CHAPTER
6
Financial Statements
Analysis
RQ.6.13 You have been furnished with the financial information of Aditya Mills Ltd. for the current
year.
Balance sheet, March 31, current year
Amount Amount
Liabilities Assets
(` thousand) (` thousand)
Equity share capital (` 100 each) 1,000 Plant and equipment 640
Retained earnings 368 Land and buildings 80
Sundry creditors 104 Cash 160
Bills payable 200 Sundry debtors 360
Other current liabilities 20 Less: Allowances 40 320
Stock 480
Prepaid insurance 12
1,692 1,692
Statement of profit, year ended March 31, current year
Particulars (` thousand)
Sales 4,000
Less: Cost of goods sold 3,080
Gross profit on sales 920
Less: Operating expenses 680
Net profit 240
Less: Taxes (0.35) 84
Net profit after taxes 156
Sundry debtors and stock at the beginning of the year were ` 3,00,000 and ` 4,00,000 respectively.
(a) Determine the following ratios of the Aditya Mills Ltd: (i) Current ratio, (ii) Acid-test ratio,
(iii) Stock turnover, (iv) Debtors turnover, (v) Gross profit ratio, (vi) Net profit ratio, (vii)
Operating ratio, (viii) Earnings per share, (ix) Rate of return on equity capital, and (x) Market
value of the shares if P/E ratio is 10 times,
6.2 Financial Management – OLC
(b) Indicate for each of the following transactions whether the transaction would improve, weaken
or have an effect on the current ratio of the Aditya Mills Ltd: (i) Sell additional equity shares,
(ii) Sell 10% debentures, (iii) Pay bills payable, (iv) Collect sundry debtors, (v) Purchase
additional plant, (vi) Issuing bills payable to creditors, (vii) Collecting bills receivable from
debtors, (viii) Purchase of treasury bills, and (ix) Writing off bad debt.
Solution RQ.6.13
(a) (i) Current ratio = (Cash + Debtors + Stock + Prepaid insurance)/(Creditors + Bills payable
+ Other current liabilities) = (` 1,60,000 + ` 3,20,000 + ` 4,80,000 + ` 12,000)/(` 1,04,000
+ ` 2,00,000 + ` 20,000) = 3 : 1.
(ii) Acid test ratio = (Current assets – Stock – Prepaid insurance)/Current liabilities =
(` 9,72,000 – ` 4,92,000)/` 3,24,000 = 1.48 : 1.
(iii) Stock turnover = Cost of goods sold/Average stock = ` 30,80,000/` 4,40,000 = 7 times.
(iv) Debtors’ turnover = Cost of goods sold/Average debtors = ` 40,00,000/` 3,30,000 = 12.12
times.
(v) Gross profit ratio = (Gross profit/Sales) ¥ 100 = ` (9,20,000/` 40,00,000) ¥ 100 = 23 per
cent.
(vi) Net profit ratio = (Net profit/Sales) ¥ 100 = (` 1,56,000/` 40,00,000) ¥ 100 = 3.9 per cent.
(vii) Operating ratio = [(Cost of goods sold + Operating Expenses)/Sales] ¥ 100 =
[(` 30,80,000 + ` 6,80,000)/` 40,00,000) ¥ 100] = 94 per cent.
(viii) Earnings per share (EPS) = Earning available to equityholders/Number of equity shares
= ` 1,56,000/10,000 = ` 15.6.
(ix) Rate of return on equity capital = (` 1,56,000/` 13,68,000) ¥ 100 = 11.4 per cent.
(x) Market value of the share = EPS ¥ P/E ratio = ` 15.6 ¥ 10 times = ` 156.
(b) Effect of the transactions on current ratio: (i) Improve, (ii) Improve, (iii) Improve, (iv) No
effect, (v) Weaken, (vi) No effect, (vii) No effect, (viii) No effect, and (ix) Weaken.
