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# Analytical techniques used Horizontal analysis Trend analysis Common size statement Ratios

## 3,500.00 3,000.00 2,500.00

2,000.00
Total Income 1,500.00 1,000.00 500.00 Total Expenditure Operating Profit

## Basics of Financial Statement Analysis

Analyzing financial statements involves:
Characteristics Comparison Bases Tools of Analysis

Liquidity
Profitability Solvency

Intracompany
Industry averages Intercompany

Horizontal
Trend Vertical

Efficiency

Ratio

Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. Ratios include the i. Net Working Capital ii. Current ratio iii. Acid-test ratio, iv. Turnover ratios v. Defensive interval ratio and vii. Cash flow from operation ratio

## Net working capital = Current Assets- Current Liabilities

Current Assets Represent those assets which can be converted into cash within a short period of time, normally not exceeding one year and include Cash, Bank balance, Marketable securities, Inventories, Debtors, Bills receivables and Prepaid expenses

Current Liabilities Represent those which are short-term maturing obligations to be met within a year. Consist of Trade creditors, Bills payable, Bank credit, Short term provisions and Outstanding expenses

## Details Total current assets

Total current Liabilities

Company X 2,40,000
1,50,000

Company Y 50,000
20,000

## Net working capital (CA-CL)

90,000

30,000

Current Ratio:

It is the relationship between the current assets and current liabilities of a concern. This ratio must be at least 2 : 1 to ensure minimum margin of 25% of current assets as margin from long term sources
Current Ratio = Current Assets/Current Liabilities

ACID TEST or QUICK RATIO: It is the ratio between Quick Current Assets and Current Liabilities. The should be at least equal to 1 Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Cash Debtors Inventories Current Liabilities Total Current Assets Current Ratio Quick Ratio => =>

## 50,000 1,00,000 1,50,000 1,00,000 3,00,000 3,00,000/1,00,000 1,50,000/1,00,000 = 3:1 = 1.5 : 1

Turnover ratios
Inventory turnover ratio = Cost goods sold/Av.Inventory Sales = 3,00,000 GP = 20% Stock at the beginning and at the End = 35,000 & 45000

## Inventory holding period = 12 months/ Inventory turnover ratio

These ratios indicate the number of times the inventory is rotated during the relevant accounting period

## Debtors turnover ratio = Net credit Sales/Av.Debtors

Total Sales = 2,70,000 Cash Sales = 30,000 Debtors at the Beginning and at the End = 27,500 and 32,500 Debtors collection period = 12 months/ Debtors turnover ratio Measures how rapidly receivables are collected

## Creditors turnover ratio = Net credit purchase/ Av.creditors

Total purchase = 2,00,000 Cash purchase = 10% Creditors at the beginning and at the End = 42,500 and 47,500 Creditors payment period=12months/ Creditors turnover ratio The extent to which trade creditors are willing to wait for payment

Debt-Equity Ratio = Total debt/ Shareholders equity Measures the relationship between borrowed fund and owners capital Proprietary ratio = (Proprietors fund/Total assets) x 100 It indicates the extend to which assets are financed by owners fund

Interest Coverage Ratio Interest Coverage Ratio measures the firms ability to make contractual interest payments. Interest coverage ratio = Dividend Coverage Ratio
Dividend Coverage Ratio measures the firms ability to pay dividend on preference share which carry a stated rate of return.

## Total fixed charge coverage ratio

Total fixed charge coverage ratio measures the firms ability to meet all fixed payment obligations. Total fixed charge coverage ratio

EBIT + Lease Payment Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)

## Total Cashflow Coverage Ratio

However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firms ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations.
EBIT + Lease Payments + Depreciation + Non-cash expenses
(Principal repayment) Lease payment + (1 t) + Interest (Preference dividend) + (1 - t)

## Total cashflow coverage ratio

Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt service capacity of a business firm.

DSCR

EATt
t=1

Interestt

n t=1

Depreciationt

OAt

Iinstalmentt

## DEBT SERVICE CAPACITY

Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.

Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR.
(Figures in Rs lakh) Year 1 2 3 4 5 6 7 8 Net profit for the year 21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41 Interest on term loan during the year 19.14 17.64 15.12 12.60 10.08 7.56 5.04 Nil Repayment of term loan in the year 10.70 18.00 18.00 18.00 18.00 18.00 18.00 18.00

The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.

