# Accounting and Interpretation of Financial Statements

**Introduction:**

Ratio analysis is one of the techniques of financial analysis to
evaluate the financial condition and performance of a business concern. Simply,
ratio means the comparison of one figure to other relevant figure or figures.

According to Myers, “Ratio analysis of financial statements is a
study of relationship among various financial factors in a business as
disclosed by a single set of statements and a study of trend of these factors
as shown in a series of statements."

*Objectives of Ratio analysis:*
a)
To know the area of the business which need more
attention.

b)
To know about the potential areas which can be
improved with the effort in the desired direction.

c)
To provide a deeper analysis of the profitability,
liquidity, solvency and efficiency levels in the business.

d)
To provide information for decision making cross
sectional analysis by comparing the performance with the best industry
standards.

e)
To provide information derived from financial
statement useful for making projection and estimates for the future.

*Advantages and Uses of Ratio Analysis:*
There are various groups of people who are interested
in analysis of financial position of a company used the ratio analysis to
workout a particular financial characteristic of the company in which they are
interested. Ratio analysis helps the various groups in the following manner: -

a)
To workout the profitability: Accounting ratio help to
measure the profitability of the business by calculating the various
profitability ratios. It helps the management to know about the earning
capacity of the business concern.

b)
Helpful in analysis of financial statement: Ratio
analysis help the outsiders just like creditors, shareholders,
debenture-holders, bankers to know about the profitability and ability of the
company to pay them interest and dividend etc.

c)
Helpful in comparative analysis of the performance:
With the help of ratio analysis a company may have comparative study of its
performance to the previous years. In this way company comes to know about its
weak point and be able to improve them.

d)
To simplify the accounting information: Accounting
ratios are very useful as they briefly summaries the result of detailed and
complicated computations.

e)
To workout the operating efficiency: Ratio analysis
helps to workout the operating efficiency of the company with the help of
various turnover ratios. All turnover ratios are worked out to evaluate the
performance of the business in utilising the resources.

*Limitations of Ratio Analysis*
In spite of many advantages, there are certain limitations of the
ratio analysis techniques. The following are the main limitations of accounting
ratios:

a)
Limited Comparability: Different firms apply different
accounting policies. Therefore the ratio of one firm can not always be compared
with the ratio of other firm.

b)
False Results: Accounting ratios are based on data
drawn from accounting records. In case that data is correct, then only the
ratios will be correct. For example, valuation of stock is based on very high
price, the profits of the concern will be inflated and it will indicate a wrong
financial position. The data therefore must be absolutely correct.

c)
Effect of Price Level Changes: Price level changes
often make the comparison of figures difficult over a period of time. Changes
in price affects the cost of production, sales and also the value of assets.
Therefore, it is necessary to make proper adjustment for price-level changes
before any comparison.

d)
Qualitative factors are ignored: Ratio analysis is a
technique of quantitative analysis and thus, ignores qualitative factors, which
may be important in decision making. For example, average collection period may
be equal to standard credit period, but some debtors may be in the list of
doubtful debts, which is not disclosed by ratio analysis.

e)
Effect of window-dressing: In order to cover up their
bad financial position some companies resort to window dressing. They may
record the accounting data according to the convenience to show the financial
position of the company in a better way.

**Types of Accounting Ratio:**

Ratio can be classified on the basis of the their functions in the
following groups:

(A) Liquidity
Ratios :

(i)
Short term solvency ratio

(ii)
Long term solvency ratio

(B)
Profitability Ratios

(C) Activity
Ratios/ Turnover Ratios

(D) Financial
Ratios

The above groups are
further classified into following parts :

(i) Short
term solvency ratio :

