Financial Statement and

Ratio Analysis
 Business Survival:
There are two key factors for business survival:
• Profitability
• Solvency

• Profitability is important if the business is to

generate revenue (income) in excess of the
expenses incurred in operating that business.
• The solvency of a business is important
because it looks at the ability of the business in
meeting its financial obligations.
 Financial Statement Analysis
• Financial Statement Analysis will help business
owners and other interested people to analyse
the data in financial statements to provide them
with better information about such key factors for
decision making and ultimate business survival.
• Financial Statement Analysis is the
collective name for the tools and
techniques that are intended to provide
relevant information to the decision
makers. The purpose of the FSA is to
assess the financial health and
performance of the company.
• FSA consist of the comparisons for the
same company over the period of time and
comparisions of different companies either
in the same industry or in different
industries.
© Mary Low
 Financial Statement Analysis
Purpose:
• To use financial statements to evaluate an
organization’s
– Financial performance
– Financial position
– Prediction of future performance
• To have a means of comparative analysis across time
in terms of:
– Intracompany basis (within the company itself)
– Intercompany basis (between companies)
– Industry Averages (against that particular industry’s averages)
• To apply analytical tools and techniques to financial
statements to obtain useful information to aid decision
making.
 Financial Statement Analysis
Financial statement analysis involves analysing the
information provided in the financial statements to:
– Provide information about the organisation’s:
• Past performance
• Present condition
• Future performance
– Assess the organisation’s:
• Earnings in terms of power, persistence, quality
and growth
• Solvency
 Financial Statements…

1. The Income Statement

2. The Balance Sheet
3. The Statement of Cash Flows
4. The Statement of Shareholder’s Equity

© Mary Low
 Financial Statements
Diagram 1

Financial
Statements

D. Shareholders
A. Statement of C. Statement of
B. Balance Sheet Equity
Income Cash Flow (CF)
Statement
 Financial Statements Diagram 1 - a

Financial
Statements

A. Statement of B. Balance D. Shareholders

C. Statement of
Income Sheet Equity
Cash Flow (CF)
Statement

-Revenue - Assets -Operating CF

-Income -Investing CF
-Liabilities
-Profit -Financing CF
-Debt
-Equity
Balance Sheet
 A summary of a firm’s financial position on
a given date that shows total assets = total
liabilities + owners’ equity.
Income Statement
 A summary of a firm’s revenues and
expenses over a specified period, ending
with net income or loss for the period.
Basket Wonders Balance Sheet (thousands) Dec. 31, 2016
Current Assets:
Cash and Cash Equivalents 90
Accounts Receivable 394
Inventories 696
Prepaid Expenses 5
Accumulated Tax Prepayment 10
Total Current Assets 1,195
Non- current Assets:
Fixed Assets 1,030
Less: Accumulated Depreciation (329)
Investments 50
Other Noncurrent Assets 223
Total Non-Current Assets 974
TOTAL ASSETS 2,169
Basket Wonders Balance Sheet (thousands) Dec. 31, 2016
Current Liabilities:
Notes Payable 290
Accounts Payable 94
Accrued Taxes 16
Other Accrued Liabilities 100
Total Current Liabilities 500
Non- Current Liabilities
Loans Payable 530
TOTAL LIABILITIES 1,030

Shareholder's Equity:
Common Stock (1 par) 200
Add: Paid In Capital 729
Retained Earnings 210
TOTAL SHAREHOLDER'S EQUITY 1,139
TOTAL LIABILITIES & SHAREHOLDER'S EQUITY 2,169
Basket Wonders Statement of Earnings (in thousands)
for Year Ending December 31, 2016
Net Sales 2,211
Cost of Goods Sold 1,599
Gross Profit 612
Selling and Administrative Expenses 402
Earnings Before Interest and Tax (EBIT) 210
Interest Expense 59
Earnings Before Tax (EBT) 151
Income Taxes 60
Earnings After Tax (EAT) 91
Cash Dividends 38
Increase in Retained Earnings 53
 Effective Financial Statement Analysis

• To perform an effective financial statement

analysis, you need to be aware of the
organisation’s:
– business strategy
– objectives
– annual report and other documents like articles about
the organisation in newspapers and business reviews.
These are called individual organisational factors.
Effective Financial Statement Analysis
Requires that you:
• Understand the nature of the industry in which
the organisation works. This is an industry
factor.
• Understand that the overall state of the
economy may also have an impact on the
performance of the organisation.

