38  Financial Statement Analysis

38.1 What is Financial Statement Analysis?

Financial statement analysis is the systematic study of an entity’s financial statements to evaluate its past performance, current position, and future prospects. The aim is to interpret the numbers — to convert raw figures into insight on profitability, liquidity, solvency, efficiency and market value (maheshwari2018?).

S.N. Maheshwari and S.K. Maheshwari define it as “the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit and loss account”. M.Y. Khan and P.K. Jain treat it as “the systematic numerical representation of the relationship of one financial fact with another to measure the profitability, operational efficiency, solvency and growth potential of a business” (khanjain2020?).

TipThree Working Definitions
Author Definition What it foregrounds
Maheshwari & Maheshwari “Identifying the financial strengths and weaknesses of the firm by establishing relationships between items of the balance sheet and P&L.” Relationships
Khan & Jain “Numerical representation of the relationship of one financial fact with another to measure profitability, efficiency, solvency, growth.” Measurement
Foulke “A study of any treatment accorded by accountancy of the data presented in the financial statements with a view to extracting information of strategic significance.” Strategic use

38.1.1 Users and their interests

TipUsers of Financial Statement Analysis
User Primary interest
Equity investors Profitability, growth, return
Lenders / creditors Liquidity and solvency
Management Operational efficiency, control, strategy
Suppliers Short-term liquidity
Customers Continuity of supply
Employees Stability, growth
Government / regulators Tax, compliance, employment
Public Social impact

38.2 Tools of Analysis

TipFive Standard Tools of Financial Statement Analysis
Tool What it does
Comparative statements Show items for two or more years side-by-side; absolute and percentage change
Common-size statements Each item as a percentage of a base figure (Sales for P&L; Total Assets for B/S)
Trend analysis Index numbers, base-year = 100; multi-year direction
Ratio analysis Mathematical relationships between items
Cash-flow / Funds-flow analysis Movement of cash and funds across activities 

flowchart LR
  FS[Financial Statements] --> CS[Comparative<br/>Common-size]
  FS --> T[Trend analysis]
  FS --> R[Ratio analysis]
  FS --> CF[Cash-flow /<br/>Funds-flow]
  CS & T & R & CF --> I[Insight:<br/>Liquidity · Solvency ·<br/>Profitability · Efficiency · Market]
  style FS fill:#E3F2FD,stroke:#1565C0
  style I fill:#E8F5E9,stroke:#1B5E20

38.3 Ratio Analysis — the Workhorse

A financial ratio is a mathematical relationship between two financial-statement items. Ratios are grouped into five families.

TipFive Families of Financial Ratios
Family What it measures
Liquidity Short-term ability to meet obligations
Solvency / Leverage Long-term ability to meet obligations; capital structure
Profitability Ability to generate profit
Activity / Efficiency / Turnover How effectively assets are used
Market Investor perspective — earnings, dividends, market price

38.3.1 Liquidity ratios

TipLiquidity Ratios
Ratio Formula Benchmark
Current Ratio Current Assets ÷ Current Liabilities 2 : 1 (rule of thumb)
Quick / Acid-test Ratio (Current Assets − Inventory − Prepaid) ÷ Current Liabilities 1 : 1
Cash Ratio (Cash + Marketable securities) ÷ Current Liabilities 0.5 : 1

38.3.2 Solvency / Leverage ratios

TipSolvency / Leverage Ratios
Ratio Formula Comment
Debt-Equity Ratio Long-term Debt ÷ Equity 2 : 1 traditional benchmark; varies by industry
Debt Ratio Total Debt ÷ Total Assets What share of assets are debt-financed
Interest Coverage EBIT ÷ Interest expense ≥ 2 typical floor
Debt-Service Coverage (DSCR) (EBIT + non-cash charges) ÷ (Interest + Principal repayment) Used by lenders

