Financial Reporting & Accounting

Standards
Session I
Business Organization & Accounting

Dr Rashmi Soni
Rashmi Soni
• Doctor of Philosophy (Finance2008)
• Fellow Member of Cost and Management Accountants( India rank holder 1998)
• Post Graduate in Commerce/ Management
• 20+ years’ experience of imparting Finance & Management courses to
MBA/PGDM/MMS/PGPX in India and Abroad
• Conducted 20+ MDPs across industries in the areas related to Finance and
Strategic Mgmt.
• 29+ research paper publications across ABDC listed International and National
Journals. Also 2 books for MMS course of Univ. of Mumbai
• Research Guide- University of Mumbai (Four completed and some working)
Rashmi Soni
• Faculty and Examiner of Institutes of Chartered Accountants of India and The

Institute of Cost Accountants of India

• Received various awards from various management bodies from India

• Editorial member and reviewer of International Journals

• Member of National and International professional bodies of Accounting and

Finance

• FDP Scholar from Aston University, Birmingham (UK), IIM Bangalore, IIM Kolkata

& IIM Indore

• Foreign Faculty at “Uniglobe Collage, Pokhra University, Nepal” for Management

• Most Important- married with two sons

Accounting & Finance

Accounting is the language of business.

 Why Accounting?
• Every business entity is exposed to three types
of risks of varying degree:
– Market Risk
– Credit Risk
– Operational Risk
• Accounting help reduce operational risks.
Internal Users ask?
External Users ask?
 What does accounting track ..
Financial Year

Inflows & Outflows of cash

Consumption of resources & Sales

End of earlier End of this

financial year financial year

Assets & Assets &

Liabilities Liabilities
 Accounting Method

Two general methods exist:

- Cash Basis
- Accrual Basis

To Determines which time period revenues and

expenses are recorded.
 Accrual Basis

Record revenues when earned.

- (when goods are sold or services performed)
- Called Revenue Recognition Principle
Record expenses when incurred.
- (When they were used up to produce
revenue)
- Called Matching Principle.
 Accrual Basis Example
Magazine Inc sells only 3 year subscriptions for $60 each.
On 1/1/18 sold 10,000 subscriptions and received full
payment of $600,000.
Wages, rent, and miscellaneous operating expenses
incurred and paid are $50,000 per year.
On 1/1/18, a special deal came along and the company
bought $200,000 of paper which should be enough to
complete the 10,000 subscriptions for 2 years.
Compute net income for 2018 and 2019 using cash
method and then using accrual method.
Accrual Basis & Cash Basis Impact
Case Study
 Basic Concepts
1. Money measurement.
2. Entity.
3. Going concern.
4. Cost.
5. Dual aspect.
6. Accounting period.
7. Conservatism.
8. Realization.
9. Matching.
10.Consistency.
11.Materiality.
 Accounting Assumptions
Economic Entity
The business is accounted for
separately from other business
entities, including its owner
Monetary Unit Principle
Express transactions and events in
monetary, or money, units
Now Future
Going-Concern Principle
Reflects assumption that the
business will continue operating
instead of being closed or sold
Time Period
The economic life of business can be
divided into artificial time period for
the purpose of financial reporting
 Accounting Principles

Revenue Recognition
1. Recognize revenue when it is
Historical Cost
earned.
Accounting information is based
2. Proceeds need not be in cash.
on actual cost.
3. Measure revenue by cash
received plus cash value of
items received.

Full Disclosure
Matching
Report enough information for
Expenses are matched against
users to make knowledgeable
revenues, and recorded in the
decisions about the company
same period in which the related
revenues are earned
 Accounting Constraints

Conservatism
Income and assets be reported at
their lowest reasonable amounts (i.e.
minimizing the assets and
understating the income) Materiality
Accountants are required to
accurately account for significant
items and transactions
 Accounting Equation
• The relationship among three elements of the
balance sheet can be expressed through an
equation, known as fundamental accounting
equation:
Assets (A) = Liabilities (L) + Equity (E)
• The unique feature of the above equation is
that all transactions will affect the equation in
such a way that the equality will always be
maintained.
• This happens due to double entry rule.
 Accounting Equation

