Module 5: Financial

Analysis
• Ratio Analysis

• Cash Flow Analysis

• Balance Score Card (BSC)

• Economic Value Added (EVA)

• Cash Value Added (CVA)

 Financial Analysis
Definition and Purpose
• Financial Analysis: Identifies financial strengths and weaknesses by establishing relationships between balance sheet
items and profit and loss accounts.
• Users: Can be internal (management) or external (owners, creditors, investors).

Users Focus Concern

Trade Creditors Short-term liquidity Firm’s ability to meet short-term claims

Firm’s profitability over time, cash generation for

interest and principal repayment, and capital
Long-term Debt Suppliers Long-term solvency and survival structure relationships

Present and future profitability, steady growth in

earnings, and financial structure impacting earnings
Investors Earnings and profitability and risk

Effective and efficient use of resources, overall

Management Comprehensive financial health financial condition of the firm
 Ratio Analysis

Definition and Importance

• Ratio Analysis: A powerful tool for financial analysis, involving the relationship between two or

more financial figures.

• Purpose: Serves as a benchmark for evaluating the financial position and performance of a firm.
Objectives of Accounting Analysis
• Example: Net profit related to investment, current ratio (current assets divided by current

liabilities).

Characteristics of Ratios
• Quantitative Relationship: Ratios summarize large quantities of financial data.

• Qualitative Judgment: Ratios help form qualitative assessments of financial performance, such

as liquidity or profitability.

Standards of Comparison
• Past Ratios: Historical ratios of the same firm.

• Competitors’ Ratios: Ratios of selected competing firms at the same point in time.

• Industry Ratios: Average ratios of the industry to which the firm belongs.

• Projected Ratios: Ratios from projected (pro forma) financial statements.

Types of Ratios

Did you check

your
profitability?
What about your
funding situation?
What about your – Debt and Equity
The current efficiency ?
obligation status?
– Assets and
Liabilities

Leverage Ratio
Current Ratio Activity Ratio Profit Ratio
Current/Liquidity Ratios

Liquidity Ratios measure a firm's ability to meet its current obligations as they become due.
These ratios provide a quick measure of liquidity by establishing a relationship between current
assets and current liabilities. Ensuring proper liquidity is crucial as insufficient liquidity can lead
Objectives of Accounting Analysis
to poor creditworthiness, loss of creditors' confidence, or even legal issues, while excess liquidity
indicates idle assets that earn nothing.

Common Liquidity Ratios:

1. Net Working Capital Measure

Particulars Amount (A) Amount (B)
2. Current Ratio Particulars Year 1 Year 2
Current Assets 180 30
Current Assets 150 300
3. Quick Ratio
Current Liabilities 120 10
4. Cash Ratio
NWC 60 20 Current Liabilities 75 200
5. Interval Measure NWC 75 100
LEVERAGE RATIOS

Purpose: Measure long-term financial strength and risk Types of Leverage Ratios:
• Focus: Mix of funds from owners (equity) and lenders (debt) 1. Debt-to-Equity Ratio: Measures the proportion of debt
• Importance: and equity in financing the firm's assets.
• Indicate financial risk level 2. Interest Coverage Ratio: Assesses the firm's ability to
Objectives of Accounting Analysis
• Show ability to use debt advantageously
cover interest payments with operating profits.
• Implications of Debt Financing: 3. Debt Ratio: Calculates the percentage of total assets
• Higher risk for the firm
financed by debt.
• Legal obligation to pay interest
• Potential for legal action by creditors
Financial Metric Company A Company B
•
Assets $1,000,000 $1,000,000
Debt $500,000 $900,000
Equity $500,000 $100,000
Net Income $100,000 $100,000
Interest Expense $25,000 $45,000
Activity Ratios

•Purpose: Evaluate how efficiently a firm manages and

utilizes its assets to generate sales.
•Also known as: Turnover ratios, as they measure how
Objectives of Accounting Analysis
quickly assets are converted into sales.
•Key Relationship: They reflect the relationship between
sales and various types of assets.

Types of Activity Ratios

• Inventory Turnover
• Debtors (Accounts Receivable) Turnover
• Assets Turnover Ratios
 PROFITABILITY RATIOS

Purpose of Profits:

• Profits are crucial for the survival and growth of a company over the long term.

• They enable businesses to attract investment for expansion and contribute to societal welfare.
Objectives of Accounting Analysis
• Profitability is essential but should not be pursued at the expense of stakeholders' interests (e.g., customers,

employees, suppliers).

Measurement of Profit:

• Gross Profit Margin: Represents the difference between sales revenue and the cost of goods sold.

• Net Profit Margin: Indicates the percentage of revenue that translates into profit after all expenses, including
taxes.

• Operating Profit: Also known as EBIT (Earnings Before Interest and Taxes), it reflects earnings from core
business operations before interest and taxes are deducted.

• Net Operating Profit After Tax (NOPAT): Represents the profit available to all investors (lenders and owners)
after accounting for taxes. It is calculated as EBIT adjusted for taxes.
 Types of Profitability Ratios:

Profitability in relation to sales:

• Measures how effectively a company generates profits from its sales revenue.
• Gross Profit Margin
• Net Profit Margin
Objectives of Accounting
• Operating Expense RatioAnalysis

Profitability in relation to investment:

• Evaluates the return on investment for shareholders and creditors.

