Auditor Report Financial Statements

and Analysis
A' external auditor is an independent certified public accountant hired by management
~U assess whether company's financial statements are prepared in conformity with
generally accepted accounting principles. Auditors provide an important check on fmancial
statements prior to their public release.

Explanatory Notes
Explanatory notes accompanying financial reports play an integral role in financial
statement analysis. Notes are a means of communicating additional information regarding
items included and excluded from the body of statements. It is the often technical nature
of notes that creates a need for a certain level of accounting sophistication on the part of
financial statement users. Explanatory notes include information on:
• Accounting principles and methods employed,
• Detailed disclosures regarding individual financial statement elements,
• Commitments and contingencies,
• Business combinations,
• Transactions with related parties,
• Stock option plans,
• Legal proceedings,
• Significant customer.
Whatever approach to financial statement analysis taken and whatever methods used,
we always examine one or more important aspects of a company's financial condition
and results of operations. Our financial analysis, motivated by various objectives, falls
within any or all of the six areas of inquiry below - in any sequence and with the degree
of relative emphasis required under the circumstances. These six areas of inquiry and
investigation are the building blocks of financial statement analysis.
• Short-term liquidity: A company's ability to meet short-term obligations.
• Funds flow: Future availability and disposition of cash
• Capital structure and long-term solvency: A company's ability to generate
future revenues and meet long-term obligations.
• Return on investment: A company's ability to provide financial rewards sufficient
to attract and retain suppliers of financing.
• Asset utilization: Asset intensity in generating revenues to reach a sufficient
level of profitability.
• Operating performance: A company's success at maximizing revenues and
minimizing expenses from long-run operating activities

14.7 RATIO ANALYSIS OF FINANCIAL STATEMENTS

The Balance Sheet and the P&L account are the starting point for analysis of a company.
Analysis of specific ratios based on the information provided by the financial statements.
Ratio Analysis enables the company to spot trends in its business activities and to compare
its performance and condition with the' average performance of similar businesses in the
same industry.
To do this, the ratios are compared with the average of similar businesses for several
successive years, watching especially for any unfavorable trends that may be starting.
Ratio analysis may provide the all-important early warning indications that allow you to
solve your business problems before your business is destroyed by them.
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Valuation Classification of Financial Ratios
Ratios were developed to standardize a company's results. They allow analysts to quickly
look through a company's financial statements and identify trends and anomalies. Ratios
can be classified in terms of the information they provide to the reader.
There are five major classifications of financial ratios:
1) Liquidity Ratios: The ratios used in this classification enable analysis of a
company's financial ability to meet short-term obligations (usually within 1 year
time period).
2) Leverage Ratios: The ratios used in this classification are useful to stockholders
and creditors as it allows the stockholders to determine what the company is worth,
and allows creditors to estimate the company's ability to pay its existing debt and
evaluate their additional debt applications, if any.
3) Thrnover Ratios: These are also referred to as Efficiency / Performance / Activity
ratios or Asset Management ratios. The ratios used in this classification were
developed to analyze and determine how efficiently a company deploys its assets.
4) Profitability Ratios: These ratios are used to measure the firm's return on its
investments. Profitability ratios mainly focus on the firm's profit.
5) Valuation Ratios: This estimates how the equity stock of a company is assessed
in the capital markets.
Let us individually analyze each of the above mentioned classification of ratios.

1) Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current
Ratio, Quick Ratio, Cash Ratio and Working Capital.

a) Current Ratio: The Current Ratio is one of the best known measures of financial
strength. It is measured as shown below:

. Current Assets
Current ratio = C urrentL· b·li .
la 1 ties

Current Assets include cash, current investments, debtors, inventories (stocks), loans
and advances and pre-paid expenses. Current Liabilities represent liabilities that are
expected to mature in the next 12 months. These include installments of loans (secured
or unsecured) and current liabilities and provisions. A generally acceptable current ratio
is 2 to 1.. In India, the general norm for acceptable current ratio is 1.33. But it also
depends on the nature of business (industry segment) and the characteristics of its
current assets and liabilities. If you decide your business's current ratio is too low, you
may be able to increase it by:

• Paying back debt.

