Financial Statement Analysis

Prof. Ram Kumar Kakani

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 Financial Statements –
Basic Relationships
Financial Statements

Balance Sheet Profit & Loss Account

Cash Flow
Statement

Primary
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 Financial Statements
Balance Sheet
 The entity in order to achieve its objectives has arrived at a
decision to apportion the resources and deployed it in fixed
assets and in current assets
 The proportions of funds that are borrowed on short term, on
long term as well as what is the contribution of owners towards
the total financial requirement of the entity
Profit & Loss Account
 Gives the cost structure of the business and the relationship of
costs to the revenues
 It gives the information relating to margin available on the sales
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 Steps to Analyse Financial
Statements
 Establish the objectives of analysis of the firm
 Study the industry, in which the firm operates, the dynamics therein,
and the impact on the objective of analysis
 Based on the objectives of analysis, decide on the appropriate
financial tools
 Know about the firm(s) and their management styles; and take the
same into account at the time of making your interpretations.
Thus, the resources used for financial analysis would compulsorily
include:(a) Published Financial Statements; (b) Auditors’ Report plus
Report on Corporate Governance; and (c) Report of the Directors plus
Management Discussion & Analysis.
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 Relation and Comparison of Data
 Accounting data in absolute terms do not provide much
meaning – the analysis involves comparison and relation
 Ratio  Whenever one item is expressed (as a fraction or a
decimal fraction or an integer) in terms of another item
 Example – A firm earns a net profit of Rs. 20,000 on a sale of
Rs. 500,000. We could express this relationship as ____?
 Comparisons could be made
 With Company’s past performance
 With Competing Firms
 With an Absolute Standard
 With Industry/Economy trend
 With Budgets (Planning and Control)
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 But…
 In most cases, there are no standards against which a
particular ratio value could be tested
 We make relative conclusions by comparing the ratios with
industry averages
 Thus, at best the conclusions could be ‘better than’ or ‘worse
than’ or ‘average’
 Possible pitfalls in these comparisons could be the different
accounting conventions
 Inventory valuation (LIFO vs. FIFO)
 Different methods of depreciation
 Typical items (eg. Retirement benefits)
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 Common Size Financial Statements
 A financial statement presented by representing each item as a
percentage to the total amount of which it is a part
 Example:X had a sale of Rs 15 mn during the year and cost of
goods sold of Rs 12 mn whereas Y has a sale of Rs 8 mn and
cost of goods sold of Rs 4.8 mn
 The above is not amenable to direct understanding.
 Cost of goods sold of X is 80% of sales and for Y it is 60% of
sales
 This is more lucid and meaningful. Useful while dealing with
many companies in the same industry

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 Common Size Financial Statements
Profit & Loss Account
 Here we show the net sales as 100% and each of the components of
expenses and profits as a percentage of net sales
 When there are other revenues and expenses of a non-operating
nature, it may be advantageous to treat them separately

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 Tools & Tools Ltd
Common Size Profit & Loss Account
For the year ended Dec 31,2011
2011 2010
Rs Million % Rs Million %
Sales 300 100 280 100
Cost of Goods Sold 148 49.33 140 50.00
Gross Profit 152 50.67 140 50.00
Selling Expenses 25 8.33 22 7.86
General Expenses 60 20.00 58 20.71
Total Operating Expenses 85 28.33 80 28.57
Operating Income 67 22.33 60 21.43
Interest Expense 14 4.67 13 4.64
Net Income before tax 53 17.67 47 16.79
Income Tax 26 8.67 23 8.21
Profit After Tax 27 9.00 24 8.57
Dividends 2 0.67 2 0.71
Profits retained 25 8.33 22 7.86
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 Tools & Tools Limited
Dis-aggregation of change in Net Income
% Change in expenses and net income in
relation to sales
Decrease in cost of goods sold 0.67
Decrease in general expenses 0.71
Total decrease in the cost increasing net income 1.38
Increase in selling expense 0.47
Increase in interest expense 0.03
Increase in income tax 0.46
Cost increases decreasing net income 0.96
Net change in net income 0.42
Interpretation:
Net profit earned by the company has increased from 8.6% to 9.0%
Dis-aggregation of change shows an increase in net income of 0.4%
It is the combined result of 1.4% reduction in cost and 1% increase in the
indirect cost
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 Contd. . .
 Balance Sheet
 Constructed by showing each item of asset as a percentage
of total assets, similarly each item of liability and owner’s
equity is shown as a percentage of total liabilities and owners
equity
 The common-size financial statements could either be
prepared in summary or in details

