Here are more detailed notes on Financial Analysis, expanding on the tools and techniques.

This document is designed to be comprehensive and printable for your UGC NET Commerce
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UGC NET Commerce: Financial

Statement Analysis - Detailed Notes
Financial Statement Analysis is the process of reviewing and analyzing a company's financial
reports (Balance Sheet, Income Statement, Cash Flow Statement) to make better economic
decisions. It involves understanding the relationships between different financial numbers and
trends over time.

I. Meaning and Objectives of Financial Analysis

1. Meaning
Financial analysis involves breaking down financial information into meaningful insights to
evaluate a company's past performance, current financial health, and future prospects. It's used
by a wide range of stakeholders including investors, creditors, management, employees, and
regulators.

2. Objectives
The primary objectives of financial analysis include:
●​ Assessing Liquidity: Evaluating the company's ability to meet its short-term obligations
(current liabilities).
●​ Assessing Solvency: Evaluating the company's ability to meet its long-term obligations
(long-term debt).
●​ Evaluating Profitability: Measuring the company's ability to generate profits from its
operations, assets, and equity.
●​ Analyzing Efficiency: Assessing how effectively the company is utilizing its assets and
resources to generate sales and profits.
●​ Forecasting Future Performance: Projecting future earnings, cash flows, and financial
position based on historical trends and current conditions.
●​ Assisting in Investment Decisions: Helping investors decide whether to buy, sell, or
hold a company's shares.
●​ Assisting in Lending Decisions: Helping banks and other creditors assess the
creditworthiness of a company before granting loans.
●​ Identifying Strengths and Weaknesses: Pinpointing areas where the company excels
and areas that need improvement.
●​ Benchmarking: Comparing the company's performance against industry averages,
competitors, or its own past performance.

II. Tools of Financial Analysis

Various tools and techniques are employed to conduct financial analysis. Each tool offers a
different perspective on the financial health of an organization.

1. Comparative Statements (Horizontal Analysis)

●​ Concept: Also known as Horizontal Analysis or Trend Analysis. These statements
present financial data for two or more accounting periods side-by-side, along with the
absolute changes and percentage changes from one period to another.
●​ Purpose: To identify trends, patterns, and growth rates over time. It helps in
understanding the direction and magnitude of changes in key financial metrics.
●​ Preparation:
○​ Step 1: Select a base year.
○​ Step 2: For each item, calculate the absolute change from the base year to the
current year.
○​ Step 3: Calculate the percentage change for each item: (Current Year Value - Base
Year Value) / Base Year Value * 100.
●​ Advantages:
○​ Highlights the growth or decline of specific accounts over time.
○​ Simple to understand and interpret.
○​ Useful for analyzing long-term performance.
●​ Limitations:
○​ If the base year figure is zero or negative, percentage change cannot be calculated
or is misleading.
○​ Doesn't provide insights into the relative importance of items within a single period.

2. Common Size Statements (Vertical Analysis)

●​ Concept: Also known as Vertical Analysis. In common size statements, each item in a
financial statement is expressed as a percentage of a base figure within the same
statement.
○​ For the Income Statement, each item is expressed as a percentage of Net Sales
(Revenue from Operations).
○​ For the Balance Sheet, each item is expressed as a percentage of Total Assets
(or Total Liabilities + Equity).
●​ Purpose: To analyze the relative importance of different items within a single accounting
period and to facilitate comparison between companies of different sizes or over different
periods when absolute figures are not comparable.
●​ Preparation: Each line item / Total Revenue (or Total Assets) * 100.
●​ Advantages:
○​ Facilitates internal analysis by highlighting the proportional contribution of each
item.
○​ Enables easy comparison of financial structures between companies of varying
sizes (benchmarking).
○​ Reveals changes in the composition of assets, liabilities, and expenses over time.
●​ Limitations:
○​ Does not show absolute changes or growth rates.
○​ Can be misleading if the base figure itself is very small or distorted.
3. Trend Analysis
●​ Concept: A sophisticated form of horizontal analysis where financial data for several
years (more than two) is compared to a base year. Trend percentages are calculated to
show the direction and speed of change.
●​ Purpose: To identify long-term patterns, consistent growth or decline, and to forecast
future performance.
●​ Preparation: Select a base year. For each subsequent year, express each financial
statement item as a percentage of the base year's corresponding item.
○​ Trend Percentage = (Current Year Value / Base Year Value) * 100
●​ Advantages:
○​ Provides a clearer picture of long-term performance than just comparing two years.
○​ Helps in identifying early warning signs of deterioration or opportunities for growth.
●​ Limitations:
○​ Selection of an appropriate base year is crucial; an abnormal base year can distort
trends.
○​ Economic changes and industry-specific factors might influence trends, requiring
careful interpretation.

