FINANCIAL STATEMENT ANALYSIS

Methods

FINANCIAL STATEMENT ANALYSIS

Objectives of Analysis
1.

2.
3.

4.

To know whether the company is making enough profit or not To evaluate the financial strength of the company To judge the ability of the company to generate enough cash and cash equivalents and their timing To know the future growth prospects

FINANCIAL STATEMENT ANALYSIS

Tools available for analysis

1. 2. 3. 4. 5.

Multi-step income statement Horizontal (comparative) analysis Common-sized analysis Trend analysis Analytical balance sheet

Multi-step Income Statement

From the reported statement , it is necessary to segregate information and break-up of manufacturing, administrative and selling expenses which will show the profitability and disclose the following:
a)
b) c) d) e) f)

Gross ProfitGP Profit before depreciation, interest and taxPBDIT Operating ProfitOP or PBIT Profit before tax and extraordinary itemsPBTEOT Profit before taxPBT Net profit--PAT

Horizontal Analysis
The percentage analysis of increase or decrease in each item of comparative balance sheet and profit and loss account is known as horizontal analysis.
Formula: (Current years fig.- Previous years fig.)*100 ---------------------------------------------------------Previous years fig.

COMPARATIVE INCOME STATEMENTS

For the years ended December 31, 1998 and 1999
1999 1998
Absolute Increase/ decrease % increase (or decrease)

Sales (Net)
Less: Cost of goods sold

1100000 1000000 100000 840000 260000 60000 200000 20000 220000 20000 200000 100000 800000 200000 50000 150000 20000 170000 2000 150000 75000 40000 60000 10000 50000 50000 50000 25000

10 5 30 20 33.33 29.4 33.33 33.33

Gross Profit
Less: Operating Expenses (office, admin., selling & distribn.)

Net operating Profit Other Income Earnings before interest n tax Interest paid Profit before Tax Income Tax payable

Profit after Tax

100000

75000

25000

33.33

COMPARATIVE BALANCE SHEETS

As on 31st December 1978 and 1979
1999 Fixed assets Investment 500000 100000 1998 400000 100000
Absolute Increase/ decrease % increase /decrease

100000 -

25 -

Working Capital (CA-CL)

Capital employed Less: Debentures

200000
800000 200000 600000

100000
600000 200000 400000

100000
200000 200000

100
33.33 50

Shareholders Fund:
Preference share capital Equity share capital Reserves and Surplus

600000
200000 300000 100000

400000
100000 200000 100000

200000
100000 100000 -

50
100 50 -

Advantages of comparative analysis

These statements indicate trends in sales, cost of production, profits, etc., helping the analyst to evaluate the performance, efficiency and financial condition of the undertaking.
For example, if the sales are increasing coupled with the same or better profit margins, it indicates healthy growth.

Comparative statements can also be used to compare the position of the firm with the average performance of the industry or with other firms. Such a comparison facilitates the identification or weaknesses and remedying the situation.

Disadvantages of comparative analysis

Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies in relation to depreciation, valuation of stock, etc., and do not cater to the same market. Inter-period comparison will also be misleading if the period has witnessed frequent changes in accounting policies.

Common-sized Analysis
1.

2.

3.

The tool is useful in comparing the performance and financial position of two companies within the same industry or in different industries In case of balance sheet , each item is restated taking the total sources of fund or application of fund as 100 Similarly, in case of income statement, all items are expressed as a percentage of net sales which is taken at 100

Common Size Balance Sheet

A company balance sheet that displays all items as percentages of a common base figure. This type of financial statement can be used to allow for easy analysis between companies or between time periods of a company.

Common Size Income Statement

An income statement in which each account is expressed as a percentage of the value of sales. This type of financial statement can be used to allow for easy analysis between companies or between time periods of a company.

Common-sized Analysis
2006 Gross Sales Less: Returns Net Sales Cost of goods sold Gross profit Expenses: Selling Expenses General expenses Financial expenses Total expenses 7500 4500 750 12750 7560 4500 560 12620 5.0 3.0 0.5 8.5 5.4 3.2 0.4 9.0 151500 1500 150000 105000 45000 2007 141540 1540 140000 99400 40600 2006 101 1.0 100 70.0 30.0 2007 101.1 1.1 100 71.0 29.0

Net Profit

32250

29980

21.5

20.0

Analytical Balance Sheet

1. 2.

It is a modified version of vertical balance sheet It starts with Application of funds side as against the vertical balance sheet that starts with Sources of Funds side It proves the basic accounting equation : Assets - outside liabilities= Owners Funds It shows that equity shareholders are the residual claimants on the assets of the company

3.

4.

Trend Analysis
1.

It is an extension of horizontal analysis

Unlike in horizontal analysis, trend analysis compares position for more than two years, say, five years Analysis for a longer period confirms the findings of horizontal analysis

2.

3.

