ANALYSIS OF FINANCIAL

STATEMENTS
ANALYSIS OF FINANCIAL STATEMENTS
Means:
What is the financial standing of the business organization as on given date
How did the business perform over a long period and in the recent past
Are lending banks financial interests safe?

In order to provide answers, the lending banker has to lay his hands on
certain financial statements. They are:
1. Balance sheet
2. Profit and Loss account
3. Fund flow and Cash flow statements
ANALYSIS OF FINANCIAL STATEMENTS
BALANCE SHEET:
Balance sheet is a statement of assets and liabilities of the business
concern as on a particular date. It indicates quantity and not the
quality
It indicates how the funds have been raised and how they have been
utilized
From Balance sheet, we can determine the nature and size of the
assets and liabilities of the business but will have no way of
determining how the business organization has performed in relation
to cost of production, sales, income earned, expenditure incurred,
etc. For this, study of P&L account is necessary.
ANALYSIS OF FINANCIAL STATEMENTS
From the analysis of the above statements, we find out whether the business organization:

1. Has applied sound methods for financing its assets

2. Has a stake in the business
3. Has short-term financial stability or solvency i.e. the ability of the company to meet its current
obligations
4. Is doing its business with its own funds or borrowed funds i.e. the extent of outside funds in the
business
5. Enjoys credits from suppliers and whether making prompt payment to suppliers
6. Extends credit to its customers and customer pay their dues within a reasonable time
7. Holding level of stock of raw materials and finished goods
8. Has diverted its funds from business
9. Is earning reasonable returns on investments
10. Has been run efficiently
 Financial Statement and Analysis
A corporate balance sheet format:

Liabilities Assets

Share Capital Fixed assets

Reserves and surplus Investments

Secured loans Current assets, loans and

advances

Unsecured loans Misc expenditure

Current liabilities and

INTANGIBLE ASSETS
provisions
 Financial Statement and Analysis
RBI has issued guidelines for reclassifying the items of the
balance sheet to help bankers for better understanding and
intelligent use of information.
Reclassification

Liabilities Assets
Net worth Fixed assets
Term liabilities Current assets
Current liabilities Non current assets
Intangible assets
 Financial Statement and Analysis
Tangible Net worth: Paid-up capital + reserves and
surplus Intangible assets.

Term liabilities: Funded liability, long term source

and funds, not payable during the 12 month period
from the date of balance sheet.
e.g. Term loans from banks/financial institutions,
debentures, redeemable preference shares

Unsecured loans: Loans raised from the promoters/

directors/partners, from their relatives and friends.

Current liability: Market credit, provisions, bank

borrowing (working capital purpose).
 Financial Statement and Analysis
Assets:
Fixed assets:
Gross block land, building, machinery, furniture, fixture
Net block gross block depreciation
Current assets: Inventory, receivables, other current assets:
cash and bank balance, RBI approved investments, advance
given for supply of raw materials, advance payment of tax,
interest accrued on investment, prepaid expenses.
Noncurrent assets: Dead inventory, receivables outstanding
beyond 6 months, various kinds of advances made to
staff/partners/directors
Intangible assets: An asset that is not physical in nature
(Corporate intellectual property, trade mark, copy right) good
will, carried forward loss, preliminary expenses etc.,
ANALYSIS OF FINANCIAL STATEMENTS
Trading and Profit and Loss Account (Revenue Statement):

It gives the account of income and expenditure and resultant profit

i.e. direction in which the business organization is moving, the volume
of business, cost of manufacturing, cost of selling and administrative
expenses
ANALYSIS OF FINANCIAL STATEMENTS
GENERAL INTERPRETATION OF P&L ACCOUNT:
Following items are to be closely scrutinized while studying the P&L
account of a company whether the company is running the business
on sound lines.
1.Sales return particulars. 2.Carriage inward. 3.Gross profit margin.
4.Advertisement expenses to sales. 5.Rental expenses to net profit.
5.Legal expenses. 6.Bad debts written off. 7.Disc earned on purchases.
8.Disc paid on sales. 9.High expenses on repairs. 10.Heavy interest
earned in the course of business.
ANALYSIS OF FINANCIAL STATEMENTS
SOUND METHODS OF FINANCING:
A.
1. Fixed assets should be financed from net worth and/or long-term
borrowings
2. Current assets should be financed partly from long-term borrowings or
net-worth and partly from current liabilities
B. To find out whether company has stake in the business, it is necessary to
calculate the net-worth. Net-worth means capital/reserves plus net profit
minus intangible assets like goodwill etc.

