Financial Statements Analysis

Accounting Ratios

Financial statements analysis is largely a study

of relationship among the various financial
factors in a business as disclosed by a single set
of statements and a study of the trend of these
functions as shown in a series of statements

Myers

Ratio
A Ratio is simply one number expressed in
terms of another. It is found by dividing
one number into the other.

Objectives and Advantages of

Ratio Analysis
Helpful in Analysis of Financial Statements.
Simplification of Accounting Data
Helpful in Comparative Study
Helpful in locating the Weak Spots of the
Business
Helpful in Forecasting
Estimate about the trend of the Business
Fixation of Ideal Standards
Effective Control
Study of Financial Soundness

Limitations of Ratio Analysis

False Accounting data gives false ratio

Comparison not Possible if Different Firms adopt
different accounting policies
Ratio analysis becomes less effective due to price
level changes.
Ratio may be misleading in the absence of
absolute data
Limited use of a single ratio
Window-Dressing
Lack of Proper Standards
Ratio alone are not adequate for Proper
Conclusions
Effect of Personal Ability and Bias of the Analyst

Classification of Ratios

Liquidity Ratios

Current Ratio
Quick Ratio

Leverage or Capital Structure Ratios

Debt Equity Ratio

Debt to Total Funds Ratio
Proprietary Ratio
Fixed Assets to Proprietor's Fund Ratio
Capital Gearing Ratio
Interest Coverage Ratio

Classification of Ratios

Activity Ratio
Stock Turnover Ratio or Inventory Turnover Ratio
Debtors of Receivables Turnover Ratio
Average Collection Ratio
Creditors or Payables Turnover Ratio
Average Payment Period
Fixed Assets Turnover Ratio
Working Capital Turnover Ratio

Classification of Ratios

Profitability Ratio

Profitability Ratios based on Sales

Gross Profit Ratio

Net Profit Ratio
Operating Ratio
Expenses Ratio

Classification of Ratios

Profitability Ratios based on Investment

Return on Capital Employed

Return on Shareholders Funds
Return on Total Shareholders Funds
Return of Equity Shareholders Funds
Earning per share
Dividend per share
Dividend payout ratio
Earning and Dividend Yield
Price Earning Ratio

Current Ratio: Current Ratio also known as

working Capital Ratio, Solvency (short term ratio,
Two to one ratio) shows the companys ability to
meet its maturing current obligations. In other
words, the ratio indicates the relation between
the current assets and current liabilities. The
formulation for the ratio is as follows:

Current Ratio =
Current Assets
Current Liabilities

Current Assets = Cash in Hand+ Cash at Bank +

B/R + Short term Investment (Marketable
Securities) + debtors + Stock ( Stock of Finished
Goods + Stock of Raw material + Work in
Progress) + Prepaid Expenses.
Quick Assets = Cash in Hand+ Cash at Bank +
B/R + Short term Investment (Marketable
Securities) + debtors
Current Liabilities = Bank Overdraft + Creditors +
B/P + Provision for Taxation + Proposed
Dividends + Unclaimed Dividends + Outstanding
Expenses + Loans Payable within a Year

Acid Test Ratio: Acid Test Ratio is also called

Quick Ratio or Liquid Ratio. It shows the
relationship that exists between the liquid
assets and liquid liabilities. The formulation for
the ratio is as:

Acid Test Ratio =

Liquid assets
Liquid Liabilities

Capital Structure Ratio: Liquidity ratios

analyze the short term solvency of a firm
whereas the long-term solvency can be
examined by the help of leverage or Capital
structure ratio
Capital structure ratio is used to judge the
ability of a firm to pay the interest regularly as
well as repay the principal when due.

Debt-Equity Ratio: According to this

approach, this ratio express the relationship
between long term debts and shareholders
funds. It indicates the proportion of funds
which are acquired by long term borrowings
in comparison to shareholders funds.
The formulation for the ratio is as:
Acid Test Ratio =

Debt
Equity

Long Term Loans: Debentures + Mortgage

Loans + Bank Loan + Loan from Financial
Institutions + Public Deposits
Shareholders Loans = Equity share capital
+ Preference Share Capital + Share
Premium + General Reserve + Capital
Reserve + Other Reserve + Credit Balance
of P&L A/c Accumulated losses
Fictitious assets ( Preliminary Expenses,
Underwriting commissions, share issue
expenses )

Debt to Equity ratio is also known as ExternalInternal Equity Ratio. The formula for the ratio is as
below:
Debt to Equity Ratio=

