FADM 2 CA.N.

Nabeel Ahmed

Relevance of Accounting Numbers

y It helps in determining value of the Firm y It helps in predicting bankruptcy of the Firm y It helps in taking managerial decisions y Pricing y Make or buy y Close or continue y Analyze financial statements

Financial Statement Analysis Users

y The users of financial reports can broadly be

categorised as:

y resource providers e.g., creditors, lenders, shareholders, employees y recipients of goods and services i.e., customers, debtors y parties performing an overview or regulatory function e.g., tax office, corporate regulator, statistical bureaus y internal management to assist in their decision making

duties

NATURE AND PURPOSE OF FINANCIAL ANALYSIS

y Financial analysis involves expressing the reported numbers in relative

terms (percentages, ratios, comparison)

y Highlights the strengths and weaknesses of firms y By evaluating an entity s financial past, users are in a better position to

form an opinion as to the entity s future financial health

y Uses reported financial numbers to form opinions about the entity s

financial performance.

ANALYTICAL METHODS
y It is essential in financial analysis to compare figures with:
y the equivalent figures from previous years y other figures in the financial statements (competitors)

y Analytical methods include y (A) Horizontal analysis y (B)Vertical analysis y (C)Ratio analysis y (D)Trend analysis y (E) Benchmarks
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(A) Horizontal analysis

y Compares reported numbers in different reporting periods to highlight magnitude and significance of changes y Dollar change is calculated by:
Accounting number in current reporting period ( ) Accounting number in previous reporting period

y Percentage change is calculated by:

(Current Year Number Previous Year number) * 100 Previous Year Number

Example:
Cash Accounts receivable Inventory Prepaid Expenses Land Building Total assets

Comparative Balance Sheet December 31, 2009, and 2010 2010 $1,200 6,000 8,000 300 4,000 12,000 ----------31,500 ====== Accounts payables Accrued payables Loan Bank Over Draft Total paid in capital Retained earnings Total liabilities and stockholders' equity $5,800 900 300 7,500 9,000 8,000 ---------$31,500 ===== 2009 Assets $2,350 4,000 10,000 120 4,000 8,500 ----------28,970 ====== $4,000 400 600 8,000 9,000 6,970 ---------$28,970 ====== $(1,150) 2000 -2000 180 0 3,500 ---------2,530 ====== 1800 500 -300 -500 0 1,030 ---------$2,530 ====== 8.70% ====== 45% 125% -50% -6.30% 0% 14.80% --------8.70% ====== -48.90% 50% -20.00% 150.00% 0% 41.20% Amount Percent

Liabilities and Stockholders' Equity

Cont
y A horizontal analysis can be for y Income Statement y Balance Sheet y Cash Flow statement y Easy to identify which reported numbers have gone up

or gone down in the period.

y Acts as a base for auditors to have enquiries on any

significant changes in the period

2. Vertical analysis
y Involves comparing the items in a financial statement to an

anchor item in the same financial statement:

INCOME STATEMENT y Revenue and expense items are expressed as a percentage of sales or revenue BALANCE SHEET y A, L and Equity items are expressed as a percentage of total assets
y When expressed this way, the financial statements are often

referred to as common size statements

Company A
Particulars Revenue Cost of sales Gross profit Other income Sales and marketing Occupancy Admin expenses Finance Cost Profit Amount 200,000 50000 150000 10000 -20000 -5000 -15000 -25000 95000 % 100 25 75 5 -10 -2.5 -7.5 -12.5 47.5

Common Size Analysis

Company A Company B

Particulars Revenue Cost of sales Gross profit Other income Sales and marketing Occupancy Admin expenses Finance Cost Profit

Amount 200,000 50,000 150,000

% 100 25 75

Amounts 1,000,000 400,000 600,000 50,000 (150,000) (80,000) (35,000) (60,000) 325,000

% 100 40 60 5 -15 -8 -3.5 -6 32.5

10,000 5 (20,000) -10 (5,000) -2.5 (15,000) -7.5 (25,000) -12.5 95,000 47.5

Common Size Analysis Balance Sheet

Sewage Water Treatment Companies( Amounts in $000) Assets Company A % Company B Cash $1,200 3.8 2,350.0 ts r i a l ,000 1 . ,000.0 I t ry 8,000 25.4 10,000.0 Pr paid Exp s s 300 1. 120.0 La d ,000 12.7 ,000.0 B ildi g 12,000 38.1 8,500.0 Total assets 31,5 1 . 28, 7 .
Liabilitites ts paya l s r d paya l s L a Ba k O r Draft T tal paid i apital R tai d ar i gs Total ====== Company A $5,800 900 300 7,500 9,000 8,000 $31,5 ===== % 18.4 2. 1. 23.8 28.6 25.4 1 . ====== Company B ,000.0 00.0 00.0 8,000.0 9,000.0 ,970.0 $28, 7 ====== % 8.1 13.8 34.5 .4 13.8 2 .3 1 . % 13.8 1.4 2.1 27.6 31.1 24.1 1 .

