P R E S E N T E D B Y: S O M YA S H U K L A

P R I YA D A S
YO G E S H V E R M A

Overview
Financial statement analysis (or financial analysis)
is the process of reviewing and analyzing a
company's financial statements. These
statements include the Income Statement,
Balance Sheet, and Statement of Cash Flows.
Financial statement analysis is a method or
process involving specific techniques for
evaluating risks, financial health, and future
prospects of an organization. It is used by
investors, stakeholders, the public, and decision
makers within the organization. Popular methods
of financial statement analysis include horizontal
and vertical analysis and the use of financial
ratios.

METHODS

Horizontal
Analysis/ Trends

Vertical Analysis/
Common Size
Analysis

Financial Ratio
Analysis

Horizontal analysis / Trend analysis

Horizontal analysis (also known as trend analysis) is a financial
statement analysis technique that shows changes in the amounts of
corresponding financial statement items over a period of time. It is a useful tool to
evaluate the trend situations.
The statements for two or more periods are used in horizontal analysis.

The earliest period is usually used as the base period and the items on the
statements for all later periods are compared with items on the statements of
the base period.
Horizontal analysis may be conducted for balance sheet, income statement,
schedules of current and fixed assets and statement of retained earnings.

Comparative income statement with horizontal analysis:

Comparative balance sheet with horizontal analysis:

Vertical analysis / Common-Size analysis

Vertical analysis is the proportional analysis of a financial statement,
where each line item on a financial statement is listed as a percentage
of another item. Typically, this means that every line item on an income
statement is stated as a percentage of gross sales, while every line item
on a balance sheet is stated as a percentage of total assets.
Uses:

within a financial statement for a single time period,to see the

relative proportions of account balances
for timeline analysis, where you can see relative changes in accounts
over time, such as on a comparative basis over a five-year period. For
example, if the cost of goods sold has a history of being 40% of sales
in each of the past four years, then a new percentage of 48% would
be a cause for alarm.

Comparative income statement with vertical analysis:

Cost of goods sold:

2008: (1,043,000/1,498,000) 100 = 69.6%
2007: (820,000/1200,000) 100 = 68.3%

Comparative balance sheet with vertical analysis :

Cost of goods sold:

2008: (1,043,000/1,498,000) 100 = 69.6%
2007: (820,000/1200,000) 100 = 68.3%

Financial Ratio Analysis

Financial ratio analysis involves calculating and analyzing ratios that
use data from one, two or more financial statements.
Ratio analysis also expresses relationships between different financial
statements.

Financial Ratios can be classified into 5 main categories:

Profitability Ratios
Liquidity or Short-Term Solvency ratios

Activity Ratios or Asset Management

Leverage ratios

Profitability ratios
Profitability ratios measure the efficiency of management in
the employment of business resources to earn profits.
Ratios include:
Gross Profit % = Gross Profit/ Net Sales* 100

Net Profit % = Net Profit/Net Sales* 100

Return on Assets = Net Profit /Average Total Assets* 100
Return on Equity = Net Profit /Average Total Equity* 100

Liquidity or Short-Term Solvency ratios

This is the most fundamentally important set of ratios, because they
measure the ability of a company to remain in business.
Ratios include:
Working Capital = Current assets Current Liabilities

Current Ratio = Current Assets /Current Liabilities

Quick Ratio = Current Assets Inventory Prepayments/ Current
Liabilities Bank Overdraft
Cash coverage ratio = Net Cash provided by Operating Profit/ Average
Current Liabilities

Activity Ratios or Asset Management Ratios

These ratios are a strong indicator of the quality of
management, since they reveal how well management is
utilizing company resources.
Ratios include:
Asset Turnover = Net Sales/ Average Total Assets
Inventory Turnover = Cost of Goods Sold /Average Ending
Inventory

Average Collection Period = Average accounts Receivable/

Average daily net credit sales*
* Average daily net credit sales = net credit sales / 365

Leverage ratios
These ratios reveal the extent to which a company is relying
upon debt to fund its operations, and its ability to pay back the
debt.
Ratios include:

Debt/Equity ratio = Debt / Equity

Debt/Total Assets ratio = Debt /Total Assets*100
Equity ratio = Equity/ Total Assets*100
Times Interest Earned = Earnings before Interest and Tax
/Interest

Problems with Financial Statement

Analysis
While financial statement analysis is an excellent tool, there are several issues to be aware
of that can interfere with your interpretation of the analysis results. These issues are:

Comparability between periods. The company preparing the financial statements may have
changed the accounts in which it stores financial information, so that results may differ
from period to period. For example, an expense may appear in the cost of goods sold in
one period, and in administrative expenses in another period.
Comparability between companies. An analyst frequently compares the financial ratios of
different companies in order to see how they match up against each other. However, each
company may aggregate financial information differently, so that the results of their
ratios are not really comparable. This can lead an analyst to draw incorrect conclusions
about the results of a company in comparison to its competitors.
Operational information. Financial analysis only reviews a company's financial information,
not its operational information, so you cannot see a variety of key indicators of future
performance, such as the size of the order backlog, or changes in warranty claims. Thus,
financial analysis only presents part of the total picture.