Analysing the Financial Statements

MUMBAI, India - Jan. 11, 2017 - PRLog -- In everything right from your school to sports, you've probably been judged with your results. At the end of class/semester or game, you get either a grade or a score. And that grade or score measures how poor or good you have performed. And then that grade or score is benchmarked against your peers.

When you measure the success of a company, you really don't do anything differently than when you analyze the results of last night's T-20 game. Fundamental analysis of a company helps you to understand how well the company did (profitability), if the business position is solvent (liquidity and capital structuring) and if the management is running the business efficiently (using assets of company to generate sales and returns).

Financial statements provide useful financial information for the purpose of decision-making. However, these statements provide the absolute numbers, which are not sufficient to predict, compare and evaluate the entity's earnings ability. To evaluate and analyze the performance of a company, analysts do certain calculations and derive different ratios and multiples. The relationship between two or more accounting figures is called a financial ratio. The ratio analysis is based on the fact that a single accounting figure by itself may not communicate any meaningful information but when expressed as a relative to some other figure, it definitely provides some significant information. E.g. a net profit figure of $60,000 does not throw any light as to how the company has performed. However, net profit ratio of 20% on sales of $300,000 helps in analyzing performance of the company.

Ratios look at the relationships between individual values, and relate them to how a company has performed in the past, and might perform in the future. Financial ratios allow the analyst to assess and analyze the strengths and weaknesses of a given company with regard to such measures as liquidity, performance, profitability, leverage and growth, on an absolute basis and by comparison to other companies in its industry or to an industry standard.

  Measuring Performance With Ratios

The core objective of the financial statements analysis is to understand and evaluate the performance of the company – historically and with peer group companies. Performance of a company can be measured in terms of:

A) Profitability

Profitability can be measured in terms of profit margins – gross margin, operating margin (EBIT or EBITDA), net margin and EPS.

B) Solvency/Liquidity

Solvency position of the company can be assessed with working capital or liquidity ratios that help in understanding the ability of the company to meet short-term liabilities. The key ratios include current ratio, quick ratio and cash ratio

C) Debt Management

Debt management by the company can be calculated understanding the capital structure of the company and its ability to meet debt related obligations. The key ratios include debt to equity ratio, net debt to EBITDA ratio, interest coverage ratio and debt service coverage ratio.

D) Efficiency

Here we are interested in understanding the effectiveness and efficiency of the management in using the funds invested in the business. Return on equity and capital employed, assets turnover ratios and operating cash conversion cycle of the company play an important role in assessing the efficiency of the company.

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