FINANCIAL STATEMENT

ANALYSIS
 Significance of Financial
statement analysis
• Financial statement analysis enables the
financial manager to analyze the success,
failure, and progress of the business.
• It helps him to spot trends in a business and to
compare its performance and condition with the
average performance of similar businesses in
the same industry.
• An assessment of the current status will help to
provide the financial analyst with the all-
important early warning indications especially for
any unfavorable trends that may be starting.
• Financial analysis can reveal much about a company
and its operations. However, there are several points to
keep in mind about ratios. First, a ratio is a "flag"
indicating areas of strength or weakness. One or even
several ratios might be misleading, but when combined
with other knowledge of a company's management and
economic circumstances, financial analysis can tell much
about a corporation. Second, there is no single correct
value for a ratio. The observation that the value of a
particular ratio is too high, too low, or just right depends
on the perspective of the analyst and on the company's
competitive strategy. Third, financial ratios are
meaningful only when compared with some standard,
such as an industry trend, ratio trend, a trend for the
specific company being analyzed, or a stated
management objective.
 Techniques of Financial
Statement analysis
• Three commonly used tools of financial
statement analysis are
• Horizontal analysis
• Vertical analysis
• Ratio analysis.
 Ratio Analysis

• Ratio analysis is an excellent financial

analysis tool for determining the overall
financial condition of a business. It puts
the information from a financial statement
into perspective, helping to spot trends
that may threaten the health of the
company
 Some important aspects which should be kept in
mind when analyzing ratios are:
• Ratios taken alone mean very little. They should
be compared with others ratios, norms,
standards, etc.
• The analyst should decide the ratios which are
appro­priate in a specific situation and what
combination of ratios to use.
• Ratios give clues about the strengths and
weakness of a firm.
 Purpose of Ratio Analysis

• Management, creditors, and investors have different purposes in

using ratio analysis to evaluate financial statements
• Used to communicate financial performance that may not be
apparent in financial statements.
•  1. Management
• Monitor operating performance in meeting goals and objectives
• Maintain effectiveness and efficiency of operation
• Identify potential problem areas when actual results fall short
•   2. Creditors
• Evaluate solvency of firm and assess riskiness of future loans
• Set requirements for certain financial requirements
•   3. Investors
• Evaluate financial performance of the firm
• Assess potential for future investment
 Kinds of Ratios

• Financial ratios may be classified in terms

of four basic categories, each representing
an important aspect of the firm's financial
condition:
• Liquidity Ratios
• Profitability Ratios
• Leverage Ratios
Turnover or Efficiency Ratios
 Liquidity Ratios

• The following liquidity ratios are all

designed to measure a company's ability
to cover its short-term obligations.

• Current Ratio
• Acid Test (or Quick Ratio)
• Working Capital
• .
 Balance Sheet of ABC Limited

Rs Rs

Cash and Cash 23,000 Creditors 15,000

equivalents
Debtors 28,000 Accounts Payable 10,000
Accounts receivable 24,000 Income Tax payable 7,000
Inventory 25,000 Deferred liabilities 8,000
Pre- paid expenses 5,000 Long term debt 80,000
Plant and Machinery 120,000 Debentures 40,000
Land 70,000 Interest payable 5,000
Supplies 35,000 Reserves and Surplus 70,000
Intangible assets 5,000 Equity Share capital 100000
Total 3,35,000 Total 3,35,000

Income Statement
Revenues Rs 3,50,000
Less Expenses – Salaries 80,000
Rent and Insurance 6,000
Advertising 15000
Other operating expenses 20,000
EBDIT 2,29,000
Depreciation 40,000
EBIT 1,89,000
Interest 40,000
EBT or PBT 1,49,000
Taxes 74,500
EAT or PAT Rs 74,500
• Liquidity Ratios
• Liquidity ratios indicate how capable a business is of meeting its
short-term obligations as they fall due
• The main concern of liquidity ratio is to measure the ability of the
firms to meet their short-term maturing obligations. Failure to do this
will result in the total failure of the business, as it would be forced
into liquidation
• Current Ratio Current Assets / Current Liabilities
• A simple measure that estimates whether the business can pay
debts due within one year from assets that it expects to turn into
cash within that year. A ratio of less than one is often a cause for
concern, particularly if it persists for any length of time.
• Quick Ratio (or "Acid Test“ Cash and near cash (short-term
investments + trade debtors)
• Not all assets can be turned into cash quickly or easily. Some -
notably raw materials and other stocks - must first be turned into
final product, then sold and the cash collected from debtors. The
Quick Ratio therefore adjusts the Current Ratio to eliminate all
assets that are not already in cash (or "near-cash") form. Once
again, a ratio of less than one would start to send out danger
signals.
• Positive and Negative Working capital

