Analysis Financial

Statement
Lecture # 01
Basic understanding of Finance

Irfan Nepal
Key Topics
 Financial Ratios
 Using Financial ratios
 Measuring Company Performance
 The Role of Financial Ratios
FINANCIAL STATEMENT ANALYSIS
 Financial analysis is a process of selecting, evaluating, &
interpreting financial data, along with other pertinent (suitable)
information, in order to formulate an assessment of a company’s
present and future financial condition and performance.
 In other words financial statement analysis is the process of
reviewing and evaluating a company's financial statements (such as
the balance sheet or profit and loss statement), thereby gaining an
understanding of the financial health of the company and enabling
more effective decision making.
WHAT IS “FINANCIAL STATEMENT”
 Financial statements for businesses usually include Income
statements, Balance sheets, statements of retained earnings and
Cash flows.
 It is standard practice for businesses to present financial statements
that adhere to generally accepted accounting principles (GAAP) to
maintain continuity of information and presentation across
international borders. Financial statements are often audited by
government agencies, accountants, firms, etc. to ensure accuracy and
for tax, financing or investing purposes
Analyzing Financial Statements
Financial Ratio:
Common-Size Financial Statements
Common-size balance sheets and income statements are used to
compare the performance of different companies or a company's
progress over time.
Common-Size Balance Sheet is a balance sheet where every
dollar amount has been restated to be a percentage of total assets.
Common-Size Income Statement is an income statement where
every dollar amount has been restated to be a percentage of sales.
BALANCE SHEET
 A balance sheet is a financial statement that summarizes a
company's assets, liabilities and shareholders' equity at a
specific point in time.
 These three balance sheet segments give investors an idea as to
what the company owns and owes, as well as the amount
invested by shareholders.
INCOME STATEMENT
 An income statement is a financial statement that reports a
company's financial performance over a specific accounting
period.
 Financial performance is assessed by giving a summary of how
the business incurs its revenues and expenses through both
operating and non-operating activities.
 It also shows the net profit or loss incurred over a specific
accounting period.
CASH FLOW STATEMENT
 The cash flow statement merges the balance sheet and the
income statement and reconciles the income statement with the
balance sheet in three major business activities. These
activities include operating, investing and financing activities.
 Operating activities include cash flows made from regular
business operations.
 Investing activities include cash flows due to the buying and
selling of assets such as real estate and equipment.
 Financing activities include cash flows from debt and equity.
STATEMENT OF RETAINED EARNINGS
The statement of Retained Earnings reconciles the net income
earned during a given year, and any cash dividends paid, with the
change in retained earnings between the start and the end of the
year.
Classification of Financial Ratios
Ratios were developed to standardize a company’s results. They
allow analysts to quickly look through a company’s financial
statements and identify trends and anomalies. Ratios can be
classified in terms of the information they provide to the reader.
There are four classifications of financial ratios:
Internal liquidity

Operating performance

Risk profile

Growth potential
Classification of Financial Ratios
Internal liquidity
The ratios used in this classification were developed to analyze and determine

a company’s financial ability to meet short-term liabilities.

Operating Performance
The ratios used in this classification were developed to analyze and determine
how well management operates a company. Operating profitability relates the
company’s overall profitability, and operating efficiency reveals if the
company’s assets were utilized efficiently.
Classification of Financial Ratios
Risk Profile - The ratios found in this classification can be divided
into ‘business risk’ and ‘financial risk’. Business risk relates the
company’s income variance, i.e. the risk of not generating consistent
cash flows over time. Financial risk is the risk that relates to the
company’s financial structure, i.e. use of debt.