Ratio Analysis
Ratio refers to relationship between two variables expressed either in percentages or in multiples and seeks to establish the cause and effect relationship.
It assists in the following cases:
1.

2.
3. 4.

Inter-firm comparison Intra-firm comparison Comparison against industry benchmark Analysis of performance over a long period

Ratio Analysis

Classification of Ratios
1. 2.

3.
4. 5. 6. 7.

Return on Investment ( ROI ) ratios Solvency ratios Liquidity ratios Efficiency or Turnover ratios Profitability ratios Du Pont Analysis Capital Market ratios

Return on Investment (ROI) ratios

This ratio seeks to measure the efficiency of performance or otherwise of the company. Higher the ratio, greater is the financial security for investors. Maximization of ROI is the ultimate objective of any company.
Under this group, the following ratios are computed
1.

2.

Return on Net Worth Earnings per Share

Return on Net Worth (RONW)

The ratio measures the net profit earned on equity shareholders funds. It is the measure of overall profitability of a company.
Formula: (PAT-Pref.dividend)*100 ---------------------------------------------------------Net Worth (Equity capital + Reserves & SurplusMisc. expenditure not written off)

Earning per Share ( EPS)

The ratio measures the overall profitability in terms of per equity share of capital contributed.This is the most widely used ratio across industries.
Formula: PAT- Pref.Dividend ------------------------------------------------Weighted average no. of equity shares O/S

Solvency Ratios

The capacity of a company to discharge its longterm obligation indicates its financial strength and solvency position.

Under this group, following ratios are computed.

1. Debt-Equity ratio 2. Interest coverage ratio 3. Debt-service coverage ratio

Debt-Equity ratio (times)

The ratio measures the proportion of debt and capital both equity and preference in the capital structure of a company. It helps in knowing whether a company is relying more on debt or capital for financing its assets. Higher the debt , more is the financial risk.

Formula: Long term debt ---------------------------------------------------------Total net worth (E.g. shareholders funds+Pref. cap)

Interest Coverage Ratio (times)

The ratio measures the ability of a company to service the interest obligations out of its cash profits. Higher the ratio, greater is the ability. Formula:
PAT+ Int. on long-term debt+Non-cash charges ---------------------------------------------------------Interest on long-term debt

Debt Service Coverage Ratio (times)

This ratio helps in assessing whether a company has the ability to service its installments of the principal due and the interest obligations out of the revenues generated. Higher the ratio, greater is the ability. Formula:
PAT+ Int. on long term debt+Non-cash charges

------------------------------------------------------Int. on long term-debt +Installments of principal due

Liquidity Ratio
Liquidity refers to the capacity a company to meet its day to day expenses and discharge short-term obligations of suppliers and other creditors smoothly. Following ratios are calculated under this head. 1. Current Ratio 2. Quick Ratio 3. Collection period 4. Suppliers Credit 5. Inventory Holding period

Current Ratio (times)

The ratio measures the ability of a company to discharge its day to day obligations. A company should possess adequate level of current assets over current liabilities to be able to do so. A current ratio of more than 1 indicates that value of short-term assets is more than short-term liabilities. A current ratio of less than 1 indicates poor liquidity. Formula: Current Assets, loans & advances + short-term Investments --------------------------------------------------------------------Current Liabilities + Provisions + Short-term debt

Quick Ratio (times)

The ratio measures as to how fast the company is able to meet its current obligations as and when they fall due. This is also known as acid-test ratio. Inventory and working capital limits are taken out of current assets and current liabilities respectively. A quick ratio of 1: 1 is indicates highly solvent position. Formula: Current Assets, Loans and Advances - Inventories -------------------------------------------------------------------Current Liabilities+Provisions-Working Capital Limits

Collection Period (days)

The ratio measures how fast the company is able to realize the dues from the customers on credit sales. It helps to understand the credit policy of the company.
Formula: Receivables x 365 --------------------------Credit sales

Suppliers Credit (days)

The ratio measures the average credit period enjoyed by the company from its suppliers. It also helps to understand the credit policy extended to a company by the suppliers.
Formula: Payables x 365 ---------------------Credit Purchases

Inventory Holding Period (days)

The ratio measures the average period for which cash is blocked in inventory. In other words the ratio explains how fast the company is able to convert its inventory into cash.
Formula: Inventory x 365 -------------------Cost of goods sold

Turnover Ratios
These ratios indicate how efficiently the assets of the company are used to generate revenue . Following ratios are calculated under this group.
1.
2. 3. 4. 5.

