Business Accounting &

Finance
(ACC:501)

Credit Hours- 4 Credits

Hari Dallakoti
 Unit – Two

Financial
Statement Analysis
 Concept of Financial Statement
⮚ Financial statements are the summary reports of a company’s financial
transactions or affairs.
⮚ Generally Accounting and Finance Professionals get their information
from Financial Statements.
⮚ Financial Statements are used to determine how the firm “is doing,” in
particular.
⮚ They reflect the financial health of companies.
⮚ The purpose of these statements is to help users make better decisions.
⮚ Most corporations prepare three basic financial statements:
✔ Income Statement
✔ Statement of Retained Earnings
✔ Balance sheet
✔ Cash Flow Statement
 Objectives of Financial Statement

⮚ To provide the financial information to the potential users.

⮚ To reveal the profitability and solvency of the firms.

⮚ To help to evaluate the financial position and efficiency of the

management.

⮚ To facilitate the intra and inter firms comparison of the financial

performance.
 Features of Financial Statement

⮚ Expressed in monetary terms.

⮚ Definite time.

⮚ Historical in nature.
 Importance of Financial Statement
⮚ Better Decision Making: Financial statements are vital for
making crucial business decisions.
⮚ More On-time Payments: Financial reports like accounts
receivables are essential for ensuring customers pay on time and
account payable reports will make sure that suppliers are paid on
time.
⮚ Prepared for Tax Time: Regularly updated financial statements
will keep the information neatly organized for tax time.
⮚ Provide Proof of Success: Financial statements will act as a
historical record of the overall success of a business, if there is
ever a decision to sell the business or obtain new investors. 
⮚ Catch Costly Mistakes: A set schedule for reviewing financial
statements will help catch mistakes earlier and help to detect
theft, fraud or illegal activities within their business.
 Limitation of Financial Statement

⮚ Provide only quantitative information.

⮚ Historical in nature.

⮚ Summarized reports.

⮚ No adjustment of price level change .

Concept of Financial Statement Analysis
⮚ An analysis of financial statement that highlights the important
relationships in the financial statements.

⮚ Focuses on evaluation of past performance of the business firms

in terms of profitability, liquidity, solvency, operational
efficiency and growth potentiality.

⮚ Includes the methods used in assessing and interpreting the

results of past performance and current financial position as they
relate to particular factors of interest in investment decisions.

⮚ An important means of assessing past performance.

⮚ Helps in forecasting and planning future performance.

Objectives of Financial Statement Analysis
⮚ Assessment of past performance.

⮚ Assessment of current position.

⮚ Prediction of profitability and growth prospects.

⮚ Prediction of bankruptcy and failure.

⮚ Loan decisions by banks and financial institutions.

⮚ Assessment of the operational efficiency.

⮚ Simplifying the information.

 Importance of Financial Statement Analysis
⮚ Helpful in planning and decision making.

⮚ Helps in the evaluation of performance.

⮚ Helps in the diagnosis of managerial and operating problems.

⮚ Helpful to the bankers for credit decision.

⮚ Basis for tax calculations.

⮚ Helps the government to formulate policies.

⮚ Basis of controlling.
 Limitations of Financial Statement Analysis
⮚ Ignores the qualitative aspects of the business.

⮚ Not free from the biasness of the analysts.

⮚ Accurate comparison may not be possible if the companies have

followed different accounting principles.

⮚ Diagnose the problems but cannot suggest the solutions.

⮚ Not possible to adjust the effect of the price level changes in the

analysis of financial statements.

⮚ Chance of wrong analysis and misleading to the users.

