FINANCIAL STATEMENT

ANALYSIS
 MEANING OF FINANCIAL STATEMENTS

Financial statements refers to two basic statements

which an accountant prepares at the end of an
accounting period for a business enterprise.

These are Balance Sheet (or Statement of Financial

Position), which reflects the assets, liabilities and capital
as on a certain date, and Profit and Loss Account (or
Income Statement), which shows the results of
operations,
i.e., profit or loss during a certain period.

Also prepared are Funds Flow Statement, which

explains increase or decrease in working capital during
the accounting period. Cash Flow Statement, which
explains changes in cash position between the beginning
and end of the accounting period.
MEANING OF FINANCIAL STATEMENTS ANALYSIS

Financial statements analysis is a judgemental process

which aims to estimate current and past financial
positions and the result of the operation of a company,
with the primary objective of determining the best
possible estimate and prediction about future
conditions. It involve the following steps:

Determining the purpose and scope of analysis.

Carefully study of financial statement.
Collection of relevant information.
Re-grouping and classification of data.
Analysis of data using appropriate tool.
Interpretation, presentation and preparation of report.
 NEED OF FINANCIAL STATEMENTS ANALYSIS

To assess profitability.
To know liquidity position.
To evaluate solvency position.
To judge operational efficiency.
To control expenses.
To compare performance.
To identify reason for change.
To establish relationship.
To disclose hidden information.
To plan and forcast.
External Analysis: Analysis of financial statement by the parties
external to the firm is termed as external analysis. This is to verify if
their interest has been well protected.

Internal Analysis: Analysis of financial statement by the parties

internal to the firm is termed as internal analysis. This is to verify the
operational efficiency.
Intra Firm Analysis: Analysis of financial statement of a single
enterprise during one year or over a number of years is termed as
Intra-Firm analysis. This is to know the trend of its own performance
over the past years.

Inter Firm Analysis: Analysis of financial statement of two or more

similar enterprise during one year or over a number of years is termed
as Inter-Firm analysis. This is to know the strength and weakness of the
enterprise of its own performance over the past years with compare to
its competitors.
Horizontal Analysis: horizontal analysis looks at amounts from the
financial statements over a horizon of many years. Horizontal analysis is
also referred to as trend analysis. It is also known as Dynamic analysis. Is
often used by management to drive strategic decision-making.

Vertical Analysis: vertical analysis is focused on the relationships

between the numbers in a single reporting period, or one moment in
time. Vertical analysis is also known as common size financial statement
analysis. It is also known as Static analysis. Is often used by investors or
creditors to evaluate risk and corporate finance profiles.
 PARTIES INTERESTED IN FINANCIAL
STATEMENT ANALYSIS
‘Financial statement analysis is largely a study of the relationships among the various financial
factors in a business as disclosed by a single set of statements and a study of the trends of these factors
as shown in a series of statements.’

Parties Interested in Financial Statement Analysis

Management Shareholders Creditors

• Management of a company is • Shareholders are interested • All creditors are mainly
interested in its financial in the profitability, dividends interested in the short-term
condition, profitability and declared and market value of and long-term solvency of the
progress. their holdings. company.

Purchaser of Business Government Other Interested Groups

• Any person interested in the • Financial statements are used • Financial statement analysis
purchase of a going concern by various government also serves the needs of
analyses the financial departments, to determine many other user groups. For
statements to determine its the tax liability of the example, workers' trade
real value. company. unions ETC.
 PRINCIPAL TOOLS OF ANALYSIS

Comparative
Statements Analysis

Common-si
ze
Ratio Statements
Analysis Analysis

Trend Percentages
Analysis
COMPARATIVE FINANCIAL STATEMENTS

• A comparative balance sheet has two • An income statement shows the net
columns for the data of the original profit or net loss resulting from the
balance sheets. A third column is operation of a business for a definite
prepared to show the increases and period of time. A comparative income
decreases in rupees in various assets statement is prepared to show the net
and liabilities. A fourth column is profit or loss for a number of years in
generally added to show percentages comparative form. By comparing
of increases and decreases. income statement for two or more
years, it is possible to observe the
progress of a business.

Comparative Income
Comparative
Statement (or Profit
Balance Sheet
and Loss Account)
COMMON-SIZE FINANCIAL STATEMENTS

Common Common
Size Size
Balance In common size balance Income This statement is
Sheet sheet, each item of asset Statment similar to common
is shown as a percentage size balance sheet. In
of total assets and each the common size
item of liability and
capital is shown as a
income statement, total
percentage of total sales figure is taken as
liabilities and capital 100 per cent and each
(which is the same as item is then calculated
total assets). as a percentage of sales.
 RATIO
ANALySIS
Ratio analysis is a very powerful and most commonly used tool of analysis and interpretation
of financial statements. It concentrates on the inter-relationship among the figures appearing
in the financial statements.

