Financial Statement Analysis

There are two key factors for business survival:

1) Profitability
2) Solvency/Liquidity
Profitability: if the business generates revenue (income) in
excess of the expenses incurred in operating of the business.
Solvency & Liquidity: ability of the business in meeting its
financial obligations.
Solvent: Total outside liabilities are less than total tangible
assets.
Liquid: Sufficient current assets for meeting current
liabilities as and when they fall due.

Financial statement is the most important source of the above

information.
 What is a Financial statement
A financial statement is a collection of data organized
according to logical and consistent accounting procedure.
Analysis and interpretation of financial statements help in
determining the liquidity position, long term solvency, financial
viability and profitability of a firm.
“Financial Statement” refers to two basic accounting
statements: Balance sheet and Profit & Loss Statement.
B/S and P/L statement is a part of ‘Annual Report’ of a company
among others like Statement of retained earnings, Cash flow
Statement, etc.
Financial analysis requires comparison of financial data of
the firm over a period of time.
Past data (audited/unaudited)
Estimated/Provisional data
Projected data
 Use of Financial Statements
Provide information that is useful to investors and creditors in order
to predict the amount, timing and uncertainty of future cash flows.
Why do we want to predict the amount, timing and uncertainty of
future cash flows?
We need to know the amount of the return (cash flows) we will get
on our investment, when we will realize this return, and how certain
we are of realizing those cash flows
Users of Financial Statements :
a) Internal users (i.e., management): For Planning, evaluating and
controlling company operations.
b) External users: Investors, creditors, regulatory agencies, stock
market analysts, auditors etc. for assessing past performance and
current financial position and making predictions about the future
profitability and solvency of the company as well as evaluating the
effectiveness of management.
Banker’s need financial statement for better Credit decision &
management.
 Balance sheet and P/L account
Balance sheet is a financial statement showing what a
business enterprise owns and owes on a given date.
Prepared on “business entity” concept - business
enterprise and its owners are treated as separate entity.
Double entry Book keeping system-both debit and
credit sides to be equal and so total of assets and
liabilities match and balance each other. The sheet on
which balances of the a/cs are written is Balance sheet.
Capital is liability - for these fund proprietor is creditor
and enterprise owes this fund to him. Loss is asset -
owner has to pay it to the enterprise.
B/S as on a given date while P/L ac for a given period.
B/S is compared to a “snapshot” and P/L ac to a “moving
picture”
 Analysis of Financial Statements
Ratio analysis is as old as accounting concept. Financial
analysis is a vital apparatus for the interpretation of
financial statements. It also helps to find out any cross-
sectional and time series linkages between various ratios.
Ratio analysis shows whether the company is improving
or deteriorating in past years. Moreover, Comparison of
different aspects of all the firms can be done effectively
with this. 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.
Lending decision - shift from security orientation to
need based and financial viability based
Further all credit decision contains an element of risk.
Ratio analysis and other quantitative techniques
facilitate assessment of this risk.
 Financial Statement Analysis
Purpose:
To use financial statements to evaluate an organisation’s
Financial performance (P/L Statement)
Financial position ( Balance Sheet)
To have a means of comparative analysis across time in
terms of:
Intra company basis (within the company itself)
Inter company basis (between companies)
Industry Averages (against that particular industry’s
averages)
To apply analytical tools and techniques to financial
statements to obtain useful information to aid decision
making.
 Financial Statement Analysis
Financial statement analysis involves analysing the
information provided in the financial statements to:
 Provide information about the organisation’s:
 Past performance
 Present condition
 Future performance

 Assess the organisation’s:

 Earnings in terms of power, persistence, quality
and growth
 Solvency

 Financial statement analysis is the process of

identifying financial strengths and weaknesses of
the firm by properly establishing relationship
between the items of the balance sheet and the
profit and loss account.
 Tools of Financial Statement Analysis
The commonly used tools for financial statement analysis are:
 Financial Ratio Analysis
 Comparative financial statements analysis:
Horizontal analysis/Trend analysis
Vertical analysis/Common size analysis/ Component
Percentages
Financial Ratio can be expressed as:
As Percentage - such as 25%. For example if net profit is
Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit
will be 25% of the sales.
As Proportion - The above figures may be expressed in
terms of the relationship between net profit to sales as 1 : 4.
As Pure Number /Times - The same can also be expressed
as the sale is 4 times of the net profit or profit is 1/4 th of the
sales.
 Word of Cautions for financial analysis

a. The dates and duration of the financial statements being

compared should be the same. If not, the effects of
seasonality may cause erroneous conclusions to be
drawn.

