Accounting with Ratio Analysis

Dr. C.PADMAVATHI. FCA

Financial Statements
• What is the objective of Financial Statements ?

To provide information about the financial position, performance and cash flows of an
enterprise that is useful to a wide range of users in making economic decisions.

The financial position depicts the economic resources an entity controls, its financial
structure, its liquidity and solvency, and its capacity to adapt to changes in the environment
in which it operates.

Information about the performance of an enterprise, in particular its profitability, is

required in order to assess potential changes in the economic resources that it is likely to
control in the future

Information concerning cash flows of an enterprise is useful in order to evaluate its

investing, financing and operating activities during the reporting period.
What are the components of Financial Statements ?
What are the underlying assumptions in the Preparation of Financial Statements?
Accrual Basis
Going Concern
Consistency
What are the attributes that make Financial Statements useful to users?
Understandability
Relevance : Materiality
Reliability : Substance over form – faithful representation – Neutrality –
completeness- Prudence.
Comparability
What are the elements in the Financial Statements?

Assets: An economic resource controlled by an entity, from which economic

benefits will flow to the entity
Liabilities : Present obligation the settlement of which usually involves the
enterprise giving up resources embodying economic benefits
Equity: Residual Interest in the Net assets of the entity
Income : Income encompasses Revenues and Gains. Revenues arise in the course
of the ordinary activities of an enterprise and is referred to by a variety of
different names including sales, fees, interest, dividends, royalties and rent. They
take the form of inflow of economic benefits to the firm or reduction in liabilities.
Expenses: expenses encompasses those expenses that arise in the course of the
ordinary activities of the enterprise, as well as losses. They take the form of an
outflow or depletion of assets or enhancement of liabilities.
 Concepts, principles & conventions

 Business Entity:
The legal entity of a corporate business is distinct from the entity of its owners and managers and people
who are associated with it.

 Going Concern:
This concept assumes that the business will continue in operation for as long as possible and will not be
dissolved in the immediate future.

 Accounting Period Concept :

Financial Statements should be prepared at regular intervals to ascertain information about the business.

 Dual concept:
This concept states that for every transaction, there will be two aspects.

 Money Measurement:
This concept requires that those transactions alone that are capable of being measured in terms of money
are only to be recorded in the books of accounts.
 Accrual :
Revenues earned in a period are recognized in that period, regardless of when cash
is paid and to recognize all expenses incurred during a period, regardless of when
cash payment is made.

 Cost Concept:
Cost concept implies that in accounting, all transactions are generally recorded at
cost at which they are transacted.

 Matching Concept:
In order to determine the profits or losses accrued in an accounting period, the
expenses must relate to the goods or services sold during the period.

 Conservatism:
This concept emphasizes that revenues are recognized only when they are
 Consistency :
The consistency concept requires that once an entity has decided on one method, it will treat
all subsequent events of the same character in the same fashion unless it has a sound reason
to change the method of treatment of that event.

 Realisation principle:
According to this concept, revenues are recognized only when the goods and services have
been delivered and there is certainty that the revenue will be realized.

 Materiality:
The concept of materiality is the threshold for recognition of a transaction in accounting
process. All significant items should be reported properly in the Financial Statements.
 Full Disclosure:
Requires that circumstances, information, events that make a difference to the decision
making of user should be disclosed.
• What are different types of Accounts? What are the rules of
Accounting?
Real Account • Debit what comes in
Real • Credit what goes out
Personal Account Accounts

Nominal Accounts
• Debit the Receiver
Personal
Accounts
• Credit the Giver

• Debit all Expenses and Losses

Nominal
Accounts
• Credit all Incomes and Gains
 Assets
Economic Resources – controlled – economic
benefits flow to the entity

Current Expected to be realised in cash or sold or consumed

during the normal operating cycle or one year .
Assets
Eg.Cash - Marketable Securities -Accounts Receivable / Notes Receivable
– Inventories- Prepaid Expenses

Long –lived / fixed Assets . Acquired to use them

Non-Current to produce goods and services not for resale.
Assets
 Non – Current Assets

• With Physical form . Eg.Plant,

Tangible Property , Equipment,
Machinery etc.

• Non Physical Eg.Patents,

Intangible Goodwill, Trademarks,
Copyrights, Franchises etc.

Investments • Financial Assets

 Liabilities + Equity
• Obligations extinguished, settled
Current during the normal operating
Liabilities cycle or within one year.

