What is Financial Analysis?
Financial analysis is defined as an assessment of the viability, stability and profitability of a business, sub-business or a project (Source: Wikipedia). Financial analysis is used by decision makers to assess the economic and financial situation of a business. Financial analysis mostly relies on analyzing and interpreting a variety of financial ratios that make use of information taken from the company’s financial statements.
The Basis: Financial Statements
Financial analysis bases on the analysis of the company’s financial statements as per the yearly period end or interim accounts. These statements are the record or report of all the financial activities and standing of a business or entity. It is created in a structured and managed manner which will make it easy to understand.
There are 3 main financial statements.
- Balance Sheet – Also known as statement of financial position, showcases the company’s assets, liabilities and owner’s equity at a given point in time.
- Income Statement – Also known as statement of comprehensive income, statement of revenue and expense, P&L or profit and loss report. This showcases the record of a company’s income, expenses, profits or loss over a period of time.
- Cash Flow Statement – As straightforward as its name implies, it reports on all the cash flow activities, especially its operating, investing and financing activities. It is used to understand the movements of cash and especially where the cash has been used or generated.
Additional sources of information can be the footnotes provided in the appendix to such financial statements or management accounts.
Financial Analysis now seeks to better understand the financial statements by investigating the company’s financial situation around the following topics:
- Liquidity – positive cash flow for immediate obligations [cash flow statement]
- Profitability – yield capability in both short and long term [income statement]
- Solvency – debt payment capability to creditors and third parties in the long term [balance sheet]
- Stability – remain in business in the long run without losses [all financial statements]
Important Financial Ratios used in Financial Analysis
Below we provide some of the most relevant financial ratios which can be used to analyze nearly any business:
- Current Ratio – Also known as the working capital ratio, is used to measure a company’s repayment ability in short-term and long-term debts. Basically, this ratio is used to ensure if the company is capable of paying its liabilities both short-term and long-term. To better understand how the current ratio is calculated, use the formula: Current Ratio = Current Assets / Current Liabilities
- Quick Ratio – Also known as the acid-test ratio, is used to measure a company’s ability to pay its short-term debts using its most liquid assets. This ratio focuses more to measure if the company is capable of paying its liabilities in a short-term using liquid assets, which means inventories are excluded from the current assets. The formula to calculate the quick ratio is: Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
- Cash Ratio – This ratio is used to measure a company’s ability to pay its short-term liabilities using only cash and cash equivalents on hand. Testing a company’s ability whether it can handle paying the full brunt amount of all current debts immediately without having to resort to liquidating any assets. The formula to derive the cash ratio is: Cash Ratio = (Cash + Cash Equivalents) / Total Current Liabilities
- Days in Receivable – Commonly known as Days Sales Outstanding (DSO), is used to calculate the estimation of a company’s average collection period. Basically, this will represent a company’s management condition of their accounts receivables. The formula to calculate DSO is : Days in Receivable = (Accounts Receivable / Annual Sales) * 365 days
- Days in Inventory – Commonly known as Days’ Sales in Inventory (DSI), is used to measure the average number of days a company was able to sell the average number of inventories they held during that time period of a year. Basically, this will serve as proof of a company’s ability to turn its inventory into sales. The formula to calculate DSI is: Days Sales of Inventory = (Inventory / Cost of Sales) x 365 days
- Days in Payable – Commonly known as Days Payable Outstanding (DPO), is used to measure a company’s ability to pay its invoices or bills to its suppliers, vendors or creditors. The ratio derived from this will be the company’s average payable period, depicting a company’s proper management of its cash flows in a given number of days to pay off its account payables. To calculate the DPO, this formula is used: Days Payable Outstanding = (Ending Accounts Payable / Cost of Sales) * Number of Days
- Debt / EBITDA – refers to the relationship between Debt to Earnings before Interest Depreciation and Amortization. A ratio leverage measurement to calculate how long it would take for a company to pay back its debt if its Debt/ EBITDA are held constant. This is the formula to calculate this ratio: Debt / EBITDA Ratio = Debt / EBITDA
- Interest Coverage Ratio. It is a ratio to measure a company’s credit-worth both by rating agencies and in debt-financed takeovers. Basically, this is to ensure that the company can pay their interest expenses on its outstanding debt by comparing how many times EBIT is covering the interest expenses.. The formula to calculate this ratio is as simple as how it looks: Interest Coverage Ratio = EBIT / Interest Expense
- Debt to Equity – This ratio is used to assess the company’s debt to finance its assets relative to the value of the shareholders equity. Basically, this ratio will help measure a company’s debt relative to the total value of its stock. To calculate the D/E ratio, this is the formula: Debt / Equity Ratio = Total Liabilities / Shareholder’s Equity
- Debt to Total Assets – This ratio is used to assess the total percentage of all assets that were financed by creditors, liabilities, or debt. This is actually a broad ratio since it includes short-term and long-term debts, as well as both tangible and intangible assets. Hence, analysts often prefer using Debt to Equity instead of Debt to total assets. To calculate, use the following formula:
Total Debt to Total Assets Ratio = (Short-Term Debt + Long-Term Debt) / Total Assets
- Total Assets Turnover – This ratio is simply used to measure a company’s ability to yield sales from its assets by comparing net sales with the average total assets. As simple as its definition, the formula to calculate this ratio is the following: Asset Turnover Ratio = Net Sales / Average Total Assets
- Fixed Assets Turnover – This is the ratio of sales referred from the Profit and Loss Account to the value of Fixed Assets in the Balance Sheet. Basically, this ratio is used to measure a company’s ability to generate sales from its fixed assets. The formula is the following: Fixed Asset Turnover = Net Sales / Average net Fixed Assets
- ROCE – Return on Capital Employed, a ratio which assess a company’s ability to earn a return on all the capital it employs. Helping investors see through growth forecasts and able to determine how reliable the performance of a company without including the effect of debt financing. This ratio is also used to measure for comparable companies relative profitability and compares the Net Operating Profit Less Adjusted Taxes (NOPLAT) to the Capital Employed (or Invested Capital). To calculate this ratio, the following formula is used: ROCE = NOPLAT/ Capital Employed
- ROA – Return on Assets ratio or sometimes referred to as return on investment, is used to assess a company’s ability to earn profit relative to its overall resources. Determining if a company is profitable due to its assets yield. To calculate this ratio, the following formula is used: ROA = (Net Income + Interest Expenses) / Total Assets
- ROE – Return on Equity or also known as return on net worth, is used to measure a company’s profitability by assessing the company’s ability to generate sales using the funding given by investors or shareholders. Basically, it is the net income returned as a ratio of the shareholder’s equity. This can be calculated by using the following formula: ROE = Net Income / Shareholder’s Equity
Financial Analysis Excel Template
Aside from fundamental analysis, there are many factors that affects the accuracy of the analyzations of the financial data, especially when using the financial ratios comparisons. Hence, depending on how you conducted your financial analysis and on what basis you’re following, the results will still vary.
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