Techniques of Financial Statement Analysis

⮚ Horizontal Analysis

⮚ Vertical Analysis

⮚ Trend Analysis

⮚ Ratio Analysis
 Horizontal Analysis
⮚ The percentage analysis of increases or decreases in corresponding
items in comparative financial statements is called horizontal analysis.
⮚ Involves the computation of amount changes and percentage changes
from the previous to the current year.
⮚ The amount of each item in the most recent statement is compared
with the corresponding item on the earlier statements.
⮚ The increase or decrease in the amount of the item is then listed
together with the percent of increase or decrease.
⮚ When the comparison is made between two statements, the earlier
statement is used as the base.
 Vertical Analysis
⮚ Vertical analysis uses percentages to show the relationship of the
different parts to the total in a single statement.
⮚ Vertical analysis sets a total figure in the statement equal to 100
percent and computes the percentages of each component of that
figure.
⮚ The figure to be used as 100 percent will be total assets or total
assets or total liabilities and equity capital in the case of balance
sheet and revenue or sales in the case of the profit and loss
account.
 Trend Analysis

⮚ Using the previous year’s data of a business, trend analysis can

be done to observe percentage changes over time in selected data.

⮚ In it, percentage changes are calculated for several successive

years instead of between two years.

⮚ It is important because it may point to basic changes in the nature

of business.

⮚ By looking at a trend in a particular ratio, one may find whether

that ratio is falling, rising or remaining relatively constant.
 Ratio Analysis

⮚ Ratio is the relationship in between two different components.

⮚ Ratio analysis is an important measure of expressing the

relationship between two numbers.

⮚ A ratio can be computed from any pair of numbers.

⮚ To be useful a ratio must represent a meaningful relationship.

⮚ Ratios are useful in evaluating the financial position and

operations of a company and in comparing them to previous
years or to other companies.
 Purposes of the Ratio Analysis
⮚ The general purposes of ratio analysis are:

⮚ To study the short-term solvency of the firm — liquidity of

the firm.

⮚ To study the long-term solvency of the firm — leverage

position of the firm.

⮚ To interpret the profitability of the firm — Profit earning

capacity of the firm.

⮚ To identify the operating efficiency of the firm — turnover

of the ratios.
 Liquidity Ratio
⮚ To study the short-term solvency or liquidity of the firm, the following

are various ratios:

1. Current Assets Ratio

2. Acid Test Ratio or Quick Assets Ratio

3. Absolute Liquid Ratio

 Current Assets Ratio
⮚ Finds out the ability of a firm to meet the short financial commitment.
⮚ Establishes the relationship in between the current assets and current
liabilities.
⮚ Current assets are nothing but available in the form of cash, equivalent
to cash or easily convertible in to cash.
⮚ Current liabilities are nothing but short-term financial resources or
payable in short span of time within a year.

⮚ Formula: Current Ratio =

⮚ Standard norm of the current ratio: The ideal norm is 2:1.

⮚ Interpretation: High ratio leads to greater the volume of current assets

and denotes that the firm possesses excessive current assets than the
requirement portrays idle funds invested in the current assets.
 Acid Test Ratio or Quick Assets Ratio or Liquid Ratio
⮚ It is a ratio expresses the relationship in between the quick assets and
current liabilities.
⮚ This ratio is to replace the bottleneck associated with the current ratio.
⮚ It considers only the liquid assets which can be easily translated into
cash to meet out the financial commitments.

⮚ Formula: Acid Test Ratio =

⮚ Liquid Asset = Current Assets – (Closing Stock + Prepaid Expenses)

⮚ Standard norm of the ratio: The ideal norm is 1:1.

⮚ Interpretation: High ratio leads to greater the volume of liquid assets
and denotes that the firm possesses excessive liquid assets than the
requirement portrays idle funds invested in the liquid assets.
 Absolute Liquid Ratio
⮚ Relates cash, bank and marketable securities to the current
liabilities.

⮚ Since this ratio lays down very strict and exacting standard of
liquidity, acceptable norm of this ratio is 50 percent.

⮚ However, this ratio is not as popular as the previous two ratios

discussed.

⮚ Formula: Absolute liquid ratio =

⮚ Where absolute liquid assets = Cash + Bank + marketable

securities.
 Current Assets and Current Liabilities
Current Assets Current Liabilities
Sundry debtors Sundry creditors
Inventory Bank overdraft
Marketable securities Account payable
Account receivable Bills payable
Bills receivable Outstanding expenses
Prepaid expenses Advance income
Accrued incomes Provision for taxation
Cash at bank
Cash in hand
 Capital Structure Ratio
⮚ The capital structure ratios are classified into two categories:
✔ Leverage Ratios: Long-term solvency position of the firm.
✔ Coverage Ratios: Fixed commitment charge solvency of the firm.
⮚ Under the capital structure ratios, the composition of the capital
structure is analyzed only in the angle of long term solvency of the firm.

Capital Structure Ratios

Leverage Ratios Coverage Ratios
Debt – Equity Ratio Interest Coverage Ratio
Total Debt – Equity Ratio
Proprietary Ratio Dividend Coverage Ratio
Fixed Assets Ratio
 Debt-Equity Ratio
⮚ It is the ratio expresses the relationship between the ownership
funds and the outsiders' funds.

⮚ It is more specifically highlighted that an expression of

relationship in between the debt and shareholders' funds.

⮚ Formula: Debt-equity Ratio =

⮚ Standard of the Debt-Equity Ratio: The ideal norm is 1:2.

⮚ Interpretation: Higher ratio indicates the riskier financial status

of the firm which means that the firm has been financed by the
greater outsiders' fund rather than that of the owners' fund
contribution and vice-versa.
 Total Debt – Equity Ratio
• The relationship total volume of debt irrespective of nature and
shareholders' funds.
• Less volume of the owners' contribution shows the worse situation in
recovering the amount of outsiders’ contribution.
•  
• Formula: Total Debt-equity Ratio =

• Standard norm of the Debt-Equity Ratio: The ideal norm is 1:2

• Interpretation: Higher ratio indicates the riskier financial status of the

firm which means that the firm has been financed by the greater
outsiders' fund rather than that of the owners' fund and vice-versa.
 Proprietary Ratio
• The relationship in between the owners' contribution and the total
volume of assets.
• Greater the ratio means that greater contribution made by the
owners' in financing the assets.

• Formula: Proprietary Ratio =

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio, better is the position.
 Fixed Assets Ratio
• The relationship in between the fixed assets and long-term source
of funds.
• Formula:

Fixed Assets Ratio =

• Standard norm of the ratio: The ideal norm of the ratio is 1:1.
• Interpretation: If the long-term funds raised are wholly utilized
for the acquisition of long-term assets of the enterprise, that shows
the better use of resources.
 Interest Coverage Ratio
• Facilitates the lender to study the strength of the firm in making the
payment of interest regularly out of the total income.
• The ability is analyzed only on the basis of Earnings Before Interest and
Taxes (EBIT) available in the hands of the firms.

• Formula: Interest Coverage Ratio =

• Standard Norm of the ratio: No standard

• Interpretation: Greater the ratio means that better the capacity of the
firm in making the payment of interest as well as greater the safety and
vice-versa.
 Dividend Coverage Ratio
• Illustrates the firms' ability in making the payment of preference
dividend out of the earnings available in the hands of the firm after
the payment of taxation.
• Formula:
Dividend Coverage Ratio =

• Standard Norm of the ratio: No standard

• Interpretation: Greater the size of the profits after taxation, greater

is the chances for the payment of preference dividend and vice-
versa.
 Activity Ratio

• Also known as turnover ratio.

• Highlights the relationship in between the sales and various assets.

• Indicates that the rate of speed which is taken by the firm for

converting the assets into sales.

• Express in times.
 Stock Turnover Ratio
• The ratio expresses the speed of converting the stock into sales.

• The greater the ratio of conversion leads to lesser the number of

days/weeks/months required to convert the stock into sales.
• Formula:
Stock Turnover Ratio = Or

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the firm in converting
the stock into sales and vice-versa.
 Stock Conversion Period / Stock Velocity
• Shows the number of days or weeks or months taken by the firm
to convert the stock into sales.
• Formula:
Stock Velocity =

• Standard Norm of the ratio: No standard

• Interpretation: Lower the duration is better the position of the

firm in converting the stock into sales and vice-versa.
 Debtor Turnover Ratio
• Shows the speed of the collection process of the firm in collecting
the amount of the debtors and Bills receivables.
• Formula:

Debtors Turnover Ratio = Or

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the position of the firm
in collecting the overdue means the effectiveness of the collection
department and vice-versa.
 Debtors Collection Period
• Also known as Average Collection Period.

