3.

Financial Statement Analysis

(1) Ratio Analysis
• Relationship expressed in mathematical between
2Figures or 2 groups of Figures
• Expressed as : pure ratio or as % age
• 3 step process
a) Calculate ratio
b) Compare it with standard ratio
c) Find conclusion which is useful for decision

making & control

Ratio Analysis has 3 forms -

a) Cross sectional analysis

b) Time series analysis

c) Combined analysis
• Precautions in Ratio Analysis
a) Same accounting policies
b) Same period
c) Group of ratios to single ratio
d) Figs. must be related to each other
• Significance: R.A. is useful to assess
following aspects of business :
a) Liquidity position
b) Long term solvency
c) Operating efficiency
d) Overall profitability
e) Inter firm comparison
f) Trend analysis
g) Investibility of company
• Limitations of ratio analysis
a) Indicate problems not solutions
b) Do not consider inflation
c) Cannot point out changes in accounting policies
Classification of ratios
(A) Liquidity group
i) Current ratio = Current Assets

Current Liabilities
- Ability of firm to pay C.L. out of C.
- 2:1 STD. (1.33 accepted by bank)
- STD. ratio may vary industry to industry
- More ratio means more C.A.
ii) Liquid ratio = (C.A.) – (stocks & prepaid Exp. )
(C.L.) – (bank O/D)
- 1:1 is satisfactory
- Better test of liquidity
- Ratio less than 1 payment problems
- Ratio more than 1 excess cash
(B)Solvency Group
i) Debt-Equity Ratio = Long Term Debt Only

Eq. + Res. + Pref.

OR
= Total Debt. Incl. C.L.
Equity + Reserve +
Pref.
- % of owner’s stake in business
- Excess debt- insolvency
- Dependence on Ext. funds
- Control over Co. by owners
ii) Proprietary Ratio = Shareholders Funds
Total Tangible
assets
 - High ratio preferred by creditor
----- Low ratio indicates greater risk to creditors
iii) Capital gearing ratio = L.T. Debts + Pref. capital
Equity + Reserves
- Ratio > 1 – Business high geared (Boom)
- Ratio < 1 – Business low geared ( slack)
iv) Interest coverage ratio = EBIT Or EBDIT
Interest
- Show interest payment capabilities of Co.
v) Debt service coverage ratio = P.A.T. + Int. + Depreciation
Int. + Principal
- Useful to assess loan service capability of Co.
- Generally 1.5 to 2 considered satisfactory
(C)Activity Group :
i) Inventory Turnover Ratio (I.T.R.)
Ratio = Sales or C.O.G.S.
Av. or Clo. Inventory
• High ratio low inventory level
• Low ratio high inventory level
ii) Debtors Turnover ratio (D.T.R.)
Ratio = Annual credit sales
Av. Receivables
• More ratio means less receivables
• Lower ratio means high receivables
• Reflects credit & collection policy of Co.
iii) Creditors Turnover ratio (C.T.R. )
Ratio = Annual credit purchases
Av. Payable
• More ratio means less payables
• Lower ratio means more payables
• Indicated credit period availed by Co.
iv) Working capital turnover ratio (W.C.T.R.)
Ratio = Annual sales
Av. Working capital
Higher ratio means lower investment in working capital
i.e. better w.c. Mgt.
v) Total Assets Turnover Ratio
Ratio = Annual Sales
Av. Net Tangible Assets
 -Indicates how efficiently assets have been used by
Co. for generating sales.
-Higher ratio better is efficiency
vi) Fixed assets turnover ratio
Ratio = Annual sales
Net Fixed Assets
Shows efficiency of using fixed assets.
Higher the ratio better it is

vii) Capital Turnover Ratio

Ratio = Annual Sales
Av. Capital Employed
Ratio shows efficiency of using capital
(D) Profitability Group
i) G/P Ratio = G/P x 100
Sales
= Sales - C.O.G.S. x 100
Sales
Ratio reflects efficiency of purchase & production
ii) Operating profit ratio
Ratio = Operating profit x 100
Sales
Indicates operating efficiency of management i.e.
Mfg. , ADMN , S&D & expenses on depreciation.
When ratio is high it means management has
controlled these expenses.
iii) Operating ratio = Total Operating Cost x 100
Net Sales
Complimentry to operating profit ratio
If this ratio is 85% then operating profit ratio is 15%
iv) N / P ratio = N / P x 100
Sales
= PAT x 100
Sales
Reflects overall efficiency of organisation
v) Return On Investment (R.O.I.)
(R.O.I.) = N/P

