Key pointers to balance sheet and profit and loss statements:

 A balance sheet represents the financial affairs of the company and is also referred
to as “Assets and Liabilities” statement and is always as on a particular date and
not for a period.

 A profit and loss account represents the summary of financial transactions during
a particular period and depicts the profit or loss for the period along with income
tax paid on the profit and how the profit has been allocated (appropriated).

 Net worth means total of share capital and reserves and surplus. This includes
preference share capital unlike in Accounts preference share capital is treated as a
debt. For the purpose of debt to equity ratio, the necessary adjustment has to
be done by reducing preference share capital from net worth and adding it to
the debt in the numerator.

 Reserves and surplus represent the profit retained in business since inception of
business. “Surplus” indicates the figure carried forward from the profit and loss
appropriation account to the balance sheet, without allocating the same to any
specific reserve. Hence, it is mostly called “unallocated surplus”. The company
wants to keep a portion of profit in the free form so that it is available during the next
year for appropriation without any problem. In the absence of this arrangement
during the year of inadequate profits, the company may have to write back a part of
the general reserves for which approval from the board and the general members
would be required.

 Secured loans represent loans taken from banks, financial institutions, debentures
(either from public or through private placement), bonds etc. for which the company
has mortgaged immovable fixed assets (land and building) and/or hypothecated
movable fixed assets (at times even working capital assets with the explicit
permission of the working capital banks)

Usually, debentures, bonds and loans for fixed assets are secured by fixed
assets, while loans from banks for working capital, i.e., current assets are
secured by current assets. These loans enjoy priority over unsecured loans
for settlement of claims against the company.

 Unsecured loans represent fixed deposits taken from public (if any) as per the
provisions of Section 58 (A) of The Companies Act, 1956 and in accordance with
the provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from
promoters, friends, relatives etc. for which no security has been offered.

Such unsecured loans rank second and subsequent to secured loans for
settlement of claims against the company. There are other unsecured
creditors also, forming part of current liabilities, like, creditors for purchase of
materials, provisions etc.

 Gross block = gross fixed assets mean the cost price of the fixed assets.
Cumulative depreciation in the books is as per the provisions of The Companies
Act, 1956, Schedule XIV. It is last cumulative depreciation till last year +
 depreciation claimed during the current year. Net block = net fixed assets mean the
depreciated value of fixed assets.

 Capital work-in-progress – This represents advances, if any, given to building

contractors, value of building yet to be completed, advances, if any, given to
equipment suppliers etc. Once the equipment is received and the building is
complete, the fixed assets are capitalised in the books, for claiming depreciation
from that year onwards. Till then, it is reflected in the form of capital work in
progress.

 Investments – Investment made in shares/bonds/units of Unit Trust of India etc. This

type of investment should be ideally from the profits of the organisation and not from
any other funds, which are required either for working capital or capital expenditure.
They are bifurcated in the schedule, into “quoted and traded” and “unquoted and not
traded” depending upon the nature of the investment, as to whether they can be
liquidiated in the secondary market or not.

 Current assets – Both gross and net current assets (net of current liabilities) are
given in the balance sheet.

 Miscellaneous expenditure not written off can be one of the following –

Company incorporation expenses or public issue of share capital, debenture etc.
together known as “preliminary expenses” written off over a period of 5 years as per
provisions of Income Tax. Misc. expense could also be other deferred revenue
expense like product launch expenses.

 Other income in the profit and loss account includes income from dividend on share
investment made in other companies, interest on fixed deposits/debentures, sale
proceeds of special import licenses, profit on sale of fixed assets and any other
sundry receipts.

 Provision for tax could include short provision made for the earlier years.

 Provision for tax is made after making all adjustments for the following:

• Carried forward loss, if any;

• Book depreciation and depreciation as per income tax and
• Concessions available to a business entity, depending upon their activity (export
business, S.S.I. etc.) and location in a backward area (like Goa etc.)

 As per the provisions of The Companies Act, 1956, in the event of a limited
company declaring dividend, a fixed percentage of the profit after tax has to be
transferred to the General Reserves of the Company and entire PAT cannot be
given as dividend.

