Chapter - 3

Analysis of Financial statements

3.1 Introduction

As observed in the previous chapter, a basic limitation of the tradition financial

statements comprising the balance sheet and the profit and loss account is that they
do not give all the information related to the financial operations of a firm.
Nevertheless, they provide some extremely useful information to the extent that the
balance sheet mirrors the financial position on a particular date in term of the
structures of assets, liabilities and owners’ equity, and so on and the profit and loss
account shows the results of operations during a certain period of time in term of
the revenues obtained and the cost incurred during the year. Thus, the financial
statements provide a summarized view of the financial position and operation of a
firm. Therefore, much can be learnt about a firm from a careful examination of its
financial statements as invaluable documents/performance reports. The analysis of
financial statements is, thus, an important aid to financial analysis.

The focus of financial analysis is on key figure in the financial statements and the
significant relationship that exits between them. The analysis of financial statements
is a process of evaluating the relationship between components parts of financial
statements to obtain a better understanding of the firm’s position and performance.
The first task of the financial analyst is to select the information relevant to the
decision under consideration from the total information contained in the financial
statements. The second step is to arrange the information in a way to highlight
significant relationships. The final step is interpretation and drawing of inferences
and conclusions. In brief financial analysis is the process of selection and evaluation.

3.2 Financial Ratios – Meaning and Rationale

Ratio analysis is widely-used tool of financial analysis. It can be used to compare the
risk and return relationship to firm of different sizes. It is defined as the systematic
use of ratio to interpret the financial statements so that the strength and weaknesses
of a firm as well as its historical performance and 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 as

(i) Percentage, say, net profits are 25 percent of sales (assuming net
profits of Rs 25,000 and sales of Rs 1,00,000,
(ii) Fraction (net profits is one-fourth of sales) and
(iii) Proportion of numbers (the relationship between net profits and sales
is 1:4).

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These alternative methods of expressing items which are related to each other are,
for purpose of financial analysis, referred to as ratio analysis. It should be noted
that computing the ratios does not add any information not already inherent in the
above figure of profits and sales. What the ratios do is that they reveal the
relationship in a more meaningful way so as to enable equity investors, management
and lenders made better investment and credit decisions.

The rationale of ratio analysis lies in the fact that it makes related information
comparable. A single figure by itself has no meaning but when expressed in term of
a related figure, it yields significant inferences. For instance, the fact that the net
profits of a firm amount to, say, Rs 10 lakhs throws no light on its adequacy or
otherwise. The figure of net profit has to be considered in relation to other variables.
How does it stand in relation to sales? What does it represents by way of return on
total assets used or total capital employed? If, therefore, net profits are shown in
terms of their relationship with items such as, assets, capital employed, equity and
so on, meaningful conclusion can be drawn regarding their adequacy. To carry the
above example further, assuming the capital employed to be Rs 50 lakh and Rs 100
lakh, the net profits are 20 per cent and 10 per cent respectively. Ratio analysis,
thus, as quantitative tool, enables analysis to draw quantitative answers to questions
such as: Are the net profits adequate? Are the assets being used efficiency? Is the
solvent? Can the firm meet its current obligations and so on?

Ratio analysis is one of the techniques of financial analysis where ratios are used as
a yardstick for evaluating the financial condition and performance of a firm.
Analysis and interpretation of various accounting ratios gives skilled and
experienced analysts a better understanding of the financial condition and
performance of the firm than what he could have obtained only through a perusal of
financial statements.

3.3 Financial Ratio Analysis

The ratio is an arithmetical between two figures. Financial ration analysis is a study
of ratios between various items or groups of items in financial statements. Financial
ratios have been classified in several ways. For our purpose, we divide them into five
broad categories as follows:

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 • Liquidity ratios
• Leverage ratios
• Turnover ration
• Profitability ration
• Valuation ratio

To facilitate the discussion of various ratios the financial statements of Horizon

Limited shown in the following statements will be used.

Horizon Limited: Profit and Loss Account for the year Endings 31st March 2001

(Rs in Million)

Items 2001 2000

Net sales 701 623
Cost of goods sold 552 475
Stocks 421 370
Wages and salaries 68 55
Other manufacturing expanses 63 50
Gross profit 149 148
Operating expanses 56 49
Depression 30 26
General administration 12 11
Selling 14 12
Operating profit 93 99
Non- operating surplus/deficit (4) 6
Profit before interest and tax (PBIT) 89 105
Interest 21 22
Profit before tax (PBT) 68 83
Tax 34 41
Profit after tax (PAT) 34 42
Dividends 28 27
Retained earnings 6 15
Per share data(in rupees)
Earning per share 2.3 2.8
Dividend per share 1.8 1.8
Market Price per share 21.00 20.0
Book value per share 17.47 17.07

Horizon Limited: balance Sheet as on 31st March 2001

(Rs in Million)

2001 2000
I Sources of Funds
1. Shareholders’ Funds 262 256
(a) Share Capital 150 150
(b) Reserves & Surplus 112 106
2. Loans Funds 212 156
(a) Secured Loans 143 131
(i) Due after 1 year 108 29

