Financial Statements Analysis-corporate Finance

8/8/2019 Financial Statements Analysis-corporate Finance

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FINANCIAL STATEMENTSANALYSIS OF ABC INDUSTRIES(PVT) LIMITED FOR THE YEARS2008-2009: A Time SeriesAnalysis

submitted to:

Mr. Muhammad ImranLecturer, IMS, University of Peshawar

submitted by:

Team Leader: Yasir Muhib

Team Members: Ayaz Ahmad, Muhammad Jamal Qadir,

Muhammad Naseem, Naveed Ali Khan, FaizanHayat, Sajjad Khan, Waqas Ahmad

BBA (HONORS) EIGHTH SEMESTER [FINANCE]MORNING SHIFTSESSION 2006-2010

I N S T I T U T E O F M A N A G E M E NT S T U D I E S

U N I V E R S I T Y O F P E S H A W A R


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EXECUTIVE SUMMARY The main objective of this work is to evaluate the Financial Performance of a Peshawarbased manufacturing company through the financial statements analysis for the years 2008and 2009. Ratio Analysis is employed for the purpose of analysis which entails computing,determining and presenting the relationship of related items and groups of items of thefinancial statements.

The Current Ratio of ABC Industries Ltd for the year 2009 is 1.80 i.e. against each Re. 1short-term Liability, the company has worth Rs. 1. This value is deteriorated as compared to


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the current ratio of previous year which was Rs. 2.33 worth of current assets against eachRe. 1 liability. The Value of Acid-test Ratio is revealed to be 0.94 for the year 2009 i.e. Rs.0.94 (94 paisa) are available for discharging a short-term obligation of Re. 1. This value is28.79% lower than that of for the year 2008 i.e. 1.32.

The Gearing Ratio of 7.74 (774%) indicates the presence of a huge amount of debt in thetotal investment of ABC Industries Ltd. This ratio has inflated by almost 62% as compared tothe Gearing Ratio for the year 2008 which was 478%. The Debt-to Total Assets ratio for theyear 2009 reveals that 42% of the assets are being financed through debt. This ratio hasinflated by 31.25% as compared to the value of previous year which stood at 32%. TheLong-term debt to Equity Ratio for the year 2009 is revealed to be 48% i.e. long-term debtforms 48% of the amount of Equity. This is almost 300% higher than the previous year whichwas only 12%.

Comparatively, in 2008, ABC Industries LTD was in better position to pay the interest on itsdebts. Also, the ABC Industries PVT Limited is not generating enough cash to pay its debtsand the DSCR has further decreased to 0.177 times from 0.443 times in 2009.

The Gross profit Margin of ABC Industries LTD for the year 2009 is 12% which is 7.14%higher than the previous year. On the other hand, the Net Profit Margin for the year 2009 is2% as compared to 6% in the previous year. For the year 2009, the ROA is just 2% which issignificantly lower (i.e. 79%) as compared to that of last year which was 9%. The ROE of ABCIndustries PVT Ltd was very impressive during the year 2008 i.e. 136 % but has significantlyreduced to 36% in the year 2009. This indicates a significant decrease in shareholderswealth.

The Total assets turnover is 1.04 times for year 2009 which means that every Re. 1 of assetsgenerate sales of worth Rs. 1.04. This figure is, however, 35% lower than that of the year2008 which was 1.6 times. The main reason behind this decrease is the decrease of sales inthe year 2009. The Inventory Turnover is 2.67 times i.e. it converted its inventory 2.67 timesinto sales in the year 2009. This figure has declined by 41.32% as compared to 4.55 times inthe previous year. The Days Receivable Ratio of ABC Industries PVT Limited indicates thatthe company takes nearly the period of two months to receive the cash from its credit sales.

No marked change from the period 2008 through 2009 has occurred in the Days receivable. The Days Payable has reduced from 6 days in the year 2008 to 10 days in the year 2009.

The EBIT for the year 2009 is Rs. 7,011,186 which is almost 28% lower than that of the previous. Thisis mainly due to decrease in the level of sales and increased cost of sales in the year 2009. The EBITfor the year 2008 was Rs. 9,692, 473.

The financial performance of the company is revealed to be very weak and also deteriorated ascompared to the preceding year.

