SRI LANKA INSTITUTE OF ADVANCED TECHNOLOGICAL EDUCATION

(Established in the Ministry of Higher Education, vide in Act No. 29 of 1995)

Higher National Diploma in Accountancy

HNDA 4202 – Financial Statement Analysis
Short Notes
Digitalized By: Nusky Ahameth Nafeel (ATI- Sammanturai)

Financial Statement Analysis

1. Financial Statement Analysis

 FS Analysis is the process of identification the firm's Strength & weakness using the
Financial Statements.

2. Financial Statement Analytical Tools

 Comparative FS Analysis
 Common size FS Analysis
 Ratio Analysis
 Cash Flow analysis
 Valuation

3. “All Components of FS are generally prepared on accrued basis". Comment on the

Statement.
 No, Disagree.
 Financial Statements consists of Five components. There are, Income Statement,
Balance Sheet, Cash Flow, Changes in equity and notes. From that Five, three
Statements are accrual basis. And notes are only description. The cash flow Statement
is prepared on cash basis

4. Limitation of financial Analysis

 Accounting policies and practices  Windows dressing
 Calculation of ratio  Seasonality
 Historical data
5. Importance of FS Analysis
 Valuation of past performance
 Performance
 Assessment of current status
 Prediction of future potential
 To maximize the profit resources

6. Business analysis and its relation to FS analysis

 Business analysis is the evaluation of a company's prospect: And risk for business
decisions.
 FS provide more information about a company. As a result, FS analysis is as part of
business analysis.

7. Firm window dresses its Financial analysis

 Window dressing is the FS to make annual results look better.

e.g.: Improve liquidity ratio, Delay payments for raw material, Build up their liquid
account

8. Time Series analysis and cross sectional analysis

 Time Series, analysis is the analysis to evaluate the performance of the firm over time.
 Cross Sectional analysis is the analysis to evaluate the performance of the firm against
one or more companies in the same industry.

9. Information given by time series & & cross sectional analysis for users
 Analyzing ratio trends over time, along with absolute ratio levels gives information
about whether a firm's Financial conditions is improving.

10. Importance of time series analysis

 It is very useful to identify and accounting trend and behaviors of financial data.
Because, it compares financial data over the period of time
11. Importance of Cross Sectional analysis
 Easy to make comparison among the companies.
 Gives best indicators of the companies.
 Evaluate the performance against one or more companies

12. Earnings management

 Earning management is the intentional manipulation of financial Statements by
managers to achieve personal benefits.

13. Earning management strategies

 Increasing Income
 Big bath
 Income Smoothing

14. Difference between Internal growth rate and Sustainable growth rate
 The internal growth rate is the growth rate of a firm can sustain that it uses only
internal financing to finance future growth.
 Sustainable growth rate is the maximum growth rate that is used to maintain a debt
ratio that view as optimal.

15. Differences between Economics earning and Accounting earning.

 Economic earning is the sustainable cash flow that can be paid out to stockholders
without impairing the product’s capacity of the firm.
 Accounting earning is based on accrual methods and it can be manipulated to a
certain extent.

16. Difference between depreciation & Amortization

 Depreciation is a method of allocating the cost of tangible fixed asset over their useful
lives.
 Amortization is a method of allocating the cost of an intangible fired asset over their
useful lives.
17. “Practical usefulness of statement of financial position is limited, as it’s only a
snapshot”. Explain
 Statement of financial position's information shows at a particular point of time
probably as at 31st December or 31st March, that is the only snapshot that has not
practical usage.

18. Additional Information to be disclosed in an annual report.

 Management report
 Auditor report
 Proxy Statement
 Explanatory notes

19. Net worth

 Net worth is the equal to total asset minus by total liability of a company.

