Chapter 6

FINANCIAL STATEMENT ANALYSIS

The Information Maze
 OUTLINE
• FINANCIAL STATEMENTS

• GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

• FINANCIAL RATIOS

• STANDARDISED FINANCIAL STATEMENTS

• APPLICATIONS OF FINANCIAL STATEMENT

ANALYSIS

• USING FINANCIAL STATEMENT ANALYSIS

 Important Questions
Managers, shareholders, creditors and other interested groups
seek answers to the following important questions about a
firm:
• What is the financial position of the firm at a given point of
time?
• How has the firm performed financially over a given period of
time?
• What have been the sources and uses of cash over a period of
time?
The accountant prepares the balance sheet, the profit and
loss account, and the statement of cash flows to answer the
above questions.
 Balance Sheet
Horizontal Form
Liabilities + Equity Assets
 Share capital  Fixed assets

 Reserves and surplus  Investments

 Secured loans  Current assets, loans and

 Unsecured loans advances

 Current liabilities and  Miscellaneous
provisions expenditure and
losses
 Balance Sheet
Vertical (or Report) Form
I. Sources of Funds
(1) Shareholders’ funds:
(a) Capital
(b) Reserves and Surplus
(2) Loan funds:
(a) Secured loans
(b) Unsecured loans
II. Application of funds
(1) Fixed assets
(2) Investments
(3) Current assets, loans and advances
Less: Current liabilities and provisions:
Net current assets
(4) Miscellaneous expenditures and losses
 Balance Sheet Of Horizon Limited As On
March 31, 20 X 1 Rs.in million

A. Account Form Rs.in million

Liabilities 20 x 1 20 x 0 Assets 20 x 1 20 x 0

Share capital 150 150 Fixed assets 330 322

Equity 150 Investments*** 15 15

Preference – Current assets, loans
Reserves & surplus 112 106 and advances 234 156
Secured loans* 143 131 Miscellaneous
Unsecured loans** 69 25 expenditures and losses

Current liabilities
and provisions 105 81
* 579are due
Rs. 35 million of secured loans 493 within 1 year, the balance being due579 493
after 1 year.
**
Rs.40 million of unsecured loans are due within 1 year, the balance being due after 1 year.
***
Rs.3 million out of Rs.15 million represent current investments.
 Balance Sheet Of Horizon Limited As On
March 31, 20 X 1 Rs.in million
20 x 1 20 x 0
I. Sources of Funds
(1) Shareholders’ funds: 262 256
(a) Capital 150
(b) Reserves and surplus 112
(2) Loan funds: 212 156
(a) Secured loans 143
(b) Unsecured loans 69
474 412
II. Application of Funds
(1) Fixed assets 330 322
(2) Investments 15 15
(3) Current assets, loans and advances 234 156

Less: Current liabilities and provisions: 105 81

Net current assets 129 75
(4) Miscellaneous expenditures and losses
474 412
 Liabilities

• Share Capital

• Reserves & Surplus

• Secured Loans

• Unsecured Loans

• Deferred Tax Liability

• Current Liabilities and Provisions

 Assets

• Fixed Assets

• Investments

• Current Assets, Loans, & Advances

• Miscellaneous Expenditure & Losses

 Profit & Loss Account Of Horizon Ltd, For The Year
Ending On March 31, 20 X 1
(Rs.in million)
Income
Sales 701
Other income –
701
Expenditure
Material and other expenditure 582
Interest 21
Depreciation 30
Provision for tax 34
Profit after tax 34
 Profit & Loss Account Of Horizon Ltd, For The Year

