FINANCIAL STATEMENTS
ANALYSIS
Financial Statement Analysis
Financial statement is largely a study of relationship
among the various financial factors in a business
Financial statement analysis is the process of identifying
the financial strengths and weaknesses of the firm by
establishing the relationships by means of ratios between
the balance sheet and profit and loss account.
Purpose of preparation of Financial Ratio
Analysis
To epitomize and facilitate comparison with reference
to periods, another organization or an industry average
Objectives of Ratios
Liquidity of Firm
Profitability
Leverage
Operational Efficiency
Effective Utilisation of Resources
Tools of analysis
Comparative Financial Statements
Common-size statement
Trend Percentages
Ratio Analysis
Statement of changes in working capital
Cash flows and fund flows
Ratio Analysis
Ratio Analysis is widely used tool for analysis
(Ratio is a quotient of two numbers and is an expression of
relationship between the figures or two amounts)
Types of Ratios
Liquidity
Profitability
Leverage
Operating
Turnover
Liquidity Ratio
These ratios measure the short-term solvency or
financial position of a firm
Current Ratio
Liquid Ratio
Absolute Cash Ratio
Current Ratio = CA / CL
CA – Cash in hand, bank, short term securities, bills
receivables, Su. Debtors, inventories, prepaid
expenses and work-in-progress
CL – Su. Creditor, short-term advances, dividends
payable
Rule is 2 : 1 ( CA 2 : CL1)
Liquid Ratio = LA / CL
LA – Cash in hand, bank, BR, Su.Drs, short-term
Securities and investments
CL – Su. Creditor, short-term advances, dividends
payable
Rule : 1 : 1 (LA1 : CL 1)
Absolute Cash Ratio :
Cash +Short-term securities / CL
CL – Su. Creditor, short-term advances,
dividends payable
Rule : 0.5 : 1 (Cash & Bank 0.5 : 1 CL )
Significance
Stringent test of the firms ability to meet its immediate
liabilities
It indicates the inventory build up when studied along
with current ratio because inventory is not included
Profitability Ratio
They are calculated on sales or on investment. They are two
types general ratios and overall performance ratios
Gross Profit Return on Investment
Operating Profit Return on Total Assets
Net Profit Return on Equity
Earning per Share Dividend Per Share
Return on Investment Net Profit to Newt Worth
Gross Profit
= Gross profit / Net sales X 100
GPR Shows the extent to which selling prices of goods per
unit may decline without resulting in losses on operations
of firms.
Higher the GPR better the results
Operating Profit to Sales
Indicates how for each rupee of sale, there remained gross
profit from operations.
Operating profit
= ------------------------ X100
Sales
Operating profit = CoS + Operating Expenses
(Example : If Operating ratio is 80 % , OP would be 20% ie {1-
OR})
Net Profit Ratio
NPR = Net Profit / Net Sales X100
This is used as a measure of overall profitability and is
useful to the owner.
Earnings Per Share
EPS = Profit After Tax Less Preference Dividend / No.
of Equity Share
Dividend Per Share = Dividend Declared /
No. of Equity Shares
Net Profit to Net Worth =
PAT – Preference Dividend /
Equity Capital + Reserves
Return on Capital Employed : is considered to be the
best measure of profitability in order to assess the
overall performance of business
PBIT
= ------------------------
Total Capital Employed
Return on Net Worth
Indicates how much of the profits are available for share
holders funds.
Net Profit
= ---------------
Net Worth
Return on Investment
Gives measurement of profit for internal use by top
management.
This ratio can increase if revenue is kept constant and cost is
reduced
Net Profit after interest and tax
= -------------------------------------- X 100
share holders funds
Significance
It indicates the basic profiatbilty of firm
Indicates the efficeincy of production, purchase, sales
and cost control systems
A comparision of GP over 5 to 10 years will indicate
trend of trading results
Higher ratios indicate higher profitablity – lower
indicate unfavourabel condition
Leverage and Solvency Ratios
Solvency ratios refer to the ability to meet long term
obligations – they also indicate the long-term financial
position of the firm
Debt –equity
Fixed assets to long term funds
Equity ratio
Current assets to proprietors funds
Interest coverage ratio
Debt Equity Ratio:
= Long term Debt
-------------------------
Share holders fund
It is also known as External – Internal Equity
Ratio.
It measures the relative claims of outsiders and the
owners equity against the firm.
Net Fixed Assets to long term debt
= Fixed Assets
----------------
Long term debt
Equity Ratio = Share holders Equity /
Total Assets
(proprietor ratio)
Longterm debt to Net working capital
= Long term debt/ Net working capital
(the ratio should be 1:1 and long term debt should not
exceed net working capita)
Current Assets / Networth Ratio
Current assets to proprietors funds
CA / Shareholders funds
Debt service / Interest Coverage ratio
Indicates the no. of times interest is covered by profit to
pay the interest charges.
=(EBIT) net profit (before interest and taxes) / Fixed
interest
Inventory Ratios
Turnover ratios indicate the effectiveness with which
the assets are utilized in a firm
These are also called as Activity Ratio
Inventory Turnover Ratio
Cost of Goods sold
= --------------------------------
Average Inventory
or
Cost of Goods sold
----------------------------
½ (Opening Inventory + Closing Inventory)
A minimum ratio of 6 or 7 times is considered satisfactory
Debtors turnover – indicates the velocity
of debt collection of firms
Debtors turnover = Net Credit Sales/
(No. of times) Average trade Drs
(trade drs - Drs + BR)
Higher the value of debtors turnover the more efficient is the management of drs.
Creditors turnover ratio=
net credit purchases / average trade crs
trade crs = crs + Bp)
Working capital = Cost of sales / Av WC
OR
Cost of sales / Net WC
Avg. WC =Opening WC + Closing WC /2
Higher ratio indicates efficient utilisation of WC
Significance
It indicates the number of times its average inventory
has been sold
Ratio reflects excess stock and or accumulation of
obsolete items of stock
Useful in preparation of working capital budgets
Advantages of Ratios
They provide insights to decision makers
Furture projections
Overall efficiency and performance of the firm can be
measured
Inter firm comparisons can also be made
Limitations
Comuptation would be difficult interms of selection of
base year
Changes in accounting practices between the two years
may render difficult for comparisons
They are calculated on past financial statements and they
do not indicate future trends
Window dressing in finanlisation of accounts
