Analysis of Financial Statements
N. Gopal
Deputy General Manager,
RBI CAB Pune
Structure of the Presentation
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What are Financial Statements
Why Analyze them
What do we see in them
How do we analyze them
What do we get to know
Cash Flow
Funds Flow
Definition of Financial Statements
• Financial Statements present a periodical view or
reports on the progress by the Management. They
present the status of investments in business as
also the results achieved during a period.
• They are a combination of recorded facts,
accounting conventions and personal
judgments.
American
Institute of Public Accounts
Features of Financial Statements
i. Periodical review of the status of investment and
progress made by the Management
ii. Facts recorded on the basis of accounting
conventions and exercise of personal judgments.
iii. Integrity and competence of accountants who
prepare them have a vital bearing on the ultimate
results furnished
iv. Reliability, authenticity of the analysis would be
just as much as that the of Financial Statements
themselves.
Weakness of Financial Statements
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Lack of objectivity
Influenced by the subjective exercise of judgments
Reliance on the intentions of the recorder
Requires an external independent agency to
certify its “true and fair view”
• Non financial assets do not get recorded or
reflected in financial statements
Who analyzes them and why
1. Investors or provider of funds:
– Whether the enterprise would be profitable- focus on
returns or dividends- Profitability
2. Creditors:
– Whether he would get his money back- repayment ability,
interest servicing ability- Liquidity – Safety of funds lent,
viability
3. Banker:
– Safety of Funds lent, Yield, End-use of funds, viability
4. The enterprise itself:
– Whether it would repay the external debts as well as carry
on operations
– Service the paid-up-share capital- good or comparable yield
– Leave surplus to meet its growth needs
Typical Balance sheet
Sources of Funds (Liabilities)
Uses of Funds (Assets)
Share holders’ Funds (Paid-upCapital and Reserves) ………1
Factory, Land and Building Plant
and Machinery ……..4
Term Liabilities (Debentures,
Investments, Expansion of assets
Bonds, long term borrowing from ……5
term lenders) ……2
Bank loans, Trade creditors and
other liabilities …….3
Operating assets (cash, inventory,
debtors receivables etc) …….6
Summary: Analysis of the financial Statement indicates and involves
1. Checking the investment (or deployment) of funds decision by the
enterprise
2. Verifying the financing (funding) pattern proposed/in use by the
enterprise
3. Examining the operating efficiency
Banker and his interest in Financial Statement
• Analysis of Financial Statement constitutes “back-bone
of “good lending”
 Parameters taken must satisfy the criteria of “good lending”
• What is “Good Lending” ? – Lending that takes care of
the interest of the depositors or keeps depositors
interest in mind.
• Depositors interest ? (SLY)
• Safety
• Interest (Yield)
• Ease or availability when needed (Liquidity)
Analyses of Financial Statements should provide answers to the
above questions. To instill confidence in depositors banker is
also interested in knowing the “Purpose”
What is seen in a balance sheet
1. Judicious investment of funds provided by owners and
creditors
 Creation of useful assets
2. Do the assets by use yield sufficient returns to the
providers after meeting all expenses and charges
 Assets capable of generating income
3. Whether there is surplus left to enable future growth and
meet future claims on the enterprise.
 Ability to generate surplus for future growth
Limitations of a Balance sheet
1. “Snap Shot of a Moving Train”
2. Static Statement of balances on a given date
3. Inexactness owing to personal bias or judgment –
valuation of assets, provisions etc
4. Only the rupee or monetary value of all assets and
liabilities reflected – no scope for factoring in “inflation”just historical costs
5. Exclusion of non-monetary but critical assets (human
resources, strategic position, monopoly etc)
6. Dated- Open to Window Dressing
7. Does not give insight into process or movement of funds
Overcoming the shortcomings
• Examine a series of balance sheets or examine balance
sheets of three to five years
• Do not read balance sheet on ABSOLUTE terms but
RELATIVE terms
• Analyze the profit and loss account
• Analyze Ratios
• Analyze the Funds flow statement with the balance
sheet
• Analyze the cash flow statement with the balance sheet
• Read the Auditors notes along with the figures in the
Balance sheet
Analyzing Ratios- Return on Capital Employed
• Profit before Depreciation
and Taxes / Total Capital
Employed
PBIT/Total Assets x100
• High Ratio indicates that
business is Profitable
• Indicates the Earning
power of business
• Measure of the
Management’s skill in
deploying or investing
funds of the company
• Reasonable or comparable
returns – indication of
continuation of business
Operating profit ratio
• Operating Profits/Net
Sales x 100
• Indicates operating
efficiency
• Can be used to compare
similar industries
• Gives trend of
performance over several
periods
Expenses ratio
Expenditure x 100
Sales
Net Profit after Tax x 100
Tangible Networth
• Indicates Efficiency
• As years go by Sales
should increase without
much increase in the
Expenditure
• Indicates profit earning
capacity
• High ratio means Owners
funds have been invested
profitably
Liquidity Ratio
Current Ratio
Current Assets x 100
Current Liab.