Assets = Liabilities + Equity

Liabilities &
Assets Equity
 Types of Accounting

FINANCIAL COST MANAGEMENT

ACCOUNTING ACCOUNTIN ACCOUNTING
G
 What do we keep account of?
• ???????
 Money
Income
What we earn by selling goods
& services
We may also earn some
incidental earnings
Money
Liabilities
Direct or indirect financing by
others. We have received
value from others but we have
not yet compensated them for
the same.
Expenses
Also called as costs.
Resources that we consume in
the process of making the good
or service deliverable. We also
incur some incidental expenses
Assets
What we own. Some of these
would remain with us for long
time and some others would be
processed & sold off
Assets can be physical or
monetary.
24
Financial Statements
Understanding & Analysis
 Financial Statements and Financial Reporting

Economic Entity Financial Statements Additional Information

• President’s letter
Financial
• Balance Sheet
Information • Prospectuses,
• Income Statement • SEC Reporting
Accounting?
• Statement of Cash • News releases
Flows
• Forecasts
1. Identifies • Statement of Owners’
2. Measures or Stockholders’ Equity • Environmental
Reports
3. Communicates • Note Disclosures
• Etc.

GAAP Not GAAP

 Relationship among financial statements
Profit & Loss
Statement
Shows financial performance
throughout the period
Other reports
Notes on accounts, auditors
report, corporate governance
etc.
Balance Sheet
Shows financial performance
on a particular date
Cash Flow Statement
Shows movement of cash
and its usage during the
period
Change in equity
Shows change in equity
during the period
 Basic questions by stakeholders

 How is revenue performance?

 Are costs within norms?
 How is the profit performance?
 How well are different segments doing?
 How is the financial position of the firm?
 How is liquidity i.e. ability to pay dues?
 How well are the available resources managed?
 What is the composition of various liabilities?
Financial Statements provide answers to these

28
 Statement of Profit and Loss
• Inflow of economic benefit

Revenue

Profit/
• Less
Loss

Expenses
Returned Earned / Excess Expenditure

• Cost incurred to generate revenue

Hence, revenue and profit are two different terms

 Statement of Profit and Loss
Particulars Amount
Revenue xxxx
Expenses xxxx
Profit xxxx

TOP Line

BOTTOM line
 Statement of Profit and Loss
Particulars Amount

Revenue xxxx

Expenses xxxx

Profit xxxx

Revenue
Revenue from operations and Other income

Cost of material consumed, purchase of stock in

trade , Employee benefit expenses, Finance cost
Expenses , Depreciation & Amortization, Other expenses
Taxes
 Statement of profit and loss
Particulars Amount
Revenue from operations
Less- Cost of goods sold (COGS)
Gross Margin / Profit
Less- Office and administration expenses
Less- General expenses
Less- Selling & distribution expenses
EBITDA
Less- Depreciation and amortization
EBIT
Less- Interest and finance costs
EBT / PBT
Less- Taxes
PAT / Net Profit
 Concept of EBITDA
• What is EBITDA? • Why is it important?

• Indicator of financial
• EBITDA is ‘earnings before performance
interest, tax, depreciation • Represents performance of
and amortization’. different taxes, financial and
capital investment
• Tool to determine whether
company can service its debt
• Useful for evaluating
companies with different
capital structure, tax rates and
depreciation and amortization
policies
Balance Sheet
 Balance Sheet
• Owners fund

Equity

Assets
±
Liabilities
Utilization of the fund

• Borrowed fund
Hence, Equities + Liabilities always match the assets
 Balance Sheet
Equity and Liabilities Amount
Equity xxxx
Liabilities xxxx

Total xxxx
Assets Amount
Assets xxxx

Total xxxx
 Assets- Something valuable that an entity owns,
benefits from or has use of, in generating income

Non current Assets/ Fixed Assets Current Assets

• Non current investments • Current investments

• Long term loans and
advances
• Tangible assets
• Intangible assets
• Capital work in progress
• Intangible assets under
development (R & D )
• Inventories
• Trade receivables
• Cash and cash equivalents
• Short term loan and
advances
• Other current assets
 Balance Sheet

