Financial Statement Analysis

Financial Statement Analysis

Introduction

·       Financial Statement Analysis is the process of reviewing, interpreting, and evaluating the financial statements of an organization in order to understand its financial performance and position.

·       It provides insights into the efficiency, profitability, liquidity, and solvency of an organization, helping internal and external stakeholders make informed decisions.

• Primary financial statements used:
1. Income Statement (Profit & Loss Account): Shows revenue, expenses, and net profit or loss.
2. Balance Sheet (Statement of Financial Position): Shows assets, liabilities, and shareholders’ equity at a point in time.
3. Cash Flow Statement: Shows inflows and outflows of cash from operations, investing, and financing activities.
4. Statement of Changes in Equity: Shows changes in ownership interest, reserves, and retained earnings.
• Users of financial statement analysis:

• Internal: Management, employees, owners.
• External: Investors, creditors, regulators, tax authorities, analysts.

Types of Financial Statement Analysis

1. Horizontal Analysis (Trend Analysis):
• Compares financial data over multiple periods.
• Helps in identifying growth trends, patterns, and changes.
• Example: Comparing revenue growth for 3 consecutive years.
2. Vertical Analysis (Common-Size Analysis):
• Expresses each item in the financial statement as a percentage of a base figure.
• Example: In Income Statement, every item is expressed as % of sales.
• Useful for comparing companies of different sizes.
3. Comparative Analysis:
• Comparison of financial statements of two or more firms for the same period.
• Useful for benchmarking.
4. Ratio Analysis:
• Establishes relationships between two or more financial variables.
• Provides quick insights into liquidity, profitability, efficiency, and solvency.
5. Fund Flow Analysis:
• Examines changes in working capital between two balance sheet dates.
6. Cash Flow Analysis:
• Focuses on sources and uses of cash.
• Helps in assessing liquidity and short-term financial health.
7. Trend Analysis:
• Studies long-term movement of financial variables over multiple years.

Importance of Financial Statement Analysis

1. For Management:
• Helps in decision-making regarding investment, expansion, and cost control.
• Identifies financial strengths and weaknesses.
2. For Investors:
• Assesses profitability and return on investment.
• Helps in deciding whether to buy, hold, or sell shares.
3. For Creditors and Banks:
• Assesses liquidity and solvency to determine repayment capacity.
• Used in loan approval and credit decisions.
4. For Regulators:
• Ensures compliance with financial disclosure standards.
• Helps detect fraud or mismanagement.
5. For Employees:
• Indicates job security and growth potential.
• Helps in wage and benefit negotiations.
6. For Government:
• Assists in taxation and policy-making.
7. For Public:
• Shows corporate responsibility and contribution to society.

Methods of Financial Statement Analysis

1. Comparative Financial Statements:
• Compare two or more years’ statements side by side.
• Shows absolute and percentage changes.
2. Common Size Statements:
• Expresses figures as percentages of a common base (e.g., total assets or sales).
• Useful in cross-sectional comparison.
3. Trend Analysis:
• Percentage changes over multiple years to identify direction and magnitude of changes.
4. Ratio Analysis:
• Establishes meaningful relationships between figures to evaluate financial health.
5. Fund Flow and Cash Flow Analysis:
• Fund flow: Long-term financial planning.
• Cash flow: Short-term liquidity.

Theoretical Concepts of Ratio Analysis

(A) Liquidity Ratios

Measure the ability of a firm to meet its short-term obligations.

1. Current Ratio = Current Assets / Current Liabilities
• Ideal standard: 2:1
• Indicates short-term solvency.
2. Quick Ratio (Acid-Test Ratio) = (Current Assets – Inventory) / Current Liabilities
• Ideal standard: 1:1
• Focuses on highly liquid assets.
3. Cash Ratio = Cash & Cash Equivalents / Current Liabilities
• Measures immediate liquidity.

(B) Solvency Ratios (Leverage Ratios)

Measure long-term stability and ability to repay debts.

1. Debt-Equity Ratio = Total Debt / Shareholders’ Equity
• Indicates proportion of debt and equity financing.
• Ideal: 2:1 (varies by industry).
2. Interest Coverage Ratio = EBIT / Interest Expense
• Shows ability to meet interest obligations.
• Higher ratio indicates financial safety.
3. Debt Ratio = Total Debt / Total Assets
• Proportion of assets financed through debt.
4. Proprietary Ratio = Shareholders’ Funds / Total Assets
• Shows long-term solvency and financial soundness.

(C) Profitability Ratios

Measure earning capacity and efficiency.

1. Gross Profit Ratio = Gross Profit / Net Sales × 100
• Indicates production and pricing efficiency.
2. Net Profit Ratio = Net Profit / Net Sales × 100
• Measures overall profitability.
3. Return on Assets (ROA) = Net Profit / Total Assets × 100
• Efficiency of using assets to generate profits.
4. Return on Equity (ROE) = Net Profit / Shareholders’ Equity × 100
• Indicates return to equity shareholders.
5. Earnings Per Share (EPS) = Net Profit – Preference Dividend / No. of Equity Shares
• Shows profit earned per equity share.
6. Operating Ratio = (Operating Expenses + COGS) / Net Sales × 100
• Indicates operating efficiency.

(D) Efficiency / Activity Ratios (sometimes grouped under profitability/turnover ratios)

Show how effectively resources are being used.

1. Inventory Turnover = Cost of Goods Sold / Average Inventory
• High ratio = efficient inventory management.
2. Debtors Turnover = Net Credit Sales / Average Debtors
• Measures collection efficiency.
3. Total Asset Turnover = Net Sales / Total Assets
• Measures utilization of assets.

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