Unit I Financial Modelling description and details

Financial Statement Analysis
The Information Maze
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Understand the contents of balance sheet, profit and loss statement, and cash flow state-
ment.
Explain the discrepancy between accounting income and economic income.
Identify the devices used in practice to manipulate the bottom line.
Use a firm’s financial statements to calculate standard financial ratios.
Decompose the return on equity into its key determinants.
Carry out comparative analysis.
Show how financial statement analysis is used for different purposes.
Financial statements are perhaps the most important source of information for
evaluating the performance and prospects of a firm. As a student of finance and
investments, you should understand how these statements are prepared, what these
statements contain, and how these statements may be analysed.
The preparation of financial statements is covered in a course on financial accounting
which is almost invariably a prerequisite for students of finance and investments.
Assuming that you have received such an exposure, this chapter focuses on the contents,
analysis, and interpretation of financial statements.
If properly analysed and interpreted, financial statements can provide valuable
insights into a firm’s performance. Analysis of financial statements is of interest to
lenders (short-term as well as long-term), investors, security analysts, managers, and
others. Financial statement analysis may be done for a variety of purposes, which
may range from a simple analysis of the short-term liquidity position of the firm to a
comprehensive assessment of the strengths and weaknesses of the firm in various areas.
It is helpful in assessing corporate excellence, judging creditworthiness, forecasting
bond ratings, evaluating intrinsic value of equity shares, predicting bankruptcy, and
assessing market risk.
Chapter 6

6.2 Investment Analysis and Portfolio Management
6.1 FINANCIAL STATEMENTS
Managers, shareholders, creditors, and other interested groups seek answers to the
following questions about a firm: What is the financial position of a firm at a given point
of time? How has the firm performed financially over a given period of time? What
have been the sources and uses of cash over a given period? To answer these questions,
companies prepare three statements, the balance sheet, the profit and loss account,
and the statement of cash flows. The Companies Act, 1956 requires every company to
prepare a balance sheet and a profit and loss account. While the Companies Act does
not require a cash flow statement to be presented as part of financial statements, the
Accounting Standard 3 issued by the Institute of Chartered Accountants of India (ICAI)
mandates a cash flow statement when the turnover of a company exceeds Rs. 50 crore
or its debt or equity is listed or proposed to be listed on a stock exchange.
Balance Sheet
The balance sheet shows the financial condition of a firm at a given point of time, usually
at the end of the month, or the quarter, or the fiscal year. In effect, the balance sheet
shows what the firm owns (in the form of various assets) and what the form owes (to
shareholders and creditors). It reflects the following accounting equation:
Assets = Equity + Liabilities
A specimen balance sheet is shown in Exhibit 6.1. A word about various items in the
balance sheet is in order.
Shareholders’ Funds Shareholders’ funds represent the contribution made by
shareholders in some form or the other. They include share capital, reserves and surplus,
and money received against share warrants. Share capital includes equity (or ordinary)
capital and preference capital. Equity capital represents the contribution of equity
shareholders who are the owners of the firm. Equity capital, being risk capital, carries
no fixed rate of dividend. Preference capital represents the contribution of preference
shareholders and the dividend rate payable on it is generally fixed.
Reserves and surplus, often the most significant item on the balance sheet, represent
retained earnings as well as non-earnings items such as share premium. Reserves and
surplus comprise of capital reserves, securities premium reserve, debenture redemption
reserve, revaluation reserve, general reserve, and so on.
Non-current Liabilities Non – current liabilities are liabilities which are expected to
be settled after one year of the reporting date. They include long-term borrowings,
deferred tax liabilities, long-term provisions, and other long-term liabilities. Long-term
borrowings are borrowings which have a tenor of more than one year. They generally
comprise of term loans from financial institutions and banks in India and abroad, rupee
bonds (debentures) and foreign currency bonds, and public deposits. Term loans and
bonds are typically secured by a charge on the assets of the firm, whereas public deposits
represent unsecured borrowings.

