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FINANCIAL ACCOUNTING
“ANALYSIS OF FINANCIAL STATEMENTS”
See chapter 7

Financial Statements
1. Profit & Loss Account shows a. cost structure of the business b. relationship of costs to the revenues c. information relating to margin available on sales 2. Balance Sheet shows a. owner’s contribution in the total funds requirement b. proportion of short term and long term funds c. proportion of fixed and current asset

However, accounting data in absolute terms does not have much meaning without analysis and comparison

Continued…
In most cases, there are no standards against which a given set of data could be tested or compared

Example X had sale of Rs 15L & cost of goods sold of Rs 12L Y had sale of Rs 20L & cost of goods sold of Rs 14L This set of data is not open to direct comparison easily.
But if we say that for X, Cost of goods sold is 80% of sales and for Y it is 70% of sales - it is more lucid and meaningful.

Common Size Statements
Profit & Loss Account
shows the net sales as 100% and each component of expenses and profits as a % of net sales

Balance Sheet
1. shows each item of asset as a % of total assets 2. similarly each item of liability and owner’s equity is shown as a % of total liabilities

PROFIT/COST COMPARISONS
Rs Million Industry Rs Million ABC Ltd Average 100 280 100 40.00 140 50.00 60.00 140 50.00 25.00 35.00 4.00 31.00 8.00 23.00 10.00 13.00 0.50 80 60 13 47 23 24 2 22 5.6 28.57 21.43 4.64 16.79 8.21 8.57 0.71 7.86 2.00

Sales Cost of goods sold Gross Profit (i)
Total operating expenses Operating Profit (ii) Interest expense Profit Before Tax (iii) Income tax Profit After Tax (iv) Dividends Profit Retained (v) Repairs to Plant & Machinery

600 240 360
150 210 24 186 48 138 60 78 3

FINANCIAL RATIOS
1. Many pieces of information do not have significant meaning in isolation. They become more meaningful when related to an appropriate base. 2. Ratios reduce large figures to an easily understood relationship. 3. Ratios do not make conclusions. There are no “good” or “bad” ratios. It is for the analyst to draw conclusion by evaluating ratios. 4. Company performance is usually analyzed on two parameters - (1) Profitability, and (2) Solvency/Liquidity

Profitability Ratios
Gross Profit Margin

Margin on sales Return on Investment Efficiency (Activity) Return per share

Operating Profit Margin Earnings Before Interest & Tax Profit before tax Net Profit Margin (i.e., Profit after tax) Operating Profit to Operating Assets (ROA) Net Income to Total Assets (ROTA)

Return on Equity (ROE)
Total Asset Turnover Fixed Asset Turnover Working Capital Turnover

Shareholder Equity Turnover
Earnings per share (EPS) Price to Earnings (P/E ratio) Dividend per share

Solvency Ratios
Net Working Capital Current Ratio Quick Ratio Accounts Receivable Turnover Collection Period Inventory Turnover Conversion Period Total Debt to Total Capital Long Term Debt to Total Capital

Short-term (Liquidity)

Long-term (Leverage)

Long Term Debt to Fixed Assets Interest Cover Times Fixed Charges Covered Gearing Equity Multiplier

PROFITABILITY
The long-term survival depends on ability to earn sufficient surpluses and to grow

Margin on Sales
• • Profits are generated by sales First step in analyzing profitability is understanding costs in relation to revenue and thus profits in relation to revenue Each component of profit & loss account is expressed as percentages of sales

P & L a/c of M/s ABC Ltd
Rs Million % (2006) Rs Million % (2005) 300 100 280 100 148 49.33 140 50.00 152 50.67 140 50.00 85 67 14 53 28.33 22.33 4.67 17.67 80 60 13 47 28.57 21.43 4.64 16.79

Sales Cost of goods sold Gross Profit (i) Total operating expenses Operating Profit (ii) Interest expense Profit Before Tax (iii)

Income tax Profit After Tax (iv)
Dividends Profit Retained (v)

