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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios

Statement, Financial Statement Analysis & Ratio Analysis

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement,
Financial Financial
StatementStatement Analysis & Ratio Analysis
Analysis: ......................................................................................... 3
Tools for Analyzing Financial Statement: .......................................................................................................... 3
Types of Financial Statement Analysis............................................................................................................... 3
Purpose of Financial Statement Analysis ........................................................................................................... 4
Stakeholder interested in Financial Analysis ...................................................................................................... 4
Limitations of Financial Statement Analysis ...................................................................................................... 5
Cash Flow Statement: .................................................................................................... 5
Structure of CFS: ................................................................................................................................................ 5
Methods: ............................................................................................................................................................. 6
Format of a Cash Flow Statement:...................................................................................................................... 6
What is the use of CFS? ...................................................................................................................................... 8
Limitations of CFS.............................................................................................................................................. 8
Fund flow statement: ..................................................................................................... 9
What is the meaning of the Fund? ...................................................................................................................... 9
Objective/Significance of Fund Flow Statement: ............................................................................................... 9
Limitations of Fund Flow Statement: ................................................................................................................. 9
Format of Fund Flow Statement: ........................................................................................................................ 9
Format for Statement of Change in Working Capital ....................................................................................... 10
Rules to be followed by identifying Working Capital change due to change in Current Assets and Current
Liabilities ...................................................................................................................................................... 10
Difference between Cash Flow Statement and Fund Flow Statement .................................... 11
Ratio Analysis:............................................................................................................ 12
Significance of Ratio Analysis: ........................................................................................................................ 12
Limitations of Ratio Analysis: .......................................................................................................................... 12
Classification of Ratios: .................................................................................................................................... 13
Liquidity Ratios: ............................................................................................................................................... 13
Solvency Ratios: ............................................................................................................................................... 14
Activity Ratios: ................................................................................................................................................. 15
Profitability Ratios: ........................................................................................................................................... 16
Some Other Ratios ............................................................................................................................................ 18

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial
Financial Statement Analysis
Statement & Ratio Analysis
Analysis:
Financial Statement Analysis (FSA) is a process of critically examining the financial information in the
financial statements to understand and make a decision regarding the operations of the enterprise. It can
help in understanding the relationship between various financial numbers as given in the financial
statements, i.e. Income Statement and Balance Sheet, to assess the Liquidity, Long-term Solvency,
Operating Efficiency, and Profitability of the company. Hence, the process of establishing relationships and
interpretation to understand the working and financial position of a business is known as the Analysis of
Financial Statement.

Tools for Analyzing Financial Statement:


The financial statements, i.e. Balance Sheet and Income Statements, gives information about the assets,
liabilities, equity, revenue, expense and profit and loss of a company in absolute amount. They can be
analyzed with the help of analytical tools using the financial statements of the company for the earlier year
or with that of another company. The following are some tools that can be used in FSA.

1. Comparative Statements: This helps in doing a comparative study of individual items or components
of financial statements of two or more years of the company itself. In the case of Comparative Statement,
the amount of two or more years are placed next to each other along with the change in the amount in
absolute and percentage terms for comparison purpose.

2. Common-size Statements: In this type of statement, individual items or components of financial


statements of two or more years of the company are placed next to each other, and then converted into
percentage taking a common base. In the case of a Common-size Balance Sheet, the common base taken
is either Total of Assets or Total of Equity and Liabilities, while in case of Common-size Income Statement,
the common base taken is Revenue from Operation (or Net Sales). The common base is taken as 100 and
then the other figures are expressed as a percentage of the total. For instance, in the case of a Common-
size Balance Sheet, the Total of Assets or Total of Equity and Liabilities is taken as 100 and all the other
figures are expressed as a percentage of 100. Similarly, in the case of Common-size Income Statement, the
Revenue from Operation is taken as 100 and all the other figures are expressed as a percentage of Revenue
from Operations.

3. Cash Flow Statement: The cash flow statement (CFS) is a statement that shows the flow of cash and
cash equivalents over a period of time. In other words, CFS shows how well a company can generate cash
to pay its debt obligation and fund its operating expenses. Besides, it also shows the change in cash position
from one period to another.

4. Ratio Analysis: It is an arithmetical expression that expresses a relationship between two related or
independent items or components of financial statements. With the help of this method, one can analyze
the financial performance, financial stability and financial health of a company.

Types of Financial Statement Analysis


The FSA can be classified into the following categories:

External and Internal Analysis: External Analysis is done by those who may not have complete access
to the detailed records of the company, and so they mostly depend on the published financial accounts such
as Income Statement, Balance Sheet Cash Flow Statement, Auditor’s Report, and Directors’ Reports.
Generally, investors, credit agencies, government agencies, and researchers do this type of analysis. On
the other hand, internal analysis is done by the management of the company to understand the financial
position and operating efficiency of the company. Further, since the management has complete access to
the information, they can do a more detailed, extensive and accurate analysis.

