Chapter 6

FINANCIAL STATEMENT ANALYSIS

The Information Maze

Outline
Financial statements
Generally accepted accounting principles
Financial ratios

Standardised financial statements

Applications of financial statement analysis Using financial statement analysis Going beyond the numbers

Important Questions
Managers, shareholders, creditors and other interested groups seek answers to the following important questions about a firm: What is the financial position of the firm at a given point of time? How has the firm performed financially over a given period of time?

What have been the sources and uses of cash over a period of time?
The accountant prepares the balance sheet, the profit and loss account, and the statement of cash flows to answer the above questions.

Balance Sheet of Horizon Limited as at March 31, 20X1

RS. in million

EQUITY AND LIABILITIES Shareholders Funds Share capital (Par value Rs.10) Reserves and surplus Non-current Liabilities Long-term borrowings Deferred tax liabilities (net) Long-term provisions Current Liabilities Short-term borrowings @ Trade payables Other current liabilities Short-term provisions

20X1 500 100 400 300 200 50 50 200 40 120 30 10 1,000 600 500 50 50 400 20 160 140 60 20 1000

20X0 450 100 350 270 180 45 45 180 30 110 30 10 900 550 450 40 60 350 20 140 120 50 20 900

ASSETS Non-current Assets Fixed assets Non-current investments Long-term loans and advances Current Assets Current investments Inventories Trade receivables Cash and cash equivalents Short-term loans and advances

Equity and Liabilities

Shareholders Funds Share capital

Reserves and surplus

Non-current Liabilities Long-term Borrowings

Deferred tax liabilities (net)

Long-term provisions Current Liabilities

Short-term borrowings Trade payables Other current liabilities Short-term provisions

Assets
Non-current Assets Fixed assets

Non-current investments
Long-term loans and advances

Current Assets

Current investments
Inventories Trade receivables Cash and cash equivalents Short-term loans and advances

Divergence Between Accounting Values and Economic Values

Use of the Historical Cost Principle Exclusion of Intangible Assets Understatement or Omission of Certain Liabilities

Statement of Profit and Loss

Rs. in million
Current Period Previous Period

Revenues from Operations Other Income Total Revenues Expenses Material expenses Employee benefit expenses Finance costs Depreciation and amortisation expenses Other expenses Total expenses Profit before Exceptional and Extraordinary Items and Tax Exceptional items Profit before Extraordinary Items and Tax Extraordinary items Profit Before Tax Tax Expense Profit (Loss) for the Period Earnings Per Equity Share Basic Diluted

1290 10 1300 600 200 30 50 240 1120 180 180 180 50 130 13 13

1172 8 1180 560 180 25 45 210 1020 160 160 160 40 120

Basic and diluted earnings per share

To calculate the basic earnings per share, the net profit or loss for the period attributable to equity shareholders is divided by the weighted

average number of equity shares during the period.

To calculate the diluted earnings per share, the net profit or loss for the period attributable to equity shareholders and the weighted average

number of shares outstanding during the period should be adjusted for the
potential dilution arising from conversion of debt into equity, exercise of warrants and stock options, and so on.

Convertible Debentures
To illustrate how diluted EPS is calculated, when a company has outstanding convertible debentures let us consider an example. Magnum Company has 10 million equity shares of Rs. 10 each and 200,000 convertible debentures of Rs. 100 each carrying a coupon rate of 8 percent. Each convertible debenture is convertible into 4 equity shares. Magnums profit after tax for the year ended March 31, 20X5, was Rs. 25 million and its tax rate is 30 percent. The basic earnings per share is:
Basic earnings per share = Rs. 25,000,000 Rs. 10,000,000 = Rs. 2.50

The diluted earnings per share is calculated as follows:

Number of existing equity shares Equivalent number of equity shares corresponding to convertible debentures Number of equity shares for calculating the diluted earnings per share Profit after tax Add: After-tax debenture interest 200,000 x 100 x .08 x 0.70 Adjusted profit after tax

