Financial Statement Analysis

• Financial statement analysis is the process of evaluating

a company's financial health and performance by
examining its financial statements. It involves analyzing
a company's income statement, balance sheet, cash
flow statement, and other financial documents
Definitions
1.Charles T. Horngren: Describes it as the process of
examining financial statements to make informed business
decisions.
2.K. R. Subramanyam: Defines it as the use of financial
statements to evaluate a company’s past performance and
predict future performance.
3.David F. Hawkins: Emphasizes that financial statement
analysis is a systematic approach to understanding a
company's financial position, focusing on ratios and trends.
4.Robert N. Anthony: Views it as a tool for management to
evaluate the financial implications of business decisions.
• These definitions underscore the significance of financial
statement analysis in decision-making, performance
evaluation, and forecasting.
Objectives of Financial Statement
Analysis
• Assessment of Past Performance
• Assessment of Current Position
• Prediction of Profitability and Growth Prospects
• Prediction of Bankruptcy and Failure
• Assessment of the operational Efficiency
The objectives of financial statement analysis include:

1.Assessing Financial Performance: To evaluate a company's profitability,

efficiency, and overall financial health over a specific period.
2.Identifying Trends: To analyze financial data over multiple periods to identify
patterns or trends that can inform future performance and strategy.
3.Evaluating Financial Position: To determine the company's stability and
solvency by examining its assets, liabilities, and equity.
4.Facilitating Investment Decisions: To provide investors with essential data
to make informed decisions regarding buying, holding, or selling securities.
5.Supporting Credit Decisions: To help creditors assess the creditworthiness of
a company and make decisions regarding lending.
6.Enhancing Strategic Planning: To provide insights that assist management
in making informed operational and strategic decisions.
7.Benchmarking: To compare financial performance against industry standards
or competitors to identify strengths and weaknesses.
• These objectives aim to provide a comprehensive understanding of a
company's financial health and support informed decision-making by various
stakeholders.
Importance of financial statement
analysis
• Financial statement analysis is important because it helps
businesses and investors make informed decisions about a
company's financial health and potential for growth:
• Understand a company's financial health
• Financial statement analysis provides a comprehensive
view of a company's financial performance and condition.
This includes a company's profitability, liquidity, solvency,
and operational effectiveness.
• Identify growth opportunities
• Financial statement analysis can help identify areas where
a company can grow, such as by analyzing revenue trends,
asset utilization, and cash flow.
• Make better decisions
• Financial statement analysis helps businesses and
investors make data-driven decisions by providing
current, unbiased data.
• Protect against legal issues
• Complying with financial reporting standards is a legal
requirement and helps businesses maintain their
reputation.
• Attract investment
• Investors use financial statement analysis to decide
whether to invest in a company.
Types of Statements
• The four primary types of financial statements are:
• Balance sheet
• Income statement
• Cash flow statement
• Statement of shareholders' equity:
Various Techniques of Financial Statement analysis
Common Size Statements:
• Definition: Convert financial statement items into percentages of a
base figure (e.g., total assets for balance sheets, total revenue for
income statements).
•Purpose: Simplifies comparison across companies of different sizes
and over different periods.
•Use:
• Analyze the proportion of expenses to revenue.
• Evaluate the composition of assets, liabilities, and equity.
Comparative Statements
These are the statements showing the profitability and financial position of a firm for
different periods of time in a comparative form to give an idea about the position of two
or more periods. It usually applies to the two important financial statements, namely,
balance sheet and statement of profit and loss prepared in a comparative form. The
financial data will be comparative only when same accounting principles are used in
preparing these statements. If this is not the case, the deviation in the use of accounting
principles should be mentioned as a footnote. Comparative figures indicate the trend and
direction of financial position and operating results. This analysis is also known as
‘horizontal analysis’
Trend Analysis

• In trend analysis First year amount is consider as base

year and compares the amounts of all years (2nd , 3rd,
4th) with that base year to ascertain the trend in
percentage.
• Calculate trend percentages by:
• • Selecting a base year as 100.
• • Assigning a weight of 100% to the all amounts
appearing
• on the base-year financial statements.
• • Trend % = current year amount/ Base year × 100 to
get a
• Percentage
RATIO ANALYSIS

A ratio shows the relationship between two numbers. Accounting ratio shows the relationship
between two accounting figures. Ratio analysis is the process of computing and presenting the
relationships between the items in the financial statement. It is an important tool of financial
analysis, because it helps to study the financial performance and position of a concern. Ratios
show strengths and weaknesses of the business.
Liquidity Ratio
• Liquidity is a very critical part of a business. Liquidity is
required for a business to meet its short term obligations.
Liquidity ratios are a measure of the ability of a company to
pay off its short-term liabilities.

