- Financial Statements are the end products of financial accounting. By financial Statements we mean the summarised statements and reports prepared by business concerns to disclose their accounting information and communicate them to the interested parties.
- The financial statements become meaningless unless they are analysed and interpreted. Analysis of financial statement is the process of determining the significant operating and financial characteristics of affirm from accounting data. It is the treatment of the information contained in the financial statements to afford a full diagnosis of the profitability and financial position of the firm.
- Quotient / Pure ratio ;ratio of current assets to current liabilities is 2:1
- Percentages, it is arrived by multiplying the quotient by 100; the gross profit is 40% of sales.
- Rates; Stock turnover is 5 times a year.
- Accounting ratios simplifies, summarises and systemises accounting figures to make them understandable.
- It makes it easy to grasp the relationship between various items and helps for better understanding of the financial position of the concern.
- They are helpful in business planning and & as it indicates trends in important items which can be useful for forecasting.
- Accounting ratios are of great assistance in locating the weak spots in the business even though the overall performance may be good.
- A firm would like to compare in performance with that of other firm and of industry in general. This comparison is called inter-firm comparison. If the performance of different units belonging to the same firm is to be compared, it is called intra- firm comparison.
FINANCIAL STATEMENT ANALYSIS: MEANING, CLASSIFICATION & TOOLS
Types of Financial Analysis
Distinction between the different types of financial analysis can be made either on the basis of material used for the same or according to the modus operandi of analysis or the object of analysis
TYPES OF FINANCIAL ANALYSIS
1. According to materials used
(i) External Analysis
(ii) Internal Analysis
2. According to modus operandi
(i) Horizontal Analysis
(ii) Vertical Analysis
3. According to the objectives of analysis
(i) Long Term Analysis
(ii) Short Term Analysis
1. External Analysis
• Analysis done by outsiders, who do not have access to the detailed internal accounting records of the business firm.
• Outsiders include investors, creditors, government, banks, general public
2. Internal Analysis
• Analysis by the finance and accounting departments to help the top management.
• They have direct approach to the relevant financial records.
3. Horizontal Analysis
• When financial statements for a number of years are reviewed and analysed is called “horizontal analysis”.
• The preparation is comparative statements is an example of horizontal analysis.
• As it is based on data from year to year ,this is known as “Dynamic Analysis”
4. Vertical Analysis
• Also known as “Static Analysis”
• When ratios are calculated from the Balance Sheet of one year, it is called Vertical Analysis.
• It is not very useful for long-term planning as it does not include the trend study for future.
5. Long-term Analysis
• In the long-term the company must earn a minimum amount sufficient to maintain a suitable rate of return on the investment to provide for the necessary growth and development of the company and to meet the cost of capital.
6. Short-term Analysis
• It is mainly concerned with the working capital analysis.
• In the short run a company must have ample funds readily available to meet its current needs and sufficient borrowing capacity to meet the contingencies.
Techniques and Tools of Financial Analysis (Methods)
The analysis of financial statements consists of a study of relationships and trends to determine whether or not the financial position of the concern and its operating efficiency have been satisfactory. In the process of this analysis various tools or methods are used by the financial analyst .The analytical tools generally available to an analyst for this purpose are as follows:
A. Comparative financial and operating statements
B. Common – size statements
C. Trend ratios(trend percentages)
D. Fund flow Statement
E. cash flow analysis
F. Ratio analysis
A. COMPARATIVE FINANCIAL AND OPERATING STATEMENTS
The preparation of comparative financial and operating statements is an important device of horizontal financial analysis.
Statements prepared in a form that reflects financial data of two / more periods are known as Comparative Statements.
Comparative Statement show
(i) Absolute figures
(ii) Change in the absolute figures(increase/decrease in absolute figures)
(iii) Absolute data in terms of percentages
(iv) Increase / decrease in terms of percentages
Comparative statements can be of 2 types:
(i)Comparative Balance Sheet
The Comparative Balance Sheet analysis is the study of the trend of the same items or group of items of two or more Balance Sheets of the same business enterprise on different dates.
