Chapter 10: Financial Statement Analysis and Nepal's Financial System
Financial statement analysis evaluates a company's financial health using ratio analysis, trend analysis, and comparative analysis. Understanding these tools, along with Nepal's financial system, prepares BBS graduates for financial decision-making in banking, investment, and corporate sectors.
10.1 Financial Ratio Analysis
Liquidity Ratios
| Ratio | Formula | Ideal | Interpretation |
|---|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | 2:1 | Ability to meet short-term obligations |
| Quick/Acid Test | (CA - Inventory) / CL | 1:1 | Immediate liquidity without selling inventory |
| Cash Ratio | Cash / Current Liabilities | 0.5:1 | Most conservative liquidity measure |
Profitability Ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| Gross Profit Margin | Gross Profit / Sales × 100 | Production efficiency |
| Net Profit Margin | Net Profit / Sales × 100 | Overall profitability |
| Return on Assets (ROA) | Net Income / Total Assets × 100 | How efficiently assets generate profit |
| Return on Equity (ROE) | Net Income / Shareholders' Equity × 100 | Return for equity shareholders |
| Earnings Per Share (EPS) | Net Income / Outstanding Shares | Profit attributable to each share |
Leverage/Solvency Ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| Debt-to-Equity | Total Debt / Shareholders' Equity | Financial leverage; higher = more risk |
| Debt Ratio | Total Debt / Total Assets | Proportion of assets financed by debt |
| Interest Coverage | EBIT / Interest Expense | Ability to meet interest payments; higher = safer |
Efficiency/Activity Ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| Inventory Turnover | COGS / Average Inventory | How quickly inventory is sold |
| Receivables Turnover | Credit Sales / Average Receivables | How quickly receivables are collected |
| Total Asset Turnover | Sales / Total Assets | How efficiently assets generate revenue |
Market/Valuation Ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| P/E Ratio | Market Price / EPS | How much investors pay per rupee of earnings |
| P/B Ratio | Market Price / Book Value per Share | Premium over book value |
| Dividend Yield | DPS / Market Price × 100 | Return from dividends |
10.2 DuPont Analysis
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
ROE = (NI/Sales) × (Sales/Assets) × (Assets/Equity)
This decomposition shows whether ROE is driven by profitability, efficiency, or leverage.
Example: NI=NPR 5L, Sales=NPR 50L, Assets=NPR 40L, Equity=NPR 20L
NPM = 5/50 = 10% | AT = 50/40 = 1.25 | EM = 40/20 = 2.0
ROE = 10% × 1.25 × 2.0 = 25%
Verify: 5/20 = 25% ✓
10.3 Comprehensive Ratio Analysis Example
Data for XYZ Ltd (NEPSE-listed):
| Item | Amount (NPR Lakhs) |
|---|---|
| Sales | 100 |
| COGS | 65 |
| Net Profit | 12 |
| Total Assets | 80 |
| Current Assets | 35 |
| Current Liabilities | 20 |
| Inventory | 15 |
| Total Debt | 30 |
| Equity | 50 |
| Shares Outstanding | 5,000 |
| Market Price/Share | NPR 400 |
| EBIT | 20 |
| Interest | 4 |
Calculations:
Current Ratio = 35/20 = 1.75 | Quick Ratio = (35-15)/20 = 1.0
GP Margin = 35/100 = 35% | NP Margin = 12/100 = 12%
ROA = 12/80 = 15% | ROE = 12/50 = 24%
D/E = 30/50 = 0.6 | Interest Coverage = 20/4 = 5x
EPS = 12L/5000 = NPR 240 | P/E = 400/240 = 1.67x
Asset Turnover = 100/80 = 1.25x
10.4 Nepal's Financial System Overview
| Component | Institutions | Role |
|---|---|---|
| Regulator | NRB (banking), SEBON (securities), Insurance Board | Supervision, regulation, policy |
| Banking | 27 commercial banks, development banks, finance companies, MFIs | Deposit mobilization, lending |
| Capital Market | NEPSE (stock exchange), CDS and Clearing Ltd, merchant bankers | Primary and secondary market for securities |
| Insurance | Life and non-life insurance companies | Risk management, long-term savings |
| Others | Employee Provident Fund, Citizen Investment Trust, cooperatives | Long-term savings, investment |
10.5 Trend Analysis and Common-Size Statements
Trend Analysis (Horizontal Analysis)
Compares financial data over multiple periods to identify trends.
| Item | Year 1 (Base) | Year 2 | Year 3 | Trend (Y3 vs Y1) |
|---|---|---|---|---|
| Sales | 100L (100%) | 120L (120%) | 150L (150%) | +50% growth |
| COGS | 65L (100%) | 80L (123%) | 105L (162%) | +62% (growing faster than sales — margin squeeze) |
| Net Profit | 12L (100%) | 14L (117%) | 13L (108%) | Profit growth slowing despite rising sales |
| Total Assets | 80L (100%) | 95L (119%) | 120L (150%) | Asset growth matching sales growth |
Analysis: Sales grew 50% but COGS grew 62% — cost management deteriorating. Profit grew only 8% on 50% sales growth — profitability declining. Management needs to address rising input costs.
