1. Analytical techniques used
 Horizontal analysis
 Trend analysis
 Common size statement
 Ratios

3. 3,500.00
3,000.00
2,500.00
2,000.00
Total Income
1,500.00
Total Expenditure
1,000.00
Operating Profit
500.00
-

6. Basics of Financial Statement Analysis
Analyzing financial statements involves:
Comparison Tools of
Characteristics
Bases Analysis
Liquidity Intra- Horizontal
Profitability company Trend
Solvency Industry Vertical
averages
Efficiency Ratio
Inter-
company

8.  Measure the short-term ability of the company to pay
its maturing obligations and to meet unexpected needs
for cash.
 Short-term creditors such as bankers and suppliers
are particularly interested in assessing liquidity.
 Ratios include the i. Net Working Capital ii. Current
ratio iii. Acid-test ratio, iv. Turnover ratios v.
Defensive interval ratio and vii. Cash flow from
operation ratio

9.  Net working capital = Current Assets- Current Liabilities
Current Assets – Represent those assets which can be converted into
cash within a short period of time, normally not exceeding one year
and include Cash, Bank balance, Marketable
securities, Inventories, Debtors, Bills receivables and Prepaid
expenses
Current Liabilities – Represent those which are short-term maturing
obligations to be met within a year. Consist of Trade creditors, Bills
payable, Bank credit, Short term provisions and Outstanding
expenses

10. Details Company X Company Y
Total current assets 2,40,000 50,000
Total current Liabilities 1,50,000 20,000
Net working capital (CA-CL) 90,000 30,000

11. Current Ratio: It is the relationship between the current
assets and current liabilities of a concern. This ratio must be
at least 2 : 1 to ensure minimum margin of 25% of current
assets as margin from long term sources
Current Ratio = Current Assets/Current Liabilities
ACID TEST or QUICK RATIO: It is the ratio between Quick Current
Assets and Current Liabilities. The should be at least equal
to 1
Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

12. Cash 50,000
Debtors 1,00,000
Inventories 1,50,000
Current Liabilities 1,00,000
Total Current Assets 3,00,000
Current Ratio => 3,00,000/1,00,000 = 3:1
Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1

13. Turnover ratios
Inventory turnover ratio = Cost goods sold/Av.Inventory
Sales = 3,00,000
GP = 20%
Stock at the beginning and at the End = 35,000 & 45000
Inventory holding period = 12 months/ Inventory turnover ratio
These ratios indicate the number of times the inventory is
rotated during the relevant accounting period

14.  Debtors turnover ratio = Net credit Sales/Av.Debtors
Total Sales = 2,70,000
Cash Sales = 30,000
Debtors at the Beginning and at the End = 27,500 and 32,500
Debtors collection period = 12 months/ Debtors turnover ratio
Measures how rapidly receivables are collected

15.  Creditors turnover ratio = Net credit purchase/ Av.creditors
Total purchase = 2,00,000
Cash purchase = 10%
Creditors at the beginning and at the End = 42,500 and 47,500
Creditors payment period=12months/ Creditors turnover ratio
The extent to which trade creditors are willing to wait for
payment

16. Debt-Equity Ratio = Total debt/ Shareholder’s equity
Measures the relationship between borrowed fund and owner’s
capital
Proprietary ratio = (Proprietor’s fund/Total assets) x 100
It indicates the extend to which assets are financed by owners
fund

17. Interest Coverage Ratio
Interest Coverage Ratio measures the firm’s ability to make
contractual interest payments.
EBIT (Earning before interest and taxes)
Interest coverage ratio =
Interest
Dividend Coverage Ratio
Dividend Coverage Ratio measures the firm’s ability to pay dividend
on preference share which carry a stated rate of return.
EAT (Earning after taxes)
Dividend coverage ratio =
Preference dividend

18. Total fixed charge coverage ratio
Total fixed charge coverage ratio measures the firm’s ability to meet all
fixed payment obligations.
Total fixed charge EBIT + Lease Payment
coverage ratio =
Interest + Lease payments + (Preference dividend
+ Instalment of Principal)/(1-t)
Total Cashflow Coverage Ratio
However, coverage ratios mentioned above, suffer from one major
limitation, that is, they relate the firm’s ability to meet its various
financial obligations to its earnings. Accordingly, it would be
more appropriate to relate cash resources of a firm to its
various fixed financial obligations.
EBIT + Lease Payments + Depreciation + Non-cash expenses
Total cashflow
=
coverage ratio (Principal repayment) (Preference dividend)
Lease payment +
+
+ Interest (1– t) (1 - t)

19. Debt-service coverage ratio (DSCR) is considered a more
comprehensive and apt measure to compute debt
service capacity of a business firm.
n
∑ EATt + Interestt + Depreciationt + OAt
=
t=1
DSCR
Iinstalmentt
n
∑
t=1
DEBT SERVICE CAPACITY
Debt service capacity is the ability of a firm to make the
contractual payments required on a scheduled
basis over the life of the debt.

