Financial Management - Financial Statements Analysis Notes

Subject: Financial Management
Chapter no. 8: Financial statements analysis
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Chapter No. 8 – Financial statements

analysis
Contents
Introduction to financial statements and their differing objectives

Schedule VI of The Companies’ Act format for Balance Sheet and Profit
and Loss statements
Limitations on Schedule VI balance sheet format and need for regrouping
in the “Analytical” form of balance sheet to overcome these limitations
Financial ratios and their usefulness
Inter-firm and intra-firm analysis
Limitations to financial statement analysis and study of financial ratios
Funds flow statement and its construction from balance sheet as on two
successive annual dates with additional information
Numerical exercises on:
Financial statement analysis and calculation of ratios
Interpretation of these ratios
Funds flow statement preparation
At the end of the chapter the student will be able to
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Regroup the assets and liabilities in the “Analytical form” of balance sheet
Calculate the financial ratios relating both to Profit and Loss and Balance
Sheet
Interpret the financial ratios for their impact on business enterprise
Appreciate the limitations to the study of financial statements and ratios
Prepare funds flow statement given two successive dates balance sheets
Introduction to Financial Statements and their differing objectives:
What are financial statements in a business enterprise?

The financial statements are:
Profit and Loss statement
Balance Sheet
Cash flow statement and
Funds flow statement
Objectives are:
Profit and Loss statement – to know whether the enterprise is in profit or loss at the end of a
given period or not. The period would usually be one year. It could be as short a period as one
month even. However preparing the Profit and Loss Account every year is a must.
Balance Sheet – it is also referred to as statement of assets and liabilities. This is as on a
particular date. The objective is to know the financial position of the enterprise, how much it
owes to outsiders in the form of liabilities and how much it owns in the form of various assets.
Although it could be prepared on a monthly basis as at the end of every month, it is prepared
as at the end of every year – again a statutory requirement besides being a business
necessity.
Cash flow statement – as explained in the chapter on working capital management, cash flow
statement is primarily to know the cash from operations, investments and finance obtained
and manage the liquidity in the short-run. In the short-run, the objective could be financial
planning. It lists all the cash inflows and cash outflows to verify as to whether the system has
the required liquidity or not. The business should not have too little or too much cash. The
frequency of preparing it depends upon the business needs – it could even be on a weekly
basis. The minimum frequency is one month.
Funds flow statement – this is the fundamental statement used for financial planning. The
minimum period is one year. It talks of all resources, be it short-term or medium-term/long-
term and the uses to which these are put to. The objective is to ensure that proper funding
takes place in the business enterprise and that there is no diversion of working capital to
acquiring fixed assets.
Out of the above we have seen cash flow statement in the chapter on “working capital
management”. Hence the same is not repeated here. The students should take “funds flow”

statement as summary statement of sources and application for a given period; they would
realise that the format for the statement as given in the annexure to this chapter is different
from the one they are used to under “Management Accounting”.
Example no. 1 - A sample of “Profit and Loss” Account (Rupees in Lacs)

Income from operations 100
Operating expenses:
Salaries 30
Repairs and maintenance 3
Depreciation 10
Office and general expenses 10
Marketing expenses including
Commission, if any 7
Interest and other
Charges 10
Total expenses 70
Profit before tax 30
Tax at 35% 10.5
Profit after tax 19.5
Dividend 7.5
Profit retained in
Business [Retained Earnings] 12
Learning points:
♦ Interest is charged to income before determining the profit of the organisation. Once the profit of
the organisation is determined, tax is paid at the stipulated rate and the dividend is paid only after
this. Thus, dividend is profit allocation.
♦ This difference between “interest” and “dividend” gives opportunity to business enterprises, to
have a mix of capital of the owners and loans taken from outside, so that they can save on tax,
through the interest charged as expense on the income. The amount of tax so saved is called “tax
shield” on the interest.
♦ In the case of profit distributed among the partners as well in the case of dividend distributed
among the shareholders, these are not taxed again in the hands of the owners.
Linkage between balance sheet and profit and loss accounts

The above statement is known as the “Profit and Loss Account”. This records the income and
expenditure for a given period and is closed as soon as the period is over. The residual profit, as it
belongs to the owners, gets transferred to the capital account in another statement, called “Balance
Sheet”.
The balance sheet tells us about the following:

How much money has the business enterprise raised?
Which are the sources for the money?

What is the use for this money?
Example no. 2
The balance sheet is also known as “Assets and Liability” statement. A sample balance sheet is shown
below:
(Rupees in lacs)
Liabilities Assets
Share capital: 100 Fixed Assets 60
Reserves: 150 Less: Depreciation 30
(Retained profits Net Fixed Assets: 30
over a period of Investments: 80
time) Current Assets:
Net worth 250 Bills Receivable 100
Bank overdraft 30 Cash and Bank 35
Creditors for expenses 10 Other current assets 60
Other current liabilities 15 Total current assets 195
Total current liabilities 55
Total Liabilities 305 Total Assets 305
Suppose profit for the year is Rs.30 lacs after paying tax and dividend. This would be transferred to
the balance sheet and the reserves at the end of the current year would be Rs.150 lacs + Rs.30 lacs =
Rs.180 lacs. Similarly the depreciation claimed on the fixed assets and shown as an operating expense
would also get transferred to the balance sheet to reduce the value of the fixed assets.
Let us assume that there is no increase in the fixed assets during the year that there are no other
changes and the depreciation for the year is Rs.10 lacs. We can construct the balance sheet for the
next year without much change, excepting to accommodate these figures of depreciation and increase
in reserves.
The balance sheet as at the end of the next year would look as under:
(Rupees in Lacs)
Liabilities Assets
Share capital 100 Fixed assets 60
Reserves and surplus 180 Less: depreciation 40
Net worth 280 Net fixed assets 20
Bank overdraft 30 Investments 100
Creditors for expenses 10 Bill Receivable 120
Other current liabilities 15 Cash and Bank 35
Total current Other current assets 60
liabilities 55 Total current assets 195
Total liabilities 335 Total Assets 335

