Analysis of financial

statements
 Tools and techniques of FSA
1. Ratio Analysis
2. Comparative financial statements
3. Common-size financial statements
4. Trend percentages
5. Funds flow analysis
6. Cash flow analysis
7. CVP Analysis
 Ratio analysis
 Is a method or process by which the
relationship of items or groups of items in the
financial statements are computed, and
presented.
 Is an important tool of financial analysis.
 Is used to interpret the financial statements so
that the strengths and weaknesses of a firm, its
historical performance and current financial
condition can be determined.
 Ratio
 ‘A mathematical yardstick that measures
the relationship between two figures or
groups of figures which are related to
each other and are mutually inter-
dependent’.
 It can be expressed as a pure ratio,
percentage, or as a rate
 Words of caution
 A ratio is not an end in itself. They are only a
means to get to know the financial position of
an enterprise.
 Computing ratios does not add any information
to the available figures.
 It only reveals the relationship in a more
meaningful way so as to enable us to draw
conclusions there from.
 Utility of Ratios
 Accounting ratios are very useful in
assessing the financial position and
profitability of an enterprise.

 However its utility lies in comparison of

the ratios.
 Utility of Ratios
 Comparison may be in any one of the following
forms:
 For the same enterprise over a number of years
 For two enterprises in the same industry
 For one enterprise against the industry as a whole
 For one enterprise against a pre-determined standard
 For inter-segment comparison within the same
organisation
 Classification of Ratios
Traditional Modern/Functional
 Profit & loss Account  Liquidity/Solvency ratios
ratios  Capital
 Balance Sheet Ratios structure/leverage
 Composite Ratio ratios/Capitalisation
ratios
 Profitability/Earnings
ratios
 Activity ratios/turnover
ratios/efficiency ratios
 Market ratios
 Liquidity ratios(times)
These ratios analyse the short-term financial
position of a firm and indicate the ability of the firm
to meet its short-term commitments (current
liabilities) out of its short-term resources (current
assets).
These are also known as ‘short term solvency
ratios’. The ratios which indicate the liquidity of a
firm are:
1. Current ratio
2. Liquid ratio or Quick ratio or acid test ratio
3. Absolute liquid or super quick ratio or cash
position ratio`
 L1. Current ratio

It is calculated by dividing current assets by

current liabilities.
Current ratio = Current assets where
Current liabilities
Conventionally a current ratio of 2:1 is
considered satisfactory
 CURRENT ASSETS
include –
Inventories of raw material, WIP, finished goods,
stores and spares,
sundry debtors/receivables,
short term loans deposits and advances,
cash in hand and bank,
prepaid expenses,
incomes receivables and
marketable investments and short term securities.
 CURRENT LIABILITIES
include –
sundry creditors/bills payable,
outstanding expenses,
unclaimed dividend,
advances received,
incomes received in advance,
provision for taxation,
proposed dividend,
instalments of loans payable within 12 months,
bank overdraft and cash credit
 L2.Quick Ratio or Acid Test or
liquid Ratio
This is a ratio between quick current assets and current
liabilities (alternatively quick liabilities).
It is calculated by dividing quick current assets by
current liabilities (quick current liabilities)
Quick ratio = quick assets where
Current liabilities/(quick liabilities)

Conventionally a quick ratio of 1:1 is considered

satisfactory.
 QUICK ASSETS & QUICK
LIABILITIES
QUICK ASSETS are current assets (as stated
earlier) less prepaid expenses and inventories.

QUICK LIABILITIES are current liabilities (as

stated earlier) less bank overdraft and incomes
received in advance.
 L3.Absolute liquid Ratio
This is a ratio between Cash & Marketable securities
and current liabilities (alternatively quick liabilities).
Absolute liquid Ratio= Cash + Marketable Securities
Current liabilities/(quick liabilities)

Conventionally a quick ratio of 0.75:1 is considered

satisfactory.
 Capital structure/ leverage
ratios/long term solvency(times)
These ratios indicate the long term solvency
of a firm and indicate the ability of the firm
to meet its long-term commitment with
respect to
(i) Debt and Equity
(ii) repayment of principal on maturity or in
predetermined instalments at due dates and
(iii) periodic payment of interest during the
period of the loan.
 Capital structure/ leverage /long
term solvency/coverage ratios
Capital Structure Ratios:
1. Debt equity ratio
2. Proprietary ratio
3. Debt to total capital ratio
4. Total debt to total assets ratio
5. Long term debt to total assets ratio
6. Interest coverage ratio
7. Preference dividend cover ratio
8. Debt service coverage ratio
9. Capital Gearing Ratio
 C1. Debt equity ratio
This ratio indicates the relative proportion of debt and
equity in financing the assets of the firm. It is
calculated by dividing long-term debt by shareholder’s
funds.
Debt equity ratio = long-term debts where
Shareholders funds
Generally, financial institutions favour a ratio of 2:1.

