UNIT III FINANCIAL STATEMENT ANALYSIS

BASIC ACCOUNTING TERMINOLOGIES

Account : An account is a summary of relevant transactions at one place to a particular head. Accounting : It is the process of identifying, measuring, and communicating the economic information of an organisation to its users who need the information for decision making. Transaction : is an exchange in which each participant receives or sacrifices value. Voucher : is a document which serves as a record of transactions Entry : is the record made in the books of accounts in respect of transaction.

Credits : A contractual agreement in which a borrower receives something of value now, with the agreement to repay the lender at some date in the future. Also, the borrowing capacity of an individual or company.

Creditors : One who extends credit by giving a person or organization permission to borrow money if they promise to pay it back at a later date. Debits : An accounting entry which results in either an increase in assets or a decrease in liabilities or in your bank account. Debtors : A company or individual that owes money.
Assets : refers to the tangible objects or intangible rights of an enterprise which carry probable future benefits.

Broadly assets may be categorised into two : - Fixed assets refer to those assets which are held for the purpose of providing or producing goods or services and those are not for resale in the normal course of business. They may be tangible or intangible in nature. - Current assets are those which are held in the form of cash, for their conversion into cash (like cash at bank, stock of finished goods, debtors, bills receivables), for their consumption into production of goods or rendering services (r/m, WIP)

Liabilities : refer to the financial obligations of an enterprise other than owners funds. Broadly it may be classified into two
- current liabilities refer to those liabilities which fall due for payment generally within one year. eg. B/P, trade creditors, outstanding expenses etc.

- long term liabilities relatively long term. For example long term loans, debentures etc.
Capital : it is excess of assets over external liabilities. It refers to the amount invested in an enterprise by the proprietor, partners, or owners. This amount is increased by the amount of profits earned and amount of additional capital introduced and vice versa. It is also known as owners equity or net assets or net worth.

 Share capital is owners contribution divided into shares. A share is a certificate acknowledging the amount of capital contributed by the shareholder.

Reserves & surplus or retained earnings are undistributed profits. Shareholders funds or equity is the sum of share capital plus reserves & surplus. It is also called net worth.

Total assets (TA) equal net fixed assets (NFA) plus current assets (CA): TA = NFA + CA Net current assets (NCA) is the difference between current assets (CA) and current liabilities (CL): NCA = CA CL

 Net assets (NA) equal net fixed assets (NFA) plus net current assets (NCA): NA = NFA + NCA

Capital employed (CE) is the sum of net worth or equity (E) and borrowing/debt (D) and it is equivalent of net assets:

CE = Net Worth + Borrowing = E + D

Sequential Steps Involved in an Accounting Cycle :

1. Journalising : record the transitions in the journal. 2. Posting : transfer the transactions (recorded in the Journal), in the respective accounts opened in the ledger. 3. Balancing : ascertain the difference between the total of debit amount column and the total of credit amount column of each ledger account. 4. Trial Balance : prepare a list showing the balances of each and every account to verify whether the sum of the debit balances is equal to the sum of the credit balances. J L

5. Income Statement : prepare Trading and Profit and Loss A/c to ascertain the profit/loss for the accounting period. 6. Position Statement : prepare balance sheet to ascertain the financial position as at the end of accounting period.

FINANCIAL STATEMENTS
They are organised summaries of detailed information about the financial position and performance of an enterprise.
Traditionally the term Financial Statements is used to denote only two basic statements - Balance Sheet or Position Statement, and - Trading and Profit & Loss account or Income Statement M T P B

Arrange the following items into their respective accounts: Opening Stock Sales Purchases Closing Stock Wages Salaries Office Rent Factory Rent Furniture Debtors Creditors Capital Bank Overdraft Stationary Carriage Inwards Carriage Outwards Depreciation Pre-paid Expenses Outstanding Expenses Profit Interest Received

