Key pointers to balance sheet and profit and loss statements:

 A balance sheet represents the financial affairs of the company and is also
referred to as “Assets and Liabilities” statement and is always as on a
particular date and not for a period.

 A profit and loss account represents the summary of financial transactions

during a particular period and depicts the profit or loss for the period along
with income tax paid on the profit and how the profit has been allocated
(appropriated).

 Net worth means total of share capital and reserves and surplus. This includes
preference share capital unlike in Accounts preference share capital is treated
as a debt. For the purpose of debt to equity ratio, the necessary adjustment
has to be done by reducing preference share capital from net worth and adding
it to the debt in the numerator.

 Reserves and surplus represent the profit retained in business since inception
of business. “Surplus” indicates the figure carried forward from the profit and
loss appropriation account to the balance sheet, without allocating the same to
any specific reserve. Hence, it is mostly called “unallocated surplus”. The
company wants to keep a portion of profit in the free form so that it is
available during the next year for appropriation without any problem. In the
absence of this arrangement during the year of inadequate profits, the
company may have to write back a part of the general reserves for which
approval from the board and the general members would be required.

 Secured loans represent loans taken from banks, financial institutions,

debentures (either from public or through private placement), bonds etc. for
which the company has mortgaged immovable fixed assets (land and building)
and/or hypothecated movable fixed assets (at times even working capital
assets with the explicit permission of the working capital banks)

Usually, debentures, bonds and loans for fixed assets are secured by
fixed assets, while loans from banks for working capital, i.e., current
assets are secured by current assets. These loans enjoy priority over
unsecured loans for settlement of claims against the company.

 Unsecured loans represent fixed deposits taken from public (if any) as per the
provisions of Section 58 (A) of The Companies Act, 1956 and in accordance
with the provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from
promoters, friends, relatives etc. for which no security has been offered.
 Such unsecured loans rank second and subsequent to secured loans for
settlement of claims against the company. There are other unsecured
creditors also, forming part of current liabilities, like, creditors for
purchase of materials, provisions etc.

 Gross block = gross fixed assets mean the cost price of the fixed assets.
Cumulative depreciation in the books is as per the provisions of The Companies
Act, 1956, Schedule XIV. It is last cumulative depreciation till last year +
depreciation claimed during the current year. Net block = net fixed assets
mean the depreciated value of fixed assets.

 Capital work-in-progress – This represents advances, if any, given to building

contractors, value of building yet to be completed, advances, if any, given to
equipment suppliers etc. Once the equipment is received and the building is
complete, the fixed assets are capitalised in the books, for claiming
depreciation from that year onwards. Till then, it is reflected in the form of
capital work in progress.

 Investments – Investment made in shares/bonds/units of Unit Trust of India

etc. This type of investment should be ideally from the profits of the
organisation and not from any other funds, which are required either for
working capital or capital expenditure. They are bifurcated in the schedule,
into “quoted and traded” and “unquoted and not traded” depending upon the
nature of the investment, as to whether they can be liquidiated in the
secondary market or not.

 Current assets – Both gross and net current assets (net of current liabilities)
are given in the balance sheet.

 Miscellaneous expenditure not written off can be one of the following –

Company incorporation expenses or public issue of share capital, debenture etc.
together known as “preliminary expenses” written off over a period of 5 years
as per provisions of Income Tax. Misc. expense could also be other deferred
revenue expense like product launch expenses.

 Other income in the profit and loss account includes income from dividend on
share investment made in other companies, interest on fixed
deposits/debentures, sale proceeds of special import licenses, profit on sale of
fixed assets and any other sundry receipts.

 Provision for tax could include short provision made for the earlier years.
 Provision for tax is made after making all adjustments for the following:

• Carried forward loss, if any;

• Book depreciation and depreciation as per income tax and
• Concessions available to a business entity, depending upon their activity (export
business, S.S.I. etc.) and location in a backward area (like Goa etc.)

 As per the provisions of The Companies Act, 1956, in the event of a limited
company declaring dividend, a fixed percentage of the profit after tax has to
be transferred to the General Reserves of the Company and entire PAT cannot
be given as dividend.

 With effect from 01/04/02, dividend tax on dividends paid by the company has
been withdrawn. From that date, the shareholders are liable to pay tax on
dividend income. Thus for a period of 5 years, the position was different in the
sense that the company was bearing the additional tax on dividend.

