Financial Statement Analysis

Text Book- Chapter 12

 Introduction

• Financial statement analysis involves applying techniques to condense

the mass of numbers in the FS into a set of incisive measures.
• It is an aid to inform investment and credit decisions.
• Comparison with rule of thumb indicators , a firm’s past , internal
standards and industry standards are useful.
• Horizontal , Vertical and Trend analyses give an overview of
performance.
• GVK- Case ( 6 lane expressway, shinning airports in Bengaluru. But
companies Loan proportion has increased significantly between 2008-
2015. Loan is very much like a dynamite, it is an instrument which is
very useful in right places and explosive in others)
 Objective of FS Analyses and Public Source of Info

• Helps us understand how a business enterprises fared in the past and find out where it was successful and
where it veered off course. With these information, we can develop expectations for the future.
• Investors look at fixed asset, capital structure
• Creditors look at repayment of their dues
• Small investors look at Dividend pay out ratios to decide their investment decisions
• Past trends of sales, earning, cash flow , profits margin, asset utilization, debt, return on investment aid in
assessing a firm’s prospects.
• Source of Info- The most common sources of info about listed companies are annual and quarterly reports,
stock exchanges and govt reports.
• The annual report is sent to the shareholders of the company free of charge and is usually available on
company’s website. Listed companies also publish in leading newspapers.
• The GoI and RBI issue reports on the performance of the economy. These include past data and forecasts
on GDP , agricultural and industrial production, rainfall and foreign exchange reserve.
 Standards of Comparison

• Rule –of-Thumb Indicators (benchmark): Current Ratio of 2.1 or above is satisfactory. This rule measures
are useful in making broad comparison of firms .
• Past Performance: Comparing a company’s current performance with its past performance will show
whether the company is improving or declining. But one should always keep in mind Apple to Apple
comparison, fundamental changes in company’s environment, govt rule and regulations, technology effect
needs to be adjusted. A change in policy ( depreciation method) will affect the comparability of the past
figures.
• ( Case- Kodak camera was the iphone of its day. It was among the first to invest the instant camera and
digital camera. Kodak’s sale peaked at $16 Billion in 1996 and profits at $2.5 Billion in 1999. Digital
cameras and smartphones gutted Kodak. The company filed for bankruptcy in Jan’2012. In Boardroom it
is often discussed how a company can become of its own success and complacency.)
• Internal Standard- It is greatly useful in evaluating an enterprise's performance. They are regularly revised
in light of changes in enterprise’s economic and business environment. ( e.g. Management reports,
budget, etc)
 Standards of Comparison and Horizontal Analysis

• Industry Standard: The performance of a company can be compared with that of other companies in the
industry. If a company’s margin is 7% compared to 12% of industry, we will say its operations are not as
profitable as some of its peers.
• Industry comparison can be problematic for the following reasons:
• Size and Products: HUL and ITC both are FMCG companies but there are variants. So comparison is not much
useful.
• Accounting Policies: Companies often follow different accounting policies. Inventory valuation methods, useful
estimates for assets, revenue recognitions practices differ across companies.
• Horizontal Analysis: Financial Statements present comparative information for at least two years. It
provides two broad info: Amount and Percentage of previous year to the current year.

2016 2015 Change%

Revenue 1,56,978 1,50,233 4.49
Other Income 2,693 2,741 (1.75)
Total Expenses (1,28,299) (1,23,978) 3.49
 Trend Analysis

• Trend Analysis: It takes into many years. It is an extension of horizontal analysis. Assign a value of 100 to
the Financial Statement items in past financial year used as the base year and then express the amounts in
the following years as percentage of the base- year value. Using 2013 as base year, calculate percentage
increase or decrease.
Year and Revenue % year growth and CAGR
2016- 1,56,978 156/118*100=132.20, 32.20%
2015-1,50,233 150/118*100=127.11, 27.11%
2014-1,34,153 134/118*100=113.55, 13.55%
2013-1,18,956 100 as base

• CAGR isn't the actual return in reality. It's an imaginary number that describes the rate at which an
investment would have grown if it grew at a steady rate. You can think of CAGR as a way to smooth out
the returns. (Use RRI function in Excel) ( CAGR= 9.68%)
 Vertical Analysis

• Amount in FS as a percentage of “ Statement Total “. So each component of FS is a percentage and

summation of each financial items is 100.
Particulars 2019 (%) 2018(%)
Asset
Plant& machinery 40 32
Building 10 10
Investment 15 13
Receivable 15 30
Bank 30 15
Total Asset 100 100
Liability
Capital 50 40
Long Term Loan 20 15
Current Liability 30 45
Total Liability 100 100
 Ratio Analysis

