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DEVELPOMENT DAY PROJECT REPOR T

FINANCIAL STATEMENT ANALYSIS

SUBMITTED TO SUBMITTED BY:

Prof. Harpreet Singh Suman pathria(213)
Neeraj
hotwani(134)
 ACKNOWLEDGEMENT

We present this project report on “FINANCIAL STATEMENT ANALYSIS”

with a sense of great pleasure and satisfaction. We undersign with pleasure to
take this opportunity to thank all those related directly or indirectly in
preparation of this project report.

We express our sincere thanks to Prof. Harpreet singh

Date: 14/09/2010
Place: NEW DELHI
 Business survival
There are two key factors for business survival:

• Profitability

• Solvency

• Profitability is important if the business is to generate revenue (income)

in excess of the expenses incurred in operating that business.

• The solvency of a business is important because it looks at the ability of

the business in meeting its financial obligations.

NEED OF FINANCIAL ANALYSIS:

Lenders’ need it for carrying out the following
 • Technical Appraisal

• Commercial Appraisal

• Financial Appraisal

• Economic Appraisal

• Management Appraisal

FINANCIAL STATEMENT ANALYSIS

Financial Statement Analysis will help business owners and other interested
people to analyse the data in financial statements to provide them with better
information about such key factors for decision making and ultimate business
survival.

Purpose:
 • To use financial statements to evaluate an organisation’s

– Financial performance

– Financial position.

• To have a means of comparative analysis across time in terms of:

– Intracompany basis (within the company itself)

– Intercompany basis (between companies)

– Industry Averages (against that particular industry’s averages)

• To apply analytical tools and techniques to financial statements to

obtain useful information to aid decision making.

Financial statement analysis involves analysing the information

provided in the financial statements to:
-Provide information about the organisation’s:

• Past performance

• Present condition

• Future performance

-Assess the organisation’s:

• Earnings in terms of power, persistence, quality and growth

• Solvency
Effective Financial Statement Analysis
• To perform an effective financial statement analysis, you need to be
aware of the organisation’s:

– business strategy

– objectives

– annual report and other documents like articles about the

organisation in newspapers and business reviews.

These are called individual organisational factors.

Requires that you:
• Understand the nature of the industry in which the organisation works.
This is an industry factor.

• Understand that the overall state of the economy may also have an
impact on the performance of the organisation.

• Financial statement analysis is more than just “crunching numbers”; it

involves obtaining a broader picture of the organisation in order to
evaluate appropriately how that organisation is performing

Tools of Financial Statement Analysis:

The commonly used tools for financial statement analysis are:

• Financial Ratio Analysis

• Comparative financial statements analysis:

– Horizontal analysis/Trend analysis

– Vertical analysis/Common size analysis/ Component Percentages

Financial Ratio Analysis
• Financial ratio analysis involves calculating and analysing ratios that
use data from one, two or more financial statements.

• Ratio analysis also expresses relationships between different financial

statements.

• Financial Ratios can be classified into 5 main categories:

– Profitability Ratios

– Liquidity or Short-Term Solvency ratios

 – Asset Management or Activity Ratios

– Financial Structure or Capitalisation Ratios

– Market Test Ratios

Profitability Ratios3 elements of the profitability

analysis:
• Analysing on sales and trading margin

– focus on gross profit

• Analysing on the control of expenses

– focus on net profit

 • Assessing the return on assets and return on equity

Profitability Ratios

• Gross Profit % = Gross Profit * 100

Net Sales

• Net Profit % = Net Profit after tax * 100

Net Sales

Or in some cases, firms use the net profit before tax figure. Firms have
no control over tax expense as they would have over other expenses.

