Financial Management

ANALYSIS OF FINANCIAL
STATEMENTS
By Kaniz Fatema
Lecturer, Finance, AIBA
Financial Analysis
Financial Analysis is the analysis of firms financial
statements aimed at diagnosing the profitability and
financial condition of the firms business.
Need of Financial Analysis
It is a report find out the -
▪ Possibility of future earnings.
▪ Ability to pay interest and principal at maturity.
▪ Probability of sound dividend policy.
Uses of Financial Analysis
1. Insiders- specially by management uses the analysis
for the following major reasons:
measuring the success and failure of the business
making sound decisions in all aspects of business
controlling the activities
determining the relative efficiency among various
department & process or method.
2. Outsiders- specially by creditors, investors and
governments use the analysis for the following major
process:
Creditors:
Creditors use the analysis as a basis for granting credit or
not.
Investors:
Investors use the analysis for taking decisions of selling ,
buying or holding the securities of a given firm.
3. Government- various governmental bodies use the
analysis for the regulations and other legal administrations.
Techniques of Financial Analysis

Most common techniques/tools/ways are:
▪ Ratio Analysis
▪ Trend Analysis
▪ Common-Size Analysis
▪ Break-Even Analysis
▪ Fund-Flow Analysis
▪ Ratio Analysis
Ratio Analysis is a statistical yardstick that measures the
relationship between two accounting figures. It expressed
the result base on comparison between two figures in
numerical term.
What does ratio point out:
It point out weather the financial conditions and
performance of a firms business is very strong, good,
questionable or poor?
How does ratio analysis become meaningful:
It becomes meaningful when there is comparison and it
involves two types of comparison.
1. Ratio of given year must be compare with the future
year (same company).
2. Comparison of different company at the same year.
Classification of Ratio Analysis
Total 429 Business Ratio
From the view point of managers and investors the ratios
can be classified into 5 broad categories.
1. Liquidity ratio
2. Asset management or activity or efficiency ratio
3. Debt management or leverage or solvency ratio
4. Profitability ratio
5. Market value ratio
1. Liquidity ratio
This ratio is used to increase the ability of a firm to meet its
short term obligations when they become due or it
measures the firm short term solvency.
Types of liquidity ratio:
▪ Current ratio = Current Assets / Current Liabilities
▪ Acid test or quick ratio = Quick Assets / Current Liabilities
▪ Cash ratio = Cash, Marketable Securities / Current
Liabilities
2. Asset management or activity or efficiency ratio
These ratios are used to measure how efficiently the firm is
utilizing and managing its assets to generate the sales.
Types:
▪ Inventory Turnover Ratio:
This ratio is used to evaluate the firms inventories. It
measures how rapidly the firms inventories are trying into
sales.
Inventory Turnover Ratio = Net Sales / Average Inventories
▪ Days Sales Outstanding (DSO):
This ratio is used to evaluate the firms account receivable.
This indicates the average length of time for which a firm
must wait after making sales until receive cash.
DSO ratio = Account Receivable / Average Sales Per Day
▪ Fixed Assets Turnover Ratio:
This ratio is used to measure how efficiently the firm is
utilize its plants and equipment's to generate sales.
Fixed Assets Turnover Ratio = Net Sales / Net Fixed Assets
▪ Total Assets Turnover Ratio:
Total Assets Turnover ratio = Net Sales / Total Net Assets
3. Debt management or leverage or solvency ratio
The use of fixed cost fund (Debt) in financing a firm
looseness is called the leverage. This ratio are used to
measure the relative contribution of owners and creditors
in the firms capital structure.
Types:
▪ Debt ratio:
It indicates the percentage of fund supplied by the
creditors.
Debt ratio = (Total Debt / Total Assets) * 100
▪ Time Interest Earned (TIE) ratio:
This is used to measure the ability of a firm to pay its
annual interest charges.
TIE ratio = EBIT / Annual Interest Payment
▪ Earning Before Interest, Taxes, Depreciation and
Amortization (EBITDA) Coverage ratio:
EBITDA Coverage ratio = EBITDA + Lease payments /
Interest + Principal payments + Lease payments
4. Profitability Ratio
These ratios are used to measure the operating efficiency
of a firm. It shows the combined effect of liquidity
management, asset management.
Types:
▪ Profit Margin on Sales Ratio:
This ratio measures the percentage of net income on sales.
Profit Margin on Sales = (Net Income / Net Sales) * 100
▪ Basic Earning Power ( BEP) ratio:
This ratio is used to measure the ability of the firm’s assets
generate the operating income.
BEP ratio = (EBIT / Total Assets) * 100
▪ Return on Assets (ROA) ratio:
It measures the percentage of net income on firm’s total
assets.
ROA = (Net Income / Total Assets) * 100
▪ Return on Equity (ROE) ratio:
It measures the rate of return on the common stockholders
investment.
ROE = (Net Income / Total Common Equity) * 100
5. Market Value Ratio

