Financial Statement Analysis and Ratio Analysis
Financial Statement Analysis and Ratio Analysis tests whether you can read financial statements and convert them into comparable measures of liquidity, solvency, activity and profitability.
Tools and ratios
Comparative statements show changes across years; common-size statements express items as percentages of a base; trend analysis uses an index. Liquidity: current ratio = current assets / current liabilities; quick ratio = quick assets / current liabilities. Solvency: debt-equity ratio = debt / equity; proprietary ratio = proprietors' funds / total assets. Activity: inventory turnover = cost of goods sold / average inventory; debtors turnover = credit sales / average debtors. Profitability: gross profit ratio = gross profit / revenue from operations × 100; net profit ratio = net profit / revenue × 100; return on capital employed = profit before interest and tax / capital employed.
Worked example
Revenue from operations is Rs 5,00,000 and gross profit is Rs 1,25,000. Gross profit ratio = 1,25,000 / 5,00,000 × 100 = 25%. Current assets are Rs 2,00,000, inventory Rs 60,000 and current liabilities Rs 80,000. Current ratio = 2,00,000 / 80,000 = 2.5. Quick assets = 1,40,000, so quick ratio = 1.75. The firm is liquid, but the inventory holding still needs comparison with the industry.
Traps
Use revenue, not cost of sales, for the gross profit ratio when the formula specifies revenue. A high current ratio may hide slow-moving inventory. Use average receivables or inventory where data allow. A ratio alone is not a conclusion; compare across years, firms or norms.