Analysis and

Interpretation of
Financial Statements
Financial Ratios
 FINANCIAL STATEMENTS

Financial statements (or financial reports) are formal records of the

financial activities of a business, person, or other entity. Financial statements
provide an overview of a business or person's financial condition in both short
and long term. All the relevant financial information of a business enterprise,
presented in a structured manner and in a form easy to understand is called
the financial statements. There are four basic financial statements:

1. Balance sheet: It is also referred to as statement of financial position or

condition, reports on a company's assets, liabilities, and Ownership equity as
of a given point in time.

2. Income statement: It is also referred to as Profit and Loss statement (or

"P&L"), reports on a company's income, expenses, and profits over a period of
time. Profit & Loss account provide information on the operation of the
enterprise. These include sale and the various expenses incurred during the
processing state.

3. Statement of Retained Earnings: It explains the changes in a company's

retained earnings over the reporting period.

4. Cash Flow Statement: It reports on a company's cash flow activities;

particularly its operating, investing and financing activities.
 FINANCIAL RATIOS

OBJECTIVES
The importance of ratio analysis lies in the fact that it presents data on a
comparative basis and enables the drawing of inferences regarding the
performance of the firm. Ratio analysis helps in concluding the following
aspects.

Liquidity Position:
Ratio analysis helps in determining the liquidity position of the firm. A firm can
be said to have the ability to meet its current obligations when they become
due. It is measured with the help of liquidity ratios.

Long- Term Solvency:

Ratio analysis helps in assessing the long term financial viability of a firm.
Long- term solvency measured by leverage/capital structure and profitability
ratios.

Operating Efficiency:
Ratio analysis determines the degree of efficiency of management and
utilization of assets. It is measured by the activity ratios.

Over-All Profitability:
The management of the firm is concerned about the overall profitability of the
firm which ensures a reasonable return to its owners and optimum utilization
of its assets. This is possible if an integrated view is taken and all the ratios are
considered together.

Inter- firm Comparison:

Ratio analysis helps in comparing the various aspects of one firm with the
other.
FINANCIAL RATIOS AND THEIR INTERPRETATION

Sl.
Category Types of Ratios Interpretation
No.
Net Working Capital =
It measures the liquidity
Current assets - Current
of a firm.
liabilities
It measures the short
term financial
Current ratio = position/liquidity of a
Liquidity Current Assets firm. A firm with a higher
1 Current Liabilities ratio has better liquidity.
ratios
A ratio of 2:1 is
considered safe.
It measures the liquidity
Acid test or Quick ratio =
position of a firm.
Quick assets
A ratio of 1:1 is
Current Liabilities
considered safe.
This ratio indicates how
Inventory Turnover ratio= fast inventory is sold.
Cost of goods sold
A firm with a higher ratio
Average inventory
has better liquidity.
This ratio measures how
fast debts are collected.
Turnover Debtor Turnover ratio =
2 A high ratio indicates
ratios Net credit sales
shorter time lag between
Average debtors
credit sales and cash
collection.
Creditors Turnover ratio= A high ratio shows that
Net credit purchases accounts are to be settled
Average Creditors rapidly.
This ratio indicates the
relative proportions of
Capital Debt-Equity ratio = debt and equity in
3 Structure Long term debt financing the assets of a
Ratios Shareholders Equity firm.
A ratio of 1:1 is
considered safe.
 It indicates what
proportion of the
Debt to Total capital permanent capital of a
ratio= firm consists of long-term
Long term debt debt.
Permanent Capital A ratio 1:2 is considered
safe.
Or It measures the share of
Total debt the total assets financed
Permanent capital + Current by outside funds.
liabilities
It shows what portion of
the total assets is
Or financed by the owners
Total Shareholders Equity capital.
Total Assets A firm should neither
have a high ratio nor a
low ratio.
A ratio used to determine
Interest Coverage = how easily a company
Earning before Interests and can pay on outstanding
Tax debt.
Interest A ratio of more than 1.5
is satisfactory.
Coverage Dividend Coverage = It measures the ability of
4
ratios Earnings after tax firm to pay dividend on
Preference Dividend preference shares.
It shows the overall
Total Coverage ratio = ability of the firm to fulfill
Earning before interests and
the liabilities.
tax
Total fixed charges A high ratio indicates
better ability.
It measures the profit in
Gross Profit margin = relation to sales.
Gross profit X 100 A firm should neither
Net Sales have a high ratio nor a
low ratio.
Profitability It measures the net profit
5 Net Profit margin =
ratios of a firm with respect to
Net Profit after tax X100
sale.
Net Sales
Or
A firm should neither
Net Operating Profit X 100
have a high ratio nor a
Net Sales
low ratio.
 Operating ratio shows
Operating ratio = the operational efficiency
Cost of Goods sold + other of the business.
expenses Lower operating ratio
Expenses Sales
6 shows higher operating
ratios
profit and vice versa.
Cost of Goods sold ratio =
It measures the cost of
Cost of Goods sold
goods sold per sale.
Sales

Return on Assets (ROA) =

Net Profit after Taxes X 100 It measures the
Total Assets profitability of the
Or total funds per
Net Operating Profit X 100 investment of a firm.
Total Assets

Return on Return on Total

7 It reveals how profitably
Investments Shareholders Equity =
the owners fund has
Net Profit after Taxes X100
been utilized by the firm.
Total Shareholders equity
It measures profitability
of the firm with respect
Return on Capital to the total capital
Employed (ROCE) = employed.
Net Profit after Taxes X100
Total Capital Employed The higher the ratio, the
more efficient use of
capital employed.
Earnings per Share (EPS) = It measures the profit
Net Profit of Equity available to the equity
shareholders holders on a per share
Number of Ordinary Shares basis.
Dividend per Share (DPS) = It is the net distributed
Net profits after interest and profit belonging to the
Shareholders preference dividend paid to
8 shareholders divided by
ratios ordinary shareholders
Number of ordinary shares the number of ordinary
outstanding shares.
Dividend Payout ratio (D/P) = It shows what percentage
Total Dividend To Equity share of the net profit after
Shareholders taxes and preference
Total net profit of Equity dividend is paid to the
shareholders equity holders.

