Analysis of
Financial
Statements
Study of relationships between the
variables of the same statement or
different financial statements and the
trend of these elements.
Analysis of
Financial
Analysis can be external or internal;
Statements
horizontal or vertical; and
intra-firm or inter-firm.
Horizontal analysis
Comparative financial statements
Trend percentage
Tools of
Analysis Vertical analysis (common size
financial statements)
Ratio analysis
Figures of two or more periods are
Horizontal Analysis
placed side by side.
Comparative Comparison of absolute and
Financial percentage change in the figures
Statements over the periods is made to derive
meaningful conclusions.
Lets do it on your company.
Trend percentages are useful for
making a comparative study of the
financial statements over a number
of years.
Horizontal Analysis
The earliest year used for
comparison is treated as the base
year.
Trend
Percentages
The base year figure for each item
of the financial statement is taken as
100.
The figures for the subsequent years
are expressed as percentages of the
base year figure
Expressing various components of the
financial statements as a percentage of
a common base which is taken as 100
Vertical analysis
Balance sheet – Percentage of total of
assets
Profit and loss a/c – Percentage of
Common Size sales
Statements
Helps is understanding the relative
importance of different components.
Change in weight over a period of
time.
Ratio analysis makes use of financial ratios
for financial analysis.
Financial ratios are relationships between
two financial variables appearing in
financial statements.
Ratio Analysis
Interpreting the relationships to form
judgment regarding the financial affairs of
the unit.
The averages for the industry in
which the company operates
The ratios of another company in its
industry
Benefits of Ratio
Analysis
Its own ratios from previous years
Its planned ratios for the current and
future years
Depending on the purpose they
serve, ratios may be classified as:
Profitability Analysis
Classification of Efficiency/Turnover Analysis
Ratios Liquidity Analysis
Leverage Analysis
Ratios involving Share Information.
The profitability ratios are used to
check if the company is generating
an acceptable return for its owners.
Both creditors and investors are
interested in the profit-making
Profitability ability of a company.
Ratios
Lack of adequate profitability
adversely affects the liquidity of the
company, its ability to raise external
financing and its growth prospects.
Widely used measures of profitability
include
1. Gross profit margins,
2. Operating profit margins
Profitability 3. Net profit margins
Ratios 4. Earnings per share (EPS),
5. Return on capital employed
(ROCE),
6. Return on assets (ROA) and
7. Return on equity (ROE).
Profit margins are used to analyze the
profit made per unit of sales.
Three kinds of profit margins are
Profitability Ratios generally used: gross profit margin,
operating profit margin and net profit
margin.
Gross profit
Gross profit ratio= 100
Profit Margin Sales
Profit before interest and tax
Operating profit ratio= 100
Sales
Net profit
Net profit ratio= 100
Sales
Example
Last year, XYZ Corporation had net
sales of $8,000,000 and its cost of
goods sold was $6,000,000.
1. Gross Profit
Margin Gross margin = gross profit / net
sales
Example
Assume that XYZ is a regular corporation which
had $8,000,000 of net sales Its expenses were:
cost of goods sold of $6,000,000; SG&A
3. Net profit expenses of $1,250,000; interest expense of
margin $30,000; and income tax expense of $160,000.
Profitability
ratio
Year-on-Year (Current Year Sales – Previous Year Sales) /
(Y-o-Y) Growth Previous Year Sales
This ratio helps in evaluating the
prevailing market price of the share.
Profitability Ratios
Higher earnings per share translate into a
higher market price because it indicates
4. Earnings per better performance and prospects of the
Share company
Net profit - preference dividend
Earnings per share=
Number of equity shares
Assume that XYZ is a corporation with
Example
100,000 shares of common stock that is
outstanding and publicly traded. In
addition, XYZ has 1,000 shares of
4. Earnings per preferred stock which requires an
EPS annual dividend of $40,000. Assuming
Share that XYZ's net income after tax was
$560,000 and it had 100,000 shares of
common stock outstanding throughout
the entire year
Profitability Ratios Diluted EPS = (net income – preferred
dividends) / (weighted average number
of shares outstanding + the conversion of
any in-the-money options, warrants, and
4. Earnings per other dilutive securities)
Share (Diluted)
Return on Capital Employed measures
the returns generated by the business on
the amount invested in the business.
Profitability Ratios
This is a key ratio and all other ratios can
be linked to this.
5. Return on
Capital
This ratio can be used to judge the
Employed enterprise’s borrowing policy and
whether the funds have been usefully
deployed in the business
Profit before interest and tax
Return on capital employed= 100
Average (Long-term liabilities+Owner's equity)
This ratio relates profit to investment in
the enterprise and shows how much the
Profitability Ratios firm has earned on the investment of all
the financial resources, that is, owners’
equity, long-term liabilities and current
liabilities.
