Analysis Presentation for External Users

ACCOUNTING AS A TOOL FOR BUSINESS DECISION

MAKING

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Quality Decision

requires

Quality Data

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INFORMATION DEPENDABILITY

For analysis we need data , so we to decide

1What data is required?

2Whether the decision maker is:

inside user or outside user?

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Internal Users

DirectorsOperating Managers

like marketing inventory

Internal Auditors

USERS INFORMATIONA

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Acc

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External Users

ShareholdersCustomers Bankers

Tax authorities

The external users have to depend

on financial statements and annual report to judge operating efficiency, financial condition and future prospects.

DECISION MAKING FOR EXTERNAL USERS

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• What are the usual steps for Decision Making ?

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DECISION MAKING FOR EXTERNAL USERS (2)

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• Before moving to Step A to B, we need another step i.e.

• Before reaching to conclusion based on analysis we need to consider

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• Understanding of the following helps the users of the financial statements to improve their reading ability and understanding of the financial information:

– Concepts and assumptions for preparation of financial statements like Going Concern , Accrual etc

– Understanding of Generally Accepted Accounting Standards like IFRS and IAS

– Statuary requirements for preparation– Terminologies used in Financial Statements – Annual Report

HOW CAN ONE IMPROVE READING ABILITY AND UNDERSTANDING OF FINANCIAL INFORMATION ?

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• Techniques to analyze– Horizontal – Vertical Analysis– Common-size Financial Statements – Ratio Analysis

• Broad Categories of Financial Ratios– Liquidity – Assets Efficiency – Profitability– Market ratios– Capital Structure

• Analysis of Cash flow Statements

ANALYSIS OF FINANCIAL STATEMENTS

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NON-FINANCIAL FACTORS AFFECTING ANALYSIS WHICH ARE NOT PART OF FINANCIAL STATEMENTS

Within Annual Report

• Auditors’ Report • Directors’ Report

Outside Annual Report

• Government policy, • Currency devaluation,• Change in products’ fashion etc.

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RELEVANT RATIOS FOR VARIOUS EXTERNAL USERS OF FINANCIAL STATEMENTS

• Creditors– Liquidity– Profitability– Cash flow analysis

• Banker– Debt Equity– Interest Coverage– Liquidity– Profitability

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Employees• Profitability growth

Shareholders• Dividend yield, • Dividend payout , EPS• Liquidity • Cash Flow Analysis

DECISION MAKING FOR INTERNAL USERS

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Relevant ratios for various internal users

• Marketing & Sales Manager– No of days in Account Receivable and Receivable turnover– Sales v/s Profit– Sales v/s Expenses

• Inventory Manager– No of days in Inventory– Inventory turnover

• Production Manager– Input v/s output ratio– cost of sales v/s sales

• Are these ratios and analysis based on financial statements enough for internal users?

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DECISION MAKING FOR INTERNAL USERS (2)

THE ANSWER IS

NO

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DECISION MAKING FOR INTERNAL USERS (2)

IFAC has published an article “THE ROLE OF CFO IN 2010” .This contains interviews of leading CFOs of international companies. One of the interviews is of CFO of SEIMENS Mr Heinz-Joachim whose observation is as follows:

“ACCOUNTING IS GOING TO BE LESS RELEVENT, BUT TO KEEP A COMPANY AFLOAT IN DIFFICULT TIMES , TREASURY AND CASH ARE THE IMPORTANT THINGS , NOT BOOK PROFIT.”

Cash Flow- LATEST VIEWSAnalysis of Financial Statements by External and Internal Usersfor Business decision Making

The word ANALYSIS is a noun and its verb is ANALYSE which means:

“to examine in detail in order to discover meanings”

ANALYSIS OF FINANCIAL STAEMENTS

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Analysis of financial statements is the process of: arranging, manipulating and comparing the results in order that users may make their decisions...


Analysis of financial statements help provide answers to questions concerning specific issues and insights into the operations of a business enterprise.


Analysis of financial statements can help in learning about a company’s

strength, weakness, emerging problems, operating efficiency, profitability etc.


Business managers may require to do some analysis of financial data to take help for efficient decisions making.


These analysis may include :

• Cash flow statement review• Liquidity review • Efficiency of receivable and

inventory management• Profitability and • Capital structure review.


INTERPRETATION PROCESS

• Identification of the recipient of the analysis;• An understanding of the nature of the business,

industry and organization;• Identification of sources of data for analysis;• Numerical analysis of the data available;• Interpretation of the results of the analysis;• Writing the report detailing the analysis of the

results and recommendations.

MATERIAL NEEDED FOR ANALYSIS

• Profit and loss account data for a number of years;

• Industry-wide ratios and benchmarks;

• Balance sheet data for a number of years;

• Budget data, and variance analysis;

• Data regarding a competitor, potential subsidiary, or customer applying for credit

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To help me interpret our financial statements, I

use several standards of comparison.

Intracompany

Intercompany

Industry

Guidelines

Benchmark for Comparison

1. Comparative financial statements:a. Horizontal analysis (Trend % are a form

of horizontal analysis)b. Vertical analysis (reveals the

relationship of each statement item to a specified base)

2. Common-size financial statements (reports only in percentages.)

3. Ratio analysis

TECHNIQUES TO ANALYSE

• Sales Rs 1000 100%• Cost of Goods Sold 650 65%• Gross Profit 350 35%• Administration Exp 100 10%• Marketing Expenses 150 15%• Financial Charges 50 5%

300 30%• Net Profit 50 5%

Example of Vertical Analysis of P/L

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Time

Now, let’s look at some ways to use horizontal analysis.

