TT 8751 FINANCIAL MANAGEMENT TEXTILE INDUSTRIES

Unit 4
Financial analysis

Financial analysis is the process of evaluating businesses, projects,

budgets, and other finance-related transactions to determine their
performance and suitability. Typically, financial analysis is used to
analyze whether an entity is stable, solvent, liquid, or profitable enough
to warrant a monetary investment.

 If conducted internally, financial analysis can help managers make

future business decisions or review historical trends for past
successes.
 If conducted externally, financial analysis can help investors
choose the best possible investment opportunities.
 Fundamental analysis and technical analysis are the two main
types of financial analysis.
 Fundamental analysis uses ratios and financial statement data to
determine the intrinsic value of a security.
 Technical analysis assumes a security's value is already
determined by its price, and it focuses instead on trends in value
over time.

Financial analysis is used to evaluate economic trends, set financial

policy, build long-term plans for business activity, and identify projects or
companies for investment. This is done through the synthesis of financial
numbers and data. A financial analyst will thoroughly examine a
company's financial statements—the income statement, balance sheet,
and cash flow statement. Financial analysis can be conducted in both
corporate finance and investment finance settings.

One of the most common ways to analyze financial data is to

calculate ratios from the data in the financial statements to
compare against those of other companies or against the
company's own historical performance.

For example, return on assets (ROA) is a common ratio used to

determine how efficient a company is at using its assets and as a
measure of profitability. This ratio could be calculated for several
companies in the same industry and compared to one another as
part of a larger analysis.
Corporate Financial Analysis
In corporate finance, the analysis is conducted internally by the
accounting department and shared with management in order to
improve business decision making. This type of internal analysis
may include ratios such as net present value (NPV) and internal
rate of return (IRR) to find projects worth executing.

Many companies extend credit to their customers. As a result, the

cash receipt from sales may be delayed for a period of time. For
companies with large receivable balances, it is useful to track days
sales outstanding (DSO), which helps the company identify the
length of time it takes to turn a credit sale into cash. The average
collection period is an important aspect of a company's
overall cash conversion cycle.

A key area of corporate financial analysis involves extrapolating a

company's past performance, such as net earnings or profit
margin, into an estimate of the company's future performance. This
type of historical trend analysis is beneficial to identify seasonal
trends.

For example, retailers may see a drastic upswing in sales in the

few months leading up to Christmas. This allows the business to
forecast budgets and make decisions, such as necessary
minimum inventory levels, based on past trends.

Investment Financial Analysis

In investment finance, an analyst external to the company
conducts an analysis for investment purposes. Analysts can either
conduct a top-down or bottom-up investment approach. A top-
down approach first looks for macroeconomic opportunities, such
as high-performing sectors, and then drills down to find the best
companies within that sector. From this point, they further analyze
the stocks of specific companies to choose potentially successful
ones as investments by looking last at a particular
company's fundamentals.

A bottom-up approach, on the other hand, looks at a specific

company and conducts a similar ratio analysis to the ones used in
corporate financial analysis, looking at past performance and
expected future performance as investment indicators. Bottom-up
investing forces investors to consider microeconomic factors first
and foremost. These factors include a company's overall financial
health, analysis of financial statements, the products and services
 offered, supply and demand, and other individual indicators of
corporate performance over time.

Types of Financial Analysis

There are two types of financial analysis: fundamental
analysis and technical analysis.

Fundamental Analysis
Fundamental analysis uses ratios gathered from data within the
financial statements, such as a company's earnings per
share (EPS), in order to determine the business's value. Using
ratio analysis in addition to a thorough review of economic and
financial situations surrounding the company, the analyst is able to
arrive at an intrinsic value for the security. The end goal is to arrive
at a number that an investor can compare with a security's current
price in order to see whether the security is undervalued or
overvalued.

