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Four published financial statements:

• Statement of Financial Position (Balance Sheet)• Statement of Profit and Loss• Statement of Cash Flows• Statement of Changes in Equity

Standardization derives from certain well-organized processes and organizations. In theUnited States, a private sector group called the Financial Accounting Standards Board(FASB) is primarily responsible for developing the rules that form the foundation offinancial reporting.

The FASB’s global counterpart is the International Accounting Standards Board (IASB).The IASB and FASB are working toward convergence, such that there may eventually bea single harmonious set of international financial reporting standards (IFRS).

Institute of Chartered Accountants of Pakistan is responsible for implementing IFRS toalign financial reporting to international standards.

In the global economy, the growing demand for financial transparency has permeatedall aspects of corporate operations, from the way a business prepares its accountingreports to the way it publishes them. Various groups, including investors andregulators, pay heed to when and how organizations prepare and publish financialstatements.

Perhaps the most important aspect of financial-statement publication is that it handsinvestors the tools to understand an organization's memory. By revealing to the publicwhat goes on behind corporate closed doors, senior management takes importantsteps to open the firm up for public scrutiny. Organizational memory deals with theway a company uses various items to prepare accurate financial data and publishaccounting reports in a timely and consistent manner. Organizational-memory leversinclude a firm's products and services, mission statement, short-term goals and long-term plans, rank-and-file personnel, traditions and values.

The process of reviewing and evaluating a company's financial statements (such as thebalance sheet or profit and loss statement), thereby gaining an understanding of thefinancial health of the company and enabling more effective decision making. Financialstatements record financial data; however, this information must be evaluated throughfinancial statement analysis to become more useful to investors, shareholders,managers and other interested parties.

Financial statement analysis is an evaluative method of determining the past, currentand projected performance of a company. Several techniques are commonly used aspart of financial statement analysis including horizontal analysis, which compares twoor more years of financial data in both dollar and percentage form; vertical analysis,where each category of accounts on the balance sheet is shown as a percentage of thetotal account; and ratio analysis, which calculates statistical relationships betweendata.

It is a method or process by which the relationship of items or group of items in thefinancial statements are computed and presented.

It is used to interpret financial statements so that the strengths and weaknesses of afirm, its historical performance and current financial condition can be determined.

A ratio is not an end in itself. Computing ratios does not add any value to the availableinformation. It only reveals the relationship in a more meaningful way and enables todraw conclusions.

Accounting ratios are very useful in determining the financial position and profitabilityof an enterprise. However it utility lies in comparison of ratios.

Comparison of accounting ratios could be in one or more of the following forms:• For same enterprise over number of years• For two enterprises in the same industry• For one enterprise against the industry as a whole• For one enterprise against pre-determined standards• For inter-segment comparison within the same organisation

Ratios can be broadly classified into four groups:• Liquidity ratios• Capital structure/leverage ratios• Profitability ratios• Activity ratios

Liquidity ratios measure the ability of a company to repay its short‐term debts andmeet unexpected cash needs.

Current RatioThe current ratio is also called the working capital ratio, as working capital is thedifference between current assets and current liabilities. This ratio measures the abilityof a company to pay its current obligations using current assets. The current ratio iscalculated by dividing current assets by current liabilities.

=

Exercise:i. List current assetsii. List current liabilities

Current Assets:• Inventories of raw materials/WIP/finished goods• Debtors/receivables• Short term loans and deposits• Cash in hand and bank• Prepaid expenses• Income receivableCurrent Liabilities:• Creditors• Bills payable• Unclaimed dividend• Advances received• Income received in advance• Loans payable in next 12 months• Bank overdraft or cash credit

Exercise:

20X1 20X2Current Assets $38,336 $38,294Current Liabilities $27,945 $30,347Current Ratio 1.4 : 1 1.3 : 1

Quick Ratio or Acid Test ratioAn indicator of a company’s short-term liquidity. The quick ratio measures a company’sability to meet its short-term obligations with its most liquid assets. For this reason, theratio excludes inventories from current assets, and is calculated as follows:

= −

Exercise:

20X1Current Assets:

Trade Receivables (<6m) $28,566Trade Receivables (>6m) $12,000Inventory $28,500Bank balance $18,686Cash $5,122