(Quick Ratio or Acid test
Ratio)
C.A- Inventory x100
C.L-Bank borrowings
• Whether current assets
are enough to cover
current liabilities
• Higher ratio could be bad
or good
• Lower ratio not
necessarily bad
• Whether current liabilities
are funding current assets
Solvency Ratio
Total Outside Liabilities
Tangible Networth
Total term liabilities
Tangible Networth
or
Debt
Equity
• Indicates Solvency
• Indicates size of owners
stake
• Indicates stake of
creditors
• Indicates the coverage of
liabilities by the net-worth
• Lower ratio indicates
greater solvency
Other Ratios
Retained Earnings x 100
Net Profit after tax
• Indicates the plough back
of profits into business
• Higher ratio indicates
prudence
Dividend x 100
Net Profit
• High ratio indicates large
distribution of profits and
lesser plough back
Turnover Ratio
Annual Sales x 100
Closing Stock
• High ratio indicates good
turnover of stock
• Efficient management of
sales
• Low ratio indicator of
large unsold stock
Turnover Ratios cont….
Trade Creditors x 100
Average monthly
Credit Purchases
• Indicates the number of
months credit received by
the company
• High ratio means that the
creditors are willing to
give more than normal
credit
• High ratio could also
indicate that the company
unable to service
creditors on time
• High ratio could be a
warning signal
Turnover Ratios cont….
Sundry debtors x 100
Average monthly
Credit Sales
• Indicates the number of
months credit given by
the company
• High ratio means that
the easy credit terms
given by the company
• High ratio could also
indicate that the
company unable to
collect on time
• High ratio could be a
warning signal
Turnover Ratios cont….
Raw Material stock x 100
Average monthly
Consumption
• High ratio indicates
accumulated raw
materials, slow
production process,
unusable materials,
indiscreet buying and
stocking, seasonal
nature of raw materials
• Trend over a period of
time say 1 or 2 years to
be seen to come to a
conclusion
Turnover Ratios cont….
Stock-in-process x 100
Average monthly Cost of
production
• High ratio indicates
delayed process of
manufacturing
• High ratio also indicates
complicated and time
consuming process
Turnover Ratios cont….
Finished Goods stock x 100
Average monthly
Cost of sales
• High ratio indicates
unsalable items
accumulating
• High ratio could also
mean over produced
and stocked
• High ratio also means no
demand for the finished
goods.
Profitability ratios
Net Profit after tax x 100
Total number of shares
• Indicates the return
available to
shareholders
• Dividend paying
capacity of the company
Profitability ratios
Net Profit after tax x 100
Total Dividend Paid
• Indicates dividend paid
to the shareholders
• Dividend payout ratio
• Conversely the extent of
retained earnings
Ratios for Working Capital
• Current Ratio
• Solvency Ratio
• Interest Coverage Ratio
• Profit to Sales Ratio
• Return on Capital Employed or Return on Assets
• Turnover ratio (Inventory + Receivables)/Net Sales
Some ratios explained
• PBIT/Interest (Times)
– Interest coverage ratio, explains how many times the
firm earns to cover the interest payable by
– Higher ratio means comfortable debt servicing capacity
from cash accruals
– A ratio of 3 or 4 is very comfortable.
– A ratio of 2 could be risky
• (Inventory + Receivables) / Net Sales
– Expressed in days ratio captures turnover time for major
current assets
– Higher ratio indicates slower turn over and higher risk
Ratios for Term loans
• Project Debt to Equity Ratio
• TOL/TNW
• Gross Average Debt Service Coverage Ratio (Project)
• Gross Average Debt Service Coverage Ratio (Company)
Some Ratios Explained
• Project Debt/Equity
– The debt raised for the project vis-à-vis the equity
– High leverage will be riskier if the environment were to turn
adverse
– Ratio indicates viability of the project under implementation
• Gross Average DSCR (Project)
PAT + Dep + non Cash expenses + interest on term
loan for project
Annual term loan installment + Interest on term loan
– The cash accruals for the entire period of project to be taken
and divided by the repayment obligation for the entire period
Cash Flow Statement
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What is it ?
What it tries to state
How does one prepare it
What are its limitations
CASH FLOW
What is Cash Flow Statement
• Where from is cash generated in a business?
