Chapter 7

FINANCIAL STATEMENT ANALYSIS

The Information Maze

OUTLINE

• FINANCIAL STATEMENTS

• FINANCIAL RATIOS

• STANDARDISED FINANCIAL STATEMENTS

• APPLICATIONS OF FINANCIAL STATEMENT ANALYSIS

• USING FINANCIAL STATEMENT ANALYSIS

• GOING BEYOND THE NUMBERS

IMPORTANT QUESTIONS

Managers, shareholders, creditors and other interested groups seek answers to the following important questions about a firm:

• What is the financial position of the firm at a given point of time?

• How has the firm performed financially over a given period of time?

• What have been the sources and uses of cash over a period of time?

The accountant prepares the balance sheet, the profit and loss account, and the statement of cash flows to answer the above questions

BALANCE SHEET

Horizontal Form

Liabilities + Equity Assets

Share capital Fixed assets

Reserves and surplus Investments

Secured loans Current assets, loans and

Unsecured loans advances

Current liabilities and provisions Miscellaneous expenditures

and losses

BALANCE SHEET

Vertical (or Report) FormI. Sources of Funds

(1) Shareholders’ funds:

(a) Capital

(b) Reserves and Surplus

(2) Loan funds:

(a) Secured loans

(b) Unsecured loans

II. Application of funds

(1) Fixed assets

(2) Investments

(3) Current assets, loans and advances

Less: Current liabilities and provisions:

Net current assets

(4) Miscellaneous expenditures and losses

BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1

A. Account Form Rs.in million

Liabilities 20 x 1 20 x 0 Assets 20 x 1 20 x 0

Share capital 150 150 Fixed assets 330 322

Equity 150 Investments*** 15 15 Preference – Current assets, loans

Reserves & surplus 112 106 and advances 234 156

Secured loans* 143 131 Miscellaneous

Unsecured loans** 69 25 expenditures and losses

Current liabilities

and provisions 105 81

579 493 579 493

* Rs. 35 million of secured loans are due within 1 year, the balance being due after 1 year. ** Rs.40 million of unsecured loans are due within 1 year, the balance being due after 1 year.*** Rs.3 million out of Rs.15 million represent current investments.

BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1

Rs.in million

20 x 1 20 x 0 I. Sources of Funds

(1) Shareholders’ funds: 262 256(a) Capital 150 (b) Reserves and surplus 112

(2) Loan funds: 212 156(a) Secured loans 143

(b) Unsecured loans 69 474 412

II. Application of Funds (1) Fixed assets 330 322(2) Investments 15 15 (3) Current assets, loans and advances 234 156

Less: Current liabilities and provisions: 105 81Net current assets 129 75

(4) Miscellaneous expenditures and losses 474 412

LIABILITIES

• Share Capital

• Reserves & Surplus

• Secured Loans

• Unsecured Loans

• Current Liabilities and Provisions

ASSETS

• Fixed Assets

• Investments

• Current Assets, Loans, & Advances

• Miscellaneous Expenditure & Losses

PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR

THE YEAR ENDING ON MARCH 31, 20 X 1(Rs.in million)

Income Sales 701 Other income –

701Expenditure Material and other expenditure 582 Interest 21 Depreciation 30 Provision for tax 34Profit after tax 34

PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR

THE YEAR ENDING ON MARCH 31, 20 X 1 (Rs. in million)

20 x 1 20 x 0Net sales 701 623Cost of goods sold 552 475 Stocks 421 Wages and salaries 68 Other manufacturing expenses 63Gross profit 149 148Operating expenses 60 49 Depreciation 30 General administration 12 Selling 18Operating profit 89 99Other income (expense) – 06 Profit before interest and tax 89 105Interest 21 22Profit before tax 68 83Provision for tax 34 41Profit after tax 34 42

PROFIT AND LOSS ACCOUNT ITEMS Net Sales

Cost of Goods Sold

Gross Profit

Operating Expenses

Operating Profit

Non-operating Gains and Losses

Profit Before Interest and Taxes

Interest

Profit before Tax

Income Tax Provision

Profit After Tax

Prior Period Adjustments

Amount Available for Appropriation

Appropriations

Balance Carried Forward

NET CASH FLOW

Net cash Profit after Non cash Non cash flow tax revenues expenses

In practice, analysts use the following approximation:

Net cash Profit after + Depreciation + Amortisation Flow tax

= –

+

=

STATEMENT OF CASH FLOW

Sources of Cash

• Increase in liabilities and owners’ equity

• Decrease in assets (other than cash)

Uses of Cash

• Decrease in liabilities and owners’ equity

• Increase in assets (other than cash)

