Subject: Financial Management

Chapter no. 8: Financial statements analysis

Chapter No. 8 – Financial statements analysis

Contents

Introduction to financial statements and their differing objectives Schedule VI of The Companies’ Act format for Balance Sheet and Profit and Loss statements Limitations on Schedule VI balance sheet format and need for regrouping in the “Analytical” form of balance sheet to overcome these limitations Financial ratios and their usefulness Inter-firm and intra-firm analysis Limitations to financial statement analysis and study of financial ratios Funds flow statement and its construction from balance sheet as on two successive annual dates with additional information Numerical exercises on: Financial statement analysis and calculation of ratios Interpretation of these ratios Funds flow statement preparation

At the end of the chapter the student will be able to Regroup the assets and liabilities in the “Analytical form” of balance sheet Calculate the financial ratios relating both to Profit and Loss and Balance Sheet Interpret the financial ratios for their impact on business enterprise Appreciate the limitations to the study of financial statements and ratios Prepare funds flow statement given two successive dates balance sheets

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Subject: Financial Management

Chapter no. 8: Financial statements analysis

Introduction to Financial Statements and their differing objectives: What are financial statements in a business enterprise?
The financial statements are: Profit and Loss statement Balance Sheet Cash flow statement and Funds flow statement Objectives are: Profit and Loss statement – to know whether the enterprise is in profit or loss at the end of a given period or not. The period would usually be one year. It could be as short a period as one month even. However preparing the Profit and Loss Account every year is a must. Balance Sheet – it is also referred to as statement of assets and liabilities. This is as on a particular date. The objective is to know the financial position of the enterprise, how much it owes to outsiders in the form of liabilities and how much it owns in the form of various assets. Although it could be prepared on a monthly basis as at the end of every month, it is prepared as at the end of every year – again a statutory requirement besides being a business necessity. Cash flow statement – as explained in the chapter on working capital management, cash flow statement is primarily to know the cash from operations, investments and finance obtained and manage the liquidity in the short-run. In the short-run, the objective could be financial planning. It lists all the cash inflows and cash outflows to verify as to whether the system has the required liquidity or not. The business should not have too little or too much cash. The frequency of preparing it depends upon the business needs – it could even be on a weekly basis. The minimum frequency is one month. Funds flow statement – this is the fundamental statement used for financial planning. The minimum period is one year. It talks of all resources, be it short-term or medium-term/longterm and the uses to which these are put to. The objective is to ensure that proper funding takes place in the business enterprise and that there is no diversion of working capital to acquiring fixed assets. Out of the above we have seen cash flow statement in the chapter on “working capital management”. Hence the same is not repeated here. The students should take “funds flow” statement as summary statement of sources and application for a given period; they would realise that the format for the statement as given in the annexure to this chapter is different from the one they are used to under “Management Accounting”.

Example no. 1 - A sample of “Profit and Loss” Account (Rupees in Lacs)
Income from operations Operating expenses: Salaries Repairs and maintenance Depreciation Office and general expenses Marketing expenses including Commission, if any 7 30 3 10 10 100

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Chapter no. 8: Financial statements analysis Interest and other Charges Total expenses Profit before tax Tax at 35% Profit after tax Dividend Profit retained in Business [Retained Earnings] 12 10 70 30 10.5 19.5 7.5

Learning points: ♦ Interest is charged to income before determining the profit of the organisation. Once the profit of the organisation is determined, tax is paid at the stipulated rate and the dividend is paid only after this. Thus, dividend is profit allocation. This difference between “interest” and “dividend” gives opportunity to business enterprises, to have a mix of capital of the owners and loans taken from outside, so that they can save on tax, through the interest charged as expense on the income. The amount of tax so saved is called “tax shield” on the interest. In the case of profit distributed among the partners as well in the case of dividend distributed among the shareholders, these are not taxed again in the hands of the owners.

Linkage between balance sheet and profit and loss accounts The above statement is known as the “Profit and Loss Account”. This records the income and expenditure for a given period and is closed as soon as the period is over. The residual profit, as it belongs to the owners, gets transferred to the capital account in another statement, called “Balance Sheet”.

The balance sheet tells us about the following: How much money has the business enterprise raised? Which are the sources for the money? What is the use for this money?

Example no. 2
The balance sheet is also known as “Assets and Liability” statement. A sample balance sheet is shown below: (Rupees in lacs) Liabilities Share capital: Reserves: (Retained profits over a period of time) Net worth 250 100 150 Assets Fixed Assets Less: Depreciation Net Fixed Assets: Investments: Current Assets: Bills Receivable 100
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60 30 30

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Chapter no. 8: Financial statements analysis Bank overdraft Creditors for expenses Other current liabilities Total current liabilities Total Liabilities 305 30 10 15 55 Total Assets 305 Cash and Bank Other current assets Total current assets 35 60 195

Suppose profit for the year is Rs.30 lacs after paying tax and dividend. This would be transferred to the balance sheet and the reserves at the end of the current year would be Rs.150 lacs + Rs.30 lacs = Rs.180 lacs. Similarly the depreciation claimed on the fixed assets and shown as an operating expense would also get transferred to the balance sheet to reduce the value of the fixed assets. Let us assume that there is no increase in the fixed assets during the year that there are no other changes and the depreciation for the year is Rs.10 lacs. We can construct the balance sheet for the next year without much change, excepting to accommodate these figures of depreciation and increase in reserves.