Horizontal Analysis

The term horizontal analysishorizontal analysis arises from left-to-right (or right-to-left) movement of

our eyes as we review comparative financial statements across time.

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The study of percentage changes in comparative statements is called horizontal analysis. It is more useful to know that sales have increased by 20 percent than to know that the increase in sales is $20,000.

It compares the financial data of a single company over several years.

Horizontal Analysis

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An extract of balance sheet :Year Year %‘98 ‘97 Inc/Dec

Fixed Assets 1000 800 + 25%Current AssetsStocks 350 700 - 50%Receivable 200 300 - 33%Cash at Bank 250 200 - 25%

800 1200 -33%Total Assets 1800 2000 - 10%

Example –Horizontal Analysis of Balance Sheet

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CLOVER CORPORATIONComparative Balance Sheets

31-Dec

2004 2003Dollar

ChangePercent Change

AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200

Total current assets 155,000$ 164,700$

Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000

Total property and equipment 160,000$ 125,000$

Total assets 315,000$ 289,700$

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Calculate Change in amount

RupeeChange

Analysis Period Amount

Base PeriodAmount= –

Since we are measuring the amount of the change between 2003 and 2004, the

Rupee amounts for 2003 become the “base” period amounts.

Comparative Statements

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Calculate Change as a Percent

PercentChange

Rupee Change Base Period Amount

100%= ×

Comparative Statements

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31-Dec

2004 2003Dollar

ChangePercent Change*

AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200

Total current assets 155,000$ 164,700$

Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000

Total property and equipment 160,000$ 125,000$

Total assets 315,000$ 289,700$

* Percent rounded to first decimal point.

(Rs11,500 ÷ Rs23,500) × 100% = 48.9%

Rs12,000 – Rs23,500 = Rs(11,500)

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31-Dec

2004 2003Dollar

ChangePercent Change*

AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 20,000 50.0 Inventory 80,000 100,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1,800 150.0

Total current assets 155,000$ 164,700$ (9,700)$ (5.9)

Property and equipment: Land 40,000 40,000 - 0.0 Buildings and equipment, net 120,000 85,000 35,000 41.2

Total property and equipment 160,000$ 125,000$ 35,000$ 28.0

Total assets 315,000$ 289,700$ 25,300$ 8.7

* Percent rounded to first decimal point.

TREND PERCENTAGES

Trend % are a form of horizontal analysis.It is necessary to look at the trends, generally 3 to 5years’ to ascertain how the firm’s performance is changingover time and to diagnose trends that indicate the magnitude,timing or risk of the firm’s future out look. And its comparison with industry in which it operates.

Trend percentages are computed by selecting a base year,with each amount during that year set equal to 100 percent.The amount of each year expressed as a percent ofthe base amount.

Common size statementThe percentages presented as a separate statement that reports only percentages (no rupee amounts). Such a statement, called a common-size statement, is a type of vertical analysis.

EXAMPLE Percent of Total Assets19X7 19X6

Current assets :Cash ………………………………….. 3.7% 5.0%Accounts receivable, net …………….. 14.5 13.2Inventories …………………………… 14.3 17.2Prepaid expenses…………………. .8 1.2Total current assets …………………... 33.3% 36.6%Investment advisory services report common-size statements for various industries, and analyst use them to compare a company with its competitorsand with the industry average.

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Case Study

Prepare Vertical, Horizontal analysis and common size statement for Profit and Loss account of any company

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Using key relations among financial statement items

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Why ratios ?

• Figure appearing in Financial Statements normally does not convey any meaning

unless its relation is seen with some other figure.

• Example: Distribution cost may look too high or low but when it is compared with sales it will suggest some purposeful meanings and then this percentage is compared with industry trend.

• A ratio can be computed from any pair of numbers.

• Ratios are generally not significant of themselves but assume significance when they are compared with :1. Previous ratios of the same company2. Some predetermined standard or budget3. Ratios of other enterprises in the same industry

or4. Ratios of the whole industry within which the

company operates

Ratio Analysis

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• Ratios are not ends in themselves but help provide answers to questions concerning specific issues and insights into the operations of a business enterprise.

• Ratios be used with caution and should not be the sole basis for decision-making. They should be treated as additional evidence (not conclusive evidence) leading to a decision or solution.

Ratio Analysis ..II

• RATIO provide questions rather than the answers while they are tools which can help managers to make better financial decisions, they should form part of an overall business judgment based on many additional factors.

Ratio Analysis ..III

An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgments about the future. Nothing could be further from the truth. Conclusions based on ratio analysis must be regarded as tentative in nature.

The need to look beyond ratios

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Ratios should not be viewed as an end, but rather they should be viewed as a starting point, as indicators of what to pursue in greater depth. They raise many questions, but they rarely answer any questions by themselves.

In addition to ratios, other sources of data

should be analyzed in order to make judgments about the future of an organization.


The analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself.

A recent change in a key management position, for example, might provide a basis for optimism about the future, even though the past performance of the firm (as shown by its ratios) may have been mediocre.



