FINANCIAL ANALYSIS(RATIO ANALYSIS , FUND FLOW/ CASH FLOW)

SHIVAM GUPTASHIVANI GUPTASUSHANT GUPTA SHWETA TALWARSHWETANSHU GUPTASIDHARTH GUPTA

Financial analysis It is a process of :

Analyzing and interpreting financial statements.

Analyzing means simplifying the data and interpreting means explaining the meaning and significance of data so simplified.

Critically examining the accounting information given in the financial statements.

Evaluating relationships between the component parts of financial statements to obtain a better understanding of firm’s position and performance.

Financial Statements

It is the outcome of summarising process of accounting.

Means of conveying to management, owners and to interested outsiders a concise picture of profitability and financial position of the business.

Its purpose is to convey an understanding of financial aspects of business firm.

Objectives / Importance:

• To assess the earning capacity and profitability of firm• To assess the operational efficiency and managerial

effectiveness.• To make inter-firm comparisons.• To make forecasts about future prospects of firm• To help in decision making and control• To guide or determine the dividend action• To identify the reason for change in profitability and financial

position of the firm.• To assess the progress of firm over a period of time.

Potential financial statement users:

• Creditors• Investors•Managers• Employees• Taxation authorities• Shareholders

Internal analysis is conducted by persons who have access to internal accounting records of a business firm, such as executives and employees of organization.

External analysis is conducted by persons outsiders who don’t have access to the internal accounting records of business firm such as investors, creditors, govt. agencies, credit agencies and general public.

Horizontal analysis: It refers to the comparison of financial data of a company for several years. This type is also called ‘ dynamic analysis’ as it is based on the data from year to year rather than single year.

Vertical analysis: it refers to the study of relationships of the various items in the financial statements of one accounting period. It is also called as ‘ static analysis’.

Steps of financial analysis:

Establish objectives of the analysis.Defining extent of analysis.Re- organization and re-

arrangement of financial data.Relationship among financial

statements with help of tools and techniques

Interpretation of informationDrawing a conclusion.

Limitations:

• It is based on monetary information and monetary factors are ignored• It doesn’t consider changes in price level.• Changes in accounting procedures by a firm

may often make financial analysis misleading• Analysis is only a means and not the end itself.

The analyst has to make interpretation and draw his own conclusions. • Different people may interpret same analysis in

different ways.

Tools and Techniques

Comparative statementsTrend- analysisFund flow analysisCash flow analysisRatio analysisCommon-size statements

Ratio analysis:

• LIQUIDITY RATIOS• LEVERAGE RATIOS•ACTIVITY RATIO• PROFITABILITY RATIOS

Uses:• Helps in decision making• Helps in financial forecasting nad planning• Helps in communicating strength and weakness opf a firm• Helps in co-ordinating various business activities to achieve

goals• Helps in making effective control of the business.

Limitations :• A single ratio can’t convey much of sense.• Lack of adequate standards• Industries differ in nature and hence their ratios can’t be

compared.• No consideration is made to the changes in price level.

Cont’d

• Change in accounting procedures by a firm often make analysis misleading.

• Financial statements can be easily window-dressed to provide a better picture of financial and profitable position of business firm to outsiders.(window dressing)

• Ratio analysis is merely a tool of financial statements. Hence ratios become useless if separated from statements.

LIQUIDITY RATIOS:

• Current Ratio• Current Assets/Current Liabilities• Measures ability to meet short-term cash needs

• Quick or Acid Test Ratio• Current Assets-Inventory/Current Liabilities• Measure ability to meet short-term cash needs more

rigorously

• Absolute Liquid Ratio• Cash + short term marketable securities/Current Liabilities• Focuses on ability of the firm to generate operating cash

flows as a source of liquidity

Leverage ratios:• Debt-to-Equity: Debt/Equity= outsider’s funds/ shareholder’s

fundsThe debt/equity ratio, The ratio indicates what proportion of equity and debt a company uses to finance its assets.

• Debt-to-Capital: funded debt/total capitalisationThe ratio is used to evaluate a firm's financial structure and how it's financing operations.

• Debt Ratio: Total Liabilities/Total Assets

• All three measure extent of firm’s financing with debt.

Activity ratios:Inventory turnover ratio= cost of goods sold/inventory• Every firm has to maintain a minimum level of inventory of

finished goods to meet business requirements.• Inventory turnover ratio indicates whether inventory has been

efficiently used or not.

• Debtors turnover ratio = net credit sales/average trade debtors.• Indicates number of times average debtors are turned over a

given year.

• Average collection period = no of days or months/debtor turnover ratio.• Represents average number of days for which a firm has to

wait before its receivable are converted into cash.

• Creditor turnover ratio = credit purchases/average trade creditors

• Working capital turnover ratio = net sales/working capital• Measures efficiency with which working capital is

being used by the firm.

Profitability ratio• Gross Profit ratio = Gross Profit/Net Sales• Operating Profit ratio = Operating Profit/Net Sales• Net Profit ratio = Net profit/Net Sales• Fixed asset turnover ratio = cost of goods sold/fixed assets

All measure firm’s ability

to translate sales into

Profits.

• Return on Investment (or Return on Assets)= Net Earnings/Total Assets

• Return on Equity= Net Earnings/Stockholders’ Equity

• Both measure overall efficiency of firm in managing investment in assets and generating return to stockholders

Caution!!Ratios are valuable, BUT…..

They do not provide answers in an of themselves and are not predictive

They should be used with other elements of financial analysis

There are no “rules of thumb” that apply to interpretation of ratios

Fund flow analysis

• It is analysis of fund flow statement.• Fund flow statement indicates various means

by which the funds were obtained during a particular period and the ways in which these funds were employed• In simple words it is analysis of sources and

application of funds.

Importance:•Gives information about amount of working

capital and changes in the amount of working capital.• It analyses Balance sheet to reveal the

financing & investing activities.• It analyses the Profit & Loss Account to reveal

the effect of business activities of the concern on the flow of funds.• It is a tool for planning future activities of

business.

Fund flow format:

Cash flow analysis:• Cash flow statement is a statement which

describes the inflows(sources) and outflows(uses) of cash and cash equivalents & depicts the net change in cash position during a period.

• Cash- comprises of cash in hand and bank.

• Cash equivalents- short term highly liquid investments readily converted into cash.

• Cash flows: inflows and outflows of cash and cash equivalents.

Classification:

• Cash flow from operating activities- these are principal revenue producing activities.

• Cash flow from investing activities- the acquisition & disposal of long term assets & other investments not included in cash equivalents.

• Cash flow from financing activities- composition of the owners capital and borrowings of the enterprise.

Uses:

• Evaluate management’s abilities to manage cash now and in the future.• Assess the company’s ability to pay dividends

and to pay creditors.• The firms ability to generate future cash flow.• The financing and investment activities during a

period.