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Financial Statement Analysis

We Make The Difference

OBJECTIVE

After reading this lesson the students must be able :

(i) To understand the meaning of financial statements and their analysis and interpretation.

(ii) To apply various tools to analyse financial statements.

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MEANING OF ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

• An analysis of financial statements is the process of critically examining in detail accounting

information given in the financial statements.
• For the purpose of analysis, individual items are studied, their interrelationships with other
related figures are established, the data is sometimes rearranged to have better understanding
of the information with the help of different techniques or tools for the purpose.
• Analysing financial statements is a process of evaluating relationship between component parts
of financial statements to obtain a better understanding of firm's position and performance.
• The analysis of financial statements thus refers to the treatment of the information contained
in the financial statements in a way so as to afford a full diagnosis of the profitability and
financial position of the firm concerned.
• For this purpose financial statements are classified methodically, analysed and compared with
the figures of previous years or other similar firms.

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OBJECTIVES OF FINANCIAL ANALYSIS

(i) to assess the profitability of the concern;

(ii) to examine the operational efficiency of the concern as a whole and of its various
parts or departments;
(iii) to measure the short-term and long-term solvency of the concern for the benefit of
the debenture holders and trade creditors;
(iv) to undertake a comparative study in regard to one firm with another firm or one
department with another department; and
(v) to assess the financial stability of a business concern.

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TOOLS OF FINANCIAL ANALYSIS

Financial Analyst can use a variety of tools for the purposes of analysis and interpretation
of financial statements particularly with a view to suit the requirements of the specific
enterprise.
The principal tools are as under :

1. Comparative Financial Statements

2. Common-size Statements
3. Trend Analysis
4. Ratio Analysis

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1. Comparative Financial Statements

• Comparative financial statements are those statements which have been designed in a
way so as to provide time perspective to the consideration of various elements of
financial position embodied in such statements.
• In these statements figures for two or more periods are placed side by side to facilitate
comparison.
• Both the Income Statement and Balance Sheet can be prepared in the form of
Comparative Financial Statements.

a) Comparative Income Statement: The comparative Income Statement is the study of the
trend of the same items/group of items in two or more Income Statements of the firm for
different periods. The changes in the Income Statement items over the period would 4 help
in forming opinion about the performance of the enterprise in its business operations. The
Interpretation of Comparative Income Statement would be as follows:

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The Income Statement of Sumit Ltd. are given for the years 2001 and 2002. Rearrange the figures in a
comparative form and study the profitability position of the firm :

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b) Comparative Balance Sheet

The comparative Balance Sheet analysis would highlight the trend of various items and groups of items
appearing in two or more Balance Sheets of a firm on different dates. The changes in periodic balance sheet
items would reflect the changes in the financial position at two or more periods.
The Interpretation of Comparative Balance Sheets are as follows :
i) The increase in working capital would imply increase in the liquidity position of the firm over the period and
the decrease in working capital would imply deterioration in the liquidity position of the firm.
(ii) An assessment about the long-term financial position can be made by studying the changes in fixed assets,
capital and long-term liabilities. If the increase in capital and long-term liabilities is more than the increase in
fixed assets, it implies that a part of capital and long-term liabilities has been used for financing a part of
working capital as well. This will be a reflection of the good financial policy.
iii) The changes in retained earnings, reserves and surpluses will give an indication about the trend in
profitability of the concern. An increase in reserve and surplus and the Profit and Loss Account is an indication
of improvement in profitability of the concern. The decrease in these accounts may imply payment of
dividends, issue of bonus shares or deterioration in profitability of the concern.

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From the following Balance Sheets of Ram Ltd. as on 31st December, 2000 and 2001, prepare a
comparative Balance Sheet for the concern :

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2. Common-size Financial Statements :

Common-size Financial Statements are those in which figures reported are converted into
percentages to some common base. In the Income Statement the sale figure is assumed to be
100 and all figures are expressed as a percentage of sales. Similarly in the Balance sheet the
total of assets or liabilities is taken as 100 and all the figures are expressed as a percentage of
this total.

a) Common Size Income Statement In the case of Income Statement, the sales figure is
assumed to be equal to 100 and all other figures are expressed as percentage of sales. The
relationship between items of Income Statement and volume of sales is quite significant since
it would be helpful in evaluating operational activities of the concern. The selling expenses will
certainly go up with increase in sales. The administrative and financial expenses may go up or
may remain at the same level. In case of decline in sale, selling expenses should definitely
decrease.

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From the following Profit and Loss Accounts and the Balance Sheets of Swadeshi Polytex Ltd. for the
year ended 31st December 2000 and 2001, you are required to prepare common size statements.

