Financial Statements Analysis: Statements, Ratios & Decision-Making

Core Concepts: The Three Financial Statements

Financial statements are the language of business finance. They tell you:

• How much money a company made (or lost) in a period (Income Statement).
• What the company owns and owes at a point in time (Balance Sheet).
• Where cash actually came from and went (Cash Flow Statement).

These statements are interconnected—changes in one affect the others. For example, if a tourism business like Kathmandu’s Himalayan Trekking Adventures sells more trekking packages (revenue ↑), its Income Statement shows higher profit, which increases retained earnings in the Balance Sheet, and finally affects cash flows from operations.

1. Income Statement (Profit & Loss Statement)

Definition: Shows revenue, expenses, and net profit/loss over a period (month, quarter, year). Key Line Items:

Why It Matters:

• Helps owners/managers see if the business is profitable.
• Used to calculate ratios (e.g., profit margin = Net Profit / Revenue).
• Real World: Nepal Airlines uses its Income Statement to decide whether to expand routes or cut costs.

2. Balance Sheet (Financial Position)

Definition: A snapshot of a company’s assets, liabilities, and equity at a specific date (e.g., 31 Dec 2023). Key Equation:

Assets = Liabilities + Owner’s Equity

Structure:

Example: Himalayan Trekking Adventures (31 Dec 2023)

Why It Matters:

• Shows liquidity (can the business pay short-term debts?).
• Helps banks decide loan eligibility (e.g., NMB Bank checks assets before approving a loan).
• Real World: Nepal Rastra Bank (NRB) reviews balance sheets to monitor financial stability of businesses.

3. Cash Flow Statement

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

1. Operating Activities (core business cash flows)
2. Investing Activities (buying/selling assets)
3. Financing Activities (loans, dividends, share issuance)

Example: Himalayan Trekking Adventures (2023)

Why It Matters:

• Cash ≠ Profit: A business can be profitable but run out of cash (e.g., if customers pay late but suppliers demand immediate payment).
• Real World: Pathao drivers track cash flow daily—they need enough cash to buy fuel, pay for the bike, and still have money left for personal use.

How the Statements Are Linked: The Accounting Cycle

The three statements are not independent—they follow a cycle. Changes in one affect the others.

flowchart TD
    A["Income Statement\n(Revenue - Expenses = Net Profit)"] --> B["Balance Sheet\n(Net Profit → Retained Earnings → Equity ↑)"]
    B --> C["Cash Flow Statement\n(Net Profit + Non-Cash Items = Operating Cash Flow)"]
    C --> D["Balance Sheet\n(Cash Balance Updates)"]
    D --> A

Example Trace:

1. Himalayan Trekking Adventures earns NPR 5,000,000 from trekking packages (Income Statement).
2. After expenses, Net Profit = NPR 975,000 → This increases Retained Earnings in the Balance Sheet.
3. The Cash Flow Statement shows NPR 1,300,000 from operations (since some expenses were non-cash, like depreciation).
4. The ending cash balance in the Cash Flow Statement updates the Cash asset in the Balance Sheet.

Financial Ratios: Turning Numbers into Decisions

Ratios simplify financial data into actionable insights. Common types:

1. Profitability Ratios (Is the business making enough profit?)

Real World:

• Nepal Stock Exchange (NEPSE) lists companies with high ROE (e.g., Nabil Bank) as better investments.
• Daraz Nepal uses gross profit margin to decide which products to stock more of.

2. Liquidity Ratios (Can the business pay short-term debts?)

Real World:

• Nepal Rastra Bank (NRB) checks current ratio before approving loans to SMEs.
• Khalti uses liquidity ratios to decide which merchants get instant payouts.

3. Solvency Ratios (Can the business survive long-term?)

Real World:

• Global IME Bank uses D/E ratio to assess loan risk for tourism businesses.
• NTC checks interest coverage before approving telecom infrastructure loans.

Comparative Analysis: Horizontal vs. Vertical Analysis

Real World:

• Nepal Airlines uses horizontal analysis to see if fuel costs are rising faster than revenue.
• Kathmandu’s hotels use vertical analysis to check if housekeeping costs are too high compared to revenue.

Limitations of Financial Statements

While powerful, financial statements have blind spots:

1. No Qualitative Factors: Can’t measure customer satisfaction, brand reputation, or management quality.
2. Window Dressing: Companies may manipulate numbers (e.g., delaying expense recognition to show higher profit).
3. Inflation Impact: Historical cost accounting doesn’t adjust for inflation (e.g., a 2010 asset may be worth less today).
4. Non-Cash Items: Depreciation and amortization reduce profit but don’t affect cash.

