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ACCOUNTING AND AUDITING

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ANALYSIS OF FINANCIAL STATEMENTS

The process of critical evaluation of the financial information contained in the financial statements in order to
understand and make decisions regarding the operations of the firm is called ‘Financial Statement Analysis’.
The term ‘financial analysis’ includes both ‘analysis and interpretation’. The term analysis means simplification of
financial data by methodical classification given in the financial statements. Interpretation means explaining the
meaning and significance of the data. These two are complimentary to each other.
Significance of Analysis of Financial Statements To
1. Finance manager: Financial analysis focusses on the facts and relationships related to managerial performance,
corporate efficiency, financial strengths and weaknesses and creditworthiness of the company.
2. Top management: The importance of financial analysis is not limited to the finance manager alone. It has a
broad scope which includes top management in general and other functional managers
3. Trade payables: Trade payables, through an analysis of financial statements, appraises not only the ability of
the company to meet its short-term obligations, but also judges the probability of its continued ability to meet
all its financial obligations in future.
4. Lenders: Suppliers of long-term debt are concerned with the firm’s long- term solvency and survival.
5. Investors: Investors, who have invested their money in the firm’s shares, are interested about the firm’s
earnings.
6. Labour unions: Labour unions analyse the financial statements to assess whether it can presently afford a wage
increase and whether it can absorb a wage increase through increased productivity or by raising the prices.
7. Others: The economists, researchers, etc., analyse the financial statements to study the present business and
economic conditions. The government agencies need it for price regulations, taxation and other similar
purposes.

Tools of Analysis of Financial Statements

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.
Common Size Statements: These are the statements which indicate the relationship of different items of a financial
statement with a common item by expressing each item as a percentage of that common item.
Trend Analysis: It is a technique of studying the operational results and financial position over a series of years.
Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage
changes over time in the selected data.
Ratio Analysis: It describes the significant relationship which exists between various items of a balance sheet and
a statement of profit and loss of a firm.

Cash Flow Analysis: It refers to the analysis of actual movement of cash into and out of an organisation. The flow
of cash into the business is called as cash inflow or positive cash flow and the flow of cash out of the firm is called
as cash outflow or a negative cash flow.
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RATIO ANALYSIS
As stated earlier, accounting ratios are an important tool of financial statements analysis. A ratio is a mathematical
number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction,
proportion, percentage and a number of times. When the number is calculated by referring to two accounting
numbers derived from the financial statements, it is termed as accounting ratio. For example, if the gross profit of
the business is Rs. 10,000 and the ‘Revenue from Operations’ are Rs. 1,00,000, it can be said that the gross profit
is 10% i.e. 10, 000/1,00,000 * 100 of the ‘Revenue from Operations’. This ratio is termed as gross profit ratio.
Similarly, inventory turnover ratio may be 6 which implies that inventory turns into ‘Revenue from Operations’ six
times in a year.
OBJECTIVE OF RATIO ANALYSIS
1. To know the areas of the business which need more attention;
2. To know about the potential areas which can be improved with the effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;
4. To provide information for making cross-sectional analysis by comparing the performance with the best industry
standards; and
5. To provide information derived from financial statements useful for making projections and estimates for the
future.
TYPES OF RATIOS
There is a two-way classification of ratios:
(1) Traditional classification, and
(2) Functional classification.
TRADITIONAL CLASSIFICATION
The traditional classification has been on the basis of financial statements to which the determinants of ratios
belong. On this basis the ratios are classified as follows:
1. Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as
statement of profit and loss ratio. For example, ratio of gross profit to revenue from operations is known as
gross profit ratio. It is calculated using both figures from the statement of profit and loss.
2. Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios.
For example, ratio of current assets to current liabilities known as current ratio. It is calculated using both figures
from balance sheet.
3. Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another
variable from the balance sheet, it is called composite ratio. For example, ratio of credit revenue from operations
to trade receivables (known as trade receivables turnover ratio) is calculated using one figure from the statement
of profit and loss (credit revenue from operations) and another figure (trade receivables) from the balance sheet.
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FUNCTIONAL CLASSIFICATION
As such, the alternative classification (functional classification) based on the purpose for which a ratio is computed,
is the most commonly used classification which is as follows:
1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the business to pay the
amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to measure it are
known as ‘Liquidity Ratios’. These are essentially short-term in nature.

