Cost of Capital

Cost of capital from premarhea

Financial Statement Analysis

Financial Analyses and Planning

2.1 Financial statements

Meaning

Financial statements refers to formal and original statements which are prepared to disclose financial health of the business in terms of profits, position and prospects as on a certain data.

Definition

According to John N. Myer, “The financial statements provide a summary of the accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as on a certain data and the income statement showing the results of operations during a certain period.”

2.2 Financial Statements Analysis

            According to John N. Myer, “The financial statements analysis is largely a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of the trends of these factors as shown in a series of statements.”

2.3 Types of analysis of financial statements

1. External Analysis

            External analysis is made by outsiders who have no access to the books of accounts. They constitute investors, creditors, credit agencies and government agencies. External analysis is not done in detail and hence it serves limited purpose.

2. Internal Analysis

            It is done by those parties in the business who have access to the books of accounts. Such parties can be designated as accountant and financial analyst. Sometimes it can also be done by employees to know the performance of the business. Internal analysis is done in more detail when compared to external analysis.

3. Horizontal analysis

            When financial analysis is done for number of years, it is known as horizontal analysis. It sets a trend wherein the figures of various years are compared with one standard year as base year. Based on the trend prevailing it is possible to make decision and form a rationaljudgment about the progress of the business. It is also known as dynamic analysis as it measures the change of position of the business over a number of years.

4. Vertical analysis

            When analysis made for data covering one years period it is known as vertical analysis. This type is also known as static analysis as it measures the state of the affairs of the business as on given period of time.

2.4 Tools or Techniques or Methods of financial analysis

            1. Comparative financial statements

            2. Common-size statement analysis

            3. Trend analysis

            4. Average analysis

            5. Ratio analysis

6. Fund flow analysis

7. Cash flow analysis

2.5 Comparative Financial Statements

            These are statements indicating the direction of movement with respect to financial positions and operating results. Comparative financial statements may include comparative balance sheet and comparative income statement.

            A comparative balance sheet is prepared to know change of assets, liabilities and capital of the business on two different dates. The changes may relate to an increase or decrease in any of the items. Similarly a comparative income statement is prepared to compare all items of profit and loss account and to know the increase or decrease in the items. By looking into the changes in expenditures and revenues it is possible to know the operating efficiency of the business.

Example 1:

The following are the income statements of Swadeshi cotton mills for the year 2000 and 2001. Prepare comparative income statement and comment on the profitability of the company.

	2000	2001		2000	2001
To opening stock To purchase less returns To wages To salaries To rent, rates and insurance To Depreciation To selling expenses To Discount allowed To loss on sale of plant To interest paid To net profit	85,000 500,000 60,000 42,000 35,000 40,000 12,000 5,000 - 12,000 426,000	200,000 550,000 80,000 64,000 40,000 60,000 12,000 7,000 8,000 14,000 412,500	By sales less returns By closing stock By income received from investment By Dividend received	1,000,000 200,000 12,000 5,000	1,200,000 225,000 15,000 7,500
	1,217,000	1,447,500		1,217,000	1,447,500

Example 2:

Following are the Balance Sheets of a company for the year 1997 and 1998. Prepare a comparative balance sheet and explain the financial position of the concern.

Balance sheet as on….

	1997	1998		1997	1998
Share capital Reserve and surplus Debentures (Bond) Long term loan Bills payable Creditors Other current Liabilities	300,000 165,000 100,000 75,000 25,000 50,000 2,500	400,000 111,000 150,000 100,000 22,500 60,000 5,000	Land and buildings Plant and machinery Furniture and fixtures Other fixed assets Cash at bank Bills receivable Debtors Stock	185,000 200,000 10,000 12,500 10,000 75,000 100,000 125,000	135,000 300,000 12,500 15,000 40,000 46,000 125,000 175,000
	717,500	848,500		717,500	848,500

2.6 Common Size Financial Statement Analysis

            They are comparative statements that give only the percentages for financial data without giving the rupee value. They are also known as 100 percent statements because each statement is reduced to the total of 100 and each individual item is stated as a percentage of the total of 100. Each percentage shows the relation of the individual items to its respective total. The common size financial statements are most valuable in making comparison between the firms in the same industry. The 2 common size financial statements usually prepared are common size income statement and common size balance sheet.

Computation of common size statements:

i) In case of common size income statement, total net sales are stated as 100 percent. In case of position statement either total assets or total of liabilities and capital is taken as 100.

ii) The quotient of each item is found out by dividing individual money amount by the total amount in the statement. This is expressed in the form of percentage.

