Analysis of Financial Statements

The One Thing

Financial statement analysis uses comparative statements, common-size statements and accounting ratios to evaluate a company’s profitability, liquidity, solvency and efficiency. Its conclusions are reliable only when figures are accurate, comparable and interpreted with industry standards, past performance, business conditions and relevant qualitative information.

Definitions and Results

• Financial Statements: Formal statements prepared to show a company’s financial performance and financial position, mainly the Statement of Profit and Loss and Balance Sheet.
• Statement of Profit and Loss: A statement showing revenue, expenses and profit or loss for an accounting period.
• Balance Sheet: A statement showing the assets, equity and liabilities of a company on a particular date.
• Financial Statement Analysis: The systematic examination and interpretation of financial statements to assess performance, position and financial health.
• Comparative Financial Statements: Statements presenting figures for two or more periods together to show absolute changes and percentage changes.
• Absolute Change: The difference between the current-year figure and the previous-year figure.

Formula: Current-year figure − Previous-year figure.

• Percentage Change: The change in a figure expressed as a percentage of the previous-year figure.

Formula: $$\frac{\text{Absolute Change}}{\text{Previous-year Figure}}\times 100$$

• Common-Size Financial Statements: Statements in which each item is shown as a percentage of a common base figure.
• Common-Size Statement of Profit and Loss: Each item is expressed as a percentage of revenue from operations or total revenue, as applicable. Revenue from operations is generally taken as 100%.
• Common-Size Balance Sheet: Each asset, equity and liability item is expressed as a percentage of total assets or total equity and liabilities. The relevant total is generally taken as 100%.
• Accounting Ratio: A mathematical relationship between two accounting figures used to analyse financial performance and position.
• Liquidity Ratios: Ratios measuring the ability of a company to meet its short-term obligations.
• Solvency Ratios: Ratios measuring the ability of a company to meet its long-term obligations and assessing long-term financial stability.
• Activity or Turnover Ratios: Ratios measuring how efficiently a company uses its assets and working capital.
• Profitability Ratios: Ratios measuring the earning capacity of a company in relation to sales, assets or shareholders’ funds.
• Current Ratio: Measures short-term solvency.

Formula: $$\frac{\text{Current Assets}}{\text{Current Liabilities}}$$ The commonly regarded ideal is 2:1, although the appropriate level depends on industry and business conditions.

• Quick Ratio: Measures the ability to pay current liabilities using quick assets.

Formula: $$\frac{\text{Quick Assets}}{\text{Current Liabilities}}$$ where $$\text{Quick Assets}=\text{Current Assets}-\text{Inventory}-\text{Prepaid Expenses}.$$ The commonly regarded ideal is 1:1, subject to business circumstances.

• Debt-Equity Ratio: Shows the relationship between long-term debt and shareholders’ funds.

Formula: $$\frac{\text{Long-term Debt}}{\text{Shareholders’ Funds}}$$

• Proprietary Ratio: Shows the proportion of total assets financed by shareholders’ funds.

Formula: $$\frac{\text{Shareholders’ Funds}}{\text{Total Assets}}$$

• Total Assets to Debt Ratio: Measures the relationship between total assets and long-term debt.

Formula: $$\frac{\text{Total Assets}}{\text{Long-term Debt}}$$

• Interest Coverage Ratio: Shows the ability to pay interest on long-term debt.

Formula: $$\frac{\text{Profit before Interest and Tax}}{\text{Interest}}$$

• Inventory Turnover Ratio: Measures how quickly inventory is converted into sales.

Formula: $$\frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}}$$

• Trade Receivables Turnover Ratio: Measures the efficiency of collecting credit sales.

Formula: $$\frac{\text{Net Credit Revenue from Operations}}{\text{Average Trade Receivables}}$$

• Trade Payables Turnover Ratio: Measures the speed at which credit purchases are paid to suppliers.

Formula: $$\frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}}$$

• Working Capital Turnover Ratio: Measures how efficiently working capital generates revenue.

Formula: $$\frac{\text{Revenue from Operations}}{\text{Working Capital}}$$

• Gross Profit Ratio: Shows gross profit earned on revenue from operations.

Formula: $$\frac{\text{Gross Profit}}{\text{Revenue from Operations}}\times 100$$

• Operating Ratio: Shows the proportion of revenue consumed by operating costs.

Formula: $$\frac{\text{Cost of Revenue from Operations}+\text{Operating Expenses}}{\text{Revenue from Operations}}\times 100$$

• Operating Profit Ratio: Shows operating profit earned on revenue from operations.

