AMITY UNIVERSITY HARYANA

AMITY BUSINESS SCHOOL

MBA-MODULE 4-FINANCIAL STATEMENT ANALYSIS(USING RATIOS)

The primary objective of financial reporting is to provide information to

present and potential investors and creditors and others in making rational
investment, credit and other decisions.
Effective decision making requires evaluation of the past performance of
companies and assessment of their future prospects.
OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS: OBJECTIVES ARE TO ASSESS
a) the present and future earning capacity or profitability of the concern
b) The operational efficiency of the concern as a whole and of its various
parts or departments
c) Short-term and long-term solvency of the concern for the benefits of the
debenture holders and trade creditors
d) the comparative study in regard to one firm with another firm or one
department with another department
e) the possibility of developments in the future by making forecasts and
preparing budgets
f) the financial stability of a business concern
g) the long-term liquidity of its funds

Financial statement analysis enables investors and creditors to

-evaluate past performance and financial position
-predict future performance
SOURCES OF INFORMATION
Individual investors and creditors must often depend upon published
sources of information about a company. The most common sources of
information about listed companies are

a)company’s annual reports( annual reports which include directors’

report, financial statements, schedules and notes to the financial
statements and auditor’s report)
 b)-stock exchanges(BSE and NSE have a number of publications giving
useful financial information about companies)
c)business periodicals( the economic times, business line, business
standard etc papers give daily stock prices and carry news items and
analytical write-ups on companies)

d)information services(periodical company and industry studies are

brought out by CRISIL, and ICRA. These studies contain condensed
financial statements of companies as well as other information such as
management, foreign collaborations, major competitors, and industry
overview. Several useful studies of financial ratios are also available,
notably the ones published by CMIE, Centre for Monitoring Indian
Economy).

ANALYSIS AND INTERPRETATION

Analysis is the process of critically examining in detail accounting
information given in the financial statement. For the purpose of
analysis, individual items are studied, their interrelationships with other
related figures established, the data is sometimes rearranged to have
better understanding of the information with the help of different
techniques or tools for the purpose.
Analyzing financial statement is the process of evaluating relationship
between component parts of financial statements to obtain a better
understanding of firm’s position and performance.
Analysis and Interpretation are closed related. Interpretation is not
possible without analysis and without interpretation analysis has no
value. Interpretation is drawing of inference and stating what the
figures in the financial statements really mean.
TYPES OF FINANCIAL STATEMENTS ANALYSIS
(i) according to the nature of analyst and the material used by him
a) External analysis: It is made by those persons who are not
connected with the enterprise. They do not have access to the
enterprise. This type of analysis is made by investors, credit
agencies, government agencies and research scholars.
b) Internal analysis: This is made by those persons who have access
to the books of accounts. They are the members of organization.
 The internal analyst can give more reliable result than the external
analyst because every type of information is at his disposal.
(ii) According to the objectives of analysis
a)Long-term analysis: This is made in order to study the long-term
financial stability, solvency and liquidity as well as profitability and
earning capacity of a business concern. The purpose of this analysis is
to know whether in the long-run the concern will be able to earn a
minimum amount which will be sufficient to maintain a reasonable
rate of return on the investment so as to provide the funds required
for modernization, growth and development of the business and to
meet its cost of capital.
b)Short-term analysis: This is made to determine the short-term
solvency, stability and liquidity as well as earning capacity of the
business. The purpose of this analysis is to know whether in the
short-run a business concern will have adequate funds readily
available to meet its short-term requirements and sufficient
borrowing capacity to meet contingencies in the near future.
This analysis is made with reference to items of current assets and
current liabilities(working capital analysis) to have fairly sufficient
knowledge about the company’s current position which may be
helpful for short-term financial planning and long-term financial
planning.
(iii) According to the modus operandi of the analysis
a) Horizontal analysis(dynamic analysis): This analysis is made to
review and analyse financial statements of a number of years and
therefore, based on financial data taken from several years. This
is very useful for long-term trend analysis and planning.
b) Vertical analysis(static analysis): This analysis is made to review
and analyse the financial statement of one particular year only.
Ratio analysis of the financial year relating toa particular
accounting year is an example of this type of analysis.

TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

a) comparative financial statements
b) common size statements
 c) trend analysis
d) funds flow statement
e) cash flow statement
f) ratio analysis
RATO ANALYSIS
Ratio analysis is one of the most powerful tools of financial analysis.
A ratio can be defined as “the indicated quotient of two mathematical
expressions” and as “ the relationship between two or more things”.
Thus a ratio is the numerical or arithmetical relationship between two figures.
It is expressed where one number is divided by another.
A ratio between 200 and 100 can be expressed as 2 or 2:1 or 2/1 or 200:100 or
200%. A ratio can be used as a yardstick for evaluating the financial position
and performance of a concern. Ratio analysis helps the analyst to make
quantitative judgement with regard to concern’s financial position and
performance.
TYPES OF RATIOS
(i)Profitability Ratios (ii)Solvency Ratios(short-term and long-term) (iii)
Turnover ratios
Gross profit
a)Gross profit ratio= Net Sales x100

This ratio is also known as gross margin ratio or trade margin ratio. This ratio
indicates the difference between sales and direct costs. It explains the
relationship between gross profit and net sales. A higher G/P ratio is the result
of
Increase in selling price without changing the cost of goods sold
Decrease in cost of goods sold, with selling price remaining constant

net profit
b)Net profit ratio= net sales x100

this ratio measures the management’s efficiency in operating the business

successfully from the owner’s point of view . Higher the ratio better is the
operational efficiency of the business concern.
 operating profit
c)Operating profit ratio = net sales
x100

It is the ratio of profit made from operating sources to the sales, usually shown
as a percentage. It shows the operational efficiency of the firm and is a
measure of the management’s efficiency in running operations of the firm.
Operating profit=net profit+ operating expenses-non-operating incomes
Or operating profit=gross profit -operating expenses
Operating expenses include administrative, selling and distribution expenses.
Finance expenses are generally excluded.
d)Operating ratio=(cost of goods sold+ operating expenses)÷ net sales*100
This ratio indicates the relationship between total operating expenses and
sales.
Cost of goods sold =sales-gross profit
Cost of goods sold= opening stock+ purchases excluding returns+direct
expenses- closing stock
Total operating expenses include cost of goods sold, administrative expenses
and selling and distribution expenses. Generally finance expenses like interest
are not included under operating expenses.
Net sales means sales minus sales returns
net profit after tax∧ preference dividend
e)Earnings per share(EPS)= no of equity shares
x100

EPS= EAS/N
EPS=Earnings available to equity shareholders/number of equity shares
EAS=EBIT-Interest-Tax-Preferential Dividend
This ratio highlights the overall success of the concern from owners’ point of
view and it is helpful in determining market price of equity shares.
It reflects upon the capacity of the concern to pay dividend to its equity
shareholders. Generally investors are accustomed to judge companies in the
context of the share market, with the help of EPS.
Price -earnings ratio=market price per share/earnings per share
 operating profit
f)Return on investment(ROI or ROCE)= capital employed x100

It measures the sufficiency or otherwise of profit in relation to capital

employed. Return on investment is used to measure the operational and
managerial efficiency. A comparison of ROI with that of similar firms, with that
of industry and with past ratio will be helpful in determining how efficiency the
long-term funds of owners and creditors being put into use. Higher the ratio,
the more efficient is the use of the capital employed.
The term capital employed has been interpreted in different ways by different
accountants and authors Some of the meanings of capital employed are given
below:
Total of all assets ie fixed as well as current assets
Total of fixed assets
Total of long-term funds employed in the business
Ie. (Share capital + reserves and suplus+ long-term loans)- (non-business
assets+ fictitious assets)
Net working capital + fixed assets
net profit after interest ∧taxes
g)Return on shareholders’ funds= '
x 100
shareholder s fund

the net profit here is net income after payment of interest and tax and it
includes net non-operating income also.
Shareholders funds includes equity share capital, preference share capital and
all reserves and profits belongs to shareholders.
g) Return on equity shareholders funds on Return on Equity or Return
on Net worth: This ratio signifies the return on equity shareholders
funds. The profit considered for computing the ratio is taken after
payment of preference dividend. The ratio of return on equity
shareholders funds is calculated as follows;
Return on equity shareholders funds=
net profi after interest , tax∧preference dividend
x100
equity shareholders funds

