Tuesday, 11 December 2018

Tools to Analyse the Financial Statements

Financial Statements

Financial Statement

Before starting the tools to analyze the financial statement, let us have a look at what is financial statements and what are them.

Financial statements are formal records of financial affairs of the business. These statements quantitatively present the performance, position, and liquidity of a company. 

These statements are 

1. Income Statement
2. Balance Sheet
3. Cash Flow Statement
4. Statement of Changes in Equity

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Income Statement: Income Statement is also known as Profit & Loss Account, Statement of Revenue and Expenses. This statement records the activities of the business for a period like for a financial year. This statement contains sales, purchases, stock and other expenses relating to the activities of the business and finally arrive at the profit of the company.

    Balance Sheet: This statement reports the asset, liabilities, and shareholders equity on a specific date. This statement will give us a clear picture of what the company owns and owes and how much the shareholders invested in the company.

      Cash Flow Statement: This statement will provide information regarding the cash flow of the company in its operating, investing and financing activities.

        Statement of changes in Equity: This statement is also known as the Statement of Retained Earnings. This statement will provide information about the changes in the equity of the company during a particular period.

          What is Financial Statement Analysis?

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            Financial statement analysis is the process of analyzing the financial statements like Balance sheet, Income statement, Cash Flow Statement, and Statement of changes in Equity. 

            Purpose of the financial analysis is to provide valuable insight into the performance of the company to help the management and other stakeholders in their decision-making process.

            Methods of Analysing Financial Statement

            Analysis of the financial statement is time-consuming. It requires special knowledge. Depends on the nature and size of the organization, analysts decide the methods of analyzing the financial statement. 

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              The tools or methods used in the analysis of financial statement are given below.

              I.    Vertical Analysis
              II.  Horizontal Analysis or Trend Analysis
              III. Ratio Analysis

              I. VERTICAL ANALYSIS

              When we analyze a single year financial statement, then a vertical analysis will work there. In this analysis, the analyst does a look from top to bottom or a vertical look. This analysis shows each amount as a percentage to another item.


              From the above example, we can understand how the vertical analysis works in the income statement.

              Sales or Revenue is converting to 100 %. All other line items are converting to Sales as a proportion. These percentages are using to analyze the performance of the business activities for a period.

              Example to find the formula to find the percentage of each item is 

                   =  (Cost of Goods Sold / Sales ) X 100

              Click here to Download the Example File


              Horizontal Analysis also is known as Trend Analysis, used to analyze financial statements. The method analyses trends over the number of accounting periods. 

              In the horizontal analysis, we need to analyze financial statements of two or more years like 2017 and 2018.  

              By preparing a Horizontal Analysis of two consecutive years' financial statement, you may able to compare the data and find the relationship and trend among the data. This information helps you to identify the areas of strength and weakness and predict the future of the company.

              Let us consider an example of a horizontal analysis of an income statement for the year 2017 & 2018. 

              We are considering Income of 2017 as a Base Year for comparison.


              Horizontal Analysis of the given example is only a basic one. The formula used to find the percentage is 

              = ( Amount in Analysing Year - Amount in Base Year ) / 
              The amount in Base Year X 100

              Click here to Download the Example File

              III. RATIO ANALYSIS

              A ratio is a statistical measure used to find the relationship between variables and figures, expressed as a percentage or quotient. 

              Ratio Analysis is the process of quantitative measurement of various information in the financial statement.

              If the user desirous a quantitative analysis, Ratio analysis is the one referred to them.

              Importance of Ratio Analysis


              The investors or owners are interested to know the profitability of the business, capitalization rate, Price Earning Ratio, Dividend Yield.


              Creditors may be interested in the working capital to analyze the ability of the borrower to repay the loan in case they face any downturn in the business. 

              Creditors are interested in Total Debt to Equity Ratio, Net Worth to Total Asset Ratio, Long-term Debt to Equity Ratio, Long-Term Debt to Net Working Capital Ratio.


              Commercial banks and other lenders are interested in ratios like Current Ratio, Acis Test Ratio, Inventory Turnover Ratio, Receivable Turnover Ratio. 

              These ratios help the banks to analyze the ability of the company to meet its financial obligations in time.

              Classification of Financial Ratios

              Below diagram shows the classification of Ratios

              Classification of Financial Ratios

              A. Profitability Ratios

              Profitability Ratios are financial metrics used to analyze the capacity of the company to generate profit. If the ratio is high, it is considering as the best for the company as the business is performing efficiently.

              When we analyze these ratios, it is advising to use as a comparison with previous years or compare with the similar companies.

              Important Profitability Ratios explained below.

