Accounting for Managers 20MBA13

Module -3 Analysis of Financial Statements 10 hours

Limitations of Financial Statements; Meaning and Purpose of Financial Statement Analysis,

Trend Analysis, Comparative Analysis, Financial Ratio Analysis, Preparation of Financial
Statements using Financial Ratios, Case Study on Financial Ratio Analysis. Preparation of
Cash flow Statement (indirect method).

Meaning of Financial Statement Analysis:

Financial Statement Analysis is an analysis which highlights important relationships in the

financial statements. Financial Statement analysis embraces the methods used in assessing and
interpreting the results of past performance and current financial position as they relate to
particular factors of interest in investment decisions. It is an important means of assessing past
performance and in forecasting and planning future performance.

The process of reviewing and analysing a company’s financial statements to make better
economic decisions is called analysis of financial statements. Financial Statement Analysis is
an analysis which highlights important relationships between items in the financial statements.
Financial Statement analysis embraces the methods used in as-sessing and interpreting the
results of past performance and current financial position as they relate to particular factors of
interest in investment decisions. It is an important means of assessing past performance and in
forecasting and planning future performance.

Definition

According to Lev: “Financial Statement Analysis is an information processing system designed

to provide data for decision making models, such as the portfolio selection model, bank lending
decision models, and corporate financial management models.”

In the words of Myers, “Financial statement analysis is largely a study of relationship among
the various financial factors in a business as disclosed by a single set-of statements and a study
of the trend of these factors as shown in a series of statements.”

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Purpose or Objectives of Financial Statement Analysis

• To assess the earning capacity or profitability of the firm.

• To assess the operational efficiency and managerial effectiveness.
• To assess the short term as well as long term solvency position of the firm.
• To identify the reasons for change in profitability and financial position of the firm.
• To make inter-firm comparison.
• To make forecasts about future prospects of the firm.
• To assess the progress of the firm over a period of time.
• To help in decision making and control.
• To guide or determine the dividend action.
• To provide important information for granting credit.

Limitations of Financial Statement Analysis:

(i) It is only a study of interim reports

(ii) Financial analysis is based upon only monetary information and non-monetary factors are
ignored.

(iii) It does not consider changes in price levels.

(iv) As the financial statements are prepared on the basis of a going concern, it does not give
exact position. Thus, accounting concepts and conventions cause a serious limitation to
financial analysis.

(v) Changes in accounting procedure by a firm may often make financial analysis misleading.

(vi) Analysis is only a means and not an end in itself. The analyst has to make interpretation
and draw his own conclusions. Different people may interpret the same analysis in different
ways.

Tools of Financial Statement Analysis:

1. Comparative Statements
Comparative statements deal with the comparison of different items of the Profit and
Loss Account and Balance Sheets of two or more periods. Separate comparative
statements are prepared for Profit and Loss Account as Comparative Income Statement
and for Balance Sheets.

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As a rule, any financial statement can be presented in the form of comparative statement
such as comparative balance sheet, comparative profit and loss account, comparative
cost of production statement, comparative statement of working capital and the like.
Comparative Income Statement: Three important information are obtained from the
Comparative Income Statement. They are Gross Profit, Operating Profit and Net Profit.
The changes or the improvement in the profitability of the business concern is find out
over a period of time. If the changes or improvement is not satisfactory, the
management can find out the reasons for it and some corrective action can be taken.
Comparative Balance Sheet: The financial condition of the business concern can be
find out by preparing comparative balance sheet. The various items of Balance sheet
for two different periods are used. The assets are classified as current assets and fixed
assets for comparison. Likewise, the liabilities are classified as current liabilities, long
term liabilities and shareholders’ net worth. The term shareholders’ net worth includes
Equity Share Capital, Preference Share Capital, Reserves and Surplus and the like.

2. Common Size Statements

A vertical presentation of financial information is followed for preparing common-size
statements. Besides, the rupee value of financial statement contents are not taken into
consideration. But only percentage is considered for preparing common size statement.
The total assets or total liabilities or sales is taken as 100 and the balance items are
compared to the total assets, total liabilities or sales in terms of percentage. Thus, a
common size statement shows the relation of each component to the whole. Separate
common size statement is prepared for profit and loss account as Common Size Income
Statement and for balance sheet as Common Size Balance Sheet.