These ratios are used to measure how the investors think
about the firm’s past performance as well as the firm’s
future performance. It links the firm’s stock price to its
earning, cash and book value per share.
Types:
▪ Price/ Earning (P/E) ratio:
This ratio indicates how much investors are interested to pay for
a taka/ dollar of reported profit.
P/E ratio = Market Price Per Share / Earning Per Share
▪ Price Cash Flow ratio:
a taka/ dollar of reported cash flow.
Price Cash Flow ratio = Market Price Per Share / Cash Flow Per
Share
▪ Market/Book Value ratio:
a taka/ dollar of reported book value per share.
M/B ratio = Market Price Per Share / Book Value Per Share
DU PONT Equation
Trying the ratio together;
DU Pont equation is a equation where ROE is breaks into
three parts.
ROE = Net Income / Total Equity
So,
ROE = Profit margin x Total assets turnover x Equity
Multiplier
= (Net Income / Net Sales) x (Net Sales / Total
Assets) x ( Total Assets / Total Equity)
=(Net Income / Total Assets) x (Total Assets / Total
Equity)
= Net Income / Total Equity
Also,
ROE = ROA x Equity Multiplier
# ROA = Profit margin x Total assets turnover
Net Income / Total Assets = (Net Income / Net Sales) x (Net
Sales / Total Assets)
Let see an example:
Profit margin = 4%
Total assets turnover 1.5
Assets = $2000
Equity = $900,
ROE = ?
Solution:
ROE = ROA x Equity Multiplier
Now,
ROA = 4% x 1.5
= 6%
Equity Multiplier = Total Assets / Total Equity
= $2000 / $900
= 2.22
So, ROE = 6% x 2.22
= 13.32%
Limitation of Ratio Analysis
❑ Meaningful industry average
❑ Better than average
❑ Inflation
❑ Seasonal factors
❑ Window dressing
❑ Accounting practice
❑ Non-monetary factors
❑ Formulas
❑ Number of ratios
❑ Nature of ratios
▪ Trend Analysis
Any analysis of a firm’s financial ratio over time is called the
trend analysis. This analysis is used to know the
improvement or deterioration of a firm’s business time. To
do a trend analysis one can simply plot the ratio over time.
▪ Common- Size Analysis
Common-size analysis is also called vertical analysis. That
express each line items on a single year’s financial
statement as a percent of one line item, which is referred to
as a base amount.
▪ Break-Even analysis
Break-Even analysis is used to analyze the break-even
point based on fixed costs, variable costs per unit of sales
and revenue per unit of sales.
▪ Fund-Flow analysis
Fund-flow analysis is the analysis of flow of fund from
current asset to fixed asset or current asset to long tem
liabilities or vice-versa. It refers to working capital. It
describes changes in net working capital between two
dates balance sheet.

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ANALYSIS OF FINANCIAL

Techniques of Financial Analysis

5. Market Value Ratio

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