UNIT 2

Techniques of
Financial
Analysis

2.1 Financial Analysis

2.2 Techniques of
Financial Analysis
2.3 Fund Flow Analysis
2.4 Cash Flow
Statement
2.5 Ratio Analysis
 Introduction

The massive amount of numbers in a company's financial statements can be

bewildering and intimidating to many investors. On the other hand, analysed
financial statements are a gold mine of information.

Financial statements are the medium by which a company discloses

information concerning its financial performance

Followers of fundamental analysis use the quantitative information gleaned

from financial statements to make investment decisions. It ultimately helps
company to grow in market.
 2.1 financial analysis
A) Meaning :
Financial analysis (also referred to as financial statement analysis or accounting
analysis or Analysis of finance) refers to an assessment of the viability, stability and
profitability of a business, sub-business or project.
B) Definitions :
1) John N. Myer :
"Relationships among the various financial factors in a business, as disclosed by a
single set of statements and study of these factors as shown in a series of statements"
2) R.W. Metcalf and P.L. Titard :
“Analysis of financial statement is a process of evaluating the relationship between
component parts of a financial statement to obtain a better understanding of a firm’s
position and performance".
 2.1 financial analysis
C) Objectives of Financial Analysis :
 2.1 financial analysis
D) Types of Financial Analysis :
There are many different types of financial analysis used by analysts and
investors alike to determine the financial strength, both in the present time and projected
into the future, of companies and corporations. Financial statement analysis is classified
into different categories as follows:
1) On the Basis of Concerned Parties :
According to different parties concerned with the operation of the company, the
financial statement analysis can be of two types:
a) External Analysis :
When the analysis is undertaken by outside parties namely, existing and
prospective investors, suppliers, lenders, government agencies, customers etc., it is
external financial statement analysis.
b) Internal Analysis :
This analysis is undertaken by the management of the company to monitor its
financial and operating performance.
 2.1 financial analysis
2) On the Basis of Time Period of Study :
Based on the time period covered for the study, the financial statement analysis
can be grouped into: Horizontal Analysis, Vertical Analysis.
a) Horizontal Analysis :
This analysis refers to the study of past consecutive balance sheets, income statements
or statements of cash flow at a time. The analysis can be made between two periods or
over a series of periods. The relevant accounting numbers of all years of the study are
presented horizontally in a statement over a number of columns each representing a
year those figures can also be graphically presented.
b) Vertical Analysis :
When the analysis is restricted to the financial statements of one particular period
only, it is known as vertical analysis of financial statements. In this analysis each item of
a particular financial statement is expressed as percentage of a base figure selected
from the same statement. It is also known as ‘Static Analysis’ as it concentrates solely
on one year’s financial statement.
 2.1 financial analysis
E) Limitations of Financial Analysis :
1) Lack of an Underlying Theory :
The basic problem in financial statement analysis is that there is no theory that tells
us which numbers to look at and how to interpret them.
2) Conglomerate Firms :
Many firms, particularly the large ones, have operations spanning a wide range of
industries. Given the diversity of their product lines, it is difficult to find suitable
benchmarks for evaluating their financial performance and condition.
3) Window Dressing :
Firms may resort to window dressing to project a favourable financial picture. When
window dressing of this kind is suspected, the financial analyst should look at the
average level of inventory over a period of time and the not the level of inventory at
just one point of time.
4) Price Level Changes :
Financial accounting, as it is currently practiced in India and most other countries,
does not take into account price level changes. As a result, balance sheet figures are
distorted and profits misreported.
 2.1 financial analysis
5) Variations in Accounting Policies :
Business firms have some latitude in the accounting treatment of items like
depreciation, valuation of stocks, research and development expenses, foreign
exchange transactions, installment sales, preliminary and pre-operative expenses,
provision of reserves, and revaluation of assets.
6) Interpretation of Results :
Though industry averages and other yardsticks are commonly used in financial
ratios, it is somewhat, difficult to judge whether a certain ratio is ’good’ or ’bad’.
7) Correlation among Ratios :
Financial ratios of a firm often show a high degree of correlation. This is because several
ratios have some common element and several items tend to move in harmony because
of some common underlying factor.
8) Accounting Estimates :
Accounting requires the use of estimates in the preparation of financial statements
where precise amounts cannot be established. Estimates are inherently subjective
and therefore lack precision as they involve the use of management's foresight in
determining values included in the financial statements.
 2.1 financial analysis
9) Professional Judgment :
The use of professional judgment by the preparers of financial statements is
important in applying accounting policies in a manner that is consistent with the
economic reality of an entity's transactions.
10) Use of Historical Cost :
Historical cost is the most widely used basis of measurement of assets. Use of
historical cost presents various problems for the users of financial statements as it
fails to account for the change in price levels of assets over a period of time.
11) Different Industries :
Different industries may be affected by different social policies, special accounting
procedures, or other individual industry attributes. Ratios of companies in different
industries are not comparable without considering industry characteristics.
12) Changing Economic Environment :
When comparing firms, analysts must be alert to changes in general economic trends
from year to year. Significant changes in fuel costs and interest rates in recent
years make old rule-of-thumb guidelines for evaluating these factors obsolete.
 2.2 Techniques of financial
analysis and interpretation
 Financial statement analysis involves the comparison of information of one entity
over different periods of time or the comparison of information of different entities
during the same period. The following two methods depict the analysis of financial
statements :
1) Ratio Analysis :
Ratios are among the best-known and most widely used tools of financial analysis. Ratio
analysis is the systematic process of determining and interpreting the numerical
relationship of various items derived from the financial statement of a business.
2) Fund Flow Analysis/Statement :
It is the statement, which portrays the change in financial structure of a concern. A
statement of funds received and expended. The fund flow statement of changes, in
financial position such as reserves and application or uses of fund
3) Cash Flow Analysis :
The cash flow analysis is the statement which shows inflow and outflow of cash
during a particular period. The cash flow analysis speaks about the reasons of
changes in cash and bank balance during two or more accounting periods.
 2.2 Techniques of financial
analysis and interpretation
4) Cash Budget :
The preparation of cash budget is useful for efficient working of an enterprise. The cash
budget is based on the cash forecast. The forecast is an estimate of probable uses, is
kept in mind.
5) Comparative Financial Statements :
The comparative financial statements of two or more periods can be compared by
placing them side by side and noting the changes in each item of balance sheet and
income statement.
6) Common Measurement or Analysis :
Here the total of group figure is taken as 100 and all the component items are calculated
in percentage of the total which has a common size i.e. 100. Thus, the financial
statements are known as common size financial statement.
7)Trend Percentage Analysis :
Trend percentage is used for analysis when comparison is made for long period.
Trend percentage can be computed by Index numbers.
 2.3 fund flow statement

