how to undertake financial analysis and predict the future of the companies

8/14/2019 How to Undertake Financial Analysis and Predict the Future of the Companies

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5 DECEMBER 09

AFTERSCHOOOL CENTRE FOR SOCIALENTREPRENEURSHIP'S MATERIAL FOR PGPSE

PARTICIPANTS. 1

HOW TO UNDERTAKE FINANCIALANALYSIS AND PREDICT THE

FUTURE OF THE COMPANIES?

DR. T.K. JAIN

AFTERSCHO OLcentre for social entrepreneurship

sivakamu veterinary hospital road

bikaner 334001 rajasthan, indiamobile : 91+9414430763

JOIN PGPSE

free for all open for all

[email protected]
mailto:[email protected]:[email protected]


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steps...

1. identify, collect and read the financialstatement

2. normalise the statement (remove allexceptional items)3. try to read between the lines and figure outthe areas, which require deeper analysis and

interpretation4. identify the tools to apply to figure out the

issues


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Popular tools....

Common size financial statementscomparative financial statement analysis

ratio analysistrend analysis

regression analysisadvanced statistical analysis

other tools as per requirements. . .


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WHAT IS CVP??

C=COST,V=VOLUME,P=PROFITTHERE IS RELATION BETWEEN THESE,THIS RELATION IS IDENTIFIED IN CVP

ANALYSIS


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WHAT IS BEP?

B=BREAK E=EVEN

P=PROFITthe point where there is no profit no loss


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WHAT IS BEP?

There are two formula :BEP (in units) = fixed cost / contribution per

unitBEP (in value) = fixed cost / PV ratio


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What is fixed cost?

The cost which will remain same whether production is 0 unit or 100 units or 10000

units. Thus this cost has no relation to production volume.Example : if you produce 100 units, your cost

of material consumption is Rs. 1000, if youmake 1000 units it is 10000, but the rent paidfor the office remains the same, Rs. 3000 thus

rent is fixed but material is variable cost.


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What is variable cost?

As we discussed earlier : the cost which variesdirectly with volume is called variable cost.

Material cost, labour cost, power cost, etc. Are

variable cost. If production will increase, thesecosts will also increase


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Examples of fixed cost...

Rent, salary, office expenses, interest on loan,etc.


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Examples of variable expenditure

Raw materialwages

power carriage inward / outward

sales commission


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What is CONTRIBUTION?

Difference of sales price per unit and variablecost per unit is called contribution per unit.Suppose sales price per unit is 10, variable cost

per unit is 6, contribution per unit is 4.thus contribution has two components in it =

fixed cost + profit


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What is PV ratio

Contribution as % of sales is called PV ratiocontribution is 4, sales price is 10, thus PV

ratio is 40%


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What is target profit pricing?

Here you keep the target profit in mind and price the goods accordingly, so you have tokeep the target profit along with fixed cost in

all your calculations


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What is target profit volume?

It's formula is : (fixed cost + targe profit ) /contribution per unit


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What is margin of safety?

How safe you are ?It is the difference of your present sales to theBEP level. If you are well above BEP level,

you are safe. Thus it is measured bycomparison to BEP level.

Its formula : (sales BEP) / sales * 100


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Example of margin of safety :

Your BEP sales is 40000, your present sales is100000

margin of safety = 60000margin of safety in % = 60%


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Find BEP ?Depreciation = 200,material cost = 500,labour

cost = 100, rent = 200, interest = 200, other expenses = 100, sales = 2000, no. Of units =

100here fixed cost = (rent 200, interest 200, other

exp. 100) = 500

variable cost per unit = (500+100)/100 =6contribution = 20-6, BEP = 500/14=35.7


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Price=10, variable works cost =5.5,variable selling cost =1.5,fixed works

cost=2.7 lakh, fixed selling cost = 1.26lakh, what should be the sales to earn

10% on sales?

Contribution = 3, pv ratio=30%let sales = x

x=3.96 lakh+.1x+.7x.2x=3.96 lakh, or x= 19.8 lakhs. Answer


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Explanation

Sale s= variable cost + contributioncontribution = fixed cost + profit

here fixed cost is given and profit is given as %of sales, thus we can write profit as .1X,

variable cost is 70% of sales price, so we canwrite it as .7X answer


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Sales : 11.5 lakh, price 11.5 per unit, fixedexp.=2 lakh, variable cost =7.5 per unit,

selling price is to be reduced to 11, profitshould be same, what should be the sales?

