FINANCIAL

STATEMENT
ANALYSIS
1
FINANCIAL STATEMENT
ANALYSIS/RATIO ANALYSIS

Financial Statement includes:

Income Statement

Trading A/C

Profit and Loss A/C

Balance Sheet

2
TRADING AND PROFIT & LOSS A/C
Particulars Amount Particulars Amount
To Opening Stock xxx By Sales xxx
To Purchase xxx - Sales return xx xxx
- Purchase return xx xxx By Closing Stock xxx
To Wages xxx By all other direct incomes xxx
To Carriage Inwards xxx By Gross Loss c/d xxx
To Power(factory) xxx (transferred to P&L A/c)
To all other direct expenses xxx
To Gross Profit c/d xxx
(transferred to P&L A/c)

xxxx xxxx

To Gross Loss xxx By Gross Profit xxx

(transferred from Trading A/c) (transferred from Trading A/c)
To Salaries xxx By Rent Rec. xxx
To Rent xxx By Discount Rec. xxx
To all other indirect expenses xxx By all other indirect incomes xxx
To Net Profit c/d xxx To Net Loss c/d xxx
(transferred to Balance sheet) (transferred to Balance sheet)

xxxx xxxx
 BALANCE SHEET
Liabilities Amount Assets Amount

Capital: Fixed Assets:

Equity Share Capital xxx Land & Building xxx
Preference Share Capital xxx Plant & Machinery xxx
Reserve fund xxx Furniture & fitting xxx
Undistributed Profits xxx Business premises xxx

Long Term Liabilities: Intangible Assets:

Mortgage loans xxx Patents & trademarks xxx
Bank loan xxx Good will xxx

Current Liabilities: Current Assets:

Creditors xxx Cash in hand & at bank xxx
Bills payable xxx Debtors xxx
Short term loans xxx Bills receivable xxx
Bank overdraft xxx Stock xxx
Provisions for taxes xxx Prepaid expenses xxx
Outstanding expenses xxx

xxxx xxxx 4
 RATIO

The term 'ratio' refers to the mathematical relationship
between any two inter-related variables. In other words,
it establishes relationship between two items expressed
in quantitative form.

It can be expressed as a pure ratio, percentage, or as a
rate
RATIO ANALYSIS

It is a method or process by which the relationship of
items or groups of items in the financial statements are
computed, and presented.

It is used to interpret the financial statements so that
the strengths and weaknesses of a firm, its historical
performance and current financial condition can be 5
determined.
ANALYSIS OR INTERPRETATIONS OF
RATIOS

For the same enterprise over a number of
years

For two enterprises in the same industry

For one enterprise against the industry as

a whole

For one enterprise against a pre-
determined standard

For inter-segment comparison within the
same organization
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 CLASSIFICATION OF RATIOS

Accounting Ratios are classified on the basis of the
different parties interested in making use of the ratios.
A very large number of accounting ratios are used for
the purpose of determining the financial position of a
concern for different purposes.

Ratios may be broadly classified in to:

Classification of Ratios on the basis of Balance Sheet.

Classification of Ratios on the basis of Profit and Loss

Account.

Classification of Ratios on the basis of Mixed Statement
(or) Balance Sheet and Profit and Loss Account.
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CLASSIFICATION OF RATIOS
Ratios can be broadly classified into four groups
namely:

Liquidity Ratios

Capital Structure/Leverage Ratios

Profitability Ratios

Activity/Turnover Ratios

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LIQUIDITY RATIOS

Liquidity Ratios are also termed as Short-Term
Solvency Ratios.

The term liquidity means the extent of quick

convertibility of assets into money for paying
obligation of short-term nature.

These ratios analyse the short-term financial

position of a firm and indicate the ability of the
firm to meet its short-term commitments
(current liabilities) out of its short-term resources 9
(current assets).

To measure the liquidity of a firm, the following
ratios are commonly used:

1. Current ratio
2. Liquid ratio or Quick ratio or Acid test ratio

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CURRENT RATIO

Current Ratio establishes the relationship between current
Assets and current Liabilities. It attempts to measure the
ability of a firm to meet its current obligations.

In order to compute this ratio, the following formula is used :

Current ratio = Current assets

Current liabilities

The two basic components of this ratio are current assets and
current liabilities.

Current asset normally means assets which can be easily

converted into cash within a year's time.

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On the other hand, current liabilities represent those
liabilities which are payable within a year.
Current Assets Include –

Cash in hand and at bank

Debtors

Bills Receivables

Stock (Raw materials, Work-in-progress, Finished
Goods)

Short term deposits/Government and other marketable
securities

Prepaid expenses/Advance Payments

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Current Liabilities Include –

Creditors

Bills Payable

Short term loans

Bank overdraft and Cash credit

Provision for taxation

Outstanding expenses

Unclaimed dividend/Proposed dividend

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INTERPRETATION OF CURRENT
RATIO

The ideal current ratio is 2:1.

