sebi grade a 2020: commerce & accountancy: …...sebi grade a 2020: commerce & accountancy:...

SEBI Grade A 2020: Commerce & Accountancy: Finacial Statements & Ratios Statement, Financial Statement Analysis & Ratio Analysis

www.practicemock.com 1 [email protected] 011-49032737

http://www.practicemock.com/

mailto:[email protected]

mailto:011-49032737



Financial Statement Analysis: ......................................................................................... 3

Tools for Analyzing Financial Statement: .......................................................................................................... 3

Types of Financial Statement Analysis............................................................................................................... 3

Purpose of Financial Statement Analysis ........................................................................................................... 4

Stakeholder interested in Financial Analysis ...................................................................................................... 4

Limitations of Financial Statement Analysis ...................................................................................................... 5

Cash Flow Statement: .................................................................................................... 5

Structure of CFS: ................................................................................................................................................ 5

Methods: ............................................................................................................................................................. 6

Format of a Cash Flow Statement:...................................................................................................................... 6

What is the use of CFS? ...................................................................................................................................... 8

Limitations of CFS .............................................................................................................................................. 8

Fund flow statement: ..................................................................................................... 9

What is the meaning of the Fund? ...................................................................................................................... 9

Objective/Significance of Fund Flow Statement: ............................................................................................... 9

Limitations of Fund Flow Statement: ................................................................................................................. 9

Format of Fund Flow Statement: ........................................................................................................................ 9

Format for Statement of Change in Working Capital ....................................................................................... 10

Rules to be followed by identifying Working Capital change due to change in Current Assets and Current

Liabilities ...................................................................................................................................................... 10

Difference between Cash Flow Statement and Fund Flow Statement .................................... 11

Ratio Analysis: ............................................................................................................ 12

Significance of Ratio Analysis: ........................................................................................................................ 12

Limitations of Ratio Analysis: .......................................................................................................................... 12

Classification of Ratios: .................................................................................................................................... 13

Liquidity Ratios: ............................................................................................................................................... 13

Solvency Ratios: ............................................................................................................................................... 14

Activity Ratios: ................................................................................................................................................. 15

Profitability Ratios: ........................................................................................................................................... 16

Some Other Ratios ............................................................................................................................................ 18



mailto:011-49032737

https://www.practicemock.com/packages/sebi-grade-a/?refcode=ssm_35&utm_source=SEBIGrAStudyMaterial_Blog_180320_SebiGrAPackage&utm_medium=Link&utm_campaign=SebiGrAPackage



Financial Statement Analysis: Financial Statement Analysis (FSA) is a process of critically examining the financial information in the

financial statements to understand and make a decision regarding the operations of the enterprise. It can

help in understanding the relationship between various financial numbers as given in the financial

statements, i.e. Income Statement and Balance Sheet, to assess the Liquidity, Long-term Solvency,

Operating Efficiency, and Profitability of the company. Hence, the process of establishing relationships and

interpretation to understand the working and financial position of a business is known as the Analysis of

Financial Statement.

Tools for Analyzing Financial Statement: The financial statements, i.e. Balance Sheet and Income Statements, gives information about the assets,

liabilities, equity, revenue, expense and profit and loss of a company in absolute amount. They can be

analyzed with the help of analytical tools using the financial statements of the company for the earlier year

or with that of another company. The following are some tools that can be used in FSA.

1. Comparative Statements: This helps in doing a comparative study of individual items or components

of financial statements of two or more years of the company itself. In the case of Comparative Statement,

the amount of two or more years are placed next to each other along with the change in the amount in

absolute and percentage terms for comparison purpose.

2. Common-size Statements: In this type of statement, individual items or components of financial

statements of two or more years of the company are placed next to each other, and then converted into

percentage taking a common base. In the case of a Common-size Balance Sheet, the common base taken

is either Total of Assets or Total of Equity and Liabilities, while in case of Common-size Income Statement,

the common base taken is Revenue from Operation (or Net Sales). The common base is taken as 100 and

then the other figures are expressed as a percentage of the total. For instance, in the case of a Common-

size Balance Sheet, the Total of Assets or Total of Equity and Liabilities is taken as 100 and all the other

figures are expressed as a percentage of 100. Similarly, in the case of Common-size Income Statement, the

Revenue from Operation is taken as 100 and all the other figures are expressed as a percentage of Revenue

from Operations.

3. Cash Flow Statement: The cash flow statement (CFS) is a statement that shows the flow of cash and

cash equivalents over a period of time. In other words, CFS shows how well a company can generate cash

to pay its debt obligation and fund its operating expenses. Besides, it also shows the change in cash position

from one period to another.

4. Ratio Analysis: It is an arithmetical expression that expresses a relationship between two related or

independent items or components of financial statements. With the help of this method, one can analyze

the financial performance, financial stability and financial health of a company.

Types of Financial Statement Analysis The FSA can be classified into the following categories:

External and Internal Analysis: External Analysis is done by those who may not have complete access

to the detailed records of the company, and so they mostly depend on the published financial accounts such

as Income Statement, Balance Sheet Cash Flow Statement, Auditor’s Report, and Directors’ Reports.

