Basics of Financial Statement Analysis

Analyzing financial statements involves evaluating three characteristics of a

company: its liquidity, its profitability, and its insolvency. A short-term
creditor, such as a bank, is primarily interested in the ability of the borrower
to pay obligations when they come due. The liquidity of the borrower is
extremely important in evaluating the safety of a loan. A long-term
creditor, such as a bondholder, however, looks to profitability and solvency
measures that indicate the company’s ability to survive over a long period of
time. Long-term creditors consider such measures as the amount of debt in
the company’s capital structure and its ability to meet interest payments.
Similarly, stockholders are interested in the profitability and solvency of the
company. They want to assess the likelihood of dividends and the growth
potential of the stock.

Need for Comparative Analysis

Every item reported in a financial statement has significance. When Sears,

Roebuck and Co. reports cash of $729 million on its balance sheet, we
know the company had that amount of cash on the balance sheet date. But,
we do not know whether the amount represents an increase over prior years,
or whether it is adequate in relation to the company’s need for cash. To
obtain such information, it is necessary to compare the amount of cash with
other fiancial statement data.

Comparison can be made on a number of different bases. Three are

illustrated here:

1. Intracompany basis.
This basis compares an item or financial relationship within a company
in the current year with the same item or relationship in one or more prior
years. For example, Sears, Roebuck and Co. can compare its cash balance at
the end of the current year with last year’s balance to find the amount of the
increase or decrease. Likewise, Sears can compare the percentage of cash to
current assets at the end of the current year with the percentage in one or
more prior years. Intracompany comparisons are useful in detecting changes
in financial relationships and significant trends.
2. Industry averages.
This basis compares an item or financial relationship of a company with
industry averages (or norms) published by financial ratings organizations
such as Dun & Bradstreet, Moody’s and Standard & Poor’s. For
example, Sears’s net income can be compared with the average net income
of all companies in the retail chain-store industry. Comparisons with
industry averages provide information as to a company’s relative
performance within the industry.

3. Intercompany basis.
This basis compares an item or financial relationship of one company
with the same item or relationship in one or more competing companies.
The comparisons are made on the basis of the published financial statements
of the individual companies. For example, Sears’s total sales for the year can
be compared with the total sales of its major competitors such as Kmart and
Wal-Mart. Intercompany comparisons are useful in determining a
company’s competitive position.

Tools of Financial Statement Analysis

Various tools are used to evaluate the significance of financial statement

data. Three commonly used tools are these:
• Funds Flow Analysis
• Cash Flow Analysis
• Ratio Analysis

1. Fund Flow Analysis

Fund may be interpreted in various ways as (a) Cash, (b) Total current
assets, (c) Net working capital, (d) Net current assets. For the purpose of
fund flow statement the term means net working capital. The flow of fund
will occur in a business, when a transaction results in a change i.e., increase
or decrease in the amount of fund.
According to Robert Anthony the funds flow statement describes the sources
from which additional funds were derived and the uses to which these funds
were put.
In short, it is a technical device designed to highlight the changes in the
financial condition of a business enterprise between two balance sheets.
Different names of Fund-Flow Statement
o A Funds Statement
o A statement of sources and uses of fund
o A statement of sources and application of fund
o Where got and where gone statement
o Inflow and outflow of fund statement

Objectives of Fund Flow Statement

The main purposes of FFS are:]
o To help to understand the changes in assets and asset sources which
are not readily evident in the income statement or financial statement.
o To inform as to how the loans to the business have been used.
o To point out the financial strengths and weaknesses of the business.

Format of Fund Flow Statement

Sources
Fund from operation
Non-trading incomes
Issue of shares
Issue of debentures
Borrowing of loans
Acceptance of deposits
Sale of fixed assets
Sale of investments (Long Term)
Decrease in working capital
Applications
Fund lost in operations
Non-operating expenses
Redemption of redeemable
preference share
Redemption of debentures
Repayment of loans
Repayment of deposits
Purchase of fixed assets
Purchase of long term investments
Increase in working capital

Steps in Preparation of Fund Flow Statement.

