2. Financial Analysis and Interpretation
The following are the techniques of Financial Analysis
1. Ratio Analysis
2. Funds flow and Cash flow analysis
3. Common size statement analysis
4. Comparative statement analysis
5. Trend analysis
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3. Ratio Analysis
It is the process of analysing and interpreting the financial statements to explain the issue of
Liquidity, Solvency and Profitability based on certain parameters with the help of ratios,
proportions, percentages etc., It is a valuable tool for decision making and forward planning.
By using the ratios,the financial performance of given firm can be analysed and compared
from year to year, with that of other firms and even with that of industry.
Ratio analysis is the process of determining and interpreting numerical relationship
based on financial statements.
It is the technique of interpretation of financial statements with the help of
accounting ratios derived from the balance sheet and profit and loss account.
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4. Objectives of Ratio Analysis
• Standardize financial information for comparisons
• Evaluate current operations
• Compare performance with past performance
• Compare performance against other firms or industry
standards
• Study the efficiency of operations
• Study the risk of operations
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5. Advantages of Ratio Analysis
Simplification of Mass accounting data.
An individual aid to management.
Facilitates better co-ordination and control.
A tool to assess important characteristics of business.
An effective tool of analysis of intra-firm and inter-firm
comparisons.
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6. Limitations of Ratio Analysis
Limitations of Financial Statements
Accounting ratios are retrospective
Accounting methods, policies and procedures are not common
Qualitative factors are ignored
Lack of standard formulae
Problems of price level changes
Ratios alone are not adequate
It is no substitute for personal judgement
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8. Liquidity ratios
1. Current Ratio
It is calculated by dividing current assets by current liabilities.
Current ratio = Current assets where
Current liabilities
Conventionally a current ratio of 2:1(ideal ratio) is considered satisfactory.
Current Assets include
Cash in hand, Cash at bank, Short-term investments, Stock, Debtors,
Bills receivable, Prepaid expenses, Accrued Income(income yet to be received)
etc.,
Current Liabilities include
Creditors. Bills Payable, Bank overdraft, Outstanding expenses, Pre-received
incomes, all provisions, dividends payable etc.,
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9. Liquidity ratios
2. Quick Ratio/Acid test Ratio/Liquid Ratio
Quick Ratio = Quick assets
Current liabilities
Quick Assets=Current assets-(Stock + Prepaid expenses)
Ideal Rato is 1:1
Quick assets include
Cash, Bank, Marketable securities, Debtors and Bills receivables
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10. Liquidity ratios
3. Absolute Quick Ratio
Absolute Quick Ratio = Absolute Quick assets
Current Liabilities
Ideal Ratio is 0.5:1 or 1:2
Absolute Quick Assets include
Cash, Bank balance and Marketable securities.
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11. Solvency Ratios or Capital Structure Ratios
or Leverage Ratios
1. Debt-equity Ratio = Long term debts
Share holders' funds
= Outsiders funds
Share holders' funds
Long-term debts –Debentures, Bonds, Long-term loans etc.,
Share holders' funds- Equity share capital, Preference share capital, reserves, retained earnings and
such other(or)
Shareholder's funds - Equity share capital +Preference share capital+ Reserves &
Surplus(-) Accumulated losses(-) Defered revenue expenses(Or) Fictitious assets
Ideal Ratio is 1:1
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12. Solvency Ratios or Capital Structure
Ratios or Leverage Ratios
2. Interest coverage ratio = Net profit before interest and taxes
Fixed Interest charges
3. Proprietary ratio/Ratio of proprietors' funds to Total assets
= Shareholders Funds/Proprietors’ funds
Total Assets
Shareholders funds-Equity share capital+ Preference share capital+ Reserves+
Retained earnings & Surplus(-) Accumulated losses(-) Deferred revenue
