Corporate Financial Management

Chapter-4

ANALYSIS OF FINANCIAL STATEMENTS

Having understood how a balance sheet and profit and loss statement is organized, we
can now see how they might be analyzed.
There are three ways in which we can analyze.
a.
analysis
b.
c.

Common size
Index analysis
Ratio analysis.

Common Size analysis

Under this analysis, in the balance sheet the total assets and total liabilities are
taken as equivalent to 100. The percentage of other items in the balance sheet is then
computed. All the items are expressed as a percentage of the total assets/liabilities. A
comparison of the changes is then made and results interpreted accordingly.
Similarly in the case of Profit and Loss statement, the sales or total income is taken as
equivalent of 100. The other items are expressed as a percentage of sales.
Example 1
The financial statements of Khilafat Bros show the following position. Convert them into
a common size statement. What observations can you make?
Liabilities
Equity Share Capital
Reserves and Surplus
Term loans
Total
Assets
Fixed Assets
Investments in subsidiary concerns
Current assets
Misc. expenditure not written off
Total

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Amount (Riyals)
678
2456
1345
4479
2088
932
878
581
4479

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The common size balance sheet would look as follows:

it

Liabilities
Equity share capital
Reserves and Surplus
Term Loans
Total
Assets

Amount
15.2
54.8
30.0
100.0

Fixed Assets

46.6

Investment in Subsidiary concerns

20.8

Current Assets

19.6

Misc. Expenditure not written off

13.0

Total

100.0

From the above statement,

might be observed that, the
company has used much
more of own funds than
borrowed funds (15.2+54.8
70.0).Fixed assets form
largest
component
of
assets. Around 21% of the
funds raised have been
invested in a subsidiary
concern.

Similarly in the case of

profit and loss account, the common size can be shown as below
Sales

7432

71.2

Other income

3000

28.8

Total income

10432

100.0

Material

4401

42.2

Power and Fuel

1234

11.8

Salaries and wages

1138

10.9

Selling expenses

1431

13.7

Administrative expenses

654

6.3

Depreciation

256

2.5

Interest

768

7.4

Profit before tax

550

5.2

Tax

234

2.2

Profit after tax

316

3.0

Expenses

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From the Profit and Loss account, it might be observed that other incomes contribute
significantly to the profits. Materials account for 42% of the sales. The ability of the
company to make profits is low. Net profits are only 3 % of the total income.
Index Analysis
In the Index Analysis, the financial statements of different periods are compared. Earliest
period is taken as the base period. The various figures in the base period are treated as
equivalent to 100. The figures appearing in the later period are expressed as a percentage
of the base period. The changes in these periods for different elements of the statements
are observed. Interpretations of these are made thereafter.
Example 2:
Balance Sheet
2000
Equity
Share
Capital
Reserves
and
Surplus
Term
Loans
Total
Assets
Fixed
Assets
Current
Assets
Exp. Not
W/O
Total

2850

100

2002
2850

100

2003
2850

100

3550

100

4360

123

5460

154

3020

100

2820

93

2420

80

9420

100

10030

106

10730

114

2859

100

3560

125

4780

167

5690

100

6280

110

4980

88

871

100

190

22

970

111

9420

100

10030

106

10730

114

From the above index analysis, it might be observed that total assets and accordingly
liabilities have increased 14% in the last two years. However fixed assets have increased
67%. Current assets have actually decreased by 12 %. Reserves and Surplus has increased
by 54%, while term loans have decreased by 20%. In other words, profits generated have
been ploughed back into the business. The dependence on term loan has decreased.

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Ratio Analysis:
This is a tool for analyzing financial performance and health of a business. Ratio is
proportion of one figure over another. There are five types of ratios which indicate the
financial health and performance. They are;
- Liquidity
- Turnover
- Structural or leverage
- Profitability
- Valuation ratios
Liquidity ratios:
These ratios indicate how liquid a business is. Liquidity means, the ability of the
company to pay back its short term creditors. This ability is measured in terms of the
current assets available for conversion to cash or equivalent to enable repayment of
creditors. It is defined as;

Current Ratio = Current Assets / Current Liabilities

Another ratio which also indicates liquidity is the acid test ratio.

Acid test ratio = (Current Assets Receivables) / Current Liabilities.

Higher these two ratios, better the liquidity.
Turnover ratios
These ratios reflect the level of activity in the business. The number of times the assets of
the company have been turned over to generate sales/ total income is indicated in this
ratio. The ratios are, total turnover, fixed asset turnover, current asset turnover, inventory
turnover and receivables turnover.

Total asset turnover = Sales (Total income) / Avg. Total Assets.