 With effect from 01/04/02, dividend tax on dividends paid by the company has been
withdrawn. From that date, the shareholders are liable to pay tax on dividend
income. Thus for a period of 5 years, the position was different in the sense that the
company was bearing the additional tax on dividend.
 Other parts of annual statements –

1. The Directors’ Report on the year passed and the future plans;

2. Annexure to the Directors’ Report containing particulars regarding conservation of

energy etc;

3. Auditors’ Report as per the Manufacturing and Other Companies (Auditors’ Report)
Order, 1998) along with Annexure;

4. Schedules to Balance Sheet and Profit and Loss Account;

5. Accounting policies adopted by the company and notes on accounts giving details
about changes if any, in method of valuation of stocks, fixed assets, method of
depreciation on fixed assets, contingent liabilities, like guarantees given by the
banks on behalf of the company, guarantees given by the company, quantitative
details regarding performance of the year passed, foreign exchange inflow and
outflow etc. and
6. Statement of cash flows for the same period for which final accounts have been
presented.

There is a significant difference between the way in which the statements of accounts
are prepared as per Schedule VI of the Companies Act and the manner in which these
statements, especially, balance sheet is analysed by a finance person or an analyst.
For example, in the Schedule VI, the current liabilities are netted off against current
assets and only net current assets are shown. This is not so in the case of financial
statement analysis. Both are shown fully and separately without any netting off.

At the end of any financial year, there are certain adjustments to be made in the books
of accounts to get the proper picture of profit or loss, as the case may be, for that
particular period. For example, if stocks of raw materials are outstanding at the end of
the period, the value of the same has to be deducted from the total of the opening stock
(closing stock of the previous year) and the current year’s purchases. This alone would
show the correct picture of materials consumed during the current year.

For example, the figures for a company are as under:

♦ Purchases during the year: Rs.600lacs
♦ Opening stock of raw material: Rs.100lacs
♦ Closing stock of raw material: Rs.120lacs

Then, the quantum of raw material consumed during the year is Rs.580lacs and only
this can be booked as expenditure during the year. Consumption is always valued in
this manner and cross verified with the value of materials issued from stores during the
year to compare with the previous year;

Similarly, a second adjustment arises due to the difference between closing stocks of
work-in-progress and finished goods on one hand and opening stocks of work-in-
progress and finished goods on the other hand. Suppose the closing stocks are higher
in value, the difference has to be either added to this year’s income or deducted from
this year’s expense. (Different ways of presentation). Similarly in case the closing
stocks are less than the opening stocks, the difference has to be deducted from income
or added to expenses for that year. Let us study the following example.

In a company, the opening stocks were Rs.100lacs and closing stocks are Rs.120lacs.
This means that during the course of this year, the stocks on hand have gone up by
Rs.20lacs from the goods produced during this year. This does have an effect on the
profit of the company. The company cannot book expenditure incurred on producing
this incremental stock of Rs.20lacs, as they have not sold the goods. However the
materials and other expenses have already been incurred and hence this value is
deducted.

The basic assumption is that the carry forward stocks have been sold during the current
year while at the end of the current year fresh stocks worth Rs.120lacs have come in
for stocking. Hence, on an ongoing basis, opening stocks are added and closing
stocks are deducted. In the above example, the effect of adding the opening stock and
deducting the closing stock would be as under:

Let us assume the production for the year was Rs.1000lacs

Then, sales for the year could only be Rs.980lacs derived as follows:

Production during the year: Rs.1000lacs

Add: Opening stock: Rs. 100lacs
Deduct: Closing stock: Rs. 120lacs
Sales for the year: Rs. 980lacs.

On the other hand, in case the closing stocks would have been Rs.90lacs, the sales
would have been Rs.1010lacs, more than the production value. Thus, the difference
between the opening and closing stocks of work-in-progress and finished goods affects
income and thereby profit. The companies always use this as a tool, either to increase
or decrease income. In case they show more closing stocks, income is less and
thereby profit is less and tax is saved and similarly if they show less closing stocks,
income is more and profit is also more.

The principal tools of analysis are –

♦ Ratio analysis – i.e. to determine the relationship between any set of two
parameters and compare it with the past trend. In the statements of accounts, there
are several such pairs of parameters and hence ratio analysis assumes great
significance. The most important thing to remember in the case of ratio
analysis is that you can compare two units in the same industry only and
other factors like the relative ages of the units, the scales of operation etc.
come into play.

♦ Funds flow analysis – this is to understand the movement of funds (please note the
difference between cash and fund – cash means only physical cash while funds
include cash and credit) during any given period and mostly this period is 1 year.
This means that during the course of the year, we study the sources and uses of
funds, starting from the funds generated from activity during the period under
review.

