UNIT 3

ANALYSIS OF FINANCIAL STATEMENT: Ratio Analysis, Solvency Ratios, Profitability Ratios, Activity Ratios, Liquidity Ratios, Common Size tatement, Common Balance Sheet And Trend Analysis Of Manufacturing,

ANALYSIS OF FINANCIAL STATEMENT

Accounting Ratio

Ratio is an expression of relationship between two or more items in mathematical terms. Exhibition of meaningful and useful relation between different accounting data is called Accounting Ratio. Ratio may be expressed as a:b (a is to b), in terms of simple fraction, integer, or percentage. If the current assets of a concern is Rs 4,00,000 and the current liabilities is Rs 2,00,000, then the ratio of current assets to current liabilities is given as 4,00,000 / 2,00,000 = 2. This is called simple ratio. Multiply a ratio by 100 to express it in terms of percentage. We can express the ratio between 200 and 100 in any of the following ways:
(a) 2 : 1 (b) 2/1 (c) 200% (d) 2 to 1 (e) 2
Ratios are extremely useful in drawing the financial position of a concern.

Accounting Analysis

Comparative analysis and interpretation of accounting data is called Accounting Analysis. When accounting data is expressed in relation to some other data, it conveys some significant information to the users of data.

Ratio Analysis and its Applications

Ratio analysis is a medium to understand the financial weakness and soundness of an organization. Keeping in mind the objective of analysis, the analyst has to select appropriate data to calculate appropriate ratios. Interpretation depends upon the caliber of the analyst. Ratio analysis is useful in many ways to different concerned parties according to their respective requirements. Ratio analysis can be used in the following ways:

Advantages of Ratio Analysis

Limitations Of Ratio Analysis

Although Ratio Analysis is a very useful accounting tools to analyze and interpret different accounting equations, it comes with its own set of limitations: Ratio analysis is a useful tool only in the hands of an expert.

Types Of Ratio

Ratios can be classified on the basis of financial statements or on the basis of functional aspects.

Classification on the Basis of Financial Statement

Balance Sheet Ratios:

Ratios calculated from taking various data from the balance sheet are called balance sheet ratio. For example, current ratio, liquid ratio, capital gearing ratio, debt equity ratio, and proprietary ratio, etc.

Revenue Statement Ratio:

Ratios calculated on the basis of data appearing in the trading account or the profit and loss account are called revenue statement ratios. For example, operating ratio, net profit ratio, gross profit ratio, stock turnover ratio.

Mixed Or Composite Ratio:

When the data from both balance sheet and revenue statements are used, it is called mixed or composite ratio. For example, working capital turnover ratio, inventory turnover ratio, accounts payable turnover ratio, fixed assets turnover ratio, return of net worth ratio, return on investment ratio.

Functional Classification of Ratios

Ratios can be further classified based on their functional aspects as discussed below.

Liquidity Ratios

Liquidity ratios are used to find out the short-term paying capacity of a firm, to comment short term solvency of the firm, or to meet its current liabilities. Similarly, turnover ratios are calculated to know the efficiency of liquid resources of the firm, Accounts Receivable (Debtors) Turnover Ratio and Accounts Payable (Creditors).

Long-Term Solvency And Leverage Ratios

Debt equity ratio and interest coverage ratio are calculated to know the efficiency of a firm to pay long-term debts and to meet interest costs. Leverage ratios are calculated to know the proportion of debt and equity in the financing of a firm.

Activity Ratios

Activity ratios are also called turnover ratios. Activity ratios measure the efficiency with which the resources of a firm are employed.

Profitability Ratios

The results of business operations can be calculated through profitability ratios. These ratios can also be used to know the overall performance and effectiveness of a firm. Two types of profitability ratios are calculated in relation to sales and investments.

Common Size Balance Sheet

A common size balance sheet is a balance sheet that displays both the numeric value and relative percentage for total assets, total liabilities and equity accounts. Common size balance sheets are used by internal and external analysts and are not a reporting requirement of GAAP. A common size balance sheet allows for the relative level of each [asset, liability and equity account to be quickly analyzed.

Breaking Down 'Common Size Balance Sheet'

Any single asset line item is compared to the value of total assets. Likewise, any single liability is compared the value of total liabilities and any equity account is compared to the value of total equity. For this reason, each major classification of account will equal 100% as all smaller components will add up to the major account classification. Example of Common Size Balance Sheet A company has $8 million in total assets, $5 million in total liabilities and $3 million in total equity. The company also has $1 million in cash. The common size balance sheet reports the total assets first in order of liquidity. For this reason, the top line of the financial statement would list the cash account and financial value of $1 million. In addition, the cash represents $1 million of the total $8 million in total assets. Therefore, along with reporting the dollar amount of cash, the common size financial statement reports that cash represents 12.5% ($1 million divided by $8 million) of total assets.

