Financial Statement

analysis/Leverage /Ratio analysis

Subhojit Chakraborty
Financial statement
What is financial statement.
• Financial statements are written records that convey the business activities and the financial
performance of an entity.
• The balance sheet provides an overview of assets, liabilities, and shareholders' equity as a snapshot in
time.
• primarily financial statements include the balance sheet, income statement, statement of cash flow, and
statement of changes in equity. Nonprofit entities use a similar but different set of financial statements.
• The income statement primarily focuses on a company’s revenues and expenses during a particular
period. Once expenses are subtracted from revenues, the statement produces a company's profit figure
called net income.
• The cash flow statement (CFS) measures how well a company generates cash to pay its debt obligations,
fund its operating expenses, and fund investments.
• The statement of changes in equity records how profits are retained within a company for future growth
or distributed to external parties.
• Financial statements are often audited by government agencies, accountants, firms, etc. to ensure
accuracy and for tax, financing, or investing purposes
Balance Sheet

• Asset

• Liability

• Share holders equity

Asset
• Cash and cash equivalents are liquid assets, which may include Treasury bills and certificates of
deposit.
• Accounts receivables are the amount of money owed to the company by its customers for the sale
of its product and service.
• Inventory is the goods a company on hand it intends to sell as a course of business. Inventory may
include finished goods, work in progress that are not yet finished, or raw materials on hand that
have yet to be worked.
• Property, plant, and equipment are capital assets owned by a company for its long-term benefit.
This includes buildings used for manufacturing for heavy machinery used for processing raw
materials.
• Investments are assets held for speculative future growth. These aren't used in operations; they
are simply held for capital appreciation.
• Trademarks, patents, goodwill, and other intangible assets can't be physically be touched but have
future economic (and often long-term benefits) for the company.
Liability
• Accounts payable are the bills due as part of the normal course of operations of
a business. This includes the utility bills, rent invoices, and obligations to buy
raw materials.
• Wages payable are payments due to staff for time worked.
• Notes payable are recorded debt instruments that record official debt
agreements including the payment schedule and amount.
• Dividends payable are dividends that have been declared to be awarded to
shareholders but have not yet been paid.
• Long-term debt can include a variety of obligations including sinking bond funds,
mortgages, or other loans that are due in their entirety in longer than one year.
Note that the short-term portion of this debt is recorded as a current liability.
Shareholders' Equity

• Shareholders' equity is a company's total assets minus its total liabilities.

Shareholders' equity (also known as stockholders' equity) represents the
amount of money that would be returned to shareholders if all of the assets
were liquidated and all of the company's debt was paid off.

• Retained earnings are part of shareholders' equity and are the amount of net
earnings that were not paid to shareholders as dividends.
Balance sheet Format
Profit and Loss
• Operating Revenue
• Other Income/Non Operating Income
• Cost of Goods sold
• Direct Expenses
• Indirect Expenses
• Income Tax
• Dividend
• EBITDA
• EBITD
• EBIT
• EBT
• EAT/PAT
• Divisible profit.
• EPS
Operating Revenue
• Operating revenue is the revenue earned by selling a company's products or
services.

• The operating revenue for an auto manufacturer would be realized through the
production and sale of autos.

• Operating revenue is generated from the core business activities of a company.

 Other Income/Non Operating Income

• Non-operating revenue is the income earned from non-core business activities

• Non-operating revenue is the income earned from non-core business activities.

• Example of non operating income 1.Interest earned on cash in the bank,

2.Rental income from a property, 3.Income from strategic partnerships
like royalty payment receipts, 4.Income from an advertisement display located
on the company's property
 Cost of Goods sold

• Primary expenses are incurred during the process of earning revenue from the primary activity of
the business.
• Cost of Goods Sold (COGS) represents all costs involved in producing goods that a company
sells over a certain period of time. The cost of goods sold, also known as the cost of services or
the cost of sales, includes both the cost of materials used to create the goods, and the cost of
direct labor (employees salaries)
• COGS = beginning inventory + purchases+ Direct labor – ending inventory.
• Beginning inventory: this is the company’s inventory from the previous period. It could be the
previous quarter, month, year, etc.
• Purchases: these are the total costs of what your company purchased during the specified
accounting period.
• Labor:- Direct Labor.
• Ending inventory: the inventory that remained during that period.
Direct Expenses
• Direct Expenses:- Direct Expenses are those expenses which are related to
manufacturing or production or trading.