6. Return on
Assets (ROA) ROA is often used by the top management
to evaluate the performance of divisional
managers in the use of assets.
Profit before interest and tax
Return on assets= 100
Average Total assets
This ratio relates profit earned on
shareholder’s funds.
Profitability Ratios
Return = Profit after Tax/Shareholder’s
funds * 100
Return on Shareholder’s funds = Equity Capital +
Shareholder’s Res. & Surplus + Pref. Share Capital –
Funds Fictitious Assets
The return on equity relates profits to
owners’ equity. Equity stands for owners’
funds.
Profitability Ratios
This ratio may be used for declaration of
dividend and building up of reserves.
Return on
It also indicates the efficiency with which
Equity (ROE)
funds are deployed in the business
ROE = PAT/Equity Cap.
Equity Cap. = Eq. Share Cap. + Res. &
Surplus – Fictitious Assets
Example Assume that during the past year a
corporation had net income after tax
(earnings) of $560,000. It was
determined that a representative average
Return on amount of stockholders' equity during
Equity the year was $2,800,000.
Share of Shareholder’s funds in the total
Profitability Ratios assets of the company
PR = Shareholder’s funds/Total Assets
Proprietary Shareholder’s funds = Equity Capital +
Ratio Res. & Surplus + Pref. Share Capital –
Fictitious Assets
Total Assets = Total Assets – Fictitious
Assets
The efficiency ratios measure the
effectiveness with which a concern uses the
resources or assets at its disposal.
These ratios are usually calculated on the
basis of sales or cost of sales, and are
expressed in number of times rather than as
Efficiency a percentage.
Ratios
Such ratios should be calculated separately
for each type of asset.
The greater the ratio, the more will be the
efficiency of asset usage. A lower ratio will
show under utilization of resources
available to the concern.
Inventory Turnover Ratio
Days to sell
Debtors’ Turnover Ratio
Efficiency ratios Average collection period
Creditors’ Turnover Ratio
Average payment period
The inventory turnover ratio indicates the
speed at which a company's inventory of
goods was sold during the past year.
Efficiency ratios Higher ratio is good.
Since there are risks and costs associated
with holding inventory, companies strive
for a high inventory turnover ratio, so
8. Inventory long as its inventory items are never out
Turnover Ratio of stock.
A very high ratio resulting from
extremely low level of inventory may
result in loss of sales in future due to the
inability to deliver goods promptly
Cost of goods sold or Sales
Inventory turnover ratio=
Average inventory
Example
A company had sales of $420,000 and its
cost of goods sold was $280,000. Also
assume that the company's balance sheet at
8. Inventory
the end of the year reported the cost of its
Turnover Ratio inventory as $75,000 and was $65,000 at
the end of the previous year.
The days' sales in inventory (also known
as days to sell) indicates
the average number of days that it took
Efficiency ratios for a company to sell its inventory.
The goal is to have the fewest number of
days of inventory on hand
9. Number of Of course, there is also a cost for being
Days’ Inventory out of stock. Number of days’ inventory
indicates how long the inventory is held
by the company on an average. Lower
ratio is good.
=365/inventory turnover
Average inventory
Number of days' inventory= 365
Cost of goods sold or Sales
The debtors’ turnover ratio shows
the relation between sales and
Efficiency ratios outstanding amount due from the
debtors to whom goods were sold
on credit.
10. Debtors’
/ARs’ Turnover A high debtors’ turnover ratio shows
Ratio prompt collection of bills.
Ratio = Net Credit Sales/Closing
Debtors
Example
Assume that the company had $570,000
10. Debtors’ of net credit sales during the year and
on average it had accounts receivable
/ARs’ Turnover
during the year of $60,000.
Ratio
This is a measure of the average length
of time taken for debtors to settle their
Efficiency ratios
balance
11. Average Having a smaller number of days' sales
in receivables means that on average,
Collection the company is converting its
Period receivables into the cash needed to pay
its current liabilities.
365
Average collection period=
Debtors' turnover ratio
The creditors’ turnover ratio shows the
relation between purchases and
outstanding amount due to the creditors
from whom goods were purchased on
Efficiency ratios credit.
A high creditors’ turnover ratio means
that the company takes a long time to
12. Creditors’
pay for credit purchases.
Turnover Ratio
Ratio = Net Credit Purchases/Closing
Creditors
Creditors’ turnover ratio can be better
interpreted by converting it into Average
Efficiency ratios Payment Period.
