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# Financial Statement Analysis

Assistant Professor
University of Dhaka
A simple algorithm for ratio analysis
1. Compare with past years ratios.
2. Compare the ratio with similar company.
3. Compare with benchmark (with industry leader/ industry average).
4. Explain what the ratio indicates as per as financial condition of the company is concerned.

Liquidity Ratios Measure short-term ability of the company to pay its maturing obligations and to
meet unexpected needs for cash.
Profitability Ratios Measure the income or operating success of a company for a given period of
time Net Revenues Expenses income
Capital Structure/ Gearing Ratio Measure the ability of the company to survive over a long
period of time
Market Performance Ratio Measure the performance related to shareholders expectations of public limited
companies and companies listed on stock exchanges.
Profitability Ratio:
ROE = Net Income/ Average Common Shareholders Equity
With Preferred Stock:
ROE = (Net Income Preferred Dividend)/ Average Common Shareholders Equity
ROA = Net Income/Average Total Asset
Gross Profit Margin = Gross Profit/Sales
Net Profit Margin = Net Profit/ Sales
Asset Efficiency Ratio
Asset Turnover Ratio = Sales/ Average Total Assets
Inventory Turnover = Cost of Goods Sold/ Average Inventories
Accounts Receivables Turnover = Credit Sales/Average Accounts Receivables
Accounts Payable Turnover = Cost of Goods Sold/ Average Accounts Payable
Days inventory/ Inventory Conversion Period = 365/ Inventory Turnover
Average Collection Period = 365 / Accounts Receivables Turnover
Average Payment Period = 365/ Accounts Payable Turnover
Cash Conversion Cycle = (365/Inventory Turnover)+(365/Accounts Receivable Turnover)- ( 365/Accounts
Payable Turnover)

Liquidity Analysis:
Current ratio = Current Asset/ Current Liabilities
Acid test ratio/ quick asset ratio = (Current Asset Inventory)/ Current Liabilities
Solvency / Capital Structure/ Leverage / Gearing Ratio:
Debt to equity: Total Debt/ Shareholders Equity
Debt ratio: Total Debt/ Total Asset
Equity ratio: Shareholders Equity/ Total Asset
Interest coverage ratio: EBIT/ Interest
Market Performance Ratio:
EPS = (Net Income Dividend on Preferred Stock)/ Weighted Average Number of Share Outstanding
Dividend payout ratio = Dividend paid per share/ Earning Per Share
PER = Price Per Share/ Earning Per Share

Analysis of ratios
Profitability Ratio:
ROE: the higher the better (compare with past years and/or similar companies, analyse the trend)
ROA: the higher the better (,,)
Profit Margin Ratio: generally, the higher the better
Gross Profit Margin Ratio: generally, the higher the better
Asset Efficiency Ratio
Asset Turnover: the higher the better (,,)
Inventory turnover: the higher the better (,,)
Accounts Receivables turnover: the higher the better (,,)
Days inventory: the lower the better (,,)
Average collection period: the lower the better (,,)
Liquidity Analysis:
Current ratio: 1.5 (higher than this means more liquidity for the company but indicates unprofitable
investment of current asset, lower than this indicates liquidity problem)
Acid test ratio/ quick asset ratio: 0.8 (higher than this means more liquidity for the company but indicates
unprofitable investment of current asset, lower than this indicates liquidity problem)
Capital Structure:
Debt to equity: 100% (higher than this benchmark indicate higher dependence of debt. Too much high may
indicate financial risk.)
Debt ratio: 50%. (same as above)

Equity ratio: 50% (less than this benchmark figure indicates indicate higher dependence of debt. Too low
may indicates high financial risk.)
Interest coverage ratio: the higher the better. Less than 1 indicates bankruptcy in near future.
Market Performance Ratio:
Intangible assets: copyright, patent, trademark, goodwill; Tangible asset: land, building, furniture, equipment
Net tangible asset backing: the higher the better (compare with past years and/or similar companies,
analyse the trend)
EPS: the higher the better.
Dividend payout ratio: the higher the better for the investors.
PER: High PER indicates high expectation of the investors about the future of the company and vice versa.

## Use of Ratios by Users of Financial Statements

1. A short-term creditor, such as a bank, is primarily interested in liquiditythe ability of the

## borrower to pay obligations when they come due.

2. A long-term creditor, such as a bondholder, looks to profitability and solvency measures that

indicate the companys ability to survive over a long period of time. Long-term creditors
consider such measures as the amount of debt in the companys capital structure and its
ability to meet interest payments.
3. Stockholders look at the profitability and solvency of the company. They want to assess the

likelihood of dividends and the growth potential of the stock. They also use the market
perforce ratios.