Module 2: Analysing Financials

Session: Financial Analysis

____________________________________________________________________________

Video 1:
Let's imagine a scenario. You started a business two years ago. In the first year, the
sales were average but you were left with a decent amount at the end of that year.
However, in the second year, you did quite well in sales. But at the end of the year, your
cash balance was almost negligible.

This definitely seems like a conundrum. Something you would need to solve right away
but also prevent from happening again next year. But how do you understand what
went wrong? The answer to this is financial analysis. Based on all that you have learnt
in the last module, you must have created the financial statements for the last two
years.

Now we analyse them. So what exactly is financial analysis? Financial analysis is like a
health checkup for your company. It involves diving into your financial statements to
gauge how well your business is doing. The goal is to understand your profitability and
overall financial health by examining various financial metrics.

Now why is this important? Let's understand why financial analysis is crucial. Evaluate
profitability and efficiency. This helps you see how well you are turning a profit and
managing your resources. Assesses liquidity and solvency.

This shows if you have enough cash to cover your short-term and long-term obligations.
Guides investment decisions. Informs decisions about where to invest more or cut back.
Tracks financial trends. Helps identify patterns and trends over time.

Communicates with stakeholders. Provides insights to investors, creditors and others

interested in your financial status. You might think that so many businesses run daily
without performing much analysis. For example your mum-and-pop stores, local Kirana
stores and more. But think of this, what would happen if they knew how to analyse the
ledgers and journals they maintained well?

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

Let's take a look at a few probable scenarios for Mahesh who runs a local Kirana store
in Gwalior. After going through his records and analysing them thoroughly, he realises
that he always has very little cash left at the end of the month because most of his
customers are familiar faces who pay together at the start of a new month for all they
bought the previous month. Essentially this is the Kirana store version of accounts
receivables. Because of this, he is unable to buy more inventory as he is trapped for
cash. As a solution, he can change the accounts receivable cycle and ask the customers
to pay twice a month.

This way the cycle becomes 15 days instead of 30 days. He also has a lot of cash
available at the end of every month which he can use to buy more inventory that is
selling quickly. With a clear idea of what financial analysis is and why it matters, let's
now look into the different tools or types of financial analysis There are five types of
financial analysis. Let's take a look at these concepts using an Excel sheet. Let's
summarise the different types of financial analysis tools.

First, horizontal analysis. It compares the data over multiple periods to identify the
change, and the direction in the overall performance and also it helps us to identify
trends. The use case here would be Horizontal analysis helps in understanding the
growth trajectory of a company over a period of time. For example, comparing revenue
and expenses on a year-over-year basis will help us to understand at what growth rate
the sales or the expenses are growing or declining. The second type of financial
analysis is vertical analysis.

Vertical analysis analyses the proportion and relationships of items within a single
financial statement. Here we consider one line item as a base and we calculate the
percentage of other line items to the base. This helps in providing insights into the
composition of assets, liabilities, equities or the proportion of expenses towards the
sales that were generated during the period. For example, calculating percentages of
expenses on total revenue helps us to understand in order to generate the revenue
during the period what was the percentage of different expenses incurred for that
period. The third type of financial analysis is ratio analysis.

Ratio analysis helps us to evaluate various factors or aspects of a company's

performance. The use case here would be it helps in benchmarking against industry
standards and peers. For example, comparing different ratios like current ratio, quick
ratio or return on investment will help us to compare different companies across the
industry in order to understand who is performing better over a period of time. The
fourth type of analysis is trend analysis. Trend analysis helps us to examine the trend or
the pattern of the financial data over multiple periods.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

Here it helps us in future projections and also helps us to make strategic decisions
accordingly. An example would be when we look at the trend of sales, growth or
expenses. This also helps us understand whether the trend has been increasing or
declining. Also, it helps us to project for the coming years. The next is fund flow analysis.

Fund flow analysis tracks the flow of funds into and out of a company over a specific
period. Here we generally analyse what are the sources of the fund. Where have we
used the particular fund? This helps us to understand the liquidity and the other
financial metrics of the business. For example, analysing the changes in current assets
and current liability which has actually changed the requirement of working capital will
help us to determine the overall cash flow management in the business.

Lastly, we have a cash flow analysis. Cash flow analysis focuses on cash inflows and
outflows from three different categories, Operating, investing and financing. Here cash
flow analysis helps to evaluate the ability of the company to generate cash and also
the ability of the company to meet the financial obligations during the period. An
example would be calculating operating cash flows or free cash flows to assess
financial stability during the period. In this session we will focus on horizontal analysis,
which is also known as trend analysis, followed by vertical analysis and conclude with a
brief overview of ratio analysis.