• Liquidity ratios determine how quickly a company can convert

the assets and use them for meeting the dues that arise. The
higher the ratio, the easier is the ability to clear the debts and
avoid defaulting on payments.

• This is a very important criterion that creditors check before

offering short term loans to the business. An organisation
which is unable to clear dues results in creating impact on the
creditworthiness and also affects credit rating of the company.
Current ratio

• The current ratio, also known as the working capital

ratio, measures the capability of a business to meet its
short-term obligations that are due within a year. The
ratio considers the weight of total current assets versus
total current liabilities.
• It indicates the financial health of a company and how it
can maximize the liquidity of its current assets to settle
debt and payables. The current ratio formula (below)
can be used to easily measure a company’s liquidity.
• Current Ratio > 1: The company has more current
assets than current liabilities, indicating good short-
term liquidity.
• Current Ratio < 1: The company may face challenges in
covering its short-term obligations, which could signal
liquidity problems.
• Current Ratio = 1: The company has just enough assets
to cover its liabilities, but no safety margin.

• Ideal current ratio is 2:1

Current Asset
Current Liability
•Accounts Payable – Amounts owed to
suppliers and vendors for goods or services
•Cash and Cash Equivalents – Physical cash, received.
bank deposits, and short-term investments. •Short-term Debt – Loans and borrowings due
•Accounts Receivable – Money owed by within a year.
customers for goods or services delivered on •Accrued Expenses – Expenses incurred but
credit. not yet paid, such as salaries, interest, and
•Inventory – Raw materials, work-in-progress, taxes.
and finished goods available for sale. •Unearned Revenue – Payments received for
•Marketable Securities – Short-term goods or services that are yet to be delivered.
investments that can be quickly sold for cash. •Taxes Payable – Income tax, sales tax, or other
•Prepaid Expenses – Advance payments for taxes owed to the government.
expenses such as rent, insurance, or utilities. •Dividends Payable – Declared dividends that
•Short-term Loans and Advances – Loans are yet to be paid to shareholders.
given to employees, suppliers, or other entities •Bank Overdraft – A negative balance in a bank
expected to be repaid within a year. account due to withdrawals exceeding deposits.
•Provision for tax
Quick Ratio
• The quick ratio, also called an acid-test ratio, measures a
company’s short-term liquidity against its short-term obligations.
Essentially, the ratio seeks to figure out if a company has enough
liquid assets (cash or things that can easily be converted into
cash) to cover its current liabilities and impending debts.
• Quick assets are a subset of current assets that can be quickly
converted into cash. They typically include:
• Cash and cash equivalents
• Marketable securities
• Accounts receivable

Note: Inventory and prepaid expenses are excluded because they

are less liquid.
• Quick Ratio > 1: The company has more than enough
liquid assets to cover its short-term liabilities, indicating
good financial health.
• Quick Ratio < 1: The company may struggle to meet its
short-term obligations without selling inventory or
securing additional financing.
• Quick Ratio = 1: The company's liquid assets exactly
match its current liabilities, providing minimal cushion.
• The Ideal Quick Ratio is 1:1
Quick Assets = Current Assets –(Stock(Inventory) and prepaid Expenses
Quick Liabilities = Current Liabilities –(Bank Overdraft +Cash credit)
• Quick assets
• 45000+60000
+55000+4000
0
= 200000
Quick Liabilities
30000+40000=
70000
Quick ratio =
200000/70000
=2.85
2.28:1
or
200000/130000
=1.53
What is Solvency Ratio?