Example 3:

Prepare common size income statement in vertical form from the following income statement and briefly comment thereon.

Profit and loss account for the year ended 31.3.1999

To cost of sales To administrative expenses To selling expenses To non-operating expenses To tax provision To proposed dividend To retained earnings	491,400 81,000 162,000 10,800 36,450 7,000 29,450	By gross sales Less returns By non operating income	826,200 16,200 810,000 8100
	818,100		818,100

Example 4:

Following are the Balance sheet of Vinay Ltd., for the year ended December 1996 and 1997.Prepare a common size balance sheet and interpret the same.

Liabilities	1996	1997	Assets	1996	1997
Equity capital Pref. capital Reserves P&L A/c Bank overdraft Creditors Provision for taxation Proposed dividend	100,000 50,000 10,000 7,500 25,000 20,000 10,000 7,500	165,000 75,000 15,000 10,000 25,000 25,000 12,500 12,500	Fixed assets Stock Debtors Bills receivable Prepaid expenses Cash at bank Cash in hand	120,000 20,000 50,000 10,000 5,000 20,000 5,000	175,000 25,000 62,500 30,000 6,000 26,500 15,000
	230,000	340,000		230,000	340,000

2.7 Ratio Analysis

It is the process of determining and interpreting numerical relationship based on financial statements. It is the technique of interpretation of financial statements with the help of accounting ratios derived from the balance sheet and profit and loss account.

Meaning of accounting ratios

            According to J. batty the term accounting ratio is used to describe the significant relationship which exists between figures shown in a balance sheet and profit and loss account in a budgetary control system or any other part of accounting organization.

Classification of Ratios

I) Analysis of short term financial position or test of liquidity

It enables to know whether short term liabilities can be paid out of short term assets. This ratio also indicates whether a firm has adequate working capital to carry out routine business activity.

1. Current ratio

            It establishes the relationship between total current assets and current liabilities. It is the barometer of general measure of liquidity and state of trading.

Current Ratio = Current assets / Current Liabilities

Current assets includes cash in hand, cash at bank, bills receivable, sundry debtors, stock of raw material, work-in-process and finished goods, short term investments, prepaid expense, accrued income etc..

Current liabilities includes Sundry creditors, bills payable, bank overdraft, outstanding expenses, income received in advance, provision for taxation, short term borrowing, unclaimed dividend, proposed dividend etc..

Standard current ratio of 2:1 is considered ideal as a rule of thumb.

2. Quick ratio or acid test ratio or liquid ratio

It is concerned with the relationship between liquid assets and current liabilities.

Quick ratio = Quick assets / Current liabilities

Quick assets include all current assets except stock and prepaid expenses.

Standard quick ratio is 1:1

3. Absolute liquidity ratio or cash position ratio

This ratio establishes a relation between absolute liquid assets to liquid liabilities.

Absolute liquidity ratio = Absolute liquid assets / Liquid liabilities

Absolute liquid assets include cash in hand, cash at bank, marketable securities and temporary investments. The following assets are not included in absolute liquid assets – closing stock, prepaid expenses, outstanding income, sundry debtors and bills receivable.

Quick liabilities include all current liabilities except bank overdraft.

Standard absolute liquid assets is 1:2

II) Analysis of long term financial position or test of solvency

1. Debt – Equity ratio or External-Internal equity ratio

It expresses the relationship between debt and equity.

Debt-equity ratio = Debt / Equity   or   External equities / Internal equities

Debt includes long term as well as short term debt.

Equity consists of shareholders funds funds, reserves and accumulated profit.

Standard debt equity ratio is 2:1

2.Proprietory ratio or net worth ratio

            This ratio establishes the relationship between the proprietors fund and total assets.

Proprietory ratio = Proprietors fund / Total assets or Capital employed / Total liabilities

Standard Proprietory ratio is 0.5:1

3. Solvency ratio

It expresses the relationship between total assets and total liabilities of a business.

Solvency ratio = Total assets / Total liabilities

4. Fixed assets to net worth ratio

It is obtained by dividing the depreciated book value of fixed assets by the amount of proprietor’s funds.

Fixed assets to net worth ratio = Net fixed assets / Net worth or proprietors funds

Standard ratio is 0.75:1

5. Current assets to net worth ratio

It is obtained by the dividing the value of current assets by the amount of proprietors funds.

Current assets to net worth ratio = Current assets / Proprietors funds

6. Current Liabilities to net worth ratio

It is obtained by the dividing the value of current liabilities by the amount of proprietors funds.