Generally, investors, credit agencies, government agencies, and researchers do this type of analysis. On

the other hand, internal analysis is done by the management of the company to understand the financial

position and operating efficiency of the company. Further, since the management has complete access to

the information, they can do a more detailed, extensive and accurate analysis.

Horizontal and Vertical Analysis: Horizontal analysis is done to analyze the financial statement for a

number of years and so is based on the financial data taken for those years. It is also known as a time

series analysis, as the financial data are compared for several years against the chosen base year. An

example of horizontal analysis is Comparative Financial Statement. On the other hand, the vertical analysis

is done to analyze the performance of the company for one year only. This analysis is useful in comparing



mailto:011-49032737



the performance of several companies of the same type of divisions or department of the company. A

Common-size Statement is an example of vertical analysis.

Intra-firm and Inter-firm Analysis: Intra-firm Analysis or Time Series Analysis or Trend Analysis, helps

to compare financial variables of an enterprise over a period of time, showing the trend of financial factors.

The Inter-firm Analysis or Cross-Sectional Analysis compares the financial position of two or more companies

to determine their competitive position.

Purpose of Financial Statement Analysis Various stakeholders may refer to financial statements for different reasons. The following are some of the

purposes of financial statement analysis.

To assess the profitability: The financial analysis can help in assessing the earning capacity of the

company. Further, it can also help in forecasting the future earning capacity of the company, which will be

of interest to investors and potential investors.

To assess the managerial efficiency: Identifying areas where the managers have been efficient and the

areas where they need to improve upon is another objective of financial analysis. For instance, with the help

of a financial ratio, it is possible to understand the relative proportion of production, administration and

marketing expenses. Further, any favorable and unfavorable variations can be identified and the manager

could be then questioned on the same.

To assess the short term and long term solvency: A financial statement analysis can help in

ascertaining the short term and long term solvency of the company. The creditors or suppliers would be

interested in knowing the short term solvency position of the company as they would like to know if the

company can meet the short term liabilities, while the banks, debenture holders and other lenders would be

interested in knowing the long term solvency of the company as they are more interested in understanding

whether the company can service its interest and principal payment on time.

Inter-firm comparison: Financial Analysis can help a company to compare its performance with that of

others. This is heavily used while looking for Mergers and Acquisition opportunities as well.

Forecasting and Budgeting: A company usually forecasts and prepare budgets for the future years based

on the past financial statement.

Understandable: Finally, financial analysis can help a reader understand the financial statement of the

company in a more simplified manner, as financial data can be made more comprehensive with the help of

charts, graphs, and diagrams, which is easy to explain and understand.

Stakeholder interested in Financial Analysis Several parties may be interested in the analysis of the financial statement. They are listed below:

Management: It helps the management to ascertain the overall and segment-wise efficiency of the

business. Further, it also helps them in decision making and evaluation of the performance of the business.

Employees and Trade Unions: Employees are interested in their welfare and so they would be interested

in the profitability, sustainability and financial strength of the business, while the trade unions are interested

because this may help them negotiate and enter into wage contracts with the employer.

Shareholders or Owners or Investors: Since they invest their money into the business, they would be

interested in knowing whether the business is profitable and has growth potential or not.

Potential Investors: They are interested in the financial statement because they would invest their money

into the company only if they find the company profitable and has good growth potential.



mailto:011-49032737

http://bit.ly/2w8nwoN



Supplier or Creditors: They are more interested in knowing the short-term solvency position of the

company, as they would provide goods and/or services on credit only they find that the company can repay

them.

Bankers and Lenders: They are interested to know whether the company can service the interest payment

and also repay the principal, in case they grant a loan to the company. For this, they would look at the long-

term and short-term solvency of the firm.

Researcher: They are interested in knowing the profitability, growth, financial position and future prospects

of business and industry.

Government: The government is interested because they would like to have an understanding that which

industry is progressing, and which ones need protection and incentive. It also helps them in formulating

relevant policies and law.

Tax Authorities: The tax authorities want to ensure that the tax liabilities calculated are correct and that

the firm is not evading taxes.

Customers: They mostly look at the fact whether the company can continue or not, especially when they

have or intend to have long-term involvement with the company.

Limitations of Financial Statement Analysis Even though financial analysis helps in understanding the position and financial strength of the company,

there do exist certain limitations as well, such as:

• It is an analysis of historical data and does not reflect the future, while the stakeholders will be more

interested in knowing the future position of the company

• The qualitative aspect, such as quality of management, staffs, public relations, etc. are ignored while

carrying out the analysis of financial statements

• Reliability can be a question mark as the analysis is done based on the information given in the financial

statements.

• There can be some amount of bias involved as well. This is because there are situations where an

accountant has to choose from the alternatives available (such as the method of inventory evaluation or

method of depreciation to be followed). In such a case, they will generally choose the method which

gives a rosy picture of the company.

• In case there is variation in the accounting policies every year, the comparison cannot be done. For

instance, in one year the company followed a straight-line method of depreciation, while next year it

follows a written down value method.

• There can be a situation where the accountant is doing window dressing, i.e. presenting a better financial

position of the company that what it is by manipulating the books of accounts.

