ANALYSIS OF FINANCIAL STATEMENT We know that Financial Accounting ends with preparation of preparation of Financial Statements i.e. Profit and Loss Account, Balance Sheet (also Cash flow Statement in case of Listed Companies) So when we talk about Analysis of Financial Statement, we mean analysis of Profit and Loss Account, Balance Sheet etc. Then what is Analysis? As per Dictionary, it is the separation of a whole into its components for study and interpretation.
So analysis of Financial Statement refers to classification of the various items given in Financial Statement and further its interpretation. It is the powerful mechanism of ascertaining the financial strengths and weaknesses of a firm. The importance of making analysis of Financial Statement may be better understood from this fact that Financial Statement, though itself reflects the net results for a particular period and state of affairs of the company on that date, but still we have to go for analysis of the same for more specific and deeper understanding of strengths and weaknesses . For example, NTPC Ltd., though a very good profit making company, but often it faces fund problem because of purchasing inputs from Coal India Ltd., GAIL etc on cash basis while selling electricity to various State Electricity Board on credit basis.
Types of Financial Analysis : A) External Analysis : Done by outsiders like Shareholders, Banks, Creditors, Clients etc B) Internal Analysis : Done by Management, Employees etc C) Horizontal Analysis : Financial statements for a number of years are reviewed, compared and analyzed. D) Vertical Analysis : The Analysis is made by reviewing the relationship quantitatively of various items in the financial statement on a particular date.
Techniques of Financial Analysis: - Comparative Statements : In this case Comparative Balance Sheet and Comparative Income Statement are prepared on the basis of financial statement of two periods. The objective is to see the increase or decrease in assets, liabilities, income and expenditure in the current year as compared to last year (Say). - Trend Analysis : Here one year is taken as the base year and increase or decrease in items of financial statements over a number of years is calculated based on the base year. - Common Size statement : In this case one item say Net Sales of any year is taken as the base and all other items of the Income statement are evaluated in terms of % of net sales and then over the years, the increase or decrease in every item is analyzed. - Ratio Analysis : So analysis is made on the basis of some important ratios. - Cash Flow Statement : Sources and application of cash and cash equivalents are presented through a statement. As per the listed companies’ requirement, the sources and applications are presented under three heads i.e. Operation, Investment and Financing. - Funds Flow Statement : In this case sources and application of funds are prepared through a statement. Here fund means working capital.
RATIO ANALYSIS A Ratio refers to arithmetical or numerical relationship between items or variables. This relation can be expressed as percentage (%) or Fraction (one-fifth) or Proportion (1:4). So ratio analysis in the context of Financial Statement refers to establishing an arithmetical relationship between various items of the same, so as to draw some meaningful conclusion from them. This is one of techniques of analysis of Financial Statement. It gives answers to various important questions such as, Is the company financially viable? Will the company be able to pay for its short term obligations? Is the profitability of the company sufficient enough for shareholders/Bank/Creditors? Etc .
Types of Ratios : Ratios can be classified into the following four broad groups: A) Liquidity Ratios B) Capital Structure or Leverage Ratios C) Profitability Ratios D) Activity Ratios
Liquidity Ratios : The objective of this ratio is to assess the ability of the firm to meet its current/short tem obligations . The concerned users of this ratio here are creditors, Banks, who are interested in the short term solvency or liquidity of a firm. Every company should strike a balance between two very essential contradictory requirements i.e. liquidity and profitability for efficient financial management. The example of NTPC Ltd., as already given is more appropriate to substantiate the aforesaid statement. The appropriate ratios to throw light on liquidity are as follows : A) Current Ratio B) Liquid / Quick Ratio C) Super Quick Ratio
1) Current Ratio : Current Assets Current Ratio = --------------------------- Current liabilities Current Assets include Cash and Bank Balance, Marketable Securities, Inventory, Debtors, Bills Receivable, Prepaid Expenses etc. Current Liabilities include Creditors, Bills Payable, Bank Overdraft, Proposed Dividend, Provision for Taxation, Outstanding expense etc. Current Ratio assesses short term solvency i.e. the ability to meet short term obligation of the company. Subject to deeper enquiry, generally a current ration of 2:1 is considered satisfactory.
