LESSON 4

ASSESSMENT OF THE FIRM’S OPERATING

EFFICIENCY AND FINANCIAL POSITION
THROUGH FINANCIAL STATEMENS ANALYSIS

LEARNING OBJECTIVES:

At the end of the lesson, the students will be able to:

a. Define financial statements analysis;
b. Understand the need to analyze the broader business environment
c. Know the basics of profitability analysis
d. Realize the limitations of financial statements
e. Analyze the business’ short-term financial position, asset liquidity and
management, long-term financial position and profitability using financial
ratios.

TIME FRAME:

September 4 - 15, 2023

ABSTRACTION:

Financial statement analysis is the process of extracting information from financial

statements to better understand a company's current and future performance and
financial condition.
ANALYZING THE BROADER BUSINESS ENVIRONMENT
Quality analysis depends on an effective business analysis. The broader business
context in which a company operates must be assessed as its financial statements
are read and interpreted. A review of financial statements which reflect business
activities is contextual and can only be effectively undertaken within the framework
of a thorough understanding of the broader forces that impact company
performance. Some of these questions about a company's business environment
are:

Life cycle. At what stage in its life is this company? Is it a startup, experiencing
growing pains? Is it strong and mature, reaping the benefits of competitive
advantages? Is it nearing the end of its life, trying to milk what it can from stagnant
product lines?
Outputs. What products does it sell? Are its products new, established or dated? Do
its products have substitutes? How complicated are its products to produce?
Buyers. Who are its buyers? Are buyers in good financial condition? Do buyers have
substantial purchasing power? Can the seller dictate sales terms to buyers?
Inputs. Who are its suppliers? Are there many supply sources? Does the company
depend on a few supply sources with potential for high input costs?
Competition. In what kind of markets does it operate? Are markets open? Is the
market competitive? Does the company have competitive advantages? Can it protect
itself from new entrants? At what cost? How must it compete to survive?
Financing. Must it seek financing from public markets? Is it going public? Is it
seeking to use its stock to acquire another company? Is it in danger of defaulting on
debt covenants? Are there incentives to tell an overly optimistic story to attract lower
cost financing or to avoid default on debt?
Labor. Who are its managers? What are their backgrounds? Can they be trusted?
Are they competent? What is the state of employee relations? Is labor unionized?
Governance. How effective is its corporate governance? Does it have a strong and
independent board of directors? Does a strong audit committee of the board exist,
and is it populated with outsiders? Does management have a large portion of its
wealth tied to the company's stock?
Risk. Is it subject to lawsuits from competitors or shareholders? Is it under
investigation by regulators? Has it changed auditors? If so, why? Are its auditors
independent? Does it face environmental and/or political risks?

We must assess the broader business context in which a company operates as we

read and interpret its financial statements. A review of financial statements, which
reflect business activities, cannot be undertaken in a vacuum. It is contextual and
can only be effectively undertaken within the framework of a thorough
understanding of the broader forces that impact company performance.

BASICS OF PROFITABILITY ANALYSIS

The primary goal of financial management is to maximize shareholders' wealth,
not accounting measures such as net income or earnings per share (EPS). However,
accounting data influence stock prices and this data can be used to see why a
company is performing the way it is and where it is heading.

Financial Analysis involves

 comparing the firm's performance to that of other firms in the same industry,
and
 Evaluating trends in the firm's financial position over time.

These studies help managers identify deficiencies and take corrective actions.

LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS

Although financial statement analysis is a highly useful tool, the analyst should
consider its limitations. The limitations involve the comparability of financial data
between companies and the need to look beyond ratios. These limitations are:

1. Information derived by the analysis are not absolute measures of performance in

any and all of the areas of business operations. They are only indicators of degrees
of profitability and financial strength of the firm.
2. Limitations inherent in the accounting data the analyst works with. These are
brought about by among others: (a) variation and lack of consistency in the
application of accounting principles, policies and procedures, (b) too-condensed
presentation of data, and (c) failure to reflect change in purchasing power.
3. Limitations of the performance measures or tools and techniques used in the
analysis. Quantitative measurements are not absolute measures but should be
interpreted relative to the nature of the business and in the light of past, current and
future operations. Timing of transactions and the use of averages can also affect the
results obtained in applying the techniques in financial analysis.
4. Analysts should be alert to the potential for management to influence the
outcome of financial statements in order to appeal to creditors, investors and others.
Limitations of analysis may be overcome to some extent by finding appropriate
benchmarks used by most analysts such as the performance of comparable
components and the average performance of several companies in the same
industry

FINANCIAL RATIO ANALYSIS

There are a number of different ways to analyze financial statements. The most
applied is the financial ratio. Financial ratio is a comparison in fraction, proportion,
decimal or percentage of two significant figures taken from financial statements. It
expresses the direct relationship between two or more quantities in the statement of
financial position and statement of comprehensive income of a business firm.