The balance sheet as at the end of the next year would look as under: (Rupees in Lacs) Liabilities Share capital Reserves and surplus Net worth Bank overdraft Creditors for expenses Other current liabilities Total current liabilities Total liabilities 55 335 100 180 280 30 10 15 Fixed assets Less: depreciation Net fixed assets Investments Bill Receivable Cash and Bank Other current assets Total current assets Total Assets 100 120 35 60 195 335 Assets 60 40 20

We see that between the two balance sheets, there are two changes – Investment has gone up by Rs.20 lacs and Bill receivable has gone up by Rs.20 lacs. The total is Rs.40 lacs. Where have these funds come from? This amount is the total of profit transferred to balance sheet from the profit and loss account and depreciation added back, as it does not involve any cash outlay. The figure is Rs.30 lacs + Rs.10 lacs = Rs.40 lacs. This figure is referred to as “internal accruals”. This need not be the case all the times. Where we use these funds entirely depends upon the business priority and what we have shown is only a sample.

Learning points: ♦ ♦ The business enterprise generates funds from operations, known as “internal accruals” comprising depreciation (which is added back, being only a book-entry) and profit after tax and dividend; Where these funds are used is entirely dependent upon business exigencies;

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Chapter no. 8: Financial statements analysis ♦ Depreciation claimed in the books as an expense goes to reduce the value of the fixed assets in the books, while profit after tax and dividend is shown as “Reserves” and increases the net worth of the company.

Key pointers to balance sheet and profit and loss statements:
♦ ♦ A balance sheet represents the financial affairs of the company and is also referred to as “Assets and Liabilities” statement and is always as on a particular date and not for a period. A profit and loss account represents the summary of financial transactions during a particular period and depicts the profit or loss for the period along with income tax paid on the profit and how the profit has been allocated (appropriated). Net worth means total of share capital and reserves and surplus. This includes preference share capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to equity ratio, the necessary adjustment has to be done by reducing preference share capital from net worth and adding it to the debt in the numerator. Reserves and surplus represent the profit retained in business since inception of business. “Surplus” indicates the figure carried forward from the profit and loss appropriation account to the balance sheet, without allocating the same to any specific reserve. Hence, it is mostly called “unallocated surplus”. The company wants to keep a portion of profit in the free form so that it is available during the next year for appropriation without any problem. In the absence of this arrangement during the year of inadequate profits, the company may have to write back a part of the general reserves for which approval from the board and the general members would be required. Secured loans represent loans taken from banks, financial institutions, debentures (either from public or through private placement), bonds etc. for which the company has mortgaged immovable fixed assets (land and building) and/or hypothecated movable fixed assets (at times even working capital assets with the explicit permission of the working capital banks) Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while loans from banks for working capital, i.e., current assets are secured by current assets. These loans enjoy priority over unsecured loans for settlement of claims against the company. Unsecured loans represent fixed deposits taken from public (if any) as per the provisions of Section 58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been offered. Such unsecured loans rank second and subsequent to secured loans for settlement of claims against the company. There are other unsecured creditors also, forming part of current liabilities, like, creditors for purchase of materials, provisions etc. Gross block = gross fixed assets mean the cost price of the fixed assets. Cumulative depreciation in the books is as per the provisions of The Companies Act, 1956, Schedule XIV. It is last cumulative depreciation till last year + depreciation claimed during the current year. Net block = net fixed assets mean the depreciated value of fixed assets. Capital work-in-progress – This represents advances, if any, given to building contractors, value of building yet to be completed, advances, if any, given to equipment suppliers etc. Once the equipment is received and the building is complete, the fixed assets are capitalised in the books, for claiming depreciation from that year onwards. Till then, it is reflected in the form of capital work in progress. Investments – Investment made in shares/bonds/units of Unit Trust of India etc. This type of investment should be ideally from the profits of the organisation and not from any other funds, which are required either for working capital or capital expenditure. They are bifurcated in the schedule, into “quoted and traded” and “unquoted and not traded” depending upon the nature of the investment, as to whether they can be liquidated in the secondary market or not. Current assets – Both gross and net current assets (net of current liabilities) are given in the balance sheet.
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Chapter no. 8: Financial statements analysis ♦ ♦ Miscellaneous expenditure not written off can be one of the following – Company incorporation expenses or public issue of share capital, debenture etc. together known as “preliminary expenses” written off over a period of 5 years as per provisions of Income Tax. Misc. expense could also be other deferred revenue expense like product launch expenses. Other income in the profit and loss account includes income from dividend on share investment made in other companies, interest on fixed deposits/debentures, sale proceeds of special import licenses, profit on sale of fixed assets and any other sundry receipts. Provision for tax could include short provision made for the earlier years. Provision for tax is made after making all adjustments for the following: Carried forward loss, if any; Book depreciation and depreciation as per income tax and Concessions available to a business entity, depending upon their activity (export business, S.S.I. etc.) and location in a backward area (like Goa etc.) As per the provisions of The Companies Act, 1956, in the event of a limited company declaring dividend, a fixed percentage of the profit after tax has to be transferred to the General Reserves of the Company and entire PAT cannot be given as dividend. With effect from 01/04/02, dividend tax on dividends paid by the company has been withdrawn. From that date, the shareholders are liable to pay tax on dividend income. Thus for a period of 5 years, the position was different in the sense that the company was bearing the additional tax on dividend.

