What is Financial Statement Analysis?
Financial statement analysis is the process of evaluating a company’s financial statements, which include the balance sheet, income statement, and cash flow statement. This analysis helps stakeholders understand the company’s financial health, performance, and trends over time. Key metrics and ratios, such as profitability, liquidity, solvency, and operational efficiency, are used to assess the company’s strengths and weaknesses. By interpreting these financial statements, analysts can make informed decisions regarding investments, lending, and strategic planning. Overall, financial statement analysis provides valuable insights into a company’s financial stability and growth potential, aiding in better decision-making and risk management.
Balance Sheet
What is a Balance Sheet?
A balance sheet is a financial statement that provides a snapshot of a company’s financial position at a specific point in time. It outlines the company’s assets, liabilities, and equity, allowing stakeholders to assess its financial health.
Components of a Balance Sheet
Assets:
Assets are resources owned by the company that have economic value. They are classified into two main categories:
Current Assets: These are assets that can be converted into cash within one year. Examples include:
- Cash and Cash Equivalents: Actual cash and short-term investments that can be quickly converted into cash.
- Accounts Receivable: Money owed to the company by customers for goods or services provided on credit.
- Inventory: Goods available for sale.
- Prepaid Expenses: Payments made in advance for goods or services to be received in the future.
Non-Current Assets:
These are long-term assets that cannot be easily converted into cash within one year. Examples include:
- Property, Plant, and Equipment (PP&E): Tangible assets like buildings, machinery, and vehicles.
- Intangible Assets: Non-physical assets like patents, trademarks, and goodwill.
- Long-Term Investments: Investments that the company intends to hold for more than one year.
Liabilities:
Liabilities are the company’s obligations or debts that need to be paid in the future. They are classified into two main categories:
Current Liabilities:
These are obligations that need to be settled within one year. Examples include:
- Accounts Payable: Money the company owes to suppliers for goods or services received.
- Short-Term Loans: Loans that are due within one year.
- Accrued Expenses: Expenses that have been incurred but not yet paid.
- Unearned Revenue: Money received from customers for goods or services not yet delivered.
Non-Current Liabilities:
These are long-term debts that are due after one year. Examples include:
- Long-Term Loans: Loans that are due after one year.
- Bonds Payable: Long-term debt instruments issued by the company.
- Deferred Tax Liabilities: Taxes owed in the future due to temporary differences between accounting and tax treatment.
Equity:
Equity represents the owner’s claims on the company’s assets after all liabilities have been paid off. It includes:
- Common Stock: The value of the shares issued to shareholders.
- Retained Earnings: The cumulative amount of profit that has been retained in the business after dividends have been paid.
- Additional Paid-In Capital: The amount of money shareholders have invested in the company above the par value of the shares.
The Fundamental Accounting Equation
The balance sheet is based on the fundamental accounting equation:
Assets=Liabilities+ Equity
This equation must always balance, ensuring that the company’s resources are financed either through debt or owner’s equity.
Example Balance Sheet of ABC Ltd.
Balance Sheet as of 31st March 2024 (All amounts in ₹ Crores)
Particulars | Note No. | 31-Mar-2024 | 31-Mar-2023 |
ASSETS | |||
Non-Current Assets | |||
Property, Plant & Equipment | 1 | 1,200.00 | 1,100.00 |
Capital Work-in-Progress | 2 | 150.00 | 120.00 |
Intangible Assets | 3 | 250.00 | 230.00 |
Financial Assets | |||
– Investments | 4 | 500.00 | 450.00 |
– Loans | 5 | 50.00 | 45.00 |
Other Non-Current Assets | 6 | 100.00 | 90.00 |
Total Non-Current Assets | 2,250.00 | 2,035.00 | |
Current Assets | |||
Inventories | 7 | 800.00 | 750.00 |
Trade Receivables | 8 | 600.00 | 500.00 |
Cash & Bank Balances | 9 | 350.00 | 300.00 |
Other Financial Assets | 10 | 200.00 | 180.00 |
Other Current Assets | 11 | 100.00 | 90.00 |
Total Current Assets | 2,050.00 | 1,820.00 | |
TOTAL ASSETS | 4,300.00 | 3,855.00 |
EQUITY & LIABILITIES | Note No. | 31-Mar-2024 | 31-Mar-2023 |
Equity | |||
Equity Share Capital | 12 | 1,200.00 | 1,000.00 |
Other Equity | 13 | 1,000.00 | 900.00 |
Total Equity | 2,200.00 | 1,900.00 | |
Non-Current Liabilities | |||
Financial Liabilities | |||
– Borrowings | 14 | 800.00 | 750.00 |
– Lease Liabilities | 15 | 100.00 | 90.00 |
Provisions | 16 | 120.00 | 110.00 |
Deferred Tax Liabilities (Net) | 17 | 80.00 | 75.00 |
Total Non-Current Liabilities | 1,100.00 | 1,025.00 | |
Current Liabilities | |||
Financial Liabilities | |||
– Borrowings | 18 | 400.00 | 350.00 |
– Trade Payables | 19 | 300.00 | 280.00 |
– Other Financial Liabilities | 20 | 200.00 | 180.00 |
Provisions | 21 | 50.00 | 45.00 |
Other Current Liabilities | 22 | 50.00 | 45.00 |
Total Current Liabilities | 1,000.00 | 900.00 | |
TOTAL EQUITY & LIABILITIES | 4,300.00 | 3,855.00 |
B. Cash Flow Statement
A Cash Flow Statement in India is a financial document that provides a detailed overview of the cash inflows and outflows of a business over a specific period. It is prepared in accordance with the Indian Accounting Standard (Ind AS) 7. The statement is divided into three main sections:
- Operating Activities: This section includes cash flows from the core business operations, such as receipts from sales of goods and services, payments to suppliers, and other operating expenses.