We see that between the two balance sheets, there are two changes –
Investment has gone up by Rs.20 lacs and
Bill receivable has gone up by Rs.20 lacs.
The total is Rs.40 lacs. Where have these funds come from? This amount is the total of profit
transferred to balance sheet from the profit and loss account and depreciation added back, as it does
not involve any cash outlay. The figure is Rs.30 lacs + Rs.10 lacs = Rs.40 lacs. This figure is referred
to as “internal accruals”.
This need not be the case all the times. Where we use these funds entirely depends upon the business
priority and what we have shown is only a sample.
Learning points:
♦ The business enterprise generates funds from operations, known as “internal accruals” comprising
depreciation (which is added back, being only a book-entry) and profit after tax and dividend;
♦ Where these funds are used is entirely dependent upon business exigencies;
♦ Depreciation claimed in the books as an expense goes to reduce the value of the fixed assets in
the books, while profit after tax and dividend is shown as “Reserves” and increases the net worth
of the company.
Key pointers to balance sheet and profit and loss statements:

♦ A balance sheet represents the financial affairs of the company and is also referred to as “Assets
and Liabilities” statement and is always as on a particular date and not for a period.
♦ A profit and loss account represents the summary of financial transactions during a particular
period and depicts the profit or loss for the period along with income tax paid on the profit and
how the profit has been allocated (appropriated).
♦ Net worth means total of share capital and reserves and surplus. This includes preference share
capital unlike in Accounts preference share capital is treated as a debt. For the purpose of debt to
equity ratio, the necessary adjustment has to be done by reducing preference share capital from
net worth and adding it to the debt in the numerator.
♦ Reserves and surplus represent the profit retained in business since inception of business.
“Surplus” indicates the figure carried forward from the profit and loss appropriation account to the
balance sheet, without allocating the same to any specific reserve. Hence, it is mostly called
“unallocated surplus”. The company wants to keep a portion of profit in the free form so that it is
available during the next year for appropriation without any problem. In the absence of this
arrangement during the year of inadequate profits, the company may have to write back a part of
the general reserves for which approval from the board and the general members would be
required.
♦ Secured loans represent loans taken from banks, financial institutions, debentures (either from
public or through private placement), bonds etc. for which the company has mortgaged immovable
fixed assets (land and building) and/or hypothecated movable fixed assets (at times even working
capital assets with the explicit permission of the working capital banks)
♦ Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while loans
from banks for working capital, i.e., current assets are secured by current assets. These loans
enjoy priority over unsecured loans for settlement of claims against the company.
♦ Unsecured loans represent fixed deposits taken from public (if any) as per the provisions of Section
58 (A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of Deposit
Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no security has been
offered.

♦ Such unsecured loans rank second and subsequent to secured loans for settlement of claims
against the company. There are other unsecured creditors also, forming part of current liabilities,
like, creditors for purchase of materials, provisions etc.
♦ Gross block = gross fixed assets mean the cost price of the fixed assets. Cumulative depreciation
in the books is as per the provisions of The Companies Act, 1956, Schedule XIV. It is last
cumulative depreciation till last year + depreciation claimed during the current year. Net block =
net fixed assets mean the depreciated value of fixed assets.
♦ Capital work-in-progress – This represents advances, if any, given to building contractors, value of
building yet to be completed, advances, if any, given to equipment suppliers etc. Once the
equipment is received and the building is complete, the fixed assets are capitalised in the books,
for claiming depreciation from that year onwards. Till then, it is reflected in the form of capital
work in progress.
♦ Investments – Investment made in shares/bonds/units of Unit Trust of India etc. This type of
investment should be ideally from the profits of the organisation and not from any other funds,
which are required either for working capital or capital expenditure. They are bifurcated in the
schedule, into “quoted and traded” and “unquoted and not traded” depending upon the nature of
the investment, as to whether they can be liquidated in the secondary market or not.
♦ Current assets – Both gross and net current assets (net of current liabilities) are given in the
balance sheet.
♦ Miscellaneous expenditure not written off can be one of the following –
♦ Company incorporation expenses or public issue of share capital, debenture etc. together known
as “preliminary expenses” written off over a period of 5 years as per provisions of Income Tax.
Misc. expense could also be other deferred revenue expense like product launch expenses.
♦ Other income in the profit and loss account includes income from dividend on share investment
made in other companies, interest on fixed deposits/debentures, sale proceeds of special import
licenses, profit on sale of fixed assets and any other sundry receipts.
♦ Provision for tax could include short provision made for the earlier years.
♦ Provision for tax is made after making all adjustments for the following:
♦ Carried forward loss, if any;
♦ Book depreciation and depreciation as per income tax and
♦ Concessions available to a business entity, depending upon their activity (export business, S.S.I.
etc.) and location in a backward area (like Goa etc.)
♦ As per the provisions of The Companies Act, 1956, in the event of a limited company declaring
dividend, a fixed percentage of the profit after tax has to be transferred to the General Reserves of
the Company and entire PAT cannot be given as dividend.
♦ With effect from 01/04/02, dividend tax on dividends paid by the company has been withdrawn.
From that date, the shareholders are liable to pay tax on dividend income. Thus for a period of 5
years, the position was different in the sense that the company was bearing the additional tax on
dividend.
Other parts of annual statements –

♦ The Directors’ Report on the year passed and the future plans;
♦ Annexure to the Directors’ Report containing particulars regarding conservation of energy etc;
♦ Auditors’ Report as per the Manufacturing and Other Companies (Auditors’ Report) Order, 1998)
along with Annexure;
♦ Schedules to Balance Sheet and Profit and Loss Account;
♦ Accounting policies adopted by the company and notes on accounts giving details about changes
if any, in method of valuation of stocks, fixed assets, method of depreciation on fixed assets,

contingent liabilities, like guarantees given by the banks on behalf of the company, guarantees
given by the company, quantitative details regarding performance of the year passed, foreign
exchange inflow and outflow etc. and
♦ Statement of cash flows for the same period for which final accounts have been presented.
There is a significant difference between the way in which the statements of accounts are prepared as
per Schedule VI of the Companies Act and the manner in which these statements, especially, balance
sheet is analysed by a finance person or an analyst. For example, in the Schedule VI, the current
liabilities are netted off against current assets and only net current assets are shown. This is not so in
the case of financial statement analysis. Both are shown fully and separately without any netting off.
At the end of any financial year, there are certain adjustments to be made in the books of accounts to
get the proper picture of profit or loss, as the case may be, for that particular period. For example, if
stocks of raw materials are outstanding at the end of the period, the value of the same has to be
deducted from the total of the opening stock (closing stock of the previous year) and the current
year’s purchases. This alone would show the correct picture of materials consumed during the current
year.
Example no. 3
Purchases during the year: Rs.600lacs
Opening stock of raw material: Rs.100lacs
Closing stock of raw material: Rs.120lacs
Then, the quantum of raw material consumed during the year is Rs.580lacs and only this can be
booked as expenditure during the year. Consumption is always valued in this manner and cross
verified with the value of materials issued from stores during the year to compare with the previous
year;
Similarly, a second adjustment arises due to the difference between closing stocks of work-in-progress
and finished goods on one hand and opening stocks of work-in-progress and finished goods on the
other hand. Suppose the closing stocks are higher in value, the difference has to be either added to
this year’s income or deducted from this year’s expense. (Different ways of presentation). Similarly in
case the closing stocks are less than the opening stocks, the difference has to be deducted from
income or added to expenses for that year. Let us study the following example.
In a company, the opening stocks were Rs.100lacs and closing stocks are Rs.120lacs. This means that
during the course of this year, the stocks on hand have gone up by Rs.20lacs from the goods produced
during this year. This does have an effect on the profit of the company. The company cannot book
expenditure incurred on producing this incremental stock of Rs.20lacs, as they have not sold the
goods. However the materials and other expenses have already been incurred and hence this value is
deducted.
The basic assumption is that the carry forward stocks have been sold during the current year while at
the end of the current year fresh stocks worth Rs.120lacs have come in for stocking. Hence, on an
ongoing basis, opening stocks are added and closing stocks are deducted. In the above example, the
effect of adding the opening stock and deducting the closing stock would be as under:
Example no. 4
Let us assume the production for the year was Rs.1000lacs
Then, sales for the year could only be Rs.980lacs derived as follows:
Production during the year: Rs.1000lacs
Add: Opening stock: Rs. 100lacs
Deduct: Closing stock: Rs. 120lacs
Sales for the year: Rs. 980lacs.

On the other hand, in case the closing stocks would have been Rs.90lacs, the sales would have been
Rs.1010lacs, more than the production value. Thus, the difference between the opening and closing
stocks of work-in-progress and finished goods affects income and thereby profit. The companies
always use this as a tool, either to increase or decrease income. In case they show more closing
stocks, income is less and thereby profit is less and tax is saved and similarly if they show less closing
stocks, income is more and profit is also more.
The principal tools of analysis are –

Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it
with the past trend. In the statements of accounts, there are several such pairs of parameters and
hence ratio analysis assumes great significance. The most important thing to remember in the case of
ratio analysis is that you can compare two units in the same industry only and other factors like the
relative ages of the units, the scales of operation etc. come into play.
Funds flow analysis – this is to understand the movement of funds (please note the difference
between cash and fund – cash means only physical cash while funds include cash and credit) during
any given period and mostly this period is 1 year. This means that during the course of the year, we
study the sources and uses of funds, starting from the funds generated from activity during the period
under review.
Let us see some of the important types of ratios and their significance:
Liquidity ratios;
Turnover ratios;
Profitability ratios;
Investment on capital/return ratios;
Leverage ratios and
Coverage ratios.
Liquidity ratios:
Current ratio: Formula = Current assets/Current liabilities.
Min. Expected even for a new unit in India = 1.33:1.
Significance = Net working capital should always be positive. In short, the higher the net working
capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate
liquidity of the enterprise.
Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This
means that we are carrying either cash in large quantities or inventory in large quantities or
receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you
compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working
capital.
Range – No fixed range is possible. Unless the activity is very profitable and there are no immediate
means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an
examination of the profitability of the operations and the need for high level of current assets. Reason
= net working capital could mean that external borrowing is involved in this and hence cost goes up in
maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all
assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we
see “quick asset ratio” or “acid test ratio”.
Acid test ratio or quick asset ratio:

Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This
assumes that all other current assets like receivables can be converted into cash easily. This ratio
examines whether the quick assets are sufficient to cover all the current liabilities. Some of the
authors indicate that the entire current liabilities should not be considered for this purpose and only
quick liabilities should be considered by deducting from the current liabilities the short-term bank
borrowing, as usually for an on going company, there is no need to pay back this amount, unlike the
other current liabilities.
Significance = coverage of current liabilities by quick assets. As quick assets are a part of current
assets, this ratio would obviously be less than current ratio. This directly indicates the degree of
excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this
ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost
associated with high level of liquidity could also be high.
What is working capital gap? The difference between all the current assets known as “Gross working
capital” and all the current liabilities other than “bank borrowing”. This gap is met from one of the two
sources, namely, net working capital and bank borrowing. Net working capital is hence defined as
medium and long-term funds invested in current assets.
Turn over ratios:

Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the higher the
degree of efficiency and hence these assume significance. Further, depending upon the type of turn
over ratio, indication would either be about liquidity or profitability also. For example, inventory or
stocks turn over would give us a measure of the profitability of the operations, while receivables turn
over ratio would indicate the liquidity in the system.
Debtors turn over ratio – this indicates the efficiency of collection of receivables and contributes to
the liquidity of the system. Formula = Total credit sales/Average debtors outstanding during the year.
Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of
industry like capital goods, consumer goods – capital goods, this would be less and consumer goods,
this would be significantly higher;
Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and
competitive it would be less as you are forced to give credit;
Whether new enterprise or established – new enterprise would be required to give higher credit in the
initial stages while an existing business would have a more fixed credit policy evolved over the years
of business;
Hence any deterioration over a period of time assumes significance for an existing business – this
indicates change in the market conditions to the business and this could happen due to general
recession in the economy or the industry specifically due to very high capacity or could be this unit
employs outmoded technology, which is forcing them to dump stocks on its distributors and hence
realisation is coming in late etc.
Average collection period = inversely related to debtors turn over ratio. For example debtors
turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90
days. In case the debtors turn over ratio increases, the average collection period would reduce,
indicating improvement in liquidity. Formula for average collection period = 360/receivables turn over
ratio. The above points for debtors turn over ratio hold good for this also. Any significant deviation
from the past trend is of greater significance here than the absolute numbers. No minimum and no
maximum.
Inventory turn over ratio – as said earlier, this directly contributes to the profitability of the
organisation. Formula = Cost of goods sold/Average inventory held during the year. The inventory
should turn over at least 4 times in a year, even for a capital goods industry. But there are capital
goods industries with a very long production cycle and in such cases, the ratio would be low. While
receivables turn over contributes to liquidity, this contributes to profitability due to higher turn over.
The production cycle and the corporate policy of keeping high stocks affect this ratio. The less the
production cycle, the better the ratio and vice-versa. The higher the level of stocks, the lower would
be the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges.

Current assets turn over ratio – not much of significance as the entire current assets are involved.
However, this could indicate deterioration or improvement over a period of time. Indicates operating
efficiency. Formula = Cost of goods sold/Average current assets held in business during the year.
There is no min. Or maximum. Again this depends upon the type of industry, market conditions,
management’s policy towards working capital etc.
Fixed assets turn over ratio
Not much of significance as fixed assets cannot contribute directly either to liquidity or profitability.
This is used as a very broad parameter to compare two units in the same industry and especially when
the scales of operations are quite significant. Formula = Cost of goods sold/Average value of fixed
assets in the period (book value).
Profitability ratios –
Profit in relation to sales and profit in relation to assets:
Profit in relation to sales – this indicates the margin available on sales;
Profit in relation to assets – this indicates the degree of return on the capital employed in
business that means the earning efficiency. Please appreciate that these two are totally
different.
Example no. 5
Units A and B are in the same type of business and operate at the same levels of capacities. Unit A
employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and profits are as under:
Parameter Unit A Unit B
Sales 1000lacs 1000lacs
Profits 100lacs 90lacs
Profit margin on sales 10% 9%
Return on capital employed 40% 45%
While Unit A has higher profit margins, Unit B has better returns on capital employed.
Profit margin on sales:

Gross profit margin on sales and net profit margin ratio –
Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of production
before selling, general, administrative expenses and interest charges. Net sales = Gross sales (-)
Excise duty. This indicates the efficiency of production and serves well to compare with another unit in
the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit
B let us assume that the sales are same at Rs.100lacs.
Example no. 6
Parameter Unit A Unit B
Sales 100lacs 100lacs

Cost of production 60lacs 5lacs
Gross profit 40lacs 35lacs
Deduct: Selling general,
Administrative expenses and interest 35lacs 30lacs

Net profit 5lacs 5lacs
While both the units have the same net profit to sales ratio, the significant difference lies in the fact
that while Unit A has less cost of production and more office and selling expenses, Unit B has more
cost of production and less of office and selling expenses. This ratio helps in controlling either
production costs if cost of production is high or selling and administration costs, in case these are high.
Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula =
Net profit/net sales. Tax rate being the same, this ratio indicates operating efficiency directly in the
sense that a unit having higher net profitability percentage means that it has a higher operating
efficiency. In case there are tax concessions due to location in a backward area, export activity etc.
available to one unit and not available to another unit, then this comparison would not hold well.
Investment on capital ratios/Earnings ratios:

Return on net worth
Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds including Preference
Share capital. Hence Preference Share capital is not deducted. There is no standard range for this
ratio. If it reduces it indicates less return on the net worth.
Return on equity
Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share capital.
Although reference is equity here, all equity shareholders’ funds are taken in the denominator. Hence
Preference dividend and Preference share capital are excluded. There is no standard range for this
ratio. If it comes down over a period it means that the profitability of the organisation is suffering a
setback.
Return on capital employed (pre-tax)
Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives
return on long-term funds employed in business in pre-tax terms. Again there is no standard range for
this ratio. If it reduces, it is a cause for concern.
Earning per share (EPS)
Dividend per share (DPS) + Retained earnings per share (REPS). Here the share refers to equity share
and not preference share. The formula is = Profit after tax (-) Preference dividend (-) Dividend tax both
on preference and equity dividend / number of equity shares. This is an important indicator about the
return to equity shareholder. In fact P/E ratio is related to this, as P/E ratio is the relationship between
“Market value” of the share and the EPS. The higher the PE the stronger is the recommendation to sell
the share and the lower the PE, the stronger is the recommendation to buy the share.
This is only indicative and by and large followed. There is something known as industry average EPS. If
the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and
growth prospects are quite good, it is the time for buying the shares, unless we know for certain that
the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than
industry average P/E, it is time for us to sell unless we expect further increase in the near future.
Leverage ratios
Leverages are of two kinds, operating leverage and financial leverage. However, we are concerned
more with financial leverage. Financial leverage is the advantage of debt over equity in a capital
structure. Capital structure indicates the relationship between medium and long-term debt on the one
hand and equity on the other hand. Equity in the beginning is the equity share capital. Over a period of
time it is net worth (-) redeemable preference share capital.
It is well known that EPS increases with increased dose of debt capital within the same capital
structure. Given the advantage of debt also, as even risk of default, i.e., non-payment of interest and