♦ ♦ ♦ ♦ ♦ ♦

Other parts of annual statements – ♦ ♦ ♦ ♦ ♦ The Directors’ Report on the year passed and the future plans; Annexure to the Directors’ Report containing particulars regarding Auditors’ Report as per the Manufacturing and Other Companies along with Annexure; Schedules to Balance Sheet and Profit and Loss Account; Accounting policies adopted by the company and notes on accounts giving details about changes if any, in method of valuation of stocks, fixed assets, method of depreciation on fixed assets, contingent liabilities, like guarantees given by the banks on behalf of the company, guarantees given by the company, quantitative details regarding performance of the year passed, foreign exchange inflow and outflow etc. and Statement of cash flows for the same period for which final accounts have been presented. conservation of energy etc; (Auditors’ Report) Order, 1998)

There is a significant difference between the way in which the statements of accounts are prepared as per Schedule VI of the Companies Act and the manner in which these statements, especially, balance sheet is analysed by a finance person or an analyst. For example, in the Schedule VI, the current liabilities are netted off against current assets and only net current assets are shown. This is not so in the case of financial statement analysis. Both are shown fully and separately without any netting off. At the end of any financial year, there are certain adjustments to be made in the books of accounts to get the proper picture of profit or loss, as the case may be, for that particular period. For example, if stocks of raw materials are outstanding at the end of the period, the value of the same has to be deducted from the total of the opening stock (closing stock of the previous year) and the current year’s purchases. This alone would show the correct picture of materials consumed during the current year.

Example no. 3
Purchases during the year: Rs.600lacs
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Chapter no. 8: Financial statements analysis Opening stock of raw material: Rs.100lacs Closing stock of raw material: Rs.120lacs Then, the quantum of raw material consumed during the year is Rs.580lacs and only this can be booked as expenditure during the year. Consumption is always valued in this manner and cross verified with the value of materials issued from stores during the year to compare with the previous year; Similarly, a second adjustment arises due to the difference between closing stocks of work-in-progress and finished goods on one hand and opening stocks of work-in-progress and finished goods on the other hand. Suppose the closing stocks are higher in value, the difference has to be either added to this year’s income or deducted from this year’s expense. (Different ways of presentation). Similarly in case the closing stocks are less than the opening stocks, the difference has to be deducted from income or added to expenses for that year. Let us study the following example. In a company, the opening stocks were Rs.100lacs and closing stocks are Rs.120lacs. This means that during the course of this year, the stocks on hand have gone up by Rs.20lacs from the goods produced during this year. This does have an effect on the profit of the company. The company cannot book expenditure incurred on producing this incremental stock of Rs.20lacs, as they have not sold the goods. However the materials and other expenses have already been incurred and hence this value is deducted. The basic assumption is that the carry forward stocks have been sold during the current year while at the end of the current year fresh stocks worth Rs.120lacs have come in for stocking. Hence, on an ongoing basis, opening stocks are added and closing stocks are deducted. In the above example, the effect of adding the opening stock and deducting the closing stock would be as under:

Example no. 4
Let us assume the production for the year was Rs.1000lacs Then, sales for the year could only be Rs.980lacs derived as follows: Production during the year: Add: Opening stock: Deduct: Closing stock: Sales for the year: Rs.1000lacs Rs. 100lacs Rs. 120lacs Rs. 980lacs.

On the other hand, in case the closing stocks would have been Rs.90lacs, the sales would have been Rs.1010lacs, more than the production value. Thus, the difference between the opening and closing stocks of work-in-progress and finished goods affects income and thereby profit. The companies always use this as a tool, either to increase or decrease income. In case they show more closing stocks, income is less and thereby profit is less and tax is saved and similarly if they show less closing stocks, income is more and profit is also more.

The principal tools of analysis are – Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play. Funds flow analysis – this is to understand the movement of funds (please note the difference between cash and fund – cash means only physical cash while funds include cash and credit) during any given period and mostly this period is 1 year. This means that during the course of the year, we study the sources and uses of funds, starting from the funds generated from activity during the period under review.

Let us see some of the important types of ratios and their significance:
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Chapter no. 8: Financial statements analysis Liquidity ratios; Turnover ratios; Profitability ratios; Investment on capital/return ratios; Leverage ratios and Coverage ratios.

Liquidity ratios: Current ratio: Formula = Current assets/Current liabilities.
Min. Expected even for a new unit in India = 1.33:1. Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital. Range – No fixed range is possible. Unless the activity is very profitable and there are no immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see “quick asset ratio” or “acid test ratio”.

Acid test ratio or quick asset ratio:
Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This assumes that all other current assets like receivables can be converted into cash easily. This ratio examines whether the quick assets are sufficient to cover all the current liabilities. Some of the authors indicate that the entire current liabilities should not be considered for this purpose and only quick liabilities should be considered by deducting from the current liabilities the short-term bank borrowing, as usually for an on going company, there is no need to pay back this amount, unlike the other current liabilities. Significance = coverage of current liabilities by quick assets. As quick assets are a part of current assets, this ratio would obviously be less than current ratio. This directly indicates the degree of excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost associated with high level of liquidity could also be high. What is working capital gap? The difference between all the current assets known as “Gross working capital” and all the current liabilities other than “bank borrowing”. This gap is met from one of the two sources, namely, net working capital and bank borrowing. Net working capital is hence defined as medium and long-term funds invested in current assets.

Turn over ratios:
Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or

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Chapter no. 8: Financial statements analysis stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system.

Debtors turn over ratio – this indicates the efficiency of collection of receivables and contributes to
the liquidity of the system. Formula = Total credit sales/Average debtors outstanding during the year. Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of industry like capital goods, consumer goods – capital goods, this would be less and consumer goods, this would be significantly higher;

Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and competitive it would be less as you are forced to give credit; Whether new enterprise or established – new enterprise would be required to give higher credit in the initial stages while an existing business would have a more fixed credit policy evolved over the years of business; Hence any deterioration over a period of time assumes significance for an existing business – this indicates change in the market conditions to the business and this could happen due to general recession in the economy or the industry specifically due to very high capacity or could be this unit employs outmoded technology, which is forcing them to dump stocks on its distributors and hence realisation is coming in late etc.

