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INTRODUCTION

FINANCIAL STATEMENT ANALYSIS


Financial statement analysis can be referred as a process of understanding the risk and
profitability of a company by analyzing reported financial info, especially annual and quarterly
reports. Putting another way, financial statement analysis is a study about accounting ratios
among various items included in the balance sheet. These ratios include Market prospects ratios,
Profitability ratios, Leverage ratios, Liquidity ratios, and Efficiency ratios. Moreover, financial
statement analysis is a quantifying method for determining the past, current, and prospective
performance of a company.

ADVANTAGES OF FINANCIAL STATEMENT ANALYSIS


The different advantages of financial statement analysis are:
The most important benefit of financial statement analysis is that it provides an idea to the
investors about deciding on investing their funds in a particular company.
Another advantage of financial statement analysis is that regulatory authorities like IASB
can ensure the company following the required accounting standards.
Financial statement analysis is helpful to the government agencies in analyzing the taxation
owed to the firm.
Above all, the company is able to analyze its own performance over a specific time period.

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS


In spite of financial statement analysis being a highly useful tool, it also features some
limitations, including comparability of financial data and the need to look beyond ratios:

Although comparisons between two companies can provide valuable clues about a
companys financial health, the differences between companies accounting methods
make it, sometimes, difficult to compare the data of the two.

Besides, many a times, sufficient data are on hand in the form of foot notes to the
financial statements so as to restate data to a comparable basis. Or else, the analyst should
remember the lack of data comparability before reaching any clear conclusion.

However, even with this limitation, comparisons between the key ratios of two companies along
with industry averages often propose avenues for further investigation.

KEY ELEMENTS
The role of financial reporting for companies is to provide information about their fiscal health and financial
performance. As investors, we use financial reports to evaluate the past, current and prospective performance
and financial position of a company. These statements allow us to compare one firm to another and form the
basis of valuing the worth of a stock.

Understanding financial statements is key to understand financial stock analysis and overall
investment research. Financial statements provide an account of a companys past performance, a
picture of its current financial strength and a glimpse into the future potential of a firm.
Several financial statements are reported by companies.
The Three most important and often used by investors are:

INCOME STATEMENT

BALANCE SHEET

CASH FLOW STATEMENT

INCOME STATEMENT
The income statement reports how much revenue the company generated during a period of time, the expenses
it incurred and the resulting profits or losses.
The basic equation underlying the income statement is:
Revenue Expenses = Income

All companies use a reporting period of one year, which can start and end at the same time as a calendar year,
or could start and end at different point in the year (the firms fiscal year).
There are several important pieces of information on the income statement that are relevant to Stock
Analysis .Investment analysts use the income statement to monitor revenues, expenses and profits and their
trends over time. The direction and rate of change in not only profits but also top-line revenue influence the
valuation of the firm. The rate of growth, and whether it is accelerating or decelerating, for both revenue and
net income, is a critical component in stock valuation. Investors often reward high-growth companies with a
higher valuation.
Near the bottom of the income statement is earnings per share. Earnings per share is simply the earnings the
company generated per share of outstanding company stock.
BALANCE SHEET

Although the income statement may be the most popular financial statement, the balance sheet provides vital
information on a companys financial position. In contrast to the income statement, which provides revenue
and earnings data over a period of time, the data contained in the balance sheet is a snapshot for a specific date.
The balance sheet provides information on what a company owns (assets), what it owes (liabilities), and the
shareholder ownership interest (equity).
The equation underlying the balance sheet is:
Assets = Liabilities + Equity

Analysts use balance sheets to determine trends in assets and liabilities and to ascertain how adequately the
firm is financed. For example, trends in inventory (an asset) and supplier invoices (accounts payable, a
liability) can provide insight on product demand and the ordering patterns of the firm. An increase in inventory
can suggest that a company is gearing up for an expected increase in product demand. However, analysts must
be cognizant that holding too much inventory can be problematic.
In addition, the balance sheet shows changes in a firms debt and provides clues as to whether the firm is
becoming too highly levered. The shareholders equity determines the valuation of a firm by providing the
book value (which is used as the denominator in the price-to-book ratio), or theoretical value left for the
shareholders in event of liquidation.

CASH FLOW STATEMENT


The cash flow statement is the third major financial statement provided by companies. This financial report
tabulates how much cash is coming in and going out of the firm. When it comes to financial statements, cash is
entirely different from profits. A firm can easily generate healthy profits without generating sufficient cash.
There are three major elements in the cash flow statement:

Cash Flow From Operating Activities

Cash flow from operating activities encompasses cash generated from a companys day-to-day
operations. The simplest example would be cash inflows resulting from sale of a product for cash,
which would represent an increase in cash flow from operating activities. Offsetting this would be
money spent to manufacture products, pay suppliers and pay employee salaries, which would mark a
decrease in cash from operating activities.

Analysts are very interested in cash flow from operations because it represents the exact amount of
cash the firm has been able to generate using its core business operations. Increasing profits while
cash flow from operations shrinking is a potential red flag.

Cash Flow From Investing Activities

Cash flow from investing activities pertains to the purchasing and selling of investments. Investments
include property, plant and equipment and other long-term assets, as well as both long- and short-term
investments in equity and debt issued by other companies. Generally, when management feels there is
strong demand for products and growth is expected to be robust, cash outflows from investing activities
will increase as the firm gears up production.

Cash Flow From Financing Activities.