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 Tools & Tools Ltd
Common Size Balance Sheet
As at Dec 31, 2011
2011 2010
ASSETS Rs Million % Rs Million %
Cash 19 5.76 11 4.07
Accounts Receivable 32 9.70 20 7.41
Loans and Advances 43 13.03 34 12.59
Inventory 121 36.67 99 36.67
Other Current Assets 17 5.15 26 9.69
Total Current Assets 232 70.31 190 70.37
Fixed Assets 94 28.48 79 29.26
Other Assets 4 1.21 1 0.37
Total Assets 330 100.00 270 100
Total Liabilities & Capital
Current Liabilities
Acceptances 5 1.52 2 0.74
Accounts Payable 27 8.18 19 7.04
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Contd. . . .
Advance Against Sale 26 7.88 21 7.78
Other Liability 9 2.73 8 2.96
Interest accrues but not due 3 0.90 2 0.74
Total Current Liabilities 70 21.21 52 19.26
Provisions:
For Tax 26 7.88 21 7.77
For Proposed Dividends 2 0.61 2 0.74
For Bonus 3 0.90 2 0.74
For Other 4 1.21 3 1.11
Total Provision 35 10.61 28 10.37
Total Current Liabilities and Provisions 105 31.82 80 29.63
Long Term Liabilities
Bank term loans 40 12.12 32 11.85
10.5%Debentures 26 7.88 26 9.63
Financial Institutions 24 7.27 22 8.15
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Contd. . . .
Total Long Term Liabilities 90 27.27 80 29.63
Total Liabilities 195 59.08 160 59.26
Shareholders Equity
Paid up capital 37 11.21 37 13.70
Retained Earning 98 29.70 73 27.04
Total Shareholder Equity 135 40.91 110 40.74
Total Liabilities & Shareholders 330 100 270 100
Equity

Interpretation:
During both the years, over two-thirds of the total assets were current assets
viz., 2010 (70.4%) and 2011 (70.3%) – and this was stable.

Similarly in 2010, 29.3% total assets were fixed assets which came down to
28.5% in 2011

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 Financial pattern has remained stable over 2 yrs at around 59% by out
sources and 41% by shareholders
Hence it has maintained a stable financial structure during the period,
in term of current assets versus fixed assets and outside finances versus
shareholder’s equity
Working capital has increased in Rupee by 17 million
But the proportionate term, working capital has decline by 2.3%

Working Capital Change as Percentage of Total Assets

2011 2010 Change in
WC
Total Current Assets 70.31 70.37 -0.07
Total Current Liability & 31.82 29.63 -2.19
Provision
Working Capital 38.49 40.74 -2.25
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 Index Based Analysis
 Accounting information represent by over multiple year as a
percentage of amounts of an observant base year
 It helps to compare accounts for two or more years to the
corresponding items for a single company
 The base year figures of each item are always indexed to 100
 And the changes from the base year are determined
 A longer time frame of data always help in better understanding
index based analysis
 We present the Index based balance sheet numbers of CPIL
Colgate Palmolive (India) Ltd with FY2007 taken as base years

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 Index Based Balance Sheet of CPIL

Balance Sheet Items Colgate Palmolive (India) Ltd

Assets Side FY2010 FY2009 FY2008 FY2007
Cash & Bank Balances 302.7 220.6 129.0 100.0
Accounts Receivable 103.8 118.3 99.8 100.0
Loans & Advances 77.1 89.5 99.1 100.0
Inventories 138.6 112.3 107.4 100.0
Current Assets 164.1 137.5 110.5 100.0
Fixed Assets 135.8 133.9 125.1 100.0
Other Assets 23.9 31.9 60.0 100.0
Total Assets 125.4 113.2 103.4 100.0

