MODULE 1 FINANCIAL ANALYSIS

It consists in separating facts according to some definite plan, arranging them in groups according to certain circumstances and then presenting them in a convenient and easily readable and understandable form. Features To present complex data contained in financial statements in simple and understandable form To classify items contained in financial statements in convenient and rational groups To make comparisons between various groups to draw various conclusions Objects of financial analysis To know the earning capacity or profitability To know the solvency To know the strength To make comparative study with other firms To know the capability of payment of interest and dividend To know the trend of business To know the efficiency of management To provide useful information to the management

Limitations Affected by window-dressing Do not reflect price level changes Different accounting policies Effect of personal ability and bias of analyst Difficulty in forecasting Lack of qualitative analysis Limited use of single years analysis of financial statements

Tools for financial analysis Comparative statements Common size statements Trend analysis Accounting ratios Cash flow statements Funds flow statements

Comparative Statements
Financial statements figures for two or more years are placed side by side to facilitate comparison Columns indicate increase or decrease in figures from one year to another or change as a percentage Utility To make data simpler and more understandable To indicate the trend To indicate strong and weak points To compare firms performance with average performance of the industry To help in forecasting

Techniques of presenting comparative statements To show the absolute data in rupee amount only To show increase or decrease in absolute data in terms of money value To show increase or decrease in absolute data in terms of percentage Comparison expressed in ratios Use of comparative figures and averages Comparative Balance Sheet Particulars 2002 2003 Absolute increase / decrease over 02 Percentage increase / decrease in relation to 02

Fixed Assets (A) Investments (B) Net Fixed Assets (A + B) Working Capital : Current Assets (i) Current Liabilities (ii) Working Capital (C) (i-ii) Capital Employed (A+B+C) Less : Long Term Debts Shareholders Funds Represented by : Preference Share Capital + Equity Share Capital + Reserves & Surplus

Comparative Income Statements

 Shows revenue and expenses over the current and previous years, how much revenue and expenses have increased or decreased and the percentage change Shows changes in sales, cost of goods sold, gross profit, operating profit and net profit Comparative income statement Particulars 2002 2003 Absolute increase / decrease over 02 Percentage increase / decrease in relation to 02

Net Sales Less : Cost of goods sold Gross Profit (A) Less : Operating Expenses : Office and administration expenses Selling and distribution expenses Total Operating Expenses (B) Operating Profit (A - B) Add : Non-Operating Incomes Total Income Less : Non-Operating Expenses Net Profit before Tax Less : Tax Net Profit after Tax

Common Size Statements

Trend Analysis
Helps in making comparative study of financial statements for several years Based on the idea that what has happened in the past is what will happen in the future Method involves calculation of percentage relationship that each item bears to the same item in the base year Any year may be taken as the base year (usually the earliest year) Each item of base year is taken as 100

Ratio Analysis

A ratio is a relationship between two figures, expressed in arithmetical terms. They are of three types Pure ratio or Simple ratio (e.g. 2:1) Rate or so many times (e.g. 2 times) Percentage (e.g. 20 %) Advantages Helpful in analysis of financial statements Simplification of accounting data Helpful in comparative study Helpful in locating weakness of the business Helpful in forecasting Estimate about the trend of the business Fixation of ideal standards Effective control Study of financial soundness

Limitations False accounting data gives false ratios Comparison not possible if different firms adopt different accounting policies Less effective when there are price level changes May be misleading in absence of absolute data Limited use of single ratio Window-dressing Lack of proper standards Ratios alone not adequate for proper conclusions Effect of personal ability and bias of the analyst

Classification of ratios Liquidity ratios Current ratio Quick ratio / Acid Test ratio / Liquid ratio Solvency ratios Debt Equity ratio Proprietary ratio Total Assets to Debts ratio

 Profitability or Income ratios Gross Profit ratio Net Profit ratio Operating ratio Return on Capital Employed / Overall Profitability Ratio Activity or Turnover ratios Inventory Turnover ratio Debtors / Receivables Turnover ratio Creditors Turnover ratio Working Capital Turnover ratio Fixed Assets Turnover ratio

LIQUIDITY RATIOS
Current Ratio Ratio explains relationships between current assets and current liabilities Current ratio =