 Other parts of annual statements –

1. The Directors’ Report on the year passed and the future plans;

2. Annexure to the Directors’ Report containing particulars regarding

conservation of energy etc;

3. Auditors’ Report as per the Manufacturing and Other Companies (Auditors’

Report) Order, 1998) along with Annexure;

4. Schedules to Balance Sheet and Profit and Loss Account;

5. Accounting policies adopted by the company and notes on accounts giving

details about changes if any, in method of valuation of stocks, fixed assets,
method of depreciation on fixed assets, contingent liabilities, like guarantees
given by the banks on behalf of the company, guarantees given by the company,
quantitative details regarding performance of the year passed, foreign
exchange inflow and outflow etc. and
6. Statement of cash flows for the same period for which final accounts have
been presented.

There is a significant difference between the way in which the statements of

accounts are prepared as per Schedule VI of the Companies Act and the manner in
which these statements, especially, balance sheet is analysed by a finance person
or an analyst. For example, in the Schedule VI, the current liabilities are netted
off against current assets and only net current assets are shown. This is not so in
the case of financial statement analysis. Both are shown fully and separately
without any netting off.

At the end of any financial year, there are certain adjustments to be made in the
books of accounts to get the proper picture of profit or loss, as the case may be,
for that particular period. For example, if stocks of raw materials are outstanding
at the end of the period, the value of the same has to be deducted from the total
of the opening stock (closing stock of the previous year) and the current year’s
purchases. This alone would show the correct picture of materials consumed
during the current year.

For example, the figures for a company are as under:

♦ Purchases during the year: Rs.600lacs
♦ Opening stock of raw material: Rs.100lacs
♦ Closing stock of raw material: Rs.120lacs

Then, the quantum of raw material consumed during the year is Rs.580lacs and only
this can be booked as expenditure during the year. Consumption is always valued in
this manner and cross verified with the value of materials issued from stores
during the year to compare with the previous year;

Similarly, a second adjustment arises due to the difference between closing

stocks of work-in-progress and finished goods on one hand and opening stocks of
work-in-progress and finished goods on the other hand. Suppose the closing
stocks are higher in value, the difference has to be either added to this year’s
income or deducted from this year’s expense. (Different ways of presentation).
Similarly in case the closing stocks are less than the opening stocks, the
difference has to be deducted from income or added to expenses for that year.
Let us study the following example.

In a company, the opening stocks were Rs.100lacs and closing stocks are
Rs.120lacs. This means that during the course of this year, the stocks on hand
have gone up by Rs.20lacs from the goods produced during this year. This does
have an effect on the profit of the company. The company cannot book
expenditure incurred on producing this incremental stock of Rs.20lacs, as they
have not sold the goods. However the materials and other expenses have already
been incurred and hence this value is deducted.

The basic assumption is that the carry forward stocks have been sold during the
current year while at the end of the current year fresh stocks worth Rs.120lacs
have come in for stocking. Hence, on an ongoing basis, opening stocks are added
and closing stocks are deducted. In the above example, the effect of adding the
opening stock and deducting the closing stock would be as under:

Let us assume the production for the year was Rs.1000lacs

Then, sales for the year could only be Rs.980lacs derived as follows:

Production during the year: Rs.1000lacs

Add: Opening stock: Rs. 100lacs
Deduct: Closing stock: Rs. 120lacs
Sales for the year: Rs. 980lacs.

On the other hand, in case the closing stocks would have been Rs.90lacs, the sales
would have been Rs.1010lacs, more than the production value. Thus, the
difference between the opening and closing stocks of work-in-progress and
finished goods affects income and thereby profit. The companies always use this
as a tool, either to increase or decrease income. In case they show more closing
stocks, income is less and thereby profit is less and tax is saved and similarly if
they show less closing stocks, income is more and profit is also more.

The principal tools of analysis are –

♦ Ratio analysis – i.e. to determine the relationship between any set of two
parameters and compare it with the past trend. In the statements of
accounts, there are several such pairs of parameters and hence ratio analysis
assumes great significance. The most important thing to remember in the
case of ratio analysis is that you can compare two units in the same
industry only and other factors like the relative ages of the units, the
scales of operation etc. come into play.

♦ Funds flow analysis – this is to understand the movement of funds (please note
the difference between cash and fund – cash means only physical cash while
funds include cash and credit) during any given period and mostly this period is
1 year. This means that during the course of the year, we study the sources
and uses of funds, starting from the funds generated from activity during the
period under review.