⇒ Net Profit % = Net Profit before tax *100

Net Sales

• Return on Assets = Net Profit * 100

Average Total Assets

• Return on Equity = Net Profit *100

Average Total Equity

Liquidity or Short-Term Solvency ratios

Short-term funds management

• Working capital management is important as it signals the firm’s ability

to meet short term debt obligations.
For example: Current ratio

• The ideal benchmark for the current ratio is $2:$1 where there are two
dollars of current assets (CA) to cover $1 of current liabilities (CL). The
acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents
liquidity riskiness as there is insufficient current assets to cover $1 of
current liabilities.

Liquidity or Short-Term Solvency ratios

• Working Capital = Current assets – Current Liabilities

• Current Ratio = Current Assets

Current Liabilities

• Quick Ratio = Current Assets – Inventory – Prepayments

Current Liabilities – Bank Overdraft

Asset Management or Activity Ratios

• Efficiency of asset usage

– How well assets are used to generate revenues (income) will

impact on the overall profitability of the business.
For example: Asset Turnover

• This ratio represents the efficiency of asset usage to generate sales

revenue.

Asset Management or Activity Ratios

• Asset Turnover = Net Sales

Average Total Assets

• Inventory Turnover = Cost of Goods Sold

Average Ending Inventory

• Average Collection Period = Average accounts Receivable

Average daily net credit sales*

* Average daily net credit sales = net credit sales / 365

Financial Structure or Capitalisation Ratios

Long term funds management

 • Measures the riskiness of business in terms of debt gearing.

For example: Debt/Equity

• This ratio measures the relationship between debt and equity. A ratio of
1 indicates that debt and equity funding are equal (i.e. there is $1 of debt
to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt
gearing in the business (i.e. there is $1.5 of debt to $1 of equity). This
higher debt gearing is usually interpreted as bringing in more financial
risk for the business particularly if the business has profitability or cash
flow problems.

• Debt/Equity ratio = Debt / Equity

• Debt/Total Assets ratio = Debt *100

Total Assets

• Equity ratio = Equity *100

Total Assets

• Times Interest Earned = Earnings before Interest and Tax

Interest

Market Test Ratios

 • Based on the share market's perception of the company.

For example: Price/Earnings ratio

• The higher the ratio, the higher the perceived quality of the earnings by
the share market.

RATIOS:

• Earnings per share = Net Profit after tax

Number of issued ordinary shares

• Dividends per share = Dividends

Number of issued ordinary shares

• Dividend payout ratio = Dividends per share *100

Earnings per share

• Price Earnings ratio = Market price per share

Earnings per share

Horizontal analysis/Trend analysis

 • Trend percentage

• Line-by-line item analysis

• Items are expressed as a percentage of a base year

• This is a time series analysis

• For example, a line item could look at increase in sales turnover over a
period of 5 years to identify what the growth in sales is over this period.

Vertical analysis/Common size analysis/ Component Percentages

Vertical analysis/Common size analysis/ Component

Percentages
• All items are expressed as a percentage of a common base item within a
financial statement

• e.g. Financial Performance – sales is the base

• e.g. Financial Position – total assets is the base

• Important analysis for comparative purposes

– Over time and

– For different sized enterprises

Limitations of Financial Statement Analysis
• We must be careful with financial statement analysis.

– Strong financial statement analysis does not necessarily mean that

the organisation has a strong financial future.

– Financial statement analysis might look good but there may be

other factors that can cause an organisation to collapse.

Illustration: Financial statement analysis

• The following financial statements of Walker Ltd were prepared in

accordance with New Zealand GAAPs. Walker Ltd is a diversified
enterprise with its main interests in the manufacture and retail of plastic
products.

• The financial statements of Walker Ltd need to be analysed. An investor

is considering purchasing shares in the company. Relevant ratios need
to be selected and calculated and a report needs to be written for the
investor. The report should evaluate the company’s performance and
position
Walker Ltd
Statement of Financial Position as at 31 March

Current
Bank
Account
Inventor
Walker Ltd
Statement of Financial Performance for year ended
31 March
Walker LtdStatement of Cash Flows for the year
ended 31 March

Cash flow from

Additional information:
• Credit purchases for the year 2006 were $2,142,800.

