Financial statements hold the key to understanding a company’s performance and potential. Analysing these documents effectively can empower businesses, investors, and stakeholders to make informed decisions. Whether you’re evaluating trends, comparing industry peers, or planning future strategies, mastering financial statement analysis is a crucial skill for success.
In this blog, we will delve into key strategies to better analyse company financial statements.
Simplifying Financial Analysis for Smarter Decisions
1. Horizontal Analysis:
This a comparison of financial statements with that of two or more previous years and its elements. The analysis allows investors and analysts to see what has been driving a company’s financial performance over several years, as well as to spot trends and growth patterns. It enables analysts to assess relative changes in different line items over time.
By looking at the income statement, balance sheet, and cash flow statement over time, one can create a complete picture of operational results. It can either use absolute comparisons or percentage comparisons, where the numbers in each succeeding period are expressed as a percentage of the amount in the baseline year, with the baseline amount being listed as 100%. This comparison provides analysts with insight into the aspects that could contribute significantly to the financial position or profitability of the organization.
2. Vertical Analysis:
Vertical analysis is a method of analysing financial statements that lists each line item as a percentage of a base figure within the statement. One line item of the statement always shows the base figure at 100%, with each of the other items representing a percentage of the base figure. For example, each line of an income statement represents a percentage of Revenues, while each line of a balance sheet represents a percentage of Total Assets & Liabilities.
One can use vertical analysis on an income statement, balance sheet or cash flow statement to understand the proportions of each line item to the whole, understand key trends that occur over time, compare multiple companies of varying sizes, or compare a company’s financial statements to averages within their industry.
3. Ratio Analysis:
Ratio analysis refers to the analysis of various pieces of financial information in the financial statements of a business which are mainly used by external analysts to determine various aspects of a business. Generally, ratios are typically not used in isolation but rather in combination with other ratios.
This data can also compare a company’s financial position with industry averages while measuring how a company stacks up against others within the same sector. There are four different ways to represent Financial ratios given their nature:
-Simple or Pure: A simple ratio is shown as a quotient, for example – 3:1
-Percentage: This type of representation is done in the form of a percentage, for example – 30%
-Turnover Rate: Accounting ratio expressed in the form of rate or times, for example – 3 times
-Fraction: It is when a ratio is expressed in a fraction, for example – 2/3 or 0.67
Key Uses of Ratio Analysis
1. Comparisons:
Ratio analysis compares a company’s performance with industry peers to identify competitive strengths, weaknesses, and market gaps. This helps management make strategic decisions to enhance market positioning.
2. Trend Line:
Analysing financial ratios over time reveals performance trends and predicts future outcomes. It helps identify potential financial challenges early for proactive decision-making.
3. Operational Efficiency:
Ratios evaluate how efficiently assets and liabilities are managed. They highlight underused resources and unnecessary costs, enabling improvements in operational efficiency.
There are four different ways to represent Financial ratios given their nature:
- Simple or Pure – A simple ratio is shown as a quotient, example – 3:1
- Percentage – This type of representation is done in form of a percentage, example 30%
- Turnover Rate or Times – Accounting ratio expressed in form of rate or times, example 3 times.
- Fraction – It is when a ratio is expressed in a fraction, example 2/3 or 0.67
Understanding the Different Types of Ratios
1. Liquidity Ratios:
This type of ratio helps in measuring the ability of a company to take care of its short-term debt obligations. A higher liquidity ratio represents that the company is highly rich in cash. The types of liquidity ratios are:
Current Ratio:
The current ratio is the ratio between the current assets and current liabilities of a company. The current ratio is used to indicate the liquidity of an organization in being able to meet its debt obligations in the upcoming twelve months. A higher current ratio will indicate that the organization is highly capable of repaying its short-term debt obligations. It is represented as:
Current Ratio = Current Assets/Current Liabilities
Quick Ratio:
The quick ratio is used to ascertain information about the capability of a company to pay off its current liabilities on an immediate basis. It is represented as:
Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivables)/Current Liabilities
2. Profitability Ratios:
This type of ratio helps in measuring the ability of a company to earn sufficient profits. The types of profitability ratios are:
Gross Profit Ratios:
Gross profit ratios are calculated to represent the operating profits of an organization after making necessary adjustments about the COGS or cost of goods sold. Numerically, it is represented as:
Gross Profit Ratio = (Gross Profit/Net Sales) * 100
Operating Profit Ratio:
Operating profit ratio is used to determine the soundness of an organization and its financial ability to repay all the short-term and long-term debt obligations. Numerically, it is represented as:
Operating Profit Ratio = (Earnings Before Interest and Taxes/Net Sales) * 100
Net Profit Ratio:
Net profit ratios are calculated to determine the overall profitability of an organization after reducing both cash and non-cash expenditures. Numerically, it is represented as:
Net Profit Ratio = (Net Profit/Net Sales) * 100
Return on Equity (ROE):
Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. It is represented as:
ROE = Net Profit/Shareholder’s Equity
Return on Capital Employed (ROCE):
Return on capital employed is used to determine the profitability of an organization concerning the capital that is invested in the business. It is represented as:
ROCE = Earnings Before Interest and Taxes/Capital Employed
3. Solvency Ratios:
Solvency ratios can be defined as a type of ratio that is used to evaluate whether a company is solvent and well capable of paying off its debt obligations or not. The types of solvency ratios are:
Debt-Equity Ratio:
The debt-equity ratio can be defined as a ratio between total debt and shareholders’ funds. The debt-equity ratio is used to calculate the leverage of an organization. An ideal debt-equity ratio for an organization is 2:1. It is represented as:
Debt Equity Ratio = Total Debts/Shareholders Fund
Interest Coverage Ratio:
The interest coverage ratio is used to determine the solvency of an organization in the nearing time as well as how many times the profits earned by that very organization were capable of absorbing its interest-related expenses. It is represented as:
Interest Coverage Ratio = Earnings Before Interest and Taxes/Interest Expense
4. Turnover Ratios:
Turnover ratios are used to determine how efficiently the financial assets and liabilities of an organization have been used to generate revenues. The types of turnover ratios are:
Fixed Assets Turnover Ratios:
Fixed assets turnover ratio is used to determine the efficiency of an organization in utilizing its fixed assets to generate revenues. It is represented as:
Fixed Assets Turnover Ratio = Net Sales/Average Fixed Assets
Inventory Turnover Ratio:
Inventory turnover ratio is used to determine the speed of a company in converting its inventories into sales. Numerically, it is represented as:
Inventory Turnover Ratio = Cost of Goods Sold/Average Inventories
Receivable Turnover Ratio:
Receivable turnover ratio is used to determine the efficiency of an organization in collecting or realizing its account receivables. It is represented as:
Receivables Turnover Ratio = Net Credit Sales/Average Receivable
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Frequently Asked Questions (FAQs)
1. What are the key methods for analyzing financial statements?
Horizontal analysis, vertical analysis, and ratio analysis are the primary methods used to evaluate financial statements. Each technique offers unique insights into a company’s financial health, performance trends, and industry comparisons.
2. How do liquidity ratios differ from solvency ratios?
Liquidity ratios measure a company’s ability to meet short-term obligations, while solvency ratios evaluate its capacity to meet long-term debt obligations and maintain financial stability.
3. What is the importance of ratio analysis in financial statement evaluation?
Ratio analysis helps assess a company’s performance, compare it with industry peers, identify trends, and evaluate operational efficiency. It serves as a critical tool for strategic decision-making.
