Financial analysis provides stakeholders with an external view of a company's financial health and outlook based on its financial reports and statements. Key financial issues are highlighted and potential risks and benefits identified. Ratio and trend analysis against industry standards can reveal strengths or weaknesses that may impact profitability or require management attention. The results of financial analysis may indicate areas for further operational or strategic analysis and improve a company's financial efficiency.

1. Financial Analysis Series:
FINANCIAL ANALYSIS

2. Statement of the issue
• In order to assess the financial health and outlook of a
company, owners, shareholders and other stakeholders
receive various reports and financial statements. The
important information from these reports and statements
must be highlighted
• Once the important financial issues are highlighted, the
possible risks and benefits can be identified, so that the
stakeholder knows what to look for, and perhaps see
what information he is missing in order to make a
decision
• A financial analysis will provide an external view of “what
the numbers tell us”
• The results of the financial analysis may lead to insights
that have implications on operational and strategic
management
© Robin Bhattacharya 2010. All rights reserved.

3. Methodology
• Financial analysis is based mostly on ratio and trend
analysis
• In comparison with industry standards, examining ratios
can identify possible strengths or weaknesses
• These strengths or weaknesses can be the target of
discussion with management, focus in a due diligence
exercise, areas identified for operational analysis, etc.
• Note: financial analysis may point to a need to verify
consistency and for aggressive or defensive accounting
treatments
• Examples: percentage-of-completion accounting, end-of-year
liabilities paydown
© Robin Bhattacharya 2010. All rights reserved.

4. Example: possible results of analysis
• For example, current asset levels can point to possible
causes:
Cash and short-term Accounts
investments receivable Inventory Likely situation
high high high poor asset management
high high low end of peak sales period; possible overcapitalisation
high low low low point of season; possible overcapitalisation
low high high peak of season; poor management of receivables and inventory
low high low poor receivables management; possible brief period of sales activity
low low high start of peak sales; possible poor inventory control
low low low adequate or excellent control of receivables or inventory
© Robin Bhattacharya 2010. All rights reserved.

5. Your benefit as a manger/owner
• You receive an analysis that points out where possible
sources of problems are that may place the
profitability/cash flow at risk
• The analysis can show where external stakeholders may
have questions that need management attention and
preparation
• For example, a bank may be concerned about the causes of
relatively high financial leverage. It may be due to low equity (as
measured by sales to equity or ROE), low asset utilisation, weak
working capital balance, or a low quick ratio
• The analysis indicates possible focus for increasing the
financial efficiency of a company
• For more information, please contact
RobinBhattacharya@yahoo.com
© Robin Bhattacharya 2010. All rights reserved.

6. APPENDICES
Fit with other analytical financial functions
Ratio analysis (common ratios used)
Red flags on financial accounts
Financial shenanigans

7. Fit with other analytical financial functions
Strategic Corporate Financial
Due Diligence Strategy Communications
Operational Financial
Analysis Analysis Valuation
Performance
M&A Support
Monitoring & Control
Treasury
Investment &
Asset Management
© Robin Bhattacharya 2010. All rights reserved.

8. Ratio Analysis: Activity Analysis
Inventory Turnover
Average No. Days Inventory in Stock
Receivables Turnover
Average No. Days Receivables Outstanding
Payables Turnover
Average No. Days Payables Outstanding
Working Capital Turnover
Fixed Assets Turnover
Total Assets Turnover
© Robin Bhattacharya 2010. All rights reserved.

9. Ratio Analysis: Liquidity Analysis
Current Ratio
Quick Ratio
Cash Ratio
Cash Flow from Operations Ratio
Length of Cash Cycle
(Raw Material + Work-in-Progress + Inventory) Days +
Receivables Days – Payables Days
© Robin Bhattacharya 2010. All rights reserved.

10. Ratio Analysis: Long-term Debt and Solvency
Analysis
Debt to Total Capital
Debt to Equity
Times Interest Earned
Fixed Charge Coverage
Capital Expenditure Ratio (CFO/Capex)
CFO to Debt
Debt Service Coverage Ratios (varying bases,
e.g., FCF/DSC)
© Robin Bhattacharya 2010. All rights reserved.

11. Ratio Analysis: Profitability Analysis
Return on Sales
Gross Margin
Contribution Margin
Operating Margin
EBIT/Sales
Return on Investment
Return on Assets
Return on Total Capital
Return on Equity
© Robin Bhattacharya 2010. All rights reserved.

12. Ratio Analysis: Operating and Financial
Leverage
Contribution Margin Ratio
Operating Leverage (CM/Operating Income)
Financial Leverage (OI/NI)
Total Leverage (OL x FL)
© Robin Bhattacharya 2010. All rights reserved.

13. Ratio Analysis: Other
Fixed Assets Growth Rate (Net
Investment/Dep – 1)
Internal Growth Rate w Debt (Retained
Earnings/Equity)
Internal Growth Rate w/o Debt (Retained
Earnings/Total Capital)
© Robin Bhattacharya 2010. All rights reserved.

14. Some Red Flags on financial accounts*
Divergences between net income and operating
cash flow
Increasing day sales outstanding (DSO)
Increasing day sales inventory (DSI)
Increasing other current assets to revenues
Declines on depreciation relative to gross
property plant and equipment
Increasing total asset growth
*James Montier, Societe General, 2008
© Robin Bhattacharya 2010. All rights reserved.

15. Value shares check*
1. Net Income
Score 1 if the bottom line net income is a positive figure
2. Operating Cash Flow
Score 1 if the figure is positive
3. Return on Assets (Net Income / Total Assets)
Score 1 if the current year ROA exceeds the prior year ROA
4. Quality of Earnings
One point if the OCF exceeds the Net Income.
5. Long-Term Debt to Assets
Score 1 if the ratio of long-term debt to assets is below the
prior year value (If long-term debt is zero but assets are
increasing, score 1 anyway).
*Elements of the Piotroski F score
© Robin Bhattacharya 2010. All rights reserved.

16. Value shares check (cont)
6. Current Ratio (Current Assets / Current Liabilities)
One point if the ratio has increased over the prior year
7. Issued Share Capital (No. of shares)
Score 1 if the number of shares in issue is no greater than the
prior year figure. (This is a measure of possible dilution).
8. Gross Margin
Score a point if the current year GM is higher than the prior
year figure.
9. Asset Turnover (Total Sales / Total Assets)
Score 1 if the ratio has increased over the prior year figure.
The higher the score, the better the shares tend to perform. Historically, shares
with 2 or fewer points were 5 times more likely to go bankrupt or delist due to
financial problems.
© Robin Bhattacharya 2010. All rights reserved.

17. Financial Shenanigans*
Howard Schilit’s book looks into seven areas of
‘earnings management with dubious intentions’:
1. Recording revenue too soon or of questionable quality
2. Recording bogus revenue
3. Boosting income with one-time gains
4. Shifting expenses to a later or earlier period
5. Failing to record or improperly reducing liabilities
6. Shifting current revenue to a later period
7. Shifting future expenses to the current period as a special charge
*Source: Howard Schilit, Financial Shenanigans
© Robin Bhattacharya 2010. All rights reserved.