expenses(or)Fictitious assets
Total Assets= Fixed assets+ Current assets
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13. Solvency Ratios or Capital
Structure Ratios or Leverage Ratios
4. Fixed Assets to Net worth Ratio (or) Fixed Assets to Shareholder's funds
= Fixed assets
Shareholders' funds
Net worth= Total assets-Outside liabilities(Long term liabilities and Current liabilities)
5. Ratio of Current Assets to Proprietors' funds
= Current assets
Proprietors' funds
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14. Activity Ratios or Turnover Ratios
1. Inventory Turnover Ratio/ Stock turnover ratio
= Cost of goods sold
Average Stock/Inventory
Cost of goods sold = Sales-Gross Profit (or)
= Opening Stock+ Purchases+ Direct Expenses(-
Closing stock
Average stock =Opening stock+ Closing Stock
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•Inventory holding period = 365 days/Inventory turnover ratio
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15. Activity Ratios or Turnover Ratios
2. Debtors Turnover Ratio = Net Credit Sales
Average Debtors
Average Debtors =Opening Debtors+ Closing Debtors
2
Debtors include Trade debtors and also Bills Receivable
*Debt Collection period = 365 days/Debtors turnover ratio
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16. Activity Ratios or Turnover Ratios
3. Creditors Turnover Ratio = Net Credit Purchases
Average Creditors
Average Creditors =Opening Creditors+ Closing Creditors
2
Creditors include Trade creditors and also Bills Payable
*Credit Collection period = 365 days/Creditors turnover ratio
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17. Activity Ratios or Turnover Ratios
4. A) Assets turnover ratio = Sales/Total assets (or) Cost of sales/Total assets
B) Fixed assets turnover ratio = Sales/ Fixed assets
C) Current assets turnover ratio = Sales/ Current assets (or)
Cost of sales/Current assets
5. Capital turnover ratio
A) Total Capital turnover ratio = Sales/ Total capital employed
*Capital employed= Shareholders’ Net worth+ Long term liabilities(or)
Net Fixed assets + Current assets-Current liabilities
B) Shareholders Capital turnover ratio= Sales/ Shareholders funds
C) Working Capital turnover ratio = Sales/ Net working capital
Net working Capital= Total of Current Assets – Total of Current Liabilities
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18. Profitability Ratios or Efficiency Ratios
A)General Profitability Ratios
1. Gross Profit ratio = Gross Profit X 100
Net Sales
2. Operating ratio = Cost of goods sold + Operating expenses X 100
Net Sales
3. Expenses Ratio
I) Administrative expenses Ratio = Administrative Expenses X 100
Net Sales
II) Selling expenses Ratio = Selling Expenses X 100
Net Sales
4. I) Net Operating Profit Ratio = Net Operating Profit X 100
Net Sales
II) Net Profit ratio = Net Profit X 100
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19. Profitability Ratios or Efficiency Ratios
B) Overall Profitability Ratios
A) Return on Capital Ratios
1) Return on Capital employed= Net profit before interest and taxes
Capital employed
*Capital employed = Total assets- Current Liabilities (Or) Fixed assets +Current assets-Current liabilities (Or) Fixed
assets- Net Working capital
2)Return on Shareholders Investment Ratio(ROI)
= Net Profit after taxes X 100
Shareholders Funds
3) Return on Equity Capital Ratio(R.E.C)
= Net Profit after taxes- Preference dividend X 100
Equity Share capital
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20. Profitability Ratios or Efficiency Ratios
B) General Profitability Ratios
B) Investment Ratios
1) Earning Per Share(E.P.S.) = Net Profits to equity shareholders
No. of Equity Shares
2) Dividend Per Share(D.P.S.) = Dividends to Equity Share holders
No. Of Equity Shares
3) Price Earning Ratio (P.E.R.) or P/E Ratio= Market Price of the Equity Share
E.P.S(Earning per share)
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21. Profitability Ratios or Efficiency Ratios
B) Overall Profitability Ratios
4) Pay out Ratio = Dividend per equity share
Earning per equity share
5) Dividend Yield Ratio (D.Y.R.) = Dividend Per Share X 100
Market Price per share
6) Earning Yield Ratio (E.Y.R.) = Earning per share X 100
Market Price per share
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