Financial Statement Analysis for Decisions: Ratios, Cash Flow and Funds Flow (Basics) Questions

Question 1

Define financial statement analysis.

Accepted Answer

Financial statement analysis is the process of evaluating financial statements to understand **profitability, liquidity, solvency and efficiency** for decision-making.

Question 2

What is ratio analysis?

Accepted Answer

Ratio analysis is the technique of using relationships between financial figures (ratios) to interpret a firm’s performance and position.

Question 3

State the formula for current ratio.

Accepted Answer

Current ratio = **Current Assets / Current Liabilities**.

Question 4

What is cash flow statement?

Accepted Answer

Cash flow statement shows cash inflows and outflows classified into **operating, investing and financing** activities during a period.

Question 5

What is funds flow statement (basic)?

Accepted Answer

Funds flow statement explains changes in **working capital (CA − CL)** between two balance sheet dates by showing sources and applications of funds.

Question 6

Quick ratio excludes inventory.

Accepted Answer

True. Quick ratio uses quick assets (highly liquid assets) and generally excludes inventory.

Question 7

Classify ratios into major categories and give one example each.

Accepted Answer

Major ratio categories:

| Category | Meaning | Example |
|---|---|---|
| **Liquidity** | short-term solvency | current ratio |
| **Profitability** | earning capacity | net profit ratio |
| **Solvency** | long-term solvency | debt–equity |
| **Activity** | efficiency | inventory turnover |

These ratios together give a complete financial picture.

Question 8

Compute current ratio: CA ₹6,00,000 and CL ₹3,00,000. Interpret briefly.

Accepted Answer

Current ratio = **CA/CL** = 6,00,000 / 3,00,000 = **2:1**.

Interpretation: The firm has ₹2 of current assets for every ₹1 of current liabilities (good liquidity, basic view).

| CA | CL | **Current ratio** |
|---:|---:|---:|
| 6,00,000 | 3,00,000 | **2.0** |

Question 9

Compute interest coverage ratio: EBIT ₹4,00,000 and interest ₹1,00,000. Interpret.

Accepted Answer

Interest coverage = **EBIT / Interest**

= 4,00,000 / 1,00,000 = **4 times**.

Interpretation: EBIT covers interest 4 times, indicating comfortable interest-paying capacity.

| EBIT | Interest | **ICR** |
|---:|---:|---:|
| 4,00,000 | 1,00,000 | **4×** |

Question 10

Differentiate between cash flow statement and funds flow statement using a table (any three points).

Accepted Answer

Cash flow vs funds flow:

| Basis | **Cash flow** | **Funds flow** |
|---|---|---|
| Focus | cash movement | **working capital** movement |
| Use | liquidity planning | sources/uses affecting WC |
| Classification | operating/investing/financing | sources & applications |

Thus, cash flow is stricter; funds flow is broader (working capital-based).

Question 11

Compute debt–equity ratio: Total debt ₹6,00,000 and equity ₹4,00,000. Interpret briefly.

Accepted Answer

Debt–equity ratio = **Debt / Equity**

= 6,00,000 / 4,00,000 = **1.5 : 1**.

Interpretation: The firm has higher debt relative to equity, indicating **higher leverage** (basic).

| Debt | Equity | **D/E** |
|---:|---:|---:|
| 6,00,000 | 4,00,000 | **1.5** |

Question 12

Explain why trend analysis and industry comparison are important while interpreting ratios (any three points).

Accepted Answer

Ratios are meaningful only with comparison:

- **Trend (time series)** shows improvement or deterioration over years.
- **Industry comparison** shows relative performance vs competitors.
- Absolute ratio may mislead due to different accounting policies or seasonal factors.

Flow: Compute ratio → compare with **past + industry** → interpret → decision

Thus, context is essential for correct interpretation.

Question 13

Explain limitations of ratio analysis (exam-style) with a table and conclusion.

Accepted Answer

### Limitations
Ratio analysis is useful, but it has limitations:

- depends on **accounting policies** (depreciation, inventory valuation)
- ignores inflation effects
- ratios can be window-dressed
- single ratio is misleading without comparison and context

| Limitation | Impact |
|---|---|
| **Policy differences** | reduces comparability |
| Window dressing | misleading liquidity/profitability |
| Inflation | distorts asset-based ratios |

### Conclusion
Therefore, ratios should be interpreted with trends, industry comparison and qualitative information.

Question 14

Explain cash flow statement structure and why it is important for decisions (exam-style) with a table and conclusion.

Accepted Answer

### Structure
Cash flow statement classifies cash flows into:
- **Operating** activities
- **Investing** activities
- **Financing** activities

| Section | Examples |
|---|---|
| **Operating** | cash from customers, cash paid to suppliers |
| **Investing** | purchase/sale of fixed assets, investments |
| **Financing** | issue/repayment of debt/equity, dividends |

### Importance
It shows actual cash generation, liquidity strength and ability to pay dividends/loans.

### Conclusion
Cash flow analysis supports better financing and liquidity decisions than profit alone.

Question 15

Explain how ratio analysis supports managerial decisions (exam-style) with a flow and conclusion.

Accepted Answer

### How ratios support decisions
Ratios convert raw accounting numbers into meaningful indicators for control and planning.

Flow:
Financial statements → compute **ratios** → compare with past/industry → identify issues → take decisions

Examples of decisions:
- liquidity ratios guide **working capital** policy
- profitability ratios guide pricing/cost control
- solvency ratios guide borrowing capacity
- activity ratios guide inventory/credit policy

### Conclusion
Thus, ratio analysis is a practical tool for managerial **diagnosis and decision-making**.

Category	Meaning	Example
Liquidity	short-term solvency	current ratio
Profitability	earning capacity	net profit ratio
Solvency	long-term solvency	debt–equity
Activity	efficiency	inventory turnover

Financial Statement Analysis for Decisions: Ratios, Cash Flow and Funds Flow (Basics)

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