UNIUYO ACC 422 Lecture Note: Complete Guide Financial Statement Analysis
UNIUYO ACC 422 Lecture Note. Complete guide to financial statement analysis covering liquidity, profitability, activity, and leverage ratios with formulas, calculations.
UNIUYO ACC 422 Full Lecture Note for students
Introduction
Financial statement analysis is a critical skill for investors, creditors, business managers, and accounting students seeking to evaluate a company’s financial health and performance. Knowing how to interpret financial statements and calculate key financial ratios enables stakeholders to make informed economic decisions about investments, credit extensions, and operational improvements.
What Are Financial Statements?
Financial statements are formal records prepared by an entity to present its operational results over a specific period and its financial position at a particular date. According to the IFRS Conceptual Framework, complete financial statements include:
- Income Statement (Statement of Profit or Loss)
- Statement of Financial Position (Balance Sheet)
- Statement of Cash Flows
- Statement of Changes in Equity
- Notes to the Accounts
Understanding Financial Statement Analysis
Financial statement analysis is the systematic process of reviewing and evaluating a company’s financial statements to make better economic decisions and assess future income potential. This analytical process involves evaluating organizational risks, performance metrics, financial health indicators, and future prospects using specialized techniques.
Key Stakeholders and Their Interests
Different stakeholders utilize financial statement analysis for varying purposes:
Equity Investors focus on long-term earnings power, dividend sustainability, and growth potential. They analyze profitability and return ratios to assess whether the company can generate adequate returns on their investment.
Creditors and Lenders prioritize the company’s ability to meet interest payments and repay principal amounts on debt securities when due. They emphasize liquidity and leverage ratios to evaluate credit risk.
Management uses financial analysis to assess operational efficiency, identify areas for improvement, and make strategic decisions about resource allocation.
Government and Regulatory Bodies monitor compliance and tax obligations while assessing economic contributions.
Types of Financial Statement Analysis
Financial statement analysis employs three primary methods: horizontal analysis, vertical analysis, and ratio analysis. Each technique offers unique insights into company performance.
Horizontal Analysis
Horizontal analysis compares financial information across multiple time periods, typically quarters or years. This method identifies trends by examining financial data from past statements and looking for significant variations such as revenue growth, increased expenses, or changing profit margins. Analysts can spot patterns indicating improving or deteriorating financial performance by tracking changes over time.
Vertical Analysis
Vertical analysis, also called common-sizing or normalization, expresses each line item in financial statements as a percentage of a base figure. On an income statement, each item typically appears as a percentage of gross sales or revenue. On a balance sheet, items are shown as percentages of total assets. This technique facilitates comparison across companies of different sizes and helps identify unusual relationships between financial statement components.
Ratio Analysis
Financial ratios provide powerful analytical tools for quick assessment of financial statements. Ratios fall into four main categories: liquidity ratios, profitability ratios, activity ratios, and leverage ratios. These metrics are most meaningful when analyzed over time and compared against industry competitors.
Liquidity Ratios (Short-Term Solvency Ratios)
Liquidity ratios measure a firm’s ability to meet short-term obligations using current assets. These ratios are crucial for assessing whether a company can pay its bills and handle unexpected cash needs.
Current Ratio
Formula: Current Assets ÷ Current Liabilities
The current ratio measures short-term solvency and indicates a firm’s ability to satisfy current liabilities. A ratio of 2:1 is generally considered satisfactory, providing a margin of safety for creditors. Higher current ratios indicate greater safety margins, though excessively high ratios may suggest inefficient asset utilization.
Quick Ratio (Acid Test Ratio)
Formula: (Current Assets – Inventory) ÷ Current Liabilities
The quick ratio provides a more stringent test of liquidity by excluding inventory, which may not be quickly convertible to cash. A quick ratio of 1:1 is considered satisfactory, indicating the company can meet immediate obligations without relying on inventory sales.
Cash Ratio
Formula: (Cash + Marketable Securities) ÷ Current Liabilities
Since cash represents the most liquid asset, the cash ratio may be the most appropriate measure of immediate liquidity. Marketable securities are included because they function as cash equivalents and can be quickly converted to cash.
Profitability Ratios
Profitability ratios demonstrate how effectively a company generates profit from its operations. These metrics interest management, creditors, and shareholders alike, as they measure operating efficiency and return generation.
