Unit 4: Analysis of financial statement

Analysis of financial statement

The analysis of financial statements involves examining financial data to evaluate a company's performance, financial stability, and overall health. This process aids stakeholders like investors, management, and creditors in making informed decisions.

Objectives of Financial Statement Analysis

• Assess Profitability: Analyze income to understand profitability trends.
• Evaluate Liquidity: Ensure the company can meet its short-term obligations.
• Measure Solvency: Assess long-term stability and debt repayment ability.
• Identify Financial Strengths and Weaknesses: Detect areas for improvement.
• Assist Decision-Making: Provide data-driven insights for strategic decisions.

Types of Financial Analysis

Benefits of Financial Statement Analysis

• Better Financial Planning: Helps set strategic goals.
• Creditworthiness Assessment: Useful for lenders and creditors.
• Investment Decision Support: Aids investors in choosing stocks or bonds.
• Performance Monitoring: Allows businesses to track efficiency.

Ratio Analysis

Ratio Analysis is a financial tool used to evaluate the performance, efficiency, liquidity, solvency, and profitability of a business by analyzing its financial statements. It helps stakeholders make informed decisions by comparing different financial metrics.

Importance of Ratio Analysis

• Evaluates Financial Health: Helps assess liquidity, profitability, and solvency.
• Aids in Decision-Making: Assists managers in resource allocation.
• Identifies Trends: Tracks performance over time.
• Facilitates Comparison: Allows benchmarking with competitors or industry standards.

Example Calculation

Debt to Equity Ratio

If Total Debt = Rs. 5,00,000 and Total Equity = Rs. 2,50,000

Formula:

Debt to Equity Ratio = 5,00,000 / 2,50,000 = 2:1

Solvency Ratios

Solvency Ratios measure a company's ability to meet its long-term financial obligations. They help assess the financial stability and risk of insolvency.

Formula Breakdown and Example Calculations

Debt to Equity Ratio

Formula: Total Debt / Total Equity

Example: If Total Debt is Rs. 5,00,000 and Total Equity is Rs. 2,50,000

Debt to Equity = 5,00,000 / 2,50,000 = 2:1

Interest Coverage Ratio

Formula: EBIT / Interest Expense

Example: If EBIT is Rs. 2,00,000 and Interest Expense is Rs. 50,000

Interest Coverage Ratio = 2,00,000 / 50,000 = 4 times

Debt to Assets Ratio

Formula: Total Debt / Total Assets

Example: If Total Debt is Rs. 4,00,000 and Total Assets are Rs. 8,00,000

Debt to Assets Ratio = 4,00,000 / 8,00,000 = 0.5 (50%)

Profitability Ratios

Profitability ratios assess a company's ability to generate profits relative to its sales, assets, equity, or other financial metrics.

Formula Breakdown and Example Calculations

Gross Profit Ratio

Formula: (Gross Profit / Net Sales) × 100

Example: If Gross Profit = Rs. 2,00,000, Net Sales = Rs. 10,00,000

Gross Profit Ratio = (2,00,000 / 10,00,000) × 100 = 20%

Net Profit Ratio

Formula: (Net Profit / Net Sales) × 100

Example: Net Profit = Rs. 1,00,000, Net Sales = Rs. 10,00,000

Net Profit Ratio = (1,00,000 / 10,00,000) × 100 = 10%

Return on Equity (ROE)

Formula: (Net Income / Shareholder’s Equity) × 100

Example: Net Income = Rs. 3,00,000, Shareholder's Equity = Rs. 15,00,000

ROE = (3,00,000 / 15,00,000) × 100 = 20%

Activity Ratios (Efficiency Ratios)

Activity ratios measure how efficiently a company uses its assets to generate revenue and manage operations. They help in evaluating operational efficiency.

Formula Breakdown and Example Calculations

Inventory Turnover Ratio

Formula: Cost of Goods Sold / Average Inventory

Example: COGS = Rs. 4,00,000, Average Inventory = Rs. 80,000

Inventory Turnover Ratio = 4,00,000 / 80,000 = 5 times

Accounts Receivable Turnover Ratio

Formula: Net Credit Sales / Average Accounts Receivable

Example: Net Credit Sales = Rs. 5,00,000, Average Receivables = Rs. 1,00,000

Accounts Receivable Turnover Ratio = 5,00,000 / 1,00,000 = 5 times

Asset Turnover Ratio

Formula: Net Sales / Average Total Assets

Example: Net Sales = Rs. 10,00,000, Average Assets = Rs. 5,00,000

Asset Turnover Ratio = 10,00,000 / 5,00,000 = 2 times

Liquidity Ratios

Liquidity ratios measure a company's ability to meet its short-term financial obligations using its current assets.