• Indirect expenses:- Indirect expenses are those expenses which are not related to the
main activity of the business but very essential to run the business.

• Income Tax:- Income tax is government expenses.

• Dividend:-Dividend refers to a reward, cash or otherwise, that a company gives to its

shareholders. Dividends can be issued in various forms, such as cash payment, stocks
or any other form. A company's dividend is decided by its board of directors and it requires
the shareholders' approval.
Relationship Building between all
the accounting Profit
• Gross Profit= Revenue-Cost of Goods Sold-Direct Expense.
• Net Profit=Gross Profit-operational expenses.
• EBITDA(Earning before interest tax depreciation and amortization)
• EBITD=EBITDA-Amortization.
• EBIT=EBITD-Deprecation.
• EBT=EBIT-interest.
• PAT=EBT-Tax.
• Divisible profit=PAT-General reserve-specific reserve-preference dividend
• EPS=Divisible profit/Number of share.
Profit and Loss Format
Cash Flow
• A cash flow statement summarizes the amount of cash and cash equivalents
entering and leaving a company.
• The CFS highlights a company's cash management, including how well it
generates cash.
• This financial statement complements the balance sheet and the income
statement.
• The main components of the CFS are cash from three areas: Operating
activities, investing activities, and financing activities.
• The two methods of calculating cash flow are the direct method and the indirect
method.
Cash flow from operating activity
The operating activities on the CFS include any sources and uses of cash from business activities.
In other words, it reflects how much cash is generated from a company’s products or services.
• These operating activities might include.
• Receipts from sales of goods and services.
• Interest payments.
• Income tax payments.
• Payments made to suppliers of goods and services used in production.
• Salary and wage payments to employees.
• Rent payments.
• Any other type of operating expenses.
In the case of a trading portfolio or an investment company, receipts from the sale of loans, debt, or
equity instruments are also included because it is a business activity.
Changes made in cash, accounts receivable, depreciation, inventory, and accounts payable are
generally reflected in cash from operations.
Cash flow from Investing Activity
• Investing activities include any sources and uses of cash from a company’s investments.
Purchases or sales of assets, loans made to vendors or received from customers, or any
payments related to mergers and acquisitions (M&A) are included in this category. In
short, changes in equipment, assets, or investments relate to cash from investing.

• Changes in cash from investing are usually considered cash-out items because cash is
used to buy new equipment, buildings, or short-term assets such as marketable
securities. But when a company divests an asset, the transaction is considered cash-in for
calculating cash from investing.
Cash flow from Financing activity
• Cash from financing activities includes the sources of cash from investors and banks, as
well as the way cash is paid to shareholders. This includes any dividends, payments for
stock repurchases, and repayment of debt principal (loans) that are made by the
company.

• Changes in cash from financing are cash-in when capital is raised and cash-out when
dividends are paid. Thus, if a company issues a bond to the public, the company receives
cash financing. However, when interest is paid to bondholders, the company is reducing
its cash. And remember, although interest is a cash-out expense, it is reported as an
operating activity—not a financing activity.
Direct Method of Cash flow
• The direct method adds up all of the cash payments and receipts, including cash paid to
suppliers, cash receipts from customers, and cash paid out in salaries. This method of
CFS is easier for very small businesses that use the cash basis accounting method.

