A Note on Financial Ratio Analysis

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.

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.

• 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.

Liquidity refers to the ability of a firm to meet its short-term (usually up to 1 year) obligations. The ratios which indicate the liquidity of a company are Current ratio, Quick/Acid-Test ratio, and Cash ratio. These ratios are discussed below.

CURRENT RATIO

Current ratio (CR) is the ratio of total current assets (CA) to total current liabilities (CL). Current assets include cash and bank balances; inventory of raw materials, semi-finished and finished goods; marketable securities; debtors (net of provision for bad and doubtful debts); bills receivable; and prepaid expenses. Current liabilities consist of trade creditors, bills payable, bank credit, provision for taxation, dividends payable and outstanding expenses. This ratio measures the liquidity of the current assets and the ability of a company to meet its short-term debt obligation.....

        Case Code   MISC010
   Case Length    17 Pages
              Period   
 Organization    
        Pub Date     2003
Teaching Note    Not Available
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Issues

Technical note, financial statements, financial tools, ratio analysis, common size, statements analysis, financial position, financial analysis, Hindustan Lever Limited’s, HLL, balance sheet, income statements.