Notes - Financial Statement Analysis
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24.1 Introduction to Financial Statement Analysis
The process of critical evaluation of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm is called financial statement analysis.
24.1.1 Objectives of Financial Statement Analysis
24.1.2 Importance of Analysis of Financial Statements
The following are the importance of analysis of financial statements
(i) It helps in evaluating the earning capacity of the business concerns.
(ii) It helps in predicting the future earning capacity of the business concerns.
(iii) It helps to point out the areas wherein the managers have shown better efficiency and the areas of inefficiencies.
(iv) It helps in assessing own performance as well as that of others.
(v) It helps in preparation of budgets.
24.1.3 Types of Financial Statement Analysis
External Analysis This analysis is done by outsiders who do not have access to the detailed internal accounting records of the business firm. (Investors, creditors, government agencies, credit agencies and general public).
Internal Analysis This analysis is conducted by persons who have access to the internal accounting records of a business firm. (Executives and records of a business firm. Executives and employees of the organisation and government agencies which have statutory powers vested in them.)
Horizontal Analysis Analysis of changes in different components of the financial statements over different periods with the help of series of the statements is known as ‘Horizontal Analysis’. It is also known as ‘Dynamic Analysis’.
Vertical Analysis Vertical analysis refers to the study of relationship of the various items in the financial statements of one accounting period. Since this sort of analysis examines relationships between different components for a given point of time and does not shed light on changing behaviour of the above relationships, it is also regarded as ‘Static Analysis’. Common-size statements are the form of vertical analysis.
24.1.4 Limitations of Financial Statement Analysis
Following are the drawbacks or limitations of analysis of financial statements
24.1.5 Parties Interested in Financial Statement Analysis
24.1.6 Tools or Techniques for Financial Statement Analysis
Comparative Financial Statements
It includes
Common Size Statements
It includes
Statement in which amount of revenue from operations (net sales) is assumed to be equal to 100 and other amounts are expressed as percentage of revenue from operations (net sales) is common size income statement.
24.2 Fund Flow Statement
It is a statement in which the changes in the financial position of a business unit are studied. It is a statement showing sources and uses of funds for a period of time. Fund means working capital.
So, basically a fund flow statement studies the changes in current assets and current liabilities in the course of an accounting year.
24.2.1 Objectives of Fund Flow Statement
24.2.2 Procedure of Preparation of Fund Flow Statement
Following steps are taken to prepare fund flow statement
Step 1 Preparation of schedule of changes in working capital to determine Increase/Decrease in working capital.
Step 2 Calculation of fund from operations.
Step 3 Preparation of fund flow statement.
Schedule of Changes in working Capital
Particulars |
Previous Year |
Current Year |
Increase in Working Capital (+) |
Decrease in Working Capital (-) |
(A) Current Assets:
Cash in Hand
Cash at Bank
Marketable Securities
Bills Receivable
Sundry Debtors
Closing Stock
Prepaid Expenses
Total (A) |
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(B) Creditors Bills Payable
Outstanding Expenses
Pre-received Income
Provision for doubtful and bad debts
Total (B)
Net Working Capital (A-B)
Increase/Decrease in Working Capital |
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Total |
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Calculation of Funds from Operation
Net Profit earned during the year ADD Non-Fund and Non-operating items which are already debited to profit and loss a/c Depredation on fixed Assets Goodwill written-off Discount on issue of shares, written-off Preliminary expenses written-off Patents written-off Transfer to reserves Loss on sale of fixed assets LESS Non-fund and Non-operating items which are already Credited to profit and loss a/c Profit on sale of fixed assets Profit on revaluation of assets Rent received Dividend received Refund of income tax |
xxx
xxx xxx xxx xxx xxx xxx xxx xxx
xxx xxx xxx
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Funds from Operations |
xxx |
Fund Flow Statement
Source of Fund |
Amount (`) |
Uses of Funds |
Amount (`) |
Fund from Operation Issue of share Issue of debenture Long-term loans Sales of fixed assets/Investment Non-trading receipts Decrease in working capital (if any)
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xxx xxx xxx xxx xxx xxx xxx
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Loss from Operation Redemption of preference shares Redemption of debentures Repayment of long-term loans Purchase of fixed assets/Investments Payment of dividend and taxes Increase in working capital
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xxx xxx xxx xxx xxx xxx xxx
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xxx |
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xxx |
24.3. Cash Flow Statement
It is a statement showing the changes in financial position of a business concern during different intervals of time in terms of cash and cash equivalents.
