Key Pointers to Balance Sheet

and
Profit & Loss Statements

Compiled by :
Achin Nirwani
SPRG - North

Key Pointers to Balance Sheet and Profit & Loss Statements Page 1 of 17
 A balance sheet represents the financial affairs of the company and is also referred to as “Assets
and Liabilities” statement and is always as on a particular date and not for a period.

 A profit and loss account represents the summary of financial transactions during a particular
period and depicts the profit or loss for the period along with income tax paid on the profit and how
the profit has been allocated (appropriated).

 Net worth means total of share capital and reserves and surplus. This includes preference share
capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to
equity ratio, the necessary adjustment has to be done by reducing preference share capital from net
worth and adding it to the debt in the numerator.

 Reserves and surplus represent the profit retained in business since inception of business. “Surplus”
indicates the figure carried forward from the profit and loss appropriation account to the balance
sheet, without allocating the same to any specific reserve. Hence, it is mostly called “unallocated
surplus”. The company wants to keep a portion of profit in the free form so that it is available
during the next year for appropriation without any problem. In the absence of this arrangement
during the year of inadequate profits, the company may have to write back a part of the general
reserves for which approval from the board and the general members would be required.

 Secured loans represent loans taken from banks, financial institutions, debentures (either from public
or through private placement), bonds etc. for which the company has mortgaged immovable fixed
assets (land and building) and/or hypothecated movable fixed assets (at times even working capital
assets with the explicit permission of the working capital banks)

Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while
loans from banks for working capital, i.e., current assets are secured by current assets.
These loans enjoy priority over unsecured loans for settlement of claims against the
company.

 Unsecured loans represent fixed deposits taken from public (if any) as per the provisions of Section
58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit
Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been
offered.

Such unsecured loans rank second and subsequent to secured loans for settlement of
claims against the company. There are other unsecured creditors also, forming part of
current liabilities, like, creditors for purchase of materials, provisions etc.

 Gross block = gross fixed assets mean the cost price of the fixed assets. Cumulative depreciation in
the books is as per the provisions of The Companies Act, 1956, Schedule XIV. It is last cumulative
depreciation till last year + depreciation claimed during the current year. Net block = net fixed
assets mean the depreciated value of fixed assets.

 Capital work-in-progress – This represents advances, if any, given to building contractors, value of
building yet to be completed, advances, if any, given to equipment suppliers etc. Once the
equipment is received and the building is complete, the fixed assets are capitalised in the books, for
claiming depreciation from that year onwards. Till then, it is reflected in the form of capital work in
progress.

 Investments – Investment made in shares/bonds/units of Unit Trust of India etc. This type of
investment should be ideally from the profits of the organisation and not from any other funds,
which are required either for working capital or capital expenditure. They are bifurcated in the
schedule, into “quoted and traded” and “unquoted and not traded” depending upon the nature of
the investment, as to whether they can be liquidated in the secondary market or not.

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 Current assets – Both gross and net current assets (net of current liabilities) are given in the balance
sheet.

 Miscellaneous expenditure not written off can be one of the following –

Company incorporation expenses or public issue of share capital, debenture etc. together known as
“preliminary expenses” written off over a period of 5 years as per provisions of Income Tax. Misc.
expense could also be other deferred revenue expense like product launch expenses.

 Other income in the profit and loss account includes income from dividend on share investment
made in other companies, interest on fixed deposits/debentures, sale proceeds of special import
licenses, profit on sale of fixed assets and any other sundry receipts.

 Provision for tax could include short provision made for the earlier years.

 Provision for tax is made after making all adjustments for the following:

• Carried forward loss, if any;

• Book depreciation and depreciation as per income tax and
• Concessions available to a business entity, depending upon their activity (export business, S.S.I.
etc.) and location in a backward area (like Goa etc.)

