BCA II SEMESTER (ACCOUNTING AND FINANCIAL MANAGEMENT) UNIT

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 and to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

Types of Financial Statements

Companies use the balance sheet, income statement, and cash flow statement to manage the operations of their business and to provide transparency to their stakeholders. All three statements are interconnected and create different views of a company’s activities and performance.

Balance Sheet

The balance sheet is a report of a company’s financial worth in terms of book value. It is broken into three parts to include a company’s assets, liabilities, and shareholder equity. Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency; liabilities include the company’s expense arrangements and the debt capital it is paying off; and shareholder equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance assets and liabilities to equal shareholder equity. This figure is considered a company’s book value and serves as an important performance metric that increases or decreases with the financial activities of a company.

Income Statement

The income statement breaks down the revenue that a company earns against the expenses involved in its business to provide a bottom line, meaning the net profit or loss. The income statement is broken into three parts that help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit. It then moves to operating profit, which subtracts indirect expenses like marketing costs, general costs, and depreciation. Finally, after deducting interest and taxes, the net income is reached.

Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin, which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company’s cash flows from operating activities, investing activities, and financing activities. Net income is carried over to the cash flow statement, where it is included as the top line item for operating activities. Like its title, investing activities include cash flows involved with firm-wide investments. The financing activities section includes cash flow from both debt and equity financing. The bottom line shows how much cash a company has available.

Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a company. Free cash flow statements arrive at a net present value by discounting the free cash flow that a company is estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially going public.

Financial Performance

Financial statements are maintained by companies daily and used internally for business management. In general, both internal and external stakeholders use the same corporate finance methodologies for maintaining business activities and evaluating overall financial performance.

When doing comprehensive financial statement analysis, analysts typically use multiple years of data to facilitate horizontal analysis. Each financial statement is also analyzed with vertical analysis to understand how different categories of the statement are influencing results. Finally, ratio analysis can be used to isolate some performance metrics in each statement and bring together data points across statements collectively.

Below is a breakdown of some of the most common ratio metrics:

Balance sheet: This includes asset turnover, quick ratio, receivables turnover, days to sales, debt to assets, and debt to equity.
Income statement: This includes gross profit margin, operating profit margin, net profit margin, tax ratio efficiency, and interest coverage.
Cash flow: This includes cash and earnings before interest, taxes, depreciation, and amortization (EBITDA). These metrics may be shown on a per-share basis.
Comprehensive: This includes return on assets (ROA) and return on equity (ROE), along with DuPont analysis.

What are the advantages of financial statement analysis?

Financial statement analysis evaluates a company’s performance or value through a company’s balance sheet, income statement, or statement of cash flows. By using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may develop a more nuanced picture of a company’s financial profile.

What are the different types of financial statement analysis?

Most often, analysts will use three main techniques for analyzing a company’s financial statements.

First, horizontal analysis involves comparing historical data. Usually, the purpose of horizontal analysis is to detect growth trends across different time periods.

Second, vertical analysis compares items on a financial statement in relation to each other. For instance, an expense item could be expressed as a percentage of company sales.

Finally, ratio analysis, a central part of fundamental equity analysis, compares line-item data. Price-to-earnings (P/E) ratios, earnings per share, or dividend yield are examples of ratio analysis.

What is an example of financial statement analysis?

An analyst may first look at a number of ratios on a company’s income statement to determine how efficiently it generates profits and shareholder value. For instance, gross profit margin will show the difference between revenues and the cost of goods sold. If the company has a higher gross profit margin than its competitors, this may indicate a positive sign for the company. At the same time, the analyst may observe that the gross profit margin has been increasing over nine fiscal periods, applying a horizontal analysis to the company’s operating trends.

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.

KEY TAKEAWAYS

Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
Ratio analysis may also be required by external parties that set benchmarks often tied to risk.
While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company's financial health.
Examples of ratio analysis include current ratio, gross profit margin ratio, inventory turnover ratio.

Types of Ratio Analysis

The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:

1. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.

2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of profitability ratios.

4. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory.

Profitability ratios are a type of accounting ratio that helps in determining the financial performance of business at the end of an accounting period. Profitability ratios show how well a company is able to make profits from its operations.

Let us now discuss the types of profitability ratios.

Types of Profitability Ratios

The following types of profitability ratios are discussed for the students of Class 12 Accountancy as per the new syllabus prescribed by CBSE:

Gross Profit Ratio
Operating Ratio
Operating Profit Ratio
Net Profit Ratio
Return on Investment (ROI)
Return on Net Worth
Earnings per share
Book Value per share
Dividend Payout Ratio
Price Earning Ratio

Gross Profit Ratio

Gross Profit Ratio is a profitability ratio that measures the relationship between the gross profit and net sales revenue. When it is expressed as a percentage, it is also known as the Gross Profit Margin.

