Basics Of Financial Statement Analysis

Basics of Financial Statement Analysis Analyzing financial statements involves evaluating three characteristics of a company: its liquidity, its profitability, and its insolvency. A short-term creditor, such as a bank, is primarily interested in the ability of the borrower to pay obligations when they come due. The liquidity of the borrower is extremely important in evaluating the safety of a loan. A long-term creditor, such as a bondholder, however, looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time. Long-term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments. Similarly, stockholders are interested in the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of the stock.

Need for Comparative Analysis Every item reported in a financial statement has significance. When Sears, Roebuck and Co. reports cash of $729 million on its balance sheet, we know the company had that amount of cash on the balance sheet date. But, we do not know whether the amount represents an increase over prior years, or whether it is adequate in relation to the company’s need for cash. To obtain such information, it is necessary to compare the amount of cash with other fiancial statement data. Comparison can be made on a number of different bases. Three are illustrated here: 1. Intracompany basis. This basis compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years. For example, Sears, Roebuck and Co. can compare its cash balance at the end of the current year with last year’s balance to find the amount of the increase or decrease. Likewise, Sears can compare the percentage of cash to current assets at the end of the current year with the percentage in one or more prior years. Intracompany comparisons are useful in detecting changes in financial relationships and significant trends.

2. Industry averages. This basis compares an item or financial relationship of a company with industry averages (or norms) published by financial ratings organizations such as Dun & Bradstreet, Moody’s and Standard & Poor’s. For example, Sears’s net income can be compared with the average net income of all companies in the retail chain-store industry. Comparisons with industry averages provide information as to a company’s relative performance within the industry. 3. Intercompany basis. This basis compares an item or financial relationship of one company with the same item or relationship in one or more competing companies. The comparisons are made on the basis of the published financial statements of the individual companies. For example, Sears’s total sales for the year can be compared with the total sales of its major competitors such as Kmart and Wal-Mart. Intercompany comparisons are useful in determining a company’s competitive position.

Tools of Financial Statement Analysis Various tools are used to evaluate the significance of financial statement data. Three commonly used tools are these: • Funds Flow Analysis • Cash Flow Analysis • Ratio Analysis 1. Fund Flow Analysis Fund may be interpreted in various ways as (a) Cash, (b) Total current assets, (c) Net working capital, (d) Net current assets. For the purpose of fund flow statement the term means net working capital. The flow of fund will occur in a business, when a transaction results in a change i.e., increase or decrease in the amount of fund. According to Robert Anthony the funds flow statement describes the sources from which additional funds were derived and the uses to which these funds were put. In short, it is a technical device designed to highlight the changes in the financial condition of a business enterprise between two balance sheets.

Different names of Fund-Flow Statement o A Funds Statement o A statement of sources and uses of fund o A statement of sources and application of fund o Where got and where gone statement o Inflow and outflow of fund statement Objectives of Fund Flow Statement The main purposes of FFS are:] o To help to understand the changes in assets and asset sources which are not readily evident in the income statement or financial statement. o To inform as to how the loans to the business have been used. o To point out the financial strengths and weaknesses of the business. Format of Fund Flow Statement Sources Fund from operation Non-trading incomes Issue of shares Issue of debentures Borrowing of loans Acceptance of deposits Sale of fixed assets Sale of investments (Long Term) Decrease in working capital

Applications Fund lost in operations Non-operating expenses Redemption of redeemable preference share Redemption of debentures Repayment of loans Repayment of deposits Purchase of fixed assets Purchase of long term investments Increase in working capital

Steps in Preparation of Fund Flow Statement. 1. Preparation of schedule changes in working capital (taking current items only). 2. Preparation of adjusted profit and loss account (to know fund from or fund lost in operations). 3. Preparation of accounts for non-current items (Ascertain the hidden information). 4. Preparation of the fund flow statement.

