Financial analysis is a systematic method to evaluate the performance and the financial health of a company.
Three core financial statements- Profit and Loss Statement, Balance Sheet, and Cash Flow Statement are used to conduct the financial analysis of a company. The financial data from these statements are converted into ratios and percentages. Such ratios and percentages are compared on a year-to-year basis to check consistency in parameters like sales, and net profit margin.
Financial analysis is useful to both the external and the internal users.
External users such as investors and then other stakeholders can learn more about the company’s profitability. They can compare and see how the company has performed during strenuous times (e.g., pandemics and recession). The analysis greatly helps the investors in making informed decisions regarding capital allocation.
The internal users can also make use of the financial analysis to learn about their performance and make improvements. Financial managers can decide whether to take/ reject a new project based on the calculation of the payback period and the Internal Rate of Return.
For example- The fixed Assets Turnover Ratio is used to understand how much sales are generated from 1 rupee of investment. This can be compared intra- company for internal use and inter-company for external use.
What are the most commonly used parameters on which financial analysis is done?
From Profit and Loss Statement:
1. Sales Growth- The current year’s sales divided by the last year’s sales is used to calculate sales growth.
2. EBIT Growth- The earnings before paying interest and taxes of the current year divided by last year’s EBIT.
3. Net Profit Margin- Net profit divided by sales.
You must convert the resultant ratios into a percentage form for easier analysis.
From Balance Sheet:
Fixed Asset Turnover Ratio:
This ratio tells us how much sales are generated for each rupee of investment. It is computed by dividing the sales by fixed assets.
Net Working Capital:
Current Assets excluding cash- Current liabilities
Within how many days are the debtors paying back. This is calculated in the following manner: 365/Sales/ Average Debtors. This ratio should ideally be decreasing or at the least be consistent.
How many days does it take for the company to procure the raw material, convert it into finished good and sell it off. Computed as follows: 365/Purchases/Average inventory.
How long is the concerned company paying back to its creditors. The formula to get this: 365/Purchases/Average Creditors. This should ideally be on an increasing trend.
Debt to Total Capital:
Debt divided by the sum of debt, reserves, and share capital. The Debt to total capital must be on the lower side.
From Cash Flow Statement
Cash Flow from Operations
A positive cash flow from the core operation of a business indicates progress.
Cash flow from Investing Activity
This should always be negative. Why so? This indicates that the company is constantly investing in fixed assets which in turn earns profits. This is a healthy loop.
Cash flow from Financing Activity
Such cash flow must also remain negative. It means that the company can pay the dividends and interests year on year basis.