PAPER CODE – MB102

Course: ACCOUNTING FOR MANAGEMENT

UNIT-III

By
Dr Gampala Prabhakar
MBA, [Link], UGC JRF&NET(Management), UGC NET (Commerce), PhD
Associate Professor
Unit – III: Financial Statement Analysis
• Ratio analysis
– Rationale and utility of ratio analysis
– Classification of ratios
– Calculation and interpretation of ratios
• liquidity ratios,
• activity/turn over ratios,
• Profitability ratios,
• leverage and structural ratios
(Including Numerical Problems)
– Advantages and disadvantages.
• Common size statement analysis.
 Introduction of Ratio Analysis
• Ratio analysis refers to the analysis and
interpretation of the figures appearing in the
financial statements (i.e., Profit and Loss Account,
Balance Sheet).
• It is a process of comparison of one figure against
another. It enables the users to get better
understanding of financial statements.
• Accounting ratios are used by the financial analysts
to analyze the accounting ratios to diagnose the
financial health of an enterprise.
• Meaning of financial ratios
– A ratio is a mathematical number calculated as a
reference to relationship of two or more numbers
and can be expressed as a fraction, proportion,
percentage and a number of times. When the
number is calculated by referring to two accounting
numbers derived from the financial statements, it is
termed as accounting ratio.
– It needs to be observed that accounting ratios
exhibit relationship, if any, between accounting
numbers extracted from financial statements.
– Ratios are essentially derived numbers and their
efficacy depends a great deal upon the basic
numbers from which they are calculated. Hence, if
the financial statements contain some errors, the
derived numbers in terms of ratio analysis would
also present an erroneous scenario. Further, a ratio
must be calculated using numbers which are
meaningfully correlated.
– A ratio calculated by using two unrelated numbers
would hardly serve any purpose. For example, the
furniture of the business is Rs. 1,00,000 and
Purchases are Rs. 3,00,000. The ratio of purchases
to furniture is 3 (3,00,000/1,00,000) but it hardly has
any relevance.
Procedure for computation of ratios
• Generally, ratio analysis involves four steps:
– (i) Collection of relevant accounting data from
financial statements.
– (ii) Constructing ratios of related accounting figures.
– (iii) Comparing the ratios thus constructed with the
standard ratios which may be the corresponding
past ratios of the firm or industry average ratios of
the firm or ratios of competitors.
– (iv) Interpretation of ratios to arrive at valid
conclusions.
 Objectives of ratio analysis
• 1. To know the areas of the business which need
more attention;
• 2. To know about the potential areas which can be
improved with the effort in the desired direction;
• 3. To provide a deeper analysis of the profitability,
liquidity, solvency and efficiency levels in the
business;
• 4. To provide information for making cross-sectional
analysis by comparing the performance with the best
industry standards;
• 5. To provide information derived from financial
statements useful for making projections and
estimates for the future.
 Types of ratios
• Although accounting ratios are calculated by taking
data from financial statements but classification of
ratios on the basis of financial statements is rarely
used in practice.
• It must be recalled that basic purpose of accounting is
to throw light on the financial performance
(profitability) and financial position (its capacity to
raise money and invest them wisely) as well as
changes occurring in financial position (possible
explanation of changes in the activity level). As such,
the alternative classification (functional classification)
based on the purpose for which a ratio is computed, is
the most commonly used classification which is as
follows:
• Liquidity ratios,
• Activity/turnover ratios,
• Profitability ratios,
• Leverage and structural ratios
(Including Numerical Problems)
 LIQUIDITY RATIOS
• Liquidity ratios measure the adequacy of current
and liquid assets and help evaluate the ability of
the business to pay its short-term debts. The
ability of a business to pay its short-term debts
is frequently referred to as short-term solvency
position or liquidity position of the business.
• Generally a business with sufficient current and
liquid assets to pay its current liabilities as and
when they become due is considered to have a
strong liquidity position and a businesses with
insufficient current and liquid assets is
considered to have weak liquidity position.
• Short-term creditors like suppliers of goods and
commercial banks use liquidity ratios to know
whether the business has adequate current and
liquid assets to meet its current obligations.
Financial institutions hesitate to offer short-term
loans to businesses with weak short-term
solvency position.
• Three commonly used liquidity ratios are given
below:
– (i) Current ratio or working capital ratio
– (ii) Quick ratio or acid test ratio
– (iii) Absolute liquid ratio
• Current ratio (also known as working capital ratio)
is a popular tool to evaluate short-term solvency
position of a business. Short-term solvency refers to
the ability of a business to pay its short-term
obligations when they become due. Short term
obligations (also known as current liabilities) are the
liabilities payable within a short period of time,
usually one year. Current ratio is computed by
dividing total current assets by total current
liabilities of the business. This relationship can be
expressed in the form of following formula or
equation:
• Above formula comprises of two components i.e.,
current assets and current liabilities. Both the
components are available from the balance sheet of
the company.
• Some examples of current assets are given below:
Cash, Bank, Inventory (raw material, work-in-
progress and finished goods), Marketable securities,
Accounts receivables (Debtors and bills
receivables), Prepaid expenses
• Some examples of current liabilities are given
below: Accounts payable (Bills payable and
creditors), Accrued payable, Bonds payable and
Bank OD etc.
• (ii) Quick ratio (also known as “acid test ratio”
and “liquid ratio”) is used to test the ability of a
business to pay its short-term debts. It
measures the relationship between liquid
assets and current liabilities. Liquid assets are
equal to total current assets minus inventories
and prepaid expenses. The formula for the
calculation of quick ratio is given below:

– Liquid assets = current assets – inventory

• (iii) Absolute Liquid ratio-some analysts also
compute absolute liquid ratio to test the liquidity of
the business. Absolute liquid ratio is computed by
dividing the absolute liquid assets by current
liabilities. The formula to compute this ratio is given
below:

• Absolute liquid assets are equal to liquid assets

minus accounts receivables (including bills
receivables). Some examples of absolute liquid
assets are cash, bank balance and marketable
securities etc.
 ACTIVITY / TURNOVER RATIOS

• Activity ratios (also known as turnover ratios)

measure the efficiency of a firm or company in
generating revenues by converting its production
into cash or sales. Generally a fast conversion
increases revenues and profits
• Activity ratios show how frequently the assets are
converted into cash or sales and, therefore, are
frequently used in conjunction with liquidity ratios
for a deep analysis of liquidity.
• Some important activity ratios are:
– (i) Inventory turnover ratio
– (ii) Debtors/Receivables turnover ratio
– (iii) Average collection period
– (iv)Creditors/AccountsPayable turnover
ratio
– (V) Creditors payment period
– (vi) Working capital turnover ratio
– (vii) Fixed assets turnover ratio
• (i) Inventory turnover ratio (ITR) is an activity
ratio is a tool to evaluate the liquidity of inventory.
It measures how many times a company has sold
and replaced its inventory during a certain period of
time.
• Inventory turnover ratio is computed by dividing the
cost of goods sold by average inventory at cost. The
formula/equation is given below:

• COGS= Sales – Gross Profit

• (ii) Receivables turnover ratio (also known as
debtors turnover ratio) is computed by dividing
the net credit sales during a period by average
receivables. Accounts receivable turnover ratio
simply measures how many times the receivables
are collected during a particular period. It is a
helpful tool to evaluate the liquidity of receivables.
• iii) The average collection period is the average
number of days it takes a business to collect and
convert its accounts receivable into cash. Accounts
receivable are the money that customers owe to a
company for buying goods or services on credit.
The average collection period is an important
measure of a company’s liquidity, efficiency, and
cash flow management.
• The formula for calculating the average collection
period is:
 (iv) Creditors/Accounts payable turnover ratio
• The creditors or accounts payable
turnover ratio is a liquidity ratio that
measures how often a company pays its
suppliers or creditors in a given period. It
indicates how efficiently a company
manages its short-term obligations and
cash flow.
• The formula for the creditors or accounts
payable turnover ratio is:
 (v) Creditors payment period
• The creditor’s payment period, also known as
the days payable outstanding (DPO), is a liquidity
ratio that measures the average number of days that
a company takes to pay its bills and invoices to its
creditors, such as suppliers, vendors, or financiers.
The ratio indicates how well a company manages its
short-term obligations and cash flow.
 (vi) Working capital turnover ratio
• The working capital turnover ratio is a measure of
how efficiently a company uses its working capital
to generate sales. Working capital is the difference
between current assets and current liabilities, which
represents the funds available for day-to-day
operations. The ratio is calculated by dividing net
sales by average working capital. A higher ratio
indicates that the company generates more revenue
per unit of working capital, while a lower ratio
suggests that the company has excess or idle
working capital.
(vii) Fixed assets turnover ratio
•The fixed assets turnover ratio is a measure of how
efficiently a company uses its fixed assets to generate
sales. Fixed assets are long-term assets that are used in
the production process, such as property, plant, and
equipment. The ratio is calculated by dividing net
sales by the average net fixed assets. A higher ratio
indicates that the company is able to generate more
sales per unit of fixed assets, while a lower ratio
suggests that the company has excess or idle fixed
assets.
 PROFITABILITY RATIOS
• Profit is the primary objective of all businesses. All businesses
need a consistent improvement in profit to survive and
prosper. A business that continually suffers losses cannot
survive for a long period.
• Profitability ratios measure the efficiency of management in
the employment of business resources to earn profits. These
ratios indicate the success or failure of a business enterprise
for a particular period of time. Profitability ratios are used by
almost all the parties connected with the business. A strong
profitability position ensures common stockholders a higher
dividend income and appreciation in the value of the common
stock in future. Creditors, financial institutions and preferred
stockholders expect a prompt payment of interest and fixed
dividend income if the business has good profitability
position.
• Some important profitability ratios are given
below:
– (i) Gross profit (GP) ratio
– (ii) Net profit (NP) ratio
– (iii) Price earnings ratio (P/E ratio)
– (iv) Operating ratio
– (v) Expense ratio
– (vi) Dividend yield ratio
– (vii) Dividend payout ratio
– (viii) Return on capital employed ratio
– (ix) Earnings per share (EPS) ratio
– (x) Return on shareholder’s investment/Return on equity
– (xi) Return on common stockholders’ equity ratio
• (i) Gross profit ratio (GP ratio) is a profitability
ratio that shows the relationship between gross
profit and total net sales revenue. It is a popular tool
to evaluate the operational performance of the
business . The ratio is computed by dividing the
gross profit figure by net sales
• (ii) Net profit ratio (NP ratio) is a popular profitability
ratio that shows relationship between net profit after tax and
net sales. It is computed by dividing the net profit (after tax)
by net sales.