Let us see some of the important types of ratios and their significance:

♦ Liquidity ratios;
♦ Turnover ratios;
♦ Profitability ratios;
♦ Investment on capital/return ratios;
♦ Leverage ratios and
♦ Coverage ratios.

Liquidity ratios:

o Current ratio: Formula = Current assets/Current liabilities.

Min. Expected even for a new unit in India = 1.33:1.

Significance = Net working capital should always be positive. In short, the
higher the net working capital, the greater is the degree of overall short-term
liquidity. Means current ratio does indicate liquidity of the enterprise.
Too much liquidity is also not good, as opportunity cost is very high of holding
such liquidity. This means that we are carrying either cash in large quantities
or inventory in large quantities or receivables are getting delayed. All these
indicate higher costs. Hence, if you are too liquid, you compromise with profits
and if your liquidity is very thin, you run the risk of inadequacy of working
capital.

Range – No fixed range is possible. Unless the activity is very profitable and
there are no immediate means of reinvesting the excess profits in fixed assets,
any current ratio above 2.5:1 calls for an examination of the profitability of the
operations and the need for high level of current assets. Reason = net working
capital could mean that external borrowing is involved in this and hence cost
goes up in maintaining the net working capital. It is only a broad indication of
the liquidity of the company, as all assets cannot be exchanged for cash
easily and hence for a more accurate measure of liquidity, we see “quick
asset ratio” or “acid test ratio”.

o Acid test ratio or quick asset ratio:

Quick assets = Current assets (-) Inventories which cannot be easily converted
into cash. This assumes that all other current assets like receivables can be
converted into cash easily. This ratio examines whether the quick assets are
sufficient to cover all the current liabilities. Some of the authors indicate that
the entire current liabilities should not be considered for this purpose and only
quick liabilities should be considered by deducting from the current liabilities
the short-term bank borrowing, as usually for an on going company, there is no
need to pay back this amount, unlike the other current liabilities.

Significance = coverage of current liabilities by quick assets. As quick assets

are a part of current assets, this ratio would obviously be less than current
 ratio. This directly indicates the degree of excess liquidity or absence of
liquidity in the system and hence for proper measure of liquidity, this ratio
is preferred. The minimum should be 1:1. This should not be too high as the
opportunity cost associated with high level of liquidity could also be high.

What is working capital gap? The difference between all the current assets
known as “Gross working capital” and all the current liabilities other than “bank
borrowing”. This gap is met from one of the two sources, namely, net working
capital and bank borrowing. Net working capital is hence defined as medium and
long-term funds invested in current assets.

Turn over ratios:

Generally, turn over ratios indicate the operating efficiency. The higher the
ratio, the higher the degree of efficiency and hence these assume significance.
Further, depending upon the type of turn over ratio, indication would either be
about liquidity or profitability also. For example, inventory or stocks turn over
would give us a measure of the profitability of the operations, while receivables
turn over ratio would indicate the liquidity in the system.

o Debtors turn over ratio – this indicates the efficiency of collection of

receivables and contributes to the liquidity of the system. Formula = Total
credit sales/Average debtors outstanding during the year. Hence the
minimum would be 3 to 4 times, but this depends upon so many factors such
as, type of industry like capital goods, consumer goods – capital goods, this
would be less and consumer goods, this would be significantly higher;
Conditions of the market – monopolistic or competitive – monopolistic, this
would be higher and competitive it would be less as you are forced to give
credit;

Whether new enterprise or established – new enterprise would be required to

give higher credit in the initial stages while an existing business would have a
more fixed credit policy evolved over the years of business;
Hence any deterioration over a period of time assumes significance for an
existing business – this indicates change in the market conditions to the
business and this could happen due to general recession in the economy or the
industry specifically due to very high capacity or could be this unit employs
outmoded technology, which is forcing them to dump stocks on its distributors
and hence realisation is coming in late etc.

o Average collection period = inversely related to debtors turn over ratio.

