14 Financial Statements Analysis
14.1 Meaning of Financial Statement Analysis
Financial statement analysis is the process of identifying the financial strengths and weaknesses of a firm by establishing relationships between items in the balance sheet, the statement of profit and loss, and other related schedules. The output is a set of measures and judgements that decision-makers — managers, lenders, investors, regulators — can act on (khan2022?; pandey2021?).
Myer’s classic definition — financial statement analysis “is largely a study of relationships among the various financial factors in a business as disclosed by a single set of statements, and a study of the trends of these factors as shown in a series of statements” — captures both the cross-sectional and the time-series dimensions of the exercise.
14.2 Objectives and Users
The same set of statements speaks differently to different audiences.
| User | Question being asked |
|---|---|
| Owners and shareholders | What is the return on my equity? Is the dividend safe? |
| Management | How are operations performing? Where do we cut cost? |
| Lenders (banks, debenture-holders) | Will the firm service its debt? |
| Trade creditors | Will I be paid within 60 days? |
| Employees and unions | Is there room for higher wages? |
| Government and regulators | Is the firm complying? Tax, GST, sectoral rules? |
| Investors and analysts | Is the share fairly priced? |
| Society | Is the firm contributing or extracting? |
14.3 Types of Analysis
Analysis is classified along three intersecting axes (khan2022?).
| Basis | Categories |
|---|---|
| Material used | External (outsiders, on published statements) vs Internal (insiders, with full data) |
| Time horizon | Short-term (liquidity) vs Long-term (solvency, profitability) |
| Method | Horizontal (over time) vs Vertical (within one period, common-size) |
Horizontal analysis looks across years — comparative statements and trend percentages. Vertical analysis stays within a single year — every line is expressed as a percentage of a base (sales for the P&L; total assets for the balance sheet).
14.4 Tools and Techniques
| Tool | What it produces |
|---|---|
| Comparative statements | Two-period side-by-side, with absolute and percentage changes |
| Common-size statements | Each line as a percentage of a base (sales or total assets) |
| Trend analysis | Index numbers across years against a base year (= 100) |
| Ratio analysis | Numerical ratios linking line items |
| Fund-flow statement | Sources and applications of working capital between two dates |
| Cash-flow statement | Cash inflows and outflows split into operating, investing, financing |
14.5 Ratio Analysis — Five Families
The most-used tool is ratio analysis, which reduces accounting magnitudes to comparable proportions. The five recurring families are liquidity, solvency, activity, profitability and market ratios.
14.5.1 Liquidity ratios
| Ratio | Formula | Standard / Norm |
|---|---|---|
| Current ratio | Current Assets ÷ Current Liabilities | 2 : 1 |
| Quick / Acid-test ratio | (Current Assets − Inventory − Prepaid Expenses) ÷ Current Liabilities | 1 : 1 |
| Cash ratio | (Cash + Marketable Securities) ÷ Current Liabilities | 0.5 : 1 |
14.5.2 Solvency / Leverage ratios
| Ratio | Formula |
|---|---|
| Debt-Equity ratio | Long-term Debt ÷ Shareholders’ Funds |
| Total Debt ratio | Total Debt ÷ Total Assets |
| Proprietary ratio | Shareholders’ Funds ÷ Total Assets |
| Interest Coverage ratio | EBIT ÷ Interest |
