What Is Financial Statement Analysis?
Financial statement analysis is the process of analyzing a
company's financial statements for decision-making purposes. External
stakeholders use it to understand the overall health of an organization as
well as to evaluate financial performance and business value. Internal
constituents use it as a monitoring tool for managing the finances.
Top 4 Financial Analysis Tools
#1 – Common Size Statements
It is the first financial analysis tool. In the market, companies of
various sizes and structures are available. To compare them, one
must prepare their financial statement in absolute formats bringing
all the particulars. The globally acceptable form to disclose the
financials for comparison is to bring in data in a percentage format.
The organization will prepare main financial statements
like financial statements like Common size Balance
sheet, Common size Income statement, and common-size cash
flow statement.
#2 – Comparative Financial Statement
Comparative financial statements are used in horizontal
analysis or trend analysis. It helps analyze the periodic change in
various components of the financial statements and displays
which element has the maximum impact.
One can prepare such financial statements in currency amount
terms or percentage terms.
#3 – Ratio Analysis
Ratio analysis is the most commonly used financial analysis tool by
analysts, experts, internal financial planners, the analysis
department, and other stakeholders. It has various kinds of ratios,
which can help in commenting on.






Profitability Ratio Formula
Rate of return analysis
Solvency Ratios
Liquidity
Coverage of interest or any cost
Comparing any component with turnover
#4 – Benchmarking
Benchmarking is the process of comparing the actuals with the
targets set by the top management. It also refers to the comparison
made with the best practices and strives to achieve the same.
In this procedure, the below steps are to be performed: –






Step 1: Select the area which needs to be optimized.
Step 2: Identify the trigger points to compare them.
Step 3: Try to set up a better standard or take industrial standards
as the benchmark.
Step 4: Evaluate the periodic performance and measure the trigger
points.
Step 5: Check whether the same is achieved; if not, do variance
analysis.
Step 6: If achieved, strive to set up a better benchmark.
Types of Analysis
What is Common Size Analysis?
Common size analysis, also referred as vertical analysis, is a tool that
financial managers use to analyze financial statements. It evaluates financial
statements by expressing each line item as a percentage of the base
amount for that period. The analysis helps to understand the impact of
each item in the financial statement and its contribution to the resulting
figure.
What Is Vertical Analysis?
Vertical analysis is a method of financial statement analysis in which each line item is listed
as a percentage of a base figure within the statement. Thus, line items on an income
statement can be stated as a percentage of gross sales, while line items on a balance sheet
can be stated as a percentage of total assets or liabilities, and vertical analysis of a cash flow
statement shows each cash inflow or outflow as a percentage of the total cash inflows.
What Is Horizontal Analysis?
Horizontal analysis is used in financial statement analysis to compare historical data, such as
ratios, or line items, over a number of accounting periods. Horizontal analysis can either use
absolute comparisons or percentage comparisons, where the numbers in each succeeding
period are expressed as a percentage of the amount in the baseline year, with the baseline
amount being listed as 100%. This is also known as base-year analysis.
Trend Analysis
Trend analysis calculates the percentage change for one account over a period of time of
two years or more.
What is the Trend Analysis Formula?
The term “Trend Analysis” refers to one of the most useful analytical tools employed for
financial analysis of statements such as income statements, balance sheets, and cash flow
statements. In other words, trend analysis compares the movement in each line item across
time periods in order to draw actionable insights.
Change in Amount = Current Year Amount – Base Year Amount
Percentage Change = [(Current Year Amount – Base Year Amount) /
Base Year Amount]
What is Inter-firm Comparison?
Inter-firm comparison means a comparison of two or more similar business units with the
objective of finding the competitive position to improve the profitability and productivity of
those business units.
What Is Ratio Analysis?
Ratio analysis is a quantitative method of gaining insight into a company's liquidity,
operational efficiency, and profitability by studying its financial statements such as the
balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity
analysis.
Classification of ratios
Liquidity Ratios
Current Ratio
The current ratio determines the ability of a company or business to clear its short-term
debts using its current assets. This makes it an important liquidity measure because shortterm liabilities are due within the next year. The current ratio will show how easily the
company can change its quick assets to cash to pay current debts.
Current ratio=current asset/current liability
Quick Ratio
The quick ratio, also referred to as the acid test ratio, is a liquidity ratio that measures the
ability of a company to pay off its short-term liabilities with quick assets that can be
converted into cash within 90 days. Put simply, the quick ratio measures how much money a
business could raise from selling its near cash assets in order to pay current liabilities.
Quick ratio=Total current asset-inventories-prepaid expenses/current liabilities
Capital Structure Analysis
capital structure analysis as the process of determining the accurate valuation of the different
sources of capital that a firm uses. It includes the current capital valuation and future payments of
principal, interest, and dividends.
What is Financial Leverage?
Financial leverage is the use of borrowed money (debt) to finance the
purchase of assets with the expectation that the income or capital gain
from the new asset will exceed the cost of borrowing.
Debt-to-equity ratio=total debt / total equity
What is Activity Analysis?
Activity analysis is the examination of the process steps within a selected area of an
organization. This analysis determines the following items:

