Lecture_5-Analysis_of_financial_statements

8/7/2019 Lecture_5-Analysis_of_financial_statements

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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 thestarting point for successful financial management of a Company.

A single accounting figure by itself does communicate any meaningfulinformation.

Financial statements shows overall analysis only size of revenue, profit/loss, size of expenses, size of equity, assets etc.

It doesnt explain much of relationship between these figures

Financial analysis - Analysis of key figures in the statements and therelationship between them

Process of computing, determining and presenting the relationship oftimes and groups of times in financial statements is called ratio analysis.

Ratio analysis key approach to financial analysis of risk/returnrelationship. Also inter-company comparison to understand the relativestrengths and weaknesses

Trends studying several financial statements over a series of years tounderstand the direction a company is heading


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Classification of Ratios

Accounting Ratios

Traditional ratios Functional ratios

Balance sheet ratios Composite ratiosP&L a/c ratios

Turnover ratiosCoverage ratios Functional ratiosProfitability ratios

Stability ratiosLiquidity ratios


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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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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.


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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, cashflow coverage, operating leverage, financial leverage

Liquidity ratios

Net working capital, current ratios, acid test ratio, turnoverratios, defensive-interval ratio, cash flow from operations

Profitability ratios

Gross profit ratio, Net profit ratio, Operating ratio, Operatingprofit 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/ Leverageratios

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 theres an excess of current assets over current liabilities, then the firmshould look at its investments of current assets

Is it inventory heavy? possibility of obsolete or non-required build up. Is itpossible 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

creditorsIf 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 forequity infusion? Its already facing liquidity crunch and may be at insolvency

stage (need for distress sale of fixed assets?)


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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 infusionLiquidityStatement for the Month XXXActivity

Book value

RealisableValue

InflowsOutstanding DebtorsOpening StockCurrent Sales

Total InflowsOutflows

PurchasesOverheadsDebt ServicingTotal Outflow

Net Cash inflow/ (outflow)Cash in Hand/ BankCapital Expenditure PaymentsCash Shortfall/ SurplusSurplus to be reinvestedShortfallto be sourced

LiquidityStatement for the Month XXXActivity

Book value

RealisableValue

InflowsOutstanding DebtorsOpening StockCurrent Sales

Total InflowsOutflows

PurchasesOverheadsDebt ServicingTotal Outflow

Net Cash inflow/ (outflow)Capital Expenditure PaymentsCash Shortfall/ SurplusSurplus to be reinvestedShortfallto 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 etcFinancial 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 Activityratios.

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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DuPont Chart

Net Sales

70.1

Fixed

Asset

33.0

Tax

3.4

Cost of

goods sold

55.2

Operating

Expenses

6.0

Interest

2.1

Net Current

Assets

12.9

Other

Assets

1.50

Profit after

tax

3.4

Sales

70.1

Net Profit

Margin

4.85 %

Sales

70.1 Total

Assets

Turnover

1.48

Total

Assets

47.4

Total

Assets

47.4

Net Worth

26.2

Return on

Total

assets

7.18%

Financial

Leverage

1.81

Return on

Equity

13.0 %

+

+

.

.

.

.

X

X

.

.

Net Sales

70.1

Fixed

Asset

33.0

Tax

3.4

Cost of

goods sold

55.2

Operating

Expenses

6.0

Interest

2.1

Net Current

Assets

12.9

Other

Assets

1.50

Profit after

tax

3.4

Sales

70.1

Net Profit

Margin

4.85 %

Sales

70.1 Total

Assets

Turnover

1.48

Total

Assets

47.4

Total

Assets

47.4

Net Worth

26.2

Return on

Total

assets

7.18%

Financial

Leverage

1.81

Return on

Equity

13.0 %

+

+

.

.

.

.

X

X

.

.

Integrated approach to theearnings power of the company

Profitability on sales and onassets


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Limitation ofratio 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 companys 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

Lecture_5-Analysis_of_financial_statements

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