Handout On Financial Statement Analysis And Ratios

Key pointers to balance sheet and profit and loss statements:
A balance sheet represents the financial affairs of the company and is also referred to as “Assets and Liabilities” statement and is always as on a particular date and not for a period.
A profit and loss account represents the summary of financial transactions during a particular period and depicts the profit or loss for the period along with income tax paid on the profit and how the profit has been allocated (appropriated).
Net worth means total of share capital and reserves and surplus. This includes preference share capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to equity ratio, the necessary adjustment has to be done by reducing preference share capital from net worth and adding it to the debt in the numerator.
Reserves and surplus represent the profit retained in business since inception of business. “Surplus” indicates the figure carried forward from the profit and loss appropriation account to the balance sheet, without allocating the same to any specific reserve. Hence, it is mostly called “unallocated surplus”. The company wants to keep a portion of profit in the free form so that it is available during the next year for appropriation without any problem. In the absence of this arrangement during the year of inadequate profits, the company may have to write back a part of the general reserves for which approval from the board and the general members would be required.
Secured loans represent loans taken from banks, financial institutions, debentures (either from public or through private placement), bonds etc. for which the company has mortgaged immovable fixed assets (land and building) and/or hypothecated movable fixed assets (at times even working capital assets with the explicit permission of the working capital banks) Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while loans from banks for working capital, i.e., current assets are secured by current assets. These loans enjoy priority over unsecured loans for settlement of claims against the company.
Unsecured loans represent fixed deposits taken from public (if any) as per the provisions of Section 58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been offered. Such unsecured loans rank second and subsequent to secured loans for settlement of claims against the company. There are other unsecured creditors also, forming part of current liabilities, like, creditors for purchase of materials, provisions etc.
Gross block = gross fixed assets mean the cost price of the fixed assets. Cumulative depreciation in the books is as per the provisions of The Companies Act, 1956, Schedule XIV. It is last cumulative depreciation till last year +

depreciation claimed during the current year. Net block = net fixed assets mean the depreciated value of fixed assets.
Capital work-in-progress – This represents advances, if any, given to building contractors, value of building yet to be completed, advances, if any, given to equipment suppliers etc. Once the equipment is received and the building is complete, the fixed assets are capitalised in the books, for claiming depreciation from that year onwards. Till then, it is reflected in the form of capital work in progress.
Investments – Investment made in shares/bonds/units of Unit Trust of India etc. This type of investment should be ideally from the profits of the organisation and not from any other funds, which are required either for working capital or capital expenditure. They are bifurcated in the schedule, into “quoted and traded” and “unquoted and not traded” depending upon the nature of the investment, as to whether they can be liquidated in the secondary market or not.
Current assets – Both gross and net current assets (net of current liabilities) are given in the balance sheet.
Miscellaneous expenditure not written off can be one of the following – Company incorporation expenses or public issue of share capital, debenture etc. together known as “preliminary expenses” written off over a period of 5 years as per provisions of Income Tax. Misc. expense could also be other deferred revenue expense like product launch expenses.
Other income in the profit and loss account includes income from dividend on share investment made in other companies, interest on fixed deposits/debentures, sale proceeds of special import licenses, profit on sale of fixed assets and any other sundry receipts.
Provision for tax could include short provision made for the earlier years.
Provision for tax is made after making all adjustments for the following: • • •

Carried forward loss, if any; Book depreciation and depreciation as per income tax and Concessions available to a business entity, depending upon their activity (export business, S.S.I. etc.) and location in a backward area (like Goa etc.)


As per the provisions of The Companies Act, 1956, in the event of a limited company declaring dividend, a fixed percentage of the profit after tax has to be transferred to the General Reserves of the Company and entire PAT cannot be given as dividend.
With effect from 01/04/02, dividend tax on dividends paid by the company has been withdrawn. From that date, the shareholders are liable to pay tax on dividend income. Thus for a period of 5 years, the position was different in the sense that the company was bearing the additional tax on dividend.


