Question

Describe and summarize the key financial statements used in a business organization. Explain three to five key financial ratios used to analyze a company.

Answer 1

Financial statement analysis uses horizontal analysis, vertical analysis and ratio analysis which is used to analyse historical data and also to compare with other industries.Financial Statement analysis help in comparing a company with other companies or the same company across different time periods. It provides information about the profitability, operational efficiency, leverage , debt repaying capacity and liquidity of firm which can be used by shareholders, lenders, investors for analysis.
Key financial statements

1. Ratio analysis:
The Ratios like Profitability ratios, Liquidity ratios, activity ratios, Debt Ratios,P/E ratio etc can help in identifying the performance of nay company. However these ratios are meaningful only when compared with the industry benchmark. It also pinpoints the area of concern for a company.

2. Horizontal and Vertical Analysis: Horizontal Analysis is comparing the financial statements over a period of time and analyzing whether a company is improving or performing poorly with respect to previous years.
Vertical analysis is converting all items in balance sheet in proportion to total assets and all items in income statement to sales.This helps in identifying the assets as proportion to total assets.

3. Technical Analysis : It focuses on the trend line or historical data to forecast or predict the future performance of company without any qualitative inputs.It is based on historical trends

Important ratios are

Liquidity ratio consists of current, quick ratio and cash ratio. Current ratio   is the ratio of the current assets to current liabilities. If current ratio is greater than 1 then the company can pay off its short liabilities through its short term assets.
Quick ratio is the current assets minus inventories to the current liabilities. It focuses on liquidity other than the inventory.
Cash Ratio is the ratio of cash and cash equivalent the current liabilities. The higher the cash ratio with respect to the market the higher is its liquidity position.

Debt management ratios are Debt to total Asset ratio, debt equity ratio, time interest earned ratio and EBIDTA coverage Ratio.
Debt to Total Assets ratio included the short term and long term debt as proportion to asset. Higher the ratio as compared to industry average more is the risk involved in the firm. Higher Debt equity ratio also indicates higher risk. Time interest earned ratio is EBIT to Interest paid. It indicated the debt repaying capacity of the firm and important for creditors. EBIDTA coverage Ratio = EBIDTA/ (Interest + Principal) . This also indicates the repaying capacity of the firm in terms of interest and principal.

DuPoint ratio for calculation of ROE includes net profit margin , Average assets turnover and Equity multiplier. ROE = Net profit Margin* Asset Turnover * Equity Multiplier. ROE is broken down into profitability, operating efficiency and the capital structure of the firm. It helps in identifying which portion contributes least or most t0 the ROE.