• There is no specific format prescribed for preparing statements for analysis.
(ii)Comparative Income Statement
The comparative income statement is a statement prepared to get an idea of the progress of a business over a period of time. The changes in absolute data in money and percentages help to analyse the profitability of a business.
B. COMMON SIZE STATEMENTS
These are prepared to show the relationship of different individual items with some common items. These are comparative statements that give only the vertical percentage ratio for financial data without giving rupee value. It is also known as 100% Statements which is useful financial analysis and comparison of two business enterprises at a certain date.
Common Size statements include:
(i)Common Size Balance sheet: In which Balance sheet items are expressed as percentage of each asset to total assets and percentage of each liability to total liabilities is called Common size Balance sheet
(ii)Common Size Income Statement: In which each item of expense is shown as a percentage of sales.
C. TREND RATIOS(TREND PERCENTAGE)
Trend signifies tendency. Therefore, it is the review and appraisal of tendency in accounting variables.It is an important tool of horizontal analysis. The ratios of different items for various periods are calculated and then a comparison made.An analysis of the ratio over past few years may well suggest the trend or direction in which the concern is going upward or downward.
For calculation, One year is taken as base year (usually first year)
• The figure of base year are taken as 100
• Trend percentage = Current yr. amount ÷ Base yr. amount × 100
D. FUND FLOW STATEMENT
The main objective of this statement is to derive a fairly accurate summary of the events that affected the amount of working capital. That is about increase/decrease in current assets and current liabilities.
E. CASH FLOW ANALYSIS
A cash flow statement reveals the sources of cash and its application. It helps to analyse the liquidity position of concern.
F. RATIO ANALYSIS
It is an important and widely used tool of analysis of financial statements. It is essentially an attempt to develop meaningful relationship between individual items or group items in the Balance Sheet or P&L Account
RATIO ANALYSIS
Ratio analysis is the analysis of financial statements with the help of ratios. It includes comparison and interpretation of these ratios and their use for future projection. It does not provide an end itself, but only a means to understand the financial position and performance of business concerned.
A ratio may be expressed in any forms:
ADVANTAGES OF RATIO ANALYSIS
LIMITATIONS OF RATIO ANALYSIS
• There is no single standard ratio against, which the ratio may be measured and compared.
• While preparing the financial statement, personal judgement or decision play a very important role hence, it affects the ratio analysis also.
• Ratios are calculated by using the accounting information; hence, the ratio analysis depends upon the accuracy of financial statement. If financial statements are not showing accurate or true results, the analysis will give absolute wrong idea.
• Chance for window dressing, that is manipulation of accounts in a way to conceal vital facts and present the statement better than, what they actually are in such a situation, ratios are affected.
Classification of Ratio
1. Statement wise classification (Traditional Classification)
a) Balance Sheet Ratios: These ratios deal with the relationships between 2 items or groups of items which are both in Balance Sheet.
Current Ratio, Debt-equity Ratio, Acid test Ratio, Absolute liquidity Ratio, Working capital Ratio and Proprietary Ratio
b) Income Statement Ratios: Focus on relationship between the 2 items or group of Items, all of which are drawn from the revenue statement. Also known as “Operating Ratios “.
Gross profit Ratio, Net profit Ratio, Stock turnover Ratio ,Operating Ratio, Expense Ratio
c) Combined Ratios: Depicts the relationship between 2 items or group of items, one of which is drawn from Balance Sheet and other from the revenue statement.
Return on shareholder’s fund, Debtors turnover Ratio, Return on capital employed. Stock turnover Ratio.
2. According to importance
a) Primary Ratio: As the success of any business undertaking is measured by the quantum of profit earned by it, the ratio which related the profit to capital employed is termed as primary ratio. E.g. Return on capital employed, Operating profit ratio, etc.
b) Secondary Ratio: This classification is effected to facilitate inter firm comparison and to focus on some factors responsible for the success of the unit. When such factors are isolated by means of ratios, they are called secondary ratios.
