Financial Statement Analysis

Analytical techniques used Horizontal analysis Trend analysis Common size statement Ratios

Horizontal analysis

Trend analysis

2000-03

2001-03

2002-03

2003-03

2004-03

2005-03

2006-03

2007-03

2008-03

2009-03

2010-03

2011-03

-

500.00

1,000.00

1,500.00

2,000.00

2,500.00

3,000.00

3,500.00

Total IncomeTotal ExpenditureOperating Profit

Common size statement

Ratios

Basics of Financial Statement AnalysisBasics of Financial Statement AnalysisAnalyzing financial statements involves:

CharacteristicsComparison Bases

Tools of Analysis

Liquidity

Profitability

Solvency

Efficiency

Intra-company

Industry averages

Inter-company

Horizontal

Trend

Vertical

Ratio

Comparison Bases

Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.

Ratios include the i. Net Working Capital ii. Current ratio iii. Acid-test ratio, iv. Turnover ratios v. Defensive interval ratio and vii. Cash flow from operation ratio

Liquidity Ratios

Net working capital = Current Assets- Current Liabilities

Net Working Capital

Current Assets – Represent those assets which can be converted into cash within a short period of time, normally not exceeding one year and include Cash, Bank balance, Marketable securities, Inventories, Debtors, Bills receivables and Prepaid expenses

Current Liabilities – Represent those which are short-term maturing obligations to be met within a year. Consist of Trade creditors, Bills payable, Bank credit, Short term provisions and Outstanding expenses

Details Company X Company Y

Total current assets 2,40,000 50,000

Total current Liabilities 1,50,000 20,000

Net working capital (CA-CL)

90,000 30,000

Current Ratio: It is the relationship between the current assets and current liabilities of a concern. This ratio must be at least 2 : 1 to ensure minimum margin of 25% of current assets as margin from long term sources

Current Ratio = Current Assets/Current Liabilities

ACID TEST or QUICK RATIO: It is the ratio between Quick Current Assets and Current Liabilities. The should be at least equal to 1

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Cash 50,000Debtors 1,00,000Inventories 1,50,000Current Liabilities 1,00,000Total Current Assets 3,00,000

Current Ratio => 3,00,000/1,00,000 = 3 : 1Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1

Turnover ratios

Inventory turnover ratio = Cost goods sold/Av.Inventory

Sales = 3,00,000GP = 20%Stock at the beginning and at the End = 35,000 &

45000

Inventory holding period = 12 months/ Inventory turnover ratio

These ratios indicate the number of times the inventory is rotated during the relevant accounting period

Debtors turnover ratio = Net credit Sales/Av.Debtors

Total Sales = 2,70,000Cash Sales = 30,000Debtors at the Beginning and at the End = 27,500 and

32,500

Debtors collection period = 12 months/ Debtors turnover ratio

Measures how rapidly receivables are collected

Creditors turnover ratio = Net credit purchase/ Av.creditors

Total purchase = 2,00,000Cash purchase = 10%Creditors at the beginning and at the End = 42,500 and

47,500

Creditors payment period=12months/ Creditors turnover ratio

The extent to which trade creditors are willing to wait for payment

Debt-Equity Ratio = Total debt/ Shareholder’s equity

Measures the relationship between borrowed fund and owner’s capital

Proprietary ratio = (Proprietor’s fund/Total assets) x 100

It indicates the extend to which assets are financed by owners fund

Solvency ratios

Coverage Ratio

Interest Coverage Ratio measures the firm’s ability to make contractual interest payments.

Interest coverage ratio =

EBIT (Earning before interest and taxes)

Interest

Dividend coverage ratio =

EAT (Earning after taxes)Preference

dividend

Dividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return.

Interest Coverage Ratio

Dividend Coverage Ratio

Total fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations.

Total fixed charge coverage ratio

EBIT + Lease Payment

Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)

=

Total fixed charge coverage ratio

However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations.

Total Cashflow Coverage Ratio 

Total cashflow coverage ratio

Lease payment + Interest

EBIT + Lease Payments + Depreciation + Non-cash expenses=

(Principal repayment)

(1– t)

(Preference dividend)

(1 - t)

+ +

Debt Service Coverage RatioDebt-service coverage ratio (DSCR)  is considered a more comprehensive and apt measure to compute debt

service capacity of a business firm.

DEBT SERVICE CAPACITY

DSCR =Iinstalmentt∑

n

t=1

EATt OAt+ +∑n

t=1Depreciationt

+Interestt

Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.

Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. (Figures in Rs lakh)

Year Net profit for the year

Interest on term loan during the year

Repayment of termloan in the year

12345678

21.6734.7736.0119.2018.6118.4018.3316.41

19.1417.6415.1212.6010.087.565.04Nil 

10.7018.0018.0018.0018.0018.0018.0018.00

The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.

Debt-Service Coverage Ratio

SolutionTable 3:  Determination of Debt Service Coverage Ratio

(Amount in lakh of rupees)Year

Net profit

Depreciation Interest Cashavailable

(col. 2+3+4)

 Principalinstalment

 Debtobligation

(col. 4 + col. 6)

DSCR [col. 5 ÷ col. 7

(No. of times)]

1 2 3 4 5 6 7 8

12345678

21.6734.7736.0119.2018.6118.4018.3316.41

17.6817.6817.6817.6817.6817.6817.6817.68

19.1417.6415.1212.6010.087.565.04Nil 

58.4970.0968.8149.4846.3743.6441.0534.09

10.7018.0018.0018.0018.0018.0018.0018.00

29.8435.6433.1230.6028.0825.5623.0418.00

1.961.972.081.621.651.711.781.89

  Average DSCR (DSCR ÷ 8) 1.83

© Tata McGraw-Hill Publishing Company Limited, Management Accounting

6 - 22

Profitability Ratio

Profitability ratios can be computed either from sales or investment.

