FINANCIAL ANALYSIS
A RIGHT WAY FOR FINANCIAL DECISION
Analysis means to put the meaning of a statement in to simple terms for the benefit of a person. analysis comprises
resolving the statements by breaking them in to simpler statements by a process of rearranging, regrouping and
collection of information broadly the term is applied to almost any kind of detailed enquiry in to financial data.
A financial manager has to evaluate the past performance, present financial position, liquidity situation, enquire in to
profitability of the firm and to plan for future operations. for all this, they have to study the relationship among
various financial variables in a business as disclosed in various financial statements.
written by Dr. Malik Mohummed K. Shahzad Awan
or
Financial statement analysis (or financial analysis) is the process of understanding the risk and profitability of a
firm (business, sub-business or project) through analysis of reported financial information, particularly annual and
quarterly reports.
Financial statement analysis consists of 1) reformulating reported financial statements, 2) analysis and adjustments
of measurement errors, and 3) financial ratio analysis on the basis of reformulated and adjusted financial statements.
FINANCIAL STATEMENTS / FINANCIAL REPORTS
Financial statements (financial reports) are formal records of a business financial activities. these statements
provide an overview of a business profitability and financial condition in both short and long term. There are five
basic financial statements:
Balance Sheet
Balance sheet also referred to as statement of financial position or condition, reports on a company assets, liabilities
and net equity as of a given point in time.
Income Statement
Income statement also referred to as profit or loss statement. reports on a company results of operations over a
period of time.
Cash Flow Statement
Statement of cash flows reports on a company cash flow activities, particularly its operating, investing and
financing activities.
Statement of Changes in Equity
Statement of retained earnings explains the changes in a company retained earnings over the reporting period.
Notes to the Financial Statements
Notes to the financial statements explain the necessary details and calculations about the key figures nominated at
the face of balance sheet and income statement. Commonly this section is called footnotes but it’s a comprehensive
part of financial statements that describe the accounting procedures and policies.
USER OF FINANCIAL STATEMENTS
Analysis of financial statements is linked with the objective and interest of the individual agency involved. some
of the agencies interested include management, investors, creditors, bankers, workers, government and public at
large.
MANAGEMENT
Management is interested in the financial performance and financial condition of the enterprise. it would like to
know about its viability as an ongoing concern, management of cash, debtors, inventory and fixed asset and
adequacy of capital structure. Management would also be interested in the overall financial position and profitability
of the enterprise as a whole and its various departments and divisions.
INVESTORS
An investor is interested in the profitability and safety of his investment and would like to know whether the
business is profitable, has growth potential and is progressing on sound lines. The present investors want to decide
whether they should hold thesecurities of the company or sell them. potential investors, on the other hand, want to
know whether they should invest in the shares of the company or not. investors (Shareholders or owners) and
potential investors, thus, make use of the financialstatements to judge the present and future earning capacity of the
business, to judge the operational efficiency of the business and to know the safety of investment and growth
prospects.
BANKERS AND LENDERS
Bankers and lenders are interested in serving of their loans by the enterprise, i.e. regular payment of interest and
repayment of principal amount on schedule dates. They also like to know the safety of their investment and
reliability of returns.
SUPPLIERS / CREDITORS
Creditors dealing with the enterprise are interested in receiving their payments as and when fall due and would like
to know its ability to honor its short-term commitments.
EMPLOYEES
Employees interested in better emoluments, bonus and continuance of the business, would like to know
its financial performance and profitability.
GOVERNMENT
Government and regulatory authorities would like to ensure that the financial statements prepared areas per the
specified laws and rules and are to safe guard the interest of various concerned agencies. e.g.: Taxation authorities
would be interested in ensuring proper assessment of tax liability of the enterprise as per the laws.
STOCK EXCHANGE
Stock exchange uses the financial statements to analyse and thereafter, inform its members about the
performance, financial health etc, of the company, to see whether financial statements prepared are in conformity
with the specified laws and rules and to see whether they safeguard the interest of various concerned agencies.
Other regulatory authorities (such as, company law board, SEBI, stock exchanges, tax authorities etc) would like
that the financial statements prepared are in conformity with the specified laws and rules and are to safeguard
the interest of various concerned agencies, For example, taxation authorities would be interested in ensuring proper
assessment of tax liability of the enterprise as per the laws in force from time to time.
CUSTOMER
Customer are interested to ascertain continuance of an enterprise. for example, an enterprise may be supplier of a
particular type of consumer goods and in case it appears that the enterprise may not continue for a long time, the
customer has to find an alternate source.
PUBLIC
