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Financial Statement Analysis
Analytical techniques used Horizontal analysis Trend analysis Common size statement Ratios
Horizontal analysis
Trend analysis
2000-03
2001-03
2002-03
2003-03
2004-03
2005-03
2006-03
2007-03
2008-03
2009-03
2010-03
2011-03
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500.00
1,000.00
1,500.00
2,000.00
2,500.00
3,000.00
3,500.00
Total IncomeTotal ExpenditureOperating Profit
Common size statement
Ratios
Basics of Financial Statement AnalysisBasics of Financial Statement AnalysisAnalyzing financial statements involves:
CharacteristicsComparison Bases
Tools of Analysis
Liquidity
Profitability
Solvency
Efficiency
Intra-company
Industry averages
Inter-company
Horizontal
Trend
Vertical
Ratio
Comparison Bases
Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.
Ratios include the i. Net Working Capital ii. Current ratio iii. Acid-test ratio, iv. Turnover ratios v. Defensive interval ratio and vii. Cash flow from operation ratio
Liquidity Ratios
Net working capital = Current Assets- Current Liabilities
Net Working Capital
Current Assets – Represent those assets which can be converted into cash within a short period of time, normally not exceeding one year and include Cash, Bank balance, Marketable securities, Inventories, Debtors, Bills receivables and Prepaid expenses
Current Liabilities – Represent those which are short-term maturing obligations to be met within a year. Consist of Trade creditors, Bills payable, Bank credit, Short term provisions and Outstanding expenses
Details Company X Company Y
Total current assets 2,40,000 50,000
Total current Liabilities 1,50,000 20,000
Net working capital (CA-CL)
90,000 30,000
Current Ratio: It is the relationship between the current assets and current liabilities of a concern. This ratio must be at least 2 : 1 to ensure minimum margin of 25% of current assets as margin from long term sources
Current Ratio = Current Assets/Current Liabilities
ACID TEST or QUICK RATIO: It is the ratio between Quick Current Assets and Current Liabilities. The should be at least equal to 1
Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
Cash 50,000Debtors 1,00,000Inventories 1,50,000Current Liabilities 1,00,000Total Current Assets 3,00,000
Current Ratio => 3,00,000/1,00,000 = 3 : 1Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1
Turnover ratios
Inventory turnover ratio = Cost goods sold/Av.Inventory
Sales = 3,00,000GP = 20%Stock at the beginning and at the End = 35,000 &
45000
Inventory holding period = 12 months/ Inventory turnover ratio
These ratios indicate the number of times the inventory is rotated during the relevant accounting period
Debtors turnover ratio = Net credit Sales/Av.Debtors
Total Sales = 2,70,000Cash Sales = 30,000Debtors at the Beginning and at the End = 27,500 and
32,500
Debtors collection period = 12 months/ Debtors turnover ratio
Measures how rapidly receivables are collected
Creditors turnover ratio = Net credit purchase/ Av.creditors
Total purchase = 2,00,000Cash purchase = 10%Creditors at the beginning and at the End = 42,500 and
47,500
Creditors payment period=12months/ Creditors turnover ratio
The extent to which trade creditors are willing to wait for payment
Debt-Equity Ratio = Total debt/ Shareholder’s equity
Measures the relationship between borrowed fund and owner’s capital
Proprietary ratio = (Proprietor’s fund/Total assets) x 100
It indicates the extend to which assets are financed by owners fund
Solvency ratios
Coverage Ratio
Interest Coverage Ratio measures the firm’s ability to make contractual interest payments.
Interest coverage ratio =
EBIT (Earning before interest and taxes)
Interest
Dividend coverage ratio =
EAT (Earning after taxes)Preference
dividend
Dividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return.
Interest Coverage Ratio
Dividend Coverage Ratio
Total fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations.
Total fixed charge coverage ratio
EBIT + Lease Payment
Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)
=
Total fixed charge coverage ratio
However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations.
Total Cashflow Coverage Ratio
Total cashflow coverage ratio
Lease payment + Interest
EBIT + Lease Payments + Depreciation + Non-cash expenses=
(Principal repayment)
(1– t)
(Preference dividend)
(1 - t)
+ +
Debt Service Coverage RatioDebt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt
service capacity of a business firm.
DEBT SERVICE CAPACITY
DSCR =Iinstalmentt∑
n
t=1
EATt OAt+ +∑n
t=1Depreciationt
+Interestt
Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt.
Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. (Figures in Rs lakh)
Year Net profit for the year
Interest on term loan during the year
Repayment of termloan in the year
12345678
21.6734.7736.0119.2018.6118.4018.3316.41
19.1417.6415.1212.6010.087.565.04Nil
10.7018.0018.0018.0018.0018.0018.0018.00
The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.
Debt-Service Coverage Ratio
SolutionTable 3: Determination of Debt Service Coverage Ratio
(Amount in lakh of rupees)Year
Net profit
Depreciation Interest Cashavailable
(col. 2+3+4)
Principalinstalment
Debtobligation
(col. 4 + col. 6)
DSCR [col. 5 ÷ col. 7
(No. of times)]
1 2 3 4 5 6 7 8
12345678
21.6734.7736.0119.2018.6118.4018.3316.41
17.6817.6817.6817.6817.6817.6817.6817.68
19.1417.6415.1212.6010.087.565.04Nil
58.4970.0968.8149.4846.3743.6441.0534.09
10.7018.0018.0018.0018.0018.0018.0018.00
29.8435.6433.1230.6028.0825.5623.0418.00
1.961.972.081.621.651.711.781.89
Average DSCR (DSCR ÷ 8) 1.83
© Tata McGraw-Hill Publishing Company Limited, Management Accounting
6 - 22
Profitability Ratio
Profitability ratios can be computed either from sales or investment.
