Financial Statement Analysis: Tools & Techniques

TAKEAWAYS:

• Vertical analysis compares line items to a base (e.g., sales) to reveal profit margins and cost structures.
• Horizontal analysis tracks changes over time (e.g., year-over-year growth) to spot trends like rising debt or declining efficiency.
• Common-size statements standardize financial data (e.g., all figures as % of sales) for easy cross-company comparisons.
• Ratio analysis decodes financial health: liquidity (can the company pay short-term debts?), profitability (is it generating returns?), solvency (can it survive long-term?), and efficiency (how well does it use assets?).
• Limitations include window-dressing (e.g., aggressive revenue recognition) and industry-specific benchmarks.
• Nepal context: Use NEPSE-listed companies (e.g., NMB Bank, Global IME) or local SMEs (e.g., a Kathmandu retail shop) to apply these tools to real-world financials.

Core Concepts: Why Analyze Financial Statements?

Financial statements (Income Statement, Balance Sheet, Cash Flow Statement) are like a company’s report card—but raw numbers don’t tell the full story. Analysis turns data into insights. For example:

• A growing revenue might hide shrinking profit margins (costs rising faster than sales).
• A high current ratio (current assets/current liabilities) might mask aging inventory (assets not turning into cash).
• A low debt-to-equity ratio could signal missed growth opportunities (too little leverage).

Key question: Are the numbers telling the truth? Analysis helps detect red flags (e.g., channel stuffing—forcing distributors to buy more inventory than they can sell) or hidden strengths (e.g., efficient working capital management).

1. Vertical Analysis: The "Percentage of Sales" Lens

Vertical analysis expresses each line item as a percentage of a base (usually total sales for the Income Statement or total assets for the Balance Sheet). This reveals:

• Profitability structure: Are COGS (Cost of Goods Sold) or operating expenses eating into profits?
• Liquidity focus: What % of assets are cash vs. inventory?
• Leverage: How much debt funds operations vs. equity?

How to Do It

1. Pick a base (e.g., Net Sales for Income Statement).
2. Divide each line item by the base and multiply by 100.
3. Compare percentages across years or vs. industry averages.

Example: Kathmandu Retail Shop (FY 2023 vs. 2022)

Assume the shop’s Income Statement (in NPR ’000):

Insights:

• Gross profit margin stayed at 40%, but operating expenses rose (from 22% to 24% of sales), squeezing net profit.
• Net profit margin dropped from 18% to 16%, even though sales grew. Warning: Cost control is needed.

2. Horizontal Analysis: Tracking Trends Over Time

Horizontal analysis compares absolute changes and percentage changes in line items over multiple periods (e.g., 2022 vs. 2023). It answers:

• Is revenue growing faster than expenses?
• Are liabilities increasing faster than assets?
• Is cash flow from operations improving or declining?

Formula

For any line item:

• Absolute Change = Current Year Value – Previous Year Value
• Percentage Change = (Absolute Change / Previous Year Value) × 100

Example: NMB Bank’s Net Income (Simplified)

Assume NMB Bank’s net income was NPR 12 billion in 2022 and NPR 15 billion in 2023.

Insight: A 25% jump in net income is great—but dig deeper:

• Did it come from higher loan interest income or lower provisions for bad loans?
• Check the Cash Flow Statement to see if it’s sustainable (e.g., from core operations or one-time gains).

3. Common-Size Financial Statements

Common-size statements standardize all items as percentages of a base (e.g., total assets for Balance Sheet, total sales for Income Statement). This lets you:

• Compare different-sized companies (e.g., a small Kathmandu shop vs. a large Daraz seller).
• Spot industry trends (e.g., tech firms have higher R&D % than retail).

Example: Balance Sheet Comparison (Retail Shop vs. NMB Bank)

Assume both have total assets of NPR 100 million in 2023.

Insights:

• The retail shop is asset-heavy (30% in inventory vs. NMB’s 2%), meaning it’s less liquid but may have higher margins.
• NMB is highly leveraged (85% liabilities vs. 15% equity)—typical for banks but risky if interest rates rise.