Other parts of annual statements – 1. The Directors’ Report on the year passed and the future plans; 2. Annexure to the Directors’ Report containing particulars regarding of energy etc; 3. Auditors’ Report as per the Manufacturing and Other Companies Report) Order, 1998) along with Annexure;

conservation

(Auditors’

4. Schedules to Balance Sheet and Profit and Loss Account; 5. Accounting policies adopted by the company and notes on accounts giving details about changes if any, in method of valuation of stocks, fixed assets, method of depreciation on fixed assets, contingent liabilities, like guarantees given by the banks on behalf of the company, guarantees given by the company, quantitative details regarding performance of the year passed, foreign exchange inflow and outflow etc. and 6. Statement of cash flows for the same period for which final accounts have been presented. There is a significant difference between the way in which the statements of accounts are prepared as per Schedule VI of the Companies Act and the manner in which these statements, especially, balance sheet is analysed by a finance person or an analyst. For example, in the Schedule VI, the current liabilities are netted off against current assets and only net current assets are shown. This is not so in the case of financial statement analysis. Both are shown fully and separately without any netting off. At the end of any financial year, there are certain adjustments to be made in the books of accounts to get the proper picture of profit or loss, as the case may be, for that particular period. For example, if stocks of raw materials are outstanding at the end of the period, the value of the same has to be deducted from the total of the opening stock (closing stock of the previous year) and the current year’s purchases. This alone would show the correct picture of materials consumed during the current year. For example, the figures for a company are as under: ♦ Purchases during the year: Rs.600lacs ♦ Opening stock of raw material: Rs.100lacs ♦ Closing stock of raw material: Rs.120lacs Then, the quantum of raw material consumed during the year is Rs.580lacs and only this can be booked as expenditure during the year. Consumption is always valued in this manner and cross verified with the value of materials issued from stores during the year to compare with the previous year; Similarly, a second adjustment arises due to the difference between closing stocks of work-in-progress and finished goods on one hand and opening stocks of work-inprogress and finished goods on the other hand. Suppose the closing stocks are higher in value, the difference has to be either added to this year’s income or deducted from this year’s expense. (Different ways of presentation). Similarly in case the closing

stocks are less than the opening stocks, the difference has to be deducted from income or added to expenses for that year. Let us study the following example. In a company, the opening stocks were Rs.100lacs and closing stocks are Rs.120lacs. This means that during the course of this year, the stocks on hand have gone up by Rs.20lacs from the goods produced during this year. This does have an effect on the profit of the company. The company cannot book expenditure incurred on producing this incremental stock of Rs.20lacs, as they have not sold the goods. However the materials and other expenses have already been incurred and hence this value is deducted. The basic assumption is that the carry forward stocks have been sold during the current year while at the end of the current year fresh stocks worth Rs.120lacs have come in for stocking. Hence, on an ongoing basis, opening stocks are added and closing stocks are deducted. In the above example, the effect of adding the opening stock and deducting the closing stock would be as under: Let us assume the production for the year was Rs.1000lacs Then, sales for the year could only be Rs.980lacs derived as follows: Production during the year: Add: Opening stock: Deduct: Closing stock: Sales for the year:

Rs.1000lacs Rs. 100lacs Rs. 120lacs Rs. 980lacs.

On the other hand, in case the closing stocks would have been Rs.90lacs, the sales would have been Rs.1010lacs, more than the production value. Thus, the difference between the opening and closing stocks of work-in-progress and finished goods affects income and thereby profit. The companies always use this as a tool, either to increase or decrease income. In case they show more closing stocks, income is less and thereby profit is less and tax is saved and similarly if they show less closing stocks, income is more and profit is also more. The principal tools of analysis are – ♦ Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play. ♦ Funds flow analysis – this is to understand the movement of funds (please note the difference between cash and fund – cash means only physical cash while funds include cash and credit) during any given period and mostly this period is 1 year. This means that during the course of the year, we study the sources and uses of funds, starting from the funds generated from activity during the period under review.