Technical Analysis
Technical analysis uses statistical trends gathered from trading
activity, such as moving averages (MA). Essentially, technical
analysis assumes that a security’s price already reflects all publicly
available information and instead focuses on the statistical
analysis of price movements. Technical analysis attempts to
understand the market sentiment behind price trends by looking for
patterns and trends rather than analyzing a security’s fundamental
attributes

Financial analysis is the examination of financial information to reach

business decisions. This analysis typically involves an examination of
both historical and projected profitability, cash flows, and risk. It may
result in the reallocation of resources to or from a business or a
specific internal operation. This type of analysis applies particularly
well to the following situations:

 Investment decisions by external investor. In this situation, a financial

analyst or investor reviews the financial statements and
accompanying disclosures of a company to see if it is worthwhile to
invest in or lend money to the entity. This typically involves ratio
analysis to see if the organization is sufficiently liquid and generates a
sufficient amount of cash flow. It may also involve combining the
information in the financial statements for multiple periods to derive
 trend lines that can be used to extrapolate financial results into the
future.

 Investment decisions by internal investor. In this situation, an internal

analyst reviews the projected cash flows and other information related
to a prospective investment (usually for a fixed asset). The intent is to
see if the expected cash outflows from the project will generate a
sufficient return on investment. This examination can also focus on
whether to rent, lease, or purchase an asset.
The key source of information for financial analysis is the financial
statements of a business. The financial analyst uses these documents
to derive ratios, create trend lines, and conduct comparisons against
similar information for comparable firms.

The outcome of financial analysis may be any of these decisions:

 Whether to invest in a business, and at what price per share.
 Whether to lend money to a business, and if so, what terms to offer.
 Whether to invest internally in an asset or working capital, and how to
finance it.

Financial analysis is one of the key tools needed by the managers of

a business to examine how their organization is performing. For this
reason, they are constantly querying the financial analyst about the
profitability, cash flows, and other financial aspects of their business.
Tools for Financial analysis

1. Comparative Statement or Comparative Financial and Operating

Statements.
2. Common Size Statements.
3. Trend Ratios or Trend Analysis.
4. Average Analysis.
5. Statement of Changes in Working Capital.
6. Fund Flow Analysis.
7. Cash Flow Analysis.
8. Ratio Analysis.
9. Cost Volume Profit Analysis

A brief explanation of the tools or techniques of financial statement

analysis presented below.
1. Comparative Statements
Comparative statements deal with the comparison of different items of
the Profit and Loss Account and Balance Sheets of two or more periods.
Separate comparative statements are prepared for Profit and Loss
Account as Comparative Income Statement and for Balance Sheets.
As a rule, any financial statement can be presented in the form of
comparative statement such as comparative balance sheet, comparative
profit and loss account, comparative cost of production statement,
comparative statement of working capital and the like.
2. Comparative Income Statement
Three important information are obtained from the Comparative Income
Statement. They are Gross Profit, Operating Profit and Net Profit. The
changes or the improvement in the profitability of the business concern
is find out over a period of time. If the changes or improvement is not
satisfactory, the management can find out the reasons for it and some
corrective action can be taken.
3. Comparative Balance Sheet
The financial condition of the business concern can be find out by
preparing comparative balance sheet. The various items of Balance
sheet for two different periods are used. The assets are classified as
current assets and fixed assets for comparison. Likewise, the liabilities
are classified as current liabilities, long term liabilities and shareholders’
net worth. The term shareholders’ net worth includes Equity Share
Capital, Preference Share Capital, Reserves and Surplus and the like.
4. Common Size Statements
A vertical presentation of financial information is followed for preparing
common-size statements. Besides, the rupee value of financial
statement contents are not taken into consideration. But, only
percentage is considered for preparing common size statement.
The total assets or total liabilities or sales is taken as 100 and the
balance items are compared to the total assets, total liabilities or sales in
terms of percentage. Thus, a common size statement shows the relation
of each component to the whole. Separate common size statement is
prepared for profit and loss account as Common Size Income Statement
and for balance sheet as Common Size Balance Sheet.
5. Trend Analysis
The ratios of different items for various periods are find out and then
compared under this analysis. The analysis of the ratios over a period of
years gives an idea of whether the business concern is trending upward
or downward. This analysis is otherwise called as Pyramid Method.
6. Average Analysis
Whenever, the trend ratios are calculated for a business concern, such
ratios are compared with industry average. These both trends can be
presented on the graph paper also in the shape of curves. This
presentation of facts in the shape of pictures makes the analysis and
comparison more comprehensive and impressive.
7. Statement of Changes in Working Capital
The extent of increase or decrease of working capital is identified by
preparing the statement of changes in working capital. The amount of
net working capital is calculated by subtracting the sum of current
liabilities from the sum of current assets. It does not detail the reasons
for changes in working capital.
8. Fund Flow Analysis
Fund flow analysis deals with detailed sources and application of funds
of the business concern for a specific period. It indicates where funds
come from and how they are used during the period under review. It
highlights the changes in the financial structure of the company.
9. Cash Flow Analysis
Cash flow analysis is based on the movement of cash and bank
balances. In other words, the movement of cash instead of movement of
working capital would be considered in the cash flow analysis. There are
two types of cash flows. They are actual cash flows and notional cash
flows.
10. Ratio Analysis
Ratio analysis is an attempt of developing meaningful relationship
between individual items (or group of items) in the balance sheet or profit
and loss account. Ratio analysis is not only useful to internal parties of
business concern but also useful to external parties. Ratio analysis
highlights the liquidity, solvency, profitability and capital gearing.
11. Cost Volume Profit Analysis
This analysis discloses the prevailing relationship among sales, cost and
profit. The cost is divided into two. They are fixed cost and variable cost.
There is a constant relationship between sales and variable cost. Cost
analysis enables the management for better profit planning.
Financial Control
Financial controls are the procedures, policies, and means by which
an organization monitors and controls the direction, allocation, and
usage of its financial resources. Financial controls are at the very core of
resource management and operational efficiency in any organization.
 