Cash Flows It implies movement of cash in and out of non-cash items. Receipt of cash from a non-cash item is termed as cash inflow while cash payment in respect of such items is termed as cash outflow.
Cash and Cash Equivalents As per AS-3, ‘cash’ comprises cash in hand and demand deposits with banks and ‘cash equivalents’ means short-term highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value, e.g. Short-term marketable securities, which can be readily converted into cash, are treated as cash equivalents.
24.3.1 Objectives of Cash Flow Statement
The main objectives of cash flow statement are as follows
24.3.2 Classification of Business Activities
Accounting Standard-3 (Revised) requires that the changes resulting in inflows and outflows of cash and cash equivalents be classified into following three activities
Cash Flow from Operating Activities
Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.
Cash Flow from Investing Activities
As per AS-3, investing activities are the acquisition and disposal of the long-term assets and other investments, not included in cash equivalents. Cash flow from investing activities are exhibited as follows
Cash Flow from Financing Activities
These are the activities which result in change in the size and composition of the owner’s capital (including preference share capital) and borrowings (including debentures) of the enterprise from other sources.
Cash flow arising from financing activities are exhibited as follows
Format of Cash Flow Statement
Indirect Method [As per Accounting Standard-3 (Revised)]
for the year ended...
Particulars |
Amt (`) |
I. Cash Flow from Operating Activities |
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Net Profit before Taxation and Extraordinary Items |
... |
Adjustments for |
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(+) Items to be Added |
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Depreciation ... |
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Goodwill, Patents and Trademarks Amortised ... |
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Interest on Borrowings and Debentures ... |
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Loss on Sale of Fixed Assets ... |
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Increase in Provision for Doubtful Debts … |
… |
(\[-\]) Items to be Deducted |
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Interest Income (...) |
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Dividend Income (...) |
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Rental Income (...) |
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Gain (Profit) on Sale of Fixed Assets (...) |
(...) |
Operating Profit before Working Capital Changes |
… |
(+) Decrease in Current Assets and Increase in Current liabilities |
... |
(\[-\]) Increase in Current Assets and Decrease in Current Liabilities |
(...) |
Cash Generated from Operations |
… |
(\[-\]) Income Tax Paid (Net of tax refund received) |
(...) |
Cash Flow before Extraordinary Items |
… |
(+/\[-\]) Extraordinary Items |
… |
Net Cash from (or used in) Operating Activities |
… |
II. Cash Flow from Investing Activities |
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Proceeds from Sale of Tangible Fixed Assets … |
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Proceeds from Sale of Investments (Other than marketable securities) ... |
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Proceeds from Sale of Intangible Fixed Assets ... |
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Interest and Dividend Received (For non-financial companies only) … |
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Rent Received … |
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Purchase of Tangible Fixed Assets (...) |
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Purchase of Investments (Other than marketable securities) (...) |
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Purchase of Intangible Fixed Assets like Goodwill (...) |
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(+/\[-\]) Extraordinary Items … |
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Net Cash from (or used in) Investing Activities |
… |
III. Cash Flow from Financing Activities |
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Proceeds from Issue of Shares and Debentures … |
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Proceeds from Other Long-term Borrowings … |
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Increase/Decrease in Bank Overdraft and Cash Credit … |
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Final Dividend Paid (...) |
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Interim Dividend Paid (...) |
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Interest on Debentures and Loans (…) |
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Repayment of Loans (…) |
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Redemption of Debentures/Preference Shares (...) |
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(+/-) Extraordinary Items … |
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Net Cash from (or used in) Financing Activities |
… |
IV. Net Increase/Decrease in Cash and Cash Equivalents (I+II+III) |
… |
V. (+) Cash and Cash Equivalents in the Beginning of the Year |
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Cash in Hand ... |
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Cash at Bank ... |
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Short-term Deposits ... |
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Marketable Securities … |
… |
VI. Cash and Cash Equivalents at the End of the Year |
… |
Cash in Hand ... |
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Cash at Bank ... |
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Short-term Deposits ... |
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Marketable Securities … |
… |
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... |
Note · Amounts in brackets indicate negative amounts, i.e. amounts that are to be deducted. · Increase/decrease in unpaid interest on debentures/loans affects the cash flow from financing activities and not from the operating activities. · Increase/decrease in unclaimed dividend affects the cash flow from financing activities and not from the operating activities. · Increase/decrease in accrued interest on investments affects the cash flow from investing activities and not from the operating activities. |
24.4 Ratio Analysis
It is a technique which involves regrouping of data by application of arithmetical relationships. It is the most important and powerful tool for measuring performance of a business enterprises.
