Financial Statement Analysis

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 Financial Analysis
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Financial analysis is the process of identifying the

financial strengths and weaknesses of the firm by
property establishing relationships between the item
of the balance sheet and the profit and loss account.

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 USERS OF FINANCIAL ANALYSIS
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Trade creditors
Suppliers of long-term debt
Investors
Management

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 NATURE OF RATIO ANALYSIS
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A financial ratio is a relationship between two

accounting numbers.
Ratios help to make a qualitative judgement
about the firm’s financial performance.

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 Standards of Comparison
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Time series analysis

Inter-firm analysis
Industryanalysis
Proforma financial statement analysis

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 Types of Financial Ratios
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Liquidity ratios
Leverage ratios
Activity ratios
Profitability ratios

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 LIQUIDITY RATIOS
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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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 Cont…
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 LEVERAGE RATIOS
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 To judge the long-term financial position of the firm,

financial leverage, or capital structure ratios are
calculated.
 These ratios indicate mix of funds provided by owners
and lenders.

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 Cont…
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 Cont…
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 ACTIVITY RATIOS
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 Activity ratios are employed to evaluate the

efficiency with which the firm manages and utilizes
its assets.
 These ratios are also called turnover ratios
because they indicate the speed with which assets
are being converted or turned over into sales.
 Activity ratios, thus, involve a relationship between
sales and assets.

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 Inventory Turnover and
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Debtors Turnover

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 Assets Turnover Ratios
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 PROFITABILITY RATIOS
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The profitability ratios are calculated to

measure the operating efficiency of the
company.

Generally, two major types of profitability

ratios are calculated:
1. profitability in relation to sales
2. profitability in relation to investment.

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 Cont…
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 Cont…
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 Cont…
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 Cont…
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 Cont…
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 CAUTIONS IN USING RATIO
21 ANALYSIS
Standards for comparison
Company differences
Price level changes
Different definitions of variables
Changing situations
Historical data

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 UTILITY OF RATIO ANALYSIS
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the ability of the firm to meet its current

obligations;
the extent to which the firm has used its long-term
solvency by borrowing funds;
the efficiency with which the firm is utilizing its
assets in generating sales revenue
the overall operating efficiency and performance of
the firm.

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 EVALUATION OF A FIRM’S EARNING
POWER: DUPONT ANALYSIS
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RONA (or ROCE) is the measure of the firm’s

operating performance. It indicates the firm’s earning
power.
RONA can be computed as follows:

A firm can convert its RONA into an impressive ROE

through financial efficiency.

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 COMPARATIVE STATEMENTS
ANALYSIS
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A simple method of tracing periodic changes in

the financial performance of a company is to
prepare comparative statements.
Comparative financial statements will contain
items at least for two periods.
Changes—increases and decreases—in income
statement and balance sheet over a period can be
shown in two ways:
 (1) aggregate changes and
 (2) proportional changes.
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 TREND ANALYSIS
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In financial analysis the direction of changes

over a period of years is of crucial importance.
Time series or trend analysis of ratios
indicates the direction of change.
This kind of analysis is particularly applicable
to the items of profit and loss account.

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 Cont…
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For trend analysis, the use of index numbers is

generally advocated.
 The procedure followed is to assign the
number 100 to items of the base year and to
calculate percentage changes in each items of
other years in relation to the base year. This
procedure may be called as “trend-percentage
method.”

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 Example: Hindustan
27 Manufacturing Company

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 INTER-FIRM ANALYSIS
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The analysis of the financial performance of all

firms in an industry and their comparison at a
given point of time is referred to the cross-
section analysis or the inter-firm analysis.
To ascertain the relative financial standing of a
firm, its financial ratios are compared either with
its immediate competitors or with the industry
average.

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 Example: Construction industry: Inter-
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firm Comparison Market Share

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