b. The accounts to be compared should have been

prepared on the same bases. Different treatment of
stocks or depreciations or asset valuations will distort
the results.

c. In order to judge the overall performance of the firm a

group of ratios, as opposed to just one or two should be
used. In order to identify trends at least three years of
ratios are normally required.
 Classification of Ratios
Balance Sheet P&L Ratio or Balance Sheet and
Ratio Income/Revenue Profit & Loss Ratio
Statement Ratio
Financial Ratio Operating Ratio Composite Ratio
Current Ratio Gross Profit Ratio Fixed Asset Turnover
Quick Asset Ratio Operating Ratio Ratio,
Proprietary Ratio Expense Ratio Return on Total
Debt Equity Ratio Net profit Ratio Resources Ratio,
Return on Own
Funds Ratio,
Earning per Share
Ratio,
Debtors’ Turnover
Ratio,
Stock Turnover Ratio
 Format of Balance Sheet
LIABILITIES ASSETS
NET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS:
Share Capital/Partner’s Capital/Paid up Land & Building, Plant & Machineries
Capital/ Owners Funds (Original Value Less Depreciation-
Reserves (General, Capital, Revaluation & Net Value or Book Value or Written down
Other Reserves) value)
Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED NON CURRENT ASSETS
FUNDS: Investments in quoted shares & securities
Term Loans (Banks & Institutions), Old stocks or old/disputed book debts
Debentures/Bonds, Unsecured Loans, Fixed Long Term Security Deposits
Deposits, Other Long Term Liabilities Other Misc. assets which are not current or
fixed in nature
CURRENT LIABILTIES CURRENT ASSETS:
Bank Working Capital Limits such as Cash & Bank Balance, Marketable/quoted
CC/OD/Bills/Export Credit, Govt. or other securities, Book
Sundry/Trade Creditors/ Creditors/ Bills Debts/Sundry Debtors, Bills Receivables,
Payable, Stocks & inventory (RM,SIP,FG) Stores &
Short duration loans or deposits, Spares, Advance Payment of Taxes, Prepaid
Expenses payable & provisions against expenses, Loans and Advances recoverable
various items within 12 months
INTANGIBLE ASSETS
Patent, Goodwill, Debit balance in P&L A/c,
Preliminary or Preoperative expenses
 Important Notes
 Liabilities have Credit balance and implies promises to be fulfilled
Assets have Debit balance
 Current Liabilities are those which have either become due for
payment or shall fall due for payment within 12 months from the date
of Balance Sheet
 Current Assets are those which undergo change in their shape/form
within 12 months. These are also called Working Capital or Gross
Working Capital
 Net Worth & Long Term Liabilities are also called Long Term
Sources of Funds
 Current Liabilities are known as Short Term Sources of Funds
 Long Term Liabilities & Short Term Liabilities are also called Outside
Liabilities
 Current Assets are Short Term Use of Funds
 Assets other than Current Assets are Long Term Use of Funds
 Installments of Term Loan Payable in 12 months are to be taken as
Current Liability only for Calculation of Current Ratio & Quick Ratio.
 If there is profit it shall become part of Net Worth under the head
Reserves and if there is loss it will become part of Intangible Assets
 Financial Ratio Analysis

Financial Ratios can be classified into 5 main categories:

 Profitability Ratios
 Liquidity or Short-Term Solvency ratios
 Asset Management or Activity Ratios
 Capitalisation Ratios or Leverage Ratios
 Market Test Ratios
 Profitability Ratios

The starting point in financial statement analysis is the

evaluating the profitability of the company.
It measures earning ability of a firm . Also measures
ability to operate efficiently and so is a concern for all
stake holders.