Current Liabilities to net worth ratio = Current liabilities / Net worth

Standard ratio fixed is 1/3.

7. Capital gearing ratio

It expresses the relationship between equity capital and fixed interest bearing securities and fixed dividend bearing shares.

Capital gearing ratio = (Fixed interest bearing securities + Fixed dividend bearing shares) / Equity shareholders funds

Fixed interest bearing securities include debentures, long term loans and long term fixed deposits.

Equity shareholders funds include equity share capital, accumulated reserve and profits and deduction of losses and fictitious assets.

8. Fixed assets ratio

It establishes the relationship between fixed assets and capital employed.

Fixed assets ratio = Fixed assets / Capital employed

Capital employed includes owner’s funds, long term loans, long term deposits and debentures.

The standard ratio is 0.67.

9.Fixed charges cover ratio or debt service ratio

It is determined by dividing the net profit by fixed interest charges.

Fixed charges cover ratio = (Net profit before deduction of interest and income tax) / Fixed interest charges

Standard Fixed charges cover ratio is 6 or 7 times.

10. Dividend cover ratio

It is the ratio between disposable profit and dividend.

Dividend cover ratio = Net profit after interest and tax / Dividend declared

III) Activity ratios or Performance ratios

1. Stock turnover ratio

It establishes the relationship between the cost of goods sold during a given period and the average stock holding during that period.

Inventory turnover ratio = Cost of goods sold / Average stock

The ideal inventory turnover ratio is 8 times a year.

2. Debtors turnover ratio or debtor’s velocity ratio

It explains the relationship of net credit sales of a firm to its book debts indicating the rate at which cash is generated by turnover of receivables or debtors.

Debtors turnover ratio = Net annual credit sales / Average debtors

3. Debt collection period ratio

This ratio is helpful in knowing the speed at which debts are collected. It refers to the time involved in collecting the debts by a business enterprise.

Debt collection period ratio = Number of days in a year / Debtors turnover ratio

(Or)                  = (Debtors / Net annual credit sales) × Number of days in a year

            (Or)                  = Net annual credit sales / Number of days in a year

4. Creditors turnover ratio or creditors velocity

It indicates the number of times the creditors are paid in a year.

Creditors turnover ratio = Net annual credit purchases / Average creditors

5. Average payment period

Average payment period = Number of days in a year / Creditors turnover ratio

6. Working capital turnover ratio

It refers to excess of current assets over current liabilities

Working capital turnover ratio = Net sales / Working capital

7. Fixed assets turnover ratio

It establishes a relationship between fixed assets and sales.

Fixed assets turnover ratio = Net sales / Fixed assets

8. Current assets turnover ratio

It establishes a relationship between current assets and sales.

Current assets turnover ratio = Net sales / Current assets

9. Total assets turnover ratio

It enables to know the efficient utilization of total assets of a business

Total assets turnover ratio = Net sales / Total assets

10. Sales to net worth

It enables to know the efficient utilization of owners funds.

IV) Profitability ratios

A) General Profitability ratios

1. Gross profit ratio

It expresses the relationship of gross profit to net sales and is expressed in terms of percentage

Gross profit ratio =(Gross profit / Net sales) × 100

2. Operating ratio

It expresses the relationship between cost of goods sold plus other operating expenses and net sales.

Operating ratio = (Cost of goods sold + operating expenses) / Net sales

3. Operating profit ratio

It expresses the relationship between operating profit and net sales.

Operating profit ratio = (Operating profit / Net sales) × 100

4. Expense ratio

It is calculated by dividing each individual operating expense by net sales revenue.

a) Material consumed ratio = (Materials consumed / Net sales) × 100

b) Office and administration expenses ratio = (Office and administration expenses / Net sales) × 100

c) Selling and distribution expenses ratio = (Selling and distribution expenses / Net sales) × 100

d) Financial expenses ratio = (Financial expenses / Net sales) × 100

e) Non operating expenditure ratio = (Non operating expenditure / Net sales) × 100

5. Net profit ratio

It expresses the relationship between net profits after taxes to net sales

Net profit ratio = (Net profit after tax /Net sales) × 100

B) Tests of overall profitability

1. Return on shareholders’ investment or net worth ratio

Shareholders’ investment also called return on proprietor’s funds is the ratio of net profit to proprietor’s funds.

Return on shareholders’ investment = Net profit (after tax and interest) / Proprietors fund

2. Return on equity capital

It establishes relationship between net profit available to equity shareholders and the amount of capital invested by them.

Return on equity capital = Net profit – Dividend due to preference shareholders / Equity share capital (paid up)

3. Return on capital employed

It is the most appropriate indicator of the earning power of the capital employed in the business.