• Market size and growth, possibility of substitution of other products, and industry prospects;

• Competitors’ shares of the market, competitors’ manning levels, wage rates and productivity the extent of spare capacity in the industry, economic forecasts for the industry as a whole and relevant financial analysis and press reports;

Limitation of Ratio Analysis

1. Ratios reflect past conditions (not future)2. Ratios reflect book values, not current cost or

realizable value.3. The computation of ratios is not completely

standardized.4. The application of accounting principles and

policies varies among companies.5. Inter company comparisons are difficult when

companies are diversified or have different risk characteristics.

Ratios

1. Please refer page 71 to 74 for the master list of ratios

2 And page 128 and 129 for the live

example of FFCL ratios and page 20 of Siemens

Ratios Categories

– Liquidity – Assets Efficiency – Profitability

– Market ratios

– Capital Structure

Liquidity Ratios

• It reflect short term financial strength or solvency

• Liquidity implies an ability to convert assets its cash or to obtain cash.

Liquidity Ratios

•Liquidity and certain areas of operating activity are dependent upon the working capital position ,and their evaluation through ratio is useful in knowing certain trends and relationships involving various aspects of the operating cycle of a business

Liquidity Ratios

•Working capital–is the excess of current assets over current liabilities

–the amount of and changes in working capital from period to period are significant measures of a company’s ability to pay its debts as they mature.

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CurrentRatio

Current Assets Current Liabilities

=

This ratio measures the short-term debt-paying ability of the company.

Current Ratio

CurrentRatio

Rs65,000Rs42,000

= = 1.55 : 1

Liquidity Ratios .. IICURRENT RATIO or WORKING CAPITAL RATIO

• It express the relative relationships between current assets and current liabilities.

• FORMULA: Current ratio = Current assetsCurrent

liabilities• Current Liability is paid from current assets ,not from

selling fixed assets.• A very low current ratio is an indication of cash flow

problems.• An excessively high current ratio could suggest that the

company is not managing its current assets like Debtors and Inventory properly.

• A rule of thumb suggests that 2:1 ratio is satisfactory, but minimum it should be 1:1

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Quick assets are Cash, Short-Term Investments,and Current Receivables.

This ratio is like the currentratio but excludes current assets such as inventories and prepaid expenses that may be difficult to

quickly convert into cash.

Acid-Test Ratio

Quick AssetsCurrent Liabilities

=Acid-TestRatio

Rs50,000Rs42,000

= 1.19 : 1=Acid-TestRatio

Liquidity Ratios .. III

ACID – TEST RATIO or QUICK RATIO• Formula: Acid – test ratio = Quick Assets

Current Liabilities

• It is a quick measure of the debt paying ability• Quick assets = Cash, Bank balances, Marketable

Securities and Accounts Receivables• Inventories and prepaid expenses are not considered

quick assets because they may not be easily convertible into cash .But if we look at our culture ,debtors are less liquid then stocks.

• A rule of thumb for the quick ratio is suggested as 1:1

Liquidity Ratios .. IV

CASH RATIO OR SUPER QUICK RATIO

• It is a more severe test of liquidity than acid test ratio

• Formula: Cash Ratio = Cash + marketable Securities

Current Liabilities

Liquidity Ratios .. V

WORKING CAPITAL TURNOVER• Working capital has special relationship to sales,

especially through accounts receivable, inventory, and cash.

• The ratio of sales to working capital can be used as a measure of the effectiveness of a company’s use of working capital to generate sales.

• Working capital turnover = Net sales Average working Capital

• It is concerned with measuring the efficiency in current assets management

• It is used to evaluate a company’s operating cycle

Assets Management RatiosActivity / Turnover / Efficiency/Performance Ratios

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Accounts Receivable

Turnover

Accounts Receivable

Turnover

Inventory Turnover

Inventory Turnover

Days’ Sales Uncollected

Days’ Sales Uncollected

Days’ Sales in Inventory

Days’ Sales in Inventory

Total Asset Turnover

Total Asset Turnover

Efficiency Ratios

INVENTORY RATIOS• It indicates the number of times inventory is replaced during

the year or how quickly the goods are sold• It is a test of efficient inventory management.• The inventory turnover ratio establishes the relationship

between the volume of goods sold and inventory. • The inventory turnover for business in different industries and

within industries can vary widely. A grocery store may have an average turnover of 20, for all items. A furniture store would normally have a much smaller turnover.

• Formula: Inventory turnover = Cost of goods sold Average inventory


BENIFITS OF HIGH INVENTORY TURNOVER 1. Operating effectively as far as inventory is concerned

(purchasing, receiving, storing, selling)2. Investment in inventory is reduced3. The operating cycle (converting inventory to cash )is

shortened, 4. Less opportunity for the inventory to become obsolete5. Saving in storage cost and financial chargesDISADVANTAGES an excessive high inventory turnover may suggest that the

company is not keeping sufficient inventory to meet sales requirements resulting in stock outs and unhappy customers.


LOW INVENTORY TURNOVER INDICATES :

1. Slow Sales

2. High carrying cost for Inventory

3. Weak cash flow prospects

4. Exposure to future financing problems


NO OF DAY IN INVENTORY

• Formula = No of days in a year Inventory turnover

• This ratio may be useful to assess:(i) future expiry of inventories and (ii) stock out position.

• How many no of days inventory is to be kept depends on lead time to order & management policy for inventory investment.


INPUT – OUT PUT RATIO

• Technique to evaluate yield

• In a manufacturing concern standard yield is compared with actual Input-Output ratio

• Example : sugar and pharmaceutical industry.



