Financial Statement Ratios

- Activity, Liquidity, Solvency,

Profitability and Valuation
Ratios

Guided by – Dr. Himanshu Gupta

Subject Name – Industrial Engineering and Management

(MSR 15152)

By – Anuja Priyadarshini (16je002165)

Sneha Kishore Priti(16je002195)
Aishwarya Barnwal(16je002225)
Aditi Yadav(16je002231)
Taniya Shah (16je002506)
Branch – Electrical Engineering
Semester – VIIth
 INDEX

S. No. Topics Page number

1 Introduction 2-4
2 Ratio Analysis 5-6
3 Activity Ratios 7-9
4 Liquidity Ratios 10-11
5 Solvency Ratios 12-13
6 Profitability Ratios 14-17
7. Valuation Ratios 18
8. Relationships among ratios and ratio analysis 19-23
of a hypothetical company
9. Conclusion 24

10. References 25

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Introduction
 Definition
 Financial statements are records which indicate the financial status of an
organisation quantitatively. In other words, it tells us about the health of the
company in financial terms.
 Financial reporting is a way in which company shows its financial performance to its
investors, creditors, and other parties involved with it in the form of financial
statements.

According to the IASB Conceptual Framework for Financial Reporting 2010:

“The objective of general purpose financial reporting is to provide financial information
about the reporting entity that is useful to existing and potential investors, lenders, and
other creditors in making decisions about providing resources to the entity. Those decisions
involve buying, selling or holding equity and debt instruments, and providing or settling
loans and other forms of credit.”

 Objective - to give information regarding the performance and position of the

company financially and also to inform about the changes in its financial position so that
it can help the users to make economic decisions.

 Role of Financial Statement Analysis:

 The financial statements help in making economic decisions in an efficient way. (like
should we invest in securities or extend trade or bank credit to company).
 to evaluate past performance of a company and know its current financial position
which will help form opinions about the ability of the company to earn profits and
generate cash flow in the future.

 Steps for Financial Analysis

Financial analysis basically involves 6 major steps:

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 1. The analyst should state the objective of the statement.
2. Gather the required data.
3. Process the data accordingly.
4. Go for analysis and interpretation of the data.
5. Inform the conclusions or recommendations to user end.
6. Update the financial analysis.

 Elements of Financial Statement :

 Assets- These are the resources controlled by the firm.
 Liabilities- Its the amount owed by company to lenders and other creditors.
 Equity- Its the residual interest in net assets of an entity that after subtracting its
liabilities
 Revenues- It’s the inflows= from delivering/producing goods, rendering services, or
other financial activities that are the major operations of the firm.
 Expenses- It’s the outflow from delivering/producing goods or services that that are
the major operations of the firm.

 Required Financial Statements

Required financial statements are:
 Balance sheet- It reports on the assets, liabilities, and equity of a company. It is basically
a statement of financial condition of the company.
 Income statement- It presents an entity’s income, expenses, profits or loss. It can also
be called Profit and Loss Statement.
 Cash flow statement- It provides information about the cash receipts and cash
payments during an accounting period for a company. In short, it tells about cash flow
activitiee of a company’s operating, investing, and financing activities.
 Statement of changes in owners’ equity- It shows changes in the capital account of a
firm due to contributions, withdrawals, and net income/loss i.e. reports on a company’s
retained earnings.

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 Explanatory notes- It provides information in addition to those presented in above four
like disclosures, supporting computations, etc.

 Financial analysis techniques

Financial
Analysis

Common-size Regression
Ratio analysis Graphical analysis
analysis analysis

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Ratio Analysis

Ratios help in expressing the relationships among data which can be used for
internal comparisons or comparisons across different rival companies. It gives data on
comparative basis.

 Applications -
Ratios are used to:
 Project future earnings and cash flow of a firm.
 Evaluate the flexibility of firm (its ability to grow and meet obligations in adverse
conditions).
 Assess the performance of the management.
 Evaluate the changes which have occurred in the firm and industry over time.
 Compare the firm with its rivals.

 Limitations of ratios-
 Useless when viewed in isolation. These are useful only when compared to past
performance or that with its rival firms.
 Difference in accounting treatments can create differences.
 Difficult to find comparable ratios when analysing companies which operate in
multiple industries.
 Single ratio won’t help conclude. All ratios must be viewed relative to each other.
 Difficult to determine target or comparison value for a ratio

 Classification of Financial Ratios-

Based on the type of information they provide, classification is as followed:

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  Activity ratios/ Operating ratios- It includes several ratios which tells how
efficiently the resources are being utilised and managed such as inventory and fixed
assets.
 Liquidity ratio- Liquidity means the ability to pay short-term obligations when they
become due. It can be determined by liquidity ratios.
 Solvency ratios- Solvency ratios give information on the financial leverage of the
company and it’s ability to meet its longer-term obligations. So it helps to determine
a company’s long term financial viability
 Profitability ratios- It provides information on how well company is generating
operating profits and net profits from its sales. Profitability ensures the owner is
getting a reasonable return and assets are being optimally utilised.
 Valuation ratios/Inter-firm comparison- It is used in comparing the companies on
various aspects
S.
n Category Types of ratio Analysis
o

Net Working Capital = Used to measure liquidity of

Current assets-current liabilities the firm.