• Equity • Liabilities

– Residual interest in the – Company’s legal debts

assets of the entity after or obligations arising
deducting all its during the course of
liabilities operations
– They are payable to third
– (Share capital & parties (other than
reserves) owners)
– (Non current & current
liabilities)
 Equity and Liabilities
Equity Liabilities
• Shareholders funds • Non Current liabilities
– Share capital – Long term borrowings
– Reserves and surplus – Deferred tax liability
– Other long term liabilities
– Long term Provisions (Fin
Services co)
• Current Liabilities
– Short term borrowings
– Trade payables
– Other current liabilities
– Short term provisions
 Balance Sheet
Equity & Liabilities INR Assets INR
Equity Non-current assets
Equity share capital Property, plant &
Equipment
Reserve & Surplus Capital work in
progress
Non Current Liabilities Intangible assets
Borrowings Long term investment
LT Provisions Other non current
assets
Deferred tax liabilities Deferred tax assets
Other non current Current assets
liabilities
Current Liabilities Inventories
Short term borrowings Short term investment
Trade payables Trade receivables
 Current vs Non- current Assets
• Current Assets
– Expected realizability
within 12 months
– Primarily held for trading
purpose
– Expected to be realized in
normal operating cycle
– Cash and cash equivalents
unless restricted from use
for at least 12 months after
the reporting date
– Examples: Inventory,
receivables, cash bank
balance, short term loan
and advances
• Non Current Assets
– Will not be realized within
a year
– Primarily held for
manufacturing or assets
generation
– Realization will not occur in
1 operating cycle
– Fixed deposits or
investments made for a
period grater then 12
months
– Examples- Fixed deposits,
PPE, capital WIP, long term
loan and advances
 Current vs Non Current Liabilities
• Current Liabilities • Non- Current Liabilities
– Settlement due within – Settlement will become
12 months after the due after 12 months
reporting date from the reporting date
– Primarily held for trading – Primarily held for long
purpose term financing
– Expected to be settled in – Settlement will occur
normal operating cycle after a operating cycle
– Examples: Current – Example: Long term
borrowings, trade borrowings, bonds, non
payables, current current provisions
provisions
Example- Identify current and non current assets and
liabilities

Raw material Long term loan

Finished goods Creditors
Tangible fixed assets Bank overdraft
Debtors expected to be realized in 12 Bonus with vesting period of 3 years
months

Cash and cash equivalents Salary payable

Intangible assets Provision for taxes
Investment in subsidiaries Advanced salary paid
 Quiz

 Which of the following cannot be regarded as a

current asset?
a) Inventory
b) Advance to suppliers
c) Strategic Investment in another company
d) Bank balance
 Quiz

 Which of the following cannot be regarded as a

current liability?
a) Share capital
b) 8% Bonds
c) Loan from a financial institution repayable after 8 years
d) Salary dues

45
Cash Flow Statement
 Information on cash flows
• Cash flow statement of an entity informs us about how the
enterprise generates cash and how the generated cash is
utilized it also tells us about timing and certainty
• Cash flow statement can be prepared regardless of the
nature on the entity and nature of transactions incurred as
in the case of a financial enterprise
• Principle cash generating activities of enterprises differs but
all the entities require a decent cash flow from its operating
activities
– They need cash to conduct their operations, to pay their
obligations and to provide returns to their investors

As a thumb rule, increase in assets results in cash outflow

And increase in liabilities results in cash inflow, and vice versa…
 Cash Flow Statement

Cash flow from operating activities

Cash flow from investing activities

Cash flow from financing activities

 Example
Classify the following items into cash flows from operating, investing or
financing activities-

• Increase in debtors balance

• Purchase of machinery
• Decrease in trade payables
• Dividend paid
• Increase in inventory
• Interest received
• Sale of investment
• Issue of share capital
• Depreciation
• Dividend received
 Answer
Classify the following items into cash flows from operating, investing or
financing activities-

