FINANCIAL STATEMENT ANALYSIS
Introduction
Financial statement analysis is the process of analyzing a company's financial statements for
decision-making purposes and to understand the overall health of an organization. Financial
statement analysis involves (1) comparing the firm’s performance with that of other firms in the
same industry and (2) evaluating trends in the firm’s financial position over time. Financial
statements record financial data, which must be evaluated through financial statement analysis to
become more useful to investors, shareholders, managers, and other interested parties.
To make rational decisions in keeping with the objectives of the firm, the financial manager must
have analytical tools. The firm itself and outside providers of capital – creditors and investors –
all undertake financial statement analysis. The type of analysis varies according to the specific
interests of the party involved.
Trade creditors (suppliers owed money for goods and services) are primarily interested in the
liquidity of a firm. Their claims are short term, and the ability of the firm to pay these claims
quickly is best judged by an analysis of the firm’s liquidity. The claims of bondholders, on the
other hand, are long term. Accordingly, bondholders are more interested in the cash-flow ability
of the firm to service debt over a long period of time. They may evaluate this ability by
analyzing the capital structure of the firm, the major sources and uses of funds, the firm’s
profitability over time, and projections of future profitability.
Investors in a company’s common stock are principally concerned with present and expected
future earnings as well as with the stability of these earnings about a trend line. As a result,
investors usually focus on analyzing profitability. They would also be concerned with the firm’s
financial condition insofar as it affects the ability of the firm to pay dividends and avoid
bankruptcy.
Internally, management also employs financial analysis for the purpose of internal control and to
better provide what capital suppliers seek in financial condition and performance from the firm.
From an internal control standpoint, management needs to undertake financial analysis in order
to plan and control effectively. To plan for the future, the financial manager must assess the
firm’s present financial position and evaluate opportunities in relation to this current position.
With respect to internal control, the financial manager is particularly concerned with the return
on investment provided by the various assets of the company, and with the efficiency of asset
management. Finally, to bargain effectively for outside funds, the financial manager needs to be
attuned to all aspects of financial analysis that outside suppliers of capital use in evaluating the
firm.
Objectives of Financial Statement Analysis
1. Assessment of Past Performance - Past performance is a good indicator of future
performance. Investors or creditors are interested in the trend of past sales, cost of goods
sold, operating expenses, net income, cash flows and return on investment. These trends
offer a means for judging management's past performance and are possible indicators of
future performance.
2. Assessment of Current Position - Financial statement analysis shows the current position
of the firm in terms of the types of assets owned by a business firm and the different
liabilities due against the enterprise.
3. Prediction of profitability and growth prospects - Financial statement analysis helps in
assessing and predicting the earning prospects and growth rates in earning which are used
by investors while comparing investment alternatives and other users in judging earning
potential of business enterprise.
4. Prediction of bankruptcy and failure - Financial statement analysis is an important tool in
assessing and predicting bankruptcy and probability of business failure.
5. Assessment of the operational efficiency - Financial statement analysis helps to assess the
operational efficiency of the management of a company. The actual performance of the
firm which are revealed in the financial statements can be compared with some standards
set earlier and the deviation of any between standards and actual performance can be used
as the indicator of efficiency of the management.
Types of Financial Statement Analysis
Figure 1 – Types of Financial Statement Analysis
Analysis Based on Materials Used
Based on the material used, financial statement analysis may be classified into two major types
such as external analysis and internal analysis.
A. External Analysis
Outsiders of the business concern normally conduct external analysis. These are stakeholders
who are indirectly involved in the business concern such as investors, creditors, government
organizations and other credit agencies. External analysis is very much useful to understand the
financial and operational position of the business concern. External analysis mainly depends on
the published financial statement of the business concern. This analysis provides only limited
information about the business concern.
B. Internal Analysis
The company itself does disclose some of the valuable information of the business concern in
this type of analysis. This analysis is used to understand the operational performances of each
and every department and unit of the business concern. Internal analysis helps to take decisions
regarding achieving the goals of the business concern.
Analysis Based on Method of Operation
Based on the methods of operation, financial statement analysis may be classified into two major
types such as horizontal analysis and vertical analysis.
A. Horizontal Analysis
Horizontal analysis, also known as trend analysis, is the comparison of financial information
over a series of reporting periods, that is, the review of the results of multiple time periods. In a
horizontal analysis, financial statements are compared over several years and based on that, a
firm may take decisions. Normally, the current year’s figures are compared with the base year
(base year is considered as 100) and how the financial information have changed from one year
to another. This analysis is also called dynamic analysis.
