A ANTHI INSTITUTE OF ENGINEERING& TECHNOLOGY

GUNTHAPALLY (V), HAYAT NAGAR (M), R. R (D) – 501512

Subject Name : Business Economics & Financial Analysis
Subject Code : SM504MS
Program/Course : B.Tech
Year/Semester : III-I (R-18)
Branch : ECE
Section : A&B
Academic Year : 2020 – 2021
Subject Faculty : Mr. N. RAMANA REDDY, Associate Professor.
M.Tech, MBA(Ph.D)

Unit-V: Financial Analysis through Ratios

Concept of Ratio Analysis, Importance, Liquidity Ratios, Turnover Ratios, Profitability
Ratios, Proprietary Ratios, Solvency Ratios, Leverage Ratios – Analysis and
Interpretation (simple problems).

Ratio Analysis:- Ratio analysis is used to evaluate relationships among financial

statement items. The ratios are used to identify trends over time for one company or to
compare two or more companies at one point in time.

Uses or Advantages or Importance of Ratio Analysis:-

Ratio Analysis stands for the process of determining and presenting the relationship of items
and groups of items in the financial statements. It is an important technique of financial
analysis.
The following are the main uses of Ratio analysis:
(i) Useful in financial position analysis:- Accounting reveals the financial position of the
concern. This helps banks, insurance companies and other financial institution in lending and
making investment decisions.
(ii) Useful in simplifying accounting figures:- Accounting ratios simplify, summaries and
systematic the accounting figures in order to make them more understandable and in lucid
form.
(iii) Useful in assessing the operational efficiency:- Accounting ratios helps to have an idea
of the working of a concern. The efficiency of the firm becomes evident when analysis is
based on accounting ratio.
(iv) Useful in forecasting purposes:- If accounting ratios are calculated for number of years,
then a trend is established. This trend helps in setting up future plans and forecasting.
(v) Useful in locating the weak spots of the business:- Accounting ratios are of great
assistance in locating the weak spots in the business even through the overall performance
may be efficient.
(vi) Useful in comparison of performance:- Managers are usually interested to know which
department performance is good and for that he compare one department with the another
department of the same firm.
Limitations of Ratio Analysis:-
These limitations should be kept in mind while making use of ratio analyses for interpreting
the financial statements. The following are the main limitations of ratio analysis.
1. False results if based on incorrect accounting data: - Accounting ratios can be correct only if
the data (on which they are based) is correct.
2. No idea of probable happenings in future:- Ratios are an attempt to make an analysis of the
past financial statements; so they are historical documents. Now-a-days keeping in view the
complexities of the business, it is important to have an idea of the probable happenings in
future.
3. Variation in accounting methods:- The two firms’ results are comparable with the help of
accounting ratios only if they follow the some accounting methods or bases.

4. Price level change:- Change in price levels make comparison for various years difficult.
5. Only one method of analysis:- Ratio analysis is only a beginning and gives just a fraction of
information needed for decision-making so, to have a comprehensive analysis of financial
statements, ratios should be used along with other methods of analysis.
6. No common standards:- It is very difficult to by down a common standard for comparison
because circumstances differ from concern to concern and the nature of each industry is
different.

Types of Ratios Analysis:-

Figure: Types of Ratios Analysis

1). Liquidity Ratios:- It measures the ability of a company to repay its short‐term debts and
meet unexpected cash needs.
 Current Ratio
 Quick Ratio
Current Ratio: - The current ratio is also called the working capital ratio, as working capital
is the difference between current assets and current liabilities. This ratio measures the ability
of a company to pay its current obligations using current assets. The current ratio is calculated
by dividing current assets by current liabilities.

This ratio indicates the company has more current assets than current liabilities. The firm is
said to be comfortable in its liquidity position when the Current Ratio is 2:1.

Quick Ratio: - Quick Ratio is also called as Acid‐Test Ratio. It measures the firm’s ability
to convert its current assets quickly into cash to meet its current liabilities. The acid‐test ratio
is calculated by dividing quick assets by current liabilities.

The firm is said to be comfortable in its liquidity position when the Current Ratio is 1:1.

2). Turnover Ratios:- It is also called as Activity ratio. The inventory turnover ratio
measures the number of times the company sells its inventory during the period.

Where, Cost of goods = Sales – Gross profits.

