FINANCIAL ANALYSIS

Reference Books:
Financial Management by M. Y. Khan
P. K. Jain
WHAT IS FINANCIAL ANALYSIS

Analyzing the information present in the financial statement is
called financial analysis.


WHY DO WE DO FINANCIAL ANALYSIS

Financial Statements are reports meant for various users. Such
reports lose their significance if the users do not analyse and
interpret them in their own perspective for decision making.

Management
Top management will be concerned about the
market share or the growth potential of the
concerned enterprise. The middle management
will see the operational efficiency.

Shareholders and Investors
Will check on the profitability and solvency to the
concerned enterprise.

Lenders
Long term lenders will see the solvency whereas a
short term investor will be interested in the
liquidity.
USERS OF FINANCIAL STATEMENTS
Suppliers
Supplier will check on the liquidity of the
enterprise

Employees
Will be concerned with the profitability ratios

Government and Regulatory Agencies
Will see whether the income is deflated. It will
check the industry ratios.

HOW DO WE DO FINANCIAL ANALYSIS



Collection of information

Correction of information

Analysis

Interpretation and Reporting.

COLLECTION OF INFORMATION


1. Annual Reports

2. Web Sites

3. ROC

4. SEBI

5. RBI

6. CMIE

7. Prowess

8. Euro Monitor

9. Trade Magazines

10. Trade Associations like FICCI, ASO CHAM, NASCOM
CORRECTION OF INFORMATION

The information should be annualised.

The information obtained should be corrected after taking into
account the auditors notes to accounts like change in any
accounting policy, or booking of any abnormal profits/ losses and
the qualifications present in the audit report.


The reliability of the information should be verified.

ANALYSIS

1. Vertical Analysis Common size statement
2. Horizontal Analysis Trend Analysis
3. Ratio analysis
VERTICAL ANALYSIS- COMMON SIZE STATEMENT
Vertical analysis is suitable for time series analysis.
It helps in analysing and explaining the cost
structure, allocation of assets and capital structure
over time.
It makes inter firm comparison or comparison with
industry averages easier.
It provide efficient means of comparing among
small, medium and large size firm. It eliminates
the impact of difference in size.
COMMON SIZE INCOME STATEMENT
Trading and Profit & Loss a/c of J Ltd. For the year ending 31.3.2010
Particulars Amount Particulars Amount
To Opening Stock 195 By Sales 1300
To Purchases 715 By Closing Stock 260
To Wages 260
To Carriage inward 65
To Gross Profit 325
Total 1560 Total 1560
To Administrative Exp. 65 By Gross Profit 325
To Selling & Dist. Exp. 110 By Profit on sale of Machinery 26
To Depreciation 33
To Interest on debentures 52
To Provision for income tax 26
To Net Profit 65
Total 351 Total 351
(Rs. In lacs)
J Ltd. Common Size income statement for the year ending March 31,
2010
Particulars Rs. In lacs % of net sales
Net Sales 1300 100%
Cost of Goods sold 975 75%
Gross Profit 325 25%
Operating Expenses
Administration Expenses 98 7.5%
Selling & Distribution Expenses 110 8.5%
Total Operating Expenses 208 16%
Operating Income 116 9%
Interest on debentures 52 4%
Earning from usual sources 65 5%
Income Tax 26 2%
Profit after Tax 39 3%
Earning from unusual sources 26 2%
Net Earning 65 5%
COMMON SIZE BALANCE SHEET OF A Ltd. As on
March 31, 2010
Liability Amount % Asset Amount %
Equity Fund 390 30% Fixed Assets 780 60%
Long Term
Liability
650 50% Current
Assets
520 40%
Current
Liability
260 20%
TOTAL 1300 100% TOTAL 1300 100%
Rs. In lacs.
2006 2007 2008 2009 2010
Total Sales
2002 1990 2220 2701 3240
Cost of Sales 460 358 377 432 551
Gross Profit 1542 1632 1843 2269 2689
Selling and Administrative
expenses
701 697 821 1026 1166
Research and Development
Expenses
320 358 400 513 617
Other deduction (income) net 40 40 44 136 32
Operating Income 481 537 578 594 874
Interest Expense
21 20 10 10 12
PBT
460 517 568 584 862
Provision for tax
160 159 168 189 251
PAT
300 358 400 395 611
HORIZONTAL ANALYSIS
It helps in identifying the direction towards which an enterprise moves.
Income Statement of ABC Ltd. for the year ending March 31, 2006 to 2010
Rs. In lacs
Horizontal Common Size Statements of Income Statement for the year ending
March 31, 2006 to 2010 (as % of 2006 level)
2006 2007 2008 2009 2010
Total Sales 100 99 111 135 162
Cost of goods sold
100 78 82 94 120
Gross Profit
100 106 120 147 174
Selling and Administrative
expenses
100 99 117 146 166
Research and Development
Expenses
100 112 125 160 193
Other deduction (income)
net
100 100 110 340 80
Operating Income
100 112 120 123 182
Interest Expense
100 95 48 48 57
Profit before tax
100 112 123 127 187
M Ltd. Condensed Comparative balance sheets as on 31 Dec. 2003-2008
2003 2004 2005 2006 2007 2008
Assets
Current Assets
Cash 36 50 66 38 34 38
Receivables 130 134 144 270 320 340
Inventories 122 146 170 242 308 366
Total Current Assets 288 330 380 550 662 744
Land Property and
equipment (net)
304 310 312 620 650 600
Total Assets 592 640 692 1170 1312 1344
Liabilities and owners
equity
Current liabilities 82 86 104 306 390 440
Long term debt 60 60 60 260 260 320
Total liabilities 142 146 164 566 650 760
Capital stock 220 220 220 420 500 500
Retained earnings 230 274 308 184 162 84
Total Owners equity 450 494 528 604 662 584
Rs. crore
M Ltd. Condensed Comparative Income Statement for the year ended 31 Dec. 2003-2008
Items 2003 2004 2005 2006 2007 2008
Net Sales 500 574 680 760 850 870
Cost of goods sold 326 378 456 538 616 628
Gross Margin on sales 174 196 224 222 234 242
Administrative
expenses
110 120 150 180 212 228
Operating Income 64 76 74 42 22 14
Other expenses and
revenue items
8 10 4 12 10 12
Net income after tax 56 66 70 30 12 2
Rs. crore
M Ltd. Condensed Comparative balance sheets as on 31 Dec. 2003-2008
2003 2004 2005 2006 2007 2008
Assets
Current Assets
Cash 100 139 183 106 94 106
Receivables 100 103 111 208 246 262
Inventories 100 120 139 198 252 300
Total Current Assets 100 115 132 191 230 258
Land Property and
equipment (net)
100 102 103 204 214 197
Total Assets 100 108 117 198 222 227
Liabilities and owners
equity
Current liabilities 100 105 127 373 476 537
Long term debt 100 100 100 433 433 533
Total liabilities 100 103 115 399 458 535
Share Capital 100 100 100 191 227 227
Retained earnings 100 119 134 80 70 37
Total Owners equity 100 110 117 134 147 130
M Ltd. Condensed Comparative Income Statement for the year ended 31 Dec. 2003-2008
Items 2003 2004 2005 2006 2007 2008
Net Sales 100 115 136 152 170 174
Cost of goods sold 100 116 140 165 189 192
Gross Margin on sales 100 113 129 128 134 139
Administrative
expenses
100 109 136 164 193 207
Operating Income 100 119 116 66 34 22
Other expenses and
revenue items
100 125 50 150 125 150
Net income after tax 100 118 125 54 21 1
RATIO ANALYSIS
MEASURING LIQUIDITY
Liquidity is the ease with which assets can be converted into cash. It is the
ability of an enterprise to meet its short term obligations.
Assets which can be most quickly converted into cash are called quick assets
The current ratio, the quick ratio and turnover ratios are measures of liquidity:
Current ratio = current assets : currents liabilities
The current ratio measures general liquidity of an enterprise.
If the current ratio is lower than 1:1 (e.g. 0.5:1, which can also be expressed as
1.2), current liabilities exceed current assets. This generally shows that there is
a high financial risk because, in business, cash is more important than profit.
If the current ratio is too high (perhaps 3:1 or more) this may mean that the
company has more money than it can efficiently use. There is no hard and fast
rule about a ratio being too high, but when it rises continually over time the
situation should be examined.
It should be remembered that, when calculating current ratio, current assets
should be taken as inclusive of marketable securities.
A current ratio of 2:1 is considered satisfactory.
Quick ratio = Quick assets : Current liabilities

