Analysis of Financial

Statements
Dr. Chhavi Mehta
International Management Institute, New Delhi
 Income Statement Balance Sheet
Revenue from operations Non-current assets
+ Other income Current assets
Total income Total assets

Operating expenses Share capital

EBITDA
Other equity
Depreciation & Amortization
Total Equity
EBIT
Non-current liability
Interest
Current liability
PBT
Total liability
Tax
PAT
OCI
TCI
 Basic Caveats
• Focus of analysis depends upon the purpose in hand
• Analysis depends upon data availability – Data availability to external
and internal users
• Analysis of an entity for a period may not be adequate
Inter-period comparison & Inter-firm comparison
• Analysis as a management tool is very flexible
No fixed formats / formula – Anything that helps in better understanding
of the financials as depicted by financial statements is acceptable
 Tools for Analysis
• Vertical analysis/ Common size statements
• Horizontal analysis/ Trend analysis/ Indexed statements
• Ratios
 Vertical Analysis: Common Size Statements
• Expressing various components of the financial statements as a
percentage of a common denominator.
Balance sheet – Percentage of total of the balance sheet
Profit and loss a/c – Percentage of sales
• Helps is understanding the relative importance of different
components.
• Change in weight over a period of time.
 Horizontal Analysis:
Indexed Financial Statements
• Expressing various components of the balance sheet, and profit and
loss a/c as a percentage of the base year.
• Helps is understanding the growth/ trend of different items in the
financial statements over a period of time.
 Ratio Analysis
• Expressing one item of financial statement in relation to
another
Profit and loss a/c ratios: Relating different numbers of profit and loss
a/c
Balance sheet a/c ratios: Relating different numbers of balance sheet
Cross ratios: Relating a number of profit and loss a/c with a number of
balance sheets.
 Question while Calculating Ratios
• What is the intended purpose of ratio?
• How was ratio calculated?
• What is the unit of the calculated ratio?
• What is a high or low value is telling us? Can these values be
misleading?
• How could we improve on these measures?
 Types of Ratios
• Depending upon focus of analysis
Profitability Rations
Profit margin ratios
Return ratios
Growth
Dividend Policy
Asset utilization/ Asset Management/ Efficiency
Liquidity/ Short-term Solvency
Capital structure/ Long-term Solvency
Market Value
 Profitability Ratios
• How efficiently a firm manages its operations and assets?
• Profits in relation to operations/sales - Margins
• Profits in relation to assets/investments – Returns
 Defining Profit
• Gross profit
• EBIT
• EBIDTA/EBITDA
• PAT
• NOPAT – Net Operating Profit After Tax
– PAT + Interest (1-t)
– PBT (1-t) + Interest (1-t)
– [PBT + Interest] (1-t)
– EBIT(1-t)
• Note: Profit is in rupee terms and profitability is in relative terms i.e. is profit earned in relation to
sales or investments etc.
 Profitability Ratios
Ratios Expressed Comments
Gross margin ratio % Higher the margin, better it is.
Gross profit / Compare with the industry average and trend over a period of
Sales time.

Cash operating margin % Higher the margin, better it is.

EBITDA / Compare with the industry average and trend over a period of
Total income time.
Operating margin
EBIT/
Total income

Net margin % Higher the margin, better it is.

PAT/ Compare with the industry average and trend over a period of
Total income time.

Earnings per share Rs. Higher the EPS, better it is.

PAT / Compare the trend over a period of time.
Number of shares
 Return Ratios
Ratios Expressed Comments
Return on assets % EBIT (1-Tax rate) is also called the Net Operating Profit
EBIT (1-Tax rate) / After Tax (NOPAT). Can also be calculated as PAT/ Total
Total assets assets
ability of the firm, to generate return on the total
assets. Higher the better. Compare with industry
average and past trends.
Return on Capital Employed (ROCE) % Can also be calculated as PAT/ Capital employed ability
EBIT (1-Tax rate) / of the firm, to generate return on the capital
(Borrowed funds + Shareholders’ employed. Higher the better. Compare with industry
funds) average and past trends.
Return on equity % Shareholders’ funds include reserve and surplus. Any
PAT / accumulated losses and fictitious assets should be
Shareholders’ funds deducted
Ability of the firm to generate return on the
shareholders’ funds. Higher the better. Compare with
industry average and past trends.
 Relationships in Ratios
Debt + Equity

Assets

Operating income – Interest = Net Income

Operating income = Interest + Net Income

 Growth Ratio
• Compound Annual Growth Rate (CAGR)
Find the value of g using the following expression
A = P (1+g)^n
g = [(A/P)^(1/n)]-1
Where,
A is current year’s number
P is base year’s number
n is number of years
CAGR can be calculated for various parameters
 Growth Ratio

• Year-on-year growth
(Current year – Previous year) / Previous year
Can be calculated for sales, income, different measures of profit
Expressed as percentage

