Chapter VII Financial Analysis

I Introduction

Financial analysis is the process of evaluating the financial performance and

ascertaining the financial condition of an enterprise.

Financial analysis is employed by

(i) The management

(ii) Outside suppliers of capital, viz., lenders, share holders and other

investors

(iii) Trade creditors

(iv) Others like rating agencies, regulators etc.

Management does financial analysis for purposes of better control, to assess the

profitability on investment in various assets and the efficiency in managing

those assets.

Lenders of debts like debenture holders are interested in the cash flow ability of

the company to service debts over the long term.

Investors in the companys shares are primarily concerned with the present and

expected future earnings and the stability of those earnings in a trend.

Basically, investors concentrate their analysis on a companys profitability and

performance in so far as it affects the ability to pay dividends.

Trade creditors are interested primarily in the liquidity of the company, as their

claims are short term in nature.

 Thus the type of analysis varies according to the specific interests of the party

involved.

II Types of analysis

(i) Comparative statement analysis

(ii) Common size statement analysis

(iii) Trend analysis

(iv) Average analysis

(v) Ratio analysis

(vi) Funds flow and Cash flow analysis

Standards of comparison consist of past & projected figures of a company with

the figures of similar firms in the industry.

The approach in common size statement analysis (also called index analysis) is

that the items of balance sheet and income statements are expressed as

percentages. Various components of a balance sheet are expressed as a % to

the total assets. In the income statement, the items are related to sales. The

common size statement analysis assists in a better understanding of the

underlying improvement or detoriation in the financial performance of a

company.

Trend analysis involves comparison of the current financials with the past &

future financial figures of a particular company.

Average means the industrial average. Standards for various industries are

available from several agencies like Trade Bodies, Stock Exchanges, Rating

Agencies Reports etc.

 Ratio analysis is the most important analytical tool which is used by various

interested parties to ascertain the financial performance of a company.

Funds flow and cash flow statement analysis facilitates financial planning for a

company. Basically, funds flow and cash flow statement analysis helps to

evaluate how a company uses funds and how the uses are financed. This also

assists a company to plan a realistic level of liquidity.

III Utility of Accounting Ratios

(a) To have a better understanding of the financial health and performance

of a company. Through analysis and interpretation of various ratios, a

better picture on the financial position of a company can be obtained

rather than through the raw financial data / figures.

(b) Financial ratios assist in the budgeting exercise as ratios can be

computed for the projected financial figures and compared with the

present and past ratios. Thus ratio analysis is effective in the

establishment of various budgets.

(c) Variance analysis is facilitated through accounting ratios.

(d) Inter-firm and intra-firm comparisons can be made using financial

ratios. These comparisons give a better understanding on the relative

financial performance of a company.

(e) Financial ratios help in achieving the principle of management by

exception. Exceptions are brought to the notice of the top level

 management for suitable action while routine matters are left to the

middle order executives for managing them properly.

IV Limitation of financial ratios

(i) Ratios cannot be computed and compared with any general standard or

norm as they vary depending on the industry.

(ii) Ratios at times do not reflect the real performance of a company even

when compared with the industry, as companies in an industry need not

be homogenous and may also differ substantially in size. Also,

companies with multiple product lines often defy precise industry

categorization.

(iii) Mere ratios at times may be misleading unless actual figures are also

considered. Accounting figures such as depreciation, provision for bad

debts and other losses do affect the ratios.

(iv) Ratios are just relationship between two figures. High degree of technical

& conceptual knowledge is required for analysis. Otherwise, a

correlation of two unrelated figures may lead to incorrect assessment of

the financial condition.

V Classification (Types) of accounting ratios

Financial ratios can be grouped under 4 categories:

Long Term
(referred to as Debt Ratios)
(1) Liquidity / Solvency
Short Term
 (referred to as Liquidity Ratios)

(2) Profitability

(3) Activity

(4) Market Test / Earnings ratios

Liquidity Ratios

(A) Short Term Liquidity Ratios

Short Term Liquidity ratios are used to judge a companys ability to meet

short-term obligations.

By the analysis of liquidity ratios, we can get an idea into the present cash

solvency of a company and its ability to remain solvent in the event of

adversities.

In the liquidity analysis, comparison of short-term obligations with the

available short-term resources is made.

The widely used short term liquidity ratios include -

(i) Current Ratio Current Assets__

Current Liabilities

1. Generally, higher the ratio, greater is the ability of a company to meet its

short-term obligations.

2. For availing bank finance to meet the working capital needs, the current

ratio should be a minimum of 1.3 : 1 (as per Tandon Committee norms).

Note:

Current ratio is regarded as a crude measure of liquidity as it does not

consider the liquidity of the individual components of current assets.

Liquidity has two dimensions, viz.,

(i) The time required to convert other current assets into cash / money.

(ii) The certainty of cash realization.

Usually receivables are regarded as more liquid than inventories. Reason -

Receivables represent the price already realized on inventory. It is likely to

convert to money over a shorter time subject of course to the certainty of

realization.

To have a finer look at liquidity, inventory is excluded from current assets.

The resultant ratio is the Quick Ratio (also referred to as liquidity ratio or

acid test ratio).

(ii) Quick Ratio Current Assets Inventories

Current Liabilities

Quick ratio of 1:1 is generally regarded as a comfortable liquidity

position.

(iii) Absolute Liquidity / Cash Ratio

Cash + Marketable Securities

Current Liabilities
 0.75 is generally regarded as comfortable

Note: A company carrying a smaller amount of cash is not a situation for

concern if it has reserve borrowing power or unutilized sanctioned credit

limits.

(B) Long Term Liquidity ratios

Long term liquidity ratios would include

(i) Debt ratios &

(ii) Coverage ratios.

(i) Debt Ratios:

To analyze the long-term liquidity of a company (i.e., ability to meet long

term obligations), several debt ratios are computed and used. Debt ratios

basically reflect the relative proportion of debt funds employed by a

company in its business.

(i) Debt Equity Ratio (Generally referred to as Long-term debt to

networth ratio)

Long term debt / shareholders funds

Note: This ratio is relatively not a conservative ratio and hence not

advocated by many authors. However, this ratio is generally adopted in

practice.

(ii) Debt Equity Ratio (as defined by various authors)

Debt equity ratio = Total debt / Net worth

Note: Total debt will include short term liabilities

(iii) Long term debt to total capitalization

Formula - Long term debt / capital employed

(Capital employed includes networth plus long-term debts)

Note: Debt ratios vary according to the nature of business and volatility of cash

flows. For example, a power utility company has stable cash flows and

hence can have a higher debt equity ratio than a machine tool company

whose cash flows are far less stable.

Details of certain terms used in the above ratios:

(1) Net worth = Equity share capital

(+)
Preference share capital
(+)
Reserves and surplus (i.e. retained
earnings)
(-)
Miscellaneous Expenses (4th item on the asset
side of a companys Balance sheet)
(-)
Accumulated losses (i.e. Profit & Loss A/c
appearing as the 5th item on the asset side of a
companys Balance Sheet)

(2) Capital Employed = Net worth (as indicated above)

(+)
Long term loans

(ii) The coverage ratios include

(i) Interest Coverage Ratio (ICR)

This is the most widely used coverage ratio to assess the ability of a

company to service the cost of debt. In other words, this ratio signifies

the ability of the company to pay the interest charges when they are due.

ICR = EBIT / Interest charges on debt

EBIT is Earnings before interest and taxes

Example: If a company has an EBIT of Rs.6 cr. during a financial

year and the interest payments on all debt obligations were Rs.1.5 cr.,

interest coverage ratio is 4 times (i.e., 6/1.5). This would suggest that

even if EBIT drops even by 75%, the company would still be able to cover

its interest payments out of its earnings.

