What Is Financial Statement Analysis?

Dear Stewart

Your question has two parts - financial statement(s) and analysis.

Every organisation prepares, usually once in a year, financial statements, there are three key statements, namely the ‘Statement of Affairs’ or ‘Balance Sheet’, ‘Statement of Profit and Loss’ or ‘Income and Expenditure’ and ‘Cash Flows Statement’. These three, along with the schedules and notes annexed, provide the information required to enable the public to analyse them and draw meaningful conclusions.

Now we come to the key part of your question; what does analysis mean? It means studying, dissecting, drawing up certain important ratios or proportions generally employed by the financial world. These ratios fall under four broad heads, as follows:

1. Profitability Ratios: These include margins or profits under the various ‘Gross Profit’, ‘Earnings Before Depreciation, Interest, Tax and Appropriations (EBDITA)’, ‘Earnings Before Tax (EBT)’, ‘Profit Before Tax (PBT)’ and ‘Profit After Tax (PAT)’. All these various ratios evaluate the profitability of the operations of the company or organisation.
2. Liquidity Ratios: Liquidity ratios assess the ability of the organisation to meet its short term liabilities, maturing within one year, like trades payable or sundry creditors, outstanding expenses, etc. out of current assets like inventory, customer receivables, cash and bank balances. Even though the operations may be profitable, unless the organisation ploughs back adequate amount of profits into current assets, the organisation will become sick. ‘Current’ and ‘Quick’ ratios are usually used.
3. Solvency Ratios: Solvency ratios measure the ability of the corporation to meet the long term commitments. This is measured by comparing the long term debts with the the net worth (equity capital and reserves). One to one is considered adequate, more net worth the better and lower than one shows weakness.
4. Efficiency Ratios: These evaluate how efficiently various assets are turned around in the business. Inventory and receivables ratios measure how many these are rotated during the year and obtained by dividing annual sales turnover by amount of inventory and receivables. Similarly, ‘Fixed Assets Turnover Ratio’ is obtained by dividing sales by value of fixed assets. More the turnover number, better is the efficiency.

The cash flow statement describes how cash is generated and how it is used, judging the judiciousness of cash, the most valuable resource.

Kindly note analysis of financial statements is not just a mechanical process. Drawing meaningful conclusion about the business, the managers, their attitudes and so on, with the aim of making critical investment decisions is the real purpose of the exercise, which requires besides knowledge, a lot of experience.

So in conclusion, analysis of financial statements employs widely accepted techniques to draw valuable conclusions about the business with an objective of making investment decisions.

To learn about finance and investing, please visit my blog ‘Wealth Vidya’ regularly, and learn for FREE!

Thank you,

With Best Regards

Anand

Written 26m ago · Answer requested by Stewart Desjardins

Note: This is a reproduction of the question I had answered on the website ‘Quora’.

Which One is Better: Recurring Deposit in Bank or SIP in Mutual Funds?

Savings and Investment are two separate concepts. Savings are generally short term in nature and may be intended for a specific purpose like education of child, marriage of a girl child, including savings for investment. Investment on the other hand is long term in nature, say for 20 to 30 years and should not be broken or sold or withdrawn before that period.

A recurring deposit (RD) with a bank for savings purpose is alright. If one is talking about investing and multiplying the sum many times then systematic investment plan (SIP) is the only answer and there is no comparison with RD.

Even though you have not touched this aspect, I have repeatedly mention every time, everywhere that starting a SIP and discontinuing it after a short time, citing reasons of market conditions, is quite useless. A SIP can yield benefits only if it is kept alive irrespective of any reasons for 20 to thirty or even 50 years. During that long, long period the ‘Miracle of Compounding’, propounded by Albert Einstein, will work in favour of the investor. Also the companies constituting the mutual fund grow naturally in size and profits, again benefiting the investor.

Believe me, following the simple principle described herein can not only multiply the investment many times but make the investor really Rich.

If you want to learn ‘Value Investing’ for FREE, please visit ‘Wealth Vidya’.

Anand

Note: This is a reproduction of the question I had answered on the website ‘Quora’.

I would like to buy a stock or bond for my newborn grandchild. What would you recommend?

Dear Sir/ Madam, you are on the right track, while thinking on financial instruments as a gift for your newborn grandchild, instead of thinking gold or such non-income earning avenues.

Between bonds and equity, the later is better, especially considering that the child is just born and has a very, very long and bright future ahead for the initial investment to multiply, on the back of the ‘Miracle of Compounding’, espoused by Albert Einstein.

A bond, though appears to be relatively safe, has its own woes. It will yield a fixed regular income but no capital appreciation. On the contrary equity offers both regular income in the form of dividends as well as capital appreciation. If you think equity investments are complex, you may invest the money in an Exchange Traded Fund (ETF) like Goldman Sachs’ NIFTY BEES, or any mutual fund.

The key to investing, however, is to simply forget about it. By the time child grows up to the 40s, he or she already would have achieved ‘Total Financial Freedom’. Just imagine what a wonderful thing financial freedom is - one does not have to work - one may work in areas of passion, purely for the joy, rather than the drudgery of making a living!

Note: This is a reproduction of the question I had answered on the website ‘Quora’.

What would happen if the stock market failed to start?

Dear Friend,

If the stock market failed start for a few years, investors will be much better off both financially as well as health wise.

In fact, my guru Warren Buffett exactly used the words in your question. He said, “When You Make an Investment, Think that the Stock Market Is Going to be Closed for Five Years”.

To learn more of Buffett’s wisdom and to learn and practice for FREE, please visit my blog ‘Value Investing at Wealth Vidya

Note: This is a reproduction of the question I had answered on the website ‘Quora’.

I have US$50,000 now. I want to invest in US stocks for 20 years. Which stocks will you recommend? How much would I have at that time?

Friend, I am glad that you are thinking of a 20 year investment horizon. None can suggest you a single stock that you can invest and forget about for 20 years. Of course there are stock of great corporations but at what price are they available in the market? If you buy the stock of an excellent company at a very high price, you as an investor will not benefit. Under the circumstances, You have two options before you, as follows:

1. You may learn ‘Value Investing’, in which case please buy the best book, ‘The Intelligent Investor’ by Benjamin Graham and get started immediately. You may visit my blog atValue Investing.

2. If you do not want to spend a lot of time on investing, you may simply invest your corpus in an ‘Exchange Traded Fund (ETF)’ that mirrors a popular index like DAX, Dow Jones, etcetera or any good mutual fund.

Now the most important aspect of investing begins. You simply forget about the investment till 20 years.

Following table shows what your investment could be if it is able to generate a compounded annual growth rate (CAGR) of 15% per annum or 1.25% per month, which is very much possible.

Future Value of Investment

I have assumed an annual inflation rate of 9.96%, which is probable in India, where I live, but in the US it is very unlikely. So, if the inflation rate is 2% per annum, you will end up with a net future value of US$ 911,208, quite a significant sum.