ACCOUNTING FOR

MANAGERS – MODULE 3
Financial Analysis - Objectives
 Identify the Strengths and Weaknesses of the Firm
 Establish Relationship between Various Components
 Decision Making
Objectives of financial statement analysis

 Equity investors
 Return on capital
 Capital preservation

 Credit grantors
 Short-term – interest cover
 Long-term – interest cover and capital preservation

 Management
 Decision making
 Control
Objectives of financial statement analysis

 Employees
 Job security
 Wage & salary negotiations

 Acquisition and merger analysts

 Valuation of potential candidates

 Auditors
 Analytical review

 Other/Tax authorities
 Income fairly stated
Anatomy/Types of financial statements

 Position statement(Balance Sheet)

 Income Statement (P&L account)
 Statement of change in owners equity (Retained
earnings)
 Statement of changes in financial Position
 Cash Flow statement
 Fund Flow Statement
Class activity………

Prepare a balance sheet format and

income statement format
 Income Statement & Statement of changes in equity
Typical Limited
Income Statement
For the year ended 30 June 20.2 20.2 20.1
Rm Rm
Sales revenue 3,573 2,320
Cost of Sales 2,036 1,206
Gross Profit 1,537 1,114
Distribution, selling and marketing expenses 679 394
Administration and general expenses 322 186
Other expenses 254 116
Profit (earnings) before interest and tax expense 282 418
Finance costs 100 80
Profit before tax 182 338
Income tax expense 54 101
Profit for the period 128 237
Earnings per share 0.256 0.474

Statement of changes in equity

for the year ended 30 June 20.2
Balance at 30 June 20.1 340 202
Profit for the period 128 237
468 439
Dividends -53 -99
Balance at 30 June 20.2 415 340
 Balance Sheet
Typical Limited
Balance Sheet
as at 30 June 20.2 20.2 20.1
Rm Rm
ASSETS
Non-Current Assets
Property, plant & equipment 1,227 1,137
Current Assets
Inventories 65 60
Receivables 122 108
Cash assets 21 15
Total Current Assets 208 183

Total Assets 1,435 1,320

EQUITY AND LIABILITIES

Equity
Share Capital (500m shares of R1 each) 500 500
Retained earnings 415 340
Total Equity 915 840
Non-current Liabilities
Long-term borrowings 400 380
Total non-current liabilities 400 380
Current Liabilities
Trade and other payables 98 88
Short-term borrowings 22 12
Total current liabilities 120 100

Total Equity and Liabilities 1,435 1,320

Tools of Analysis

Horizontal Analysis

Comparing a company’s financial condition and performance

across time

Time
Horizontal Analysis

Now, let’s look at

some ways to use
horizontal
analysis.

Time
The term horizontal analysis arises from left-
to-right (or right-to-left) movement of our
eyes as we review comparative financial
statements across time.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Dollar Percent
2004 2003 Change Change
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
Comparative Statements

Calculate Change in Dollar Amount

Dollar Analysis Period Base Period

Change = Amount – Amount

Since we are measuring the amount of the

change between 2003 and 2004, the dollar
amounts for 2003 become the base period
amounts.
Comparative Statements

Calculate Change as a Percent

Percent Dollar Change

Change
=
Base Period Amount × 100%
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Dollar Percent
2004 2003 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
$12,000 – $23,500 = $(11,500)
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land ($11,500 ÷ $23,500)
40,000 40,000× 100% = 48.9%
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
* Percent rounded to first decimal point.
No , let’s re ie the dollar and
percent changes for the
liabilities and shareholders’
equity accounts.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Dollar Percent
2004 2003 Change Change*
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities $ 70,000 $ 50,000 $ 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities $ 145,000 $ 130,000 $ 15,000 11.5
Shareholders' equity:
Preferred shares 20,000 20,000 - 0.0
Common shares 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital $ 90,000 $ 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total shareholders' equity $ 170,000 $ 159,700 $ 10,300 6.4
Total liabilities and shareholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
* Percent rounded to first decimal point.
No , let’s look
at trend
analysis!
 Trend Analysis

Also called trend

percent analysis or
index number trend
analysis.

Trend analysis is used to reveal patterns in data covering

successive periods.