• Increasing current assets from loans or other borrowings with a maturity of more
than one year.
• Converting non-current assets into current assets.
• Increasing "our current assets from new equity contributions.
• Putting profits back into the business.

b) Quick Ratio (or Acid Test Ratio): The Quick Ratio is sometimes called the "acid-
test" ratio and is another measure of liquidity. It is calculated as shown below:
. k . _ Current Assets - Inventories
Q uic ratio - C urrent L·la bili .
nines
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 The Quick Ratio is a much more stringent measure of liquidity than the Current Ratio. Financial Statements
By excluding inventories, it concentrates on the really liquid assets, with value that is and Analysis
fairly certain. It helps answer the question: If all sales revenues should disappear,
could my business meet its current obligations with the readily convertible "quick"
funds on hand? An acid-test of I: 1 is considered satisfactory unless the majority of
your "quick assets" are in accounts receivable, and the pattern of accounts receivable
collection lags behind the schedule for paying current liabilities.

c) Cash Ratio: This ratio helps in determining if the cash and bank balances as well as
short term marketable securities (current investments) are sufficient to meet the current
liabilities.

Cash rati CashandBankBalances + Current Investments

as ratio = C urrent L'la bili .
I ities

Among all the liquidity ratios, the cash ratio is the most stringent measure of liquidity.

d) Note on Working Capital: Working Capital is more a measure of cash flow than
a ratio. The result of this calculation must be a positive number. It is calculated as shown
below:

Working Capital = 'Total Current Assets - Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company's ability to
weather financial crises. Loans are often tied to minimum working capital requirements.

2) Leverage Ratios: The ratios used in this classification are useful to stockholders
and creditors as it allows the stockholders to determine what the company is worth, and
allows creditors to estimate the company's ability to pay its existing debt and evaluate
their additional debt applications, if any. The different ratios under this category are
Debt-Equity Ratio, Debt-Asset Ratio, Interest Coverage Ratio, Fixed Charges Coverage
Ratio and Debt Service Coverage Ratio.

a). Debt-Equity Ratio: This DebtIWorth or Leverage Ratio indicates the extent to
which the business is reliant on debt financing (creditor money versus owner's equity).
The debt to equity ratio is calculated as follows:

D eb t - E·quity ratio
.
= EDebt.
quity

The numerator consists of both short term and long term debt. Denominator usually
includes net worth plus preference capital plus deferred tax liability. Alternatively, the
numerator may comprise only of long-term debt (without considering short term debt).
Deferred tax liability is considered as quasi equity. Generally, the higher this ratio, the
more risky a creditor will perceive its exposure in the company, making it correspondingly
harder to obtain credit. If the ratio is low, the degree of protection enjoyed by creditors
is high. It may be observed that if the book value of equity is considered (as is usually
the case), this understates its market value. This is because the value of tangible assets
is assessed based on historical values (less depreciation). Also, usually many highly "
valuable intangible assets are not recorded in the balance sheet. The ratio also does not
consider the secured nature of most of debt. For example, debentures, long-term and
short-term debt may be obtained only upon providing adequate security in the form of
hypothecating fixed assets.

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1
Valuation b) Debt-Asset Ratio: The debt-asset ratio measures the extent to which borrowed
funds are secured using the company's assets. This is defined as follows:

Debt - Asset ratio = ADebt

sset

The numerator usually includes short term as well as long-term debt. The denominator
consists of all assets (the balance sheet total).

c) Interest Coverage Ratio (or Times Interest Earned Ratio): It is the measure
of extent to which interest is covered by profit before interest and taxes. The numerator
does not include taxes because the payment of interest is completed before tax is applied.
The interest payment provides the company with a tax-shield. The ratio is calculated as
follows:

·
Interest C overage R atio = Profit Before Interest and Taxes
I
nterest

Banks prefer to lend to firms whose profit are far in excess of interest payments.
Therefore, analysts often calculate the ratio of profit before interest and taxes (EBIT)
to interest payments.

d) Fixed Charges Coverage Ratio: The ratio analyses the extent to which the profit
before interest and taxes plus depreciation covers all the fixed financing charges. It is
calculated as follows:

