finolex - ratio analysis etc.

The ratios calculated in this exercise are wrong, try to do it yourself for finolex industries and prepare new report. 

RATIO ANALYSIS
Financial ratios are useful indicators of a firm's performance and financial situation. Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms.

Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:

1. Liquidity ratios
2. Asset management ratios
3. Debt management ratios
4. Profitability ratios
5. Market value ratios

LIQUIDITY RATIOS
Liquidity ratios are the first ones to come in the picture. These ratios actually show the relationship of a firm’s cash and other current assets to its current liabilities. Two ratios are discussed under Liquidity ratios. They are:

1. Current ratio
2. Quick/ Acid Test ratio.

1. Current ratio:  This ratio indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. Current assets normally include cash, marketable securities, accounts receivables, and inventories. Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses (principally wages).

Current Ratio=Current Assets/Current Liabilities

Following table shows the Current ratios of  Finolex in different years:

Year	2005-06	2004-05	2003-04
Current ratio	1.78 times	1.66 times	1.62 times

Following graph shows the change of Current ratios over different periods:

From the analysis, we can see that in 2003-04 the current assets were 1.62 times than the current liabilities that has not fluctuated much through out these three years. A minimal increase is seen in 2004-05 and it went up to 1.66 times which kept slightly increasing and resulted at 1.78 times in 2005-06. The reason for such stability can be there not investing remarkably on assets and not making any huge loan or financing from outside. If we take a closer look on the balance sheet, this assumption gets a more realistic touch. Year by year assets have gone slightly up and the liabilities as well, but proportionately assets were a littler higher than the liabilities which actually reflected as a marginal increase in the ratio.

2.  Quick/ Acid Test ratio:  This ratio indicates the firm’s liquidity position as well. It actually refers to the extent to which current liabilities are covered by those assets except inventories.

Quick Ratio=(Current Assets-Inventories)/Current Liabilities

Following table shows the Quick/ acid test ratios of  Finolex in different years:

Year	2005-06	2004-05	2003-04
Quick ratio	1.19 times	1.08 times	.98 times

Following graph shows the change of Current ratios over different periods:

Analysis of this ratio speaks in a same language as current ratio. In 2003-04, the quick ratio was .98 times which increased very silently just like current ratio and resulted as 1.19 times in 2005-06. Both of these ratios portray the idea that square has so far an almost constant liquidity position which is good at some point, but at the same token it can be said that they have not been able to improve them-selves. Standing at this point, we can make an assumption that may be their profit margin was not so high that they can make some investments paying off the liabilities that could result in an increase in assets and decrease in liabilities to make the liquidity position far better. This assumption can only be proved as we go on analyzing their financial statement and calculate the profitability ratios.

Asset Management Ratios

ASSET MANAGEMENT RATIOS
Asset management ratios are the financial statement ratios that measure how effectively a business uses and controls its assets. Below are discussed five types of asset management ratios:
 
1. Inventory turnover ratio
2. The days sales outstanding
3. Average payment period
4. Fixed asset turnover ratio
5. Total asset turnover ratio
   
1.  Inventory turnover ratio: The ratio is regarded as a test of efficiency and indicates the rapidity with which the company is able to move its merchandise.

Inventory turnover ratio = Gross Turnover / Inventories

Following table shows the Inventory Turnover ratio of  Finolex in different years:

Year	2005-06	2004-05	2003-04
Inventory Turnover Ratio	5.27 times	5.41 times	6.89 times

Analysis shows a gradual declination of Inventory Turnover Ratio over the last three yeas. In 2003-04, the ratio was 6.89 times, then it rapidly declined to 5.41 times in following year and dropped further to 5.27 times in the year 2005-06.

The company’s balance sheets show increase of inventory with declining turnover every year. Declining inventory turnover commonly indicates that the company is not being able to flush its inventory very well as it was doing in the previous years. A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. High inventory levels are unhealthy because they represent an investment with a zero rate of return in addition to the increased cost associated with maintaining those inventories. It also opens the company up to trouble should prices begin to fall. However, in some instances a low rate may by appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or shortages.

In order to improve Inventory Turnover ratio, at first an end-to-end view in addressing inventory needs to be looked at. Supply chains need to be optimized, production processes should have to be efficient as well, so that the suppliers become able to produce and deliver materials in a timely, low cost fashion that allows the company to minimize their inventory and cost of materials. Collaborative relationships with customers can allow them to make their demand for products more predictable thereby allowing to minimize finished product inventory without failing to meet their needs for volume and timeliness.

Discount-driven sales may generate a boost in sales. Such discounts can erode the company’s profit margins but will boost revenue and rate of inventory turnover. The company might look like it is becoming leaner, when in fact it may simply be pushing products into the marketplace using artificial low pricing. However, before it can be done, the gross margins reported by the business needs to be analyzed carefully. If gross margins decrease as a percentage of sales in spite of an increase in inventory turnover, they should not apply this policy.

Supplier-financed inventory may reduce inventories and show improved inventory turnover by forcing suppliers to carry the inventory for the company. The suppliers assume the cost of maintaining inventory and passes that cost on. Alternatively, the company may reduce inventory by the use of express shipment or other costly means of delivery to ensure the availability of materials and supplies when needed. Solutions of maintaining inventory that simply shift cost to suppliers return the cost in added mark-ups to the materials and supplies purchased. This results in a rise in unit product unit cost.


2.  The Days Sales Outstanding: The Days Sales Outstanding ratio shows both the average time it takes to turn the receivables into cash and the age, in terms of days, of a company's accounts receivable. This ratio is of particular importance to credit and collection associates.

Days Sales Outstanding (DSO) = Trade Debtors/(Annual gross turnover/365)

Following table shows the DSOs of  Finolex in different years:

Year	2005-06	2004-05	2003-04
DSO	14.87 days	15.75 days	14.99 days

Analysis shows that DSO was 15.75 days in 2003-04; highest among the three years. In 2003-04, it was 14.99 days and in 2005-06 it was 14.87 days; lowest among the three years.

Since the DSO was the highest in 2004-05 that indicates that customers were taking longer times to pay their bills, which may be a warning that customers were dissatisfied with the company's product or service, or that salespeople were making sales to customers that are less credit-worthy, or that salespeople have to offer longer payment terms in order to seal the deal. Long credit policy might be used deliberately to boost sales temporarily. Of course, it could also mean that the company has an inefficient or overtaxed accounts receivables department. However, the significant improvement in 2005-06 signifies that the company collected its outstanding receivables quicker than the previous years and that the credit terms are getting more realistic. It also connotes that the company had greater control over quality of its customer relationship management (CRM) during the following year.

3. Average payment period: The accounts payable turnover ratio includes all outstanding obligations that a company owes its creditors.

Average Payment Period (APP) = Payables / (Cost of goods sold/365)

Following table shows the APPs of  Finolex in different years:

Year	2005-06	2004-05	2003-04
APP	234.07 days	225.27 days	161.25 days

Analysis shows a gradual increase of company’s average payment period. In 2003-04, the average payment period was 161.25 days, and then it became 225.27 days and 234.07 days consecutively for the following two years.

The underlying reason for the ratio to go up is the significant increase of company’s debt; especially short and long term bank loans (which made the current portion of long-term loans high). Each year this amount is getting higher than the previous years. Furthermore, in 2004-05 there was a huge sum trade credits unpaid. All these played key role for the payables to increase. A long payment period at first improves the company's liquidity, but my also be an indicator for liquidity problems. Therefore, it is important to keep the value equal or close to the average value. Since the company’s payment period is getting longer, i.e. the company pays too late, then it means the liquidity problem of the company. The company probably lacks of the money to pay its liability. Hence, questions may arise on the company's credit worthiness and paying habits. It has long been recognized that late payment of business debt is a serious problem for suppliers of goods and services. Late Payment can make it necessary for a company to increase borrowing and to extend overdraft facilities.  Time and resources can be taken up on maintaining and collecting late payments instead of being devoted to other areas of business.

4. Fixed asset turnover ratio: The Fixed Asset Turnover ratio measures the effectiveness in generating Net Sales revenue from investments in Net Property, Plant, and Equipment back into the company evaluates only the investments. 

Fixed assets turnover ratio (FATO) = Gross Turnover / Net fixed assets

Following table shows the FATO ratios of  Finolex in different years:

Year	2005-06	2004-05	2003-04
FATO	1.35 times	1.33 times	1.42 times

Analysis shows that the fixed asset turnover ratio was as high as 1.42 times among three years. However, it declined to 1.33 times in the following year. In 2005-06 the turnover somewhat increased to 1.35 times.   

The rapid declination of turnover in 2004-05 occurred because sales did not keep pace with the increase of company’s fixed assets. Company’s capital work-in-progress increased substantially in the year 2005-06. 2004-05 capital work-in-progress was also higher then the previous year. It may happen if the company was not being able to utilize its assets efficiently. However, conclusions should not be drawn solely on the numerical results of this ratio. A careful study on the balance sheet shows that large amount of investments were made during that year that inflate the dollar volume of fixed assets, and give an impression of mismanagement. The case is applicable for the 2005-06 as well. The turnover was highest in 2003-04 only because no significant investments were made during that period and the capital work-in-progress was lowest amongst the three years. Therefore, enough evidence is not available from this ratio analysis whether the company is really performing inefficiently or it is the investments that pulled down the turnover. Perhaps total asset turnover ratio can tell more about what really went wrong.

5. Total asset turnover ratio: The Total Asset Turnover is similar to fixed asset turnover since both measures a company's effectiveness in generating sales revenue from investments back into the company. Total Asset Turnover evaluates the efficiency of managing all of the company's assets.

Total assets turnover ratio (TATO) = Gross Turnover/Total Assets

Following table shows the TATO ratios of  Finolex in different years:

Year	2005-06	2004-05	2003-04
TATO	0.76 times	0.78 times	0.93 times

Analysis shows a gradual fall of company’s total asset turnover. In 2003-04, it was 0.93 times, declined to 0.78 times in the following year and then again declined slightly to 0.76% in 2005-06.

It may be an indicator of company’s pricing strategy as company with high profit margins tends to have low asset turnover. It is in fact might be one of the reasons for why the assets turnover was low in the year 2004-05. Profit margin went up from 17.69% in 2003-04 to 20.25% in the next year. However, there are other reasons as well. In 2004-05 total assets increased by 25.68% while sales increased by only 11.57%. Other than investment in marketable securities, every other asset especially long-term investments, inventories, short-term loans and cash balance had gone up substantially. Same is the case for the year 2006-06 as sales could not keep up with assets. Long-term investment, capital work-in-progress, inventories, short-term loan was also high during this year. On the other hand, the profit margin was only 16.45%. So it could be concluded than higher profit margin may not be the actual reason for the turnover to go down. Perhaps the company is not utilizing its assets efficiently.

 

Debt Management Ratios

Debt management ratios reveal 1) the extent to which the firm is financed with debt and 2) its likelihood of defaulting on its debt obligations. These ratios include:

1.  Debt ratio
2.  Times-Interest-Earned (TIE) ratio
 
1. Debt ratio: The ratio of total debt to total assets, generally called the debt ratio, measures the percentage of funds provided by the creditors.

Debt ratio = Total Debt / Total Assets

Following table shows the Debt ratios of  Finolex in different years:

Year	2005-06	2004-05	2003-04
Debt ratio	31%	46%	37%

Calculating the debt ratio, we came to see that this company is not that highly leveraged one. In 2003-04, it was 37%, in 2004-05, it suddenly went up to 46%, and than again in 2005-06, it climbed down to 31%. A little bit of fluctuation is seen here in debt management, which is actually nothing but their strategic move. The reason behind such fluctuation is better understandable form the balance sheet. In 2004-05, the company has issued long-term loan, which happens to be BTD 389,193,080 that is way too high than the previous year’s loan, which is BDT 36,544,158 that actually increased the total debt thus resulting in a high debt ratio. Again, in the following year they paid off the loans and have not made any huge financing from outside which decreased.

2. Times-Interest-Earned (TIE) ratio: This ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest cost.

TIE ratio = EBIT / Interest Charges

Following table shows the times-interest-earned (TIE) ratios of  Finolex in different years:

Year	2005-06	2004-05	2003-04
TIE ratio	11.30 times	14.92 times	11.12 times

We can see from this ratio analysis that, this company has covered their interest expenses 11 times in 2003-04, 15 times in 2004-05 and 11 times in 2005-06. It means they have performed pretty much same in 2003-04 and 2005-06 but has taken a different look in 2004-05.  As in 2004-05 they issued a little high number of long-term loans and does not have good liquidity position, their EBIT became high thus making TIE a little high as well.

PROFITIBILITY RATIO:
Profitability is the net result of a number of policies and decisions. Profitability ratios show the combined effects of liquidity, asset management and debt on operating results.
There are four important profitability ratios that we are going to analyze:

1.  Net Profit Margin
2.  Gross Profit Margin
3.  Return on Asset
4.  Return on Equity

1. Net Profit Margin: Net Profit Margin gives us the net profit that the business is earning per dollar of sales. The equation is as follows:

Net Profit margin = Net income available to the stockholders / gross turnover

Following shows the Net Profit Margin of  Finolex in different years:

Year	2005-06	2004-05	2003-04
Net Profit Margin	16.45%	20.26%	17.69%

Therefore, the Net Profit Margin was 17.69% in 2003-04, increase to 20.26% in 2004-05 and then again decreased to 16.45% in 2005-06.