3 elements of the profitability analysis:

Analysing on sales and trading margin
focus on gross profit
Analysing on the control of expenses
focus on net profit
Assessing the return on assets and return on equity
 Profitability Ratios
 Gross Profit Ratio: Gross Profit Ratio = (Gross Profit /
Net Sales ) x 100
Alternatively , since Gross Profit is equal to Sales minus Cost of
Goods Sold, it can also be interpreted as below :
Gross Profit Ratio = [ (Sales – Cost of goods sold)/ Net
Sales] x 100
Example:
Total sales = Rs. 520,000; Sales returns = Rs. 20,000; Cost of
goods sold Rs.400,000
Calculation: Gross profit = [(520,000 – 20,000) – 400,000]
  = 100,000
Gross Profit Ratio = (100,000 / 500,000) × 100 = 20%

A high ratio is a sign of good management .May indicate higher sales

price without corresponding increase in cost of goods sold .May also
indicate decline in cost of sales without decline in sale price.
Low ratio may indicate high cost of production or inefficient use of both
current and fixed assets .May also indicate low selling price due to
competition ,poor quality of product or lack of demand.
 .

 Net Profit ratio : ( Net Profit / Net Sales ) x

100
It measures overall profitability.
Example: Total sales=Rs.520,000; Sales returns=Rs.20,000; 
Net profit Rs.40,000
Calculation: Net sales = (520,000 – 20,000) = 500,000
Net Profit Ratio = [(40,000 / 500,000) × 100]
= 8%
High ratio means adequate return to organization and ability to withstand
adverse conditions like fall in selling price ,rise in cost of production
and fall in market demand.
Low ratio means slight unfavorable condition in selling price without
proportionate change in cost may result in loss.
No standard profitability ratio .Best course to compare with market trend.
 .

 Operating Profit ratio:

 => (Operating Profit / Net Sales ) x 100
Higher the ratio indicates operational efficiency
Operating Ratio:
Operating ratio is the ratio of cost of goods sold plus operating expenses to net
sales in %.
Operating ratio measures the cost of operations per rupee of sales. This is closely
related to the ratio of operating profit to net sales.
Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] ×
100

Example: Cost of goods sold is Rs.180,000 and other operating expenses are
Rs.30,000 and net sales is Rs.300,000.

Calculation: Operating ratio = [(180,000 + 30,000) / 300,000] × 100

= [210,000 / 300,000] × 100 = 70%

Significance: Lower operating ratio shows higher operating profit and vice
versa. An operating ratio ranging between 75% and 80% is generally
considered as standard for manufacturing concerns.
 .

Expense ratios indicate the relationship of various expenses to net

sales.

While interpreting expense ratio, it must be remembered that for a

fixed expense like rent, the ratio will fall if the sales increase and for a
variable expense, the ratio in proportion to sales shall remain nearly
the same.

Formula of Expense Ratio:

Particular Expense = (Particular expense / Net sales) × 100
Example:
Administrative expenses are Rs.2,500, selling expenses are
Rs.3,200 and sales are Rs.25,00,000.

Calculation:
Administrative expenses ratio = (2,500 / 25,00,000) × 100
= 0.1%
Selling expense ratio = (3,200 / 25,00,000) × 100
= 0.128%
 Profitability
 Return on Asset:
( Net Profit after Taxes + Interest)/Total Assets
Total Asset means : Net Fixed asset and net working capital (NWC) excluding
intangible assets , fictitious assets ,idle / unused assets ,obsolete stocks and
doubtful debts.
 Return on Investment/Capital employed: (ROCE)
( Profit after Tax / Average Capital Employed) x 100
Average Capital Employed is the average of the equity share capital
and long term funds provided by the owners and the creditors of the firm
at the beginning and end of the accounting period.
It is a measure of efficiency of the use of capital employed.

Example:
Equity share capital (Rs.1): Rs.1,000,000; 9% Preference share capital:
Rs.500,000; Taxation rate: 50% of net profit; Net profit before tax:
Rs.400,000.

Calculation:
Return on Equity Capital (ROEC) ratio = [(400,000 − 200,000 − 45,000) /
1000,000 )× 100]
= 15.5%
 Liquidity or Short-Term Solvency ratios

It measures firms ability to meet current obligation .

Concept of converting an asset into cash with little or
no loss in value.
Short-term funds management
Working capital management is important as it
signals the firm’s ability to meet short term debt
obligations.
 Liquidity or Short-Term Solvency ratios
Net Working Capital = Current assets – Current Liabilities
If liquid surplus or NWC is too high it may indicate less effective
utilization of funds and vice versa . Decline in NWC in comparison to
previous years or in other similar type activities is the first signal of
financial problem being faced and is a warning signal for the Banker.

Current Ratio = Current Assets /Current Liability.

