Chapter 3

Analysis of Financial
Statements
 Key Financial Statements
 Balance Sheet
 Income Statement
 Statement of Cash Flows
 Analysis and interpretation of
Financial Statements
 Ratio Analysis
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Contents of Financial Statements:
 Balance sheet – provides a snapshot of a firm’s financial position
at one point in time. Balance Sheet is a statement of Asset and
Liabilities of the business. Assets minus liabilities towards
outsiders are called as Net Worth or Owners Equity.
 Income statement – summarizes a firm’s revenues and
expenses over a given period of time. It is an account of
Revenues and Expenses and it shows profits for the financial year.
 Statement of stockholders’ equity – shows how much of the
firm’s earnings were retained, rather than paid out as dividends.
 Statement of cash flows – reports the impact of a firm’s
activities on cash flows over a given period of time. Statement of
Cash Flows is a statement of Sources of Cash and Application of
Cash between two Balance Sheet Dates.

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 What is Analysis of Financial Statements?

Financial Statements mainly contains, Revenue Statement (Also called

as Profit and Loss Account) and Balance Sheet.
Revenue statements give profits and balance sheet is a statement of
Asset and Liabilities.
But if we consider Financial Statements of one financial year, then we
can get little information about company and its performance.
If financial Statements are analyzed the we can come out with
meaningful information which can be sued for decision making
purposes.
And therefore we do Ratio Analysis which facilitate trend analysis and
inter firm comparison.
 Why Financial Analysis is done? What are its uses?
Financial analysts often assess the following elements of a firm:

Profitability - its ability to earn income and sustain growth in both the short- and long-term.
A company's degree of profitability is usually based on the income statement, which reports
on the company's results of operations;

Solvency - its ability to pay its obligation to creditors and other third parties in the long-
term;
Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations;
Both Solvency and Liquidity are based on the company's balance sheet, which indicates the
financial condition of a business as of a given point in time.
Stability - the firm's ability to remain in business in the long run, without having to sustain
significant losses in the conduct of its business. Assessing a company's stability requires the
use of both the income statement and the balance sheet, as well as other financial and non-
financial indicators. etc.

Future Expansion of the business requires careful Financial analysis.

Financial Analysis helps in Managing Cash Flows and Working Capital.
For taking Investment Decisions detailed Financial analysis is required.
For taking day to day business decisions financial analysis is required
Banks and Financial Institutions do not sanction loan without studying key
indicators in Financial Statements.
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Tools for Analysis and interpretation of Financial
Statements:

 Ratio Analysis
 Comparative Statements
a) Vertical analysis
b) Horizontal analysis
 Common size statements
 Trend analysis
 Funds Flow Analysis
 Cash Flow Analysis

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Sources of Data for Analysis and Interpretation Financial
Statements:

 Boomberg
 Investor Relations section on the portal of a
company
 Stock Exchanges
 CRISIL
 Dun and Bradstreet
 News Paper and Business and Finance
magazine

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Ratio Analysis:
A financial ratio (or accounting ratio) is a relative magnitude of two
selected numerical values taken from an enterprise's financial statements.
Often used in accounting, there are many standard ratios used to try to
evaluate the overall financial condition of a corporation or other organization.
Financial ratios may be used by managers within a firm, by current and
potential shareholders (owners) of a firm, and by a firm's creditors. Financial
analysts use financial ratios to compare the strengths and weaknesses in
various companies.  If shares in a company are traded in a financial market,
the market price of the shares is used in certain financial ratios.
Ratios can be expressed as a decimal value, such as 0.10, or given as an
equivalent percent value, such as 10%. Some ratios are usually quoted as
percentages, especially ratios that are usually or always less than 1, such
as earnings yield, while others are usually quoted as decimal numbers,
especially ratios that are usually more than 1, such as P/E ratio; these latter
are also called multiples.

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 PROFITABILITY RATIOS

Gross Profit
Gross profit margin = × 100
Net sales

Net profit margin = EAT

× 100
Net sales
 SHORT TERM LIQUIDITY RATIOS

current assets
Current ratio = current liabilities

current assets – inventory

Quick ratio = current liabilities

Return on equity and Liquidity Ratio:

Earnings After Tax X 100

Return on Equity = Equity

Debt Equity Ratio = Debt

Equity
 Q1. From the following balance sheet of M/s Mayur company Ltd.
As on 31st March 2013.
You are required to calculate Current Ratio and Quick Ratio.

Liabilities Amount in $ Assets Amount IN $

Share capital 600,000 Long term investment 20,000
Reserve& surplus 250,000 Cash 5,000
Bank overdraft 50,000 Bills receivable 35,000
Creditors 140,000 Bank balance 40,000
Bill payable 50,000 Debtors 90,000
Outstanding 10,000 Stock 200,000
expenses Machinery 130,000
Land & Building 500,000
Motor van 80,000
  1000,000   1000,000

current assets
1. Current Ratio = = 370,000 / 250,000 = 1.48
current liabilities
current assets – inventory
2. Quick Ratio = = 170,000 / 250,000 = 0.68
current liabilities

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 Q2. From the following balance sheet of M/s Mayur company Ltd. As on
31st March 2012. Calculate current ratio and quick ratio from the following
information.
Liabilities Amount in $ Assets Amount in
$
Equity share capital 600,000 Investments 50,000
Reserve 50,000 Cash 10,000
P&L Account 150,000 Bills receivable 60,000
Bank overdraft 20,000 Bank balance 120,000
Creditors 100,000 Debtors 60,000
Bill payable 20,000 Stock 100,000
Outstanding exp. 10,000 Machinery 150,000
Land & Building 250,000
Motor van 150,000
  1. Current Ratio = 950,000
current assets  950,000
= 350,000 / 150,000 = 2.33
current liabilities

current assets – inventory

2. Quick Ratio = = 250,000 / 150,000 = 1.67
current liabilities

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 Q3. Calculate current ratio and quick ratio from the following information.

