Financial Analysis & Interpretation: Ratios, Statements & Decision-Making

TAKEAWAYS:

• Financial analysis turns raw numbers into actionable insights using ratios, trends, and comparisons to assess a company’s health.
• The three core statements (income, balance sheet, cash flow) must be analyzed together—never in isolation.
• Liquidity ratios (current, quick) reveal short-term survival; profitability ratios (ROA, ROE) show long-term success.
• Benchmarking against industry averages or competitors exposes strengths/weaknesses (e.g., comparing Ncell’s debt ratios to NTC).
• Trend analysis over 3–5 years spots early warning signs (e.g., rising inventory turnover at Daraz signals efficiency gains).
• Limitations (e.g., window dressing, inflation, different accounting methods) must be disclosed to avoid misleading conclusions.

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1. The Three Pillars: Financial Statements

Financial analysis starts with three interconnected statements. Each tells a different story about the business.

A. Income Statement (Profit & Loss Statement)

Shows revenue, expenses, and net profit over a period (usually a year). Key items:

• Sales Revenue (e.g., Rs 500,000 for a Kathmandu tea shop)
• Cost of Goods Sold (COGS) (e.g., Rs 300,000 for tea leaves, packaging)
• Gross Profit = Revenue – COGS
• Operating Expenses (rent, salaries, utilities)
• Net Profit = Gross Profit – Operating Expenses – Taxes

| Particulars                     | Amount (Rs) |
|---------------------------------|-------------|
| **Sales Revenue**               | 500,000     |
| Less: COGS                      | (300,000)   |
| **Gross Profit**                | 200,000     |
| Less: Operating Expenses        | (120,000)   |
| **Operating Profit**            | 80,000      |
| Less: Interest Expense          | (5,000)     |
| **Profit Before Tax**           | 75,000      |
| Less: Tax (25%)                 | (18,750)    |
| **Net Profit**                  | 56,250      |

B. Balance Sheet (Financial Position)

Shows what a company owns (assets) and owes (liabilities) at a specific date (e.g., December 31, 2023). Key sections:

1. Assets (Current: Cash, Inventory; Non-Current: Property, Equipment)
2. Liabilities (Current: Accounts Payable; Non-Current: Long-term Loans)
3. Equity (Owner’s Capital + Retained Earnings)

| **Assets**                     | **Liabilities + Equity** |
|--------------------------------|--------------------------|
| **Current Assets**             | **Current Liabilities**  |
| Cash                           | 50,000                   | Accounts Payable        | 30,000   |
| Inventory                      | 80,000                   | Short-term Loan         | 20,000   |
| Accounts Receivable            | 40,000                   | **Total Current Liab.** | 50,000   |
| **Total Current Assets**       | 170,000                  | **Non-Current Liab.**   |
| **Non-Current Assets**         |                          | Long-term Loan          | 100,000  |
| Property, Plant & Equipment    | 200,000                  | **Total Liabilities**   | 150,000  |
| Less: Depreciation             | (50,000)                 | **Equity**              |
| **Net PPE**                    | 150,000                  | Owner’s Capital         | 100,000  |
| **Total Assets**               | 320,000                  | Retained Earnings       | 70,000   |
|                                |                          | **Total Equity**        | 170,000  |
|                                |                          | **Total Liab. + Equity**| 320,000  |

C. Cash Flow Statement

Tracks actual cash inflows and outflows (not just profits). Divided into:

1. Operating Activities (Cash from sales, supplier payments)
2. Investing Activities (Buying/selling assets like machinery)
3. Financing Activities (Loans, dividends, share issuance)

| Particulars                     | Amount (Rs) |
|---------------------------------|-------------|
| **Cash from Operations**        |             |
| Net Profit                      | 56,250      |
| + Depreciation                  | 50,000      |
| – Increase in Inventory         | (10,000)    |
| **Net Cash from Operations**    | 96,250      |
| **Cash from Investing**         |             |
| Purchase of Equipment           | (70,000)    |
| **Cash from Financing**         |             |
| Loan Proceeds                   | 50,000      |
| **Net Increase in Cash**        | 76,250      |
| **Opening Cash Balance**        | 30,000      |
| **Closing Cash Balance**        | 106,250     |

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2. Why Analyze Financial Statements?

