Concept note on Financial Statement Analysis: Ratio Analysis Prof.

Bhavana Raj

(1)An accountants snapshot of the firms accounting value as of a particular date.
(2)The Balance Sheet Identity is: Assets = Liabilities + Stockholders Equity
(3)When analyzing a balance sheet, the financial manager should be aware of three concerns:
accounting liquidity, debt versus equity, and value versus cost.

Balance Sheet Analysis: When analyzing a balance sheet, the financial manager should be
aware of three concerns:

(1)Accounting liquidity:

(1)Refers to the ease and quickness with which assets can be converted to cash.
(2)Current assets are the most liquid.
(3)Some fixed assets are intangible.
(4)The more liquid a firms assets, the less likely the firm is to experience problems meeting
short-term obligations.
(5)Liquid assets frequently have lower rates of return than fixed assets.

(2)Debt versus equity:

(1)Generally, when a firm borrows it gives the bondholders first claim on the firms cash flow.
(2)Thus shareholders equity is the residual difference between assets and liabilities.

(3)Value versus cost:

(1)Under GAAP audited financial statements of firms in the U.S. carry assets at cost.
(2)Market value is a completely different concept.

The Income Statement:

(1)The income statement measures performance over a specific period of time.
(2)The accounting definition of income is :Revenue Expenses = Income.

Income Statement Analysis: There are three things to keep in mind when analyzing an income
statement:

(1)GAAP:

The matching principal of GAAP dictates that revenues be matched with expenses. Thus,
income is reported when it is earned, even though no cash flow may have occurred.

(2)Non Cash Items:

Depreciation is the most apparent. No firm ever writes a check for depreciation. Another
noncash item is deferred taxes, which does not represent a cash flow.

(3)Time and Costs:

In the short run, certain equipment, resources, and commitments of the firm are fixed, but
the firm can vary such inputs as labor and raw materials.
In the long run, all inputs of production (and hence costs) are variable.
Financial accountants do not distinguish between variable costs and fixed costs. Instead,
accounting costs usually fit into a classification that distinguishes product costs from period
costs.

Net Working Capital:
(1)Working Capital = Current Assets Current Liabilities.
(2)NWC is usually growing with the firm.

Managers, shareholders, creditors and other interested groups seek answers to the following
important questions about a firm:
(1)What is the financial position of the firm at a given point of time?
(2)How has the firm performed financially over a given period of time?
(3)What have been the sources and uses of cash over a period of time?
The accountant prepares the balance sheet, the profit and loss account, and the statement of
cash flows to answer the above questions.

Financial Analysis: Financial analysis is the process of identifying the financial strengths and
weaknesses of the firm by property establishing relationships between the item of the
balance sheet and the profit and loss account.

USERS OF FINANCIAL ANALYSIS:
(1)Trade creditors (2)Suppliers of long-term debt (3)Investors (4)Management

NATURE OF RATIO ANALYSIS:
(1)A financial ratio is a relationship between two accounting numbers.
(2)Ratios help to make a qualitative judgment about the firms financial performance.

Standards of Comparison:
(1)Time series analysis (2)Inter-firm analysis
(3)Industry analysis (4)Pro-forma financial statement analysis

Types of Financial Ratios:
(1)Liquidity ratios:

Liquidity ratios measure a firms ability to meet its current obligations.

(1)Current Ratio= [Current Assets]/ [Current Liabilities].

(2)Quick Ratio=[Current Assets-Inventories]/ [Current Liabilities].

(3)Cash Ratio=[Cash + Marketable Securities]/ [Current liabilities].

(4)Interval Measure=[Current Assets-Inventories]/ [Average daily operating expenses].

(5)NWC (Net Working Capital) ratio=[Net Working Capital or NWC]/[Net Assets (NA)].

(2)Leverage ratios:

To judge the long-term financial position of the firm, financial leverage, or capital structure
ratios are calculated. These ratios indicate mix of funds provided by owners and lenders.

(1)Debt ratio=[Total Debt (TD)]/[ Total Debt (TD) + Net-worth (NW)] OR
=[Total Debt (TD)]/[ Capital Employed (CE)].

(2)Debt-Equity ratio=[Total Debt (TD)]/[ Net-worth (NW)].
(3)CE-to-NW ratio=[ Capital Employed (CE)]/[ Net-worth (NW)].

(4)NA-to-NW ratio=[ Net Assets (NA)]/ [ Net-worth (NW)].

(5)TL-to-LF ratio=[Total Liabilities]/[Total Assets].

(6)LT-to-LF ratio=[Long-Term Debt (LD)]/[Long-Term Debt (LD) + Net-worth (NW)].

(7)LT-to-NW ratio=[Long-Term Debt (LD)]/ [Net-worth (NW)].

(8)Debt ratio=
[Total Debt + Value of the Lease]/[Total Debt + Value of the Lease+ Net-worth (NW)].

(9)Debt-Equity ratio=[Total Debt + Value of the Lease]/ [Net-worth (NW)].

(3)Activity ratios:

Activity ratios are employed to evaluate the efficiency with which the firm manages and
utilizes its assets. These ratios are also called turnover ratios because they indicate the speed
with which assets are being converted or turned over into sales. Activity ratios, thus, involve
a relationship between sales and assets.

(1)Inventory Turnover Ratio=[Cost of Goods Sold (COGS)]/[Average inventory].

(2)Debtors Turnover Ratio=[Credit Sales]/[Average Debtors].

(3)Net Assets Turnover Ratio=[Sales]/[Net Sales].

(4)Profitability ratios:

The profitability ratios are calculated to measure the operating efficiency of the company.
Generally, two major types of profitability ratios are calculated:
(1)Profitability in relation to sales & (2)Profitability in relation to investment.

(1)Gross Profit Margin (GPM) =[Sales- Cost of Goods Sold (COGS)]/[Sales]. OR
=[Gross Profit]/[Sales].

(2)Net Profit Margin (NPM)=[Profit After Tax (PAT)]/[Sales]. OR =[EBIT*(1-T)]/[Sales] OR
=[NOPAT]/[Sales].

(3)Operating Expenses Ratio=[Operating Expenses]/[Sales].

(4)ROI=ROTA=[EBIT*(1-T)]/[Total Assets] OR =[EBIT*(1-T)]/[TA] .

(5)ROI=RONA=[EBIT*(1-T)]/[Net Assets] OR =[EBIT*(1-T)]/[NA] .

(6)ROE=[Profit After Taxes (PAT)]/[Net-worth (EQUITY)] OR [PAT]/[NW].

(7)EPS=[Profit After Taxes (PAT)]/[Number of Equity Shares Outstanding].

(8)DPS=
[Dividend or Earnings Paid to the Shareholders]/[ Number of Ordinary Shares Outstanding].

(9)Payout ratio=[Equity Dividends]/[Profit After Taxes (PAT)]. OR [DPS]/[EPS]
=[Dividend Per Share]/[Earnings Per Share].

(10)Dividend Yield =[ DPS]/[MV]=[Dividend Per Share]/[Market Value per Share].

(11)Earnings Yield=[EPS]/[MV]= [Earnings Per Share]/[Market Value per Share].

(12)Price-Earnings Ratio=[MV]/[EPS]= [Market Value per Share]/ [Earnings Per Share].

(13)M/B Ratio=[Market Value per Share]/[Book Value per Share].

(14)Tobins q=[Market Value of Assets]/[Replacement Cost of Assets].

EVALUATION OF A FIRMS EARNING POWER: DUPONT ANALYSIS:
(1)RONA (or ROCE) is the measure of the firms operating performance. It indicates the firms
earning power.

(2)RONA can be computed as follows: RONA = [EBIT/NA]=[Sales/NA]*[GP/Sales]*[EBIT/GP].

(3) A firm can convert its RONA into an impressive ROE through financial efficiency.

(4)ROE=[Operating Performance] *[Leverage Factor].

(5)ROE=[PAT/NW]=[EBIT/NA]*[PAT/EBIT]*[NA/NW].