(a) Current ratio

(b) Liquid ratio/Acid Test ratio

(c) Absolute liquid ratio

(ii) Long
term solvency ratio :

a)
Equity ratio

b)
Debt ratio

c)
Equity ratio

d)
Net income to debt service ratio

(iii)
Profitability ratio :

a)
Gross Profit Ratio

b)
Net Profit Ratio

c)
Operating Net Profit Ratio

d)
Operating Ratio

e)
Return on Investment or Return on Capital Employed

f)
Return on Equity

g)
Earning Per Share

(iv) Activity Ratios/ Turnover Ratios :

a)
Capital Turnover Ratio

b)
Fixed Assets Turnover Ratio

c)
Working Capital Turnover Ratio

d)
Stock Turnover Ratio

e)
Debtors Turnover Ratio

f)
Creditors turnover ratio

(v) Financial Ratios :

(a)
Debt-Equity Ratio

(b) Proprietary
Ratio

(C) Capital
Gearing Ratio

(d) Debt to
Total Funds Ratio

(e) Fixed
Assets Ratio

(f) Interest
Coverage Ratio

**Meaning, Objective and Method of Calculation of various types of ratios :**

Current
Ratio: Current ratio is calculated in order to work out
firm’s ability to pay off its short-term liabilities. This ratio is also called
working capital ratio. This ratio explains the relationship between current
assets and current liabilities of a business. It is calculated by applying the
following formula :

Current Ratio = Current Assets/Current Liabilities

Current Assets includes Cash in hand, Cash at Bank,
Sundry Debtors, Bills Receivable, Stock of Goods, Short-term Investments,
Prepaid Expenses, Accrued Incomes etc.

Current Liabilities includes Sundry Creditors, Bills
Payable, Bank Overdraft, Outstanding Expenses etc.

Objective and Significance: Current ratio shows the
short-term financial position of the business. This ratio measures the ability
of the business to pay its current liabilities. The ideal current ratio is
supposed to be 2:1. In case, if this ratio is less than 2:1, the short-term
financial position is not supposed to be very sound and in case, if it is more
than 2:1, it indicates idleness of working capital.

Liquid
Ratio: Liquid ratio shows short-term solvency of a business.
It is also called acid-test ratio and quick ratio. It is calculated in order to
know whether or not current liabilities can be paid with the help of quick
assets quickly. Quick assets mean those assets, which are quickly convertible
into cash.

Liquid Ratio = Liquid Assets/Current Liabilities

Liquid assets includes Cash in hand, Cash at Bank,
Sundry Debtors, Bills Receivable, Short-term investments etc. In other words,
all current assets are liquid assets except stock and prepaid expenses.

Current liabilities includes Sundry Creditors, Bills
Payable, Bank Overdraft, Outstanding Expenses etc.

Objective and Significance: Liquid ratio is calculated
to work out the liquidity of a business. This ratio measures the ability of the
business to pay its current liabilities in a real way. The ideal liquid ratio
is supposed to be 1:1. In case, this ratio is less than 1:1, it shows a very
weak short-term financial position and in case, it is more than 1:1, it shows a
better short-term financial position.

Gross
Profit Ratio: Gross Profit Ratio shows the relationship between
Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be
calculated in the following manner: -

Gross Profit Ratio = Gross Profit/Net Sales x 100

Where Gross Profit = Net Sales – Cost of Goods Sold

Cost of Goods Sold = Opening Stock + Net Purchases +
Direct Expenses – Closing Stock

And Net Sales = Total Sales – Sales Return

Objective and Significance: Gross Profit Ratio
provides guidelines to the concern whether it is earning sufficient profit to
cover administration and marketing expenses and is able to cover its fixed
expenses. This ratio can also be used in stock-inventory control. Maintenance
of steady gross profit ratio is important .Any fall in this ratio would put the
management in difficulty in the realisation of fixed overheads of the business.

Net Profit
Ratio: Net Profit Ratio shows the relationship between Net
Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in
the following manner: -

Net Profit Ratio = Net Profit/Net Sales x 100

Where, Net Profit = Gross Profit – Selling and
Distribution Expenses – Office and Administration Expenses – Financial Expenses
– Non Operating Expenses + Non Operating Incomes.