• Shows the number of days or weeks or months taken by the firm

to collect the debtors and receivables.
• Formula:
Average Collection Period =

• Standard Norm of the ratio: No standard

• Interpretation: Lower the duration of this ratio shows the better
position of the firm and vice-versa.
 Creditor Turnover Ratio
• Shows effectiveness of the firm in making use of credit period
allowed by the creditors.
• Formula:

Creditors Turnover Ratio = Or

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the position of the firm

in liquidity management means enjoying the more credit period
from the creditors and vice-versa.
 Creditors Payment Period
• Shows the number of days or weeks or months available from
suppliers to pay the creditor and payables.
• Formula:
Average Payment Period =

• Standard Norm of the ratio: No standard

• Interpretation: Lower the duration of this ratio shows the better

position of the firm and vice-versa.
 Fixed Assets Turnover Ratio
• Shows the relationship of fixed assets with the sales volume.
• Indicates the efficiency of fixed assets in the firm.
• Formula:

Fixed Assets Turnover Ratio =

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the position of the firm

in using the fixed assets and vice-versa.
 Total Assets Turnover Ratio
• Shows the relationship of total assets with the sales volume.
• Indicates the efficiency of total assets in the firm.
• Formula:

Total Assets Turnover Ratio =

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the position of the firm

in using the total assets and vice-versa.
 Capital Employed Turnover Ratio
• Shows the relationship of capital employed with the sales volume.
• Indicates the efficiency of capital employed in the firm.
• Formula:

Capital Employed Turnover Ratio =

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the position of the firm

in using the long term funds available and vice-versa.
 Profitability Ratio
• These ratios are measurement of the profitability of the firms in various angles, viz:

⮚On sales

⮚On investments

⮚On capital employed and so on

• While measuring the profitability, the profits are normally classified into various

categories:

1. Gross Profit

2. Net Profit

3. Operating Profit Ratio

4. Return on Assets Ratio

5. Return on Capital Employed

• All profitability ratios are normally expressed only in terms of percentage.

 Gross Profit Ratio
• The relationship in between the gross profit and sales volume.

• Facilitates to study the profit earning capacity of the firm from

the manufacturing or trading operations.

• Formula: Gross Profit Ratio = × 100%

• Standard Norm of the ratio: No standard

• Interpretation: Greater the size of the ratio shows the better

position of the firm and vice-versa.
 Net Profit Ratio
• Expresses the relationship in between the net profit and sales
volume.
• The net profit ratio is an indicator of over all earning capacity of
the firm.

• Formula: Net Profit Ratio = ×100%

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio the better the position of the firm
is, which means that the firm earns greater profits.
 Operating Profit Ratio
• The relationship in between the operating profit with the total
sales volume.
• Formula:
Operating Profit Ratio = ×100%

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio the better the position of the firm
is, which means that the firm earns greater profits.
 Operating Expenses Ratio
• Establishes the relationship in between the cost of goods sold and
operating expenses with the total sales volume.
• Formula:
Operating Ratio = ×100%

• Standard Norm of the ratio: No standard

• Interpretation: Lower the ratio, the more favorable and better the
firm's position is, as the lower ratio leads to a higher margin of
operating profit.
 Return on Fixed Assets
• Shows the relationship in between the earnings and fixed assets in
the business firm.
• Highlights the effective utilization of the fixed assets of the firm.

• Formula: Return on Fixed Assets = ×100%

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio illustrates that the firm has
greater effectiveness in the utilization of fixed assets, means
greater profits reaped by the fixed assets and vice-versa.
 Return on Assets
• Shows the relationship in between the earnings and total assets
employed in the business firm.
• Highlights the effective utilization of the assets of the firm.

• Formula: Return on Assets = ×100%

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio illustrates that the firm has
greater effectiveness in the utilization of assets, means greater
profits reaped by the total assets and vice-versa.
 Return on Equity
• Illustrates the relationship between Net profit after taxes and the

equity capital of the firm.

• The equity is the amount contributed by the equity shareholders .