ACCOUNTS RECEIVABLE RATIOS• The accounts receivable turnover ratio

expresses the relationship between credit sales and accounts receivable.

• Turnover refers to how often the average receivables were collected during the period.

• Formula: Accounts Receivable turnover

= Net credit sales

Average accounts receivable


HIGH ACCOUNTS RECEIVABLE TURNOVER RATIO reflects that the receivable are being :

• Effectively managed• Fewer resources are invested in receivables• Better credit policies• Better collection practices• Last but not least, it reflects that demand of the

company’s product and services is good. Naturally if the products or services are not up to mark then it will effect all viz sales , collection , credit policy etc.


NO OF DAYS’ SALES IN RECEIVABLES• Formula:

Collection period = Days in a year Accounts Receivable

Turnover• Number of days sales is compared with

Company’s credit term and industry’s normal credit terms.

• It also help in knowing age of receivables (which helps in credit control and avoid bad debts )


ASSETS TURNOVER • It indicates how efficiently assets are used to

achieve sales.• The higher ratio indicates that the assets are

more effectively used to generate sales .• Its comparison with other company in the same

industry provides meaningful data is to how efficiently the management using the assets to generate sales.

• Formula : Assets Turnover = Sales Average total assets

• Formula Payables to Purchases = A/c Payable

Purchases Average day’s purchase = Purchases

Days Day’s purchases in payables = A/Cs Payable

average day’s purchases

• The day’s payable ratio is useful when compared to the credit terms given by suppliers. If the average day’s payables is increasing, it could mean that trade credit is being used increasingly as a source of funds.


OPERATING CYCLE OF A BUSINESS• Formula = No of days Sales in receivable

+ No of days in Company’s inventory - No of days purchases in creditors

• Operating cycle indicates no of days the Company’s cash is tied up in inventory & receivables

• A Company with a short operating cycle typically requires only a small amount of working capital

• It helps in assessing working capital requirements


Ratio To Analyze Sales/number of calls Response per callTravel expense/days Cost awarenessSelling expenses/sales Response per selling effortSales/sales orders Sales efficiencyNumber of calls/days Sales effort

These ratios are useful in developing trend information and an overall picture of the company’s sales efforts

We can see the relation of sales with various expenses and other marketing activities, as there may be many other ratios depending upon the need of the company.


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Profit Margin

Profit Margin

Gross Margin

Gross Margin

Return on Total Assets


Basic Earnings per

Share

Basic Earnings per

Share

Book Value per Common

Share

Book Value per Common

Share

Return on Common

Shareholders’ Equity

Return on Common


Profitability

Profitability

• Profitability is the ability of the Company to generate earnings

• Concerned Person– Shareholder

• Dividend• Rise in Stock Market & avail Capital Gain

– Creditors/Bankers • Profits are source of funds for debt • Coverage & repayment on due dates

• Absolute profit figures are meaningful when it is measured with sales, capital Employed, Productive assets

• Profitability ratios have been developed to measure operational performance.

Profit Margin on Sales

Formula-1 = Net income Net sales

• This ratio reflect the ability of the Company to control costs and expenses in relation to sales

Formula- 2 = Gross Profit Net sales

• GP ratio is important for Tax Authorities and also for management of the company to know the efficiency of sales and cost pricing

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This ratio is indicates how company’s resources were used in generating profits

Return onTotal Assets

Net Income Average Total Assets

=


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Return on Common


Net Income - Preferred Dividends Average Common


=

This measure indicates how well the company employed the owners’

investments to earn income.

Return on Shareholders’ Equity

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Return on Stockholders’ Equity

• Return on stockholders’ equity indicates management’s success or failure at maximizing the return to stockholders based on their investment in the company.

• This ratio emphasizes the income yield in relationship to the amount invested.

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This measure indicates how muchincome was earned for each share of

common shares outstanding.

Basic Earnings

per Share

Net Income - Preferred DividendsWeighted-Average Common

Shares Outstanding

=

Basic Earnings per Share

EPS is disclosed below the P/L A/c

Return on Investments

• Many analysts Consider return on investment (ROI) one of the most important ratios for evaluating profitability because it relates earnings to investment. Return on investment can be computed on the following bases:

1. Total assets

2. Shareholders’ equity

3. Comprehensive basis

Return on Investment

• Formula :• ROI = Capital Turnover x Profit Margin

= Sales x Net income

Capital employed Sales

• It is a comprehensive measure of financial performance

Condensed Income Statement

Sales $1,000,000Less: Costs and expenses $800,000Net income $200,000

Balance Sheet

Working capital $100,000Plant and equipment $300,000Total assets (Capital employed) $400,000

Capital Turnover (Sales / Capital employed) 250%

Profit Margin (Net Income / Sales) 20%

ROI (Capital Turnover x Profit Margin) 50%

Activity / Turnover / Efficiency Ratios ..V

Capital Employed Turnover

• Capital turnover is the ratio of sales to capital employed in generating the sales

• Capital turnover is a measure of the use of assets in relation to sales

• Capital employed can be either – Working Capital – Total assets

Investment Turnover Ratio / Assets Turnover Ratio

Formula = Net Sales Average Total

Assets

• This ratio also measures the effectiveness with which management used available resources in relation to sales

Advantages of ROI Analyses

1. Focuses management’s attention upon earning the best return on total assets.

2. Serves as a measure of management’s efficiency and effectiveness.

3. Integrates financial planning, budgeting, sales objectives, cost control, and profit-making activities.

4. Provides a basis for comparing companies.5. Provides a motivational basis for management.6. Identifies weaknesses in the utilization of assets.

