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# Management Accounting I-13

## Analysis of Financial StatementsRatio Analysis

Financial Analysis
Financial Analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the Profit & Loss Account. It can be under taken by management of the firm, or by parties outside the firm, viz. owners, Creditors, Investors and others. E.g.

Financial Analysis
Trade Creditors Suppliers of Long Term Debt Liquidity Solvency Survival & Profitability of the firm Firms Earnings Firms Present & Future Profitability Firms financial results as they influence its earnings ability & risk. Every aspect of Financial Analysis.

Investors

Management

## Nature of Ratio Analysis

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 

A tool of Financial Analysis. Indicates the relationship between two accounting figures, expressed mathematically. Index or yardstick for evaluating the financial position & performance of a firm. Summarizes the financial data to make qualitative relationship, which can be, in turn used to make a qualitative judgment.

Standards of Comparison
.Ratios calculated from the past financial statements of the same firm. 2. Ratios developed using the projected, or Performa, financial statements of the same firm. 3. Cross sectional analysis 4. Industry analysis 5. Comparison of ratios over a period of time.

Types of Ratios
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2.

3.

4.

Liquidity Ratios Firms ability to meet current obligations. Leverage Ratios Proportion of Debt & Equity in Financing the firms Assets. Activity Ratios Firms efficiency in utilizing its assets. Profitability Ratios overall Performance & Effectiveness of the Firm.

Liquidity Ratios
.Liquidity Ratios measure the ability of the firm to meet its current obligations. 2.The failure of co. to meet its current obligations due to lack of sufficient liquidity, will result in : Bad credit image  Loss of Creditors confidence  Litigations resulting in the closure of the company. 3.A very high degree of liquidity is also bad, idle assets earn nothing. 4.Most common liquidity ratios are: (i) Current Ratio (ideal 2:1) (ii) Quick Ratio (ideal 1:1)

## Formulas of Liquidity ratios

Current ratio = Current assets Current Liabilities Quick Ratio = Current assets Inventory Current Liabilities Cash Ratio = Cash + Marketable securities Current liabilities

## Current Ratio calculation of Hindustan Manufacturing Company & Interpretation

For The Hindustan Manufacturing Co., The Ratio For 1993 is: Current ratio =Rs1404.55 = 1.25, Rs 1870.92 = 1.20:1 Rs1123.57 Rs 1555.75 This ratio establishes a relation between current assets and current liablities of a firm. As a conventional rule, a current ratio of 2:1 or more is considered satisfactory. The Hindustan manufacturing company has current ratios of 1.24:1 (1991), 1.25:1(1992), 1.20:1 (1993) which are interpreted to be insufficiently liquid. But this standard should not be blindly followed firms with less than 2:1 ratio may be doing well it depends upon the components of current assets if a company's Current Assets consist of slow moving debtors and unsaleble stock, then the firms ability to pay its bills is impaired. Thus investigation about quality of current assets should be carried out. However it is a crude and a quick measure of firms liquidity.

## Quick Ratio calculation of Hindustan Manufacturing Company & Interpretation

Quick ratio,1993 = Rs 720.53 = 0.46:1 Rs 1555.75 This ratio establishes a relationship between Quick or Liquid assets and current liabilities. Thus, if the Hindustan manufacturing Cos inventories do not sell, and it has to pay all its current liabilities, it may find it difficult to meet its obligations because its quick assets are 0.46 times of Current liabilities. A quick ratio of 1:1 or more is considered to represent a satisfactory current financial condition but it should be used cautiously. A quick ratio of 1:1 or more doesn't imply sound liquidity position if its book debts and receivables are slow paying, doubtful and stretched-out-in age. Nevertheless, the quick ratio remains an important index of firms liquidity.