10,000,000 800,000 10,800,000 Rs. 25,000,000 1,120,000 26,120,000 Rs. 2.42

Diluted earnings per share

26,120,000 / 10,800,000

Stock Options
To illustrate how the diluted earnings per share is calculated when a company has issued stock options, assume that the Magnum Company does not have convertible debentures but has issued stock options for 1 million shares which are exercisable at a price of Rs. 24. The fair value of an equity share is Rs. 30. The excess of fair value (Rs. 30) over the exercise price (Rs. 24) is translated into an equivalent number of equity shares for calculating the diluted earnings per share. The calculation of the diluted earnings per share is shown below:
Number of existing equity shares Number of equity shares under 1,000,000 stock option Number of equity shares that would have been issued at fair 800,000 value: 1,000,000 x 24/30 Dilution impact in terms of equivalent number of shares Number of equity shares for calculating the diluted earnings per share Diluted earnings per share : Rs. 25,000,000 / 10,200,000 10,000,000

200,000

10,200,000

Rs. 2.45

Accounting Income versus Economic Income

Accounting income may diverge from economic income due to the

following reasons.
Use of the accrual principle Omission of changes in value

Depreciation
Treatment of R&D and advertising expenditures Inflation

Creative accounting

Statement of Cash Flow

Sources of Cash
Increase in liabilities and owners equity Decrease in assets (other than cash)

Uses of Cash
Decrease in liabilities and owners equity
Increase in assets (other than cash)

Changes in Balance Sheet Items

Rs. in million

Equity and Liabilities

March 31 20 x 1 500 100 400 300 200 50 50 200 40 120 30 10

1,000

March 31 20 x 0 Increase 450 100 350 50 270 180 20 45 5 45 5 180 30 10 110 10 30 10 900

Shareholders Funds Share capital Reserves and surplus Non-current Liabilities Long-term borrowings Deferred tax liabilities (net) Long-term provisions Current Liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions

Decrease -

Assets Non-current Assets Fixed assets Non-current investments Long-term loans and advances Current Assets Current investments Inventories Trade receivables Cash and cash equivalents Short-term loans and advances

600 500 50 50

550 450 40 60

50 10
10

400 20 160 140 60 20

350 20 140 120 50 20

20 20 10 -

1000

900

Using the above framework we can summarize the sources and uses of cash from the balance sheet data as follows:

Sources Increase in reserves and surplus Increase in long-term borrowings Increase in deferred tax liabilities Increase in long-term provisions Increase in short-term borrowings Increase in trade payables Decrease in long-term loans and advances Total sources 50 20 5 5 10 10 10 110

Uses Increase in fixed assets (net) 50

Increase in non-current 10 investments Increase in inventories 20 Increase in trade receivables 20

Total uses Net addition to cash

100 10

Sources Net profit

Uses 130 Dividend payment 80

Depreciation and amortisation

Increase in long-term borrowings Increase in deferred-tax liabilities Increase in long-term provisions Increase in short-term borrowings Increase in trade payables Decrease in long-term loans and advances Total sources

50
20

Purchase of fixed assets

Increase in non-current investments

100
10

5 5 10 10 10

Increase in inventories Increase in trade receivables

20 20

240

Total uses Net addition to cash

230 10

Statement Of Cash Flow

Operating Cash inflows from operations Cash outflows from operations = Cash flow from operations + Investing Cash inflows from investing activities Cash outflows from investing activities = Cash flow from investing activities + Financing Cash inflows from financing activities Cash outflows from financing activities = Cash flow from financing activities = Net cash flow for the period

Sources
Financing
Operating

Uses
Capital
Res. & Surplus

Capital
Res. & Surplus

Financing
Operating

Loans
Current Liabilities & Provisions Fixed Assets Investments Inventories Debtors a

Loans
Current Liabilities & Provisions Fixed Assets Investments Inventories Debtors