• For the purpose of this ratio, net profit is equal to gross

profit minus operating expenses and income tax. All non-
operating revenues and expenses are not taken into account
because the purpose of this ratio is to evaluate the
profitability of the business from its primary operations. Net
profit (NP) ratio is a useful tool to measure the overall
profitability of the business. A high ratio indicates the
efficient management of the affairs of business.
 (iii) Price earnings ratio (P/E ratio)
• The price-earnings ratio (P/E ratio) is a measure of
how much investors are willing to pay for a
company’s earnings per share (EPS). It is calculated
by dividing the current stock price by the EPS. A
higher P/E ratio means that investors are expecting
higher growth or profitability from the company,
while a lower P/E ratio means that investors are
more cautious or pessimistic. The P/E ratio can be
used to compare the valuation of different
companies or sectors, or to assess the historical or
future performance of a company.
 (iv) Operating ratio
• The operating ratio is a measure of how efficiently a
company uses its operating expenses to generate
sales. It is calculated by dividing the total operating
expenses and the cost of goods sold by the net sales.
A lower ratio indicates that the company is more
profitable and has better cost management, while a
higher ratio suggests that the company is less
profitable and has higher costs.
(v) Expense ratio
An expense ratio is the annual fee that investors pay for the
management and operation of an investment fund, such as
a mutual fund or an exchange-traded fund (ETF). It is
expressed as a percentage of the fund’s assets and reflects
the costs of running the fund, such as administration,
marketing, and advisory fees. A lower expense ratio means
lower costs for investors and higher returns, while a higher
expense ratio means higher costs and lower returns.
 (vi) Dividend yield ratio
• The dividend yield ratio is a measure of how much a
company pays out in dividends each year relative to
its stock price. It is calculated by dividing the annual
dividends per share by the price per share. It can be
used to compare the attractiveness of different
dividend-paying stocks or to estimate the income
from investing in them.
 (vii) Dividend payout ratio
• The dividend payout ratio is the percentage of net
income that a company pays out as dividends to its
shareholders. It shows how much of the earnings are
distributed to the owners and how much are retained
for reinvestment. The formula for the dividend
payout ratio is:
 (viii) Return on capital employed ratio
• The return on capital employed ratio (ROCE) is a
measure of how efficiently a company uses its
capital to generate profits. It is calculated by
dividing the earnings before interest and tax (EBIT)
by the total capital employed, which includes both
debt and equity. A higher ROCE indicates that the
company is more profitable and has better capital
management, while a lower ROCE suggests that the
company is less profitable and has higher costs.
• (viii) Earnings per share (EPS) ratio measures
how many dollars of net income have been earned
by each share of common stock. It is computed by
dividing net income less preferred dividend by the
number of shares of common stock outstanding
during the period. It is a popular measure of overall
profitability of the company and is usually
expressed in dollars. Earnings per share ratio (EPS
ratio) is computed by the following formula:
 (x) Return on shareholder’s investment/Return
on equity
• Return on shareholder’s investment or return on
equity (ROE) is a measure of how much profit a
company generates for each dollar of equity
invested by its shareholders. It is calculated by
dividing the net income by the average
shareholders’ equity. A higher ROE means that the
company is more efficient and profitable in using its
equity capital, while a lower ROE means the
opposite.
• (xi) Return on common stockholders’ equity
ratio
The return on common stockholders’ equity ratio
(ROCE) is a measure of how much profit a
company generates for its common shareholders. It
is calculated by dividing the net income available to
common shareholders by the average common
stockholders’ equity. A higher ROCE means that the
company is more efficient and profitable in using its
common equity capital, while a lower ROCE means
the opposite.
 LEVERAGE AND STRUCTURAL RATIOS
• Also called solvency ratios (also known as long-term
solvency ratios) measure the ability of a business to survive
for a long period. These ratios are very important for
stockholders and creditors.
• Solvency ratios are normally used to:
– Analyze the capital structure of the company
– Evaluate the ability of the company to pay interest on
long-term borrowings
– Evaluate the ability of the company to repay the principal
amount of the long-term loans (debentures, bonds,
medium and long-term loans etc.).
– Evaluate whether the internal equities (stockholders’
funds) and external equities (creditors’ funds) are in the
right proportion.
• Some frequently used long-term solvency
ratios are given below:
– (i) Debt-to-equity ratio
– (ii) Proprietary ratio
– (iii)Fixed assets to equity ratio
– (iv)Capital gearing ratio
– (v) Coverage ratios
• Interest coverage ratio
• Dividend coverage ratio
• (i) Debt to equity ratio is a long term solvency ratio
that indicates the soundness of long-term financial
policies of a company. It shows the relation between
the portion of assets financed by creditors and the
portion of assets financed by stockholders. As the
debt to equity ratio expresses the relationship
between external equity (liabilities) and internal
equity (stockholder’s equity), it is also known as
“external-internal equity ratio”
• Debt to equity ratio is calculated by dividing total
liabilities by stockholder’s equity.
• A ratio of 1 (or 1: 1) means that creditors and
stockholders equally contribute to the assets of the
business. A less than 1 ratio indicates that the portion of
assets provided by stockholders is greater than the
portion of assets provided by creditors and a greater
than 1 ratio indicates that the portion of assets provided
by creditors is greater than the portion of assets
provided by stockholders.
• Creditors usually like a low debt to equity ratio because
a low ratio (less than 1) is the indication of greater
protection to their money. But stockholders like to get
benefit from the funds provided by the creditors
therefore they would like a high debt to equity ratio.
• (ii) The proprietary ratio (also known as net worth ratio or
equity ratio) is used to evaluate the soundness of the capital
structure of a company. It is computed by dividing the
stockholders’ equity by total assets.

