63
Chapter - 3Analysis of Financial statements
3.1 Introduction
As observed in the previous chapter, a basic limitation of the tradition financialstatements comprising the balance sheet and the profit and loss account is that theydo not give all the information related to the financial operations of a firm.Nevertheless, they provide some extremely useful information to the extent that thebalance sheet mirrors the financial position on a particular date in term of thestructures of assets, liabilities and owners’ equity, and so on and the profit and lossaccount shows the results of operations during a certain period of time in term of the revenues obtained and the cost incurred during the year. Thus, the financialstatements provide a summarized view of the financial position and operation of afirm. Therefore, much can be learnt about a firm from a careful examination of itsfinancial statements as invaluable documents/performance reports. The analysis of financial statements is, thus, an important aid to financial analysis.The focus of financial analysis is on key figure in the financial statements and thesignificant relationship that exits between them. The analysis of financial statementsis a process of evaluating the relationship between components parts of financialstatements to obtain a better understanding of the firm’s position and performance.The first task of the financial analyst is to select the information relevant to thedecision under consideration from the total information contained in the financialstatements. The second step is to arrange the information in a way to highlightsignificant relationships. The final step is interpretation and drawing of inferencesand conclusions.
In brief financial analysis is the process of selection and evaluation.
3.2 Financial Ratios – Meaning and Rationale
Ratio analysis is widely-used tool of financial analysis. It can be used to compare therisk and return relationship to firm of different sizes. It is defined as the systematicuse of ratio to interpret the financial statements so that the strength and weaknessesof a firm as well as its historical performance and current financial condition can bedetermined. The term ratio refers to the numerical or quantitative relationshipbetween two items/variables.This relationship can be expressed as(i) Percentage, say, net profits are 25 percent of sales (assuming netprofits of Rs 25,000 and sales of Rs 1,00,000,(ii) Fraction (net profits is one-fourth of sales) and(iii) Proportion of numbers (the relationship between net profits and salesis 1:4).
64
These alternative methods of expressing items which are related to each other are,for purpose of financial analysis, referred to as ratio analysis. It should be notedthat computing the ratios does not add any information not already inherent in theabove figure of profits and sales. What the ratios do is that they reveal therelationship in a more meaningful way so as to enable equity investors, managementand lenders made better investment and credit decisions.The rationale of ratio analysis lies in the fact that it makes related informationcomparable. A single figure by itself has no meaning but when expressed in term of a related figure, it yields significant inferences. For instance, the fact that the netprofits of a firm amount to, say, Rs 10 lakhs throws no light on its adequacy orotherwise. The figure of net profit has to be considered in relation to other variables.How does it stand in relation to sales? What does it represents by way of return ontotal assets used or total capital employed? If, therefore, net profits are shown interms of their relationship with items such as, assets, capital employed, equity andso on, meaningful conclusion can be drawn regarding their adequacy. To carry theabove example further, assuming the capital employed to be Rs 50 lakh and Rs 100lakh, the net profits are 20 per cent and 10 per cent respectively. Ratio analysis,thus, as quantitative tool, enables analysis to draw quantitative answers to questionssuch as: Are the net profits adequate? Are the assets being used efficiency? Is thesolvent? Can the firm meet its current obligations and so on?Ratio analysis is one of the techniques of financial analysis where ratios are used asa yardstick for evaluating the financial condition and performance of a firm.Analysis and interpretation of various accounting ratios gives skilled andexperienced analysts a better understanding of the financial condition andperformance of the firm than what he could have obtained only through a perusal of financial statements.
3.3 Financial Ratio Analysis
The ratio is an arithmetical between two figures. Financial ration analysis is a studyof ratios between various items or groups of items in financial statements. Financialratios have been classified in several ways. For our purpose, we divide them into fivebroad categories as follows:
65
•
Liquidity ratios
•
Leverage ratios
•
Turnover ration
•
Profitability ration
•
Valuation ratioTo facilitate the discussion of various ratios the financial statements of HorizonLimited shown in the following statements will be used.Horizon Limited: Profit and Loss Account for the year Endings 31
st
March 2001(Rs in Million)
Items 2001 2000Net sales 701 623Cost of goods sold 552 475Stocks 421 370Wages and salaries 68 55Other manufacturing expanses 63 50Gross profit 149 148Operating expanses 56 49Depression 30 26General administration 12 11Selling 14 12Operating profit 93 99Non- operating surplus/deficit (4) 6Profit before interest and tax (PBIT) 89 105Interest 21 22Profit before tax (PBT) 68 83Tax 34 41Profit after tax (PAT) 34 42Dividends 28 27Retained earnings 6 15Per share data(in rupees)Earning per share 2.3 2.8Dividend per share 1.8 1.8Market Price per share 21.00 20.0Book value per share 17.47 17.07
Horizon Limited: balance Sheet as on 31
st
March 2001(Rs in Million)
2001 2000I Sources of Funds1. Shareholders’ Funds 262 256(a) Share Capital 150 150(b) Reserves & Surplus 112 1062. Loans Funds 212 156(a) Secured Loans 143 131(i) Due after 1 year 108 29
of 00
Chapter 03 {Final Energy Financial Management}.Doc
800 Reads
Info and Rating
| Category: | |
| Rating: | (1 Rating) |
| Upload Date: | 02/19/2009 |
| Copyright: | Attribution Non-commercial |
| Tags: |
Leave a Comment