Financial Statement Analysis

Financial statements include :

•Income Statement or Profit and Loss A/C,
•Position Statement or Balance Sheet and
•A statement of changes in financial position or a
cash flow statement
These financial statements are the end
product of accounting process that starts with
recording of monetary transactions and events and
culminates in the preparation of financial statements.
Financial statements help in achieving the
objectives of accounting. The main objective of
accounting is to supply 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 these groups –
on which they base their decisions.
• Main financial statements :
1. Income statement : it is a report on the firm’s operation
over some past period. Revenue from business
operations and income from other sources is matched
with the expenses required to generate the revenue.
What is the net result over a period of time.
2. Position statement : it reports on the financial position
on a particular 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

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 Financial statement analysis : means detailed and in-
depth study of the information 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 relations 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 are 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 numbers.

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Users of Financial Analysis : These groups are the various
stakeholders, who have come to be associated with the firm
over a period of time with the developments in the field of trade
and commerce.
Important groups are :
• Proprietor – shareholders
• Prospective investors
• Trade creditors
• Lenders
• Investment 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 year 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 analyzed.
• Vertical analysis or common size statements : in this
different figures given in the financial statements are
expressed as a percentage of some important aggregate
(sales in case of income statement and assets, liabilities in
case of position statement).
• Ratios analysis : financial statements numbers are divided
by one another to study the underlying relationship. Ratio is
one number divided 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 two 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
statement.
Advantages of Ratio Analysis :
• Ratio is always a pure number which is not affected by
size. We can make meaningful comparison even among
the firms of different sizes.
• Ratios can be used by interested groups to make
projections about future profitability, solvency or liquidity.
• Ratios help to make a qualitative judgment about the
firm’s financial performance

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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 types 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-related 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
Quick ratio =
Current liabilities
Cash + Marketable securities
Cash ratio =
Current liabilities
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 Solvency ratios : these ratios measure the dependence
of a firm on borrowed funds.

• Debt – Equity Ratio = Debt / Equity

Where Debt = long term borrowings
Equity = proprietor funds or net worth

• Debt To total capitalization = Debt /(Debt + Equity)

Where Debt + Equity = total long term funds

• Interest coverage ratio = EBIT / Annual interest

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Turnover or activity ratios : these ratios measure the
firm’s efficiency in utilizing its assets.
1. Inventory turnover ratio
= cost of goods sold / average inventory

2. Inventory conversion period

= 365 days/inventory turnover ratio

3. Accounts receivable turnover ratio

= Net credit sales / Average account receivable

4. Accounts receivable collection period

= 365 days/account receivable turnover ratio

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5. Working capital turnover ratio
= net sales / working capital

6. Fixed asset turnover ratio

= net sales / fixed assets

7. Accounts payable turnover ratio

= net credit purchase/average a/c
payable

8. Average payment period

= 365 days/account payable turnover

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Profitability ratios : measure a firm’s overall
efficiency and effectiveness in generating profit.
• Gross profit ratio = Gross Profit / Net sales

• Net profit ratio = Net Profit / Net sales

• Operating profit ratio = Operating profit / Net sales

• Operating ratio = COGS + operating exp./ Net sales

• All kinds of expense ratios – Administration, financial etc

• ROI or Return on capital employed = net profit/ capital

employed where capital 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/investment

As Investment = Fixed assets + Working capital

Investment turnover can be broken down into fixed asset
turnover and working capital turnover.

Working capital turnover can be broken down into turnover

of individual current assets.

Net profit ratio can be broken down into various expense

ratios and operating ratio.

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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 payout ratio = dividend per share/EPS
• Retention ratio = 1 – Dividend payout ratio or
(EPS – Dividend per share)/EPS
• Dividend yield ratio = dividend per share/market price
per share
• P/E ratio = market price per share/earnings per share
• Earnings capitalization ratio = EPS/Ke or cost of equity.
• Dividend capitalization = D/Ke
• Book value per share = net worth/no of equity shares
• Earnings yield ratio = EPS/market value per share.

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 Utility of Ratio Analysis
• Assessment of the firm’s financial
conditions and capabilities.
• Diagnosis of the firm’s problems,
weaknesses and strengths.
• Credit analysis
• Security analysis
• Comparative 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 policies.
• Price level : financial statements are prepared on the
assumption of fixed monetary unit. Fixed assets are
shown at historic cost.
• Possibility of window dressing.
• Financial statements provide only financial
information and ignore the qualitative aspects or non
financial information.

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