Investment Investment Operating Operating

Cash Flow Statement

A. CASH FLOW FROM OPERATING ACTIVITES PROFIT BEFORE TAX Adjustments for : Depreciation and amortisation Finance costs Interest income OPERATING PROFIT BEFORE WORKING CAPITAL CHANGES Adjustments for changes in working capital : Trade receivables and short-term loan and advances Inventories Trade payables, short-term provisions, and other current liabilities CASH GENERATED FROM OPERATIONS Direct taxes paid NET CASH FROM OPERATING ACTIVITIES B. CASH FLOW FFROM INVESTING ACTIVITIES Purchase of fixed assets Increase of non-current investments Reduction in long-term loans and advances Interest income NET CASH USED IN INVESTING ACTIVITIES C. CASH FLOW FROM FINANCING ACTIVITIES Increase in long term borrowings Increase in short-term borrowings Increase in deferred tax liabilities Increase in long-term provisions Dividend paid Finance costs NET CASH FROM FINANCING ACTIVITIES NET CASH GENERATED (A+B+C) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD CASH AND CASH EQUIVALENTS AT THE END OF PERIOD 180 50 30 (10) 250 (20) (20) 10 220 (50) 170 (100) (10) 10 10 (90) 20 10 5 5 (80) (30) (70) 10 70 80

Stand Alone and Consolidated Financial Statements

Clause 32 of the listing agreement with the stock exchange(s) requires a company to provide consolidated financial statements in addition to the stand-alone financial statements. The consolidated financial statements are prepared by consolidating the accounts of the parent company with those of its subsidiaries in accordance with generally accepted accounting principles and in consonance with Accounting Standard 21 entitled Consolidated Financial Statements, issued by the Institute of Chartered Accountants of India. The consolidation of the financial statements has to be done on a line by line basis by adding together like items of assets, liabilities, income, and expenses after eliminating intra-group balances/transactions and resulting unrealised profits/losses in full. The amount shown in respect of reserves comprise the amount of the relevant reserves as per the balance sheet of the parent company and its share in the post-acquisition increase in the relevant reserves of the consolidated entities. The consolidated financial statements are prepared using uniform accounting policies for like transactions and other events in similar circumstances. The consolidated financial statements are presented, to the extent possible, in the same format as that adopted by the parent company for its stand-alone financial statements.

Alternative Measures of Cash Flow

As an analyst, you can use the following measures of cash flow to

determine the financial health of a company.

Cash flow from operations

Free cash flow

Cash Flow from Operations

When we looked at the profit and loss account, the emphasis was on profit after tax (also called the bottom line). In finance, however, the focus is on cash flow. A firms cash flow generally differs from its profit after tax because some of the revenues/expenses shown on its profit and loss account may not have been received/ paid in cash during the year. The relationship between net cash flow and profit after tax is as follows: Net cash flow = Profit after tax Non cash revenues + Non cash expenses An example of non cash revenue is accrued interest income that has not yet been received. It increases the bottom line but is not matched by a cash inflow during the accounting period the cash inflow would occur in a subsequent period. An example of a noncash expense is depreciation. In practice, analysts define the net cash flow as: Net cash flow = Profit after tax + Depreciation + Amortisation

Free Cash Flow

The cash flow from operations does not recognise that the firm has to make investments in fixed capital and net working capital for sustaining operations. So, a measure called free cash flow is considered.

The free cash flow is the post-tax cash flow generated from the operations of the firm after providing for investments in fixed capital and net working capital required for the operations of the firm. It is the cash flow available for distribution to shareholders (by way of dividend and share buyback) and lenders (by way of interest and debt repayment.)

Accounting Standards
Globally, the US GAAP and IFRS dominate. Accounting Standards (AS) in India are notified by the central government Initiatives taken by International Organisation of Securities

Commission(IOSCO) towards promoting International Accounting

Standards (IAS) and International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board

(IASB) have created a momentum for harmonising Indian

Accounting Standards with IFRS.

Indian GAAP
In India, Accounting Standards (AS) are notified by the central government in exercise of powers under Section 211 (3C) of the Companies Act, 1956. The central government notifies AS on the recommendations of the National Advisory Committee of Accounting Standards (NACAS) constituted under Section 210 A of the Companies Act, 1956. Before the establishment of NACAS, the Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India used to issue AS for its members to follow.
In a bid to align Indian GAAP with IFRS, in February 2011, the MCA notified Indian Accounting Standards (Ind AS) converged with IFRS. The effective date of Ind AS, which was previously announced to be April 1, 2011, has been deferred. The MCA is yet to announce notify the revised effective date. Though very similar to the IFRS, the Ind AS have some carve outs meant to tailor these standards to the needs of the Indian environment

Global Situation
The Financial Accounting Standards Board (FASB), a nongovernmental body, issues accounting standards that form the US GAAP. The FASB standards are supported by the Securities Exchange Commission in the US. The International Accounting Standards Board (IASB) is an independent, privately funded body having members from nine countries with varied functional backgrounds. It is based in London. Committed to developing a single set of high-quality, global accounting standards, the IASB publishes its standards in the form of pronouncements called International Financial Reporting Standards (IFRS). IASB has also adopted the standards issued by the Board of the International Accounting Committee, which continue to be called International Accounting standards.

