Financial Statement Analysis

Ratio Analysis

Meaning of Financial Statements

Financial statements are summaries of the operating, financing, and investment activities of a firm.

According to the Financial Accounting Standards Board (FASB), the financial statements of a firm should provide sufficient information that is useful to investors and creditors in making their investment and credit decisions in an

informed way.

The financial statements are expected to be prepared in accordance with a set of standards known as generally accepted accounting principles (GAAP).

The financial statements of publicly traded firms must be audited at least annually by independent public accountants.

The auditors are expected to attest to the fact that these financial statements of a firm have been prepared in accordance with GAAP.

Types of Financial Statements and

Reports

      The Income Statement

      The Balance Sheet

      The Statement of Cash Flows

The Income Statement

 An income statement is a summary of the revenues and expenses of a business over a period of time, usually either one month, three months, or one year.

  Summarizes the results of the firm’s operating and financing decisions during that time.

  Operating decisions of the company apply to production and marketing such as sales/revenues, cost of goods sold, administrative and general expenses (advertising, office salaries)

 

The Balance Sheet

A summary of the assets, liabilities, and equity of a business at a particular point in time, usually at the end of the firm’s fiscal year.

 Assets = Liabilities + Equity(Resources of the (Obligations of (ownership left over business enterprise) the business) Residual) Fixed Assets Long-term Common stock outstanding(Plant, Machinery, Equipment(Notes, bonds, & Additional paid-in capitalBuildings) Capital Lease Retained EarningsCurrent Assets Obligation)(Cash, Marketable Securities, Current LiabilitiesAccount Receivable, Inventories) (Accounts Payable,

Wages and salaries,Short-term loans Any portion of long-termIndebtedness due in one-year)

THE STATEMENT OF CASH FLOWS The statement is designed to show how the firm’s operations have

affected its cash position and to help answer questions such as these: 

Is the firm generating the cash needed to purchase additional fixed assets for growth?

Is the growth so rapid that external financing is required both to maintain operations and for investment in new fixed assets?

  Does the firm have excess cash flows that can be used to repay debt or to

invest in new products?

 

Importance of Financial Statements

Financial statements report both on a firm’s position at a point in time and on its operations over some past period.

From management’s viewpoint, financial statement analysis is useful both as a way to anticipate future conditions and more important, as a starting point for planning actions that will influence the future course of events or to show whether a firm’s position has been improving or

deteriorating over time.

Meaning of Ratio Analysis Ratio analysis is a systematic use of ratio to

interpret/assess the performance status of the firm.

It is a widely used tool of financial analysis. The term ratio refers to numerical or

quantitative relationship between two items/variables.

The basic objective of ratio analysis is to compare the risk and return relationship of firms of different sizes.

Ratio analysis helps in finding out the strengths and weakness of a firm.

The relationship in ratio can be expressed in:-(i) percentage- e.g. net profit are 25% of Sales

(ii) fraction – e.g. net profit is one-fourth of Sales.

(iii) proportion: e.g. relationship between net profit and sales is 1:4.

Nature of Ratio analysis

A financial ratio is a relationship between two accounting numbers.

Ratios help to make a qualitative judgment about the firm’s financial performance.

Basis or Standard of Comparison

Time series analysis Inter-firm analysis Industry analysis Comparison with standard

Ratio analysis begins with the calculation of a set of financial ratios designed to show the relative strengths and weaknesses of

a company as compared to Other firms in the industry Leadings firms in the industry The previous year of the same firm

Ratio analysis helps to show whether the firm’s position has been improving or deteriorating

Ratio analysis can also help plan for the future.

Types of Ratios

Liquidity ratios Capital Structure/Solvency ratios/

leverage ratios Turnover ratios/ Activity/efficency ratios Profitability ratios Equity-related ratios

Liquidity Ratio Ability of the firm to satisfy its short term

obligations as they become due. A liquid asset is one that can be easily

converted into cash at a fair market value Liquidity question deals with this question

Will the firm be able to meet its current obligations?

Three measures of liquidity Current Ratio Quick/Acid Test Ratio Cash ratio

Liquidity Ratios..Current assets

Current ratio = Current liabilities

Current assets – InventoriesQuick ratio =

Current liabilitiesCash + Marketable securities

Cash ratio = Current liabilities

Current assets are those assets which can be converted into cash easily in one accounting period. Cash in hand+ bank+ stock + debtors+ bills receivables

+prepaid expenses Current liabilities are those which have to be paid in one

accounting year Bank overdraft+ provision for tax+ creditors+ outstanding

expenses+ bills payable+ dividend payable

Current Ratio : It is the relationship between the current assets and current liabilities of a concern.