38.3.3 Profitability ratios

TipProfitability Ratios
Ratio Formula What it tells
Gross Profit Margin Gross Profit ÷ Sales Pricing and product-mix economics
Operating Profit Margin EBIT ÷ Sales Core operating efficiency
Net Profit Margin PAT ÷ Sales Bottom-line conversion
Return on Assets (ROA) PAT ÷ Average Total Assets Asset productivity
Return on Equity (ROE) PAT ÷ Average Equity Shareholder return
Return on Capital Employed (ROCE) EBIT ÷ Capital Employed Use of long-term capital

38.3.4 Activity / Turnover ratios

TipActivity / Turnover Ratios
Ratio Formula What it tells
Inventory Turnover COGS ÷ Average Inventory How fast inventory turns
Debtors / Receivables Turnover Credit Sales ÷ Average Debtors Collection speed
Days’ Sales Outstanding (DSO) (Average Debtors ÷ Credit Sales) × 365 Average collection period
Creditors Turnover Credit Purchases ÷ Average Creditors Payment speed
Asset Turnover Sales ÷ Total Assets Sales generated per ₹ of assets
Working-Capital Turnover Sales ÷ Net Working Capital Sales per ₹ of working capital

38.3.5 Market ratios

TipMarket / Investor Ratios
Ratio Formula What it tells
Earnings per Share (EPS) (PAT − Preference Dividend) ÷ No. of Equity Shares Earnings per share
Price-Earnings (P/E) Ratio Market Price per Share ÷ EPS Investor expectations
Dividend Yield Dividend per Share ÷ Market Price per Share Income return
Dividend Pay-out Dividend per Share ÷ EPS Pay-out policy
Book Value per Share Equity ÷ No. of Equity Shares Accounting value
Market-to-Book (P/B) Market Price per Share ÷ Book Value per Share Investor premium / discount

38.4 DuPont Analysis

The DuPont identity decomposes Return on Equity (ROE) into the three drivers — operating efficiency, asset use efficiency, financial leverage. The three-factor form:

\[\text{ROE} = \frac{\text{PAT}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Total Assets}} \times \frac{\text{Total Assets}}{\text{Equity}}\]

That is — Net Profit Margin × Asset Turnover × Equity Multiplier.

TipThe DuPont Drivers of ROE
Driver What it captures What it tells the firm
Net profit margin Operating efficiency Profit per ₹ of sales
Asset turnover Asset productivity Sales per ₹ of assets
Equity multiplier Financial leverage How much of the asset base is equity-funded 

flowchart LR
  ROE[ROE] --> NPM[Net Profit Margin<br/>= PAT / Sales]
  ROE --> AT[Asset Turnover<br/>= Sales / Total Assets]
  ROE --> EM[Equity Multiplier<br/>= Total Assets / Equity]
  style ROE fill:#FCE4EC,stroke:#AD1457
  style NPM fill:#E3F2FD,stroke:#1565C0
  style AT fill:#FFF3E0,stroke:#EF6C00
  style EM fill:#E8F5E9,stroke:#2E7D32

The five-factor DuPont further splits net profit margin into a tax burden, interest burden and EBIT margin — used for deeper diagnosis.

38.5 Limitations of Financial-Statement Analysis

TipSix Limitations of Financial-Statement Analysis
Limitation Implication
Historical Past data; not always indicative of the future
Inflation Historical-cost accounting distorts comparisons across years
Accounting policy choices Two firms can show different ratios for the same economics
Window dressing Year-end transactions can flatter ratios
Single-firm focus Ratios are most useful with industry or peer benchmarks
Qualitative ignored Brand, talent, R&D pipeline, ESG do not show up cleanly

38.6 Practice Questions

Q 01 Quick Ratio Easy

The quick (acid-test) ratio is computed as:

  • ACurrent Assets ÷ Current Liabilities
  • B(Current Assets − Inventory − Prepaid expenses) ÷ Current Liabilities
  • CCash ÷ Total Liabilities
  • DSales ÷ Inventory
View solution
Correct Option: B
Quick ratio strips out the least liquid current assets (inventory, prepayments). Rule of thumb: 1 : 1.
Q 02 DuPont Medium

