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Financial Analysis
Financial analysis
Financial analysis is the process of evaluating businesses, projects, budgets and other finance-
related entities to determine their performance and suitability. Typically, financial analysis is
used to analyze whether an entity is stable, solvent, liquid or profitable enough to warrant a
monetary investment.
Financial analysis involves using financial data to assess a company’s performance and
make recommendations about how it can improve going forward. Financial
Analysts primarily carry out their work in Excel, using a spreadsheet to analyze historical
data and make projections of how they think the company will perform in the future. This
guide will cover the most common types of financial analysis performed by professionals.
Learn more in CFI’s Financial Analysis Fundamentals Course.
1. Vertical
2. Horizontal
3. Leverage
4. Growth
5. Profitability
6. Liquidity
7. Efficiency
8. Cash Flow
9. Rates of Return
10. Valuation
11. Scenario & Sensitivity
12. Variance
Comparative analysis
Describe comparative analysis as comparison analysis. Use comparison analysis to measure the
financial relationships between variables over two or more reporting periods. Businesses
use comparative analysis as a way to identify their competitive positions and operating results
over a defined period.
What is a Comparative Analysis?
A common size financial statement displays all items as percentages of a common base
figure rather than as absolute numerical figures. This type of financial statement allows for
easy analysis between companies or between time periods for the same company.
A common size financial statement displays all items as percentages of a common base figure
rather than as absolute numerical figures. This type of financial statement allows for easy
analysis between companies or between time periods for the same company. The values on the
common size statement are expressed as ratios or percentages of a statement component, such
as revenue.
While most firms don't report their statements in common size format, it is beneficial for analysts
to compute it to compare two or more companies of differing size or different sectors of the
economy. Formatting financial statements, in this way, reduces bias that can occur and allows for
the analysis of a company over various time periods, revealing, for example, what percentage of
sales is the cost of goods sold, and how that value has changed over time. Common size financial
statements commonly include the income statement, balance sheet, and cash flow statement.
As a result, analysts define the balance sheet as a percentage of assets. Another version of the
common size balance sheet shows asset line items as a percentage of total assets, liabilities as a
percentage of total liabilities and stockholders' equityas a percentage of total stockholders'
equity.
One version of the common size cash flow statement expresses all line items as a percentage
of total cash flow. The more popular version expresses cash flow in terms of total operational
cash flow for items in cash flows from operations, total investing cash flows for cash flows from
investing activities, and total financing cash flows for cash flows from financing activities.
Common Size Income Statement
The income statement (also referred to as the profit and loss (P&L) statement) provides an
overview of flows of sales, expenses, and net income during the reporting period. The income
statement equation is sales, minus expenses and adjustments, equals net income. This is why the
common size income statement defines all items as a percentage of sales. The term "common
size" is most often used when analyzing elements of the income statement, but the balance sheet
and the cash flow statement can also be expressed as a common size statement.
Fund flow analysis is the analysis of flow of fund from current asset to fixed asset or current
asset to long term liabilities or vice-versa. Fund refers to working capital. Funds flow
statement is an assertion of sources and uses of funds. It describes changes in net working
capital between two balance sheet dates.
Problem 1:
From the following information relating to A Ltd., prepare Funds Flow Statement:
Problem 2:
Ramco Cements presents the following information and you are required to calculate funds
from operations:
Problem 3:
The Balance Sheets of National Co. as on 31st December, 2003 and 31st December 2004 are
as follows:
Additional Information:
ADVERTISEMENTS:
(1) Rs. 50,000 depreciation has been charged on Plant and Machinery during 2004.
(2) A piece of Machinery was sold for Rs. 8,000 during the year 2004. It had cost Rs. 12,000;
depreciation of Rs. 7,000 had been provided on it.
Prepare a Schedule of changes in Working Capital and a Statement showing the Sources and
Application of Funds for 2004.
Problem 4:
From the following Balance Sheets of X Ltd. make out:
(i) Statement of Changes in Working Capital
(2) A piece of Machinery was sold for Rs. 8,000 during the year 2004. It had cost Rs. 12,000;
depreciation of Rs. 7,000 had been provided on it.
Prepare a Schedule of changes in Working Capital and a Statement showing the Sources and
Application of Funds for 2004.
