Professional Documents
Culture Documents
CHAPTER-1
1.1 INTRODUCTION
information to present informed judgment and decision by users of the information. It involves
recording, classifying and summarizing various business transactions. The end products of the
business transaction are the financial statements comprising primarily the position statement or
the balance sheet and outcome of the summarizing process of accounting and are therefore the
sources of information on the basis of which conclusions are drawn about the profitability and
Financial statements are the basis for decision making by the management as well as all
the outsiders who are interested in the affairs of the firm such as investors, creditors, customers
and general public. The analysis and the interpretation of financial statements depend upon the
nature and type of information available in these statements i.e the balance sheet and income
component parts of financial statements to obtain a better understanding of the firm’s position
and performance.
1.2 FINANCIAL STATEMENTS
Financial statements are the source of the information on the basis of which conclusions
are drawn about the profitability and liquidity position of a business enterprise at the end of
financial year. They are the major means employed by firms to present their financial situation to
Financial statements are the end products of financial accounting, prepared by the
accountant that purport to reveal the financial position of the enterprise, the result of its recent
activities and an analysis of what has been done with the earnings.
of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as on a
certain date and the income statement showing the results of operation during a certain period”.
Financial statements are prepared for the purpose of presenting a periodical review or
report by the management and deal with the state of investment in business and result achieved
during the period under review. According to the American institute of Certified public
conventions applied affects them materially”. This implies that data exhibited in the Financial
Statements are affected by recorded facts, accounting conventions and personal judgment.
Recorded Facts: The term-recorded fact means facts that have been in the accounting
books. Facts that have not been recorded in the financial books are not depicted in the
principles, which have been sanctioned by long usage. For example on account of the
convention of conversation provision is made for expected losses but the real financial
position of the business may be much better than what has been shown by financial
statements.
Personal judgment: Personal judgment has also an important bearing on the financial
statement. For example, the choice of selection method of depreciation lies on the
accountant, similarly the made of amortization of fictitious assets also depends on the
The financial statements are mirrors, which reflect the financial position and operating
strength or weakness of the concern (firm). These statements are useful to management,
investors, creditors, bankers, workers, government and public at large. The importance of
a) As a report of Stewardship
Financial ratios are widely used for modelling purposes both by practitioners and
researchers. The firm involves many interested parties, like the owners, management, personnel,
customers, suppliers, competitors, regulatory agencies, and academics, each having their views
in applying financial statement analysis in their evaluations. Practitioners use financial ratios, for
instance, to forecast the future success of companies, while the researchers' main interest has
been to develop models exploiting these ratios. Many distinct areas of research involving
financial ratios can be discerned. Historically one can observe several major themes in the
financial analysis literature. There is overlapping in the observable themes, and they do not
necessarily coincide with what theoretically might be the best founded areas.
Financial Management is the specific area of finance dealing with the financial decision
corporations make, and the tools and analysis used to make the decisions. The discipline as a
whole may be divided between long-term and short-term decisions and techniques. Both share
the same goal of enhancing firm value by ensuring that return on capital exceeds cost of capital,
without taking excessive financial risks.
Analysis means establishing a meaningful relationship between various items of the two
financial statements with each other in such a way that a conclusion is drawn. By financial
statements, we mean two statements- (1) profit & loss a/c (2) balance sheet. These are prepared
at the end of a given period of time. They are indicators of profitability and financial soundness
of the business concern.
Analysis of financial statement has become very significant due to widespread interest of
various parties in the financial result of a business unit. The various persons interested in the
analysis of financial statements are:-
They are interested in knowing whether the amounts owing to them will be paid as and
when fall due for payment or not.
They are interested in knowing whether the principal amount and interest thereon will be
paid on time or not.
3. Shareholders
4. Management
The management is interested in the financial position and performance of the enterprise
as a whole and of its various divisions.
5. Trade unions
They are interested in financial statements for negotiating the wages or salaries or bonus
agreement with management.
6. Taxation authorities
These authorities are interested in financial statements for determining the tax liability.
7. Researchers
They are interested in the financial statements in undertaking research in business affairs
and practices.
8. Employees
They are interested as it enables them to justify their demands for bonus and increase in
remuneration.
You have seen that different parties are interested in the results reported in the financial
statements. These results are reported by analyzing financial statements through the use of ratio
analysis.
1.2 Need for the Study:
The performance of any organization is evaluated through their sales performance and
their profitability during the existence of the firm. Essentially my study, which is part of the
undertaken to find the gap between the target and achieved results of the company. Its
The present study entitled “Financial statement analysis” is under taken with the
following objectives.
