Chapter 4

ANALYSING FINANCIAL
PERFORMANCE

 Centre for Financial Management , Bangalore

 OUTLINE

• Financial Ratios

• Du Pont Analysis

• Standardised Financial Statements

• Applications of Financial Analysis

• Using Financial Statements

• Going Beyond the Numbers

 Centre for Financial Management , Bangalore

 Horizon Limited: Profit and Loss Account for the Year
Ending 31st March 20X1
(Rs. in million)
20X1 20X0
Net sales 701 623
Cost of goods sold 552 475
Stocks 421 370
Wages and salaries 68 55
Other manufacturing expenses 63 50
Gross profit 149 148
Operating expenses 60 49
Depreciation 30 26
General administration 12 11
Selling 18 12
Operating profit 89 99
Non-operating surplus/deficit - 6
Profit before interest and tax 89 105
Interest 21 22
Profit before tax 68 83
Tax 34 41
Profit after tax 34 42
Dividends 28 27
Retained earnings 6 15
Per share data ( in rupees)
Earning per share 2.27 2.80
Dividend per share 1.80 1.80
Market price per share 21.0 20.0
Book value per share 17.47 17.07
 
 Centre for Financial Management , Bangalore
 Horizon Limited: Balance Sheet as on 31st March 20X1
(Rs. in million)
20X1 20X0
  I. Sources of funds
1. Shareholders' funds 262 256
(a)   Share capital 150 150
(b) Reserves and surplus 112 106
2. Loan funds
(a)  Secured loans 143 131
(i) Due after 1 year 108 29
(ii) Due within 1 year 35 40
(b)  Unsecured Loans 69 25
(i) Due after 1 year 29 10
(ii) Due within 1 year 40 15
  474 412
II. Application of funds
1. Fixed assets 330 322
2. Investments 15 15
(a) Long term investments 12 12
(b) Current investments 3 3
3. Current assets, loans and advances 234 156
(a) Inventories 105 72
(b) Sundry debtors 114 68
(c) Cash and bank balance 10 6
(d) Loans and advances 5 10
Less: Current liabilities and provisions 105 81
Net current assets 129 75
Total 474 412
 Centre for Financial Management , Bangalore
 LIQUIDITY RATIOS
• Current Ratio
Current assets 237
= = 1.32
Current liabilities 180

• Acid-Test Ratio
Quick assets (237 – 105)
= = 0.73
Current liabilities 180

• Cash Ratio
Cash and bank Current
+
balances investments (10 + 3)
= = 0.07
Current liabilities 180

 Centre for Financial Management , Bangalore

 LEVERAGE RATIOS
• Debt-equity Ratio
Debt 212
= = 0.809
Equity 262
• Debt-asset Ratio
Debt 212
= = 0.45
Assets 474
• Interest Coverage Ratio
Profit before interest and tax 89
= = 4.23
Interest 21
 Centre for Financial Management , Bangalore
Fixed Charges Coverage Ratio
Profit before Interest and Taxes + Depreciation
= ---------------------------------------------------------------
Repayment of Loan
Interest + -----------------------------
1 – Tax
119
= ----------- = 0.70
75
21 + -------
0.50
Debt Service Coverage Ratio
Profit after Tax + Depreciation + Other Non-Cash Charges
+ Interest on Term Loan + Lease Rentals
= ----------------------------------------------------------------------------------
Interest on Term Loan + Lease Rentals + Repayment of Term Loan
 TURNOVER RATIOS
• Inventory Turnover
Cost of goods sold 552
= = 6.24
Average inventory (105 + 72)/2
• Debtors’ Turnover
Net credit sales = 701
= 7.70
Average debtors (114 + 68)/2
• Fixed Assets Turnover
Net sales = 701 = 2.15
Average net fixed assets (330 + 322)/2
• Total Assets Turnover
Net sales = 701 = 1.58
Average total assets (474 + 412)/2
 Centre for Financial Management , Bangalore
 PROFITABILITY RATIOS
• Gross Profit Margin Ratio
Gross profit 149
= = 0.21 or 21 percent
Net sales 701

• Net Profit Margin Ratio

Net profit 34
= = 0.049 or 4.9 percent
Net sales 701

• Return on Assets (ROA)

