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Financial Statement Analysis: Understanding Ratios and Their Utility

Learn how financial ratios provide valuable insights into a firm's financial strength, creditworthiness, and competitive position. Discover the different types of ratios and their limitations in analyzing financial statements.

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Financial Statement Analysis: Understanding Ratios and Their Utility

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  1. Chapter25 Financial Statement Analysis

  2. LEARNING OBJECTIVES • Show the use of financial ratios to get useful information from financial statements • Recognize the diagnostic role of financial ratios • Highlight the utility of financial ratios in credit analysis and competitive analysis as well as in determining the financial capability of the firm • Understand the limitations of financial ratios

  3. Financial Analysis Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by property establishing relationships between the item of the balance sheet and the profit and loss account.

  4. USERS OF FINANCIAL ANALYSIS • Trade creditors • Suppliers of long-term debt • Investors • Management

  5. NATURE OF RATIO ANALYSIS • A financial ratio is a relationship between two accounting numbers. • Ratios help to make a qualitative judgement about the firm’s financial performance.

  6. Standards of Comparison • Time series analysis • Inter-firm analysis • Industry analysis • Proforma financial statement analysis

  7. Types of Financial Ratios • Liquidity ratios • Leverage ratios • Activity ratios • Profitability ratios

  8. LIQUIDITY RATIOS • Liquidity ratios measure a firm’s ability to meet its current obligations.

  9. Cont…

  10. LEVERAGE RATIOS • To judge the long-term financial position of the firm, financial leverage, or capital structure ratios are calculated. • These ratios indicate mix of funds provided by owners and lenders.

  11. Cont…

  12. Cont…

  13. ACTIVITY RATIOS • Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its assets. • These ratios are also called turnover ratios because they indicate the speed with which assets are being converted or turned over into sales. • Activity ratios, thus, involve a relationship between sales and assets.

  14. Inventory Turnover and Debtors Turnover

  15. Assets Turnover Ratios

  16. PROFITABILITY RATIOS • The profitability ratios are calculated to measure the operating efficiency of the company. • Generally, two major types of profitability ratios are calculated: • profitability in relation to sales • profitability in relation to investment.

  17. Cont…

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  22. EVALUATION OF A FIRM’S EARNINGPOWER: DUPONT ANALYSIS • RONA (or ROCE) is the measure of the firm’s operating performance. It indicates the firm’s earning power. • RONA can be computed as follows: • A firm can convert its RONA into an impressive ROE through financial efficiency.

  23. COMPARATIVE STATEMENTS ANALYSIS • A simple method of tracing periodic changes in the financial performance of a company is to prepare comparative statements. • Comparative financial statements will contain items at least for two periods. • Changes—increases and decreases—in income statement and balance sheet over a period can be shown in two ways: • (1) aggregate changes and • (2) proportional changes.

  24. TREND ANALYSIS • In financial analysis the direction of changes over a period of years is of crucial importance. • Time series or trend analysis of ratios indicates the direction of change. • This kind of analysis is particularly applicable to the items of profit and loss account.

  25. Cont… • For trend analysis, the use of index numbers is generally advocated. • The procedure followed is to assign the number 100 to items of the base year and to calculate percentage changes in each items of other years in relation to the base year. This procedure may be called as “trend-percentage method.”

  26. Example: Hindustan Manufacturing Company

  27. INTER-FIRM ANALYSIS • The analysis of the financial performance of all firms in an industry and their comparison at a given point of time is referred to the cross-section analysis or the inter-firm analysis. • To ascertain the relative financial standing of a firm, its financial ratios are compared either with its immediate competitors or with the industry average.

  28. Example: Construction industry: Inter-firm Comparison Market Share

  29. UTILITY AND LIMITATIONS OF RATIO ANALYSIS

  30. UTILITY OF RATIO ANALYSIS • the ability of the firm to meet its current obligations; • the extent to which the firm has used its long-term solvency by borrowing funds; • the efficiency with which the firm is utilizing its assets in generating sales revenue • the overall operating efficiency and performance of the firm.

  31. Diagnostic Role of Ratios • Profitability analysis • Assets utilization • Liquidity analysis • Strategic Analysis

  32. CAUTIONS IN USING RATIO ANALYSIS • Standards for comparison • Company differences • Price level changes • Different definitions of variables • Changing situations • Historical data

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