Analysis of Financial Statements: Ratio Analysis and Cash Flow Statement
Ratio analysis and the cash flow statement test interpretation of financial statements. Ratio questions are formula-driven; cash flow questions test classification and adjustments under the indirect method.
Ratios
- 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, net profit ratio and return on capital employed.
Cash flow statement
Classify cash flows into operating, investing and financing activities. Under the indirect method, start with net profit before tax, add back non-cash expenses such as depreciation, deduct non-operating income, and adjust changes in working capital. Purchase or sale of fixed assets is investing; issue of shares, debentures and dividends are financing.
Worked example
Current assets ₹3,00,000 include inventory ₹80,000 and prepaid expenses ₹20,000; current liabilities are ₹1,50,000. Current ratio = 3,00,000 ÷ 1,50,000 = 2:1. Quick ratio = (3,00,000 − 80,000 − 20,000) ÷ 1,50,000 = 1.33:1.
Traps
- Including prepaid expenses and inventory in quick assets.
- Using closing inventory instead of average inventory.
- Treating depreciation as a cash flow.
- Classifying interest paid by a non-financial company as operating instead of financing.
- Forgetting that dividends paid are financing outflows.