Reporting Requirements

Common size balance sheets are not required under generally accepted accounting principles. The percentage information presented in these financial statements are not required by any regulatory agency. Although the information presented is useful to financial institutions and other lenders, a common size balance sheet is typically not required during the application of a loan. Although common size balance sheets are typically utilized by internal management, they provide useful information to external parties including independent auditors.

Usefulness Of Common Size Balance Sheet

The value of a common size balance sheet resides in the ease of comparability. The purpose of a common size balance sheet is to allow quick comparisons for different applications. First, a common size balance sheet permits the ability to quickly compare the historical trend of a specific chart of accounts. Second, the percentages may be applied across companies and across industries. Although companies may vary in size, common size balance sheets eliminate any issues when comparing businesses of varying sizes as the use of percentages establishes a comparable baseline. Finally, the percentages – similar to the dollar amounts – may be analyzed over time. Common size balance sheets offer simplicity in comparing relative financial data over specific periods.

Comparative Balance Sheet Analysis

A comparative balance sheet analysis is a method of analyzing a company's balance sheet over time to identify changes and trends. Public companies are required to include the information needed for a comparative balance sheet analysis in their quarterly and annual reports to the SEC, though it can be useful to pull together more data on your own for a longer-term analysis.

How To Complete A Comparative Balance Sheet Analysis

The first step to complete a comparative balance sheet analysis is to get organized. Locate the company's balance sheet data and arrange it in a table such that each account is shown side by side over time. Make sure the data is in regular time intervals for consistency. In its most basic form, this could be as simple as two quarterly snapshots, side by side. In other cases, it may be more informative to compare more snapshots over time. A farming company with distinct seasonal activities, for example, may require that you review 12 consecutive monthly balance sheets in order to understand how its seasonality impacts the balance sheet's inventory, accounts receivable, and accounts payable. Next, compare how each account has changed over time. Did cash go up, down, or remain constant? What about inventory, accounts receivable, or accounts payable? Continue working down the balance sheet, noting how the different accounts interact and change together over time. For example, if the company shows an increase in real estate assets, do you see a corresponding increase in debt or equity capital? Can you formulate an educated guess as to how the company was likely to have funded the real estate purchase?

More Advanced Techniques To Compliment A Comparative Balance Sheet Analysis

To take your analysis to the next level, you can add additional techniques to make the comparative balance sheet analysis even more powerful. For example, you can show each of the balance sheet accounts as a percentage of the company's total assets. By comparing how these numbers change over time, you can see not just how the balance sheet is changing, but also how its composition is shifting on a common-sized basis. Another common technique is to include additional financial ratios related to the balance sheet in the comparative analysis. A bank, for example, may require a company to maintain a maximum debt to equity ratio. By including that ratio in the comparative analysis, an equity analyst can monitor the company's balance sheet to ensure there is minimal risk of tripping that restriction. The key in each case is to consider the numbers over time to understand and identify changes and trends.

An Example Of A Comparative Balance Sheet Analysis

Let's consider the following hypothetical balance sheet, with common-sized calculations already included
In this example, we start our comparative balance sheet analysis by examining how each account changed from the first year to the second. In this case, the company's cash has increased quite a bit, alongside a steep decline in inventory. The decline in inventory is greater than the increase in cash, driving a decrease in total assets. Reviewing the common-sized figures gives even more context to the changes. Cash increased from 19% of total assets to over 73%, while inventory ended year two at just 12%. The company's accounts payable decrease sharply as well on the liabilities side, while its other short-term debt declined, but to a much lesser degree. Together, those accounts drove total liabilities lower, while shareholders' equity increased from $75 to $130. The common-sized numbers on this side of the balance sheet are even more informative, here. In year one, the company was considerably leveraged with liabilities at 86% of total assets. In year two, that number is much lower, at just 68%. Without the income statement, statement of cash flows, and the ability to ask management questions, we can't know for sure what drove these changes to the company's balance sheet. This company could be winding down operations, it could be going out of business, or it may have tripped a loan covenant and been forced to deleverage quickly. Whatever the case, our comparative analysis revealed major changes across the entire balance sheet. Now it's your turn Performing a comparative balance sheet analysis is a straightforward and highly effective method for analyzing a company's balance sheet. As you follow the company over time, the trends and changes will become even easier to spot with more familiarity. Remember, though, that the company's balance sheet is just a snapshot in time. It's equally important to consider its income statement and statement of cash flow. And, at the end of the day, the company's financial statements are just a report of how the company has performed over time. Always take the time to take what you've learned from the numbers and apply it to what's actually happening at the company. That last step is the key to taking a financial analysis and translating it into an actionable investment decision