3. Trend Analysis
The ratios of different items for various periods are find out and then compared under
this analysis. The analysis of the ratios over a period of years gives an idea of whether
the business concern is trending upward or downward. This analysis is otherwise called
as Pyramid Method.

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4. Ratio Analysis
Ratio analysis is the process of determining and interpreting numerical relationships
based on financial statements. A ratio is a statistical yardstick that provides a measure
of the relationship between two variables or figures.

Financial Ratio Analysis

Ratio analysis is the process of determining and interpreting numerical relationships based on
financial statements. A ratio is a statistical yardstick that provides a measure of the relationship
between two variables or figures. This relationship can be expressed as a percent or as a
quotient. Ratios are simple to calculate and easy to understand. Ratio analysis refers to the
analysis and interpretation of the figures appearing in the financial statements (i.e., Profit and
Loss Account, Balance Sheet and Fund Flow statement etc.). It is a process of comparison of
one figure against another. It enables the users like shareholders, investors, creditors,
Government, and analysts etc. to get better understanding of financial statements.

Khan and Jain define the term ratio analysis as “the systematic use of ratios to interpret the
financial statements so that the strengths and weaknesses of a firm as well as its historical
performance and current financial conditions can be determined.”

Ratio analysis is a very powerful analytical tool useful for measuring performance of an
organisation. Accounting ratios may just be used as symptom like blood pressure, pulse rate,
body temperature etc. The physician analyses this information to know the causes of illness.
Similarly, the financial analyst should also analyse the accounting ratios to diagnose the
financial health of an enterprise.

Objectives of Ratio Analysis

Interpreting the financial statements and other financial data is essential for all stakeholders of
an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial
management.

1] Measure of Profitability

Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5
lakhs last year, how will you determine if that is a good or bad figure? Context is required to
measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio,

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Expense ratio etc provide a measure of the profitability of a firm. The management can use
such ratios to find out problem areas and improve upon them.

2] Evaluation of Operational Efficiency

Certain ratios highlight the degree of efficiency of a company in the management of its assets
and other resources. It is important that assets and financial resources be allocated and used
efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point
out any mismanagement of assets.

3] Ensure Suitable Liquidity

Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately.
So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These
help a firm maintain the required level of short-term solvency.

4] Overall Financial Strength

There are some ratios that help determine the firm’s long-term solvency. They help determine
if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will
need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios
are Debt-Equity Ratio, Leverage ratios etc.

5] Comparison

The organizations’ ratios must be compared to the industry standards to get a better
understanding of its financial health and fiscal position. The management can take corrective
action if the standards of the market are not met by the company. The ratios can also be
compared to the previous years’ ratio’s to see the progress of the company. This is known as
trend analysis.

Advantages of Ratio Analysis:

Ratio analysis is widely used as a powerful tool of financial statement analysis. It establishes
the numerical or quantitative relationship between two figures of a financial statement to
ascertain strengths and weaknesses of a firm as well as its current financial position and
historical performance. It helps various interested parties to make an evaluation of certain
aspect of a firm’s performance.

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1. Forecasting and Planning:

The trend in costs, sales, profits and other facts can be known by computing ratios of relevant
accounting figures of last few years. This trend analysis with the help of ratios may be useful
for forecasting and planning future business activities.

2. Budgeting:

Budget is an estimate of future activities on the basis of past experience. Accounting ratios help
to estimate budgeted figures. For example, sales budget may be prepared with the help of
analysis of past sales.

3. Measurement of Operating Efficiency:

Ratio analysis indicates the degree of efficiency in the management and utilisation of its assets.
Different activity ratios indicate the operational efficiency. In fact, solvency of a firm depends
upon the sales revenues generated by utilizing its assets.

4. Communication:

Ratios are effective means of communication and play a vital role in informing the position of
and progress made by the business concern to the owners or other parties.

5. Control of Performance and Cost:

Ratios may also be used for control of performances of the different divisions or departments
of an undertaking as well as control of costs.

6. Inter-firm Comparison:

Comparison of performance of two or more firms reveals efficient and inefficient firms,
thereby enabling the inefficient firms to adopt suitable measures for improving their efficiency.
The best way of inter-firm comparison is to compare the relevant ratios of the organisation with
the average ratios of the industry.

7. Indication of Liquidity Position:

Ratio analysis helps to assess the liquidity position i.e., short-term debt paying ability of a firm.
Liquidity ratios indicate the ability of the firm to pay and help in credit analysis by banks,
creditors and other suppliers of short-term loans.

