Meaning of Financial
Financial statements are summaries of the operating,
financing, and investment activities of a firm.
According to the Financial Accounting Standards
Board (FASB), the financial statements of a firm should
provide sufficient information that is useful to
in making their investment and credit decisions in an
The financial statements are expected to be prepared in
accordance with a set of standards known as generally
accepted accounting principles (GAAP).
The financial statements of publicly traded firms must be
audited at least annually by independent public
The auditors are expected to attest to the fact that these
financial statements of a firm have been prepared in
accordance with GAAP.
Types of Financial Statements and
The Income Statement
The Balance Sheet
The Statement of Cash Flows
The Income Statement
An income statement is a summary of the revenues and
expenses of a business over a period of time, usually either
one month, three months, or one year.
Summarizes the results of the firm’s operating and financing
decisions during that time.
Operating decisions of the company apply to production and
marketing such as sales/revenues, cost of goods sold,
administrative and general expenses (advertising, office
The Balance Sheet
A summary of the assets, liabilities, and equity of a business at a particular point in time, usually at the
end of the firm’s fiscal year.
(Resources of the
(Plant, Machinery, Equipment
(Cash, Marketable Securities,
Account Receivable, Inventories)
(ownership left over
Common stock outstanding
(Notes, bonds, &
Additional paid-in capital
Wages and salaries,
Any portion of long-term
Indebtedness due in one-year)
THE STATEMENT OF CASH
The statement is designed to show how the firm’s operations have
affected its cash position and to help answer questions such as these:
Is the firm generating the cash needed to purchase additional fixed assets
Is the growth so rapid that external financing is required both to maintain
operations and for investment in new fixed assets?
Does the firm have excess cash flows that can be used to repay debt or to
invest in new products?
Importance of Financial Statements
Financial statements report both on a firm’s position
at a point in time and on its operations over some
From management’s viewpoint, financial statement
analysis is useful both as a way to
anticipate future conditions and
more important, as a starting point for planning actions
that will influence the future course of events or
to show whether a firm’s position has been improving or
deteriorating over time.
Meaning of Ratio Analysis
Ratio analysis is a systematic use of ratio to
interpret/assess the performance status of the
It is a widely used tool of financial analysis.
The term ratio refers to
quantitative relationship between two
The basic objective of ratio analysis is
compare the risk and return relationship of
firms of different sizes.
analysis helps in finding out the
strengths and weakness of a firm.
The relationship in ratio can be expressed
in:(i) percentage- e.g. net profit are 25% of Sales
(ii) fraction – e.g. net profit is one-fourth of Sales.
(iii) proportion: e.g. relationship between net profit
and sales is 1:4.
Nature of Ratio analysis
financial ratio is a relationship between two
Ratios help to make a qualitative judgment
about the firm’s financial performance.
Basis or Standard of
Comparison with standard
Ratio analysis begins
with the calculation of a set of financial ratios
designed to show the relative strengths and weaknesses of
a company as compared to
Other firms in the industry
Leadings firms in the industry
The previous year of the same firm
Ratio analysis helps to show whether the firm’s
position has been improving or deteriorating
Ratio analysis can also help plan for the future.
of the firm to satisfy its short term
obligations as they become due.
A liquid asset is one that can be easily
converted into cash at a fair market value
Liquidity question deals with this question
Will the firm be able to meet its current
measures of liquidity
Quick/Acid Test Ratio
Current assets – Inventories
Quick ratio =
Cash + Marketable securities
Cash ratio =
Current ratio =
Current assets are those assets which can be converted
into cash easily in one accounting period.
Cash in hand+ bank+ stock + debtors+ bills receivables
Current liabilities are those which have to be paid in one
Bank overdraft+ provision for tax+ creditors+ outstanding
expenses+ bills payable+ dividend payable
Current Ratio : It is the relationship between the current
assets and current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a concern
are Rs.4,00,000 and Rs.2,00,000 respectively, then the
Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
The ideal Current Ratio preferred by Banks is 1.33 : 1
Current Assets : Raw Material, Work-in Progress. Finished
Goods, Debtors, Bills Receivables, Cash, marketable securities,
Current Liabilities : Trade Creditors, Installments of Term Loan,
payable within one year, bank overdraft, provision of taxation,
Acid Test/Quick ratio
One limitation of current ratio is that it fails to
convey the liquidity of the form as it consider one
Rupees cash equal to one Rupee of Stock or
A rupee of cash is more readily available ( i.e.
more liquid) to meet current obligations than a
rupee of, say, inventory.
The acid test ratio is a measure of liquidity
designed to overcome this defect of the current
The acid- test ratio referred to as quick ratio
because it is a measurement of firm’s ability to
convert its current assets quickly into cash to
meet its current liabilities.
The acid-test ratio between quick current assets and
current liabilities and is calculated by dividing the quick
assets by the current liabilities.
Acid- test ratio: Quick Assets/Current liabilities
Quick assets: Current Assets- Inventory- prepaid exp.
ratios relate to the liquidity of the
firm as a whole.
Another way of examining the liquidity is to
determine how efficiently the capital
employed is rotated in the business.
The ratios to measure these are referred to
as turnover ratio or Activity ratio.
Cost of goods sold: Sales- Gross profit
Average inventory: Simple average of opening
and closing stock inventory
Interpretation: Generally, a high inventory ratio
means that the company is efficiently managing
and selling its inventory. The faster the inventory
sells, the less funds the company has tied up.
Example: A firm has sold good worth Rs 3,00,000
with a margin of 20percent. The stock at beginning
and the end of the year was Rs 35,000 and Rs.
What is the Inventory turnover ratio?
Days of inventory holding period indicates how
long the stock is held in the company. Longer
the period indicates the inefficiency of the
Debtors turnover ratio or accounts receivable turnover
ratio indicates the velocity of debt collection of a firm.
In simple words it indicates the number of times average
debtors (receivable) are turned over during a year.
Interpretation: The higher the value of ratio, the more
efficient is the management of debtors or more liquid the
debtors are. Similarly, low debtors turnover ratio implies
inefficient management of debtors or less liquid debtors.
It is the reliable measure of the time of cash flow from
There is no rule of thumb which may be used as a norm
to interpret the ratio as it may be different from firm to
A firm has made credit sales of Rs
2,40,000 during the year. The outstanding
amount of debtors at the beginning and the
end of the year respectively was Rs 27,500
and Rs 32,500.
Determine the debtors turnover ratio.
Creditors Turnover Ratio (Creditor’s Velocity):
Net Credit Purchases
Months (or days) in a year
Fixed Assets ratio
Fixed asset Turnover ratio
= -------------Fixed assets
refers to the ability of the firm to pay
its long term liabilities like loan and other
These ratio show whether company can pay
the long term liabilities.
Is the company solvent?.
What is the proportion of debt and equity in the
Debt-equity ratio =
Equity (Net Worth)
Debt ratio =
Debt + Equity Capital employed
Earnings before interest and tax
Interest coverage =
Debt- Equity Ratio
relationship between borrowed funds
and owner’s capital is a popular measure of
long term financial solvency of a firm.
The relationship is shown by the debt-equity
D-E ratio measures the ratio if long-term, or
total debt to shareholders equity.
result of a number of policies and
Show the combined effect of liquidity, asset
management, and debt management on
profitability ratios are calculated to
measure the operating efficiency of the
Generally, two major types of profitability
ratios are calculated:
profitability in relation to sales
profitability in relation to investment.
UTILITY OF RATIO ANALYSIS
the ability of the firm to meet its current
the extent to which the firm has used its long-term
solvency by borrowing funds;
the efficiency with which the firm is utilizing its
assets in generating sales revenue
the overall operating efficiency and performance of
Diagnostic Role of Ratios
CAUTIONS IN USING RATIO
Price level changes
Different definitions of variables