ACCOUNTING AS A TOOL FOR BUSINESS DECISION MAKING

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A. R. Suriya & Co.
Chartered Accountants

requires

Quality Decision

Quality Data

INFORMATION DEPENDABILITY
For analysis we need data , so we to decide
A. R. Suriya & Co.
Chartered Accountants

1 What data is required? 2 Whether the decision maker is: 

inside user or
outside user?

Suriya & Co. R. Chartered Accountants External Users Shareholders Customers Bankers Tax authorities Internal Users Directors Operating Managers like marketing inventory 4 Internal Auditors .USERS INFORMATION A.

A. Chartered Accountants . financial condition and future prospects. R. Suriya & Co.DECISION MAKING FOR EXTERNAL USERS The external users have to depend on financial statements and annual report to judge operating efficiency.

Suriya & Co.DECISION MAKING FOR EXTERNAL USERS (2) • What are the usual steps for Decision Making ? Chartered Accountants A. R. .

Chartered Accountants DECISION MAKING FOR EXTERNAL USERS (3) . R.A. Suriya & Co.

Chartered Accountants • Before reaching to conclusion based on analysis we need to consider . Suriya & Co. R.DECISION MAKING FOR EXTERNAL USERS (4) • Before moving to Step A to B. A. we need another step i.e.

Chartered Accountants – – – – .HOW CAN ONE IMPROVE READING ABILITY AND UNDERSTANDING OF FINANCIAL INFORMATION ? • Understanding of the following helps the users of the financial statements to improve their reading ability and understanding of the financial information: – Concepts and assumptions for preparation of financial statements like Going Concern . Accrual etc Understanding of Generally Accepted Accounting Standards like IFRS and IAS Statuary requirements for preparation Terminologies used in Financial Statements Annual Report A. Suriya & Co. R.

ANALYSIS OF FINANCIAL STATEMENTS • Techniques to analyze – – – – Horizontal Vertical Analysis Common-size Financial Statements Ratio Analysis A. Chartered Accountants • Broad Categories of Financial Ratios – – – – – Liquidity Assets Efficiency Profitability Market ratios Capital Structure • Analysis of Cash flow Statements . Suriya & Co. R.

Suriya & Co. 11 . R. • Change in products‟ fashion etc.NON-FINANCIAL FACTORS AFFECTING ANALYSIS WHICH ARE NOT PART OF FINANCIAL STATEMENTS  Within Annual Report • Auditors‟ Report • Directors‟ Report Chartered Accountants A. • Currency devaluation.  Outside Annual Report • Government policy.

RELEVANT RATIOS FOR VARIOUS EXTERNAL USERS OF FINANCIAL STATEMENTS
• Creditors
– Liquidity – Profitability – Cash flow analysis
Chartered Accountants

 Employees
• Profitability growth

A. R. Suriya & Co.

 Shareholders
• • • • Dividend yield, Dividend payout , EPS Liquidity Cash Flow Analysis

• Banker
– – – – Debt Equity Interest Coverage Liquidity Profitability

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DECISION MAKING FOR INTERNAL USERS
Relevant ratios for various internal users
• Marketing & Sales Manager
A. R. Suriya & Co.
Chartered Accountants

– No of days in Account Receivable and Receivable turnover – Sales v/s Profit – Sales v/s Expenses

• Inventory Manager
– No of days in Inventory – Inventory turnover

• Production Manager
– Input v/s output ratio – cost of sales v/s sales

DECISION MAKING FOR INTERNAL USERS (2)
• Are these ratios and analysis based on financial statements enough for internal users?

A. R. Suriya & Co.

Chartered Accountants

Suriya & Co. R. Chartered Accountants THE ANSWER IS NO .DECISION MAKING FOR INTERNAL USERS (2) A.

One of interviews CFO of SEIMENS Mr observation is as follows: Heinz-Joachim whose “ACCOUNTING IS GOING TO BE LESS RELEVENT.” .Analysis of Financial Statements Cash Flow. BUT TO KEEP A COMPANY AFLOAT IN DIFFICULT TIMES . TREASURY AND CASH ARE THE IMPORTANT THINGS . NOT BOOK PROFIT.LATEST VIEWS by External and Internal Users OF CFO IN IFAC has published an article “THE ROLE 2010” .This contains interviews of for Business decision the leading CFOs of Making is of international companies.

ANALYSIS OF FINANCIAL STAEMENTS The word ANALYSIS is a noun and its verb is ANALYSE which means: “to examine in detail in order to discover meanings” .

ANALYSIS OF FINANCIAL STAEMENTS Analysis of financial statements is the process of:  arranging. 18 ..  manipulating and  comparing the results in order that users may make their decisions..

.ANALYSIS OF FINANCIAL STAEMENTS Analysis of financial statements help provide answers to questions concerning specific issues and insights into the operations of a business enterprise.

 weakness.  profitability etc.  emerging  problems.ANALYSIS OF FINANCIAL STATEMENTS Analysis of financial statements can help in learning about a company‟s strength. .  operating efficiency.

.ANALYSIS OF FINANCIAL STATEMENTS Business managers may require to do some analysis of financial data to take help for efficient decisions making.

ANALYSIS OF FINANCIAL STATEMENTS These analysis may include : • • • Cash flow statement review Liquidity review Efficiency of receivable and inventory management Profitability and Capital structure review. • • .

industry and organization.INTERPRETATION PROCESS • Identification of the recipient of the analysis. • Numerical analysis of the data available. • Writing the report detailing the analysis of the results and recommendations. • An understanding of the nature of the business. • Identification of sources of data for analysis. . • Interpretation of the results of the analysis.