## Cash Ratio calculation of Hindustan Manufacturing Company & Interpretation

Cash ratio, 1993 = Rs 26.08 = 0.017 or 0.02 Rs 1555.75 Since cash is the most liquid asset, a relation ship is established between cash + marketable securities and current liabilities. Hindustan manufacturing Co is carrying a very small amount of cash in comparison to its current liabilities. But a company need not worry if it has reserve borrowing power and credit limits sanctioned by the banks.

Ratio
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2.

3.

## Current ratio Quick ratio Cash Ratio

The overall trend of major liquidity ratios of Hindustan Manufacturing Company vividly shows that on one hand its liquidity ratios are unsatisfactory and on the other hand Liquidity is deteriorating over the years. If such a condition continues for coming years as well it may lead the company into troubles like Bad credit image, Loss of Creditors confidence, Litigations resulting in the closure of the company etc.

Leverage Ratios
    (i) (ii) (iii)

To judge the long term financial position. To measure the financial risk and the firms ability of using debt for the benefit of shareholders. There should be an appropriate mix of debt and owners equity in financing the firms assets. Most important leverage ratios are: Total debt ratio Debt Equity Ratio (ideal 2:1, lower this ratio better it is) Interest coverage ratio

## Formulas of Leverage Ratios

Total Debt Ratio = Total Debt Capital employed or Total Debt + Net worth Where, capital employed is Net assets (FA + CA CL) Debt-Equity Ratio = Total Debt Net Worth Interest Coverage ratio = EBIT Interest

## Total Debt Ratio calculation of Hindustan Manufacturing Company & Interpretation

Total debt Ratio,1993 = TD = Rs 1229.6 = 0.646 CE Rs 1901.87 For Hindustan manufacturing co. the debt ratio of 0.646 means that lenders have financed 64.6 % or about two thirds of Hindustan's net assets (Capital employed). It obviously implies that owner's have provided the remaining finances. They have financed (1- 0.646 = 0.354 or 35.4 % or about one third of net assets.

## Debt-Equity Ratio calculation of Hindustan Manufacturing Company & Interpretation

Debt-EquityRatio1993=TD = Rs 1229.06 = 1.83 NW Rs 672.81 This ratio describes the lenders contribution for each rupee of the owners contribution. It is clear in case of Hindustan, lenders have contributed more funds than owners; lenders contribution is 1.83 times of owners contribution, (0.646 / 0.354 = 1.83)

## Hindustan Manufacturing Company: Leverage ratios

1991 Total Debt to 0.56 capita Employed Debt Equity 0.28 1992 0.63 1.72 1993 0.65 1.83

The co seems to depend more on outsiders funds to finance its expanding activities. As much as of the cos funds are financed by outsiders money: the stake of the owners is quite low in the total capital employed by the firm. From creditors point of view, the trend is risky and undesirable.

## Interest Coverage Ratio calculation of Hindustan Manufacturing Company & Interpretation

Interest coverage1993 = Rs 342.61 = 2.4 times Rs 143.46 The interest coverage shows the no of times the interest charges are covered by the funds that are ordinarily available for their payment. The earnings available to Hindustan to meet its interest obligation are 2.4 times its interest charges which shows a good margin of safety for lenders.

Activity Ratios
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##  (i) (ii) (iii)

These are employed to evaluate the efficiency with which the firm manages and utilizes its assets. They indicate the speed with which assets are being converted or turned over into sales, hence also called Turnover Ratios. Important Activity ratios are: Inventory Turnover Ratio (efficiency in selling) Debtors Turnover Ratio ( efficiency in converting the debtors into cash) Assets Turnover Ratio (ability of assets to generate sales)

## Inventory Turnover Ratio calculation of Hindustan Manufacturing Company & Interpretation

Inventory Turnover Ratios = Cost of goods sold Average inventory If the figure of COGS is not available then sales/Inventory can be used. ITR for Hindustan, 1993 = Rs 3053.66 (Rs 244.26 + Rs 461.81)/2 = Rs 3053.66 = 8.6 times Rs 353.03 Days of Inventory holding (DIH) =360 / Inventory Turnover = 360/8.6 = 42 days. Hindustan is turning its inventory of finished goods into sales (at cost) 8.6 times in a year. In other words, it holds average inventory for 42 days. Note: in a manufacturing co inventory of finished goods is used to calculate inventory turnover.

