ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Financial statements comprise

Trading / Manufacturing account and Profit and Loss account. Balance sheet.

Financial statement analysis means

An analysis and interpretation of balance sheet and Profit and Loss account, Also going through directors report, auditors report and chairmans speech etc. We take into account last two years audited balance sheets, current years estimated and the next years projected balance sheet.

Analysis is not an end in itself, but a base for interpretation

Analysis of financial statements means
to find out various ingredients by way of rearranging, regrouping of various items calculation of various ratios.

Just as a chemist analyses a compound in order to understand its elements, analyst is also required to interpret the financial statements.

What interpretation means

Interpretation means to draw conclusions on the basis of analysed statements to form opinion or draw inferences about the financial health, profitability, efficiency and such other aspects of the business enterprise.

Why Bankers Analyze

for a banker, the need to analyze and interpret the financial statement arises for calculating the lending risk involved in the credit decision.

Objectives for analysis & interpretation

To judge the financial health of business enterprise. To judge the performance and profitability. To judge the growth potential and sound financial base for expansion. To judge the ability to pay back the debts with interest and availability of sufficient security cover therefor. To judge the solvency.

LIMITATIONS
The balance sheet analysis does not reflect Reputation and creditworthiness of business enterprise. Efficiency of management. Quality and morale of employees / labour. Reasons for improvement / fall in various items in the financial statement. Sources and commitments for materials, SIP and supplies.

LIMITATIONS (contd.)
Balance sheet figures are on a historical basis. Accounting is done on the basis of certain conventions e.g. going concern concept. Balance sheet is prepared on a particular date when window dressing can be done to depict a favourable picture. Non recognition of inflation.

P&L Account and B/S

All corporate enterprises by law are required to compile P&L accounts and B/S Both compiled at annual intervals and under exceptional cases the time lag b/w the two statements could be 15 months As per Income Tax, all cos are required to finalize their financial statements on 31st March

Profit and Loss account

Indicates the working results of the company during specified period No format prescribed by Companies Act 1956 Schedule-VI part II of Companies Act 1956 lays down the requirement for the preparation and disclosures to be made in the P&L account Both statements looked together for the purpose of Credit Analysis

Foll. steps are involved in the analysis of P&L account

Gross sales broken into domestic sales, exports and deferred sales Net sales arrived at after deducting excise duty from gross sales The cost of production is arrived at taking into account RM consumption, direct expenses and increase/ decrease in stock in progress The cost of sales is arrived at after adjusting in the cost of production, the increase/ decrease in the stock

 Other operating expenses( like admin., selling, financial i.e. interest are deducted out of gross profit to arrive at net profit Other non operative income is added & other non operative expenses are deducted out of operating profit to arrive at PBT Non operative income arise from secondary activities like interest, rent and dividend received by an enterprise whose main business is not to deal in finance, property and investment

 Other expenses arise from incidental activities Net provision for income tax is deducted from PBT to arrive PAT Profit appropriation i.e. dividend, transfer of a part / full profit to various reserves
Balance remained after the appropriation is carried to balance sheet

Balance Sheet
Statement of balances- depicting the affairs/position of a business enterprise on a GIVEN DATE T shaped or vertical format Format for companies- Companies Act 1956 Grouped into Assets and liabilities

Liabilities
Obligation of the business to the others Sources of funds Business is a distinct entity- capital invested by Owners / S.H is liability for business

Assets
Normally property of the business
Certain items- treated as assets though not classified as property such as goodwill, patents, losses etc

In accounting terms all debit balances are assets and all credit balances are liabilities

Balance sheet As prescribed by RBI as per CMA data format

Liabilities
Current liabilities Term liabilities Net worth

Assets
Current assets Fixed assets Non current assets Intangible assets

Analysis of Liabilities and Assets

Liabilities
Share Capital
Paid up capital includes Equity and Preference shares Equity capital only taken as share capital and preference shares are given separate treatment RBI classifies redeemable pref. shares which are redeemable after 1 yr but before 12 yrs as Term Loans and not under Net worth Principle redeemable pref. shares have to be redeemed and follows treatment accorded to such share capital by the All India term Lending Institutions (AITLIs) Redeemable pref. shares redeemed within 12 months are classified as current liability

