MBA

1. THE BUSINESS SCHOOL
UNIVERSITY OF JAMMU
REPORT ON - FINANCIAL ANALYSIS :- Explain the
various techniques including ratio & fund flow statement with
the special reference to du point analysis:
SUBMITTED BY:
RADHIKA GUPTA
ROLL NO – 32- Mba -14

2. Q: FINANCIAL ANALYSIS :- Explain the various techniques including ratio & fund flow
statement with the special reference to du point analysis:
Financial analysis
Financial analysis (also referred to as financial statement analysis or accounting analysis or
Analysis of finance) refers to an assessment of the viability, stability and profitability of a
business, sub-business or project.
It is performed by professionals who prepare reports using ratios that make use of information
taken from financial statements and other reports. These reports are usually presented to top
management as one of their bases in making business decisions.
 Continue or discontinue its main operation or part of its business;
 Make or purchase certain materials in the manufacture of its product;
 Acquire or rent/lease certain machineries and equipment in the production of its goods;
 Issue stocks or negotiate for a bank loan to increase its working capital;
 Make decisions regarding investing or lending capital;
 Other decisions that allow management to make an informed selection on various
alternatives in the conduct of its business.
Goals
Financial analysts often assess the following elements of a firm:
1. Profitability - its ability to earn income and sustain growth in both the short- and long-term.
A company's degree of profitability is usually based on the income statement, which reports on
the company's results of operations;
2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations;
Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition
of a business as of a given point in time.
4. Stability - the firm's ability to remain in business in the long run, without having to sustain
significant losses in the conduct of its business. Assessing a company's stability requires the use
of both the income statement and the balance sheet, as well as other financial and non-financial
indicators. etc.
Method
Financial analysts often compare financial ratios (of solvency, profitability, growth, etc.):
 Past Performance - Across historical time periods for the same firm (the last 5 years for
example),

3.  Future Performance - Using historical figures and certain mathematical and statistical
techniques, including present and future values, This extrapolation method is the main
source of errors in financial analysis as past statistics can be poor predictors of future
prospects.
 Comparative Performance - Comparison between similar firms.
These ratios are calculated by dividing a (group of) account balance(s), taken from the balance
sheet and / or the income statement, by another, for example :
Net income / equity = return on equity (ROE)
Net income / total assets = return on assets (ROA)
Asset Management Ratios gauge how efficiently a company can change assets into sales.
Stock price / earnings per share = P/E ratio
Comparing financial ratios is merely one way of conducting financial analysis. Financial ratios
face several theoretical challenges:
 They say little about the firm's prospects in an absolute sense. Their insights about
relative performance require a reference point from other time periods or similar firms.
 One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least
two ways. One can partially overcome this problem by combining several related ratios to
paint a more comprehensive picture of the firm's performance.
 Seasonal factors may prevent year-end values from being representative. A ratio's values
may be distorted as account balances change from the beginning to the end of an
accounting period. Use average values for such accounts whenever possible.
 Financial ratios are no more objective than the accounting methods employed. Changes
in accounting policies or choices can yield drastically different ratio values.
 Fundamental analysis.
Financial analysts can also use percentage analysis which involves reducing a series of figures as
a percentage of some base amount. For example, a group of items can be expressed as a
percentage of net income. When proportionate changes in the same figure over a given time
period expressed as a percentage is known as horizontal analysis. Vertical or common-size
analysis, reduces all items on a statement to a “common size” as a percentage of some base value
which assists in comparability with other companies of different sizes. As a result, all Income
Statement items are divided by Sales, and all Balance Sheet items are divided by Total Assets.
Another method is comparative analysis. This provides a better way to determine trends.
Comparative analysis presents the same information for two or more time periods and is
presented side-by-side to allow for easy analysis.
DuPont Analysis

