Financial Statements & Ratio Analysis: Reading Business Health

TAKEAWAYS:

• Financial statements (balance sheet, income statement, cash flow) are the numerical reports that summarize a firm’s financial position, performance, and cash flows over a period.
• Ratio analysis converts raw financial data into meaningful insights (e.g., liquidity ratios show if a business can pay short-term debts; profitability ratios reveal efficiency).
• Nepal’s NEPSE and banks (e.g., NMB, Global IME) use these tools to evaluate listed companies and loan applicants before approving investments or loans.
• Common-size statements standardize financial data for trend analysis (e.g., comparing Himalayan Bank’s 2022 vs. 2023 income statements).
• Limitations of ratios include industry-specific benchmarks, inflation effects, and the need for qualitative judgment (e.g., a high debt-to-equity ratio may signal risk or growth potential).
• Exam focus: Link ratios to real scenarios (e.g., "Why did Daraz’s current ratio drop in Q2 2023?" or "How does Pathao’s DSO affect its cash flow?").

1. Introduction to Financial Statements

Financial statements are the backbone of financial reporting, providing structured data to stakeholders (investors, creditors, regulators) to assess a firm’s financial health. They are prepared based on generally accepted accounting principles (GAAP) in Nepal (adopted from IFRS).

Key Types of Financial Statements

Three primary statements form the financial reporting framework:

Why it matters:

• The balance sheet is called the "accounting equation" because it must always balance (Assets = Liabilities + Equity).
• Example: If Sagar Retail (a Kathmandu shop) has Rs 1M in assets but Rs 800K in liabilities, its equity is Rs 200K—this tells creditors how much owners have invested.

2. The Income Statement: Profitability in Action

The income statement answers: "Did the business make or lose money over a period?"

Structure of an Income Statement (for Himalayan Tours, FY 2079/80):

Revenue (Sales)                     Rs 5,000,000
Less: Cost of Goods Sold (COGS)     Rs 2,500,000
= Gross Profit                       Rs 2,500,000
Less: Operating Expenses:
  - Salaries                          Rs 800,000
  - Rent                              Rs 300,000
  - Depreciation                      Rs 100,000
= Operating Income (EBIT)            Rs 1,400,000
Less: Interest Expense               Rs   200,000
= Earnings Before Tax (EBT)          Rs 1,200,000
Less: Tax (30%)                      Rs   360,000
= Net Income                         Rs   840,000

Key Terms:

• Gross Profit: Revenue – COGS (measures core business efficiency).
• EBIT (Earnings Before Interest & Tax): Operating profit (ignores financing/tax).
• Net Income: Final profit after all expenses (what shareholders earn).

Real-World Tie:

• NEPSE-listed companies (e.g., Nepal Investment Bank) disclose their income statements quarterly. Investors compare their net profit margins (Net Income / Sales) to industry averages (e.g., banks target 20–30%).
• Worked Example: If Daraz Nepal reports Rs 2B sales but Rs 1.2B COGS, its gross profit margin is 40%—higher than competitors like Sastodeal, signaling better pricing power.

3. The Cash Flow Statement: Liquidity Beyond Accounting

While the income statement shows profit, the cash flow statement reveals cash generation—critical for paying salaries, suppliers, and debts.

Three Cash Flow Categories:

1. Operating Activities: Cash from core business (e.g., collecting payments from customers).
2. Investing Activities: Cash used to buy/sell assets (e.g., purchasing new delivery vans for Pathao).
3. Financing Activities: Cash from loans, equity, or dividends (e.g., NMB Bank issuing bonds).

Example for Kathmandu Café (FY 2079/80):

Cash Flow from Operations:   Rs 1,200,000
Cash Flow from Investing:   -Rs 300,000 (bought espresso machine)
Cash Flow from Financing:   -Rs 200,000 (repaid loan)
Net Cash Flow               Rs   700,000

Why it’s critical:

• A company can be profitable (net income > 0) but cash-poor (e.g., Sagar Retail sells on credit but struggles to pay suppliers).
• Nepal’s banks (e.g., Global IME) use cash flow statements to assess loan applicants’ ability to repay.

4. Ratio Analysis: Turning Numbers into Insights

Ratios standardize financial data to compare firms of different sizes or track performance over time. They are classified into five categories:

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

1. Current Ratio $$\text{Current Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$$

• Interpretation:
  • > 1.5: Healthy (e.g., NMB Bank = 2.1).
  • < 1: Risk of illiquidity (e.g., Sagar Retail = 0.9 → may struggle to pay suppliers).
• Example: If Himalayan Tours has Rs 1.5M current assets and Rs 1M current liabilities, its current ratio is 1.5:1.