The main reason that the profit margin declined is high cost. High cost, in turn, generally occurs due to inefficient operations. Profit margin also declined because in 2005-06  Finolex used a lot of long-term debt. This invariably resulted in more interest cost, which brought the Net income down.

2. Gross Profit Margin: Gross Profit Margin gives us the amount of Gross profit a firm is earning per dollar of its sales. The equation is as follows:

Gross Profit Margin (GPM) = Gross profit / Gross trunover

Following shows the Gross Profit Margin of  Finolex in different years:

Year	2005-06	2004-05	2003-04
Gross Profit Margin	36.19%	35.04%	34.78%

So, the Gross Profit Margin has remained pretty much stable throughout the whole three years. It increased slowly each year. It indicates that Square Pharmaceutical is managing its Sales and Cost of Goods Sold very well.

Return on Total Assets (ROA): Return of total asset measures the amount of Net Income earned by utilizing each dollar of Total Assets. The equation is:

Return on Total Assets (ROA) = Net income available to total common shareholders / Total assets

Following shows the Return on Total Assets of  Finolex in different years:

Year	2005-06	2004-05	2003-04
ROA	12.54%	15.88%	16.52%

So, return on total assets decreased gradually throughout the years. This may have occurred because Square used more debt financing in 2005-06 and 2004-05 compared to 2003-04 which resulted in more interest cost and brought the Net income down.

4. Return on Equity (ROE): Return on Equity measures the amount of Net Income earned by utilizing each dollar of Total common equity. It is the most important of the “Bottom line” ratio. By this, we can find out how much the shareholders are going to get for their shares. The equation is:

Return on Equity (ROE) = Net income available to common shareholders / Total common equity

Following shows the Return on equity of  Finolex in different years:

Year	2005-06	2004-05	2003-04
Return on Equity	18.21%	22.55%	21.13%

Therefore, the Return on Equity increased in 2004-05 but decreased a little in 2005-06. This again may have happened due to the issue of more long-term debt in 2005-06.

MARKET VALUE RATIOS
The final group of ratios, the market value ratios relates the firm’s stock price to its earnings and book value per share. These ratios give management an indication of what investors think of the company’s past performance and future prospects. In this section, we are going to have a discussion mainly on two types of ratios:

1.  Price/ Earnings ratio
2.  Market/ Book ratio

1.  Price/ Earnings ratio: The Price/ Earnings ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to the income or profit earned by the firm per share.

P/E ratio - Price per share / earnings per share

2.  Market/ Book ratio: The ratio of book value to market value of stocks.

Market/Book ratio (M/B) = Market price per share / Book value per share

Following table shows the P/E and M/B ratios of  Finolex in different years:

Year	2005-06	2004-05	2003-04
P/E Ratio	9.70 times	12.95 times	8.43 times
M/B ratio	1.77 times	2.92 times	1.78 times

The P/E ratio was 8.43 times in 2003-04 and increased further to as high as 12.95 times in the following year. However, in 2005-06 it declined to 9.70 times which is an alarming signal for the potential investors.

The M/B ratio was 1.78 times in 2003-04 and increased further to 2.92 times in the following year which was excellent to draw the attention of investors. However, in 2005-06 it became as same as 2003-04 value.

The main reason behind the declination of P/E and M/B ratio is the fall of price per share. Price of share may fall for several reasons. Failing to meet market expectations is one of the main reasons for the market to lose interest in a share. Shares are usually valued according to what investors reckon the company will do in future. Therefore, when a business fails to meet those expectations then it is not unreasonable for investors to reconsider their position. We can see this fact applicable for this company too. As the company was doing well in 2000-05, the share price was higher than among the three years. Interestingly, the impact on shares depends to a large degree on the influence that they have on the market as well. During 2005-06 financial year the capital market situation deteriorated to the level that the DSE General Index fell by 14.91%. The overall hostile market situation put a negative impact on Square Pharmaceutical’s stock price too. Therefore, the investors should not be concerned much about the particular company’s P/E and M/B ratio.

Overall Financial Summary of Square Pharmaceuticals

OVERALL FINANCIAL SUMMARY

After analyzing all the ratios, we have found out the following information:

1.  Liquidity Ratios: In the liquidity ratio we can see that both current ratio and quick ratio improved over time marginally. The situation was almost stable.

2.  Asset Management Ratios: Inventory turnover, Total Asset Turnover, Fixed Asset Turnover all had been relatively stable throughout the three years. Average Collection period is also very good. The only problem here is the Average collection period which is way high. However, such a situation is actually pretty much normal for big companies.

3.  Debt Management Ratios: Here Debt ratio has improved over time and TIE has remained pretty much stable.

4.  Profitability Ratios: Apart from Gross Profit Ratio, most of the Profitability ratios have actually decreased in 2005-06. Although the decrease rate is very minimal still it is a problem for Square and they need to try to improve these ratios.

5.  Market Value Ratios: Both P/E ratio and M/B ratio declined in the year 2005-06. But this happened mostly not because of the company’s failure but for the fact that the whole market was not so friendly for investment in that year.

From the total analysis, we can summarize that  Finolex Ltd. has been doing pretty good through out the years. It is true that last year there return did decline but it is still pretty much satisfactory. Therefore, we can conclude that  Finolex Ltd. is a good enough company to invest on.

APPENDIX

All the ratios below are calculated for 2005-06 financial year:
1.  Current ratio = 1.78 times
2.  Quick ratio = .299 times
3.  Inventory turnover ratio = 5.27 times
4.  Days Sales Outstanding (DSO) = 14.87 days
5.  Average Payment Period (APP) = 234.07 days
6.  Fixed assets turnover ratio (FATO) = 1.35 times
7.  Total assets turnover ratio (TATO) = 0.76 times
8.  Debt ratio = 31%
9.  TIE ratio = 11.30 times
10. Net Profit margin = 16.45%
11. Gross Profit Margin (GPM) = 20.19%
12. ROA = 12.54%
13. ROE = 18.21%
14. P/E ratio = 9.70 times
15. Market/Book ratio (M/B) = 1.77 times
 

 

FINANCIAL ANALYSIS

FINANCIAL ANALYSIS OF A COMPANY 

In any business venture, a correct analysis of the financial indicators are crucial to successful decision making.  This is only possible if the accounts are maintained and recorded well, properly verified, are up-to-date and accurate, and financial information is presented neatly and without confusion.  The end products of business transactions are the financial statements comprising primarily the position statement or the balance sheet and the income statement or the profit and loss account.  Financial statements are the basis for decision making by the management as well as all other outsiders who are interested in the affairs of the firm such as investors, creditors, customers, suppliers, financial institutions, employees, potential investors, government and the general public.

 

Financial Statements

Financial statements primarily comprise two basic statements: (i) the position statement or the balance sheet; and (ii) the income statement or the profit and loss account. However, Generally Accepted Accounting Principles (GAAP) specify that a complete set of financial statements must include:

(i)                  a Balance Sheet

(ii)                an Income Statement

(iii)               a Statement of  Changes in Owner’s Accounts, and

(iv)              a Statement of Changes in Financial Position.

 

(i)                 Balance Sheet shows the financial condition or the state of the firm at a particular point of time.  More specifically, balance sheet contains detailed information about the firm’s assets and liabilities.  Assets represent economic resources possessed by the firm.  Fixed assets are used in business for more than an accounting period of one year, while current assets are converted into cash within an accounting period.  Liabilities are amounts payable by the firm.  Liabilities payable within an account period are called current liabilities and those payable after a year or so are called long term liabilities.  Funds contributed by the owner’s to the firm are called owner’s equity.  Thus, balance sheet gives a concise summary of the firm’s resources and obligations, and measures the firm’s liquidity and solvency.

(ii)               The Profit and Loss Account (or income statement) shows the profitability of the firm by giving details about revenue and expenses.  Revenues are benefits which customers contribute to the firm in exchange for goods or services provided by the firm.  The cost of the economic resources used in providing goods or services to the customers is called expenses.  Profit is the difference between revenues and expenses.  Thus the basic purpose of profit and loss account is to provide a concise summary of the firm’s revenues and expenses during a period of time and measure its profitability.

(iii)             Statement of Changes in Owner’s Accounts: Also called profit and loss appropriation account.   The term retained earnings means the accumulated excess of earnings over losses and dividends. The balance shown by the income statement is transferred to the balance sheet through this statement, after making necessary appropriations.  It is thus, a connecting link between the balance sheet and the income statement.  It is fundamentally a display of things that have caused the beginning-of-the period retained earnings balance to be changed into the one shown in the end-of-the period balance sheet.

(iv)             Statement of Changes in Financial Position (SCFP): For better understanding of the affairs of business, it is essential to identify the movement of working capital or cash in and out of the business.  This information is available in the statement of changes in financial position of the business.  The statement may emphasize any of the following aspects relating to change in financial position of the business.

(a)                Change in working capital position.  In such a case the statement is termed as SCFP (working capital basis) or popularly funds flows statement.

(b)               Change in cash position.  In such a case the statement is termed as SCFP (cash basis) or popularly cash flow statement.

(c)                Change in overall financial position.  In such a case the statement is termed simply as statement of changes in financial position (SCFP).

 

Financial Statements Analysis

The term “financial analysis”, also known as ‘analysis and interpretation of financial statements’, refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data.  According to Metcalf and Titard, “Analyzing financial statements is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm’s position and performance”.

 

The purpose of financial analysis is to diagnose the information contained in financial statements so as to judge the profitability and financial soundness of the firm  a financial analyst analyses  the financial statements with various tools of analysis before commenting upon the financial health or weakness of an enterprise.  Financial statements analysis is an attempt to determine the significance and meaning of the financial statement data so that forecast may be made of the future earnings, ability to pay interest and debt maturities (both current and long-term) and profitability of a sound dividend policy.

 

Methods or Devices of Financial Analysis

The analysis and interpretation of financial statements is used to determine the financial position and results of operations as well.  A number of methods or devices are used to study the relationship between different statements.  The following methods of analysis are generally used:

·                    Comparative Statements,

·                    Common-Size Statements,

·                    Trend Analysis,

·                    Funds Flow Analysis,

·                    Cash Flow Analysis, and

·                    Ratio Analysis.

 

Comparative Statements

            Comparative financial statements for two or more years are drawn to have useful comparative information for purposes of financial analysis. Comparative balance sheets contain balances of assets and liabilities on different dates and present size and direction of change i.e. increase or decrease in various items of balance sheets.  In one year balance sheet the focus is on status, while the comparative balance sheet emphasizes on change.  The latter one is more useful as it enables a  financial  analyst   to  study   the    direction increase or decrease of change.  Comparative financial statements are useful in analyzing:

·                    Financial information in absolute rupees, i.e., balances on comparative dates;

·                    Increase or decrease in rupee amounts for various items.

·                    Percentage changes for various items, rupee increase and decrease are converted into percentage by taking the data of the previous year as base.

 

The two comparative statements are (i) Balance sheet, and (ii) Income statement:

 

(I) Comparative Balance Sheet

            The comparative balance sheet analysis is the study of the trend of the same items, group of items and computed items in two or more balance sheets of the same business enterprise on different dates.  The changes can be observed by comparison of the balance sheet at the beginning and at the end of the period and these changes can help in forming an opinion about the progress of an enterprise.  The comparative balance sheet has two columns for the data of original balance sheets.  A third column is used to show increases in figures.  The fourth column may be added for giving percentages of increases or decreases.

Guidelines for Interpretation of Comparative Balance Sheet

While interpreting comparative balance sheet the interpreter is expected to study the following aspects:

(i)                  For Current Financial Position and Liquidity Position, one should see the working capital in both the years.  The excess of current assets over current liabilities will give the figures or working capital. The increase in working capital will mean improvement in the current financial position of the business.  If liquid assets like cash in hand, cash at bank, bills receivable, debtors etc., show an increase in the second year over the first year this will improve the liquidity position of the concern.  The increase in inventory, can be on account of accumulation of stocks for want of customers, decrease in demand or inadequate sales promotion efforts, is not good for the business.

(ii)                The Long-term Financial Position of the concern can be analyzed by studying the changes in fixed assets, long-term liabilities and capital.  The proper financial policy of concern will be to finance fixed assets by the issue of either long-term securities such as debentures, bonds, loans from financial institutions or issue of fresh share capital.

(iii)               The Profitability of the Concern is the next aspect.  The study of increase or decrease in retained earnings, various resources and surpluses, etc. will enable the interpreter to see whether the profitability has improved or not.  An increase in the balance of profit and loss account and other resources created from profits will mean an increase in profitability to the concern.  The decrease in such accounts may mean issue of dividend, issue of bonus shares or deterioration in profitability of the concern.

(iv)              After studying various assets and liabilities an opinion should be formed about the financial position of the concern.  One cannot say if short-term financial position is good then long-term financial position will also be good or vice-versa.  A concluding word about the overall financial position must be given at the end.

 

(ii) Comparative Income Statement

The income statement gives the results of the operations of a business.  The comparative income statement gives an idea of the progress of a business over a period of time.  The changes in absolute data in money values and percentages can be determined to analyze the profitability of the business. Like comparative balance sheet, income statement also has four columns.  First two columns give figures of various items for two years.  Third and fourth columns are used to show increase or decrease in figures in absolute amounts and percentages respectively. 

 

Guidelines for Interpretation of Income Statements

The analysis & interpretation of income statement will involve the following steps:

(i)                  The increase or decrease in sales should be compared with the increase or decrease in cost of goods sold.  An increase in sales will not always mean an increase in profit.  The profitability will improve if increase in sales is more than the increase in cost of goods sold. The amount of gross profit should be studied in the first step.

(ii)                The second step of analysis should be the study of operational profits.  The operating expenses such as office and administrative expenses, selling and distribution expenses should be deducted from gross profit to find out operating profits.  An increase in operating profit will result from the increase in sales position and control of operating expenses.  A decrease in operating profit may be due to an increase in operating expenses or decrease in sales.  The change in individual expenses should also be studied.  Some expenses may increase due to the expansion of business activities while others may go up due to managerial inefficiency.

(iii)               The increase or decrease in net profit will give an idea about the overall profitability of the concern.  Non –operating expenses such as interest paid, losses form sales of assets, writing off of deferred expenses, payment of tax, etc. decrease the figure of operating profit.  When all non-operating expenses are deducted from operational profit, we get a figure of net profit.  Some non-operating  incomes may also be there which will increase net profit.  An increase in net profit will gave us an idea about the progress of the concern.

(iv)              An opinion should be formed about profitability of the concern and it should be given at the end.  It should be mentioned whether the overall profitability is good or not.

 

Trend Analysis

The financial statements may be analyzed by computing trends of series of information. This method determines the direction upwards or downwards and involves the computation of the percentage relationship that each statement item bears to the same item in base year. The information for a number of years is taken up and one year, generally the first year, is taken as a base year. The figures of the base year are taken as 100 and trend ratios for other years are calculated on the basis of base year. The analyst is able to see the trend of figures, whether upward or downward.

 

Procedure for Calculating Trends

(i)                  One year is taken as a base year.  Generally, the first or the last is taken as base year.

(ii)                The figures of base year are taken as 100

(iii)               Trend percentages are calculated in relation to base year.  If a figure in other year is less than the figure in base year the trend percentage will be less than 100 and it will be more than 100 if figure is more than base year figure.  Each year’s figure is divided by the base year’s figure.

 

The interpretation of trend analysis involves a cautious study.  The mere increase or decrease in trend percentage may give misleading results if studied in isolation.  An increase of 20% in current assets may be treated favourable.  If this increase in current assets is accompanied by an equivalent increase in current liabilities, then this increase will be unsatisfactory.  The increase in sales may not increase profits if the cost of production has also gone up. The base period should be carefully selected.  The base period should be a normal period.  The price level changes in subsequent years may reduce the utility of trend ratios.  If the figure of the base period is very small, then the ratios calculated on this basis may not give a true idea about the financial data.  The accounting procedures and conventions used for collecting data and preparation of financial statements should be similar, otherwise the figures will not be comparable.

 

Common-Size Statements

              The common –size statements, balance sheet and income statement, are shown in analytical percentages. The figures are shown as percentages of total assets, total liabilities and total sales. The total assets are taken as 100 and different assets are expressed as a percentage of the total. Similarly, various liabilities are taken as a part of total liabilities. These statements are also known as component percentage or 100 percent statements because every individual item is stated as a percentage of the total 100. The shortcomings in comparative statements and trend percentages where changes in items could not be compared with the totals have been covered up. The analyst is able to assess the figures in relation to total values. The common-size statements may be prepared in the following way:

·                    The totals of assets or liabilities are taken as 100.

·                    The individual assets are expressed as a percentage of total assets, i.e., 100 and different liabilities are calculated in relation to total liabilities.

 

(i) Common Size Balance Sheet

A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities is called common-size balance sheet for example, following assets are shown in a common-size balance sheet:

                                                                                                Rs.                   Percentage

Cash in hand and at bank                                                          5,000                 2.50

Sundry debtors                                                           20,000               10.00  

Stock                                                                                     25,000               12.50

Land and Buildings                                                                 50,000               25.00

Plant and Machinery                                                            1,00,000               50.00

            Total Assets:                                                            2,00,000             100.00

_____________________________________________________________________                                                                                    

            The total figure of assets Rs. 2,00,000, is taken as 100 and all other assets are expressed as a percentage of total assets.  The relation of each asset to total assets is expressed in the statement.  The relation of each liability to total liabilities is similarly expressed.

            The common-size balance sheet can be used to compare companies of differing size.  The comparison of figures in different periods is not useful because total figures may be affected by a number of factors.  It is not possible to establish standard norms for various assets.  The trends of figures from year to year may not be studied and even they may not give proper results.

 

(ii) Common Size Income Statement

            The items in income statement can be shown as percentages of sales to show the relation of each item to sales.  A significant t relationship can be established between items of income statement and volume of sales.  The increases in sales will certainly increase selling expenses and not administrative or financial expenses.  In case the volume of sales increases to a considerable extent, administrative and financial expenses may go up.  In case the sales or declining, the selling expenses should be reduced at once.  So, a relationship is established between sales and other items in income statement and this relationship is helpful in evaluating operational activities of the enterprise. 

 

Funds Flow Analysis

Meaning of Funds Flow Statement

            The funds flow statement is an attempt to report the flow of funds between various assets and liabilities and owner’s capital during an accounting period.  In words of Smith and Brown, “Funds flow Statement is prepared to indicate in summary form, changes (and trends, if prepared regularly) occurring in items of financial position between two different balance sheet dates.”  Such a statement is prepared to indicate the increases and utilization of resources of a business during an accounting period.  A funds flow statement is also known by various other names such as ‘Statement of Sources and Application of Funds’, ‘Where Got, Where Gone Statement’ ‘Statement of Funds Generated and Expended’, etc.  In order to clearly understand and meaning of funds flow statement; it is necessary to understand the meaning of the terms ‘Funds’ and ‘Flow’.

 

Meaning of ‘Funds’

            The term funds have a variety of meanings.  However, for the purpose of funds flow statement, the term ‘funds’ means ‘Net Working Capital’ also known as ‘Net Current Assets’.  It is defined as the difference between current assets and current liabilities.  Thus: Fund = Current Assets-Current Liabilities.

 

Preparation of Funds Flow Statement

In order to prepare funds flow statement, it is necessary to find out the various ‘sources’ and ‘applications’ of funds.  The various sources and applications of funds are given below in a Proforma of funds flow statement.

 

Statement of Sources and Applications of Funds

 

Sources of Funds:                                                                                                                                                                             

1. Issue of Share Capital
2. Issue of Debentures
3. Loans from Institutions
4. Sale of non-current assets and investments
5. Funds from operations (Profit)

Total Sources

Applications of Funds:

1. Redemption of Preference Shares
2. Redemption of Debentures
3. Repayment of loans
4. Purchase of non-current assets
5. Loss from operations (Loss)
6. Payment of dividend, taxes, etc.

Total Applications

Net Increase or Decrease in Working Capital

(Total Sources-Total Applications)

Advantage and Uses of Funds Flow Statement

            The funds flow statement is an extremely useful tool for the management.  It gives a clear picture of the causes of changes in the working capital position of the company during a period.  It shows the various sources from which funds are obtained and also the uses to which these funds are put to.  The information given by funds flow statement is not apparently available from other financial statements.  The main uses of funds Flow statement are listed below:

1.                  Guides proper use of available funds: For the continued financial health or well being of a firm, it is necessary to use available working capital carefully and properly.  The funds flow statement shows up boldly how the funds made available in a year were used.  Thus, the wisdom or otherwise of management’s decisions in this regard will be revealed in the funds flow statement.

2.                  Acts as a basis for financial plan and budgeting: The funds flow statement can be used easily as a basis for preparing financial plans for the coming period.   On an estimated basis, it becomes the financial budget for the next year.  In fact, when large sums are borrowed and repayment is made by annual installments, funds flow statements prepared in anticipation for future years will help determine the amount that can be paid each year. Thus the statement can serve as a tool for planning also.

3.                  It gives early warning of coming financial dangers: To judge whether a firm faces any danger of becoming sick, i.e., of facin g financial difficulties, it is essential to know the amount of funds generated by operations, i.e., the inflow from operations.  If the flow is not big enough, the firm will not enjoy good financial position; if it is minus; it will face great difficulties.  The funds flow statement thus may give early warn in g of coming financial dangers if the inflow is small and the use of funds is not proper.

4.                  It reveals the net result of business operations during the year in terms of cash: The profit shown by the profit and loss account can be manipulated by the management by changing the amount of depreciation and the amount of other write offs.  It is because these amounts are the results of the personal decisions of the management.  For example, if amount of depreciation is increased the profit will decrease and vice versa.  Similarly, if larger amount of goodwill is written off, the profit will reduce to that extent.  This means it is not easy to compare profit in two years or of two firms.  But profit plus depreciation and write offs will be the same and comparable.  This means ‘inflow from operations’ i.e. the total profit before various write offs is quite reliable for comparison purposes the funds flow statement always shows prominently the funds from operations and is thus useful.

5.                  Helps in borrowing: Banks and other financial institutions like IDBI, State Finance Corporations etc. like to satisfy themselves about the ability of the company to repay the loans.  Before lending, these institutions like to see projected Flow Statements which indicates ability or otherwise of the company to pay off the loan as per the terms of repayment.

 

Cash Flow Analysis

Meaning

            A cash flow statement is statement of changes in cash position between the beginning and end of the period.  It is a statement, which summarizes the sources from which cash payments are made during particular period of time, say a months or a year.  In other words, a cash flow statement shows the various sources of cash inflow and uses of cash outflow during a period thus explaining the changes in cash position of the business. A cash flow statement is not very much different from a funds flow statement.  In fact, the main difference between funds flow statement and cash flow statement relates to meaning and concept of the terms ‘fund’.  The term ‘fund’ as used in funds flow statement means net working capital i.e. the difference between current assets and current liabilities.  But in a cash flow statement the term ‘fund’ means cash.

 

Definition of Cash Fund

            As per Accounting Standard (AS-3) issued by the Institute of Charted Accountants of India, the term cash includes:

(i)                  Cash in hand.

(ii)                Demand deposits with banks.

(iii)               Cash equivalents. These are short-term highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value.

 

Preparation of Cash Flow Statement

            Preparation of cash flow statement is similar to that of funds flow statement.  Infact, the basic difference arises from the definition of funds.  In funds flow statement, fund means ‘net working capital’ while in cash flow statement it means ‘cash’.  AS-3 has not prescribed any specific format of cash flow statement but SEBI requires the cash flow statement to be prepared in the following form.

Proforma of Cash Flow Statement

Cash Flows from Operating Activities                                              Rs                   Rs

Net profit before tax and extra ordinary items

Adjustment for:                                                                        

            Depreciation                                                                             xxx      

            Interest income                                                                         xxx

            Dividend income                                                                       xxx

            Interest expense                                                                        xxx

            Foreign exchange loss                                                               xxx

Operating profit before working capital changes                                    xxx

Adjustment for changes in current assets and current liabilities    xxx

Cash generated from of used in operations before tax                xxx      

Income tax paid                                                                                    xxx

Cash flow before extra ordinary items                                       xxx

Extra ordinary items                                                                              xxx

Net cash from (or used in) operating activities                                                    xxx

Cash Flow from Investing Activities

Purchase of fixed assets                                                                        xxx                              

Proceeds from sale of fixed assets                                                         xxx

Interest and dividend received                                                               xxx

Net cash from (or used in) investing activities                                         xxx                   xxx

Cash Flow from Finance Activities

Proceeds from issue of shares/debentures                                          xxx

Proceeds from long term borrowings                                                  xxx   

Repayment of long-term borrowings                                                      xxx

Interest paid                                                                                         xxx

Dividends paid                                                                          xxx

Net cash from (or used in) financing activities                                                     xxx

Net increase (or Decrease) in cash and cash equivalents                                                xxx

Cash and cash equivalents at the beginning of the period                                                xxx

Cash and cash equivalents at the end of the period                                                         xxx

Objective and Uses of Cash Flow Statement

1.                  Useful in cash planning: A cash flow statement proves very useful to management by providing a basis to evaluate the ability of a company to generate cash. A cash flow statement prepared on an estimated basis for the next accounting period enables the management to know how much cash can be generated internally and how much it should arrange from outside. Such estimated amounts are used for preparing cash budget.

2.                  Assesses cash flow from operating activities: Cash flow statement provides information about cash generated from operating activities. It provides explanation for the difference net profit and cash from operations. Cash provided by operating activities is very important to assess the cash generated by internal sources.

3.                  Payment of dividends: Decisions to pay dividends cannot be based on net profit only. Availability of profit in the form of cash is also important for dividend disbursement. Thus cash provided by operating activities assumes importance for declaration of divided.

4.                  Cash form investing and financing activities: Cash flow statement provides information not only about cash provided by operating activities but also by non-operating activities under two heads, namely investing activities and financing activities. This helps to explain the overall liquidity position of the enterprise and its ability to meet its cash commitments.

5.                  Explains reasons for surplus or shortage of cash: A business may have made profit and yet running short of cash.  Similarly a business may have suffered a loss and still has sufficient cash at the bank.  A cash flow statement discloses reasons for such increases or decreases of cash balance.

