Unit 15: Analysis of Financial Statement

Meaning of Financial Statement Analysis

 Financial statement analysis is an analysis which critically examines the relationship between
various elements of the financial statements with a view to obtain the necessary and
effective information from them.
 Financial statement analysis is defined as the process of analyzing and interpreting the
financial figures contained in the statement by developing some relationship among the
figures in such a manner that meaningful information can be obtained about the liquidity,
efficiency, profitability and leverage position of the company.
 Analysis of financial statement is concerned with arranging, classifying and grouping of
financial data in a purposeful manner whereby a user can easily understand.

Objectives/Importance/Need of Financial Statement Analysis

 To assess of past performance
 To assess of current position
 To predict of bankruptcy & failure
 To make loan decision by banks & financial institutions
 To assess of the operational efficiency
 To simplify the information

Limitations of Financial Statement Analysis

 It ignores the qualitative aspects of the business such management labour relation,
customer's satisfaction, management skills and so on.
 The analysis is not free from biasness of the analysts.
 If the companies have followed different accounting principles, accurate comparision may
not be possible.
 It only identifies/diagnose the problems but cannot suggest the solution.
 It is not possible to adjust the effect of the price level changes in the analysis of financial
statement.
 There is chance of wrong analysis & misinterpreting to the users.

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Interested Parties involved in Financial Statement Analysis
Shareholders Government
Investors Customers
Lenders General Public
Creditors Management
Employees

Types of Financial Statement Analysis

a) Comparative Financial Statement: It deals with the comparison of the different item of the
profit & loss account and balance sheet of two or more periods. Separate comparative
statements are prepared for Profit & Loss Account as comparative Income Statement and for
Balance Sheet.
b) Common Size Statement: Common size statement indicates the relationship of various items
with some common items (expressed as percentage of the common item). In the income
statement, sales figure is taken as base and all other figures are expressed as percentage of
sales. Similarly, in the Balance Sheet, the total of assets and liabilities is taken as base and all
other figures are expressed as percentage of the total.
c) Trend Analysis: It is analysis of the trend of the financial ratios of the company over the
year. The methods to be selected for the analysis depend upon the circumstances and the
need of users. The user should use appropriate method to derive required information to
fulfill their needs.
d) Horizontal Analysis: The analysis of the statements over a series of years is often called
Horizontal Analysis. It is a method of evaluating financial information by expressing each
item in a financial statement as a percentage of a base amount for the same time period. For
example, we compare a company's sales revenue in 2075 to its sales in 2076.
e) Vertical Analysis: Under vertical analysis, each item on the statement is typically expressed a
percentage of some particular items. A company can use vertical analysis on its balance
sheet or its income statement. In a vertical analysis, all income statement items are
expressed as percentage of sales and all balance sheet items are expressed as percentage of
the total assets.

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Ratio Analysis
 An arithmetical relationship between two figures is known as Ratio. It is computed by
dividing one item of relationship with others. Ratio simply means one number express in
term of another.
 Ratio analysis is a technique of analysis and interpretation of financial statements through
mathematical expression. It may be defined as the mathematical expression of the
relationship between two accounting figures. In short, ratio analysis can be defined as thee
financial statement with the help of ratio.

Importance of Ratio Analysis

 Helpful in measuring the financial solvency
 Helpful in decision making
 Helpful in cost control
 Helpful in future forecasting

Limitations of Ratio Analysis

 Lack of proper basis of comparison
 Give false results if the ratios are based on incorrect accounting data
 Difficult future forecast future on the basis of past facts.
 Ignores qualitative facts
 Window dressing

Types of Ratio
1) Liquidity Ratio

a) Current Ratio = =…:…

b) Quick Ratio/Liquid Ratio/Acid-test Ratio = =…:…

Where,
Current Assets = Cash in hand + Cash at bank + Sundry debtors + Bills receivables + Accounts
receivables + Notes receivables + Book debts + Closing stock/inventory + Prepaid/advance
expenses + Accrued/outstanding incomes + Loose tools + Spare parts + Marketable securities
+ Short term investment + Loans & advances (provided for short period) + Franchise

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 Current Liabilities = Sundry creditors + Accounts payable + Bills payable + Note payable +
Bank overdraft + Short term loan + Outstanding expenses + Acceptance + Provision for bad &
doubtful debts + Unearned/unexpired/advance incomes + Provision for tax/tax payable +
Proposed dividend (dividend payable) + Unclaimed dividend