• Establishing a relevant financial relationship between components of financial statements. E.g. Two
companies may have the same amount of profits in a year but unless the profit is related to sales, we
cannot say which of them is more profitable.
• Financial ratios are used to evaluate Profitability, Liquidity, Solvency, and Capital Market Strength.
PROFITABILITY- Degree of operating success of a business. Investors finance a firm in the hope of the
getting a reasonable return in the form of capital gain and dividend. Following are the few ratios under this
categories-
• Profit Margin
• Asset Turnover
• Return on Assets
• Return on Equity
• Earning per Share
 Profitability Ratio

• Profit Ratio- Formula= Profit/Sales

Ratio 2016 2016 Ratio 2015 2015 Ratio
Profit Ratio 21,514/1,56,978 13.71% 23,364/1,50,233 15.55%

• It is a noisy figure. Why? Profit includes all non-operating and exceptional items . However, it provides a
fair view on profitability.
• Gross Profit= Gross Profit/Sales ( GP means after deducting all direct expenses from the Sales ) GP is
always more than Net Profit. It is generally used in Manufacturing unit.
• Asset Turnover-Net Sales/ (beginning Asset+ Closing Asset)/2 i.e Net Sales/Average Assets. It measure a
firm efficiency in utilizing its assets. If the ratio is high, we can infer that enterprise is managing its assets
efficiently. A low value implies idle assets. Manufacturing companies have less value whereas Service
sector has higher value.
• Sales in 2019= Rs. 250 Crore, Beginning Asset= Rs. 150, Closing Asset= Rs. 250 Crore.
• Sales in 2020= Rs. 350 Crore, Beginning Asset= Rs. 250 Crore, Closing Asset= Rs. 250 Crore
 Profitability Ratio and Liquidity Ratio

• Return on Investment( Return on Assets): It is an excellent indicator of a company’s overall performance.

(Formula-Profit/Average Asset).
• 2019: Profit Rs. 15 Crore, Beginning Asset= Rs. 150, Closing Asset= Rs. 250 Crore.
• 2020: Profit Rs. 20 Crore, Beginning Asset= Rs. 250 Crore, Closing Asset= Rs. 250 Crore.
• Return on Equity: It is an analysis from Shareholder’s point of view. Formula= Profit/Average Equity Share
capital [ i.e. Opening equity Share Capital+ Ending Share Capital)/2]
• 2019: Profit Rs. 15 Crore, Opening Equity Capital= Rs. 50 Crore, Closing Equity = Rs. 75
• 2020: Profit Rs 20 Crore, Opening Equity Capital= Rs. 75 Crore, Closing Equity Capital= Rs. 75 Crore.
Liquidity Ratio- Ability of business to meet its short-term obligation. A business should have enough current
asset which can be converted into cash so that it can pay its supplier and lenders on time.
• Current Ratio
• Quick Ratio
• Receivable and Inventory Turnover
 Liquidity Ratio

• Current Ratio- Current Asset to Current Liability. It shows the amount of current assets a company has per
RUPEE of current liabilities. More than 1 means, business is not going to be disrupted as current asset will
fetch at least the stated amounts.
• Current asset and current liabilities are those receivable or payable in normal operating cycle or within 12
months after the reporting period.
• Current Asset/ Current Liabilities= 2016- 118,201/68,368=1.73, 2015=118,767/68,213=1.74
• Quick Ratio- Current asset contains Cash to Sticky Inventories. Receivable can be converted into cash
with some effort. Inventories are two step away cash; Sale and Collection. Therefore, a large current ratio
by itself is not a satisfactory measures of liquidity when inventories constitute a major part of the
current asset. Quick or Acid Test Ratio is computed to supplement to current Ratio. In this ratio, current
asset minus inventories is Numerator with denominator same.
• Quick ratio= Current Asset- Inventories/ Current Liabilities=2016=92,402/68,368= 1.35,
2015=93,068/68,213=1.36
 Liquidity Ratio

• Receivable Turnover (RO): A company’s ability to collect promptly from its customers enhances its
liquidity. RO measures the efficiency of a firm’s credit policy and collection mechanism and shows
the number of times each year the receivable are turned into cash.
• RO=Net Sales/ Avg. Receivable . Avg. Receivable is Opening Receivable+Closing Receivable/2.
• 2016= 159,671/41,340=3.8 Times, 2015= 152,974/37,133=4.05 Times. Lower RO means weaker
management of receivable.
• Average Collection Period= No of days in a year (360)/ Receivable Turnover
• 2016= 360/3.8= 94.8 days, 2015= 37,133/4.05= 88.98 days. It is compared with company’s credit terms .
If credit period in general is 120 days, then it is good.
• Inventory Turnover(ITO): No of times a company’s inventories are turned into sales. Investment in
inventory is idle cash. The lower the inventory level, the greater the cash available for day-to-day
operating needs. Fast moving inventory runs a lower risk of obsolesces.
 Liquidity Ratio and Solvency Ratio

• Formula= Cost of goods sold/Inventories. ( often use Average Inventories)

• 2016= 62,427/25,749=2.42 Times,
• 2015=62,786/24,944=2.52 Times.
• Lower the ratio, less efficient inventory management. ( as denominator is more)
Solvency Ratio