 Other parts of annual statements –

1. The Directors’ Report on the year passed and the future plans;

2. Annexure to the Directors’ Report containing particulars regarding conservation of energy etc;

3. Auditors’ Report along with Annexure;

4. Schedules to Balance Sheet and Profit and Loss Account;

5. Accounting policies adopted by the company and notes on accounts giving details about changes if
any, in method of valuation of stocks, fixed assets, method of depreciation on fixed assets,
contingent liabilities, like guarantees given by the banks on behalf of the company, guarantees given
by the company, quantitative details regarding performance of the year passed, foreign exchange
inflow and outflow etc. and

6. Statement of cash flows for the same period for which final accounts have been presented.

There is a significant difference between the way in which the statements of accounts are prepared as
per Schedule VI of the Companies Act and the manner in which these statements, especially, balance
sheet is analysed by a finance person or an analyst. For example, in the Schedule VI, the current
liabilities are netted off against current assets and only net current assets are shown. This is not so in
the case of financial statement analysis. Both are shown fully and separately without any netting off.

At the end of any financial year, there are certain adjustments to be made in the books of accounts to
get the proper picture of profit or loss, as the case may be, for that particular period. For example, if
stocks of raw materials are outstanding at the end of the period, the value of the same has to be
deducted from the total of the opening stock (closing stock of the previous year) and the current year’s
purchases. This alone would show the correct picture of materials consumed during the current year.

For example, the figures for a company are as under:

♦ Purchases during the year: Rs.600lacs
♦ Opening stock of raw material: Rs.100lacs
♦ Closing stock of raw material: Rs.120lacs

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Then, the quantum of raw material consumed during the year is Rs.580lacs and only this can be booked
as expenditure during the year. Consumption is always valued in this manner and cross verified with the
value of materials issued from stores during the year to compare with the previous year;

Similarly, a second adjustment arises due to the difference between closing stocks of work-in-progress
and finished goods on one hand and opening stocks of work-in-progress and finished goods on the other
hand. Suppose the closing stocks are higher in value, the difference has to be either added to this year’s
income or deducted from this year’s expense. (Different ways of presentation). Similarly in case the
closing stocks are less than the opening stocks, the difference has to be deducted from income or added
to expenses for that year.

The principal tools of analysis are –

♦ Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it
with the past trend. In the statements of accounts, there are several such pairs of parameters and
hence ratio analysis assumes great significance. The most important thing to remember in the
case of ratio analysis is that you can compare two units in the same industry only and
other factors like the relative ages of the units, the scales of operation etc. come into
play.

♦ Funds flow analysis – this is to understand the movement of funds (please note the difference
between cash and fund – cash means only physical cash while funds include cash and credit) during
any given period and mostly this period is 1 year. This means that during the course of the year, we
study the sources and uses of funds, starting from the funds generated from activity during the
period under review.

Let us see some of the important types of ratios and their significance:

♦ Liquidity ratios;
♦ Turnover ratios;
♦ Profitability ratios;
♦ Investment on capital/return ratios;
♦ Leverage ratios and
♦ Coverage ratios.

Liquidity ratios:

o Current ratio: Formula = Current assets/Current liabilities.

Min. Expected even for a new unit in India = 1.33:1.

Significance = Net working capital should always be positive. In short, the higher the net working
capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate
liquidity of the enterprise.
Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This
means that we are carrying either cash in large quantities or inventory in large quantities or
receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you
compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working
capital.

Range – No fixed range is possible. Unless the activity is very profitable and there are no immediate
means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an

Key Pointers to Balance Sheet and Profit & Loss Statements Page 4 of 17
 examination of the profitability of the operations and the need for high level of current assets.
Reason = net working capital could mean that external borrowing is involved in this and hence cost
goes up in maintaining the net working capital. It is only a broad indication of the liquidity of
the company, as all assets cannot be exchanged for cash easily and hence for a more
accurate measure of liquidity, we see “quick asset ratio” or “acid test ratio”.

o Acid test ratio or quick asset ratio:

Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This
assumes that all other current assets like receivables can be converted into cash easily. This ratio
examines whether the quick assets are sufficient to cover all the current liabilities. Some of the
authors indicate that the entire current liabilities should not be considered for this purpose and only
quick liabilities should be considered by deducting from the current liabilities the short-term bank
borrowing, as usually for an on going company, there is no need to pay back this amount, unlike the
other current liabilities.

