FINANCIAL STATEMENT ANALYSIS Financial Statement Analysis is a systematic process of identifying the financial strengths and weaknesses of the

Company by properly establishing relationships between items of the balance sheet & Income Statement. Techniques of Financial Statement analysis

Comparative Financial Statements: Comparative Financial Statements are the statements in which figures for two or more years are placed side by side along with change in figures in absolute and percentage terms to facilitate comparison. For example Common Size Statements: Common size financial statements express figures of financial statements as percentage of a common base. In case of Profit and loss accounts Sales are assumed to be the base and all other figures are expressed as a percentage of sales. In case of Balance Sheet, total of Assets & Liabilities is taken as a base. Funds Flow Statement: This statement shows changes in the working capital position. It shows sources and uses of working capital Cash Flow Statement: This statement shows changes in the cash position from one period to another. It shows sources and uses of cash Ratio Analysis: Accounting ratio is a mathematical expression of relationship between two items or group of items in the Financial Statements. Ratio Analysis is the process of computing, determining and presenting relationship of items and group of items in the Financial Statements. It is important technique of financial analysis Trend Analysis: In this method trend percentages are calculated, which involves calculation of percentage relationship that each item bears to the same item in the base year. A year, usually the earlier year is taken as a base year. Each item of the base year is taken as 100 and on that basis percentage for each of the item for each of the year is calculated. Trend analysis is carried out for many years

In this course we will cover only Ratio Analysis in detail.

Inter-firm Comparison
When the Financial statements of two or more firms/Companies are compared, it is known as inter firm analysis. Inter-firm analysis is useful for assessing own performance as well as the performance of the others especially in case of mergers or acquisitions.

Intra-firm Comparison
When the Financial statements of same firm/Company are compared for two or more years , it is known as intra firm analysis.

RATIO ANALYSIS
Objectives of Ratio Analysis To judge the earning capacity, financial soundness and operating efficiency of an enterprise/Company To simplify the understanding of accounting information To help in comparative analysis Uses of Ratio Analysis: Ratio Analysis is useful in Analysis of Financial Statements Judging profitability of the business Judging liquidity or short tem solvency of the business Judging the long term solvency of the business Judging the operating efficiency of the business Intra firm or inter firm comparison Limitations of Ratio Analysis Qualitative factors are ignored Ratio Analysis is technique of quantitative analysis thus ignores qualitative factors which may be important for decision making Lack of standard ratio There is almost no single standard against which the actual ratio may be measured and compared False results if based on incorrect information Conclusions drawn may be false if ratios are based on incorrect information May not be comparable Ratios may not be comparable if different firms follow different accounting policies or procedures Types of Ratios I. Liquidity Measurement/Short term Leverage/Short Term Solvency Ratios: Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets (or, those that can be easily converted to cash), its short-term liabilities. Higher the ratio better it is as this demonstrates ability to pay short term liabilities. Current Ratio: The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its shortterm liabilities (Bills payable, Creditors, outstanding expenses). In theory, the higher the current ratio, the better. Formula:

Quick Ratio: The quick ratio or the acid test ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position. Quick Assets = Current Assets Inventory/Stock Formula:

II. Profitability Indicator Ratios: These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value.

Gross Profit Ratio: A company's cost of sales, or cost of goods sold, represents the expense related to labor, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company's net sales/revenue, which results in a company's first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator.

Operating Ratio : By subtracting selling, general and administrative, or operating, expenses from a company's gross profit number, we get operating income. Management has much more control over operating expenses than its cost of sales outlays. Thus, investors need to scrutinize the operating profit margin carefully. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.

Net Profit Ratio:

Proprietary Ratio Return On Assets: This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company's total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage. Formula:

Return On Equity: This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors. Formula:

Return On Capital Employed: The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company's debt liabilities, or funded debt, to equity to reflect a company's total "capital employed". This measure narrows the focus to gain a better

understanding of a company's ability to generate returns from its available capital base. Formula:

Capital Employed = Share Capital + Reserves + long term liabilities fictitious assets Or Capital Employed = Fixed Assets + Investments + Current Assets Current Liabilities Net Income = EBIT III. Debt/ Long term Leverage/Long Term Solvency Ratios Debt-Equity Ratio: The debt-equity ratio is another leverage ratio that compares a company's total liabilities to its total shareholders' equity. This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed. Formula: Debt Equity Ratio = Long term Liabilities Equity (Shareholders Funds) Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves fictitious Assets Interest Coverage Ratio: The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The lower the ratio, the more the company is burdened by debt expense Formula:

IV. Investment Valuation/Market Ratios (refer table) Price/Earnings Ratio Dividend Yield

V. Turnover Ratio (refer table) Stock Turnover Ratio Debtors Turnover Ratio Average Debt Collection Period Asset Turnover Ratio Creditors Turnover Ratio