A coverage ratio of just only one would indicate that the earnings are just

sufficient to satisfy the interest payments.

Although generalization on what an appropriate interest coverage ratio is

difficult, a minimum of 4 is widely considered as comfortable depending

upon the industry and the future financing plans.

(ii) Debt Service Coverage Ratio (DSCR)

The interest coverage ratio indicates only the ability of a company to

service the interest cost.

The inability to meet the principal repayment also constitutes default.

Hence, DSCR is computed for ascertaining the full debt-servicing ability.

DSCR = EBDIT
Interest + Principal Repayment
(1-T)
 As principal repayments are not tax deductible, they are calculated in

pre-tax terms to be consistent with EBIT. Hence, principal repayment is

divided by 1 minus tax rate in the denominator.

Profitability Ratios

Profitability ratios fall under two categories

(i) Profit in relation to sales &

(ii) Return in relation to investment.

Key Profitability Ratios

(a) Gross Profit / Gross Profit Margin Ratio

Gross Profit x 100 or Sales Cost of goods sold x 100

Sales Sales

This ratio gives the percentage of gross profit to sales.

This ratio though compares gross profit with the sales; it actually signifies
the percentage of the cost of production in relation to the sales value.

From this ratio, two indications emerge:

(a) The efficiency of operations &

 (b) Product pricing, i.e. how the products are priced.

(b) Net Profit Ratio

Net Profit (after tax) x 100 (or) PAT_ x 100

Sales Sales

Net Profit margin signifies the relative efficiency of the firm in generating

profits after considering all expenses including interest and tax.

Note: When both GP and NP ratios are considered together, considerable clarity

can be obtained into the efficiency of the operations of a company. For

example, when Gross Profit margin remains unchanged over time, but

Net Profit margin has declined over the same period, the cause can be

higher financing, selling & / or administration expenses. In the opposite

situation, it may signify an increase in cost of producing goods, which in

turn may be due to problems in pricing.

(c) Operating Profit Margin Ratio

Operating Profit x 100

Sales (EBIT)

This ratio signifies the net operating profit margin for the sales achieved.

(d) Return on Equity or Return on Shareholders funds

PAT Pref Dividend x 100

Shareholders funds

Note: Shareholders funds is basically networth Refer components of Networth as

given before.
 This ratio highlights the earning power (i.e., profitability) of Shareholders

funds. This ratio is useful for inter-firm comparison in an industry.

(e) ROI or Return on Assets

(i) General ratio

PAT___
Total Assets

This ratio signifies the net profit made for employing various assets in

business.

Note: The share holders and the lenders provide funds for a company. The

funds are invested in various assets. To ascertain the profitability of the

total funds invested in the assets, this ratio is computed.

The profit figure in the numerator being after tax, it means that it is after

deducting interest charges also. As total assets are financed by both

share holders and lenders, the profit figure in the numerator should be

before any payment to either of them. Therefore a variant of this ratio is

also computed for the purpose of arriving at ROI. This ratio is generally

called return on capital employed.

EBIT____________
Capital Employed

Note: Capital employed = Share holders funds + long term debts. As the

funds provided by them are generally invested in fixed assets and current

assets net of current liabilities, the denominator represents net fixed

assets.
 It can be observed that capital employed basically denotes Net Assets

for a company. In other words, Net Assets = Fixed Assets + Net Current

Assets.

The ratio given brings out the profitability independent of the way the

assets of a company are financed.

Activity or Turnover Ratios

Activity ratios signify the efficiency with which a company manages and

utilizes its assets.

Since activity ratios indicate the speed with which assets are translated to

sales, they are also referred to as turnover ratios.

Basically, activity ratios incorporate the relationship between sales and

assets.

(i) Inventory Turnover Ratio

Inventory Turnover Ratio is used to gauge the liquidity of inventories.

It basically indicates the amount of funds being tied up in inventories.