• General prospects for the major industries in which Walker is involved

look good with a forecast glut of oil set to reduce the cost of production
and world demand for plastic remaining strong.

Benchmarks:

• There are no exact benchmarks for Walker Ltd because it is a diversified

company. The following are average indicators that relate to the plastic
retailing and manufacturing industries for the year 2006.

– Gross profit margin 25%

– Net profit margin 7%

– Inventory turnover 6 times

– Debt/equity ratio 0.6 : 1

– Return on Assets 12%

– Return on Equity 20%

 Asset Benchmarks 2005 2006
Management
• ratios:
Profitability Benchmarks 2005 2006
ratios:
Inventory Industry 5.8 times 5.58 times
Turnover 6%
• Gross Profit Industry 22% 22.7%
Margin
Asset Turnover Not25%
given 2.2 2.53

• Net Profit Industry 7.1% 6.1%

Margin 7%

• Return on 12% 15.6% 15.5%

Assets
• Return on Industry 32% 26%
Equity 20%
Relevant ratios
Liquidity Benchmarks 2005 2006
ratios:

Current Ideal standard 2:1 1.78:1 1.70:1

Ratio Acceptable standard
1:1

Quick Ratio Ideal standard 2:1 0.85:1 0.69:1

Acceptable standard
1:1
Days Standard Credit 49.19
Payable 30 days purchases not days
available

Financial Benchmarks 2005 2006

Structure ratios:

Debt/Equity Industry 1.05: 1 0.67:1

0.6:1
Standard benchmark
1:1
 TIE Standard benchmark: 10.14 times 39.74 times
Between 3 and 5.
Below 3 risky. Above 5
very favourable

REPORT

• For the investor considering the purchase of shares in the company, the
return they will earn is the key financial factor but an overall evaluation
of the company’s performance and position is also important to get a
better picture of how well the company is actually doing.

• ROE in 2006 is 26%. Whether or not this is attractive depends on the

perceived riskiness of this investment and other alternatives available
 but this return is certainly more attractive than current bank interest
rates.

• ROE has decreased by 4% but the company’s ROE at 26% is still better
than the industry average of 20%

• Riskiness of business is being reduced by the significant repayment of

loan in 2006.

Profitability
– The NP% and ROA ratios show a small downward trend in %
over the 2 year period. ROE% ratio show a more significant
decrease but is still better than the industry average.

– Gross Profit Margin is slightly unfavourable at about 2.3% below

the industry benchmark of 25%.

– The horizontal analysis information show that Sales have

increased by 20%. However operating costs have increased by
34%.

Asset Management
– IT has gone down slightly from 5.8 to 5.58 times.

– IT is still close to the industry benchmark of 6 times.

– AT has increased showing more sales being generated from asset

usage

LIQUIDITY
-Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels but
below ideal level.

-Quick ratios appear more of a concern being below acceptable levels in both
years and even more so in 2006 (0.69:1).
-Raises some concerns over the liquidity of the business and inventory
management (although IT ratio only shows a slight decline in 2006).

-Days Payable is a concern as there may be poor debt payment management.

FINANCIAL STRUCTURE
-Although slightly higher than D/E industry benchmark (0.67:1), business has
become less risky due to the significant repayment of loan in 2006.

-TIE is extremely good for the business at 39.74 times (well above 5 the
standard benchmark).

Cash flow situation

-Strong cash flow from operating activities (increased from 160,600 to
185,000).

-Spending under investing activities suggest more growth.

-Repayment of debt under financing activities imply restructuring of business

to have more equity funding rather than debt funding.

Recommendation
Given:

1) the strong forecast for the industry (ie general prospects looking good
and world demand for plastic products remaining strong),

2) the sales growth in this business,

3) acceptable ratios as they are quite close to the industry averages,

4) good cash flows from operating activities and

5) favourable ROE, although it has decreased, it is still better than the

industry average ROE.

=> it is recommended that the investor purchase shares in the Walker Ltd
company.