FINANCIAL STATEMENT ANALYSIS

Financial Analysis

Introduction

  • Financial analysis identifies financial strengths and weaknesses of an organization.

  • Management uses historical performance to forecast and plan for the future.

  • Helps management correct weaknesses and enhance strengths.

  • Investors, creditors, and stakeholders use this information as a performance gauge.

  • The analysis includes understanding the relationship between items in the Statement of Financial Position and the Statement of Comprehensive Income.

Ratio Analysis

  • Ratios serve as a quotient indicating relationships between two or more financial variables.

  • Ratio Analysis is a powerful tool in analyzing financial statements, providing benchmarks for performance evaluation.

  • Ratios must be compared with previous periods or similar entities to understand financial conditions.

  • Example: A strong income statement may mask poor performance when benchmarked against total investment.

Definitions and Importance of Ratios

  • Financial Ratios summarize quantitative judgments about organizational performance.

  • A Current Ratio reflects the relationship between current assets and current liabilities:

    • Greater current ratio indicates better performance and higher market rating.

Ratio Comparison

  • Ratio analysis involves comparing financial situations to interpret financial statements accurately.

  • A single ratio lack context; thus, it should be benchmarked against:

    1. Past Ratios: Historical ratios of the organization.

    2. Competitors’ Ratios: Financial ratios from similar businesses.

    3. Industry Ratios: Aggregate ratios across an industry for objective comparison.

    4. Projected Ratios: Ratios derived from future financial statements.

Bases of Ratio Analysis

  • Time Series Analysis: Compares current ratios with those from the past to analyze trends.

  • Industry Analysis: Compares a firm’s ratios with the industry average despite potential complications in defining the average.

  • Cross Sectional Analysis: Evaluates a firm’s ratios against selected peers in the industry to gauge performance.

  • Pro-forma Analysis: Involves comparing historical performance with projected performance to assess future strengths or weaknesses.

Types of Financial Ratios

  • Financial ratios aid in assessing performance in both short and long-term contexts. Key categories include:

    1. Liquidity Ratios

    2. Leverage Ratios

    3. Activity Ratios

    4. Profitability Ratios

I. Liquidity Ratios

  • Liquidity Ratios measure an organization's ability to fulfill current obligations.

  • High liquidity is essential for smooth operations, avoiding excessive idle assets.

Key Liquidity Ratios

  1. Current Ratio:

    • Formula: Current Assets / Current Liabilities

    • Example (Lizzy & Company Ltd): N1,870,920 / N715,880 = 2.6:1

    • Indicates sufficient liquidity to meet obligations.

  2. Quick Ratio (Acid Test):

    • Formula: (Current Assets - Inventories) / Current Liabilities

    • Example: (N1,870,920 - N1,150,390) / N715,880 = 1.01:1

    • Reflects ability to meet short-term obligations without liquidating inventory.

  3. Cash Ratio:

    • Formula: (Cash + Marketable Securities) / Current Liabilities

    • Example: (N26,080) / N715,880 = 0.036 or 3.6%

    • Indicates ready cash availability.

  4. Internal Measurement:

    • Formula: (Current Assets - Inventories) / Average Daily Operating Expenses

    • Example: N720,530 / N9,346 = 77 days

    • Indicates how long the firm can meet expenses without income.

Summary of Liquidity Ratios for Lizzy & Co. Ltd.

  • Current Ratio: 2.6:1

  • Quick Ratio: 1.01:1

  • Cash Ratio: 0.04:1

  • Internal Measurement: 77 days

II. Leverage Ratios

  • Leverage Ratios assess a firm’s debt position, indicating the proportion of debt in total financing.

  • High leverage can increase the risk of financial distress.

Key Leverage Ratios

  1. Debt Ratio:

    • Formula: Total Debt / Total Capital Employed

    • Interpretation involves understanding the share of debt in financing.

    • Example Ratio: 0.65:1 or 65% of net assets financed by debt.

  2. Debt/Equity Ratio:

    • Formula: Total Debt / Net Worth

    • High ratios indicate financial risk, advising for greater equity financing.

    • Example Ratio: 1.83:1.

  3. Capital Employed to Net Worth Ratio:

    • Shows debt vs. equity contributions in financing operations.

    • Example Ratio: 2.83:1.

  4. Total Liabilities to Total Assets Ratio:

    • Indicates funds provided by outsiders related to total assets.

    • Example Ratio: 0.74:1 (total liabilities vs. total assets).

Recommendations

  • High debt ratios necessitate debt reduction strategies and alternate financing approaches.

III. Activity Ratios

  • Activity Ratios evaluate how well an organization manages its assets to generate sales.

Key Activity Ratios

  1. Inventory Turnover Ratio:

    • Formula: Cost of Sales / Average Inventory

    • Example Ratio: 8.6 times (indicates efficiency in inventory management).

  2. Days of Inventory Holding:

    • Represents how long inventory is held.

    • Example: 42 days (determined from inventory turnover).

  3. Trade Receivables Turnover Ratio:

    • Formula: Credit Sales / Average Trade Receivables

    • Example Ratio: 7.7 times (showing efficiency in debt collection).

  4. Trade Receivables Collection Period:

    • Formula: 360 / Trade Receivables Turnover

    • Example Calculation: 47 days (indicates the length debts are outstanding).

Summary of Activity Ratios for Lizzy & Co. Ltd.

  • Inventory Turnover: 8.6

  • Days of Inventory Holding: 42

  • Trade Receivables Turnover: 7.7

  • Average Collection Period: 47 days

Conclusion

  • Financial analysis provides comprehensive insights into performance through various ratio analyses.

  • Each category of ratios sheds light on different operational aspects, guiding management decisions and stakeholder evaluations.