Introduction to financial statement analysis
Financial statement analysis is a process that helps individuals and organizations understand a company’s financial performance and health. This analysis involves examining a company’s balance sheet, income statement, and cash flow statement to identify trends and assess how the company is performing financially. It is a useful tool for investors, creditors, and management to make informed decisions about the company’s financial position and potential for growth. By comparing a company’s financial performance to its peers and the industry as a whole, financial statement analysis can provide valuable insights into a company’s strengths and weaknesses.
Stand–alone financial statement and consolidated financial statement analysis
Financial statement analysis can be conducted on either a stand–alone or a consolidated basis. A stand–alone analysis examines the financial statements of a single entity, while a consolidated analysis examines the financial statements of multiple entities that are combined in a group.
In stand-alone analysis, the financial statements of the company being analyzed are examined independently. This type of analysis is typically used to assess the financial performance of a single company and identify potential areas of improvement.
In consolidated analysis, the financial statements of multiple entities are combined, and the financial performance of the entire group is analyzed. This type of analysis is used to assess the financial performance of a group of entities and identify areas of improvement across the entire group.
Balance Sheet Analysis
Balance sheet analysis is an important tool for evaluating a company’s financial position and performance. The balance sheet presents a snapshot of a company’s financial position at a specific point in time, and is divided into three main sections: assets, liabilities, and shareholder’s equity.
Assets represent the resources that a company owns and controls, which can be used to generate future economic benefits. Common balance sheet line items for assets include cash, accounts receivable, inventory, investments, fixed assets, and intangible assets.
Liabilities represent the company’s obligations to third parties, such as lenders and suppliers. Common balance sheet line items for liabilities include accounts payable, accrued liabilities, bank loans, and long-term debt.
Shareholder’s equity represents the residual interest in the assets of the company after deducting liabilities. It consists of two main components: capital stock (common and preferred stock) and retained earnings. Retained earnings represent the cumulative earnings of the company that have not been paid out as dividends.
Balance sheet analysis involves examining the relationship between the various line items on the balance sheet to identify potential areas of improvement in the company’s financial position. For example, a high level of accounts receivable relative to sales may indicate that the company is having difficulty collecting payments from customers. Similarly, a high level of long-term debt relative to shareholder’s equity may indicate that the company is heavily leveraged and may be at risk of defaulting on its debt obligations.
In addition to the prescribed format under Schedule 3 of the Companies Act 2013, companies are also required to report changes in shareholder’s equity under IndAS 1. This provides additional information on the movements in shareholder’s equity, including changes in capital stock, retained earnings, and other comprehensive income.
Basics of Profit and Loss Account (P/L)
A Profit and Loss Account, also known as an income statement, is a financial statement that summarizes the revenues, expenses, and net income of a company during a specific period of time. The Profit and Loss Account is used to assess a company’s financial performance and health. It typically includes line items such as sales, cost of goods sold, operating expenses, and net income.
The Profit and Loss Account follows the accrual accounting method, which means that revenues and expenses are recognized when they are earned or incurred, regardless of when the cash is actually received or paid. This allows for a more accurate reflection of a company’s financial performance during a given period of time. Additionally, the P/L statement can be used to compare a company’s performance over different periods, helping investors and stakeholders to identify trends and make informed decisions.
Common Profit and Loss Account Line Items:
Revenues: Sales, Interest, Dividends Expenses: Cost of Goods Sold, Selling, General, and Administrative Expenses, Interest Expense, Taxes Net Income: Revenues minus Expenses
Key Metrics from Profit and Loss Account:
Gross Profit: Revenues minus Cost of Goods Sold Operating Profit: Gross Profit minus Operating Expenses Net Profit: Operating Profit minus Interest Expenses and Taxes
Basics of Cash Flows
Cash flow is the movement of cash into and out of a business. The cash flow statement is a financial statement that summarizes the inflows and outflows of cash during a specific period of time. It is used to assess a company’s ability to generate cash and identify potential areas of improvement.
The Cash Flow Statement follows the cash accounting method, which means that it only records the actual cash inflows and outflows during the period, regardless of when the corresponding revenues and expenses were recognized. This provides a more accurate reflection of a company’s cash position and ability to meet its financial obligations.
Common Cash Flow Statement Line Items:
Cash from Operating Activities: Cash from sales, Cash from collections of accounts receivable, Cash paid for expenses, Cash paid for taxes
Cash from Investing Activities: Cash investments in property, plant, and equipment, Cash investments in other companies, Cash received from sale of investments
Cash from Financing Activities: Cash from issuing stock or bonds, Cash from taking out loans, Cash paid for dividends
Net Cash Flow: Cash from Operating Activities plus Cash from Investing Activities plus Cash from Financing Activities
Financial statement analysis using ratios
Financial statement analysis using ratios is a method of reviewing and analyzing a company‘s financial statements in order to gain insight into its financial performance. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry average, or other benchmarks. This comparison provides information about trends and helps in predicting future performance. Ratios are used to measure liquidity, profitability, efficiency, solvency, and shareholder return. Each ratio provides a different view of the company‘s financial performance and can be used to identify areas of strength and weakness.