Let us see some of the important types of ratios and their significance:
♦ Liquidity ratios;
♦ Turnover ratios;
♦ Profitability ratios;
♦ Investment on capital/return ratios;
♦ Leverage ratios and
♦ Coverage ratios.

Liquidity ratios:

o Current ratio: Formula = Current assets/Current liabilities.

Min. Expected even for a new unit in India = 1.33:1.

Significance = Net working capital should always be positive. In short, the higher
the net working capital, the greater is the degree of overall short-term liquidity.
Means current ratio does indicate liquidity of the enterprise.
Too much liquidity is also not good, as opportunity cost is very high of holding such
liquidity. This means that we are carrying either cash in large quantities or inventory
in large quantities or receivables are getting delayed. All these indicate higher
costs. Hence, if you are too liquid, you compromise with profits and if your liquidity
is very thin, you run the risk of inadequacy of working capital.

Range – No fixed range is possible. Unless the activity is very profitable and there
are no immediate means of reinvesting the excess profits in fixed assets, any
current ratio above 2.5:1 calls for an examination of the profitability of the operations
and the need for high level of current assets. Reason = net working capital could
mean that external borrowing is involved in this and hence cost goes up in
maintaining the net working capital. It is only a broad indication of the liquidity
of the company, as all assets cannot be exchanged for cash easily and hence
for a more accurate measure of liquidity, we see “quick asset ratio” or “acid
test ratio”.

o Acid test ratio or quick asset ratio:

Quick assets = Current assets (-) Inventories which cannot be easily converted into
cash. This assumes that all other current assets like receivables can be converted
into cash easily. This ratio examines whether the quick assets are sufficient to
cover all the current liabilities. Some of the authors indicate that the entire current
liabilities should not be considered for this purpose and only quick liabilities should
be considered by deducting from the current liabilities the short-term bank
borrowing, as usually for an on going company, there is no need to pay back this
amount, unlike the other current liabilities.

Significance = coverage of current liabilities by quick assets. As quick assets are a

part of current assets, this ratio would obviously be less than current ratio. This
directly indicates the degree of excess liquidity or absence of liquidity in the
system and hence for proper measure of liquidity, this ratio is preferred. The
minimum should be 1:1. This should not be too high as the opportunity cost
associated with high level of liquidity could also be high.
 What is working capital gap? The difference between all the current assets
known as “Gross working capital” and all the current liabilities other than “bank
borrowing”. This gap is met from one of the two sources, namely, net working
capital and bank borrowing. Net working capital is hence defined as medium and
long-term funds invested in current assets.

Turn over ratios:

Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the
higher the degree of efficiency and hence these assume significance. Further,
depending upon the type of turn over ratio, indication would either be about liquidity
or profitability also. For example, inventory or stocks turn over would give us a
measure of the profitability of the operations, while receivables turn over ratio would
indicate the liquidity in the system.

o Debtors turn over ratio – this indicates the efficiency of collection of

receivables and contributes to the liquidity of the system. Formula = Total credit
sales/Average debtors outstanding during the year. Hence the minimum would
be 3 to 4 times, but this depends upon so many factors such as, type of
industry like capital goods, consumer goods – capital goods, this would be less
and consumer goods, this would be significantly higher;
Conditions of the market – monopolistic or competitive – monopolistic, this would be
higher and competitive it would be less as you are forced to give credit;

Whether new enterprise or established – new enterprise would be required to give

higher credit in the initial stages while an existing business would have a more fixed
credit policy evolved over the years of business;
Hence any deterioration over a period of time assumes significance for an existing
business – this indicates change in the market conditions to the business and this
could happen due to general recession in the economy or the industry specifically
due to very high capacity or could be this unit employs outmoded technology, which
is forcing them to dump stocks on its distributors and hence realisation is coming in
late etc.

o Average collection period = inversely related to debtors turn over ratio. For
example debtors turn over ratio is 4. Then considering 360 days in a year, the average
collection period would be 90 days. In case the debtors turn over ratio increases, the
average collection period would reduce, indicating improvement in liquidity. Formula
for average collection period = 360/receivables turn over ratio. The above points for
debtors turn over ratio hold good for this also. Any significant deviation from the past
trend is of greater significance here than the absolute numbers. No minimum and no
maximum.