B. Vertical Analysis
Vertical analysis is the proportional analysis of a financial statement, where each line item on a
financial statement is listed as a percentage of another item. It is the review of the proportion of
accounts to each other within a single period. Typically, this means that every line item on an
income statement is stated as a percentage of gross sales, while every line item on a balance
sheet is stated as a percentage of total assets.
FINANCIAL STATEMENTS AND ITS COMPONENTS
Financial statements (or financial reports) are formal records of the financial activities and
position of a business, person, or other entity. Relevant financial information is presented in a
structured manner and in a form, which is easy to understand.
They typically include four basic financial statements accompanied by a management discussion
and analysis
1. Balance sheet or Statement of Financial Position: this is a report on a company's
assets, liabilities, and owners’ equity at a given point in time. The balance sheet mainly
tells us how the company’s assets and liabilities are in that current situation. Therefore,
the key to the report is the time that is seen. And time has a great impact on the report.
The most important checking relationship is that the debt plus equity equals the asset. In
accounting, what I have at present is called assets, and the borrowed money is the debt,
and my own money is called equity.
2. Income Statement or Profit and Loss report (P&L report), or statement of
Comprehensive Income, or Statement of Revenue & Expense: these are the reports on
a company's income, expenses, and profits over a stated period of time. A profit and loss
statement provides information on the operation of the enterprise. These include sales and
the various expenses incurred during the stated period.
3. Statement of Changes in Equity or Equity Statement, or Statement of Retained
Earnings: these are reports on the changes in equity of the company over a stated period
of time.
4. Cash Flow Statement: these are the reports on a company's cash flow activities,
particularly its operating, investing and financing activities over a stated period of time.
The cash flow statement mainly tells us how much cash the company has received in a
period of time, how much cash it has paid, and how much cash is left in the bank. The
key to this report is also to see how long this period is, which is the same as the profit
sheet. The most important checking relationship of the cash flow sheet is that the inflow
of cash minus the outflow of cash is equal to the remaining cash.
Notably, a balance sheet represents a single point in time, whereas the income statement, the
statement of changes in equity, and the cash flow statement each represent activities over a
stated period of time.
Interrelationship among Component of Financial Statements
The income statement, balance sheet and cash flow statement are all interrelated. The income
statement describes how the assets and liabilities were used in the stated accounting period. The
cash flow statement explains cash inflows and outflows, and it will ultimately reveal the amount
of cash the company has at hand, which is also reported in the balance sheet. By themselves,
each financial statement only provides a portion of the story of a company's financial condition.
Together, they provide a more complete picture as noted below:
The net income figure in the income statement is added to the retained earnings line item
in the balance sheet, which alters the amount of equity listed on the balance sheet.
The net income figure also appears as a line item in the cash flows from operating
activities section of the statement of cash flows.
Changes in various line items in the balance sheet roll forward into the cash flow line
items listed on the statement of cash flows. For example, an increase in the outstanding
amount of a loan appears in both the liabilities section of the balance sheet (as an ongoing
balance) and in the cash flows from financing activities section of the statement of cash
flows (in the amount of the incremental change).
The ending cash balance in the balance sheet also appears in the statement of cash flows.
The purchase, sale, or other disposition of assets appears on both the balance sheet (as an
asset reduction) and the income statement (as a gain or loss, if any).
Fig 2 – Interrelationship of Components of Financial Statements
Techniques of Financial Statement Analysis
Financial statement analysis is interpreted mainly to determine the financial and operational
performance of the business concern. A number of methods or techniques are used to analyse the
financial statement of the business concern. The following are the common methods or
techniques, which are widely used by the business concern.
Figure 3 – Financial Statement Analysis Techniques
Financial Data Comparison Using Ratios
Ratio is used as an index for evaluating the financial performance of a business concern and is
calculated by comparing key financial information appearing in financial statements of a
business, analyzing those to find out the reasons behind the business’s current financial position
and its recent financial performance, and develop expectation about its future outlook.
Ratio can be classified into various types:
Liquidity Ratios:
Liquidity Ratios measure a company's ability to provide sufficient cash to cover its short-term
obligations (debt). The most common liquidity ratios include the current ratio and the quick
ratio.