Real-world example 1: eSewa’s Liquidity Crisis (2021)

• eSewa, Nepal’s leading digital payment platform, faced liquidity shortages in 2021 due to high cash outflows (refunds, withdrawals) but slow collections from merchants.
• Financial analysis would have revealed:
  • Current Ratio = Current Assets / Current Liabilities = 1.2 (below ideal 2.0).
  • Quick Ratio = (Cash + Receivables) / Current Liabilities = 0.8 (critical).
• Action: eSewa had to negotiate emergency loans from NMB Bank to meet short-term obligations.

Real-world example 2: Daraz’s Inventory Turnover

• Daraz Nepal struggles with high inventory levels in some categories (e.g., electronics).
• Inventory Turnover Ratio = COGS / Average Inventory.
  • If Daraz’s ratio drops from 8 to 5, it means inventory sits unsold for longer, tying up cash.
• Solution: Daraz uses financial analysis to identify slow-moving items and discounts them via "Daraz Big Billion Days."

Real-world example 3: Ncell’s Debt Management

• Ncell’s Debt-to-Equity Ratio (Total Debt / Shareholders’ Equity) was 1.8 in 2022.
• Comparison: NTC’s ratio was 0.9 (safer).
• Implication: Ncell relies more on debt, increasing financial risk. Investors and regulators monitor this closely.

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3. Key Financial Ratios: Your Decision-Making Tools

Ratios standardize numbers for comparison across companies/sizes. Divided into four categories:

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

Measures short-term survival ability.

Interpretation:

• Current Ratio = 3.4 → Strong liquidity (can pay bills 3.4x over).
• Quick Ratio = 1.8 → Even without selling inventory, the shop can cover liabilities.
• Cash Ratio = 1.0 → Warning: Over-reliance on cash may mean underinvestment in growth.

Mermaid Diagram: Liquidity Ratio Flow

B. Profitability Ratios: Is the Business Making Money?

Measures long-term success.

Interpretation:

• ROA = 17.6% → Excellent: The shop generates Rs 17.6 in profit per Rs 100 invested in assets.
• ROE = 33.1% → Very high: Shareholders earn Rs 33.1 per Rs 100 invested.
• Net Profit Margin = 11.25% → Good, but could improve by cutting operating costs.

Real-world tie-in: Pathao’s Profitability

• Pathao’s gross profit margin is ~20–25% (lower than Uber’s 30% due to Nepal’s high commission fees).
• Financial analysis shows Pathao must increase ride volume or negotiate lower payment processor fees to boost margins.

C. Leverage Ratios: How Much Debt Does the Company Use?

Measures financial risk from debt.

Interpretation:

• D/E = 0.59 → Safe: For every Rs 1 of equity, the shop has Rs 0.59 in debt.
• Interest Coverage = 16 → Very safe: Can pay interest 16x over with current earnings.

Real-world tie-in: NEPSE Listed Companies

• Nabil Bank: D/E = 0.8 (moderate risk)
• Global IME: D/E = 1.5 (higher risk, but higher growth potential)
• Investors use leverage ratios to decide whether a stock is "safe" or "high-reward/high-risk."

D. Efficiency Ratios: How Well Does the Company Use Its Resources?

Measures operational effectiveness.

Interpretation:

• Inventory Turnover = 3.75 → Slow: Inventory sits ~96 days (365/3.75). Action: Reduce bulk orders or offer discounts.
• Receivables Turnover = 12.5 → Fast: Collects payments every ~29 days (365/12.5). Good credit control.

Real-world tie-in: Daraz’s Supply Chain

• Daraz’s inventory turnover varies by category:
  • Fast-moving: Mobile phones (turnover = 15)
  • Slow-moving: Furniture (turnover = 3)
• Financial analysis helps Daraz adjust stock levels to avoid dead inventory.