Commonly used ratios include:
| Ratio Name | Description | Formula | Ideal Ratio |
|---|---|---|---|
| Liquidity Ratios | Measure the company's ability to meet its short-term obligations such as paying bills and meeting payroll | Current Ratio = Current Assets / Current Liabilities Quick Ratio = (Current Assets - Inventories) / Current Liabilities |
Current Ratio: 2:1 Quick Ratio: 1:1 |
| Profitability Ratios | Measure the company's ability to generate income and profits from operations | Gross Profit Margin = Gross Profit / Net Sales Operating Profit Margin = Operating Profit / Net Sales Return on Assets = Net Income / Total Assets |
Gross Profit Margin: 40% Operating Profit Margin: 15% Return on Assets: 10% |
| Efficiency Ratios | Measure the company's ability to use its assets and resources efficiently | Inventory Turnover = Cost of Goods Sold / Average Inventory Accounts Receivable Turnover = Net Sales / Average Accounts Receivable Asset Turnover = Net Sales / Total Assets |
Inventory Turnover: 6 times per year Accounts Receivable Turnover: 8 times per year Asset Turnover: 2 times per year |
| Solvency Ratios | Measure the company's ability to meet its long-term obligations such as debt payments and other liabilities | Debt to Equity Ratio = Total Liabilities / Total Equity Interest Coverage Ratio = Earnings Before Interest & Taxes / Interest Expense |
Debt to Equity Ratio: 1:1 Interest Coverage Ratio: 5:1 |
| Shareholder Return Ratios | Measure the company's ability to generate returns for its shareholders | Return on Equity = Net Income / Shareholder Equity Dividend Yield = Dividends per Share / Share Price |
Return on Equity: 15% Dividend Yield: 3% |
Dupont analysis
Dupont analysis is a financial analysis tool used to analyze the return on equity of a company. It provides insight into the firm’s financial performance by breaking it down into three parts: (1) profit margin (2) asset turnover, and (3) financial leverage. By breaking down the return on equity into its components, investors can get a better understanding of the firm’s performance and can identify potential areas of improvement.
The formula for Dupont analysis is:
Return on Equity (ROE) = Profit Margin x Asset Turnover x Financial Leverage
Profit Margin: The profit margin ratio measures how much of each dollar of sales is converted into profits. It is calculated by dividing net income by net sales.
Asset Turnover: The asset turnover ratio measures how efficiently the firm is using its assets to generate sales. It is calculated by dividing net sales by total assets.
Financial Leverage: The financial leverage ratio measures how the firm is using debt to finance its operations. It is calculated by dividing total liabilities by total equity. By understanding how each of these components affects the firm’s return on equity, investors can gain insight into the firm
Forecasting Using Ratio Analysis
To forecast a company’s future performance using ratio analysis, historical financial data is used to identify trends in the company’s financial ratios. The trend analysis can be used to estimate the future values of these ratios, and the estimated ratios can then be used to forecast future financial performance.
For example, if a company’s current ratio has been increasing over the past few years, it can be assumed that the company will continue to have sufficient liquidity to pay its debts in the future. Similarly, if a company’s debt-to-equity ratio has been decreasing, it can be assumed that the company is reducing its reliance on debt financing and is moving towards a more sustainable financial structure.
However, it is important to note that forecasting using ratio analysis is not foolproof, as external factors such as changes in the economy, industry trends, and unexpected events can impact a company’s financial performance. Therefore, it is important to use ratio analysis in conjunction with other forecasting methods and to continuously monitor and adjust the forecasts as new information becomes available.
Peer Comparison
Peer comparison is a valuable technique for evaluating a company’s performance and assessing its position relative to its peers in the industry. By comparing financial ratios, such as profitability ratios, liquidity ratios, and efficiency ratios, among others, investors and managers can determine how well a company is performing compared to others in the same industry. This analysis can also identify areas where the company may be lagging behind its competitors or where it may have a competitive advantage. This information can be used to inform decisions about the company’s future strategy, investments, and operations.
Other aspects to study from financial reports
| Aspect | Description |
|---|---|
| History of Equity Expansion/Reduction | Analyzing the history of equity expansion/reduction, such as through issuing stock, can provide valuable insight into the company’s financial health. This can be used to forecast the potential for future expansion or contraction. |
| Dividend and Earnings History | Examining the dividend and earnings history can provide insight into how the company has managed its profits and cash flow. This can be used to forecast the potential for future dividend payments and profits. |
| History of Corporate Actions | Examining the history of corporate actions, such as mergers and acquisitions, can provide important insight into the company’s strategic direction. This can be used to forecast the potential for future corporate actions. |
| Ownership and Insiders’ Sales and Purchase of Stocks in The Past | Analyzing the ownership and insiders’ sales and purchase of stocks in the past can provide insight into how the company is managed and what the company’s goals may be. This can be used to forecast the potential for future changes in ownership and insider trading. |
| Industry Trends | Studying industry trends can provide insight into the overall health of the industry and how it may impact the company’s performance. This can include analyzing market size, market growth, and the competitive landscape. |
| Macroeconomic Conditions | Analyzing macroeconomic conditions such as interest rates, inflation, and unemployment rates can provide insight into how the broader economy may impact the company’s performance. |
| Risk Factors | Understanding the risks that a company faces, such as market risk, credit risk, and operational risk, can provide insight into the potential for future financial performance. |
| Management Discussion and Analysis (MD&A) | Examining the company’s MD&A section can provide valuable information on the company’s performance, strategy, and future plans. |
| Corporate Governance | Understanding the company’s corporate governance structure and policies can provide insight into how the company is managed and whether there are any potential conflicts of interest or unethical practices. |
| Non-Financial Metrics | In addition to financial metrics, non-financial metrics such as customer satisfaction, employee turnover, and environmental impact can also provide insight into the company’s performance and future potential. |