It can also be calculated as
13. Average
Payment Period
365
Average payment period=
Creditor's turnover ratio
Efficiency ratios Average Holding Period + Average
Collection Period – Average Payment
Period
Length of Cash
Cycle
Tests of short-term solvency focus on
the liquidity position of the company
The following ratios will be discussed
under it:
Liquidity 14. Working Capital
Analysis 15. Current ratio
16. Quick ratio
Liquidity Analysis Working capital is defined as the amount
remaining after subtracting a corporation's
total amount of current liabilities from the
total amount of its current assets.
14. Working
capital Generally, the larger the amount of
working capital, the more likely a
company will be able to pay its suppliers,
lenders, employees, etc. when the amounts
are due.
Working capital = current assets -
current liabilities
Liquidity Analysis Current ratio is the relation of a
company’s current assets to its current
liabilities.
15. Current
This ratio establishes the ability of the
Ratio business to meet its short-term
obligations. and is therefore of particular
significance to short-term creditors
Current assets
Current ratio=
Current liabilities
Example
ABC is a large manufacturing
corporation with $4,200,000 of
current assets and $4,000,000 of
15. Current current liabilities. Therefore, ABC's
Ratio current ratio is:
Beta Company is an internet
Example business with significant daily sales
to customers who must pay with a
credit card when ordering.
15. Current If Beta Company had $35,000 of
Ratio current assets and $20,000 of
current liabilities, its current ratio at
that moment would be:
The quick ratio is more conservative
than the current ratio because the
amounts of a company's inventory and
prepaid expenses are not included.
Liquidity Analysis
As a result, only the company's "quick"
assets consisting of cash, cash
16. Quick Ratio equivalents, investments and AR are
divided by the total amount of the
company's current liabilities.
The quick ratio is commonly known as
the acid test ratio.
Current assets - Inventories
Quick ratio=
Current liabilities
Example
A manufacturing corporation has
$4,200,000 of current assets and
$4,000,000 of current liabilities. However,
the $4,200,000 of current assets includes
16. Quick Ratio $2,600,000 of inventory and prepaid
expenses.
Example Assume that Beta Company is an
internet business with lots of sales
every day and customers pay when
ordering.
16. Quick Ratio
Beta's current assets of $35,000
includes $9,000 of inventory and
$1,000 of prepaid expenses.
Tests of long-term solvency focus
on the ability of the company to pay
interest and repay principal of its
long-term borrowings.
Solvency Ratio
These ratios are commonly called
“Solvency Ratios”.
The main ratios in this category are
17. debt–equity ratio and
18. interest coverage ratio
Solvency Ratio 19. Net Debt
The debt–equity ratio relates debt to equity or
owners’ funds.
Capital Structure This ratio indicates the degree of protection
Ratio enjoyed by long-term lenders.
The lower the ratio, the higher will be the
degree of protection to the lenders.
17. Debt–Equity
Ratio A debt–equity ratio of 2:1 was considered
satisfactory in the past.
For capital-intensive industries such as ship-
building, power units, cement units etc. a
Debt higher ratio is allowed.
Debt--equity ratio=
Equity Equity means Shareholder’s Funds
Capital Structure
Ratio
Financial Ratio = Total Assets/ Shareholder’s Funds
Leverage Ratio Higher ratio implies financial leverage
The interest coverage ratio relates interest
obligations to profits before interest and
tax
Solvency Ratio
It indicates the number of times interest
obligation is covered by the profits for
the period.
18. Interest
Coverage Ratio It is always desirable to have profits more
than the interest payable; otherwise the
position of the lenders is unsafe.
This ratio is calculated as follows:
Profit before interest and tax
Interest coverage ratio=
Interest
Example
Assume that XYZ Corporation had net
income after income tax of $560,000,
interest expense of $30,000 and income tax
18. Interest expense of $160,000.
Coverage Ratio
Solvency Ratio
Often used by the banks and financial
Debt Service institutions to ascertain the adequacy of
Coverage Ratio the firm’s cash flows to cover its debt
obligations
(EBITDA)/{Interest+Loan
Repayment/(1-Tax Rate)}
Net debt is a financial liquidity metric that
measures a company’s ability to pay all its
debts if they were due today.
Solvency Ratio
In other words, net debt compares a
company’s total debt with its liquid assets.
19. Net Debt It is used to determine if a company can
repay its obligations if they were all due
today and whether the company is able to
take on more debt.
Net debt = Short-term debt + Long-term debt – Cash and equivalents
Net debt is a financial liquidity metric that
measures a company’s ability to pay all its
debts if they were due today.
Solvency Ratio
In other words, net debt compares a
company’s total debt with its liquid assets.
19. Net Debt It is used to determine if a company can
repay its obligations if they were all due
today and whether the company is able to
take on more debt.
Net debt = Short-term debt + Long-term debt – Cash and equivalents
Investors in equity shares are more
interested in the return from their
investment in the form of dividend and
price appreciation.
