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FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is an information processing system designed to provide data for people
concerned with the economic situation of a fir=m and predicting its future course.

Definition
In the words of John N. Myers, Financial statement analysis is largely a study of the relationships among
the various financial factors in a business as disclosed by a single set of statements and a study of the trends
of these factors as shown in a series of statements.

The major groups of users are:-
1. Investors for making portfolio decisions
2. Managers, for evaluating the operational and financial efficiency of the firm.
3. Lenders for determining the credit worthiness of the loan applicants
4. Labour unions, for establishing an economic basis for collective bargaining.
5. Regulatory agencies for controlling the activities of companies under the jurisdictions.
6. Researchers, for studying firm and individual behavior.
The ability to analyze and understand a financial statement is as much an art form as it is and application
of several techniques. The technical side of financial analysis is straightforward. We calculate a variety of
common financial ratios to provide insight into the financial condition of a company. The artistic dimension
of financial analysis is important because the accounting process relies to a great extent upon the application
of judgment, which introduces subjectivity and values. Different, yet valid views and interpretations of the
economic consequences of a specific transaction often exist.
Significance and purposes of financial statement analysis
1. Judging profitability
Profitability is a measure of the efficiency and success of a business enterprise. A company which
earns profits at a higher rate is definitely considered a good company by the potential investors. The
potential investors analyze the financial statements to judge the profitability and earning capacity of a
company so as to decide whether to invest in a company or not.
2. Judging liquidity
Liquidity of a business refers to the ability of a company to pay off its short-term liabilities when these
become due. Short-term creditors like trade creditors and bankers make an assessment of liquidity
before granting credit to the company
3. Judging solvency
Solvency refers to the ability o a company to meet its long-term debts. Long-term creditors like
debenture-holders and financial institutions judge the solvency of a company before any lending
decisions. They analyze companys profitability over a number of years and its ability to generate
sufficient cash to be able to repay their claims
4. Judging the efficiency of management
Performance and efficiency of management of a company can be easily judged by analyzing it s
financial statements. Profitability of a company is not the only measure of companys managerial
efficiency. There are a number of other ways to judge the operational efficiency of management.
Financial analysis tells whether the resources of the business are being used in the most effective and
efficient way
5. Inter-firm comparison
A comparative study of financial and operating efficiency of different firms is possible only after
proper analysis of their financial statements. For this purpose it is also necessary that the financial
statements are kept on a uniform basis so that the financial data of various firms are comparable
6. Forecasting and budgeting
Financial analysis is the starting point for making plans by forecasting and preparing budgets.
Analysis of the financial statements of the past years helps a great deal in forecasting for the future.
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Limitations of financial statements.
1. Effect of accounting concepts and conventions
Various concepts and conventions of accounting affect the values of assets and liabilities as shown in
the balance sheet. Similarly, profit or loss disclosed by profit and loss account is also affected by these
concepts and conventions. For example, on account of the going concern concept and also the
convention of conservatism, the balance sheet does not show current economic values of various
assets and liabilities

2. Effect of personal judgments
The financial statements are influenced, to a certain extent, by the personal judgements of the
accountant. For example, the amount of provision for bad and doubtful debts depends entirely on the
judgment and past experience of the accountant. Similarly, an accountant has also to make a
judgement about the method and rate of depreciation for fixed assets. There are numerous instances
when an accountant has to exercise his personal judgement in which there is an element of
subjectivity. The quality of the financial statements thus depends upon the competence and integrity
of those who are responsible for preparing these statements.
3. Recording only monetary transactions
Financial statements record only those transactions and events which can be expressed in terms of
money. But there are many factors which are qualitative in nature and cannot be expressed in
monetary terms. These non-monetary factors do not find any place in the financial statements. For
example, efficiency of workers, personal reputation and integrity of the managing director of the
company, advertisement policy of the company etc. are not capable of being expressed in money
terms and thus find no place in financial statements even though they materially affect the profitability
of a business
4. Historical in nature
Financial statements disclose date which is basically historical in nature i.e it tells what has happened
in the past. These statements do not give future projections.
5. Ignores human resources.
No business can prosper without an efficient work force. But financial statements do not include
human resources which is very important asset for a business
6. Ignores social costs
Apart from earning a fair return on investments, a business has certain social responsibilities.
Financial statements do not make any attempt to show the social costs of its activities. Examples of
social cost of a manufacturing company are air pollution, water pollution, occupational diseases, work
injuries etc