MARKET RATIOSPrice Earning Ratios (P/E)

• P/E is often referred to as the Market Capitalization ratio.

• P/E is used to measure the relationship between the market value of shares and earnings.

• P/E reflects to some extent the growth potential of a company and the market’s evaluation of the firms’ earning.

• P/E ratio express what the market is willing to pay for every single rupee

• P/E increasing ratio is generally considered a favorable growth indicator

Formula : MV of Ordinary Shares EPS• For buying shares the PE ratio differs from company to

company and market situation.

Dividend per Share

It reflects the dividend distributed per share

Formula = Dividend

No Ordinary Shares

Dividend Yield

It is a measure to calculate total return

Formula = Dividend per share

M/V of Ordinary Shares

Dividend Payout Ratio

• It indicates the income available to Ordinary Shareholders that has been distributed as dividend.

• It reflects the dividend policy and to some extent management’s perceptions regarding the uncertainties associated with future earnings.

Formula-1 = Cash DividendNet Income – Preference Shares’ Dividend

Formula 2 = Dividend on Ordinary Shares EPS

Other Analyses1. Additional ratios are available to evaluate specific areas of

profitability related factors.

2. The ratio of selling, general, and administrative expense to sales provides some information concerning the effectiveness of cost control efforts undertaken by the company as well as management’s efficiency of managing operating expenses in relationship to changing sales volumes.

3. Trend analysis is particularly useful in identifying areas of strength or weakness; any significant fluctuations in the trend should be investigated

4. The ratio of advertising to sales is especially useful in evaluating consumer-oriented enterprises. Inter-company and industry comparisons are especially relevant in such situations.

Other Analyses

5. Operating profit per unit of capacity or service, such as per room for hotels or per bed for hospitals, indicates the profitability of available physical resources and compares operations of different sizes.

6. Productivity ratios attempt to measure both output and input in physical volumes, thus eliminating the impact of price changes.

Productivity ratios are usually set up as follows:Output (physical goods or services

quantified) Input (direct labor hours or machine

hours)

Capital Structure and Insolvency Ratio

• The capital structure of an enterprise consists of debt an equity funds.

• The sources and composition of the two of capital determine to a considerable extent the financial stability and long –term solvency of the firm.

• Equity capital is risk capital, and the return on investment to invertors is subject to many uncertainties.

• Debt is paid is paid on a specified date, usually with interest.• There is no ideal capital structure common to all firms.• In general, a firm should not have a heavy amount of long-term

debt and preferred stock in relation to common stock and retained earnings.

• Companies with only common stock capitalization can be attractive to both investors and creditors because there are no prior claims ahead of the common.

CAPITAL STRUCTURE RATIOEquity to Total Liabilities

• The relationship of equity to total liabilities is an important measure of capital structure of a business.

• The enterprise is less vulnerable to declines in business or the economy, the cost of carrying debt is reduced, and the company should be able to meet its obligations more easily.

Formula Equity to total liabilities = Shareholders’ equity

Total liabilities

Debt to Equity Ratio

• This ratio measures the amount of leverage used by a company.

• It measures the number of times the shareholders capital has been leveraged by the use of debt.

• A highly leveraged company involves a substantial use of debt and a limited use of equity.

• This ratio is an indicator of creditors’ risk.

Formula Debt to equity ratio = Total liabilities

Shareholders’ equity

Shareholders’ Equity to Total Assets

• The shareholders equity to total assets ratio measures the proportion of the firm’s assets that are provided or claimed by the shareholders.

• If the shareholders’ equity is a small proportion of total assets, the firm may be viewed as being financially weak, because the shareholders would be viewed as having a relatively small investment in the firm. On the other hand, a high ratio of shareholders’ equity to assets can represent a relatively large degree of security for the firm, but it also indicates that the firm is not highly leveraged.

Formula

Equity to Total Assets Shareholders’ equity Total assets

Number of Times Interest Earned

• The number of times interest is earned ratio is a measure of the debt position of a firm in relation to its earnings.

• The ratio indicates the company’s ability to meet interest payments and the degree of safety available to creditors.

Formula

Times interest earned = Income before taxes & interest charges

Interest Charges

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Book Value per

Common Share

Shareholders’ Equity Applicable to Common Shares

Number of Common Shares Outstanding

=

This ratio measures liquidation at reported

amounts.

Book Value per Common Share

• Book value per share is a figure that represents what the shareholders would receive for their shares of ownership if the corporation were liquidated without gain or loss (i.e. based on going concern concept basis).