 Reserves appropriation of profits and created for

Redemption of a known liability Strengthen the liquidity resources for a definite amount

Reserves and Surplus

Classified as Net worth Different from provisions Provisions

Charge against profit for a specific purposes( bad and doubtful debt, depreciation etc.) Necessity even when there is no profit While analysis classified as current liabilities as the provisions are immediate liability to be settled by their nature

Secured and Unsecured loans

Banker concerned with the maturity of loan Loan repayable within 12 months from the date of balance sheet current liabilities

Loan repayable beyond 12 months from the date of balance sheet term liabilities Even w.r.t long term loan, portion of loan repayable within 12 months current liability and the remaining portion as term liability

Secured and Unsecured loans (contd.)

Installment of loan due in next 12 months are NOT classified as current liability for the limited purpose of arriving at MPBF However for the purpose of calculation of ratios, same would be treated as current liability

Assets
Fixed Assets
Gross block in the balance sheet include intangibles like goodwill patents etc. which should be classified as intangible assets and the remaining portion as gross block If assets have been revalued upwards at any time in the past, the same amount should be deducted from gross block and shown as intangible asset

Investments
Includes Govt. and other trustee securities besides fixed deposits with banks Investment not expected to convert into cash within a period of 1 year need not be put under current assets Investment in shares in other cos. / associates should be classified as non current assets except in case of pure investment cos. where it should be classified as current assets at cost or market price whichever is lower

Miscellaneous Expenses
Entire miscellaneous expenditure will be classified as intangible asset If debit balance in the P&L account is shown as miscellaneous expense, the amount will be taken to the liabilities and shown as a deduction from the net worth

Current liability
Short-term borrowings from banks

The outstanding balances of cash credit, overdraft,export packing credit are classified under this head.
Bills purchased/discounted

Normally shown as contingent liability as notes attached to the balance sheet.This item should be added to the bank borrowings on the liability side and receivableson the assets.
Deposits maturing within 12 months

The company normally shows all deposits together in the balance sheet. While analysing, deposits maturing within 12 months should be classified as current liabilities and those maturing beyond 12 months as term liabilities.

Current liability
Sundry Creditors (Trade) A detailed break-up of trade and other creditors should be obtained and the creditors relating to trade should only be classified under this head. Creditors for expenses and for purchase of capital goods are also classified under a separate head under current liabilities.

Provision for taxation Provision for income tax(no other taxes such as sales tax) less advance payment of tax is shown as current liability. Dividend Payable Dividend declared for the year should be added to the figure of dividend payable in the balance sheet and the total figure should be shown under a separate head under the current liabilities.

Current liability (contd.)

Instalments of term loan the instalment of term loan which has already fallen due,and due within 12 months from the date of balance sheet should be shown as current liability. It would also include deferred payment guarantee Instalments, debentures,redeemable preference shares,due within 1 year. This should be done only for the limited purpose of calculation of current ratio.however,for arriving at MPBF,these should not be classified as current liabilities,as per RBI guidelines.

Advance payments from customers

Where deposits are required in terms of regulations framed by the government,to be invested in a particular manner, the benefit of netting may be allowed to the extent of such investment in approved securities and only the balance amount need to be classified as current liability.

Current liability (contd.)

Advance payments from customers

Advance payments received can be adjusted progressively from the value of work completed as agreed in the contract. Outstanding advance payments are to be reckoned as current liabilities or otherwise,depending upon whether they are adjustable within a year.

Deposits from dealers,selling agents

These deposits may be treated as term liabilities irrespective of their tenure if such deposits are accepted to be repayable only when the dealership/ agency is terminated.the deposits which dont satisfy the above condition should continue to be classified as current liabilities.

Current liability (contd.)

Sales Tax
Disputed Excise Liabilities shown as contingent liabilities or as a note to the balance sheet, is not treated as a current liability for calculating MPBF, provided it has been collected or shown in the accounts.
Provision for disputed excise duty is taken as a current liability unless the amount payable in installments is spread over a period of one year. Where such provision is invested separately in fixed deposits with banks, it can be setoff against the relative investment.