 

Ratio Analysis

Meaning of Ratio and Ratio Analysis

            A ratio is simply one number expressed in terms of another number.  In other words, a ratio expresses mathematical relationship between one number and another. An accounting ratio shows the mathematical relationship between two figures which have meaningful relation with each other e.g. gross profit and sales, net profit and sales, current assets and current liabilities etc.  No useful purpose is served if ratios are calculated between two figures, which are not, related at all to each other e.g. purchases and premium on the issue of shares.

 

            Ratio analysis is a powerful tool of financial analysis.  A ratio is defined as ‘the indicated quotient of two mathematical expression’ 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.  The relationship between two accounting figures, expressed mathematically, is known as financial ratio or simply as a ratio.  Ratios help to summarize large quantities of data and to make qualitative judgment about the firms’ financial performance.  It is the process of establishing and interpreting the relationship between two numerical items.

 

Types of Ratios

            Several ratios calculated from the accounting data, can be grouped into various classes according to financial activity to be evaluated.  The parties interested on financial analysis are short and long-term creditors, owners and management  short-term creditors main interest is in the liquidity position (or) the short-term solvency of the firm  long-term creditors on the other hand, are more interested in evaluating every aspect of the firm’s performance.  Since they have to protect the interests of all parties and see that the firm grows profitability.

 

            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.                  Activity ratios

4.                  Profitability ratios

1. LIQUIDITY RATIOS

            It is extremely essential for a firm to be able to meet it obligations, as they become due liquidity ratios measure the ability of the firm to meet its current obligations.  These ratios are calculated to comment upon the short-term paying capacity of a concern.  The most common ratios that indicate the extent of liquidity or lack of it are:

(i)                  Current ratio

(ii)                Quick ratio

(iii)               Absolute ratio

 

(i) Current Ratio

            Current ratio may be defined as the relationship between current assets and current liabilities.  This ratio is also known as working capital ratio is a measure of general liquidity and is most widely used to make the analysis of a short-term financial position or liquidity of a firm, it indicates the availability of current assets in rupees for every one rupee of current liability. A ratio that is greater than one means that the firm has more current asset than current claims against them.  As a conventional rule a ratio of 2:1 or more is considered satisfactory.

            The current ratio is calculated by the following formula:

           

 

(ii) Quick Ratio

            Quick ratio is the ratio of quick assets to current liabilities quick assets are assets, which can be converted into cash very quickly without much loss. Quick liabilities are liabilities, which have to be necessarily paid with in one year.

 

            Quick ratio of 1 is considered to be satisfactory a quick ratio of less than one is an indicative of inadequate liquidity of the business.  A very high quick ratio is also not advisable, as funds can be more profitably employed.  Quick ratio can be calculated by the following formula:

           

Quick Assets = Current assets-Closing Stock-Prepaid Expenses.

(iii) Absolute Liquid Ratio or Cash Ratio

            This ratio is useful when it is used in conjunction with current and acid test ratios this ratio is also known as super quick ratio.  The ideal absolute liquid ratio is taken as 0.5:1.  This ratio can be calculated by the following formula:

 

2. LEVERAGE RATIOS

             These ratios are calculated to judge a long-term financial position of the firm, financial leverage, or capital structure.  These ratios indicate mix of fund provided by owners and lenders.  The leverage or capital structure ratios bay be defined as financial ratios which throw light on the long-term solvency of the firm as reflected in its ability to assure the long-term creditors with regard to (i) periodic payment of interest during the period of the loan and (ii) repayment of principal of maturity or in predetermined installments at due dates.

 

            These ratios are computed from the balance sheet and have many variations such as:

(i)                  Proprietary ratio

(ii)                Debt-equity ratio

(iii)               Fixed assets to net worth ratio

(iv)              Fixed assets to capital employed ratio

(v)                Debt ratio

 

(i) Proprietary Ratio

            It is the ratio of funds belonging to shareholders to the total assets of the company.  Funds belonging to shareholders means share capital plus reserves and surpluses, both of capital and revenue nature.  Losses should be deducted.  Funds payable to others should not be added.  The higher the ratio, the greater the long term stability of the company and consequently greater protection to creditors.

           

 

(ii) Debt-Equity Ratio

 The debt-equity ratio attempts to measure the relationship between long term debts and share holders funds. This ratio is calculated as:

 

This ratio shows the relative amount of funds supplied to the company by outsiders and by owners. A low debt equity ratio implies a greater claim of owners on the assets of the company than the creditors. On the other hand, a high debt equity ratio indicates that the claims of the creditors are greater than those of the owners. The debt equity ratio of 1:1 is generally acceptable.

 

(iii) Fixed Assets to Net Worth Ratio

             The ratio of long-term loans to fixed assets is therefore important and another aspect of long-term financial policy.  It is well established that fixed assets should be acquired only out of long-term funds’ this ratio shows whether this is so.  The ratio will be 1 if the two are equal but if the ratio is less than 1, it means the company has followed the imprudent policy of using short-term funds (like bank over-draft or amounts due to suppliers) for acquiring fixed assets.

           

 

(iv) Fixed Assets to Capital Employed Ratio

            It is the  ratio between fixed assets and capital employed that explains the relation between the fixed assets and capital employed by interpreting the proportion of fixed investment of various long term assets of the company out of fixed capital employed higher the ratio depicts higher amount of fixed capital investment information fixed assets, lower the ratio the lower will be the proportion of company’s fixed investment in various assets in the fixed capital employed.  It can be calculated as:

           

 

(v) Debt Ratio

            Debt-ratios are used to analyze the long-term solvency of firm.  The firm may be interested in knowing the proportion of the interest bearing debt also called funded debt in the capital structure.  It may therefore, compute debt ratio by dividing total debt by capital employed or net assets.  Total debt will include short and long-term borrowings from financial institutions, debentures/bonds, deferred payment arrangements for buying capital equipments, bank borrowings, public deposits and any other interest-bearing loans.  Capital will include total debt and net worth.  It can be ascertained as:

 

(vi) Interest Coverage Ratio

            Also called Debt service or Fixed charges cover ratio indicates whether the business earns sufficient profit to pay  periodically the interest charges.

           

Here EBIT means Earnings Before Interest and Taxes, Fixed interest charges means interest on debentures and long term loans.  This ratio is very important from lender’s point of view because it indicates the ability of a company to pay interest out of its profits. The standard for this ratio for an industrial economy is that interest charges should be covered six to seven times.