Cash Flow Statement: The cash flow statement (CFS) is a statement that shows the flow of cash and cash equivalents over a

period of time. In other words, CFS shows how well a company can generate cash to pay its debt obligation

and fund its operating expenses.

The Cash and Cash Equivalents consists of the following:

i. Cash

ii. Bank Balance

iii. Short Term Marketable Securities (i.e. those that can be realized within a period of 3 months). These

typically includes the treasury bills, commercial papers, money market instruments, and investments in

preference shares redeemable within three months if there is insignificant risk of change in its value.

Structure of CFS: A CFS will consist of the following components:

1. Cash from Operating Activities, i.e. the primary revenue-generating activities of an organization and

other activities that are not investing or financing in nature. Further, any cash flows from current assets and

current liabilities shall be included in this section. The followings are a few examples of cash flow from

operating activities:

a. Cash receipt from sale of goods and services

b. Payment made to suppliers for goods and services in cash

c. Payment made towards salaries, wages, etc. in cash



mailto:011-49032737



2. Cash from Investing Activities, i.e. flow of cash due to the acquisition and disposal of long-term assets

and other investments, not forming part of cash equivalents. Thus, this will include cash generated or spent

due to selling or buying of property, plant and equipment, other non-current assets and other financial

assets. The following are a few examples of cash flow from investing activities:

a. Purchase of tangible and intangible assets in cash

b. Receipt from sale of tangible and intangible assets

c. Loans and advances given to third party

d. Payment made for purchase of securities or long term investments of other companies

3. Cash from Financing Activities, i.e. any cash flow that will result in changes in the size and composition

of the equity capital or borrowings (such as loan and debentures) of the entity. This will include the issue of

share capital or buyback of shares, payment of dividends, issuance, and repayment of debts (or loans and

debentures). The following are a few examples of cash flow from financing activities:

a. Cash received from issue of shares

b. Payment of dividend in cash

c. Cash received from issue of debentures, bonds, long-term borrowings and short-term borrowings

d. Repayment of debentures, bonds, long-term borrowings and short-term borrowings

e. Payment of interest on borrowing

Methods: There are two ways by which a CFS can be prepared, namely:

1. Direct method, wherein, the operating cash flows are presented as a list of cash flows. For instance,

cash received (inflow) from sales and cash paid (outflow) for expenditure. However, this method is seldom

used.

2. Indirect method, wherein, cash flows are identified from Adjusted Net Profit before Tax. In this case,

the adjustments are basically done for the non-cash expenses such as depreciation, which reduces the profit

but does not impact the cash flow, and non-operating income and expenses, such as interest and taxes, as

in most cases are non-operating items in nature.

Format of a Cash Flow Statement: Cash Flow Statement for the period ended …..

Particulars Amount Amount Comments

A. Cash Flow from Operating

Activities

Net Profit as per Profit and Loss a/c XXX In an Indirect method, we can start the

CFS with the Net Profit and then go

ahead with doing the below

adjustments

Adjustment for Non-Cash and Non-

Operating Items

Depreciation & Amortization XXX Depreciation is a non cash item, hence,

needs to be added back

Provision for Tax XXX Provision for tax is a non cash item,

hence, needs to be added back



mailto:011-49032737

https://www.practicemock.com/exams/government/sebi-grade-a/?refcode=ssm_35&utm_source=SEBIGrAStudyMaterial_Blog_180320_SignUp&utm_medium=Link&utm_campaign=SignUp



Interest on Loan Paid XXX This should form part of Financing

Activities, hence we add back here

Interest on Loan Received (XXX) This should form part of Investing

Activities as it is an income recorded in

the Profit & Loss A/c (P&L), hence we

will subtract from here

Interest / Dividend Received (XXX) This should form part of Investing

Activities as it is an income recorded in

the P&L, hence we will subtract from

here

Operating Profit before change in

Working Capital

XXX

Adjustments for Change in Working

Capital

Now, we shall adjust for the change in

the Working Capital during the

year/period

Add: Decrease in Account Receivables XXX The thumb rule here is that:

Decrease in Current Asset - Subtract

Increase in Current Asset - Add

Decrease in Current Liabilities - Add

Increase in Current Liabilities - Less

Add: Decrease in Closing Stock XXX

Add: Decrease in Other Current Asset XXX

Less: Decrease in Creditors (XXX)

Less: Decrease in Outstanding

Expenses

(XXX)

Less: Decrease in Current Liabilities (XXX)

XXX

Less: Income Tax Paid XXX Subtract for the Income Tax Paid in

cash

Net Cash Flow from Operating

Activities (A)

XXX

B. Cash Flow from Investing

Activities

Purchase of Property and Equipment (XXX) Purchase of any asset result in cash

outflow, hence we subtract

Loan given (XXX) Loan given also results in cash outflow,

hence, we subtract

Investments made in any other fixed

assets

(XXX) Any investments made will also result

in cash outflow, and so we will subtract

Proceeds from Property and Equipment XXX Cash received from sale of any asset

result in cash inflow, hence we add

Interest / Dividend Received XXX Interest/Dividend received from

investments made results in cash

inflow, hence, we add

Investments proceed received from sale

of any other fixed assets

XXX On selling any investments that was

made, we will receive cash and so we

will add

Net Cash Flow from Investing

Activities (B)