Average collection period = inversely related to debtors turn over ratio. For example debtors

turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90 days. In case the debtors turn over ratio increases, the average collection period would reduce, indicating improvement in liquidity. Formula for average collection period = 360/receivables turn over ratio. The above points for debtors turn over ratio hold good for this also. Any significant deviation from the past trend is of greater significance here than the absolute numbers. No minimum and no maximum.

Inventory turn over ratio – as said earlier, this directly contributes to the profitability of the

organisation. Formula = Cost of goods sold/Average inventory held during the year. The inventory should turn over at least 4 times in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle and in such cases, the ratio would be low. While receivables turn over contributes to liquidity, this contributes to profitability due to higher turn over. The production cycle and the corporate policy of keeping high stocks affect this ratio. The less the production cycle, the better the ratio and vice-versa. The higher the level of stocks, the lower would be the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges.

Current assets turn over ratio – not much of significance as the entire current assets are involved.
However, this could indicate deterioration or improvement over a period of time. Indicates operating efficiency. Formula = Cost of goods sold/Average current assets held in business during the year. There is no min. Or maximum. Again this depends upon the type of industry, market conditions, management’s policy towards working capital etc.

Fixed assets turn over ratio
Not much of significance as fixed assets cannot contribute directly either to liquidity or profitability. This is used as a very broad parameter to compare two units in the same industry and especially when the scales of operations are quite significant. Formula = Cost of goods sold/Average value of fixed assets in the period (book value).

Profitability ratios – Profit in relation to sales and profit in relation to assets: Profit in relation to sales – this indicates the margin available on sales; Profit in relation to assets – this indicates the degree of return on the capital employed in business that means the earning efficiency. Please appreciate that these two are totally different. Example no. 5
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Chapter no. 8: Financial statements analysis Units A and B are in the same type of business and operate at the same levels of capacities. Unit A employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and profits are as under: Parameter Sales Profits Profit margin on sales Return on capital employed Unit A 1000lacs 100lacs 10% 40% 90lacs 9% 45% Unit B 1000lacs

While Unit A has higher profit margins, Unit B has better returns on capital employed.

Profit margin on sales:
Gross profit margin on sales and net profit margin ratio – Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges. Net sales = Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with another unit in the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs.

Example no. 6
Parameter Unit A Unit B

Sales Cost of production Gross profit Deduct: Selling general, Administrative expenses and interest Net profit

100lacs 60lacs 40lacs

100lacs 5lacs 35lacs

35lacs 5lacs

30lacs 5lacs

While both the units have the same net profit to sales ratio, the significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses. This ratio helps in controlling either production costs if cost of production is high or selling and administration costs, in case these are high. Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula = Net profit/net sales. Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency. In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well.

Investment on capital ratios/Earnings ratios: Return on net worth
Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds including Preference Share capital. Hence Preference Share capital is not deducted. There is no standard range for this ratio. If it reduces it indicates less return on the net worth.

Return on equity

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Chapter no. 8: Financial statements analysis Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share capital. Although reference is equity here, all equity shareholders’ funds are taken in the denominator. Hence Preference dividend and Preference share capital are excluded. There is no standard range for this ratio. If it comes down over a period it means that the profitability of the organisation is suffering a setback.

Return on capital employed (pre-tax)
Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives return on long-term funds employed in business in pre-tax terms. Again there is no standard range for this ratio. If it reduces, it is a cause for concern.

Earning per share (EPS)
Dividend per share (DPS) + Retained earnings per share (REPS). Here the share refers to equity share and not preference share. The formula is = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares. This is an important indicator about the return to equity shareholder. In fact P/E ratio is related to this, as P/E ratio is the relationship between “Market value” of the share and the EPS. The higher the PE the stronger is the recommendation to sell the share and the lower the PE, the stronger is the recommendation to buy the share. This is only indicative and by and large followed. There is something known as industry average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and growth prospects are quite good, it is the time for buying the shares, unless we know for certain that the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time for us to sell unless we expect further increase in the near future.

Leverage ratios
Leverages are of two kinds, operating leverage and financial leverage. However, we are concerned more with financial leverage. Financial leverage is the advantage of debt over equity in a capital structure. Capital structure indicates the relationship between medium and long-term debt on the one hand and equity on the other hand. Equity in the beginning is the equity share capital. Over a period of time it is net worth (-) redeemable preference share capital. It is well known that EPS increases with increased dose of debt capital within the same capital structure. Given the advantage of debt also, as even risk of default, i.e., non-payment of interest and non-repayment of principal amount increases with increase in debt capital component, the market accepts a maximum of 2:1 at present. It can be less. Formula for debt/equity ratio = Medium and longterm loans + redeemable preference share capital / Net worth (-) Redeemable preference share capital. From the working capital lending banks’ point of view, all liabilities are to be included in debt. Hence all external liabilities including current liabilities are taken into account for this ratio. We have to add redeemable preference share capital and reduce from the net worth the same as in the previous formula.

Coverage ratios Interest coverage ratio
This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest payment on all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1. Less than that is not desirable, as after paying interest, tax has to be paid and afterwards dividend and dividend tax.

