Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis. Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements
The tools and techniques of financial statement analysis are:
- Horizontal and Vertical Analysis
- Ratios Analysis
- Horizontal and Vertical Analysis
Comparison of two or more year’s financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both shillings and percentage form. Horizontal analysis of financial statements can also be carried out by computing trend percentages. Trend percentage states several years’ financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base.
Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in shilling form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements.
- Ratios Analysis
The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply mean one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured.
Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under:
1. Gross Profit Ratio (GP Ratio)
Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed as a percentage. It expresses the relationship between gross profit and sales. The basic components for the calculation of gross profit ratio are gross profit and net sales. Net sales means that sales minus sales returns. Gross profit would be the difference between net sales and cost of goods sold.
Gross Profit Ratio = (Gross profit / Net sales) × 100
Example: Total sales = $520,000; Sales returns = $ 20,000; Cost of goods sold $400,000
Gross profit = [(520,000 – 20,000) – 400,000]
Gross Profit Ratio = (100,000 / 500,000) × 100
Gross profit ratio may be indicated to what extent the selling prices of goods per unit may be reduced without incurring losses on operations. It reflects efficiency with which a firm produces its products. As the gross profit is found by deducting cost of goods sold from net sales, higher the gross profit better it is. There is no standard GP ratio for evaluation. It may vary from business to business. However, the gross profit earned should be sufficient to recover all operating expenses and to build up reserves after paying all fixed interest charges and dividends.
2. Net Profit Ratio (NP Ratio)
Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed as percentage. The two basic components of the net profit ratio are the net profit and sales. The net profits are obtained after deducting income-tax and, generally, non-operating expenses and incomes are excluded from the net profits for calculating this ratio. Thus, incomes such as interest on investments outside the business, profit on sales of fixed assets and losses on sales of fixed assets, etc are excluded.
Net Profit Ratio = (Net profit / Net sales) × 100
Example: Total sales = $520,000; Sales returns = $ 20,000; Net profit $40,000
Net sales = (520,000 – 20,000) = 500,000
Net Profit Ratio = [(40,000 / 500,000) × 100]
NP ratio is used to measure the overall profitability and hence it is very useful to proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment. This ratio also indicates the firm’s capacity to face adverse economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the better is the profitability. But while interpreting the ratio it should be kept in mind that the performance of profits also be seen in relation to investments or capital of the firm and not only in relation to sales.
3. Operating Ratio
Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is generally expressed in percentage. Operating ratio measures the cost of operations per shilling of sales. This is closely related to the ratio of operating profit to net sales. The two basic components for the calculation of operating ratio are operating cost (cost of goods sold plus operating expenses) and net sales. Operating expenses normally include (a) administrative and office expenses and (b) selling and distribution expenses. Financial charges such as interest, provision for taxation etc. are generally excluded from operating expenses.
Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100
Example: Cost of goods sold is $180,000 and other operating expenses are $30,000 and net sales is $300,000.
Operating ratio = [(180,000 + 30,000) / 300,000] × 100
= [210,000 / 300,000] × 100
Operating ratio shows the operational efficiency of the business. Lower operating ratio shows higher operating profit and vice versa. This ratio is considered to be a yardstick of operating efficiency but it should be used cautiously because it may be affected by a number of uncontrollable factors beyond the control of the firm. Moreover, in some firms, non-operating expenses from a substantial part of the total expenses and in such cases operating ratio may give misleading results.
Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm’s ability to meet its current obligations.
1. Current Ratio
It is a measure of general liquidity and is most widely used to make the analysis for short term financial position or liquidity of a firm. It is calculated by dividing the total of the current assets by total of the current liabilities.
Current Ratio = Current Assets / Current Liabilities
Example: Current assets are $1,200,000 and total current liabilities are $600,000.
Current Ratio = 1,200,000 / 600,000
This ratio is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firms financial stability. It is also an index of technical solvency and an index of the strength of working capital. A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time and when they become due. On the other hand, a relatively low current ratio represents that the liquidity position of the firm is not good and the firm shall not be able to pay its current liabilities in time without facing difficulties. An increase in the current ratio represents improvement in the liquidity position of the firm while a decrease in the current ratio represents that there has been deterioration in the liquidity position of the firm.