Quick AssetsCurrent Liabilities $62,945Quick Ratio

$52,374

0.83 : 1

These ratios indicate the long term solvency of a firm and indicate the ability of thefirm to meet its long-term commitments with respect to:

i. Repayment of principal on maturity or in predetermined instalments at due datesii. Periodic payment of interest during the period of a loan

Capital structure/leverage ratios:• Debt equity ratio• Proprietary ratio• Debt to total capital ratio• Interest coverage ratio• Debt service coverage ratio

A measure of a company's financial leverage calculated by dividing its long-termliabilities by stockholders' equity. It indicates what proportion of equity and debt thecompany is using to finance its assets.= −ℎℎA high debt/equity ratio generally means that a company has been aggressive infinancing its growth with debt. This can result in volatile earnings as a result of theadditional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), thecompany could potentially generate more earnings than it would have without thisoutside financing. If this were to increase earnings by a greater amount than the debtcost (interest), then the shareholders benefit as more earnings are being spreadamong the same amount of shareholders. However, the cost of this debt financing mayoutweigh the return that the company generates on the debt through investment andbusiness activities and become too much for the company to handle. This can lead tobankruptcy, which would leave shareholders with nothing.

Exercise:

20X1 ($ millions)Current Liabilities:Accounts Payable 200Notes Payable 600Total Current Liabilities 800Long-Term Liabilities:Corporate bonds issued 800Long-Term Debt 500Total Long-Term Liabilities 1,300Total long-term debtTotal owners’ equity 900Debt Equity Ratio

1,300

1.44 : 1

Exercise:

20X1 ($ millions)Total Assets 2200Total shareholders equity 900Debt Equity Ratio 1.44 : 1

= ℎℎ

This ratio indicates the general financial strength of the firm and the long-termsolvency of the business. The ratio is calculated by dividing Proprietor’s funds by totalfunds: = /If the ratio is high, this indicates that a company has a sufficient amount of equity tosupport the functions of the business, and probably has room in its financial structureto take on additional debt, if necessary. Conversely, a low ratio indicates that abusiness may be making use of too much debt or trade payables, rather than equity, tosupport operations (which may place the company at risk of bankruptcy).

Thus, the equity ratio is a general indicator of financial stability. It should be used inconjunction with the net profit ratio and an examination of the statement of cash flowsto gain a better overview of the financial circumstances of a business. These additionalmeasures reveal the ability of a business to earn a profit and generate cash flows,respectively.

Exercise:ABC Company has shareholders' equity of $2,000,000 and total assets of $5,000,000.There is no goodwill on its balance sheet, nor any intangible assets. Its proprietary ratiowould be:

= /= 2,000,0005,000,000 = 40%

A measurement of a company's financial leverage, calculated as the company's debtdivided by its total capital. Debt includes all short-term and long-term obligations. Totalcapital includes the company's debt and shareholders' equity, which includes commonstock, preferred stock, minority interest and net debt.

= −ℎℎ + −Companies can finance their operations through either debt or equity. The debt-to-capital ratio gives users an idea of a company's financial structure, or how it isfinancing its operations, along with some insight into its financial strength. The higherthe debt-to-capital ratio, the more debt the company has compared to its equity. Thistells investors whether a company is more prone to using debt financing or equityfinancing. A company with high debt-to-capital ratios, compared to a general orindustry average, may show weak financial strength because the cost of these debtsmay weigh on the company and increase its default risk.

Exercise:

20X1 ($ millions)Long-Term Liabilities:Corporate bonds issued 800Long-Term Debt 500Total Long-Term Liabilities 1,300Total long-term debtTotal owners’ equity 900Debt to Total Equity Ratio

1,300

0.59 : 1

A ratio used to determine how easily a company can pay interest on outstanding debt.The interest coverage ratio is calculated by dividing a company's earnings beforeinterest and taxes (EBIT) of one period by the company's interest expenses of the sameperiod: =The lower the ratio, the more the company is burdened by debt expense. When acompany's interest coverage ratio is 1.5 or lower, its ability to meet interest expensesmay be questionable. An interest coverage ratio below 1 indicates the company is notgenerating sufficient revenues to satisfy interest expenses.

A company that barely manages to cover its interest costs may easily fall intobankruptcy if its earnings suffer for even a single month.