Asset coverage ratio
This indicates the number of times the medium and long-term liabilities are covered by the book value of fixed assets. Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. Accepted ratio is minimum 1.5:1. Less than that indicates inadequate coverage of the liabilities.

Debt Service coverage ratio
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Chapter no. 8: Financial statements analysis This indicates the ability of the business enterprise to service its borrowing, especially medium and long-term. Servicing consists of two aspects namely, payment of interest and repayment of principal amount. As interest is paid out of income and booked as an expense, in the formula it gets added back to profit after tax. The assumption here is that dividend is ignored. In case dividend is paid out, the formula gets amended to deduct from PAT dividend paid and dividend tax. Formula is: PAT (+) Depreciation (+) Amortisation (DRE write-off) (+) Int. on med. & long-term liabilities Interest on medium and long-term borrowing (+) Instalment on medium and long-term borrowing. This is assuming that dividend is not paid. In the case of an existing company dividend will have to be paid and hence in the numerator, instead of PAT, retained earnings would appear. The above ratio is calculated for the entire period of the loan with the bank/financial institution. The minimum acceptable average for the entire period is 1.75:1. This means that in one year this could be less but it has to be made up in the other years to get an average of 1.75:1.

What is the objective behind analysis of financial statements?
Objective (To know about) Relevant indicator/Remarks Net worth, i.e., share capital, reserves and unallocated surplus in balance sheet carried down from profit and loss appropriation account. For a healthy company, it is necessary that there is a balance struck between dividend paid and profit retained in business so much the net worth keeps on increasing.

Financial position of the company

Liquidity of the company, i.e., whether the company is in a position to meet all its shortterm liabilities (also called “current liabilities”) with the help of its current assets

Current ratio and quick ratio or acid test ratio. Current ratio = Current assets/current liabilities. Quick ratio = Current assets (-) inventory/ current liabilities. Current ratio should not be too high like 4:1 or 5:1 or too low like less than 1.5:1. This means that the company is either too liquid thereby increasing its opportunity cost or not liquid at all, both of which are not desirable. Quick ratio could be at least 1:1. Quick ratio is a better indicator of liquidity position. Examination of increase in secured or unsecured loans for this purpose. Without adequate financial planning, there is always the risk of diverting working capital funds for fixed assets. This is best assessed through a funds flow statement for the period as even net cash accruals (Retained earnings + depreciation + amortisation) would be available for fixed assets. Percentage of profit before tax to total income including other income, like dividend or interest income. Operating profit, i.e., profit before tax (-) other income as above as a percentage of income from the main operations of the
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Whether the company has acquired new fixed assets during the year and if so, what are the sources, besides internal accruals to finance the same?

Profitability of the company in general and operating profits in particular, i.e., whether the main operations of the company like manufacturing have been in profit or the profit of the company is derived from other income,
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Chapter no. 8: Financial statements analysis i.e., income from shares/debentures etc. investment in company, services. be it manufacturing, trading or

Relationship between the net worth of the company and its external liabilities (both shortterm and long-term). What about only medium and long-term debts?

Debt/Equity ratio, which establishes this relationship. Formula = External liabilities + preference share capital /net worth of the company (-) preference share capital (redeemable kind). From the lender’s point of view, this should not exceed 3:1. Is there any sharp deterioration in this ratio? Is so, please be on guard, as the financial risk for the company increases to that extent. For only medium and long-term debts, it cannot exceed 2:1.

Has the company’s investments in shares/debentures of other companies reduced in value in comparison with last year?

Difference between the market value of the investments and the purchase price, which is theoretically a loss in value of the investment. Actual loss is booked upon only selling. The periodic reduction every year should warn us that at the time of actual sales, there would be substantial loss, which immediately would reduce the net worth of the company. Banks, Financial Institutions, Investment companies or NBFCs would be required to declare their investment every year in the balance sheet at cost price or market price whichever is less. Average debtors in the year/average creditors in the year. This should be greater than 1:1, as bills receivable are at gross value {cost of development (+) profit margin}, whereas; creditors are at purchase price for software or components, which would be much less than the final sales value. If it is less than 1:1, it shows that while receivable management is quite good, the company is not paying its creditors, which could cause problems in future. Too high a ratio would indicate that receivable management is very poor. Directors’ report. This would reveal the financial plans for the company, like whether they are coming out with a public issue/Rights issue etc. Auditors’ comments in the “Notes to Accounts” relevant for this. Frequent revaluation is not desirable and healthy.

Relationship between average debtors (bills receivable) and average creditors (bills payable) during the year.

Future plans of the company, like acquisition of new technology, entering into new collaboration agreement, diversification programme, expansion programme etc. Has the company revalued its fixed assets during the year, thereby creating revaluation reserves, without any inflow of capital into the company, as this is just an entry passed in the books? Whether the company has increased its investment and if so, what is the source for it? What is the nature of investment? Is it in tradable securities or long-term Securities, which can have a lock-in-period and cannot be liquidated in the near future?
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Increase in amount of investment in shares/debentures/Govt. securities etc. in comparison with last year and any investment within group companies? Any undue increase in investment should put us on guard, as working capital funds could have been diverted for it.

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Subject: Financial Management

Chapter no. 8: Financial statements analysis Has the company during the year given any unsecured loans substantially other than to employees of the company? Any increase in unsecured loans. If the loans are to group companies, then all the more reason to be cautious. Hence, where the figures have increased, further probing is called for. Any comments to this effect in the notes to accounts should put us on caution. This examination would indicate about likely impact on the future profits of the company. Any comments about over dues as in the “Notes to Accounts” should be looked into. Any serious default is likely to affect the “credit rating” of the company with its lenders, thereby increasing its cost of borrowing in future. Any comments about this in the “Notes to Accounts” should be looked into.