Net worth = Total Asset – Total Liability

20. Economic Profit V/S Accounting Profit

Economic Profit Accounting Profit

- Determined by economics principles - Determined by G.A.A.P (Generally
accepted Accounting principles)
- Includes explicit & opportunity cost - Include only explicit cost
- Macro market - Single entity

21. Leverage
 Leverage is the business term, how a business acquired new assets in Startup.

22. Liquidity
 Liquidity is degree to which asset or security can be quickly bought or sold in market.

23. Solvency of a business

 Solvency of a business is the ability to meet its long term financial obligation.
 Common Size Analysis

1. Types of common size analysis

 Vertical analysis
 Horizontal analysis

2. Common Size analysis - Importance /Advantages

 It converts FS into common size or as percentage value.
 It is easy to the comparison in two different years and competitive companies
 It is easy to understand FS without any account knowledge

3. Limitation of Common Size Analysis

 Change in price level
 Seasonal changes.
 Different accounting policies
 Following consistency
 Standard ratio
 Window dressing

4. Difference between Horizontal Analysis & Vertical Analysis

Horizontal Analysis. Vertical Analysis

- One part of common size analysis - One part of common size analysis
- Discuss Changes in the period using base - Discuss changes in same year using %
year value.
- It used to analysis the FS over the period: - It used to analysis the FS company itself.

5. Purpose of common size analysis

 Evaluation of internal makeup of FS
 Evaluation of FS with similar companies

6. Features / Factors indicating from common size Statement

 Equity  Liability
 Revenue  Proportionate size of asset
 Expenses
7. “Horizontal analysis, is a time series analysis” Explain
 Horizontal analysis is a time series analysis in the sense that it shows comparison of
financial data for several years against a base year.

8. Useful information derived from horizontal analysis

 The analyst can measure a change over time
 The analyst enables to assess management Policies
 Examined in the light of the economic
 The ability of the company to effectively confront challenges and opportunities.

9. Criteria in Selecting a base year for index number trend analysis

 When selecting base year, it is desirable to choose a year that is “typical” for business.
 If the earliest year is not typical, then a subsequent year should be chosen as the base
year.
 Cash Flow Analysis

1. Free Cash Flow

 Free Cash Flow is the excess of operating cash inflows over operating cash outflows:

2. Operating Cash Flow per Share

 Operating cash flow per share is the amount for one share of the company from the
cash flow activities.

3. Importance of free cash flow

 Can be used as per wishes of the management if it is positive, it is good single for the
company cash position.
 Allows the company to re-invest the cash
 Make acquisitions
 Pay dividends

4. Difference between Cash Flow Statement and Income Statement

 Cash flow statement prepare on cash basis for the period of time. But Income
statement prepare on accrual basis for the period of time.
 Cash flow discuss about operating, investment and financing activities. But Income
Statement discuss only operating return

5. Operating Cash Flow per Share VS Earning per Share

Operating cash flow per share Earnings per share

- This is calculated, operating cash flow - This is calculated, PAT divided by no. of
divided by no. of shares shares
- Higher value than earning per share - Lower value than operating cash flow
per share
6. Difference between Cash Flow Statement and Cash budget

Cash flow statement Cash budget

Component of FS Not a component of FS
Compulsory requirement Internal requirement
Prepared on cash basis for the period Prepared on cash basis for future period

7. Ratios of cash flow analysis

Operating cash flow to total debt = Net operating cash flow

(cash flow liquidity) Total debt

Operating cash flow to per share = Net operating cash flow

No. of Shares

Operating cash flow to cash dividend = Net operating cash flow

Cash dividend

Free cash flow = Net operating cash flow – Cash + Capital

Dividend expenditure

Cash flow adequacy = Net operating cash flow

(cash flow liquidity) Cash dividend + capital expenditure
 Common Size Analysis

From : Financial Director

To : The board of Directors

Subject: Financial Analysis of A PLC using horizontal or vertical analysis

Date : 05th of Sep 2020

Introduction

This analysis was made with intention of drawing the board of directors' attention on same
key changes and issues identified with respect to the company’s performances

Changes & Issues identified

………………………………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………………………………

Recommendation

Cash Flow Analysis

A PLC has generated positive / negative cash flow from operations. Both companies net cash
provided by operating activities was Rs. ……….., Rs. …………… respectively in A PLC & B PLC.
 Ratio Analysis

1. Limitation of Ratio Analysis

 Window Dressing
 No Standard for ratio calculation
 Different entities use different accounting Policies
 Qualitative information is not disclosure
 Effect on inflation

2. DuPont analysis
 Dupont analysis is the evaluate the earning power in term of operating & financial
efficiency.
 Dupont analysis show the ROE ratio

ROE = Return or PAT

Equity.