MATERIAL NEEDED FOR ANALYSIS • Profit and loss account data for a number of years. • Data regarding a competitor. • Industry-wide ratios and benchmarks. or customer applying for credit . and variance analysis. • Balance sheet data for a number of years. • Budget data. potential subsidiary.

Benchmark for Comparison To help me interpret our financial statements. I use several standards of comparison.  Intracompany  Intercompany  Industry  Guidelines 25 .

Horizontal analysis (Trend % are a form of horizontal analysis) b. Ratio analysis . Vertical analysis (reveals the relationship of each statement item to a specified base) 2. Comparative financial statements: a.TECHNIQUES TO ANALYSE 1. Common-size financial statements (reports only in percentages.) 3.

Example of Vertical Analysis of P/L • • • • • • Sales Rs Cost of Goods Sold Gross Profit Administration Exp Marketing Expenses Financial Charges 1000 650 350 100 150 50 300 50 100% 65% 35% 10% 15% 5% 30% 5% • Net Profit .

Horizontal Analysis Now. let’s look at some ways to use horizontal analysis. Time The term horizontal analysis arises from left-to-right (or right-to-left) movement of our eyes as we review comparative financial statements across time. 28 .

000. It compares the financial data of a single company over several years. It is more useful to know that sales have increased by 20 percent than to know that the increase in sales is $20. 29 .Horizontal Analysis The study of percentage changes in comparative statements is called horizontal analysis.

Example – Horizontal Analysis of Balance Sheet An extract of balance sheet : Year „98 Fixed Assets 1000 Current Assets Stocks 350 Receivable 200 Cash at Bank 250 800 Total Assets 1800 Year „97 800 700 300 200 1200 2000 % Inc/Dec + 25% .25% -33% .10% 30 .33% .50% .

net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment.000 $ 23.200 $ 164.000 $ 155.700 31 .000 $ 289.CLOVER CORPORATION Comparative Balance Sheets 31-Dec 2004 Assets Current assets: Cash and equivalents Accounts receivable.000 1.000 60.000 $ 125.000 3.700 40.000 40.000 $ 160.000 80.000 100. net Total property and equipment Total assets 2003 Dollar Change Percent Change $ 12.000 $ 315.000 120.500 40.000 85.

Comparative Statements Calculate Change in amount Rupee Change = Analysis Period Amount – Base Period Amount Since we are measuring the amount of the change between 2003 and 2004. 32 . the Rupee amounts for 2003 become the “base” period amounts.

Comparative Statements Calculate Change as a Percent Percent Change = Rupee Change Base Period Amount × 100% 33 .

700 Rs(11.CLOVER CORPORATION Comparative Balance Sheets 31-Dec 2004 2003 Dollar Change Percent Change* Assets Current assets: Cash and equivalents $ 12.000 – Rs23.000 Total property and equipment $ 160.000 $ 289.500 ÷ Rs23.500 $ (11.000 Prepaid expenses 3.000 $ 23.700 * Percent rounded to first decimal point.9% 34 .000 100.9) 48.500) × 100% = Land 40.000 40.000 1.500) Accounts receivable.000 $ 125.500 = Total current assets $ 155.000 40. net 120.500) Property and equipment: (Rs11. net 60.000 85.000 Buildings and equipment.200 Rs12.000 Inventory 80.000 Total assets $ 315.000 $ 164. (48.

0 (5.000 $ 289.300 (48.0 (20.500 $ (11. net 120.000 Prepaid expenses 3.700 $ 25.CLOVER CORPORATION Comparative Balance Sheets 31-Dec 2004 Assets Current assets: Cash and equivalents $ 12.800 $ 164.700 $ (9.0 41.000 $ 125.000 Accounts receivable.000 (20.700) 40.0 8.000 Property and equipment: Land 40.500) 40.000 Total assets $ 315. net 60.000 35.000 Total property and equipment $ 160.9) 0.000 20.7 35 .200 1.000 Buildings and equipment.9) 50.2 28.000 * Percent rounded to first decimal point.000 Total current assets $ 155. 2003 Dollar Change Percent Change* $ 23.000) 1.000 85.000 $ 35.000 Inventory 80.000 100.0) 150.

And its comparison with industry in which it operates. The amount of each year expressed as a percent of the base amount. It is necessary to look at the trends. with each amount during that year set equal to 100 percent.timing or risk of the firm’s future out look. Trend percentages are computed by selecting a base year. generally 3 to 5 years’ to ascertain how the firm’s performance is changing over time and to diagnose trends that indicate the magnitude .TREND PERCENTAGES Trend % are a form of horizontal analysis. .

Common size statement
The percentages presented as a separate statement that reports only percentages (no rupee amounts). Such a statement, called a commonsize statement, is a type of vertical analysis. EXAMPLE Percent of Total Assets 19X7 19X6

Current assets : Cash ………………………………….. 3.7% 5.0% Accounts receivable, net …………….. 14.5 13.2 Inventories …………………………… 14.3 17.2 Prepaid expenses…………………. .8 1.2 Total current assets …………………... 33.3% 36.6% Investment advisory services report common-size statements for various industries, and analyst use them to compare a company with its competitors and with the industry average.

Case Study
Prepare Vertical, Horizontal analysis and common size statement for Profit and Loss account of any company

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Using key relations among financial statement items

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Why ratios ? • Figure appearing in Financial Statements normally does not convey any meaning unless its relation is seen with some other figure. • Example: Distribution cost may look too high or low but when it is compared with sales it will suggest some purposeful meanings and then this percentage is compared with industry trend. 40 .

