UNDERSTANDING AND ANALYSING

FINANCIAL STATEMENTS
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BY
DR. ARCHANA SINGH
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What are Financial Statements?
 The “HOW” of Financial Decision
Making
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⚫ To make the three basic decisions

Financial statements are
analyzed
compared
interpreted
Analysis – reclassification of given data
into homogenous and comparable groups
Comparison – relative magnitude is
ascertained
Interpretation – drawing proper
conclusions for future decisions.
 Balance sheet
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⚫ Prepared from the point of view of the firm

⚫ Relates to a point of time not a period
⚫ Is in terms of money
⚫ Is always balanced – A=L+Eq
⚫ Reflects the health of the firm at that moment
 Profit & Loss account
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⚫ Shows the financial results for a period

⚫ The period is normally a year – accounting
year

Both the financial statements are analyzed

by tools like:
- Ratio Analysis
- Funds flow statements
- Cash flow statements
 Balance Sheet – common entries
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⚫ SHARE CAPITAL – capital provided by the

owners
⚫ RESERVES & SURPLUS – capital belonging
to owners
- share-premium reserve
- general reserve

Together share capital + reserves = NET

WORTH
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LONG TERM LOANS – major part of the
liabilities can be raised from
- banks
- FI’s
- public deposits
CURRENT LIABILITIES – short term
source e.g.- wages/interest payable,
sundry creditors etc
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⚫ FIXED ASSETS – Are not normally
traded for liquidity, do not change in
form or quantity thus gross fixed assets
are depreciated

⚫ DEPRECIATION is the process of

allocating the original purchase price of a
fixed asset over the course of its useful
life.
⚫ All Fixed assets except land are
depreciated
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⚫ CURRENT ASSETS continually change in
form & quantity and follow a sequence of
change such as-
- cash &marketable securities
- bank balance
- loans advances & prepaid expenses
- receivables & sundry debtors
- inventory
⚫ INVESTMENTS – after
10 fulfilling the need
of FA & CA ‘the financial manager uses
the surplus cash towards investments (as
cash is dead & decaying asset).
Investments are in
- outside/firm’s securities
- other businesses
- subsidiary companies
The investments are valued at actual cost
or market value or the lesser of the two
depending on the firm’s policy
 Flowchart of a balance sheet
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⚫ Capital & Liabilities ⚫ Assets

⚫ Where the funds ⚫ Where the funds are
come from deployed
Share Capital Fixed assets
Reserves&Surplus Investments
Long term loans Current assets
Short term debt
 Profit & Loss Account
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Shows the financial results for a period.

⚫ List of all revenues/sales

------
------ X
⚫ List of all expenses (only expenses for
current year)
------
------ Y
If X>Y then profit if X<Y then loss
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⚫ Gross Profit = Sales – COGS

⚫ Operating Profit/EBIT = Gross Profit –
Operating Expenses (administrative and
selling & distribution expenses)
⚫ EAIBT = Operating Profit + Non-operating
Income – Non Operating Expenses
(Interest, Depreciation incl. Amortization
schedule)
⚫ EAT/Net Profit = EAIBT – Tax

The Net Profit is either to be distributed as

dividend amongst shareholders or kept
back in the firm as retained earnings.
 Schedules & Notes to Accounts
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⚫ Schedules give a break-up of items in the

balance sheet and P & L account
⚫ Note to Accounts are meant for qualitative
explanation of certain items as well as
disclosure of off-balance sheet items
 Evaluation of financial performance
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⚫ Comparison is essential
⚪ The comparison can be of the ratio of the same
company over several successive years
⚪ Comparison with similar figures of other firms and
units in the same industry
⚪ Comparison with similar figures of other firms and
units in different industries
 Fundamental Question
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⚫ 1) How is the business doing?

⚫ (2) How is the business placed at present?
⚫ (3) What are the future prospects of the
business?
We can use
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⚫ Ratio Analysis
⚪ Trend Analysis
⚪ Inter firm Comparison
⚪ Comparative statements
⚪ Common size statements
⚪ Fund flow analysis
⚪ Cash Flow analysis
⚪ Benchmarking
Performance Key Issues
Area

Profitability Is the business making a profit? Is it

enough? ROI,ROCE,ROE,Margin ratios
Efficiency Is the business making best use of its
resources? Is it generating adequate sales
from its investment in equipment and
people? Is it managing its working capital
properly? Turnover ratios.

