Chapter 7 FINANCIAL STATEMENT ANALYSIS The Information Maze
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Transcript of Chapter 7 FINANCIAL STATEMENT ANALYSIS The Information Maze
Chapter 7
FINANCIAL STATEMENT ANALYSIS
The Information Maze
OUTLINE
• FINANCIAL STATEMENTS
• FINANCIAL RATIOS
• STANDARDISED FINANCIAL STATEMENTS
• APPLICATIONS OF FINANCIAL STATEMENT ANALYSIS
• USING FINANCIAL STATEMENT ANALYSIS
• GOING BEYOND THE NUMBERS
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 provisions Miscellaneous expenditures
and losses
BALANCE SHEET
Vertical (or Report) FormI. 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
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
579 493 579 493
* Rs. 35 million of secured loans are due within 1 year, the balance being due 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 81Net current assets 129 75
(4) Miscellaneous expenditures and losses 474 412
LIABILITIES
• Share Capital
• Reserves & Surplus
• Secured Loans
• Unsecured Loans
• 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 –
701Expenditure Material and other expenditure 582 Interest 21 Depreciation 30 Provision for tax 34Profit 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 0Net sales 701 623Cost of goods sold 552 475 Stocks 421 Wages and salaries 68 Other manufacturing expenses 63Gross profit 149 148Operating expenses 60 49 Depreciation 30 General administration 12 Selling 18Operating profit 89 99Other income (expense) – 06 Profit before interest and tax 89 105Interest 21 22Profit before tax 68 83Provision for tax 34 41Profit 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)
Cash inflows from operations
Cash inflows from investing
activities
Cash inflows from financing
activities
Cash outflows from investing
activities
Cash flow from investing
activities
Cash outflows from financing
activities
Cash flow from financing
activities
Operating
Investing
Financing
–
–
=
=
=
+ –
+ –
=
–
Cash outflows from operations
Cash flow from operations
Net cash flow for the period
STATEMENT OF CASH FLOWS
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 21Depreciation 30
Operating profit before working capital changes 119 Adjustments
Debtors (46)Inventories (33)Advances 05Trade credit 15Advances 07Provisions 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
HORIZON LIMITED: PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING 31ST MARCH 20X1
(Rs. in million) 20X1 20X0
Net sales 701 623Cost of goods sold 552 475Stocks 421 370Wages and salaries 68 55
Other manufacturing expenses 63 50 Gross profit 149 148 Operating expenses 60 49
Depreciation 30 26General Administration 12 11Selling 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 2.80Dividend per share 1.80 1.80Market price per share 21.0 20.0Book 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
Current liabilities 180
• Acid-Test Ratio
Quick assets (237 – 105)
Current liabilities 180
• Cash Ratio
Cash and bank Current balances investments (10 + 3)
Current liabilities 180
= = 1.32
= = 0.73
+= = 0.07
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 TurnoverCost of goods sold 552Average inventory (105 + 72)/2
• Debtors’ TurnoverNet credit sales 701Average debtors (114 + 68)/2
• Fixed Assets Turnover Net sales 701Average net fixed assets (330 + 322)/2
• Total Assets Turnover Net sales 701
Average total assets (474 + 412)/2
= = 6.24
= = 7.70
= = 2.15
= = 1.58
PROFITABILITY RATIOS
• Gross Profit Margin Ratio
Gross profit 149
Net sales 701
• Net Profit Margin Ratio
Net profit 34
Net sales 701
• Return on Assets (ROA)
Profit after tax 34
Average total assets (474 + 412)/2
= = 0.21 or 21 percent
= = 0.049 or 4.9 percent
= = 0.077 or 7.7 percent
PROFITABILITY RATIOS
• Earning Power
Profit before interest and tax 89
Average total assets (474 + 412)/2
• Return on Capital Employed
Profit before interest and tax (1 – Tax rate) 89 (1 – 0.5)
Average total assets (474 + 412)/2
• Return on Equity
Equity earnings 34
Average equity (262 + 256)/2
= 0.201 or 20.1 percent
= 0.101 or 10.1 percent
= 0.131 or 13.1 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 RatioMarket value per share 21.00 = = 1.20Book value per share 17.47
COMPARISON WITH INDUSTRY AVERAGES Ratios Formula Horizon Industry
Limited AverageLiquidity
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
InterestTurnover
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 worthValuation
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
Average 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)
Return on Total Assets 7.7 %
Net Profit Margin 4.9%
Total AssetsTurnover 1.58
Net Profit 34
Net Sales701
Net Sales701
Average Total
Assets 443
Net Sales +/- Non operating
Surplus/Deficit
701
Total Costs
667
Average Fixed assets
326
Average Investments
15
Average Net Current Assets 102
DU PONT CHART APPLIED TO HORIZON LIMITED
X
–
+
+
EXTENSION OF THE DU PONT CHART
Return of Equity13.1%
Return of Assets7.7%
Average Total AssetsTo Average Equity
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 & SCIENCE
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.