Financial Analysis

Business, Accounting and Financial Studies · Senior Secondary (HKDSE) · 5 min read · Updated: 7 Sept 2026

Introduction to Financial Analysis

Imagine you are looking at two different companies. Company A has \$1 million in the bank, and Company B has \$500,000. Which one is doing better? You might say Company A, but what if Company A owes \$2 million in debt while Company B owes nothing? This is why we need Financial Analysis.

Financial analysis is like a "medical check-up" for a business. Instead of checking a heartbeat or blood pressure, we use Financial Ratios to see if a business is healthy, profitable, and stable. In this chapter, we will learn how to use numbers from financial statements to tell the real story of a business's performance.

1. The Role of Financial Management and Ratios

Financial management involves planning and monitoring a firm's financial resources. The general functions of using ratios include:

1. Evaluation: Comparing current performance against past years (Trend Analysis).
2. Benchmarking: Comparing the business against competitors or industry standards.
3. Decision Making: Helping managers, investors, and creditors decide whether to invest in or lend money to the company.

2. Profitability Ratios

Profitability ratios measure how well a company generates profit relative to its sales or investment. Think of this as: "For every dollar I put in or sell, how much do I get to keep as profit?"

A. Gross Profit Ratio

This shows the percentage of profit made after deducting the direct cost of goods sold.

Formula: $ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100\% $

Interpretation: A higher ratio is better. It means the company is good at controlling production costs or can sell its products at a high price.

B. Net Profit Ratio

This measures the "bottom line" profit after all expenses (like rent and salaries) are paid.

Formula: $ \text{Net Profit Ratio} = \frac{\text{Net Profit before Tax}}{\text{Sales}} \times 100\% $

Interpretation: A higher ratio means the company is efficient at managing its operating expenses.

C. Return on Capital Employed (ROCE)

This is often considered the most important ratio because it shows how much profit the company generates from the total capital invested in the business.

Formula: $ \text{ROCE} = \frac{\text{Profit before Interest and Tax}}{\text{Average Capital Employed}} \times 100\% $

Key Definition: For a limited company, Capital Employed = $ \text{Non-current Liabilities} + \text{Shareholders' Fund} $.

Interpretation: A higher ROCE shows that the company is using its long-term funds effectively to create wealth.

3. Liquidity Ratios

Liquidity measures a company's ability to pay its short-term debts (bills due within a year). Analogy: Do you have enough cash in your wallet right now to pay for your lunch?

A. Working Capital / Current Ratio

Formula: $ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} : 1 $

Interpretation: A ratio of $ 2:1 $ is generally considered healthy. If the ratio is less than $ 1:1 $, the company might struggle to pay its immediate bills.

B. Quick / Liquid / Acid Test Ratio

Inventory (stock) can be hard to sell quickly in an emergency. This ratio ignores inventory to give a "stricter" view of liquidity.

Formula: $ \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}} : 1 $

Interpretation: A ratio of $ 1:1 $ is usually the target. It means you have \$1 of "quick" cash for every \$1 you owe.

4. Management Efficiency Ratios

These ratios (also called Turnover Ratios) show how quickly a business turns its assets into cash or sales. Think of this as: "How fast is the business moving its wheels?"

A. Inventory Turnover (times)

Formula: $ \text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} $

Interpretation: Higher is usually better. It means goods are flying off the shelves quickly and aren't sitting in the warehouse getting dusty.

B. Trade Receivables Turnover (times)

Formula: $ \text{Trade Receivables Turnover} = \frac{\text{Credit Sales}}{\text{Average Trade Receivables}} $

Interpretation: This shows how many times a year the company collects its debts from customers. Higher means customers are paying faster.

C. Trade Payables Turnover (times)

Formula: $ \text{Trade Payables Turnover} = \frac{\text{Credit Purchases}}{\text{Average Trade Payables}} $

Interpretation: This shows how many times a year the company pays its suppliers. (Note: In BAFS, we focus on the calculation rather than suggesting changes to payment behavior).