We suggest that the organization should identify loopholes in the working capital management and itsadministrative structure. It should flatten the structure of the company. It should reduce its reliance onshort-term / bank borrowings and utilize the available option so as to reduce the degree of financialleverage. We also suggest the introduction of accelerated depreciation method and FIFO inventorymanagement method to reduce the tax expenses.


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INTRODUCTION This work is aimed at the evaluation of financial performance of ABCIndustries (PVT) Limited, a Peshawar based company carrying out themanufacturing and sale of adhesive tapes. Comparative time-series ratioanalysis is conducted for the information provided in the FinancialStatements and accompanying notes for the periods ended August 31, 2008and August 31, 2009.

Ratio Analysis is conducted in the following categories;

Liquidity RatiosLeverage/ Debt RatiosProfitability ratiosEfficiency / Activity / Asset Management RatiosCoverage Ratios

In addition, Growth / Trend Analysis for each ratio is conducted for evaluationof the performance in the financial year ended August 31, 2009 as comparedto the previous years performance. The Red color downward sloped curvesshow the declining trend in the ratios; while the green color upward slopedcurves show the increasing trend in the ratios.

Trend Analysis, wherever used in this report, is calculated by using theformula;

Trend Analysis / Growth Ratio = (Current Year-Previous Year)Previous Year100

RATIO ANALYSISRatio-analysis means the process of computing, determining and presentingthe relationship of related items and groups of items of the financialstatements. They provide a fairly good idea about the financial position of anorganization in a summarized and concise form of. Financial Ratios areimportant tools for appraising the real worth of an enterprise, its performanceduring a period of time and its pit falls. Ratio Analysis is two major types;

Horizontal AnalysisVertical Analysis

LIQUIDITY RATIOS


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Liquidity Ratios indicate the short-term debt paying ability of a company. Themost common Liquidity Ratios are Current Ratio and Acid-Test Ratio. Theseratios are calculated as follows;

i. Current Ratio =Current Assets Current Liabilities

Current Ratio measures the organizations ability to discharge its short-termliabilities and when they become due.

The Current Ratio of ABC Industries Ltd for the year 2009 is 1.80 i.e. againsteach Re. 1 short-term Liability, the company has worth Rs. 1.80 of currentassets to pay. The company has sufficient current assets to pay off the short-term obligations but its liquidity position has deteriorated as compared tothe current ratio of previous year which was Rs. 2.33 worth of current assetsagainst each Re. 1 liability. The current ratio has declined by 22.75% as

compared to the year 2008 which stands unfavorable for the companysliquidity condition.

ii. Acid Test Ratio = Current Assets Stock in Trade Current Liabilities

Another and more rigorous measure of Liquidity is the Acid-test ratio whichdisregards the inventory from the current assets. The Value of Acid-test Ratiois revealed to be 0.94 for the year 2009 i.e. Rs. 0.94 (94 paisa) are availablefor discharging a short-term obligation of Re. 1. This value is 28.79% lowerthan that of for the year 2008 i.e. 1.32 which entails a comparatively betterliquidity position (i.e. Rs. 1.32 against each Re. 1 short-term liability). Thismeasure also stands unfavorable and needs to be improved.

TIMES 2008 2009 TRENDANALYSIS

(growth/decline)

INDICATION

CURRENT RATIO 2.33 1.80 -22.75% [UNFAVORABLE]

ACID-TEST RATIO 1.32 0.94 -28.79% [UNFAVORABLE]


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TABLE 1: LIQUIDITY RATIOS OF ABC INDUSTRIES (PVT) LIMITED FOR THE YEAR 2008 AND2009

FIGURE 1: COMPARISON AND TREND ANALYSIS OFLIQUIDITY RATIOS

LEVERAGE RATIOS

Leverage Ratios determine the amount of debt in the composition of a firmsCapital structure i.e. how has it financed its investment. Pertinent Leverageratios are given as follows;

Leverage Ratios are of two broad categories:

1. Capitalization RatiosCapitalization Ratios determine how a firm finances its investment or capitalstructure. It contains the following ratios;

i. Debt-to-Equity Ratio = Total Debt Shareholders'Equity 100

Gearing Ratio measures the extent to which a business is dependent on

borrowed funds, as opposed to equity funding. Gearing gives an indication of

longterm liquidity and the risk inherent within the business. According to the

tools and principles of analysis the lower the debt to equity ratio the better it is for


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the organization. The ratio moves from 12.1% to 48.3% over the two years showing

that the organization is financed by creditors more than its equity holders.