3. According to users
a) Managerial Tools: which includes Operating Ratio, Debtors turnover Ratio, Inventory turnover Ratio, Solvency Ratio, Return on capital employed.
b) For creditors : which includes
Current Ratio, Solvency Ratio, Creditors turnover Ratio, Fixed asset Ratio
c) For Shareholders: which includes
Earning rate, Dividend yield , Capital gearing Ratio
4. According to Nature/Function
a) Liquidity Ratio
b) Leverage Ratios
c) Profitability Ratios
d) Activity Ratios
LIQUIDITY RATIOS
The liquidity ratios deal with the relationship between current assets and current liabilities.These ratios help to evaluate the firm’s ability to pay its short-term liabilities, i.e. current liabilities.It shows how many of their assets can be quickly converted to cash to pay off their obligations when they become due. It is not only a measure of how much cash there is but also how easily current assets can be converted to cash or marketable securities.
I. Current Ratio
II. Quick Ratio
III. Absolute Liquidity Ratio
(I) Current Ratio (working capital ratio)
• Current Ratio measures the relationship between current assets and current liabilities.
• Measures the firm’s ability to pay for all its current liabilities, due within the next one year by selling off all their current assets.
• Current Ratio = Current Assets ÷ Current Liabilities
• The ideal current ratio, according to the industry standard is 2:1.
• If the ratio is very high it may indicate that certain current assets are lying idle and not being utilized properly.
(II) Quick Ratio (Liquid ratio or Acid test ratio).
Quick Ratio measures a firm’s ability to pay off its current liabilities (minus a few) with only selling off their quick assets. Quick assets are those which can be easily converted to cash with only 90 days’ notice. Quick assets generally exclude stock & prepaid expenses.
Quick Ratio = Quick Assets /Quick Liabilities
 Quick Assets = All Current Assets – Stock – Prepaid Expenses
 Quick Liabilities = All Current Liabilities – Bank Overdraft
The ideal quick ratio is considered to be 1:1, so that the firm is able to pay off all quick assets with no liquidity problems.Many firms believe it is a better test of liquidity than the current ratio since it is more practical.
(III) Absolute Cash Ratio
Absolute Cash Ratio measures the availability of cash and cash equivalents to meet the short-term commitment of the firm.
Absolute Cash ratio = Cash +Bank Balance + Marketable Securities ÷ Current Liabilities
It measures the cash availability of the firm to meet the current liabilities. No ideal ratio, it helps the management understand the level of cash availability of the firm and make any changes required.If the ratio is greater than 1 it indicates poor resource management and very high liquidity. (High liquidity may mean low profitability).
LEVERAGE RATIO
Leverage Ratio determines an entity’s ability to service its debt. These ratios calculate if the company can meet its long-term debt.They are also known as Solvency ratios Liquidity ratios compare current assets with current liabilities, i.e. short-term debt while Solvency ratios analyse the ability to pay long-term debt.
1. Debt-Equity Ratio
2. Proprietary Ratio
3. Solvency Ratio
4. Fixed Asset Ratio
5. Debt Service Ratio(ICR)
6. Long term Debt to Shareholders Fund
7. Fixed Assets to Net Worth
8. Capital Gearing Ratio
1] Debt to Equity Ratio
The debt to equity ratio measures the relationship between long-term debt of a firm and its total equity. It is a balance sheet ratio. A great way for the company to measure its leverage or indebtedness. A low ratio means the firm is more financially secure, but it also means that the equity is diluted.High ratio indicates a risky business where there are more creditors of the firm than there are investors. The maximum a company should maintain is the ratio of 2:1
Debt to Equity Ratio = Long-Term Debt/Shareholders Funds
• Long Term Debt = Debentures + Long Term Loans
• Shareholders’ Funds = Equity Share Capital + Preference Share Capital + Reserves &Surplus – Fictitious Assets
 A low debt- equity ratio indicates, a lower amount of financing through debt than that of equity
 If the company depends more on borrowed capital, company needs to pay more interest or fixed cost
 A highly leveraged company suffers if the earnings declines
2]Proprietary Ratio
Ratio expresses the relationship between the proprietor’s funds.It shows the comparison between owner’s funds and total capital or net assets. A high ratio is a good indication of the financial health of the firm. A larger portion of the total capital comes from equity. Or that a larger portion of net assets is financed by equity rather than debt.