2. Quick Ratio (Acid-Test) $$\text{Quick Ratio}=\frac{\text{Current Assets}-\text{Inventory}}{\text{Current Liabilities}}$$

• Why exclude inventory? It’s harder to convert to cash quickly.
• Example: Kathmandu Café’s quick ratio = (Rs 800K cash + Rs 200K receivables) / Rs 500K liabilities = 2.0 (strong liquidity).

B. Profitability Ratios: Is the Business Efficient?

1. Gross Profit Margin $$\text{Gross Margin}=\frac{\text{Gross Profit}}{\text{Sales}}\times 100$$

• Example: Daraz’s gross margin = (Rs 2B – Rs 1.2B) / Rs 2B = 40% (higher than Sastodeal’s 35%).

2. Net Profit Margin $$\text{Net Margin}=\frac{\text{Net Income}}{\text{Sales}}\times 100$$

• Example: NMB Bank’s net margin = Rs 500M / Rs 5B = 10% (typical for banks).

3. Return on Equity (ROE) $$\text{ROE}=\frac{\text{Net Income}}{\text{Shareholders’ Equity}}\times 100$$

• Example: NEPSE-listed Nepal Investment Bank has ROE = 15% (strong return for shareholders).

C. Efficiency Ratios: Are Assets Being Used Well?

1. Inventory Turnover $$\text{Inventory Turnover}=\frac{\text{COGS}}{\text{Average Inventory}}$$

• High turnover = fast sales (e.g., Daraz’s turnover = 12x/year).
• Low turnover = slow-moving stock (e.g., Sagar Retail’s turnover = 4x/year → may need discounting).

2. Days Sales Outstanding (DSO) $$\text{DSO}=\frac{\text{Accounts Receivable}}{\text{Annual Credit Sales}}\times 365$$

• Example: Pathao’s DSO = 10 days (customers pay quickly).
• Example: Himalayan Tours’ DSO = 45 days (may need stricter credit policies).

D. Leverage Ratios: How Much Debt is Too Much?

1. Debt-to-Equity Ratio $$\text{Debt-to-Equity}=\frac{\text{Total Debt}}{\text{Shareholders’ Equity}}$$

• Rule of thumb:
  • < 0.5: Conservative (e.g., NMB Bank = 0.4).
  • > 1.0: Risky (e.g., NEPSE-listed Nepal Investment Bank = 0.7).
• Example: If Himalayan Tours has Rs 3M debt and Rs 2M equity, its ratio = 1.5 (high risk).

2. Times Interest Earned (TIE) $$\text{TIE}=\frac{\text{EBIT}}{\text{Interest Expense}}$$

• Example: NMB Bank’s TIE = Rs 500M / Rs 100M = 5x (can easily cover interest).

E. Market Ratios: What Do Investors Think?

1. Price-to-Earnings (P/E) Ratio $$\text{P/E}=\frac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}}$$

• High P/E = Growth expectations (e.g., NEPSE’s Nepal Bank = 20x).
• Low P/E = Undervalued or low growth (e.g., Global IME = 12x).

2. Dividend Yield $$\text{Dividend Yield}=\frac{\text{Annual Dividend per Share}}{\text{Market Price}}\times 100$$

• Example: NMB Bank’s dividend yield = 4% (attractive for income investors).

5. Limitations of Ratio Analysis

While ratios are powerful, they have key limitations:

Real-World Example:

• NEPSE’s Nepal Investment Bank had a debt-to-equity ratio of 0.7 in 2079, which seemed risky. However, its high ROE (18%) and strong cash flow justified the leverage—showing that ratios must be analyzed holistically.

6. Common-Size Financial Statements

To compare firms of different sizes, we use common-size statements, which express each line item as a percentage of a base figure (e.g., total assets for balance sheet, sales for income statement).

Example: Common-Size Income Statement for Himalayan Tours (FY 2079/80):

Sales Revenue               100% (Rs 5,000,000)
Less: COGS                  50% (Rs 2,500,000)
= Gross Profit              50%
Less: Operating Expenses:
  - Salaries                 16% (Rs 800,000)
  - Rent                     6%  (Rs 300,000)
  - Depreciation             2%  (Rs 100,000)
= Operating Income (EBIT)   28%
Less: Interest Expense      4%  (Rs 200,000)
= EBT                       24%
Less: Tax (30%)             7.2%
= Net Income                16.8%

Why it’s useful:

• Trend analysis: Compare Himalayan Tours’ 2079 vs. 2080 common-size statements to spot shifts (e.g., rising COGS % may signal cost pressures).
• Benchmarking: Compare against industry averages (e.g., Daraz’s COGS % = 60% vs. Himalayan Tours’ 50%).