o Inventory turn over ratio – as said earlier, this directly contributes to the
profitability of the organisation. Formula = Cost of goods sold/Average inventory
held during the year. The inventory should turn over at least 4 times in a year,
even for a capital goods industry. But there are capital goods industries with a
very long production cycle and in such cases, the ratio would be low. While
receivables turn over contributes to liquidity, this contributes to profitability due to
higher turn over. The production cycle and the corporate policy of keeping high
 stocks affect this ratio. The less the production cycle, the better the ratio and
vice-versa. The higher the level of stocks, the lower would be the ratio and vice-
versa. Cost of goods sold = Sales – profit – Interest charges.

o Current assets turn over ratio – not much of significance as the entire current
assets are involved. However, this could indicate deterioration or improvement
over a period of time. Indicates operating efficiency. Formula = Cost of goods
sold/Average current assets held in business during the year. There is no min.
Or maximum. Again this depends upon the type of industry, market conditions,
management’s policy towards working capital etc.

o Fixed assets turn over ratio

Not much of significance as fixed assets cannot contribute directly either to
liquidity or profitability. This is used as a very broad parameter to compare two
units in the same industry and especially when the scales of operations are quite
significant. Formula = Cost of goods sold/Average value of fixed assets in the
period (book value).

Profitability ratios -Profit in relation to sales and profit in relation to assets:

o Profit in relation to sales – this indicates the margin available on sales;

o Profit in relation to assets – this indicates the degree of return on the capital
employed in business that means the earning efficiency. Please appreciate that
these two are totally different.

For example, we will study the following;

Units A and B are in the same type of business and operate at the same levels of
capacities. Unit A employs capital of 250 lacs and unit B employs capital of
200lacs. The sales and profits are as under:

Parameter Unit A Unit B

Sales 1000lacs 1000lacs
Profits 100lacs 90lacs
Profit margin on sales 10% 9%
Return on capital employed 40% 45%
While Unit A has higher profit margins, Unit B has better returns on capital
employed.

o Profit margin on sales:

Gross profit margin on sales and net profit margin ratio –

Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-)
Cost of production before selling, general, administrative expenses and interest
charges. Net sales = Gross sales (-) Excise duty. This indicates the efficiency of
production and serves well to compare with another unit in the same industry or in
the same unit for comparing it with past trend. For example in Unit A and Unit B let
us assume that the sales are same at Rs.100lacs.
 Parameter Unit AUnit B

Sales 100lacs 100lacs

Cost of production 60lacs 65lacs
Gross profit 40lacs 35lacs
Deduct: Selling general,
Administrative expenses and interest 35lacs 30lacs
Net profit 5lacs 5lacs

While both the units have the same net profit to sales ratio, the significant difference
lies in the fact that while Unit A has less cost of production and more office and
selling expenses, Unit B has more cost of production and less of office and selling
expenses. This ratio helps in controlling either production costs if cost of production
is high or selling and administration costs, in case these are high.

Net profit/sales ratio – net profit means profit after tax but before distribution in any
form = Formula = Net profit/net sales. Tax rate being the same, this ratio indicates
operating efficiency directly in the sense that a unit having higher net profitability
percentage means that it has a higher operating efficiency. In case there are tax
concessions due to location in a backward area, export activity etc. available to one
unit and not available to another unit, then this comparison would not hold well.

Investment on capital ratios/Earnings ratios:

o Return on net worth

Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds
including Preference Share capital. Hence Preference Share capital is not
deducted. There is no standard range for this ratio. If it reduces it indicates less
return on the net worth.

o Return on equity
Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth –
Preference share capital. Although reference is equity here, all equity
shareholders’ funds are taken in the denominator. Hence Preference dividend
and Preference share capital are excluded. There is no standard range for this
ratio. If it comes down over a period it means that the profitability of the
organisation is suffering a setback.

o Return on capital employed (pre-tax)

Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term
liabilities. This gives return on long-term funds employed in business in pre-tax
terms. Again there is no standard range for this ratio. If it reduces, it is a cause
for concern.

o Earning per share (EPS)

Dividend per share (DPS) + Retained earnings per share (REPS). Here the
share refers to equity share and not preference share. The formula is = Profit
after tax (-) Preference dividend (-) Dividend tax both on preference and equity
dividend / number of equity shares. This is an important indicator about the
 return to equity shareholder. In fact P/E ratio is related to this, as P/E ratio is the
relationship between “Market value” of the share and the EPS. The higher the
PE the stronger is the recommendation to sell the share and the lower the PE,
the stronger is the recommendation to buy the share.

