Chapter 7 FINANCIAL STATEMENT ANALYSIS The Information Maze

OUTLINE FINANCIAL STATEMENTS FINANCIAL RATIOS STANDARDISED FINANCIAL STATEMENTS APPLICATIONS OF FINANCIAL STATEMENT ANALYSIS USING FINANCIAL STATEMENT ANALYSIS GOING BEYOND THE NUMBERS

IMPORTANT QUESTIONS Managers, shareholders, creditors and other interested groups seek answers to the following important questions about a firm: What is the financial position of the firm at a given point of time? How has the firm performed financially over a given period of time? What have been the sources and uses of cash over a period of time? The accountant prepares the balance sheet, the profit and loss account, and the statement of cash flows to answer the above questions

BALANCE SHEET Horizontal Form Liabilities + Equity Assets  Share capital  Fixed assets  Reserves and surplus  Investments  Secured loans  Current assets, loans and  Unsecured loans advances  Current liabilities and provisions  Miscellaneous expenditures and losses

BALANCE SHEET Vertical (or Report) Form I.Sources of Funds (1) Shareholders’ funds: (a) Capital (b) Reserves and Surplus (2) Loan funds: (a) Secured loans (b) Unsecured loans II.Application of funds (1) Fixed assets (2) Investments (3) Current assets, loans and advances Less: Current liabilities and provisions: Net current assets (4) Miscellaneous expenditures and losses

BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1 A. Account Form Rs.in million Liabilities20 x 120 x 0Assets 20 x 1 20 x 0 Share capital Fixed assets Equity 150 Investments *** Preference – Current assets, loans Reserves & surplus and advances Secured loans * Miscellaneous Unsecured loans ** expenditures and losses Current liabilities and provisions * Rs. 35 million of secured loans are due within 1 year, the balance being due after 1 year. ** Rs.40 million of unsecured loans are due within 1 year, the balance being due after 1 year. *** Rs.3 million out of Rs.15 million represent current investments.

BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1 Rs.in million 20 x 1 20 x 0 I.Sources of Funds (1) Shareholders’ funds: (a) Capital 150 (b) Reserves and surplus 112 (2) Loan funds: (a) Secured loans 143 (b) Unsecured loans II.Application of Funds (1) Fixed assets (2) Investments (3) Current assets, loans and advances Less: Current liabilities and provisions: Net current assets (4) Miscellaneous expenditures and losses

LIABILITIES Share Capital Reserves & Surplus Secured Loans Unsecured Loans Current Liabilities and Provisions

ASSETS Fixed Assets Investments Current Assets, Loans, & Advances Miscellaneous Expenditure & Losses

PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR ENDING ON MARCH 31, 20 X 1 (Rs.in million) Income Sales 701 Other income – 701 Expenditure Material and other expenditure 582 Interest 21 Depreciation 30 Provision for tax 34 Profit after tax 34

PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR ENDING ON MARCH 31, 20 X 1 (Rs. in million) 20 x 1 20 x 0 Net sales Cost of goods sold Stocks421 Wages and salaries 68 Other manufacturing expenses 63 Gross profit Operating expenses Depreciation 30 General administration 12 Selling 18 Operating profit Other income (expense) – 06 Profit before interest and tax Interest Profit before tax Provision for tax Profit after tax 34 42

PROFIT AND LOSS ACCOUNT ITEMS  Net Sales  Cost of Goods Sold  Gross Profit  Operating Expenses  Operating Profit  Non-operating Gains and Losses  Profit Before Interest and Taxes  Interest  Profit before Tax  Income Tax Provision  Profit After Tax  Prior Period Adjustments  Amount Available for Appropriation  Appropriations  Balance Carried Forward

NET CASH FLOW Net cash Profit after Non cash Non cash flow tax revenues expenses In practice, analysts use the following approximation: Net cash Profit after + Depreciation + Amortisation Flow tax = – + =