Financial Statement Analysis 6.3
Exhibit 6.1 Balance Sheet of Horizon Limited as at March 31, 20X1
Rs in million
Equity and Liabilities 20 1 20 0
Shareholders’ Funds 500 450
Share capital (Par value Rs.10) 100 100
Reserves and surplus 400 350
Non-current Liabilities 300 270
Long-term borrowings* 200 180
Deferred tax liabilities (net) 50 45
Long-term provisions 50 45
Current Liabilities 200 180
Short-term borrowings @ 40 30
Trade payables 120 110
Other current liabilities 30 30
Short-term provisions 10 10
1,000 900
Assets
Non-current Assets 600 550
Fixed assets 500 450
Non-current investments 50 40
Long-term loans and advances 50 60
Current Assets 400 350
Current investments 20 20
Inventories 160 140
Trade receivables 140 120
Cash and cash equivalents 60 50
Short-term loans and advances 20 20
1000 900
* Rs. 50 million of long-term borrowings are repayable within a year
@
These borrowings are working capital loans which are likely to be renewed in the normal
course of business.
Deferred tax liability ( or asset) arises because of the temporary difference between
taxable income and accounting proﬁt. A deferred tax liability (asset) is recognised when
the charge in the ﬁnancial statements is less (more) than the amount allowed for tax
purposes.

Long-term provisions include provisions for employee benefits such as provident
fund, gratuity, superannuation, leave encashment, and other provisions.
Current Liabilities Current liabilities are liabilities which are due to be settled within
twelve months after the reporting date. They include short-term borrowings, trade
payables, short-term provisions, and other current liabilities. Short-term borrowings
are borrowings which have a tenor of less than one year. They comprise mainly of
working capital loans, inter-corporate deposits, commercial paper, and public deposits
maturing in less than one year.
Trade payables are amounts owed to suppliers who have sold goods and services on
credit.
Short-term provisions mainly represent provisions for dividend and taxes.
Non-current Assets Non-current assets are relatively long-lived assets. They consist
of fixed assets, non-current investments, deferred tax assets (net), long-term loans and
advances, and other non-current assets. Fixed assets comprise of tangible fixed assets,
intangiblefixedassets,capitalwork-inprogress,andintangibleassetsunderdevelopment.
Tangible fixed assets include items such as land, buildings, plant, machinery, furniture,
and computers. They are reported in the balance sheet at their net book value, which is
simply the gross value (the cost of acquiring the asset) less accumulated depreciation.
Intangible fixed assets include items such as patents, copyrights, trademarks, and
goodwill. Intangible fixed assets are reported at their net book value, which is simply
the gross value less accumulated amortisation.
Non-current investments generally comprise of financial securities like equity
shares, preference shares, and debentures of other companies, most of which are likely
to be associate companies and subsidiary companies. These investments are meant to
be held for a long period and are made for the purpose of income and control.Non-
current investments are stated at cost less any diminution of value which is regarded as
permanent in the opinion of management.
Long-term loans and advances are usually loans and advances to subsidiaries,
associate companies, employees, and others for a period of more than one year.
Current Assets An asset is classified as a current asset when it satisfies any of the
following criteria: (a) it is expected to be realised in, or is intended for sale or consumption
in, the company’s normal operating cycle, (b) it is held primarily for the purpose of being
traded, (c) it is expected to be realised within twelve months after the reporting date, or
(d) it is cash or cash equivalent unless it is restricted from being exchanged or used to
settle a liability for at least twelve months after the reporting date. All other assets are
classified as non-current.
Current assets include current investments, inventories, trade receivables, cash and
cash equivalents, short-term loans and advances, and other currents assets. Current
investments mainly represent short-term holdings of units or shares of mutual fund
schemes. These investments are made primarily to generate income from short-term
cash surpluses of the firm. Current investments are carried at cost or market (fair) value,
whichever is lower.

Inventories (also called stocks) comprise of raw materials, work-in-process, finished
goods, packing materials, and stores and spares. Inventories are generally valued at cost
or net realisable value, whichever is lower. The cost of inventories includes purchase
cost, conversion cost, and other cost incurred to bring them to their respective present
location and condition. The cost of raw materials, stores and spares, packing materials,
trading and other products is generally determined on weighted average basis. The cost
of work-in-process and finished goods is generally determined on absorption costing
basis - this means that the cost figure includes allocation of manufacturing overheads.
Trade receivables (also called accounts receivable or sundry debtors) represent
the amounts owed to the firm by its customers (who have bought goods and services
on credit) and others. Sundry debtors are classified into two categories viz., debts
outstanding for a period exceeding six months and other debts. Further, sundry debtors
are classified as debts considered good and debts considered doubtful. Generally, firms
make a provision for doubtful debts which is equal to debts considered doubtful. The
net figure of trade receivables is arrived at after deducting the provision for doubtful
debts.
Cash and cash equivalents comprise of cash on hand and credit balances with
scheduled banks and non-scheduled banks.
Short-term loans and advances comprise of loans and advances given to suppliers,
employees, and other companies that are recoverable within a year. The net figure of
short-term loans and advances is arrived at after deducting a provision for doubtful
advances, if any.
Other current assets comprise of items such as interest accrued on investments,
dividends receivable, and fixed assets held for sale (the last item is valued at net book
value or estimated net realisable value, whichever is lower).
Accounting Values versus Economic Values Accounting values and economic values
ought to be similar, at least in theory. In reality, however, the two diverge very often.
There are three main reasons for such a discrepancy.
Use of the Historical Cost Principle For purposes of valuation, accountants use the
historical cost as the basis. The value of an asset is shown at its historical cost less
accumulated depreciation. Likewise, the value of a liability reflects a historical number.
Hence accounting values differ significantly from current economic values.
Exclusion of Intangible Assets Intangible assets like technical know-how, brand equity,
managerial capability, and goodwill with suppliers often have substantial economic
value. Yet they are ignored in financial accounting because it is difficult to objectively
value them.
Understatement or Omission of Certain Liabilities Firms usually understate or even
wholly omit certain liabilities that are of a contingent nature. They may be mentioned
by way of a footnote to the balance sheet but they are not recorded on the main balance
sheet. Sometimes such liabilities are substantial.