IFRS and the US GAAP

The key differences between IFRS (formulated by the International Accounting Standards Board or IASB) and the US GAAP (formulated by the Financial Accounting Standards Board or FASB) are as follows: IFRS is a more principle-based accounting system whereas the US GAAP is a more rule-based accounting system IFRS permits a company to revalue its fixed assets like land and buildings whereas the US GAAP does not. IFRS allows a company to amortise certain expenses like R & D expenses over several years, whereas the US GAAP does not IFRS has a less elaborate format for the accounting of derivatives whereas the US GAAP requires a detailed mention of various kinds of exposures and liabilities arising from derivative contracts.

IFRS permits separate accounting in unusual circumstances such as a hyperinflationary situation whereas the US GAAP does not.

Key Trends in Accounting Standards

While presently there are substantial differences between accounting standards in different countries, accounting bodies have been working to evolve common standards. Here are some pointers: On January 1, 2005, Europes 7000 listed companies adopted International Financial Reporting Standards (IFRS), replacing 25 different local accounting regimes with one set of rules. IFRS formulated by the International Accounting Standards Board (IASB) has been growing in popularity. It has been adopted or will be adopted by nearly 100 countries. India too is moving in the direction of IFRS.

In June2007,SEC decided to allow foreign companies listed in the US to issue their financial reports using the English version of IFRS.

Financial Ratios
A ratio is an arithmetical relationship between two figures. Financial ratio analysis is a study of ratios between various items or groups

of items in financial statements. Financial ratios have been classified in

several ways. For our purposes, we divide them into five broad categories as follows:

Liquidity ratios Leverage ratios Turnover ratios Profitability ratios Valuation ratios

Liquidity Ratios
Liquidity refers to the ability of a firm to meet its obligations in the short run, usually one year. Liquidity ratios are generally based on

the relationship between current assets (the sources for meeting

short-term obligations) and current liabilities. The important liquidity ratios are: current ratio, acid-test ratio, and cash ratio.

Current Ratio
A very popular ratio, the current ratio is defined as: Current assets

Current liabilities
Current assets include cash, current investments, debtors,

inventories (stocks), loans and advances, and pre-paid expenses. Current liabilities represent liabilities that are expected to mature in the next twelve months. These comprise (i) loans, secured or

unsecured, that are due in the next twelve months and (ii) current
liabilities and provisions. Horizon Limiteds current ratio for 20X1 is 400/200 = 2.00

Acid-test Ratio
Also called the quick ratio, the acid-test ratio is defined as: Quick assets

Current liabilities
Quick assets are defined as current assets excluding inventories. Horizon's acid-test ratio for 20X1 is: (400- 160)/200 = 1.20

Cash Ratio
Because cash and bank balances and short term marketable securities are the most liquid assets of a firm, financial analysts look

at cash ratio, which is defined as:

Cash and bank balances + Current investments Cash ratio = Current liabilities Horizon Limiteds cash ratio for 20X1 is: (60 + 20)/200 = 0.40

Leverage Ratios
Financial leverage refers to the use of debt finance. There are two types of ratios commonly employed to analyse financial leverage: structural ratios and coverage ratios. Structural ratios

Debt-equity ratio
Debt-assets ratio

Coverage ratios

Interest coverage ratio

Fixed charges coverage ratio Debt service coverage ratio

Debt-equity Ratio
The debt-equity ratio shows the relative contributions of creditors and owners. It is defined as:

Total liabilities (Debt)

Shareholders funds (equity) The numerator of this ratio consists of all liabilities, noncurrent and the denominator consists of share capital and reserves and surplus.

Horizons debt-equity ratio for the 20X1 year-end is:

(300+200)/500=1.0

Debt-asset Ratio
The debt-asset ratio measures the extent to which liabilities support the firm's assets. It is defined as: Total liabilities (Debt)

Total assets
The numerator of this ratio includes all liabilities (non-current and current) and the denominator of this ratio is the total of all assets (the balance sheet total).

