Analysis and Interpretation of Financial Statements

It is the process of identifying the financial strengths and weakness of the firm by properly establishing relationship between the items of the Balance Sheet and Profit & Loss Account and other operating data. Therefore it refers to such a treatment of information contained in Income Statement and Balance Sheet so as to afford full diagnosis of the profitability and financial soundness of the business.

Meaning
Analysis It is used to mean the simplification of financial data by methodical classification of the data given in the financial statements.

Interpretation It is the explaining the meaning and significance of the data so simplified.

Comparative Income Statement

This statement shows the operational results of the business for a number of accounting periods so that changes in absolute figures from one period to another period may be stated in terms of money and percentage.

Comparative Balance Sheet

Comparative Balance Sheet analysis is the study of the trend of the same items, group of items and computed items in two or more balance sheets of the same business enterprise on different dates

Common- Size Statements

Common-size statements cover up the shortcomings of the comparative statements by expressing each item of the statements as a percentage of total. In common-size statements relative values of items are shown.

Common-Size Balance Sheet

In common-size balance sheets, various items of assets and liabilities of balance sheets of two or more years are shown at their relative values. That is ,each item of the assets is shown as percentage of total assets and each item of liabilities as percentage of total liabilities and capital fund.

Common-Size Income Statement

In this statement relationship is established between items of income statement and volume of sales in percentage form. In other words, in a common size income statement ,each item of income statement is shown in percentage based on net sales.

Funds Flow Statement

Fund: Fund is used both in broader and narrow sense. In broader sense, it represents the working capital (current assets current liabilities) of a concern while in narrow sense it represents only cash balance of firm

FLOW

flow of fund would mean when a business transaction causes a change in the amount of fund (working capital) that exists before the maturity of the transaction. The flow of fund is recognized from the degree of change in the amount of working capital. It is referred to as source of fund (inflow) whereas decrease in working capital indicates application of funds (out flow) If a transaction fails to cause change in amount of working capital, it does not amount to flow of funds.

No Flow of Funds

Where both the accounts affected in any transaction belonging to current assets category Where both the account affected in any transaction belong to current liability category Where the change in current assets and current liabilities is in the same direction and same proportion. Where the accounts related to fixed assets and fixed liabilities or capital are affected in a same proportion. Where both the accounts affected by the transaction are of non-current category.

Flow of Funds

The effect of transaction lies on a current asset and a fixed asset e.g. sale or purchase of a fixed assets. The effect of transaction lies on a current asset and a fixed liability e.g issue of debentures for cash. A current asset and capital are affected by the transaction e.g issue of shares for cash A fixed asset and current liability are affected by the transaction e.g credit purchase of machine

Contd.

A current liability and fixed liability are affected by the transaction e.g issue of debentures for satisfying the claims of creditors The capital and current liability are affected by the transaction e.g issue of shares in payment to creditors, acceptance of bill payable for redemption of preference shares. The net profit or losses arising as a result of the business activities also generate the flow of funds, which is called funds from operation.

Current Assets
Inventories Bills receivable Cash and bank balance Investments (temporary) Sundry debtors Prepaid expenses Incomes receivable

Current Liabilities
Bills payable Sundry creditors Outstanding expenses Provision against current assets Proposed dividend Provision for tax Bank overdraft

Non-current : Fixed assets and others

Land and building Plant and machinery Furniture Long-term investment Goodwill preliminary expenses Trade mark Patent right Deferred expenses Discount on issue of shares/ debentures Debit of balance sheet of profit/loss account

Long-term liability and others

Share capital (equity and preferential) Share premium Share forfeited Capital redemption reserve Capital reserve Capital reserve Loans (long- term) Debentures General reserve Provision for depreciation on fixed assets Bank loan Credit balance of profit and loss account

Impact on Working Capital on change in CA and CL

Nature of transaction Increase in current assets Decrease in current assets Increase in current liabilities Decrease in current liabilities

Effect on working capital Increase (+) Decrease (-) Decrease (-) Increase (+)