Return on capital employed = Net profit before taxes and interest on long term loans and debentures / Capital employed

4. Return on total resources

It acts as an yardstick to assess the efficiency of the operations of the business as it indicates the extent to which assets employed in the business are utilized to result in net profit.

Return on total resources = (Net profit / Total assets) × 100

5. Dividend yield ratio

It refers to the percentage or ratio of dividend paid per share to the market price per share.

Dividend yield ratio = Dividend paid per equity share / Market price per equity share

6. Preference dividend cover

It indicates how many times the preference dividend covered by profit after tax. This ratio measures the margin of safety for preference shareholders.

Preference dividend cover = Profit after tax / Annual programme dividend

7. Equity dividend cover

It indicates the number of times the dividend is covered the amount of profit available for equity shareholders.

Equity dividend cover = (Net profit after tax – preference dividend) /Dividend paid on equity capital

(Or)                 = Earnings per equity share / Dividend per equity share

8. Price – earnings ratio

It shows how many times the annual earnings the present shareholders are willing to pay to get a share. It helps the investors to know the effect of earnings per share on the market price of the share.

Price – earnings ratio = Average market price per share / Earnings per share

9.Dividend pay-out ratio

It indicates proportion of earnings available which equity shareholders actually receive in the form of dividend.

Dividend pay-out ratio = Dividend paid per share / Earnings per share

10. Earnings per share

It indicates the earnings per equity share. It establishes the relationship between net profit available for equity shareholders and number of equity shares.

Earnings per share = Net profit available for equity shareholders / Number of equity shares

Example: 5

The following is the balance sheet of super star company ltd., on 31^st December 1995. Calculate the liquidity group ratios and comment upon the same.

Equity share capital Profit & loss A/c General reserve Bank overdraft Sundry creditors Bills payable	1,000,000 150,000 300,000 2,000,000 500,000 250,000	Land & buildings Plant & machinery Stock Sundry debtors Bills receivable Cash at bank	700,000 1,750,000 1,000,000 500,000 50,000 200,000
	4,200,000		4,200,000

Example: 6

The comparative figures of X ltd and Y ltd are given below

	X Ltd	Y Ltd
Total assets Total liabilities Owners equity	200,000 40,000 160,000	300,000 100,000 200,000

Example: 7

Given Total assets – Br 800,000; Proprietor’s equity – Br 400,000. Calculate Proprietory ratio

Example: 8

Rate of gross profit is 20% on sales; Total sales – Br 500,000; Average stock – Br 80,000. Calculate stock turnover ratio

Example: 9

Find out debtors turnover ratio and average collection period from the following information

	1994 in Br	1995 in Br
Annual credit sales Debtors in the beginning Debtors at the end No. of days for the year	500,000 80,000 100,000 360 days	600,000 90,000 110,000 360 days

Example: 10

A company purchases goods both on cash sales as well as on credit sales. Calculate average payment period. The following particulars are obtained from the books:

	Br		Br
Total purchases Cash purchases Purchase returns	300,000 30,000 51,000	Creditors at the end Bills payable at the end Reserve for discount on creditors	105,000 60,000 8,000

Example: 11

From the following balance sheet of Tara Ltd. Calculate a) Long term debt equity, b) Proprietory ratio, c) Capital gearing ratio, d) Stock working capital ratio

Equity share capital 8% Pref. share capital Reserve Profit & loss A/c 9% debentures Sundry creditors O/s expenses Provision for taxation Proposed dividend	200,000 60,000 30,000 20,000 40,000 60,000 5,000 20,000 15,000	Land & buildings Plant & machinery Furniture and fixtures Sundry debtors Stock Cash in hand Prepaid expenses Preliminary expenses	140,000 80,000 20,000 80,000 70,000 30,000 10,000 20,000
	450,000		450,000

Example: 12

The following are the Trading and P/L for the year ended 31^st December 1998 and the Balance sheet as on that date of K Ltd.

