ANALYSIS OF FINANCIAL STATEMENT - BASICS OF ANALYSIS
Various techniques are used for analysis of financial statements. Comparative and relative status of each item, in the financial statements, is worked out to evaluate financial performance of a company. For example, cost of filter used may have increased by four-times from Rs.30,000 in 2006 to Rs.150,000 in 2007. This looks staggering but it was only 0.1% and 0.2% respectively of the total production costs and need not be investigated.
Analytical techniques would help the analyst to identify items which have not only shown unusual increases but were instrumental in the visible changes due to their high magnitude. In this way, one can concentrate on major items which have affected the sales or profitability or working capital position of an entity.
The analytical techniques include common-size ratios, profitability ratios, liquidity ratios, turnover ratios and solvency ratios. These ratios are compared with industrial ratios and economic ratios to determine whether the changes were caused by internal factors or external factors. If internal, was it in-efficiency or dishonesty? With a few calculations, an experienced analyst can spot gray areas to be further investigated to establish a cause and effect relationship. Someone has rightly said that ratios do not provide absolute answers but suggest questions that need to be answered.
What is a ratio?
A ratio is one thing expressed in term another related thing. It could be in form of a percentage like 12% gross profit margin, a rate such as commission @ Rs.5 per kg, an average e.g. Rs.12 per unit or a relationship as a current ratio of 1.2:1.
An appropriate ratio reduces complex data into meaningful and simple indicators. This, in turn, reduces reliance on pure hunches, guesses, and intuition. Also, it reduces and narrows down the inevitable areas of uncertainty associated with decision making process.
Inter-connection of ratios
RATIOS OF DIFFERENT INDUSTRIES
Comparison of two companies
Characteristics of the ratios:
- Have little, if any, absolute significance
- All ratios are inter-connected
- Their interpretation depends on the view-point of different users.
- Ratios differ from industry to industry.
- Even in the same industry, ratio would difference from company to company but the difference would not be as large as in industry to industry.
- Ratios are based on past data.
- Ratios do not provide absolute answer but suggest questions that need to be answered.
- There are many factors which influence the ratios:
- a) Economic conditions
b) Climatic conditions
c) Government policies
d) Industrial group
e) Unusual troubles
As ratios differ from industry to industry, an analyst must have a sound knowledge about the operations of an industry to which the company under study belongs to. There are many industries which have either seasonal production or seasonal sales or both. The ratios would be accordingly affected as explained below:
- Seasonal Production but year round sales – sugar mills, fruit-processing plants and ginning factory work in a certain season lasting for 5-6 months. Obviously, their finished goods inventories would be high compared to other industries operating and selling in the year round. The would increase the ratio - days production in stock.
- Year round Production but seasonal sales – footwear, woolen fabrics, air-conditioning unit and deep-freezers have a large receivable as they manufacture the goods and pass it on to retailers on credit. In the season, the retailers would sell the goods and settle the account. The average collection period and defaults as percentage of sale would be unusually high.
TOOLS & TECHNIQUES OF FINANCIAL ANALYSIS
The first and foremost job is prepare comparative statements for the past three to five years. This job is quite skillful as the companies normally do not maintain consistency in presentation of the account data and resort to window dressing.
In order to have a clue of the major reason for any increase or decrease in sales or profitability, use of trends and structure is a good starting point. Later, depending of the finding, an analyst can calculate pertinent ratios keeping view-point of the user. A banker would be interested not only in high magnitude of current assets but also their liquidity potentials. An owner would, on the other hand, be keen to know return on equity, dividend payout and earning per share. A manager would, however, be anxious to find out turnover and cashflow ratios.
Horizontal Analysis of Packages Ltd for the past years is given in the side table. It shown an abrupt increase in 2006 in non-current assets and non-current liabilities. A study the 2006 accounts shows the reasons behind this:
- Non-current assets increased due to massive investment (about Rs.5 billion) in share specially Nestle Pak Ltd,
- The increase in non-current liabilities reflected 6 billion loan from a consortium of commercial bank for financing of expansion project.
Since both these factors augur well for future of the company, the analyst would feel comfortable. This is further strengthened by the fact that company has well maintained a financial discipline: its currents assets have been much more than current liabilities, its long term liabilities were well secured by mortgages on the fixed assets and it debt equity has always been very sound.
For a sound analysis, an analyst must study the time-frame and background of the industry. What were the economic conditions and how these affected the particular industry? Thereafter, the analyst should obtain three to five years annual accounts and note what changes have been reported in the case of directors, auditors, bankers, key-personnel and valuation policies. If there are frequrent changes in anyone item, one should try to findout whether these changes were for the better or worse. Also, the footnote should studied for finding out magnitude or contingent liabilities. The analyst should construct a worst scenario to see if the company would remain solvent if all the contingent liabilites are to be met.
Having satisfied himself or herself with credibility of the accounts, he or she should proceed ahead keeping in mind viewpoint of the users. With use of appropriate ratios, a report should be prepared and submitted to the management. It must not be in clash with independent parameters like stock-exchange quotations, government polices and credit-rating of the concerned company.
PREVIOUS HUB: Income Statement
More by this Author
This is in continuation of a hub: Case Study: PERT/CPM – calculating floats. Some terms used in the said hub would be repeated for a complete understanding of the concepts and techniques. A float is a slack or...
Profit is the yard-stick for evaluating performance of any business concern. Since ultimate profit depends upon plan and control, cost accounting plays a vital role. Previously, cost accounting was mostly engaged in...
This is in continuation of my previous Case Study on CPM & PERT. Here I would describe ways and means to calculate Floats or Slacks. A little change has been made in Sketch # 3 in the previous article. Description...