• Increase in debtors balance - Operating

• Purchase of machinery- Investing
• Decrease in trade payables- Operating
• Dividend paid - Financing
• Increase in inventory- Operating
• Interest received - Investing
• Sale of investment- Investing
• Issue of share capital - Financing
• Depreciation - Operating
• Dividend received - Investing
 Net profit ≠ net cash …… why?
• There are many items that will not affect the
profit and loss account (Ref – accounting
equation) exp- loan taken, share issued, freehold
land purchased
• Similarly there are many non cash items that will
affect the profit and loss account
– Matching principle, exp- depreciation on fixed assets
charged over
– Revenue being recognised on sale

Turnover is vanity, profit is sanity but cash flow is reality

 Free Cash Flow Defined
The calculation starts with cash
flows from operating activities,
which is a measure of a company’s It then subtracts
ability to generate cash from its capital
current operations. expenditures,
which refers to the
cash that a
company spends on
fixed assets during
the year, and
The cash that remains is
dividends, which
“free” to be used as the are payments to
company chooses. stockholders
during the year.
Case Studies …..
Financial Statements
Analysis
Analysis of Financial Statements

Process of By establishing
identifying relationship
financial between items
Financial
strength and of balance
Analysis
weaknesses of sheet and
a company statement of
profit and loss
Why Financial Statements Are
Analyzed???
Why Financial Statements Are
Analyzed???
 Company’s
Credit
Worthiness

Value its Analysis of Company’s

Equity Financial Competitive
Shares Statements Standing

Evaluate its
Financial
Soundness
 Business Analysis

Evaluate Prospects Evaluate Risks

Business Decision Makers

Equity investors

Creditors

Managers

Merger and Acquisition Analysts

External Auditors

Directors

Regulators

Employees & Unions

Lawyers
Financial Analysis Framework
Who uses Financial Statement Analysis?
• Almost Everyone in the Business World
– Bankers – analyze loans and cash flow
– Portfolio Managers – projections of stock prices
– Marketing Managers – market penetration and
impacts to profitability
– Human Resources – compensation analysis
– Senior Management – corporate strategy
– Sales Managers – commission rates on sales
– Internal Financial Analysts – profitability analysis
– Customer Service Managers – efficiency ratios
 Data may be compared with the
following:
• The firm's own data from prior years
• Data from another firm in the same industry
• Data from another firm in which the analyst
may invest
• Industry averages
• Benchmarks or targets
 Types of financial analysis
• Cross sectional techniques
– At a point of time
Between
• Different companies or different items of financial
statements
• Time series techniques
– Over a period of time
 Methods of
Financial Statement Analysis
• Horizontal Analysis
• Vertical Analysis
• Trend Percentages
• Ratio Analysis
 Horizontal Analysis

Using comparative financial

statements to calculate amount
or percentage changes in a
financial statement item from
one period to the next
Horizontal Analysis
Now, let’s
look at some
ways to use
horizontal
analysis.
Time
The term horizontal analysis arises from left-to-right
(or right-to-left) movement of our eyes as we review
comparative financial statements across time.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Dollar Percent
2004 2003 Change Change
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
 Comparative Statements
Calculate Change in Dollar Amount

Dollar Analysis Period Base Period

Change = Amount – Amount

Since we are measuring the amount of

the change between 2003 and 2004, the
dollar amounts for 2003 become the
“base” period amounts.
 Comparative Statements
Calculate Change as a Percent

Percent Dollar Change

Change
=
Base Period Amount × 100%
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Dollar Percent
2004 2003 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
$12,000 – $23,500 = $(11,500)
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land ($11,500 ÷ $23,500)
40,000 40,000× 100% = 48.9%
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to first decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Dollar Percent
2004 2003 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets $ 155,000 $ 164,700 $ (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment $ 160,000 $ 125,000 $ 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
* Percent rounded to first decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Dollar Percent
2004 2003 Change Change*
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities $ 70,000 $ 50,000 $ 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities $ 145,000 $ 130,000 $ 15,000 11.5
Shareholders' equity:
Preferred shares 20,000 20,000 - 0.0
Common shares 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital $ 90,000 $ 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total shareholders' equity $ 170,000 $ 159,700 $ 10,300 6.4
Total liabilities and shareholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
* Percent rounded to first decimal point.
 Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a significant
total,
e.g., all income statement
items are expressed as a
percentage of sales
 Common-Size Statements
Calculate Common-size Percent