Formula for Gross Profit ratio is

Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100

A fluctuating gross profit ratio is indicative of inferior product or management practices.

Operating Ratio

Operating ratio is calculated to determine the cost of operation in relation to the revenue earned from the operations.

The formula for operating ratio is as follows

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/

Net Revenue from Operations ×100

Operating Profit Ratio

Operating profit ratio is a type of profitability ratio that is used for determining the operating profit and net revenue generated from the operations. It is expressed as a percentage.

The formula for calculating operating profit ratio is:

Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100

Or Operating Profit Ratio = 100 – Operating ratio

Net Profit Ratio

Net profit ratio is an important profitability ratio that shows the relationship between net sales and net profit after tax. When expressed as percentage, it is known as net profit margin.

Formula for net profit ratio is

Net Profit Ratio = Net Profit after tax ÷ Net sales

Net Profit Ratio = Net profit/Revenue from Operations × 100

It helps investors in determining whether the company’s management is able to generate profit from the sales and how well the operating costs and costs related to overhead are contained.

Also read: Net Profit Ratio

Return on Capital Employed (ROCE) or Return on Investment (ROI)

Return on capital employed (ROCE) or Return on Investment is a profitability ratio that measures how well a company is able to generate profits from its capital. It is an important ratio that is mostly used by investors while screening for companies to invest.

The formula for calculating Return on Capital Employed is :

ROCE or ROI = EBIT ÷ Capital Employed × 100

Where EBIT = Earnings before interest and taxes or Profit before interest and taxes

Capital Employed = Total Assets – Current Liabilities

Return on Net Worth

This is also known as Return on Shareholders funds and is used for determining whether the investment done by the shareholders are able to generate profitable returns or not.

It should always be higher than the return on investment which otherwise would indicate that the company funds are not utilised properly.

The formula for Return on Net Worth is calculated as :

Return on Shareholders’ Fund = Profit after Tax / Shareholders’ Funds × 100

Or Return on Net Worth = Profit after Tax / Shareholders’ Funds × 100

Earnings Per Share (EPS)

Earnings per share or EPS is a profitability ratio that measures the extent to which a company earns profit. It is calculated by dividing the net profit earned by outstanding shares.

The formula for calculating EPS is:

Earnings per share = Net Profit ÷ Total no. of shares outstanding

Having higher EPS translates into more profitability for the company.

Book Value Per Share

Book value per share is referred to as the equity that is available to the the common shareholders divided by the number of outstanding shares

Equity can be calculated by:

Equity funds = Shareholders funds – Preference share capital

The formula for calculating book value per share is:

Book Value per Share = (Shareholders’ Equity – Preferred Equity) / Total Outstanding Common Shares.

Dividend Payout Ratio

Dividend payout ratio calculates the amount paid to shareholders as dividends in relation to the amount of net income generated by the business.

It can be calculated as follows:

Dividend Payout Ratio (DPR) : Dividends per share / Earnings per share

Price Earning Ratio

This is also known as P/E Ratio. It establishes a relationship between the stock (share) price of a company and the earnings per share. It is very helpful for investors as they will be more interested in knowing the profitability of the shares of the company and how much profitable it will be in future.

P/E ratio is calculated as follows:

P/E Ratio = Market value per share ÷ Earnings per share

It shows if the company’s stock is overvalued or undervalued.

Activity ratios are used to determine the efficiency of the organisation in utilising its assets for generating cash and revenue. It is used to check the level of investment made on an asset and the revenue that it is generating. For this reason, the activity ratio is also known as the efficiency ratio or the more popular turnover ratio.

The role of activity ratio or turnover ratio is in the evaluation of the efficiency of a business by careful analysis of the inventories, fixed assets and accounts receivables.

Let us discuss the types of activity ratios.

Types of Activity Ratios

Stock Turnover ratio or Inventory Turnover Ratio
Debtors Turnover ratio or Accounts Receivable Turnover Ratio
Creditors Turnover ratio or Accounts Payable Turnover Ratio
Working Capital turnover ratio.
Investment Turnover Ratio

The following are discussed below.

Stock Turnover Ratio

This is one of the most important turnover ratios which highlights the relationship between the inventory or stock in the business and cost of the goods sold. It shows how fast the inventory gets cleared in an accounting period or in other words, the number of times the inventory or the stock gets sold or consumed. For this reason, it is also known as the inventory turnover ratio.

