# Analysis by liaoqinmei

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```									          ANALYSIS OF FINANCIAL STATEMENT

We know that Financial Accounting ends with
preparation   of    preparation   of    Financial
Statements i.e. Profit and Loss Account, Balance
Sheet (also Cash flow Statement in case of Listed
Companies)

So when we talk about Analysis of Financial
Statement, we mean analysis of Profit and Loss
Account, Balance Sheet etc.

Then what is Analysis?

As per Dictionary, it is the separation of a whole
into its components for study and interpretation.
So analysis of       Financial Statement refers to
classification of the various items given in Financial
Statement and further its interpretation. It is the
powerful mechanism of ascertaining the financial
strengths and weaknesses of a firm.

The importance of making analysis of Financial
Statement may be better understood from this fact that
Financial Statement, though itself reflects the net
results for a particular period and state of affairs of the
company on that date, but still we have to go for
analysis of the same for more specific and deeper
understanding of strengths and weaknesses.

For example, NTPC Ltd., though a very good profit
making company, but often it faces fund problem
because of purchasing inputs from Coal India Ltd., GAIL
etc on cash basis while selling electricity to various
State Electricity Board on credit basis.
Types of Financial Analysis:

A)     External Analysis : Done by outsiders like
Shareholders, Banks, Creditors, Clients etc

B) Internal Analysis : Done by Management,
Employees etc

C) Horizontal Analysis: Financial statements for a
number of years are reviewed, compared and
analyzed.

D) Vertical Analysis : The Analysis is made by
reviewing the relationship quantitatively of various
items in the financial statement on a particular
date.
Techniques of Financial Analysis:
- Comparative Statements: In this case Comparative Balance Sheet
and Comparative Income Statement are prepared on the basis of
financial statement of two periods. The objective is to see the
increase or decrease in assets, liabilities, income and
expenditure in the current year as compared to last year (Say).
- Trend Analysis: Here one year is taken as the base year and
increase or decrease in items of financial statements over a
number of years is calculated based on the base year.
- Common Size statement: In this case one item say Net Sales of
any year is taken as the base and all other items of the Income
statement are evaluated in terms of % of net sales and then over
the years, the increase or decrease in every item is analyzed.
- Ratio Analysis: So analysis is made on the basis of some important
ratios.
- Cash Flow Statement: Sources and application of cash and cash
equivalents are presented through a statement. As per the listed
companies’ requirement, the sources and applications are
presented under three heads i.e. Operation, Investment and
Financing.
- Funds Flow Statement: In this case sources and application of
funds are prepared through a statement. Here fund means
working capital.
RATIO ANALYSIS
A Ratio refers to arithmetical or numerical relationship
between items or variables.

This relation can be expressed as percentage (%) or
Fraction (one-fifth) or Proportion (1:4).

So ratio analysis in the context of Financial Statement
refers to establishing an arithmetical relationship
between various items of the same, so as to draw
some meaningful conclusion from them. This is one of
techniques of analysis of Financial Statement.

It gives answers to various important questions such
as, Is the company financially viable? Will the
company be able to pay for its short term obligations?
Is the profitability of the company sufficient enough
for shareholders/Bank/Creditors? Etc.
Types of Ratios:

Ratios can be classified into the following

A) Liquidity Ratios

B) Capital Structure or Leverage Ratios

C) Profitability Ratios

D) Activity Ratios
Liquidity Ratios:

The objective of this ratio is to assess the ability of
the firm to meet its current/short tem obligations.
The concerned users of this ratio here are
creditors, Banks, who are interested in the short
term solvency or liquidity of a firm.

Every company should strike a balance between
i.e. liquidity and profitability for efficient financial
management. The example of NTPC Ltd., as
already given is more appropriate to substantiate
the aforesaid statement.

The appropriate ratios to throw light on liquidity are
as follows :
A) Current Ratio
B) Liquid / Quick Ratio
C) Super Quick Ratio
1) Current Ratio:
Current Assets
Current Ratio =                ---------------------------
Current liabilities

Current Assets include Cash and Bank Balance,
Marketable Securities, Inventory, Debtors, Bills
Receivable, Prepaid Expenses etc.

Current Liabilities include Creditors, Bills Payable,
Bank Overdraft, Proposed Dividend, Provision for
Taxation, Outstanding expense etc.

Current Ratio assesses short term solvency i.e. the
ability to meet short term obligation of the
company.
Subject to deeper enquiry, generally a current ration
of 2:1 is considered satisfactory.
2) Liquid / Quick Ratio :
Quick Assets
Quick Ratio =               ---------------------------
Current liabilities

Quick Assets: CA - (Inventory + Prepaid Expenses)

The idea behind Quick Ratio is to assess more strictly
the firm’s ability to meet out short term obligations.

Inventory and prepaid expenses being excluded
because these two items are generally considered
less liquid-able than any other items of Current
assets.

