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Analysis of Financial Statements

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Balance Sheet

The key financial statement showing the what

firm owns and what a firm owes.

The summary statement of assets and

liabilities of the firm.

The difference between the assets and the

liabilities gives us the owner equity.

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Components of Balance sheet

Total value of assets Total value of liabilities

and shareholders equity

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Current assets

Current

liabilities

Fixed assets

1.Tangible assets2. Intangible fixed

assets

Long term

debt

Shareholder

equity

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Relationship between components

Assets-Liabilities= Owner's equity(I)

Current liabilities and long term debt are themain components of the liabilities side of the

balance sheet. Shareholder equity, the difference between the

assets of the firm and its liabilities.

Finally, balance sheet reflects the facts that, if thefirm were sell all its assets and use the money topay off its debt then whatever residual valueremained would belong to the shareholders.

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Net working capital

The difference between current assets andcurrent liabilities of the firm is known as thenet working capital.

Net working capital is positive when itscurrent assets exceed the current liabilitiesand vice versa.

For example,Net working capital =Current assets-Current

liabilities.(ii)

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Balance sheet

Assets Amount Liabilities and Amount

shareholders'

Equity

Current assets 100 Current liabilities 80Net fixed assets 600 Long-term debt 200

Shareholders' equity 420

Total liabilities andTotal assets 700 shareholders' equity 700

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Debt versus Equity

Firm usually gives first claim to the firms cashflow to creditors.

Equity holder entitled to only the residual

value i.e. also known as the shareholdersequity.

The firm uses the debt in their capital

structure is called the levered firm. The more the firm use the debt more is the

degree of financial leverage to the firm.

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Debt versus Equity

So, financial leverage increases the potential

reward to shareholders, but it also increases

the potential forfinancial distress and

business failure.

Use of debt serve as a means of signalingit

may signal the firm positively or negatively.

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Market value vs. Book value

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Market value

The value of the assets in the market ratherthan the book of the company.

Market value is also called the economic value

of the firm. Managers and investors will frequently be

interested in knowing the value of the firm.

This information is not on the balance sheetbecause the balance sheet assets are listed incost term.

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Book value

The value shown on the balance sheet for the

firms asset are book values.

Assets are carried on the books at what the

firm paid for them, no matter how long they

were purchased or how much they are worth

today.

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Which is more important for financial

manager?

For the financial manager the accounting or

book value is not an especially important

concern.

But, the matter is the market value of the

firm.

So, when we discuss the value maximization

objective of the financial manager the market

value is the concern.

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Example

Balance sheet

Market value versus book value

Assets Liabilities and equities

Book Market Book Market

Net Working 500 600 Debt 600 500

Capital

Net fixed 800 1200 Equity 700 1300

assets 1300 1800 1300 1800

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In above example the market value of the

equity is almost double as much as what is

shown on the books.

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Income statement

The summary statement showing the revenue

and expenses is known as the income

statement.

Income statement is basically prepared for

some specific time period such as quarter, half

yearly, yearly and so on.

Revenue- Expenses=Income.(iii)

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Income statement

The revenue and expenses of the firms

principal operation is the major body of the

income statement.

The main goal of the income statement is to

find out the net income of the firm.

Performance of the firm can be evaluated

from the income statement.

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Example

Income statementNet sales 2500

Cost of goods sold(COGS) 800

Depreciation 100Earning before interest and taxes 1600

Interest paid 400

Taxable income 1200

Tax 300

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Income statement

Out of the net income 450 is distributed among theshareholder as a divided and rest of the net income isretained by the firm.

The difference between the net income and divided is

the addition to retained earning. Net income and dividend can also be expressed as per

share basis.

Earning per share=Net income/Total shareoutstanding..(IV)

Dividend per share= Total dividend/ Total shareoutstanding(V)

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GAAP

An income statement prepared using GAAP

will show revenue when it accrues.

It is not necessary the actual cash flow.

In practices, this principle means that revenue

is recognized at the time of sale, which need

not be the same as the time of collection.

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Ratio analysis

Key analysis based on the financial

information of the firm.

Ratio analysis helps to determine the

relations from a firms financial information

and used for comparison.

Industry average is the benchmark for

comparison.

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Liquidity Ratio

Liquidity ratio measure the short term

solvency of the firm. So it is also called the

short-term solvency ratio.

The primary concern is the firms ability to pay

its bills over the short run without undue

stress.

Liquidity ratio focus on current assets and

current liabilities of firm.

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Liquidity ratios

Two common ratios used to evaluate the

solvency position of a firm are as follows:-

a) Current Ratio

b) Quick or Acid test ratio

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Current Ratio

Current ratio measure the short tem liquidity

of a firm.

The degree of liquidity reflects by the current

ratio.

It help to measure the firm ability to pay its

current liabilities by its current assets.

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Current

ratio=

=Times(i)

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Current ratio

Interpretation of ratio is very important to useit in practices.

For example if the calculated value of current

ratio is 1.5 the we can say that the firm haveRs.1.5 in current assets for every Rs.1 currentliabilities. Or we can also interpret as thecompany has its current liabilities covered 1.5times.

The standard of current ratio is 2:1.

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Quick Ratio

This ratio measure the very quick liquidity of

the firm.

This ratio omitted the inventory while

calculating the current assets.

Quick ratio can be calculated as follows.

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Current ratio=

=(ii)

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Quick Ratio

Quick ratio exclude the major part of the

current asset i.e. inventory.

Inventory is excluded because it is illiquid in

nature.

Secondly, book value of inventory is different

from the market value.

