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Financial Analysis
Financial Analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the Profit & Loss Account. It can be under taken by management of the firm, or by parties outside the firm, viz. owners, Creditors, Investors and others. E.g.
Financial Analysis
Trade Creditors Suppliers of Long Term Debt Liquidity Solvency Survival & Profitability of the firm Firms Earnings Firms Present & Future Profitability Firms financial results as they influence its earnings ability & risk. Every aspect of Financial Analysis.
Investors
Management
A tool of Financial Analysis. Indicates the relationship between two accounting figures, expressed mathematically. Index or yardstick for evaluating the financial position & performance of a firm. Summarizes the financial data to make qualitative relationship, which can be, in turn used to make a qualitative judgment.
Standards of Comparison
.Ratios calculated from the past financial statements of the same firm. 2. Ratios developed using the projected, or Performa, financial statements of the same firm. 3. Cross sectional analysis 4. Industry analysis 5. Comparison of ratios over a period of time.
Types of Ratios
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2.
3.
4.
Liquidity Ratios Firms ability to meet current obligations. Leverage Ratios Proportion of Debt & Equity in Financing the firms Assets. Activity Ratios Firms efficiency in utilizing its assets. Profitability Ratios overall Performance & Effectiveness of the Firm.
Liquidity Ratios
.Liquidity Ratios measure the ability of the firm to meet its current obligations. 2.The failure of co. to meet its current obligations due to lack of sufficient liquidity, will result in : Bad credit image Loss of Creditors confidence Litigations resulting in the closure of the company. 3.A very high degree of liquidity is also bad, idle assets earn nothing. 4.Most common liquidity ratios are: (i) Current Ratio (ideal 2:1) (ii) Quick Ratio (ideal 1:1)
Cash ratio, 1993 = Rs 26.08 = 0.017 or 0.02 Rs 1555.75 Since cash is the most liquid asset, a relation ship is established between cash + marketable securities and current liabilities. Hindustan manufacturing Co is carrying a very small amount of cash in comparison to its current liabilities. But a company need not worry if it has reserve borrowing power and credit limits sanctioned by the banks.
2.
3.
The overall trend of major liquidity ratios of Hindustan Manufacturing Company vividly shows that on one hand its liquidity ratios are unsatisfactory and on the other hand Liquidity is deteriorating over the years. If such a condition continues for coming years as well it may lead the company into troubles like Bad credit image, Loss of Creditors confidence, Litigations resulting in the closure of the company etc.
Leverage Ratios
(i) (ii) (iii)
To judge the long term financial position. To measure the financial risk and the firms ability of using debt for the benefit of shareholders. There should be an appropriate mix of debt and owners equity in financing the firms assets. Most important leverage ratios are: Total debt ratio Debt Equity Ratio (ideal 2:1, lower this ratio better it is) Interest coverage ratio
Debt-EquityRatio1993=TD = Rs 1229.06 = 1.83 NW Rs 672.81 This ratio describes the lenders contribution for each rupee of the owners contribution. It is clear in case of Hindustan, lenders have contributed more funds than owners; lenders contribution is 1.83 times of owners contribution, (0.646 / 0.354 = 1.83)
The co seems to depend more on outsiders funds to finance its expanding activities. As much as of the cos funds are financed by outsiders money: the stake of the owners is quite low in the total capital employed by the firm. From creditors point of view, the trend is risky and undesirable.
Activity Ratios
These are employed to evaluate the efficiency with which the firm manages and utilizes its assets. They indicate the speed with which assets are being converted or turned over into sales, hence also called Turnover Ratios. Important Activity ratios are: Inventory Turnover Ratio (efficiency in selling) Debtors Turnover Ratio ( efficiency in converting the debtors into cash) Assets Turnover Ratio (ability of assets to generate sales)
28
30
42
It is clear that Hindustan manufacturing companys efficiency in turning its inventories is continuously deteriorating and the yearly holding of all types of inventories is increasing.
Debtors Turnover Ratio calculation of Hindustan Manufacturing Company & Interpretation 1991 Debtors Turnover (times) Average Collection Period Asset Turnover ratio 9.2 1992 8.3 1993 7.7
39
43
47
2.03
1.78
1.95
Hindustans ACP has been increasing; it has increased from 39 days in 1991 to 47 days in 1993. this may be due to change in the economic conditions and/or laxity in managing receivables. Hindustans asset turnover ratio over three years also do not any improvement.
Profitability Ratios
(i) (ii)
The profitability ratios are calculated to measure the operating efficiency of the company, creditors & Owners are also interested in Profitability of the firm. Generally, two Major Types of profitability ratios are calculated: Profitability in relation to Sales. Profitability in relation to Investment.
Return on Investment (ROI) Return on Total Assets ROTA = EBIT Total assets For Hindustan 1993 = Rs 342.61 = 0.131 or 13.1% Rs 2617.75 Return on Net Assets RONA = EBIT Net Assets For Hindustan 1993 = Rs 342.61 = .180 or 18.0% Rs 1901.87 Return On Shareholder's equity ROE =Profit After Taxes Net Worth Where NW, (SC + SP + Reserves & surpluses Accumulated Losses if any) For Hindustan 1993 = Rs 134.86 = .20 or 20% Rs 672.81 ROE indicates how well the firm has used the resources of owners. It is of great interest to the present and prospective shareholders and also of great concern to management, which has the responsibility of maximizing the owners welfare.
The sales as well as the investment related ratios of the co. have remained more or less constant. ROE has shown an increase. This is perhaps because of employment of more debt over the years by the company.
It is indicated that the Co.s EPS and DPS are increasing; but the proportionate increase in DPS is Less Than That In EPS and Therefore, DP is declining EPS may be increasing more as a result of increased use of Debt Because of the increase in The financial risk the MP of Share may come down as a result there is Decline in P/E MV/BV. Thus in relation to market performance co is showing Deterioration.