Ratio Analysis • • A ratio can be computed from any pair of numbers. Previous ratios of the same company 2. Ratios are generally not significant of themselves but assume significance when they are compared with : 1. Ratios of other enterprises in the same industry or 4. Ratios of the whole industry within which the company operates . Some predetermined standard or budget 3.

42 .II • Ratios are not ends in themselves but help provide answers to questions concerning specific issues and insights into the operations of a business enterprise. They should be treated as additional evidence (not conclusive evidence) leading to a decision or solution. • Ratios be used with caution and should not be the sole basis for decision-making.Ratio Analysis ..

III • RATIO provide questions rather than the answers while they are tools which can help managers to make better financial decisions. they should form part of an overall business judgment based on many additional factors.Ratio Analysis . ..

Nothing could be further from the truth.The need to look beyond ratios An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgments about the future. . Conclusions based on ratio analysis must be regarded as tentative in nature.

The need to look beyond ratios Ratios should not be viewed as an end. In addition to ratios. as indicators of what to pursue in greater depth. but they rarely answer any questions by themselves. but rather they should be viewed as a starting point. They raise many questions. other sources of data should be analyzed in order to make judgments about the future of an organization. 45 .

at industry trends. and changes within the firm itself. A recent change in a key management position. might provide a basis for optimism about the future. changes in broad economic factors. changes in consumer tastes. .The need to look beyond ratios The analyst should look. for example. technological changes. even though the past performance of the firm (as shown by its ratios) may have been mediocre. for example.

competitors‟ manning levels.The need to look beyond ratios • Market size and growth. economic forecasts for the industry as a whole and relevant financial analysis and press reports. possibility of substitution of other products. wage rates and productivity the extent of spare capacity in the industry. and industry prospects. . • Competitors‟ shares of the market.

The application of accounting principles and policies varies among companies.Limitation of Ratio Analysis 1. Ratios reflect past conditions (not future) 2. Ratios reflect book values. 5. Inter company comparisons are difficult when companies are diversified or have different risk characteristics. 3. . The computation of ratios is not completely standardized. not current cost or realizable value. 4.

Ratios 1. Please refer page 71 to 74 for the master list of ratios 2 And page 128 and 129 for the live example of FFCL ratios and page 20 of Siemens .

Ratios Categories – Liquidity – Assets Efficiency – Profitability – Market ratios – Capital Structure .

.Liquidity Ratios • It reflect short term financial strength or solvency • Liquidity implies an ability to convert assets its cash or to obtain cash.

and their evaluation through ratio is useful in knowing certain trends and relationships involving various aspects of the operating cycle of a business .Liquidity Ratios • Liquidity and certain areas of operating activity are dependent upon the working capital position .

.Liquidity Ratios • Working capital – is the excess of current assets over current liabilities – the amount of and changes in working capital from period to period are significant measures of a company’s ability to pay its debts as they mature.

000 This ratio measures the short-term debt-paying ability of the company.55 : 1 Ratio Rs42.Current Ratio Current Current Assets = Ratio Current Liabilities Current Rs65.000 = = 1. 54 .

not from selling fixed assets.Liquidity Ratios . • A rule of thumb suggests that 2:1 ratio is satisfactory. • An excessively high current ratio could suggest that the company is not managing its current assets like Debtors and Inventory properly. • A very low current ratio is an indication of cash flow problems. II CURRENT RATIO or WORKING CAPITAL RATIO • It express the relative relationships between current assets and current liabilities. • FORMULA: Current ratio = Current assets Current liabilities • Current Liability is paid from current assets .. but minimum it should be 1:1 .

56 . and Current Receivables. Acid-Test = Rs50. Short-Term Investments.Acid-Test Ratio Quick Assets Acid-Test = Current Liabilities Ratio Quick assets are Cash.000 = 1.19 : 1 Rs42.000 Ratio This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash.

. Marketable Securities and Accounts Receivables • Inventories and prepaid expenses are not considered quick assets because they may not be easily convertible into cash .But if we look at our culture .Liquidity Ratios . Bank balances. • A rule of thumb for the quick ratio is suggested as 1:1 . III ACID – TEST RATIO or QUICK RATIO • Formula: Acid – test ratio = Quick Assets Current Liabilities • It is a quick measure of the debt paying ability • Quick assets = Cash.debtors are less liquid then stocks.

IV CASH RATIO OR SUPER QUICK RATIO • It is a more severe test of liquidity than acid test ratio • Formula: Cash Ratio = Cash + marketable Securities Current Liabilities ..Liquidity Ratios .

V WORKING CAPITAL TURNOVER • Working capital has special relationship to sales. • Working capital turnover = Net sales Average working Capital . and cash.Liquidity Ratios .. inventory. • The ratio of sales to working capital can be used as a measure of the effectiveness of a company‟s use of working capital to generate sales. especially through accounts receivable.

Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios

• It is concerned with measuring the efficiency in current assets management • It is used to evaluate a company‟s operating cycle

Efficiency Ratios

Days’ Sales Uncollected Accounts Receivable Turnover Inventory Turnover Total Asset Turnover

Days’ Sales in Inventory

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Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios
INVENTORY RATIOS • It indicates the number of times inventory is replaced during the year or how quickly the goods are sold • It is a test of efficient inventory management. • The inventory turnover ratio establishes the relationship between the volume of goods sold and inventory. • The inventory turnover for business in different industries and within industries can vary widely. A grocery store may have an average turnover of 20, for all items. A furniture store would normally have a much smaller turnover. • Formula: Inventory turnover = Cost of goods sold Average inventory

storing. Less opportunity for the inventory to become obsolete 5. 4. receiving. Saving in storage cost and financial charges DISADVANTAGES an excessive high inventory turnover may suggest that the company is not keeping sufficient inventory to meet sales requirements resulting in stock outs and unhappy customers.Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios BENIFITS OF HIGH INVENTORY TURNOVER 1. The operating cycle (converting inventory to cash )is shortened. . Investment in inventory is reduced 3. Operating effectively as far as inventory is concerned (purchasing. selling) 2.

Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios 1. LOW INVENTORY TURNOVER INDICATES : Slow Sales High carrying cost for Inventory Weak cash flow prospects Exposure to future financing problems . 2. 3. 4.

. • How many no of days inventory is to be kept depends on lead time to order & management policy for inventory investment.Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios NO OF DAY IN INVENTORY • Formula = No of days in a year Inventory turnover • This ratio may be useful to assess: (i) future expiry of inventories and (ii) stock out position.

.Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios INPUT – OUT PUT RATIO • Technique to evaluate yield • In a manufacturing concern standard yield is compared with actual Input-Output ratio • Example : sugar and pharmaceutical industry.

• Turnover refers to how often the average receivables were collected during the period. • Formula: Accounts Receivable turnover = Net credit sales Average accounts receivable .Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios ACCOUNTS RECEIVABLE RATIOS • The accounts receivable turnover ratio expresses the relationship between credit sales and accounts receivable.

it reflects that demand of the company‟s product and services is good. . credit policy etc. Naturally if the products or services are not up to mark then it will effect all viz sales . collection .Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios HIGH ACCOUNTS RECEIVABLE TURNOVER RATIO reflects that the receivable are being : • • • • • Effectively managed Fewer resources are invested in receivables Better credit policies Better collection practices Last but not least.

Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios NO OF DAYS’ SALES IN RECEIVABLES • Formula: Collection period = Days in a year Accounts Receivable Turnover • Number of days sales is compared with Company‟s credit term and industry‟s normal credit terms. • It also help in knowing age of receivables (which helps in credit control and avoid bad debts ) .

• Its comparison with other company in the same industry provides meaningful data is to how efficiently the management using the assets to generate sales. • Formula : Assets Turnover = Sales Average total assets . • The higher ratio indicates that the assets are more effectively used to generate sales .Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios ASSETS TURNOVER • It indicates how efficiently assets are used to achieve sales.

. it could mean that trade credit is being used increasingly as a source of funds.Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios • Formula Payables to Purchases A/c Payable Purchases Average day’s purchase = Purchases Days Day’s purchases in payables = A/Cs Payable average day’s purchases = • The day’s payable ratio is useful when compared to the credit terms given by suppliers. If the average day’s payables is increasing.

No of days purchases in creditors • Operating cycle indicates no of days the Company‟s cash is tied up in inventory & receivables • A Company with a short operating cycle typically requires only a small amount of working capital • It helps in assessing working capital requirements .Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios OPERATING CYCLE OF A BUSINESS • Formula = No of days Sales in receivable + No of days in Company‟s inventory .

as there may be many other ratios depending upon the need of the company.Assets Management Ratios Activity / Turnover / Efficiency/Performance Ratios Ratio Sales/number of calls Travel expense/days Selling expenses/sales Sales/sales orders Number of calls/days To Analyze Response per call Cost awareness Response per selling effort Sales efficiency Sales effort These ratios are useful in developing trend information and an overall picture of the company’s sales efforts We can see the relation of sales with various expenses and other marketing activities. .

Profitability Profit Margin Basic Earnings per Share Book Value per Common Share Return on Common Shareholders’ Equity Gross Margin Return on Total Assets 74 .

capital Employed. .Profitability • Profitability is the ability of the Company to generate earnings • Concerned Person – Shareholder • Dividend • Rise in Stock Market & avail Capital Gain – Creditors/Bankers • Profits are source of funds for debt • Coverage & repayment on due dates • Absolute profit figures are meaningful when it is measured with sales. Productive assets • Profitability ratios have been developed to measure operational performance.

2 = Gross Profit Net sales • GP ratio is important for Tax Authorities and also for management of the company to know the efficiency of sales and cost pricing .Profit Margin on Sales Formula-1 = Net income Net sales • This ratio reflect the ability of the Company to control costs and expenses in relation to sales Formula.

Return on Total Assets Return on = Net Income Total Assets Average Total Assets This ratio is indicates how company’s resources were used in generating profits 77 .

78 .Return on Shareholders‟ Equity Return on Common Shareholders’ = Equity Net Income .Preferred Dividends Average Common Shareholders’ Equity This measure indicates how well the company employed the owners’ investments to earn income.

79 . • This ratio emphasizes the income yield in relationship to the amount invested.Return on Stockholders‟ Equity • Return on stockholders‟ equity indicates management‟s success or failure at maximizing the return to stockholders based on their investment in the company.

80 .Preferred Dividends = per Weighted-Average Common Share Shares Outstanding EPS is disclosed below the P/L A/c This measure indicates how much income was earned for each share of common shares outstanding.Basic Earnings per Share Basic Earnings Net Income .

Total assets 2. Return on investment can be computed on the following bases: 1.Return on Investments • Many analysts Consider return on investment (ROI) one of the most important ratios for evaluating profitability because it relates earnings to investment. Comprehensive basis . Shareholders‟ equity 3.

Return on Investment • Formula : • ROI = = Capital Turnover x Profit Margin Sales x Capital employed Net income Sales • It is a comprehensive measure of financial performance .

