Financial Statement Analysis and Ratio Analysis
Financial Statement Analysis and Ratio Analysis
This domain tests comparative and common-size statements, interpretation of financial statements and the computation of liquidity, solvency, turnover and profitability ratios.
Core rules
- Current ratio = current assets / current liabilities; quick ratio = quick assets / current liabilities.
- Quick assets exclude stock and prepaid expenses because they are not readily convertible into cash.
- Debt-equity ratio = long-term debt / shareholders' funds; stock turnover = cost of goods sold / average stock.
- Ratios are expressed as times, proportions or percentages and are meaningful only when compared over time or against a standard.
Worked example
Current assets are Rs.3,00,000, including stock Rs.80,000 and prepaid expenses Rs.10,000. Current liabilities are Rs.1,50,000. Current ratio = Rs.3,00,000 / Rs.1,50,000 = 2:1. Quick assets = Rs.3,00,000 - Rs.80,000 - Rs.10,000 = Rs.2,10,000. Quick ratio = Rs.2,10,000 / Rs.1,50,000 = 1.4:1. The firm can meet short-term obligations, but the quick ratio shows reliance on stock and prepayments is limited.
Traps
Including stock and prepaid expenses in quick assets; treating bank overdraft as a non-current liability; using closing stock instead of average stock; and comparing ratios across firms of different sizes without interpretation.