Growth Potential - The ratios used in this classification are useful to

stockholders and creditors as it allows the stockholders to determine
what the company is worth, and allows creditors to estimate the
company’s ability to pay its existing debt and evaluate their additional
debt applications, if any.
List of Financial Ratios
 Gross Profit Rate = Gross Profit ÷ Net Sales

 Return on Sales = Net Income ÷ Net Sales

 Return on Assets = Net Income ÷ Average Total Assets

 Return on Stockholders' Equity = Net Income ÷ Average

Stockholders' Equity
Management Efficiency Ratios
 Receivable Turnover = Net Credit Sales ÷ Average Accounts
Receivable

 Days Sales Outstanding = 360 Days ÷ Receivable Turnover

 Inventory Turnover = Cost of Sales ÷ Average Inventory

 Days Inventory Outstanding = 360 Days ÷ Inventory Turnover

Management Efficiency Ratios Cont..
 Accounts Payable Turnover = Net Credit Purchases ÷ Ave.
Accounts Payable

 Days Payable Outstanding = 360 Days ÷ Accounts

Payable Turnover

 Operating Cycle = Days Inventory Outstanding + Days

Sales Outstanding

 Cash Conversion Cycle = Operating Cycle - Days Payable

Outstanding

 Total Asset Turnover = Net Sales ÷ Average Total Assets

Management Efficiency Ratios Cont..
 Debt Ratio = Total Liabilities ÷ Total Assets

 Equity Ratio = Total Equity ÷ Total Assets

 Debt-Equity Ratio = Total Liabilities ÷ Total Equity

 Times Interest Earned = EBIT ÷ Interest Expense

Liquidity Ratios
 Current Ratio = Current Assets ÷ Current Liabilities

 Acid Test Ratio = Quick Assets ÷ Current Liabilities

 Cash Ratio =(Cash + Marketable Sec)÷Current Liabilities

 Net Working Capital = Current Assets - Current Liabilities

Internal Liquidity Ratios
Current Ratio:

This ratio is a measure of the ability of a firm to meet its short-term

obligations. In general, a ratio of 2 to 3 is usually considered good. Too
small a ratio indicates that there is some potential difficulty in covering
obligations. A high ratio may indicate that the firm has too many assets
tied up in current assets and is not making efficient use to them.

Current ratio = current assets / current liabilities

Internal Liquidity Ratios Conti..
Quick Ratio
The quick (or acid-test) ratio is a more stringent measure of liquidity.

Only liquid assets are taken into account. Inventory and other assets are

excluded, as they may be difficult to dispose of

Quick ratio = (cash+ marketable securities + accounts receivables)

current liabilities
Internal Liquidity Ratios Conti..
Cash Ratio
The cash ratio reveals how must cash and marketable securities
the company has on hand to pay off its current obligations.

Cash ratio = (cash + marketable securities)/current liabilities

Working Capital Ratio

Working Capital Ratio = CA – CL / Sales

Valuation and Growth Ratios
 Earnings per Share = ( Net Income - Preferred Dividends ) ÷ Average
Common Shares Outstanding
 Price-Earnings Ratio = Market Price per Share ÷ Earnings per Share
 Dividend Pay-out Ratio = Dividend per Share ÷ Earnings per Share
 Dividend Yield Ratio = Dividend per Share÷ Market Price per Share
 Book Value per Share = Common SHE ÷ Average Common Shares
CLASS ACTIVITY
 Calculate the Inventory Turnover given that COGS = $1747 and
Inventory = $572. 3.05

 Calculate the Days' Inventory given that COGS = $1170 and

Inventory = $473. 147.56 days

 Calculate the Equity Multiplier given that Total Equity = $1127 and
Total Assets = $2012 1.79

 Calculate the Total Assets Turnover given that Sales = $1154 and
Total Assets = $1413. 0.82

 Calculate the Total Assets Turnover given that Sales = $1800 and
Total Assets = $1341. 1.34
CLASS ACTIVITY Conti..
 Calculate the Return on Assets (ROA) given that Net Income = $256
and Total Assets = $1885. 13.58%

 Calculate the Total Assets Turnover given that Sales = $1704 and
Total Assets = $511. . 3.33

 Calculate the Debt to Equity Ratio given that Total Assets = $1172
and Total Owners' Equity = $859 0.36

 Calculate the Debt to Equity Ratio given that Total Equity = $1107
and Total Debt = $454. . 0.41

 Calculate the Days' Inventory given that COGS = $1712 and

Inventory = $525. 111.93 days
Analyzing Financial Statements
Financial Ratio:

Common-Size Financial Statements

Common-size balance sheets and income statements are used to

compare the performance of different companies or a company's
progress over time.

