FINANCIAL STATEMENT

ANALYSIS (FSA)
• FSA is the collective name for the tools &
techniques that are intended to provide
relevant information to decision-makers
(Investors, management, owners,
creditors, government).
• Evaluation of past performance & financial
position (trend of past sales, earnings,
cash flows, profit margin & ROI).
STANDARDS OF COMPARISONS

• Rule of Thumb Indicators (benchmark

financial ratios);
• Past performance of the company (over a
period of time) – trend analysis;
• Industry standards.
SOURCES OF INFORMATION
• Company Reports: (i) Directors’ Report,
(ii) Financial Statements, (iii) Schedules &
Notes to Financial Statements, (iv)
Auditor’s Report.
• Stock Exchanges: BSE Official Directory &
BSE Library for Annual Reports.
• Business Periodicals.
• Information Services: CMIE, CRISIL,
ICRA, CARE.
 QUALITY OF EARNINGS

• Refers to probability of earnings trends

continuing and the extent to which
earnings could represent distributable
cash.
 May be affected by:
• Choice of Accounting Methods & Estimates:
GAAP provides flexibility in determining accounting
methods:
• (a) Depreciation: SLM, WDVM, SOYDM.
• (b) Inventories: LIFO, FIFO, Weighted Average Cost.
• (c) Doubtful Debts: % of Receivables Method, % of
Sales Method.
• (d) Goodwill: Full Write-off Method, Amortization
Method, Not Write-off Method.
• Revenue Recognition in Long-Term Contracts: %
Completion Method, Completed Contract Method.
 May be affected by:….contd.
• 2. Extra-Ordinary Items:
• Incomes/Expenses arise from events that are distinct
from ordinary activities of the business (Not expected to
recur regularly).
• Decision to treat an item as ‘extra-ordinary’ affects
operating earnings:
• Write down of inventories to net realizable value;
• Write down of fixed assets to recoverable amount;
• Restructuring activities if an enterprise;
• Dispose of Long-term investments;
• Litigation Settlement.
 May be affected by: ….contd.
3. Prior Period Items:
• Incomes/Expenses that arise in the
current period as a result of errors or
omissions in the preparation of Financial
Statements of one or more prior periods:
• Errors in totaling Inventory Sheets;
• Mistakes in computing depreciation
amount arising from use of incorrect asset
lives or failure to consider residual value.
 May be affected by: ….contd.
4. Discontinued Operations:

• It is the result of the sale or abandonment of a

separate, major and identifiable line of business.
• For predicting earnings from regular, on-going
activities, the results of continuing operations
need to be separated from those of the
discontinued operations.
 May be affected by: ….contd.
5. Change in Accounting Policies:
• GAAP do not permit an enterprise to change its
accounting policies unless there is adequate
justification for the change.
• Adequate justification refers that the change is
required by law or any accounting standard or by
an accounting enterprise.
• When a change is executed, the fact and effect
of the change on net profit should be disclosed.
 May be affected by: ….contd.
6. Income from Non-Operating Sources:
• Dividend income from units, dividends
from subsidiaries & associated
companies, interest from inter-corporate
deposits & profits from sale of fixed
assets.
• These incomes help the companies to
hide the losses from their normal business
operations & hence should be disclosed.
 TECHNIQUES OF FINANCIAL
STATEMENT ANALYSIS
1. HORIZONTAL ANALYSIS:
• It is the calculation of amount changes &
% changes from the previous year to the
current year.
3. TREND ANALYSIS:
• Involves the calculation of % changes in
financial statement items for a number of
successive years. It is en extension of
Horizontal Analysis to several years.
 TECHNIQUES OF FINANCIAL
STATEMENT ANALYSIS….contd.
3. VERTICAL ANALYSIS:
• It is the proportional expression of each item on
a financial statement to the statement total.