Ending On March 31, 20 X 1

(Rs. in million)
20 x 1 20 x 0
Net sales 701 623
Cost of goods sold 552 475
Stocks 421
Wages and salaries 68
Other manufacturing expenses 63
Gross profit 149 148
Operating expenses 60 49
Depreciation 30
General administration 12
Selling 18
Operating profit 89 99
Other income (expense) – 06
Profit before interest and tax 89 105
Interest 21 22
Profit before tax 68 83
Provision for tax 34 41
Profit after tax 34 42
 Profit And Loss Account Items
 Net Sales
 Cost of Goods Sold
 Gross Profit
 Operating Expenses
 Operating Profit
 Non-operating Gains and Losses
 Profit Before Interest and Taxes
 Interest
 Profit before Tax
 Income Tax Provision
 Profit After Tax
 Prior Period Adjustments
 Amount Available for Appropriation
 Appropriations
 Balance Carried Forward
 Net Cash Flow

Net cash = Profit after – Non cash + Non cash

flow tax revenues expenses

In practice, analysts use the following approximation:

Net cash = Profit after + Depreciation + Amortisation

Flow tax
 Statement of Cash Flow
Sources of Cash

• Increase in liabilities and owners’ equity

• Decrease in assets (other than cash)

Uses of Cash

• Decrease in liabilities and owners’ equity

• Increase in assets (other than cash)

 Statement Of Cash Flow
Operating Cash inflows – Cash outflows Cash flow
from operations = from operations
from operations

+ –

Cash inflows Cash outflows Cash flow

Investing from investing – from investing = from investing
activities activities activities
+ –

Cash inflows Cash outflows Cash flow

Financing from financing – from financing = from financing
activities activities activities
=

Net cash flow

for the period
 SOURCES USES
• FINANCING CAPITAL CAPITAL

• OPERATING RES. & SURPLUS RES. & SURPLUS

• FINANCING LOANS LOANS

• OPERATING CURRENT LIABILITIES CURRENT LIABILITIES

& PROVISIONS & PROVISIONS

• INVESTMENT FIXED ASSETS FIXED ASSETS

• INVESTMENT INVESTMENTS INVESTMENTS

• OPERATING INVENTORIES INVENTORIES

• OPERATING DEBTORS DEBTORS

CASH FLOW STATEMENT FOR HORIZON LTD, FOR
THE PERIOD 1.4.20X0 TO 31.3.20X1
(Rs. in million)
(A) Cash Flow from Operating Activities
Net profit before tax and extraordinary items 68
Adjustments for
Interest paid 21
Depreciation 30
Operating profit before working capital changes 119
Adjustments
Debtors (46)
Inventories (33)
Advances 05
Trade credit 15
Advances 07
Provisions 02
Cash generated from operations 69
Income tax paid 34
Cash flow before extraordinary items 35
Extraordinary item –
Net cash flow from operating activities 35

(Contd.)
(Contd.)
(Rs.in
million)
(B) Cash Flow from Investing Activities
Purchase of fixed assets (38)
Net cash flow from investing activities (38)
(C) Cash Flow from Financing Activities
Proceeds from term loans 12
Proceeds from inter-corporate deposits 44
Interest paid (21)
Dividend paid (28)
Net cash flow from financing activities 07
(D) Net Increase in Cash and Cash Equivalents (A) + (B) + (C) 04
Cash and cash equivalents as on 1.04.20x0 06
Cash and cash equivalents as on 31.03.20x1 10
 Manipulation Of The Bottom Line
1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE

FOLLOWING YEAR
2. ALTER THE ‘OTHER INCOME’ FIGURE BY PLAYING WITH NON-OPERATIONAL ITEMS
3. FIDDLE WITH THE METHOD & RATE OF DEPR’N
4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR.
5. MAKE INADEQUATE PROVISIONS . . LIABILITIES
6. MAKE EXTRA PROVISIONS . . PROSPEROUS PERIODS . . WRITE THEM BACK . . LEAN PERIODS
7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES.
8. REVALUE ASSETS . . CREATE . . IMPR’N . . RESERVES
9. LENGTHEN … ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE.

WHY ? PROJECT IMAGE OF LOW RISK

PROMOTE PERCEP’N . . COMPETENT MGT
INCREASE MGRL COMPEN’N

QUALITY PROMPTNESS
OF CANDOUR IN ANALYSING PAST PERFORMANCE
REPORTING MEANINGFUL DISCUSSION . . PROSPECTS
Generally Accepted Accounting Principles

• Indian GAAP

• Indian GAAP and the US GAAP

• IFRS and the US GAAP

• Key Trends in Accounting Standards

 Indian GAAP

The Indian GAAP is influenced by the following:

• Provisions relating to accounts in the Companies Act
and special statutes and regulations that govern
businesses like banking and insurance.
• SEBI regulations applicable to listed companies.
• Accounting standards issued by ICAI and endorsed by
the Government.
• Guidance notes issued by ICAI.
 HORIZON LIMITED: PROFIT AND LOSS ACCOUNT
FOR THE YEAR ENDING 31ST MARCH 20X1
(Rs. in million)
20X1 20X0
Net sales 701 623
Cost of goods sold 552 475
Stocks 421 370
Wages and salaries 68 55
Other manufacturing expenses 63 50
Gross profit 149 148
Operating expenses 60 49
Depreciation 30 26
General Administration 12 11
Selling 18 12
Operating profit 89 99
Non-operating surplus/deficit - 6
Profit before interest and tax 89 105
Interest 21 22
Profit before tax 68 83
Tax 34 41
Profit after tax 34 42
Dividends 28 27
Retained earnings 6 15
Per share data ( in rupees)
Earning per share 2.27 2.80
Dividend per share 1.80 1.80
Market price per share 21.0 20.0
Book value per share 17.47 17.07
 
HORIZON LIMITED: BALANCE SHEET AS ON
31ST MARCH 20X1
(Rs. in million)
20X1 20X0
  I. Sources of funds
1. Shareholders' funds 262 256
(a)   Share capital 150 150
(b) Reserves and surplus 112 106
2. Loan funds
(a)  Secured loans 143 131
(i) Due after 1 year 108 29
(ii) Due within 1 year 35 40
(b)  Unsecured Loans 69 25
(i) Due after 1 year 29 10
(ii) Due within 1 year 40 15
  474 412
II. Application of funds
1. Fixed assets 330 322
2. Investments 15 15
(a) Long term investments 12 12
(b) Current investments 3 3
3. Current assets, loans and advances 234 156
(a) Inventories 105 72
(b) Sundry debtors 114 68
(c) Cash and bank balance 10 6
(d) Loans and advances 5 10
Less: Current liabilities and provisions 105 81
Net current assets 129 75
Total 474 412
 Liquidity Ratios
• Current Ratio
Current assets 237
= = 1.32
Current liabilities 180

• Acid-Test Ratio
Quick assets (237 – 105)
= = 0.73
Current liabilities 180

• Cash Ratio
Cash and bank Current
+
balances investments (10 + 3)
= = 0.07
Current liabilities 180
 Leverage Ratios
• Debt-equity Ratio
Debt 212
= = 0.809
Equity 262
• Debt-asset Ratio
Debt 212
= = 0.45
Assets 474
• Interest Coverage Ratio
Profit before interest and tax 89
= = 4.23
Interest 21
 Turnover Ratios
• Inventory Turnover
Cost of goods sold 552
= = 6.24
Average inventory (105 + 72)/2
• Debtors’ Turnover
Net credit sales = 701
= 7.70
Average debtors (114 + 68)/2
• Fixed Assets Turnover
Net sales = 701 = 2.15
Average net fixed assets (330 + 322)/2
• Total Assets Turnover
Net sales = 701 = 1.58
Average total assets (474 + 412)/2
 Profitability Ratios
• Gross Profit Margin Ratio
Gross profit 149
= = 0.21 or 21 percent
Net sales 701

• Net Profit Margin Ratio

Net profit 34
= = 0.049 or 4.9 percent
Net sales 701

• Return on Assets (ROA)

Profit after tax 34
= = 0.077 or 7.7 percent
Average total assets (474 + 412)/2
 Profitability Ratios