Video 2:
Now, let's consider the objectives of financial analysis from different perspectives.
Manager's Perspective Managers want to understand the earning capacity or
profitability of the business. Shareholders Perspective Shareholders are interested in
comparing results across companies, forecasting future performance and
understanding the company's health. Creditor's Perspective Creditors use financial
analysis to decide whether to extend credit or not, depending on the financial position
of the company. These are the broad objectives that key stakeholders aim to achieve
through the analysis of financial statements.

Despite all its benefits, financial statement analysis has inherent limitations. First,
financial analyses are based on interim reports. Financial statements such as the
balance sheet, income statement or cash flow statement are typically prepared at the
end of an accounting period, for example, quarterly, semiannually or annually.
However, companies operate daily with ongoing changes not reflected in these interim
reports. This can limit the analysis.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

For example, imagine a retail company that experiences a rise in sales during the
holiday season. The company's financial statements are prepared quarterly if the
company's Q3 report shows a decent performance, but Q4 the holiday season is yet to
be reported. How might this affect your analysis of the company's performance? As you
might expect, this might not reflect the company's seasonal profitability and can limit
the analysis of the company's current performance. This is one of the limitations of
financial analysis.

Next, it usually focuses on monetary information. Financial statements account for

monetary transactions, but non-monetary information crucial to a company such as
customer demographics or user lifetime value is not included. This restricts the scope of
the analysis. For example, say the retail company has high customer satisfaction and a
growing user base, which are key to its future success. However, financial statements
include monetary transactions such as sales and expenses but do not record
non-monetary items such as user engagement metrics and customer feedback.

This limits the understanding of the company's market position and future growth
potential. Third, it ignores price level changes and inflation. Assets in the balance sheet
are recorded at their historical purchase value without accounting for changes in price
levels or inflation over time. This can lead to discrepancies in asset valuation. For
instance, consider the same retail store you stocked up on inventory, say rise backs for
about one lakh rupees, but after three to four days the market value appreciates,
increasing the price of each bag and the 1 lakh rupees inventory you stocked up might
now be worth 1 35,000 rupees.

Despite this significant rise, the financial statements might undervalue the company's
assets and give a misleading picture of its financial health. Fourth is different
accounting procedures. Companies may follow different accounting procedures. For
example, some companies use a calendar year, whereas others use a financial year as
their accounting period. These variations can complicate comparisons between
companies.

Let's say the retail company uses a fiscal year ending in June, whereas its competitor
follows a calendar year ending in December. Will this not result in differences during
competitors' analysis? Definitely yes. When comparing financial performance such as
annual revenue or profitability, the differences in accounting periods can make it
challenging to perform a direct comparison without adjusting for the timing
discrepancies. Last is subjectivity.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

Even with the same financial statements, interpretations can vary. Different analysts or
stakeholders might draw different conclusions leading to subjective decision making.
Say, for example, you must have heard of the full, half-empty glass interpretation. If
not, here's what it is. What do you see in this picture?

Some might think it is half empty, while others might say it is half full. This is known as
subjectivity in thoughts. Similarly, differences in subjectivity when interpreting financial
statements can lead to different conclusions about a company's performance and
valuation. These are some of the inherent limitations of financial statement analysis
that users should be aware of when interpreting a company's financial health and
performance. So that's about financial analysis.

It's all about digging into your numbers to get a clear picture of your business's
financial health.

Video 3:

Imagine you are working as the head of marketing in a startup. You hired three
managers a year ago and now during the appraisal cycle, you need to evaluate their
performance and identify one manager who you can promote to a director in your
company. How will you go about doing this? The obvious method is to compare their
efficiency, output, KRAs, which are the key responsibility areas, etc. In the last 12
months.

Identify a manager with a consistently good performance over that duration and
promote them. This essentially analyses data horizontally if you put the data in a table.
Similarly, horizontal analysis as a financial technique is used to compare line items in a
financial statement over different time periods. This method helps you understand
trends and changes in financial performance. First of all, how would you choose a
period?

Now you can compare multiple periods that can range from a month to a year. It is
actually a subjective decision to choose a period and its duration for horizontal
analysis. So various stakeholders, depending on their requirements, can choose a
particular period. For example, potential investors might look at the yearly
performance data of a company they aim to invest in for the long term. Managers are
more involved in day-to-day operations and might look at the monthly numbers to
identify trends and make decisions that will impact the revenue, profitability, efficiency
and other such metrics.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

Now, where can it be used? So, horizontal analysis of financial statements can be
performed on any of the items in the income statement, balance sheet or statement of
cash flows. It can also be performed on all ratios that are arrived at after performing
ratio analysis using financial statements. There are various approaches to horizontal
analysis. We will focus on two key methods.

