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Unit 08 - Financial Statement Analysis
Master's in Business Administration (MBA001)
Manipal University Jaipur
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Unit 8 Financial Statement Analysis
Structure: 8 Introduction Objectives 8 Techniques of Financial Statement Analysis 8 Horizontal Analysis (Comparative Statements) 8 Trend Analysis 8 Vertical Analysis (Common Size Statements) 8 Ratio Analysis Meaning of ratio Steps in ratio analysis Classification of ratios Du pont chart Solved problems Advantages of ratio analysis Limitations of ratio analysis 8 Summary 8 Glossary 8 Terminal Questions 8 Answers 8 Case Study
8 Introduction
We have so far learnt journalising, posting to a ledger, and the preparation of financial statements. The financial statements provide facts about the company to the users. However, for the financial statements to become more meaningful and useful to the users, they need to be understood in the light of policies adopted and the assumptions made to prepare them. Such an attempt to get a better understanding of the present and expected future financial health of the company is called financial statement analysis or simply financial analysis.
The objective of financial analysis is to identify the firm’s strengths and weaknesses so that the stakeholders can take decisions based on such inputs. In order to do this, financial analysis provides various tools or techniques.
In this unit, we will understand how to use the tools of financial analysis to analyse financial statements and interpret the financial health of a company.
Objectives: After studying this unit, you should be able to:
- explain the meaning of financial statement analysis
- analyse the need for financial statement analysis
- apply various tools of financial statement analysis to analyse financial statements
- interpret the financial health of a company using tools of financial statement analysis
8 Techniques of Financial Statement Analysis
As mentioned earlier, several tools are available for financial analysis. They are complementary and may be used simultaneously for a more rigorous evaluation of the financial performance and financial position of the company. The tools are:
- Horizontal analysis (comparative statements)
- Trend analysis
- Vertical analysis (common size statements)
- Ratio analysis
- Fund flow analysis
- Cash flow analysis
We shall discuss the first four tools in this unit. Fund flow analysis and cash flow analysis shall be discussed separately in unit 9 and unit 10 respectively.
8 Horizontal Analysis (Comparative Statements)
This technique involves comparison of the firm’s current year figures with previous year’s figures. The amount and the percentage of changes are computed and analysed. The change contributes to either the good health or the bad health of the organisation. It may be done with a balance sheet (comparative balance sheet) as well as with profit and loss a/c or income statement (Comparative Profit and Loss a/c / Income Statement.)
Let us understand this with the help of an illustration.
- The provision for tax has increased significantly by 48%. It implies that the company has been subject to a higher rate of tax or might have lost some tax benefits that it was getting earlier.
- The company’s PAT has increased only by 617 (9%) while the dividends have increased by 2339 (139%). It implies that the company has used reserves to pay out dividends.
8 Trend Analysis
This technique involves computation of trend ratios (trend percentages) for a series of years. Horizontal analysis gives a picture of only two years, the current year in comparison with the previous year. This leaves the user with no idea about tracking the growth of the company. To overcome this limitation, trend analysis may be used.
Under this technique, the data to be analysed is taken for a series of years. The base year data is taken as 100. For the subsequent years, the trend percentages are computed.
The formula for computing trend percentage for a particular year is given by:
Figureforthebase year
Trend ratio=Figureforthatparticularyear 100
Let us understand this with the help of an illustration.
Illustration 2: Compute trend ratios and comment on the financial performance of Infosys Technologies Ltd. from the following extract of its income statements of five years.
(in Rs. Crore) Particulars 2010-11 2009-10 2008-09 2007-08 2006- Revenue 27,501 22,742 21,693 16,692 13, Operating Profit (PBIDT) 8,968 7,861 7,195 5,238 4, PAT from ordinary activities 6,835 6,218 5,988 4,659 3,
(Source: Infosys Technologies Ltd. – Annual Report)
Solution: Infosys Technologies Ltd. Trend Analysis Particulars 2010-11 2009-10 2008-09 2007-08 2006- Revenue 27,501 22,742 21,693 16,692 13, Operating Profit (PBIDT) 8,968 7,861 7,195 5,238 4, PAT from ordinary activities 6,835 6,218 5,988 4,659 3, Trend ratios Revenue 197 163 156 120 100 Operating Profit (PBIDT) 204 179 163 119 100 PAT from ordinary activities 177 161 155 120 100
Comment: The Revenue and Operating Profit (PBIDT) have almost doubled in four years. The PAT from ordinary activities has increased by 77% in the same period.