Statement of changes in Working Capital 2002 ____________________________________________________________ Particulars 2000 2001 Effect on working capital Rs. Rs. Increase Rs. Decrease Rs Current Assets: Cash 30000 10000 20000 Accounts Receivable 70000 140000 70000 Stock-in-trade 150000 225000 75000 Work-in-progress 80000 90000 10000 Total Current Assets 330000 465000 Tax payable 77000 43000 34000 Accounts payable 96000 192000 96000 Interest payable 37000 45000 8000 Dividend payable 50000 35000 15000 Total Current Liabilities 260000 315000 Working Capital (CA - CL) 70000 150000 Net increase in Working Capital (B/f) 80000 80000 Total 150000 150000 204000 204000

2. Cash Flow Analysis (CFS) Cash is a life blood of business. It sis an important tool of cash planning and control. A firm receives cash from various sources like sales, debtors, sale of assets investments etc. Likewise, the firm needs cash to make payment to salaries, rent dividend, interest etc. Cash flow statement reveals that inflow and outflow of cash during a particular period. It is prepared on the basis of historical data showing the inflow and outflow of cash. Objectives of CFS 1. To show the causes of changes in cash balance between the balance sheet dates. 2. To show the actors contributing to the reduction of cash balance inspire of increasing of profit or decreasing profit. Uses of CFS 1. It explaining the reasons for low cash balance. 2. It shows the major sources and uses of cash. 3. It helps in short term financial decisions relating to liquidity. 4. From the past year statements projections can be made for the future. 5. It helps the management in planning the repayment of loans, credit arrangements etc. Steps in Preparing CFS 1. Opening of accounts for non-current items (to find out the hidden information). 2. Preparation of adjusted P&L account (to find out cash from operation or profit, and cash lot in operation or loss). 3. Comparison of current items (to find out inflow or outflow of cash). 4. Preparation of Cash Flow Statement. To preparing Account for all non-current items is easier for preparing Cash Flow Statement. Cash from operation can be prepared by this formula also. Net Profit + Decrease in Current Assets Increase in Current Liabilities

Increase in Current Assets Decrease in Current Liabil..

Usefulness of the Statement of Cash Flows The information in a statement of cash flows should help investors, creditors, and others assess the following aspects of the firm’s financial position. 1. The entity’s ability to generate future cash flows. By examining relationships between items in the statement of cash flows, investors and others can make predictions of the amounts, timing, and uncertainty of future cash flows better than they can from accrual basis data. 2. The entity’s ability to pay dividends and meet obligations. If a company does not have adequate cash, employees cannot be paid, debts settled, or dividends paid. Employees, creditors, and stockholders should be particularly interested in this statement, because it alone shows the flows of cash in a business. 3. The cash investing and financing transactions during the period. By examining a company’s investing and financing transactions, a financial statement reader can better understand why assets and liabilities changed during the period. 4. The reasons for the difference between net income and net cash provided (used) by operating activities. Net income provides information on the success or failure of a business enterprise. However, some are critical of accrual basis net income because it requires many estimates. As a result, the reliability of the number is often challenged. Such is not the case with cash. Many readers of the statement of cash flows want to know the reasons for the difference between net income and net cash provided by operating activities. Then they can assess for themselves the reliability of the income number. In summary, the information in the statement of cash flows is useful in answering the following questions. How did cash increase when there was a net loss for the period? How were the proceeds of the bond issue used? How was the expansions in the plant and equipment financed? Why were dividends not increased? How was the retirement of debt accomplished? How much money was borrowed during the year? Is cash flow greater or less than net income?

Cash Flow Statement Inflow of Cash Opening cash balance Cash from operation Sales of assets Issue of debentures Raising of loans Collection from debentures Refund of tax

Amount *** *** *** *** *** *** *** ***

Outflow of cash Amount Redemption of preference *** shares Redemption of debentures *** Repayment of loans *** Payment of dividends *** Pay of tax *** Cash lost in debentures *** Closing cash balance

*** ***

Cash from operation can be calculated in two ways: 1. Cash Sales Method Cash Sales – (Cash Purchase + Cash Operation Expenses) 2. Net Profit Method It can be prepared in statement form or by Adjusted Profit and Loss Account. Illustration From the following balance sheets of Joy Ltd., prepare cash flow statement: Liabilities Particulars Equity share capital 8% Redeemable Pref. share capital General reserve P & L A/c Proposed dividends Creditors Bills payable Provision for taxation

Previous year 300000 150000 40000 30000 42000 55000 20000 40000 677000

Current year 400000 100000 70000 48000 50000 83000 16000 50000 817000

Assets Particulars Goodwill Building Plant Debtors Stock Bills receivable Cash Bank

