 Analysis and Interpretation of Financial Statements Topics:
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENT

Financial statements are the basis and formal annual reports through which the corporate management communicates Financial information to its owners and various other external parties which include-investors, tax authorities, government, employees etc. According to Bernstein financial statement analysis can be defined as “A judgmental process which aims to estimate current and past financial position and the results of the operation of an enterprises, with primary objective of determining the best possible estimates and predictions about the future conditions.

The process of critical evaluation of the financial information contained in the financial statement in order to understand and make decisions regarding the operations of the firm is called “Financial statement analysis and interpretation.”

It is basically a study of relationship among various financial facts and figures as given in a set of financial statement, and the interpretation thereof to gain an insight into the profitability and operational efficiency of the firm to access its financial health and future prospects.

Analysis of financial statement reveals important facts concerning managerial performance and the efficiency of the firm through:

• Horizontal analysis.
• Vertical analysis.
• Ratio analysis.

## HORIZONTAL ANALYSIS

• Set all amounts in base year at 100%.
• Compute percentages for a number of years.
• Shows degree of increase or decrease in individual statement item.

## VERTCAL ANALYSIS

• Shows how each item in a financial statement compares to the total of that statement.
• Balance sheet set both total assets and total equities at 100% Income statement.
• Set net sales at 100%.

## RATIO ANALYSIS

• Shows the relative size of one financial statement component to another.
• Effective only when used in combination with other ratios, analysis, and information.

THE RATIO ANALYSIS CAN BE DIVIDED INTO FOUR DIFFERENT METHODS AS:

SHORT – TERM LIQUIDITY

1. Current ratio.
2. Quick ratio.
3. Accounts receivable turnover.
4. Days’ sales in receivables.
5. Inventory turnover.

LONG-TERM SOLVENCY

1.Debt ratio.
2. Times Interest earned.

PROFITABILITY

1. Profit margin.
2. Total asset turnover.
3. Return on total assets.
4. Return on owners’ equity.
5. Earning per share.

MARKET PERFORMANCE

1. Price/Earning (P/E) ratio.
2. Dividend yield.

RELATIONSHIP BETWEEN ANALYSIS AND INTRPRETATION OF FINANCIAL STATEMENT

The term “Financial Statement” includes both “Analysis and Interpretation.” The term analysis means simplification of financial data by methodical classification given in the financial statements .Interpretation means explaining the meaning and significance of the data. These two are complimentary to each other, analysis is useless without interpretation, and interpretation without analysis is difficult or even impossible.
RATIO ANALYSIS

DEFINITION: The study and interpretation of the relationship between various financial variables, by investors or lenders.

LIQUIDITY RATIOS: Liquidity ratio measures a business’s ability to cover its obligations, without having to borrow or invest more money in the business. The idea is that there should be sufficient cash and assets that can be readily converted into cash to cover liabilities as they come due.

One of the most common liquidity ratios is:

Current Ratio = Current Assets/Current Liabilities

Current assets basically include cash, short- term investments and marketable securities, accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts payable to vendors and employees, and installments on notes or loans that are due within one year. This ratio could also be seen as a measure of working capital ---the difference between current assets and current liabilities, A company with a lot of working capital dos not have sufficient resources to meet its current obligations, and therefore is not in a position to take advantage of opportunities for growth.

Another strongest test of liquidity is the:

Acid-test radio = Current Assets minus Inventories / Current Liabilities

Inventory is a current asset that may or may not be quickly converted into cash. This depends on the rate at which inventory is being turned over. By excluding inventory, the acid-test ratio only considers that part of current assets that can be readily converted into cash. This ratio, also called the Quick Ratio ,tells how much of the business’s short-term debt can be met by using the company’s liquid assets at short notice.

A ratio that shows how many times inventory is turned over, or sold during the period is:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

A high turnover ratio is a sign that products are being produced and sold quickly during the period. A ratio of 1.0, for example, would mean that at any given time you have enough inventory on hand to cover sales for the period. The higher this ratio, the more quickly inventory is being turned over and producing assets that are more liquid account receivable and then cash.