And Net Sales = Total Sales – Sales Return

Objective and Significance: In order to work out
overall efficiency of the concern Net Profit ratio is calculated. This ratio is
helpful to determine the operational ability of the concern. While comparing
the ratio to previous years’ ratios, the increment shows the efficiency of the
concern.

Operating
Profit Ratio:. Operating Profit Ratio shows the relationship between
Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the
following manner: -

Operating Profit Ratio = (Operating Profit/Net Sales)
x 100

Where Operating Profit = Gross Profit – Operating
Expenses

Or Operating Profit = Net Profit + Non Operating
Expenses – Non Operating Incomes

And Net Sales = Total Sales – Sales Return

Objective and Significance: Operating Profit Ratio
indicates the earning capacity of the concern on the basis of its business
operations and not from earning from the other sources. It shows whether the
business is able to stand in the market or not.

Operating
Ratio: Operating Ratio matches the operating cost to the net
sales of the business. Operating Cost means Cost of goods sold plus Operating
Expenses.

Operating Ratio = Operating Cost/Net Sales x 100

Where Operating Cost = Cost of goods sold + Operating
Expenses

(Operating Expenses = Selling and Distribution
Expenses, Office and Administration Expenses, Repair and Maintenance.)

Cost of Goods Sold = Opening Stock + Net Purchases +
Direct Expenses – Closing Stock

Or Cost of Goods Sold = Net sales – Gross Profit

Objective and Significance: Operating Ratio is
calculated in order to calculate the operating efficiency of the concern. As
this ratio indicates about the percentage of operating cost to the net sales,
so it is better for a concern to have this ratio in less percentage. The less
percentage of cost means higher margin to earn profit.

Return on
Investment or Return on Capital Employed: This ratio shows the
relationship between the profit earned before interest and tax and the capital
employed to earn such profit.

Return on Capital Employed = Net Profit before
Interest, Tax and Dividend/Capital Employed x 100

Where Capital Employed = Share Capital (Equity +
Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets

Or

Capital Employed = Fixed Assets + Current Assets –
Current Liabilities

Objective and Significance: Return on capital employed
measures the profit, which a firm earns on investing a unit of capital. The
profit being the net result of all operations, the return on capital expresses
all efficiencies and inefficiencies of a business. This ratio has a great
importance to the shareholders and investors and also to management. To
shareholders it indicates how much their capital is earning and to the
management as to how efficiently it has been working. This ratio influences the
market price of the shares. The higher the ratio, the better it is.

. Return on Equity: Return on equity is
also known as return on shareholders’ investment. The ratio establishes
relationship between profit available to equity shareholders with equity
shareholders’ funds.

Return on Equity = Net Profit after Interest, Tax and
Preference Dividend/Equity Shareholders’ Funds x 100

Where Equity Shareholders’ Funds = Equity Share
Capital + Reserves and Surplus – Fictitious Assets

Objective and Significance: Return on Equity judges
the profitability from the point of view of equity shareholders. This ratio has
great interest to equity shareholders. The return on equity measures the
profitability of equity funds invested in the firm. The investors favour the
company with higher ROE.

Earning
Per Share: Earning per share is calculated by dividing the net
profit (after interest, tax and preference dividend) by the number of equity
shares.

Earning Per Share = Net Profit after Interest, Tax and
Preference Dividend/No. Of Equity Shares

Objective and Significance: Earning per share helps in
determining the market price of the equity share of the company. It also helps
to know whether the company is able to use its equity share capital effectively
with compare to other companies. It also tells about the capacity of the
company to pay dividends to its equity shareholders.

Debt-Equity
Ratio: Debt equity ratio shows the relationship between
long-term debts and shareholders funds’. It is also known as
‘External-Internal’ equity ratio.

Debt Equity Ratio = Debt/Equity

Where Debt (long term loans) include Debentures,
Mortgage Loan, Bank Loan, Public Deposits, Loan from financial institution etc.

