Analysis of Financial Statement

Analysis of Financial Statement

Towards this end, he can use the following simple analysis.

Comparative financial statements

Trend analysis

Common size statements

Fund flow analysis

Cash flow analysis

Ratio analysis

Comparative Financial Statement

In the comparative statement balance sheet figures are provided for more than one year. The comparative financial statement provides time perspective to the balance sheet figures. The annual data are compared with similar data of previous years, either in absolute terms or in percentages.

Trend Analysis

Here percentages are calculated with a base year. This would provide insight into the growth or decline of the sale or profit over the years. Sometimes sales may be increasing continuously, and the inventories may also be rising. Likewise sales may have an increasing trend but profits may remain the same.  Here the investor has to look into the cost and management efficiency of the company.

Common Size Statement

Common size balance sheet shows the percentage of each asset item to the total assets and each liability item to the total liabilities. Similarly, a common size income statement shows each item of expense as a percentage of net sales. With common size statement comparison can be made between two different size firms belonging to the same industry. For a same company over the years common size statement can be prepared.

Fund Flow Analysis

The balance sheet gives a static picture of the company’s position on a particular date. It does not revel the changes that have occurred in the financial position of the unit over a period of time.

The investor should know, 

How are the profit utilized?

Financial source of dividend

Source of finance for capital expenditures

Source of finance for repayment of debt

The destiny of the sale proceeds of the fixed assets and

Use of the proceeds of the share for debenture issue or fixed deposits raised from public.

These items of information are provided in the funds flow statement. It is a statement of the sources and applications of funds. It highlights the changes in the financial condition of a business enterprise between two balance sheet dates. The investor could see clearly the amount of funds generated or lost in operations. He could see how these funds have been divided into three significant uses like taxes, dividends and reserves. Moreover, the application of long term funds towards the acquisition of current assets can be found out. This would reveal the real picture of the financial position of the company.

Cash Flow Statement

The investor is interested in knowing the cash inflow and outflow of the enterprise. The cash flow statement is prepared with the help of balance sheet, income statement and some additional information. It can be either prepared in the vertical form or in the horizontal form. Cash flows related to operations and other transactions are calculated. The statement shows the causes of changes in cash balance between two balance sheet dates. With the help of this statement the investor can review the cash movements over an operating cycle. The factors responsible for the reduction of cash balances in spite of increase in profits or vice versa can be found out.

Example

The balance sheet and the profit and loss account of the Sky Ltd are given is table. As an investor in the company’s scrips, you can prepare

Common size balance sheet

Fund flow statement

Cash flow statement and analyse them.

Profit and Loss Account of Sky Ltd as on 31st March 1999 (Rs in Lakhs)

Common Size Balance sheet of Sky Ltd as on 31st march 1999 (` in Lakhs)

The change in the capital components caused the fluctuations in the profit. The common size balance sheet reveals that there is a reduction in the long term loans, while the current liabilities increased. The fixed assets have also increased.

The fund flow statement shows that the majority of the fund is obtained from business operations. The funds are applied for used like acquisition or fixed assets and redemption of debentures. Profit and working capital are sufficient to pay dividend and taxes.

Cash flow statement indicates that the company is following the policy of sales on credit basis because the inventory and the sundry debtors have increased.

Ratio Analysis

Ratio is a relationship between two figures expressed mathematically. Financial ratio provides numerical relationship between two relevant financial data. Financial ratios are calculated from the balance sheet and loss account. The relationship can be either expressed as a percent or as a quotient. Ratios summarise the data for easy understanding, comparison and interpretation. Financial ratios may be divided into six groups.

They are listed below:

Liquidity Ratios

Turnover Ratios

Leverage Ratios

Profit Margin Ratios

Return on Investment Ratios

Valuation Ratios

Liquidity Ratio

Liquidity means the ability of the firm to meet its short term obligations. Current ratio and acid test ratio are the most popular ratios used to analyse the liquidity. The liquidity ratio indicates the liquidity in a rough fashion and the adequacy of the working capital.

The ratios for the Sky Ltd are given below:

For the current ratio the minimum value set is 1.33. Compared to that the liquidity position of Sky Ltd. is favourable. The acid test ratio of 1.06 shows that the company is able to meet current liabilities. Yet, the company has to work out plans to reduce the inventory level a little below the present level.