→ Financial statement analysis is more than just

“crunching numbers”; it involves obtaining a
broader picture of the organisation in order to
evaluate appropriately how that organisation is
performing
 Tools of Financial Statement Analysis:
The commonly used tools for financial statement
analysis are:
• Financial Ratio Analysis
• Comparative financial statements analysis:
– Horizontal analysis/Trend analysis
– Vertical analysis/Common size analysis/ Component
Percentages
 Financial Ratio Analysis
• Financial ratio analysis involves calculating and analysing
ratios that use data from one, two or more financial
statements.
• Ratio analysis also expresses relationships between
different financial statements.

• A ratio is a statistical yardstick that provides a measure of

the relationship between two variables/ figures
 Financial Ratio Analysis
• A ratio is not an end in itself. They are
only a means to get to know the financial
position of an enterprise.
• Computing ratios does not add any
information to the available figures.
• It only reveals the relationship in a more
meaningful way so as to enable us to
draw conclusions there from.
 Importance of Ratios
• Accounting ratios are very useful in
assessing the financial position and
profitability of an enterprise.

• However its utility lies in comparison of

the ratios.
 Importance of Ratios
Comparison may be in any one of the following
forms:

• For the same enterprise over a number of years

• For two enterprises in the same industry
• For one enterprise against the industry as a whole
• For one enterprise against a pre-determined standard
• For inter-segment comparison within the same
organization
Financial Ratios can be classified into 5
main categories:

A. Profitability Ratios
B. Liquidity or Short-Term Solvency ratios
C. Asset Management or Activity Ratios
D. Financial Structure or Capitalization
Ratios
E. Market Test Ratios
A. Profitability Ratios
3 elements of the profitability analysis:
• Analysing on sales and trading margin
– focus on gross profit
• Analysing on the control of expenses
– focus on net profit
• Assessing the return on assets and return
on equity
A. Profitability Ratios
• Gross Profit % = Gross Profit * 100
Net Sales
• Net Profit % = Net Profit after tax * 100
Net Sales
Or in some cases, firms use the net profit before tax figure. Firms
have no control over tax expense as they would have over other
expenses.
 Net Profit % = Net Profit before tax *100
Net Sales

• Return on Assets = Net Profit * 100

Average Total Assets

• Return on Equity = Net Profit *100

Average Total Equity
 Profitability Ratio
Gross Profit
Gross profit Margin  x100
Sales
Net Profit
Net profit Margin  x 100
Sales

• Represented as a %age to Sales

• Greater the margin/%age better it is
 Income Statement / Gross Profit Margin
Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2016
Indicates the efficiency
of operations and firm 612 = .277
pricing policies. 2,211
6-25
 Gross Profit Margin
Year BW Industry
2016 27.7% 31.1%
2017 28.7 30.8
2018 31.3 27.6
BW has a weak Gross Profit Margin.
6-26
 Income Statement / Net Profit Margin
Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2016
Indicates the firm’s
91 = .041
profitability after taking 2,211
account of all expenses
and income taxes. 6-27
 Net Profit Margin
Year BW Industry
2016 4.1% 8.2%
2017 4.9 8.1
2018 9.0 7.6
BW has a poor Net Profit Margin.
6-28
 Income Statement / Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For Basket Wonders
Indicates the December 31, 2018
profitability on the
assets of the firm (after 91 = .042
all expenses and taxes). 2,160
6-29
 Return on Investment
Year BW Industry
2016 4.2% 9.8%
2017 5.0 9.1
2018 9.1 10.8
BW has a poor Return on Investment.
6-30
 Income Statement / Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders’ Equity
Profitability Ratios
For Basket Wonders
Indicates the profitability December 31, 2016
to the shareholders of 91
the firm (after all = .08
1,139
expenses and taxes).
6-31
 Return on Equity
Year BW Industry
2016 8.0% 17.9%
2017 9.4 17.2
2018 16.6 20.4
BW has a poor Return on Equity.
6-32
 B. Liquidity or Short-Term Solvency ratios
Short-term funds management
-Working capital management is important as it signals the firm’s
ability to meet short term debt obligations.