For example debtors turn over ratio is 4. Then considering 360 days in a year, the
average collection period would be 90 days. In case the debtors turn over ratio
increases, the average collection period would reduce, indicating improvement in
liquidity. Formula for average collection period = 360/receivables turn over ratio.
The above points for debtors turn over ratio hold good for this also. Any
significant deviation from the past trend is of greater significance here than the
absolute numbers. No minimum and no maximum.

o Inventory turn over ratio – as said earlier, this directly contributes to the
profitability of the organisation. Formula = Cost of goods sold/Average
inventory held during the year. The inventory should turn over at least 4
times in a year, even for a capital goods industry. But there are capital
goods industries with a very long production cycle and in such cases, the
ratio would be low. While receivables turn over contributes to liquidity, this
contributes to profitability due to higher turn over. The production cycle
and the corporate policy of keeping high stocks affect this ratio. The less
the production cycle, the better the ratio and vice-versa. The higher the
level of stocks, the lower would be the ratio and vice-versa. Cost of goods
sold = Sales – profit – Interest charges.

o Current assets turn over ratio – not much of significance as the entire
current assets are involved. However, this could indicate deterioration or
improvement over a period of time. Indicates operating efficiency. Formula
= Cost of goods sold/Average current assets held in business during the
year. There is no min. Or maximum. Again this depends upon the type of
industry, market conditions, management’s policy towards working capital
etc.

o Fixed assets turn over ratio

Not much of significance as fixed assets cannot contribute directly either
to liquidity or profitability. This is used as a very broad parameter to
compare two units in the same industry and especially when the scales of
operations are quite significant. Formula = Cost of goods sold/Average value
of fixed assets in the period (book value).

Profitability ratios -Profit in relation to sales and profit in relation to assets:

o Profit in relation to sales – this indicates the margin available on sales;

o Profit in relation to assets – this indicates the degree of return on the

capital employed in business that means the earning efficiency. Please
appreciate that these two are totally different.
For example, we will study the following;

Units A and B are in the same type of business and operate at the same levels
of capacities. Unit A employs capital of 250 lacs and unit B employs capital of
200lacs. The sales and profits are as under:

Parameter Unit A Unit B

Sales 1000lacs 1000lacs
Profits 100lacs 90lacs
Profit margin on sales 10% 9%
Return on capital employed 40% 45%
While Unit A has higher profit margins, Unit B has better returns on capital
employed.

o Profit margin on sales:

Gross profit margin on sales and net profit margin ratio –

Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net
sales (-) Cost of production before selling, general, administrative expenses and
interest charges. Net sales = Gross sales (-) Excise duty. This indicates the
efficiency of production and serves well to compare with another unit in the
same industry or in the same unit for comparing it with past trend. For
example in Unit A and Unit B let us assume that the sales are same at
Rs.100lacs.

Parameter Unit A Unit B

Sales 100lacs 100lacs

Cost of production 60lacs 65lacs
Gross profit 40lacs 35lacs
Deduct: Selling general,
Administrative expenses and interest 35lacs 30lacs
Net profit 5lacs 5lacs

While both the units have the same net profit to sales ratio, the significant
difference lies in the fact that while Unit A has less cost of production and
more office and selling expenses, Unit B has more cost of production and less
of office and selling expenses. This ratio helps in controlling either production
costs if cost of production is high or selling and administration costs, in case
these are high.
 Net profit/sales ratio – net profit means profit after tax but before
distribution in any form = Formula = Net profit/net sales. Tax rate being the
same, this ratio indicates operating efficiency directly in the sense that a unit
having higher net profitability percentage means that it has a higher operating
efficiency. In case there are tax concessions due to location in a backward
area, export activity etc. available to one unit and not available to another unit,
then this comparison would not hold well.

Investment on capital ratios/Earnings ratios:

o Return on net worth

Profit After Tax (PAT) / Net worth. This is the return on the shareholders’
funds including Preference Share capital. Hence Preference Share capital is
not deducted. There is no standard range for this ratio. If it reduces it
indicates less return on the net worth.

o Return on equity
Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth
– Preference share capital. Although reference is equity here, all equity
shareholders’ funds are taken in the denominator. Hence Preference
dividend and Preference share capital are excluded. There is no standard
range for this ratio. If it comes down over a period it means that the
profitability of the organisation is suffering a setback.

o Return on capital employed (pre-tax)

Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-
term liabilities. This gives return on long-term funds employed in business in
pre-tax terms. Again there is no standard range for this ratio. If it
reduces, it is a cause for concern.

o Earning per share (EPS)

Dividend per share (DPS) + Retained earnings per share (REPS). Here the
share refers to equity share and not preference share. The formula is =
Profit after tax (-) Preference dividend (-) Dividend tax both on preference
and equity dividend / number of equity shares. This is an important indicator
about the return to equity shareholder. In fact P/E ratio is related to this,
as P/E ratio is the relationship between “Market value” of the share and the
EPS. The higher the PE the stronger is the recommendation to sell the
share and the lower the PE, the stronger is the recommendation to buy the
share.