· d Ch CR· Profit Before Interest & Taxes + Depreciation

F ixe arges overage atio = R f Lo
In terest + e payment 0 an
1- T ax R ate

It may be observed that the numerator includes depreciation because it is the measure
of fixed assets which have been considered to be utilized for the financial period. In the
denominator, the extent of repayment of loan is adjusted for the tax rate. The repayment
of loan comprises of the outstanding principal amount of loan that needs to be repaid
back within 1 year time period.
A more comprehensive calculation is as follows:

Profit Before interest, Depreciation and Taxes

. Le Loan Repayment Installment Preference Dividends
In terest + ase payment + 1 7' R + 1 7' R
+ L ax ate - L ax ate

c) Debt Service Coverage Ratio: This provides the average debt service coverage
for the duration of the term loan borrowed for the project. Following is the formula for
calculating the same:

Pr ofit After Tax + Eepreciation + Other noncnsh ch arg es + Interest on Term Loan + Lease Re ntals
Interest on term loan + lease rentaIs + Re payment of term loan

3) 'Iurnover Ratios
These are also referred to as Efficiency / Performance / Activity ratios or Asset
Management ratios. The ratios used in this classification were developed to analyze and
determine how efficiently a company deploys its assets. The different ratios include
Inventory Turnover Ratio, Debtors Turnover ratio, Average Collection period, Fixed
Assets Turnover Ratio and Total Assets Turnover ratio. Let us analyse each of these
26 ratios:

I
a) Inventory Turnover Ratio: This ratio reveals how well inventory is being managed. Financial Statements
It is also an indication of the number oftimes the inventory is replaced in a given operating and Analysis
cycle. If this number is high, then the profit would increase due to lower working capital
requirement in terms of locked-up value of inventory. It is the reflection of efficiency in
managing inventory. InventoryTurnover Ratio is calculated as follows:

· Cost of goods sold

Inventory T urnover = In
Average ventory

Efficient firms turn over their inventory rapidly and don't tie up more capital than they
need in raw materials or finished goods. It may be noted that a high inventory turnover
ratio may not indicate efficiency in all cases. It may so happen that production has been
affected and the inventory has been reduced drastically for operational reasons - this
may also lead to high inventory turnover ratio, resulting in incorrect assumptions.

b) Debtor Turnover Ratio (or Accounts Receivable Turnover ratio): This ratio
indicates how well accounts receivable are being collected. If receivables are not collected
reasonably in accordance with their terms, management should rethink its collection
policy. If receivables are excessively slow in being converted to cash, liquidity could be
severely impaired. The Debtor Turnover Ratio is calculated as follows:

Net Credit Sales

Average Sundry Debtors

The term, "Net Credit Sales" refers to the extent of sales that has been done on credit.
If it is not possible to ascertain the "Net Credit Sales", then the "Net Sales" figure is
considered. The higher the debtor turnover ratio, greater is the efficiency of credit
management.

c) Average Collection Period (or Accounts Receivables Turnover ratio): The

average collection period represents the number of days' worth of credit sales that is
locked up in sundry debtors.

AverageSundry Debtors
AccountsReceivab lesTumover( indays ) =----~~--~~------
AverageDailyCreditSales
The average collection period can also be calculated as follows:

365
DebtorTumoverRatio
If the average collection period is lower than the average credit period offered on sales,
then this implies that the collection is efficient. On the other hand, if the average collection
period is sometimes lower than the credit period allowed by the company, may imply
that excess efficiency in credit management can result in potential loss in sales. Also, it
may be the result of an unduly restrictive credit policy, so that the firm offers credit only
to customers that can be relied on to pay promptly.

d) Fixed Assets Turnover Ratio: This ratio is used to calculate the Sales per Ruppee
of Investment in fixed assets. It is calculated as follows:

NetSales
FixedAssetsTumoverRatio
AverageN etF ixedAssets

27 ..•••.
~
------------------------------------------------------------------------~

I
Valuation e) Total Assets Turnover Ratio: The total asset turnover ratio indicates the extent to
which the firm's assets are utilized for achieving the sales figure. This ratio is calculated
by the following formula:

. Net Sales
Total Assets Turnover Ratio = A verage N F dA
et ixe ssets

A high ratio compared with other fIrms in the same industry could indicate that the firm
is working close to capacity. It may prove difficult to generate further business without
additional investment. For the purpose of calculation, a company's assets are likely to
change over the year. Hence, we use the average of the assets at the beginning and end
of the year.

