4. Financial Statement Analysis

7/31/2019 4. Financial Statement Analysis

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FINANCIAL STATEMENTANALYSIS

Methods


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FINANCIAL STATEMENT ANALYSIS

Objectives of Analysis

1. To know whether the company is makingenough profit or not

2. To evaluate the financial strength of thecompany

3. To judge the ability of the company togenerate enough cash and cash equivalentsand their timing

4. To know the future growth prospects


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FINANCIAL STATEMENT ANALYSIS

Tools available for analysis

1. Multi-step income statement2. Horizontal (comparative) analysis

3. Common-sized analysis

4. Trend analysis

5. Analytical balance sheet


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Multi-step Income Statement

From the reported statement , it is necessary tosegregate information and break-up of manufacturing,administrative and selling expenses which will show theprofitability and disclose the following:

a) Gross ProfitGP

b) Profit before depreciation, interest and taxPBDIT

c) Operating ProfitOP or PBIT

d) Profit before tax and extraordinary itemsPBTEOT

e) Profit before taxPBT

f) Net profit--PAT


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Horizontal Analysis

The percentage analysis of increase or decreasein each item of comparative balance sheet andprofit and loss account is known as horizontal

analysis.

Formula:

(Current years fig.- Previous years fig.)*100----------------------------------------------------------

Previous years fig.


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COMPARATIVE INCOME STATEMENTSFor the years ended December 31, 1998 and 1999

1999 1998 AbsoluteIncrease/

decrease

% increase

(or decrease)

Sales (Net) 1100000 1000000 100000 10

Less: Cost of goods sold 840000 800000 40000 5

Gross Profit 260000 200000 60000 30Less: Operating Expenses(office, admin., selling & distribn.)

60000 50000 10000 20

Net operating Profit 200000 150000 50000 33.33

Other Income 20000 20000 - -

Earnings before interest n tax 220000 170000 50000 29.4

Interest paid 20000 2000 - -

Profit before Tax 200000 150000 50000 33.33

Income Tax payable 100000 75000 25000 33.33

Profit after Tax 100000 75000 25000 33.33


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COMPARATIVE BALANCE SHEETSAs on 31st December 1978 and 1979

1999 1998 AbsoluteIncrease/

decrease

% increase

/decrease

Fixed assets 500000 400000 100000 25

Investment 100000 100000 - -

Working Capital (CA-CL) 200000 100000 100000 100

Capital employed 800000 600000 200000 33.33

Less: Debentures 200000 200000 - -

600000 400000 200000 50

Shareholders Fund: 600000 400000 200000 50Preference share capital 200000 100000 100000 100

Equity share capital 300000 200000 100000 50

Reserves and Surplus 100000 100000 - -


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Advantages of comparative analysis

These statements indicate trends in sales, cost ofproduction, profits, etc., helping the analyst to evaluate theperformance, efficiency and financial condition of theundertaking.

For example, if the sales are increasing coupled with the same orbetter profit margins, it indicates healthy growth.

Comparative statements can also be used to compare theposition of the firm with the average performance of the

industry or with other firms. Such a comparison facilitatesthe identification or weaknesses and remedying thesituation.


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Disadvantages of comparative analysis

Inter-firm comparison may be misleading if thefirms are not of the same age and size, followdifferent accounting policies in relation to

depreciation, valuation of stock, etc., and do notcater to the same market.

Inter-period comparison will also be misleading if

the period has witnessed frequent changes inaccounting policies.


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Common-sized Analysis

1. The tool is useful in comparing the performanceand financial position of two companies withinthe same industry or in different industries

2. In case of balance sheet , each item is restatedtaking the total sources of fund or application offund as 100

3. Similarly, in case of income statement, all itemsare expressed as a percentage of net saleswhich is taken at 100


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Common Size Balance Sheet

A company balance sheet that displays all itemsas percentages of a common base figure. This type offinancial statement can be used to allow for easy analysisbetween companies or between time periods ofa company.


