39  Financial Statement Analysis

39.1 What is Financial Statement Analysis?

Financial Statement Analysis (FSA) is the process of evaluating a firm’s past, present and projected performance and position by analysing its financial statements through ratios, trends and comparisons. John N. Myer, in Financial Statement Analysis (1952), gave the first systematic textbook on FSA. Alexander Wall in 1919 pioneered the use of ratios for credit appraisal.

TipWorking definitions
Author Definition
John N. Myer (1952) “The process of determining the significant operating and financial characteristics of a firm from accounting data, with a view to making it useful for decision-making.”
Foulke “A study of the relationship among the various financial factors in a business as disclosed by a single set of statements and a study of the trends of these factors as shown in a series of statements.”
Kennedy & McMullen “Analysis and interpretation of financial statements helps in determining the liquidity, solvency, profitability and growth potential of the enterprise.”
AAA “The classification of data on financial statements and the establishment of relationships among them for decision-making.”

39.2 Tools / Techniques of FSA

TipMajor tools of FSA
Technique What it does
Horizontal / Comparative analysis Compare line items across years; base-year %
Vertical / Common-size analysis Each item as % of a base (Sales for P&L, Total Assets for BS)
Trend analysis Multi-year index numbers; base year = 100
Ratio analysis Financial ratios — liquidity, leverage, profitability, activity, market
Fund flow analysis Movement of working capital (legacy)
Cash flow analysis Movement of cash (AS-3 / Ind AS-7)
Du Pont analysis ROE decomposition
EVA / MVA Economic Value Added; Market Value Added

39.3 Comparative & Common-Size Statements

TipTwo cousins of financial-statement analysis
  • Comparative statements — show absolute amounts + absolute change + % change across years; horizontal analysis.
  • Common-size statements — every line shown as a % of a base — Sales (P&L) or Total Assets (BS); vertical analysis. Allows comparison across firms of different sizes.
  • Trend statements — show indexed values relative to a base year (= 100).

39.4 Ratio Analysis — The Centrepiece

A financial ratio is a quantified relationship between two items of the financial statements. Alexander Wall (1919) pioneered ratio analysis for credit appraisal at the American Bankers Association.

Ratios are grouped into five classes (NTA stems favour this classification):

TipFive classes of ratios
Class Purpose Examples
Liquidity Short-term solvency Current, Quick, Cash
Leverage / Solvency Long-term solvency Debt-Equity, Interest Coverage, DSCR
Activity / Turnover Efficiency of asset use Inventory T/O, Debtors T/O, Asset T/O
Profitability Earning power GP, NP, OP, ROA, ROE, ROCE
Market / Valuation Investor perspective EPS, P/E, DPS, Dividend Yield, M/B, Tobin’s Q

39.4.1 Liquidity Ratios

TipLiquidity ratios — formulas
Ratio Formula Ideal
Current Ratio Current Assets / Current Liabilities 2 : 1
Quick / Acid-Test / Liquid Ratio (CA − Inventory − Prepaid) / CL 1 : 1
Cash / Absolute Liquid Ratio (Cash + Marketable Securities) / CL 0.5 : 1
Defensive Interval Ratio Liquid Assets / Daily Operating Expenses days
Net Working Capital CA − CL absolute

39.4.2 Leverage / Solvency Ratios

TipLeverage ratios
Ratio Formula Ideal
Debt-Equity Long-term Debt / Equity (Shareholders’ Funds) 2 : 1 (varies)
Total Debt to Total Assets Total Debt / Total Assets < 0.5
Proprietary Ratio Shareholders’ Funds / Total Assets > 0.5
Capital Gearing Pref + Debt / Equity Shareholders’ Funds varies
Interest Coverage EBIT / Interest ≥ 4
DSCR (Debt Service Coverage) (EBIT + Depreciation) / (Interest + Principal) ≥ 1.5

39.4.3 Activity / Turnover Ratios

TipActivity ratios
Ratio Formula
Inventory Turnover COGS / Avg Inventory
Inventory Holding Period 365 / Inv T/O
Debtors / Receivables T/O Credit Sales / Avg Debtors
Avg Collection Period 365 / Debtors T/O
Creditors / Payables T/O Credit Purchases / Avg Creditors
Avg Payment Period 365 / Creditors T/O
Working Capital T/O Sales / Net WC
Fixed Assets T/O Sales / Net Fixed Assets
Total Assets T/O Sales / Total Assets
NoteOperating Cycle / Cash Conversion Cycle

Cash Conversion Cycle (CCC) = Inventory Days + Debtors Days − Creditors Days. Lower (or negative) CCC = stronger working-capital efficiency. Amazon famously runs a negative CCC.

