GLOSSARY
MODULE 4
ANALYSIS OF FINANCIAL STATEMENT
1. Analysis of financial statement refers to the application of different tools to know the
behaviour of the accounting information.
2. Financial Ratio: Ratio is a relationship between two accounting figures, expressed
mathematically. Ratios are the indictors for further investigation.
3. Analysis: Means methodical classification of data and presentation in a simplified
form for easy understanding. Interpretation means assigning reasons for the
behaviour in respect of the data, presented in the simplified form.
4. Liquidity ratio: measures the firm’s ability to meet current obligations.
5. Leverage ratio: These ratios show the proportion of debt and equity in financing the
firm’s assets.
6. Activity ratios: They reflect the firm’s efficiency in utilising the assets.
7. Profitability ratios: These ratios measure overall performance and effectiveness of
the firm.
8. Current ratio: Is defined as the relationship between current assets and current
liabilities.
9. Liquid ratio: Establishes the relationship between liquid assets and current liabilities.
10. Leverage: Means using of debt or borrowed capital to undertake an investment or
project. It indicates the solvency of the firm.
11. Gross profit ratio: Indicates the spread between the cost of goods sold and revenue.
12. Net profit ratio: indicates the overall efficiency of the management in manufacturing,
administering and selling the product.
NOTES OF MODULE 4
Meaning of Accounting Ratios
Accounting ratios are quantitative relationships calculated from the financial
statements of a business (such as the Profit & Loss Account and Balance Sheet).
They help measure the performance, efficiency, liquidity, profitability, and financial
stability of an organization.
Accounting ratios show how one financial figure relates to another, helping us
understand the financial health and operational efficiency of a business.
For example:
Current Ratio = Current Assets / Current Liabilities → shows liquidity
Gross Profit Ratio = Gross Profit / Net Sales × 100 → shows profitability
Objectives of analysis of financial statements
1, Assess Financial Performance –
Assessing financial performance means evaluating how well a business is earning
profits and managing its resources during a specific period. It helps determine
whether the company is performing better, worse, or the same compared to previous
years or competitors.
2. Assist in Decision-Making –
This objective means that the analysis of financial statements helps managers,
investors, and lenders make better and informed decisions based on the financial
health of the business.
3. Identify Strengths and Weaknesses –
This objective means that the analysis of financial statements helps find out what the
business is doing well (strengths) and where it is facing problems (weaknesses).
4. Forecast Future Performance –
Forecasting future performance means using the information from past and present
financial statements to predict how the business is likely to perform in the future.
5. Ensure Efficient Control -
Ensuring efficient control means using financial statement analysis to monitor and
control the operations, costs, and resources of the business so that everything runs
smoothly and efficiently.
Financial Ratios
Financial ratios are numerical relationships calculated from the financial statements
of a business. They compare two related financial figures to help understand the
company’s performance, profitability, liquidity, efficiency, and financial stability.
1. Liquidity Ratios
These ratios show the ability of a business to meet its short-term obligations.
a)
Current Ratio: Shows whether the company can pay its short-term debts using its
short-term assets.
Formula:
Current Assets
Current Ratio=
Current Liabilities
b) Quick Ratio (Acid Test Ratio): Measures immediate liquidity by excluding
inventory.
Formula:
Quick Assets
Quick Ratio=
Current Liabilities
Quick Assets = Current Assets – Inventory
2. Solvency Ratios (Long-term financial position)
These show whether the business can meet its long-term obligations.
a) Debt-Equity Ratio: Shows the proportion of debt and equity in financing the
company.
Formula:
Total Long-term Debt
Debt–Equity Ratio=
Shareholders’ Equity
b) Proprietary Ratio: Indicates the extent of owners’ contribution to total assets.
Formula:
Shareholders’ Funds
Proprietary Ratio=
Total Assets
3. Profitability Ratios:
Measure how efficiently a business earns profits.
a) Gross Profit Ratio: Shows margin earned from trading activities.
Formula:
Gross Profit
Gross Profit Ratio= × 100
Net Sales
b) Net Profit Ratio: Shows the overall profitability after all expenses.
Formula:
Net Profit
Net Profit Ratio= × 100
Net Sales
c) Return on Investment (ROI) / Return on Capital Employed (ROCE): Measures how
efficiently the business uses its capital.
Formula:
Net Profit before Interest and Tax
ROCE= ×100
Capital Employed
4. Activity (Turnover) Ratios
These measure how efficiently the company uses its assets.
a) Inventory Turnover : Ratio Shows how many times inventory is sold in a year.
Formula:
Cost of Goods Sold
Inventory Turnover Ratio=
Average Inventory
b) Debtors Turnover Ratio: Measures efficiency in collecting credit sales.
Formula:
Net Credit Sales
Debtors Turnover Ratio=
Average Debtors
c) Total Asset Turnover Ratio: Shows how effectively assets generate revenue.
Formula:
Net Sales
Asset Turnover=
Total Assets