THE PRIMARY CLASSIFICATION OF FINANCIAL RATIOS.

The primary classification of financial ratios includes:

1. Liquidity Ratios – Measure a company's ability to meet short-term obligations.
o Examples: Current Ratio, Quick Ratio, Cash Ratio.
2. Profitability Ratios – Assess a company’s ability to generate profits relative to
revenue, assets, or equity.
o Examples: Gross Profit Margin, Net Profit Margin, Return on Assets (ROA),
Return on Equity (ROE).
3. Efficiency (Activity) Ratios – Evaluate how effectively a company utilizes its assets
and liabilities.
o Examples: Inventory Turnover, Accounts Receivable Turnover, Asset Turnover.
4. Solvency (Leverage) Ratios – Indicate a company’s ability to sustain operations in the
long run by analyzing debt levels.
o Examples: Debt-to-Equity Ratio, Interest Coverage Ratio, Debt Ratio.
5. Market Valuation Ratios – Help investors assess a company's market performance
and stock valuation.
o Examples: Earnings Per Share (EPS), Price-to-Earnings (P/E) Ratio, Dividend
Yield, Price-to-Book (P/B) Ratio.
These ratios collectively provide insights into a company's financial health and performance.
THE KEY COMPONENTS OF A BALANCE SHEET USED IN RATIO ANALYSIS.
A balance sheet is a financial statement that provides a snapshot of a company's
financial position at a specific point in time. It consists of three main sections: Assets,
Liabilities, and Shareholders' Equity. These components are essential for conducting
financial ratio analysis, which helps in assessing a company's financial health, liquidity,
profitability, and solvency.
1. Assets (What the Company Owns)
Assets represent resources owned by the company that have economic value and can be
converted into cash.
A. Current Assets (Short-Term Assets)
Current assets are assets that are expected to be converted into cash, sold, or consumed
within one financial year. These are crucial for calculating liquidity ratios such as the current
ratio and quick ratio.
  Cash & Cash Equivalents – Includes cash on hand, bank balances, and highly liquid
short-term investments.
 Accounts Receivable (Trade Receivables) – Money owed by customers for goods or
services delivered but not yet paid for. Used in the receivables turnover ratio.
 Inventory – Raw materials, work-in-progress, and finished goods available for sale.
Important for calculating inventory turnover ratio.
 Marketable Securities – Short-term investments that can be quickly sold for cash,
like government bonds and stocks.
 Prepaid Expenses – Payments made in advance for services or goods that will be
received in the future (e.g., insurance, rent).
Financial Ratios Related to Current Assets:
 Current Ratio = Current Assets / Current Liabilities
 Quick Ratio = (Current Assets – Inventory) / Current Liabilities
 Cash Ratio = Cash & Cash Equivalents / Current Liabilities
 Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
B. Non-Current Assets (Long-Term Assets)
Non-current assets are long-term resources used by the company to generate revenue over
time.
 Property, Plant, and Equipment (PPE) – Includes tangible fixed assets like land,
buildings, machinery, and equipment.
 Intangible Assets – Non-physical assets like patents, trademarks, copyrights, and
goodwill.
 Long-Term Investments – Investments in bonds, stocks, or other businesses meant to
be held for several years.
Financial Ratios Related to Non-Current Assets:
 Return on Assets (ROA) = Net Income / Average Total Assets
 Fixed Asset Turnover = Net Sales / Average Fixed Assets
2. Liabilities (What the Company Owes)
Liabilities are financial obligations that a company must pay to external parties. These
include short-term (current liabilities) and long-term (non-current liabilities) debts.
A. Current Liabilities (Short-Term Obligations)
Current liabilities are obligations that the company must settle within one financial year.
  Accounts Payable (Trade Payables) – Amounts owed to suppliers for goods or
services received but not yet paid for.
 Short-Term Debt (Bank Overdraft, Short-Term Loans) – Loans and borrowings due
within a year.
 Accrued Expenses (Accruals) – Expenses incurred but not yet paid (e.g., wages,
interest).
 Taxes Payable – Corporate income tax and other taxes owed to the government.
Financial Ratios Related to Current Liabilities:
 Current Ratio = Current Assets / Current Liabilities
 Quick Ratio = (Current Assets – Inventory) / Current Liabilities
B. Non-Current Liabilities (Long-Term Obligations)
Non-current liabilities are obligations that extend beyond one financial year.
 Long-Term Debt – Includes bonds, loans, and debentures payable over a long period.
 Deferred Tax Liabilities – Taxes that are owed but not yet payable under accounting
rules.
 Pension Liabilities – Obligations related to employee retirement benefits.
Financial Ratios Related to Non-Current Liabilities:
 Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
 Interest Coverage Ratio = EBIT / Interest Expense
3. Shareholders' Equity (Net Worth of the Company)
Shareholders' equity represents the residual interest in the company after deducting
liabilities from assets. It is also known as owners' equity or net worth.
A. Key Components of Shareholders' Equity
 Common Stock (Equity Capital) – The initial investment by shareholders in exchange
for ownership.
 Retained Earnings – Profits that are reinvested in the business rather than
distributed as dividends.
 Additional Paid-in Capital (Share Premium) – Amount received from shareholders
above the par value of shares.
 Treasury Stock (Repurchased Shares) – Shares that were bought back by the
company and are no longer in circulation.
Financial Ratios Related to Shareholders’ Equity:
  Return on Equity (ROE) = Net Income / Shareholders' Equity
 Earnings Per Share (EPS) = Net Income / Total Outstanding Shares
 Book Value Per Share = Shareholders’ Equity / Total Outstanding Shares
THE CONCEPT OF A COMMON SIZE STATEMENT WITH AN EXAMPLE.
A Common Size Statement is a financial analysis tool that expresses each item in a
financial statement as a percentage of a base amount, making it easier to compare financial
data across different periods or companies.
Types of Common Size Statements:
1. Common Size Balance Sheet – Each item is expressed as a percentage of total assets
(or total liabilities & equity).
2. Common Size Income Statement – Each item is expressed as a percentage of total
revenue (sales).
Example of a Common Size Statement
Common Size Balance Sheet Example
Consider a company's balance sheet for 2022 and 2023:
Items 2022 (Rs.) 2023 (Rs.)
Total Assets 10,00,000 12,00,000
Fixed 4,00,000 5,00,000
Assets
Inventory 2,00,000 3,00,000