39.4.4 Profitability Ratios

TipProfitability ratios
Ratio Formula
Gross Profit Ratio GP / Sales × 100
Operating Profit Ratio OP (EBIT) / Sales × 100
Net Profit Ratio PAT / Sales × 100
Operating Ratio (COGS + Opex) / Sales × 100
Return on Assets (ROA) PAT / Avg Total Assets × 100
Return on Equity (ROE) PAT / Avg Shareholders’ Funds × 100
Return on Capital Employed (ROCE) EBIT / Capital Employed × 100
Return on Investment (ROI) Return / Investment × 100

39.4.5 Market / Valuation Ratios

TipMarket ratios
Ratio Formula
Earnings Per Share (EPS) (PAT − Pref Div) / No. of Equity Shares
Price-to-Earnings (P/E) Market Price / EPS
Dividend Per Share (DPS) Total Equity Dividend / No. of Equity Shares
Dividend Yield DPS / Market Price × 100
Dividend Payout Ratio DPS / EPS × 100
Earnings Yield EPS / Market Price × 100
Book Value Per Share Equity SH Funds / No. of Shares
Price-to-Book (P/B, M/B) Market Price / Book Value
Tobin’s Q Market Value of Firm / Replacement Cost of Assets
PEG Ratio P/E ÷ Earnings Growth Rate

39.5 Du Pont Analysis

Du Pont Analysis — developed at DuPont Corporation in 1919 by F. Donaldson Brown — decomposes Return on Equity (ROE) into its drivers:

39.5.1 3-Step Du Pont

ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier

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

The three drivers tell you whether ROE comes from profitability (margins), efficiency (asset use) or leverage.

39.5.2 5-Step Du Pont (Modern)

ROE = Tax Burden × Interest Burden × EBIT Margin × Asset Turnover × Equity Multiplier

flowchart TB
  ROE[ROE]
  ROE --> NPM[Net Profit<br/>Margin]
  ROE --> TAT[Total Asset<br/>Turnover]
  ROE --> EM[Equity<br/>Multiplier]
  NPM --> P[Profitability]
  TAT --> E[Efficiency]
  EM --> L[Leverage]
    classDef default fill:#003366,color:#ffffff,stroke:#ffcc00,stroke-width:3px,rx:10px,ry:10px;

39.6 Fund Flow Statement

A Fund Flow Statement is a statement of the changes in the financial position of an enterprise between two balance-sheet dates, focusing on movement of working capital (current assets − current liabilities). Pioneered by William Morse Cole (1908); systematised by H.A. Finney.

TipFund flow statement — three components
  • Schedule of Changes in Working Capital — shows increase/decrease.
  • Statement of Sources and Applications of Funds — funds generated and used.
  • Adjusted P&L — derives Funds from Operations.
TipSources and applications of funds
Sources of Funds Applications of Funds
Funds from operations Funds lost in operations
Issue of shares / debentures Redemption of shares / debentures
Long-term borrowings Repayment of long-term loans
Sale of fixed assets / investments Purchase of fixed assets / investments
Decrease in working capital Increase in working capital
Dividend paid · Tax paid
NoteFund Flow vs Cash Flow

Fund Flow = changes in working capital; Cash Flow = changes in cash. AS-3 (1985) made cash-flow statement standard; Ind AS does not require fund-flow statement. Fund flow is largely a legacy tool now.

39.7 Cash Flow Statement (Recap)

Covered in Topic 37 — AS-3 / Ind AS-7 classifies cash flows into Operating, Investing and Financing. Direct method vs Indirect method (most listed firms use indirect).

TipDirect vs Indirect method
  • Direct method — shows actual cash receipts and payments (from customers, to suppliers, to employees).
  • Indirect method — starts from PAT, adjusts for non-cash items (depreciation, provisions) and changes in working capital.