In the three-factor DuPont identity, ROE is decomposed into:

  • ANet profit margin × Asset turnover × Equity multiplier
  • BGross margin × Sales × Debt
  • CCurrent ratio × Quick ratio × Inventory turnover
  • DEBIT × Sales × Equity
View solution
Correct Option: A
ROE = (PAT/Sales) × (Sales/Assets) × (Assets/Equity) — NPM × AT × EM.
Q 03 Debt-Equity Medium

A high debt-equity ratio indicates:

  • AHigh operating efficiency
  • BHigh financial leverage and increased financial risk
  • CStrong liquidity
  • DLow working capital
View solution
Correct Option: B
D/E captures the mix of borrowed funds and equity in long-term capital. High D/E means more financial leverage and higher financial risk.
Q 04 Common Size Medium

A common-size income statement expresses each item as a percentage of:

  • ATotal assets
  • BTotal equity
  • CNet sales / Revenue from operations
  • DNet profit
View solution
Correct Option: C
In a common-size P&L, the base is Sales / Revenue from Operations. In a common-size Balance Sheet the base is Total Assets.
Q 05 Match Ratios Medium

Match the ratio with its family:

(i) Current Ratio (a) Profitability
(ii) Inventory Turnover (b) Liquidity
(iii) Net Profit Margin (c) Activity / Turnover
(iv) Debt-Equity Ratio (d) Solvency / Leverage
  • A(i)-(b), (ii)-(c), (iii)-(a), (iv)-(d)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(c), (ii)-(d), (iii)-(a), (iv)-(b)
  • D(i)-(d), (ii)-(a), (iii)-(b), (iv)-(c)
View solution
Correct Option: A
Current → liquidity; Inventory turnover → activity; Net profit margin → profitability; D/E → solvency.
Q 06 DSO Medium

If a firm has annual credit sales of ₹360 lakh and average debtors of ₹60 lakh, the average collection period (DSO) is:

  • A30 days
  • B60 days
  • C90 days
  • D180 days
View solution
Correct Option: B
DSO = (Avg Debtors / Credit Sales) × 365 ≈ (60 / 360) × 365 ≈ 61 days. (Using 360 as the conventional year, exactly 60 days.)
Q 07 Interest Coverage Medium

An interest-coverage ratio of less than 1 means:

  • AEBIT is more than enough to cover interest
  • BEBIT is insufficient to cover interest
  • CThere is no interest expense
  • DThe firm is debt-free
View solution
Correct Option: B
Interest coverage = EBIT / Interest. Below 1 means operating profit cannot cover the interest burden — a serious credit warning.
Q 08 Limitations Easy

Which of the following is not a recognised limitation of financial-statement analysis?

  • AHistorical-cost basis distorts comparisons across years
  • BWindow-dressing at year-end
  • CChoice of accounting policy can distort comparisons
  • DIt does not require any data
View solution
Correct Option: D
Financial-statement analysis is data-intensive. Limitations are historical, inflation, policy choices, window dressing, single-firm focus, and the omission of qualitative factors.
ImportantQuick recall
  • Financial statement analysis = systematic interpretation of statements to assess profitability, liquidity, solvency, efficiency, market value.
  • Five tools: comparative · common-size · trend · ratio · cash-flow / funds-flow.
  • Five ratio families: liquidity (Current, Quick, Cash) · solvency (D/E, Debt, Interest Coverage, DSCR) · profitability (GP/OP/NP margin, ROA, ROE, ROCE) · activity (inventory, debtor, creditor turnover; DSO; asset turnover) · market (EPS, P/E, dividend yield/payout, book value, P/B).
  • DuPont (3-factor): ROE = Net Profit Margin × Asset Turnover × Equity Multiplier.
  • Common-size: P&L base = Sales; B/S base = Total Assets.
  • Limitations: historical, inflation, policy choice, window dressing, single-firm focus, qualitative blind spots.