Trading A/c
Debit

P&L A/c
Debit

Balance Sheet
Liabilities

Credit
Credit

Assets

Profit Calculation :
Net Sales - Variable Cost Contribution - Fixed Operating Cost Operating Profit +/- (Non operating surplus/deficit) EBDIT/PBDIT - Depreciation EBIT/PBIT - Interest EBT/PBT - Tax PAT - Preference Dividend EATC S/h - Equity Dividend Retained Earning Net Sales - Cost of goods sold Gross Profit - Operating Expenses Operating Profit +/- (NOS/D) EBDIT/PBDIT - Depreciation EBIT/PBIT - Interest EBT/PBT - Tax PAT - Preference Dividend EATC S/h - Equity Dividend Retained Earning

ANALYSING FINANCIAL PERFORMANCE

On Proper analysis and interpretation, financial statements can provide valuable insights into a firms performance. Analysis of financial statements is of interest to lenders (both l/t & s/t), investors, security analyst, managers and others. It is helpful in assessing corporate excellence, judging creditworthiness, predicting bankruptcy, assessing market risk and forecasting securities ratings. There are five basic ways of analysing financial statements - ratio analysis, - comparative analysis - index analysis - common size statement analysis - DuPont analysis.

I.

FINANCIAL RATIOS

A ratio is an arithmetical relationship between two figures. Financial ratio analysis is a study of ratios between various items or groups of items in financial statements.

Broadly financial ratios are categorised into five categories

- liquidity ratios - leverage ratios - turnover ratios - profitability ratios, - valuation ratios.

Financial Ratios
Liquidity Ratios: Current Ratio, Quick Ratio, Cash Ratio D/E, Debt Ratio, D/A, E/A

Leverage Ratios:
Interest Coverage Turnover Ratios: Inventory, Debtors (Creditors), ACP (APP), NCA t/o, FA t/o, NA t/o GPM, OPM, NPM, Expense Profitability Ratios: ROTA, ROCE, EP, ROI, ROE

Valuation Ratios: EPS, DPS, Payout, Dividend Yield, Earnings Yield, P/E, Book Value per share, M/B value,

1. Liquidity Ratio : Liquidity refers to the ability of a firm to meet its obligations in the short run, usually one year. It is based on current assets and current liabilities and computed from balance sheets figures.

Current Assets Current Ratio Current Liabilitie s

(2 : 1)

Current Assets - Inventories Quick Ratio Current Liabilitie s Cash Marketable Securities Cash Ratio Current Liabilitie s

(1: 1)

Apart from these three major ratios, there are two more ratios which also assess the liquidity conditions of a firm. These are IM and NWC

Current Assets- Inventories Interval Measure Av. daily operating expenses

here daily operating expenses are : (cogs + selling & administrative + general expenses) depreciation
It measures the amount of liquid assets, available with a company, to finance its operation for the calculated number of days, even if it does not receive any cash from outside.
Net Workin g Capital (NWC) Net Workin g Capital ratio Net Assets (NA)

NWC ratio also indicates the firms ability to meet its current obligations. Normally, higher the ratio reflects better condition.

2. Leverage Ratios (Capital Structure) :

Financial leverage refers to the use of debt finance.

Debt is cheaper source of finance but it is riskier also.

Leverage ratios help in assessing the risk arising from the use of debt capital. These ratios helps in judging the long term financial strength of the firm in terms of its ability to pay interest regularly as well as repay the principal on due dates, which is essential for long term creditors and investors. There are two different but interrelated types of leverage ratios First, which are based on the relationship between borrowed funds & owners capital. It is called as financial leverage or capital structure ratios like D/E ratio, Debt ratio etc.

The second type of leverage ratio is also known as coverage ratio, are calculated from profit & loss account, such as interest coverage ratio, dividend coverage ratio, total fixed charges coverage ratio, and debt services coverage ratio.