Problem 4:
From the following Balance Sheets of X Ltd. make out:
(i) Statement of Changes in Working Capital
Problem 1:
From the following summary of Cash Account of X Ltd., prepare Cash Flow Statement for the
year ended 31st March 2007 in accordance with AS-3 using the direct method. The company
does not have any cash equivalents.
Problem 2:
Prepare Cash Flow Statement of Suryan Ltd. from the following:
Additional Information:
(a) During 2006, the business of a sole trader was purchased by issuing shares for Rs. 2, 00,000.
The assets acquired from him were: Goodwill Rs. 20,000, Machinery Rs. 1, 00,000, Stock Rs.
50,000 and Debtors Rs. 30,000.
(c) The debentures were issued at a premium of 5% which is included in the retained earnings.
Additional Information:
(a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged on Plant and Land and
Buildings in 2004.
The following points highlight the five main types of ratio analysis. The types
are: 1. Profitability Ratios 2. Coverage Ratios 3. Turnover Ratios 4. Financial
Ratios 5. Control Ratios.
Ratio Analysis:
Higher the ratio, the better it is. A low ratio indicates unfavorable trends in the form of reduction
in selling prices not accompanied by proportionate decrease in cost of goods or increase in cost
of production. The gross profit should be adequate to cover fixed expenses, dividends and
building up of reserves.
It is calculated as follows:
Lower the ratio, the better it is. Higher the ratio, the less favourable it is because it would have a
smaller margin of operating profit for the payment of dividends and the creation of reserves. This
ratio should be analysed further to throw light on levels of efficiency prevailing in different
elements of total cost.
Where
Operating profit ratio can also be calculated with the help of operating ratio as follows:
Operating Profit Ratio = 100 − Operating Ratio.
This ratio indicates the portion remaining out of every rupee worth of sales after all operating
costs and expenses have been met. Higher the ratio the better it is.
This is the ratio of net profit after taxes to net sales and is calculated as follows:
The ratio differs from the operating profit ratio in as much as it is calculated after deducting non
operating expenses, such as loss on sale of fixed assets etc., from operating profit and adding
non-operating income like interest or dividends on investments, profit on sale of investments or
fixed assets, etc., to such profit. Higher the ratio, the better it is because it gives idea of improved
efficiency of the concern.
It is calculated as under:
For example if the net profit before interest and tax is Rs.32,000 and interest charges are
Rs.4,000 then fixed interest cover will be 8 times (i.e., 32,000 ÷ 4,000). The higher the ratio, the
more secured the lenders will be in respect of their periodical interest income.
For example, if the profits after interest and tax are Rs.2,70,000 and dividend on preference
shares is Rs.27,000, the fixed dividend cover will be 10 times (i.e., Rs.2,70,000 ÷ Rs.27,000).
The higher the ratio, the greater are the profits. A low capital turnover ratio should be taken to
mean that sufficient sales are not being made and profits are lower.
Hence the management must strive for using total resources at optimum level, to achieve higher
RIO. This ratio expresses the number of times fixed assets are being turned-over in a stated
period.
Where,
Cost of Goods Sold = Opening Stock + Purchases + Manufacturing Expenses − Closing Stock or
Sales − Gross profit.
Suppose the cost of goods sold is Rs.4,50,000 and average stock is Rs.1,50,000. Then stock
turnover ratio will be 3 times i.e., 4,50,000 ÷ Rs 1,50,000).
It is calculated as follows:
This ratio is a measure of the collectability of accounts receivables and tells about how the credit
policy of the company is being enforced. Suppose, a company allows 30 days credit to its
customers and the ratio is 45; it is a cause of anxiety to the management because debts are
outstanding for a period of 45 days.
Efforts should be made to make the collection machinery efficient so that the amount due from
debtors may be realized in time.
Higher the ratio, more the chances of bad debts and lower the ratio, less the chances of bad debts.
Suppose in 2000 Debtors in the beginning Rs 40,000; Debtors at the end Rs.50,000; Credit sales
during the year Rs 2,25,000. The debtors’ turnover ratio will be calculated as under:
For example, if credit purchases during 1996 are Rs.2,00,000 and accounts payable on 1-1-2000
and 31-12-2000 are Rs.46,000 and Rs.34,000 respectively, then creditor’s turnover ratio will be 5
times
A high ratio indicates that creditors are not paid in time while a low ratio gives an idea that the
business is not taking full advantages of credit period allowed by the creditors.