• Is Negative working capital Good for your

Company??
Negative Working capital – When there are more short-
term debt than there are short-term assets. Generally,
having anything negative is not good, but in case
of working capital it could be good as a company with
negative working capital funds its growth in sales by
effectively borrowing from its suppliers and customers.
•In order to run a sustainable business with a negative
working capital it’s essential to understand.
•Approach your suppliers and persuade them to let you
purchase the inventory on 1-2 month credit terms, but keep
in mind that you must sell the purchased goods, to
consumers, for money.
• Negative working capital illustrates the amount of
bargaining power major chains like Walmart exert on
suppliers. These big chains only pay their suppliers
months later, so they are effectively borrowing money
from suppliers.
• Positive working capital can sometimes mean lack of a
dominant position and higher inventory risk assumed.
• On a side note, that's why it's " easy " for supermarkets
to open in new locations, since they have that kind of
leverage dealing with suppliers. If they had to pay for all
the products upfront, it would be much more demanding
and risky.
• Retail and restaurant companies like Amazon, Wal-Mart,
and McDonald's often have negative Working Capital
because customers pay upfront - so they can use the
cash generated to pay off their Accounts Payable rather
than keeping a large cash balance on-hand. This can be
a sign of business efficiency.

• Big companies like McDonald’s, Amazon, Dell, General

Electric and Wal-Mart are giants with negative working
capital.
 Leverage Ratios
• Leverage is a ratio that measures a
company's capital structure. In other
words, it measures how a company
finances their assets.
• A firm that finances its assets with a high
percentage of debt is risking bankruptcy
should it be unable to make its debt
payments
• These ratios concentrate on the long-term health of a
business - particularly the effect of the capital/finance
structure on the business:
• Gearing Borrowing (all long-term debts + normal
overdraft) / Net Assets (or Shareholders' Funds)
• Gearing (otherwise known as "leverage") measures the
proportion of assets invested in a business that are
financed by borrowing. In theory, the higher the level of
borrowing (gearing) the higher are the risks to a
business, since the payment of interest and repayment
of debts are not "optional" in the same way as
dividends. However, gearing can be a financially sound
part of a business's capital structure particularly if the
business has strong, predictable cash flows.
• Times Interest Earned Ratio
EBIT/ Interest
• This measures the ability of the business to "service" its
debt. Are profits sufficient to be able to pay interest and
other finance costs?
• This ratio measure the extent to which earnings can
decline without causing financial losses to the firm and
creating an inability to meet the interest cost.
• The times interest earned shows how many times the
business can pay its interest bills from profit earned.
• Present and prospective loan creditors such as
bondholders, are vitally interested to know how adequate
the interest payments on their loans are covered by the
earnings available for such payments.
• Owners, managers and directors are also interested in
the ability of the business to service the fixed interest
charges on outstanding debt.
• Profitability Ratios
• These ratios tell us whether a business is making profits - and
if so whether at an acceptable rate.
• Profitability is the ability of a business to earn profit over a period of
time. Although the profit figure is the starting point for any
calculation of cash flow, as already pointed out, profitable
companies can still fail for a lack of cash.
• Note: Without profit, there is no cash and therefore profitability must
be seen as a critical success factors.
• A company should earn profits to survive and grow over a long
period of time.
• Profits are essential, but it would be wrong to assume that every
action initiated by management of a company should be aimed at
maximising profits, irrespective of social consequences.
• Profitability is a result of a larger number of policies and decisions.
The profitability ratios show the combined effects of liquidity, asset
management (activity) and debt management (gearing) on operating
results. The overall measure of success of a business is the
profitability which results from the effective use of its resources.
 PROFITABILITY RATIOS
• Profitability is an important measure of a
company's operating success. The profitability
ratios measure the firm's ability to generate
profits and are of central interest to security
analysts, shareholders and investors
• a. Gross Profit Margin: Gross profit/Sales
•
• (b) Net Profit Margin: Net profit/Sales  100
 c) Return on total assets: PAT/ SALES

