Financial Statement Analysis

Financial Statement Analysis

What is Financial Statement Analysis

• Financial Statement Analysis is the process of identifying the financial

strengths and weaknesses of the firm by properly establishing
relationships between the items of the balance sheet and the profit
and loss account.

• Financial statement analysis is a quantifying method for determining

the past, present and prospective performance of a company.

• It focuses on evaluation of past performance of the business firms in

terms of profitability, liquidity, solvency, operation efficiency and
growth potentiality.

• Thus, it is an important means of assessing past performance and in

forecasting and planning future performance.
 Financial Statement Analysis
Users of Financial Statement Analysis

• Suppliers or Trade Creditors are interested in firm’s ability to meet their

claims over a very short period of time. Their analysis will therefore,
confine to the evaluation of the firm’s liquidity position.

• Suppliers of long-term debt are concerned with the firm’s long-term

solvency and survival. They analyse the firm’s profitability over time,
its ability to generate cash to be able to pay interest and repay
principal and the relationship between various sources of funds.
Hence, it analyses the future solvency and profitability.

• Investors, who have invested their money in the firm’s shares, are most
concerned about the firm’s earnings. They restore more confidence in
those firms that show steady growth in earnings. As such, they
concentrate on the analysis of the firm’s present and future
profitability.
 Financial Statement Analysis

• Customers will be interested in the continuance of the entity, especially

if they depend on it themselves.

• Employees wish to know about the stability and profitability of their

employers. This may give them confidence about their jobs and could
be used to discuss salary and conditions of employment.

• Government and Government Agencies are interested in the allocation

of resources and the activities of the entities in general.

• Management of the firm would be interested in every aspect of the

financial analysis. It is their overall responsibility to see that the
resources of the firm are used most effectively and efficiently and that
the firm’s financial condition is sound.
 Financial Statement Analysis
Importance of Financial Statement Analysis

• Holding of Share: The financial statement analysis is important as it provides

meaningful information to the shareholders in taking decisions with respect
to their holdings of the company’s share or sell them out.

• Decisions and Plans: Financial statement analysis is important to the

company’s management as it helps them to evaluate the performance and
effectiveness of their action to realise the company’s goal in the past.

• Extension of Credit: The financial statement analysis provides important

information to the creditors as it helps them to take decision as to whether
they have to extend loans to the company and demand for highest interest
rates.

• Investment Decisions: The financial statement analysis is important to the

prospective investors because they can obtain useful information for their
investment decision making purpose.
 Financial Statement Analysis

Ratio Analysis

• Ratio analysis is a powerful tool of financial analysis.

• A ratio is defined as “the indicated quotient of two mathematical

expressions” and as “the relationship between two or more things.”

• In financial analysis, a ratio is used as a benchmark for evaluating the

financial position and performance of a firm.

• The relationship between two accounting figures, expressed

mathematically is known as a financial ratio.

• Ratios help to summaries large quantities of financial data and to

make qualitative judgement about the firms’ financial performance.
 Financial Statement Analysis

The ratio Analysis involves comparison for a useful interpretation of

the financial statements. Standards of comparison may consist of :

Time series analysis: When financial ratios over a period of time are
compared, it is known as the time series analysis. It involves the
comparison of present ratios with past ratios for the same firm. It gives
an indication of the direction of change and reflects whether the firm’s
financial performance has improved, deteriorated or remained
constant over time.

Cross-sectional analysis: It compares ratios of one firm with some

selected firms in the same industry at the same point in time. This kind
of a comparison indicates the relative financial position and
performance of the firm.
 Financial Statement Analysis

Industry analysis: To determine the financial condition and performance

of a firm, its ratios may be compared with average ratios of the industry
of which the firm is a member. This sort of analysis known as the
industry analysis. It helps to ascertain the financial standing and
capability of the firm vis-à-vis other firms in the industry.

Proforma Analysis: Future ratios are developed from the projected or

proforma financial statements. The comparison of current or past ratios
with future ratios shows the firm’s relative strengths and weaknesses in
the past and the future.
 Financial Statement Analysis

Types of Ratios

Based on the requirements of the various users, ratios are classifies into
the following categories:

• Liquidity Ratios
• Leverage Ratios
• Activity Ratios
• Profitability Ratios
 Financial Statement Analysis
Liquidity Ratios

• The Liquidity ratios measure the ability of a firm to meet its short-term
obligations and reflect the short-term financial strength/solvency of a
firm.
• Liquidity ratio helps the firm to maintain the proper balance between
high liquidity and lack of liquidity.

• The most common ratios, which indicate the extent of liquidity or lack
of it are
Current Ratio
Quick Ratio
Cash Ratio
Interval Measure
Net Working Capital Ratio
 Financial Statement Analysis
Liquidity Ratio- Current Ratio

• Current ratio is calculated by dividing the current assets by current

liabilities.
Current Ratio= Current assets/ Current Liabilities

• Current asset include cash and those assets that can be converted into
cash within a year such as marketable securities, debtors and
inventories. Prepaid expenses are also included in current assets as
they represent the payments that will not be made by the firm in the
future.
• Current liabilities include all the obligations maturing within a year. It
incudes creditors, bills payable, accrued expenses, short-term bank
loan, income-tax liability and long-term debt maturing in the current
year.
 Financial Statement Analysis
Liquidity Ratio- Current Ratio

• Current ratio is a measure of the firm’s short-term solvency.