2) Liquid / Quick Ratio : Quick Assets Quick Ratio = --------------------------- Current liabilities Quick Assets: CA - (Inventory + Prepaid Expenses) The idea behind Quick Ratio is to assess more strictly the firm’s ability to meet out short term obligations. Inventory and prepaid expenses being excluded because these two items are generally considered less liquid-able than any other items of Current assets . Generally a quick ratio of 1:1 is considered satisfactory, subject to deeper enquiry .
3) Super Quick / Acid Test Ratio: Super Quick Assets Super Quick Ratio = --------------------------- Current liabilities In a more appropriate sense, this ratio is also interpreted as follows: Super Quick Assets Super Quick Ratio = --------------------------- Quick liabilities Super Quick Assets: Cash and marketable Securities Quick Liabilities: Current Liabilities – Bank Overdraft Super quick assets does not include also debtors and bills receivable. Bank overdraft being excluded because of its kind of permanent nature with the Bank. This ratio is the most strict and very conservative test of the firm’s liquidity position .
General Interpretation of Liquidity Ratios:
-- General rule of thumb or standard say 2:1 (for current ratio) or 1:1 (for quick ratio) is always subject to deeper scrutiny .
Liquidity ratios of number of years are to be reviewed so also to be compared with the best industrial standard, to arrive at a reasonable & logical ratio.
- A higher current ratio may be generally acceptable while making inter-firm comparison.
- A very high current ratio may not be acceptable due to the fact that the same may include higher inventory and prepaid expenses.
General Interpretation Contd…
In case of rich countries, where long term funds are available, they may not depend on current liabilities to finance current assets. So in poor countries, a major portion of Current assets are financed by current liabilities.
For example Hindustan Unilever Ltd. Generally asks for more credit period from suppliers than the credit period allowed to their clients. So major portion of their stock is financed by creditors .
- Similarly FMCG firms generally use to maintain low current ratio as they have less need for current assets compared to dealers who generally have higher current ratio.
CAPITAL STRUCTURE / LEVERAGE RATIOS
The ratios under this category are very relevant from the point of view of long term funds providers. They are interested to know whether the company is viable enough to refund the long term loan along with interest or whether the company shall be able to pay dividend to shareholders etc.
So ratios here focus on the long term solvency of the company.
The various ratios discussed under this head are as follows:
Debt Equity Ratio
Interest Coverage Ratio
C) Dividend coverage Ratio
D) Capital Gearing Ratio
1) Debt Equity Ratio : Outsiders’ Funds External Equities Debt Equity Ratio = --------------------------- or ---------------------------- Insiders’ Funds Internal Equities Total Debt or ---------------------------- Shareholders’ Funds Long Term Loan + Current Liabilities = --------------------------------------------------------- Share Capital (Equity+Pref.)+ Reserve &Surplus- Accumulated loss
General Interpretation :
- This ratio reflects the proportion of owners’ stake in the business. Excess liabilities tend to cause insolvency and working capital problem .
- There is standard of 2:1, which says that debts should not exceed twice of the Shareholders’ funds. (Subject to deeper enquiry)
- A higher ratio shows a large share of financing by the creditors of the firm, a low ratio shows the opposite .
- If a debt equity ratio is 1:2, it shows that for every rupee of outsiders, the firm has two rupee of owners’ capital. In other words, the stake of creditors is one-half of the owners. So creditors are safe.
- If Debt equity ratio is high, the owners have liquidated their stake or if the project fails, the creditors would lose. So also it gives a very bad impression that owners do not have faith in their company.
General Interpretation Contd.
This can be substantiated by the glaring example of Wipro, where once the Chief Mr. Azim Premji had said that when he gets money, he purchases shares of his company. If I don’t rely my company, then why others will be interested?
- A high debt equity ratio may not be good for the company also since creditors would start pressurizing the company and may like to interfere with the management .
- A high D/E ratio also puts burden on the profitability of the company as less amount will be available for shareholders, so also the company may face problem in mobilization of further loans/equity.
- A low D/E ratio implies sufficient margin available for creditors. The servicing of debt is also not that burdening. So more mobilization of funds is possible .
2) Interest Coverage Ratio :
Net Profit before Interest & Tax
Interest Coverage Ratio = ------------------------------------------------------
Fixed Interest Charges
General Interpretation :
- Higher the ratio, more safe are the long term creditors because even if earnings of the firm fall later, the firm shall be able to meet its commitment of fixed interest charges.
- But too high is not good, since it depict that company is not interested in major development activities .
- Similarly a low ratio may point towards danger signal as the firm is using excessive debt and does not have the capacity to pay guaranteed interest to the creditors.