4. Ratio Analysis
●​ Concept: Involves calculating and interpreting relationships between different financial
figures from the financial statements. Ratios simplify complex financial data into easily
understandable metrics.
●​ Purpose: To assess various aspects of a company's performance and financial health.
Ratios are often compared to historical ratios of the same company (intra-firm
comparison) or to industry averages/competitors (inter-firm comparison).
●​ Classification of Ratios: Ratios are broadly classified into several categories based on
the aspect of financial health they measure:

a) Liquidity Ratios

Measure a company's ability to meet its short-term obligations (within one year).
●​ Current Ratio:
○​ Formula: Current Assets / Current Liabilities
○​ Interpretation: Indicates the extent to which current assets cover current liabilities.
A higher ratio (e.g., 2:1 or above) generally indicates better short-term solvency.
However, too high a ratio might suggest inefficient use of current assets.
●​ Quick Ratio (Acid Test Ratio):
○​ Formula: (Current Assets - Inventory) / Current Liabilities
○​ Interpretation: A more conservative measure of liquidity as it excludes inventory
(which may not be quickly convertible to cash). An ideal quick ratio is often
considered 1:1.
●​ Cash Ratio:
○​ Formula: (Cash + Marketable Securities) / Current Liabilities
○​ Interpretation: The most stringent liquidity measure, showing the immediate ability
to pay off current liabilities using only the most liquid assets.
b) Solvency Ratios (Leverage Ratios)

Measure a company's ability to meet its long-term obligations and the extent to which it relies on
debt financing.
●​ Debt-Equity Ratio:
○​ Formula: Total External Debt / Shareholders' Equity (or Total Long-Term Debt /
Shareholders' Equity)
○​ Interpretation: Indicates the proportion of debt financing relative to equity
financing. A higher ratio means more reliance on debt, which increases financial
risk but can also amplify returns for shareholders if debt is used effectively.
●​ Total Debt to Total Assets Ratio:
○​ Formula: Total Debt / Total Assets
○​ Interpretation: Measures the proportion of assets financed by debt. A higher
percentage indicates greater financial risk.
●​ Proprietary Ratio:
○​ Formula: Shareholders' Equity / Total Assets
○​ Interpretation: Shows the proportion of total assets financed by owner's funds. A
higher ratio indicates more financial strength and lower risk.
●​ Interest Coverage Ratio (Times Interest Earned Ratio):
○​ Formula: EBIT (Earnings Before Interest & Tax) / Interest Expense
○​ Interpretation: Measures a company's ability to cover its interest payments with its
operating earnings. A higher ratio indicates a greater cushion for meeting interest
obligations.

c) Activity Ratios (Efficiency/Turnover Ratios)

