Unit 3: Financial statement analysis
Accounting for Management and Reporting notes · PTU syllabus (MBA 104-18)
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Unit summary
Financial statements must be analysed to judge a company's performance and health. This unit covers the concepts and objectives of financial analysis, trend analysis, common-size and comparative statements, ratio analysis — liquidity, solvency, profitability and turnover — and cash flow and funds flow statements.
After this unit you can
- Explain the objectives and tools of financial analysis
- Prepare comparative, common-size and trend statements
- Compute and interpret ratios
- Prepare cash flow and funds flow statements
PTU syllabus topics
- Concepts and objectives of financial analysis
- trend analysis
- common size and comparative statements
- ratio analysis (liquidity, solvency, profitability, turnover)
- cash flow and funds flow statements
Current ratio
Current assets / current liabilities
Debt-equity
Long-term debt / equity
Return on capital employed
EBIT / capital employed × 100
Inventory turnover
COGS / average inventory
Debtors collection period
Average debtors / credit sales × 365
Topic 1
Concepts and objectives of financial analysis
Financial analysis is the process of identifying the financial strengths and weaknesses of a firm by establishing relationships between items in the balance sheet and the profit and loss account.
By material used
External analysis (by outsiders) vs internal analysis (by management)
By modus operandi
Horizontal (over years) vs vertical (one year)
Tools (methods)
- Comparative statements.
- Common-size statements.
- Trend analysis.
- Ratio analysis (Unit 2).
- Fund flow and cash flow analysis (Unit 3).
Topic 2
Comparative statements
Comparative statements show the financial position or results for two or more periods side by side, with absolute change and percentage change.
| Particulars | 2024 (₹) | 2025 (₹) | Change (₹) | Change (%) |
|---|---|---|---|---|
| Revenue from operations | 10,00,000 | 12,50,000 | 2,50,000 | 25.0 |
| Cost of goods sold | 6,00,000 | 7,80,000 | 1,80,000 | 30.0 |
| Gross profit | 4,00,000 | 4,70,000 | 70,000 | 17.5 |
| Operating expenses | 1,50,000 | 1,60,000 | 10,000 | 6.7 |
| Operating profit | 2,50,000 | 3,10,000 | 60,000 | 24.0 |
- Interpretation: sales grew 25% but COGS grew faster (30%) — gross margin is under pressure; tight control of operating expenses still lifted operating profit by 24%.
- Limitation: inflation distorts comparisons; different accounting policies across years.
Topic 3
Common-size statements
Common-size statements express each item as a percentage of a common base — total revenue (income statement) or total assets/total liabilities (balance sheet). They enable comparison across firms of different sizes (vertical analysis).
| Particulars | Firm A (₹) | % | Firm B (₹) | % |
|---|---|---|---|---|
| Revenue | 5,00,000 | 100 | 20,00,000 | 100 |
| Cost of goods sold | 3,00,000 | 60 | 13,00,000 | 65 |
| Gross profit | 2,00,000 | 40 | 7,00,000 | 35 |
| Operating expenses | 75,000 | 15 | 2,00,000 | 10 |
| Net profit | 1,25,000 | 25 | 5,00,000 | 25 |
Example
Both firms earn 25% net margin — A through a better gross margin, B through lower overheads relative to sales; absolute figures alone hide this.
Topic 4
Trend analysis
Trend analysis shows the direction of change over several years by expressing each year's figure as a percentage of a base year (= 100).
Trend % for a year
Figure of the year ÷ Figure of the base year × 100
| Year | Sales (₹ lakh) | Trend % (2021 = 100) |
|---|---|---|
| 2021 | 40 | 100 |
| 2022 | 46 | 115 |
| 2023 | 52 | 130 |
| 2024 | 50 | 125 |
| 2025 | 60 | 150 |
- Choose a normal base year; compare related items together (sales with debtors and stock trends).
Exam tip
In exams, always end comparative, common-size or trend tables with 3–4 lines of interpretation — the numbers alone fetch only half the marks.
Topic 5
Liquidity and turnover ratios
Current ratio
Current assets ÷ Current liabilities (ideal 2:1)
Quick (acid-test) ratio
Quick assets ÷ Current liabilities (ideal 1:1); quick assets = current assets − inventory − prepaid expenses
Absolute liquid ratio
(Cash + Marketable securities) ÷ Current liabilities (ideal 0.5:1)
Inventory turnover
Cost of goods sold ÷ Average inventory
Debtors (receivables) turnover
Net credit sales ÷ Average debtors and bills receivable
Average collection period
365 ÷ Debtors turnover (days)
Creditors turnover
Net credit purchases ÷ Average creditors
Working capital turnover
Net sales ÷ Working capital
Fixed assets turnover
Net sales ÷ Net fixed assets
Example
Current assets ₹4,00,000 (including inventory ₹1,50,000 and prepaid ₹10,000); current liabilities ₹2,00,000. Current ratio = 2:1; quick ratio = (4,00,000 − 1,60,000) ÷ 2,00,000 = 1.2:1 — comfortable liquidity.