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 Contd..
Liability Side FY2010 FY2009 FY2008 FY2007
Account payables 158.1 155.3 131.7 100.0
Other Current Liabilities & Provision 95.7 112.3 129.7 100.0
Current Liabilities & Provision 130.0 135.9 130.8 100.0
Long Term Liabilities 107.5 109.8 109.8 100.0
Net Worth 118.6 78.7 61.6 100.0
Total Liabilities 125.4 113.2 103.4 100.0
 Comparing this with actual number of CPIL, one can make out that it
involves calculating each year’s ‘item-wise’ balances as percentages
of the first year, also known as the base year
 It computes, percentage change from year to year for all items in
balance sheet, such as cash and inventory
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 CPIL Balance Sheet
Colgate Palmolive (India) Ltd, Financial Year 2007-10, All Figure in Rs Crores
Balance Sheet
Assets Side FY2010 FY2009 FY2008 FY2007
Cash & Bank Balance (a) 347.67 253.40 148.13 114.86
Accounts Receivable (b) 9.77 11.13 9.39 9.41
Loans and Advances (c) 118.00 137.05 151.64 153.08
Inventories (d) 111.36 90.24 86.25 80.33
Current Assets 586.80 491.82 395.41 357.68
(a+b+c+d)
Fixed Assets 260.73 257.12 240.31 192.03
Other Assets 37.18 49.69 93.52 155.88
Total Assets 884.71 798.63 729.24 705.59
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 Contd. . .
Liability Side FY2010 FY2009 FY2008 FY2007
Account Payable (e) 367.80 361.22 306.49 232.66
Other Current Liabilities & 182.11 213.72 246.70 190.26
Provisions (f)
Current Liabilities 549.91 574.94 553.19 422.92
Long-Term Liabilities 4.59 4.69 4.69 4.47
Net Worth (Total 330.22 219.01 171.37 278.40
Shareholders’ Fund)
Total Liabilities 884.72 798.64 729.25 705.59

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 Contd...
 Example, the computation of Cash & Bank Balance for FY2010

 The analysis shows that during the four year period CPIL’s assets
had increased by about 25%
 Other Assets and loans & Advances item decreased continuously
 A stark contrast to these items is the massive rise in its Cash and
Bank Balances – which has gone up by over two times

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 Possible reasons include
 CPIL sold off its investment in FY2008 and parked them as cash …
possibly due … Guess?
 Volatility in Capital Markets AND / OR
 Sale of its Nepal subsidiaries AND / OR
 Some other informed strategy (such as, to chase potential takeover
opportunity or for impending needs of its parent firm) AND / OR
 Huge profits with no big investment in fixed assets during the four
year period
 … all these add to the bulging cash balance

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 Further Interpretations
 Are feasible on the accounts receivable of CPIL trends …
 On the decreasing trend of CPIL’s ‘Loans and Advances’ from
FY2008.

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 Using Financial Ratios…
 Many pieces of information do not have significant meaning in
isolation – they become more meaningful when related to an
appropriate base
 Ratios reduce large figures to an easily understood relationship
 Ratios do not make conclusions – It is for the analyst to draw
conclusion by evaluating and relating the ratios
 There are no “good” ratios and “bad” ratios – It is only possible to
make relative inferences
 Company performance is usually analyzed on two parameters
 Profitability
 Liquidity
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 Profitability Ratios
Gross Profit Margin
Operating Profit Margin
Margin
Earnings Before Interest & Tax
on sales Profit before tax
Net Profit Margin (i.e., Profit after tax)
Operating Profit to Operating Assets
Return on
Net Income to Total Assets
Investment
Return on Equity
Total Asset Turnover
Operating Asset Turnover
Efficiency
Working Capital Turnover
Shareholder Equity Turnover
Earnings per share
Return
Earnings to price
per share
Dividends per share
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 Solvency Ratios
Net Working Capital
Current Ratio
Short-term Quick Ratio
Accounts Receivable Turnover
Collection Period
Inventory Turnover
Conversion Period
Total Debt to Total Capital
Long Term Debt to Total Capital
Long-term Long Term Debt to Fixed Assets
Interest Cover
Times Fixed Charges Covered
Gearing
Equity Multiplier
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 Profitability
 The long-term survival depends on ability to earn sufficient
surpluses and to grow
 Only if the operations are profitable the company will survive in
the long run
 Margin on Sales
 Profits are generated by sales
 First step in analyzing profitability is understanding of costs
in relation to revenue and thus profits in relation to revenue
 Each component of profit & loss account is expressed as
percentages of sales

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 Illustration – Tools & Tools Ltd.
(Table on Profit Margins)
FY 2011 FY 2010
Rs Million % Rs Million %
Sales 300 100 280 100
Cost of goods sold 148 49.33 140 50.00
Gross Profit (i) 152 50.67 140 50.00
Total operating expenses 85 28.33 80 28.57
Operating Profit (ii) 67 22.33 60 21.43
Interest expense 14 4.67 13 4.64
Profit Before Tax (iii) 53 17.67 47 16.79
Income tax 26 8.67 23 8.21
Profit After Tax (iv) 27 9.00 24 8.57
Dividends 2 0.67 2 0.71
Profit Retained (v) 25 8.33 22 7.86
Depreciation expense 13 11
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 Gross Margins & Operating Margins
 Gross Margins
 The surplus available out of sales revenues after subtracting cost
of goods sold
 It is obtained over the input costs and as such would reflect the
efficiency of use of direct inputs given the price
Gross Profit = Sales – COGS