It is calculated by the following formula

Stock Turnover Ratio = Cost of Goods Sold / Average Inventory

A high stock turnover ratio is indicative of fast moving goods in a company while a low stock turnover ratio indicates that goods are not getting sold and are being stored at warehouses for an extended period of time.

Debtor Turnover Ratio

This ratio is an important indicator of a company which shows how well a company is able to provide credit facilities to its customers and at the same time is also able to recover the due amount within the payment period.

It is also known as accounts receivable turnover ratio as the payments for credit sales that will be received in the future are known as accounts receivables.

The formula for calculating Debtor Turnover ratio is

Debtor Turnover Ratio = Credit Sales / Average Debtors

A higher ratio indicates that the credit policy of the company is sound, while a lower ratio shows a weak credit policy.

Creditors Turnover Ratio

Creditors turnover ratio is a measure of the capability of the company to pay off the amount for credit purchases successfully in an accounting period.

It shows the number of times the account payables are cleared by the company in an accounting period. For this reason, it is also known as the Accounts payable turnover ratio.

The formula for calculating creditors turnover ratio is

Creditors Turnover ratio = Net Credit Purchases / Average Creditors

Where average creditors are also known as average accounts payable.

A high ratio is indicative that a company is able to finance all the credit purchases and vice versa.

Working Capital Turnover Ratio

This ratio is helpful in determining the effectiveness with which a company is able to utilise its working capital for generating sales of its goods.

The formula for calculating working capital turnover ratio is

Working capital turnover ratio = Sale or Costs of Goods Sold / Working Capital

If a company has a higher level of working capital it shows that the working capital of the business is utilized properly and on the other hand, a low working capital suggests that business has too many debtors and the inventory is unused.

Also read: Working Capital Turnover Ratio

Investment Turnover Ratio or Net Asset Turnover Ratio

Investment Turnover Ratio is related to the sales taking place in the business and the net assets or the capital employed. It determines the ability of the business to generate sales revenue by the use of net assets of the business. The ratio is calculated using the following formula

Investment Turnover Ratio = Net Sales/ Capital Employed

Importance of Activity Ratios

Activity ratios are very important indicators of the operating efficiency of the business. It also shows the way in which revenue is generated in a company and the way in which the elements of the balance sheet are utilised for managing the business.

Liquidity is a very critical part of a business. Liquidity is required for a business to meet its short term obligations. Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities.

Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments.

This is a very important criterion that creditors check before offering short term loans to the business. An organisation which is unable to clear dues results in creating impact on the creditworthiness and also affects credit rating of the company.

Let us now discuss the different types of liquidity ratios.

Types of Liquidity Ratio

There are following types of liquidity ratios:

Current Ratio or Working Capital Ratio
Quick Ratio also known as Acid Test Ratio
Cash Ratio also known Cash Asset Ratio or Absolute Liquidity Ratio
Net Working Capital Ratio

Let us know more in detail about these ratios.

Current Ratio or Working Capital Ratio

The current ratio is a measure of a company’s ability to pay off the obligations within the next twelve months. This ratio is used by creditors to evaluate whether a company can be offered short term debts. It also provides information about the company’s operating cycle. It is also popularly known as Working capital ratio. It is obtained by dividing the current assets with current liabilities.

Current ratio is calculated as follows:

Current ratio = Current Assets / Current Liabilities

A higher current ratio around two(2) is suggested to be ideal for most of the industries while a lower value (less than 1) is indicative of a firm having difficulty in meeting its current liabilities.

Also read: Difference Between Current Ratio and Quick Ratio

Quick Ratio or Acid Test Ratio

Quick ratio is also known as Acid test ratio is used to determine whether a company or a business has enough liquid assets which are able to be instantly converted into cash to meet short term dues. It is calculated by dividing the liquid current assets by the current liabilities

It is represented as

Quick Ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities

The ideal quick ratio should be one(1) for a financially stable company.

See more: Working Capital Turnover Ratio

Cash Ratio or Absolute Liquidity Ratio

Cash ratio is a measure of a company’s liquidity in which it is measured whether the company has the ability to clear off debts only using the liquid assets (cash and cash equivalents such as marketable securities). It is used by creditors for determining the relative ease with which a company can clear short term liabilities.

It is calculated by dividing the cash and cash equivalents by current liabilities.

Cash ratio = Cash and equivalent / Current liabilities

Net Working Capital Ratio

The net working capital ratio is used to determine whether a company has sufficient cash or funds to continue its operations. It is calculated by subtracting the current liabilities from the current assets.

