The basis of financial analysis, planning and decision making is financial information. A firm prepares final accounts viz. Balance Sheet and Profit and Loss Account providing information for decision making. Financial information is needed to predict, compare and evaluate the firm's earning ability. Profit and Loss account shows the concern's operating activities and the Balance Sheet depicts the balance value of the acquired assets and of liabilities at a particular point of time. However, these statements do not disclose all of the necessary and relevant information. For the purpose of obtaining the material and relevant information necessary for ascertaining of financial strengths and weaknesses of an enterprise, it is essential to analyses the data depicted in the financial statement. The financial manager has certain analytical tools that help in financial analysis and planning. In addition to studying the past flow, the financial manager can evaluate future flows by means of funds statement based on forecasts.
Purposes of Financial Statement Analysis: Financial Statement Analysis is the meaningful interpretation of 'Financial Statements' for 'Parties Demanding Financial Information', such as :
1) The Government may be interested in knowing the comparative energy consumption of some private and public sector cement companies.
2) A nationalised bank may may be keen to know the possible debt coverage out of profit at the time of lending.
3) Prospective investors may be desirous to know the actual and forecasted yield data.
4) Customers want to know the business viability prior to entering into a long-term contract.
There are other purposes also, in general, the purpose of financial statement analysis aids decision making by users of accounts.
Steps for financial statement analysis:
· Identification of the user's purpose
· Identification of data source, which part of the annual report or other information is required to be analyzed to suit the purpose
· Selecting the techniques to be used for such analysis
As such analysis is purposive, it may be restricted to any particular portion of the available financial statement, taking care to ensure objectivity and unbiasedness. It covers study of relationships with a set of financial statements at a point of time and with trends, in them, over time. It covers a study of some comparable firms at a particular time or of a particular firm over a period of time or may cover both.
Types of Financial statement analysis : The main objective of financial analysis is to determine the financial health of a business enterprise, which may be of the following types :
1) External analysis : It is performed by outside parties, such as trade creditors, investors, suppliers of long term debt, etc.
2) Internal analysis : It is performed by corporate finance and accounting department and is more detailed than external analysis.
3) Horizontal analysis : This analysis compares financial statements viz. profit and loss account and balance sheet of previous year with that of current year.
4) Vertical analysis : Vertical analysis converts each element of the information into a percentage of the total amount of statement so as to establish relationship with other components of the same statement.
5) Trend analysis: Trend analysis compares ratios of different components of financial statements related to different period with that of the base year.
6) Ratio Analysis: It establishes the numerical or quantitative relationship between 2 items/variables of financial statement so that the strengths and weaknesses of a firm as also its historical performance and current financial position may be determined.
7) Funds flow statement : This statement provides a comprehensive idea about the movement of finance in a business unit during a particular period of time.
8) Break-even analysis : This type of analysis refers to the interpretation of financial data that represent operating activities.
Classification of Ratios:
I) According to source: Financial ratios according to source from which the figures are obtained may be classified as below :
1) Revenue ratios : When 2 variables are taken from revenue statement the ratio so computed is known as, Revenue ratio.
2) Balance sheet ratio : When 2 variables are taken from the balance sheet, the ratio so computed is known as, Balance sheet ratio.
3) Mixed ratio: When one variable is taken from the Revenue statement and other from the Balance sheet, the ratio so computed is known as, Mixed ratio.
II) According to usage: George Foster of Stanford University gave seven categories of financial ratios that exhaustively cover different aspects of a business organisation, they are:
1) Cash position
3) Working Capital/Cash Flow
4) Capital structure
6) Debt Service Coverage
While working on ratio analysis, it is important to avoid duplication of work, as same information may be provided by more than one ratio, the analyst has to be selective in respect of the use of financial ratios. The operations and financial position of a firm can be described by studying its short and long term liquidity position, profitability and operational activities. Thus, ratios may be classified as follows:
1) Liquidity ratios:
'Liquidity' and 'short-term solvency' are used as synonyms, meaning ability of the business to pay its short-term liabilities. Inability to pay-off short term liabilities affects the concern's credibility and credit rating; continuous default in payments leads to commercial bankruptcy that eventually leads to sickness and dissolution. Short-term lenders and creditors of a business are interested in knowing the concern's state of liquidity for their financial stake. Traditionally current and quick ratios are used to highlight the business 'liquidity', others may be cash ratio, interval measure ratio and net working capital ratio.
i) Current ratio:
Current ratio = Current Assets/Current Liabilities
Current assets = Inventories + Sundry debtors + Cash and Bank balances + Receivables/Accruals + Loans and advances + Disposable Investments.