Topic 6
Profitability, coverage and solvency ratios
Gross profit ratio
Gross profit ÷ Net sales × 100
Net profit ratio
Net profit ÷ Net sales × 100
Operating ratio
(COGS + Operating expenses) ÷ Net sales × 100
Return on capital employed
EBIT ÷ Capital employed × 100
Return on equity
Profit after tax − preference dividend ÷ Equity shareholders' funds × 100
Earnings per share
(PAT − Preference dividend) ÷ Number of equity shares
Price-earnings ratio
Market price per share ÷ EPS
Debt-equity ratio
Long-term debt ÷ Shareholders' funds (ideal about 2:1 or lower)
Proprietary ratio
Shareholders' funds ÷ Total assets
Total assets to debt
Total assets ÷ Long-term debt
Interest coverage ratio
EBIT ÷ Interest charges
Debt service coverage ratio
(PAT + Depreciation + Interest) ÷ (Interest + Loan instalment)
Dividend coverage ratio
PAT ÷ Dividend
| Ratio group | Tells about | Who is most interested |
|---|---|---|
| Liquidity | Ability to pay short-term obligations | Short-term creditors, banks |
| Turnover | Efficiency in using assets | Management |
| Profitability | Earning capacity | Shareholders, investors |
| Solvency and coverage | Long-term stability and debt servicing | Lenders, debenture holders |
Exam tip
Interpret every ratio you compute — "the current ratio of 2:1 indicates satisfactory liquidity" — and compare with the ideal or industry average.
Topic 7
Cash flow statement
AS-3 (revised) requires classification of cash flows into three activities.
Operating activities
Principal revenue-producing activities — receipts from customers, payments to suppliers and employees, income tax
Investing activities
Purchase and sale of fixed assets and investments, interest and dividends received (non-financial company)
Financing activities
Issue and redemption of shares and debentures, borrowings and repayments, dividends and interest paid
- Cash equivalents: short-term, highly liquid investments readily convertible to cash with insignificant risk (maturity ≤ 3 months).
Indirect method of operating cash flow
- 1
Net profit before tax and extraordinary items
- 2
Add non-cash and non-operating charges
Depreciation, amortisation, loss on sale of assets, interest expense
- 3
Less non-operating incomes
Profit on sale of assets, interest/dividend received
- 4
Operating profit before working capital changes
- 5
Adjust working capital
Add decrease in current assets and increase in current liabilities; deduct increase in current assets and decrease in current liabilities
- 6
Less income tax paid
- 7
Net cash from operating activities
Example
Net profit before tax ₹1,50,000; depreciation ₹30,000; profit on sale of land ₹10,000; increase in debtors ₹25,000; decrease in stock ₹5,000; increase in creditors ₹12,000; tax paid ₹40,000. Operating profit before WC changes = 1,70,000; after WC changes = 1,70,000 − 25,000 + 5,000 + 12,000 = 1,62,000; net cash from operating activities = ₹1,22,000.
Exam tip
Interest paid is a financing activity and dividend received is investing for a non-financial company — misclassifying these is the most common error.
Topic 8
Funds flow statement
- 1Schedule of changes in working capital
Increase or decrease in each current item
- 2Funds from operations
Adjusted profit and loss account
- 3Prepare accounts for non-current items
Fixed assets, depreciation, provision for tax, dividends
- 4Fund flow statement
Sources = Applications (including change in working capital)
Funds from operations
Funds from operations
Net profit (closing P&L − opening P&L) + Non-fund and non-operating debits (depreciation, goodwill and preliminary expenses written off, loss on sale of fixed assets, transfer to reserves, provision for tax and proposed dividend if treated as non-current) − Non-operating credits (profit on sale of fixed assets, dividend received, refund of tax)
| Sources of funds | Applications of funds |
|---|---|
| Funds from operations | Funds lost in operations |
| Issue of shares and debentures | Redemption of shares/debentures |
| Long-term loans raised | Repayment of long-term loans |
| Sale of fixed assets and investments | Purchase of fixed assets and investments |
| Non-trading income (dividends received) | Payment of tax and dividends (when non-current) |
| Decrease in working capital | Increase in working capital |
Example
Net profit ₹80,000; depreciation ₹20,000; goodwill written off ₹5,000; profit on sale of machine ₹3,000. Funds from operations = 80,000 + 20,000 + 5,000 − 3,000 = ₹1,02,000.
Uses of fund flow statement
- Shows how funds were raised and used; reveals use of long-term funds for short-term needs.
- Helps plan future financing and dividend policy; assesses working capital management.
Key terms
- Comparative statement
- Figures of two or more periods side by side
- Common-size statement
- Items as percentages of a common base
- Current ratio
- Current assets ÷ current liabilities
- Debt-equity ratio
- Long-term debt ÷ shareholders' funds
- Operating cash flow
- Cash generated from principal revenue activities
Quick revision
- Horizontal (comparative, trend) and vertical (common-size) analysis.
- Liquidity, turnover, profitability, solvency ratios.
- Cash flow: operating, investing, financing (AS-3/Ind AS 7).
- Funds flow: working capital changes and funds from operations.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.What are the objectives of financial analysis?
- Q2.What is trend analysis?
- Q3.Define quick ratio.
- Q4.What is return on capital employed?
- Q5.Classify cash flows under AS-3.
- Q6.How are funds from operations calculated?
Long-answer questions
- Q1.Explain the tools of financial statement analysis.
- Q2.Prepare and interpret comparative and common-size statements.
- Q3.Explain ratio analysis with its classification.
- Q4.Prepare a cash flow statement and a funds flow statement.
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