Significance Assess firms ability to meet its short term liabilities on time Ideal current ratio is 2:1 Higher the ratio, the better Less than 2:1, it indicates lack of liquidity and storage of working capital Higher ratio is also considered adverse Stock piling up because of poor sales Large amount locked up in debtors due to inefficient collection policy Cash or Bank balances lying idle, no proper investment opportunities available Susceptible to window dressing Quick Ratio Also known as Acid Test ratio or Liquid ratio Quick ratio =

Liquid Assets = Current Assets Stock Prepaid Expenses Liquid Liabilities = Current Liabilities Bank Overdraft

 Ideal ratio 1:1 Better test of short term financial position

SOLVENCY RATIOS
Debt Equity Ratio Calculated to ascertain the soundness of the long term financial policies of the firm Indicates the proportion of funds which are acquired by long term borrowing in comparison to shareholders funds Debt Equity Ratio = Long Term Loans = Debentures, Bank Loan, Loan from financial institutions Net worth or shareholders funds = includes Equity Share Capital, Preference Share Capital, General Reserve, Securities Premium and P&L a/c (cr.) and excludes all accumulated losses and fictitious assets Ideal ratio 2:1 High ratio Danger signal for long term lenders Low ratio Better signal for long term lenders Total Assets to Debts Ratio Long term debt is expressed in relation to total assets Total Assets to Debts Ratio = Total assets = All fixed and current assets, excludes fictitious assets such as Dr balance of P&L a/c, preliminary expenses, underwriting commission, share issue expenses, discount on issue etc. Significance Measures the proportion of assets financed through long term loans High ratio is indicator of risky financial position Proprietary Ratio Indicates proportion of total funds provided by owners or shareholders Proprietary Ratio = Ideal ratio 33 % or more

 High ratio Indicator of financial soundness Low ratio Danger signal for long-term lenders as they are less secured

PROFITABILITY RATIOS
Gross profit ratio Indicates relationship between gross profit and sales Gross profit ratio =

Net sales = Sales Sales Returns Measures the margin of profit available on sales No ideal fixed standard

Net profit ratio Indicates relationship between net profit and sales Net profit ratio =

Net sales = Sales Sales Returns Measures the margin of profit available on sales No ideal fixed standard

Operating ratio Measures proportion of an enterprises cost of sales and operating expenses in comparison to sales Operating ratio = Measurement of efficiency and profitability Indicates the extent of sales that is absorbed by the cost of goods sold and operating expenses

 Lower the better

Return on capital employed Also known as Overall Profitability Ratio Indicator of the earning capacity of the capital employed in the business Return on Capital Employed = Operating Profit = Profit before interest on long term loans and tax Capital Employed = Equity Share Capital + Preference Share Capital + Undistributed Profits + Reserves and Surplus + Long term Liabilities Fictitious Assets OR Capital Employed = Fixed Assets + Current Assets Current Liabilities Stock turnover ratio Indicates the relationship between the cost of goods sold during the year and average stock kept during that year Stock Turnover Ratio =

Cost of goods sold = Opening Stock + Purchases + Carriage Inwards + Wages + Other Direct charges Closing Stock OR Cost of goods sold = Net Sales Gross Profit Average Stock = Indicates whether stock has been efficiently used or not Higher the ratio, better it is.

Debtors Turnover Ratio

Debtors Turnover Ratio =

= Provision for Bad and Doubtful debts is not deducted from debtors If amount of credit sales is not given total sales is to be taken Indicates speed with which amount is collected from debtors Higher the ratio, the better it is Low ratio indicates inefficient credit sales policy of management Average Collection Period Represents the average number of days for which a firm has to wait before its receivables are converted into cash Average Collection Period =

= Measure quality of debtors Shorter the better, but very short ratio implies conservative credit policy High collection period inefficient collection performance, larger chances of bad debts Creditors / Payable Turnover Ratio Represents average number of days taken by the firm to pay its creditors Creditors Turnover Ratio = High ratio indicates creditors are not paid in time Low ratio indicates business is not taking full advantage of credit period allowed

Average Age of Payables Indicates speed with which payments for credit purchases are made to creditors Average age of payables =

Working Capital Turnover Ratio Indicates number of times the working capital is turned over in the course over the year Measures efficiency with which the working capital is used by the firm High ratio indicates efficient utilization Working Capital Turnover Ratio =

= Fixed Assets Turnover Ratio Measures the efficiency in the utilization of fixed assets Fixed Assets Turnover Ratio = Higher the better Low ratio indicates idle capacity and excessive investment in fixed assets Ideal ratio is 5 times