Horizontal and Vertical Analysis: Horizontal analysis is done to analyze the financial statement for a
number of years and so is based on the financial data taken for those years. It is also known as a time
series analysis, as the financial data are compared for several years against the chosen base year. An
example of horizontal analysis is Comparative Financial Statement. On the other hand, the vertical analysis
is done to analyze the performance of the company for one year only. This analysis is useful in comparing

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial
the performance Statement
of several Analysis
companies & Ratio
of the sameAnalysis
type of divisions or department of the company. A
Common-size Statement is an example of vertical analysis.

Intra-firm and Inter-firm Analysis: Intra-firm Analysis or Time Series Analysis or Trend Analysis, helps
to compare financial variables of an enterprise over a period of time, showing the trend of financial factors.
The Inter-firm Analysis or Cross-Sectional Analysis compares the financial position of two or more companies
to determine their competitive position.

Purpose of Financial Statement Analysis


Various stakeholders may refer to financial statements for different reasons. The following are some of the
purposes of financial statement analysis.

To assess the profitability: The financial analysis can help in assessing the earning capacity of the
company. Further, it can also help in forecasting the future earning capacity of the company, which will be
of interest to investors and potential investors.

To assess the managerial efficiency: Identifying areas where the managers have been efficient and the
areas where they need to improve upon is another objective of financial analysis. For instance, with the help
of a financial ratio, it is possible to understand the relative proportion of production, administration and
marketing expenses. Further, any favorable and unfavorable variations can be identified and the manager
could be then questioned on the same.

To assess the short term and long term solvency: A financial statement analysis can help in
ascertaining the short term and long term solvency of the company. The creditors or suppliers would be
interested in knowing the short term solvency position of the company as they would like to know if the
company can meet the short term liabilities, while the banks, debenture holders and other lenders would be
interested in knowing the long term solvency of the company as they are more interested in understanding
whether the company can service its interest and principal payment on time.

Inter-firm comparison: Financial Analysis can help a company to compare its performance with that of
others. This is heavily used while looking for Mergers and Acquisition opportunities as well.

Forecasting and Budgeting: A company usually forecasts and prepare budgets for the future years based
on the past financial statement.

Understandable: Finally, financial analysis can help a reader understand the financial statement of the
company in a more simplified manner, as financial data can be made more comprehensive with the help of
charts, graphs, and diagrams, which is easy to explain and understand.

Stakeholder interested in Financial Analysis


Several parties may be interested in the analysis of the financial statement. They are listed below:
Management: It helps the management to ascertain the overall and segment-wise efficiency of the
business. Further, it also helps them in decision making and evaluation of the performance of the business.
Employees and Trade Unions: Employees are interested in their welfare and so they would be interested
in the profitability, sustainability and financial strength of the business, while the trade unions are interested
because this may help them negotiate and enter into wage contracts with the employer.
Shareholders or Owners or Investors: Since they invest their money into the business, they would be
interested in knowing whether the business is profitable and has growth potential or not.
Potential Investors: They are interested in the financial statement because they would invest their money
into the company only if they find the company profitable and has good growth potential.

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement,
Supplier Financial Statement
or Creditors: Analysis
They are & Ratio Analysis
more interested in knowing the short-term solvency position of the
company, as they would provide goods and/or services on credit only they find that the company can repay
them.
Bankers and Lenders: They are interested to know whether the company can service the interest payment
and also repay the principal, in case they grant a loan to the company. For this, they would look at the long-
term and short-term solvency of the firm.
Researcher: They are interested in knowing the profitability, growth, financial position and future prospects
of business and industry.
Government: The government is interested because they would like to have an understanding that which
industry is progressing, and which ones need protection and incentive. It also helps them in formulating
relevant policies and law.
Tax Authorities: The tax authorities want to ensure that the tax liabilities calculated are correct and that
the firm is not evading taxes.
Customers: They mostly look at the fact whether the company can continue or not, especially when they
have or intend to have long-term involvement with the company.

Limitations of Financial Statement Analysis


Even though financial analysis helps in understanding the position and financial strength of the company,
there do exist certain limitations as well, such as:
• It is an analysis of historical data and does not reflect the future, while the stakeholders will be more
interested in knowing the future position of the company
• The qualitative aspect, such as quality of management, staffs, public relations, etc. are ignored while
carrying out the analysis of financial statements
• Reliability can be a question mark as the analysis is done based on the information given in the financial
statements.
• There can be some amount of bias involved as well. This is because there are situations where an
accountant has to choose from the alternatives available (such as the method of inventory evaluation or
method of depreciation to be followed). In such a case, they will generally choose the method which
gives a rosy picture of the company.
• In case there is variation in the accounting policies every year, the comparison cannot be done. For
instance, in one year the company followed a straight-line method of depreciation, while next year it
follows a written down value method.
• There can be a situation where the accountant is doing window dressing, i.e. presenting a better financial
position of the company that what it is by manipulating the books of accounts.

Cash Flow Statement:


The cash flow statement (CFS) is a statement that shows the flow of cash and cash equivalents over a
period of time. In other words, CFS shows how well a company can generate cash to pay its debt obligation
and fund its operating expenses.

