Financial Statement Analysis

Ashish Thapa
Faculty, MUSOM
Financial Statement
Financial statement contains the basic financial information about
revenues, expenses, assets, liabilities and cash flows during a specified
period.
These information provide an input to general community of investors
to form expectations about the required return and riskiness associated
to the firm’s financial affairs.
The basic financial statement of the firm are the income statement and
the balance sheet, which are prepared in accordance with generally
accepted accounting principles (GAAP).
Uses of Financial Statement
1. Bridging the GAP in Management:
Financial statements basically reflect a company’s financial performances.
They show profits and liabilities of the business. They show how successful a
company’s decisions have been. Since shareholders have access to these
statements, they can gauge their company’s performance. This further helps in
bridging the gap between lapses in management and expectations of owners.
2. Availing Credit from Lender:
Every business needs to borrow funds for functioning. They have to rely on
lenders like banks and financial institutions for this purpose. Financial
statements play a huge role in this purpose. Since they show a company’s
liabilities, debts and profits, investors can use them to make informed
decisions.
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3. Use of Investors:
Investors also extensively use a company’s financial statements to asses
its finances. That helps them figure out how the company’s solvency
will be in the longer term. Thus, the better a company’s financial
position is, the greater the investment it will receive.
4. Use of Government:
Governmental policies pertaining to corporates depend heavily
on financial statements. This is because these statements depict how
companies are functioning in general. The government can use this
information to decide taxation and regulatory policies.
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5. Use of Stock Exchanges:
Regulatory bodies like SEBON and Stock exchanges like NEPSE also use
financial statements for many reasons. SEBON can assess a company’s
internal matters using them to ensure the protection of investors. They
are also a great source of information for stock traders and investors.
6. Information on Investments:
The shareholders of a company rely on these statements to understand
how their investments are paying off. If a company is earning profits,
they might decide to invest even more money. On the contrary,
stagnant profits or even losses will prompt them to pull out. Despite all
these uses of financial statements, there are some limitations to them
as well.
Balance Sheet
Balance sheet is a statement of the firm’s financial position at a specific
point in time.
It balances the firm’s assets (what it owns) against its financing which
can be either debt (what it owes) or equity (what was provided by
owners).
The balance sheet is a statement of assets, liabilities and capital fund
because it contains the summary of these item at a given date.
Assets: The financial resources owned by the firm. Current Assets are
the short-term assets that are convertible into cash within a year like
cash and marketable securities, account receivable and inventories. And
Fixed Assets include assets such as plant and equipment, land and
building, etc which have more than one year of life.
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Liabilities: The claim of outsiders to the firm. Current Liabilities are
due for payment within a year, such as account payable, notes payable
and accruals. Long-term liabilities (debts) have maturities over one year,
such as long-term loan, bonds, debenture etc.
Capital fund represents the capital supplied by or belonging to
shareholders. It includes paid up capital, paid in capital, retained
earnings etc.
Income Statement
A summary of revenues and expenses of a firm for the specific period;
the period could be a month, quarter, semi-annually or a year depending
on the time period for which revenues and expenses are summarized.
For analyzing profitability managers, bank loan officers, security
analysts, often calculate earning before interest, tax, depreciation and
amortization (EBITDA). It is the amount of profit after deducting all the
operating cost except depreciation and amortization.
For planning and control purposes, management generally forecasts
monthly income statements, and then compares actual results to the
forecast statements. If revenues are lower or costs higher than the
forecast levels, the management should take corrective steps before the
problems become too serious.
 Statement of Retained Earnings
• Retained Earnings (RE) are the portion of a business’s profit that are
not distributed as dividends to shareholders but instead are reserved
for reinvestment back into the business. Normally, these funds are
used for working capital and fixed asset purchases (capital
expenditure) or allotted for paying off debt obligations.
• Retained Earnings are reported on the Balance sheet under the
shareholder’s equity section at the end of each accounting period. To
calculate RE, the beginning RE balance is added to the net income or
loss and then dividend payouts are subtracted. A summary report
called a statement of retained earnings is also maintained, outlining the
changes in RE for a specific period.
RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock
Dividends
Or; RE = Beginning period RE + Net Income/Loss - Dividends
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Using the information from the
Balance Sheet and the Income
Statement, Find the amount of
dividends paid by XYZ.
Statement of Cash Flow
Net Cash Flow (NCF) is the total of net income and non cash expenses.
It differs from accounting profit because some of the revenues and
expenses listed on the income statement are not paid in cash during the
year.
NCF= Net income – Non cash revenues + Non cash expenses
Some revenue may not be collected in cash during the year, which are to
be subtracted from net income while calculating net cash flow.
Depreciation and Amortization are non cash expenses which reduce net
income but are not paid in cash, so we add them back to net income for
calculating net cash flow. D&A are by far the largest non-cash items and
in many cases, the other non-cash items roughly net out zero. For this
reason.
NCF = Net income + Depreciation & Amortization
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Cash flow may be used to pay dividends, to increase inventories, to invest in
fixed assets, to reduce debt, or buy back common stock.
Statement of cash flow reflects these activities and summarizes the changes in
cash position of the firm. These activities are grouped in three categories.
• Operating activities
This includes net income, depreciation, and change in current assets and current
liabilities other than cash and short term debt.
• Investing activities
This includes investments in or sales of fixed assets
• Financing activities
This includes cash raised during the year by issuing short-term debt, long-term
debt, or stock. It also includes dividends paid or cash used to buy back
outstanding stock or bonds because such transaction reduce the firm’s cash
balance.
 Particular Detail Amount

