Analysis of Financial Statements
Question 1:
What is the meaning of financial statements?
Answer 1:
Financial statements comprise of the profit and loss account, the balance sheet and the notes forming
part of the profit and loss account and balance sheet and the cash flow statement.
Question 2:
What is financial statements analysis?
Answer 2:
Analysis of financial statements is an in depth study of financial statements todiagnose the financial
health of an organisation. It helps to analyse the profitability, solvency and efficiency of an
organisation.
Question 3:
What are tools of analysis of Financial Statements?
Answer 3:
Ratio analysis, cash flow analysis, common size statement, comparative statement and trend analysis
are some of the tools of analysis of financial statements.
Question 4:
What is common size statement?
Answer 4:
A common size statement is a statement in which all the items of the financial statements are
converted into percentage to some common base. In case of a common size profit and loss account
the common base is revenue from operations (net sales). In case of a common size position statement
(balance sheet) the common base is the total of asset side and the liability side.
Question 5:
What is horizontal analysis? What is vertical analysis?
EAnswer 5:
Horizontal analysis means analysing the financial statements for a number of years with reference to
a chosen base year. It isalso called trend analysisor dynamic analysis. Analysis of the ratios relating
to one year for one company (and its different department) or analysis of the ratios of different
companies for the same year is called vertical analysis.
Question 6:
What is external analysis and internal analysis?
Answer 6:
External Analysis is conducted by those who do not have access to the detailed records of an
enterprise and, therefore, have to depend on published accounts, i.e., statement of profit and loss,
balance sheet, directors' and auditor's reports. Such type of analysis is made by investors, lenders.
Internal analysis is conducted by the management to know the financial position and operational
efficiency of the organisation.
Question 7:
What are comparative statements?
Answer 7:
Comparative statements are a comparative study of different components of financial statements for
two or more years. The absolute and percentage change are calculated to facilitate comparison
between the base year and the current year.
IWARI
ACADEMY
Ratio Analysis
Question 1:
What is meant by Ratio? What is an accounting ratio?
Answer 1:
'Ratio' is an arithmetical expression of relationship between two interdependent or related items.
Ratios, when calculated on the basis of accounting information, are called Accounting Ratios.
Accounting ratio may be expressed as an arithmetical relationship between two accounting variables.
Question 2:
What is meant by ratio analysis?
Answer 2:
"Ratio analysis is a study of relationship among various financial factors in a business." Ratio analysis
is a process of determining and interpreting relationships between the items of financial statements
toprovide a meaningful understanding of the performance and financial position of an enterprise.
Question 3:
How do you classify ratios?
EAnswer 3:
Ratios are classified into four categories. Solvency ratios, liquidity ratios, profitability ratios and
turnover or activity ratios.
Question 4:
What are the main/important ratios? Give their formulae.
Answer 4:
The important ratios are:
1. Liquidity ratios
Current Assets
() Current Ratio =
Current Liabilities
Current assets include cash, bank, inventory (excluding loose tools and stores and spares), trade
receivables (debtors and B/R less provisions, if any), prepaid expense, accrued income and short
term investments/ current investment/ marketable securities. Current liabilities include cash credit,
bank overdraft, trade payables, outstanding expenses, unearned income (income received in
advance) and short term borrowings. They also include other current liabilities (current maturities
of long-term debts, interest accrued but not due on borrowings, interest accrued and due on
borrowings unclaimed dividend, calls-in-advance, etc., and short-term provisions but not provisions
against assets. The ideal current ratio is 2:1. A high current ratio is good but a very high current ratio
indicates that the firm has high amount of cash, stock or debtors. Aratio less than 2 :1 is fair enough
if it is not too low.
Quick Assets
(ii) Quick Ratio =
Current Liabilities
Quick assets are current assets less inventory/stock and prepaid expenses. Conventionally, these two
are deducted from current assets because it cannot be said when the inventory or stock will be sold
and prepaid expenses will not yield cash. The ideal quick ratio is 1:1.
2. Solvency Ratios
Solvency means ability of a firm to repay its liabilities. Solvency in the context of solvency ratios
indicates long ternm solvency of a business enterprise.
Debt
(i)Debt to Equity Ratio =
Equity
Debt =public deposits, debentures, mortgage, term loans for a period greater than one year and
bonds. Equity is also known as shareholders' funds, proprietors' funds and net worth. Equity = share
capital + all reserves + credit balance of P & L account - debit balance of P&L account.
Total Asset
(iü) Total Asset to Debt Ratio = Debt
Total assets include net fixed assets + current assets + all investments. Debt includes public deposits,
debentures, mortgage, term loans for a period greater than one year and bonds. This ratio should be
ideally 2:1, that means the total assets should be twice the amount of debt. This ratio measures a
safety margin to the lenders of long term loans to the organisation. A ratio higher than this is also
acceptable. It isto be noted that long term debts include long term provisions also.