Inventory Turnover Ratio = Cost of goods sold

Average inventory (Op + Cl.)/2

Generally a higher inventory turnover ratio signifies efficiency of

inventory management by the company Reason lesser inventory being

carried over as compared to the cost of sales.

 When the inventory turnover ratio is relatively low, it indicates higher

amount of inventory being carried over. The reason could be slow

moving of goods and even obsolescence of some portion of the stock.

(ii) Asset Turnover Ratio

Asset Turnover Ratio signifies whether a higher or lower investment is

necessary to achieve sales.

This ratio also indicates the relative efficiency with which a company

utilizes its assets to generate sales.

Asset Turnover Ratio = Sales____

Total Assets

(iii) Debtors or Receivables Turnover Ratio

This ratio basically indicates the proportion of credit sales being

carried over as debtors or receivables.

Debtors Turnover Ratio = Annual Credit Sales_____

Receivables (Closing Debtors)

Note:

(i) Receivables ordinarily represent year-end receivables.

(ii) When sales are seasonal or have grown considerably during the

year, using year-end receivables balance may not be appropriate.

 For seasonality, an average of the monthly closing balances may be the most

appropriate figure.

Where sales have grown steadily during the year, an average of the receivables at the

beginning and at the end of the year might be appropriate.

(iv) Average Collection Period (ACP)

The reciprocal of the Debtors Turnover Ratio is the ACP

ACP = Receivables__ x 365

Annual Credit Sales

This ratio indicates the credit time period being allowed by the company for its

customers.

(v) Average Payment Period (APP)

The creditors would require information on the average time the company

takes to pay outstanding amounts.

Hence, from the creditors standpoint, it would be desirable to obtain an

aging of the accounts payable. As this information may not be easily

available, Average Payment Period may be computed as given below:

APP = Accounts Payable x 365

Purchases

Note:

(i) For taking purchases figure, only external purchases need to be

considered.

(ii) Where information on purchases is not available, one may, in

such a case, take the cost of goods sold in the denominator.

 (iii) A longer period for payment to creditors generally denotes the

ability of a company to negotiate for longer credit periods from

various suppliers. However, where the cash flow position of a

company is strained, the longer period can denote delays and / or

defaults.

Market Test / Market Value / Earnings Ratios

These ratios relate the market value of the shares of a company to its profitability,

dividend payouts and the book value of the equity shares.

(i) Earnings per share or EPS

PAT___
No of shares

(ii) Price Earning Ratio (PE Ratio)

Market Price / Share

EPS

Higher the ratio would indicate that the investors value the expected future

growth of the company.

(iii) Dividend Yield for Stock

Dividend / Share_

Market Price / Share

Typically companies with good growth potential retain a high proportion of

earnings for reinvestment in the business and hence have a low dividend

yield.

Companies in more mature industries payout a higher proportion of their

earnings as dividends.

(iv) Payout Ratio

 Equity Dividend x 100 or Dividend paid per share x 100
PAT EPS

(v) Market to Book Value Ratio

Market Share Price___

Book Value / Share

Market to Book Value Ratio is a relative measure of how the growth opportunity

for a company is being valued.

Greater the expected growth and the value placed on the growth, higher the

ratio.

General

(1) No single ratio gives sufficient insight to judge the financial performance of a

company. Hence, analysis of a group of ratios is essential to reasonably gauge

the financial condition.

(2) Seasonal character of a business needs to be taken into account.

(3) Assessment of underlying trends needs to be assessed through comparison of

ratios and actual figures at the same time.

(4) Comparative analysis needs to be for similar periods. Example: Financials for

two periods can be analyzed and compared only if both the periods have the

same number of months. Suitable modifications need to be provided in case the

periods differ.

Other points for consideration in financial analysis

Due consideration must be given in financial analysis on certain information. These

information include

(i) Standard accounting policies of a company and any variations in the said

policies among companies.

(ii) Auditors qualification, if any.

(iii) Any change in grouping of accounts in different years.

(iv) Current economic and industry scenario.

(v) Market reports about the company.