Tools for Financial Statement Analysis
Various tools are used to evaluate the significance of financial statement data. Three commonly
used tools in financial analysis are:
1. Horizontal Analysis (Trend Analysis):
o Evaluates the year-over-year change in each line item of financial statement data
over a period of time.
o Primarily used in intra-company comparisons to determine the increase or
decrease, expressed as either an amount or a percentage.
o Formula to calculate change:
Change (%) = Current Year Amount – Base Year Amount/Base Year Amount
2. Vertical Analysis (Common Size Analysis):
o Expresses each item in a financial statement as a percentage of a base amount.
o For balance sheet items, total assets are used as the base.
o For income statement items, sales (revenue) are used as the base.
o Useful in both intra-company and inter-company comparisons.
In vertical analysis, each line item is compared to:
o Revenue (for income statements)
o Total assets (for balance sheets)
Common items evaluated include:
o COGS as a % of revenue
o Gross profit as a % of revenue
o SG&A as a % of revenue
o Interest expense as a % of revenue
o EBT (Earnings Before Tax) as a % of revenue
o Tax as a % of revenue
o Net earnings as a % of revenue
Classification of Ratios
1. Classification based on the statement from which the ratios are calculated:
a) Balance Sheet Ratios – Based on balance sheet figures.
b) Profit and Loss Account Ratios – Based on profit and loss account figures.
c) Combined Ratios – Based on figures from both balance sheet and profit and loss
account.
2. Classification based on the users of the ratios:
a) From the shareholders’ point of view
b) From the short-term creditors’ point of view
c) From the long-term creditors’ point of view
3. Classification based on their functions:
a) Liquidity Ratios
b) Activity or Efficiency Ratios
c) Leverage Ratios
d) Coverage Ratios
e) Profitability Ratios
f) Market Value Measures
Fundamental Ratios (According to Financial Spreadsheet - FSS)
There are six types of fundamental ratios:
1. Growth Ratios
o Measure the company’s potential and overall performance.
o Indicate whether the company is growing and sustainable in the long run.
o Examples: Sales growth, asset growth, earnings growth.
2. Profitability Ratios
o Indicate the efficiency of the company in generating surplus (profit).
o Compare profit to key factors such as sales, total assets, or equity.
o Measure the income or operating success of a business over a given period.
o Examples: Gross Profit Margin, Net Profit Margin, Return on Assets (ROA),
Return on Equity (ROE).
3. Coverage Ratios
o Measure a company’s ability to generate sufficient cash to pay interest and
principal obligations.
o Focus on debt servicing capacity.
o Example: Interest Coverage Ratio.
4. Activity Ratios (also called Efficiency Ratios or Asset Management Ratios)
o Assess how efficiently the company utilizes its assets to generate revenue.
o Directly linked to profitability, since efficient asset usage leads to higher returns.
o Examples: Inventory Turnover Ratio, Accounts Receivable Turnover Ratio, Asset
Turnover Ratio.
5. Liquidity Ratios
o Measure the short-term solvency of a company, i.e., its ability to meet current
liabilities using current assets.
o Reflect the company’s capacity to handle short-term obligations.
o Examples: Current Ratio, Quick Ratio (Acid-Test Ratio).
6. Leverage Ratios (also called Debt Management Ratios)
o Show the extent to which a firm is financed by debt versus equity.
o Indicate financial risk and capital structure decisions.
o Examples: Debt Ratio, Debt-to-Equity Ratio.
