Chapter – 14
Financial statement analysis
Sr. No Chapter outline - Topics
172 Financial statement analysis
173 Vertical Analysis
174 Horizontal Analysis
175 Ratio Analysis
176 Profitability Ratio
177 Liquidity Ratio
178 Debt Ratios or Leverage Ratios
179 Efficiency Ratios
180 Market Ratios or Owner Ratios
181 Cash Flow Ratios
182 Limitations in Financial Statement Analysis
Topic Videos 172-182 are mandatory part of this chapter
Topic 172 – Financial Statement Analysis
Forms of information:
1. Absolute form
2. Relative form
Mostly users look for analytical information that is provided in relative form to asses entity’s
performance and position.
Absolute Vs. Relative
Sample Co. Absolute Relative
in Rupees % of sales
Sales 800 100%
Cost of Sales 640 80%
Gross Profit 160 20%
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Simple Co Absolute Relative
in Rupees % of sales
Sales 1,800 100%
Cost of Sales 1,620 90%
Gross Profit 180 10%
Financial Statement Analysis
• Vertical Analysis
• Horizontal Analysis
• Ratio Analysis
• Cash Flow Analysis
Use of Analysis
• Interpretation
• Decision Making
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Topic 173 – Vertical Analysis
Up-down or Down-up
Vertical analysis restates balance sheet or income statement amounts as a percentage of total assets
(balance sheet) or net sales (income statement).
Common Size Analysis
Wherein, each item in the financial statement is shown as percentage of base figure.
Comparing results for two or more successive periods help in analyzing financial statements.
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Topic 174 – Horizontal Analysis
Line by Line Item Analysis
It analyses information of one accounting period (comparison period) with the same information of
other accounting period (base period).
• Chain analysis
• Index analysis
Chain Analysis
Sales in the year
Rs.
20X0 7,500
20X1 5,400 72% of 20X0
20X2 10,500 194% of 20X1
20X3 11,250 107% of 20X2
Index Analysis
Sales in the year
Rs.
20X0 7,500 Base Year
20X1 5,400 72%
20X2 10,500 140%
20X3 11,250 150%
Spotting Trend
Normally two accounting periods are required for a valid comparison.
In order to spot actual trends, it’s better to include three or more accounting periods when calculating
horizontal analysis.
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Topic 175 – Ratio Analysis
Financial Performance
A process of ascertaining the financial ratios for indicating the ongoing financial performance of an
entity.
Types of Ratio Analysis
• Profitability Ratios
• Liquidity Ratios
• Debt or Leverage Ratios
• Efficiency Ratios
• Market or Owners Ratios
Management Tool
Ratio analysis is a useful management tool that improves understanding of financial results and trends
over time, and provides key indicators of organizational performance.
Use of Ratio Analysis
Managers use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives
can be formed.
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Topic 176 – Profitability Ratios
Profitability Ratios
These ratios measure an entity’s ability to generate profits relative to revenue, costs, assets and equity.
Ratios Include
• Profit on sales
• Cost of goods sold on sales
• Specific expense on sales
• Return on capital employed
• Return on owners’ equity
• Return on Assets
Other Profitability Ratios
• Markup rate
• Analysis of different profits on sales
• Percentage annual growth in sales
• Percentage annual change in operating expenses
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Topic 177 – Liquidity Ratios
Liquidity Ratios
These are the financial ratios that measure an entity’s ability to repay both short term and long-term
obligations.
Ratios Include
• Current Ratio
• Acid Test Ratio
• Cash Ratio
• Operating Cash Flow Ratio
Liquidity Position
Holding excessive liquid assets is always a bad sign. Liquidity should be managed in a way that current
and noncurrent obligation could be managed conveniently.
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Topic 178 – Debt/Leverage Ratios
Leverage Ratios
These are the financial ratios that measure the amount of capital that comes from debt. In other words,
leverage financial ratios are used to evaluate an entity’s debt levels.
Ratios Include
• Debt Ratio
• Debt to Equity
• Gearing Ratio
• Interest Coverage Ratio
High Geared Vs. Low Geared
• An entity is high-geared when its gearing ratio is above 50%
• An entity is low-geared when its gearing ratio is below 50%
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Topic 179 – Efficiency Ratios
Efficiency Ratios
These are also known as activity financial ratios. Efficiency Ratios are used to measure how well an
entity is utilizing its assets and other resources.
Ratios Include
• Asset Turnover Ratio
• Inventory Turnover Ratio
• Receivable Turnover Ratio
• Inventory Holding Period
• Receivable Collection Period
Alternative Replacements
• Total sales instead of credit sales
• Total purchases instead of credit purchases
• Ending Accounts Receivable instead of average amount
• Ending Accounts Payable instead of average amount
• Ending Inventory instead of average amount
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Topic 180 – Market/Owners’ Ratios
Market Ratios
These are also known as Owners or Shareholders Ratios.
Market ratios are used to evaluate the share price of an entity’s stock.
Ratios Include
• Book Value Per Share
• Dividend Yield Ratio
• Earnings Per Share
• Price Earnings Ratio
Potential and Current Investors
Current and potential investors are interested to know the results of market ratios that are also known
as investors’ ratios or shareholders’ ratios.
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Topic 181 – Cash Flow Ratios
Cash Flow Ratios
Cash flow ratios compare cash flows to other elements of an entity’s financial statements.
These ratios are especially important when evaluating entities whose cash flows diverge substantially
from their reported profits.
Ratios Include
• Cash flow coverage ratio
• Current liability coverage ratio
• Cash flow margin ratio
• Price to cash flow ratio
• Cash flow to net income
Indicator
A higher level of cash flow indicates a better ability to withstand declines in operating performance, as
well as a better ability to pay dividends to investors.
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Topic 182 – Limitations in Financial Statement Analysis
Limitations
Financial Statement analysis is used to compare relative information and to gain an analytical
understanding of financial position, financial performance and cash flows of an entity.
This analysis is a useful tool, however, there are a number of limitations.
Historical
Information used in the analysis is derived from actual historical results.
This does not mean that the same results will be carried forward in the future.
Historical Vs. Current Cost
Information on the income statement is stated in current costs (or close to it), whereas many elements
of the balance sheet are stated at historical cost.
This disparity may result in unusual ratio results.
For example, assets turnover ratio.
Inflationary effect
If the rate of inflation has changed in any of the periods under review, this can mean that the numbers
are not comparable across periods.
For example, if the inflation rate was 100% in one year, sales would appear to have doubled over the
preceding year, whereas in fact sales did not change at all.
Accounting policies and estimates
Different entities in a similar industry may have different policies for recording the same accounting
transaction.
For example, one entity may use reducing balance method while another entity uses straight-line
method for depreciation.
Interpretation
It can be quite difficult to ascertain the reason for the results of a ratio.
For example, an “acid-test ratio of 1.2:1” might appear to be excellent, until one realizes that the entity
just sold a large amount of its stock to bolster its cash position.
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