The first is absolute comparison. In this approach, horizontal analysis involves

comparing the absolute monetary value of certain items over a period of time. For
example, you can compare the total sales figures over the last few years. Another
example is comparing the cash on hand at the end of one accounting period with the
cash on hand at the end of other accounting periods. This method helps identify which
items are changing the most for a company over time.

The second approach to horizontal analysis is percentage comparison. In this method,

the percentage differences in certain items are compared over a period of time.
Essentially, one particular time period is taken as the base year, month, etc. Now, all
values of any line items coming after that base period are expressed as a percentage
of the base period value. The formula for horizontal analysis percentage and horizontal
analysis absolute are as follows.

The horizontal analysis percentage is equal to the amount in the comparison year, less
amount in a base year divided by the amount in the base year multiplied by 100.
Horizontal analysis absolute is equal to the amount in the comparison year, less amount
in the base year. Suppose you want to compare various financial aspects of a company
over two years. The interpreter in this case is expected to study the minimum aspects
such as to assess the current financial position and liquidity position. C the working
capital in both years Working capital is WC is essentially how many more current assets
that is CAS you have over current liabilities that are CALS which is WC is equal to CA ca.

The increase in WC will mean an improvement in the business's current financial

position. Liquid assets such as cash in hand, cash at the bank and receivables show the
liquidity position to understand the long-term financial position. Studying changes in
fixed assets, long-term liabilities and capital structure along with a thorough analysis of
financial ratios, cash flow and industry trends provide a comprehensive view of a
long-term financial position to examine the profitability of the concern. Studying the
increase or decrease in retained earnings, various reserves, surplus etc. This will enable
us to see whether the profitability has improved or not.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

Video 4:

Let's take a look at an example to better understand horizontal analysis. Let's start with
a horizontal analysis of Hindustan Unilever. We can see that in the balance sheet, we
have three key elements, Assets, liabilities and equity. Under horizontal analysis, we
compare these elements of the balance sheet on a year-over-year basis. So here we will
be comparing our current year that is the comparison year to the previous year which
would be considered as the base year.

So we will be mapping the changes that have taken place from the previous year to the
current year. This change will be calculated as an absolute change. In order to calculate
absolute change, the formula will be the current year minus the base year along with
the absolute change. As we know, horizontal analysis can be also analysed using
percentage change. In order to calculate percentage change, we will factor the
absolute change on the base year number.

So this will help us to understand whether the change that has taken place is positive or
negative. And also it will help us to understand at what rate the change has taken
place. Let's quickly go through a few line items wherein we can see that there has been
a major change taking place from the base year to the current year. Let's begin
analysing the assets of the business. Under current assets, if you notice that there is a
major change that is taking place in cash and bank balance, the change is absolute
change is 21,600 and the percentage change is 91.53% negative.

What understanding do we get here? We understand that the cash balance in the
current year has reduced by 91.53%. Now what could be the inference or what could be
the reason for for the decrease in cash and bank balance? Ideally, it could be either the
expenses of Hindustan Unilever during the period have increased due to which there
has been a payout or the investments done in the business towards other assets or
fixed assets have grown during the period. We notice that after several current assets
have changed, the overall total current assets have declined by 33.91%.

Now this decrease we can majorly see coming from a decrease in the cash balance and
also the decrease that has taken place in inventory and other current assets. Coming
down to fixed assets, the major change that you will notice is in the plant and
machinery. Over here we notice that in plant and machinery, there has been an
increase in the investment done by 95,200. This increase amounts to 153.55% in

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

comparison to the base year. And this is where we can also correlate where the cash or
bank balance could be utilised.

So the decrease in cash balance could correlate or interlink it to the use done while
purchasing plant or machinery. The overall total assets have grown by 19.76%. Again,
this helps us to understand that overall HUL has been investing in assets for the future
growth of the business Coming down to the liability part here, the major change that
we notice is long-term debt. We can see the long-term debt has increased to 65,000
from 40,000 in the base year. This absolute change of 25,000 has resulted in an increase
in debt by 62.50%.

Now again, what could be our inference here? The inference would be in order to grow
in order to increase the asset, the company might have facilitated this purchase by
using existing cash as well as financing it via long-term debt. Another change that we
see under equities and liabilities is towards owner's equity. Coming down to owner's
equity, owner's equity has increased from 80,000 to 1 20,000. This shows the increase in
owner's equity by 50%.

