Financial Statement Analysis in theory

The balance sheet shows the financial condition of a firm at a given point of time, in terms of assets and liabilities. Assets are classified into following categories: (1) fixed assets, (2) investments, (3) current assets, loans and advances and, (4) miscellaneous expenditure and losses. Liabilities are classified into the following categories: (1) share capital, (2) reserves and surplus, (3) secured loans, (4) unsecured loans, (5) current liabilities and provisions.

The important items in the profit and loss account are: (1) net sales, (2) cost of goods sold, (3) gross profit, (4) operating expenses, (5) operating profit (6) non-operating income, (7) profit before interest and tax (8) interest, (9) profit before tax, (10) tax and (11) profit after tax.

From a financial point of view, a firm basically generates cash and spends cash. The activities that generate cash are called sources of cash and the activities that absorb cash are called uses of cash. Increase in owners’ equity and liabilities and decrease in assets represents sources of cash. Decrease in owners’ equity and liabilities and increase in assets, on the hand represent uses of cash.

To understand how cash flows have been influenced by various decisions, it is helpful to classify cash flows into three categories: cash flows from operating activities, cash flows from investing activities and cash flows from financing activities.

Corporate managements have discretion in influencing the occurrence, measurement and reporting of revenues, expenses, assets, and liabilities. They may use this latitude to manage the bottom line.

Financial statements contain wealth of information which, if properly analyzed and interpreted, can provide valuable insights into a firm’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 statements 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 obligation 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. Two types of ratios are commonly used to analyze leverage: structural ratios and coverage ratios. Structural ratios are based on the proportions of debt and equity in the financial structure of the firm. The important structural ratios are: debt equity ratio and debt assets ratio. Coverage ratios reflect the relationship between debt servicing commitments and the sources for meetings these commitments. The important coverage ratios are: interest coverage ratio and fixed charges coverage ratio.

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 of various assets. The important turnover ratios are: inventory turnover ratio, receivables turnover ratio, fixed assets turnover ratio and total assets turnover ratio.

Profitability ratios reflect the final result of business operations. There are two types of profitability ratios: profit margin ratios and rate of return ratios. Profit margin ratios show the relationship between profit and sales. 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 measures are: net income to total assets ratio, return on investment, 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 a firm’s performance. The important valuation ratios are: price earnings ratio, yield, and market value to book value ratio.

Generally the financial ratios of a company are compared with some benchmark ratios. Industry averages often serve as Benchmark ratios Sometimes the ratios of a firm which is deemed to be representative 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’s performance and condition over a period of time. In this context, analysis of time series of financial ratios is helpful.