(i) Debt Ratio: It is calculated as:

Total Debt (TD) Debt Ratio Total Debt (TD) Net Worth (NW) Total Debt (TD) Capital Employed (CE)
here total debt will include short and long-term borrowings from financial institutions, debentures/bonds, deferred payment arrangements for buying capital equipments, bank borrowings, public deposits and any other interest-bearing loan.

here capital employed (CE) equals net assets (NA) that consist of net fixed assets (NFA) and net current assets (NCA). NCA equals to CA-CL excluding interest-bearing short-term debt for WC. These relationships are shown as: NFA + CA = NW + TD + CL NFA + CA CL = NW + TD NFA + NCA = NW + TD NA = CE Because of the equality of CE and NA, debt ratio can also be defined as:

Total Debt (TD) Debt Ratio Net Asset (NA)

(ii) Debt-Equity Ratio : it shows the relative contributions of creditors and owners. It is defined as

Total Debt (TD) Debt - Equity Ratio Net Worth (NW)

Debt here consists of all debts short term as well as long term, and equity consists of net worth plus preference capital.
This ratio indicates the margin of safety to creditors. Lower the ratio higher will be the margin of safety for creditors. In general, 2:1 ratio is considered as satisfactory.

A high debt-equity ratio will lead to inflexibility in the operation of the firm and frequent interference will be there from creditors side. Moreover firm would face difficulty in raising funds. But shareholders will be benefited with high debt-equity ratio, because without much investment they would be able to retain the control of the firm; and there profit would be magnified. (iii) Debt-Asset Ratio : it measures the extent to which borrowed funds support the firms assets. It is defined as

Total Debt (TD) Total Asset (TA)

Debt here is all debts (s/t and l/t) and assets is the total of all assets i.e., the balance sheet total.

Different types of debt ratios show that the extent to which debt financing has been used in business.
A high ratio indicates that claims of outsiders are more than that of owners and vice-versa. However, it will give more return to shareholders on their investment, although the risk will be more in this condition. Therefore, there is a need to strike a proper balance between the use of debt and equity.

The second category of leverage ratios are coverage ratios. These ratios are computed from information available in the profit and loss account. These are important because, in the ordinary course of business, the claims of creditors are not met out of the sale proceeds of the permanent assets.

The coverage ratio measure the relationship between what is normally available from operations of the firm and the claims of the outsiders. Important coverage ratios are (i) Interest Coverage Ratio : it is also known as time interest earned ratio. It is defined as

EBIT ICR Interest

This ratio measures the debt servicing capacity of a firm.
A high ratio means that the firm can easily meet its interest burden even if PBIT suffer a considerable decline. For example, interest coverage of 10 times means even if the firms EBIT were to decline to one-tenth, the net profit earned by the firm is sufficient to meet its interest burden.

ii) Preference Dividend Coverage Ratio : it measures the ability of a firm to pay dividend on preference share which carry a stated rate of return. It is defined as

PAT PDCR PreferenceDividend

This ratio reveals safety margin to preference shareholders. Higher the ratio better it is.
All the coverage ratio measure the risk of default in payment by the firm. Lower the ratio, more risky the firm would be from the point of view of the lenders / investors. Thus analysis of coverage ratio would reveal that whether the firm has the capacity to service the additional debts or not.

3. Turnover / Activity / Asset Management Ratio : It measures how efficiently the assets are employed by the firm. These ratios are also called as efficiency ratios. The efficiency of assets would be reflected in the speed with which it is converted into sales. The greater is the rate of turnover, the efficient is the utilisation / management. Depending on various types of assets, there are various types of activity ratios.

i) Inventory (Stock) Turnover Ratio : it measures how fast the inventory is moving through the firm and generating sales. It is defined as
ITR Cost of goods sold Average inventory

Cost of goods sold may be obtained by deducting gross profit from net sales.
Average inventory may be calculated as - average of opening stocks of a year; or - (opening stock + closing stock) / 2

If cost of goods sold is not known, then it can be calculate as

Sales Closing inventory
. .

