THEORETICAL FRAME WORK OF FINANCIAL STATEMENT ANALYSIS

Financial Statements:

A business enterprise conveys financial information to the users through

financial statements.” Financial statements possess summarized information of the
firm’s financial affairs”. They are the means to financial position of the enterprise
to the investor’s creditors and financial institutions and to the society as a whole”.
A financial statement is an organized collection of data according to logical and
consistent accounting procedures”. Its purpose is to present an understanding of
financial aspects of a business firm. It may show a position at a point of time as in
the case of a balance sheet, or to provide information regarding a series of activities
over a given period of time like an income statement.
The term financial statements refer two basic statements:
1. Income statement
2. Balance sheet
3. Statement of retained earnings
4. Statement of changes in financial position.

Types of financial statements

1. Income Statements:
The income statement or profit and loss accounts are considered to be the most useful
of all financial statements. It’s explained the position of business as a result of
operations. It matchews the revenues and costs show the net profit earning or loss
suffered during a period of time. It is scoring board of company’s performance
during a period of times.
The nature of the “Income” which is the center points of the income statement can
be stated as surplus of output over inputs. The outputs are the goods and services
that the business provides to its customs. The values of these outputs are the money
paid by the customers for them. These amounts are called “revenue”. The inputs are
the economic resources used by the business in providing these goods and services,
these are as ‘expenses’, when expenses are excluded from revenue profits can be
secured.

2. Balance Sheet:
Balance sheet is a statement of financial position of a business at a specified point
of time. It represents all assets owned by the business at a particular point of time.
It is a blue print of the financial condition of the business at the time. the vital
distinction between an income statement and a balance sheet is for a period while
balance sheet is on particular date. Income statement is a flow report as different
from the balance sheet, which is static report .but both are complementary to each
other.

3. Statement of retained earnings:

Retained earnings means they accumulated surplus of earnings over loss and
dividends. The favourable balance shown by the income statement is transferred to
the balance sheet through this statement, after making necessary appropriations. So
it is a connecting link between balance sheet and the income statement. The
statement is also termed as profit and loss appropriation account in case of
companies.
4. Statement of changes in financial position:
The balance sheet shows the financial position of business at a particular point of
time while the income statement provides the results of operations of business over
a period of time. In order to understand the affairs of the business it is necessary to
identify the movement of working capital or cash in and out of the business. This
information is available for the statement of changes in financial position.
ANALYSIS OF FINANCIAL STATMENTS
Analysis of financial statements refers to process of the critical examination of
financial information contained in the financial statements in order to understand
and make decisions regarding the operations of the firm. The AFS is basically a
study of the relationship among various financial facts and figures as given in asset
of financial statements. The basic financial statements are the balance sheet and the
income statement contains a whole lot of historical data. The complex figures as
given in these financial statements are deselected or broken up into simple and
valuable elements and significant relationships are established between the elements
of the same statement or different financial statements. The process of dissections,
establishing relationships and interpretation these are to understand the working and
financial position of a firm is called the AFS. Thus, AFS is the process of
establishing and identifying the financial weakness and strength of the firm.

Financial analysis can be classified in to different categories depending up on

1. On the basis of material used.

2. On the basis of modules
On the basis of material used:
According to the basis, financial analysis can be of two types

External Analysis:
This analysis is done by those who are outsiders for business. These persons mainly
depend up on the published financial statements. Their analysis serves only a limited
purpose.

Internal Analysis:
This analysis is done by persons who have access to the books of account and at
other information related to the business. Such as analysis can be done by executives
and employees of the organizations. The analysis is done depending up on the
objective to be achieved through this analysis.

On the basis of modules operandi:

According to this financial analysis can also be of two types:

Horizontal Analysis:
In case of this type of analysis, financial statements for a number of years are
reviewed and analyzed the current year’s figures are compared with the standard or
base year. The analysis statement usually contains figures for two or more year and
the change are shown regarding each item from the base year usually in the form of
percentage. Since this type of analysis based on the data from year to year rather
than on date, it is also termed as “Dynamic analysis”.