RQ.6.14 The XYZ Ltd’s financial statement contains the following information:
Balance sheet as at March 31, current year
Particulars Previous year Current year
(` thousand) (` thousand)
Cash 200 160
Sundry debtors 320 400
Temporary investments 200 320
Stock 1,840 2,160
Prepaid expenses 28 12
Total current assets 2,588 3,052
Total assets 5,600 6,400
Current liabilities 640 800
15% Debentures 1,600 1,600
Equity share capital 2,000 2,000
Retained earnings 468 904
Financial Statements Analysis 6.3
Statement of profits year ended March 31, current year
Particulars (` thousand)
Sales 4,000
Less: Cost of goods sold 2,800
Less: Interest 160
Net profit for current year 1,040
Less: Taxes 364
Earnings after taxes 676
Dividend declared on equity shares 220
From the above, appraise the financial position of the company from the points of view of (a)
liquidity, (b) solvency, (c) profitability, and (d) activity.
Solution RQ.6.14
(i) Liquidity ratios
(a) Current ratio = CA/CL = ` 25,88,000/` 6,40,000 = 4.04 : 1 (previous year); ` 30,52,000/
` 8,00,000 = 3.82 : 1 (current year)
(b) Acid-test ratio = (` 25,88,000 – ` 18,68,000)/` 6,40,000 = 1.125 : 1 (previous year);
(` 30,52,000 – ` 21,72,000)/` 8,00,000 = 1.1 : 1 (current year)
(ii) Solvency ratios
(a) Debt-equity ratios
(1) Total outside debts/Equity funds = ` 22,40,000/` 24,68,000 = 0.91 (previous year):
` 24,00,000/` 28,12,000 = 0.85 (current year)
(2) Long-term debts/Equity funds = ` 16,00,000/` 24,68,000 = 0.65 (previous year);
` 16,00,000/` 28,12,000 = 0.57 (current year)
(b) Interest coverage ratio
= EBIT/Interest charges = ` 12,00,000/` 1,60,000 = 7.5 times (current year)
(iii) Profitability ratios (current year)
(a) Gross profit ratio = (Gross profit/Sales) ¥ 100 = (` 12,00,000/` 40,00,000) ¥ 100 = 30 per
cent
(b) Net profit ratio = (Net profit/Sales) ¥ 100 = (` 6,76,000/` 40,00,000) ¥ 100 = 16.9 per cent.
(c) Return on total resources = [(EAT + Interest – Tax savings on interest)/Total assets] ¥ 100
= [(` 6,76,000 + ` 1,60,000 – ` 56,000)/` 64,00,000] ¥ 100 = 12.2 per cent.
(d) Return on capital employed = [(EAT + Interest – Tax savings on interest)/Total capital
employed] ¥ 100 = [(` 6,76,000 + ` 1,60,000 – ` 56,000)/44,12,000] ¥ 100 = 17.7 per cent.
(e) Return on equity funds = (Net profit after taxes/Equity funds) ¥ 100 = (` 6,76,000/
` 28,12,000) ¥ 100 = 24 per cent.
Notes: Ratios (c), (d) and (e) can also be determined by taking average total assets/capital em-
ployed/equity funds.
(iv) Activity ratios
(a) Debtors turnover = ` 40,00,000/` 3,60,000 = 11.1 times
(b) Stock turnover = ` 28,00,000/` 20,00,000 = 1.4 times
(c) Total assets turnover = ` 28,00,000/` 64,00,000 = 0.44 times
The company’s position is quite sound from the point of view of liquidity, solvency and profit-
ability. However, its activity ratios, particularly in term of the utilisation of total assets and holding
of stocks, do not seem to be satisfactory.
6.4 Financial Management – OLC
RQ.6.15 You have been supplied data for Royal Plastic Ltd. and its industry averages.
(a) Determine the indicated ratios for the Royal Plastic Ltd.
(b) Indicate the company’s strengths and weaknesses in terms of liquidity, solvency and profit-
ability, as revealed by your analysis.