Let us see some of the important types of ratios and their significance: ♦ ♦ ♦ ♦ ♦ ♦

Liquidity ratios; Turnover ratios; Profitability ratios; Investment on capital/return ratios; Leverage ratios and Coverage ratios

Liquidity ratios: o Current ratio: Formula = Current assets/Current liabilities. Min. Expected even for a new unit in India = 1.33:1. Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital. Range – No fixed range is possible. Unless the activity is very profitable and there are no immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see “quick asset ratio” or “acid test ratio”. o Acid test ratio or quick asset ratio: Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This assumes that all other current assets like receivables can be converted into cash easily. This ratio examines whether the quick assets are sufficient to cover all the current liabilities. Some of the authors indicate that the entire current liabilities should not be considered for this purpose and only quick liabilities should be considered by deducting from the current liabilities the short-term bank borrowing, as usually for an on going company, there is no need to pay back this amount, unlike the other current liabilities. Significance = coverage of current liabilities by quick assets. As quick assets are a part of current assets, this ratio would obviously be less than current ratio. This directly indicates the degree of excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost associated with high level of liquidity could also be high.

What is working capital gap? The difference between all the current assets known as “Gross working capital” and all the current liabilities other than “bank borrowing”. This gap is met from one of the two sources, namely, net working capital and bank borrowing. Net working capital is hence defined as medium and long-term funds invested in current assets. Turn over ratios: Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system. o Debtors turn over ratio – this indicates the efficiency of collection of receivables and contributes to the liquidity of the system. Formula = Total credit sales/Average debtors outstanding during the year. Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of industry like capital goods, consumer goods – capital goods, this would be less and consumer goods, this would be significantly higher; Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and competitive it would be less as you are forced to give credit; Whether new enterprise or established – new enterprise would be required to give higher credit in the initial stages while an existing business would have a more fixed credit policy evolved over the years of business; Hence any deterioration over a period of time assumes significance for an existing business – this indicates change in the market conditions to the business and this could happen due to general recession in the economy or the industry specifically due to very high capacity or could be this unit employs outmoded technology, which is forcing them to dump stocks on its distributors and hence realisation is coming in late etc. o

Average collection period = inversely related to debtors turn over ratio. For example debtors turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90 days. In case the debtors turn over ratio increases, the average collection period would reduce, indicating improvement in liquidity. Formula for average collection period = 360/receivables turn over ratio. The above points for debtors turn over ratio hold good for this also. Any significant deviation from the past trend is of greater significance here than the absolute numbers. No minimum and no maximum.

o Inventory turn over ratio – as said earlier, this directly contributes to the profitability of the organisation. Formula = Cost of goods sold/Average inventory held during the year. The inventory should turn over at least 4 times in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle and in such cases, the ratio would be low. While receivables turn over contributes to liquidity, this contributes to

profitability due to higher turn over. The production cycle and the corporate policy of keeping high stocks affect this ratio. The less the production cycle, the better the ratio and vice-versa. The higher the level of stocks, the lower would be the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges. o Current assets turn over ratio – not much of significance as the entire current assets are involved. However, this could indicate deterioration or improvement over a period of time. Indicates operating efficiency. Formula = Cost of goods sold/Average current assets held in business during the year. There is no min. Or maximum. Again this depends upon the type of industry, market conditions, management’s policy towards working capital etc. o Fixed assets turn over ratio Not much of significance as fixed assets cannot contribute directly either to liquidity or profitability. This is used as a very broad parameter to compare two units in the same industry and especially when the scales of operations are quite significant. Formula = Cost of goods sold/Average value of fixed assets in the period (book value). Profitability ratios -Profit in relation to sales and profit in relation to assets: o Profit in relation to sales – this indicates the margin available on sales; o Profit in relation to assets – this indicates the degree of return on the capital employed in business that means the earning efficiency. Please appreciate that these two are totally different. For example, we will study the following; Units A and B are in the same type of business and operate at the same levels of capacities. Unit A employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and profits are as under: Parameter Unit A Unit B Sales 1000lacs 1000lacs Profits 100lacs 90lacs Profit margin on sales 10% 9% Return on capital employed 40% 45% While Unit A has higher profit margins, Unit B has better returns on capital employed. o Profit margin on sales: Gross profit margin on sales and net profit margin ratio – Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges. Net sales = Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with another unit in the same industry or in

the same unit for comparing it with past trend. For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs. Parameter Sales Cost of production Gross profit Deduct: Selling general, Administrative expenses and interest Net profit