The term quick assets refer to current assets which can be
converted into cash immediately or at a short notice without
diminution of value.

Thus quick assets include cash and bank balance, short term
marketable securities, debtors/ receivables. It excludes prepaid
expenses and inventory.
MEASURING SOLVENCY
Solvency Indicates the proportion of shareholders
funds in the total liabilities. The higher the
solvency ratio, the higher the proportion of
shareholders funds in the total financing of the
business.
Following ratios help in measuring the solvency of
an enterprise
Debt Equity ratio
Debt Service Coverage ratio
DEBT EQUITY RATIO = Total outside Debts
Share Holders Fund

Total outside debts = (long term debts+ short term debts)

If D/E Ratio is 1:2 it means that total stake of the share holders is double the stake of
the outsiders.
Higher D/E Ratio is adverse from the point of view of the creditors. If project fails, the
creditors will lose heavily.
High D/E Ratio is also adverse from the point of view of the business. Higher Debts
will result in interference of the creditors in the management of the enterprise.
Further business will have to face heavy burden of interest payments, particularly at
the time of low profits. Finally the firm will face difficulty in raising additional funds.

However higher D/E Ratio is beneficial from the point of view of shareholders . With a
limited stake they will be able to retain control of the firm.
Also in times of high profits, the earning available to shareholders will increase. This is
because the debts carry a fixed rate of return.

What should be the debt equity ratio depends on the nature of industry and degree of
risk involved. Firms having stable income should have higher debt equity ratio.


DEBT SERVICE COVERAGE RATIO = PAT + Interest + Depreciation + Non cash exp.
Installment

Higher ratios are better


PROFITABILITY RATIOS
G. P Ratio = Gross Profit X 100
Sales
N. P Ratio = Net Profit X 100
Sales
RETURN ON INVESTMENT

Return on capital employed = PAT + Interest X 100
Av total cap. Employed
Return on Shareholders Fund = PAT X 100
Av. Shareholders funds
P/E Ratio = Market Price of share
EPS


Share Holders Funds = Equity shares + Preference shares + Reserve & surplus
-Fictitious assets
Capital employed = Shareholders fund + Long term debts