This is only indicative and by and large followed. There is something known
 as industry average EPS. If the P/E ratio of the unit whose shares we
contemplate to purchase is less than industry average and growth prospects
are quite good, it is the time for buying the shares, unless we know for
certain that the price is going to come down further. If on the other hand,
the P/E ratio of the unit is more than industry average P/E, it is time for us
to sell unless we expect further increase in the near future.

Leverage ratios

Leverages are of two kinds, operating leverage and financial leverage.

However, we are concerned more with financial leverage. Financial leverage
is the advantage of debt over equity in a capital structure. Capital structure
indicates the relationship between medium and long-term debt on the one
hand and equity on the other hand. Equity in the beginning is the equity
share capital. Over a period of time it is net worth (-) redeemable
preference share capital.

It is well known that EPS increases with increased dose of debt capital
within the same capital structure. Given the advantage of debt also, as even
risk of default, i.e., non-payment of interest and non-repayment of principal
amount increases with increase in debt capital component, the market
accepts a maximum of 2:1 at present. It can be less. Formula for
debt/equity ratio = Medium and long-term loans + redeemable preference
share capital / Net worth (-) Redeemable preference share capital.

From the working capital lending banks’ point of view, all liabilities are to be
included in debt. Hence all external liabilities including current liabilities are
taken into account for this ratio. We have to add redeemable preference
share capital and reduce from the net worth the same as in the previous
formula.

Coverage ratios

o Interest coverage ratio

This indicates the number of times interest is covered by EBIT. Formula =
EBIT / Interest payment on all loans including short-term liabilities.
Minimum acceptable is 2 to 2.5:1. Less than that is not desirable, as after
paying interest, tax has to be paid and afterwards dividend and dividend
tax.

o Asset coverage ratio

 This indicates the number of times the medium and long-term liabilities are
covered by the book value of fixed assets.
Formula = Book value of Fixed assets / Outstanding medium and long-term
liabilities. Accepted ratio is minimum 1.5:1. Less than that indicates
inadequate coverage of the liabilities.

o Debt Service coverage ratio

This indicates the ability of the business enterprise to service its
borrowing, especially medium and long-term. Servicing consists of two
aspects namely, payment of interest and repayment of principal amount. As
interest is paid out of income and booked as an expense, in the formula it
gets added back to profit after tax. The assumption here is that dividend is
ignored. In case dividend is paid out, the formula gets amended to deduct
from PAT dividend paid and dividend tax.

Formula is:
(Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue
Expenditure written off (+) Interest on medium and long-term borrowing

(Denominator) Interest on medium and long-term borrowing (+) Installment

on medium and long-term borrowing.

This is assuming that dividend is not paid. In the case of an existing

company dividend will have to be paid and hence in the numerator, instead of
PAT, retained earnings would appear. The above ratio is calculated for the
entire period of the loan with the bank/financial institution. The minimum
acceptable average for the entire period is 1.75:1. This means that in one
year this could be less but it has to be made up in the other years to get an
average of 1.75:1.

What is the objective behind analysis of financial statements?

Objective (To know about) Relevant indicator/Remarks

1. Financial position of the Net worth, i.e., share capital, reserves

company and unallocated surplus in balance
sheet carried down from profit and
loss appropriation account. For a
healthy company, it is necessary that
there is a balance struck between
dividend paid and profit retained in