STATEMENT OF CASH FLOW Sources of Cash Increase in liabilities and owners’ equity Decrease in assets (other than cash) Uses of Cash Decrease in liabilities and owners’ equity Increase in assets (other than cash)

Cash inflows from operations Cash inflows from investing activities Cash inflows from financing activities Cash outflows from investing activities Cash flow from investing activities Cash outflows from financing activities Cash flow from financing activities Operating Investing Financing – – = = = + – = – Cash outflows from operations Cash flow from operations Net cash flow for the period STATEMENT OF CASH FLOWS

SOURCES USES FINANCING CAPITAL CAPITAL OPERATING RES. & SURPLUS RES. & SURPLUS FINANCING LOANS LOANS OPERATING CURRENT LIABILITIES CURRENT LIABILITIES & PROVISIONS & PROVISIONS INVESTMENT FIXED ASSETS FIXED ASSETS INVESTMENT INVESTMENTS INVESTMENTS OPERATING INVENTORIES INVENTORIES OPERATING DEBTORS DEBTORS

CASH FLOW STATEMENT FOR HORIZON LTD, FOR THE PERIOD X0 TO X1 (Rs. in million) (A) Cash Flow from Operating Activities Net profit before tax and extraordinary items 68 Adjustments for Interest paid 21 Depreciation 30 Operating profit before working capital changes 119 Adjustments Debtors (46) Inventories (33) Advances 05 Trade credit 15 Advances 07 Provisions 02 Cash generated from operations 69 Income tax paid 34 Cash flow before extraordinary items 35 Extraordinary item – Net cash flow from operating activities 35 (Contd.)

(Rs.in million) (B) Cash Flow from Investing Activities Purchase of fixed assets (38) Net cash flow from investing activities (38) (C) Cash Flow from Financing Activities Proceeds from term loans 12 Proceeds from inter-corporate deposits 44 Interest paid (21) Dividend paid (28) Net cash flow from financing activities 07 (D) Net Increase in Cash and Cash Equivalents (A) + (B) + (C) 04 Cash and cash equivalents as on x0 06 Cash and cash equivalents as on x1 10

MANIPULATION OF THE BOTTOM LINE 1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE FOLLOWING YEAR 2. ALTER THE ‘OTHER INCOME’ FIGURE BY PLAYING WITH NON-OPERATIONAL ITEMS 3. FIDDLE WITH THE METHOD & RATE OF DEPR’N 4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR. 5. MAKE INADEQUATE PROVISIONS.. LIABILITIES 6. MAKE EXTRA PROVISIONS.. PROSPEROUS PERIODS.. WRITE THEM BACK.. LEAN PERIODS 7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES. 8. REVALUE ASSETS.. CREATE.. IMPR’N.. RESERVES 9. LENGTHEN … ACCOUNTING YEAR.. ATTEMPT COVER POOR PERFORMANCE. WHY ? PROJECT IMAGE OF LOW RISK PROMOTE PERCEP’N.. COMPETENT MGT INCREASE MGRL COMPEN’N QUALITY PROMPTNESS OF CANDOUR IN ANALYSING PAST PERFORMANCE REPORTING MEANINGFUL DISCUSSION.. PROSPECTS

HORIZON LIMITED: PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING 31 ST MARCH 20X1 (Rs. in million) 20X1 20X0 Net sales Cost of goods sold Stocks Wages and salaries Other manufacturing expenses Gross profit Operating expenses Depreciation General Administration Selling Operating profit Non-operating surplus/deficit - 6 Profit before interest and tax Interest Profit before tax Tax Profit after tax Dividends Retained earnings 6 15 Per share data ( in rupees) Earning per share Dividend per share Market price per share Book value per share

