Financial Statement

Analysis
Ratios
Ratio Analysis
 They simplify financial statements: Ratio analysis simplify information given in
companies’ financial statements. Investors can easily obtain data from a few ratios
instead of trying to understand entire statements.
 They help detect a problematic trend: Each type of ratio analysed over a long
period can point to a defect in the functioning of a business. The analysis can also
predict the future performance of a company in a particular aspect of business.
Ratio Analysis
 They facilitate comparisons: Ratios not only help analyse the performance of
one company but also facilitate a comparison of the performances of two or
more companies within an industry or a sector.
 For example, two companies in the traditional manufacturing sector can be
compared on the basis of their current ratios.
 A company with a current ratio of 3:1 can more easily clear its current debts than
one with a current ratio of 1.5:1.
 These ratios can be compared with the general standard current ratio for
companies in this sector, which may be 2:1.
Liquidity Ratios
•To help identify the short term liquidity of a firm, this ratio is
used. It has mainly two types of ratio under this.
•Current ratio which let us know the short term solvency of a firm.

Current Ratio = Current Asset /Current Liabilities

•Quick ratio helps us find the solvency for six months and the reason why
inventory is subtracted is that inventory usually take more than six month to
convert into liquid asset.  

•Quick Ratio= Quick Assets/ Current Liabilities

Quick Assets= Current assets- Inventories
Current assets= Quick Assets+ Inventories
Liquidity Ratios

 The quick ratio shows how quickly a company can convert its quick assets into
cash to clear its current dues, without disturbing its capital assets. This indicates
the level of liquidity of the company.
Quick Ratio= Quick Assets/ Current Liabilities
Quick Assets= Current assets- Inventories
Current assets= Quick Assets+ Inventories

The working capital ratio, or the current ratio, shows whether a company can
meet its current liabilities using its current assets (assets that can be converted into
cash within a year: for example, cash and cash equivalents).
Current Ratio
 Liquidity Ratio : 2:1
 Current Liabilities: Rs 50,000/-
 Inventories : Rs 20,000/-
 If liabilities are Rs50,000/-; Current assets would be Rs 1,00,000/-+ 20,000/-
 Current Ratio = 1,20,000/50000

2.4:1
Quick ratio
 Quick ratio 1.5:1
 Current assets Rs 1,00,000
 Current Liability: 40000/-
 Calculate Value of Inventory
Quick ratio
Quick ratio 1.5:1
Current assets Rs 1,00,000
Current Liability: 40000/-
Calculate Value of Inventory
Quick Ratio = Quick Assets / Liability
Quick Assets = 1.5x 40000= 60000/-
Quick assets= current Assets - Inventory
Inventory =1,00000-60000 = 40000/-
 Profitability Ratios
 Profit is the main objective of business. All business needs to be operating on
profit. These ratios are used to know the profitability of a business and the
measure the success effectively over a period of time.
 These ratios are used by the business owners, creditors, government officials
to know how the business is faring. If a business is asking for loan from a
bank, then the bank with by default check the profitability status using these
ratios.
Profitability Ratios
These ratios analyze another key aspect of a company and that
is how it uses its assets and how effectively it generates the profit
from the assets and equities.
This also then gives the analyst information on the effectiveness
of the use of the company’s operations.
Net Profit Ratio= Net profit after tax ×100
Net Sales
Gross Profit Ratio= Gross Profit ×100
Net Sales
Operating Ratio= Operating Cost ×100
Net Sales
Earnings per share = Net Income−Preferred Dividend ×100
number of shares outstanding
No RATIOS
1 Gross Profit Ratio
2 Operating Cost Ratio
3 Operating Profit ratio
4 Net Profit Ratio
5 Return on Investment Ratio
6 Return on Capital Employed Ratio
7 Earnings Per Share Ratio
8 Dividend Pay Out Ratio
9 Earning Per Equity Share
10 Dividend Yield Ratio
11 Price Earnings Ratio
12 Net Profit to Net Worth Ratio
FORMULAS
Gross Profit/Net Sales X 100
Operating Cost/Net Sales X 100
Operating Profit/Net Sales X 100
Operating Profit/Net Sales X 100
Net Profit After Interest  And Taxes/ Shareholders Funds or
Investments  X 100
Net Profit after Taxes/ Gross Capital Employed X 100
Net Profit After Tax & Preference Dividend /No of Equity Shares
Dividend Per Equity Share/Earning Per Equity Share X 100
Net Profit after Tax & Preference Dividend / No. of Equity Share
Dividend Per Share/ Market Value Per Share X 100
Market Price Per Share Equity Share/ Earning Per Share X 100
Net Profit after Taxes / Shareholders Net Worth X 100
Solvency ratios

Solvency ratios indicate a company’s viability in the long term—whether it can

meet its long-term obligations to creditors and sustain itself. These ratios
compare the debt of a company with its equity, earnings, and assets.
Debt-to-equity ratio.
The debt-to equity ratio relates the amount of debt taken on by a company to
its equity. It shows how much of its funds have come from banks and other
creditors compared with how much from its shareholders.

Debt-to-equity ratio: Total liabilities/total equity.