7. Financial Statement Analysis: A Worked Example

Scenario: Sagar Retail (a Kathmandu clothing store) provides the following data for FY 2079/80:

• Current Assets: Rs 1,500,000
• Current Liabilities: Rs 1,000,000
• Sales: Rs 10,000,000
• COGS: Rs 6,000,000
• Net Income: Rs 500,000
• Total Assets: Rs 5,000,000
• Shareholders' Equity: Rs 2,000,000

flowchart TD
    A["Balance Sheet: Assets = Liab. + Equity"]
    B["Income Statement: Revenue - Expenses = Net Income"]
    C["Cash Flow Statement: Operating + Investing + Financing"]
    D["Ratio Analysis: Liquidity/Profitability"]
    E["Qualitative Judgment: Industry Context"]
    
    A -->|"Rs 1,000,000"| B
    B -->|"Rs 840,000 Net Income"| C
    C -->|"Rs 700,000 Net Cash"| D
    D -->|"Current Ratio: 1.67"| E
    E -->|"Nepal’s retail sector avg: 1.8"| Conclusion

Tasks:

1. Prepare a balance sheet and income statement.
2. Calculate key ratios and assess financial health.
3. Provide management recommendations.

Step 1: Prepare Financial Statements

Balance Sheet (Simplified):

Assets:
  Current Assets: Rs 1,500,000
  Fixed Assets: Rs 3,500,000 (Total Assets: Rs 5,000,000)
Liabilities + Equity:
  Current Liabilities: Rs 1,000,000
  Long-term Debt: Rs 1,500,000
  Shareholders' Equity: Rs 2,000,000 (Total: Rs 5,000,000)

Income Statement:

Sales Revenue: Rs 10,000,000
Less: COGS: Rs 6,000,000
= Gross Profit: Rs 4,000,000
Less: Operating Expenses: Rs 3,500,000 (Net Income: Rs 500,000)

Step 2: Calculate Ratios

Step 3: Recommendations

1. Improve Liquidity:

   • Reduce inventory (current ratio = 1.5 but quick ratio = 0.8 → inventory is dragging liquidity).
   • Negotiate better payment terms with suppliers (e.g., 30-day instead of 60-day credit).

2. Boost Profitability:

   • Increase sales (e.g., digital marketing like Daraz or Sastodeal).
   • Reduce COGS (e.g., bulk purchasing or supplier discounts).

3. Manage Debt:

   • Current debt-to-equity = 0.75 is acceptable, but monitor interest expenses (TIE = EBIT / Interest).
   • Consider equity financing (e.g., issuing shares to investors) to reduce leverage.

4. Improve Cash Flow:

   • Shorten DSO from 60 to 30 days (e.g., offer discounts for early payment).
   • Track cash flow statement to ensure operating cash covers expenses.

🔴 Weaknesses:
- Quick Ratio = 0.8x (illiquid)
- DSO = 60 days (slow collections)
- Net Profit Margin = 5% (below industry avg.)

🟢 Strengths:
- Current Ratio = 1.5x (acceptable)
- Gross Margin = 40% (strong)
- Debt-to-Equity = 0.75x (moderate risk)

💡 Recommendations:
1. Sell excess inventory (Rs 500K).
2. Offer discounts for early payments (reduce DSO).
3. Explore digital marketing (increase sales).

8. In the Real World

Financial statements and ratio analysis are the backbone of decision-making in Nepal’s business ecosystem. Here’s how they’re used in everyday companies and apps:

1. NEPSE and Stock Investments

• How it’s used: Investors analyze P/E ratios, dividend yields, and ROE to decide whether to buy/sell stocks.
  • Example: Nepal Investment Bank’s P/E ratio of 15x suggests it’s fairly valued compared to Global IME’s 12x (cheaper).
  • Worked Example: If NEPSE’s NMB Bank reports a net profit margin of 10% and a dividend yield of 4%, an investor can compare it to risk-free government bonds (yielding 6%) and decide whether to invest.

2. Banks and Loan Approvals

• How it’s used: Banks (e.g., NMB, Global IME) use liquidity ratios (current ratio, quick ratio) and profitability ratios (ROA, ROE) to assess loan applicants.
  • Example: Sagar Retail applies for a Rs 500K loan. The bank checks:
    • Current Ratio = 1.5x (meets minimum 1.2x requirement).
    • Quick Ratio = 0.8x (below ideal 1.0x → bank may ask for collateral).
    • DSO = 60 days (high → bank may require a personal guarantee).

3. E-commerce: Daraz vs. Sastodeal

• How it’s used: Competitors like Daraz and Sastodeal compare gross margins, inventory turnover, and DSO to optimize operations.
  • Example: Daraz’s gross margin of 40% vs. Sastodeal’s 35% shows Daraz has better pricing power or lower COGS.
  • DSO Comparison:
    • Daraz: 7 days (customers pay quickly via eSewa/Khalti).
    • Sastodeal: 15 days (may need stricter credit policies).