Enterprises affect members of the public in a variety of ways. for example, enterprises may make a
substantial contribution to the local economy in many ways including the number of people, they employ and their
patronage of local suppliers, Financial statements may assist the public by providing information about trends and
recent developments in the prosperity of the enterprise and the range of its activities.
Different agencies thus look at the enterprise from their respective viewpoint and are interested in knowing about
its profitability and financial condition. In short a detailed cause and effect study of profitability
and financial condition is the overall objective of financial statement analysis.
TYPES OF FINANCIAL ANALYSIS
Following are the various types of financial analysis.
A. On the basis of material used.
1. External Analysis
Analysis of financial statements may be carried out on the basis of published information. i.e.., information
made available in the annual report of the enterprise. Such analysis are usually carried out by those who do not have
access to the detailed accounting records of the Co. i.e., Banks, Creditors etc.
2. Internal Analysis
Analysis may also be based on detailed information available within the Co. which is not available to the outsiders.
Such analysis is called internal analysis. This type of analysis is of a detailed one and is carried out on behalf of the
management for the purpose of providing necessary information for decision making, such analysis emphasizes on
the performance appraisal and assessing the profitability of different activities.
B. According to objectives of analysis
1. Short Term Analysis
Short term analysis is mainly concerned with the working capital analysis.in the short run, a Co. must have ample
funds readily available to meet its current needs and sufficient borrowing capacity to meet the contingencies. in
short term analysis the current assets and current liabilities are analyzed and liquidity is determined.
2. Long Term Analysis
In the long term a Co. must earn a minimum amount sufficient to maintain a reasonable rate of return on the
investment to provide for the necessary growth and development of the Co., and to meet the cost of capital.
Financial planning is also desirable for the continued success of a Co. Thus in the long term analysis the stability
and the earning potentiality of the C. is analyzed i.e., fixed assets, long term debt structure and the ownership
interest is analyzed.
C. According to the Modus Operandi of analysis
1. Horizontal Analysis
Analysis of financial statements involves making comparisons and establishing relationship among related items.
such comparison or establishing of relationship may be based on financial statements of a Co. For a number of years
and the financial statements of different Co's for the same year. such analysis is called horizontal analysis. It may
take the following two forms.
a. comparative financial statement analysis
b. trend analysis.
2. Vertical Analysis.
Analysis of financial data based on relationship among items in a single period of financial statement is called
vertical analysis. from a single balance sheet or P&L A/C relationships of various items may be established.
e.g. various assets can be expressed as percentage of total assets. Statements containing such analysis are also called
as common size statements. The common size P&L A/C is more useful in analyzing the operating results and costs
during the year. It shows each element of cost as a percentage of sales. Similarly common size balance sheet
show fixed assets as a percentage to total assets.
TOOLS OF FINANCIAL ANALYSIS (METHODS)
The analysis of financial statements consists of a study of relationship and trends to determine whether or not
the financial position of the concern and its operating efficiency have been satisfactory. In the process of this
analysis various tools or methods are used by financial analyst.
these tools are:
1. comparative statements
2. common size statements
3. Trend analysis
4. Average analysis
5. Statement of changes in working capital
6. Fund flow analysis
7. Cash flow analysis
8. Ratio analysis
RATIO ANALYSIS
A company's financial information is contained in 3 basic financial statements the balance sheet, the
trading and profit and loss account and profit and loss appropriation account. These statements are very useful to
different parties concerned such as management, creditors, investors and so on. These statements may be more
fruitfully used if they are analysed an interpreted to have an insight into the strengths and weakness of the firm.
Analysis of statements means such a treatment of the information contained in the two statements as to afford a
diagnosis of the profitability and financial position of the firm concerned. In the analysis of financial statements, the
analyst has variety of tools available from which he can choose those best suited to his specific purpose.
The most important tools used now days are ratio analysis, fund flow analysis and comparative and common size
statements.
Ratio Analysis
Ratios are well known and most widely used tools of financial analysis, A ratio gives the mathematical relationship
between one variable and another, Accounting ratios are relationships, expressed in quantitative terms between
figures which have a cause and effect relationship or which are connected with each other in some manner or the
other. The analysis of a ratio can disclose the relationships as well as bass of comparison that reveals conditions and
trends that can’t be detected by going through the individual components of the ratio.
The usefulness of ratios is ultimately dependent on their intelligent and skillful interpretation.
CLASSIFICATION OF RATIO ANALYSIS
"Ratios" can be grouped into various classes according to "financial" activity or function to be evaluated. In view of
the requirements of the various users of "ratios", we can classify then into the following categories.