Limitations of Current Ratio
This ratio is measure of liquidity and should be used very carefully because it suffers from many limitations. It is, therefore, suggested that it should not be used as the sole index of short term solvency.
- It is crude ratio because it measure only the quantity and not the quality of the current assets.
- Even if the ratio is favorable, the firm may be in financial trouble, because of more stock and work in process which is not easily convertible into cash, and, therefore firm may have less cash to pay off current liabilities.
- Valuation of current assets and window dressing is another problem. This ratio can be very easily manipulated by overvaluing the current assets. An equal increase in both current assets and current liabilities would decrease the ratio and similarly equal decrease in current assets and current liabilities would increase current ratio.
2. Liquid or Liquidity or Acid Test or Quick Ratio:
Liquid ratio is also termed as “Liquidity Ratio”,”Acid Test Ratio” or “Quick Ratio”. It is the ratio of liquid assets to current liabilities. The true liquidity refers to the ability of a firm to pay its short term obligations as and when they become due. The two components of liquid ratio (acid test ratio or quick ratio) are liquid assets and liquid liabilities. Liquid assets normally include cash, bank, sundry debtors, bills receivable and marketable securities or temporary investments. In other words they are current assets minus inventories (stock) and prepaid expenses. Inventories cannot be termed as liquid assets because it cannot be converted into cash immediately without a loss of value. In the same manner, prepaid expenses are also excluded from the list of liquid assets because they are not expected to be converted into cash. Similarly, Liquid liabilities means current liabilities i.e., sundry creditors, bills payable, outstanding expenses, short term advances, income tax payable, dividends payable, and bank overdraft (only if payable on demand). Some time bank overdraft is not included in current liabilities, on the argument that bank overdraft is generally permanent way of financing and is not subject to be called on demand. In such cases overdraft will be excluded from current liabilities.
Liquid Ratio = Liquid Assets / Current Liabilities
From the following information of a company, calculate liquid ratio. Cash $180; Debtors $1,420; inventory $1,800; Bills payable $270; Creditors $500 Accrued expenses $150; Tax payable $750.
Liquid Assets = 180 + 1,420 = 1,600
Current Liabilities = 270 + 500 + 150 + 750 = 1,670
Liquid Ratio = 1,600 / 1,670
= 0.958 : 1
The quick ratio/acid test ratio is very useful in measuring the liquidity position of a firm. It measures the firm’s capacity to pay off current obligations immediately and is more rigorous test of liquidity than the current ratio. It is used as a complementary ratio to the current ratio. Liquid ratio is more rigorous test of liquidity than the current ratio because it eliminates inventories and prepaid expenses as a part of current assets. Usually a high liquid ratios an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand a low liquidity ratio represents that the firm’s liquidity position is not good. As a convention, generally, a quick ratio of “one to one” (1:1) is considered to be satisfactory.
Although liquidity ratio is more rigorous test of liquidity than the current ratio, yet it should be used cautiously and 1:1 standard should not be used blindly. A liquid ratio of 1:1 does not necessarily mean satisfactory liquidity position of the firm if all the debtors cannot be realized and cash is needed immediately to meet the current obligations. In the same manner, a low liquid ratio does not necessarily mean a bad liquidity position as inventories are not absolutely non-liquid. Though this ratio is definitely an improvement over current ratio, the interpretation of this ratio also suffers from the same limitations as of current ratio.
3. Absolute Liquid Ratio:
Absolute liquidity is represented by cash and near cash items. It is a ratio of absolute liquid assets to current liabilities. In the computation of this ratio only the absolute liquid assets are compared with the liquid liabilities. The absolute liquid assets are cash, bank and marketable securities. It is to be observed that receivables are eliminated from the list of liquid assets in order to obtain absolute liquid assets since there may be some doubt in their liquidity.
