Financial Statement Analysis: Ratios, Funds Flow/Cash Flow Basics and Interpretation

Overview

Financial statement analysis means studying the balance sheet, profit and loss statement and cash flow information to understand a firm’s liquidity, profitability, solvency and efficiency. The most common tool is ratio analysis, supported by comparative statements and trend analysis (concept).

In exams, this topic is often asked as:

• classification of ratios with formulas,
• interpretation of liquidity/profitability/solvency,
• difference between funds flow and cash flow,
• meaning of operating/investing/financing cash flows.

Learning objectives

You should be able to:

• Define financial statement analysis and list tools.
• Explain ratio analysis and its uses/limitations.
• Classify ratios and write key formulas.
• Interpret liquidity, profitability and solvency ratios at a basic level.
• Differentiate funds flow and cash flow.
• Explain cash flow statement activities and basic interpretation.

Meaning of financial statement analysis

Financial statement analysis is the process of evaluating financial information from statements to make judgments about performance and financial position (concept).

Tools/techniques of analysis (brief)

Common tools:

• comparative financial statements (year-to-year comparison) (concept)
• common-size statements (percent of sales/total assets) (concept)
• trend analysis (over multiple periods) (concept)
• ratio analysis
• cash flow and funds flow analysis (concept)

Ratio analysis: meaning and uses

Ratio analysis expresses a relationship between two numbers (e.g., current assets to current liabilities) to simplify understanding.

Uses:

• evaluate liquidity, profitability and solvency
• compare performance over time (trend) and across firms (benchmark) (concept)
• support decisions for lenders, investors and managers

Limitations (concept):

• based on historical data
• affected by accounting policies/estimates
• ratios must be interpreted together, not in isolation

Types of ratios (classification table)

Key liquidity ratios (table)

Key profitability ratios (table)

Key solvency/leverage ratios (table)

Interpretation tips (how to write answers)

When asked to interpret ratios:

• mention what ratio measures (definition),
• compare with previous year/industry standard (concept),
• give a short conclusion: liquidity improved/worsened, profitability strengthened/weak, etc.

Avoid judging a ratio alone; combine with other ratios (e.g., current ratio + quick ratio + cash flow).

Funds flow vs cash flow (table)

Cash flow statement: 3 activities (overview)

Cash flows are classified into:

• Operating activities: cash from main business operations
• Investing activities: purchase/sale of long-term assets/investments
• Financing activities: borrowing, repayment, issue of shares, dividend payment (concept)

Simple cash flow interpretation pointers

Basic interpretation points:

• positive operating cash flow is a sign of healthy core business (concept)
• heavy investing outflow may indicate growth/expansion (concept)
• financing inflows may indicate borrowing; outflows may indicate repayment/dividends

Quick recap (1-minute revision)

• Statement analysis evaluates liquidity, profitability and solvency.
• Ratio analysis is the main tool; classify ratios: liquidity, profitability, solvency, activity.
• Funds flow tracks working capital changes; cash flow tracks cash movements.
• Cash flow activities: operating, investing, financing.