Understanding

Financial Statement

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How to read Q o Q / Y o Y results

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 FINANCIAL STATEMENT
ANALYSIS
Financial statements are the means of
communicating accounting information which
is generated in the various accounting
processes to the external user of accounts.
In India, a complete set of financial statements
includes B/S, P/L A/C (Income statements)
and schedule & notes forming the part of B/S
and P/L A/C.

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 FINANCIAL STATEMENT
ANALYSIS
In addition to the financial statements, annual
reports contain the following:
Notes to the financial statements, including a
summary of the accounting methods used
Managements discussion and analysis (MD&A)
of the financial results
The auditors report
Comparative financial data for a series of years

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 FINANCIAL STATEMENT
ANALYSIS
The objectives of financial statement analysis
are to help investors
Predict their expected returns
Assess the risks associated with those returns

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FINANCIAL STATEMENT
ANALYSIS

For example, the graphs in the next exhibit

show ONGCS three-year trend of net
sales, market value of the companys stock,
and cumulative return to the companys
stockholders

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 Representative Financial Data of ONGCS

Net Sales Market Value

Cumulative Return
Rs. Millions Rs. Millions to Shareholders
20,000 140,000 250%

200
15,000 105,000

150
10,000 70,000
100

5,000 35,000
50

0 0 0
03 04 05 03 04 05 03 04 05
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 FINANCIAL STATEMENT
ANALYSIS
Methods are:
Horizontal Analysis

Trend Analysis

Vertical Analysis
Fund Flow Statement

Cash Flow Statement

Ratio Analysis
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HORIZONTAL ANALYSIS

The study of percentage changes in

comparative statements is called horizontal
analysis
Computing a percentage change in
comparative statements requires two steps:
Computing the amount of the change from the
base period to the later period
Dividing the amount of change by the base-
period amount
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 Horizontal analysis is illustrated for OILS as follows (Rs.
in millions):

Increase (Decrease)
2005 2004 Amount Percent
Sales 38137.44 30642.98 7494.46 24.4%
Net income 16303.67 14817.25 1486.42 10.03%

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 Trend analysis
YEAR SALES TREND RATIO
1998 100000 100
1999 120000 120
2000 150000 150
2001 175000 175
2002 200000 200

CURRENT YEAR *100

BASE YEAR

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 VERTICAL ANALYSIS
Vertical analysis of a financial statement
reveals the relationship of each statement item
to a specified base, which is the 100% figure
Every other item on the financial statement is
then reported as a percentage of that base
When an income statement is analyzed
vertically, net sales is usually the base

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 VERTICAL ANALYSIS
Vertical analysis of balance sheet amounts are shown
as a percentage of total assets
The next exhibit shows the vertical analysis of OILS
income statement as a percentage of net sales

Each income statement item

Vertical analysis % =
Net Sales

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COMMON-SIZE STATEMENTS
A common-size statement simplifies the
comparison of different companies because
their amounts are stated in percentages
On a common-size income statement, each
item is expressed as a percentage of the net
sales amount
In the balance sheet, the common size is
total assets or the sum of total liabilities and
stockholders equity
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 ONGCS Analysis of Current Assets
December 31,2004 and 2005

Percent of Total Assets

2005 2004
Current Assets:
Cash and cash equivalents 13.8% 9.7%
Time deposits and marketable securities 1.8 2.3
Receivables, net 19.6 19.9
Inventories 11.5 12.0
Prepaid expenses 7.3 7.8
Total current assets 54.0 51.7
Long-Term Assets 46.0 48.3
Total Assets 100.0% 100.0%
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 USING RATIOS TO MAKE
BUSINESS DECISIONS
A ratio expresses the relationship of one number
to another. The ratios used to make business
decisions may be classified as follows:
Solvency analysis

