INTRODUCTION:

What Is Financial Statement Analysis?

Financial statement analysis is the process of analyzing a

company's financial statements for decision-making purposes.
External stakeholders use it to understand the overall health of an
organization as well as to evaluate financial performance and
business value. Internal constituents use it as a monitoring tool for
managing the finances.

Analyzing Financial Statements

The financial statements of a company record important financial

data on every aspect of a business’s activities. As such they can
be evaluated on the basis of past, current, and projected
performance.

In general, financial statements are centered around generally

accepted accounting principles (GAAP) in the U.S. These
principles require a company to create and maintain three main
financial statements: the balance sheet, the income statement,
and the cash flow statement. Public companies have stricter
standards for financial statement reporting. Public companies
must follow GAAP standards which requires accrual
accounting.1 Private companies have greater flexibility in their
financial statement preparation and also have the option to use
either accrual or cash accounting.2

Several techniques are commonly used as part of financial

statement analysis. Three of the most important techniques
include horizontal analysis, vertical analysis, and ratio analysis.
Horizontal analysis compares data horizontally, by analyzing
values of line items across two or more years. Vertical analysis
looks at the vertical affects line items have on other parts of the
business and also the business’s proportions. Ratio analysis uses
important ratio metrics to calculate statistical relationships.

Financial Statements

As mentioned, there are three main financial statements that

every company creates and monitors: the balance sheet, income
statement, and cash flow statement. Companies use these
financial statements to manage the operations of their business
and also to provide reporting transparency to their stakeholders.
All three statements are interconnected and create different views
of a company’s activities and performance.

 Balance Sheet
The balance sheet is a report of a company's financial worth in
terms of book value. It is broken into three parts to include a
company’s assets, liabilities, and shareholders' equity. Short-term
assets such as cash and accounts receivable can tell a lot about
a company’s operational efficiency. Liabilities include its expense
arrangements and the debt capital it is paying off. Shareholder’s
equity includes details on equity capital investments and retained
earnings from periodic net income. The balance sheet must
balance with assets minus liabilities equaling shareholder’s
equity. The resulting shareholder’s equity is considered a
company’s book value. This value is an important performance
metric that increases or decreases with the financial activities of a
company.

 Income Statement
The income statement breaks down the revenue a company
earns against the expenses involved in its business to provide a
bottom line, net income profit or loss. The income statement is
broken into three parts which help to analyze business efficiency
at three different points. It begins with revenue and the direct
costs associated with revenue to identify gross profit. It then
moves to operating profit which subtracts indirect expenses such
as marketing costs, general costs, and depreciation. Finally it
ends with net profit which deducts interest and taxes.

Basic analysis of the income statement usually involves the

calculation of gross profit margin, operating profit margin, and net
profit margin which each divide profit by revenue. Profit margin
helps to show where company costs are low or high at different
points of the operations.

 Cash Flow Statement

The cash flow statement provides an overview of the company's
cash flows from operating activities, investing activities, and
financing activities. Net income is carried over to the cash flow
statement where it is included as the top line item for operating
activities. Like its title, investing activities include cash flows
involved with firmwide investments. The financing activities
section includes cash flow from both debt and equity financing.
The bottom line shows how much cash a company has available.

 Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and
other valuation statements to analyze the value of a company.
Free cash flow statements arrive at a net present value by
discounting the free cash flow a company is estimated to
generate over time. Private companies may keep a valuation
statement as they progress toward potentially going public.

Financial Performance

Financial statements are maintained by companies daily and used

internally for business management. In general both internal and
external stakeholders use the same corporate finance
methodologies for maintaining business activities and evaluating
overall financial performance.

When doing comprehensive financial statement analysis, analysts

typically use multiple years of data to facilitate horizontal analysis.
Each financial statement is also analyzed with vertical analysis to
understand how different categories of the statement are
influencing results. Finally ratio analysis can be used to isolate
some performance metrics in each statement and also bring
together data points across statements collectively.

Below is a breakdown of some of the most common ratio metrics:

Balance sheet: asset turnover, quick ratio, receivables turnover,

days to sales, debt to assets, and debt to equity

Income statement: gross profit margin, operating profit margin,

net profit margin, tax ratio efficiency, and interest coverage

Cash Flow: Cash and earnings before interest, taxes,

depreciation, and amortization (EBITDA). These metrics may be
shown on a per share basis.

Comprehensive: Return on assets (ROA) and return on equity

(ROE). Also DuPont Analysis.

Meaning of financial analysis:

The process of reviewing and analyzing a company’s financial

statements to make better economic decisions is called analysis
of financial statements. In other words, the process of determining
financial strengths and weaknesses of the entity by establishing
the strategic relationship between the items of the balance
sheet, profit and loss account, and other financial statements.

The term ‘analysis’ means the simplification of financial data by

methodical classification of the data given in the financial
statements, ‘interpretation’ means, ‘explaining the meaning and
significance of the data so simplified.’ However, both’ analysis
and interpretation’ are interlinked and complementary to each
other.

Significance of Financial Analysis

To Finance Manager
Analysis of financial statements helps the finance manager in:

 Assessing the operational efficiency and managerial

effectiveness of the company.
 Analyzing the financial strengths and weaknesses and
creditworthiness of the company.
 Analyzing the current position of financial analysis,
 Assessing the types of assets owned by a business enterprise
and the liabilities which are due to the enterprise.
 Providing information about the cash position company is
holding and how much debt the company has in relation to
equity.
 Studying the reasonability of stock and debtors held by the
company.
To Top Management
Financial analysis helps the top management

 To assess whether the resources of the firm are used in the

most efficient manner
 Whether the financial condition of the firm is sound
 To determine the success of the company’s operations
 Appraising the individual’s performance
 evaluating the system of internal control
 To investigate the future prospects of the enterprise.
To Trade Payables
Trade payables analyze of financial statements for:

 Appraising the ability of the company to meet its short-term

obligations
 Judging the probability of firm’s continued ability to meet all its
financial obligations in the future.
 Firm’s ability to meet claims of creditors over a very short
period of time.
 Evaluating the financial position and ability to pay off the
concerns.
To Lenders
Suppliers of long-term debt are concerned with the firm’s long-term
solvency and survival. They analyze the firm’s financial statements
  To ascertain the profitability of the company over a period of
time,
 For determining a company’s ability to generate cash, to pay
interest and repay the principal amount
 To assess the relationship between various sources of funds
(i.e. capital structure relationships)
 To assess financial statements which contain information on
past performances and interpret it as a basis for forecasting
future rates of return and for assessing risk.
 For determining credit risk, deciding the terms and conditions
of a loan if sanctioned, interest rate, and maturity date etc.
To Investors
Investors, who have invested their money in the firm’s shares, are
interested in the firm’s earnings and future profitability.
Financial statement analysis helps them in predicting the
bankruptcy and failure probability of business enterprises. After
being aware of the probable failure, investors can take preventive
measures to avoid/minimize losses.

To Labour Unions
Labour unions analyze the financial statements:

 To assess whether an enterprise can increase their pay.

 To check whether an enterprise can increase productivity or
raise the prices of products/ services to absorb a wage
increase.

Objectives of Financial Analysis

 1. Reviewing the performance of a company over the past
periods: To predict the future prospects of the company, past
performance is analyzed. Past performance is analyzed by
reviewing the trend of past sales, profitability, cash flows,
return on investment, debt-equity structure and operating
expenses, etc. 

2. Assessing the current position & operational

efficiency: Examining the current profitability & operational
efficiency of the enterprise so that the financial health of the
company can be determined. For long-term decision making,
assets & liabilities of the company are reviewed. Analysis
helps in finding out the earning capacity & operating
performance of the company.
3. Predicting growth & profitability prospects: The top
management is concerned with future prospects of the
company. Financial analysis helps them in reviewing the
investment alternatives for judging the earning potential of the
enterprise. With the help of financial statement analysis,
assessment and prediction of the bankruptcy and probability of
business failure can be done.
4. Loan Decision by Financial Institutions and
Banks: Financial analysis helps the financial institutions, loan
agencies & banks to decide whether a loan can be given to the
company or not. It helps them in determining the credit risk,
deciding the terms and conditions of a loan if sanctioned,
interest rate, and maturity date etc.

Limitations of Financial Analysis

Although there are many advantages of the financial statements,

there are certain disadvantages of the same. As the analysis is
done on the basis of data provided in the financial statements
which can be incorrect.

Hence, it is necessary for the firms to consider in mind various

limitations as well.

1. While doing the financial analysis, firms often fail to consider the
price changes. When firms compare data from various time
periods, they do it without providing the index to the figures. Hence,
the firm does not show the inflation impact.

2. Intangible assets not recorded. Firms do not record many

intangible assets. Instead, any expenditure made to create an
intangible asset are immediately charged to expense.

3. Firms consider only the monetary aspects of the financial

statements. They do not consider the non-monetary aspect.

4. Firms prepare the financial statements on the basis of on-going

concept, as such, it does not reflect the current position.

5. The statements do not necessarily provide any value in

predicting what will happen in the future.

Tools of Financial Analysis

Financial statements are prepared to have complete information
regarding assets, liabilities, equity, reserves, expenses and profit
and loss of an enterprise. To analyze & interpret the financial
statements, commonly used tools are comparative statements,
common size statements etc. Let us take a look.
1. Comparative Statements

Also known as ‘horizontal analysis, are financial statements

showing financial position & profitability at different periods of time.
These statements give an idea of the enterprise financial position
of two or more periods. Comparison of financial statements is
possible only when same accounting principles are used in
preparing these statements.

Comparative Balance Sheet

The progress of the company can be seen by observing the
different assets and liabilities of the firm on different dates to make
the comparison of balances from one date to another. To
understand the comparative balance sheet, it must have two
columns for the data of original balance sheets. A third column is
used to show increases/decrease in figures. The fourth column
gives percentages of increases or decreases.

By comparing the balance sheets of different dates, one can

observe the following aspects

 Current financial position and Liquidity position

 Long-term financial position
 Profitability of the concern

Comparative Income Statement

Traditionally known as trading and profit and loss A/c. Net sales,
cost of goods sold, selling expenses, office expenses etc are
important components of an income statement. To compare
the profitability, particulars of profit & loss are compared with the
corresponding figures of previous years individually. To analyze the
profitability of the business, the changes in money value and
percentage is determined.

By comparing the profits of different dates, one can observe the

following aspects:

 The increase/decrease in gross profit.

 The study of operational profits.
 The increase or decrease in net profit
 Study of the overall profitability of the business.
Steps to prepare comparative statement:
1. Firstly, put the absolute figures from the financial statement in
the relevant years.

2. Then, find the absolute change by deducting the values of the

1st year from the values of the 2nd year.

3. In order to find out the % change, use the given formula:

Absolute Change/Values of 1st year X 100

Advantages of Comparative Financial Statement:

(a) Comparison:
The comparative statements show the figures of various firms or
number of years side by side i.e. both for inter-firm comparison
and intra-firm comparison.
(b) Horizontal Analysis:
The variables are arranged horizontally for the purpose of
analysis and interpretations of data taken from financial
statements for assessing profitability, overall efficiency and
financial position of a firm.

(c) Trend Analysis:

The comparative financial statement helps to ascertain the ‘trend’
relating to sales, cost of goods sold, operating expenses etc. so
that a proper comparison can easily be made which helps the
analyst to understand the overall performance of a firm.

(d) Trend and Directions:

The comparative financial statement provides necessary
information for comparison of trends in related items e.g. the
analyst can compare the trend of sales with the trend of accounts
receivable which gives very useful information. A 20% increase in
accounts receivable and an increase of sales by only 10%
warrants investigation into the reasons for this difference in the
rate of increase.

(e) Evaluation of:

The comparative financial statement helps the analyst to compare
Performance the performance of one firm with that of other similar
firm in the industry and also compare the performance of the
competitors in the line. This comparison helps to find out the
weakness or strength of a firm and to take adequate steps.