Vertical Analysis:
In case of this type of analysis a study is made of the qualitative relationship of
various items in the financial statement on a particular date. Since this analysis
depends on the data for one period, this is not very conductive to a proper analysis
of the company’s financial position. It is also called “Static analyses as it is
frequently used for referring to ratio developed on one date or for one accounting
period.
INTERPRETATION:
After making analysis of financial statements the next step is interpretation for
forming an opinion about the enterprise. This is also known as interpretation stage.
The interpretation involves the explanation of financial facts in a simplified manner.
Interpretation means explaining the business concern in simple language which may
be understand even by a layman.
Interpretation is impossible without analysis. Interpretation is not possible
without analysis and without interpretation analysis has no value.

OBJECTIVES OF ANALYSIS AND INTERPRETATION

The following are the objectives of analysis and interpretation of financial statements:

1. To estimate the earning capacity and efficiency of the firm.

2. To determine the short-term and long-term solvency of the firm.
3. To determine the profitability and future prospects of the concern.
4. To enquire about the financial soundness of the business concern.
5. To investigate the future potential of the convert.
6. To study whether their profits commensurate with the capital employed or not.
 RATIO ANALYSIS

INTRODUCTION:

Ratios analysis is one of the powerful tools of the financial analysis. A ratio can be
defined as “the indicated quotient of two mathematical expressions”, and as “the
relationship between two or more things”. Ratio is the numerical or an arithmetical
relationship between two figures. It is expressed where one figure is divided by
another. If 4,000 is divided by 10,000, the ratio can be expressed as;4 or 2:5 or 40%.
A ratio can be used as a yardstick for evaluating the financial position and
performance of a concern because the absolute accounting data cannot provide
meaningful understanding and interpretation. A ratio is relationship between two
accounting items expressed mathematically. Ratio analysis helps the analyst to make
quantitative judgment with regard to concern’s financial position and performance.
Ratios are the numerical relationship between two numbers which are related in
some manner.

Absolute figures are valuable but they standing alone convey no meaning unless
compared with another. Accounting ratios show inter-relationships with exist among
various accounting data. When relationships among various accounting data
supplied by statements are worked out, they are known as accounting ratios.

DEFINITION:

“The relation of one amount, a to another b, expressed as the ratio of a to b”.

KHOLER

“Ratios is the relationship or proportion that one amount bears to another the first
number being the numerator and the later denominator”.

H.G. GUTHMANN
NATURE OF RATIOS ANALYSIS:

Ratio analysis is a technique of analysis and interpretation of financial accounting

data. Calculation of mere ratios does not serve any purpose, unless several
appropriate ratios are analyzed and interpretated. The following are the three
important steps involved in the ratio analysis:

1) Selection of relevant data from the financial statement depending upon the

objectives of analysis.
2) Calculation of appropriate ratios from the data.

3) Comparison of the calculated ratios with the ratios of the same firm in the past,

or the ratios developed from projected financial statement or the ratios of

competitors firms.

SIGNIFICANCE OF RATIO ANALYSIS:

The major benefits arising from ratio analysis are as follows:

1) Ratios analysis is a very powerful analytical tool useful for measuring

performance of an organization.

2) Ratio analysis concentrates on the interrelationship among the figures appearing

in the financial statements.

3) Ratios make comparison easy. Ratio is compared with the standard ratio and this

show the degree of efficiency utilization of assets etc.

4) Ratio analysis helps the management to analyze the past performance of the
firm and to make further projections.

5) Ratio analysis allows interested parties like shareholders, investors, creditors,

government and analysts to make on evaluation of certain aspects of a firm’s
performance.

TYPES OF RATIO ANALYSIS:

Several ratios calculated from the accounting data, can be grouped into various
classes according to financial activity or function to be evaluated. As stated earlier,
the parties interested in financial analysis are short-term and long-term creditors,
owners and management. Short term creditor’s main interest is in the liquidity
position or the short-term solvency of the firm. Long term creditors, on the other
hand, are more interested in the long-term solvency and profitability of the firm.
Similarly, owners concentrate on the firm’s profitability and the financial condition.
Management is interested in evaluating every aspect of the firm’s performance.
They have to protect the interests of all parties and see that the firm grows
profitably. In view of the requirement of the various users of ratios, we may classify
them into the following four important categories: -

1) Liquidity Ratio
2) Leverage Ratio
3) Activity Ratio
4) Profitability Ratio
 LIQUIDITY RATIO

It is extremely essential for a firm to be able to meet its obligations as they become
due. Liquidity ratios measure the firm’s ability to meet current obligations.

