FINANCIAL STATEMENT ANALYSIS

The art of transforming data from financial statements into

information that is useful for informed decision making.
 Types of Financial Statements

Balance Sheet (tells about

Income Statement (tells
firm’s assets and claims
regarding profit / loss)
against those assets)

Cash flow statement (tells Owner’s Equity statement

about cash inflow and (tells about changes in
outflow) owner’s equity or funds)
 Use of Financial Statements
All interested parties use these statements to
assess the company’s performance and its position.
Performance is analyzed by looking at profit or
loss made by the company (income statement);
Position is assessed using the Balance Sheet of
the Company that informs regarding the Assets =
Liabilities + Capital of the owner’s equity.
 XYZ COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED 31 DECEMBER 2013
  $
SALES   500000
LESS: COST OF GOODS SOLD   260000
GROSS PROFIT   240000
   

LESS: OPERATING EXPENSES   36000

NET OPERATING PROFIT   204000
   
ADD: OTHER INCOME   8600
LESS: OTHER EXPENSES (Interest and Tax)   9450
NET PROFIT   203150
 XYZ BUSINESS BALANCE SHEET AS AT………………
Assets Rs. Liabilities Rs.
Current Assets Current Liabilities
Cash 98,000 Accounts Payable 130,000
Format Accounts Receivable 54,000 Wages Payable 70,000
Supplies 39,000 Total Current Liabilities 200,000
Total current assets 191,000
Non-current liabilities
Non-Current Assets Owner's Equity
Land 370,000 Notes/Bonds Payable 159,000
Building 123,000 Owner's Equity/Capital 350,000
Less: Accumulated
Depreciation 25,000 Total 509,000
Total Non-current Assets 518,000
Total Liabilities and Owner's
Total Assets 709,000 Equity 709,000
 CASH FLOW STATEMENT
The cash flow statement explains the change during the period in cash and
cash equivalents. Cash includes currency on hand and cash at bank while
Cash equivalents are short-term, highly liquid investments that are readily
convertible to cash.
The cash flow statement follows an activity format and is divided into three
sections:
1. Operating Activities: to record the changes in Current Assets and Current
Liabilities.
2. Investing Activities: to record the changes in Non-Current Assets.
3. Financing activities: to record the changes in Non-Current Liabilities and
Equity.
 METHOD OF MAKING CASH FLOW
STATEMENT

There are two methods of calculating and reporting the net cash flow
from operating activities. Both methods result in identical figures for
net cash flow from operating activities because the underlying
accounting concepts are the same.
1. The direct method reports gross cash inflows and gross outflows
from operating activities (starts with sales)
2. The indirect method reconciles net income with net cash flow from
operating activities by adjusting net income for deferrals, accruals,
and items that effect investing and financing cash flows. (starts with
Net Profit)
Rules for recording Inflows
and Outflows
Cash inflows Cash outflows

• Decrease in asset • Increase in asset

accounts accounts
• Increase in liability • Decrease in liability
accounts accounts
• Increase in equity • Decrease in equity
account account
 CASH INFLOWS
OPERATING ACTIVITIES:
Collections from Customers, Interest Income, Dividends Receipts, Other
Operating Cash Receipts
INVESTING ACTIVITIES:
Collection on Loans, Sale of Debt Instruments, Sale of Equity
Instruments, Sale of Productive Assets
FINANCING ACTIVITIES:
Issuance of Long-Term Debt, Issuance of Equity Securities
 CASH OUTFLOWS
OPERATING ACTIVITIES:
Payments to Suppliers, Payments to Employees, Interest Payments,
Payment of Income Taxes, Other Operating Cash Payments
INVESTING ACTIVITIES:
Purchase of Productive Assets, Purchase of Debt Instruments, Purchase
of Equity Instruments, Making Loans
FINANCING ACTIVITIES:
Payment of Dividends, Acquisition of an Entity’s, Own Equity Securities,
Repayment of Amounts Borrowed
Financial Statements Users

Internal Users External Users

Owner Creditors
Management Analysts
Internal Auditors Government
Employees Academics
 Financial Ratios
A Financial Ratio is an index that Types of
relates or compares two accounting Comparisons
numbers and is obtained by dividing Internal
one number by the other. Comparisons
External
Comparisons
Financial Ratios and Analysis
1. LIQUIDITY RATIOS
2. SOLVENCY RATIOS
3. ACTIVITY RATIOS
4. PROFITABILITY RATIOS
5. MARKET RATIOS
 1. LIQUIDITY RATIOS
Used to measure short-
term debt-paying ability
of the firm.