Contribution = 4 lakh & profit=contribution-fixed cost, so Earlier profit =2 lakh

Sales = x,

x=2lakh(fixed cost) +2lakh(profit)+.68X(variable cost)


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continued...

.32x = 4 lakhsX = 12.5 lakhs. Answer

at this sales, the company will earn same profit


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Fixed cost=20 lakhs, sales=5 lakhunit, variable cost=20 per

unit,profit=25% on cost, what isBEP?COST = FIXED + VARIABLE

=20+100 = 120 LAKHPROFIT = 30 LAKHSSALES = 150 LAKHS, SELLING PRICE = 30 PER

UNIT, CONTRIBUTION=10

BEP=20LAKH/10=2LAKH UNITSPV RATIO 10/30*100 = 33 %


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Sales 3.2 lakh, fixed cost 66000, variablecost=62% of sales, now fixed cost will increase by 32000, sales will increase to 4.6 lakhs, what

is new BEP, and what should be the sales toget profit of 55600?

New contribution = 4.6 *38%= 1.748 lakhsPV ratio = 38%

BEP = fixed cost / PV ratio=98000/38% = 2.578 lakh

sales at profit of 55600:(98000+55600)/38%=4.042 lakh


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sales=30lakh,variable cost=21lakh,profit=1.8 lakh, find BEP if variable cost increases by 5%?

BEP=fixed cost / PV ratiofixed cost =9-1.8=7.2

PV ratio=9/30*100=30%, present BEP=7.2/30% = 24 lakhs.

New variable cost = 22.05, new PV ratio =26.5%, new BEP= 27.1 lakhs answer


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In the previous question, what should bethe sales to maintain profit at present

level, but the selling price per unit isreduced by 5%?

Selling price reduced = 28.5 lakhPV ratio = (28.5-21)/28.5 *100 = 26.3%

desired sales = (fixed cost + profit)/PV ratio=(7.2+1.8)/26.3% = 34.2 lakhs. Answer


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What is sunk cost?

The cost which has already been incurred isignored in all such calculations, it is called

sunk cost. (past cost cost related to previousyears)


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What is opportunity cost?

It is the best opportunity forgone. It is nottaken into account in financial analysis.

However, it is taken into account in economicanalysis.


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Example

A toy manufacturer makes an average net profit of Rs. 2.50 per piece on a selling price of Rs. 14.30 by producing and selling 60,000

pieces or 60% of the potential capacity. His cost of sales is: Directmaterial Rs. 3.50 Direct wages Rs. 1.25

Works overhead Rs. 6.25 (50% fixed) Sales overhead Rs. 0.80(25% variable) During the current year, he anticipates that his

works overhead will go up by 10%, while rates of direct material anddirect labour will increase by 6% and 8% respectively. But he has nooption of increasing the selling price. Under this situation he obtains

an offer for an order equal to 20% of his capacity. The concernedcustomer is a special customer. What minimum price will you

recommend for acceptance to ensure the manufacturer an overall profit of Rs. 1,67,300?


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solution

Sales (60000 * 14.5) =870000material (60000*3.5*1.06)=222600labour (60000*1.25*1.08)=81000

overheads (60000*6.25*1.1=412500sales (60000*.8) = 48000

profit = 105900 profit left = 61400


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Target profit pricing New variables costs : (3.5*1.06) = 3.71, labour (1.25*1.08) = 1.35, overhead = (6.25*1.1*.5)=

3.43, sales overhead=.2total variable cost =8.69

+ target profit 61400/20000 = 3.07thus target price = 11.76

we have ignored other fixed cost, as it hasalready been recovered in sale of 60000 routine

sales.


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ROI / ROCE

Return on Investment / Return on Capitalemployed are very popular tools of ratioanalysis used for financial analysis of acompany. In this tool we try to use the

following formula : (Profit before interest andtaxes ) / (total capital employed )


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Explanation

Capital employed = equity + prefererence+debt

Different scholars use different structures, butthis is better as it denotes the capital employedwhether that of shareholders or of lenders.

Some scholars use average capital employed which is better which is simple average of

campital employed in the beginning of the year and at the end of the year.


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Profit??? in ROI

Profit here means the profit due to shareholdersand lenders all. Thus we take profit as profit before interest. Some scholars take profit before interest but after taxes, this is even

better. Our purpose is to find the return oninvestment and investment means all theresources deployed equity + debt


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EPS

Earnings per share : it is calculated by dividingnet profit after interest and taxes by the number of shares. Thus if profit after interest and taxes

is 100 and number of shares is 50, EPS is 2.Higher the EPS, the better it is.