Are the company’s unsecured loans (given) not recoverable and very old?

Has the company been regular in payment of its dues on account of loans or periodic interest on its liabilities?

Has the company defaulted in providing for bonus liability, P.F. liability, E.S.I. liability, gratuity liability etc? Whether the company is holding very huge cash, as it is not desirable and increases the opportunity cost? How many times the average inventory has turned over during the year?

Cash balance together with bank balance in current account, if any, is very high in the current assets. Relationship between cost of goods sold and average inventory during the year (only where cost of goods sold cannot be determined, net sales can be taken as the numerator). In a manufacturing company, which is not in capital goods sector, this should not be less than 4:1 and for a consumer goods industry, this should be higher even. For a capital goods industry, this would be less. Increase in paid-up capital in the balance sheet and share premium reserves in case the issue has been at a premium.

Has the company issued fresh share capital during the period and what is the purpose for which it has raised equity capital? If it was a public issue, how did it fare in the market? Has the company issued any bonus shares during the year?

Increase in paid-up capital and simultaneous reduction in general reserves. Enquiry into the company’s ability to keep up the dividend rate of the immediate past. Increase in paid-up capital and share premium reserves, in case the issue has been at a premium.

Has the company made any rights issue in the period and what is the purpose of the issue? If it was a public issue, how did it fare in the market? What is the proportion of marketable investment to total investment and whether this has decreased in comparison with the previous year?

Percentage of marketable investment to total investment and comparison with previous year. Any decrease should put us on guard, as it reduces liquidity on one hand and increases the risk of non-payment on due date, especially if the investment is in its own subsidiary or group companies, thereby forcing the company to provide for the loss. Comparison with previous year’s sales income
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What is the increase in sales income over last
Punjab Technical University, Online Virtual Campus

Subject: Financial Management

Chapter no. 8: Financial statements analysis year in % terms? Is it due to increase in numbers or change in product mix or increase in prices of finished products only? What is the amount of provision for bad and doubtful debts or advances outstanding? and whether the growth has been more or less than the estimate.

In percentage terms, how much is it of total debts outstanding and what are the reasons for such provision in the notes to accounts by the auditors? Is there any comment about valuation of work in progress by the auditors? It can be seen that profit from operations can be manipulated by increase/decrease in closing stocks of both finished goods and work in progress. Examination of expenses schedule would show this. What is the comment in notes to accounts about this? Lease liability is an off-balance sheet item and hence this examination, to ascertain the correct external liability and to include the lease rentals in future also in projected income statements; otherwise, the company may be having much less disclosed liability and much more lease liability which is not disclosed. This has to be taken into consideration by an analyst while estimating future expenses for the purpose of estimating future profits. Auditors’ comments on “Accounting” policies. Change over from straight-line method to written down value method or vice-versa does affect the deprecation charge for the year thereby affecting the profits during the year of change. Relationship between materials during the year and the sales. consumed

What is the amount of work in progress as shown in the Profit and Loss Account?

Whether the company is paying any lease rentals and if so what is the amount of lease liability outstanding?

Has the company changed its method of depreciation on fixed assets, due to which, there is an impact on the profits of the company?

If it is a manufacturing company, whether the % of materials consumed is increasing in relation to sales? Has the company changed its method of valuation of inventory, due to which there is an impact of the profits of the company? Whether the % of administration and general expenses has increased during the year under review?

Auditors’ comments on “Accounting” policies.

Relationship between general and administrative expenses during the year and the sales. In case there is any extraordinary increase, what are the reasons therefore?

Whether the company had sufficient income to pay the interest charges?

Interest coverage ratio = earnings before interest and tax/total interest on all short-term and long-term liabilities. Minimum should be 3:1 and anything less than this is not satisfactory.

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Subject: Financial Management

Chapter no. 8: Financial statements analysis Whether the finance charges have gone up disproportionately as compared with the increase in sales income during the same period? Relationship between interest charges and sales income – whether it is consistent with the previous year or is there any spurt? Is there any explanation for this, like substantial expansion or new project or diversification for which the company has taken financial assistance? While a benchmark % is not available, any level in excess of 6% calls for examination. Relationship between “payment to and provision for employees” and the sales. In case any undue increase is seen, it could be due to expansion of activity etc. that would be included in the Directors’ Report. Relationship between “selling and marketing” expenses and the sales. Any undue increase could either mean that the company is in a very competitive industry or it is aggressive to increase its market share by adopting a marketing strategy that would increase the marketing expenses including offer of higher commission to the intermediaries like agents etc. Debt service coverage ratio = Internal accruals (+) interest on medium and long-term external liabilities/interest on medium and long-term liabilities (+) repayment of medium and longterm external liabilities. The term-lending institution or bank looks for 1.75:1 on an average for the loan period. This is a very critical ratio to indicate the ability of the company to take care of its obligation towards the loans it has taken both by way of interest as well as repayment of the principal. Earnings before interest and tax/average total invested capital, i.e., net worth (+) debt capital. This should be higher than the average cost of funds in the form of loans, i.e., interest cost on loans/debentures etc. Profit after tax (-) dividend on preference share capital/net worth (-) preference share capital (return in percentage). Anything less than 15% means that our investment in this company is earning less than the average return in the market. Profit after tax (-) dividend on preference share capital/number of equity shares. In terms of percentage anything less than 40% to 50% of the face value of the shares would not go well with the market sentiments.