Formula Common stockholder’s equity

---------------------------------------------- Number of common shares outstanding

Book Value per Share or Break up Value per Share

Concept Review TestFill in the correct answer from choices given:

1. Cash flow statement classifies cash flow during the period from operating, __________ and financing activities.

a) non-operating b) investing c) working capital

2. Auditors’ Report of a listed company is addressed to _______ .

a) Directorsb) Chief Executivec) Members

3. The relationship of current assets and current liabilities is an indicator of a firms’ ______________ positions.

a) Financialb) liquidc) profitability

4. EPS is widely used in judging the ________ performance

a) Operatingb) Leveragec) ROI


5. Dividend yield = Dividend per share / _______________

a) Face value per share

b) Market value per share

c) Net Income per share


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Case studies

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Discussion on relevant ratios for various users of financial statements

INTERNAL USERS

Marketing & Sales Manager

No of days in Account Receivable and Receivable turnover

Product wise profitability ratio

Key sales and profit contributing products( 80 / 20 rule )

Inventory Manager

No of days in Inventory ,

Inventory turnover

Production Manager

Input vs output ratio

Yield / wastage ratio vs standard and industry trend

Database – Labour efficiency ratio

105

Discussion on relevant ratios for various users of financial statements

EXTERNAL USERS

Creditors

Liquidity

Profitability

Cash flow analysis

Banker

Debt Equity , Interest Coverage

Liquidity , Profitability

Employees

Profitability growth

Shareholders

Dividend yield, Dividend payout , EPS

Liquidity , Cash Flow Analysis ,PE

106

The comparison of two years data of a company are as follows.(matter of concern ,A/C Receivable has increased by 20%) 2001 2002

Sales Rs. 1,200,000 Rs. 1,560,000Accounts receivable 100,000 120,000Turnover ratio 12 14.2Days’ sales outstanding 30 28Credit terms 30 days Required: Evaluate this information and advise effectiveness of

receivable management

Case Study – IAccount Receivable Ratio

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The following information is available for a small manufacturing company:

(matter of concern ,Inventory has increased by 42%)

2001 2002Sales Rs. 1,200,000 Rs. 1,560,000Inventory 200,000 284,000Cost of goods sold 881,000 1,000,000Inventory turnover 4.4 4.1Days in inventory 83 89

Required: Comment on the above trend from the point of view of

inventory management.

Case Study – II Inventory Ratios

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Mr Rick Burrock, the managing director of an accounting company based in Minneapolis, advises his small business clients to keep a tight rein on credit extended to customers. “You need to convey to your customers, right from the beginning, that you will work very hard to satisfy them and that in return, you expect to be paid on time. Start by investigating all new customers. A credit report helps, but with a business customer you can find out even more by requesting financial statements….. Using the balance sheet, divide current assets by current liabilities to calculate the current ratio. If a company’s current ratio is below 1.00 it will be paying out more than it expects to collect; you may want to reconsider doing business with that company or insist on stricter credit terms.”

Source: Jill Andresky Fraser, “Hands on Collections: Get paid Promptly,” Inc., November 1996, p. 87.

Required: Comment on above based on your practical experience.

Case Study – IIIBusiness Focus

109

M/s Tycon Corporation was formed in 1985 with a share Capital Rs.10 million to start the business of chemical manufacturing and sales. The land, building and machinery cost was Rs.15 million. Therefore sponsors financed shortage of Rs.5 million from acquiring long term loans for GBL Financing Corporation at 8% interest per annum. Now in order to operate the business activities working capital funds were required to finance inventory and receivables.

You are required to submit your proposal for working capital requirement to one of bankers based on following information.

The company generally pays its suppliers six weeks after receiving an invoice, while its debtors usually pay within four weeks of invoicing. Raw materials stocks are held for a week before processing which takes three weeks, begins. Finished goods stay in stock for an average of two weeks.The size of weekly investment in inventory or receivable is Rs.500,000.

Case Study – IV Operating Cycle

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The main cost of offering credit is the interest expense and of course risk of bad debts . How can we assess the effect on profit?

Beeta Company sells Toys for Rs 1,000 which enables it to earn a profit, of Rs 100. The customer does not pay until a year. Beeta relies on overdraft finance, which costs 10 % pa. The effect is:

Net Profit on sale of Toys Rs 100

Interest cost overdraft Rs 1,000 x 10% pa (100)

Real profit after 12 months credit Nil

The entire profit margin has been wiped out in 12 months because of delayed payment.

CASE STUDY-VEffect on Profit for Extending Credit

111

If customer paid after six months, the effect would be:

Net Profit Rs 100

Interest cost overdraft cost (Rs 1000 x 10% pa x 6/12 months) ( 50)

50 Half the profit has been wiped out.

---------------------------------------------------------------------------------------------------------

• If the cost of borrowing is 18%, then the profit would be absorbed before seven months had elapsed.

• If the net profit is 5% and borrowing costs were 15%, the interest expense would exceed the net profit after four months.

CASE STUDY-VEffect on Profit for Extending Credit

112

Based on following data complete the Balance Sheet

RATIOS:Current ratio 1.6 , Long term debt to equity is 40%, shareholders’ equity is Rs 50,000, Total assets turnover is 3 times. Inventory turnover to cost of sales is 8 times,credit sales to total sales 80% , average collection period is 18days (360days a year).Gross profit at 20% is Rs 20,000/=

HEADS OF B/SCASH+DEBTORS+INVENTORY+FIXED ASSETS= CREDITORS+LONG TERM LOAN+EQUITY

Case Study –VI

113

A company’s annual sales is Rs 8 million with a gross profit on cost of 60%. It normally pays creditors two months after purchases are made, holding month’s worth of stock. It allows debtors 1.5 months credit and its cash balance currently stands at 1,250,000 rupees. What are its current and quick ratios?

