Corporate Financial Management

Chapter-4

ANALYSIS OF FINANCIAL STATEMENTS
Having understood how a balance sheet and profit and loss statement is organized, we
can now see how they might be analyzed.
There are three ways in which we can analyze.
a.
analysis
b.
c.

Common size
Index analysis
Ratio analysis.

Common Size analysis
Under this analysis, in the balance sheet the total assets and total liabilities are
taken as equivalent to 100. The percentage of other items in the balance sheet is then
computed. All the items are expressed as a percentage of the total assets/liabilities. A
comparison of the changes is then made and results interpreted accordingly.
Similarly in the case of Profit and Loss statement, the sales or total income is taken as
equivalent of 100. The other items are expressed as a percentage of sales.
Example 1
The financial statements of Khilafat Bros show the following position. Convert them into
a common size statement. What observations can you make?
Liabilities
Equity Share Capital
Reserves and Surplus
Term loans
Total
Assets
Fixed Assets
Investments in subsidiary concerns
Current assets
Misc. expenditure not written off
Total

ICFAI Business School-Chennai

Amount (Riyals)
678
2456
1345
4479
2088
932
878
581
4479

32

Around 21% of the funds raised have been invested in a subsidiary concern.8 Total income 10432 100.8 70.6 Investment in Subsidiary concerns 20.8 Current Assets 19. the company has used much more of own funds than borrowed funds (15.0 Material 4401 42.3 Depreciation 256 2.8 30.0 = Fixed Assets 46.2 Power and Fuel 1234 11. the common size can be shown as below Sales 7432 71.Fixed assets form largest component of assets.9 Selling expenses 1431 13.2 Tax 234 2.8 Salaries and wages 1138 10.2+54.2 54. might be observed that.0 From the above statement.0 Expenses ICFAI Business School-Chennai 33 . Similarly in the case of profit and loss account.2 Profit after tax 316 3. Expenditure not written off 13.0 100.0 Total 100.5 Interest 768 7.4 Profit before tax 550 5.7 Administrative expenses 654 6.2 Other income 3000 28.Corporate Financial Management The common size balance sheet would look as follows: it Liabilities Equity share capital Reserves and Surplus Term Loans Total Assets Amount 15.0).6 Misc.

The various figures in the base period are treated as equivalent to 100. In other words. it might be observed that other incomes contribute significantly to the profits. the financial statements of different periods are compared. it might be observed that total assets and accordingly liabilities have increased 14% in the last two years.Corporate Financial Management From the Profit and Loss account. Interpretations of these are made thereafter. while term loans have decreased by 20%. Earliest period is taken as the base period. However fixed assets have increased 67%. Reserves and Surplus has increased by 54%. Current assets have actually decreased by 12 %. The changes in these periods for different elements of the statements are observed. 34 ICFAI Business School-Chennai . The dependence on term loan has decreased. Example 2: Balance Sheet 2000 Equity Share Capital Reserves and Surplus Term Loans Total Assets Fixed Assets Current Assets Exp. Not W/O Total 2850 100 2002 2850 100 2003 2850 100 3550 100 4360 123 5460 154 3020 100 2820 93 2420 80 9420 100 10030 106 10730 114 2859 100 3560 125 4780 167 5690 100 6280 110 4980 88 871 100 190 22 970 111 9420 100 10030 106 10730 114 From the above index analysis. Materials account for 42% of the sales. profits generated have been ploughed back into the business. The ability of the company to make profits is low. Net profits are only 3 % of the total income. The figures appearing in the later period are expressed as a percentage of the base period. Index Analysis In the Index Analysis.

current asset turnover. Turnover ratios These ratios reflect the level of activity in the business. Fixed Assets Avg.Valuation ratios Liquidity ratios: These ratios indicate how liquid a business is. total turnover. It is defined as. Ratio is proportion of one figure over another.Liquidity . the ability of the company to pay back its short term creditors. current assets = opening current assets + closing current assets / 2) ICFAI Business School-Chennai 35 .Corporate Financial Management Ratio Analysis: This is a tool for analyzing financial performance and health of a business. . There are five types of ratios which indicate the financial health and performance.Turnover .Structural or leverage . fixed asset turnover. current assets (Avg. Avg. Liquidity means. fixed Assets = (Opening fixed assets + closing fixed assets / 2) Current Asset turnover = Sales (total income) / Avg.Profitability . Higher these two ratios. Total asset turnover = Sales (Total income) / Avg. total assets = (Opening balance + closing balance/ 2) Fixed asset turnover = Sales (Total income) / Avg. inventory turnover and receivables turnover. Acid test ratio = (Current Assets – Receivables) / Current Liabilities. This ability is measured in terms of the current assets available for conversion to cash or equivalent to enable repayment of creditors. They are. The ratios are. Current Ratio = Current Assets / Current Liabilities Another ratio which also indicates liquidity is the acid test ratio. better the liquidity. The number of times the assets of the company have been turned over to generate sales/ total income is indicated in this ratio. Total Assets.