 Operating Margins
 It is the reflection of the operations of the company and hence
considered as a reflection of the management’s performance
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 Contd…
 Frequently used as a basis of comparison across companies
Operating Profit = PBDIT – Depreciation

 Earnings before interest & taxes

 Any non-operating surplus or deficit is adjusted to the operating
profit margin to obtain the earnings before interest and taxes

 Profit Before Tax

 It is the surplus amount obtained after meeting interest expense
 Influenced to a great extent by the financing decisions
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 PAT, and Retained Earnings
 Profit After Tax (a.k.a. Net Income)
 Overall surplus available out of sales to shareholders
 This is influenced by three major factors namely, operating
efficiency, financing efficiency and taxation
 As a percentage of sales it is known as Net Profit Margin and is
used to compare margins of players in the same industry

 Retained Earnings (a.k.a. Retained Profit)

 Amount of profit remaining after the distribution of dividends

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 Tools & Tools Ltd. – Analysis
Rs Million % (11) Rs Million % (10)
Most margin
Sales Indicators are 300 100 280 100
improving
Cost of goods sold 148 49.33 140 50.00
Gross Profit (i) 152 50.67 140 50.00
Net margins
Total operating expenses 85 28.33 80 28.57
increased to 9%
Operating Profit (ii) 67 22.33 60 21.43
Interest expense 14 4.67 13 4.64
Gross margins
Profit Before Tax (iii) 53 17.67 47 16.79
increased to 50.6%
Income tax 26 8.67 23 8.21
Profit After Tax (iv) 27 9.00 24 8.57
Decrease in
company’s direct costs
Dividends 2 0.67 2 0.71
& operating
Profit Retained (v)expenses 25 8.33 22 7.86
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 Return on Investment
 The management has to be evaluated on the basis of how far
they had been successful in profitably utilizing the assets
 The assets used is to be related to the profit earned
 Return on Operating Assets (ROA)
 Operating profit to operating assets is obtained by
dividing the operating profit by average value of operating
assets used during the year

 Operating assets refer to total current assets and fixed

assets used
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 Tools & Tools Ltd. - ROA
Return on Operating Assets (ROA) 2011 2010
Current assets (Rs Million) 232 190
Fixed assets (Rs Million) 94 79
Total operating assets (Rs Million) 326 269
Operating Profit Before Interest and Taxes (OPBIT) 67 60
(Rs Million)
Return on Operating Assets (%) 20.55 22.30
ROA based on average operating assets i.e., 22.52
(326+269)/2 (%)
The company had used on average Rs 297.5 million and it has to be justified in
terms of the opportunity cost
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 ROTA
 Return on Total Assets (ROTA)
 The rate of profit the company is able to earn after meeting the
cost of financing of a portion of the total assets
 It is the amount available to the shareholders in relation to the
total amount of resources used in the business
 Here again the average total assets is used (Why?)

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 ROE
 Return on Equity (ROE)
 Net income is the amount available to owners for
compensating their investment and the risk being carried by
them
 It measures the net income as a percentage of shareholders
investment

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 Net Income to Total Assets
Return on Total Assets (ROTA) 2011 2010
Total Assets (Rs Million) 330 270
Profit After Taxes (PAT) 27 24
Return on Total Assets 8.18% 8.89%
ROTA based on average total assets 9.00%
(330+270)/2

Able to earn The company used

9% return on an average Rs 300 mn
Total Assets in total assets to
earn Rs 27 mn
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 ROE Computations …
Return on Equity (ROE) 2011 2010
Total Equity (Rs Million) 135 110
Profit After Taxes (PAT) 27 24
Return on Equity (%) 20.00 21.82
ROE based on average total assets 22.04

 ROE of 22% is not only the result of management’s ability to

employ the assets profitably, but also the result of its ability to use
a favorable debt equity structure
 Whenever, management is able to borrow money and use it to
earn more than the cost of such borrowing the ROE increases
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 Return Per Share
 Interest of a shareholder lies in the amount of dividend that can
be earned on the investment in shares and the increase in the
price of shares that can be had by holding the same
 Earnings per share (EPS) is computed by dividing ‘net income
to ordinary shareholders’ by the ‘number of ordinary shares
outstanding’