- but it will give misleading results. In general, higher the inventory turnover ratio, the more efficient the management of inventories and vice-versa. However, it may be possible that higher ratio may be caused by a low level of inventory which may results in frequent stockout and loss of sales and customer goodwill. Low ratio may indicate slow movement of goods which may be caused by inferior quality, poor management; and funds would be locked in the form of inventory.

Thus a firm should have neither too high nor too low inventory turnover. It should be compared with the best firm in the industry or with the industry average. (i.a) Days of Inventory Holding (DIH): The ratio is calculated using the same figures and give an idea about inventory holding period. It is calculated as:

Average Inventory DIH x No. of days in the year Cost of Goods Sold
In general lower the ratio better is the stock management.

ii) Debtors (Receivables) Turnover Ratio : it shows how many times accounts receivables (debtors) turn over during the year. It is defined as Net Credit Sales Average accounts receivables (i.e., Av. debtors + Av. B/R)
. .

The denominators can be calculated as in the case of inventory turnover ratio. If the data regarding net credit sales is not available, in that case total sales figure can be used.

In general, higher the ratio, better is the credit management and better is the liquidity of the debtors. But in case of very high ratio, it may be possible that the firm is loosing some sales due to its stringent credit policy. iii) Average Collection Period : this is another ways of measuring the liquidity of a firms debtor. It represents the number days worth of credit sales that is locked in debtors (a/c receivables). It is defined as
.

Average debtors Average daily credit sales

.

OR Months (days) in a year Debtors turnover

Normally, higher the ratio better is the credit management policy of the firm.

iv) Asset Turnover Ratio : also known as the investment turnover ratio. It is based on the relationship between the cost of goods sold and assets/investments of a firm. Different types of asset turnover ratios are
Sales Total assets turnover Total assets Sales Fixed assets turnover Net fixed assets Sales Current assets turnover Current assets Net CA(WC) turnover Sales Net current assets

Sales Net assets turnover Net assets

Here it may be noticed that the net assets (NA) includes net fixed assets (NFA) and net current assets (NCA).
NCA = CA AL Since NA equals to capital employed, therefore, the above ratio is also called as capital employed turnover ratio.

The asset turnover ratio measures the efficiency of a firm in managing and utilising its assets.
Higher the turnover ratio, the more efficient is the management and utilisation of assets and vice-versa. But to determine the efficiency of the ratio, it must be compared across time as well as with the industry average. One should be cautious while anlysing the ratio of an old firm because fixed assets of old firm would be substantially depreciated and hence the asset turnover ratio would be high.

4. Profitability Ratios :
Profitability reflects the final result of business operations.

These ratios provide the answers of following questions :

- is the profit earned by the firm sufficient?

- what rate of return does it represent?

- what is the rate of profit for different divisions?

- what are the earning per share?

- what was the amount paid in dividends?

- what is the rate of return to equity shareholders?

There are two types of profitability ratios - profit margin ratios and rate of return ratios. i) Profit margin ratios (Profitability in relation to Sales):

It measures the relationship between profit and sales. Different types of profit margin ratios are:
a) Gross Profit Margin Ratio: gross profit means difference between net sales and cost of goods sold. It is defined as

Gross Profit Gross Profit Margin (GPM) 100 Sales

This ratio shows the margin left after meeting manufacturing cost. It measures efficiency of production as well as pricing. Higher the ratio, better is the condition.

b) Operating & Net Profit Margin Ratio :

Operating Profit Operating Profit Margin (OPM) 100 Sales Net Profit Net Profit Margin (NPM) 100 Sales

This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of net sales.
It measures the overall efficiency of the production, administration, selling, financing, pricing and tax management. Higher the ratio, better for owners.

c) Expenses Ratio : it is computed by dividing expenses by sales. Cost of goods sold = expenses ratio Cost of goods sold Sales