Earnings per Yield =
Earnings per Share
Market Value per Share
Dividend Yield =
Dividend per share
Market Value per share
Price- Earnings ratio (P/E) =
Market value per Share
Earnings per Share
Earning Power =
Net profit after Taxes
Total Assets
Inventory turnover =
Sales
Closing Inventory
Activity
9
Ratios
Debtors turnover =
Cost of Goods manufactured
Average Work in Process
Inventory
Total Assets turnover =
Cost of Goods Sold
Total Assets
Fixed Assets turnover =
Cost of Goods Sold
Assets Fixed Assets
10 Turnover
Ratios Capital turnover =
Cost of Goods Sold
Capital Employed
Current Assets turnover =
Cost of Goods Sold
Current Assets
It shows the percentage
of each rupee invested in
the stock that was
earned by the company.
It shows how much a
company pays out in
dividends each year
relative to its share price.
It reflects the price
currently paid by the
market for each rupee of
EPS.
Higher the ratio better it is
for owners.
It measures the overall
profitability and
operational efficiency of a
firm.
It measures how quickly
inventory is sold.
A firm should neither
have a high ratio nor a
low ratio.
It shows how quickly
current assets i.e.
receivables or debtors are
converted to cash.
A firm should neither
have a high ratio nor a
low ratio.
It measures the
efficiency of a firm in
managing and
utilizing its assets.
Higher the ratio,
more efficient is the
firm in utilizing its
assets.
With an Illustration we would show how some of the Ratios are
actually calculated and how will they be analyzed to make the best
use of it.

The Information Given:-

X Co. ltd of the year 2010
Particulars Amount
Cash 30,000

Accounts Receivable:
Beginning of the year 17,000
End of the year 20,000

Inventory
Beginning of the year 10,000
End of the year 12,000

Total Current Assets 65,000

Total Current Liabilities 42,000
Sales on Account 4,94,000
Cost of Goods Sold 1,40,000

Common Shares Outstanding

Beginning of the year 17,000
End of the Year 27,400

Net Income 53,690

Stock Holders Equity

Beginning of the year 1,80,000
End of the Year 2,34,390

Dividend per share 2

Market Price per share 20
Interest Expense 7,300

Total Assets
Beginning of the year 3,00,000
End of the Year 3,46,390
Calculation of Ratios:
1) Net Working Capital:

Working Capital = Current Assets Current Liabilities

65,000 42,000 = 23,000

2) Current Ratio:

Current Ratio = Current Assets = 65,000 = 1.55:1

Current Liabilities 42,000
Measures the ability of the Company to pay Current Debts as
they become due.

3) Acid Test Ratio or Quick Ratio:

Quick Ratio = Quick Assets = 50,000 = 1.19:1
Current Liabilities 42,000
Quick Assets are Cash, Marketable Securities & Receivables.
4) Accounts Receivable Turnover:

Accounts Receivable turnover = Sales on Account

Average Accounts Receivable
= 494,000 = 26.70 times
18,500
This ratio measures how many times a company converts its
receivables into cash each year.

5) Number of Days Sales in Accounts Receivable:

Days Sales 365 Days 365

In Accounts = Accounts Receivable Turnover = 26.70
Receivables
That is 14 days approximately.
Measures, on average, how many days it takes to collect an
account receivable.
 6) Inventory Turnover Ratio:

Inventory Turnover =Cost of Goods Sold

Average Inventory

=140,000 = 12.73times
11,000
Measures the number of times inventory is sold and replaced
during the year.

7) Equity Ratio

Equity Ratio = Share Holders Equity = 2,34,390 = 67.7%

Total Assets 3,46,390
Measure the Proposition of Total Assets provided by Stock
Holders.

8) Net Income to Sales

Net Income to Sales = Net Income = 53,690 = 10.9%

Net Sales 494,000
Measures the proportion of the sales which is retained as
profit.

9) Earnings Per Share

Earnings/ Share = Earnings Available to Equity Share Holders

Number of Shares
= 53,690 = 2.42
22,200

10) Price-Earnings Ratio

Price Earnings Ratio = Market Price per Share = 20.00 = 8.3:1

Earnings per Share 2.42
CONCLUSION

Analysis and interpretation of financial statements is an important

tool in assessing companys performance. It reveals the strengths
and weaknesses of a firm. It helps the clients to decide in which
firm the risk is less or in which one they should invest so that
maximum benefit can be earned. It is known that investing in any
company involves a lot of risk. So before putting up money in any
company one must have thorough knowledge about its past records
and performances. Based on the data available the trend of the
company can be predicted in near future.
REFERENCES

Khan, M.Y. (1988). Financial Management, Tata Mc-Graw Hill ,

New Delhi, 1st edition, Chapter -03 , Financial Statement
Analysis: Ratio Analysis, pp.114-158

Bhattacharya, Asish. K. (2007). Introduction to Financial

Statement Analysis, Elsevier , New Delhi , 1st edition, Chapter -
03, Ratio Analysis, pp.32-45

WEB REFERENCES

http://en.wikipedia.org/wiki/Financial_statements
http://en.wikipedia.org/wiki/Balance_sheet
http://en.wikipedia.org/wiki/Asset
http://economictimes.indiatimes.com/bsheet.cms
http://economictimes.indiatimes.com/profitloss.cms