Earnings per Share (EPS) 2011 2010

Profit After Taxes (PAT) (Rs Million) 27 24
Number of ordinary shares (Million) 3.7 3.7
Earnings per Share (EPS) (Rs) 7.30 6.49
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 Earnings-Price Ratio (E/P)
 The earnings per share related to the current market price of the
share provides a measure of the rate of yield

 This yield measure could be used by the shareholder in making

decisions about this investment in comparison to other alternate
investments
Earnings-Price Ratios (E/P) 2011 2010
Earnings per Share (EPS) (Rs) 7.30 6.49
Market price per share (Rs) 30 28
Earnings/Price Ratio (%) 24.3 23.18
Price Earnings Ratio 4.1 4.31
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 Contd…
 It is a common practice to express the E/P ratio by reversing the
relationship to measure the price-earnings (P/E) relationship
 Here, this relationship expresses market price as a certain multiple
of the earnings per share
 Dividend per Share
 It shows the cash income available to the shareholder of a share

Dividend per Share (DPS) (Rs) 2011 2010

Dividend (Rs Million) 2 2
Number of ordinary shares (Million) 3.7 3.7
Dividend per Share (Rs) 0.54 0.54
Ram, 2013 41
 Efficiency
 The relationship of assets used to sales measures the level of sales
generated by given quantum of assets
 This is a measure of the efficiency of use of assets
 This relationship of assets to sales indicates the number of times
assets turned over as a result of volume of sales generated
 Thus, the relationship of net income to assets is the turnover of
assets times’ margin on sales
 The return on total assets, measured by net income to total assets,
comes about by calculating the net income to sales times sales to
total assets

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 Example – Tools & Tools Ltd
Particulars 2011 2010
Total Assets (Rs Million) 330 270
Profit After Taxes (PAT) (Rs Million) 27 24
Sales (Rs Million) 300 280
Net Income/ Sales (%) 9.00 8.57
Sales / Total Assets (a.k.a. Asset Utilization Ratio) 0.91 1.04
Return on Total Assets (Net Income / Total Assets) (%) 8.18 8.89
Sales / Average Total Assets 1.00

 Various asset (or investment) turnover ratios are measures of efficiency

of their use in terms of their ability to convert profit margins to rate of
return on assets
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 Operating Assets Turnover
 Relates sales to the operating assets used
 This ratio assesses the efficiency of the use of operating assets,
that is, their ability to generate revenue
 Similar to return on total assets the operating assets turnover
times operating profit margin gives us the operating profit to
operating asset

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 Example – Tools & Tools
Operating Assets Turnover and Return (ROA) 2011 2010
Sales (Rs Million) 300 280
Operating profit (Rs Million) 67 60
Operating Profit Margin (OPM) (%) 22.33 21.43
Fixed assets (Rs Million) 94 79
Total operating assets (Rs Million) 326 269
Operating Asset Turnover (OAT) 0.92 1.04
Fixed Asset Turnover 3.19 3.54
Return on Operating Assets (OPM×OAT) (%) 20.55 22.30
Avg. Operating Assets Turnover = Sales /AO Assets 1.01
ROA - on average operating assets (326+269)/2 (%) 22.52

Ram, 2013 45
 Working Capital Turnover
 It is an efficiency ratio intended at evaluating the efficiency of
use of working capital
 It looks at the relationship of revenues earned to working capital
investment

Net Working Capital efficiency 2011 2010

Sales (Rs Million) 300 280
Net Working Capital 127 110
Working Capital Turnover 2.36 2.55
Avg. Working Capital Turnover (127 + 110)×0.5 2.53
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 Shareholders Equity Turnover
 Shows the management ability in terms of efficiently utilizing the
shareholders funds both with respect to efficient operations and
in terms of efficient financial management

Particulars 2011 2010

Sales (Rs Million) 300 280
Shareholders Equity 135 110
Shareholders Equity Turnover (ETO) 2.22 2.55
Average Equity Turnover (135 + 110)×0.5 2.45
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 Solvency
 Ability to meet all the short-term commitments and ability to
keep sufficient assets to cover all the liabilities in the long run
 Companies can be liquid (solvent) but not profitable.
 For example, imagine a cash rich construction company
with no orders
 Companies can be profitable but not liquid.
 For example, a construction company with lot of orders but
no cash to execute them
 Hence, we need both profitability and solvency
 Solvency can be of two types – Short Term and Long Term