Operating expenses ratio = Administrative expenses + Selling exp Sales

Administrative expenses ratio = Administrative expenses Sales

Selling expenses ratio = Selling expenses Sales Operating ratio = Cost of goods sold + Operating expenses Sales Financial expenses ratio = Financial expenses / Sales

Lower the expense ratio, efficient is the firm.

ii) Rate of return ratios (Profitability in relation to Investment):

It reflects the relationship between profit and investment. The important ratios are
a) Return on Investment (ROI):

ROI ROTA

Profit after tax Total assets

Profit after tax ROI RONA ROCE Net assets

It shows how efficiently the asset of the firm is utilised. Higher the ratio, better utilisation of asset will be.

c) Return on equity (ROE):

Profit after tax ROE Net worth (Equity)

here net worth includes paid-up share capital, share premium and reserve and surplus less accumulated losses.

The ratio indicates how well the firm has used the resources of owners.

Few other important ratios of the category are:

Profit after tax Earning per share (EPS) Number of share outstanding Dividends Dividend per share (DPS) No. of ordinary share outstanding Dividend - Payout (D/P) DPS EPS

EPS Earnings Yield Market Value per share DPS Dividend Yield Market value per share

5. Valuation Ratios :
These ratios indicate how the equity stock of the company is assessed in the capital market. Since the market value of equity reflects the combined influence of risk and return, the valuation ratios are most comprehensive measures of a firms performance. Different types of valuation ratios are

Market value per share Price - Earnings Ratio EPS

The P/E ratio reflects the price currently being paid by the market for each rupee of currently reported EPS.

In other words, the P/E ratio measures investors expectations and the market appraisal of the performance of the firm.
P/E ratio is popularly used by security analyst to assess a firms performance as expected by the investors.

Market val ue per share Market val ue to Book Value ratio Book value per share

here book value per share is net worth divided by number of shares outstanding

II. Comparative Analysis :

After calculating different ratios, we have to make a comparative analysis such as a cross section analysis (in which industry average may be used as benchmark) or time series analysis (where ratios of firm are compared over time).

Comparison with Industry Average :

In this case different ratios of the firm will be compared with industry average, and then financial performance should be analysed. Time Series of Financial Ratio :

Here financial ratio of several years (of the firm) will be taken and then financial performance will be analysed. 1 2

III. Index Analysis :

In this case, the items in comparative financial statements (balance sheets and income statements) are expressed as an index relative to the base year. All items in the base year naturally assume a value of 100.

IV. Common Size Statement Analysis :

In common size analysis, the items in the balance sheet are expressed as percentage of total assets and the items in the income statement are expressed as percentage of total sales.

V. DUPONT Analysis : Pioneered by DuPont Company of USA. It analyse important interrelationships based on information found in financial statements. At the left of the Du Pont chart is the return on total assets (ROTA) which is defined as the the product of net profit margin (NPM) and the total asset turnover ratio (TATR): Net Profit Total assets ROTA = Net Profit Net sales NPM Net Sales Total assets TATR

Such a decomposition helps in understanding how the return on total assets is influenced by the net profit margin and the total asset turnover ratio. 1

The basic Du Pont analysis may be extended to explore the determinants of the return on equity (ROE): Net Profit Equity ROE = Net Profit Sales NPM Sales Total assets
.

Total assets Equity 1 / (1- DR)

TATR

where DR is the debt ratio i.e., Debt / Asset, asA = E

.

A A-D

1 1 - D/A

1 1 DR
.

Thus it may be shown as: Return on Equity Return on total assets Total asset to total equity

DuPont Analysis
Profit Margin
EBIT RONA NA

EBIT Sales

x
Assets Turnover Sales NA

x
PAT ROE NW

PAT Fin Leverage (Income) EBIT

x
Fin Leverage (Bal. Sheet) NA NW