Corporate Financial Management
Chapter-4
ANALYSIS OF FINANCIAL STATEMENTS
Having understood how a balance sheet and profit and loss statement is organized, we
can now see how they might be analyzed.
There are three ways in which we can analyze.
a.
analysis
b.
c.
Common size
Index analysis
Ratio analysis.
Common Size analysis
Under this analysis, in the balance sheet the total assets and total liabilities are
taken as equivalent to 100. The percentage of other items in the balance sheet is then
computed. All the items are expressed as a percentage of the total assets/liabilities. A
comparison of the changes is then made and results interpreted accordingly.
Similarly in the case of Profit and Loss statement, the sales or total income is taken as
equivalent of 100. The other items are expressed as a percentage of sales.
Example 1
The financial statements of Khilafat Bros show the following position. Convert them into
a common size statement. What observations can you make?
Liabilities
Equity Share Capital
Reserves and Surplus
Term loans
Total
Assets
Fixed Assets
Investments in subsidiary concerns
Current assets
Misc. expenditure not written off
Total
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Amount (Riyals)
678
2456
1345
4479
2088
932
878
581
4479
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Corporate Financial Management
The common size balance sheet would look as follows:
it
Liabilities
Equity share capital
Reserves and Surplus
Term Loans
Total
Assets
Amount
15.2
54.8
30.0
100.0
Fixed Assets
46.6
Investment in Subsidiary concerns
20.8
Current Assets
19.6
Misc. Expenditure not written off
13.0
Total
100.0
From the above statement,
might be observed that, the
company has used much
more of own funds than
borrowed funds (15.2+54.8
70.0).Fixed assets form
largest
component
of
assets. Around 21% of the
funds raised have been
invested in a subsidiary
concern.
Similarly in the case of
profit and loss account, the common size can be shown as below
Sales
7432
71.2
Other income
3000
28.8
Total income
10432
100.0
Material
4401
42.2
Power and Fuel
1234
11.8
Salaries and wages
1138
10.9
Selling expenses
1431
13.7
Administrative expenses
654
6.3
Depreciation
256
2.5
Interest
768
7.4
Profit before tax
550
5.2
Tax
234
2.2
Profit after tax
316
3.0
Expenses
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Corporate Financial Management
From the Profit and Loss account, it might be observed that other incomes contribute
significantly to the profits. Materials account for 42% of the sales. The ability of the
company to make profits is low. Net profits are only 3 % of the total income.
Index Analysis
In the Index Analysis, the financial statements of different periods are compared. Earliest
period is taken as the base period. The various figures in the base period are treated as
equivalent to 100. The figures appearing in the later period are expressed as a percentage
of the base period. The changes in these periods for different elements of the statements
are observed. Interpretations of these are made thereafter.
Example 2:
Balance Sheet
2000
Equity
Share
Capital
Reserves
and
Surplus
Term
Loans
Total
Assets
Fixed
Assets
Current
Assets
Exp. Not
W/O
Total
2850
100
2002
2850
100
2003
2850
100
3550
100
4360
123
5460
154
3020
100
2820
93
2420
80
9420
100
10030
106
10730
114
2859
100
3560
125
4780
167
5690
100
6280
110
4980
88
871
100
190
22
970
111
9420
100
10030
106
10730
114
From the above index analysis, it might be observed that total assets and accordingly
liabilities have increased 14% in the last two years. However fixed assets have increased
67%. Current assets have actually decreased by 12 %. Reserves and Surplus has increased
by 54%, while term loans have decreased by 20%. In other words, profits generated have
been ploughed back into the business. The dependence on term loan has decreased.
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Corporate Financial Management
Ratio Analysis:
This is a tool for analyzing financial performance and health of a business. Ratio is
proportion of one figure over another. There are five types of ratios which indicate the
financial health and performance. They are;
- Liquidity
- Turnover
- Structural or leverage
- Profitability
- Valuation ratios
Liquidity ratios:
These ratios indicate how liquid a business is. Liquidity means, the ability of the
company to pay back its short term creditors. This ability is measured in terms of the
current assets available for conversion to cash or equivalent to enable repayment of
creditors. It is defined as;
Current Ratio = Current Assets / Current Liabilities
Another ratio which also indicates liquidity is the acid test ratio.
Acid test ratio = (Current Assets Receivables) / Current Liabilities.
Higher these two ratios, better the liquidity.
Turnover ratios
These ratios reflect the level of activity in the business. The number of times the assets of
the company have been turned over to generate sales/ total income is indicated in this
ratio. The ratios are, total turnover, fixed asset turnover, current asset turnover, inventory
turnover and receivables turnover.
Total asset turnover = Sales (Total income) / Avg. Total Assets.