It indicates that current assets double the current
liabilities is considered to be satisfactory.

Higher value of current ratio indicates more liquid
the firm's ability to pay its current obligations in
time.

On the other hand, a low value of current ratio
means that the firm may find it difficult to pay its
current liabilities.

Current ratio as one which is generally recognized
as the patriarch among ratios. 14
QUICK RATIO

Quick Ratio also termed as Acid Test or Liquid Ratio. It
is supplementary to the current ratio.

The acid test ratio is a more severe and stringent test of

a firm's ability to pay its short-term obligations as and
when they become due.

Quick Ratio establishes the relationship between the

quick assets and quick liabilities.

It is calculated by dividing quick assets by quick

liabilities

Quick ratio = Quick assets 15

Quick liabilities
 QUICK ASSETS & QUICK
LIABILITIES

Quick Assets are current assets less prepaid expenses
and inventories.

Quick Liabilities are current liabilities less bank

overdraft and cash credit.

These are subtracted because Bank Overdraft and Cash

Credit Facility are not withdrawn by banks all of a
sudden and liquid liability should only include those
liabilities which may be due immediately at a very short
notice. 16
INTERPRETATION OF QUICK RATIO

The ideal Quick Ratio of 1:1 is considered to be
satisfactory.

High Acid Test Ratio is an indication that the

firm has relatively better position to meet its
current obligation in time.

On the other hand, a low value of quick ratio

exhibiting that the firm's liquidity position is not
good.
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 CAPITAL STRUCTURE/ LEVERAGE
/SOLVENCY RATIOS

The term 'Solvency' generally refers to the capacity of the
business to meet its short-term and long term obligations.

Short-term obligations include creditors, bank loans and

bills payable etc.

Long-term obligations consists of debenture, long-term

loans and long-term creditors etc.

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Solvency Ratio indicates the sound financial
position of a concern to carry on its business
smoothly and meet its all obligations.

These ratios indicate the long term solvency of a

firm and indicate the ability of the firm to meet
its long-term commitment with respect to:

Repayment of principal on maturity or in

predetermined installments at due dates and

Periodic payment of interest during the period of the

loan.
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CAPITAL STRUCTURE/
LEVERAGE/SOLVENCY RATIOS

The different ratios are:

Debt equity ratio

Proprietary ratio

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 DEBT EQUITY RATIO

This ratio also termed as External - Internal Equity Ratio.

This ratio is calculated to ascertain the firm's obligations to
creditors in relation to funds invested by the owners.

This ratio also indicates all external liabilities to owner
recorded claims.

It may be calculated as:

(a) Debt-Equity Ratio =External Equities
Internal Equities

The term External Equities refers to total outside liabilities.

The term Internal Equities refers to all claims of preference
shareholders, equity shareholders, reserve & surpluses and 21
profits

(b) Debt - Equity Ratio = Total Long-Term Debt
Shareholders' Funds

OR

(c) Debt - Equity Ratio = Outsiders’ Funds

Shareholders' Funds

(d)Debt - Equity Ratio= Total Long-Term Debt

Total Long-Term Funds
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The term Total Long-Term Debt refers to outside debt
including debenture and long-term loans raised from
banks.

Shareholder’s Funds are equity share capital plus

preference share capital plus reserves and surplus and
profits.

The ideal Debt Equity Ratio is 1:1.

Significance: This ratio indicates the proportion of

owner's stake in the business. Excessive liabilities tend to
cause insolvency.

This ratio also indicate the extent to which the firm

depends upon outsiders for its existence. 23
PROPRIETARY RATIO

This is one of the variant of Debt-Equity Ratio.

Proprietary Ratio is also known as Capital Ratio or

Net Worth to Total Asset Ratio.

The term proprietors’ fund is called Net Worth.

This ratio shows the relationship between

shareholders' fund and total assets.

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It may be calculated as :

Proprietary ratio = Proprietors’ Fund

Total funds

OR

Proprietary ratio = Shareholders’ fund

Total Assets

Shareholders' Fund = Preference Share Capital +

Equity Share Capital+ All Reserves and Surplus +
Profits

Total Assets =Net Fixed Assets + Current Assets 25


Significance : This ratio used to determine the financial
stability of the concern in general.

Proprietary Ratio indicates the share of owners in the

total assets of the company.

It serves as an indicator to the creditors who can find out

the proportion of shareholders' funds in the total assets
employed in the business.

A higher proprietary ratio indicates secure position of the

creditors in the event of insolvency of a concern. A lower
ratio indicates greater risk to the creditors.

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A ratio below 0.5 is alarming for the creditors.
PROFITABILITY RATIOS

These ratios measure the operating efficiency of the
firm and its ability to ensure adequate returns to its
shareholders.