Current liabilities = Creditors for goods and services + Short-term Loans + Bank Overdraft + Cash credit + Outstanding expenses + Provision for taxation + Proposed dividend + Unclaimed dividend.
Current ratio indicates the availability of current assets to meet current liabilities, higher the ratio, better is the coverage. Traditionally, it is called 2 : 1 ratio i.e. 2 is the standard current assets for each unit of current liability. The level of current ratio vary from industry to industry depending on the specific industry characteristics and also a firm differs from the industry ratio due to its policy.
ii) Quick ratio:
Quick ratio or acid test ratio = Quick Assets/Current or Quick liabilities
Quick assets = Sundry debtors + Cash and Bank balances + Receivables/Accruals + Loans and advances + Disposable Investments i.e. = Current assets Inventories.
Current liabilities = Creditors for goods and services + Short-term Loans + Bank Overdraft + Cash credit + Outstanding expenses + Provision for taxation + Proposed dividend + Unclaimed dividend.
Quick liabilities = Creditors for goods and services + Short-term Loans + Outstanding expenses + Provision for taxation + Proposed dividend + Unclaimed dividend i.e. = Current liabilities - Bank overdraft - Cash credit.
In the above formula, instead of total current liabilities only those current liabilities are taken that are payable within 1 year that are known as quick liabilities. Quick assets are also called liquid assets, they consists of cash and only 'near cash assets'. Inventories are deducted from current assets, as they are not considered as 'near cash assets', but in a seller's market they are not so considered. Just like lag in collection of debtors, there is lag in conversion of inventories into finished goods and sundry debtors, also slow-moving inventories are not near cash assets. While calculating the quick ratio, the conservatism convention, quick liabilities are that portion of current liabilities that fall due immediately, hence bank overdraft and cash credit are excluded.
iii) Cash ratio :
Cash ratio = (Cash + Marketable securities)/Current liabilities
The cash ratio measures absolute liquidity of the business available with the concern.
iv) Interval measure:
Interval measure = (Current assets - Inventory)/Average daily operating expenses
Average daily operating expenses = (Cost of goods + Selling, administrative and general expenses -Depreciation and other non-cash expenditure)/no. of days in a year.
2) Capital structure/Leverage ratios:
The capital structure or leverage ratios are defined as, those financial ratios that measure long term stability and structure of the firm and indicate mix of funds provided by owners and lenders, in order to assure lenders of long term funds as to:
· Periodic payment of interest during the period of the loan, and
· Repayment of the principal amount on maturity.
They are classified as :
i) Capital structure ratios :
Capital structure ratios provide an insight into the financing techniques used by a business and consequently focus on the long-term solvency position. From the balance sheet one can get absolute fund employed and its sources, but capital structure ratios show relative weight of different sources. Funds on liabilities side of balance sheet are classified as 'owner's equities' and 'external equities' also called 'equity' and 'debt'. Owner's equities or equity means shareholder's funds consisting of equity and preference share capital and reserves and surplus. External equities means all outside liabilities inclusive of current liabilities and provisions, while debt is classified as long term borrowed funds thus, excluding short-term loans, current liabilities and provisions. As per guidelines for issue of 'Debentures by Public Limited Company' debt means term loans, debentures and bonds with an initial maturity period of years or more inclusive of interest accrued thereon, all deferred payment liabilities, proposed debenture issue but excluding short-term bank borrowings and advances, unsecured loans or deposits from the public, shareholders and employees and unsecured loans and deposits from others. Capital structure ratios used are :
a) Owner's Equity to total Equity:
Owner's Equity to total equity ratio = Owner's Equity/Total Equity
It indicates proportion of owners' fund to total fund invested in business. Traditional belief says, higher the proportion of owner's fund lower is the degree of risk.
b) Debt Equity Ratio :
Debt-equity ratio = Debt/Equity
It is the indicator of leverage, showing the proportion of debt fund in relation to equity. It is referred in capital structure decision as also in the legislations dealing with the capital structure decisions i.e. issue of shares and debentures. Lenders are keen to know this ratio as it shows relative weights of debt and equity. As per traditional school, cost of capital firstly decreases due to the higher dose of leverage, reaches minimum and thereafter increases, thus infinite increase in leverage i.e. debt-equity ratio is not possible. However, according to Modigliani-Miller theory, cost of capital and leverage are independent of each other and based on certain restrictive assumptions, namely,
- perfect capital markets
- homogeneous expectations by the present and prospective investors
- presence of homogeneous risk class firms
- 100 % dividend pay-out
- no tax situation and so on.