Profitability Ratios
Related to Sales
Profitability Ratios
Related to Investments
(i) Profit Margin
(ii) Expenses Ratio
(i) Return on Investments
(ii) Return on Shareholders’
Equity
© Tata McGraw-Hill Publishing Company Limited, Management Accounting
6 - 23
Profit Margin
Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods
Gross profit margin =
Gross ProfitSales
X 100
Gross Profit Margin
Net profit margin can be computed in three ways
iii. Net Profit Ratio =
Earning after interest and taxes Net sales
ii. Pre-tax Profit Ratio =
Earnings before taxes Net sales
i. Operating Profit Ratio =
Earning before interest and taxes Net
sales
Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted.
Net Profit Margin
(1) Gross profit margin =Rs 1,00,000
= 50 per centRs 2,00,000
From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin.
1. Sales2. Cost of goods sold3. Other operating expenses
Rs 2,00,0001,00,000
50,000
(2) Net profit margin =Rs 50,000
= 25 per centRs 2,00,000
Expenses Ratio
i. Cost of goods sold =
Cost of goods soldNet sales
X 100
ii. Operating expenses =
Administrative exp. + Selling exp. Net sales
X 100
iii. Administrative expenses =
Administrative expensesNet sales
X 100
iv. Selling expenses ratio =
Selling expensesNet sales
X 100
v. Operating ratio =
Cost of goods sold + Operating expenses Net sales
X 100
vi. Financial expenses =
Financial expensesNet sales
X 100
Return on Investment
Return on Investments measures the overall effectiveness of management in generating profits with its available assets.i. Return on Assets (ROA)
ROA =EAT + (Interest – Tax advantage on interest)
Average total assets
ii. Return on Capital Employed (ROCE)
ROCE =
EAT + (Interest – Tax advantage on interest)Average total capital employed
Return on Shareholders’ Equity
Return on total shareholders’ fund =
Net profit after taxesAverage total shareholders’ fundX
100
Return on ordinary shareholders’ equity (Net worth) =Net profit after taxes – Preference
dividendAverage ordinary shareholders’ equity
X 100
Return on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm.
Efficiency Ratio
Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
Inventory Turnover Ratio =
Cost of goods soldAverage inventory
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
Raw materials turnover =
Cost of raw materials usedAverage raw material
inventoryi. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
Work-in-progress turnover =
Cost of goods manufacturedAverage work-in-progress
inventory
Inventory turnover measures the efficiency of various types of inventories.
Liquidity of a firm’s receivables can be examined in two ways.i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
i. Debtors turnover =Credit salesAverage debtors + Average bills
receivable (B/R)
2. Average collection period =
Months (days) in a yearDebtors turnover
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldAlternatively =
Months (days) in a year (x) (Average Debtors + Average (B/R) Total credit sales
Ageing Schedule enables analysis to identify slow paying debtors.
Debtors Turnover Ratio
Assets Turnover Ratio
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
i. Total assets turnover =
Cost of goods soldAverage total assets
ii. Fixed assets turnover =
Cost of goods soldAverage fixed assets
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
iii. Capital turnover =Cost of goods sold
Average capital employed
iv. Current assets turnover =
Cost of goods soldAverage current
assetsi. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
v. Working capital turnover =
Cost of goods soldNet working capital
Assets turnover indicates the efficiency with which firm uses all its assets to generate sales.
1) Return on shareholders’ equity = EAT/Average total
shareholders’ equity
2) Return on equity funds = (EAT – Preference dividend)/Average
ordinary shareholders’ equity (net worth)
3) Earnings per share (EPS) = Net profit available to equity
shareholders’ (EAT – Dp)/Number of equity shares outstanding
(N)
4) Dividends per share (DPS) = Dividend paid to ordinary
shareholders/Number of ordinary shares outstanding (N)
5) Earnings yield = EPS/Market price per share
6) Dividend Yield = DPS/Market price per share
7) Dividend payment/payout (D/P) ratio = DPS/EPS
8) Price-earnings (P/E) ratio = Market price of a share/EPS
9) Book value per share = Ordinary shareholders’ equity/Number
of equity shares outstanding
Integrated Analysis Ratio
(1) Rate of return on assets (ROA) can be decomposed in to
(i) Net profit margin (EAT/Sales)
(ii) Assets turnover (Sales/Total assets)
(2) Return on Equity (ROE) can be decomposed in to (DU PONT)
(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)
Integrated ratios provide better insight about financial and economic analysis of a firm.
Return on Assets
Earning PowerEarning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover.Earning power = Net profit margin × Assets turnoverWhere, Net profit margin = Earning after taxes/SalesAsset turnover = Sales/Total assets
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
Earning Power =
Earning after taxesSale
s
Sales
Total Assets
EAT
Total assets
xx x
Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each.
Return on Assets (ROA) of Firms A and B
Particulars Firm A Firm B
1. Net sales2. Net profit3. Total assets4. Profit margin (2 ÷ 1) (per cent)5. Assets turnover (1 ÷ 3) (times)6. ROA ratio (4 × 5) (per cent)
Rs 4,00,00040,000
4,00,00010
110
Rs 40,00,00040,000
4,00,0001
1010
Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components.