• These figures can also be calculated by using the beginning and ending balances of a
variety of asset and liability accounts and examining the net decrease or increase in the
accounts. It is presented in a straightforward manner.
Format of Cash flow direct Method
Indirect Method of cash flow
• With the indirect method, cash flow is calculated by adjusting net income by adding or subtracting differences
resulting from non-cash transactions. Non-cash items show up in the changes to a company’s assets and
liabilities on the balance sheet from one period to the next. Therefore, the accountant will identify any
increases and decreases to asset and liability accounts that need to be added back to or removed from the net
income figure, in order to identify an accurate cash inflow or outflow.
• Changes in accounts receivable (AR) on the balance sheet from one accounting period to the next must be
reflected in cash flow.
• If AR decreases, more cash may have entered the company from customers paying off their credit accounts—
the amount by which AR has decreased is then added to net earnings.
• An increase in AR must be deducted from net earnings because, although the amounts represented in AR are
in revenue, they are not cash.
• An increase in inventory signals that a company spent more money on raw materials. Using cash means the
increase in the inventory's value is deducted from net earnings.
• A decrease in inventory would be added to net earnings. Credit purchases are reflected by an increase in
accounts payable on the balance sheet, and the amount of the increase from one year to the next is added to
net earnings.
• A decrease in inventory would be added to net earnings. Credit purchases are reflected by an increase in
accounts payable on the balance sheet, and the amount of the increase from one year to the next is added to
net earnings.
Format of Cash flow Indirect
Method
Limitation of cash flow
• Negative cash flow should not automatically raise a red flag without further analysis.
Poor cash flow is sometimes the result of a company’s decision to expand its business
at a certain point in time, which would be a good thing for the future.
• Analyzing changes in cash flow from one period to the next gives the investor a better
idea of how the company is performing, and whether a company may be on the brink
of bankruptcy or success. The CFS should also be considered in unison with the other
two financial statements
Leverage
What is Leverage
• Leverage refers to the use of an asset or source of funds for which the enterprise has to pay a
fixed cost or fixed return
• In other words, it refers to a relationship between two variables. Such variables include cost,
output, sales, revenue, earnings before interest and taxes (EBIT), or earnings per share
(EPS), among others.
• If an enterprise can estimate how much capital is needed, the next task is to determine the
optimal mix of fundraising sources. This process is called capital structure planning.
• In leverage analysis, the emphasis is on measuring the relationships between two variables rather
than the variables themselves.
• leverage analysis to serve a useful purpose, the two variables for which the relationship is to be
established and measured should be interrelated. If the variables are not interrelated, leverage
analysis won’t serve a purpose.
• leverage analysis to serve a useful purpose, the two variables for which the relationship is to be
established and measured should be interrelated. If the variables are not interrelated, leverage
analysis won’t serve a purpose.
 Example of Leverage
• Suppose that a company boosts its advertising expenses from $100,000 to $120,000. This is an increase of
20%.Due to the advertising spend, the company increased its units sold from 500 to 750 units, representing an
increase of 50%.

• In this example, leverage is calculated as

• Here, the percentage increase in the number of units sold is 2.5 times that of the percentage increase in
advertising expenses. This illustrates that the leverage is favorable.

• In particular, it means that a lower percentage increase in the variable cost has resulted in a higher
percentage increase in sales, which is bound to enhance earnings.

• This reflects that the operating profit of an enterprise is directly influenced by sales revenue.
Type of leverage
• Financial Leverage
• Financial leverage is the use of debt in combination with equity in capital structure. Managers
may decide to take on more debt than the proportionate amount in order to increase EPS. The
degree of financial leverage shows how much the EBIT changes if there is a certain change in
sales revenue after deducting the component of interest. Financial leverage increases
Operating Leverage and, consequently, increases Contribution Margin as well.
• Operating Leverage
• Operating Leverage is the degree to which a firm’s EBIT changes if there is a certain change in
sales revenue after deducting the component of interest. Operating Leverage shows how much
an increase or decrease in sales revenue affects the EBIT post-sales interest. The greater the
Operating Leverage, the higher is the proportion of fixed cost in total cost structure.
• Combined Leverage
• Combined leverage shows how much an increase or decrease in sales revenue affects net
income after deducting taxes and interest charges. It compares EBIT and EPS changes due to
a certain change in sales revenue. The greater the combined leverage, the higher is EBIT as a
percentage of sales revenue.
Formulas Used in Leverage
• Operation Leverage:- Contribution/EBIT(Contribution=Sales-Variable cost).