(f) Measuring Financial:

Comparative financial statements help to measure important
Distress financial ratios which are used for predicting financial
distress and predicting corporate failure with the help of
Multivariate Model.

Disadvantages of Comparative Financial Statement:

(a) Inter-firm Comparison:
Inter firm comparison will only be effective if both the firms follow
the same accounting principles, method of valuations of stocks,
assets etc. i.e. all the accounting concepts and conventions,
which in real world situation, are not identically followed by both
the firms e.g. Firm A follows the FIFO method of valuing stock
whereas Firm B follows LIFO method for the same.

(b) Inflationary Effect:

Comparative financial statements do not recognise the change in
prices level and, as such, it will be of no use.

(c) Ascertaining Correct Trend:

It is very difficult to ascertain the correct trend if there is a
structural changes in a firm which are frequently happened.

(d) Supply Misleading Information:

Sometimes a comparative financial statement provides
meaningless information, e.g. if a negative amount comes in base
year, and a positive amount in the next year, it is not possible to
find out the change in percentage.

(e) Uniformity in Principle:

There must be a consistency while following accounting
principles, concepts and convention. But in practice, this is not
done and as such, multi-year analysis becomes useless.

2. Common Size Statements

Common size statements are also known as ‘Vertical analysis’.

Financial statements, when read with absolute figures, can be
misleading. Therefore, a vertical analysis of financial information is
done by considering the percentage form. The balance sheet items
are compared:

 to the total assets in terms of percentage by taking the total

assets as 100.
 to the total liabilities in terms of percentage by taking the total
liabilities as 100.
Therefore the whole Balance Sheet is converted into percentage
form. And such converted Balance Sheet is known as Common-
Size Balance Sheet. Similarly profit & loss items are compared:

 to the total incomes in terms of percentage by taking the total

incomes as 100.
 to the total expenses in terms of percentage by taking the total
expenses as 100.
Therefore the whole Profit & loss account is converted into
percentage form. And such converted profit & loss account is
known as Common-Size Profit & Loss account. As the numbers
are brought to a common base, the percentage can be easily
compared with the results of corresponding percentages of the
previous year or of some other firms.

Fact : Common size financial statements make it easier to

determine what drives a company's profits and to compare the
company to similar businesses.

Common Size Balance Sheet Statement

The balance sheet provides a snapshot overview of the firm's
assets, liabilities, and shareholders' equity for the reporting
period. A common size balance sheet is set up with the same
logic as the common size income statement. The balance sheet
equation is assets equals liabilities plus stockholders' equity.

The balance sheet thus represents a percentage of assets.

Another version of the common size balance sheet shows asset
line items as a percentage of total assets, liabilities as a
percentage of total liabilities, and stockholders' equity as a
percentage of total stockholders' equity.

Common Size Cash Flow Statement

The cash flow statement provides an overview of the firm's
sources and uses of cash. The cash flow statement is divided
among cash flows from operations, cash flows from investing, and
cash flows from financing. Each section provides additional
information about the sources and uses of cash in each business
activity.

One version of the common size cash flow statement expresses

all line items as a percentage of total cash flow. The more popular
version expresses cash flow in terms of total operational cash
flow for items in cash flows from operations, total investing cash
flows for cash flows from investing activities, and total financing
cash flows for cash flows from financing activities.

Common Size Income Statement

The income statement (also referred to as the profit and loss
(P&L) statement) provides an overview of flows of sales,
expenses, and net income during the reporting period. The
income statement equation is sales minus expenses and
adjustments equals net income. This is why the common size
income statement defines all items as a percentage of sales. The
term "common size" is most often used when analyzing elements
of the income statement, but the balance sheet and the cash flow
statement can also be expressed as a common size statement.
Advantages of Common-Size Statement:
(a) Easy to Understand:
Common-size Statement helps the users of financial statement to
make clear about the ratio or percentage of each individual item
to total assets/liabilities of a firm. For example, if an analyst wants
to know the working capital position he may ascertain the
percentage of each individual component of current assets
against total assets of a firm and also the percentage share of
each individual component of current liabilities.
(b) Helpful for Time Series Analysis:
A Common-Size Statement helps an analyst to find out a trend
relating to percentage share of each asset in total assets and
percentage share of each liability in total liabilities.

(c) Comparison at a Glance:

An analyst can compare the financial performances at a glance
since percentage of increase or decrease of each individual
component of cost, assets, liabilities etc. are available and he can
easily ascertain his required ratio.

(d) Helpful in analysing Structural Composition:

A Common-Size Statement helps the analyst to ascertain the
structural relations of various components of
cost/expenses/assets/liabilities etc. to the required total of
assets/liabilities and capital.

Limitations of Common-Size Statement:

(a) Standard Ratio:
Common-Size Statement does not help to take decisions since
there is no standard ratio/percentage regarding the change of
percentage in the various component of assets, liabilities, sales
etc.

(b) Change in Price-level:

Common-Size statement does riot recognise the change in price
level i.e. inflationary effect. So, it supplies misleading
information’s since it is based on historical cost.

(c) Following Consistency:

If consistency in the accounting principle, concepts, conventions
is not maintained then Common Size Statement becomes
useless.

(d) Seasonal Fluctuation:

Common-Size Statement fails to convey proper records during
seasonal fluctuations in various components of sales, assets
liabilities etc. e.g. sales and closing stock significantly vary. Thus,
the statement fails to supply the real information to the users of
financial statements.

(e) Window Dressing:

Effect of window dressing in financial statements cannot be
ignored and Common-Size Statements fail to supply the real
positions of sales, assets, liabilities etc. due to the evil effects of
window dressing appearing in the financial statements.

(f) Qualitative Element:

Common-Size Statement fails to recognise the qualitative
elements, e.g. quality of works, customer relations etc. while
measuring the performance of a firm although the same should
not be ignored.