Common-Size Balance Sheet is a balance sheet where every dollar

amount has been restated to be a percentage of total assets.

Common-Size Income Statement is an income statement where every

dollar amount has been restated to be a percentage of sales.
Income Statement
Classification of Financial Ratios
Classification of Financial Ratios

Ratios were developed to standardize a company’s results. They

allow analysts to quickly look through a company’s financial

statements and identify trends and anomalies. Ratios can be

classified in terms of the information they provide to the reader.

There are four classifications of financial ratios:

1-Internal liquidity – The ratios used in this classification were

developed to analyze and determine a company’s financial ability

to meet short-term liabilities.

Classification of Financial Ratios
2- Operating performance

The ratios used in this classification were developed to analyze

and determine how well management operates a company. The
ratios found in this classification can be divided into ‘operating
profitability’ and ‘operating efficiency’. Operating profitability
relates the company’s overall profitability, and operating
efficiency reveals if the company’s assets were utilized
efficiently.
Classification of Financial Ratios
3- Risk profile
The ratios found in this classification can be divided into
‘business risk’ and ‘financial risk’. Business risk relates the
company’s income variance, i.e. the risk of not generating
consistent cash flows over time. Financial risk is the risk that
relates to the company’s financial structure, i.e. use of debt.
4-Growth potential
The ratios used in this classification are useful to stockholders
and creditors as it allows the stockholders to determine what the
company is worth, and allows creditors to estimate the
company’s ability to pay its existing debt and evaluate their
additional debt applications, if any.
 Internal Liquidity Ratios
Current Ratio:

This ratio is a measure of the ability of a firm to meet its short-term

obligations. In general, a ratio of 2 to 3 is usually considered good. Too
small a ratio indicates that there is some potential
difficulty in covering obligations. A high ratio may indicate that the firm has
too many assets tied up in current assets and is not making efficient use to them.
Current ratio = current assets / current liabilities

2. Quick Ratio
The quick (or acid-test) ratio is a more stringent measure of liquidity. Only
liquid assets are taken into account. Inventory and other assets are excluded, as
they may be difficult to dispose of
Internal Liquidity Ratios
Quick ratio = (cash+ marketable securities + accounts receivables)
current liabilities
3. Cash Ratio
The cash ratio reveals how must cash and marketable securities the
company has on hand to pay off its current obligations.

Cash ratio = (cash + marketable securities)/current liabilities

4. Working Capital Ratio

Working Capital Ratio = CA – CL / Sales
Efficiency / Turnover Ratios
5. Receivable Turnover Ratio

This ratio provides an indicator of the effectiveness of a company's

credit policy. The high receivable turnover will indicate that the

company collects its dues from its customers quickly. If this ratio is

too high compared to the industry, this may indicate that the company

does not offer its clients a long enough credit facility, and as a result

may be losing sales. A decreasing receivable-turnover ratio may

indicate that the company is having difficulties collecting cash from

customers, and may be a sign that sales are perhaps overstated.