Current Ratio: The current ratio indicates the extent to which the claims of short-term
creditors are covered by assets that are expected to be converted to cash in a period roughly
corresponding to the maturity of the liabilities. Here's how the current ratio is calculated:
Current Ratio = Current Assets
Current Liabilities
A current liability represents the money a company owes and is due in the near future - less than
one year. A current asset, on the other hand, is cash or other short-term assets that can be
converted into cash in the near future (i.e. less than a year). Inventory, for example, is a current
asset that is purchased and sold by a company to obtain cash.
By dividing the current assets by the current liabilities, we can determine whether or not a
company has the ability to pay off its short-term debt (current liabilities).
Below shows the current assets and current liabilities for The Widget Manufacturing Company
as at 31 December 2019:
ASSETS: LIABILITIES:
Current Assets: Current Liabilities:
Cash N 2,550 Accounts Payable N 9,500
Marketable securities N 2,000 Short-term Bank Loan N11,375
Account Receivable (Net) N16,675 Total Current Liabilities N20,875
Inventories N26,470
Total Current Assets N47,695
Using the information provided, calculate the company's current ratio.
Current Ratio = Current Assets = N47,695
Current Liabilities N20,875
= 2.28
The Widget Manufacturing Company has a current ratio of 2.28. That is, for every N1.00 the
company owes in current liabilities, it has N2.28 worth of current assets. Therefore, if the Widget
Manufacturing Company's short-term debt was due tomorrow, they would not have any
difficulty in paying their creditors. Moreover, they would simply use the cash in their bank
account, redeem their marketable securities, collect cash from customers who owe them
(Accounts Receivable) and sell more products to customers.
Note: the higher the current ratio, the stronger the company is thought to be.
Quick Ratio: Some conservative minded investors don't like to use the current ratio as an
indicator of whether or not a company has the ability to pay its short-term obligations (debt).
Instead, the quick ratio is used. The quick ratio is similar to the current ratio with one exception;
it measures a company's ability to pay its short-term debts, without relying on the sale of its
inventory. Therefore, in calculating a quick ratio, business owners must subtract the inventory
from the current assets. The formula used to calculate the quick ratio is:
Quick Ratio = Current Assets - Inventories
Current Liabilities
Using the information earlier provided, calculate the quick ratio for Widget Manufacturing
Company.
Quick Ratio Current Assets - Inventories = N47,695 - N26,470
Current Liabilities N20,875
= 1.02
As shown above, The Widget Manufacturing Company has a quick ratio of 1.02. This means that
for every N1.00 owed by the company in short-term debt, it has N1.02 of current assets
(excluding inventory) to pay it. In theory, if The Widget Manufacturing Company does not sell
any more products, then it would have the ability to pay all of its short-term debts using its
current assets other than inventory. Note: the higher the quick ratio, the stronger the company is
perceived to be.
Asset Management Ratios
Asset Management Ratios attempt to measure the firm's success in managing its assets to
generate sales. For example, these ratios can provide insight into the success of the firm's credit
policy and inventory management. These ratios are also known as Activity or Turnover Ratios.
Receivables Turnover and Days' Receivables
The Receivables Turnover and Days' Receivables Ratios assess the firm's management of its
Accounts Receivables and, thus, its credit policy. In general, the higher the Receivables
Turnover Ratio the better since this implies that the firm is collecting on its accounts receivables
sooner. However, if the ratio is too high then the firm may be offering too large of a discount for
early payment or may have too restrictive credit terms. The Receivables Turnover Ratio is
calculated by dividing Sales by Accounts Receivables.
Receivables turnover= sales/accounts receivable
The Days' Receivables Ratio is calculated by dividing the number of days in a year, 365, by the
Receivables Turnover Ratio. Therefore, the Days' Receivables indicates how long, on average, it
takes for the firm to collect on its sales to customers on credit. This ratio is also known as the
Days' Sales Outstanding (DSO) or Average Collection Period (ACP).
Example
Use the information below to calculate the Receivables Turnover
and Days' Receivables Ratios.
1500
Sales: $
150
Accounts Receivable: $
Receivables Turnover:
Days' Receivables:
Solution
1500
Sales: $
Accounts Receivable: 150
$
10
Receivables Turnover:
36.5
Days' Receivables:
Inventory Turnover and Days' Inventory
The Inventory Turnover and Days' Inventory Ratios measure the firm's management of its
Inventory. In general, a higher Inventory Turnover Ratio is indicative of better performance
since this indicates that the firm's inventories are being sold more quickly. However, if the ratio
is too high then the firm may be losing sales to competitors due to inventory shortages. The
Inventory Turnover Ratio is calculated by dividing Cost of Goods Sold by Inventory. When
comparing one firms' Inventory Turnover ratio with that of another firm it is important to
consider the inventory valuation method used by the firms. Some firms use a FIFO (first-in-first-
out) method, others use a LIFO (last-in-first-out) method, while still others use a weighted
average method.