Equity (Shareholders’ Funds) = Share Capital (Equity +
Preference) + Reserves and Surplus – Fictitious Assets

Objective and Significance: This ratio is a measure of
owner’s stock in the business. Proprietors are always keen to have more funds
from borrowings because:

(i) Their stake in the business is reduced and
subsequently their risk too

(ii) Interest on loans or borrowings is a deductible
expenditure while computing taxable profits. Dividend on shares is not so
allowed by Income Tax Authorities.

The normally acceptable debt-equity ratio is 2:1.

Debt to
Total Funds Ratio: This ratio gives same indication as the debt-equity
ratio as this is a variation of debt-equity ratio. This ratio is also known as
solvency ratio. This is a ratio between long-term debt and total long-term
funds.

Debt to Total Funds Ratio = Debt/Total Funds

Where Debt (long term loans) include Debentures,
Mortgage Loan, Bank Loan, Public Deposits, Loan from financial institution etc.

Total Funds = Equity + Debt = Capital Employed

Equity (Shareholders’ Funds) = Share Capital (Equity +
Preference) + Reserves and Surplus – Fictitious Assets

Objective and Significance: - Debt to Total Funds
Ratios shows the proportion of long-term funds, which have been raised by way
of loans. This ratio measures the long-term financial position and soundness of
long-term financial policies. A higher proportion is not considered good and
treated an indicator of risky long-term financial position of the business.

Fixed
Assets Ratio: Fixed Assets Ratio establishes the relationship of
Fixed Assets to Long-term Funds.

Fixed Assets Ratio = Long-term Funds/Net Fixed Assets

Where Long-term Funds = Share Capital (Equity +
Preference) + Reserves and Surplus + Long- term Loans – Fictitious Assets

Net Fixed Assets means Fixed Assets at cost less
depreciation. It will also include trade investments.

Objective and Significance: This ratio indicates as to
what extent fixed assets are financed out of long-term funds. It is well
established that fixed assets should be financed only out of long-term funds.
This ratio workout the proportion of investment of funds from the point of view
of long-term financial soundness. This ratio should be equal to 1. If the ratio
is less than 1, it means the firm has adopted the impudent policy of using
short-term funds for acquiring fixed assets. On the other hand, a very high
ratio would indicate that long-term funds are being used for short-term
purposes, i.e. for financing working capital.

Proprietary
Ratio: Proprietary Ratio establishes the relationship
between proprietors’ funds and total tangible assets. This ratio is also termed
as ‘Net Worth to Total Assets’ or ‘Equity-Assets Ratio’.

Proprietary Ratio = Proprietors’ Funds/Total Assets

Where Proprietors’ Funds = Shareholders’ Funds = Share
Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets

Total Assets include only Fixed Assets and Current
Assets. Any intangible assets without any market value and fictitious assets
are not included.

Objective and Significance: This ratio indicates the
general financial position of the business concern. This ratio has a particular
importance for the creditors who can ascertain the proportion of shareholder’s
funds in the total assets of the business. Higher the ratio, greater the
satisfaction for creditors of all types.

indicates that how many times the profit covers the
interest. It measures the margin of safety for the lenders. The higher the
number, more secure the lender is in respect of periodical interest.

Fixed
Assets Turnover Ratio: Fixed assets turnover ratio establishes a
relationship between net sales and net fixed assets. This ratio indicates how
well the fixed assets are being utilised.

Fixed Assets Turnover Ratio = Net Sales/Net Fixed
Assets

In case Net Sales are not given in the question cost
of goods sold may also be used in place of net sales. Net fixed assets are
considered cost less depreciation.

Objective and Significance: This ratio expresses the
number to times the fixed assets are being turned over in a stated period. It
measures the efficiency with which fixed assets are employed. A high ratio
means a high rate of efficiency of utilisation of fixed asset and low ratio
means improper use of the assets.

Working
Capital Turnover Ratio: Working capital turnover ratio establishes a
relationship between net sales and working capital. This ratio measures the
efficiency of utilisation of working capital.

