Measuring financial performance 4

Financial Statement
Analysis

© 2001 Prentice Hall Business 1
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Publishing Financial Accounting,

How to read Q o Q / Y o Y results


FINANCIAL STATEMENT
ANALYSIS
 Financial statements are the means of
communicating accounting information which
is generated in the various accounting
processes to the external user of accounts.
 In India, a complete set of financial statements
includes B/S, P/L A/C (Income statements)
and schedule & notes forming the part of B/S
and P/L A/C.

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FINANCIAL STATEMENT
ANALYSIS
 In addition to the financial statements, annual
reports contain the following:
 Notes to the financial statements, including a
summary of the accounting methods used
 Management’s discussion and analysis (MD&A)
of the financial results
 The auditor’s report
 Comparative financial data for a series of years

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FINANCIAL STATEMENT
ANALYSIS
 The objectives of financial statement analysis
are to help investors
 Predict their expected returns
 Assess the risks associated with those returns

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FINANCIAL STATEMENT
ANALYSIS

For example, the graphs in the next exhibit
show NTPC’S three-year trend of net
sales, market value of the company’s stock,
and cumulative return to the company’s
stockholders

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Representative Financial Data of NTPC’S
Representative Financial Data of NTPC’S

Net Sales Market Value
Cumulative Return
Rs. Millions Rs. Millions to Shareholders
20,000 140,000 250%

200
15,000 105,000

150
10,000 70,000
100

5,000 35,000
50

0 0 0
03 04 05 03 04 05 03 04 05
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FINANCIAL STATEMENT
ANALYSIS
Methods are:
 Horizontal Analysis

 Trend Analysis

 Vertical Analysis

 Fund Flow Statement

 Cash Flow Statement

 Ratio Analysis
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HORIZONTAL ANALYSIS
 The study of percentage changes in
comparative statements is called horizontal
analysis
 Computing a percentage change in
comparative statements requires two steps:
 Computing the amount of the change from the
base period to the later period
 Dividing the amount of change by the base-
period amount
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Horizontal analysis is illustrated for OIL’S as follows (Rs.
in millions):

Increase (Decrease)
2005 2004 Amount Percent
Sales 38137.44 30642.98 7494.46 24.4%
Net income 16303.67 14817.25 1486.42 10.03%

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The percentage change in OIL’s sales during 2005 is ,
computed as follows:

Step 1. Compute the amount of change in sales from
2004 to 2005:
2005 2004 Increase
- =
38137.44 30642.98 7494.46
Step 2. Divide the amount of change by the base-period
amount to compute the percentage change during the later
period:
Amount of change
Percentage Change = Base-year amount
7494.46 = 24.4%
=
30642.98
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HORIZONTAL ANALYSIS
 Trend percentages
 Are a form of horizontal analysis that examine
more than a two- or three-year period
 Use a selected base year whose amounts are set
equal to 100 percent

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HORIZONTAL ANALYSIS
 To compute trend percentages, each item for
following years is divided by the
corresponding amount during the base year

Amount of Any year
Trend % =
Amount of Base year

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 YEAR SALES TREND RATIO
1998 100000 100
1999 120000 120
2000 150000 150
2001 175000 175
2002 200000 200

CURRENT YEAR *100
BASE YEAR

14

VERTICAL ANALYSIS
 Vertical analysis of a financial statement
reveals the relationship of each statement item
to a specified base, which is the 100% figure
 Every other item on the financial statement is
then reported as a percentage of that base
 When an income statement is analyzed
vertically, net sales is usually the base

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VERTICAL ANALYSIS
 Vertical analysis of balance sheet amounts are shown
as a percentage of total assets
 The next exhibit shows the vertical analysis of OIL’S
income statement as a percentage of net sales

Each income statement item
Vertical analysis % =
Net Sales

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COMMON-SIZE STATEMENTS
 A common-size statement simplifies the
comparison of different companies because
their amounts are stated in percentages
 On a common-size income statement, each
item is expressed as a percentage of the net
sales amount
 In the balance sheet, the common size is
total assets or the sum of total liabilities and
stockholders’ equity
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ONGC’S Analysis of Current Assets
December 31,2004 and 2005

Percent of Total Assets
2005 2004
Current Assets:
Cash and cash equivalents 13.8% 9.7%
Time deposits and marketable securities 1.8 2.3
Receivables, net 19.6 19.9
Inventories 11.5 12.0
Prepaid expenses 7.3 7.8
Total current assets 54.0 51.7
Long-Term Assets 46.0 48.3
Total Assets 100.0% 100.0%
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USING RATIOS TO MAKE
BUSINESS DECISIONS
A ratio expresses the relationship of one number
to another. The ratios used to make business
decisions may be classified as follows:
 Liquidity ratios