Which process steps are being executed

Which personnel are involved with each step

The amount of time required to complete each step

The amount of resources consumed by each step

Which process steps should be measured and which measurements to use

The value produced by each step
This analysis can then be used to improve the efficiency and effectiveness of
operations. This can be accomplished in many ways, such as with the use of
automation, the complete replacement of existing processes, outsourcing to lower -cost
regions, merging processes, breaking apart processes, and so forth.
What Are Profitability Ratios?
Profitability ratios are a class of financial metrics that are used to assess a business's
ability to generate earnings relative to its revenue, operating costs, balance sheet
assets, or shareholders' equity over time, using data from a specific point in time.
Profitability ratios can be compared with efficiency ratios, which consider how well a
company uses its assets internally to generate income (as opposed to after -cost
profits).
What are the Different Types of Profitability Ratios?
There are various profitability ratios that are used by companies to provide
useful insights into the financial well-being and performance of the
business.
All of these ratios can be generalized into two categories, as follows:
A. Margin Ratios
Margin ratios represent the company’s ability to convert sales into profits at
various degrees of measurement.
Examples are gross profit margin, operating profit margin, net profit
margin, cash flow margin, EBIT, EBITDA, EBITDAR, NOPAT, operating
expense ratio, and overhead ratio.
B. Return Ratios
Return ratios represent the company’s ability to generate returns to its
shareholders.
Examples include return on assets, return on equity, cash return on assets,
return on debt, return on retained earnings, return on revenue, riskadjusted return, return on invested capital, and return on capital employed.
What are the Most Commonly Used Profitability Ratios and Their
Significance?
Most companies refer to profitability ratios when analyzing business
productivity, by comparing income to sales, assets, and equity.
Six of the most frequently used profitability ratios are:
#1 Gross Profit Margin
Gross profit margin – compares gross profit to sales revenue. This shows
how much a business is earning, taking into account the needed costs to
produce its goods and services. A high gross profit margin ratio reflects a
higher efficiency of core operations, meaning it can still cover operating
expenses, fixed costs, dividends, and depreciation, while also providing net
earnings to the business. On the other hand, a low profit margin indicates a
high cost of goods sold, which can be attributed to adverse purchasing
policies, low selling prices, low sales, stiff market competition, or wrong
sales promotion policies.
Learn more about these ratios in CFI’s financial analysis courses.
#2 EBITDA Margin
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and
Amortization. It represents the profitability of a company before taking into
account non-operating items like interest and taxes, as well as non-cash
items like depreciation and amortization. The benefit of analyzing a
company’s EBITDA margin is that it is easy to compare it to other
companies since it excludes expenses that may be volatile or somewhat
discretionary. The downside of EBTIDA margin is that it can be very
different from net profit and actual cash flow generation, which are better
indicators of company performance. EBITDA is widely used in
many valuation methods.
#3 Operating Profit Margin
Operating profit margin – looks at earnings as a percentage of sales before
interest expense and income taxes are deduced. Companies with high
operating profit margins are generally more well-equipped to pay for fixed
costs and interest on obligations, have better chances to survive an
economic slowdown, and are more capable of offering lower prices than
their competitors that have a lower profit margin. Operating profit margin
is frequently used to assess the strength of a company’s management since
good management can substantially improve the profitability of a company
by managing its operating costs.
#4 Net Profit Margin
Net profit margin is the bottom line. It looks at a company’s net income
and divides it into total revenue. It provides the final picture of how
profitable a company is after all expenses, including interest and taxes, have