Proprietors Funds
(iii) Proprietary Ratio = TotalAssets
Proprietors funds have the same meaning as explained in equity. Total assets have been listed above.
The proprietary ratio measures what part of total assets have been financed out of proprietors' fund.
A high ratio is an indication that the lenders of the organisation have adequate safety margin
available to them. Hence, this ratio should be greater than or equal to 50%.
PBIT
(iv) Interest Coverage Ratio =
Interest on long term borrowings
This ratio ascertains the profit available to cover interest on long term borrowings. Higher the ratio
more is the margin to meet interest cost.
3. Profitability Ratios
Gross Profit
() Gross Profit Ratio = Revenue from Operations (Net Sales) X100 =.%
(V) ROI
Return on Capital Employed or Return on Investment assesses overall performance (profitability) of
the enterprise. It measures how efficiently the resources of the business are used. Return on capital
employed is a fair measure of the profitability of any concern with the result that the performance of
different industries may be compared.
An enterprise should have satisfactory ratio. To assess whether the ratio is satisfactory or not, it
should be compared with its own ratios of the past years or with the ratios of similar enterprises in
the industry or with the ratio of industry average.
4. Turnover Ratios
() Trade Receivables Turnover Ratio = Credit Revenue from Operations, i.e.,Net Credit Sales
Average Trade Receivables
It shows how quickly trade receivables are converted into cash and cash equivalents and thus, shows
the efficiency in collection of amounts due against trade receivables. Ahigh ratio is better since it
shows that debts are collected more promptly.
When Trade Receivalbles Turnover Ratio is computed it should be kept in mind that provision for
doubtful debts is not deducted from trade receivables since the purpose is to calculate the number
of days for which sales are tied up in trade receivables and not to ascertain realisable value of the
debtors.
Net Credit Purchases
(ii) Trade Payables Turnover Ratio =
Average Trade Payables
High turnover ratio or shorter payment period shows the availability of less credit period or early
payments. Ahigh ratio also indicates that the enterprise is not availing full credit period. this boosts
up the credit worthiness of the enterprise. A low ratio or longer payment period indicates that
creditors are not paid in time or increased credit period.
Revenue from 0perations
(iii)Working Capital Turnover Ratio= Working Capital
If the amount of Revenue from Operations is not given, it may be calculated on the basis of cost of
Revenue from Operations (cost of goods sold).
Higher the ratio, better it is. But, a very high ratio indicates overtrading - the working capital being
inadequate for the scale of operations.
Cost of Revenue from Operations (Cost of Goods Sold)
(iv) Inventory Turnover Ratio =
Average Inventory
It shows the number of times amount invested in inventory is rotated.
Ahigh ratio shows that more sales are being produced by a rupee of investment in inventories. A
very high nventory Turnover Ratio shows overtrading and it may result in working capital shortage.
Alow Inventory Turnover Ratio means inefficient use of investment in inventory, over-investment
in stocks, accumulation of inventory, etc.
* If cost of revenue from operations is not given, as an alternate, sales can be taken as numerator.
Question 5:
What is the significance of a high inventory turnover ratio and low working capital?
Answer 5:
It indicates over trading. The business may be in danger of closing down because there will not be
sufficient liquidity to purchase raw material and to sell goods.
Question 6:
How are different ratios expressed?
Answer 6:
Profitability ratios are expressed as percentage. Turnover ratios are expressed number of times.
Solvency and liquidity ratios are expressed either as pure number (example 2:1) or as percentage.
For example, proprietary ratio may be expressed as 1:2 or 50%.
Question 7:
Explain the advantages of ratios analysis.
Answer 7:
Simplifies Accounting Data
> Useful in Assessing the Operating Efficiency of Business
> Useful in Locating the Weak Areas in Performance
> Useful for Forecasting.
Question 8:
Explain the limitation of ratios.
Answer 8: IWARI
> False result: Accounting ratios are calculated from the financial statements, so the reliability
of ratio and its analysis dependent upon the correctness of the financial statements.
> Price Level Changes are not considered: during periods of inflation, adjustments should be
made to the data for price changes. Or else, ratio analysis would be meaningless.
Window Dressing: Manipulation of accounts is a way to conceal vital facts and present the
financial position better than what it actually is. On account of such a situation, presence of
particular ratio may not be a definite indicator of good or bad management.
> Personal Bias: Different people may interpret the same ratio in different ways.
Question 9:
Why is 'Net credit sales' taken as numerator in the formula for Receivable Turnover Ratio.?
Answer 9:
The fundamental premise of an accounting ratio is cause-effect relationship. Receivables means
amounts which a firm has to receive on credit sales (not on total sales). Hence, it is shown in the
numerator.