Required Processes
The implementation of effective financial control policies should be done
after a thorough analysis of the existing policies and future outlook of a
company. In addition, it is important to ensure the following four
processes are completed before implementing financial control in a
business:
 
1. Detecting overlaps and anomalies
Financial budgets, financial reports, profit & loss statements, balance
sheets, etc. present the overall performance and/or operational picture of
a business. Hence, while formulating financial control policies, it is very
important to detect any overlaps and/or anomalies arising out of the data
available. It helps in detecting any existing loopholes in the current
management framework and eliminating them.
 
2. Timely updating
Financial control is the essence of resource management and, hence,
the overall operational efficiency and profitability of a business. Timely
updates of all available data are very important. In addition, updating all
management practices and policies concerning the existing financial
control methods is also equally important.
 
3. Analyzing all possible operational scenarios
Before implementing a fixed financial control strategy in an organization,
it is important to thoroughly evaluate all possible operational scenarios.
Viewing the policies from the perspectives of different operational
scenarios – such as profitability, expenditures, safety, and scale of
production or volume – can provide the necessary information. Also, it
helps establish an effective financial control policy that covers all
operational aspects of the organization.
 
4. Forecasting and making projections
While implementing a financial control policy, forecasting and making
projections are very important steps. They provide an insight into the
future goals and objectives of the business. In addition, they can help
establish a financial control policy in accordance with the business
objectives and act as a catalyst in achieving such goals.
 
Importance of Financial Controls
 
1. Cash flow maintenance
Efficient financial control measures contribute significantly to the cash
flow maintenance of an organization. When an effective control
mechanism is in place, the overall cash inflows and outflows are
monitored and planned, which results in efficient operations.
 
2. Resource management
The financial resources of an organization are at the very core of any
organization’s operational efficiency. Financial resources make available
all other resources needed for operating a business. Hence, financial
resource management crucial in order to manage all other resources.
Effective financial control measures hence are crucial to ensure resource
management in an organization.
 
3. Operational efficiency
An effective financial control mechanism ensures overall operational
efficiency in an organization.
 
4. Profitability
Ensuring an organization’s overall operational efficiency leads to the
smooth functioning of every organizational department. It, in turn,
increases productivity. which comes with a direct, positive relationship
with profitability. Hence, establishing effective financial control measures
ensures improved profitability of any business.
 
5. Fraud prevention
Financial control serves as a preventative measure against fraudulent
activities in an organization. It can help prevent any undesirable activities
such as employee fraud, online theft, and many others by monitoring the
inflow and outflow of financial resources.
 