d) Return on net worth: PAT/ NW OR

EBIT/NW

e) ROKE = PAT/KE
• Gross Profit Margin This ratio tells us something about the business's
ability consistently to control its production costs or to manage the margins
its makes on products its buys and sells. Whilst sales value and volumes
may move up and down significantly, the gross profit margin is usually quite
stable (in percentage terms). However, a small increase (or decrease) in
profit margin, however caused can produce a substantial change in overall
profits.
• Net Profit Margin
This is a widely used measure of performance and is comparable across
companies in similar industries. The fact that a business works on a very
low margin need not cause alarm because there are some sectors in the
industry that work on a basis of high turnover and low margins, for examples
supermarkets and motorcar dealers.
What is more important in any trend is the margin and whether it compares
well with similar businesses.

• Return on capital employed ("ROCE") Net profit before tax, interest and
dividends ("EBIT") / total assets (or total assets less current liabilities.
ROCE is sometimes referred to as the "primary ratio"; it tells us what returns
management has made on the resources made available to them before
making any distribution of those returns.
• Net Profit margin or PAT
• Compare to other businesses in the same
industry to see if your business is
operating as profitably as it should be.
 Look at the trend from month to month. Is
it staying the same? Improving?
Deteriorating?
 Are you generating enough sales to
leave an acceptable profit?
 Trend from month to month can show
how well you are managing your operating
or overhead costs.
• Return on Shareholders' Equity (ROSE)
•

• Times-Interest Earned Ratio

• Earnings per share (EPS) PAT/EPS

• Price-Earnings Ratio (P/E) = MPS/EPS

• Investor Ratios
• There are several ratios commonly used by investors to
assess the performance of a business as an investment:
• Earnings per share ("EPS") Earnings (profits)
attributable to ordinary shareholders / Weighted average
ordinary shares in issue during the year A requirement of
the London Stock Exchange - an important ratio. EPS
measures the overall profit generated for each share in
existence over a particular period.
• Whatever income remains in the business after all prior
claims, other than owners claims (i.e. ordinary dividends)
have been paid, will belong to the ordinary shareholders
who can then make a decision as to how much of this
income they wish to remove from the business in the
form of a dividend, and how much they wish to retain in
the business. The shareholders are particularly
interested in knowing how much has been earned during
the financial year on each of the shares held by them.
• Price-Earnings Ratio ("P/E Ratio") Market
price of share / Earnings per Share
• At any time, the P/E ratio is an indication of how
highly the market "rates" or "values" a business.
A P/E ratio is best viewed in the context of a
sector or market average to get a feel for relative
value and stock market pricing.
• P/E ratio is a useful indicator of what premium or
discount investors are prepared to pay or
receive for the investment.
• The higher the price in relation to earnings, the
higher the P/E ratio which indicates the higher
the premium an investor is prepared to pay for
the share. This occurs because the investor is
extremely confident of the potential growth and
earnings of the share
• Dividend Ratios: The three ratios are
as follows:

• Dividend per Share (DPS): Equity share

dividend/ No. of Equity Shares

• Dividend payout ratio = DPS/EPS

• Dividend = DPS/ Market price per share

• Dividend Payout ratio: DPS/ EPS
• This is known as the "payout ratio". It provides a guide
as to the ability of a business to maintain a dividend
payment. It also measures the proportion of earnings
that are being retained by the business rather than
distributed as dividends.