Horizon's debt-asset ratio for 20X1 is: 500 / 1000 = 0.5

This ratio is related to the debt-equity ratio as follows: Debt = Assets 1 + Debt/Equity Debt/Equity

Interest Coverage Ratio

Also called the times interest earned, the interest coverage ratio is

defined as:
Profit before interest and taxes Interest

Horizon's interest coverage ratio for 20X1 is: 210 / 30 = 7.0

Fixed Charges Coverage Ratio

This ratio shows how many times the cash flow before interest and taxes covers all fixed financing charges. It is defined as: Profit before interest and taxes + Depreciation and amortisation Repayment of loan Interest + 1 - Tax rate In the denominator of this ratio the repayment of loan alone is adjusted upwards for the tax factor because the loan repayment amount, unlike interest, is not tax deductible. Horizons tax rate has been assumed to be 30 percent. Horizon's fixed charges coverage ratio for 20X1 is: 210 + 50 = 2.56 30+ 50 (1-0.3)

Debt Service Coverage Ratio

Used by financial institutions in India, the debt service coverage ratio is defined as:
Profit after tax + Depreciation + Other non-cash charges + Interest on term loan + Lease rentals
Interest on term loan + Lease rentals + Repayment of term loan

Financial institutions calculate the average debt service coverage

ratio for the period during which the term loan for the project is repayable. Normally, financial institutions regard a debt service coverage ratio of 1.5 to 2.0 as satisfactory.

Turnover Ratios
Turnover ratios, also referred to as activity ratios or asset management ratios, measure how efficiently the assets are employed by a firm. These ratios are based on the relationship between the level of activity, represented by revenues or cost of goods sold, and

levels of various assets. The important turnover ratios are: inventory

turnover, average collection period, receivables turnover, fixed assets turnover, and total assets turnover.

Inventory Turnover
The inventory turnover, or stock turnover, measures how fast the inventory is moving through the firm and generating sales. It is

defined as:
Revenues from operations Average inventory Horizons inventory turnover for 20X1 is:

1290
= 8.6 (160 + 140) / 2

Debtors' Turnover
This ratio shows how many times sundry debtors trade receivables turn over during the year. It is defined as:

Net credit sales

Average trade receivables If the figure for net credit sales is not available, one may have to make do with the revenues from operations. Horizon's debtors turnover for 20X1 is:

1290 [(140+120)/2] = 9.92

Obviously, the higher the debtors turnover the greater the efficiency of credit management.

Average Collection Period

The average collection period represents the number of days' worth of credit sales that is locked in trade receivables. It is defined as: Average trade receivables Average daily credit sales If the figure for credit sales is not available, one may have to make do with the revenue from operations. Horizon's average collection period for 20X1 is: [(140 + 120) / 2] (1290 / 365) = 36.8 days Note that the average collection period and the debtors turnover are related as follows: 365 Average collection period = Debtors turnover

Fixed Assets Turnover

This ratio measures sales per rupee of investment in fixed assets. It is defined as: Revenues from operations Average net fixed assets

Horizon's fixed assets turnover ratio for 20X1 is:

1290 [(500+450)/2] = 2.72

Total Assets Turnover

Akin to the output-capital ratio in economic analysis, the total assets turnover is defined as:

Total revenues
Average total assets Horizon's total assets turnover ratio for 20X1 is: 1300 [(1000+900)/2] = 1.37

This ratio measures how efficiently assets are employed, overall.

Profitability Ratios
Profitability ratios reflect the final result of business operations. There are two types of profitability ratios Profit margin ratio Rate of return ratios Profit margin ratios Gross profit margin ratio Net profit margin ratio Rate of return ratios Return on assets Earning power Return on capital employed Return on equity

Gross Profit Margin Ratio

The gross profit margin ratio is defined as: Gross profit

Revenues from operations

Gross profit is defined as the difference between revenues from operations and cost of goods sold. Cost of goods sold is the sum of manufacturing costs relating to the operating revenues of the period. Manufacturing costs include material costs, employee benefit costs

for manufacturing personnel, and manufacturing expenses.