non-repayment of principal amount increases with increase in debt capital component, the market
accepts a maximum of 2:1 at present. It can be less. Formula for debt/equity ratio = Medium and long-
term loans + redeemable preference share capital / Net worth (-) Redeemable preference share
capital.
From the working capital lending banks’ point of view, all liabilities are to be included in debt. Hence
all external liabilities including current liabilities are taken into account for this ratio. We have to add
redeemable preference share capital and reduce from the net worth the same as in the previous
formula.
Coverage ratios
Interest coverage ratio
This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest payment on
all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1. Less than that is not
desirable, as after paying interest, tax has to be paid and afterwards dividend and dividend tax.
Asset coverage ratio
This indicates the number of times the medium and long-term liabilities are covered by the book value
of fixed assets.
Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. Accepted ratio is
minimum 1.5:1. Less than that indicates inadequate coverage of the liabilities.
Debt Service coverage ratio
This indicates the ability of the business enterprise to service its borrowing, especially medium and
long-term. Servicing consists of two aspects namely, payment of interest and repayment of principal
amount. As interest is paid out of income and booked as an expense, in the formula it gets added back
to profit after tax. The assumption here is that dividend is ignored. In case dividend is paid out, the
formula gets amended to deduct from PAT dividend paid and dividend tax.
Formula is:
PAT (+) Depreciation (+) Amortisation (DRE write-off) (+) Int. on med. & long-term liabilities
Interest on medium and long-term borrowing (+) Instalment on medium and long-term borrowing.
This is assuming that dividend is not paid. In the case of an existing company dividend will have to be
paid and hence in the numerator, instead of PAT, retained earnings would appear. The above ratio is
calculated for the entire period of the loan with the bank/financial institution. The minimum acceptable
average for the entire period is 1.75:1. This means that in one year this could be less but it has to be
made up in the other years to get an average of 1.75:1.
What is the objective behind analysis of financial statements?
Objective (To know about) Relevant indicator/Remarks
Net worth, i.e., share capital, reserves and

unallocated surplus in balance sheet carried
Financial position of the company down from profit and loss appropriation
account. For a healthy company, it is necessary
that there is a balance struck between dividend
paid and profit retained in business so much the
net worth keeps on increasing.

Liquidity of the company, i.e., whether the Current ratio and quick ratio or acid test ratio.
company is in a position to meet all its short- Current ratio = Current assets/current liabilities.
term liabilities (also called “current liabilities”) Quick ratio = Current assets (-) inventory/
with the help of its current assets current liabilities. Current ratio should not be
too high like 4:1 or 5:1 or too low like less than
1.5:1. This means that the company is either
too liquid thereby increasing its opportunity cost
or not liquid at all, both of which are not
desirable. Quick ratio could be at least 1:1.
Quick ratio is a better indicator of liquidity
position.
Whether the company has acquired new fixed Examination of increase in secured or
assets during the year and if so, what are the unsecured loans for this purpose. Without
sources, besides internal accruals to finance the adequate financial planning, there is always the
same? risk of diverting working capital funds for fixed
assets. This is best assessed through a funds
flow statement for the period as even net cash
accruals (Retained earnings + depreciation +
amortisation) would be available for fixed
assets.
Profitability of the company in general and Percentage of profit before tax to total income
operating profits in particular, i.e., whether the including other income, like dividend or interest
main operations of the company like income. Operating profit, i.e., profit before tax
manufacturing have been in profit or the profit (-) other income as above as a percentage of
of the company is derived from other income, income from the main operations of the
i.e., income from investment in company, be it manufacturing, trading or
shares/debentures etc. services.
Relationship between the net worth of the Debt/Equity ratio, which establishes this
company and its external liabilities (both short- relationship. Formula = External liabilities +
term and long-term). What about only medium preference share capital /net worth of the
and long-term debts? company (-) preference share capital
(redeemable kind). From the lender’s point of
view, this should not exceed 3:1. Is there any
sharp deterioration in this ratio? Is so, please
be on guard, as the financial risk for the
company increases to that extent.
For only medium and long-term debts, it cannot
exceed 2:1.
Has the company’s investments in Difference between the market value of the
shares/debentures of other companies reduced investments and the purchase price, which is
in value in comparison with last year? theoretically a loss in value of the investment.
Actual loss is booked upon only selling. The
periodic reduction every year should warn us
that at the time of actual sales, there would be
substantial loss, which immediately would
reduce the net worth of the company. Banks,
Financial Institutions, Investment companies or
NBFCs would be required to declare their
investment every year in the balance sheet at
cost price or market price whichever is less.
Relationship between average debtors (bills Average debtors in the year/average creditors in
receivable) and average creditors (bills payable) the year. This should be greater than 1:1, as
during the year. bills receivable are at gross value {cost of
development (+) profit margin}, whereas;

creditors are at purchase price for software or

components, which would be much less than
the final sales value. If it is less than 1:1, it
shows that while receivable management is
quite good, the company is not paying its
creditors, which could cause problems in future.
Too high a ratio would indicate that receivable
management is very poor.
Future plans of the company, like acquisition of Directors’ report. This would reveal the
new technology, entering into new collaboration financial plans for the company, like whether
agreement, diversification programme, they are coming out with a public issue/Rights
expansion programme etc. issue etc.
Has the company revalued its fixed assets Auditors’ comments in the “Notes to Accounts”
during the year, thereby creating revaluation relevant for this. Frequent revaluation is not
reserves, without any inflow of capital into the desirable and healthy.
company, as this is just an entry passed in the
books?
Whether the company has increased its Increase in amount of investment in

investment and if so, what is the source for it? shares/debentures/Govt. securities etc. in
What is the nature of investment? Is it in comparison with last year and any investment
tradable securities or long-term within group companies? Any undue increase in
investment should put us on guard, as working
Securities, which can have a lock-in-period capital funds could have been diverted for it.
and cannot be liquidated in the near future?
Has the company during the year given any Any increase in unsecured loans. If the loans
unsecured loans substantially other than to are to group companies, then all the more
employees of the company? reason to be cautious. Hence, where the figures
have increased, further probing is called for.
Are the company’s unsecured loans (given) not Any comments to this effect in the notes to
recoverable and very old? accounts should put us on caution. This
examination would indicate about likely impact
on the future profits of the company.
Has the company been regular in payment of its Any comments about over dues as in the “Notes
dues on account of loans or periodic interest on to Accounts” should be looked into. Any serious
its liabilities? default is likely to affect the “credit rating” of
the company with its lenders, thereby
increasing its cost of borrowing in future.
Has the company defaulted in providing for Any comments about this in the “Notes to
bonus liability, P.F. liability, E.S.I. liability, Accounts” should be looked into.
gratuity liability etc?
Whether the company is holding very huge Cash balance together with bank balance in
cash, as it is not desirable and increases the current account, if any, is very high in the
opportunity cost? current assets.