Significance = coverage of current liabilities by quick assets. As quick assets are a part of current
assets, this ratio would obviously be less than current ratio. This directly indicates the degree
of excess liquidity or absence of liquidity in the system and hence for proper measure of
liquidity, this ratio is preferred. The minimum should be 1:1. This should not be too high as the
opportunity cost associated with high level of liquidity could also be high.

What is working capital gap? The difference between all the current assets known as “Gross
working capital” and all the current liabilities other than “bank borrowing”. This gap is met from one
of the two sources, namely, net working capital and bank borrowing. Net working capital is hence
defined as medium and long-term funds invested in current assets.

Turnover ratios:

Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the higher the
degree of efficiency and hence these assume significance. Further, depending upon the type of turn
over ratio, indication would either be about liquidity or profitability also. For example, inventory or
stocks turn over would give us a measure of the profitability of the operations, while receivables turn
over ratio would indicate the liquidity in the system.

o Debtors turn over ratio – this indicates the efficiency of collection of receivables and
contributes to the liquidity of the system. Formula = Total credit sales/Average debtors
outstanding during the year. Hence the minimum would be 3 to 4 times, but this depends
upon so many factors such as, type of industry like capital goods, consumer goods – capital
goods, this would be less and consumer goods, this would be significantly higher;
Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and
competitive it would be less as you are forced to give credit;

Whether new enterprise or established – new enterprise would be required to give higher credit in
the initial stages while an existing business would have a more fixed credit policy evolved over the
years of business;
Hence any deterioration over a period of time assumes significance for an existing business – this
indicates change in the market conditions to the business and this could happen due to general
recession in the economy or the industry specifically due to very high capacity or could be this unit
employs outmoded technology, which is forcing them to dump stocks on its distributors and hence
realisation is coming in late etc.

o Average collection period = inversely related to debtors turn over ratio. For example debtors
turn over ratio is 4. Then considering 360 days in a year, the average collection period would be
90 days. In case the debtors turn over ratio increases, the average collection period would

Key Pointers to Balance Sheet and Profit & Loss Statements Page 5 of 17
 reduce, indicating improvement in liquidity. Formula for average collection period =
360/receivables turn over ratio. The above points for debtors turn over ratio hold good for this
also. Any significant deviation from the past trend is of greater significance here than the
absolute numbers. No minimum and no maximum.

o Inventory turn over ratio – as said earlier, this directly contributes to the profitability of the
organisation. Formula = Cost of goods sold/Average inventory held during the year. The
inventory should turn over at least 4 times in a year, even for a capital goods industry. But
there are capital goods industries with a very long production cycle and in such cases, the ratio
would be low. While receivables turn over contributes to liquidity, this contributes to profitability
due to higher turn over. The production cycle and the corporate policy of keeping high stocks
affect this ratio. The less the production cycle, the better the ratio and vice-versa. The higher
the level of stocks, the lower would be the ratio and vice-versa. Cost of goods sold = Sales –
profit – Interest charges.

o Current assets turn over ratio – not much of significance as the entire current assets are
involved. However, this could indicate deterioration or improvement over a period of time.
Indicates operating efficiency. Formula = Cost of goods sold/Average current assets held in
business during the year. There is no min. Or maximum. Again this depends upon the type of
industry, market conditions, management’s policy towards working capital etc.

o Fixed assets turn over ratio

Not much of significance as fixed assets cannot contribute directly either to liquidity or
profitability. This is used as a very broad parameter to compare two units in the same industry
and especially when the scales of operations are quite significant. Formula = Cost of goods
sold/Average value of fixed assets in the period (book value).

Profitability ratios -Profit in relation to sales and profit in relation to assets:

o Profit in relation to sales – this indicates the margin available on sales;

o Profit in relation to assets – this indicates the degree of return on the capital employed in
business that means the earning efficiency. Please appreciate that these two are totally
different.