I. COMMON SIZE ANALYSIS AND TRENDS
Common size analysis is a technique that enables us to determine the makeup and patterns of a companys
balance sheet and income statement. The analysis can be either horizontal (across years) or vertical (within
years). In a financial statement, common-size analysis reduces absolute numbers to percentages of
components at one point in time or the percentages of change in components overtime, thereby revealing
possible trends.
a. Horizontal Analysis.
Common-size analysis that compares the same accounts from year to year. When we arrange
several annual balance sheets and income statements in vertical columns we can horizontally compare
the annual charges in related items.
This comparison or horizontal analysis of the accounts reveals a pattern that may suggest
managements underlying philosophy, policies and motivations. Also called comparative analysis.
b. Vertical Analysis.
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Common-size analysis that compares accounts in the income statement to net sales and amounts in
the balance sheet to total assets.
When we analyze the financial statements for one period, we often use vertical analysis. It is the
process of finding the proportion that an item, such as inventory, represents of a total group.
A vertical analysis of annual balance sheets reveals how the mix of assets and financing is changing
over time.
II. RATIO ANALYSIS
Common size analysis provides some insight to the financial condition of the firm. Financial ratios
analysis is the next step in the process. Ratios are among the widely used tools of the financial analysis. They
are helpful in providing clues and spotting patterns in the direction of better or poorer performance.

Important points to keep in mind when doing ratio analysis are:-
1. We calculate ratios for specific dates: - If management issues financial statements infrequently, we
may not uncover any seasonal characteristics of the business.
2. Financial statements show what has happened in the past: - An Important purpose for calculating
ratios is to uncover clues to the futures so that we can prepare for the problems and opportunities
that lie ahead. When we use ratios we must consider our knowledge of judgement about the
future.
3. Ratios are not ends in themselves: - They are tools that can help answer some of our financial
questions, but we must interpret them with care. For example, it is possible to improve the ratio
of operating expenses to sales by reducing costs that act to stimulate sales. However, if the cost
reduction results in loss of sales or market share, any profit improvement may have an overall
detrimental effect.
4. Businesses are not exactly comparable: - There are different ways of computing and recording
some of the items on financial statements. Because the figures for one business may not
correspond exactly to those of another firm, good comparisons require reasoned judgment.
Four Categories:-
1. Efficiency Ratios
Efficiency ratios are used to indicate the
efficiency with which assets and resources
of the firm are being utilized.
These ratios are called turnover ratios
because they indicate the speed with
Which assets are being converted or
turned over into sales. These ratios,
thus express the relationship between
sales and various assets. A higher turnover ratio generally indicates better use of capital resources
which in turn has a favorable effect on the profitability of the firm.

2. Liquidity Ratios
Liquidity means ability of a firm to meet its current
Liabilities. The liquidity ratios, therefore, try
to establish a relationship between current liabilities,
which are the obligations soon becoming due and
current assets, which presumably provide the source from which these obligations will be met.

3. Leverage Ratios
Leverage ratios are used to analyze the long term
Solvency of any particular business concern.
There are two aspects of long term solvency of a
1. Current ratio
2. Quick ratio
3. Absolute quick
ratio
1. Inventory turnover ratio
2. Debtors turnover ratio
3. Fixed assets turnover
ratio
4. Working capital turnover
ratio
5. Capital turnover ratio
1. Debt equity
ratio
2. Proprietary
ratio
3. Interest
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Firm (a) ability to repay the principal amount when
Due and (b) regular payment of interest.
In other words, long term creditors like debenture holders, financial institution etc, are interested in
the security of their loan amount as well as the ability of the company to meet interest costs. They,
therefore, also consider the earning capacity of the company to know whether it will be able to pay off
interest on loan amount. Liquidity ratios discussed earlier indicate short term financial strength
whereas solvency ratios judge the ability of a firm to pay off its long term liabilities.

4. Profitability Ratios
Every business should earn sufficient profits to
Survive and grow over a long period of time.
Infact efficiency of a business is measured in
Terms of profits. Profitability ratios are cal-
culated to measure the efficiency of the business
Profitability of a business may be measured in two ways:
1. Profitability in relation to sales
2. Profitability in relation to investments
Importance of Ratio Analysis
1. Liquidity Position: with the help of ratio analysis can know the liquidity position of the firm. We can
know whether it is able to meet its short term liabilities. This ability is reflected in the liquidity ratios
of the firm.