Balance sheet, March 31, current year
Liabilities Assets
Equity share capital ` 1,00,000 Plant and equipment ` 1,51,000
10% Preference share capital 40,000 Cash 12,300
Retained earnings 27,400 Debtors 36,000
Long-term debt 34,000 Stock 60,800
Sundry creditors 31,500
Outstanding expenses 1,200
Other current liabilities 26,000
2,60,100 2,60,100
Statement of profit, year ended March 31, current year
Sales—net ` 2,25,000
Less: Cost of goods sold ` 1,52,500
Selling expenses 29,500
Administrative expenses 14,800
Research and development expenses 6,500
Interest 2,900 2,06,200
Earnings before taxes 18,800
Less: Income taxes (0.35) 6,580
Net income 12,220
Dividends paid to equity holders 5,000
Financial ratios of industry
1. Current ratio 2.2 : 1
2. Stock turnover (times) 2.8
3. Collection period (days) 56
4. Total debt/shareholders’ equity (percentage) 45
5. Interest coverage ratio (times) 10
6. Turnover of assets (times) 1.35
7. Income before tax/sales (percentage) 11.9
8. Rate of return on shareholders’ equity (percentage) 10.9
Solution RQ.6.15
(a) (1) Current ratio = ` 1,09,100/` 58,700 = 1.86
(2) Stock turnover = ` 1,52,500/` 60,800 = 2.51 times
(3) Collection period = (360 ¥ ` 36,000)/` 2,25,000 = 58 days
(4) Total debt/Shareholders’ equity = (` 92,700/` 1,67,400) ¥ 100 = 55 per cent.
(5) Fixed charge cover before tax = EBIT/Interest + Dividend on preference shares =
` 21,700/` 6,900 = 3.14 times.
(6) Turnover of assets = ` 1,52,500/` 2,60,100 = 0.59 times
(7) Income before tax/Sales = (` 18,800/` 2,25,100) ¥ 100 = 8.36 per cent.
(8) Rate of return on shareholders’ equity = (` 12,220/` 1,27,400) ¥ 100 = 9.6 per cent.
Financial Statements Analysis 6.5
(b)
Financial ratios Industry Company
(a) Current ratio 2.2 1.86
(b) Stock turnover (times) 2.8 2.51
(c) Collection period (days) 56 58
(d) Total debt/Shareholders’ equity 0.45 0.55
(e) Fixed charge coverage before tax (times) 10 3.14
(f) Turnover assets (times) 1.35 0.59
(g) Income before tax/Sales 0.119 0.0836
(h) Rate of return on equity funds 0.15 0.096
The financial position of Royal Plastics Ltd. vis-a-vis industry is weaker both in terms of profit-
ability and solvency. It is indicated by lower profitability ratios (g and h). The higher debt-equity
ratio and lower fixed charge coverage before tax are indicative of weakness from the point of view
of its solvency. Its liquidity position also does not seem to be very satisfactory. The acid test ratio
is likely to be much below one as stock turnover ratio is very low.
RQ.6.16 Below are selected ratios for two companies in the same industry, along with industry
average:
Ratios A B Industry
Current ratio 221 561 241
Acid-test ratio 121 301 131
Debt-asset ratio 36 5 35
Operating expenses ratio 18 17.5 20
Number of times interest earned 6 12 5
Stock turnover 8.5 6.5 7.0
Debtors turnover 11.0 15.0 11.4
Rate of return on total assets 17 10 13.5
Can we say on the basis of above ratios and information that company B is better than company
A because its ratios are better in six out of eight areas (all except stock turnover and rate of return
on total assets)? The company B is better than the industry average in the same six categories.
Solution RQ.6.16
B need not necessarily be better than A only because its ratios are better in six out of eight areas
for the following reasons:
(a) Profitability ratios of A are better than those of B. In fact, the rate of return on total assets of
B is lower than that of the industry.
(b) Liquidity ratios of B cannot be considered to be better than those of A, merely on the ground
that they are very high. In fact, these ratios reflect the excessive investment of the former
in current assets, depressing its rate of return. After all, working capital investment involves
cost. This is true particularly in the case of stock. Low stock turnover ratio reflects excessive
investment in stock.
(c) Low debt-asset ratio and, consequently, higher interest coverage ratio may be indicative of B
not availing of debt for enhancing the rate of return to the equityholders.
(d) Higher debtors’ turnover ratio of B may be indicative of its rigorous credit sales as well as
rigorous credit collection policy leading to low credit sales, eventually leading to low profits.
The low operating ratio certainly goes to the credit of B.
6.6 Financial Management – OLC
RQ.6.17 The following data are extracted from the published accounts of two companies, ABC Ltd.
and XYZ Ltd., in an industry.
Particulars ABC Ltd. XYZ Ltd.
