Financial Statements Analysis

The purpose of financial statements is to provide decision makers with useful information about economic activities. These include both information about recent activities and forecasts of what may happen in the future. All type of decision makers -managers, investors, lenders and consumers use accounting information as a basis for making economic decisions.

Financial statements are set of accounting reports which taken together, describe the financial position of the business and the results of its recent operations. Financial position is described by identifying the company's financial resources and obligations as of a specific date.

A complete set of financial statements for a corporation includes three related accounting reports
(a) A balance sheet, which shows the financial position of the business at a specific date by describing its financial resources and obligations
(b) An income statement i.e. profit and loss a/c reports the company's profitability over a period of time.
(c) A statement of cash flows, which summarizes the company's cash receipts and cash payments over a period of time covered by the income statements.

A complete set of financial statement also includes several pages of notes .These notes provide additional information that is useful interpreting the statements. Publicly owned companies are required by law to report quarterly profit and loss statements in summarized format and furnish detailed financial statements at the end of each year. In exceptional cases, companies are allowed to change their accounting year and hence some period should comprise of more or less than 12 months.

The purpose of the balance sheet is to show the financial position of a business entity at a specific date. A balance sheet consists of a listing of the assets, the liability's and the owner's equity of a business. The balance sheet date is important, as the financial position of the business may change quickly. The body of the balance sheet also consists of two distinct sections: assets and liabilities. Liabilities include liabilities towards outsiders and towards shareholders or owners. Shareholders funds comprise of capital and reserves.

Assets are economic resources owned by a business and expected to benefit future operations. Assets may have definite physical form such as buildings, machinery, or an inventory of merchandise. On the other hand, some assets exist not in physical or tangible form, but in the form of valuable legal claims or rights. Liabilities are debts. The person or organization to whom the debt is owed is called a creditor.

Shareholders funds, also known commonly as equity or net worth, represent the owners' claim to the assets of the business. Because creditors' claims have legal priority over those of owners, owners' equity is a residual amount. Owners are entitled to "what is left" after the claims of creditors have been satisfied in full.

Owners' equity = Total Assets - Total Liabilities.

Owners' equity does not represent a specific claim to cash or any other particular asset. Rather it is the owners' overall financial interest in all of the company's assets

The accounting report that summarizes the revenues and the expenses of an accounting period is called the income statement and reports the results of operations and indicates reasons for the entity's profitability. Mere statistics/ data presented in the different financial statements do not reveal the true picture of a financial position of a firm. Properly analyzed and interpreted financial statements can provide valuable insights into a firm's performance: To extract the information from the financial statements, a number of tools are used to analyze these statements. The popular tools are:

• Comparative Financial Statements,
• Common Sized Statements and
• Ratio Analysis

Comparative Financial Statements
Many annual reports provide summarized numbers for the past several years, could be 5 or even 10 years in some cases. These comparative financial statements enable users to spot trends in the company's operating results.

Analysts can also compare different organizations by putting beside each other figures in a comparative form and indicating differences between them in terms of rupees and percentages.

Current Ratio
The ratio of current assets to current liabilities is called the current ratio. It is an important indication of an entity's ability to meet its current obligations because if current assets do not exceed current liabilities by a comfortable margin, the entity may be unable to pay its current bills. This is because most current assets are expected to be converted into cash within a year or less. The higher the current ratio, the more is the firm’s ability to meet current obligations, and greater is the safety of funds of short term creditors.

Hence Current Ratio = Current Assets / Current Liabilities

Quick Ratio /Acid Test Ratio
Some of the current assets are non-monetary assets. Some of these assets are difficult to convert to cash quickly. A ratio that focuses on the relationship of monetary assets to current liabilities is called the acid-test ratio, or quick ratio. Quick assets are those current assets that are also monetary assets; therefore they exclude inventories and prepaid expenses. 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 current ratio.

Acid Test Ratio = Current Assets - (Inventory + Prepaid Expenses) / Current Liabilities.

Debt /Equity Ratio
A company with a high proportion of long term debt is said to be highly leveraged. The debt/equity ratio shows the balance that the management of a particular company has struck between these forces of risk versus cost. This is often called simply the debt ratio. It may be calculated in several ways. Debt may be defined as total liabilities, as interest-bearing current liabilities plus non-current liabilities, or as only non-current liabilities. The user must always be careful to ascertain which method is used in a given situation. Including current liabilities, the debt/equity ratio is: Total liabilities / Shareholders' Equity. Excluding current liabilities, the ratio is: Interest bearing Liabilities / Shareholders'
Equity.

It is more popular in India to use the second formula of the Debt Equity ratio indicated above. Some practitioners exclude Short term Debt in the above computation, but a practical problem arises as short term and long term debt details are not always available in the audited annual reports. A common approach is to then consider all debt for this purpose. A high debt to equity ratio implies greater financial risk (on account of interest payment
and legal actions by creditors). Therefore, for a newly set up firm equity finance is preferred to debt finance.

Interest Coverage Ratio
Another measure of a company's financial soundness is the times interest earned, or interest coverage ratio. This is the relationship of company's income to its interest requirements. The numerator of this ratio is the company's pretax income before subtraction of interest expense.

Interest Coverage Ratio = Earnings before Depreciation, Interest and Tax / Interest.

Gross Margin Ratio
The difference between net sales revenue and cost of sales is the gross margin. It is the difference between the revenue generated from selling products and the related product costs. This ratio is defined as ratio between gross profit to net sales.

Gross Margin Ratio = Gross Profit / Net Sales.

Net Profit Ratio
It is defined as ratio between net profit to net sales i.e.

Net Profit Ratio = Net Profit / Net Sales.

This ratio shows the profits left for shareholders as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing and tax management

Inventory Turnover Ratio
The ratio most commonly used in analyzing the size of the inventory item is inventory turnover.

Inventory Turnover = Cost of Goods Sold / Inventory.

Some companies calculate this ratio on the basis of the ending inventory, others on the basis of the average inventory. The average may be simply one-half the sum beginning and ending inventories for the year, or it may be an average of monthly inventory levels. The end-of-period basis is more representative of the current state of the inventory if volume is expected to continue at previous levels: The average basis is a better reflection of events that occurred during the period because it measures the amount of inventory that supported the sales activity of that period. Inventory turnover varies greatly with the nature of business. One must also consider the seasonality of sales. For example, college book stores have high inventories before the start of each new term, with lower inventories in between. In such cases, inventory measured at various seasonal high and low points is of more significance.