Financial statement analysis is the process of assessing a firm’s worth and performance to identify areas of strengths and weaknesses.
The aim of analysing the financial statement of a firm is to identify:
- Its liquidity position.
- The extent of debt and equity financing.
- Its profitability.
- The efficiency in use of resources.
Tools and techniques of financial statement analysis
- Financial ratio analysis
- Common size statement
- Trend analysis
- Cash flow analysis
- Comparative statement
Financial Ratio analysis
It is the technique of comparing the relationship (or ratio) between two or more items of financial data from a company’s financial statements. Ratio analysis shows comparisons within a period and between different accounts, companies or industries. It involves analysing the financial information of a firm to ascertain its liquidity, solvency, efficiency and profitability.
Users of financial ratios include parties external and internal to the company:
- External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers
- Internal users: Management team, employees, and owners
Types of Financial Ratios
Financial ratio is usually grouped into five categories, namely:
- Liquidity ratios
- Leverage ratios
- Activity ratios
- Profitability ratio
- Investors ratio
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 leverage ratio measures the ability of a firm to meet its long-term obligation. It measures the ability of the firm to pay its maturing long-term debt. Leverage ratio can also be referred to stability ratio or long-term solvency ratio.
This ratio indicates the degree of safety of a firm not going into distress and also if the firm is highly levered and exposed to financial risk. Key ratios under leverage ratio category include:
- Debt ratio
- Gearing ratio
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 the ability of a firm to earn a decent return on its investment. Key ratios under this category include:
- Gross profit margin
- Return on total assets
- Return on equity
Shareholders and investors use this ratio to assess the value and quality of their investment in a firm.
The ratio shows the actual and potential growth of the firm. Key ratios under this category includes:
- Earnings per share (EPS)
- Dividend per share (DPS)
- Price-earnings ratio (P/E)
Advantages of ratio analysis
- Ratio analysis will help validate or disprove the financing, investment and operating decisions of the firm. It compares the figures in the financial statement. Management can the evaluate the financial position of the firm and use the results to make decisions.
- It simplifies complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency, long-term positions etc.
- Ratio analysis help identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the complex accounting statements, and ratios will help pinpoint such problems.
- Allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons etc. This will help the organization better understand its fiscal position in the economy.