Cash inflows from operations

Cash inflows from investing

activities

Cash inflows from financing

activities

Cash outflows from investing

activities

Cash flow from investing

activities

Cash outflows from financing

activities

Cash flow from financing

activities

Operating

Investing

Financing

–

–

=

=

=

+ –

+ –

=

–

Cash outflows from operations

Cash flow from operations

Net cash flow for the period

STATEMENT OF CASH FLOWS

SOURCES USES

• FINANCING CAPITAL CAPITAL

• OPERATING RES. & SURPLUS RES. & SURPLUS

• FINANCING LOANS LOANS

• OPERATING CURRENT LIABILITIES CURRENT LIABILITIES & PROVISIONS & PROVISIONS

• INVESTMENT FIXED ASSETS FIXED ASSETS

• INVESTMENT INVESTMENTS INVESTMENTS

• OPERATING INVENTORIES INVENTORIES

• OPERATING DEBTORS DEBTORS

CASH FLOW STATEMENT FOR HORIZON LTD, FOR THE PERIOD 1.4.20X0 TO 31.3.20X1

(Rs. in million)

(A) Cash Flow from Operating Activities Net profit before tax and extraordinary items 68 Adjustments for

Interest paid 21Depreciation 30

Operating profit before working capital changes 119 Adjustments

Debtors (46)Inventories (33)Advances 05Trade credit 15Advances 07Provisions 02

Cash generated from operations 69 Income tax paid 34 Cash flow before extraordinary items 35

Extraordinary item – Net cash flow from operating activities 35

(Contd.)

(Contd.)

(Rs.in million)

(B) Cash Flow from Investing Activities

Purchase of fixed assets (38)

Net cash flow from investing activities (38)

(C) Cash Flow from Financing Activities

Proceeds from term loans 12

Proceeds from inter-corporate deposits 44

Interest paid (21)

Dividend paid (28)

Net cash flow from financing activities 07

(D) Net Increase in Cash and Cash Equivalents (A) + (B) + (C) 04

Cash and cash equivalents as on 1.04.20x0 06

Cash and cash equivalents as on 31.03.20x1 10

MANIPULATION OF THE BOTTOM LINE

1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE

FOLLOWING YEAR

2. ALTER THE ‘OTHER INCOME’ FIGURE BY PLAYING WITH NON-OPERATIONAL ITEMS

3. FIDDLE WITH THE METHOD & RATE OF DEPR’N

4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR.

5. MAKE INADEQUATE PROVISIONS . . LIABILITIES

6. MAKE EXTRA PROVISIONS . . PROSPEROUS PERIODS . . WRITE THEM BACK . . LEAN PERIODS

7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES.

8. REVALUE ASSETS . . CREATE . . IMPR’N . . RESERVES

9. LENGTHEN … ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE.

WHY ? PROJECT IMAGE OF LOW RISK

PROMOTE PERCEP’N . . COMPETENT MGT

INCREASE MGRL COMPEN’N

QUALITY PROMPTNESS

OF CANDOUR IN ANALYSING PAST PERFORMANCE

REPORTING MEANINGFUL DISCUSSION . . PROSPECTS

HORIZON LIMITED: PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING 31ST MARCH 20X1

(Rs. in million) 20X1 20X0

Net sales 701 623Cost of goods sold 552 475Stocks 421 370Wages and salaries 68 55

Other manufacturing expenses 63 50 Gross profit 149 148 Operating expenses 60 49

Depreciation 30 26General Administration 12 11Selling 18 12

Operating profit 89 99 Non-operating surplus/deficit - 6 Profit before interest and tax 89 105 Interest 21 22 Profit before tax 68 83 Tax 34 41 Profit after tax 34 42 Dividends 28 27 Retained earnings 6 15 Per share data ( in rupees)

Earning per share 2.27 2.80Dividend per share 1.80 1.80Market price per share 21.0 20.0Book value per share 17.47 17.07

 

HORIZON LIMITED: BALANCE SHEET AS ON 31ST MARCH 20X1

(Rs. in million) 20X1 20X0

  I. Sources of funds 1. Shareholders' funds 262 256 (a)   Share capital 150 150 (b) Reserves and surplus 112 106 2. Loan funds (a)  Secured loans 143 131

(i) Due after 1 year 108 29 (ii) Due within 1 year 35 40 (b)  Unsecured Loans 69 25 (i) Due after 1 year 29 10 (ii) Due within 1 year 40 15   474 412 II. Application of funds 1. Fixed assets 330 322 2. Investments 15 15 (a) Long term investments 12 12 (b) Current investments 3 3 3. Current assets, loans and advances 234 156 (a) Inventories 105 72 (b) Sundry debtors 114 68 (c) Cash and bank balance 10 6 (d) Loans and advances 5 10 Less: Current liabilities and provisions 105 81 Net current assets 129 75