• Earning Power
Profit before interest and tax 89
= = 0.201 or 20.1
Average total assets (474 + 412)/2
percent
• Return on Capital Employed
Profit before interest and tax
(1 – Tax rate) 89 (1 – 0.5)
= = 0.101 or 10.1
Average total assets (474 + 412)/2 percent
• Return on Equity
Equity earnings 34
= = 0.131 or 13.1
Average equity (262 + 256)/2 percent
 Valuation Ratios
 Price-earnings Ratio
Market price per share 21.0
= = 9.25
Earnings per share 2.27
 Yield
Dividend Price change
+
Initial price Initial price
Dividend yield Capital gains/losses yield
1.87 1.0
= 9.35% = 5%
20.0 20.0
 Market Value to Book Value Ratio
Market value per share 21.00
= = 1.20
Book value per share 17.47
 Comparison With Industry Averages
Ratios Formula Horizon Industry
Limited Average
Liquidity
Current assets
• Current ratio 1.32 1.26
Current liabilities
Quick assets
• Acid-test ratio 0.73 0.69
Current liabilities
Leverage
Debt
• Debt-equity ratio 0.81 1.25
Equity
Debt
• Debt-ratio 0.45 0.56
Assets
PBIT
• Interest coverage ratio 4.23 4.14
Interest
Turnover
Net sales
• Inventory turnover 6.24 6.43
Average Inventory
Net credit sales
• Accounts receivable turnover 7.70 7.50
Average accounts receivable
Net sales
• Fixed assets turnover 2.15 2.23
Average net fixed assets
Net sales
• Total assets turnover 1.58 1.26
Average Total assets
 Ratios Formula Horizon Industry
Limited Average
Profitability
Gross profit
• Gross profit margin ratio 21.0% 18.0%
Net sales
Net profit
• Net profit margin ratio 4.7% 4.0%
Net sales
Net profit
• Return on assets 7.7% 6.9%
Average total assets
PBIT
• Earning power 20.1% 17.7%
Average total assets
PBIT (1–T)
• Return on capital employed 10.1% 8.8%
Average total assets
Equity earnings
• Return on equity 13.1% 11.9%
Average net worth
Valuation
Market price per share
• Price-earnings ratio 9.25 9.26
Earnings per share
Dividend + Price change
• Yield 14. 0% 14.1%
Initial price
Market price per share
• Market value to book 1.20 1.16
value ratio Book value per share
 Time Series Of Certain Financial Ratios

1 2 3 4 5
Debt-equity ratio 0.91 0.98 0.65 0.61 0.81
Total assets turnover ratio 1.51 1.59 1.58 1.53 1.58
Net profit margin (%) 8.8 11.6 9.8 6.6 4.9
Return on equity (%) 25.4 30.7 24.5 16.7 13.1
Price-earnings ratio 18.6 15.3 10.3 7.1 9.3
 Dupont Analysis

Basic Du Pont Analysis

Net profit Net profit Net sales
= x
Aveage total assets Net sales Average total assets
ROA = NPM x TATR

Extended Du Pont Analysis

Net profit Net profit Sales Average total assets
= x x
Equity Sales Average total assets Average equity

ROE NPM x TATR x 1/(1 – DAR)

 Du Pont Chart Applied To Horizon Limited
Net Sales
+/- Non operating

Surplus/Deficit
Net Profit 701
34
–
Net Profit
Margin
4.9%
 Total Costs
667

Net Sales
701
Return on
Total Assets
7.7 % X Average
Fixed assets
Net Sales 326
701

+
Total Assets
Turnover 1.58

Average
Average Investments
Total 15
Assets 443
+
Average
Net Current
Assets 102
 Extension Of The Du Pont Chart