Shareholders funds or networth refers to equity share capital+ reserves+

proits – accumulated losses.
 net profit after tax+interest
h)Return on Total Assets= total assets−ficticious assets x100

This ratio is calculated to measure the productive of total assets. There are two
ways to calculate this ratio.
net profit after tax
Return of total assets= total assets
x 100

Or
net profit after tax +interest
Return on total assets= total assets excluding ficticious assets

Fictitious assets refers preliminary expenses, debit balance of profit and loss
account and other similar losses shown on balance sheet assets side.
PROBLEMS
Q.No.1
Calculate gross profit ratio from the following: Rs.
Sales 10,00,000
Sales returns 1,00,000
Opening stock 2,00,000
Purchases 6,00,000
Purchase returns 1,50,000
Closing stock 65,000

Solution
Dr Trading Account Cr
particulars Amount(Rs) particulars Amount(Rs)
To Opening stock 2,00,000 By Sales 10,00,000 9,00,000
Less: sales
returns1,00,000
To 4,50,000 By Closing stock 65,000
Purchases6,00,00
0
 Less
returns1,50,000
To Gross profit
To Gross 3,15,000
profit(balance)
9,65,000 9,65,000

Or
Gross profit= Net sales- cost of goods sold
Net sales= sales-sales returns
10,00,000-1,00,000=9,00,000
Cost of goods sold= opening stock+ purchases excluding returns-closing stock
2,00,000+4,50,000-65,000=5,85,000
Therefore, gross profit=9,00,000-5,85,000= Rs 3,15,000

Q.No.2
a) from the following details of a business concern, calculate net profit ratio
sales 3,50,000
cost of goods sold Rs 1,50,000
administrative expenses Rs 50,000
selling expenses Rs 10,000
Solution:
net profit
Net profit ratio= net sales x100

Net Profit=Gross profit-Operating expenses

Gross profit=sales-cost of goods sold
=3,50,000-1,50,000=Rs 2,00,000
Operating expenses=administrative expenses+ selling& distribution expenses
 50,000+10,000=Rs 60,000
Net profit= 2,00,000-60,000=Rs 1,40,000
1,40,000
Net profit ratio= 3,50,000 x 100=40 %

b)from the following details you are required to ascertain net profit and
calculate the net profit ratio

Sales 5,40,000
Sales returns 40,000
Gross profit 3,00,000
Income from investments 40,000
Loss on sale of plant 30,000
Operating expenses 1,20,000
Provision for tax 50,000
Solution:
Net profit is ascertained by preparing Profit & Loss A/c
particulars Rs particulars Rs
To operating 1,20,000 By Gross profit 3,00,000
expenses
To Loss on sale of 30,000 By income from 40,000
asset investments
To Provision for 50,000
tax
To Net 1,40,000
profit(balance)
3,40,000 3,40,000

Net sales= sales -sales returns

5,40,000-40,000=Rs 5,00,000
1,40,000
Therefore, Net profit ratio= 5,00,000 x100

=28%
Q.No.3
Anil enterprises present you the following income statement and request you
to calculate
a) Operating ratio
b) Expenses ratio
c) Operating profit ratio
d) Gross profit ratio
e) Net profit ratio
Income Statement
Particulars Rs Rs
Sales 8,60,000
Less: sales returns 60,000
------------ 8,00,000
Net sales
3,50,000
Less: cost of goods sold
Gross profit 4,50,000
Add: non-operating incomes:
Income from investments 20,000
Profit on sale of investments 30,000
5,00,000
Less: Operating expenses:
Administrative expenses 40,000
Selling expenses 60,000
Distribution expenses 20,000
Non-operating expenses:
Finance expenses 30,000
Loss on sale of plant 20,000
Provision of tax 30,000 2,00,000
Net profit 3,00,000

