,

A number of useful techniques involving simple math and a bit of research can
help you perform some qualitative and quantitative financial statement analysis for
your business, depending on the type of information you want to investigate.

You'll use the three main financial statements, balance sheet, income statement,
and statement of cash flows. Make sure, especially if you're using financial
statements from more than one reporting period, that each financial statement has
been prepared the same way so that you have data that's directly comparable from
one period to another. Take this into consideration also if you choose to compare
your financial data to that of outside firms or industry averages.

Each of the following methods gives visibility into business trends, variances, and
issues, raising questions about the company that needs to be answered.
Examining the business, finding the explanations for variances and making
changes based on positive or negative trends is the real outcome of financial
statement analysis.

 01

Trend Analysis

Trend analysis is also called time-series analysis. Trend analysis helps a firm's
financial manager determine how the firm is likely to perform over time, based on
trends shown by past history.

Trend analysis uses historical data from the firm's financial statements, along with
forecasted data from the company's pro forma, or forward-looking, financial
statements, to assemble a longer-term view of its financial activity and look for
variations over time.
 One popular way of doing trend analysis is through financial ratio analysis. If you
calculate financial ratios for a business firm, you'll want to calculate at least two
years of ratios to compare side-by-side to provide any meaningful information.

Ratios mean nothing unless you have something to compare them to, such as
other years of data. Trend analysis is even more powerful if you have and use
several years of financial ratios. Some firms also compare data to average ratios
for their industry or competitors.

 02

Common-Size Financial Statement Analysis

Common-size financial statement analysis involves analyzing the balance sheet

and income statement using percentages. All income statement line items are
stated as a percentage of sales. All balance sheet line items are stated as a
percentage of total assets.

For example, on the income statement, every line item is divided by sales and on
the balance sheet, every line item is divided by total assets. This type of analysis
enables the financial manager to view the income statement and balance sheet in
a percentage format, making it easier to interpret.

Looking at an income statement, for example, you can turn it into a common-size
income statement easily. If you calculate net income as a percentage of total sales,
it would look like this example: $64,000 net income / $1,000,000 total sales = 6.4
percent.

Apply that formula to every line item on the income statement to develop your
common-size income statement. In other words, set each line item as a percent of
sales, with sales equal to 100 percent of itself.

As with financial ratio analysis, you can compare the common-size income
statement from one year to other years of data to see how your firm is doing. It is
 generally easier to make that comparison using percentages rather than absolute
numbers.

Using percentages also makes it easier to compare two firms of very different
sizes. Even if one firm's three times larger than its competitor in sales terms,
percentage-wise, it probably spends the same proportions of expenses, for
example.

 03

Percentage Change Financial Statement Analysis

Percentage change financial statement analysis gets a little more complicated.

When you use this form of analysis, you calculate growth rates for all income
statement items and balance sheet accounts relative to a base year.

This is a very powerful form of financial statement analysis. You can actually see
how different income statement items and balance sheet accounts grew or
declined in relation to the growth or declines in sales and total assets.

For example, say that XYZ, Inc. has $500 in inventory on its balance sheet in 2015
and $700 in inventory on its balance sheet in 2016. How much has inventory grown
in 2016?

The formula to calculate the growth rate in inventory is the following: (2016 ending
inventory - 2015 beginning inventory) / 2015 beginning inventory = $200 / $500 =
0.40, or 40 percent. The growth or change in inventory for XYZ, Inc. in 2016 is 40
percent.

If you do a percentage change analysis for all balance sheet and income statement
items, compare two or three years' worth of data side by side to spot important
trends in items such as excessive spending or improved sales growth.

 04

Benchmarking
 Benchmarking is also called industry analysis. Benchmarking involves comparing
a company to other companies in the same industry to see how one company is
doing financially compared to others in the industry.

This type of analysis is very useful to the financial manager as it helps them see if
they have a competitive advantage or spot inefficiencies relative to others in the
same business.

Financial ratio analysis is often used for benchmarking. Financial ratios for
individual, mainly public companies can be obtained from a number of sources. A
few publications offer industry average ratios, although they may require a paid
subscription, such as Risk Management Association's Annual Statement Studies.

You can also obtain industry average ratios from Value Line and Dun and
Bradstreet. Check for all three of these publications at your local public library or a
local college business library.

To do benchmarking, compare the ratios for one company to the ratios of other
companies in the same industry. Make sure that the industry average ratios are
calculated in the same way the ratios for your company are calculated when you
perform benchmarking.

Using these four financial statement analysis techniques can assist financial
managers in understanding a business firm's financial state both internally and as
compared to other firms in its industry. Together, these methods provide powerful
analysis tools that can help companies gain insight into staying solvent and
profitable.

What is 'Ratio Analysis'

A ratio analysis is a quantitative analysis of information contained in a company’s
financial statements. Ratio analysis is used to evaluate various aspects of a company’s
operating and financial performance such as its efficiency, liquidity, profitability and
solvency.
1. Liquidity Ratios: liquidity ratios measure a company's ability to pay off its short-term
debts as they come due using the company's current or quick assets. Liquidity ratios
include current ratio, quick ratio, and working capital ratio.