Measure how efficiently a company is utilizing its assets to generate sales or revenues.
●​ Inventory Turnover Ratio:
○​ Formula: Cost of Goods Sold / Average Inventory
○​ Interpretation: Indicates how many times inventory is sold and replenished during
a period. A higher ratio generally means efficient inventory management, but too
high could suggest stockouts.
●​ Debtors Turnover Ratio (Receivables Turnover Ratio):
○​ Formula: Net Credit Sales / Average Trade Receivables
○​ Interpretation: Measures how quickly a company collects its receivables. A higher
ratio implies efficient collection.
○​ Average Collection Period (Days Sales Outstanding): 365 Days / Debtors
Turnover Ratio.
●​ Creditors Turnover Ratio (Payables Turnover Ratio):
○​ Formula: Net Credit Purchases / Average Trade Payables
○​ Interpretation: Indicates how quickly a company pays its suppliers.
○​ Average Payment Period: 365 Days / Creditors Turnover Ratio.
●​ Working Capital Turnover Ratio:
○​ Formula: Net Sales / Working Capital (Current Assets - Current Liabilities)
○​ Interpretation: Measures how effectively working capital is utilized to generate
sales.
●​ Fixed Assets Turnover Ratio:
 ○​ Formula: Net Sales / Net Fixed Assets
○​ Interpretation: Measures how efficiently fixed assets are used to generate sales.
●​ Total Assets Turnover Ratio:
○​ Formula: Net Sales / Total Assets
○​ Interpretation: Measures the overall efficiency of asset utilization in generating
sales.