Funds Flow Statement

Sources of funds Funds from operation Issue of share capital Issue of debentures Long-term loans Sale of non-current assets Non-operating receipts Decrease in working capital

Application of funds Funds lost in operation Redemption of preference shares Repayment of loans Purchase of non current assets Non-operating payments Increase in working capital

Cash Flow Statement

A cash flow statement is a statement depicting change in cash position from one period to another period. Here, the term cash stands for cash and cash equivalents, while flow means movement of cash. Thus cash flow statement may be defined as a summary of receipts and disbursements (or payments), reconciling the opening cash and bank balance with closing balance concerned period related to various items appearing in the Balance Sheet and Profit/ Loss Account

Impact of cash position of concern

Change in balance sheet items Increase in current assets other than cash Decrease in current assets other than cash Increase in non-current assets Decrease in non-current assets Increase in current liability Decrease in current liability Increase in long-term liability Decrease in long-term liability

Impact on cash Out flow of cash Inflow of cash Outflow of cash Inflow of cash Inflow of cash Outflow of cash Inflow of cash Outflow of cash

Sources of Cash
Issue of share capital Issue of long-term debt such as debentures Sale of assets Cash from operation Decrease in current assets Increase in current liability

Application of Cash
Redemption of capital Purchase of fixed assets Repayment of long term debt Cash lost in operation Increase in current assets Decrease in current liability

Non-cash transactions
Depreciation on fixed assets Profit/Loss on the sale of fixed assets Profit /Loss on revaluation of fixed assets Writing off intangible assets like patents, goodwill and trade mark Writing of miscellaneous expenses like preliminary expenses, discount on issue of share or debentures

Ratio Analysis

Meaning: - In general words, a ratio is an expression of relationship of one figure with another. It may be defined as the relationship, or proportion that one amount bears to another. It is found by dividing a figure with another. A ratio may be expressed in percentage in which the base, is taken as equal to 100 and the quotient is expressed as per hundred of the base

Various Ratios
Liquidity ratios Capital structure or leverage ratio Activity or turnover ratio Profitability or profit earning capacity ratios.

Current Assets

Cash in hand, cash at bank, debtors, prepaid expenses, short term deposits, bills receivable, money at call and short notice, stock ,finished goods, work in progress stock of raw materials and sundry supplies

Current Liabilities

Bills payable, income tax payable, creditors. Outstanding expenses, bank overdraft, provision for taxation, interest due on fixed liabilities, reserve for unbilled expenses, installment payable on long-term loans.

Current Ratio
Current ratio = Current assets / Current liabilities Standard Norm:=2:1

Liquid Ratio

Liquid ratio = Liquid assets / Current liabilities Or Liquid ratio = Liquid assets / Liquid liability Liquid assets = Current assets Stock prepaid expenses Liquid liability = Current liability Bank over draft Standard norm: 1 : 1

Absolute Liquid Ratio

Absolute liquid ratio = Absolute liquid assets / Absolute liquid liabilities Absolute liquid assets = Cash in hand, cash at bank and short term marketable securities. Absolute liquid liabilities = Current liability bank over draft. Standard norm: .5 :1

Capital Structure Ratio or long term solvency ratios

Debt equity ratio Solvency ratio Proprietary ratio Fixed asset ratio Capital gearing ratio Debt service ratio or interest coverage ratio

Debt Equity Ratio

Debt equity ratio = Outsiders fund / shareholders fund Alternative: Debt equity ratio = long-term debt / share holders fund or net worth Note: in this case current liabilities will be ignored. Standard norm: 2 : 1, however lending institutions prefer 1:1 A low ratio signifies a smaller claim of creditors. More precisely, the greater the debtequity ratio, greater the risk to the creditor.

Outsiders fund

Debt, long-term or short term, whether in the form of mortgage, bills or debentures

Share holders fund

Preference share capital, equity share capital, capital reserves, retained earnings and any other reserves representing the accumulated profit

Proprietary Ratio
This is also known as equity ratio, net worth to total assets ratio. Proprietary ratio = Share holders fund / Total assets Higher the ratio better is the financial position of the firm.