Real World:

• Nepal Stock Exchange (NEPSE) scandals (e.g., 2015 fraud cases) showed how fake financials misled investors.
• Pathao drivers know that high revenue ≠ high cash—some customers pay late, creating a cash flow crisis.

In the Real World

Financial statement analysis is everywhere in Nepal’s business ecosystem:

1. eSewa & Khalti (Digital Payments)

   • Liquidity Ratios: These apps must maintain a high current ratio to ensure instant payouts to merchants.
   • Cash Flow Statement: They track daily cash inflows (transactions) vs. outflows (withdrawals, fees).

2. Daraz Nepal (E-Commerce)

   • Inventory Turnover Ratio: Measures how quickly products sell (e.g., electronics sell faster than furniture).
   • Gross Profit Margin: Helps decide discount strategies (e.g., if margin is 20%, they can’t afford 30% discounts).

3. Nepal Rastra Bank (NRB) & Commercial Banks

   • Debt-to-Equity (D/E): Used to approve loans (e.g., a D/E > 2 may get rejected).
   • Cash Flow Analysis: Banks check if a business has enough operating cash flow to repay loans.

4. NTC & Ncell (Telecom)

   • Capital Expenditure (CapEx): Analyzed to see if network expansion is sustainable.
   • Free Cash Flow: Determines dividend payouts to shareholders.

5. Tourism Businesses (e.g., Himalayan Trekking Adventures)

   • Seasonal Analysis: Income Statement shows peak season (Oct-Dec) vs. slow season (Jan-Mar).
   • Working Capital: Ensures enough cash for guide salaries during off-peak months.

Worked Example: Analyzing a Kathmandu Hotel’s Financial Health

Scenario: Everest View Hotel (Kathmandu) has the following data for 2023:

Step 1: Calculate Key Ratios

Step 2: Identify Red Flags & Opportunities

• Problem: Current Ratio = 1.18 (below ideal 1.5). The hotel may face cash crunch if guests pay late or expenses rise.
• Solution:
  • Negotiate longer payment terms with suppliers.
  • Offer early-bird discounts to ensure cash receipts are timely.
• Opportunity: High Net Profit Margin (27.5%) suggests upselling opportunities (e.g., premium rooms, spa services).

Step 3: Cash Flow Analysis

Assume:

• Depreciation (NPR 500,000) is a non-cash expense.
• Net Profit = NPR 5,500,000, but actual cash flow is lower due to:
  • Increase in Inventory (food stocks rose by NPR 500,000).
  • Increase in Accounts Receivable (guests owe NPR 1.5M).

Adjusted Cash Flow from Operations:

Net Profit (5.5M)
+ Depreciation (500K) → Non-cash
- Increase in Inventory (500K)
- Increase in Accounts Receivable (1.5M)
= **Cash Flow from Operations = 4,000,000**

Conclusion: The hotel is profitable but not cash-rich. Management should improve collections and reduce inventory waste.

Exam Tip: How to Score Full Marks

1. Structure Your Answer:

   • Always start with definitions (e.g., "The Income Statement measures revenue, expenses, and profit over a period...").
   • Use tables for financial statements (Dr/Cr columns, totals).
   • Label all ratios clearly (e.g., "Current Ratio = Current Assets / Current Liabilities = X").

2. Show Workings:

   • Never just write "Current Ratio = 2.5". Show:

     Current Assets = Cash (3M) + Receivables (1.5M) + Inventory (2M) = 6.5M
     Current Liabilities = 5.5M
     Current Ratio = 6.5M / 5.5M = 1.18
     

3. Interpret Results:

   • Compare with benchmarks (e.g., "A current ratio of 1.18 is below the ideal 1.5, indicating liquidity risk").
   • Suggest improvements (e.g., "The hotel should negotiate better payment terms with suppliers").

4. Use Nepali Business Examples:

   • Examiners love real-world ties. Always relate to:
     • Tourism (hotels, trekking companies).
     • Retail (Daraz, local shops).
     • Banks (NMB, Global IME).
     • Digital Payments (eSewa, Khalti).

5. Common Mistakes to Avoid:

   • ❌ Ignoring non-cash items (e.g., forgetting to add back depreciation in cash flow).
   • ❌ Mixing up ratios (e.g., using D/E instead of Current Ratio for liquidity).
   • ❌ No units (always write "NPR" or "%" where needed).

Final Checklist for Exam Answers: ✅ Definitions (1 mark each). ✅ Calculations (show steps, 2-3 marks). ✅ Interpretation (compare with benchmarks, 2 marks). ✅ Recommendations (1-2 marks for practical suggestions). ✅ Real-world tie (1 mark for Nepali business example).