• Obligations that do not meet the

Non-current criteria above. Ie. They will not
Liabilities be settled in the one year.
• Paid in Capital / Contributed
EQUITY Capital
• Retained Earnings
 Equity Explained
• Capital / Shareholders’ Equity/ stockholders’ Equity
• Contributed Capital
• Paid in Capital – Additional Paid in Capital/Share premium
• Treasury Stock
• Retained Earnings
• How are the assets and liabilities measured in Financial Statements?
Historical cost: Assets are recorded at the amount of cash or cash equivalents
paid or the fair value of the consideration given to acquire them at the time of
acquisition.
Current cost: Assets are carried at the amount of cash or cash equivalents that
would have to be paid if the same or an equivalent asset was acquired currently.
Realisable (settlement) value: Assets are carried at the amount of cash or cash
equivalents that could currently be obtained by selling the asset in an orderly
disposal.
Present value: Assets are carried at the present discounted value of the future
net cash inflows that the item is expected to generate in the normal course of
business.
Fair value: Assets are carried at the amount at which they could be exchanged,
or a liability settled, between knowledgeable, willing parties in an arm’s length
transaction
Can you classify all the business activities ?

Operating activities:
Are those activities that are part of the day- to- day business
functioning of an entity. Core activities of the entity.
 Investing activities are
Those activities associated with acquisition and disposal of long- term
assets.
Financing activities are
Those activities associated with the sourcing of funds- related to
obtaining or repaying capital. The two primary sources for such funds
are owners (shareholders) or creditors.
Ratios

Activity ratios/Activity Ratios/Efficiency Ratios/Fund Ratios

Measure the efficiency of a company’s operations, such as
collection of receivables or management of inventory.
Liquidity ratios
Measure the ability of a company to meet short-term obligations.
Major liquidity ratios include the current ratio, quick ratio, cash
ratio, and defensive interval ratio.
Solvency ratios/Leverage Ratios
Measure the ability of a company to meet long-term obligations.
Major solvency ratios include debt ratios.
Profitability ratios
Measure the ability of a company to generate profits from revenue
and assets.
Valuation ratios
Express the relation between the market value of a company or its
equity (for example, price per share) and some fundamental financial
metric (for example, earnings per share).

Margin Ratios
Margin ratios represent the company’s ability to convert sales into
profits at various degrees of measurement.

Return Ratios
Return ratios represent the company’s ability to generate returns to its
shareholders.
Gross profit margin – compares gross profit to sales revenue.

Net Profit margin ratio – shows the net profits relative to the company’s sales revenue.

Return on assets (ROA), as the name suggests, shows the percentage of net earnings
relative to the company’s total assets.

Return on equity (ROE) – expresses the percentage of net income relative to

stockholders’ equity.

Return on Tangible common Equity (ROTCE) : Key performance indicator used by

Financial Institutions and Insurance Companies. ROTCE is computed by dividing net
earnings applicable to common shareholders by average monthly tangible common
shareholders' equity.
 Accounts receivable turnover measures how efficiently a company is able to
manage its credit sales and convert its account receivables into cash.

Payables turnover measures how quickly a company is paying off its accounts
payable to creditors.

Inventory turnover measures how efficiently a company is able to manage its

inventory.

Fixed Assets Turnover measures how efficiently a company is using its fixed
assets.
Cash Conversion Cycle
The cash conversion cycle is an important metric in determining how efficiently a
company can convert its inventories into cash.
 PRICE EARNING RATIO

The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price
and earnings per share (EPS). It is a popular ratio that gives investors a better sense of the
value of the company. The P/E is also called an earnings multiple.

High P/E
Companies with a high Price Earnings Ratio are often considered to be growth stocks.

Low P/E
Companies with a low Price Earnings Ratio are often considered to be value stocks.
 LEVERAGE

Leverage is the use of fixed costs in a company’s cost structure.

Fixed costs that are operating costs (such as depreciation or rent) create
operating leverage.

The degree of operating leverage (DOL) is the ratio of the percentage

change in operating income to the percentage change in units sold.

Operating Leverage is used to evaluate Break Even Point.

 FINANCIAL LEVERAGE

Fixed costs that are financial costs (such as interest expense) in the capital structure
create financial leverage.

The degree of financial leverage (DFL) is the percentage change in net income for a
one percent change in operating income.

The degree of total leverage (DTL) is a measure of the sensitivity of net income to
changes in unit sales, which is equivalent to DTL = DOL × DFL.
 COVERAGE RATIOS

• Interest Coverage Ratio (ICR)?

The Interest Coverage Ratio (ICR) is a financial ratio that measures the ability of a
company can pay the interest on its outstanding debts.

• Debt Service Coverage Ratio?

• The Debt Service Coverage Ratio (sometimes called DSC or DSCR) is a credit
metric that measures borrower’s ability to service debt obligations (interest and
principal obligations) using its operating cash flows.