Unit A Unit B 100lacs 100lacs 60lacs 65lacs 40lacs 35lacs 35lacs 5lacs

30lacs 5lacs

While both the units have the same net profit to sales ratio, the significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses. This ratio helps in controlling either production costs if cost of production is high or selling and administration costs, in case these are high. Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula = Net profit/net sales. Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency. In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well. Investment on capital ratios/Earnings ratios: o Return on net worth Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds including Preference Share capital. Hence Preference Share capital is not deducted. There is no standard range for this ratio. If it reduces it indicates less return on the net worth. o Return on equity Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share capital. Although reference is equity here, all equity shareholders’ funds are taken in the denominator. Hence Preference dividend and Preference share capital are excluded. There is no standard range for this ratio. If it comes down over a period it means that the profitability of the organisation is suffering a setback. o Return on capital employed (pre-tax) Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives return on long-term funds employed in business in pretax terms. Again there is no standard range for this ratio. If it reduces, it is a cause for concern. o Earning per share (EPS) Dividend per share (DPS) + Retained earnings per share (REPS). Here the

share refers to equity share and not preference share. The formula is = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares. This is an important indicator about the return to equity shareholder. In fact P/E ratio is related to this, as P/E ratio is the relationship between “Market value” of the share and the EPS. The higher the PE the stronger is the recommendation to sell the share and the lower the PE, the stronger is the recommendation to buy the share. This is only indicative and by and large followed. There is something known as industry average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and growth prospects are quite good, it is the time for buying the shares, unless we know for certain that the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time for us to sell unless we expect further increase in the near future. Leverage ratios Leverages are of two kinds, operating leverage and financial leverage. However, we are concerned more with financial leverage. Financial leverage is the advantage of debt over equity in a capital structure. Capital structure indicates the relationship between medium and long-term debt on the one hand and equity on the other hand. Equity in the beginning is the equity share capital. Over a period of time it is net worth (-) redeemable preference share capital. It is well known that EPS increases with increased dose of debt capital within the same capital structure. Given the advantage of debt also, as even risk of default, i.e., non-payment of interest and non-repayment of principal amount increases with increase in debt capital component, the market accepts a maximum of 2:1 at present. It can be less. Formula for debt/equity ratio = Medium and long-term loans + redeemable preference share capital / Net worth (-) Redeemable preference share capital. From the working capital lending banks’ point of view, all liabilities are to be included in debt. Hence all external liabilities including current liabilities are taken into account for this ratio. We have to add redeemable preference share capital and reduce from the net worth the same as in the previous formula. Coverage ratios o Interest coverage ratio This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest payment on all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1. Less than that is not desirable, as after paying interest, tax has to be paid and afterwards dividend and dividend tax.

o Asset coverage ratio

This indicates the number of times the medium and long-term liabilities are covered by the book value of fixed assets. Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. Accepted ratio is minimum 1.5:1. Less than that indicates inadequate coverage of the liabilities. o Debt Service coverage ratio This indicates the ability of the business enterprise to service its borrowing, especially medium and long-term. Servicing consists of two aspects namely, payment of interest and repayment of principal amount. As interest is paid out of income and booked as an expense, in the formula it gets added back to profit after tax. The assumption here is that dividend is ignored. In case dividend is paid out, the formula gets amended to deduct from PAT dividend paid and dividend tax. Formula is: (Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue Expenditure written off (+) Interest on medium and long-term borrowing (Denominator) Interest on medium and long-term borrowing (+) Installment on medium and long-term borrowing. This is assuming that dividend is not paid. In the case of an existing company dividend will have to be paid and hence in the numerator, instead of PAT, retained earnings would appear. The above ratio is calculated for the entire period of the loan with the bank/financial institution. The minimum acceptable average for the entire period is 1.75:1. This means that in one year this could be less but it has to be made up in the other years to get an average of 1.75:1.

What is the objective behind analysis of financial statements? Objective (To know about)

Relevant indicator/Remarks

1. Financial position of the company

Net worth, i.e., share capital, reserves and unallocated surplus in balance sheet carried down from profit and loss appropriation account. For a healthy company, it is necessary that there is a balance struck between dividend paid and profit retained in business so much the net worth keeps on increasing.