2) Capital Structure/ Leverage/Solvency Ratio

a) Debt – Equity Ratio = Or,

= = ….. pure ratio or %

b) Debt to Total Capital Ratio = Or,

= = ….. pure ratio or %

(express as pure ratio for more than 1 & % for less than 1)
Where,
Long term Debts = Unsecured Loans + Secured Loans + Mortgage Loan + Bank Loan + Term
Loan + Debentures + Bonds Payable + Public Deposits + Provident Fund
Shareholders' Fund/Equity = Equity Share Capital + Preference Share Capital + Share Premium +
Debenture Premium + General Reserve + Reserve & Surplus + Share Forfeiture + Reserve for
Contingency + Sinking Fund + Dividend Equalization Fund + Capital Reserve + Capital Redemption
Reserve + Retained Earnings + Accumulated Profit + Profit & Loss A/c (Cr.) - Fictitious
Assets/Miscellaneous Expenditures {Preliminary expenses + Underwriting commission + Discount on
issue of shares/debentures + Premium on redemption of Debentures + Profit & Loss (Dr.)}
Shareholders' Equity = Total assets expect fictitious assets – Total Debts
Total Debts = Long term Debts + Current Liabilities
Total Capital = Shareholders' Fund/Equity + Long term Debts
Capital Employed = Shareholders' Fund/Equity + Long term Debts
= Total Assets except fictitious assets – Total Debts
= Total Assets except fictitious assets – Long term Liabilities – Current Liabilities
= Total Assets – Current Liabilities – Fictitious Assets
= Fixed Assets + Working Capital
= Total Assets expect fictitious assets – Current Liabilities

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 c) Interest Coverage Ratio/Debt Service Ratio =
= ….. times

d) Fixed Charge/Obligation/Coverage Ratio =

= ….. times
Where,
Fixed Charges = Interest + Preference Dividend + Annual Debt Payment + Lease Payment

e) Debt Coverage Ratio = = ….. times

3) Efficiency/Activity/Turnover Ratio

a) Stock/Inventory Turnover Ratio = = ….. times

Where,
Cost of Goods Sold = Net Sales – Gross Profit
Net Sales = Total Sales – Sales Return
Total Sales = Cash Sales + Credit Sales
Cost of Goods Sold = Opening Stock + Purchase + Other Direct Expenses – Closing Stock

Average Stock =

Sometimes, if opening stock/inventory is not given in Question, we use next formula,

Stock/Inventory Turnover Ratio = = ….. times

b) Debtors/Receivables Turnover Ratio = = ….. times

Where,
Net Credit Sales = Total Credit Sales – Credit Sales Return

If credit sales is not given in Question, assume all sales is credit sales

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Average Debtors =

Sometimes, if opening debtor is not given in Question, we use next formula,

Debtors/Receivables Turnover Ratio = = ….. times

c) Average Collection Period/Debtors Collection Period/Days Sales Outstanding =

Or,

Or,

d) Fixed Assets Turnover Ratio = = ….. times

Where,
Net Fixed Assets = Total Fixed Assets – Total Depreciation on Fixed Assets

e) Total Assets Turnover Ratio = = ….. times

Where,
Total Assets = Total Assets – Total Depreciation
= Total Net Fixed Assets + Total Current Assets (expect fictitious assets)

f) Capital Employed Turnover Ratio = = ….. times

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4) Profitability

a) Gross Profit Margin/Ratio =

b) Net Profit Margin/Ratio = × 100%

Where,
Net profit after tax = Gross Profit – Operating Expenses – Tax
= (Gross Profit – Operating Expenses) (1 – tax rate)
= Net Income before tax – Tax

c) Operating Ratio = × 100%

Where,
Operating Expenses = Cost of goods sold + Office & administrative expenses + Selling &
distribution expenses + Depreciation
Operating expenses do not include financial expenses such as interestt

d) Return on Shareholders' Equity (ROSE) =

e) Return on Ordinary/Common Shareholders' Fund =

OR,

OR,

f) Return on Assets (ROA) =

g) Return on Capital Employed/Yield to Total Capital =

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5) Earning Evaluation Ratio
–
a) Earnings per Share (EPS) = OR,

= Rs. …

b) Dividend per Share (DPS) = = Rs. …

Where,
Dividend Paid = Paid of Equity Capital × % of Dividend

c) Dividend Payout Ratio (DPR) =

d) Dividend Yield Ratio (DYR) =

e) Earning Yield Ratio (EYR) =

f) Price Earnings Ratio (P/E Ratio) = = ….. times

g) Earning Power Ratio (EPR) =