              1. Gross Profit Ratio
              2. Net Profit Ratio
              3. Operating Ratio
              4. Break-Even Point
              5. Return On Equity (ROE)
              6. Return On Net Asset (RONA)
              7. Return On Total Asset (ROTA

              #1. Gross Profit Ratio (GPR).

              This ratio expresses the relationship between Gross Profit and Net Sales. It is comparing how much a business is earning by spending a particular amount on its goods and services. 

              If the Gross Profit Ratio is high, it may indicate the efficiency of the corporation. Suppose the ratio is low, it may give insight to the high Cost of Goods Sold (CGS). Then we need to analyze all the components of the CGS to find the inefficiency. Even it may lead the analyst to poor marketing policies or competition also.

              A high ratio helps us to know that the average percentage of markup on the goods and services ensured. 

              It can be computed as follows

                GPR = (Gross Profit / Net Sales)  X 100  

              #2. Net Profit Ratio (NPR).

              Net Profit Ratio is the ratio of net profit to net sales. Net Profit is the amount remaining, after deducting all operating expenses, interest, tax and preferred stock dividend from the total revenue of the company.

              NPR provides information about the efficiency of the business. A continuous increase in the ratio from year to year is indicating the improvement in the company.

              It can be computed as follows 

              NPR= (Net Profit / Net Sales) X 100

              #3. Operating Ratio.

              Operating Ratio is calculating by dividing the operating expenses of a particular period by net sales of the period. Operating Cost consists of direct material, direct labour, direct expenses, and all overheads.

              This ratio will help us to ascertain the operating efficiency of the company.

              It can be computed as follows 

              Operating Ratio = (Operatoing Cost Net Sales) X 100

              #4. Break-Even Point.

              Break-Even Point is a point where the cost and the revenue are equal. In this point, the company has no profit or loss.

              Management of any company always checks the break-even point by cost analysis, margin analysis, pricing analysis. 

              So this analysis will help the management to assess the revenue needed to cover the cost of the company.

              The formula used to calculate the break-even point is 

              = Fixed Costs / (Sales price per Unit - Variable cost per Unit) 

              #5. Return On Equity (ROE)

              By using the Return On Equity Ratio, we can measure the profitability of the company. It implies the amount of return earned by the company by investing the shareholder's equity in the business. 

              Investors use this ratio to assess investments or future investments in companies. Return On Equity (ROE) is also known as Return on Net Worth.

              The formula used to calculate Return on Equity (ROE)  is 

              = Net Income / Shareholders's Equity

              #6. Return On Net Asset (RONA)

              Return On Net Asset (RONA) calculates the ratio of net profit to net assets of the company.  This ratio helps the investors to know the companies financial performance with the fixed asset and working capital.

              The formula used to calculate Return On Net Asset (RONA)  is 

              = Net Income / (Fixed Asset + Working Capital )  

              #7. Return On Total Asset (ROTA)

              Return On Total Asset (ROTA) is a tool to analyze the effectiveness of the company. ROTA calculates the ratio by which the earnings before interest and tax (EBIT) to its total net assets. EBIT means earnings before interest and tax or net income plus interest expenses and taxes.

              The formula used to calculate Return On Net Asset (RONA)  is

               = EBIT /  Total Net Assets  

              B. Liquidity Ratios

              Business and Financial Modeling from the Wharton School
              Liquidity Ratios are important ratios in analyzing the financial statements of any company. These ratios are using to determine the ability of the company to settle the current liabilities without raising fund from outside.

              Main Liquidity Ratios mentioned below.

              1. Current Ratio
              2. Quick Ratio
              3. Interest Coverage Ratio

              #1. Current Ratio

              Current Ratio is using to determine the short-term liquidity of a company. To find the ratio, Current Assets are comparing to Current Liabilities. 

              Current Assets include cash and all other assets expected to convert into cash within one year or the operating cycle of the company. Liabilities are termed as Current Liabilities if those are payable within the one year or normal operating period.

              The formula used to calculate Current Ratio is 

               = Current Assets / Current Liabilities 

              #2. Quick Ratio

              Quick Ratio also is known as Acis Test Ratio. This ratio compares the liquid or most liquidate assets to current liabilities. 

              Here the Current Asset includes cash and equivalents, marketable securities and accounts receivables. Inventory not included in the current asset.

              Quick Ratio helps to find whether the business is able to pay off its nearest liabilities immediately.

              The formula used to calculate Quick Ratio is 

              = Liquid Assets / Current Liabilities 

              #3. Interest Coverage Ratio

              Interest Coverage Ratio (ICR) is calculating the ability of the company to meet the obligation towards the payment of interest. This ratio compares the Earnings Before Interest and Tax (EBIT) to the interest expenses for a period. 

              The formula used to calculate Interest Coverage Ratio is 

               = EBIT / Interest Expenses 

              C. Activity Ratios

              Activity ratios reflect the efficiency of the resources used in the company. This ratio is comparing the sales to various assets and analyzing how the assets managed to generate the sales.

