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# Financial statement analysis

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### Financial statement analysis

1. 1. Analytical techniques used Horizontal analysis Trend analysis Common size statement Ratios
2. 2. 3,500.003,000.002,500.002,000.00 Total Income1,500.00 Total Expenditure1,000.00 Operating Profit 500.00 -
3. 3. Basics of Financial Statement AnalysisAnalyzing financial statements involves: Comparison Tools of Characteristics Bases Analysis Liquidity Intra- Horizontal Profitability company Trend Solvency Industry Vertical averages Efficiency Ratio Inter- company
4. 4.  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
5. 5.  Net working capital = Current Assets- Current Liabilities 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
6. 6. Details Company X Company YTotal current assets 2,40,000 50,000Total current Liabilities 1,50,000 20,000Net working capital (CA-CL) 90,000 30,000
7. 7. 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 LiabilitiesACID TEST or QUICK RATIO: It is the ratio between Quick Current Assets and Current Liabilities. The should be at least equal to 1Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
8. 8. Cash 50,000Debtors 1,00,000Inventories 1,50,000Current Liabilities 1,00,000Total Current Assets 3,00,000Current Ratio => 3,00,000/1,00,000 = 3:1Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1
9. 9. Turnover ratiosInventory turnover ratio = Cost goods sold/Av.InventorySales = 3,00,000GP = 20%Stock at the beginning and at the End = 35,000 & 45000Inventory holding period = 12 months/ Inventory turnover ratioThese ratios indicate the number of times the inventory is rotated during the relevant accounting period
10. 10.  Debtors turnover ratio = Net credit Sales/Av.DebtorsTotal Sales = 2,70,000Cash Sales = 30,000Debtors at the Beginning and at the End = 27,500 and 32,500Debtors collection period = 12 months/ Debtors turnover ratioMeasures how rapidly receivables are collected
11. 11.  Creditors turnover ratio = Net credit purchase/ Av.creditorsTotal purchase = 2,00,000Cash purchase = 10%Creditors at the beginning and at the End = 42,500 and 47,500Creditors payment period=12months/ Creditors turnover ratioThe extent to which trade creditors are willing to wait for payment
12. 12. Debt-Equity Ratio = Total debt/ Shareholder’s equityMeasures the relationship between borrowed fund and owner’s capitalProprietary ratio = (Proprietor’s fund/Total assets) x 100It indicates the extend to which assets are financed by owners fund
13. 13. Interest Coverage RatioInterest Coverage Ratio measures the firm’s ability to makecontractual interest payments. EBIT (Earning before interest and taxes)Interest coverage ratio = InterestDividend Coverage RatioDividend Coverage Ratio measures the firm’s ability to pay dividendon preference share which carry a stated rate of return. EAT (Earning after taxes)Dividend coverage ratio = Preference dividend
14. 14. Total fixed charge coverage ratio Total fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations. Total fixed charge EBIT + Lease Payment coverage ratio = Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t) Total Cashflow 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. EBIT + Lease Payments + Depreciation + Non-cash expensesTotal cashflow =coverage ratio (Principal repayment) (Preference dividend) Lease payment + + + Interest (1– t) (1 - t)
15. 15. Debt-service coverage ratio (DSCR) is considered a morecomprehensive and apt measure to compute debtservice capacity of a business firm. n ∑ EATt + Interestt + Depreciationt + OAt = t=1 DSCR Iinstalmentt n ∑ t=1DEBT SERVICE CAPACITYDebt service capacity is the ability of a firm to make thecontractual payments required on a scheduledbasis over the life of the debt.
16. 16. Agro Industries Ltd has submitted the following projections. Youare required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. (Figures in Rs lakh)Year Net profit for the Interest on term loan Repayment of term year during the year loan in the year 1 21.67 19.14 10.70 2 34.77 17.64 18.00 3 36.01 15.12 18.00 4 19.20 12.60 18.00 5 18.61 10.08 18.00 6 18.40 7.56 18.00 7 18.33 5.04 18.00 8 16.41 Nil 18.00The net profit has been arrived after charging depreciation of Rs 17.68 lakhevery year.