2. Liquidity of the company, i.e., whether the company is in a position to meet all its short-term liabilities (also called “current liabilities”) with the help of its current assets

Current ratio and quick ratio or acid test ratio. Current ratio = Current assets/current liabilities. Quick ratio = Current assets (-) inventory/ current liabilities. Current ratio should not be too high like 4:1 or 5:1 or too low like less than 1.5:1. This means that the company is either too liquid thereby

increasing its opportunity cost or not liquid at all, both of which are not desirable. Quick ratio could be at least 1:1. Quick ratio is a better indicator of liquidity position.

3. Whether the company has acquired new fixed assets during the year and if so, what are the sources, besides internal accruals to finance the same?

Examination of increase in secured or unsecured loans for this purpose. Without adequate financial planning, there is always the risk of diverting working capital funds for fixed assets. This is best assessed through a funds flow statement for the period as even net cash accruals (Retained earnings + depreciation + amortisation) would be available for fixed assets.

4. Profitability of the company in general and operating profits in particular, i.e., whether the main operations of the company like manufacturing have been in profit or the profit of the company is derived from other income, i.e., income from investment in shares/debentures etc.

Percentage of profit before tax to total income including other income, like dividend or interest income. Operating profit, i.e., profit before tax (-) other income as above as a percentage of income from the main operations of the company, be it manufacturing, trading or services.

5. Relationship between the net worth of the company and its external liabilities (both short-term and long-term). What about only medium and long-term debts?

Debt/Equity ratio, which establishes this relationship. Formula = External liabilities + preference share capital /net worth of the company (-) preference share capital (redeemable kind). From the lender’s point of view, this should not exceed 3:1. Is there any sharp deterioration in this ratio? Is so, please be on guard, as the financial risk for the company increases to that extent. For only medium and long-term debts, it cannot exceed 2:1.

6. Has the company’s investments in shares/debentures of other companies reduced in value in comparison with last year?

Difference between the market value of the investments and the purchase price, which is theoretically a loss in value of the investment. Actual loss is booked upon only selling. The periodic reduction every year should warn us that at the time of actual sales, there would be substantial loss, which immediately would reduce the net worth of the company. Banks, Financial Institutions, Investment companies or NBFCs would be required to declare their investment every year in the balance sheet at cost price or market price whichever is less.

7. Relationship between average debtors Average debtors in the year/average creditors (bills receivable) and average creditors in the year. This should be greater than 1:1, (bills payable) during the year. as bills receivable are at gross value {cost of development (+) profit margin}, whereas; creditors are at purchase price for software or components, which would be much less than the final sales value. If it is less than 1:1, it shows that while receivable management is quite good, the company is not paying its creditors, which could cause problems in future. Too high a ratio would indicate that receivable management is very poor.

8. Future plans of the company, like acquisition of new technology, entering into new collaboration agreement, diversification programme, expansion programme etc.

Directors’ report. This would reveal the financial plans for the company, like whether they are coming out with a public issue/Rights issue etc.

9. Has the company revalued its fixed assets Auditors’ comments in the “Notes to Frequent during the year, thereby creating Accounts” relevant for this. revaluation reserves, without any inflow revaluation is not desirable and healthy. of capital into the company, as this is just an entry passed in the books?

10. Whether the company has increased its investment and if so, what is the source for it? What is the nature of investment? Is it in tradable securities or long-term Securities, which can have a lock-inperiod and cannot be liquidated in the near future?

Increase in amount of investment in shares/debentures/Govt. securities etc. in comparison with last year and any investment within group companies? Any undue increase in investment should put us on guard, as working capital funds could have been diverted for it.

11. Has the company during the year given Any increase in unsecured loans. If the loans any unsecured loans substantially other are to group companies, then all the more than to employees of the company? reason to be cautious. Hence, where the figures have increased, further probing is called for.

12. Are the company’s unsecured loans Any comments to this effect in the notes to (given) not recoverable and very old? accounts should put us on caution. This examination would indicate about likely impact on the future profits of the company.

13. Has the company been regular in Any comments about over dues as in the payment of its dues on account of loans “Notes to Accounts” should be looked into. Any serious default is likely to affect the or periodic interest on its liabilities? “credit rating” of the company with its lenders, thereby increasing its cost of borrowing in future.