APPLICATIONS OF FINANCIAL ANALYSIS: Financial ratios may be employed to:
(1)Assess corporate excellence (2)Judge creditworthiness (3)Forecast bankruptcy
(4)Value equity shares (5)Predict bond ratings (6)Estimate market risk

PROBLEMS IN FINANCIAL STATEMENT ANALYSIS:
(1)Heuristic and Intuitive Character (2)Development of Benchmarks (3)Window Dressing
(4)Price Level Changes (5)Variations in Accounting Policies
(6)Interpretation of Results (7)Correlation among Ratios

GUIDELINES:
(1)USE RATIO TO GET CLUES TO ASK THE RIGHT QUESTIONS
(2)BE SELECTIVE IN THE CHOICE OF RATIOS
(3)EMPLOY PROPER BENCHMARKS
(4)KNOW THE TRICKS USED BY ACCOUNTANTS
(5)READ THE FOOT NOTES
(6)UNDERSTAND HOW THE RATIOS ARE INTER-RELATED
(7)REMEMBER FSA .. ODD MIXTURE OF ART & SCIENCE

LOOKING BEYOND THE NUMBERS
(1)ARE THE COMPANYS REVENUES TIED TO ONE KEY CUSTOMER ?
(2)TO WHAT EXTENT ARE THE COMPANYS REVENUES TIED TO ONE KEY PRODUCT ?
(3)TO WHAT EXTENT DOES THE COMPANY RELY ON A SINGLE SUPPLIER ?
(4)WHAT PERCENTAGE OF THE COMPANYS BUSINESS IS GENERATED OVERSEAS ?
(5)COMPETITION
(6)FUTURE PROSPECTS
(7)LEGAL AND REGULATORY ENVIRONMENT

COMPARATIVE STATEMENTS ANALYSIS:
(1)A simple method of tracing periodic changes in the financial performance of a company is
to prepare comparative statements.
(2)Comparative financial statements will contain items at least for two periods.
(3)Changesincreases and decreasesin income statement and balance sheet over a period
can be shown in two ways: (1) aggregate changes and (2) proportional changes.


TREND ANALYSIS:
(1)In financial analysis the direction of changes over a period of years is of crucial importance.
(2)Time series or trend analysis of ratios indicates the direction of change.
(3)This kind of analysis is particularly applicable to the items of profit and loss account.
(4)For trend analysis, the use of index numbers is generally advocated.
(5)The procedure followed is to assign the number 100 to items of the base year and to
calculate percentage changes in each items of other years in relation to the base year. This
procedure may be called as trend-percentage method.

INTER-FIRM ANALYSIS:
(1)The analysis of the financial performance of all firms in an industry and their comparison at
a given point of time is referred to the cross-section analysis or the inter-firm analysis.
(2)To ascertain the relative financial standing of a firm, its financial ratios are compared
either with its immediate competitors or with the industry average.

UTILITY OF RATIO ANALYSIS:
(1)The ability of the firm to meet its current obligations.
(2)The extent to which the firm has used its long-term solvency by borrowing funds.
(3)The efficiency with which the firm is utilizing its assets in generating sales revenue.
(4)The overall operating efficiency and performance of the firm.

Diagnostic Role of Ratios:
(1)Profitability analysis (2)Assets utilization (3)Liquidity analysis (4)Strategic Analysis

CAUTIONS IN USING RATIO ANALYSIS:
(1)Standards for comparison (2)Company differences (3)Price level changes
(4)Different definitions of variables (5)Changing situations (6)Historical data

SUMMING UP:
(1)Financial statements provide important information regarding the value of the firm.
(2)Measures of profitability do not take risk or timing of cash flows into account.
(3)Financial ratios are linked to one another.
(4)Financial statement analysis can provide valuable insights into a firms performance and
position.
(5)The principal tool of financial statement analysis is financial ratio analysis.
(6) Financial ratios may be divided into five broad categories:
Liquidity ratios, Leverage ratios, Turnover ratios, Profitability ratios & Valuation ratios.
(7) Generally, the financial ratios of a company are compared with some benchmark ratios.
(8) The Du Pont chart is a popular tool of financial analysis. It provides insights into the
determinants of the return on equity.
(9)There are certain problems and issues in financial statement analysis that call for care,
circumspection, and judgment.