This is only indicative and by and large followed. There is something known as
industry average EPS. If the P/E ratio of the unit whose shares we contemplate
to purchase is less than industry average and growth prospects are quite good, it
is the time for buying the shares, unless we know for certain that the price is
going to come down further. If on the other hand, the P/E ratio of the unit is more
than industry average P/E, it is time for us to sell unless we expect further
increase in the near future.

Leverage ratios

Leverages are of two kinds, operating leverage and financial leverage. However,
we are concerned more with financial leverage. Financial leverage is the
advantage of debt over equity in a capital structure. Capital structure indicates
the relationship between medium and long-term debt on the one hand and equity
on the other hand. Equity in the beginning is the equity share capital. Over a
period of time it is net worth (-) redeemable preference share capital.

It is well known that EPS increases with increased dose of debt capital within the
same capital structure. Given the advantage of debt also, as even risk of default,
i.e., non-payment of interest and non-repayment of principal amount increases
with increase in debt capital component, the market accepts a maximum of 2:1
at present. It can be less. Formula for debt/equity ratio = Medium and long-term
loans + redeemable preference share capital / Net worth (-) Redeemable
preference share capital.

From the working capital lending banks’ point of view, all liabilities are to be
included in debt. Hence all external liabilities including current liabilities are taken
into account for this ratio. We have to add redeemable preference share capital
and reduce from the net worth the same as in the previous formula.

Coverage ratios

o Interest coverage ratio

This indicates the number of times interest is covered by EBIT. Formula = EBIT /
Interest payment on all loans including short-term liabilities. Minimum acceptable
is 2 to 2.5:1. Less than that is not desirable, as after paying interest, tax has to
be paid and afterwards dividend and dividend tax.

o Asset coverage ratio

This indicates the number of times the medium and long-term liabilities are
covered by the book value of fixed assets.
Formula = Book value of Fixed assets / Outstanding medium and long-term
liabilities. Accepted ratio is minimum 1.5:1. Less than that indicates inadequate
coverage of the liabilities.
 o Debt Service coverage ratio
This indicates the ability of the business enterprise to service its borrowing,
especially medium and long-term. Servicing consists of two aspects namely,
payment of interest and repayment of principal amount. As interest is paid out of
income and booked as an expense, in the formula it gets added back to profit
after tax. The assumption here is that dividend is ignored. In case dividend is
paid out, the formula gets amended to deduct from PAT dividend paid and
dividend tax.

Formula is:
(Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue Expenditure
written off (+) Interest on medium and long-term borrowing
(Denominator) Interest on medium and long-term borrowing (+) Installment on
medium and long-term borrowing.

This is assuming that dividend is not paid. In the case of an existing company
dividend will have to be paid and hence in the numerator, instead of PAT,
retained earnings would appear. The above ratio is calculated for the entire
period of the loan with the bank/financial institution. The minimum acceptable
average for the entire period is 1.75:1. This means that in one year this could be
less but it has to be made up in the other years to get an average of 1.75:1.

What is the objective behind analysis of financial statements?

Objective (To know about) Relevant indicator/Remarks

1. Financial position of the company
Net worth, i.e., share capital, reserves
and unallocated surplus in balance sheet
carried down from profit and loss
appropriation account. For a healthy
company, it is necessary that there is a
balance struck between dividend paid
and profit retained in business so much
the net worth keeps on increasing.