Examples of Financial Controls
 
1. Overall financial management and implementation
 Placing certain qualification restrictions and employing only
certified, qualified financial managers and staff working with the
formulation and implementation of financial management policies
 Establishing an efficient, direct chain of communication among the
accounting staff, financial managers, and senior-level managers,
including the CFO
 Periodic training sessions and information sessions among
accounting staff, etc. to ensure being updated with the changing
laws and evolving business environment concerning business
finance
 Periodic, thorough financial analysis and evaluation of financial
ratios and statements wherever fluctuations are significant
 Delegation of financial duties in a segregated and hierarchical
fashion in order to establish a chain of operation and efficiency via
specialization
 
2. Cash inflows
 Stringent credit reporting policy for all customers before entering
into a creditor-debtor relationship with them
 Periodic reconciliation of bank statements to the general ledger in
addition to annual reporting for more efficient financial control
 Establishing a periodic review policy with all existing customers
that the business establishes a creditor-debtor relationship with. It
ensures the ongoing creditworthiness of customers and eliminates
the probability of bad debts
 Support files and backups for all financial data in a separate
secured database with access only permitted to senior
management staff
 
3. Cash outflows
 Automatic/subscription payments to be monitored and requiring
proper authorization in order to control extravagant business
expenditure
  Maintaining a vendor database with detailed purchase records with
restricted access in order to monitor cash outflow efficiently
 Periodic reconciliation of bank statements to the general ledger
 Clear and precise expense reimbursement policy to be maintained,
including detailed expense reports and receipt verifications in order
to curb extravagant business expenses and employee fraud
 

Analysis and Control of Profit/Loss Account

The profit and loss statement (AKA P&L) is one of the main financial
statements that businesses produce. Get a better understanding of your
financial position with this guide to analyzing your business’ P&L
statement.
What is a Profit and Loss (P&L) Statement?
Simply put, a profit and loss statement shows whether a business is
profitable or not. According to Investopedia, “a profit and loss statement
is a financial statement that summarizes the revenues, costs and
expenses incurred during a specific period of time, usually a fiscal
quarter or year.”
A profit and loss statement can go by many names such as a P&L,
income statement, earnings statement, revenue statement, operating
statement, statement of operations, and statement of financial
performance.
Cash vs. Accrual Basis
One important thing to know before you get started analyzing your P&L
is whether you are on a cash basis or accrual basis of accounting.
With a cash basis, revenue and expenses are recognized when there’s
movement of cash (for example, if I agree to pay a vendor $50 for a
service in a month, I don’t account for that until the $50 leaves my bank).
The accrual method accounts for revenue when it is earned (before the
money reaches the bank) and expenses when they are incurred (but
before the vendors have been paid).
Analyzing a P&L Statement
So now that you know what a P&L is and all of its different names, how
do you analyze it? Let’s start with a simple example:
Above you will see an example of a simple profit and loss statement.
Many people get overwhelmed by the numbers, but a few quick tips and
tricks on where to look and why will have you feeling confident and
analyzing statements like a pro.
Below are a list of some of the easiest yet effective things to analyze in
your profit and loss statement:
1. Sales
This may seem obvious, but you should review your sales first since
increased sales is generally the best way to improve profitability. If you
see a month was particularly good, try to remember why so you can
duplicate what you did in the future.
In this example, we see that June was the best month in terms of sales,
gross profit, net income, and profit margin. Upon review of the other
numbers, we see that this could’ve been due to seasonality (see more
below) and/or an increased marketing expense.