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 (ii) Due within 1 year 35 40
(b) Unsecured Loans 69 25
(i) Due after 1 year 29 10
(ii) Due within 1 year 40 15
--------- ----------
474 412
II Application of Funds
1. Fixed Assets 330 322
2. Investments 15 15
(i) Long term investments 12 12
(ii) Current investments 3 3
3. Current Assets, loans, Advances 234 156
a. Inventories 105 72
b. Sundry Debtors 114 68
c. Cash & bank balance 10 6
d. Loans & advances 5 10
less: Current Liabilities and Provision 105 81
Net Current Assets 129 75
-------- ----------
Total 474 412

3.3.1 Liquidity Ratios

Liquidity refers to the ability of a firm to meet its obligations in the short run,
usually one year. Liquidity ratios are generally based on the relationship between
current assets (the sources for meeting short-term obligations) and current
liabilities. The important liquidity ratios are

Current ratio: - A very popular ratio, current ratio is defined as:

Current Assets
Current Liabilities

Current assets include cash, current investments, debtors, inventories (stocks), loans
and advances, and pre-paid expanses. Current liabilities represent liabilities that are
expected to mature in the next twelve months. These comprise (i) loans, secured or
unsecured, that are due in the next twelve months and (ii) current liabilities and
provisions.

Horizon Limited’s current ration is: 237/180 = 1.32

The current ration measures the ability of the firm to meet its current liabilities –
current assets converted into cash in the operating cycle of the firm and provide the
funds needed to pay current liabilities. Apparently, higher the current ratio, the
greater the short-term solvency. However, in interpreting the current ratio the
composition of current assets must not be overlooked. A firm with a higher
proportion of current assets in the form of cash and debtors is more liquid than one
with a high proportion of current assets in the form of inventories even though both
the firms have the same current ratio.

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The general norm for current ratio in India is 1.33. Internationally it is 2

Acid-test ratio: - Also called the quick ratio, the acid – test ratio is defined as:

Quick Assets
Current Liabilities

Quick assets are defined as current assets excluding inventories.

Horizon’s acid-test ratio for 2001 is: (237-105)/180 = 0.73

The acid – test ratio is a fairly stringent measure of liquidity. It is based on those
current assets which are highly liquid – inventories are excluded from the
numerator of this ratio because inventories are deemed to be least liquid component
of current assets.

Cash ratio:- Because cash and bank balance and short term marketable securities
are the most liquid assets of a firm, financial analysts look at cash ratio, which is
defined as:

cash and bank balance + Current investments

Current liabilities

Horizon’s cash ratio for 2001 is: (10+3)/180 = 0.07

Clearly, the cash ratio is perhaps the most stringent measure of liquidity. Indeed,
one can argue that it is outlay stringent. Lack of immediate cash may not matter if
the firm can stretch its payments or borrows money at short notice.

3.3.2 Leverage Ratios

Financial leverage refers to the use of debt finance. While debt capital is a cheaper
source of finance, it is also a riskier source of finance. Leverage ratios help in
assessing the risk arising from the use of dept capital. Two types of ratios are
commonly used to analyze financial leverage: structure ratios and coverage ratios.
Structure ratios are based on the proportions of dept and equity in the financial
structure of the firm. The important structure ratios are: debt-equity ratio and
dept-assets ratio. Coverage ratios show the relationship between debt servicing
commitment and the sources for meeting these burdens. The important coverage
ratios are: interest coverage ratio, fixed charges coverage ratio, and debt services
coverage ratio.

Debt – equity Ratio:-The debt-equity ratio shows the relative contributions of

creditors and owners. It is defined as:

67
 Debt
a
Equity

The numerator of this ratio consists of all debt, short-term as well long-term, and
the denominator consists of net worth plus preference capital.

Horizon’s debt-equity ratio for the 2001 year-end is: 212/262 = 0.809

In general, the lower the debt-equity ratio, the higher the degree of protection
enjoyed by the creditors. In using this ratio, however, the following points should be
borne in mind:

1. The book value of equity may be an understanding of its true value in a

period of rising prices. This happens because assets are carried at their
historical values less depreciation, not at current value.
2. Some forms of debt (like term loans, secured debentures, and secured short-
term bank borrowing) are usually protected by specific collateral and enjoy
superior protection.

Debt-assets ratio: - The debt-assets ratio measure the extant to which borrowed
funds supports the firm’s assets. It is defined as:

Debt
Assets

The numerator of this ratio includes all debt, short-term as well as long-term, and
the denominator of this ratio is the total of all assets (the balance sheet total).

Horizon’s debt-assets ratio for 2001 is: 212/474 = 0.45

Interest coverage Ratio Also called the times interest earned, the interest
coverage ratio is defined as:

Profit before int erest and taxes

int erest

Horizon’s interest coverage ratio for 2001 is: 89/21 = 4.23

Note that profit interest and taxes is used in the numerator of this ratio because the
ability of a firm to pay interest is not affected by tax payment, as interest on debt
funds is a tax-deductible expanse. A high interest coverage ratio means that the firm
can easily meet its interest burden even if profit before interest and taxes suffer a
considerable decline. A low interest coverage ratio may result is widely in financial
embarrassment when profit before interest and taxes decline. This ratio is widely
used by lenders to assess a firm’s debt capacity. Further, it is major determine of

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bond rating. Though widely used, this ratio is not very appropriate measure of
interest coverage because the source of interest payment is cash flow before interest
and taxes, not profit before interest and taxes. In view of this, we may use a
modified interest coverage ratio:

profit before int erest and taxes + Depreciation

Debt int erest

For horizon’s Limited, this ratio for 2001 is: 119/21 = 5.67

Fixed charges Coverage Ratio:- This ratio shows how many times the cash
flow before interest and taxes covers all fixed financing charges. It is defined as:

profit before int erest and taxes + Depreciation

Re payment of loan
Interest +
1 − Tax rate

In the denominator of this ratio only the repayment of loan is adjusted upwards for
the tax factor because the loan repayment amount, unlike interest, is not tax
deductible.

