Financial Statement Analysis: Ratios, Trends & Decision-Making

TAKEAWAYS:

• Ratios reveal hidden truths: Liquidity ratios (e.g., current ratio) show if a business like Ncell can pay bills; profitability ratios (e.g., ROE) explain why Daraz’s margins differ from Khalti’s.
• Trends > snapshots: Comparing Nepal Bank’s 2077 vs. 2078 financials spot growth in loans or shrinking deposits—critical for investors.
• Common-size statements standardize: Convert Everest Bank’s Rs 500M sales to 100% to compare with Global IME’s Rs 2B—scale doesn’t distort.
• Cash ≠ profit: Pathao’s high revenue but negative cash flow from operations (CFSO) explains why it needs constant funding.
• Red flags: Rising inventory turnover for BigMart might mean unsold stock; declining debt-to-equity for NTC signals conservative financing.
• Limitations matter: Ratios ignore inflation, qualitative factors (e.g., Nepalgunj’s brand reputation), and industry differences.

1. Why Analyze Financial Statements?

Financial statements (Income Statement, Balance Sheet, Cash Flow Statement) are like a car’s dashboard: they show speed (profit), fuel (cash), and engine health (assets/liabilities). But raw numbers don’t tell the story—analysis turns data into decisions.

Key Users of Financial Analysis

2. Tools of Financial Statement Analysis

A. Ratio Analysis: The "Math Behind the Numbers"

Ratios compare two financial figures to reveal relationships. All ratios use data from the Balance Sheet, Income Statement, or Cash Flow Statement.

1. Liquidity Ratios: Can the Company Pay Its Bills?

Formula: Current Ratio = Current Assets / Current Liabilities Interpretation:

• >1.5: Healthy (e.g., Ncell in 2078: Rs 800M current assets / Rs 300M liabilities = 2.67).
• <1: Risky (e.g., a struggling Kathmandu garment shop with Rs 500K assets vs. Rs 600K creditors).

Real World:

• NTC’s liquidity crisis (2077): Current ratio dropped to 0.9 due to unpaid supplier bills, forcing emergency loans from Nepal Bank.
• Khalti’s advantage: Holds 80% of transactions in cash equivalents, giving it a cash ratio of 0.7—far higher than banks.

2. Profitability Ratios: Is the Business Making Money?

Worked Example: Kathmandu Retail Shop (Rs in ‘000)

• Sales: Rs 5,000
• COGS: Rs 3,500
• Operating Expenses: Rs 1,200
• Net Income: Rs 300
• Total Assets: Rs 2,000
• Equity: Rs 1,000

| Ratio               | Calculation                     | Value  | Industry Benchmark | Verdict                     |
|---------------------|---------------------------------|--------|--------------------|-----------------------------|
| Gross Margin        | (5000 - 3500) / 5000           | 30%    | 40-50%             | **Weak**: High theft/discounts? |
| Net Margin          | 300 / 5000                     | 6%     | 8-12%              | **Poor**: High overheads?    |
| ROA                 | 300 / 2000                     | 15%    | 10-15%             | **Average**                 |
| ROE                 | 300 / 1000                     | 30%    | 15-20%             | **Strong**: Leveraged well? |

Real World:

• Nepalgunj’s ROE (2078): 18% vs. Daraz’s 5%—explains why investors prefer retail over e-commerce.
• Banking sector: Nabil Bank’s ROA of 1.2% reflects low-interest margins vs. Standard Chartered’s 1.8%.

3. Solvency Ratios: Can the Company Survive Long-Term?

Real World:

• NTC’s D/E ratio: 4.5 (2077) → 3.8 (2078). Still high due to infrastructure loans.
• Khalti’s D/E: 0.1—no debt, funded by equity/investors.

4. Efficiency Ratios: How Well Does the Company Use Assets?

Real World:

• BigMart’s inventory turnover: 6 times → 4 times (2077-78). Problem: Overstocking perishables.
• Nepal Oil’s turnover: 12 times—efficient supply chain.

3. Trend Analysis: Spotting Patterns Over Time

How it works: Compare ratios across 3-5 years to see improvements or declines.

Example: Comparative Financials of Rara Company (2076-2078)

| Year  | Current Ratio | Gross Margin | Debt/Equity | Comment                          |
|-------|---------------|---------------|-------------|----------------------------------|
| 2076  | 1.2           | 35%           | 1.8         | **Weak liquidity**, high debt.   |
| 2077  | 1.5           | 38%           | 1.5         | **Improving**, but still risky.  |
| 2078  | 2.1           | 42%           | 1.2         | **Strong**: Better management.   |

Mermaid Trend Diagram:

graph LR
    A["2076: Current Ratio = 1.2"] -->|"↑"| B["2077: 1.5"]
    B -->|"↑"| C["2078: 2.1"]
    A["2076: Debt/Equity = 1.8"] -->|"↓"| D["2077: 1.5"]
    D -->|"↓"| E["2078: 1.2"]

Key Insight: Rara Company’s liquidity and solvency improved, but profitability stagnated (gross margin only rose by 7% over 3 years).

Real World:

• Nepal Electricity Authority (NEA): Current ratio fell from 1.3 (2076) to 0.9 (2078) due to delayed payments from Nepal Government.
• Nepal Bank’s ROA: Rose from 0.8% (2076) to 1.2% (2078)—better loan portfolio management.

4. Comparative Financial Statements: "Apples-to-Apples" Analysis

Why? Companies grow/shrink over time. Common-size statements adjust for scale.

Example: Common-Size Income Statement for Two Nepali Retailers

| Particular          | Kathmandu Retail (Rs 5M Sales) | Nepalgunj (Rs 50M Sales) | Difference                     |
|---------------------|--------------------------------|--------------------------|---------------------------------|
| Revenue             | 100%                           | 100%                     | Same base.                     |
| COGS                | 70%                            | 65%                      | Nepalgunj **more efficient**.   |
| Gross Profit        | 30%                            | 35%                      | **5% better margin**.           |
| Operating Expenses  | 25%                            | 20%                      | Nepalgunj **lower costs**.      |
| Net Income          | 5%                             | 10%                      | **Double profitability**.       |

Real World:

• Daraz vs. BigMart: Both have ~30% gross margins, but Daraz’s operating expenses are 40% vs. BigMart’s 25% (high tech costs).
• NTC vs. Ncell: NTC’s revenue is 80% from tariffs, while Ncell’s is 60% from data—different business models.

5. Cash Flow Statement Analysis: Profit ≠ Cash

Key Question: Can the company generate cash from operations? Formula: Cash Flow from Operations (CFO) = Net Income + Non-Cash Expenses (e.g., Depreciation) - ΔWorking Capital

Example: Pathao’s Cash Flow (2078)

| Particular               | Amount (Rs ‘000) |
|--------------------------|------------------|
| Net Income               | 20,000           |
| + Depreciation           | 5,000            |
| - Increase in Receivables| (10,000)         |
| - Increase in Inventory  | (2,000)          |
| **CFO**                  | **13,000**       |
| **CFI (Investing)**      | (15,000)         | *Bought new vehicles* |
| **CFF (Financing)**      | 5,000            | *Issued shares*       |
| **Net Change in Cash**   | **3,000**        |

Red Flags:

• Negative CFO: Company relies on loans/investments (e.g., a startup with Rs 50M revenue but -Rs 10M CFO).
• High CFI: Heavy capital expenditure (e.g., NTC’s Rs 20B spent on fiber optics).

Real World:

• Khalti’s CFO: Rs 800M (2078)—strong cash generation from transaction fees.
• Nepalgunj’s CFO: Rs 150M but CFI of -Rs 200M (expanding stores).

6. Limitations of Financial Statement Analysis

In the Real World

1. eSewa’s Profitability Puzzle

   • Ratio Used: Net Profit Margin
   • How? eSewa’s revenue is Rs 12B (2078), but net income is only Rs 100M (0.83% margin).
   • Why? High transaction fees to banks (3-5%) and fraud losses (Rs 200M/year).
   • Decision: Investors push for AI fraud detection to improve margins.

2. NTC’s Solvency Crisis

   • Ratio Used: Debt-to-Equity (D/E) and Interest Coverage
   • Numbers:
     • D/E = 4.5 (2077) → 3.8 (2078).
     • Interest Coverage = 1.2 (barely covers interest).
   • Real Impact: NTC had to negotiate with creditors to avoid default.