Profit after tax 34
= = 0.077 or 7.7 percent
Average total assets (474 + 412)/2

 Centre for Financial Management , Bangalore

 PROFITABILITY RATIOS
• Earning Power
Profit before interest and tax 89
= = 0.201 or 20.1
Average total assets (474 + 412)/2 percent
• Return on Capital Employed
Profit before interest and tax
(1 – Tax rate) 89 (1 – 0.5)
= = 0.101 or 10.1
Average total assets (474 + 412)/2 percent

• Return on Equity
Equity earnings 34
= = 0.131 or 13.1
Average equity (262 + 256)/2 percent

 Centre for Financial Management , Bangalore

 VALUATION RATIOS
 Price-earnings Ratio
Market price per share 21.0
= = 9.25
Earnings per share 2.27
 Yield
Dividend Price change
+
Initial price Initial price
Dividend yield Capital gains/losses yield
1.87 1.0
= 9.35% = 5%
20.0 20.0
Total yield = 14.35 %
 Market Value to Book Value Ratio
Market value per share 21.00
= = 1.20
Book value per share 17.47
 Centre for Financial Management , Bangalore
 COMPARISON WITH INDUSTRY AVERAGES
Ratios Formula Horizon Industry
Limited Average
Liquidity
Current assets
• Current ratio 1.32 1.26
Current liabilities
Quick assets
• Acid-test ratio 0.73 0.69
Current liabilities
Leverage
Debt
• Debt-equity ratio 0.81 1.25
Equity
Debt
• Debt-ratio 0.45 0.56
Assets
PBIT
• Interest coverage ratio 4.23 4.14
Interest
Turnover
Net sales
• Inventory turnover 6.24 6.43
Average inventory
Net credit sales
• Accounts receivable turnover 7.70 7.50
Average accounts receivable
Net sales
• Fixed assets turnover 2.15 2.23
Average net fixed assets
Net sales
• Total assets turnover 1.58 1.26
Average Total assets
 Centre for Financial Management , Bangalore
 Ratios Formula Horizon Industry
Limited Average
Profitability
Gross profit
• Gross profit margin ratio 21.0% 18.0%
Net sales
Net profit
• Net profit margin ratio 4.9% 4.0%
Net sales
Net profit
• Return on assets 7.7% 6.9%
Average total assets
PBIT
• Earning power 20.1% 17.7%
Average total assets
PBIT (1–T)
• Return on capital employed 10.1% 8.8%
Average total assets
Equity earnings
• Return on equity 13.1% 11.9%
Average net worth
Valuation
Market price per share
• Price-earnings ratio 9.25 9.26
Earnings per share
Dividend + Price change
• Yield 14. 0% 14.1%
Initial price
Market price per share
• Market value to book 1.20 1.16
value ratio Book value per share
 TIME SERIES OF CERTAIN
FINANCIAL RATIOS

1 2 3 4 5
Debt-equity ratio 0.91 0.98 0.65 0.61 0.81
Total assets turnover ratio 1.51 1.59 1.58 1.53 1.58
Net profit margin (%) 8.8 11.6 9.8 6.6 4.9
Return on equity (%) 25.4 30.7 24.5 16.7 13.1
Price-earnings ratio 18.6 15.3 10.3 7.1 9.3

 Centre for Financial Management , Bangalore

 DUPONT ANALYSIS

Basic Du Pont Analysis

Net profit Net profit Net sales
= x
Average total assets Net sales Average total assets
ROA = NPM x TATR

Extended Du Pont Analysis

Net profit Net profit Sales Average total assets
------------------- = ------------- x --------------------- x ------------------------
Average Equity Sales Average total asset Average equity

ROE NPM x TATR x 1/(1 – DAR)

 Centre for Financial Management , Bangalore

DU PONT CHART APPLIED TO HORIZON LIMITED
Net Sales
+/- Non
operating
Surplus/Deficit
Net Profit
34
–
701

Net Profit
Margin
4.9%
 Total Costs
667

Net Sales
701
Return on
Total Assets
7.7 % X Average
Fixed assets
Net Sales 326
701

+
Total Assets
Turnover

1.58 Average
Average Investments
Total 15
Assets 443
+
Average
Net Current
Assets 102
 Centre for Financial Management , Bangalore
 EXTENSION OF THE DU PONT CHART