Formula: $$\frac{\text{Operating Profit}}{\text{Revenue from Operations}}\times 100$$

• Net Profit Ratio: Shows net profit earned on revenue from operations.

Formula: $$\frac{\text{Net Profit}}{\text{Revenue from Operations}}\times 100$$

• Return on Investment: Measures the return earned on capital employed.

Formula: $$\frac{\text{Profit before Interest and Tax}}{\text{Capital Employed}}\times 100$$

• Capital Employed: The long-term funds used in the business. It may be calculated as:

$$\text{Shareholders’ Funds}+\text{Long-term Debt}$$ or $$\text{Total Assets}-\text{Current Liabilities}.$$

• Trend Analysis: The study of financial figures over several periods to identify upward, downward or stable movements.
• Limitations of Analysis: Financial analysis may be affected by different accounting policies, inflation, window dressing, non-monetary factors and the use of historical information.

Worked Methods

1. Preparing Comparative Financial Statements

• Present the figures for two or more accounting periods together.
• Calculate the absolute change:

$$\text{Current-year Figure}-\text{Previous-year Figure}.$$

• Calculate the percentage change:

$$\frac{\text{Current-year Figure}-\text{Previous-year Figure}}{\text{Previous-year Figure}}\times 100.$$

• Interpret whether the item has increased or decreased and relate the movement to business performance.

Comparative statements are useful for measuring growth and decline because they show both the amount and percentage of change.

2. Preparing Common-Size Financial Statements

Common-Size Statement of Profit and Loss

• Take revenue from operations, or total revenue as applicable, as the common base.
• Treat the base figure as 100%.
• Express every other item as a percentage of that base.

Common-Size Balance Sheet

• Take total assets, or total equity and liabilities, as the common base.
• Treat the base figure as 100%.
• Express each asset, equity and liability item as a percentage of the base.

Common-size statements are useful for studying the relative composition of financial statements rather than merely their absolute growth.

3. Calculating the Current Ratio

• Identify current assets.
• Identify current liabilities.
• Apply:

$$\text{Current Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}.$$

• Compare the result with the commonly regarded ideal of 2:1, while considering industry and business conditions.

Current assets include inventory, trade receivables, cash and bank balances and short-term investments. Current liabilities include trade payables, short-term borrowings, outstanding expenses and other obligations payable within the operating cycle or one year.

4. Calculating the Quick Ratio

• Determine current assets.
• Deduct inventory and prepaid expenses:

$$\text{Quick Assets}=\text{Current Assets}-\text{Inventory}-\text{Prepaid Expenses}.$$

• Divide quick assets by current liabilities:

$$\text{Quick Ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}.$$

• Compare the result with the commonly regarded ideal of 1:1, subject to business circumstances.

5. Calculating Solvency Ratios

Apply the relevant formula:

• Debt-Equity Ratio

$$\frac{\text{Long-term Debt}}{\text{Shareholders’ Funds}}$$

• Proprietary Ratio

$$\frac{\text{Shareholders’ Funds}}{\text{Total Assets}}$$

• Total Assets to Debt Ratio

$$\frac{\text{Total Assets}}{\text{Long-term Debt}}$$

• Interest Coverage Ratio

$$\frac{\text{Profit before Interest and Tax}}{\text{Interest}}$$

A higher interest coverage ratio generally indicates a greater ability to meet interest obligations.

Shareholders’ funds generally include share capital and reserves and surplus after considering relevant adjustments.

6. Calculating Activity or Turnover Ratios

Inventory Turnover Ratio

• Calculate average inventory:

$$\text{Average Inventory}=\frac{\text{Opening Inventory}+\text{Closing Inventory}}{2}.$$

• Apply:

$$\text{Inventory Turnover Ratio}=\frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}}.$$

• Interpret the result. A higher ratio generally indicates efficient inventory movement, although an extremely high ratio may suggest insufficient stock.

Trade Receivables Turnover Ratio

• Calculate net credit revenue from operations:

$$\text{Net Credit Revenue from Operations}=\text{Credit Revenue from Operations}-\text{Sales Returns}.$$

• Calculate average trade receivables:

$$\text{Average Trade Receivables}=\frac{\text{Opening Trade Receivables}+\text{Closing Trade Receivables}}{2}.$$

• Apply:

$$\text{Trade Receivables Turnover Ratio}=\frac{\text{Net Credit Revenue from Operations}}{\text{Average Trade Receivables}}.$$

Trade Payables Turnover Ratio

• Calculate net credit purchases:

$$\text{Net Credit Purchases}=\text{Credit Purchases}-\text{Purchase Returns}.$$

• Calculate average trade payables:

$$\text{Average Trade Payables}=\frac{\text{Opening Trade Payables}+\text{Closing Trade Payables}}{2}.$$