Proprietary Ratio = Shareholder’s Fund/ Net Assets
3] Solvency Ratio
This ratio indicates the relationship between total outside liabilities to total assets except fictitious asset.
(Total Liabilities to outider's)/(Total Assets-Fictitious Assets)
4] Fixed Asset Ratio
This ratio of fixed assets after depreciation to long term funds.Long term fund means shareholder’s fund including preference share capital + long term borrowings. It indicates the extent to which the total of fixed assets are financed by long term funds of the firm.It is better if the total of fixed assets is equal to long term fund
Fixed Asset Ratio = Fixed Asset(after dep.)/ Total Long-term Funds
5] Interest Coverage Ratio
All debt has a cost, which we normally term as an interest.Debentures, loans, deposits etc. all have an interest cost. ICR measures the security of this interest payable on long-term debt. This ratio between the profits of a firm available and the interest payable on debt instruments.
ICR = Net Profit before Interest and Tax(EBIT) / Fixed Interest Charges
6] Ratio of Long term Debt to Shareholders Funds
This ratio shows the relationship between long term debt & shareholder’s fund.A high ratio is not a healthy sign of financial management.
Ratio of Long term Debt to Shareholders Funds
= Long term debt / Shareholder’s Fund
7] Fixed Asset to Net worth
This ratio shows the relationship between fixed assets & shareholders fund.Its purpose is to find out the percentage of the owners fund invested in fixed assets.
Fixed Asset to Net Worth = Fixed Asset/ Net Worth(Shareholder’s Fund)
8] Capital Gearing Ratio
CGR are mainly used to analyse the capital structure of a company.The term capital gearing refers to the proportion between fixed income bearing securities & non- fixed income bearing securities.
C.G.R = Fixed Interest Bearing Funds ÷ Equity Sh.Cap+ Reserves & Surplus
PROFITABILITY RATIOS
Profitability ratios help the management determine an entity’s ability to use its assets and create earnings.
• Profitability Ratios Based On Sales
(a) Gross Profit ratio
(b) Net Profit Ratio
(c) Operating Ratio
(d) Operating profit ratio
(e) Expenses Ratio
(a)Gross Profit Ratio
G/P Ratio compares the gross profit of a company to its net sales. They are P&L Ratios. G/P ratios are also known as Margin ratio or the Rate of Gross Profit and is represented as a percentage of sales.
Gross Profit Ratio = Gross Profits ÷ Net Sales× 100
• Net Sales = Sales – Sale Returns
• Gross Profit = Sales – Cost of Sales
(b)Net Profit Ratio
Net profit ratio includes the total revenue of the firm. This includes both the operating income as well as the non-operating income, which is represented as a percentage. N/P ratio also reflects on the efficiency of the business and is a very important ratio for investors and financiers.
Net Profit Ratio = Net Profit / Net Sales × 100
(c)Operating Ratio
An indicative of the proportion that the cost of sales bears to net sales. Operating ratio also takes into account operating expenses such as administration and office expenses, selling and distribution costs, salaries paid, depreciation expenses etc. It ignores the non-operating incomes such as interests, commissions, dividends etc.This helps to ascertain the efficiency of the organization along with its profitability. There are no standard for operating ratio, but a trend analysis must be done on year on year basis to check the progress of the firm.
Operating Ratio = COGS + Operating Expenses / Net Sales × 100
• A higher ratio would indicate that the company’s ability as inefficient
• A Lower ratio would considered to be a good sign as the company’s expenses are less than that of its revenue
• High operating ratio means less margin to meet non-operating expenses.