The Cash and Cash Equivalents consists of the following:


i. Cash
ii. Bank Balance
iii. Short Term Marketable Securities (i.e. those that can be realized within a period of 3 months). These
typically includes the treasury bills, commercial papers, money market instruments, and investments in
preference shares redeemable within three months if there is insignificant risk of change in its value.

Structure of CFS:
A CFS will consist of the following components:
1. Cash from Operating Activities, i.e. the primary revenue-generating activities of an organization and
other activities that are not investing or financing in nature. Further, any cash flows from current assets and
current liabilities shall be included in this section. The followings are a few examples of cash flow from
operating activities:
a. Cash receipt from sale of goods and services
b. Payment made to suppliers for goods and services in cash
c. Payment made towards salaries, wages, etc. in cash

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial
2. Cash from Statement
Investing Analysis
Activities, &ofRatio
i.e. flow cash Analysis
due to the acquisition and disposal of long-term assets
and other investments, not forming part of cash equivalents. Thus, this will include cash generated or spent
due to selling or buying of property, plant and equipment, other non-current assets and other financial
assets. The following are a few examples of cash flow from investing activities:
a. Purchase of tangible and intangible assets in cash
b. Receipt from sale of tangible and intangible assets
c. Loans and advances given to third party
d. Payment made for purchase of securities or long term investments of other companies

3. Cash from Financing Activities, i.e. any cash flow that will result in changes in the size and composition
of the equity capital or borrowings (such as loan and debentures) of the entity. This will include the issue of
share capital or buyback of shares, payment of dividends, issuance, and repayment of debts (or loans and
debentures). The following are a few examples of cash flow from financing activities:
a. Cash received from issue of shares
b. Payment of dividend in cash
c. Cash received from issue of debentures, bonds, long-term borrowings and short-term borrowings
d. Repayment of debentures, bonds, long-term borrowings and short-term borrowings
e. Payment of interest on borrowing

Methods:
There are two ways by which a CFS can be prepared, namely:
1. Direct method, wherein, the operating cash flows are presented as a list of cash flows. For instance,
cash received (inflow) from sales and cash paid (outflow) for expenditure. However, this method is seldom
used.
2. Indirect method, wherein, cash flows are identified from Adjusted Net Profit before Tax. In this case,
the adjustments are basically done for the non-cash expenses such as depreciation, which reduces the profit
but does not impact the cash flow, and non-operating income and expenses, such as interest and taxes, as
in most cases are non-operating items in nature.

Format of a Cash Flow Statement:


Cash Flow Statement for the period ended …..

Particulars Amount Amount Comments

A. Cash Flow from Operating


Activities

Net Profit as per Profit and Loss a/c XXX In an Indirect method, we can start the
CFS with the Net Profit and then go
ahead with doing the below
adjustments
Adjustment for Non-Cash and Non-
Operating Items
Depreciation & Amortization XXX Depreciation is a non cash item, hence,
needs to be added back
Provision for Tax XXX Provision for tax is a non cash item,
hence, needs to be added back

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial
Interest on Statement AnalysisXXX
Loan Paid & Ratio Analysis This should form part of Financing
Activities, hence we add back here
Interest on Loan Received (XXX) This should form part of Investing
Activities as it is an income recorded in
the Profit & Loss A/c (P&L), hence we
will subtract from here
Interest / Dividend Received (XXX) This should form part of Investing
Activities as it is an income recorded in
the P&L, hence we will subtract from
here
Operating Profit before change in XXX
Working Capital

Adjustments for Change in Working Now, we shall adjust for the change in
Capital the Working Capital during the
year/period
Add: Decrease in Account Receivables XXX The thumb rule here is that:
Decrease in Current Asset - Subtract
Increase in Current Asset - Add
Decrease in Current Liabilities - Add
Increase in Current Liabilities - Less
Add: Decrease in Closing Stock XXX
Add: Decrease in Other Current Asset XXX
Less: Decrease in Creditors (XXX)
Less: Decrease in Outstanding (XXX)
Expenses
Less: Decrease in Current Liabilities (XXX)
XXX
Less: Income Tax Paid XXX Subtract for the Income Tax Paid in
cash
Net Cash Flow from Operating XXX
Activities (A)

B. Cash Flow from Investing


Activities
Purchase of Property and Equipment (XXX) Purchase of any asset result in cash
outflow, hence we subtract
Loan given (XXX) Loan given also results in cash outflow,
hence, we subtract
Investments made in any other fixed (XXX) Any investments made will also result
assets in cash outflow, and so we will subtract
Proceeds from Property and Equipment XXX Cash received from sale of any asset
result in cash inflow, hence we add
Interest / Dividend Received XXX Interest/Dividend received from
investments made results in cash
inflow, hence, we add
Investments proceed received from sale XXX On selling any investments that was
of any other fixed assets made, we will receive cash and so we
will add
Net Cash Flow from Investing XXX
Activities (B)