Profitability analysis

Activity analysis

Capital structure analysis

Ratios for Prospective Investors

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SALES
Income Statement
LESS COGS
GROSS PROFIT
LESS OPERATING EXPENSES
GROSS OPERATING PROFIT OR EBIDTA
LESS DDA OR NON OPERATING EXPENSES
EBIT OR EARNING BEFORE INTEREST AND TAXES
LESS INTEREST ON DEB. OR BANK LOAN INTEST.
PBT OR PROFIT BEFORE TAX
LESS TAXES
PAT OR PROFIT AFTER TAX
LESS TRANSFER TO RESERVES / PREF. DIVIDENDS
PAPD OR PROFIT AFTER PREFERENCE DIVIDENDS
LESS EQUITY DIVIDENDS
RETAINED EARNING 17
 LIABILTY ASSETS
SHARE CAPITAL -1 1+2 = FIXED ASSETS
PREFERENCE SH. CAPITAL Proprietor fund
EQUITY SHARE CAPITAL or
Share holder fund
or
RESERVES & SURPLUS -2 Net Worth
or
GENERAL RESERVE Internal Equity
P/L A/C (RETAINED CURRENT
EARNING) ASSETS
1 +2+3 =
LONG TERM DEBTS -3 Long term Funds
LOAN ON MORTGAGE Or
BANK LOAN Total Investment
Or
Capital Block
DEBENTURES

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CURRENT LIABILITIES -4 3+4= External Equity
 Solvency Analysis
Short term solvency: It refers to the ability of
the firm to meet its current obligations.
Long term solvency analysis refers to the
ability of the firm to meet its long term
obligations.
Following are the ratios which will highlight
short term solvency positions.
 1
Current ratio=CA/CL: The current ratio
indicates the extent or ability of the firm to
meet its obligation. It measures short term
solvency. It basically shows the margin
available after meeting current liability and
thus it shows the extent of working capital
available to the firm.
According to convention CR should be 2:1.
 2
Liquid/ Quick/ Acid Test Ratio:
Liquid Assets/ Current Liabilities
Liquid assets= current assets-(inventories+ppe)
Liquidity of a firm can be measured more precisely
by excluding inventories from CA. This is done
because inventories are not as liquid as other assets.
According to convention LR should be 1:1.
 3
Absolute Liquid or Cash Ratio
= Absolute liquid assets/ Liquid liabilities
ALA=cash in hand/bank + Quick

Marketable sec.
Liquid Liabilities=Current liability- Bank O/D

Normally Bank O/D is generally a permanent way of

financing are to be excluded from current liability.
According to convention ALR should be 0.5:1.
 4
Stock turnover Ratio: COGS or Sales
----------------------
Avg.Stock or Cl.Stock
These ratios are also referred to as Activity ratios because they show
how quickly assets are being converted into sales.
Or in other words this ratio shows how fast inventory is sold.
High turnover ratio are usually associated with good assets
management and low turnover ratios are associated with bad asset
management.
 4.5
Average age of inventory= 365 / STR
The average age of inventory represents in how
many days an item remains in the firm inventory.
The shorter the average age of inventory, the more
liquid or active it may be considered.
Example Co.1 Co.2
STR 10 20
AAof Inventory=36.5 18.25
Means in co.1 stock was there for 36.5 days as
compared to co.2 in which stock was there only
for 18.25 days.
 5
Debtors Turnover Ratio= Net credit sales
------------------------
Avg. Debtors / Closing
Dbs
This ratio is very important as it depicts the
efficiency or inefficiency of the staff entrusted
with the task of collection from debtors. The
higher the ratio the better it is.
In other words this ratio shows how rapidly debts
are collected.
 5.5
Average age of Debtors= 365 / DTR
The average age of Debtors represents the extent to which
the debt have been collected in time.
The longer period indicates blockage of funds in debtors.
Example Co.1 Co.2
DTR 10 20
AAof Debtors=36.5 18.25
Means in co.1 debtors are collected in 36.5 days as compared
to co.2 in which debtors are collected in 18.25 days
 6 Long Term Solvency
Debt Equity Ratio= External Equity
-------------------
Internal Equity
External= Long term debt + current liability
Internal= Share Capital + Res.& Surplus
The lower the ratio it means that the Co. has
borrowed more from internal resources and
there is a large extent up to which the Co. can
borrow from external resources.
Ideal is 2:1
 7
Propritory or Equity Ratio= Propritor fund
-------------------
Total Assets
Propritor fund is also knows as Net Worth
This ratio depicts that how much is the net worth
of the company in term of total asset of the
company.
 8) Fixed asset to propritors fund ratio
Fixed asset after dep. *100
-------------------------------
Propritors fund.
9) Fixed Asset ratio
Fixed asset after dep.
-----------------------------
Long term Funds ( sh.cap + r/s+ lt debt)
 Profitability Analysis
General Profitability
1) Gross Profit RATIO= GP / SALES*100
2) Net profit ratio=NP after tax/ sales*100
3) Operating ratio= operating cost *100
--------------------
sales
Where operating cost= COGS+ OPERATING EXP.
Low, operating ratio means more % of net profit.
4). Particular expense ratio= any particular exp. *100
-----------------------
Sales
 Contd
Overall Profitability analysis
1).Return on Propritors fund
=PAT / Propritors fund
2). Return on equity capital
= PAPD / Equity capital
3). Return on total investment
= EBIT / Total investment
4). Return on Total assets
= EBIT / Total assets
All above are in percentage(%)
 Important things to remember
Capital block
Total investment