External Equities
Internal Equities

Where external equities represent outsiders funds

while internal equities represent shareholders
funds. Accordingly, Debt to Equity Ratio may also be
calculated as follows:
Debt to Equity Ratio=

Outsiders Funds
Shareholders Funds

Debt to Total Funds Ratio is a variation of

the debt equity ratio and gives the same
indication as the debt equity ratio. In this
ratio, debt is expressed in relation to total
funds, i.e. , both equity and debt. It is
calculated as under:
Debt to Equity Ratio=

Debt
Equity + Debt

Proprietary Ratio:
This ratio indicates the proportion of total
assets funded by owners or shareholders. It
is calculated as under:

Proprietary Ratio =
Equity
Total Assets

Fixed Assets to Proprietors

Fixed Assets
Fund Ratio

Proprietors Fund
This ratio indicates the extent to which
proprietors (Shareholder's ) funds are sunk
into fixed assets. If this ratio is less than 100
%, it would mean that proprietors fund are
more than fixed assets and a part of working
capital is provided by the proprietors. This
will indicate the long term financial
soundness of business. The lower the ratio,
the better it is for the long term solvency of
the business because more proprietor's funds
will be available for working capital.

Capital Gearing Capital:

This ratio establish a relationship between
equity capital ( including all reserve and
undistributed profit ) and Fixed Cost bearing
capital.
Fixed cost bearing : Pref. Share Cap + Deb
+ Long term capital
Capital Bearing Capital=
Equity Share Cap + Reserve + P&L Balance
Fixed cost bearing capital

Interest Coverage Ratio

This ratio is also termed as Debt Service
Ratio. This ratio is calculated by dividing the
net profit before charging interest and
income-tax by fixed interest charges.
Net profit before charging interest and Income
tax
Fixed Interest charges

Activity Ratios

These ratio measure how well the

resources at the disposal of the concern
are being utilized. These ratios are known
as turnover ratios as they indicate the
rapidity with which the resources available
to the concern are being used to produce
sales.
Measure the efficiency

Inventory Turnover Ratio: Inventory Turnover

Ratio expresses the relation between the cost of
goods sold during a given period and the average
amount of inventory outstanding during the period.
Cost of Goods Sold
Average Stock

Cost of Goods Sold= OS + P + Carriage +

Wages + Other Direct Expenses Closing Stock
Or
Net Sales- Gross Profit

Debtors Turnover Ratio: Debtors Turnover

Ratio shows outstanding amount (i.e. uncollected
accounts) by debtors in respect of number of days
of sales. In other words, it shows how many days
credit is outstanding by debtors. The formulation
for the ratio is as follows:

DTR =

Trade Debtors
Average Deb+ Average B/R

Average Collection Period: This ratio indicate

the time within which the amount is collected from
debtors and bills receivables. The formulation for
the ratio is as follows:

Deb+ B/R
Credit Sales Per Day

Creditors Turnover Ratio: Debtors Turnover

Ratio shows the relationship between credit
purchases and average creditors during the year.
The formulation for the ratio is as follows:

DTR =

Trade Creditors
Average Creditors+ Average B/P

Average payment Period: This ratio indicate

the period which is normally taken by the firm to
make payment to its creditors. The formulation for
the ratio is as follows:

Creditors+ B/R
Credit Sales Per Day

Working Capital Turnover Ratio: Debtors

Turnover Ratio shows the relationship between
credit purchases and average creditors during the
year. The formulation for the ratio is as follows:

DTR =

Cost of Goods Sold

Working Capital

Operating Ratio
This ratio expresses the relationship of cost of
goods sold plus operating expenses to Net
Sales. Formulation for this ratio is as:
Operating Ratio = Cost of goods sold +
Operating Expenses/Net sales
Operating Expenses- Operating Expenses
consist of:

Selling and Distributions Expenses

Financial Expenses
Administrative Expenses

Revenue Statement Ratios Explained:

Revenue Statement ratios mainly include the following ratios:
Gross Profit Ratio
Operating Ratio
Expense Ratios and
Net Profit ratio
Above ratios are very useful to measure the profitability of the
business

Gross Profit Ratio:

This ratio is also called Turn-over Ratio. It shows the relationship of
gross profit on sales to net sales. The ratio is expressed in
percentage of gross profit to sales, Formulation for this ratio is as
follows:
Gross Profit Ratio= Gross Profit/Net Sales

Key Concepts

Accounting Ratio
Balance Sheet
Balance Sheet Ratios
Composite Ratios
Financial Analysis
Financial Ratios
Financial Statement
Interpretation
Profitability Ratio
Turnover Ratios