Chapter 3

ANALYSIS OF
FINANCIAL
STATEMENTS

LEARNING OBJECTIVES

Define the concept of financial statement

Objectives of preparing financial statements
Explain different techniques of financial statement analysis
List out liquidity ratios
List out leverage ratios
List out efficiency ratios
List out profitability ratios
List out market value ratios
Know the limitations of ratios

Financial Statement
It is an organised collection of data arranged according to logical
and consistent accounting principles

Financial Statements
Financial Statements

Income
Statement

Statement of
Retained Earnings
Balance
Statements

Statement of
Changes in
Financial Position

Objective of Financial Statement Analysis

The objective of financial statement analysis is a detailed cause
and effect study of the financial position of a firm

Techniques of Financial Statement Analysis

1.
2.
3.
4.
5.

Common-size analysis
Trend analysis
Comparative statement analysis
Funds flow analysis
Ratio analysis

Techniques of Financial Statement Analysis

1. Common-size Analysis:

Income and balance sheet items are

shown as a percentage of sales and total assets respectively.

2. Trend Analysis: trend percentages are index figures giving a
birds eye view of the comparative data presenting then over a
period of time.

Techniques of Financial Statement Analysis

3. Comparative Statement Analysis: This provides trends of
the items of income statement and balance sheet, which
provide immediate future of a business enterprise.
4. Funds Flow Analysis: Funds flow statement that record and
report the flow of funds between various assets and liabilities
and owners capital during a select accounting period.
5. Ratio Analysis: It measures the relationship between two
variables both in terms of percentage as well as quotient.

Classification of Ratios
Traditional or
Basis of Statements
Profit & Loss
A/c Ratios

Liquidity or
Short-term
Ratios

Balance Sheet
Ratios

Leverage or
Long-term
Solvency
Ratios

Financial or Purpose
of using Ratios
Composition
Ratios

Activity or
Efficiency or
Asset
Turnover
Ratios

Profitability
Ratios

Market
Value
Ratios

Liquidity Ratios
Liquidity refers to the firms ability to meet financial obligations
in the short-run usually one year.
Current Assets
Current Ratio = ---------------------Current Liabilities
Quick Ratio =

Liquid Assets
---------------------Current Liabilities

Cash Ratio:
Cash & Bank Balance + Short-term Marketable Securities
= ----------------------------------------------------------------------Current Liabilities
Interval Measure: =

Current Assets
--------------------------------------------Average Daily Operating Expenses

Leverage Ratios
Leverage is the firms ability to use fixed cost source of
finance or fixed assets or both to maximise profitability
Debt
Debt-Equity Ratio = ---------------------Shareholders Equity
Total Debt
Total Debt to Total Assets Quick Ratio = -----------------Total Assets
EBIT
Interest Coverage Ratio = ---------------------Interest
EBIT + Depreciation + Amortisation
Cash Coverage Ratio: = -------------------------------------------Interest

EBIT
Fixed Charge Coverage Ratio = ---------------------Repayment of Loan
Interest + ------------------------1- Tax rate
Debt Service Coverage Ratio
EBIT
= ----------------------------------------------------------------------Interest of term-loan + Lease Rent + Repayment of Loan
Net Fixed Assets
Fixed Assets to Net worth = ---------------------Net worth
Fixed Cost Bearing Funds
Capital Gearing Ratio = -------------------------------------Total Capital Employed

Activity (Efficiency or Turnover) Ratios

Turnover ratio refers the number of times as asset / resource
flows through a firms operations into sales.
Sales
Inventory Turnover Ratio = -------------------------------Year End (or Avg)Inventory
365 Days
Accounts Payable Period = -----------------Inventory turnover
Net Credit Sales
Debtors Turnover Ratio = -------------------------Debtors or Accounts Receivables
365 Days
Average Collection period: = ---------------------------------------Receivables Turnover

Sales
Working Capital Turnover Ratio = ----------------------- -----New Working Capital
Net Sales
Fixed Assets Turnover Ratio = -------------------------Net Fixed Assets
Sales
Total Assets Turnover Ratio = -------------------------Total Assets

Profitability Ratios
Profitability is the firms ability to earn satisfactory profit.
Gross Profit
Gross Profit Ratio = ----------------------- 100
Sales
Net Profit
Net Profit Ratio = ---------------- 100
Sales
EBIT
Basic Earning Power (BEP)= ------------------- 100
Total Assets
Net profit
Return on Total Assets = ------------------- 100
Total Assets

EBIT (1-tax rate)

Return on Capital Employed = ----------------------- 100
Total Assets
Equity Earnings
Return on Equity (ROE) = -------------------------- 100
Total Equity Capital
Operating Ratio =

Operating Expenses
--------------------------- 100
Net Sales

Net Profit after preference Dividend

Earnings per Share = --------------------------------------------No. of Outstanding Equity Shares
Dividend Per Share
Dividend Payout Ratio = -----------------------------Earnings per Share

Du Pont Analysis
Return on Total Assets
Total Assets Turnover

Net Profit Margin

Net Income

Sales

COGS

minus

Depre.

Sales

Total
Cost

Admin
&
Selling
Exps

Sales

Total Assets

Fixed
Assets

Interest
Taxes

Shortterm
Investment

Cash

Current
Assets

plus

Inventory

Accounts
receivables

Limitations of Ratios
1. Deferent Accounting Policies
2. Creative Accounting
3. Ratios are not Definitive measures
4. Ratios are the result of outdated financial information
5. Ratios uses Historical cost
6. Changes in rupee value
7. Changes in price
8. Changes in accounting policy
9. Different risk profile
10. Window dressing
11. Financial statements do not reflect many factors