Gross Profit Margin
Formula: Gross Profit ÷ Turnover (Sales) × 100
A high gross profit margin signals good management and indicates the firm can produce at relatively lower costs. Conversely, low margins may reflect higher costs of goods sold due to unfavorable purchasing terms, inefficient production processes, or poor plant and machinery utilization.
Net Profit Margin
Formula: Net Profit ÷ Turnover × 100 or (PBT ÷ Turnover) × 100
This ratio shows what percentage of revenue converts to net income after all expenses. Higher net profit margins indicate superior profitability and efficient cost management.
Return on Investment (ROI)
Formula: PAT (Profit After Tax) ÷ Total Assets × 100
ROI measures how effectively the company uses its total assets to generate profits. This ratio helps investors assess the efficiency of their capital deployment.
Return on Equity (ROE)
Formula: Profit After Tax ÷ Equity (Net Worth) × 100
ROE indicates returns generated for shareholders and is particularly important for equity investors evaluating investment performance.
Return on Capital Employed (ROCE)
Formula: Profit Before Interest and Tax ÷ Capital Employed × 100
Where Capital Employed = Total Debt + Net Worth (or Net Assets)
ROCE measures how efficiently a company generates earnings from its capital base. Higher ROCE values indicate superior capital efficiency and better profitability.
Return on Shareholders’ Equity
Formula: Profit After Tax ÷ Shareholders’ Fund × 100
This ratio specifically focuses on returns generated for ordinary shareholders, excluding preference shareholders in some analyses.
Activity Ratios (Turnover Ratios)
Activity ratios evaluate how efficiently a firm manages and utilizes its resources and assets. These ratios indicate the speed at which assets convert into sales, hence their alternate name: turnover ratios.
Inventory Turnover
Formula: Cost of Goods Sold ÷ Average Inventory
This ratio measures inventory management efficiency. High inventory turnover suggests efficient operations and strong sales, while low turnover indicates poor inventory management or weak demand. However, extremely high turnover may lead to stockout costs and lost sales.
Account Receivable Turnover
Formula: Credit Sales ÷ Average Account Receivables or Total Sales ÷ Account Receivables
This ratio demonstrates how quickly a company collects payments from customers. Higher turnover indicates efficient collection processes and good credit management.
Account Payables Turnover
Formula: Credit Purchases ÷ Average Account Payables or Total Purchases ÷ Account Payables
This ratio shows how quickly a company pays its suppliers. The optimal rate balances maintaining good supplier relationships with preserving cash flow.
Days of Inventory Holding
Formula: (Average Inventory ÷ Cost of Goods Sold) × 365 or 365 ÷ Inventory Turnover
This metric indicates the average number of days inventory remains in stock before sale, helping assess inventory management efficiency.
Average Collection Period
Formula: (Account Receivables ÷ Turnover) × 365 or 365 ÷ Account Receivable Turnover
This calculation shows the average days required to collect receivables, providing insight into credit policy effectiveness and collection efficiency.
Net Assets Turnover
Formula: Turnover ÷ Net Assets
Where Net Assets = Total Assets – Current Liabilities
This ratio measures how efficiently net assets generate revenue.
Total Assets Turnover
Formula: Turnover ÷ Total Assets
This metric indicates how effectively all assets generate sales revenue.
Non-Current Assets Turnover
Formula: Turnover ÷ Net Non-Current Assets
This ratio specifically measures the efficiency of long-term asset utilization in generating sales.
Current Asset Turnover
Formula: Turnover ÷ Current Assets
This calculation shows how efficiently short-term assets generate revenue.
Working Capital Turnover
Formula: Turnover ÷ Net Current Assets
Where Net Current Assets = Current Assets – Current Liabilities
This ratio evaluates how effectively working capital generates sales.
Leverage Ratios (Gearing Ratios)
Leverage ratios assess a firm’s long-term financial position by revealing how much the company relies on debt to fund operations. These ratios show the mixture of debt and equity in the capital structure, which is crucial for evaluating financial risk.
Debt Ratio
Formula: Total Debt ÷ Capital Employed
Where Capital Employed = Total Debt + Net Worth = Net Assets
This ratio indicates what proportion of capital comes from debt financing versus equity financing.
Debt-Equity Ratio
Formula: Total Debt (Long-term debt + Short-term debt + Leases) ÷ Net Worth (Equity)
This ratio reveals the extent to which management uses debt to fund operations. Higher ratios indicate greater financial leverage and risk.
Proprietary Ratio
Formula: Shareholders’ Fund ÷ Tangible Assets
This ratio shows what proportion of tangible assets is financed by shareholders’ equity rather than debt.
