ANALYSIS OF FINANCIAL

STATEMENTS
Formal Report to Board of Directors

[NAME OF STUDENT] [STUDENT ID]

[NAME OF INSTITUTION]
B9AC106 Financial Analysis

Table of Contents

Role of Ratio Analysis ............................................................................................................... 3

Calculation and Meaning of Main Ratios .................................................................................. 4

Profitability Ratios ................................................................................................................. 5

Efficiency Ratios .................................................................................................................... 6

Liquidity Ratios ..................................................................................................................... 7

Solvency Ratios ..................................................................................................................... 8

Key Users of Ratio Analysis and Their Purpose ....................................................................... 9

Employees .............................................................................................................................. 9

Creditors and Suppliers .......................................................................................................... 9

Shareholders and Investors .................................................................................................. 10

Government Authorities....................................................................................................... 10

Customers ............................................................................................................................ 10

Lenders and Banks ............................................................................................................... 11

Management ......................................................................................................................... 11

Limitations, Drawbacks and Concerns .................................................................................... 11

References ................................................................................................................................ 13

[Name of Student] [Student ID] 2|Page

B9AC106 Financial Analysis

Role of Ratio Analysis

Glantz (2005) states that ratio Analysis is a measure to analyze and evaluate the financial
progress and strength of a company through the information that is contained in the final
accounts of the company also known as the financial statements. Ratio Analysis uses the
elements from the financial statements; for instance, the Income Statement and the Statement
of Financial Position. However, no single element is used solely in order to analyze the
financial position and strength, whereas, two or more than two elements are been used in order
to work out any ratio. Different ratios are been used in order to make analysis in different
dimensions. For instance, elements are been taken from the Income Statement if the progress
of the company has to be analyzed (Davis and Davis, 2012).

However, Bragg (2011) mentions that the level of analysis is been determined by the selection
of the appropriate ratio. In addition, to analyze the financial strength and position of the
company, the elements for the ratio analysis are been taken from the Statement of the Financial
Statement. Ratio Analysis illustrates the performance of the company from different aspects,
for instance, the ability of the company to pay its short term debts, the margin of the company
that it is left with in making the sales. Furthermore, ratio analysis further demonstrates the
ability of the company to pay off all of its debts as a measure of analyzing and evaluating the
financial progress of the company (Bangs, 2010).

Additionally, according to the viewpoint of (Winston, 2013) ratio analysis is a significant

measure and an effective tool to make comparisons. The comparisons can be made by
comparing the past performance of the company with the current performance of the company
hence comparisons are not only made within the company from time to time but comparisons
can also be made between the financial performance and strength of the company with the
progress and strength of other companies both in the same industry but also with the companies
operating in the other industries (Vandyck, 2006). Hence such comparisons can be made by
reviewing the previous performance of the company. Also, the ratio analysis can also be used
to make comparisons between the financial progresses of the company with the progress of its
rival companies. Hence, ratio analysis allows a critical inter and intra financial comparisons.

In addition, according to Taparia (2004) the conception of International Accounting Standards

has brought uniformity in the preparation of the financial statements of companies, hence
making comparisons has become more feasible and authentic by using the tools of ratio
analysis which has strengthened the importance and value of the usage of ratio analysis.

[Name of Student] [Student ID] 3|Page

B9AC106 Financial Analysis

Moreover, an important aspect in the ratio analysis is the interpretation of the figures that are
been worked out through ratios (Sharan, 2009). Although, the interpretations are subjective and
may vary from entity to entity however some basic and primary ranges have been demonstrated
by the experts that act as a basic framework to develop further detailed and critical
interpretations.

Furthermore, ratio analysis also plays an effective role in the success of the company as the
management can make effective use of such ratios in the processes of formulating and
structuring the strategies and devising the policies and setting the targets and goals of the
company (Robinson et al., 2015). The core notion in the success of the company is setting
attainable targets which can be done effectively making use of ratio analysis. Ratio Analysis
relieves management in the procedures of the planning and decision making as the ratio
analysis provides a clear and authentic picture of the operating progress and financial progress.
In addition, Ramagopal (2009) establishes that each segment of the financial statements can be
analyzed in ratio analysis which allows a thorough evaluation of the progress of the company
accompanied with its financial strength and position.