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Interpretation : The above statement shows that though in absolute terms, the cost of goods sold has gone up, the
percentage of its cost to sales remains consistent at 75%. This is the reason why the Gross Profit continues at 25% of
sales. Similarly, in absolute terms the amount of administration expenses remains the same but as percentage to sales it
has come down by 5%. Selling expenses have increased by 25%. This all leads to net increase in net profit by 25% (i.e.,
from 18.75% to 19%).
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b) Common Size Balance Sheet For the purpose of common size Balance Sheet, the total of assets or
liabilities is taken as 100 and all the figures are expressed as percentage of the total. In other words, each asset is
expressed as percentage to total assets/liabilities and each liability is expressed as percentage to total
assets/liabilities. This statement will throw light on the solvency position of the concern by providing an analysis
of pattern of financing both long-term and working capital needs of the concern.

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Interpretation : The percentage of current assets to total assets was 38.46 in 2000. It has gone up to 48.69 in
2001. Similarly the percentage of current liabilities to total liabilities (including capital) has also gone up from
23.07 to 27.95 in 2001. Thus, the proportion of current assets has increased by a higher percentage (about 10)
as compared to increase in the proportion of current liabilities (about 5). This has improved the working capital
position of the company. There has been a slight deterioration in the debt-equity ratio though it continues to be
very sound. The proportion of shareholder’s funds in the total liabilities has come down from 69.24% to 62.19%
while that of the debenture-holders has gone up from 7.69% to 9.86%.

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Trend Analysis

• The third tool of financial analysis is trend analysis. This is immensely helpful in making a
comparative study of the financial statements of several years.
• Under this method trend percentages are calculated for each item of the financial
statement taking the figure of base year as 100.
• The starting year is usually taken as the base year. The trend percentages show the
relationship of each item with its preceding year's percentages.
• This will exhibit the direction, (i.e., upward or downward trend) to which the concern is
proceeding.
• These trend ratios may be compared with industry ratios in order to know the strong or
weak points of a concern.
• These are calculated only for major items instead of calculating for all items in the
financial statements.
• Trend percentages should be calculated only for those items which have logical
relationship with one another.

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Interpret the results of operations of a trading concern using trend ratios, on the following information :

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Interpretation From the above statement the following points are worth noting :
(a) The sales volume, cost of goods sold and selling expenses all declined in 1999 as compared to 1998 but the
decrease in cost of goods sold and selling expenses was lesser to the decrease in sales volume.
(b) The sales volume, cost of goods sold and selling expenses in 2000 and 2001 have increased in comparison to
1998 but the increase in cost of goods sold and selling expenses is lesser to the increase in sales volume.
(c) In conclusion, it can be said that a large proportion of cost of goods sold and selling expenses is fixed and is
not affected by changes in sales volume. This fact also becomes clear that in 1999 when sales fell down, the
decrease in the company's net operating profit was faster to sales volume and in 2001 when the sales volume
increased, the increase in company's net profit was faster to sales volume.

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RATIO ANALYSIS

A ratio is a simple arithmetical expression of the relationship of one number to another. In

simple language ratio is one number expressed in terms of the other and can be worked out
by dividing one number into the other.
This relationship can be expressed as
(i) percentages, say, net profits are 20 per cent of sales (assuming net profits of Rs. 20,000
and sales of Rs. 1,00,000),
(ii) fraction (net profit is one-fourth of sales) and
(iii) proportion of numbers (the relationship between net profits and sales is 1:4).

The rational of ratio analysis lies in the fact that it makes related information comparable.
Ratio analysis helps in financial forecasting, making comparisons, evaluating solvency
position of a firm

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RATIO ANALYSIS

Calculation of mere ratios does not serve any purpose, unless several appropriate ratios are
analysed and interpreted. The following are the four steps involved in the ratio analysis :
(i) Selection of relevant data from the financial statements depending upon the objective of
the analysis.
(ii) Calculation of appropriate ratios from the above data.
(iii) Comparison of the calculated ratios with the ratios of the same firm in the past, or the
ratios developed from projected financial statements or the ratios of some other firms or the
comparison with ratios of industry to which the firm belongs.
(iv) Interpretation of the ratio.

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CLASSIFICATION OF RATIOS

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Profitability Ratios

Profitability Ratios : The stakeholders are always interested in the financial soundness of a firm. The
management of the firm is naturally eager to measure its operating efficiency. Similarly, the owners
invest their funds in the expectation of reasonable returns. Profitability ratios can be determined on
the basis of either sales or investments.

1. Profitability Ratios Related to Sales : These ratios are based on the premise that a firm should earn
sufficient profit on each rupee of sales.