Total 474 412

LIQUIDITY RATIOS

• Current Ratio

Current assets 237

Current liabilities 180

• Acid-Test Ratio

Quick assets (237 – 105)

Current liabilities 180

• Cash Ratio

Cash and bank Current balances investments (10 + 3)

Current liabilities 180

= = 1.32

= = 0.73

+= = 0.07

LEVERAGE RATIOS

• Debt-equity Ratio

Debt 212 = = 0.809

Equity 262

• Debt-asset Ratio

Debt 212 = = 0.45

Assets 474

• Interest Coverage Ratio

Profit before interest and tax 89 = = 4.23

Interest 21

TURNOVER RATIOS

• Inventory TurnoverCost of goods sold 552Average inventory (105 + 72)/2

• Debtors’ TurnoverNet credit sales 701Average debtors (114 + 68)/2

• Fixed Assets Turnover Net sales 701Average net fixed assets (330 + 322)/2

• Total Assets Turnover Net sales 701

Average total assets (474 + 412)/2

= = 6.24

= = 7.70

= = 2.15

= = 1.58

PROFITABILITY RATIOS

• Gross Profit Margin Ratio

Gross profit 149

Net sales 701

• Net Profit Margin Ratio

Net profit 34

Net sales 701

• Return on Assets (ROA)

Profit after tax 34

Average total assets (474 + 412)/2

= = 0.21 or 21 percent

= = 0.049 or 4.9 percent

= = 0.077 or 7.7 percent

PROFITABILITY RATIOS

• Earning Power

Profit before interest and tax 89

Average total assets (474 + 412)/2

• Return on Capital Employed

Profit before interest and tax (1 – Tax rate) 89 (1 – 0.5)

Average total assets (474 + 412)/2

• Return on Equity

Equity earnings 34

Average equity (262 + 256)/2

= 0.201 or 20.1 percent

= 0.101 or 10.1 percent

= 0.131 or 13.1 percent

=

=

=

VALUATION RATIOS Price-earnings Ratio

Market price per share 21.0 = = 9.25

Earnings per share 2.27

Yield Dividend Price change

+ Initial price Initial price

Dividend yield Capital gains/losses yield 1.87 1.0 = 9.35% = 5% 20.0 20.0

Market Value to Book Value RatioMarket value per share 21.00 = = 1.20Book value per share 17.47

COMPARISON WITH INDUSTRY AVERAGES Ratios Formula Horizon Industry

Limited AverageLiquidity

Current assets • Current ratio 1.32 1.26

Current liabilities Quick assets

• Acid-test ratio 0.73 0.69 Current liabilities

Leverage Debt

• Debt-equity ratio 0.81 1.25 Equity Debt

• Debt-ratio 0.45 0.56 Assets

PBIT • Interest coverage ratio 4.23 4.14

InterestTurnover

Net sales • Inventory turnover 6.24 6.43

Average Inventory Net credit sales • Accounts receivable turnover 7.70 7.50

Average accounts receivable Net sales

• Fixed assets turnover 2.15 2.23 Average net fixed assets

Net sales • Total assets turnover 1.58 1.26

Average Total assets

Ratios Formula Horizon Industry Limited Average

Profitability Gross profit

• Gross profit margin ratio 21.0% 18.0% Net sales Net profit

• Net profit margin ratio 4.7% 4.0% Net sales Net profit

• Return on assets 7.7% 6.9% Average total assets

PBIT • Earning power 20.1% 17.7%

Average total assets PBIT (1–T)

• Return on capital employed 10.1% 8.8% Average total assets

Equity earnings • Return on equity 13.1% 11.9%

Average net worthValuation

Market price per share • Price-earnings ratio 9.25 9.26

Earnings per share Dividend + Price change

• Yield 14. 0% 14.1% Initial price

Market price per share • Market value to book 1.20 1.16 value ratio Book value per share

TIME SERIES OF CERTAIN FINANCIAL RATIOS

1 2 3 4 5

Debt-equity ratio 0.91 0.98 0.65 0.61 0.81

Total assets turnover ratio 1.51 1.59 1.58 1.53 1.58

Net profit margin (%) 8.8 11.6 9.8 6.6 4.9

Return on equity (%) 25.4 30.7 24.5 16.7 13.1

Price-earnings ratio 18.6 15.3 10.3 7.1 9.3

DUPONT ANALYSIS

Basic Du Pont Analysis

Net profit Net profit Net sales = x

Average total assets Net sales Average total assets

ROA = NPM x TATR

Extended Du Pont Analysis

Net profit Net profit Sales Average total assets = x x

Equity Sales Average total assets Average equity

ROE NPM x TATR x 1/(1 – DAR)