For example, we will study the following;

Units A and B are in the same type of business and operate at the same levels of capacities. Unit A
employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and profits are as
under:
Parameters Unit A Unit B
Sales 1000lacs 1000lacs
Profits 100lacs 90lacs
Profit margin on sales 10% 9%
Return on capital employed 40% 45%
While Unit A has higher profit margins, Unit B has better returns on capital employed.

o Profit margin on sales:

Gross profit margin on sales and net profit margin ratio –

Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of
production before selling, general, administrative expenses and interest charges. Net sales = Gross
sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with

Key Pointers to Balance Sheet and Profit & Loss Statements Page 6 of 17
 another unit in the same industry or in the same unit for comparing it with past trend. For example
in Unit A and Unit B let us assume that the sales are same at Rs.100lacs.

Parameters Unit A Unit B

Sales 100lacs 100lacs

Cost of production 60lacs 65lacs
Gross profit 40lacs 35lacs
Deduct: Selling general,
Administrative expenses and interest 35lacs 30lacs
Net profit 5lacs 5lacs

While both the units have the same net profit to sales ratio, the significant difference lies in the fact
that while Unit A has less cost of production and more office and selling expenses, Unit B has more
cost of production and less of office and selling expenses. This ratio helps in controlling either
production costs if cost of production is high or selling and administration costs, in case these are
high.

Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula
= Net profit/net sales. Tax rate being the same, this ratio indicates operating efficiency directly in
the sense that a unit having higher net profitability percentage means that it has a higher operating
efficiency. In case there are tax concessions due to location in a backward area, export activity etc.
available to one unit and not available to another unit, then this comparison would not hold well.

Investment on capital ratios/Earnings ratios:

o Return on net worth

Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds including
Preference Share capital. Hence Preference Share capital is not deducted. There is no standard
range for this ratio. If it reduces it indicates less return on the net worth.

o Return on equity
Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share
capital. Although reference is equity here, all equity shareholders’ funds are taken in the
denominator. Hence Preference dividend and Preference share capital are excluded. There is no
standard range for this ratio. If it comes down over a period it means that the profitability of the
organisation is suffering a setback.

o Return on capital employed (pre-tax)

Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This
gives return on long-term funds employed in business in pre-tax terms. Again there is no
standard range for this ratio. If it reduces, it is a cause for concern.

o Earning per share (EPS)

Dividend per share (DPS) + Retained earnings per share (REPS). Here the share refers to equity
share and not preference share. The formula is = Profit after tax (-) Preference dividend (-)
Dividend tax both on preference and equity dividend / number of equity shares. This is an
important indicator about the return to equity shareholder. In fact P/E ratio is related to this, as
P/E ratio is the relationship between “Market value” of the share and the EPS. The higher the PE
the stronger is the recommendation to sell the share and the lower the PE, the stronger is the
recommendation to buy the share.

This is only indicative and by and large followed. There is something known as industry average
EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry
average and growth prospects are quite good, it is the time for buying the shares, unless we
know for certain that the price is going to come down further. If on the other hand, the P/E ratio

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 of the unit is more than industry average P/E, it is time for us to sell unless we expect further
increase in the near future.

Leverage ratios

Leverages are of two kinds, operating leverage and financial leverage. However, we are
concerned more with financial leverage. Financial leverage is the advantage of debt over equity
in a capital structure. Capital structure indicates the relationship between medium and long-term
debt on the one hand and equity on the other hand. Equity in the beginning is the equity share
capital. Over a period of time it is net worth (-) redeemable preference share capital.

It is well known that EPS increases with increased dose of debt capital within the same capital
structure. Given the advantage of debt also, as even risk of default, i.e., non-payment of interest
and non-repayment of principal amount increases with increase in debt capital component, the
market accepts a maximum of 2:1 at present. It can be less. Formula for debt/equity ratio =
Medium and long-term loans + redeemable preference share capital / Net worth (-) Redeemable
preference share capital.