Efficiency / Turnover Ratios
Receivable turnover = net annual sales / average receivables
Where:
Average receivables = (previously reported account receivable +
current account receivables) / 2

6. Average Number of Days Receivables Outstanding (Average

Collection Period)
This ratio provides the same information as receivable turnover except
that it indicates it as number of days.
Avg number of days receivables outstanding = 365 days_
receivables turnover
Inventory Turnover Ratio
7. Inventory Turnover Ratio
This ratio provides an indication of how efficiently the company's
inventory is utilized by management. A high inventory ratio is an
indicator that the company sells its inventory rapidly and that the
inventory does not languish, which may mean there is less risk that
the inventory reported has decreased in value. Too high a ratio could
indicate a level of inventory that is too low, perhaps resulting
in frequent shortages of stock and the potential of losing customers. It
could also indicate inadequate production levels for meeting
customer demand
Inventory turnover = cost of goods sold / average inventory
Where:
Average inventory = (previously reported inventory + current
inventory)/2
8. Average Number of Days in Stock
8. Average Number of Days in Stock
This ratio provides the same information as inventory turnover except
that it indicates it as number of days.
Average number of days in stock = 365 / inventory turnover
9. Payable Turnover Ratio
This ratio will indicate how much credit the company uses from its
suppliers. Note that this ratio is very useful in credit checks of firms
applying for credit. Payable turnover that is too small may negatively
affect a company's credit rating.
Payable turnover = Annual purchases / average payables
Average Number of Days in Stock
Where:
Annual purchases = cost of goods sold + ending inventory beginning
Inventory
Average payables = (previously reported accounts payable + current
accounts payable) / 2

10. Average Number of Days Payables Outstanding (Average Age of

Payables)
This ratio provides the same information as payable turnover except that
it indicates it by number of days.

Average number of days payables outstanding = 365_____

payable turnover
Other Internal-Liquidity Ratios
11.Cash Conversion Cycle
This ratio will indicate how much time it takes for the company
to convert collection or their investment into cash. A high
conversion cycle indicates that the company has a large amount
of money invested in sales in process.
Cash conversion cycle = average collection period + average
number of days in stock - average age of payables
Defensive Interval
12.Defensive Interval
This measure is essentially a worst-case scenario that estimates how
many days the company has to maintain its current operations without
any additional sales.

Defensive interval = 365 * (cash + marketable securities + accounts

receivable) projected expenditures
Where:
Projected expenditures = projected outflow needed to operate the
company
Operating Profitability Ratios
Operating Profitability can be divided into measurements of
return on sales and return on investment Return on Sales
1. Gross Profit Margin
This shows the average amount of profit considering only
sales and the cost of the items sold. This tells how much profit
the product or service is making without over head
considerations. As such, it indicates the efficiency of
operations as well as how products are priced. Wide variations
occur from industry to industry.

Gross profit margin = gross profit / net sales

Gross profit = net sales – cost of goods sold
 Operating Profitability Ratios
2. Operating Profit Margin
This ratio indicates the profitability of current operations. This ratio
does not take into account the company's capital and tax structure.

Operating profit margin = operating income/net sales

3. Per-Tax Margin (EBT margin)

This ratio indicates the profitability of Company's operations. This ratio
does not take into account the company's tax structure.

Pre-tax margin = Earning before tax/sales

Operating Profitability Ratios
4. Net Margin (Profit Margin)

This ratio indicates the profitability of a company's operations.

Net margin = net income/sales

5. Contribution Margin

This ratio indicates how much each sale contributes to fixed

expenditures.

Contribution margin = contribution / sales

Where: Contributions = sales - variable cost
Return on Investment Ratios
Return on Assets (ROA)

Return on assets = (net income + after-tax cost of interest)

average total assets
OR
Return on assets = earnings before interest and taxes
average total assets
Return on Investment Ratios
2. Return on Common Equity (ROCE)

This ratio measures the return accruing to common stockholders and

excludes preferred
stockholders.
Return on common equity = (net income – preferred dividends)
average common equity

3. Return on Total Equity (ROE)

This is a more general form of ROCE and includes preferred
stockholders.