• Degree of operating leverage=% change in EBIT/% change in Sales revenue.

• Financial Leverage=EBIT/EPS.

• Degree of financial leverage=%EPS/% change in EBIT.

• Combined leverage=Operating Leverage*Financial Leverage

 How to Evaluate the Result of Leverages

• High operating leverage and high financial leverage: This situation suggests high risk. Any slight change in
sales or contribution may affect the EPS to a large extent. Managers should avoid such situations.
• High operating leverage and low financial leverage: In this situation, the existence of high fixed costs may
affect EBIT, if there is a slight decrease in sales or contribution. This slight change may be addressed with
low-cost debt.
• Low operating leverage and high financing leverage: This situation is potentially ideal because the
company has risked borrowing more debt capital to increase EPS. Any slight decrease in sales or contribution
may not affect EBIT to a large extent, given that the component of fixed cost is negligible in the cost structure.
• Low operating leverage and low financial leverage: This situation indicates that managers are following a
very cautious policy. This is also known as the policy of contentment. Any slight decrease in sales or
contribution may not affect the EBIT to a large extent because the fixed cost component is negligible in the
overall cost structure. Also, the manager has not taken a significant risk in formulating the capital structure.
• Combined leverage: When making decisions based on combined leverage, managers should be cautious to
note the influence of operating and financial leverages. If the influence of the financial leverage is slightly high,
the result of the combined leverage may be taken for a positive decision.
 Financial Statement
analysis/Ratio Analysis
What is ratio analysis.
• Ratio analysis compares line-item data from a company's financial statements to reveal
insights regarding profitability, liquidity, operational efficiency, and solvency.

• Ratio analysis can mark how a company is performing over time, while comparing a
company to another within the same industry or sector.

• Ratio analysis may also be required by external parties that set benchmarks often tied to
risk.

• Higher ratio results are often more favorable, but these ratios provide much more
information when compared to results of similar companies, the company's own historical
performance, or the industry average.
Insight of ratio analysis
• Comparative data can demonstrate how a company is performing over time and can be
used to estimate likely future performance.

• Ratio analysis data can also compare a company's financial standing with industry
averages while measuring how a company stacks up against others within the same
sector.

• Investors can use ratio analysis easily, and every figure needed to calculate the ratios is
found on a company's financial statements.
Different types of Ratio Analysis
• Liquidity Ratios.

• Leverage Ratio.

• Valuation Ratios.

• Performance Ratios/Profitability Ratio.

• Activity Ratios
Liquidity Ratios
• Operating Cash Flow Margin = Cash from operating activities / Sales Revenue
The operating cash flow margin indicates how efficiently a company generates cash flow
from sales and indicates earnings quality.

• Cash Ratio = (Cash + Cash Equivalents) / Total Liabilities

The cash ratio will give you the amount of cash a company has compared to its total
assets.

• Quick Ratio = (Current Assets – Inventory) / Current Liabilities

The quick ratio, aka acid-test ratio, will assess a company’s marketable securities,
receivables, and cash against its liabilities. This gives you an idea about the company’s
ability to pay for its current obligations.

• Current Ratio = Current Assets / Current Liabilities

The current ratio will give you an idea about how well the company can meet its financial
obligations in the coming 12 months.
Key takeaways for liquidity ratio
• Liquidity ratios are an important class of financial metrics used to determine a debtor's
ability to pay off current debt obligations without raising external capital.

• Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.

• Liquidity ratios determine a company's ability to cover short-term obligations and cash
flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts
Leverage Ratio.

Debt Ratio = Total Debt / Total Assets

The debt ratio compares a company’s debt to its assets as a whole.

Interest Coverage Ratio = Earnings Before Interest and Tax / Interest Expense
The interest coverage ratio gives insights into a company’s ability to handle the interest
payments on its debts.