| Debt-Service Coverage Ratio (DSCR) | (EBIT + Depreciation) ÷ (Interest + Loan Instalment) |
14.5.3 Activity / Turnover ratios
| Ratio | Formula |
|---|---|
| Inventory Turnover | Cost of Goods Sold ÷ Average Inventory |
| Debtors / Receivables Turnover | Net Credit Sales ÷ Average Debtors |
| Average Collection Period | 365 ÷ Debtors Turnover |
| Creditors / Payables Turnover | Net Credit Purchases ÷ Average Creditors |
| Working Capital Turnover | Sales ÷ Net Working Capital |
| Total Asset Turnover | Sales ÷ Total Assets |
14.5.4 Profitability ratios
| Ratio | Formula |
|---|---|
| Gross Profit Margin | (Gross Profit ÷ Sales) × 100 |
| Operating Profit Margin | (Operating Profit ÷ Sales) × 100 |
| Net Profit Margin | (Net Profit after Tax ÷ Sales) × 100 |
| Return on Capital Employed (ROCE) | (EBIT ÷ Capital Employed) × 100 |
| Return on Equity (ROE) | (PAT − Preference Dividend) ÷ Equity Shareholders’ Funds × 100 |
| Return on Assets (ROA) | (Net Profit ÷ Total Assets) × 100 |
| Earnings per Share (EPS) | (PAT − Preference Dividend) ÷ Number of Equity Shares |
14.5.5 Market / Valuation ratios
| Ratio | Formula |
|---|---|
| Price-Earnings (P/E) ratio | Market Price per Share ÷ EPS |
| Earnings Yield | EPS ÷ Market Price per Share |
| Dividend Yield | DPS ÷ Market Price per Share |
| Dividend Payout ratio | DPS ÷ EPS |
| Price-to-Book (P/B) ratio | Market Price per Share ÷ Book Value per Share |
14.6 DuPont Analysis
Developed by F. Donaldson Brown at DuPont Corporation in the 1920s, DuPont analysis decomposes ROE into three drivers (kapoor2023?):
\[ \text{ROE} = \underbrace{\frac{\text{PAT}}{\text{Sales}}}_{\text{Net Profit Margin}} \times \underbrace{\frac{\text{Sales}}{\text{Total Assets}}}_{\text{Asset Turnover}} \times \underbrace{\frac{\text{Total Assets}}{\text{Equity}}}_{\text{Equity Multiplier}} \]
The decomposition tells the analyst why ROE has changed — through margin (efficiency of operations), turnover (efficiency of asset use), or leverage (use of debt). A firm earning the same ROE through high margin is fundamentally different from one earning it through high leverage.
14.7 Worked Example
Selected items from a balance sheet and P&L for the year ended 31 March 2026:
| Item | Value |
|---|---|
| Sales | 1,000 |
| Cost of Goods Sold | 700 |
| Operating Profit | 200 |
| PAT | 120 |
| Total Assets | 800 |
| Shareholders’ Funds | 500 |
| Long-term Debt | 200 |
| Current Assets | 240 |
| Inventory | 80 |
| Current Liabilities | 120 |
A few derived ratios:
- Current ratio = 240 ÷ 120 = 2
- Quick ratio = (240 − 80) ÷ 120 = 1.33
- Debt-Equity ratio = 200 ÷ 500 = 0.4
- Net Profit Margin = (120 ÷ 1,000) × 100 = 12 %
- Asset Turnover = 1,000 ÷ 800 = 1.25
- Equity Multiplier = 800 ÷ 500 = 1.6
- ROE = 12 % × 1.25 × 1.6 = 24 %
The DuPont identity reproduces the same ROE that direct calculation gives: 120 ÷ 500 = 24 per cent.
14.8 Fund-Flow Statement
A fund-flow statement explains the change in working capital between two balance-sheet dates. Fund is taken to mean net working capital = Current Assets − Current Liabilities.
The statement has two halves:
- Sources of funds: profit from operations, issue of shares, issue of debentures, sale of fixed assets, long-term borrowing.
- Applications of funds: redemption of debentures, repayment of long-term loans, purchase of fixed assets, payment of dividend, payment of tax.
A Schedule of Changes in Working Capital is prepared to verify the net change. The fund-flow statement was the standard analytical tool until the cash-flow statement superseded it under Ind-AS 7 / AS 3 (Revised).
