THEORETICAL FRAME WORK

The term ‘financial performance analysis also known as analysis and

interpretation of financial statements’ , refers to the process of determining financial
strength and weaknesses of the firm by establishing strategic relationship between the
items of the balance sheet , profit and loss account and other operative data.

“Financial performance analysis is a process of evaluating the relationship

between component parts of a financial statement to obtain a better understanding of
a firm’s position and performance.

The purpose of financial analysis is to diagnose the information contained in

financial statements so as to judge the profitability and financial soundness of the
firm. Just like a doctor examines his patient by recording his body temperature, blood
pressure etc. Before making his conclusion regarding the illness and before giving his
treatment. A financial analyst analyses the financial statements with various tools of
analysis before commenting upon the financial health or weaknesses of an enterprise.

The analysis and interpretation of financial statements is essential to bring out

the mystery behind the figures in financial statements. Financial statements analysis
is an attempt to determine the significance and meaning of the financial statement
data so that forecast may be made of the future earnings, ability to pay interest and
debt maturities (both current and long term) and profitability of a sound divided
policy.

Financial performance refers to the act of performing financial activity. In broader

sense, financial performance refers to the degree to which financial objectives being
or has been accomplished. It is the process of measuring the results of a firm's
policies and operations in monetary terms. It is used to measure firm's overall
financial health over a given period of time and can also be used to compare similar
firms across the same industry or to compare industries or sectors in aggregation.

In short, the firm itself as well as various interested groups such as managers,
shareholders, creditors, tax authorities, and others seeks answers to the

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 Following important questions:
1. What is the financial position of the firm at a given point of time?
2. How is the financial performance of the firm over a
given period? Of time?

These questions can be answered with the help of financial analysis of a firm.
Financial analysis involves the use of financial statements. A financial statement is an
organized collection of data according to logical and conceptual framework 50
consistent accounting procedures. Its purpose is to convey an understanding of some
financial aspects of a business firm. It may show a position at a moment of time as in
the case of a balance sheet, or may reveal a series of activities over a given period of
time, as in the case of an income statement.

Thus, the term ‘financial statements’ generally refers to two basic

statements: The balance sheet and the income statement.

The balance sheet shows the financial position (condition) of the firm at a given
point of time. It provides a snapshot and may be regarded as a static picture.

“Balance sheet is a summary of a firm’s financial position on a given

date that Shows total assets = total liabilities + owner’s equity.”

The income statement (referred to in India as the profit and loss statement) reflects
the performance of the firm over a period of time.

“Income statement is a summary of a firm’s revenues and expenses over a specified

period, ending with net income or loss for the period.”

However, financial statements do not reveal all the information related to the
financial operations of a firm, but they furnish some extremely useful information,
which highlights two important factors profitability and financial soundness. Thus
analysis of financial statements is an important aid to financial performance analysis.
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Financial performance analysis includes analysis and interpretation of financial
statements in such a way that it Undertakes full diagnosis of the profitability and
financial soundness of the business.

“The analysis of financial statements is a process of evaluating the relationship

between component parts of financial statements to obtain a better understanding of
the firm’s position and performance.”

Financial Performance Analysis:

The term ‘financial performance analysis also known as analysis and

interpretation of financial statements’ , refers to the process of determining financial
strength and weaknesses of the firm by establishing strategic relationship between the
items of the balance sheet , profit and loss account and other operative data.

“Analyzing financial statements” by Metcalf and Titard

“Financial analysis is a process of evaluating the relationship between

component parts of a financial statement to obtain a better understanding of a firms
position and performance” by Myers

Financial Performance:

The word ‘Performance is derived from the word ‘parfourmen’, which means ‘to do’,
‘to carry out’ or ‘to render’. It refers the act of performing, execution,
accomplishment, fulfillment etc. In border sense, performance refers to the
accomplishment of a given task measured against preset standards of accuracy,
completeness, cost, and speed. In other words, it refers to the degree to which an
achievement is being or has been accomplished. In the Words of Frich Kohlar “The
performance is a general term applied to a part or to all the conducts of activities of
an organization over a period of time often with reference to past or projected cost
efficiency, management responsibility or accountability or the like. Thus, not just the
presentation, but the quality of results achieved refers to the performance.