Solvency Ratio or debt to total assets ratio

Solvency ratio = Total outside liabilities / total assets If the amount is enough to pay the external liabilities then the company is said to be solvent.

Fixed Asset Ratio

Fixed assets ratio = Net fixed assets / (shareholders fund + long term liability) Or Fixed asset ratio = Net fixed assets / Share holders fund Standard norm: 1 :1. It is well established that fixed assets should be financed only out of long-term funds. This ratio shows whether this is so.

Capital gearing ratio

CGR = Share holders fund / out siders fund Share holders fund = Equity capital + reserve +surplus Outsiders fund = Preference share capital + Debentures + Other long term loans. Note : If capital gearing ratio is less than 1, we will call it high gearing of capital and if gearing ratio is more than 1 then low gearing of capital is assumed

Debt service ratio or interest coverage ratio

Interest coverage ratio = Net profit before interest and tax /Interest on fixed long term loans or debentures. Note : This ratio measures the margin of safety for the lenders. The higher the number, more secure the lender is in respect of his periodical interest income. Normally, fixed interest charges should be covered six to seven times.

Activity analysis or turnover ratio

Stock or inventory turnover ratio Debtors or receivable turnover ratio Average collection period or debtor velocity Creditors or payable turnover ratio Average payment period Total assets turnover ratio Fixed asset turnover ratio Current asset turnover ratio Working capital turnover ratio Capital or net worth turnover ratio Total capital turnover ratio

Stock turnover ratio

Cost of goods sold / Average stock Cost of goods sold = opening stock + purchases+ direct expenses closing stock Average stock = opening stock + closing stock / 2 Note :1. If cost of goods sold cannot be calculated then sales will be taken as base 2. if opening and closing stock is not given in that case closing stock will be treated as average stock 3. Higher the ratio good for the organization. A low stock turnover ratio indicates that the goods do not sell quickly and efficiently, so the maximum inventory remains lying in the warehouse.

Debtors or receivable turnover ratio

DTR = Net credit sales / Average receivables Net credit sales = Total sales cash sales sales return Avg. receivables = opening receivable +closing receivable / 2 Receivable = Debtors + Bills receivable

Average collection period or debtor velocity (in months or days)

Average trade receivable / Net credit sales X no of month or day or weeks Or Months or weeks or days in a year / DTR Note: The amount of provision for bad and doubtful debts may be given in the question but this figure does not affect the calculation of debtor turnover ratio or average collection period. However, if closing debtors are to be computed, then the amount of bad debts is taken in to account.

Creditors or payable turnover ratio

CTR = Net credit purchases / Average payables (creditor +BP) Net credit purchase = Total purchase cash purchase purchase return Average payable = opening payable + closing payable / 2 Note : if opening and closing is not given then closing will be considered as average

Average payment period

Average payable / net credit purchase X no. of month or weeks or days Or No. of month or week or days / CTR

Total assets turnover ratio

Cost of goods sold or net sales / Total assets Total assets = Fixed assets + current assets fictitious assets- depreciation on fixed assets This relationship indicates the efficiency of the utilization of assets to attain the maximum turnover on sales. A rise in the ratio indicates more intensive utilization of assets, while fall in the turnover suggests under utilization of assets.

Fixed assets turnover ratio

Cost of goods sold or net sales / net fixed assets Net fixed assets = Fixed assets depreciation If there is an increase in this ratio, it will show that there is better utilization of fixed assets .If there is a fall in this ratio, it will show that investment in fixed has not been utilized efficiently. Ideal of this in a manufacturing company is 5:1.

Current assets turnover ratio

Cost of goods sold or net sales / current assets This ratio measures the concerns efficiency in utilization of its current assets. This ratio also indicates the over investment or under investment position of current assets in a concern.

Working capital turnover ratio

Cost of goods sold or net sales / working capital The high ratio indicates efficient use of working capital in the concern while low working capital turnover ratio indicates under utilization of working capital in the concern.