(g) Liquidity and Solvency Position:

Liquidity and solvency position cannot be measured by Common-
Size Statement. It considers the percentage of increase or
decrease in various components of sales, assets, liabilities etc. In
other words it does not help to ascertain the Current Ratio, Liquid
Ratio, Debt Equity Capital Ratio, Capital Gearing Ratio etc. which
are applied in testing liquidity and solvency position of a firm.

Steps to prepare Common Size Statements

1. Firstly, put the absolute figures in the relevant year columns.
(Col. 2 and 4)

2. Then, select a Common Base as 100. In the case of Income

Statements, take Sales Revenue as 100. In the case of Balance
Sheet, take Total Assets or Liabilities as 100.

3. Find out the % value with the help of following formula:

Absolute Value/Common Base Value X 100

3. Ratio Analysis

Quantitative analysis of information contained in a company’s

financial statements is ratio analysis. It describes the significant
relationship which exists between various items of a balance sheet
and a statement of profit and loss of a firm.

To assess the profitability, solvency, and efficiency of a business,

management can go through the technique of ratio analysis. It is an
attempt at developing a meaningful relationship between individual
items (or group of items) in the balance sheet or profit and loss
account.

What is Ratio Analysis?

Ratio analysis is a quantitative analysis of data enclosed in an
enterprise’s financial statements. It is used to assess multiple
perspectives of an enterprise’s working and financial performance
such as its liquidity, turnover, solvency and profitability.
To put it in other words, Ratio analysis is the method of analysing
and comparing financial data by computing meaningful financial
statement value percentages rather than comparing line items
from each financial statement.
Ratio analysis has its own merits and demerits too. Below
mentioned points highlights those points.

Advantages of Ratio Analysis are as follows:

 Helps in forecasting and planning by performing trend

analysis.
 Helps in estimating budget for the firm by analysing previous
trends.
 It helps in determining how efficiently a firm or an
organisation is operating.
 It provides significant information to users of accounting
information regarding the performance of the business.
 It helps in comparison of two or more firms.
 It helps in determining both liquidity and long term solvency
of the firm.

Disadvantages of Ratio Analysis are as follows:

 Financial statements seem to be complicated.

 Several organisations work in various enterprises each
possessing different environmental positions such as market
 structure, regulation, etc., Such factors are important that a
comparison of 2 organisations from varied industries might
be ambiguous.
 Financial accounting data is influenced by views and
hypotheses. Accounting criteria provide different accounting
methods, which reduces comparability and thus ratio
analysis is less helpful in such circumstances.
 Ratio analysis illustrates the associations between prior data
while users are more concerned about current and future
data.

Uses of Ratio Analysis 

1. Comparisons
One of the uses of ratio analysis is to compare a company’s
financial performance to similar firms in the industry to understand
the company’s position in the market. Obtaining financial ratios,
such as Price/Earnings, from known competitors and comparing it
to the company’s ratios can help management identify market
gaps and examine its competitive advantages, strengths, and
weaknesses. The management can then use the information to
formulate decisions that aim to improve the company’s position in
the market.
 
2. Trend line
Companies can also use ratios to see if there is a trend in
financial performance. Established companies collect data from
the financial statements over a large number of reporting periods.
The trend obtained can be used to predict the direction of future
financial performance, and also identify any expected financial
turbulence that would not be possible to predict using ratios for a
single reporting period.
 
3. Operational efficiency
The management of a company can also use financial ratio
analysis to determine the degree of efficiency in the management
of assets and liabilities. Inefficient use of assets such as motor
vehicles, land, and building results in unnecessary expenses that
ought to be eliminated. Financial ratios can also help to determine
if the financial resources are over- or under-utilized.

Ratio Analysis Categories:

The various kinds of financial ratios available may be broadly
grouped into the following six silos, based on the sets of data they
provide:

1. Liquidity Ratios
Liquidity ratios measure a company's ability to pay off its short-
term debts as they become due, using the company's current or
quick assets. Liquidity ratios include the current ratio, quick ratio,
and working capital ratio.

2. Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a
company's debt levels with its assets, equity, and earnings, to
evaluate the likelihood of a company staying afloat over the long
haul, by paying off its long-term debt as well as the interest on its
debt. Examples of solvency ratios include: debt-equity ratios,
debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios
These ratios convey how well a company can generate profits
from its operations. Profit margin, return on assets, return on
equity, return on capital employed, and gross margin ratios are all
examples of profitability ratios.

4. Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how
efficiently a company uses its assets and liabilities to generate
sales and maximize profits. Key efficiency ratios include: turnover
ratio, inventory turnover, and days' sales in inventory.

5. Coverage Ratios
Coverage ratios measure a company's ability to make the
interest payments and other obligations associated with its debts.
Examples include the times interest earned ratio and the debt-
service coverage ratio.

6. Market Prospect Ratios

These are the most commonly used ratios in fundamental
analysis. They include dividend yield, P/E ratio, earnings per
share (EPS), and dividend payout ratio. Investors use these
metrics to predict earnings and future performance.

For example, if the average P/E ratio of all companies in the S&P
500 index is 20, and the majority of companies have P/Es
between 15 and 25, a stock with a P/E ratio of seven would be
considered undervalued. In contrast, one with a P/E ratio of 50
would be considered overvalued. The former may trend upwards
in the future, while the latter may trend downwards until each
aligns with its intrinsic value.
(EXPLANATION ABOUT THE CATEGORIES OF RATIOS IS
PLACED AT THE END OF THIS DOCUMENT)

4. Trend Analysis

Also known as the Pyramid Method. Studying the operational

results and financial position over a series of years is
trend analysis. Calculations of ratios of different items for various
periods is done & then compared under this analysis. Whether the
enterprise is trending upward or backward, the analysis of the
ratios over a period of years is done. By observing this analysis,
the sign of good or poor management is detected.

Steps to prepare trend analysis

1. Firstly, put the relevant absolute figures in the relevant columns.

2. Then, choose the base year which is mostly the first year and
put it as 100 in trend. Otherwise, the question will specify.