WORKING CAPITAL-Case Study VII

114

Rs in millionSALES 160% 8COST OF SALES 100% 5 ------- -----GROSS PROFIT 60% 3

CREDITORS = 2/12 x RS 5m = Rs 0.833mDEBITORS = 1.5/12 x RS 8m = Rs 1mSTOCK = 1/12 x RS 5m = Rs 0.417m

CURRENT RATIO = 0.417+1+1.25 0.833 = 3.2

QUICK RATIO = 1+1.25 0.833 = 2.7

WORKING CAPITAL-SOLUTION - Case Study VII

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McDonald’s Corporation provides an interesting illustration of the use of financial ratios. Data for a recent year appear below :

Rs.

Net income 1,427 million

Interest expense 340 million

Average total assets 14,503 millionStockholders’ equity 6,857

millionDividends per share 0.26Earnings per share 1.97Market price per share 42.125Book value per share 10.73

WORKING CAPITAL-Case Study VIII

116

Some key financial ratios are computed below :Return on 1,427 total assets 14,503 = 9.8%

Return on common 1,427stockholders’ equity 6,857 = 20.8%

Dividend payout ratio 0.26 1.97 = 13.2%

Dividend yield ratio 0.26 42.125 = 0.62%

WORKING CAPITAL-Case Study Solution

117

The return on common stockholders’ equity of 21% is higher than the return on total assets of 9.8%, and therefore the company has positive financial leverage. About half of the company’s financing is provided by creditors; the rest is provided by stockholders. According to the company’s annual report, “Given McDonald’s high return on equity and assets, management believes it is prudent to reinvest a significant portion of earnings back into the business. Accordingly, the dividend yield is relatively modest.” Indeed, only 13.2% of earnings are paid out in dividends. In relation to the stock price, this is a dividend yield of less than 1%. Finally, note that the market value per share is over four times as large as the book value per share. This premium over book value reflects the market’s perception that McDonald’s earnings will continue to grow in the future.

WORKING CAPITALCase Study -comments

118

Analyze the following information from the viewpoint of its implications for working capital policy:

Present position Budget for next year

Sales 250,000 288,000

Cost of sales 210,000 248,000

Purchases 140,000 170,000

Debtors 31,250 36,000

Creditors 21,000 30,000

Raw materials 35,000 60,000

Finished goods 40,000 43,000

Work-in-process 17,500 30,000

Assume all sales and purchases are on credit.

WORKING CAPITAL-Case Study IX

119

Analysis of the figures and cash operating cycle it is revealed that working capital investment is being increased. Debtor balances are moving pro-rata with sales, the current and budgeted collection period both being 46 days. However, some additional finance will be taken from creditors as a result of the payment period being increased from 55 days to 64 days. This increase represents about 16% and is not particularly significant unless creditors demand payment within 60 days, or offer discounts for payment within that time (which will be lost).

WORKING CAPITALCase Study -Solution

120

A significant change in the turnover of stock levels is anticipated. Raw materials stocks turnover will be decreased by 29% and work-in-progress by 31%, while finished goods stock turnover will increase by 10%. The implication is that production will increase while sales will fall; in the period following the budget, stocks will be very high. The overall impression is that unnecessarily high investment in raw materials and work-in-progress is being undertaken. A reappraisal of the situation should be made to see if these stocks can be reduced, thereby releasing funds for other uses. It may also be possible to reduce debtors to their current levels.

WORKING CAPITALCase Study-

121

WORKINGSCURRENT BUDGET

1. CreditorsAverage payment period(365 x Creditors) 365 x 21 = (55 days) 365 x 30 = (64 days)

Purchases 140 1702. Debtors

Average collection period(365 x Debtors) 365 x 31.25 = 46 days 365 x 36 = 46 days)

Sales 250 2883. Finished stock turnover

= Cost of goods sold 210 248Finished goods stock 40 43

= 5.25 times pa or 70 days = 5.8 times pa or 63 days


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WORKINGSCURRENT BUDGET

4. Raw materials stock turnover= Purchases 140 170

Raw materials stock 35 60

= 4 times pa or 91 days = 2.83 times pa or 129 days

5. Work-in-progress turnover= Cost of goods sold 210 248

Work-in-progress stock 17.5 30 = 12 times pa or 30 days = 8.26 times pa or 44

days

Length of cash operating cycle 182 days 218 days


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Case Study-XCHANGES IN CREDIT TERMS

JF Ltd achieves current annual sales of Rs 1,800,000. The annual profit and loss account is as follows.

Sales Rs 1,800,000Cost of sales 1,440,000

360,000Bad debts expenses 18,000Profit 342,000

The management consider that if credit terms were eased from 30 days to 60 days credit, the sales will increase by 25% but bad debts will also increase from 1% to 3%.

The company cost is 20% on its investments. The costs of sales are 75% variable and 25% fixed. Assume there would be no increase in fixed costs from the extra turnover; and that there would be no increase in average stocks or creditors. Should the company opt for easing the credit terms?

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Case Study X–SOLUTION

The increase in profit before the cost of additional finance for Option. A can be found as follows.a) Increase in contribution from additional sales

25% x Rs 1,800,000 x 40% * Rs 180,000Less increase in bad debts

(3% x Rs 2,250,000) – Rs 18,000 49,500Increase in annual profit 130,500

* The C/M ratio is 100% - (75% x 80%) = 40%b) Proposed investment in debtors

Rs 2,250m=,000 x 1/6 Rs 375,000 Less current investment in debtors

Rs 1,800,000 x 1/12 150,000Additional investment required 225,000Cost of additional finance at 20% Rs 45,000

c) CONCLUSIONAs the increase in profit is Rs 130,500 which exceeds the cost of additional financing cost of Rs45,000, therefore credit terms be relexed.