Common-size Analysis Amount

Percent
= Base Amount × 100%

Financial Statement Base Amount

Balance Sheet Total Assets
Income Statement Revenues
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
($12,000 ÷ $315,000)
Total current assets
× 100% = 3.8%
$ 155,000 $ 164,700
Property and equipment:
Land ÷ $289,700)
($23,50040,000 × 100% = 8.1%
40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 21.3% 15.2%
Notes payable 3,000 6,000 1.0% 2.1%
Total current liabilities $ 70,000 $ 50,000 22.2% 17.3%
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 23.8% 27.6%
Total liabilities $ 145,000 $ 130,000 46.0% 44.9%
Shareholders' equity:
Preferred shares 20,000 20,000 6.3% 6.9%
Common shares 60,000 60,000 19.0% 20.7%
Additional paid-in capital 10,000 10,000 3.2% 3.5%
Total paid-in capital $ 90,000 $ 90,000 28.6% 31.1%
Retained earnings 80,000 69,700 25.4% 24.1%
Total shareholders' equity $ 170,000 $ 159,700 54.0% 55.1%
Total liabilities and shareholders' equity $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended 31 December
Common-size
Percents*
2004 2003 2004 2003
Revenues $ 520,000 $ 480,000 100.0% 100.0%
Less: Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes $ 25,000 $ 32,000 4.8% 6.7%
Less: Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income $ 17,500 $ 22,400 3.4% 4.7%
Net income per share $ 0.79 $ 1.01
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.
 Trend Analysis

Also called trend

percent analysis
or index number
trend analysis.

Trend analysis is used to reveal patterns in data

covering successive periods.

Trend Analysis Period Amount

Percent = Base Period Amount
× 100%
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

2000 is the base period so its

amounts will equal 100%.
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2004 2003 2002 2001 2000

Revenues 105% 100%
Cost of sales 104% 100%
Gross profit 108% 100%

(290,000 ¸ 275,000) ´ 100% = 105%

(198,000 ¸ 190,000) ´ 100% = 104%
(92,000 ¸ 85,000) ´ 100% = 108%
 Trend Analysis
Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2004 2003 2002 2001 2000

Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%

How would this trend analysis

look on a line graph?
 Ratio Analysis
Purpose:
• To identify aspects of a business’s
performance to aid decision making
• Quantitative process – may need to be
supplemented by qualitative factors to get a
complete picture
 Financial Ratio Analysis
• What is ratio?
• A figure expressed in
terms of another
• Financial ratio
– An expression of
relationship between two
accounting figures
expressed mathematically
Financial ratio analysis is most widely used cross sectional technique
• Why ratios?
• Limitation of absolute
number
• Convey the inter
relationship between
various accounting data
• Inter relationship
conveyed enables
decision making
• Help to summarise large
quantities of data
 Types of financial ratios
Performance ratios
Company’s profitability by expressing its profit as a percentage of something else

(a) Return on sales – profit margin

(b) Return on equity
Liquidity ratio
Company’s ability to meet current financial obligations
(a) Current ratio
(b) Quick ratio
Solvency ratio
How extensively company relies on debt
(a) Debt equity ratio
(b) Interest coverage ratio
Efficiency ratio
How effectively company is using its recourses
(a) Stock turnover ratio
(b) Receivable and payable time
Groups of Financial Ratios
 Analyzing Liquidity
 Liquidity refers to the solvency of the firm's
overall financial position, i.e. a "liquid firm" is
one that can easily meet its short-term
obligations as they come due.