8 Vertical Analysis (Common Size Statements)
It involves analysing the proportion of each component of the financial statement to its total. It is presented in the form of a statement called common size statement.
In a common size income statement, the sales are converted into 100 and the components are proportionately converted.
In a common size balance sheet, the total of the balance sheet (i., total of assets side and total of the liabilities side) is converted into 100 and the components are proportionately converted.
The common size statements show if the proportion of the components are normal or abnormal. For example, if the balance sheet total is Rs,50, and the long-term debts is Rs,00,000, then it shows that long-term debts constitute 80% (i., 2,00,000/2,50,000) of the total funds.
8 Ratio Analysis
Absolute numbers notify very little. Assume that two companies A and B, operating within the same industry vertical, submit the following information:
Company A Company B Net profit 10000 100000
One would say that Company B made more profits. But if it is given that the sales of Company A is Rs and sales of Company B is Rs, then we understand the Company A is more efficient than Company B because Company A made a profit of 50% (10000/20000) whereas Company B made a profit of only 25% (100000/400000).
Therefore, ratios are very useful.
8.6 Meaning of ratio A ratio represents a relationship between two numbers. An accounting ratio represents a relationship between two accounting numbers.
A ratio can be expressed in the following three forms:
- Proportion
- Percentage
- Turnover rate
8.6 Steps in ratio analysis The following three steps are used in ration analysis.
Calculate the firm’s ratios for the current and/or recent period.
Compare these ratios to those calculated in the past records. The purpose of this comparison is to identify trends in the firm’s ratios. This is known as trend analysis.
Compare the ratios to industry averages to show how the company can be compared with firms of the same size in its industry. This process is known as cross-sectional analysis.
Self Assessment Questions
- Vertical analysis involves computation of trend ratios. (True/False)
- In horizontal analysis, comparative statements are prepared. (True/False)
- Trend analysis involves preparation of common size statements. (True/False)
8.6 Classification of ratios There are different types of ratios which may be classified as shown in figure 8.
Figure 8: Types of Ratios
Let us now discuss each type of ratio in detail.
Liquidity ratios Liquidity is the ability of a firm to satisfy its short-term obligations as they become due for payment. It reflects the short-term solvency of the firm. The ratios which indicate the liquidity of the firm are:
- Net working capital
- Current ratios
- Acid test or quick ratio
- Super quick ratio
- Net working capital – It is the excess of current assets over current liabilities. Net WorkingCapital(NWC)=CurrentAssets(CA)−CurrentLiabilities(CL ) If CA is more than CL, it is called positive NWC and vice versa.
Illustration 4: Given: Current ratio is 2 and working capital is Rs,80,000. Calculate the current assets and current liabilities.
Solution: Current ratio = CA/CL 2 = CA/ CA = 2 (In the absence of any value, the current liability is always taken as 1 unit) Working capital = CA – CL = 2 - 1 Working capital = 1. For 1 WCR = Rs,80,000 ( Working capital value) For 2 CAR, = Rs,80,000 x 2/1.
- Current assets = Rs,00, For 1 CLR = Rs. 1,80,000 x 2/
- Current liabilities = Rs,20,
Illustration 5: Given: Current ratio 1:1; quick ratio 1:1, and current liabilities is Rs,000. Calculate current assets, quick assets, and inventory.
Solution: 1. Current ratio = 1: 1 [CA/CL] Current liabilities = Rs, Current ratio (1) = CA/50, Current assets = Rs, 2. Quick assets (QR) = QA / 1 [ QA/CL] 1 = QA / 50, Quick assets = Rs, 3. Inventory = CA – QA = Rs. 75,000 – Rs. 50, Inventory = Rs. 25,
So far we have studied the ratios which indicate the liquidity of the firm. Let us now discuss solvency ratios.
