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
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 31st 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 31st 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 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
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
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 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
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.
References:
1. Ross,
Westerfield & Jordan. Fundamentals of corporate finance. 9th
Ed.
2. Brigham
Ehrhadt. Financial Management Theory & Practice. 13th Ed.
*****
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