• (iii) Fixed assets to equity ratio measures the contribution of

stockholders and the contribution of debt sources in the
fixed assets of the company. It is computed by dividing the
fixed assets by the stockholders’ equity.
(iv) Capital gearing ratio is a useful tool to analyze the capital structure
of a company and is computed by dividing the common stockholders’
equity by fixed interest or dividend bearing funds.
 Limitations of ratio analysis

• Historical Information
• Inflationary effects
• Changes in accounting policies
• Operational changes
• Seasonal effects
• Manipulation of financial statements
Numerical Problems
COMMON SIZE STATEMENT ANALYSIS
• A common size statement analysis is a method of
analyzing and interpreting the financial statements
of a company by expressing each line item as a
percentage of a base amount. This technique is also
known as vertical analysis, as it compares the items
within the same financial period. The purpose of a
common size statement analysis is to evaluate the
relative importance, contribution, and impact of
each item in the financial statements.
• There are two types of common size statements:
common size income statement and common size
balance sheet. A common size income statement
expresses each line item as a percentage of the total
revenue or sales. For example, the cost of goods
sold, operating expenses, and net income are all
calculated as a percentage of the sales. A common
size income statement can help to assess the
profitability, efficiency, and cost structure of a
company. It can also help to compare the
performance of different companies or periods,
regardless of their size or scale.
• A common size balance sheet expresses each line
item as a percentage of the total assets or liabilities.
For example, the cash, inventory, and fixed assets
are all calculated as a percentage of the total assets.
Similarly, the accounts payable, long-term debt, and
equity are all calculated as a percentage of the total
liabilities. A common size balance sheet can help to
evaluate the liquidity, solvency, and capital structure
of a company. It can also help to compare the
financial position of different companies or periods,
regardless of their size or scale.
• The formula for a common size statement analysis
is:

• Where:
• Line Item is any item in the income statement or
balance sheet, such as revenue, expenses, assets, or
liabilities.
• Base Amount is the total revenue or sales for the
income statement, or the total assets or liabilities for
the balance sheet.
• For example, if a company has revenue of
$1,000,000, cost of goods sold of $600,000, and net
income of $100,000 in a year, its common size
income statement analysis is:

• This means that the company spends 60% of its

revenue on producing the goods, and earns 10% of
its revenue as net income.
Some of the benefits of a common size statement
analysis are:
•It allows investors to identify significant changes in a
company’s financial statements over time or across
different companies.
•It eliminates the effect of size or scale, and enables a
fair comparison of the financial performance and
position of different companies or periods.
•It simplifies the financial statements and makes them
easier to understand and interpret.
•It highlights the trends, patterns, and ratios that may
not be apparent from the absolute numbers.
Some of the limitations of a common size statement analysis
are:
•It does not provide a complete picture of a company’s
financial situation, as it does not consider the external factors,
such as the industry, market, or economy, that may affect the
company’s performance or position.
•It does not account for the quality, reliability, or accuracy of
the financial data, as it may be influenced by the accounting
methods, policies, or standards used by the company.
•It does not provide any information about the cash flow,
timing, or risk of the financial items, as it only focuses on the
percentage values.
Thank You