been taken into account. A reason to use the net profit margin as a
measure of profitability is that it takes everything into account. A drawback
of this metric is that it includes a lot of “noise” such as one-time expenses
and gains, which makes it harder to compare a company’s performance
with its competitors.
#5 Cash Flow Margin
Cash flow margin – expresses the relationship between cash flows from
operating activities and sales generated by the business. It measures the
ability of the company to convert sales into cash. The higher the percentage
of cash flow, the more cash available from sales to pay for suppliers,
dividends, utilities, and service debt, as well as to purchase capital assets.
Negative cash flow, however, means that even if the business is generating
sales or profits, it may still be losing money. In the instance of a company
with inadequate cash flow, the company may opt to borrow funds or to
raise money through investors in order to keep operations going.
Managing cash flow is critical to a company’s success because always
having adequate cash flow both minimizes expenses (e.g., avoid late
payment fees and extra interest expense) and enables a company to take
advantage of any extra profit or growth opportunities that may arise (e.g.
the opportunity to purchase at a substantial discount the inventory of a
competitor who goes out of business).
#6 Return on Assets
Return on assets (ROA), as the name suggests, shows the percentage of net
earnings relative to the company’s total assets. The ROA ratio specifically
reveals how much after-tax profit a company generates for every one dollar
of assets it holds. It also measures the asset intensity of a business. The
lower the profit per dollar of assets, the more asset-intensive a company is
considered to be. Highly asset-intensive companies require big investments
to purchase machinery and equipment in order to generate income.
Examples of industries that are typically very asset-intensive include
telecommunications services, car manufacturers, and railroads. Examples of
less asset-intensive companies are advertising agencies and software
companies.
Learn more about these ratios in CFI’s financial analysis courses.
#7 Return on Equity
Return on equity (ROE) – expresses the percentage of net income relative to
stockholders’ equity, or the rate of return on the money that equity
investors have put into the business. The ROE ratio is one that is particularly
watched by stock analysts and investors. A favorably high ROE ratio is often
cited as a reason to purchase a company’s stock. Companies with a high
return on equity are usually more capable of generating cash internally, and
therefore less dependent on debt financing.
#8 Return on Invested Capital
Return on invested capital (ROIC) is a measure of return generated by all
providers of capital, including both bondholders and shareholders. It is
similar to the ROE ratio, but more all-encompassing in its scope since it
includes returns generated from capital supplied by bondholders.
The simplified ROIC formula can be calculated as: EBIT x (1 – tax rate) /
(value of debt + value of + equity). EBIT is used because it represents
income generated before subtracting interest expenses, and therefore
represents earnings that are available to all investors, not just to
shareholders.
Gross Margin
Gross margin tells you about the profitability of your goods and services. It tells you how much it
costs you to produce the product.
Operating Margin
Operating margin takes into account the costs of producing the product or services that are
unrelated to the direct production of the product or services, such as overhead and administrative
expenses.
Return on Assets
Return on assets measures how effectively the company produces income from its assets.
This means that you generate 18.5 cents of income for every dollar your company holds in
assets.
Return on Equity
Return on equity measures how much a company makes for each dollar that investors put into
it.
Profitability ratio is used to evaluate the company’s ability to generate
income as compared to its expenses and other cost associated with the
generation of income during a particular period. This ratio represents the
final result of the company.
Return on Equity = Profit After tax / Net worth,
Importance
Profitability represents final performance of company i.e. how profitable
company. It also represents how profitable owner’s funds have been
utilized in the company.
Types of Profitability Ratio