The knowledge about the financial and operating strength and performance can greatly assist
the management in taking crucial decisions and setting the strategies ensuring the success of
the company (Rajasekaran and Lalitha, 2011). Moreover, operating performance of the
company can also be determined by the ratio analysis as the efficiency can be evaluated of the
company for its operations. For instance, incurring high expenses can be an indicator of the
ineffective utilization of the resources by the company indicating the inefficiencies in the
particular area. For illustration, if the inefficient utilization of the resources is being done in
the manufacturing of the goods and services, the margin ratio can highlight the operating
inefficiency of the company (Peterson et al., 2004). Moreover, net profit ratio further depicts
the efficiency of the utilization of the resources in terms of controlling the overheads.

Calculation and Meaning of Main Ratios

There are numerous ratios that are being used in order to assess the financial strengths and
progress of the company. However, Needles and Powers (2014) advances that every ratio
indicates a separate segment. In addition, ratios are being worked out for both being used
internally as well as for the external usages. These ratios cover the elements from different

[Name of Student] [Student ID] 4|Page

B9AC106 Financial Analysis

segments of different financial statements such as the Income Statements and Statement of
Financial Statements. Combinations of different elements from different segments are being
made in ratio analysis such that every combination illustrates a new aspect in the interpretation
of the financial progress of the company. The ratios are being categorized broadly into
profitability ratios, efficiency ratios, liquidity ratios and solvency ratios (Khan. and Jain, 2007).
For instance, a company may be highly profitable considering the profitability ratios and at the
same time, highly geared. Hence, numerous ratios are being utilized in order to get a more firm
and clear picture of the progress of the company.

Profitability Ratios

Profitability ratios as Kass-Shraibman and Sampath (2011) states, illustrate the financial
progress of the company over the period of time. In determining the overall progress of the
company profitability are an effective tool to determine whether the company was effective in
its operations. However, profitability ratios are being calculated in two structures, the first one
is in the form of margins and the second one in the form of returns.

Return on Capital Employed

Return on capital employed as Peterson et al. (2004) establishes, illustrates the level of
efficiency of the company that how efficiently it generates income from its capital. It is
calculated by dividing the net operating profit with the capital that is employed in the company
illustrated below

𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡

× 100
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Gross Margin Ratio

According to (Needles and Powers, 2014) it determines the efficiency of the business in
converting the inventory into sales. It illustrates how profitably the company turned the

[Name of Student] [Student ID] 5|Page

B9AC106 Financial Analysis

inventory into net sales. It is calculated by dividing the gross profit with the net sales. Gross
profit is calculated by subtracting the cost of goods sold from the revenue illustrated below

𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

× 100
𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Profit Margin

It illustrates the overall profitability of the company that how efficiently it has utilized its
resources in controlling the overheads and the cost of goods sold in making revenues (Glynn,
2008). It is calculated by dividing the net income with the revenue as illustrated below

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
× 100
𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Efficiency Ratios

Efficiency ratios illustrate the utilization of the resources by the company, whether the resource
utilization was efficient or ineffective (Peterson et al., 2004). These ratios provide an adequate
picture of the current resources utilization of the company that are mainly from assets and
liabilities. However, efficiency ratios are a comparison and contrast between the effectiveness
of the company in utilization of its assets in order to make revenues.

Inventory Turnover Ratio

This ratio shows that how many times the company has reordered the inventory or has sold the
inventory (Kass-Shraibman and Sampath, 2011). It is calculated by dividing the cost of goods
sold with the average inventory that is calculate by taking average of opening and the closing
inventory, illustrated below

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

[Name of Student] [Student ID] 6|Page

B9AC106 Financial Analysis

Accounts Receivables Turnover Ratio

According to Khan and Jain (2007), it shows the average times of collection by the company
from its debtors. It is calculated by dividing the net credit sales with the average accounts
receivables, illustrated below

𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

Liquidity Ratios

Liquidity ratios outline and illustrate the ability of the company to meet its short term debts
(Glynn, 2008). For illustration, liquidity ratios are a measure to determine how effective a
business is in turning in its non-cash current assets into liquid or cash form so that the short
term debts can be paid.