A) Meaning :
Fund flow statement is a technical tool used to show the change in financial
conditions of an enterprise between the opening and closing date of balance sheet.
Funds Flow Statement is a statement prepared to analyse the reasons for changes in
the Financial Position of a Company between two Balance Sheets.
B) Definitions :
1) Malchman and Slavin :
“The term fund has a variety of meanings. Cash and securities, working capital,
current assets, quick assets, net purchasing power, etc.”
2) Robert Anthony :
“The fund flow statement describes the sources from which additional funds were
derived and the use to which these funds were put,”
3) Eric L. Kohler :
“ A statement of funds received and expended; a statement of change in financial
position or sources and application of funds in which elements of net income and
working capital.”
 2.3 fund flow statement

C) Concepts of Fund Flow Statement :

1) Concept of Fund :
Concept of funds means cash or working capital. The term working capital may be :
a) Gross Working Capital :
"Gross Working Capital" represents total of all Current Assets.
b) Net Working Capital :
"Net Working Capital" refers to excess of Current Assets over Current Liabilities.
In a narrow sense the word "Fund" denotes cash or cash equivalents.
2) Concept of Flow of Funds :
In the simplest words, ‘Flow is a movement which refers to change’. Change of fund
means an increase or decrease in funds.
3) Source of Fund :
It is any transaction that results in an increase in working capital (inflow of funds.
4) Application of Funds :
It is any transaction that results in a decrease in working capital (outflow of funds
 2.3 fund flow statement
D) Importance of Fund Flow Statement :
Following are the uses of the fund flow statement which show its importance:
1) Help in Decision Making :
In the evaluation of alternative finance & investment plans, funds flow statement
helps the management in the assessment of long-range forecasts of cash
requirements & availability of liquid resources. The management can judge the
quality of management decisions.
2) Helpful for Investors :
On the basis of comparative study of the past with the present, investors can locate
and identify possible drains on funds in the near future.
3) Economic Analysis :
Funds statement serve as effective tools to the management for economic analysis
as it supplies additional information, which cannot be provided by financial
statements, based on historical data.
4) Show the Result :
Fund statement explains the relationship between changes in working capital & net
profits. Funds statement clearly shows the quantum of funds generated from
operations.
 2.3 fund flow statement
5) Help in Planning :
Funds statement helps in the planning process of a company.
6) Determination of Consequences :
Funds statement explains the financial consequences of business activities
7) Help in Forecasting :
The fund flow statement highlights the sources and its future uses.
8) Provide Clues to Creditors :
Fund statement provides clues to the creditors & financial institutions as to the ability of
a company to use funds effectively in the best interest of the investors, creditors & the
owners of the company.
9) Decision Making :
In the modern setup, large scale business is done which requires financial planning.
Before the loans are granted, a number of questions are asked regarding the worthiness
of credit and all other things. All such questions can be answered with the help of fund
flow statement.
10) Source of Reliable Information :
The information contained in fund flow statement is more reliable, dependable &
consistent as it is prepared to include funds generated from operations & not net profit
after depreciation.
 2.3 fund flow statement