How many times the average inventory has Relationship between cost of goods sold and
turned over during the year? average inventory during the year (only where
cost of goods sold cannot be determined, net
sales can be taken as the numerator). In a
manufacturing company, which is not in capital
goods sector, this should not be less than 4:1
and for a consumer goods industry, this should
be higher even. For a capital goods industry,
this would be less.
Has the company issued fresh share capital Increase in paid-up capital in the balance sheet
during the period and what is the purpose for and share premium reserves in case the issue
which it has raised equity capital? If it was a has been at a premium.
public issue, how did it fare in the market?
Has the company issued any bonus shares Increase in paid-up capital and simultaneous
during the year? reduction in general reserves. Enquiry into the
company’s ability to keep up the dividend rate
of the immediate past.
Has the company made any rights issue in the Increase in paid-up capital and share premium
period and what is the purpose of the issue? If reserves, in case the issue has been at a
it was a public issue, how did it fare in the premium.
market?
What is the proportion of marketable Percentage of marketable investment to total

investment to total investment and whether this investment and comparison with previous year.
has decreased in comparison with the previous Any decrease should put us on guard, as it
year? reduces liquidity on one hand and increases the
risk of non-payment on due date, especially if
the investment is in its own subsidiary or group
companies, thereby forcing the company to
provide for the loss.
What is the increase in sales income over last Comparison with previous year’s sales income
year in % terms? Is it due to increase in and whether the growth has been more or less
numbers or change in product mix or increase in than the estimate.
prices of finished products only?
What is the amount of provision for bad and In percentage terms, how much is it of total
doubtful debts or advances outstanding? debts outstanding and what are the reasons for
such provision in the notes to accounts by the
auditors?
What is the amount of work in progress as Is there any comment about valuation of work in
shown in the Profit and Loss Account? progress by the auditors? It can be seen that
profit from operations can be manipulated by
increase/decrease in closing stocks of both
finished goods and work in progress.
Whether the company is paying any lease Examination of expenses schedule would show
rentals and if so what is the amount of lease this. What is the comment in notes to accounts
liability outstanding? about this? Lease liability is an off-balance
sheet item and hence this examination, to
ascertain the correct external liability and to
include the lease rentals in future also in
projected income statements; otherwise, the
company may be having much less disclosed
liability and much more lease liability which is

not disclosed. This has to be taken into

consideration by an analyst while estimating
future expenses for the purpose of estimating
future profits.
Has the company changed its method of Auditors’ comments on “Accounting” policies.
depreciation on fixed assets, due to which, Change over from straight-line method to
there is an impact on the profits of the written down value method or vice-versa does
company? affect the deprecation charge for the year
thereby affecting the profits during the year of
change.
If it is a manufacturing company, whether the % Relationship between materials consumed

of materials consumed is increasing in relation during the year and the sales.
to sales?
Has the company changed its method of Auditors’ comments on “Accounting” policies.
valuation of inventory, due to which there is an
impact of the profits of the company?
Whether the % of administration and general Relationship between general and

expenses has increased during the year under administrative expenses during the year and
review? the sales. In case there is any extraordinary
increase, what are the reasons therefore?
Whether the company had sufficient income to Interest coverage ratio = earnings before
pay the interest charges? interest and tax/total interest on all short-term
and long-term liabilities. Minimum should be
3:1 and anything less than this is not
satisfactory.
Whether the finance charges have gone up Relationship between interest charges and sales
disproportionately as compared with the income – whether it is consistent with the
increase in sales income during the same previous year or is there any spurt?
period?
Is there any explanation for this, like substantial
expansion or new project or diversification for
which the company has taken financial
assistance? While a benchmark % is not
available, any level in excess of 6% calls for
examination.
Whether the % of employee costs to sales has Relationship between “payment to and
increased? provision for employees” and the sales. In case
any undue increase is seen, it could be due to
expansion of activity etc. that would be included
in the Directors’ Report.
Whether the % of selling expenses in relation to Relationship between “selling and marketing”
sales has gone up? expenses and the sales. Any undue increase
could either mean that the company is in a very
competitive industry or it is aggressive to
increase its market share by adopting a
marketing strategy that would increase the
marketing expenses including offer of higher
commission to the intermediaries like agents
etc.

Whether the company had sufficient internal Debt service coverage ratio = Internal accruals
accruals {Profit after tax (-) dividend (+) any (+) interest on medium and long-term external
non-cash expenditure like depreciation, liabilities/interest on medium and long-term
preliminary expenses write-off etc.} to meet liabilities (+) repayment of medium and long-
repayment obligation of principal amount of term external liabilities. The term-lending
loans, debentures etc.? institution or bank looks for 1.75:1 on an
average for the loan period. This is a very
critical ratio to indicate the ability of the
company to take care of its obligation towards
the loans it has taken both by way of interest as
well as repayment of the principal.
Return on investment in business to compare it Earnings before interest and tax/average total
with return on similar investment elsewhere. invested capital, i.e., net worth (+) debt capital.
This should be higher than the average cost of
funds in the form of loans, i.e., interest cost on
loans/debentures etc.
Return on equity (includes reserves and surplus) Profit after tax (-) dividend on preference share
capital/net worth (-) preference share capital
(return in percentage). Anything less than 15%
means that our investment in this company is
earning less than the average return in the
market.
How much earning has our share made? (EPS) Profit after tax (-) dividend on preference share
capital/number of equity shares. In terms of
percentage anything less than 40% to 50% of
the face value of the shares would not go well
with the market sentiments.
Whether the company has reduced its dividend Relationship between amount of dividend
payout in comparison with last year? payout and profit after tax last year and this
year. Is there any reason for this like liquidity
crunch that the company is experiencing or the
need for conserving cash for business activity,
like purchase of fixed assets in the immediate
future?
Is there any significant increase in the “Notes on Accounts” as given at the end of the
contingent liabilities due to any of the following? accounts.
Disputed central excise duty, customs duty, Any substantial increase especially in disputed
income tax, octroi, sales tax, contracts amount of duties should put us on guard.
remaining unexecuted, guarantees given by the
banks on behalf of the company as well as the
guarantees given by the company on behalf of
its subsidiary or associate company, letter of
credit outstanding for which goods not yet
received etc.
Has the company changed its policy of Substantial change in vendor charges, or
outsourcing its work from vendors and if so, subcontracting charges.
what are the reasons?
Is there any substantial increase in charges paid Increase in consultancy charges.

to consultants?

