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UNIT -II:

Financial Analysis

Financial analysis

Financial analysis is the process of evaluating businesses, projects, budgets and other finance-
related entities to determine their performance and suitability. Typically, financial analysis is
used to analyze whether an entity is stable, solvent, liquid or profitable enough to warrant a
monetary investment.

Financial analysis involves using financial data to assess a company’s performance and
make recommendations about how it can improve going forward. Financial
Analysts primarily carry out their work in Excel, using a spreadsheet to analyze historical
data and make projections of how they think the company will perform in the future. This
guide will cover the most common types of financial analysis performed by professionals.
Learn more in CFI’s Financial Analysis Fundamentals Course.

Types of Financial Analysis


The most common types of financial analysis are:

1. Vertical
2. Horizontal
3. Leverage
4. Growth
5. Profitability
6. Liquidity
7. Efficiency
8. Cash Flow
9. Rates of Return
10. Valuation
11. Scenario & Sensitivity
12. Variance

Comparative analysis

Describe comparative analysis as comparison analysis. Use comparison analysis to measure the
financial relationships between variables over two or more reporting periods. Businesses
use comparative analysis as a way to identify their competitive positions and operating results
over a defined period.
What is a Comparative Analysis?

Definition, Concept & Usage

In academics, is mandatory especially at higher education level. In comparative analysis


technique, you are asked to compare and contrast two different theories, two school of thoughts,
two scientific techniques or any two historical personalities.
With the help of a comparative analysis, you may find some amazing commonalities beside
contrasts or differences. For example Barack Obama and John Mccain have serious differences
as far as political views are concerned but they may have similarities in views to bring social
reforms and for the betterment of common people.
Financial Comparatives
Financial statements outline the financial comparatives, which are the variables
defining operating activities, investing activities and financing activities for a company. Analysts
assess company financial statements using percentages, ratios and amounts when making
financial comparative analysis. This information is the business intelligencedecision makers use
for determining future business decisions. A financial comparison analysis may also be
performed to determine company profitability and stability. For example, management of a
new venture may make a financial comparison analysisperiodically to
evaluate company performance. Determining losses prematurely and redefining processes in a
shorter period will favor compared to unforeseen annual losses.
Comparative Format
The comparative format for comparative analysis in accounting is a side by side view of the
financial comparatives in the financial statements. Comparative analysis accountingidentifies an
organization’s financial performance. For example, income statementsidentify financial
comparables such as company income, expenses, and profit over a period of time. A comparison
analysis report identifies where a business meets or exceeds budgets. Potential lenders will also
utilize this information to determine a company’s credit limit.
Comparative Analysis in Business
Financial statements play a pivotal role in comparative analysis in business. By analyzing
financial comparatives, businesses are able to pinpoint significant trends and project
future trends with the identification of considerable or abnormal changes. Business comparative
analysis against others in their industry allows a company to evaluate industry results and gauge
overall company performance. Different factors such as political events, economics changes, or
industry changes influence the changes in trends. Companies may often document significant
events in their financial statements that have a major influence on a change in trends.
Common Size Analysis

A common size financial statement displays all items as percentages of a common base
figure rather than as absolute numerical figures. This type of financial statement allows for
easy analysis between companies or between time periods for the same company.

What Is a Common Size Financial Statement

A common size financial statement displays all items as percentages of a common base figure
rather than as absolute numerical figures. This type of financial statement allows for easy
analysis between companies or between time periods for the same company. The values on the
common size statement are expressed as ratios or percentages of a statement component, such
as revenue.

While most firms don't report their statements in common size format, it is beneficial for analysts
to compute it to compare two or more companies of differing size or different sectors of the
economy. Formatting financial statements, in this way, reduces bias that can occur and allows for
the analysis of a company over various time periods, revealing, for example, what percentage of
sales is the cost of goods sold, and how that value has changed over time. Common size financial
statements commonly include the income statement, balance sheet, and cash flow statement.

common Size Balance Sheet Statement


The balance sheet provides a snapshot overview of the firm's assets, liabilities and shareholders'
equity for the reporting period. A common size balance sheet is set up with the same logic as the
common size income statement. The balance sheet equation is assets equals liabilities plus
stockholders' equity.