24.4.1 Objectives of Ratio Analysis
Classification or Types of Ratios
Ratio |
Formula |
Explanation |
Liquidity Ratios
1.
2. |
Current Ratio
Liquid Ratio/ Acid Test Ratio/ Quick Ratio |
\[\frac{Current\text{ }Assets}{Current\text{ }Liabilities}=...:...\]
\[\frac{Quick\text{ }Assets\text{ }or\text{ }Liquid\text{ }Assets}{Current\text{ }Liabilities}=...:...\] |
Current Assets = Current Investments + Inventories (Excluding stores and spares and loose tools) + Trade Receivables (Net of provision for doubtful debts) + Cash and Cash Equivalents + Short-term Loans and Advances + Other Current Assets Current Liabilities = Short-term Borrowings + Trade Payables + Other Current Liabilities + Short-term Provisions
Quick Assets = Current Assets - Inventories - Prepaid Expenses |
Solvency Ratios
1.
2.
3.
4. |
Debt Equity Ratio
Total Assets to Debt Ratio
Proprietary Ratio
Interest Coverage Ratio |
\[\frac{Debt}{Equtiy\,(Shareholder's\,Funds)}=...:...\]
\[\frac{Total\,Assets}{Long-term\text{ }Debt}=...\,:...\]
\[\frac{Shareholders\text{ }Funds\text{ }or\text{ }Proprietors\text{ }Funds}{Total\,Assets}=...%\]
\[\frac{Net\text{ }Profit\text{ }before\text{ }Interest\text{ }and\text{ }Tax}{Interest\text{ }on\text{ }Long-term\text{ }Debt}=...\,times\] |
Debt = Long-term Borrowings (i.e. debentures, mortgage, public deposits) + Long-term Provisions Shareholders’ Funds = Share Capital + Reserves and Surplus Or. Non-current Assets (Tangible assets + Intangible assets + Non-current investments + Long-term loans and advances) + Working Capital \[-\] Non-current Liabilities (Long-term borrowings + Long-term provisions) Working Capital = Current Assets \[-\]Current Liabilities
Total Assets = Non-current Assets (Tangible assets + Intangible assets + Non-current investments + Long-term loans and advances) + Current Assets [Current investments + Inventories (Including stores and spares and loose tools) + Trade receivables + Cash and cash equivalents + Short-term loans and advances] + Other Current Assets Debt = Long-term Borrowings + Long-term Provisions
Shareholders’ Funds = Share Capital + Reserves and Surplus Total Assets as per Total Assets to Debt Ratio.