2. Liquidity of the company, i.e.,
whether the company is in a position
to meet all its short-term liabilities
(also called “current liabilities”) with
the help of its current assets
Current ratio and quick ratio or acid test
ratio. Current ratio = Current
assets/current liabilities. Quick ratio =
Current assets (-) inventory/ current
liabilities. Current ratio should not be too
high like 4:1 or 5:1 or too low like less
than 1.5:1. This means that the
company is either too liquid thereby
increasing its opportunity cost or not
liquid at all, both of which are not
desirable. Quick ratio could be at least
1:1. Quick ratio is a better indicator of
liquidity position.
3. Whether the company has
acquired new fixed assets during the
year and if so, what are the sources,
besides internal accruals to finance
the same?
4. Profitability of the company in
general and operating profits in
particular, i.e., whether the main
operations of the company like
manufacturing have been in profit or
the profit of the company is derived
from other income, i.e., income from
investment in shares/debentures etc.
5. Relationship between the net
worth of the company and its external
liabilities (both short-term and long-
term). What about only medium and
long-term debts?
Examination of increase in secured or
unsecured loans for this purpose.
Without adequate financial planning,
there is always the risk of diverting
working capital funds for fixed assets.
This is best assessed through a funds
flow statement for the period as even net
cash accruals (Retained earnings +
depreciation + amortisation) would be
available for fixed assets.
Percentage of profit before tax to total
income including other income, like
dividend or interest income. Operating
profit, i.e., profit before tax (-) other
income as above as a percentage of
income from the main operations of the
company, be it manufacturing, trading or
services.
Debt/Equity ratio, which establishes this
relationship. Formula = External
liabilities + preference share capital /net
worth of the company (-) preference
share capital (redeemable kind). From
the lender’s point of view, this should not
exceed 3:1. Is there any sharp
deterioration in this ratio? Is so, please
be on guard, as the financial risk for the
company increases to that extent.
For only medium and long-term debts, it
cannot exceed 2:1.
6. Has the company’s investments in
shares/debentures of other
companies reduced in value in
comparison with last year?
7. Relationship between average
debtors (bills receivable) and average
creditors (bills payable) during the
year.
8. Future plans of the company, like
acquisition of new technology,
entering into new collaboration
agreement, diversification
programme, expansion programme
etc.
9. Has the company revalued its Auditors’ comments in the “Notes to
fixed assets during the year, thereby Accounts” relevant for this. Frequent
creating revaluation reserves, without revaluation is not desirable and healthy.
any inflow of capital into the
company, as this is just an entry
passed in the books?
Difference between the market value of
the investments and the purchase price,
which is theoretically a loss in value of
the investment. Actual loss is booked
upon only selling. The periodic reduction
every year should warn us that at the
time of actual sales, there would be
substantial loss, which immediately
would reduce the net worth of the
company. Banks, Financial Institutions,
Investment companies or NBFCs would
be required to declare their investment
every year in the balance sheet at cost
price or market price whichever is less.
Average debtors in the year/average
creditors in the year. This should be
greater than 1:1, as bills receivable are at
gross value {cost of development (+)
profit margin}, whereas; creditors are at
purchase price for software or
components, which would be much less
than the final sales value. If it is less
than 1:1, it shows that while receivable
management is quite good, the company
is not paying its creditors, which could
cause problems in future. Too high a
ratio would indicate that receivable
management is very poor.
Directors’ report. This would reveal the
financial plans for the company, like
whether they are coming out with a
public issue/Rights issue etc.
10. Whether the company has
increased its investment and if so,
what is the source for it? What is the
nature of investment? Is it in tradable
securities or long-term
Securities, which can have a lock-in-
period and cannot be liquidated in the
near future?
Increase in amount of investment in
shares/debentures/Govt. securities etc.
in comparison with last year and any
investment within group companies?
Any undue increase in investment should
put us on guard, as working capital funds
could have been diverted for it.

11. Has the company during the year Any increase in unsecured loans. If the
given any unsecured loans loans are to group companies, then all
substantially other than to employees the more reason to be cautious. Hence,
of the company? where the figures have increased, further
probing is called for.

12. Are the company’s unsecured Any comments to this effect in the notes
loans (given) not recoverable and to accounts should put us on caution.
very old? This examination would indicate about
likely impact on the future profits of the
company.

13. Has the company been regular in
payment of its dues on account of
loans or periodic interest on its
liabilities?
Any comments about over dues as in the
“Notes to Accounts” should be looked
into. Any serious default is likely to affect
the “credit rating” of the company with its
lenders, thereby increasing its cost of
borrowing in future.

14. Has the company defaulted in Any comments about this in the “Notes to
providing for bonus liability, P.F. Accounts” should be looked into.
liability, E.S.I. liability, gratuity
liability etc?

15. Whether the company is holding Cash balance together with bank balance
very huge cash, as it is not desirable in current account, if any, is very high in
and increases the opportunity cost? the current assets.

