Financial Statement and Ratio

Analysis

Financial Statement Analysis

Financial Statement Analysis is the application of analytical

tools to financial statements and related data for business
decisions. It involves transforming accounting data into useful
information. It provides us an effective and systematic basis for
business decision. It gives an insight about the company's
operating performance and financial health both to the internal
and external users of financial information.

Standards for Comparison

A) Intra-company:
With in the company, the company can compare the financial performance of
the current year with in that of the previous year. For example, the turnover of
Beximco Textile ltd. in 2004 can be compared with that in 2003.

B) Inter-Company/Competitor:
A company can compare its financial performance with other companies in the
industry. For example, the turnover of Beximco Textile ltd. in 2004 can be
compared with that of Square Textile ltd. in the same year.

C) Industry Average:
Industry average can also provide standards for comparison.

D) Guidelines (rules of thumbs):

General standards of comparison can develop from past experiences. For
example: 2:1 is the standards for the current ratio or 1:1 for the quick ratio.

Ratio Analysis

A ratio expresses a mathematical relationship between two quantities. It can be expressed

as a percent, rate or proportion.

Comparison done in the absolute measure does not always give us a true picture. Look at
the following figure:
Company X
Net sales

5,00,000

Net Profit

50,000

Company Y
8,00,000
55,000

Apparently, we tell that Company Y has operating performance better than Company X. But
it is not. Take a look at the following figure:
Company X
Net sales
Net Profit
Net Profit to net sales

Company Y
5,00,000
50,000
10%

8,00,000
55,000
8.75%

So ratio analysis expresses the relative size of one amount to another. Based on ratio
analysis, we see that Company Xs profit sounds better than Company Y.

Types of Ratios
We classify ratios under the following categories:

Liquidity and Efficiency

Solvency

Profitability

Market

Liquidity and Efficiency Ratio:

Liquidity refers to the ability to meet short term obligations and efficiency refers to
the ability of being productive in using the asset. Under this section :
a) Current ratio:
The current ratio measures the relationship between total current asset and total
current liabilities at a specific date.
Current Ratio= Current Asset / Current Liabilities
A high current ratio suggest a strong liquidity position. An excessively high ratio
means the company has invested too much in current assets comparing to its
current obligations.

Current Asset Composition

Cash
Cash Equivalent
Short term investment
Accounts Receivables
Prepaid Expenses
Merchandise inventory

Current Liabilities Composition

Accounts Payable
Current notes payable
Current portion of any long term debt
Accrued Expenses
Income Tax Payable

B) Quick Ratio/ Acid test Ratio:

The quick ratio is similar to the current ratio except that it is a mere stringent test of short term
liability.
Quick Ratio= Quick asset/ Current Liabilities
Quick Asset include:
Cash
Short term investment
Accounts Receivables

c) Accounts Receivables Turnover:

How frequently a company converts its receivables into cash.
Receivables Turnover= Sales/ Average Accounts Receivables
This ratio measures the effectiveness of the companys credit granting and
collection activities.
Average Accounts Receivable=( Opening accounts receivable+ Ending
accounts receivable)/2
d) Inventory Turnover:
Inventory turnover measures the liquidity of the inventory. It reflects the
relationship of the inventory to the volume of goods sold during the period.
Inventory Turnover = Cost of Goods sold/ Average Inventory
Cost of goods sold = Sales-Gross Profit
Average inventory=( Opening inventory+ Ending inventory)/2

Solvency/ Leverage/ Capital Structure Ratio :

Solvency refers to a companys long run financial viability and its ability to
meet long term obligations.
a) Debt Ratio:
Debt ratio measures the portion of a companys assets contributed by creditors.
Debt Ratio = Total Liabilities / Total Asset
Companies are said to be highly leveraged if a large portion of their asset is
financed by debt.
b) Equity Ratio:
Equity ratio measures the portion of a companys assets contributed by its
owners.
Equity Ratio = Total Equity/ Total Asset

Profitability Ratio:
Profitability refers to a companys ability to use its assets efficiently to
generate revenues ( positive cash flows). Profitability also refers to
solvency. Profitability Ratios are:
a) Profit Margin ratio:

Measures the profitability of a company.

Profit Margin = (Net income / Net Sales)*100
Net Income = Income after Interest and Tax
b) Gross Margin ratio:

Gross Margin =( Gross Margin / Net Sales)*100

Gross Margin = Sales Cost of Goods Sold

C) Return on asset (ROA) :

Relates income to total asset invested.
ROA= Net income/ Average total asset
Average Total Asset=( Opening total asset+ Ending total asset) /2

d) Return on Equity (ROE):

Return on equity is a fundamental test of equity.
ROE= Net Income/ Average owners equity
Income excluded preferred dividend if any.

e) Earning per share:

EPS= Net Income
Average number of equity/common stock outstanding

f) Book value per share:

It measures the book value (balance sheet amount) per common stock
outstanding in the market.
Book value per share= Share holders equity applicable to common share
Number of common share outstanding

Market:
Test of market in view of financial statement analysis measures the ability to
generate positive market expectations. Market measures are useful when
analyzing companies having publicly traded stock. These market measures
use stock price in their computation. Stock price reflects what the market
(public) expectations are for the company. Under this section, we have:
a) Price Earning Ratio.
b) Dividend Yield Ratio.

a) Price Earning (PE) Ratio:

The price earning ratio measures the relationship between the current
market price of the stock and its earning per share. The PE ratio can be
viewed as an indicator of investors expected growth and risk for a
company's stock. A high growth rate suggest a high PE ratio and a high
level of perceived risk suggest a low PE ratio.
PE Ratio= Current Market price per share/ Earning per share
b) Dividend Yield:
The dividend yield ratio measures the relationship between the dividend per
share paid and the current market price of the stock.
Dividend Yield Ratio= Annual dividend per share/ Market price per share