Financial Statement Analysis- By Ratio Analysis Method

Meaning of Financial Statement Analysis

Financial Statement analysis is the process of analyzing financial statements of a company so as to obtain meaningful information about its survival, stability, profitability, solvency, and growth prospect.The financial statement analysis can be performed by using a number of techniques such as Horizontal (Comparative Statements) analysis, Vertical (Common Size Statements) analysis, Trend Analysis.  and Ratio analysis. Ratio analysis is the most popularly and widely used technique of financial statement analysis.

Ratio analysis is a widely used tools of financial analysis. The systematic use of ratio helps to interpret the financial statements so that the strength and weakness of a firm can be determined and assessed. The ratios describe the significant relationship that exits between figures shown on a balance sheet and income statement or any part of a financial statement.

Financial Statement Analysis

List of Financial Ratios

  • Liquidity Ratios

    • Current or Working Capital Ratio = Current Assets /Current Liabilities

    • Quick or Acid-test Ratio = Quick Assets/Current Liabilities

where, Quick Assets = (Current Assets- Stock- Prepaid Expenses)

  • Solvency (Leverage) Ratios

    • Debt-to-Equity Ratio = Total Debt (i.e. Short-Term+ Long-Term)/Total Shareholders' Fund

where, Shareholders' Fund or Net Worth of the Business = Equity Shares Capital+ Preference Shares Capital+ Reserve & Surplus+ Retained Earnings

    • Debt-to-Total Capital Ratio = Total Debt (i.e. Short-Term+ Long-Term)/ Total Capital Employed

      Where, Total Capital Employed = Total Debt + Shareholders' Fund

  • Efficiency (Turnover) Ratios

    • Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory

    • Debtors/Receivable Turnover Ratio = Annual Credit Sales / (Average Debtors + Receivables)

    • Average or Receivable Collection Period = No. of Days in a Year/ Debtors or Receivable Turnover Ratio

    • Fixed Assets Turnover Ratio = Net Sales / Net Fixed Assets

    • Total Assets Turnover Ratio = Net Sales / Average Total Assets

    • Capital Employed Turnover Ratio = Net Sales / Capital Employed , Where Capital Employed = Total Assets - Current Liabilities)

  • Profitability Ratios

    • Gross Profit Margin = Gross Profit / Net Sales*100

    • Net Profit Margin = Net Profit After Tax / Net Sales*100

    • Operating Expenses Ratio = (Total Operating Expenses + COGS) / Net Sales*100

    • Return on Fixed Assets (ROFA) = (Net Profit After Tax  + Interest Expenses)/ Total Fixed Assets

    • Return on Total Assets (ROTA) = (Net Profit After Tax  + Interest Expenses)/ Total Assets

    • Return on Equity (ROE) = Net Profit After Tax / Average Shareholders’ Equity

    • Return on Shareholders' Fund (ROSE) = Net Profit After Tax / Total Shareholders' Fund

    • Return on Equity Shareholders' Fund (ROES) = (Net Profit After Tax- Preference Dividend) / Total Equity Shareholders' Fund

    • Return on Capital Employed (ROCE) = (Net Profit After Tax  + Interest Expenses)/ Capital Employed

Where, Capital Employed = (Equity Shares Capital+ Preference Shares Capital+ Reserve & Surplus+ Retained Earnings+ Long-term Debt)

    • Earnings Per Share (EPS) = (Net Profit - Preferred Divided)/(Average Equity Shares)

    • Dividend Per Share (DPS) = Total Dividend Amount / No. of Shares 

Ratio Analysis Interpretation

The following are the standards position that should be at least occurred. Before I show you the financial standards I would like to show you that you can expressed the ratio by various forms. For instance: suppose the current assets is 500,000/- and Current Liabilities is 250,000/-. What is the current ratio?

The answer is 2:1, meaning that you have the assets two times of current liabilities. But you can use any forms from the presented list below: 

  • 2:1

  • 2 to 1

  • 2/1

  • 200%

  • 2

Basically, the above all types of forms has been categorized into three parts includes Proportion, Times, and Percentage. The proportion form can be expressed as 2:1 or 2 to 1 or 2/1. Similarly, the times form can be expressed by directly any numeric value like 2 while in the percentage form you can expressed as 200%. The standard form for current ratio is proportion way. Now let's see the standards rule for measurements:

  1. Current or Working Capital Ratio = 2:1

  2. Quick or Acid-test Ratio = 1:1

  3. Debt-to-Equity Ratio = 50:50

  4. Debt-to-Total Capital Ratio = As much as low: 1

  5. Inventory Turnover Ratio = As much as high

  6. Debtors/Receivable Turnover Ratio = As much as high 

  7. Average or Receivable Collection Period = As much as low

  8. Fixed Assets Turnover Ratio = As much as high

  9. Total Assets Turnover Ratio  = As much as high

  10. Capital Employed Turnover Ratio = As much as high

  11. Gross Profit Margin = As much as high

  12. Net Profit Margin = As much as high

  13. Operating Expenses Ratio = As much as low:1

  14. Return on Fixed Assets (ROFA) = As much as high

  15. Return on Total Assets (ROTA) = As much as high

  16. Return on Equity (ROE)  = As much as high

  17. Return on Shareholders' Fund (ROSE) = As much as high

  18. Return on Equity Shareholders' Fund (ROES) = As much as high

  19. Return on Capital Employed (ROCE) = As much as high

  20. Earning Per Share (EPS) = As much as high:1

  21. Dividend Per Share (DPS) = As much as high:1

These financial ratios can be classified into various groups. Some of the major groups for these ratios could be the following:

  1. Classified by Purpose or Functions: The purpose could be anything of business like to earn profit, reduce solvency etc.

  2. Classified by Financial Statements: The financial statements include basically three documents income statement, balance sheet and cash flow statement.

  3. Classified by Users of Financial Information: The users for financial information are various stakeholders of the company like owner, creditors, shareholders etc.

  4. Classified by Relative Importance: The relative importance ratios are those ratios which are performing independently from the company like P/E Ratio, P/B Ratio, etc.

Conclusion

Financial Statement analysis is the process of analyzing financial statements of a company so as to obtain meaningful information about its survival, stability, profitability, solvency, and growth prospect. Ratio analysis is a widely used tools of financial analysis. The systematic use of ratio helps to interpret the financial statements so that the strength and weakness of a firm can be determined and assessed.

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