• Dividend Yield (Latest dividend per ordinary share /

current market price of share) x 100
• The dividend yield ratio indicates the return that
investors are obtaining on their investment in the form of
dividends. This yield is usually fairly low as the investors
are also receiving capital growth on their investment in
the form of an increased share price. It is interesting to
note that there is strong correlation between dividend
yields and market prices. Invariably, the higher the
dividend, the higher the market value of the share.
• Return on Equity
• Definition: Determines the rate of return on your
investment in the business. As an owner or shareholder
this is one of the most important ratios as it shows the
hard fact about the business -- are you making enough
of a profit to compensate you for the risk of being in
• business?
Analysis:  Compare the return on equity to other
investment alternatives, such as a savings account,
stock or bond.
 Compare your ratio to other businesses in the same or
similar industry.
 Efficiency Ratios
• (a) Fixed Assets Turnover Ratio:
• Fixed Assets Turnover Ratio = Sales/Fixed Assets

• (b) Total Assets Turnover: = Sales/Total Assets

• (c) Accounts Receivable Turnover (also known as Debtors Turnover):

• Accounts Receivable Turnover
• = Net Credit Sales (or net sales)/Debtors
• d) Average Collection Period: This ratio
determines how rapidly the credit accounts
of a firm are being collected.
• i.e. No. of days in a year/Debtors turnover
• (e) Inventory Turnover: Inventory turnover
shows how many times the average rupee
invested in inventory were turned over
during a period. It is computed as follows:
• Inventory turnover = Cost of goods
sold/Average Inventory (or closing stock)
• Efficiency ratios ( also known as activity ratios)
• These ratios give us an insight into how efficiently the
business is employing those resources invested in fixed
assets and working capital.
• If a business does not use its assets effectively,
investors in the business would rather take their money
and place it somewhere else. In order for the assets to
be used effectively, the business needs a high turnover.
• Unless the business continues to generate high turnover,
assets will be idle as it is impossible to buy and sell fixed
assets continuously as turnover changes. Activity ratios
are therefore used to assess how active various assets
are in the business.
• Note: Increased turnover can be just as dangerous as
reduced turnover if the business does not have the
working capital to support the turnover increase. As
turnover increases more working capital and cash is
required and if not, overtrading occurs.
• Inventory Turnover
This ratio measures the stock in relation to turnover in
order to determine how often the stock turns over in the
business.
It indicates the efficiency of the firm in selling its product.
It is calculated by dividing he cost of goods sold by the
average inventory.
• IT = Sales or cost of sales / Average Inventory
• A relatively high stock turnover would seem to suggest
that the business deals in fast moving consumer goods.
• The high stock turnover ratio would also tend to indicate
that there was little chance of the firm holding damaged
or obsolete stock.
• Stock turnover helps answer questions such as "have
we got too much money tied up in inventory"?. An
increasing stock turnover figure or one which is much
larger than the "average" for an industry, may indicate
poor stock management.
• Average Collection Period
The average collection period measures the quality of
debtors since it indicates the speed of their collection.
• The shorter the average collection period, the better
the quality of debtors, as a short collection period
implies the prompt payment by debtors.
• The average collection period should be compared
against the firm’s credit terms and policy to judge its
credit and collection efficiency.
• An excessively long collection period implies a very
liberal and inefficient credit and collection
performance.
• The delay in collection of cash impairs the firm’s
liquidity. On the other hand, too low a collection
period is not necessarily favourable, rather it may
indicate a very restrictive credit and collection policy
which may curtail sales and hence adversely affect
profit.
 Du Pont Analysis
• DuPont analysis is a useful technique used to
decompose the different drivers of return on equity for a
business. This allows an investor to determine what
financial activities are contributing the most to the
changes in ROE. An investor can use an analysis like
this to compare the operational efficiency of two similar
firms.
 Return on Equity using the Du Pont
Model
Helps to gain insight into the capital structure of a firm, 
the quality of the business, and the levers that are driving the 
return on invested capital.
To calculate return on equity using the Du Pont model, we have to multiply three
components - the net profit margin, asset turnover, and the equity multiplier.
Equity Multiplier: It is possible for a company with terrible sales and margins to
take on excessive debt and artificially increase its return on equity. The equity
multiplier, a measure of financial leverage, allows the investor to see what
portion of the return on equity is the result of debt.
ROE = (Net Income / Revenue) (Revenue/Assets) (Assets/ Shareholders
Equity)

= Net Income / Shareholders Equity