Ratio analysis
y Ratio analysis is a 3-step process 1. Calculate a meaningful ratio by expressing $ amt of an item by $ amount of another item
2. Compare the ratio with a benchmark 3. Interpret the ratio, seek to explain why it differs
y y y

from previous years from comparative entities or from industry averages

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Performance of Firm (Some Indicators)

y y y y y y y y y y

EPS Return on Capital Debt Equity Ratios Market Price of the Share Distribution of Dividend Value of Company Cash flow from operation Working Capital Bonus Shares PBIT

(1)Liquidity (2)Turnover Ratios (3)Profitability (4)Capital Structure (5)Market Performance

Ratio Analysis
(1)Liquidity (2)Turnover Ratios (3)Profitability (4)Capital Structure (5)Market Performance

1) LIQUIDITY ANALYSIS
y The survival of the entity depends on its ability to pay

its debts when they fall due (its liquidity)

y An entity must have sufficient working capital to

satisfy its short-term requirements and obligations

y But excess working capital is undesirable because the

funds could be invested in other assets that would generate higher returns.
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Liquidity Ratios
y A group of ratios which helps to analyze the ability of the company to pay off its short term liabilities. y It Analyses the Current assets and Current Liabilities. y Ability to meet short term liability y If CA > CL Shows that liquidity position is good y Also throws a light on financing of Assets y If CA>CL y Part of Current assets are financed by Long term sources y If CA<CL y Part of Fixed assets are financed by Current liabilities

a. Current Ratio
y Current ratio y Current ratio (or working capital ratio) indicates $ of current assets per $ of current liabilities.
Current ratio Current assets = x times Current liabilities
y We need to know :y Composition of the ratio y Interpretation of the ratio

an arbitrary rule of thumb is that it should be around 1.5 : 1

Example
y If Current ratio = 2:1 y What do you infer from it? y Current ratios is twice Current liability y Current ratio is positive y Can we say whether Current ratio is favorable or

unfavorable?
y Unless Compared, cannot be interpreted.

Lets compare
CR
Recall :- Composition of CA and CL Is it necessary for accounting policies to be same for each of the three companies? -Stock (FIFO , WA) -Accounts Receivable ( Difference in Provision for Bad debts)

A 4:1

B 3:1

C 1:1

Limitations of Current Ratio

y Focus on Quantity rather than Quality y Current Ratio is subject to accounting

assumptions:

y Stock valuation, y Provision for Doubtful debts

y So window dressing is possible .

Address the limitations of Window Dressing

y (a) Current Ratio = CA / CL y (b) Liquid Ratio y = (CA- Stock) / CL y (c )Absolute Cash ratio y = (CA Stock Debtors) / CL

2)Turnover Ratios a. Debtors Days ( Accounts Receivable Days)

y Days debtors ratio indicates average period of time it

takes to collect the money from its trade related accounts receivable. y In other words, No. Of days of sales, remaining as a debtor. Days debtors Average Debtors = Sales revenue Per day

x days

Example
y Sales Revenue per year = 7200 y Average Debtors

= 500

y Sales per day = 7200/365 = $20 per day y Debtors days = 500/20 = 25 days y DD : Is 25 days a good indication of Debtors days? y Cannot conclude unless compared with Creditor days or company s policy for collection of Debtors

No stringent Nr & Dr for Debtors Days

Days debtors Average Debtors Sales revenue Per day Days debtors Average Debtors = x days Credit Sales revenue Per day = x days

Which company is doing better?

Debtor Days Creditor Days A 50 25 B 150 175

Credit policy for both company = 75 days! Is it bad to have HUGE DEBTORS? Ageing Analysis shows quantum of good quality Debtors!

b. Creditor Days
y Creditor days, shows the number of days purchases

which is standing as creditor.

Creditors Days Average Creditors Purchases per day = x days

c. Inventory Days
y Days inventory ratio indicates the average period of time

it takes to sell inventory .

y In other words, Number of days of sales in Inventory.

Days inventory Average Inventory Cost of goods sold per day

Cost of goods sold = Sales - Profit

= x days

Putting it Together.
y Debtors Days + Inventory Days

Creditors Days = Working capital Days

Current Assets

Current Liabilities Cash Conversion Cycle

The cash conversion cycle attempts to measure the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sales to customers.

Example
5. The following ratios have been calculated for Interport Pty LLc, a manufacturing company. 2010 2009 Current Ratio------------2.5:1 1.3:1 Quick asset ratio--------1.3:1 0.7:1 Inventory Days----------130 90 Debtor Days-------------62 45 Creditor Days------------44 43 Profit Margin------------5% 7% Comment on Liquidity Management Efficiency Profitability

Summarizing Liquidity Ratio

Liquidity Ratios Current Ratio Liquid Ratio Absolute Cash Ratio

Turn over Ratios Days Debtors Creditor Days Inventory Days