Liquidity Is the business able to meet its short-term

obligations as they fall due from cash
resources immediately available to it?
current ratio
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Performance Key Issues
Area
Stability What about the long-term
prospects of the business? Is the
business generating sufficient
resources to repay long-term
liabilities and re-invest in
required new technology? What is
the overall structure of the
businesses' finance - does it place
a burden on the business?
DEBT/Equity
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 Performance Area Key Issues

Investment Return What return can investors or

lender expect to get out of the
business? How does this compare
with similar, alternative
investments in other businesses?
P/E ratio, P/B ratio.

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 RATIO ANALYSIS
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⚫ Is a primary tool for analyzing the firm’s

financial position
External analysis – by outsiders (creditors,
stockholders, analysts):they have limited access
to confidential information
Internal analysis – by the finance & accounting
departments. They have access to detailed
(future) information and can do a SWOT
analysis too
⚫ Ratio Analysis just indicates the SYMPTOMS
of problems. 22
⚫ After locating symptom the cause has to be
determined
⚫ Ratios point out the relationships which are
not obvious from the raw data.
⚫ Ratios are used for:
⚪ Comparing different industries
⚪ Comparing different companies in the same
industry (to reveal strong & weak
companies)
⚪ Comparing performance in different time
periods
(they indicate future success or failure)
⚪
There can be 1000s of different kinds of
ratios based on financial 23statements, but
different analysts require different kinds of
Ratios:
⚫ ST Creditor : Liquidity ratios
⚫ LT Creditor : Liquidity & Profitability
⚫ Stockholders : Liquidity, Profitability & Policies
of firm which affect market price.
⚫ LIQUIDITY RATIOS
• Current ratio
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• Quick/acid test ratio

⚫ LEVERAGE RATIOS/stability
• debt-equity ratio
• debt ratio
⚫ PROFITABILITY RATIOS
▪ P/E ratio
▪ Market value to book value ratio
▪ Gross profit ratio
▪ Operating profit ratio
▪ Net profit ratio
▪ ROTA
▪ ROE/-ROCE
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⚫ ACTIVITY RATIOS
• Total assets turnover ratio
• Fixed assets turnover ratio
• Current assets turnover ratio
• Interest coverage ratio
• Accounts receivable ratio
• Average collection period
Liquidity ratios 26
▪ CR= CA/CL
▪ QR= CA-Inventory/CL
Coverage ratios
▪ EAIBT/Annual interest payment= Interest coverage
▪ EAT + Depreciation/Annual amount of loan
installment= loan repayment coverage ratio
▪ EAT + Depreciation/Annual interest(1-tax
rate)=Coverage for principal & interest loan
repayment
▪ EAT-Preference Dividend/Annual dividend
payment=Dividend Coverage
⚫ Profitability ratios
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⚪ PBIT*100/Total capital employed=ROCE
⚪ EAIT/Sales=Net Profit ratio
⚪ EBIT/Sales=Gross Profit ratio

⚫ Turnover ratios
▪ Net sales/Total capital employed=Capital
turnover ratio
▪ Net sales/Net FA= FA turnover ratio
▪ COGS/Average inventory=Inventory
Turnover ratio
▪ Net sales/Gross CA=CA turnover ratio
▪ Annual credit sales/amt. of debtors at the
end of the month=Debtors turnover ratio
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⚫ Capital structure ratios
⚪ Total of LT liabilities/Total shareholders funds =
Debt to Equity ratio
⚪ Net worth to total assets shows stability of the
firm
⚪ Net worth to Fixed Assets shows extent to which
FA have been financed out of owner’s funds.
 Symptoms, Causes
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& Solutions
revealed
Symptoms
by Financial
Problem
Ratios
Solution
A. Abnormal 1.Inadequate 1.Raise
Liquidity Cash
additional
Ratio funds
2. Excessive 2. Restrict
Receivables terms of
trade: more aggressive
collection
policy
Symptoms Problem Solution
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3.Excessive 3.Improve
inventory inventory
mgmt.

