One of the key motives to conduct a basic financial analysis is to see and observe, from the financial perspectives, how a business organization is doing. In the following article, a set of brief guidelines and some essential formulas have been explained which would help you to make a brief financial statement analysis.
A financial statement is a document which denotes the status of the organization or a fraction of the organization, in monetary terms. Such statement is chiefly made up of 4 probable elements, assets, liabilities, incomes and expenditures. Incomes and expenditures essentially denote transactions, whereas the assets and liabilities are an inventory of what the organization owns and at the same time, owes. By examining these 4 aspects of the organization, it becomes quite easy to predict or derive how the business organization is doing. Furthermore, since the analysis is conducted by taking into consideration its monetary dimension, it becomes a comprehensive report of the financial statement.
What to Consider?
The following are some common rules of thumbs that you need to bear in mind while making a financial statement analysis:
- The assets should always exceed the liabilities, and if it is so, then the organization is safe and solvent. In cases where liabilities exceed assets, the organization is said to be insolvent.
- The income of the organization should exceed all the expenditures put together plus all current liabilities (liabilities payable before 12 months).
- Last but not the least, it is essential that one takes into consideration the element of time while making a basic financial statement analysis. The time period of the statements may be for a year, 6 months, 3 months, 1 month, a week and even a day. Hence some ratios and formulas (which have been mentioned below) may not be applicable.
Apart from the aforementioned considerations, you can also always, calculate and see whether a said operation is proving to be profitable for the business. All you need to do to arrive at a conclusion is subtract the expenditures from the income.
Ratios, Formulas and Calculations
One of the best, super solid, concrete and rational methods to assess the financial situation of any given business organization is to calculate ratios, percentages and derive comparative figures which give us a numerical value that indicates the comparison between two or more elements of the financial statements.
1. Profitability Ratios
Profitability ratios are the ones which compare the income and expenditures of the organization, comprehensively, thereby giving us the answer to the question, ‘are we running our business profitably?’. These ratios can also be used for one single transaction or an operation. These ratios can also be used for a time period including a single day or even an entire year.
|General Profit||Profit = Income (-) Expenditures||This ratio of course gives us the comprehensive earning of profit. It must be noted that incomes which are in bulk (such as payment for construction projects) and expenditures which have to be done in a single go (such as purchase of machinery) have their total value split and divided over a certain number of years.|
|Return on Assets||Return on Assets (ROA) = Net Income / Average Total Assets, where, average total assets = Assets at the start of the accounting period (+) Assets at the end of the accounting period / 2||This ratio talks of the utilization of assets and their contribution towards the income of business. This ratio is sometimes also calculated for one single asset to determine its contribution to income generation of the business.|
|Return on Equity||Return on Equity (ROE) = Net Income / Average Stockholders’ Equity, where Average Share Holders Equity = Equity at the Beginning of Accounting Period (-) Equity at the end of the accounting period / 2||This ratio talks of the contribution of the shareholder’s equity, towards net income. It indicates how much the equity of the company has earned.|
|Profit Margin||Profit Margin = Net Income / Sales||Sales is the overall income of the company and out of the proceeds of sales, expenditures of the company have to be paid off. The profit margin denotes the portion of sales revenue which is income and not the expenditure that needs to be paid off.|
|Earnings per share||Earnings Per Share (EPS) = Net Income / Number of Common Shares Outstanding||This ratio is a hybrid of the return on equity. Earnings per share indicates the earning of every common share or how much every share has contributed towards the income.|
|Return on Common Equity||Return on Common Equity (ROCE) = Net Income / Average Common Stockholders’ Equity, where Average Share Holders Equity = Common Stock at the beginning of accounting period (+) Common stock at the end of accounting period / 2||This ratio indicates the contribution and earning of the common stock towards the revenue of the business. It must be noted that common stock is a part of the company’s equity.|
2. Liquidity Ratios
Liquidity ratios are the ones which indicate the relation between liability, assets, income and expenditures. However, liquidity ratios are always centric to liabilities.
|Current Ratio||Current Ratio (CR) = Current Assets / Current Liabilities||The current ratio establishes the ratio between the assets and payable liabilities.|
|Quick Ratio||Quick Ratio (QR) = Quick Assets / Current Liabilities||A quick ratio indicates the relation between the quick assets (assets such as bank balance and cash) and current liabilities which have to be paid off with immediate effect.|
|Net Working Capital Ratio||Net Working Capital Ratio (NWCR) = Net Working Capital / Total Assets||This ratio signifies the relation between the assets and the working capital which has been invested in production. Such a ratio chiefly signifies the contribution of capital per every asset which is engaged in the production process.|
3. Operations or Activity Ratios
These ratios chiefly signify the ratios and relationships between the operations, income, expenditures, assets and liabilities.
|Asset Turnover Ratio||Asset Turnover Ratio = Sales / Average Total Assets||This ratio signifies the relation between the sales and the total assets which are engaged in the production process.|
|Accounts Receivable Turnover Ratio||Accounts Receivable Turnover Ratio (ARTR) = Sales / Average Accounts Receivable||Accounts receivable (debtors) always contribute to the sales of the business. This very ratio indicates the relation between the accounts receivable and their contribution to sales.|
|Inventory Turnover Ratio||Inventory Turnover Ratio (ITR) = Cost of Goods Sold / Average Inventories||An inventory is a very important contributor to the total assets and also to the production process. This ratio thus basically establishes a relation between sales and inventory, or in simpler words it talks of the contribution of inventories to the total sales.|
These ratios are not just the only ones which are used for financial analysis. Apart from these ratios, there are several more indicators such as financial graphs and comparative tables which are released by companies periodically, which would also help you to conduct a proper financial analysis.