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Performance is used to indicate firm’s success, conditions, and compliance.

Financial performance refers to the act of performing financial activity. In

broader sense, financial performance refers to the degree to which financial
objectives being or has been accomplished. It is the process of measuring the results
of a firm's policies and operations in monetary terms. It is used to measure firm's
overall financial health over a given period of time and can also be used to compare
similar firms across the same industry or to compare industries or sectors in
aggregation.

The purpose of financial analysis is to diagnose the information contained in

financial statements so as to Jude the profitability and financial soundness of the firm.
Just like a doctor examines his patient by recording his body temperature, blood
pressure, etc. Before

making his conclusion regarding the illness and before giving his treatment, a
financial analyst analysis the financial statements with various tools of analysis
before commenting upon the financial health or weaknesses of an enterprise.

The analysis and interpretation of financial statements is essential to bring out

the mystery behind the figures in financial statements. Financial statements analysis
is an attempt to determine the significance and meaning of the financial statement
data so that forecast may be made of the future earnings, ability to pay interest and
debt maturities (both current and long term) and profitability of a sound divided
policy.

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 Types of financial analysis:-

Financial analysis into different categories depending upon

(1) The material used and

(2) The method of operation followed in the analysis or the modus operandi of
analysis

Types of financial analysis

On the basis of material used on the basis of modus operandi
External Internal Horizontal Vertical
Analysis
Analysis Analysis Analysis
1. On the basis of material used: - According to material used, financial analysis
can

be of two types

External analysis

Internal analysis

External analysis:-

This analysis is done by outsiders who do not have access to the detailed
internal outsiders include investors, potential investors, Creditors, Potential Creditors,
Government Agencies, Credit Agencies and General Public. For financial analysis,
these external parties to the firm depend almost entirely on the published financial
statements.
Internal analysis:-

This analysis is undertaken by the persons namely executives and employees of the
organization or by the officers appointed by government or court who have access to
the
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books of account ( internal accounting records) and other information related to the
business.

2. On the basis of modus operandi:-

According to the modus operandi financial analysis can also be of two types

a.Horizontalanalys
b.Vertical analysis

Horizontal analysis:-
Horizontal analysis refers to the comparison of financial data of a company for
several years. The figures for this type of analysis are presented horizontally over a
number of columns. The figures of the various years are compared with standard or
base year. a base year is year chosen as beginning point. This type of analysis is also
called ‘dynamic analysis’ as it is based on the data from year to year rather than on
data of any one year. The horizontal analysis makes it possible to focus attention on
items that have changed significantly during the period under view.

b. Vertical analysis:-

Vertical analysis refers to the study of relationship of the various items in the
financial statements of one accounting period. In this types of analysis the figures
from financial statement of a year are compared with a base selected from the same
year’s statement

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 Methods of financial analysis:-

The following methods of analysis are generally used:-

1. Comparative Statements.
2. Trend Analysis.
3. Common-Size Statements.
4. Funds flow Analysis.
5. Cash Analysis
6. Ratio Analysis
7. Cost-volume-Profit Analysis

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 Comparative statements:-

The comparative financial statements are statements of the financial position at

different periods of time .the elements of financial position are show in a

Comparative Statement provides an idea of financial position at two or more periods.

Generally two financial statements (balance sheet and income statement) are prepared in
comparative form for financial analysis.

The Comparative Statement May Show:-

1. Absolute figures (rupee amounts)

2. Changes in absolute figures i.e. increase or decrease in absolute figures.
3. Absolute data in terms of percentages.
4. Increase or decrease in terms of percentages.
The Two Comparative Statements Are:-
1. Comparative balance sheet, and
2. Income statement.
1.
2. Comparative balance sheet:-

The comparative balance sheet analysis is the study of the trend of the same items, group of
items and computed items in two or more balance sheets of the same business enterprise on
different dates. The change in periodic balance sheet items reflect the conduct of a business
the change can be observed by comparison of the balance sheet at the beginning and at the
end of a period and these changes can help in forming an opinion about the progress of an
enterprise.
Guide Lines for Interpretation of Comparative Balance Sheet:-
While interpreting comparative balance sheet the interpreter is expected to study the
following aspects:-
1. Current financial position and liquidity position
2. Long-term financial position
3. Profitability of the concern.

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Common Size Statement:-

The common-size statements, balance sheet and income statement are show in
analytical percentages. The figures are shown as percentages of total assets, total liabilities
and total sales. The total assets are taken as 120 and different assets are expressed as a
percentage of the total similarly, various liabilities are taken as a part of total liabilities.
Common Size Balance Sheet:-

A statement in which balance sheet items are expressed as the ratio of each asset to
total assets and the ratio of each liability is expressed as a ratio of total liabilities is called
common size balance. The common size balance sheet can be used to compare companies of
differing size. The comparison of figures in different periods is not useful because total
figures may be affected by a number of factors. It is not possible to establish standard norms
for various assets. The trends of figures from year to year may not be studied and even they
may not give proper results.

Trend Analysis of Balance Sheet:-

Trend analysis is Very important tool of horizontal financial analysis.

This analysis enables to known the change in the financial function and operating efficiency
in between the time period chosen.

By studding the trend analysis of each item we can known the direction of changes and
based upon the direction of changes, the options can be changed.

Trend =Absolute Value of item in the statement understudy *120 Absolute

Value of same item in the base statement
Ratio Analysis:

Ratio analysis is used as a technique of analyzing the financial information, contained in the
balance sheet and profit and loss accounts, for a more meaningful understanding of the
financial position and performance of a firm.

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The relationship between two accounting figures, expressed mathematically, is known as a
financial ratio. A ratio helps the analyst to make qualitative judgment about the firm’s
financial position and performance.

Several ratios can be calculated from the accounting data contained in the financial
statements. The parties which generally undertake financial analysis is short –term creditors,
long-term creditors, owner and management. In view of the requirements of the various
ratios, ratios are classified into the following four important categories.

Liquidity ratios

Leverage ratios

Activity ratios

Profitability ratios
Liquidity Ratios:

It is extremely essential for a firm to be able to meet its obligations as they become due.
Liquidity ratios measure the ability of the firm to meet its current obligations. A firm should
ensure that it does not suffer from lack of liquidity, and also that it does not have excess
liquidity. The failure of a company to meet its obligations due to lack of sufficient liquidity,
will result in a poor creditworthiness, loss of creditors’ confidence, or even in legal tangles
resulting in the closure of the company. A very high degree of liquidity is also bad; idle
assets earn nothing. The firm’s funds will be unnecessarily tied up in current assets.
Therefore it is necessary to strike a proper balance high liquidity and lack of liquidity.

The most common ratios which indicate the extent of liquidity or lack of it are
Current ratio

Quick ratio

Other ratios include Cash ratio, Interval Measure and Net working capital ratio.

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Current Ratio:

The current ratio is calculated by dividing current assets by current liabilities.

Current-assets Current ratio = ------------------

-----
Current liabilities
Current ratio is a measure of the firm’s short term solvency. It indicates the availability of
current assets in rupees for every one rupee of current liability. A ratio of greater than one
means that the firm has more current assets than current claims against the, Current ratio of 2
to 1 or more is considered satisfactory. Current ratio represents a margin of safety for
creditors.
Quick Ratio:

Quick ratio also known as acid-test ratio establishes a relationship between quick assets and
the current liabilities. Cash is the most liquid asset. It is calculated by dividing quick assets
by current liabilities.