The profitability of a firm can be measured by its

profitability ratios.

Further the profitability ratios can be determined

(i) In Relation to Sales and

(ii) In Relation to Investments

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PROFITABILITY RATIOS IN RELATION
TO SALES:

Gross profit Ratio

Operating Ratio

Operating Profit Ratio

Net profit Ratio

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GROSS PROFIT RATIO

Gross Profit Ratio established the relationship
between gross profit and net sales. This ratio is
calculated by dividing the Gross Profit by Sales.

It is usually indicated as percentage.

Gross Profit Ratio = Gross profit x 100

Net sales

Higher Gross Profit Ratio is an indication that the firm

has higher profitability.

It also reflects the effective standard of performance of
firm's business
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Significance : A firm should have a reasonable
gross profit margin to ensure coverage of its
operating expenses and ensure adequate return
to the owners of the business.

To judge whether the ratio is satisfactory or not,

it should be compared with the firm’s past ratios
or with the ratio of similar firms in the same
industry.

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OPERATING RATIO

Operating Ratio is calculated to measure the
relationship between total operating expenses and
sales.

The total operating expenses is the sum total of cost

of Goods sold, office and administrative expenses and
selling and distribution expenses.

In other words, this ratio indicates a firm's ability to

cover total operating expenses.
31

In order to compute this ratio, the following formula
is used:

Operating Ratio = Operating Cost x100

Net Sales

Operating Cost = Cost of Goods sold +

Administrative Expenses+ Selling and Distribution
Expenses

Net Sales = Sales - Sales Return (or) Return

Inwards 32
OPERATING PROFIT RATIO

Operating Profit Ratio indicates the operational
efficiency of the firm and is a measure of the firm's
ability to cover the total operating expenses.

Operating Profit Ratio can be calculated as:

Operating Profit Ratio =Operating Profit x 100

Net Sales

Operating Profit =Net Sales - Operating Cost

(or)
Net Sales - (Cost of Goods sold + Office and
Administrative Expenses + Selling and Distribution 33
Expenses)
NET PROFIT RATIO

This ratio is calculated by dividing Net Profit by Sales.

This ratio is indicative of the firm’s ability to leave a

margin of reasonable compensation to the owners for
providing capital, after meeting the cost of production,
operating charges and the cost of borrowed funds.

Net Profit Ratio=

Net profit after interest and taxes x 100
Net sales

Higher the ratio, greater is the capacity of the firm to

withstand adverse economic conditions and vice versa 34
PROFITABILITY RATIOS IN RELATION
TO INVESTMENTS
Profitability ratios in relation to investments

Return on Assets (ROA)

Return on Equity (ROE)

Return on Capital Employed (ROCE)

Earnings Per Share (EPS)

Dividend Payout Ratio (D/P)

Dividend Yield Ratio

Price Earning Ratio (P/E)

Interest Coverage Ratio

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RETURN ON ASSETS(ROA)

Profitability can be measured in terms of relationship
between Net profit and Assets.

This ratio is known as profit to assets ratio.

Return on Assets=
Net Profit after Interest and Taxes x 100
Total Assets

It indicates Net Income per rupee of average Fixed

Assets.
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RETURN ON EQUITY(ROE) OR
RETURN ON NET WORTH(RONW)

As this ratio measures a return on the owner's equity

or shareholder’s investment so it is also called as
Return on Shareholders Equity.

This ratio establishes the relationship between net

profit after interest and taxes and the owner's
investment.

Return on Equity Ratio =

Net Profit after Interest and Tax x100
Shareholders' Fund 37
RETURN ON CAPITAL EMPLOYED(ROCE)

Return on Capital Employed Ratio measures a relationship
between profit and capital employed.

This ratio is also called as Return on Investment Ratio.

It indicates how efficiently the long-term funds of owners

and creditors are being used.

Return on Capital Employed=

Net Profit after Tax + Interest x 100
Capital employed

Net Capital employed=
Fixed Assets + (Current Asset-Current Liabilities)38
 EARNINGS PER SHARE (EPS)

Earning Per Share Ratio (EPS) measures the earning
capacity of the concern from the owner's point of view
and it is helpful in determining the price of the equity
share in the market place.

This ratio measures the profit available to the equity
shareholders on a per share basis.

This ratio is calculated by dividing net profit available
to equity shareholders by the number of equity shares.

Earnings per share =

Net Profit After Interest, Tax & Preference Dividend
Number of equity shares 39
 DIVIDEND PAYOUT RATIO

This ratio highlights the relationship between payment of
dividend on equity share capital and the profits available
after meeting tax and preference dividend.

This ratio indicates the dividend policy adopted by the top
management about utilization of divisible profit to pay
dividend or to retain or both.

This ratio shows the dividend paid to the shareholder on a per
share basis.