E) Limitations :
Some of the limitations of funds flow statement are:
It cannot be Used Alone
It does not Reveal Cash Position of Company
It Lacks Originality
Historic in Nature
Static
Incomplete Statement
Non Original Statement
Non Substitutable
 2.4 cash flow statement
analysis
The Cash flow statement analysis is the final component of a company’s annual
report. It throws light on the cash generating ability of a company. The statement records
the actual movements in cash in an accounting period.
A) Meaning :
The cash flow statement is one of several core financial documents in any business
enterprise. Cash flow statements and projections express a business's results or
plans in terms of cash in and out of the business, without adjusting for accrued
revenues and expenses. The cash flow statement does not show whether the
business will be profitable, but it does show the cash position of the business at
any given point in time by measuring revenue against outlays.
B) Definition :
“A financial statement that reflects the inflow of revenue vs. the outflow of
expenses resulting from operating, investing and financing activities during a
specific time period.”
 2.4 cash flow statement
analysis
C) Objectives of Cash Flow Statement :
The information in a statement of cash flows should help investors, creditors, and
others assess:
 2.4 cash flow statement
analysis
1) Generate Future Cash Flows :
By examining relationships between items in the statement of cash flows, investors
and others can better predict the amounts, timing, and uncertainty of future cash
flows.
2) Compare Reliability of Encashment :
The reasons for the difference between net income and net cash provided (used)
by operating activities.
3) Investing and Financing Transactions :
The investing and financing transactions during the period by examining a
company’s investing activities and financing activities, a financial statement reader
can better understand why assets and liabilities increased or decreased during the
period.
4) Show Relationship of Net Income to Changes in Business Cash:
Usually cash and net Income move together. High levels of Income tend to lead to
Increase In cash and vice-versa. However, a company’s cash balance can
decrease when its net Income is high and cash can increase when income is low.
 2.4 cash flow statement
analysis
5) Efficiency in Cash Management :
Cash flow analysis helps in evaluating financial policies and cash position. It
facilitates the management to plan and co-ordinate the financial operations
properly.
6) Discloses the Movement of Cash :
A comparison of cash flow statement for the previous year with the budget for that
year would indicate to what extent the resources of the enterprise were raised and
applied.
7) Discloses Success or Failure of Cash Planning :
A success or failure of cash planning can be known by comparing the projected
cash flow statement with the actual cash flow statement and necessary remedial
measures can be taken.
8) Evaluate Management Decisions :
The statement of cash flows reports the companies‘investing and financing
activities and thus gives the Investors and creditors about cash flow information for
evaluating managers‘decisions.
 
 2.4 cash flow statement
analysis
D) Information Comprises in Cash Flow Statement :
A Cash Flow Statement comprises information on following 3 activities:
1) Operating Activities :
Operating activities include cash flows from all standard business operations. Cash
receipts from selling goods and services represent the inflows. The revenues from
interest and dividends are also included here.
2) Investing Activities:
Investing activities include transactions with assets, marketable securities and credit
instruments. The sale of property, plant and equipment or marketable securities is
a cash inflow.
3) Financing Activities:
Financing activities on the statement of cash flows are much more defined in nature.
The receipts come from borrowing money or issuing stock. The outflows occur
when a company repays loans, purchases treasury stock or pays dividends to
stockholders.
 2.4 cash flow statement
analysis
E) Advantages of Cash Flow Statement :
The chief advantage of the cash flow analysis is as follows-
Helpful in Coordinate of Financial Operations
Facilitate in Preparing Cash Budget
Efficient Cash Management
Disclosing Movement of Cash
Management in Explaining Company's Position :
Provide Short-term Financial Position
Helps to Determine the Likely Flow of Cash
Supplemental to Funds Flow Statement
Better Tool of Analysis
Helps in Financial Planning
Aids Internal Financial Management
Reveals Success or Failure of Cash Planning
 2.4 cash flow statement
analysis

F) Disdvantages of Cash Flow Statement :