1. Current Ratio
2. Quick Ratio
3. Absolute Liquid Ratio
4. Working Capital
 CURRENT RATIO
CURRENT ASSETS
CURRENT LIABILITIES
Measures the firm’s ability to pay off
its short term debts. Favorable answer
is 1.5 or higher than last years.
 QUICK RATIO
CURRENT ASSETS - INVENTORIES
CURRENT LIABILITIES
Measures the firm’s ability to pay off
its short term debts. Favorable answer
is 1 or higher than last year’s ratio
 ABSOLUTE LIQUID RATIO
CASH + MARKETABLE SECURITIES
CURRENT LIABILITIES
OR
{CA-(Inventories and Accounts
Receivables)} divided by CL
Measures the firm’s ability to pay off
its short term debts. Favorable answer
is 0.5 or higher than last year
WORKING CAPITAL
Current Assets – Current Liabilities

Favorable if higher than last year.

 CLASS ACTIVITY
Calculate liquidity ratios and also provide
your analysis
ASSETS 2013 2014 LIABILITIES 2013 2014

Current Assets Current Liabilities

Cash in Hand 500,600 487,000 Trade Payable 500,400 520,000
Cash at Bank 560,000 697,500 Accruals 350,000 337,000
Mkt. Securities 145,000 138,000
Stock in Trade 386,000 430,200
Trade Debts 338,000 325,000
 2. SOLVENCY RATIOS
Used to check long term debt paying ability of a firm.

1. Interest Coverage Ratio

2. Debt Ratio
3. Equity Ratio
4. Debt to Equity Ratio
 Interest Coverage Ratio
Tells about a firms ability to pay its fixed charge of
interest out of its operating profit.
EBIT
Interest Expense
I.e. EBIT = Earning Before Interest and Tax or
Operating Profit Divided by Interest Amount
Higher Answer is preferable.
 Debt Ratio
This ratio tells the percentage of a firm’s assets
that are financed using Debt. Higher Answer shows
high degree of financial leverage and financial risk.
Measured as:
Total Debt
Total Assets
i.e. Total Debt or Total Liabilities divided by Total
Assets
 Equity Ratio
This ratio tells the percentage of a firm’s assets that
are financed using Owner’s Equity.
Total Equity
Total Assets
i.e. Total Equity or Capital divided by Total Assets
 Debt to Equity Ratio

 This Ratio indicates degree of financial Leverage. Rising

Debt to Equity implies higher interest expense. Calculated
as:
Total Debt
Total Equity
 Total Debt or Total Liabilities divided by Total Equity or
Capital. Higher answer up to a certain limit is not
preferable.
 Additional
Information
CLASS ACTIVITY Calculate Solvency Ratios
Balance Sheet
ASSETS 2018 (Rs.) 2019 (Rs.) LIABILITIES 2018 (Rs.) 2019 (Rs.)
Current Assets 10,00,000 12,00,000 Current Liabilities 600,000 620,000
Non-Current Assets 15,00,000 15,50,000 Non-Current Liabilities 750,000 780,000
Total Liabilities 13,50,000 14,00,000

Capital 11,50,000 13,50,000

Total Assets 25,00,000 27,50,000 Total Liabilities & Capital 25,00,000 27,50,000

Particulars 2018 (Rs.) 2019 (Rs.)

Income Statement Sales 35,00,000 42,00,000

Cost of Sales (12,00,000) (12,50,000)
Gross Profit 23,00,000 29,50,000
Operating Expenses (860,000) (880,000)
Operating Profit 14,40,000 20,70,000
Finance Cost (145,000) (150,000)
Earning before tax 12,95,000 19,20,000
Tax (259,000) (384,000)
Profit for the year 10,36,000 15,36,000
 3. ACITIVITY RATIOS
Measures a firm’s Operating Performance.
1. Total Asset Turnover Ratio
2. Inventory Turnover Ratio and Age of Inventory
3. Receivable Turnover Ratio and Collection Period
Total Asset Turnover Ratio
Net Sales/ Total Assets
Measures the return on each
dollar invested in assets; is equal
to the net sales
Higher Answer Preferred.
 Inventory Turnover

Inventory Turnover = CGS/Avg. Inventory Cost

Age of Inventory = 365/Inventory Turnover

A higher inventory turnover ratio indicates more effective cash

management and reduces the incidence of inventory obsolescence.
A.K.A Inventory Utilization Ratio, higher answer preferred while age
of inventory should be low.
 Receivables Turnover