The Gearing Ratio of 7.74 (774%) indicates the presence of a huge amountof debt in the total investment of ABC Industries Ltd. This reveals that theCreditors are providing Rs. 7.74 of financing against each Re. 1 beingprovided by the Shareholders. This ratio has inflated by almost 62% ascompared to the Gearing Ratio for the year 2008 which was 478%. Theseamounts indicate that over the period of two years the company is having avery low ability to absorb financial shocks and is more sensitive to financialrisk. Its assets structure contains more element of debt as compared toequity.

ii. Debt to Total Assets Ratio 1 = Total DebtTotal Assets 100

The Debt-to Total Assets ratio for the year 2009 reveals that 42% of theassets are being financed through debt. This ratio has inflated by 31.25% ascompared to the value of previous year which stood at 32% (32% of theassets were financed through debt). This increase is again going against thebetter financial position of the company and makes the company moresensitive to financial shocks.

iii. Long-term Debt 2 to Equity Ratio = Long-term LiabilityTotal Equity

100

Another measure of Leverage, long-term debt to Equity Ratio measures theextent to which long-term debt is present in the capital structure againstEquity. For the year 2009 it reveals to be 48% i.e. long-term debt forms 48%of the amount of Equity. This is almost 300% higher than the previous yearwhich was only 12%. It means that the portion of long-term debt hasincreased tremendously over the year which serves as an unattractiveindication to both the investors and creditors.

1 Total Assets for the year 2008 and 2009 were Rs. 75,092,982 and Rs. 91,629,172respectively.

2 Long-term Debt for the year 2008 and 2009 were Rs. 605,898 and Rs. 2,414,607respectively. It is the amount of long-term obligations under financial lease.


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iv. Long-term Debt to Total Capitalization Ratio 3 = Long-termLiabilityLong-term Liability+ Total Equity 100

The Long-term debt to Total Capitalization Ratio is 33% i.e. the long-termdebt forms 33% of the total shareholders equity and long-term debt

collectively. This is again 200% higher as compared to the value for the year2008 i.e. 11%.

These values make the company very unattractive for investors as well aslong-term creditors. Higher the values of Leverage Ratios, higher will be thefinancial risk.

PERCENT 2008 2009 TREND ANALYSIS

(growth / decline)

INDICATION

Gearing Ratio / Debt-to-Equity Ratio 478% 774% 61.92% [UNFAVORABLE]

Debt to Total AssetsRatio

32% 42% 31.25% [UNFAVORABLE]

Long-Term Debt toEquity Ratio

12% 48% 299.17% [UNFAVORABLE]

Long-Term Debt to

Total CapitalizationRatio

11% 33% 200.00% [UNFAVORABL

E]

TABLE 2 (A): LEVERAGE RATIOS OF ABC INDUSTRIES (PVT) LIMITED FOR THE YEAR 2008AND 2009

3 Total Capitalization means the sum of long-term liability and total equity.


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FIGURE 2 (A): COMPARISON AND TREND ANALYSIS OF LEVERAGE RATIOS(CAPITALIZATION RATIOS)

1. Coverage RatiosAnother category of leverage ratios, Coverage Ratios assess the firmsability to service the source of financing (payment debt, interest, leases,dividend payments i.e., fixed financial charges.

Two main coverage ratios are;

i. Times Interest Earned / Interest Coverage Ratio = EBITInterestExpense

Times interest earned (TIE), also known as interest coverage ratio, indicateshow well a company can cover its interest payments on a pretax basis. Thelarger the time interest earned, the more capable the company is at paying

the interest on its debt. The times interest earned ratio indicates how wellthe firm's earnings can cover the interest payments on its debt.

