Interpretation of Financial Statements

Limitations of Financial Statements (P&L A/C and B/S)

Technical
As on date
Static

Rationale

Techniques
1. Common Size Statements
2.Comparative Statements
3.Trend Percentages
4.Ratio Analysis
5.Funds Flow Analysis
1
Rationale

Sr. Description “A” “B”

1 Sales 2,00,000 50,000

2
Rationale

Which of the two firms is performing better?

Sr. Description “A” “B”

1 Sales 2,00,000 50,000

2 Profit 20,000 6,000

3
Rationale

Which of the two firms is performing better – Any change in

your decision?

Sr. Description “A” “B”

1 Sales 2,00,000 50,000

2 Profit 20,000 6,000

3 Assets 50,000 5,000

4
Rationale

Which of the two firms is performing better – Any change in

your decision?

Sr. Description “A” “B”

1 Sales 2,00,000 50,000

2 Profit 20,000 6,000

3 Assets 50,000 5,000

4 Liabilities 25,000 3,000

5
 Techniques of financial statement Analysis

1. Common Size Statements – bring all figures to a common parameter

Sr. Details A   B
01 Sales 1,10,000 %   1,70,000 %
02 Sales Return 10,000 0.10  25,000 0.17
03 Net Sales 1,00,000 100  1,45,000 100
04 Purchases 60,000 60.00  80,000 55.17
05 Wages 5,000 5.00  15,000 10.34
06 Fuel 3,000 3.00  6,000 4.14
07 Factory Expenses 7,000 7.00  9,000 6.21
08 Office Expenses 2,000 2.00  4,000 2.76
09 Salaries 5,000 5.00  7,500 5.17
10 Rent 6,000 6.00  6,000 4.14
11 Interest 1,000 1.00  1,350 0.93
12 Misc Expenses 1,000 1.00  1,650 1.14
13 Total Expenses 90,000  90  1,30,500 90
14 Net Profit 10,000 10.00  14,500 10.00
6
Techniques of financial statement Analysis
2. Comparative Statement – Compare one firm with another

Sr. Details ABC   XYZ

01 Sales 2,30,000 %   4,50,000 %
02 Sales Return 30,000 0.15  40,000 0.10
03 Net Sales 2,00,000 100  4,10,000 100
04 Purchases 1,00,000 50.00  2,80,000 68.29
05 Wages 7,000 3.50  21,000 5.12
06 Fuel 5,000 2.50  10,000 2.44
07 Factory Expenses 12,000 6.00  18,000 4.39
08 Office Expenses 5,000 2.50  7,000 1.71
09 Salaries 8,000 4.00  13,000 3.17
10 Rent 15,000 7.50  15,000 3.66
11 Interest 4,000 2.00  2,500 0.61
12 Misc Expenses 10,000 5.00  11,000 2.68
13 Total Expenses 1,66,000 83.00  3,77,500 92.07
14 Net Profit 34,000 17.00  32,500 7.93
7
TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