1. Preparation of schedule changes in working capital (taking current

items only).
2. Preparation of adjusted profit and loss account (to know fund from or
fund lost in operations).
3. Preparation of accounts for non-current items (Ascertain the hidden
information).
4. Preparation of the fund flow statement.
 Statement of changes in Working Capital
2002
____________________________________________________________
Particulars 2000 2001 Effect on working capital
Rs. Rs. Increase Rs. Decrease Rs
Current Assets:
Cash 30000 10000 20000
Accounts Receivable 70000 140000 70000
Stock-in-trade 150000 225000 75000
Work-in-progress 80000 90000 10000
Total Current Assets 330000 465000
Tax payable 77000 43000 34000
Accounts payable 96000 192000 96000
Interest payable 37000 45000 8000
Dividend payable 50000 35000 15000
Total Current
Liabilities 260000 315000
Working Capital
(CA - CL) 70000 150000
Net increase in
Working Capital (B/f) 80000 80000
Total 150000 150000 204000 204000
2. Cash Flow Analysis (CFS)
Cash is a life blood of business. It sis an important tool of cash planning
and control. A firm receives cash from various sources like sales, debtors,
sale of assets investments etc. Likewise, the firm needs cash to make
payment to salaries, rent dividend, interest etc.
Cash flow statement reveals that inflow and outflow of cash during a
particular period. It is prepared on the basis of historical data showing the
inflow and outflow of cash.

Objectives of CFS
1. To show the causes of changes in cash balance between the balance
sheet dates.
2. To show the actors contributing to the reduction of cash balance
inspire of increasing of profit or decreasing profit.

Uses of CFS
1. It explaining the reasons for low cash balance.
2. It shows the major sources and uses of cash.
3. It helps in short term financial decisions relating to liquidity.
4. From the past year statements projections can be made for the future.
5. It helps the management in planning the repayment of loans, credit
arrangements etc.

Steps in Preparing CFS

1. Opening of accounts for non-current items (to find out the hidden
information).
2. Preparation of adjusted P&L account (to find out cash from operation
or profit, and cash lot in operation or loss).
3. Comparison of current items (to find out inflow or outflow of cash).
4. Preparation of Cash Flow Statement.

To preparing Account for all non-current items is easier for preparing Cash
Flow Statement.
Cash from operation can be prepared by this formula also.

Net Profit + Decrease in Current Assets - Increase in Current Assets

Increase in Current Liabilities Decrease in Current Liabil..
Usefulness of the Statement of Cash Flows

The information in a statement of cash flows should help investors,

creditors, and others assess the following aspects of the firm’s financial
position.

1. The entity’s ability to generate future cash flows.

By examining relationships between items in the statement of cash
flows, investors and others can make predictions of the amounts,
timing, and uncertainty of future cash flows better than they can from
accrual basis data.
2. The entity’s ability to pay dividends and meet obligations.
If a company does not have adequate cash, employees cannot be paid,
debts settled, or dividends paid. Employees, creditors, and
stockholders should be particularly interested in this statement,
because it alone shows the flows of cash in a business.
3. The cash investing and financing transactions during the period.
By examining a company’s investing and financing transactions, a
financial statement reader can better understand why assets and
liabilities changed during the period.
4. The reasons for the difference between net income and net cash
provided (used) by operating activities.
Net income provides information on the success or failure of a
business enterprise. However, some are critical of accrual basis net
income because it requires many estimates. As a result, the reliability
of the number is often challenged. Such is not the case with cash.
Many readers of the statement of cash flows want to know the reasons
for the difference between net income and net cash provided by
operating activities. Then they can assess for themselves the reliability
of the income number.

In summary, the information in the statement of cash flows is useful in

answering the following questions.
How did cash increase when there was a net loss for the period?
How were the proceeds of the bond issue used?
How was the expansions in the plant and equipment financed?
Why were dividends not increased?
How was the retirement of debt accomplished?
How much money was borrowed during the year?
Is cash flow greater or less than net income?
 Cash Flow Statement

Inflow of Cash Amount Outflow of cash Amount

Opening cash balance *** Redemption of preference ***
shares
Cash from operation *** Redemption of debentures ***
Sales of assets *** Repayment of loans ***
Issue of debentures *** Payment of dividends ***
Raising of loans *** Pay of tax ***
Collection from *** Cash lost in debentures ***
debentures
Refund of tax *** Closing cash balance ***
*** ***

Cash from operation can be calculated in two ways:

1. Cash Sales Method
Cash Sales – (Cash Purchase + Cash Operation Expenses)

2. Net Profit Method

It can be prepared in statement form or by Adjusted Profit and Loss
Account.

Illustration From the following balance sheets of Joy Ltd., prepare cash
flow statement:

Liabilities
Particulars Previous year Current year
Equity share capital 300000 400000
8% Redeemable Pref. share capital 150000 100000
General reserve 40000 70000
P & L A/c 30000 48000
Proposed dividends 42000 50000
Creditors 55000 83000
Bills payable 20000 16000
Provision for taxation 40000 50000
677000 817000
Assets
Particulars Previous year Current year
Goodwill 115000 90000
Building 200000 170000
Plant 80000 200000
Debtors 160000 200000
Stock 77000 109000
Bills receivable 20000 30000
Cash 15000 10000
Bank 10000 8000
677000 817000

Additional information
(a) Depreciation of Rs. 10000 and Rs. 20000 have been changed
on plant and buildings during the current year.
(b) An interim dividend of Rs. 20000 has been paid during the
current year.
(c) Rs. 35000 was paid during the current year for income tax.