Has the company opened any branch office in Directors’ Report or sudden spurt in general and
the last year? administration expenses.
The principal tools of analysis are:

Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it
with the past trend. In the statements of accounts, there are several such pairs of parameters and
hence ratio analysis assumes great significance. The most important thing to remember in the case of
ratio analysis is that you can compare two units in the same industry only and other factors like the
relative ages of the units, the scales of operation etc. come into play.
Comparison with past trend within the same company is one type of analysis and comparison with the
industrial average is another analysis
While one can derive a lot of useful information from analysis of the financial statements, we have to
keep in mind some of the limitations of the financial statements. Analysis of financial statements does
indicate a definite trend, though not accurately, due to the intrinsic nature of the data itself.
Some of the limitations of the financial statements are given below.
♦ Analysis and understanding of financial statements is only one of the tools in
understanding of the company
♦ The annual statements do have great limitations in their value, as they do not speak
about the following-
♦ Management, its strength, inadequacy etc.
♦ Key personnel behind the activity and human resources in the organisation.
♦ Average key ratios in the industry in the country, of which the company is an integral
part. This information has to be obtained separately.
♦ Balance sheet is as on a particular date and hence it does not indicate about the
average for the entire year. Hence it cannot indicate the position with 100% reliability. (Link it
with fundamental analysis.)
♦ The auditors’ report is based more on information given by the management, company
personnel etc.
♦ To an extent at least, there can be manipulation in the level of expenditure, level of
closing stocks and sales income to manipulate profits of the organisation, depending upon the
requirement of the management during a particular year.
♦ One cannot come to know from study of financial statements about the tax planning of
the company or the basis on which the company pays tax, as it is not mandatory under the
provisions of The Companies’ Act, 1956, to furnish details of tax paid in the annual statement
of accounts.
♦ Notwithstanding all the above, continuous study of financial statements relating to an
industry can provide the reader and analyst with an in-depth knowledge of the industry and
the trend over a period of time. This may prove invaluable as a tool in investment decision or
sale decision of shares/debentures/fixed deposits etc.
Funds flow statement – its format and construction
Financial funds flow statement is different from what the students would have learnt by this time as
“Funds flow for Management Accounting”. Financial funds flow statement bifurcates the funds into
short-term and long-term instead of working capital and funds from operations etc. It further bifurcates
the long-term funds into internal and external resources.
The purpose of this bifurcation is to ensure proper financial planning. Financial planning essentially
involves planning for resources and obtain matching resources in terms of duration, rate of interest
etc. For example, short-term resource cannot be used for fixed assets. This is called “diversion” of
funds and could land the enterprise in serious shortfall of working capital funds. Similarly long-term

funds would always be more than long-term use, as internal accruals are a part of long-term funds
along with share capital. These could be used for short-term as well as long-term purposes. Please
refer to the Chapter on “Working capital management”.
Increase in liability = source of funds; decrease in assets = source of funds
Increase in assets = use of funds; decrease in liability = use of funds
Thus a liability can reduce during a year and increase because of fresh borrowing. Let us take for
example, term loans. During the period under review, a part of the outstanding loan would have been
paid during the year and the enterprise would have taken fresh loans. Thus in the following statement,
increase in term-loans has been shown as a source of fund and decrease in term-loan has been shown
as use of fund. This is true of all medium and long-term liabilities. The student should keep this in
mind while preparing funds flow statement. He should not be tempted to adjust and
present only the net position as a source or use. For example fresh loan taken = Rs. 100 lacs
and loans repaid during the year = Rs. 30 lacs. The student may be tempted to present the net
position of Rs. 70 lacs as source of funds. This will not give the correct picture.
However in the case of short-term source or use, only net position has to be presented as
they are constantly fluctuating and do not stay in business for a long period of time.
Keeping these in mind let us examine the following funds flow statement and comment at the end:
Financial statements - Funds flow

statement - Format
Funds inflow – sources
1999-2000
Long-term funds 2000-2001
Profit after Tax 240 265
Less:
Dividend paid 80 80
Net profit 151 176
Add:
Depreciation for the year 36 40
Amount amortised 15 15
(A) - Long-term funds (internal) 202 231
Increase in share capital 0 0
Increase in term loans 150 0
Increase in debentures/bonds 0 250
Increase in fixed deposits/acceptances and 75 50

other medium and long-term liabilities
Decrease in investments 25 15
Sale proceeds of fixed assets 15 22
(B) - Long-term funds (external) 265 337
Total Long-term funds (A+B) 467 568
Increase in short-term bank borrowing –

overdraft/cash credit 133 132
Increase in trade creditors 0 67
Increase in short-term loans 65 22
Increase in provisions and other 33 45
Short-term liabilities 0 0
Decrease in cash and bank
Decrease in inventory 0 0
Decrease in receivables 52 0
Decrease in other current assets 0 0
(C) - Short-term funds 283 286
Total funds generated during the year 750 854
Funds outflow - uses
1999- 2000-
Long-term use 2000 2001
Increase in fixed assets 175 268
Increase in investment 75 50
Decrease in term loans, redemption of

bonds and debentures and decrease in
other medium and long-term liabilities 230 200
(D) – Long-term uses 480 518
Short-term use
Increase in inventory 122 160
Increase in receivables 0 147

Increase in cash and bank 32 14
Increase in other current assets 31 15
Decrease in overdraft/cash credit 0 0
Decrease in trade creditors 85 0
Decrease in provisions and other

Short-term liabilities 0 0
Decrease in short-term loans 0 0
(E) - Short-term uses 270 336
Total uses = D + E 750 854
Summary of Funds flow statement
Long - term funds 467 568
Long- term use 480 518
Surplus or (deficit) (13) 50
Short - term funds 283 286
Short - term use 270 336
Surplus or (deficit) 13 (50)
What do we observe in the above statement?

