FINANCIAL

STATEMENT
ANALYSIS
DEFINITION -FINANCIAL
STATEMENT ANALYSIS
It is the process of identifying financial strength and
weakness of a company by properly establishing
relationships between the items in the statement of
financial position and income statement.
The nature of the analysis will differ depending on
the purpose of the analyst.
DEFINITION… CNTD
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 clear picture of a
company's financial profile.
FIVE METHODS OF
FINANCIAL STATEMENT
ANALYSIS
Horizontal analysis,
Vertical analysis,
Ratio analysis,
Trend analysis and
Cost-volume profit analysis
HORIZONTAL ANALYSIS

Horizontal analysis compares historical data (such as

ratios and line items) and is usually depicted as a
percentage growth over the same line item in the
base year.
This allows financiers to easily spot trends and
growth patterns and forecast future projections. It
makes it easier to compare growth rates amongst
sector competitors.
VERTICAL ANALYSIS

Vertical analysis is the proportional analysis of a financial

statement, where each line item on a financial statement is
listed as a percentage of another item.
For example, every line item on an income statement is
stated as a percentage of gross sales, while every line item
on a balance sheet is stated as a percentage of total assets.
Vertical analysis can also be referred to as common sizing.
It gives analysts an understanding of overall performance in
terms of revenue and expenses.
RATIO ANALYSIS

Ratio analysis allows for meaningful comparison

between the different elements of a financial
statement and is used to reveal a general upward or
downward trend.
Once a ratio has been calculated, it can be
compared against the previous period, which is
crucial for setting performance targets.
TREND ANALYSIS

Trend Analysis. evaluates an organization's financial

information over a period of time. The goal is to
calculate and analyse the amount of change and
percent changes from one period to the other.
Trend Analysis is a form of horizontal analysis.
COST VOLUME PROFIT
ANALYSIS

This analysis technique helps businesses

better understand the relationship
between sales, costs, and business
profit. It examines the fixed cost and
variable cost and establishes the
relationship between sales and variable
cost to help business leaders better plan
and project profit.
RATIO ANALYSIS
PURPOSE OF RATIO
ANALYSIS
Ratios help compare current performance with previous records.
Ratios help compare a firm’s performance with similar competitors.
Ratios help monitor and identify issues that can be highlighted and
resolved.
Ratios help with future decision making.
CATEGORIES OF RATIOS
Financial ratios are grouped into the following
categories:
Liquidity ratios
Leverage ratios
Efficiency ratios
Profitability ratios
Market value ratios
LIQUIDITY RATIOS
Liquidity ratios are financial ratios that measure a
company’s ability to repay both short- and long-term
obligations. Common liquidity ratios include the following:
1. The current ratio measures a company’s ability to pay
off short-term liabilities with current assets:
Current ratio = Current assets / Current liabilities
2. The acid-test ratio measures a company’s ability to
pay off short-term liabilities with quick assets:
Acid-test ratio = Current assets – Inventories /
Current liabilities
3. The cash ratio measures a company’s ability to
pay off short-term liabilities with cash and cash
equivalents:
Cash ratio = Cash and Cash equivalents /
Current Liabilities
4. The operating cash flow ratio is a measure of the
number of times a company can pay off current
liabilities with the cash generated in a given period:
Operating cash flow ratio = Operating cash
flow / Current liabilities
EFFICIENCY RATIOS
Efficiency ratios, also known as activity financial ratios,
are used to measure how well a company is utilizing its
assets and resources. Common efficiency ratios include:
1. The asset turnover ratio measures a company’s ability
to generate sales from assets:
Asset turnover ratio = Net sales / Average total
assets
2. The inventory turnover ratio measures how many times
a company’s inventory is sold and replaced over a given
period:
Inventory turnover ratio = Cost of goods sold /
Average inventory
3. The accounts receivable turnover ratio measures how
many times a company can turn receivables into cash
over a given period:
Receivables turnover ratio = Net credit sales /
Average accounts receivable
4. The days sales in inventory ratio measures the
average number of days that a company holds on to
inventory before selling it to customers:
Days sales in inventory ratio = 365 days /
Inventory turnover ratio
PROFITABILITY RATIOS
Profitability ratios measure a company’s
ability to generate income relative to
revenue, balance sheet assets, operating
costs, and equity. Common profitability
financial ratios include the following:
1. The gross margin ratio compares the gross profit
of a company to its net sales to show how much
profit a company makes after paying its cost of
goods sold:
Gross margin ratio = Gross profit / Net sales
2. The operating margin ratio compares the
operating income of a company to its net sales to
determine operating efficiency:
Operating margin ratio = Operating income /
Net sales
3. The return on assets ratio measures how
efficiently a company is using its assets to generate
profit:
Return on assets ratio = Net income / Total
assets

4. The return on equity ratio measures how

efficiently a company is using its equity to generate
profit:
Return on equity ratio = Net income /
LEVERAGE FINANCIAL
RATIOS
Leverage ratios measure the amount of capital that comes
from debt. In other words, leverage financial ratios are used
to evaluate a company’s debt levels. Common leverage ratios
include the following:
1. The debt ratio measures the relative amount of a
company’s assets that are provided from debt:
Debt ratio = Total liabilities / Total assets
2. The debt to equity ratio calculates the weight of total debt
and financial liabilities against shareholders’ equity:
Debt to equity ratio = Total liabilities / Shareholder’s
equity
3. The interest coverage ratio shows how easily a
company can pay its interest expenses:
Interest coverage ratio = Operating income /
Interest expenses

4. The debt service coverage ratio reveals how easily

a company can pay its debt obligations:
Debt service coverage ratio = Operating
income / Total debt service
 LIMITATIONS OF RATIO
ANALYSIS
Inflationary effects: Financial statements are
released periodically and, therefore, there are time
differences between each release. If inflation has
occurred in between periods, then real prices are not
reflected in the financial statements. Thus, the
numbers across different periods are not comparable
until they are adjusted for inflation.
Changes in accounting policies: If the company
has changed its accounting policies and procedures,
this may significantly affect financial reporting. In
this case, the key financial metrics utilized in ratio
analysis are altered, and the financial results
recorded after the change are not comparable to the
results recorded before the change. It is up to the
analyst to be up to date with changes to accounting
policies. Changes made are generally found in the
notes to the financial statements section.
Operational changes: A company may
significantly change its operational structure,
anything from their supply chain strategy to
the product that they are selling. When
significant operational changes occur, the
comparison of financial metrics before and
after the operational change may lead to
misleading conclusions about the company’s
performance and future prospects.
Seasonal effects: An analyst should be
aware of seasonal factors that could
potentially result in limitations of ratio
analysis. The inability to adjust the ratio
analysis to the seasonality effects may
lead to false interpretations of the results
from the analysis.
Manipulation of financial statements: Ratio
analysis is based on information that is reported by
the company in its financial statements. This
information may be manipulated by the company’s
management to report a better result than its actual
performance.
Ratio analysis may not accurately reflect the true
nature of the business, if the misrepresentation or
manipulation of information is not detected by
simple analysis.
OTHER LIMITATIONS OF
RATIO ANALYSIS
Ratio analysis information is historic – it is not current.
Ratio analysis does not take into account external factors
such as a worldwide recession.
Ratio analysis does not measure the human element of a
firm.
Ratio analysis can only be used for comparison with other
firms of the same size and type.
it may be difficult to compare with other businesses as they
may not be willing to share the information.