4. Ride-Hailing: Pathao’s Cash Flow Management

• How it’s used: Pathao tracks cash flow from operations to ensure it can cover driver payouts and platform fees.
  • Example: If Pathao’s operating cash flow is Rs 500M/year but driver payouts are Rs 600M, it must either:
    • Increase fares (reduce gross margin).
    • Negotiate better terms with drivers (improve efficiency).
  • DSO Impact: Pathao’s DSO of 10 days means customers pay quickly, improving liquidity.

5. Nepal’s Working Capital Crisis (Real-World Tie)

• Problem: Many Nepali businesses (e.g., Sagar Retail) struggle with low liquidity due to:
  • Long DSO (customers take 30–60 days to pay).
  • High inventory holding costs (perishable goods).
• Solution: The government and banks promote working capital loans (short-term financing) to cover gaps between cash inflows and outflows.
  • Example: If Himalayan Tours has a current ratio of 1.2x but needs Rs 200K for payroll, a bank may approve a working capital loan to bridge the gap.

Mermaid Diagram: The Accounting Cycle (Financial Statements Flow)

flowchart TD
    A["Transactions (Sales, Purchases, Loans)"] --> B["Journal Entries (Dr/Cr)"]
    B --> C["Ledger Postings (T-accounts)"]
    C --> D["Trial Balance (Debits = Credits)"]
    D --> E["Financial Statements\n1. Income Statement\n2. Balance Sheet\n3. Cash Flow Statement"]
    E --> F["Ratio Analysis\n(Liquidity, Profitability, etc.)"]
    F --> G["Management Decisions\n(Loans, Investments, Cost Cutting)"]
    G --> A

9. Exam Tips for Unit 2

1. Memorize the Three Financial Statements:
   • Balance Sheet: Assets = Liabilities + Equity (snapshot).
   • Income Statement: Revenue – Expenses = Net Income (period).
   • Cash Flow Statement: Cash inflows/outflows (operations, investing, financing).

2. Ratio Formulas Are Your Best Friend:

   • Liquidity: Current Ratio = Current Assets / Current Liabilities.
   • Profitability: ROE = Net Income / Shareholders' Equity.
   • Efficiency: DSO = (Accounts Receivable / Sales) × 365.
   • Always show calculations in exams—even if you forget the formula, you can derive it.

3. Link Ratios to Real Scenarios:

   • Example Question: "Why did Daraz’s current ratio drop from 1.8x to 1.5x in Q2 2023?"
     • Answer: Likely due to increased inventory (seasonal stock for Diwali) or expanded credit sales (DSO increased).
   • Example Question: "Analyze NMB Bank’s financial health using ratios."
     • Answer:
       • Liquidity: Current Ratio = 2.1x (healthy).
       • Profitability: Net Margin = 10% (strong for banking).
       • Leverage: Debt-to-Equity = 0.4x (low risk).
       • Conclusion: NMB is financially stable.

4. Common Mistakes to Avoid:

   • Mixing up assets/liabilities: Always remember Assets = Liabilities + Equity.
   • Ignoring qualitative factors: Ratios alone don’t tell the full story (e.g., Pathao’s high DSO may hide strong customer trust).
   • Forgetting units: Always label ratios (e.g., "Current Ratio = 1.5x", not just "1.5").

5. Worked Example Practice:

   • Exam-style question: "Primal Transport has current assets of Rs 2M and current liabilities of Rs 1M. What effect would (a) selling inventory for Rs 500K cash, and (b) taking a Rs 300K loan have on its current ratio?"
     • Solution:
       • Initial Current Ratio: 2M / 1M = 2.0x.
       • (a) Selling inventory:
         • New Current Assets = 2M + 500K = 2.5M.
         • Current Liabilities unchanged = 1M.
         • New Current Ratio = 2.5M / 1M = 2.5x (improved liquidity).
       • (b) Taking a Rs 300K loan:
         • Current Assets unchanged = 2.5M.
         • New Current Liabilities = 1M + 300K = 1.3M.
         • New Current Ratio = 2.5M / 1.3M ≈ 1.92x (slightly reduced liquidity).

6. Time Management:

   • Allocate 30–40 minutes for ratio calculations in exams.
   • Show all steps—even if you make a small error, partial credit is often given.

Final Note: Financial statements and ratio analysis are not just numbers—they tell the story of a business. Whether you’re evaluating NEPSE-listed stocks, applying for a bank loan, or managing a small shop like Sagar Retail, these tools are essential. Master them, and you’ll see financial health clearly.

Mermaid Diagram: How Ratios Help Investors

mindmap
  root((Investor Decision-Making))
    Liquidity Ratios
      Current Ratio
      Quick Ratio
    Profitability Ratios
      Gross Margin
      Net Profit Margin
      ROE
    Efficiency Ratios
      Inventory Turnover
      DSO
    Leverage Ratios
      Debt-to-Equity
      TIE
    Market Ratios
      P/E Ratio
      Dividend Yield