4. Excessive 4.Obtain
CL LT financing
Symptoms Problem Solution
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2. Abnormal 1. High 1. Institute
Profitability Production cost cutting
Ratio costs measures
2. Idle 2. Sell excess
assets assets 3.
Inadequate 3. Increase
sales size of
sales force &
advertising
4. Inadequate 4. Raise SP
selling price
Symptoms Problem Solution
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5. High 5.Reduce
administrative them
expenses

6. Excessive 6. Seek
interest lower cost
payments debt or shift
to
equity
financing
 DU PONT33 Analysis
⚫ ROCE= Net profit margin * capital turnover
Ratio
⚫ N.P.(EAIT) Sales
---------------- * --------------------------
Sales Capital employed
 Sources & Uses of Funds
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⚫ Flow of funds in a firm is continuous.

⚫ Assets are the net use
⚫ Liabilities are the net sources
⚫ The fund flow is a method by which we
study net fund flow between 2 points of
time: we take the balance sheet of 2
consecutive periods and the P&L a/c for the
period
⚫ Funds can be defined as Cash; Working
Capital; Total funds
THREE STEP PROCESS
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1. Classify net B/S changes that occur between 2

times
2. Classify from P&L a/c (increase or decrease)
3. Consolidate this information into a source
and use of funds.
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⚫ Sources ⚫ Uses
1. A net decrease in 1. A net increase in
any asset any asset
2. A net increase in 2. A net decrease in
any liability any liability
3. Sale of stock 3. Retirement/
4. Fund From purchase of stock
operation 4. Cash dividends
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⚫ Funds flow statement helps to alert the

management to the problems that can later be
analyzed in detail

⚫ This facilitates the proper action to be taken

⚫ Helps to evaluate the firm’s financing

 Case 1: Anandam Manufacturing
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⚫ Objective of the case:

⚫ Calculate a series of financial ratios and perform

basic financial statement analysis, which requires the
preparation of cash flow statements, trend analysis
and common size statements.
 Assignment questions:
⚫ Prepare and analyze the Cash
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flow statement?
⚫ Prepare and analyze the common size statement?
⚫ Compute and analyze the trend analysis of the
company?
⚫ Compute various ratios to analyze the performance
of the company?
⚫ Based on these ratios and in comparison to the
industry average, will you grant loan to the
company?
⚫ What areas of improvement can you suggest
Anandam for future?
⚫ Is there any limitation to ratio analysis?
 Ratio analysis conclusion
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⚫ Current ratio and acid test ratio are declining from

1-3 shows liquidity problem
⚫ Slow recovery of accounts receivable and piling up of
inventories again indicate liquidity problem.
⚫ Shows poor management of working capital
⚫ D/E ratio compared to industry is too high –
improper management of funds.
⚫ Interest paying capacity is decreasing
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⚫ All the profitability ratios are decent due to control of

expenses but Net profit margin is coming down
because of growing interest expense.
⚫ Utilization of assets is fine.
⚫ ROE is fine and in line with the industry.
 Suggest areas of improvement
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⚫ Efficient steps to recover money from debtors

⚫ Reduce stock
⚫ Ensure proper management of funds
⚫ Manage D/E ratio
⚫ Reducing/controlling operating expenses
 AT & T case
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⚫ What trend do you see in the overall wireline and
wireless industry?
⚫ Has either of the company been reinvesting in its
business? Provide evidence.
⚫ What are the driving factors behind each firm,s
performance?
⚫ Reorganize the balance sheet in terms of operating
and financial componenets.
⚫ Identify the elements of working capital and
calculate associated ratios.
⚫ Analyze profitability ratio at cosolidated as well as at
segment levels
 What trend do you see in the overall wireline and wireless industry?

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⚫ Competition in Wireless is more than wireline.

⚫ Tend to commoditize industries and in these low cost
providers usually win.
⚫ Second defining aspect is Technology- industry
participants make large fixed investments and profit
margin expansion is directly related to capacity
utilisation.
⚫ The firm with the best technology will most
effectively exploit the spectrum and other things
remaining the same, would be the low cost producer
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⚫ Industry wide shift to instalment sales model-

decreased serice revenue and margins.
⚫ Wireline sector has been on decline for sometime.
⚫ But critical for infrastructure and no network could
function without them.
⚫ Wireline operating margins are below that of
wireless
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THANK YOU