Financial Statement Analysis

Balance sheet mirrors the financial position on a particular date in terms of the structure of assets, liabilities and owners equity. Profit & loss A/c shows the results of operations during a certain period of time in terms of the revenue obtained & the cost incurred during the year.

 Focus of financial analysis is on key figures in the financial statements & the significant relationships that exist between them. The analysis of financial statements is a process of evaluating relationships between component parts of financial statements to obtain a better understanding of the firms position & performance.

 Select the information relevant to the decision under consideration from the total information contained in the financial statement. Arrange the information in a way to highlight significant relationships Interpretation and drawing of inferences and conclusions.

Ratio Analysis
Ratio Analysis is the systematic use of ratio to interpret the financial statements so that the strengths & weaknesses of a firm as well as its historical performance & current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two items/variables. This relationship can be expressed in terms of percentage, fraction or proportion.

Basis of Comparison
Trend Ratios. Inter-firm comparison. Intra year comparison of same firms statements. Comparison with standards or plans.

 Trend ratios means comparison of ratios of a firm over time, i.e. present ratios are compared with past ratios for the same firm. Trend ratios indicate the direction of change in the performance-improvement, deterioration or constancy-over the years. The inter-firm comparison involves comparison of the ratios of a firm with those of others in the same line of business or for the industry as whole reflects its performance in relation to its competitors.

Types of Ratios
Liquidity Ratios. Leverage Ratios. Coverage Ratios. Profitability Ratios. Activity Ratios.

Liquidity Ratios
The liquidity ratios measure the ability of a firm to meet its short-term obligations & reflect the short-term financial strength/solvency of a firm. Short term creditors of the firm are interested in the short-term solvency or liquidity of a firm. Proper balance between liquidity & profitability is required for efficient financial management. NWC, Current Ratio, Acid Test Ratio, Super Quick Ratio, turnover ratios indicate liquidity of the firm.

Current Ratio
The current ratio is the ratio of total current assets to total current liabilities. Current Ratio = Current Assets / Current Liabilities Current ratio indicates the rupees of current assets available for each rupee of current liability/obligation. The higher the current ratio the larger the amount of rupees available per rupee of current liability, the more the firms ability to meet current obligations & the greater the safety of funds of short-term creditors. Current ratio is a measure of margin of safety. Need for safety margin arises from the inevitable unevenness in the flow of funds through the current assets & liabilities account.

Interpretations
In inter-firm comparison, the firm with the higher current ratio has better liquidity/ short-term solvency. Very high ratio indicates slack mgt practices, as it might signal excessive inventories for the current requirements and poor credit mgt. General rule is a current ratio of 2:1 is ok.

Acid Test Ratio

Current liabilities are fixed in the sense that they have to be paid in full where as current assets are subject to shrinkage in value, e.g. possibility of bad debts, un-sale ability of inventory. A rupee of cash is more readily available (liquid) to meet current obligations than a rupee of say inventory or receivables. Acid test ratio is a measurement of a firms ability to convert its current assets quickly into cash in order to meet its current liabilities. Thus, it is a measure of quick or acid liquidity.

 Acid-test ratio = quick assets / current liabilities cash, bank balance, short term marketable securities, debtors excluding prepaid expenses & inventory. From liabilities you exclude BOD as it is usually given 1yr time for payment. Ratio of 1:1 is considered satisfactory.

Turnover Ratios
Turnover ratios determine how quickly certain current assets are converted into cash. ITR = cost of goods sold / average inventory This ratio indicates how fast the inventory is sold. High ratio means liquidity & low ratio would signify that inventory does not sell fast & stays on the shelf/ ware house for a long time. IHP=12mts/ITR Cogs=sales-gross profit Cogs=opening stock + mfg cost (including purchases ) closing stock

 DTR = net credit sales / average debtors This ratio measures how rapidly debts are collected. A high ratio is indicative of shorter time lag between credit sales & cash collection. A low ratio shows that debts are not collected rapidly. DCP= 12mts/DTR CTR = net credit purchases / average creditors A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. CCP=12mts/CTR

Activity Ratios
Activity ratios are concerned with measuring the efficiency in asset management. These ratios are also called efficiency ratios or asset utilization ratios. Efficiency with assets are used would be reflected in the speed & rapidity with which assets are converted into sales. The greater the rate of turnover or conversion, the more efficient the utilization/ management, other things being equal.

Assets Turnover Ratio

This is also known as investment turnover ratio. Total assets and fixed assets are net of depreciation. Higher the turnover ratio, the more efficient the mgt & utilization of the assets while low turnover ratios are indicative of under-utilization of available resources & presence of idle capacity.

