FINANCIAL ANALYSIS

Reference Books:
Financial Management by M. Y. Khan
P. K. Jain

Financial statements provide a summarized view of the financial

position and operations of an enterprise. The analysis of financial
statement is an important aid to financial analysis.
Focus of financial analysis is on key figures in the financial statement
and the significant relationship that exist between them.
The first task of financial analyst is to select the information relevant
to the decision under consideration from the total information
contained in the financial statement.
The second step is to arrange the information in a way to highlight
significant relationship.
In brief financial analysis is the process of selection, relation and
evaluation.

MEASURING LIQUIDITY

Liquidity is the ease with which assets can be converted into cash. It is the
ability of an enterprise to meet its short term obligations.
Assets which can be most quickly converted into cash are called quick assets
The current ratio, the quick ratio and turnover ratios are measures of
liquidity:
Current ratio = current assets : currents liabilities
The current ratio measures general liquidity of an enterprise.
If the current ratio is lower than 1:1 (e.g. 0.5:1, which can also be expressed
as 1.2), current liabilities exceed current assets. This generally shows that
there is a high financial risk because, in business, cash is more important
than profit.
If the current ratio is too high (perhaps 3:1 or more) this may mean that the
company has more money than it can efficiently use. There is no hard and
fast rule about a ratio being too high, but when it rises continually over time
the situation should be examined.
It should be remembered that, when calculating current ratio, current assets
should be taken as inclusive of marketable securities.
A current ratio of 2:1 is considered satisfactory.

Quick ratio = Quick assets : Current liabilities

The term quick assets refer to current assets which can be
converted into cash immediately or at a short notice
without diminution of value.
Thus quick assets include cash and bank balance, short
term marketable securities, debtors/ receivables. It
excludes prepaid expenses and inventory.

Turnover Ratios
Three relevant turnover ratios are Inventory turnover ratio,
Debtors turnover ratio and creditors turnover ratio
INVENTORY TURNOVER RATIO
Inventory Turnover Ratio = Cost of goods sold/ Average inventory
Cost of goods sold = Sales- Gross Profit
Average means (Opening + Closing)/2
The ratio indicates how fast inventory is sold. Higher ratio is
better
Eg. A firm has sold goods worth Rs. 300000 at a gross margin of
20%. The stock at the beginning and at the end of the year is
Rs. 35000 and Rs. 45000 respectively. What is the inventory
turnover ratio
Inventory turnover ratio= (300000-60000)/40000= 6 times
Inventory Holding period = 12months/6 = 2 months

Debtors Turnover Ratio

Net Credit Sales

Average debtors

This ratio tells us how rapidly debts are collected.

Higher ratio is indicative of shorter time lag between credit sales
and cash collection. Higher the ratio better is the case
Eg. Credit sales = 240000
Av Debtors = 30000
Debtors Turnover Ratio = 240000 = 8 times
30000
Debt collection period = 12 months = 1.5 months
Debtors turnover
Net credit sale =Gross credit sales returns
Creditors Turnover Ratio
Lower Ratio is better

Net Credit purchases

Average Creditors

The summing up of the three turnover ratios has a bearing on

the liquidity of the firm. The combined effect of the three
turnover ratios is
Inventory holding period
Add: Debtors collection period
Less: Creditors payment period

2 months
+1.5 month
-3 months
.5 month
The shorter is this period , the better is the liquidity of the
enterprise

MEASURING SOLVENCY
Solvency Indicates the proportion of shareholders
funds in the total liabilities. The higher the
solvency ratio, the higher the proportion of
shareholders funds in the total financing of the
business.
Following ratios help in measuring the solvency of
an enterprise
Debt Equity ratio
Interest Coverage ratio
Debt Service Coverage ratio

DEBT EQUITY RATIO = Total outside Debts

Share Holders Fund

Total outside debts = (long term debts+ short term debts)

If D/E Ratio is 1:2 it means that total stake of the share holders is double the
stake of the outsiders.
Higher D/E Ratio is adverse from the point of view of the creditors. If project
fails, the creditors will lose heavily.
High D/E Ratio is also adverse from the point of view of the business. Higher
Debts will result in interference of the creditors in the management of the
enterprise.
Further business will have to face heavy burden of interest payments,
particularly at the time of low profits. Finally the firm will face difficulty in
raising additional funds.
However higher D/E Ratio is beneficial from the point of view of shareholders
. With a limited stake they will be able to retain control of the firm.
Also in times of high profits, the earning available to shareholders will
increase. This is because the debts carry a fixed rate of return.
What should be the debt equity ratio depends on the nature of industry and
degree of risk involved. Firms having stable income should have higher debt
equity ratio.

INTEREST COVERAGE RATIO = EBIT

Interest

DEBT SERVICE COVERAGE RATIO = PAT + Interest + Depreciation + Non cash

Installment
Higher ratios are better

PROFITABILITY RATIOS

G. P Ratio = Gross Profit X 100

Sales
N. P Ratio = Net Profit X 100
Sales
RETURN ON INVESTMENT

Return on capital employed =

PAT + Interest X 100

Av total cap. Employed
Return on Shareholders Fund = PAT X 100
Av. Shareholders funds
P/E Ratio = Market Price of share
EPS
Lower is the ratio better is the position from the point of view of investors
Share Holders Funds = Equity shares + Preference shares + Reserve & surplus
-Fictitious assets
Capital employed = Shareholders fund + Long term debts

The XYZ Ltd. Financial statement contains the following information

Balance Sheet as at 31st March , current year
P/Y
C/Y
(Rs. 000)
Rs. (000)
Cash
Sundry debtors
Temporary Investment
Stock
Pre paid exp
Total current assets
Total assets
Current liability
15% Debentures
Equity share capital
Retained earnings

200
320
200
1840
28

160
400
320
2160
12
2588

5600
640
1600

3052
6400
800
1600

2000
468

2000
904

Statement of profit year ended March 31, current year

Sales
Less: Cost of goods sold
Less: Interest
Net profit for current year
Less: Taxes
Earning After Tax

4000
2800
160
1040
364
676

From the above, appraise the financial position of the company form