However this standard should be applied having regard

to size and type and nature of business and the degree of
risk involved.
 Where..
LONG-TERM FUNDS are long-term loans whether
secured or unsecured like – debentures, bonds, loans
from financial institutions etc.

SHAREHOLDER’S FUNDS are equity share

capital plus preference share capital plus reserves and
surplus minus fictitious assets (eg. Preliminary
expenses, past accumulated losses, discount on issue
of shares etc.)
 C2.Proprietary ratio
This ratio indicates the general financial strength of the
firm and the long- term solvency of the business.
This ratio is calculated by dividing proprietor’s funds by
total funds.
Proprietary ratio = Shareholder’s funds
Total Tangible funds/Assets
As a rough guide a 65% to 75% proprietary ratio is
advisable
 Where…
PROPRIETOR’S FUNDS are same as
explained in shareholder’s funds

TOTAL FUNDS are all fixed assets and all

current assets.
Alternatively it can be calculated as
proprietor’s funds plus long-term funds plus
current liabilities.
 C3.Debt to total capital ratio
In this ratio the outside liabilities are related to
the total capitalisation of the firm. It indicates
what proportion of the permanent capital of the
firm is in the form of long-term debt.
Debt to total capital ratio =long- term debt
Shareholder’s funds + long- term debt
Conventionally a ratio of 2/3 is considered
satisfactory.
 C4.Total Debt to Total Assets
Ratio
 It indicates that the company has sufficient
assets to meet its debt obligation i.e. Fixed &
Current liabilities.

= Total Debt
Total Assets
 C5. Long Term debt to Assets
Ratio
 This ratio indicates the amount of borrowings
against the assets used in the business

= Long term debt

Total Assets
 C6.Interest coverage ratio
This ratio measures the debt servicing capacity of a firm
in so far as the fixed interest on long-term loan is
concerned. It shows how many times the interest
charges are covered by EBIT out of which they will be
paid.
Interest coverage ratio = EBIT
Interest
A ratio of 6 to 7 times is considered satisfactory.
Higher the ratio greater the ability of the firm to pay
interest out of its profits. But too high a ratio may
imply lesser use of debt and/or very efficient operations
C7.Preference dividend Coverage
ratio
 This Ratio measures the prompt payment of
preference dividend by the company

 Preference dividend coverage ratio =

Net profit after Tax
Preference Dividend
 C8.Debt service coverage ratio
This is a more comprehensive measure to compute the
debt servicing capacity of a firm. It shows how many
times the total debt service obligations consisting of
interest and repayment of principal in instalments are
covered by the total operating funds after payment of
tax.
Debt service coverage ratio =
EBIT
(Interest + principal instalment)
(1-T)
EBIT= Earnings before interest & tax
Generally financial institutions consider 2:1 as a
satisfactory ratio.
 C9.Capital Gearing Ratio

Capital Gearing Ratio =

Fixed Interest bearing funds

Equity Shareholder’s fund
 Profitability ratios(%)
These ratios measure the operating efficiency of
the firm and its ability to ensure adequate returns
to its shareholders.
The profitability of a firm can be measured by its
profitability ratios.

Further the profitability ratios can be determined

(i) in relation to sales and
(ii) in relation to investments
 Profitability ratios/margin
Profitability ratios in relation to sales:
1. gross profit margin/ratio
2. Operating profit Margin/ratio
3. Net profit Ratio/margin
4. Expenses ratio
Profitability ratios in relation to investments
5. Return on Investment (ROI)
6. Return on capital employed (ROCE)
7. Return on shareholder’s equity (RONW)
8. Return on ordinary shareholders equity
9. Return on Equity (ROE)
10. Return on assets (ROA)
 P1.Gross profit margin

This ratio is calculated by dividing gross

profit by sales. It is expressed as a percentage.