Question 10:
Why is 'COGS' taken as numerator in the formula for Inventory Turnover Ratio?
Answer 10:
According toAS-2, inventory is valued at cost or net realisable value, whichever is low. Generally,
cost is less than the net realisable value. In other words, in the formula for ITR, the denominator
average stock is generally taken at cost. To established cause effect relationship, the element of
profit is subtracted from selling price in the numerator. Therefore, what remains is the cost of goods
sold (cost of revenue from operations).
Question 11:
What is the difference between liquidity ratios and liquid ratio?
Answer 11:
Liquidity ratios comprise of current ratio and quick ratio. Liquid ratio (acid test ratio/quick ratio) is
a part of liquidity ratios.
Question 12:
What is the meaning of the term 'solvency'?
EAnswer 12:
Solvency means the ability of a firm to repay its liabilities.
Question 13:
How do you calculate capital employed?
Answer 13:
Liabilities side approach:
Debt + Equity - Non-trade investment
Assets side approach
Net fixed assets + working capital (current assets - current liabilities) + Trade investments.
Question 14:
Why ROIl is considered the most important among ratios?
Answer 14:
ROI can be calculated as net profit ratio multiplied by capital turnover ratio. It shows that ROl can be
increased either by increasing the profit margin on sales or by increasing the turnover.
Question 15:
The total of which two ratios is 100%.
Answer 15:
The total of operating profit ratio and operating ratio is 100%.
Question 16:
What will be G.L ratio, if GL on cost is 1/3? G.L. ratio is 1/2.
Answer 16:
G.L. ratio is 1/2.
Question 17:
What will be the GP ratio, if GP on cost is 25%.
EAnswer 17:
GP ratio is 20%.
Question 18:
What will be the GP on cost, if GP ratio is Y4.
EmAnswer 18:
GP on cost is 1/3.
Question 19:
What will be the GP on cost, if GP on sale is 40%.
Answer 19:
G.P. on cost is 2/3 or 669%.
3
Question 20:
How do youfind out COGS/Cost of revenue from operations?
Answer 20:
COGS can be calculated as follows:
(opening stock + purchases - closing stock) +direct expenses.
material consumed + direct expenses
purchases - increase in stock + direct expenses
purchases + decrease in stock + direct expenses
> sales - gross profit RI
sales + gross loss
Question 21:
What are included in inventory?
Answer 21:
Raw material, semi-finished goods and finished goods, loose tools and spare parts.
Question 22:
How are 'provision for doubtful debts' treated while finding
a) current ratio b) Quick ratio and c) Receivable turnover ratio.
Answer 22:
(a) &(b) it is deducted from debtors
(c) It is to be ignored.
Cash Flow Analysis
Question 1:
What is cash from operating activities?
Answer 1:
Operating Activities are the principal revenue producing activities of the enterprise and other
activities that are not investing or Financing Activities.
For trading company, purchase and sale of goods is its principal revenue producing activity.
For a finance company, giving and taking loans, purchase and sale of securities is its principal revenue
producing activity.
For example, receipts from royalties, fees and commission etc.; Receipts from Trade Receivables (i.e.,
Debtors and Bills Receivable); Payment for purchase of goods and/or services; Payment for purchase
of goods and/or services; Payment to Trade Payables (i.e., Creditors and Bills Payable); Payment
wages, salaries and other payments to employees; Receipts of premium and payment of claims (for
an Insurance Company).
Question 2:
What is cash from investing activities?
EAnswer 2:
Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.
Question 3:
What is cash from financing activities? TWARI
EaAnswer 3:
Financing Activities are the activities that result in change in the size and composition of the owners'
capital (including preference share capital in the case of a company) and borrowings, of the
enterprise.
Question 4:
What is cash? What are cash equivalent?
EAnswer 4:
Cash comprises of cash on hand and demand deposits with banks.
Cash equivalents are short-term, highly liquid investments that are readily convertible into the
known amount of cash and which are subject to an insignificant risk of change in value. An investment
normally qualifies as cash equivalent only when it has a short maturity of, say, three months or less
from the date of acquisition.
Cash and Cash Equivalents is calculated as:
Cash on hand + cash at bank + cheques and drafts on hand + short-term investments (marketable
securities) + short-term deposits in banks.
Question 5:
What is a Cash Flow Statement? Which AS is applicable to it?
EAnswer 5:
Cash Flow Statement is a statement that shows the flows, i.e., inflow and outflow of Cash and Cash
Equivalents during the period under report. AS - 3 (revised) is the relevant AS applicable to the
preparation of cash flow statement.
Question 6:
Where would you show the following in preparation of Cash Flow Statement:
()) interest paid (ii) interest or dividend received (ii) dividend paid
(iv) loan taken (v) loan granted.