Shareholders Ratios (Investors Ratios)
Shareholder ratios help investors evaluate company performance relative to share price, dividends, and the number of outstanding shares. These metrics are essential for investment decision-making.
Earnings per Share (EPS)
Formula: PAT ÷ Number of Shares Outstanding
EPS indicates the profit allocated to each outstanding share and is one of the most widely watched metrics by investors.
Dividend per Share (DPS)
Formula: Dividends ÷ Number of Shares Outstanding
DPS shows the dividend payment per share, helping investors assess income potential.
Dividend Yield
Formula: Dividend per Share ÷ Market Value per Share × 100
This ratio expresses dividend return as a percentage of the share price, allowing comparison with other investment returns.
Earnings Yield
Formula: Earnings per Share ÷ Market Value per Share × 100
Earnings yield provides an alternative perspective on returns by expressing earnings as a percentage of share price.
Price Earnings Ratio (P/E Ratio)
Formula: Market Value per Share ÷ Earnings per Share
The P/E ratio indicates how much investors are willing to pay for each unit of earnings, reflecting market expectations about future growth.
Interest Cover
Formula: Profit Before Interest and Tax ÷ Interest
This ratio measures how easily a company can pay interest expenses from operating profits, indicating financial stability.
Dividend Cover
Formula: Profit After Tax ÷ Dividend
Dividend cover shows how many times the company could pay its current dividend from available profits, indicating dividend sustainability.
Practical Illustration: ABC Plc Financial Statement Analysis
The following example demonstrates comprehensive ratio calculation using financial statements from ABC Plc for the year ended December 31, 2008.
Financial Statement Summary
Statement of Profit or Loss:
- Turnover: ₦300,000
- Cost of Sales: (₦160,000)
- Gross Profit: ₦140,000
- Operating Expenses: (₦50,000)
- Operating Profit: ₦90,000
- Finance Costs: (₦10,000)
- Profit Before Tax: ₦80,000
- Income Tax: (₦24,000)
- Net Profit: ₦56,000
Statement of Financial Position (Selected Items):
- Total Assets: ₦770,000
- Current Assets: ₦360,000
- Current Liabilities: ₦140,000
- Shareholders’ Funds: ₦370,000
- Total Debt: ₦400,000
Calculated Profitability Ratios
Net Profit Margin: 56,000 ÷ 300,000 × 100 = 18.67%
Interpretation: ABC Plc generates ₦18.67 in net profit for every ₦100 in sales. This indicates reasonable profitability, with nearly one-fifth of revenue converting to bottom-line profit.
Gross Profit Margin: 140,000 ÷ 300,000 × 100 = 46.67%
Interpretation: The company earns ₦46.67 in gross profit for every ₦100 in sales, suggesting effective production cost management.
Operating Profit Margin: 90,000 ÷ 300,000 × 100 = 30%
Interpretation: Operating activities generate ₦30 for every ₦100 in sales before financing costs.
Return on Assets (ROA): 56,000 ÷ 770,000 × 100 = 7.27%
Interpretation: ABC Plc earns ₦7.27 for every ₦100 invested in assets, indicating moderate asset efficiency.
Return on Equity (ROE): 56,000 ÷ 370,000 × 100 = 15.14%
Interpretation: Shareholders earn a return of ₦15.14 for every ₦100 of equity invested, which represents attractive shareholder value creation.
Return on Capital Employed (ROCE): 90,000 ÷ 630,000 × 100 = 14.29%
Interpretation: The company generates ₦14.29 in operating profit for every ₦100 of capital employed, demonstrating reasonable capital efficiency.
Calculated Activity Ratios
Inventory Turnover: 160,000 ÷ 115,000 = 1.39 times
Interpretation: ABC Plc sells and replaces its inventory 1.39 times annually, which may indicate slow-moving inventory requiring management attention.
Account Receivable Turnover: 300,000 ÷ 100,000 = 3 times
Interpretation: The company collects its receivables three times per year.
Days of Inventory Holding: (115,000 ÷ 160,000) × 365 = 262 days
Interpretation: Inventory sits for an average of 262 days before sale, suggesting potential overstocking or slow-moving items.
Average Collection Period: (100,000 ÷ 300,000) × 365 = 122 days
Interpretation: ABC Plc takes approximately four months to collect receivables, which may indicate lenient credit terms or collection inefficiencies.
Total Assets Turnover: 300,000 ÷ 770,000 = 0.39
Interpretation: The company generates ₦0.39 in sales for every ₦1 invested in assets, suggesting potential underutilization of asset base.