Liquidity "Ratios"

Profitability "Ratios"

Solvency "Ratios"
"Financial" statement "analysis" is a judgemental process. One of the primary objectives is identification of major
changes in trends and relationships andthe investigation of the reasons underlying those changes,
The judgement process can be improved by experience and the use of analytical tools. Probably the most widely
used "financial" "analysis: technique is "ratio" "analysis" the "analysis" of relationships between two or more line
items on the "financial" statement. "Financial" "ratios" are usually expressed in percentage or times. Generally,
"financial" "ratios" are calculated for the purpose of evaluating aspects of company's operations and fall into the
following categories:

Liquidity ratios: measure a firm's ability to meet its current obligations.

Profitability ratios: measure management's ability to control expenses and to earn a return on the resources
committed to the business.

Leverage ratios: measure the degree of protection of suppliers of long-term funds and can also aid in
judging a firm's ability to raise additional debt and its capacity to pay its liabilities on time.

efficiency, activity or turnover ratios: provide information about management's ability to control expenses
and to earn a return on the resources committed to the business.
A "ratio" can be computed from any pair of numbers. Given the large quantity of variables included in "financial"
statements, a very long list of meaningful ratios can be derived. A standard list of "ratios" or standard computation
of them does not exist, The following ratio presentation includes "ratios" that are most often used when evaluating
the credit worthiness of customer. "Ratio" "analysis" becomes a very personal or company driven procedure.
Analysts are drawn to and use the ones they are comfortable with and understand.
LIQUIDITY RATIOS
WORKING CAPITAL:
Working capital compares current assets to current liabilities and serves as the liquid reserve available to satisfy
contingencies and uncertainties, A high working capitalbalance is mandated if the entity is unable to borrow on short
notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current
liabilities when due.
Formula:
Current assets - Current liabilities
ACID TEST OR QUICK RATIO:
A measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and
accounts receivable to the current liabilities. the primary difference between the current ratio and the quick ratio
is the quick ratio does not include inventory and prepaid expenses in the calculation. Consequently, a
business's quick ratio will be lower than its current ratio. It is a stringent test of liquidity.
Formula:
Cash+Marketable securities+Account Receivable
Current Liabilities
CURRENT RATIO:
Provides an indication of the liquidity of the business by comparing the amount ofcurrent assets to current liabilities.
A business's current assets generally consist of cash, marketable securities, accounts receivable
and inventories Current liabilitiesinclude accounts payable current maturities of long-term debt, accrued income
taxes and other accrued expenses that are due within one year, In general businesses prefer to have at least one dollar
of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to
industry. A current ratio significantly higher than the industry average could indicate the existence of
redundant assets Conversely a current ratio significantly lowers than the industry average could indicate a lack of
liquidity.
Formula:
Current Assets
Current Liabilities
CASH RATIO:
Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or
the analyst suspect's severe liquidity problems with inventory and receivables.
Formula:
Cash Equivalents + Marketable Securities
Current Liabilities
PROFITABILITY RATIOS
Net Profit Margin (Return on Sales):
A measure of net income dollars generated by each dollar of sales.
Formula:
Net Income
Net Sales
Refinements to the net income figure can make it more accurate than this ratio computation. They could
include removal of equity earnings from investments Other income and other expense items as well as
minority share of earnings and non-recurring items.
Formula:
Net income
(beginning + Ending Total Assets)/2
Operating Income Margin:
A measure of the operating income generated by each dollar of sales
Formula:
Operating Income
Net Sales
Return on Investment:
Measures the income earned on the invested capital.
Formula:
Net Income
Long-term Liabilities + Equity