Return on Total Assets 7.7 %

Net Profit Margin 4.9%

Total AssetsTurnover 1.58

Net Profit 34

Net Sales701

Net Sales701

Average Total

Assets 443

Net Sales +/- Non operating

Surplus/Deficit

701

Total Costs

667

Average Fixed assets

326

Average Investments

15

Average Net Current Assets 102

DU PONT CHART APPLIED TO HORIZON LIMITED

X

–

+

+

EXTENSION OF THE DU PONT CHART

Return of Equity13.1%

Return of Assets7.7%

Average Total AssetsTo Average Equity

Ratio 1.70

COMMON SIZE FINANCIAL STATEMENTS Part A : Profit and Loss Account

  Reg ular (in million) Common Size (%) 20X0 20X1 20X0 20X1 • Net sales Rs.623 Rs. 701 100 100 • Cost of goods sold 475 552 76 79 • Gross profit 148 149 24 21 • PBIT 105 89 17 13 • Interest 22 21 4 3 • PBT 83 68 13 10 • Tax 41 34 7 5 • PAT 42 34 7 5

Part B: Balance Sheet

Regular (in million) Common Size (%) 20X0 20X1 20X0 20X1

• Shareholders’ funds 256 262 62 55 • Loan funds 156 212 38 45

Total 412 414 100 100 • Fixed assets 322 330 78 70 • Investments 15 15 4 3 • Net current assets 75 129 18 27 Total 412 474 100 100

COMMON-BASE YEAR FINANCIAL STATEMENTS Part A : Profit and Loss Account

  Regular (in million) Common Base Year (%) 20X0 20X1 20X0 20X1 • Net sales Rs.623 Rs. 701 100 113 • Cost of goods sold 475 552 100 116 • Gross profit 148 149 100 101 • PBIT 105 89 100 85 • Interest 22 21 100 95 • PBT 83 68 100 82 • Tax 41 34 100 83 • PAT 42 34 100 81

Part B: Balance Sheet

Regular (in million) Common Size (%) 20X0 20X1 20X0 20X1

• Shareholders’ funds 256 262 100 102 • Loan funds 156 212 100 136

Total 412 414 100 115 • Fixed assets 322 330 100 102 • Investments 15 15 100 100 • Net current assets 75 129 100 172 Total 412 474 100 115

APPLICATIONS OF FINANCIAL ANALYSIS

Financial ratios may be employed to:

• Assess corporate excellence

• Judge creditworthiness

• Forecast bankruptcy

• Value equity shares

• Predict bond ratings

• Estimate market risk

PROBLEMS IN FINANCIAL

STATEMENT ANALYSIS

• Heuristic and Intuitive Character

• Development of Benchmarks

• Window Dressing

• Price Level Changes

• Variations in Accounting Policies

• Interpretation of Results

• Correlation among Ratios

GUIDELINES

• USE RATIO TO GET CLUES TO ASK THE RIGHT QUESTIONS

• BE SELECTIVE IN THE CHOICE OF RATIOS

• EMPLOY PROPER BENCHMARKS

• KNOW THE TRICKS USED BY ACCOUNTANTS

• READ THE FOOT NOTES

• UNDERSTAND HOW THE RATIOS ARE INTER- RELATED

• REMEMBER … FSA .. ODD MIXTURE OF ART & SCIENCE

LOOKING BEYOND THE NUMBERS

1. ARE THE COMPANY’S REVENUES TIED TO ONE KEY

CUSTOMER ?

2. TO WHAT EXTENT ARE THE COMPANY’S REVENUES

TIED TO ONE KEY PRODUCT ?

3. TO WHAT EXTENT DOES THE COMPANY RELY ON A

SINGLE SUPPLIER ?

4. WHAT PERCENTAGE OF THE COMPANY’S BUSINESS IS

GENERATED OVERSEAS ?

5. COMPETITION

6. FUTURE PROSPECTS

7. LEGAL AND REGULATORY ENVIRONMENT

SUMMING UP

• Balance sheet, profit and loss account, and the statement of cash flows are the three financial statements

• The balance sheet shows the financial position at a given point of time, the profit and loss account reflects the financial performance over a period of time, and the statement of cash flows displays the sources and uses of cash over a period of time.

• Financial statement analysis can provide valuable insights into a firm’s performance and position.

• The principal tool of financial statement analysis is financial ratio analysis.

• Financial ratios may be divided into five broad categories:• Liquidity ratios• Leverage ratios• Turnover ratios• Profitability ratios• Valuation ratios

• Generally, the financial ratios of a company are compared with some benchmark ratios.

• The Du Pont chart is a popular tool of financial analysis. It provides insights into the determinants of the return on equity

• There are certain problems and issues in financial statement analysis that call for care, circumspection, and judgment.