• It indicates the availability of current assets in rupees for every one
rupee of current liability.
• The higher the current ratio, the larger is the amount of rupees
available per rupee of current liability, the more is the firm’s ability to
meet current obligations and the greater is the safety of funds of short-
term creditors.
• Thus, current ratio is a measure of margin of safety to the creditors.
• The higher the current ratio, the greater the margin of safety, the
larger the amount of current assets in relation to current liabilities, the
more the firm’s ability to meet its current obligation.
 Financial Statement Analysis
Liquidity Ratio- Current Ratio

Interpretation of Current Ratio

For HMC Current ratio is:
Current Ratio = Rs. 1870.92/Rs. 1555.75 = 1.20:1
• As a conventional rule , a current ratio of 2 to 1 or more is considered
satisfactory. The HMC has a current ratio of 1.20:1; it may be
interpreted to be insufficiently liquid.
• This rule is based on the logic that in a worse situation, even if the
value of current asset becomes half, the firm will be able to meet its
obligations.
• The rule of thumb (a current ratio of 2:1) cannot be applied
mechanically.
• What is the satisfactory ratio will differ depending on the
development of the capital market and the availability of long -term
funds to finance current assets, the nature of industry and so on.
 Financial Statement Analysis
Liquidity Ratio- Quick Ratio

• The quick ratio or acid test ratio is the ratio between quick current
assets and current labilities and is calculated by dividing the quick asset
by the current liabilities.
• Quick or liquid assets include cash, debtors/bills receivables and
marketable securities. Inventories and prepaid expenses are not
considered as a liquid asset since it normally requires some time for
realising into cash.

Quick Ratio= Current assets-Inventories/ Current liabilities

Quick Ratio = Rs. 720.53/ Rs. 1555.75 = 0.46:1

HMC may find it difficult to meet its obligations because its quick assets
are 0.46 times of current liabilities.
 Financial Statement Analysis
Liquidity Ratio- Quick Ratio

Is quick ratio a better measure of liquidity?

• Generally, a quick ratio of 1 to 1 is considered to represent a

satisfactory current financial condition.
• Although quick ratio is a more penetrating test of liquidity than the
current ratio, yet it should be used cautiously.
• Since, all debtors may not be liquid and all inventories are not
absolutely non-liquid.
• As a result, a company with a high value of quick ratio can suffer from
the shortage of funds. On the other hand, a company with a low value
of quick ratio may really be prospering and paying its current
obligation in time.
 Financial Statement Analysis
Liquidity Ratio- Cash Ratio

• Since cash is the most liquid asset, a financial analyst may examine
cash ratio and it equivalent to current liabilities.
• Trade investment or marketable securities are equivalent of cash,
therefore, they may be included in the computation of cash ratio:

Cash ratio = Cash+ Marketable securities/Current liabilities

For the HMC, cash ratio is as follows:

26.08/1555.75 = 0.017 or 2% approx.

• The company carries a small amount of cash. However, if the company
has reserve borrowing power then they should not be worried about
the lack of cash.
 Financial Statement Analysis
Liquidity Ratio: Interval Measure

The interval measure relates liquid assets to average daily operating

cash outflows and assesses a firm’s ability to meet its regular cash
expenses.

The daily operating expenses will be equal to cost of goods sold plus
selling, administrative and general expenses less depreciation (and
other non-cash expenditures) divided by number of days in the year.

Interval measure = Current assets-Inventory/Average daily operating

expenses
For HMC the interval measure is:
1870.92-1150.39/3369.94/360= 77 days
For HMC, interval measure indicates that it has sufficient liquid assets
to finance its operations for 77 days, even if it does not receive any
cash.
 Financial Statement Analysis
Liquidity Ratio: Net Working Capital Ratio

The difference between current assets and current liabilities excluding

short-term bank borrowing is called net working capital (NWC or net
current assets (NCA).
NWC is sometimes used as a measure of a firm’s liquidity. It is
considered that, between two firms, the one having the larger NWC
has the greater ability to meet its current obligations.

NWC = Net working capital (NWC)/Net assets (NA)

For HMC, NWC ratio is:

1,154.04/1,901.87 = 0.61
 Financial Statement Analysis

Table 1: HMC Liquidity Ratios

1991 1992 1993

Current Ratio 1.24 1.25 1.20

Quick Ratio 0.56 0.56 0.46
Cash Ratio 0.01 0.09 0.02
Interval Measure (days) 65.00 87.00 77.00
Net working capital ratio 0.53 0.58 0.61

Ratios indicates that HMC’s liquidity is deteriorating. However, a note of caution may
be sounded: liquidity ratio can mislead since current assets and current liabilities can
change quickly.