financial analysis

Financial Analysis
Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit and loss account.
Financial analysis can be undertaken by management of the firm, or by parties outside the firm ex-owners, creditors, investors and others. The nature of analysis will differ depending on the purpose of the analyst.

®Trade Creditors are interested in firm’s ability to meet their claims over a very short period of time. Their analysis will therefore confine to the evaluation of the firms liquidity position.

®Suppliers of Long Term Debt, on the other hand, are concerned with the firms’ long-term solvency and survival. They analyze the firms’ profitability over time, it’s ability to generate cash to be able to pay interest and repay principal and the relationship between various sources of funds. Long term Creditors do analyze the historical financial statements, but they place more emphasis on the firms’ projected, or Performa, financial statements make analysis about it’s future solvency and profitability.

® Investors, who have invested their money is the firms’ shares, are most concerned about the firms’ earnings. They restore more confidence in those firms’ that show steady growth in earnings. As such, they concentrate on the analysis of the firms’ present and future profitability.

® Management, of the firm would be interested in every aspect of the financial analysis. It is their overall responsibility to see that resources of the firm are used most effectively and efficiently and that the firms’ financial condition is sound.


NATURE OF RATIO ANALYSIS

Ratio analysis is a powerful tool of financial analysis. A ratio is defined as “the indicated quotient of two mathematical expressions” and as “ the relationship between two or more things.” In financial analysis, a ratio is used as a benchmark for evaluating the financial position and performance of a firm. Ratio indicates a quantitative relationship, which can be in turn used to make a qualitative judgment. Such is the nature of all financial ratios.


STANDARDS OF COMPARISON
The ratio analysis involves comparison for a useful of the financial
Statements. A single ratio in itself does not indicate favorable or unfavorable condition.
It should be compared with some standard. Standards of comparison may consist of:

Past ratios®Ratios calculated from the past financial
Statements of the same firm.

Projected ratios ®Ratios developed using the projected, or Performa, financial statements of the same firm.


Competitor’s ratios ®Ratios of some selected firms,
Especially the most progressive and
Successful competitor at the same
Point in time.

Industry ratios®Ratios of the industry to which the firm
Belongs.



TYPES OF RATIOS
In view of the requirements of the various users of ratios, we may classify them into the following four important categories:
1.liquidity ratios
2.Leverage ratios
3.profitability ratios
4.Activity/Turn over ratios

Liquidity ratios measure the firms’ ability to meet current
Obligations.
Leverage ratios show the proportions of debt and equity in
Financing the firms’ assets.
Activity ratios reflect the firms’ efficiency in utilizing it’s assets.
Profitability ratios measure overall performance and
Effectiveness of the firm.


1.Liquidity ratios® It is extremely essential for a firm to be able to meat it’s obligations as they become due, Liquidity ratios measure the ability of the firm to meet it’s current obligations. In fact, analysis of liquidity needs the preparation of cash budgets and cash and fund flow statements but liquidity ratios by establishing a relationship between cash and other current assets to current obligations, provide a quick measure of liquidity.
A very high degree of liquidity is also bad; idle asset earn nothing. The firms’ funds will be unnecessarily tide up in current assets. Therefore, it is necessary to strike a proper balance between high liquidity and lack of liquidity.
The most common ratios that indicate the extent of liquidity or lack of it are:
A. Current ratio
B.Quick ratio

A. Current ratio® the current ratio is calculated by dividing current assets by current liabilities.


Current ratio = Current Assets
Current Liabilities



Current Assets:® These are the assets, which indicate short-term solvency of the organization (which means finding out how far an organization can repay it’s current liabilities with the help of it’s current assets)
By current assets we mean such assets which are either in the form of cash or likely to be converted into cash within one year or one operating cycle.
For ex: cash, bank balance, and marketable securities, short term investment, sundry debtors, Bills receivable (B/R), prepaid expenses, inventory, accrued income, advance payments.