 Profitability ratios

 Activity ratios

 Leverage ratios

 Ratio’s for Prospective Investors

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SALES
Income Statement
LESS COGS
GROSS PROFIT
LESS OPERATING EXPENSES
GROSS OPERATING PROFIT OR EBIDTA
LESS DDA OR NON OPERATING EXPENSES
EBIT OR EARNING BEFORE INTEREST AND TAXES
LESS INTEREST ON DEB. OR BANK LOAN
INTEST.
PBT OR PROFIT BEFORE TAX
LESS TAXES
PAT OR PROFIT AFTER TAX
LESS TRANSFER TO RESERVES / PREF. DIVIDENDS
PAPD OR PROFIT AFTER PREFERENCE DIVIDENDS
LESS EQUITY DIVIDENDS
RETAINED EARNING
20

LIABILTY ASSETS
SHARE CAPITAL -1 1+2 = FIXED ASSETS
PREFERENCE SH. Proprietor fund
CAPITAL or
Share holder fund
EQUITY SHARE CAPITAL
or
Net Worth
RESERVES & SURPLUS -2 or
Internal Equity
GENERAL RESERVE
P/L A/C (RETAINED CURRENT
EARNING) ASSETS
1 +2+3 =
LONG TERM DEBTS -3 Long term Funds
Or
LOAN ON MORTGAGE
Total Investment
BANK LOAN
Or
DEBENTURES Capital Block

CURRENT LIABILITIES -4 3+4= External Equity
21

USING RATIOS TO MAKE
BUSINESS DECISIONS
Liquidity ratios: Measuring a company’s ability to
pay current liabilities. The main liquidity ratios
are:
 Current ratio

 Quick ratio

 Working capital

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CURRENT RATIO
 The current ratio
 Is current assets divided by current liabilities
 Measures the ability of the company to pay current
liabilities with current assets

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The current ratio of Oil India Limited, for 2005,:

OIL’s Current Ratio

Formula 2005
Current assets 352173.18
Current ratio = = 4.03
Current liabilities 87196.26

In most industries a
current ratio of 2.0 is
considered good

In general, a higher current ratio indicates a stronger financial position
In general, a higher current ratio indicates a stronger financial position
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ACID TEST RATIO
 The acid-test (or quick/ liquid) ratio
 Indicates whether the entity could pay all its
current liabilities if they came due immediately
 Is computed by dividing cash, short-term
investments, and net current receivables (accounts
and notes receivable, net of allowances) by current
liabilities

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The acid-test ratio of Oil India Limited, for 2005,:

OIL’s Acid-Test Ratio

Formula 2005
Cash + short-term
Acid-Test ratio = investments + net 326094.96
current receivables
= 3.73
Current liabilities 87196.26

An acid-test ratio of 0.90
to 1.00 is acceptable in
most industries

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Working Capital

Working capital is defined as follows:

Working capital = Current assets - Current liabilities

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Working Capital

 Working capital is widely used to measure a
business’s ability to meet its short-term
obligations with its current assets
 The larger the working capital, the better able
is the business to pay its debts

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MEASURING A COMPANY’S
PROFITABILITY
Measure the degree of operating success of a
company in the accounting period. The main
profitability ratios are:
 Rate of return on net sales
 Rate of return on total assets
 Rate of return on common stockholders’ equity
 Earnings per share of common stock

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RATE OF RETURN ON
NET SALES
 The rate of return on net sales shows the
percentage of each sales earned as net income

 The higher the rate of return, the more net sales
are providing income to the business and the
fewer net sales are absorbed by expenses

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The rate-of-return-on-sales ratios for OIL’s is calculated
as follows:
OIL’s Rate of Return on
Sales
Formula 2005

Rate of return PBT 155522
on sales = = 40.77%
Net Sales 381374.43

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RATE OF RETURN ON
TOTAL ASSETS
 The rate of return on total assets (return on
assets) measures a company’s success in using
its assets to earn a profit
 The sum of interest expense and net income in
the numerator is the return to creditors and
shareholders who have financed the
company’s operations

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Computation of the return-on-assets ratio :

Formula

Rate of return EBIT
on assets =
total assets

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RATE OF RETURN ON COMMON
STOCKHOLDERS’ EQUITY
 Rate of return on stockholders’ equity (return
on equity)
 Shows the relationship between net income and
common stockholders’ investment in the company
 Is calculated by dividing net income available to
common stockholders by the average stockholders’
equity during the year

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The rate of return on common stockholders’ equity is
calculated as follows:

Formula
Rate of return Net Preferred
on common income - Dividends
stockholders’ = common
equity stockholders’ equity

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EARNINGS PER SHARE OF
COMMON STOCK
 Earnings per share (EPS) is
 The amount of net income per share of the
company’s outstanding common stock
 Computed by dividing net income available to
common stockholders by the number of common
shares outstanding during the year

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Computation of the firm’s EPS is as follows:

Formula

Earnings Net Preferred
per share income - Dividends
=
of common Number of shares of
stock common stock
outstanding