HORIZON LIMITED: BALANCE SHEET AS ON 31 ST MARCH 20X1 (Rs. in million) 20X1 20X0 I. Sources of funds 1. Shareholders' funds (a) Share capital (b) Reserves and surplus Loan funds (a) Secured loans (i) Due after 1 year (ii) Due within 1 year (b) Unsecured Loans (i) Due after 1 year (ii) Due within 1 year II. Application of funds 1. Fixed assets Investments (a) Long term investments (b) Current investments Current assets, loans and advances (a) Inventories (b) Sundry debtors (c) Cash and bank balance 10 6 (d) Loans and advances 5 10 Less: Current liabilities and provisions Net current assets Total

LIQUIDITY RATIOS Current Ratio Current assets 237 Current liabilities 180 Acid-Test Ratio Quick assets (237 – 105) Current liabilities 180 Cash Ratio Cash and bank Current balances investments (10 + 3) Current liabilities 180 == 1.32 == = = 0.07

LEVERAGE RATIOS Debt-equity Ratio Debt 212 = = Equity 262 Debt-asset Ratio Debt 212 = = 0.45 Assets 474 Interest Coverage Ratio Profit before interest and tax 89 = = 4.23 Interest 21

TURNOVER RATIOS Inventory Turnover Cost of goods sold 552 Average inventory ( )/2 Debtors’ Turnover Net credit sales 701 Average debtors ( )/2 Fixed Assets Turnover Net sales 701 Average net fixed assets ( )/2 Total Assets Turnover Net sales 701 Average total assets ( )/2 = = 6.24 = = 7.70 = = 2.15 = = 1.58

PROFITABILITY RATIOS Gross Profit Margin Ratio Gross profit 149 Net sales 701 Net Profit Margin Ratio Net profit 34 Net sales 701 Return on Assets (ROA) Profit after tax 34 Average total assets ( )/2 == 0.21 or 21 percent == or 4.9 percent = = or 7.7 percent

PROFITABILITY RATIOS Earning Power Profit before interest and tax 89 Average total assets ( )/2 Return on Capital Employed Profit before interest and tax (1 – Tax rate) 89 (1 – 0.5) Average total assets ( )/2 Return on Equity Equity earnings 34 Average equity ( )/2 = or 20.1 percent = or 10.1 percent = or 13.1 percent = = =

VALUATION RATIOS  Price-earnings Ratio Market price per share 21.0 = = 9.25 Earnings per share 2.27  Yield Dividend Price change + Initial price Initial price Dividend yield Capital gains/losses yield = 9.35% = 5%  Market Value to Book Value Ratio Market value per share = = 1.20 Book value per share 17.47

COMPARISON WITH INDUSTRY AVERAGES RatiosFormula Horizon Industry Limited Average Liquidity Current assets Current ratio Current liabilities Quick assets Acid-test ratio Current liabilities Leverage Debt Debt-equity ratio Equity Debt Debt-ratio Assets PBIT Interest coverage ratio Interest Turnover Net sales Inventory turnover Average Inventory Net credit sales Accounts receivable turnover Average accounts receivable Net sales Fixed assets turnover Average net fixed assets Net sales Total assets turnover Average Total assets

RatiosFormula Horizon Industry Limited Average Profitability Gross profit Gross profit margin ratio 21.0% 18.0% Net sales Net profit Net profit margin ratio 4.7% 4.0% Net sales Net profit Return on assets 7.7% 6.9% Average total assets PBIT Earning power 20.1% 17.7% Average total assets PBIT (1–T) Return on capital employed 10.1% 8.8% Average total assets Equity earnings Return on equity 13.1% 11.9% Average net worth Valuation Market price per share Price-earnings ratio Earnings per share Dividend + Price change Yield 14. 0% 14.1% Initial price Market price per share Market value to book value ratio Book value per share

TIME SERIES OF CERTAIN FINANCIAL RATIOS Debt-equity ratio Total assets turnover ratio Net profit margin (%) Return on equity (%) Price-earnings ratio

DUPONT ANALYSIS Basic Du Pont Analysis Net profit Net profit Net sales = x Average total assets Net sales Average total assets ROA = NPM xTATR Extended Du Pont Analysis Net profitNet profit Sales Average total assets = x x Equity Sales Average total assets Average equity ROE NPM x TATR x 1/(1 – DAR)

