Financial Statement Analysis and Ratio Analysis
What the exam tests
This domain tests tools of analysis: comparative and common-size statements, trend analysis, and ratios, plus interpretation. A ratio is meaningful only with its components and a comparison base.
Core ratios
- Liquidity: Current Ratio = Current Assets / Current Liabilities; Quick Ratio = Quick Assets / Current Liabilities. Quick assets exclude inventory and prepaid expenses.
- Solvency: Debt-Equity = Debt / Equity; Proprietary Ratio = Proprietors' Funds / Total Assets; Interest Coverage = EBIT / Interest.
- Activity: Inventory Turnover = Cost of Revenue from Operations / Average Inventory; Debtors Turnover = Credit Revenue / Average Trade Receivables; Fixed Asset Turnover = Revenue / Net Fixed Assets.
- Profitability: Gross Profit Ratio = Gross Profit / Revenue × 100; Net Profit Ratio = Net Profit / Revenue × 100; Return on Capital Employed = EBIT / Capital Employed × 100.
- Use average balances for turnover ratios when opening and closing figures are available; otherwise use closing.
Worked example
Current assets ₹3,60,000 include inventory ₹1,20,000 and prepaid insurance ₹10,000. Current liabilities ₹1,50,000 include bank overdraft ₹20,000. Current ratio = 3,60,000 / 1,50,000 = 2.4:1. Quick assets = 3,60,000 − 1,20,000 − 10,000 = ₹2,30,000. Quick ratio = 2,30,000 / 1,50,000 = 1.53:1. Reasoning: bank overdraft is a current liability; prepaid insurance is not quick. The firm is liquid, but inventory is a large part of current assets.
Traps
Using profit after tax in EBIT without adding back interest and tax; including inventory in quick assets; using closing inventory only when averages are required; and comparing ratios across firms of different sizes without common-size analysis.