Return on total equity = net income/average total equity

Operating Efficiency Ratios
Total Asset Turnover
This ratio measures a company's ability to generate sales given
its investment in total assets. A ratio of 3 will mean that for
every dollar invested in total assets, the company will generate
3 dollars in revenues. Capital-intensive businesses will have a
lower total asset turnover than non-capital-intensive businesses.
Total asset turnover = net sales / average total assets
Operating Efficiency Ratios
Fixed-Asset Turnover
This ratio is similar to total asset turnover; the difference is that only
fixed assets are taken into account.
Fixed-asset turnover = net sales / average net fixed assets

Equity Turnover
This ratio measures a company's ability to generate sales given its
investment in total equity (common shareholders and preferred
stockholders). A ratio of 3 will mean that for every dollar invested in
total equity, the company will generate 3 dollars in revenues.
Equity turnover = net sales / average total equity
FINANCIAL RISK RATIOS
Financial Risk

This is risk related to the company's financial structure.

1.Debt to Total Capital

This measures the proportion of debt used given the total capital structure of
the company. A large debt-to-capital ratio

indicates that equity holders are making extensive use of debt,

making the overall business riskier.

Debt to capital = total debt / total capital

Where:
Total debt = current + long-term debt
Total capital = total debt + stockholders' equity
FINANCIAL RISK RATIOS

2. Debt to Equity
This ratio is similar to debt to capital.
Debt to equity = total debt / total equity
Analysis of the Interest Coverage Ratio

3. Times Interest Earned (Interest Coverage ratio)

This ratio indicates the degree of protection available to creditors by

measuring the extent to which earnings available for interest covers

required interest payments.

Times interest earned = earnings before interest and tax
interest expense
 Market Ratios
1. Sustainable Growth Rate
G = RR * ROE

Where:
RR = retention rate = % of total net income reinvested in the company
or, RR = 1 – (dividend declared / net income)

ROE = return on equity = net income / total equity

Note that dividend payout is the residual portion of RR. If RR is 80%

then 80% of the net income is reinvested in the company and the
remaining 20% is distributed in the form of cash dividends.
Therefore, Dividend Payout = Dividend Declared/Net Income
Let's consider an example:
Dividend Yield
Dividend Yield:
It is the return on dividend on the investment, expressed
in percentage and can be calculated as follows:
Dy = D / price

P/E Multiple = Price / Earning

This ratio show how much will you willing to pay for a stock
against a single rupee earning of a company.

Payout Ratio:
This show how mush you pay for dividends out of the total
income. And can be calculated as follows: DPS / EPS
DuPont System
A system of analysis has been developed that focuses the attention on all
three critical elements of the financial condition of a company: the
operating management, management of assets and
the capital structure. This analysis technique is called the "DuPont

Formula". The DuPont Formula shows the interrelationship

between key financial ratios. It can be presented in several ways.
The first is:

Return on equity (ROE) = net income / total equity

If we multiply ROE by sales, we get:

Return on equity = (net income / sales) * (sales / total equity)

Said differently:
DuPont System
ROE = net profit margin * return on equity

The second is:

Return on equity (ROE) = net income / total equity

If in a second instance we multiply ROE by assets, we get:

ROE = (net income / sales) * (sales / assets) * (assets / equity)

Said differently:

ROE = net profit margin * asset turnover * equity multiplier

DuPont System
DuPont System
SWOT Analysis
What Is a SWOT Analysis
SWOT stands for Strengths, Weaknesses, Opportunities, and
Threats, and so a SWOT analysis is a technique for assessing
these four aspects of your business. SWOT Analysis is a tool that
can help you to analyze what your company does best now, and
to devise a successful strategy for the future.
SWOT Analysis
SWOT model

The analysis of strengths and weaknesses focuses on the strength

of the company itself and its comparison with competitors, while
the opportunity and threat analysis focus on changes in the
external environment and possible impact on the company. In the
analysis, all internal factors (i.e., strengths and weaknesses)
should be grouped together and then evaluated by external forces
(opportunities and threats).
Internal Factors (Strengths and weaknesses