39.8 EVA and MVA — Modern Performance Measures

TipEVA and MVA
Measure Formula What it shows
EVA — Economic Value Added NOPAT − (WACC × Capital Employed) Value created above cost of capital
MVA — Market Value Added Market Value − Book Value of Capital Cumulative wealth created for shareholders
NOPAT EBIT × (1 − Tax rate) Operating profit after tax (pre-interest)

EVA was popularised by Stern Stewart & Co. (G. Bennett Stewart, 1991) — many firms (Coca-Cola, Tata, Infosys) adopted it as the headline performance metric.

39.9 Z-Score — Altman’s Bankruptcy Prediction

Edward I. Altman (1968) developed the Z-Score to predict bankruptcy 1-2 years ahead:

\[Z = 1.2X_1 + 1.4X_2 + 3.3X_3 + 0.6X_4 + 1.0X_5\]

where X₁ = WC/Total Assets, X₂ = Retained Earnings/TA, X₃ = EBIT/TA, X₄ = Market Value Equity/Book Value Debt, X₅ = Sales/TA.

TipAltman Z-Score zones
  • Z > 2.99 — Safe Zone — low probability of bankruptcy.
  • 1.81 < Z < 2.99 — Grey Zone — caution.
  • Z < 1.81 — Distress Zone — high bankruptcy risk.

Modified versions (Z’-Score for private firms; Z’’-Score for non-manufacturers, emerging markets) are widely used.

39.10 Beneish M-Score & Piotroski F-Score

TipOther diagnostic scores
  • Beneish M-Score (Messod Beneish, 1999) — detects earnings manipulation through 8 ratios. Famous for flagging Enron.
  • Piotroski F-Score (Joseph Piotroski, 2000) — 9-point score of financial strength; widely used by value investors.

39.11 Limitations of Financial Statement Analysis

TipLimitations of FSA
  • Based on historical data; may not reflect future.
  • Ignores inflation / price-level changes.
  • Influenced by accounting policies — depreciation method, inventory valuation.
  • Window dressing / earnings management can distort.
  • Qualitative factors (management, brand, IP) not captured.
  • No universal benchmarks for ratios.
  • Cross-firm comparability limited if size, industry, or geography differ.
  • Off-balance-sheet items missing.
  • Susceptible to fraud — Satyam, Enron, WorldCom.

39.12 Common Indian Accounting Frauds — Cases

TipLandmark Indian fraud cases (PYQ-relevant)
Case Year Issue
Satyam Computer Services 2009 India’s biggest corporate accounting fraud (₹7,800 cr) — Ramalinga Raju
Kingfisher Airlines 2012 Mounting losses, bank defaults
Punjab National Bank (Nirav Modi) 2018 LoU fraud — ₹14,000 cr
IL&FS 2018 Debt crisis, governance failure
DHFL 2019 Misappropriation; insolvency
Yes Bank 2020 Lending crisis
PMC Bank 2019 HDIL exposure
Reliance Capital, Future Group 2020-22 Distress / IBC

39.14 Practice Questions

Q 01 Wall Hard

The pioneer of using ratio analysis for credit appraisal (1919) is:

  • AAlexander Wall
  • BJohn Myer
  • CFoulke
  • DEdward Altman
View solution
Correct Option: A
Alexander Wall, 1919 — American Bankers Association.
Q 02 Current ratio Easy

The ideal current ratio is generally taken as:

  • A0.5 : 1
  • B1 : 1
  • C2 : 1
  • D3 : 1
View solution
Correct Option: C
2 : 1. Quick / Acid-test = 1 : 1; Cash = 0.5 : 1.
Q 03 Quick ratio Medium

Quick Ratio is computed by excluding which from current assets?

  • ACash
  • BDebtors
  • CInventory and Prepaid expenses
  • DMarketable securities
View solution
Correct Option: C
Quick = (CA − Inventory − Prepaid) / CL.
Q 04 Du Pont Medium

In the 3-step Du Pont, ROE equals Net Profit Margin × Total Asset Turnover × ___ :

  • AInterest coverage
  • BEquity multiplier
  • CDebt-equity ratio
  • DGross margin
View solution
Correct Option: B
Equity multiplier (Assets/Equity) — leverage driver.
Q 05 Altman Medium

An Altman Z-Score below 1.81 indicates:

  • ASafe Zone
  • BGrey Zone
  • CDistress Zone
  • DGrowth Zone
View solution
Correct Option: C
Z < 1.81 → Distress; 1.81–2.99 grey; >2.99 safe.
Q 06 EVA Medium

Economic Value Added (EVA) is calculated as:

  • ANOPAT − (WACC × Capital Employed)
  • BPAT − Dividends
  • CEBIT × (1 − Tax)
  • DMarket Cap − Book Equity
View solution
Correct Option: A
EVA = NOPAT − (WACC × Capital Employed). Stern Stewart (1991).
Q 07 Common-size Easy

In common-size income statement, each item is expressed as % of:

  • ATotal Assets
  • BSales
  • CCapital Employed
  • DNet Profit
View solution
Correct Option: B
Sales. For balance sheet, base is Total Assets.
Q 08 Inventory turnover Medium

Inventory Turnover Ratio is calculated as:

  • ASales / Avg Inventory
  • BCOGS / Avg Inventory
  • CInventory / Sales
  • DAvg Inventory / 365
View solution
Correct Option: B
Standard definition uses COGS / Avg Inventory.
Q 09 Interest coverage Medium

Interest Coverage Ratio is:

  • APAT / Interest
  • BEBIT / Interest
  • CSales / Interest
  • DEBITDA / Sales
View solution
Correct Option: B
EBIT / Interest; ideally ≥ 4.
Q 10 P/E Easy

P/E ratio is computed as:

  • AEPS / Market Price
  • BMarket Price / EPS
  • CDPS / EPS
  • DBook Value / Market Price
View solution
Correct Option: B
P/E = Market Price / EPS.
Q 11 Fund flow Medium

The fund flow statement tracks changes in:

  • ACash
  • BWorking capital
  • CCapital structure
  • DProfit
View solution
Correct Option: B
Fund flow = working capital movement; Cash flow = cash movement.
Q 12 DuPont origin Hard

Du Pont analysis was developed at DuPont Corp in 1919 by:

  • AF. Donaldson Brown
  • BAlexander Wall
  • CG. Bennett Stewart
  • DJoseph Piotroski
View solution
Correct Option: A
F. Donaldson Brown at DuPont (1919).
Q 13 Beneish Hard

The Beneish M-Score is used to detect:

  • ABankruptcy
  • BEarnings manipulation
  • CWorking capital health
  • DDividend sustainability
View solution
Correct Option: B
Earnings manipulation. Messod Beneish (1999); flagged Enron.
Q 14 Piotroski Hard

The Piotroski F-Score has a maximum score of:

  • A5
  • B7
  • C9
  • D10
View solution
Correct Option: C
9-point score of financial strength; Piotroski (2000).
Q 15 ROCE Medium

Return on Capital Employed (ROCE) is:

  • APAT / Equity × 100
  • BEBIT / Capital Employed × 100
  • CSales / Capital Employed × 100
  • DPAT / Total Assets × 100
View solution
Correct Option: B
ROCE = EBIT / Capital Employed × 100.
Q 16 Tobin's Q Hard

Tobin's Q is:

  • AMarket Value / Replacement Cost
  • BPrice / Earnings
  • CPAT / Sales
  • DDividend / Price
View solution
Correct Option: A
**Tobin's Q** = Market Value of Firm / Replacement Cost of Assets. James Tobin (Nobel 1981).
Q 17 CCC Medium

Cash Conversion Cycle (CCC) equals:

  • AInventory Days + Debtor Days − Creditor Days
  • BInventory Days − Debtor Days + Creditor Days
  • CDebtor Days − Creditor Days
  • DInventory Days + Creditor Days
View solution
Correct Option: A
CCC = Inventory + Debtors − Creditors. Lower (or negative) is better.
Q 18 Satyam Medium

India's biggest corporate accounting fraud (2009) was at:

  • ASatyam Computer Services
  • BInfosys
  • CWipro
  • DTCS
View solution
Correct Option: A
**Satyam** (Ramalinga Raju, 2009) — ₹7,800 cr fraud.
Q 19 Proprietary Medium

Proprietary Ratio is:

  • AEquity / Total Debt
  • BShareholders' Funds / Total Assets
  • CDebt / Equity
  • DPAT / Sales
View solution
Correct Option: B
Shareholders' Funds / Total Assets; ideal > 0.5.
Q 20 Match ratios Hard