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• Review the Financial Statements and comment on following:

1. Workout Horizontal, Vertical, Common Size Statement & all Ratios2. Comment separately on:

a. Liquidityb. Profitabilityc. Turn over of Inventory & Receivabled. Market ratioe. Capital Structure

• With help of above results, advise for buying this company’s Share

at Rs. per share • Discuss other factors which may effects the decision of buying

above shares • The net profit is Rs. million whereas cash flow statement shows

net surplus of Rs. million. Justify the difference.

Case Study Select a company’s annual report

126

6- Find out purchases of raw material, direct labor and factory overheads figure in Notes to the Accounts.

7- Read the Nature of Business and Company’s history, Accounting Policies, Director Report’ Auditors’ Report shareholding break-up, Contingent Liability &

Commitments, value added statement and briefly comment on each of above separately

8- Is the company meeting its current obligations? 9- How the inventory is financed ? And comment on

efficiency of inventory management. 10- What is other significant matter in financial statement

beside discussed above which is useful for shareholders and bankers.

11- Why the dividend is much less than profits? ( dividend payout )

Case Study XV – Review of Financial Statement

127

Based on all above data and analysis results, you are required to write a Business Review that way be published in a newspapers about this company.

Case Study –XVI

Comments for News paper on Financial Statements

128

Based on the financial statement just reviewed, you are required to:

1- Prepare projected profit & loss account for next year considering following assumptions:

• Sales to grow by 20 %annually.• Cost of goods sold consists of 30% Material, 20% Labor and

50% factory overhead of which 40% are fixed overhead .• No inflation is expected in Material prices, labor cost and variable

overhead.• Fixed overhead and admn., selling, financial charges etc to

increase by 10% only.

2- Advise expected profits and dividend for the next year.

Case Study –XVIIREVIEW OF ACTUAL PUBLISHED ACCOUNTS

129

ANALYSIS OF FINANCIAL STATEME

Concept Review Test PART (A) Tick the correct answer in relevant column.

TRUE FALSE1. The financial statements are normally prepared on

current cost concept. ______ ______

2. Revenue & costs are recognized as they are received or paid respectively and not when earned or incurred. ______ ______

3. Shareholders’ equity includes share capital and liabilities. ______

______

4. Balance Sheet shows operating results of the company. _____ ______

5 . Sales is recorded at the time of receipt of order from the customer ______ ______

6- Financial Statements are prepared on cash basis. ______ ______

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Concept Review Test PART (A) Tick the correct answer in relevant column.

TRUE FALSE

7. Dividend is distribution of profits to shareholders and bankers ----------- -----------

8. Ordinary Shares issued at a discount-It has no effect on current ratio ----------- -----------

9. Low Inventory Turnover indicates that carrying cost of inventory is also low ----------- -----------

10. Formula to calculate EPS is = Net Income ÷ Value of Ordinary Shares ----------- -----------

11. Going Concern concept effect Valuation of Assets ----------- -----------

• Inventories are valued at lower of cost and net realizable value ----------- -----------

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Concept Review Test PART (B) Fill in the blank:

1. Dividend income is recorded in books of account when it is approved by ______________

(a) Shareholders at AGM (b) Board of Directors (c) Managing Director2. Capital Reserve can not be used for issuing _______________ (a) Cash Dividend (b) Bonus Shares 3 . Bonus Share is also called ______________ (a) Right Shares (b) Stock Dividend (c) Preference Shares 4. Associated company means any two or more companies interconnected with each

other and director of a company hold or control share with atleast ________ voting power in another company.

(a) 50% (b) 25% (c) 20% 5. ____________ opinion by External Auditors is expressed when the auditor

concludes that the financial statements give a true and fair view in accordance with identified financial reporting framework (a) A Qualified (b) An unqualified (c) An adverse

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Concept Review Test 6.A ____________ is a postponement of the recognition of a revenue

expenditure already incurred or paid because it is likely that the benefits may be available for more than one year.

(a) Capital Expenditure(b) Revenue Expenditure (c) Deferred Revenue Expenditure

7. The liability of Partners in Partnership firm is _____________

(a) Limited (b) Unlimited (c) nil

8. Financial Statement analysis involves tools and techniques which enable analyst to examine past and __________.

(a) Future position ( b) Current position (c) Previous Trend

9. Current ratio express _________ position of the company

(a)Financial ( b) Liquidity (c) Profitability

10. Higher inventory turn over express _________ investment in inventory

a) Low (b) High (c) Reasonable

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Concept Review Test 11. Low A/c receivable turn over ratio shows ____________ Receivable Management. a) Efficient b) inefficient c) inappropriate 12 Working Capital Ratio express the relationship between current assets and _________

. a) Fixed Assets b) Long Term Liab c) Current Liab 13.Dividend yield = Divided per share -- ________________ a) EPS b) Break up value c) M/V of shares 14.Price Earning Ratio express what market is willing to pay for every ________ rupees. a) Rs.5 b) Rs.3 c) Rs.1 15. Book value per share = Shareholder Equity -- _______________.

a) Reverses b) No. of shares c) Value of shares 16.) Ratio can be computed from any _________________.

a) Single number b) Pair of numbers

Analysis Presentation for External Users

Documents

concept review

concept review

comparative

common shares

cash operating

ordinary shares

case study

operating