4) Profitability Ratios
Profitability ratios are used to measure the firm's return on its investments. Profitability
ratios mainly focus on the firm's profit. The different ratios analyzed are: Gross Profit
Margin Ratio, Net profit Margin Ratio, Return on Assets Ratio, Earning Power, Return
on Capital Employed and Return on Equity. Let us analyze each of these ratios:

a) Gross Profit Margin Ratio: This ratio is the percentage of sales left after subtracting
the cost of goods sold from net sales. Comparison of a company's Gross profit Margin
ratio with other companies in same or similar business reveals relative strengths or
weaknesses. The Gross Profit Margin Ratio is calculated as follows: .

. _ Gross Prifit
G ross M arg m - N S 1
et a es

It may be noted that Gross Profit = Net Sales - Cost of Goods Sold

b) Net Profit Margin Ratio: This ratio is the percentage of sales left after subtracting
the Cost of Goods sold and all expenses except taxes. It provides a good opportunity to
compare a company's net profit on sales with the performance of other companies. It is
calculated before income tax because tax rates and tax liabilities vary from company to
company for a wide variety of reasons, making comparisons after taxes much more
difficult. The Net Profit Margin Ratio is calculated as follows:

. Net Profit Before Tax

N et P ro fiIt M argm = N Sal
et es

c) Return on Assets Ratio: The Return on Assets Ratio measures how efficiently
profits are being generated from the assets employed in the business when compared
with the ratios of firms in same or similar business. A low ratio in comparison with
industry averages indicates an inefficient use of business assets. The Return on Assets
Ratio is calculated as follows:

Pr ofit After Tax

Re turn on Assets = --------
Average Total Assets

d) Earning Power: Earning Power is calculated as follows:

. P Pr ofit before interest and Tax

E arnmg ower = -----------
Average Total Assets

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I
This ratio analyzes the impact of profit before considering interest and taxes fro the Financial 'Statements
extent of assets deployed. This focuses more on the operating performance of the and Analysis
, .mpany. Thus, this ratio can effectively compare different companies.

e) Return on Capital Employed (ROCE):This ratio is calculated as follows:

ROCE = Profit Before Interest and Tax (1- Tax Rate) .

Average Total Assets

The numerator is also referred to as the "Net Operating profit After Tax" or NOPAT.
ROCE is the post-tax version of Earning Power. It considers the effect of taxation
without factoring the capital structure. This ratio is important for comparative analysis,
because irrespective of the capital structure adopted by different companies and the
taxation involved, the ratio provides an effective measure of performance.

f) Return on Equity: This ratio can effectively provide information to shareholders

about the returns on shareholder wealth. It is calculated as follows:

. Equity Earnings
Return on Equity = A E'
verage quity

The numerator is calculated as Profit after Tax less Preference Dividends. The
denominator considers Paid-up equity capital as well as reserves and surplus. This is
also commonly referred to as the return on Net Worth. This may also be construed as a
measure of profitability of equity funds invested in the company. It is also a measure of
productivity of ownership capital.

5) Valuation Ratios

This estimates how the equity Pr eference Devidend assessed in the capital markets.
The ratios include: Price to Earnings ratio, EV-EBIDTA, and Market Value to Book
Value ratio.

a) Price to Earnings Ratio: This is commonly known as the PE ratio.

Market price per Share

Eqrning per Share

The Earnings per Share or EPS is calculated as follows:

· Sh Profit After Tax - PreferenceDevidend

E arnmgs per are = ..
Number of outs tan dmg equity shares

The EPS and PE are parameters that can be used for comparison purpose, across
different companies in same industry. These ratios are indicators of company future
growth prospects, risk characteristics and extent of liquidity.

b) EV-EBIDTA Ratio: The EV-EBIDTA ratio is calculated as follows:

Enterprise Value (EV)

Earnings before Interest, Tax, Depreciation and amortisation (EBIDTA)

EV is the sum of the market values of both equity and debt. While market value of debt
is to be calculated using present value of all future expected cash outflows, the market
value of equity is number of outstanding shares times the price per share.