Comparatively, in 2008, ABC Industries LTD was in better position to pay theinterest on its debts. But, in 2009, this ratio has fallen very badly indicatingthat in this year of 2009, the corp. is not in good position to pay the intereston its taken debts. In the year 2009, either the sales volume has shrink orthe corp. has taken more debts / bank loans.


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ii. Debt service Coverage Ratio = EBITPrincipal+Interest+Rental Payments

The Debt Service Coverage Ratio (DSCR) measures the company's ability topay its debts by way of payment of installments of Term Loans and Interestthereon from out of the cash accruals and forms the basis for fixation of the

repayment schedule in respect of the Term Loans raised for a project.. Inbroad terms the debt service coverage ratio is defined as the cash flow of the company divided by the total debt service.

As per the Rule of Thumb, the debt service coverage ratio (DSCR) 2.0indicates that the company is generating sufficient cash flow to pay theirdebts. A debt service coverage ratio (DSCR) < 2.0 should be a cause forconcern because it indicates that the company is deficient of cash fordischarging its debt payments for the period.

In both the years, DSCR is less than 1 indicating that the ABC Industries PVTLimited is not generating enough cash to pay its debts. But when wecompare 2008 and 2009, we find that DSCR of ABC Industries PVT Limitedhas further decreased to 0.177 times from 0.443 times, which is a badsignal. Comparatively, the company was in better position to pay its debts in2008 than in 2009.

TIMES 2008 2009 TREND ANALYSIS

(growth/decline)

INDICATION

TIMES INTERESTEARNED / INTERESTCOVERAGE RATIO

4.65 1.53 -67.10 [UNFAVORABLE]

DEBT SERVICECOVERAGE RATIO

0.443 0.177 -60.05% [UNFAVORABLE]

TABLE 3 (B): LEVERAGE RATIOS OF ABC INDUSTRIES (PVT) LIMITED FOR THE YEAR 2008AND 2009


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FIGURE 3: COMPARISON AND TREND ANALYSIS OF COVERAGE RTIOS

FIGURE 2 (B): COMPARISON AND TREND ANALYSIS OF LEVERAGE RATIOS(COVERAGE RATIOS)

PROFITABILITY RATIOS 4Profitability Ratios are concerned with evaluating a firms earnings with

respect to a given level of sales / assets / owners investment or share value.Major Profitability ratios are given as follows;

i. Gross Profit Margin = Gross ProfitTotal Sales100

The Gross Profit Margin measures how much profit remains out of out of sales after the cost of goods sold has been deducted. A low margin couldindicate selling prices too low or cost of sales too high.

PERCENT 2008 2009 TREND ANALYSIS

(growth/decline)

INDICATION

Gross ProfitMargin

11% 12% 7.14 % [FAVORABLE]

Net ProfitMargin

6% 2% -68.42% [UNFAVORABLE]

Return onAssets /

Investment(ROA/ROI)

9% 2% -79.12% [UNFAVORABLE]

Return onEquity (ROE)

136% 36% -73.90% [UNFAVORABLE]

4 All Amounts for these Ratios are taken from the Profit and Loss Account the company forthe year ended August 31, 2009. ( Attached at the end of document)


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The ROE of ABC Industries PVT Ltd was very impressive during the year 2008i.e. 136 % but has significantly reduced to 36% in the year 2009. Thisindicates a significant decrease in shareholders wealth and the companybecomes less attractive for potential investors. The decrease in ROE seemsmainly due to the inefficient expenses management.

FIGURE 3: COMPARISON AND TREND ANALYSIS OF COVERAGE RATIOS

EFFICIENCY RATIOSEfficiency / Activity / Asset Management Ratios measure the firmseffectiveness at managing accounts receivable, inventory, accounts payable,fixed assets, and total assets. Major efficiency ratios are given as follows;

i. Total Assets Turnover = Total SalesTotal Assets


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2008 2009 TRENDANALYSIS

(growth/decline)

INDICATION

TOTAL ASSETSTURNOVER

(TIMES)

1.6 1.04 -35.00% [UNFAVORABLE]

INVENTORY TURNOVER

(TIMES)

4.55 2.67 -41.32 [UNFAVORABLE]

DAYSRECEIVABLE

(DAYS)

57 58 1.75% [SLIGHTLY UNFAVORABLE]