Capital on net worth turnover ratio

Net sales or cost of goods sold / net worth or share holders fund It indicates whether the capital employed by the shareholders in a business is used efficiently or not.

Total capital turnover ratio

Cost of goods sold or net sales / capital employed Capital employed = long term and short term capital By calculating this ratio, efficiency of capital employed may be known. This ratio shows how many times capital has been rotated for generating the sales. The higher the ratio, better it is for the business concerns. No ideal standard can be fixed for this ratio.

Profitability ratios: Based on sales

Gross profit ratio Operating ratio Expenses ratio Operating profit ratio Net profit ratio

Gross profit ratio

Gross profit / net sales X100 Net sales = Sales sales return Gross profit = net sales cost of goods sold. The gross profit ratio is primarily a test of the efficiency of purchases and sales management. No ideal standard is fixed for this ratio, but the gross profit ratio must be adequate.

Operating ratio
Cost of sales + operating expenses / net sales X 100 Operating expenses = office and administrative expenses + selling expenses + discount allowed + bad debts etc.

Expenses ratio

Particular expenses / net sales X100

Operating profit ratio

Operating profit / net sales X100

Net profit ratio

Net profit / net sales X100

Profitability ratios based on capital

Return on gross capital employed Return on net capital employed Return on proprietors net capital Return on average capital employed Return on total assets

Return on gross capital employed

EBIT / Gross capital employed X100 Gross capital = Equity share capital + preference share capital +reserve and surplus + all long and short term external loans Or All net fixed assets + current assets + including goodwill of the firm but fictitious assets are not included

Return on net capital

EBIT / Net capital employed X100 Net capital employed = Equity share capital + preference share capital + reserve and surplus + long term loans

Return on proprietors capital employed

Net profit after interest and tax / proprietors net capital employed X100 Proprietors net capital = Equity share capital + preference share capital + reserves and surplus accumulated losses, if any

Return on average capital employed

Net profit / average capital X100 Average capital = Opening capital + closing capital / 2 Or Opening capital +1/2 of current years profit Or Closing capital of current years profit Return on capital employed reflects the overall profitability of the business

Return on total assets

Net profit / Total net assets X 100 Total net assets = Total assets fictitious assets

Return on proprietors fund or equity or return on net worth

Net profit / Proprietors fund X100 Proprietors fund =Equity share capital + preference share capital +reserves and surplus+ undistributed profit debit balance of profit & loss if any.

Ratios showing profitability on shares

Earning per share(EPS) Earning Yield Ratio(EYR) Dividend Per share (DPS) Pay-out Ratio (POR) Dividend Yield Ratio (DYR) Dividend coverage ratio (DCR) Price earning ratio (PER)

Earning Per share (EPS)

EPS = Net profit after tax, interest and preference dividend / no of equity shares the amount of earnings that an equity share commands. It indicates

Earning Yield ratio (EYR)

EYR = EPS / Market price per share X 100 This ratio indicates the relationship between earning per share and market price per share

Dividend Per Share (DPS)

DPS = Dividend for equity share holders/ no. of equity shares Higher the ratio, the better is for equity share holders of the concern. This ratio shows the amount of dividend per share paid by the management of the company

Pay-out ratio (POR)

Payout ratio= dividend per equity shares/ earning per share X100 This ratio helps us to calculate the percentage of dividend paid out of earned incomes and the percentage of earned profits retained in the business concern

Dividend Yield Ratio (DYR)

Dividend Yield Ratio = Dividend per share / Market price per share X100 Dividend yield ratio helps investors to ascertain the effective return on the amount they invest or intend to invest in the equity shares of a company.

Dividend cover ratio (DCR)

y

This ratio indicates the relationship between dividend per share and earning per share. This ratio calculated by dividing earning per share by dividend per share.

Dividend Cover = EPS / DPS

Price Earning Ratio (PER)

y

This ratio indicates relationship between market price per equity shares and earning per share. In other words, this ratio indicates the number of times the earning per share is covered by its market price.

P/E ratio = MPS /EPS