4. Ratio Analysis: The "Financial Health Check"

Ratios quantify relationships between financial statement items. They’re divided into four categories:

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

Measures short-term survival ability.

Example: A Kathmandu garment factory has:

• Current Assets = NPR 20M (Cash: 5M, Inventory: 10M, Receivables: 5M)
• Current Liabilities = NPR 15M
• Current Ratio = 20M / 15M = 1.33 (⚠️ Borderline—needs to sell inventory faster).
• Quick Ratio = (20M – 10M) / 15M = 0.67 (❌ Risky—can’t cover liabilities without selling inventory).

B. Profitability Ratios: Is the Company Making Money?

Measures return on investments.

Example: Nepal Food Industries (NFI) reports:

• Net Profit = NPR 500M
• Sales = NPR 5,000M
• Total Assets = NPR 8,000M
• Equity = NPR 3,000M
• Net Profit Margin = (500M / 5,000M) × 100 = 10% (✅ Strong for FMCG).
• ROE = (500M / 3,000M) × 100 = 16.7% (✅ Above industry avg).

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

Measures long-term debt sustainability.

Example: Himalayan Brewery has:

• Total Debt = NPR 2,000M
• Equity = NPR 1,000M
• EBIT = NPR 800M
• Interest Expense = NPR 200M
• D/E Ratio = 2,000M / 1,000M = 2.0 (⚠️ High—vulnerable to interest rate hikes).
• Times Interest Earned = 800M / 200M = 4.0 (✅ Can cover interest easily).

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

Measures asset turnover and working capital management.

Example: Everest Cables has:

• COGS = NPR 10,000M
• Avg Inventory = NPR 2,000M
• Sales = NPR 15,000M
• Avg Receivables = NPR 1,500M
• Inventory Turnover = 10,000M / 2,000M = 5 times/year (✅ Fast—inventory not sitting idle).
• Receivables Turnover = 15,000M / 1,500M = 10 times/year (✅ Collects payments quickly).

5. Limitations of Financial Statement Analysis

Even with ratios, numbers can lie. Common pitfalls:

• Window-Dressing: Companies manipulate numbers (e.g., delaying expense recognition to boost current-year profits).
• Industry Differences: A high D/E ratio is normal for banks but risky for retail.
• Inflation Effects: Historical cost accounting understates asset values in high-inflation economies like Nepal.
• Off-Balance-Sheet Items: Leases or contingent liabilities (e.g., lawsuits) may not appear in financials.
• Qualitative Factors: Customer loyalty, brand strength, or management quality aren’t in the numbers.

Example: Daraz Nepal might show high sales growth but negative cash flow—because it’s offering deep discounts to attract users (a strategy, not a problem—yet).

In the Real World

1. eSewa (Nepal’s Digital Payment Gateway)

   • Ratio Used: Liquidity Ratios (Current Ratio, Quick Ratio)
   • How? eSewa must maintain high liquidity to process millions of transactions daily. A low current ratio (e.g., <1.2) would mean it can’t cover sudden withdrawal surges, risking bankruptcy (as seen in 2021’s liquidity crisis).
   • Real Example: In 2022, eSewa’s cash reserves (part of current assets) were ~30% of its liabilities, giving it a current ratio of ~1.5—safe but tight.

2. NMB Bank (Nepal’s Largest Bank)

   • Ratio Used: Solvency Ratios (D/E, ROE), Profitability (ROA)
   • How? NMB’s high debt-to-equity ratio (~8–10) is normal for banks (they borrow to lend), but its ROE (~18%) shows it’s efficiently using debt. However, if non-performing loans (NPLs) rise, its profitability ratios (like Net Profit Margin) will drop.
   • Real Example: In 2023, NMB’s NPL ratio was 1.2%, but if it rises to 3%+, the bank’s interest coverage ratio (Times Interest Earned) could weaken.

3. Pathao (Ride-Hailing App)

   • Ratio Used: Efficiency Ratios (Asset Turnover, Working Capital Turnover)
   • How? Pathao’s high asset turnover (e.g., sales of NPR 5B on assets of NPR 1B) shows it’s lean and efficient. But its negative working capital (liabilities > assets) is normal for startups—it relies on driver payments upfront (liability) to fund operations.
   • Real Example: Pathao’s receivables turnover is extremely high (daily collections from drivers), but its inventory turnover is irrelevant (no physical inventory).