The analysis of strengths and weaknesses (S-W) of internal

conditions is an internal method of assessment. The main purpose
is to confirm the relationship between expertise and ability of the
organization’s internal conditions. The strengths and weaknesses
of its internal conditions are internal factors that the organization
can control, including financial resources, technical resources,
research and development, organizational culture, human
resources, product characteristics, and marketing resources.
External Factors (opportunities and threats)
The Opportunity and Threat (O-T) analysis is a method of
evaluating the external environment. The main purpose is to
confirm the relationship between the competitions of the
industrial environment outside the organization. The
opportunities and threats of the external environment are external
factors that cannot be controlled by the organization, including
factors such as competition, politics, economy, law, society,
culture, science and technology, and demographic environment.
External Factors Challenges
With the rapid development of economy, science and technology
and many other aspects, especially the acceleration of
globalization and integration of the world economy, the
establishment of global information networks and the
diversification of consumer demand, the environment in which
companies are located are more open and volatile. This change
has had a profound effect on almost all businesses. Because of
this, environmental analysis has become an increasingly
important corporate function. Challenges
SWOT Analysis and Strategic Planning
SWOT Analysis helps in strategic planning in following manner-
It is a source of information for strategic planning.
Builds organization’s strengths.
Reverse its weaknesses.
Maximize its response to opportunities.
Overcome organization’s threats.
It helps in identifying core competencies of the firm.
It helps in setting of objectives for strategic planning.
It helps in knowing past, present and future so that by using past and current
data, future plans can be chalked out.
SWOT Analysis & its Limitations
There are certain limitations of SWOT Analysis which are not in
control of management. These include-
•Price increase;
•Inputs/raw materials;
•Government legislation;
•Economic environment;
•Searching a new market for the product which is not having
overseas market due to import restrictions; etc.
•Insufficient research and development facilities;
•Faulty products due to poor quality control;
•Poor industrial relations;
•Lack of skilled and efficient labour; etc
What Is PEST Analysis?
 PEST analysis stands for political, economic, social, and
technological.
 This type of analysis is used to gauge external factors that
could impact the profitability of a company.
 Generally, it is more effective with larger organizations that are
more likely to experience the effects of macro events.
 PEST analysis is commonly used in conjunction with SWOT
analysis, which stands for strengths, weaknesses, opportunities,
and threats.
Components of PEST analysis
 Political
 Economic
 Sociocultural
 Technological
Nokia CEO Says,
“We Didn’t Do Anything Wrong
Nokia CEO Says, “We Didn’t Do Anything Wrong
During the press conference to announce that NOKIA is being
acquired by Microsoft, Nokia CEO ended his speech saying “we
didn’t do anything wrong, but somehow, we lost”.
This made me think why such a respectable company like Nokia
go wrong.
Well, they didn’t do anything wrong in their business, however,
the world changed too fast. Their opponents were just too
powerful.
NOKIA missed out on observing market trends, the constantly
changing environment and missed opportunities to stride ahead.
Nokia CEO Says,
“We Didn’t Do Anything Wrong
The message of this story is, if you don’t innovate and change
with the times your business will slowly die.

Conclusion:
The advantage that you had yesterday will be replaced by the
trends of tomorrow. You don’t have to do anything wrong, as
long as your competitors catch the wave and do it RIGHT, you
can still lose out and fail. So, how can you improve your
business?
‘Why and How’ information can be manipulated
 Companies are required to produce financial statements and
disclosures to inform the public of their profitability and
growth potential.
 Some companies acting in bad faith, however, can manipulate
their financial statements to hide losses or wrongdoing.
 Manipulating statements can include: accelerating revenues;
delaying expenses; accelerating pre-merger expenses; and
leveraging pension plans, off-balance sheet items, and
synthetic leases.
Off-Balance Sheet