3. TREND PERCENTAGES

 Refer to Page no. 78 of teaching material

uploaded on webpage

8
  

This data will be used for illustration of Ratios

 
  Sr Description Amount Remarks
1 Cash in hand 10,000  
2 Bank balance 15,000  
3 Book debt 25,000  
4 Investment (short term) 5,000  
5 Total Liquid Assets 55,000  1 to 4
6 Material and supplies 30,000  
7 Pre-paid Expenses 5,000  
8 Non-liquid Assets 35,000 6 and 7
9 Total Current Assets 90,000 5 and 8
10 Bills Payable 15,000  
11 Sundry Creditors 20,000  
12 Outstanding Expenses 5,000  
13 Dividend Declared 10,000  
14 Total Current Liabilities 50,000 10 to 13
15 Net Current Assets (NWC) 40,000 9 minus 14
16 Building 100,000  
17 Vehicles 50,000  
18 Equipments 100,000  
19 Furniture 50,000  
20 Total Fixed Assets 300,000 16 to 19
21 Capital Employed 260,000 15 and 20
22 Loans 250,000  
23 Shareholders' Funds 510,000 21 and 22
Represented by
24 Equity Share Capital 310,000  
25 Preference Share Capital 150,000  
26 Reserve & Surplus 50,000  
27 Total 510,000  24 to 26
Techniques of financial statement Analysis
4. Ratio Analysis
4.1 Meaning
4.2 Types of Ratios
4.2.1 Liquidity Ratios
4.2.1.a Current Ratio
4.2.1.b Quick Ratio
4.2.1.c Defensive Interval Ratio
4.2.1.d Debt Service Coverage Ratio
4.2.2 Activity Ratios
4.2.2.a Inventory Turnover
4.2.2.b Inventory Holding Period
4.2.2.c Debtors Turnover
4.2.2.d Average Debt Collection Period
4.2.2.e Creditors Turnover
4.2.2.f Average Creditors Payement Period
4.2.2.g Net Operating Cycle
4.2.2.h Fixed Assets Turnover 10
Techniques of financial statement Analysis
4.2.3 Profitablity Ratios
4.2.3.a Gross Profit Ratio / Margin
4.2.3.b Net Profit Ratio / Margin
4.2.3.c Investment Turnover
4.2.3.d Return on Investment (ROI)
4.2.3.e EPS
4.2.3.f DPS
4.2.3.g Retention Ratio
4.2.3.h Price Earning Ratio

4.2.4 Capital Structure Ratios

4.2.4.a Debt Equity Ratio
4.2.4.b Total Debt to Equity Ratio
4.2.4.c Financial Leverage Analysis

11
 COMMON SIZE STATEMENT

Details Firm A Firm B

Sales 100000 100 140000 100
Purchases 60000 60 950000 67.86
 
Wages 10000 10 12000 8.57
Rent 10000 10 15000 10.71
NP 20000 20 18000 12.86
1.1 CURRENT RATIO

Meaning:
Calculations: CA / CL
If CA are 2,000 and CL 10,000 ratio = 2:1
Standard: usually 2:1
Decision and Comments

Ratios Firm A Firm B Firm C

CR 2:1 3:1 4:1
1.2 ACID TEST RATIO

Meaning:
Calculations: (CA-Stock) / CL
If CA are 2,000, stock is 5,000 and CL 10,000 ratio = 1.5:1
Standard: usually 1:1
Decision and Comments; Which one is better

Ratios Firm A Firm B Firm C

CR 2:1 3:1 4:1

Acid Test Ratio 3:1 2:1 3:1

2.1 INVENTORY TURNOVER AND 2.2 INVENTORY HOLDING PERIOD

Meaning of 2.1 Inventory Turnover

Calculations: Credit Sales / Average Inventory
If Credit Sales = 1,00,000, Opening and Closing
Inventories are 10,000 and 30,000, Inv TO =
1,00,000/20K = 5 times
2.2 Inv Holding Period
360 / Inv Turnover
In this case IHP = 360 / 5 = 72 days
Interpretation:??
2.3 DEBTORS TURNOVER AND 2.4 AVG DEBT COLLECTION PERIOD

2.3 Meaning of Debtors Turnover

Calculations: Credit Sales / Average Debtors
If Credit Sales = 3,00,000, Opening and Closing Debtors
are 10,000 and 20,000, Debtors TO = 3,00,000/15000 =
20 times
2.2 Inv Debt Collection Period
360 / Debtors Turnover
In this case ADCP = 360 / 20 = 18 days
Interpretation:??
2.5 CREDITORS TURNOVER AND 2.6 AVG CREDITORS PAYMENT
PERIOD

2.5 Meaning of Creditors Turnover

Calculations: Credit Purchases / Average Creditors
If Credit Purchases = 1,00,000, Opening and Closing
Creditors are 15,000 and 25 ,000, Creditors TO =
1,00,000/20,000 = 5 times
2.2 Avg Creditors Payment Period
360 / ACPP
In this case ACPP = 360 / 5 = 72 days
Interpretation:??
OVER ALL ANALYSIS