From the working capital lending banks’ point of view, all liabilities are to be included in debt.
Hence all external liabilities including current liabilities are taken into account for this ratio. We
have to add redeemable preference share capital and reduce from the net worth the same as in
the previous formula.

Coverage ratios

o Interest coverage ratio

This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest
payment on all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1. Less than
that is not desirable, as after paying interest, tax has to be paid and afterwards dividend and
dividend tax.

o Asset coverage ratio

This indicates the number of times the medium and long-term liabilities are covered by the book
value of fixed assets.
Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. Accepted
ratio is minimum 1.5:1. Less than that indicates inadequate coverage of the liabilities.

o Debt Service coverage ratio

This indicates the ability of the business enterprise to service its borrowing, especially medium
and long-term. Servicing consists of two aspects namely, payment of interest and repayment of
principal amount. As interest is paid out of income and is booked as an expense, in the formula
it gets added back to PAT. The assumption here is that dividend is ignored. In case dividend is
paid out, the formula gets amended to deduct from PAT dividend paid and dividend tax.

Formula:

(Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue Expenditure written off
(+) Interest on medium and long-term borrowing
_______________________________________________________________________

(Denominator) Interest on medium and long-term borrowing (+) Instalment on medium and
long-term borrowing.

This is assuming that dividend is not paid. In the case of an existing company dividend will have
to be paid and hence in the numerator, instead of PAT, retained earnings would appear. The
above ratio is calculated for the entire period of the loan with the bank/financial institution. The