Current liability (contd.)

Sales Tax
Disputed liabilities with respect to income tax, customs need not be treated as a current liability for the purpose of calculation of MPBF except the extent provided in the books. The amount of convertible debentures should be classified as part of net worth if they are fully convertible. If partly convertible, only the convertible part should be taken as networth.

Current Assets
Current Assets
Inventory It comprises of goods held for processing and conversion into saleable products, goods and process and finished products. Stores and spares used in the process of manufacturing and packaging is a part of inventory. Stores and spares not exceeding 12 months consumption of, imported items and exceeding 9 months consumption of indigenous items are taken as current assets. Slow moving or obsolete items should not be treated as current assets.

Current Assets (contd.)

Current Assets
Receivables It represents cash claims relating to sale of products or services by business enterprise. Receivables of subsidiary firms or sister concerns would also be included if these have arisen in the normal course of business. The bad debts not provided for are to be classified as intangible assets.

Current Assets (contd.)

Other Current Assets
Advances given to the suppliers, material / stores towards future supplies. Interest accrued in investments and other accrued income. Prepaid expenses which relate to current expenses and not future expenses. Investment in government securities and bank deposits.

 Non Current Assets

Non consumable stores and spares. Deferred receivables. Advances to group companies and capital equipments supplier Investment in subsidiary group companies. Dues from directors, officers and staff. Security deposits of permanent nature with government authorities like electricity boards.

 Intangible Assets
This includes Goodwill, Patent, Trademark, Preliminary expenses not written off and deferred revenue expenditures. In certain cases it could also include accumulated losses to the extent not wiped off and shown in the balance sheet.

Tangible Net Worth

It includes paid up share capital, preference shares, redeemable after 12 years, reserves and surplus. It is arrived at after deducting intangible assets.

 Interpretation of Financial Statements

It is done by the following methods: Percentage Method In this all the figures of the balance sheet are reduced to percentage terms in relation to the grand total at the bottom of the balance sheet. Relationship between various group of assets and liabilities can be computed from the percentage-wise balance sheet. This method has its own limitation and is not widely used in banks. However it is useful in respect of operating statements where all items are expressed in percentage terms and increase or decrease in various costs, expenses can be easily studied.

 Trend Method Under this financial statements for a number of years are studied. This method involves calculation of percentage relationship that each item bears to the same item in the base year. it discloses the changes in the financial and operating data between specified periods and helps to find out favorable and unfavorable tendencies. This method is not very popular.

Ratio Method They are expressed in various forms. Pure ratio, in terms of number of times and percentage terms. Limitations of Ratios The ratios are worked out in the basis of past years statements, which gives only a fair idea about what will happen in the future.

 Interpretation of Financial Statements

Various types of Ratio
Balance Sheet Ratios Operating Statement Ratios Inter-statement Ratios Financial or Capitalization Ratios Debt Equity Ratio Funded Debt / Equity Ratio
Liquidity Ratios Current Ratios Acid Test Ratio

 Profitability Ratios Operating Profit / Sales Net Profit / Sales Net Profit / Tangible Net Worth Retained Profit / Net Profit Raw Material Consumed / Sales Expense / Sales
Turn over Ratios Raw Material / Consumption Stock in Process / Cost of Production Finished Goods / Cost of Sales Receivables / Gross Sales Sundry Creditors / Purchases Stores and Spares / Consumption Net Sales / Total Tangible Assets

Financial or Capitalization Ratios

Debt / Equity Ratio

Also called Total outside liabilities to TNW ratio Total outside liabilities (Debt) Tangible Net Worth (Equity)
Total outside liabilities (viz. Current and term liabilities) and TNW are compared To ascertain the relative financial stakes of the creditors vis-vis the owners of an enterprise. Ratio differs from industry to industry

Debt-Equity Ratio
0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 Debt/Equity Ratio 2004-05 0.14 2003-04 0.05 0.05 0.14