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4. Horizontal vs. Vertical Analysis

A. Horizontal (Trend) Analysis

Compares financial data over time (e.g., 3–5 years) to spot trends.

Example: Kathmandu Tea Shop (2021–2023)

| Year | Sales (Rs) | Net Profit (Rs) | Current Ratio |
|------|------------|-----------------|---------------|
| 2021 | 400,000    | 40,000          | 2.5           |
| 2022 | 450,000    | 50,000          | 2.8           |
| 2023 | 500,000    | 56,250          | 3.4           |

Trends:

• Sales ↑ 25% (good growth).
• Net Profit ↑ 40.6% (better than sales growth → improving efficiency).
• Current Ratio ↑ 36% (stronger liquidity).

Mermaid Diagram: Trend Analysis

B. Vertical (Common-Size) Analysis

Converts absolute numbers to percentages of a base (e.g., sales = 100%) for cross-company comparison.

Example: Kathmandu Tea Shop (2023)

| Particulars          | Amount (Rs) | % of Sales |
|----------------------|-------------|------------|
| Sales Revenue        | 500,000     | 100%       |
| COGS                 | 300,000     | 60%        |
| Gross Profit         | 200,000     | 40%        |
| Operating Expenses   | 120,000     | 24%        |
| Net Profit           | 56,250      | 11.25%     |

Comparison with Industry Average (Nepal F&B):

| Ratio               | Kathmandu Shop | Industry Avg. |
|---------------------|----------------|---------------|
| Gross Profit Margin | 40%            | 35%           |
| Net Profit Margin   | 11.25%         | 8%            |
| Current Ratio       | 3.4            | 1.8           |

Insight: The shop outperforms the industry in profitability and liquidity.

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5. Benchmarking: How Does Your Company Stack Up?

Compare your company’s ratios against:

1. Industry Averages (e.g., Nepal’s retail vs. manufacturing).
2. Competitors (e.g., Daraz vs. Hamrobazaar).
3. Past Performance (your own historical data).

Example: Comparing Ncell and NTC (2023)

| Ratio               | Ncell (2023) | NTC (2023) | Industry Avg. |
|---------------------|--------------|------------|---------------|
| Debt-to-Equity      | 1.8          | 0.9        | 1.2           |
| ROA                 | 8%           | 12%        | 10%           |
| Current Ratio       | 0.7          | 1.1        | 0.9           |

Insights:

• Ncell is more leveraged (higher risk) but has lower profitability.
• NTC is safer but may be less aggressive in growth.

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6. Limitations of Financial Analysis

Even the best ratios can mislead if you ignore these pitfalls:

Real-world example: Kathmandu’s Financials

• Kathmandu’s inventory turnover dropped in 2022 due to supply chain delays (COVID-19), not poor management.
• Solution: Adjust ratios for external shocks before making decisions.

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7. Step-by-Step Worked Example: Analyzing a Nepali Business

Scenario: You’re evaluating Lalitpur Electronics, a small shop selling mobile phones and accessories. Here’s its 2023 data:

Income Statement (Rs)

| Particulars          | Amount |
|----------------------|--------|
| Sales Revenue        | 800,000|
| Less: COGS           | 500,000|
| Gross Profit         | 300,000|
| Less: Operating Expenses | 200,000|
| Net Profit           | 100,000|

Balance Sheet (Rs)

| Assets               | Liabilities + Equity |
|----------------------|----------------------|
| Cash                 | 50,000               | Accounts Payable     | 40,000   |
| Inventory            | 150,000              | Short-term Loan      | 30,000   |
| Accounts Receivable  | 80,000               | **Total Current Liab.** | 70,000 |
| Equipment (Net)      | 400,000              | Long-term Loan       | 100,000  |
| **Total Assets**     | 680,000              | **Total Liabilities** | 170,000 |
|                      |                      | Owner’s Equity       | 510,000  |
|                      |                      | **Total**            | 680,000  |