50 is considered risky. work in process. finished goods and stores and consumables) Avg. Inventory = [(Opening inventory + Closing inventory / 2)] Receivables turnover = Sales / Avg. The respective share of debt and equity in financing the business is indicated in this ratio. Total Debt to Equity Ratio = Total outside liabilities/ Tangible net worth Tangible net worth = [Equity + Reserves and surplus – Intangible assets. Long term debt to equity == Long Term debt/ Tangible net worth Generally the ratios exceeding 1. ISCR = Profit before interest and taxes / Interest Debt service coverage ratios [DSCR]: DSCR = [(Net profit + Interest + Depreciation)] / [(Interest + Repayment installments)] The higher the ratios better the ability to pay interest and also repay principal installments.Corporate Financial Management Inventory turnover = Sales (total income) / Avg. Coverage Ratio: Interest service coverage ratio [ISCR] indicates the ability to pay interest. Structural Ratios (Leverage ratio) This ratio indicates the capital structure of the business. Inventory (Inventory would comprise raw material. The efficiency of utilization of assets is reflected in these ratios. The important ratios are. Receivables Average Receivables = [(Opening receivables+ closing receivables) / 2] Higher these ratios better the utilization of the assets.] Too high a ratio is considered risky in the event of downward fluctuations in the fortunes of the business. 36 ICFAI Business School-Chennai .

total assets Return on Net worth (Equity) = PAT / Avg. Gross profit margin = Gross Profit/ Sales (total operating income) Operating profit margin = Operating Profit / Sales (total income) In case there is no non operating income or expenses. Price Earnings multiple [PE] = Market Price/ EPS Limitations of the ratio Analysis Ratio analysis is helpful only if their limitations (to what extent they can be used) are understood. Higher the ratios. The important ratios are. total assets. The analysis is carried only with reference to the figures at the end of accounting periods. This might not be indicative of financial position that might have been ICFAI Business School-Chennai 37 . These ratios are defined with respect to sales and also with respect to total assets. Book value = Net worth / No of outstanding shares. Earnings per share (EPS) = PAT / no of outstanding shares. Valuation Ratios These ratios measure the value of a share. 1. this ratio is also identical to = Earnings before interest and taxes (EBIT) / Sales (total income) Net profit margin = Profit after tax (PAT) / Sales (total income) Return on Investment = Operating Profit / Avg. Some of the major limitations are. more profitable the business.Corporate Financial Management Profitability Ratios: These ratios indicate the ability of the business to make profits.

000 40% 5% ? 4. The analysis is based on financial statements prepared by the company. For other types of business in most countries they are not subject to a proper audit. how much additional trade credit can be taken without bringing the current ratio below 2? 38 ICFAI Business School-Chennai . Some of the accounting areas where the accountants have some flexibility to fudge the reporting are . it has to be interpreted carefully with full awareness of the limitations. Even in the case of joint stock companies. Practice Exercise 1.Corporate Financial Management present during the rest of the period. Revaluation Therefore while ratio analysis is very helpful. the accounts are often window dressed to distort the position of profits or the financial position.000 =5 =? 3. Interest Charge = Sales = Tax rate = Net profit margin = Interest coverage ratio = 200. Profit before tax Interest coverage ratio Total interest charge = 50. If a company’s current assets are RO 12000 and current liabilities are RO 4000. Inventory valuation b. The auditor’s responsibility is only to certify that the statements have been prepared based on figures correctly extracted from the books of accounts maintained by the company.500. Capitalizing revenue expenditure e. a. Depreciation c.50 = 0. Therefore the inferences drawn might not be proper. The auditor does not certify that the financial statements present a true and fair picture of the financial position and working results of the company.50 =? 2. Writing off expenditure d.000 7. For joint stock companies these statements are subject to audit and therefore somewhat reliable. The analysis is based on past data and not necessarily providing any indication or direction for the future. = 1. 4. Net profit margin Total asset turnover ratio Debt to Total asset ratio Return on equity = 7%. 2. 3.

Current ratio Acid Test ratio Current liability Inventory turnover ratio = 1.000 ? 0 ? ? ? ? ? ? ? ? ? ? 39 Assets Plant and Equipment Inventory Accounts receivable Cash Total ? ? ? ? ? .000.000.000 and its average accounts receivable are RO 100.Corporate Financial Management 5.000? (Average collection period = Accounts receivable/ credit sales per day) 6.000 50. What will be the sales of a company if its. Complete the balance sheet and sales data (fill in the blanks) using the following financial data? Debt/Equity ratio =1 Acid-test ratio =1 Total asset turnover ratio =2 Day’s sales outstanding in accounts receivable (Accounts receivable/sales per day) = 30 days Gross profit margin = 15% Inventory turnover ratio =6 Operating profit margin = 10 % Net profit margin = 5% Cash profit margin = 6% Taxation rate = 20% Liabilities Equity capital Retained earnings Current liability Non current liability Total Sales Cost of goods sold Gross profit Depreciation Selling General and Administrative expenses Operating profit Interest Profit before tax Profit after tax ICFAI Business School-Chennai 100.000.30 =1 = RO 1.000 = 4 times 7. By what period of time should the average collection period be reduced. if the average accounts receivable are to be reduced to RO 75. The annual sales of a company are RO 1.