3. Daraz’s Cash Flow Struggle

   • Ratio Used: Cash Flow from Operations (CFO)
   • Problem: Daraz’s CFO is negative despite Rs 800M revenue because:
     • High inventory costs (unsold goods).
     • Aggressive discounts (low gross margins).
   • Solution: Layoffs (2078) to cut operating expenses.

Exam Tip: How to Score Full Marks

1. Structure Your Answer
   • Step 1: Define the ratio/tool (e.g., "Current Ratio = Current Assets / Current Liabilities").
   • Step 2: Interpret the formula (e.g., "Measures short-term liquidity").
   • Step 3: Apply to given data (show calculations).
   • Step 4: Compare with benchmarks/industry standards.
   • Step 5: State limitations (e.g., "Ignores qualitative factors").

2. Common Exam Traps

   • ❌ Ignoring units: Always label ratios (e.g., "Current Ratio = 2.5:1").
   • ❌ Using wrong data: Ensure you’re using Balance Sheet (for assets/liabilities) or Income Statement (for revenue/expenses).
   • ❌ Overlooking trends: If given 3 years of data, always compare them.

3. Numerical Questions: Show All Work

   • Example Question: "Calculate the gross profit margin for a company with Rs 10M revenue and Rs 6M COGS."
   • Full-Mark Answer:

     Gross Profit Margin = (Revenue - COGS) / Revenue
                        = (10M - 6M) / 10M
                        = 4M / 10M
                        = 0.4 or 40%.
     Interpretation: The company retains **40% of revenue after COGS**, which is **above the retail industry average of 30-35%**.
     

4. Descriptive Questions: Use Real Examples

   • Example Question: "Explain the importance of trend analysis."
   • Full-Mark Answer:

     Trend analysis helps identify patterns over time, such as NTC’s declining current ratio from 1.3 (2076) to 0.9 (2078), signaling liquidity risks. For Nepal Bank, rising ROA from 0.8% to 1.2% indicates better asset utilization. Without trends, a single-year snapshot (e.g., 2078’s ratios) could mislead investors into thinking a struggling company (like a garment exporter with a one-time high sales year) is healthy.

5. Cash Flow Statement Questions

   • Key Focus Areas:
     • Operating Activities: Is the company self-sustaining?
     • Investing Activities: Is it growing (e.g., NTC buying fiber optics) or shrinking?
     • Financing Activities: Is it borrowing too much (e.g., a startup with high CFF)?

Practice Questions (With Solutions)

Q1: Ratio Calculation

Given: Everest Company’s Balance Sheet (2078)

• Current Assets: Rs 500M
• Current Liabilities: Rs 300M
• Total Assets: Rs 1.2B
• Total Equity: Rs 600M
• Net Income: Rs 50M

Calculate and interpret:

1. Current Ratio
2. Debt-to-Equity Ratio
3. ROE

Solution:

| Ratio               | Calculation                     | Value  | Interpretation                          |
|---------------------|---------------------------------|--------|-----------------------------------------|
| Current Ratio       | 500M / 300M                     | 1.67   | **Strong liquidity** (can pay short-term debts). |
| Debt-to-Equity      | (1.2B - 600M) / 600M            | 1.0    | **Moderate leverage** (equal debt/equity). |
| ROE                 | 50M / 600M                      | 8.33%  | **Good return for shareholders** (vs. bank ROE of ~1.2%). |

Q2: Trend Analysis

Given: Rara Company’s Net Profit Margin (2076-2078)

• 2076: 5%
• 2077: 6%
• 2078: 4%

Answer:

The net profit margin declined from 6% (2077) to 4% (2078), reversing a previous 1% improvement (2076-77). This suggests:

• Rising costs (e.g., higher raw material prices for a Kathmandu textile shop).
• Pricing pressure (e.g., Daraz undercutting competitors).
• One-time expenses (e.g., a lawsuit or asset write-down). Investors should investigate whether this is a temporary dip or a structural issue.

Final Checklist for Exam Day

✅ Memorize key ratios (liquidity, profitability, solvency, efficiency). ✅ Practice calculations—don’t rely on calculators in exams. ✅ Relate to Nepali businesses (NTC, Khalti, Daraz, banks). ✅ State limitations in every analysis (e.g., "Ignores inflation"). ✅ Use real examples in descriptive answers (e.g., "Like NTC’s declining current ratio").