Now owner's equity increase states that the overall share capital of the company has
increased. So it might as well state that the company has issued fresh shares in the
market. The other equity that is the reserves and surplus of the company have also
increased by 13.46%. This states that the company is profitable and the retained
earnings from the base year have increased the total of the reserves and surplus to
70,800amounting 13.46% overall growth of other equity or reserves and surplus. This
brings us to the total increase of liabilities and capital by 19.76%.

Video 5:

Horizontal analysis can be performed on statements of profit and loss. Also, let's see
the profit and loss account of Hindustan. Unable. Again here we have two years. The
current year is the comparison year and the previous year is the base year.

We will calculate the change from the base year to the current year to understand
during the period how much revenue has increased or decreased or how much
expenses have increased or decreased. Along with the absolute change, we would also
calculate the percentage change. Percentage change would be calculated as the
absolute change divided by the base year amount. The line items that you see in P and
L for comparison would be the revenue from operations, other income, the expenses
like cost of material consumed, purchase expense, employee benefit, finance cost,

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

depreciation and other expenses. This will allow us to compare the performance of the
company during two different years.

Let us start analysing the profit and loss account for Hulu. Here we will see the major
changes that are taking place in the line items over these two periods. The first change
that we can see is for revenue from operations. The revenue from operations has
increased from 59,549 to 60,966. This is the absolute change of 1417amounting to 2.38%
growth in revenue from operations.

This can be a positive sign for a business showing us that overall sales from the
operations have increased during the period. Along with this change, we also see the
change that has taken place in the other income. Now other income particularly
includes the income that is received not from the core operations but other
non-operating activities like investments or deposits. So the interest received on
deposits or the dividend that is received from the share investment done in some other
company. So over here we see again there has been a good increase in the other
income by 58.40%.

Now this helps us to understand that HUL must be doing well on the investing part
wherein they are able to make more money in comparison to the previous year. So we
see that the overall other income has increased from 512 to 811. Now let's come down to
the expenses. Let us analyse the year-over-year changes taking place in different
expenses. So the first change that we notice here is the cost of material consumed
which is a negative change of 4.72%.

Now what this infers is that although the revenue from operations has increased by
2.38% still the expenses or the cost of materials has not increased. This shows
thecost-cuttingg measures taken by the business or the efficiency in which the
operations are conducted by Hindustan Unilever. The other change that we see is again
a negative change in the purchase of stock in trade. So overall the purchase cost has
also decreased by 9.20%. Talking about the next line item here is changes in inventory.

Now again over here, if you see there is a negative change of 85.33%. Now if you're
wondering what this change is, normally changes in inventory are calculated as
opening inventory, less closing inventory. So when you see a negative number in
changes in inventory, basically this means that you're closing inventory was higher than
your opening inventory. It means that during the current period, you manufactured
more goods than what you sold. And that's the reason the overall expenses will be
reduced by 85.33%.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

So this is the mere adjustment of whatever cost that you have incurred while
consuming the raw material or while purchasing the stock in trade. Now that you have
not used it, now that you have not sold it, that particular expense will be deducted by
85.33%. The next major change that we see here in HUL is the increase in finance costs.
So we see that the finance cost has gone up by 192.98%. And also if you see the
absolute change, the absolute changes by 220, the numbers are in crores here.

So the interest expense has increased by 220 crores. So this is a major change that we
see in our statement of profit and loss where we understand that the company might
have taken additional loans or debt during the period which has increased the interest
expense of the company. Overall we see in spite of the increase in the interest expense,
due to the efficiency and decrease in the cost of the product, the overall total expense
has increased only by 2.31%. Now this comparison, okay, when we compare the total
increase in the revenue which has gone up by 2.64% vis a vis the total expense which
has only gone up by 2.31%. We understand that the overall profits of the business have
gone up by 3.38%.

This is what we are able to see it in. Absolute change. Also, we manage reducing our
expenses and we manage improving our overall revenue. The profit of the company has
increased by 514 crores for the period. If we further scroll through, we also understand
that whether the tax liabilities have increased or decreased since the income has
increased, obviously the tax liability will also increase.

And that's why we can see the current tax has increased by 17.33%. This further gives us
the net increase in the profit and loss for the period which is from now 3% or the
increase that we saw in the profit before taxes which was 3.83%. Now, after an increase
in the tax liability, we see that overall the company managed to improve their net
profits after taxes for the period by 1.40%. Overall, Hindustan Unilever shows overall
growth in revenue, profitability and total income Efforts to reduce costs in materials
consumed and stock in trade while managing higher employee costs and finance
expenses. Increased profitability before taxes and exceptional items with improved net
profit after taxes.