Activity / Turnover / Efficiency Ratios .000 $300.V Condensed Income Statement Sales Less: Costs and expenses Net income Balance Sheet Working capital Plant and equipment Total assets (Capital employed) Capital Turnover (Sales / Capital employed) Profit Margin (Net Income / Sales) ROI (Capital Turnover x Profit Margin) $100.000 $800.000..000 $200.000 .000 $400.000 250% 20% 50% $1.

Capital Employed Turnover • Capital turnover is the ratio of sales to capital employed in generating the sales • Capital turnover is a measure of the use of assets in relation to sales • Capital employed can be either – Working Capital – Total assets .

Investment Turnover Ratio / Assets Turnover Ratio Formula Assets • This ratio also measures the effectiveness with which management used available resources in relation to sales = Net Sales Average Total .

6. 4. Provides a basis for comparing companies. Provides a motivational basis for management. Serves as a measure of management‟s efficiency and effectiveness. Integrates financial planning. budgeting. 2. Focuses management‟s attention upon earning the best return on total assets. . 5. 3. and profit-making activities.Advantages of ROI Analyses 1. Identifies weaknesses in the utilization of assets. sales objectives. cost control.

MARKET RATIOS Price Earning Ratios (P/E) • P/E is often referred to as the Market Capitalization ratio. • P/E reflects to some extent the growth potential of a company and the market‟s evaluation of the firms‟ earning. • P/E is used to measure the relationship between the market value of shares and earnings. . • P/E ratio express what the market is willing to pay for every single rupee • P/E increasing ratio is generally considered a favorable growth indicator Formula : MV of Ordinary Shares EPS • For buying shares the PE ratio differs from company to company and market situation.

Dividend per Share It reflects the dividend distributed per share Formula = Dividend No Ordinary Shares .

Dividend Yield It is a measure to calculate total return Formula = Dividend per share M/V of Ordinary Shares .

Dividend Payout Ratio • It indicates the income available to Ordinary Shareholders that has been distributed as dividend. Formula-1 = Cash Dividend Net Income – Preference Shares‟ Dividend Formula 2 = Dividend on Ordinary Shares EPS . • It reflects the dividend policy and to some extent management‟s perceptions regarding the uncertainties associated with future earnings.

Trend analysis is particularly useful in identifying areas of strength or weakness. The ratio of selling. 2.Other Analyses 1. . any significant fluctuations in the trend should be investigated The ratio of advertising to sales is especially useful in evaluating consumer-oriented enterprises. 3. Additional ratios are available to evaluate specific areas of profitability related factors. 4. general. Inter-company and industry comparisons are especially relevant in such situations. and administrative expense to sales provides some information concerning the effectiveness of cost control efforts undertaken by the company as well as management‟s efficiency of managing operating expenses in relationship to changing sales volumes.

thus eliminating the impact of price changes. Operating profit per unit of capacity or service.Other Analyses 5. 6. Productivity ratios attempt to measure both output and input in physical volumes. indicates the profitability of available physical resources and compares operations of different sizes. Productivity ratios are usually set up as follows: Output (physical goods or services quantified) Input (direct labor hours or machine hours) . such as per room for hotels or per bed for hospitals.

• Equity capital is risk capital.Capital Structure and Insolvency Ratio • The capital structure of an enterprise consists of debt an equity funds. and the return on investment to invertors is subject to many uncertainties. • In general. • Companies with only common stock capitalization can be attractive to both investors and creditors because there are no prior claims ahead of the common. usually with interest. a firm should not have a heavy amount of long-term debt and preferred stock in relation to common stock and retained earnings. • The sources and composition of the two of capital determine to a considerable extent the financial stability and long –term solvency of the firm. • Debt is paid is paid on a specified date. • There is no ideal capital structure common to all firms. .

CAPITAL STRUCTURE RATIO Equity to Total Liabilities • The relationship of equity to total liabilities is an important measure of capital structure of a business. the cost of carrying debt is reduced. and the company should be able to meet its obligations more easily. Formula Equity to total liabilities = Shareholders‟ equity Total liabilities . • The enterprise is less vulnerable to declines in business or the economy.

Debt to Equity Ratio • This ratio measures the amount of leverage used by a company. • This ratio is an indicator of creditors‟ risk. • A highly leveraged company involves a substantial use of debt and a limited use of equity. • It measures the number of times the shareholders capital has been leveraged by the use of debt. Formula Debt to equity ratio = Total liabilities Shareholders‟ equity .

On the other hand. because the shareholders would be viewed as having a relatively small investment in the firm. • If the shareholders‟ equity is a small proportion of total assets.Shareholders‟ Equity to Total Assets • The shareholders equity to total assets ratio measures the proportion of the firm‟s assets that are provided or claimed by the shareholders. Formula Equity to Total Assets Shareholders‟ equity Total assets . a high ratio of shareholders‟ equity to assets can represent a relatively large degree of security for the firm. the firm may be viewed as being financially weak. but it also indicates that the firm is not highly leveraged.

Formula Times interest earned = Income before taxes & interest charges Interest Charges . • The ratio indicates the company‟s ability to meet interest payments and the degree of safety available to creditors.Number of Times Interest Earned • The number of times interest is earned ratio is a measure of the debt position of a firm in relation to its earnings.

98 .Book Value per Common Share Book Value Shareholders’ Equity Applicable to per Common Shares = Common Number of Common Shares Share Outstanding This ratio measures liquidation at reported amounts.

based on going concern concept basis).Book Value per Share or Break up Value per Share • Book value per share is a figure that represents what the shareholders would receive for their shares of ownership if the corporation were liquidated without gain or loss (i.e. Formula Common stockholder‟s equity ---------------------------------------------Number of common shares outstanding .

a) Directors b) Chief Executive c) Members .Concept Review Test Fill in the correct answer from choices given: 1. Cash flow statement classifies cash flow during the period from operating. __________ and financing activities. Auditors‟ Report of a listed company is addressed to _______ . a) non-operating b) investing c) working capital 2.

