CHAPTER IV

FINANCIAL STATEMENT AND ITS

ANALYSIS

INTRODUCTION
Accounting is rightly known as the language of business. It is a language that

communicates the transaction and monetary business that a business entity

undertakes. Accounting is records that are maintained to calculate the financial

position of the business entity. It is maintained in a systematic method, so that

anybody having interest in the business, creditor, debtor, supplier of raw material,

government etc. can understand the records, and can trace the information

required.

METHODS OF ANALYZING FINANCIAL STATEMENTS

The various methods to analyze the financial statements are-

Comparative Financial Statements

Common Size Statements

Trend Analysis
 Fund Flow Analysis

Cash Flow Analysis

RATIO ANALYSIS

Ratio analysis is an advance form of accounting. It a road ahead of after the

preparation of final accounts like profit and loss and balance sheets. Ratio analysis

is used as a yard stick to measure the performance of the company. It is a

technique where relationship between two numerical values form the final

accounts like balance or profit and loss are taken to, to draw a comparison or

relationship between them. Ratio can be expressed in two ways.

TIMES--- When one value is divided by another, to express the quotient

in terms of times.

PERCENTAGE---- When one value is divided by another, to express the

quotient in terms of percentage.

KINDS OF RATIO ANALYSIS.

Liquidity Ratio.
Leverage Ratio
Asset management Ratio
Profitability Ratio
 Operating Ratio
Market based Ratio

LIQUIDITY RATIO.

Liquidity means the ability of the company to pay in cash. Its ability to meet its

short term liabilities. It can be the cash position of the firm also. A strong liquidity

position ensures the solvency of the company.

KINDS OF LIQUIDITY RATIO.

CURRENT RATIO

This ratio measures the solvency of the company in short terms. It is also known as

working capital ratio or short term solvency of the company. A company with

strong working capital can meet its day to day operation or expenses. It is

represented as follows.

Current Ratio = Current Assets/ Current Liability

Here current assets and current liability means all current assets and current

liability of the balance sheet. The ideal current ratio is 2:1. It shows a highly

solvent position. The ratio of 2 indicates a safe margin. A low ratio than this,

means less efficient use of funds. It means excessive dependence on long term

sources of raising fund. Long term liabilities are costlier than current liabilities,

therefore shall lower down the profitability of the concern. It is also a danger sign,
indicating that the company is over trading it resources. A higher current ratio

indicates piled up inventory, not converted into cash on time, inefficiency in

collecting money from the debtors and bill receivables. Huge cash and bank

balance in banks lying ideal unproductively. It an unemployment of assets. A

current ratio of 1.33:1 is considered ideal for the banking sector. 3:1 current ratio is

considered ideal for the capital intensive industries.

QUICK/LIQUID/ACID TEST RATIO

This test measures the liquid assets with the current assets of the company. Here

prepaid expenses and stocks are not taken into consideration to calculate the acid

ratio.

Quick Ratio = Liquid assets (Current assets prepaid expenses & stocks) /
Current liability

An ideal liquid ratio is 1:1. It indicates a highly solvent ratio.

PROFITABILITY RATIO

Profitability Ratio measures the profit earning ability of the firm. It shows the

efficiency of the company of the company. It shows a combined effect of liquidity,

assets management, and debt management. Sales, capital employed, total assets etc

are taken into consideration. Profitability indicates the earning or return, the

company is getting from its investments.

 GROSS PROFIT RATIO

Gross profit ratio is a relationship between gross profit and sales. It reveals the

profit earning capacity of the firm with reference to sale.

Gross Profit = Sales + Closing stock (Opening stock + Purchases + Direct

Expenses)

= Sales Cost of goods sold

Gross Profit = Gross Profit * 100/ Sales

The following above items of this ratio is available from trading account.

NET PROFIT RATIO

This ratio establishes a relationship between net profit and sales. An increase in the

net profit ratio from the previous year indicates the operational efficiencies of the

company. Here net profit means EBIT (Earnings before Interest and Tax). Net

profit means gross profit after operating expenses and non-operating expenses, but

before interest and taxes

Net Profit ratio = Net profit * 100/ sales

All the above items are available in the profit and loss account of the company.
 RETURN ON INVESTMENT (ROI) OR RETURN TO CAPITAL

EMPLOYED.

This test also measures the overall profitability of the company. A relationship

between profit and investment is established. Here profit means EBIT and

investment mean capital employed in long term funds. The ratio helps in

determining the capital structure of the company. It indicates the operational

efficiency also. It helps in making investing decision. Only those investment

proposals should be accepted that have a high ROI.

