Financial Statement Analysis

By Aditi Rode
 Basic of Financial Statement
Analysis
• What are the components of Financial
Statement?
• What is the objective of a Financial
Statement Analysis?
• Who are the users of Financial Statement?
• What are the elements of Financial
Statement?
 What are the components of
Financial Statement?
• Balance Sheet
• Income Statement
• Cash Flow Statement
• Notes to Accounts and Accounting
Policies
 Objective of Financial Statement
Analysis
• To provide information about the financial
position, performance and cash flow of an
enterprise
• However they do not provide all the
information because
• [Link] largely portray the financial
effects of past events
• [Link] do not provide information of non-
financial nature
 Users of Financial Statement
• Investors
• Lenders
• Management and Owners
• Suppliers and Creditors
• Government and Regulatory
• Employees
• Security Analysts and Advisers
 Elements of Financial Statement
• Financial Position
-- Assets
-- Liabilities
--Equity
. Performance
-- Income
-- Expenses
. Cash Flows
 Ratio Analysis
• Ratios provide a quick and simple means of
examining the financial health of a business
• A ratio simply expresses the relationship
between one figure appearing in the financial
statements with another eg net profit in relation
to capital employed
• Ratios are simple enough to calculate, and a
good picture can be built up with just a few,
however, ratios can be difficult to interpret
• Can be expressed in various forms eg
percentages, fractions, proportions, depending
on the need and use for the information
• Profitability - Measure of success in wealth
creation
• Efficiency - Effectiveness of utilisation of
resources
• Liquidity - The ability to meet short-term
obligations
• Gearing - Measure of degree of risk to do with
the amount of leverage used to finance the
business
• Investment - Measure of the returns and
performance of shares held by a business
 The Key Steps in Financial Ratio
Analysis
Step 1:
• Identify which key indicators and
relationships require examination
• Identify who needs the information and why
they need it
Step 2:
• Choose the most relevant set of ratios that will
accomplish the desired purposes
• Calculate and record the results using the
selected ratios
Step 3:
• Interpret and evaluate the results
 Profitability ratios
Some profitability ratios include the
following:
• Return on ordinary shareholders funds
• Return on total assets
• Return on capital employed
• Net profit margin
• Gross profit margin
 The Ratios Calculated - Profitability Ratios

Return on shareholders funds (ROSF):

ROSF
 Compares the amount of profit for the period
available to the owners with the owners’
stake in the business
 Normally expressed as a percentage

ROSF = NP after taxation & preference div (if any) x 100

Average ord share capital plus reserves
 The Ratios Calculated - Profitability
Ratios cont’d
Return on total assets (ROA):
ROA
• Compares the net profit generated by the
business with the assets owned by the
business
• Normally expressed as a percentage

ROA = NP before interest & taxation x 100

Average total assets
 The Ratios Calculated - Profitability Ratios
cont’d

Return on capital employed (ROCE):

ROCE
• Expresses the relationship between the net
profit generated and the average long term
capital invested
• Normally expressed as a percentage

ROCE = NP before interest and taxation x 100

(Share capital + long term loans)
 The Ratios Calculated - Profitability Ratios
cont’d

Net profit margin:

 Relates the PAT for the period to the sales
during that period
 Normally expressed as a percentage

NP = Profit after tax x 100

margin Sales
 The Ratios Calculated - Profitability
Ratios cont’d
Gross profit margin:
 Relates the gross profit of the business to
the sales generated during the same period
 Gross profit represents the difference
between sales and COS
 Normally expressed as a percentage

Gross profit (GP) margin = Gross profit x 100

Sales
 Efficiency ratios
Efficiency ratios include the following:
• Average inventory turnover period
• Average settlement period for debtors
• Average settlement period for creditors
• Asset turnover
 The Ratios Calculated - Efficiency
Ratios
Average inventory turnover period:
period
 Measures the average period inventory was
held
 Normally expressed in terms of days
 Average inventory is the simple average of
opening and closing inventory for the period

Inventory Average inventory held x 365

turnover = Cost of sales
period
 The Ratios Calculated - Efficiency
Ratios cont’d
Average settlement period for accounts
receivable/debtors
• Calculates an average of how long credit
customers take to pay amounts owed
• Normally expressed in terms of days

Average = Average trade debtors x 365

settlement period Credit sales

 The Ratios Calculated - Efficiency
Ratios cont’d
Average settlement period for accounts
payable/creditors:
payable/creditors
 Calculates how long,
long on average the
business takes to pay its creditors
 Normally expressed in terms of days