2. Liquidity of the company, i.e.,
whether the company is in a
position to meet all its short-term
liabilities (also called “current
liabilities”) with the help of its
current assets
3. Whether the company has
acquired new fixed assets during
the year and if so, what are the
sources, besides internal accruals
to finance the same?
4. Profitability of the company in
general and operating profits in
particular, i.e., whether the main
operations of the company like
manufacturing have been in profit
or the profit of the company is
derived from other income, i.e.,
income from investment in
shares/debentures etc.
business so much the net worth keeps
on increasing.
Current ratio and quick ratio or acid
test ratio. Current ratio = Current
assets/current liabilities. Quick ratio
= Current assets (-) inventory/ current
liabilities. Current ratio should not be
too high like 4:1 or 5:1 or too low like
less than 1.5:1. This means that the
company is either too liquid thereby
increasing its opportunity cost or not
liquid at all, both of which are not
desirable. Quick ratio could be at least
1:1. Quick ratio is a better indicator of
liquidity position.
Examination of increase in secured or
unsecured loans for this purpose.
Without adequate financial planning,
there is always the risk of diverting
working capital funds for fixed assets.
This is best assessed through a funds
flow statement for the period as even
net cash accruals (Retained earnings +
depreciation + amortisation) would be
available for fixed assets.
Percentage of profit before tax to
total income including other income,
like dividend or interest income.
Operating profit, i.e., profit before
tax (-) other income as above as a
percentage of income from the main
operations of the company, be it
manufacturing, trading or services.
5. Relationship between the net
worth of the company and its
external liabilities (both short-
term and long-term). What about
only medium and long-term debts?
6. Has the company’s investments
in shares/debentures of other
companies reduced in value in
comparison with last year?
7. Relationship between average
debtors (bills receivable) and
average creditors (bills payable)
during the year.
Debt/Equity ratio, which establishes
this relationship. Formula = External
liabilities + preference share capital
/net worth of the company (-)
preference share capital (redeemable
kind). From the lender’s point of view,
this should not exceed 3:1. Is there
any sharp deterioration in this ratio?
Is so, please be on guard, as the
financial risk for the company
increases to that extent.
For only medium and long-term debts,
it cannot exceed 2:1.
Difference between the market value
of the investments and the purchase
price, which is theoretically a loss in
value of the investment. Actual loss is
booked upon only selling. The periodic
reduction every year should warn us
that at the time of actual sales, there
would be substantial loss, which
immediately would reduce the net
worth of the company. Banks, Financial
Institutions, Investment companies or
NBFCs would be required to declare
their investment every year in the
balance sheet at cost price or market
price whichever is less.
Average debtors in the year/average
creditors in the year. This should be
greater than 1:1, as bills receivable are
at gross value {cost of development (+)
profit margin}, whereas; creditors are
at purchase price for software or
components, which would be much less
than the final sales value. If it is less

8. Future plans of the company,
like acquisition of new technology,
entering into new collaboration
agreement, diversification
programme, expansion programme
etc.
9. Has the company revalued its
fixed assets during the year,
thereby creating revaluation
reserves, without any inflow of
capital into the company, as this is
just an entry passed in the books?
10. Whether the company has
increased its investment and if so,
what is the source for it? What is
the nature of investment? Is it in
tradable securities or long-term
Securities, which can have a lock-
in-period and cannot be liquidated
in the near future?
11. Has the company during the year
given any unsecured loans
substantially other than to
employees of the company?
than 1:1, it shows that while receivable
management is quite good, the company
is not paying its creditors, which could
cause problems in future. Too high a
ratio would indicate that receivable
management is very poor.
Directors’ report. This would reveal
the financial plans for the company,
like whether they are coming out with
a public issue/Rights issue etc.
Auditors’ comments in the “Notes to
Accounts” relevant for this. Frequent
revaluation is not desirable and
healthy.
Increase in amount of investment in
shares/debentures/Govt. securities
etc. in comparison with last year and
any investment within group
companies? Any undue increase in
investment should put us on guard, as
working capital funds could have been
diverted for it.
Any increase in unsecured loans. If
the loans are to group companies, then
all the more reason to be cautious.
Hence, where the figures have
increased, further probing is called
for.
12. Are the company’s unsecured Any comments to this effect in the
loans (given) not recoverable and notes to accounts should put us on
very old? caution. This examination would
indicate about likely impact on the
future profits of the company.

13. Has the company been regular in
payment of its dues on account of
loans or periodic interest on its
liabilities?
Any comments about over dues as in
the “Notes to Accounts” should be
looked into. Any serious default is
likely to affect the “credit rating” of
the company with its lenders, thereby
increasing its cost of borrowing in
future.

14. Has the company defaulted in Any comments about this in the “Notes
providing for bonus liability, P.F. to Accounts” should be looked into.
liability, E.S.I. liability, gratuity
liability etc?

15. Whether the company is holding Cash balance together with bank
very huge cash, as it is not balance in current account, if any, is
desirable and increases the very high in the current assets.
opportunity cost?