14.9 Cash-Flow Statement (Ind-AS 7 / AS 3)
The cash-flow statement classifies cash inflows and outflows into three activities.
| Activity | Typical contents |
|---|---|
| Operating | Cash from customers; cash to suppliers and employees; tax paid |
| Investing | Purchase / sale of fixed assets; purchase / sale of investments; interest and dividend received |
| Financing | Issue / redemption of shares and debentures; long-term borrowing; dividend paid; interest paid |
Operating cash flow may be presented by the direct method (showing actual gross receipts and payments) or the indirect method (starting from net profit and adjusting for non-cash items and working-capital changes). Indian companies overwhelmingly use the indirect method.
| Step | Item |
|---|---|
| 1 | Net Profit before Tax |
| 2 | Add: Non-cash items (Depreciation, Amortisation, Provisions) |
| 3 | Add: Loss on sale of assets; Less: Gain on sale of assets |
| 4 | Adjust: Working-capital changes (Increase in CA → deduct; Decrease in CA → add; opposite for CL) |
| 5 | Less: Income tax paid |
| 6 | = Cash from Operating Activities |
A positive operating cash flow that consistently exceeds reported net profit is a sign of high earnings quality; the reverse signals possible accrual aggression.
14.10 Limitations of Financial Statement Analysis
Even the best analysis has constraints (pandey2021?).
- Historical data. Statements record the past; the future must still be inferred.
- Window dressing. Year-end transactions can be timed to flatter ratios.
- Differences in accounting policies. Inventory valuation, depreciation method, revenue recognition.
- Inflation distortion. Historical-cost values understate replacement cost in inflation.
- Qualitative factors absent. Management quality, brand, customer relationships do not appear in numbers.
- No absolute norm. “Good” and “bad” depend on industry, size and stage of life cycle.
14.11 Exam-Pattern MCQs
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| Ratio | Formula | ||
| (i) | Current ratio | (a) | EBIT ÷ Interest |
| (ii) | Quick ratio | (b) | Current Assets ÷ Current Liabilities |
| (iii) | Debt-Equity ratio | (c) | (Current Assets − Inventory − Prepaid) ÷ Current Liabilities |
| (iv) | Interest Coverage | (d) | Long-term Debt ÷ Shareholders' Funds |
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| Item | Activity | ||
| (i) | Cash received from customers | (a) | Investing |
| (ii) | Purchase of plant and machinery | (b) | Financing |
| (iii) | Issue of equity shares | (c) | Operating |
| (iv) | Dividend paid to shareholders | (d) | Financing |
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| Term | Content | ||
| (i) | Common-size statement | (a) | Each line as a percentage of a base item |
| (ii) | DuPont analysis | (b) | Decomposes ROE into margin, turnover and leverage |
| (iii) | Quick ratio | (c) | Excludes inventory and prepaid expenses |
| (iv) | Operating activity (Ind-AS 7) | (d) | Cash from customers and to suppliers |
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- Six tools: Comparative, Common-size, Trend, Ratio, Fund-flow, Cash-flow.
- Five ratio families: Liquidity, Solvency, Activity, Profitability, Market.
- Liquidity norms: Current 2 : 1, Quick 1 : 1, Cash 0.5 : 1.
- Solvency: Debt-Equity, Interest Coverage (EBIT/Interest), DSCR.
- Activity: Inventory, Debtors, Creditors, Asset turnover; Average Collection Period = 365 ÷ Debtors Turnover.
- Profitability: GP, OP, NP margins; ROCE, ROE, ROA, EPS.
- Market: P/E, Earnings Yield, Dividend Yield, Payout, P/B.
- DuPont: ROE = Net Profit Margin × Asset Turnover × Equity Multiplier.
- Fund-flow explains change in Working Capital; Cash-flow (Ind-AS 7 / AS 3) splits into Operating, Investing, Financing.
- Indirect method: PBT → +Non-cash → ±WC changes → −Tax = Cash from Operations.