Financial Statement Analysis

Financial statement analysis involves reviewing and interpreting financial statements to assess a
company’s performance, profitability, liquidity, and solvency. This process provides valuable
insights for investors, management, creditors, and other stakeholders.

1. Overview of Financial Statements

 Balance Sheet (Statement of Financial Position): Shows a company’s assets, liabilities,

and equity at a specific point in time. It provides a snapshot of financial position.
 Income Statement (Profit and Loss Statement): Details revenues, expenses, and profits
or losses over a period of time. It measures operational performance.
 Cash Flow Statement: Reports cash inflows and outflows from operating, investing, and
financing activities over a period. It highlights liquidity and cash management.
 Statement of Changes in Equity: Shows changes in equity accounts over a period,
including issued shares, retained earnings, and other equity adjustments.

2. Key Financial Ratios

 Liquidity Ratios:
o Current Ratio: Measures the ability to pay short-term obligations with short-
term assets. Current Ratio=Current AssetsCurrent Liabilities\text{Current Ratio}
= \frac{\text{Current Assets}}{\text{Current
Liabilities}}Current Ratio=Current LiabilitiesCurrent Assets
o Quick Ratio (Acid-Test Ratio): Measures the ability to meet short-term
obligations with liquid assets.
Quick Ratio=Current Assets−InventoryCurrent Liabilities\text{Quick Ratio} = \
frac{\text{Current Assets} - \text{Inventory}}{\text{Current
Liabilities}}Quick Ratio=Current LiabilitiesCurrent Assets−Inventory
 Profitability Ratios:
o Gross Profit Margin: Indicates the percentage of revenue that exceeds the cost
of goods sold. Gross Profit Margin=Gross ProfitRevenue×100\text{Gross Profit
Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times
100Gross Profit Margin=RevenueGross Profit×100
o Net Profit Margin: Measures the percentage of profit after all expenses have
been deducted from revenue. Net Profit Margin=Net IncomeRevenue×100\
text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} \times
100Net Profit Margin=RevenueNet Income×100
o Return on Assets (ROA): Shows how effectively assets are used to generate
profit. ROA=Net IncomeTotal Assets\text{ROA} = \frac{\text{Net Income}}{\
text{Total Assets}}ROA=Total AssetsNet Income
o Return on Equity (ROE): Measures the return on shareholders’ equity.
ROE=Net IncomeShareholders’ Equity\text{ROE} = \frac{\text{Net Income}}{\
text{Shareholders' Equity}}ROE=Shareholders’ EquityNet Income
 Solvency Ratios:
 o Debt-to-Equity Ratio: Compares total liabilities to shareholders’ equity,
indicating financial leverage. Debt-to-
Equity Ratio=Total LiabilitiesShareholders’ Equity\text{Debt-to-Equity Ratio}
= \frac{\text{Total Liabilities}}{\text{Shareholders' Equity}}Debt-to-
Equity Ratio=Shareholders’ EquityTotal Liabilities
o Interest Coverage Ratio: Measures the ability to cover interest expenses with
operating income. Interest Coverage Ratio=EBITInterest Expense\text{Interest
Coverage Ratio} = \frac{\text{EBIT}}{\text{Interest
Expense}}Interest Coverage Ratio=Interest ExpenseEBIT
 Efficiency Ratios:
o Inventory Turnover Ratio: Indicates how efficiently inventory is managed and
sold. Inventory Turnover Ratio=Cost of Goods SoldAverage Inventory\
text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\
text{Average
Inventory}}Inventory Turnover Ratio=Average InventoryCost of Goods Sold
o Receivables Turnover Ratio: Measures how efficiently a company collects
receivables.
Receivables Turnover Ratio=Net Credit SalesAverage Accounts Receivable\
text{Receivables Turnover Ratio} = \frac{\text{Net Credit Sales}}{\text{Average
Accounts
Receivable}}Receivables Turnover Ratio=Average Accounts ReceivableNet Cred
it Sales

3. Horizontal and Vertical Analysis

 Horizontal Analysis:
o Overview: Compares financial statements over multiple periods to identify trends
and changes.
o Method: Calculate percentage changes in financial statement items from one
period to another.
o Example: Comparing sales revenue from the current year to the previous year to
analyze growth trends.
 Vertical Analysis:
o Overview: Analyzes financial statements by expressing each line item as a
percentage of a base amount.
o Method: For the income statement, each item is expressed as a percentage of total
revenue; for the balance sheet, each item is expressed as a percentage of total
assets.
o Example: Calculating the percentage of total assets represented by cash and
receivables.

4. Common-Size Financial Statements

 Definition: Financial statements in which all items are expressed as a percentage of a

base amount, such as total revenue or total assets.
  Purpose: Allows for easier comparison across periods or with other companies,
regardless of size.

5. Financial Analysis Techniques

 Trend Analysis: Examines financial data over multiple periods to identify patterns or
trends.
 Ratio Analysis: Uses financial ratios to evaluate performance and compare with industry
benchmarks or competitors.
 Benchmarking: Compares a company’s financial performance with industry standards
or key competitors.

6. Limitations of Financial Statement Analysis

 Historical Data: Financial statements reflect past performance and may not accurately
predict future results.
 Accounting Policies: Differences in accounting methods can affect comparability
between companies.
 Non-Financial Factors: Financial statements do not account for qualitative factors such
as management quality or market conditions.

7. Real-World Applications

 Investment Decisions: Investors use financial statement analysis to evaluate the

profitability and risk of investing in a company.
 Credit Evaluation: Creditors assess a company’s ability to repay loans based on its
financial health and liquidity.
 Management Decisions: Management uses financial analysis to make strategic
decisions, set goals, and improve operations.

8. Case Studies and Examples

 Case Study 1: Analyzing a tech company’s financial statements to assess its growth
potential and profitability.
 Case Study 2: Evaluating a retail company's financial ratios to determine its operational
efficiency and cash flow management.
 Example: Comparing a company’s financial ratios with industry averages to evaluate
relative performance.