The relationship of current assets and current liabilities is an indicator of a firms‟ ______________ positions. a) Financial b) liquid c) profitability 4. EPS is widely used in judging the ________ performance a) Operating b) Leverage c) ROI .Concept Review Test Fill in the correct answer from choices given: 3.

Concept Review Test Fill in the correct answer from choices given: 5. Dividend yield = Dividend per share / _______________ a) Face value per share b) Market value per share c) Net Income per share .

Case studies 103 .

Discussion on relevant ratios for various users of financial statements INTERNAL USERS Marketing & Sales Manager No of days in Account Receivable and Receivable turnover Product wise profitability ratio Key sales and profit contributing products( 80 / 20 rule ) Inventory Manager No of days in Inventory . Inventory turnover Production Manager Input vs output ratio Yield / wastage ratio vs standard and industry trend Database – Labour efficiency ratio 104 .

EPS Liquidity .Discussion on relevant ratios for various users of financial statements EXTERNAL USERS Creditors Liquidity Profitability Cash flow analysis Banker Debt Equity . Cash Flow Analysis . Dividend payout .PE 105 . Interest Coverage Liquidity . Profitability Employees Profitability growth Shareholders Dividend yield.

A/C Receivable has increased by 20%) 2001 2002 Sales Rs.Case Study – I Account Receivable Ratio The comparison of two years data of a company are as follows. (matter of concern . 1.000 Turnover ratio 12 14.200.000 Accounts receivable 100.000 120. 1.560.2 Days’ sales outstanding 30 28 Credit terms 30 days Required: Evaluate this information and advise effectiveness of receivable management 106 .000 Rs.

000 Cost of goods sold 881.000 4.4 Days in inventory 83 2002 Rs. 1.000 Inventory turnover 4.560.000 1.000 284.1 89 Required: Comment on the above trend from the point of view of 107 inventory management. .Case Study – II Inventory Ratios The following information is available for a small manufacturing company: (matter of concern .200.Inventory has increased by 42%) 2001 Sales Rs.000.000 Inventory 200. 1.

but with a business customer you can find out even more by requesting financial statements…. If a company‟s current ratio is below 1. the managing director of an accounting company based in Minneapolis.” Inc.. Required: Comment on above based on your practical experience. “Hands on Collections: Get paid Promptly.. 87 . p. right from the beginning.Case Study – III Business Focus Mr Rick Burrock. Using the balance sheet. you may want to reconsider doing business with that company or insist on stricter credit terms. 108 . November 1996. Start by investigating all new customers. that you will work very hard to satisfy them and that in return.” Source: Jill Andresky Fraser.00 it will be paying out more than it expects to collect. you expect to be paid on time. A credit report helps. divide current assets by current liabilities to calculate the current ratio. advises his small business clients to keep a tight rein on credit extended to customers. “You need to convey to your customers.

You are required to submit your proposal for working capital requirement to one of bankers based on following information. building and machinery cost was Rs.000. begins. The land.10 million to start the business of chemical manufacturing and sales. Raw materials stocks are held for a week before processing which takes three weeks. while its debtors usually pay within four weeks of invoicing.5 million from acquiring long term loans for GBL Financing Corporation at 8% interest per annum. The company generally pays its suppliers six weeks after receiving an invoice. Finished goods stay in stock for an average of two weeks.Case Study – IV Operating Cycle M/s Tycon Corporation was formed in 1985 with a share Capital Rs. 109 . Therefore sponsors financed shortage of Rs. The size of weekly investment in inventory or receivable is Rs.15 million. Now in order to operate the business activities working capital funds were required to finance inventory and receivables.500.

000 x 10% pa Real profit after 12 months credit Rs 100 (100) Nil The entire profit margin has been wiped out in 12 months because of delayed payment. How can we assess the effect on profit? Beeta Company sells Toys for Rs 1. The customer does not pay until a year. Beeta relies on overdraft finance.CASE STUDY-V Effect on Profit for Extending Credit The main cost of offering credit is the interest expense and of course risk of bad debts .000 which enables it to earn a profit. 110 . of Rs 100. The effect is: Net Profit on sale of Toys Interest cost overdraft Rs 1. which costs 10 % pa.

CASE STUDY-V Effect on Profit for Extending Credit If customer paid after six months. then the profit would be absorbed before seven months had elapsed. • If the net profit is 5% and borrowing costs were 15%. the interest expense would exceed the net profit after four months. the effect would be: Net Profit Interest cost overdraft cost (Rs 1000 x 10% pa x 6/12 months) Rs 100 ( 50) 50 Half the profit has been wiped out. 111 . --------------------------------------------------------------------------------------------------------- • If the cost of borrowing is 18%.

shareholders‟ equity is Rs 50. Long term debt to equity is 40%.000/= HEADS OF B/S CASH+DEBTORS+INVENTORY+FIXED ASSETS= CREDITORS+LONG TERM LOAN+EQUITY 112 . Total assets turnover is 3 times.000.Gross profit at 20% is Rs 20. average collection period is 18days (360days a year). Inventory turnover to cost of sales is 8 times.credit sales to total sales 80% .Case Study –VI Based on following data complete the Balance Sheet RATIOS: Current ratio 1.6 .

It allows debtors 1. holding month‟s worth of stock. What are its current and quick ratios? 113 .WORKING CAPITALCase Study VII A company‟s annual sales is Rs 8 million with a gross profit on cost of 60%. It normally pays creditors two months after purchases are made.000 rupees.5 months credit and its cash balance currently stands at 1.250.