For example Quick ratio 1.2 means the firm

has 1.2 times quick assets than liabilities.

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Other liquidity Ratio

Cash Ratio: The relation between the cash and

current liabilities of the firm.

Net working capital to total asset ratio:

Measure the amount of short term liquidity of

the firm with the total assets.

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Cash ratio=

= (iii)

Net working capital to total assets ratio=

=

(iv)

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Asset Management ratio

This ratio measure the efficiency of the firm to

use the assets.

It is also called turnover ratio.

This ratio concern how efficiently firm uses

their assets to generate the sales.

Now, we are going to discuss the following

asset management ratio.

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Asset Management ratio

Inventory turnover

Days sales in inventory

Receivable turnover Days sales in Receivable

Net working capital turnover ratio

Fixed assets turnover

Total assets turnover

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Inventory turnover

Inventory turnover measure how many times

firm is turns out its inventory in to sales.

Higher this ratio means the greater the

efficiency of managing the inventory.

Inventory turnover can be calculated as

follows.

Inventory turnover=Cost of goods

sold/Inventory.(V)

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Days sales in inventory

Days sales in inventory measure the time

required to turnout inventory.

Days sales in inventory can be calculated as

follows.

Days sales in inventory=Days in year/Inventory

turnover(VI)

(Note: Days in year is 365 and we use sales

instead of COGS if COGS is not given)

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Receivable Turnover Ratio

Receivable turnover ratio measure the

efficiency of the firm to collect the cash from

the market.

Receivable turnover ratio=Sales/Account

receivable.(VII)

This ratio gives us the indication of an ability

of firm to reloaded the money form the

market.

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Days sales in Receivable

Receivable turnover ratio makes more sense if

we convert it to days.

Receivable turnover ratio measure the days

required to collect credit sales from the

market.

Days sales in Receivable can be calculated as

follows.

=Days in year/Receivable turnover.(viii)

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Other turnover ratio

Net working capital turnover ratio measurethe efficiency of working capital to generatethe sales

Net working capitalturnover=Sales/NWC..(ix)

Fixed asset turnover ratio measure theefficiency of mobilizing the fixed assets.

Fixed asset turnover=Sales/Net fixedassets(x)

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Other turnover ratio

Total assets turnover ration measure the

efficiency of the firm to utilize the fixed asset

of the firm.

Total assets turnover ratio=Sales/Total

assets(xi)

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Debt Management Ratio

Debt management ratio measure the long

term solvency of the firm.

Mainly following ratio will be discussed

Total debt ratio

Debt equity ratio

Equity Multiplier

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Total Debt Ratio

Total debt ratio measure the percentage of

debt in a capital structure of the firm.

Total debt ratio can be calculated as follows;-

Total debt ratio=Total assets-Total equity/Total

assets(xii)

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Debt-Equity Ratio

The ratio between debt and equity of the firm.

Debt-equity ratio=Total debt/Total

equity.(xiii)

Generally, debt equity ratio express in times.

We can also calculate the Equity multiplier(EM)

from the help of Debt and equity.

EM=Total assets/Total equity(xiv)

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Profitability Ratio

Profitability ratio measure the profit in terms

of sales, total assets and equity employed.

Three generally used ratio for measuring

profitability are as follows;-

Profit margin

Return on assets (ROA)

Return on Equity (ROE)

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Profit Margin

Profit margin measure the profit in every

rupees sales.

Profit margin=Net income/Sales(xv)

If other things remain constant then a

relatively high profit margin is preferable.

This situation means low expenses ration in

relation to sales.

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Return on Assets (ROA)

Return on assets is profit per rupees of assets

employed by the firm.

ROA=Net income/Total assets=%...............(xvi)

Higher the ROA better the performance of the

company.

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Return of Equity (ROE)

ROE measure how the shareholder benefiting

from the company.

ROE=Net Income/Total equity=%........(xvii)

If the other thing same, the higher ROE is

desirable for a firm.

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Market Value Measures

Market value measures used the information

from the market.

Price earning ratio(PE ratio)

Market-to-book ratio

Price-sales ratio

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Price Earning Ratio

P/E ratio gives us the idea that how many

times the market value from its earnings.

P/E ratio can be calculated as follows;-

P/E=Price per share/Earnings per share(xviii)

Earning per share=Price per share/Earnings per

share(xix)

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Market to book Ratio

The ratio between market value per share and

book value per share.

The market to book Ratio can be calculated as

follows.

Market-to-book Ratio=Market value per

share/Book value per share.(xx)

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Price-sales Ratio

The ratio based on price per share and sales

per share.

Price sales Ratio=Price per share/Sales per

share.(xxi)

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Du Pont Equation

The relation between profit margin, total assets

turnover and equity multiplier is known as the Du

Pont equation.

ROE=PM x TAT x EM(xxii)

Where,

ROE=Return on equity

PM=Profit Margin

TAT=Total assets turnover EM=Equity Multiplier

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Uses and limitation of Ratio analysis

Uses of Ratio Analysis

To evaluate the performance of the firm.

To facilitate the comparison of the ratio.

Uses for creditors and shareholder.

Uses for identification of the relative position

of the firm. Uses for arriving decision making.

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Limitation of the ratio

Required basis of comparison

Different in interpretation

Different in situation of two firm.

Changes in price level

Short-term changes

No indication of the future

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Homework-1

1) Solve problem No. 2,3,5,6,10,18,19,21,24

2) How can you define ratio analysis? What are

the limitation of ratio analysis?

3) Define Du Pont identity with suitable

example.

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Quiz

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