Higher tax expenses despite improved profitability impacting net profit margins. This
analysis provides insights into Hindustan Unilever's financial health, highlighting areas
of strength and potential challenges in its operational and financial strategies.

Video 6:

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

Horizontal analysis of financial statements can easily be expanded to include more
than a single change from one year to the next. This is known as trend analysis. This
method helps identify long-term trends and patterns in financial data. In many
instances, it's crucial to analyse changes over a specific period to understand emerging
trends that could impact future performance. In trend analysis, percentage changes
are calculated for several years instead of between two years. So when examining
more than two years of data, index numbers are typically used instead of percentage
changes. The following formula is used to calculate percentage change. Percentage
change is equal to the current year amount minus the base year amount divided by the
base year amount into 100. Annual reports often include a five-year summary of key
financial data which is particularly valuable for this purpose.

Now let us take a look at it.

This is with the help of an example.

Let us conduct a trend analysis for Hindustan Unilever. As we know in trend analysis we
would be taking more than two years to compare. In the given scenario, we have taken
March 2020 as our base year. We are calling our base year as by now, any changes that
are going to take place from the base year will be mapped in the trend analysis. So for
March 2020, all the line items will be kept as an index and the rest of the line items of
the years 21, 22, 23, and 24 respectively will be calculated as the changes with the
respective years. So for example, if I want to calculate the change that has taken place
in the year 2024, we will be calculating it as 60,966 minus the base year which is March
2020 where the number is 39,238 for revenue from operations. So that change in the
base year will help us to ascertain the overall growth of revenue from operations. For
holes from 2020 to 2024, let us see what major trend changes we see in HUL over a
period of five years. If we notice revenue from operations, there has been a consistent
increase in the revenue from operations.

So from 18,000 from 18.05% to 55.37% in March 2024. The other change that we see
here is for the other income. Again, earlier the other income was negative. But over a
period of time.

This.

Negative change in other income has increased in the current year by 28.32%.
Againtotallingg up the revenue we see, there has been n increasing trend from 17.38% in
2021 to 55.16% in 2024 coming to the expense. As we noticed in our horizontal analysis
overall, the cost of raw material consumption had decreased, and the purchase of stock

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

in trade had decreased. And this is what we also notice when we look at the trend. So if
you see from the base year till March 2023, the overall cost of material consumed or
purchase of stock in trade has been consistently increasing. So we can see that change
from 0 to 28% to 37% coming up to 68%. But when we come down to March 2024, we
see that the overall cost of material consumed expense has decreased from 68% to
60%. Similarly, this observation can be seen in the line item purchase of stock in trade
which had an increasing trend till March 2023 but now has a decreased but now has
decreased from March 23 to 2024. Another major change that we had seen was the
change in finance cost earlier in the base year. We see from base year till March 2021,
2022.

Overall there has been a decrease in the interest expense. But during this year there
has been a major increase in the finance cost by 183.05%. This we can cross verify by
looking at the trend of debt in the balance sheet. So we can map that okay, at what
rate the debt has been decreasing over a period of time and suddenly we should be
able to see that there has been an increase in the debt that is in the liabilities of the
balance sheet of HUL during March 2024, which has led to this increase in finance cost.
Overall total expenses have an increasing trend from 17% to 57.15%. And the profit of
the company has also been consistently increasing. So we can see profit before tax has
been consistently increasing from 0 to 15 to 29 coming down to 51.86%. And if we
consider the changes for the final profits, that is Profit or loss for the period, we again
see there has been an increasing trend for HUL from the base year 2020 to March 2024
and the overall growth we can see is by 52.25% signalling that the company has been
growing and has been performing consistently better year over year basis.

The advantages of using a trend analysis of financial statements include the ability to
identify relationships and trends, make predictions and set prices. In summary,
horizontal analysis compares financial data over different periods to see how things
have changed over time. Helps to spot trends and patterns in performance such as
where things are growing or declining. Helps understand if strategies are working well
or not so businesses can make smart decisions. Also helps track how things are going,
see if finances are stable and find any risks or chances to do better.

Video 7:

Let's take the same example of the business where you hired three managers and
eventually promoted one of them after looking at their consistent performance. Now,
the remaining two managers are not as consistent with their performance and
analysing their efficiency becomes a real hassle. So what you do instead is take the

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

performance of the ideal employee as a reference and tabulate the individual
efficiencies of the other two. This makes it easier to compare their performance and
understand who is doing better. Similarly, vertical analysis, also known as common size
analysis, is a popular method of financial statement analysis that shows each item on a
statement as a percentage of the base figure within that statement. Now, these
financial statements can be either the income statement or the balance sheet in which
this vertical analysis is performed. But how is this different from horizontal analysis? In
horizontal analysis, you must remember that we look at the value of different financial
metrics and how they vary compared to a base financial metric of a base year. In
vertical, we keep one particular financial metric as the base metric and all the financial
metrics of that time period are measured with respect to that metric.

