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Financial analysis refers to an activity of assessing financial statements to judge the performance of a company. Financial statement analysis has three broad tools – Ratio Analysis, DuPont Analysis and Common Size Financials. Out of all, ratio analysis is the most prominent. Liquidity, capital structure, turnover, growth and valuation ratios are utilized to judge different aspects of a business. Financial analysis is useful in assessment, comparison, and valuation of a company. Different stakeholders utilize different ratios for their varied purposes.
Financial analysis is the most talked about term in the financial world. When we think of financial analysis, the first thing that comes to mind is ratio analysis. But, ratio analysis of what? Ratio analysis of financial statements of a business is done. So, essentially, it is safe to say that financial analysis is as good as financial statement analysis.
Analysis of Financial Statements Using Financial Ratios
Though ratio analysis is the most prominent tool for analyzing financial statements, there are some more tools which assist in conducting the financial analysis for a business organization. The tools are as follows:
Ratio / Financial Analysis
Ratio analysis, the most widely utilized tool, involves calculating ratios from the financial statements to draw significant insight into the financial statements. Financial statements include the profit and loss account and balance sheet of a company. In general, we understand ratios as some figure divided by other. They have a very significant role to play in finance because these ratios provide an in-depth understanding of the business which cannot be understood by just looking at the standalone financial statements.
In essence, ratio analysis enhances the usability of financial statements. Profit and loss statement, one part of financial statements, just calculate the profit that the company has made. It does not answer the question whether it is sufficient or not but it is answered by ratio analysis.
For example, a ratio of net profit to sales indicates the percentage of net profit margin. When this ratio is compared with the industry standards, we can come to a conclusion whether the company has performed good or bad. In the other instance, if we compare it with previous year’s margins, we can assess whether the company is improving, stable or downgraded compared to its past performance. This is how financial analysis augments the worth of preparing financial statements.
Ratios are classified into following types:
Profitability ratios are the evaluation method for an organization. Profit is the main motive of every organization and these ratios judge how well an organization has achieved its goal of profits. There are 2 types such as profit margin & rate of return ratios. Profit margin ratios include gross profit margin and a net profit margin and it judges the profitability at different stages. The rate of return ratios include return on equity, return on assets, earning power, return on capital employed.
These ratios are calculated to find out the liquidity position of an organization. Liquidity means an ability to pay as and when some obligations are due. It is the lifeblood of any business organization because the lack of liquidity can bring bankruptcy situation for the organization. For calculating liquidity ratios, we use current assets and current liabilities. The important liquidity ratios are the current ratio, acid-test ratio or quick ratio, cash ratio.
Capital Structure Ratios / Leverage Ratios
It would be difficult to find a company with no debt in its capital structure. Use of debt in its capital structure is commonly known as leverage. Leverage ratios or capital structure ratios revolve around the debt of an organization. There are two types of ratios such as capital structure ratios and coverage ratios. Capital structure ratios assess the risk of bankruptcy for the organization and coverage ratios, apart from judging the bankruptcy risk, also judges the servicing capacity of payment by comparing the future debt obligations with resources used for honoring them. Capital structure ratios are debt-equity ratio and debt-asset ratio. Coverage ratios are interest coverage ratios, fixed charge coverage ratios, and debt service coverage ratios.
Activity / Efficiency / Turnover Ratios
Also known as asset management ratios, efficiency ratios judge the efficiency in the management of assets. Assets are employed to generate sales for a firm and these ratios determine how well the asset is utilized to efficiently generate or convert an asset into sales. Important activity/ efficiency/turnover ratios are inventory turnover, average collection period, receivables turnover, fixed assets turnover and total asset turnover.
Growth ratios are the measures of growth of a firm. Factors such as investment in the fixed asset, profit margins, retention ratio etc are responsible for the growth of a firm. Growth ratios are of two types such as internal growth rate and sustainable growth rate (when external financing is used to support growth). It is said that higher growth can be achieved when external financing used.
These ratios are the mainly utilized for analyzing the worth of a stock in share market or to value a company as a whole. Valuation ratios include price to earnings ratio, dividend yield, market value to book value etc.
DuPont is a US based company established in 1802. It has pioneered a method of financial analysis widely used by the business organization. It has not produced any ratio but has come up with inter-relationship between some ratios to understand cause and effect of a ratio to others. For example, DuPont Analysis defines Return on Assets as the product of Net Profit Margin and Total Asset Turnover Ratio.
Common Size Financials
Common size financials are nothing but expressing all the figures of profit and loss account as a percentage of sales and in the balance sheet as a percentage of total assets. It helps in comparing two companies because their financial statements are in the same format and an item to item comparison is possible easily.