• Do operating and regular activities of a business
result in cash movement – in and out ?
• Does cash movement arise from financing activities
as well ?
• Does investment activity result in cash movement ?
• Cash is an important component in business and
economic activity
• A business entity needs cash to pay wages, procure
materials, pay interest, dividends, pay for utility
services
“Cash is to business as blood is to human body”
What is cash
• A business may be earning profits or it may be
profitable but it may not have cash to pay dividends !!!!
• What message such a situation convey to the
Stakeholders?
• Improper cash management would result in the above
situation
• Cash Means: i. Cash in hand, ii. Demand deposits
with the bank and iii. Cash Equivalents
• Cash Equivalents Mean: Near Cash assets, such as
Overdrafts, Cash Credits, Short term deposits and
highly liquid and marketable securities
Cash Flow Statement
• A Statement which depicts the flow of cash in an
organization- also includes cash equivalents.
• The statements shows
1. How cash flows into and out of the organization
2. Ability of the organization to generate and utilize cash
3. Summary of receipts and disbursements of cash in an
organization for a particular period of time
4. Gives reasons for change in cash position of an
organization.
Objective of Cash Flow Statement
1. Highlight the cash generated from various activities a
firm undertakes
2. Helps in planning replacements of fixed assets,
repayment of debt
3. Helps in Investment decisions
4. Indicate and evaluate the Liquidity of an enterprise
5. Acts as a cash management tool
6. Helps an organization understand the dynamics of cash
movements
How does cash flow arise
1. Operating Activities : Principal revenue generating
activities of an organization such as sales, purchases,
meeting expenses etc. (cash from operations)
2. Investing Activities: Activities involving acquisition
and disposal of long term or capital assets– also
includes non cash equivalents of investments (long
term investments) ( cash from investments)
3. Financing Activities: Activities that result in change
in size and composition of owners’ equity and long
term borrowings. (cash from financing)
To understand and arrive at the cash flow one has to
look into 3 different areas of activities
CASH IN OPERATING ACTIVITIES
CASH INFLOW
CASH OUTFLOW
CASH SALE
CASH FROM DEBTORS
CASH FROM FEE COMMISSION
CASH PURCHASES
PAYMENT TO CREDITORS
OPERATING EXPENSES
PAYMENT OF WAGES
OTHER CASH REVENUES
PAYMENT OF TAXES
Some operating activities resulting in cash flow
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Cash receipts from sale of goods and rendering of service
Cash receipts from royalties, fees, commission etc
Cash payments to suppliers of goods and services
Cash payment to employees, (salaries, wages )
Cash receipt from premiums
Cash payment of premiums
Cash refunds from income tax unless specially identified
with financing or investing activities.
Cash flows from operating activities are primarily from principal
revenue generating activities.
Result from transactions and other events that enter into the
Profit and Loss Account
CASH IN INVESTMENT ACTIVITIES
CASH INFLOW
CASH OUTFLOW
Sale of Fixed Assets
Sale of Investments
and Securities
Interest Income
Dividend Income
Purchase of Fixed Assets
Investments
Some investing activities resulting in cash flow
• Cash payments to acquire fixed assets, self constructed
fixed assets, intangibles
• Cash receipts on disposal of fixed assets (plant and
machinery, land and building) intangibles etc
• Cash investments in shares
• Cash receipts in disposal of shares
• Cash advances and loans to third parties
CASH IN FINANCING ACTIVITIES
CASH INFLOW
CASH OUTFLOW
Issue of Shares
Issue of Debentures
Raising Long term
Loans
Retiring of Preference Shares
Retirement of long term
loans
Interest on debentures
Dividends paid on
equity
Some financing activities resulting in cash flow
• Cash proceeds from issue of shares or similar capital
instruments (raising of capital)
• Cash proceeds from issue of Debentures, long term
loans, bonds and other borrowings
• Cash repayment of borrowings and loans
Method of Preparing Cash Flow Statement
• Direct Method
– Only those items, which impact the cash, are taken for
two years to compute the net cash flow
• Indirect Method
– The cash flow is worked out in a reverse direction
by taking the profit figure
FUNDS FLOW
Funds Flow Statement ?
• A summary of a firm’s changes in financial
position of a business entity from one period to
another; it is also called a sources and uses of
funds statement or a statement of changes in
financial position.
Why Examine the Funds Flow ?
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Financial Statements for a particular period do not give
complete information- information is as on a particular
date
Where from funds came and how where they deployedis not answered.
Includes important non-cash transactions while the cash
flow statement does not.
Is easy to prepare and often preferred by managers for
analysis purposes over the more complex cash flow
statement.