, Cash Flow from financing activities covers obtaining or repaying capital. Cash inflows from financing
activities include the sale of stock and issuance of debt. Cash outflows include stock repurchases, the
issuance of dividends, and the repayment of bonds or other long-term debt.
Analysts keep a watchful eye on cash flow from financing for a variety of reasons. An increase in debt
financing can generate additional value for shareholders if profits are successfully generated from the
borrowed capital. As always, analysts must be cautious when firms are showing significant increases in debt.
Alternatively, a company buying its own shares may indicate managements willingness to return cash to
shareholders, or it may signal managements belief that the companys shares are undervalued.
Net cash flow is the total sum of cash flow from operations, cash flow from investing, and cash flow from
financing. This figure is the basis of numerous cash flow valuation models; analysts often use cash flow as a
basis to develop target prices for the companys stock.

RATIO ANALYSIS
What is Ratio Analysis?
Financial ratios are mathematical comparisons of financial statement accounts or categories. These
relationships between the financial statement accounts help investors, creditors, and internal
company management understand how well a business is performing and areas of needing
improvement.
Financial ratios are the most common and widespread tools used to analyze a business' financial
standing. Ratios are easy to understand and simple to compute. They can also be used to compare
different companies in different industries. Since a ratio is simply a mathematically comparison
based on proportions, big and small companies can be use ratios to compare their financial
information. In a sense, financial ratios don't take into consideration the size of a company or the
industry. Ratios are just a raw computation of financial position and performance.

Ratios allow us to compare companies across industries, big and small, to identify their strengths and
weaknesses. Financial ratios are often divided up into six main categories: liquidity, solvency,
efficiency, profitability, market prospect, investment leverage, and coverage.

Standards of Comparison
The Ratio Analysis involves comparison for a useful interpretation of the financial
statements. A single ratio in itself does not indicate favourable or unfavourable
condition. It should be compared with some standard.
Standards of comparison may consist of:

Time series analysis:


The easiest way to evaluate the performance of a firm is to compare its present ratios
with the past ratios. When financial ratios over a period of time are compared, it is
known as the Time Series Analysis. It gives an indication of the direction of change and
reflects whether the firms financial performance has improved, deteriorated or remained
constant over time. The analyst should not simply determine the change but more
importantly, he/she should understand why ratios have changed. The change, for
example, may be affected by changes in the accounting policies without a material
change in the firms performance.

Cross-sectional Analysis:
Another way of comparison is to compare ratios of one firm with some selected firms in
the same industry at the same point in time. This kind of comparison is known as the
cross-sectional analysis or inter-firm analysis. In most cases, it is more useful to compare
the firms ratios with ratios of a few carefully selected competitors, who have similar
operations. This kind of a comparison indicates the relative financial position and
performance of the firm. A firm can easily resort to such a comparison, as it is not
difficult to get the published financial statements of the similar firms.

Industry Analysis:
To determine the financial condition and performance of a firm, its ratios may be
compared with average ratios of the industry of which the firm is a member. This sort of
analysis, known as the industry analysis, helps to ascertain the financial standing and
capability of the firm through other firms in the industry. Industry ratios are important
standards in view of the fact that each industry has its characteristics, which influence the
operating relationships. But there are certain practical difficulties in using the industry
ratios. First, It is difficult to get average ratios for the industry. Second, even if industry
ratios are available, they are averages of the ratios of strong and weak firms. Sometimes
differences may be so wide that the average may be of little utility. Thirdly, averages will
be meaningless and the comparison futile if firms within the same industry widely differ
in their accounting policies and practices. If it is possible to standardize the accounting
data for companies in the industry and eliminate extremely strong and extremely week
firms, the industry ratios will prove to be very useful in evaluating the relative financial
condition and performance of a firm.

Pro forma Analysis:


Sometimes future ratios are used as standard of comparison. Future ratios can be
developed from the projected, or pro forma financial statements. The comparison of
current or past ratios with future ratios shows the firms relative strengths and
weaknesses in the past and the future. If the future ratios indicate weak financial
position, corrective actions should be initiated.

Types Of Ratios

Liquidity Ratios
Leverage Ratios
Efficiency Ratios
Profitability Ratios
Market Prospects Ratio
LIQUIDITY RATIOS

Liquidity ratios analyze the ability of a company to pay off both its current liabilities as they become
due as well as their long-term liabilities as they become current. In other words, these ratios show the
cash levels of a company and the ability to turn other assets into cash to pay off liabilities and other
current obligations.
Liquidity is not only a measure of how much cash a business has. It is also a measure of how easy it
will be for the company to raise enough cash or convert assets into cash. Assets like accounts
receivable, trading securities, and inventory are relatively easy for many companies to convert into
cash in the short term. Thus, all of these assets go into the liquidity calculation of a company.
The most common liquidity ratios are:
1. CURRENT RATIO
The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its shortterm liabilities with its current assets. The current ratio is an important measure of liquidity because
short-term liabilities are due within the next year.
This means that a company has a limited amount of time in order to raise the funds to pay for these
liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be
converted into cash in the short term. This means that companies with larger amounts of current
assets will more easily be able to pay off current liabilities when they become due without having to
sell off long-term, revenue generating assets.
FORMULAE :

Analysis
The current ratio helps investors and creditors understand the liquidity of a company and how easily
that company will be able to pay off its current liabilities. This ratio expresses a firm's current debt in
terms of current assets. So a current ratio of 4 would mean that the company has 4 times more current
assets than current liabilities.
A higher current ratio is always more favorable than a lower current ratio because it shows the
company can more easily make current debt payments.
If a company has to sell of fixed assets to pay for its current liabilities, this usually means the
company isn't making enough from operations to support activities. In other words, the company is
losing money. Sometimes this is the result of poor collections of accounts receivable.
The current ratio also sheds light on the overall debt burden of the company. If a company is
weighted down with a current debt, its cash flow will suffer.

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