UNDERSTANDING AND ANALYSING

FINANCIAL STATEMENTS

By
ARCHANA SINGH

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 What are Financial Statements?

F I N A N C I A L

B A L A P N R C O E F SI T C H AA E SN E H DT

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The “HOW” of Financial Decision
Making
 To make the three basic decisions
Financial statements are
analyzed
compared
interpreted
Analysis – reclassification of given data
into homogenous and comparable groups
Comparison – relative magnitude is
ascertained
Interpretation – drawing proper
conclusions for future decisions.

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Balance sheet
 Prepared from the point of view of the
firm
 Relates to a point of time not a period
 Is in terms of money
 Is always balanced
 Reflects the health of the firm at that
moment

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Profit & Loss account
 Shows the financial results for a period
 The period is normally a year

Both the financial statements are

analyzed by tools like:
- Ratio Analysis
- Funds flow statements
- Cash flow statements

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Balance Sheet – common entries
 SHARE CAPITAL – capital provided by
the owners
 RESERVES & SURPLUS – capital
belonging to owners
- share-premium reserve
- general reserve
- dividend capitalization reserve
Together share capital + reserves =
NET WORTH

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LONG TERM LOANS – major part of
the liabilities can be raised from
- banks
- FI’s
- public deposits
CURRENT LIABILITIES – short term
source e.g.- wages/interest
payable, sundry creditors etc

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 FIXED ASSETS – Are not normally traded for
liquidity, do not change in form or quantity
thus gross fixed assets are depreciated

 DEPRECIATION is the process of allocating the

original purchase price of a fixed asset over
the course of its useful life.
 All Fixed assets except land are depreciated

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 CURRENT ASSETS continually change
in form & quantity and follow a
sequence of change such as-
- cash &marketable securities
- bank balance
- loans advances & prepaid expenses
- receivables & sundry debtors
- inventory

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 INVESTMENTS – after fulfilling the need of FA
& CA ‘the financial manager uses the surplus
cash towards investments (as cash is dead &
decaying asset). Investments are in
- outside/firm’s securities
- other businesses
- subsidiary companies
The investments are valued at actual cost or
market value or the lesser of the two
depending on the firm’s policy

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Flowchart of a balance sheet
 Capital & Liabilities  Assets
 Where the funds
 Where the
come from
Share Capital funds are
Reserves&Surplus deployed
Long term loans Fixed assets
Short term debt Investments
Current assets

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Profit & Loss Account
Shows the financial results for a period.

 List of all revenues/sales

------
------ X
 List of all expenses (only expenses for
current year)
------
------ Y
If X>Y then profit if X<Y then loss

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 Gross Profit = Sales – COGS
 Operating Profit/EBIT = Gross Profit –
Operating Expenses (administrative and
selling & distribution expenses)
 EAIBT = Operating Profit + Non-operating
Income – Non Operating Expenses (Interest,
Depreciation incl. Amortization schedule)
 EAT/Net Profit = EAIBT – Tax

The Net Profit is either to be distributed as

dividend amongst shareholders or kept back
in the firm as retained earnings.

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Schedules & Notes to Accounts
 Schedules give a break-up of items
in the balance sheet and P & L
account
 Note to Accounts are meant for
qualitative explanation of certain
items as well as disclosure of off-
balance sheet items

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Evaluation of financial performance
 Comparison is essential
The comparison can be of the ratio of
the same company over several
successive years
Comparison with similar figures of
other firms and units in the same
industry
Comparison with similar figures of
other firms and units in different
industries

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Fundamental Question
 1) How is the business doing?
 (2) How is the business placed at
present?
 (3) What are the future prospects of
the business?

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 We can use

 Ratio Analysis
Trend Analysis
Inter firm Comparison
Comparative statements
Common size statements
Fund flow analysis
Cash Flow analysis
Benchmarking

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Performance Key Issues
Area

Profitability Is the business making a profit? Is it

enough?
Efficiency Is the business making best use of its
resources? Is it generating adequate sales
from its investment in equipment and
people? Is it managing its working capital
properly?

Liquidity Is the business able to meet its short-term

obligations as they fall due from cash
resources immediately available to it?

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Performance Key Issues
Area
Stability What about the long-term
prospects of the business? Is the
business generating sufficient
resources to repay long-term
liabilities and re-invest in
required new
technology? What is the overall
structure of the businesses'
finance - does it place a burden
on the business?
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 Performance Area Key Issues

Investment Return What return can investors or

lender expect to get out of the
business? How does this compare
with similar, alternative
investments in other businesses?