-Shows ability of company to pay its current f financial obligations

For example: Current ratio
• The ideal benchmark for the current ratio is $2:$1 where there are two
dollars of current assets (CA) to cover $1 of current liabilities (CL).
The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL
represents liquidity riskiness as there is insufficient current assets to
cover $1 of current liabilities.
 B. Liquidity or Short-Term Solvency ratios
• Working Capital = Current assets – Current Liabilities

• Current Ratio = Current Assets

Current Liabilities

• Quick Ratio = Current Assets – Inventory – Prepayments

Current Liabilities – Bank Overdraft
 CURRENT RATIO
Current Assets
Current Ratio 
Current Liabilites

• Where current assets represent the assets that can be converted into
cash within a short period, conventionally with one year
• Like wise the current liabilities refer to liabilities the payment of which is
to be made within 1 year
• This ratio represents the amount in Rs. Available in current assets to
pay off the each peso of Current Liabilities
• This Ratio refers to the potential of the company to cover its current
liabilities payments through its current assets.
• Greater the availability of current assets to cover current liabilities better
it is
• There is no thumb rule to say what would be the best. However
conventionally a current ratio of 2:1 is considered satisfactory.
 Acid-Test or Quick Ratio
Quick Assets
Acid test Ratio 
Current Liabilities

• Where Quick assets refers to assets that on short notice can be

converted into cash. Normally this means current assets-Stocks
• This ratio is a derived from current ratio and represents and more critical
analysis
• Greater the companies ability to cover its current liabilities from Quick
assets better it is
• Conventionally a ratio of 1:1 is considered satisfactory
 Balance Sheet Ratios Current

Current Assets
Liquidity Ratios Current Liabilities

Shows a firm’s For Basket Wonders

ability to cover its December 31, 2016
current liabilities 1,195 = 2.39
with its current 500
6-16
assets.
 Current Ratio
Year BW Industry
2016 2.39 2.15
2017 2.26 2.09
2018 1.91 2.01
Ratio is stronger than the industry average.
6-17
 Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios Current Liabilities

Shows a firm’s For Basket Wonders

ability to meet December 31, 2016
current liabilities 1,195 - 696
with its most liquid 500 = 1.00

6-18
assets.
 Acid-Test Ratio
Year BW Industry
2016 1.00 1.25
2017 1.04 1.23
2018 1.11 1.25
Ratio is weaker than the industry average.
6-19
 Ratio BW Industry
Current 2.39 2.15
Acid-Test 1.00 1.25
 Strong current ratio and weak acid-test
ratio indicates a potential problem in the
inventories account.
 Note that this industry has a relatively
high level of inventories.
6-20
 The current ratio for BW has been rising
at the same time the acid-test ratio has
been declining.
 The current ratio for the industry has
been rising slowly at the same time the
acid-test ratio has been relatively stable.
 This indicates that inventories are a
significant problem for BW.
6-42
 B. Liquidity or Short-Term Solvency ratios
IMPORTANCE:

• Higher ratio ensures firm does not face problems in

meeting increased working capital requirements

• Low ratio implies repeated withdrawals f rom bank

to meet l liquidity requirements

• High CR as compared to other firms implies advantage

of lower interest rates f rom banks
C. Asset Management or Activity Ratios
• Efficiency of asset usage
– How well assets are used to generate revenues
(income) will impact on the overall profitability of the
business.