Return on Investment = Net Profit before interest and tax (EBIT) /

Capital Employed

Capital Employed = Equity Capital + Preference Share Capital + Reserves

OR

Net Fixed Assets + Working Capital

RETURN ON EQUITY SHAREHOLDER (ROE)

This ratio measures the profitability of capital invested in equity shares. How much

profit or return does the company earn on equity shares to measure the efficiency

of the concern.
Return on Equity (ROE) = Net profit after tax interest and preference
share dividend/ Equity shareholders fund

Here equity capital means paid up equity shares, reserve and surpluses. The ratio

shows net profit per rupee. If multiplied by 100, we get the percentage of the ratio.

RETURN ON TOTAL ASSETS.

The ratio indicates the return on total assets. Here assets mean only tangible assets

and not intangible assets.

Return on Total Assets = Net Profit after tax * 100 / Total Assets

OR

Net Profit after Tax & Interest * 100 / Total Assets

ASSETS MANGEMENT RATIO OR TURNOVER RATIO

The assets management ratio is also called as activity ratio or efficiency ratio. It

indicates how efficiently the capital employed is rotated in the business. Here

turnover is sales, so all ratios are calculated with sales. Sales have a direct

relationship with the performance of the company. Higher sales mean high

efficiency .High sales mean that the assets are being used properly. Lower sales

means the lessor productivity and poor performance of the concern.

Higher the rotation, the greater will be the profitability. Following are some of the
turnover ratio.
 DEBTORS TURNOVER RATIO

This ratio indicates the extent to which the debts have been collected in time. It

shows the lenders how much time it takes for the company to collect money from

its debtors. A high ratio indicates how frequently the money gets collected from its

debtors. It shows the efficiency of the company. A longer collection period shows

that the company has a liberal and inefficient credit collection performance.

Debtors Turnover Ratio = Credit sales / Average Debtors

Average Debtors = Opening Debtor + Closing Debtors / 2

DEBTOR COLLECTION PERIOD RATIO

This ratio shows how long does it takes for the company to collect its credit sales.

For how many days or months a company keeps the sales uncollected. A low ratio

indicates; prompt collection of money from debtors. It is always good for the

soundness of the concern; the stuck money gets quickly converted into cash.

Debtors Collection Period Ratio = Average Debtors * 100 / Credit

Sales
 FIXED ASSETS TURNOVER RATIO

This ratio indicates the extent to which the investment in fixed assets contributes

towards the sales. It shows the effective utilization of fixed assets, how

productively the fixed assets are put to use to earn sales and profit to the company.

The effectively utilization of fixed assets will result in increased production and

reduced cost.

Fixed Assets Turnover Ratio = Sales / Fixed Assets

MARKET BASED RATIO

These ratios calculate the stock market price of the shares, its book values and the

revenue per share, the company is generating. Its per share market price, is an

indication, as to how a share is perceived in the mind of the investors. How the

investor think about the past performance and future performance of the concern.

A company who has a strong solvency, liquidity, turnover and profitability will

vidend

policy also has a clientele effect on the investors.

 EARNING PER SHARE

The ratio measures the return per share receivable by equity shareholders. Wealth

maximization or Net Present Value maximization objective has been endorsed by

many. To judge

investor who is not interested in the entire financial statements can only look at the

Earnings Per Share = Net profit after tax and preference dividend/ No. of
equity shares

PRICE EARNING RATIO (P/E)

This ratio indicates the relationship between market price of share and the earning

available on the share. It measures the number of times the earnings per share

discount the market price of an equity share. It shows to what extend an investor is

interested to pay per rupee of earnings. P/E ratio is the most popular method to

value shares. A high P/E ratio boosts confidence in the investors, it reflects high

earnings potential and a low P/E ratio shows low earning per share.

Price Earnings Ratio (P/E) = Current Market Price of Equity Share /

Earnings per Share
 LEVERAGE RATIO

Long term stability of the firm is considered as dependent upon its ability to meet

its long term liabilities, and not the current liabilities. There are many ratios to

measure the financial leverage of the company.

DEBT-EQUITY RATIO

This ratio measures the relationship between the long term loans and equity funds.

The use of long term loan in capital s

debt loan is more in the capital structure, than the company is called highly geared.

If the company has less debt loan in the capital structure than it is called low

gearing ratio. The ideal debt equity ratio is 2:1.

Debt Equity Ratio = Long term Debt / Shareholders Fund

Long term debt means long term loans like debentures.

Share capital = Equity share capital + Preference Share Capital + Reserve

PROPRIETORY RATIO

It expresses the relationsh

and total assets. The proprietary fund includes equity fund, preference share
capital, reserve and accumulated surplus. Total assets include fixed, current assets

and fictitious assets.