Avg. total assets = (Opening balance + closing balance/ 2)
Fixed asset turnover = Sales (Total income) / Avg. Fixed Assets
Avg. fixed Assets = (Opening fixed assets + closing fixed assets / 2)
Current Asset turnover = Sales (total income) / Avg. current assets
(Avg. current assets = opening current assets + closing current assets / 2)
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Corporate Financial Management
Inventory turnover = Sales (total income) / Avg. Inventory
(Inventory would comprise raw material, work in process, finished goods and stores and
consumables)
Avg. Inventory = [(Opening inventory + Closing inventory / 2)]
Receivables turnover = Sales / Avg. Receivables
Average Receivables = [(Opening receivables+ closing receivables) / 2]
Higher these ratios better the utilization of the assets. The efficiency of utilization of
assets is reflected in these ratios.
Structural Ratios (Leverage ratio)
This ratio indicates the capital structure of the business. The respective share of debt and
equity in financing the business is indicated in this ratio. The important ratios are;
Total Debt to Equity Ratio = Total outside liabilities/ Tangible net worth
Tangible net worth
= [Equity + Reserves and surplus Intangible assets.]
Too high a ratio is considered risky in the event of downward fluctuations in the fortunes
of the business.
Long term debt to equity == Long Term debt/ Tangible net worth
Generally the ratios exceeding 1.50 is considered risky.
Coverage Ratio:
Interest service coverage ratio [ISCR] indicates the ability to pay interest.
ISCR =
Profit before interest and taxes / Interest
Debt service coverage ratios [DSCR]:
DSCR = [(Net profit + Interest + Depreciation)] /
[(Interest + Repayment installments)]
The higher the ratios better the ability to pay interest and also repay principal
installments.
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Corporate Financial Management
Profitability Ratios:
These ratios indicate the ability of the business to make profits. These ratios are defined
with respect to sales and also with respect to total assets.
Gross profit margin = Gross Profit/ Sales (total operating income)
Operating profit margin = Operating Profit / Sales (total income)
In case there is no non operating income or expenses, this ratio is also identical to
= Earnings before interest and taxes (EBIT) / Sales (total income)
Net profit margin = Profit after tax (PAT) / Sales (total income)
Return on Investment = Operating Profit / Avg. total assets
Return on Net worth (Equity) = PAT / Avg. total assets.
Earnings per share (EPS) = PAT / no of outstanding shares.
Higher the ratios, more profitable the business.
Valuation Ratios
These ratios measure the value of a share.
The important ratios are;
Book value = Net worth / No of outstanding shares.
Price Earnings multiple [PE] = Market Price/ EPS
Limitations of the ratio Analysis
Ratio analysis is helpful only if their limitations (to what extent they can be used) are
understood. Some of the major limitations are;
1. The analysis is carried only with reference to the figures at the end of accounting
periods. This might not be indicative of financial position that might have been
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Corporate Financial Management
present during the rest of the period. Therefore the inferences drawn might not be
proper.
2. The analysis is based on past data and not necessarily providing any indication or
direction for the future.
3. The analysis is based on financial statements prepared by the company. For joint
stock companies these statements are subject to audit and therefore somewhat
reliable. For other types of business in most countries they are not subject to a
proper audit. The auditors responsibility is only to certify that the statements
have been prepared based on figures correctly extracted from the books of
accounts maintained by the company. The auditor does not certify that the
financial statements present a true and fair picture of the financial position and
working results of the company.
4. Even in the case of joint stock companies, the accounts are often window dressed
to distort the position of profits or the financial position. Some of the accounting
areas where the accountants have some flexibility to fudge the reporting are ;
a. Inventory valuation
b. Depreciation
c. Writing off expenditure
d. Capitalizing revenue expenditure
e. Revaluation
Therefore while ratio analysis is very helpful, it has to be interpreted carefully with full
awareness of the limitations.
Practice Exercise
1. Net profit margin
Total asset turnover ratio
Debt to Total asset ratio
Return on equity
= 7%,
= 1.50
= 0.50
=?
2. Profit before tax
Interest coverage ratio
Total interest charge
= 50,000
=5
=?
3. Interest Charge
=
Sales
=
Tax rate
=
Net profit margin
=
Interest coverage ratio =
200,000
7,500,000
40%
5%
?
4. If a companys current assets are RO 12000 and current liabilities are RO 4000,
how much additional trade credit can be taken without bringing the current ratio
below 2?
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Corporate Financial Management
5. The annual sales of a company are RO 1,000,000 and its average accounts
receivable are RO 100,000. By what period of time should the average collection
period be reduced, if the average accounts receivable are to be reduced to RO
75,000? (Average collection period = Accounts receivable/ credit sales per day)
6. What will be the sales of a company if its;
Current ratio
Acid Test ratio
Current liability
Inventory turnover ratio
= 1.30
=1
= RO 1,000,000
= 4 times
7. Complete the balance sheet and sales data (fill in the blanks) using the following
financial data?
Debt/Equity ratio
=1
Acid-test ratio
=1
Total asset turnover ratio
=2
Days sales outstanding in accounts receivable
(Accounts receivable/sales per day) = 30 days
Gross profit margin
= 15%
Inventory turnover ratio
=6
Operating profit margin
= 10 %
Net profit margin
= 5%
Cash profit margin
= 6%
Taxation rate
= 20%
Liabilities
Equity capital
Retained earnings
Current liability
Non current liability
Total
Sales
Cost of goods sold
Gross profit
Depreciation
Selling General and
Administrative expenses
Operating profit
Interest
Profit before tax
Profit after tax
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100,000
50,000
?