CURRENT LIABILITIES:® These are the liabilities, which are to be paid in one year or one operating cycle.
For ex: creditors, Bills payable, unearned income (Income received in advance), provision for tax and dividend, bank over-draft, short-term loan.


B. Quick ratio:® This ratio establishes a relationship between quick or liquid assets and current liabilities. An asset is liquid if it can be converted into cash immediately or reasonably soon without a loss of value. Cash is the most liquid asset. Other assets, which are considered to be relatively liquid and included in quick assets, are book debts and marketable securities. Inventories are considered to be less liquid.


Quick ratio = Current Assets – Inventory – Prepaid Exp.
Current Liabilities

C. Cash ratio / Super Quick ratio:® Since cash is the most liquid asset, a financial analyst may examine the ratio of cash and it’s equivalent to current liabilities. Trade investment or marketable securities are equivalent of cash; therefore they may be included in the computation of cash ratio:


Cash ratio = Cash& bank bal. + Marketable Securities
Current Liabilities




2. Leverage ratios:® The short term creditors, like bankers and suppliers of raw material, are more concerned with the firms’ current debt – paying ability. On the other hand, long-term creditors like debenture holders, financial institutions are more concerned with the firms’ long-term financial strength. In fact, a firm should have a strong short as well as long-term financial position. To judge the long-term financial position of the firm, financial leverage, or capital structure, ratios are calculated. These ratios indicate mix of funds provided by owners and lender.
Leverage ratios may be calculated from the balance sheet items to determine the proportion of debt in total financing. Leverage ratios are also computed from the profit and loss items by determining the extent to which operating profits are sufficient to cover the fixed charges.

A. Debt Equity Ratio:® The debt equity ratio is determined to as certain the soundness of the long term financial policies of the company. It is also known as “ External- Internal” equity ratio.


Debt Equity Ratio = Long term Debt
Shareholder’s
Net Worth


OR
Debt Equity Ratio = Total Debt
S.H N.W



Total Debt = Long term Debt + Current Liability





Share holders = Equity + preference + Reserve & + P&L
N.W. Capital capital surplus A/C on
Liab.side

- Intangible Assets – Fictitious Assets





Intangible Assets:® Goodwill, patents, trade mark/logo, copyright etc.

Fictitious assets:® Preliminary expenses, R&D expenses, established exp., discount on issue of securities, issue exp., P&L A/c on asset side.


B. Debt Ratio:® Several debt ratios may be used to analyze the long – term solvency of a firm. The firm may be interested in knowing the proportion of the interest bearing debt in the capital structure.

Debt Ratio = Total Debt
Total Tangible
Assets



Total Tangible = Total – Intangible - Fictitious
Assets Assets Assets Assets




3. Profitability Ratios:® Which is the ratio, which indicates profit-earning capacity of the organization with the help of this efficiency of the assets with profit, is reflected. These ratios are classified into two categories: -

1. Based on Sales
2. Based on Investments


1. Based on sales:® Under this category profit is shown in relation to sales of organization that indicates profit-generating capacity. With the help of this different level of profit can be reflected in terms of sales. These are as follows:

A. Gross profit ratio or Gross profit Margin:® The gross profit margin reflects the efficiency with which management produces each unit of product. This ratio indicates the average spread between the cost of good sold and sales revenue.
A high gross profit margin ratio is a sign of goods management. A gross margin ratio may increase due to any of the following factors:

1. Higher sales prices cost of goods sold remaining constant.
2. Lower cost of good sold, sales prices remaining constant.
3. A combination of variations in sales prices and cost the margin widening.
4. An increase in the proportionate volume of higher margin item.

Gross profit ratio is calculated as follows: -
Gross profit = Gross profit * 100
Ratio Net Sales





Gross Profit = Net Sales – Cost of Good Sold



B. Operating Profit Ratio:® This ratio indicates operating profit is a percentage of sales. By operating profit we mean profit, which is calculated after adjusting all the operating cost. It is calculated as follows: -


Operating Profit = EBIT * 100
Ratio Net Sales




EBIT / OP. = Gross Profit – Operating + Other
Expenses Income



The operating profit ratio is an important ratio that explains the changes in the profit margin (EBIT to sales) ratio.