Net Profit Margin Ratio

The net profit margin ratio is defined as: Net profit Total revenues Horizon's net profit margin ratio for 20X1 is: 130 / 1300 = 0.10 or 10 percent This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of total revenues. It measures the overall efficiency of production, administration, selling, financing, pricing, treasury, and tax management. Jointly considered, the gross and net profit margin ratios provide a valuable understanding of the cost and profit structure of the firm and enable the analyst to identify the sources of business efficiency/inefficiency.

Return on Assets
The return on assets (ROA) is defined as: Profit after tax

ROA =
Average total assets Horizons ROA for the year 20X1 is:

130 [(1000 + 900) / 2] = 13.7 percent

Earning Power
The earning power is defined as:

Profit before interest and tax

Earning power = Average total assets Horizons earning power for the year 20X1 is: 210 [(1000 + 900) / 2] = 22.1 percent

Return on Capital Employed

The return on capital employed is defined as: Profit before interest and tax (1 Tax rate) ROCE = Average total assets

The numerator of this ratio viz., profit before interest and tax (1-tax rate) is also called net operating profit after tax (NOPAT).

Horizons ROCE for the year 20X1 is:

210 (1 0.3) [(1000 + 900 ) / 2 ] = 15.5 percent

Return on Equity
A measure of great interest to equity shareholders, the return on equity is defined as: Equity earnings Average equity The numerator of this ratio is equal to profit after tax less preference dividends. The denominator includes all contributions made by shareholders (paid-up capital + reserves and surplus). This ratio is also called the return on net worth or return on shareholders funds. For our purpose equity, net worth, and shareholders funds are synonymous. Horizon's return on equity for 20X1 is: 130 [(500 + 450) / 2] = 27.4 per cent

Valuation Ratios
Valuation ratios indicate how the equity stock of the company is assessed in the capital market. Since the market value of equity

reflects the combined influence of risk and return, valuation ratios

are the most comprehensive measures of a firm's performance. The important valuation ratios are: price-earnings ratio, yield, and market value to book value ratio.

Price-earnings Ratio
Perhaps the most popular financial statistic in stock market discussion, the price-earnings ratio is defined as:

Market price per share Earnings per share

The market price per share may be the price prevailing on a certain day or the average price over a period of time. The market price per share of Horizon as on 31st March 20 x 1 is Rs. 200. The earnings per share is simply: profit after tax less preference dividend divided by the number of outstanding equity shares. Horizon' price-earnings ratio at the end of 20X1 is: 200 / 13 = 15.4

EV-EBITDA Ratio
A widely used multiple in company valuation, the EV-EBITDA ratio is defined as:
Enterprise value (EV) Earnings before interest, taxes, depreciation, and amortisation (EBITDA)

EV is the sum of the market value of equity and the market value of debt. The market value of equity is simply the number of outstanding equity shares times the price per share. As far as debt is concerned, its market value has to be imputed. Generally, a rupee of loan is deemed to have a rupee of market value.

Horizon's EV-EBITDA ratio for 20X1 is: 10 x 200 + 500 2500 = = 9.62 260 260

Market Value to Book Value Ratio

Another popular stock market statistic, the market value to book value is defined as:

Market value per share Book value per share

Horizon's market value to book value ratio at the end of 20X1 was:

200 / 50 = 4.00

Q Ratio
Proposed by James Tobin, the q ratio is defined as: Market value of equity and liabilities

Estimated replacement cost of assets

The q ratio resembles the market value to book value ratio. However, there are two key differences: (i) The numerator of the q ratio represents the market value of equity as well as debt, not just

equity. (ii) The denominator of the q ratio represents all assets.

Further these assets are reckoned at their replacement cost, not book value.