Ratio
Dividend payout ratio
(Dividend + Dividend tax) /PAT
Rétention ratio
1 – Dividend Payout ratio
Dividend yield
Dividend per share/
Current market price
Dividend Policy
Expressed Comments
% As dividend attracts dividend distribution tax, the
same is also considered a part of the payout.
What % of profits after tax is being distributed?
Growing companies have a lower payout.
% What % of profits after tax is being retained.
Growing companies have a higher retention.
% Return to the shareholder by way of dividend on
the current market price.
 Assets Utilization/ Asset Management Ratio
Ratios Unit Comments
Total assets turnover ratio Times May use average assets in the denominators i.e. (Opening +
Total income/ Closing)/2
Total assets Indicator of efficiency in utilization of assets, higher turnover
means higher ability to generate revenue for the same set of
assets.
Fixed assets turnover ratio Times May use average assets in the denominators i.e., (Opening +
Total income/ Closing)/2.
Fixed assets
Working capital turnover Times Working capital means current assets less current liabilities,
ratio Indicator of efficiency in utilization of working capital , higher
Total income/ turnover means higher ability to generate revenue for the same
Working capital set of working capital.
 Assets Utilization Ratio
Ratio Unit Comments
Debtors turnover ratio Times If credit sales figure is not available, use total sales .
Credit sales / Debtors Indicator of efficiency in receivables collection, higher turnover
means better receivables collection.
Average collection period Number of Also called Day’s Sales Outstanding (DSO).
365 / Debtors turnover ratio days Can be calculated as Debtors / Average daily sales.
Increased ACP means some customers are facing difficulty is
paying and Credit department is doing a poor job.

Inventory turnover ratio Times If cost of goods sold is not available, use total sales.
Cost of goods sold / Indicator of efficiency in managing inventories, higher turnover
Inventories means better inventory management.
Average holding period Number of Can also be calculated as: Inventories / Average daily
365 / Inventory turnover ratio days consumption or Average daily sales.
Average payment period Number of Measures how quickly a firm is paying its suppliers.
365 x Creditors / Purchases days
 DuPont Analysis
Ratios Comments
Return on equity = Helps in breaking down
PAT/ Shareholders’ Funds the ROE into
(PAT/Sales) × (Sales/Assets ) × (Assets/Shareholders’ funds) profitability, assets
= Net margin × Assets turnover × Financial leverage utilization and financial
leverage.
Return on Assets = Helps in breaking down
Operating Income / Assets the ROA into
(Operating Income / Sales) × (Sales / Assets) profitability, assets
= Operating margin × Assets turnover utilization.
 Liquidity Ratios
Ratio Unit Comments
Current ratio Times Short term investments should also be included in the current
Current assets / assets
Current liabilities 2:1 considered adequate; higher ratio indicates blockage of
funds in unproductive assets, whereas low ratio indicated
inability of company’s current assets to cover its current
liabilities.

Quick ratio Times Inventories are less liquid;

(Current ratio – Inventories) / Also called liquid ratio or acid test ratio
Current liabilities 1 : 1 considered adequate; higher ratio indicates blockage of
funds in unproductive assets.

Cash Ratio Times Represents liquidity measure in a crisis situation

(Cash + Short-term Marketable Only highly marketable short-term securities are considered
Securities)/ Current liabilities
 Liquidity Ratios
• High Current Ratio vs. Low Current Ratio
• A company with large current ratio might be using its cash inefficiently
and missing out on profitable investment opportunities
 Capital Structure Ratios
Ratios
Debt equity ratio
Borrowed funds / Shareholders’ funds
Financial leverage ratio
Total assets / Shareholders’ funds
Interest coverage ratio
EBIT / Interest and finance charges
Cash flow coverage ratio
(EBIT + Depreciation) /
[Interest +
Loan repayment/(1-Tax Rate)]
Unit Comments
Times Only long tern debts to be considered;
Measures that for each rupee invested by shareholders, how
much the firm has borrowed. Higher ratio implies higher
financial leverage and Lower ratio means that the company is
not taking advantage of financial leverage.
Times Higher ratio implies higher financial leverage.
Times Ability of the firm’s operating profits to cover its interest
obligation.
Higher the ratio better it is. Compare with the industry average
and trend over a period of time.
Times Often used by the banks and financial institution to ascertain the
adequacy of the firm’s cash flows to cover its debt obligation—
interest as well as principal.
 Market Ratios
Ratios Unit Expressed/Comments
Market capitalization Rupees / Total market value of all the shares issued by the firm higher
No. of shares × market capitalization acts as a safeguard against hostile takeover
Market price per shares

Book value per share Rupees / Shareholders’ funds include reserve and surplus. Any accumulated
Shareholders’ funds / losses and fictitious assets should be deducted.
Number of shares Not much meaningful as based upon historical cost of the assets and
does not consider the earning capacity of the assets.

Price to book value ratio Times

Current Market Price /
Book Value per Share

Price earning multiple Times Times/ Inverse of earning yields (EPS/CMP) High growth firms/
Current market price / industries normally have a higher P/E multiple
EPS
 Ratio to Predict Insolvency
Ratios Expressed Comments

Altman’s Z Score Number 3 or more:

Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5 Financially sound

X1 = Working capital/ Total assets 1.81 to 2.99:

X2 = Retained earnings / Total assets Grey area
X3 = EBIT / Total assets Less than 1.8:
X4 = Market value of equity / Book value of total liabilities Higher chances of
X5 = Sales / Total assets financial
embarrassment