Financial Analysis of a Company Using Ratios and Statements

Financial analysis of a company is the process of using its financial statements and ratios to assess how well it is performing, how much risk it carries and whether it can meet its obligations.

In India, this analysis relies on three core financial statements that every company registered under the Companies Act, 2013 must prepare, namely the balance sheet, the profit and loss (P&L) account and the cash flow statement. Ratios do not replace those documents. Instead, they convert the underlying figures into comparable measures that reveal patterns across years and companies.

Which financial statements are used in company analysis?

Three financial statements form the basis of any financial analysis. Together, they give a complete picture of a company’s financial position at a point in time and its performance over a period.

• Balance sheet: Records what a company owns (assets), what it owes (liabilities) and what belongs to its shareholders (equity) as of a specific date.
• Profit and loss (P&L) account: Shows revenue, expenses and profit or loss over a financial year (FY). In India, the FY runs from 1 April to 31 March.
• Cash flow statement: Tracks actual cash movement across three activities: operations, investing and financing. A company can show profit on the P&L and still run out of cash, which is why this statement cannot be skipped.

What are the key financial ratios, and what do they measure?

Financial ratios fall into four broad categories. Each category answers a different question about the company.

How do you read a balance sheet for financial analysis?

Begin with the balance sheet structure. It has two sides that must always balance:

Assets = Liabilities + Shareholders' Equity

• Assets are divided into current assets (cash, receivables, inventory and short-term investments) and non-current assets (property, plant, equipment and intangible assets). A higher share of current assets often indicates greater financial flexibility, while excessive inventory compared to industry peers may suggest slow-moving stock.
• Liabilities are classified as current liabilities (payables and short-term borrowings) and long-term liabilities (term loans and debentures). If current liabilities grow faster than current assets over time, the company may face liquidity pressure.
• Shareholders' equity consists mainly of share capital and retained earnings. Declining retained earnings can indicate that the company is relying on its reserves to support operations.

Businesses should also review revaluation reserves. Asset revaluations can increase equity without generating cash, which may make return on equity and leverage ratios appear stronger than they actually are.

How do you analyse a profit and loss statement?

The P&L account moves from the top line (revenue) to the bottom line (net profit) by deducting costs in layers. Reading it layer by layer shows where the business is gaining or losing ground.

• Revenue: This is the company's total income from sales and serves as the starting point for profitability analysis. Check whether revenue is increasing and understand whether the growth comes from higher sales volumes, price increases or both.
• Gross profit: This is calculated by subtracting the cost of goods sold (COGS) from revenue. The gross profit margin indicates how efficiently a company controls its direct production or service delivery costs. A consistently falling margin may signal rising costs or increased competitive pressure on pricing.
• Operating profit: This is the profit earned from core business operations after deducting operating expenses such as salaries, rent and depreciation. It shows how effectively the business generates profit before considering interest and taxes.
• Net profit: This is the amount left after all expenses, including interest and taxes, have been paid. The net profit margin reflects the company's overall profitability and its ability to convert revenue into earnings.

In India, companies are required to disclose exceptional items and prior-period adjustments separately in the P&L. These are one-time events and should not be treated as recurring when calculating ratios. A company that shows profit only because of an asset sale or insurance claim is in a different position from one with genuine operational earnings.

What should you look for in a cash flow statement?

The cash flow statement is divided into three sections, and the relationships among them matter more than any individual figure.

• Cash from operations: This should be positive and, for a healthy business, broadly in line with net profit. If a company is profitable but consistently reports negative operating cash flow, it may be accumulating unpaid receivables or paying suppliers significantly faster than it collects money from customers.
• Cash from investing: Outflows here (buying equipment, acquiring businesses) are not necessarily bad and can indicate growth. But if a company is selling assets to generate positive investing cash flow while operations are negative, that is a warning sign.
• Cash from financing: Covers loans raised or repaid and dividends paid. A company consistently borrowing to fund operations rather than growth needs closer scrutiny.

How do ratios and statements work together?

Ratios are derived from statements, so they inherit the limitations of the underlying data. A ratio calculated from a restated or auditor-qualified set of accounts is only as reliable as those accounts. The more useful practice is to use ratios to ask questions of the statements, not to replace reading them. For example:

• A deteriorating inventory turnover ratio sends you back to the balance sheet to check how inventory has changed and to the P&L to see if COGS is rising.
• A declining interest coverage ratio sends you to the cash flow statement to check whether EBIT is being backed by actual cash or only by accounting profit.
• A high RoE should always be viewed alongside the debt-to-equity ratio because excessive borrowing can inflate RoE even when the business is underperforming.

Trend analysis adds another layer. A single year’s ratio provides a snapshot, while three to five years of ratios reveal the direction of the business. A company where gross margins have been compressing for four consecutive years is in a structurally different position from one that had a single bad year.

What are the common mistakes in financial ratio analysis?

Several errors appear regularly in ratio-based analysis, particularly when it is done quickly or without reference to the underlying statements.

• Do not compare ratios across different industries: A debt-to-equity ratio that is normal for a power or infrastructure company may be considered high for an IT services business. Always compare ratios with industry peers.
• Look beyond consolidated numbers: A parent company may appear financially strong on a consolidated basis, while one of its subsidiaries carries significant debt or financial risks. Check subsidiary performance separately when possible.
• Review off-balance-sheet obligations: Some financial commitments, such as lease obligations and contingent liabilities, may not be obvious on the balance sheet. These are usually disclosed in the notes to accounts and should not be ignored.
• Use ratios as indicators, not goals: Financial ratios help assess a company's condition. A company can temporarily improve certain ratios by changing the timing of payments or collections without making any real improvement to its finances.
• Pay attention to auditor remarks: If auditors have raised concerns in their report, financial ratios based on those accounts may not present the full picture. Auditor qualifications should always be reviewed alongside ratio analysis.

Conclusion

Financial statements and ratios work best when used together and over time. The statements provide the raw picture, ratios convert that information into a comparable format and trend analysis reveals the direction in which the business is moving. For businesses managing their own accounts, having clean, well-organised books is a prerequisite for such analysis to be reliable.

TallyPrime helps businesses in India maintain accurate books, generate statutory-compliant financial statements and track the numbers that matter, so financial analysis starts from data you can trust.