Generally a quick ratio of 1:1 is                considered
satisfactory, subject to deeper enquiry.
3) Super Quick / Acid Test Ratio:
Super Quick Assets
Super Quick Ratio =             ---------------------------
Current liabilities

In a more appropriate sense, this ratio is also
interpreted as follows:
Super Quick Assets
Super Quick Ratio =             ---------------------------
Quick liabilities

Super Quick Assets: Cash and marketable Securities
Quick Liabilities: Current Liabilities – Bank Overdraft

Super quick assets does not include also debtors and
bills receivable.
Bank overdraft being excluded because of its kind of
permanent nature with the Bank.

This ratio is the most strict and very conservative test
of the firm’s liquidity position.
General Interpretation of Liquidity Ratios:

-- General rule of thumb or standard say 2:1 (for
current ratio) or 1:1 (for quick ratio) is always
subject to deeper scrutiny.

-Liquidity ratios of number of years are to be
reviewed so also to be compared with the best
industrial standard, to arrive at a reasonable &
logical ratio.

- A higher current ratio may be generally
acceptable while making inter-firm comparison.

- A very high current ratio may not be
acceptable due to the fact that the same may
include higher inventory and prepaid expenses.
General Interpretation Contd…

- In case of rich countries, where long term funds
are available, they may not depend on current
liabilities to finance current assets. So in poor
countries, a major portion of Current assets are
financed by current liabilities.
For example Hindustan Unilever Ltd. Generally
asks for more credit period from suppliers than
the credit period allowed to their clients. So
major portion of their stock is financed by
creditors.

- Similarly FMCG firms generally use to maintain low
current ratio as they have less need for current
assets compared to dealers who generally have
higher current ratio.
CAPITAL STRUCTURE / LEVERAGE RATIOS

The ratios under this category are very relevant from
the point of view of long term funds providers. They
are interested to know whether the company is
viable enough to refund the long term loan along
with interest or whether the company shall be able
to pay dividend to shareholders etc.

So ratios here focus on the long term solvency of the
company.

The various ratios discussed under this head are as
follows:

A) Debt Equity Ratio
B) Interest Coverage Ratio
C) Dividend coverage Ratio
D) Capital Gearing Ratio
1) Debt Equity Ratio:
Outsiders’ Funds External Equities
Debt Equity Ratio = --------------------------- or ----------------------------
Insiders’ Funds                Internal Equities

Total Debt
or       ----------------------------
Shareholders’ Funds

Long Term Loan + Current Liabilities
=    ---------------------------------------------------------
Share Capital (Equity+Pref.)+ Reserve
&Surplus- Accumulated loss
General Interpretation :

- This ratio reflects the proportion of owners’ stake in the
business. Excess liabilities tend to cause insolvency and
working capital problem.
- There is standard of 2:1, which says that debts should
not exceed twice of the Shareholders’ funds. (Subject to
deeper enquiry)
- A higher ratio shows a large share of financing by the
creditors of the firm, a low ratio shows the opposite.
- If a debt equity ratio is 1:2, it shows that for every rupee
of outsiders, the firm has two rupee of owners’ capital. In
other words, the stake of creditors is one-half of the
owners. So creditors are safe.
- If Debt equity ratio is high, the owners have liquidated
their stake or if the project fails, the creditors would lose.
So also it gives a very bad impression that owners do not
have faith in their company.
General Interpretation Contd.

This can be substantiated by the glaring example of
Wipro, where once the Chief Mr. Azim Premji had said
that when he gets money, he purchases shares of his
company. If I don’t rely my company, then why others
will be interested?
- A high debt equity ratio may not be good for the
company also since creditors would start
pressurizing the company and may like to interfere
with the management.
- A high D/E ratio also puts burden on the
profitability of the company as less amount will be
available for shareholders, so also the company
may face problem in mobilization of further
loans/equity.
- A low D/E ratio implies sufficient margin available
for creditors. The servicing of debt is also not that
burdening. So more mobilization of funds is
possible.
2) Interest Coverage Ratio:

Net Profit before Interest & Tax
Interest Coverage Ratio = ------------------------------------------------------
Fixed Interest Charges

General Interpretation :

- Higher the ratio, more safe are the long term creditors
because even if earnings of the firm fall later, the firm
shall be able to meet its commitment of fixed interest
charges.

- But too high is not good, since it depict that company is
not interested in major development activities.

- Similarly a low ratio may point towards danger signal
as the firm is using excessive debt and does not have
the capacity to pay guaranteed interest to the
creditors.
3) Dividend Coverage Ratio:
Earning after Tax
Dividend Coverage Ratio: = ----------------------------
Preference Dividend
General Interpretation:

-   This ratio shows the ability of a firm to
pay fix amount of dividend on preference
shares.

- Like the interest coverage ratio, this ratio
also ascertains the margin available to
Preference Share Holders.
4)Capital Gearing Ratio :
Equity Share Capital + Res. & Surps.
Capital Gearing Ratio = ---------------------------------------------------------
Pref. Share Capital + Long Term Debt

General Interpretation:

-    This ratio is calculated to test the long term
financial position of a firm.

- If numerator is higher than denominator, it’s a low
gearing ratio and otherwise is high gearing ratio.

- A high gearing ratio is not good for a new company or
in such companies where future earnings are
uncertain.

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