3. Types of Ratio and its importance

i. Profitability ratio
o Profitability ratio shows companies overall efficiency & performance
o Measure how company uses its assets & how control its expenses to generate
an acceptable return.
ii. Liquidity ratio
o Measure the ability to pay of its short term obligation comparing most liquidity
assets.
iii. Efficiency (Turn over) ratio

iv. Investment ratio

v. Gearing ratio
 Measure of a company's Financial leverage & show the extent funded by lenders Vs
shareholders
 1. Profitability Ratio

Gross profit Margin = Gross profit

100
Sales

 IF the GP ratio is high. That is best

Net profit Margin = Gross profit

100
Sales

 If the Net profit margin is higher than that is best.

Operating profit Margin = Gross profit
100
Sales

ROE = PAT ROE = Return or PAT

Total Asset Equity

ROCE = Profit
100
Capital Employed

ROCE = Attributable profit

(R/E + O/S + Reserves)

ROCE = PAT

Equity + P/S

ROCE = PBIT

(Equity + P/S + NCL)

ROCE = PBIT

(Equity + P/S + NCL + CL)

• If ROE, ROCE & ROA ratio is high. That is best for the company
 2. Liquidity Ratio (working capital)

Current Ratio = Current Asset

Current Liability

If the Current ratio is higher than acceptable level, company can invest in the asset. If current
ratio is less than expected level, company should think about to keep the standard level.

Quick Asset / Liquidity = Current Asset – (Inventory + Prepaid)

Ratio Current Liability

3. Efficiency Turnover Ratio

Debtor Turnover ratio = Credit Sale

Average Debtors

• Terms ↑ that is best

Debtor Collection Period = 365

Debtor Turnover

Debtor Collection Period = Average Debtors 365

Credit Sale

• Days that is best

Creditor Turnover ratio = Credit Purchase

Average Creditors

• Days that is best

Creditor collection period = 365

Creditor Turnover
Creditor collection period = Average Creditors 365
Credit purchase

• ↑ days, that is best

Inventory Turnover = Cost of sale

Average Inventory
• ↑ terms, that is best

Inventory holding period = 365

Inventory turnover

Inventory holding period = Average inventory 365

Cost of sale

• Days that is best

4. Investment ratio

EPS = Attributable profit

No. of shares

• EPS ↑ , that is best

Price Earning = Market price per share

EPS

Earning Yield = EPS

365
Market price per share

Dividend Yield = Dividend per share

100
Market price per share
Dividend payout = Dividend per share
100
EPS

5. Gearing ratio

Gearing ratio = Debt Capital

Total Capital

Debt capital P/S, Debenture, Bank Loan, Bonds

Total capital O/S, Reserves, RE

 Debt capital > Equity capital, highly geared

 Debt capital < Equity capital, Lowly geared

• If gearing ratio is higher than 50 %. It is not good. (financial expenses ↑ profit )

• Gearing ratio 50% low risk

Cover ratio = EBIT

Interest expenditure

Debt ratio = Total liabilities

Total Assets

Debt equity ratio = Total debt

Shareholders’ equity
 Ratio Analysis Report

From : Finance Manager / Finance Analyst

To : Board of Director
Subject : Analyzing the finance and profitability, liquidity, efficiency and investment
Date : 05/09/2023

Introduction
This report was prepared at the request of board of directors to provide information for decision of
acquisition. This report was prepared from only the information available of FS of two companies.

Profitability
From the above ratio both companies are profitable, However Maxi PLC show high better position
than Tutu Plc.

Conclusion
According to the ratio calculation, most of the ratios are almost favorable in a company. Therefore,
we can advise to P PLC’s board of director to investing A company. After considering other internal &
external doctors.

……………………………..
Finance analyst