Analysis of financial statements

-Ratio analysis-

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What is financial analysis?
 Timely presentation of Balance Sheet and P&L accounts are only the
starting point for successful financial management of a Company.
 A single accounting figure by itself does communicate any meaningful
information.
 Financial statements shows overall analysis only – size of revenue,
profit/ loss, size of expenses, size of equity, assets etc.
 It doesn’t explain much of relationship between these figures
 Financial analysis - Analysis of key figures in the statements and the
relationship between them
 Process of computing, determining and presenting the relationship of
times and groups of times in financial statements is called ratio analysis.
 Ratio analysis – key approach to financial analysis of risk/return
relationship. Also inter-company comparison to understand the relative
strengths and weaknesses
 Trends – studying several financial statements over a series of years to
understand the direction a company is heading
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Classification of Ratios
Accounting Ratios

Traditional ratios Functional ratios

P&L a/c ratios Balance sheet ratios Composite ratios

Profitability ratios Coverage ratios Turnover ratios Functional ratios

Liquidity ratios Stability ratios

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Classification of Ratios
 Traditional Ratios

 P&L account ratios

 Gross profit ratio
 Net profit ratio
 Operating profit ratio etc.
 Balance sheet ratios
 Current ratio
 Quick ratio
 Debt to equity ratio etc.
 Composite ratios
 Earnings per share
 Stock turnover ratio
 Debtors turnover ratio
 Creditors turnover ratio etc.
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 Classification of Ratios
 Functional Ratios
 Profitability ratios
 Gross profit ratio
 Net profit ratio
 Operating profit ratio
 Price earnings ratio
 Expense ratios etc.
 Coverage ratios
 Interest coverage ratio
 Dividend coverage ratio etc
 Turnover ratios
 Fixed Asset turnover ratio
 Stock turnover ratio
 Debtors turnover ratio
 Average collection period
 Creditors turnover ratio etc.
 Financial ratios
 Current ratio
 Quick ratio
 Fixed assets to net worth
 Fixed assets to Long term debt etc. 5
Classification of Ratios
 Ratios are also classified into
 Capital structure/ Leverage ratio
 Debt-equity, debt-assets, equity-assets, interest coverage, debt
service coverage, dividend coverage, fixed cost coverage,
cash flow coverage, operating leverage, financial leverage
 Liquidity ratios
 Net working capital, current ratios, acid test ratio, turnover
ratios, defensive-interval ratio, cash flow from operations
 Profitability ratios
 Gross profit ratio, Net profit ratio, Operating ratio, Operating
profit ratio, RoCE, Expense ratios
 Activity/ Efficiency ratios
 Receivables turn over ratio, Inventory turnover ratio,
Creditors turnover ratio, other efficiency ratios
 Integrated ratio
 Du Pont analysis
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Capital Structure/ Leverage ratios
 Helps in knowing the financial strength of the organisation
 Long term solvency of the company and its capability to service
various providers of capital
 Company needs to leverage its capital productivity – between
borrowing, equity infusion
 High leverages produce large fluctuations in earnings for equity holders
– however may limit access to debt for expansion
 Coverage ratios show the security of payment to lenders
 For Discoms – consumer security should be calculated as long term
debt, since they are not repayable immediately
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 Liquidity ratios
 Uses
 Measures the ability to meet the short-term obligations, reflects the strength/
solvency of the organization
 Mainly useful to creditors and lenders (annual repayments falling within a
year)
 Financial manager – understand the deployment of resources and whether the
firm is earning right value without excess liquidity (and hence low return?)
 Working capital related – shows whether the firm has invested adequately in running
its business. If there’s an excess of current assets over current liabilities, then the
firm should look at its investments of current assets
 Is it inventory heavy? – possibility of obsolete or non-required build up. Is it
possible to liquidate it without heavy costs?
 Is it receivables heavy – possibility of non-recovery or over/ disputed billing,
can it lead to short term liquidity crunch?
 Is it advance heavy – large advances for works given?
 Is it liability light – has it not exploited the credit period available from
creditors
If its current liabilities exceed its current assets, it shows that its creditors are
funding its operations i.e. its defaulting in payments to creditors – need for
equity infusion? Its already facing liquidity crunch and may be at insolvency
stage (need for distress sale of fixed assets?) 8
 Liquidity ratios

 Finance manager should prepare a liquidity balance sheet – example shown to

understand his cash flows and plan for raising bridge finance/ long term corrections
including equity infusion
Liquidity Statement for the Month XXX
Activity Book value Realisable
Value
Inflows
Outstanding Debtors
Opening Stock
Current Sales
Total Inflows
Outflows
Purchases
Overheads
Debt Servicing
Total Outflow
Net Cash inflow/ (outflow)
Cash in Hand/ Bank

Capital Expenditure Payments

Cash Shortfall/ Surplus
Surplus to be reinvested
Shortfallto be sourced
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Profitability ratios
 Profitability is a measure of efficiency and control.
 Profitability is the main base for liquidity as well as solvency

 These ratios are very important for the management, share holders and
the lending institutions
 Discloses the profitability margin and cost ratios

 Operating leverage – ability use fixed costs to magnify the effects of

changes in sales on its earnings before interest and taxes
 Also shows the return on investments to the capital employed/
investment made in the business including earnings per share, dividend
per share, cash per share etc
Financial appraisal of an organization is incomplete unless its overall
profitability is measured in relations to sales, assets, capital employed,
net worth, EPS etc.

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Efficiency ratios
 They are also called turnover ratios or Performance ratios or Activity
ratios.
 Shows the utilisation of various assets in the business
 Measure the effectiveness with which the company uses its resources
 Quicker the turnover, the efficient they are
 Analysis is required in terms of understanding various causes for lower
efficiency
 Allows for analysis of the collection efficiency and whether it follows
the stated credit policy of the company
 Eg. If Domestic consumer receivables turns over 8 times, it shows that
the average collection period is 1/8 or 1.5 months, whereas the stated
policy of the company could be 60 days or 2 months

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Du Pont Chart • Integrated approach to the
earnings power of the company
Net Sales
70.1 –Profitability on sales and
Cost of
on assets
goods sold
55.2 Profit after
tax
3.4

Operating Net Profit

Expenses Margin
6.0 . 4.85 %
.

Sales
Interest 70.1
2.1

Return on
X
Total
assets
Tax 7.18%
3.4

Sales
Net Current 70.1 Total Return on
Assets Assets Equity
12.9 Turnover X 13.0 %
. 1.48
+ .

Fixed
Total
Asset Total
Assets
33.0 Assets
47.4
47.4
Financial
+ . Leverage
. 1.81
Other
Net Worth
Assets
26.2
1.50

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 Limitation of ratio analysis

 A single ratio does not convey much information.

 It has to be compared over a number of years to study the trend

 Mere judging company’s performance without relating it to the performance

of other similar companies, or the industry average is meaningless

 The weakness in financial accounting may through up wrong results

 Ratio analysis does not capture the effect of inflation, changes in economy

etc.

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Worked out example

•Working sheets are provided separately

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