Analysis of Financial Statements and Accounting Ratios
Analysis of Financial Statements and Accounting Ratios tests whether you can compute and interpret ratios from a given balance sheet or P&L. Ratios are grouped as liquidity, solvency, activity and profitability.
Key formulas
Current ratio = current assets/current liabilities. Quick ratio = quick assets/current liabilities, where quick assets exclude inventory and prepaid expenses. Debt-equity = long-term debt/shareholders' funds. Inventory turnover = cost of goods sold/average inventory. Trade receivables turnover = credit revenue/average trade receivables. Trade payables turnover = credit purchases/average trade payables. Gross profit ratio = gross profit/revenue from operations × 100. Operating ratio = operating cost/revenue from operations × 100. Return on investment = profit before interest and tax/capital employed × 100.
Interpretation
A high current ratio is not always good: it may mean idle inventory or poor collection. A high debt-equity means greater financial risk. Activity ratios measure efficiency; profitability ratios measure earning quality. Use averages for turnover ratios; use year-end figures only when averages are not available.
Worked example
Cost of goods sold ₹12,00,000; opening inventory ₹1,80,000; closing inventory ₹2,20,000. Average inventory = ₹2,00,000. Inventory turnover = 12,00,000/2,00,000 = 6 times. Inventory holding period = 365/6 = about 61 days. This means the firm sells its average stock about six times a year.
Traps
Do not include prepaid expenses in quick assets. Do not treat current liabilities as debt for debt-equity. Shareholders' funds include reserves but exclude fictitious assets. Use credit sales/purchases for turnover ratios if the split is available. Do not compare ratios across industries without context.