The chief disadvantage of the cash flow analysis is as follows-
It does not Represent Real Liquid Position of Business
It cannot Replace Fund Flow or Income Statement
Considered as In -Accurate and Misleading
Misleading Inter-Firm Comparison
Influenced by Changes in Management Policies
Cannot be Equated with Income Statements
Cash Flow Statement Cannot Replace the Funds Flow Statement
 2.5 ratio analysis
 The ratio analysis is one of the most powerful tools of financial analysis. It is used as
a device to analyze and interpret the financial health of enterprise. With the help of
ratios analysis, the financial statements can be analyzed more clearly and decisions
can be made on such analysis.
A) Meaning :
It is defined as the systematic use of ratio to interpret the financial statements so
that the strength and weaknesses of a firm as well as its historical performance and
current financial condition can be determined. The term ratio refers to the numerical
or quantitative relationship between two variables.
B) Definitions :
1) J. Batty :
"The term accounting ratio is used to describe significant relationships which exist
between figures shown in a balance shoot and profit and loss account in a
budgetary control system or any other part of the accounting management.”
 2.5 ratio analysis
C) Types of Ratios and its Interpretation :
Financial ratios can be classified according to the information they provide. The
following types of ratios frequently are used:
1) Liquidity Ratios :
Liquidity ratios provide information about a firm's ability to meet its short-term
financial obligations
a) Current Ratio :
The current ratio is the ratio of current assets to current liabilities.
Current Assets
Current Ratio 
Current Liabilities
b) Quick Ratio :
The quick ratio is an alternative measure of liquidity that does not include inventory
in the current assets.

c) Cash Ratio :
Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current
assets except the most liquid: cash and cash equivalents
 2.5 ratio analysis
2) Asset Turnover Ratios :
Asset turnover ratios indicate of how efficiently the firm utilizes its assets. .
Receivables turnover is an indication of how quickly the firm collects its accounts
receivables and is defined as follows:
a) Receivables Turnover :
The receivables turnover often is reported in terms of the number of days that credit
sales remain in accounts receivable before they are collected.

b) Inventory Turnover:
Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in
a time period divided by the average inventory level during that period:
 2.5 ratio analysis
3) Financial Leverage Ratios :
Financial leverage ratios provide an indication of the long-term solvency of the firm.
Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial
leverage ratios measure the extent to which the firm is using long term debt. The debt
ratio is defined as total debt divided by total assets:

Total Debt
Debt Ratio 
Total Assets

Total Debt
Debt to Equity Ratio 
Total Equity

EBIT
Interest Coverage 
Interest Ch arg es
 2.5 ratio analysis
4) Profitability Ratios :
The main aim of an enterprise is to earn profit which is necessary for the survival
and growth of the business enterprise. It is earned with the help of amount invested
in business. It is necessary to know how much profit has been earned with the help
of the amount invested in the business. This is possible through profitability ratio.
a) Gross Profit Ratio :
It expresses the relationship of gross profit to net sales. It is expressed in
percentage. It is computed as:

b) Net Profit Ratio :

A ratio of net profit to sales is called Net profit ratio. The ratio is calculated as
 2.5 ratio analysis
c) Operating Profit Ratio :
Operating profit is an indicator of operational efficienciesThis ratio is expressed as
a percentage. It is calculated as :

d) Return on Investment Ratio (ROI) :

ROI is the basic profitability ratio. This ratio establishes relationship between
net profit (before interest, tax and dividend) and capital employed. This ratio is also
known as Return on capital employed ratio. It is calculated as under

5) Dividend Policy Ratios :

Dividend policy ratios provide insight into the dividend policy of the firm and the
prospects for future growth.. The dividend yield is defined as follows:
Dividends per share
Payout Ratio 
Earnings per share
 2.5 ratio analysis
D) Importance of Ratio Analysis :
The ratio analysis is the most important tools of financial analysis. The importance
of ratio analysis can be summarised as under:
1) It Helps in Evaluating the Firms Performance :
With the help of ratio analysis conclusion can be drawn regarding several
aspects such as financial health, profitability and operational efficiency of the
undertaking.
2) Facilitate Inter-Firm Comparison :
Ratio analysis helps in inter-firm comparison by providing necessary data.
3) It Simplifies Financial Statement :
The information given in the basic financial statements serves no useful
Purpose unless it s interrupted and analyzed in some comparable terms.
4) Aids in Determining Financial Position of Company :
Ratio analysis facilitates the management to know whether the firm’s financial
position is improving or deteriorating or is constant over the years by setting a trend
with the help of ratios
 2.5 ratio analysis

5) Useful in Budgeting and Forecasting :

Accounting ratios provide a reliable data, which can be compared, studied and
analyzed. These ratios provide sound footing for future prospectus
6) Analyse Liquidity Position of a Firm :
With help of ratio analysis conclusions can be drawn regarding the Liquidity position
of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its
current obligation
7) Assesses Long Term Financial Ability:
Ratio analysis is equally for assessing the long term financial ability of the Firm.
8) Determine Operating Efficiency :
Yet another dimension of usefulness or ratio analysis, relevant from the View point of
management is that it throws light on the degree efficiency in the various activity ratios
measures this kind of operational efficiency.