0
?
?
?
?
?
?
?
?
?
?
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Assets
Plant and Equipment
Inventory
Accounts receivable
Cash
Total
?
?
?
?
?
Corporate Financial Management
8. The balance sheet and the income statement of Al Hassan Food Products SAOG
are given below. Evaluate the performance with reference to the standards?
Balance Sheet
Equity Capital
Reserves and surplus
Long term debt
Short term bank
borrowing
Trade creditors
Provisions
Total
Fixed assets (Net)
Cash and bank balance
Receivable
Inventories
Pre-paid expenses
Others
Total
Current Ratio
Acid-test ratio
Debt Equity ratio
Interest coverage ratio
Inventory turnover ratio
Average collection period
Total asset turnover ratio
Net profit margin
Return on Investment
Return on Equity
Income and expenses statement
Net Sales
100000
Non operating surplus
2000
Cost of goods sold
70000
Other Operating
10000
expenses
Profit before Interest and
22000
tax
Interest
5000
Tax
7000
Dividends
4000
Retained Earnings
6000
15000
25000
20000
15000
10000
5000
90000
40000
5000
15000
20000
5000
5000
90000
Standard
1.30
1.00
1.25
3.00
5.00
40 days
0.80
5%
8%
10%
9. The following data pertains to XYZ Industries LLC.
Current Ratio = 1.50
Acid-Test Ratio = 0.75
Inventory Ratio = 8
Total asset turnover ratio = 1.20
Current liabilities = RO 1,000,000.
Calculate the net Fixed Assets of the company? What assumptions do you need to
make for the answer?
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Corporate Financial Management
10. The following details are available with regard to Swift Industries LLC. for the
year December 31, 2004.
Gross profit margin
Average collection period
Average payment period= (Accounts
payable/credit purchases per day)
Gross profit
20%
2 months
2.40 months
600,000
It was also ascertained that the closing stock as on December 31, 2004, was RO 50,000 in
excess of the opening stock as on January 1, 2005. You may assume that Swift Industries
is a trading concern and cost of goods purchased is the only expense. Determine the
balance of Debtors and creditors as on December 31, 2004?
11. Compute the various ratios for the three companies A, B and C whose summary of
balance sheet and profit and loss account is given below and make a comparative analysis
and interpret your results?
Assets
Fixed Assets
Investments of long term
nature
Cash
Receivables
Inventory
Total
Liabilities
Share Capital
Reserves& Surplus
Long Term loans
Bank overdraft
Trade creditors
Total
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2003
2004
Company A
2003
2004
Company B
2003
2004
Company C
75
25
125
50
250
50
300
29
300
100
420
80
10
50
40
200
20
70
60
325
30
103.33
66.67
500
40
140.64
90.36
600
53.80
100
246.20
800
62.30
130
307.70
1000
50
16.67
33.33
60.00
40.00
200
50
58.33
66.66
90.00
60.00
325
150
100
116.67
100.00
33.33
500
150
150
119.34
140.00
40.66
600
400
133.33
66.67
120
80
800
470
196.67
83.33
130
120
1000
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Corporate Financial Management
Sales
Cost of goods sold
Selling , general and
administrative expenses
Interest
Profit before tax
Tax @15%
Profit after tax
Answers:
Q1. 15%
Q7.
A
656.25
492.19
65.62
B
825
618.75
107.25
C
900
675
135
36.68
61.76
9.26
52.50
21.36
77.64
11.64
66.00
5.30
84.70
12.70
Q 2. RO 12500 Q3. 4.125 Q4. RO 4000 Q5. 9 days Q6. RO 1200,000
Liabilities
Equity capital
Retained earnings
Current liability
Non current liability
Total
Sales
Cost of goods sold
Gross profit
Depreciation
Selling General and
Administrative expenses
Operating profit
Interest
Profit before tax
Profit after tax
100,000
50,000
150,000
0
300,000
600,000
510,000
90,000
6000
24000
Assets
Plant and Equipment
Inventory
Accounts receivable
Cash
Total
50,000
100,000
50,000
100,000
300,000
60,000
22500
37500
30000
Q8.
Ratio
Current ratio
Acid test
Debt Equity ratio
Interest coverage
Inventory turnover
Average collection period
Total asset turnover
Net profit margin
Return on Investment
Return on Equity
Standard
1.3
1.5
1.25
3.00
5.00
40 days
0.80
5%
8%
10%
Company
1.5
1.33
1.25
4.40
5.00
54 days
1.11
10%
18.88%
25%
The company is doing very well compared to standards provided in respect of most of the ratios . It is
providing more than twice returns to the shareholders when compared to standards. This is possible by
better utilization of assets. The only area of concern for the company is the collection period which is
higher than standards.
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