As a result, analysts define the balance sheet as a percentage of assets. Another version of the
common size balance sheet shows asset line items as a percentage of total assets, liabilities as a
percentage of total liabilities and stockholders' equityas a percentage of total stockholders'
equity.

Common Size Cash Flow Statement


The cash flow statement provides an overview of the firm's sources and uses of cash. The cash
flow statement is divided among cash flows from operations, cash flows from investing and cash
flows from financing. Each section provides additional information about the sources and uses of
cash in each business activity.

One version of the common size cash flow statement expresses all line items as a percentage
of total cash flow. The more popular version expresses cash flow in terms of total operational
cash flow for items in cash flows from operations, total investing cash flows for cash flows from
investing activities, and total financing cash flows for cash flows from financing activities.
Common Size Income Statement
The income statement (also referred to as the profit and loss (P&L) statement) provides an
overview of flows of sales, expenses, and net income during the reporting period. The income
statement equation is sales, minus expenses and adjustments, equals net income. This is why the
common size income statement defines all items as a percentage of sales. The term "common
size" is most often used when analyzing elements of the income statement, but the balance sheet
and the cash flow statement can also be expressed as a common size statement.

Funds Flow Analysis

Fund flow analysis is the analysis of flow of fund from current asset to fixed asset or current
asset to long term liabilities or vice-versa. Fund refers to working capital. Funds flow
statement is an assertion of sources and uses of funds. It describes changes in net working
capital between two balance sheet dates.

Problem 1:
From the following information relating to A Ltd., prepare Funds Flow Statement:
Problem 2:
Ramco Cements presents the following information and you are required to calculate funds
from operations:
Problem 3:
The Balance Sheets of National Co. as on 31st December, 2003 and 31st December 2004 are
as follows:
Additional Information:
ADVERTISEMENTS:

(1) Rs. 50,000 depreciation has been charged on Plant and Machinery during 2004.

(2) A piece of Machinery was sold for Rs. 8,000 during the year 2004. It had cost Rs. 12,000;
depreciation of Rs. 7,000 had been provided on it.

Prepare a Schedule of changes in Working Capital and a Statement showing the Sources and
Application of Funds for 2004.
Problem 4:
From the following Balance Sheets of X Ltd. make out:
(i) Statement of Changes in Working Capital

(ii) Fund Flow Statement:


Problem 1:
From the following information relating to A Ltd., prepare Funds Flow Statement:
Problem 2:
Ramco Cements presents the following information and you are required to calculate funds
from operations:
Problem 3:
The Balance Sheets of National Co. as on 31st December, 2003 and 31st December 2004 are
as follows:
Additional Information:
(1) Rs. 50,000 depreciation has been charged on Plant and Machinery during 2004.

(2) A piece of Machinery was sold for Rs. 8,000 during the year 2004. It had cost Rs. 12,000;
depreciation of Rs. 7,000 had been provided on it.

Prepare a Schedule of changes in Working Capital and a Statement showing the Sources and
Application of Funds for 2004.
Problem 4:
From the following Balance Sheets of X Ltd. make out:
(i) Statement of Changes in Working Capital

(ii) Fund Flow Statement:


Cash Flow Analysis

An examination of a company's cash inflows and outflows during a specific


period. The analysis begins with a starting balance and generates an ending balance after
accounting for all cash receipts and paid expenses during the period. The cash flow analysis is
often used for financial reporting purposes.

Cash flow Analysis –Examples

Problem 1:
From the following summary of Cash Account of X Ltd., prepare Cash Flow Statement for the
year ended 31st March 2007 in accordance with AS-3 using the direct method. The company
does not have any cash equivalents.
Problem 2:
Prepare Cash Flow Statement of Suryan Ltd. from the following:

Additional Information:
(a) During 2006, the business of a sole trader was purchased by issuing shares for Rs. 2, 00,000.
The assets acquired from him were: Goodwill Rs. 20,000, Machinery Rs. 1, 00,000, Stock Rs.
50,000 and Debtors Rs. 30,000.

(b) Provision for tax charged in 2006 was Rs. 35,000.

(c) The debentures were issued at a premium of 5% which is included in the retained earnings.