d) Profitability Ratios

Measure a company's ability to generate profits from its sales, assets, and equity.
●​ Gross Profit Ratio:
○​ Formula: (Gross Profit / Net Sales) * 100
○​ Interpretation: Indicates the percentage of sales revenue remaining after
deducting the cost of goods sold. Reflects pricing policy and production efficiency.
●​ Net Profit Ratio:
○​ Formula: (Net Profit After Tax / Net Sales) * 100
○​ Interpretation: Shows the percentage of sales revenue that remains as net profit
after all expenses, including taxes. Represents overall operational efficiency and
cost control.
●​ Operating Profit Ratio:
○​ Formula: (Operating Profit (EBIT) / Net Sales) * 100
○​ Interpretation: Focuses on the profitability from core business operations before
interest and taxes.
●​ Return on Capital Employed (ROCE):
○​ Formula: EBIT / Capital Employed (Shareholders' Equity + Long-Term Debt)
○​ Interpretation: Measures the efficiency with which a company is using its capital to
generate profits before interest and taxes.
●​ Return on Shareholders' Funds (ROSF) / Return on Equity (ROE):
○​ Formula: (Net Profit After Tax - Preference Dividend) / Shareholders' Equity
○​ Interpretation: Measures the return generated for equity shareholders on their
investment. A key ratio for investors.
●​ Earnings Per Share (EPS):
○​ Formula: (Net Profit After Tax - Preference Dividend) / Number of Equity Shares
Outstanding
○​ Interpretation: The portion of a company's profit allocated to each outstanding
share of common stock. A widely used indicator of a company's profitability.
●​ Dividend Per Share (DPS):
○​ Formula: Total Dividend Paid / Number of Equity Shares Outstanding
○​ Interpretation: The amount of dividend declared per equity share.
●​ Price-Earnings (P/E) Ratio:
○​ Formula: Market Price Per Share / Earnings Per Share
○​ Interpretation: Measures the market's expectation of a company's future earnings.
A higher P/E often indicates investors are willing to pay more for each rupee of
earnings, implying growth prospects.
●​ Dividend Yield Ratio:
○​ Formula: (Dividend Per Share / Market Price Per Share) * 100
○​ Interpretation: Measures the return on investment in terms of dividends received.
5. Cash Flow Statement (As per AS-3 / Ind AS 7)
●​ Concept: A financial statement that reports the cash generated and used by a company
during a specific accounting period. Unlike the Income Statement (accrual basis), it
focuses solely on actual cash inflows and outflows.
●​ Purpose: To provide information about the liquidity and solvency of a company and its
ability to generate cash from its operations, investments, and financing activities. It helps
users understand where cash comes from and where it goes.
●​ Classification of Cash Flows: Cash flows are categorized into three main activities:
○​ Operating Activities: Cash flows derived from the principal revenue-generating
activities of the enterprise. These are generally the cash effects of transactions that
enter into the determination of net profit or loss.
■​ Examples of Inflows: Cash receipts from sale of goods and services,
royalties, fees, commissions.
■​ Examples of Outflows: Cash payments to suppliers for goods and services, to
employees, for operating expenses, for income taxes.
○​ Investing Activities: Cash flows arising from the acquisition and disposal of
long-term assets and other investments not included in cash equivalents.
■​ Examples of Inflows: Sale of property, plant & equipment, sale of
investments, collection of loans made to others.
■​ Examples of Outflows: Purchase of property, plant & equipment, purchase of
investments, making loans to others.
○​ Financing Activities: Cash flows resulting from changes in the size and
composition of the owner's capital and borrowings of the enterprise.
■​ Examples of Inflows: Proceeds from issue of shares/debentures, long-term
borrowings.
■​ Examples of Outflows: Repayment of borrowings, redemption of preference
shares/debentures, payment of dividends.
●​ Methods of Preparation (Operating Activities only):
○​ Direct Method:
■​ Concept: Presents major classes of gross cash receipts and gross cash
payments. It converts the accrual-based revenue and expenses directly into
cash inflows and outflows.
■​ Preparation: Lists actual cash received from customers, cash paid to
suppliers, cash paid for operating expenses, cash paid for taxes, etc.
■​ Advantage: Provides a clear and intuitive picture of where cash comes from
and where it goes, useful for short-term cash management.
■​ Disadvantage: More difficult to prepare as it requires tracking individual cash
transactions for operating activities.
■​ Example (Simplified Operating Activities): Cash received from customers:
XXX Less: Cash paid to suppliers: XXX Less: Cash paid to employees: XXX
Less: Cash paid for other operating expenses: XXX Less: Cash paid for
income tax: XXX Net Cash from Operating Activities: XXX
○​ Indirect Method:
■​ Concept: Begins with Net Profit/Loss (from the Income Statement) and
adjusts it for non-cash items, non-operating items, and changes in working
capital accounts to arrive at cash flow from operating activities.
 ■​ Preparation:
■​ Start with Net Profit Before Tax and Extraordinary Items.
■​ Add back non-cash expenses (e.g., depreciation, amortization,
provision for doubtful debts) and non-operating losses (e.g., loss on
sale of fixed assets).
■​ Deduct non-cash incomes (e.g., profit on sale of fixed assets,
interest/dividend income).
■​ Adjust for changes in Current Assets and Current Liabilities
(excluding cash and bank overdraft):
■​ Increase in Current Asset \rightarrow Deduct
■​ Decrease in Current Asset \rightarrow Add
■​ Increase in Current Liability \rightarrow Add
■​ Decrease in Current Liability \rightarrow Deduct
■​ Advantage: Easier to prepare as it starts with readily available Net Profit and
balance sheet changes.
■​ Disadvantage: Does not show the actual cash receipts and payments from
core operations.
■​ Example (Simplified Operating Activities): Net Profit Before Tax and
Extraordinary Items: XXX Add: Depreciation: XXX Add: Amortization: XXX
Less: Profit on Sale of Fixed Asset: XXX Operating Profit before Working
Capital Changes: XXX Add: Decrease in Accounts Receivable: XXX Less:
Increase in Inventory: XXX Add: Increase in Accounts Payable: XXX Cash
Generated from Operations: XXX Less: Income Tax Paid: XXX Net Cash
from Operating Activities: XXX
●​ Note: Cash flows from Investing and Financing activities are presented identically under
both direct and indirect methods.