C. Cash Flow from Financing


Activities
Issue of Share Capital XXX By issuing new shares, we shall get
cash, hence we add

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial Statement AnalysisXXX
Issue of Loan/Debentures & Ratio Analysis By issuing new loans/debentures, we
shall get cash, hence we add
Redemption/Buyback of Shares (XXX) Here, we are buying back our own
shares for which cash will have to be
paid to shareholders, hence this is cash
outflow
Repayment of Loan (XXX) Repayment of loan results in cash
outflow, hence we will subtract
Redemption of Debentures (XXX) Redemption of debentures results in
cash outflow, hence we will subtract
Interest on Loan/Debentures Paid (XXX) Payment of any kind of interest will lead
to cash outflow, hence we shall subtract
Payment of Dividend (XXX) Dividend on shares paid by company
also lead to cash outflow. Hence, this
shall be subtracted as well
Net Cash Flow from Financing XXX
Activities ( C)

Net Increase in Cash & Cash XXX This is the summation of A, B and C
Equivalents (A+B+C)
Add: Opening Cash & Cash XXX Here, add the cash and cash
Equivalents equivalents

Closing Cash & Cash Equivalents XXX This is the amount standing in your
balance sheet as at the end of the
period/year.
What is the use of CFS?
• CFS helps the management of the company to plan its future operating, investing and financing
requirements
• It can also help in understanding the solvency and liquidity position of the company, and whether the
company has the ability to pay off its liabilities on the due date or not.
• One can compare the cash from operating activities with the net income of the company to analyze the
quality of earnings. For instance, the company’s net earnings are said to be of high quality in case it can
generate higher net cash from its operating activities as compared to its net income, and vice-versa.
• CFS helps investors to understand the overall performance of the company through the flow of cash
(both inflow and outflow). It is said that a company can expand its operations, replace inefficient
equipment, increase its dividend, buy back some of its stock, reduce its debt, or even acquire another
company if it can generate more cash than it is using.
Limitations of CFS
• The non-cash transaction are excluded from the CFS, as it only shows the inflows and outflows of cash
and cash equivalents. An example of non-cash transaction can be purchase of assets by issuing shares
or debentures to the vendors. Hence, to overcome this, such transactions can be disclosed as a footnote.
• It cannot substitute the Income Statement (or Profit and Loss Account), as income statement shows
both cash and non-cash transaction, leading to determination of profit and loss.
• It cannot substitute Balance Sheet as well, CFS does not disclose the financial position of the company
(i.e., Total Equity, Non-Current Liabilities, Current Liabilities, Non-Current Assets and Current Assets).
• CFS ignores the fundamental accounting of concept of Accrual as it is prepared on a cash basis
• Finally, CFS is historical in nature as it simply rearranged the information available in income statement
and balance sheet.

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial
Fund flow Statement Analysis & Ratio Analysis
statement:
Fund Flow Statement (FFS) is a statement that shows movement of funds in and out of the business. In
other words, it is a statement showing sources and application of fund. FFS gives information on how a
company has got access to funds and how or where they are using the same. Hence, it helps the
management in taking decisions regarding allocation of fund more efficiently. The important thing to note
here that the sources and application of fund can be both capital and revenue in nature. Besides, it also
helps the financial manager to assess the:
1. Growth of the fund
2. Its resulting financial needs, and
3. Determine the best way to finance those needs

What is the meaning of the Fund?


Fund can be mean any of the following:
• Cash
• Net Working Capital, i.e. Current Asset less Current Liabilities
• Total resources or total funds
• Internal resources
• Net Worth, i.e. Owner’s Equity Capital plus Reserves and Surplus

Objective/Significance of Fund Flow Statement:


The following are the reasons why a fund flow statement is be prepared:
1. It can explain the changes in the financial position of the company, while also disclosing the cause of
changes in the assets, liabilities and shareholders’ equity between the two balance sheet dates.
2. It can help in analysing the operational position of the company, as the balance sheet merely gives a
static view of the financial position while the profit and loss statement cannot exactly tell the actual liquidate
position of the firm. For instance, a firm may be generating high profit but it is still not able to pay off its
liabilities due to cash crunch. Hence, fund flow statement can give information on the liquidity position of
the firm.
3. The fund flow statement can also assist in proper allocation of resources, as it can give information
regarding the allocation of limited resources more efficiently and effectively.
4. A fund flow statement can help in evaluating the financial performance of the company as it shows the
weakness and strengths of the company.
5. It can act as a guide for future management as it provides information about the historical changes in
net assets and capital which enable the management to develop a projected funds flow statement.

Limitations of Fund Flow Statement:


Even though fund flow statement is a good tool to financial analysis, there still exist some limitations as
listed follow:
1. The non-fund transactions (i.e. those that do not affect the working capital) are ignored while preparing
the fund flow statement. For instance, purchase of fixed asset through issue of shares/debentures are not
recorded.
2. It does not reveal the cash position of the company and so the company also prepares a Cash Flow
Statement in addition to the Fund Flow Statement
3. The statement is prepared based on historical financial data and does not communicate anything about
the future. Further, any estimates can be only made on the basis of the past data available. Hence, it is not
a very useful tool for taking decisions related to future.
4. It is based on secondary data as it is prepared based on income statement and balance sheet. Hence, it
lacks originality.