16. How many times the average Relationship between cost of goods sold
inventory has turned over during the and average inventory during the year
year? (only where cost of goods sold cannot be
 determined, net sales can be taken as
the numerator). In a manufacturing
company, which is not in capital goods
sector, this should not be less than 4:1
and for a consumer goods industry, this
should be higher even. For a capital
goods industry, this would be less.

17. Has the company issued fresh Increase in paid-up capital in the balance
share capital during the period and sheet and share premium reserves in
what is the purpose for which it has case the issue has been at a premium.
raised equity capital? If it was a
public issue, how did it fare in the
market?

18. Has the company issued any Increase in paid-up capital and
bonus shares during the year? simultaneous reduction in general
reserves. Enquiry into the company’s
ability to keep up the dividend rate of the
immediate past.

19. Has the company made any rights Increase in paid-up capital and share
issue in the period and what is the premium reserves, in case the issue has
purpose of the issue? If it was a been at a premium.
public issue, how did it fare in the
market?

20. What is the proportion of Percentage of marketable investment to

marketable investment to total
investment and whether this has
decreased in comparison with the
previous year?
total investment and comparison with
previous year. Any decrease should put
us on guard, as it reduces liquidity on
one hand and increases the risk of non-
payment on due date, especially if the
investment is in its own subsidiary or
group companies, thereby forcing the
company to provide for the loss.

21. What is the increase in sales Comparison with previous year’s sales
income over last year in % terms? Is income and whether the growth has been
it due to increase in numbers or more or less than the estimate.
change in product mix or increase in
prices of finished products only?

22. What is the amount of provision In percentage terms, how much is it of

for bad and doubtful debts or total debts outstanding and what are the
advances outstanding? reasons for such provision in the notes to
accounts by the auditors?

23. What is the amount of work in Is there any comment about valuation of
progress as shown in the Profit and work in progress by the auditors? It can
Loss Account? be seen that profit from operations can
be manipulated by increase/decrease in
closing stocks of both finished goods and
work in progress.

24. Whether the company is paying Examination of expenses schedule would

any lease rentals and if so what is the show this. What is the comment in notes
amount of lease liability outstanding? to accounts about this? Lease liability is
an off-balance sheet item and hence this
examination, to ascertain the correct
external liability and to include the lease
rentals in future also in projected income
statements; otherwise, the company may
be having much less disclosed liability
and much more lease liability which is
not disclosed. This has to be taken into
consideration by an analyst while
estimating future expenses for the
purpose of estimating future profits.

25. Has the company changed its Auditors’ comments on “Accounting”

method of depreciation on fixed
assets, due to which, there is an
impact on the profits of the company?
policies. Change over from straight-line
method to written down value method or
vice-versa does affect the deprecation
charge for the year thereby affecting the
profits during the year of change.

26. If it is a manufacturing company, Relationship between materials

whether the % of materials consumed consumed during the year and the sales.
is increasing in relation to sales?

27. Has the company changed its Auditors’ comments on “Accounting”

method of valuation of inventory, due policies.
to which there is an impact of the
profits of the company?

28. Whether the % of administration Relationship between general and

and general expenses has increased administrative expenses during the year
during the year under review? and the sales. In case there is any
extraordinary increase, what are the
reasons therefore?

29. Whether the company had Interest coverage ratio = earnings before
sufficient income to pay the interest interest and tax/total interest on all short-
charges? term and long-term liabilities. Minimum
should be 3:1 and anything less than this
is not satisfactory.

30. Whether the finance charges have
gone up disproportionately as
compared with the increase in sales
income during the same period?
Relationship between interest charges
and sales income – whether it is
consistent with the previous year or is
there any spurt?
Is there any explanation for this, like
substantial expansion or new project or
diversification for which the company has
taken financial assistance? While a
benchmark % is not available, any level
in excess of 6% calls for examination.

31. Whether the % of employee costs Relationship between “payment to and

to sales has increased?
provision for employees” and the sales.
In case any undue increase is seen, it
could be due to expansion of activity etc.
that would be included in the Directors’
Report.

32. Whether the % of selling Relationship between “selling and

expenses in relation to sales has marketing” expenses and the sales. Any
gone up? undue increase could either mean that
the company is in a very competitive
industry or it is aggressive to increase its
market share by adopting a marketing
strategy that would increase the
marketing expenses including offer of
higher commission to the intermediaries
like agents etc.