Avg. total assets = (Opening balance + closing balance/ 2)

Fixed asset turnover = Sales (Total income) / Avg. Fixed Assets

Avg. fixed Assets = (Opening fixed assets + closing fixed assets / 2)

Current Asset turnover = Sales (total income) / Avg. current assets

(Avg. current assets = opening current assets + closing current assets / 2)

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Corporate Financial Management

Inventory turnover = Sales (total income) / Avg. Inventory

(Inventory would comprise raw material, work in process, finished goods and stores and
consumables)
Avg. Inventory = [(Opening inventory + Closing inventory / 2)]

Receivables turnover = Sales / Avg. Receivables

Average Receivables = [(Opening receivables+ closing receivables) / 2]
Higher these ratios better the utilization of the assets. The efficiency of utilization of
assets is reflected in these ratios.
Structural Ratios (Leverage ratio)
This ratio indicates the capital structure of the business. The respective share of debt and
equity in financing the business is indicated in this ratio. The important ratios are;

Total Debt to Equity Ratio = Total outside liabilities/ Tangible net worth
Tangible net worth

= [Equity + Reserves and surplus Intangible assets.]

Too high a ratio is considered risky in the event of downward fluctuations in the fortunes
of the business.

Long term debt to equity == Long Term debt/ Tangible net worth
Generally the ratios exceeding 1.50 is considered risky.
Coverage Ratio:
Interest service coverage ratio [ISCR] indicates the ability to pay interest.

ISCR =

Profit before interest and taxes / Interest

Debt service coverage ratios [DSCR]:

DSCR = [(Net profit + Interest + Depreciation)] /
[(Interest + Repayment installments)]
The higher the ratios better the ability to pay interest and also repay principal
installments.

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Profitability Ratios:
These ratios indicate the ability of the business to make profits. These ratios are defined
with respect to sales and also with respect to total assets.

Gross profit margin = Gross Profit/ Sales (total operating income)

Operating profit margin = Operating Profit / Sales (total income)
In case there is no non operating income or expenses, this ratio is also identical to
= Earnings before interest and taxes (EBIT) / Sales (total income)

Net profit margin = Profit after tax (PAT) / Sales (total income)
Return on Investment = Operating Profit / Avg. total assets
Return on Net worth (Equity) = PAT / Avg. total assets.
Earnings per share (EPS) = PAT / no of outstanding shares.
Higher the ratios, more profitable the business.
Valuation Ratios
These ratios measure the value of a share.
The important ratios are;
Book value = Net worth / No of outstanding shares.
Price Earnings multiple [PE] = Market Price/ EPS
Limitations of the ratio Analysis
Ratio analysis is helpful only if their limitations (to what extent they can be used) are
understood. Some of the major limitations are;
1. The analysis is carried only with reference to the figures at the end of accounting
periods. This might not be indicative of financial position that might have been

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present during the rest of the period. Therefore the inferences drawn might not be
proper.
2. The analysis is based on past data and not necessarily providing any indication or
direction for the future.
3. The analysis is based on financial statements prepared by the company. For joint
stock companies these statements are subject to audit and therefore somewhat
reliable. For other types of business in most countries they are not subject to a
proper audit. The auditors responsibility is only to certify that the statements
have been prepared based on figures correctly extracted from the books of
accounts maintained by the company. The auditor does not certify that the
financial statements present a true and fair picture of the financial position and
working results of the company.
4. Even in the case of joint stock companies, the accounts are often window dressed
to distort the position of profits or the financial position. Some of the accounting
areas where the accountants have some flexibility to fudge the reporting are ;
a. Inventory valuation
b. Depreciation
c. Writing off expenditure
d. Capitalizing revenue expenditure
e. Revaluation
Therefore while ratio analysis is very helpful, it has to be interpreted carefully with full
awareness of the limitations.
Practice Exercise
1. Net profit margin
Total asset turnover ratio
Debt to Total asset ratio
Return on equity

= 7%,
= 1.50
= 0.50
=?

2. Profit before tax

Interest coverage ratio
Total interest charge

= 50,000
=5
=?

3. Interest Charge
=
Sales
=
Tax rate
=
Net profit margin
=
Interest coverage ratio =

200,000
7,500,000
40%
5%
?

4. If a companys current assets are RO 12000 and current liabilities are RO 4000,
how much additional trade credit can be taken without bringing the current ratio
below 2?

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5. The annual sales of a company are RO 1,000,000 and its average accounts
receivable are RO 100,000. By what period of time should the average collection
period be reduced, if the average accounts receivable are to be reduced to RO
75,000? (Average collection period = Accounts receivable/ credit sales per day)
6. What will be the sales of a company if its;
Current ratio
Acid Test ratio
Current liability
Inventory turnover ratio

= 1.30
=1
= RO 1,000,000
= 4 times

7. Complete the balance sheet and sales data (fill in the blanks) using the following
financial data?
Debt/Equity ratio
=1
Acid-test ratio
=1
Total asset turnover ratio
=2
Days sales outstanding in accounts receivable
(Accounts receivable/sales per day) = 30 days
Gross profit margin
= 15%
Inventory turnover ratio
=6
Operating profit margin
= 10 %
Net profit margin
= 5%
Cash profit margin
= 6%
Taxation rate
= 20%
Liabilities
Equity capital
Retained earnings
Current liability
Non current liability
Total
Sales
Cost of goods sold
Gross profit
Depreciation
Selling General and
Administrative expenses
Operating profit
Interest
Profit before tax
Profit after tax

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100,000
50,000
?
0
?
?
?
?
?
?
?
?
?
?