If you want an even clearer idea of exactly how much ready cash is on hand to cover current liabilities, You can use the:

Cash ratio = Cash + Marketable securities/ Current Liabilities

The cash ratio measures the extent to which a business could quickly cover short-term liabilities, and therefore is of particular interest to short-term creditors. A ratio of 1.0.would indicate that all current liabilities would be covered at any average point in time by cash and marketable securities that could be readily sold and converted to cash. A ratio of less than 1.0 would mean that other assets, such as accounts receivable or inventory, would have to be converted to cash to cover short-term obligations. A ratio of greater than 1.0. means that there is more than enough cash on hand.

SOLVENCY RATIOS

Solvency ratios are measures to assess a company’s ability to meet its long-term obligations and thereby remain solvent and avoid bankruptcy. Two general, overall solvency ratios include:

Solvency Ratio= Total Assets/ Total Liabilities

And

Solvency Ratio = Net Worth (Total Capital or Equity)/ Total Liabilities

These ratio basically tell whether a company owns more than it owes. The higher the ratio, the more solvent the company.

Another ratio that can tell how much a company relies on debt to finance its assets is:

Debt Ratio = Total Debt / Total Assets

Traditionally, both short-term and long-term debts and assets are used in determining this ratio. In general, the lower a company’s reliance on debt to finance its assets, the less risky the company.

The debt to equity ratio is a measure of a company’s leverage-how much financing it has in the form of debt as compared with how much it has invested in the form of debt as compared with how much it has invested in the business.

Debt-equity Ratio = Total Liabilities / Total Owners’ Equity, or Debt-equity Ratio = Long-Term Liabilities / Total Owners’ Equity

In assessing solvency, it is also important to take into consideration the breakdown of a company’s liabilities. Not all liabilities are debt in the form of bank loans or notes payable, for example. There are also accounts payable to vendors, salaries and wages payable, taxes payable, and accrued liabilities, among others. One of the measures of what debt constitutes in terms of total liabilities among others. One of the measures of what debt constitutes in terms of total liabilities is:

Indebtedness Ratio = Total Liabilities

In general, a company that is heavy on debt may b better leveraged, but is also less solvent.

The debt repayment terms are another consideration. Short-term debt, payable within one year, may pose a greater burden on cash flow and eventual solvency than long-term debt, which is due beyond one year. A ratio used to quantify this is:

Short- term Debt Ratio or Quality of Debt = Short-term Debt/ Total Debt

A lower value for this ratio would indicate less concern for installment coming due within a year.

There are other ratios intended to assess a company’s capacity to cover its debt repayments and financing costs. One of these rations measures how interest expense is being covered by the net income the company is generating:

Interest expense coverage= Net income before interest and taxes / Interest expense

This ratio is also called Number of Times Interest Earned, and represents how many times the net income generated by the company, without considering interest and taxes, covers the total interest change, The higher the ratio the more solvent the company.

Another similar ratio often used to measure a company’s capacity to cover its fixed charges is:

Ratio of Earnings to Fixed Charges = Earnings before income tax and fixed charges /Interest expense (including capitalized interest) and amortization of bond discount and issue costs

' Capitalized interest is the amount of interest on a loan to finance a project or acquisition of fixed assets that has been capitalized and included as part of the cost of the project or asset on the balance sheet. You will probably need to see the notes to the financial statements to find this figure.

ACTIVITY RATIOS

Many useful gauges of operations can be calculated from data reported in the financial statements. For example, you can determine the average number of days it takes to collect on customer accounts, the average number of days to pay vendors, and how much of the operation is effectively being financed with payment terms extended by vendors.

Accounts Receivable Turnover = Total Credit Sales / Average Accounts Receivable

This tells you the average duration of accounts receivable for credit sales to customers. This in turn can be expressed in terms of the collection period, as follows:

Average collection period = Days in Year / Accounts Receivable Turn over

OR

Days to Collect = Trade Accounts Receivable / Credit Sales x 365

A similar calculation can be made on the liabilities side, with accounts payable to vendors:

Day to Pay = Trade Account Payable / Purchases x 365

To determine how much of a company’s accounts receivable and inventory are effectively being financed by the credit extended to the company by its vendors:

Financing of inventory in terms of Trade Accounts Payable = trade Accounts Payable /Inventory.