Quick ratio = Quick Assets / Current Liabilities

(Quick Assets = Current assets – Inventory)
One defect of the current ratio is that it fails to convey any information on the composition
of the current assets of the firm. A rupee of cash is considered equivalent to a rupee of
inventory of receivables. But it is not so. A rupee of cash is more readily available to meet
current liabilities than a rupee of say inventory. This implies the usefulness of the current
ratio.
The Acid –test ratio measures the firm’s ability to convert its current assets quickly into
cash in order to meet its current liabilities.
A quick ratio of 1 to 1 is considered to represent a satisfactory current financial condition. It
is an important index of the firm’s liquidity.
Leverage Ratios:

Leverage ratios identify the source of a firm’s capital –owners or outside creditors. Financial
leverage refers to the use of debt in financing non-current assets. If the return on assets
exceeds the cost of debt, the leverage is successful – i.e., it improves return on equity.

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Debt –Equity Ratio:

The Debt – Equity is determined to analyze the soundness of the long term financial policies
of the organization. It is also known as “Internal External Equity Ratio”.
It is calculated as follows:

Debt – Equity Ratio = Total long term debt / Share holders funds.
Equity Ratio:

This ratio is also called as proprietary ratio establishes a relationship between share holder’s
funds to total assets of company. Equity Ratio is calculated by dividing share holders fund
by total assets.

Fixed Asset Ratio:

This ratio indicates the extent to which the assets of the company’s can be lost without
affecting the interest of the creditors of the company. Higher the ratios better the long-term
position of the company.

Activity Ratios:

They are primarily used for studying a firm’s working capital situation. A well managed
firm should have good activity ratios.

Working Capital Turnover Ratio:

The working capital turnover ratio indicates whether or not working capital has been
effectively used in making sales.

Working capital turnover = Sales / Net current assets

Inventory Turnover Ratio:

This ratio also known as Stock Turnover Ratio establishes the relationship between costs of
goods sold or net sales during the given period and the average amt of stock held during the

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 period. This ratio reveals the number of times finished stock in turnover during a given
accounting period.

Higher the ratio the better is it because it shows the finished stock is rapidly turned
in to sales. On the other hand, a low stock turnover ratio is not desirable, because it reveals
the accumulation of stock.
Debtors Turnover Ratio:

This ratio indicates the velocity of debt collection of a company. In other words it shows the
number of times average turnover during a year.

A Higher Debtor Turnover Ratio indicates a more efficient is the management towards
debtors and low ratio ratio implies inefficient management of debtors.

Total Assets Turnover Ratio:

The asset turnover ratio indicates how efficiently management is employing Assets.
Total Assets Turnover Ratio = Sales / Total Assets

Profitability Ratios:

Profitability ratios are the ratios which measure a firm’s overall effectiveness as revealed by
the returns generated on sales and investment.

General Profitability Ratios:

1. Gross Profit Ratio

2. Net profit Ratio

3. Operating or Expenses Ratio.

Gross Profit Ratio:

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 Gross profit Ratio measures the relationships to net sales and is usually represented as a
percentage. It is a good measure of profitability.

The gross profit ratio indicates the extent to which selling price of goods per unit may
decline without resulting in losses on operation. Higher the gross profit betters the result.

Net Profit Ratio:

Net Profit Ratio indicates net margin on sales. It is given by the following equation. Net
Profit Ratio = (Net Profit / Sales) * 120

Operating or Expenses Ratio:

This ratio is complimentary of Net Profit Ratio. The more the net profit, the less the
Operating Ratio. Operating costs include the cost of direct materials, direct labors and other
overheads, viz., are generally excluded from operating costs. A comparison of the Operating
Ratio will indicate whether the cost efficiency is high or low in the figure of sales. This less
the ratio it depicts the efficiency of the management.

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