Analysis of Financial Statements

Definition

Think of a company's financial statements—the Balance Sheet, Profit & Loss Account, and Cash Flow Statement—as a "medical report card" for a business. Analysis is the process of digging into these numbers to understand the true story behind the figures, rather than just looking at a single number like "Total Sales."

Objectives of Analysis

• To assess profitability: Determining if the business is making enough profit.
• To check solvency: Assessing if the business can meet long-term debts.
• To judge liquidity: Checking if the business can pay immediate bills (salaries, electricity).
• To predict future trends: Using past data to forecast where the company is heading.

Importance of Analysis

• Management: To identify weaknesses and make better decisions.
• Investors: To decide whether to buy or sell shares.
• Creditors/Banks: To determine if the company is a "safe bet" for a loan.
• Employees: To understand job security and bonus potential.

Limitations (The "Watch Out" Factors)

• Historical Nature: It shows what happened in the past, not necessarily what will happen.
• Price Level Changes: It often ignores the impact of inflation.
• Window Dressing: Companies may "beautify" accounts to look better than they are.
• Qualitative Factors Ignored: It doesn't reflect employee morale, brand reputation, or management quality.

Real-Life Example

If you lend $50,000 to a bakery, you analyze their statements to see if monthly sales cover rent (Liquidity) and if they have assets like ovens to back the loan (Solvency).

A. Comparative Statements

This is "side-by-side" analysis comparing data from two or more years to show absolute and percentage changes.

• Example: Comparing Sales in 2023 ($100k) vs 2024 ($120k) to show 20% growth.

B. Common Size Statements

Converting every item in a statement into a percentage of a common base (e.g., Total Assets or Total Revenue).

• Example: If Sales is $100 and Net Profit is $10, the Common Size Net Profit is 10%.

Comparison Summary

Profit is an opinion; Cash is a fact. Under AS-3, cash flows are divided into:

I. Operating Activities

The "heartbeat" of the company—day-to-day revenue activities.

• Inflow: Cash from customers.
• Outflow: Cash paid to suppliers or employees.

II. Investing Activities

Relates to the "growth" and "infrastructure" of the company.

• Inflow: Selling old machinery or investments.
• Outflow: Buying a new factory or equipment.

III. Financing Activities

Relates to how the company is "funded."

• Inflow: Taking a bank loan or issuing shares.
• Outflow: Repaying loan principal or paying dividends.

I. Liquidity Ratios (Immediate Bills)

• Current Ratio: $\text{Current Assets} \div \text{Current Liabilities}$ (Ideal: 2:1)
• Quick Ratio: $(\text{Current Assets} - \text{Inventory} - \text{Prepaid Expenses}) \div \text{Current Liabilities}$ (Ideal: 1:1)

II. Solvency Ratios (Long-term Survival)

• Debt-to-Equity Ratio: $\text{Total Long-term Debt} \div \text{Shareholders' Funds}$
• Interest Coverage Ratio: $\text{Net Profit before Interest and Tax} \div \text{Interest Expense}$

III. Activity/Turnover Ratios (Efficiency)

• Inventory Turnover Ratio: $\text{Cost of Goods Sold} \div \text{Average Inventory}$
• Debtors Turnover Ratio: $\text{Net Credit Sales} \div \text{Average Receivables}$

IV. Profitability Ratios (Returns)

• Gross Profit Ratio: $(\text{Gross Profit} \div \text{Net Sales}) \times 100$
• Net Profit Ratio: $(\text{Net Profit} \div \text{Net Sales}) \times 100$

Problem: Calculate Current Ratio and Debt-to-Equity Ratio for "Alpha Ltd."

Data:

• Cash: $10,000 | Inventory: $20,000 | Trade Receivables: $15,000
• Trade Payables: $15,000 | Bank Overdraft: $5,000
• Long-term Loan: $50,000 | Shareholders' Equity: $100,000

Step-by-Step Solution:

1. Grouping:
   Current Assets (CA) = 10,000 + 20,000 + 15,000 = $45,000
   Current Liabilities (CL) = 15,000 + 5,000 = $20,000
   Long-term Debt = $50,000
   Equity = $100,000

2. Calculations:
   Current Ratio = CA / CL = 45,000 / 20,000 = 2.25:1
   Debt-to-Equity = Long-term Debt / Equity = 50,000 / 100,000 = 0.5:1

Interpretation: 
The company is liquid (Ratio > 2) and has a safe debt level (0.5).

• ERP Systems (SAP, Oracle): Automatically generate statements and ratios in real-time.
• Business Intelligence (BI) Tools (Tableau, Power BI): Create visual dashboards with "Red/Green" status indicators.
• FinTech: Apps that allow instant "Common Size" analysis of stocks for retail investors.

Analysis: An investor seeking "safety" chooses Quick-Brew; an investor seeking "growth" might prefer Slow-Roast.

1. Which ratio measures a company's ability to meet short-term obligations?
   a) Debt-Equity b) Current Ratio c) Gross Profit d) Inventory Turnover
   Ans: b
2. Cash flow from selling machinery is categorized as:
   a) Operating b) Investing c) Financing d) None
   Ans: b
3. Common size statements express items as a percentage of:
   a) Previous year b) Net Profit c) Total Sales/Assets d) Total Debt
   Ans: c
4. The ideal Current Ratio is:
   a) 1:1 b) 2:1 c) 0.5:1 d) 5:1
   Ans: b
5. AS-3 deals with:
   a) Ratio Analysis b) Comparative Statements c) Cash Flow Statement d) Balance Sheets
   Ans: c

1. Distinguish between Comparative and Common Size statements.
   Ans: Comparative focuses on year-on-year changes (trends), while Common Size focuses on the internal percentage composition of a single period.
2. Explain why a company might have high profits but low cash.
   Ans: This happens due to "Accrual Accounting." A company might record a sale on credit (Profit), but if the customer hasn't paid yet, there is no actual cash in the bank.
3. What are the three categories of Cash Flow under AS-3?
   Ans: Operating (core business), Investing (assets), and Financing (capital/loans).
4. Why is the Quick Ratio considered more "stringent" than the Current Ratio?
   Ans: Because it excludes Inventory, which might take time to convert into cash during an emergency.

• Cash Flow Categories: Operating, Investing, Financing.
• Ratio Types: Liquidity, Solvency, Activity, Profitability.
• Ideal Current Ratio: 2:1.
• Ideal Quick Ratio: 1:1.

Mnemonics:

• For Cash Flow (O-I-F): "Our Income Flows" (Operating $\rightarrow$ Investing $\rightarrow$ Financing).
• For Ratio Types (L-S-A-P): "Let's Study All Profits" (Liquidity $\rightarrow$ Solvency $\rightarrow$ Activity $\rightarrow$ Profitability).