Return on Equity:
Measures the income earned on the shareholder's investment in the business.
Formula:
Net Income
Equity
Du Point Return on Assets:
A combination of financial ratios in a series to evaluate investment return. The benefit of the method id that it
provides an understanding of how the company generates its return.
Formula:
Net Income
Sales
x Sales
Assets
x
Assets
Equity
Gross Profit Margin:
Indicates the relationship between net sales revenue and the cost of goods sold. This ratio should
be compared with industry data as it may indicate insufficient volume and excessive purchasing
or labour costs.
Formula:
Gross Profit
Net Sales
FINANCIAL LEVERAGE RATIO
Total Debts to Assets:
Provides information about the company's ability to absorb asset reductions arising from losses without jeopardizing
the interest of creditors.
Formula
Total Liabilities
Total Assets
Capitalization Ratio:
Indicates long-term debt usage.
Formula
Long-Term Debit
Long-Term + Owners Equity
Debt to Equity:
Indicates how well creditors are protected in case of the company's insolvency.
Formula
Total Debt
Total Equity
Interest Coverage Ratio (Times Interest Earned):
Indicates a compaany's capacity to meet interest payments. Uses EBIT (Earnings before interest and taxes)
Formula
EBIT
Interest Expense
Long-term Debt to Net Working Capital:
Provides insight into the ability to pay long term debt from current assets after paying current liabilities.
Formula
Long-term Debt
Current Assets - Current Liabilities
EFFICIENCY RATIOS
Cash Turnover
Measures how effective a company is utilizing its cash.
Formula
Net Sales
Cash
Sales to Working Capital (Net Working Capital Turnover)
Indicates the turnover in working capital per year. A low ratio indicates inefficiency, while a high level implies that
the company's working capital is working too hard.
Formula
Net Sales
Average Working Capital
Total Asset Turnover
Measures the activity of the assets and the ability of the business to generate sales through the use of the assets.
Formula
Net Sales
Average Total Assets
Fixed Assets Turnover
Measures the capacity utilization and the quality of fixed assets.
Formula
Net Sales
Net Fixed Assets
Day's Sales in Receivables
Indicates the average time in days, those receivables are outstanding (DSO). It helps determine if a change in
receivables is due to a change in sales, or to another factor such as a change in selling terms. An analyst might
compare the days sales in receivables with the company's credit terms as an indication of how efficiently the
company manages its receivables.
Formula
Gross Receivables
Annual Net Sales/365
Accounts Receivable Turnover
Indicates the liquidity of the company's receivables.
Formula
Net Sales
Average Gross Receivables
Accounts Receivable Turnover in Days
Indicates the liquidity of the company's receivable in days.
Formula
Average Gross Receivables
Annual Net Sales/365
Inventory Turnover
Indicates the liquidity of the inventory.
Formula
Cost of Goods Sold
Average Inventory
Inventory Turnover in Days
Indicates the liquidity of the inventory in days.
Formula
Average Inventory
Cost of Goods Sold / 365
Operating Cycle
Indicates the time between the acquisition of inventory and the realization of cash from sales of inventory. For most
companies the operating cycle is less than one year, but in some industries it is longer.
Formula
Accounts Receivable turnover in Days + Inventory Turnover in Day
Days Payables Outstanding
Indicates how the firm handles obligations of its suppliers.
Formula
Ending Accounts Payable
Purchases / 365
Payables Turnover
Indicates the liquidity of the firm's payables.
Formula
Purchases
Average Accounts
Payables Turnover in Days
Indicates the liquidity of the firm's Payables in days.
Formula
Average Accounts Payable
Purchases / 365
Balance Sheet
The principal financial statements are the balance sheet, income statement, and statement of cash flows.
This chapter will review the balance sheet in detail. Other titles used for the balance sheet are statement
of financial position and statement of financial condition. The title balance sheet is the predominant title
used.1Another statement, called the statement of stockholders’ equity, reconciles the changes in
stockholders’ equity, a section of the balance sheet. This statement will also be reviewed in this chapter.
Many alternative titles are used for the statement of stockholders’ equity. The title most frequently used is
the statement of stockholders’