3. Find out the trend with the given formula:

Absolute Value/Base Year Value X 100

5. Cash Flow Analysis

The actual movement of cash into and out of a business is cash

flow analysis. The flow of cash into the business is called the cash
inflow. Similarly, the flow of cash out of the firm is called cash
outflow. The difference between the inflow and outflow of cash is
the net cash flow.
Cash flow statement is prepared to project the manner in which the
cash has been received and has been utilized during
an accounting year. It is an important analytical tool. Analysis of
cash flow explains the reason for a change in cash. It helps in
assessing the liquidity of the enterprise and in evaluating the
operating, investment & financing decisions.

FINANCIAL STATEMENT ANALYSIS PROCESS:

The process of Financial Statement Analysis Consists 3 major

Steps:

1. Reformulating Reported Financial Statements: Reformulating

reported financial statement is restating financial statement in
such a way that financial statements serve the purpose of
analysis better and allows to more efficiently and accurately
interpret the performance of the company. In case of income
statement reformulation takes form of dividing reported items into
recurring and non-recurring items, separating earnings into core
and transitory earnings. In case of balance sheet reformulation
takes form of breaking the balance sheet items into operating
assets/liabilities and financial asset/liabilities. For cash flow
statements removing financing activities(for example interest
expense) from cash flow from operations etc.

2. Adjustments of Measurement Errors: Adjustment of

measurement errors is done to remove the noise present in the
input data to enhance the quality of the reported accounting
numbers. For example removing the R&D expenses from the
income statement and showing in the balance sheet.

3. Financial Ratio Analysis on the Basis of Reformulated and

Adjusted Financial Statements: Conducting ratio analysis on the
adjusted financial statements involves calculating various ratios to
derive insight about the performance of a company.
ATTRIBUTES OF GOOD FINANCIAL STATEMENT ANALYSIS

 1. Objectivity: Results of financial statement analysis should

be analyzed objectively to reduce the possibility of any
behavioral bias to minimum.
 2. Precision and Brevity: Financial statement analysis should
done with precision and should provide relevant information
in concise form.
 3. Understandability: Information provided by financial
statement analysis should be presented in such a way that
the analysis fosters understandability.
 4. Relevance: Analysis of financial statement should be
relevant to the purpose of the analysis. Financial statements
used in analysis should be timely and should have a
predictive value.
 5. Reliability: The information derived from the analysis of
financial statement must be free of material error and bias
and should provide full and fair disclosure of the financial
performance and other relevant information.

USERS OF FINANCIAL STATEMENTS ANALYSIS

 1. Creditors: Creditors are concerned with the company’s

ability to pay interest and principal when due and are
concerned with the company’s cash flow ability.
 2. Shareholders: Shareholders provide company with the
much needed capital and are interested to know company’s
ability to pay dividend, and growth of dividends and
maximize shareholders wealth.
 3. Prospective Investors: Financial statement analysis is
used by the prospective investors to evaluate the
attractiveness of the investment in the business.
 4. Management: Management uses financial statement
analysis to analysis the efficiency of operations and make
 important business decisions. For example whether or not to
continue or discontinue part of its business, to make or buy
certain material, or to acquire or rent/lease certain
equipment.
 5. Regulatory Authorities: For publicly traded companies,
financial statements are analyzed to ensure compliance to
various rules and regulations.

1. LIQUIDITY RATIO

A liquidity ratio is a type of financial ratio used to determine a

company’s ability to pay its short-term debt obligations. The
metric helps determine if a company can use its current, or liquid,
assets to cover its current liabilities.
Three liquidity ratios are commonly used – the current ratio, quick
ratio, and cash ratio. In each of the liquidity ratios, the current
liabilities amount is placed in the denominator of the equation,
and the liquid assets amount is placed in the numerator.
Given the structure of the ratio, with assets on top and liabilities
on the bottom, ratios above 1.0 are sought after. A ratio of 1
means that a company can exactly pay off all its current liabilities
with its current assets. A ratio of less than 1 (e.g., 0.75) would
imply that a company is not able to satisfy its current liabilities.
A ratio greater than 1 (e.g., 2.0) would imply that a company is
able to satisfy its current bills. In fact, a ratio of 2.0 means that a
company can cover its current liabilities two times over. A ratio of
3.0 would mean they could cover their current liabilities three
times over, and so forth.
Types of Liquidity Ratios
 1. Current Ratio
Current Ratio = Current Assets / Current Liabilities
The current ratio is the simplest liquidity ratio to calculate and
interpret. Anyone can easily find the current assets and current
liabilities line items on a company’s balance sheet. Divide current
assets by current liabilities, and you will arrive at the current ratio.
2. Quick Ratio
Quick Ratio = (Cash + Accounts Receivables + Marketable
Securities) / Current Liabilities
The quick ratio is a stricter test of liquidity than the current ratio.
Both are similar in the sense that current assets is the numerator,
and current liabilities is the denominator.
However, the quick ratio only considers certain current assets. It
considers more liquid assets such as cash, accounts receivables,
and marketable securities. It leaves out current assets such as
inventory and prepaid expenses because the two are less liquid.
So, the quick ratio is more of a true test of a company’s ability to
cover its short-term obligations. 
3. Cash Ratio
Cash Ratio = (Cash + Marketable Securities) / Current
Liabilities
The cash ratio takes the test of liquidity even further. This ratio
only considers a company’s most liquid assets – cash and
marketable securities. They are the assets that are most readily
available to a company to pay short-term obligations.
In terms of how strict the tests of liquidity are, you can view the
current ratio, quick ratio, and cash ratio as easy, medium, and
hard.
Important Notes
Since the three ratios vary by what is used in the numerator of the
equation, an acceptable ratio will differ between the three. It is
logical because the cash ratio only considers cash
and marketable securities in the numerator, whereas the current
ratio considers all current assets.
Therefore, an acceptable current ratio will be higher than an
acceptable quick ratio. Both will be higher than an acceptable
cash ratio. For example, a company may have a current ratio of
3.9, a quick ratio of 1.9, and a cash ratio of 0.94. All three may be
considered healthy by analysts and investors, depending on the
company.
 