Gross profit is the result of relationship

between prices, sales volume and costs.
Gross profit margin = gross profit x 100
Net sales
 Gross profit margin
 A firm should have a reasonable gross profit
margin to ensure coverage of its operating
expenses and ensure adequate return to the
owners of the business ie. the shareholders.
 To judge whether the ratio is satisfactory or
not, it should be compared with the firm’s past
ratios or with the ratio of similar firms in the
same industry or with the industry average.
 P2. Operating profit margin
Another variant of net profit margin is operating
profit margin which is calculated as:
Operating Profit Margin =
Net profit before interest and tax-Non OI x 100
Net sales
Higher the ratio, greater is the capacity of the
firm to withstand adverse economic conditions
and vice versa
 P3. Net profit margin
This ratio is calculated by dividing net profit by sales.
It is expressed as a percentage.
This ratio is indicative of the firm’s ability to leave a
margin of reasonable compensation to the owners for
providing capital, after meeting the cost of production,
operating charges and the cost of borrowed funds.
Net profit margin =
Net profit after interest and tax x 100
Net sales
 P4. Expenses ratio
These ratios are calculated by dividing the various expenses by
sales. The variants of expenses ratios are:
Material consumed ratio = Material consumed x 100
Net sales
Manufacturing expenses ratio = manufacturing expenses x 100
Net sales
Administration expenses ratio = administration expenses x 100
Net sales
Selling & distrn expenses ratio = Selling expenses x 100
Net sales
Operating ratio = cost of goods sold + operating expenses x 100
Net sales
Financial expense ratio = financial expenses x 100
Net sales
 Expenses ratio
 The expenses ratios should be compared
over a period of time with the industry average
as well as with the ratios of firms of similar
type. A low expenses ratio is favourable.
 The implication of a high ratio is that only
a small percentage share of sales is available
for meeting financial liabilities like interest,
tax, dividend etc.
 P5. Return on Investment (ROI)/
Return on Net Assets
This ratio measures the relationship between operating profit and
capital employed. It indicates how efficiently the long-term
funds of owners and creditors are being used.
Return on Investment =
Net profit plus Interest x 100
Capital employed/Total Investment
CAPITAL EMPLOYED denotes
shareholders funds + long-term borrowings
OR
Calculated as Total assets- current liabilities
 P6. Return on capital employed
(ROCE)
This ratio measures the relationship between net profit and capital
employed. It indicates how efficiently the long-term funds of
owners and creditors are being used.
Return on capital employed =
EBIT x 100
Capital employed
CAPITAL EMPLOYED denotes shareholders funds and long-
term borrowings.
To have a fair representation of the capital employed, average
capital employed may be used as the denominator.
P7. Return on shareholders
equity
This ratio measures the relationship of profits to
owner’s funds. Shareholders fall into two groups
i.e. preference shareholders and equity
shareholders. So the variants of return on
shareholders equity are

Return on total shareholder’s equity =

net profits after taxes x 100
Total shareholders equity
.
 TOTAL SHAREHOLDER’S EQUITY
includes preference share capital plus equity
share capital plus reserves and surplus less
accumulated losses and fictitious assets. To
have a fair representation of the total
shareholders funds, average total shareholders
funds may be used as the denominator
 P8. Return on ordinary
shareholder’s equity
Return on ordinary shareholders equity =
net profit after taxes – pref. dividend x 100
Ordinary shareholders equity or net worth

ORDINARY SHAREHOLDERS EQUITY

OR NET WORTH includes equity share capital
plus reserves and surplus minus fictitious assets.
 P9. Return on Equity
Return on equity =
Net profit after taxes – pref. dividend x 100
Equity Share Capital

Only equity share capital

 P10. Return on assets (ROA)
This ratio measures the profitability of the total funds of
a firm. It measures the relationship between net profits
and total assets. The objective is to find out how
efficiently the total assets have been used by the
management.
Return on assets =
net profit after taxes plus interest x 100
Total assets
Total assets exclude fictitious assets. As the total assets
at the beginning of the year and end of the year may not
be the same, average total assets may be used as the
denominator.
 Activity ratios/Turnover
ratios/efficiency/ velocity ratios
These ratios show the relationship between sales and
various assets of a firm. The various ratios under this
group are:
1. Inventory or stock turnover ratio (Times)
2. Average days of Inventory or Stock velocity(Months or
days)
3. Debtors turnover ratio(Times)
4. average collection period/ average days of debtors/
Debtors Velocity (Months or days)
5. Creditors turnover ratio(Times)
6. average credit period/ average days of creditors/ creditors
velocity(Months or days)
7. Asset Turnover ratio (Total, Fixed and Current)-(Times)
8. Capital Turnover ratio ( CE and Working Capital)
(Times)

