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Methods
Objectives of Analysis
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To know whether the company is making enough profit or not To evaluate the financial strength of the company To judge the ability of the company to generate enough cash and cash equivalents and their timing To know the future growth prospects
Multi-step income statement Horizontal (comparative) analysis Common-sized analysis Trend analysis Analytical balance sheet
Gross ProfitGP Profit before depreciation, interest and taxPBDIT Operating ProfitOP or PBIT Profit before tax and extraordinary itemsPBTEOT Profit before taxPBT Net profit--PAT
Horizontal Analysis
The percentage analysis of increase or decrease in each item of comparative balance sheet and profit and loss account is known as horizontal analysis.
Formula: (Current years fig.- Previous years fig.)*100 ---------------------------------------------------------Previous years fig.
Sales (Net)
Less: Cost of goods sold
1100000 1000000 100000 840000 260000 60000 200000 20000 220000 20000 200000 100000 800000 200000 50000 150000 20000 170000 2000 150000 75000 40000 60000 10000 50000 50000 50000 25000
Gross Profit
Less: Operating Expenses (office, admin., selling & distribn.)
Net operating Profit Other Income Earnings before interest n tax Interest paid Profit before Tax Income Tax payable
100000
75000
25000
33.33
100000 -
25 -
200000
800000 200000 600000
100000
600000 200000 400000
100000
200000 200000
100
33.33 50
Shareholders Fund:
Preference share capital Equity share capital Reserves and Surplus
600000
200000 300000 100000
400000
100000 200000 100000
200000
100000 100000 -
50
100 50 -
These statements indicate trends in sales, cost of production, profits, etc., helping the analyst to evaluate the performance, efficiency and financial condition of the undertaking.
For example, if the sales are increasing coupled with the same or better profit margins, it indicates healthy growth.
Comparative statements can also be used to compare the position of the firm with the average performance of the industry or with other firms. Such a comparison facilitates the identification or weaknesses and remedying the situation.
Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies in relation to depreciation, valuation of stock, etc., and do not cater to the same market. Inter-period comparison will also be misleading if the period has witnessed frequent changes in accounting policies.
Common-sized Analysis
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The tool is useful in comparing the performance and financial position of two companies within the same industry or in different industries In case of balance sheet , each item is restated taking the total sources of fund or application of fund as 100 Similarly, in case of income statement, all items are expressed as a percentage of net sales which is taken at 100
A company balance sheet that displays all items as percentages of a common base figure. This type of financial statement can be used to allow for easy analysis between companies or between time periods of a company.
An income statement in which each account is expressed as a percentage of the value of sales. This type of financial statement can be used to allow for easy analysis between companies or between time periods of a company.
Common-sized Analysis
2006 Gross Sales Less: Returns Net Sales Cost of goods sold Gross profit Expenses: Selling Expenses General expenses Financial expenses Total expenses 7500 4500 750 12750 7560 4500 560 12620 5.0 3.0 0.5 8.5 5.4 3.2 0.4 9.0 151500 1500 150000 105000 45000 2007 141540 1540 140000 99400 40600 2006 101 1.0 100 70.0 30.0 2007 101.1 1.1 100 71.0 29.0
Net Profit
32250
29980
21.5
20.0
It is a modified version of vertical balance sheet It starts with Application of funds side as against the vertical balance sheet that starts with Sources of Funds side It proves the basic accounting equation : Assets - outside liabilities= Owners Funds It shows that equity shareholders are the residual claimants on the assets of the company
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Trend Analysis
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Ratio Analysis
Ratio refers to relationship between two variables expressed either in percentages or in multiples and seeks to establish the cause and effect relationship.
It assists in the following cases:
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3. 4.
Inter-firm comparison Intra-firm comparison Comparison against industry benchmark Analysis of performance over a long period
Ratio Analysis
Classification of Ratios
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Return on Investment ( ROI ) ratios Solvency ratios Liquidity ratios Efficiency or Turnover ratios Profitability ratios Du Pont Analysis Capital Market ratios
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Solvency Ratios
The capacity of a company to discharge its longterm obligation indicates its financial strength and solvency position.
The ratio measures the proportion of debt and capital both equity and preference in the capital structure of a company. It helps in knowing whether a company is relying more on debt or capital for financing its assets. Higher the debt , more is the financial risk.
Formula: Long term debt ---------------------------------------------------------Total net worth (E.g. shareholders funds+Pref. cap)
Liquidity Ratio
Liquidity refers to the capacity a company to meet its day to day expenses and discharge short-term obligations of suppliers and other creditors smoothly. Following ratios are calculated under this head. 1. Current Ratio 2. Quick Ratio 3. Collection period 4. Suppliers Credit 5. Inventory Holding period
Turnover Ratios
These ratios indicate how efficiently the assets of the company are used to generate revenue . Following ratios are calculated under this group.
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Overall Efficiency Ratio Fixed Assets Turnover Ratio Debtors Turnover Ratio Inventory Turnover Ratio Creditors Turnover Ratio
Profitability Ratios
The purpose of study of these ratios is to assess the adequacy or otherwise of the profit earned by the company. The following ratios are calculated under this group:
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Multi-step Profit Margin to Sales Individual Cost and Expense to Sales Other Income , Extraordinary Items and Prior Period Adjustments to PBT or Sales Effective Tax Rate
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3. 4. 5. 6.
Gross Profit Margin-GP Profit Before Depreciation, Interest and Tax-PBDIT Operating Profit-OP Profit Before Tax and Extra-ordinary Items-PBTEOT Profit Before Tax-PBT Net Profit Margin-PAT
Gross Profit Margin (%) This reflects the efficiency with which management produces each unit of output. It also indicates the spread between the cost of goods sold and the sales revenue. Formula: Sales- Cost of Goods Sold ----------------------------- x 100 Sales Operating Profit Margin (%) This ratio indicates profitability from operating activities. A higher margin implies better sales realization and effective cost control. Formula: Operating Profit ------------------ X 100 Sales
Net Profit Margin( % ) The ratio is the overall measure of the firms ability to earn profit per rupee of sales. It also establishes relationship between manufacturing, administering and selling the products. Formula: Profit After Tax ------------------- x100 Sales
Other Income, Extraordinary Items and Prior Period Adjustments to PBT or Net Sales (%) These ratios seek to measure the impact of the above items on PBT or net sales. Formula: Extraordinary Item --------------------- x 100 PBT
Formula:
Raw Materials Consumed ---------------------------------- x100 Net Sales
It is an integrative approach used to dissect a firm's financial statements and assess its financial condition It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers
A profitability measure (net profit margin) An efficiency measure (total asset turnover) A leverage measure (financial leverage multiplier)
Equity Multiplier
ROE ROA Equity Multiplier Net Income Net Sales Total Assets Net Sales Total Assets Common Equity
DU PONT Analysis
RONW is a function of Net Profit Margin and Net worth Turnover. DU PONT analysis seeks to measure and establish this relationship between the two determinants. Through these ratios a firm can devise suitable remedies to overcome the weak area of overall performance. Formula: (PAT-Pref. Div)X100 Net Sales ------------------------ X ----------------Net Sales Net Worth
EPS (Earning per share) Price Earning Ratio-P/E Market Capitalization Yield to Investors
An approach that views all aspects of the firm's activities to isolate key areas of concern Comparisons are made to industry standards (cross-sectional analysis) Comparisons to the firm itself over time are also made (time-series analysis)
Evaluate performance Structure analysis Show the connection between activities and performance
Benchmark with
A firms industry category is often difficult to identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios