Accounting and Financial Management
Dr S. Velavan, B.E., M.B.A., PhD.,
DoMS, NIT Trichy
Learning Objectives
RNS Chapter 12: Balance Sheet and Statement of Profit & Loss
Objectives of Financial Statement Analysis
Public Sources of Information
Standards of Comparison
Techniques of Financial Statement Analysis
Ratio Analysis
Profitability Analysis
Liquidity Analysis
Solvency Analysis
Capital Market Standing
Objectives of Financial Statement Analysis
Evaluating past performance
Predicting future performance
Standards of Comparison
1. Rule-of-thumb indicators
A current ratio of 2:1 is a satisfactory. However, a firm with 2.2:1 may have slow moving
inventory and past-due receivables compared to another firm with 1.6:1
2. Past performance
Comparing a company’s current performance with its past performance will show
whether the company is improving or declining
Disadvantages:
Fundamental changes in the company’s environment like regulation, competition,
technology
Accounting policy changes
Non-operating items are not predictable
Own history may be different from the industry
Standards of Comparison
3. Internal Standards
Companies follow internal goals and standards for rewarding performance. However,
inaccessible to outsiders
4. Industry standards
Comparing a company with its industry will be better than comparing the historical
performance.
Disadvantages:
Different size and products
Accounting policies
Fiscal year
Techniques of Financial Statement Analysis
1. Horizontal Analysis
Techniques of Financial Statement Analysis
2. Trend Analysis
Techniques of Financial Statement Analysis
3. Vertical Analysis (Common Size Statement analysis)
Techniques of Financial Statement Analysis
4. Ratio Analysis
Liquidity Analysis
Profitability Analysis
Solvency Analysis
Capital Market Standing
Ratio Analysis
Liquidity Ratios
The ability of a business to meet its short-term obligations
a) Current Ratio:
It shows the amount of current assets a company has per rupee of current liabilities.
Usually, 2:1 is preferred by the banks.
Ratio Analysis
Liquidity Ratios
b) Quick Ratio:
Current assets majorly includes Cash, Investments, Receivables, Inventories. The large
current ratio by itself is not a satisfactory measure of liquidity when inventories are a
major portion of current assets. Hence, the quick ratio is computed to check how much
of current liabilities can be repaid quickly using current assets by excluding Inventories.
Ratio Analysis
Liquidity Ratios
c) Inventory Turnover Ratio (RTO):
It measures the number of times a company’s inventories are converted into sales.
Higher inventory turnover ratio is a sign of efficient management system.
Ratio Analysis
Liquidity Ratios
d) Receivable Turnover Ratio (RTO):
It measures the efficacy of a firm’s credit policy and collection mechanism and shows
the number of times each year the receivables are turned into cash. A high RTO
indicates that receivables are being converted rapidly into cash.
Ratio Analysis
Liquidity Ratios
e) Payables Turnover Ratio (RTO):
It measures the number of times a company’s inventories are converted into sales.
Higher inventory turnover ratio is a sign of efficient management system.
Ratio Analysis
Net Operating Cycle
Operating Cycle = Avg Inventory Holding Period + Avg Receivables Collection Period
Net Operating Cycle = Avg Inventory Holding Period + Avg Receivables Collection
Period – Avg Payables Payment Period
Purchase of Inventory, Sale of Inventory,
Raw materials Finished Goods
Inventory Holding Period Receivables Collection Period
Payables Payment Cash Cycle
Period (Net Operating Cycle)
Cash Paid of Inventory, Cash received from
Raw materials Sale
Ratio Analysis
Profitability Ratios
a) Gross Profit Margin:
It measures the profitability of trading or manufacturing activities. It tells us what
portion of revenue remained after paying for the goods sold.
b) Net Profit Margin:
It measures the overall profitability of the business. High Gross margin does not
necessarily means that the operations are profitable on the whole. Operating expenses
are significant for many enterprises.
Ratio Analysis
Profitability Ratios
c) Asset Turnover Ratio:
It measures a firm’s efficiency in utilizing its assets (Higher the ratio, higher the
efficiency). It indicates how many times the assets were turned over in a period in order
to generate sales
Ratio Analysis
Profitability Ratios
d) Return on Assets:
It measures the profitability of a firm for a given level of investment
e) Return on Equity:
It measures a firm’s profitability from the shareholder’s point of view. It measures the
efficiency in the use of shareholders’ funds.