Summary
Name of the Ratio Formula Significance How Expressed Remarks

LIQUIDITY RATIOS
Current Ratio
Current Assets Current Liabilities

The ratio shows short term financial soundness of the company. Higher the ratio better it is. Ratio of 2:1 is considered to be ideal

Fraction (times)

Current Assets are those assets which are either in the form of cash or can be converted into cash within one year, like cash, cash equivalents, marketable securities, receivables and inventory Current Liabilities are those Liabilities which are required to be paid within one year, like Bills payable, creditors, outstanding expenses

Quick Ratio

Quick Assets Current Liabilities

This is stringent measure of liquidity. Ratio of 1:1 is considered to be ideal. Higher the ratio better the short term financial position

Fraction

Quick Assets = Current Assets Stock (inventory) Prepaid Expenses

SOLVENCY RATIOS
Debt Equity Ratio
Long term Liabilities Equity (Shareholders Funds)

This ratio measures the long term financial position of the company. In general lower the ratio, higher the degree of security for the lenders This ratio shows extent to which assets are financed by the proprietors funds. Higher the ratio, greater the satisfaction to the lenders & creditors This ratio measures companys ability to pay the interest to its

Fraction

Long Term Debt/Liabilities - Debentures, Long term loan, Public Deposits Shareholders Funds - Equity Share Capital + Preference Share Capital + Reserves & Surplus fictitious Assets

Proprietary Ratio

Shareholders Funds/Proprietors funds Total Assets

Fraction

Interest Coverage

Earnings before Interest & Tax Interest Expense

Fraction

Earnings before Interest & Tax (EBIT) = Net profit +Interest + taxes

Ratio

lenders. Higher the ratio better it is.

Or EBIT = Gross Profit All operating expenses ( except interest & taxes) Times Average Stock = Opening Stock + Closing Stock 2 Cost of Goods sold = Opening Stock + Purchases + Direct Expenses Closing Stock

TURNOVER RATIOS Stock Cost of goods sold Turnover Average Stock Ratio

Debtors Turnover Ratio

Net Credit Sales Average Debtors

This ratio measures how fast the stock is moving through the company or how quickly stock is getting converted into sales. Higher the ratio, more efficient is the management of inventories and hence better This ratio measures how fast the debtors are getting converted into sales. Higher the ratio, better it is as it indicates economy & efficiency in debt collection

Times

Net Credit Sales = Total Sales Cash Sales - Sales Returns Or Net Credit Sales = Credit Sales - Sales Returns Average Debtors = Opening Debtors + Closing Debtors 2

Average Collection period Creditors Turnover Ratio

365days/52 weeks/12 months Debtors Turnover Net Credit Purchases Average Creditors This ratio indicates number of times the creditors are turned over in relation to purchases. A higher turnover ratio indicates shorter payment period which means availability of lesser credit Times Net Credit Purchases = Total Purchase Cash Purchases Purchase Returns Or Net Credit Purchases = Credit Purchase - Purchase Returns Average Creditors = Opening Creditors + Closing Creditors 2

Average payment period Working Capital Turnover Ratio

365days/52 weeks/12 months Creditors Turnover Net Sales or Cost of goods sold Net Working Capital This ratio shows the number of times Times working capital is employed in the process of carrying out the business. Higher the ratio better the efficiency in utilisation of working capital

Working Capital = Current Assets Current Liabilities

Fixed Assets Turnover Ratio Gross Profit Ratio Net Profit Ratio Operating Profit Ratio Operating Ratio Return on capital Employed/Ret urn on investment Earnings per share(EPS)

Net Sales Net Fixed Assets

A higher the ratio indicates Times efficiency in utilisation of fixed assets

Net Fixed Assets = total fixed Assets - depreciation

PROFITABILITY RATIOS
Gross Profit Net Sales x 100 Higher the ratio better it is Percentage Gross Profit = Net Sales Cost of Goods Sold

Net Profit x 100 Net Sales Operating Profit Net Sales x 100

It indicates overall efficiency of the business. Higher the ratio better it is This ratio indicates operational efficiency of the business. Higher the ratio better it is This ratio indicates operational efficiency of the business. Lower the ratio better it is This ratio measures overall performance of the Company. Its judges how efficiently the resources entrusted to business are used This ratio helps in evaluating the prevailing market price of the share in light of profit earning capacity of the Company The objective of calculating this ratio is to find out expectations of the shareholders. A high P/E indicates shareholders faith in stability of the company

Percentage

Net Profit = Gross Profit All operating Costs Interest Taxes Operating Profit = Gross Profit All operating Costs (except Interest & Taxes) Operating Expenses include factory expanses, administrative expenses, selling expenses, office expenses Capital Employed = Share Capital + Reserves + long term liabilities fictitious assets Or Capital Employed = Fixed Assets + Investments + Current Assets Current Liabilities

Percentage

Operating Expenses Net Sales EBIT x 100 Capital Employed

x 100

Percentage

Percentage

Profit (earnings) after taxes preference dividend Number of Equity Shares

Per share

Price Earnings Ratio (P/E)

Market Price EPS

Times