Financial Statement Analysis

FINANCIAL
STATEMENT ANALYSIS
By Dr. Mukesh Pal

FINANCIAL RATIOS
• A ratio is an arithmetical relationship between two figures. Financial ratio analysis
is a study of ratios between various items or groups of items in financial
statements
• Ration classified into five broad categories as follows:
• Liquidity ratios
• Leverage ratios
• Turnover ratios
• Profitability ratios
• Valuation ratios
Liquidity Ratios
Liquidity Ratios
• Liquidity refers to the ability of a firm to meet its obligations in the short run,
usually one year
• Liquidity ratios are generally based on the relationship between current assets (the
sources for meeting short-term obligations) and current liabilities
• The important liquidity ratios are:

• Current ratio
• Acid-test ratio
Current Ratio
• Current Ratio : The current ratio is defined as the ratio of current assets to current
liabilities
• The current ratio measures the ability of the firm to meet its current liabilities
• Current assets get converted into cash during the operating cycle of the firm and
provide the funds needed to pay current liabilities
• The higher the current ratio, the greater will be the short-term solvency
• However, in interpreting the current ratio the composition of current assets must
not be overlooked like a firm with a high proportion of current assets in the form of
cash and debtors is more liquid than current assets in the form of inventories
• The general norm for current ratio in India is 1.33. Internationally it is 2
Acid-test ratio
• It is also known as quick ratio. The Acid-test ration is defined as :
• Quick assets are defined as current assets excluding inventories

• The acid-test ratio is a fairly stringent measure of liquidity
• Inventories are deemed to be the least liquid component of current assets, hence
it is excluded from current assets.
Leverage Ratios
Leverage Ratios
• Financial leverage refers to the use of debt finance
• Leverage ratios help in assessing the risk arising from the use of debt capital
• Structural ratios are based on the proportions of debt and equity in the financial
structure of the firm. The important structural ratios is debt-equity ratio
• Coverage ratios show the relationship between debt servicing commitments and the
sources for meeting these burden such as interest coverage ratio and debt service
coverage ratio
Debt-equity Ratio
• It shows the relative contributions of creditors and owners. It is defined as:
• The numerator of this ratio consists of all liabilities , non-current and current, and the
denominator consists of share capital and reserves and surplus
• The lower the debt-equity ratio, the higher the degree of protection enjoyed by the creditors
• The book value of equity often understates its market value.
• Some forms of debt (like term loans, secured debentures, and secured short-term bank
borrowing) are usually protected by charges on specific assets and hence enjoy superior
protection
Interest Coverage Ratio
• The interest coverage ratio is used to measure how well a firm can pay the interest
due on outstanding debt
• It represents how many times the company can pay its obligations using its earnings
• Note that profit before interest and taxes is used in the numerator of this ratio
because the ability of a firm to pay interest is not affected by tax payment, as interest
(or finance costs) on debt funds is a tax-deductible expense
• Generally, a higher coverage ratio is better, although the ideal ratio may vary by
industry
Interest Coverage Ratio
• Many analyst used EBITDA for interest coverage analysis to check the financial
abilities to meet its interest burden
• Depreciation and amortization are expenses made as an accounting norms, but cash
remain in the company
Turnover Ratios
Turnover Ratios
• The turnover ratios are used to check the efficiency of the company that how it uses
its assets to earn revenue
• The sales figure is compared with the assets (different assets) to measure how much
of the assets are used to generate the number of sales
• The important turnover ratios are:
• Inventory Turnover
• Debtors’ Turnover
• Average Collection Period
• Fixed Assets Turnover
• Total Assets Turnover
Inventory Turnover
• The inventory turnover, or stock turnover, measures how fast the inventory is
moving through the firm and generating sales. It is defined as:
• The higher is the ratio, the more efficient is the management of inventories and
vice versa.
• A high inventory turnover may be caused by a low level of inventory which may
result in frequent stockouts and loss of sales and customer goodwill
Debtors’ Turnover
• Debtor's turnover ratio shows how many times sundry debtors (trade receivables)
turn over during the year. It is defined as:
• If the figure for net credit sales is not available, one may have to make do with the
revenues from operations.
• The higher is the debtors’ turnover the greater is the efficiency of credit management
Average Collection Period
• The average collection period represents the number of days’ worth of credit sales that
is locked in trade receivables. It is defined as:
• Note that the average collection period and the debtors’ turnover are related as follows:
• The average collection period may be compared with the firm’s credit terms to judge the
efficiency of credit management ( Credit term is 45 days& collection period is 85 days Vs
40 days)
Fixed Assets Turnover
• Fixed Assets Turnover measures sales per rupee of investment in fixed assets. It is
defined as:
• A high ratio indicates a high degree of efficiency in asset utilisation and a low ratio
reflects inefficient use of assets
• When the fixed assets of the firm are old and substantially depreciated, the fixed
assets turnover ratio tends to be high
Total Assets Turnover
• Total Assets Turnover ratio represents the output-capital ratio in economic analysis,
the total assets turnover is defined as:
• This ratio measures how efficiently assets are employed, overall.