RATIO ANALYSIS
The term “Ratio” refers to the numerical and quantitative relationship between two items
or variables. This relationship can be exposed as
Percentages
Fractions
Proportion of numbers
Ratio analysis is defined as the systematic use of the ratio to interpret the financial
statements. Hence the strengths and weaknesses of a firm, as well as its historical performance
and current financial condition can be determined. Ratio reflects a quantitative relationship helps
to form a quantitative judgment.
The calculation of ratios may not be a difficult task but their useis not easy. Following
guidelines or factors may be kept in mind whileinterpreting various ratios is
Differences in definitions
Limitations of accounting records
Lack of proper standards
No allowances for price level changes
Changes in accounting procedures
Quantitative factors are ignored
Limited use of single ratio
Background is over looked
Limited use
Personal bias
Classifications of Ratios
The use of ratio analysis is not confined to financial manager only. There are different
parties interested in the ratio analysis for knowingthe financial position of a firm for different
purposes. Various accountingratios can be classified as follows:
1. Traditional Classification
2. Functional Classification
3. Significance ratios
1. Traditional Classification
2. Functional Classification
These include liquidity ratios, long term solvency and leverageratios, activity ratios and
profitability ratios.
3. Significance ratios
Some ratios are important than others and the firm may classifythem as primary and
secondary ratios. The primary ratio is one, which is of the prime importance to a concern. The
other ratios that support the primaryratio are called secondary ratios.
1. Liquidity ratio
2. Leverage ratio
3. Activity ratio
4. Profitability ratio
1. Liquidity Ratios
Liquidity refers to the ability of a concern to meet its currentobligations as & when there
becomes due. The short term obligations of afirm can be met only when there are sufficient
liquid assets. The short termobligations are met by realizing amounts from current, floating
(or)circulating assets The current assets should either be calculated liquid (or)near liquidity.
They should be convertible into cash for paying obligations of short term nature. The sufficiency
(or) insufficiency of current assets should be assessed by comparing them with short-term
current liabilities. If currentassets can pay off current liabilities, then liquidity position will
besatisfactory. To measure the liquidity of a firm the following ratios can becalculated
Current ratio
Quick (or) Acid-test (or) Liquid ratio
Absolute liquid ratio (or) Cash position ratio
Current ratio may be defined as the relationship betweencurrent assets and current
liabilities. This ratio also known as Workingcapital ratio is a measure of general liquidity and is
most widely used tomake the analysis of a short-term financial position (or) liquidity of a firm.
Current Ratio =
Quick ratio is a test of liquidity than the current ratio. The term liquidity refers to the
ability of a firm to pay its short-term obligations as &when they become due. Quick ratio may be
defined as the relationship between quick or liquid assets and current liabilities. An asset is said
to be liquid if it is converted into cash within a short period without loss of value.
Although receivable, debtors and bills receivable are generallymore liquid than
inventories, yet there may be doubts regarding their realization into cash immediately or in time.
Hence, absolute liquid ratioshould also be calculated together with current ratio and quick ratio
so as toexclude even receivables from the current assets and find out the absoluteliquid assets.
/ Current liabilities
Absolute Liquid Ratio =
Absolute liquid assets include cash in hand etc. The acceptable forms for this ratio is 50%
(or) 0.5:1 (or) 1:2 i.e., Rs.1 worth absolute liquid assets are considered to pay Rs.2 worth current
liabilities in time as all thecreditors are nor accepted to demand cash at the same time and then
cashmay also be realized from debtors and inventories.
2. Leverage Ratios
The leverage or solvency ratio refers to the ability of a concern to meet its long term
obligations. Accordingly, long term solvency ratios indicate firm’s ability to meet the fixed
interest and costs and repayment schedules associated with its long term borrowings.
The following ratio serves the purpose of determining the solvency of the concern.
Debt-to-equity ratio is the key financial ratio and is used as a standard for judging a
bank's financial standing. It is also a measure of a bank's ability to repay its obligations. When
examining the health of a bank, it is critical to pay attention to the debt/equity ratio.If the ratio is
increasing, the bank is being financed by creditors rather than from its own financial sources
which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios
because their interests are better protected in the event of a business decline. Thus, companies
with high debt-to-equity ratios may not be able to attract additional lending capital.
/ Current liabilities
A fixed asset to equity ratio measures the contribution of stockholders and the
contribution of debt sources in the fixed assets of the bank. It is computed by dividing the fixed
assets by the stockholders’ equity.
Other names of this ratio are fixed assets to net worth ratio and fixed assets to
proprietors fund ratio.