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 Evaluating Short-Term Solvency
 Liquidity is of major concern to short-term creditors and
management
 Sale of merchandise (inventory turnover) and collection of
receivable generates liquidity (receivable turnover)
 Assessing excess of current assets over current liabilities –
Working Capital
 Net working capital is financed by long-term sources of funds
and as such provides a cushion for liquidity
 This is obvious since it is financed by long-term sources it is not
required to be repaid in the short-term

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 Illustration – Ramsons
RAMSONS, Balance sheet
Assets Rs Liabilities & Capital Rs
Current Assets 500 Current liabilities 250
Short
Net Fixed Term
Assets 500 Long-term loans 500
finance available Shareholders equity 250
is Rs. 250
Total Assets 1000 Liabilities & Capital 1000
 Net Working capital is: Current assets – Current liabilities = 250
RAMSONS, Balance sheet (Long-Term)
Assets Rs Liabilities & Capital Rs
Net Working Capital 250 Long-term loans 500
Net Fixed Assets 500 Shareholders equity 250
Total Assets 750 Liabilities & Capital 750
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 Current Ratio
 Current Ratio is one of the most widely used balance sheet
ratios
 However, making a specific conclusion on the adequacy of any
value of current ratio would depend on several factors such as:
 Proportion of various components of the current assets
 Time taken for conversion of these current assets to cash
 Speed of maturity of current liabilities, etc.

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 Discussion …
 The rationale for financing part of the current assets with long-term
finance is that a part of the current asset remains in stock all
through the life of the business
 So, Working Capital is the long-term investment in operating CA
 Current Ratio measures the relationship of CA to CLs
Margin
Toolsof& Tools Limited 2011 2010
Safety increased
Current By
assets (Rs Million)
Rs. 17mn 232 190
Current liabilities(Rs Million) Increase in 105 80
Current
NetRatio has Capital(Rs Million) CA is
Working 127 110
decreased not in proportion to
Current ratio: CA / CL that of CL 2.21 2.38
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 Quick Ratio
 Quick ratio or Acid test ratio is usually computed by taking assets,
which are quick to be converted into cash and divide them by
the current liability
 As a practical simplification, it is usual practice to subtract the
inventories from the current assets, to arrive at the quick assets
Quick Ratio-Tools & Tools Ltd 2011 2010
Current assets (Rs Million) 232 190
Inventory (Rs Million) 121 99
Quick Assets(Rs Million) 111 91
Current liabilities(Rs Million) 105 80
Net Working Capital(Rs Million) 127 110
Quick ratio: Quick assets/Current liabilities 1.06 1.14
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 Expenses Cover
 We hold the current asset mostly as an insurance against future
contingencies
 Cash is held with the objective of making payments whenever
required
 Inventory is held to meet the need for inventory either for
production or for sale
 Liquidity is essential as cover for the daily operating expenses

Ram, 2013 54
 Example…
Current
Particulars
assets 2011 2010
Cash amount to more 19 11
than a year’s
Current assets (Rs Million) 232 190
Operating expenses
Quick Assets (Rs Million) 111 91
Current liabilities (Rs Million) 105 80
Cash holding
Average Daily expenses
sufficient for a (Rs Million) 0.6027 0.5726
month’s
Cash cover (number of days) 32 19
expenses
Quick assets cover (number Current
of days) liabilities 184 158
Current assets cover (number amount to almost
of days) 384 332
6 months’
Current liabilities cover (number of days) 174 140
daily expenses
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 Account Receivable Turnover

 When credit sales figures are not available we could still

compute using net sales (assuming that all the sales are on
credit basis)
 The time period taken for collection of receivable is of great
interest in evaluating working capital, known as, Average
Collection Period
 Comments will depend on the normal period of credit and credit
terms given by the company and the level of deviation