 Measures margin of safety for creditors.
 Very high ratio implies slack management practice like accumulation
of idle cash or inventories ,obsolete stock and long pending
receivables .May also due to excessive current assets financed by long
term funds ,which may affect profitability.
Example:
Current assets are Rs.12,00,000 and total current liabilities are
Rs.600,000.

Calculation: Current Ratio = 12,00,000 / 600,000

=2 or 2 : 1
 .

Quick Ratio or Acid Test Ratio =

Current Assets – Inventory – Prepayments
Current Liabilities – Bank Overdraft
High Current Ratio accompanied by low Acid Test Ratio
indicates disproportionately high investment in
stocks.
Example:
From the following information of a company, calculate liquid
ratio. Cash Rs.180; Debtors Rs.1,420; inventory Rs.1,800; Bills
payable Rs.270; Creditors Rs.500 Accrued expenses Rs.150; Tax
payable Rs.750.
Liquid Assets = 180 + 1,420 = 1.600
Current Liabilities = 270 + 500 + 150 + 750 = 1,670
Liquid Ratio = 1,600 / 1,670
= 0.958 : 1
 Asset Management or Activity Ratios

 More sophisticated analyses of firms liquidity . Measures speed with

which firm is able to convert different accounts within the B/Sheet
into cash or sales . Measure of firms efficiency.

 How well assets are used to generate revenues (income).Will

impact on the overall profitability of the business.

For example: Asset Turnover

Fixed asset/Current asset Turnover Ratio :
= Cost of goods sold
Average Fixed /current Assets
This ratio represents the efficiency of asset usage to generate sales
revenue
Since the net Fixed asset value is considered ,the ratio will be higher for
old assets-(misleading impression).
High value indicates efficiency of assets and low value indicates
underutilisation of assets .Causes to be looked into.
 Asset Management or Activity Ratios
 Inventory Turnover = Cost of Goods Sold
Average Inventory
High ITR means good inventory management ,Higher profitability lesser
capital requirement for inventory .Very high ratio may create problem
of optimum stock .Should not be very high or very low.
Example:
The cost of goods sold is Rs.500,000. The opening stock is Rs.40,000
and the closing stock is Rs.60,000 (at cost).
Calculation:
Inventory Turnover Ratio (ITR) = 500,000 / 50,000*
= 10 times
 .

 Average Collection Period/Debtors turnover ratio

= Average accounts Receivable
Average daily net credit sales*
• Average daily net credit sales = net credit sales / 365
• Longer period means less effective collection machinery resulting in additional
interest burden and chances of receivables turning bad and doubtful.
• Remedial action of restrictive sales policy may also be counter productive by
decrease in sales and profitability.
Example: Credit sales Rs.25,000; Return inwards Rs.1,000; Debtors Rs.3,000; Bills
Receivables Rs.1,000.
Calculation:
Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors
= 24,000* / 4,000** = 6 Times
*25,000 less 1,000 return inwards, **3,000 plus 1,000 B/R
Average Collection Period = (Trade Debtors × No. of Working Days) / Net Credit
Sales
4,000** × 360*** / 24,000 = 60 Days
***For calculating this ratio usually the number of working days in a year are
assumed to be 360.
 Activity Ratio


 Creditors Turnover Ratio or Accounts Payable Ratio
: This is also called Creditors Velocity Ratio, which
determines the creditor payment period.
= (Average Creditors/Purchases)x365 for days
(52 for weeks & 12 for months)
Speed with which creditors are paid.
High ratio means creditors are paid promptly enhancing
creditworthiness of the enterprise.
Very high ratio indicate that enterprise is not taking
advantage of credit facility by suppliers.
 .

Working capital turnover ratio indicates the velocity of the utilization of net
working capital.
This ratio represents the number of times the working capital is turned over in
the course of year and is calculated as follows:
= Cost of Sales / Net Working Capital
If the information about cost of sales is not available the figure of sales may be
taken as the numerator.
Significance:
 The working capital turnover ratio measure the efficiency with which the
working capital is being used by a firm. A high ratio indicates efficient
utilization of working capital and a low ratio indicates otherwise. But a very high
working capital turnover ratio may also mean lack of sufficient working capital
which is not a good situation.
Fixed Assets Turnover Ratio:
Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio
measures the efficiency and profit earning capacity of the concern.
Fixed Assets Turnover Ratio = Cost of Sales / Net Fixed Assets.
Higher the ratio, greater is the intensive utilization of fixed assets. Lower ratio
means under-utilization of fixed assets.
 Leverage or Capitalisation Ratios