For example: Asset Turnover

• This ratio represents the efficiency of asset

usage to generate sales revenue

© Mary L
C. Asset Management or Activity Ratios

• Asset Turnover = Net Sales

Average Total Assets

• Inventory Turnover = Cost of Goods Sold

Average Ending Inventory

• Average Collection Period = Average accounts Receivable

Average daily net credit sales*

* Average daily net credit sales = net credit sales / 365

© Mary Low
Turnover Ratio-Inventory Turnover

Cost Of GoodsSold
Inventory Ternover Ratio 
AverageInventory

• This is another form to check the liquidity position of the firm

• This ratio determines how quickly certain current assets e.g. as in above
inventory transfers/converts itself into cash
• Turnovers are normally calculated with reference to Inventory, Debtors,
Creditors etc.
• Greater the conversion rate better it is
• Now its clear from above that inventory rotates “X” times in a year so if we
want to calculate number of days we held inventory or no of months. What
we have to do is to just divide No. of days/months by the answer of the
above equation.
 Income Statement / Receivable Turnover
(Assume all sales are credit sales.)
Balance Sheet
Ratios Annual Net Credit Sales
Receivables
Activity Ratios
For Basket Wonders
Indicates quality of December 31, 2016
receivables and how
successful the firm is in 2,211 = 5.61
its collections. 94
6-47
 Income Statement / Avg Collection Period
Balance Sheet
Ratios Days in the Year
Receivable Turnover

Activity Ratios For Basket Wonders

December 31, 2016
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
6-48
 Average Collection Period
Year BW Industry
2016 65.0 65.7
2017 71.1 66.3
2018 83.6 69.2
BW has improved the average collection
period to that of the industry average.6-49
 Income Statement / Payable Turnover (PT)
(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios
For Basket Wonders
Indicates the
December 31, 2016
promptness of payment
to suppliers by the firm. 1551
= 16.5
94
6-37
 Income Statement / PT in Days
Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For Basket Wonders
December 31, 2016
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
6-51
Payable Turnover in Days
Year BW Industry
2016 22.1 46.7
2017 25.4 51.1
2018 43.5 48.5
BW has improved the PT in Days.
Is this good? 6-52
 Income Statement / Inventory Turnover
Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For Basket Wonders
December 31, 2016
Indicates the
effectiveness of the 1,599 = 2.30
inventory management 696
practices of the firm. 6-53
 Inventory Turnover Ratio
Year BW Industry
2016 2.30 3.45
2017 2.44 3.76
2018 2.64 3.69
BW has a very poor inventory turnover ratio.
6-54
 Income Statement / Total Asset Turnover
Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For Basket Wonders
December 31, 2016
Indicates the overall
effectiveness of the firm 2,211
in utilizing its assets to = 1.02
2,169
generate sales. 6-55
 Total Asset Turnover Ratio
Year BW Industry
2016 1.02 1.17
2017 1.03 1.14
2018 1.01 1.13
BW has a weak total asset turnover ratio.
6-44
Why is this ratio considered weak?
D. Financial Structure or Capitalization Ratios
Long term funds management
• Measures the riskiness of business in terms of debt
gearing.

For example: Debt/Equity

• This ratio measures the relationship between debt and
equity. A ratio of 1 indicates that debt and equity funding
are equal (i.e. there is $1 of debt to $1 of equity) whereas
a ratio of 1.5 indicates that there is higher debt gearing in
the business (i.e. there is $1.5 of debt to $1 of equity).
This higher debt gearing is usually interpreted as bringing
in more financial risk for the business particularly if the
business has profitability or cash flow problems.