16. How many times the average Relationship between cost of goods
inventory has turned over during sold and average inventory during the
the year? year (only where cost of goods sold
cannot be determined, net sales can be
taken as the numerator). In a
manufacturing company, which is not in
capital goods sector, this should not be
less than 4:1 and for a consumer goods
industry, this should be higher even.
For a capital goods industry, this would
be less.
17. Has the company issued fresh
share capital during the period and
what is the purpose for which it has
raised equity capital? If it was a
public issue, how did it fare in the
market?
Increase in paid-up capital in the
balance sheet and share premium
reserves in case the issue has been at
a premium.

18. Has the company issued any Increase in paid-up capital and
bonus shares during the year? simultaneous reduction in general
reserves. Enquiry into the company’s
ability to keep up the dividend rate of
the immediate past.

19. Has the company made any Increase in paid-up capital and share
rights issue in the period and what premium reserves, in case the issue
is the purpose of the issue? If it has been at a premium.
was a public issue, how did it fare in
the market?

20.What is the proportion of Percentage of marketable investment

marketable investment to total
investment and whether this has
decreased in comparison with the
previous year?
to total investment and comparison
with previous year. Any decrease
should put us on guard, as it reduces
liquidity on one hand and increases the
risk of non-payment on due date,
especially if the investment is in its
own subsidiary or group companies,
thereby forcing the company to
provide for the loss.

21. What is the increase in sales Comparison with previous year’s sales
income over last year in % terms? income and whether the growth has
Is it due to increase in numbers or been more or less than the estimate.
change in product mix or increase in
prices of finished products only?
22.What is the amount of provision In percentage terms, how much is it of
for bad and doubtful debts or total debts outstanding and what are
advances outstanding? the reasons for such provision in the
notes to accounts by the auditors?

23.What is the amount of work in Is there any comment about valuation

progress as shown in the Profit and of work in progress by the auditors?
Loss Account? It can be seen that profit from
operations can be manipulated by
increase/decrease in closing stocks of
both finished goods and work in
progress.

24.Whether the company is paying Examination of expenses schedule

any lease rentals and if so what is
the amount of lease liability
outstanding?
would show this. What is the comment
in notes to accounts about this? Lease
liability is an off-balance sheet item
and hence this examination, to
ascertain the correct external liability
and to include the lease rentals in
future also in projected income
statements; otherwise, the company
may be having much less disclosed
liability and much more lease liability
which is not disclosed. This has to be
taken into consideration by an analyst
while estimating future expenses for
the purpose of estimating future
profits.

25.Has the company changed its Auditors’ comments on “Accounting”

method of depreciation on fixed policies. Change over from straight-
assets, due to which, there is an line method to written down value
impact on the profits of the method or vice-versa does affect the
company? deprecation charge for the year
thereby affecting the profits during
the year of change.
26.If it is a manufacturing Relationship between materials
company, whether the % of consumed during the year and the
materials consumed is increasing in sales.
relation to sales?

27.Has the company changed its Auditors’ comments on “Accounting”

method of valuation of inventory, policies.
due to which there is an impact of
the profits of the company?

28.Whether the % of Relationship between general and

administration and general administrative expenses during the
expenses has increased during the year and the sales. In case there is
year under review? any extraordinary increase, what are
the reasons therefore?

29.Whether the company had Interest coverage ratio = earnings

sufficient income to pay
interest charges?
the before interest and tax/total interest
on all short-term and long-term
liabilities. Minimum should be 3:1 and
anything less than this is not
satisfactory.

30.Whether the finance charges Relationship between interest charges

have gone up disproportionately as
compared with the increase in sales
income during the same period?
and sales income – whether it is
consistent with the previous year or is
there any spurt?
Is there any explanation for this, like
substantial expansion or new project
or diversification for which the
company has taken financial
assistance? While a benchmark % is
not available, any level in excess of 6%
calls for examination.

31. Whether the % of employee Relationship between “payment to and

costs to sales has increased? provision for employees” and the sales.
In case any undue increase is seen, it
could be due to expansion of activity
etc. that would be included in the
Directors’ Report.

32.Whether the % of selling Relationship between “selling and

expenses in relation to sales has marketing” expenses and the sales.
gone up? Any undue increase could either mean
that the company is in a very
competitive industry or it is aggressive
to increase its market share by
adopting a marketing strategy that
would increase the marketing expenses
including offer of higher commission to
the intermediaries like agents etc.