Previous year 115000 200000 80000 160000 77000 20000 15000 10000 677000

Current year 90000 170000 200000 200000 109000 30000 10000 8000 817000

Additional information (a) Depreciation of Rs. 10000 and Rs. 20000 have been changed on plant and buildings during the current year. (b) An interim dividend of Rs. 20000 has been paid during the current year. (c) Rs. 35000 was paid during the current year for income tax. Solution Step – 1: A/c for Non-current items Building A/c Rs To balance c/d

200000

Rs By Depreciation (Ad P&L) By Cash (sales) (bal.) (4) By Balance c/d

200000

20000 10000 170000 200000

Plant A/c To Balance c/d To Cash(purchase)

Rs 80000 130000 210000

By Depreciation (Ad P&L) By Balance c/d

Rs 20000 200000 210000

To Balance c/d

To redemption (bal) To balance c/d

To cash (Tax paid) To balance c/d

Equity Share Capital A/c Rs 400000 By Balance c/d By Issue of shares 400000 Pref. Share Capital A/c Rs 50000 By balance b/d 100000 150000 Provision for Taxation A/c Rs 35000 By balance b/d 50000 By balance (Ad. P&L A/c) 85000

Adjusted P & L A/c Rs To depreciation on plant 10000 By balance b/d To deprecation on 20000 By CFO (balance) building To goodwill write-off 25000 To provision for tax 45000 To interim dividend 20000 To proposed dividend 50000 (current year) To general reserve 30000 To balance C/d 48000 248000

Rs 300000 100000 400000 Rs 150000 150000 Rs 40000 45000 85000 Rs 30000 218000

248000

3. Ratio analysis: The most important task of a financial manager is to interpret the financial information in such a manner, that it can be well-understood by the people, who are not well versed in financial information figures. The technique , by which it is so done, known as ‘Ratio analysis’. Ratio Analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. Ratio is a relationship between two or more variable expressed in; (i) Percentage, (ii) Rate (iii) Proportion. Ratio analysis is an important technique of financial analysis. It depicts the efficiency or short-fall of the organization in the form of trend analysis. Different ratios appeal to different people. Management, having the task of running a business efficiently, will be interested in all ratios. A supplier of goods on credit will be particularly interested in liquidity ratios, which indicate the ability of the business to pay its bills. Existing and future shareholders will be interested in investment ratios, which indicate the level of return that can be expected on an investment in the business. Major customers, intent on having a continuing source of supply, will be interested in the financial stability, as revealed by the capital structure, liquidity and profitability ratios. Debenture and loan stock holders will be interested in the ability of a business to pay interest, and ultimately to repay the capital. A banker, only giving short-term loans, will be interested mainly in the liquidity of the business, and its ability to repay those loans. The overall advantages of ratios are that they enable valid comparisons to be made between business of varying size and in different industries. All the problems of a business can’t be solved by ratio analysis. It will merely give a general indication of a trend, at the same time spotlighting any divergence from normality. This knowledge, however, should enable management to correct whatever may be going wrong in business. Classifications of Ratio Analysis • Liquidity Ratios • Profitability Ratios • Solvency Ratios

Liquidity Ratios Liquidity ratios measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. The ratios that can be used to determine the enterprise’s short-term debt-paying ability are the current ratio, the acid-test ratio, the current-cash debt coverage ratio, receivables turnover, and inventory turnover. Profitability Ratios Profitability ratios measure the income or operating success of an enterprise for a given period of time. Income, or the lack of it, affects the company’s liquidity position and the company’s ability to grow. As a consequence, both creditors and investors are interested in evaluating earning power – profitability. Profitability is frequently used as the ultimate test of management’s operating effectiveness. Solvency Ratios Solvency ratios measure the ability of the company to survive over a long period of time. Long-term creditors and stockholders are particularly interested in a company’s ability to pay interest a sit comes due and to repay the face value of debt at maturity. Debt to total assets, times interest earned, and cash debt coverage are three rations that provide information about debtpaying ability. Steps in Ratio Analysis Step 1 : Collection of information, which are relevant from the financial statements and then to calculate different ratios accordingly. Step 2 : Comparison of computed ratios of the same organizations or with the industry ratios. Step 3 : Interpretation, drawing of inference and report-writing.

