It is a process of :
Analyzing and interpreting financial statements.
Analyzing means simplifying the data and interpreting
means explaining the meaning and significance of data so
Critically examining the accounting information given in
the financial statements.
Evaluating relationships between the component parts of
financial statements to obtain a better understanding of firm’s
position and performance.
It is the outcome of summarising process of accounting.
Means of conveying to management, owners and to interested
outsiders a concise picture of profitability and financial
position of the business.
Its purpose is to convey an understanding of financial
aspects of business firm.
Objectives / Importance:
• To assess the earning capacity and profitability of firm
• To assess the operational efficiency and managerial
• To make inter-firm comparisons.
• To make forecasts about future prospects of firm
• To help in decision making and control
• To guide or determine the dividend action
• To identify the reason for change in profitability and financial
position of the firm.
• To assess the progress of firm over a period of time.
External analysis is conducted by persons outsiders who don’t have
access to the internal accounting records of business firm such as
investors, creditors, govt. agencies, credit agencies and general public.
Internal analysis is conducted by persons who have access to internal
accounting records of a business firm, such as executives and employees
Horizontal analysis: It refers to the comparison of financial
data of a company for several years. This type is also called ‘
dynamic analysis’ as it is based on the data from year to year
rather than single year.
Vertical analysis: it refers to the study of relationships
of the various items in the financial statements of one
accounting period. It is also called as ‘ static analysis’.
Steps of financial analysis:
Establish objectives of the analysis.
Defining extent of analysis.
rearrangement of financial data.
statements with help of tools and
Interpretation of information
Drawing a conclusion.
• It is based on monetary information and
monetary factors are ignored
• It doesn’t consider changes in price level.
• Changes in accounting procedures by a firm
may often make financial analysis misleading
• Analysis is only a means and not the end itself.
The analyst has to make interpretation and draw
his own conclusions.
• Different people may interpret same analysis in
• LIQUIDITY RATIOS
• LEVERAGE RATIOS
• ACTIVITY RATIO
• PROFITABILITY RATIOS
Helps in decision making
Helps in financial forecasting nad planning
Helps in communicating strength and weakness opf a firm
Helps in co-ordinating various business activities to achieve
• Helps in making effective control of the business.
• A single ratio can’t convey much of sense.
• Lack of adequate standards
• Industries differ in nature and hence their ratios can’t be
• No consideration is made to the changes in price level.
• Change in accounting procedures by a firm often make analysis
• Financial statements can be easily window-dressed to provide a
better picture of financial and profitable position of business
firm to outsiders.(window dressing)
• Ratio analysis is merely a tool of financial statements. Hence
ratios become useless if separated from statements.
• Current Ratio
• Current Assets/Current Liabilities
• Measures ability to meet short-term cash needs
• Quick or Acid Test Ratio
• Current Assets-Inventory/Current Liabilities
• Measure ability to meet short-term cash needs more
• Absolute Liquid Ratio
• Cash + short term marketable securities/Current Liabilities
• Focuses on ability of the firm to generate operating cash
flows as a source of liquidity
• Debt-to-Equity: Debt/Equity= outsider’s funds/ shareholder’s
The debt/equity ratio, The ratio indicates what proportion of
equity and debt a company uses to finance its assets.
• Debt-to-Capital: funded debt/total capitalisation
The ratio is used to evaluate a firm's financial structure and how
it's financing operations.
• Debt Ratio: Total Liabilities/Total Assets
• All three measure extent of firm’s financing with debt.
Inventory turnover ratio= cost of goods sold/inventory
• Every firm has to maintain a minimum level of inventory of
finished goods to meet business requirements.
• Inventory turnover ratio indicates whether inventory has been
efficiently used or not.
• Debtors turnover ratio = net credit sales/average trade debtors.
• Indicates number of times average debtors are turned over a
• Average collection period = no of days or months/debtor
• Represents average number of days for which a firm has to
wait before its receivable are converted into cash.
• Creditor turnover ratio = credit purchases/average trade
• Working capital turnover ratio = net sales/working
• Measures efficiency with which working capital is
being used by the firm.
Gross Profit ratio = Gross Profit/Net Sales
Operating Profit ratio = Operating Profit/Net Sales
Net Profit ratio = Net profit/Net Sales
Fixed asset turnover ratio = cost of goods sold/fixed assets
All measure firm’s ability
to translate sales into
• Return on Investment (or Return on Assets)=
Net Earnings/Total Assets
• Return on Equity= Net Earnings/Stockholders’
• Both measure overall efficiency of firm in
managing investment in assets and generating
return to stockholders
Ratios are valuable, BUT…..
They do not provide answers in
an of themselves and are not
They should be used with other
elements of financial analysis
There are no “rules of thumb”
that apply to interpretation of
Fund flow analysis
• It is analysis of fund flow statement.
• Fund flow statement indicates various means by
which the funds were obtained during a
particular period and the ways in which these
funds were employed
• In simple words it is analysis of sources and
application of funds.
• Gives information about amount of working
capital and changes in the amount of working
• It analyses Balance sheet to reveal the
financing & investing activities.
• It analyses the Profit & Loss Account to reveal
the effect of business activities of the concern
on the flow of funds.
• It is a tool for planning future activities of
Cash flow analysis:
• Cash flow statement is a statement which
describes the inflows(sources) and outflows(uses)
of cash and cash equivalents & depicts the net
change in cash position during a period.
• Cash- comprises of cash in hand and bank.
• Cash equivalents- short term highly liquid
investments readily converted into cash.
• Cash flows: inflows and outflows of cash and
• Cash flow from operating activities- these are
principal revenue producing activities.
• Cash flow from investing activities- the acquisition
& disposal of long term assets & other investments not
included in cash equivalents.
• Cash flow from financing activities- composition of
the owners capital and borrowings of the enterprise.
• Evaluate management’s abilities to manage cash
now and in the future.
• Assess the company’s ability to pay dividends and
to pay creditors.
• The firms ability to generate future cash flow.
• The financing and investment activities during a