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Horizon’s fixed charge coverage ratio for 2001 is: = 0.70
21 + (75 0.5)

This ratio measures debt servicing ability comprehensive because it considers both
the interest and the principle repayment obligations. The ratio may be amplified to
include other fixed charge like lease payment and preference dividends.

Debt Service Coverage Ratio:- Used by term-lending financial institution in

India, the debt service coverage ratio is defined as:

Pr ofit after tax + Depreciation + Other non − cash ch arg e + int erest on term loan
Interest on term loan + Re payment of term loan

Financial institutions calculate the average debt service coverage ratio for the
period during which the term loan for the project is repayable. Normally, financial
institutions regard a debt service coverage ratio of 1.5 to 2.0 satisfactory.

3.3.3 Turnover Ratios

Turnover ratios, also refereed to as activity ratios or assets management ratios

measure, how efficiently the assets are employed by a firm. These ratios are based
on the relationship between the level of activity, represented by sales or cost of
goods sold, and levels of various assets. The important turnover ratios are:

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inventory turnover, average collection period, receivable turnover, fixed assets
turnover, and assets turnover.

Inventory turnover: - The inventory turnover, or stock turnover, measure how

fast the inventory is moving through the firm and generating sales. It is defined as:

Cost of goods sold

Average inventory

552
Horizon’s inventory turnover for 2001 is: = 6.24
(105 + 72 ) 2
In inventory turnover reflects the efficiency of inventory management. The higher
the ratio, the more efficient the management of inventories and vice verse. However,
this may not always be true. A high inventory turnover may be caused by a low level
of inventory which may result in frequent stockouts and loss of sales and customers
goodwill.

Notice that as inventories tend to change over the year, we use the average of the
inventories at the beginning and end of the year. In general, average may be used
when a flow figure (in this case, cost of goods sold) is related to a stock figure
(inventories).

Debtors’ turnover: - This ratio shows how many accounts receivable (debtors)
turn over during the year. It is defined as:

Net credit sales

Average Accounts Receivable (debtors)

If the figure for net credit sales is not available, one may have to make do with net
sales figure.

701
Horizon’s debtors’ turnover for 2001 is: = 7.70
(114 + 68) 2
Obviously, the higher the debtors turnover the greater the efficiency of credit
management.

Average Collection Period: - The average collection period represents the

number of days’ worth of credit sales that is locked in debtors (accounts receivable).
It is defined as:

70
 Average Debtors
Average daily credit sales

If the figure for credit sales is not available, one may have to make do with the net
sales figure.

Horizon’s average collection period for 2001 is:

(114 + 68) 2
= 47.4 days
701 365

Note that the average collection period and the accounts receivable turnover are
related as follows:

365
average collection period=
accounts receivable (debtors) turn over

The average collection period may be compared with the firm’s credit terms to
judge the efficiency of credit management. For example, if the credit terms are 2/10,
net 45, an average collection period of 85 days means that the collections is slow and
an average collection period of 40 days means that the collection is prompt. An
average collection period which is shorter than the credit period allowed by the firm
needs to be interpreted carefully. It may mean efficiently of credit management or
excessive conservation in credit granting that may result in the loss of some
desirable sales.

Fixed Assets Turnover: - this ratio measure sales per rupee of investment in
fixed assets. It is defined as:

Net Sales
Average net fixed assets

701
Horizon’s fixed Asserts turnover ratio for 2001 is: = 2.15
( 330+322 ) 2
This ratio is supposed to measure the efficiency with which fixed assets are
employed- a high ratio indicates a high degree of efficiency in assets utilization and
how a low ratio reflects inefficient use of assets. However, in interpreting this ratio,
one caution should be borne in mind. When the fixed assets of the firm are old and
substantially depreciated, the fixed assets turnover ratio tends to be high because
the denominator of the ratio is very low.

Total Assets Turnover:- Akin to the output-capital ratio in economic analysis,

the total asserts turnover is defined as:

71
 Net Sales
Average Total Assets

701
Horizon’s total assets turnover ratio for 2001 is: = 1.58
( 474+412 ) 2
This ratio measure how efficiently assets are employed, overall.

3.3.4 Profitability ratio

Profitably reflects the final results of business operation.

There are two types of profitability

(i) Profit margins ratio show the relationship between profit and sales.

Gross profit margin ratio and

Net profit margin ratio

(ii) Rate of return ratios reflects the relationship between profit and
investment.

Return on total assets,

Earning power, and

Return on equity.

Gross Profit Margin Ratio: - The gross profit margin ratio is defined as:

Gross Pr ofit
Net Sales

Gross profit is defined as the difference between net sales and cost of goods sold.

Horizon’s gross profit margin ratio for 2001 is: 149/701=0.21 or 21 Per cent

This ratio shows the margin left after meeting manufacturing costs. It measure the
efficiently of production as well as pricing.