Average Average trade creditors x 365

settlement = Credit purchases
period
 The Ratios Calculated - Efficiency
Ratios cont’d
Asset turnover :
• Examines how effectively the assets of the
business are being employed in generating
sales revenue

Average asset = Average total assets employed

turnover Sales
 The Relationship Between Profitability and
Efficiency
The overall return on funds employed in the
business will be determined both by the
profitability of sales,
sales and by efficiency in
the use of assets
 Liquidity ratios
Liquidity ratios include the following:
• Current ratio
• Acid test ratio
• Cash flow from operations ratio
The Ratios Calculated - Liquidity Ratios

Current ratio:
 Compares the business’s liquid assets with
its short-term liabilities (current liabilities)
 Expressed in terms of the number of times
the current assets will cover the current
liabilities

Current ratio = Current assets (CA)

Current liabilities (CL)
The Ratios Calculated - Liquidity Ratios
cont’d

Acid test (also known as the quick/liquid ratio):

ratio
 Represents a more stringent test of liquidity
than the current ratio
 Expressed in terms of the number of times the
liquid current assets will cover the current
liabilities

Acid test = CA (excl. inventory & prepayments)

CL
The Ratios Calculated - Liquidity Ratios
cont’d

Cash flows from operations ratio:

• Compares the operating cash flows with the
current liabilities of the business
• Expressed in terms of the number of times
the operating cash flows will cover the
current liabilities

Cash flows from = Operating cash flows

operations ratio CL
 Financial Gearing (Leverage)
Financial Gearing:
Gearing The existence of fixed
payment bearing securities (eg loans) in the
capital structure of a company
• The level of gearing, or the extent to which a
business is financed by outside parties is an
important factor in assessing risk
• Gearing may be used both to adequately
finance the business, and to increase the
returns to owners - provided that the returns
generated from the borrowed funds exceed the
interest cost of borrowing
 Financial Gearing ratios
Financial gearing or leverage ratios include
the following:
• Gearing ratio
• Interest cover ratio
 The Ratios Calculated - Financial Gearing
(Leverage) cont’d
Gearing ratio:
• Measures the contribution of long-term
lenders to the long-term capital structure of
the business
• Expressed in terms of a percentage

Gearing ratio = Long-term liabilities

x 100 Share capital + Reserves +
L/term liab
 The Ratios Calculated - Financial Gearing
(Leverage) cont’d
Interest cover ratio (times interest earned):
• Measures the amount of profit available to
cover interest expense of the business
• Expressed in terms of the number of times the
profit generated by the business will cover the
interest expense of its gearing

Interest cover ratio = Profit before interest and taxation

Interest expense
 Investment ratios
Investment ratios include the following:
• Dividends per share
• Dividend payout ratio
• Dividend yield ratio
• Earnings per share
• Operating cash flow per share
• Price/earnings ratio
 The Ratios Calculated - Investment
Ratios cont’d
Dividends per share:
• Relates the dividends announced to the
number of shares on issue of the business
during a period
• Not a measure of total return of the business

Dividends = Dividends announced during period

per share No. of shares on issue during period
 The Ratios Calculated - Investment
Ratios cont’d
Dividend payout ratio:
• Measures the proportion of earnings
that a company pays out to
shareholders in the form of dividends
• Expressed as a percentage

Dividend = Dividends announced for the year

x 100
payout ratio Earnings for year available for
dividends
 The Ratios Calculated - Investment
Ratios cont’d
Dividend yield ratio:
• Relates the cash return from a share to its
current market value
• Expressed as a percentage

Dividend yield = Dividends per share/(1 - t) x 100

Market value per share

where: t = company tax rate

 The Ratios Calculated - Investment
Ratios cont’d
Earnings per share:
• Relates the earnings generated by the
company during a period to the number
of shares on issue during the period
• Expressed as an amount

Earnings per share = Earnings available to ord.

s/holders Number of ordinary shares
on issue
 The Ratios Calculated - Investment
Ratios cont’d
Operating cash flow per share:
• Relates the operating cash flow of the
business during a period to the number
of shares on issue during the period
• Expressed as an amount

Operating cash = Operating cash flows - Pref

dividends
flow per share Number of ord. shares on issue
 The Ratios Calculated - Investment
Ratios cont’d
Price earnings ratio:
 Relates the market value of a share to the
earnings per share
 Expressed in terms of the number of times
the share price is greater than the current
earnings per share

Price earnings ratio = Market value per share

Earnings per share