Ratios A B C

IHP 30 days 40 days 50 days

ADCP 50 days 40 days 30 days

ACPP 20 days 20 days 20 days

NOC
FA TURNOVER, PROFTABILITY RATIOS
 Sales divided by FA
 If this is 6 times, what is its interpretation?
 Profitability Ratios
 GP Margin / Net Profit Margin / Investment T.O. /
Return on Investment (ROI)
 EPS / DPS / Retention Ratio / PE Ratio

19
 ROI = 30%
ROI = NPM * Investment Turnover
NPM=NP/Sales ITO=Sales/Inv

NP=GP-IDE Inv 2000

NPM= 6 ITO 5

GP=Sales-DE 2000 NP=GP-IDE 600

Sales=Sales-Return Inv = FA=CA-CL

Sales 10000 DE IDE FA CA CL

Pur 4000 Rent 500 Buil 500 Cash 175 BOD 50

Wages 2000 Sal 300 Fur 400 Bank 150 Crs 25

Elec 1000 Dep 300 Mach 600 Inv 175 BP 25

Excise 1000 Advt 200 1500 Debt 100 Tot 100

Tot 8000 Misc 100 Total 600

Total 1400
20
 Financial Leverage - Effect of using more / less debt on EPS
Details Firm A Firm B Firm B – 2
1. Total Assets 1000 1000 1000
2. Equity 1000 500 200
3. Debt carrying 10% interest 00 500 800
4. ROA 20% 200 200 200
5. Less Interest 00 50 80
6. EAIBT 200 150 120
7. Less Taxes (50%) 100 75 60
8. EAIT 100 75 60
9. Nos of Shares 100 50 20
10. EPS 1.00 1.50 3.00
Observations: See next slide

21
 Financial Leverage - Effect of using more / less debt on EPS
Details Firm A Firm B Firm B – 2
1. Total Assets 1000 1000 1000
2. Equity 1000 500 200
3. Debt carrying 10% interest 00 500 800
4. ROA 20% 200 200 200
5.EPS 1.00 1.50 3.00
Observations
A. Difference between A and B?
B. Difference between B and B-2? 
C. Percent change in Debt from B to B – 2 and % change in EPS?
D. What will be EPS of B if Debt is 900 and equity is 100
E. Can firm ‘B’ continue increasing Debt and take it from 50% to 90%
F. Conditions in which firm should lower down or increase D/E Ratio
G. Any other observation???

22
 Financial Leverage - Effect of using more / less debt
Assets 1000 1000 1000 1000 1000 1000 1000 1000
1. Equity 800 700 600 500 400 300 200 100
2. Debt (10% interest) 200 300 400 500 600 700 800 900
3. Debt - Equity Ratio 1:4 3:7 2:3 1:1 3:2 7:3 4:1 9:1
4. ROA 20% 200 200 200 200 200 200 200 200
5. Less Interest 20 30 40 50 60 70 80 90
6. EAIBT 180 170 160 150 140 130 120 110
7. Less Taxes 90 85 80 75 70 65 60 55
8. EAIT 90 85 80 75 70 65 60 55
9. Nos of Shares 80 70 60 50 40 30 20 10
10. EPS 1.125 1.214 1.333 1.500 1.750 2.167 3.000 5.500
11. % increase in Debt   50.00 33.33 25.00 20.00 16.67 14.29 12.5
12. Trend in % increase     16.67 8.33 5.00 3.33 2.38 1.79
13. % increase in EPS   7.9365 9.8039 12.5 16.667 23.81 38.462 83.333
14. Trend in increase in EPS  1.87 2.69 4.17 7.14 14.65 44.87
Observations: At 10% debt, EPS is 1.125, at 50% debt EPS is 1.50 and at 90% it is 5.50
Can a firm afford to increase to this level? What can be maximum limit?
23