Net Profit Margin Ratio: - The net profit margin ratio is defined as:

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Net Pr ofit
Net Sales

Horizon’s net profits margin ratio for 2001 is: 34/701 = 0.049 or 4.9 percent

This ratio shows the earning left for shareholders (both equity and preference) as
percentage of net sales. It measures the overall efficiency of production,
administrations, selling, financing, pricing and tax management. Jointly consider,
the gross and net profit margin ratios provides a valuables understanding of the cost
and profit structure of the firm and enable the analysis to identify the sources of
business efficiency / inefficiency.

Return on Total Assets: - A commonly used tare of return measure, the return
on total assets (also called return on capital employed or return on investment) is
defined as:

Net Income ( Pr ofit )

Average Total Assets

Horizon’s return on total assets for 2001 is:

34
= 0.077 or 7.7%
( 474 + 412 ) 2
The net income to total assets ratio is supposedly a measure of how efficiently the
capital is employed. Though widely used, this is an odd measure because the
numerator measures the return to shareholders (equity and preference) and the
denominator represents the contribution of shareholders as well as creditors.

To ensure internal consistency, the following variants of return on total assets may
be employed:

Net Income + Interest

Average Total Assets

Horizon’s return on total assets modified measure for 2001 is:

( 34 + 21) = 0.124 or 12.4%

( 474 + 412 ) 2

Earning Power: - A measure of operating profitability, the earning power is

defined as:

73
Pr ofit before Interest and Taxs
Average Total assets

Horizon’s earning power for 2001 is:

89
= 0.201 or 20.1 %
( 474 + 412 ) 2
The earning power is a measure of business performance which is not affected by
interest charges and tax payments. It abstracts away the effects of financial
structure and tax rate and focus on operating performance. Hence, it is eminently
suited for inter-firm comparisons. Further, it is internally consistent. The
numerator represents a measure of pre-tax earning belonging to all sources of
finance and the denominator represents total financing.

Return on Equity: - A measure of greater interest to equity shareholder, the

return on equity is defined as:

Equity earning
Ave arg e Net worth

The numerator of this ratio is equal to profit after tax less preference dividends. The
denominator includes all contributions made by equity shareholders (paid-up
capital + reserves and surplus). This ratio is also called the return on net worth.

34
Horizon’s return on equity for 2001 is: = 0.131 or13.1 %
( 262 + 256 ) 2
The return on equity measures the profitability of equity funds invested in the firm.
It is regarded as a very important measure because it reflects the productively of the
ownership (or risk) capital employed in the firm. It is influenced by several factors:
earning power, debt-equity ratio, average cost of debt funds, and tax rate.

In judging all the profitability measures it should be borne in mind that the
historical valuation of assets imparts an upwards bias to profitability measures
during an inflationary period. This happens because the numerator of these
measures represents current values, whereas the denominator represents historical
values.

3.3.5 Valuations Ratios

Valuation ratios indicate how the equity stock of the company is assessed in the
capital market. Since the market value of equity reflects the combined influence of
risk and return, valuation ratios are the most comprehensive measure of a firm’s

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performance. The important valuation ratios are: price-earning ratios, yield, and
market value to book value ratio.

Price – earning ratio: - Perhaps the most popular financial statistic in stock
market discussion, the price-earning ratio is defined as:

Market price per share

Earnings per share

The market price per share may be the price prevailing on a certain day or the
average price over a period of time. The earnings per share is simply: profit after
tax less preference dividend divided by the number of outstanding equity shares.

Harizon’s price-earning ratio at the end of 2001 is :

21
= 9.13
2.3

The price-earning ratio (or the price-earnings multiple as it is commonly referred

to) is a summary measure which primarily reflects the following factors: growth
prospects, risk characteristics, shareholders orientations, corporation image, and
degree of liquidity.

Yield: - This is a measure of the rate of return earned by shareholders. It is defined

as:

Dividend + Pr ice Change

Initial Pr ice

This may be split into two parts:

Dividend Pr ice Change

+ .i.e. Dividend yield + Capital gains/Losses yield
Initial Pr ice Initial Pr ice

For Horizon’s the dividend yield and the capital gains yield for 2001 are as follows:

Dividend yield = 1.8/20.0 = 9% and Capital gains yield = 1.0/20.0 = 5 %.

Hence, the total yield for 2001 was 14 Percent. Generally companies with low
growth prospects offer a high dividend yield and a low capital gains yield. On the
other hand, companies with superior growth prospects offer a low dividend yield
and a high capital gains yield.

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Market value to Book value ratio: - Another popular stock market statistic,
the market value to book value is defined as:

Market value per share

Book value per share

Horizon’s market value to book value ratio at the end of 2001 was:

= 21.00/17.47 = 1.20

In a way, this ratio reflects the contribution of a firm to the wealth of society. When
this ratio exceeds 1 it means that the firm has contributed to the creation of wealth
in the society – if this ratio is, say, 2, the firm has created a wealth of one rupee for
every rupee invested in it. When this ratio is equal to 1, it implies that the firm has
neither contributed to nor detracted from the wealth of society.

It may be emphasized here that if the market value to book value ratio is equal to 1,
all the three ratios, namely, return on equity, earning-price ratio (which is the
inverse of the price earning ratio), and total yield, are equal.

3.4 Common size statements

Ratio analysis apart, another useful way of analyzing financial statements is to
convert them into common size statements by expressing absolute rupee amounts
into percentage. When this method is pursued, the income statement exhibits each
expanse item or group of expense items as a percentage of net sales, and net sales
are taken at 100 per cent. Similarly, each individual assets and liability classification
is shown as a percentage of total assets and liabilities respectively. Statements
prepared in this way are referred to as Common-Size statements.