DAYS PAYABLE

(DAYS)

10 6 -40.00% [UNFAVORABLE]

TABLE 4: EFFICIENCY RATIOS

The Total Assets Turnover measures how efficiently a firm generates saleswhile utilizing its entire assets base. The Total assets turnover of ABCIndustries PVT Limited is 1.04 times for year 2009 which means that everyRe. 1 of assets generate sales of worth Rs. 1.04 or the sales realizes the

amount of total assets 1.04 times in the year 2009. This figure is, however,35% lower than that of the year 2008 which was 1.6 times. The main reasonbehind this decrease is the decrease of sales in the year 2009.

i. Inventory Turnover = Cost of Goods Sold Average Inventory

Another measure of efficiency, Inventory Turnover indicates that howefficiently the firm converts inventory into sales or how many times itconverts inventory into sales. The Inventory Turnover of ABC Industries PVTLimited for the year 2009 is 2.67 i.e. it converted its inventory 2.67 times

into sales in the year 2009. This figure has declined by 41.32% as comparedto 4.55 times Inventory Turnover in the previous year.

ii. Days Receivable = Accounts ReceivableCredit Sales 360

Days Receivable measures of the average number of days that a companytakes to collect Accounts Receivable after a sale. A low Days receivable Ratiomeans that it takes a company fewer days to collect its accounts


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receivable. A higher number shows that a company is selling its product tocustomers on credit and taking longer to collect money.

The Days Receivable Ratio of ABC Industries PVT Limited indicates that thecompany takes nearly the period of two months to receive the cash from its

credit sales. No marked change from the period 2008 through 2009 hasoccurred in the Days receivable.

i. Days Payable = Accounts PayableCredit Sales 360

The Days Payable calculates the total time it takes a business to pay back forits purchases to its creditors and suppliers. The Days Payable has reducedfrom 6 days in the year 2008 to 10 days in the year 2009.

FIGURE 4 (A): COMPARISON AND TREND ANALYSIS OF EFFICIENCY RATIOS


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FIGURE 4 (B): COMPARISON and trend analysis OF EFFICIENCY RATIOS

EARNINGS BEFORE INTEREST AND TAXES (EBIT) The EBIT of ABC Industries (PVT) Limited is calculated by deducting theSelling and Administrative expenses from the Gross Profit i.e. ;

EBIT = Gross Profit - (Administrative Expenses + Selling Expenses)

RUPEES 2008 2009 TREND ANALYSIS

(growth/decline)

INDICATION

Earnings BeforeInterest & Taxes (EBIT)

9,692,473

7,011,186

-27.66% [UNFAVORABLE]

TABLE 5: EARNINGS BEFORE INTEREST AND TAXES (EBIT)

The EBIT for the year 2009 is Rs. 7,011,186 which is almost 28% lower than that of the previous. This is mainly due to decrease in the level of sales and increased costof sales in the year 2009. The EBIT for the year 2008 was Rs. 9,692, 473.

FIGURE 4: COMPARISON AND TREND ANALYSIS OF EBIT


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CONCLUSION The Ratio Analysis of ABC Industries PVT Limited reveals a dissatisfactoryfinancial performance for the year 2009 as compared to the previous year.Lack of investors interest, worsening security conditions, inflated cost of electricity and raw materials and lack of effective management and controlmeasures could be the contributing factors for such financial performance.Except the Gross Profit Margin, which inflated in the year 2009, all otherratios showed declining and unfavorable trends.

The Liquidity Ratios are declining, which is an alarming signal to the existingand potential creditors and it is likely to disrupt the creditworthiness of thefirm. The proportion debt in the capital structure of company has increasedsignificantly, which is again contributing in the financial vulnerability of thecompany. The overwhelming leveraged condition makes the company more

sensitive to the financial shocks. The profitability of the company has also slashed significantly as comparedto previous year. The net profit margin has decreased from 6% to 2%. TheROI and ROE have also decreased to almost one third of the previous year.

The alarming downturn in ROE would certainly obstruct the shareholdersand potential investors confidence.