Format of Fund Flow Statement:


The following is the format of a Fund Flow Statement

Statement of Sources and Application of Funds for the period

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement,
Sources Financial
of Fund Statement Analysis & Ratio Analysis
Amount Application of Funds Amount
Issue of Equity Shares XXX Purchase of Fixed Assets XXX
Issue of Preference Shares XXX Purchase of Investments XXX
Issue of Debentures XXX Redemption of Shares XXX
Loan borrowed XXX Redemption of Debentures XXX
Sale of Fixed Assets XXX Repayment of Loan XXX
Sale of Investments XXX Payment of Tax XXX
Non-trading incomes XXX Payment of Dividend XXX
Fund from operation (profit) XXX Non-trading losses XXX
Decrease in Working Capital XXX Increase in Working Capital XXX
Fund from Operation (loss) XXX

XXX XXX

Format for Statement of Change in Working Capital

Particulars Change in Working Capital


Increase (Rs) Decrease (Rs)
A. Current Assets
Cash XXX -
Bank Balance XXX -
Stock / Inventories XXX -
Bills Receivables XXX -
Debtor XXX -
Prepaid Expenses XXX -
Accrued Income XXX -
Marketable Securities XXX -
Short-term investments XXX -

B. Current Liabilities
Creditors - XXX
Bills Payable - XXX
Outstanding Expenses - XXX
Advance Income - XXX
Bank Overdraft - XXX
Short term loan - XXX
Provision for Taxation - XXX
Provision for Dividend - XXX

Increase/Decrease in Working XXX XXX


Capital

Total XXX XXX

Rules to be followed by identifying Working Capital change due to change in Current Assets and
Current Liabilities
Condition Result Relationship
Current Asset Increase Woking Capital Increases Direct Relationship
Current Asset Decrease Woking Capital Decreases Direct Relationship

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, FinancialIncrease
Current Liabilities Statement Analysis & Ratio
Woking Analysis
Capital Decreases Inverse Relationship
Current Liabilities Decrease Woking Capital Increases Inverse Relationship

Difference between Cash Flow Statement and Fund Flow


Statement
Criteria Cash Flow Statement (CFS) Fund Flow Statement (FFS)

Meaning CFS is a statement that shows the FFS is a statement showing the changes in the
inflows and outflows of cash and cash financial position of the company in different
equivalents over a period accounting years

Purpose of It shows the reasons for movements in It shows the reasons for the changes in the
Preparation the cash at the beginning and at the financial position, with respect to previous year
end of the accounting period and current accounting year

Accounting Cash Basis Accrual Basis


Principle

Analysis Short Term Analysis of cash planning Long Term Analysis of financial planning

Usage It is more useful in understanding the It is more useful in assessing the long-range
short-term phenomena affecting the financial strategy
liquidity of the business

End Result It shows the changes in cash and cash It shows the causes of changes in net working
equivalents capital

Discloses Inflows and Outflows of Cash Sources and applications of funds

Opening and It contains the opening and closing It does not contain opening balance of cash and
closing balance of cash and cash equivalents cash equivalents
balance

Part of Yes No
Financial
Statement

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49032737
SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial Statement Analysis & Ratio Analysis

Ratio Analysis:
Ratio is an arithmetical expression that expresses relationship between two related and interdependent
items. When a ratio is calculated on the basis of the accounting data, it is termed as Accounting Ratio,
hence, here we can say that ratio is arithmetical expression that expresses relationship between two
accounting variable. Further, it is of significance only if it has a cause and effect relationship. For instance,
turnover is not related to investment in shares, while profit earned to capital employed is related.
A ratio can be expressed in four difference forms, namely,
• Pure, where the number is expressed as a quotient. Current Ratio, Quick Ratio, etc. are some of the
measures that expresses the relationship in this form.
• Percentage, where the relationship is expressed in percentage term. For example, Net Profit Margin,
Operating Margin, etc. are expressed in percentage.
• Times, where the ratio is expressed in number of times, when a particular amount is compared with
another amount. An example of this can be Inventory Turnover Ratio and Receivable Turnover Ratio.
• Fraction, where the number is expressed in fraction. For example, when the business has a debt of Rs
2,00,000 and total capital of Rs 3,00,000, then it can be said that Debt consist of 2/3 rd of Total Capital.

Significance of Ratio Analysis:


• It can help in understanding the financial position of the company. Almost all stakeholders analyses the
financial statement of the company by means of ratios.
• It simplifies, summarises and systematises a long array of accounting information to make them
understandable. It also helps in stating the relationship that exists between various elements of financial
statements.
• Accounting Ratio can also help in assessing the operating efficiency of the business by evaluating the
liquidity, solvency and profitability of the business.
• Ratios can help in preparing business plans and forecasts, as trends of the ratios are analysed and used
as a guide to future planning.
• It can help in identifying the weak areas in the business even though the overall performance of the
business may seem to be good. This can help management to work on the weak areas by taking
corrective action.
• Finally, ratios can be helpful in Inter-firm and Intra-firm comparison.

Limitations of Ratio Analysis:


• It can mislead if the ratios are calculated based on incorrect information, especially when the reliability
of the financial statement is a question mark.
• On many occasions the definitions of terms are not standardised. For instance, one company may
compute ratios on the basis of profit after interest and taxes, while another company may consider profit
after interest but before taxes. Hence, in such a scenario, the ratios computed will be different and will
not be comparable. Hence, it is important to calculate the ratio on the basis of same definition.
• The limitation of ratio analysis also arises when different firm follows different accounting policies. For
instance, one firm may follow straight line method for calculating depreciation, while another may follow
written down value method. In such a scenario, the comparison will not be possible as well.
• Another limitation of ratio analysis is that it only does quantitative analysis and ignores the qualitative
analysis, which is important in decision-making as well.
• A single ratio may not be able to explain the financial position of a company and so making a decision
merely on the basis of that may not be possible. For instance, Current Ratio of 2:1 will only tell that
Current Assets are 2 while the Current Liabilities are 1.
• Window dressing, a technique to conceal important facts while presenting the financial statement better
than what it actually is, may affect the ratios as well. In such a case, the ratio will not be able to state
correctly whether the company’s position is good or bad.
• Accounting Ratio may also not be effective when there is a personal bias involved while preparing the
financial statements.

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financialof
Classification Statement
Ratios:Analysis & Ratio Analysis
Ratios can be classified into the following:
1. Liquidity Ratios: Also known as short-term solvency ratio, it measures the ability of the company to
meet its short-term financial obligations as and when they become due for payment. The examples of
Liquidity Ratios are: Current Ratio and Quick Ratio/Liquid Ratio/Acid Test Ratio.
2. Solvency Ratios: It helps to measure the company’s ability to meet its debt obligations and is used
often by prospective business lenders. The examples of Solvency Ratios are: Debt to Equity Ratio,
Proprietary Ratio, Total Debt to Total Asset Ratio and Interest Coverage Ratio.
3. Activity Ratios: The activity ratio indicates how efficiently a company is able to leverage its assets on
the balance sheet to generate revenues and cash. The examples of Activity Ratios are: Trade Receivables
Turnover Ratio, Trade Payables Turnover Ratio, Inventory Turnover Ratio and Working Capital Turnover
Ratio.
4. Profitability Ratios: These ratios help to assess the business ability to generate profits relative to its
revenue, costs, assets on balance sheet and shareholders’ equity. The examples of Profitability Ratios
are: Gross Profit Ratio, Net Profit Ratio, Operating Profit Ratio, Earnings Per Share (EPS), Price to Earning
(P/E) Ratio and Return on Investment (ROI).

Liquidity Ratios:
Current Ratio

It is a liquidity ratio, measuring the company’s ability to meet its short term liabilities. Although the
acceptable ratios vary from one industry to another, they are generally between 1.5 and 3. If the company’s
ratio falls in this range, then it indicates a short term financial strength. The company may face trouble
meeting its short term liabilities in case the current ratio falls below 1. A higher current ratio is not also
good as it suggests the company is unable to efficiently use its current assets or its short term financing
facilities. The current ratio is calculated as follows:

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
Current Ratio =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

Quick Ratio

Also referred to as Acid Test Ratio or Liquid Ratio, it measures the ability of a company to use its near cash
or quick assets to pay its current liabilities immediately. Quick assets include current assets that can easily
be converted into cash at close to their book values.

Generally speaking, the ratio includes all current assets, except:

Prepaid expenses – because they cannot be used to pay other liabilities

Inventory – because it may take too long to convert inventory to cash to cover pressing liabilities

A company with a quick ratio of less than 1 cannot fully pay back its current liabilities. Quick Ratio is
calculated as follow:

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬−𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐢𝐞𝐬−𝐏𝐫𝐞𝐩𝐚𝐢𝐝 𝐄𝐱𝐩𝐞𝐧𝐬𝐞𝐬


Quick Ratio =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬−𝐁𝐚𝐧𝐤 𝐎𝐯𝐞𝐫𝐝𝐫𝐚𝐟𝐭𝐬

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Statement,
SolvencyFinancial
Ratios:Statement Analysis & Ratio Analysis

Debt to Equity Ratio

Also known as Risk, Gearing or Leveraging ratio, it indicates the relative proportion of shareholder’s fund
and debt used to finance a company’s assets. It also tells about the amount of borrowed capital (debt) that
can be fulfilled in the event of liquidation using shareholder contributions. It is used for the assessment of
the financial leverage and soundness of a firm. A low debt-equity ratio is favorable from an investment point
of view as the firm is less risky in times of increasing interest rate. It, therefore, can attract additional capital
for further investment and expansion of the business. This can be calculated using two formulas:

Long Term Debt


1. Debt to Equity Ratio =
Shareholder Funds

Where, Shareholder Funds = Share Capital + Reserve & Surplus


OR

Total Liabilities
2. Debt to Equity Ratio =
Shareholder Funds

Where, Total Liabilities = Non-Current Liabilities + Current Liabilities

Interest Coverage Ratio

Also, referred to as Time interest earned, this ratio is a measure of a company’s ability to honor its debt
payments. The interest coverage ratio of less than 1 signifies that the company is not generating enough
cash from its operations to meet its interest obligations. A higher interest coverage ratio is better for the
firm. Generally, a ratio of 2.5 and above are considered to be good. The following is the formula to calculate
interest coverage ratio:

EBIT
Interest Coverage Ratio =
Interest Charges

Proprietary Ratio

Also known as Equity Ratio, this ratio gives the proportion of total assets of the company that is funded by
the proprietors’ funds. It helps to understand the financial position of the company and can be useful for
lenders to assess the ratio of shareholders’ fund employed out of the total assets of the company. A higher
proprietary ratio is better for the firm. The following is the formula to calculate interest coverage ratio:

Shareholders′ Equity
Proprietary Ratio =
Total Assets

Where, Shareholders’ Equity = Share Capital + Reserves & Surplus

Total Debt to Total Assets Ratio

It is a leverage ratio that defines the total amount of debt standing in the balance sheet of the company
relative to its assets. The higher the ratio, the higher is the degree of leverage and higher the financial risk.
Generally, a ratio of 0.4 or 40% is considered to be a good debt ratio. The following is the formula to
calculate interest coverage ratio:

Short Term Debt+Long Term Debt


Total Debt to Total Assets =
Total Assets

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement,
ActivityFinancial
Ratios:Statement Analysis & Ratio Analysis
Receivable Turnover Ratio

It is an accounting measure to quantify a firm’s effectiveness in extending credit as well as collecting debts.
It measures how many times a business can turn its accounts receivable into cash during the reporting
period. In other words, it measures how many times a business can collect its average accounts receivable
during the year. A higher ratio here is more favorable for the business. This ratio is calculated using the
following formula:

Net Credit Sales


Receivable Turnover Ratio =
Average Accounts Receivable

Where,

Net Credit Sales = Total credit sales during the year net of discounts if any.

Opening Receivable+ Closing Receivable


Average Account Receivable =
2

Here, we may also be interested in calculating the average collection period of the firm. For that, the below
mention formula shall be used. The lower the average collection period, the better it is for the firm.

365 days
Average Collection Period =
Receivable Turnover Ratio

Inventory Turnover Ratio

Also known as Stock Turnover Ratio, it measures the number of times the inventory is sold or used in a
certain period of time. High inventory turnover is unhealthy as they represent an investment with a rate of
return of zero. Further, the company may face trouble in case the prices begin to fall. The following formula
is used to calculate this ratio:

Cost of Goods Sold


Inventory Turnover Ratio =
Average Inventory

Where,

Opening Inventory+ Closing Inventory


Average Inventory =
2

Here also we may calculate the average inventory holding period by using the below-mentioned formula.
The lower is the average number of days to sell the inventory, the better it is for the company.

365 days
Average Days to Sell the Inventory =
Inventory Turnover Ratio

Payables Turnover Ratio

Also known as Payables Turnover or the Creditor’s Turnover Ratio, measures the average number of times
a company pays its creditors in a certain period of time. A Low Payable Turnover signifies that a company
is slow in paying its supplier. The following formula is used to calculate this ratio:

Net Credit Purchases


Payables Turnover Ratio =
Average Accounts Payables

Where,

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial Statement Analysis
Opening & Ratio
Payables Analysis
+ Closing Payables
Average Accounts Payables =
2

Here also we may calculate the average payables period by using the below-mentioned formula. The higher
is the average number of days to make the payment, the better it is for the company.

365 days
Average Days to Pay =
Payables Turnover Ratio

Working Capital Turnover Ratio

The ratio is used to analyze the relationship between the money used to fund operations and the sales
generated from these operations. A higher working capital turnover means that the company is generating
huge sales compared to the money it uses to fund sales. This ratio is computed by the following formula:

Total Turnover
Working Capital Turnover Ratio =
Working Capital

Where,

Working Capital = Current Assets – Current Liabilities

Fixed Asset Turnover Ratio

It is the ratio of total turnover to the value of fixed assets. It indicates how well the business is using its
fixed assets to generate sales. A higher fixed assets turnover ratio indicates that the business is highly
efficient in using its fixed assets to generate revenue. A declining ratio may indicate that the business is
over-invested in fixed assets. It is calculated as follow:

Total Turnover
Fixed Asset Turnover Ratio =
Average Fixed Assets

Where,

Opening Fixed Assets + Closing Fixed Assets


Average Fixed Assets =
2

Profitability Ratios:
Gross Profit Margin:
It is a profitability ratio which shows the relationship between gross profit and total net sales revenue of the
company. Expressed in a percentage form, it is one of the popular ways to evaluate the operational
performance of the company.