- Investing Activities: This section reports cash flows related to the acquisition and disposal of long-term assets, such as property, plant, equipment, and investments.
- Financing Activities: This section includes cash flows related to borrowing and repaying loans, issuing and repurchasing shares, and paying dividends to shareholders.
- Operating Activities
This section focuses on the cash flow from the core business operations. It includes:
- Cash Receipts from Sales of Goods and Services: Money received from customers for the sale of goods and services.
- Cash Payments to Suppliers and Employees: Money paid to suppliers for raw materials, inventory, and to employees for salaries and wages.
- Other Operating Expenses: Payments for other operating expenses such as rent, utilities, and advertising.
- Interest and Taxes Paid: Cash paid for interest on loans and taxes to the government.
- Interest and Dividends Received: Cash received from investments in other companies.
The result is the net cash flow from operating activities, which reflects the ability of the business to generate cash from its core operations.
- Investing Activities
This section reports cash flows related to the acquisition and disposal of long-term assets. It includes:
- Purchases of Property, Plant, and Equipment (PPE): Cash spent on acquiring physical assets such as buildings, machinery, and equipment.
- Proceeds from Sale of PPE: Cash received from selling long-term assets.
- Purchases of Investments: Cash spent on acquiring investments such as stocks, bonds, and other securities.
- Proceeds from Sale of Investments: Cash received from selling investments.
- Loans Made to Other Entities: Cash lent to other businesses or individuals.
- Collections on Loans: Cash received from repayments of loans made to others.
The result is the net cash flow from investing activities, which shows how much cash is used or generated from investing in long-term assets.
- Financing Activities
This section includes cash flows related to borrowing and repaying loans, issuing and repurchasing shares, and paying dividends. It includes:
- Proceeds from Issuance of Shares: Cash received from issuing new shares to investors.
- Repurchase of Shares: Cash spent on buying back shares from investors.
- Proceeds from Borrowings: Cash received from taking out loans or issuing bonds.
- Repayment of Borrowings: Cash spent on repaying loans or redeeming bonds.
- Dividends Paid: Cash paid to shareholders as dividends.
Ratios of Balance Sheet and Cash Flow Statement
Balance Sheet Ratios
Current Ratio:
Measures a company’s ability to pay off its short-term liabilities with its short-term assets.
- Formula: Current Assets / Current Liabilities
- Purpose: Indicates liquidity and short-term financial health.
Example:
- Current Assets: ₹500,000
- Current Liabilities: ₹250,000
Calculation:
Current Ratio=Current Assets/Current Liabilities=₹500,000/₹250,000= ₹2
Interpretation:
In this example, the Current Ratio is 2.0. This means that for every ₹1 of current liabilities, the company has ₹2 of current assets. A ratio of 2.0 indicates that the company has a strong liquidity position and can comfortably meet its short-term obligations.
Quick Ratio (Acid Test):
Similar to the current ratio but excludes inventory from current assets.
- Formula: (Current Assets – Inventory) / Current Liabilities
- Purpose: Provides a more stringent measure of liquidity.
Example:
- Current Assets: ₹500,000
- Inventory: ₹150,000
- Current Liabilities: ₹250,000
Calculation:
Quick Ratio= Current Assets−Inventory/ Current Liabilities =₹500,000−₹150,000/ ₹250,000
= ₹350,000/ ₹250,000
=1.4
Interpretation:
In this example, the Quick Ratio is 1.4. This means that for every ₹1 of current liabilities, the company has ₹1.40 of quick assets (current assets excluding inventory). A ratio above 1.0 indicates that the company has sufficient liquid assets to cover its short-term liabilities without relying on the sale of inventory.
Debt-to-Equity Ratio:
Indicates the relative proportion of shareholders’ equity and debt used to finance a company’s assets.