Return on Equity

Earnings Per Share

Dividend Per Share

Price Earnings Ratio

Return on Capital Employed

Return on Assets

Gross Profit

Net Profit
Return on Equity
This ratio measures Profitability of equity fund invested the company. It
also measures how profitably owner’s funds have been utilized to generate
company’s revenues. A high ratio represents better the company
is. Formula: Profit after Tax ÷ Net worth Where, Net worth = Equity share
capital, and Reserve and Surplus
Earnings Per Share
This ratio measures profitability from the point of view of the ordinary
shareholder. A high ratio represents better the company is. Formula: Net
Profit ÷ Total no of shares outstanding
Dividend Per Share
This ratio measures the amount of dividend distributed by the company to
its shareholders. The high ratio represents that the company is having
surplus cash. Formula: Amount Distributed to Shareholders ÷ No of
Shares outstanding
Price Earnings Ratio
This ratio is used by the investor to check the undervalued and overvalued
share price of the company. This ratio also indicates Expectation about the
earning of the company and payback period to the investors. Formula:
Market Price of Share ÷ Earnings per share
Return on Capital Employed
This ratio computes percentage return in the company on the funds
invested in the business by its owners. A high ratio represents better the
Formula: Net Operating Profit ÷ Capital Employed ×
company is.
100 Capital Employed = Equity share capital, Reserve and Surplus,
Debentures
and long-term Loans Capital Employed = Total Assets –
Current Liability
Return on Assets
This ratio measures the earning per rupee of assets invested in the
company. A high ratio represents better the company is. Formula: Net
Profit ÷ Total Assets
Gross Profit
This ratio measures the marginal profit of the company. This ratio is also
used to measure the segment revenue. A high ratio represents the greater
profit margin and it’s good for the company. Formula: Gross Profit ÷
Sales × 100 Gross Profit= Sales + Closing Stock – op stock – Purchases –
Direct Expenses
Net Profit
This ratio measures the overall profitability of company considering all
direct as well as indirect cost. A high ratio represents a positive return in
the company and better the company is. Formula: Net Profit ÷ Sales ×
100 Net Profit = Gross Profit + Indirect Income – Indirect Expenses
Uses and Users of Financial Ratio Analysis
Analysis of financial ratios serves two main purposes:
1. Track company performance
Determining individual financial ratios per period and tracking the change
in their values over time is done to spot trends that may be developing in a
company. For example, an increasing debt-to-asset ratio may indicate that
a company is overburdened with debt and may eventually be facing default
risk.
2. Make comparative judgments regarding company performance
Comparing financial ratios with that of major competitors is done to
identify whether a company is performing better or worse than the industry
average. For example, comparing the return on assets between companies
helps an analyst or investor to determine which company is making the
most efficient use of its assets.
Users of financial ratios include parties external and internal to the
company:


External users: Financial analysts, retail investors, creditors,
competitors, tax authorities, regulatory authorities, and industry
observers
Internal users: Management team, employees, and owners
Liquidity Ratios
Liquidity ratios are financial ratios that measure a company’s ability to
repay both short- and long-term obligations. Common liquidity ratios
include the following:
The current ratio measures a company’s ability to pay off short-term
liabilities with current assets:
Current ratio = Current assets / Current liabilities
The acid-test ratio measures a company’s ability to pay off short-term
liabilities with quick assets:
Acid-test ratio = Current assets – Inventories / Current liabilities
The cash ratio measures a company’s ability to pay off short-term liabilities
with cash and cash equivalents:
Cash ratio = Cash and Cash equivalents / Current Liabilities
The operating cash flow ratio is a measure of the number of times a
company can pay off current liabilities with the cash generated in a given
period:
Operating cash flow ratio = Operating cash flow / Current liabilities
Leverage Financial Ratios
Leverage ratios measure the amount of capital that comes from debt. In
other words, leverage financial ratios are used to evaluate a company’s
debt levels. Common leverage ratios include the following:
The debt ratio measures the relative amount of a company’s assets that are
provided from debt:
Debt ratio = Total liabilities / Total assets
The debt to equity ratio calculates the weight of total debt and financial
liabilities against shareholders’ equity:
Debt to equity ratio = Total liabilities / Shareholder’s equity
The interest coverage ratio shows how easily a company can pay its interest
expenses:
Interest coverage ratio = Operating income / Interest expenses
The debt service coverage ratio reveals how easily a company can pay its
debt obligations:
Debt service coverage ratio = Operating income / Total debt service
Efficiency Ratios
Efficiency ratios, also known as activity financial ratios, are used to measure
how well a company is utilizing its assets and resources. Common efficiency
ratios include:
The asset turnover ratio measures a company’s ability to generate sales
from assets:
Asset turnover ratio = Net sales / Average total assets
The inventory turnover ratio measures how many times a company’s
inventory is sold and replaced over a given period:
Inventory turnover ratio = Cost of goods sold / Average inventory
The accounts receivable turnover ratio measures how many times a
company can turn receivables into cash over a given period:
Receivables turnover ratio = Net credit sales / Average accounts
receivable
The days sales in inventory ratio measures the average number of days that
a company holds on to inventory before selling it to customers:
Days sales in inventory ratio = 365 days / Inventory turnover ratio
Profitability Ratios
Profitability ratios measure a company’s ability to generate income relative
to revenue, balance sheet assets, operating costs, and equity. Common
profitability financial ratios include the following:
The gross margin ratio compares the gross profit of a company to its net
sales to show how much profit a company makes after paying its cost of
goods sold:
Gross margin ratio = Gross profit / Net sales
The operating margin ratio compares the operating income of a company
to its net sales to determine operating efficiency:
Operating margin ratio = Operating income / Net sales
The return on assets ratio measures how efficiently a company is using its
assets to generate profit:
Return on assets ratio = Net income / Total assets
The return on equity ratio measures how efficiently a company is using its
equity to generate profit:
Return on equity ratio = Net income / Shareholder’s equity
Stock market related ratios