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Assets
Plant and Equipment
Inventory
Accounts receivable
Cash
Total

?
?
?
?
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Corporate Financial Management

8. The balance sheet and the income statement of Al Hassan Food Products SAOG
are given below. Evaluate the performance with reference to the standards?
Balance Sheet
Equity Capital
Reserves and surplus
Long term debt
Short term bank
borrowing
Trade creditors
Provisions
Total
Fixed assets (Net)
Cash and bank balance
Receivable
Inventories
Pre-paid expenses
Others
Total
Current Ratio
Acid-test ratio
Debt Equity ratio
Interest coverage ratio
Inventory turnover ratio
Average collection period
Total asset turnover ratio
Net profit margin
Return on Investment
Return on Equity

Income and expenses statement

Net Sales
100000
Non operating surplus
2000
Cost of goods sold
70000
Other Operating
10000
expenses
Profit before Interest and
22000
tax
Interest
5000
Tax
7000
Dividends
4000
Retained Earnings
6000

15000
25000
20000
15000
10000
5000
90000
40000
5000
15000
20000
5000
5000
90000

Standard
1.30
1.00
1.25
3.00
5.00
40 days
0.80
5%
8%
10%

9. The following data pertains to XYZ Industries LLC.

Current Ratio = 1.50
Acid-Test Ratio = 0.75
Inventory Ratio = 8
Total asset turnover ratio = 1.20
Current liabilities = RO 1,000,000.
Calculate the net Fixed Assets of the company? What assumptions do you need to
make for the answer?

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10. The following details are available with regard to Swift Industries LLC. for the
year December 31, 2004.
Gross profit margin
Average collection period
Average payment period= (Accounts
payable/credit purchases per day)
Gross profit

20%
2 months
2.40 months
600,000

It was also ascertained that the closing stock as on December 31, 2004, was RO 50,000 in
excess of the opening stock as on January 1, 2005. You may assume that Swift Industries
is a trading concern and cost of goods purchased is the only expense. Determine the
balance of Debtors and creditors as on December 31, 2004?
11. Compute the various ratios for the three companies A, B and C whose summary of
balance sheet and profit and loss account is given below and make a comparative analysis
and interpret your results?

Assets
Fixed Assets
Investments of long term
nature
Cash
Receivables
Inventory
Total
Liabilities
Share Capital
Reserves& Surplus
Long Term loans
Bank overdraft
Trade creditors
Total

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2003
2004
Company A

2003
2004
Company B

2003
2004
Company C

75
25

125
50

250
50

300
29

300
100

420
80

10
50
40
200

20
70
60
325

30
103.33
66.67
500

40
140.64
90.36
600

53.80
100
246.20
800

62.30
130
307.70
1000

50
16.67
33.33
60.00
40.00
200

50
58.33
66.66
90.00
60.00
325

150
100
116.67
100.00
33.33
500

150
150
119.34
140.00
40.66
600

400
133.33
66.67
120
80
800

470
196.67
83.33
130
120
1000

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Corporate Financial Management

Sales
Cost of goods sold
Selling , general and
administrative expenses
Interest
Profit before tax
Tax @15%
Profit after tax
Answers:
Q1. 15%
Q7.

A
656.25
492.19
65.62

B
825
618.75
107.25

C
900
675
135

36.68
61.76
9.26
52.50

21.36
77.64
11.64
66.00

5.30
84.70
12.70

Q 2. RO 12500 Q3. 4.125 Q4. RO 4000 Q5. 9 days Q6. RO 1200,000

Liabilities
Equity capital
Retained earnings
Current liability
Non current liability
Total
Sales
Cost of goods sold
Gross profit
Depreciation
Selling General and
Administrative expenses
Operating profit
Interest
Profit before tax
Profit after tax

100,000
50,000
150,000
0
300,000
600,000
510,000
90,000
6000
24000

Assets
Plant and Equipment
Inventory
Accounts receivable
Cash
Total

50,000
100,000
50,000
100,000
300,000

60,000
22500
37500
30000

Q8.
Ratio
Current ratio
Acid test
Debt Equity ratio
Interest coverage
Inventory turnover
Average collection period
Total asset turnover
Net profit margin
Return on Investment
Return on Equity

Standard
1.3
1.5
1.25
3.00
5.00
40 days
0.80
5%
8%
10%

Company
1.5
1.33
1.25
4.40
5.00
54 days
1.11
10%
18.88%
25%

The company is doing very well compared to standards provided in respect of most of the ratios . It is
providing more than twice returns to the shareholders when compared to standards. This is possible by
better utilization of assets. The only area of concern for the company is the collection period which is
higher than standards.

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