• Return on Investment (ROI)
• Return on Equity (ROE)
• Earnings per Share (EPS)
• Dividend per Share (DPS or DIV)
• Dividend-Payout Ratio
• Price–Earnings Ratio
• Dividend Yield and Earnings Yield
• Market Value-to-Book Value (MV/BV) Ratio
 Some cautions

• Different Industries, Different Benchmarks • Non-Recurring Items Skew Ratios

• Liquidity vs. Efficiency Trade-Off
• Seasonal Variations Can Skew Results
• High Dividend Payout Ratios Can Signal Weak Growth Prospects
• The Impact of Accounting Methods
• Interest Coverage Ratio Can Be Misleading in Low-Interest
• Leverage Can Inflate ROE Environments

• Profitability Ratios Don’t Equal Cash Flow • Price-to-Sales Ratio May Be Better for Growth Companies

• Liquidity Ratios Can Be Misleading Without Context • A High Quick Ratio May Signal Over-Cautiousness

• High P/E Doesn’t Always Mean Overvaluation

• Inventory Turnover Ratio Can Reflect Both Demand and Supply

Chain Efficiency

• Debt Ratios Are More Meaningful in Combination

• Earnings Manipulation Can Distort Ratios

Limitations of Ratio Analysis:
• Impact of Price Level Changes:
• Difficulty in comparison: Choosing the right basis for comparison
among companies or over different periods can be challenging due to • Inflation affects ratio analysis by altering the value of money
varying circumstances.
over time, impacting inventory valuation, asset values, and
• Changes in price levels: Fluctuations in the general price level can
Objectives
distort ratioof Accounting especially
interpretations, Analysis in terms of inventory valuation borrowing costs.
and asset depreciation.
• This leads to discrepancies in accounting profits, as financial
• Differences in definitions: Varied definitions of items in financial
statements (e.g., assets, liabilities) complicate ratio analysis across statements are based on historical cost rather than current
companies or industries.
market values.
• Static nature of ratios: Ratios calculated at a single point in time
may not provide a comprehensive view due to short-term fluctuations • Use of Historical Data:
and changes.
• While ratios are derived from historical financial statements,
• Historical focus: Ratios are based on historical financial statements
and may not predict future performance accurately. they provide a retrospective view and may not accurately reflect
• Standards for Comparison: future financial outcomes.
• Ratios gain meaning when compared against standards such as • Management has insights into future plans and policies that are
industry averages. However, obtaining reliable industry data can be
challenging. not reflected in historical ratios, posing a challenge for external
• Differences in company situations and economic factors over time analysts relying on past data.
make meaningful comparisons difficult.
Cash Flow Analysis

• Purpose of Cash Flow Analysis:

• Cash flow analysis is crucial for short-term planning, ensuring a firm has enough
cash to meet immediate obligations such as debt payments, expenses, and
Objectives of Accounting Analysis
dividends.

• Historical Analysis for Projections:

• Historical cash flow analysis provides insights to prepare reliable projections for
the near future, helping management anticipate cash needs and surpluses.

• Comparison with Funds Flow Statement:

• The Cash Flow Statement focuses specifically on cash movements, contrasting

with the Funds Flow Statement that emphasizes changes in working capital and
long-term funds.

• Preparation Methods:

• The direct method

• Indirect method
Direct Method Indirect Method
(A) Sales Revenues
(B) Less: Expenses Using Working Capital (A) Net Income (or Loss) as Shown by Profit and Loss Account
•Cost of raw materials used (or cost of goods sold) (B) Add:
•Depreciation expenses
•Wages and salary expenses •Amortisation of goodwill, patents, and other intangible assets
•Other manufacturing expenses (excluding depreciation) •Amortisation of discount on debentures or share issue expenses
•Office expenses
•Amortisation of extraordinary losses incurred in previous years
•Loss on sale of non-current assets
•Selling and distribution expenses (C) Less:
•Interest •Amortisation of premium received on debentures
•Profit on sale of equipment (already included under sources)
•Income tax
•Profit on revaluation of non-current assets (does not contribute to working
(C) Working Capital from Business Operations capital)
(D) Adjustments to Convert to Cash Basis •Dividends and interest received on investments (reported separately)
(A + B – C) = Working Capital from Business Operations
1.Add: Decrease in Working Capital (–CA or +CL) (D) Adjustments to Convert to Cash Basis
1. Decrease in current assets other than cash (item-wise) 1.Add: Decrease in Working Capital (–CA or +CL)
2. Increase in current liabilities (item-wise)
1. Decrease in current assets other than cash (item-wise)
2. Increase in current liabilities (item-wise)
2.Less: Increase in Working Capital (+CA or –CL) 2.Less: Increase in Working Capital (+CA or –CL)
1. Increase in current assets other than cash (item-wise) 1. Increase in current assets other than cash (item-wise)
2. Decrease in current liabilities (item-wise)
2. Decrease in current liabilities (item-wise)
(E) Cash Flow from Business Operations
(E) Cash Flow from Business Operations
 Usefulness

Analysts:
• Investors and Shareholders: • How do cash flows compare to reported earnings?
• Is the company generating enough cash from operations?
• What are the trends in operating, investing, and financing cash
• How effectively is the company using its cash? flows?
• Can the company sustain or increase dividends? Is the company's cash flow sustainable?
Objectives of Accounting Analysis •

• Is the company relying too heavily on external financing? • Suppliers:

• Creditors and Lenders: • Can the company pay its bills on time?

• Can the company meet its debt obligations? • Is the business financially stable enough for long-term
• Is the company generating sufficient cash to cover interest partnerships?
payments? • Employees:
• What is the quality of the company's earnings? • company financially healthy enough to provide job security?

• Management: • Can the company afford salary increases or bonuses?

• Are current operations providing enough cash for future • Regulators:
growth? • Is the company complying with financial regulations?

• Which activities are generating or consuming the most • Are there any unusual cash flow patterns that warrant
cash? investigation?
• Is there a need to adjust business strategy or operations? • Competitors:
• Is there enough cash for capital expenditures or • cash management compare to industry standards?

acquisitions? • What investment or financing strategies is the company using?