Cash flow from operating activities:

Net income Xxx

Add: source of cash

Deprecation for the year xxx

Increase in account payable Xxx

Increase in accruals Xxx

Decrease in inventory Xxx

Decrease in account receivable Xxx Xxx

Subtraction: Use of cash

Increase in account receivable (xxx)

Increase in inventories (xxx)

Decrease in account payable (xxx)

Decrease in accruals (xxx) (xxx)

Net cash flow from operating activities ‘A’ XXX

Cash flow from investing activities:

Sale of fixed assets xxx

Sale of long term investment xxx

Less:

Purchase of fixed assets (xxx)

Purchase of long term investment (xxx)

Net cash flow from investing activities ‘B’ XXX

Cash flow from financing activities:

Increase in notes payable xxx

Increase in long term debt and preferred stock xxx

Payment of common and preferred dividends (xxx)

Decrease in notes payable (xxx)

Decrease in long term debt and preferred stock (xxx)

Net cash flow from financing activities XXX

Total cash Flow(A+B+C) XXX

Add: Cash and cash equivalent at the beginning XXX

Cash and cash equivalent at the end XXX

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Operating Assets and Operating Capital
Operating assets includes the cash and marketable securities, account
receivable, inventories and fixed assets necessary for normal operation
of the business.
Operating working capital (OWC) refers to all the current assets used
in operation of the firm and the net operating working capital
(NOWC) is the part of operating working capital, which is financed by
interest bearing funds. While calculating NOWC non-interest bearing
funds (account payable, accruals, etc.) are deducted from OWC.
NOWC= OWC – Non interest bearing current liabilities
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Total Operating Capital
Total operating capital (TOC) is the sum of net operating working
capital (NOWC) and Net fixed assets.
Total operating capital (TOC)= NOWC + Net fixed assets
Net Operating Profit After Tax
Net Operating Profit after Tax (NOPAT) is a profitability measurement
that calculates the theoretical amount of cash that a company could
distribute to its shareholders if it had no debt. In other words, this is the
amount of profits that a company makes from its operations after taxes
without regard to interest payments.
Net operating profit after tax (NOPAT) = EBIT (1- t)
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Operating Cash Flow
Depreciation is the non-cash operating expenses of the business of the
firm. While calculating operating cash flow, depreciation is included in
the net operating profit after tax
Operating Cash Flow (OCF) = NOPAT + Depreciation
Free Cash Flow
free cash flow (FCF) is the cash flow actually available for distribution to all
investors after the company has made all the investment in fixed assets. Therefore,
the financial manager must increase the free cash flows to make their firms more
valuable.
FCF = NOPAT + depreciation – net investment in total operating capital
Financial Ratio Analysis
• Financial analysis is concerned with analyzing the financial statement
of a firm with the view to identify strengths and weaknesses in various
aspects.
• It is a tool, which shows the relationship between two or more sets if
data taken from financial statements i.e., income statement and
balance sheet.
• It also includes consideration of the strategic and the analysis required
to consider the other aspects of business operation as well.
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Financial ratio analysis is the process of calculating financial ratios,
which are mathematical indicators calculated by comparing key
financial information appearing in financial statements of a business,
and analyzing those to find out reasons behind the business’s current
financial position and its recent financial performance, and develop
expectation about its future outlook.
Types of Financial Ratio Analysis
• There are different financial ratios to analyze different aspects of a
business’ financial position, performance and cash flows. Financial
ratios calculated and analyzed in a particular situation depend on the
user of the financial statements. For example, a shareholder is
primarily concerned about a business’s profitability and solvency; a
debt-holder is concerned about its solvency, liquidity and profitability
in the descending order of importance; a creditor/supplier is worried
mainly about the business’ liquidity, etc.
• There are various types of financial ratios to evaluate the firm’s
financial strengths and weakness. Some important types of financial
ratios are as following:
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1. Liquidity Ratios
2. Assets Management or Efficiency Ratios.
3. Debt Management or Leverage Ratios.
4. Profitability Ratios.
5. Market Value Ratios.
Liquidity Ratios
The most commonly used measures of firm’s ability to meet its short-
term obligation. It examines the extent to which the claims of short-term
creditors are covered by current assets. The two major liquidity ratio are
:
1. Current Ratio: is the quantitative relationship between current
assets and current liabilities. It is calculated by dividing current
assets by current liabilities
Current Ratio (CR)=