To convert this into a Common Size Balance Sheet, we express each item as a percentage of
Total Assets:
Items 2022 (Rs.) 2022 (%) 2023 2023 (%)
(Rs.)
Total Assets 10,00,000 100% 12,00,000 100%
Fixed 4,00,000 40% 5,00,000 41.67%
Assets
Inventory 2,00,000 20% 3,00,000 25%

Why Use Common Size Statements?

 1. Easy Comparison – Helps in comparing financial statements across different periods
and companies.
2. Trend Analysis – Identifies changes in financial structure over time.
3. Better Decision-Making – Helps investors and analysts assess financial stability and
growth.
THE RELATIONSHIP BETWEEN OPERATING PROFIT AND NET PROFIT RATIOS.
Aspect Operating Profit Ratio Net Profit Ratio

Definition Measures the profitability of core Measures the final profitability

business operations before after deducting all expenses,
deducting interest and taxes. including interest and taxes.

Formula Operating Profit / Net Sales × 100 Net Profit / Net Sales × 100

Key Components Gross Profit – Operating Expenses Operating Profit – Interest –

Taxes – Other Non-Operating
Expenses

Focus Operational efficiency and cost Overall profitability after all

control within business operations. costs and financial obligations.

Influence of Not affected by taxes and interest Reduced if interest expenses and
Taxes & Interest expenses. taxes are high.

Impact on Helps assess the efficiency of the Indicates how much profit
Business company's core operations. remains for shareholders after
all expenses.

Relationship Forms the base for net profit. A Always lower than Operating
higher Operating Profit can lead to Profit since additional expenses
a higher Net Profit. are deducted.

THE PURPOSE OF COMMON SIZE ANALYSIS

Purpose of Common Size Analysis
Common size analysis is a financial analysis technique used to evaluate and compare
financial statements by expressing each item as a percentage of a base amount. This method
helps in understanding financial statements more clearly and allows for easier comparison
across different companies or different time periods. The main purposes of common size
analysis are:
1. Comparability – It allows for the comparison of companies of different sizes by
standardizing financial statements.

2. Trend Analysis – It helps in identifying trends over time within a single company.

3. Industry Benchmarking – It enables comparison with industry standards or

competitors.

4. Financial Performance Evaluation – It helps in assessing the financial health and

efficiency of a company.

5. Decision Making – It aids investors and management in making informed decisions

by identifying strengths and weaknesses.

Detailed Explanation of Common Size Analysis

Common size analysis is applied to financial statements, primarily the income statement and
balance sheet, by converting each line item into a percentage of a specific base amount.
1. Common Size Income Statement
In a common size income statement, each item is expressed as a percentage of total
revenue (sales). This helps in understanding the cost structure and profitability trends.

Benefits of Common Size Income Statement:

  Helps in understanding profitability ratios (gross profit margin, operating margin, net
margin).

 Identifies cost structures and efficiency in cost management.

 Allows for comparison with competitors regardless of size.

2. Common Size Balance Sheet

In a common size balance sheet, each item is expressed as a percentage of total assets (for
assets section) or total liabilities and equity (for liabilities and equity section). This helps in
analyzing the financial structure of a company.

Benefits of Common Size Balance Sheet:

 Helps in analyzing the company’s capital structure (debt vs. equity financing).

 Identifies trends in asset management and liquidity.

 Assists in comparing financial structures of different companies.

Applications of Common Size Analysis

 Investor Analysis: Helps investors compare companies in the same industry.

 Managerial Decision-Making: Aids in financial planning and cost control.

 Credit Analysis: Lenders use it to assess financial stability.

 Competitor Benchmarking: Allows businesses to assess their financial standing

relative to competitors.

LIMITATIONS OF RATIO ANALYSIS IN EVALUATING A COMPANY'S PERFORMANCE

While ratio analysis is a widely used financial tool for evaluating a company's performance,
it has several limitations. These limitations can affect its reliability and usefulness in
decision-making.