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RATIO ANALYSIS
 Isa primary tool for analyzing the firm’s
financial position
External analysis – by outsiders (creditors,
stockholders, analysts):they have limited
access to confidential information
Internal analysis – by the finance &
accounting departments. They have access
to detailed (future) information and can do
a SWOT analysis too

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 Ratio Analysis just indicates the SYMPTOMS of
problems.
 After locating symptom the cause has to be
determined
 Ratios point out the relationships which are
not obvious from the raw data.
 Ratios are used for:
Comparing different industries
Comparing different companies in the same industry
(to reveal strong & weak companies)
Comparing performance in different time periods
(they indicate future success or failure)

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There can be 1000s of different kinds of
ratios based on financial statements, but
different analysts require different kinds of
Ratios:
 ST Creditor : Liquidity ratios
 LT Creditor : Liquidity & Profitability
 Stockholders : Liquidity, Profitability & Policies of
firm which affect market price.

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 LIQUIDITY RATIOS
Current ratio
Quick/acid test ratio
 LEVERAGE RATIOS
debt-equity ratio
debt ratio
 PROFITABILITY RATIOS
 P/E ratio
 Market value to book value ratio
 Gross profit ratio
 Operating profit ratio
 Net profit ratio
 ROTA
 ROE/-ROCE
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 ACTIVITY RATIOS
Total assets turnover ratio
Fixed assets turnover ratio
Current assets turnover ratio
Interest coverage ratio
Accounts receivable ratio
Average collection period

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Liquidity ratios
 CR= CA/CL
 QR= CA-Inventory/CL
Coverage ratios
 EAIBT/Annual interest payment= Interest
coverage
 EAT + Depreciation/Annual amount of loan
installment= loan repayment coverage
ratio
 EAT + Depreciation/Annual interest(1-tax
rate)=Coverage for principal & interest
loan repayment
 EAT-Preference Dividend/Annual dividend
payment=Dividend Coverage

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 Profitability ratios
PBIT*100/Total capital employed=ROCE
EAIT/Sales=Net Profit ratio
EBIT/Sales=Gross Profit ratio
 Turnover ratios
 Net sales/Total capital employed=Capital
turnover ratio
 Net sales/Net FA= FA turnover ratio
 COGS/Average inventory=Inventory
Turnover ratio
 Net sales/Gross CA=CA turnover ratio
 Annual credit sales/amt. of debtors at the
end of the month=Debtors turnover ratio

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 Capital structure ratios
Total of LT liabilities/Total
shareholders funds = Debt to Equity
ratio
Net worth to total assets shows
stability of the firm
Net worth to Fixed Assets shows
extent to which FA have been
financed out of owner’s funds.

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 Symptoms, Causes & Solutions
revealed by Financial Ratios
Symptoms Problem Solution
A. Abnormal 1.Inadequate 1.Raise
Liquidity Cash additional
Ratio funds
2. Excessive 2. Restrict
Receivables terms of trade: more
aggressive collection policy

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Symptoms Problem Solution

3.Excessive 3.Improve
inventory inventory mgmt.

4. Excessive 4.Obtain CL LT
financing

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Symptoms Problem Solution

2. Abnormal 1. High 1. Institute

Profitability Production cost cutting
Ratio costs measures
2. Idle 2. Sell excess
assets assets 3. Inadequate
3. Increase sales size of sales force
& advertising
4. Inadequate 4. Raise SP
selling price

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Symptoms Problem Solution

5. High 5.Reduce
administrative them
expenses

6. Excessive 6. Seek interest

lower cost
payments debt or shift to
equity financing

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DU PONT Analysis

 ROCE= Net profit margin *

capital turnover Ratio
 N.P.(EAIT) Sales
---------------- * --------------------------
Sales Capital employed

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Sources & Uses of Funds
 Flow of funds in a firm is continuous.
 Assets are the net use
 Liabilities are the net sources
 The fund flow is a method by which we
study net fund flow between 2 points of
time: we take the balance sheet of 2
consecutive periods and the P&L a/c for
the period
 Funds can be defined as Cash; Working
Capital; Total funds

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THREE STEP PROCESS
1. Classify net B/S changes that
occur between 2 times
2. Classify from P&L a/c (increase or
decrease)
3. Consolidate this information into
a source and use of funds.

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 Sources  Uses
1. A net decrease 1. A net increase
in any asset in any asset
2. A net increase 2. A net decrease
in any liability in any liability
3. Sale of stock 3. Retirement/
4. Fund From purchase of
operation stock
4. Cash dividends

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 Funds flow statement helps to alert
the management to the problems
that can later be analyzed in detail

 Thisfacilitates the proper action to

be taken

 Helpsto evaluate the firm’s

financing

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THANK YOU

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