Standard measure of CR is 2 to 1.
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2. Quick Ratio or Acid Test Ratio: is the ratio between quick assets
and current liabilities. This ratio is used to measure firm’s ability to pay
its short-term obligation without relying on the sales of inventories.
It is calculated by deducting inventories and prepaid expenses from
current assets and dividing by current liabilities.
Quick Ratio=
Quick Assets= Total current assets – inventories

The standard measure of quick ratio is 1 to 1.

Assets Management or Efficiency Ratios
• It is the ratios that measures the effective utilization of assets.
• It is also called activity ratio or turnover ratio or management
efficiency ratio.
• The main purpose of this ratio is used to measure how effectively
the firm utilizes its assets to generate sales.
• Some commonly used ratios to measure the efficiency of a firm in
mobilizing its assets to generate sales and make profit are :
1. Inventory Turnover Ratio
2. Receivable Turnover or Debtors Turnover Ratio
3. Fixed Assets Turnover Ratio
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1. Inventory turnover ratio: is the quantitative relationship between
cost of goods sold and inventories. It is the test of liquidity of firm’s
investment in inventories.
Inventory turnover ratio =
where, Cost of goods sold = Sales - Gross profit
Average inventory =
If the value of cost of goods sold is not available or it cannot be
calculated, then inventory turnover ratio is calculated as net sales
divided by inventory.
Inventory turnover ratio =