XXX

C. Cash Flow from Financing

Activities

Issue of Share Capital XXX By issuing new shares, we shall get

cash, hence we add



mailto:011-49032737



Issue of Loan/Debentures XXX By issuing new loans/debentures, we

shall get cash, hence we add

Redemption/Buyback of Shares (XXX) Here, we are buying back our own

shares for which cash will have to be

paid to shareholders, hence this is cash

outflow

Repayment of Loan (XXX) Repayment of loan results in cash

outflow, hence we will subtract

Redemption of Debentures (XXX) Redemption of debentures results in

cash outflow, hence we will subtract

Interest on Loan/Debentures Paid (XXX) Payment of any kind of interest will lead

to cash outflow, hence we shall subtract

Payment of Dividend (XXX) Dividend on shares paid by company

also lead to cash outflow. Hence, this

shall be subtracted as well

Net Cash Flow from Financing

Activities ( C)

XXX

Net Increase in Cash & Cash

Equivalents (A+B+C)

XXX This is the summation of A, B and C

Add: Opening Cash & Cash

Equivalents

XXX Here, add the cash and cash

equivalents

Closing Cash & Cash Equivalents XXX This is the amount standing in your

balance sheet as at the end of the

period/year.

What is the use of CFS? • CFS helps the management of the company to plan its future operating, investing and financing

requirements

• It can also help in understanding the solvency and liquidity position of the company, and whether the

company has the ability to pay off its liabilities on the due date or not.

• One can compare the cash from operating activities with the net income of the company to analyze the

quality of earnings. For instance, the company’s net earnings are said to be of high quality in case it can

generate higher net cash from its operating activities as compared to its net income, and vice-versa.

• CFS helps investors to understand the overall performance of the company through the flow of cash

(both inflow and outflow). It is said that a company can expand its operations, replace inefficient

equipment, increase its dividend, buy back some of its stock, reduce its debt, or even acquire another

company if it can generate more cash than it is using.

Limitations of CFS • The non-cash transaction are excluded from the CFS, as it only shows the inflows and outflows of cash

and cash equivalents. An example of non-cash transaction can be purchase of assets by issuing shares

or debentures to the vendors. Hence, to overcome this, such transactions can be disclosed as a footnote.

• It cannot substitute the Income Statement (or Profit and Loss Account), as income statement shows

both cash and non-cash transaction, leading to determination of profit and loss.

• It cannot substitute Balance Sheet as well, CFS does not disclose the financial position of the company

(i.e., Total Equity, Non-Current Liabilities, Current Liabilities, Non-Current Assets and Current Assets).

• CFS ignores the fundamental accounting of concept of Accrual as it is prepared on a cash basis

• Finally, CFS is historical in nature as it simply rearranged the information available in income statement

and balance sheet.



mailto:011-49032737

https://www.practicemock.com/exams/government/sebi-grade-a/?refcode=ssm_35&utm_source=SEBIGrAStudyMaterial_Blog_180320_SebiGrAMock&utm_medium=Link&utm_campaign=SebiGrAMock



Fund flow statement: Fund Flow Statement (FFS) is a statement that shows movement of funds in and out of the business. In

other words, it is a statement showing sources and application of fund. FFS gives information on how a

company has got access to funds and how or where they are using the same. Hence, it helps the

management in taking decisions regarding allocation of fund more efficiently. The important thing to note

here that the sources and application of fund can be both capital and revenue in nature. Besides, it also

helps the financial manager to assess the:

1. Growth of the fund

2. Its resulting financial needs, and

3. Determine the best way to finance those needs

What is the meaning of the Fund?

Fund can be mean any of the following:

• Cash

• Net Working Capital, i.e. Current Asset less Current Liabilities

• Total resources or total funds

• Internal resources

• Net Worth, i.e. Owner’s Equity Capital plus Reserves and Surplus

Objective/Significance of Fund Flow Statement: The following are the reasons why a fund flow statement is be prepared:

1. It can explain the changes in the financial position of the company, while also disclosing the cause of

changes in the assets, liabilities and shareholders’ equity between the two balance sheet dates.

2. It can help in analysing the operational position of the company, as the balance sheet merely gives a

static view of the financial position while the profit and loss statement cannot exactly tell the actual liquidate

position of the firm. For instance, a firm may be generating high profit but it is still not able to pay off its

liabilities due to cash crunch. Hence, fund flow statement can give information on the liquidity position of

the firm.

3. The fund flow statement can also assist in proper allocation of resources, as it can give information

regarding the allocation of limited resources more efficiently and effectively.

4. A fund flow statement can help in evaluating the financial performance of the company as it shows the

weakness and strengths of the company.

5. It can act as a guide for future management as it provides information about the historical changes in

net assets and capital which enable the management to develop a projected funds flow statement.

Limitations of Fund Flow Statement: Even though fund flow statement is a good tool to financial analysis, there still exist some limitations as

listed follow:

1. The non-fund transactions (i.e. those that do not affect the working capital) are ignored while preparing

the fund flow statement. For instance, purchase of fixed asset through issue of shares/debentures are not

recorded.