Overall Efficiency Ratio Fixed Assets Turnover Ratio Debtors Turnover Ratio Inventory Turnover Ratio Creditors Turnover Ratio

Overall Efficiency Ratio (times)

It shows how effectively the capital employed has helped in revenue generation. Higher the ratio greater is the efficiency. Formula:
Sales --------------------------Capital Employed

Fixed Assets Turnover Ratio (times)

The ratio measures the sales revenue per rupee of fixed assets. It plays an important role in improving the overall profitability and financial position of the company. Formula : Sales ---------------------------------------Net Block of Fixed Assets

Debtors Turnover Ratio (times)

It represents the number of times average dues from customers are realized. Higher the ratio, the better is the position. Formula:
Credit Sales ----------------------Average Debtors

Creditors Turnover Ratio (times)

The ratio shows the average time taken to pay for goods and services. Longer the credit period achieved the better. Formula: Credit Purchase -------------------------Average Creditors

Inventory Turnover Ratio

The ratio measures the amount of capital tied up in raw material, W.I.P. and finished goods Formula:
Cost of Goods Sold ----------------------Average Inventory

Profitability Ratios
The purpose of study of these ratios is to assess the adequacy or otherwise of the profit earned by the company. The following ratios are calculated under this group:
1. 2. 3. 4.

Multi-step Profit Margin to Sales Individual Cost and Expense to Sales Other Income , Extraordinary Items and Prior Period Adjustments to PBT or Sales Effective Tax Rate

Multi-step Profit Margin to Sales Ratios(%)

These ratios measure several profit margin indicators. All these ratios are computed in relation to Sales.
1.

2.
3. 4. 5. 6.

Gross Profit Margin-GP Profit Before Depreciation, Interest and Tax-PBDIT Operating Profit-OP Profit Before Tax and Extra-ordinary Items-PBTEOT Profit Before Tax-PBT Net Profit Margin-PAT

Gross Profit Margin (%) This reflects the efficiency with which management produces each unit of output. It also indicates the spread between the cost of goods sold and the sales revenue. Formula: Sales- Cost of Goods Sold ----------------------------- x 100 Sales Operating Profit Margin (%) This ratio indicates profitability from operating activities. A higher margin implies better sales realization and effective cost control. Formula: Operating Profit ------------------ X 100 Sales

Net Profit Margin( % ) The ratio is the overall measure of the firms ability to earn profit per rupee of sales. It also establishes relationship between manufacturing, administering and selling the products. Formula: Profit After Tax ------------------- x100 Sales

Other Income, Extraordinary Items and Prior Period Adjustments to PBT or Net Sales (%) These ratios seek to measure the impact of the above items on PBT or net sales. Formula: Extraordinary Item --------------------- x 100 PBT

Individual Costs and Expenses to Sales Ratios (%)

These ratios measure the proportion of individual items of cost and expense in relation to sales. They also assist the analyst in cost minimization and cost reduction.

Formula:
Raw Materials Consumed ---------------------------------- x100 Net Sales

Effective Tax Rate(%)

The ratio measures the actual effective rate at which a company pays income tax as against the statutory rate.
Formula: Current Income Tax ------------------------ x100 PBT

Dupont System of Analysis

It is an integrative approach used to dissect a firm's financial statements and assess its financial condition It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers

The DuPont System

Method to breakdown ROE into:

ROA and Equity Multiplier

ROA is further broken down as:

Profit Margin and Asset Turnover

Thus the firm's return is broken into three components:

A profitability measure (net profit margin) An efficiency measure (total asset turnover) A leverage measure (financial leverage multiplier)

The DuPont System

ROE

ROA Profit Margin

Equity Multiplier

Total Asset Turnover

ROE ROA Equity Multiplier Net Income Net Sales Total Assets Net Sales Total Assets Common Equity

DU PONT Analysis
RONW is a function of Net Profit Margin and Net worth Turnover. DU PONT analysis seeks to measure and establish this relationship between the two determinants. Through these ratios a firm can devise suitable remedies to overcome the weak area of overall performance. Formula: (PAT-Pref. Div)X100 Net Sales ------------------------ X ----------------Net Sales Net Worth

Capital Market Ratios

Following ratios are computed under this group:
1. 2. 3. 4.

EPS (Earning per share) Price Earning Ratio-P/E Market Capitalization Yield to Investors

Price Earning Ratio (times)

P/E multiple is an important indicator of the premium that the market wishes to put on a firms earnings. It can be used to price a share and value a firm.
Formula: Market Price of Equity Share -------------------------------------EPS

Market Capitalization (Rs.)

The ratio measures the total market value of the number of equity shares outstanding. Formula:
No. of Equity Shares O/S X Market Price

Yield to Investors (%)

The ratio measures the total gain or loss suffered by investors in relation to their investment in equity shares of a company.
Dividend recd.+ Market Appreciation ------------------------------------------x100 Initial Investment

Summarizing All Ratios

An approach that views all aspects of the firm's activities to isolate key areas of concern Comparisons are made to industry standards (cross-sectional analysis) Comparisons to the firm itself over time are also made (time-series analysis)

Advantages of Financial Ratios

Ratios help to:

Evaluate performance Structure analysis Show the connection between activities and performance

Benchmark with

Past for the company Industry

Ratios adjust for size differences

Limitations of Ratio Analysis

A firms industry category is often difficult to identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios