FINANCIAL STATEMENTS

ANALYSIS
(LEARNING UNIT-2)

Lectured

By

Dr. Pawan Kumar Jha

Assistant Professor-Finance & Account
Kathmandu University School of Management1

(KUSOM)
 LECTURE OUTLINES
 Introduction

 Types of Financial Statements

 Financial Statement Analysis (FSA)

 Ratio Analysis-Classification of Accounting Ratios

 DuPont System of Analysis

 Window Dressing

 Implications and Limitations of Ratio Analysis

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 INTRODUCTION
 Company’s formal record of the financial activities
 Contain the basic financial information about revenues, expenses,
assets, liabilities, and cash flows during a specified period.
 Quantify the financial strength, performance, and liquidity
position of a company.
 Means of communicating economic information about the company
to individuals who want to make decisions and informed judgments
about the company’s financial position, results of operations, and
cash flows.
 Provide an input to the investors and general community of
investors to form expectations about the required return and
riskiness associated to the company’s financial affairs.
 The four main types of financial statements are: Income statement,
Statement of REs, B/S, and Statement of Cash flows 3
 1. INCOME STATEMENT (STATEMENT OF
OPERATION)
 Summary of the revenues and expenses of a business
 Summarizes the results of the company’s operating and financing
decisions during that time.
 Operating decisions of the company apply to production and
marketing such as sales/revenues, cost of goods sold, administrative,
and general expenses (advertising, office salaries).
 The results of financing decisions are reflected in the remainder of the
income statement.
 When interest expenses and taxes are subtracted from EBIT, the result
is net income available to shareholders.
 Note that net income does not necessarily equal actual cash flow from
operations and financing.
 Only those transactions that have an impact on revenue or expenses
will be included in the income statement. These same transactions will
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also have an impact on owner’s equity.

 2. STATEMENT OF RETAINED EARNINGS
 Summarizes the changes in the amount of retained earnings
(portion of net income left after distributing dividends among
shareholders) during a particular period of time.
 Useful for business growth and meeting debt obligation

 Increases when company earns net income and decreases when

company incurs net loss or declares dividends during the period.
 Retained earnings appears in the balance sheet as a component of
stockholders equity.
 Prepared after the preparation of income statement  but before the
preparation of balance sheet.
 The amount of retained earnings at the end of the period can be
found using the following formula/equation:
Retained earnings at the end = [Retained earnings at the 5
beginning + Net income – Dividends]
 3.THE BALANCE SHEET (FINANCIAL POSITION)
Assets- resources: Future economic value owned or controlled by the company.
 Current assets: Converted into cash, sold, or consumed within a year or less. These
assets again subdivided into two parts: liquid current assets and non-liquid current
assets.
 Fixed assets: Long-term assets that are basically held with the intention of being used
for the purpose of producing or providing goods or services and are not held for sale in
the normal course of business. These usually include:
- Tangible fixed assets: Have physical existence and can be seen and felt, and include
land, building, plant, equipment, and vehicles, etc.
- Intangible assets: No physical existence; rather they represent legal rights or
economic benefits. Trademarks, patents, franchises, copy right and goodwill are
examples of intangible assets.
- Fictitious assets: Assets which are represented in balance sheet that has no tangible
existence but represent actual cash expenditure. Examples: Preliminary expenses,
Promotional expenses of a business, Loss incurred on issue of shares or debentures
 Natural resources: These constitute a category by themselves because of their special
characteristics. Examples are oil and gas, mines and forests.
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 Investments: Short term and Long term
 3. THE BALANCE SHEET (FINANCIAL
POSITION) CONTI…
Liabilities: Present obligation of the enterprise
 Current and Long-Term Liabilities: Examples: Trade creditors, bills payable, bank
overdraft, unearned revenues and accrued expenses (outstanding expenses).
Debentures payable, long-term bank loans, lease rentals payable, and pensions
payable.
 Secured and Unsecured Liabilities: In the case of secured liabilities, specific assets
of the borrower are pledged, hypothecated or mortgaged as security. If the borrower
defaults, the creditors can sell the assets and use the proceeds to settle the dues.
Whereas unsecured liabilities are incurred based on the general credit standing of the
borrower since they are only backed by a legal claim against the general assets of the
borrower.
 Contingent Liabilities: The liabilities which are not the liabilities of the firm on the
date of the balance sheet but may become liabilities in the future on the happening of
an uncertain event are called contingent liabilities. If the event does not occur, no
liability is incurred. A bill discounted with a bank is a contingent liability, if the
acceptor fails to meet the bill amount
Shareholders’ Equity: Also referred to as net worth or capital, is normally divided into
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two major components:
 Contributed capital (i.e. common stock and paid-in capital excess of par) and
 4. STATEMENT OF CASH FLOWS
 