Sales ` 32,00,000 ` 30,00,000
Net profit after tax 1,23,000 1,58,000
Equity capital (` 10 per share fully paid) 10,00,000 8,00,000
General reserves 2,32,000 6,42,000
Long-term debt 8,00,000 5,60,000
Creditors 3,82,000 5,49,000
Bank credit (short-term) 60,000 2,00,000
Fixed assets 15,99,000 15,90,000
Inventories 3,31,000 8,09,000
Other current assets 5,44,000 4,52,000
Prepare a statement of comparative ratios showing liquidity, profitability, activity and financial
position of the two companies.
Solution RQ.6.17
Statement of comparative ratios of ABC Ltd. and XYZ Ltd.
ABC Ltd. XYZ Ltd.
(i) Liquidity Ratios
(a) Current ratio (CA ÷ CL) ` 8,75,000 ` 12 ,61,000
= 1.98 = 1.68
` 4,42,000 ` 7,49,000
(b) Acid-test ratio (QA ÷ CL) ` 5 ,44,000 ` 4 ,52,000
= 1.23 = 0.60
` 4 ,42,000 ` 7 ,49,000
(ii) Profitability Ratios
(a) Net profit ratio
(NP ÷ Sales) ¥ 100 = ` 1,23,000 ` 1,58,000
¥ 100 = 3.84% ¥ 100 = 5.27%
` 32,00,000 ` 30,00,000
(b) ROR on total assets
(NP ÷ Total assets) ¥ 100 ` 1,23,000 ` 1,58,000
¥ 100 = 4.97% ¥ 100 = 5.54%
` 24,74,000 ` 28,51,000
(c) ROR on owners’ funds
(NP ÷ Equity funds) ¥ 100 ` 1,23,000 ` 1,58,000
¥ 100 = 9.98% ¥ 100 = 10.96%
` 12,32,000 ` 14,42,000
(d) EPS (NP ÷ Number of shares) ` 1,23,000 ` 1,58,000
= ` 1.23 = ` 1.97
` 1,00,000 ` 80,000
(iii) Activity Ratios
(a) Stock turnover
(Sales ÷ Closing stock) ` 32,00,000 ` 30,00,000
= 9 .7 times = 3 .71 times
` 3,31,000 ` 8,09,000
Financial Statements Analysis 6.7
(b) Fixed assets turnover
(Sales ÷ Fixed assets)1 ` 32,00,000 ` 30,00,000
= 2 times = 1.89 times
` 15,99,000 ` 15,90,000
(c) Current assets turnover
(Sales ÷ Current assets)1 ` 32,00,000 ` 30,00,000
= 3 .66 times = 2 .38 times
` 8,75,000 ` 12,61,000
(d) Total assets turnover
(Sales ÷ Total assets)1 ` 32,00,000 ` 30,00,000
= 1.29 times = 1.05 times
` 24,74,000 ` 28,51,000
(iv) Solvency Ratios (to show financial position)
(a) Debt-equity ratios
(i) External funds ` 12,42,000
= 1.01 times
` 13,09,000
= 0 .91 times
Internal funds ` 12,32,000 ` 14,42,000
Long-term debts ` 8,00,000 ` 5,60,000
(ii) = 0 .65 times = 0 .39 times
Internal funds ` 12,32,000 ` 14,42,000
(b) Interest coverage ratio Not possible to determine Not possible to determine
Working Notes:
1. Theoretically, activity ratios should have been determined by relating a particular category of
asset (current or fixed) with cost of goods sold.
2. In the absence of information of gross profit, GP ratio and debtors, cost of goods sold could
not be determined.
ABC Ltd. is better placed than XYZ Ltd. in respect of liquidity, activity and solvency ratios, the
primary factor being the accumulation of stocks with XYZ Ltd. It is reflected in its inventory
turnover ratio which is only 3.71 times vis-a-vis 9.66 times of ABC Ltd. However, XYZ Ltd. has
an edge over ABC Ltd. in respect of profitability ratios.
RQ.6.18 Hypothetical Industries Ltd. (HIL) has submitted the following projections (` lakh). You
are required to determine yearly debt service coverage ratio (DSCR) and the average DSCR
and comment.
Year EAT Interest on loan Repayment of term loan
1 20 19 11
2 35 17 18
3 40 15 18
4 20 12 18
5 18 10 18
6 18 7 8
7 16 5 8
8 16 2 8
The net profit (EAT) has been arrived at after charging depreciation of ` 20 lakh every year.
6.8 Financial Management – OLC
Solution RQ.6.18
Determination of debt service coverage ratio (amount in lakh of rupees)
Year EAT Depreciation Interest Cash available Principal Debt DSCR
(Col. 2 + 3 + 4) instalment obligations (Col. 5 ÷ Col. 7)
1 2 3 4 5 6 7 8
1 20 20 19 59 11 30 1.97
2 35 20 17 72 18 35 2.06
3 40 20 15 75 18 33 2.27
4 20 20 12 52 18 30 1.73
5 18 20 10 48 18 28 1.71
6 18 20 7 45 8 15 3.00
7 16 20 5 41 8 13 3.15
8 16 20 2 38 8 10 3.80
Average DSCR (SDSCR/8) = 19.69/8 = 2.46
Comment: The DSCR of HIL is very satisfactory.
RQ.6.22 A partial list of trend and common-size percentage for ABC Ltd. for years 1 and 2 is given
below:
Particulars Year 2 Year 1
Trend percentages:
Sales (net) 120 100
Cost of goods sold ? 100
Gross profit on sales ? 100
Operating expenses and income taxes ? 100
Net income ? 100
Common size percentages:
Sales (net) 100 100
Cost of goods sold ? ?
Gross profit on sales 40 ?
Operating expenses and income taxes 20 25
Net income 20 10
= (` 20,000)
(a) Determine the missing trend and common-size percentages.
(b) Compute the net income for year 2.
Solution RQ.6.22
(a) Determination of common-size percentages and missing trends
Particulars Common-size percentages Trend percentages
March current March previous March current March previous
year year year year
Sales (net) 100 100 120 100
Cost of goods sold 60 65 110.76 100
Gross profit on sales 40 35 137.14 100
Operating expenses and income taxes 20 25 96 100
Net income 20 10 240 100
Financial Statements Analysis 6.9
(b) Determination of net income for current year
Sales (net) ` 2,40,000
Less cost of goods sold (0.60 ¥ sales) 1,44,000
Gross profit on sales 96,000
Less operating expenses and income taxes 48,000
Net income 48,000
Sales in previous year = ` 20,000/0.10 = ` 2,00,000
Sales in current year = 1.20 ¥ ` 2,00,000 = ` 2,40,000.
On the basis of other common-size percentages (given), the figures of cost of goods sold, gross
profit, operating expenses, and so on, have been determined.
RQ.6.23 Presented below is the financial information of two companies – A and B, belonging to the
same industry:
Particulars A B
Current ratio 3.2:1 2.0:1
Acid-test ratio 1.7:1 1.1:1
Debt-equity ratio (percentage) 30 40
Number of times interest earned 6 5
Assume you are loan officer of a bank and both the companies have requested a loan of equal
amount to be repaid over the next two years. Based on the information above,
(a) If you could grant a loan to only one company, which would it be? Explain.
(b) If you could grant a loan to both the companies, would you be willing to do so? Explain.
Solution RQ.6.23
(a) Loan would be granted to company A on account of its lower debt-equity ratio and higher
interest coverage ratio.
(b) Yes. Company B’s debt-equity ratio of 40 per cent and interest coverage ratio of 5 times are
fairly satisfactory solvency ratios.
RQ.6.24 Below are selected ratios for three years ending March 31 for the Worst Company Ltd:
Ratios Year 1 Year 2 Year 3
Current ratio 200 500 150
Acid-test ratio 110 320 80
Debt-asset ratio 15 40 55
Operating expenses ratio 24 25 32
Number of times interest earned 6 6 (–1)
Stock turnover 5 4 3
Debtors turnover 12 10 6
Rate of return on total assets 15 10 5
Outline possible explanations for the drastic changes in some of the ratios during these years.
Solution RQ.6.24
The company has made additional borrowings through the issue of debentures or by taking long-
term loans in year 2, entailing an increase in the debt-equity ratio from 15 to 40 per cent in year
2. The amounts so obtained could have been invested either in stock, or remained in the form of
idle cash balance with the company. This is likely to have resulted in higher current ratio, higher
6.10 Financial Management – OLC
acid-test ratio, higher debt-equity ratio and low stock turnover. As a possible consequence, the rate
of return on total assets has declined from 15 in year 1 to 10 per cent in year 2.
In year 3, the situation appears to have become worse. The reasons may be: (a) high operating
expenses ratio not being matched by increase in sales price; (b) excessive interest cost due to large
amount of borrowings; (c) higher inventory cost; (d) liberal grant of credit, as revealed by lower
debtors’ turnover ratio, resulting in bad debts.
RQ.6.25 From the following details, prepare a statement of proprietory funds with as many details
as possible:
(a) Stock velocity = 6
(b) Capital turnover = 2
(c) Fixed assets turnover ratio = 4
(d) Gross profit turnover ratio = 20
(e) Debtors velocity = 2 months
(f) Creditors velocity = 73 days
The gross profit was ` 60,000; Reserves and surplus amounted to ` 20,000; Closing stock was
` 5,000 in excess of opening stock.
Solution RQ.6.25
Statement of proprietory funds
Fixed assets ` 60,000
Net working capital:
Current assets:
Stock ` 42,500
Debtors 50,000
Cash 16,500
1,09,000
Less Current liabilities 49,000 60,000
Proprietory funds 1,20,000
Share capital 1,00,000
Reserves and surplus 20,000
Working Notes:
0.20 = (Gross profit/Sales) ¥ 100 = Sales = (` 60,000 ¥ 100)/20 = ` 3,00,000
Cost of goods sold = Sales – Gross profit = ` 3,00,000 – 60,000 = ` 2,40,000
Average stock = ` 2,40,000/6 = ` 40,000
Opening stock + Closing stock = ` 80,000
Closing stock – Opening stock = ` 5,000
Closing stock = ` 42,500
Debtors = ` 3,00,000/6(12 ∏ 2 months) = ` 50,000
Fixed assets = ` 2,40,000 ∏ 4 = ` 60,000
Creditors = Credit purchases/Creditors turnover = ` 2,45,000/5 = ` 49,000
Capital = ` 2,40,000 ∏ 2 = ` 1,20,000
Reserves and surplus = ` 20,000
Share capital = ` 1,00,000 (` 1,20,000 – ` 20,000)
Net working capital = ` 1,20,000 – ` 60,000 = ` 60,000
Financial Statements Analysis 6.11
Stock + Debtors + Cash – Creditors = ` 60,000
` 42,500 + ` 50,000 + Cash – ` 49,000 = ` 60,000
Cash = ` 16,500
RQ.6.26 From the following information of a textile company complete the proforma balance sheet
if its sales are ` 32,00,000.
Sales to net worth (times) 2.3
Current debt to net worth (ratio) 42
Total debt to net worth (ratio) 75
Current ratio (times) 2.9
Net sales to inventory (times) 4.7
Average collection period (days) 64
Fixed assets to net worth (ratio) 53.2
Solution RQ.6.26
Proforma balance sheet of the textile company
Liabilities Amount Assets Amount
Net worth ` 13,91,304 Fixed assets ` 7,40,173
Long-term debt 4,59,130 Cash 4,44,869
Current debt 5,84,348 Stock 6,80,851
Sundry debtors 5,68,889
24,34,782 24,34,782
Working Notes:
1. Net worth = ` 32,00,000 ∏ 2.3 = ` 13,91,304
2. Current debt = (` 13,91,304/100) ¥ 42 = ` 5,84,348
3. Total debt = (` 13,91,304/100) ¥ 75 = ` 10,43,478
4. Long-term debt = ` 10,43,478 – ` 5,84,348 = ` 4,59,130
5. Fixed assets = (` 13,91,304/1,000) ¥ 532 = ` 7,40,173
6. Current assets = ` 5,84,348 ¥ 2.9 = ` 16,94,609
7. Inventory = ` 32,00,000 ∏ 4.7 = ` 6,80,851
8. Debtors = (` 32,00,000/360) ¥ 64 = ` 5,68,889
9. Cash = ` 16,94,609 – (` 6,80,851 + ` 5,68,889) = ` 4,44,869