833 = 1+1.25 0.417+1+1.Case Study VII Rs in million SALES COST OF SALES GROSS PROFIT 160% 100% ------60% 8 5 ----3 CREDITORS DEBITORS STOCK CURRENT RATIO QUICK RATIO = 2/12 x RS 5m = 1.WORKING CAPITALSOLUTION .5/12 x RS 8m = 1/12 x RS 5m = 0.7 114 .833 = Rs 0.833m = Rs 1m = Rs 0.2 = 2.25 0.417m = 3.

427 million 340 million 14.73 115 . Data for a recent year appear below : Rs.26 1.125 10.857 million 0.WORKING CAPITAL-Case Study VIII McDonald’s Corporation provides an interesting illustration of the use of financial ratios.503 million 6.97 42. Net income Interest expense Average total assets Stockholders’ equity Dividends per share Earnings per share Market price per share Book value per share 1.

26 1.WORKING CAPITAL-Case Study Solution Some key financial ratios are computed below : Return on 1.503 Return on common stockholders’ equity Dividend payout ratio 1.125 = 0.8% = 13.8% = 20.26 42.97 = 9.427 6.427 total assets 14.2% Dividend yield ratio 0.62% 116 .857 0.

This premium over book value reflects the market‟s perception that McDonald‟s earnings will continue to grow in the future. 117 . Finally. About half of the company‟s financing is provided by creditors. In relation to the stock price. this is a dividend yield of less than 1%. only 13.8%. Accordingly.” Indeed. the dividend yield is relatively modest. According to the company‟s annual report. and therefore the company has positive financial leverage. “Given McDonald‟s high return on equity and assets.2% of earnings are paid out in dividends. note that the market value per share is over four times as large as the book value per share. management believes it is prudent to reinvest a significant portion of earnings back into the business. the rest is provided by stockholders.WORKING CAPITAL Case Study -comments The return on common stockholders‟ equity of 21% is higher than the return on total assets of 9.

000 Debtors 31.000 43.000 288.000 Assume all sales and purchases are on credit.000 170.000 Finished goods 40.WORKING CAPITALCase Study IX Analyze the following information from the viewpoint of its implications for working capital policy: Present position Budget for next year Sales 250.000 30.000 248. 118 .000 Raw materials 35.000 Creditors 21.000 Work-in-process 17.000 60.250 36.000 Purchases 140.000 Cost of sales 210.500 30.

some additional finance will be taken from creditors as a result of the payment period being increased from 55 days to 64 days. the current and budgeted collection period both being 46 days. or offer discounts for payment within that 119 time (which will be lost). However. This increase represents about 16% and is not particularly significant unless creditors demand payment within 60 days. Debtor balances are moving pro-rata with sales. .WORKING CAPITAL Case Study -Solution Analysis of the figures and cash operating cycle it is revealed that working capital investment is being increased.

in the period following the budget. stocks will be very high. The implication is that production will increase while sales will fall. 120 . A reappraisal of the situation should be made to see if these stocks can be reduced. thereby releasing funds for other uses. Raw materials stocks turnover will be decreased by 29% and work-in-progress by 31%. It may also be possible to reduce debtors to their current levels. while finished goods stock turnover will increase by 10%. The overall impression is that unnecessarily high investment in raw materials and work-in-progress is being undertaken.WORKING CAPITAL Case StudyA significant change in the turnover of stock levels is anticipated.

25 = 46 days Sales 250 Finished stock turnover = Cost of goods sold 210 Finished goods stock 40 = 5.8 times pa or 63 days 121 . 3.WORKING CAPITALCase Study IX WORKINGS CURRENT BUDGET 1.25 times pa or 70 days 365 x 30 = (64 days) 170 365 x 36 = 46 days) 288 248 43 = 5. Creditors Average payment period (365 x Creditors) 365 x 21 = (55 days) Purchases 140 Debtors Average collection period (365 x Debtors) 365 x 31. 2.

5 30 = 12 times pa or 30 days = 8.26 times pa or 44 days Length of cash operating cycle 182 days 218 days 122 .WORKING CAPITALCase Study IX WORKINGS 4. CURRENT Raw materials stock turnover = Purchases 140 Raw materials stock 35 = 4 times pa or 91 days BUDGET 170 60 = 2.83 times pa or 129 days 5. Work-in-progress turnover = Cost of goods sold 210 248 Work-in-progress stock 17.

440. Assume there would be no increase in fixed costs from the extra turnover.000 Bad debts expenses 18.800.000. Should the company opt for easing the credit terms? 123 .000 360.000 Cost of sales 1.800. The annual profit and loss account is as follows.000 Profit 342.Case Study-X CHANGES IN CREDIT TERMS JF Ltd achieves current annual sales of Rs 1.000 The management consider that if credit terms were eased from 30 days to 60 days credit. and that there would be no increase in average stocks or creditors. The costs of sales are 75% variable and 25% fixed. The company cost is 20% on its investments. Sales Rs 1. the sales will increase by 25% but bad debts will also increase from 1% to 3%.