Comparative Analysis

Cross Section Analysis

Time Series Analysis

Time Series of Certain Ratios

Time Series of Certain Financial Ratios

1
Debtequity ratio Total asset turn over ratio Net profit margin (%) Return on equity (%) Price-earning ratios 1.3 1.34 8.0 20.1 12.5

5
1.0 1.37 10.0 27.4 15.4

1.2 1.0 0.9 1.41 1.35 1.39 9.0 10.2 10.5 22.0 26.0 27.6 13.2 13.8 14.9

Du Pont Chart Applied to Horizon Limited

Total Revenues 1300 Net Profit 130

Total Costs 1170

Net Profit margin 10%

Total Revenues 1300

Return on Assets 13.7%

Total Revenues 1300

Average Noncurrent assets 575

Total Assets Turnover 1.37

Average Total Assets 950

+
Average Current Assets 375

Extension of Du Pont Chart

Return on Equity 27.4 %

Return on Assets 13.7%

Average Total Assets to Average Equity Ratio 2.0

Common Size Statements

Part A: Profit and Loss Account
Regular(in million) 20x1 20X0 Rs. 1300 Rs.1180 1090 210 30 180 50 130 995 185 20 160 40 120 Common Size(%) 20X1 20X0 100 100 84 16 2 14 4 10 84 16 2 14 4 10 Total revenues Total expenses other than finance cost PBIT Interest (Finance costs) PBT Tax PAT

Part B: Balance Sheet Regular(in million) 20x1 20X0 500 450 300 270 200 180 1000 900 600 550 400 350 1000 900 Common Size(%) 20X1 20X0 50 50 30 30 20 20 100 100 60 61 40 39 100 100

Shareholders funds Non-current liabilities Current liabilities Total Non current assets Current assets Total

Common Base Year Financial Statements

Part A: Profit and Loss Account
Regular(in million) 20x1 20X0 Rs. 1300 Rs.1180 1090 210 30 180 50 130 995 185 20 160 40 120 Common Size(%) 20X1 20X0 110 100 110 114 150 113 125 108 100 100 100 100 100 100 Total revenues Total expenses other than finance cost PBIT Interest (Finance costs) PBT Tax PAT

Part B: Balance Sheet Regular(in million) 20x1 20X0 500 450 300 270 200 180 1000 900 600 550 400 350 1000 900 Common Size(%) 20X1 20X0 111 100 111 100 111 100 111 100 109 100 114 100 111 100

Shareholders funds Non-current liabilities Current liabilities Total Non current assets Current assets Total

Applications Of Financial Analysis

Financial ratios may be employed to: Assess corporate excellence Judge creditworthiness Forecast bankruptcy

Value equity shares

Predict bond ratings

Estimate market risk

Shortcomings of Financial Statements

The Annual Reporting Requirements

Inability of Management to Report Objectively on Itself

Choice Between Flexibility and Consistency

Problems In Financial Statement Analysis

Heuristic and Intuitive Character
Development of Benchmarks

Window Dressing
Price Level Changes Variations in Accounting Policies Interpretation of Results Correlation among Ratios

Potential Red Flags

As an analyst, you should learn to identify potential red flags. Here is a list of common red flags. A qualified audit opinion. A change in accounting policy that is not satisfactorily explained.

An unusual increase in accruals.

A widening gap between reported income and cash flow from operations.

Large adjustments in the fourth quarter.

An abrupt change in external or internal auditor.

An increase in transactions with related parties.

An unusual increase in short-term financing or lending.

Guidelines

Use ratio to get clues to ask the right questions Be selective in the choice of ratios Employ proper benchmarks

Know the tricks used by accountants

Read the foot notes

Understand how the ratios are inter- Related

Remember fsa .. odd mixture of art & science

Looking Beyond the Numbers

1. Are the companys revenues tied to one key customer ? 2. To what extent are the companys revenues tied to one key product ?

3. To what extent does the company rely on a single supplier ?

4. What percentage of the companys business is generated overseas ?

5. Competition
6. Future prospects 7. Legal and regulatory environment

Summing Up
Balance sheet, profit and loss account, and the statement of
cash flows are the three financial statements The balance sheet shows the financial position at a given point of time, the profit and loss account reflects the financial performance over a period of time, and the statement of cash flows displays the sources and uses of cash over a period of time. Financial statement analysis can provide insights into a firms performance and position. valuable

The principal tool of financial statement analysis is financial ratio analysis.

 Financial ratios may be divided into five broad categories:

Liquidity ratios Leverage ratios Turnover ratios Profitability ratios Valuation ratios Generally, the financial ratios of a company are compared with some benchmark ratios.

The Du Pont chart is a popular tool of financial analysis. It provides insights into the determinants of the return on equity
There are certain problems and issues in financial statement analysis that call for care, circumspection, and judgment.