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Common Size Income Statement

An income statement in which each account is expressed asa percentage of the value of sales. This type of financialstatement can be used to allow for easy analysis betweencompanies or between time periods of a company.


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Common-sized Analysis

2006 2007 2006 2007

Gross Sales 151500 141540 101 101.1

Less: Returns 1500 1540 1.0 1.1

Net Sales 150000 140000 100 100

Cost of goods sold 105000 99400 70.0 71.0

Gross profit 45000 40600 30.0 29.0

Expenses:

Selling Expenses 7500 7560 5.0 5.4

General expenses 4500 4500 3.0 3.2

Financial expenses 750 560 0.5 0.4

Total expenses 12750 12620 8.5 9.0

Net Profit 32250 29980 21.5 20.0


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Analytical Balance Sheet

1. It is a modified version of vertical balance sheet

2. It starts with Application of funds side as against thevertical balance sheet that starts with Sources of Fundsside

3. It proves the basic accounting equation : Assets - outsideliabilities= Owners Funds

4. It shows that equity shareholders are the residualclaimants on the assets of the company


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Trend Analysis

1. It is an extension of horizontal analysis

2. Unlike in horizontal analysis, trend analysiscompares position for more than two years,say, five years

3. Analysis for a longer period confirms thefindings of horizontal analysis


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Ratio Analysis

Ratio refers to relationship between twovariables expressed either in percentages or inmultiples and seeks to establish the cause and

effect relationship.

It assists in the following cases:

1. Inter-firm comparison2. Intra-firm comparison

3. Comparison against industry benchmark

4. Analysis of performance over a long period


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Ratio Analysis

Classification of Ratios

1. Return on Investment ( ROI ) ratios

2. Solvency ratios

3. Liquidity ratios

4. Efficiency or Turnover ratios

5.

Profitability ratios6. Du Pont Analysis

7. Capital Market ratios


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Return on Investment (ROI) ratios

This ratio seeks to measure the efficiency ofperformance or otherwise of the company.Higher the ratio, greater is the financial securityfor investors. Maximization of ROI is theultimate objective of any company.

Under this group, the following ratios are computed

1. Return on Net Worth2. Earnings per Share


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Return on Net Worth (RONW)

The ratio measures the net profit earned onequity shareholders funds. It is the measure ofoverall profitability of a company.

Formula:

(PAT-Pref.dividend)*100

----------------------------------------------------------Net Worth (Equity capital + Reserves & Surplus-

Misc. expenditure not written off)


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Earning per Share ( EPS)

The ratio measures the overall profitabilityin terms of per equity share of capital

contributed.This is the most widely usedratio across industries.

Formula:

PAT- Pref.Dividend-------------------------------------------------

Weighted average no. of equity shares O/S


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Solvency Ratios

The capacity of a company to discharge its long-term obligation indicates its financial strengthand solvency position.

Under this group, following ratios are computed.

1. Debt-Equity ratio

2. Interest coverage ratio

3. Debt-service coverage ratio


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Debt-Equity ratio (times)

The ratio measures the proportion of debt andcapital both equity and preference in the capitalstructure of a company. It helps in knowingwhether a company is relying more on debt or

capital for financing its assets. Higher the debt ,more is the financial risk.

Formula:

Long term debt

----------------------------------------------------------

Total net worth (E.g. shareholders funds+Pref. cap)


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Interest Coverage Ratio (times)

The ratio measures the ability of a company toservice the interest obligations out of its cashprofits. Higher the ratio, greater is the ability.

Formula:

PAT+ Int. on long-term debt+Non-cash charges

----------------------------------------------------------Interest on long-term debt


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Debt Service Coverage Ratio (times)

This ratio helps in assessing whether a companyhas the ability to service its installments of theprincipal due and the interest obligations out ofthe revenues generated. Higher the ratio, greater

is the ability.

Formula:

PAT+ Int. on long term debt+Non-cash charges

-------------------------------------------------------Int. on long term-debt +Installments of principal due


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Liquidity Ratio

Liquidity refers to the capacity a company tomeet its day to day expenses and dischargeshort-term obligations of suppliers and othercreditors smoothly.