## Inventory Turnover Ratio calculation of Hindustan Manufacturing Company & Interpretation

1991 Inventory turnover ratio Days of Inventory holding 12.9 1992 11.9 1993 8.6

28

30

42

It is clear that Hindustan manufacturing companys efficiency in turning its inventories is continuously deteriorating and the yearly holding of all types of inventories is increasing.

## Debtors Turnover Ratio calculation of Hindustan Manufacturing Company & Interpretation

Debtors Turnover Ratio = Credit sales Average Debtors If the figure of credit sales and op & cl Debtors are not given then DTR = Sales Debtors For Hindustan DTR, 1993 = Rs 3717.23 = 7.7 times Rs 483.18 Average Collection Period (ACP) = 360/DTR = 360/7.7 = 47 days Hindustan is able to turnover its debtors 7.7 times in a year. In other words, its book debts remain outstanding for 47 days. The ACP measures the quality of debtors since it indicates the rapidity or slowness of their collectablity. The shorter this period the better the quality of debtors.

## Asset Turnover Ratio calculation of Hindustan Manufacturing Company & Interpretation

Net Asset Turnover Ratio = Sales Net Assets For Hindustan 1993 = Rs 3717.23 = 1.95 times Rs 1901.87 A firms ability to produce a large volume of sales for a given amount of net assets is the most important aspect of its operating performance. Since net assets equal capital employed, net assets turnover may also be called Capital Employed Turnover. The net assets ratio of 1.95 times indicates that Hindustan is producing Rs 1.95 of sales for one rupee of capital employed. There can also be Total asset Turnover ratio, FAT, CAT,NCAT ratios as well.

Debtors Turnover Ratio calculation of Hindustan Manufacturing Company & Interpretation 1991 Debtors Turnover (times) Average Collection Period Asset Turnover ratio 9.2 1992 8.3 1993 7.7

39

43

47

2.03

1.78

1.95

Hindustans ACP has been increasing; it has increased from 39 days in 1991 to 47 days in 1993. this may be due to change in the economic conditions and/or laxity in managing receivables. Hindustans asset turnover ratio over three years also do not any improvement.

Profitability Ratios
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(i) (ii)

The profitability ratios are calculated to measure the operating efficiency of the company, creditors & Owners are also interested in Profitability of the firm. Generally, two Major Types of profitability ratios are calculated: Profitability in relation to Sales. Profitability in relation to Investment.

## Formulas of Profitability ratios in relation to sales

Gross Profit margin = Gross profit sales For Hindustan 1993 = Rs 663.57 = 0.179 or 17.9% Rs 3717.23 The gross profit margin reflects the efficiency with which mgmt. produces each unit of product. This ratio indicates the avg. spread between COGS and sales revenue.  Net Profit Margin = Profit After Tax Sales For Hindustan 1993 = Rs 134.86 = 0.036 or 3.6% Rs 3717.23 Net profit margin ratio establishes a relation ship between net profit and sales and indicates managements efficiency in manufacturing, administering and selling the products. This ratio is the overall measure of the firms ability to turn each rupee sales into net profit.  High gross profit & Net Profit margin is a sign of good management and reduces the risk of firm from falling prices rising costs, declining demand and helps the firm to withstand adversities
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Return on Investment (ROI)  Return on Total Assets ROTA = EBIT Total assets For Hindustan 1993 = Rs 342.61 = 0.131 or 13.1% Rs 2617.75  Return on Net Assets RONA = EBIT Net Assets For Hindustan 1993 = Rs 342.61 = .180 or 18.0% Rs 1901.87 Return On Shareholder's equity ROE =Profit After Taxes Net Worth Where NW, (SC + SP + Reserves & surpluses Accumulated Losses if any) For Hindustan 1993 = Rs 134.86 = .20 or 20% Rs 672.81 ROE indicates how well the firm has used the resources of owners. It is of great interest to the present and prospective shareholders and also of great concern to management, which has the responsibility of maximizing the owners welfare.

