Financial Analysis & Decision-Making: Tools, Ratios & Strategic Use

Core Concepts & Definitions

Financial analysis is the process of evaluating businesses, projects, or financial statements to make informed decisions. It relies on:

• Historical data (past financial statements)
• Comparative analysis (trends over time or vs. competitors)
• Projections (future performance estimates)

Why is it essential?

mindmap
  root((Why Financial Analysis?))
    Decision-Making["Investors: Buy/Sell Stocks (NEPSE: Nabil, NMB)"]
    Risk Assessment["Banks: Loan Approval (NMB, Global IME)"]
    Performance Evaluation["Managers: Profitability of Branches (eSewa, Daraz)"]
    Compliance["Regulators: NFRS Reporting (NTC, Ncell)"]
    Stakeholder Communication["Shareholders: Dividend Decisions"]

1. Types of Financial Analysis

A. Horizontal (Trend) Analysis

Compares financial data over multiple periods (e.g., 2078 vs. 2079). Example: Growth in eSewa’s revenue from Rs. 50B (2078) to Rs. 80B (2079). Formula: $$\text{Percentage Change}=\frac{\text{Current Year}-\text{Previous Year}}{\text{Previous Year}}\times 100$$

B. Vertical (Common-Size) Analysis

Expresses each line item as a % of a base (e.g., sales for income statement, total assets for balance sheet). Example: If Daraz’s COGS was Rs. 400M in 2079 (sales = Rs. 1B), its COGS % = 40%. Table: Vertical Analysis of Kathmandu Retail Shop (2079)

2. Key Financial Ratios

Ratios convert raw data into actionable insights. Categorized as:

A. Liquidity Ratios (Can the company pay short-term debts?)

B. Profitability Ratios (Is the business making money?)

Worked Example: Kathmandu Retail Shop’s Profitability

• Sales (2079): Rs. 5,000,000
• COGS: Rs. 3,500,000
• Operating Expenses: Rs. 800,000
• Net Profit: Rs. 700,000 Calculations: $$\text{Gross Profit Margin}=\frac{1,500,000}{5,000,000}\times 100=\ast \ast 30\%\ast \ast$$ $$\text{Net Profit Margin}=\frac{700,000}{5,000,000}\times 100=\ast \ast 14\%\ast \ast$$ Insight: The shop’s gross margin is high, but operating costs (16% of sales) are squeezing net profit.

C. Leverage Ratios (How much debt is used?)

3. DuPont Analysis (Breaking down ROE)

ROE = Net Profit Margin × Asset Turnover × Leverage Example: eSewa’s ROE (Simplified)

Insight: eSewa’s high ROE comes from efficient asset use (high turnover) and leverage.

4. Comparative Analysis

A. Industry Benchmarking

Compare ratios against industry averages (e.g., NEPSE’s FMCG vs. Banking). Table: Liquidity Comparison (2079)

Insight: Himalayan Coffee is illiquid (current ratio <1), risking cash flow issues.

B. Competitor Analysis

Example: Pathao vs. Daraz (Delivery Apps)

5. Projections & Forecasting

A. Trend Analysis for Future Estimates

Example: NTC’s Revenue Growth (2077–2079)

B. Break-Even Analysis

Example: Kathmandu Retail Shop

• Fixed Costs (Rent, Salaries): Rs. 200,000/year
• Variable Cost (COGS per unit): Rs. 100
• Selling Price per unit: Rs. 200 Break-Even Point (Units): $$\text{BE}=\frac{\text{Fixed Costs}}{\text{Price}-\text{Variable Cost}}=\frac{200,000}{200-100}=\ast \ast 2,000units\ast \ast$$ Insight: The shop must sell 2,000 units/year to cover costs.

6. Limitations of Financial Analysis

In the Real World

1. eSewa’s Decision-Making

   • Ratio Used: Liquidity Ratios (Current Ratio = 1.6)
   • How? Ensures eSewa can process Rs. 10B+ daily transactions without cash shortages.

2. NMB Bank’s Loan Approvals

   • Ratio Used: Debt-to-Equity (<1.0 for safe loans)
   • How? Rejects high-risk borrowers (e.g., startups with D/E > 2.0).

3. Daraz’s Inventory Management

   • Ratio Used: Inventory Turnover = COGS / Avg. Inventory
   • How? Daraz maintains turnover = 8 (sells inventory 8x/year) to avoid stockouts.

4. NEPSE Investors’ Stock Picks

   • Ratio Used: P/E Ratio (Price-to-Earnings)
   • Example: If Nabil Bank’s P/E = 12, investors compare it to industry avg. (10–15) to decide.

Exam Tip

What Examiners Want to See

✅ Clear ratio calculations (show formulas + plug in numbers). ✅ Real-world ties (e.g., "Like NMB Bank’s current ratio of 1.8, this company is liquid"). ✅ Comparative insights (e.g., "Unlike Pathao (35% margin), Daraz’s 8% shows lower profitability"). ✅ Limitations acknowledged (e.g., "While the current ratio is high, inventory aging may hide illiquidity").

Common Mistakes to Avoid

❌ Ignoring units (always label ratios as "times" or "%"). ❌ Mismatched years (compare 2078 vs. 2079, not 2078 vs. 2080). ❌ Overlooking qualitative factors (e.g., "High ROE could be due to aggressive debt, not efficiency").

Past Exam Patterns

• Short Questions (5 marks):
  • Define horizontal analysis and calculate a 2-year trend.
  • Explain why ROA is better than ROE for comparing firms.
• Long Questions (10–15 marks):
  • Given trial balance + ratios, prepare adjusted financial statements.
  • Analyze two companies’ performance using 5 ratios and suggest improvements.

flowchart TD
    A["Financial Statements"] --> B["Horizontal Analysis"]
    A --> C["Vertical Analysis"]
    B --> D["Trend Identification"]
    C --> E["Common-Size %"]
    D & E --> F["Ratio Calculation"]
    F --> G["Liquidity Ratios"]
    F --> H["Profitability Ratios"]
    F --> I["Leverage Ratios"]
    G & H & I --> J["Comparative Analysis"]
    J --> K["Decision-Making"]
    K --> L["Loan Approval\n(Banks)"]
    K --> M["Investment\n(NEPSE)"]
    K --> N["Strategy\n(eSewa, Daraz)"]