/ Current liabilities
(c) Interest cover ratio
The interest coverage ratio (ICR) is a measure of a bank's ability to meet its interest
payments. Interest coverage ratio is equal to earnings before interest and taxes (EBIT) for a time
period, often one year, divided by interest expenses for the same time period. The interest
coverage ratio is a measure of the number of times a bank could make the interest payments on
its debt with its EBIT. It determines how easily a bank can pay interest expenses on outstanding
debt.
Interest coverage ratio is also known as interest coverage, debt service ratio or debt
service coverage ratio.
/ Current liabilities
(d) Debit service
amount of cash flow available to meet annual interest and principal payments on debt, coverage
ratio
In government finance, it is the amount of export earnings needed to meet annual interest
and principal payments on a country's external debts.
(PAT+Depreciation+ Interest
Debt service coverage ratio = Loan)/ (Interest on loan+ loan
repayment in a year)
4. Asset management Ratio
Asset management (turnover) ratios compare the assets of a bank to its sales revenue.
Asset management ratios indicate how successfully a bank is utilizing its assets to generate
revenues. Analysis of asset management ratios tells how efficiently and effectively a bank is
using its assets in the generation of revenues. They indicate the ability of a bank to translate its
assets into the sales. Asset management ratios are also known as asset turnover ratios and asset
efficiency ratios
/ Current liabilities
The receivable turnover ratio (debtor’s turnover ratio, accounts receivable turnover ratio)
indicates the velocity of a bank’s debt collection, the number of times average receivables are
turned over during a year. This ratio determines how quickly a bank collects outstanding cash
balances from its customers during an accounting period. It is an important indicator of a bank’s
financial and operational performance and can be used to determine if a bank is having
difficulties collecting sales made on credit.
Debtor’s turnover ratio = Credit sales/ Average debtors
/ Current liabilities
This ratio is similar to the debtor’s turnover ratio. It compares creditors with the total
credit purchases.
It signifies the credit period enjoyed by the firm in paying creditors. Accounts payable
include both sundry creditors and bills payable. Same as debtor’s turnover ratio, creditor’s
turnover ratio can be calculated in two forms, creditors’ turnover ratio and average payment
period.
/ Current liabilities
(d) Fixed asset turnover ratio
Fixed asset turnover ratio compares the sales revenue a bank to its fixed assets. This ratio
tells us how effectively and efficiently a bank is using its fixed assets to generate revenues. This
ratio indicates the productivity of fixed assets in generating revenues. If a bank has a high fixed
asset turnover ratio, it shows that the bank is efficient at managing its fixed assets. Fixed assets
are important because they usually represent the largest component of total assets.
/ Current liabilities
(e) Total asset turnover ratio
Asset turnover ratio is the ratio of a bank’s sales to its assets. It is an efficiency ratio
which tells how successfully the bank is using its assets to generate revenue.
/ Current liabilities
The working capital turnover ratio measures how well a bank is utilizing its working
capital to support a given level of sales. Working capital is current assets minus current
liabilities. A high turnover ratio indicates that management is being extremely efficient in using a
firm’s short-term assets and liabilities to support sales. Conversely, a low ratio indicates that a
business is investing in too many accounts receivable and inventory assets to support its sales,
which could eventually lead to an excessive amount of bad debts and obsolete inventory.
(Or)
/ Current liabilities
Sales/ Net current assets
/ Current liabilities
5. Profitability Ratios
Profitability ratios measure a bank’s ability to generate earnings relative to sales, assets
and equity. These ratios assess the ability of a bank to generate earnings, profits and cash flows
relative to relative to some metric, often the amount of money invested. They highlight how
effectively the profitability of a bank is being managed.
(a) Gross profit margin
Gross profit margin (gross margin) is the ratio of gross profit (gross sales less cost of
sales) to sales revenue. It is the percentage by which gross profits exceed production costs. Gross
margins reveal how much a bank earns taking into consideration the costs that it incurs for
producing its products or services. Gross margin is a good indication of how profitable a bank is
at the most fundamental level, how efficiently a bank uses its resources, materials, and labour. It
is usually expressed as a percentage, and indicates the profitability of a business before overhead
costs; it is a measure of how well a bank controls its costs.
/ Current liabilities
Net profit margin (or profit margin, net margin, return on revenue) is a ratio of
profitability calculated as after-tax net income (net profits) divided by sales (revenue). Net profit
margin is displayed as a percentage. It shows the amount of each sales dollar left over after all
expenses have been paid.
/ Current liabilities
(c) Return on capital employed
(Or)
/ Current liabilities
PBIT/ Average net worth + loan funds
/ Current liabilities