There are six basic ratios that are often used to pick stocks for
investment portfolios.
These include the working capital ratio, the quick ratio, earnings per
share (EPS), price-earnings (P/E), debt-to-equity, and return on
equity (ROE).
1. Working Capital Ratio
Assessing the health of a company in which you want to invest involves
measuring its liquidity. Liquidity refers to how easily a company can turn
assets into cash to pay short-term obligations. The working capital ratio
can be useful in helping you measure liquidity.
Working capital is the difference between a firm’s current assets and
current liabilities. It represents a company's ability to pay its current
liabilities with its current assets.
The working capital ratio, like working capital, compares current assets to
current liabilities and is a metric used to measure liquidity. The working
capital ratio is calculated by dividing current assets by current liabilities.
It can be a challenge to determine the proper category for the vast array of
assets and liabilities on a corporate balance sheet in order to decipher the
overall ability of a firm to meet its short-term commitments.
2. Quick Ratio
Also called the acid test, the quick ratio is another measure of liquidity. It
represents a company's ability to pay current liabilities with assets that can
be converted to cash quickly.
The calculation for the quick ratio is current assets minus inventory minus
prepaid expenses divided by current liabilities. The formula removes
inventory because it can take time to sell and convert inventory into liquid
assets.
3. Earnings per Share (EPS)
When buying a stock, you participate in the future earnings (or risk of loss)
of the company. Earnings per share (EPS) is a measure of the profitability
of a company. Investors use it to gain an understanding of company value.
The company's analysts calculate EPS by dividing net income by
the weighted average number of common shares outstanding during the
year.
If a company has zero or negative earnings (i.e., a loss), then earnings per
share will also be zero or negative. A higher EPS indicates greater value.
4. Price-Earnings Ratio (P/E)
Called P/E for short, this ratio is used by investors to determine a stock's
potential for growth. It reflects how much they would pay to receive $1 of
earnings. It's often used to compare the potential value of a selection of
stocks.
To calculate the P/E ratio, divide a company's current stock price by
earnings-per-share.
If a company has zero or negative earnings, the P/E ratio will no longer
make sense. It will appear as N/A for not applicable.
When ratios are properly understood and applied, they can help improve
your investing results.
5. Debt-to-Equity Ratio
What if your prospective investment target is borrowing too much? This
can increase fixed charges, reduce earnings available for dividends, and
pose a risk to shareholders.
The debt-to-equity (D/E) ratio measures how much a company is funding
its operations using borrowed money. It can indicate whether shareholder
equity can cover all debts, if needed. Investors often use it to compare the
leverage used by different companies in the same industry. This can help
them to determine which might be a lower risk investment.
6. Return on Equity (ROE)
Return on equity (ROE) measures profitability and how effectively a
company uses shareholder money to make a profit. For common stock
shareholders, ROE (which is expressed as a percentage) is calculated by
taking net income (income less expenses and taxes) figured before paying
common share dividends and after paying preferred share dividends, and
dividing the result by total shareholders' equity.