Profitability Ratios

Related to Sales

Profitability Ratios

Related to Investments

(i) Profit Margin

(ii) Expenses Ratio

(i) Return on Investments

(ii) Return on Shareholders’

Equity

© Tata McGraw-Hill Publishing Company Limited, Management Accounting

6 - 23

Profit Margin

Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods

Gross profit margin =

Gross ProfitSales

X 100

Gross Profit Margin

Net profit margin can be computed in three ways

iii. Net Profit Ratio =

Earning after interest and taxes Net sales

ii. Pre-tax Profit Ratio =

Earnings before taxes Net sales

i. Operating Profit Ratio =

Earning before interest and taxes Net

sales

Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted.

Net Profit Margin

(1) Gross profit margin =Rs 1,00,000

= 50 per centRs 2,00,000

From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin.

1. Sales2. Cost of goods sold3. Other operating expenses

Rs 2,00,0001,00,000

50,000

(2) Net profit margin =Rs 50,000

= 25 per centRs 2,00,000

Expenses Ratio

i. Cost of goods sold =

Cost of goods soldNet sales

X 100

ii. Operating expenses =

Administrative exp. + Selling exp. Net sales

X 100

iii. Administrative expenses =

Administrative expensesNet sales

X 100

iv. Selling expenses ratio =

Selling expensesNet sales

X 100

v. Operating ratio =

Cost of goods sold + Operating expenses Net sales

X 100

vi. Financial expenses =

Financial expensesNet sales

X 100

Return on Investment

Return on Investments measures the overall effectiveness of management in generating profits with its available assets.i. Return on Assets (ROA)

ROA =EAT + (Interest – Tax advantage on interest)

Average total assets

ii. Return on Capital Employed (ROCE)

ROCE =

EAT + (Interest – Tax advantage on interest)Average total capital employed

Return on Shareholders’ Equity

Return on total shareholders’ fund =

Net profit after taxesAverage total shareholders’ fundX

100

Return on ordinary shareholders’ equity (Net worth) =Net profit after taxes – Preference

dividendAverage ordinary shareholders’ equity

X 100

Return on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm.

Efficiency Ratio

Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

Inventory Turnover Ratio =

Cost of goods soldAverage inventory

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

Raw materials turnover =

Cost of raw materials usedAverage raw material

inventoryi. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

Work-in-progress turnover =

Cost of goods manufacturedAverage work-in-progress

inventory

Inventory turnover measures the efficiency of various types of inventories.

Liquidity of a firm’s receivables can be examined in two ways.i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

i. Debtors turnover =Credit salesAverage debtors + Average bills

receivable (B/R)

2. Average collection period =

Months (days) in a yearDebtors turnover

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldAlternatively =

Months (days) in a year (x) (Average Debtors + Average (B/R) Total credit sales

Ageing Schedule enables analysis to identify slow paying debtors.

Debtors Turnover Ratio

Assets Turnover Ratio

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

i. Total assets turnover =

Cost of goods soldAverage total assets

ii. Fixed assets turnover =

Cost of goods soldAverage fixed assets

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

iii. Capital turnover =Cost of goods sold

Average capital employed

iv. Current assets turnover =

Cost of goods soldAverage current

assetsi. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

v. Working capital turnover =

Cost of goods soldNet working capital

Assets turnover indicates the efficiency with which firm uses all its assets to generate sales.

1) Return on shareholders’ equity = EAT/Average total

shareholders’ equity

2) Return on equity funds = (EAT – Preference dividend)/Average

ordinary shareholders’ equity (net worth)

3) Earnings per share (EPS) = Net profit available to equity

shareholders’ (EAT – Dp)/Number of equity shares outstanding

(N)

4) Dividends per share (DPS) = Dividend paid to ordinary

shareholders/Number of ordinary shares outstanding (N)

5) Earnings yield = EPS/Market price per share

6) Dividend Yield = DPS/Market price per share

7) Dividend payment/payout (D/P) ratio = DPS/EPS

8) Price-earnings (P/E) ratio = Market price of a share/EPS

9) Book value per share = Ordinary shareholders’ equity/Number

of equity shares outstanding

Integrated Analysis Ratio

(1) Rate of return on assets (ROA) can be decomposed in to

(i) Net profit margin (EAT/Sales)

(ii) Assets turnover (Sales/Total assets)

(2) Return on Equity (ROE) can be decomposed in to (DU PONT)

(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)

Integrated ratios provide better insight about financial and economic analysis of a firm.

Return on Assets

Earning PowerEarning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover.Earning power = Net profit margin × Assets turnoverWhere, Net profit margin = Earning after taxes/SalesAsset turnover = Sales/Total assets

i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold

Earning Power =

Earning after taxesSale

s

Sales

Total Assets

EAT

Total assets

xx x

Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each.

Return on Assets (ROA) of Firms A and B

Particulars Firm A Firm B

1. Net sales2. Net profit3. Total assets4. Profit margin (2 ÷ 1) (per cent)5. Assets turnover (1 ÷ 3) (times)6. ROA ratio (4 × 5) (per cent)

Rs 4,00,00040,000

4,00,00010

110

Rs 40,00,00040,000

4,00,0001

1010

Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components.