The balance sheet and the income statement of Al Hassan Food Products SAOG are given below.000.25 3. The following data pertains to XYZ Industries LLC. Current Ratio = 1.Corporate Financial Management 8.00 1. Evaluate the performance with reference to the standards? Balance Sheet Equity Capital Reserves and surplus Long term debt Short term bank borrowing Trade creditors Provisions Total Fixed assets (Net) Cash and bank balance Receivable Inventories Pre-paid expenses Others Total Current Ratio Acid-test ratio Debt Equity ratio Interest coverage ratio Inventory turnover ratio Average collection period Total asset turnover ratio Net profit margin Return on Investment Return on Equity Income and expenses statement Net Sales 100000 Non operating surplus 2000 Cost of goods sold 70000 Other Operating 10000 expenses Profit before Interest and 22000 tax Interest 5000 Tax 7000 Dividends 4000 Retained Earnings 6000 15000 25000 20000 15000 10000 5000 90000 40000 5000 15000 20000 5000 5000 90000 Standard 1.75 Inventory Ratio = 8 Total asset turnover ratio = 1.50 Acid-Test Ratio = 0.80 5% 8% 10% 9.20 Current liabilities = RO 1.000.30 1.00 40 days 0. Calculate the net Fixed Assets of the company? What assumptions do you need to make for the answer? 40 ICFAI Business School-Chennai .00 5.

2004? 11.40 months 600.67 120 80 800 470 196. B and C whose summary of balance sheet and profit and loss account is given below and make a comparative analysis and interpret your results? Assets Fixed Assets Investments of long term nature Cash Receivables Inventory Total Liabilities Share Capital Reserves& Surplus Long Term loans Bank overdraft Trade creditors Total ICFAI Business School-Chennai 2003 2004 Company –A 2003 2004 Company –B 2003 2004 Company –C 75 25 125 50 250 50 300 29 300 100 420 80 10 50 40 200 20 70 60 325 30 103. Gross profit margin Average collection period Average payment period= (Accounts payable/credit purchases per day) Gross profit 20% 2 months 2.00 325 150 100 116. for the year December 31.33 130 120 1000 41 .00 60.Corporate Financial Management 10. Determine the balance of Debtors and creditors as on December 31.00 40.33 500 150 150 119.000 It was also ascertained that the closing stock as on December 31.00 33.67 100.80 100 246.30 130 307.36 600 53.67 83.64 90.00 200 50 58. 2004.67 500 40 140.000 in excess of the opening stock as on January 1. 2004. The following details are available with regard to Swift Industries LLC.33 60. You may assume that Swift Industries is a trading concern and cost of goods purchased is the only expense.66 90.66 600 400 133. Compute the various ratios for the three companies A.33 66.00 40.67 33. was RO 50.33 66.34 140.70 1000 50 16.20 800 62. 2005.33 66.

19 65.64 66.Corporate Financial Management Sales Cost of goods sold Selling . RO 1200. 15% Q7.125 Q4.000 300.40 5.80 5% 8% 10% Company 1.26 52.000 50.68 61.5 1. This is possible by better utilization of assets.30 84. Ratio Current ratio Acid test Debt Equity ratio Interest coverage Inventory turnover Average collection period Total asset turnover Net profit margin Return on Investment Return on Equity Standard 1.000 90. general and administrative expenses Interest Profit before tax Tax @15% Profit after tax Answers: Q1.50 21.25 3.25 492.000 100.3 1. A 656.00 5.5 1.000 510.11 10% 18.64 11. RO 4000 Q5. 9 days Q6.000 150.00 54 days 1.88% 25% The company is doing very well compared to standards provided in respect of most of the ratios .000 0 300.70 12.36 77.25 4. 42 ICFAI Business School-Chennai .70 Q 2.33 1. It is providing more than twice returns to the shareholders when compared to standards.62 B 825 618.000 6000 24000 Assets Plant and Equipment Inventory Accounts receivable Cash Total 50.000 600.25 C 900 675 135 36.000 60.75 107.000 50.000 100.000 22500 37500 30000 Q8.76 9. 4.000 Liabilities Equity capital Retained earnings Current liability Non current liability Total Sales Cost of goods sold Gross profit Depreciation Selling General and Administrative expenses Operating profit Interest Profit before tax Profit after tax 100. The only area of concern for the company is the collection period which is higher than standards.00 5.00 40 days 0. RO 12500 Q3.