 A cash flow statement is a statement depicting change in cash
position from one period to another.
 It provides a summary of cash inflows and outflows from the
three main business activities:
- Operating Activities: Shows cash flows from operating
income (from income statement)
- Investing Activities: Shows cash flows to investments and
from sales of investments
- Financing Activities: Shows cash flows from borrowing
and sales of original equity issues and subsequent pay back of
loans, equity re-acquisitions, and dividends
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 WHY FINANCIAL ANALYSIS?

 Solvency Evaluation (Short-range and Long-range)

 Changes in Company Value (Owner’s net worth)

 Earnings and Quality of Earnings Trend

 Management Efficiency

 Utilization and Control of Organization Resources (Assets)

 Cash Generation Efficiency of Organization

 Risk Assessment

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 RATIO ANALYSIS
 The term ratio refers to the numerical or quantitative relationship between two
items/variables.
 The analysis of the financial statements and interpretations of financial results
of a particular period of operations with the help of 'ratio' is termed as "ratio
analysis."
 Ratio analysis used to determine the financial soundness of a business concern.
Alexander Wall designed a system of ratio analysis and presented it in useful
form in the year 1909.
 It is defined as the systematic use of ratio to interpret the financial statements
so that the strengths and weaknesses of a firm as well as its historical
performance and current financial condition can be determined.
CAUTION!
“Using ratios and percentages without considering the underlying causes may
be hazardous to your health!” lead to incorrect conclusions.”

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 CLASSIFICATION OF RATIOS
 Accounting Ratios are classified on the basis of the different
parties interested in making use of the ratios.
 A very large number of accounting ratios are used for the
purpose of determining the financial position of a concern for
different purposes.
 Ratios may be broadly classified in to:

1. Classification of Ratios on the basis of Income Statement

2. Classification of Ratios on the basis of Balance Sheet.
3. Classification of Ratios on the basis of Mixed Statement (or)
Balance Sheet and Income Statement.

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 CLASSIFICATION OF RATIOS

This classification further grouped in to:

A. Short-Term Solvency or Liquidity ratios;

B. Asset Management or Turnover ratios;
C. Profitability ratios;
D. Debt or Financial Leverage ratios; and
E. Market or Valuation ratios

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 (1) LIQUIDITY RATIOS
 The liquidity of a firm is measured by its ability to satisfy its
short-term obligations as they come due. Liquidity refers to the
solvency of the firm’s overall financial position-the ease with
which it pay its bills.
 A liquidity ratio is a ratio that shows the relationship of a firm’s
cash and other current assets to its current liabilities. The two
basic measures of liquidity are the current ratio and the quick
(acid-test) ratio.
 The current ratio (CR) is found by dividing current assets by
current liabilities. It indicates the extent to which current
liabilities are covered by those assets expected to be converted
to cash in the near future.
 The quick is found by taking current assets less inventories and
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then dividing by current liabilities.
 (2) ASSET MANAGEMENT RATIOS
 Asset management ratios are a set of ratios which measure how effectively a
firm is managing its assets.
 The inventory turnover ratio (ITOR) is sales divided by inventories. The
receivable turnover ratio (RTOR) measures how many times a company
converts its receivables into cash each year.
 Whereas Days sales outstanding (DSO) is used to appraise accounts
receivable and indicates the length of time the firm must wait after making a
sale before receiving cash. It is found by dividing receivables by average
sales per day.
 The fixed assets turnover ratio (FATOR) measures how effectively the firm
uses its plant and equipment. It is the ratio of sales to net fixed assets.
 Total assets turnover ratio (TATOR) measures the turnover of all the firm’s
assets; it is calculated by dividing sales by total assets.