Absolute Liquid Ratio = Absolute Liquid Assets / Current Assets
This ratio gains much significance only when it is used in conjunction with the current and liquid ratios. A standard of 0.5: 1 absolute liquidity ratio is considered an acceptable norm. That is, from the point of view of absolute liquidity, fifty cents worth of absolute liquid assets are considered sufficient for one shilling worth of liquid liabilities. However, this ratio is not in much use.
Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales. Following are the most important activity ratios:
1. Inventory Turnover Ratio or Stock Turnover Ratio (ITR):
Every firm has to maintain a certain level of inventory of finished goods so as to be able to meet the requirements of the business. But the level of inventory should neither be too high nor too low. A too high inventory means higher carrying costs and higher risk of stocks becoming obsolete whereas too low inventory may mean the loss of business opportunities. It is very essential to keep sufficient stock in business. Stock turn over ratio and inventory turn over ratio are the same. This ratio is a relationship between the cost of goods sold during a particular period of time and the cost of average inventory during a particular period. It is expressed in number of times. Stock turn over ratio/Inventory turn over ratio indicates the number of time the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory. This ratio indicates whether investment in stock is within proper limit or not.
(a) Inventory Turnover Ratio = Cost of goods sold / Average inventory at cost
Generally, the cost of goods sold may not be known from the published financial statements. In such circumstances, the inventory turnover ratio may be calculated by dividing net sales by average inventory at cost. If average inventory at cost is not known then inventory at selling price may be taken as the denominator and where the opening inventory is also not known the closing inventory figure may be taken as the average inventory.
(b) Inventory Turnover Ratio = Net Sales / Average Inventory at Cost
(c) Inventory Turnover Ratio = Net Sales / Average inventory at Selling Price
(d) Inventory Turnover Ratio = Net Sales / Inventory
The cost of goods sold is $500,000. The opening stock is $40,000 and the closing stock is $60,000 (at cost). Calculate inventory turnover ratio
Inventory Turnover Ratio (ITR) = 500,000 / 50,000*
= 10 times
This means that an average one dollar invested in stock will turn into ten times in sales
*($40,000 + $60,000) / 2
Significance of ITR
Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually a high inventory turnover/stock velocity indicates efficient management of inventory because more frequently the stocks are sold, the lesser amount of money is required to finance the inventory. A low inventory turnover ratio indicates an inefficient management of inventory. A low inventory turnover implies over-investment in inventories, dull business, poor quality of goods, stock accumulation, accumulation of obsolete and slow moving goods and low profits as compared to total investment. The inventory turnover ratio is also an index of profitability, where a high ratio signifies more profit, a low ratio signifies low profit. Sometimes, a high inventory turnover ratio may not be accompanied by relatively a high profits. Similarly a high turnover ratio may be due to under-investment in inventories. It may also be mentioned here that there are no rule of thumb or standard for interpreting the inventory turnover ratio. The norms may be different for different firms depending upon the nature of industry and business conditions. However the study of the comparative or trend analysis of inventory turnover is still useful for financial analysis.
2. Debtors Turnover Ratio | Accounts Receivable Turnover Ratio:
A concern may sell goods on cash as well as on credit. Credit is one of the important elements of sales promotion. The volume of sales can be increased by following a liberal credit policy. The effect of a liberal credit policy may result in tying up substantial funds of a firm in the form of trade debtors (or receivables). Trade debtors are expected to be converted into cash within a short period of time and are included in current assets. Hence, the liquidity position of concern to pay its short term obligations in time depends upon the quality of its trade debtors. Debtors turnover ratio or accounts receivable turnover ratio indicates the velocity of debt collection of a firm. In simple words it indicates the number of times average debtors (receivable) are turned over during a year.
Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors
The two basic components of accounts receivable turnover ratio are net credit annual sales and average trade debtors. The trade debtors for the purpose of this ratio include the amount of Trade Debtors & Bills Receivables. The average receivables are found by adding the opening receivables and closing balance of receivables and dividing the total by two. It should be noted that provision for bad and doubtful debts should not be deducted since this may give an impression that some amount of receivables has been collected. But when the information about opening and closing balances of trade debtors and credit sales is not available, then the debtors turnover ratio can be calculated by dividing the total sales by the balance of debtors (inclusive of bills receivables) given.
Debtors Turnover Ratio = Total Sales / Debtors
Credit sales $25,000; Return inwards $1,000; Debtors $3,000; Bills Receivables $1,000.
Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors
= 24,000* / 4,000**
= 6 Times
*25000 less 1000 return inwards, **3000 plus 1000 B/R
Significance of the Ratio
Accounts receivable turnover ratio or debtors turnover ratio indicates the number of times the debtors are turned over a year. The higher the value of debtors turnover the more efficient is the management of debtors or more liquid the debtors are. Similarly, low debtors turnover ratio implies inefficient management of debtors or less liquid debtors. It is the reliable measure of the time of cash flow from credit sales. There is no rule of thumb which may be used as a norm to interpret the ratio as it may be different from firm to firm.
Solvency ratios measure the ability of a company to pay its long term debt and the interest on that debt. Solvency ratios, as a part of financial ratio analysis, help the business owner determine the chances of the firm’s long-term survival. Solvency ratios are of interest to long-term creditors and shareholders. In other words, solvency ratios have to prove that business firms can service their debt or pay the interest on their debt as well as pay the principal when the debt matures.
- Total Debt/Total Assets ratio.
This ratio measures how much of the firm’s asset base is financed using debt. If the Total Debt/Total Assets ratio = 50% this means that half the firm’s assets are financed using debt and the other half are financed using equity sources. The only way you know if this is high or low or average is if you have industry average data to compare to. If industry average data for this firm’s industry is around 50%, then you know your firm is in line with the industry and you are probably doing well with regard to the Debt/Assets ratio. If the Debt/Assets ratio for your company is, for example, 65%, then your debt is high as compared to other firms in your industry and you should definitely take a look at it. Your company is not as solvent as other firms in the industry. As the Debt/Asset ratio increases, the likelihood of bankruptcy also increases as the firm is financed more and more with debt as opposed to equity sources.
Solvency vs Liquidity
Solvency and liquidity are not the same thing. Liquidity is a measure of the firm’s ability to pay short-term debt. Solvency is a measure of the firm’s ability to pay all debt, particularly long-term debt and is a measure of the firm’s long-term survival.
2. Debt to asset ratio
The debt to asset ratio is the percentage of total debt financing the firm uses as compared to the percentage of the firm’s total assets. It helps you see how much of your assets are financed using debt financing
Step 1: Add together the current liabilities and the long-term debt.
Step 2: Add together the current assets and the net fixed assets.
Step 3: Divide the result from Step 1 (total liabilities or debt) by the result from Step 2 (total assets).
For example, if your total debt is $100 and your total assets are $200, then your debt to assets ratio is 50%. This means that 50% of your firm is financed by debt financing and 50% of your firm’s assets is financed by your investors or by equity financing. In order for this to mean anything to you, you need to compare this result with other years of data for your firm (trend analysis) and with the debt to assets ratio for other firms in your industry. If your debt ratio is too high, then you need to take a serious look at why.
Limitations of Financial Statement Analysis
Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Sometimes enough data are presented in foot notes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusion. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry average often suggest avenues for further investigation.
Conclusions based on ratios analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as starting point, as indicators of what to pursue in greater depth. They raise many questions, but they rarely answer any question by themselves.
In addition to ratios, other sources of data should be analyzed in order to make judgment about the future of an organization. The analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself.
Advantages of Financial Statement Analysis
The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.
Brezigar-Masten, A., Coricelli, F., & Masten, I. (2011). FINANCIAL INTEGRATION AND FINANCIAL DEVELOPMENT IN TRANSITION ECONOMIES: WHAT HAPPENS DURING FINANCIAL CRISES? Economic and Business Review for Central and South – Eastern Europe, 13(1), 119-137.