FINANCIAL STATEMENT ANALYSIS

INTRODUCTION
• WHAT IS ACCOUNTING?
Accounting is the art of recording, classifying and summarizing the
financial transactions and interpreting the results thereof.
Thus involves the following four major phases:
Recording of transactions: This is done in book called journal
Classifying the transactions: This is done in a book called ledger.
Summarizing the transactions: This includes preparation of trial balance,
profit and loss account and balance sheet of the business.
Interpreting the results: This involves computation of various accounting
ratios etc. to know about the liquidity, solvency and profitability of the
business
FINANCIAL STATEMENT
 Financial Statement
• Financial statement refers to formal and original
statements prepared by business concern to
disclose its financial information.
The following reasons the financial statement is
prepared:
• Presenting periodical review or report on the
progress by the management
• Deal with status of investments in the business
• The result achieved during the period.
 Financial Statement Types
• The statement disclose the status of investments is
known as balance sheet
• Statement showing result means that is P&L a/c or
income statement.
• Another statement also being prepared called surplus
statement or retained earnings statement
• Schedule of fixed assets, schedule of investments,
schedule of creditors, schedule of debtor. –
supplementary schedules.
• All of the above is called package of financial statement
Profit and Loss a/c (or) Income statement

• The earnings capacity and potential of a firm

are reflected by the income statement.
• The P&L a/c is the score board of the firm’s
performance during a particular period of
time.
• Net Income Income exceeds Expenses
• Net Loss Expenses exceeds Income
 Surplus statement (or) Retained earnings
statement
• It refers to accumulated excess profit over losses and
dividends.
• Such retained earnings are taken to Balance sheet from the
retained earning statement
• The statement starts with accumulated profits at beginning
of the current year, brought down from previous year’s net
profit and any profit on revaluation of assets increase
retained earnings.
• Any appropriation like dividend and transfer to specific
reserves reduce retained earnings. Link between balance
sheet and Income Statement.
 BALANCE SHEET
• The balance sheet comprises of a list of assets,
liabilities and capital fund at a given date. It
sets forth the financial conditions of a
business concern as revealed by the
accounting records.
• It reflects the assets owned by the concern
and the sources of fund (from creditors &
owners) used in acquisition of those assets
 Functions and Uses Importance of Financial
Statement
• For Management: Legal requirement, Decision making
• For Creditors: Creditor Extension
• For Investor: Investing prospective
• For Owners: Their capital is properly used or not
• For Employees: Remuneration , Bonus
• For Consumers: Product price is reasonable or justified
• Government: Formulate tax policies, Export Import
policies
• For tax authorities: levied and collected tax
• For Researchers and academicians: ?
Limitations of Financial Statements
1. Financial statements do not always disclose the correct financial
position of business concerns as they are influenced by the personal
opinions, judgment subjective views and of accountants of each concern.
2. Balance sheet of a concern is a static document as it discloses the
financial position of a concern on particular date. But the values shown
and composition of items keep changing day-by-day. There fore, the data
and information does not disclose the current realities.
3. Information disclosed by profit and loss account may not be real profit as
many items shown in the profit and loss account are not real but
estimated.
4. Financial statements are dumb because they cannot speak themselves.
The statement require further detailed analysis and interpretation.
 Window Dressing
• The practice of manipulating the financial statements of a firm to present
an untrue or exaggerated, position termed as windows dressing.
• Window dressing is practiced in corporate world also for different
purposes, as motioned below,
(a) Mergers or Amalgamations:
(b) Issue of Shares and Debentures
(c) Control Needs
Methods of Window Dressing:
(d) Valuation of stocks
(e) Depreciation
(f) Under valuation of assets
(g) Provisioning
(h) Tampering sales and purchases
FINANCIAL STATEMENT ANALYSIS
 Understanding the financial statement
Analysis and Interpretation
• Analysis and interpretation of financial statements are
an attempt to determine the significance and meaning
of the financial statement data so that forecast may be
of the prospects for future earnings, ability to pay,
interest and debt maturities (both current and long
term ) and profitability of a sound dividend policy
• Financial statement analysis is undertaken by
creditors, investors, and other financial statement
users in order to determine the credit worthiness of
an entity
 Objectives of Analysis and Interpretation

