UNIT II ANALYSIS OF FINANCIAL STATEMENTS

Financial ratio analysis, Interpretation of ratio for financial decisions - Dupont Ratios –
Comparative statements - common size statements. Cash flow (as per Accounting Standard
3) and Funds flow statement analysis – Trend Analysis.

Analysis of Financial statement

Financial statement analysis is the process of analyzing a company's financial statements for
decision-making purposes. External stakeholders use it to understand the overall health of an
organization as well as to evaluate financial performance and business value.

1. Identify the industry economic characteristics. ...

2. Identify company strategies. ...
3. Assess the quality of the firm's financial statements. ...
4. Analyze current profitability and risk. ...
5. Prepare forecasted financial statements. ...
6. Value the firm.

The basic financial statements of an enterprise include the 1) balance sheet (or statement of
financial position), 2) income statement, 3) cash flow statement, and 4) statement of changes in
owners' equity or stockholders' equity.

Financial Statements

As mentioned, there are three main financial statements that every company creates and
monitors: the balance sheet, income statement, and cash flow statement. Companies use these
financial statements to manage the operations of their business and also to provide reporting
transparency to their stakeholders. All three statements are interconnected and create different
views of a company’s activities and performance.

Balance Sheet

The balance sheet is a report of a company's financial worth in terms of book value. It is broken
into three parts to include a company’s assets, liabilities, and shareholders' equity. Short-term
assets such as cash and accounts receivable can tell a lot about a company’s operational
efficiency. Liabilities include its expense arrangements and the debt capital it is paying off.
Shareholder’s equity includes details on equity capital investments and retained earnings from
periodic net income. The balance sheet must balance with assets minus liabilities equaling
shareholder’s equity. The resulting shareholder’s equity is considered a company’s book value.
This value is an important performance metric that increases or decreases with the financial
activities of a company.

Income Statement

The income statement breaks down the revenue a company earns against the expenses involved
in its business to provide a bottom line, net income profit or loss. The income statement is
broken into three parts which help to analyze business efficiency at three different points. It
begins with revenue and the direct costs associated with revenue to identify gross profit. It then
moves to operating profit which subtracts indirect expenses such as marketing costs, general
costs, and depreciation. Finally it ends with net profit which deducts interest and taxes.

Basic analysis of the income statement usually involves the calculation of gross profit margin,
operating profit margin, and net profit margin which each divide profit by revenue. Profit margin
helps to show where company costs are low or high at different points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company's cash flows from operating
activities, investing activities, and financing activities. Net income is carried over to the cash
flow statement where it is included as the top line item for operating activities. Like its title,
investing activities include cash flows involved with firmwide investments. The financing
activities section includes cash flow from both debt and equity financing. The bottom line shows
how much cash a company has available.

FINANCIAL STATEMENT ANALYSIS

ON THE BASIS OF INFORMATION USED ANALYSIS ON THE BASIS OF

MODUS OPERATION

1. External Analysis 1. Horizontal Analysis

2. Internal Analysis 2. Vertical Analysis

External Analysis

It is made by those persons who are not connected with the business. They do not have
access to the business. They do not have access to the detailed record of the company and have
to depend mostly on published statements. Such type of analysis is made by investors, credit
agencies, governmental agencies and research scholars.
Internal Analysis

Internal analysis is done on the basis of unpublished records. internal analysis done by
executives or other authorized officials. It is very much useful and significant to employees and
management.

Horizontal Analysis

Horizontal analysis made to review and verify the financial statement of a number of
years.it is based on financial data taken from several years.this is very useful for long-term trend
analysis and planning.

It is also called as dynamic or trend analysis.

Eg. Comparative statement.

Vertical Analysis

Vertical analysis is otherwise called as static analysis or structural analysis. This analysis
is made to review and analyze the financial statements of one particular year only.

Eg. Common size balance sheet and ratio analysis.

Common size statement is a form of analysis and interpretation of the financial statement. It is
also known as vertical analysis. This method analyses financial statements by taking into
consideration each of the line items as a percentage of the base amount for that particular
accounting period.