Trading and P/L A/c

To opening stock To purchases To wages To gross profit c/d To administrative expenses To selling expenses To financial expenses To loss on sale of fixed assets To net profit	9,950 54,525 1,425 34,000 99,900 15,000 3,000 1,500 400 15,000	By sales By closing stock By gross profit b/d By interest By profit on sale of shares	85,000 14,900 99,900 34,000 300 600
	34,900		34,900

Balance Sheet

Share capital Reserves Current liabilities P&L a/c	20,000 9,000 13,000 6,000	Land and buildings Plant and machinery Stock Debtors Cash at bank	15,000 8,000 14,900 7,100 3,000
	48,000		48,000

You are required to calculate:

a) Current ratio            b) operating ratio         c) Stock turnover ratio d) Net profit ratio         e) Fixed assets turnover ratio

Example: 13

Balance sheet of Good value traders Ltd foe the year ended 31.3.1998 is given below

Equity Share capital Reserves & surplus P&L a/c Provision for taxation Sundry creditors	140 45 20 10 40	Fixed assets           210 Less depreciation     25 Stock Debtors Cash	185 25 30 15
	255		255

The following further particulars also given for the year

Sales – Br 120; Earnings before interest and tax (EBIT) – Br 30; Net profit after tax (PAT) – Br 20

Calculate

1) Current ratio            2) Liquidity ratio          3) Profitability ratio     4) Profitability on funds employed

5) Debtors turnover ratio         6) Stock turnover ratio 7) Average collection period    8) Return on equity

Example: 14

Profit and loss account and balance sheet is summarized below

Trading and P/L A/c

To opening stock To purchases To gross profit c/d To administrative expenses To selling expenses To loss on sale of assets To net profit	76,250 322,250 200,000 598,500 98,000 22,000 2,000 90,000	By sales By closing stock By gross profit b/d By dividend By profit on sale of shares	500,000 98,500 598,500 200,000 9,000 3,000
	212,000		212,000

Balance Sheet

Share capital (2600 equity shares of Rs100 each) Reserves P&L a/c Current liabilities	260,000 70,000 20,000 130,000	Land and buildings Plant and machinery Stock Debtors Bills receivable Bank	150,000 80,000 98,000 61,500 60,000 30,000
	480,000		480,000

You are required to calculate:

a) Gross profit ratio     b) Net profit ratio         c) Operating ratio         d) Operating profit ratio                      

e) Stock turnover ratio f) Turnover of fixed assets

Example: 15

Calculate return on investment

Net profit – Br 35,000; fixed assets– Br 70,000; Current assets – Br 55,000; Current liabilities – Br 20,000

Example: 16

Calculate current assets and inventory Current ratio - 2.6:1                 Current liability – Br 40,000

Example: 17

Cost of sales of a firm is Br 250,000 and stock turnover ratio is 5 times. Find out the value of stock

Example: 18

Gross profit ratio is 20%, Gross profit is Br 30,000. Calculate the sales.

Example: 19

Turnover to fixed assets ratio is 1:1.2; value of goods sold is Br 900,000; Calculate value of fixed assets

Example: 20

Average stock is Br 40,000; Its opening stock is Br 5,000 less than closing stock. Find out the opening stock.

2.8 Financial Forecasting

Financial Forecasting describes the process by which firms think about and prepare for the future. The forecasting process provides the means for a firm to express its goals and priorities and to ensure that they are internally consistent. It also assists the firm in identifying the asset requirements and needs for external financing.

For example, the principal driver of the forecasting process is generally the sales forecast. Since most balance sheet and income statement accounts are related to sales, the forecasting process can help the firm assess the increase in current and fixed assets which will be needed to support the forecasted sales level. Similarly, the external financing which will be needed to pay for the forecasted increase in assets can be determined.

Firms also have goals related to capital structure (the mix of debt and equity used to finance the firms assets), dividend policy, and working capital management. Therefore, the forecasting process allows the firm to determine if its forecasted sales growth rate is consistent with its desired capital structure and dividend policy.

Percentage of Sales Method

The percentage of sales method is a financial forecasting approach which is based on the premise that most balance sheet and income statement accounts vary with sales. Therefore, the key driver of this method is the sales forecast and based upon this, pro-forma financial statements (i.e., forecasted) can be constructed and the firms needs for external financing can be identified.

Partial Pro-Forma

The next step is to construct the partial pro-forma financial statements. First, determine the forecasted sales level. This is done my multiplying sales for the current year by one plus the forecasted growth rate in sales.

S₁= S₀(1 + g) where,

• S₁ = the forecasted Sales level,
• S₀ = the current Sales level, and
• g = the forecasted growth rate in Sales.

Once the forecasts sales level has been determined, the balance sheet and income statement accounts which vary directly with sales can be determined by multiplying the percentages by the sales forecast. The accounts which do not vary directly with sales are simply transferred to the partial pro-forma financial statements at their current levels.

External Financing Needed (EFN)

The external financing needed (EFN) can be determined from the partial pro-forma balance sheet. It is simply equal to the difference between partial pro-forma total assets and partial pro-forma total liabilities and owners' equity.

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