Common-Size Statement (Vertical Analysis)
Expresses each line item as percentage of a base (Sales for income statement, Total Assets for balance sheet).
| Income Statement | Company A | Company B | Industry Avg |
|---|---|---|---|
| Sales | 100% | 100% | 100% |
| COGS | 65% | 72% | 68% |
| Gross Profit | 35% | 28% | 32% |
| Operating Expenses | 18% | 15% | 17% |
| EBIT | 17% | 13% | 15% |
| Interest | 3% | 6% | 4% |
| Net Profit | 10.5% | 5.25% | 8.25% |
Analysis: Company A has better GP margin (35% vs 28%) — more efficient production. Company B has lower operating expenses (15% vs 18%) but higher interest (6% vs 3%) — heavily leveraged. Company A is more profitable overall (10.5% vs 5.25%).
10.6 Limitations of Ratio Analysis
| Limitation | Explanation | How to Mitigate |
|---|---|---|
| Historical Data | Ratios based on past data; may not predict future | Use alongside forward-looking analysis (budgets, forecasts) |
| Accounting Policies | Different depreciation, inventory methods affect comparability | Check accounting policies before comparing companies |
| Window Dressing | Companies may manipulate year-end figures | Look at quarterly trends, not just annual snapshots |
| Industry Differences | Ratios vary by industry; cross-industry comparison misleading | Compare only within same industry |
| Inflation | Historical cost accounting distorts asset values during inflation | Use inflation-adjusted figures where available |
| Qualitative Factors Ignored | Management quality, brand, customer loyalty not captured | Supplement with qualitative assessment |
| Single Point | One ratio in isolation can mislead | Always analyze multiple ratios together; look at trends |
10.7 DuPont Analysis — Extended (Five-Factor)
Extended DuPont breaks ROE into five components for deeper analysis:
ROE = Tax Burden × Interest Burden × Operating Margin × Asset Turnover × Equity Multiplier
= (NI/EBT) × (EBT/EBIT) × (EBIT/Sales) × (Sales/Assets) × (Assets/Equity)
Example — Comparing Two NEPSE Banks:
| Component | Bank X | Bank Y | Better |
|---|---|---|---|
| Tax Burden (NI/EBT) | 0.70 | 0.72 | Y (lower tax rate) |
| Interest Burden (EBT/EBIT) | 0.60 | 0.45 | X (less interest cost) |
| Operating Margin (EBIT/Revenue) | 0.25 | 0.30 | Y (more operationally efficient) |
| Asset Turnover (Revenue/Assets) | 0.08 | 0.06 | X (uses assets more productively) |
| Equity Multiplier (Assets/Equity) | 10 | 12 | Y (more leveraged — higher risk) |
| ROE | 0.70×0.60×0.25×0.08×10 = 8.4% | 0.72×0.45×0.30×0.06×12 = 6.99% | X |
Bank X has higher ROE despite lower operating margin because it uses assets more efficiently and has lower interest burden. Bank Y's higher leverage (12x) doesn't compensate for poor interest management.
10.8 Financial Analysis for NEPSE Investment
| Step | What to Analyze | Key Ratios | Red Flags |
|---|---|---|---|
| 1. Profitability | Is the company making money? | NPM, ROE, ROA, EPS growth | Declining margins, negative EPS trend |
| 2. Liquidity | Can it meet short-term obligations? | Current ratio, quick ratio | Current ratio below 1; declining trend |
| 3. Solvency | Can it survive long-term? | D/E ratio, interest coverage | D/E above 3; coverage below 2x |
| 4. Efficiency | How well does it use resources? | Asset turnover, inventory turnover | Falling turnover; rising receivables days |
| 5. Valuation | Is the stock price fair? | P/E, P/B, dividend yield | P/E much above industry; P/B below 1 |
| 6. Growth | Is it growing sustainably? | Revenue growth, EPS growth, sustainable growth rate | Growth fueled only by debt, not operations |
Practice Questions
Short Answer:
1. List and define four categories of financial ratios.
2. What is DuPont analysis? Decompose ROE.
3. Explain the significance of P/E ratio for NEPSE investors.
4. What is interest coverage ratio? Why is it important?
5. Describe the structure of Nepal's financial system.
Long Answer:
6. From the following data, calculate all major ratios: Sales 200L, NP 20L, Assets 150L, CA 60L, CL 40L, Inventory 25L, Equity 80L, Debt 70L, EBIT 35L, Interest 8L, Shares 10,000, MPS NPR 600. (15 marks)
7. Perform DuPont analysis for two companies and explain which has better ROE and why. (15 marks)
8. "Ratio analysis has limitations." Discuss the limitations and how to overcome them. (15 marks)
9. Analyze the financial health of a hypothetical Nepali manufacturing company using comprehensive ratio analysis. (15 marks)
10. Discuss the role of NEPSE and SEBON in Nepal's capital market development. What reforms are needed? (15 marks)
Exam Tips: ✓ Ratio calculations from given data are ALWAYS asked ✓ Know formulas for ALL major ratios (15-20 ratios) ✓ DuPont decomposition is popular ✓ Always interpret ratios, don't just calculate ✓ Compare with industry benchmarks when analyzing