2. It does not reveal the cash position of the company and so the company also prepares a Cash Flow

Statement in addition to the Fund Flow Statement

3. The statement is prepared based on historical financial data and does not communicate anything about

the future. Further, any estimates can be only made on the basis of the past data available. Hence, it is not

a very useful tool for taking decisions related to future.

4. It is based on secondary data as it is prepared based on income statement and balance sheet. Hence, it

lacks originality.

Format of Fund Flow Statement: The following is the format of a Fund Flow Statement

Statement of Sources and Application of Funds for the period



mailto:011-49032737


www.practicemock.com 10 [email protected] 011-

49032737

Sources of Fund Amount Application of Funds Amount

Issue of Equity Shares XXX Purchase of Fixed Assets XXX

Issue of Preference Shares XXX Purchase of Investments XXX

Issue of Debentures XXX Redemption of Shares XXX

Loan borrowed XXX Redemption of Debentures XXX

Sale of Fixed Assets XXX Repayment of Loan XXX

Sale of Investments XXX Payment of Tax XXX

Non-trading incomes XXX Payment of Dividend XXX

Fund from operation (profit) XXX Non-trading losses XXX

Decrease in Working Capital XXX Increase in Working Capital XXX

Fund from Operation (loss) XXX

XXX XXX

Format for Statement of Change in Working Capital

Particulars Change in Working Capital

Increase (Rs) Decrease (Rs)

A. Current Assets

Cash XXX -

Bank Balance XXX -

Stock / Inventories XXX -

Bills Receivables XXX -

Debtor XXX -

Prepaid Expenses XXX -

Accrued Income XXX -

Marketable Securities XXX -

Short-term investments XXX -

B. Current Liabilities

Creditors - XXX

Bills Payable - XXX

Outstanding Expenses - XXX

Advance Income - XXX

Bank Overdraft - XXX

Short term loan - XXX

Provision for Taxation - XXX

Provision for Dividend - XXX

Increase/Decrease in Working

Capital

XXX XXX

Total XXX XXX

Rules to be followed by identifying Working Capital change due to change in Current Assets and

Current Liabilities

Condition Result Relationship

Current Asset Increase Woking Capital Increases Direct Relationship

Current Asset Decrease Woking Capital Decreases Direct Relationship



mailto:011-49032737

mailto:011-49032737



49032737

Current Liabilities Increase Woking Capital Decreases Inverse Relationship

Current Liabilities Decrease Woking Capital Increases Inverse Relationship

Difference between Cash Flow Statement and Fund Flow

Statement Criteria Cash Flow Statement (CFS) Fund Flow Statement (FFS)

Meaning CFS is a statement that shows the

inflows and outflows of cash and cash

equivalents over a period

FFS is a statement showing the changes in the

financial position of the company in different

accounting years

Purpose of

Preparation

It shows the reasons for movements in

the cash at the beginning and at the

end of the accounting period

It shows the reasons for the changes in the

financial position, with respect to previous year

and current accounting year

Accounting

Principle

Cash Basis Accrual Basis

Analysis Short Term Analysis of cash planning Long Term Analysis of financial planning

Usage It is more useful in understanding the

short-term phenomena affecting the

liquidity of the business

It is more useful in assessing the long-range

financial strategy

End Result It shows the changes in cash and cash

equivalents

It shows the causes of changes in net working

capital

Discloses Inflows and Outflows of Cash Sources and applications of funds

Opening and

closing

balance

It contains the opening and closing

balance of cash and cash equivalents

It does not contain opening balance of cash and

cash equivalents

Part of

Financial

Statement

Yes No



mailto:011-49032737

mailto:011-49032737

https://www.practicemock.com/blog/tag/sebi-study-material/



49032737

Ratio Analysis: Ratio is an arithmetical expression that expresses relationship between two related and interdependent

items. When a ratio is calculated on the basis of the accounting data, it is termed as Accounting Ratio,

hence, here we can say that ratio is arithmetical expression that expresses relationship between two

accounting variable. Further, it is of significance only if it has a cause and effect relationship. For instance,

turnover is not related to investment in shares, while profit earned to capital employed is related.

A ratio can be expressed in four difference forms, namely,

• Pure, where the number is expressed as a quotient. Current Ratio, Quick Ratio, etc. are some of the

measures that expresses the relationship in this form.

• Percentage, where the relationship is expressed in percentage term. For example, Net Profit Margin,

Operating Margin, etc. are expressed in percentage.

• Times, where the ratio is expressed in number of times, when a particular amount is compared with

another amount. An example of this can be Inventory Turnover Ratio and Receivable Turnover Ratio.

• Fraction, where the number is expressed in fraction. For example, when the business has a debt of Rs

2,00,000 and total capital of Rs 3,00,000, then it can be said that Debt consist of 2/3rd of Total Capital.

Significance of Ratio Analysis: • It can help in understanding the financial position of the company. Almost all stakeholders analyses the

financial statement of the company by means of ratios.

• It simplifies, summarises and systematises a long array of accounting information to make them

understandable. It also helps in stating the relationship that exists between various elements of financial

statements.

