Chapter II

Financial Statement
Analysis
Financial Statement Analysis /FSA/
 Financial analysis is a process of selecting, evaluating,
and interpreting financial data, along with other pertinent
information, in order to formulate an assessment of a
company’s present and future financial condition and
performance.
 Financial analysis refers to an assessment of the
viability, stability and profitability of a business, sub-
business or project.
 Financial analysis is also known as analysis and
interpretation of financial statements.
 Interpretation means identifying relationship between
variables
Need for FSA
 Financial statement analysis is used to identify the
trends and relationships between financial statement
items.
 Both internal management and external users (such as
analysts, creditors, and investors) of the financial
statements need to evaluate a company's profitability,
liquidity, and solvency.
 Nature of Analysis: The nature of the analysis depends
upon their [users] purpose or requirement. They [users]
make the necessary analysis and take the decision,
based on their assessment of the results obtained.
Users & their interests
I. Lenders (trade creditors): interested in
determining whether they will be repaid money they
lent.
II. Shareholders & Investors: are concerned with present
and future profitability.
III. Employees: may want to compare the current
performance or financial status of their employer
with earlier periods.
IV. Regulatory agencies :often need to assess
organizational or industry financial health and
performance.
V. Management: interested in every aspect of financial
analysis.
Types of financial statement analysis
Horizontal Analysis:
Here financial statements are compared
with several years.

Vertical Analysis:
Here, financial statements measure the
quantities relationship of the various items
in the financial statement on a particular
period.
It is also called as static analysis
 Comparative Statement Analysis
 Include
 Is an analysis of financial statement at different
period of time.
 Helps to understand the comparative position of
financial and operational performance at different
period of time
 Comparative Income Statement Analysis
 Helps to understand the operational performance of the
business concern in a given period
 Comparative Position Statement Analysis
 Here elements of balance sheet are compared with
previous year’s figures.
Trend Analysis
 Helps to understand the trend relationship with
various items, which appear in the financial
statements.
 These percentages may also be taken as index
number showing relative changes in the financial
information resulting with the various period of
time.
 In this analysis, only major items are considered
for calculating the trend percentage (e.g.
Deposits, advances, etc.)
Common Size Analysis

 Here, figures reported are converted into

percentage to some common base.
 In the balance sheet the total assets figures is
assumed to be 100 and all figures are
expressed as a percentage of this total.

 It is one of the simplest methods of financial

statement analysis, which reflects the
relationship of each and every item with the
base value of 100%.
Funds Flow Analysis
 This is one of the important tools, which is used
in many ways.
 It helps to understand the changes in the
financial position of a business enterprise
between the beginning and ending financial
statement dates.
 It is also called as statement of sources and
uses of funds.
Cash Flow Statement
 is a statement which shows the sources of cash
inflow and uses of cash out-flow of the business
concern during a particular period of time.
 Involves only short-term financial position of the
business concern.
 It provides a summary of operating, investment
and financing cash flows and reconciles them
with changes in its cash and cash equivalents
such as marketable securities.
Ratio Analysis
 Is a commonly used tool of financial statement
analysis.
 Is a mathematical relationship between one
number to another number.
 Is used as an index for evaluating the financial
performance of the business concern.
 An accounting ratio shows the mathematical
relationship between two figures, which have
meaningful relation with each other. Ratio can
be classified into various types.
What can we do with financial ratios?
Standards of Comparisons
Amounts of ratio may be compared with industry
norms

Amounts or ratios may be compared with the

same measurement in a prior period

Amounts of ratio may be compared with same

measurement in a competitor’s organization

Amounts of ratio may be compared with planned or

budgeted amounts previously established
Ratio Analysis
 From financial management view point, ratios
include:
A. Liquidity Ratio
B. Activity Ratio
C. Solvency Ratio
D. Profitability Ratio
E. Market Ratio
Relationships of the ratios

Profitability

Activity Liquidity

Leverage
A. Liquidity Ratios
 Also called as short-term ratio.
 Help to understand the liquidity in a business
which is the potential ability to meet current
obligations.
 This ratio expresses the relationship between
current assets and current liabilities of the
business concern during a particular period.
 Include:
 Current Ratio
 Quick Ratio
A. Liquidity Ratios

B. Activity Ratios
 Are also called turnover ratio.
 Reflect firm’s efficiency in utilizing assets (the speed with
which various accounts are converted into sales or cash)
 This ratio is helpful to understand the performance of the
business concern.
 Some of the activity ratios are given below:
 Inventory turnover ratio
 Debtors (Receivables) turnover ratio
 Creditors turnover ratio
 Working Capital Ratios
 Total Assets Turnover ratio
B. Activity Ratios