2. Sources of Income or Sales

Another factor related to sales that you should analyze are your sources
of income.
Ask yourself if all of your sources of income make sense and are
profitable for your business. Are any of them overly time consuming with
very low margins? In this example, our sources of income include selling
lemonade and chips. Neither of these are negatively impacting our
business so we’ll keep them, but if the chips weren’t selling we may
eliminate them or change the type.
3. Seasonality
Seasonality is simply the fact that things change based on the season.
Seasonality can be seen in many parts of a business including but not
limited to both sales and expenses.
In this example, we see seasonality in sales. As the summer months
approach and the temperatures rise so do the sales. This example does
not show seasonality in expenses, but if it were to show up it could be in
increased prices of lemons because of heightened demand and lower
production in the summer months. We could also see seasonality in
decreased cost of lemons in the fall and winter quarters due to increased
production of lemons and lower demand.
4. Cost of Goods Sold
Next you should review your cost of goods sold. It would make sense for
cost of goods sold to go up as revenue goes up since these expenses
are directly related to your product. The opposite would not make sense
and should be a red flag.
Additionally, when you review cost of goods sold you can ask yourself
questions like, “Is there any way I can reduce these expenses?” Finding
ways to decrease your cost of goods sold will ultimately increase your
bottom line and profit margin.
In this example, the business owner may want to consider purchasing
items that won’t go bad (chips, cups, and sugar) in bulk to reduce my
cost throughout the year and increase my yearly profit margin.
5. Net Income
Net income is your profit and is one of the most important parts of your
business if you want it to succeed and be sustainable over time.
You want to see your profit positive (also known as “in the black”) in
most cases. Some exceptions where it’s acceptable to see a loss is
when the company made a strategic investment during one period to
decrease costs or increase sales in a later period. For example, in our
lemonade stand example, the business owner could’ve decided to
purchase chips, sugar and cups in bulk for the entire year in the month
of April. If this was done it could bring the company into a loss for the
month, but that expense would be recouped with savings and higher
margins throughout the rest of the year.
6. Net Income as a Percentage of Sales (also known a profit margin)
Net income is simply your bottom line, but it’s important to do a quick
calculation to determine your net income percentage so that you create
a baseline and compare “apples to apples” across time periods and
across other companies in your industry.
To determine net income as a percentage of sales simply divide net
income by net revenue then multiple your result by 100. It may sound
complicated, but let’s use the lemonade stand as an example. Take
$206.07 (net income in April) and divide it by $416 (total sales in April) to
get 0.4954. Once you multiple that number by 100 you get 49.54%.
Once you have your net income as a percentage of sales figured out for
each period you can use that information to assess if your profit margins
are going up (usually a good thing), going down (usually a bad thing), or
staying the same.
Additionally, once you have your profit margin figured out you can use
this data to compare your profit margin to other companies in your
industry. To compare your profit margin to others in your industry simply
try a google search to find that data, or review a profit and loss
statement (and do the calculation discussed above) for a public
company in your industry since they publish their financial statements..
Company XYZ ltd is in the textile industry, which is manufacturing
and selling the different readymade garments in the market. The
company has the policy to prepare Profit and Loss Statement every
month and then after the end of the financial year, one profit and
loss statement for the whole year.

During the month of June-2019 Company has generated revenue

by selling the garments of $ 100,000, when the cost of goods sold
was $ 60,000. Along with this, the Company generates income from
selling the waste material left after making the garments worth $
9,000 and an interest income of $ 4,000.

On the expense side, during the month company incurs expenditure

on rent of premises of $ 5,500, wages to factory workers of $
15,000, an annual depreciation charge of $ 7,700, utility expense of
$ 9,000.
Prepare the Profit and Loss Statement for the month ending on
June 31, 2019, for the company.

Statement of the Profit and Loss Account

Thus during the month, the company generated a net income of
$15,800 for the month ending on June 31, 2019. The above Profit
and Loss Statement for the company XYZ ltd is prepared using the
Single-step Profit and Loss Statement approach, where all the
expenses are listed in the statement in major the single broad
category without the further division of the categories into the
subcategories. It is simple and easy to make as a further division of
the categories is not required, which saves time as well.

Balance Sheet

Fundamental analysts, when valuing a company or considering an

investment opportunity, normally start by examining the balance sheet.
This is because the balance sheet is a snapshot of a
company's assets and liabilities at a single point in time, not spread over
the course of a year such as with the income statement.

The balance sheet contains a lot of important information, some of which

are more important to focus on to get a general understanding of the
solvency and business dealings of a company.