Solution
Step – 1: A/c for Non-current items

Building A/c
Rs Rs
To balance c/d 200000 By Depreciation (Ad P&L) 20000
By Cash (sales) (bal.) (4) 10000
By Balance c/d 170000
200000 200000

Plant A/c
Rs Rs
To Balance c/d 80000 By Depreciation (Ad P&L) 20000
To Cash(purchase) 130000 By Balance c/d 200000
210000 210000
 Equity Share Capital A/c
Rs Rs
To Balance c/d 400000 By Balance c/d 300000
By Issue of shares 100000
400000 400000

Pref. Share Capital A/c

Rs Rs
To redemption (bal) 50000 By balance b/d 150000
To balance c/d 100000
150000 150000

Provision for Taxation A/c

Rs Rs
To cash (Tax paid) 35000 By balance b/d 40000
To balance c/d 50000 By balance (Ad. P&L A/c) 45000

85000 85000

Adjusted P & L A/c

Rs Rs
To depreciation on plant 10000 By balance b/d 30000
To deprecation on 20000 By CFO (balance) 218000
building
To goodwill write-off 25000
To provision for tax 45000
To interim dividend 20000
To proposed dividend 50000
(current year)
To general reserve 30000
To balance C/d 48000
248000 248000
3. Ratio analysis:
The most important task of a financial manager is to interpret the financial
information in such a manner, that it can be well-understood by the people,
who are not well versed in financial information figures. The technique , by
which it is so done, known as ‘Ratio analysis’.

Ratio Analysis expresses the relationship among selected items of financial

statement data. A ratio expresses the mathematical relationship between one
quantity and another. Ratio is a relationship between two or more variable
expressed in; (i) Percentage, (ii) Rate (iii) Proportion.

Ratio analysis is an important technique of financial analysis. It depicts the

efficiency or short-fall of the organization in the form of trend analysis.

Different ratios appeal to different people. Management, having the task of

running a business efficiently, will be interested in all ratios. A supplier of
goods on credit will be particularly interested in liquidity ratios, which
indicate the ability of the business to pay its bills. Existing and future
shareholders will be interested in investment ratios, which indicate the level
of return that can be expected on an investment in the business. Major
customers, intent on having a continuing source of supply, will be interested
in the financial stability, as revealed by the capital structure, liquidity and
profitability ratios. Debenture and loan stock holders will be interested in the
ability of a business to pay interest, and ultimately to repay the capital. A
banker, only giving short-term loans, will be interested mainly in the
liquidity of the business, and its ability to repay those loans.

The overall advantages of ratios are that they enable valid comparisons to be
made between business of varying size and in different industries.

All the problems of a business can’t be solved by ratio analysis. It will

merely give a general indication of a trend, at the same time spotlighting any
divergence from normality. This knowledge, however, should enable
management to correct whatever may be going wrong in business.

Classifications of Ratio Analysis

• Liquidity Ratios
• Profitability Ratios
• Solvency Ratios
Liquidity Ratios
Liquidity ratios measure the short-term ability of the enterprise to pay its
maturing obligations and to meet unexpected needs for cash. Short-term
creditors such as bankers and suppliers are particularly interested in
assessing liquidity. The ratios that can be used to determine the enterprise’s
short-term debt-paying ability are the current ratio, the acid-test ratio, the
current-cash debt coverage ratio, receivables turnover, and inventory
turnover.

Profitability Ratios
Profitability ratios measure the income or operating success of an enterprise
for a given period of time. Income, or the lack of it, affects the company’s
liquidity position and the company’s ability to grow. As a consequence, both
creditors and investors are interested in evaluating earning power –
profitability. Profitability is frequently used as the ultimate test of
management’s operating effectiveness.

Solvency Ratios
Solvency ratios measure the ability of the company to survive over a long
period of time. Long-term creditors and stockholders are particularly
interested in a company’s ability to pay interest a sit comes due and to repay
the face value of debt at maturity. Debt to total assets, times interest earned,
and cash debt coverage are three rations that provide information about debt-
paying ability.