20. Agro Industries Ltd has submitted the following projections. You
are required to work out yearly debt service coverage ratio (DSCR)
and the average DSCR.
(Figures in Rs lakh)
Year Net profit for the Interest on term loan Repayment of term
year during the year loan in the year
1 21.67 19.14 10.70
2 34.77 17.64 18.00
3 36.01 15.12 18.00
4 19.20 12.60 18.00
5 18.61 10.08 18.00
6 18.40 7.56 18.00
7 18.33 5.04 18.00
8 16.41 Nil 18.00
The net profit has been arrived after charging depreciation of Rs 17.68 lakh
every year.

21. Table 3: Determination of Debt Service Coverage Ratio
(Amount in lakh of rupees)
Ye Net Depreciation Interest Cash Principal Debt DSCR [col. 5
ar profit available instalment obligation ÷ col. 7
(col. (col. 4 + col. 6) (No. of times)]
2+3+4)
1 2 3 4 5 6 7 8
1 21.67 17.68 19.14 58.49 10.70 29.84 1.96
2 34.77 17.68 17.64 70.09 18.00 35.64 1.97
3 36.01 17.68 15.12 68.81 18.00 33.12 2.08
4 19.20 17.68 12.60 49.48 18.00 30.60 1.62
5 18.61 17.68 10.08 46.37 18.00 28.08 1.65
6 18.40 17.68 7.56 43.64 18.00 25.56 1.71
7 18.33 17.68 5.04 41.05 18.00 23.04 1.78
8 16.41 17.68 Nil 34.09 18.00 18.00 1.89
Average DSCR (DSCR ÷ 8) 1.83

22. Profitability ratios can be computed either from
sales or investment.
Profitability Ratios Profitability Ratios
Related to Sales Related to Investments
(i) Profit Margin (i) Return on Investments
(ii) Expenses Ratio (ii) Return on Shareholders’
Equity
© Tata McGraw-Hill Publishing 6
Company Limited, Management -
Accounting 22

23. Gross Profit Margin
Gross profit margin measures the percentage of each sales
rupee remaining after the firm has paid for its goods
Gross profit margin = Gross Profit
X 100
Sales
© Tata McGraw-Hill Publishing 6
Company Limited, Management -
Accounting 23

24. Net Profit Margin
Net profit margin measures the percentage of each sales rupee
remaining after all costs and expense including interest
and taxes have been deducted.
Net profit margin can be computed in three ways
Earning before interest and taxes
i. Operating Profit Ratio =
Net sales
Earnings before taxes
ii. Pre-tax Profit Ratio =
Net sales
Earning after interest and taxes
iii. Net Profit Ratio = Net sales

25. From the following information of a firm, determine (i)
Gross profit margin and (ii) Net profit margin.
1. Sales Rs 2,00,000
2. Cost of goods sold 1,00,000
3. Other operating expenses 50,000
Rs 1,00,000
(1) Gross profit margin = = 50 per cent
Rs 2,00,000
Rs 50,000
(2) Net profit margin = = 25 per cent
Rs 2,00,000

26. Cost of goods sold
i. Cost of goods sold = X 100
Net sales
Administrative exp. + Selling exp.
ii. Operating expenses = X 100
Net sales
Administrative expenses
iii. Administrative expenses = X 100
Net sales
Selling expenses
iv. Selling expenses ratio = X 100
Net sales
Cost of goods sold + Operating expenses
v. Operating ratio = X 100
Net sales
Financial expenses
vi. Financial expenses = X 100
Net sales

27. Return on Investments measures the overall effectiveness
of management in generating profits with
its available assets.
i. Return on Assets (ROA)
EAT + (Interest – Tax advantage on interest)
ROA =
Average total assets
ii. Return on Capital Employed (ROCE)
EAT + (Interest – Tax advantage on interest)
ROCE =
Average total capital employed