A company financial statement that displays all items as percentages of a common

base figure. This type of financial statement allows for easy analysis between
companies or between time periods of a company.

The values on the common size statement are expressed as percentages of a

statement component such as revenue. While most firms don't report their
statements in common size, it is beneficial to compute if you want to analyze two or
more companies of differing size against each other.

Formatting financial statements in this way reduces the bias that can occur when
analyzing companies of differing sizes. It also allows for the analysis of a company
over various time periods, revealing, for example, what percentage of sales is cost of
goods sold and how that value has changed over time.

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3.4.1 What are common-size financial statements?

Common-size financial statements usually involve the balance sheet and the income
statement. These two financial statements become “common-size” when their dollar
amounts are expressed in percentages.

For example, a common-size balance sheet will report all of the balance sheet
amounts as a percentage of the “Total Assets” amount. If Cash was $80,000 and
Total Assets were $1,000,000 then Cash will appear as 8% and Total Assets will
appear as 100%. If the Current Assets were $350,000 they will appear as 35%. If
Current Liabilities were $180,000 then on the common-size statement they will
appear as 18%. By having all of the balance sheet amounts as a percentage of Total
Assets, you can compare your company’s current asset percentage (and all other
line items) to your industry’s percentage or to any other company’s percentages. It
doesn’t matter if the other company is larger or smaller than your company,
because all amounts are in percentages of Total Assets. Hence, the name “common-
size.”

A common-size income statement will show all of the income statement amounts as a
percentage of net sales. If net sales are $10,000,000 and the cost of goods sold is
$7,800,000, the common-size income statement will report net sales as 100% and the
cost of goods sold as 78%. If SG&A expenses are $1,300,000 they will appear as
13%. Having the income statement in percentages of net sales allows you to compare
your company’s SG&A expenses and its gross profit to your industry percentages
and to other companies regardless of size.

An easy way to spot trends in your balance sheet and income statement data from a
number of years, or to compare your information with that of another company or
industry group, is to use "common size" financial statements.

To create common size statements, you simply take the information from your
regular statements, and express it as percentages rather than as absolute dollars.
This makes it much easier to pinpoint differences from year to year, and to compare
your data with that of one or more companies that may be considerably larger or
smaller than yours. Moreover, if you get industry data or financial data on your
competitors from a commercial service, the best way to compare the data is to
express all financials in the common-size, percentage, and format.

Here's an example of an income statement that shows both absolute dollar values
for four years, and also common size percentages for the same four years. Note that
all items on the common size part of the statement are expressed in terms of a
percentage of sales. To arrive at the common size percentage for an item, we simply
divided the dollar value of that item by the dollar value of sales for the period.

Dollars, in Thousands Common Size Percentage

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 1 2 3 4 Years 1 2 3 4

$525 $595 $630 $724 Sales 100 100 100 100

158 190 208 217 Gross Margin 30 32 33 30

79 95 95 101 Selling Exp. 15 16 15 14

31 31 32 32 Gen. & Admin. 6 5 5 4

$ 48 $ 64 $ 81 $ 84 Operating Inc. 9 11 13 12

6 6 6 8 Interest 1 1 1 1

$ 42 $ 58 $ 75 $ 76 Pretax Income 8 10 12 10

14 20 26 26 Fed. Inc. Tax 3 3 4 4

$ 28 $ 38 $ 49 $ 50 Net Income 5 6 8 7

Here's an example of a balance sheet that shows both absolute dollar values for four
years, and common-size percentages for the same four years. Notice that items
normally appearing on the asset side of the balance sheet are presented as a
percentage of total assets. Items normally on the liabilities and equity side of the
sheet are presented as a percentage of total liabilities and equity.

Dollars, in Thousands Common Size Percentage

1 2 3 4 Years 1 2 3 4

$ 50 $ 40 $ 45 $ 70 Cash 6 4 5 7

230 250 175 225 Accts. Rec. 26 27 19 22

175 180 195 185 Inventory 20 19 21 18

10 15 10 310 Other Current Assets 1 2 1 1

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 $465 $485 $425 $490 Total Current Assets 53 52 46 48

400 425 500 515 Plant & Equip. 45 46 54 51

15 20 5 10 Other Non-Current Assets 2 2 1 1

$880 $930 $930 $1015 Total Assets 100 100 100 100

200 225 220 210 Accts. Pay. 23 24 24 21

50 45 20 80 Bank Debt 6 5 2 8

$ 250 $ 270 $ 240 $ 290 Total Current Liabs. 28 29 26 29

150 100 60 250 Long-Term Debt 17 11 6 25

$ 400 $ 370 $ 300 $ 540 Total Liabs. 45 43 32 53

480 560 630 475 Owner's Equity 54 52 68 47

$ 880 $ 930 $ 930 $ 1015 Total Liabs. & Equity 100 100 100 100

Common Size Income Statements

Industry
1997 1998 1998
Net Sales 100.0% 100.0% 100.0%
Costs excluding depreciation 87.6 87.2 87.6
Depreciation 3.2 3.3 2.8
Total Operating Costs 90.8 90.5 90.4
Earnings before interest & taxes 9.2 9.5 9.6
Less interest 2.1 2.9 1.3
Earnings before taxes 7.1 6.5 8.3
Taxes (40%) 2.8 2.6 3.3
Net income before preferred dividends 4.3 3.9 5.0
Preferred dividends 0.1 0.1 0.0
Net income available to common stockholders 4.1 3.8 5.0