Working Capital Ratio

It illustrates that how much of the current assets the company have to pay off its short term
liabilities (Helfert, 2009). It is calculated by dividing the current assets with the current
liabilities illustrated below

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Quick Ratio

Friedlob and Welton (2008) states that this ratio shows that how much of current assets the
company has to pay off its short term liabilities which can be quickly converted into cash. It is
worked out by dividing the current assets except cash by creditors, illustrated below

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝑒𝑥𝑐𝑒𝑝𝑡 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑦

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

[Name of Student] [Student ID] 7|Page

B9AC106 Financial Analysis

Solvency Ratios

Solvency ratios illustrate the ability of the company and its financial stability (Winston, 2013).
For instance, if the company is able to pay off all of its legal obligations including both the
short term and the long term. Solvency ratio covers a wider sphere than liquidity ratio as it also
addresses the long term liabilities that the company is obliged to pay.

Debt Ratio

This ratio according to Bangs (2010) illustrates that how much of total assets does a company
owns to pay off the total debts that the company owes. It is calculated by dividing total assets
by total liabilities illustrated below

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Equity Ratio

As Taparia (2004) states, this ratio illustrates that how much of the total assets that the company
has which are backed by the capital. It is worked by dividing the total equity by total assets,
illustrated below

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Debt to Equity Ratio

According to Davis and Davis (2012) this ratio illustrates that how much of the financing in
the company is from the sources of liability. It is worked out by dividing total liabilities with
total assets, as illustrated below

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

[Name of Student] [Student ID] 8|Page

B9AC106 Financial Analysis

Key Users of Ratio Analysis and Their Purpose

Ratio Analysis are widely and commonly used by the stakeholders of the company that have
direct interest in the financial performance and the financial position and the stability of the
company (Helfert, 2009). In addition, ratio analysis is also being used by the users in order to
determine the variations and the patterns in the performance of the progress of the company.
Forecasting and predictions are also being made after analyzing the ratios of the company after
which important decisions are being taken which vary from the end of user to user. Users of
the ratio analysis make use of it from time to time depending upon their varying needs and
usage associated with the financial performance of the company.

Employees

Employees are the core part of the company that have significant contribution in its success,
better financial progress and sound financial strength and considerable financial stability.
However, in return of their efforts and dedications they have expectations from the company,
hence they make use of the financial ratios (Glynn, 2008). The primary reason they may make
use of the financial ratios is to evaluate if their job security which is a primary motivator, is
safe or not which they can judge by assessing the profitability ratios as well as liquidity ratios.
In addition, they may also make use of the financial ratios as they have expectations attached
from the company regarding their pay increments, performance related rewards, bonuses,
commissions and so on.

Creditors and Suppliers

For any company, its credit suppliers and accounts payable would be one of the key users of
the ratio analysis who would be highly interested to know that if it would be feasible for them
to provide the company with the raw materials and supplies on credit terms and basis. In
addition, the creditors of the company take risks by providing the company with the raw
materials on credit hence they have to make sure that if their investment is safe or not. Hence,
before making any transaction that is considerable in the monetary worth, they would first like
to evaluate the financial position and progress of the company which can be done with the help
of ratio analysis (Friedlob and Welton, 2008).

[Name of Student] [Student ID] 9|Page

B9AC106 Financial Analysis

Shareholders and Investors

Shareholders do not have any say or authority in the functioning of the company as they have
invested in the company after evaluating its financial strength and stability. Shareholders use
the ratio analysis to make sure that their investment is safe. Furthermore, Fabozzi and Ake
(2013) mentions that another purpose for shareholders to make use of the ratio analysis to judge
if their investment would generate good returns for them for which they compare and assess
the financial ratios of different companies to make sure that their investment is safe as well as
generates good returns on their invested money.