Return of Equity
13.1%

Return of Assets Average Total Assets

To Average Equity
7.7% Ratio 1.70
 Common Size Financial Statements
Part A : Profit and Loss Account
  Reg ular (in million) Common Size (%)
20X0 20X1 20X0 20X1
• Net sales Rs.623 Rs. 701 100 100
• Cost of goods sold 475 552 76 79
• Gross profit 148 149 24 21
• PBIT 105 89 17 13
• Interest 22 21 4 3
• PBT 83 68 13 10
• Tax 41 34 7 5
• PAT 42 34 7 5
Part B: Balance Sheet
Regular (in million) Common Size (%)
20X0 20X1 20X0 20X1
• Shareholders’ funds 256 262 62 55
• Loan funds 156 212 38 45
Total 412 414 100 100
• Fixed assets 322 330 78 70
• Investments 15 15 4 3
• Net current assets 75 129 18 27
Total 412 474 100 100
 Common-Base Year Financial Statements
Part A : Profit and Loss Account
  Regular (in million) Common Base Year (%)
20X0 20X1 20X0 20X1
• Net sales Rs.623 Rs. 701 100 113
• Cost of goods sold 475 552 100 116
• Gross profit 148 149 100 101
• PBIT 105 89 100 85
• Interest 22 21 100 95
• PBT 83 68 100 82
• Tax 41 34 100 83
• PAT 42 34 100 81
Part B: Balance Sheet
Regular (in million) Common Size (%)
20X0 20X1 20X0 20X1
• Shareholders’ funds 256 262 100 102
• Loan funds 156 212 100 136
Total 412 414 100 115
• Fixed assets 322 330 100 102
• Investments 15 15 100 100
• Net current assets 75 129 100 172
Total 412 474 100 115
 Applications Of Financial Analysis
Financial ratios may be employed to:

• Assess corporate excellence

• Judge creditworthiness

• Forecast bankruptcy

• Value equity shares

• Predict bond ratings

• Estimate market risk

Problems In Financial Statement Analysis
• Heuristic and Intuitive Character

• Development of Benchmarks

• Window Dressing

• Price Level Changes

• Variations in Accounting Policies

• Interpretation of Results

• Correlation among Ratios

 Guidelines

• USE RATIO TO GET CLUES TO ASK THE RIGHT

QUESTIONS
• BE SELECTIVE IN THE CHOICE OF RATIOS
• EMPLOY PROPER BENCHMARKS
• KNOW THE TRICKS USED BY ACCOUNTANTS
• READ THE FOOT NOTES
• UNDERSTAND HOW THE RATIOS ARE INTER-
RELATED
• REMEMBER … FSA .. ODD MIXTURE OF ART &
 Looking Beyond the Numbers
1. ARE THE COMPANY’S REVENUES TIED TO ONE
KEY CUSTOMER ?
2. TO WHAT EXTENT ARE THE COMPANY’S
REVENUES TIED TO ONE KEY PRODUCT ?
3. TO WHAT EXTENT DOES THE COMPANY RELY
ON A SINGLE SUPPLIER ?
4. WHAT PERCENTAGE OF THE COMPANY’S
BUSINESS IS GENERATED OVERSEAS ?
5. COMPETITION
6. FUTURE PROSPECTS
7. LEGAL AND REGULATORY ENVIRONMENT
 SUMMING UP
• Balance sheet, profit and loss account, and the statement of
cash flows are the three financial statements

• The balance sheet shows the financial position at a given

point of time, the profit and loss account reflects the
financial performance over a period of time, and the
statement of cash flows displays the sources and uses of
cash over a period of time.

• Financial statement analysis can provide valuable insights

into a firm’s performance and position.

• The principal tool of financial statement analysis is

financial ratio analysis.
• Financial ratios may be divided into five broad categories:
• Liquidity ratios
• Leverage ratios
• Turnover ratios
• Profitability ratios
• Valuation ratios
• Generally, the financial ratios of a company are compared
with some benchmark ratios.
• The Du Pont chart is a popular tool of financial analysis. It
provides insights into the determinants of the return on
equity
• There are certain problems and issues in financial
statement analysis that call for care, circumspection, and
judgment.