26 27
15 12

8.67 9.00
5.00 4.00

23 24
10 14

8.21 8.57
3.57 5.00

Margin on Sales
(i) Gross Margins 1.Surplus available from sales after subtracting cost of goods sold 2.Reflects the efficiency of use of direct inputs given the sales price (ii) Operating Margins 1.It is considered as a reflection of the management’s performance 2.Frequently used as a basis of comparison across companies (iii) Profit Before Tax (PBT) 1.Surplus after meeting interest expense 2.Influenced to a great extent by the financing decisions (iv) Profit After Tax (Net Income or PAT) 1.Overall surplus available out of sales to shareholders 2.Influenced by operating efficiency & financing efficiency 3.As a percentage of sales it is known as Net Profit Margin

Balance Sheet of M/s ABC Ltd
Rs Million 180 18 162 258 30 450 175 12 187 150 113 450 % (2006) Rs Million % (2005) 40.00 200 50.00 4.00 20 5.00 36.00 180 45.00 57.33 200 50.00 6.67 20 5.00 100 400 100 38.89 2.67 41.56 33.33 25.11 100.00 175 43.75 14 3.50 189 47.25 125 31.25 86 21.50 400 100.00

Fixed Assets Less depreciation Net Fixed Assets Total Current Assets Other Assets
Total Assets Share Capital Retained Earnings Total Shareholders’ Equity Total Long term Liabilities Current Liabilities/Provs Total Liabilities

Return on Investment
• Reflects successful utilization of the assets. • Profitability should be judged on the basis of amount of resources used for obtaining the profit (i) Return on Operating Assets (ROA) Operating profit as a % of average operating assets Operating assets = fixed + current Average operating assets = (opening + closing) / 2 67 / ((420 + 380) / 2) = 67 / 400 = 16.75 %

Continued…
(ii) Return on Total Assets (ROTA) PAT as a % of average total assets 27 / ((450 + 400) / 2) = 27 / 425 = 6.35 % (iii) Return on Capital Employed (ROCE), or Return on Equity (ROE) PAT as a % of average shareholders fund (capital + retained earnings)

27 / ((187 + 189) / 2) = 27 / 188 = 14.36 %
NOTE : When borrowed money is used to earn more than the cost of such borrowing, the ROE increases

Return per Share
(i) Earnings per share (EPS) (PAT – Dividend on Preference shares) / Number of equity shares Measures profit available to equity shareholders on per share basis
(ii) Price Earnings Ratio (P/E) MP per share / EPS Used by investors to compare alternate investment avenues (iii) Dividend per share Shows the cash income available to the shareholder

Efficiency (Activity) Ratios
1. Measure the level of sales generated by a given quantum of assets 2. Are a measure of the efficiency of the management in using the assets

3. Measure the speed at which various assets are converted into sales (or cash)

4. The greater is the rate of turnover or conversion, the more efficient is the utilization of assets, other things being equal.

Continued…
1. Total assets turnover Sales / Average total assets Indicates the efficiency with which the assets are used 2. Fixed assets turnover Sales / Average fixed assets Indicates the efficient use of fixed assets 3. Working Capital turnover Sales / Average Net working capital 4. Shareholder equity Turnover Sales/Average Shareholders Equity Indicates efficiency in the use of equity

Solvency (Liquidity)
• • • Ability to meet all short-term commitments and to have enough assets to cover all the liabilities arising in the long run Companies can be liquid (solvent) but not profitable. Example : a cash rich construction company with no orders Companies can be profitable but not liquid. Example : a construction company with lot of orders but no cash to execute them


Hence, we need both profitability and solvency
Solvency is of two types – Short Term and Long Term

Short term Solvency
• • Liquidity is of major concern to short-term creditors and management Sale of merchandise (inventory turnover) and collection of receivable (receivable turnover) generate liquidity

1. Net Working Capital Excess of current assets over current liabilities a. Net working capital is financed by long-term sources of funds and as such provides a cushion for liquidity b. It is obvious that since it is financed by long-term sources it is not required to be repaid in the short-term

2. Current Ratio Current Assets / Current Liabilities Indicates amount of current assets available for each rupee of current liability. However, making a specific conclusion based on current ratio would depend on: (a) Various components of current assets, (b) Time taken for conversion of current assets to cash, and (c) Speed of maturity of current liabilities, etc. 3. Quick Ratio, or Acid Test Ratio Quick Assets / Current Liabilities Quick Assets = Current assets - inventories