In fact, analysis of liquidity needs the preparation of cash budgets and cash and
Funds Flow Statement, liquidity ratios, by establishing a relationship between cash
and other current assets to current obligations provided a quick measure of liquidity.
The firm should ensure that it does not suffer from lack of liquidity, and also that it
does not have excess liquidity. The failure of company to meet its obligations due
to lack of sufficient liquidity, will result in a poor creditworthiness, loss of
creditor’s confidence, or even in legal tangles resulting in the closure of the
company. A very high degree of liquidity is also bad; idle assets earn nothing. The
firm’s fund will be unnecessarily tied up in current assets. Therefore, it is necessary
to strike a proper balance high liquidity and low liquidity. The most common ratios,
which indicate the extent of liquidity or lack of it, are:

a. CURRENT RATIO:

The current ratio (CR) is equal to total current assets divided by total current
liabilities. This indicates the extent to which current liabilities can be paid off
through current assets.
Current Ratio = Current Assets / Current Liabilities

b. QUICK RATIO:

One Key problem with the current ratio is that it assumes that all current assets can
be converted in to cash in order to meet short-term obligations. We know this
assumption is highly untrue. Firms carry current assets, such as inventory and pre-
paid expenses which cannot be converted into cash quickly. To correct this
problem, the quick asset ratio (QAR) removes from current assets less liquid current
 assets, such as inventory and pre-paid expenses, which cannot be converted into
cash quickly. The quick ratio, also called the acid test ratio, is equal to liquid current
assets, divided by current liabilities. It indicates the extent to which current
liabilities can be paid off through liquid current assets such as cash, marketable
securities, and accounts receivables.

Quick ratio = (Current Assets – Inventory) / Current Liabilities

c. CASH RATIO:

The cash ratio goes a step further and examines the ability of the firm to settle short-
term liabilities using only cash and cash equivalents such as marketable securities.
In other words, the cash ratio indicates the extent to which current liabilities can be
paid through very liquid assets.

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

 LEVERAGE RATIO

Leverage ratios are financial ratios that specify the level of debt incurred by a
business relative to other accounting heads on its balance sheet.

For example, the debt-to-equity ratio is a leverage ratio that displays the total
amount of debt for a business in relation to its stockholder equity.

While they were originally designed to evaluate companies in the stock market,
leverage ratios have become important tools after the 2008 financial crisis to
prevent systemically-important financial institutions from defaulting or going
bankrupt.

Leverage ratios are different from liquidity ratios, which are primarily used to
measure the amount of liquidity available to a company to fund their operations and
their debt obligations.

They are indicators of a company's ability to meet its short-term and long-term debt
obligations.Debt generally gets a bad rep but it has its advantages. For
example, interest payments on certain kinds of debt are tax-deductible and can
reduce the overall amount of debt that a company incurs.
 A leverage ratio greater than 1 indicates that the company is operating with
significant amounts of debt and may not be able to service its future payments on
that debt.

Similarly, the Assets-to-Equity ratio can be used to measure its assets versus
stockholder equity. Together, both ratios provide a window into the company's
spending and debt allocations

a) Equity Ratio = Shareholder’s Equity / Net Assets

b) Debt Ratio = Total Debt / Net Assets
c) Debt to Equity = Total Debt / Shareholder’s Equity
d) Debt to Total Assets = Total Debt / Total Assets

 ACTIVITY RATIOS

An activity ratio is a type of financial metric that indicates how efficiently a

company is leveraging the assets on its balance sheet, to generate revenues and
cash. Commonly referred to as efficiency ratios, activity ratios help analysts gauge
how a company handles inventory management, which is key to its operational
fluidity and overall fiscal health.

