Analysis of financial

statement

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 Financial statement that reports a company's financial

performance over a specific accounting period. It is a

summary of financial performance assessed by how the

business incurs its revenues and expenses through both

operating and non-operating activities.

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 A ratio is defined as “the indicated quotient of two

mathematical expressions” and as “the relationship

between two or more things”

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 The ratios can be expressed as:-

1) Percentages:- Say, net profits are 25 per cent of sales

(assuming net profits of Rs 25,000 and sales of Rs
1,00,000)

2) Fraction:- net profit is one-fourth of sales

3) Proportion of numbers:- The relationship between net

profits and sales is 1:4.

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Advantages of Ratio analysis:

1. Helps to understand effectiveness of decisions:

The ratio analysis helps you to understand whether the

business firm has taken the right kind of operating, investing
and financing decisions. It indicates how far they have
helped in improving the performance.

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 2. Simplify complex figures and establish relationships:
Ratios help in simplifying the complex accounting figures
and bring out their relationships. They help summarize the
financial information effectively and assess the managerial
efficiency, firm’s credit worthiness, earning capacity, etc.

3. Helpful in comparative analysis:

The ratios are not be calculated for one year only. When
many year figures are kept side by side, they help a great
deal in exploring the trends visible in the business. The
knowledge of trend helps in making projections about the
business which is a very useful feature.

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4. Identification of problem areas:
Ratios help business in identifying the problem areas as well
as the bright areas of the business. Problem areas would
need more attention and bright areas will need polishing to
have still better results.

5. Enables SWOT analysis:

Ratios help a great deal in explaining the changes occurring
in the business. The information of change helps the
management a great deal in understanding the current
threats and opportunities and allows business to do its own
SWOT (Strength-Weakness-Opportunity-Threat) analysis.

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6. Various comparisons:

Ratios help comparisons with certain bench marks to assess

as to whether firm’s performance is better or otherwise. For
this purpose, the profitability, liquidity, solvency, etc. of a
business, may be compared: (i) over a number of accounting
periods with itself (Intra-firm Comparison/Time Series
Analysis), (ii) with other business enterprises (Inter-firm
Comparison/Cross-sectional Analysis) and (iii) with standards
set for that firm/industry (comparison with standard (or
industry
8 expectations).
Fundamentals of Finance
 Limitations of Ratio analysis
1. Ignores Price-level Changes:

The financial accounting is based on stable money measurement

principle. It implicitly assumes that price level changes are either non-
existent or minimal. But the truth is otherwise. We are normally living
in inflationary economies where the power of money declines
constantly. A change in the price-level makes analysis of financial
statement of different accounting years meaningless because
accounting records ignore changes in value of money.
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 2. Ignore Qualitative or Non-monetary Aspects:

Accounting provides information about quantitative (or

monetary) aspects of business. Hence, the ratios also reflect
only the monetary aspects, ignoring completely the non-
monetary (qualitative) factors.

3. Forecasting:

Forecasting of future trends based only on historical analysis

is not feasible. Proper forecasting requires consideration of
non-financial factors as well.
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4. Variations in Accounting Practices:

There are differing accounting policies for valuation of

inventory, calculation of depreciation, treatment of
intangibles Assets definition of certain financial variables
etc., available for various aspects of business transactions.
These variations leave a big question mark on the cross-
sectional analysis. As there are variations in accounting
practices followed by different business enterprises, a valid
comparison of their financial statements is not possible.
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 Classification of Ratios:
Ratios are generally classified by the type of
information that they provide.

1. According to financial statements

a) Income statement ratios

b) Balance sheet ratios

c) Inter statement ratios

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 2. According to information

a) Liquidity ratios

b) Solvency ratios

c) Activity ratios

d) Profitability ratios

e) Operating ratios

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Income Statement Ratios:

1. Profit Margin ratio

2. Operating efficiency ratios

3. No. of times interest earned ratios

4. Fixed charges coverage ratios

5. Stock turn over ratio/ inventory turn over ratio

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1. Net profit ratio or Profit margin ratio
Profit margin, is determined by dividing net income by
total revenue. It is an overall measurement of management’s
ability to generate sales and control expenses.
In this ratio, net income is the income remaining after all
expenses have been deducted.

Formula= Net profit * 100

Sales

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2. Operating Efficiency Ratio:
This ratio is the result of dividing income after
undistributed operating expenses by total revenue. Income
after undistributed operating expenses is the result of
subtracting expenses generally controllable by management
from revenues.
A high Operating efficiency ratio indicates greater
efficiency of the firm.
Formula= Income After undistributed operating
expenses
Total Revenue (Sales)

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 3. Number of Times Interest Earned Ratio:
This ratio is used to test the firm’s debt-servicing
capacity. The interest coverage ratio is computed by
dividing earnings before interest and taxes (EBIT) by
interest charges.
Interest coverage ratio shows the number of times
the interest charges are covered by funds that are
ordinarily available for their payment.
Since taxes are computed after interest, interest
coverage is calculated in relation to before tax earnings.

Formula= EBIT
Interest Expense
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The Number of times interest earned ratio indicates the
extent of which earnings are available to meet interest
payments.

A lower number of times interest earned ratio means

less earnings are available to meet interest payments and
that the business is more vulnerable to increases in interest
rates.

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 4. Fixed Charge Coverage Ratio:

A ratio that indicates a firm's ability to satisfy fixed financing

expenses, such as interest and leases. This ratio is calculated
the same as the number of times interest earned ratio, except
that lease expense (rent expense) is added to both the
numerator and denominator of the equation.

Formula= EBIT+ Lease expense (rent expense)

Interest expense + Lease expense

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 5. Stock Turnover / Inventory Turnover Ratio:

This ratio shows how quickly the inventory is being

used. The quicker the inventory turnover the better,
because inventory can be expensive to maintain. High ratio
indicates brisk sales.

Formula = Cost of goods sold

Average Inventory

Average inventory= Beginning inventory + Ending

inventory
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 Balance Sheet Ratios

1. Current Ratio

2. Acid Test or Quick Ratio

3. Debt – equity Ratio

4. Long – term Debt to Total Capitalization Ratio

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Current Ratio:

This is the ratio of total current assets to total

current liabilities. The current ratio is a measure of the firm’s
short-term solvency. It indicates the availability of current
assets in rupees for every one rupee of current liability. A
ratio of greater than one means that the firm has more
current asset than current claims against them.

Formula = Current Assets

Current Liabilities
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 Acid test or Quick ratio:
The Acid-test or quick ratio or liquid
ratio measures the ability of a company to use its near
cash or quick assets to immediately extinguish or retire its
current liabilities. Quick assets include those current assets
that presumably can be quickly converted to cash at close
to their book values.

Formula = Current assets – Inventories

Current Liabilities

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Debt – Equity Ratio:
This ratio compares the hospitality establishment’s
debt to its net worth (owners’ equity). This ratio indicates
the establishment’s ability to withstand adversity and meet
its long-term debt obligations.

Formula = Total Liabilities

Total Owner’s equity (Net Worth)

Total liabilities= Long term liability + current liability

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For example, if a company has long term debt of $3,000 and

share holder’s equity of $12,000, then the debt/equity ratio

would be 3000 divided by 12000 = 0.25. It is important to

realize that if the ratio is greater than 1, the majority of

assets are financed through debt. If it is smaller than 1,

assets are primarily financed through equity.

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Long-Term Debt to Total Capitalization Ratio:
This ratio is similar to the debt-equity ratio except
that current liabilities are excluded in the numerator, and
long-term debt is added to the denominator of the debt-
equity ratio. Current liabilities are excluded because current
assets are normally adequate to cover them, therefore, they
are not a long-term concern.

Formula = Long-term Debt

Long-term Debt + Owners’ Equity

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A variation of the traditional debt-to-equity ratio, this
value computes the proportion of a company's long-term
debt compared to its available capital. By using this ratio,
investors can identify the amount of leverage utilized by a
specific company and compare it to others to help analyze
the company's risk exposure. Generally, companies that
finance a greater portion of their capital via debt are
considered riskier than those with lower leverage ratios.

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 Inter statement ratio:
1. Return on Capital Employed or Investment
2. Return on Shareholders’ Funds
3. Earnings per Share
4. Dividend Payout Ratio
5. Price / Earning Ratio
6. Fixed Assets Turnover Ratio
7. Working Capital Turnover Ratio

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1. Return on Capital Employed or Investment
It explains the overall utilisation of funds by a business
enterprise. Capital
employed means the long-term funds employed in the
business and includes shareholders’ funds, debentures and
long-term loans. Alternatively, capital employed may be
taken as the total of non-current assets and working capital.
Profit refers to the Profit after Interest and Tax (PBIT) for
computation of this ratio. Thus, it is computed as follows:

Return on Investment = Profit after Tax *100

Capital Employed

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2. Return on Shareholders’ Funds
This ratio is very important from shareholders’ point of view
in assessing whether their investment in the firm generates
a reasonable return or not. It should be higher than the
return on investment otherwise it would imply that
company’s funds have not been employed profitably. A
better measure of profitability from shareholders point of
view is obtained by determining return on total shareholders’
funds.

Return on Shareholders’ Fund = Profit after Tax *100

Shareholders' Funds

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3. Earnings per Share
This ratio is very important from equity shareholders point of
view and
also, for the share price in the stock market. This also helps
comparison with other to ascertain its reasonableness and
capacity to pay dividend.
The ratio is computed as:

EPS = Profit available for equity shareholders

Number of Equity Shares

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4. Dividend Payout Ratio
This refers to the proportion of earning that are distributed
to the shareholders. This reflects company’s dividend policy
and growth in owner’s equity.
It is calculated as –

Dividend Payout Ratio =Dividend per share

Earnings per share

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5. Price / Earning Ratio

The ratio is computed as –

P/E Ratio = Market Price of a share
Earnings per share
It is an important measure of value used by investors in the
marketplace before making purchases.

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6. Fixed Assets Turnover Ratio :
It is computed as follows:
Fixed asset turnover Ratio =Net Revenue from Operation
(Sales)
Net Fixed Assets
Fixed Asset Turnover (FAT) is an efficiency ratio that indicates
how well or efficiently a business uses fixed assets to
generate sales. This ratio divides net sales by net fixed
assets, calculated over an annual period. The net fixed assets
include the amount of property, plant, and equipment, less
the accumulated depreciation. Generally, a higher fixed asset
ratio implies more effective utilization of investments in fixed
assets to generate revenue.
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7. Working Capital Turnover Ratio :
It is calculated as follows :
Working Capital Turnover Ratio =Net Revenue from Operation
(Sales)
Working Capital

Working capital turnover is a ratio that measures how

efficiently a company is using its working capital to support
sales and growth. Also known as net sales to working capital,
working capital turnover measures the relationship between
the funds used to finance a company's operations and the
revenues a company generates to continue operations and
turn a profit.

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 Ratio [Link]

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