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 (3) FINANCIAL LEVERAGE RATIOS
These ratios measure the use of debt financing. The commonly used financial
leverage include:
 The debt ratio (DR) is the ratio of total debt to total assets, it measures the
percentage of funds provided by creditors.
 Equity multiplier (EM)  is the ratio that measures the amount of a firm's
assets that are financed by its shareholders by comparing total assets with
total shareholder's equity. In other words, the equity multiplier shows the
percentage of assets that are financed or owed by the shareholders.
 The times-interest-earned ratio (TIER) is determined by dividing earnings
before interest and taxes by the interest charges. This ratio measures the
extent to which operating income can decline before the firm is unable to
meet its annual interest costs.
 Cash coverage ratio-A problem with the TIE is that it is based on EBIT,
which is not really a measure cash available to pay interest. The reason is
that depreciation and amortization, noncash expenses, have been deducted15
out. It is the ratio of EBIT + (Dep. & Amortization)/Interest.
 (4) PROFITABILITY RATIOS
 Profitability ratios are a group of ratios which show the
combined effects of liquidity, asset management, and debt on
operations.
 The profit margin on sales, calculated by dividing net income by
sales, gives the profit per rupee of sales.
 Basic earning power is calculated by dividing EBIT by total
assets. This ratio shows the raw earning power of the firm’s
assets, before the influence of taxes and leverage.
 Return on total assets (ROA) is the ratio of net income to total
assets. Return on common equity is found by dividing net income
into common equity.
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 (5) MARKET VALUE RATIOS
 Market value ratios relate the firm’s stock price to its earnings
and book value per share.
 The price/earnings (P/E) ratio is calculated by dividing price per
share by earnings per share. This shows how much investors are
willing to pay per rupee of reported profits.
 The price/cash flow is calculated by dividing price per share by
cash flow per share. This shows how much investors are willing
to pay per rupee of cash flow.
 Market-to-book ratio is simply the market price per share divided
by the book value per share.
 Book value per share (BVPS) is common equity divided by the
number of shares outstanding.
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DUPONT SYSTEM FOR FINANCIAL ANALYSIS

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 DUPONT SYSTEM
 Developed in 1919 by a finance executive at E.I. du Pont de
Nemours and Co.
 The Du Pont chart is a chart designed to show the relationships
among return on investment, asset turnover, the profit margin,
and leverage.
 The Du Pont equation is a formula which shows that the rate of
return on assets can be found as the product of the profit margin
times the total assets turnover.
 This method of analysis is used to analyze the firm’s financial
statements and to assess its financial conditions.
 It merges the income statement and balance sheet into two
summary measures of profitability: Return on Total Assets
(ROA) and Return on Common Equity (ROE). 19
 DUPONT SYSTEM – WHAT IS IT?
The system identifies profitability as being impacted by three
different levers:

1. Earnings & efficiency in earnings Earnings

2. Ability of your assets to be turned into profits Turnings
3. Financial leverage Leverage

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 DUPONT SYSTEM

Earnings/Efficiency
Operating
Profit Margin
Return On
Income X = Assets (less
Stream interest adj.)
Asset
Turnover Return On
X =
Equity
Turnings/Asset Use

Financial
Investment
Structure
Stream 21
Leverage
 DUPONT SYSTEM RATIOS

Earnings R
OP M
Operating
Profit Margin A
RO
Return On RO
Income X = Assets (less
Stream interest adj.)
O ROE
R
Asset ATO
Turnover Return On
X =
Equity
Turnings

E quity et
/ T o tal To Ass
s
sset e Debt
l A
Tota from th D:A)
Financial r i v ed a t i o(
Investment
Structure De R
Stream 22
Leverage
 DU PONT SYSTEM OF ANALYSIS-FORMULA

 DuPont Formula:
ROE = ROA × Equity multiplier (EM)
Where, ROA = Net profit margin × Total asset turnover
= EAT/ Sales × Sales / Total assets = EAT ÷ Total assets
EM = 1/(1-Debt ratio) = 1/ Equity ratio = 1 ÷ Total common
equity/Total assets = Total assets ÷ Total common equity

 Extended DuPont equation is written as under:

ROE = ROA×EM = Net profit margin × Total assets turnover ×
EM

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 WINDOW DRESSING
 Window dressing is a technique employed by firms to make their
financial statements look better than they really are.
 Seasonal factors can distort ratio analysis. At certain times of the
year a firm may have excessive inventories in preparation of a
“season” of high demand.
 Therefore, an inventory turnover ratio taken at this time as
opposed to after the season will be radically distorted.

