What is financial analysis?
Financial statement analysis is the process of assessing a firm’s worth and performance to identify areas of strengths and weaknesses
Some of the tools and techniques of financial statement analysis
- Financial ratio analysis
- Common size statement
- Comparative statement
- Trend analysis
Ratio analysis involves analysing the firm’s financial information to ascertain its liquidity, solvency, efficiency and profitability. It is a useful tool that can reveal a firm’s strengths and weaknesses.
Carrying out financial analysis involves computing financial ratio
A financial ratio examines the link between two sets of financial data.
To have a better insight into the financial affairs of the firm, financial analyst compute the financial ratio between two set of financial data
Financial ratio is usually grouped into five categories, namely:
- Liquidity ratios
- Leverage (or gearing) ratios
- Activity ratios
- Profitability ratios
- Investors ratios
The liquidity ratio measures the ability of the firm to meet its short-term obligation. It measures the ability of the firm to pay its short-term maturing debt.
Key ratios under the category of liquidity ratio are:
- Current ratio
- Acid-test ratio
The current ratio measures the extent to which a firm’s current assets can cover its short-term debt. It measures the capacity of the firm to settle its short-term obligation.
The acid-test ratio is also known as the quick ratio.
The ratio measures a firm’s capacity to pay its short-term debt without recourse to selling its inventory (otherwise known as stock).
A low ratio is an indication that a firm is having a liquidity problem
This ratio indicates the degree of safety of a firm not going into distress
Key ratios under leverage ratio category include:
The debt ratio shows the proportion of a firm’s asset that is financed by debt.
The ratio can be expressed in percentage or decimal.
A debt ratio higher than 1 (100%) indicates that a firm has more debt than its asset
The gearing ratio is also known as the debt to equity ratio.
This ratio measures the extent to which the equity of a firm covers its long-term debt.
The ratio also shows the proportion of the firm’s borrowed fund to its shareholder equity.
Activity ratio is also known as efficiency ratio.
This ratio measures how efficient the management is in using the asset of the firm in generating revenue.
Key ratios under this category are:
- Account receivables turnover ratio
- Average collection period
- Average payment period
- This ratio measures credit sales to average debtors.
- This ratio measures the length of time it takes a firm to collect cash from account receivables.
- In other words, it refers to how long it takes the account receivables to pay the firm.
- The ratio shows how effective the firm’s credit and account receivables management policy is.
- A shorter average collection period indicates prompt payment by debtors.
- The ratio indicates the number of times account receivables are This ratio measures how long it takes a firm to settle its account payables.
- Gross profit margin shows the relative efficiency of a firm after taking into consideration its cost of sales.
- The gross profit margin shows the percentage of sale that exceeds its cost of sales.
- A high gross profit margin is an indication that the firm’s management is efficient in generating profit for every naira of cost involved.