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8. Indication of Long-term Solvency Position:

Ratio analysis is also used to assess the long-term debt-paying capacity of a firm. Long-term
solvency position of a borrower is a prime concern to the long-term creditors, security analysts
and the present and potential owners of a business. It is measured by the leverage/capital
structure and profitability ratios which indicate the earning power and operating efficiency.
Ratio analysis shows the strength and weakness of a firm in this respect.

9. Indication of Overall Profitability:

The management is always concerned with the overall profitability of the firm. They want to
know whether the firm has the ability to meet its short-term as well as long-term obligations to
its creditors, to ensure a reasonable return to its owners and secure optimum utilisation of the
assets of the firm. This is possible if all the ratios are considered together.

10. Signal of Corporate Sickness:

A company is sick when it fails to generate profit on a continuous basis and suffers a severe
liquidity crisis. Proper ratio analysis can give signal of corporate sickness in advance so that
timely measures can be taken to prevent the occurrence of such sickness.

11. Aid to Decision-making:

Ratio analysis helps to take decisions like whether to supply goods on credit to a firm, whether
bank loans will be made available etc.

12. Simplification of Financial Statements:

Ratio analysis makes it easy to grasp the relationship between various items and helps in
understanding the financial statements.

Limitations of Ratio Analysis:

The technique of ratio analysis is a very useful device for making a study of the financial health
of a firm. But it has some limitations which must not be lost sight of before undertaking such
analysis. Some of these limitations are:

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1. Limitations of Financial Statements:

Ratios are calculated from the information recorded in the financial statements. But financial
statements suffer from a number of limitations and may, therefore, affect the quality of ratio
analysis.

2. Historical Information:

Financial statements provide historical information. They do not reflect current conditions.
Hence, it is not useful in predicting the future.

3. Different Accounting Policies:

Different accounting policies regarding valuation of inventories, charging depreciation etc.

make the accounting data and accounting ratios of two firms non-comparable.

4. Lack of Standard of Comparison:

No fixed standards can be laid down for ideal ratios. For example, current ratio is said to be
ideal if current assets are twice the current liabilities. But this conclusion may not be justifiable
in case of those concerns which have adequate arrangements with their bankers for providing
funds when they require, it may be perfectly ideal if current assets are equal to or slightly more
than current liabilities.

5. Quantitative Analysis:

Ratios are tools of quantitative analysis only and qualitative factors are ignored while
computing the ratios. For example, a high current ratio may not necessarily mean sound liquid
position when current assets include a large inventory consisting of mostly obsolete items.

6. Window-Dressing:

The term ‘window-dressing’ means presenting the financial statements in such a way to show
a better position than what it actually is. If, for instance, low rate of depreciation is charged, an
item of revenue expense is treated as capital expenditure etc. the position of the concern may
be made to appear in the balance sheet much better than what it is. Ratios computed from such
balance sheet cannot be used for scanning the financial position of the business.

7. Changes in Price Level:

Fixed assets show the position statement at cost only. Hence, it does not reflect the changes in
price level. Thus, it makes comparison difficult.

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8. Causal Relationship Must:

Proper care should be taken to study only such figures as have a cause-and-effect relationship;
otherwise, ratios will only be misleading.

9. Ratios Account for one Variable:

Since ratios account for only one variable, they cannot always give correct picture since several
other variables such Government policy, economic conditions, availability of resources etc.
should be kept in mind while interpreting ratios.

10. Seasonal Factors Affect Financial Data:

Proper care must be taken when interpreting accounting ratios calculated for seasonal business.
For example, an umbrella company main-tains high inventory during rainy season and for the
rest of year its inventory level becomes 25% of the seasonal inventory level. Hence, liquidity
ratios and inventory turnover ratio will give biased picture.

Classification of Ratios

1. Profitability ratios

Profitability ratios help to assess the profitability of a business concern. These ratios also help
to analyse the earning capacity of the business in terms of utilisation of resources employed in
the business. Generally, these ratios are expressed as a percentage.

(i) Gross profit ratio

Gross profit ratio is the proportion of gross profit to net revenue from operations. Gross profit
ratio shows the margin of profit available out of revenue from operations. It is computed as
below:

Gross profit ratio = [ Gross profit / Revenue from operations ] × 100

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Gross profit = Revenue from operations – Cost of revenue from operations

A higher gross profit ratio indicates high profitability. It should be sufficiently high to provide
for indirect expenses to be paid by a business.