2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations towards
stakeholders, particularly towards external stakeholders, and the ratios calculated to measure solvency position
are known as ‘Solvency Ratios’. These are essentially long-term in nature.
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the efficiency of
operations of business based on effective utilisation of resources. Hence, these are also known as ‘Efficiency
Ratios’.
4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from operations or funds (or assets)
employed in the business and the ratios calculated to meet this objective are known as ‘Profitability Ratios’.
LIQUIDITY RATIOS
Liquidity ratios are calculated to measure the short-term solvency of the business, i.e. the firm’s ability to meet its
current obligations. These are analysed by looking at the amounts of current assets and current liabilities in the
balance sheet. The two ratios included in this category are current ratio and liquidity ratio/Quick ratio/ Acid Test
Ratio.
Current Ratio
Current ratio is the proportion of current assets to current liabilities. It is expressed as follows:
Current Ratio = Current Assets: Current Liabilities or Current assets / Current Liabilities
Ideal current ratio is 2:1
Significance: It provides a measure of degree to which current assets cover current liabilities.
Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and
cash equivalents, short-term loans and advances and other current assets such as prepaid expenses, advance tax
and accrued income, etc.
Liquidity Ratio/Quick ratio/Acid Test Ratio
It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as
Quick ratio = Quick Assets: Current Liabilities or Quick Assets/Current Liabilities
Ideal current ratio is 1:1
Significance: The ratio provides a measure of the capacity of the business to meet its short-term obligations
without any flaw
While calculating quick assets we exclude the inventories at the end and other current assets such as prepaid
expenses, advance tax, etc. Because of exclusion of non-liquid current assets it is considered better than current
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ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary check on liquidity
position of the business and is therefore, also known as ‘Acid-Test Ratio’.
SOLVENCY RATIOS
The persons who have advanced money to the business on long-term basis are interested in safety of their periodic
payment of interest as well as the repayment of principal amount at the end of the loan period. Solvency ratios
are calculated to determine the ability of the business to service its debt in the long run. The following ratios are
normally computed for evaluating solvency of the business.
1. Debt-Equity Ratio;
2. Debt to Capital Employed Ratio;
3. Proprietary Ratio;
4. Total Assets to Debt Ratio;
5. Interest Coverage Ratio.

1. Debt-Equity Ratio

Debt-Equity Ratio measures the relationship between long-term debt and

equity. If debt component of the total long-term funds employed is small,
outsiders feel more secure. From security point of view, capital structure
with less debt and more equity is considered favourable as it reduces the
chances of bankruptcy. Normally, it is considered to be safe if debt equity
ratio is 2 : 1. However, it may vary from industry to industry. It is computed
as follows:

Debt-Equity Ratio = Long − term Debts or debts / Shareholders’ Funds or Equity

Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-term
lender regarding extent of security of the debt. As indicated earlier, a low debt equity ratio reflects more
security. A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in meeting its
obligations to outsiders.

Shareholders’ Funds (Equity)= Share capital + Reserves and Surplus + Money received against share warrants +
Share application money pending allotment

Or

Shareholders’ Funds (Equity) = Non-current assets + Working capital – Non-current liabilities

Share Capital = Equity share capital + Preference share capital

Working Capital = Current Assets – Current Liabilities

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2. Debt to Capital Employed Ratio

The Debt to capital employed ratio refers to the ratio of long-term debt to the
total of external and internal funds (capital employed or net assets). It is computed as follows:

Debt to Capital Employed Ratio = Long-term Debt/Capital Employed (or Net Assets)

Capital employed is equal to the long-term debt + shareholders’ funds

Significance: Like debt-equity ratio, it shows proportion of long-term debts in capital employed. Low ratio
provides security to lenders and high ratio helps management in trading on equity.

It may be noted that Debt to Capital Employed Ratio can also be computed
in relation to total assets. In that case, it usually refers to the ratio of total
debts (long-term debts + current liabilities) to total assets, i.e. total of non- current and current assets or
shareholders’, funds + long-term debts + current liabilities), and is expressed as

Debt to Capital Employed Ratio = Total Debts / Total Assets

3. Proprietary Ratio

Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets and is calculated as
follows:

Proprietary Ratio= Shareholders’, Funds/Capital employed (or net assets)

Significance: Higher proportion of shareholders’ funds in financing the assets is a positive feature as it provides
security to creditors.

4. Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debts by assets. It is calculated as

Total assets to Debt Ratio = Total assets/Long-term debts

Significance: This ratio primarily indicates the rate of external funds in

financing the assets and the extent of coverage of their debts are covered
by assets.

5. Interest Coverage Ratio

It is a ratio which deals with the servicing of interest on loan. It is a measure of security of interest payable on long-
term debts. It expresses the relationship between profits available for payment of interest and the amount of
interest payable. It is calculated as follows:
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Interest Coverage Ratio = Net Profit before Interest and Tax/ Interest on long-term debts
Significance: It reveals the number of times interest on long-term debts is covered by the profits available for
interest. A higher ratio ensures safety of interest on debts.
ACTIVITY/TURNOVER RATIO
These ratios indicate the speed at which, activities of the business are being performed. The activity ratios express
the number of times assets employed, or, for that matter, any constituent of assets, is turned into sales during an
accounting period. Higher turnover ratio means better utilisation of assets and signifies improved efficiency and
profitability, and as such are known as efficiency ratios. The important activity ratios calculated under this category
are

1. Inventory Turnover;
2. Trade receivable Turnover;
3. Trade payable Turnover;
4. Investment (Net assets) Turnover
5. Fixed assets Turnover; and
6. Working capital Turnover.

6. Inventory Turnover ratio

It determines the number of times inventory is converted into revenue from operations during the accounting
period under consideration. It expresses the relationship between the cost of revenue from operations and
average inventory. The formula for its calculation is as follows:

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory

Average Debtors = Opening + Closing / 2

Significance: It studies the frequency of conversion of inventory of finished goods into revenue from operations.

7. Trade Receivables Turnover Ratio

It expresses the relationship between credit revenue from operations and trade receivable. It is calculated as
follows:

Trade Receivable Turnover ratio = Net Credit Revenue from Operations/Average Trade Receivable

Where Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing Debtors and Bills
Receivable)/2

Significance: The liquidity position of the firm depends upon the speed with which trade receivables are realised.
This ratio indicates the number of times the receivables are turned over and converted into cash in an accounting
period.
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Higher turnover means speedy collection from trade receivable. This ratio also helps in working out the average
collection period. The ratio is calculated by dividing the days or months in a year by trade receivables turnover
ratio.

Which is = Number of days or Months/Trade receivables turnover ratio

8. Trade Payable Turnover Ratio

Trade payables turnover ratio indicates the pattern of payment of trade payable. As trade payable arise on account
of credit purchases, it expresses relationship between credit purchases and trade payable. It is calculated as
follows:

Trade Payables Turnover ratio = Net Credit purchases/ Average trade payable

Where Average Trade Payable = (Opening Creditors and Bills Payable +

Closing Creditors and Bills Payable)/2

Significance: It reveals average payment period. Lower ratio means credit allowed by the supplier is for a long
period or it may reflect delayed payment to suppliers which is not a very good policy as it may affect the
reputation of the business.
The average period of payment can be worked out by days/ months in a year by the Trade Payable Turnover
Ratio.

9. Net Assets or Capital Employed Turnover Ratio

It reflects relationship between revenue from operations and net assets (capital employed) in the business. Higher
turnover means better activity and profitability. It is calculated as follows:

Net Assets or Capital Employed Turnover ratio = Revenue from Operation

/Capital Employed

Capital employed turnover ratio which studies turnover of capital employed (or Net Assets) is analysed further
by following two turnover ratios :

10. Fixed Assets Turnover Ratio : It is computed as follows:

Fixed asset turnover Ratio = Net Revenue from Operation/ Net Fixed Assets

11. Working Capital Turnover Ratio: It is calculated as follows:

Working Capital Turnover Ratio = Net Revenue from Operation/Working Capital

Significance: High turnover of capital employed, working capital and fixed assets is a good sign and implies
efficient utilisation of resources. Utilisation of capital employed or, for that matter, any of its components is
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revealed by the turnover ratios. Higher turnover reflects efficient utilisation resulting in higher liquidity and
profitability in the business.

PROFITABILITY RATIO

The profitability or financial performance is mainly summarised in the statement of profit and loss. Profitability
ratios are calculated to analyse the earning capacity of the business which is the outcome of utilisation of resources
employed in the business. There is a close relationship between the profit and the efficiency with which the
resources employed in the business are utilised. The various ratios which are commonly used to analyse the
profitability of the business are:

1. Gross profit ratio

2. Operating ratio
3. Operating profit ratio
4. Net profit ratio
5. Return on Investment (ROI) or Return on Capital Employed (ROCE)
6. Return on Net Worth (RONW)
7. Earnings per share
8. Book value per share
9. Dividend pay-out ratio
10. Price earnings ratio.