4. Expenses Cover Current Assets / Daily Operating Exp(Operating Expenses/365) (Current assets as equal to number of days’ expenses) 5. Accounts Receivable Turnover Net Sales / Average Accounts Receivable say 300 / ((70 + 90) / 2) = 300 / 80 = 3.75 (means credit sales and its collection happened 3.75 times during the year) 6. Average Collection Period 365 / Accounts Receivable Turnover say 365 / 3.75 = 97.33 days (means it takes approx 97.33 days for collection of accounts receivable) 7. Inventory Turnover Cost of Goods sold /Average Inventory (Indicates the speed of conversion of inventories to cash)

Long Term Solvency
Capital Structure / Leverage Ratios The Long-term creditors would judge the soundness of a firm on the basis of the long-term financial strength measured in terms of its ability to pay 1. 2. the interest regularly as well as repay the installment of the principal on due dates or in one lump sum at the time of maturity

Creditors have a prior claim on the assets of the company and hence the owners’ equity forms the margin of safety for lenders’ claims

Continued…
1. Debt-Equity Ratio Long-term Debt / Shareholders’ equity A high ratio shows a large share of financing by the creditors of the firm. 2. Long-term Debt to Total Capital (Shareholders’ Equity) Measures amount of long-term debt for every rupee of shareholders’ equity 3. Long-term debt to Fixed Assets Measures fixed assets available as a backing for long-term debt

Continued…
4. Times Interest Earned EBIT / Expenses on Interest outflow Larger this cover, greater is the safety of the lenders’ interest Also shows the risk in case the firm’s earnings decrease 5. Capital Gearing Ratio (Preference Capital + Debentures + other borrowed funds) (Equity + Reserves & Surplus – Fictitious Assets) Shows the extent to which the company is in a position to increase the earnings to shareholders by having fixed interest bearing borrowing in the capital structure.

Continued…

6. Equity Multiplier Total Assets / Owners Equity The equity multiplier will show the extent of enhancement of return to equity holder due to leverage or borrowing

DUPONT ANALYSIS
A combination of margin on sales ratio, efficiency ratio, and long-term solvency ratio is popularly known as the DuPont analysis

Return on Equity (ROE) Net Profit Margin (defined as Net Profit/Sales) x Asset Utilization Ratio (defined as Sales/Total Asset) x Equity Multiplier Ratio (Total Assets/Owners Equity)
Net Profit x Sales x Total Assests Sales Total Assets Owners’ Equity

The DuPont analysis approach helps in identifying and pinpointing the reasons behind high or low profitability of a firm vis-à-vis its competitors

Hidden Assumptions Mean Caution
We generally tend to assume :1. 2. 3. All the firms have similar accounting policies and practices (such as the method of depreciation allocation) All the firms did not have any significant change in accounting policy (such as a change in the inventory valuation policy) The processes of generating the accounting numbers are reliable across the firms A large number of such assumptions might be violated even while making comparisons of a single firm over many years Hence, care must be taken while making significant conclusions

ILLUSTRATION
Some details about a firm are given below :-

1. Total Sales 2. Gross Profit Margin 3. Operating Profit Margin 4. Net Profit Margin 5. Total Assets Turnover 6. Current Ratio 7. Working Capital Turnover 8. Equity Multiplier

50,000 40% 25% 10% 5:7 4:3 10 2

Construct the P & L a/c and the Balance Sheet to find the Debt : Equity Ratio of the firm

1. Total Assets Turnover = Sales / Total assets = 5:7 Since Sales = 50,000, Total Assets = 70,000 So Total Liabilities also = 70,000 2. Working Capital Turnover = Sales / Working Capital = 10 Since Sales = 50,000, Working capital = 5,000 3. Current Ratio = Current assets / current liabilities = 4:3 Since Working capital = 5,000 = 4x – 3x = x So, Current assets = 20,000; Current liabilities = 15,000 4. Equity Multiplier = Total Assets / Owner’s equity = 2 Since Total Assets = 70,000; Owner’s equity = 35,000 5. On the Liabilities side in the balance sheet, we have : – a. Owner’s equity = 35,000 b. Current Liabilities = 15,000 c. Total Liabilities = 70,000 so Long term liabilities = 20,000 6. Hence, Debt : Equity ratio = Long term debt / owner’s equity = 35,000 / 20,000 = 7 : 4 Answer

Answer

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