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Fixed charge cover?

It is calculated by the following formula :

interest before interest and taxes / interestcharges

if interest before interest and taxes is 20 and

interest is 5, then fixed charge is 4.its other names are DSCR (Debt Service

Coverage Ratio)


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ENTREPRENEURSHIP'S MATERIAL FOR PGPSE

PARTICIPANTS.37

Payout Ratio

These ratios denote the ratio of payout. It is

calculated by the following formula : DPS /EPSif dividend per share is 5 and earning per share

is 10, payout ratio is 50%.DPS is calculated by the following formula :Dividend payable / total number of shares.


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Working capital turnover ratio

It is calculated by the following formula :sales / average working capital employed

suppose sales = 100, cash : 10, debtors : 20,inventory : 20, BR :10, current liabilities : 10

WCTR = 100 / 50 = 2 answer

if you have opening and closing figures of current assets and current liabilities, just take

simple average of working capital.


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PARTICIPANTS.39

What is current ratio?

It is calculated by the following formula :

current assets / current liabilitiesideally it should be above 2, means currentassets should be at least double the current

liabilities. It also depends on the quality of assets.


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PARTICIPANTS.40

Acid test ratio / quick ratio /

liquidity ratioIt denotes the ability of the company to meet shortterm liquidity requirements. It is calculated by the

following formula :liquid assets / current liabilities

liquid assets = current assets inventorysome people use liquid liabilities :

current liabilities bank overdraft and cash credit =liquid liability

this ratio should be at least 1:1.


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PARTICIPANTS.41

Debt Equity Ratio

This denotes the ratio of debt to equity. It is

calculated by the following formula :debt / equity

debt = all long term liablities

equity = shareholders fundit should not be more than 2:1, or debt should

not be more than double equity.


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PARTICIPANTS.42

Fixed assets ratio

It is calculated by the following formula :fixed assets / long term liabilities

it should not be more than 1:1, or fixed assetsshould not be more than long term loans taken,

in that case it would mean that all your long

term loans have gone into fixed assets. Butsome of it must go towards fixed workingcapital also.


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What is fixed working capital?Banks give WCTL working capital term loan

long term loan for fixed working capitalrequirements. There are two parts of workingcapital : fixed and fluctuating. It is better to

finance fixed working capital through WCTL.Suppose that you require working capital of

maximum 100 and minimum 40 during a year,so we can say that you need WCTL of 40 andcash credit of 60 (for fluctuating working

capital).


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PARTICIPANTS.44

PE ratio

It denotes the ratio of market price to EPS.

It is calculated by the following formula : Price per share/ earning per share

If market price of reliance is 1000 and its

earnings per share is 50, we can say PE ratio is20.PE ratio is generally in the range of 5 to 30.


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PARTICIPANTS.45

Operating ratio

It is the ratio of operating cost to sales.It is calculated by the following formula :

operating cost / sales * 100

if operating cost is 40 and sales is 100,operating ratio is 40%.


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PARTICIPANTS.46

Prepare balance sheet from the

following information:

DSCR = 20, Current ratio : 2:1, Liquidityratio : 1:1, Inventory turnover ratio : 30 times,

fixed assets turnover : 5 times,PE ratio : 20 EPS 2, Number of shares : 5

Net profit to sales ratio : 10% Debt equity ratio: 2:1


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solution...

Earning : 2*5 = 10, sales : 100 (from net profitto sales ratio), fixed assets: 100/5 = 20,

inventory = (100-10)/30 = 3 , current liabilities= 3, current assets (including inventory) = 6,

total assets : 26, capital employed = 26-(3+10)= 13 interest payment : 10/20 = .5debt : 2/3*13 = 8.6 Equity = 4.4

rate of interest = .5/8.6 *100 = 6% approx


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Balance sheet

Liabilities :debt : 8.6

equity 4.4current liabilities 3

assets :

fixed assets : 20inventory 3

other current assets : 3


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Analysis

Analysis require comparison to industry, bestcompanies, benchmarks etc. We must have knowledge

of industry practices before we start analysis of any balance sheet or financial statement. We may also usehistorical data for analysis. Thus analysis is a

subjective exercise.

In the balance sheet I personally believe that the firmrequires more working capital and need to use fixed

assets better.


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how to undertake financial analysis and predict the future of the companies

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