## Hindustan manufacturing Company : Profitability ratios

1991 Gross margin Net Margin ROTA RONA ROE .175 .036 .131 .161 .164 1992 .178 .039 .129 .168 .191 1993 .179 .036 .131 .180 .200

The sales as well as the investment related ratios of the co. have remained more or less constant. ROE has shown an increase. This is perhaps because of employment of more debt over the years by the company.

## Formulas of Profitability ratios in relation to Investment

Earnings Per share = Profit after tax No of Common shares Outstanding For Hindustan 1993 = Rs 134.86 = Rs 6.00 22.50 (it indicates whether or not the firms earnings power on per share basis has changed over that period . It simply shows the Profitability of the firm on Per share basis. The companys EPS for 1993 is Rs 6.00) Dividend Per share = Earnings Paid to shareholders No of Common shares Outstanding

## Formulas of Profitability ratios in relation to Investment

For Hindustan 1993 = Rs 45.00 = Rs 2.00 Rs 22.50 (Though the PAT belongs to shareholders but the income they really receive is the amount of earnings distributed as cash dividends. Therefore a large no of present and potential investors may be interested in DPS than EPS. The company distributed Rs 2.00 per share as dividend out of Rs 6.00 earned per share. The difference per share is retained in the business) Dividend Payout Ratio = DPS EPS For Hindustan 1993 = Rs 2.00 = 0.333 or 33.3% Rs 6.00 (earnings not distribute to shareholders are retained in the business. Thus retention ratio is 1 payout ratio = 1 0.333 = .667. we can also know the growth in shareholders equity as a result of retention policy. ) For Hindustan growth in Equity1993 = Retention ratio X ROE = .667 X .20 = .113 or 13.3%)

## Formulas of Profitability ratios in relation to Investment

Dividend Yield = DPS MVPS For Hindustan 1993 = RS 2.00 = 0.068 or 6.8% Rs 29.25 Earnings Yield = EPS MVPS For Hindustan 1993 = Rs 6.00 = 0.205 or 20.5% Rs 29.25 The Dividend Yield and earnings yield evaluate the shareholder's return in relation to the market value of the share.

## Formulas of Profitability ratios in relation to Investment

Price Earning Ratio (P/E) = Market value per share (MVPS) Earning Per Share (EPS) For Hindustan 1993 = Rs 29.25 = 4.88 times Rs 6.00 (P/E ratio reflects the investors expectations about the growth of the firms earnings management is also interested in this market appraisal of the firms performance and will like to find the causes if the P/E ratio declines) Market Value- to-Book-Value (MV/BV) Ratio = MVPS BVPS (NW/ No of Shares) For Hindustan 1993 = Rs 29.25 = 0.98 Rs 29.90 (Hindustans MV/BV ratio of 0.98 means that the company is worth 2 % less than the funds which shareholders have put into it)

## Formulas of Profitability ratios in relation to Investment

EPS DPS DP Earnings Yield Dividend Yield P/E 1.16 MV/BV 1.33 .98 1991 3.72 1.50 .40 .141 .057 7.09 1992 4.94 1.75 .35 .143 .051 7.00 1993 5.99 2.00 .33 .205 .068 4.88

## Formulas of Profitability ratios in relation to Investment & Interpretation

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It is indicated that the Co.s EPS and DPS are increasing; but the proportionate increase in DPS is Less Than That In EPS and Therefore, DP is declining EPS may be increasing more as a result of increased use of Debt Because of the increase in The financial risk the MP of Share may come down as a result there is Decline in P/E MV/BV. Thus in relation to market performance co is showing Deterioration.