Chart Showing Application of Different Ratios For Testing Ratio Concerned A. Profitability 1. Gross Profit Ratio 2. Net Profit Ratio 3. Operating Ratio 4. Return of Capital Employed 5. Dividend Ratio 6. Earning per Share 7. Dividend per Share

Interested Parties Shareholders Creditors (Long Term) Government Purchase of Enterprise Employees

B. Liquidity and Solvency

1. Current Ratio 2. Liquid Ratio 3. Absolute Liquid Ratio 4. Proprietary Ratio 5. Assets to Proprietorship Ratio 6. Debt-Equity Ratio 7. Capital Gearing Ratio

Creditors (short term) Investors Money Lenders

C. Capital Structure

1. Capital Gearing Ratio

Shareholders and Outsiders

2. Equity Capital Ratio 3. Long-term Loans to Networth D. Activity

1. Debtors Turnover Ratio Management 2. Creditors Turnover Ratio Shareholders 3. Stock Turnover Ratio Creditors (Long and Short term) 4. Fixed Assets Turnover Customers Ratio 5. Current Asset Turnover 6. Total Asset Turnover Ratio 7. Working Capital Turnover Ratio

E. Management Efficiency

All concerned Ratios

Management

Advantages of Ratio Analysis Ratio analysis is a very important and useful tool for financial analysis. It serves many purpose and is helpful not only for internal management but also for prospective investors, creditors and other outsiders. 1. It is an important and useful tool to check upon the efficiency with which the working capital is being used (managed) in a business enterprise. Efficient management of working capital. 2. It helps the management of business concern in evaluating its financial position and efficiency of performance. 3. It serves as a sort of health test of a business firm, because with the help of this analysis financial manager can determine whether the firm is financially healthy or not. 4. A ratio analysis covering a number of past accounting (financial) periods clearly shows the trend of changes in the business position (i.e., whether the trend in financial position, income position etc. is upward, or downward or static). The progress or downfall of a business concern is clearly indicated by this analysis. Use to measure the trend of the business. 5. It helps in making financial estimates for the future (i.e., in financial forecasting). 6. It helps the task of managerial control to a great extent. 7. It helps the credit suppliers and investors in evaluating a business firm as a desirable debtor or as a potential investment outlet. 8. With the help of this analysis ideal (standard) ratios can be established and these can be used for the purpose of comparison of a firm’s progress and performance. 9. This analysis communicates important information regarding financial strength and standing, earning capacity, debt (borrowing) capacity, liquidity position, capacity to meet fixed commitments (charges, solvency, capital gearing, working capital management, future prospects etc.) of a business concern. 10.This analysis may be employed for the purpose of comparing the working result and efficiency of performance of a business enterprise with that of other enterprises engaged in the same industry (interterm-comparisons).

Limitations of Ratio Analysis 1. Accounting Ratios (calculated under the system of ratio analysis) will

be correct only if the accounting data (figures), on which they are based, are correct. 2. It is mainly a historical analysis or an analysis of the past financial data. 3. in regard to profits of a business concern, ratio analysis may, in certain circumstances be misleading. 4. continues changes in price levels (or, purchasing power of money) seriously affect the validity or comparison of accounting ratios calculated for different accounting (financial) periods and make such comparisons very difficult. 5. Comparisons become difficult also on account of difference in the definition of several financial (accounting) terms like gross profit, operating profit, net profit etc., and on account of a considerable diversely in practice as regards their measurement. 6. The validity of comparison is also seriously affected by window dressing in the basic financial statements and by differences in accounting methods used by different business concerns. 7. A single ratio will not be able to convey much information. 8. This analysis gives only a part of the total information required for proper decision-making. 9. Ratio analysis should not be taken as substitute for sound judgment. 10.It should not be overlooked that business problems cannot be solved simple mechanically through ratio analysis or other types of financial analysis.