Working Capital Turnover Ratio = Net Sales or Cost of
Goods Sold/Net Working Capital

Where Net Working Capital = Current Assets – Current
Liabilities

Objective and Significance: This ratio indicates the
number of times the utilisation of working capital in the process of doing
business. The higher is the ratio, the lower is the investment in working
capital and the greater are the profits. However, a very high turnover
indicates a sign of over-trading and puts the firm in financial difficulties. A
low working capital turnover ratio indicates that the working capital has not
been used efficiently.

Stock
Turnover Ratio: Stock turnover ratio is a ratio between cost of goods
sold and average stock. This ratio is also known as stock velocity or inventory
turnover ratio.

Stock Turnover Ratio = Cost of Goods Sold/Average
Stock

Where Average Stock = [Opening Stock + Closing
Stock]/2

Cost of Goods Sold = Opening Stock + Net Purchases +
Direct Expenses – Closing Stock

Objective and Significance: Stock is a most important
component of working capital. This ratio provides guidelines to the management
while framing stock policy. It measures how fast the stock is moving through
the firm and generating sales. It helps to maintain a proper amount of stock to
fulfill the requirements of the concern. A proper inventory turnover makes the
business to earn a reasonable margin of profit.

Debtors’
Turnover Ratio: Debtors turnover ratio indicates the relation between
net credit sales and average accounts receivables of the year. This ratio is
also known as Debtors’ Velocity.

Debtors Turnover Ratio = Net Credit Sales/Average
Accounts Receivables

Where Average Accounts Receivables = [Opening Debtors
and B/R + Closing Debtors and B/R]/2

Credit Sales = Total Sales – Cash Sales-Return Inward

Objective and Significance: This ratio indicates the
efficiency of the concern to collect the amount due from debtors. It determines
the efficiency with which the trade debtors are managed. Higher the ratio,
better it is as it proves that the debts are being collected very quickly.

Debt
Collection Period: Debt collection period is the period over which the
debtors are collected on an average basis. It indicates the rapidity or
slowness with which the money is collected from debtors.

Debt Collection Period = 12 Months or 365 Days/Debtors
Turnover Ratio

Or

Debt Collection Period = Average Trade Debtors/Average
Net Credit Sales per day

Or

365 days or 12 months x Average Debtors/Credit Sales

(360 days can also be used instead of 365 days)

Objective and Significance: This ratio indicates how
quickly and efficiently the debts are collected. The shorter the period the
better it is and longer the period more the chances of bad debts. Although no
standard period is prescribed anywhere, it depends on the nature of the
industry.

Liquidity Ratio: Liquidity ratios are calculated to have indications
about the short term solvency of the business, i.e. the firm’s ability to meet
its current obligations.

Solvency Ratio: Solvency ratios are calculated to determine the ability of the
business to service its debt in the long Run.

Earning per Share: EPS = Profit available for Equity Shareholders / No. of Equity
Shares

Book Value per Share: Book Value Per Share = Equity shareholders’ Funds / No. of Equity
Shares

What are the types of
Ratios according to traditional classification?

Types of ratio according to traditional classification:

Income Statement Ratio:- A ratio of two variables from the
income statement is known as Income Statement Ratio.

Balance Sheet Ratio:- In case both variables are from balance
sheet, it is classified as balance sheet ratio.

Composite Ratio:- If a ratio is computed with one variable
from income statement and another variable from balance sheet, it is called
Composite Ratio.

Profitability Ratios: The profitability or financial performance is mainly summarised
in Income statement. Profitability ratios are calculated to analyse the
earning capacity of the business which is the outcome of utilisation of
resources employed in the business. There is a close relationship between the
profit and the efficiency with which the resources employed in the business are
utilised. The various ratios are:

a)
Gross Profit Ratio

b)
Operation Ratio

c)
Operating Profit Ratio

d)
Net Profit Ratio

e)
Return in Investment or Return on Capital Employed

f)
Return on Net Worth

g)
Earning per share

h)
Book value per Share

i)
Dividend Payout Ratio

j)
Price Earning Ratio