Most of the above assumptions are unrealistic. It is believed that leverage and cost of capital are related. There is no norm for maximum debt-equity ratio, lending institutions usually, set their own norms considering the capital intensity and other factors.
ii) Coverage ratios :
The coverage ratio measures the firm's ability to service fixed liabilities. These ratios establish the relationship between fixed claims and what is usually available out of which these claims are to be paid. The fixed claims consist of :
a. Interest on loans
b. Preference dividend
c. Amortization of principal or repayment of the installment of loans or redemption of preference capital on maturity. They are classified as follows :
a) Debt service coverage ratio :
Lenders are interested in judging the firm's ability to pay off current interest and instalments and thus the debt service coverage ratio.
Debt service coverage ratio = Earnings available for debt service/(Interest + Instalments)
Earning available for debt service = Net profit + Non-cash operating expenses like depreciation and other amortizations + Non-operating adjustments as loss on sale of fixed assets + Interest on debt fund.
b) Interest coverage ratio :
It is also known as "times interest earned ratio" and indicates the firm's ability to meet interest obligations and other fixed charges.
Interest coverage ratio = EBIT/Interest
EBIT = Earnings Before Interest and Tax
EBIT is used in the numerator as the ability to pay interest is not affected by tax burden as interest on debt funds is a deductible expense. This ratio indicates the extent to which earnings may fall without causing any difficult to the firm regarding the payment of interest charges. A high interest coverage ratio means that an enterprise can easily meet its interest obligations even if EBIT suffer a considerable decline, while a lower ratio indicates excessive use of debt or inefficient operations.
c) Preference dividend coverage ratio :
It measures the firm's ability to pay preference dividend at the stated rate.
Preference dividend coverage ratio = EAT/Preference dividend liability
EAT = Earnings after tax
EAT is considered as unlike debt on which interest is a charge on the firm's profit, preference dividend is an appropriation of profit. The ratio indicates margin of safety available to preference shareholders. A higher ratio is desirable from preference shareholders point of view.
iii) Capital Gearing ratio :
Capital gearing ratio = (Preference Share Capital + Debentures + Long term loan)/(Equity share capital + Reserves & Surplus - Losses)
It is used in addition to debt equity ratio to show the proportion of fixed interest/dividend bearing capital to funds belonging to equity shareholders.
For the judging of the long-term solvency position, in addition to debt-equity and capital gearing ratios, the following are used :
a) Fixed Assets / Long term fund : Fixed assets and core working capital are expected to be financed by long term fund. In various industries the proportion of fixed and current assets are different, thus there can be no uniform standard of this ratio, but it should be less than 1. If it is more than 1, it means short-term fund has been used to finance fixed assets, often big companies resort to such practice during expansion. This may be a temporary arrangement but not a long-term remedy.
b) Proprietary ratio :
Proprietary ratio = Proprietary fund/Total assets
Proprietary fund = Equity share capital + Preference share capital + Reserves & surplus - Fictitious assets
Total assets = All assets, but excludes fictitious assets and losses.
It is possible to reduce equity stake by lowering liquidity ratio i.e current ratio,
Example: When current and debt-equity ratios are both 2 : 1 each, and the proportion of fixed and current assets is
5 : 1 Equity/total assets = 31.67 % but if the current ratio is reduced to 1.5 : 1 equity/total assets = 31.11 %.
3) Activity ratios:
The activity ratios also known as turnover or performance ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets. These ratios usually indicate the frequency of sales with respect to its assets, which may be capital assets or working capital or average inventory. These are calculated with reference to sales/cost of goods sold and are expressed in terms of rate or times. They are as follows:
i) Capital turnover ratio :
Capital turnover ratio = Sales/Capital employed
It indicates the firm's ability of generating sales per rupee of long term investment, the higher the ratio, more efficient is the utilisation of the owner's and long-term creditors' funds.
ii) Fixed Assets turnover ratio :
Fixed Assets turnover ratio = Sales/Capital assets
A high fixed assets turnover ratio indicates efficient utilisation of fixed assets in generation of sales. A firm whose plant and machinery are old may show a higher fixed assets turnover ratio than the firm who purchased them recently.
iii) Working capital turnover ratio :
Working capital turnover = Sales/Working Capital
It is further divided as below:
a) Inventory turnover ratio :
Inventory turnover ratio = Sales/Average inventory
Average inventory = (Opening Stock + Closing stock)/2
It may also be calculated with reference to cost of sales instead of sales, as:
Inventory turnover ratio = Cost of sales/Average inventory For inventory of raw material,
Inventory turnover ratio = Raw material consumed/Average raw material stock.