Solution:
a)Operating ratio=(cost of goods+ operating expenses)/Net Sales*100
=(3,50,000+40,000+60,000+20,000)/8,60,000*100
=4,70,000/8,00,000*100=58.75%
b)Expenses ratio
Administrative expenses to net sales
=Administrative expenses/net sales*100
40,000/8,00,000*100=5%
Selling expenses to net sales
=60,000/8,00,000*100=7.5%
Distribution expenses to net sales
=20,000/8,00,000*100=2.5%

c)operating profit ratio= operating profit/net sales*100

operating profit=Gross profit-operating expenses

=4,50,000-(40,000+60,000+20,000)=Rs 3,30,000
Or
Operating profit=Net profit+ non-operating expenses and losses-non
operating incomes
=3,00,000+(30,000+20,000+30,000) -(20,000+30,000)
=3,80,000-50,000= Rs 3,30,000
Operating profit Ratio=3,30,000/8,00,000*100=41.25%
d)Gross profit ratio=Gross profit/net sales*100
4,50,000/8,00,000*100=56.25%
f) Net Profit Ratio=Net profit/Net sales*100
=3,00,000/8,00,000*100=37.5%
 (ii)Solvency ratios or Financial ratios
There are also known as balance sheet ratios .These ratios express financial
position of the concern. The term financial position generally refers to
short-term and long-term solvency of the business concern, indicating
safety of different interested parties. These ratios are analysed to find
judicious use of funds.
Therefore, financial ratios are as under:
1.Overall solvency
2.Short-term solvency or liquidity ratios
a) Current ratio
b) Liquid ratio
c) Cash position ratio
3.Long-term solvency ratio
a) Fixed assets ratio
b) Debt equity ratio
c) Proprietary ratio
d) Capital gearing ratio
1.Overall solvency or Total debt or Debt ratio
It is a ratio which relates the total tangible assets with the total borrowed
funds. Total debt includes short-term and long-term borrowings. It shows the
proportion of assets needed to repay the debts. A higher ratio indicates
greater risk and lower safety to the owners.
Total debt ratio or solvency ratio=Total debt/Total tangible assets
2.Short-term solvency ratios
a) current ratio: The ratio of current assets to current liabilities is called current
ratio. In order to measure the short-term liquidity of solvency of a concern,
comparison of current assets and current liabilities is inevitable. This indicates
the ability the ability of a concern to meet its current obligations as and when
they are due for payment.
Current ratio=Current assets/Current liabilities
Current assets include debtors, stock, bills receivables, bank and cash balances,
prepaid expenses, income due and short-term investments.
The term current liabilities includes creditors, bank overdraft, bills payable,
outstanding expenses, income received in advance etc.
Accepted current ratio is 2:1
b)Liquid ratio: Quick assets or liquid assets/Current liabilities
ACID TEST RATIO/LIQUID RATIO/QUICK RATIO:
It is used to measure a firm’s ability to convert its current assets quickly into
cash in order to meet its current liabilities (i.e. instant debt-paying ability of a
firm). Standard ratio is 1: 1. This is considered more conservative manner of
computing the ratio. It is a measure of quick or acid liquidity. A firm having
relatively higher current ratio than quick ratio implies a large part of the
current assets being tied up in slow moving and unsleable inventories and slow
paying debts. The firm would find it difficult to pay its current liabilities.

Acid Test Ratio = Quick Assets

Quick Liabilities or current liabilities
Quick Assets/Liquid Assets = Current Assets – (Inventory + Prepaid Expenses).
These are the assets which can be immediately converted into cash without
much loss. Inventory & prepaid expenses are not easily and readily convertible
into cash.
Quick Liabilities/Liquid Liabilities = Current Liabilities & Provisions – [Bank
overdraft (If it becomes permanent mode of financing) + Cash Credit].