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============================================================
Common Size Balance Sheets
Industry
1997 1998 1998
Assets
Cash & Marketable securities 4.8% 0.5% 3.2%
Accounts receivable 18.8 18.8 17.8
Inventories 24.7 30.8 19.8
Total Current Assets 48.2 50.0 40.8
Net plant & equipment 51.8 50.0 59.2
Total Assets 100.0 100.0 100.0

Liabilities & Equity

Accounts payable 1.8% 3.0% 1.8%
Notes payable 3.6 5.5 4.4
Accruals 7.7 7.0 3.6
Total current liabilities 13.1 15.5 9.8
Long term bonds 34.5 37.7 30.2
Total Debt 47.6 53.2 40.0
Preferred equity 2.4 2.0 0.0
Common equity 50.0 44.8 60.0
Total Liab. & Equity 100.0 100.0 100.0

Common size comparative statements prepared for one firm over the year would
highlights the relative changes in each group of expanses, assets and liabilities.
These statements can be equally useful for inter-firm comparisons, given the fact
that absolute figure of two firms of the same industry are not comparable. Financial
statements and common-size statements of the Hypothetical Ltd are presented in
Example 7.10.

The accompanying balance sheet and profit and loss account relate to Hypothetical
Ltd. Convert these into common-size statements.

Balance Sheet as at March 31 (Amount in lakh of rupees)

Particular Previous Year Current Year

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Liabilities

Equity share capital (of Rs 10 each) 240 240.0

General Reserves 96 182.0

Long-term loans 182 169.5

Creditors 67 52.0

Outstanding expanses 6 ---

Other current liabilities 9 6.5

600 650.0

Assets

Plant (net of accumulated depreciation) 402 390

Cash 54 78

Debtors 60 65

Inventories 84 117

600 650

Income Statements for the Year Ended March 31 (Amount in lakh of rupees)

Particular Previous Year Current year

Gross sales 370 480

Less: Return 20 30

Net Sales 350 450

Less: Cost of Goods Sold 190 215

Gross Profit 160 235

Less: Selling, general, and administrative cost 50 72

Operating Profit
110 163

Less: Interest expanses

20 17

Earning before taxes

90 146

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 Less: Taxes 31.5 51.5

Earning after taxes 58.5 94.9

Solution

Balance Sheet as at March 31 (Amount in lakh of rupees)

Particular Previous Year Current Year

Owners’ Equity:

Equity share capital (of Rs 10 each) 40.0 36.9

General Reserves 16.0 28.0

56.0 64.9

Long-term borrowings:

Loans 30.3 26.1

Current liabilities:

Creditors
11.2 8.0

Outstanding expanses
1.0 ---

Other current liabilities

1.5 1.0

13.7 9.0

Total liabilities
100 100

Fixed Assets:
67.0 60.0
Plant (net of accumulated depreciation)

Current assets:
9.0 12.0
Cash
10.0

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Debtors 10.0 18.0

Inventories 14.0 40.0

33.0 100

100

Income Statements for the Year Ended March 31 (Percentage)

Particular Previous Year Current year

Net sales 100.0 100.0

Less: Cost of Goods Sold 54.3 47.8

Gross Profit 45.7 52.2

Selling, general, and administrative cost 14.3 16.0

Operating Profit
31.4 36.2

Interest
5.7 3.8

Earning before taxes

25.7 32,4
Taxes
9.0 11.4

16.7 21.0

These percentages figures bring out clearly the relative significance of each group of
items in the aggregate position of the firm. For instance, in the current year the
EAT of Hypothetical Ltd has increased to 21 percent from 16.7 percent in the
previous year. This improvement inn profitability can mainly be traced to the
decreases of 6.5 percent in the cost of goods sold, reflecting improvement in
efficiency of manufacturing operations. The decreases in financial overheads
(interest) by 1.9 percent during the current year can be traced to the repayment of a
part of long-term loans. Further analysis indicates that profitability would have
been more but for an increase in operating expanses ratio by 1.7 percent.

The common-size balance sheets shown that current assets as a percentage of total
assets have increased by 7 percent over previous year. This increase was shared by
inventories (4 percent) and cash (3 percent); the share of debtors remained
unchanged at 10 percent. The proportion of current liabilities (mainly due to
creditors) was also lower at 9 percent in the current year compared to 13.7 percent
in the previous year. These facts signal overall increase in the liquidity position of
the firm. Further, the share of long-term debt has also declined and owners’ equity
has gone up from 56 percent in the precious year to 64.9 percent in the current year.

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3.5 Projected Financial Statements

Understanding the Role of Financial Statement Projections

Financial projections are an integral part of any comprehensive business plan. But,
just what are they and what benefit can they provide to your business?

Most businesses are accustomed to traditional financial statements which are

"historical" in nature. That is to say that they measure income or present a
financial position for past events. The information as reported in historical financial
statements is a summarized presentation of the operations of the business during a
specific period of time.

While it is certainly important to know where you have been, it is equally important
to know where you are going. Thus, the purpose of "projected" financial statements
is to show what is likely to occur in the future based on key financial and business
assumptions of the present.