A Ratio can be expressed in any of the following ways:

Suppose CA is 200000 and CL is 100000

1. Percentage – Means CA/CL * 100 = 200000/100000 * 100 = 200%, CA is 200% of CL

2. Times – Means CA/CL = 200000/100000 = 2, CA is 2 times of CL

3. Proportion – Means CA:CL = 200000:100000 = 2:1, the Ratio of CA to CL is 2:1

4. Fraction – Means CA/CL = 200000/100000 = 2/1, CA is 2/1th of CL

 CLASSIFICATION OF RATIOS
Classification According to the Nature of
Classification from the Point of View of
Accounting Statement from which the
Financial Management or Objective
Ratios are Derived
• Balance Sheet Ratios These ratios deal • Liquidity Ratios to test the ability of a
with the relationship between two items firm to meet its current liabilities.
appearing in the balance sheet, e.g., • Capital Structure Ratios to test the long
current ratio, liquid ratio, debt equity term solvency of a firm.
ratio, etc. • Turnover Ratios to indicate the efficiency
• Profit and Loss Account Ratios This type with which assets are utilized.
of ratios show the relationship between • Profitability Ratios to measure the
two items which are in the profit and loss efficiency of a business.
account itself, e.g., gross profit ratio, net
profit ratio, operating ratio and stock
turnover ratio.
• Combined or Composite Ratios These
ratios show the relationship between
items one of which is taken from Profit
and Loss Account and the other from the
Balance Sheet, e.g., Rate of return on
capital employed, debtors turnover ratio,
stock turnover ratio and capital turnover
ratio.
LIQUIDITY RATIOS (Short - term Solvency)
‘Liquidity 'means ability of a firm to meet its current liabilities. The liquidity ratios, therefore,
try to establish a relationship between current liabilities, which are the obligations soon
becoming due and current assets, which presumably
provide the source from which these obligations will be met.
CAPITAL STRUCTURE RATIOS OR GEARING
RATIOS (Long- term Solvency)
Capital Structure Ratios are also known as gearing ratios or solvency ratios or leverage
ratios. These are used to analyse the long-term solvency of any particular business
concern. There are two aspects of long-term solvency of a firm (i) ability to repay the
principal amount when due and (ii) regular payment of interest.

Debt equity
ratio

Capital Proprietary
gearing ratio ratio

Debt to total Interest

funds ratio coverage ratio
 TURNOVER RATIOS (Performance Ratios or
Activity Ratios)
Inventory Turnover Ratio (Stock Turnover Ratio): This ratio is calculated by dividing the
cost of goods sold by average inventory.

Debtors Turnover Ratio (Receivables Turnover Ratio): This ratio indicates the relationship
between net credit sales and trade debtors. It shows the rate at which cash is generated by
the turnover of debtors.

Creditors Turnover Ratio (Payables Turnover Ratio): This ratio indicates the relationship
between net credit purchase and trade creditors. It shows the rate at which cash is required
to pay to the turnover of creditors.
 TURNOVER RATIOS
(Performance Ratios or Activity Ratios)

Working Capital Turnover Ratio: This ratio indicates the efficiency or inefficiency in
the utilization of working capital in making sales.

Capital Turnover Ratio: This ratio shows the relationship between cost of sales (or
sales) and the total capital employed.

Fixed Assets Turnover Ratio: This ratio indicates the efficiency with which the firm is utilizing
its investments in fixed assets such as plant and machinery, land and building, etc.
 PROFITABILITY RATIOS
Profitability Ratios Based on Sales

Gross Profit Ratio (Gross Profit Margin): This ratio expresses the relationship between gross
profit and sales.

Net Profit Ratio (Net Profit Margin)

(a) Net Operating Profit Ratio: This is the ratio of net operating profit to net sales.

(b) Net Profit Ratio: This is the ratio of net profit to net sales.

Operating Ratio: This is also an important profitability ratio. This ratio explains the
relationship between cost of goods sold and operating expenses on the one hand and net
sales on the other.
 PROFITABILITY RATIOS
Profitability Ratios based on Investments

Return on Investment (ROI) or Return on Capital Employed (ROCE)

This is the most important test of profitability of a business. It measures the overall
profitability. It is ascertained by comparing the profit earned and the capital (or funds)
employed to earn it.

Return on Equity Capital

This ratio establishes the relationship between the net profit available to equity
shareholder and the amount of capital invested by them.
 OTHER PROFITABILITY RATIOS
Earning Per Share ( EPS)
This ratio measures the earnings per equity share, i.e., it measures the profitability of the firm
on a per share basis.

Dividend Payout Ratio (Or Payout Ratio)

It indicates the percentage of equity share earnings distributed as dividends to equity
shareholders.

Price Earning Ratio (P/E Ratio)

This ratio is the market price of shares, expressed as multiple of earning per share (EPS).