Applications of financial statement analysis

Having learnt how to compute and interpret a number of financial ratios, let us now examine how a set of financial ratios may be combined ratios may be combined to answers some questions that are commonly raised by investors (shareholders and debt holders) and others.

Assessing Corporate Excellence:

Every year, The Economic Times gives corporate excellence award for the Company of the year and the Emerging Company of the year. The Economic Times considers the following financial indicators in its quantitative evaluation for judging corporate excellence:

1) Increase in market capitalization over 12 months on the date of calculation.
2) Increase in revenues over one accounting year
3) Return on net worth
4) Compound annual growth in EPS over the past three years
5) Price earnings ratio
6) Market capitalization as on July 15.
7) Sales for the latest financial year.
8) Profit after tax for the latest financial year.

The determination of the top 20 companies in each category is based on a combined ranking over the nine indicators which are equally weighted

To judge corporate excellence other studies have employed different sets of financial indicators. Exhibit shows the indicators employed in some other studies.

Judging Credit worthiness:

For judging credit worthiness of a potential customer or client a number of ad hoc scoring models employing several financial factors have been used.

One such model is shown in Exhibit below:

In this model you assess a client on various factors by assigning points in the range 0 – 15. By looking at the total points you judge the creditworthiness of the client.

Forecasting bankruptcy:

A multivariate model of the kind displayed in exhibit represents a distinct improvement over a single ratio analysis. It seems to comprehensively consider almost all the key factors relevant for credit evaluation. A critical look at this model, however, raises several issues: Why should the model have eleven factors? What is the sanctity about the scale of rating? Why should the factors be regarded equally important? Is there any conceptual framework or theory that supports such scoring? In sum, the approach seems to be ad hoc.

Exhibit: Indicators to Judge Corporate Excellence

Peters and Waterman: In search of Excellence

= Compound asset growth
= Compound equity growth
= Market value to book value ratio
= Return on equity
= Return on sales

Industrial Development Bank of India study

= Growth rate of sales
= Growth arte of assets
=Profit before tax to capital employed
= Working capital to gross sales
= Dividend coverage
= Debt equity ratio

To overcome some of these limitations, the modern approach to financial analysis employs multivariate statistical techniques. What is the key difference between scientific multivariate analysis and ad hoc multivariate analysis? In scientific multivariate analysis, the selection of variables, the form of the model, the scheme of weighting, and the determination of cut off levels (wherever it is done) are guided largely by objective statistical methodology, not subjective managerial judgment.

A widely cited example of scientific multivariate analysis is the classic study by Altman on prediction of corporate bankruptcy. In this study Altman examined a sample of 33 bankrupt firms with a pair of 33 non bankrupt firms. He considered 22 accounting and non accounting variables in various combinations as predictors of failure. He found that the following function discriminated best between the bankrupt and non bankrupt firms:

Z= 1.3X1 + 1.4X2 + 3.3X3 + 0.6X4 +1.0X5


X1 = working capital / total assets (a liquidity measure)
X2 = retained earnings / total assets (a measure for reinvestment of earnings
X3 = earnings before interest and taxes / total assets (a profitability measure)
X4 = market value of equity / book value of total debt (a leverage measure)
X5 =sales/ total assets (a turnover measure)

Altman found that forms which had a Z score below 1.81 mostly went bankrupt, firms which had a Z score value above 2.99 remained healthy, and firms which had a Z score between 1.81 and 2.99 fell in grey area.