Activity ratios are most useful when employed to compare two competing
businesses within the same industry, to determine how a particular company stacks
up among its peers. But activity ratios may also be used to track a company’s fiscal
progress over multiple recording periods, to detect changes over time. These
numbers can be mapped to present a forward-looking picture of a company’s
prospective performance.

a) Total Assets Turnover = Sales or COGS / Total Assets

b) Fixed Assets Turnover = Sales or COGS / Fixed Assets
c) Capital Turnover = Total Assets – Current Liabilities
d) Current Assets Turnover = Sales or COGS / Current Assets
e) Inventory Turnover = COGS or Sales / Average Inventory
f) Receivable Turnover = Credit Sales / Average Receivables
g) Payables Turnover = Credit Purchases / Average Accounts Payable
 PROFITABILITY RATIOS

Profitability ratios are a type of accounting ratio that helps in determining the
financial performance of business at the end of an accounting period. Profitability
ratios show how well a company is able to make profits from its operations.

a) Gross Profit Ratio = (Gross Profit / Sales) * 100

b) Net Profit Ratio = (Net Profit / Sales) * 100
c) Operating Profit Ratio = (Operating Profit /Sales) * 100

USERS & OBJECTIVE OF FINANCIAL ANALYSIS

1) SHAREHOLDERS
 Objective
Being owners of the organization, they are interested to know about profitability
and growth of the organization.
 Ratios used in General
Mainly Profitability Ratio [In particular Earning per share (EPS), Dividend per
share (DPS), Price Earnings (P/E), Dividend Payout ratio (DP)].

2) INVESTORS
 Objective
They are interested to know overall financial health of the organization
particularly future perspective of the organizations.
 Ratios used in General
 Profitability Ratios
 Capital structure Ratios
 Solvency Ratios
 Turnover Ratios

3) LENDERS
 Objective
They will keep an eye on the safety perspective of their money lended to the
organization.
 Ratios used in general
 Coverage Ratios
 Solvency Ratios
 Turnover Ratios
 Profitability Ratios

4) CREDITORS
 Objective
They are interested to know liability position of the organization particularly in
short term. Creditors would like to know whether the organization will be able
to pay the amount to due date.
 Ratios used in general
 Liquidity Ratios
 Short term solvency Ratios/ Liquidity Ratios

5) EMPLOYEES
 Objective
They will be interested to know the overall financial wealth of the organization
and compare it with competitor company.
 Ratios used in general
 Liquidity Ratios
 Long terms solvency Ratios
 Profitability Ratios
 Return of investment

6) REGULATORY / GOVERNMENT
 Objective
They will analyze the financial statements to determine taxation and other
details to the government.
 Ratios used in general
Profitability Ratios

7) MANAGERS

a) Production Managers
 Objective
They are interested to know various data regarding input output, production
quantities etc.
 Ratios used in general
 Input output Ratio
 Raw material consumption
 b) Sales Managers
 Objective
Data related to quantities of sales for various years, other associated figures and
produced future sales figure will be an area of interest for them.
 Ratios used in general
 Turnover ratios (basically receivable turnover ratio)
 Expenses Ratios
c) Financial Managers
 Objective
They are interested to know various ratios for their future predictions of
financial requirement.
 Ratios used in general
 Profitability Ratios (particularly related to Return on investment)
 Turnover Ratios
 Capital Structure Ratios
d) Chief Executive/ General Manager
 Objective
They will try to find the entire perspective of the company, starting from Sales,
Finance, Inventory, Human resources, Production etc.
 Ratios used in general
All ratios

8) DIFFERENT INDUSTRIES
I. Telecom
 Objective
Financial Manager/ Analyst will calculate ratios of their company and compare
it with Industry norms.

 Ratios used in general

 Ratio related to ‘call’
 Revenue and expenses per customer
II. Bank
 Objective
Finance Manager/ Analyst will calculate ratios of their company and compare it
with Industry norms.
 Ratios used in general
 Loan to deposit Ratios
 Operating expenses and income ratios
III. Hotel
 Objective
Finance Manager/ Analyst will calculate ratios of their company and compare it
with Industry norms.
 Ratios used in general
 Room occupancy ratio
 Bed occupancy ratios
IV. Transport
 Objective
Finance Manager/ Analyst will calculate ratios of their company and compare it
with Industry norms.
 Ratios used in general
 Passenger -kilometer
 Operating cost -per passenger kilometer.