Financial Statement Analysis

Introduction:

Financial statements need to be properly analyzed and interpreted for measuring the performance and position of a firm. This is of immense help to lenders (short-term as well as long term), investors, security analysts, managers' etc.

Types of Financial Ratios:

Liquidity Ratio:

Liquidity is the ability of a firm to meet its short-term (usually up to 1 year) obligations.

Current Ratio:

Current Ratio = Current Assets/Current Liabilities

Current Assets include cash, debtors, marketable securities, inventories, loans and advances, prepaid expenses.
Current liabilities include loans and advances (taken), creditors, accrued expenses and provisions.

This ratio measures the ability of the firm to meet its current liabilities. Usually, higher the current ratio, the greater the short term solvency of the firm. The break up of the current assets is very important to assess the liquidity of a firm. A firm with a large proportion of current assets in the form of cash and accounts receivable is more liquid than a firm with a high proportion of inventories even though two firms might have the same ratio.

Quick Ratio:

Quick Ratio = Quick Assets / Current Liabilities

Quick Assets imply Current assets less inventories.
This ratio is based on very highly liquid assets and inventories are deemed to be the least liquid of the current assets.

Leverage Ratio:

Financial leverage refers to the use debt finance. Debt finance is thought to be a cheaper source of finance and at the same time a riskier source. Leverage ratios help in assessing the risk arising from the use of debt finance.

Debt Equity Ratio:

Debt Equity Ratio = Debt / Equity

Debt - Long term as well as short term.
Equity - Share Capital plus Reserves and Surplus (Net Worth)
It is generally felt that lower the ratio, the greater the degree of protection enjoyed by the creditors. Generally, incase of capital-intensive industries a higher debt-equity ratio is observed.

Debt Assets Ratio:

Debt Assets Ratio = Debt / Assets

Debt includes Long term as well as short term debt and Assets include total of all assets.

Interest Coverage Ratio:

Interest coverage Ratio = EBIT / Interest charges

This ratio measures the margin of safety a firm enjoys with respects to its interest burden. The higher the ratio, the greater the margin of safety.

Turnover Ratios:

Inventory Turnover Ratio:

Inventory Turnover Ratio = COGS / Inventory

Inventory implies balance of the stock of goods at the end of the year.

This ratio implies the efficiency of inventory management. The higher the ratio, the more efficient the inventory management.

Average Collection Period:

Average collection Period = Receivables / Average Sales per day

Receivables Turnover Ratio:

Receivables Turnover Ratio = Net Sales / Receivables

Fixed Assets Turnover Ratio:

Fixed Assets Turnover Ratio = Net Sales / Fixed Assets

This ratio used to measure the efficiency with which fixed assets are employed. A high ratio indicates an efficient use of fixed assets. Generally this ratio is high when the fixed assets are old and substantially depreciated.

Return on Investment:

Return on Investment = Earnings before Interest and taxes / Total assets

This measures the performance of the firm without the effect of interest and tax burden.

Return on Equity:

Return on Equity = Equity earnings / Net worth

Equity earnings = Profit after tax - preference dividend

Net worth = Share capital + Reserves & surplus

This Ratio measures the profitability of equity funds invested in the firm. This reflects the productivity of the ownership capital employed in the firm.