Importance of Liquidity Ratios
 1. Determine the ability to cover short-term obligations
Liquidity ratios are important to investors and creditors to
determine if a company can cover their short-term obligations,
and to what degree. A ratio of 1 is better than a ratio of less than
1, but it isn’t ideal.
Creditors and investors like to see higher liquidity ratios, such as
2 or 3. The higher the ratio is, the more likely a company is able to
pay its short-term bills. A ratio of less than 1 means the company
faces a negative working capital and can be experiencing a
liquidity crisis.
2. Determine creditworthiness
Creditors analyze liquidity ratios when deciding whether or not
they should extend credit to a company. They want to be sure that
the company they lend to has the ability to pay them back. Any
hint of financial instability may disqualify a company from
obtaining loans.
 3. Determine investment worthiness
For investors, they will analyze a company using liquidity ratios to
ensure that a company is financially healthy and worthy of their
investment. Working capital issues will put restraints on the rest of
the business as well. A company needs to be able to pay its
short-term bills with some leeway.
Low liquidity ratios raise a red flag, but “the higher, the better” is
only true to a certain extent. At some point, investors will question
why a company’s liquidity ratios are so high. Yes, a company with
a liquidity ratio of 8.5 will be able to confidently pay its short-term
bills, but investors may deem such a ratio excessive. An
abnormally high ratio means the company holds a large amount
of liquid assets.
For example, if a company’s cash ratio was 8.5, investors and
analysts may consider that too high. The company holds too
much cash on hand, which isn’t earning anything more than the
interest the bank offers to hold their cash. It can be argued that
the company should allocate the cash amount towards other
initiatives and investments that can achieve a higher return.
With liquidity ratios, there is a balance between a company being
able to safely cover their bills and improper capital allocation.
Capital should be allocated in the best way to increase the value
of the firm for shareholders.

2. LEVERAGE RATIO:
Leverage ratios are used in determining the amount of debt loan
the business has taken on the assets or equity of the business, a
high ratio indicates that the company has taken a large amount of
debt than its capacity and that they will not be able to service the
obligations with the on-going cash flows. It includes analysis of
debt to equity, debt to capital, debt to assets and debt to EBITDA.

#1 – Debt Equity Ratio

The most common leverage ratio is the debt-equity ratio. Through

this ratio, we get an idea about the capital structure of the
company.

Debt Equity Ratio Formula

The formula of this ratio is as follows –

Debt Equity Ratio Formula = Total Debt / Total Equity

 Debt Equity Ratio Interpretation – 

Debt Equity ratio helps us see the proportion of debt and equity in
the capital structure of the company. For example, if a company is
too dependent on debt, then the company is too risky to invest in.
On the other hand, if a company doesn’t take debt at all, it may
lose out on the leverage.

Debt Equity Ratio Practical example

Company Zing has a total equity of $300,000 and total debt of

$60,000. Find out the debt-equity leverage ratio of the company.

This is a simple example.

 Debt Equity Ratio = Total Debt / Total Equity

 Or, Debt Equity Ratio = $60,000 / $300,000 = 1/5 = 0.2

That means the debt is not quite high in Company Zing’s capital
structure. That means it may have a solid cash-inflow. After
looking into other ratios and the financial statements, an
investor can invest in this company.

#2 – Debt Capital Ratio

This leverage ratio calculation is the extension of the previous

ratio. Instead of doing a comparison between debt and equity, this
ratio would help us see at capital structure holistically.

Debt Capital Ratio Formula

The formula of this ratio is as follows –

Debt Capital Ratio Formula = Total Debt / (Total Equity +

Total Debt)
 Debt Capital Ratio Interpretation 

This leverage ratio will help us understand the exact proportion of

debt in the capital structure. Through this ratio, we will get to know
whether a company has taken a higher risk of feeding its capital
with more loans or not.

Debt Capital Ratio example

Company Tree’s capital structure consists of both equity and

debt. Its equity is $400,000 and the debt is $100,000. Calculate
the debt capital leverage ratio of Company Tree.

Let’s use the formula to find out the ratio.

 Total debt = $100,000

 Total equity = $400,000
 Total Capital = ($100,000 + $400,000) = $500,000

Putting the values in the formula, we get –

 Debt Capital Ratio = Total Debt / (Total Equity + Total Debt)

 Or, Debt Capital Ratio = $100,000 / $500,000 = 0.2

That means the debt is just 20% of the total capital of Company
Tree. From the figure, we get that it’s a high equity company and
low debt company.

#3 – Debt-Assets Ratio

How much debt a company takes to source its assets would be

known by the debt-assets ratio. This leverage ratio can be an eye-
opener for many investors.
 Debt Asset Ratio Formula

The formula of this ratio is as follows –

Debt-Assets Ratio Formula = Total Debt / Total Assets

Debt Asset Ratio Interpretation

This leverage ratio talks about how much assets can be sourced
through debt. In other words, if assets are more than debt (in the
ratio), that means it’s rightly leveraged. But if the assets are less
than debt, then the firm needs to look at the utilization of its
capital.

Debt Asset Ratio Example

Company High has total assets of $500,000 and total debt of

$100,000. Find out the debt-assets leverage ratio.

Let’s put in the figures in the ratio –

 Debt-Assets Ratio = Total Debt / Total Assets Or, Debt-Assets

Ratio = $100,000 / $500,000 = 0.2.

That means Company High has more assets than the loans which
are quite a good signal.

#4 – Debt EBITDA Ratio

This leverage ratio is the ultimate ratio that finds out how much
impact debt has on the earnings of a company. You may ask
why? Because, here we’re talking about EBITDA, i.e. earnings
before interests, taxes, depreciation, and amortization. And since
 a company needs to pay interests (cost of debt), this ratio will
have a huge impact on the company’s earnings.