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Valuation Dividend Payout Ratio: The dividend payout ratio measures the proportion of profit
that is paid out as dividends. The dividend payout ratio is calculated as follows:

D·IVIiden d P ayout Dividend per share

= ---. -~---
Earning per share

c) Market Value to Book Value Ratio

This value is calculated by dividing the market price of a share by the book value per
share. If the Market Value to Book Value ratio is greater than 1, then the company has
created shareholder wealth.

DuPont Analysis
A system of analysis has been developed that focuses the attention on all three critical
elements of the fmancial condition of a company: the operating management, management
of assets and the capital structure. This analysis technique is called the "DuPont Formula".
The DuPont formula shows the inter-relationship between key financial ratios.
The basic DuPont formula is as follows:

Net Profit Net Profit Sales Average Total Assets

---0-..- = X X ---=------
Equity Sales TotalAssets Equity

This implies the following:

ROE = Net Profit Margin x Total Assets Thrnover x Equity Multiplier

By using the DuPont equation, it would be possible for an analyst to determine whether
the business processes are doing well and which processes can be improved.
Furthermore, ROE represents the profitability of funds invested by the owners of the
firm. All firms should attempt to make ROE as high as possible over the long term.
However, analysts should be aware that ROE can be high for the wrong reasons. For
example, when ROE is high because the equity multiplier is high, this means that high
retums are really coming from overuse of debt, which can spell trouble.
Note:

Average Total Assets = 1+ Dabt

Equity Equity

If two companies have the same ROE, but the first is well managed (high net-profit
margin) and managed assets efficiently (high asset tumover) but has a low equity multiplier
compared to the other company, then an investor is better off investing in the first
company, because the capital structure can be changed easily (increase use of debt).
Thus, all these ratios allow the business owner to identify trends in a business and to
compare its progress with the performance of others through data published by various
sources. A company's management may thus determine the business's relative strengths
and weaknesses using financial, ratios.

Limitations of Financial Ratios

There are some important limitations of financial ratios that analysts should be aware
of. Many large firms operate different divisions in different industries. For these companies
it is difficult to find a meaningful set of industry-average ratios. Inflation may have badly
distorted a company's balance sheet. In this case, profits will also be affected. Thus a
ratio analysis of one company over time or a comparative analysis of companies of
different ages must be interpreted with judgment. Seasonal factors can also distort ratio
30

I
analysis. Understanding seasonal factors that affect a business can reduce the chance Financial Statements
of misinterpretation. Different accounting practices can distort comparisons even within and Analysis
e. same company It is difficult to generalize about whether a ratio is good or not. A
company may have some good and some bad ratios, making it difficult to tell if it's a
good or weak company.

14.8 SUMMARY
In this unit, we have covered the basics of various financial statements like Income
statement, Balance sheet and Cash Flow statement. We have also touched upon the
various components of these financial state!llents. An overview of important financial
ratios and their significance has also been covered in this unit. Knowing how to calculate
and use financial ratios is important for not only analysts, but for investors, lenders and
more. Ratios allow analysts to compare various aspects of a company's financial
statements against others in its industry, to determine a company's ability to pay dividends,
and more.

14.9 SELF ASSESSMENT QUESTIONS

1) What are the components of income statement?
2) What is a balance sheet and its significar.ce?
3) Give the various liquidity ratios and their significance?
4) List down the profitability ratios and ~~emethodology to calculate them.
5) What is the advantage of calculating DuPont ratio?

14.10 FURTHER READINGS

1) Damodaran, Aswath (2004) Corporate Finance: Theory and Practice, 2nd ed,
John Wiley and Sons.
2) Chandra, Prasanna (2008) Investment Analysis and Portfolio Management, Tata
McGraw Hill.
3) Bhalla,V.K., (2001) Investment Management ,Security Analysis and Portfolio
ManagementS" edition, S Chand New Delhi.
4) Fisher, Donald E. and Jordan, (1995) Security Analysis and Portfolio
Management.S" edition, Prentice Hall of India, New Delhi.

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