When preparing projected financial statements for a company, we begin the process
by developing a computer spreadsheet model. These models consist of an
interrelated set of equations, formulas and linking expressions that define the key
assumptions used in the projections. A full projection will consist of an income
statement, balance sheet, cash flow statement, various supporting schedules and
notes explaining the key assumptions used to develop the projected statements.
Although projections may extend out to five years or more, usually several months
to a year is more common due to the decreasing reliability of predicting future
events.

Historical financial statements typically provide the starting point to develop the
projected reports. By studying the results of past operations we can identify key
relationships within the financial results of the company. This information, along
with interviews with the business owners, allows us to define the values and
calculations that will be used in the projected financial statements.

Developing these financial models can become rather complex. However, once
completed, these financial models can be used to run various "what if analysis"
whereby a given value change can be entered in the model to see what effect it will
have on the results of business operations throughout all the reports.

Financial projections can be used as a "compass" to steer your company toward the
future using a variety of possible scenarios. For example, projections can help to
highlight and answer such questions as:

• How will my projected growth rate in revenues affect my variable and fixed
costs?
• At what level of revenues does my break even point occur?

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 • What will be the impact of expanding or discontinuing a product line?
• In order to grow revenues by X% per year, what will be the required
increase in inventory? How will I finance this inventory increase?
• To achieve my projected growth, what new machinery acquisitions will be
required? What is the best means to finance it?
• What would be the financial impact of leasing the equipment rather than
purchasing it?
• What impact will inflation have on my business operations?
• How will our key financial ratios change given our expected projected
results?
• Will we be able to service our existing debt?

A comprehensive projection is like a road map. It shows you the best course to plot
in managing the growth of your business and gives you a clearer vision of your
destination.

Our firm has extensive experience in preparing projected financial statements for
various industries and purposes. If you’re applying for a bank loan, seeking
investment capital or planning a business expansion we are available to answer any
questions you might have with regard to preparing financial projections.

3.5.1 Preparing Monthly Projected Financial Statements for a Valuation

There are many things more interesting than the subject of monthly financial
projections or forecasts. But if you are called upon to prepare them, you will quickly
discover that there is very little guidance available on the subject.

This article provides an overview of the reasons for including monthly projections in
a valuation; the issues to be considered by an analyst when including them and
considerations that will help an analyst prepare a more diligent set of projections.

There are three primary reasons that an analyst would want to include monthly
projections as part of a valuation.

1. There are interim financial statements that are closer to the valuation date
and the analyst wants to project earnings and financial position from the
interim date until the end of the fiscal year (sometimes referred to as an
annualization).
2. The interim statements reflect substantial changes to the structure of the
financial statements thus making them a more reliable base for projecting
forward.
3. The analyst is concerned about the changes in a company’s financial
performance and position on a short-term (month-to-month) basis.

The process of preparing monthly statements requires a deeper look into the various
cyclical, seasonal and operational assumptions that impact the company. In addition

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to estimating monthly earnings, monthly financial statements can provide insight
into:

1. The liquidity and ability to meet its financial obligations.

2. The adequacy of a company’s working capital in light of growth.
3. The impact of capital expenditures and related financing activities.

3.5.2 Interim versus Annual Financial Statements

Interim Financial Statements are statements prepared at any time other than the
end of the company’s fiscal year. The usefulness of Interim Statements is largely
determined by the proximity to the valuation date and the reliability of the
numbers. If the company’s business cycle(s) is seasonal or the statements suggest a
significant change in financial performance, it may be useful to include them as part
of a valuation.

There is an important difference between Annual (Year-End) and Interim

Financials. In privately owned companies, interim statements are prepared in-house
and, unless required by funding sources, are usually intended only for internal
purposes. Interim Statements may not be as complete or accurate as the Year-End
statements. In some companies, certain adjustments typically addressed in the
Annual Statements might not be included in the Interim Statements. Such
adjustments include account receivable write-offs, reconciliation of inventory (book
versus physical), accrual accounts (interest, depreciation & amortization), prepaid
expenses, dividends, retirement contributions, contracts-in-process, and the
treatment of disbursements to owners and shareholders. Interim Statements seldom
include Accountant’s Notes and other appropriate disclosures further complicating
the analyst’s job. Therefore, an analyst will need to obtain the needed information
from management.

An analyst who wants to include monthly projections (whether from an interim

period or year-end) can either obtain them from the company being valued or
prepare them on his/her own. Projections prepared by the company may be more
reliable because the preparer has access to accounting information and access to
plans and budgets.

3.5.3 Key Components of Monthly Projections

If an analyst decides to proceed with monthly projections, it’s advisable to project

the Income Statement, Balance Sheet, and Statement of Cash Flows. It is a mistake
to just project the Income Statement. Revenues and earnings impact Accounts
Receivable, Accounts Payable, and Inventory balances as well as potentially
necessitating the acquisition and disposals of Fixed Asset. Increases in revenues and
earnings can easily be absorbed by the Balance Sheet sometimes, counter-intuitively,
reducing bank balances.

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There are four basic approaches that an analyst can use to prepare monthly
projected financial statements:

1. Use all or part of projections prepared by the client or company.

2. Prepare projections using the Top-Down approach. In the Top-Down
approach, the analyst prepares the projection on an annual basis and then
allocates the numbers for each line item into the monthly projections.
3. Prepare projections using the Bottom-Up approach. When using the Bottom
Up approach, the analyst projects each line item for every individual month
with the sum of the months equaling the annual amount.
4. Prepare projections using a hybrid of all of the above.