 A second meaning includes the concept of

converting an asset into cash with little or no
loss in value.
 Analyzing Debt / Solvency
 Debt is a true "double-edged" sword as it
allows for the generation of profits with the
use of other people's (creditors) money, but
creates claims on earnings with a higher
priority than those of the firm's owners.
 Financial Leverage is a term used to describe
the magnification of risk and return resulting
from the use of fixed-cost financing such as
debt and preferred stock.
 Liquidity Ratios
Ratio Formula Interpretation
Current ratio Current assets/ Current Liquidity position of the
liabilities firm
Quick ratio Cash+ short term Ability to pay liabilities fast
marketable investment+
receivables / Current
liabilities
Cash ratio Cash + short term Cash availability
marketable investment /
Current liabilities

Solvency ratio
Debt to assets ratio Total debt / total assets portion of total assets
finance by debt
Debt to capital ratio Total debt / Total debt + Portion of debt in
total shareholders equity company
Debt to equity ratio Total debt / Total How much debt and
shareholders equity equity company has
Interest coverage ratios EBIT / Interest Interest payment capacity
 Analyzing Activity / Turnover /
Efficiency
Activity is a more sophisticated
analysis of a firm's liquidity,
evaluating the speed with which
certain accounts are converted into
sales or cash; also measures a firm's
efficiency
 Activity Ratios
Activity Ratio Formula Interpretation
Inventory Turnover Cost of goods sold / Average How many times per period
ratio inventory entire inventory was sold
Days of inventory on Number of days in period / On average how many days of
hand Inventory turnover inventory kept on hand
Receivable Turnover Revenue(credit) / Average How quickly does a company
receivables collect cash
Days of sales Number of days in period / Time between credit sales and
outstanding or Receivable turnover cash collection
Receivable collection
period
Payable Turnover Purchase(Credit) / Average Time company pays to suppliers
Creditors
Average payment Number of days in period/ payable Average number of days to pay
period turnover suppliers
Working capital Revenue / average working capital How efficiently does a company
turnover generate revenue from working
capital
Fixed assets turnover Revenue / average net fixed assets How efficiently does a company
generate revenue from fixed
assets
 Analyzing Profitability

– Profitability Measures assess the firm's

ability to operate efficiently and are of
concern to owners, creditors, and
management
– A Common-Size Income Statement, which
expresses each income statement item as a
percentage of sales, allows for easy
evaluation of the firm’s profitability relative
to sales.
Eight Basic Profitability Measures
Gross Profit Margin (GPM)
Operating Profit Margin (OPM)
Net Profit Margin (NPM)
Return on Total Assets (ROA)
Return On Equity (ROE)
Earnings Per Share (EPS)
Price/Earnings (P/E) Ratio
Return on Capital Employed (ROCE)
 Liquidity and Efficiency

Current Inventory
Ratio Turnover

Acid-test Days’ Sales

Ratio Uncollected

Accounts
Days’ Sales
Receivable
in Inventory
Turnover

Total Asset
Turnover
 Current Ratio

Current Current Assets

=
Ratio Current Liabilities

This ratio measures the

short-term debt-paying
ability of the company.
 Acid-Test Ratio
Acid-Test = Quick Assets
Ratio Current Liabilities
Quick assets are Cash, Short-Term Investments,
and Current Receivables.

This ratio is like the current

ratio but excludes current assets
such as inventories and prepaid
expenses that may be difficult to
quickly convert into cash.
 Accounts Receivable Turnover
Accounts Sales on Account
Receivable = Average Accounts Receivable
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
 Inventory Turnover
Inventory Cost of Goods Sold
=
Turnover Average Inventory

This ratio measures the number

of times merchandise
is sold and replaced during the year.
 Total Asset Turnover
Total Asset Net Sales
=
Turnover Average Total Assets

This ratio measures the

efficiency of assets in producing
sales.
 Solvency
Debt
Ratio

Equity
Ratio

Pledged Assets
to Secured
Liabilities

Times
Interest
Earned
 Debt Equity Ratio
Debt = Total Debt
Equity Total Equity
Ratio

This ratio measures what portion of a

debt and owners equity in the
company
 Interest Coverage Ratio
Net Income before Interest Expense
Interest and Income Taxes
coverage =
ratio Interest Expense

This is the most common measure of the

ability of a firm’s operations to provide
protection to the long-term creditor.
 Profitability

Profit Basic
Margin Earnings per
Share

Gross Book Value

Margin per Common
Share

Return on Return on
Total Assets Shareholders’
Equity
 Profit Margin

Profit Net Income

=
Margin Net Sales

This ratio describes a

company’s ability to earn a net
income from sales.
 Gross Margin
Gross Net Sales - Cost of Sales
=
Margin Net Sales

