Use of ratio analysis and interpretation of financial statements

Use of ratio analysis and interpretation of financial statements

Finance and Financial Statement Analysis is a topic carrying 6% weightage as per the latest (2020) syllabus published by the Insolvency and Bankruptcy Board of India (IBBI) valuation examination for securities or financial assets (SFA). The syllabus can be found here > The areas tested include basics of finance, time value of money and ratio analysis.

This is a topic which professionals such as Chartered Accountant or Cost Accountant would find it easy. Students with a weak accounting background should first revise basic accounting such as preparation of financial statements. A thorough understanding of the terms of items appearing on the Balance Sheet viz current assets, inventory, investments etc is necessary. Financial Statement Analysis builds on top a thorough knowledge of book keeping/accounting and financial statement preparation techniques.

In this article we will give you a brief overview of the topic covered under the valuer’s examination.

Financial Statement Analysis

Companies show their financial performance by preparing and presenting financial statements. The users of these statements may be investor, creditors, or any other third party. The purpose of financial statement analysis is to use the data of a company’s financial statements, alongside other relevant information, to form economic decisions. Examples of such decisions include whether to open a position within the company’s securities or recommend them to investors and whether to increase trade or bank credit to the corporate.

Analysts use financial data to gauge a company’s past performance and current financial position so as to formulate opinions about the company’s ability to earn profits and generate cash flow in the future. There are four main financial statements that every company has to compute and publish. They are the balance sheet, income statement, cash flow statement and the statement of changes in equity. Analysts utilize the data from the financial statements to derive ratios which they can use to understand the strengths and weaknesses of the company relative to itself and to its competition.

The balance sheet reports the firm’s financial position at a specific time. The balance sheet consists of three elements consisting of assets, which are the resources used by the company to generate revenue, liabilities are amounts owed to lenders and other creditors, and owners’ equity which is the residual interest within the net assets of an entity that results after deducting its liabilities from its assets.

The statement of comprehensive income reports all changes in equity apart from shareholder transactions. The income statement report, also referred to as the statement of operations or the profit and loss statement, reports on the financial performance of the firm in a specific time frame. The elements of the income statement report include revenues, expenses, and gains and losses.

The statement of changes in equity reports the amounts and sources of changes in equity investors’ investment within the firm in a specific time frame. The statement of cash flows reports the company’s cash receipts and payments.

Now let’s get a bit more immersed on this matter. Since forecasts of future earnings, and thus estimates of firm value, depend crucially on understanding a firm’s income report. Some of the items requiring calculation include depreciation, COGS, and inventory under different cost flow assumptions, as well as basic and diluted EPS. The separation of things into operating and non-operating categories is vital when estimating recurring income as a primary step in forecasting future firm earnings. Note that this data is vital and they have effects on financial ratios.

The statement of comprehensive income reports the revenues and expenses of the firm over a specific time frame. The income statement is sometimes referred to as the statement of operations, the statement of earnings, or the profit and loss statement (P&L).

Earnings per share (EPS) ratio is one among the foremost used corporate profitability performance measures for publicly-traded firms. EPS is reported just for shares of common shares which are also referred to as ordinary stock.

A vertical common-size income statement report expresses each category of the income report as a percentage of revenue. The common-size format standardizes the income statement by eliminating the factor of size and time, making comparisons easier.

While the income statement presents a picture of a firm’s economic activities over a period of time, its balance sheet is a snapshot of its financial and physical assets and its liabilities at a point in time. Understanding balance sheet accounts, how they're valued, and what they represent, is crucial to the financial analysis of a firm. Again, different choices of accounting methods and different accounting estimates will affect a firm’s financial ratios, and an analyst must be careful to make the necessary adjustments in order to compare two or more firms. Special attention should be paid to the methodology by which each item is recorded and calculated, and the way the changes in the balance sheet values reflect on the income statement and to shareholders’ equity.

One usage of a balance sheet may be to assess a firm’s liquidity, solvency, and the possibility to pay dividends to shareholders. From the company’s perspective, liquidity is the capability to satisfy short-term obligations and solvency is the capability to satisfy long-term obligations. A vertical common-size balance sheet expresses each of its items as a percentage of total assets. The common-size format standardizes the balance sheet by eliminating the factor of size and time, making comparisons easier.

Liquidity ratios measure the firm’s ability to satisfy its short-term obligations as they are due. Liquidity ratios include the current ratio, the quick ratio, and last but not least, the cash ratio. Although all three ratios measure the firm’s ability to pay current liabilities, they should be considered collectively. For example, assume Firm A features a higher current ratio but a lower quick ratio as compared to Firm B. This is the result of higher inventory as compared to Firm B. The quick ratio, also referred to as the acid-test ratio, is calculated by excluding inventory from current assets. Similar analyses are often performed by comparing the quick ratio and the cash ratio. The cash ratio is calculated by subtracting inventory and receivables.

Solvency ratios measure the firm’s ability to satisfy its long-term obligations. Solvency ratios include the long-term debt-to-equity ratio, the total debt-to-equity ratio, the debt ratio, and lastly the financial leverage ratio. Even though all four ratios measure solvency, it is best to utilize all of them together in order to get the most accurate opinion. For example, the data from Firm A may indicate a larger long-term debt-to-equity ratio but a smaller total debt-to-equity ratio as compared to Firm B. This is a sign that Firm B is utilizing more short-term debt to finance itself. When calculating solvency ratios, debt is defined as being any interest-bearing obligation. Meanwhile, the financial leverage ratio captures the impact of all obligations, both interest bearing and non-interest bearing.

Hopefully this was interesting to you. Remember that the syllabus for the IBBI valuation examination accords a 6% weightage to this area. It is not helpful to say that this is just ratio analysis. Without a thorough understanding of the basics of accounting and financial statement preparation, scoring in this area is hard. Chartered Accountants and Cost Accountants have a definite advantage in this area. For the rest, a bit of accounting refresher would be helpful before proceeding to financial statement analysis.

But do keep in mind that the IBBI does not expect you to prepare financial statements. A valuer’s job is to interpret and analyze financial statements prepared by management. The Insolvency and Bankruptcy Board of India (IBBI) valuation examination is a test of interpretation and analysis of financial statement by applying ratio analysis. An understanding of balance sheet terms and the meaning of the ratios will help one score well in this area.