What does it mean to investors? The lower the debt-to-equity ratio, the

better is the company’s health, since funding by shareholders and other
investors is often seen as better than funding by banks and other creditors.
 
Proprietary Ratio
Proprietary Ratio: is used to evaluate the soundness of capital
structure of a business. Different business use different capital
structure, It could be 50% equity and 50% debt, while for some it
might 30% equity and 70% debt.

The ratio is given as:

Proprietary Ratio = Stakeholder′s Equity
Total Assets
Capital Structure Ratios
Each firm or company has capital or funds to finance its operations. These ratios, i.e.,
the Capital Structure Ratios, analyze how structurally a firm uses the capital or funds.

S. No. RATIOS FORMULAS

1 Debt Equity Ratio Total Long Term Debts /
Shareholders Fund

2 Proprietary Ratio Shareholders Fund/

Total Assets
3 Capital Gearing ratio Equity Share Capital /
Fixed Interest Bearing Funds

4 Debt Service Ratio Net profit Before Interest & Taxes /

Fixed Interest Charges
Activity Ratios
This ratio is also known as turnover ratio, this ratio measures the efficiency of
a firm and converting its products into cash.
The ratio is measured in days.
This ratio helps in letting the business know how many times the product is
turning into cash during a specified period of time.

Inventory Turnover Ratio= Cost of goods sold

Average Inventory
•Receivables turnover Ratio helps in knowing how many times the credit is
collected in a given period of time. 

Receivables Turnover Ratio= Net Credit Sales

Average Trade Receivable
Efficiency ratios
 Efficiency ratios show how efficiently a company uses its assets to make profits or
convert its inventories into cash. These ratios measure how promptly a company is able
to collect cash from its clients for goods or services delivered to them on credit.
 In other words, the efficiency ratios indicate how efficiently the managers in charge of
day-to-day operations are manufacturing and selling products to make profits.
  Accounts receivable turnover ratio
 Accounts receivable is the cash due to a company from its customers who enjoy credit.
 The accounts receivable turnover ratio expresses how efficient a company is at collecting
cash owed to it by its clients for goods or services delivered on credit, or how many times
(turns) a year it collects these amounts.
Accounts receivable turnover ratio
 If a company’s average account receivable for a particular year is Rs. 1 crore (the
average is calculated by using the receivables at the start and at the end of the year),
and it collected Rs. 2 crore during the year, its accounts receivable turnover ratio is
Rs. 2 crore divided by Rs. 1 crore, that is, 2.
 This means that the company collected its accounts receivable twice during the
year, or once every six months.
 A company that has recorded an accounts receivable turnover ratio of 4 has
collected its accounts receivable every 90 days, or four times a year.
 What does it mean to investors? The higher the accounts receivable turnover
ratio, the more frequently does the company collect its receivables, and, thereby,
the more efficient it is.
Valuation ratios
 Valuation ratios help investors measure the value of a company stock and decide whether
to buy, hold, or sell its shares. These ratios also enable them to predict the future of the
stock and what returns to expect from it.
 Price earnings ratio:
 The price earnings (PE) ratio is a valuation ratio that relates the price paid for a share to
the earnings from it. It shows the stock market’s assessment of the value of a share of a
company based on the share earnings declared.
 Formula for Price earnings ratio: The ratio is arrived at by dividing the
market value price for a share
earnings per share,
 and is usually calculated at the end of a financial year.
What does it mean to investors? 
 The PE ratio gives the expected price of a share based on its earnings. It tells a share
buyer what earnings can be expected from the share in the form of higher dividends or
higher share price at the time of sale.

 The ratio can be used to compare businesses in the same industry but is prone to
manipulation by management. An extremely high ratio, for example, may indicate that
profits have probably been overstated and that a fall in share price may be round the
corner.

 Financial ratios are signboards indicating the performance of a company on various

parameters. Ratio analysis reveals to the investors the sustainability and future of their
investments.
 PROBLEMS IN FINANCIAL STATEMENT
ANALYSIS
      Developing and Using Comparative Data
      Distortion of Comparative Data
      Notes to Financial Statements
      Interpretation of Results
      Differences in Accounting Treatment
      Window Dressing
      Effects of Inflation
Working Capital Ratios
Like the Liquidity ratios, it also analyses if the company can pay off the current debts or liabilities using the current
assets. This ratio is crucial for the creditors to establish the liquidity of a company, and how quickly a company
converts its assets to bring in cash for resolving the debts.

S. No. RATIOS FORMULAS

1 Inventory Ratio Net Sales / Inventory
2 Debtors Turnover Ratio Total Sales /  Account Receivables

3 Debt Collection Ratio Receivables  x Months or days in a year / Net Credit Sales for
the year

4 Creditors Turnover Ratio Net Credit Purchases / Average Accounts Payable

5 Average Payment Period Average Trade Creditors / Net Credit Purchases X 100

6 Working Capital Turnover Ratio Net Sales / Working Capital

7 Fixed Assets Turnover Ratio Cost of goods Sold / Total Fixed Assets
8 Capital Turnover Ratio Cost of Sales / Capital Employed
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