(ii) Operating cost ratio

Operating cost ratio is the proportion of operating cost to revenue from operations. This ratio
is a test of the operational efficiency of the business. It is calculated as under.

Operating cost ratio = [ Operating cost / Revenue from operations ] × 100

Operating cost is the cost which is associated with the operating activities of the business.

Operating cost = Cost of revenue from operations + Operating expenses

Operating expenses = Employee benefit expenses + Depreciation + Other expenses related to

office and administration, selling and distribution

A lower operating ratio indicates better profitability. Lesser the operating cost ratio, higher is
the margin available for payment of non-operating expenses such as interest on loans, loss on
sale of fixed assets, etc.

(iii) Operating profit ratio

Operating profit ratio gives the proportion of operating profit to revenue from
operations. Operating profit ratio is an indicator of operational efficiency of an
organisation. It may be computed as follows:

Operating profit ratio = [ Operating profit x Revenue from operations ] × 100

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 Accounting for Managers 20MBA13

Alternatively, it is calculated as under.

Operating profit ratio = 100 – Operating cost ratio

Operating profit = Revenue from operations – Operating cost

A higher ratio indicates better profitability. Greater the operating ratio, higher is
the margin available for paying non-operating expenses.

(iv) Net profit ratio

Net profit ratio is the percentage of net profit on revenue from operations. It is
calculated as under:

Net profit ratio = [ Net profit after tax / Revenue from operations ] × 100

Net profit after tax = Gross profit + Indirect income – Indirect expenses – Tax
(OR)
Net profit after tax = Revenue from operations – Cost of revenue from operations
– Operating expenses –Non operating expenses + Non-operating income - Tax
Net profit ratio is an indicator of the overall profitability of the business. A higher
net profit ratio indicates high profitability.

(v) Return on Investment (ROI)

Return on investment shows the proportion of net profit before interest and tax to
capital employed (shareholders’ funds and long term debts). This ratio measures
how efficiently the capital employed is used in the business. It is an overall
measure of profitability of a business concern. It is computed as below:

Return on Investment (ROI) = [ Net profit before interest and tax / Capital
employed ] x 100

Capital employed = Shareholders’ funds + Non current liabilities

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Greater the return on investment better is the profitability of a business and vice
versa.

Turnover ratios

Turnover ratios show how efficiently assets or other items have been used to generate revenue
from operations. They are also called as activity ratios or efficiency ratios. They show the speed
of movement of various items. They are expressed as number of times in relation to the item
compared.

(i) Inventory turnover ratio

It indicates the number of times inventory is turned over to make revenue from operations
(sales) during a particular accounting period. It is a comparison of cost of revenue from
operations (cost of goods sold) with average amount of inventory during a given period. It is
calculated as under:

Inventory turnover ratio = Cost of revenue from operations / Average inventory

Cost of revenue from operations = Purchases of stock in trade + Changes in

inventories of finished goods + Direct expenses
(or)

= Revenue from operations – Gross profit

(ii) Trade receivables turnover ratio

Trade receivables turnover ratio is the comparison of credit revenue from operations with
average trade receivables during an accounting period. It gives the velocity of collection of
cash from trade receivables. It is calculated as follows:

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Trade receivables turnover ratio = Credit revenue from operations / Average trade
receivables
Average trade receivables = [ Opening trade receivables + Closing trade
receivables ] / 2

Trade receivables = Trade debtors + Bills receivable

Credit revenue from operations (net credit sales) is taken for trade receivables
turnover ratio as trade receivables arise only from credit sales. Greater the trade
receivables turnover ratio, greater is the efficiency of management in collection
of receivables.

Debt collection period

Debt collection period is the average time taken to collect the amount due from
trade receivables. Lesser the debt collection period, greater is the efficiency of
management in collection of cash from trade receivables. It is calculated as
follows:

Debt collection period (in days) = Number of days in a year / Trade receivables
turnover ratio

Debt collection period (in months) = Number of months in a year / Trade

receivables turnover ratio

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(iii) Trade payables turnover ratio

Trade payables turnover ratio is the comparison of net credit purchases with
average trade paybles during an accounting period. It gives the velocity of
payment of cash towards trade payables. It is calculated as follows:

Trade payables turnover ratio = Net credit purchases / Average trade payables
Net credit purchases = Total credit purchases – Purchases returns

Average trade payables = [ Opening trade payables + Closing trade payables ] /

2

Trade payables = Trade creditors + Bills payable

Greater the trade payable turnover ratio, better is the efficiency of the
management in managing trade payable as it indicates that amount due to
suppliers are settled quicker.