Steps in Ratio Analysis

Step 1 : Collection of information, which are relevant from the financial
statements and then to calculate different ratios accordingly.
Step 2 : Comparison of computed ratios of the same organizations or with
the industry ratios.
Step 3 : Interpretation, drawing of inference and report-writing.
Chart Showing Application of Different Ratios
For Testing Ratio Concerned Interested Parties
A. Profitability 1. Gross Profit Ratio Shareholders
2. Net Profit Ratio Creditors (Long Term)
3. Operating Ratio Government
4. Return of Capital Purchase of Enterprise
Employed Employees
5. Dividend Ratio
6. Earning per Share
7. Dividend per Share

B. Liquidity and 1. Current Ratio Creditors (short term)

Solvency 2. Liquid Ratio Investors
3. Absolute Liquid Ratio Money Lenders
4. Proprietary Ratio
5. Assets to Proprietorship
Ratio
6. Debt-Equity Ratio
7. Capital Gearing Ratio

C. Capital Structure 1. Capital Gearing Ratio Shareholders and

Outsiders
2. Equity Capital Ratio
3. Long-term Loans to
Networth

D. Activity 1. Debtors Turnover Ratio Management

2. Creditors Turnover Ratio Shareholders
3. Stock Turnover Ratio Creditors (Long and
Short term)
4. Fixed Assets Turnover Customers
Ratio
5. Current Asset Turnover
6. Total Asset Turnover Ratio
7. Working Capital Turnover
Ratio

E. Management All concerned Ratios Management

Efficiency
Advantages of Ratio Analysis

Ratio analysis is a very important and useful tool for financial analysis. It
serves many purpose and is helpful not only for internal management but
also for prospective investors, creditors and other outsiders.

1. It is an important and useful tool to check upon the efficiency with

which the working capital is being used (managed) in a business
enterprise. Efficient management of working capital.
2. It helps the management of business concern in evaluating its
financial position and efficiency of performance.
3. It serves as a sort of health test of a business firm, because with the
help of this analysis financial manager can determine whether the firm
is financially healthy or not.
4. A ratio analysis covering a number of past accounting (financial)
periods clearly shows the trend of changes in the business position
(i.e., whether the trend in financial position, income position etc. is
upward, or downward or static). The progress or downfall of a
business concern is clearly indicated by this analysis. Use to measure
the trend of the business.
5. It helps in making financial estimates for the future (i.e., in financial
forecasting).
6. It helps the task of managerial control to a great extent.
7. It helps the credit suppliers and investors in evaluating a business firm
as a desirable debtor or as a potential investment outlet.
8. With the help of this analysis ideal (standard) ratios can be established
and these can be used for the purpose of comparison of a firm’s
progress and performance.
9. This analysis communicates important information regarding financial
strength and standing, earning capacity, debt (borrowing) capacity,
liquidity position, capacity to meet fixed commitments (charges,
solvency, capital gearing, working capital management, future
prospects etc.) of a business concern.
10.This analysis may be employed for the purpose of comparing the
working result and efficiency of performance of a business enterprise
with that of other enterprises engaged in the same industry (inter-
term-comparisons).
Limitations of Ratio Analysis

1. Accounting Ratios (calculated under the system of ratio analysis) will

be correct only if the accounting data (figures), on which they are
based, are correct.
2. It is mainly a historical analysis or an analysis of the past financial
data.
3. in regard to profits of a business concern, ratio analysis may, in certain
circumstances be misleading.
4. continues changes in price levels (or, purchasing power of money)
seriously affect the validity or comparison of accounting ratios
calculated for different accounting (financial) periods and make such
comparisons very difficult.
5. Comparisons become difficult also on account of difference in the
definition of several financial (accounting) terms like gross profit,
operating profit, net profit etc., and on account of a considerable
diversely in practice as regards their measurement.
6. The validity of comparison is also seriously affected by window
dressing in the basic financial statements and by differences in
accounting methods used by different business concerns.
7. A single ratio will not be able to convey much information.
8. This analysis gives only a part of the total information required for
proper decision-making.
9. Ratio analysis should not be taken as substitute for sound judgment.
10.It should not be overlooked that business problems cannot be solved
simple mechanically through ratio analysis or other types of financial
analysis.
Illustration : The following is the trading and profit and loss account of
Ram Sons (Pvt.) Ltd. For the year ended June 30, 2000.
Rs. Rs.
To stock-in-hand 76250 By sales 500000
To purchases 315000 By stock in hand 98500
To carriage and freight 2000
To wages 5000
To gross profit 200000
_______ ______
Rs 598000 Rs 598000
To administrative 101000 By Gross profit 200000
Expenses
To finance expenses: By Non-operating incomes:
Interest 1200 Interest on security 1500
Discount 2400 Dividend on shares 3750
Bad debts 3400 Profit on sale’s shares 750
7000 6000
To selling and distribu-
tion expenses 12000
To non-operating
expenses:
Loss on sale of
securities 350
Provision for
legal suit 1650 2000
To Net profit 84000 _________
Rs 206000 Rs 206000

