Chapter 3.

Financial Statements:
Analysis & Interpretation
Meaning & Types of Financial
Statements
A Financial Statement is an organized collection of data
according to logical and consistent accounting procedures.
Its purpose is to convey an understanding of some financial
aspects of a business firm.
Two basic financial statements are :
 The Income Statement : Also termed as the profit and loss
account, it shows the net profit earned or loss suffered
during a particular period.
 Balance Sheet : It is a statement of financial position of a
business at a specified moment of time. It represents all
assets owned by the business at a particular moment of
time and the claims of the owners and outsiders against
those assets at that time.

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Meaning & Types of Financial
Statements
( Contd., )

In addition to the above two, a business may also prepare :

 Statement of Retained Earnings: Retained earnings means
the excess of earnings over losses and dividends. This
statement displays the things that have caused retained
earnings to change over the period under consideration.
 Statement of Changes in Financial Position: Statement of
changes in Financial Position is provided by emphasizing on
the following :
i) Changes in the firm’s working capital
ii) Changes in the firm’s cash position
iii) Changes in the firm’s total financial position.

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Analysis & Interpretation of
Financial
Statements
Analysis & Interpretation refers to such treatment of the
information contained in the Balance Sheet and the
Income Statement so as to afford full diagnosis of the
profitability and financial soundness of the business.
 Analysis means methodical classification of the data given
in the financial statements. The figures in the Financial
Statements will not help one unless they are put in a
simplified form.
 Interpretation means explaining the meaning and
significance of the data so simplified.
Analysis and interpretation are complementary to each
other. Interpretation requires analysis while analysis is
useless without interpretation.

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Steps in Financial Statement
Analysis

 Methodical Classification of data: For meaningful analysis it is

necessary that figures should be properly arranged. Usually
instead of the two-column ( T form ) statements, the
statements are prepared in single ( Vertical ) column form
which should throw up significant figures by adding or
subtracting.

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RATIO ANALYSIS
• Ratio Analysis: Accounting ratios are relationships
expressed in mathematical terms between figures
which are connected with each other in some
manner.
2:1

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Classification of Ratios
Traditional Classification :This is done on the basis of the
financial statement to which the determinants of the ratio
belong. Ratios could be classified as:
 Profit & Loss Account Ratios: ex. gross profit ratio, stock
turnover ratio etc.
 Balance Sheet Ratios: ex. current ratio, debt-equity ratio etc.
 Composite Ratios or Inter-statement Ratios: these are ratios
based on figures from the P & L account as well as the Balance
Sheet ex. fixed assets turnover ratio, overall profitability ratio
etc.
Functional Classification: Ratios are classified according to their
function as follows:
 Profitability Ratios
 Turnover Ratios
 Financial Ratios
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Profitability Ratios

Profitability indicates the efficiency with which a business is

carried out. Owners are interested to know the profitability as it
indicates the returns which they can get on their investments.
The important profitability ratios are :
 Overall Profitability Ratio: Also called Return on Investment
ROI = (Operating Profit / Capital Employed ) * 100
Operating Profit means ‘Profit before interest and tax’
Capital Employed is the sum total of long term funds employed in
the business.
Significance : It measures the profit that a firm earns on investing
a unit of capital. The business can survive only when the return
on capital employed is more than the cost of capital employed.
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Profitability Ratios ( Contd )

 Earnings Per Share:

EPS = ( Net profit after tax & Preference dividend / No. of
Equity Shares )
Significance :Helps in determining the market price of the equity
share of the company. A comparison of the EPS of one
company with another will help in deciding if the equity share
capital is being effectively used or not. It also helps in
estimating the company’s capacity to pay dividend to its equity
shareholders.
 Price Earning Ratio :This ratio indicates the no. of times the
earning per share is covered by its market price.
PER = ( Mkt. price per equity share / Earning per share )

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Profitability Ratios ( Contd )
Significance : Helps the investor in determining whether or not
to buy the shares of a company at a particular price.
 Gross Profit Ratio:
Gross profit ratio = ( Gross Profit / Net Sales ) * 100
Significance : Indicates the degree to which the selling price of
goods per unit may decline without resulting in losses from
operations to the firm. It also helps in ascertaining whether
the average percentage of markup on the goods is maintained.
Gross profits should be adequate to cover operating expenses
and to provide for fixed charges, dividends and building up of
reserves.
 Net Profit Ratio :
Net Profit Ratio = ( Net Operating Profit / Net Sales ) * 100
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Profitability Ratios ( Contd )
Significance :An increase in this ratio over the previous period
indicates improvement in the operational efficiency of the
business provided the gross profit ratio is constant.
 Operating Ratio : This ratio is the complementary of the net
profit ratio. In case the net profit ratio is 20 per cent, the
operating ratio is 80 per cent.
Operating Ratio = ( Operating Costs / Net Sales ) * 100
Operating costs include the cost of direct materials, direct labour
and other overheads viz. factory, office or selling.
Significance : It tests the operational efficiency with which the
business is being carried. The ratio should be low enough to
leave a portion of sales to give a fair return to the investors.
Incase of an increase in the ratio overtime, the reason should
be found out and management be advised to check the same.
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Profitability Ratios ( Contd )
 Fixed Charges Cover: Also known as the Debt Service Ratio/
Interest Coverage Ratio, it indicates whether the business
would earn sufficient profits to pay periodically the interest
charges.
Debt Service Ratio=(Income before Int & Tax / Interest charges )
The standard for this ratio for an industrial company is that
interest charges should be covered six to seven times.
 Debt Service Coverage Ratio: The interest coverage ratio does
not tell anything about the ability of the company to make
principal payment on time. This insight is provided by
Debt Service Coverage = (Net Profit before Interest & Tax) /
Ratio (Interest + Principal payment
installment)
1- Tax rate
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 Profitability Ratios ( Contd )
The principal installment is adjusted for tax effects since such
payments is not deductible from net profit for tax purposes.
 Payout Ratio: Indicates the proportion of earnings per share that
has been used for paying dividends.
Payout Ratio = Dividend per equity share/ Earnings per equity share
A complementary to this ratio is the Retained Earning Ratio =
Retained Earning per equity share/ Earning per equity share
Significance: The payout and retained earning ratios are indicators
of the amount of earnings that have been ploughed back in the
business. Lower the payout ratio, higher will be the earnings
ploughed back in the business and vice versa.
 Dividend Yield Ratio: Useful for investors interested only in
dividend income;
DYR = Dividend per share/ Mkt price per share

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Turnover Ratios

Turnover Ratios or activity ratios indicate the efficiency with which

capital employed is rotated in the business.
 Fixed Assets Turnover Ratio: Indicates the extent to which
investments in fixed assets contributed towards sales. It is
calculated as : Net Sales / Fixed Assets ( Net )
 Working Capital Turnover Ratio: Indicates whether or not
working capital has been effectively utilized in making sales. It
is calculated as : Net Sales / Working Capital.
It can take the following different forms :
1. Debtor’s Turnover Ratio = Credit Sales / Avg. Accts receivable
Higher the ratio, better it is, since it would indicate that debts
are being collected more promptly.

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 Turnover Ratios ( Contd )
2. Debt Collection Period Ratio: Indicates the extent to which debt
is collected on time. An increase in the period will result in
greater blockage of funds in debtors. The ratio may be
calculated as under :
- Months ( or days) in a year/ Debtor’s Turnover
- Accounts Receivable/ Avg. Monthly or daily credit sales
3. Creditor’s Turnover Ratio : Indicates the speed with which
payments for credit purchases are made to creditors. It is
calculated as : Credit Purchases / Avg. Accts. Payable
4. Average Age of Payables : Indicates the average credit period
enjoyed from creditors. It may be calculated as :
- Months ( or days ) in a year / Creditor’s Turnover
- Avg Accts payable/ Avg Monthly ( or daily ) Credit Purchases

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 Turnover Ratios ( Contd )
5. Stock Turnover Ratio: Indicates whether investment in
inventory is efficiently used or not. It is measured as :
Cost of goods sold during the year / Avg. Inventory
A high ratio indicates brisk sales. A low ratio results in blocking
of funds in inventory which may ultimately result in heavy
losses due to inventory becoming obsolete or deteriorating in
quality.

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 Financial Ratios ( Contd )
Financial Ratios indicate the financial soundness of the
company. Some important Financial Ratios are :
 Fixed Asset Ratio : Fixed Assets / Long term funds
Ideal ratio is 0.67. A ratio of less than 1 indicates that a part of
the working capital has been financed through long term funds,
which is desirable, because ‘core working capital’ is more or
less fixed in nature.
 Current Ratio : Current Assets / Current Liabilities
Indicator of the firm’s ability to meet its short term liabilities. A
ratio of 2 is considered as a safe margin of solvency, because if
the current assets are reduced to half, then also the creditors
will be able to get their payment in full.
A very high ratio is also not desirable since it indicates less
efficient use of funds.

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 Financial Ratios ( Contd )
 Liquidity Ratio : Also termed as the acid test ratio or the quick
ratio, is an indicator of the short term solvency of the company.
Calculated as = Liquid Assets / Current Liabilities
Liquid assets are assets which can be immediately converted
into cash. Prepaid expenses and stock are not considered as
liquid assets. An ideal liquidity ratio is 1.
 Debt- Equity Ratio : Ascertains the soundness of long term
financial policies of the company. Calculated as :
Total long term debt / Shareholders’ funds
The ratio indicates the extent to which the firm depends upon
outsiders for its existence.

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 Financial Ratios ( Contd )
 Proprietary Ratio :
= Shareholders’ Funds/ Total tangible assets
The ratio focuses on the general financial strength of the
business enterprise. A high ratio indicates relatively little
danger to the creditors in the event of forced reorganization or
winding up of the company. A low ratio indicates higher risk to
the creditors since in the vent of losses, a part of their money
may also be lost.

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 Advantages of Ratio Analysis

 Simplifies Financial Statements

 Facilitates Inter-Firm comparison
 Makes Intra- Firm comparison possible
 Helps in Planning

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LIQUIDITY RATIOS
• Current Ratio=Current Assets/Current Liabilities
• Rule of thumb=2:1
• 340000/167000= 2:1
• Quick Ratio/Acid Test Ratio/Liquid Ratio
=Quick(Liquid) Assets/Quick(Liquid) Liabilities
Rule of thumb =1:1
= Quick Assets/Current Liabilities
QA = CA- (STOCK+PREPAID EXPENSES)
QL = CL-BANK OVERDRAFT

160000/167000=0.95:1
• Absolute Liquid Ratio= Cash+Bank+Marketable
Securities / Current Liabilities
• Rule of thumb = 0.5:1
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