A NOTE ON FINANCIAL RATIO ANALYSIS

Case code - MISC010
Published - 2004

ABSTRACT

This technical note explains in detail the analysis of financial statements of a company. It provides insights into two widely used financial tools, ratio analysis and common size statements analysis. The objective of this note is to help the reader understand how these tools should be used to analyze the financial position of a firm. To demonstrate the process of financial analysis, Hindustan Lever Limited's (HLL's) balance sheet and income statements are analyzed in this note.

INTRODUCTION

The major financial statements of a company are the balance sheet, income statement and cash flow statement (statement of sources and applications of funds). These statements present an overview of the financial position of a firm to both the stakeholders and the management of the firm. But unless the information provided by these statements is analyzed and interpreted systematically, the true financial position of the firm cannot be understood. The analysis of financial statements plays an important role in determining the financial strengths and weaknesses of a company relative to that of other companies in the same industry. The analysis also reveals whether the company's financial position has been improving or deteriorating over time.

FINANCIAL RATIO ANALYSIS

Financial ratio analysis involves the calculation and comparison of ratios which are derived from the information given in the company's financial statements. The historical trends of these ratios can be used to make inferences about a company's financial condition, its operations and its investment attractiveness.

Financial ratio analysis groups the ratios into categories that tell us about the different facets of a company's financial state of affairs. Some of the categories of ratios are described below:

Liquidity Ratios give a picture of a company's short term financial situation or solvency.
Operational/Turnover Ratios show how efficient a company's operations and how well it is using its assets.
Leverage/Capital Structure Ratios show the quantum of debt in a company's capital structure.
Profitability Ratios use margin analysis and show the return on sales and capital employed.
Valuation Ratios show the performance of a company in the capital market.