This ratio indicates the speed of inventory usage. A high ratio is good from liquidity point of view and vice versa. A low ratio indicates that inventory is not used/sold or is lost and stays in a shelf or in the warehouse for a long time.
b) Debtors turnover ratio:
When a firm sells goods on credit, the realisation of sales revenue is delayed and receivable are created. Cash is realised from these receivables later on, the speed with which it is realised affects the firm's liquidity position. Debtors turnover ratio throws light on the collection and credit policies of the firm.
Debtors turnover ratio = Sales or Credit sales/Average accounts receivable
As account receivable pertains to credit sales only, it is often recommended to compute debtor's turnover with reference to credit sales rather than total sales.
Average collection period = Average accounts receivables/average daily credit sales
Average daily credit sales = Credit sales/365
The above ratios provide a unique guide for determining the firm's credit policy.
c)Creditors turnover ratio :
It is calculated on same line as debtors turnover ratio and shows the velocity of debt payment by the firm, Creditors turnover ratio = Credit purchases or Annual net credit purchases/Average accounts payable
A low ratio reflects liberal credit terms granted by suppliers, while a high ratio reflects rapid settlement of accounts.
Average payment period = Average accounts payable/average daily credit purchases
Average daily credit purchases = credit purchases/365
The firm can compare what credit period it receives from the suppliers and what it offers to the customers. It can also compare the average credit period offered to the customers in the industry to which it belongs.
4) Profitability ratio:
The profitability ratios measure profitability or the operational efficiency of the firm reflecting the final results of business operations. The results of the firm may be evaluated in terms of its earnings with reference to a given level of assets or sales or owners interest, etc. Thus, the profitability ratios are broadly classified in following categories:
i) Profitability ratios are required for analysis from owners point of view :
a) Return on equity (ROE): It measures the profitability of equity funds invested in the firm and reveals how profitably the owner's funds are utilised by the business.
ROE = Profit after taxes/Net worth
b) Earnings per share (EPS) : The profitability of a firm from view point of ordinary shareholders can be measured in terms of number of equity shares known as earnings per share.
EPS = Net profit available to equity holders/no. of ordinary shares outstanding
c) Dividend per share : EPS as above reflects the profitability of a firm per share, it does not reflect how much profit is paid as dividend and how much is retained by the business. Dividend per share ratio indicates the amount of profit distributed to shareholders per share.
Dividend per share = Total profits distributed to equity share holders/Number of equity shares
d) Price Earning Ratio (P. E. Ratio) : The price earning ratio indicates the expectation of equity investors about the earnings of the firm and relates to market price and is generally taken as a summary measure of growth potential of an investment, risk characteristics, shareholders orientation, corporate image and degree of liquidity.
P. E. Ratio = Market price per share/EPS
ii) Profitability ratios based on assets/investments :
a) Return on capital employed/Return on Investment (ROI) :
ROI = Return/Capital employed * 100
Return = Net profit +/- Non-trading adjustments excluding accrual adjustments for amortisation of preliminary expenses, goodwill, etc. + Interest on long term debts + Provision for tax Interest/Dividend from non-trade investments.
Capital employed = Equity share capital + Reserves & Surplus + Preference share capital + Debentures and other long term loan - Miscellaneous expenditure and losses - Non-trade investments.
It can be further bifurcated as :
ROI = (Return/sales) * (Sales /Capital employed) * 100
Return/sales * 100 = Profitability ratio
Sales /Capital employed = Capital turnover ratio
ROI = Profitability ratio * Capital turnover ratio
ROI can be improved by improving operating profit or capital turnover or both.
c) Return on assets (ROA) :
The profitability ratio is measured in terms of relationship between net profits and assets employed to earn that profit. It measures the firm's profitability in terms of assets employed in the firm.
ROA = Net profit after taxes/Average total assets or
= Net profit after taxes/Average tangible assets or
= Net profit after taxes/Average fixed assets.
The cause of any increase or decrease in ROI can be traced out only after a complete analysis through expenses and turnover ratios.
iii) Profitability ratios based on sales of the firm :
a) Gross profit ratio:
Gross profit ratio = Gross profit/sales * 100
It is used to compare departmental or product profitability. If costs are classified suitably into fixed and variable elements, then instead of gross profit ratio one may find P/V ratio.
P/V ratio = (Sales - Variable cost)/Sales * 100
Fixed cost remaining same, higher the P/V ratio lower is the break even point (B.E.P.) Operating profit ratio is calculated to evaluate operating performance of business.
b) Operating profit ratio:
Operating profit ratio = Operating profit/Sales * 100
Operating profit = Sales - Cost of sales
c) Net profit ratio : It measures the overall profitability of the business.
Net profit ratio = Net profit/sales * 100
(NOTE: The above article is given for the limited purpose of bringing awareness about the subject matter for readers.)
CS Ajay Mishra
Email: email@example.com & firstname.lastname@example.org