The ratio is very important for the creditors, because, they come to know the share

of proprietary funds in the total assets, this helps him to identify as what extend his

loan is secured. The higher the ratio, safer is the loan of the creditors. This ratio

shows the financial positon of the concern. The ratio more than 50% shows that the

company. Lesser than 50% is the sign of risk for creditors

t Worth / Total Assets

+ Reserve Fictitious assets

Total Assets = Fixed assets + Current Assets - Fictitious assets

ECONOMIC VALUE ADDED

the New York based financial advisory Stern Stewart and co. It is majorly used by

companies by Coca-Cola and Siemens. It was a new version of residual income

concept. It is an internal managerial performance measure which monitors whether

managers are increasing shareholders value or not. It uses residual income, to

assess the performance of division, in which a finance charge is deducted from the

profits of division. Finance charge is WACC. The concept of EVA has boosted

shareholders return and the value of the companies. The excess of return over cost

of capital is called economic value added. It is the incremental difference in the

rate of return over cost of capital. It measures the company return generates from

fund invested into it. If the EVA is negative, it means it is not generating value

from the funds invested into the business. If the EVA is favourable, it means that

the funds invested are generating great value. It measures, whether the operating

profit is enough to cover cost of capital. The EVA is better than ROI, to encourage

growth in new product, new equipment and new manufacturing facilities.

CALCULATION OF EVA

EVA= NOPAT-Capital Charges

NOPAT= PAT+ Interest*(1-Tax)

Capital Charges= WACC* Capital Employed

EVA AND RISK: When EVA is increased with an increase in the cost of capital,
it can be due to operating risk or financial leverage. The firm value may decrease
even as EVA increases.
 MARKET VALUE ADDED

When a company wants to see how the company is performing for its shareholders,

than it looks for Market Value Added or MVA. This measure indicates the

As increasing the wealth of the company is the main objective of the company.

MVA is the difference between the market value of a company and the capital

contributed by the shareholders. These investors are the shareholders and

debenture holders. When the market value of the capital is less than the book

value, than it implies that the company is not performing well and is not creating

wealth for the equity shareholders. A high MVA reflects the managerial

efficiencies and strong operational capacities. A positive MVA indicates that that

the value has been created and negative MVA indicates that the value has been

destroyed.

MVA does not take considers the opportunity cost of the invested capital. Similarly

MVA cannot be used for SBU (Strategic Business Unit) or private held companies.

MVA does not take into account intermediate cash returns to shareholder
MVA = (Number of common shares outstanding x share price) + (Number of
preference shares outstanding x share price) Book value of invested capital

OR

MARKET VALUE ADDED = MARKET VALUE CAPITAL INVESTED

RELATIONSHIP BETWEEN MVA AND EVA

Market value Added is an external measure to checks how much the shareholders

are benefited by the performance and efficiency of the company.

Economic Value Added is an internal measure ensuring whether the managers are

performing well to increase the value of the shareholders.

CORRELATION ANALYSIS

In many situations we want to know the relationship between many variable. When

there is one variable, it is called univariate, like for example income, price, rainfall

etc. When there are two variables like rainfall and crop yield, than it is called

bivariate variable. Sometime there are more than two variables for analysis like

relationship between rainfall, fertilizer and crop yield, than it is called multivariate

analysis. When two or more variables are varying in same or opposite directions,

that means there exist a relationship between the two.

The degree of relationship between two variables under consideration is measured

through correlation. It is a statistical tool to measure the relationship between the

given two variables.

REGRESSION

Regression is a statistical tool used in finance and investing etc, to determine the

strength of the relationship between the one independent variable and dependent

variable. There are two types of regression, linear and multiple regression. In

multiple regression, there are more than one independent variable.

COMMON SIZE STATEMENTS

A common size statement displays items of financial statement as a percentage of

one common figure. By using common size financial statements any interested

party gets an idea of the trends happening in the business which may not be visible

in regular final accounts. All three financial accounts can be written in a common

size. The figures shown in financial statements like profit and loss and Balance

Sheet are converted in percentage so as to establish each element to the total figure

of the statement and these statements are called common size statements.
 COMMON SIZE INCOME STATEMENT

In common size income statement, the sales figures is taken as 100 and all other

figures of costs and expenses are expressed as percentage to sales.

COMMON SIZE BALANCE SHEET

helps in interfirm comparison and highlights the financial health of the company.

This method is helpful for industry analysis or acquisition analysis. This technique

can be used to study benchmarking. The company should set a benchmark for its

financial position against the best performing company in the industry and the

performances should be measured and any deviation appearing should be analyzed

and steps should be taken to correct it, so that the best practice should be brought

in use and work in alignment with it. It is not mandatory to make a common size

balance sheet, as it not make compulsory by the GAAP and IFRS, but it is widely

used by management and it is available in many accounting software packages.

TREND ANALYSIS

Trend Analysis is a tool to predict the future movement of any given data

mentioned in the financial statement. It gives an idea to the interested party about

the future trend based on the past performance. The current trend helps to predict
the future. Percentage method and trend ratio are some of the various trend

techniques. Graphical representation is also a technique of trend analysis.