Analysis of Financial Statements
Analysis converts statements into comparisons and ratios; marks come from applying the right formula to the right figure.
Comparative, common-size and trend
Comparative statements show absolute change and percentage change, computed as (current year − previous year) ÷ previous year × 100. A common-size income statement shows each item as a percentage of revenue from operations; a common-size balance sheet shows each item as a percentage of total assets or of total equity and liabilities, each side totalling 100. Trend analysis fixes a base year at 100 and expresses later years as (current year ÷ base year) × 100.
Ratios to memorise
Liquidity: current ratio = current assets ÷ current liabilities (ideal 2:1); quick ratio = quick assets ÷ current liabilities (ideal 1:1), quick assets excluding inventory and prepaid expenses. Solvency: debt-equity = long-term debt ÷ shareholders' funds; proprietary ratio = shareholders' funds ÷ total assets; interest coverage = EBIT ÷ interest. Activity: inventory turnover = cost of revenue from operations ÷ average inventory; debtors turnover = revenue from operations ÷ average trade receivables. Profitability: gross profit, operating and net profit ratios, return on capital employed = EBIT ÷ capital employed.
Worked example
Current assets ₹4,00,000 including inventory ₹1,20,000 and prepaid expenses ₹20,000; current liabilities ₹2,00,000. Current ratio = 2:1. Quick ratio = (₹4,00,000 − ₹1,20,000 − ₹20,000) ÷ ₹2,00,000 = 1.3:1.
Traps
Including prepaid expenses in quick assets; using profit after tax in the interest coverage ratio; using total debt where the question asks for long-term debt in the debt-equity ratio; averaging figures when only closing balances are given.