share ) X 100
j. Price Earnings Ratio: Highlights the earning per share reflected by market share.
Price Earnings Ratio = Market Price per Equity Share / Earnings per Share
k. Net Profit to Net worth Ratio: Measures the profit return on investment.
Net Profit to Net-Worth =(Net Profit / Shareholders’ Net Worth ) x 100C. Turnover Ratios: Measures the efficiency with which different assets are utilized to run a business.
a. Inventory Ratio or Stock Turnover Ratio: Measures whether the investment in stock in trade is effectively utilized or not.
Stock Turnover Ratio = Cost of Goods Sold/ Average Inventory at cost
b. Debtor’s Turnover Ratio or Receivables Turnover Ratio: Represents how quickly the debtors are converted into cash.
Debtor’s Turnover Ratio = Net credit sales/ Average Receivables
Debt Collection Period Ratio = (Average
Receivables x 365) /
Annual Net Credit Sales
c. Creditor’s Turnover Ratio or Payables Turnover Ratio: Indicates the number of times with which the payment is made to the supplier in respect of credit purchase.
Creditor’s Turnover Ratio = Net
Credit Purchases /
Average Account Payables
Creditor’s
Payment Period = (Average Account Payables x 365) /
Net Credit Purchases
d. Working Capital Turnover Ratio: Represents the firm’s liquidity position.
Working Capital Turnover Ratio = Net Sales / Working Capital
e. Fixed Assets Turnover Ratio: Measures the utilization of the fixed assets.
Fixed Assets Turnover Ratio = Cost of Goods Sold/ Total fixed assets
= Sales / Net Fixed Assets
f. Capital Turnover Ratio: Measures the efficiency of capital utilization in the business.
Capital Turnover Ratio = Cost of Sales / Capital Employed
D. Solvency Ratios: Indicate the sound financial position of the concern to carry on its business smoothly and meet its all obligations.
a. Debt Equity Ratio: Ascertains the firm’s obligations to creditors in relation to funds invested by the owners.
Debt-Equity Ratio = Total Long Term Debt / Shareholders’ Funds
Shareholders’ Funds = Preference Share Capital + Equity Share Capital+ Reserves and Surplus
b. Proprietary Ratio: Indicates the share of owners in the total assets of the company.
Proprietary Ratio = Shareholders’ Funds / Total Assets
Total Assets = Tangible assets + Non-tangible Assets + Current Assets
c. Capital Gearing Ratio: Also known as Capitalization or Leverage Ratio.
Capital Gearing Ratio = Equity Share Capital /Fixed Interest Bearing Funds
Fixed Interest Bearing Funds = Debentures + Preference Share Capital + Other Long-Term Loans
d. Debt Service Ratio or Interest Coverage Ratio: Measures the capacity of the company to service its debt obligations.
Interest Coverage Ratio = ( Net Profit before
Interest and Income Tax / Fixed
Interest Charges) x 100
4. Du Pont Analysis: Du Pont Analysis provides insight into how a company’s return on equity was generated by decomposing the return into three components:
|
Operating Efficiency |
Asset Effectiveness |
Capital Structure |
Return on Equity |
|
Net Income Sales |
Sales Assets |
Assets Equity |
= Net Income Equity |
The company can increase its Return on Equity if it
- Generates a high Net Profit Margin
- Effectively uses its assets so as to generate more sales
- Has a high Financial Leverage
5. Fund Flow Analysis:
Funds Flow Statement is a report of the financial operations of the firm. For the purpose of fund flow the information in the balance sheet is organized into two principal groups: Sources of funds and Application of funds. This statement summarizes the sources of funds available to finance the activities of the enterprise and the uses to which such funds have been put. It helps to understand the changes in the financial position of a business enterprise between two accounting periods. If long-term fund requirement is met just out of long-term sources, then the whole fund generated from operations will be represented by increase in working capital. On the other hand, if the fund generated from operations is not sufficient to bridge a gap of long-term fund requirement, then there will be a decline in working capital.
6. Cash Flow Analysis:
Cash flow statement refers to the financial statement which summarizes the company’s cash inflows and outflows over a specific period of time. Its purpose is to inform users on how and why a company’s cash changed during the period. It also distinguishes among the sources and uses of cash flows by separating them into operating, investing and financing activities.Net cash flow is the end measure of profitability.
- Cash flows from Operating Activities: Earning related activities such as extending credit to customers, investing in inventories and obtaining credit from suppliers. Operating activities usually relate to working capital accounts like receivables, payables, inventories, prepayments, and accrued expenses.
- Cash flows from Investing Activities: Acquiring and disposing of non-cash assets which generate income for a company such as purchase and sale of equity funds and investment in securities.
- Cash flows from Financing Activities: Contributing withdrawing and servicing funds to support business activities which include borrowing and repaying funds with bonds and other loans.
Methods of computation:
- Indirect method: With this method, net income is adjusted for non-cash income items and accruals to yield cash flows from operations. An advantage of this method is the disclosure of a reconciliation of differences between net income and operating cash flows.
- Direct method: This method adjusts each income item for its related accruals and provides a better format to assess the amount of operating cash flows.
The format for computing net cash provided by investing and financing activities is the same for both methods, only operating activities differ.
Analysis implications:
- Cash flows from operations are useful for evaluating and projecting both short-term liquidity and longer-term solvency.
- Analysis enables to appraise the quality of management’s decisions over time and their impact on the company’s results of operations and financial position.
- Inferences from analysis of cash flows include where management committed its resources, where it reduced investments, where additional cash was derived from, where claims against the company were reduced.
- Analysis pertains to the disposition of earnings and the investments of discretionary cash flows.
- Analysis also enables to infer the size, composition, pattern, and stability of operating cash flows.
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