(d) Depreciation charged on machinery was Rs. 30,000.


Problem 3:
From the following Balance Sheets of Exe Ltd. make-out Cash Flow Statement:

Additional Information:
(a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged on Plant and Land and
Buildings in 2004.

(b) An interim dividend of Rs. 20,000 has been paid in 2004.

(c) Rs. 35,000 Income tax was paid during 2004.


Ratio Analysis

Ratio analysis is a quantitative method of gaining insight into a company's liquidity,


operational efficiency, and profitability by comparing information contained in its financial
statements. Ratio analysis is a cornerstone of fundamental analysis.

5 Main Types of Ratio Analysis

The following points highlight the five main types of ratio analysis. The types
are: 1. Profitability Ratios 2. Coverage Ratios 3. Turnover Ratios 4. Financial
Ratios 5. Control Ratios.
Ratio Analysis:

Type # 1. Profitability Ratios:


Profitability ratios are of utmost importance for a concern. These ratios are calculated to
enlighten the end results of business activities which is the sole criterion of the overall efficiency
of a business concern.

Following are the important profitability ratios:


(i) Gross Profit Ratio:
This ratio tells gross margin on trading and is calculated as under:

Higher the ratio, the better it is. A low ratio indicates unfavorable trends in the form of reduction
in selling prices not accompanied by proportionate decrease in cost of goods or increase in cost
of production. The gross profit should be adequate to cover fixed expenses, dividends and
building up of reserves.

(ii) Operating Ratio:


This ratio indicates the proportion that the cost of sales bears to sales. Cost of sales includes
direct cost of goods sold as well as other operating expenses, administration, selling and
distribution expenses which have matching relationship with sales.

It is calculated as follows:

Lower the ratio, the better it is. Higher the ratio, the less favourable it is because it would have a
smaller margin of operating profit for the payment of dividends and the creation of reserves. This
ratio should be analysed further to throw light on levels of efficiency prevailing in different
elements of total cost.

(iii) Expenses Ratios:


These are calculated to ascertain the relationship that exists between operating expenses and
volume of sales. Following ratios will help in analysing operating ratio:
(iv) Operating Profit Ratio:
This ratio establishes the relationship between operating profit and sales and is calculated
as follows:

Where

Operating Profit = Net Profit + Non-operating Expenses − Non-operating Income

Or = Gross Profit − Operating expenses

Or = Net profit before interest and tax.

Operating profit ratio can also be calculated with the help of operating ratio as follows:
Operating Profit Ratio = 100 − Operating Ratio.

This ratio indicates the portion remaining out of every rupee worth of sales after all operating
costs and expenses have been met. Higher the ratio the better it is.

(v) Net Profit Ratio:


This ratio is very useful to the proprietors and prospective investors because it reveals the overall
profitability of the concern.

This is the ratio of net profit after taxes to net sales and is calculated as follows:

The ratio differs from the operating profit ratio in as much as it is calculated after deducting non
operating expenses, such as loss on sale of fixed assets etc., from operating profit and adding
non-operating income like interest or dividends on investments, profit on sale of investments or
fixed assets, etc., to such profit. Higher the ratio, the better it is because it gives idea of improved
efficiency of the concern.

Ratio Analysis: Type # 2. Coverage Ratios:


These ratios indicate the extent to which the interests of the persons entitled to get a fixed return
(i.e. interest or dividend) or a scheduled repayment as per agreed terms are safe. The higher the
cover, the better it is.

Under this category the following ratios are calculated:


(i) Fixed Interest Cover:
It really measures the ability of the concern to service the debt. This ratio is very important from
lender’s point of view and indicates whether the business would earn sufficient profits to pay
periodically the interest charges.

It is calculated as under:

For example if the net profit before interest and tax is Rs.32,000 and interest charges are
Rs.4,000 then fixed interest cover will be 8 times (i.e., 32,000 ÷ 4,000). The higher the ratio, the
more secured the lenders will be in respect of their periodical interest income.