17. 17. Table 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees)Ye Net Depreciation Interest Cash Principal Debt DSCR [col. 5ar profit available instalment obligation ÷ col. 7 (col. (col. 4 + col. 6) (No. of times)] 2+3+4)1 2 3 4 5 6 7 81 21.67 17.68 19.14 58.49 10.70 29.84 1.962 34.77 17.68 17.64 70.09 18.00 35.64 1.973 36.01 17.68 15.12 68.81 18.00 33.12 2.084 19.20 17.68 12.60 49.48 18.00 30.60 1.625 18.61 17.68 10.08 46.37 18.00 28.08 1.656 18.40 17.68 7.56 43.64 18.00 25.56 1.717 18.33 17.68 5.04 41.05 18.00 23.04 1.788 16.41 17.68 Nil 34.09 18.00 18.00 1.89Average DSCR (DSCR ÷ 8) 1.83
18. 18. Profitability ratios can be computed either fromsales or investment. Profitability Ratios Profitability Ratios Related to Sales Related to Investments(i) Profit Margin (i) Return on Investments(ii) Expenses Ratio (ii) Return on Shareholders’ Equity © Tata McGraw-Hill Publishing 6 Company Limited, Management - Accounting 22
19. 19. Gross Profit MarginGross profit margin measures the percentage of each salesrupee remaining after the firm has paid for its goodsGross profit margin = Gross Profit X 100 Sales © Tata McGraw-Hill Publishing 6 Company Limited, Management - Accounting 23
20. 20. Net Profit MarginNet profit margin measures the percentage of each sales rupeeremaining after all costs and expense including interestand taxes have been deducted.Net profit margin can be computed in three ways Earning before interest and taxesi. Operating Profit Ratio = Net sales Earnings before taxesii. Pre-tax Profit Ratio = Net sales Earning after interest and taxesiii. Net Profit Ratio = Net sales
21. 21. From the following information of a firm, determine (i)Gross profit margin and (ii) Net profit margin.1. Sales Rs 2,00,0002. Cost of goods sold 1,00,0003. Other operating expenses 50,000 Rs 1,00,000 (1) Gross profit margin = = 50 per cent Rs 2,00,000 Rs 50,000 (2) Net profit margin = = 25 per cent Rs 2,00,000
22. 22. Cost of goods soldi. Cost of goods sold = X 100 Net sales Administrative exp. + Selling exp.ii. Operating expenses = X 100 Net sales Administrative expensesiii. Administrative expenses = X 100 Net sales Selling expensesiv. Selling expenses ratio = X 100 Net sales Cost of goods sold + Operating expensesv. Operating ratio = X 100 Net sales Financial expensesvi. Financial expenses = X 100 Net sales
23. 23. Return on Investments measures the overall effectivenessof management in generating profits withits available assets.i. Return on Assets (ROA) EAT + (Interest – Tax advantage on interest)ROA = Average total assetsii. Return on Capital Employed (ROCE) EAT + (Interest – Tax advantage on interest)ROCE = Average total capital employed
24. 24. Return on shareholders equity measures the return on theowners (both preference and equity shareholders )investment in the firm.Return on total shareholders’ fund = Net profit after taxes X 100 Average total shareholders’ fundReturn on ordinary shareholders’ equity (Net worth) = Net profit after taxes – Preference dividend X 100 Average ordinary shareholders’ equity
25. 25. Activity ratios measure the speed with which variousaccounts/assets are converted into sales or cash.Inventory turnover measures the efficiency of various typesof inventories. Cost of goods soldi. Inventory Turnover measures the activity/liquidity ofInventory Turnover Ratio = Average inventoryinventory of a firm; the speed with which inventory is sold Cost of raw materials usedi. Inventory Turnover measures the activity/liquidity ofRaw materials turnover =inventory of a firm; the speed with which inventory is sold Average raw material inventoryi. Inventory Turnover measures the of goods manufactured Cost activity/liquidity ofWork-in-progress turnover =inventory of a firm; the speed with work-in-progressis sold Average which inventory inventory
26. 26. Debtors Turnover RatioLiquidity of a firm’s receivables can be examined in two ways. Credit salesi. Debtors turnover = measures the activity/liquidity of inventoryi. Inventory Turnoverof a firm; the speed with which inventory is sold Average debtors + Average bills receivable (B/R) Months (days) in a year2. Average collection period = Debtors turnoveri. Inventory= Months (days) in a year (x) activity/liquidity + Average (B/R) Turnover measures the (Average Debtors of inventoryAlternativelyof a firm; the speed with which inventory sales Total credit is soldAgeing Schedule enables analysis to identifyslow paying debtors.
27. 27. Assets turnover indicates the efficiency with which firmuses all its assets to generate sales. Inventory Turnover measures theof goods soldi. Total assets turnover =i. Cost activity/liquidity of inventoryof a firm; the speed with which inventory isassets Average total sold Cost of goods soldii. Fixed assets turnover = Average fixed assets Cost of goods soldi. Inventory Turnover measures the activity/liquidity of inventoryiii. Capital turnover = Average capital employedof a firm; the speed with which inventory is sold Cost of goods soldiv. Current assets turnover = Average current assetsi. Inventorycapital turnover = Cost of goods soldv. Working Turnover measures the activity/liquidity of inventoryof a firm; the speed with which inventory iscapital Net working sold
28. 28. 1) Return on shareholders’ equity = EAT/Average total shareholders’ equity2) 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 share6) Dividend Yield = DPS/Market price per share7) Dividend payment/payout (D/P) ratio = DPS/EPS8) Price-earnings (P/E) ratio = Market price of a share/EPS9) Book value per share = Ordinary shareholders’ equity/Number of equity shares outstanding
29. 29. Integrated ratios provide better insight about financial andeconomic analysis of a firm.(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)
30. 30. Earning PowerEarning power is the overall profitability of a firm; is computedby multiplying net profit margin andassets turnover.Earning power = Net profit margin Assets turnoverWhere, Net profit margin = Earning after taxes/SalesAsset turnover = Sales/Total assetsi. Inventory Turnover measurestaxes xEarning Power = Earning after the activity/liquidity of inventory Sales x EATof a firm; the speed with which inventory is sold Sales Total Assets Total assets
31. 31. Assume that there are two firms, A and B, each having total assetsamounting to Rs 4,00,000, and average net profits aftertaxes of 10 per cent, that is, Rs 40,000, each.Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregateRs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components.Return on Assets (ROA) of Firms A and BParticulars Firm A Firm B1. Net sales Rs 4,00,000 Rs 40,00,0002. Net profit 40,000 40,0003. Total assets 4,00,000 4,00,0004. Profit margin (2 ÷ 1) (per cent) 10 15. Assets turnover (1 ÷ 3) (times) 1 106. ROA ratio (4 × 5) (per cent) 10 10