Ram, 2013 56
 Accounts Receivable Turnover …
On an average
it takes Particulars
approximately 2011 2010
32 days for collection of
Sales (Rs Million) 300 280
accounts receivable
Sales per day (Rs Million) 0.82 0.77
Accounts receivable(Rs Million) 32 20
Accounts receivable turnover 9.37 14
Average Collection period (number of days) 38.9 26.1
Average Collection period using Average Accounts 31.6
Receivable during the period (number of days)
Cycle
Average of credit
Accounts receivable turnover 11.54
Sales and its collection
happened more
than 11 times
during the year
Ram, 2013 57
 Inventory Turnover …
Particulars 2011 2010
Cost of goods sold (Rs Million) 148 140
Cost of goods sold per day (Rs Million) 0.41 0.38
Inventory (Rs Million) 121 99
Inventory turnover 1.22 1.41
Inventory Holding
Inventory turnoverPeriod
= (number of days) 299 259
Average
Cost Inventory
of Goods Turnover
Sold/Average inventory 1.35
Inventory Holding Period based on average inventory 270
(number of days) Inventory
Inventory
Holding period is
turns over just
270 days or
about 1.3 times
9 months
Ram, 2013 58
 Inventory Conversion Period
 Excess inventory represents wasteful use of the resources
 The need for holding inventory will also be influenced by the
availability, time taken for deliveries, seasonal nature of business
and a host of other factors
 Inventory turnover tries to assess the velocity with which
inventories are converted to revenue
 Conversion period is the time taken for the money invested in raw
material to convert into a sale. In Tools & Tools case this is about 9
months on the average
 Management’s objective should be to turn over the inventory as
fast as possible
Ram, 2013 59
 Account Payable Turnover
 Account Payable Turnover analyze the trade liabilities on the
balance sheet to see how long it takes a firm to pay its creditors
 Average Payables Turnover (APT) is computed by dividing Cost
of Goods Sold by Average Accounts payable

 A high accounts payable turnover means a relatively short time

between purchase of goods and services and payment for them
i.e. the company pays its bills quickly
 A low turnover would indicate the opposite.

Ram, 2013 60
 Operating Cycle and Cash
Conversion Period
 Operating Cycle is the duration of the period to generate cash
through the investment of cash
 To measure operating cycle we need to know
 Time taken to convert “cash inventory sales
accounts receivable” – Inventory Conversion Period (ICP)
does capture this period
 Time taken to collect accounts receivable “accounts
receivable cash” – Average Collection Period (ACP)
does capture this period

Ram, 2013 61
 Example of Colgate Palmolive
CPIL: Operating Cycle Per Year and Cash Conversion Period (in Days)
CPIL’s Operating Cycle
Cash
has Conversion
come down from 53Period FY2010 FY2009 FY2008
days in FY2008
Average to 50 Period (ACP) (in
Collection 2 2 2
days in FY2010 Due to
days)
reduction in the
Inventory
InventoryCollection
Holding Period (ICP) (in 48 47 CCP51has been
days) Period negative
throughout and
Operating Cycle (in days) 50 50 53 steady at
has been
Average Payable Period (APP) (in days) 175 179 over 3 month
164
duration
Operating Cycle per Year 7.3 7.4 6.9
Cash Conversion Period (CCP) -124 -129 -111

Ram, 2013 62
 Contd….
 Cash Conversion Period (CCP) is calculated by subtracting Average
Payable Period from Operating Cycle
 Based on CCP figure generated, one can make the following
interpretation
 In case of positive figure, CCP conveys the duration, for which a
firm will need to tie up cash. The longer the CCP, the greater is
the need for liquidity and working capital funding arrangements
especially using long term sources
 In case of negative figure CCP conveys the duration, for which , a
firm will have excess cash to invest. The more negative is the
CCP, the greater will be the scope for the firm to use these funds
elsewhere
Ram, 2013 63
 Long-Term Solvency
 Two approaches in evaluating long-term solvency
 Evaluating the margin of safety available for lenders
represented by owners’ equity
 Ability of the firm to earn sufficient surpluses to meet all the
long-term commitments
 Debt-Equity Ratios
 The claims against assets are those of creditors and
shareholders
 Creditors have a prior claim on the assets of the company and to
that extent the owner’s equity forms the extent of margin of
safety for lenders’ claims
Ram, 2013 64
 Debt-Equity Ratio
Particulars of Tools & Tools Limited 2011 2010
Total Debt (Rs Million) 195 160
Shareholders Equity (Rs Million) 135 110
Total Debt to Shareholders Equity 1.44 1.45

 For every Rupee of shareholders funds in the company there is

Rs 1.4 of lenders claim
 Lower the lender’s claim to shareholders claim; lower are the
demands on firm’s earnings for meeting fixed commitment in
terms of interest
 There is lesser leverage in the capital structure of the company
Ram, 2013 65
 Long-term Debt to Total Capital
 Measures the relationship long-term debt bears to owners’ total
investment in the company

Tools & Tools Ltd. 2011 2010

Long-term Debt (Rs Million) 90 80
Shareholders Equity (Rs Million) 135 110
Long-term Debt to Shareholders Equity (%) 66.67 72.73