28. Return on shareholders equity measures the return on the
owners (both preference and equity shareholders )
investment in the firm.
Return on total shareholders’ fund =
Net profit after taxes
X 100
Average total shareholders’ fund
Return on ordinary shareholders’ equity (Net worth) =
Net profit after taxes – Preference dividend
X 100
Average ordinary shareholders’ equity

29. Activity ratios measure the speed with which various
accounts/assets are converted into sales or cash.
Inventory turnover measures the efficiency of various types
of inventories.
Cost of goods sold
i. Inventory Turnover measures the activity/liquidity of
Inventory Turnover Ratio =
Average inventory
inventory of a firm; the speed with which inventory is sold
Cost of raw materials used
i. Inventory Turnover measures the activity/liquidity of
Raw materials turnover =
inventory of a firm; the speed with which inventory is sold
Average raw material
inventory
i. Inventory Turnover measures the of goods manufactured
Cost activity/liquidity of
Work-in-progress turnover =
inventory of a firm; the speed with work-in-progressis sold
Average which inventory inventory

30. Debtors Turnover Ratio
Liquidity of a firm’s receivables can be examined
in two ways.
Credit sales
i. Debtors turnover = measures the activity/liquidity of inventory
i. Inventory Turnover
of a firm; the speed with which inventory is sold
Average debtors + Average bills receivable (B/R)
Months (days) in a year
2. Average collection period =
Debtors turnover
i. Inventory= Months (days) in a year (x) activity/liquidity + Average (B/R)
Turnover measures the (Average Debtors of inventory
Alternatively
of a firm; the speed with which inventory sales
Total credit is sold
Ageing Schedule enables analysis to identify
slow paying debtors.

31. Assets turnover indicates the efficiency with which firm
uses all its assets to generate sales.
Inventory Turnover measures theof goods sold
i. Total assets turnover =
i.
Cost activity/liquidity of inventory
of a firm; the speed with which inventory isassets
Average total sold
Cost of goods sold
ii. Fixed assets turnover =
Average fixed assets
Cost of goods sold
i. Inventory Turnover measures the activity/liquidity of inventory
iii. Capital turnover = Average capital employed
of a firm; the speed with which inventory is sold
Cost of goods sold
iv. Current assets turnover =
Average current assets
i. Inventorycapital turnover = Cost of goods sold
v. Working Turnover measures the activity/liquidity of inventory
of a firm; the speed with which inventory iscapital
Net working sold

32. 1) Return on shareholders’ equity = EAT/Average total shareholders’ equity
2) Return on equity funds = (EAT – Preference dividend)/Average ordinary
shareholders’ equity (net worth)
3) Earnings per share (EPS) = Net profit available to equity shareholders’ (EAT
– Dp)/Number of equity shares outstanding (N)
4) Dividends per share (DPS) = Dividend paid to ordinary
shareholders/Number of ordinary shares outstanding (N)
5) Earnings yield = EPS/Market price per share
6) Dividend Yield = DPS/Market price per share
7) Dividend payment/payout (D/P) ratio = DPS/EPS
8) Price-earnings (P/E) ratio = Market price of a share/EPS
9) Book value per share = Ordinary shareholders’ equity/Number of equity
shares outstanding

33. Integrated ratios provide better insight about financial and
economic analysis of a firm.
(1) Rate of return on assets (ROA) can be decomposed in to
(i) Net profit margin (EAT/Sales)
(ii) Assets turnover (Sales/Total assets)
(2) Return on Equity (ROE) can be decomposed in to (DU PONT)
(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)

34. Earning Power
Earning power is the overall profitability of a firm; is computed
by multiplying net profit margin and
assets turnover.
Earning power = Net profit margin Assets turnover
Where, Net profit margin = Earning after taxes/Sales
Asset turnover = Sales/Total assets
i. Inventory Turnover measurestaxes x
Earning Power =
Earning after the activity/liquidity of inventory
Sales
x
EAT
of a firm; the speed with which inventory is sold
Sales Total Assets Total assets

35. Assume that there are two firms, A and B, each having total assets
amounting to Rs 4,00,000, and average net profits after
taxes of 10 per cent, that is, Rs 40,000, each.
Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate
Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows
the ROA based on two components.
Return on Assets (ROA) of Firms A and B
Particulars Firm A Firm B
1. Net sales Rs 4,00,000 Rs 40,00,000
2. Net profit 40,000 40,000
3. Total assets 4,00,000 4,00,000
4. Profit margin (2 ÷ 1) (per cent) 10 1
5. Assets turnover (1 ÷ 3) (times) 1 10
6. ROA ratio (4 × 5) (per cent) 10 10