              Important Activity Ratios are mentioned below.

               1. Total Asset Turnover Ratio
               2. Fixed Asset Turnover Ratio
               3. Current Asset Turnover Ratio
               4. Working Capital Turnover Ratio

              Working capital Turnover Ratio is also divided into 

               1. Stock Turnvoer Ratio
               2. Debtor Turnvoer Ratio
               3. Creditors Turnover Ratio

              #1. Total Asset Turnover Ratio

              Total Asset Turnover Ratio is using to ascertain how efficiently the firm managed its assets to generate sales. This ratio matching sales to the assets of the company. 

              The formula used to calculate the Total Asset Turnover Ratio is 

               Net Sales / Total Asset 

              #2. Fixed Asset Turnover Ratio

              Fixed Asset Turnover Ratio is dividing the net sales by the net fixed asset. This ratio measuring how well the company managed the net fixed assets to generate sales. Net Fixed Assets include Property, Plant and Equipment less the accumulated depreciation.

              The formula used to calculate the Fixed Asset Turnover Ratio is 

               =Net Sales / Net Property,Plant and Equipment 

              #3. Current Asset Turnover Ratio

              Current Asset Turnover Ratio is calculating the ability of the company to make sales using its current assets. It is calculating by dividing the net sales by the average current assets.

              The formula used to calculate the Current Asset Turnover Ratio is 

              = Net Sales / Average Current Asset

              #4. Working Capital Turnover Ratio

              Working Capital Turnover Ratio may tell us the efficiency of the management of the working capital to achieve the reported sale. In general, Working Capital Turnover Ratio calculates by dividing the sales with Working Capital. 

              The formula used to calculate the Working Capital Turnover Ratio is 

              = Sales / Working Capital 

              To have a clear idea, Working Capital Turnover Ratio again divided into three. They are 

              1. Stock Turnover Ratio

              Stock Turnover Ratio is also known as the Inventory Turnover Ratio. This ratio is used to analyze the efficiency of managing inventory or stock.

              The formula used to calculate the Stock Turnover Ratio is

               = Cost of Goods Sold / Average Inventory 

              2. Debtor Turnover Ratio

              Debtors Ratio or Accounts Receivable  Ratio is calculating the efficiency of the debt collection.  Debtor Turnover Ratio measures the efficient usage of the asset of the company.

              The formula used to calculate the Debtors Receivables Ratio is

               = Net Credit Sales / Average Accounts Receivables 

              3. Creditors Turnover Ratio

              Creditors Turnover Ratio is also known as Accounts Payable Turnover Ratio or Payables Turnover Ratio.  This ratio analyses how the company pays off its creditors.

              The formula used to calculate the Creditors Turnover Ratio is 

               Net Credit Purchases / Average Accounts Payable 

              D. Leverage Ratio

              Leverage Ratios analyses the level of debt the company has obliged.  Leverage Ratios are any of the financial ratios that analyze the debt.

              The common leverage ratios are  

              1. Debt Ratio
              2. Debt Equity Ratio

              #1. Debt Ratio

              Debt Ratio is a leverage ratio evaluating the relation of total debt to the total assets. This ratio also is known as the Debt to Asset Ratio. 

              The formula to calculate the Debt Ratio is 

               = Total Debt / Total Asset 

              #2. Debt Equity Ratio

              Debt Equity Ratio also is known as Gearing. Because of this ratio, the analyst can find it whether the capital structure of the company is debt or equity financing.

              Debt Equity Ratio is calculating by dividing the total liabilities by the shareholder's equity.  Total liabilities include short-term debt, long-term debt, and fixed payments obligation.

              The formula to calculate the Debt Equity Ratio is 

               = Total Debt / Shareholder's Equity 

              These are the main ratios used to analyze the financial statement of a company. But there are some ratios used in the finance of some companies as the diversity of industries.

              In hotels or hospitality industries, many other ratios are using. Some of them are Room Occupancy Ratio, BedOccupany Ratio, and  Double Occupancy Ratio.
              Banks are using ratios like loans to deposit ratio.

              The transportation industry is using ratios like passenger kilometres, Seat Occupancy Ratios, Operating Cost per kilometre.

              Telecom industry is using ratios like the average duration of the outgoing call, the number of outgoing calls per connection, revenue per customer.


              Financial Statement Analysis is the best tool to analyze the business and its operation. All these historical figures may use to predict the future of the companies. But it is required to present in a standard and comparable forms in appearance and concept. This comparability must ensure in case of periods and industry.

              The tools described here are only to analyze the financial statement. So financial statement analysis is an only part of the whole analysis of the company. Many other indicators may visible in the operational analysis also.

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