 A company's balance sheet is a snapshot of assets and liabilities

at a single point in time.
 Fundamental analysts focus on the balance sheet when
considering an investment opportunity or evaluating a company.
 The primary reasons balance sheets are important to analyze are
for mergers, asset liquidations, a potential investment in the
company, or whether a company is stable enough to expand or
pay down debt.
 Many experts believe that the most important areas on a balance
sheet are cash, accounts receivable, short-term investments,
property, plant, and equipment, and other major liabilities.
 Why Balance Sheets Are Important to Analysis
 They say that "the numbers don't lie," and that is true more for
financial analysis than anything else. Balance sheets are important
for many reasons, but the most common ones are: when a merger
is being considered, when a company needs to considering asset
liquidation to prop up debt, when an investor is considering a
position in a company, and when a company looks inward to
determine if they are in a stable enough financial situation to
expand or begin paying back debts.
 Many experts consider the top line, or cash, the most important
item on a company's balance sheet. Other critical items
include accounts receivable, short-term investments, property,
plant, and equipment, and major liability items. The big three
categories on any balance sheet are assets, liabilities, and equity.

Important Assets
All assets should be divided into current and noncurrent assets. An
asset is considered current if it can reasonably be converted into
cash within one year. Cash, inventories, and net receivables are all
important current assets because they offer flexibility
and solvency.

Cash is the headliner. Companies that generate a lot of cash are

often doing a good job satisfying customers and getting paid.
While too much cash can be worrisome, too little can raise a lot of
red flags. However, some companies require little to no cash to
operate, choosing instead to invest that cash back into the
business to enhance their future profit potential.

Important Liabilities
Like assets, liabilities are either current or noncurrent. Current
liabilities are obligations due within a year. Fundamental investors
look for companies with fewer liabilities than assets, particularly
when compared against cash flow. Companies that owe more
money than they bring in are usually in trouble.

 Items on the balance sheet are used to calculate important

financial ratios, such as the quick ratio, the working capital ratio,
and the debt-to-equity ratio.

 Common liabilities include accounts payable, deferred income,

long-term debt, and customer deposits if the business is large
enough. Although assets are usually tangible and immediate,
liabilities are usually considered equally as important, as debts and
other types of liabilities must be settled before booking a profit.

Important Equity
 Equity is equal to assets minus liabilities, and it represents how
much the company's shareholders actually have a claim to;
investors should pay particular attention to retained earnings and
paid-in capital under the equity section.
  Paid-in capital represents the initial investment amount paid by
shareholders for their ownership interest. Compare this
to additional paid-in capital to show the equity premium investors
paid above par value. Equity considerations, for these reasons, are
among the top concerns when institutional investors and private
funding groups consider a business purchase or merger.

 Retained earnings show the amount of profit the firm reinvested or

used to pay down debt, rather than distributed to shareholders
as dividends.

The Bottom Line

 A company's balance sheet provides a tremendous amount of

insight into its solvency and business dealings. A balance sheet
consists of three primary sections: assets, liabilities, and equity.

 Depending on what an analyst or investor is trying to glean,

different parts of a balance sheet will provide a different insight.
That being said, some of the most important areas to pay attention
to are cash, accounts receivables, marketable securities, and
short-term and long-term debt obligations.

Balance Sheet analysis

Sub-
Section Section Description

Current Cash Current assets are those which can be

Asset liquidated within a short period of time. Cash is
the most liquid form of these assets and it
includes all funds contained in current, savings,
and money market accounts.

Accounts Accounts receivable is the amount to be

Receivable received from the customers also known as
 Sub-
Section Section Description

debtors. These receivables are created from the

time the customer is billed to the time the
company receives payment from the customer

Inventory Inventory is the items that a company

purchases/manufactures and then sells to the
customers. From the time the goods/raw
material are purchased or processed to the time
it is sold to the customer, these are termed as
inventories.

Fixed Equipments Fixed assets are items that are physical assets
Asset that are owned by the company for a long term.
Long term assets are generally depreciated over
time and so these assets are recorded with a
total accumulated depreciation amount
subtracted from them.

Vehicle Vehicle is a long term asset held by the

company for more than a year and it is
depreciated over time.

Land Land is a fixed asset and held for a longer period

of time than any other long term asset. This is
 Sub-
Section Section Description

one of the fixed assets which is not depreciated

instead the value of the land increases as the
years pass.

