Analysis by liaoqinmei



We know that Financial Accounting ends with
preparation   of    preparation   of    Financial
Statements i.e. Profit and Loss Account, Balance
Sheet (also Cash flow Statement in case of Listed

So when we talk about Analysis of Financial
Statement, we mean analysis of Profit and Loss
Account, Balance Sheet etc.

Then what is Analysis?

As per Dictionary, it is the separation of a whole
into its components for study and interpretation.
So analysis of       Financial Statement refers to
classification of the various items given in Financial
Statement and further its interpretation. It is the
powerful mechanism of ascertaining the financial
strengths and weaknesses of a firm.

The importance of making analysis of Financial
Statement may be better understood from this fact that
Financial Statement, though itself reflects the net
results for a particular period and state of affairs of the
company on that date, but still we have to go for
analysis of the same for more specific and deeper
understanding of strengths and weaknesses.

For example, NTPC Ltd., though a very good profit
making company, but often it faces fund problem
because of purchasing inputs from Coal India Ltd., GAIL
etc on cash basis while selling electricity to various
State Electricity Board on credit basis.
Types of Financial Analysis:

A)     External Analysis : Done by outsiders like
     Shareholders, Banks, Creditors, Clients etc

B) Internal Analysis : Done by Management,
     Employees etc

C) Horizontal Analysis: Financial statements for a
     number of years are reviewed, compared and

D) Vertical Analysis : The Analysis is made by
     reviewing the relationship quantitatively of various
     items in the financial statement on a particular
Techniques of Financial Analysis:
- Comparative Statements: In this case Comparative Balance Sheet
   and Comparative Income Statement are prepared on the basis of
   financial statement of two periods. The objective is to see the
   increase or decrease in assets, liabilities, income and
   expenditure in the current year as compared to last year (Say).
- Trend Analysis: Here one year is taken as the base year and
   increase or decrease in items of financial statements over a
   number of years is calculated based on the base year.
- Common Size statement: In this case one item say Net Sales of
   any year is taken as the base and all other items of the Income
   statement are evaluated in terms of % of net sales and then over
   the years, the increase or decrease in every item is analyzed.
- Ratio Analysis: So analysis is made on the basis of some important
- Cash Flow Statement: Sources and application of cash and cash
   equivalents are presented through a statement. As per the listed
   companies’ requirement, the sources and applications are
   presented under three heads i.e. Operation, Investment and
- Funds Flow Statement: In this case sources and application of
   funds are prepared through a statement. Here fund means
   working capital.
A Ratio refers to arithmetical or numerical relationship
between items or variables.

This relation can be expressed as percentage (%) or
Fraction (one-fifth) or Proportion (1:4).

So ratio analysis in the context of Financial Statement
refers to establishing an arithmetical relationship
between various items of the same, so as to draw
some meaningful conclusion from them. This is one of
techniques of analysis of Financial Statement.

It gives answers to various important questions such
as, Is the company financially viable? Will the
company be able to pay for its short term obligations?
Is the profitability of the company sufficient enough
for shareholders/Bank/Creditors? Etc.
Types of Ratios:

Ratios can be classified into the following
  four broad groups:

A) Liquidity Ratios

B) Capital Structure or Leverage Ratios

C) Profitability Ratios

D) Activity Ratios
Liquidity Ratios:

The objective of this ratio is to assess the ability of
  the firm to meet its current/short tem obligations.
The concerned users of this ratio here are
  creditors, Banks, who are interested in the short
  term solvency or liquidity of a firm.

Every company should strike a balance between
  two very essential contradictory requirements
  i.e. liquidity and profitability for efficient financial
  management. The example of NTPC Ltd., as
  already given is more appropriate to substantiate
  the aforesaid statement.

The appropriate ratios to throw light on liquidity are
   as follows :
A) Current Ratio
B) Liquid / Quick Ratio
C) Super Quick Ratio
1) Current Ratio:
                                 Current Assets
Current Ratio =                ---------------------------
                               Current liabilities

Current Assets include Cash and Bank Balance,
  Marketable Securities, Inventory, Debtors, Bills
  Receivable, Prepaid Expenses etc.

Current Liabilities include Creditors, Bills Payable,
  Bank Overdraft, Proposed Dividend, Provision for
  Taxation, Outstanding expense etc.

Current Ratio assesses short term solvency i.e. the
  ability to meet short term obligation of the
Subject to deeper enquiry, generally a current ration
  of 2:1 is considered satisfactory.
2) Liquid / Quick Ratio :
                                 Quick Assets
Quick Ratio =               ---------------------------
                               Current liabilities

Quick Assets: CA - (Inventory + Prepaid Expenses)

The idea behind Quick Ratio is to assess more strictly
  the firm’s ability to meet out short term obligations.

Inventory and prepaid expenses being excluded
   because these two items are generally considered
   less liquid-able than any other items of Current

Generally a quick ratio of 1:1 is                considered
  satisfactory, subject to deeper enquiry.
3) Super Quick / Acid Test Ratio:
                                Super Quick Assets
Super Quick Ratio =             ---------------------------
                                Current liabilities

In a more appropriate sense, this ratio is also
interpreted as follows:
                               Super Quick Assets
Super Quick Ratio =             ---------------------------
                               Quick liabilities

Super Quick Assets: Cash and marketable Securities
Quick Liabilities: Current Liabilities – Bank Overdraft

Super quick assets does not include also debtors and
bills receivable.
Bank overdraft being excluded because of its kind of
permanent nature with the Bank.

