How to Analyze Financial Statements Using Financial Ratios

We have seen that there are three important financial statements for any public limited company. They are

  1. The Balance Sheet
  2. The Statement of Profit & Loss
  3. The Cash Flow Statement

When we read the absolute figures in these statements we might get some information about the financial health of a company but not the full information. This is so because many a time absolute figures do not reveal the full story. In fact absolute figures might even be misleading. Let us take a simple example. If someone says that he runs a company whose sale is Rs. 100 crore you might feel that this is a fairly big company. Now assume there is another person who says that he runs a company which made a profit of Rs. 10 crore in previous year, you might feel that this too is a well to do company. But now if I tell you that the return on sales of first company is 5% and that of the second company is 25%, you get a better picture of how each of these companies are placed against each other in terms of business performance.

What is Financial Statement Analysis (FSA): FSA is a process of selection, relation and evaluation of individual items presented in financial statements. For example, when we are relating profits with sales we are finding the return on sales in percentage terms. This process is therefore often called as Ratio Analysis. Financial ratios are a powerful tool in the hands of management. Ratios don’t add information, they only reveal concealed facts. Ratios analysis is indeed like magnifying glass that shows the finer details hidden in the financial statements.

Types of Financial Ratios

There are four broad categories of ratios as follows:

[I] Liquidity Ratios: To know liquidity position of the business.

[II] Capital Structure Ratios: To measure the impact of borrowings on financial position of company.

[III] Profitability Ratios: To know profit generating ability of the company.

[IV] Efficiency Ratios: To know utilization /productivity of assets.

Let us take a look at a few key ratios which are used by investors to analyze financial statement of public limited companies.

Current Ratio (CR) is a ratio of Current Assets to Current Liabilities of the company. When current ratio is greater than one, it indicates that the company has positive float of funds for running its day to day operations.

Asset Turnover Ratio (ATR) is the ratio of net sales to total assets owned by the company. This ratio measure amount of revenue generated for every rupee of investment in assets. A high ATR indicates higher asset utilization.

Debt-Equity Ratio (D/E) is the ratio of a company’s outside liabilities to shareholder’s equity. This ratio is also popularly known as leverage ratio. It shows the relationship between borrowings and owned funds. A high D/E is considered to be very risky as it amounts to high interest cost on borrowed funds.

Operation Profit Margin (OPM) is the ratio of company’s profit before interest and taxes to net sales for a given financial year. A good OPM indicates operating efficiency and ability to pay interest on borrowings. Companies with low OPM (below 10%) find it difficult to generate future capital by creating their own reserves.

Return on Equity (ROE) is the ratio of Profit After Tax (PAT) to Shareholder’s Equity Capital. The ROE is expressed in percentage terms. A high ROE for a company means that shareholders are getting good returns on their investment in the form of buying of shares in that company.

Earnings Per Share (EPS) EPS is equal to Profit After Tax (PAT) divided by Number of Equity Shares held by shareholders of a company. EPS asks a simple question that is for every rupee invested by a shareholder in a company how many rupees is the company able to earn in the form of net profit.

These are just a few important ratios for FSA. This introductory note would have given you a basic idea of how to read between the lines of financial statements. The idea of any analysis is to infer meaning out of array of data thrown before us. One needs to learn the art of FSA before parking money in the hands of financial managers of any company. I wish you happy investing.

 About the author: Prof. Anil Kshatriya works as Assistant Professor in the area of Finance at Institute of Management Technology, Nagpur. His teaching and research interests include Managerial Accounting, Management Control Systems and Strategic Management. Prof. Kshatriya is a professional accountant (CMA India) having associate memberships of Institute of Cost Accountant of India (ICAI) and Chartered Institute of Management Accountants (CIMA UK). His industry experience includes working as cost accountant with the Auto Sector at Mahindra Group. Prof. Kshatriya teaches courses in Accounting and Strategy at IMT.

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