Following ratios are calculated under this head.1. Current Ratio2. Quick Ratio

3. Collection period4. Suppliers Credit5. Inventory Holding period


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Current Ratio (times)

The ratio measures the ability of a company to discharge itsday to day obligations. A company should possess adequatelevel of current assets over current liabilities to be able todo so. A current ratio of more than 1 indicates that value of

short-term assets is more than short-term liabilities. Acurrent ratio of less than 1 indicates poor liquidity.

Formula:

Current Assets, loans & advances + short-term Investments

---------------------------------------------------------------------Current Liabilities + Provisions + Short-term debt


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Quick Ratio (times)

The ratio measures as to how fast the company is able tomeet its current obligations as and when they fall due. Thisis also known as acid-test ratio. Inventory and workingcapital limits are taken out of current assets and current

liabilities respectively. A quick ratio of 1: 1 is indicateshighly solvent position.

Formula:

Current Assets, Loans and Advances - Inventories--------------------------------------------------------------------

Current Liabilities+Provisions-Working Capital Limits


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Collection Period (days)

The ratio measures how fast the company is ableto realize the dues from the customers on creditsales. It helps to understand the credit policy of

the company.

Formula:

Receivables x 365

---------------------------

Credit sales


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Suppliers Credit (days)

The ratio measures the average credit periodenjoyed by the company from its suppliers. Italso helps to understand the credit policy

extended to a company by the suppliers.

Formula:

Payables x 365

----------------------

Credit Purchases


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Inventory Holding Period (days)

The ratio measures the average period for whichcash is blocked in inventory. In other words theratio explains how fast the company is able to

convert its inventory into cash.

Formula:

Inventory x 365

--------------------

Cost of goods sold


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Turnover Ratios

These ratios indicate how efficiently the assetsof the company are used to generate revenue .

Following ratios are calculated under this group.

1. Overall Efficiency Ratio

2. Fixed Assets Turnover Ratio

3. Debtors Turnover Ratio

4. Inventory Turnover Ratio5. Creditors Turnover Ratio


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Overall Efficiency Ratio (times)

It shows how effectively the capital employedhas helped in revenue generation. Higher theratio greater is the efficiency.

Formula:

Sales

---------------------------

Capital Employed


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Fixed Assets Turnover Ratio (times)

The ratio measures the sales revenue per rupee

of fixed assets. It plays an important role inimproving the overall profitability and financialposition of the company.

Formula :

Sales

----------------------------------------Net Block of Fixed Assets


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Debtors Turnover Ratio (times)

It represents the number of times average dues

from customers are realized. Higher the ratio,the better is the position.

Formula:

Credit Sales

-----------------------

Average Debtors


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Creditors Turnover Ratio (times)

The ratio shows the average time taken to pay for

goods and services. Longer the credit period achieved

the better.

Formula:

Credit Purchase

--------------------------

Average Creditors


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Inventory Turnover Ratio

The ratio measures the amount of capital tied up

in raw material, W.I.P. and finished goods

Formula:

Cost of Goods Sold

-----------------------

Average Inventory


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Profitability Ratios

The purpose of study of these ratios is to assessthe adequacy or otherwise of the profit earnedby the company. The following ratios are

calculated under this group:

1. Multi-step Profit Margin to Sales

2. Individual Cost and Expense to Sales

3. Other Income , Extraordinary Items and PriorPeriod Adjustments to PBT or Sales

4. Effective Tax Rate


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Multi-step Profit Margin to Sales Ratios(%)

These ratios measure several profit margin indicators. Allthese ratios are computed in relation to Sales.

1. Gross Profit Margin-GP2. Profit Before Depreciation, Interest and Tax-PBDIT

3. Operating Profit-OP

4. Profit Before Tax and Extra-ordinary Items-PBTEOT

5. Profit Before Tax-PBT

6. Net Profit Margin-PAT

Gross Profit Margin (%)


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Gross Profit Margin (%)This reflects the efficiency with which managementproduces each unit of output. It also indicates the spreadbetween the cost of goods sold and the sales revenue.