Debt EBITDA Formula

The formula of this ratio is as follows –

Debt EBITDA Ratio Formula = Total Debt / EBITDA

Debt EBITDA Interpretation

The reason this ratio is important is that if we know how much

debt the company has, compared to how much the company
earns before paying out the interests; we would know how debt
can affect the earnings of the company. For example, if the debt
is more, the interests would be more (possibly, if the cost of debt
is higher) and as a result, the taxes would be less and vice versa.

Debt EBITDA example

Company Y has a debt of $300,000 and in the same year, it

reported an EBITDA of $60,000. Find out the Debt EBITDA
leverage ratio.

Let’s put in the figure to find out the ratio.

 Debt EBITDA Ratio = Total Debt / EBITDA

 Or, Debt EBITDA Ratio = $300,000 / $60,000 = 5.0

If this ratio scores higher, it means that debt is higher than the
earnings and if this ratio scores lower, debt is relatively lower
compared to earnings (it’s a great thing).
Why do you need to look at leverage ratios?

As investors, you need to look at everything. Leverage ratios will

help you how a company has structured its capital.

Many companies don’t like to take loans from outside. They

believe that they should fund all their expansion or new projects
through equity.

But to take advantage of leverage, it’s important to structure the

capital with a portion of the debt. It helps reduce the cost of
capital (by reducing the cost of equity, it is huge). Plus, it also
helps in paying less tax since the taxes are calculated after
paying the interests (i.e. the cost of debt).
As investors, you need to look at companies and calculate the
above ratios. You would get clarity about the company is able to
take advantage of the leverage or not. If the company has taken
too much debt, it’s too risky to invest in the company. At the same
time, if a company doesn’t have any debt, it may pay off too much
in cost of capital and actually reduce their earnings in the long
run.

But only leverage ratios won’t help. You need to look at all the
financial statements (especially four – cash flow
statement, income statement, balance sheet,
and shareholders’ equity statement) and all other ratios to get a
concrete idea about how a company is doing. However, it surely
does help investors in deciding whether a company is taking
advantage of the leverage or not.

3. SOLVENCY RATIO

Solvency ratios are primarily used to measure a company's ability

to meet its long-term obligations. In general, a solvency
ratio measures the size of a company's profitability and compares
it to its obligations.

By interpreting a solvency ratio, an analyst or investor can gain

insight into how likely a company will be to continue meeting its
debt obligations. A stronger or higher ratio indicates financial
strength. In stark contrast, a lower ratio, or one on the weak side,
could indicate financial struggles in the future.

A primary solvency ratio is usually calculated as follows and

measures a firm's cash-based profitability as a percentage of its
total long-term obligations.

Solvency ratios indicate a company's financial health in the

context of its debt obligations. As you might imagine, there are a
number of different ways to measure financial health.

1. Debt-to-Equity (D/E) Ratio

Often abbreviated as D/E, the debt-to-equity ratio establishes a

company’s total debts relative to its equity. To calculate the ratio,
first, get the sum of its debts. Divide the outcome by the
company’s total equity.  This is used to measure the degree to
which a company is using debt to fund operations (leverage).

2. Interest Coverage Ratio

With the interest coverage ratio, we can determine the number of

times that a company’s profits can be used to pay interest
charges on its debts. To calculate the figure, divide the company’s
profits (before subtracting any interests and taxes) by its interest
payments.
The higher the value, the more solvent the company. In other
words, it means the day-to-day operations are yielding enough
profit to meet its interest payments.

3. Debt-to-Capital Ratio

As implied in the name, the debt-to-capital ratio determines the

proportion of a business’  total capital that is financed using debt.
For example, if a company’s debt-to-capital ratio is 0.45, it means
45% of its capital comes from debt. In such a case, a lower ratio
is preferred, as it implies that the company can pay for capital
without relying so much on debt.

Limitation of the Solvency Ratio

Although the solvency ratio is a useful measure, there is one area

where it falls short. It does not factor in a company’s ability to
acquire new funding sources in the long term, such as funds from
stock or bonds. For such a reason, it should be used alongside
other types of analysis to provide a comprehensive overview of a
business’ solvency.

How to Calculate the Solvency Ratio

As explained later, there are a couple of other ways to determine

a company’s solvency, but the main formula for calculating the
solvency ratio is as follows:

Solvency Ratio = (Net Income + Depreciation) / All Liabilities

(Short-term + Long-term Liabilities)

 
If you examine keenly, you will notice that the numerator
comprises the entity’s current cash flow, while the denominator is
made up of its liabilities. Thus, it is safe to conclude that the
solvency ratio determines whether a company’s cash flow is
adequate to pay its total liabilities.

Solvency vs. Liquidity Ratios

The solvency ratio measures a company's ability to meet its long-
term obligations as the formula above indicates. Liquidity
ratios measure short-term financial health. The current
ratio and quick ratio measure a company's ability to cover short-
term liabilities with liquid (maturities of a year or less) assets.
These include cash and cash equivalents, marketable securities,
and accounts receivable.

The short-term debt figures include payables or inventories that

need to be paid for. Basically, solvency ratios look at long-term
debt obligations while liquidity ratios look at working capital
items on a firm’s balance sheet. In liquidity ratios, assets are part
of the numerator and liabilities are in the denominator.

What These Ratios Tell an Investor

Solvency ratios are different for different firms in different
industries. For instance, food and beverage firms, as well as
other consumer staples, can generally sustain higher debt
loads given their profit levels are less susceptible to economic
fluctuations.

In stark contrast, cyclical firms must be more

conservative because a recession can hamper their profitability
and leave less cushion to cover debt repayments and related
interest expenses during a downturn. Financial firms are subject
to varying state and national regulations that stipulate solvency
ratios. Falling below certain thresholds could bring the wrath of
regulators and untimely requests to raise capital and shore up low
ratios.

Acceptable solvency ratios vary from industry to industry, but as a

general rule of thumb, a solvency ratio of greater than 20% is
considered financially healthy. The lower a company's solvency
ratio, the greater the probability that the company will default on
its debt obligations.