Government Authorities

Government authorities collect revenue from companies in the form of taxes that are being
charged on the profits. Around the globe, the taxes that are being imposed on companies by
governments are primarily and broadly categorized into income tax and capital taxes. However,
they are further classified into taxes such as Value Added Tax, Property taxes on the premises
owned by the companies, Taxes on sales such as General Sales Tax, Employment taxes.
Government authorities would be interested in the ratio analysis of the company so that
adequate taxes could be charged on the profits of the companies and their ability to pay the
taxes can be judged by the profitability ratios (Choudhry, 2011).

Customers

Business markets are broadly categorized as business to business B2B and business to
customers B2C. A business’s customer can be final tail-end user who may consume the product
for personal satisfaction or other businesses that may use the products of the company as their
raw material or component that would be used in their production processes. However, in the
case of the business to business markets, transactions are been done in high volumes hence the
customer businesses as Böhm (2008) states, would be more interested in the liquidity ratios of
their supplier business to make sure that supplier would keep on operating and they would be
able to get the smooth supplies so that their operations do not get halted.

[Name of Student] [Student ID] 10 | P a g e

B9AC106 Financial Analysis

Lenders and Banks

A company is not completely financed by the capital (Beyer, 2010). However, as capital is not
easy to raise and in the case of time constraint, raising the capital get unfeasible for the
company. Hence, companies have to take short term loans to cater the deficiencies in the cash
flows. Moreover, in the scenario of long term projects or expansion companies could not fulfill
the requirements from the capital money hence they have to take long term loans (Bell et al.,
2013). However, the lenders and the banks would like to evaluate the financial strength and
progress of the company to make sure that the company can pay off its debts and lenders can
get their funds back on good rates of return.

Management

A company is being operated and managed by its management. Management is accounted and
credited for the financial progress of the company. All of the decisions, policies of the company
are being formulated and structured by the management. Furthermore, all of the long term
strategies of the company are being devised, reviewed and revised by the management.
However, such decisions cannot be taken at the instant, for this management makes use of the
financial ratio analysis so that they can make decisions and devise policies accordingly. In
addition, management makes use of the ratio analysis in order to compare the progress of the
company from the past as well as to predict the effect of their decisions and strategies on the
company in the future (Baker and Powell, 2009).

Limitations, Drawbacks and Concerns

The biggest concern related to the financial ratio analysis and the limitation associated with
that is a ratio cannot be utilized alone (Williamson, 2004). Bragg (2011) further establishes that
a ratio cannot provide the user with the complete information hence, numerous ratios would
have to be used at a time which is not feasible for any stakeholder who do not have knowledge
and expertise in the field of finance such as shareholders. Moreover, accounting systems have
flaws some of which are being critically addressed in the International Accounting Standards
however, still the techniques of window dressings are being used showing good picture of the

[Name of Student] [Student ID] 11 | P a g e

B9AC106 Financial Analysis

company. In such scenario, the answers of the ratio analysis would also depict good picture of
the financial progress and position of the company (Peterson et al., 2004).

In addition, the interpretations of the financial ratio analysis are subjective as there are no such
broadly set standards and scales to evaluate and assess the answers of the ratio analysis. Hence,
different users of the ratio analysis would have different criteria and standards for evaluating
the answers of the ratio analysis. Furthermore, financial ratio analysis is being done from the
past and current data and on the basis of the results of the data of past, predictions and forecasts
are being made for future. The dynamics of the business world are constantly changing, the
economic conditions and other external factors do not stay the same hence solely on the basis
of the answers of the ratio analysis.

Moreover, Glantz (2005) mentions there is no universal and particular accounting system hence
there are changes and variations in the accounting systems which have different explanations
and definitions of different accounting terms. Hence, considering the fact, it is not feasible to
make comparisons between the companies following different accounting conventions. In
addition, because of the absence of standards to interpret the results of the ratio analysis, the
interpretations may subject to the interpreter bias in which interpretations may not reflect the
actual scenario. Although, evaluations and judgments can be made on the basis of financial
ratio analysis however, it does not account for the critical and thorough evaluation for which
other measures and tools would also have to be used (Williamson, 2004).