Turnover Ratios

The turnover ratios show how well the assets are used the extent of excess inventory, if any. These ratios are also known as activity ratios or asset management ratios. Commonly calculated ratios are sales to current assets, sales to fixed assets, sales to inventory, receivable to sales and total assets to turnover. Each ratio has a specific application. Sales to current asset ratio shows the utilization of the current assets and sales to fixed asset ratio indicates the fixed asset utilization. The sales to inventory management. The receivable to sales gives a view of the receivable management.

The value of the calculated ratios for the Sky Ltd company are given below:

The Leverage Ratios

The investors are generally interested to find out the debt portion of the capital. The debt affects the dividend payment because of the outflow of profit in the form of interest. The financial leverage affects the risk and return aspects of holding the shares. The total debt to total assets ratio indicates the percentage of borrowed funds in the firm’s assets. 

It shows that 49 percent of the assets owned by the Sky Company is financed with borrowed money.

The debt to equity ratio compares the creditors’ funds with owners’ funds

It indicates that the creditors also have placed equal amount of money as that of the equity holders. A portion of the debt fund consists of interest free trade credit. Hence, the long term debt should be compared with the networth.

The long term debt to equity ratio specifically indicates the proportion of long term borrowings.

The long term debt portion is comparatively lower than the networth. Sky Ltd operations depend more on the owners’ equity than on the borrowed funds.

Interest Coverage Ratio

This shows how many times the operating income covers the interest payment.

The Sky Ltd’s earnings before interest and tax are sufficient to service the debt the extent of 4.79 times.

Profitability Ratio

Profitability ratios relate the firm’s profit with factors that generate the profits. The investor is very particular in knowing net profit to sales, net profit to total assets and net profit to equity. The profitability ratios measure the overall efficiency of the firm.

Net Profit Margin Ratio

This ratio indicates the net profit per rupee of sales revenue

The net profit margin of the Sky Ltd company is 7 paise in a rupee sold.

Return on Assets

The return on asset measures the overall efficiency of capital invested in business.

For every rupee invested in assets, the yield is 7.33 percent.

Return on Equity

Here, the net profit is related to the firm’s capital

The return on equity is 14.4 percent. The return on assets and the return on equity will be identical if the company carries out all of its operations with owners funds. The difference between the two ratios is caused by financial leverage. When both the ratios are compared, the ROE is greater than ROA. It indicates that the Sky Ltd has employed borrowed funds efficiently to lever the rate of return to the advantage of shareholders.

Valuation Ratios

The shareholders are interested in assessing the value of the shares. The value of the share depends on the performance of the firm and the market factors. The performance of the firm in turn depends on a host of factors. Hence, the valuation ratios provide a comprehensive measure of the performance of the firm itself. In the subsequent section, some of the valuation ratios are dealt in detail.

Book Value Per Share

This ratio indicates the share of equity shareholders after the company has paid all its liabilities, creditors, debenture holders and preference shareholders. At the time of liquidation, the shareholders can know what remains after making all the payments. In ordinary time also it helps the shareholder to find out his real position in the company.

Here, the book value of the share is 2.5 times higher than its par value of ` 10. When the book value of the share is higher than the par value, it is a healthy sign. The profits and accumulated reserves lead to high book value. Book value may be less for firms having long gestation period and when there are accumulated losses.

When the book value of the share is high, companies may issue bonus shares to the existing shareholders out of the reserves. Right issues also can bring down the book value of the share.

Dividend to Market Price

Dividend is the regular income received by the shareholder. The shareholder would like to know the relationship between the market price and the dividend. Suppose “A” company pays ` 4 per share and the market value is ` 50. Then 

Even though the “A” company provides 40 percent dividend its actual yield is low because of the high market price. Whenever companies plough back their profits to settle the loans or for expansion program, the yield would be low. At the same time, if the company distributes profits to shareholders the yield may be high. This may not be proper indicator. The earnings per share is treated as a better guide in investment decisions.

Earnings Per Share

Earnings per share is the earnings after tax divided by the number of common shares outstanding.

The model gives a comprehensive outlook of the earnings per share. According to the model the earnings per share is effected by the following factors.

Utilisation of assets in the company

Margin on sales

Effective cost of the borrowed funds

Debt-equity ratio

Equity base of the company

Effective tax rate paid by the company