Solvency or capital structure or leverage ratios The long-term lenders or creditors would judge the soundness of a firm on the basis of the long-term financial strength. There are two aspects of long- term solvency of a firm:
- The ability to repay the principal when due
- Regular payment of the interest
Accordingly, there are two types of leverage ratios. Table 8 depicts the two types of leverage ratios
Table 8: Types of Leverage Ratios Capital structure ratios Coverage ratios Debt-equity ratio Debt-asset ratio Proprietor ratio
Interest coverage ratios Dividend coverage ratios Total fixed charges coverage ratios Cash flow coverage ratios Debt services coverage ratios
Let us now discuss them in detail.
Capital structure ratios
Debt-equity ratio - – The ratio of borrowed funds and owners’ capital is known as debt-equity ratio. This ratio reflects the relative claims of creditors and shareholders against the assets of the firm. Debt-equity ratio is calculated as follows:
Debt-asset ratio – It measures the share of total assets financed by outside funds.
Shareholder's equity
Debt EquityRatio=Longtermdebt
Total Assets
Debt AssetRatio=TotalDebt
- Dividend coverage – It measures the ability of a firm to pay dividend on preference shares.
Illustration 6: The Balance Sheet of Dravid Ltd. is as follows:
Calculate the debt ratio and debt-equity ratio.
Solution:
Debt ratio = Total liabilities to outsiders/Total assets = (Debentures + trade creditors)/ (Fixed + current assets) = (2,00,000 + 1,00,000) / (10,00,000 + 5,00,000) = 3,00,000 / 15,00, = 1 : 5 Interpretation: The ratio indicates that the firm has Rs assets for every rupee of long-term liability. Hence the financial position is good.
Debt – equity ratio = Outsiders’ funds/shareholders’ equity or = (Debentures + Trade Creditors) (Eq Sh capital + Pref Sh cap + Reserves) = (2,00,000 +1,00,000) (8,00,000 + 3,00,000 +1,00,000) = 3,00,000 / 12,00, = 1 : 4
Assets: Fixed Assets 10,00, Current Assets 5,00, Represented by: Liabilities: Trade creditors 1,00, Reserves and surplus 1,00, 10% Debentures 2,00, 6% Preference Share capital 3,00, Equity Share capital 8,00,
(Preference) Preference Dividend
Dividend Coverage= NetProfitafterTax
Interpretation: the ratio indicates that the firm has Rs equity for every rupee of long-term liability. Hence the financial position is good.
So far we have studied leverage ratios and the types of leverage ratios. Let us now discuss profitability ratio.
Profitability ratio Profitability ratios are designed to provide answers to the following questions:
- Is the profit earned by the firm adequate?
- What rate of return does it represent?
- What is the rate of profit for various divisions and segments of the firm?
- What was the amount paid in dividends?
- What is the rate of return to equity-holders?
The following are the important profitability ratios:
1. Gross profit margin – It is the ratio of gross profit to sales.
2. Operating profit ratio – It is the ratio of operating profit to sales.
3. Net profit margin – It is the ratio of net profit to sales.
4. Operating cost ratio – It is the ratio of operating cost to net sales. It is
computed by dividing expenses by sales.
Net Sales
Gross Profit Margin=GrossProfit 100
Net Sales
Operating ProfitRatio= EBIT
Net Sales
Net Profit Ratio= EAT
Net Sales
Operating Ratio=Costofgoodssold+Operatingexpenses 100
Solution: Gross Sales = Cash Sales + Credit Sales = 8,00,000 + 10,00, = 18,00, Net Sales = Gross Sales – Return Inwards = 18,00,000 – 20, = 17,80, Gross Profit = Net Sales – COGS = 17,80,000 – 15,80, = 2,00,
- Gross Profit Ratio = (Gross Profit / Net Sales) x 100 = [2,00,000 / 17,80,000] x 100 = 11 %
- Ratio of COGS = 100 – GP ratio = 100 -11. = 88%
So far we have studied profitability ratios and the types of profitability ratios. Let us now discuss activity ratios.