33. Whether the company had Debt service coverage ratio = Internal
sufficient internal accruals {Profit after accruals (+) interest on medium and
tax (-) dividend (+) any non-cash long-term external liabilities/interest on
expenditure like depreciation, medium and long-term liabilities (+)
preliminary expenses write-off etc.} to repayment of medium and long-term
meet repayment obligation of external liabilities. The term-lending
principal amount of loans, debentures institution or bank looks for 1.75:1 on an
etc.? average for the loan period. This is a
very critical ratio to indicate the ability of
the company to take care of its obligation
towards the loans it has taken both by
way of interest as well as repayment of
the principal.

34. Return on investment in business Earnings before interest and tax/average

to compare it with return on similar total invested capital, i.e., net worth (+)
investment elsewhere. debt capital. This should be higher than
the average cost of funds in the form of
loans, i.e., interest cost on
loans/debentures etc.

35. Return on equity (includes Profit after tax (-) dividend on preference
reserves and surplus) share capital/net worth (-) preference
share capital (return in percentage).
Anything less than 15% means that our
investment in this company is earning
less than the average return in the
market.

36. How much earning has our share Profit after tax (-) dividend on preference
made? (EPS) share capital/number of equity shares. In
terms of percentage anything less than
40% to 50% of the face value of the
shares would not go well with the market
sentiments.

37. Whether the company has Relationship between amount of dividend

reduced its dividend payout in payout and profit after tax last year and
comparison with last year? this year. Is there any reason for this like
liquidity crunch that the company is
experiencing or the need for conserving
cash for business activity, like purchase
of fixed assets in the immediate future?
 38. Is there any significant increase in “Notes on Accounts” as given at the end
the contingent liabilities due to any of of the accounts.
the following? Any substantial increase especially in
Disputed central excise duty, customs disputed amount of duties should put us
duty, income tax, octroi, sales tax, on guard.
contracts remaining unexecuted,
guarantees given by the banks on
behalf of the company as well as the
guarantees given by the company on
behalf of its subsidiary or associate
company, letter of credit outstanding
for which goods not yet received etc.

39. Has the company changed its Substantial change in vendor charges, or
policy of outsourcing its work from subcontracting charges.
vendors and if so, what are the
reasons?

40. Is there any substantial increase Increase in consultancy charges.

in charges paid to consultants?

41. Has the company opened any Directors’ Report or sudden spurt in
branch office in the last year? general and administration expenses.

The principal tools of analysis are:

♦ Ratio analysis – i.e. to determine the relationship between any set of two
parameters and compare it with the past trend. In the statements of accounts, there
are several such pairs of parameters and hence ratio analysis assumes great
significance. The most important thing to remember in the case of ratio
analysis is that you can compare two units in the same industry only and
other factors like the relative ages of the units, the scales of operation etc.
come into play.

♦ Comparison with past trend within the same company is one type of analysis and
comparison with the industrial average is another analysis

While one can derive a lot of useful information from analysis of the financial
statements, we have to keep in mind some of the limitations of the financial
statements. Analysis of financial statements does indicate a definite trend,
though not accurately, due to the intrinsic nature of the data itself.
Some of the limitations of the financial statements are given below.

 Analysis and understanding of financial statements is only one of the tools in

understanding of the company
 The annual statements do have great limitations in their value, as they do not speak
about the following-
 Management, its strength, inadequacy etc.
 Key personnel behind the activity and human resources in the organisation.
 Average key ratios in the industry in the country, of which the company is an integral
part. This information has to be obtained separately.
 Balance sheet is as on a particular date and hence it does not indicate about the
average for the entire year. Hence it cannot indicate the position with 100%
reliability. (Link it with fundamental analysis.)
 The auditors’ report is based more on information given by the management,
company personnel etc.
 To an extent at least, there can be manipulation in the level of expenditure, level of
closing stocks and sales income to manipulate profits of the organisation,
depending upon the requirement of the management during a particular year.
 One cannot come to know from study of financial statements about the tax planning
of the company or the basis on which the company pays tax, as it is not mandatory
under the provisions of The Companies’ Act, 1956, to furnish details of tax paid in
the annual statement of accounts.

Notwithstanding all the above, continuous study of financial statements relating

to an industry can provide the reader and analyst with an in-depth knowledge of
the industry and the trend over a period of time. This may prove invaluable as a
tool in investment decision or sale decision of shares/debentures/fixed deposits
etc.
*** End of handout ***