Capital Employed
= N/P x Sales
Sales Capital Employed
= (N/P ratio ) x ( Capital Turnover Ratio )
Sales Fixed Assets
C.O.G.S Current assets
ADMN Current Liabilities
S&D
Interest
Tax
(E) Investibility Group ( Market Test)
i) E.P.S. = P.A.T. – Pref. Dividend
No. of Equity Shares
Indicates
• Earning capacity of Co.
• Amount available to shareholder
• Efficiency of management
• Market value of share
ii) Price Earning Ratio ( P/E)
(P/E) = Market Price
E.P.S.
Indicates M.V.P.S. fluctuations
iii) Dividend Per Share (D.P.S.)
D.P.S. = Total Profits Distributed
No. of Equity Shares
Reflects dividend policy of Co.
iv) Dividend payout ratio (D/P)
D/P
= D.P.S. X 100
E.P.S.
(1 – D/P) = Retention ratio
R.O.E. (1 - D/P ) = Rate of growth of shareholders funds
R.O.E. = P.A.T. – Pref. Dividends x 100
Equity + Reserves
v) Dividend Yield
Ratio = D.P.S. x 100
Mkt. price per share

Useful for investor to find returns he should earn

when he buys co’s shares from the market .
 (2)Comparative Statement Analysis

• Known as horizontal analysis or dynamic analysis.

• This analysis shows:
• i) Absolute figures in terms of money for each period
• ii) Changes ( + / - ) in absolute figures
• iii) Changes (+ / - ) in terms of percentage
• iv) Percentage of totals
• v) Comparison of period to period percentages
• Increases usefulness of the financial reports
• Gives considerable insight into strengths &
weakness of various areas.
Comparative statement Analysis
Income Statement (Amt. Rs.lakhs)
Particulars 2006 2007 (+/-) Rs. (+/-) %
Net Sales 2,000 2,100 (+) 100 (+) 5.0
(-) C.O.G.S. 1,300 1,200 (-) 100 (-) 7.7
= G /P 700 900 (+) 200 (+) 28.6
(-) Adm.Exp. 100 130 (+) 30 (+) 30.0
Selling Exp. 150 220 (+) 70 (+) 46.7
Depreciation 100 150 (+) 50 (+) 50.0
(+) Non opr.income 10 15 (+) 5 (+) 50.0
= E.B.I.T. 360 415 (+) 55 (+) 15.3
(-) Interest 60 95 (+) 35 (+) 58.3
= E.B.T. 300 320 (+) 20 (+) 6.7
(-) Tax 105 112 (+) 7 (+) 6.7
=E.A.T. 195 208 (+) 13 (+) 6.7
(-) Dividend 95 108 (+) 13 (+) 13.7
= Retained Earnings 100 100 -- --
Comparative statement Analysis
Balance Sheet ( Amt.Rs.lakhs)

Particulars 2006 2007 (+/-)Rs. (+/-) %

Equity Capital 80 250 (+)170 (+)212.5
Reserves 100 200 (+)100 (+)100
Preference Capital 20 50 (+) 30 (+)150
Shareholders’ Equity (A) 200 500 (+)300 (+)150
Debentures 250 250 - -
Secured Loans 200 100 (-)100 (-)50
Unsecured Loans 50 50 - -
Loan Funds (B) 500 400 (-)100 (-)20
Total Sources [A + B] 700 900 (+)200 (+)28.6
 Balance Sheet (Contd.)

Particulars 2006 2007 (+/-) Rs. (+/-) %

Gross Fixed Assets 400 750
(-) Depreciation 100 250
= Net Fixed Assets (C) 300 500 (+)200 66.7
Investments (D) 20 20 - -
Current Assets 480 780 (+)300 (+)62.5
(-) Current Liabilities 200 400 (+)200 (+)100
=Net Current Assets (E) 280 380 (+)100 (+)35.7
Total Applications [C+ D+ E] 700 900 (+)200 (+)28.6
 (3) Common Size Statement Analysis
• Also termed as Vertical Analysis
• Useful to compare different divisions of same company
OR
Useful to compare same divisions of different companies
• Done on Monthly, quarterly, Annual basis
• Net sales figures are taken as 100 & other items are expressed
as % of net sales (for income statement)
• Total Assets & Total Applications are taken as 100 & all
other variables are taken as % of these variables
 Common Size Statement Analysis
Income statement – 2006 (Amt. Rs. Lacs)

Particulars Div. A Div. B Div. C

Sales 105 135 140
Less sales returns 5 15 15
= Net sales (100%) 100 120 125
(-) Less C.O.G.S. 55 80 95
= Gross profit (A) 45 40 30
(-)Admin. Expenses 8 10 15
(-)Selling expenses 12 15 20
(-)Depreciation 5 8 10
(+) Non operating income 2 13 45
E.B.I.T. 22 20 30
Less interest 8 5 10
EBT 14 15 20
Less tax 4 5 8
EAT or Net Income 10 10 12
(-) Dividend 5 5 6
= Retained Earnings 5 5 6
 Common Size Statement Analysis

Balance Sheet ( Amt. Rs. Lacs .)