Trend Analysis Period Amount

Percent = Base Period Amount
× 100%
 Trend Analysis

Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

2000 is the base period so its

amounts will equal 100%.
 Trend Analysis

Berry Products
Income Information
For the Years Ended 31 December
Item 2004 2003 2002 2001 2000
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
Item 2004 2003 2002 2001 2000
Revenues 105% 100%
Cost of sales 104% 100%
Gross profit 108% 100%

(290,000 ¸ 275,000) ´ 100% = 105%

(198,000 ¸ 190,000) ´ 100% = 104%
(92,000 ¸ 85,000) ´ 100% = 108%
 Trend Analysis

Berry Products
Income Information
For the Years Ended 31 December

Item 2004 2003 2002 2001 2000

Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2004 2003 2002 2001 2000

Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%

How would this trend analysis look on

a line graph?
Trend Analysis

We can use the trend percentages to construct a

graph so we can see the trend over time.

160

150

140
Percentage

130
Revenues
120
Cost of Sales
110 Gross Profit
100
2000 2001 2002 2003 2004
Year
Vertical Analysis V
e
r
Vertical Analysis is also called as common-size
t
i
analysis c
a
l
A
n
a
l
The term vertical analysis arises from the up-down y
(down-up) movement of our eyes as we review s
common-size financial statements. i
s
Common-Size Statements

Calculate Common-size Percent

Common-size Analysis Amount

Percent
= Base Amount × 100%

Financial Statement Base Amount

Balance Sheet Total Assets
Income Statement Revenues
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
($12,000 ÷ $315,000)
Total current assets
× 100% = 3.8%
$ 155,000 $ 164,700
Property and equipment:
Land ($23,500 ÷ $289,700)
40,000 × 100% = 8.1%
40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER CORPORATION
Comparative Balance Sheets
31-Dec
Common-size
Percents*
2004 2003 2004 2003
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 21.3% 15.2%
Notes payable 3,000 6,000 1.0% 2.1%
Total current liabilities $ 70,000 $ 50,000 22.2% 17.3%
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 23.8% 27.6%
Total liabilities $ 145,000 $ 130,000 46.0% 44.9%
Shareholders' equity:
Preferred shares 20,000 20,000 6.3% 6.9%
Common shares 60,000 60,000 19.0% 20.7%
Additional paid-in capital 10,000 10,000 3.2% 3.5%
Total paid-in capital $ 90,000 $ 90,000 28.6% 31.1%
Retained earnings 80,000 69,700 25.4% 24.1%
Total shareholders' equity $ 170,000 $ 159,700 54.0% 55.1%
Total liabilities and shareholders' equity $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended 31 December
Common-size
Percents*
2004 2003 2004 2003
Revenues $ 520,000 $ 480,000 100.0% 100.0%
Less: Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes $ 25,000 $ 32,000 4.8% 6.7%
Less: Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income $ 17,500 $ 22,400 3.4% 4.7%
Net income per share $ 0.79 $ 1.01
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.
Financial Analysis - Types

Types
On Basis of On Basis of
Material Used Modus Operandi

Internal External Horizontal Vertical

(Dynamic) (Static)
Financial Analysis - Procedure
Selection
Purpose of Analysis Appropriate Data Selection

Classification
Categorization Grouping

Interpretation
Comparative Common Size Trend Ratio Analysis Funds Flow Cash Flow
Statement Statement Analysis Statement Statement
Comparative Statement
 Comparative Balance Sheet
 Comparative Income Statement
 Common Size Balance Sheet
 Common Size Income Statement
Ratio Analysis
 What is a Ratio?
 What is Analysis?
 Modes in which ratios can be presented:
 Percentage

 Proportion

 Rate or Times
 Nature of Ratio Analysis
Interpretation of Ratios
 Single Absolute Ratios
 Group Ratios
 Historical Comparison
 Projected Ratios
 Inter Firm Comparison
Liquidity Ratios
 Current Ratio
 Formula: CA/CL
 Acid Test/Quick/Liquid Ratio
 Formula: Quick Assets/CL
 Quick Assets = CA – (Prepaid Exp. + Inventory)

 Absolute Liquid Ratio

 Formula: Absolute Liquid Assets/CL
 Absolute Liquid Assets = Cash in Hand/Bank +
Marketable Securities
Efficiency Ratios
 Inventory/Stock Turnover Ratio
 Formula: COGS/Average Inventory at Cost
 Average Inventory = (Opening Stock + Closing
Stock)/2
 If COGS data is not available Net Sales can be used

 Inventory Conversion Period

 Formula: Days in a year/Inventory Turnover Ratio
Efficiency Ratios
 Debtors/Receivables Turnover Ratio
 Formula: Net Credit Annual Sales/Average Debtors
 Average Debtors = (Opening Debtors + Closing
Debtors)/2
 Debtors = Sundry Debtors + Bills Receivables +
Accounts Receivables
 Average Collection Period
 Formula: No. of Working Days/Debtors Turnover Ratio
Efficiency Ratios
 Creditors/Payables Turnover Ratio
 Formula: Net Credit Annual Purchases/Average
Creditors
 Average Creditors = (Opening Creditors + Closing
Creditors)/2
 Creditors = Sundry Creditors + Bills Payables +
Accounts Payables
 Average Payment Period
 Formula: No. of Working Days/Creditors Turnover Ratio
Efficiency Ratios
 Working Capital Turnover Ratio
 Formula: Cost of Sales/Average Net Working Capital
 Average Net Working Capital = (Opening NWC +
Closing NWC)/2
 Net Working Capital (NWC) = Current Assets – Current
Liabilities
Leverage/Capital Structure Ratios

 Repayment of Principal
 Payment of Interest Due
 Debt-Equity Ratio:
 Approach 1: Formula:
 Long-Term Debt/Shareholder’s Equity
 Approach 2: Formula:
 Total Debt/Shareholder’s Equity
 Preference Share Capital – Debt OR Shareholder’s
Equity
Leverage/Capital Structure Ratios

 Debt to Total Capital Ratio

 Approach 1: Formula:
 Long-Term Debt/Permanent Capital
 Current Liabilities are not included in Permanent Capital

 Approach 2: Formula:
 Total Debt/Total Assets
 Total Debts = Long-Term Debt + Current Liabilities
 Total Assets = Permanent Capital + Current Liabilities
Leverage/Capital Structure Ratios

 Proprietary Ratio
 Formula:Proprietor’s Fund/Total Assets
 Also Known as Capital Gearing Ratio
Coverage Ratios
 Computed from information available in P&L
Account.
 Interest Coverage Ratio
 Formula: EBIT/Interest
 Dividend Coverage Ratio
 Formula: EAT/Preference Dividend
 Debt Service Coverage Ratio
 Formula:(EAT + Interest + Depreciation + Other Non
Cash Expenses)/Instalment
Profitability Ratios – Related to Sales

 Measures Profitability of a Firm

 Interested Parties (Major):
 Management

 Investors/Shareholders

 Creditors

 Owners

 Types:
 Profit
Margin Ratios
 Expenses Ratios
Profitability Ratios – Related to Sales

 Gross Profit Margin

 Formula: (Gross Profit/Net Sales) X 100
 Operating Profit Margin
 Formula: EBIT/Net Sales
 Pre-tax Profit Margin
 Formula: EBT/Net Sales
 Net Profit Margin
 Formula: EAT/Net Sales
Profitability Ratios – Related to Sales

 Expenses Ratios
 COGS Ratio
 Formula: (COGS/Net Sales) X 100
 Operating Expenses Ratio
 Formula: (Operating Expenses/Net Sales) X 100
 Operating Expenses = Administrative Expenses + Selling
Expenses
 Operating Ratio
 Formula: (COGS + Operating Expenses/Net Sales) X 100
Profitability Ratios – Related to
Investment
 Return on Investment (ROI)
 Return on Shareholder’s Equity (ROE)
 Return on Capital Employed (ROCE)

 Return on Assets (ROA)

