Indian Institute of Banking & Finance (IIBF)



ANALYSIS OF FINANCIAL STATEMENTS1.Classification of RatiosSignificanceImportant Ratiosa) Liquidity RatiosAbility of firm to meet obligation in short termCurrent RatioDetermining the solvency of the firmAcid Test Ratiob) Capitalization Ratio/ Leverage RatioUse of debt/ financeDebt equity RatioFunded Debit Equity RatioAssessing the risk arising from the use of debt capitalD.S.C.R.c) Activity RatioMeasures how effectively the assets are employedInventory Turnover RatioTo know turnover /Asset ManagementDebtor velocity RatioCreditor velocity RatioDebtor/Creditor Ratiod) Profitability RatiosIndicator of effectiveness and efficiencyGross Profit Ratio(Operating Profit)Net Profit Ratio2.The exact implication of a higher DER than the industry average can be better understood by the following illustration:(Rs. in crore)Y E A R - 1Y E A R - 2ABC LTDIndustry AverageABC LTDIndustry Average1.Total Investment1001001001002.Debt 806080603.Equity 204020404.Debt/Equity 41.541.55.Profit on total funds employed15%15%9%9%6.Profit before Interest15.015.09.09.07.Interest on debt (@12% average)9.67.29.67.28.Balance Profit5.47.8Loss 1.89.Income Tax @ 50%2.73.9N.A.0. Profit (available for dividend)2.73.9Loss 0.911.Yield on Equity (10/3)13.5%9.75%Loss 2.25%In 1st year, even though there was high DER at 4, the yield on equity as a percentage is larger as the profit on the total funds employed is higher than the interest cost on debt.In the 2nd year, on the other hand, the profit on total funds employed is lower than cost of debt, the high DER dragged and pull down the yield on equity.The company with high DER in 2nd year would incur a net loss although the industry as a whole posted a small profit.3.Working capital Turnover RatioCost of Sales/Net working capitalWorking capital TurnoverSales/Net Working CapitalExampleYear201120122013Sales166.0151.5169.5Networking Capital53.8762.52103.09Working Capital Turnover3.082.41.64This ratio indicates low much net working capital requires for sales. In 2013, the reciprocal of this ratio (1/1.64 = .609) shows that for sales of Rs. 1 the company requires 60 paisa as working capital. Thus this ratio is helpful to forecast the working capital requirement on the basis of sale.4.Interpretation of Financial StatementsCategoryHighLowA.Liquidity Ratiosa.Current Ratioa.High level of inventorya.Unable to pay creditorsb.High level of book debtsb.Faster realization of debtorsc.Credit received is curtailedc.Diversion of fundsd.Prompt payment to creditorsb.Acid Test Ratioa.Idle Fundsa.Strain on liquidityB.Solvency Ratioa.Debt: Equity Ratioa.Low stakea.Unable to get creditb. Overtrading b. High capital gearing c.Conservative Managementb. Funded Debt: Equity -do--do-C.Activity Ratiosa.Inventory Turnover Ratioa.Brisk tradinga.Obsolete stockb.Manufacturing unit diverted to trading activitya.Marketing problemc. Poor demandb. Debtors Velocity Ratioa. Unable to insist on paymenta.Weak managementb.Highly competitive b.Cautious tradingc.Poor quality of goodsc.Only net sales takenc. Creditors Velocity Ratioa.Unable to pay the creditorsa.Poor Management reputationb.Quality of goods received is poorb.Product in great demandD.Profitability Ratiosa.Return on Investmenta.Efficient utilization of assetsa. Idle/under utilized assetsb.Heavy capital investmentb.Gross Profit Ratioa.Some manufacturing expenses not accounted a.Increase in cost of productionb.Sales value taken instead of cost of sales b.Selling raw materials instead of finished goodsc.Stocks overvaluedc.Stocks undervaluedc.Operating Profit Ratioa.High turnover a. Low turnoverb.Public utility serviceProper interpretation of financial indicators beyond mere ratio analysis helps in getting deeper insight into the affairs of a unit which is vital for a proper appraisal of its credit needs. Fund Flow Statements5. The broad pattern outlining the movements of funds within an entity may be traced through successive balance sheets as illustrated as under:-Comparative balance sheets of XYZ(Rs. in Lakh)Balance Sheet heads20122013Net Change Capital Preference Ordinary4040…..8080…..Reserves and surplus82106+24Long term loans11396-17Short term loans4736-11Current liabilities and provisions3946+ 7401404+ 3Fixed Assets Less Depreciation Net Block375412….167208203209 + 1Current assets169171+ 2Inventory9093+3Sundry debtors4463+19Cash and marketable securities 9 1- 8Loans and advances2614-12Technical know-how2424..401404+ 3The above statement reveals that there is an increase of Rs. 24 Lakh in reserves and surplus and current liabilities and provisions by Rs. 7 Lakh. This amount of Rs. 31 Lakh was used to (i) redeem long term debt of Rs. 17 Lakh; (ii) for the reduction of short term credit by Rs. 11 Lakh; (iii) for addition of net fixed assets by Rs. 1 Lakh and current assets by Rs. 2 Lakh. Further, from the asset side, it could be found that the current assets have undergone a re-engineering whereby a surplus of Rs.2 Lakh has been registered.6.Statement of Sources and uses of funds of XYZSourcesRs.UsesRs.Increase in reserves and surplus24Increase in fixed assets1Increase in current liabilities and provisions7Increase in current assets:InventorySundry Debtors319Decrease in Current Assets Cash & Marketable securities Loans and advances812Decrease in long term loansDecrease in short term loans1711Total funds - source51Total funds used517.The Fund Flow statements can also be prepared based on Profit & Loss account as under:Profit & Loss Account for year ended …….Net sales308Cost of goods sold205Gross profit103Administrative and selling expenses -21Operating profit82Other income+ 1Earnings before interest and tax (EBIT) 83Interest -13Taxes-30Net profit40Dividends-16 Preference 3 Ordinary 13Retained earnings 24Inclusive of depreciation of Rs. 36 LakhThe statement above reveals that the increase in net worth by Rs. 24 Lakh of net profit after Rs. 16 Lakh of dividend payments. Depreciation of Rs. 36 Lakh lowers profits but it is a book-keeping expense that does not draw funds from the entity. Therefore, the charge is considered a source of funds and is balance restoring correspondingly the value of the asset to which it is applicable. After making the adjustments as above the funds statement would be as per below.SourcesRsUsesRsNet IncomeDepreciation (expenses requiring no cash outlay)403676Dividends paidAdditions to gross fixed assetsNet change in working capitalReduction in long term debt163761776Cash Flow StatementUsing the data in XYZ, the Cash Flow statement can be drawn as under:-Opening Cash balance9Add Cash from operations 24 Depreciation provided for 36 Increase in current liabilities 7 Decrease in loans and advances 12Total Cash generated79Less Increase in fixed assets 37 Increase in current assets 22 Decrease in long/short term loans 28Total cash used 87Closing Cash Balance 1{Opening Cash Balance + cash generated – cash used = closing cash balance}Increases in current assets at the end of the year balance exceeding the beginning balance reduce cash flow from operations. Conversely decreases in the current assets increase the cash flow from operations. Increase in current liabilities increases cash inflow from operations while decrease in current liabilities reduces it. ................
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