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1. Gross Profit Ratios: Gross profit ratios are calculated in order to represent the operating profits of an
organization after making necessary adjustments pertaining to the COGS or cost of goods sold.
The formula used for the calculation of gross profit ratio is-
Gross Profit Ratio = (Gross Profit / Net Sales) * 100

2. Net Profit Ratio: Net profit ratios are calculated in order to determine the overall profitability of an organization
after reducing both cash and non-cash expenditures.
The formula used for the calculation of net profit ratio is-
Net Profit Ratio = (Net Profit / Net Sales) * 100

3. Operating Profit Ratio: Operating profit ratio is used to determine the soundness of an organization and its
financial ability to repay all the short term and long term debt obligations.
The formula used for the calculation of operating profit ratio is-
Operating Profit Ratio = (Earnings Before Interest and Taxes / Net sales)

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4. Expense ratio: is computed to show the relationship between an individual expense or group of expenses
and sales. It is computed by dividing a particular expense or group of expenses by net sales. Expense ratio is
expressed in percentage.
Expense Ratio = (Particular expense / Net Sales) * 100

5. Rate of Return on Equity Share Capital : This ratio is calculated by dividing the net profits (after deducing
income-tax and dividend on preference share capital) by the paid up amount of equity share capital. It is usually
expressed in percentage as below :
Rate of Return of Equity Share Capital = Net Profit (after tax and Pref. Div.) /Paid-up Equity Share Capital × 100
This ratio examines the earning capacity of equity share capital.

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6. Return on Investment (ROI) Ratio : This is one of the key profitability ratios. It examines the overall
operating efficiency or earning power of the company in relation to total investment in business. It
indicates the percentage of return on the capital employed in the business. It is calculated on the basis of
the following formula :
ROI = Operating Profit / Capital Employed X 100

The term capital employed has been given different meanings by different accountants. Some of the
popular meanings are as follows :
(i) Sum-total of long-term funds employed in the business, i.e., Share Capital + Reserves and Surplus +
Long term Loans + Non-business Assets + Fictitious Assets

The term Operating Profit means Profit before Interest and Tax. The term Interest means Interest on long-
term Borrowings. Interest on short-term borrowings will be deducted for computing operating profit..

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 Significance of ROI

• The Return on Capital invested is a concept that measures the profit which a firm earns on investing a unit of
capital. It is desirable to ascertain this periodically.
• The profit being the net result of all operations, the return on capital expresses all efficiencies or
inefficiencies of a business collectively and thus is a dependable basis for judging its overall efficiency or
inefficiency.
• On this basis, there can be comparison of the efficiency of one department with that of another or one plant
with that another, one company with that of another and one industry with that of another.
• For this purpose, the amount of profits considered is that before making deductions on account of interest,
income-tax and dividends and capital is the aggregate of all the capital at the disposal of the company, viz.,
equity capital, preference capital, reserve, debentures, etc.
• The Return on Capital when calculated in this manner would also show whether the company's borrowing
policy was wise economically and whether the capital had been employed fruitfully.
• Suppose, funds have been borrowed at 8% and the Return on Capital is 7½% it would have been better not
to borrow (unless borrowing was vital for survival). It would also show that the firm had not been employing
the funds efficiently.

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Liquidity ratios

Liquidity ratios measure the adequacy of current and liquid assets and help evaluate
the ability of the business to pay its short-term debts. The ability of a business to pay
its short-term debts is frequently referred to as short-term solvency position or
liquidity position of the business. Generally a business with sufficient current and
liquid assets to pay its current liabilities as and when they become due is considered to
have a strong liquidity position and a businesses with insufficient current and liquid
assets is considered to have weak liquidity position.
Short-term creditors like suppliers of goods and commercial banks use liquidity ratios
to know whether the business has adequate current and liquid assets to meet its
current obligations. Financial institutions hesitate to offer short-term loans to
businesses with weak short-term solvency position.

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(i)Current ratio (also known as working capital ratio) is a popular tool to evaluate short-term solvency position
of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they
become due. Short term obligations (also known as current liabilities) are the liabilities payable within a short
period of time, usually one year. Current ratio is computed by dividing total current assets by total current
liabilities of the business.
This relationship can be expressed in the form of following formula or equation:
Current Ratio = Current Assets / Current Liabilities

(ii) Quick ratio (also known as “acid test ratio” and “liquid ratio”) is used to test the ability of a business to pay
its short-term debts. It measures the relationship between liquid assets and current liabilities. Liquid assets are
equal to total current assets minus inventories and prepaid expenses.
The formula for the calculation of quick ratio is given below:
Quick Ratio = Liquid Assets / Current Liabilities
Liquid Assets = Current Assets – (Inventory + Prepaid Expenses)