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 Overall Profitability analysis
1).Return on Propritors fund
=PAT / Propritors fund
2). Return on equity capital
= PAPD / Equity capital
3). Return on total investment
= EBIT / Total investment
4). Return on Total assets
= EBIT / Total assets
All above are in percentage(%)
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Activity Ratios
 These ratios are presented company’s ability to
sell inventory and collect receivables. The
main activity ratios are
 Inventory turnover
 Accounts receivable turnover
 Days’ sales in receivables

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INVENTORY TURNOVER
 Inventory turnover is
 A measure of the number of times a company sells
its average level of inventory during a year
 Computed by dividing the cost of goods sold by
the average inventory for the period

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INVENTORY TURNOVER
 A high rate of turnover indicates relative ease
in selling inventory; a low turnover indicates
difficulty in selling
 In general, companies prefer a high inventory
turnover
 Inventory turnover varies widely with the
nature of the business

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The Inventory turnover ratio of Oil India Limited, for
2005,:
OIL’s’ Inventory
Formula Turnover

Cost of goods sold 218337.71
Inventory turnover =
Average inventory 24113.67 = 9.05

OIL’s turnover of 9.05 times a year is high for its industry, which has an
OIL’s turnover of 9.05 times a year is high for its industry, which has an
average turnover of 5.00
average turnover of 5.00

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ACCOUNTS RECEIVABLE
TURNOVER
 Accounts receivable turnover
 Measures a company’s ability to collect cash from
credit customers
 Is computed by dividing net sales by average net
accounts receivable
 The resulting ratio indicates how many times during the
year the average level of receivables was turned into
cash

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ACCOUNTS RECEIVABLE
TURNOVER
 In general, the higher the ratio, the more
successfully the business collects cash and the
better off its operations

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OILs’ accounts receivable turnover ratio for 2005 is
computed as follows:
OIL’s Accounts
Formula Receivable Turnover
Accounts
Net credit sales 381374.43
receivable = = 6.65
turnover Average net
accounts receivable 57272.03

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DAYS’ SALES IN
RECEIVABLES
 The days’-sales-in-receivables ratio tells
 How many days’ sales remain in Accounts
Receivable
 Is computed by a two-step process
 First, divide net sales by 365 days to figure the average
sales amount for one day
 Second, divide this average day’s sales amount into the

average net accounts receivable

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OIL’s Sales in Accounts
Formula Receivable

Days’ sales in 360
360
average accounts = = 54 days
receivable Accounts receivable 6.65
turnover

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Leverage Ratios-measuring a company’s
ability to pay long-term debt
 Two indicators of a business’s ability to pay
long-term liabilities are the
 Debt- Equity ratio
 Proprietary Ratio

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DEBT EQUITY RATIO
 Debt Equity Ratio= External Equity
-------------------
Internal Equity
External= Long term debt + current liability
Internal= Share Capital + Res.& Surplus
 The lower the ratio it means that the Co. has

borrowed more from internal resources and
there is a large extent up to which the Co. can
borrow from external resources.
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Proprietary Ratio
 Proprietary or Equity Ratio= Proprietor fund
-------------------
Total Assets
Proprietor fund is also knows as NetWorth
This ratio depicts that how much is the net worth
of the company in term of total asset of the
company.

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ANALYZING A COMPANY’S
STOCK AS AN INVESTMENT
 Investors purchase stock to earn a return on
their investment, which consists of two parts:
 Gains (or losses) from selling the stock at a price
that differs from the investors’ purchase price
 Dividends, the periodic distributions to

stockholders
 Return= ending price-beg. Price +dividend

______________________________________
Beg. price
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PRICE EARNINGS RATIO
 The price earnings ratio is the ratio of the
market price of a share of common stock to the
company’s earnings
 PE= MP/ EPS
 Simply tells how much the investor is
willing to pay the on 1 Rs. Earning
for the share.
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DIVIDEND YIELD
 Dividend yield is the ratio of dividends per
share of stock to the stock’s market price per
share
 This ratio measures the percentage of a stock’s
market value that is returned annually as
dividends

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LIMITATIONS OF
FINANCIAL ANALYSIS
 Ratios have their limitations
 Financial analysis may indicate that something is
wrong, but it may not identify the specific problem or
show how to correct it
 Managers must evaluate data on all ratios in the light
of other information about the company

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LIMITATIONS OF
FINANCIAL ANALYSIS
 Ratios should be analyzed over a period of
years
 Any one year, or even any two years, may not
be representative of the company’s
performance over the long term

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EFFICIENT MARKETS,
MANAGEMENT ACTION,
AND INVESTOR DECISIONS
 An efficient capital market is one in which
market prices fully reflect all information
available to the public
 Because stocks are priced in full recognition of
all publicly accessible data, it can be argued
that the stock market is efficient

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EFFICIENT MARKETS,
MANAGEMENT ACTION,
AND INVESTOR DECISIONS
 This means that managers cannot fool the
market with accounting gimmicks
 For investors, an appropriate strategy seeks to
manage risk and diversity.
 The role of financial statement analysis
consists mainly of identifying the risks of
various stocks to manage the risk of the overall
investment portfolio

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Thanks

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Measuring financial performance 4

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