12. Gross profit ratio

Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin. It
is computed as follows:

Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100

Significance: It indicates gross margin on products sold.

13. Operating Ratio

It is computed to analyse cost of operation in relation to revenue from operations. It is calculated as follows:

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Net Revenue from Operations ×100

14. Operating Profit Ratio

It is calculated to reveal operating margin. It may be computed directly or as a residual of operating ratio.

Operating Profit Ratio = 100 – Operating Ratio

Alternatively, it is calculated as under:

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Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100

Where Operating Profit = Revenue from Operations – Operating Cost

Significance: Operating ratio is computed to express cost of operations excluding financial charges in relation to
revenue from operations. A corollary of it is ‘Operating Profit Ratio’. It helps to analyse the performance of
business and throws light on the operational efficiency of the business. It is very useful for inter-firm as well as
intra-firm comparisons. Lower operating ratio is a very healthy sign.

15. Net Profit Ratio

Net profit ratio is based on all-inclusive concept of profit. It relates revenue from operations to net profit after
operational as well as non-operational expenses and incomes. It is calculated as under:

Net Profit Ratio = Net profit/Revenue from Operations × 100

Generally, net profit refers to profit after tax (PAT).

Significance: It is a measure of net profit margin in relation to revenue from operations. Besides revealing
profitability, it is the main variable in computation of Return on Investment. It reflects the overall efficiency of
the business, assumes great significance from the point of view of investors.

16. Return on Capital Employed or Investment

It explains the overall utilisation of funds by a business enterprise. Capital employed means the long-term funds
employed in the business and includes shareholders’ funds, debentures and long-term loans. Alternatively, capital
employed may be taken as the total of non-current assets and working capital. Profit refers to the Profit Before
Interest and Tax (PBIT) for computation of this ratio. Thus, it is computed as follows:

Return on Investment (or Capital Employed) = Profit before Interest and Tax/ Capital Employed × 100

Significance: It measures return on capital employed in the business. It reveals the efficiency of the business in
utilisation of funds entrusted to it by shareholders, debenture-holders and long-term loans. For inter-firm
comparison, return on capital employed funds is considered a good measure of profitability.

17. Return on Shareholders’ Funds

This ratio is very important from shareholders’ point of view in assessing whether their investment in the firm
generates a reasonable return or not. It should be higher than the return on investment otherwise it would imply
that company’s funds have not been employed profitably. A better measure of profitability from shareholders
point of view is obtained by determining return on total shareholders’ funds, it is also termed as Return on Net
Worth (RONW) and is calculated as under :

Return on Shareholders’ Fund = Profit after Tax / Shareholders’ Funds × 100

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18. Earnings per Share

The ratio is computed as:

EPS = Profit available for equity shareholders/Number of Equity Shares

In this context, earnings refer to profit available for equity shareholders which is worked out as
Profit after Tax – Dividend on Preference Shares.

This ratio is very important from equity shareholders point of view and
also for the share price in the stock market. This also helps comparison with other to ascertain its reasonableness
and capacity to pay dividend.

19. Book Value per Share

This ratio is calculated as:

Book Value per share = Equity shareholders’ funds/Number of Equity Shares

Equity shareholder fund refers to Shareholders’ Funds – Preference Share Capital.

This ratio is again very important from equity shareholders point of view as it gives an idea about the value of their
holding and affects market price of the shares.

20. Dividend Pay-out Ratio

This refers to the proportion of earning that are distributed to the shareholders.

It is calculated as
Dividend Pay-out Ratio = Dividend per share/ Earnings per share

This reflects company’s dividend policy and growth in owner’s equity.

21. Price / Earnings Ratio

The ratio is computed as –

P/E Ratio = Market Price of a share/earnings per share

For example, if the EPS of X Ltd. is Rs. 10 and market price is Rs. 100, the price earning ratio will be 10 (100/10). It
reflects investors expectation about the growth in the firm’s earnings and reasonableness of the market price of
its shares. P/E Ratio vary from industry to industry and company to company in the same industry depending upon
investors perception of their future.