Dividend payout ratio=Dividend Paid To Ordinary Shareholders x100

Net Profit After Tax & Preference Dividend

OR

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Dividend pay out ratio=Dividend per Equity share x 100
Earnings per Equity share
DIVIDEND YIELD RATIO

Dividend Yield Ratio indicates the relationship
between dividend per share and market value per
share.

This ratio is a major factor that determines the

dividend income from the investors’ point of view.

It can be calculated by the following formula:

Dividend Yield Ratio= Dividend per Share x100

Market value per Share
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 PRICE EARNING RATIO (P/E)

This ratio highlights the earning per share reflected by
market share.

Price Earning Ratio establishes the relationship between the

market price of an equity share and the earning per equity
share.

This ratio is computed by dividing the market price of the

shares by the earnings per share.

Price earning ratio = Market price per share

Earnings per share

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INTEREST COVERAGE RATIO

This ratio is also called as “Debt service ratio” or
“Fixed charges cover ratio”.

This ratio is very important from the lenders’ point of
view.

It indicates whether the business would earn sufficient
profits to pay the interest charges periodically.

It is calculated as:

Interest Coverage Ratio=

Net Profit before Interest & Tax

Interest Charges

The higher the number, the more secure the lender is43
in respect of his periodical interest income.
ACTIVITY RATIOS/TURNOVER RATIOS

Turnover Ratios may be also termed as Efficiency
Ratios or Performance Ratios.

Turnover Ratios highlight the different aspect of
financial statement to satisfy the requirements of
different parties interested in the business.

It also indicates the effectiveness with which different
assets are utilized in a business.

Turnover means the number of times assets are
converted or turned over into sales.

Various ratios are:

Inventory/stock turnover ratio

Debtors turnover ratio and Average collection period

Creditors turnover ratio and Average credit period 44

 INVENTORY /STOCK TURNOVER RATIO

This ratio is also called as Inventory Ratio or Stock
Velocity Ratio.

Stock Turnover Ratio indicates the number of times the
stock has been turned over in business during a particular
period.

It measures the relationship between cost of goods sold and
the inventory level.

Inventory turnover ratio = Cost of goods sold

Average stock

Cost of goods sold= Opening stock + Purchases + Direct Expenses - Closing stock

Average stock= Opening stock + Closing stock

2

Alternatively

Inventory turnover ratio = Sales_______ 45

Closing inventory

Significance: A firm should have neither too
high nor too low inventory turnover ratio.

Too high a ratio may indicate very low level of
inventory and a danger of being out of stock and
incurring high ‘stock out cost’.

On the contrary too low a ratio is indicative of
excessive inventory entailing excessive carrying
cost.

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 DEBTORS TURNOVER RATIO AND
AVERAGE COLLECTION PERIOD

Debtor's Turnover Ratio is also termed as Receivable
Turnover Ratio or Debtor's Velocity.

Receivables and Debtors represent the uncollected portion
of credit sales.

Debtor's Velocity indicates the number of times the
receivables are turned over in business during a particular
period.

In other words, it represents how quickly the debtors are
converted into cash. It is used to measure the liquidity
position of a concern.

This ratio establishes the relationship between receivables
and sales.

Two kinds of ratios can be used to judge a firm's liquidity 47
position on the basis of efficiency of credit collection and
credit policy.

They are (a) Debtor's Turnover Ratio
(b) Debt Collection Period

Debtors turnover ratio = Credit Sales
Average Debtors

Average collection period = Months/days in a year

Debtors turnover ratio

Significance: These ratios are indicative of the efficiency of

the trade credit management.

A high turnover ratio and shorter collection period indicate
prompt payment by the debtor.

On the contrary low turnover ratio and longer collection
period indicates delayed payments by the debtor.

In general a high debtor turnover ratio and short collection
period is preferable. 48
CREDITORS TURNOVER RATIO AND
AVERAGE CREDIT PERIOD

Creditor's Turnover Ratio is also called as Payable
Turnover Ratio or Creditor's Velocity.

The credit purchases are recorded in the accounts of the
buying companies as Creditors or Accounts Payable.

The Term Accounts Payable or Trade Creditors include
sundry creditors and bills payable.

This ratio establishes the relationship between the net
credit purchases and the average trade creditors.

Creditor's velocity ratio indicates the number of times with
which the payment is made to the supplier in respect of
credit purchases.

49

Two kinds of ratios can be used for measuring the efficiency
of payable of a business concern relating to credit purchases.

They are: (a) Creditor's Turnover Ratio
(b) Creditor's Payment Period or Average Payment
Period.

Creditors turnover ratio = Credit Purchases

Average creditors

Average credit period = Months/days in a year

Creditors turnover ratio

Significance: Higher creditors turnover ratio and short

credit period signifies that the creditors are being paid
promptly and it enhances the creditworthiness of the firm. 50