Chapter 3

ANALYSIS OF
FINANCIAL
STATEMENTS
 LEARNING OBJECTIVES
• Define the concept of financial statement
• Objectives of preparing financial statements
• Explain different techniques of financial statement analysis
• List out liquidity ratios
• List out leverage ratios
• List out efficiency ratios
• List out profitability ratios
• List out market value ratios
• Know the limitations of ratios
 Financial Statement

It is an organised collection of data arranged according to logical

and consistent accounting principles
 Financial Statements
Financial Statements

Income Statement of
Statement Retained Earnings

Statement of
Balance Changes in
Statements Financial Position
 Objective of Financial Statement Analysis
The objective of financial statement analysis is a detailed cause
and effect study of the financial position of a firm

Techniques of Financial Statement Analysis

1. Common-size analysis
2. Trend analysis
3. Comparative statement analysis
4. Funds flow analysis
5. Ratio analysis
 Techniques of Financial Statement Analysis

1. Common-size Analysis: Income and balance sheet items are

shown as a percentage of sales and total assets respectively.
2. Trend Analysis: trend percentages are index figures giving a
bird’s eye view of the comparative data presenting then over a
period of time.
Techniques of Financial Statement Analysis

3. Comparative Statement Analysis: This provides trends of

the items of income statement and balance sheet, which
provide immediate future of a business enterprise.
4. Funds Flow Analysis: Funds flow statement that record and
report the flow of funds between various assets and liabilities
and owner’s capital during a select accounting period.
5. Ratio Analysis: It measures the relationship between two
variables – both in terms of percentage as well as quotient.
 Classification of Ratios
Traditional or Financial or Purpose
Basis of Statements of using Ratios

Profit & Loss Balance Sheet Composition

A/c Ratios Ratios Ratios

Liquidity or Leverage or Activity or Profitability Market

Short-term Long-term Efficiency or Ratios Value
Ratios Solvency Asset Ratios
Ratios Turnover
Ratios
 Liquidity Ratios
Liquidity refers to the firm’s ability to meet financial obligations
in the short-run usually one year.
Current Assets
Current Ratio = ----------------------
Current Liabilities

Liquid Assets
Quick Ratio = ----------------------
Current Liabilities

Cash Ratio:
Cash & Bank Balance + Short-term Marketable Securities
= -----------------------------------------------------------------------
Current Liabilities
Current Assets
Interval Measure: = ---------------------------------------------
Average Daily Operating Expenses
 Leverage Ratios
Leverage is the firm’s ability to use fixed cost source of
finance or fixed assets or both to maximise profitability
Debt
Debt-Equity Ratio = ----------------------
Shareholders Equity
Total Debt
Total Debt to Total Assets Quick Ratio = ------------------
Total Assets
EBIT
Interest Coverage Ratio = ----------------------
Interest
EBIT + Depreciation + Amortisation
Cash Coverage Ratio: = --------------------------------------------
Interest
 EBIT
Fixed Charge Coverage Ratio = ----------------------
Repayment of Loan
Interest + -------------------------
1- Tax rate
Debt Service Coverage Ratio
EBIT
= -----------------------------------------------------------------------
Interest of term-loan + Lease Rent + Repayment of Loan

Net Fixed Assets

Fixed Assets to Net worth = ----------------------
Net worth
Fixed Cost Bearing Funds
Capital Gearing Ratio = --------------------------------------
Total Capital Employed
 Activity (Efficiency or Turnover) Ratios
Turnover ratio refers the number of times as asset / resource
flows through a firm’s operations into sales.
Sales
Inventory Turnover Ratio = --------------------------------
Year End (or Avg)Inventory
365 Days
Accounts Payable Period = ------------------
Inventory turnover
Net Credit Sales
Debtors Turnover Ratio = --------------------------
Debtors or Accounts Receivables
365 Days
Average Collection period: = ----------------------------------------
Receivables Turnover
 Sales
Working Capital Turnover Ratio = ----------------------- ------
New Working Capital
Net Sales
Fixed Assets Turnover Ratio = --------------------------
Net Fixed Assets
Sales
Total Assets Turnover Ratio = --------------------------
Total Assets
 Profitability Ratios
Profitability is the firm’s ability to earn satisfactory profit.
Gross Profit
Gross Profit Ratio = ----------------------- 100
Sales
Net Profit
Net Profit Ratio = ---------------- 100
Sales
EBIT
Basic Earning Power (BEP)= ------------------- 100
Total Assets
Net profit
Return on Total Assets = ------------------- 100
Total Assets
 EBIT (1-tax rate)
Return on Capital Employed = ----------------------- 100
Total Assets
Equity Earnings
Return on Equity (ROE) = -------------------------- 100
Total Equity Capital
Operating Expenses
Operating Ratio = --------------------------- 100
Net Sales
Net Profit after preference Dividend
Earnings per Share = ---------------------------------------------
No. of Outstanding Equity Shares
Dividend Per Share
Dividend Payout Ratio = ------------------------------
Earnings per Share
 Du Pont Analysis
Return on Total Assets

Net Profit Margin Total Assets Turnover

Net Income / Sales Sales / Total Assets

Sales minus Total Fixed Current

plus
Cost Assets Assets

Short- Cash Inven-

term tory
COGS Depre. Admin Interest Investm-
& ent Accounts
Selling Taxes receivables
Exps
 Limitations of Ratios
1. Deferent Accounting Policies
2. Creative Accounting
3. Ratios are not Definitive measures
4. Ratios are the result of outdated financial information
5. Ratios uses Historical cost
6. Changes in rupee value
7. Changes in price
8. Changes in accounting policy
9. Different risk profile
10. Window dressing
11. Financial statements do not reflect many factors