Merits:
1. It is used as a supplementary to the current ratio
2. It removes inherent defects of current ratio

c. CASH RATIO/ABSOLUTE LIQUID RATIO/SUPER QUICK RATIO

It is also known as cash position ratio. This ratio is calculated when liquidity is
restricted highly in terms of cash and cash equivalents. This measures liquidity
in terms of cash and near cash items and short-term liabilities.
Cash position ratio=(cash and bank balances+ marketable securities)/current
liabilities
An ideal cash position ratio is 0.75:1. It is not widely used ratio as this is very
rigorous measure of liquidity position.
Long-term solvency ratios
a)Fixed assets ratio: This ratio establishes the relationship between fixed assets
and long-term funds. The objective of calculating this ratio is to ascertain the
proportion of long-term funds invested in fixed assets.
Fixed assets ratio=Fixed assets/Long-term funds

Fixed assets mean fixed assets-depreciation

Long-term funds=share capital+ Reserves and surplus+ Long-term loans -
Fictitious assets
An ideal fixed assets ratio is 0.67
b)Debt-equity ratio: This ratio is calculated to determine long-term solvency
position of a company.
Debt-equity ratio =External equities/Internal equities
Internal equities refers to shareholders fund or the networth
Shareholders refers to only equity shareholders
External equities refers to total outsiders liabilities
An ideal ratio is 1
This ratio is also calculated as given below:
Debt-equity ratio=Total long-term debt/Total long-term funds
Debt-equity ratio=Shareholders funds/Total long-term funds
Debt-equity ratio=Total long-term debt/shareholders funds
c)Proprietary ratio: This ratio compares the shareholders funds or owners
funds and total tangible assets. This ratio shows the general soundness of the
company. It is of particular interest to the creditors of the company as it helps
them to ascertain the shareholders funds in the total assets of the business. A
high ratio indicates safety to the creditors and a low ratio shows greater risk to
the creditors.
A ratio below 0.5 is alarming for the creditors.
e) Capital gearing ratio: This ratio is also known as capitalization or
leverage ratio. It is used to analyse the capital structure of the
company. This ratio establishes relationship between fixed interest and
dividend securities and equity shareholders funds.
Capital gearing ratio=(long-term loans+ debentures+ preference share
capital)/total tangible assets
(iii)Turnover ratios or activity ratios
These ratios are also called as performance ratios. They highlight the
operational efficiency of the business concern. The term operational efficiency
refers to the effective, profitable and rational use of resources available to the
concern.
a)inventory turnover or stock turnover ratio
this ratio is also called as stock velocity ratio. It is calculated to ascertain the
efficiency of inventory management in terms of capital investment. It is
obtained by dividing the cost of sales or cost of goods sold by average stock. It
indicates the number of times the inventory is turned over during a particular
accounting period.
Stock turnover ratio=cost of goods sold/average inventory
Or net sales/average inventory or number of units sold/average number of
units in stock
Cost of goods sold=opening stock+purchases+direct expenses-closing stock
Average stock=(opening stock+ closing stock)/2
Inventory turn over period=days or months in the year/inventory turnover
ratio
b)Debtors turnover ratio: It is also called as receivables turnover ratio or
debtors velocity.
Customers who buy goods on credit are called debtors or book debts.
Debtors and bills receivables together are called accounts receivables
Debtors turnover ratio measures the number of times the receivables rotated
in a year in terms of sales. This ratio indicates the efficiency of company
collection and efficiency of credit policy.
Debtors or receivables turnover= net credit sales/average receivables
Average receivables =(opening receivables+ closing receivables)/2
Average collection period=months in a year or days in a year/debtors turnover.
A high turnover ratio and a short collection period convey quick payment on
the part of debtors.
c)Creditors turnover or accounts payable turnover ratio:
This ratio indicates the number of times the payables rotate in a year. The term
accounts payable includes sundry creditors and bills payable.
Creditors turnover ratio=net credit purchases/average accounts payable
Average payment period=days or months in the year/creditors turnover ratio
Average accounts payable=(opening payables+ closing payables)/2
d) Fixed assets turnover ratio: This ratio determines the efficiency of
utilization of fixed assets of a business concern. Higher the ratio, more
is the efficiency of utilization of fixed assets.
Fixed assets turnover ratio=cost of sales/net fixed assets