Long term funds

All above includes

( Sh.cap.+ R/S + Long term debts. )
 CAPITAL STRUCTURE
ANALYSIS
1.Debt equity ratio
2. Capital gearing ratio
= fixed cost bearing capital
-------------------------------
Variable cost bearing capital
Fixed cost= DEB.+PREF. SHARES
Variable cost= EQUITY + RES.& SURPLUS
 ACTIVITY RATIOS
1. Stock turnover ratio
2. Drs. Turnover ratio
3. Total assets turnover=sales/ total assets
4. Fixed assets turnover=COGS/ FIXED ASSETS
5. Current assets turnover= COGS/ CURRENT ASSETS
6. Working capital turnover=SALES/ WORKING
CAPITAL
7. Proprietors Fund Turnover
= SALES/ PROPRIETORS FUND
 Ratios for prospective investors
1. EPS= PAPD/ NO. OF EQUITY SHARES
2. DPS= Dividend paid/ declared/ No. of eq.
shares
3. Book value for share

= Eq. share capital + Res. & Surplus

------------------------------------------------
No. of equity shares
4. PRICE/ EARNING RATIO = Market price
---------------------
EPS
5. Dividend payout ratio= DPS *100
EPS
 Economic Value Added (EVA)

A measure of a company's financial performance based on the

residual wealth calculated by deducting cost of capital from its
operating profit (adjusted for taxes on a cash basis). (Also
referred to as "economic profit".)

The formula for calculating EVA is as follows:

= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost

of Capital)
This measure was devised by Stern Stewart & Co. Economic
value added attempts to capture the true economic profit of a
company.
 Market Value Added
(MVA)
A calculation that shows the difference between the
market value of a company and the capital
contributed by investors (both bondholders and
shareholders).
In other words, it is the sum of all capital claims
held against the company plus the market value of
debt and equity.
Calculated as:
MVA= Company market value Invested Value
 The higher the MVA, the better. A high MVA
indicates the company has created substantial
wealth for the shareholders. A negative MVA
means that the value of management's actions
and investments are less than the value of the
capital contributed to the company by the
capital market (or that wealth and value have
been destroyed).
 From the following prepare B/S for X.Ltd.
1. Current ratio 2.5
2. Liquid ratio 1.5
3. Proprietary ratio(fixed assets/ Proprietor fund ) 0.75
4. Working capital Rs.60000
5. Reserves & Surplus Rs.40000
6. Bank Overdraft Rs. 10,000
7. There is no long term loan.

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 A Co. having a net working capital of Rs. 2.8 lakhs.
Prepare B/S from the following information:
1. Current ratio 2.4
2. Liquidity ratio 1.6
3. Inventory Turnover (on cost of sales) 8
4. Gross profit on sales 20%
5. Credit allowed (months) 1.5
The Co.s fixed assets are equivalent to 90% of its net worth
while reserves amounted to 40% of share capital/

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 LIMITATIONS OF
FINANCIAL ANALYSIS
Ratios have their limitations
Financial analysis may indicate that something is
wrong, but it may not identify the specific problem or
show how to correct it
Managers must evaluate data on all ratios in the light
of other information about the company

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 LIMITATIONS OF
FINANCIAL ANALYSIS
Ratios should be analyzed over a period of
years
Any one year, or even any two years, may not
be representative of the companys
performance over the long term

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 EFFICIENT MARKETS,
MANAGEMENT ACTION,
AND INVESTOR DECISIONS
An efficient capital market is one in which
market prices fully reflect all information
available to the public
Because stocks are priced in full recognition of
all publicly accessible data, it can be argued
that the stock market is efficient

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 EFFICIENT MARKETS,
MANAGEMENT ACTION,
AND INVESTOR DECISIONS
This means that managers cannot fool the
market with accounting gimmicks
For investors, an appropriate strategy seeks to
manage risk and diversity.
The role of financial statement analysis
consists mainly of identifying the risks of
various stocks to manage the risk of the overall
investment portfolio

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