Common size statements are not any kind of financial ratios but are a rather easy way to express
financial statements, which makes it easier to analyse those statements.

Common size statements are always expressed in the form of percentages. Therefore, such
statements are also called 100 per cent statements or component percentage statements as all the
individual items are taken as a percentage of 100.

Types of Common Size Statements

There are two types of common size statements:

1. Common size income statement

2. Common size balance sheet

1. Common Size Income Statement

This is one type of common size statement where the sales is taken as the base for all
calculations. Therefore, the calculation of each line item will take into account the sales as a
base, and each item will be expressed as a percentage of the sales.

. 2. Common Size Balance Sheet:

A common size balance sheet is a statement in which balance sheet items are being calculated as
the ratio of each asset in relation to the total assets. For the liabilities, each liability is being
calculated as a ratio of the total liabilities.

Common size balance sheets can be used for comparing companies that differ in size. The
comparison of such figures for the different periods is not found to be that useful because the
total figures seem to be affected by a number of factors.

Standard values for various assets cannot be established by this method as the trends of the
figures cannot be studied and may not give proper results.
 3. Fund Flow Statement.

Funds Flow Statement is a statement prepared to analyse the reasons for changes in the Financial
Position of a Company between 2 Balance Sheets. It shows the inflow and outflow of funds i.e.
Sources and Applications of funds for a particular period. In other words, a Funds Flow
Statement is prepared to explain the changes in the Working Capital Position of a Company.
There are 2 types of Inflows of Funds:-

1. Long Term Funds raised by Issue of Shares, Debentures or Sale of Fixed Assets
2. Funds generated from Operations

Cash Flow Analysis

Ratio analysis can be defined as the process of ascertaining the financial ratios that are used for
indicating the ongoing financial performance of a company using few types of ratios such as
liquidity, profitability, activity, debt, market, solvency, efficiency, and coverage ratios and few
examples of such ratios are return on equity, current ratio, quick ratio, dividend payout ratio,
debt-equity ratio, and so on.

Ratio analysis is a process used for the calculation of financial ratios or in other words, for the
purpose of evaluating the financial wellbeing of a company. The values used for the calculation
of financial ratios of a company are extracted from the financial statements of that same
company.

Types of ratios are given below:

1. Liquidity Ratios
This type of ratio helps in measuring the ability of a company to take care of its short-term debt
obligations. A higher liquidity ratio represents that the company is highly rich in cash.

The types of liquidity ratios are: –

1. Current Ratio: The current ratio is the ratio between the current assets and current liabilities
of a company. The current ratio is used to indicate the liquidity of an organization in being able
to meet its debt obligations in the upcoming twelve months. A higher current ratio will indicate
that the organization is highly capable of repaying its short-term debt obligations.

Current Ratio = Current Assets / Current Liabilities

Current Asset

1. Cash
2. Cash Equivalents
3. Stock or Inventory
4. Accounts Receivable
5. Marketable Securities
6. Prepaid Expenses
7. Other Liquid Assets

Current Liabilities

1. Accounts payable
2. Interest payable
3. Income taxes payable
4. Bills payable
5. Bank account overdrafts
6. Accrued expenses
7. Short-term loans

2. Quick Ratio: The quick ratio is used to ascertain information pertaining to the capability of a
company in paying off its current liabilities on an immediate basis.

The formula used for the calculation of a quick ratio is-

 Quick Ratio = (Current Asset - stock)
Current Liabilities

2. Profitability Ratios

This type of ratio helps in measuring the ability of a company in earning sufficient profits.

The types of profitability ratios are: –

1. Gross Profit Ratios: Gross profit ratios are calculated in order to represent the operating
profits of an organization after making necessary adjustments pertaining to the COGS or cost of
goods sold.

The formula used for the calculation of gross profit ratio is-

Gross Profit Ratio = (Gross Profit / Net Sales) * 100

2. Net Profit Ratio: Net profit ratios are calculated in order to determine the overall profitability
of an organization after reducing both cash and non-cash expenditures.