Gross Profit
Gross Profit Margin =  100%
Total Sales or Turnover

Where,

Gross Profit = Opening Stock + Purchases + Direct Expenses – Closing Stock

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement,
Net ProfitFinancial
Margin Statement Analysis & Ratio Analysis
It refers to the percentage by which a company’s total sales or revenue exceeds or is less than the sum of
its expenses. A positive net profit margin in a reporting period signifies that the company has made more
money and vice-versa. It also means that the company has been able to better control its costs compared
to its competitors. This ratio is useful when we have to compare companies in similar industries. It is
calculated as under:

Net Profit
Net Profit Margin =  100%
Total Sales or Turnover

Operating Profit Margin


It measures the levels and rates of profitability. It indicates how much of each rupee of revenues is left over
after both costs of goods sold and operating expenses are considered. A higher operating margin is definitely
better. It is calculated by the following formula:

Operating Income
Operating Profit Margin =  100%
Total Turnover

Where,

Operating Income = Gross Profit – Operating Expenses

Return on Capital Employed (ROCE)


It measures a company’s profitability and the efficiency with which its capital is employed. It is highly useful
when we have to compare the profitability of a company with its peer company operating in the same
industries based on the amount of capital they use. However, the major drawback of this ratio is that it
measures return against the book value of assets in the business. Since these depreciate, the ROCE will
increase even though the cash flow has been the same. Therefore, the older business will tend to have a
better ROCE in comparison to a start-up / new business. Further, the book value of assets is not affected
by inflation while the cash flow is affected by inflation. Thus, the revenue increases with inflation while the
capital employed generally does not.

The Return on Capital Employed is calculated as:

Earnings before Interest and Taxes (EBIT)


Return on Capital Employed =
Average Capital Employed

Where,

EBIT = Gross Profit - Operating Expenses + Non-Operating Income

Opening Capital+ Closing Capital


Average Capital Employed =
2

Return on Assets (ROA)


It indicates the effectiveness of a company to use its assets to generate earnings before the contractual
obligations are met. It also indicates the capital intensity of the company, which will depend on the industry.
A company that requires large initial investments will have a lower return on ROA. Also, it is best to compare
it against a company’s previous ROA number or the ROA of a similar company. It is calculated as under:

Net Income
Return on Assets =
Average Total Assets

Where,

Opening Total Assets + Closing Total Assets


Average Total Assets =
2

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SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios
Statement, Financial
Price to Book RatioStatement Analysis & Ratio Analysis
(P/B Ratio)

This is a financial ratio used to compare a company’s current market price to its book value. Also known as
the Market-to-Book ratio, a higher P/B ratio implies that investors expect management to create more value
from a given set of assets other things remaining the same. However, this ratio does not directly provide
any information on the ability of the firm to generate profits or cash for the shareholders. The P/B ratio
calculated as follow:

Market Price per Share


Price to Book Ratio =
Book Value per Share

Where,

Total Assets +Total Liabilities


Book Value per share =
Total Number of Shares Outstanding

Earnings per Share (EPS)

It refers to a company’s profit allocated to each outstanding share of common stocks. It is also an indicator
of a company’s profitability. It is calculated as follows:

Profit after tax−Preference Dividend


Earnings per Share =
No of Shares Outstanding

Price-Earnings Ratio

A higher P/E ratio suggests that investors are expecting higher earnings growth in the future compared to
companies with a lower P/E. This ratio is useful when a comparison between firms under the same industry
is made. This is calculated as follows:

Market Price per Share


Price to Earnings Ratio =
Earnings per Share

Dividend Yield Ratio

It shows how much a company pays out in dividends each year relative to its share price. It is calculated as
follows:

Annual Dividend per Share


Dividend Yield Ratio =
Price per Share

Some Other Ratios


Altman Z - Score

The Z-score formula is used for predicting bankruptcy. It may be used for predicting the probability that a
firm will go into bankruptcy within two years. It can also predict corporate defaults and is an easy approach
to calculate the control measure for the financial distress status of companies. This ratio uses multiple
income and balance sheet values to measure the financial health of a company. A score of 1.80 or less
means that the company is heading for bankruptcy, while companies having a score of 3.0 and above are
not likely to go bankrupt. It is calculated as follows:

Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where,
A = Working Capital / Total Assets
B = Retained Earnings / Total Assets

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Statement,
C = EBIT /Financial Statement Analysis & Ratio Analysis
Total Assets
D = Market Value of Equity / Total Liabilities
E = Sales / Total Assets

Du-Pont Analysis:

It is an expression that breaks Return on Equity (ROE) into three parts, namely, Profitability, Operating
Efficiency, and Financial Leverage. This ratio helps an entity to locate the part of the entity which is under-
performing. It is calculated as follow:

Profit Turnover Assets


Du-Pont Analysis =  
Turnover Assets Equity

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