2. Long Term Solvency: ratio analysis is useful to assessing the long term financial viability of the firm.
This aspect of the financial position is concerned to the long term creditors, security analyst and
present and potential owners of a business. The long term solvency is measured by leverage ratios.
3. Operating Efficiency: it throws light on the degree of efficiency in the management and utilization
of assets. The activity ratios measure the efficiency of the management.
4. Over-All Profitability: the management is constantly concerned about the overall growth in the
enterprise. It to meet short and long term obligations to creditors
5. Trend Analysis: It shows whether the financial position of the firm is improving or deteriorating
over the years. Significance of trend analysis ratios lies in the fact to know the direction of the
financial position.
Limitations of Ratio Analysis
1. Difficulty in Comparison: One serious limitation of ratio analysis arises out of the difficulty
associated with their comparability.
The differences may relate to:
A) Differences in the basis of inventory valuation
B) Different depreciation methods.
C) Estimated life of assets
D) Amortization of intangible assets like goodwill, Patents.
E) Amortization of deferred revenue expenditure such as preliminary expenditure and discount on
issue of shares.

2. Impact of Inflation: weaken ss of traditional finance statements which are based on historical costs.
Assets are acquired at different prices and shown in the balance sheet. These prices may over value or
under value. It enters the balance sheet at different book value affect the profitability ratio of the firm.
3. Conceptual Diversity: yet another factor influences the ratios is that there is a difference of opinion
regarding the various concepts used to compute the ratios. There is always room for diversity of
opinion as to what constitutes shareholders equity, debt, assts, profit, and so on different firms may
1. Gross profit ratio
2. Net profit ratio
3. Operating ratio
and expense ratio
4. Return on equity
5. Earning per share
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use these terms in different senses or the same firm may use them to different mean different things
and different times.
Ratios are relative figures reflecting the relationship between variables. Comparison with related facts
is the basis of ratio analysis.
The following question will be used to illustrate the above classes of ratios
ABC ltd
Profit and Loss
A
/
C
for the year ended 31.12.1992

Sales
Less: Cost of Sales
Opening stock
Purchases

Less: Closing stocks
Gross profit
Less expenses
Selling and distribution
Depreciation
Administration expenses
Earnings before interest & taxes
Interest
Earnings before tax
Tax @ 50%
Less ordinary dividend
(0.75 per share)
Retained profit for the year

Sh


99,500
559,500
659,000
(149,000)


30,000
10,000
135,000









Sh
850,000




(510,000)
340,000



(175,000)
165,000
(15,000)
150,000
75,000
75,000

(15,000)
60,000


ABC
Balance Sheet as at 31 December 1992
Non Current Assets
Land and Buildings
Plant & Machinery

Current Assets
Inventory
Debtors
Less provision
Cash






75,000
(4,000)


Sh.
250,000
80,000
330,000

149,000

71,000
30,000
580,000

Issued share capital
(20000 share of Sh,
10)
Reserve
Retained profit
Long term
Current liabilities.
Sh.
200000
90000
60000
100000
130000



580,000


Additional Note
Cash purchases amount to 14,250.

Required:
Compute the relevant ratios.
LIQUDITY RATIOS
Current Ratio = Current Assets
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Current Liabilities

Current Ratio = 250,000 = 1.92 : 1
130,000

The higher the ratio then the more liquid the firm is.

Quick Ratio/ AcidTest Ratio
= Current Assets - Inventories
Current Liabilities

= 250,000 149,000 = 101,000
130,000 130,000

= 0.78 : 1

this is a more refined ration that tries to recognize the fact that stakes may not be easily converted into cash.
The higher the ratio, the better for the firm as it means an improved liquidity position.

Cash Ratio
= Cash + Marketable Securities
Current Liabilities

= 30,000 = 0.23 : 1
130,000

= 0.23 : 1

This ratio assumes that stakes may not be converted into cash easily and the debtors may not pay up their
accounts on time. The higher the ratio, the better for the firm as the Liquidity position is improved.

Net Working Capital Ratio.
= Net Working Capital
Net Assets

Net Working Capital =CA CL = 250,000-130,000=120,000

Net Working Capital = 120,000 = 0.27 : 1
450,000

= 0.27 : 1

The higher the ratio the better for the firm and therefore the improved Liquidity position.