• Apply:

$$\text{Trade Payables Turnover Ratio}=\frac{\text{Net Credit Purchases}}{\text{Average Trade Payables}}.$$

Working Capital Turnover Ratio

• Calculate working capital:

$$\text{Working Capital}=\text{Current Assets}-\text{Current Liabilities}.$$

• Apply:

$$\text{Working Capital Turnover Ratio}=\frac{\text{Revenue from Operations}}{\text{Working Capital}}.$$

7. Calculating Profitability Ratios

• Calculate gross profit:

$$\text{Gross Profit}=\text{Revenue from Operations}-\text{Cost of Revenue from Operations}.$$

• Calculate operating profit using either:

$$\text{Operating Profit}=\text{Gross Profit}-\text{Operating Expenses},$$ or: $$\text{Operating Profit}=\text{Net Profit before Tax and Interest}+\text{Non-operating Expenses}-\text{Non-operating Income}.$$

• Apply the relevant formulas:

$$\text{Gross Profit Ratio}=\frac{\text{Gross Profit}}{\text{Revenue from Operations}}\times 100$$

$$\text{Operating Ratio}=\frac{\text{Cost of Revenue from Operations}+\text{Operating Expenses}}{\text{Revenue from Operations}}\times 100$$

$$\text{Operating Profit Ratio}=\frac{\text{Operating Profit}}{\text{Revenue from Operations}}\times 100$$

$$\text{Net Profit Ratio}=\frac{\text{Net Profit}}{\text{Revenue from Operations}}\times 100$$

• Compare profitability ratios with previous years, budgets and industry averages.

A lower operating ratio is generally favourable because it indicates better control over operating costs.

8. Calculating Return on Investment

• Determine profit before interest and tax.
• Calculate capital employed as either:

$$\text{Shareholders’ Funds}+\text{Long-term Debt}$$ or: $$\text{Total Assets}-\text{Current Liabilities}.$$

• Apply:

$$\text{Return on Investment}=\frac{\text{Profit before Interest and Tax}}{\text{Capital Employed}}\times 100.$$

9. Conducting Trend Analysis

• Collect financial figures for several periods.
• Arrange the figures chronologically.
• Identify upward, downward or stable movements.
• Compare the trends with past performance, budgets, industry averages and business conditions.
• Use qualitative information, including management quality, market conditions, competition and technological changes, to interpret the trends.

Where It Goes Wrong

• Absolute change is confused with percentage change; the percentage must be calculated using the previous-year figure as the denominator.
• Comparative statements are treated as sufficient by themselves, even though they show movement but do not explain all causes of financial performance.
• Inventory and prepaid expenses are not deducted when calculating quick assets for the Quick Ratio.
• Average balances are omitted in turnover ratios; average inventory, average trade receivables and average trade payables require opening and closing figures.
• Credit sales and purchases are not adjusted for returns when calculating net credit revenue from operations and net credit purchases.
• Ratios are interpreted in isolation or against fixed ideals without considering industry, company size, business cycle, accounting policies and the specific accounting period or reporting date.

What Gets Asked

• Define financial statement analysis, financial statements, the Statement of Profit and Loss and the Balance Sheet.
• Explain the purpose and preparation of comparative financial statements.
• Calculate absolute change and percentage change from figures for different years.
• Prepare or interpret a common-size Statement of Profit and Loss and common-size Balance Sheet.
• Classify and explain liquidity, solvency, activity or turnover and profitability ratios.
• Calculate the Current Ratio and Quick Ratio, including the treatment of inventory and prepaid expenses.
• Calculate Debt-Equity Ratio, Proprietary Ratio, Total Assets to Debt Ratio and Interest Coverage Ratio.
• Calculate Inventory Turnover Ratio, Trade Receivables Turnover Ratio, Trade Payables Turnover Ratio and Working Capital Turnover Ratio.
• Calculate Gross Profit Ratio, Operating Ratio, Operating Profit Ratio, Net Profit Ratio and Return on Investment.
• Calculate average inventory, average trade receivables, average trade payables, working capital, gross profit, operating profit and capital employed.
• Interpret whether a higher or lower ratio is favourable, including the qualifications relating to liquidity, operating costs, inventory and interest coverage.
• Explain trend analysis and the limitations of financial analysis, including different accounting policies, inflation, window dressing, non-monetary factors and historical information.
• Discuss how analysis supports decisions by management, investors, lenders, creditors, employees and government authorities.
• Explain why ratios must be calculated using comparable figures and interpreted together rather than used to form conclusions from one ratio alone.