Illustration : The following is the trading and profit and loss account of Ram Sons (Pvt.) Ltd. For the year ended June 30, 2000. Rs. Rs. To stock-in-hand 76250 By sales 500000 To purchases 315000 By stock in hand 98500 To carriage and freight 2000 To wages 5000 To gross profit 200000 _______ ______ Rs 598000 Rs 598000 To administrative 101000 By Gross profit 200000 Expenses To finance expenses: By Non-operating incomes: Interest 1200 Interest on security 1500 Discount 2400 Dividend on shares 3750 Bad debts 3400 Profit on sale’s shares 750 7000 6000 To selling and distribution expenses 12000 To non-operating expenses: Loss on sale of securities 350 Provision for legal suit 1650 2000 To Net profit 84000 _________ Rs 206000 Rs 206000 Required to calculate : (a) Expense Ratio, (b) Gross Profit Ratio, (c) Net Profit Ratio, (d) Operating Net Profit Ratio, (e) Operating ratio, (f) Stock Turnover.

Solution : a) Expense ratios i) Administrative expenses Sales ii)

Finance expenses Sales

=

=

Rs. 101000 × 100 = 20.2% Rs. 500000

Rs. 7000 × 100 = 1.40% Rs. 500000

iii) Selling and Distribution Expenses = Rs. 12000 × 100 = 2.40% Sales Rs. 500000 iv) Non-operating expenses = Rs. 2000 × 100 = 0.4% Sales Rs. 500000 b) Gross Profit ratio Gross Profit = 2000 × 100 = 40% Sales 500000 c) Net Profit ratio Net Profit = 84000 × 100 = 16.80% Sales 500000 d) Operating Net Profit Ratio operating net profit = Net profit + Non-operating expenses – non-operating incomes = Rs. 84000 + Rs. 2000 – Rs. 6000 = Rs. 80000 Ratio Operating net profit = Rs. 80000 × 100 = 16% Sales Rs 500000 * It may be noted that operating ratio together with the operating net profit ratio will be equal to 100%.

e) Operating ratio This is an expression of the cost of goods sold plus all other operating expenses to net sales. This is calculated as follows: Stock in the beginning Add: Purchases Add: Direct expenses (Rs. 2000 + Rs. 5000) Less: Stock in hand at the end Cost of goods sold Add: All operating expenses: Administration expenses Finance expenses Selling and distribution expenses

Rs.

76250 315000 7000 398500 98500 300000

101000 7000 12000

Total cost of operation The operating ratio = Rs. 420000 × 100 = 84% Rs. 500000

120000 Rs. 420000

f) Stock turnover Stock at the beginning Add: Stock at the end Total Stock Average stock

Rs.

76250 98500 Rs. 174750

﴾ Rs. 174750 ﴿

2 Stock turnover = Costs of goods sold = Rs. 300000 = 3.43 times Average stock Rs. 87375 * It may be noted that operating ratio together with the operating net profit ratio will be equal to 100%.

Limitations of Financial Statement Analysis Significant business decisions are frequently made using one or more of the analytical tools illustrated in this term paper. But, one should be aware of the limitations of these tools and of the financial statements on which they are based. Estimates Financial statements contain numerous estimates. Estimates are used in determining the allowance for uncollectible receivables, periodic depreciation, the costs of warranties, and contingent losses. To the extent that these estimates are inaccurate, the financial ratios and percentages are inaccurate. Cost Traditional financial statements are based on cost. They are not adjusted for price-level changes. Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation. For example, a five-year comparison of Sears’s revenues might show a growth of 36%. But this growth trend would be misleading if the general price level had increased significantly during the same period. Alternative Accounting Methods Companies vary in the generally accepted accounting principles they use. Such variations may hamper comparibility. For example, one company may use the FIFO method of inventory costing: another company in the same industry may use LIFO. If inventory is a significant asset to both companies, it is unlikely that their current ratios are comparable. For example, If General Motors Corporation had used FIFO instead of LIFO in valuing its inventories; its inventories would have been 26% higher. This difference would significantly affect the current ratio (and other ratios as well). In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization. These differences in accounting methods might be detectable from reading the notes to the financial statements. But, adjusting the financial data to compensate for the different methods is difficult, if not impossible in some cases.

Atypical Data Fiscal year-end data may not be typical of the financial condition during the year. Firms frequently establish a fiscal year-end that coincides with the low point in operating activity or in inventory levels. Therefore, certain account balances (cash, receivables, payables, and inventories) may not be representative of the balances in the accounts during the year. Diversification of Firms Diversification in U.S. industry also limits the usefulness of financial analysis. Many firms today are so diversified that they cannot be classified by a single industry – they are true conglomerates. Others appear to be comparable but are not.