Inventory Turnover in Days= 365 Days/ ITOR

B. Activity Ratios

B. Activity Ratio
 Creditors Turnover ratio: measures the number of times,
on average, the accounts payable are paid during a period
𝑪𝒓𝒆𝒅𝒊𝒕 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔
 CTR =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒂𝒚𝒂𝒃𝒍𝒆𝒔
 Average Creditors payment Period (ACPP)
𝟑𝟔𝟓 𝒅𝒂𝒚𝒔
 ACPP =
𝑪𝑻𝑹
 Working Capital Turnover ratio (WCTR):It signifies that
how well a company is generating its sales with respect to the
working capital of the company
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
 WCTR =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑊𝐶
 Working capital = Current Assets – Current liabilities
 If last years WC is Br. 640,000, compute WCTR
B. Activity Ratio

 Total Assets Turnover ratio:

 Indicates the efficiency with which the firm uses
its assets to generate sales.
 Formula:

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
 Total Assets Turnover ratio=
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
C. Leverage or Solvency or Debt Ratios
 It is also called as solvency ratio
 Measures the long-term obligation of the
business.
 Helps to understand, how the long-term funds
are used in the business
 Indicates the amount of other people’s money
being used to generate profits.
 Some of the solvency ratios are given below:
 Debt-Equity Ratio
 Debt Ratio
 Interest Coverage Ratio
C. Solvency DE Ratio indicates how much
debt a company is using to
finance its assets relative to the
amount of value represented in
 SHE
D. Profitability Ratios
 Profitability ratio helps to measure the
profitability position of the business concern.
 Some of the major profitability ratios are given
below.
 Gross Profit Margin Ratio
 Net Profit Ratio
 Operating Profit Margin Ratio
 Return in Investment
 Return on Equity
 Earnings Per Share
Profitability Ratios
 Gross Profit Margin Ratio
Net Sales - Cost of Goods Sold
GPM 
Net Sales

 Operating Profit Margin Ratio

Operating Profit
OPR 
Net Sales

 Net Profit Ratio

Pr ofit After Tax
NPM 
Net Sales

Income Available to Common Shareholders

NPM 
Net Sales
26
D. Profitability ratio

D. Profitability

E. Market Ratios
 These relate the firm’s market value, as
measured by its current share price, to certain
accounting values.
 These ratios give insight into how well investors
in the market place fell the firm is doing in terms
of risk and return.
 Include ratios such as:
 Price/Earnings (P/E) Ratio
 Market/Book (M/B) Ratio
E. Market ratios


If the market price of the share is Br. 45.50, compute P/E ratio
E. Market Ratios

Exercise
 Balance Sheet
Assets Liabilities
Current Assets Current Liabilities
Cash 1,000 Accounts Payable 2,000
Investments 3,000 Miscellaneous Payable 2,000
Accounts Receivables 4,000 Accrued Payables 1,200
Inventories 6,000 Tax Payable 800
Fixed Assets (Net Depr.) 26,000 6% Mortgage Payable 14,000
Equities
Share Capital 12,000
Retained Earnings 8,000
Total Assets 40,000 Total Liab. & Equities 40,000
 Other Information:
 Net Sales …………………………….. Br. 60,000
 Cost of Goods Sold …………………. 51,600
 EBIT………………………………....... 4,000
 Net Income After Tax ……………..... 2,000
 Calculate
 Short-term solvency ratios (liquidity ratios)
 Current Ratio

 Quick Ratio
 Long-term solvency (Activity) Ratios
 D-E Ratio

 Fixed Interest Charge (interest coverage ratio)

Exercise

Exercise

 BALANCE SHEET ANALYSIS Complete the balance sheet
and sales information using the following financial data:
 Debt ratio: 50%
 Current ratio: 1.8×
 Total assets turnover: 1.5×
 Days sales outstanding: 36.5 days*
 Gross profit margin on sales: (Sales − Cost of goods sold)/Sales ¼ or 25%

 Inventory turnover ratio: 5×

* Calculation is based on a 365-day year.
Balance Sheet
 Cash Accounts payable
 Accounts receivable Long-term debt 60,000
 Inventories Common stock
 Fixed assets Retained earnings 97,500
 Total assets $300,000 Total liabilities and equity
 Sales Cost of goods sold