Match the ratio with its class:

(i) Quick Ratio (a) Activity
(ii) Debt-Equity (b) Profitability
(iii) Inventory T/O (c) Liquidity
(iv) ROE (d) Leverage
  • A(i)-(c), (ii)-(d), (iii)-(a), (iv)-(b)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(d), (ii)-(a), (iii)-(b), (iv)-(c)
  • D(i)-(b), (ii)-(c), (iii)-(d), (iv)-(a)
View solution
Correct Option: A
Quick — Liquidity; Debt-Equity — Leverage; Inventory T/O — Activity; ROE — Profitability.

39.14.1 Advanced Format Questions

AR 1Assertion-ReasonHard

A: DuPont analysis decomposes ROE.
R: ROE = Net margin × Asset turnover × Equity multiplier.

  • ABoth true; R explains A
  • BBoth true; R does not explain A
  • CA true, R false
  • DA false, R true
View solution
Correct Option: A
S 1Statement-basedMedium

Ratio types: (i) Liquidity. (ii) Solvency. (iii) Profitability. (iv) Activity.

  • AAll four
  • B(i) and (ii) only
  • C(iii) and (iv) only
  • D(i), (ii), (iii) only
View solution
Correct Option: A
N 1NumericalMedium

Current Assets ₹6 L; Current Liabilities ₹2 L. Current ratio is:

  • A3:1
  • B2:1
  • C1:3
  • D1.5:1
View solution
Correct Option: A
6/2 = 3:1.
N 2NumericalHard

Net Profit ₹50,000; Shareholders' Equity ₹2,50,000. ROE is:

  • A20 %
  • B25 %
  • C5 %
  • D50 %
View solution
Correct Option: A
50,000 / 2,50,000 = 20%.

39.15 Quick Recall

ImportantQuick recall
  • Pioneers: Alexander Wall (1919) — ratio analysis; John Myer (1952) — FSA textbook.
  • Tools: Comparative (horizontal) · Common-size (vertical) · Trend · Ratio · Fund flow · Cash flow · Du Pont · EVA/MVA.
  • 5 ratio classes: Liquidity · Leverage · Activity · Profitability · Market.
  • Liquidity: Current (2:1) · Quick (1:1) · Cash (0.5:1) · Defensive Interval · NWC.
  • Leverage: D/E · D/TA · Proprietary · Capital Gearing · Interest Coverage = EBIT/Int (≥4) · DSCR (≥1.5).
  • Activity: Inv T/O = COGS/Avg Inv · Debtors T/O · Creditors T/O · Asset T/O · CCC = Inv + Debtors − Creditors days.
  • Profitability: GP · OP · NP · Operating Ratio · ROA · ROE · ROCE = EBIT/CE · ROI.
  • Market: EPS · P/E · DPS · Dividend Yield · Payout · Earnings Yield · P/B · Tobin’s Q · PEG.
  • Du Pont (DuPont, F.D. Brown 1919): 3-step ROE = NPM × TAT × Equity Multiplier; 5-step adds Tax Burden + Interest Burden.
  • Fund Flow (Cole 1908, Finney) = changes in working capital (legacy; not required under Ind AS).
  • Cash Flow (AS-3 / Ind AS-7): Operating · Investing · Financing; Direct vs Indirect method.
  • EVA — Stern Stewart 1991 = NOPAT − (WACC × Capital Employed); MVA = Market Value − Book Value.
  • Altman Z-Score (1968): Z = 1.2X₁ + 1.4X₂ + 3.3X₃ + 0.6X₄ + 1.0X₅; Safe > 2.99, Distress < 1.81.
  • Beneish M-Score (1999) — earnings manipulation; Piotroski F-Score (2000) — financial strength (max 9).
  • Limitations: historical · inflation · accounting policies · window dressing · qualitative factors missed.
  • Indian frauds: Satyam 2009 (₹7,800 cr; Ramalinga Raju) · Kingfisher · PNB-Nirav Modi · IL&FS · DHFL · Yes Bank · PMC Bank.
  • Modern trends: real-time analytics · AI fraud detection · NLP on MD&A · ESG ratios · forensic ratios · industry platforms (Capital IQ, ProwessIQ) · sentiment analysis · big-data ratio benchmarking.