  $   $
Stock 60,000 Sundry creditors 20,000
Sundry debtors 70,000 Bills payable 15,000
Cash balance 20,000 Tax payable 18,000
Bill receivables 30,000 Outstanding expenses 7,000
Bank Balance 10,000 Bank overdraft 25,000
Land and building 100,000 Debenture 75,000
Goodwill 50,000

1. Current Ratio = current assets

= 190,000 / 85,000 = 2.235
current liabilities

current assets – inventory

2. Quick Ratio = = 130,000 / 85,000 = 1.53
current liabilities

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 Q4. A company provides Income Statement / Profit and Loss Account for the year ended 31 st
Dec. 2013. You are required to calculate (1) Gross Profit Ratio, (2) Net Profit Ratio, (3)
Operating Ratio, (4) Operating profit Ratio (5) Ratio of selling and marketing department
expenses to Sales. Also comment on ratios.
Income Statement for the year ended 31st December 2013.

Particulars Amount in $ Particulars Amount in $

To opening stock 100,000

By Sales 1,200,000
To Wages 300,000
To purchases 500,000
To direct expenses 100,000 By closing stock 300,000
To gross profit 500,000
  1,500,000   1,500,000
To administrative exp. 60,000
To Salary 100,000

To non-operating expenses 10,000

By gross profit 500,000
To selling and Marketing
130,000
expenses

To Net Profit / Net Income 200,000

  500,000   500,000

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 Answer:
A.Gross profit Ratio = Gross profit / Sales X 100 =
500,000/1,200,000 X100 = 41.67 %

B. Net profit Ratio = net profit / Sales X 100 =

200,000/1,200,000 X 100 = 16.67 %

C. Administrative Expenses Ratio =

Administrative Expenses/Sales X 100 =
60,000/1,200,000 X 100 = 5 %

D. Operating Ratio = Operating Cost / sales X 100 =

990,000/1,200,000 X 100 = 82.5 %

E. Ratio of selling and marketing Expenses to sales =

selling and marketing Expenses / sales X 100
130,000 / 1,200,000 X 100 = 10.83 %.

Comment on ratios: all ratios look attractive. Net margin is 16.67%

which is a very good margin.

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 Q5. The Comparative statement of income and financial position are given below.
You are required calculate the following ratios for the both the years:
a)Current Ratio b) Quick Ratio c) Debt Equity Ratio
d) Gross Profit Ratio e) Net Profit Ratio. f) Return on Equity.

Particular 2010 $ 2011 $

Net sales 100,000 150,000
Less cost of sales 70,000 110,000
Gross profit 30,000 40,000
Less operating exp. 20,000 25,000
NET PROFIT 10,000 15,000
Cash in hand 5,000 8,000
Cash at bank 4,000 2,000
Debtors 40,000 25,000
Stock at cost 15,000 10,000
Fixed assets (Net) 56,000 65,000
 TOTAL ASSESTS 120,000 110,000
Creditors 36,000 12,000
Bills payable 2,000 1,000
Mortgage loan 10,000 20,000
Equity share capital 60,000 70,000
Reserve and surplus 12,000 7,000
 TOTAL LIABILITIES 120,000 110,000
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 Ratios for Year 2010:

1. Current Ratio = current assets = 64,000 / 38,000 = 1.684

current liabilities
current assets – inventory = 49,000 / 38,000 = 1.29
current liabilities
2. Quick Ratio =

Debt
3. Debt Equity Ratio = = 10,000 / 72,000 = 0.1388
Equity

Gross Profit = (30000/100000) X100 = 30%

4. Gross Profit Ratio = Net sales × 100

EAT
5. Net Profit Ratio = × 100 = (10,000/1,00,000) X100 = 10%
Net sales

Earnings After Tax X 100 = (10,000/72,000) X 100

6. Return on Equity = Equity = 13.88 %
Ratios for Year 2011:

1. Current Ratio = current assets = 60,000 / 13,000 = 4.615

current liabilities

current assets – inventory = 50,000 / 13,000 = 3.846

2. Quick Ratio = current liabilities

Debt
3. Debt Equity Ratio = = 20,000 / 77,000 = .259
Equity

Gross Profit = (40,000/150,000) X100 = 26.67%

4. Gross Profit Ratio = Net sales × 100

EAT
5. Net Profit Ratio = × 100 = (15,000/150,000) X 100 = 10%
Net sales

Earnings After Tax X 100 = (15,000 / 77,000) X 100

6. Return on Equity = Equity = 19.48%