© Mary Low
D. Financial Structure or Capitalization Ratios

• Debt/Equity ratio = Debt / Equity

• Debt/Total Assets ratio = Debt *100

Total Assets

• Equity ratio = Equity *100

Total Assets

• Times Interest Earned = Earnings before Interest and Tax

Interest
© Mary Low
 Leverages-Debt-Equity Ratio
Total Debt
D/E Ratio 
(Total debt  Shareholders' Equity)

• This ratio is meant to disclose the structure of the capital

• Normally banks and financers use this ratio as the State Bank has bench
marked the maximum debt equity ratio to 80:20 (i.e. 80% Debt+20% equity)
maximum allowed debt structure
• Normally external debt is considered less expensive than the equity
• This ratio can be subdivided into many other ratios like Debt to Owners
equity, Owners equity to total Capital etc.
Leverages-Interest Coverage Ratio

EBIT
Interest Coverage 
Interest
• Where EBIT represents earnings/profit before interest and tax
• This ratio represents the earnings/profit available against each rupee
of interest i.e. for payment of each rupee of interest how many
rupees of profit are available
• Potent the ratio better it is
Balance Sheet Ratios Debt-to-Equity

Total Debt
Financial Leverage Shareholders’ Equity
Ratios
For Basket Wonders
December 31, 2016
Shows the extent to
which the firm is 1,030 = .90
financed by debt. 1,139
6-61
 Debt-to-Equity Ratio
Year BW Industry
2016 .90 .90
2017 .88 .90
2018 .81 .89
BW has average debt utilization
relative to the industry average. 6-62
 Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Financial Leverage Total Assets
Ratios
For Basket Wonders
Shows the percentage December 31, 2016
of the firm’s assets
that are supported by 1,030
= .47
2,169
debt financing.
6-63
Debt-to-Total-Asset Ratio
Year BW Industry
2016 .47 .47
2017 .47 .47
2018 .45 .47
BW has average debt utilization
relative to the industry average. 6-64
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)

Financial Leverage Total Debt

Ratios Total Capitalization

Shows the relative For Basket Wonders

importance of long-term December 31, 2016
debt to the long-term 1,030 = .62
financing of the firm. 1,669
6-65
 Total Capitalization Ratio
Year BW Industry
2016 .62 .60
2017 .62 .61
2018 .67 .62
BW has average long-term debt utilization
relative to the industry average. 6-66
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firm’s December 31, 2016
ability to cover 210
interest charges. 59 = 3.56
6-67
 Interest Coverage Ratio
Year BW Industry
2016 3.56 5.19
2017 4.35 5.02
2018 10.30 4.66
BW has below average interest coverage
relative to the industry average. 6-68
 The interest coverage ratio for BW has
been falling since 2001. It has been
below industry averages for the past
two years.
 This indicates that low earnings (EBIT)
may be a potential problem for BW.
 Note, we know that debt levels are in
line with the industry averages.
6-69
E. Market Test Ratios

• Based on the share market's perception of the

company.

For example: Price/Earnings ratio

• The higher the ratio, the higher the perceived

quality of the earnings by the share market.

© Mary Low
E. Market Test Ratios
• Earnings per share = Net Profit after tax
Number of issued ordinary shares

• Dividends per share = Dividends

Number of issued ordinary shares

• Dividend payout ratio = Dividends per share *100

Earnings per share

• Price Earnings ratio = Market price per share

Earnings per share
© Mary Low
 Dividend Coverage Ratio
EAT
Dividend Coverage 
Preference Dividend

• Where EAT represents earnings/profit after tax or earnings available to

shareholders
• This ratio represents the earnings/profit available against each peso of
preference dividend i.e. for payment of each peso of preference dividend how
many peso of profit are available
• Potent the ratio better it is
Limitations of Financial Statement Analysis
• We must be careful with financial statement
analysis.
– Strong financial statement analysis does not
necessarily mean that the organisation has a strong
financial future.
– Financial statement analysis might look good but there
may be other factors that can cause an organisation to
collapse.

© Mary Low
 Limitations of FSA…..
1. Financial Analysis is only a Means
2. Ignores the Price Level Changes
3. Financial Statements are essentially Intrim
Reports
4. Accounting Concepts and Conventions
5. Influence of Personal Judgments
6. Disclose only Monetary Facts

© Mary Low