15  Financial Statements Analysis: Ratio analysis; Funds flow Analysis; Cash flow analysis

15.1 Meaning of Financial Statement Analysis

Financial statement analysis is the process of “examining the financial statements of an enterprise to derive information useful for decision-making” (John N. Myer). It converts raw numbers from the Balance Sheet, Statement of Profit and Loss, Cash Flow Statement and notes into ratios, trends and inferences about a firm’s profitability, liquidity, solvency, efficiency and valuation. Users — investors, lenders, regulators, employees, managers — interpret the same statements differently depending on their stake.

15.2 Tools and Techniques

TipThree Tool Families
Family Working content
Comparative and common-size statements Horizontal (year-on-year %) and vertical (each item as % of base)
Ratio analysis Liquidity, solvency, activity, profitability, market
Flow analysis Funds Flow Statement (working-capital basis) and Cash Flow Statement (cash basis under AS 3 / Ind AS 7)

15.3 Ratio Analysis — The Five Families

15.3.1 Liquidity Ratios

TipLiquidity Ratios
Ratio Formula Standard / norm
Current Ratio Current Assets / Current Liabilities 2 : 1
Quick / Acid-Test (Current Assets − Stock − Prepaid) / Current Liabilities 1 : 1
Absolute Liquid / Cash Ratio (Cash + Marketable Securities) / Current Liabilities 0.5 : 1

15.3.2 Solvency / Leverage Ratios

TipSolvency Ratios
Ratio Formula
Debt-Equity Long-term Debt / Shareholders’ Funds (norm 2:1)
Total Debt to Total Assets Total Debt / Total Assets
Proprietary Ratio Shareholders’ Funds / Total Assets
Interest Coverage EBIT / Interest
DSCR (Debt Service Coverage) (PAT + Depn + Interest) / (Interest + Principal due)

15.3.3 Activity / Turnover Ratios

TipActivity Ratios
Ratio Formula Working
Inventory Turnover Cost of Goods Sold / Avg Inventory times per year
Inventory Days 365 / Inventory Turnover days
Debtors Turnover Net Credit Sales / Avg Debtors times
Debtors Collection Period 365 / Debtors Turnover days
Creditors Turnover Net Credit Purchases / Avg Creditors times
Working Capital Turnover Net Sales / Net Working Capital
Fixed-Assets Turnover Net Sales / Net Fixed Assets

The Cash Conversion Cycle (CCC) synthesises three activity ratios: CCC = Inventory Days + Debtor Days − Creditor Days.

15.3.4 Profitability Ratios

TipProfitability Ratios
Ratio Formula
Gross Profit (GP) Ratio Gross Profit / Net Sales × 100
Operating Profit Ratio EBIT / Net Sales × 100
Net Profit Ratio PAT / Net Sales × 100
Return on Capital Employed (ROCE) EBIT / Capital Employed × 100
Return on Equity (ROE) PAT / Shareholders’ Funds × 100
Return on Assets (ROA) PAT / Total Assets × 100

15.3.5 DuPont Analysis

The DuPont decomposition breaks ROE into operating, efficiency and leverage drivers:

\[\text{ROE} = \underbrace{\frac{\text{PAT}}{\text{Sales}}}_{\text{Net margin}} \times \underbrace{\frac{\text{Sales}}{\text{Total Assets}}}_{\text{Asset turnover}} \times \underbrace{\frac{\text{Total Assets}}{\text{Equity}}}_{\text{Leverage}}\]

15.3.6 Market and Valuation Ratios

TipMarket Ratios
Ratio Formula
Earnings per Share (EPS) PAT / Number of Equity Shares
Price-Earnings (P/E) Ratio Market Price per Share / EPS
Price-to-Book (P/B) Market Price / Book Value per Share
Dividend Payout Ratio Dividend / PAT
Dividend Yield Dividend per Share / Market Price
EV/EBITDA Enterprise Value / EBITDA
NoteDistractor warning

PYQ trap: Net Profit Ratio uses Net Sales in the denominator, while ROCE uses Capital Employed (not sales). Confusing the two is the single most common error in ratio MCQs.

15.4 Limitations of Ratio Analysis

TipLimitations
  • Window-dressing by managements can distort balance-sheet ratios.
  • Ratios reflect past — limited predictive value.
  • Different accounting policies across firms reduce comparability.
  • Inflation distorts historical-cost ratios.
  • Qualitative factors — brand, management, technology — are ignored.
  • Industry context matters — a “norm” of 2:1 current ratio may not fit every sector.

15.5 Funds Flow Analysis

The Funds Flow Statement explains changes in working capital during a period — the sources (inflows) and applications (outflows) of funds. It was the predecessor of the cash-flow statement and is still examined in UGC-NET.

15.5.1 Two Concepts of Funds

TipTwo Concepts of Funds
Concept Funds =
Working capital Current Assets − Current Liabilities
Cash Cash + Bank balances

The traditional Funds Flow Statement uses the working-capital concept; the modern Cash Flow Statement uses the cash concept.

15.5.2 Sources and Applications of Funds

TipSources and Applications
Sources Applications
Funds from operations (PAT + Depn + non-cash) Loss from operations
Issue of share capital / debentures Redemption of shares / debentures
Sale of non-current assets Purchase of non-current assets
Long-term loan raised Long-term loan repaid
Decrease in working capital Increase in working capital
Non-trading income received (rent, interest) Payment of dividend, tax

15.5.3 Schedule of Changes in Working Capital

A separate Schedule of Changes in Working Capital is prepared by computing increase/decrease in each current asset and current liability over the period. Increase in CA → increase in WC; increase in CL → decrease in WC.

15.6 Cash Flow Statement — AS 3 / Ind AS 7

The Cash Flow Statement is mandatory for companies under §129(3) of Companies Act 2013 and is governed by AS 3 (Indian GAAP) and Ind AS 7.

15.6.1 Three Sections

TipThree Activities in the Cash Flow Statement
Section Working content Examples
Cash flow from Operating activities (CFO) Cash effects of revenue-generating transactions Receipts from customers; payments to suppliers and employees
Cash flow from Investing activities (CFI) Acquisition and disposal of long-term assets Purchase/sale of PPE, investments, loans given
Cash flow from Financing activities (CFF) Changes in size and composition of own equity and borrowings Issue / buy-back of shares; new loans / repayments; dividend paid 

flowchart TB
  N[Net Profit<br/>before Tax] --> OP[CFO<br/>Operating]
  OP --> CR[Cash from<br/>Operations]
  CR --> CL[Closing<br/>Cash &<br/>Equivalents]
  IF[CFI<br/>Investing] --> CL
  FF[CFF<br/>Financing] --> CL
  OC[Opening Cash] --> CL
    classDef default fill:#003366,color:#ffffff,stroke:#ffcc00,stroke-width:3px,rx:10px,ry:10px;

15.6.2 Direct vs Indirect Method (Operating Cash Flow)

TipTwo Methods for CFO
Method Working
Direct Cash receipts from customers − cash paid to suppliers, employees, taxes
Indirect Start with PBT → add depreciation/amortisation, non-cash items → adjust for changes in working capital → less tax paid

Most companies use the indirect method.

15.6.3 Treatment of Specific Items

TipTricky Items in Cash Flow
Item Treatment
Interest paid Financing for non-financial firms; operating for financial institutions
Interest received Investing for non-financial firms; operating for financial institutions
Dividend paid Always Financing
Dividend received Investing for non-financial firms; operating for financial institutions
Tax paid Operating, unless specifically attributable to investing or financing
Forex differences Reported separately in reconciliation
Acquisitions and disposals of subsidiaries Investing — net of cash acquired/disposed

15.7 Funds Flow vs Cash Flow

TipFunds Flow vs Cash Flow
Dimension Funds Flow Cash Flow
Concept of “fund” Working capital Cash + Cash equivalents
Coverage Long-term movements only All cash movements
Statutory backing Not mandatory; pedagogical Mandatory under §129(3); AS 3 / Ind AS 7
Sections Sources + Applications CFO + CFI + CFF
Useful for Long-term capital structure Short-term liquidity + capital + dividend decisions

15.8 Common-Size and Trend Analysis

TipCommon-Size and Trend Analysis
  • Common-size income statement — every item as % of net sales.
  • Common-size balance sheet — every item as % of total assets.
  • Trend analysis — first year set as 100; subsequent years indexed; reveals growth patterns.
  • Comparative statements — two or more years’ figures with absolute and % change.

15.9 Practice Questions

Q 01 Current Ratio Easy

The conventional standard for the Current Ratio is:

  • A0.5 : 1
  • B1 : 1
  • C2 : 1
  • D3 : 1
View solution
Correct Option: C
**2 : 1** is the textbook benchmark for the current ratio.
Q 02 Quick Ratio Medium

Current assets ₹4,00,000 (including stock ₹1,20,000 and prepaid ₹20,000); current liabilities ₹2,00,000. Quick ratio is:

  • A1.0
  • B1.3
  • C2.0
  • D2.3
View solution
Correct Option: B
Quick assets = 4,00,000 − 1,20,000 − 20,000 = ₹2,60,000; Ratio = 2,60,000 / 2,00,000 = **1.3**.
Q 03 DuPont Hard

The DuPont decomposition expresses ROE as the product of:

  • ANet margin × Asset turnover × Equity multiplier
  • BGross margin × Sales growth × Debt ratio
  • CCurrent ratio × Stock turnover × P/E
  • DEBIT margin × Tax rate × Dividend yield
View solution
Correct Option: A
**ROE = Net margin × Asset turnover × Equity multiplier** — operating × efficiency × leverage.
Q 04 Ratios Medium

Match each ratio with its family:

Ratio Family
(i) Current Ratio (a) Profitability
(ii) Debt-Equity (b) Liquidity
(iii) Inventory Turnover (c) Solvency
(iv) Return on Equity (d) Activity
  • A(i)-(b), (ii)-(c), (iii)-(d), (iv)-(a)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(c), (ii)-(d), (iii)-(a), (iv)-(b)
  • D(i)-(d), (ii)-(a), (iii)-(b), (iv)-(c)
View solution
Correct Option: A
CR — liquidity; D/E — solvency; Inv. T/O — activity; ROE — profitability.
Q 05 DSCR Medium

Debt Service Coverage Ratio (DSCR) is computed as:

  • AEBIT / Interest
  • B(PAT + Depn + Interest) / (Interest + Principal due)
  • CPAT / Interest
  • DNet Sales / Debt
View solution
Correct Option: B
**DSCR** measures whether operating cash can service both interest and principal.
Q 06 CCC Hard

Inventory days 40; Debtor days 50; Creditor days 30. The Cash Conversion Cycle is:

  • A20 days
  • B40 days
  • C60 days
  • D120 days
View solution
Correct Option: C
CCC = 40 + 50 − 30 = **60 days**.
Q 07 EPS Easy

PAT ₹20,00,000; preference dividend ₹2,00,000; number of equity shares 1,80,000. EPS is:

  • A₹10
  • B₹11.11
  • C₹12.22
  • D₹15
View solution
Correct Option: A
EPS = (20,00,000 − 2,00,000) / 1,80,000 = ₹18,00,000 / 1,80,000 = **₹10**.
Q 08 Funds Flow Medium

In the traditional funds-flow statement, "funds" means:

  • ACash and bank balances
  • BWorking capital
  • CTotal assets
  • DNet worth
View solution
Correct Option: B
Traditional funds flow uses **working capital** (CA − CL); cash flow uses cash.
Q 09 CFS Easy

Under Ind AS 7, dividend paid by a non-financial company is classified under:

  • AOperating activities
  • BInvesting activities
  • CFinancing activities
  • DEither operating or financing
View solution
Correct Option: C
Dividend **paid** is always financing.
Q 10 CFS Medium

Match each Cash Flow Statement item with its classification (non-financial company):

Item Classification
(i) Issue of debentures (a) Investing
(ii) Purchase of machinery (b) Financing
(iii) Receipt from customers (c) Investing
(iv) Dividend received (d) Operating
  • A(i)-(b), (ii)-(a), (iii)-(d), (iv)-(c)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(d), (ii)-(c), (iii)-(b), (iv)-(a)
  • D(i)-(c), (ii)-(d), (iii)-(a), (iv)-(b)
View solution
Correct Option: A
Issue of debentures — Financing; Purchase of machinery — Investing; Receipt from customers — Operating; Dividend received — Investing (for a non-financial firm).
Q 11 Method Medium

In the **indirect method** of preparing the operating section of the cash flow statement, depreciation is:

  • ASubtracted from PBT
  • BAdded back to PBT
  • CIgnored
  • DTreated as investing
View solution
Correct Option: B
Depreciation is a non-cash expense — **added back** to PBT.
Q 12 Funds Flow Hard

Which of the following is **not** a source of funds in the traditional funds-flow statement?

  • AIssue of debentures
  • BFunds from operations
  • CSale of land
  • DPurchase of machinery
View solution
Correct Option: D
Purchase of machinery is an **application** of funds, not a source.
Q 13 P/E Medium

Market price ₹250; EPS ₹10. The P/E ratio is:

  • A25
  • B10
  • C2.5
  • D0.04
View solution
Correct Option: A
P/E = Market price / EPS = 250 / 10 = **25**.
Q 14 Proprietary Medium

Shareholders' funds ₹6,00,000; total assets ₹10,00,000. The Proprietary Ratio is:

  • A0.4
  • B0.6
  • C0.67
  • D1.67
View solution
Correct Option: B
Proprietary Ratio = Shareholders' Funds / Total Assets = 6 / 10 = **0.6**.
Q 15 Limitation Medium

Which of the following is **not** a limitation of ratio analysis?

  • AWindow-dressing can distort ratios
  • BDifferent accounting policies reduce comparability
  • CInflation distorts historical-cost ratios
  • DRatios convey both quantitative and qualitative information
View solution
Correct Option: D
Ratios are **purely quantitative**; that is a *limitation*, not a strength.
Q 16 Tool Easy

A statement that shows each item of the income statement as a percentage of net sales is called:

  • AComparative statement
  • BCommon-size statement
  • CTrend statement
  • DFunds flow statement
View solution
Correct Option: B
**Common-size** = vertical analysis.
Q 17 Sources / App Medium

In a funds-flow statement, payment of dividend is treated as:

  • ASource of funds
  • BApplication of funds
  • CNot recorded
  • DSource from operations
View solution
Correct Option: B
Dividend payment is an **application** of funds — reduces working capital.
Q 18 ROCE Hard

Return on Capital Employed (ROCE) is calculated as:

  • APAT / Equity
  • BEBIT / Capital Employed
  • CPAT / Sales
  • DEBIT / Sales
View solution
Correct Option: B
**ROCE = EBIT / Capital Employed** — pre-tax, pre-interest return on total long-term capital.
Q 19 CFI Medium

Which of the following is classified under cash flow from **investing** activities?

  • ARepayment of long-term loan
  • BIssue of shares
  • CSale of investment securities
  • DReceipt from customers
View solution
Correct Option: C
Sale/Purchase of long-term **investments** belongs to *investing* activities.
Q 20 Mandate Medium

Cash Flow Statement under Indian Accounting Standards is governed by:

  • AAS 1
  • BAS 3 / Ind AS 7
  • CAS 9 / Ind AS 18
  • DInd AS 1
View solution
Correct Option: B
**AS 3** (Indian GAAP) and **Ind AS 7** govern the Cash Flow Statement.

15.10 Quick Recall

ImportantQuick recall
  • Tools: Comparative, Common-size, Trend, Ratio, Funds Flow, Cash Flow.
  • Liquidity: Current Ratio (2:1), Quick (1:1), Cash (0.5:1).
  • Solvency: D/E (2:1), Proprietary, Interest Coverage = EBIT / Interest, DSCR.
  • Activity: Inventory T/O, Debtors T/O, Creditors T/O; CCC = Inventory days + Debtor days − Creditor days.
  • Profitability: GP, Operating, Net Profit, ROCE = EBIT/CE, ROE = PAT/Equity, ROA.
  • DuPont: ROE = Net margin × Asset turnover × Equity multiplier.
  • Market: EPS, P/E, P/B, Dividend payout, EV/EBITDA.
  • Funds Flow uses working-capital concept; Cash Flow uses cash concept.
  • Cash Flow (AS 3 / Ind AS 7) — three sections: CFO + CFI + CFF. Indirect method starts with PBT, adds back non-cash items, adjusts WC.
  • Dividend paid always Financing; Dividend received by non-financial firm — Investing.
  • Mandatory under §129(3) Companies Act 2013.