Financial Statement Analysis

Analysing the financial statements of a company is no mean task. The good news, though, is that all you really need is passing knowledge of arithmetic (the calculator can take care of that, can't it??) and a whole lot of common sense.

An important technique used by number crunchers is ratio analysis. So this post introduces you to ratio analysis. As we always do, will will stick to the simple ones.

Although ratios can be classified in many ways, they are popularly classified into four categories: Liquidity Ratios, Solvency Ratios, Performance Ratios, and Profitability Ratios.

Liquidity Ratios
These ratios test the company's liquidity. Can the company repay it's short-term obligations? Does the company have adequate liquid reserves (like cash)? The following ratios fall under this category:

Current Ratio = Current Assets / Current Liabilities
(A current ratio of 2:1 is considered ideal)

Quick Ratio = (Current Assets - Inventory) / Current Liabilities
(A quick ratio of 1:1 is considered ideal)

Solvency Ratios
These ratios measure the relative interests of the owners and creditor of the company. These ratios focus on long-term solvency.

Debt-Equity Ratio = Long-Term Debt / Shareholders' Equity
(A debt-equity ratio of 2:1 is considered ideal)

Solvency Ratio - Total Assets / Total Liabilities
(Higher the ratio, the stronger is the company's financial position)

Debt Service Coverage Ratio = EBIT / (Interest on Debt + Pre-tax Principal Repayment)
(Higher the ratio, the stronger is the company's financial position)

Performance Ratios
These ratios measure the performance of the company in terms of levels of activity and usage of facilities available.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
(Here Average Stock = (Opening Inventory + Closing Inventory) / 2)
(An inventory turnover of 8 times is considered ideal)

Total Assets Turnover Ratio = Net Sales / Total Assets
(Total asset turnover of at least 2 times is considered ideal)

Profitability Ratios
These ratios measure the profitability of the company.

Net Profit Ratio = Net Profit / Net Sales
(The higher the ratio, more profitable is the company)

Earnings Per Share (EPS) = Profit After Tax / Number of Equity Shares
(The more the better)

Price Earnings Ratio (PE) = Market Price per Share / EPS
(The higher the better. But one must watch out for overpricing of shares)