The ABC Industries PVT Limited has gone overwhelmingly leveraged duringthe year 2009 as compared to the previous year. Its power of paying interest

and overall debt servicing has sought a significant setback in the year 2009. The proportion of debt in its assets / capital structure has increasedsignificantly, which has made it more sensitive to financial risks and it hasbecome less potent to bear any financial shocks.

The company is unable to show any improvement in its efficiency. Its Assetsand Inventory Turnover ratios have reduced to almost 40% as compared to


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the previous year. The company is unable to utilize the available assetsbase to produce appreciable returns in the form of sales. The days receivablealmost remained intact to two months; similar to the previous year.However, the days payable have reduced to 6 days which reveals that thecompany is not making investment of the cash available before dischargingits liabilities. Rather, it should withhold the cash for an optimum period andmake short-term investments out of that amount.

The EBIT of the company has slashed by 28% as compared to the year 2008which shows that there is lack of efficient planning and control of cost andsales on the part of management. The level of sales has decreased by 21%as compared to the year 2008. Increase in the administrative expenses hasalso caused a downturn in the level of EBIT.

Overall, the company has not shown any improvements in its financialperformance in the year 2009 as compared to the operations of thepreceding year. The ROE and ROA has decreased by almost three times of the previous year. Its degree of financial leverage has significantly increased,hence making it more vulnerable to financial risks.

SUGGESTIONS The financial prospects of the ABC Industries PVT Limited has been very

dissatisfactory and need to be addressed with effective planning and controlmechanism.

For curbing the downturn of liquidity ratios, we suggest that the organizationshould manage its current assets more efficiently and reduce reliance on theshort-term borrowings. Rather, it should withhold the Accounts payable forthe optimum period and make short-term investments out of that. Thiswould, in turn, provide more liquidity for discharging the short-termliabilities. We also suggest the inventory management system to be revisedso that its level be decreased and thus little accounts payable and cash

outflows occur.

To overcome the immense financial leverage in the capital structure, wesuggest considering the issue of remaining authorized capital (i.e. 20,000shares @ Rs. 100 each) so as to diminish the level of debt and hence reducethe debt-servicing expenses. Moreover, in order to reduce the degree of leverage we again suggest reducing reliance on the bank borrowings as the


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financial charges have almost doubled in the year 2009 as compared to thepreceding year.

In order to curb the decrease in the Net Profit Margin we suggest the cost-cutting strategies and administrative efficiency. The management shouldlook for the discrepancies and inefficiencies and remove the unnecessaryslots in the organizational structure. It should flatten the organizationalstructure in order to decrease the administrative expenses and improvingefficiency. The financial charges should be given consideration and theseshould be reduced wherever possible. The assets of the organization shouldbe efficiently used to serve the very purpose of the organization and anyloopholes present be identified and removed. Accelerated depreciationmethods, and FIFO inventory management techniques be employed toreduce the taxation charges. These techniques would help enhance the ROA

and ROE of the company and would make it more attractive for the potentialinvestors.

For improving the efficiency of the company, we would suggest thatoptimum production and hence sales be made out of the available capacityand assets base. This would contribute to the total Assets turnover and thecompany will be able to realize more revenue per year. moreover, toimprove to the Inventory Turnover per period, we suggest adopting moderninventory management techniques Just as Just-in-Time (JIT) or EconomicalOrder Quantity (EOQ) so as to reduce the level of inventory to the optimum.Lower the level of inventory maintained. Higher will be the inventoryturnover per period.

The company should reduce the flexibility in its Accounts receivable so as toreduce the average collection period and should also withhold the AccountsPayable to the optimum possible period. This would contribute tomaintaining an optimum level of working capital.

The EBIT of the company has reduced by 28% in the year 2009 mainly due tothe decreased level of sales and increased Administrative expenses as

compared to the preceding year. We would again suggest adopting the cost-cutting strategies and flattening the organizational structure to reduce theadministrative expenses. Production and sales should be made to theoptimum level so as to reduce per unit cost and hence increase the grossprofit. This would, in turn, contribute to increasing the EBIT.


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REFERENCES

Gallagher, T. J. & Andrew, J. D. (2000). Financial Management: principles and Practice [Third Edition].

Das, S. (2010). Analysis and Interpretation of Financial Statements: CaseStudies, National Institute of Technology, Rourkela; India

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