Solvency ratios are a key component of the financial analysis which helps in determining
whether a company has sufficient cash flow to manage the debt obligations that are due.
Solvency ratios are also known as leverage ratios. It is believed that if a company has a low
solvency ratio, it is more at the risk of not being able to fulfil its debt obligation and is
likely to default in debt repayment.
Solvency ratios are used by prospective business lenders to determine the solvency state of
a business. Companies that have a higher solvency ratio are deemed more likely to meet the
debt obligations while companies with a lower solvency ratio are more likely to pose a risk
for the banks and creditors. Solvency ratios vary with the type of industry, but as a good
measure a solvency ratio of 0.5 is always considered as a good number to have.
Debt-Equity Ratio/Total Debt Equity Ratio

The debt-to-equity (D/E) ratio is a financial metric that compares a company's debt to its equity. It's used to
assess a company's financial health and risk, and to help determine if an investment is worthwhile

It shows the relationship between borrowed funds and owner’s funds, or external funds (debt) and internal funds
(equity). The purpose of this ratio is to show the extent of the firm’s dependence on external liabilities or external
sources of funds. In order to calculate this ratio, the required components are external liabilities and owner’s equity or
networth. ‘External liabilities, include both long-term as well as short-term borrowings. The term ‘owners equity’
includes past

•A low D/E ratio indicates that a company is less risky and has less debt
•A high D/E ratio indicates that a company is more risky and has more
debt
Where
Total Long-term debt /External Equities = Debentures + Term Loans+ loan on Mortgage +
Loan from financial Institutions + Other Long term Loans + Redeemable preference
shares
Share Holders Funds/Internal Equities = Equity Share Capital +Irredeemable Preference
share capital +Capital Reserves + Retained Earnings +Any earmarked Surplus like
provisions for Contingencies etc
Proprietary Ratio
The proprietary ratio is a financial metric that measures the proportion of a company's total
assets that are financed by its shareholders' equity. It's also known as the equity ratio, net
worth ratio, or shareholder equity ratio.

This ratio is also known as Equity Ratio or Net worth to Total Assets Ratio. It is a variant
of Debt-Equity Ratio, and shows the relationship between owners’ equity and total assets
of the firm. The purpose of this ratio is to indicate the extent of owners’ contribution
towards the total value of assets. In other words, it gives an idea about the extent to which
the owners own the firm. The components required to compute this ratio are proprietors’
funds and total assets.
A higher proprietary ratio indicates that the company is less reliant on debt and other
external financing sources. This suggests that the company is in a strong financial
position. A lower ratio may indicate higher financial risk due to greater reliance on debt

Proprietors’ funds include equity capital, preference capital, reserves and undistributed
profits. If there are accumulated losses they are deducted from the owners’ funds. ‘Total
assets’ include both fixed and current assets but exclude fictitious assets, such as
preliminary expenses; debit balance of profit and loss account etc. Intangible assets, if
any, like goodwill, patents and copy rights are taken at the amount at which they can be
realized . The formula of this ratio is as follows :
Interest coverage ratio
Interest coverage ratio is one of the most important ratios that need to be learned
when assessing risk management and the possible reduction methods. Interest
coverage ratio plays a very important role for stockholders and investors as it
measures the ability of a business to pay interests on its outstanding debt.
It acts as a solvency check for the business organisation using which financial
advisors, business analysts and investors can determine the ability of a business or a
company to pay off the accumulated interest on the debt they are holding.
Interest coverage ratio is also known as debt service coverage ratio or debt service
ratio. It is determined by dividing the earnings before interest and taxes (EBIT) with
the interest expenses payable by the company during the same period.
•Below 1: The company may have difficulty generating enough cash to cover its interest
obligations.
•Below 1.5: The company may have difficulty paying interest on its debt.
•2.5 to 3: The company can comfortably service its debt with current earnings.
 Capital Gearing Ratio

The Capital Gearing Ratio (CGR) is a financial metric used to evaluate the proportion of debt to equity in a company's
capital structure. It is particularly important for analyzing the financial stability and risk profile of a company. A higher
ratio indicates that a company relies more on borrowed funds, which can increase financial risk, especially in periods of
economic uncertainty.

w gearing ratio indicates less financial risk

h gearing ratio indicates high financial leverage
od gearing ratio depends on the industry and the company's financial strategy
• Asset to Debt Ratio
• This ratio measures how many times a company's total
assets cover its total debt. A higher ratio indicates that
the company has more assets relative to its debt, which
suggests financial stability.

A ratio greater than 1 means the company has more assets than debt.
A very high ratio indicates low financial risk.
• Debt to Asset Ratio
• This ratio measures what portion of a company's assets
is financed by debt. A higher ratio indicates higher
financial leverage and risk.
Not 670000
Its 672000
Profitability Ratios
Profitability ratios are a type of accounting ratio that helps in determining the financial
performance of business at the end of an accounting period. Profitability ratios show how
well a company is able to make profits from its operations.
Gross Profit Ratio

Gross Profit Ratio is a profitability ratio that measures the relationship between the gross
profit and net sales revenue. When it is expressed as a percentage, it is also known as the
Gross Profit Margin.