Even in cases where the client or company has prepared detailed monthly
projections; there is still a good chance that the historic statements (annual and
interim) will require certain account adjustments (normalization or recasting)
which will not be included in the client’s projection. Accordingly, the hybrid
approach gives the analyst the flexibility to use the other three approaches as
appropriate for each account.

3.5.4 Preparing Monthly Projected Financial Statements for a Valuation

-2

It can be tempting to prepare a “naïve” annualization or monthly projection using

one of two different approaches. Under the first naïve approach, the annualization is
made by dividing the interim numbers by the number of months covered and then
multiplying by twelve. The other naïve option is to apply a “sales cycle” expressed as
a percentage of the total sales in relation to a given month. These monthly
percentages are then applied to all line items. Both of these produce very specious
results because they ignore business realities.

Elements of Monthly Projections

The key elements of a projection (including monthlies) are the collection of data, the
period covered, the base values for each line item, any observations about the
behavior of a given line item, determining the appropriate approach, and the
variables to be applied.

• Collect and Organize Data: The analyst needs to obtain the information
necessary to diligently prepare the projections. Information includes
financial statements, budgets, sales forecasts, market studies and any other
reliable source. The degree of information provided by management is going
to depend upon the reasons for the valuation and the party on whose behalf
it is being prepared.
• Period Covered: Monthly projections are most useful in the short-term. They
are useful to annualize an Interim Financial Statement and can provide
insights into the impact of seasonality, business cycles and growth patterns

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 upon the company’s earnings and financial position. It’s pretty much an
article of faith. Confidence in projections decreases as the number of
projected months increase.
• Base Values: Unless an analyst magically pulls numbers out of thin air
(which is not diligent or ethical), projection assumptions should have
continuity with the past and present. The analyst starts with the last value
for the line item and the changes to that value over the observable past. The
value could be as stated on the financial statement (historic or normalized) or
adjusted.
• Observing Line-Item Behavior and Relationships: A line-item value is not a
static number. It is the result of actions undertaken by the company. It has a
relationship to the other accounts. A company can have multiple revenue
sources each having its own cycle, inventory requirements, and the related
line item expenses. Some expenses follow sales, some follow a set budget,
some expenses are level or fixed. In addition, the company’s chart of
accounts is not set in stone and new accounts may need to be added. The
same applies to Balance Sheet line items.
• Determining the Appropriate Approach: The analyst next needs to
determine whether to use all or part of projections provided by the client, the
Top-Down approach, the Bottom-Up approach or a hybrid thereof. Different
approaches can be used for different line items based upon available data.
• Variable Application: Once the analyst has determined the period covered,
base values, the best approach and has a handle on the line items’ behavior
and relationship to the whole, it is appropriate to proceed to applying the
variable. The variable is usually a percentage (i.e., percentage of growth,
percentage of sales or percentage of wages) or a turnover rate (i.e., account
receivable turns, inventory turns and so on). Variables can change from
period-to-period.
In addition, there are a number of accounts that are calculated
independently such as depreciation, amortization, interest, and such.

Focus on Substance Instead of Process

The analyst can use a spreadsheet to prepare the monthly projections or a financial
modeling system like the one that is included with Corporate Valuation
Professional. Home-grown spreadsheets give the analyst maximum flexibility, but
require formula writing, link management, print control and usually lack a cohesive
interface. Every time a line item is added or deleted or a variable is changed,
formulae need to be re-written and the entire spreadsheet should be checked to
make sure that any dependencies have also been updated. As an alternative, a
system like Corporate Valuation Professional provides all of the formulae
management and presentation formatting so the analyst can focus his or her
attention on getting inside of the numbers and their implications.

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Closing Thoughts

It’s worth keeping in mind that by annualizing the interim statement and/or using
monthly projections, you are increasing the number of assumptions that can be
challenged by the opposing side of any controversy involving the valuation. In
addition, there may be an unspoken assumption that an analyst who prepares
monthly projections has exercised care and thought beyond the level required to
prepare annual projections. For that reason, diligence and care in the gathering and
use of data is advised, plus the analyst wants to clearly disclose the limitations of the
projections.

Furthermore, the analyst wants to make certain that the projections are not used or
construed to be representations or promises of any kind with respect to the
performance of the company. This is of special concern to brokers and
intermediaries who include projections of any kind as part of a selling
memorandum or presentation.

While monthly projections take additional time for data gathering, organizing and
application, the benefits are a deeper understanding of the business and its more
immediate financial ebb and flow. If properly prepared and used, monthly
projections can be an important component of a quality valuation.

Key points

1. Projected financial statements include an opening-day balance sheet,

projected income statements for at least three years, and a cash flow
projection.
2. Common accounting methods include the cash basis, the accrual basis, and
the completed-contract method.
3. The balance sheet compares the possessions of a company and the debts that
it owes on a specific day.
4. The opening-day balance sheet will closely correspond to the startup costs.
5. The projected income statement estimates sales, cost of goods sold, expenses,
and profit.
6. The calculation for cost of goods sold varies by industry.
7. The income statement for a corporation and proprietorship are different
because the owners’ salaries are recorded differently.
8. Cash flow projection estimates cash coming into the business and cash paid
out; profitable businesses may still have cash shortages due to seasonal
fluctuations and amounts due from customers that have not been collected.

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