The formula used for the calculation of net profit ratio is-

Net Profit Ratio = (Net Profit / Net Sales) * 100

3. Operating Profit Ratio: Operating profit ratio is used to determine the soundness of an
organization and its financial ability to repay all the short term and long term debt obligations.

The formula used for the calculation of operating profit ratio is-

Operating Profit Ratio = (Earnings Before Interest and Taxes / Net Sales) * 100

4. Return on Capital Employed (ROCE): Return on capital employed is used to determine the
profitability of an organization with respect to the capital that is invested in the business.

The formula used for the calculation of ROCE is:

ROCE = Earnings Before Interest and Taxes / Capital Employed

3. Solvency Ratios
Solvency ratios can be defined as a type of ratio that is used to evaluate whether a company is
solvent and well capable of paying off its debt obligations or not.

The types of solvency ratios are: –

1. Debt Equity Ratio: The debt-equity ratio can be defined as a ratio between total debt and
shareholders fund. The debt-equity ratio is used to calculate the leverage of an organization. An
ideal debt-equity ratio for an organization is 2:1.

The formula for debt-equity ratio is-

Debt Equity Ratio = Total Debts / Shareholders Fund

2. Interest Coverage Ratio: The interest coverage ratio is used to determine the solvency of an
organization in the nearing time as well as how many times the profits earned by that very
organization were capable of absorbing its interest-related expenses.

The formula used for the calculation of interest coverage ratio is-

Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense

4. Turnover Ratios

Turnover ratios are used to determine how efficiently the financial assets and liabilities of an
organization have been used for the purpose of generating revenues.

The types of turnover ratios are: –

1. Fixed Assets Turnover Ratios: Fixed assets turnover ratio is used to determine the efficiency
of an organization in utilizing its fixed assets for the purpose of generating revenues.

The formula used for the determination of fixed assets turnover ratio is-

Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets

2. Inventory Turnover Ratio: Inventory turnover ratio is used to determine the speed of a
company in converting its inventories into sales.

The formula used for calculating inventory turnover ratio is-

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories

3. Receivable Turnover Ratio: Receivable turnover ratio is used to determine the efficiency of
an organization in collecting or realizing its account receivables.

The formula used for calculating the receivable turnover ratio is-

Receivables Turnover Ratio = Net Credit Sales / Average Receivables

5. Earnings Ratios

Earnings ratio is used for the purpose of determining the returns that an organization generates
for its investors.

The types of earnings ratios are: –

1. Profit Earnings Ratio: P/E ratio indicates the profit earning capacity of the company.

The formula used for the calculation of profit earnings ratio is:

Profit Earnings Ratio = Market Price per Share / Earnings per Share

2. Earnings per Share (EPS): EPS signifies the earnings of an equity holder based on each
share.

The formula used for EPS is:

EPS = (Net Income – Preferred Dividends) / (Weighted Average of Outstanding

Shares)

Cash Flow Statement

Cash Flow Statement also known as Statement of Cash Flows is a statement which shows the
Changes in the Cash Position of an organisation between 2 periods. Along with showing the
changes in the Cash Position of an organisation, it also depicts the reasons for such change
during the period.
The main reason for the preparation of the Cash Flow Statement is that the Income Statement of
an enterprise is always prepared on an Accrual Basis and it may show profits in the Income
Statement but the Cash received out of these profits may be low to run the business or vice-versa.

Preparation of Cash Flow Statement

Cash Flows Statement is required to be prepared using International Accounting Standard 7 (or
using the Accounting Standard 3 in India). While preparing the Cash Flow Statement, the cash
flows during the period are classified into 3 major categories:-

I. Cash Flow from Operating Activities (Direct Method/ Indirect Method)

II. Cash Flow from Investing Activities

III. Cash Flow from Financing Activities

Classification by activities provides information that allows users to assess the impact of those
activities on the financial position of the enterprise. This information also helps in evaluating the
inter-relationships between these activities.

Cash Flows from Operating Activities

Cash Flows from operating Activities are primarily derived from the Principal Revenue-
producing activities of the enterprise.