D. Total Assets Turnover (times)

Formula: $ \text{Total Assets Turnover} = \frac{\text{Sales}}{\text{Total Assets}} $

Interpretation: This measures how effectively the company uses all its assets to generate sales revenue.

5. Solvency Ratio

Solvency is about the long-term survival of the business. It looks at the relationship between debt and equity.

A. Gearing Ratio

Formula: $ \text{Gearing Ratio} = \frac{\text{Non-current Liabilities} + \text{Preference Share Capital}}{\text{Non-current Liabilities} + \text{Shareholders' Fund}} \times 100\% $

Interpretation:
- High Gearing: The company relies heavily on debt (loans). This is risky because interest must be paid even if profits are low.
- Low Gearing: The company is funded mainly by owners' equity. This is generally safer.

6. Limitations of Financial Analysis

Don't worry if ratios don't tell the whole story—they have limitations!

1. Historical Data: Ratios use past numbers. They don't guarantee what will happen in the future.
2. Different Accounting Policies: One company might use a different method to calculate depreciation than another, making comparison difficult.
3. Window Dressing: Management might "manipulate" numbers at the end of the year to make the ratios look better than they really are.
4. Non-financial Factors: Ratios ignore things like staff morale, brand reputation, or changes in the economy.

Quick Review: Tips for Success

- Averages Matter: When calculating turnover ratios, always use the Average (Opening + Closing balance divided by 2) if the data is provided.
- Be Careful with Units: Profitability ratios are usually percentages ($ \% $), Liquidity ratios are usually ratios ($ :1 $), and Efficiency ratios are usually "times" or "days".
- Check your Sales: For Receivables Turnover, use Credit Sales. For Payables Turnover, use Credit Purchases.

Key Takeaway

Financial Analysis is a powerful tool to measure Profitability, Liquidity, Management Efficiency, and Solvency. However, always remember that numbers are only part of the story, and the "limitations" of these ratios should always be considered when making final business evaluations.

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is the definition and purpose of financial analysis?

Financial analysis is the evaluation of a business's health, profitability, and stability using financial ratios derived from financial statements.

What are the three general functions of using financial ratios?

The three main functions are evaluation (trend analysis), benchmarking (comparison with competitors), and decision making (for investors and creditors).

How is the Gross Profit Ratio calculated and interpreted?

$ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Sales}} \times 100\% $. It shows the percentage of profit remaining after direct production costs.

What does the Net Profit Ratio measure?

It measures the percentage of profit kept from sales after all operating expenses are paid, using the formula: $ \frac{\text{Net Profit before Tax}}{\text{Sales}} \times 100\% $.

What is Return on Capital Employed (ROCE) and how is Capital Employed defined?

$ \text{ROCE} = \frac{\text{Profit before Interest and Tax}}{\text{Average Capital Employed}} \times 100\% $. For a limited company, Capital Employed equals Non-current Liabilities plus Shareholders' Fund.

What is the difference between the Current Ratio and the Quick Ratio?

The Current Ratio uses all Current Assets, while the Quick Ratio (Acid Test) excludes Inventories from the numerator to test immediate debt-paying ability.

What does a high Inventory Turnover ratio indicate?

A higher ratio ($ \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} $) indicates that goods are sold quickly and do not stay in the warehouse for long.

Which turnover ratios require the use of 'Credit Sales' and 'Credit Purchases'?

Trade Receivables Turnover requires 'Credit Sales', and Trade Payables Turnover requires 'Credit Purchases'.

What is the Gearing Ratio and what does high gearing imply?

$ \text{Gearing} = \frac{\text{NCL} + \text{Pref. Shares}}{\text{NCL} + \text{Shareholders' Fund}} \times 100\% $. High gearing implies high financial risk due to heavy reliance on debt.

What are the main limitations of using financial ratios for analysis?

Limitations include the use of historical data, differences in accounting policies, window dressing, and the omission of non-financial factors.

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