Required to calculate :
(a) Expense Ratio, (b) Gross Profit Ratio, (c) Net Profit Ratio, (d)
Operating Net Profit Ratio, (e) Operating ratio, (f) Stock
Turnover.
Solution :

a) Expense ratios

i) Administrative expenses = Rs. 101000 × 100 = 20.2%

Sales Rs. 500000

ii) Finance expenses = Rs. 7000 × 100 = 1.40%

Sales Rs. 500000

iii) Selling and Distribution Expenses = Rs. 12000 × 100 = 2.40%

Sales Rs. 500000

iv) Non-operating expenses = Rs. 2000 × 100 = 0.4%

Sales Rs. 500000

b) Gross Profit ratio

Gross Profit = 2000 × 100 = 40%

Sales 500000

c) Net Profit ratio

Net Profit = 84000 × 100 = 16.80%

Sales 500000

d) Operating Net Profit Ratio

operating net profit = Net profit + Non-operating expenses – non-operating

incomes
= Rs. 84000 + Rs. 2000 – Rs. 6000 = Rs. 80000

Ratio Operating net profit = Rs. 80000 × 100 = 16%

Sales Rs 500000

* It may be noted that operating ratio together with the operating net profit
ratio will be equal to 100%.
e) Operating ratio

This is an expression of the cost of goods sold plus all other operating
expenses to net sales. This is calculated as follows:

Stock in the beginning Rs. 76250

Add: Purchases 315000
Add: Direct expenses (Rs. 2000 + Rs. 5000) 7000
398500
Less: Stock in hand at the end 98500
Cost of goods sold 300000
Add: All operating expenses:
Administration expenses 101000
Finance expenses 7000
Selling and distribution expenses 12000
120000
Total cost of operation Rs. 420000
The operating ratio = Rs. 420000 × 100 = 84%
Rs. 500000

f) Stock turnover

Stock at the beginning Rs. 76250

Add: Stock at the end 98500
Total Stock Rs. 174750

Average stock ﴾ Rs. 174750 ﴿

2

Stock turnover = Costs of goods sold = Rs. 300000 = 3.43 times

Average stock Rs. 87375

* It may be noted that operating ratio together with the operating net profit
ratio will be equal to 100%.
Limitations of Financial Statement Analysis

Significant business decisions are frequently made using one or more of the
analytical tools illustrated in this term paper. But, one should be aware of the
limitations of these tools and of the financial statements on which they are
based.

Estimates
Financial statements contain numerous estimates. Estimates are used in
determining the allowance for uncollectible receivables, periodic
depreciation, the costs of warranties, and contingent losses. To the extent
that these estimates are inaccurate, the financial ratios and percentages are
inaccurate.

Cost
Traditional financial statements are based on cost. They are not adjusted for
price-level changes. Comparisons of unadjusted financial data from different
periods may be rendered invalid by significant inflation or deflation. For
example, a five-year comparison of Sears’s revenues might show a growth
of 36%. But this growth trend would be misleading if the general price level
had increased significantly during the same period.

Alternative Accounting Methods

Companies vary in the generally accepted accounting principles they use.
Such variations may hamper comparibility. For example, one company may
use the FIFO method of inventory costing: another company in the same
industry may use LIFO. If inventory is a significant asset to both companies,
it is unlikely that their current ratios are comparable. For example, If
General Motors Corporation had used FIFO instead of LIFO in valuing its
inventories; its inventories would have been 26% higher. This difference
would significantly affect the current ratio (and other ratios as well). In
addition to differences in inventory costing methods, differences also exist in
reporting such items as depreciation, depletion, and amortization. These
differences in accounting methods might be detectable from reading the
notes to the financial statements. But, adjusting the financial data to
compensate for the different methods is difficult, if not impossible in some
cases.
Atypical Data
Fiscal year-end data may not be typical of the financial condition during the
year. Firms frequently establish a fiscal year-end that coincides with the low
point in operating activity or in inventory levels. Therefore, certain account
balances (cash, receivables, payables, and inventories) may not be
representative of the balances in the accounts during the year.

Diversification of Firms
Diversification in U.S. industry also limits the usefulness of financial
analysis. Many firms today are so diversified that they cannot be classified
by a single industry – they are true conglomerates. Others appear to be
comparable but are not.