Ratio Analysis
Solvency Ratios
A company’s long-term stability is affected by the extent of debt used to finance its
assets. Since debt finance is riskier than equity, heavy reliance on debt is a potential
threaten to solvency.
a) Debt-to-Equity Ratio (also, known as financial leverage):
It measures the relationship of capital provided by creditors to the amount provided by
shareholders. This debt includes all the interest-bearing financial liabilities (Borrowings)
and excludes operational liabilities.
Ratio Analysis
Solvency Ratios
Advantages of Debt:
The debt is generally cheaper than equity
Interest expense is tax-deductible, whereas dividends are paid from after-tax profits.
In addition, dividend payment attracts dividend distribution tax.
Disadvantages of Debt:
Excessive use of debt financing is risky. The borrower has a legal obligation to make
periodical interest and principal payments.
If it is is unable to pay them on time, creditors (bankers) may force liquidation of
the firm.
Ratio Analysis
Solvency Ratios
b) Liabilities-to-Equity Ratio:
The numerator has all liabilities, and not only borrowings. Most of the operational
liabilities are interest-free, and you can delay it.
Ratio Analysis
Solvency Ratios
c) Assets-to-Equity Ratio:
The numerator has all Assets. It shows the relationship of the firm’s assets to the
portion owned by shareholders of the firm
Ratio Analysis
Solvency Ratios
d) Interest Coverage Ratio:
Interest cover is a measure of the protection available to the creditors (Bankers) for
payment of interest charges by the company. The ratio shows whether the company has
sufficient income to cover its interest requirements by a wide margin.
Ratio Analysis
DuPont Analysis of Profitability
Ratio Analysis
Capital Market Standing Ratios
a) Earnings Per Share:
Financial Analysts regards EPS as an important measure of profitability
Ratio Analysis
Capital Market Standing Ratios
b) Price-Earnings Ratio (P/E ratio)
Popular measure extensively used in investment analysis. It is the ratio of the market price of a
share to the annual EPS.
It tells us how much an investor is willing to pay per rupee of earnings. For e.g., a PE of 15
implies that an investor is ready to pay Rs. 15 for Rs. 1 of earnings.
A higher PE ratio imply that the stock might have strong growth prospects, or it might be
overpriced. Similarly, a lower PE ratio might imply that stock might have weaker growth
prospects, or it is underpriced
Further, EPS is affected by accounting method differences, one-time items, etc
Investing in a stock should be based on a detailed analysis of the company’s business, earnings
quality, competition, industry and economic trends
Market Price Per Share
Price − Earnings Ratio =
Earnings Per Share
Ratio Analysis
Capital Market Standing Ratios
c) Price-to-Book Ratio:
Compares the company’s stock price with the book value (or accounting value). Book value is
the shareholders equity divided by number of shares
Market Price Per Share
Price − to − book ratio =
Book value Per Share
Ratio Analysis
Capital Market Standing Ratios
d) Earnings Yield
It is the inverse of PE ratio. It is the investor’s return on stock based on earnings.
Earnings Per Share
Earnings Yield =
Market Price Per Share
e) Dividend Yield:
It represents the current cash return to shareholders
Dividend Per Share
Dividend Yield =
Market Price Per Share
Ratio Analysis
Capital Market Standing Ratios
f) Stock Return
Stock Returns consist of dividend and change in stock price.
Change in Stock Price over the period + Dividend for the period
Stock Return =
Beginning Stock Price
Ratio Analysis
Capital Market Standing Ratios
Ratio Analysis
Ratio Analysis
Black line: NIFTY; Red line: Midcap Index; Green line: Small-cap Index
Ratio Analysis - Note
a) Absolute results/performance doesn’t matter. It’s the ratio that gives a clear picture.
The ratios comparing this year performance with the last year performance (or) the
ratios comparing the company’s this year performance with a competitor in the
same industry
b) We can’t compare two companies from two different industries, we need to
compare two companies in the same industries. The industry standards might be
different