Sometimes it is also required to calculate the average payment period (or average age of
payables or debt period enjoyed) to indicate the speed with which payments for credit purchases
are made to creditors. It is calculated as
Continuing the example already given, the average period of payables will be 73 days (i.e., 365
days ÷ 5).
Generally 2 : 1 is considered ideal for a concern i.e., current assets should be twice of the current
liabilities. If the current assets are two times of the current liabilities, there will be no adverse
effect on business operations when the payment of current liabilities is made.
Liquid assets are those assets which are readily converted into cash and will include cash
balances, bills receivable, sundry debtors and short-term investments. Inventories and prepaid
expenses are not included in liquid assets because the emphasis is on the ready availability of
cash in case of liquid assets.
Liquid liabilities include all items of current liabilities except bank overdraft. This ratio is the
‘acid test’ of a concern’s financial soundness.
The desirable norm for this ratio is 1 : 2, i.e., Rs.1 worth of absolute liquid assets are sufficient
for Rs.2 worth of current liabilities. Even though the ratio gives a more meaningful measure of
liquidity, it is not in much use because the idea of keeping a large cash balance or near cash
items has long since teen disproved. Cash balance yields no return and as such is barren.
It is calculated as follows:
Or
Shareholders’ funds consist of preference share capital, equity share capital, Profit & Loss A/c
(Cr. Balance), capital reserves, revenue reserves and reserves representing marked surplus, like
reserves for contingencies, sinking funds for renewal of fixed assets or redemption of debentures
etc. less fictitious assets.
Whether a given debt to equity ratio shows a favourable or unfavorable financial position of the
concern depends on the industry and the pattern of earning. A low ratio is generally viewed as
favourable from long-term creditors’ point of view, because a large margin of protection
provides safety for the creditors.
The same low ratio may be taken as quite unsatisfactory by the shareholders because they find
neglected opportunity for using low-cost outsiders’ funds to acquire fixed assets that could earn a
high return. Keeping in view the interest of both (shareholders and long-term creditors), debt to
equity ratio of 2: 1 in case of (i) and 2: 3 in case of (ii) is acceptable.
Solution:
i. Current Ratio:
It indicates better position as current assets are comparatively higher than current liabilities of a
similar industry. However, the current assets may be proportionately higher due to excessive
stock as had been reflected in ratio (3).
Illustration 2:
Make an assessment of the comparative positions of firms A, B and C after calculating relevant
ratios on the oasis of the following information for a year having assuming 360 days in a year.
Solution:
From the above we see the inventory turnover of firm A is better than of B and C. Firm C has the
lowest ratio, i.e., it has the slowest moving stock.
The average number of days credit allowed to customers is 72 days in firm A and 144 days in
firms C, which is just the double of A. It indicates that firm A is following a sound credit policy
whereas firm B and C are following a liberal policy. It is possible that firm B and C may have
given credit to weak customers and they are not making the payment in time.
Inventory turnover ratio and average collection period indicate that firm A is making an efficient
use of its working capital as compared to firm B and C. C’s position in this regard is the weakest.
This is because of the highest figure of management expenses. Firm B and C should try to curtail
the expenses of management and increase the inventory turnover ratio to make an improvement
in their performance.
Illustration 3:
Prepare Profit & Loss A/c and Balance Sheet from the following information:
Capital Rs.4,00,000; Working Capital Rs.1,80,000; Bank Overdraft Rs.30,000. There are no
fictitious assets. Current assets contain only stock, debtors and cash.
Solution:
Trend Analysis
A trend analysis is a method of analysis that allows traders to predict what will happen with a
stock in the future. Trend analysis is based on historical data about the stock's performance
given the overall trends of the market and particular indicators within the market.
Depreciation Methods
There are several types of depreciation expense and different formulas for determining the book
value of an asset. The most common depreciation methods include:
1. Straight-line
2. Double declining balance
Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful
life. In other words, it is the reduction of value in an asset over time due to usage, wear and tear,
or obsolescence. The four main depreciation methods mentioned are explained in detail below.