Financial statements contain a wealth of information which if properly analyzed and interpreted, can provide valuable insights into a firmâ€™s performance and position. Analysis of financial statements is of interest to several groups interested in a variety of purposes.
The principal tool of financial statement analysis is financial ratio analysis which essentially involves a study of ratios between various items or groups of items in financial statements. Financial ratios may be divided into five broad types: liquidity ratios, leverage ratios, turnover ratios, profitability ratios, and valuation ratios.
Liquidity refers to the ability of the firm to meet its obligations in the short run, usually one year. Liquidity ratios are generally based on the relationship between current assets and current liabilities. The important liquidity ratios are: current ratio and acid test ratio.
Leverage refers to the use of debt finance. Leverage ratios reflect the ratio of debt to equity and the ability of the firm to meet its debt-related commitments. The important leverage ratios are: debt-equity ratio, times interest, and debt servicing burden.
Turnover ratios, also referred to as activity ratios or asset management ratios, measure how efficiently the assets are employed by the firm. These ratios are based on the relationship between the level of activity and the level for various assets. The important turnover ratios are: inventory turnover ratio, debtorsâ€™ turnover ratio, fixed assets turnover ratio, and total assets turnover ratio.
Profitability ratios reflect the final results of business operations. There two types of profitability ratios: profit margin ratios and rate of return ratios. Profit margin ratios show the relationship between profit and sale. The two popular profit margin ratios are: gross profit margin ratio and net profit margin ratio. Rate of return ratios reflect the relationship between profit and investment. The important rate of return are: net income to total assets ratio, return to total assets, and return on equity.
Valuation ratios indicate how the equity stock of the company is assessed in the capital market. Since the market value of equity reflects the combined influence of risk and return, valuation ratios are the most comprehensive measures of firmâ€™s performance. The important valuation ratios are: price earnings ratios, yield, and market value to book value ratio.
Generally, the financial ratios of a company are compared with some benchmark ratios. Industry average often serves as benchmark ratios. Sometimes the ratios of a firm which is deemed to be representatives may be used as benchmarks.
While analysis based on a single set of financial statements is helpful, it may often have to be supplemented with time series analysis which provides insight into a firm performance and condition over a period of time. In this context and analysis of time series of financial ratios is helpful.
The Du Pont chart is popular is a popular tool of financial analysis. A useful diagnostic tool, it provides insights into the two determinants of return on total assets: net profit margin ad total assets turnover ratio. By including the financial leverage multiplier, the Du Pont analysis may be extended to explore the determinants of the return equity.
While financial statement analysis can be a very useful tool, there are certain problems and issues encountered in such analysis that call for care, circumspection, and judgment.
Read notes the footnotes: Footnotes sometimes contain valuable information. They may reveal things that management may try to hide. The more difficult it is to read a foot note, the more information laden it may be.
Remember that financial statement analysis is an odd mixture of art and science: Financial statement analysis cannot be regarded as a simple, structured exercise .It is a process requiring care, thought, common sense, and business judgment â€“a process for which there are no mechanical substitutes.