Financial Statements Analysis

The analysis of financial statements is a process

of evaluating the relationship between
components/parts of financial statements to
obtain a better understanding of the firm’s
position and performance.
 What is the role of Financial Analyst?

• To select the information relevant to the

decision under consideration.
• To arrange the information in a way to
highlight significant relationships.
• Interpretation and drawing of inferences.
 Tools/Techniques for financial statement
analysis
Ratio Analysis:-
• Ratios are financial indicators.
• The term ratio refers to the numerical or quantitative
relationship between two items/variables.
• This relationship can be expressed as
(I) Percentages i.e. 25 percent of sales
(II) Fraction (net profit is one-fourth of sales)
(III) Proportion of numbers ( the relationship between
net profits and sales is 1:4).
Ratio analysis is a widely used tool of financial
analysis.
What the ratios do is that they reveal the
relationship in a more meaningful way so as to
enable us to draw conclusions from them.
It makes related information comparable.
 Types of comparisons
1) Trend ratios
2) Inter-firm comparison
3) Comparison of items within a single year’s
financial statement of a firm
4) Comparison with standards or plans
 Types of Ratios
i) Liquidity ratios
ii) Capital structure/leverage ratios
iii) Profitability ratios and
iv) Activity ratios
 1) Liquidity Ratios
Liquidity ratios depict the ability of a firm to meet
current/short-term obligations when they
become due.
The short-term creditors of a firm are interested
in the short-term solvency or liquidity of a firm.
The ratios which indicate the liquidity of a firm
are: (1) Net Working Capital (2) Current ratios (3)
Acid/Quick ratios (4)Super quick ratios (5)
Turnover ratios (6) Defensive-interval ratios
 Net working capital(NWC)
NWC represents the excess of current assets
over current liabilities.
Although NWC is not a ratio, it is frequently
employed as a measure of a company’s liquidity
position.
Inadequate working capital is the first sign of
financial problems for a firm.
 Net Working Capital
Company A Company B
Total Current Assets Rs 180,000 Total Current Assets Rs 30,000

Total Current Liabilities 120,000 Total Current Liabilities 10,000

NWC 60,000 NWC 20,000

 Change in Net Working Capital
Year 1 Year 2
Current assets Rs 100,000 Rs 200,000
Current liabilities 25,000 100,000

NWC 75,000 100,000

 Current Ratio
The ratio of total current assets to total current
liabilities.
Current ratio= Current Assets/Current liabilities
It measures a firm’s short term solvency i.e.,
ability to meet short term obligations.
It indicates the amount of current assets
available for each current liability.
 Current Ratio
Firm A Firm B
Current Assets/Current Current Assets/Current
Liabilities = Liabilities=
Rs 180,000/ Rs 120,000 Rs 30,000/10,000

=3:2(1.5:1) =3:1
 Acid-Test/Quick Ratio

The acid-test ratio is the ratio between quick current assets

and current liabilities.
Acid-test ratio= Quick assets/Current liabilities
Quick assets= refers to current assets which can be converted
into cash immediately or at a short notice.
Quick assets are cash and bank balances, short term
marketable securities and receivables.
Note:-
Prepaid and inventory are excluded .
 Super-quick ratio
This ratio is calculated by dividing the super-
quick assets by the current liabilities of a firm.
• The super-quick current assets are cash and
marketable securities.
• This ratio is the most rigorous and
conservative test of a firm’s liquidity position.
 Turnover Ratio
• Turnover ratios determine how quickly certain
current assets are converted into cash.
• Also referred as activity ratios.(will be
discussed later)
 Defensive-Interval Ratio
The liquidity ratios of a firm show the ability to pay its
current liabilities.
Apart from paying current liabilities, the liquidity
position of a firm should also be examined in relation to
its ability to meet projected daily expenditure from
operations.
The defensive-interval ratio provides such a measure of
liquidity.
It is a ratio between the quick/liquid assets and the
projected daily cash requirements.
Defensive-interval ratio:-
= Liquid assets/Projected daily cash requirement

Projected daily cash requirement:-

Projected cash operating expenditure/Number of days in a year (365)

Question:
The projected cash operating expenditure of a firm from the next year is Rs
1,82,500. It has liquid current assets amounting to Rs 40,000.
Required:-
Determine the defensive-interval ratio.
Projected daily cash requirement:-
= Rs 182,500/365= Rs 500

Defensive-interval ratio= Rs 40,000/Rs 500

=80 days
The figure of 80 days indicates that the firm has
liquid assets which can meet the operating cash
requirements of business for 80 days without
resorting to future revenues.
 Leverage/Capital Structure Ratios
The long-term solvency of a firm can be
examined by using leverage or capital structure
ratios.
Debt-Equity Ratios
D/E ratio= Long-term debt/ Shareholders 'equity
or
D/E ration=Total debt/ shareholders 'equity
 Coverage Ratio
Interest Coverage Ratio:-
=EBIT/Interest expense
It indicates the extent to which a fall in EBIT is
tolerable in the sense that the ability of the firm to
service its interest payments would not be
adversely affected.
It shows how many times the interest charges are
covered by the EBIT out of which they will be paid.
 Profitability Ratios
Gross Profit Margin=Gross Profit/Salesx100

Operating Profit ratio=EBIT/Sales

Net Profit ratio=EAT/Sales

 Expenses Ratios
COGS ratio=COGS/Net salesx100

Operating expenses ratio=

Administrative expenses + Selling expenses/
Net salesx100
Operating ratio= COGS + Operating
expenses/Net salesx100
 Earnings Per Share(EPS)
EPS= Net profit available to equity holders/
Number of ordinary shares outstanding

EPS measures the profit available to the equity

shareholders on a per share basis.
 Dividend Per Share (DPS)
DPS=Dividend paid to ordinary shareholders/
Number of ordinary shares outstanding

DPS is the dividends paid to the shareholders on

a per share basis.
 Price Earnings (P/E) Ratio
P/E Ratio = Market price of share/EPS

P/E Ratio reflects the price currently being paid

by the market for each rupee of currently
reported EPS.
In other words, the P/E ratio measures investors’
expectations and the market appraisal of the
performance of a firm.
 Activity Ratios
Inventory Turnover Ratio:-
= COGS/Average inventory
This ratio indicates the number of times
inventory is replaced during the year.
It measures the relationship between the cost of
goods sold and the inventory level.
 Inventory Turnover……..
The inventory/stock turnover ratio measures
how quickly inventory is sold. It is a test of
efficient inventory management.
In general, a high inventory turnover ratio is
better than a low ratio. A high implies good
inventory management.
 Receivables (Debtors) Turnover Ratio and
Average Collection Period
Receivable Turnover:-
Credit Sales/Average Accounts receivable +
Average bill receivables

It shows how quickly receivables are converted

into cash.
Average collection period=
Days in a year/Receivable turnover
 Asset Turnover Ratio
Asset Turnover:-
=Sales/Total assets

This ratio shows the relative efficiency with

which a firm utilizes its resources in order to
generate output.