Intangibl Goodwill Goodwill is an intangible asset which represents

e Asset non-physical assets  that add to a company's
value but is not tangible.

Note: In Finance Act 2021, Goodwill is explicitly

removed from the definition of depreciable
intangible assets

Current Accounts These are the obligations that will become due
Liability Payable in the current period (within a year) and
generally includes trade due to vendors and
suppliers. Accounts payable are amounts due to
creditors for services or goods that have not yet
been paid

Accrued Accrued expenses are obligations that are

Expenses recognized in the books but are not yet due, and
include wages, interest etc
 Sub-
Section Section Description

Taxes This represents the amount of taxes that a

Payable company owes to the government. All taxes are
generally due to be paid within a year and hence
classified as current liability

Long Long Term Long-term debts are those obligations which will
Term Debt not be payable within the current year and will
Liability become due in more than one year. It represents
the total amount due to be paid by the company
to  third parties and creditors for over a year or
more

Share Capital Capital represents the money invested by the

Holder’s Stock owner in the entity and it is the total assets
Equity minus the total liabilities. Capital stock changes
according to the entity type – companies report
capital as common stock, preferred stock etc
whereas Partnerships list the same Partner’s
capital.

Retained This is the excess earnings retained by the entity

Earning to invest in the business. This represents the
amount not distributed to shareholder. It is also
termed as ploughing back of profits.
Ratio Analysis

Financial ratios help you interpret any company’s finances’ raw data to get
actionable inputs on its overall performance. You can source the ratios
from a company’s financial statements to evaluate its valuation, rates of
return, profitability, growth, margins, leverage, liquidity, and more.
In simple words, a financial ratio involves taking one number from a
company’s financial statements and dividing it by another. The resulting
answer gives you a metric that you can use to compare companies to
evaluate investment opportunities.
For example, just knowing that a company’s share price is $20 doesn’t offer
any insight. But knowing that the company’s price to earnings ratio (P/E) is
4.5 gives you some more context. It means that the price ($20), when
divided by its earnings per share (EPS, in this case, 4.44), equals 4.5. You
can now compare the P/E of 4.5 to that of other companies, competitors, or
even to the company’s historical P/E ratio to better understand the
investment’s overall attractiveness.

 Types of Financial Ratios 

Different financial ratios offer different aspects of a company’s financial

health, from how it can cover its debt to how it utilizes its assets. A single
ratio may not cover the company’s entire performance unless viewed as
part of a whole.
These ratios are time-sensitive as they assess data that changes over time.
So you can use these ratios to your benefit by comparing them from
different periods to get a general idea of a company’s growth or regression
over time.
There are five broad categories of financial ratios. Let’s look at them
individually –
 1. Liquidity Ratios 

Liquidity ratios tell a company’s ability to pay its debt and other liabilities.
By analyzing liquidity ratios, you can gauge if the company has assets to
cover long-term obligations or the cash flow is enough to cover overall
expenses. If the answers are positive, you may say the company has
adequate liquidity, or else there may be problems.
These liquidity ratios are notably more critical with small-cap and penny
stocks. Newer and smaller companies often have difficulties covering their
expenses before they stabilize.
Some common liquidity ratios are

  Operating Cash Flow Margin = Cash from operating activities /

Sales Revenue
The operating cash flow margin indicates how efficiently a company
generates cash flow from sales and indicates earnings quality.
 Cash Ratio = (Cash + Cash Equivalents) / Total Liabilities
The cash ratio will give you the amount of cash a company has
compared to its total assets.
 Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The quick ratio, aka acid-test ratio, will assess a company’s
marketable securities, receivables, and cash against its liabilities.
This gives you an idea about the company’s ability to pay for its
current obligations.
 Current Ratio = Current Assets / Current Liabilities
The current ratio will give you an idea about how well the company
can meet its financial obligations in the coming 12 months.