It shows a company’s ability

to pay its short-term bills. If
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 its less than 1, it indicates
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
Liquidity = negative working capital, i.e.
1. 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
ratios company is facing a liquidity
crisis.
𝑞𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 Used to measure liquidity but
𝑐𝑎𝑠ℎ + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 +
doesn’t include inventories
= 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 and other assets that might
quick assets
= not be very liquid
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Turnover It measures the efficiency of
2. 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
ratios = the firm with respect to its
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

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 processing and inventory
management. It shows how
quick inventory is sold.
It shows how quick the debt is
𝑑𝑒𝑏𝑡𝑜𝑟 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
collected.
𝑛𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
= High ratio means the time lag
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠
between credit sales and cash
collection is short.
𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟′𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
𝑛𝑒𝑡 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 It shows how quickly the
=
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑠 account is to be settled.

3. Capital 𝑑𝑒𝑏𝑡 − 𝑡𝑜 − 𝑒𝑞𝑢𝑖𝑡𝑦 It measures the use of fixed

structure 𝑡𝑜𝑡𝑎𝑙 𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 cost financing sources by firm.
=
𝑡𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦
ratios/ It relates debt and equity in
solvency financing assets.
ratios 𝑑𝑒𝑏𝑡 − 𝑡𝑜 − 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 It shows how much of the
𝑡𝑜𝑡𝑎𝑙 𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 permanent capital of the firm
=
𝑝𝑒𝑟𝑚𝑎𝑛𝑒𝑛𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
is long term debt.

𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
= It shows share of total assets
𝑝𝑒𝑟𝑚𝑎𝑛𝑒𝑛𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑐𝑢𝑟𝑟𝑒𝑛𝑡
𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠 financed by outside funds.

𝑡𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠𝑒𝑞𝑢𝑖𝑡𝑦 It shows the share of total

=
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
assets which is financed by
the owner’s capital.
4. Coverage 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 It determines firm’s ability to
ratios 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 repay its debt obligations.
= 𝑡𝑎𝑥𝑒𝑠
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 It shows a firm’s ability to pay
𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 dividend on preference
=
𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 Dividend

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 shares.
𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 It shows a firm’s overall ability
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 to fulfil it’s liabilities.
= 𝑡𝑎𝑥𝑒𝑠
𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐h𝑎𝑟𝑔𝑒𝑠
5. Profitability It shows the profit of a
ratios 𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 company in relation to its
𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 sales.
=
𝑟𝑒𝑣𝑒𝑛𝑢𝑒
It shows net profit of a firm
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 with respect to its sales.
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑏𝑒𝑓𝑜𝑟𝑒 It’s a ratio of net income to
= 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑠𝑎𝑙𝑒𝑠 revenue.
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑎𝑛𝑑
= 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑠𝑎𝑙𝑒𝑠
6. Expense Operating ratio = Represents the operating
Cost of Goods sold + other expenses
ratio efficiency of business.
Sales
Cost of goods sold ratio = Ratio of cost of goods sold per
Cost of Goods sold sale.
Sales

𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑟𝑎𝑡𝑖𝑜 Ratio of specific expense per

specific expenses sale.
=
Sales

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7. Return on It measures profitability
investment 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠(𝑅𝑂𝐴) relative to funds invested in
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 ∗ 100 the company. So it gives
=
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
profitability of total funds per
or
investment of a company.
(𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 +
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) ∗ 100
=
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
or
(𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 +
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) ∗ 100
=
𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑎𝑠𝑠𝑒𝑡𝑠
or
(𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 +
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) ∗ 100
=
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
Or
(𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 +
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) ∗ 100
=
𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

Return on capital employed (ROCE) It shows the profitability of a

𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 ∗ 100 company with respect to total
=
𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
capital employed by the
company.
Return on total shareholders’ equity It shows how profitably the
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 ∗ 100 fund of the owner has been
=
𝑡𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦
utilised by the firm.
Return on ordinary shareholders’ It determines if the company
equity has earned satisfactory return
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 for equity holders or not.
𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 ∗ 100
=
𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦

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