There are 2 methods of preparing the Cash Flows from Operating Activities:-

1. Direct Method
2. Indirect Method

1. Cash Flow from Operating Activity- Direct Method

While preparing the Cash Flow Statement as per Direct Method, Actual Cash Receipts from
Operating Revenues and Actual Cash Payments for Operating Activities are arranged and
presented in the Cash Flow Statement. The difference between Cash Receipts and Cash
Payments is the Net Cash Flow from Operating Activities under the Direct Method. In other
words, it is a Income Statement (Profit & Loss A/c) prepared on Cash Basis under the Direct
Method.

While preparing the Cash Flow Statement as per Direct Method, items like Depreciation,
Amortisation of Intangible Assets, Preliminary Expenses, Debenture Discount etc are ignored
from Cash Flow Statement since the Direct Method includes only Cash Transactions and Non-
Cash Transactions are omitted.

Likewise, no adjustment is made for Loss/Gain on the Sale of Fixed Assets and Investments
while preparing the Cash Flow Statement as per the Direct Method.

Format for Computation of Cash Flows from Operating Activities as per Direct Method

Particulars Amount
Cash Receipts from Customers xxx
Cash Paid to suppliers and employees (xxx)
Cash generated from Operations xxx
Income Tax Paid (xxx)
Cash Flow before Extra-ordinary Items xxx
Extra-ordinary items xxx
Net Cash from Operating Activities (Direct Method) xxx

2. Cash Flow from Operating Activity – Indirect Method

While preparing the Cash Flow Statement as per the Indirect Method, the Net Profit/Loss for
the period is used as the base and then adjustments are made for items that affected the Income
Statement but did not affect the Cash

While preparing the Cash Flow Statement as per the Indirect Method, Non Cash and Non
Operating charges in the Income Statement are added back to the Net Profits while Non-Cash &
Non-Operating Credits are deducted to calculate the Operating Profit before Working Capital
Changes. The Indirect Method of preparating of Cash Flow Statement is a partial conversion of
accrual basis profit to Cash basis profit. Further, necessary adjustments are made for
Increase/Decrease in Current Assets and Current Liabilities to obtain Net Cash Flows from
Operating Activities as per the Indirect Method.

Format of Cash Flows from Operating Activities – Indirect Method

Particulars Amount
Net Profit before Tax and Extra-ordinary items xxx
Adjustments for
– Depreciation xxx
– Foreign Exchange xxx
 – Investments xxx
– Gain or Loss on Sale of Fixed Assets xxx
– Interest Dividend xxx
Operating Profit before Working Capital Changes xxx
Adjustments for
– Trade and Other Receivables xxx
– Inventories xxx
– Trade Payable xxx
Cash generated from Operations xxx
– Interest Paid (xxx)
– Direct Taxes (xxx)
Cash before Extra-Ordinary Items xxx
Deferred Revenue xxx
Net Cash Flow from Operating Activities (Indirect Method) xxx

II. Cash Flow from Investing Activities

The activities of Acquisition and Disposal of Long Term Assets and other Investments not
included in cash equivalents are Investing activities. Separate disclosure of Cash Flows arising
from Investing Activities is important because the Cash Flows represent the extent to which
expenditures have been made for resources intended to generate future income and cash flows.

Format of Cash Flow from Investing Activities:-

Particulars Amount
Purchase of Fixed Assets (xxx)
(Add) Proceeds from Sale of Fixed Assets xxx
(Add) Interest received xxx
(Add) Dividend received xxx
Net Cash Flow from Investing Activities xxx

III. Cash Flows from Financing Activities

Financing Activities are those activities which result in a change in the size and composition of
owner’s capital and borrowing of the organisation. The separate disclosure of cash flows arising
from financing activities is important because it is useful in predicting the claims on future cash
flows by the providers of funds.