The Days' Inventory Ratio is calculated by dividing the number of days in a year, 365, by the
Inventory Turnover Ratio. Therefore, the Days' Inventory indicates how long, on average, an
inventory item sits on the shelf until it is sold.
Example
Use the information below to calculate the Inventory Turnover
and Days' Inventory Ratios.
1500
Cost of Goods Sold: $
500
Inventory: $
Inventory Turnover:
Days' Inventory:
Solution
Use the information below to calculate the Inventory Turnover
and Days' Inventory Ratios.
1500
Cost of Goods Sold: $
500
Inventory: $
3
Inventory Turnover:
121.67
Days' Inventory:
Fixed Assets Turnover
The Fixed Assets Turnover Ratio measures how productively the firm is managing its Fixed
Assets to generate Sales. This ratio is calculated by dividing Sales by Net Fixed Assets. When
comparing Fixed Assets Turnover Ratios of different firms it is important to keep in mind that
the values for Net Fixed Assets reported on the firms' Balance Sheets are book values which can
be very different from market values.
Total Assets Turnover
The Total Assets Turnover Ratio measures how productively the firm is managing all of its
assets to generate Sales. This ratio is calculated by dividing Sales by Total Assets.
Example
Use the information below to calculate the Fixed Assets Turnover
and Total Assets Turnover Ratios.
1500
Sales: $
1000
Net Fixed Assets: $
1500
Total Assets: $
Fixed Assets Turnover:
Total Assets Turnover:
Solution
Use the information below to calculate the Fixed Assets Turnover
and Total Assets Turnover Ratios.
1500
Sales: $
1000
Net Fixed Assets: $
1500
Total Assets: $
1.5
Fixed Assets Turnover:
1
Total Assets Turnover:
Capital Structure
Capital structure refers to the blend of debt and equity a company uses to fund and finance its
operations.
Capital structure is a statement of the way in which a company's assets are financed. Analysis of
capital structure is relevant to understanding the level of risk which a business has.
Calculation
Market Value of Equity
Percentage of Equity =
Market Value of Equity + Market Value of Debt
Market Value of Debt
Percentage of Debt =
Market Value of Equity + Market Value of Debt
If market values are not available, the percentages are calculated based on book values.
Capital structure is also expressed by debt to total assets ratio. Percentage of equity and
percentage of debt can also be calculated if we know the financial leverage ratio or debt to equity
ratio of the business.
Example: Calculation of capital structure from financial leverage ratio: Oceanic Airlines has a
financial leverage ratio of 2.5. Find its capital structure.
Financial leverage ratio = Total Assets (A) ÷ Total Equity (E) = 2.5
Total Assets (A) ÷ (Total Assets (A) − Total Liabilities (L)) = 2.5
A = 2.5 × (A − L)
A = 2.5 A − 2.5 L
2.5 L = 2.5 A − A
2.5 L = 1.5 A
L/A% = 1.5/2.5 = 60%
Percentage of debt in the capital structure of Oceanic Airlines is 60% which gives us a
percentage of equity of 40%.
In the same way we can find capital structure as percentage of equity and percentage of debt
from debt to equity ratio
Exhibit 1 shows how financial and capital structures appear on a firm's Balance sheet.
Grande Corporation Figures
in $1,000's
Balance Sheet at 31 December 2017
ASSETS
Current Assets
LT Investments & 9,609
Funds 1,460
Property, Plant & 9,716
Equip 1,222
Intangible Assets 68
Other Assets 22,075
Total Assets Asset Structure
LIABILITIES
Current Liabilities 3,464
Long-Term
Liabilities 5,474
8,938
Total Liabilities
OWNERS
EQUITY
Contributed 3,464
Capital 5,474
Retained Earnings 13,137
Total Owners Capital Structure
Equity
Total Liabilities &
Equities 22,075
Financial
Structure
Calculating the Total Debt to Equities Ratio (Financial Leverage)
The Total debt to equities ratio results from entries on the firm's Balance sheet. Figures for this
example are from the "Financial Structure" region of Exhibit 1, above.