Key Pointers to Balance Sheet and Profit & Loss Statements Page 8 of 17
 minimum acceptable average for the entire period is 1.75:1. This means that in one year this
could be less but it has to be made up in the other years to get an average of 1.75:1.
What is the objective behind analysis of financial statements?
Objective (To know about)
1. Financial position of the company
2. Liquidity of the company, i.e., whether
the company is in a position to meet all
its short-term liabilities (also called
“current liabilities”) with the help of its
current assets
3. Whether the company has acquired new
fixed assets during the year and if so,
what are the sources, besides internal
accruals to finance the same?
4. Profitability of the company in general
and operating profits in particular, i.e.,
whether the main operations of the
company like manufacturing have been
in profit or the profit of the company is
derived from other income, i.e., income
from investment in shares/debentures
etc.
Key Pointers to Balance Sheet and Profit & Loss Statements
Relevant indicator/Remarks
Net worth, i.e., share capital, reserves and
unallocated surplus in balance sheet carried down
from profit and loss appropriation account. For a
healthy company, it is necessary that there is a
balance struck between dividend paid and profit
retained in business so much the net worth keeps
on increasing.
Current ratio and quick ratio or acid test ratio.
Current ratio = Current assets/current liabilities.
Quick ratio = Current assets (-) inventory/
current liabilities. Current ratio should not be too
high like 4:1 or 5:1 or too low like less than
1.5:1. This means that the company is either too
liquid thereby increasing its opportunity cost or
not liquid at all, both of which are not desirable.
Quick ratio could be at least 1:1. Quick ratio is a
better indicator of liquidity position.
Examination of increase in secured or unsecured
loans for this purpose. Without adequate
financial planning, there is always the risk of
diverting working capital funds for fixed assets.
This is best assessed through a funds flow
statement for the period as even net cash
accruals (Retained earnings + depreciation +
amortisation) would be available for fixed assets.
Percentage of profit before tax to total income
including other income, like dividend or interest
income. Operating profit, i.e., profit before tax
(-) other income as above as a percentage of
income from the main operations of the
company, be it manufacturing, trading or
services.
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5. Relationship between the net worth of
the company and its external liabilities
(both short-term and long-term). What
about only medium and long-term
debts?
6. Has the company’s investments in
shares/debentures of other companies
reduced in value in comparison with
last year?
7. Relationship between average debtors
(bills receivable) and average creditors
(bills payable) during the year.
Key Pointers to Balance Sheet and Profit & Loss Statements
Debt/Equity ratio, which establishes this
relationship. Formula = External liabilities +
preference share capital /net worth of the
company (-) preference share capital
(redeemable kind). From the lender’s point of
view, this should not exceed 3:1. Is there any
sharp deterioration in this ratio? Is so, please be
on guard, as the financial risk for the company
increases to that extent.
For only medium and long-term debts, it cannot
exceed 2:1.
Difference between the market value of the
investments and the purchase price, which is
theoretically a loss in value of the investment.
Actual loss is booked upon only selling. The
periodic reduction every year should warn us that
at the time of actual sales, there would be
substantial loss, which immediately would reduce
the net worth of the company. Banks, Financial
Institutions, Investment companies or NBFCs
would be required to declare their investment
every year in the balance sheet at cost price or
market price whichever is less.
Average debtors in the year/average creditors in
the year. This should be greater than 1:1, as
bills receivable are at gross value {cost of
development (+) profit margin}, whereas;
creditors are at purchase price for software or
components, which would be much less than the
final sales value. If it is less than 1:1, it shows
that while receivable management is quite good,
the company is not paying its creditors, which
could cause problems in future. Too high a ratio
would indicate that receivable management is
very poor.
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8. Future plans of the company, like
acquisition of new technology, entering
into new collaboration agreement,
diversification programme, expansion
programme etc.
9. Has the company re-valued its fixed Auditors’ comments in the “Notes to Accounts”
assets during the year, thereby creating
revaluation reserves, without any
inflow of capital into the company, as
this is just an entry passed in the
books?
10. Whether the company has increased its
investment and if so, what is the source
for it? What is the nature of
investment? Is it in tradable securities
or long-term
Securities, which can have a lock-in-
period and cannot be liquidated in the
near future?
11. Has the company during the year given
any unsecured loans substantially other
than to employees of the company?
12. Are the company’s unsecured loans
(given) not recoverable and very old?
13. Has the company been regular in
payment of its dues on account of loans
or periodic interest on its liabilities?
14. Has the company defaulted in providing
for bonus liability, P.F. liability, E.S.I.
liability, gratuity
liability etc?
Key Pointers to Balance Sheet and Profit & Loss Statements
Directors’ report. This would reveal the financial
plans for the company, like whether they are
coming out with a public issue/Rights issue etc.
relevant for this. Frequent revaluation is not
desirable and healthy.
Increase in amount of investment in
shares/debentures/Govt. securities etc. in
comparison with last year and any investment
within group companies? Any undue increase in
investment should put us on guard, as working
capital funds could have been diverted for it.
Any increase in unsecured loans. If the loans are
to group companies, then all the more reason to
be cautious. Hence, where the figures have
increased, further probing is called for.
Any comments to this effect in the notes to
accounts should put us on caution. This
examination would indicate about likely impact
on the future profits of the company.
Any comments about over dues as in the “Notes
to Accounts” should be looked into. Any serious
default is likely to affect the “credit rating” of the
company with its lenders, thereby increasing its
cost of borrowing in future.
Any comments about this in the “Notes to
Accounts” should be looked into.
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15. Whether the company is holding very
huge cash, as it is not desirable and
increases the opportunity cost?
16. How many times the average inventory
has turned over during the year?
17. Has the company issued fresh share
capital during the period and what is
the purpose for which it has raised
equity capital? If it was a public issue,
how did it fare in the market?
18. Has the company issued any bonus
shares during the year?
19. Has the company made any rights issue
in the period and what is the purpose of
the issue? If it was a public issue, how
did it fare in the market?
20. What is the proportion of marketable
investment to total investment and
whether this has decreased in
comparison with the previous year?
21. What is the increase in sales income
over last year in % terms? Is it due to
increase in numbers or change in
product mix or increase in prices of
finished products only?
22. What is the amount of provision for bad
Key Pointers to Balance Sheet and Profit & Loss Statements
Cash balance together with bank balance in
current account, if any, is very high in the current
assets.
Relationship between cost of goods sold and
average inventory during the year (only where
cost of goods sold cannot be determined, net
sales can be taken as the numerator). In a
manufacturing company, which is not in capital
goods sector, this should not be less than 4:1
and for a consumer goods industry, this should
be higher even. For a capital goods industry, this
would be less.
Increase in paid-up capital in the balance sheet
and share premium reserves in case the issue
has been at a premium.
Increase in paid-up capital and simultaneous
reduction in general reserves. Enquiry into the
company’s ability to keep up the dividend rate of
the immediate past.
Increase in paid-up capital and share premium
reserves, in case the issue has been at a
premium.
Percentage of marketable investment to total
investment and comparison with previous year.
Any decrease should put us on guard, as it
reduces liquidity on one hand and increases the
risk of non-payment on due date, especially if the
investment is in its own subsidiary or group
companies, thereby forcing the company to
provide for the loss.
Comparison with previous year’s sales income
and whether the growth has been more or less
than the estimate.
In percentage terms, how much is it of total
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 and doubtful debts or advances
outstanding?
23. What is the amount of work in progress
as shown in the Profit and Loss
Account?
24. Whether the company is paying any
lease rentals and if so what is the
amount of lease liability outstanding?
25. Has the company changed its method of
depreciation on fixed assets, due to
which, there is an impact on the profits
of the company?
26. If it is a manufacturing company,
whether the % of materials consumed
is increasing in relation to sales?
27. Has the company changed its method of
valuation of inventory, due to which
there is an impact of the profits of the
company?
28. Whether the % of administration and
general expenses has increased during
the year under review?
29. Whether the company had sufficient
income to pay the interest charges?
Key Pointers to Balance Sheet and Profit & Loss Statements
debts outstanding and what are the reasons for
such provision in the notes to accounts by the
auditors?
Is there any comment about valuation of work in
progress by the auditors? It can be seen that
profit from operations can be manipulated by
increase/decrease in closing stocks of both
finished goods and work in progress.
Examination of expenses schedule would show
this. What is the comment in notes to accounts
about this? Lease liability is an off-balance sheet
item and hence this examination, to ascertain the
correct external liability and to include the lease
rentals in future also in projected income
statements; otherwise, the company may be
having much less disclosed liability and much
more lease liability which is not disclosed. This
has to be taken into consideration by an analyst
while estimating future expenses for the purpose
of estimating future profits.
Auditors’ comments on “Accounting” policies.
Change over from straight-line method to written
down value method or vice-versa does affect the
deprecation charge for the year thereby affecting
the profits during the year of change.
Relationship between materials consumed during
the year and the sales.
Auditors’ comments on “Accounting” policies.
Relationship between general and administrative
expenses during the year and the sales. In case
there is any extraordinary increase, what are the
reasons therefore?
Interest coverage ratio = earnings before interest
and tax/total interest on all short-term and long-
Page 13 of 17