Format of Cash Flow from Financing Activities:-

Particulars Amount
Proceeds from Issue of Share Capital xxx
Proceeds from Long Term Borrowings xxx
Repayment of Long Term Borrowings (xxx)
Interest Paid (xxx)
Dividend Paid (xxx)
Net Cash Flows from Financing Activities xxx

The Comprehensive Format of the complete Cash Flow Statement is as follows:-

Particulars Amount
Cash flow from Operating Activities (Direct Method/ Indirect Method) xxx
(Add) Cash Flow from Investing Activities xxx
(Add) Cash Flow from Financing Activities xxx
(=)Net Increase/Decrease in Cash xxx
(Add) Opening Balance of Cash & Cash Equivalents xxx
(=) Closing Balance of Cash & Cash Equivalents xxx

Funds Flow Statement

Funds Flow Statement is a statement prepared to analyse the reasons for changes in the
Financial Position of a Company between 2 Balance Sheets. It shows the inflow and outflow of
funds i.e. Sources and Applications of funds for a particular period. In other words, a Funds
Flow Statement is prepared to explain the changes in the Working Capital Position of a
Company. There are 2 types of Inflows of Funds:-

1. Long Term Funds raised by Issue of Shares, Debentures or Sale of Fixed Assets
2. Funds generated from Operations

If the Long Term Fund requirements of a company are met just out of the Long Term Sources of
Funds, then the whole fund generated from operations will be represented by increase in
Working Capital. However, if the Funds generated from Operations are not sufficient to bridge a
gap of Long Term Fund Requirements, then there will be a decline in Working Capital.

PREPARATION OF FUNDS FLOW STATEMENT

Step I: Prepare Statement of Changes in Working Capital

For preparing the Funds Flow Statement, the first step is to prepare the Statement of Changes in
Working Capital. There may be several reasons for changes in the Working Capital Position of
a Company, some of which have been discussed below:-

1. Purchase of Fixed Assets or Long Term Investments without raising Long Term Funds
2. Payments of Dividends in excess of the Profits earned
3. Extension of Credit to the Customers
4. Repayment of a Long Term Liability or Redemption of Preference Shares without raising
Long Term Resources
Step II: Prepare Funds from Operations

The next Step is to prepare the Funds generated only from the Operating Activities of the
Business and not from the Investing/Financing Activities of the business. The Funds from
Operations shall be prepared as follows:-

Particulars Amount
Net Income xxx
ADD
1. Depreciation on Fixed Assets xxx
2. Amortization of Intangible Assets xxx
3. Amortisation of Loss on Sale of Investments xxx
4. Amortisation of Loss on sale of Fixed Assets xxx
5. Losses from Other Non-Operating Incomes xxx
6. Tax Provision (Created out of Current Profits) xxx
7. Proposed Dividend xxx
8. Transfer to Reserve xxx
(LESS)
1. Deferred credit xxx
2. Profit on Sale of Investments xxx
3. Profit on Sale of Fixed Assets xxx
4. Any written back Reserve & Provision xxx

Step III: Preparation of Funds Flow Statement

While preparing the Funds Flow Statement, the Sources and Uses of Funds are to be disclosed
clearly so as to highlight the Sources from where the Funds have been generated the Uses to
which these Funds have been applied. This Statement is also sometimes referred to as the
Sources and Applications of Funds Statement or Statement of Changes in Financial Position.

Sources of Funds

Items to be shown under the head Sources of Funds are as follows:-

1. Issue of Shares and Debentures for Cash: – The total amount received from the Issue of
Shares or Debentures is to shown under this head. But, the Issue of bonus Shares or
Conversion of Debentures into Equity Shares or Shares issued to vendors shall not be
shown here as there is no inflow of Cash
2. Long Term Loans: The Amount received on raising Long Term Loans is shown under
this head. Short Term Loans are not to be shown here as their treatment has already been
done while preparing the Statement of Changes in Working Capital.
3. Sale of Investments and other Fixed Assets: The Total Amount received on the sale of
Investments and other Fixed Assets is to be shown under this head.
4. Funds from Operations: The Funds generated from Operations as computed in Step II are
also required to be shown here.
5. Decrease in Working Capital: This would be the Balancing Figure of the Statement and
will come from change in Working Capital Statement