• Formula:

Return on Equity = ×100%

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the utilization of the
equity funds raised.
 Return on Shareholders’ Funds
• Illustrates the relationship between Net profit after taxes and the

shareholders’ funds of the firm.

• The shareholders’ funds is the amount contributed by the equity and

preference shareholders .
• Formula:

Return on Shareholders’ Fund = ×100%

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the utilization of the
shareholders’ funds in the organization.
 Return on Capital Employed
• Illustrates the relationship between Net profit after taxes and the total capital

employed.

• The capital employed is nothing but the combination of both non current

liabilities and owners' equity.

• Formula:

Return on Total Capital Employed = ×100%

• Standard Norm of the ratio: No standard

• Interpretation: Higher the ratio is better the utilization of the long term funds
raised under the capital structure means that greater profits are earned out of
the total capital employed.
 Market Strength Ratio
• Provides the information relating to how other investors value a
company.
• Measures the current market price of a share of common stock
versus.
• an indicator of the company's ability to generate profits or assets
held by the company.
• Market strength ratios are:
⮚ Price earnings ratio

⮚ Dividends yield
 Price Earnings Ratio
• Also known as the P/E ratio.

• Is the ratio of market price per share to earnings per share.

• Is useful for comparing the value placed on a company’s shares

in relation to the overall market.

• Formula: Price Earnings Ratio =

• Standard Norm of the ratio: No standard

• Interpretation: Higher P/E shows the better ability of the firm to

have earnings and vice versa.
 Dividends Yield
• Measures a stock’s current return to an investor in the form of dividends.

• Dividend payments are extremely important to some shareholders. 

• Some investors seek a regular stream of income from a stock, while others invest with

the hope of securing capital gains. 

• The dividend yield allows to compare the merits of these alternative investment

opportunities.

• Formula: Dividend Yield = x 100%

• Standard Norm of the ratio: No standard

• Interpretation: Stocks with high dividend yields will maximize the opportunity to

receive dividend and vice versa.

 Growth Ratio
• High P/E ratio, that value is typically justified by a high earnings

growth rate. 

• The price to earnings growth ratio, or PEG ratio, corrects the P/E

for this growth rate. 

• Formula: PEG Ratio = x 100%

• Standard Norm of the ratio: The ideal norm is 1:1.

• Interpretation: The lower PEG ratio is considered the better

value.
 Meaning of Cash Flow Statement Analysis
• A balance sheet reports the cash balance at the end of the period. 

• An income statement reports revenues, expenses and net income. 

• But, these statements cannot indicate why the cash balance changed.

• Cash flow statement reports the firm's cash flows during a period. 

• It is an indicator of the cash receipts and cash payments.

• Operating, financing and investing activities are the major business activities

that result the cash flow.

• The cash flow statement shows the net increase or decrease in cash during a

particular time period .

• Explains the causes for the changes in the cash balance.

 Objectives of Cash Flow Statement Analysis
• To provide information about the cash inflows and cash outflows from:
✔ Operating activities
✔ Investing activities
✔ Financing activities
• To show the impact of the operating, financing and investing activities on
cash resources.
• To tell how much cash came in during the period, how much cash went
out and what the net cash flow was during the period.
• To explain the causes for changes in the cash balance.
• To identify the financial needs and help in forecasting future cash flows.
Importance of Cash Flow Statement Analysis

• Furnishes the important cash activities.

• An indicator of future cash inflows and outflows.

• Discloses the movement of internal fund and thus is more appropriate

for internal financial planning, controlling and decision-making

• A critical discloser to company's investors and creditors.

• provides various groups of users a valuable starting point for evaluating

the company's financial health.

• useful in making internal as well external investment and financing

decision.
 Interpretation of Cash Flow Statement Analysis
• Cash flow from operations: They are the cash inflows and cash outflows

that directly relate to revenues and expenses reported on the income

statement.

• Cash flows from investment: They are cash inflows and outflows related

to the purchase and disposal of long-term assets and investments.

• Cash flows from finance: They include exchanges of cash with external

sources (owners and creditors) to finance the enterprise and its

operations.
 End of The Unit

Thank You