How To Analyze Financial Statement Ratios?

Why Analyzing the Financial Statement Ratios Is Important?

Every company prepares Financial Statements annually and stakeholders then analyze the Financial Statements to see their performance and predict their future prospects.

The reason I’ve used the word ‘’stakeholder’’ is that analyzing a company’s financial statements is not only vital for investors but other groups like Employees & directors (to see if the company will be able to pay our remunerations), Tax Authorities ( to know the tax position of the company ), Suppliers and creditors ( will the company able to pay our debts ).
Therefore, analyzing financial statements ratios is an important skill that you need to master!

In this article, I’ll explain how to analyze & interpret the financial statements of a company. I’ll try to keep it simple and explain the terminologies I use, thereby making it edible for people with no advanced & technical accounting knowledge. In the first part, I’ll explain how to analyze a Statement of Profit or Loss. In other words, income statement.

Read my detailed article on Investor Ratios

I’ll first put some light on the major contents of the Statement of profit or loss;

FORMAT

Revenue (Income from operations)
Cost of Sales
Gross profit (revenue minus COS)

Other Income (Income from investments or selling an asset)
Administrative Costs (costs incurred in running the business)
Other expenses
Operating profit (Gross profit + Other income – admin and other costs)

Finance costs (borrowing costs)
Finance income (income from lending money)
Profit before tax (operating profit – Finance costs + Finance income)

Income Tax expense (tax for the year)
Profit for the year (Profit before tax – tax expense)

For an in-depth understanding of formats, I recommend you this

Now that you know what a SOPL looks like, I will explain some ratios which we will use to analyze the financial statements.

How To Analyze the Financial Statement Ratios?

You have to know that Ratios are only meaningful if you compare them to the same ratio of other companies in the same sector, the Average underlying ratio of the industry, or the prior year ratio of the same company. It is then to decide if it’s better or worse. The following ratios are primarily used to analyze statements of profit or loss.

Percentage increase/decrease in Revenue is simply the comparison of the current and prior year’s revenue. you can calculate it as follows.
Change in current and prior year’s revenue / prior year’s revenue *100. Let’s take a quick example.
Revenue for 2020 is 10 million, in 2019 it was 9 million, and 7 million in 2018.
Now, there is an increase of 1 million in 2020, which is 11.11% (1/9*100). Seems great but I highly doubt that because it was 28.57% (2/7*100) in 2019. Therefore, to analyze financial statements, you need previous results of the company as well.

Gross Profit Margin

Measures gross profit as a percentage of revenue. We can calculate it by taking the gross profit figure, dividing it by revenue, and multiplying it by 100 to convert it into a percentage. It tells us how much the company earns after deducting direct costs. You can also perform a cost of sales check as follows.
COS/Revenue*100.
COS as a percentage of revenue will be calculated and the remaining must be our gross profit!
The higher the gross profit margin, the better. Two things can cause an increase or decrease in Gross profit margin. Revenue and Cost of sales. The higher the revenue, the higher the GPM and for COS it will be vice versa. Remember that an increased GPM is not always a good sign and it can also mean that the sales prices were higher for the period.
Lower costs could compromise the product quality hence low returns in future periods.

Operating Profit Margin

Is another profitability ratio that measures operating profit as a percentage of revenue. The operating profit figure arrives after deducting even more expenses and its increased sensitivity is natural!
The higher the GPM, the higher will be OPM. (operating profit margin) But if you refer back to the format, you’ll find that admin and other expenses are also deducted to arrive at OP therefore increase and decrease in those figures will result in varying OPM. The same goes for other income figures. Higher our non-operational income, the higher the OPM …

When interpreting, you should identify the reason(s) for the increase/decrease. An increase in the current period doesn’t always mean a lucrative future but could deteriorate future potential if costs such as administration are reduced excessively. These operations bring value and should be run effectively. However, excessive costs would mean that there isn’t any system in place to monitor the costs and internal controls of the company be reviewed.

Depreciation is deducted to arrive at OP. The depreciation policies used should therefore be reviewed when comparing the two companies. As this could be a material expense in some companies’ statements and will impact the operating profit.

Income from other sources such as selling an asset and side investments are also included while arriving at OPM. If repetitive and likely to occur in future periods, give a point to the company. If it’s a once-in-a-blue-moon income then it should be considered in analyzing financial statements.

INTEREST COVER

Interest cover measures how many times the company is able to pay its finance/interest costs with the profit they make. You should use profit before tax and interest.
It is calculated as; profit before tax and interest/interest costs. It gives results in time. The more times the profit covers interests, the better.

Debt is a curse and bummer. But, if the company is rich. Rich in generating money, then it is bliss. It’s a cheap source of finance due to the low risk involved from an investor’s point of view. Companies, therefore give lower returns to debt holders than equity holders.
When analyzing financial statements ratios, lenders shareholders and suppliers often analyze this ratio. A shareholder will be interested to know how much is left for him. A lender or supplier will want to know whether the company has space for loans/credits. Therefore, keeping this ratio in equilibrium is the cornerstone of a company’s success.
This, however, in no world means the company should avoid this cheap source of finance.

When interpreting interest cover, above all, you should dig into the financial position of the company. If the company’s interest cover is low but has enough liquid resources, then it’s in the zone. It’s just utilizing cheap money!
But, if the company has lower interest cover and its liquidity is struggling too. It’s in trouble. And this can even lead to the cessation of the company. No investor would want to invest in an inefficient company AND no lender will lend if a company struggles to pay current lenders.

Calculate the ratios and analyze them as explained. You can compare the results with companies in the same sector, competitors, and/or historic results of the underlying entity.

Final Words

The above ratios give you a basic understanding of how Financial statements are interpreted. I will unravel some advanced ratios in the next article and after that, analyze the financial statements ratios of a company to show you the bigger picture.
Note, however, that interpretation is subjective and you should also consider other factors that are the driving forces behind varying results. The more you dig, the clearer it becomes. Consequently, giving you an edge in understanding the position of the company.