Back to: Financial Accounting
Hello everyone!
In Week 1, we’re diving into Financial Statement Analysis. Understanding how to analyse and interpret financial statements is crucial for assessing the performance and financial health of a business. We’ll go through key analysis techniques and important financial ratios that can give insights into a company’s performance.
Financial Statement Analysis
What is Financial Statement Analysis?
Financial Statement Analysis involves examining and evaluating a company’s financial reports (Income Statement, Balance Sheet, and Cash Flow Statement) to assess its performance, profitability, liquidity, and overall financial health. Analysts use this information to make informed decisions, whether they are investors, managers, or creditors.
The goal of financial statement analysis is to interpret financial data in a way that helps stakeholders understand a company’s strengths, weaknesses, and future prospects.
Key Types of Financial Statements
The main financial statements used in analysis are:
Income Statement: Reflects a company’s performance over a period, showing revenues, expenses, and profits.
Balance Sheet: Shows a company’s assets, liabilities, and shareholders’ equity at a specific point in time.
Cash Flow Statement: Provides insight into the cash inflows and outflows from operating, investing, and financing activities.
Types of Financial Ratios
There are several ratios used to evaluate financial performance, grouped into categories based on the area of performance they measure.
Profitability Ratios
These ratios measure a company’s ability to generate profit relative to its revenue, assets, or equity.
Gross Profit Margin: Measures the percentage of revenue that exceeds the cost of goods sold (COGS).
Formula:
Gross Profit Margin=Gross ProfitRevenue×100{Gross Profit Margin} = {Gross Profit}} {Revenue} x 100
Example: If a company has a gross profit of N150,000 and revenue of N500,000:
150,000500,000×100=30%(Gross Profit Margin) {150,000}{500,000} \times 100 = 30\% \quad {(Gross Profit Margin)}
Net Profit Margin: Measures the percentage of revenue that results in profit after all expenses.
Formula:
Net Profit Margin=Net ProfitRevenue×100{Net Profit Margin} = {Net Profit} {Revenue}} x 100
Liquidity Ratios
Liquidity ratios measure a company’s ability to meet its short-term obligations.
Current Ratio: Measures whether the company has enough assets to cover its short-term liabilities.
Solvency Ratios
These ratios assess a company’s ability to meet its long-term debts.
Debt to Equity Ratio: Measures the proportion of debt used to finance the company compared to equity.
Efficiency Ratios
Efficiency ratios measure how well the company uses its assets.
Asset Turnover Ratio: Measures how effectively a company uses its assets to generate revenue.
Example of Financial Statement Analysis
Let’s assume we have the following data for a company:
Revenue: N600,000
Cost of Goods Sold (COGS): N250,000
Net Profit: N50,000
Total Assets: N1,200,000
Current Assets: N400,000
Current Liabilities: N250,000
Total Debt: N500,000
Total Equity: N700,000
Now, let’s calculate some key ratios:
Gross Profit Margin:
600,000−250,000600,000×100=58.33%\frac{600,000 – 250,000}{600,000} \times 100 = 58.33\%
Net Profit Margin:
50,000600,000×100=8.33%\frac{50,000}{600,000} \times 100 = 8.33\%
Current Ratio:
400,000250,000=1.6\frac{400,000}{250,000} = 1.6
Debt to Equity Ratio:
500,000700,000=0.71\frac{500,000}{700,000} = 0.71
These ratios help stakeholders understand the company’s profitability, liquidity, and financial structure.
Limitations of Financial Statement Analysis
While financial ratios are useful, there are some limitations:
Historical Data: Financial statements reflect past performance, which may not necessarily indicate future performance.
Accounting Methods: Different companies may use different accounting methods, making direct comparisons difficult.
Non-Financial Factors: Financial statements do not consider non-financial factors, such as market conditions, management quality, or brand reputation.