(ii) Fixed Dividend Cover:


This ratio is important for preference shareholders entitled to get dividend at a fixed rate in
priority to other shareholders. It is calculated as follows:

For example, if the profits after interest and tax are Rs.2,70,000 and dividend on preference
shares is Rs.27,000, the fixed dividend cover will be 10 times (i.e., Rs.2,70,000 ÷ Rs.27,000).

Ratio Analysis: Type # 3. Turnover Ratios:


These ratios are very important for a concern to judge how well facilities at the disposal of the
concern are being used or to measure the effectiveness with which a concern uses its resources at
its disposal. In short, these will indicate position of assets usage. These ratios are usually
calculated on the basis of sales or cost of sales and are expressed in number of times rather than
as a percentage.
(i) Sales to Capital Employed (or Capital Turnover) Ratio:
This ratio shows the efficiency of capital employed in the business by computing how many
times capital employed is turned-over in a stated period. The ratio is ascertained as follows:

The higher the ratio, the greater are the profits. A low capital turnover ratio should be taken to
mean that sufficient sales are not being made and profits are lower.

(ii) Sales to Fixed Assets (or Fixed Assets Turnover) Ratio:


This ratio measures the efficiency of the assets use. The efficient use of assets will generate
greater sales per rupee invested in all the assets of a concern. The inefficient use of the asset will
result in low sales volume coupled with higher overhead charges and under utilisation of the
available capacity.

Hence the management must strive for using total resources at optimum level, to achieve higher
RIO. This ratio expresses the number of times fixed assets are being turned-over in a stated
period.

(iv) Total Assets Turnover Ratio:


This ratio is calculated by dividing the net sales by the value of total assets (i.e. Net Sales ÷ Total
Assets). A high ratio is an indicator of over-trading of total assets while a low ratio reveals idle
capacity. The traditional standard for the ratio is two times.

(v) Stock Turnover Ratio:


It denotes the speed at which the inventory will be converted into sales, thereby contributing for
the profits of the concern. When all other factors remain constant, greater the turnover of
inventory more will be efficiency of its management.

This ratio is calculated as follows:

Where,
Cost of Goods Sold = Opening Stock + Purchases + Manufacturing Expenses − Closing Stock or
Sales − Gross profit.

Suppose the cost of goods sold is Rs.4,50,000 and average stock is Rs.1,50,000. Then stock
turnover ratio will be 3 times i.e., 4,50,000 ÷ Rs 1,50,000).

(vi) Receivable (or Debtors) Turnover Ratio:


It indicates the number of times on the average the receivable is turn over in each year. The
higher the value of ratio, the more is the efficient management of debtors. It measures the
accounts receivables (trade debtors and bills receivables) in terms of number of days of credit
sales during a particular period.

It is calculated as follows:

This ratio is a measure of the collectability of accounts receivables and tells about how the credit
policy of the company is being enforced. Suppose, a company allows 30 days credit to its
customers and the ratio is 45; it is a cause of anxiety to the management because debts are
outstanding for a period of 45 days.

Efforts should be made to make the collection machinery efficient so that the amount due from
debtors may be realized in time.

Higher the ratio, more the chances of bad debts and lower the ratio, less the chances of bad debts.
Suppose in 2000 Debtors in the beginning Rs 40,000; Debtors at the end Rs.50,000; Credit sales
during the year Rs 2,25,000. The debtors’ turnover ratio will be calculated as under:

(vii) Creditors (or Accounts Payable) Turnover Ratio:


This ratio gives the average credit period enjoyed from the creditors and is calculated as under:

For example, if credit purchases during 1996 are Rs.2,00,000 and accounts payable on 1-1-2000
and 31-12-2000 are Rs.46,000 and Rs.34,000 respectively, then creditor’s turnover ratio will be 5
times

[i.e., Rs.2,00,000 ÷ ½ (Rs.46,000 + Rs.34,000),

A high ratio indicates that creditors are not paid in time while a low ratio gives an idea that the
business is not taking full advantages of credit period allowed by the creditors.

Sometimes it is also required to calculate the average payment period (or average age of
payables or debt period enjoyed) to indicate the speed with which payments for credit purchases
are made to creditors. It is calculated as

Continuing the example already given, the average period of payables will be 73 days (i.e., 365
days ÷ 5).