Looking at some of the ratios mentioned above, a debt-to-assets

ratio above 50% could be cause for concern. A debt-to-equity
ratio above 66% is cause for further investigation, especially for a
firm that operates in a cyclical industry. A lower ratio is better
when debt is in the numerator, and a higher ratio is better when
assets are part of the numerator. Overall, a higher level of assets,
or of profitability compared to debt, is a good thing.

4. PROFIBILITY RATIOS :

Profitability ratios are a class of financial metrics that are used to

assess a business's ability to generate earnings relative to its
revenue, operating costs, balance sheet assets, or shareholders'
equity over time, using data from a specific point in time.

Profitability ratios can be compared with efficiency ratios, which

consider how well a company uses its assets internally to
generate income (as opposed to after-cost profits).

What Do Profitability Ratios Tell You?

For most profitability ratios, having a higher value relative to a
competitor's ratio or relative to the same ratio from a previous
period indicates that the company is doing well. Profitability ratios
are most useful when compared to similar companies, the
company's own history, or average ratios for the company's
industry.
Gross profit margin is one of the most widely used profitability or
margin ratios. Gross profit is the difference between revenue and
the costs of production—called cost of goods sold (COGS).

Some industries experience seasonality in their operations. For

example, retailers typically experience significantly higher
revenues and earnings during the year-end holiday season. Thus,
it would not be useful to compare a retailer's fourth-quarter gross
profit margin with its first-quarter gross profit margin because they
are not directly comparable. Comparing a retailer's fourth-quarter
profit margin with its fourth-quarter profit margin from the previous
year would be far more informative.

Examples of Profitability Ratios

Profitability ratios are one of the most popular metrics used
in financial analysis, and they generally fall into two categories—
margin ratios and return ratios.

Margin ratios give insight, from several different angles, on a

company's ability to turn sales into a profit. Return ratios offer
several different ways to examine how well a company generates
a return for its shareholders.

Some common examples of profitability ratios are the various

measures of profit margin, return on assets (ROA), and return on
equity (ROE). Others include return on invested capital (ROIC)
and return on capital employed (ROCE).
Margin Ratios

1.Gross Profit Margin

The gross profit margin calculates the cost of goods sold as a

percent of sales—both numbers can be found on the income
statement. This ratio looks at how well a company controls the
cost of its inventory and the manufacturing of its products and
subsequently passes on the costs to its customers. The larger the
gross profit margin, the better for the company.

Calculate gross profit margin by first subtracting the cost of goods

sold from sales. If sales are $100 and the cost of goods sold is
$60, the gross profit is $40. Then divide gross profit by sales
which would be: $40 / $100 = 40%. The gross profit margin, which
is the amount of sales revenue that can be devoted to utilities,
inventory, and manufacturing costs is 40% of sales.

GROSSPROFIT/SALES
2.Operating Profit Margin

The operating profit is usually called earnings before interest and

taxes or EBIT on a business's income statement. The operating
profit margin is EBIT as a percentage of sales. It is a measure of
a company's overall operating efficiency. It differs from the gross
profit margin by further subtracting out the expenses of ordinary,
daily business activity from sales.

The operating profit margin is calculated using this formula: EBIT /

Sales. If EBIT is $20 and sales are $100, then the operating profit
margin is 20%. Both terms of the equation come from the
company's income statement.

EARNINGS BEFORE INTRESTS AND TAXES/SALES

3.Net Profit Margin

When doing a simple profitability ratio analysis, the net profit

margin is the most often margin ratio used. The net profit margin
shows how much of each sales dollar remains as net income after
all expenses are paid. For example, if the net profit margin is 5%,
that means that 5 cents of every dollar of sales made are profit.
The net profit margin measures profitability after consideration of
all expenses including taxes, interest, and depreciation. The
calculation is: Net Income / Net Sales =_%. 

Both terms of the equation come from the income statement.

NETINCOME/SALES
4.Cash Flow Margin

The cash flow margin ratio is an important ratio as it expresses

the relationship between cash generated from operations and
sales. The company needs cash to pay dividends,
suppliers, service debt, and invest in new capital assets, so cash
is just as important as profit to a business firm. The Cash Flow
Margin ratio measures the ability of a firm to translate sales into
cash. The calculation is Cash From Operating Cash Flows / Net
Sales = _%. The numerator of the equation comes from the
firm's Statement of Cash Flows. The denominator comes from the
Income Statement.

CASH FLOE FROM OPERATING CASH FLOWS/NET

SALES
Return Ratios

1.Return on Assets

The return on assets ratio is an important profitability ratio

because it measures the efficiency with which the company is
managing its investment in assets and using them to generate
profit. It measures the amount of profit earned relative to the firm's
level of investment in total assets. The return on assets ratio is
related to the asset management category of financial ratios.

The calculation for the return on assets ratio is: Net Income / Total
Assets = _%. Net income is taken from the income statement,
and total assets are taken from the balance sheet. The higher the
percentage, the better, because that means the company is doing
a good job using its assets to generate sales.

NET INCOME/TOTAL ASSETS

2.Return on Equity

The return on equity ratio is perhaps the most important of all the
financial ratios to a publicly-held company's investors. It
measures the return on the money the investors have put into the
company. It is the ratio potential investors look at when deciding
whether or not to invest in the company. The calculation is Net
Income / Stockholders Equity = _%. Net income comes from the
income statement, and stockholder's equity comes from the
balance sheet. In general, the higher the percentage, the better,
with some exceptions, as it shows that the company is doing a
good job using the investors' money.

NET INCOME/ SHAREHOLDERS EQUITY

3.Cash Return on Assets

The cash return on assets ratio is generally used only in more

advanced profitability ratio analysis. It is used as a cash
comparison to return on assets since the return on assets is
stated on an accrual basis. Cash is required for future
investments. The calculation is Cash Flow From Operating
Activities / Total Assets = _%. The numerator is taken from the
Statement of Cash Flows and the denominator from the balance
sheet. The higher the percentage, the better.

CASH FLOW FROM OPERATING ACTIVITIES/TOTAL

ASSETS