FINANCIAL RATIOS
What are Ratios?
An absolute figure often does not convey much meaning. Generally, it is only in the
light of other information that the significance of a figure is realized. A weighs 70
kgs. Is he fat? One cannot answer that question unless one knows A’s age and
height. Similarly a company’s profitability cannot be known unless together with the
amount of profit, the amount of capital employed is also seen. The relationship
between the two figures expressed mathematically is called a ratio. The ratio
between 4 and 10 is 0’4 or 40%. 0’4 and 40% are ratios. Accounting ratios are
relationships, expressed in mathematical terms, between figures which have a cause
and effect relationship or which are connected with each other in some manner or
the other. Obviously no purpose will be served by working out ratios between two
entirely unrelated figures such as discount on debentures and sales. Ratios may be
worked out on the basis of figures obtained in the financial statements and,
therefore, may be classified as follows:
 Income statement ratios;
 Position statement (balance sheet) ratio; and
 Inter-statement ratios.

The first set of ratios is calculated on the basis of figures in the income statement;
for instance, ratio of gross profit or net profit to sales. The second type is based on
figures in the balance sheet, for instance, the ratio of loans to total equity or of
current assets to current liabilities. The third type of ratios shows the relation of
figures in the income statement and in the balance sheet, e.g. the ratio of net profit
to capital employed or sales to fixed assets.
The above classification, however is rather crude, since it leads one to think that
analysis of the income statement or the balance sheet ca be attempted in isolation.
Financial statements are indicators of the profitability and the financial position of a
company. Anyone, including the management, who is interested in acquiring
knowledge about a company it’s concerned with these two aspects. A good company
is that which has good profitability as sell as a sound financial position; either one or
the other being aloe good does not make accompany sound.
Ratios are broadly classified to four groups, on the basis of their functions as under:
 Liquidity Ratios - measure the short term stability of an enterprise
 Activity Ratios measure the efficiency of asset management
 Solvency/Leverage ratios – indicate the relationship between Debt and
Equity.
 Profitability Ratios measure earning success.

Liquidity Ratio
It is also called as short-term ratio. This ratio helps to understand the liquidity in a
business which is the potential ability to meet current obligations. This ratio
expresses the relationship between current assets and current assets of the business
concern during a particular period. The following are the major liquidity ratio:

S. No. Ratio Formula Significant Ratio

Current Assets
1. Current Ratio  Current Liability 2:1

Quick Assets
2. Quick Ratio  Quick / Current 1:1
Liability

Activity Ratio
It is also called as turnover ratio. This ratio measures the efficiency of the current
assets and liabilities in the business concern during a particular period. This ratio is
helpful to understand the performance of the business concern. Some of the activity
ratios are given below:
S. No. Ratio Formula

Cost of Sales
1. Stock Turnover Ratio
Average Inventory
Credit Sales
2. Debtors Turnover Ratio Average Debtors

Credit Purchase
3. Creditors Turnover Ratio
Average Credit
Sales
4. Working Capital Turnover Ratio
Net Working Capital
Solvency Ratio
It is also called as leverage ratio, which measures the long-term obligation of the
business concern. This ratio helps to understand, how the long-term funds are used
in the business concern. Some of the solvency ratios are given below:
S. No Ratio Formula
External Equity
1. Debt-Equity Ratio
Internal Equity
Shareholder / Shareholder ' s Fund
2. Proprietary Ratio
Total Assets

EBIT
3. Interest Coverage Ratio
Fixed Interest Charges

Profitability Ratio
Profitability ratio helps to measure the profitability position of the business concern.
Some of the major profitability ratios are given below.

S. No Ratio Formula

Gross Profit Net

1. Gross Profit Ratio Sales  100

2. Net Profit Ratio

Net Profit after tax
Net Sales  100

3. Operating Profit Ratio Operating Net Profit

Sales  100

4. Return in Investment Net Profit after tax

Shareholder Fund  100

Exercises:
From the following balance sheet of Mr. Arvind Industries Ltd., as 31st March 2007.