Chapter 4 Analysing Financial Performance

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Chapter 4

ANALYSING FINANCIALPERFORMANCE



OUTLINE

• Financial Ratios

• Du Pont Analysis

• Standardised Financial Statements

• Applications of Financial Analysis

•

Using Financial Statement Analysis• Going Beyond the Numbers



OUTLINE

• Financial Ratios

• Comparative Analysis

• Du Pont Analysis

• Problems in Financial Statement Analysis

• Guidelines for Financial Statement Analysis



Horizon Limited: Profit and Loss Account for the YearEnding 31 st March 20X1

(Rs. in million) 20X1 20X0

Net sales 701 623Cost of goods sold 552 475Stocks 421 370Wages and salaries 68 55Other manufacturing expenses 63 50

Gross profit 149 148Operating expenses 60 49

Depreciation 30 26General administration 12 11Selling 18 12

Operating profit 89 99Non-operating surplus/deficit - 6Profit before interest and tax 89 105Interest 21 22Profit before tax 68 83Tax 34 41Profit after tax 34 42Dividends 28 27Retained earnings 6 15Per share data ( in rupees)

Earning per share 2.27 2.80Dividend per share 1.80 1.80Market price per share 21.0 20.0Book value per share 17.47 17.07



Horizon Limited: Balance Sheet as on 31 st March 20X1( Rs. in million)

20X1 20X0

I. Sources of funds1. 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 3222. Investments 15 15

(a) Long term investments 12 12

(b) Current investments 3 33. 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 81Net current assets 129 75

Total 474 412



LIQUIDITY RATIOS

• Current Ratio

Current assets 237Current liabilities 180

• Acid-Test Ratio

Quick assets (237 – 105)Current liabilities 180

• Cash Ratio

Cash and bank Currentbalances investments (10 + 3)

Current liabilities 180

= = 1.32

= = 0.73

+= = 0.07



LEVERAGE RATIOS

• Debt-equity Ratio

Debt 212= = 0.809Equity 262

• Debt-asset Ratio

Debt 212= = 0.45

Assets 474

• Interest Coverage RatioProfit before interest and tax 89

= = 4.23Interest 21



TURNOVER RATIOS

• Inventory TurnoverCost of goods sold 552Average inventory (105 + 72)/2

• Debtors’ Turnover Net credit sales 701

Average debtors (114 + 68)/2• Fixed Assets Turnover

Net sales 701Average net fixed assets (330 + 322)/2

• Total Assets TurnoverNet sales 701

Average total assets (474 + 412)/2

= = 6.24

= = 7.70

= = 2.15

= = 1.58



PROFITABILITY RATIOS

• Gross Profit Margin Ratio

Gross profit 149

Net sales 701

• Net Profit Margin Ratio

Net profit 34

Net sales 701

• Return on Assets (ROA)

Profit after tax 34


= = 0.21 or 21 percent

= = 0.049 or 4.9 percent

= = 0.077 or 7.7 percent



PROFITABILITY RATIOS

• Earning Power

Profit before interest and tax 89Average total assets (474 + 412)/2

• Return on Capital Employed

Profit before interest and tax(1 – Tax rate) 89 (1 – 0.5)


• Return on Equity Equity earnings 34

Average equity (262 + 256)/2

= 0.201 or 20.1percent



=

=

=



VALUATION RATIOSPrice-earnings Ratio

Market price per share 21.0= = 9.25

Earnings per share 2.27

YieldDividend Price change

+Initial price Initial price

Dividend yield Capital gains/losses yield1.87 1.0

= 9.35% = 5%20.0 20.0

Market Value to Book Value RatioMarket value per share 21.00

= = 1.20Book value per share 17.47



COMPARISON WITH INDUSTRY AVERAGES Ratios Formula Horizon Industry

Limited Average Liquidity

Current assets• Current ratio 1.32 1.26

Current liabilitiesQuick assets• Acid -test ratio 0.73 0.69

Current liabilities Leverage

Debt• Debt -equity ratio 0.81 1.25

EquityDebt

• Debt -ratio 0.45 0.56AssetsPBIT

• Interest coverage ratio 4.23 4.14Interest

TurnoverNet sales

• Inventory turnover 6.24 6.43Average inventory

Net credit sales• Accounts receivable turnover 7.70 7.50Average accounts receivable

Net sales• Fixed assets turnover 2.15 2.23

Average net fixed assetsNet sales

• Total assets turnover 1.58 1.26Average Total assets



Ratios Formula Horizon Industry Limited Average

ProfitabilityGross profit

• Gross profit margin ratio 21.0% 18.0%Net sales

Net profit• Net profit margin ratio 4.9% 4.0%

Net salesNet profit

• Return on assets 7.7% 6.9%Average total assets

PBIT• Earning power 20.1% 17.7%

Average total assetsPBIT (1 – T)

• Return on capital employed 10.1% 8.8%Average total assets

Equity earnings• Return on equity 13.1% 11.9%

Average net worthValuation

Market price per share• Price -earnings ratio 9.25 9.26

Earnings per shareDividend + 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 1.58Net 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



DUPONT ANALYSIS

Basic Du Pont Analysis

Net profit Net profit Net sales= xAverage 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

Equity Sales Average total assets Average equity

ROE NPM x TATR x 1/(1 – DAR)



Return onTotal Assets

7.7 %

Net ProfitMargin

4.9%

Total Assets

Turnover1.58

Net Profit34

Net Sales701

Net Sales701

AverageTotal

Assets 443

Net Sales+/- Non

operatingSurplus/Deficit

701

Total Costs

667

AverageFixed assets

326

AverageInvestments

15

Average

Net CurrentAssets 102

DU PONT CHART APPLIED TO HORIZON LIMITED

X

–

+

+



EXTENSION OF THE DU PONT CHART

Return of Equity13.1%

Return of Assets7.7%

Average Total AssetsTo Average Equity

Ratio 1.70



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 45Total 412 414 100 100

• Fixed assets 322 330 78 70• Investments 15 15 4 3• Net current assets 75 129 18 27

Total 412 474 100 100



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 256 262 100 102• Loan funds 156 212 100 136Total 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



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



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



GUIDELINES

• USE RATIO TO GET CLUES TO ASK THE RIGHTQUESTIONS

• 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



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



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 ratiosLeverage ratios

Turnover ratiosProfitability ratiosValuation 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 insightsinto the determinants of the return on equity

There are certain problems and issues in financial statement analysis that

call for care, circumspection, and judgment.

Chapter 4 Analysing Financial Performance

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