This ratio measures the amount

remaining from $1 in sales that is left
to cover operating expenses and a
profit after considering cost of sales.
 Return on Total Assets
Return on = Net Income
Total Assets Average Total Assets

This ratio is generally considered

the best overall measure of a
company’s profitability.
 Return on Shareholders’ Equity
Return on
Shareholders’ Net Income - Preferred Dividends
=
Equity Average Common Shareholders’
Equity

This measure indicates how well the

company employed the owners’
investments to earn income.
 Basic Earnings per Share
Basic
Earnings Net Income - Preferred Dividends
=
per Common Shares Outstanding
Share

This measure indicates how much

income was earned for each share of
common shares outstanding.
 Market Prospects
Price-
Earnings
Ratio

Dividend
Yield
 Price-Earnings Ratio
Price-Earnings Market Price Per Share
=
Ratio Earnings Per Share

This measure is often used by investors as a general

guideline in gauging share values. Generally, the
higher the price-earnings ratio, the more opportunity
a company has for growth.
 Dividend Yield
Dividend Annual Dividends Per Share
=
Yield Market Price Per Share

This ratio identifies the return, in terms of

cash dividends, on the current market
price of the share.
 Example
• Ratio analysis from study material
 DuPont System of Analysis
– DuPont System of Analysis is an integrative approach used
to dissect a firm's financial statements and assess its
financial condition
– It ties together the income statement and balance sheet to
determine two summary measures of profitability, namely
ROA and ROE
 DuPont System of Analysis
 The firm's return is broken into three components:
– A profitability measure (net profit margin)
– An efficiency measure(total asset turnover)
– A leverage measure (financial leverage multiplier)
Du Pont continued…
 Financial Distress Prediction

At the time of great depression the incidences of default were increasing,

one of
the professors of Finance of the Leonard N. Stern School of Business of New
York University, named Dr Edward I. Altman developed the Financial
Model in 1967 to predict the likelihood of bankruptcy of the company which
is
named as Altman’s Z-Score Model. Altman has used five financial ratios to
predict
a company’s probability of failure. This model helps the organization to
predict the probability of collapse within 2 years. For this, model Measure
Company’s health with various financial ratios and then Discriminant analysis
used to calculate the Z score of the company.
Financial Distress Prediction
 Altman Z score model
• Altman reports that this model is between 80.90% accurate if
we use a cutoff point of 2.675. That is, a firm with a Z-score
below 2.675 can reasonably be expected to experience
severe financial distress, and possibly bankruptcy, within the
next year.
•
• The new model for privately held firms is:

• Where all of the variables are defined as before, except that X4

uses the book value of equity. Altman reports that this model is
only slightly less accurate than the one for publicly traded firms
when we use the new cutoff points shown below.
 Case of Ruchi Soya Ltd
Discrimi
Factor X1 X2 X3 X4 X5 Z Score nation
coefficien
t 1.2 1.4 3.3 0.6 1
2012 0.032634 0.009647 0.059119 0.177582 2.050335
Gray
0.039161 0.013506 0.195094 0.106549 2.050335 2.404644 Zone
2013 0.041921 0.016376 0.042948 0.121267 1.813248
Gray
0.050306 0.022927 0.141727 0.07276 1.813248 2.100968 Zone
2014 0.049647 0.00109 0.046242 0.120763 1.980526
Gray
0.059577 0.001526 0.1526 0.072458 1.980526 2.266686 Zone
2015 0.033973 0.004393 0.034466 0.08021 2.04115
Gray
0.040767 0.00615 0.113739 0.048126 2.04115 2.249932 Zone
2016 -0.15565 -0.06453 -0.00265 0.045411 1.683208
Distress
-0.18678 -0.09034 -0.00876 0.027247 1.683208 1.424579 Zone
2017 -0.32184 -0.09484 -0.06022 0.050802 1.397631
Distress
-0.38621 -0.13278 -0.19871 0.030481 1.397631 0.710417 Zone
Questions ,Comments and Reflections?

124