- Formula: Total Liabilities / Shareholders’ Equity
- Purpose: Assesses financial leverage and risk.
Example:
- Total Liabilities: ₹1,200,000
- Shareholders’ Equity: ₹800,000
Calculation:
Debt-to-Equity Ratio=Total Liabilities/Shareholders’ Equity= ₹1,200,000/ ₹800,000= 1.5
Interpretation:
A Debt-to-Equity Ratio of 1.5 indicates that the company has ₹1.50 in debt for every ₹1 of equity. This shows a moderate level of financial leverage and risk.
Return on Equity (ROE):
Measures profitability by revealing how much profit a company generates with the money shareholders have invested.
- Formula: Net Income / Average Shareholders’ Equity
- Purpose: Evaluates efficiency in generating profits.
Example
- Net Income: ₹500,000
- Average Shareholders’ Equity: ₹2,500,000
Calculation:
ROE=Net Income/ Average Shareholders’ Equity=₹500,000/₹2,500,000×100=20%
Interpretation:
An ROE of 20% means that the company generates a return of ₹0.20 for every ₹1 invested by shareholders. This indicates good profitability and efficient use of equity.
Inventory Turnover Ratio:
Indicates how often inventory is sold and replaced over a period.
- Formula: Cost of Goods Sold / Average Inventory
- Purpose: Assesses inventory management efficiency.
Example:
- Cost of Goods Sold (COGS): ₹900,000
- Average Inventory: ₹300,000
Calculation:
Inventory Turnover Ratio=Cost of Goods Sold/Average Inventory=₹900,000/₹300,000=3.0
Interpretation:
An Inventory Turnover Ratio of 3.0 indicates that the company’s inventory is sold and replaced three times over a given period. This reflects efficient inventory management.
Cash Flow Statement Ratios
Operating Cash Flow Ratio:
Measures the ability to generate cash from operations to pay off current liabilities.
- Formula: Operating Cash Flow / Current Liabilities
- Purpose: Indicates liquidity from core operations.
Example
- Operating Cash Flow: ₹600,000
- Current Liabilities: ₹300,000
Calculation:
Operating Cash Flow Ratio = Operating Cash Flow/Current Liabilities =₹600,000/₹300,000 =2.0
Interpretation:
An Operating Cash Flow Ratio of 2.0 indicates that the company generates ₹2 in cash from operations for every ₹1 of current liabilities, showing strong liquidity from core operations.
Free Cash Flow (FCF):
Represents the cash generated by the business that is available for distribution among its securities holders.
- Formula: Operating Cash Flow – Capital Expenditures
- Purpose: Evaluates the cash available for dividends, reinvestment, and debt repayment.
Example
- Operating Cash Flow: ₹600,000
- Capital Expenditures: ₹200,000
Calculation:
Free Cash Flow=Operating Cash Flow−Capital Expenditures=₹600,000−₹200,000 =₹400,000
Interpretation:
The Free Cash Flow of ₹400,000 represents the cash available for dividends, reinvestment, and debt repayment.
Cash Flow Coverage Ratio:
Measures the ability to cover debt obligations with cash flow from operations.
- Formula: Operating Cash Flow / Total Debt Service
- Purpose: Assesses the ability to service debt.
Example
- Operating Cash Flow: ₹600,000
- Total Debt Service: ₹150,000
Calculation:
Cash Flow Coverage Ratio= Operating Cash Flow/Total Debt Service=₹600,000/₹150,000=4.0
Interpretation:
A Cash Flow Coverage Ratio of 4.0 indicates that the company can cover its debt obligations four times over with the cash generated from operations, reflecting strong debt-servicing ability.
Funds from Operations (FFO):
Measures the cash generated by the business from its core operations.
- Formula: Net Income + Depreciation/Amortization – Changes in Working Capital
- Purpose: Provides insight into the cash-generating ability of the business.
Example
- Net Income: ₹500,000
- Depreciation/Amortization: ₹100,000
- Changes in Working Capital: ₹50,000 (assume a decrease in working capital)
Calculation:
FFO=Net Income + Depreciation/Amortization−Changes in Working Capital
=₹500,000+₹100,000−₹50,000
=₹550,000
Interpretation:
The Funds from Operations (FFO) of ₹550,000 provides insight into the cash-generating ability of the business from its core operations.
Conclusion
A thorough financial statement analysis is essential for understanding a company’s financial health, performance, and potential. By examining key ratios and metrics, such as liquidity, profitability, and leverage, stakeholders can make informed decisions regarding investments, lending, and strategic planning. This analysis provides valuable insights into a company’s ability to generate cash, manage debt, and create value for shareholders. Ultimately, financial statement analysis is a powerful tool that helps investors and management identify strengths, weaknesses, opportunities, and threats, ensuring the long-term success and sustainability of the business.
