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Unit 4 of 4 · M.Com Sem 2

Unit 4: Financial statement analysis

Management and Cost Accounting notes · PTU syllabus (MCOP202-18)

3 min read7 topics10 exam questions
On this page
  1. Unit summary
  2. Financial statement analysis: types and methods
  3. Nature of ratio analysis
  4. Liquidity and turnover ratios
  5. Profitability, coverage and solvency ratios
  6. Preparation of a fund flow statement
  7. Cash flow statement as per AS-3
  8. Management reporting
  9. Key terms
  10. Quick revision
  11. Important questions

Unit summary

Financial statements must be analysed before they can guide decisions. This unit covers the types, methods, objectives and limitations of financial statement analysis, ratio analysis — uses, classification, advantages and limitations — cash flow and fund flow statements, and management reporting.

After this unit you can

  • Explain the types, methods, objectives and limitations of financial statement analysis
  • Compute and interpret ratios
  • Prepare fund flow and cash flow statements
  • Explain management reporting and its essentials

PTU syllabus topics

  • Types
  • methods
  • objectives and limitations of financial statement analysis
  • ratio analysis — uses
  • classification
  • advantages and limitations
  • cash flow statement
  • fund flow statement
  • management reporting
ComparisonFund flow vs cash flow statement
Fund flow
Cash flow

Based on

Working capital

Cash and cash equivalents

Shows

Sources and uses of funds

Operating, investing, financing cash flows

Use

Long-term planning

Short-term liquidity

Standard

No mandatory standard

AS 3 / Ind AS 7

1

Topic 1

Financial statement analysis: types and methods

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.

ClassificationTypes of financial analysis
Financial analysis

  • 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).
  • Objectives: assess profitability, solvency, liquidity, efficiency and growth; compare with past and peers; forecast.
  • Limitations: historical data, ignores qualitative factors, affected by accounting policies and window dressing, inflation distortions.
2

Topic 2

Nature of ratio analysis

A ratio is an arithmetical expression of the relationship between two related figures. Ratio analysis is the process of computing, comparing and interpreting ratios.

  • Expressed as pure ratio (2:1), percentage (25%) or times (8 times).
  • Uses: judge liquidity, solvency, efficiency and profitability; inter-firm and intra-firm comparison; trend analysis; forecasting; communication.
  • Limitations: based on historical data, affected by accounting policies and window dressing, ignore price-level changes and qualitative factors, no standard ratios universally valid.
3

Topic 3

Liquidity and turnover ratios

Key formulasLiquidity 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)

Key formulasTurnover (activity) ratios

  • 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.

4

Topic 4

Profitability, coverage and solvency ratios

Key formulasProfitability 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

Key formulasSolvency and coverage ratios

  • 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 groupTells aboutWho is most interested
LiquidityAbility to pay short-term obligationsShort-term creditors, banks
TurnoverEfficiency in using assetsManagement
ProfitabilityEarning capacityShareholders, investors
Solvency and coverageLong-term stability and debt servicingLenders, 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.

5

Topic 5

Preparation of a fund flow statement

ProcessSteps in preparing a fund flow statement
  1. 1Schedule of changes in working capital

    Increase or decrease in each current item

  2. 2Funds from operations

    Adjusted profit and loss account

  3. 3Prepare accounts for non-current items

    Fixed assets, depreciation, provision for tax, dividends

  4. 4Fund flow statement

    Sources = Applications (including change in working capital)

Funds from operations

Key formulasFunds 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 fundsApplications of funds
Funds from operationsFunds lost in operations
Issue of shares and debenturesRedemption of shares/debentures
Long-term loans raisedRepayment of long-term loans
Sale of fixed assets and investmentsPurchase of fixed assets and investments
Non-trading income (dividends received)Payment of tax and dividends (when non-current)
Decrease in working capitalIncrease 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.
6

Topic 6

Cash flow statement as per AS-3

AS-3 (revised) requires classification of cash flows into three activities.

ClassificationClassification of cash flows (AS-3)
Cash flows

  • 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

ProcessCash from operating activities (indirect method)
  1. 1

    Net profit before tax and extraordinary items

  2. 2

    Add non-cash and non-operating charges

    Depreciation, amortisation, loss on sale of assets, interest expense

  3. 3

    Less non-operating incomes

    Profit on sale of assets, interest/dividend received

  4. 4

    Operating profit before working capital changes

  5. 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. 6

    Less income tax paid

  7. 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.

7

Topic 7

Management reporting

Management reporting provides managers with timely, relevant information for planning, control and decision-making.

ClassificationTypes of management reports
Management reports

  • By period

    Daily, weekly, monthly, annual

  • By purpose

    Control (variance) reports, information reports, decision reports, venture reports

  • By level

    Top management (summaries, KPIs), middle (departmental), operational (detailed)

  • By form

    Written, tabular, graphical, dashboards

  • Essentials of a good report: relevance, timeliness, accuracy, clarity, conciseness, exception-based (highlight deviations), comparability, cost-effectiveness, actionability.
  • Modern tools: ERP-based MIS, BI dashboards (Power BI, Tableau), real-time KPIs, drill-down analytics.

Exam tip

Pyramid reporting — the higher the level, the more summarised the report — is a useful diagram for this topic.

Key terms

Financial statement analysis
Evaluating financial statements to judge performance and position
Ratio
Relationship between two related figures
Funds from operations
Working capital generated from trading operations
Cash equivalents
Highly liquid short-term investments
Management reporting
Supplying managers with timely decision information

Quick revision

  • Analysis: horizontal and vertical; comparative, common-size, trend, ratios.
  • Ratios: liquidity, turnover, profitability, solvency.
  • Fund flow: working capital basis; cash flow: AS-3 activities.
  • Management reports: by period, purpose, level, form.
  • Good reports: relevant, timely, accurate, exception-based.

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

  1. Q1.State the objectives of financial statement analysis.
  2. Q2.What are the limitations of ratio analysis?
  3. Q3.Distinguish fund flow and cash flow statements.
  4. Q4.What are funds from operations?
  5. Q5.What is management reporting?
  6. Q6.State four essentials of a good management report.

Long-answer questions

  1. Q1.Explain the types, methods and limitations of financial statement analysis.
  2. Q2.Explain the classification of ratios with formulas.
  3. Q3.Prepare fund flow and cash flow statements and explain their uses.
  4. Q4.Explain management reporting and the essentials of a good report.

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