Average Inventory = Opening inventory + Closing inventory/2

3). Profitability Ratios:- Profitability ratios measure a company's operating efficiency,

including its ability to generate income and therefore, cash flow.
Gross Profit Ratio is the ratio of gross profit to net sales during accounting period. Gross Profit
Ratio is calculated as
Gross Profit Ratio = Gross profit / Sales x100

Net Profit Ratio is calculated as the ratio of net profits after taxes and net sales.

Net Profit Ratio = Net profits after taxes / Net sales x100

4). Solvency Ratios:-

Solvency ratios are used to measure long‐term risk and are of interest to long‐term creditors
and stockholders.
Debt to total assets ratio. The debt to total assets ratio calculates the percent of assets provided
by creditors. It is calculated by dividing total debt by total assets. Total debt is the same as
total liabilities.
5). Leverage Ratios:-
The price‐earnings ratio (P/E) is quoted in the financial press daily. It represents the investors'
expectations for the stock. A P/E ratio greater than 15 has historically been considered high.

Earnings per share (EPS) represent the net income earned for each share of outstanding
common stock. In a simple capital structure, it is calculated by dividing net income by the
number of weighted average common shares outstanding.
 Introduction to Funds Flow and Cash Flow Analysis
Funds Flow Analysis:-
One of the most fundamental objectives of business is to make a profit. Long run survival
requires that the business must be able to deal with any liquidity problems which arise in the
short term.
Concept of “Fund’’: The term ‘fund’ has been defined and interpreted differently by different
experts. Broadly the term ‘fund’ refers to all the financial resources of the company. On the
other extreme, fund has been understood as ‘cash’ only.
Concept of Fund Flow:-
The term "Flow of Funds" refers to changes or movement of funds or changes in working
capital in the normal course of business transactions.. In other words, any increase or decrease
in working capital when the transactions take place is called as "Flow of Funds." If the
components of working capital results in increase of the fund, it is known as Inflow of Fund or
Sources of Fund.
Working Capital and its components:-
A well-run firm manages its short-term debt and current and future operational expenses
through its management of working capital.
Working Capital is also known as Net Working Capital (NWC), is the difference between a
company's current assets, such as cash, accounts receivable and inventories of raw materials
and finished goods, and its current liabilities, such as accounts payable.
The components of which are ;
 Inventories,
 Accounts receivable,
 Accounts payable,
 Cash.

Analysis of Cash Flow:-

A cash flow statement is a financial report that describes the sources of a company's cash and
how that cash was spent over a specified time period. It does not include non-cash items. The
cash flow statement is a cash basis report on three types of financial activities: operating
activities, investing activities, and financing activities. Non-cash activities are usually reported
in footnotes.
This makes it useful for determining the short-term viability of a company, particularly its
ability to pay bills. Because the management of cash flow is so crucial for businesses and
small businesses in particular, most analysts recommend that an entrepreneur should study a
cash flow statement at least every quarter.

Classification of Cash Flow Transactions:-

Cash flows result from operating, financing, and investing activities. You must be able to
distinguish among these types of cash flows. These activities are explained as follows.
 Operating activities: Cash flows from operating activities include all cash flow
transactions that are not classified as investing or financing activities.
  Investing activities: In general, investing activities are transactions for purchasing and
selling capital assets and other productive assets. Capital assets are acquired in order to
increase productive capacity.

 Financing activities: Financing activities affect a business’ capital structure, its debt
and equity. Financing activities include the use of cash to pay dividends to
shareholders, the borrowing or payment of debt, and the issue or repurchase of shares.

Important Questions
PART- A:- Give a brief description to the following:
 Solvency Ratios
 Funds from Operations.
 Current Ratio
 Working Capital and its components.
 Liquidity Ratios

PART- B:
1. Explain the importance of Ratio analysis as a technique for analyzing Financial
Statements?
2. What is the difference between ‘current ratio’ and ‘quick ratio’?
3. What are turnover ratios? What purpose is served by debtor’s turnover ratio and
creditor’s turnover ratio?
4. Differentiate between the cash flow analysis and funds flow analysis?
5. Describe the various types of profitability ratios?
6. Elucidate the types of turnover ratios with examples?

Prepared by,
Mr. N. RAMANA REDDY
M.Tech, MBA(Ph.D)
Associate Professor.
Ph. No: 9640789300