 2. Leverage Ratios 

Leverage or solvency ratios offer insight into a company’s ability to clear its
long-term debts. These ratios evaluate the company’s dependence on debt
for its regular operations and the possibility to repay the obligations.
Some common leverage ratios are

 Debt Ratio = Total Debt / Total Assets 

The debt ratio compares a company’s debt to its assets as a whole.
 Interest Coverage Ratio = Earnings Before Interest and Tax /
Interest Expense
The interest coverage ratio gives insights into a company’s ability to
handle the interest payments on its debts.
 Debt to Equity Ratios = Total Liabilities / Total Shareholders’
Equity
A debt-to-equity ratio compares a company’s overall debt to its
investor supplied capital.

3. Valuation Ratios 

Valuation ratios generally rely on a company’s current share price and

reveal whether the stock is an attractive investment option at the time. You
can also call these ratios are market ratios as they examine a company’s
attractiveness in the stock market.
Some common valuation ratios are:

 Price to Earnings Ratio (P/E) = Price per share / Earnings per

share
P/E is one of the most commonly used financial ratios among
investors to determine whether the company is undervalued or
overvalued. The ratio indicates what the market is willing to pay today
for a stock based on its past or future earnings.
 Price/Cash Flow (P/CF) = Share Price / Operating Cash Flow per
Share
This ratio indicates a company’s stock price relative to the cash flow
the company is generating. The advantage of P/CF ratio is that it is
tough to manipulate for a company. While companies can change
revenue and earnings through accounting practices, cash flow is
relatively immune from it.
 PEG Ratio = Price to Earnings / Growth Rate
The PEG ratio is a valuation metric for determining the relative trade-
off between the stock price, earnings per share, and a company’s
expected growth. It makes it easier to compare high growth
companies that tend to have a high P/E ratio to mature companies
that have a lower P/E. It is thus a better indicator of the stock’s true
value.
 Price to Sales Ratio (P/S) = Market Capitalization/Total Revenue
A P/S ratio compares a company’s market capitalization against its
sales for the last 12 months. It is a measure of the value investors
are receiving from the company’s stock by indicating how much they
are paying for shares per dollar of the company’s overall sales.

4. Performance Ratios 

As the name indicates, performance ratios reveal a company’s market

performance (profit or loss). These ratios are also called profitability ratios.
Some common profitability ratios are

 Return on Equity = Net Income / Shareholders’ Equity

ROE is also the return on net assets, as shareholders’ equity is the
total assets minus debt.
 Return on Assets = Net Income / Total Assets
ROA measures the efficiency of a company in generating earnings
from its assets.
  Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
A gross profit margin ratio will tell you the relation between the
company’s gross sales and profits.
 Operating Profit Margin = Operating Profit / Revenue
Operating profit margin indicates a company’s profit margin before
interest payments and taxes.
 Net Profit Margin = Net Profit / Revenue
Net profit margin indicates a company’s net margins. A high net profit
margin is a good indication of an efficient business.

5. Activity Ratios 

Activity ratios demonstrate a company’s efficiency in operations. In other

words, you can see how well the company uses its resources, such as the
assets available, to generate sales.
Some commonly used activity ratios are:

 Inventory turnover = Net Sales / Average Inventory at Selling

Price
This ratio can indicate how efficient the company is at managing its
inventory. A high ratio implies either strong sales or insufficient
inventory.
 Receivables turnover = Net Sales / Average accounts receivable
Receivables turnover indicates how quickly net sales are turned into
cash.
 Payables turnover = Total supply purchase / Average Accounts
Payable
Accounts payable turnover ratio is a short-term liquidity measure that
shows how many times a company pays off its accounts payable
during a period, and indicates short term liquidity.
 Fixed asset turnover = Net Sales / Average Fixed Assets
Fixed asset turnover measures how efficient a company is in
generating sales from its fixed assets – property, plant, and
equipment.
 Total asset turnover = Net Sales / Average Total Assets
Fixed asset turnover measures how efficiently a company is using its
assets to generate sales 

Financial Ratio Analysis Interpretation

Ratio analysis can predict a company’s future performance—for better or

worse. Successful companies generally boast solid ratios in all areas,
where any sudden hint of weakness in one area may spark a significant
stock sell-off. While using these financial ratios, investors must be
careful about each’s nuances and use them in tandem for a comprehensive
analysis of a stock.