Ratio Analysis: Type # 4. Financial Ratios:


These ratios are calculated to judge the financial position of the concern from long-term as well
as short-term solvency point of view. These ratios can be divided into two broad categories:

(A) Liquidity Ratios

(B) Stability Ratios.

(A) Liquidity Ratios:


These ratios are used to measure the firm’s ability to meet short term obligations. They compare
short term obligations to short term (or current) resources available to meet these obligations.
From these ratios, much insight can be obtained into the present cash solvency of the firm and
the firm’s ability to remain solvent in the event of adversity.
The important liquidity ratios are:
(i) Current Ratio (or Working Capital Ratio):
This is the most widely used ratio. It is the ratio of current assets to current liabilities. It shows a
firm’s ability to cover its current liabilities with its current assets. It is expressed as follows:

Generally 2 : 1 is considered ideal for a concern i.e., current assets should be twice of the current
liabilities. If the current assets are two times of the current liabilities, there will be no adverse
effect on business operations when the payment of current liabilities is made.

(ii) Liquid (or Acid Test or Quick) Ratio:


This is the ratio of liquid assets to liquid liabilities. It shows a firm’s ability to meet current
liabilities with its most liquid (quick) assets. 1 : 1 ratio is considered ideal ratio for a concern
because it is wise to keep the liquid assets at least equal to the liquid liabilities at all times.

Liquid assets are those assets which are readily converted into cash and will include cash
balances, bills receivable, sundry debtors and short-term investments. Inventories and prepaid
expenses are not included in liquid assets because the emphasis is on the ready availability of
cash in case of liquid assets.

Liquid liabilities include all items of current liabilities except bank overdraft. This ratio is the
‘acid test’ of a concern’s financial soundness.

(iii) Absolute Liquidity (or Super Quick) Ratio:


Though receivables are generally more liquid than inventories, there may be debts having doubt
regarding their real stability in time. So, to get idea about the absolute liquidity of a concern,
both receivables and inventories are excluded from current assets and only absolute liquid assets,
such as cash in hand, cash at bank and readily realizable securities are taken into consideration.

Absolute liquidity ratio is calculated as follows:

The desirable norm for this ratio is 1 : 2, i.e., Rs.1 worth of absolute liquid assets are sufficient
for Rs.2 worth of current liabilities. Even though the ratio gives a more meaningful measure of
liquidity, it is not in much use because the idea of keeping a large cash balance or near cash
items has long since teen disproved. Cash balance yields no return and as such is barren.

(iii) Debt Equity Ratio:


It measures the extent of equity covering the debt. This ratio is calculated to measure the relative
proportions of outsiders’ funds and shareholders’ funds invested in the company. This ratio is
determined to ascertain the soundness of long term financial policies of that company and is also
known as external-internal equity ratio.

It is calculated as follows:

Or

Shareholders’ funds consist of preference share capital, equity share capital, Profit & Loss A/c
(Cr. Balance), capital reserves, revenue reserves and reserves representing marked surplus, like
reserves for contingencies, sinking funds for renewal of fixed assets or redemption of debentures
etc. less fictitious assets.

Whether a given debt to equity ratio shows a favourable or unfavorable financial position of the
concern depends on the industry and the pattern of earning. A low ratio is generally viewed as
favourable from long-term creditors’ point of view, because a large margin of protection
provides safety for the creditors.

The same low ratio may be taken as quite unsatisfactory by the shareholders because they find
neglected opportunity for using low-cost outsiders’ funds to acquire fixed assets that could earn a
high return. Keeping in view the interest of both (shareholders and long-term creditors), debt to
equity ratio of 2: 1 in case of (i) and 2: 3 in case of (ii) is acceptable.
Solution:
i. Current Ratio:
It indicates better position as current assets are comparatively higher than current liabilities of a
similar industry. However, the current assets may be proportionately higher due to excessive
stock as had been reflected in ratio (3).

ii. Debtors Turnover Ratio:


It indicates that industry in general allows 1.5 (12 ÷ 8) months credit to customers but company
X allows 1.2 (12 ÷ 10) months credit to customers. This indicates marginally controlled credit
facilities. This shows effective credit policy and collection policy though there is a scope for
development of potential customers with further review of credit policy.