Profitability Ratios
Profitability Ratios
• Profitability reflects the final result of business operations
• Profit margin ratios show the relationship between profit and sales such as gross
profit margin ratio and net profit margin ratio
• Rate of return ratios reflect the relationship between profit and investment. The
important rate of return measures are:
• Return on assets,
• Return on equity
Gross Profit Margin Ratio
• Gross profit is defined as the difference between revenues from operations and
cost of goods sold
• Cost of goods sold is the sum of manufacturing costs relating to the operating
revenues of the period. Manufacturing costs include material costs, employee
benefit costs for manufacturing personnel, and manufacturing expenses
• This ratio shows the margin left after meeting manufacturing costs. It measures
the efficiency of production as well as pricing
Net Profit Margin Ratio
• Net Profit Margin ratio shows the earnings left for shareholders (both equity and
preference) as a percentage of total revenues
• It measures the overall efficiency of production, administration, selling, financing,
pricing, tax management etc.
• It provides a valuable understanding of the cost and profit structure of the firm
and enable the analyst to identify the sources of business efficiency/inefficiency.
Return on Assets
• Return on assets (ROA) is an indicator of how profitable a company is relative to its
total assets
• ROA gives a manager, investor, or analyst an idea as to how efficient a company's
management is at using its assets to generate earnings
Return on equity (ROE)
• Return on equity (ROE) measures a corporation's profitability in relation to stockholders’
equity
• The return on equity is defined as:
• The numerator of this ratio is equal to profit after tax less preference dividends
• The denominator includes all contributions made by shareholders (paid-up capital +
reserves and surplus)
• The return on equity measures the profitability of equity funds invested in the firm
Valuation Ratios
Valuation Ratios
• Valuation ratios indicate how the equity and investor claims are
assessed in the capital market
• Since the market value reflects the combined influence of risk and
return, valuation ratios are the most comprehensive measures of a
firm’s performance
• The important valuation ratios are:
• Price-earnings ratio and
• Market value to book value ratio
Price-earnings Ratio
• The price-to-earnings (P/E) ratio relates a company's share price to its earnings per
share
• A high P/E ratio could mean that a company's stock is overvalued, or else that
investors are expecting high growth rates in the future
• The price-earnings ratio is a summary measure which primarily reflects the

following factors: growth prospects, risk characteristics, shareholder orientation,
corporate image, and degree of liquidity
Market Value to Book Value Ratio
• The market value to book value is defined as:
• This ratio reflects the contribution of a firm to the wealth of society

• If this ratio is, say, 2, the firm has created a wealth of one rupee for every rupee
invested in it
• When this ratio is equal to 1, it implies that the firm has neither contributed to nor
detracted from the wealth of society
Thank You..!!!
Financial Statement
Financial Statements
Calculate Following Ratios
• Current Ratio
• Acid-Test Ratio
• Debt-Equity Ratio
• Interest Coverage Ratio
• Inventory Turnover Ratio
• Debtors’ Turnover Ratio
• Average Collection period
• Fixed Asset Turnover Ratio
• Net Profit Margin Ratio
• Return on Assets Ratio

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FINANCIAL

By Dr. Mukesh Pal

• The important liquidity ratios are:

• Quick assets are defined as current assets excluding inventories

• This ratio measures how efficiently assets are employed, overall.

• The price-earnings ratio is a summary measure which primarily reflects the

• This ratio reflects the contribution of a firm to the wealth of society

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