Assets Turnover Ratios

Total assets turnover = cogs / avg total assets. Fixed assets turnover = cogs / avg fixed assets Capital turnover = cogs / avg capital employed Current assets turnover=cogs/avg current assets Working capital turnover = cogs/Nwc

Profitability Ratios
Apart from creditors, owners & mgt are the one who are interested in the financial soundness of a firm. Operating efficiency of the firm & its ability to ensure adequate return to its shareholders depend ultimately on the profits earned by it.. Profitability ratios can be determined on the basis of either sales or investments.

Profitability Ratios Based on Sales

These ratios are based on the premise that a firm should earn sufficient profit on each rupee of sales. GPR=GP/Net Sales, GP= Sales-Cogs GPR measures profit in relation to sales A high ratio of GP to sales is a sign of good mgt as it implies that the cost of production of the firm is relatively low. NPR=NOP/ Net sales

Expenses Ratios
Profits will be more only when expenses are low Cogs= cogs/net sales Cogs ratio shows what percentage share of sales is consumed by cogs & conversely, what proportion is available for meeting expenses such as selling & general distribution expenses as well as financial expenses consisting of taxes, interest & dividends & so on. Operating expenses ratio=operating exp/net sales Administrative exp ratio= admin exp / net sales Selling exp ratio=selling exp/net sales

 Operating ratio=(cogs+ operating exp)/net sales Low operating ratio is by & large a test of operational efficiency. If operating ratio is say 80% it implies that total operating expenses including cogs consume 80% of the sales receipts of the firm & 20% is left for meeting interest, tax & dividend liabilities as also retaining profit for future expansion. Financial exp ratio= financial exp/ net sales

Ratios Based on Investment (ROI)

Return on Assets. Return on Capital Employed. Return on Shareholders Equity.

Return on Assets
Profitability ratio is measured in terms of the relationship between net profits & assets. ROA measures the profitability of the total funds/investments of a firm. ROA= NPAT/avg total assets ROA= (NPAT + Interest)/ avg total assets

ROCE
ROCE is a concept that measures the profit which a firm earns on investing a unit of capital. ROCE measures overall efficiency of firm. ROCE when calculated in this manner would also show whether the companys borrowing policy was economically wise & whether the capital had been employed fruitfully. Suppose, funds have been borrowed at 8% & the ROC is 7.5 %,it would have been better not to borrow. It would also show that the firm had not been employing the funds efficiently. ROC can be calculated on Equity share holders capital. This would not indicate operational efficiency or inefficiency but merely the maximum rate of dividend that might be declared. ROCE should be always greater than Cost of capital.

ROCE
Capital employed refers to long term funds supplied by the creditors & owners of the firm. Capital employed= NWC + Fixed Assets. Higher the ratio , the more efficient is use of the capital employed. ROCE = NPAT/ avg total capital employed. ROCE= NOP/ total capital employed.

Return on Shareholders Equity

ROSE measures exclusively the return on the owners funds. Return on Total Shareholders Equity Return on Ordinary Shareholders Equity EPS DPS D/P P/E

Return on Total Shareholders Equity

ROTSE = NPAT(EAT)/avg total shareholders equity Shareholders equity=preference share capital + equity share capital +share premium + reserves & surplus accumulated losses This ratio shows how profitably the owners funds have been utilized by the firm.

Return on Ordinary Shareholders Equity (Net worth)

The profitability from the real owners point of view. ROE=EAS/ avg ordinary shareholders equity / net worth. Objective of the financial mgt to maximize the return to the owners.

 Other measures available to assess the profitability from the owners viewpoint. EPS measures the profit available to the equity holders on a per share basis, i.e. the amount they can get on every share held. EPS = EAS/n EPS does not reveal how much is paid to the owners as dividends nor how much of the earnings are retained in the business.

 Dividend paid to the shareholders on a per share basis is the DPS. It is the net distributed profit belonging to the shareholders divided by the number of ordinary shares outstanding. D/P ratio measures the relationship between the earnings belonging the ordinary shareholders & the dividend paid to them. In other words, the D/P ratio shows what % share of the net profits after taxes & preference dividend is paid out as dividend to he equity holders. D/P= total cash dividend / total EAS D/P=DPS/ EPS

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

Coverage Ratio
It indicates whether the business would earn sufficient profits to pay periodically the interest charges. EBIT/ interest charges This shows how many times the interest charges are covered by the EBIT out of which they will be paid. This ratio is also called debt service ratio Standard for this ratio for an industrial company is that interest charges should be covered 6 to 7 times

Dividend Coverage
Dividend coverage measures the ability of a firm to pay dividend on preference shares which carry a stated rate of return. Dividend coverage = EAT / Preference dividend. Safety margin available to preference share holders.

Debt-Equity Ratio
Debt Equity Ratio= Total long term debt/ shareholders funds. Ideal is 1