30. Whether the finance charges have gone
up disproportionately as compared with
the increase in sales income during the
same period?
31. Whether the % of employee costs to
sales has increased?
32. Whether the % of selling expenses in
relation to sales has gone up?
33. Whether the company had sufficient
internal accruals {Profit after tax (-)
dividend (+) any non-cash expenditure
like depreciation, preliminary expenses
write-off etc.} to meet repayment
obligation of principal amount of loans,
debentures etc.?
34. Return on investment in business to
compare it with return on similar
investment elsewhere.
Key Pointers to Balance Sheet and Profit & Loss Statements
term liabilities. Minimum should be 3:1 and
anything less than this is not satisfactory.
Relationship between interest charges and sales
income – whether it is consistent with the
previous year or is there any spurt?
Is there any explanation for this, like substantial
expansion or new project or diversification for
which the company has taken financial
assistance? While a benchmark % is not
available, any level in excess of 6% calls for
examination.
Relationship between “payment to and provision
for employees” and the sales. In case any undue
increase is seen, it could be due to expansion of
activity etc. that would be included in the
Directors’ Report.
Relationship between “selling and marketing”
expenses and the sales. Any undue increase
could either mean that the company is in a very
competitive industry or it is aggressive to
increase its market share by adopting a
marketing strategy that would increase the
marketing expenses including offer of higher
commission to the intermediaries like agents etc.
Debt service coverage ratio = Internal accruals
(+) interest on medium and long-term external
liabilities/interest on medium and long-term
liabilities (+) repayment of medium and long-
term external liabilities. The term-lending
institution or bank looks for 1.75:1 on an average
for the loan period. This is a very critical ratio to
indicate the ability of the company to take care of
its obligation towards the loans it has taken both
by way of interest as well as repayment of the
principal.
Earnings before interest and tax/average total
invested capital, i.e., net worth (+) debt capital.
This should be higher than the average cost of
funds in the form of loans, i.e., interest cost on
loans/debentures etc.
Page 14 of 17
35. Return on equity (includes reserves and
surplus)
36. How much earning has our share made?
(EPS)
37. Whether the company has reduced its
dividend payout in comparison with last
year?
38. Is there any significant increase in the
contingent liabilities due to any of the
following?
Disputed central excise duty, customs
duty, income tax, octroi, sales tax,
contracts remaining unexecuted,
guarantees given by the banks on
behalf of the company as well as the
guarantees given by the company on
behalf of its subsidiary or associate
company, letter of credit outstanding
for which goods not yet received etc.
39. Has the company changed its policy of
outsourcing its work from vendors and if
so, what are the reasons?
Key Pointers to Balance Sheet and Profit & Loss Statements
Profit after tax (-) dividend on preference share
capital/net worth (-) preference share capital
(return in percentage). Anything less than 15%
means that our investment in this company is
earning less than the average return in the
market.
Profit after tax (-) dividend on preference share
capital/number of equity shares. In terms of
percentage anything less than 40% to 50% of
the face value of the shares would not go well
with the market sentiments.
Relationship between amount of dividend payout
and profit after tax last year and this year. Is
there any reason for this like liquidity crunch that
the company is experiencing or the need for
conserving cash for business activity, like
purchase of fixed assets in the immediate future?
“Notes on Accounts” as given at the end of the
accounts.
Any substantial increase especially in disputed
amount of duties should put us on guard.
Substantial change in vendor charges, or
subcontracting charges.
Page 15 of 17
40. Is there any substantial increase in Increase in consultancy charges.
charges paid to consultants?