Formula Breakdown and Example Calculations

Current Ratio

Formula: Current Assets / Current Liabilities

Example: Current Assets = Rs. 3,00,000, Current Liabilities = Rs. 1,50,000

Current Ratio = 3,00,000 / 1,50,000 = 2:1

Quick Ratio (Acid Test)

Formula: (Current Assets - Inventory) / Current Liabilities

Example: Current Assets = Rs. 3,00,000, Inventory = Rs. 50,000, Current Liabilities = Rs. 1,50,000

Quick Ratio = (3,00,000 - 50,000) / 1,50,000 = 2:1

Cash Ratio

Formula: Cash and Cash Equivalents / Current Liabilities

Example: Cash = Rs. 1,00,000, Current Liabilities = Rs. 1,50,000

Cash Ratio = 1,00,000 / 1,50,000 = 0.67:1

Market Capitalization Ratios

Market capitalization ratios are financial metrics used to evaluate the market value of a company's stock and assess its investment potential. These ratios provide insights into the company's value in the stock market compared to its earnings, book value, and other financial factors.

Formula Breakdown and Example Calculations

Earnings Per Share (EPS)

Formula: (Net Income - Preferred Dividends) / Number of Shares

Example: Net Income = Rs. 5,00,000; No. of Shares = 50,000

EPS = 5,00,000 / 50,000 = Rs. 10 per share

Price to Earnings (P/E) Ratio

Formula: Market Price per Share / EPS

Example: Market Price per Share = Rs. 100, EPS = Rs. 10

P/E Ratio = 100 / 10 = 10 times

Dividend Yield

Formula: (Annual Dividend per Share / Market Price per Share) × 100

Example: Dividend = Rs. 5, Market Price = Rs. 100

Dividend Yield = (5 / 100) × 100 = 5%

Leverage Ratios

Leverage ratios measure a company's financial structure and its reliance on borrowed funds. These ratios assess the firm's ability to meet its long-term obligations and the extent of its financial risk.

Formula Breakdown and Example Calculations

Debt to Equity Ratio

Formula: Total Debt / Shareholder’s Equity

Example: Total Debt = Rs. 5,00,000, Shareholder’s Equity = Rs. 10,00,000

Debt to Equity Ratio = 5,00,000 / 10,00,000 = 0.5:1

Debt Ratio

Formula: Total Debt / Total Assets

Example: Total Debt = Rs. 5,00,000, Total Assets = Rs. 15,00,000

Debt Ratio = 5,00,000 / 15,00,000 = 0.33 or 33%

Interest Coverage Ratio

Formula: EBIT / Interest Expenses

Example: EBIT = Rs. 2,00,000, Interest Expenses = Rs. 50,000

Interest Coverage Ratio = 2,00,000 / 50,000 = 4 times

Detailed Analysis using excel application

Step 1: Data Collection

Prepare the following data for analysis:

• Total Debt: Includes both short-term and long-term liabilities
• Shareholder’s Equity: From the balance sheet
• Total Assets: Sum of all assets
• EBIT (Earnings Before Interest and Taxes): From the income statement
• Interest Expenses: Interest paid on debt

Step 5: Visualization in Excel

• Insert Charts:
• Go to Insert > Pie Chart for debt-to-equity distribution.
• Use Bar Charts to compare multiple ratios.
• Conditional Formatting:
• Highlight cells based on thresholds (e.g., red for high debt ratio, green for high interest coverage).

Step 6: Insights and Interpretation

• Debt to Equity Ratio (0.5): Indicates balanced capital structure.
• Debt Ratio (33%): Suggests stable financing with less reliance on debt.
• Interest Coverage Ratio (4 times): Shows strong ability to service debt.
• Equity Multiplier (1.5): Indicates moderate asset financing through equity.