Profitability Ratios – Related to
Investment
 Return on Shareholders’ Investment
 Formula: (Net Profit After Tax/Shareholders’ Funds) X
100
 Return on Equity Capital/Ordinary Shareholders’
Equity/Net Worth
 Formula: (Net Profit After Tax – Preference
Dividend)/Equity Share Capital
 Earnings Per Share (EPS)
 Formula: (Net Profit After Tax – Preference
Dividend)/No. of Outstanding Equity Shares
Profitability Ratios – Related to
Investment
 Dividend Per Share (DPS)
 Formula:Dividend Paid to Ordinary Shareholders/No.
of Ordinary Shares Outstanding
 Dividend Pay-out Ratio
 Formula: (Total dividend given to equity
shareholders/Total net profit belonging to equity
shareholders) X 100
 Formula 2: (DPS/EPS) X 100
Profitability Ratios – Related to
Investment
 Earnings Yield
 Formula: (EPS/Market Value per Share) X 100
 Dividend Yield
 Formula: (DPS/Market Value per Share) X 100
 Price Earnings Ratio:
 Formula: Market Price per Share/EPS
 Book Value Per Share:
 Formula: Net Worth/No. of Equity Shares Outstanding
Profitability Ratios – Related to
Investment
 Price to Book Value Ratio
 Formula: MPS/BPS
 Return on Assets (ROA)
 (Net Profit After Tax/Average Total Assets) X 100
 Average Tangible Assets and Average Fixed Assets can also
be used as a variant
 Return on Capital Employed (ROCE)
 Formula: EBIT/Average Capital Emloyed
 Capital Employed = Long term Liablilities + Owners Capital
OR Net Working Capital + Net Fixed Assets
Assets/Investment Turnover Ratios

 Total Assets Turnover

 Formula: COGS or Sales/Average Total Assets
 Fixed Assets Turnover
 Formula: COGS or Sales/Average Fixed Assets
 Capital Turnover
 Formula: COGS or Sales/Average Capital Employed
 Current Assets Turnover
 Formula: COGS or Sales/Average Current Assets
 Working Capital Turnover
 Formula: COGS or Sales/Net Working Capital
Statement of Changes in Financial
Position – Cash Flow Statement
 What is a Cash Flow Statement?
 Prepared on Cash Basis
 Helps in Cash Planning

 Explains Reasons for Poor Cash Position

 Procedure for Preparing Cash Flow Statement

Opening Cash Cash Cash

Balance of Inflows Outflows Balance at
Cash/Bank the End
Statement of Changes in Financial
Position – Cash Flow Statement
 Sources of Cash Inflows
 Cash Flow From Operations
 Increase in Existing Liabilities or Creation of New Liabilities
 Sale of Assets
 Non-Trading Receipts

 Application of Cash or Cash Outflows

 Cash Lost in Operations
 Discharge of Liabilities
 Purchase of Assets
 Non-Trading Payments
Calculation of Cash From Operations
Net Profit
Add: Non Cash and Non-Operating items which
have already been debited to P/L a/c
Depreciation
Transfer to Reserves and Provisions
Intangible Assets Written Off
Loss on Sale or Disposal of Fixed Assets
Increase in Accounts Payable
Increase in Outstanding Expenses
Decrease in Prepaid Expenses
Calculation of Cash From Operations
Less: Non Cash and Non-Operating items which have already been
credited to P/L a/c
Increase in Accounts Receivables
Decrease in Outstanding Expenses
Increase in Prepaid Expenses

Cash From Operations

Calculation of Cash From Operations

Add: Decrease in Current Assets

Add: Increase in Current Liabilities

Less: Increase in Current Assets

Less: Decrease in Current Liabilities
Cash Flow Statement - Format
 As per AS-3
Statement of Changes in Financial
Position
 What does P&L reflects?
 What does Balance Sheet reflects?
 What is the GAP here?
 Statement of Changes in Financial Position:
 Cash Flow Statement
 Funds Flow Statement
Funds Flow Statement
 What are FUNDS?
 What is FLOW?
 Funds Flow Statement:
 Schedule of Changes in Working Capital
 Funds from Operations

 Funds Flow Statement

Schedule of Changes in Working
Capital
Rules:
 Working Capital increases when:

 CA increases
 CL decreases

 Working Capital decreases when:

 CA decreases
 CL increases
Schedule of Changes in Working
Capital
 Lets Practice:
 Shares are issued for Cash
 Shares are issued for purchase of Building

 Debtors have made Payment

 Creditors are issued Bills payable

 Payment made to Bills payable

 Rent Paid

 Building sold on credit