• Accounting Ratio can also help in assessing the operating efficiency of the business by evaluating the

liquidity, solvency and profitability of the business.

• Ratios can help in preparing business plans and forecasts, as trends of the ratios are analysed and used

as a guide to future planning.

• It can help in identifying the weak areas in the business even though the overall performance of the

business may seem to be good. This can help management to work on the weak areas by taking

corrective action.

• Finally, ratios can be helpful in Inter-firm and Intra-firm comparison.

Limitations of Ratio Analysis: • It can mislead if the ratios are calculated based on incorrect information, especially when the reliability

of the financial statement is a question mark.

• On many occasions the definitions of terms are not standardised. For instance, one company may

compute ratios on the basis of profit after interest and taxes, while another company may consider profit

after interest but before taxes. Hence, in such a scenario, the ratios computed will be different and will

not be comparable. Hence, it is important to calculate the ratio on the basis of same definition.

• The limitation of ratio analysis also arises when different firm follows different accounting policies. For

instance, one firm may follow straight line method for calculating depreciation, while another may follow

written down value method. In such a scenario, the comparison will not be possible as well.

• Another limitation of ratio analysis is that it only does quantitative analysis and ignores the qualitative

analysis, which is important in decision-making as well.

• A single ratio may not be able to explain the financial position of a company and so making a decision

merely on the basis of that may not be possible. For instance, Current Ratio of 2:1 will only tell that

Current Assets are 2 while the Current Liabilities are 1.

• Window dressing, a technique to conceal important facts while presenting the financial statement better

than what it actually is, may affect the ratios as well. In such a case, the ratio will not be able to state

correctly whether the company’s position is good or bad.

• Accounting Ratio may also not be effective when there is a personal bias involved while preparing the

financial statements.



mailto:011-49032737

mailto:011-49032737




49032737

Classification of Ratios: Ratios can be classified into the following:

1. Liquidity Ratios: Also known as short-term solvency ratio, it measures the ability of the company to

meet its short-term financial obligations as and when they become due for payment. The examples of

Liquidity Ratios are: Current Ratio and Quick Ratio/Liquid Ratio/Acid Test Ratio.

2. Solvency Ratios: It helps to measure the company’s ability to meet its debt obligations and is used

often by prospective business lenders. The examples of Solvency Ratios are: Debt to Equity Ratio,

Proprietary Ratio, Total Debt to Total Asset Ratio and Interest Coverage Ratio.

3. Activity Ratios: The activity ratio indicates how efficiently a company is able to leverage its assets on

the balance sheet to generate revenues and cash. The examples of Activity Ratios are: Trade Receivables

Turnover Ratio, Trade Payables Turnover Ratio, Inventory Turnover Ratio and Working Capital Turnover

Ratio.

4. Profitability Ratios: These ratios help to assess the business ability to generate profits relative to its

revenue, costs, assets on balance sheet and shareholders’ equity. The examples of Profitability Ratios

are: Gross Profit Ratio, Net Profit Ratio, Operating Profit Ratio, Earnings Per Share (EPS), Price to Earning

(P/E) Ratio and Return on Investment (ROI).

Liquidity Ratios:

Current Ratio

It is a liquidity ratio, measuring the company’s ability to meet its short term liabilities. Although the

acceptable ratios vary from one industry to another, they are generally between 1.5 and 3. If the company’s

ratio falls in this range, then it indicates a short term financial strength. The company may face trouble

meeting its short term liabilities in case the current ratio falls below 1. A higher current ratio is not also

good as it suggests the company is unable to efficiently use its current assets or its short term financing

facilities. The current ratio is calculated as follows:

Current Ratio = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

Quick Ratio

Also referred to as Acid Test Ratio or Liquid Ratio, it measures the ability of a company to use its near cash

or quick assets to pay its current liabilities immediately. Quick assets include current assets that can easily

be converted into cash at close to their book values.

Generally speaking, the ratio includes all current assets, except:

Prepaid expenses – because they cannot be used to pay other liabilities

Inventory – because it may take too long to convert inventory to cash to cover pressing liabilities

A company with a quick ratio of less than 1 cannot fully pay back its current liabilities. Quick Ratio is

calculated as follow:

Quick Ratio = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬−𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐢𝐞𝐬−𝐏𝐫𝐞𝐩𝐚𝐢𝐝 𝐄𝐱𝐩𝐞𝐧𝐬𝐞𝐬

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬−𝐁𝐚𝐧𝐤 𝐎𝐯𝐞𝐫𝐝𝐫𝐚𝐟𝐭𝐬



mailto:011-49032737

mailto:011-49032737

https://www.practicemock.com/exams/government/sebi-grade-a/?refcode=ssm_35&utm_source=SEBIGrAStudyMaterial_Blog_180320_SebiGrAMock&utm_medium=Link&utm_campaign=SebiGrAMock



49032737

Solvency Ratios:

Debt to Equity Ratio

Also known as Risk, Gearing or Leveraging ratio, it indicates the relative proportion of shareholder’s fund

and debt used to finance a company’s assets. It also tells about the amount of borrowed capital (debt) that

can be fulfilled in the event of liquidation using shareholder contributions. It is used for the assessment of

the financial leverage and soundness of a firm. A low debt-equity ratio is favorable from an investment point

of view as the firm is less risky in times of increasing interest rate. It, therefore, can attract additional capital

for further investment and expansion of the business. This can be calculated using two formulas:

1. Debt to Equity Ratio = Long Term Debt

Shareholder Funds

Where, Shareholder Funds = Share Capital + Reserve & Surplus

OR

2. Debt to Equity Ratio = Total Liabilities

Shareholder Funds

Where, Total Liabilities = Non-Current Liabilities + Current Liabilities

Interest Coverage Ratio

Also, referred to as Time interest earned, this ratio is a measure of a company’s ability to honor its debt

payments. The interest coverage ratio of less than 1 signifies that the company is not generating enough

cash from its operations to meet its interest obligations. A higher interest coverage ratio is better for the

firm. Generally, a ratio of 2.5 and above are considered to be good. The following is the formula to calculate

interest coverage ratio:

Interest Coverage Ratio = EBIT

Interest Charges

Proprietary Ratio

Also known as Equity Ratio, this ratio gives the proportion of total assets of the company that is funded by

the proprietors’ funds. It helps to understand the financial position of the company and can be useful for

lenders to assess the ratio of shareholders’ fund employed out of the total assets of the company. A higher

proprietary ratio is better for the firm. The following is the formula to calculate interest coverage ratio:

Proprietary Ratio = Shareholders′ Equity

Total Assets

Where, Shareholders’ Equity = Share Capital + Reserves & Surplus

Total Debt to Total Assets Ratio

It is a leverage ratio that defines the total amount of debt standing in the balance sheet of the company

relative to its assets. The higher the ratio, the higher is the degree of leverage and higher the financial risk.

Generally, a ratio of 0.4 or 40% is considered to be a good debt ratio. The following is the formula to

calculate interest coverage ratio:

Total Debt to Total Assets = Short Term Debt+Long Term Debt

Total Assets



mailto:011-49032737

mailto:011-49032737



49032737

Activity Ratios:

Receivable Turnover Ratio

It is an accounting measure to quantify a firm’s effectiveness in extending credit as well as collecting debts.

It measures how many times a business can turn its accounts receivable into cash during the reporting

period. In other words, it measures how many times a business can collect its average accounts receivable

during the year. A higher ratio here is more favorable for the business. This ratio is calculated using the

following formula:

Receivable Turnover Ratio = Net Credit Sales

Average Accounts Receivable

Where,

Net Credit Sales = Total credit sales during the year net of discounts if any.

Average Account Receivable = Opening Receivable+ Closing Receivable

2

Here, we may also be interested in calculating the average collection period of the firm. For that, the below

mention formula shall be used. The lower the average collection period, the better it is for the firm.

Average Collection Period = 365 days

Receivable Turnover Ratio

Inventory Turnover Ratio

Also known as Stock Turnover Ratio, it measures the number of times the inventory is sold or used in a

certain period of time. High inventory turnover is unhealthy as they represent an investment with a rate of

return of zero. Further, the company may face trouble in case the prices begin to fall. The following formula

is used to calculate this ratio:

Inventory Turnover Ratio = Cost of Goods Sold

Average Inventory

Where,

Average Inventory = Opening Inventory+ Closing Inventory

2

Here also we may calculate the average inventory holding period by using the below-mentioned formula.

The lower is the average number of days to sell the inventory, the better it is for the company.

Average Days to Sell the Inventory = 365 days

Inventory Turnover Ratio

Payables Turnover Ratio

Also known as Payables Turnover or the Creditor’s Turnover Ratio, measures the average number of times

a company pays its creditors in a certain period of time. A Low Payable Turnover signifies that a company

is slow in paying its supplier. The following formula is used to calculate this ratio:

Payables Turnover Ratio = Net Credit Purchases

Average Accounts Payables

Where,



mailto:011-49032737

mailto:011-49032737



49032737

Average Accounts Payables = Opening Payables + Closing Payables

2

Here also we may calculate the average payables period by using the below-mentioned formula. The higher

is the average number of days to make the payment, the better it is for the company.

Average Days to Pay = 365 days

Payables Turnover Ratio

Working Capital Turnover Ratio

The ratio is used to analyze the relationship between the money used to fund operations and the sales

generated from these operations. A higher working capital turnover means that the company is generating

huge sales compared to the money it uses to fund sales. This ratio is computed by the following formula:

Working Capital Turnover Ratio = Total Turnover

Working Capital

Where,

Working Capital = Current Assets – Current Liabilities

Fixed Asset Turnover Ratio

It is the ratio of total turnover to the value of fixed assets. It indicates how well the business is using its

fixed assets to generate sales. A higher fixed assets turnover ratio indicates that the business is highly

efficient in using its fixed assets to generate revenue. A declining ratio may indicate that the business is

over-invested in fixed assets. It is calculated as follow:

Fixed Asset Turnover Ratio = Total Turnover

Average Fixed Assets

Where,

Average Fixed Assets = Opening Fixed Assets + Closing Fixed Assets

2

Profitability Ratios: Gross Profit Margin:

It is a profitability ratio which shows the relationship between gross profit and total net sales revenue of the

company. Expressed in a percentage form, it is one of the popular ways to evaluate the operational

performance of the company.