This ratio is the most strict and very conservative test
of the firm’s liquidity position.
General Interpretation of Liquidity Ratios:

  -- General rule of thumb or standard say 2:1 (for
  current ratio) or 1:1 (for quick ratio) is always
  subject to deeper scrutiny.

  -Liquidity ratios of number of years are to be
  reviewed so also to be compared with the best
  industrial standard, to arrive at a reasonable &
  logical ratio.

  - A higher current ratio may be generally
  acceptable while making inter-firm comparison.

  - A very high current ratio may not be
  acceptable due to the fact that the same may
  include higher inventory and prepaid expenses.
   General Interpretation Contd…

   - In case of rich countries, where long term funds
   are available, they may not depend on current
   liabilities to finance current assets. So in poor
   countries, a major portion of Current assets are
   financed by current liabilities.
   For example Hindustan Unilever Ltd. Generally
   asks for more credit period from suppliers than
   the credit period allowed to their clients. So
   major portion of their stock is financed by

- Similarly FMCG firms generally use to maintain low
current ratio as they have less need for current
assets compared to dealers who generally have
higher current ratio.

The ratios under this category are very relevant from
  the point of view of long term funds providers. They
  are interested to know whether the company is
  viable enough to refund the long term loan along
  with interest or whether the company shall be able
  to pay dividend to shareholders etc.

So ratios here focus on the long term solvency of the

The various ratios discussed under this head are as

A) Debt Equity Ratio
B) Interest Coverage Ratio
C) Dividend coverage Ratio
D) Capital Gearing Ratio
1) Debt Equity Ratio:
                    Outsiders’ Funds External Equities
Debt Equity Ratio = --------------------------- or ----------------------------
                    Insiders’ Funds                Internal Equities

                                 Total Debt
                         or       ----------------------------
                                 Shareholders’ Funds

                            Long Term Loan + Current Liabilities
                         =    ---------------------------------------------------------
                           Share Capital (Equity+Pref.)+ Reserve
                           &Surplus- Accumulated loss
General Interpretation :

   - This ratio reflects the proportion of owners’ stake in the
   business. Excess liabilities tend to cause insolvency and
   working capital problem.
   - There is standard of 2:1, which says that debts should
   not exceed twice of the Shareholders’ funds. (Subject to
   deeper enquiry)
   - A higher ratio shows a large share of financing by the
   creditors of the firm, a low ratio shows the opposite.
   - If a debt equity ratio is 1:2, it shows that for every rupee
   of outsiders, the firm has two rupee of owners’ capital. In
   other words, the stake of creditors is one-half of the
   owners. So creditors are safe.
   - If Debt equity ratio is high, the owners have liquidated
   their stake or if the project fails, the creditors would lose.
   So also it gives a very bad impression that owners do not
   have faith in their company.
General Interpretation Contd.

This can be substantiated by the glaring example of
Wipro, where once the Chief Mr. Azim Premji had said
that when he gets money, he purchases shares of his
company. If I don’t rely my company, then why others
will be interested?
    - A high debt equity ratio may not be good for the
    company also since creditors would start
    pressurizing the company and may like to interfere
    with the management.
    - A high D/E ratio also puts burden on the
    profitability of the company as less amount will be
    available for shareholders, so also the company
    may face problem in mobilization of further
    - A low D/E ratio implies sufficient margin available
    for creditors. The servicing of debt is also not that
    burdening. So more mobilization of funds is
2) Interest Coverage Ratio:

                        Net Profit before Interest & Tax
Interest Coverage Ratio = ------------------------------------------------------
                           Fixed Interest Charges

General Interpretation :

    - Higher the ratio, more safe are the long term creditors
       because even if earnings of the firm fall later, the firm
       shall be able to meet its commitment of fixed interest

    - But too high is not good, since it depict that company is
       not interested in major development activities.

    - Similarly a low ratio may point towards danger signal
       as the firm is using excessive debt and does not have
       the capacity to pay guaranteed interest to the
3) Dividend Coverage Ratio:
                           Earning after Tax
Dividend Coverage Ratio: = ----------------------------
                         Preference Dividend
General Interpretation:

   -   This ratio shows the ability of a firm to
       pay fix amount of dividend on preference

   - Like the interest coverage ratio, this ratio
      also ascertains the margin available to
      Preference Share Holders.
4)Capital Gearing Ratio :
                       Equity Share Capital + Res. & Surps.
Capital Gearing Ratio = ---------------------------------------------------------
                      Pref. Share Capital + Long Term Debt

General Interpretation:

    -    This ratio is calculated to test the long term
        financial position of a firm.

    - If numerator is higher than denominator, it’s a low
        gearing ratio and otherwise is high gearing ratio.

    - A high gearing ratio is not good for a new company or
       in such companies where future earnings are

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