Tutorial note

In the absence of opening trade payables, closing trade payables can be taken
instead of average trade payables.

Credit payment period

It is the average time taken by the business for payment of accounts payable.
Lesser the credit payment period, greater is the efficiency of the management in
managing accounts payable as it indicates quicker settlement of trade payables.
It is calculated as follows:

Credit payment period (in days) = Number of days in a year / Trade payables
turnover ratio

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Credit payment period (in months) = Number of months in a year / Trade

payables turnover ratio

(iv) Fixed assets turnover ratio

Fixed assets turnover ratio gives the number of times the fixed assets are turned
over during the year in relation to the revenue from operations. This ratio
indicates the efficiency of utilisation of fixed assets.

Fixed assets turnover ratio = Revenue from operations / Average Fixed assets
Average fixed assets = [ Opening fixed assets + Closing fixed assets ] / 2
Greater the fixed assets turnover ratio better is the efficiency of management in
utilisation of fixed assets.

Liquidity ratios
Liquidity means capability of being converted into cash with ease. Liquidity
ratios help to assess the ability of a business concern to meet its short term
financial obligations. Short term assets (current assets) are more liquid as
compared to long term assets (fixed assets). Liquidity ratios are also called as
short term solvency ratios.
Liquidity ratios include: (i) Current ratio and (ii) Quick ratio.

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(i) Current ratio

Current ratio gives the proportion of current assets to current liabilities of a
business concern. It is computed by dividing current assets by current liabilities.
Current ratio indicates the ability of an entity to meet its current liabilities as and
when they are due for payment. It is calculated as follows:

Higher the current ratio, the better is the liquidity position, as the firm will be in
a better position to pay its current liabilities. However, a much higher ratio may
indicate inefficient investment policies of the management.

(ii) Quick ratio

Quick ratio gives the proportion of quick assets to current liabilities. It indicates
whether the business concern is in a position to pay its current liabilities as and
when they become due, out of its quick assets. Quick assets are current assets

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excluding inventories and prepaid expenses. It is otherwise called liquid ratio or

acid test ratio. It is calculated as follows:

Quick ratio = Quick assets / Current liabilities

Quick assets = Current assets – Inventories – Prepaid expenses

Higher the quick ratio, better is the short-term financial position of an enterprise.

Long term solvency ratios

Long term solvency means the firm’s ability to meet its liabilities in the long run.
Long term solvency ratios help to determine the ability of the business to repay
its debts in the long run. The following ratios are normally computed for
evaluating long term solvency of the business:

i. Debt equity ratio

ii. Proprietary ratio
iii. Capital gearing ratio

(i) Debt equity ratio

Debt equity ratio is calculated to assess the long term solvency position of a
business concern.
Debt equity ratio expresses the relationship between long term debt and
shareholders’ funds.

It is computed as follows:
Debt equity ratio = Long term debt / Shareholders'funds

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In general, lower the debt equity ratio, lower is the risk to the long-term lenders.
A high ratio indicates high risk as it may be difficult for the business concern to
meet the obligation to outsiders.

(ii) Proprietary ratio

Proprietary ratio gives the proportion of shareholders’ funds to total assets.
Proprietary ratio shows the extent to which the total assets have been financed by
the shareholders’ funds. It is calculated as follows:

Higher the proprietary ratio, greater is the satisfaction for lenders and creditors,
as the firm is less dependent on external sources of finance.

(iii) Capital gearing ratio

Capital gearing ratio is the proportion of fixed income bearing funds to equity
shareholders’ funds. Fixed income bearing funds include fixed interest and fixed
dividend bearing funds. It is calculated as follows:
Capital gearing ratio = Equity shareholders ‘funds / Funds bearing Fixed interest
or Fixed dividend

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Capital gearing ratio is a measure of long term solvency as well as capital

structure. When the capital gearing ratio is greater than one, the firm is said to be
high geared.

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