GEARING RATIOS
These measure the financial risk of a firm (the probability that a firm will not be able to pay up its debts). The
more debts a business has (non owner supplied funds) the higher the financial risk.
Debt Ratio
= Total Liabilities
Total Assets
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This ratio measures the proportion of total assets financed by non owner supplied funds. The higher the ratio,
the higher the financial risk .

= 230,000 = 0.4
580,000
40% is supplied by non owners

Debt EquityRatio

= Total Liabilities
Networth (share holders funds)

= 230,000 = 0.66
350,000
40% is supplied by non-owners

This ratio measures how much has been financed by the non-owner supplied funds in relation to the amount
financed by the owners i.e. for every shilling invested in the business by the owners how much has been
financed by the non-owner supplied funds.
For ABC Ltd, for every 1 shilling contributed in the business by the owner, the creditor have put in 67 cents.
The higher the financial risk.

LongTermDebt Ratio
= Non Current Liabilities
Net Assets

= 100,000 = 0.2
450,000
This measures the proportion of the total net assets financed by the non-owner supplied funds.
The higher the ratio, then the higher the financial risk.

ACTIVITY RATIO
Stock Turnover
= Cost of Sales
Average Stocks
where
Average Stocks = Opening Stock + Closing Stock
2
= 510,000 = 4.1
124,250

= 4.1 times

This is the number of times stock has been converted to sales in a financial year. The higher the ratio the
more active the firm is.
An alternative formula is

= Sales
Closing Stock
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Debtors Turnover

= Credit Sales
Average Debtors
Where
Average Debtors = Opening debtors + Closing debtors
2
Assume the opening debtors was 89,000 and all sales are on credit

Debtor Turnover = 850,000 = 10.625
80,000

The higher the ratio, the more active the firm has been (we had debtors over 10 times to generate the sales)

Note
Average Collection Period = 360
Debtors Turnover

= 360 = 34 days
10.625

This measure the number of days it takes for debtors to pay up. The lesser the period, the better for the firm
as it improves the liquidity position.

Creditors Turnover
= Credit Purchases
Average Creditors
= 545,250
130,000

= 42 times
The ratio tries to measure how many times we have creditors during a financial period. The lesser the ratio
the better.

Non Current Assets Turnover (Fixed Assets Turnover)
= Sales
Average Fixed Assets

A.F.A = 340,000 + 330,000 = 670,000 = 335,000
2 2
= 850,000 = 2.54 times
335,000

The ratio measures the efficiency with which the firm is using its fixed/ Non Current Assets to generate sales.
The higher the ratio the more active the firm.

Total AssetsTurnover

= Sales
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Total Assets

= 850,000
580,000

= 1,046 times

Measures the efficiency with which the firm is using its total assets to generate sales.

PROFITABILITY RATIOS
Profitability in Relation to Sales
Gross Profit Margin
= Gross Profit = 165,000 = 19%
Sales 850,000

The higher the margin, the more profitable the firm is.

Net Profit Margin
= Net Profit after tax = 75,000 = 9%
Sales 850,000

The higher the margin, the more profitable the firm is.
Margin affected by:
Operating expenses for the period.

Profitability in Relation to investment
Return On Investment
= Net Profit after tax
Total Assets

= 75,000 = 13%
580,000

Shows how efficient the firm has been in using the total assets to generate returns in the business.

Return On Capital Employed
= Net Profit after tax
Net Assets

= 750,000 = 17%
450,000

How efficient the firm has been in using the net assets to generate returns in the business.

Return On Equity
= Earnings after tax
Networth

= 75,000
850,000
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= 21%

Efficiency of the firm in using the owners capital to generate returns.

NOTE
The higher the ratio the more efficient is the firm.

EQUITY RATIOS
Earnings Per Share (Eps)
EPS = Earnings attributable to ordinary shareholders
No. of ordinary shares outstanding.

= 75,000
20,000

= 3.75

This is the return expected by an investor for every share held in the firm.

Earnings Yield
= Earnings Per Share
Market price per share
Assume that the market price for the ABCS shares is Sh20/ Share.

= 3.75 100%
20
= 19%

This is the return amount expected by a shareholder for every shilling invested in the business.

DividendPer Share
= Total Dividend (ordinary shareholders)
Ordinary shares outstanding.

= 15,000
20,000

= 0.75 cts per share

This is the amount expected by an investor for every share held in the firm.