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Chapter 3: Analysis of Financial Statements

3.1 Financial Statements of a Company

Financial statements are the written records that convey the business activities and the financial performance of a company. For a company, they primarily include:

  1. Balance Sheet: Showing the financial position on a particular date.
  2. Statement of Profit and Loss: Showing the financial performance over a given period.
  3. Cash Flow Statement: Discloses the cash flows during the period.

Format of Balance Sheet (Schedule III, Companies Act 2013)

The Balance Sheet of a company is presented in vertical format. Equities and Liabilities include:

  1. Shareholders’ Funds (Share Capital, Reserves and Surplus)
  2. Non-Current Liabilities (Long-term borrowings)
  3. Current Liabilities (Trade payables, short-term borrowings)

Assets include:

  1. Non-Current Assets (Property, Plant, and Equipment, Intangible assets)
  2. Current Assets (Inventories, Trade receivables, Cash and cash equivalents)

3.2 Tools for Financial Statement Analysis

  • Comparative Statements: Show absolute data, changes in absolute data, and percentage changes between multiple periods.
  • Common Size Statements: Every item in the statement is shown as a percentage of a common base (e.g., Revenue from Operations for P&L, Total Assets for Balance Sheet).

3.3 Accounting Ratios

Accounting ratios represent the arithmetic relationship between two interconnected accounting figures.

Accounting Ratios Liquidity Solvency Activity Profitability Current, Quick Debt to Equity Inventory Turnover Net Profit, ROI

Fig 3.1: Classification of Accounting Ratios

1. Liquidity Ratios

  • Current Ratio: Measures short-term ability to pay current liabilities. \[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
  • Quick / Liquid Ratio: Measures immediate liquidity. \[ \text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} \] (Where Quick Assets = Current Assets - Inventory - Prepaid Expenses)

2. Solvency Ratios

  • Debt to Equity Ratio: \[ \text{Debt to Equity Ratio} = \frac{\text{Debt (Long-term Borrwings)}}{\text{Equity (Shareholders’ Funds)}} \]
  • Interest Coverage Ratio: \[ \text{ICR} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-term Debt}} \]

3. Activity (Turnover) Ratios

  • Inventory Turnover Ratio: \[ \text{ITR} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}} \]
  • Trade Receivables Turnover Ratio: \[ \text{TRTR} = \frac{\text{Net Credit Revenue from Operations}}{\text{Average Trade Receivables}} \]

4. Profitability Ratios

  • Gross Profit Ratio: \[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Net Revenue from Operations (Net Sales)}} \times 100 \]
  • Return on Investment (ROI): \[ \text{ROI} = \frac{\text{Net Profit before Interest, Tax, and Dividend}}{\text{Capital Employed}} \times 100 \]

Competency-Based Questions (CBQs)

Q1. Current Ratio is 2.5 : 1. Discuss the effect of “Purchasing goods on credit” on the current ratio. Context: Evaluating analytical skills on directional ratio changes resulting from transactions.

Q2. ABC Ltd. has a Current Ratio of 3:1 and a Quick Ratio of 1.2:1. If the Inventory is ₹ 1,80,000, calculate the Current Liabilities and Current Assets. Context: High-order calculation testing multiple interconnected algebraic constraints.

Q3. If the Operating Ratio of a company is 75%, what will be its Operating Profit Ratio? Why? Context: Relationship assessment between mutually exclusive percentage ratios.

Q4. A company has Debt of ₹ 10,00,000 and Shareholders’ Funds of ₹ 5,00,000. It raised a further loan of ₹ 2,00,000 from the bank. Calculate the new Debt to Equity Ratio. Context: Impact of structural capital changes on solvency.

Q5. Based on Schedule III of the Companies Act 2013, under which major head and sub-head would you present “Provision for Employee Benefits” and “Computer Software”? Context: Statutory classification of items under the prescribed balance sheet format.

Answers to CBQs

Ans 1. Current Ratio = 2.5 : 1 (e.g., CA = 2,50,000; CL = 1,00,000). Purchasing goods on credit will increase Current Assets (Inventory) and increase Current Liabilities (Creditors) by the same amount. Since the ratio is initially > 1, an equal increase in numerator and denominator will decrease the ratio. Therefore, the Current Ratio will decline.

Ans 2.

  • Current Ratio (CR) = CA / CL = 3 / 1
  • Quick Ratio (QR) = QA / CL = 1.2 / 1
  • Assuming CL = \( x \)
  • CA = \( 3x \)
  • QA = \( 1.2x \)
  • Inventory = CA - QA = \( 3x - 1.2x = 1.8x \)
  • Given Inventory = ₹ 1,80,000
  • \( 1.8x = 1,80,000 \Rightarrow x = 1,00,000 \)
  • Current Liabilities: ₹ 1,00,000
  • Current Assets: \( 3 \times 1,00,000 = ₹ 3,00,000 \)

Ans 3. Operating Ratio + Operating Profit Ratio = 100%. Therefore, Operating Profit Ratio = \( 100\% - 75\% = 25\% \). This is because operating costs and operating profit together constitute the total net revenue from operations (sales).

Ans 4.

  • Old Debt = ₹ 10,00,000
  • Old Equity = ₹ 5,00,000
  • New Loan = ₹ 2,00,000
  • New Debt = \( 10,00,000 + 2,00,000 = ₹ 12,00,000 \)
  • Equity remains unchanged = ₹ 5,00,000
  • New Debt to Equity Ratio = \( \frac{12,00,000}{5,00,000} = 2.4 : 1 \)

Ans 5.

  • Provision for Employee Benefits: Major Head: Non-Current Liabilities Sub-head: Long-term Provisions
  • Computer Software: Major Head: Non-Current Assets Sub-head: Property, Plant and Equipment and Intangible Assets (specifically Intangible Assets).