33.Whether the company had Debt service coverage ratio = Internal

sufficient internal accruals {Profit
after tax (-) dividend (+) any non-
cash expenditure like depreciation,
preliminary expenses write-off
etc.} to meet repayment obligation
of principal amount of loans,
debentures etc.?
accruals (+) interest on medium and
long-term external liabilities/interest
on medium and long-term liabilities (+)
repayment of medium and long-term
external liabilities. The term-lending
institution or bank looks for 1.75:1 on
an average for the loan period. This is
a very critical ratio to indicate the
ability of the company to take care of
its obligation towards the loans it has
taken both by way of interest as well
as repayment of the principal.

34.Return on investment in business Earnings before interest and

to compare it with return on similar tax/average total invested capital, i.e.,
investment elsewhere. net worth (+) debt capital. This should
be higher than the average cost of
funds in the form of loans, i.e.,
interest cost on loans/debentures etc.
35.Return on equity (includes Profit after tax (-) dividend on
reserves and surplus) preference share capital/net worth (-)
preference share capital (return in
percentage). Anything less than 15%
means that our investment in this
company is earning less than the
average return in the market.

36.How much earning has our share Profit after tax (-) dividend on
made? (EPS) preference share capital/number of
equity shares. In terms of percentage
anything less than 40% to 50% of the
face value of the shares would not go
well with the market sentiments.

37.Whether the company has Relationship between amount of

reduced its dividend payout in dividend payout and profit after tax
comparison with last year? last year and this year. Is there any
reason for this like liquidity crunch
that the company is experiencing or
the need for conserving cash for
business activity, like purchase of
fixed assets in the immediate future?

38.Is there any significant increase “Notes on Accounts” as given at the

in the contingent liabilities due to end of the accounts.
any of the following? Any substantial increase especially in
Disputed central excise duty, disputed amount of duties should put
customs duty, income tax, octroi, us on guard.
sales tax, contracts remaining
unexecuted, guarantees given by
the banks on behalf of the company
as well as the guarantees given by
the company on behalf of its
subsidiary or associate company,
letter of credit outstanding for
which goods not yet received etc.
 39. Has the company changed its Substantial change in vendor charges,
policy of outsourcing its work from or subcontracting charges.
vendors and if so, what are the
reasons?

40. Is there any substantial Increase in consultancy charges.

increase in charges paid to
consultants?

41. Has the company opened any Directors’ Report or sudden spurt in
branch office in the last year? general and administration expenses.

The principal tools of analysis are:

♦ Ratio analysis – i.e. to determine the relationship between any set of two
parameters and compare it with the past trend. In the statements of
accounts, there are several such pairs of parameters and hence ratio analysis
assumes great significance. The most important thing to remember in the
case of ratio analysis is that you can compare two units in the same
industry only and other factors like the relative ages of the units, the
scales of operation etc. come into play.

♦ Comparison with past trend within the same company is one type of analysis and
comparison with the industrial average is another analysis

While one can derive a lot of useful information from analysis of the financial
statements, we have to keep in mind some of the limitations of the financial
statements. Analysis of financial statements does indicate a definite trend,
though not accurately, due to the intrinsic nature of the data itself.

Some of the limitations of the financial statements are given below.

 Analysis and understanding of financial statements is only one of the tools in

understanding of the company
 The annual statements do have great limitations in their value, as they do not
speak about the following-
 Management, its strength, inadequacy etc.
 Key personnel behind the activity and human resources in the organisation.
 Average key ratios in the industry in the country, of which the company is an
integral part. This information has to be obtained separately.
 Balance sheet is as on a particular date and hence it does not indicate about
the average for the entire year. Hence it cannot indicate the position with
100% reliability. (Link it with fundamental analysis.)
 The auditors’ report is based more on information given by the management,
company personnel etc.
 To an extent at least, there can be manipulation in the level of expenditure,
level of closing stocks and sales income to manipulate profits of the
organisation, depending upon the requirement of the management during a
particular year.
 One cannot come to know from study of financial statements about the tax
planning of the company or the basis on which the company pays tax, as it is not
mandatory under the provisions of The Companies’ Act, 1956, to furnish details
of tax paid in the annual statement of accounts.

Notwithstanding all the above, continuous study of financial statements

relating to an industry can provide the reader and analyst with an in-depth
knowledge of the industry and the trend over a period of time. This may
prove invaluable as a tool in investment decision or sale decision of
shares/debentures/fixed deposits etc.

*** End of handout ***