Whether the % of employee costs to sales has increased?

Whether the % of selling expenses in relation to sales has gone up?

Whether the company had sufficient internal accruals {Profit after tax (-) dividend (+) any non-cash expenditure like depreciation, preliminary expenses write-off etc.} to meet repayment obligation of principal amount of loans, debentures etc.?

Return on investment in business to compare it with return on similar investment elsewhere.

Return on equity (includes reserves and surplus)

How much earning has our share made? (EPS)

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Subject: Financial Management

Chapter no. 8: Financial statements analysis Whether the company has reduced its dividend payout in comparison with last year? Relationship between amount of dividend payout and profit after tax last year and this year. Is there any reason for this like liquidity crunch that the company is experiencing or the need for conserving cash for business activity, like purchase of fixed assets in the immediate future? “Notes on Accounts” as given at the end of the accounts. Any substantial increase especially in disputed amount of duties should put us on guard.

Is there any significant increase in the contingent liabilities due to any of the following? Disputed central excise duty, customs duty, income tax, octroi, sales tax, contracts remaining unexecuted, guarantees given by the banks on behalf of the company as well as the guarantees given by the company on behalf of its subsidiary or associate company, letter of credit outstanding for which goods not yet received etc. Has the company changed its policy of outsourcing its work from vendors and if so, what are the reasons? Is there any substantial increase in charges paid to consultants? Has the company opened any branch office in the last year?

Substantial change in subcontracting charges.

vendor

charges,

or

Increase in consultancy charges.

Directors’ Report or sudden spurt in general and administration expenses.

The principal tools of analysis are: Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play. Comparison with past trend within the same company is one type of analysis and comparison with the industrial average is another analysis While one can derive a lot of useful information from analysis of the financial statements, we have to keep in mind some of the limitations of the financial statements. Analysis of financial statements does indicate a definite trend, though not accurately, due to the intrinsic nature of the data itself. Some of the limitations of the financial statements are given below. ♦ Analysis and understanding of financial statements is only one of the tools in understanding of the company ♦ The annual statements do have great limitations in their value, as they do not speak about the following♦ ♦ Management, its strength, inadequacy etc. Key personnel behind the activity and human resources in the organisation.

♦ Average key ratios in the industry in the country, of which the company is an integral part. This information has to be obtained separately. ♦ Balance sheet is as on a particular date and hence it does not indicate about the average for the entire year. Hence it cannot indicate the position with 100% reliability. (Link it with fundamental analysis.)
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Subject: Financial Management

Chapter no. 8: Financial statements analysis ♦ The auditors’ report is based more on information given by the management, company personnel etc. ♦ To an extent at least, there can be manipulation in the level of expenditure, level of closing stocks and sales income to manipulate profits of the organisation, depending upon the requirement of the management during a particular year. ♦ One cannot come to know from study of financial statements about the tax planning of the company or the basis on which the company pays tax, as it is not mandatory under the provisions of The Companies’ Act, 1956, to furnish details of tax paid in the annual statement of accounts. ♦ Notwithstanding all the above, continuous study of financial statements relating to an industry can provide the reader and analyst with an in-depth knowledge of the industry and the trend over a period of time. This may prove invaluable as a tool in investment decision or sale decision of shares/debentures/fixed deposits etc.

Funds flow statement – its format and construction
Financial funds flow statement is different from what the students would have learnt by this time as “Funds flow for Management Accounting”. Financial funds flow statement bifurcates the funds into short-term and long-term instead of working capital and funds from operations etc. It further bifurcates the long-term funds into internal and external resources. The purpose of this bifurcation is to ensure proper financial planning. Financial planning essentially involves planning for resources and obtain matching resources in terms of duration, rate of interest etc. For example, short-term resource cannot be used for fixed assets. This is called “diversion” of funds and could land the enterprise in serious shortfall of working capital funds. Similarly long-term funds would always be more than long-term use, as internal accruals are a part of long-term funds along with share capital. These could be used for short-term as well as long-term purposes. Please refer to the Chapter on “Working capital management”. Increase in liability = source of funds; decrease in assets = source of funds Increase in assets = use of funds; decrease in liability = use of funds

Thus a liability can reduce during a year and increase because of fresh borrowing. Let us take for example, term loans. During the period under review, a part of the outstanding loan would have been paid during the year and the enterprise would have taken fresh loans. Thus in the following statement, increase in term-loans has been shown as a source of fund and decrease in term-loan has been shown as use of fund. This is true of all medium and long-term liabilities. The student should keep this in mind while preparing funds flow statement. He should not be tempted to adjust and present only the net position as a source or use. For example fresh loan taken = Rs. 100 lacs and loans repaid during the year = Rs. 30 lacs. The student may be tempted to present the net position of Rs. 70 lacs as source of funds. This will not give the correct picture. However in the case of short-term source or use, only net position has to be presented as they are constantly fluctuating and do not stay in business for a long period of time. Keeping these in mind let us examine the following funds flow statement and comment at the end:

Financial statements - Funds flow statement - Format Funds inflow – sources 1999-2000 2000-2001

Long-term funds

Profit after Tax

240

265
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Punjab Technical University, Online Virtual Campus

Subject: Financial Management

Chapter no. 8: Financial statements analysis Less:

Dividend paid

80

80

Net profit Add: Depreciation for the year Amount amortised (A) - Long-term funds (internal) Increase in share capital Increase in term loans Increase in debentures/bonds