Statement of Profit and Loss
The statement of profit and loss reflects the results of operations over a specified period.
While the balance sheet is a snapshot of a firm’s financial condition at a point in time,
the profit and loss statement shows the results of business operations over a period of
time – typically over a month, or quarter, or year.
As in the case of the balance sheet, the contents of the statement of profit and loss can
be represented with a simple equation:
Revenues – Expenses = Profit (or loss)
The statement of profit and loss for Horizon Limited is shown in Exhibit 6.2. A word
about various items in the statement of profit and loss is in order.
Exhibit 6.2 Statement of Profit and Loss for Horizon Limited for Year
Ending March 31, 20X1
Rs. in million
Current Period Previous Period
Revenues from Operations 1290 1172
Other Income 10 8
Total Revenues 1300 1180
Expenses
Material expenses 600 560
Employee benefit expenses 200 180
Finance costs 30 25
Depreciation and amortisation expenses 50 45
Other expenses 240 210
Total Expenses 1120 1020
Profit before Exceptional and Extraordinary Items and Tax 180 160
Exceptional Items - -
Profit before Extraordinary Items and Tax 180 160
Extraordinary Items - -
Profit Before Tax 180 160
Tax Expense 50 40
Profit (Loss) for the Period 130 120
Earnings Per Equity Share
Basic 13
Diluted 13

Revenues from operations represent revenues from (a) sales of products and services
less excise duties and (b) other operating income. For a finance company, revenues from
operations consist of revenues from interest and financial services.
Other income consists of the following: (a) interest income (in case of a company other
than a finance company), (b) dividend income, (c) net gain/loss on sale of investments,
and (d) other non-operating income (net of expenses directly attributable to such
income).
Expenses comprise of material expenses, employee benefit expenses, finance costs,
depreciationandamortisationexpenses,andotherexpenses.Materialexpensesequalcost
of materials consumed plus purchase of stock-in-trade minus (plus) increase (decrease)
in inventories of finished goods, work-in-progress, and stock-in-trade. Employee benefit
expenses are classified as follows: (a) salaries and wages, (b) contribution to provident
and other funds, (c) expense on employee stock option plan (ESOP) and employee
stock purchase plan (ESPS), and (d) staff welfare expenses. Finance costs are classified
as follows: (a) interest expense, (b) other borrowing costs, and (c) applicable net gain
/ loss on foreign currency transactions and translations. Depreciation represents the
allocation of the cost of tangible fixed assets to various accounting periods that benefit
from their use; likewise, amortisation represents the allocation of the cost of intangible
fixed assets to various accounting periods that benefit from their use.
Tax expense consists of current tax and deferred tax. Current tax is computed by
multiplying the taxable income, as reported to the tax authorities, by the appropriate tax
rate. Deferred tax, also called future income tax, is an accounting concept that arises on
account of temporary difference (also called timing difference) caused by items which
are included for calculating taxable income and accounting profit but in a different
manner over time. For example, depreciation is charged as per the written down value
for the taxable income but as per the straight line method for calculating the accounting
profit. As a result, there are differences in the year-to-year depreciation charges under
the two methods, but the total depreciation charges over the life of the asset would be
the same under both the methods.
Exceptional items are material items which are infrequent, but not unusual, and
they have to be disclosed separately by virtue of their size and incidence, for financial
statements to present a true and fair view. Examples of exceptional items are profits
or losses on the disposal of fixed assets, abnormal charges for bad debts and write-
offs of inventories, surplus arising from the settlement of insurance claims, write off
of previously capitalised expenditure on intangible fixed assets other than as part of a
process of amortisation.
Extraordinary items are material items which are both infrequent and unusual, and
they have to be disclosed separately by virtue of their size and incidence, for financial
statements to present a true and fair view. Examples of extraordinary items are the
discontinuance of a business segment, either through termination or disposal, the sale
of investments in subsidiary and associated companies, provision for diminution in
value of a fixed asset because of some extraordinary event, and a change in the basis of
taxation due to change in the governmental fiscal policy.