4. DuPont analysis is an extended analysis of a company's return on equity. It concludes that a
company can earn a high return on equity if:
1. It earns a high net profit margin;
2. It uses its assets effectively to generate more sales; and/or
3. It has a high financial leverage
Formula
According to DuPont analysis:
Return on Equity = Net Profit Margin × Asset Turnover × Financial Leverage
Return on Equity =
Net Income
×
Sales
×
Total Assets
Sales Total Assets Total Equity
Analysis
DuPont equation provides a broader picture of the return the company is earning on its equity. It
tells where a company's strength lies and where there is a room for improvement.
DuPont equation could be further extended by breaking up net profit margin into EBIT margin,
tax burden and interest burden. This five-factor analysis provides an even deeper insight.
ROE = EBIT Margin × Interest Burden × Tax Burden × Asset Turnover × Financial Leverage
Return on Equity =
EBIT
×
EBT
×
Net Income
×
Sales
×
Total Assets
Sales EBIT EBT Total Assets Total Equity
Example: Three-factor Analysis
Company A and B operate in the same market and are of the same size. Both earn a return of
15% on equity. The following table shows their respective net profit margin, asset turnover and
financial leverage.
Company A Company B
Net Profit Margin 10% 10%
Asset Turnover 1 1.5

5. Financial Leverage 1.5 1
Although both the companies have a return on equity of 15% their underlying strengths and
weaknesses are quite opposite. Company B is better than company A in using its assets to
generate revenues but it is unable to capitalize this advantage into higher return on equity due to
its lower financial leverage. Company A can improve by using its total assets more effectively in
generating sales and company B can improve by raising some debt.
DuPont Analysis (also known as the dupont identity, DuPont equation, DuPont Model or the
DuPont method) is an expression which breaks ROE (Return On Equity) into three parts.
The name comes from the DuPont Corporation that started using this formula in the 1920s.
Basic formula
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net
profit/Sales)*(Sales/Assets)*(Assets/Equity)= (Net Profit/Equity)
 Profitability (measured by profit margin)
 Operating efficiency (measured by asset turnover)
 Financial leverage (measured by equity multiplier)
ROE analysis
The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive
from the firm) into three distinct elements. This analysis enables the analyst to understand the
source of superior (or inferior) return by comparison with companies in similar industries (or
between industries).

6. The Du Pont identity is less useful for industries such as investment banking, in which the
underlying elements are not meaningful. Variations of the Du Pont identity have been developed
for industries where the elements are weakly meaningful.
Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is by
definition true.
Examples
High margin industries
Other industries, such as fashion, may derive a substantial portion of their competitive advantage
from selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing
sales without sacrificing margin may be critical. The Du Pont identity allows analysts to
determine which of the elements is dominant in any change of ROE.
High turnover industries
Certain types of retail operations, particularly stores, may have very low profit margins on sales,
and relatively moderate leverage. In contrast, though, groceries may have very high turnover,
selling a significant multiple of their assets per year. The ROE of such firms may be particularly
dependent on performance of this metric, and hence asset turnover may be studied extremely
carefully for signs of under-, or, over-performance. For example, same store sales of many
retailers is considered important as an indication that the firm is deriving greater profits from
existing stores (rather than showing improved performance by continually opening stores).
High leverage industries
Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE.
Other industries would see high levels of leverage as unacceptably risky. Du Pont analysis
enables third parties that rely primarily on the financial statements to compare leverage among
similar companies.
ROA and ROE ratio
The return on assets (ROA) ratio developed by DuPont for its own use is now used by many
firms to evaluate how effectively assets are used. It measures the combined effects of profit
margins and asset turnover.
The return on equity (ROE) ratio is a measure of the rate of return to stockholders. Decomposing
the ROE into various factors influencing company performance is often called the Du Pont
system.