 A1.Inventory /stock turnover
ratio
This ratio indicates the number of times inventory is
replaced during the year. It measures the relationship
between cost of goods sold and the inventory level.
There are two approaches for calculating this ratio,
namely:
Inventory turnover ratio = cost of goods sold
Average stock
AVERAGE STOCK can be calculated as
Opening stock + closing stock
2
Alternatively
Inventory turnover ratio = sales_________
Closing inventory
 A2. Average days of Inventory/Stock
Velocity
This ratio is a test of conversion of inventory
into sales
Stock Velocity =
Months/days in a year
Stock turnover ratio
 Inventory /stock turnover ratio
 A firm should have neither too high nor too
low inventory turnover ratio.
 Too high a ratio may indicate very low level
of inventory and a danger of being out of stock
and incurring high ‘stock out cost’.
 On the contrary too low a ratio is indicative of
excessive inventory entailing excessive
carrying cost.
 A3. Debtors turnover ratio

This ratio is a test of the liquidity of the debtors

of a firm. It shows the relationship between
credit sales and debtors.
Debtors turnover ratio =
Credit sales
Average Debtors and bills receivables
 A4. average collection period/ Debtors
Velocity/ Average days of debtors
This ratio is a test of the liquidity of the debtors
of a firm. It shows the relationship between
credit sales and debtors.
Average collection period =
Months/days in a year
Debtors turnover
 Debtors turnover ratio and average
collection period
 These ratios are indicative of the efficiency of
the trade credit management.
 A high turnover ratio and shorter collection
period indicate prompt payment by the debtor.
 On the contrary low turnover ratio and longer
collection period indicates delayed payments
by the debtor.
In general a high debtor turnover ratio and
short collection period is preferable.
 A5. Creditors turnover ratio
This ratio shows the speed with which payments
are made to the suppliers for purchases made
from them. It shows the relationship between
credit purchases and average creditors.
Creditors turnover ratio =
credit purchases
Average creditors & bills payables
 A6. average credit period / Average days of
creditors/ Creditors Velocity
This ratio shows the speed with which payments
are made to the suppliers for purchases made
from them.
Average credit period = months/days in a year
Creditors turnover ratio
Creditors turnover ratio and average
credit period

Higher creditors turnover ratio and short credit

period signifies that the creditors are being
paid promptly and it enhances the
creditworthiness of the firm.
 A7. Asset turnover ratio
Depending on the different concepts of assets employed, there are
many variants of this ratio. These ratios measure the efficiency
of a firm in managing and utilising its assets.
Total asset turnover ratio = sales/cost of goods sold
Average total assets
Fixed asset turnover ratio = sales/cost of goods sold
Average fixed assets
Current Assets turnover ratio = sales/cost of goods sold
Average Current assets
Capital turnover ratio = sales/cost of goods sold
Average capital employed
Working capital turnover ratio = sales/cost of goods sold
Net working capital
 A8. Capital turnover ratio
Depending on the different concepts of capital employed and Net
Working Capital. These ratios measure the efficiency of a firm in
managing and utilising its assets.

Capital turnover ratio = sales/cost of goods sold

Average capital employed
Working capital turnover ratio = sales/cost of goods sold
Net working capital
 Asset turnover ratio

Higher ratios are indicative of efficient

management and utilisation of resources while
low ratios are indicative of under-utilisation of
resources and presence of idle capacity.
 Market Capitalization ratios
 These ratio are useful for investors or stock
market players for predicting the intrinsic
value of shares. Some of the main ratios are
1. Earnings per Share (EPS) – (per Share)
2. Dividend per Share (DPS) – (per Share)
3. Dividend Payout Ratio (DPR) – (%)
4. Retention Ratio (RR)- (%)
5. Dividend Yield Ratio (DYR)
6. Price Earnings Ratio (P/E) or (PER) – (times)
 M1. Earnings per share (EPS)
This ratio measures the profit available to the
equity shareholders on a per share basis. This
ratio is calculated by dividing net profit available
to equity shareholders by the number of equity
shares.
Earnings per share =
net profit after tax – preference dividend
Number of equity shares
 M2. Dividend per share (DPS)
This ratio shows the dividend paid to the
shareholder on a per share basis. This is a better
indicator than the EPS as it shows the amount of
dividend received by the ordinary shareholders,
while EPS merely shows theoretically how much
belongs to the ordinary shareholders
Dividend per share =
Dividend paid to ordinary shareholders
Number of equity shares
 M3. Dividend payout ratio (D/P)
This ratio measures the relationship between the
earnings belonging to the ordinary shareholders and the
dividend paid to them.
Dividend pay out ratio =
total dividend paid to ordinary shareholders x 100
Net profit after tax –preference dividend
OR
Dividend pay out ratio = Dividend per share x 100
Earnings per share
 M4. Retention Ratio(RR)
 The percentage of retained earnings for
expansion plans or other productive
investments