Funded debt / equity ratio

Also called term liabilities / TNW ratio Term Liabilities (Funded debt) Tangible Net Worth (Equity) Worked out with a view to ensure as to whether the owner has a reasonable stake in financing the enterprise In medium sized projects, a ratio of 2 is considered acceptable In cases of large projects with long gestation periods and a correspondingly long useful life, a ratio of 3 or 4 acceptable Lease finance obtained by an enterprise should also be considered as a term finance

Funded Debt-Equity Ratio

0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 Funded Debt/ Equity ratio 2004-05 0.13 2003-04 0.03 0.03 0.13

Liquidity Ratios

Current Ratio
Current Assets Current Liabilities
If the ratio is 1 or > 1, value of current assets exceeds the current liabilities. As per Tandon Committee norms, the acceptable minimum current ratio for industrial concerns should be 1.33 i.e. the NWC should be 25% of the current assets Refers to the ability of the business enterprise to meet its obligations within a time span of one year The quality of current assets is also an important factor Seasonality, peak and non peak season etc. also affect the current ratio in some industry.

Current Ratio
3.95 3.90 3.90 3.85 3.80 3.75 3.70 3.65 3.60 Current Ratio 2004-05 3.73 2003-04 3.90 3.73

Acid Test or Quick Ratio

Ratio indicates quick or instant liquidity position Cash + Receivables + Temp. Investments Current Liabilities minus Bank borrowings The quickly realisable current assets and immediate liabilities are taken into account for working out this ratio

Acid Test Ratio

3.18 3.16 3.14 3.12 3.10 3.08 3.06 3.04 3.02 3.00 2.98 2.96 Acid test ratio 3.04 3.16

2004-05 3.04

2003-04 3.16

Profitability Ratios

Operating Profit / Sales

Operating Profit x 100 Sales Expressed in percentage terms Indicates trend of operating profit over the years If the operating profit is on declining lines, then efforts could be initiated for improvement.

Operating Profit / Sales

14.00 12.00 10.00 8.00 6.00 4.00 2.00 (2.00) (4.00) Operating Profit / Sales (1.62) 2004-05 (1.62) 2003-04 13.08 13.08

Net Profit / Sales

Net Profit x 100 Sales Expressed in percentage terms This ratio for different units of same industry group should also be studied If the ratio is low than the industry average, then further enquiries should be made and reasons ascertained

Net Profit / Sales

20.00 18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 Net Profit / Sales 2004-05 2.85 2003-04 17.43 2.85 17.43

Net Profit / TNW Ratio

Also called return on networth ratio indicating yield to the owners Net Profit x 100 TNW Indicates success of business in earning profit and overall efficiency

Net Profit / TNW Ratio

16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 Net Profit / TNW Ratio 2004-05 2.17 2003-04 15.10 2.17 15.10

Retained Profit / Net Profit

Retained Profit x 100 Net Profit Expressed in percentage terms Retained profit is that portion of profit which has been ploughed back in business after drawings / payment of dividend etc. Retention of profit is a must for future growth and also for facing any eventuality in future.

Raw Material Consumed / Sales

Expresses consumption of raw material per unit of finished goods sold Raw Material Consumed x 100 Sales Gives an idea about the decline in profitability of an enterprise, in case raw material cost is goingup Effect thereof is not passed-on to customers while selling.

Raw Material / Consumption

23.50 23.00 22.50 22.00 21.50 21.00 20.50 Raw Material Consumed / Sales 21.69 23.19

2004-05 21.69

2003-04 23.19

Expenses / Sales
Expenses x 100 Sales Comparison of ratio over the years would give a fair idea about increase / decrease in various expenses items in relation to sales Management can chalk out its future strategy in regard to various expenses
whether some expenses are to be curtailed or some others are to be increased to obtain good results

Turnover Ratios

Raw Material / Consumption

Worked out in terms of period Raw Material inventory x 12 Raw Material Consumption during the year.

Should be compared for past years to ascertain the trend. The inventory of raw material
during the peak season at the year end and The average holding during the year etc. should also be kept in view while drawing conclusions.