ART= Total Credit Sales/ Avg. Accounts Receivables

Collection Period = 365/Accounts Receivable Turnover Ratio

Shows how quickly a company collects what is owed to it and

indicates the liquidity of the receivables.
ART should be higher while Collection period should be Low.
 OPERATING CYCLE
•Operating cycle is the number of days a company takes in
realizing its inventories in cash. It equals the time taken in selling
inventories plus the time taken in recovering cash from trade
receivables.
CLASS ACTIVITY Calculate Activity Ratios

ASSETS 2018 2019

Current Assets Income Statement 2018 (Rs.) 2019 (Rs.)
Cash and Equivalents 400,000 480,000 Sales 35,00,000 45,00,000
Short term Deposits 560,000 690,000 Cost of Sales (12,00,000) (13,00,000)
Stock in Trade 145,000 150,000 Gross Profit 23,00,000 32,00,000
Trade Debts 380,000 430,000

Non-Current Assets 15,00,000 15,50,000

Total Assets 29,85,000 33,00,000

 4. PROFITABILITY RATIOS

1. Gross Profit Margin

2. Operating Profit Margin
3. Net Profit Margin
4. Earning Per Share (EPS)
5. Return on Assets
6. Return on Equity
 Gross Profit Margin

Gross Profit X 100

Net Sales

This ratio measures how profitable a company sells its

inventory or merchandise. High answer is favourable.
 Operating Profit Margin

Operating Profit (EBIT) X 100

Net Sales

This ratio measures how profitable a company is after

paying off all of its operational expenses. High answer
is favourable.
 Net Profit Margin
Net Profit (NPAIT) X 100
Net Sales

The net profit margin ratio shows what percentage of

sales are left over after all expenses are paid by the
business.
 Earning Per Share
Net Profit
No. of Outstanding Shares
Earnings per share (EPS) is the portion of a company's
profit allocated to each outstanding share of common
stock. 
Earnings per share serves as an indicator of a
company's profitability. High answer is preferable.
 Return on Assets
Net Profit
Total Assets
Return on assets (ROA) is an indicator of how profitable a
company is relative to its total assets. ROA gives an idea as to
how efficient management is at using its assets to generate
earnings. Higher answer is a good sign.
 Return on Equity
Net Profit
Total Equity
Return on equity (ROE) is the amount of net income returned
as a percentage of shareholders equity. Return on equity
measures a corporation's profitability by revealing how much
profit a company generates with the money shareholders have
invested.
CLASS ACTIVITY Calculate Profit Ratios
Balance Sheet
ASSETS 2018 (Rs.) 2019 (Rs.) LIABILITIES 2018 (Rs.) 2019 (Rs.)
Current Assets 10,00,000 12,00,000 Current Liabilities 600,000 620,000
Non-Current Assets 15,00,000 15,50,000 Non-Current Liabilities 750,000 780,000
Total Liabilities 13,50,000 14,00,000

Capital 11,50,000 13,50,000

Total Assets 25,00,000 27,50,000 Total Liabilities & Capital 25,00,000 27,50,000

Income Statement 2018 (Rs.) 2019 (Rs.)

Sales 35,00,000 42,00,000
Cost of Sales (12,00,000) (12,50,000)
Assume number of shares in
Gross Profit 23,00,000 29,50,000
Operating Expenses (860,000) (880,000) 2018 to be 115,000 while in
Operating Profit 14,40,000 20,70,000 2019 it is 135,000
Finance Cost (145,000) (150,000)
Earning before tax 12,95,000 19,20,000
Tax (259,000) (384,000)
Profit for the year 10,36,000 15,36,000
 5. MARKETABILITY RATIOS

1. Market Price Per Share

2. Price to Earning Ratio
3. Dividend Payout Ratio
Market Price Per Share
Available from internet. KSE
website.
High MPS is favorable.
 Price to Earning Ratio
Market value Per Share
Earning Per Share
It shows what the market is willing to pay for a stock
based on its current earnings.
A answer indicates positive future performance and that
investors are willing to pay more for this company's
shares.
 Dividend Payout Ratio

Total Dividends
Net Income/Profit
The dividend payout ratio measures the percentage of
net income that is distributed to shareholders in the form
of dividends during the year.
A sustained percentage is preferable.
Get More Information From:
http://www.myaccountingcour
se.com/financial-ratios
Text Book: Van Horne:
Financial Management-
Chapter 6: Financial Statement
Analysis