7. Where
 Net income = net income after taxes
 Equity = shareholders' equity
 EBIT = Earnings before interest and taxes
This decomposition presents various ratios used in fundamental analysis.
 The company's tax burden is (Net income ÷ Pretax profit). This is the proportion of the
company's profits retained after paying income taxes. [NI/EBT]
 The company's interest burden is (Pretax income ÷ EBIT). This will be 1.00 for a firm
with no debt or financial leverage. [EBT/EBIT]
 The company's operating income margin or return on sales (ROS) is (EBIT ÷ Sales). This
is the operating income per dollar of sales. [EBIT/Sales]
 The company's asset turnover (ATO) is (Sales ÷ Assets).
 The company's leverage ratio is (Assets ÷ Equity), which is equal to the firm's [[debt to
equity ratio]+1] . This is a measure of financial leverage.
 The company's return on assets (ROA) is (Return on sales x Asset turnover).
 The company's compound leverage factor is (Interest burden x Leverage).
ROE can also be stated as:
ROE = Tax burden x Interest burden x Margin x Turnover x Leverage
ROE = Tax burden x ROA x Compound leverage factor
Profit margin is (Net income ÷ Sales), so the ROE equation can be restated:
Funds Flow Statement:Meaning & How to Prepare
Funds Flow Statement is a statement prepared to analyse the reasons for changes in the Financial
Position of a Company between 2 Balance Sheets. It shows the inflow and outflow of funds i.e.
Sources and Applications of funds for a particular period. In other words, a Funds Flow
Statement is prepared to explain the changes in the Working Capital Position of a Company.
There are 2 types of Inflows of Funds:-
1. Long Term Funds raised by Issue of Shares, Debentures or Sale of Fixed Assets
2. Funds generated from Operations
If the Long Term Fund requirements of a company are met just out of the Long Term Sources of
Funds, then the whole fund generated from operations will be represented by increase in

8. Working Capital. However, if the Funds generated from Operations are not sufficient to bridge a
gap of Long Term Fund Requirements, then there will be a decline in Working Capital.
Difference between Funds Flow Statement & Cash Flow Statement
Both Funds flow statement and Cash Flow Statement are used in analysis of part transactions of
a business firm. However, there are some differences between the two as given below:-
1. Funds Flow Statement is based on the Accrual System of Accounting. However, in case
of Cash Flow Statement – only the transactions effecting Cash or Cash equivalents are
taken into consideration
2. Funds Flow Statement analyses the Sources and Application of Funds of Long Term
nature and the Net Increase or Decrease in Long Term Funds will be reflected on the
Working Capital of the firm. The Cash Flow Statement only considers the Increase or
Decrease in Current Assets or Current Liabilities in calculating the Cash Flow of Funds
from Operations
3. Funds Flow Statement is more useful for Long Term Financial Planning. Cash Flow
Analysis is more useful for identifying and correcting the liquidity problems of the firm.
4. Funds Flow Statement tallies the funds generated from various sources with various uses
to which they are put. Cash Flow Statement starts with the Opening Balance of Cash and
reaches to the Closing Balance of Cash.
Benefits of Funds Flow Statement
Funds Flow Statement is useful for Long Term Analysis. It is a very useful tool in the hands of
the management for judging the financial and operating performance of the Company. The
Balance Sheet and the Profit and Loss A/c (Income Statement) fail to provide the information
which is provided by the Funds Flow Statement i.e. Changes in Financial Position of an
enterprise. Such an analysis is of great help to the management, shareholders, creditors etc
1. The Funds Flow Statement helps in answering the following questions:-
 Where have the profits gone?
 Why is there an imbalance existing between liquidity position and profitability position
of an enterprise?
 Why is the concern financially solid in spite of losses?
2. The Funds Flow Statement analysis helps the management to test whether the working capital
has been effectively used or not and the working capital level is adequate or inadequate for the
requirements of the business. The Working Capital Position helps the management in taking
policy decisions regarding payment of dividend etc.
3. The Funds Flow Statement Analysis helps the investors to decide whether the company has
managed the funds properly. It also indicates the Credit Worthiness of a company which helps
the lenders to decide whether to lend money to the company or not. It helps the management to