Let us look at a simple example to understand the difference between horizontal and
vertical analysis. Now let us see the key difference.

Between vertical analysis and horizontal analysis. So we saw horizontal analysis.

Horizontal analysis, why is it called as horizontal analysis? Because we compare one
line item year.

Over a year basis, right?

So we saw the absolute change from the current year vis a vis the.

Base year or the previous year.

However, in vertical analysis, we analyse the line items vertically. So we keep revenue
as our base, which is actually a one-line item, which is a horizontal line item kept as a
base. But when we start analysing, we analyse different line items to revenue as a
change. So in vertical analysis, what we do is we calculate the composition of different
expenses or different line items on the base. So in the income statement, we calculate
the composition of different costs on the revenue, whereas in horizontal analysis, we
keep vertical items of the base year as same. Okay, so vertically, all the line items of
the base year are the same. But when we map the changes, when we analyse the
changes, we analyse those changes horizontally by finding out the difference of the line
items from the previous year to the current year. So we see that, okay, there has been
an increase or decrease from the previous year horizontally within one line item.

Now, in vertical analysis, the main question is what value from a financial statement
would you consider a reference? You cannot take any metric as a reference, as the
value needs to provide insights when compared to other values. When applying this

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

method, on the balance sheet, all three major categories that are assets, liabilities and
Equity are compared with the total assets. So all the balance sheet items are presented
as a proportion of the total assets. Now, when applying this technique to the income
statement, each of the expenses is compared with the total sales revenue. The
expenses are presented as the proportion of the total sales revenue along with the
absolute amount. Similarly, in a cash flow statement, the net cash flow from operating
activities is usually taken as the base amount. Please note here that these reference
line items are not set in stone. Since this is a form of analysis, you can choose reference
items as you deem fit for your analysis. Just that the analysis should be logical. For
example, if you take profit after tax as the reference item, you will not get any
meaningful results from your analysis. Think about it. When you take revenue as the
reference, the formula for profit after tax in the vertical analysis would be profit after
tax divided by revenue multiplied by 100, which will come out to, let's say 20%.

This tells us that 20% of the revenue is eventually turning into profit. Everything else is
being used as either an expense or tax, etc. But if you do it the other way around,
revenue will come out to be 500%. This is not a very useful metric to understand. Let's
now take a look at the purpose and advantages of vertical analysis. Vertical analysis
makes it easier to compare the financial statements of one company with those of the
other and across the industry. As one can see the relative proportions of account
balances. It also compares previous periods for the time series analysis in which
quarterly and annual figures are compared over several years in order to gain a picture
of whether performance metrics are improving or deteriorating. So basically what we
are doing is we are trying to compare, let's say, a particular item with respect to a base
item and how it has been changing over a period of time. And this is how we can
accomplish a particular trend for that particular item. Vertical analysis is a powerful
tool for financial statement analysis, particularly when used in conjunction with
horizontal analysis which examines financial data over time.

One of the primary advantages of vertical analysis is its ability to facilitate

comparisons between companies of different and across various industries. This
method standardised financial statements by expressing each line item as a
percentage of a base figure, typically total assets for balance sheets or total revenue
for income statements. This normalisation enables meaningful comparisons between
entities with varying scales of operations, such as startups versus established
corporations or small and medium enterprises versus micro small and medium
enterprises.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

Video 8:

Now let us start with a vertical analysis of Hindustan Universe's profit and loss account.
In vertical analysis, the total revenue will be kept as a base. So this will be our
reference value where we will keep it at the base at 100% and the rest of the line items
like revenue from operations, other income, and all the expenses will be mapped
against the total revenue. So we will be calculating the composition of revenue from
operations to total revenue. The composition of other income to total revenue.

Similarly, the different expenses to total revenue. Let us analyse. After mapping all the
compositions of different line items to total revenue, we understand that the overall
composition of revenue from operations has been more or less consistent. So we say
that from the total revenue, the revenue from operations has been 97% or 98%
approximately for all three years. Similarly, when we come down to the other income,
we see that this composition has increased from 0.49% to 1.29% in the current year.