The gross profit ratio (also called the gross profit margin) is a financial metric used to evaluate
a company's profitability by showing the relationship between its gross profit and its revenue
(sales). It is expressed as a percentage and indicates how efficiently a company produces and
sells goods or services while managing its production costs.

A higher gross profit ratio indicates the

company is making more profit per dollar of
sales after covering production costs.

A lower gross profit ratio could signal higher

production costs or pricing issues.
Cost of Goods sold =Opening stock+
Purchases+ Direct expenses-Closing stock
Net Profit Ratio

The Net Profit Ratio is a financial metric that measures the after-tax profitability of a
company relative to its revenue generated in the corresponding period

The net profit ratio (or net profit margin) measures the relationship between a company's net
profit and its net sales. It indicates how much of each dollar earned in revenue translates into
profit after accounting for all expenses, including operating costs, interest, taxes, and other
expenses.

A higher net profit ratio

indicates better profitability
and cost efficiency.

A lower ratio suggests higher

expenses or lower efficiency
in generating profits.
Operating Ratio

The operating ratio is a financial metric that measures the proportion of a company's operating
expenses to its net sales. It helps assess how efficiently a company is managing its core
operations and is particularly useful for evaluating operational efficiency.

An operating cycle (OC) is the time it takes for a business to buy goods, sell them, and get paid
for them. It's a financial metric that helps businesses understand how efficiently they're using
their resources

A lower operating ratio is better,

as it means a smaller proportion
of sales is used to cover
operating costs, leaving more
room for profit.

A higher operating ratio

indicates higher costs relative to
sales, which can reduce
profitability.
Operating Profit Ratio

The Operating Profit Ratio is a key financial ratio used to measure the proportion of a
company's operating profit relative to its net sales. It provides insights into how efficiently a
company is managing its core operations to generate profit before accounting for non-operating
items like interest and taxes.
The operating profit ratio, also known as the operating margin, is a profitability ratio that
measures a company's operating profit relative to its net sales. It's expressed as a percentage

A higher ratio indicates strong

operational efficiency, as more of the
revenue is being retained as profit.

A lower ratio might signal high

operating costs, inefficiencies, or
pricing issues.
Expenses Ratio

The Expenses Ratio is a financial metric used to measure the proportion of a company's total
expenses relative to its net sales. It helps evaluate how much of the company's revenue is being
consumed by expenses, providing insights into cost efficiency and operational management.

A higher Expenses Ratio indicates that a

significant portion of sales revenue is
being used to cover expenses, leaving
less for profit.

A lower Expenses Ratio shows better

cost control and efficiency, with more
revenue retained for profit or
reinvestment.
Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE) is a financial ratio used to assess a company's

profitability and the efficiency with which its capital is employed. It indicates how well a
company is generating profit relative to the capital it has invested in its operations.

A higher ROCE indicates efficient use of capital

to generate profit.

A lower ROCE suggests underutilization of

capital or inefficiencies in operations.

Operating profit can also be total sales

Return on Equity (ROE)

Return on Equity (ROE) is a financial ratio that measures a company’s profitability relative to
the equity invested by its shareholders. It indicates how efficiently a company is using
shareholders' funds to generate profit.
Return on equity (ROE) is a financial ratio that measures how well a company generates profit
from shareholder investments. It's calculated by dividing a company's net income by its
average shareholders' equity

A higher ROE
indicates the
company is
efficiently using
shareholders'
funds to generate
profit.

A lower ROE
suggests
inefficiencies or
underperformance
in generating
returns.
Earnings Per Share (EPS) Ratio

Earnings Per Share (EPS) is a key financial metric used to measure the profitability of a
company on a per-share basis. It represents the portion of a company's profit allocated to each
outstanding share of common stock, providing an indication of the company's profitability from
the perspective of shareholders.

Earning per share = Net Profit after tax and interest –Preference Dividend
Number of Equity Shares

Net Income = Total profit of the company (after taxes and all expenses).
Preferred Dividends = Dividends paid to preferred shareholders (if any).

A higher EPS suggests that the company is more profitable on a per-share basis, which is
attractive to investors.

A lower EPS can indicate that the company is not generating as much profit per share, which
may be a concern for investors.
Price-to-Earnings (P/E) Ratio
The Price-to-Earnings (P/E) Ratio is a widely used financial metric that compares a company's
current share price to its earnings per share (EPS). It helps investors determine whether a stock
is overvalued or undervalued relative to its earnings and assess market expectations for future
growth.