9. take policy decisions and to decide about the financing policies and Capital Expenditure for the
future.
PREPARATION OF FUNDS FLOW STATEMENT
Step I: Prepare Statement of Changes in Working Capital
For preparing the Funds Flow Statement, the first step is to prepare the Statement of Changes in
Working Capital. There may be several reasons for changes in the Working Capital Position of
a Company, some of which have been discussed below:-
1. Purchase of Fixed Assets or Long Term Investments without raising Long Term Funds
2. Payments of Dividends in excess of the Profits earned
3. Extension of Credit to the Customers
4. Repayment of a Long Term Liability or Redemption of Preference Shares without raising
Long Term Resources
Eg: From the Balance Sheet of X Ltd for the year ending 2010 and 2011, prepare Statement of
Changes in Working Capital
Particulars 2010 2011 Change in Working Capital
Current Assets
Inventory 1524 1491 -33
Sundry Debtors 126 183 +57
Cash and Bank 134 166 +32
Other Current Assets 8 9 +1
Loans and Advances 1176 1474 +298
2968 3323 +355
(Less) Current Liabilities
Liabilities 1776 1483 -293
Provision for Tax 622 745 +123
Proposed Dividend 65 207 +142
2463 2435 -28
Working Capital 505 888 383
Step II: Prepare Funds from Operations
The next Step is to prepare the Funds generated only from the Operating Activities of the
Business and not from the Investing/Financing Activities of the business. The Funds from
Operations shall be prepared as follows:-
Particulars Amount

10. Net Income xxx
ADD
1. Depreciation on Fixed Assets xxx
2. Amortization of Intangible Assets xxx
3. Amortisation of Loss on Sale of Investments xxx
4. Amortisation of Loss on sale of Fixed Assets xxx
5. Losses from Other Non-Operating Incomes xxx
6. Tax Provision (Created out of Current Profits) xxx
7. Proposed Dividend xxx
8. Transfer to Reserve xxx
(LESS)
1. Deferred credit xxx
2. Profit on Sale of Investments xxx
3. Profit on Sale of Fixed Assets xxx
4. Any written back Reserve & Provision xxx
Step III: Preparation of Funds Flow Statement
While preparing the Funds Flow Statement, the Sources and Uses of Funds are to be disclosed
clearly so as to highlight the Sources from where the Funds have been generated the Uses to
which these Funds have been applied. This Statement is also sometimes referred to as the
Sources and Applications of Funds Statement or Statement of Changes in Financial Position.
Sources of Funds
Items to be shown under the head Sources of Funds are as follows:-
1. Issue of Shares and Debentures for Cash: – The total amount received from the Issue of
Shares or Debentures is to shown under this head. But, the Issue of bonus Shares or
Conversion of Debentures into Equity Shares or Shares issued to vendors shall not be
shown here as there is no inflow of Cash
2. Long Term Loans: The Amount received on raising Long Term Loans is shown under
this head. Short Term Loans are not to be shown here as their treatment has already been
done while preparing the Statement of Changes in Working Capital.
3. Sale of Investments and other Fixed Assets: The Total Amount received on the sale of
Investments and other Fixed Assets is to be shown under this head.
4. Funds from Operations: The Funds generated from Operations as computed in Step II are
also required to be shown here.
5. Decrease in Working Capital: This would be the Balancing Figure of the Statement and
will come from change in Working Capital Statement
Application of Funds

11. Items to be shown under Application of Funds are as follows:-
1. Purchase of Fixed Assets and Investments: The Cash Payment made for purchase of
Fixed Assets and Investments is an application of Funds. But if the purchase if made by
issue of shares or debentures, such a transaction will not constitute application of funds.
Similarly, if the purchases are on credit, these will not constitute fund applications.
2. Redemption of Debentures, Preference Shares and Repayment of Loan:- Payment made
including Premium (less: Discount) is to be taken as fund application
3. Payment of Dividend & Tax: Payment of Dividend and Tax are to be taken as
applications of fund if the provisions are excluded from Current Liabilities and Current
Provisions are added back to profit to determine the “Funds from Operations”
4. Increase in Working Capital: This would be the Balancing Figure of the Statement and
will come from change in Working Capital Statement
As explained above, the Funds Flow Statement summarises for a particular period the resources
made available to finance the activities of an enterprise and the uses to which such resources
have been put.