Gross Profit Margin = Gross Profit

Total Sales or Turnover 100%

Where,

Gross Profit = Opening Stock + Purchases + Direct Expenses – Closing Stock



mailto:011-49032737

mailto:011-49032737




49032737

Net Profit Margin

It refers to the percentage by which a company’s total sales or revenue exceeds or is less than the sum of

its expenses. A positive net profit margin in a reporting period signifies that the company has made more

money and vice-versa. It also means that the company has been able to better control its costs compared

to its competitors. This ratio is useful when we have to compare companies in similar industries. It is

calculated as under:

Net Profit Margin = Net Profit

Total Sales or Turnover 100%

Operating Profit Margin

It measures the levels and rates of profitability. It indicates how much of each rupee of revenues is left over

after both costs of goods sold and operating expenses are considered. A higher operating margin is definitely

better. It is calculated by the following formula:

Operating Profit Margin = Operating Income

Total Turnover 100%

Where,

Operating Income = Gross Profit – Operating Expenses

Return on Capital Employed (ROCE)

It measures a company’s profitability and the efficiency with which its capital is employed. It is highly useful

when we have to compare the profitability of a company with its peer company operating in the same

industries based on the amount of capital they use. However, the major drawback of this ratio is that it

measures return against the book value of assets in the business. Since these depreciate, the ROCE will

increase even though the cash flow has been the same. Therefore, the older business will tend to have a

better ROCE in comparison to a start-up / new business. Further, the book value of assets is not affected

by inflation while the cash flow is affected by inflation. Thus, the revenue increases with inflation while the

capital employed generally does not.

The Return on Capital Employed is calculated as:

Return on Capital Employed = Earnings before Interest and Taxes (EBIT)

Average Capital Employed

Where,

EBIT = Gross Profit - Operating Expenses + Non-Operating Income

Average Capital Employed = Opening Capital+ Closing Capital

2

Return on Assets (ROA)

It indicates the effectiveness of a company to use its assets to generate earnings before the contractual

obligations are met. It also indicates the capital intensity of the company, which will depend on the industry.

A company that requires large initial investments will have a lower return on ROA. Also, it is best to compare

it against a company’s previous ROA number or the ROA of a similar company. It is calculated as under:

Return on Assets = Net Income

Average Total Assets

Where,

Average Total Assets = Opening Total Assets + Closing Total Assets

2



mailto:011-49032737

mailto:011-49032737



49032737

Price to Book Ratio (P/B Ratio)

This is a financial ratio used to compare a company’s current market price to its book value. Also known as

the Market-to-Book ratio, a higher P/B ratio implies that investors expect management to create more value

from a given set of assets other things remaining the same. However, this ratio does not directly provide

any information on the ability of the firm to generate profits or cash for the shareholders. The P/B ratio

calculated as follow:

Price to Book Ratio = Market Price per Share

Book Value per Share

Where,

Book Value per share = Total Assets +Total Liabilities

Total Number of Shares Outstanding

Earnings per Share (EPS)

It refers to a company’s profit allocated to each outstanding share of common stocks. It is also an indicator

of a company’s profitability. It is calculated as follows:

Earnings per Share = Profit after tax−Preference Dividend

No of Shares Outstanding

Price-Earnings Ratio

A higher P/E ratio suggests that investors are expecting higher earnings growth in the future compared to

companies with a lower P/E. This ratio is useful when a comparison between firms under the same industry

is made. This is calculated as follows:

Price to Earnings Ratio = Market Price per Share

Earnings per Share

Dividend Yield Ratio

It shows how much a company pays out in dividends each year relative to its share price. It is calculated as

follows:

Dividend Yield Ratio = Annual Dividend per Share

Price per Share

Some Other Ratios

Altman Z - Score

The Z-score formula is used for predicting bankruptcy. It may be used for predicting the probability that a

firm will go into bankruptcy within two years. It can also predict corporate defaults and is an easy approach

to calculate the control measure for the financial distress status of companies. This ratio uses multiple

income and balance sheet values to measure the financial health of a company. A score of 1.80 or less

means that the company is heading for bankruptcy, while companies having a score of 3.0 and above are

not likely to go bankrupt. It is calculated as follows:

Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where,

A = Working Capital / Total Assets

B = Retained Earnings / Total Assets



mailto:011-49032737

mailto:011-49032737



49032737

C = EBIT / Total Assets

D = Market Value of Equity / Total Liabilities

E = Sales / Total Assets

Du-Pont Analysis:

It is an expression that breaks Return on Equity (ROE) into three parts, namely, Profitability, Operating

Efficiency, and Financial Leverage. This ratio helps an entity to locate the part of the entity which is under-

performing. It is calculated as follow:

Du-Pont Analysis =Profit

Turnover

Turnover

Assets

Assets

Equity



mailto:011-49032737

mailto:011-49032737

http://bit.ly/2w8nwoN

sebi grade a 2020: commerce & accountancy: …...sebi grade a 2020: commerce & accountancy:...

Documents