C. Net Profit Ratio / Net Profit Margin:® Net profit is obtained when operating expenses; interest and taxes are subtracted from the gross profit. The net profit margin ratio is measured by dividing profit after tax (P.A.T) by sales: -

N.P Margin = P.A.T * 100
Net Sales


N.P margin ratio establishes a relationship between net profit and sales and it indicates management’s efficiency in manufacturing, administering and selling the products.
This ratio is the overall measure of the firm’s ability to turn each Rupee sales into net profit. If the net margin is inadequate, the firm will fail to achieve satisfactory return on shareholders funds.

2. Based On Investments:®


A. Return on Investment (R.O.I) :® The term investment may refer to total assets or net assets. The funds employed in net assets are known as capital employed.
B.
Net Assets Equal Net F.A + C.A – C.L


R.O.I = EBIT * 100
Total Assets


OR

R.O.I = P.A.T + Interest *100
Total Assets




C. Return on Equity (R.O.E) :® R.O.E indicates how well the firm has used the resources of owners. In fact, this ratio is one of the most important relationships in financial analysis. The returns on owner’s equity of the company should be compared with the ratios for other similar companies and the industry average. This will reveal the relative performance and strength of the company in attracting future investments.


R.O.E = P.A.T * 100
N.W


D. E.P.S (Earning Per Share):® The E.P.S of the company should be compared with the industry average and earnings per share of other firms’. E.P.S simply shows the profitability of the firm on a per – share basis, it does not reflect how much is paid as dividend and how much is retained in the business. But as profitability index, it is a valuable and wisely used ratio.
E.P.S = P.A.T – Preference Dividend
No. Of Equity Shares






D. Dividends Per Share (D. P.S): ®


D.P.S = Total Dividend on Equity Shares
No. Of Equity Shares




3. Activity Ratios / Turn Over Ratios: ® These ratios
Indicate efficiency with which different assets get utilized or the efficiency of investment.
For ex: - F.A Turn Over Ratio is 3 then it means every Rupee invested in F.A support a sale of 3 Rupees. It also means velocity of F.A.
Following are the prominent ratios: -

A. Fixed Asset T.O.R:® This ratio provides the idea about velocity of F.A. By velocity we mean rotation of F.A. Generally a higher ratio indicates fast utilization / better utilization of F.A.
F.A T.O.R = Net Turn Over
Net F.A


B. Total Asset T.O.R: ® This ratio indicates the efficiency with which total assets of the organization get utilized.


Total Asset T.O.R = Net Sales
Total Assets


C. Debtors T.O.R: ® This velocity of debtors, which means how efficiently each Rupee invested in debtors, gets utilized.

Debtors T.O.R = Net Credit Sales
AV. Debtors


AV. Debtors = Opening +Closing
Debtor Debtor
2


OR
Debtors T.O.R = Net Credit Sales
Closing Debtors


Debtors => B / R, A/R & Book Debts


® If nothing is mentioned about credit sales then total sales can be taken as credit sales.

D. Average Debt Collection Period :® This ratio/ period indicates the average time period after which money is collected from debtors.
For Ex. If debt collection period is two months then it means equal to two months credit sales in our debtor.

Av. Debt = 12 or 365 or52 Collection Period Debtor T.O.R


OR

Av. Debt = Av.Debtors
Collection Period Av. Daily
Credit Sales



E. Inventory / Stock T.O.R: TE ® This ratio indicates about the velocity of inventory carried – out by an organization.

Inventory T.O.R = Cost Of Good Sold
Av. Inventory


OR

Inventory T.O.R = C.O.G.S
Closing Inventory



F. Inventory Holding Period / Stock Storage Period: ® This ratio indicates the average time period for which stock of raw material inventory is held in the organization.
For Ex. If it is 3 months then it means on & Av. = 3 months requirement of inventory is maintained in the stock

Stock Storage = 12 or 365 or 52 Period Stock T.O.R