 = 100 – Dividend Payout Ratio

 M5. Dividend Yield Ratio
 Useful for investors who are interested in
dividend income

 = Dividend Per Share (DPS)

Market Price Per Share (MPS)
 M6. Price earning ratio (P/E)
This ratio is computed by dividing the market
price of the shares by the earnings per share. It
measures the expectations of the investors and
market appraisal of the performance of the firm.
Price earning ratio = market price per share
Earnings per share
 ILLUSTRATIONS

Liquidity Ratios/
Short Term Solvency ratios
 1. Calculate liquidity Ratios from the
following particulars:
Particulars Amount(Rs) Particulars Amount(Rs)
Sundry creditors 40,000 Bank Overdraft 35,000
Bills Payable(B/P) 30,000 Sundry Debtors 70,000
Dividend Payable 36,000 Cash at Bank 40,000
Accrued Expenses 14,000 Cash in hand 60,000
Short Term Advances 50,000 Bills Receivable(B/R) 60,000
Share Capital 1,50,000 Prepaid Expenses 20,000
Debenture 2,00,000 Machinery 2,00,000
Marketable Securities 15,000 Patents 50,000
Inventories 1,20,000 Land & Building 1,50,000
 2. Calculate liquidity Ratios from the
following particulars:
Particulars Amount Particulars Amount
(Rs) (Rs)
Cash in Hand 10,000 Outstanding Expenses 20,000
Cash At Bank 15,000 Prepaid Expenses 10,000
Sundry Debtors 75,000 Dividend Payable 15,000
Stock 60,000 Land & Building 2,00,000
Bills Payable 25,000 Goodwill 1,00,000
Bills Receivable 30,000 Marketable securities 22,000
Sundry Creditors 40,000 Bank Overdraft 19,500
Accrued income 17,000 Income received in advance 13,500
Loose tools 5,000
3. Calculate

a) Current Assets b) Current Assets c) Liquid

Assets and d) Stock
Given
Current Ratio = 2.6 times
Liquid Ratio = 1.4 times
Working Capital = Rs. 1,10,000
 ILLUSTRATIONS

Capital Structure/Leverage/
long term solvency
1. Calculate the capital structure ratios from the following Balance Sheet:
a) Debt equity ratio
b) Proprietary ratio
c) Debt to total capital ratio,
d) Total debt to total assets ratio
e) Long term debt to total assets ratio

Liabilities` Amount Assets Amount

(Rs) (Rs)
Sundry Creditors 6,000 Cash 5,000
Bills Payable 10,000 Investment (Gov.Sec) 15,000
Outstanding Expenses 1,000 Sundry Debtors 20,000
Provision for Taxation 13,000 Stock 30,000
6% Mortgage Debentures 70,000 Fixed Assets 1,80,000
9% long term loan (LTL) 1,00,000 Less:Depreciation (50,000) 1,30,000
7% Preference Shares 10,000 Machinery 1,00,000
Equity Shares 50,000
Reserve & Surplus 40,000
Total 3,00,000 Total 3,00,000
 2. The Operating profit of A ltd after charging
interest on debentures and tax is a sum of
Rs.10,000. The amount of interest charged is
Rs.2,000 and the provision for tax has been
made of Rs.4,000. There is 8% preference
share capital of Rs. 10,000. Calculate
i. Interest Coverage Ratio
ii. Preference dividend coverage ratio
iii. Financial Leverage
 3. The Net profit of the firm is Rs.40,000. 8
percent debentures (payable in 10 years equal
installments) Rs. 1,00,000. Tax paid amounted
to Rs.5,000. Calculate the debt service
coverage ratio.
 ILLUSTRATIONS

Profitability Ratios
1. Calculate the Gross Profit Ratio
 Problem 1  Problem 2
Sales 5,00,000 Sales 1,00,000
Sales return 50,000 Sales Return 10,000
Closing Stock 35,000 Opening Stock 20,000
Opening Stock 70,000 Purchases 60,000
Purchases 3,50,000 Purchase returns 15,000
Wages 15,000 Closing Stock 5,000
Freight 3,000
Carriage inward 1,200
2. Calculate the operating ratio from the
following

COGS 4,00,000
Office and Administrative expense 30,000
Selling and distribution expenses 20,000
Sales 6,00,000
Sales Return 20,000
3. Calculate the operating profit ratio
Gross Sales 6,50,000
Sales return 50,000
Opening Stock 25,000
Closing Stock 30,000
Purchases 4,10,000
Purchases return 15,000
Office & Admin Expenses 50,000
Selling & Distribution Expenses 40,000
Income from investment 12,000
Rent Received 3,000