1. Ignores Qualitative Factors

 Ratio analysis is purely quantitative and does not consider qualitative factors such as
brand reputation, employee skills, customer satisfaction, or market conditions.

 For example, two companies with similar financial ratios may differ significantly in
terms of management efficiency or product quality.

2. Historical Data Dependency

 Ratios are based on past financial statements, which may not accurately reflect a
company's current or future performance.

 Sudden changes in market conditions, economic downturns, or technological

advancements can make historical ratios less relevant.

3. Different Accounting Practices

 Companies may use different accounting methods (e.g., FIFO vs. LIFO inventory
valuation, depreciation methods), affecting the comparability of financial ratios.

 International companies may follow different accounting standards (GAAP vs. IFRS),
making cross-company comparisons difficult.

4. Inflation Distortion

 Inflation can distort financial ratios, especially when comparing long-term financial
statements.

 Asset values and revenues recorded at historical cost may not reflect their real
market value, leading to misleading ratio calculations.

5. Industry Differences
  Ratio benchmarks vary across industries, making it inappropriate to compare
companies from different sectors.

 For example, a high debt-to-equity ratio may be normal in capital-intensive industries

(e.g., utilities) but risky for a technology startup.

6. Seasonal Fluctuations

 Companies with seasonal businesses (e.g., retail, tourism) experience fluctuations in

sales and profits, affecting ratio calculations.

 Comparing ratios without considering seasonal trends can lead to incorrect

conclusions.

7. Manipulation of Financial Statements

 Companies can manipulate financial statements through accounting practices such

as income smoothing, window dressing, or off-balance-sheet financing.

 This can create an illusion of strong financial health even when the company is
struggling.

8. Lack of a Universal Standard

 While some ratios have general benchmarks, there is no absolute standard for what
makes a ratio "good" or "bad."

 A ratio that looks strong in one context may indicate a problem in another, requiring
additional analysis.

9. Does Not Consider External Factors

 Ratio analysis does not account for external economic factors like inflation, interest
rates, exchange rates, or regulatory changes.

 A company may have strong financial ratios but still face risks due to economic
downturns or government policies.

10. One-Dimensional Approach

  Ratios provide insights only from a financial perspective and do not capture strategic
factors like market trends, innovation, or customer loyalty.

 A company might have strong financial ratios but still fail due to poor long-term
strategic decisions.

While ratio analysis is a valuable tool for evaluating a company's performance, it should not
be used in isolation. Investors and managers should complement ratio analysis with
qualitative insights, industry benchmarks, and external market conditions for a more
accurate assessment of financial health.
THE RELEVANCE OF USING BOTH COMMON SIZE AND COMPARATIVE STATEMENTS
TOGETHER.
Common size statements and comparative statements are essential financial analysis tools
that, when used together, provide a more comprehensive understanding of a company's
financial performance and trends over time.

1. Understanding Financial Trends Over Time

 Comparative statements show absolute changes in financial performance over

multiple periods.

 Common size statements convert these figures into percentages, making it easier to
identify trends and structural shifts.

 Example: A comparative income statement might show an increase in revenue from

$500,000 to $600,000, but a common size statement will reveal if profitability
improved or remained stagnant by showing costs as a percentage of revenue.

2. Enhanced Comparability Across Companies

 Comparative analysis is useful for tracking a company’s progress across different

years.

 Common size analysis helps compare companies of different sizes within the same
industry by expressing all financial items as percentages.
  Example: Two companies may have different revenue figures, but by using common
size statements, an analyst can compare their profit margins, cost structures, and
debt levels in a standardized way.

3. Better Decision-Making for Management and Investors

 Comparative statements provide absolute figures that help in identifying growth

trends or declining performance over time.

 Common size statements help management focus on efficiency improvements by

showing which cost components are consuming the largest percentage of revenue or
assets.

 Example: If operating expenses are rising in absolute terms but remain stable as a
percentage of revenue, it indicates proportionate growth rather than inefficiency.

4. Identifying Financial Strengths and Weaknesses

 Comparative statements help detect financial deterioration or improvements by

showing year-over-year changes in revenues, expenses, and profits.

 Common size statements highlight underlying financial health by showing how

efficiently a company is managing its resources.

 Example: If revenue grows by 20% but cost of goods sold (COGS) increases by 30%, a
common size statement will reveal that profit margins are shrinking, signaling
potential cost-control issues.

5. Supporting Ratio Analysis

 Both comparative and common size statements provide the necessary data for
financial ratio calculations.

 Common size percentages make it easier to interpret profitability ratios (e.g., gross
profit margin, net profit margin), liquidity ratios, and debt ratios in a meaningful
way.

 Comparative statements allow analysts to see how these ratios change over time,
adding further depth to financial evaluation.
Hence, using both common size and comparative statements together provides a balanced
and detailed financial analysis. Comparative statements highlight growth trends and
financial changes, while common size statements provide structural insights and allow for
industry comparisons. Together, they help management, investors, and analysts make more
informed financial decisions.