For Grande Corporation, at the end of the reporting period:
Total liabilities = $8,938,000
Stockholder equities = $13,137,000
Total debt to equities ratio (B / V):
B / V = Total liabilities / Stockholders equities
= $8,938,000 / $13,137,000
= 0.68
Increasing debt funding has two results. Firstly, the debt to equities ratio increases. And,
secondly, the firm's financial structure leverage increases.
Profitability Ratio
Profitability ratio is used to evaluate the company’s ability to generate income as compared to its
expenses and other cost associated with the generation of income during a particular period. This
ratio represents the final result of the company.
Types of Profitability Ratio
I. Return on Equity
II. Earnings per Share
III. Dividend per Share
IV. Price Earnings Ratio
V. Return on Capital Employed
VI. Return on Assets
VII. Gross Profit
VIII. Net Profit
I. Return on Equity
This ratio measures Profitability of equity fund invested in the company. It also measures how
profitably owner’s funds have been utilized to generate company’s revenues. Therefore, the
higher the return on equity ratio, the more stable a company is considered. Moreover, a higher
return on equity indicates a company is using its owner's funds wisely to generate profits. On the
other hand, the lower a company's return on equity ratio, the less efficient the owner's funds are
being utilized to generate profits, and therefore the less stable the company appears.
Formula: Profit after Tax ÷ Net worth
Where,
Net worth = Equity share capital, and Reserve and Surplus
II. Earnings per Share
This ratio measures profitability from the point of view of the ordinary shareholder. A high ratio
represents higher stability of the company
Formula: Net Profit ÷ Total no of shares outstanding
III. Dividend per Share
This ratio measures the amount of dividend distributed by the company to its shareholders. The
high ratio represents that the company is having surplus cash.
Formula: Amount Distributed to Shareholders ÷ No of Shares outstanding
IV. Price Earnings Ratio
This ratio is used by the investor to check the undervalued and overvalued share price of the
company. This ratio also indicates Expectation about the earning of the company and payback
period to the investors.
Formula: Market Price of Share ÷ Earnings per share
V. Return on Capital Employed
This ratio computes percentage return in the company on the funds invested in the business by its
owners. The higher the ratio the more stable a company is considered.
Formula: Net Operating Profit ÷ Capital Employed × 100
Capital Employed = Equity share capital, Reserve and Surplus, Debentures and long-term Loans
Capital Employed = Total Assets – Current Liability
VI. Return on Assets
This ratio measures the earning per rupee of assets invested in the company. The higher the ratio
the more stable a company is considered.
Formula: Net Profit ÷ Total Assets
VII. Gross Profit
This ratio measures the marginal profit of the company. This ratio is also used to measure the
segment revenue. A high ratio represents the greater profit margin and it’s good for the company.
Formula: Gross Profit ÷ Sales × 100
Gross Profit= Sales + Closing Stock – opening stock – Purchases – Direct Expenses
VIII. Net Profit
This ratio measures the overall profitability of company considering all direct as well as indirect
cost. A high ratio represents a positive return in the company and it’s good for the company.
Formula: Net Profit ÷ Sales × 100
Net Profit = Gross Profit + Indirect Income – Indirect Expenses
Example:
Particulars Amount
Shareholder Equity
Equity Shares, 2346 share outstanding, Par value 0.05 118
Paid In Capital 5858
Retained Earning 13826
Total Shareholder Equity 19802
Total Assets 30011
Current Liability 8035
Total Sales 53553
Gross Profit 16147
Net Operating Profit 3028.65
Net Profit 3044
Using the above figures, calculate the profitability ratio
Profitability Ratios:
1) Return on Equity = Profit After tax / Net worth (Equity share capital, and Reserve and
Surplus)
= 3044/ (118+5858+13826)
=3044/19802
=0.153
= 15.37%
2) Earnings Per share = Net Profit / Total no of shares outstanding
= 3044/2346
= 1.29
= 1.30
3) Return on Capital Employed = Net Operating Profit/Capital Employed (Total Assets – Current
Liability) × 100
=3028.65/ (30011-8035) × 100
=3028.65/ (21976) × 100
=0.1378 × 100
= 13.78%
4) Return on Assets = Net Profit / Total Assets
= 3044/30011
= 0.1014
= 10.14%
5) Gross Profit = Gross Profit / sales × 100
= 16147/53553 × 100
= 0.3015 × 100
= 30.15%
6) Net Profit = Net Profit / Sales × 100
Net Profit = 3044/53553 × 100
=0.0568 × 100
= 5.68%