Formula:Sales- Cost of Goods Sold

----------------------------- x 100

Sales

Operating Profit Margin (%)

This ratio indicates profitability from operating activities. Ahigher margin implies better sales realization and effectivecost control.

Formula:Operating Profit

------------------ X 100

Sales


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Net Profit Margin( % )

The ratio is the overall measure of the firms ability to earnprofit per rupee of sales. It also establishes relationship

between manufacturing, administering and selling theproducts.

Formula: Profit After Tax

------------------- x100

Sales

Other Income, Extraordinary Items and Prior PeriodAdjustments to PBT or Net Sales (%)

These ratios seek to measure the impact of the aboveitems on PBT or net sales.

Formula:

Extraordinary Item

--------------------- x 100

PBT


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Individual Costs and Expenses to Sales Ratios (%)

These ratios measure the proportion of individualitems of cost and expense in relation to sales.They also assist the analyst in cost minimizationand cost reduction.

Formula:

Raw Materials Consumed

---------------------------------- x100

Net Sales


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Effective Tax Rate(%)

The ratio measures the actual effective rate at

which a company pays income tax as against the

statutory rate.

Formula:

Current Income Tax

------------------------ x100PBT


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Dupont System of Analysis

It is an integrativeapproach used to dissecta firm's

financial statements and assess its financial condition

It ties together the income statement and balance sheet

to determine two summary measures of profitability,

namely ROA and ROE

Helps to identify sources of strength and weakness in

current performance

Helpsto focus attention on value drivers


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The DuPont System

Method to breakdown ROE into:

ROA and Equity Multiplier

ROA is further broken down as: Profit Margin and Asset Turnover

Thus the firm's return is broken into threecomponents:

A profitability measure (net profit margin)

An efficiency measure (total asset turnover)

A leverage measure (financial leverage multiplier)


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The DuPont System

Profit Margin Total Asset Turnover

ROA Equity Multiplier

ROE

EquityCommon

AssetsTotal

AssetsTotal

SalesNet

SalesNet

IncomeNet

MultiplierEquityROAROE


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DU PONT Analysis

RONW is a function of Net Profit Margin and Net worthTurnover. DU PONT analysis seeks to measure andestablish this relationship between the two determinants.Through these ratios a firm can devise suitable remedies to

overcome the weak area of overall performance.

Formula:

(PAT-Pref. Div)X100 Net Sales

------------------------ X -----------------Net Sales Net Worth


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Capital Market Ratios

Following ratios are computed under this

group:

1. EPS (Earning per share)

2. Price Earning Ratio-P/E

3. Market Capitalization

4. Yield to Investors


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Price Earning Ratio (times)

P/E multiple is an important indicator of thepremium that the market wishes to put on afirms earnings. It can be used to price a share

and value a firm.

Formula:

Market Price of Equity Share--------------------------------------

EPS


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Market Capitalization (Rs.)

The ratio measures the total market value of the

number of equity shares outstanding.

Formula:

No. of Equity Shares O/S X Market Price


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Yield to Investors (%)

The ratio measures the total gain or loss suffered

by investors in relation to their investment in

equity shares of a company.

Dividend recd.+ Market Appreciation

------------------------------------------x100

Initial Investment


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An approach that views all aspects of the firm'sactivities to isolate key areas of concern

Comparisons are made to industry standards(cross-sectional analysis)

Comparisons to the firm itself over time are also

made (time-series analysis)

Summarizing All Ratios


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Advantages of Financial Ratios

Ratios help to: Evaluate performance Structure analysis Show the connection between activities and

performance

Benchmark with Past for the company

Industry

Ratios adjust for size differences


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Limitations of Ratio Analysis

A firms industry category is often difficult toidentify

Published industry averages are only guidelines

Accounting practices differ across firms Sometimes difficult to interpret deviations in

ratios

Industry ratios may not be desirable targets Seasonality affects ratios

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4. Financial Statement Analysis

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