It measures degree of protection of suppliers of long

term fund.
Debt is “double edged “sword:
1. Allows for generation of profit with use of others
(creditors) money.
2. Creates claim on earnings with higher priority than
that of firms owner.
Two types of Debt measures:
1. Degree of indebtedness
2. Ability to service debt.
 Levearage or Capitalisation Ratios
 Debt/Equity ratio
Formula of Debt to Equity Ratio:
[Outsiders funds / Shareholders funds]
As a long term financial ratio it may be calculated as follows:
[Total Long Term Debts / Total Long Term Funds]
Or
[Total Long Term Debts / Shareholders Funds]

 High Debt equity means stake of creditors in the enterprise is higher than the
borrower .May lead to :
 Pressure on earnings leading to default on meeting debt obligations.
 Creditors may loose heavily in case of business failure.
 Undue interference from creditors
 Difficulty in borrowing additional fund and even when possible at restrictive
terms and higher cost.
 .

 Proprietary Ratio : This ratio indicates the extent to which Tangible

Assets are financed by Owner’s Fund.
= (Tangible Net Worth/Total Tangible Assets) x 100
The ratio will be 100% when there is no Borrowing for purchasing of
Assets.
Example:
Share holders funds are Rs.18,00,000 and the total assets, which are equal to
total liabilities are Rs.30,00,000.
Calculation:
Proprietary or Equity Ratio = 18,00,000 / 30,00,000

 Times Interest Earned

= Earnings before Intt and Tax
Interest
 TIE ratio of 10 means ,even if EBIT declines to 1/10 th of current level, net
profits available will be equivalent for servicing of intt on long term
loans .Very high ratio implies unutilized debt capacity. Very low ratio is a
signal that enterprise is using excessive long term debt and is unable to
service its intt.
.
TOL/TNW ratio =
Total Outside liability (Term + current liability)
Tangible net worth (Net Worth-Intangible assets)
Fixed Asset Coverage ratio =
Net Fixed asset/Long term debt secured by Fixed asset
Debt Service Coverage Ratio: This ratio indicates the
ability of an enterprise to meet its liabilities by way of
payment of installments of Term Loans and Interest
thereon from out of the cash accruals. (The Ideal DSCR
Ratio is considered to be 2 )
= PAT + Depr. + Annual Intt on L/Term Loans & Liabilities
Annual intt + Annual Inst payable on L/T Loans &
Liabilities
 Market Test Ratios

Based on the share market's perception of the

company.
Used by investors to assess performance of a business
as an investment and also the cost of issuing stocks.

Earnings per share = Net Profit after tax

Number of issued ordinary
shares
 Market Test Ratios

Dividends per share = Dividends

Number of issued ordinary
shares

Dividend payout ratio = Dividends per share *100

Earnings per share

Price Earnings ratio = Market price per share

Earnings per share
PE Ratio indicates the number of times the Earning Per
Share is covered by its market price.
 Important Points.
Remember, the reality is the company itself, not its
financial statements. Does it have the right products
at the right price? Does it have the right amount of
investment in order to conduct its business? Is it
utilizing the right amount of financial leverage?
The amounts reported in the financial statements are
a representation of what is really happening with the
business. The task of the analyst is to understand
the business factors that give rise to the reported
figures.
All ratios are for different purposes and have different
objectives . It is left to the judgment of the analyst
which ratio is to be considered for particular
analysis.
 Limitations of ratio analysis
Ratios are guide only ,no standard formula for
judging performance.
Single ratio rarely tells enough to make a sound
judgment.
Financial statements used in ratio analysis must be
from similar points in time.
Audited financial statements are more reliable than
unaudited statements.
The financial data used to compute ratios must be
developed in the same manner.
Inflation can distort comparisons.
Balance Sheet as on 31.03.2011 ABC Co ‘000
Liability Asset
Share Capital 3144 Gross Block 1427 994
Less Deprn 433
Reserve and Surplus 2532 Capital work in progress 1338
Term Loan 300 Investment 2368
Unsecured loan 33 Inventory 2580
Bank OD 2100 Sundry Debtors 604
Creditors 900 Cash in hand 774
Provisions 605 Loans and Advances 956
Total 9614 Total 9614.
.