Financial Statement

Analysis
by Uditha Jayasinghe
 Contents
• Understanding Financial Statements
• Accounting Equations
• Uses and Limitations of Ratio Analysis
• Short-term Solvency Ratios
• Long-term Solvency Ratios
• Asset Management Ratios
• Profitability Ratios
• Market Value Ratios
• References

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 Understanding Financial Statements
• The principal financial statements of a business are;
– The balance sheet - Statement of financial position and
– The income statement - Statement of profit or loss

• The statement of financial position is a snapshot of the firm. It has a list of the assets,
liabilities and equity of a business as at a particular date.

• An asset is a present economic resource controlled by the entity as a result of past

events. (Assets are useful or valuable things owned and controlled by a business to earn
income and profit). A business gets economic benefits out of these items e.g. cash,
building, furniture etc. Assets are classified as either current or fixed (non-current). A
current asset has a life of less than one year. A non-current asset is one that has a
relatively long life.
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 Understanding Financial Statements
• A liability is a present obligation of the entity to transfer an economic resource as a
result of past events. Current liabilities are often defined as those due to be paid within
the next 12 months, and non-current liabilities as those due to be paid after 12 months.

• Equity is the residual interest in the assets of the entity after deducting all its liabilities.
That is the amount invested in a business by its owner (the sole trader/shareholders)

• A statement of profit or loss is a record of income generated and expenditure incurred

over a given period. The statement shows whether the business has had more income
than expenses (a profit) or vice versa (loss).

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 Understanding Financial Statements
• Expenses are decrease in economic benefits during the accounting period in the form
of outflows or depletion (decrease in value) of assets or occurrence of liabilities.

Types of
expenses

Capital Revenue
expenditure expenditure

• Capital expenditure is buying non-current assets for use in business and adding to the
value of an existing non-current asset by improvement in its earning capacity (future
inflow of economic benefits)

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 Understanding Financial Statements
• Revenue expenditures are expenses incurred either:
– In the ordinary course of the business i.e. operational expenses
– To maintain the existing earning capacity of the business and non-current assets
(repair and maintenance)

• Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in increases in
equity, other than those relating to contributions from equity participants.

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 Understanding Financial Statements
Statement of financial position

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 Understanding Financial Statements
.

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 Understanding Financial Statements
Statement of profit or loss.

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 Accounting Equations
• Shareholders’ equity + Liabilities = Assets
• Shareholders’ equity + Liabilities = Non-current assets + Current assets
• Assets – Liabilities = Shareholders’ equity (Net Assets)
• Current assets – Current liabilities = Net working capital
• Revenue – Expenses = Income
• Revenue – Cost of sales = Gross profit (GP)
• Gross profit – Operational expenses = Net
Profit

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 Uses and Limitations of Ratio Analysis
Why ratio analysis?
Ratio analysis involves comparing one figure against another to produce a ratio, and
assessing whether the ratio indicates a weakness or strength in the company's affairs.

The key to obtaining meaningful information from ratio analysis is comparison.

• Comparing ratios over time within the same business.
• Comparing ratios between similar businesses.

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 Uses and Limitations of Ratio Analysis
Ratio analysis:
• Financial ratios are traditionally grouped into the following categories:
– 1. Short-term solvency, or liquidity, ratios
– 2. Long-term solvency, or financial leverage, ratios
– 3. Asset management, or turnover, ratios (Efficiency ratios)
– 4. Profitability ratios
– 5. Market value ratios (Investment ratios)

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 Uses and Limitations of Ratio Analysis
. Short-term Long-term Asset
Profitability Market value
solvency solvency management
• Current ratio • Total debt ratio • Inventory • Net profit • Price-earnings
• Quick ratio • Debt-equity turnover margin ratio (P/E)
• Cash ratio ratio • Days’ sales in • Gross profit • Price-sales ratio
• Net working • Equity inventory margin • Market-to-book
capital to total multiplier • Receivables • Return on ratio
assets • Long-term debt turnover assets (ROA) • Earnings per
ratio • Days’ sales in • Return on share
• Times interest receivables equity (ROE) • Dividends per
earned ratio • NWC turnover share
• Cash coverage • Fixed asset
ratio turnover
• Total asset
turnover

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 Uses and Limitations of Ratio Analysis
Possible limitations of financial ratio analysis
1. This approach is based on historical data and thus the ratios may not be a good guide to
the future.
2. The quality of the analysis is determined by the quality of the accounting information
upon which it is based. The quality may drop due to creative accounting such as
window dressing of financial statement to hide short term fluctuations.
3. Difference in accounting practices adopted by companies over the treatment of fixed
asset depreciation and revaluation, inventory valuation, research and development
expenditure, and goodwill write off.
4. The changes in the value of money and differences in trading enjoinments over time.
5. A difficulty in deciding on a suitable yardstick and the interpretation of change. E.g. is a
higher return on net asset good or bad.

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 Uses and Limitations of Ratio Analysis
Possible limitations of financial ratio analysis Continue…
6. The use of ratios to measure performance may encourage sub‐optimal behaviours by
managers. E.g. short term manipulation of results.
7. Ratios are normally based exclusively on finance, and reflect only financial indicators of
performance. There are non‐financial implications associated with performance.

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 References
• Ross, S. A., Westerfield, R. W. & Jordan, B. D., 2010.
Fundamentals of Corporate Finance. 9th ed. New York, NY,
10020: McGraw-Hill/Irwin.

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 Thank You

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