Debt to Equity Ratios = Total Liabilities / Total Shareholders’ Equity

A debt-to-equity ratio compares a company’s overall debt to its investor supplied capital.
Key takeaways for Leverage ratio
• A solvency ratio examines a firm's ability to meet its long-term debts and obligations.

• The main solvency ratios include the debt-to-assets ratio, the interest coverage ratio, the
equity ratio, and the debt-to-equity (D/E) ratio.

• Solvency ratios are often used by prospective lenders when evaluating a company's
creditworthiness as well as by potential bond investors.

• Solvency ratios and liquidity ratios both measure a company's financial health but
solvency ratios have a longer-term outlook than liquidity ratios.
Valuation Ratios.

• Price to Earnings Ratio (P/E) = Price per share / Earnings per share
P/E is one of the most commonly used financial ratios among investors to determine whether the company is
undervalued or overvalued. The ratio indicates what the market is willing to pay today for a stock based on its past
or future earnings.

• Price to Earnings Ratio (P/E) = Price per share / Earnings per share
P/E is one of the most commonly used financial ratios among investors to determine whether the company is
undervalued or overvalued. The ratio indicates what the market is willing to pay today for a stock based on its past
or future earnings.

• PEG Ratio = Price to Earnings / Growth Rate

The PEG ratio is a valuation metric for determining the relative trade-off between the stock price, earnings per share,
and a company’s expected growth. It makes it easier to compare high growth companies that tend to have a high
P/E ratio to mature companies that have a lower P/E. It is thus a better indicator of the stock’s true value.

• Price to Sales Ratio (P/S) = Market Capitalization/Total Revenue

A P/S ratio compares a company’s market capitalization against its sales for the last 12 months. It is a measure of
the value investors are receiving from the company’s stock by indicating how much they are paying for shares per
dollar of the company’s overall sales.
Performance/Profitability Ratios

• Return on Equity = Net Income / Shareholders’ Equity

ROE is also the return on net assets, as shareholders’ equity is the total assets minus debt.

• Return on Assets = Net Income / Total Assets

ROA measures the efficiency of a company in generating earnings from its assets.

• Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue

A gross profit margin ratio will tell you the relation between the company’s gross sales and profits.

• Operating Profit Margin = Operating Profit / Revenue

Operating profit margin indicates a company’s profit margin before interest payments and taxes.

• Net Profit Margin = Net Profit / Revenue

Net profit margin indicates a company’s net margins. A high net profit margin is a good indication of an efficient
business.
Key takeaways for
Performance/Profitability ratio
• Profitability ratios assess a company's ability to earn profits from its sales or operations,
balance sheet assets, or shareholders' equity.

• Profitability ratios indicate how efficiently a company generates profit and value for
shareholders.

• Higher ratio results are often more favorable, but these ratios provide much more
information when compared to results of similar companies, the company's own historical
performance, or the industry average.
 Turnover ratio

• Inventory turnover = Net Sales / Average Inventory at Selling Price

This ratio can indicate how efficient the company is at managing its inventory. A high ratio implies either strong
sales or insufficient inventory.

• Receivables turnover = Net Sales / Average accounts receivable

Receivables turnover indicates how quickly net sales are turned into cash.

• Payables turnover = Total supply purchase / Average Accounts Payable

Accounts payable turnover ratio is a short-term liquidity measure that shows how many times a company pays off
its accounts payable during a period, and indicates short term liquidity.

• Payables turnover = Total supply purchase / Average Accounts Payable

Accounts payable turnover ratio is a short-term liquidity measure that shows how many times a company pays off
its accounts payable during a period, and indicates short term liquidity.

• Total asset turnover = Net Sales / Average Total Assets

Fixed asset turnover measures how efficiently a company is using its assets to generate sales
Limitation of Ratio analysis
• Historical Costs

• Inflation Adjustments

• Personal Judgments

• Specific time period of Reporting

• Intangible Assets

• Comparability

• Fraudulent Practices

• No Discussion on Non-Financial Issues

• It May Not be Verified

• Future Prediction