 For every Rupee of owners’ funds there is a long-term debt

commitment of Rs 0.67 only
Ram, 2013 66
 Long-term Debt to Fixed Asset
 Measures the amount of fixed assets available as a backing for
long-term debt

Tools & Tools Ltd. 2011 2010

Long-term Debt (Rs Million) 90 80
Net Fixed Assets (Rs Million) 94 79
Long-term Debt to Net Fixed Assets (%) 95.8 101
 The long-term debt is more than covered by net fixed assets of
the company during 2011

Ram, 2013 67
 Times Interest Earned
 This ratio measures the relationship of earnings before interest
and taxes to the fixed interest commitment
 Larger the cover greater is the safety of lender's interest
 Alternately it also shows the risk in case the firm's earnings
decrease

Particulars 2011 2010

Earnings before interest and taxes 67 60
Interest expense (Rs Million) 14 13
Long-term Debt to Net Fixed Assets (%) 4.8 4.6
Ram, 2013 68
 Times fixed charges covered
 It is computed usually if the company has other fixed commitments
(say lease payments) under non-cancelable lease obligations:

 If information is available then one should also be including items

like scheduled repayment of the loans (a commitment made by the
company) in the fixed charges as above
 Interpretation of this ratio is similar to the interest cover and shows
the extent of safety provided by current operating earnings

Ram, 2013 69
 Gearing …
 It is the extent to which the company is in a position to increase
the earnings to shareholders by having fixed interest bearing
borrowing in the capital structure. This could be worked out by
disaggregating the earnings on borrowed funds as follows:
Tools & Tools Limited FY2011
Profit earned by average borrowed funds (using the 0.5(195 + 160) × 38.52
earlier computed operating profit margin) 22.33
Less: interest cost 14.0
Gain from borrowed funds 24.52
Less tax liability on the gain 24.52 × 49.06% 12.03
Net gain from borrowed funds 12.49
The net profit realized as a result of gearing (12.49/177.5)×100 7.04%
Ram, 2013 70
 Equity Multiplier
 The equity multiplier will show the extent of enhancement of
return to equity holder due to leverage or borrowing

Tools & Tools Ltd. 2011 2010

Total Debt (Rs Million) 195 160
Shareholders Equity (Rs Million) 135 110
Total Assets 330 270
Equity multiplier (Total Assets/Owners Equity) 2.44 2.45
Return on Total Assets (%) 8.18 8.89
Return on Equity ( ROTA * Equity Multiplier)(%) 20 21.8
Ram, 2013 71
 Du Pont Analysis
 A combination of margin on sales ratio, efficiency ratio, and long-
term solvency ratio is popularly known as the DuPont analysis

 The DuPont break up conveys that one can maximize profitability

(ROE) by focusing on playing a margin-based game and/or the
asset utilization, and/or the financial leverage game
 The DuPont analysis approach helps in identifying and pinpointing
the reasons behind high or low profitability of a firm vis-à-vis its
competitors

Ram, 2013 72
 Using Financial Information
 Computation of financial statement ratios does enhance the
understanding of the financial statement information
 The rich information could be used for many purposes:
 Evaluating investments
 Deciding on credit terms for customers
 Comparing financial performance of companies, etc.
 Important tool for supporting planning for future
 Financial analysis of other competing firms can be used for
tracking the “time-trend” behavior of the industry
 It is also a usual practice to identify a peer group and keep
monitoring for benchmarking
Ram, 2013 73
 Hidden Assumptions Mean Caution
… quick contexts …
 All the firms have similar accounting policies and practices
(such as the method of depreciation allocation)
 All the firms did not have any significant change in accounting
policy (such as a change in the inventory valuation policy)
 The processes of generating the accounting numbers are
reliable across the firms
 Financial ratios are primarily used for comparison (instead of
absolute values) in order to facilitate adjustments for size.
However, while doing this we are also assuming that ratios
posses the appropriate statistical properties for handling and
summarizing data
Ram, 2013 74
 Hidden Assumptions Mean Caution
… quick contexts …
 A large number of such assumptions might be violated even
while making comparisons of a single firm over many years
 Hence, care must be taken in terms of making any significant
conclusions
 One should carefully read the notes of accounts for any
significant comments such as changes on accounting policy or
any significant provisions or contingent liabilities that may arise
 Importance ought to be given to qualitative factors, such as
differing economic and cultural environments, while doing
financial analysis for firms across industries, geographies, and
time periods
Ram, 2013 75
 Thank You

Ram, 2013 76