Answer 6:
(), (ii)&(iv) Financing activity
(ii) & (v) Investing activity
Question 7:
Explain the treatment of following in CFS.
) Tax
(i) Proposed dividend
(iii) Interim dividend
(iv) Interest received
(v) Interest paid
aAnswer 7:
() When noadditional information is given, previous year figure is paid and shown as an outflow in
CFO and current year figure is added to surplus to find out net profit before tax.
(ii) After changes to AS-4, proposed dividend of previous year is shown as outflow in financing
activity (and also added to surplus..to find net profit before tax).
(iii) Shown as outflow in financing activity (and also added to surplus..to find net profit before tax)
(iv) Interest received is added in calculating CFI (and deducted in calculating CFO).
(v) Interest paid is deducted in calculating CFF (and added in calculating CFO).
Question 8:
What is the treatment of provision for debts while preparing a CFS.
Answer 8:
Increase in provision is added as a non-cash expense in CFO and decrease is subtracted.
Question 9:
What is the significance of a (-ve) CFO and payment of dividend at the same time.
aAnswer 9:
The company is not following a good financial policy because in spite of negative CFO, it is paying
dividend.
PractIcalEXaminatuon
Question 10:
Is a positive CFO and negative CFI, simultaneous a good sign for a company?
EAnsWer 10:
Yes, the company is expanding its infrastructure and deploying its resources in
upgradation/expansion of business.
Question 11:
What are the limitations of CFS?
Answer 11:
Non-cash Transactions are not shown.
Not a substitute for an income statement and balance sheet.
Accuracy of Cash Flow Statement depends upon financial statements. If financial statements
are prepared incorrectly,cash flow statement willalso be incorrect.
Question 12:
Give three examples of non-cash transactions.
aAnswer 12:
Issue of bonus shares.
Issue of shares to vendors.
Issue of shares to directors.
Question 13:
What is the significance of non-cash transactions in a CFS?
EAnswer 13:
These are not shown in a cash flow statement. WARI
Question 14:
Explain the JE for tax provision made and tax paid.
BAnswer 14:
()P& La/c....Dr.
ToProvision for Tax a/c...
(being provision made during the year)
(ii) Provision for tax a/c....Dr.
To Bank a/c.....
(being tax paid)
Question 15:
How will you treat the following in the preparation of CFS?
1. Increase/decrease in under writing commission/discount on debentures.
2. Increase/decrease in goodwill/patents etc.
3. Increase/decrease in Reserves?
4. Increase/decrease in overdraft/cash credit?
5. Increase in Securities Premium Reserves.
uAnswer 15:
1. Deduct from increase in share capital/amortisation.
2. Purchase of goodwill/amortisation.
3. Add to/deduct from surplus in CFO.
4. Add to/deduct from CFF.
5. Add to share capital in CFO.
IWARI
ADM
Question 1:
What is the heading in case of
() P&L a/c
(ii) Balance sheet
(iii) CFS
(iv) Common size statement.
Answer 1:
(1) P&L a/c: P& Laccount for the year ending...
(i) Balance Sheet: Balance sheet as at . . .
(iii) Cash Flow Statement for the year ending..
(iv) Common size statement for the year ending...
Question 2:
What is a segment? What is segment report?
LAnswer 2:
Business segment is a distinguishable component of an enterprise that is engaged in providing an
individual product or service or a group of related products or services and that is subject risks and
returns that are different from those of other business segments. All companies having, business
segment or Geographical Segment are required to report Segment-wise Revenue, Income and
Capital Employed. As per AS-17, Segment Reporting requires companies, where applicable, to
disclose segment results for better understanding of the financial statements and taking decisions by
the users.
Question 3:
What is goodwill, purchased goodwill and self-generated goodwill?
Answer 3:
Goodwill is the monetary value of the reputation of the firm.
Purchased Goodwill: Purchased Goodwill is that goodwill which is acquired by a firm for a
consideration, whether paid in cash or kind. For example, when a business is purchased and
purchase consideration is more than the value of net assets (i.e., Assets - Liabilities), the difference
amount is the value of purchased goodwill.
Self-generated Goodwill: Self-generated goodwill is the goodwill which is not purchased for a
consideration but is earned by the efforts of the management (or partners). It is an internally
generated goodwill which arises from a number of factors (such as favourable location, efficient
management, good quality of products etc.) that a running business possesses due to which it is able
to earn higher profit.
AS-26 prescribes that self-generated goodwill is not accounted as an asset, i.e, not accounted in the
books of account.
Question 4:
What is the relevant 'schedule' for preparing a Balance Sheet +P&L a/cin case of companies?
Answer 4:
Schedule III.