## (Amount in lakh of rupees)

Ye ar Net profit Depreciation Interest Cash available (col. 2+3+4) 5 58.49 70.09 68.81 49.48 46.37 43.64 41.05 34.09 Principal instalment Debt obligation (col. 4 + col. 6) 7 29.84 35.64 33.12 30.60 28.08 25.56 23.04 18.00 1.83 DSCR [col. 5 col. 7 (No. of times)] 8 1.96 1.97 2.08 1.62 1.65 1.71 1.78 1.89

1 1 2 3 4 5 6 7 8

## Average DSCR (DSCR 8)

Profitability ratios can be computed either from sales or investment. Profitability Ratios Profitability Ratios

Related to Sales
(i) Profit Margin (ii) Expenses Ratio

Related to Investments
(i) Return on Investments (ii) Return on Shareholders Equity
Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 22

## Gross Profit Margin

Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods

X 100

6 23

## Net Profit Margin

Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted. Net profit margin can be computed in three ways i. Operating Profit Ratio = Earning before interest and taxes Net sales Earnings before taxes Net sales

## Earning after interest and taxes Net sales

From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin. 1. Sales 2. Cost of goods sold 3. Other operating expenses
Rs 1,00,000

Rs 2,00,000
Rs 50,000

= 50 per cent

Rs 2,00,000

= 25 per cent

## Cost of goods sold Net sales

X 100 X 100

Administrative exp. + Selling exp. Net sales Administrative expenses Net sales Selling expenses Net sales X 100

## iii. Administrative expenses = iv. Selling expenses ratio =

X 100

v. Operating ratio =

Cost of goods sold + Operating expenses X 100 Net sales Financial expenses Net sales X 100

## vi. Financial expenses =

Return on Investments measures the overall effectiveness of management in generating profits with its available assets.
i. Return on Assets (ROA) ROA = EAT + (Interest Tax advantage on interest) Average total assets

## ii. Return on Capital Employed (ROCE)

ROCE = EAT + (Interest Tax advantage on interest) Average total capital employed

Return on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm. Return on total shareholders fund = Net profit after taxes X 100 Average total shareholders fund

## Return on ordinary shareholders equity (Net worth) =

Net profit after taxes Preference dividend X 100 Average ordinary shareholders equity

Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.
Inventory turnover measures the efficiency of various types of inventories.

Cost of goods sold i. Inventory Turnover measures the activity/liquidity of Inventory Turnover Ratio = Average inventory inventory of a firm; the speed with which inventory is sold
Cost of raw materials used i. Inventory Turnover measures the activity/liquidity of Raw materials turnover = inventory of a firm; the speed with which inventory is sold Average raw material inventory Cost activity/liquidity of i. Inventory Turnover measures the of goods manufactured Work-in-progress turnover = Average which inventory inventory inventory of a firm; the speed with work-in-progressis sold

## Debtors Turnover Ratio

Liquidity of a firms receivables can be examined in two ways.
Credit sales i. Inventory Turnover i. Debtors turnover = measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold Average debtors + Average bills receivable (B/R)

## Months (days) in a year Debtors turnover

Months (days) in a year (x) activity/liquidity + Average (B/R) i. Inventory= Turnover measures the (Average Debtors of inventory Alternatively Total credit is sold of a firm; the speed with which inventory sales

## Ageing Schedule enables analysis to identify slow paying debtors.

Assets turnover indicates the efficiency with which firm uses all its assets to generate sales. Cost activity/liquidity of inventory i. Total assets turnover = Inventory Turnover measures theof goods sold i. of a firm; the speed with which inventory isassets Average total sold ii. Fixed assets turnover = Cost of goods sold Average fixed assets

Cost of goods sold i. Inventory Turnover measures the activity/liquidity of inventory iii. Capital turnover = Average capital employed of a firm; the speed with which inventory is sold Cost of goods sold iv. Current assets turnover = Average current assets i. Inventorycapital turnover = Cost of goods sold v. Working Turnover measures the activity/liquidity of inventory Net working sold of a firm; the speed with which inventory iscapital

1)

## Return on shareholders equity = EAT/Average total shareholders equity

2)
3) 4) 5) 6) 7) 8) 9)

## Return on equity funds = (EAT Preference dividend)/Average ordinary

shareholders equity (net worth) Earnings per share (EPS) = Net profit available to equity shareholders (EAT

## Dp)/Number of equity shares outstanding (N)

Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N) Earnings yield = EPS/Market price per share Dividend Yield = DPS/Market price per share Dividend payment/payout (D/P) ratio = DPS/EPS Price-earnings (P/E) ratio = Market price of a share/EPS Book value per share = Ordinary shareholders equity/Number of equity shares outstanding

Integrated ratios provide better insight about financial and economic analysis of a firm.
(1) Rate of return on assets (ROA) can be decomposed in to (i) Net profit margin (EAT/Sales) (ii) Assets turnover (Sales/Total assets) (2) Return on Equity (ROE) can be decomposed in to (DU PONT) (i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)

Earning Power
Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover.

Earning power = Net profit margin Assets turnover Where, Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets
Earning after the activity/liquidity of inventory Sales EAT i. Inventory Turnover measurestaxes x x Earning Power = of a firm; the speed with which inventory is sold Sales Total Assets Total assets

Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each.
Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components.

## Return on Assets (ROA) of Firms A and B

Particulars 1. Net sales 2. Net profit 3. Total assets 4. Profit margin (2 1) (per cent) 5. Assets turnover (1 3) (times) 6. ROA ratio (4 5) (per cent) Firm A Rs 4,00,000 40,000 4,00,000 10 1 10 Firm B Rs 40,00,000 40,000 4,00,000 1 10 10