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Financial Statement Analysis
Introduction:
Financial statements need to be properly analyzed and interpreted for measuring
the performance and position of a firm. This is of immense help to lenders
(short-term as well as long term), investors, security analysts, managers' etc.
Types of Financial
Ratios:
Liquidity Ratio:
Liquidity is the ability of a firm to meet its short-term ( usually up to 1
year) obligations.
Current Ratio:
Current Ratio = Current
Assets/Current Liabilities
Current Assets include cash, debtors, marketable securities, inventories, loans
and advances, prepaid expenses.
Current liabilities include loans and advances (taken), creditors, accrued
expenses and provisions.
This ratio measures the ability of the firm to meet its current liabilities.
Usually, higher the current ratio, the greater the short term solvency of the
firm. The break up of the current assets is very important to assess the
liquidity of a firm. A firm with a large proportion of current assets in the
form of cash and accounts receivable is more liquid than a firm with a high
proportion of inventories even though two firms might have the same ratio.
Quick Ratio:
Quick Ratio = Quick Assets
/ Current Liabilities
Quick Assets imply Current assets less inventories.
This ratio is based on very highly liquid assets and inventories are deemed to
be the least liquid of the current assets.
Leverage Ratio:
Financial leverage refers to the use debt finance. Debt finance is thought to be
a cheaper source of finance and at the same time a riskier source. Leverage
ratios help in assessing the risk arising from the use of debt finance.
Debt Equity Ratio:
Debt Equity Ratio = Debt /
Equity
Debt - Long term as well as short term.
Equity - Share Capital plus Reserves and Surplus (Net Worth)
It is generally felt that lower the ratio, the greater the degree of protection
enjoyed by the creditors. Generally, incase of capital-intensive industries a
higher debt-equity ratio is observed.
Debt Assets Ratio:
Debt Assets Ratio = Debt / Assets
Debt includes Long term as well as short term debt and Assets include total of
all assets.
Interest Coverage Ratio:
Interest coverage Ratio =
EBIT / Interest charges
This ratio measures the margin of safety a firm enjoys with respects to its
interest burden. The higher the ratio, the greater the margin of safety.
Turnover Ratios:
Inventory Turnover Ratio:
Inventory Turnover Ratio = COGS / Inventory
Inventory implies balance of the stock of goods at the end of the year.
This ratio implies the efficiency of inventory management. The higher the ratio,
the more efficient the inventory management.
Average Collection Period:
Average collection Period = Receivables / Average Sales per day
Receivables Turnover Ratio:
Receivables Turnover Ratio = Net Sales / Receivables
Fixed Assets Turnover
Ratio:
Fixed Assets Turnover Ratio = Net Sales / Fixed Assets
This ratio used to measure the efficiency with which fixed assets are employed.
A high ratio indicates an efficient use of fixed assets. Generally this ratio is
high when the fixed assets are old and substantially depreciated.
Return on Investment:
Return on Investment = Earnings before Interest and taxes / Total assets
This measures the performance of the firm without the effect of interest and tax
burden.
Return on Equity:
Return on Equity = Equity earnings / Net worth
Equity earnings = Profit after tax - preference dividend
Net worth = Share capital + Reserves & surplus
This Ratio measures the profitability of equity funds invested in the firm. This
reflects the productivity of the ownership capital employed in the firm. |