Exercise:

20X1 ($ millions)Sales 3,700Cost of goods sold (1,200)Gross Profit 2,500Administrative Expenses (400)Depreciation (171)Interest (80)Taxes (154)Net Income 1,695Earnings Before Interest and TaxInterest Coverage Ratio

1,92924.11 : 1

It is comprehensive measure to calculate the debt servicing capacity of a firm. It showshow many times the total debt service obligations consisting of interest and repaymentprincipal in instalments are covered by the total operating income after payment oftax. =Where:Net Operating income = Net Income after tax + Depreciation + Interest Expense +Other non-cash expensesDebt Services = Principal Repayment + Interest Payments + Lease Payments

Exercise:

20X1 (12 months)($)

Net Income After Tax 120,000Depreciation 20,000Interest Payment (Per month) 2,500Principal Repayment (at year end) 72,000Net Operating IncomeAnnual Debt ServiceDebt Service Coverage Ratio

170,000102,000

1.67 : 1

These ratios measure the operating efficiency of the firm and its ability to ensureadequate returns to its stakeholders.

The profitability of the firm can be measured by its profitability ratios.

Profitability can be determined:• In relation to sales• In relation to investments

These ratios measure the operating efficiency of the firm and its ability to ensureadequate returns to its stakeholders.

The profitability of the firm can be measured by its profitability ratios.

Profitability can be determined:• In relation to sales• In relation to investments

Gross Profit MarginNet Profit Margin

Expenses Ratio

Gross Profit MarginNet Profit Margin

Expenses Ratio

These ratios measure the operating efficiency of the firm and its ability to ensureadequate returns to its stakeholders.

The profitability of the firm can be measured by its profitability ratios.

Profitability can be determined:• In relation to sales• In relation to investments

Return on Assets (ROA)Return on Capital Employed (ROCE)

Return on Shareholders’ Equity (ROE)Earnings Per Share (EPS)Dividend Per Share (DPS)

Dividend Payout Ratio (D/P)Price Earning Ratio (P/E)

Return on Assets (ROA)Return on Capital Employed (ROCE)

Return on Shareholders’ Equity (ROE)Earnings Per Share (EPS)Dividend Per Share (DPS)

Dividend Payout Ratio (D/P)Price Earning Ratio (P/E)

• Gross Profit Margin• Net Profit Margin• Expenses Ratio

The ratio is calculated by dividing Gross Profit by Sales

It is expressed as a percentage.

Gross Profit is the result of relationship between prices,sales volume and costs.

=An organisation should have at least enough Gross Profit

Margin to cover its operating expenses and ensureadequate return to the owners of the business.

The ratio is calculated by dividing Gross Profit by Sales

It is expressed as a percentage.

Gross Profit is the result of relationship between prices,sales volume and costs.

=An organisation should have at least enough Gross Profit

Margin to cover its operating expenses and ensureadequate return to the owners of the business.

• Gross Profit Margin• Net Profit Margin• Expenses Ratio

The ratio is calculated by dividing Net Profit by Sales.

It is expressed as a percentage.

The ratio is indicative of firm’s ability to leave a marginreasonable compensation to the owners for providing

capital, after meeting the cost of production, operatingcharges and the cost of borrowed funds.

=High net profit margin gives an organisation the ability to

withstand adverse economic conditions.

The ratio is calculated by dividing Net Profit by Sales.

It is expressed as a percentage.

The ratio is indicative of firm’s ability to leave a marginreasonable compensation to the owners for providing

capital, after meeting the cost of production, operatingcharges and the cost of borrowed funds.

=High net profit margin gives an organisation the ability to

withstand adverse economic conditions.

• Gross Profit Margin• Net Profit Margin• Expenses Ratio The ratio are calculated by dividing Various Expenses by

Sales. Different variants of these ratios are:==

These ratios should be compared over time againstindustry averages and firm’s own past performance.

A low expense ratio is favourable. High expense ratioshave an adverse impact on share of sales available formeeting financial liabilities like interest, dividends, etc.

The ratio are calculated by dividing Various Expenses bySales. Different variants of these ratios are:=

=These ratios should be compared over time againstindustry averages and firm’s own past performance.

A low expense ratio is favourable. High expense ratioshave an adverse impact on share of sales available formeeting financial liabilities like interest, dividends, etc.