Step 1: Calculate Key Ratios

| Ratio                          | Calculation                          | Value       |
|--------------------------------|--------------------------------------|-------------|
| Current Ratio                  | Current Assets (280,000) / Current Liab. (70,000) | **4.0**     |
| Gross Profit Margin            | (800,000 – 500,000) / 800,000        | **37.5%**   |
| ROA                            | 100,000 / 680,000                    | **14.7%**   |
| Debt-to-Equity                 | 170,000 / 510,000                    | **0.33**    |
| Inventory Turnover             | 500,000 / 150,000                    | **3.33**    |

Step 2: Compare with Industry Averages (Nepal Electronics Retail)

| Ratio               | Lalitpur Electronics | Industry Avg. |
|---------------------|----------------------|---------------|
| Current Ratio       | 4.0                  | 1.5           |
| Gross Profit Margin | 37.5%                | 30%           |
| ROA                 | 14.7%                | 10%           |
| Inventory Turnover  | 3.33                 | 6.0           |

Step 3: Draw Conclusions ✅ Strengths:

• High liquidity (Current Ratio = 4.0 > industry 1.5).
• Strong profitability (ROA = 14.7% > industry 10%).

⚠️ Weaknesses:

• Slow inventory turnover (3.33 vs. industry 6.0). Risk: Old stock, dead capital.
• Low debt usage (D/E = 0.33). Opportunity: Could leverage more for growth.

Recommendations:

1. Reduce inventory by 30% (negotiate better supplier terms).
2. Invest in marketing to boost sales (currently underperforming vs. gross margin).
3. Consider a small loan to expand product lines (e.g., laptops).

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8. Common Mistakes to Avoid in Exams

Based on past TU/PU/NEB questions, students often lose marks by:

1. Ignoring the question context: Always ask, "What is the question testing?" (e.g., break-even vs. profitability).
2. Mismatched units: Ensure all ratios use consistent time periods (e.g., annual vs. monthly).
3. Forgetting to interpret: Calculating a ratio is worth half the marks; explaining its meaning is the other half.
4. Overlooking limitations: Always state 1–2 limitations of your analysis (e.g., "This ignores inflation effects").
5. Arithmetic errors: Double-check calculations (e.g., COGS = Revenue – Gross Profit).

Exam Tip:

"Show your work" for ratio calculations. Even if the final answer is wrong, partial credit is given for correct formulas and steps.

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Exam Tip: How to Score Full Marks

1. Structure your answer like this:

   • Step 1: Define the ratio/concept.
   • Step 2: Show the formula and plug in numbers.
   • Step 3: Interpret the result (compare to benchmarks).
   • Step 4: Suggest 1–2 actions based on the analysis.

2. For numerical questions (e.g., break-even):

   • Always label axes (e.g., "Units Sold" vs. "Profit/Loss").
   • Shade the loss zone in red and profit zone in green.

3. For descriptive questions (e.g., "Differences between financial risk and business risk"):

   • Use a 2-column table with real-world examples.

4. Memorize these high-yield ratios:

   • Break-even: $\text{Units}=\frac{\text{Fixed Costs}}{\text{Selling Price}-\text{Variable Cost}}$
   • ROE: $\text{ROE}=\text{ROA}\times \text{Financial Leverage}$
   • DuPont Analysis: $\text{ROE}=\frac{\text{Net Profit}}{\text{Revenue}}\times \frac{\text{Revenue}}{\text{Assets}}\times \frac{\text{Assets}}{\text{Equity}}$

5. Use Nepali examples in answers (examiners love this!):

   • "Like Ncell’s high debt levels, [Company X] should monitor its D/E ratio to avoid bankruptcy."
   • "Daraz’s inventory turnover ratio dropped in 2023 due to supply chain delays, similar to how Kathmandu’s tea shops faced stock shortages during COVID."

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Final Checklist Before Submitting

• Did I define all terms clearly?
• Did I show calculations (not just final answers)?
• Did I compare with industry benchmarks or past data?
• Did I interpret the results (not just state numbers)?
• Did I mention limitations of the analysis?
• Did I tie back to the question (e.g., "Thus, the break-even point is...")?

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