000 49.000 c) CONCLUSION As the increase in profit is Rs 130.000) – Rs 18.250m=. therefore credit terms be relexed.000 Cost of additional finance at 20% Rs 45.000 Less increase in bad debts (3% x Rs 2. A can be found as follows.000 Additional investment required 225. a) Increase in contribution from additional sales 25% x Rs 1.800.Case Study X–SOLUTION The increase in profit before the cost of additional finance for Option.000 x 1/12 150.000 Less current investment in debtors Rs 1.000.(75% x 80%) = 40% b) Proposed investment in debtors Rs 2.500 which exceeds the cost of additional financing cost of Rs45.500 * The C/M ratio is 100% . 124 .500 Increase in annual profit 130.000 x 40% * Rs 180.800.000 x 1/6 Rs 375.250.

b. c. Workout Horizontal. Liquidity Profitability Turn over of Inventory & Receivable Market ratio Capital Structure • • • With help of above results. per share Discuss other factors which may effects the decision of buying above shares The net profit is Rs. advise for buying this company‟s Share at Rs. d. million whereas cash flow statement shows net surplus of Rs. 125 . Common Size Statement & all Ratios Comment separately on: a. 2. e. Vertical. Justify the difference. million.Case Study Select a company‟s annual report • Review the Financial Statements and comment on following: 1.

Is the company meeting its current obligations? 9. Accounting Policies.Find out purchases of raw material. 7.Case Study XV – Review of Financial Statement 6. Contingent Liability & Commitments. 10.How the inventory is financed ? And comment on efficiency of inventory management. value added statement and briefly comment on each of above separately 8.What is other significant matter in financial statement beside discussed above which is useful for shareholders and bankers.Why the dividend is much less than profits? ( dividend payout ) 126 .Read the Nature of Business and Company‟s history. Director Report‟ Auditors‟ Report shareholding break-up. 11. direct labor and factory overheads figure in Notes to the Accounts.

you are required to write a Business Review that way be published in a newspapers about this company.Case Study –XVI Comments for News paper on Financial Statements Based on all above data and analysis results. 127 .

20% Labor and 50% factory overhead of which 40% are fixed overhead . Advise expected profits and dividend for the next year. Fixed overhead and admn.Case Study –XVII REVIEW OF ACTUAL PUBLISHED ACCOUNTS Based on the financial statement just reviewed.. financial charges etc to increase by 10% only. 128 .Prepare projected profit & loss account for next year considering following assumptions: • • • • 2Sales to grow by 20 %annually. Cost of goods sold consists of 30% Material. selling. No inflation is expected in Material prices. labor cost and variable overhead. you are required to: 1.

______ ______ 129 .ANALYSIS OF FINANCIAL STATEME Concept Review Test PART (A) Tick the correct answer in relevant column. ______ Balance Sheet shows operating results of the company. Revenue & costs are recognized as they are received or paid respectively and not when earned or incurred. 5. 2. _____ Sales is recorded at the time of receipt of order from the customer ______ 6- Financial Statements are prepared on cash basis. ______ ______ 3. TRUE FALSE ______ ______ ______ ______ ______ 1. Shareholders‟ equity includes share capital and liabilities. 4. The financial statements are normally prepared on current cost concept.

----------- ----------- 9. ----------- ----------- 130 . TRUE FALSE Dividend is distribution of profits to shareholders and bankers Ordinary Shares issued at a discount-It has no effect on current ratio Low Inventory Turnover indicates that carrying cost of inventory is also low Formula to calculate EPS is = Net Income ÷ Value of Ordinary Shares Going Concern concept effect Valuation of Assets Inventories are valued at lower of cost and net realizable value ----------- ----------- 8. Tick the correct answer in relevant column. --------------------- --------------------- 11. ----------- ----------- 10. 12.ANALYSIS OF FINANCIAL STATEME Concept Review Test PART (A) 7.

____________ opinion by External Auditors is expressed when the auditor concludes that the financial statements give a true and fair view in accordance with identified financial reporting framework (a) A Qualified (b) An unqualified (c) An adverse 131 . 5. (a) 50% (b) 25% (c) 20% 4. Dividend income is recorded in books of account when it is approved by ______________ (a) Shareholders at AGM (b) Board of Directors (c) Managing Director Capital Reserve can not be used for issuing _______________ (a) Cash Dividend (b) Bonus Shares Bonus Share is also called ______________ (a) Right Shares (b) Stock Dividend (c) Preference Shares Associated company means any two or more companies interconnected with each other and director of a company hold or control share with atleast ________ voting power in another company. Fill in the blank: 2. 3.ANALYSIS OF FINANCIAL STATEME Concept Review Test PART (B) 1.

Higher inventory turn over express _________ investment in inventory a) Low (b) High (c) Reasonable 132 .ANALYSIS OF FINANCIAL STATEME Concept Review Test 6. The liability of Partners in Partnership firm is _____________ (a) Limited (b) Unlimited (c) nil 8. (a) Capital Expenditure(b) Revenue Expenditure (c) Deferred Revenue Expenditure 7.A ____________ is a postponement of the recognition of a revenue expenditure already incurred or paid because it is likely that the benefits may be available for more than one year. (a) Future position ( b) Current position (c) Previous Trend 9. Financial Statement analysis involves tools and techniques which enable analyst to examine past and __________. Current ratio express _________ position of the company (a)Financial ( b) Liquidity (c) Profitability 10.

) Ratio can be computed from any _________________. a) Single number b) Pair of numbers 133 .Price Earning Ratio express what market is willing to pay for every ________ rupees.1 15.3 c) Rs.________________ a) EPS b) Break up value c) M/V of shares 14. a) Rs.5 b) Rs. Book value per share = Shareholder Equity -.ANALYSIS OF FINANCIAL STATEME Concept Review Test 11.Dividend yield = Divided per share -. a) Efficient b) inefficient c) inappropriate 12 Working Capital Ratio express the relationship between current assets and _________ . of shares c) Value of shares 16._______________. Low A/c receivable turn over ratio shows ____________ Receivable Management. a) Reverses b) No. a) Fixed Assets b) Long Term Liab c) Current Liab 13.

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