2. Solvency Ratios: also called financial leverage ratios, solvency ratios compare a
company's debt levels with its assets, equity, and earnings to evaluate whether a
company can stay afloat in the long-term by paying its long-term debt and interest on
the debt. Examples of solvency ratios include debt-equity ratio, debt-assets ratio,
and interest coverage ratio.

3. Profitability Ratios: these ratios show how well a company can generate profits from
its operations. Profit margin, return on assets, return on equity, return on capital
employed, and gross margin ratio are examples of profitability ratios.

4. Efficiency Ratios: also called activity ratios, efficiency ratios evaluate how well a
company uses its assets and liabilities to generate sales and maximize profits. Key
efficiency ratios are the asset turnover ratio, inventory turnover, and days' sales in
inventory.

5. Coverage Ratios: these ratios measure a company's ability to make the interest
payments and other obligations associated with its debts. Times interest earned
ratio and debt-service coverage ratio are two examples of coverage ratios.

6. Market Prospect Ratios: e.g. dividend yield, P/E ratio, earnings per share, and
dividend payout ratio. These are the most commonly used ratios in fundamental
analysis. Investors use these ratios to determine what they may receive in earnings
from their investments and to predict what the trend of a stock will be in the future. For
example, if the average P/E ratio of all companies in the S&P 500 index is 20, with the
majority of companies having a P/E between 15 and 25, a stock with a P/E ratio of 7
would be considered undervalued, while one with a P/E of 50 would be considered
overvalued. The former may trend upwards in the future, while the latter will trend
downwards until it matches with its intrinsic value.

Liquidity Ratios

S. No. RATIOS FORMULAS

1 Current Ratio Current Assets/Current Liabilities

2 Quick Ratio Liquid Assets/Current Liabilities

3 Absolute Liquid Ratio Absolute Liquid Assets/Current Liabilities

Profitability Ratios

S. RATIOS FORMULAS
No.

1 Gross Profit Ratio Gross Profit/Net Sales X 100

2 Operating Cost Ratio Operating Cost/Net Sales X 100

3 Operating Profit ratio Operating Profit/Net Sales X 100

4 Net Profit Ratio Operating Profit/Net Sales X 100

5 Return on Investment Net Profit After Interest And Taxes/ Shareholders
Ratio Funds or Investments X 100

6 Return on Capital Net Profit after Taxes/ Gross Capital Employed X 100
Employed Ratio

7 Earnings Per Share Net Profit After Tax & Preference Dividend /No of
Ratio Equity Shares

8 Dividend Pay Out Ratio Dividend Per Equity Share/Earning Per Equity Share
X 100

9 Earning Per Equity Net Profit after Tax & Preference Dividend / No. of
Share Equity Share

10 Dividend Yield Ratio Dividend Per Share/ Market Value Per Share X 100

11 Price Earnings Ratio Market Price Per Share Equity Share/ Earning Per
Share X 100
12 Net Profit to Net Worth Net Profit after Taxes / Shareholders Net Worth X
Ratio 100

Working Capital Ratios

S. RATIOS FORMULAS
No.

1 Inventory Ratio Net Sales / Inventory

2 Debtors Turnover Ratio Total Sales / Account Receivables

3 Debt Collection Ratio Receivables x Months or days in a year / Net Credit

Sales for the year

4 Creditors Turnover Ratio Net Credit Purchases / Average Accounts Payable

5 Average Payment Average Trade Creditors / Net Credit Purchases X

Period 100
6 Working Capital Net Sales / Working Capital
Turnover Ratio

7 Fixed Assets Turnover Cost of goods Sold / Total Fixed Assets

Ratio

8 Capital Turnover Ratio Cost of Sales / Capital Employed

Capital Structure Ratios

S. RATIOS FORMULAS
No.

1 Debt Equity Ratio Total Long Term Debts / Shareholders Fund

2 Proprietary Ratio Shareholders Fund/ Total Assets

3 Capital Gearing Equity Share Capital / Fixed Interest Bearing Funds

ratio
4 Debt Service Ratio Net profit Before Interest & Taxes / Fixed Interest
Charges

Overall Profitability Ratio

S. No. RATIOS FORMULAS

1 Overall Profit Ability Ratio Net Profit / Total Assets

Common Size Analysis for XYZ, Inc.

Income Statement 2011 % 2012 %

Net Sales $1,000,000 100% $1,110,000 100%

Cost of Goods Sold 500,000 50% 650,000 58.5%

Gross Profit Margin $500,000 50% $460,000 41.5%

Selling & Administrative Expenses 250,000 25% 265,000 23.9%

Depreciation 80,000 8% $110,000 10%

Operating Profit (EBIT) $170,000 17% $85,000 7.6%

Interest $30,000 3% $40,000 3.6%

Earnings Before Taxes $140,000 14% $45,000 4%

Taxes (.40) $56,000 5.6% $18,000 1.6%

Net Income $84,000 8.4% $27,000 2.4%

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