14. Has the company defaulted in providing Any comments about this in the “Notes to for bonus liability, P.F. liability, E.S.I. Accounts” should be looked into. liability, gratuity liability etc?

15. Whether the company is holding very Cash balance together with bank balance in huge cash, as it is not desirable and current account, if any, is very high in the increases the opportunity cost? current assets.

16. How many times the average inventory Relationship between cost of goods sold and has turned over during the year? average inventory during the year (only where cost of goods sold cannot be determined, net sales can be taken as the numerator). In a manufacturing company,

which is not in capital goods sector, this should not be less than 4:1 and for a consumer goods industry, this should be higher even. For a capital goods industry, this would be less.

17. Has the company issued fresh share Increase in paid-up capital in the balance capital during the period and what is the sheet and share premium reserves in case the purpose for which it has raised equity issue has been at a premium. capital? If it was a public issue, how did it fare in the market?

18. Has the company issued any bonus shares Increase in paid-up capital and simultaneous during the year? reduction in general reserves. Enquiry into the company’s ability to keep up the dividend rate of the immediate past.

19. Has the company made any rights issue in Increase in paid-up capital and share the period and what is the purpose of the premium reserves, in case the issue has been issue? If it was a public issue, how did it at a premium. fare in the market?

20. What is the proportion of marketable investment to total investment and whether this has decreased in comparison with the previous year?

Percentage of marketable investment to total investment and comparison with previous year. Any decrease should put us on guard, as it reduces liquidity on one hand and increases the risk of non-payment on due date, especially if the investment is in its own subsidiary or group companies, thereby forcing the company to provide for the loss.

21. What is the increase in sales income over Comparison with previous year’s sales last year in % terms? Is it due to increase income and whether the growth has been in numbers or change in product mix or more or less than the estimate. increase in prices of finished products only?

22. What is the amount of provision for bad In percentage terms, how much is it of total and doubtful debts or advances debts outstanding and what are the reasons for such provision in the notes to accounts by outstanding? the auditors?

23. What is the amount of work in progress Is there any comment about valuation of as shown in the Profit and Loss Account? work in progress by the auditors? It can be seen that profit from operations can be manipulated by increase/decrease in closing stocks of both finished goods and work in progress.

24. Whether the company is paying any lease Examination of expenses schedule would rentals and if so what is the amount of show this. What is the comment in notes to lease liability outstanding? accounts about this? Lease liability is an offbalance sheet item and hence this examination, to ascertain the correct external liability and to include the lease rentals in future also in projected income statements; otherwise, the company may be having much less disclosed liability and much more lease liability which is not disclosed. This has to be taken into consideration by an analyst while estimating future expenses for the purpose of estimating future profits.

25. Has the company changed its method of depreciation on fixed assets, due to which, there is an impact on the profits of the company?

Auditors’ comments on “Accounting” policies. Change over from straight-line method to written down value method or vice-versa does affect the deprecation charge for the year thereby affecting the profits during the year of change.

26. If it is a manufacturing company, whether Relationship between materials consumed the % of materials consumed is during the year and the sales. increasing in relation to sales?

27. Has the company changed its method of Auditors’ valuation of inventory, due to which there policies. is an impact of the profits of the company?

comments

on

“Accounting”

28. Whether the % of administration and Relationship between general and general expenses has increased during the administrative expenses during the year and the sales. In case there is any extraordinary year under review? increase, what are the reasons therefore?

29. Whether the company had sufficient Interest coverage ratio = earnings before income to pay the interest charges? interest and tax/total interest on all short-term and long-term liabilities. Minimum should be 3:1 and anything less than this is not satisfactory.

30. Whether the finance charges have gone up disproportionately as compared with the increase in sales income during the same period?

Relationship between interest charges and sales income – whether it is consistent with the previous year or is there any spurt? Is there any explanation for this, like substantial expansion or new project or diversification for which the company has taken financial assistance? While a benchmark % is not available, any level in excess of 6% calls for examination.

31. Whether the % of employee costs to sales Relationship between “payment to and has increased? provision for employees” and the sales. In case any undue increase is seen, it could be due to expansion of activity etc. that would be included in the Directors’ Report.

32. Whether the % of selling expenses in Relationship between “selling and relation to sales has gone up? marketing” expenses and the sales. Any undue increase could either mean that the company is in a very competitive industry or it is aggressive to increase its market share by adopting a marketing strategy that would increase the marketing expenses including offer of higher commission to the intermediaries like agents etc.

33. Whether the company had sufficient internal accruals {Profit after tax (-) dividend (+) any non-cash expenditure like depreciation, preliminary expenses write-off etc.} to meet repayment obligation of principal amount of loans, debentures etc.?

Debt service coverage ratio = Internal accruals (+) interest on medium and longterm external liabilities/interest on medium and long-term liabilities (+) repayment of medium and long-term external liabilities. The term-lending institution or bank looks for 1.75:1 on an average for the loan period. This is a very critical ratio to indicate the ability of the company to take care of its obligation towards the loans it has taken both

by way of interest as well as repayment of the principal.

34. Return on investment in business to Earnings before interest and tax/average total compare it with return on similar invested capital, i.e., net worth (+) debt investment elsewhere. capital. This should be higher than the average cost of funds in the form of loans, i.e., interest cost on loans/debentures etc.

35. Return on equity (includes reserves and Profit after tax (-) dividend on preference surplus) share capital/net worth (-) preference share capital (return in percentage). Anything less than 15% means that our investment in this company is earning less than the average return in the market.

36. How much earning has our share made? Profit after tax (-) dividend on preference (EPS) share capital/number of equity shares. In terms of percentage anything less than 40% to 50% of the face value of the shares would not go well with the market sentiments.

37. Whether the company has reduced its Relationship between amount of dividend dividend payout in comparison with last payout and profit after tax last year and this year? year. Is there any reason for this like liquidity crunch that the company is experiencing or the need for conserving cash for business activity, like purchase of fixed assets in the immediate future?

38. Is there any significant increase in the contingent liabilities due to any of the following? Disputed central excise duty, customs duty, income tax, octroi, sales tax, contracts remaining unexecuted, guarantees given by the banks on behalf of the company as well as the guarantees given by the company on behalf of its subsidiary or associate company, letter of credit outstanding for which goods not yet received etc.

“Notes on Accounts” as given at the end of the accounts. Any substantial increase especially in disputed amount of duties should put us on guard.

39. Has the company changed its policy of Substantial change in vendor charges, or outsourcing its work from vendors and if subcontracting charges. so, what are the reasons?

40. Is there any substantial increase in charges Increase in consultancy charges. paid to consultants?

41. Has the company opened any branch Directors’ Report or sudden spurt in general office in the last year? and administration expenses.

The principal tools of analysis are: ♦ Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play. ♦ Comparison with past trend within the same company is one type of analysis and comparison with the industrial average is another analysis While one can derive a lot of useful information from analysis of the financial statements, we have to keep in mind some of the limitations of the financial statements. Analysis of financial statements does indicate a definite trend, though not accurately, due to the intrinsic nature of the data itself.

Some of the limitations of the financial statements are given below.
Analysis and understanding of financial statements is only one of the tools in understanding of the company
The annual statements do have great limitations in their value, as they do not speak about the following
Management, its strength, inadequacy etc.
Key personnel behind the activity and human resources in the organisation.
Average key ratios in the industry in the country, of which the company is an integral part. This information has to be obtained separately.
Balance sheet is as on a particular date and hence it does not indicate about the average for the entire year. Hence it cannot indicate the position with 100% reliability. (Link it with fundamental analysis.)
The auditors’ report is based more on information given by the management, company personnel etc.
To an extent at least, there can be manipulation in the level of expenditure, level of closing stocks and sales income to manipulate profits of the organisation, depending upon the requirement of the management during a particular year.
One cannot come to know from study of financial statements about the tax planning of the company or the basis on which the company pays tax, as it is not mandatory under the provisions of The Companies’ Act, 1956, to furnish details of tax paid in the annual statement of accounts. Notwithstanding all the above, continuous study of financial statements relating to an industry can provide the reader and analyst with an in-depth knowledge of the industry and the trend over a period of time. This may prove invaluable as a tool in investment decision or sale decision of shares/debentures/fixed deposits etc.

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