Or, Inventory turnover ratio =

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A higher the inventory turnover better the efficiency of inventory
management whereas, lower inventory turnover shows that the firm are
holding excessive stock of inventory and less efficient in inventory
utilization.
Number of Days Sales Inventory or Inventory Conversion Period
Days sales inventory is also known as inventory conversion period
which is affected by inventory turnover.
Days sales inventory =
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2. Receivable Turnover Ratio or Debtors Turnover Ratio
It indicates the velocity of receivable collection of a firm. Receivable
turnover ratio indicates how rapidly the firm is collecting its account
receivable.
It is measured by the number of times its account receivable collected or
rolled over during the year.
Receivable turnover or debtor turnover ratio =
Higher receivables or debtors turnover ratio shows more efficiency of
collecting the receivable and low receivable turnover shows that
receivables are not collected in time. Hence, higher receivable turnover
ratio shows the better liquidity.
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Average Collection Period or Days sales Outstanding ( ACP or DSO)
The average length of time for collecting the cash from debtors. It is also
known as receivable collection period. It shows that how a firm is
collecting its credit (receivables).
Days sales outstanding=
=
The lower days sales outstanding are more preferable, which indicates that
the firm is able to collect its account receivable speedily and vice versa.
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3. Fixed Assets Turnover Ratio
The quantitative relationship between sales and net fixed assets which
measures how effectively the firm uses its fixed assets (like plant &
equipment, land & building, machinery and other long term assets) to
generate sales.
Fixed assets turnover ratio =
The higher fixed assets turnover ratio reflects better utilization of fixed assets
and vice versa.
Total Assets turnover Ratio: indicates the efficiency in use of total
assets to generate revenue or to measure the efficiency of utilization of
assets.
Total assets turnover ratio=
The higher total assets turnover ratio indicates the firms is able to use its
total assets more efficiently to generate the sales and vice-versa.
Debt Management Ratios
Debt management ratio is also called Capital structure ratio or Leverage
ratio. It is the measure of long term solvency of the firm from the use of
debt financing. It is calculated to measure the long-term financial
position and riskiness of the firm.
It is important to analyze leverage position from two aspects: one is to
measure the degree of the assets of the firm have been financed by the
use of debt. And another is how far the firm is able to serve its debts in
terms of satisfying regular fixed charges.
Following ratios are commonly used to measure the debt management.
1. Debt ratio
2. Debt to equity ratio
3. Long term debt to total assets ratio
4. Interest coverage ratio (Time interest earned ratio)
5. EBITDA coverage ratio
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1. Debt ratio:
Debt ratio also known as debt-assets ratio (DA), is the percentage of
firm’s assets financed by total debt.
Debt ratio=
where, Total debt= Short-term debt or Current liabilities + Long term debt
Total Assets = Current assets + Fixed assets
A higher debt ratio is more risky than low ratio. Creditors prefer a low
debt ratio since it implies a greater protection of their position. However
from the firm’s management point of view, the firm with low debt ratio
is not able to get leverage advantage
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2. Debt to equity ratio
The relationship between debt capital and equity capital. The debt-
equity ratio is a popular measure of the long-term financial solvency of
a firm.
Debt-equity ratio (D/E ratio)=
or, Debt-equity ratio (D/E ratio)=
Debt equity ratio is used to measure the financial risks of the firm.
Higher debt-equity is more risky than lower ratio. Higher ratio shows
that most of the fund invested in the business are managed from debt
and vice versa.
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3. Long-term debt to total assets
The quantitative relationship between long term debt and total assets of
a firm. This ratio examines the contribution of long term debt to get the
total assets of the firm.
Long term debt to total assets=
* Equity Multiplier (EM)
The relationship between total assets and equity. It is used to measure
the risk of leverage. Higher the equity multiplier shows more use of
debt and less use of equity and vice versa.
Equity Multiplier (EM) =
or, EM=
or, EM= 1 + DE
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4. Interest Coverage Ratio
It is also called Time Interest Earned (TIE) ratio. It is the ratio that
indicates the extent to which the firm is able to satisfy interest payment
out of earnings before interest and tax.
Interest coverage ratio or TIE =
Higher TIE ratio is preferable because the firm can easily pay the
interest in time, which is most satisfying for the creditors and vice-
versa.
Cash Coverage Ratio
The relationship between operating cash flow and interest. It is basic
measures of the firm’s ability to generate cash flow operation to meet
financial obligation.
Cash Coverage ratio =
Profitability Ratio
It is the group of ratios define the combined effects of liquidity, assets
management and debt management on operating result. It shows the
overall profitability of the business firm. It measures profitability with
respect to sales, assets and equity.
1. Net profit margin
2. Gross profit margin
3. Operating profit margin
4. Basic earning power
5. Return on assets
6. Return on equity
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1. Net profit margin
It is the ratio between net income and sales. It indicates that how the firm is able
to generate net income in relative to sales.
Net profit margin =
Higher the net profit margin, higher the efficiency of the business and better
utilization of total resources.
2. Gross profit margin
The ratio between gross profit and sales.
Gross profit margin =
Where, Gross profit = Sales – Cost of Goods Sold
Higher gross profit margin ratio shows the firm’s ability to earn gross profit and
indicates sound financial position of the firm to pay its financing obligation.
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3. Operating profit margin
It is the ratio of operating profit to sales. It is the relationship between the
earning before interest and tax and sales of the company. It shows the
profitability of sales before interest and taxes.
Operating profit margin =
Higher operating profit margin ratio is desirable and it shows the efficient
business operation.
4. Basic earning power ratio
The ratio between EBIT and total assets. This ratio shows the ability of the
firm’s assets to generate operating profit
Basic earning power ratio =
Higher ratio is favorable because it indicates higher operating profit and
better utilization of assets which helps to increase net profit.
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5. Return on Assets (ROA)
The percentage of net profit on total assets. It measures the overall
effectiveness in generating profit with respect to available total assets. ROA
measures the firm’s profitability from the investment on its assets.
Return on assets (ROA) =
Higher the ROA shows the effectiveness of management and utilization of
assets to generate profit.
6. Return on Equity (ROE)
The percentage of net profit on common equity. Higher ratio is better for
owner.
Return on Equity (ROE) =
Higher ratio indicates that the earning power of common shareholders
investment is better.
Market Value Ratio
It is the group of ratios that related the firm’s stock price to its earning
per share and book value per share.
There are two commonly used market value ratio: the price earning ratio
and the market to book ratio.
1. Price earning ratio (P/E ratio)
The ratio of market price per share to earning per share. The higher
price earning ratio shows that investors have more confidence to invest
in the firm.
P/E ratio =
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Earning per Share (EPS)
It is the income per common share. The ratio of earning available to
common share to number of common stock.
EPS =
Where, Earning available to equity share = Net profit after tax – Preferred dividend
2. Market-to-book value
It is the ratio between market price per share and book value per share. It
measures how the financial market has put the value to the firm’s overall
management and efficiency over the time.
Market-to-book ratio =
Where, Book value per share =
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