41. Has the company opened any branch Directors’ Report or sudden spurt in general and
office in the last year? administration expenses.

Key Pointers to Balance Sheet and Profit & Loss Statements Page 16 of 17
The principal tools of analysis are:

♦ Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it
with the past trend. In the statements of accounts, there are several such pairs of parameters and
hence ratio analysis assumes great significance. The most important thing to remember in the
case of ratio analysis is that you can compare two units in the same industry only and
other factors like the relative ages of the units, the scales of operation etc. come into
play.

♦ Comparison with past trend within the same company is one type of analysis and comparison with
the industrial average is another analysis

While one can derive a lot of useful information from analysis of the financial statements,
we have to keep in mind some of the limitations of the financial statements. Analysis of
financial statements does indicate a definite trend, though not accurately, due to the
intrinsic nature of the data itself.

Some of the limitations of the financial statements are given below.

 Analysis and understanding of financial statements is only one of the tools in understanding of the
company
 The annual statements do have great limitations in their value, as they do not speak about the
following-
 Management, its strength, inadequacy etc.
 Key personnel behind the activity and human resources in the organisation.
 Average key ratios in the industry in the country, of which the company is an integral part. This
information has to be obtained separately.
 Balance sheet is as on a particular date and hence it does not indicate about the average for the
entire year. Hence it cannot indicate the position with 100% reliability. (Link it with fundamental
analysis.)
 The auditors’ report is based more on information given by the management, company personnel
etc.
 To an extent at least, there can be manipulation in the level of expenditure, level of closing stocks
and sales income to manipulate profits of the organisation, depending upon the requirement of the
management during a particular year.

Key Pointers to Balance Sheet and Profit & Loss Statements Page 17 of 17