(d)Operating Profit Ratio
Operating Profit Ratio = 100 – Operating ratio OR
Net sales – Operating cost
(e)Expenses Ratio
Expense ratio indicates the relationship of each item of expense to sales. The ratio can be calculated for each item of expense or group of expenses like cost of sales ratio, administrative expense ratio, selling expense ratio etc.
Expense Ratio = Particular Expense / Net Sales * 100
The lower the ratio , the greater is the profitability & higher the ratio, the lower is the profitability.
• Cost of goods sold ratio = CGSD/ Net Sales * 100
• Administrative expenses ratio = Admin.Expenses /Net Sales * 100
• Selling & Distribution expense ratio = S&D Expenses/Net Sales * 100
• Non-operating Expenses = Non –Operating Expenses/Net Sales *100
• Profitability Ratios Based On Investment
(a) Return on shareholder’s Fund
(b) Return on Equity Share Capital
(c) Return On Capital Employed
(d) E.P.S.
(e) P.E Ratio
(f) Dividend Yield ratio
(g) Dividend pay Out Ratio
(h) Return On Total Assets
(a)Return On Shareholder’s Fund
This ratio shows the rate of profit on shareholder’s fund, which relates the profit available for shareholder to their total investment. It is also known as ‘Profit On Net Worth’ Ratio
Return On Shareholder’s Fund = Net profit (after interest & tax) ÷ Shareholder’s Fund *100
Shareholder’s Fund :-
Equity Share Capital + Preference Share Capital + Reserves & Surplus – Fictitious Assets
(b)Return On Equity Share Capital
Owners are more interested with this ratio .Higher the ratio means better the owners like it
Return On E.S.C= N/P(after interest, tax & Pref div.) ÷ Equity Share Capital* 100
(c)Return On Capital Employed
Primary objective of making investment in any business is to obtain satisfactory return on capital invested. It is also known As ROI. This ratio indicates the return on capital employed in the business, which helps in determining efficiency of the business as a whole
ROCE =N/P (before interest, tax& dividend) / Net Capital employed* 100
Net Capital Employed:-
(Share Capital + Reserves & Surplus + Long term liabilities) - Fictitious assetsOr
Fixed Assets+ Current Asset – Current Liabilities
(d) Earning Per Share (E.P.S)
EPS assess profitability of a firm from the stand point of equity shareholders. This ratio measures the profit available to the equity shareholders per share. Comparison of E.P.S. of the company with another will also help in deciding whether the equity share capital is being effectively used or not.
E.P.S = N/P available to equity shareholders ÷ No. of equity shares
(e) Price-Earnings Ratio (P.E. Ratio)
P.E. Ratio shows the relationship between the market price of a share & the EPS. This helps the investor in deciding whether to buy or not to buy the shares of a company at a particular market price.Higher P/E ratio, better for the equity shareholders
P.E.Ratio = Market Price Per Equity Share ÷ EPS
(f) Dividend Yield Ratio
Dividend Yield Ratio is useful for those investors who are interested only in dividend income. It is calculated by comparing the rate of dividend per share with its market value
Dividend Yield Ratio = Dividend Per Share/ Market Price Per Share * 100
(g) Dividend Pay Out Ratio (D/P Ratio)
D/P ratio shows relationship between the earnings belonging to equity shareholders & dividend actually paid to them. It is also known as Pay Out Ratio
D/P Ratio = Dividend Per Equity Share ÷ EPS
(h) Return On Total Assets
Profitability can be measured in terms of relationship between net profit & total assets. Another name of this ratio is Return on gross capital employed
Return On Total Asset = Net Profit ÷ Total assets * 100
“Net Profit “ stands for Net profit before interest ,tax & dividend
ACTIVITY RATIOS
Activity Ratios measures the efficiency with which assets are being utilized or managed. It is also known as productivity ratio, efficiency ratio or more famously as turnover ratios.It is about relationship between sales and any given asset and will indicate the ratio between how much a company has invested in one particular type of group of assets and the revenue such asset is producing for the company.