• The results of Vertical Analysis are presented in

the form of Common-Size Statements in which
all elements in each statement are expressed in
percentages of some common number & always
add up to 100 percent.
 COMPARATIVE COMMON SIZE
STATEMENTS (VERTICAL ANALYSIS)
Part –A: BALANCE SHEET:
Particulars 20x1 20x2 20x3 20x4
Capital 26 22 32 30
Res.& surplus 17 23 19 22
Secured Loans 33 30 28 27
Unsec. Loans 6 6 5 5
Current Liab. 18 19 16 16
Fixed Assets 64 63 64 65
Investments 3 2 2 2
Debtors 16 15 16 16
Inventories 15 18 17 16
Misc. Expenses 2 2 1 1
TOTAL 100 100 100 100
 COMPARATIVE COMMON SIZE
STATEMENTS (VERTICAL ANALYSIS)

Part B: INCOME STATEMENT

Particulars 20x1 20x2 20x3 20x4
Net Sales 100 100 100 100
COGS 74 70 73 76
Gross Margin 26 30 27 24
Operating Exp. 7 8 7 8
Non-Op. Exp/Inc - - 1 1
EBIT 19 22 21 17
Interest 4 4 4 4
PBT 15 18 17 13
Tax 6 8 7 7
PAT 9 10 10 6
Dividends 4 4 4 4
Retained Earnings 5 6 6 2
 TECHNIQUES OF FINANCIAL
STATEMENT ANALYSIS….contd.
4. RATIO ANALYSIS:
• Establishes relevant financial relationship
between the components of financial
statements;
• These ratios are used to evaluate
profitability, liquidity, activity, solvency
aspects of the business along with its
capital market strength.
 RATIO ANALYSIS
(Liquidity Ratios)
• LIQUIDITY RATIOS: Refer to the ability of the
firm to meet its obligations in the short-run,
usually one year.
• Current Ratio: Current Assets
Current Liabilities
(C.A. includes cash, marketable securities,
debtors, inventories, loans & advances, &
prepaid expenses. C.L. includes loans &
advances taken, trade creditors, accrued
expenses & provisions)
 RATIO ANALYSIS
(Liquidity Ratios) …….contd.
(b) Acid – Test Ratio: Quick Assets
Current Liabilities
Quick assets are current assets excluding
inventories as it is the least liquid C.A.
(c) Bank finance to Working Capital Gap Ratio:
Short-term bank borrowings
Working Capital Gap
It shows the dependence on bank finance and
the working capital is equal to C.A. less C.L.
other than bank borrowings.
 RATIO ANALYSIS
(Leverage Ratios)
2. LEVERAGE RATIOS: Refer to the use of debt finance in
the capital structure.
(a) Debt – Equity Ratio: Debt
Equity
It shows the relative contribution of creditors & owners.
Numerator consists of Short & Long-term Liabilities &
denominator consists of Net Worth plus Preference
Capital)
* Net Worth = Equity Capital + Reserves &
Surplus
Lower the ratio, higher the degree of protection enjoyed
by creditors.
 RATIO ANALYSIS
(Leverage Ratios) …….contd.
(b) Debt – Asset Ratio: Measures the extent to
which borrowed funds support the firm’s assets.
Debt (All L-T & S-T Liabilities)
Assets ( The Balance sheet Total)
(c) Interest Coverage Ratio: Measures the ability of
the firm to meet its interest obligations.
Earnings before Interest & Tax (EBIT)
Interest
EBIT is used as numerator since the ability of
the firm to pay interest is not affected by tax
payment, as interest is a tax deductible expense.
 RATIO ANALYSIS
(Leverage Ratios) …….contd.
(d) Fixed Charges Coverage Ratio:
EBIT + Depreciation
Interest + (Repayment of loan/ 1-tax rate)

It measures debt servicing ability as it considers

both the interest & principal repayment
obligations – In the denominator, the repayment
of loan is adjusted upwards for the tax factor as
loan repayment, unlike interest, is not tax
deductible.
 RATIO ANALYSIS
(Turnover/Activity Ratios)
3. TURNOVER / ACTIVITY RATIOS: Are based on the
relationship between the level of activity, represented
by COGS & the level of various other assets.