And when we check our composition of expenses to the total revenue, we understand
that the overall composition of cost of material consumed and purchase of stock in
trade has been decreasing. This is what we also analysed in our horizontal analysis that
overall absolute change in the cost of material consumed and purchase of stock in
trade had reduced. The same observation can be seen in the vertical analysis wherein
we see that the total cost of raw material consumed purchase of stock in trade has
been decreased in comparison to the total revenue for that particular period. The other
change that we noticed is the finance cost overall. In our horizontal analysis, we
noticed that there was a increase absolute increase in the finance cost.

And not just that the percentage increase in finance costs was very high. So if you are
wondering okay, this increase in interest or increase in finance cost could be way too
high. But now when you compare or when you use your vertical analysis in conjunction
or in conjunction with horizontal analysis, we notice, yes, there has been an increase in
finance cost. So we see, yes, the composition of finance cost to the total revenue has
increased from 0.20% to 0.53%. But when you compare the composition, it has not been
very high.

So it is not detrimental to the health of the company. Because the overall interest
expense is hardly 0.53% of the total revenue generated by the business. For March 2024,
we notice that the overall total expense to the total revenue has decreased during the
period from 78%. It has come down to 77% approximately and which has resulted in an

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

overall increase in the profits. So we see last year the profits to the revenue were
21.85%.

Now the profits to the revenue have been increased to 22.21%, but the increase in
revenue has also increased our tax liability. So we see yes, the tax towards our revenue
has increased from 4.91% to 5.62%, resulting in the profit for the period as 16.4ofto the
total revenue. So more or less similar to the previous year. But in comparison or in the
composition that we see to the total revenue there has been a slight decrease. Although
there was an absolute increase, we could see that profit for the year had increased, but
when we compare it to the total revenue there has been a slight decrease from 16.60%
to 16.40%.

Video 9:

Imagine you are a financial analyst for a company experiencing declining profits
despite steady revenue. How could you identify the underlying issues and guide your
recommendations to management? For thi, you will have to identify the root cause for
declining profits. Mereyear-on-year growth in sales and common analysis of different
costs to sales will take a long time. To understand underlying issues, we will have to
interlink costs to sales and different profits to sales. This can be done with the help of
ratios. This might be a bit difficult to understand at first. Let us take a simple
day-to-day example of a student Aria preparing for the GMAT exam. Arya has been
studying for the GMAT exam for the last five months. Let's try to look at her results from
the multiple mock exams and try to interpret them using various ratios. Please note
that we are not analysing actual GMAT scores. This is a mock exam data. The actual
GMAT exam is of 805 marks and runs for 2 hours 15 minutes. The exam we will look at is
for 270 marks and runs for 3 hours.

Let us analyse the mock GMAT scores of Arya. So here let's say Arya has got this dump
for five or six mock exams she took and more or less. For all the six mock exams that
she has taken, she has scored more.

Or less the same scores.

174, 174, 171 and so on. Now looking at this dump, Aya definitely is going to find it very
difficult to understand okay, where she is lacking or what are the improvement areas.
So what do we do? By taking a few criteria or by taking a few metrics into
consideration, we will analyse where she can improve. So for thi, we have chosen three

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

multiples or three metrics. These three metrics are the accuracy ratio, efficiency ratio
and marks per minute ratio.

So logically let's say if we want.

To calculate what we have done here.

The accuracy ratio is basically nothing.

But how many correct questions did she get on the total questions that she attempted?
How is the efficiency ratio calculated? The efficiency ratio is the time taken for the
correct questions less the time taken for the incorrect questions divided by the total
time. And in order to calculate marks per minute we have taken total marks divided by
total time. By using these three different ratios we have tried interlinking different
parameters like the time taken the total answers that are correct that are incorrect or
the total time taken in order to attempt all the questions. So we have tried interlinking
them in order to understand where Aria can improve. Now after calculating these
ratios, let's say the idle ratio to get full marks is one for the accuracy ratio, one for the
efficiency ratio and 1.5 for the total marks on total time, that is marks per minute ratio.
When we compare the ratios that she has scored for different sections like verbal,
quant and logic with the idle ratio, we understand that she scored pretty little than
what she should have ideally scored. If there Arya had to score full marks, Arya should
have got all correct.

Questions on the total questions.

But what we see here is where.

Is she scoring the least? So her accuracy is the least in quants.

Similarly, looking at the ratios and comparing them with the ideal ratio, we understand
that the overall efficiency is also very poor in the logic section where she had to score
full for efficiency, that is the time taken for all the correct questions. Over here in logic,
we see the.

The ratio is least which is 0.05.

This shows that the time that she is taking for the correct questions is very very little.
Similarly, when we consider the total marks or marks per minute, we see that is the

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

least for quants. So where the ratio should have been 1.5 times, we understand in
quants per minute the marks that she has scored.