Return on Total Assets 7.7 % Net Profit Margin 4.9% Total Assets Turnover 1.58 Net Profit 34 Net Sales 701 Net Sales 701 Average Total Assets 443 Net Sales +/- Non operating Surplus/Deficit 701 Total Costs 667 Average Fixed assets 326 Average Investments 15 Average Net Current Assets 102 DU PONT CHART APPLIED TO HORIZON LIMITED X   – + +

EXTENSION OF THE DU PONT CHART Return of Equity 13.1% Return of Assets 7.7% Average Total Assets To Average Equity Ratio 1.70

COMMON SIZE FINANCIAL STATEMENTS Part A : Profit and Loss Account Reg ular (in million) Common Size (%) 20X0 20X1 20X0 20X1 Net sales Rs.623 Rs Cost of goods sold Gross profit PBIT Interest PBT Tax PAT Part B: Balance Sheet Regular (in million) Common Size (%) 20X0 20X1 20X0 20X1 Shareholders’ funds Loan funds Total Fixed assets Investments Net current assets Total

COMMON-BASE YEAR FINANCIAL STATEMENTS Part A : Profit and Loss Account Regular (in million) Common Base Year (%) 20X0 20X1 20X0 20X1 Net sales Rs.623 Rs Cost of goods sold Gross profit PBIT Interest PBT Tax PAT Part B: Balance Sheet Regular (in million) Common Size (%) 20X0 20X1 20X0 20X1 Shareholders’ funds Loan funds Total Fixed assets Investments Net current assets Total

APPLICATIONS OF FINANCIAL ANALYSIS Financial ratios may be employed to: Assess corporate excellence Judge creditworthiness Forecast bankruptcy Value equity shares Predict bond ratings Estimate market risk

PROBLEMS IN FINANCIAL STATEMENT ANALYSIS Heuristic and Intuitive Character Development of Benchmarks Window Dressing Price Level Changes Variations in Accounting Policies Interpretation of Results Correlation among Ratios

GUIDELINES USE RATIO TO GET CLUES TO ASK THE RIGHT QUESTIONS BE SELECTIVE IN THE CHOICE OF RATIOS EMPLOY PROPER BENCHMARKS KNOW THE TRICKS USED BY ACCOUNTANTS READ THE FOOT NOTES UNDERSTAND HOW THE RATIOS ARE INTER- RELATED REMEMBER … FSA.. ODD MIXTURE OF ART & SCIENCE

LOOKING BEYOND THE NUMBERS 1. ARE THE COMPANY’S REVENUES TIED TO ONE KEY CUSTOMER ? 2. TO WHAT EXTENT ARE THE COMPANY’S REVENUES TIED TO ONE KEY PRODUCT ? 3. TO WHAT EXTENT DOES THE COMPANY RELY ON A SINGLE SUPPLIER ? 4. WHAT PERCENTAGE OF THE COMPANY’S BUSINESS IS GENERATED OVERSEAS ? 5. COMPETITION 6. FUTURE PROSPECTS 7. LEGAL AND REGULATORY ENVIRONMENT

SUMMING UP Balance sheet, profit and loss account, and the statement of cash flows are the three financial statements The balance sheet shows the financial position at a given point of time, the profit and loss account reflects the financial performance over a period of time, and the statement of cash flows displays the sources and uses of cash over a period of time. Financial statement analysis can provide valuable insights into a firm’s performance and position. The principal tool of financial statement analysis is financial ratio analysis.

Financial ratios may be divided into five broad categories: Liquidity ratios Leverage ratios Turnover ratios Profitability ratios Valuation ratios Generally, the financial ratios of a company are compared with some benchmark ratios. The Du Pont chart is a popular tool of financial analysis. It provides insights into the determinants of the return on equity There are certain problems and issues in financial statement analysis that call for care, circumspection, and judgment.