Ratios Involving
Share Ratio that capture the relationship among
Information dividend, earnings and market price of
share are of particular interest to existing
and potential investors in a company’s
shares.
Ratios such as
Ratios Involving
Share 20. Dividend Payout,
Information 21. Dividend Yield and
22. Price Earnings
The dividend payout (D/P) ratio
Ratios Involving Share
measures the relationship between the
Information
earnings belonging to equity
shareholders and the dividend paid to
them.
20. Dividend
Payout Ratio D/P ratio is likely to be low for a growth
company as such a company would
require large amount of funds for
reinvestment. A mature company
Total dividend paid to equity shareholders
(i) Dividend payout ratio= 100
Total net profit belonging to equity shareholders
The dividend yield ratio indicates the
percentage return provided by the dividend
on the market price of the share.
Ratios Involving Share
Information
A low dividend yield may mean that either
the investors expect the dividends to grow
rapidly or the share is overpriced.
21. Dividend
Yield
A high dividend yield may indicate that
investors consider investment in the
company’s share to be a risky investment
or the share is underpriced.
Dividend per share
Dividend yield= 100
Market price per share
Stock, Dividend Payout Ratio(%), Dividend
Yield(%)
Example
ITC 81.51, 5.20
Hindustan Zinc 102.44, 7.02
Ratios Involving Indian Oil Corporation 48.87, 10.46
Share Bharti Infratel 58.87, 5.13
Information Petronet LNG 69.36, 5.08
Pfizer 296.54, 6.80
Sun TV Network 71.13, 5.16
Procter & Gamble Health 87.09, 8.71
SKF India 222.40, 7.78
Ratios Involving Share 1 – D/P Ratio
Information
What % of profits is being retained;
growing companies have a higher
Retention Ratio retention
Relating the market price to the
earnings gives an insight into how
Ratios Involving Share the investors judge the performance
Information of the concern.
A high P/E ratio suggests that the
Price/Earnings share is an attractive investment in
Ratio (P/E the eyes of investors.
Ratio) An unduly high P/E ratio relative to
companies with similar risk-return
profile may mean that the share is
overpriced.
Market price per share
Price/Earnings ratio=
Earnings per share
Ratios Involving
Asset Utilization
Ratios As Comments
Assets Turnover Ratio Time Indicator of efficiency in utilization of assets, higher
Total Income/ Total Assets s turnover means higher ability to generate revenue.
Average Assets can be used in denominator
Fixed Assets Turnover Ratio Time May use average assets in the denominators
Total Income/ Fixed Assets s
Current Assets Turnover Ratio
Sales / Current Assets
Working Capital Turnover Ratio Time Indicator of efficiency in utilization of working capital,
Total Income/ Working Capital s higher turnover means higher ability to generate revenue
for the same set of working capital
61
The Du Pont Control Chart is called as such because Du Pont Company of the USA first
used it. The various factors affecting the Return on Investment (ROI) are illustrated
through this chart. ROI represents the earning power of the business.
ROE=NPM×Asset Turnover×Equity Multiplier
where:
NPM=Net profit margin, the measure of operating efficiency
Du Pont Asset Turnover=Measure of asset use efficiency
Control Chart
Equity Multiplier=Measure of financial leverage
To understand the factors affecting a
firm’s ROE, particularly its trend
over time and its performance
relative to competitors, analysts
often “decompose” ROE into the
product of a series of ratios.
Decomposition Each component ratio is in itself
of ROE meaningful, and the process serves
to focus the analyst’s attention on
separate factors influencing
performance.
ROE=Margin Turnover Leverage
Profit after tax Sales Assets
ROE=
Sales Assets Equity
From the following details, calculate Return on Investment:
Share Capital : Equity (Rs.10) Rs. 4,00,000 Current Liabilities Rs. 1,00,000
12% Preference Rs. 1,00,000 Fixed Assets Rs. 9,50,000
General Reserve Rs. 1,84,000 Current Assets Rs. 2,34,000
10% Debentures Rs. 4,00,000
Also calculate Return on Shareholders’ Funds, EPS, Book value per share and P/E ratio if
the market price of the share is Rs. 34 and the net profit after tax was Rs. 1,50,000, and the
tax had amounted to Rs. 50,000.
Following information is given by a company from its books of accounts as on
March 31, 2015:
Particulars Rs.
Inventory 1,00,000
Total Current Assets 1,60,000
Shareholders’ funds 4,00,000
13% Debentures 3,00,000
Current liabilities 1,00,000
Net Profit Before Tax 3,51,000
Cost of revenue from operations 5,00,000
Calculate:
i) Current Ratio
ii) Liquid Ratio
iii) Debt Equity Ratio
iv) Interest Coverage Ratio
v) Inventory Turnover Ratio
71
72
73
74
75
76
77