151

176

36 15 202 0 150 0

40 15 231 0 0 250

Increase in fixed deposits/acceptances and other medium and long-term liabilities 75 Decrease in investments Sale proceeds of fixed assets (B) - Long-term funds (external) Total Long-term funds (A+B) 25 15 265 467

50 15 22 337 568

Increase in short-term bank borrowing – overdraft/cash credit 133 Increase in trade creditors Increase in short-term loans Increase in provisions and other Short-term liabilities Decrease in cash and bank Decrease in inventory Decrease in receivables Decrease in other current assets (C) - Short-term funds 0 52 0 283 0 65 33 0

132 67 22 45 0

0 0 0 286 854
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Total funds generated during the year 750
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Subject: Financial Management

Chapter no. 8: Financial statements analysis

Funds outflow - uses 19992000 175 75 20002001 268 50

Long-term use Increase in fixed assets Increase in investment

Decrease in term loans, redemption of bonds and debentures and decrease in other medium and long-term liabilities 230 (D) – Long-term uses Short-term use Increase in inventory Increase in receivables Increase in cash and bank Increase in other current assets Decrease in overdraft/cash credit Decrease in trade creditors Decrease in provisions and other Short-term liabilities Decrease in short-term loans (E) - Short-term uses Total uses = D + E Summary of Funds flow statement Long - term funds Long- term use Surplus or (deficit) Short - term funds Short - term use Surplus or (deficit) 467 480 (13) 283 270 13 0 0 270 750 122 0 32 31 0 85 480

200 518

160 147 14 15 0 0

0 0 336 854

568 518 50 286 336 (50)

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Subject: Financial Management

Chapter no. 8: Financial statements analysis What do we observe in the above statement? In the first year, the short-term funds are in excess of short-term use to the extent of Rs. 13 lacs. These funds have been used for long-term purposes. This means that the enterprise has lost Rs. 13 lacs from working capital. This could affect the liquidity of the enterprise in the long run. If this feature persists, the enterprise could see itself in what is often referred to as “debt trap”. Debt trap simply means that the enterprise takes fresh loan to repay the earlier loan. This would surely happen in case the enterprise uses constantly short-term funds for fixed assets or long-term purposes. Fortunately this has changed in the second year and during this year, the long-term funds are in excess of long-term purposes. This is the correct and desirable feature of funds flow statement in a business enterprise.

Questions and numerical exercises for practice and reinforcement of learning
1. 2. 3. What is the difference between cash flow statement and funds flow statement? What are the components of annual report of limited companies? Practise analysing the financial statements of Profit and Loss Account and Balance Sheet of limited companies in different sectors in groups and interpret the financial ratios – intra-firm analysis should be possible. What are the limitations of analysis of performance of a business enterprise based on published annual accounts? What is the usual characteristic feature of funds flow statement? If this feature is not observed in funds flow statement what is the risk to a business? Give the formulae for the following ratios: Earning per share Return on net worth Return on capital employed Return on total capital employed Debt service coverage ratio Asset coverage ratio 7. Find out the debt to equity ratio from the following – both all external debts and only medium and long-term debts. Find out both the ways, one by treating PSC as debt and another treating it as part of equity: Net worth Rs. 5000 lacs Preference share capital Rs. 500 lacs Medium and long-term liabilities Rs. Rs. 7500 lacs Current liabilities Rs. 5000 lacs 8. Give your responses to the question at the end of the following: Parameter Sales Other income Operating expenses 2000-2001 5000 lacs 250 lacs 4900 lacs 2001-2002 6200 lacs 500 lacs 6300 lacs

4. 5. 6.

Are the company’s operations profitable? What do the above figures indicate on the performance of the company? 9. Determine the required financial parameter or ratio as given at the end from the following: (Rupees in lacs)
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Subject: Financial Management

Chapter no. 8: Financial statements analysis EBIDT 2500 Interest 500 (on M&T liabilities - 340 and the rest working capital) Book depreciation 240 Income tax depreciation 360 Misc. expense written off during the year 120 Income tax 40% Dividend on preference share capital 30 (rate 10%) Dividend on equity share capital 200 (rate 20% - FV Rs. 25/-) Reserves 500 (excluding profit retained in business during the year) Medium and long term liability to be met during the period 500 WDV of fixed assets -3500 Outstanding medium and long-term liabilities 2400 Outstanding current liabilities - 2000 including dividend payable for the year and provision for tax for the year as under Misc. expenses outstanding (yet to be written off) – Rs. 240 lacs

Find out Profit before tax Profit subject to tax as per Income tax calculation Amount of income tax payable Profit after tax Profit retained in business Gross cash accruals Net cash accruals Debt/equity ratio (both) Asset coverage ratio Interest coverage ratio Debt service coverage ratio Earnings ratio Also indicate the desirable minimum or maximum within brackets against each parameter, wherever applicable 10. From the following construct the funds flow statement in the proper format including summary and offer your comments (all figures in lacs of rupees) Increase in share capital – 250 Sale of fixed assets – 50 Increase in inventory – 100 Decrease in cash and bank – 20 Repayment of loans for fixed assets – 80 Profits after tax for the period – 120 Dividend declared along with tax – 36
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Subject: Financial Management

Chapter no. 8: Financial statements analysis Increase in bank borrowing – 80 Decrease in other current liabilities – 35 Disposal of existing investment – 25 and new investment – 35 New debentures – 150 Redemption of other medium and long-term liabilities – 100 Increase in inventory – 80 Depreciation for the period – 70 Amount amortised during the period – 25 Increase in other current assets – 28 Increase in fixed assets – 226 Balance increase in receivables

*** End of handout ***

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