Share capital 30 40 44
Reserves 5 5 6
Shareholders Equity (i) 35 45 50
Secured Loans 25 10 15
Unsecured Loans 5 5 Nil
Loan Funds (ii) 30 20 15
Total Sources (i + ii) (100%) 65 65 65
Fixed assets 60 70 80
Less Depreciation 10 15 20
Net fixed assets (a) 50 55 60
Investment (b) 5 5 Nil
Current assets 40 50 60
Less current Liabilities 30 45 55
Net current assets (c) 10 5 5
Total Applications (100% ) 65 65 65
 (4) Trend Analysis

• Involves calculating index ratios of various items of

financial statements for no. of accounting periods
• Item of base year is taken to be 100
• Figure of subsequent year =[fig. of yearx100]
[figure of base year]
• Useful to know trends of various financial parameters
Trend Analysis Income Statement (Amt. Rs.lakhs)

Particulars 2005 2006 2007 2005 2006 2007

Amt. Amt. Amt. % % %
Net Sales 50 75 100 100 150 200
(-)C.O.G.S. 40 60 72 100 150 180
=G/P 10 15 28 100 150 280
(-)Admin Exp. 2 3 4 100 150 200
Selling Exp. 2 3 8 100 150 400
Depreciation 1 2 3 100 200 300
(+)Other income 1 1 2 100 100 200
=E.B.I.T. 6 8 15 100 133 250
-Interest 2 3 5 100 150 250
=E.B.T. 4 5 10 100 125 250
(-)Tax 1.5 2 4 100 133 267
=E.A.T. 2.5 3 6 100 120 240
(-)Dividend 1 1.5 2 100 150 200
=Retained Earnings 1.5 1.5 4 100 100 267
Trend Analysis Balance Sheet (Amt. Rs.Lakhs)
Particulars 2005 2006 2007 2005 2006 2007
Amt. Amt. Amt. % % %
Equity Capital 5.5 6 6 100 109 109
Reserves 1.5 3 7 100 200 467
Shareholders’Equity (A) 7 9 13 100 129 186
Debentures 1.5 3 3.5 100 200 233
Secured Loans 1 1.5 2 100 150 200
Unsecured Loans 0.5 1.5 1.5 100 300 300
Loan Funds (B) 3 6 7 100 200 233
Total Sources [A + B] 10 15 20 100 150 200
Gross Fixed Assets 7 12 18 100 171 257
(-) Depreciation 1 3 6 100 300 600
= Net Fixed Assets (C) 6 9 12 100 150 200
Investment (D) 1 1 1 100 100 100
Current Assets 6 9 12 100 150 200
(-) Current Liabilities 3 4 5 100 133 167
=Net Current Assets (E) 3 5 7 100 167 233
Total Sources [C+D=E] 10 15 20 100 150 200
 (5) Cash Flow Analysis
• Every limited company listed on recognized
stock exchange must incorporate in annual report
• As per accounting standard No.AS-3
• Cash flow statement indicates cash flows
during a particular period under following three heads
i) operating activities
ii) investing activities
iii) financing activities.
 Format of cash flow statement
(A)Cash flows from operating activities:
(i) Net profit before tax 3,350
(ii) +depreciation 450
(iii +interest [To be taken under ‘C’] 400
(iv) +Non operating loss 40
(v) - interest income [To be taken under ‘B’ ] 300
(vi) - dividend income [To be taken under ‘B’] 200
= Operating profit before W.C. changes 3,740
- Increase in Current assets 500
+ Decrease in Current assets 1,050

- Decrease in Current liabilities 2,340

+ Increase in Current liabilities 600
= Cash before Tax 2,550
- Tax 860
= Cash flow before Extraordinary items 1,690

+ Extraordinary item 180

= CASH FROM OPERATING ACTIVITIES (A) 1,870
(B) Cash flows from investment activities:

Purchase of plant (350)

Sale of plant 20
Interest Received 300
Dividend Received 200
CASH FROM INVESTMENT ACTIVITIES (B) 170
(C) Cash flows from financing activities:
Issue of share capital 250
Issue of Debentures 250
Dividend paid (1,320)
Interest paid (400)
CASH FROM FINANCING ACTIVITIES ( C) (1,220)

Increase in cash during year (A+B+C) 820

Opening balance 160
Cash balance at end 980