Activity ratios or efficiency ratios or turnover ratios They are concerned with measuring the efficiency in asset management. The efficiency with which the assets are used would be reflected in the speed and rapidity with which assets are converted into sales. The important turnover ratios are as follows:
- Stock turnover ratio – This ratio examines how quickly inventory is converted into cash. It indicates the number of times the inventory is replenished in a year.
Inventory holding period – It indicates the time interval between replenishment of inventory
Average Inventory
Inventory Turnover Ratio=Costofgoodssold
InventoryTurnover Ration
Inventory HoldingPeriod= 12 months
- Debtor’s turnover ratio – It indicates the average number of times the debtors make payment in a year.
Debt collection period: It indicates the time interval between payments by debtors.
Creditor's turnover ratio – It is the ratio between net credit purchase and the average amount of creditors outstanding during the year.
Assets turnover ratio – It indicates the efficiency with which firms use all their assets to generate sales. It is based on the relationship between cost of goods sold and assets of a firm.
Average Debtors
Debtor' sTurnoverRatio=NetCreditSales
Debtor'sTurnover Ratio
Debt CollectionPeriod=Months/weeks/daysinayear
Average Creditors
Creditor' sTurnoverRatio=NetCreditPurchase
Creditor'sTurnover Ratio
Creditor' sPaymentPeriod= 12 months
Averagetotal assets
Total AssetsTurnover=Costofgoodssold
Averagefixed assets
Fixed AssetsTurnover=Costofgoodssold
Activity 1: Total sales of a firm is Rs,00,000 of which the credit sales are Rs,65,000. Sundry debtors and Bills receivable are Rs,000 and Rs,000 respectively. Calculate the Debtors Velocity
Activity 2: Total purchases is Rs,00,000. Cash purchases Rs,000. Discount Provision on creditors is Rs,000. Purchase returns is Rs,000. Creditors at close is Rs,000. Bills payable at close is Rs,000. Calculate Creditors Velocity.
Activity 1 : Solution Debtor’s Turnover Ratio = Net Credit Sales / (Debtors + Bills Receivables) = 3,65,000/ (50000 + 2000) = 7. Debtors’ Velocity = Number of days in a year / Debtor’s turnover ratio (Drs. collection period) = 365/7. = 52 days
Note: Number of days in a year is taken as 365 days.
Activity 2: Solution: Credit purchases = Total purchase – cash purchase – purchase return = 1,00,000 – 20,000 – 2, = Rs,
Creditors’ Turnover Ratio = Net credit purchases / (Creditors + Bills Payable) = 78000 / (30000 + 25000) = 1. Creditors’ Velocity) = Number of days in a year / Creditor’s turnover ratio (Creditor’s payment period) = 365 /1. = 257 days
Note: The Reserve for discount on creditors should not be considered for calculating the net credit sales.
Illustration 9: Total sales of a firm is Rs,00,000 of which the credit sales are Rs,65,000. Sundry debtors and bills receivable are Rs,000 and Rs,000 respectively. Calculate the Debtors’ Velocity.
Solution: Debtor’s Turnover Ratio = Net Credit Sales / (Debtors + Bills Receivables)
= 3,65,000/ (50000 + 2000) = 7.
Debtors’ Velocity = Number of days in a year / Debtor’s turnover ratio
(Debtor’s collection period) = 365/7.
= 52 days
Note: Number of days in a year is taken as 365 days.
Illustration 10: Calculate Creditors’ Velocity from the data given below:
Total purchases Rs,00,
Cash purchases Rs,
Discount provision on creditors Rs,
Purchase returns Rs,
Creditors at close Rs,
Bills payable at close Rs,
Solution: Credit purchases = Total purchase – cash purchase – purchase return
= 1,00,000 – 20,000 – 2, = Rs, Creditor’s Turnover Ratio = Net credit purchases (Creditors + Bills Payable) = 78000 / (30000 + 25000) = 1. Creditors’ Velocity = No. of days in a year Creditor’s turnover ratio (Creditor’s payment period) = 365 /1. = 257 days Note: The reserve for discount on creditors should not be considered for calculating the net credit sales.
Unit 08 - Financial Statement Analysis
Course: Master's in Business Administration (MBA001)
University: Manipal University Jaipur
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