(c) Inventory Turnover Ratio:

COGS
Average Inventory
It measures how fast the inventory is moving through
the firm & generating sales - higher the ratio, more
efficient is the management of inventory & vice versa.
 RATIO ANALYSIS
(Turnover Ratios)…..contd.
(b) Accounts Receivable Turnover Ratio:
Measures how many times the debtors turn over
during the period.
Net Credit Sales
Average Accounts Receivables*
*If the figure for net credit sales is not available,
one may consider net sales figure.
The higher the A/R turnover, the greater the
efficiency of credit management.
 RATIO ANALYSIS
(Turnover Ratios)…..contd.
(c) Average collection period: Represents the
number of days’ worth of credit sales that is
locked in debtors.
Average Accounts Receivable X 365
Average daily credit sales
If the figure for credit sales is not available, one
may consider with net sales figure. Average
collection period & the A/R are related in the
following way:
Average Collection Period = 365 / A.R. Turnover
 RATIO ANALYSIS
(Turnover Ratios)…..contd.
(d) Fixed assets turnover Ratio: Measures sales
per rupee of investment in fixed assets – A
higher ratio indicates a high degree of efficiency
in asset utilization.
Net Sales
Average Net Fixed Assets

Caution: When fixed assets of a firm are old &

substantially depreciated; this ratio tends to be
high as the denominator is low.
 RATIO ANALYSIS
(Profitability Ratios)
4. PROFITABILITY RATIOS: Reflect the
final result of the business operations –
(of two types) – Profit margin ratios &
Rate of return ratios.
• Gross Profit Margin Ratio: Shows the
margin left after meeting manufacturing
costs:
Gross Profit
Net Sales
 RATIO ANALYSIS
(Profitability Ratios)…. Contd.
(b) Net Profit Margin Ratio: Shows the earnings left
for share holders (both equity & preference) as
% of net sales.
Net Profit
Net Sales
(c) Return on Equity Ratio: Measures the
profitability of equity funds invested in the firm –
reflects the productivity of the ownership capital
employed in the firm.
Equity Earnings
Average Net Worth
 RATIO ANALYSIS
(Profitability Ratios)…. Contd.
(d) Return on Total Assets: It is a measure
of capital employment efficiency:
Net Income
Average Total Assets
To ensure internal consistency, following
variant may be employed:
Net Income + Interest
Average Total Assets
 RATIO ANALYSIS
(Profitability Ratios)…. Contd.
(e) Earning Power: it is a measure of
performance, which is not affected by
interest charges & tax payments;
it abstracts away the effect of financial
structure & tax rate and focuses on
operating performance.

EBIT
Average Total Assets
 RATIO ANALYSIS
(Valuation Ratios)
5. VALUATION RATIOS: Indicate how the equity stock of
the firm is assessed in the capital market.

• Price-earning Ratio: Commonly referred to as ‘price-

earning multiple’ is a summary measure, reflecting
growth prospect, risk characteristics, shareholder
orientation, corporate image & degree of liquidity.

Market Price per share (Av. market price)

Earning per share {(PAT – Preference dIvidend)/ No. of
equity shares)}
 RATIO ANALYSIS
(Valuation Ratios)…. Contd.
(b) Yield: Measure of the rate of return earned by
the shareholders.
Dividend + Price change
Initial Price
May be split into two parts:
Dividend + Price Change
Initial Price Initial Price
(Dividend Yield) (Capital Gains/ Losses Yield)

Firms with low growth prospects offer a high

dividend yield and a low capital gains yield.
 RATIO ANALYSIS
(Valuation Ratios)…. Contd.
(c) Market Value to Book Value Ratio: reflects the
contribution of the firm to the wealth of the
society.
A ratio >1indicates that firm has created wealth.
If the ratio is 2 , it indicates that firm has created
a wealth of one rupee for every rupee invested
in it.
Market Value Per Share
Book Value Per Share
 RATIO ANALYSIS
(Valuation Ratios)…. Contd.
(d) Tobin’s q or q Ratio: Proposed by James
Tobin, the ratio identifies the ratio of market
value of a firm’s securities to the replacement
cost of its physical (non-financial) assets:
Market value of equity & liabilities
Estimated replacement cost of the assets
Firms will have incentive to invest, when q >1
and will be reluctant to invest once q becomes
equal to 1.