Helps you to better understand the cash flow statement,
especially if it is prepared under the “indirect method.”
Four good reasons for funds flow statement
1. It explains the financial consequences of business
operations: Gives answer to following conflicting situations.
i. How the business could have good liquid position in
spite of business making loses or acquisition of fixed
assets?
ii. Where have the profits gone?
iii. How a business can earn more and more profits.
2. It answers intricate queries:
i. How much fund is generated from normal business
operations?
ii. What are the sources of repayment of loans?
iii. How to utilize the funds up to optimum level?
Four good reasons for funds flow statement
3. It acts as an instrument for allocation of resources.
4. It is a test of effectiveness in use of working capital.
Profit and Loss Account and Balance Sheet do not clearly
provide complete and needed information
What are Funds ?
All of the firm’s investments and claims
against those investments.
Extends transactions involving beyond
just cash.
The letters labeling
the boxes stand for
Uses, Sources,
Assets, and Liabilities
(broadly defined).
The pluses (minuses)
indicate increases
(decreases) in assets
or liabilities.
S
U
A
+
L
+
-
Looking at the Balance Sheet
A banker has to look at the Balance Sheet of the Borrower as a set of
5 BOXES
Balance sheet for two periods
A. Convert balance sheets of two consecutive years into 5 boxes.
B. Work out the change in amounts in the boxes.
C. The result of the change would be Funds flow statement
Preparation of Funds Flow statement
A. Take balance sheets as at two dates covering the period
for which fund flows statement is intended to be prepared.
B. Work out increase /decrease in each of items
C. Classify change in each item under any of the four heads:
(1) Long term sources
(2) Long term uses
(3) Short term sources
(4) Short term uses.
D. The deficit or the surplus in the long term category will be
equal to the surplus or deficit in the short term category.
Funds Flow and Assets and Liabilities
• Changes in assets and liabilities lead to inflows or
outflows Funds
• Increase or decrease in assets liabilities does not
always lead to changes in funds flow e.g.
Depreciation or revaluation
• All increases/decreases need not necessarily
impact funds flow and hence has to be removed
from funds flow statement
Transactions not impacting funds flow
Preparation of Funds flow
• When preparing fund flow statement the non-fund based
adjustments have to be nullified in order to capture only
those changes in the values of assets and liabilities that are
accompanied by flows of fund.
• Increase in the item "reserves and surplus" indicate the
amount of retained profits for the year.
• Adding profits distributed to this figure we will get the
amount of net profit for the year after taxes.
• The net profit figure needs to be adjusted for all non-cash
expenses and noncash incomes.
Preparation of Funds Flow
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Rule:
Add all non-cash expenditure to the profits
Deduct all non-cash income from the figure of net profit.
Add Depreciation to the change in reserve and surplus
and correspondingly to the value of assets concerned.
• Deduct: The appreciation.
• Add: Add the amount of write offs to net profits.
• Income accrued but not received Expenses accrued but not
paid need not be excluded from the Funds Flow statement
Transactions that affect funds flow
1. Transactions that effect current and fixed assets. A
transaction, which changes the balance of current assets and
fixed asset, will make a flow of funds.
2. Transactions effecting current assets and non-current
liabilities. When a transaction effects a change in current asset
and non-current liability, it will result in flow of funds.
3. Transactions effecting current liability and non-current
assets. All those transactions, which involve current liabilities
and non-current assets, will result in flow of funds.
4. Transactions effecting current liability and non-current
liability: when there will be change in current liability and
non-current liability will result in flow of funds.
Transactions not impacting Funds Flow
1. If transaction effect accounts of current category
only: All those transaction which effect the current assets
or current liabilities only will never result into flow of
funds.
2. If transaction effect non current accounts only. There
will be no change in flow of funds, if a transaction affects
accounts of non-current category only.
In a nutshell
Funds Flow
Schedule of
changes in WC
Sources and
Uses of Funds
Funds from
Operations
Preparation of Funds Flow statement
LIABILITIES
CHANGE
TYPE
ASSETS
CHANGE
TYPE
CAPITAL
+
LTS
FIXED ASSETS
+
LTU
RES. SURP.
+
+
LTS
INV. ASSOCT.
LTU
LTS
INVENTORY
+
+
SHORT
TERM
LOANS
+
STS
DEBTORS
+
STU
CREDITORS
STS
CASH AND BK.
+
STU
C.L.
+
+
STS
OTHER C.A.
+
STU
OTHER LIAB.
+
STS
ADV. TO
SUPPLIERS
+
STU
LONG TERM
LOANS
STU
Preparation of Funds Flow
First Step to Preparation
The Final Statement
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