Current Ratio = Current Assets/Current Liabilities

If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1

The ideal Current Ratio preferred by Banks is 1.33 : 1 Current Assets : Raw Material, Work-in Progress. Finished

Goods, Debtors, Bills Receivables, Cash, marketable securities, prepaid expenses

Current Liabilities : Trade Creditors, Installments of Term Loan, payable within one year, bank overdraft, provision of taxation, outstanding expenses

Acid Test/Quick ratio

One limitation of current ratio is that it fails to convey the liquidity of the form as it consider one Rupees cash equal to one Rupee of Stock or receivables.

A rupee of cash is more readily available ( i.e. more liquid) to meet current obligations than a rupee of, say, inventory.

The acid test ratio is a measure of liquidity designed to overcome this defect of the current ratio.

The acid- test ratio referred to as quick ratio because it is a measurement of firm’s ability to convert its current assets quickly into cash to meet its current liabilities.

The acid-test ratio between quick current assets and current liabilities and is calculated by dividing the quick assets by the current liabilities. Acid- test ratio: Quick Assets/Current liabilities

Quick assets: Current Assets- Inventory- prepaid exp.

Turnover Ratios

Liquidity ratios relate to the liquidity of the firm as a whole.

Another way of examining the liquidity is to determine how efficiently the capital employed is rotated in the business.

The ratios to measure these are referred to as turnover ratio or Activity ratio.

Cost of goods sold: Sales- Gross profit

Average inventory: Simple average of opening and closing stock inventory

Interpretation: Generally, a high inventory ratio means that the company is efficiently managing and selling its inventory. The faster the inventory sells, the less funds the company has tied up.

Example: A firm has sold good worth Rs 3,00,000 with a margin of 20percent. The stock at beginning and the end of the year was Rs 35,000 and Rs. 45,000 respectively.What is the Inventory turnover ratio?

Days of inventory holding period indicates how long the stock is held in the company. Longer the period indicates the inefficiency of the company.

Debtors turnover ratio or accounts receivable turnover ratio indicates the velocity of debt collection of a firm. In simple words it indicates the number of times average debtors (receivable) are turned over during a year.

Interpretation: The higher the value of ratio, the more efficient is the management of debtors or more liquid the debtors are. Similarly, low debtors turnover ratio implies inefficient management of debtors or less liquid debtors. It is the reliable measure of the time of cash flow from credit sales.

There is no rule of thumb which may be used as a norm to interpret the ratio as it may be different from firm to firm.

Example: A firm has made credit sales of Rs 2,40,000 during the year. The outstanding amount of debtors at the beginning and the end of the year respectively was Rs 27,500 and Rs 32,500.

Determine the debtors turnover ratio.

Creditors Turnover Ratio (Creditor’s Velocity):Net Credit Purchases

--------------------------- Average Creditors

Payment Period:

Months (or days) in a year-----------------------------------Creditors Turnover

Fixed Assets ratio

Fixed asset Turnover ratio

Net Sales= --------------

Fixed assets

Solvency Ratios

Solvency refers to the ability of the firm to pay its long term liabilities like loan and other obligations.

These ratio show whether company can pay the long term liabilities. Is the company solvent?. What is the proportion of debt and equity in the

company?

Leverage/Capital Structure/Solvency Ratios

DebtDebt-equity ratio

Equity (Net Worth)

Debt ratio

Debt Equity employed

Earnings before interest and tax coverage

Interest

DebtDebt

Capital

Interest

Debt- Equity Ratio

The relationship between borrowed funds and owner’s capital is a popular measure of long term financial solvency of a firm.

The relationship is shown by the debt-equity ratio.

D-E ratio measures the ratio if long-term, or total debt to shareholders equity.

Profitability Ratios

Net result of a number of policies and decisions

Show the combined effect of liquidity, asset management, and debt management on operating results

PROFITABILITY RATIOS

The profitability ratios are calculated to measure the operating efficiency of the company.

Generally, two major types of profitability ratios are calculated:1. profitability in relation to sales

2. profitability in relation to investment.

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UTILITY OF RATIO ANALYSIS

the ability of the firm to meet its current obligations;

the extent to which the firm has used its long-term solvency by borrowing funds;

the efficiency with which the firm is utilizing its assets in generating sales revenue

the overall operating efficiency and performance of the firm.

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Diagnostic Role of Ratios

Profitability analysis Assets utilization Liquidity analysis Strategic Analysis

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CAUTIONS IN USING RATIO ANALYSIS

Standards for comparison Company differences Price level changes Different definitions of variables Changing situations Historical data

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