Additionally, Taparia (2004) states that another factor that mitigates the usability of ratio
analysis is that the policies that are being used by different companies are not the same. For
instance, one company may use straight-line method of depreciation whereas the other may use
the diminishing balance method which significantly affects the answers of the ratio analysis,
not giving the authentic and appropriate answers. Furthermore, another factor that financial
ratio analysis do not take into account is the changing demand patterns of the products of the
company due to seasonal factors (Rajasekaran and Lalitha, 2011). In the season of high
demand, the profitability of the company may improve whereas in the season of low demand,
the profitability of the company may worsen, which the ratio analysis do not take into account.
Hence there are many limitations of financial ratio analysis which restrict their independent,
wide and common use.

[Name of Student] [Student ID] 12 | P a g e

B9AC106 Financial Analysis

References

Baker, H. and Powell, G. (2009). Understanding Financial Management. New York, NY: John
Wiley & Sons.

Bell, A., Brooks, C. and Prokopczuk, M. (2013). Handbook of research methods and
applications in empirical finance. Cheltenham: Edward Elgar Pub., Inc.

Beyer, S. (2010). International Corporate Finance - Impact of financial ratios on long term
credit ratings. München: GRIN Verlag GmbH.

Böhm, A. (2008). Interpretation of key figures in financial analysis. München: GRIN Verlag
GmbH.

Choudhry, M. (2011). Bank Asset and Liability Management. Chichester: John Wiley & Sons.

Fabozzi, F. and Ake, P. (2013). The basics of finance. Hoboken, N.J.: Wiley.

Friedlob, G. and Welton, R. (2008). Keys to reading an annual report. Hauppauge, NY:
Barron's.

Glynn, J. (2008). Accounting for managers. London: Cengage Learning.

Helfert, E. (2009). Techniques of financial analysis. New Delhi: Tata McGraw-Hill.

Kass-Shraibman, F. and Sampath, V. (2011). Forensic accounting for dummies. Hoboken, N.J:
Wiley Pub.

Khan, M. and Jain, P. (2007). Financial management. New Delhi: Tata McGraw-Hill.

Needles, B. and Powers, M. (2014). Principles of financial accounting. Australia: South-

Western Cengage Learning.

Peterson, P., Fabozzi, F. and Habegger, W. (2004). Financial management and analysis
workbook. Hoboken, N.J.: Wiley.

Rajasekaran, V. and Lalitha, R. (2011). Financial accounting. New Delhi: Dorling Kindersley.

Ramagopal, C. (2009). Accounting for managers starting from basics. New Delhi: New Age
International.

[Name of Student] [Student ID] 13 | P a g e

B9AC106 Financial Analysis

Robinson, T., Henry, E., Pirie, W. and Broiha. (2015). International Financial Statement
Analysis, Third Edition (CFA Institute In. John Wiley & Sons.

Sharan, V. (2009). Fundamentals of financial management. Delhi: Pearson Education / Dorling

Kindersley (India).

Taparia, J. (2004). Understanding financial statements. Oak Park, IL: Marion Street Press.

Vandyck, C. (2006). Financial ratio analysis. Victoria, B.C.: Trafford.

Winston, W., Stevens, R., Sherwood, P. and Dunn, J. (2013). Market Analysis. Florence:
Taylor and Francis.

Bangs, D. (2010). A crash course on financial statements for small business owners. New
York: Entrepreneur Press.

Bragg, S. (2011). Business Ratios and Formulas. New York, NY: John Wiley & Sons.

Davis, C. and Davis, E. (2012). Managerial accounting. Hoboken, N.J.: John Wiley & Sons.

Glantz, M. (2005). Managing bank risk. Amsterdam: Academic Press.

Williamson, D. (2004). Strategic management and business analysis. Amsterdam: Elsevier.

[Name of Student] [Student ID] 14 | P a g e