 

3. ACTIVITY RATIOS

            Performance or activity ratios judge how well the facilities at the disposal of the concern are being used.  The ratios are also usually calculated on the basis of cost of sales.  The ratios are also known as turnover ratios as they express the rapidity with which a unit of capital invested in fixed assets, stocker., produces proper balance between sales and assets generally reflects that assets are managed well.  Several activity ratios can be calculated to judge effectiveness of asset utilization.  Some of activity ratios are follows:

(i)                  Inventory turnover ratio

(ii)                Debtors turnover ratio

(iii)               Total assets turnover ratio

(iv)              Fixed assets turnover ratio

(v)                Working capital turnover ratio

(i) Inventory Turnover Ratio

The term stock may include all types of stock (raw materials, work in process, and finished goods) but since sales are of finished goods only.  Higher the ratio, the better it is.  Since it indicates that a unit of investments in stocks is producing more sales.  Industries in which the stock turnover ratio is high usually work on comparatively low margin of profit the rate of profit on sales must be high if the stock turnover ratio is low.  This has the advantages that for a given figure of sale, the inventory level required can be easily ascertained.  It is calculated as:

     

 

(ii) Debtors Turnover Ratio

This ratio indicates the relationship between net credit sales and trade debtors. It shows the rate at which cash is generated by the turnover of debtors. It is computed as follows:

 

The term debtors include trade debtors and bills receivable.  This ratio indicates as to how many days average sales are tied up in the amount of debtors. A higher debtors turnover  ratio indicates that debts are being collected more quickly. Changes in this ratio show the changes in the company ‘s credit policy or changes in its ability to collect from its debtors.

 

(iii) Total Assets Turnover Ratio

This ratio shows the firm’s ability in generating  sales from all financial resources committed to total assets.  Total assets include net fixed assets and current assets. The total assets turnover ratio can be calculated as:

           

 

(iv) Fixed Assets Turnover Ratio

            This ratio indicates the efficiency with which the firm is utilizing its investments in fixed assets such as plant and machinery, land and buildings etc. It is computed as under:

 

            The term net fixed assets means depreciated value of fixed assets. A high ratio indicates efficient utilization of fixed assets in generating sales and a low ratio may signify that the firm has an excessive investment in fixed assets.

 

(v) Working Capital Turnover Ratio

            This ratio indicates the efficiency or inefficiency in the utilization of working capital in making sales. It is computed as follows:

 

            Net working capital means current assets minus current liabilities. A high working capital ratio shows the efficient utilization of working  capital  in generating sales.  A low ratio may indicate excess of net working capital .  This ratio thus shows whether working capital is efficiently utilized or not.

 

4. PROFITABILITY RATIOS

Apart from the creditors, both short-term and long-term, also interested in the financial soundness of analysis firm are the owners and management or the company itself.  The management of the firm is naturally eager to measure its operating efficiency.  Similarly, the owners invest their funds information the expectation of reasonable returns.  The operating efficiency of analysis firm and its ability to ensure adequate returns to its shareholders depends ultimately on the profits earned by it.  The profitability of a firm can be measured by its profitability ratios.

 

            Profitability ratios can be determined on the basis of either sales or investments.  The profitability ratios in relation to sales are (i) Profit margin (gross and net) and (ii) Expenses ratio.  Profitability in relation to investments is measured by (a) return on assets (b) return on capital employed and return on shareholders equity.  Some of the important profitability ratios are as follows:

(i)                  Net profit ratio

(ii)                Operating expense ratio

(iii)               Return on shareholders equity

(iv)              Return on capital employed

(v)                Return on total assets

(vi)              Earnings per share

(vii)             Dividends per share.

 

(i) Net Profit Ratio

            This is the ratio of net profit to net sales.  It is computed as:

           

            Here Net Profit = Gross Profit – All Expenses + All Incomes

 

            The net profit ratio is the overall measure of a firm’s ability to turn each rupee of sales into profit.  It indicates the efficiency with which a business is managed.  A firm with a high net profit ratio is an advantageous position to survive in the face of rising cost of production and falling selling prices.  Where the net profit ratio is low, the firm will find it difficult to withstand these types of adverse conditions.

 

(ii) Operating Expense Ratio

            This ratio explains the relationship between cost of goods sold and operating expenses on the one hand and net sales on the other.

 

Here operating expenses include cost of goods sold, selling expenses and administration expenses.  The operating ratio is the yardstick to measure the efficiency with which a business is operated.  A high operating ratio is considered unfavourable because it leaves a smaller margin of profit to meet non-operating expenses.  On the other hand a lower operating ratio is considered a good sign.

 

(iii) Return on Shareholders Equity

This is also known as Return on Proprietor’s Equity.  It shows the ratio of net profit to owners equity.

 

Return on shareholder’s funds is a very effective measure of the profitability of an enterprise.  This ratio measures the return on total equity of the shareholders.  It should be compared with the ratios of other similar companies to determine whether the rate of return is attractive.

 

(iv) Return on Capital Employed

            It measures the overall profitability of the organization.  It is ascertained by comparing profit earned and capital (or funds) employed to earn it.  It is calculated as follows:

 

            This is the only ratio which measures satisfactorily the overall performance of a business from the point of view of profitability.  This ratio indicates how well the management has utilized the funds supplied by the owners and creditors.  In other words, this ratio is intended to measure the earning power of the net assets of the business.  The higher the ratio, the more efficient the management is considered to be in using the funds available.

 

(v) Return on Total Assets

            The profitability ratio is measured in terms of the relationship between net profits and assets.  It is calculated by dividing the profits after taxes by total assets.  Thus,

           

            It measures the profitability of the total funds / investments of a firm.  It, however, throws no light on the profitability of the different sources of funds which finance the total assets.

(vi) Earnings per Share

            It measures the profitability of the firm on a per share basis.  It is calculated as follows:

 

Earnings per share is a widely used ratio.  It only shows how much earnings theoretically belong to the ordinary shareholders (per share basis).

 

(vii) Dividends per Share

It indicates dividends distributed to equity shareholders on a per share basis.  In other words, it is the net distributed profit belonging to the ordinary shareholders divided by the number of ordinary shares outstanding.  This is

 

This is a better indicator because it shows what exactly is received by the owners.

 

Limitations of Financial Analysis

            Financial analysis is a powerful mechanism of determining financial strengths and weaknesses of a firm.  But, the analysis is based on the information available in the financial statements. Thus, the financial analysis suffers from serious inherent limitations of financial statements.  The financial analyst has also to be careful about the impact of price level changes, window-dressing of financial statements, changes in accounting policies of a firm, accounting concepts and conventions, and personal judgments, etc some of the important limitations of financial analysis are:

1.                  It is only a study of interim reports

2.                  Financial analysis is based upon only monetary information and non –monetary factors are ignored.

3.                  It does not consider changes in price levels.

4.                  As the financial statements are prepared on the basis of a going concern, it does not give exact position. Thus accounting concepts and conventions cause a serious limitation to financial analysis.

5.                  Changes in accounting  procedure by a firm may often make financial analysis misleading.

6.                  Analysis is only a means and not an end in itself. The analyst has to make interpretation and draw his own conclusions.  Different people may interpret the same analysis in different ways.