• ACTIVITY RATIOS
1. Stock turnover
2. Debtors Turnover
3. Creditors turnover
4. Fixed Asset Turnover
5. Working Capital turnover
1] Stock Turnover Ratio
Stock Turnover Ratio focuses on the relationship between the cost of goods sold and average stock. It is also known as Inventory Turnover Ratio or Stock Velocity Ratio.It basically counts the number of times a stock rotates (completes a cycle) in one given accounting period and the sales it effects in the same period.This ratio calculates the speed with which the company converts stock (lying about) to sales, i.e. revenue and it allows them to figure out their inventory reordering schedule, by indicating when all the stock will run out. ITR also helps them analyse how efficiently the stock and its reordering is being managed by the purchasing department.
Inventory Turnover Ratio = COGS/Average Stock
• COGS =Sales – Gross Profit
• Average Stock= (Opening Stock + Closing Stock )÷2
If there is no opening stock, the closing stock itself may be taken as the average stock
2] Debtors Turnover Ratio
Debtors turnover ratio measures the efficiency with which Accounts Receivable are being managed. Another name commonly used for debtors turnover ratio is ‘Accounts Receivable Turnover ratio’ or Debtor’s Velocity
Debtors Turnover ratio = Net Credit Sales ÷ Average Debtors
• Average debtors include debtors & bills receivable
Average Debt Collection Period
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A shorter collection period implies prompt payment by debtors.So it reduces the chance of bad debt
3]Creditors Turnover Ratio
Creditors Turnover Ratio shows the relation between credit purchases and the average creditors of a company at any given time of the accounting year. It is also known as ‘Accounts payable turnover ratio’ or Creditor’s Velocity
Creditors Turnover ratio = Net Credit Purchases ÷ Average Creditors
Average creditors includes creditors & bills payable also.
Average Payment Period :
= Numberofdays/weeks/months ÷ Creditors Turnover Ratio
Creditors turnover ratio has great importance. It calculates the velocity with which creditors are paid off during the year. It helps the management judge how efficiently the accounts payables are being handled.
4] Fixed Asset Turnover
Fixed Asset Turnover Ratio indicates the extent to which the investments in fixed assets contribute towards sales.If compared with a previous year, it indicates whether the investment in fixed assets has been judicious or not.
Fixed Asset Turnover Ratio = Net Sales ÷ Fixed Assets
5] Working Capital Turnover Ratio
This is one of the activity ratios will measure the efficiency with which the firm is using their Working Capital to support their sale volumes. So any excess of current assets over the current liabilities of a firm is their working capital.
Working Capital Turnover ratio = Total Sales ÷ WorkingCapital
Working Capital = Current Assets – Current Liabilities
A high Working Capital Turnover ratio means that the working capital is being very efficiently utilized. But sometimes it could mean that the creditors of the company are excessive (bringing down the working capital) and this could be a problem in the future. Conversely, a low ratio could mean that there are too many debtors or a very big inventory which is not an efficient use of resources.
? Some important and indirect problems
Q) Calculate current asset & current liability
 Current Ratio – 2.25
 Working Capital – 50,000
Solution:
Current Ratio = Current asset/Current liability
= 2.25 /1
That is current asset 2.25 & current liability 1
Working Capital = Current asset – Current liability
= 2.25 - 1 = 1.25
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Q) Calculate liquid asset
 Current ratio – 2.8
 Acid –test ratio – 1.5
 Working capital – 1,62,000
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Q) Find Cost of Goods Sold?
 Gross profit Ratio -20%
 Sales – 5,00,000
Solution:
Cost of Goods Sold = Sales – Gross profit
G/P Ratio = Gross profit /Net sales × 100
Gross profit = 20% × 5, 00,000 ÷ 100
= 1, 00,000
Cost of Goods Sold = 5, 00,000 – 1, 00,000
= 4, 00,000