iii. Stock Turnover Ratio:


It indicates that stock is alarmingly high as the industry’s norm is 1.22 months (12 ÷ 9.8) sales as
against 3.6 months (12 ÷3.33) sales of company X. This has not been properly reflected in
current ratio as the current liabilities might have been also equally high. But positively the stock
is abnormally high.

iv. Assets Turnover Ratio:


It indicates that assets are comparatively higher to its turnover indicating overstocking or under-
utilisation of fixed assets. This ratio further indicates overstocking.

v. Net Profit Ratio :


It is lower as compared to standard ratio. This indicates higher cost of production and less
earnings before interest and tax. This requires either increase in sales realization or reduction in
the cost of manufacture to ensure a reasonable return on investment.

vi. Net-Profit/Total Assets Ratio:


It indicates that total assets are disproportionately higher; partially due to overstocking of
material, as indicated in (4) above. Measures are to be taken to increase the operational
efficiency and reduce cost.

vii. Net Profit/Net Worth Ratio:


It indicates that the capital structure of the X Company is having very low Debt/Equity ratio. The
earning capacity and earnings per share is also very low.

viii. Total Debts/Total Assets Ratio:


It is lower for X company which indicates low capital gearing. The total assets are substantially
high leading to this ratio lower than the standard even though the current ratio is high.

Illustration 2:
Make an assessment of the comparative positions of firms A, B and C after calculating relevant
ratios on the oasis of the following information for a year having assuming 360 days in a year.

Solution:

From the above we see the inventory turnover of firm A is better than of B and C. Firm C has the
lowest ratio, i.e., it has the slowest moving stock.

The average number of days credit allowed to customers is 72 days in firm A and 144 days in
firms C, which is just the double of A. It indicates that firm A is following a sound credit policy
whereas firm B and C are following a liberal policy. It is possible that firm B and C may have
given credit to weak customers and they are not making the payment in time.

Inventory turnover ratio and average collection period indicate that firm A is making an efficient
use of its working capital as compared to firm B and C. C’s position in this regard is the weakest.

Calculation of the amount of Net Profit


Firm A is earning a profit of Rs.1,00,000 in spite of the low percentage of gross profit. This is
because of less expenses of management. On the other hand, C is suffering a loss of Rs.40,000 in
spite of the highest percentage of gross profit.

This is because of the highest figure of management expenses. Firm B and C should try to curtail
the expenses of management and increase the inventory turnover ratio to make an improvement
in their performance.

To conclude, performance of firm A is better than the performances of firms B and C.

Illustration 3:
Prepare Profit & Loss A/c and Balance Sheet from the following information:
Capital Rs.4,00,000; Working Capital Rs.1,80,000; Bank Overdraft Rs.30,000. There are no
fictitious assets. Current assets contain only stock, debtors and cash.

Following additional data is also available:

Solution:
Trend Analysis

A trend analysis is a method of analysis that allows traders to predict what will happen with a
stock in the future. Trend analysis is based on historical data about the stock's performance
given the overall trends of the market and particular indicators within the market.
Depreciation Methods

What Are the Main Types of Depreciation Methods

There are several types of depreciation expense and different formulas for determining the book
value of an asset. The most common depreciation methods include:

1. Straight-line
2. Double declining balance
Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful
life. In other words, it is the reduction of value in an asset over time due to usage, wear and tear,
or obsolescence. The four main depreciation methods mentioned are explained in detail below.

#1 Straight-Line Depreciation Method


Straight-line depreciation is a very common and simple method of calculating the expense. In
straight-line depreciation, the expense amount is the same every year over the useful life of the
asset.

Depreciation Formula for the Straight Line Method:

Depreciation Expense = (Cost – Salvage value) / Useful life

#2 Double Declining Balance Depreciation Method

Compared to other depreciation methods, double-declining-balance depreciation results in larger


expense in the earlier years as opposed to the later years of an asset’s useful life. The method
reflects the fact that assets are more productive in its early years than in its later years. With the
double-declining-balance method, the depreciation factor is 2x that of a straight line expense
method.

Depreciation formula for the double declining balance method:

Periodic Depreciation Expense = Beginning book value x Rate of depreciation