FOA CO-3

UNIT- III: Analysis of Financial Statements: Objectives; Techniques of Financial Analysis - Financial Ratio
analysis – Funds Flow and Cash Flow Analysis.

Analysis of Financial Statements

Financial statement analysis is crucial for assessing a company's financial health and making informed
business decisions. It helps in evaluating profitability, liquidity, solvency, and operational efficiency.

Objectives of Financial Statement Analysis

The primary objectives of financial statement analysis are:

1. Assessing Profitability:
To determine how well a company generates profit from its revenue.
Example: Analyzing net profit margin helps assess the company's ability to convert revenue into
profit.

2. Evaluating Financial Position:

To understand the company's financial position, including its assets, liabilities, and equity.
Example: A company with high assets and low liabilities is in a better financial position.

3. Identifying Trends and Patterns:

To track the company's performance over time and identify trends.
Example: Examining trends in revenue and expenses over five years can indicate whether the
company is growing or declining.

4. Making Investment Decisions:

To provide investors with information to make decisions about buying, holding, or selling shares.
Example: A company with high return on equity (ROE) may attract investors.

5. Predicting Future Performance:

To estimate future cash flows, profitability, and solvency.
Example: Using past trends in revenue growth to predict future earnings.

Techniques of Financial Analysis

There are various techniques used to analyze financial statements:

Techniques of Financial Analysis

Financial analysis involves various techniques to assess the performance and financial health of a
company. These techniques help in understanding profitability, liquidity, solvency, and efficiency. Here
are the major techniques used in financial analysis:
1. Financial Ratio Analysis

Financial ratio analysis involves the use of various ratios to evaluate different aspects of a company's
financial performance. Ratios help in comparing financial data to assess profitability, liquidity, leverage,
and efficiency.

Key Ratios:

 Liquidity Ratios: Measure the company's ability to meet short-term obligations.

o Current Ratio = Current Assets / Current Liabilities

Example: If current assets are ₹500,000 and current liabilities are ₹300,000, the current
ratio is 1.67, indicating good short-term financial health.

o Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Example: If current assets are ₹500,000, inventory is ₹100,000, and current liabilities are
₹300,000, the quick ratio is 1.33.

 Profitability Ratios: Assess the company's ability to generate profits from its sales or assets.

o Net Profit Margin = Net Profit / Revenue

Example: If net profit is ₹100,000 and revenue is ₹500,000, the net profit margin is 20%.

o Return on Assets (ROA) = Net Income / Total Assets

Example: If net income is ₹50,000 and total assets are ₹200,000, ROA is 25%.

 Leverage Ratios: Evaluate the extent of a company's use of debt.

o Debt to Equity Ratio = Total Debt / Total Equity

Example: If a company has ₹400,000 in debt and ₹600,000 in equity, the ratio is 0.67.

 Efficiency Ratios: Measure how efficiently a company utilizes its assets.

o Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Example: If COGS is ₹300,000 and average inventory is ₹50,000, the inventory turnover
ratio is 6.

o Asset Turnover Ratio = Revenue / Total Assets

Example: If revenue is ₹1,000,000 and total assets are ₹500,000, the asset turnover ratio
is 2.

2. Trend Analysis

Trend analysis involves comparing financial data over multiple periods to identify patterns and trends in
the company’s performance. It helps in forecasting future performance.

Example:
  Analyzing revenue growth over the last five years:

o Year 1: ₹200,000

o Year 2: ₹250,000

o Year 3: ₹300,000

o Year 4: ₹350,000

o Year 5: ₹400,000

In this case, the company is experiencing consistent growth in revenue at a rate of ₹50,000 per year.

3. Common-Size Financial Statements

This technique involves expressing financial statement items as a percentage of a common base, such as
total revenue (for income statements) or total assets (for balance sheets). It helps in comparing
companies of different sizes or analyzing trends over time.

Example:

 Common-Size Income Statement:

If a company’s revenue is ₹1,000,000 and its cost of goods sold (COGS) is ₹600,000, the
common-size percentage for COGS is:

o COGS Percentage = (COGS / Revenue) × 100 = (₹600,000 / ₹1,000,000) × 100 = 60%

 Common-Size Balance Sheet:

If a company’s total assets are ₹2,000,000, and cash is ₹400,000, the common-size percentage
for cash is:

o Cash Percentage = (Cash / Total Assets) × 100 = (₹400,000 / ₹2,000,000) × 100 = 20%

4. Funds Flow Analysis

Funds flow analysis helps in understanding the movement of funds in and out of a company. It tracks
changes in the financial position, showing how the company has used or generated funds during a
period.

Proforma of Funds Flow Statement:

Particulars Amount (₹)

Sources of Funds

- Issue of Equity Capital X

Particulars Amount (₹)

- Long-term Borrowings X

- Depreciation X

Total Sources X

Uses of Funds

- Purchase of Fixed Assets (X)

- Repayment of Long-term Loans (X)

- Payment of Dividends (X)

Total Uses (X)

Net Increase/Decrease in Funds X

Example:

 Issue of equity capital of ₹100,000 is a source of funds.

 Repayment of loans of ₹50,000 is a use of funds.

5. Cash Flow Analysis

Cash flow analysis involves analyzing the inflow and outflow of cash in the business over a given period.
It focuses on the company's liquidity and its ability to meet short-term obligations.

Proforma of Cash Flow Statement:

Particulars Amount (₹)

Cash Flow from Operating Activities

- Net Profit X

- Depreciation X

- Changes in Working Capital

- Increase in Current Liabilities (X)

- Decrease in Current Assets X

Particulars Amount (₹)

Net Cash from Operating Activities X

Cash Flow from Investing Activities

- Purchase of Fixed Assets (X)

- Sale of Investments X

Net Cash from Investing Activities (X)

Cash Flow from Financing Activities

- Issue of Share Capital X

- Loan Repayments (X)

Net Cash from Financing Activities X

Net Increase in Cash and Cash Equivalents X

Example:

 Net profit is ₹100,000, depreciation is ₹20,000, and changes in working capital add ₹10,000 to
cash. Cash flow from operating activities will be ₹130,000.

 Purchase of fixed assets costs ₹50,000, which leads to a negative cash flow of ₹50,000 from
investing activities.

6. Vertical Analysis

Vertical analysis is similar to common-size analysis but focuses on analyzing financial statements by
expressing each item as a percentage of a key figure, such as total sales or total assets. It helps in
comparing the relative size of line items across periods or companies.

Example:

 Income Statement:
If a company’s revenue is ₹1,000,000, and its operating expenses are ₹600,000, the operating
expenses as a percentage of revenue would be:

o Operating Expenses = (₹600,000 / ₹1,000,000) × 100 = 60%

 Balance Sheet:
If total assets are ₹2,000,000, and cash is ₹400,000, cash would represent:

o Cash = (₹400,000 / ₹2,000,000) × 100 = 20%