Return of Equity
13.1%

Return of Assets Average Total Assets

To Average Equity
7.7% Ratio 1.70

 Centre for Financial Management , Bangalore

 COMMON SIZE FINANCIAL STATEMENTS
Part A : Profit and Loss Account
  Regular (in million) Common Size (%)
20X0 20X1 20X0 20X1
• Net sales Rs.623 Rs. 701 100 100
• Cost of goods sold 475 552 76 79
• Gross profit 148 149 24 21
• PBIT 105 89 17 13
• Interest 22 21 4 3
• PBT 83 68 13 10
• Tax 41 34 7 5
• PAT 42 34 7 5
Part B: Balance Sheet
Regular (in million) Common Size (%)
20X0 20X1 20X0 20X1
• Shareholders’ funds 256 262 62 55
• Loan funds 156 212 38 45
Total 412 414 100 100
• Fixed assets 322 330 78 70
  • Investments 15 15 4 3
• Net current assets 75 129 18 27
Total 412 474 100
 Centre for Financial Management , Bangalore
100
 COMMON-BASE YEAR FINANCIAL STATEMENTS
Part A : Profit and Loss Account
  Regular (in million) Common Base Year (%)
20X0 20X1 20X0 20X1
• Net sales Rs.623 Rs. 701 100 113
• Cost of goods sold 475 552 100 116
• Gross profit 148 149 100 101
• PBIT 105 89 100 85
• Interest 22 21 100 95
• PBT 83 68 100 82
• Tax 41 34 100 83
• PAT 42 34 100 81
Part B: Balance Sheet
Regular (in million) Common Base Year (%)
20X0 20X1 20X0 20X1
• Shareholders’ funds Rs.256 Rs.262 100 102
• Loan funds 156 212 100 136
Total 412 474 100 115
• Fixed assets 322 330 100 102
  • Investments 15 15 100 100
• Net current assets 75 129 100 172
Total 412 474 100 115
 Centre for Financial Management , Bangalore
 APPLICATIONS OF FINANCIAL ANALYSIS

Financial ratios may be employed to:

• Assess corporate excellence

• Judge creditworthiness

• Forecast bankruptcy

• Value equity shares

• Predict bond ratings

• Estimate market risk

 Centre for Financial Management , Bangalore
 PROBLEMS IN FINANCIAL
STATEMENT ANALYSIS

• Heuristic and Intuitive Character

• Development of Benchmarks
• Window Dressing
• Price Level Changes
• Variations in Accounting Policies
• Interpretation of Results
• Correlation among Ratios

 Centre for Financial Management , Bangalore

 GUIDELINES
• USE RATIO TO GET CLUES TO ASK THE RIGHT

QUESTIONS
• BE SELECTIVE IN THE CHOICE OF RATIOS
• EMPLOY PROPER BENCHMARKS
• KNOW THE TRICKS USED BY ACCOUNTANTS
• READ THE FOOT NOTES
• UNDERSTAND HOW THE RATIOS ARE INTER-
RELATED
• REMEMBER … FSA .. ODD MIXTURE OF ART &
SCIENCE
 Centre for Financial Management , Bangalore
 LOOKING BEYOND THE NUMBERS
1. ARE THE COMPANY’S REVENUES TIED TO ONE KEY
CUSTOMER ?
2. TO WHAT EXTENT ARE THE COMPANY’S REVENUES
TIED TO ONE KEY PRODUCT ?
3. TO WHAT EXTENT DOES THE COMPANY RELY ON A
SINGLE SUPPLIER ?
4. WHAT PERCENTAGE OF THE COMPANY’S BUSINESS IS
GENERATED OVERSEAS ?
5. COMPETITION
6. FUTURE PROSPECTS
7. LEGAL AND REGULATORY ENVIRONMENT

 Centre for Financial Management , Bangalore

 SUMMING UP
 Financial statement analysis can provide valuable insights into a firm’s
performance and position.
 The principal tool of financial statement analysis is financial ratio analysis.
 Financial ratios may be divided into five broad categories:
 Liquidity ratios
 Leverage ratios
 Turnover ratios
 Profitability ratios
 Valuation ratios
 Generally, the financial ratios of a company are compared with some
benchmark ratios.
 The Du Pont chart is a popular tool of financial analysis. It provides insights
into the determinants of the return on equity
 There are certain problems and issues in financial statement analysis that
call for care, circumspection, and judgment.
 Centre for Financial Management , Bangalore