Financial Statement Analysis is reviewing and analyzing a company’s financial statements, such as a statement of changes in equity, the income statement, balance sheet, statement of cash flows, and notes to accounts. The term ‘financial analysis’ includes both ‘analysis and interpretation’. Analysis means simplification of financial data by methodical classification given in the financial statements. Interpretation means explaining the meaning and significance of the data. Internal and external stakeholders use it. Internal Stakeholders use it as a monitoring tool for managing the finances. In contrast, External Stakeholders use it to evaluate financial performance and business value and to understand the overall health of an organization. It is a judgemental process which aims to estimate current and past financial positions and the results of the operation of an enterprise, with primary objective of determining the best possible estimates and predictions about the future conditions. It essentially involves regrouping and analysis of information provided by financial statements to establish relationships and throw light on the points of strengths and weaknesses of a business enterprise, which can be useful in comparison with other firms.
Horizontal analysis compares financial information over time, typically from past quarters or years. It is performed by comparing financial data from a past statement, such as income statement. Vertical analysis is a percentage analysis of financial statements. Each line item listed in the financial statement is listed as the percentage of another line item, such as on an income statement each line item will be listed as a percentage of gross sales.
Analysis of financial statements reveals essential facts concerning managerial performance and the firm's Efficiency. The study's objectives are to apprehend the information in financial statements to know the weaknesses and strengths of the firm and to make a forecast about the firm's prospects, thereby enabling the analysts to make decisions regarding the operation of and further investment in the firm.
The top 3 objectives of Financial Statement Analysis are as follows –
Ratio analysis is the study or research of the line items present in the company's financial statements. It can be used to check various business factors, such as profitability, liquidity, solvency, and efficiency of the company or the business. This type of analysis is beneficial to analysts outside of a business since their primary source of information about an organization is its financial statements.
Financial ratios can be grouped into the following proportions, where each collection is targeted at a different type of analysis:
These ratios convey how well a company can generate profits from its operations. Profit margin, return on capital employed, return on equity, return on assets, and gross margin ratios are all profitability ratios.
2.Liquidity Ratios
Liquidity Ratios are measurements used to examine the ability of an organization to pay off its short-term obligations. Liquidity ratios include the current, quick, and working capital ratios.
3.Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include inventory turnover, turnover ratio, and days' sales in inventory.
4.Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings to evaluate the likelihood of a company staying afloat over the long haul by paying off its long-term debt and the interest on its debt.
5.Market Prospect Ratios
These are the most commonly used ratios in fundamental analysis. They include dividends, earnings per share (EPS), and P/E ratio, dividend payout ratio. Investors use these metrics to predict revenues and future performance.
6.Coverage Ratios
Coverage ratios are used to evaluate the ability of a business to meet its debt obligations. Examples include the times interest coverage ratio and the debt-service coverage ratio.
Liquidity is a very critical part of a business. Liquidity is required for a business to meet its short-term obligations. Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities.
Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the Ratio, the easier the ability to clear the debts and avoid defaulting on payments.
Creditors check this essential criterion before offering short-term loans to the business. An organization that cannot clear dues impacts creditworthiness and also affects the company's credit rating.
Current Ratio
It is one of the most common ratios for measuring short-term solvency or the firm's liquidity. In other words, it measures whether there are enough current assets to pay the current debts with a margin of safety for potential losses in realizing the current assets. Usually, the ideal current Ratio is 2:1. However, the ideal Ratio depends on the nature of the business and the characteristics of its current assets and liabilities.
Current Ratio=Current AssetsCurrent Liabilities
Quick Ratio
It is also known as Acid-test Ratio. Quick Ratio measures the relationship between Quick Assets and Current Liabilities. It measures whether there are enough readily convertible immediate funds to pay the current debts. Quick assets include only cash and near-cash assets. It does not contain inventories and prepaid expenses as they are not readily convertible into cash.
Quick Ratio or Acid-test Ratio=Quick AssetsCurrent Liabilities
Cash Ratio or Absolute Liquidity Ratio
It measures the absolute liquidity of the firm. It measures whether a firm can pay the current debts by using only cash balances, bank balances, and marketable securities.
Businesses should strive for an absolute liquidity ratio of 0.5 or above.
Cash Ratio=Cash and Bank Balances + Marketable Securities + Current InvestmentsCurrent Liabilities
Net Working Capital Ratio
It is a measure of cash flow. The answer to this Ratio should be positive. Usually, bankers monitor this Ratio to see whether there is a financial crisis.
Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing)
The debt-to-equity ratio is used to gauge the company’s ability to pay its obligations. It shows the overall health of a particular company.
If the debt-to-equity ratio increases, the company receives more financing by lending money subject to risk. If potential debts are too high, the company may get bankrupt during these times.
Several investors and lenders opt for a low debt-to-equity ratio because their interests are safeguarded if the business is declining.
However, the debt-to-equity ratio compares a company’s total liabilities to its shareholder equity and can be used to determine how much leverage a company operates.
Generally, higher leverage signals to shareholders that a company or its stocks have a higher risk. However, comparing the debt-to-equity ratio across different industry groups where ideal debt amounts vary takes a lot of work.
Investors modify the debt-to-equity ratio to focus entirely on long-term debt because the risk of long-term liabilities differs from short-term debts and payables.
Debt to equity ratio =Total LiabilitiesShareholder’s Equity
The total liabilities include short-term, long-term, and fixed payment obligations.
There are two different types of debt-to-equity ratio
A high debt-to-equity indicates high risk. For example, if the company is lending money from the market to finance its operations for growth, it means a high debt-to-equity ratio.
A low debt-to-equity ratio means the equity of the company’s shareholders is more significant, and it does not require any money to finance its business and operations for growth.
Simply put, a company with more owned capital than borrowed capital generally has a low debt-to-equity ratio.
A high debt-to-equity ratio comes with increased risk. If the balance is high, the company is lending capital from others to finance its growth. As a result, lenders and Investors often lean toward a company with a lower debt-to-equity ratio.
However, the debt-to-equity ratio is compared to the data executed from other financial years. Therefore, if the debt-to-equity ratio shows a sudden increase, the company has a growth strategy that aggressively funds through debt.
The ratio should be compared with the average ratios to avoid confusion. Generally, companies with intensive capital tend to have a higher debt-to-equity ratio than service firms.
Benefits
Limitations
The activity ratios show the connection between sales and a given asset. It indicates the investment in one particular group of assets and the revenue the assets produce.
Assets such as raw materials and machinery are introduced to generate sales and profits. The activity ratios show the speed at which the assets are converted into sales.
Activity ratios play an active role in evaluating the operating efficiency of the business as it shows how the company generates revenue and how well the company is managing the components in its balance sheet.
Types of Activity Ratios
The accounts receivables turnover ratio, also known as the debtor's ratio, is an activity ratio that measures the efficiency with which the business is utilizing its assets. It measures how often a company can turn its accounts receivables into cash.
It is calculated by dividing net credit sales by the average accounts receivables during a specific period.
Accounts Receivable Turnover =Net Credit SalesAverage Accounts Receivable
The ratio indicates the efficiency with which the business can collect the credit it issues its customers.
The working capital ratio indicates business effectiveness in utilizing its working capital. Working capital is the total amount of current assets minus the current liabilities.
The ratio is calculated by dividing the net sales by the working capital. The ratio helps you determine the net annual sales generated by the average amount of working capital during a year.
Working Capital ratio=Net SalesWorking Capital
A high working capital ratio shows that the business efficiently uses its short-term liabilities and assets to support sales. A low ratio could indicate bad debts or obsolete inventory.
The fixed asset turnover ratio measures how well a company generates revenue from its existing fixed assets. A higher ratio indicates that management is making better use of its fixed assets. FAT may be beneficial in evaluating and monitoring the return on money invested for investors looking for investment prospects in industries with capital-intensive businesses.
Fixed Assets Turnover Ratio=Sales or Cost of Goods SoldAverage Net Fixed Assets
Sales= Annual cost of goods sold or sales
Average Net Fixed Assets= (Net fixed asset at the beginning of year + Net fixed asset at the end of year) / 2
Net Fixed Assets= Gross Fixed Assets – Accumulated Depreciation
The stock turnover ratio describes how much of the company's stock has been transformed into sales. The inventory turnover ratio is the number of times a company's inventory is sold during a specific period. A high inventory turnover ratio indicates that a company has adequate inventory controls and robust sales strategies. It explains how effective the company is at turning stock into sales. A low ratio suggests a lack of demand, an out-of-date product, or a poor sales/ inventory policy, among other things. Among different activity ratios, stock, accounts payable, and accounts receivable turnover ratios are prevalent.