Quick ratio is considered a more reliable test of short-term solvency than current ratio because it shows the
ability of the business to pay short term debts immediately

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(iii) Absolute Liquid ratio-some analysts also compute absolute liquid ratio to test the liquidity of the
business. Absolute liquid ratio is computed by dividing the absolute liquid assets by current liabilities.
The formula to compute this ratio is given below:
Absolute Liquid Ratio = Absolute Liquid Assets / Current Liabilities
Absolute Liquid Assets = Liquid Assets – Account Receivable

Some examples of absolute liquid assets are cash, bank balance and marketable securities etc.

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 Activity Ratios
Activity ratios which are also called efficiency ratio or asset utilisation ratios are concerned with
measuring the efficiency in asset management. The efficiency with which the assets are used
would be reflected in the speed and rapidity with which assets are converted into sales. The
greater is the rate of turnover or conversion, the more efficient is the utilisation/management,
other things being equal. For this reason, such ratios are also designated as turnover ratios.
Activity ratios show how frequently the assets are converted into cash or sales and, therefore,
are frequently used in conjunction with liquidity ratios. Some important activity ratios are:
(i) Inventory turnover ratio
(ii) Receivables turnover ratio
(iii) Average collection period
(iv) Accounts payable turnover ratio
(v) Average payment period
(vi) Asset turnover ratio
(vii) Working capital turnover ratio
(viii) Fixed assets turnover ratio

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1. Inventory Turnover Ratio : ITR is an activity ratio and is a tool to evaluate the liquidity of
inventory. It measures how many times a company has sold and replaced its inventory during a
certain period of time. Inventory turnover ratio is computed by dividing the cost of goods sold
by average inventory at cost. The formula/equation is given below:

Inventory Turnover Ratio = Cost of goods sold / Average Inventory

Where Cost of goods sold = Sales - Gross profit
Average Inventory = Opening Inventory + Closing Inventory
2

A high ratio is good from the viewpoint of liquidity and vice versa. A low ratio would signify that
inventory does not sell fast and stays on the shelf or in the warehouse for a long time.

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2. Debtors Turnover Ratio : This ratio is determined by dividing the net credit sales by average debtors
outstanding during the year. Thus,

Debtors Turnover Ratio = Net credit sales / Average debtors

Where Net credit sales = gross credit sales - sales returns, if any, from customers.
Average debtors = Opening debtors + Closing debtors
2

The ratio measures how rapidly debts are collected. A high ratio is indicative of shorter time-lag between
credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.

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3. Average Age of Sundry Debtors : The average age of sundry debtors (or accounts receivable), or
average collection period is more meaningful figure to use in evaluating the firm's credit and collection
policies. The main objective of calculating average collection period is to find out cash inflow rate from
realisation from debtors. It is found by a simple transformation of the firm's accounts receivable turnover:

Average age of debtors = 365/ Debtors turnover ratio

Average collection period = Trade debtors / Net credit sales X No. of working days.

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4. Creditors Turnover Ratio : It is a ratio between net credit purchases and the average amount of creditors
outstanding during the year. It is calculated as follows:

Creditors Turnover Ratio = Net credit purchases / Average creditors

Where Net credit purchases = Gross credit purchases – purchase return if any.
Average Creditors = Opening creditors + Closing creditors
2
A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to
be settled rapidly.

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5. Average payment period: It means the average period taken by the company in making payments
to its creditors. It is computed by dividing the number of working days in a year by creditors turnover
ratio. Some other formulas for its computation are given below:

Average payment period: 365 / Payable turnover ratio

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6. Assets Turnover Ratio : This ratio is also known as the investment turnover ratio. It is based on
the relationship between the cost of goods sold and assets/ investments of a firm. A reference to this
was made while working out the overall profitability of a firm as reflected in its earning power.
Depending upon the different concepts of assets employed, there are many variants of this ratio. Thus,

1. Total assets turnover = Cost of goods sold / Average total assets

2. Fixed assets turnover = Cost of goods sold / Average fixed assets
3. Capital turnover = Cost of goods sold / Average capital employed
4. Current assets turnover = Cost of goods sold / Average current assets

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7. Working capital turnover ratio: It is computed by dividing the cost of goods sold by net working
capital. It represents how many times the working capital has been turned over during the period.

Working capital turnover ratio = Cost of goods sold / Net working capital

Generally, a high working capital turnover ratio is better. A low ratio indicates inefficient utilization of
working capital. The ratio should be carefully interpreted because a very high ratio may also be a sign of
insufficient working capital.

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