In the first year, the short-term funds are in excess of short-term use to the extent of Rs. 13 lacs.
These funds have been used for long-term purposes. This means that the enterprise has lost Rs. 13
lacs from working capital. This could affect the liquidity of the enterprise in the long run. If this feature
persists, the enterprise could see itself in what is often referred to as “debt trap”. Debt trap simply
means that the enterprise takes fresh loan to repay the earlier loan. This would surely happen in case
the enterprise uses constantly short-term funds for fixed assets or long-term purposes.
Fortunately this has changed in the second year and during this year, the long-term funds are in
excess of long-term purposes. This is the correct and desirable feature of funds flow statement in a
business enterprise.
Questions and numerical exercises for practice and reinforcement of learning

1. What is the difference between cash flow statement and funds flow statement?
2. What are the components of annual report of limited companies?
3. Practise analysing the financial statements of Profit and Loss Account and Balance Sheet of limited
companies in different sectors in groups and interpret the financial ratios – intra-firm analysis
should be possible.
4. What are the limitations of analysis of performance of a business enterprise based on published
annual accounts?

5. What is the usual characteristic feature of funds flow statement? If this feature is not observed in
funds flow statement what is the risk to a business?
6. Give the formulae for the following ratios:
Earning per share
Return on net worth
Return on capital employed
Return on total capital employed
Debt service coverage ratio
7. Find out the debt to equity ratio from the following – both all external debts and only medium and
long-term debts. Find out both the ways, one by treating PSC as debt and another treating it as
part of equity:
Net worth Rs. 5000 lacs
Preference share capital Rs. 500 lacs
Medium and long-term liabilities Rs. Rs. 7500 lacs
Current liabilities Rs. 5000 lacs
8. Give your responses to the question at the end of the following:
Parameter 2000-2001 2001-2002
Sales 5000 lacs 6200 lacs
Other income 250 lacs 500 lacs
Operating expenses 4900 lacs 6300 lacs
Are the company’s operations profitable?
What do the above figures indicate on the performance of the company?
9. Determine the required financial parameter or ratio as given at the end from the following:
(Rupees in lacs)
EBIDT 2500
Interest 500 (on M&T liabilities - 340 and the rest working capital)
Book depreciation 240
Income tax depreciation 360
Misc. expense written off during the year 120
Income tax 40%
Dividend on preference share capital 30 (rate 10%)
Dividend on equity share capital 200 (rate 20% - FV Rs. 25/-)
Reserves 500 (excluding profit retained in business during the year)
Medium and long term liability to be met during the period 500
WDV of fixed assets -3500
Outstanding medium and long-term liabilities 2400
Outstanding current liabilities - 2000 including dividend payable for the year and provision for
tax for the year as under
Misc. expenses outstanding (yet to be written off) – Rs. 240 lacs

Find out -
Profit before tax
Profit subject to tax as per Income tax calculation
Amount of income tax payable
Profit after tax
Profit retained in business
Gross cash accruals
Net cash accruals
Debt/equity ratio (both)
Interest coverage ratio
Debt service coverage ratio
Earnings ratio
Also indicate the desirable minimum or maximum within brackets against each parameter,
wherever applicable
10. From the following construct the funds flow statement in the proper format including summary and
offer your comments (all figures in lacs of rupees)
Increase in share capital – 250
Sale of fixed assets – 50
Increase in inventory – 100
Decrease in cash and bank – 20
Repayment of loans for fixed assets – 80
Profits after tax for the period – 120
Dividend declared along with tax – 36
Increase in bank borrowing – 80
Decrease in other current liabilities – 35
Disposal of existing investment – 25 and new investment – 35
New debentures – 150
Redemption of other medium and long-term liabilities – 100
Increase in inventory – 80
Depreciation for the period – 70
Amount amortised during the period – 25
Increase in other current assets – 28
Increase in fixed assets – 226
Balance increase in receivables

*** End of handout ***

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Subject: Financial Management

Chapter no. 8: Financial statements analysis

Chapter No. 8 – Financial statements

Introduction to financial statements and their differing objectives

At the end of the chapter the student will be able to

Punjab Technical University, Online Virtual Campus 1

Introduction to Financial Statements and their differing objectives:

What are financial statements in a business enterprise?

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Example no. 1 - A sample of “Profit and Loss” Account (Rupees in Lacs)

Linkage between balance sheet and profit and loss accounts

The balance sheet tells us about the following:

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What is the use for this money?

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Key pointers to balance sheet and profit and loss statements:

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Other parts of annual statements –

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The principal tools of analysis are –

Acid test ratio or quick asset ratio:

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Turn over ratios:

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Profit margin on sales:

Sales 100lacs 100lacs

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Net profit 5lacs 5lacs

Investment on capital ratios/Earnings ratios:

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What is the objective behind analysis of financial statements?

Objective (To know about) Relevant indicator/Remarks

Net worth, i.e., share capital, reserves and

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creditors are at purchase price for software or

Whether the company has increased its Increase in amount of investment in

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What is the proportion of marketable Percentage of marketable investment to total

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not disclosed. This has to be taken into

If it is a manufacturing company, whether the % Relationship between materials consumed

Whether the % of administration and general Relationship between general and

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Is there any substantial increase in charges paid Increase in consultancy charges.

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The principal tools of analysis are:

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Financial statements - Funds flow

Funds inflow – sources

Profit after Tax 240 265

Net profit 151 176

Depreciation for the year 36 40

(A) - Long-term funds (internal) 202 231

Increase in share capital 0 0

Increase in term loans 150 0

Increase in debentures/bonds 0 250

Increase in fixed deposits/acceptances and 75 50

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other medium and long-term liabilities

Sale proceeds of fixed assets 15 22

(B) - Long-term funds (external) 265 337

* End of handout *