Is less than 1.

Forget about getting 1.5, it is less than 1 which is 0.85. This helps us to understand how
important.

Or how critical ratios are.

So when we compare the line items or when we are given the data, it becomes very
difficult to analyse. But when we compare them, when we interlink them, it helps us to
understand or establish the relationships between two different line items in order to
take corrective.

Measures or in order to make better decisions for future. This example shows how
analysing using multiple ratios can help assess overall performance, whether for an
individual or an organisation. Now let's understand what ratio analysis is within the
context of financial analysis. Ratio analysis is a fundamental technique used to analyse
the financial performance of a company. It involves calculating and interpreting
various ratios derived from the financial statements to assess aspects such as
profitability, liquidity, efficiency and solvency. Ratios help in a holistic understanding of
the organisation. Ratio analysis helps to summarise the data available in the financial
statements. They also help interlink different line items, thus establishing the
relationships to conclude the overall financial position and performance of the business.
Calculating and examining financial ratios is a key part of financial analysis. Financial
ratios are calculated by comparing different accounts on our financial statements.
Financial ratios are used to compare a company's year-over-year performance.
Compare a company's performance before and after a managerial decision. Compare
one company to another. Financial ratios are generally grouped into four different
categories. Profitability, liquidity, Solvency and efficiency. Each of these categories has
multiple ratios that fall under it. We will cover a basic definition here for now.

Profitability measures an organization's ability to extract profits out of revenue.

Liquidity measures an organization's ability to pay off short-termm debt. Solvency or
leverage measures an organization's ability to pay off all debt or how it has financed its
assets. Efficiency measures how efficiently an organisation uses its assets to generate
revenue. In the upcoming session, you will learn about these ratios in detail. Let's now
discuss the usage of these different types of ratios with some examples to assess a
company's earning capacity, imagine an analyst conducting a comprehensive financial

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

performance review to recommend strategic improvements and investments for future
growth. In this scenario, profitability ratios are what the analyst will focus on for the
review. For example,e the gross profit margin, net profit margin, return on assets, return
on equity, etc. To review the ability to handle short-term situations. For example, a
company is experiencing cash flow issues and needs to determine its ability to meet
short-term obligations to avoid bankruptcy. In this case, we use liquidity ratios to
analyse and determine its ability to meet these obligations, e.g. current ratio, quick
ratio, cash ratio, etc. To assess a company's asset efficiency, consider a company
experiencing cash flow issues while its account payables and inventories are rising
despite a reduction in sales.

In such a scenario, we use activity ratios, also known as efficiency ratios, to track the
cash flows, for example,e Inventory turnover ratio, receivables, turnover ratio, total
asset turnover ratio, etc. To evaluate long-term credibility, imagine a lender is assessing
whether to extend additional credit to a company by evaluating its debt obligations
and sustainability. In such a situation, we use solvency ratios to evaluate and assess
different metrics before making a decision, for example,e debt to equity ratio, interest
coverage ratio, debt ratio, etc. These are a few use cases where different ratios can be
used to analyse and make informed decisions. Let's now discuss some applications of
ratios in different contexts for investors. Use profitability, market and efficiency ratios
to evaluate investment potential for creditors. Focus on liquidity and solvency ratios to
assess creditworthiness for management uses all types to monitor and improve
operational efficiencies, financial health and profitability. Lastly, the analysis utilises all
ratios for comprehensive financial analysis and comparison with industry benchmarks.
However, please note here that these are not hard and fast. Any ratio can be used in
any context.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved

Disclaimer: All content and material on the upGrad website is copyrighted, either
belonging to upGrad or its bonafide contributors and is purely for the dissemination of
education. You are permitted to access, print and download extracts from this site
purely for your own education only and on the following basis:

● You can download this document from the website for self-use only.
● Any copies of this document, in part or full, saved to disk or to any other storage
medium, may only be used for subsequent, self-viewing purposes or to print an
individual extract or copy for non-commercial personal use only.
● Any further dissemination, distribution, reproduction, copying of the content of
the document herein or the uploading thereof on other websites, or use of the
content for any other commercial/unauthorised purposes in any way which
could infringe the intellectual property rights of upGrad or its contributors, is
strictly prohibited.
● No graphics, images or photographs from any accompanying text in this
document will be used separately for unauthorised purposes.
● No material in this document will be modified, adapted or altered in any way.
● No part of this document or upGrad content may be reproduced or stored in any
other website or included in any public or private electronic retrieval system or
service without upGrad’s prior written permission.
● Any right not expressly granted in these terms is reserved.

© Copyright. UpGrad Education Pvt. Ltd. All rights reserved