Raw Material / Consumption

120.00 100.00 80.08 80.00 60.00 40.00 20.00 Raw Material / Consumption 107.21

2004-05 107.21

2003-04 80.08

Stock-in-process / Cost of production

Stock in process inventory x 12 Cost of production during the year. Cost of production = Raw material and stores consumption + direct expenses + Opening stock of SIP minus Closing stock of SIP Compared with the past trend and the reasons for increase / decrease ascertained

Stock-in-process / Cost of production

29.00 28.13 28.00 27.00 26.00 25.00 24.00 23.00 Stock-in-process / Cost of production 24.83

2004-05 28.13

2003-04 24.83

Finished Goods / Cost of Sales

Inventory of finished goods x 12 Cost of sales during the year. Inventory of finished goods = cost of production + opening stock of finished goods minus closing stock of finished goods The inventory should neither be excessive nor low. A high level of finished goods would indicate low demand for the product. A low stock level may result in the inability of the enterprise to effect regular supplies to customers for various reasons.

Finished Goods / Cost of Sales

18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 Finished Goods / Cost of Sales 2004-05 16.87 2003-04 12.44 12.44 16.87

Receivables / Sales
Expressed in terms of period The level of receivable in an enterprise depend on various factors like trade credit practice, market conditions, demand for the product etc. A lower level of receivable may indicate effective collection machinery and the good demand for the product.

Receivables / Sales
99.00 98.00 97.00 96.00 95.00 94.00 93.00 92.00 91.00 90.00 Receivables / Sales 2004-05 97.86 2003-04 93.14 93.14 97.86

Sundry Creditors / Purchases

Expressed in terms of period Sundry creditors outstanding in B/S x 12 Total purchases during the year The high level of creditors may mean that the enterprise is unable to make payment to creditors in time due to liquidity strains and / or procedural faults If the level is quite low, it indicates that the enterprise is not availing the minimum credit available as per market trends.

Sundry Creditors / Purchases

100.00 95.00 90.00 85.00 79.89 80.00 75.00 70.00 Sundry Creditors / Purchases 94.52

2004-05 94.52

2003-04 79.89

 Expresses the turnover of assets

Net Sales / Total tangible assets

How many times the tangible assets of the enterprise have rotated in relation to sales

In the highly capital intensive industries, this ratio may be < 1 which means the annual sales may be less than the total value of tangible assets Ratio may be much more in trading concern

Net Sales / Total tangible assets

3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 Net Sales / Total tangible assets 2004-05 2.63 2003-04 3.32 2.63 3.32

Cash Flow
It is prepared to explain the changes in the cash balance from one balance sheet to another The cash flow starts with the opening cash balance to which funds obtained during the year are added and from which funds applied during the year are subtracted. The cash flow is useful in the cases of term loan proposals whereas the funds flow is useful for working capital.

Cash Budget
An exercise for management of cash prepared at shorter intervals in advance say monthly or for six months Cash budget comprises of cash receipts and cash payments during the given future period. No credit or transfer transactions in the cash budget bankers obtain cash budgets while issuing usance letter of credit or in the cases of sick units in order to ensure that the enterprise would be able to meet its obligations on the due dates when the liabilities would occur.

Funds Flow Statement

In the balance sheet all liabilities are sources and assets are uses The sources and the uses can be further classified into the following categories 1. Long Term - a. Sources b. Uses 2. Short Term - a. Sources b. Uses The short term funds indicate the variations in current assets and current liabilities

Funds Flow Format (RBI under CMA)

 1. Reasons of increase in carry of various items of inventory which is disproportionate to percentage rise in sales should be ascertained and explained. 2. Similarly reasons for decrease in current liabilities which is not commensurate will percentage rise or fall in sales should be ascertained and explained. 3. In case the increase in working capital gap is not commensurate with the increase in net sales, the position should be ascertained and explained. 4. The projected funds flow would represent companys intentions about the use of funds. Any variance in actuals and projections should be enquired into

Useful Points while deriving conclusions

Useful Points while deriving conclusions (contd.)

5. The Net Working Capital (i.e. difference between total current assets and total current liabilities) would increase / decrease with the figure at item no.3 above during the year.
6. It is often useful to prepare funds flow statement for shorter periods or over annual dates other than the fiscal year of the enterprise. This will ensure greater and stricter control over the use of funds and any wrong flow into areas unwanted can be detected much earlier.

Thank You!!!!!