Gross Net Worth means Net Worth + Up-to-date depreciation Written Off.
ANALYSIS OF FINANCIAL STATEMENTS
SHORT TERM FINANCIAL STABILITY (Financial Ratios):
To find out short term financial stability or solvency two ratios are calculated.
1. :Current Ratio
a. This is ratio of current asset to current liabilities
b. Current assets are those which are readily realizable within a period not exceeding 12 months.
Current liabilities are those which are payable on demand or that will fall due within a period
of 12 months of the balance sheet date.
c. This ratio is applied to test solvency as well as to determine the short term financial strength of
the business
d. This ratio is also known as Bankers ratio and working capital ratio & calculated as under:

Current Assets .= Current Ratio The ideal Current Ratio is 1.33:1.

Current Liabilities The bank has fixed benchmark ratio for different category
of borrowers which should be considered.
ANALYSIS OF FINANCIAL STATEMENTS
LIQUIDITY RATIO:
A. The word Liquidity means conversion of assets to cash during the
normal course of business and to have a regular and uninterrupted flow
of cash to meet outside current liabilities as and when due. The ratio is
indicative of the ability of the organization to meet its current obligations
B. This ratio provides more stringent test of solvency. This ratio is also called
Solvency ratio, Liquid asset ratio, Acid test ratio, Quick asset ratio,
Quick current ratio and Near money ratio
C. Formula for deriving this ratio:
Current Assets Inventories (Stock) = Liquidity Ratio The ideal ratio = 1:1
Current Liabilities
ANALYSIS OF FINANCIAL STATEMENTS
GEARING/LEVERAGE RATIO

1.DEBT EQUITY RATIO:(EXTENT OF BORROWED FUND)

To ascertain as to what extent the business organization is dependent
upon borrowed funds, DER is calculated as under:
Long Term Borrowings = Debt Equity Ratio The ideal ratio = 2:1
Equity
Debt means long term borrowing, whereas equity comprises of
capital & reserves and surplus less intangible assets
The ratio is very important since it shows the dependence of the
business organization on long term funds and its ability to meet the
payment obligations on due dates without undue stress on liquidity
ANALYSIS OF FINANCIAL STATEMENTS
2. TOL/TNW:
If this ratio is higher, there could be strain on liquidity of the organization when
repayment of liabilities falls due. Lower the ratio, the business organization is in a
position to meet the liability without much strain on its liquidity and indicator of
financial soundness. This brings relation between owners funds and outside debt
This ratio is calculated as under:
Total outside liability
Tangible net worth
The bank fixes certain benchmark ratios for various business activities
The tangible net worth is calculated by adding capital and reserves and deducting
intangible assets. The quasi capital (borrowed from friends and relatives) is not
reckoned. The bank will fix certain benchmark ratio which shall be kept in view
ANALYSIS OF FINANCIAL STATEMENTS
EXTENT OF CREDIT FROM SUPPLIERS:
Purchases to Accounts Payable ratio:
This ratio will help us to find out whether adequate credit is available to the
firm from its suppliers. This is calculated as under

Trade Creditors .
Annual Credit Purchases X 12 (No. of months)

2 months period may be considered as normal period of credit. If greater

than 2 months, it may be due to longer period of credit is available or
payments are delayed by the company
ANALYSIS OF FINANCIAL STATEMENTS
EXTENT OF CREDIT PERIOD FOR SALES:
Sales to Receivables ratio:
This ratio indicates the average time lag in number of months between the sales and collection of
dues. The ratio is calculated as under:
Sundry Debtors . = Credit Extended to customers
Annual Credit Sales X 12 (No. of months)
1 to 2 months credit may be considered normal period of credit. This ratio indicates number of days
credit enjoyed by debtors and also indicates the effectiveness in collection of debts due and
effectiveness in formulation credit control policy and its administration.
The financial soundness of the organization is reflected by the extent of bad and doubtful debts
The quantum of sundry debtors outstanding beyond credit periods allowed indicates inefficiency of
collection missionary and inability of the organization to realize the dues and ineffective policy of
extending credit to the customers. It effects the liquidity
The lower ratio indicates effectiveness of credit policy and negligible bad debts and quick realization
of sundry debtors
ANALYSIS OF FINANCIAL STATEMENTS
STOCK TURNOVER RATIO (INVENTORY MANAGEMENT EFFICIENCY):
1. This Ratio indicates the efficiency in inventory management
2. This will bring out whether the company is holding excessive stock.
Normally stock of raw materials should not exceed 3 months
consumption and finished stock should not exceed a months production.
However, this depends upon type of industry, nature of products, supply
source. The ratio is calculates as under:
a. Stock of Raw Materials X 12 (No. of months)
Annual consumption of raw materials
b. Stock of Finished Goods X 12 (No. of months)
Annual sales
ANALYSIS OF FINANCIAL STATEMENTS
SALES TURNOVER TO TOTAL ASSETS RATIO (Effectiveness of utilization
of assets):
This ratio is calculated as under:
Turnover (Net Sales)
Total Assets
This will indicate, in general, the effectiveness of utilization of assets.
This ratio establishes the relation between the quantum of investment
in the form of assets and increasing sales
ANALYSIS OF FINANCIAL STATEMENTS
EXTENT OF DIVERSION OF FUNDS:
Amount advanced by the business organization by way of loans and
deposits to others will indicate the extent to which the amount has
been diverted from the business.
Wherever a debtors constitute a major portion of current asset, a
close scrutiny shall be made as sometimes loans/advances made to
others or debit balance in capital account of the partners/proprietors
are clubbed under debtors account.
ANALYSIS OF FINANCIAL STATEMENTS
PERCENTAGE OF NET PROFIT TO NET WORTH (RETURN ON OWNED FUNDS):
This ratio is calculated as under:
Net Profit X 100
Net Worth
1. This will help the owners to know the percentage of profit earned on the
amount invested by them in the business
2. There should be a minimum return on investment so that the existing
owners/prospective investors will continue to show interest in running
the business
3. Earning of profit will also provide resources to plough back into business
for future growth
ANALYSIS OF FINANCIAL STATEMENTS
PERCENTAGE OF NET PROFIT TO CAPITAL EMPLOYED:(return on assets)
This is calculated as under:
Net Profit X 100 .
Capital Employed
1. Capital Employed means total assets minus intangible assets. This ratio
will reflect on the efficiency of the management in utilization of funds
and earning profits. The ratio is calculated in terms of %, & higher the
figure, better is the result.
2. An analysis can also be made department-wise/segment-wise/center-
wise to judge individual entitys performance. A higher ratio will indicate
better management performance
ANALYSIS OF FINANCIAL STATEMENTS
PROFITABILITY RATIO:-
A business firm should earn profits to survive and grow over a long
period of time. Sufficient profits must be earned to sustain the operations of
the business, to be able to obtain funds from banks and investors for the
purpose of expansion and to contribute towards the social welfare of the
society.
Gross Profit Margin = Gross profit X 100
total sales
The gross profit margin reflects the efficiency with which the management
produces each unit of product. This ratio indicates the average spread
between the cost of goods sold and the sales revenue.
ANALYSIS OF FINANCIAL STATEMENTS

LIMITATIONS OF RATAIO ANALYSIS:-

Ratio analysis is an important tool for credit analyst to evaluate the

financial health and performance of the Business Organization.
However there are limitations to use these ratios. Firstly there may be
no accurate data available for industry averages rendering comparison
of ratios difficult at times. Secondly the ratios calculated are based on a
financial statement as on a particular date which are subject to change.
The ratios at best serves the purpose of finding out direction in which
the organization is moving.
ANALYSIS OF FINANCIAL STATEMENTS
Fund flow statement:
In the vertical form of balance sheet, the liabilities are titled Source of
Funds and Assets are titled Application of Funds
When money comes into the business, liability is created. Hence, liability is
a source of fund
When asset is acquired, money flows out. Hence, every asset represents
application/use of funds. Similarly, when a loan is repaid, there is reduction
of funds and when asset is sold, there is increase in funds
Increase in the funds in a company and how it has been utilized can be
ascertained by studying variations in the assets and liabilities between two
balance sheet dates is the study of fund flow statement
 ANALYSIS OF FINANCIAL STATEMENTS
Source 31.3.12 31.3.13 Increase/ Use of Funds 31.3.12 31.3.13 Increase/
Decrease Decrease
Long term Long term use
source
Capital 100 130 30 Fixed asset 185 270 85

Reserves 40 55 15 Inv in subsidies 45 75 30

Term Loan 160 190 30

Total 300 375 75 Total 230 345 115

Short term Short term uses

sources
WC borrowing 85 135 50 Inventory 125 140 15

Other current 25 35 10 debtors 45 45 0

liabilities
Other CAs 10 15 5

Total 110 170 60 Total 180 200 20

Grand Total 410 545 135 Grand Total 410 545 135
ANALYSIS OF FINANCIAL STATEMENTS
It is observed from the above, long term funds increased by Rs. 75 Lakhs, the long term
use by way of increasing fixed assets and investment increased by Rs. 115 lakhs
Against increase of Rs. 60 lakhs in short term funds, short term use increased by Rs. 20
lakhs only
Against increase in WC Limits by 50 lakhs, inventory and debtors went up by Rs. 15 lakhs
only
It clearly indicates company has diverted short term funds for long time uses. Such
financing cause serious problem for the company as current assets are not adequate to
cover the working capital limits which results in cutting down the limits
Hence, a study of fund flow statement is useful in understanding from where the
company has got its funds and how it is utilized
The primary purpose of preparing a fund flow statement is to verify whether short term
funds have been diverted for long term use. It highlights the changes to the NWC
It also throws light on utilization of long term funds and short term funds
 CASH FLOW STATEMENT

A term lending institution has to ascertain when will the project need
money for different purposes and the different sources for such funds.
This information is furnished in the form of a cash flow statement.
A cash flow statement shows the cash accruals and cash disbursals over
different periods of time
This statement reveals the availability of cash to meet various
requirements of the project from time to time such as for acquisition of
fixed and other assets during the construction phase and for initial working
capital at the commencement of the operations.
 CASH FLOW STATEMENT

Cash flow statement is useful to the lending banker in two ways:-

This statement ensures sound financial planning. Funds should be available in
the form of cash as and when they are required for meeting the capital cost of
the project.
The funds should not only be adequate, but they must be available at the right
time so as to ensure completion of construction work in time and to provide
necessary initial working capital.
The cash flow statement serves as a guide to the lending banker for
determining (a)the time when repayment of the loan should commence and
(b) the period of repayment of the loan. The terms of repayment are
determined keeping in view the availability of funds with the borrowing
concern so that the latter does not feel unnecessary strain.
 CASH FLOW STATEMENT

PREPERATION OF CASH FLOW STATEMENT.

A cash flow statement may be prepared in respect of both a new concern and also
an existing one. In case of the new concern it will be based on the prospects of the
project under consideration while in the case of latter the estimates should relate
to the existing business as well as the proposed expansion of business.
The cash flow statement is generally prepared for a number of years which may
include in the case of new concern, the construction period and the operating
period as well.
These figures do not reflect the cumulative position but only the changes that are
likely to take place during the successive period. Thus a cash flow statement shows
the changes in the various items of B/S and also incorporates the working results of
each year.
 CASH FLOW STATEMENT
PREPERATION OF CASH FLOWSTATEMEN

The Cash flow statement is divided into two parts.

1.Sources of funds which shows inflow of cash from both capital and revenue.
2.Uses or application of funds, which shows the outflow of cash for various
purposes.

contd.,
 CASH FLOW STATEMENT
PREPERATION OF CASH FLOWSTATEMEN
I. INTERNAL SOURCES:- Internal sources of the funds mainly comprise the net profit estimated to
earned during the given periods. The net profit should be calculated before providing interest on lo
term loans and taxes but after providing depreciation and development rebate. The amounts of
depreciation and development rebate however remain available to the business concern and shou
therefore be shown as next source of interest funds.
2. EXTERNAL SOURCES:-External source of funds may be secured either by an increase in liabilitie
or a decrease in assets.
i. Increase in share capital,
ii. Increase in long term borrowings,
iii. Increase in deferred payment on plant and machinery.
iv. Increase in short term borrowings/cash credit from banks.
v. Sale of fixed assets and Investments.
 CASH FLOW STATEMENT
USE OF FUNDS:- The utilization of or application of funds may take the form of either (1) an
increase in assets, both fixed and current or (2) a decrease in liabilities.
1. Capital expenditure. The amount to be spent for acquiring additional fixed assets and normal replacements
and renewals are to be shown separately under the relevant periods.

2. Decrease in Long term loans: The long term loans raised from financial institutions are repayable in
instalments as per the schedule of repayment agreed upon. Similarly payment for plant and machinery
purchased on deferred payment basis is to be made in a agreed manner. The instalments of these
payments should be shown under the respective heads.

3. Increased current assets: Estimates about the increase in the amount of book debts, stock in trade, bills
receivable and other current assets are to be shown under this head.

4. Decrease in the unsecured loans, Deposits, and Other Current Liabilities.

5. Additional investments. In case funds are invested in securities they constitute outflow of funds for the
business.

6. Interest on long term loans, and taxation and dividends.

 ANALYSIS OF FINANCIAL
STATEMENTS
Audit:
Not mandatory for all. Compulsory for corporate bodies as per
companies act. All non-corporate business concerns with
annual turnover exceeding 60 lakhs (under section 44AB of IT
Act). All professionals (doctors, lawyers, architects,
accountants etc) with gross receipts of Rs. 15 lakhs in an
accounting year (under IT Act).

Corporate balance sheet should be as per the format given in

Schedule VI of Companies Act. No standard format is
prescribed for non-corporate business concerns.