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 SUMMARY OF FINANCIAL RATIOS
Liquidity Debt Ratios Activity Ratios Profitability Market Ratios
Ratios Ratios
•CR = •DR = TD/TA •ITOR= COGS/Av. •GPM=GP/S •PER=MPS/EPS
CA/CL Inventory
•QR = •DE = TD/SHE •TATOR= S/TA •OPM=EBIT/S •Market to Book
QA/CL Value
Ratio=MPS/BV
PS
•LTD/SHE •DTOR=CS/AD •NPM=EAT/S •EY=EPS/MPS
•TIER or ICR = EBIT/I •ACP = AR/ADS •EPS=(EAT- •DPS/MPS
Note: PD)/Total # of
Cash Coverage Ratio= Shares
(EBIT+Dep.)/I Outstanding

FCCR=(EBIT+LP)/ •APP=AP/ADP •ROA/TA

(I+LP)+
{([PP+Pref.stock div.)×
[1/ (1-T)]}
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•FATOR=S/NFA •ROE=EAS/SHE
 ADVANTAGES OF RATIO ANALYSIS
The following are the advantages of ratio analysis:
(1) It facilitates the accounting information to be summarized and
simplified in a required form.
(2) It highlights the inter-relationship between the facts and figures
of various segments of business.
(3) Ratio analysis helps to remove all type of wastages and
inefficiencies.
(4) It provides necessary information to the management to take
prompt decision relating to business.
(5) It helps to the management for effectively discharge its functions
such as planning, organizing, controlling, directing and
forecasting.
6)Ratio analysis reveals profitable and unprofitable activities. Thus,
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the management is able to concentrate on unprofitable activities
and consider to improve the efficiency.
 ADVANTAGES OF RATIO ANALYSIS CONTI…
(7) Ratio analysis is used as a measuring rod for effective control of
performance of business activities.
(8) Ratios are an effective means of communication and informing about
financial soundness made by the business concern to the proprietors,
investors, creditors and other parties.
(9) Ratio analysis is an effective tool which is used for measuring the
operating results of the enterprises.
(10) It facilitates control over the operation as well as resources of the
business.
(11) Effective co-operation can be achieved through ratio analysis.
(12) Ratio analysis provides all assistance to the management to fix
responsibilities.
(13) Ratio analysis helps to determine the performance of liquidity,
profitability and solvency position of the business concern.
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 LIMITATIONS OF RATIO ANALYSIS
 Ratio analysis is one of the important techniques of
determining the performance of financial strength and
weakness of a firm.
 Though ratio analysis is relevant and useful technique for the
business concern, the analysis is based on the information
available in the financial statements.
 There are some situations, where ratios are misused, it may
lead the management to wrong direction.
 The ratio analysis suffers from the following limitations:
 Ratio analysis is used on the basis of financial statements. Number
of limitations of financial statements may affect the accuracy or
quality of ratio analysis.
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 LIMITATIONS OF RATIO ANALYSIS CONTI…
 Ratio analysis heavily depends on quantitative facts and figures
and it ignores qualitative data. Therefore this may limit
accuracy.
 Ratio analysis is a poor measure of a firm's performance due to
lack of adequate standards laid for ideal ratios.
 It is not a substitute for analysis of financial statements. It is
merely used as a tool for measuring the performance of
business activities.
 Ratio analysis clearly has some latitude for window dressing.

 It makes comparison of ratios between companies which is

questionable due to differences in methods of accounting
operation and financing.
 Ratio analysis does not consider the change in price level, as 29

such, these ratio will not help in drawing meaningful

Thank You

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