Working Capital Turnover: 300,000 ÷ 220,000 = 1.36
Interpretation: Working capital generates ₦1.36 in sales for every ₦1 employed, indicating reasonable working capital efficiency.
Calculated Liquidity Ratios
Current Ratio: 360,000 ÷ 140,000 = 2.57:1
Interpretation: ABC Plc has ₦2.57 in current assets for every ₦1 of current liabilities, exceeding the satisfactory benchmark of 2:1 and indicating strong short-term liquidity.
Quick Ratio: 230,000 ÷ 140,000 = 1.64:1
Interpretation: Even excluding inventory, the company maintains ₦1.64 in liquid assets for every ₦1 of current liabilities, well above the 1:1 benchmark.
Cash Ratio: 180,000 ÷ 140,000 = 1.29:1
Interpretation: Cash and marketable securities alone cover 129% of current liabilities, demonstrating excellent immediate liquidity.
Calculated Leverage Ratios
Debt Ratio: 400,000 ÷ 630,000 = 0.63
Interpretation: Debt finances 63% of capital employed, indicating moderate leverage.
Debt-Equity Ratio: 400,000 ÷ 370,000 = 1.08:1
Interpretation: The company has ₦1.08 in debt for every ₦1 of equity, showing slightly more debt than equity financing.
Proprietary Ratio: 370,000 ÷ 690,000 = 0.54
Interpretation: Shareholders’ equity finances 54% of tangible assets, indicating reasonable equity cushion for creditors.
Comprehensive Analysis
Strengths: The company demonstrates excellent liquidity with all liquidity ratios exceeding industry benchmarks. Strong cash reserves provide financial flexibility. Profitability margins are reasonable, with nearly 19% of revenue flowing to net profit. Return on equity of 15.14% creates good shareholder value.
Areas for Improvement: Inventory management requires attention, as 262 days of inventory holding suggests potential inefficiencies. Collection periods of 122 days indicate opportunities to tighten credit policies or improve collection processes. Asset turnover ratios suggest the company could generate more revenue from its existing asset base.
Financial Risk Assessment: The debt-equity ratio of 1.08 indicates moderate leverage that appears manageable given the strong liquidity position. Interest coverage should be monitored to ensure debt service remains comfortable.
Strategic Recommendations: Management should focus on improving working capital management, particularly inventory turnover and receivables collection. Exploring ways to increase asset utilization could boost overall returns. The strong liquidity position provides opportunities for strategic investments or debt reduction to optimize the capital structure.
Frequently Asked Questions (FAQs)
What is the most important financial ratio for investors?
No single ratio provides a complete picture, but many investors prioritize Return on Equity (ROE) as it directly measures shareholder returns. However, comprehensive analysis requires examining multiple ratios across all categories: profitability, liquidity, activity, and leverage. Different investors may emphasize different ratios based on their investment strategy and risk tolerance.
What is a good current ratio for a company?
A current ratio of 2:1 is generally considered satisfactory, meaning the company has twice as many current assets as current liabilities. However, the ideal ratio varies by industry. Capital-intensive industries may operate successfully with lower ratios, while retail businesses might need higher ratios.
How do you calculate financial ratios from a balance sheet and income statement?
Financial ratios combine data from both statements. Profitability ratios typically use income statement figures (revenue, profit) divided by balance sheet items (assets, equity). Liquidity ratios use balance sheet current assets and liabilities. Activity ratios blend income statement sales with balance sheet asset figures. Always ensure you’re using consistent time periods and matching year-end balance sheet figures with corresponding income statement data.
What does a high debt-to-equity ratio indicate?
A high debt-to-equity ratio indicates the company relies heavily on borrowed funds relative to shareholder equity. While leverage can amplify returns during good times, it increases financial risk and fixed obligations. Ratios above 2:1 are generally considered high risk, though acceptable levels vary by industry. Capital-intensive industries typically carry higher debt loads than service businesses.
What is the difference between horizontal and vertical analysis?
Horizontal analysis compares financial data across multiple time periods to identify trends, growth rates, and changes over time. It answers “how have things changed?” Vertical analysis expresses each financial statement item as a percentage of a base figure to facilitate comparisons between companies of different sizes or across time periods. It answers “what’s the composition?”
How can financial statement analysis help in business decision-making?
Financial statement analysis provides objective data for critical business decisions including investment choices, credit extension, performance evaluation, budget planning, and strategic planning.
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