Effectively managing the credit extended by vendors can help a company’s cash flow and therefore its liquidity and solvency.

From data reported on the income statement, various relationships can be calculated between different expenses and revenues, or a certain type of expense as a percentage of total expenses.

Labor Cost Percentage = Payroll and Related Expenses /Total Revenue or Total Expenses.

Interest Expense Percentage = Interest Expense /Total Revenue or Total Expenses.

These types of ratios or percentages can be calculated for any item on the income statement. Which accounts are more important will depend on the nature of the business. For example, some operations are more labor intensive and some are more capital intensive.IN a labor intensive operation, the percentage that employee-related expenses, including wages, salaries and benefits, represent in terms of total operating expense is relevant . In a capital intensive operation, repairs and maintenance may take on more importance.

PROFITABILITY RATIOS

One of the most common profitability ratios is the profit margin. This can be expressed as the gross profit margin or net profit margin, and it can be expressed by company, by sector, by product, or by individual unit. The information reported on the income statement will enable you to determine the overall profit margin. If additional breakdowns are provided, more detailed margins can be calculated.

Gross Profit Margin = Gross Income/ total Revenue

Net profit Margin =Net Income / Total Revenue

Other commonly used ratios are returns, expressed as return on investment or equity, return on assets, and return on capital employed. These ratios measure a company’s ability to use its capital, or its assets, to generate additional value.

Return on Investment (ROI) or Return on Owners’ Equity = Net Income/ Average

Owners’ equity

Return on Assets (ROA) = Net Income / Average Total Assets. Return on Capital Employed (ROCE) = Net Income Before Interest and Tax / Capital Employed ( Total Assets mines Current Liabilities)

When evaluating investment opportunities, profits are often measured per share:

Earning per Share = Net profit After Tax and Dividends / Ordinary Shareholders’

Equity

Another commonly used ratio to show the yield on an investment is:

Dividend Yield Ratio =Dividends per Share / Market Value per Share

And, to measure how the price of an investment correlates with the earnings on that investment, you can use the:

Price to Earnings Ratio = Market Value per Share / After-Tax Earnings per Share.
CASH FLOW ANALYSIS

CASH FLOW: In finance, the discounted cash flow (or DCF) approach describes a method of valuing a project, company, or asset using the concept of the time value of money. All future cash flows are estimated and discounted to give their present values. The discount rate used is generally the appropriate cost of capital and may incorporate judgments of the uncertainty (RISKNESS) of the future cash flows.

Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

MATHEMATICS

DISCRETE CASH FLOWS

The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

The simplified version of the (for one cash flow in one future period) is expressed as; Where,

• DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt.

• FV is the nominal value of a cash flow amount in a future period.

• It is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full.

• D is the discount rate, which is /(1+i), ie the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year .

• N is the time in years before the future cash flow occurs.

Where multiple cash flows in multiple time periods are discounted, It is necessary to sum them as follows.

For each future cash flow (FV) at any time period (t) in years from the present time, summed over all time periods. The sum can then be used as a net present value figure. If the amount to be paid at time 0 (now) for all the future cash flows is known, then that amount can be submitted for substituted for DPV and the equation can be solved for I, that is the internal rate of return.

All the above assumes that the interest rate remains constant throughout the whole period.

(1+i)^(-t) can of course also be expressed as exp (-it).

CONTINUOUS CASH FLOWS

With continuous cash flows, the summation in the above formula is replaced by an integration nothing else changes:

DPV = integral over the required time period of FV(t) * (1-exp (-it) ) dt

Where FV (t) is now the rate of cash flow

Review Questions
• 1. Discuss the uses of cash flow statement.
• 2. Bring the differences between Fund flow and Cash flow statement.
• 3. Analyze the limitations of "Ratio Analysis".
• 4. What do you understand by memorandum reconcilitaion statement?
• 5. What is meant by stock turnover ratio?

Related Topics
Financial Statement Keywords