1. To interpret the profitability and efficiency of various

business activities with the help of profit and loss account
2. To measure managerial efficiency of the firm
3. To measure short-term and long-term solvency of the
business
4. To ascertain the earning capacity of the concern
5. To measure utilization of various assets during the period.
6. To compare operational efficiency of similar concern
engaged in the same industry
 Types of Analysis
• External Analysis
• Internal Analysis
• Vertical Analysis
• Horizontal Analysis
 Techniques or Tools of financial statement
analysis
• The most important techniques of analysis and
interpretation of financial statements are listed below:
1. Ratio Analysis
2. Comparative financial statements
3. Common measurement or size statements
4. Cash flow analysis
5. Fund flow analysis
6. Net working capital analysis
7. Trend analysis
 Ratio Analysis
• A ratio is a mathematical relationship between
two or more items taken from the financial
statements. Ratio analysis is helpful to
management and outsiders to diagnose the
financial health of a business concern. It helps
in measuring the profitability, solvency, and
activity of a firm.
 Classification Of Ratios
• Classification by statements
1. Balance Sheet Ratios
2. Profit and loss a/c ratios
3. Balance sheet and p&l a/c ratios (or) Mixed or composite ratios
• Classification by users
1. Ratios for Management
2. Ratios for creditors
3. Ratios for Shareholders
• Classification of ratios by purpose/ Function
1. Financial Ratios or Solvency ratios or liquidity ratio
2. Turnover Ratios
3. Profitability Ratios
 Liquidity Ratio Or short term solvency Ratio
Or Financial Ratio
• Current Assets
• Liquid Ratio
• Cash Position Ratio or absolute liquidity ratio
Liquidity Ratio or Short Term Solvency Ratios
or Financial Ratios
• Current Ratio = current assets / current liabilities
The ratio of current assets to current liabilities is
called current ratio. In order to measure the short-
term liquidity or solvency of a concern, comparison
of current assets and current liabilities is inevitable.
Standard expected current ratio: Internationally
accepted current ratio is 2:1, current assets shall be
2 times to current liabilities.
 Liquid Ratio
• Liquid Ratio also called Quick or Acid Test ratio. It
is calculated by comparing the quick assets with
current liabilities.
Liquid Ratio = Quick Assets or Liquid Assets
Current Liabilities
Liquid assets = current assets – stock + prepaid
expenses
The ideal liquid ratio or generally accepted norm
for liquidity ratio is 1
Cash position ratio OR Absolute liquidity ratio

• This ratio is called Absolute Liquidity ratio or super

quick ratio. This ratio is calculated when liquidity is
highly restricted in terms of cash and cash equivalents.
Cash Position Ratio= Cash and Bank Balance +
Marketable Securities
Current Liabilities
An ideal cash position ratio is 0.75:1. This ratio is a more
rigorous measure of a firms liquidity position . It is not
widely used ratio.
 Problem in Short Term Solvency Ratio

• You are given the following information:

• Calculate (a) Current Ratio (b) Liquidity Ratio
• C)Absolute Liquidity Ratio
CASH 18,000
DEBTORS 1,42,000
CLOSING STOCK 1,80,000
BILLS PAYABLE 27,000
CREDITORS 50,000
OUTSTANDING EXPENSES 15,000
TAX PAYABLE 70,000
 Problem No:2
• Find the current Ratio and Quick Ratio and comment on the financial condition of
the company. Find the current ratio and quick ratio and comment on the financial
condition of the company
Equity Capital 1,50,000 Fixed Assets 1,62,000
Revenue 30,000 Current Assets:
Reserves Stock 22,000
Debtors 51,000
Bills Receivable 2,000
Bank 12,000

Current 49,000
Liabilities:
Sundry Creditors
TOTAL 2,49,000 2,49,000
 Long-Term Solvency Ratio
• Fixed asset Ratio
• Debt Equity Ratio
• Proprietary Ratio
• Capital gearing Ratio
 Fixed Assets Ratio
• The 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 asset ratio = fixed assets/ long term funds
• Fixed asset means = Fixed assets-Depreciation
• Long Term funds = Share capital + Reserves and Surplus+
Long term funds – Fictitious assets assets
• An Ideal fixed asset ratio is 0.67 .
• More than 1 means it implies that fixed assets are purchased
with short term funds, which is not a prudent policy