Net Working Capital Ratio = Current Assets – Current Liabilities

Liquidity Ratio Formula

Here are the important liquidity ratio formulas in a tabular format.

Liquidity Ratios	Formula
Current Ratio	Current Assets / Current Liabilities
Quick Ratio	(Cash + Marketable securities + Accounts receivable) / Current liabilities
Cash Ratio	Cash and equivalent / Current liabilities
Net Working Capital Ratio	Current Assets – Current Liabilities

Importance of Liquidity Ratio

Here are some of the importance of liquidity ratios:

It helps understand the availability of cash in a company which determines the short term financial position of the company. A higher number is indicative of a sound financial position, while lower numbers show signs of financial distress.
It also shows how efficiently the company is able to convert inventories into cash. It determines the way a company operates in the market.
It helps in organising the company’s working capital requirements by studying the levels of cash or liquid assets available at a certain time.

All the funds that are used to run a company are not obtained directly from the owners. To manage business, companies usually take debt which can be in the form of deposits, debentures or loans. In the long-term debts that are taken by the business needs to be repaid along with interest.

Solvency is referred to as the firm’s ability to meet its long-term debt obligations.

What is Solvency Ratio?

Solvency ratios are a key component of the financial analysis which helps in determining whether a company has sufficient cash flow to manage the debt obligations that are due. Solvency ratios are also known as leverage ratios. It is believed that if a company has a low solvency ratio, it is more at the risk of not being able to fulfil its debt obligation and is likely to default in debt repayment.

Solvency ratios are used by prospective business lenders to determine the solvency state of a business. Companies that have a higher solvency ratio are deemed more likely to meet the debt obligations while companies with a lower solvency ratio are more likely to pose a risk for the banks and creditors. Solvency ratios vary with the type of industry, but as a good measure a solvency ratio of 0.5 is always considered as a good number to have.

Solvency ratios should not be confused with liquidity ratios. They are totally different. Liquidity ratios determine the capability of a business to manage its short-term liabilities while the solvency ratios are used to measure a company’s ability to pay long-term debts.

Types of Solvency Ratios

Solvency ratio is calculated from the components of the balance sheet and income statement elements. Solvency ratios help in determining whether the organisation is able to repay its long term debt. It is very important for the investors to know about this ratio as it helps in knowing about the solvency of a company or an organisation.

Let us see in detail about the various types of solvency ratios.

1. Debt to equity ratio

Debt to equity is one of the most used debt solvency ratios. It is also represented as D/E ratio. Debt to equity ratio is calculated by dividing a company’s total liabilities with the shareholder’s equity. These values are obtained from the balance sheet of the company’s financial statements.

It is an important metric which is used to evaluate a company’s financial leverage. This ratio helps understand if the shareholder’s equity has the ability to cover all the debts in case business is experiencing a rough time.

It is represented as

Debt to equity ratio = Long term debt / shareholder’s funds

Debt to equity ratio = total liabilities / shareholders’ equity

A high debt-to-equity ratio is associated with a higher risk for the business as it indicates that the company is using debt for fuelling its growth. It also indicates lower solvency of the business.

2. Debt Ratio

Debt ratio is a financial ratio that is used in measuring a company’s financial leverage. It is calculated by taking the total liabilities and dividing it by total capital. If the debt ratio is higher, it represents the company is riskier.

The long-term debts include bank loans, bonds payable, notes payable etc.

Debt ratio is represented as

Debt Ratio = Long Term Debt / Capital or Debt Ratio = Long Term Debt / Net Assets

Low debt to capital ratio is indicative of a business that is stable while a higher ratio casts doubt about a firm’s long-term stability. Trading on equity is possible with a higher ratio of debt to capital which helps generate more income for the shareholders of the company.

3. Proprietary Ratio or Equity Ratio

Proprietary ratios is also known as equity ratio. It establishes a relationship between the proprietors funds and the net assets or capital.

It is expressed as

Equity Ratio = Shareholder’s funds / Capital or Shareholder’s funds / Total Assets

4. Interest Coverage Ratio

The interest coverage ratio is used to determine whether the company is able to pay interest on the outstanding debt obligations. It is calculated by dividing company’s EBIT (Earnings before interest and taxes) with the interest payment due on debts for the accounting period.

It is represented as

Interest coverage ratio = EBIT / interest on long term debt

Where EBIT = Earnings before interest and taxes or Net Profit before interest and tax.

A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt burden on the business.