1) Growth Ratios
Name of Ratio Formula Use / Rule of Thumb
Sales Growth (%) (Current Year Sales – Previous Year Sales) ÷ Previous Higher is better; compare with
previous years or industry
Year Sales × 100
average
Higher is better; compare with
Net Sales (Current Year Net Sales – Previous Year Net Sales) ÷
previous years or industry
Growth (%) Previous Year Net Sales × 100
average
Higher is better; compare with
Net Income (Current Year Net Income – Previous Year Net Income) ÷
previous years or industry
Growth (%) Previous Year Net Income × 100
average
Higher is better; compare with
Total Assets (Current Year Assets – Previous Year Assets) ÷ Previous
previous years or industry
Growth (%) Year Assets× 100
average
Lower is better; compare with
Total Liabilities (Current Year Liabilities – Previous Year Liabilities) ÷
previous years or industry
Growth (%) Previous Year Liabilities × 100
average
Higher is better; compare with
Net Worth (Current Year Net Worth – Previous Year Net Worth) ÷
previous years or industry
Growth (%) Previous Year Net Worth × 100
average
2) Profitability Ratios
Name of Ratio Formula Use / Rule of Thumb
Efficiency of management in
Gross Margin (%) (Gross Profit ÷ Sales) × 100 generating profit from goods. Rule:
25–30%, higher is better
(Selling, General & Administrative Lower is better, compare with
SG&A Expenses (%)
Expenses ÷ Sales) × 100 previous years
(Gross Profit – SG&A Expenses) ÷ Sales
Cushion (%) Higher is better
× 100
Depreciation/Amortization
(Depreciation ÷ Sales) × 100 Lower is better
(%)
Operating Profit Margin General profitability of concern. Rule:
(EBITDA ÷ Sales) × 100
(%) 20–25%, higher is better
Interest Expense (%) (Interest ÷ Sales) × 100 Lower is better
(Profit Before Tax & Extra Income ÷
Operating Margin (%) Higher is better
Sales) × 100
Measures overall profitability. Higher
Net Margin (%) (Net Profit ÷ Sales) × 100
is better
Profitability of investment. Higher is
Return on Assets (%) (Net Profit ÷ Total Assets) × 100
better
Earning power on shareholders’
Return on Equity (%) (Net Profit ÷ Net Worth) × 100
equity. Higher is better
Dividend Payout Ratio (%) (Dividend ÷ Net Profit) × 100 Lower is better for long-term creditors
(Annual Dividend per Share ÷ Stock Shows dividend return relative to
Dividend Yield Ratio (%)
Price per Share) × 100 stock price
3) Coverage Ratios
Name of Ratio Formula Use / Rule of Thumb
Shows how many times interest charges
Interest Coverage (×) EBIT ÷ Interest
are covered by EBIT. Higher is better
Debt Service EBITDA ÷ (Interest + Current Maturity of Ability to serve long-term debt. Must be
Coverage (×) Long-Term Debt) greater than 1
4) Activity Ratios
Name of Ratio Formula Use / Rule of Thumb
Avg. collection period. Lower is better;
Receivables in Days (Accounts Receivable ÷ Sales) × 365 should not exceed 1/3 above credit
terms
Avg. time trade debt is outstanding.
Payables in Days (Accounts Payable ÷ COGS) × 365 Higher = creditors unpaid; Lower = not
using credit fully
Avg. holding period of inventory. Lower is
Inventory in Days (Inventory ÷ COGS) × 365
better
Sales to Total Assets Asset utilization efficiency. Higher is
Sales ÷ Total Assets
(×) better
5) Liquidity Ratios
Name of Ratio Formula Use / Rule of Thumb
Working Capital Current Assets – Current Liabilities Liquidity position. Larger is better
(Cash + Cash Equivalents + Receivables) ÷ Short-term solvency with quick assets.
Quick Ratio
Current Liabilities Rule: 1:1, higher is better
Ability to meet short-term obligations.
Current Ratio Current Assets ÷ Current Liabilities
Rule: 2:1, higher is better
Sales to Net Working Efficiency of working capital use. Higher
Sales ÷ Net Working Capital
Capital is better
6) Leverage Ratios
Name of Ratio Formula Use / Rule of Thumb
Indicates debt financing vs equity. Rule:
Debt to Equity (×) Total Liabilities ÷ Net Worth
1:1; higher = less safety for lenders
Affiliation Exposure (Affiliation Exposure ÷ Net Worth) × 100 Shows exposure to affiliates
(%)
Adjusted Debt to
Total Liabilities ÷ (Net Worth – Affiliates) Indicates leverage excluding affiliates
Equity (×)