4. Nepal Electricity Authority (NEA)

   • Ratio Used: Liquidity (Cash Ratio), Profitability (Net Profit Margin)
   • How? NEA’s chronically negative cash flow (due to subsidies and unpaid bills) means its cash ratio is near 0. Its net profit margin is negative because it loses money on subsidies but stays afloat due to government guarantees.
   • Real Example: In FY 2022–23, NEA’s current ratio was ~0.8, meaning it couldn’t pay short-term bills without government bailouts.

The Accounting Cycle: How Ratios Fit In

Financial statements don’t appear magically—they’re part of the accounting cycle. Here’s how analysis fits in:

Key Step: After preparing statements (Step 5), Step 6 (Analysis) turns raw data into actionable insights.

Worked Example: Analyzing a Kathmandu Retail Shop

Scenario: Thapa Brothers, a small retail shop in Kathmandu, provides the following financials for FY 2023:

Income Statement (NPR ’000)

Balance Sheet (NPR ’000)

Step 1: Vertical Analysis

Insight: High COGS (60%) suggests low markup or inefficient suppliers. Operating expenses (24%) are high—likely rent, salaries, or theft.

Step 2: Horizontal Analysis (vs. FY 2022)

Assume FY 2022 had:

• Sales: 45,000
• Net Profit: 7,000

Insight: Sales grew 11%, but net profit grew only 14%—not proportional. Costs rose faster than revenue.

Step 3: Ratio Analysis

1. Liquidity:

   • Current Ratio = 20,000 (Current Assets) / 15,000 (Liabilities) = 1.33 (⚠️ Borderline—needs to improve).
   • Quick Ratio = (20,000 – 10,000) / 15,000 = 0.67 (❌ Risky—can’t pay bills without selling inventory).

2. Profitability:

   • Gross Profit Margin = (20,000 / 50,000) × 100 = 40% (✅ Decent for retail).
   • Net Profit Margin = (8,000 / 50,000) × 100 = 16% (✅ Above Nepal’s retail avg of ~10–12%).

3. Solvency:

   • Debt-to-Equity = 5,000 (Debt) / 20,000 (Equity) = 0.25 (✅ Low risk).

4. Efficiency:

   • Inventory Turnover = 30,000 (COGS) / 10,000 (Avg Inventory) = 3 times/year (❌ Slow—inventory sits for ~4 months).
   • Asset Turnover = 50,000 / 40,000 = 1.25 (✅ Uses assets efficiently).

Recommendations for Thapa Brothers:

1. Reduce Inventory: Negotiate with suppliers for just-in-time deliveries to cut holding costs.
2. Control Operating Expenses: Renegotiate rent or salaries (currently 24% of sales is high).
3. Improve Collections: Chase receivables (currently 5,000) faster to free up cash.
4. Price Adjustment: If COGS is 60%, consider raising prices or finding cheaper suppliers.

Exam Tip

What Examiners Want to See

1. Structure: Always label ratios clearly (e.g., "Current Ratio = Current Assets / Current Liabilities = X").
2. Interpretation: Don’t just calculate—explain what the number means (e.g., "A current ratio of 1.3 is weak because...").
3. Comparisons: Relate to industry benchmarks (e.g., "For retail, a gross margin of 40% is average, but...").
4. Limitations: Mention at least one limitation (e.g., "Historical cost understates asset value in inflationary economies like Nepal.").
5. Real-World Tie: Link to Nepal examples (e.g., "Like NEA, Thapa Brothers has liquidity issues but relies on...").

Common Mistakes to Avoid

• Ignoring the Base Year: Horizontal analysis requires comparing to a previous period.
• Mixing Ratios: Don’t compare liquidity ratios to profitability ratios without context.
• Assuming All Ratios Are Good/Bad: A high D/E ratio is normal for banks but risky for retailers.
• Forgetting Qualitative Factors: Numbers alone don’t tell the full story (e.g., a new management team can turn around poor ratios).

Marks Distribution (Typical PU Exam)

Final Mermaid Summary

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