Earning per share = Net Profit after tax and interest –Preference Dividend
Number of Equity Shares
Operating Profit =Sales –(Cost of
Goods sold +Operating
Expense+ Administrative
expense
 Activity /Turnover Ratios
Activity ratios are used to determine the efficiency of the organization in utilizing its assets for generating cash and revenue. It
is used to check the level of investment made on an asset and the revenue that it is generating. For this reason, the activity
ratio is also known as the efficiency ratio or the more popular turnover ratio.
The role of activity ratio or turnover ratio is in the evaluation of the efficiency of a business by careful analysis of the
inventories, fixed assets and accounts receivables.
Stock Turnover Ratio

This is one of the most important turnover ratios which highlights the relationship between the inventory or stock in
the business and cost of the goods sold. It shows how fast the inventory gets cleared in an accounting period or in
other words, the number of times the inventory or the stock gets sold or consumed. For this reason, it is also known
as the inventory turnover ratio.
Stock Turnover ratio= Net Sales
Average Stock

What does STR indicate?

High STR
The company is selling
Cost of Goods sold =Sales –Gross profit inventory more frequently,
or which can lead to lower
Cost of Goods Sold =Opening Stock+ Purchases +Direct Expenses- holding costs and higher
Closing Stock profits
Average Stock /Inventory = Opening Stock +Closing stock
2 Low STR
The company may be
overstocked, which can lead
to higher holding costs and
obsolete inventory
Fixed Assest Turnover Ratio
The fixed asset turnover ratio (FAT) is a financial metric that measures how well a company uses
its fixed assets to generate sales. It's calculated by dividing a company's net sales by the
average value of its fixed assets over a specific period
The fixed asset turnover ratio reveals how efficiently a company generates sales from its existing
fixed assets

Net Sales =Gross Sales-Sales Return

Net Fixed Assets =Gross (Total) Fixed Assets-Depreciation

What it indicates
A higher FAT ratio indicates that a company is using its fixed assets more
effectively
A lower FAT ratio indicates that a company is underutilizing its fixed assets
A very high FAT ratio could indicate underinvestment in fixed assets
Debtor Turnover Ratio
This ratio is an important indicator of a company which shows how well a company is able to provide credit
facilities to its customers and at the same time is also able to recover the due amount within the payment
period.
It is also known as accounts receivable turnover ratio as the payments for credit sales that will be received in
the future are known as accounts receivables.

What it indicates
A high ratio indicates that a company is collecting its receivables quickly
A low ratio indicates that a company may not be collecting credit on time
Creditors Turnover Ratio
Creditors turnover ratio is a measure of the capability of the company to pay off the amount for
credit purchases successfully in an accounting period.
It shows the number of times the account payables are cleared by the company in an accounting
period. For this reason, it is also known as the Accounts payable turnover ratio.
The creditors turnover ratio, also known as the accounts payable turnover ratio, is a measure
of how often a company pays its creditors. It's a liquidity ratio that shows how well a
company manages its cash flow and short-term liquidity

What a higher ratio means

A higher ratio indicates that a company is paying off its debts more quickly
A higher ratio indicates that a company has healthy cash flow
A higher ratio indicates that a company is making use of early payment discounts
What a lower ratio means
A lower ratio indicates that a company is not taking full advantage of the credit period
allowed by creditors
A lower ratio could mean that a company has less cash than earlier assessment and might be
Working Capital Turnover Ratio
This ratio is helpful in determining the effectiveness with which a company is able to utilise its working capital
for generating sales of its goods.

The working capital turnover ratio is a financial ratio that measures how well a company uses
its working capital to generate sales. It's calculated by dividing a company's net sales by its
average working capital

Net Sales = Gross Sales-Sales Return

Net Working Capital= Current Assets-Current Liability

What it indicates
A high ratio indicates the company is efficient at using its working capital
A low ratio indicates the company may be investing too much in inventory or accounts receivable
A negative ratio indicates the company may not be generating enough sales from its working capita
Calculate Current Ratio , Quick Ratio, Net profit ratio, Fixed asset turn over ratio, Return on share holders
fund, Current asset turn over ratio, Inventory turn over ratio, capital employed turn over ratio, Debt Equity
Ratio, Proprietary ratio fixed asset