Profit before Interest and Tax = Profit after Tax + Tax + Interest |
Activity Ratios/Turnover Ratios
1. |
Inventory (Stock) Turnover Ratio |
\[\frac{Cost\text{ }of\text{ }Revenue\text{ }from\text{ }Operations}{Average\text{ }Inventory}=...times\] |
Average Inventory or Stock Opening Inventory or Stock \[=\frac{+\text{ }Closing\text{ }Inventory\text{ }or\text{ }Stock}{2}\] |
2. |
Trade Receivables or Debtors Turnover Ratio |
\[\frac{Credit\text{ }Revenue\text{ }from\text{ }Operations}{Average\text{ }Trade\text{ }Receivables}=...times\] ...tunes urnover Ratio ( |
Trade receivables means debtors plus bills receivables. Provision for doubtful debts is not deducted. Average Trade Receivables (Opening Debtors +Opening Bills Receivables) \[\frac{+\text{ }(Closing\text{ }Debtors+Closing\text{ }Bills\,Receivables)}{2}\] |
3. |
Trade Payables or Creditors’ Turnover Ratio |
\[\frac{Net\text{ }Credit\text{ }Purchases}{Average\text{ }Trade\text{ }Payables}=...times\]
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Trade payables means creditors plus bills payable. Average Trade Payables (Opening Creditors + Opening Bills Payable) \[=\frac{+\left( Closing\text{ }Creditors+Closing\text{ }Bills\text{ }Payable \right)}{2}\] |
4. |
Working Capital Turnover Ratio |
\[=\frac{Revenue\text{ }from\text{ }Operations}{Working\text{ }Capital}=...times\] |
Working Capital = Current Assets - Current Liabilities Current Assets = As per Current Ratio Current Liabilities = As per Current Ratio |
Profitability Ratios
1. |
Gross Profit Ratio Net Profit Ratio |
\[\frac{Gross\text{ }Profit}{Revenue\text{ }from\text{ }Operations}\times 100=...%~\] |
Gross Profit = Revenue from Operations \[-\] Cost of Revenue from Operations Cost of Revenue from Operations = Opening Inventory (Excluding stores and spares and loose tools) + Net Purchases + Direct Expenses \[-\] Closing Inventory (Excluding stores and spares and loose tools) Or Revenue from Operations \[-\] Gross Profit Or Cost of Materials Consumed + Purchases of Stock-in-trade + Change in Inventories of Finished Goods, WIP and Stock-in-trade + Direct Expenses. If direct expenses are not given, assume it to be nil. |
2. |
Operating Ratio |
Cost of Revenue from Operations \[\frac{+\,Operating\,Expenses}{Revenue\text{ }from\text{ }Operations}\times 100=...%~\] |
Cost of Revenue from Operations = Opening Inventory (excluding stores and spares and loose tools) + Net Purchases + Direct Expenses \[-\] Closing Inventory (Excluding stores and spares and loose tools) Or Revenue from Operations \[-\] Gross Profit Or Cost of Materials Consumed + Purchases of Stock-in-trade + Change in Inventories of Finished Goods, WIP and Stock-in-trade + Direct Expenses If direct expenses are not given, assume it to be nil Revenue from Operations = Sales \[-\] Sales Return Operating Expenses = Employees Benefit Expenses + Other Expenses (Other than non-operating expenses). |
3. |
Operating Profit Ratio |
\[\frac{Operating\,\Pr ofit}{Revenue\text{ }from\text{ }Operations}\times 100=...%~\] |
Operating Profit = Net Profit (before tax) + Non-operating Expenses \[-\] Non-operating Income Or Gross Profit + Operating Income \[-\] Operating Expenses Non-operating Expenses = Interest on Long-term Borrowings + Loss on Sale of Fixed Assets or Non-current Assets Non-operating Income = Interest Received on Investments + Profit on Sale of Fixed Assets or Non-current Assets |
4. |
Net Profit Ratio |
Net Profit before \[=\frac{Interest\text{ }and\text{ }Tax}{Revenue\text{ }from\text{ }Operations}\times 100=...%~\] |
Net Profit before Interest and Tax = Gross Profit + Other Income \[-\] Indirect Expenses |
5. |
Return on Investment or Return on Capital Employed |
Net Profit before Interest \[=\frac{Tax\text{ }and\text{ }Preference\text{ }Dividend}{Capital\text{ }Employed}\times 100=...%~\]
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Capital Employed Liabilities Approach: Share Capital + Reserves and Surplus + Long-term Borrowings + Long-term Provisions Assets Approach: Non-current Assets (Tangible assets + Intangible assets) + Non-current Investments + Long-term Loans and Advances + Working Capital Working Capital = Current Assets \[-\] Current Liabilities (Assume that all non-current investments are trade investments). (Interest on non-trade investments should be deducted from profit before interest, tax and dividend). |
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