6. Fund Flow Statement

●​ Concept: A statement that explains the changes in the financial position of a business
enterprise between two balance sheet dates, primarily focusing on the movement of
working capital. "Funds" here typically refers to working capital (Current Assets - Current
Liabilities).
●​ Purpose: To show how funds (working capital) were generated (sources) and how they
were used (applications) during an accounting period. It helps to understand the flow of
funds from long-term to short-term needs and vice-versa.
●​ Key Idea: Flow of Funds: A transaction results in a 'flow of funds' only if it affects one
current account and one non-current account. Transactions involving only current
accounts or only non-current accounts do not result in a flow of funds.
○​ Example of Fund Flow: Issue of Shares (non-current liability) for cash (current
asset).
○​ Example of No Fund Flow: Purchase of inventory on credit (both current accounts).
●​ Components:
○​ Schedule of Changes in Working Capital: This is the first step. It compares
current assets and current liabilities from two balance sheets to determine the net
increase or decrease in working capital.
■​ Increase in Current Assets: Increases Working Capital.
■​ Decrease in Current Assets: Decreases Working Capital.
 ■​ Increase in Current Liabilities: Decreases Working Capital.
■​ Decrease in Current Liabilities: Increases Working Capital.
○​ Sources of Funds:
■​ Funds from Operations (Net Profit + non-cash expenses - non-cash
incomes).
■​ Issue of Shares or Debentures (long-term).
■​ Sale of Fixed Assets (long-term).
■​ Long-term Loans received.
■​ Decrease in Working Capital.
○​ Applications of Funds:
■​ Funds lost in Operations (Net Loss + non-cash incomes - non-cash
expenses).
■​ Purchase of Fixed Assets.
■​ Redemption of Debentures or Preference Shares.
■​ Repayment of Long-term Loans.
■​ Payment of Dividends.
■​ Increase in Working Capital.
●​ Advantages:
○​ Explains the changes in working capital, which the P&L and Balance Sheet alone
don't fully clarify.
○​ Helps in understanding the long-term solvency and financial policy of the company.
○​ Useful for financial planning, especially for working capital management.
●​ Limitations:
○​ Does not show the actual movement of cash.
○​ Can be confusing as "funds" is defined as working capital, not strictly cash.
○​ Less commonly used than the Cash Flow Statement in modern financial reporting.

III. Interpretation and Limitations of Financial Analysis

1. Interpretation:
●​ Trend Interpretation: Is the company growing? Are expenses increasing faster than
revenue?
●​ Ratio Interpretation: Ratios are only meaningful when compared:
○​ Time Series Analysis (Intra-firm): Comparing current ratios with past ratios of the
same company to identify trends.
○​ Cross-Sectional Analysis (Inter-firm): Comparing ratios with industry averages or
competitors' ratios to benchmark performance.
○​ Absolute Standards: Comparing ratios against established benchmarks or ideal
ratios (e.g., current ratio of 2:1).
●​ Qualitative Factors: Financial analysis is incomplete without considering qualitative
aspects such as:
○​ Management quality and experience.
○​ Brand reputation and customer loyalty.
○​ Competitive landscape and market position.
○​ Technological advancements and innovation.
○​ Regulatory environment and economic conditions.
2. Limitations of Financial Analysis:
●​ Historical Data: Financial statements are based on past data and may not always be
indicative of future performance.
●​ Different Accounting Policies: Companies may use different accounting methods (e.g.,
depreciation methods, inventory valuation), making direct comparisons difficult.
●​ Inflationary Effects: Financial statements often ignore the effects of inflation, which can
distort real values.
●​ Window Dressing: Companies may manipulate financial figures to present a better
picture than reality.
●​ Non-Monetary Factors: Important qualitative factors (e.g., employee morale, R&D
breakthroughs, quality of customer service) are not reflected in financial statements.
●​ Industry Differences: Direct comparison of ratios across different industries can be
misleading due to varying business models and capital structures.
●​ Lack of Future Focus: Primarily analyzes past performance and does not explicitly
account for future plans or unforeseen events.
●​ Dependence on True and Fair View: The analysis is only as reliable as the financial
statements themselves. If the statements are not true and fair, the analysis will be flawed.