Basic and Diluted Earnings Per Share As perAccounting Standard 20, all listed companies
should present basic and diluted earnings per share for each class of equity share.
To calculate the basic earnings per share, the net profit or loss for the period attributable
to equity shareholders is divided by the weighted average number of equity shares
during the period.
To calculate the diluted earnings per share, the net profit or loss for the period
attributable to equity shareholders and the weighted average number of shares
outstanding during the period should be adjusted for the potential dilution arising
from conversion of debt into equity, exercise of warrants and stock options, and so on.
The nature of adjustment is illustrated below:
Convertible Debentures To illustrate how diluted EPS is calculated, when a company
has outstanding convertible debentures, let us consider an example. Magnum Company
has 10 million equity shares of Rs. 10 each and 200,000 convertible debentures of Rs. 100
each carrying a coupon rate of 8 percent. Each convertible debenture is convertible into
4 equity shares. Magnum’s profit after tax for the year ended March 31, 20X5, was Rs.
25 million and its tax rate is 30 percent.
The basic earnings per share is:
Basic earnings per share =
Rs. 25,000,000
= Rs. 2.50
Rs. 10,000,000
The diluted earnings per share is calculated as follows:
Number of existing equity shares 10,000,000
Equivalent number of equity shares corresponding to convertible
debentures
800,000
Number of equity shares for calculating the diluted earnings per
share
10,800,000
Profit after tax Rs. 25,000,000
Add: After-tax debenture interest
200,000 100 .08 0.70
1,120,000
Adjusted profit after tax 26,120,000
Diluted earnings per share
26,120,000 / 10,800,000
Rs. 2.42
Stock Options To illustrate how the diluted earnings per share is calculated when a
company has issued stock options, assume that the Magnum Company does not have
convertible debentures but has issued stock options for 1 million shares which are
exercisable at a price of Rs. 24. The fair value of an equity share is Rs. 30.
The excess of fair value (Rs. 30) over the exercise price (Rs. 24) is translated into an
equivalent number of equity shares for calculating the diluted earnings per share. The
calculation of the diluted earnings per share is shown below:

Number of existing equity shares 10,000,000
Number of equity shares under stock option 1,000,000
Number of equity shares that would have been issued at fair
value: 1,000,000 24/30
800,000
Dilution impact in terms of equivalent number of shares 200,000
Number of equity shares for calculating the diluted earnings
per share
10,200,000
Diluted earnings per share : Rs. 25,000,000 / 10,200,000 Rs. 2.45
Unaudited Quarterly Financial Results
A listed company is required to furnish unaudited financial results on a quarterly basis
within a month of expiry of the period to the stock exchange where the company is
listed. Further, the company is required to advertise the details within 48 hours of the
disclosure. The advertisement must appear in at least one national English daily and
one regional newspaper published from where the registered office of the company is
located.
The pro forma specified for such disclosure calls for providing the following details:
Net sales/income from operations
Other income
Total expenditure
Interest
Gross profit/loss after interest but before depreciation and taxation.
Depreciation and amortisation
Profit before tax
Provision for taxation.
Net profit/loss
Paid-up equity capital and reserves excluding revaluation reserves (as per the
balance sheet of the previous accounting year).
Basic and diluted earnings per share
Non-promoter shareholding
The pro forma requires a company to give financial results for the quarter ended, for
the corresponding quarter of the previous year, and for the previous accounting year.
Accounting Income versus Economic Income The economic income of a period is
defined as the change in wealth during the period. Suppose you buy a share for Rs.50
at the beginning of a year. If you receive a dividend of Rs.2 and the price of the share
moves up to Rs.60 at the end of the year, then the economic income from the share is
Rs.12, the increase in your wealth.
While it is easy to measure the change in the wealth of an investor, it is somewhat
difficult to measure the change in the value of a firm. The profit and loss account
represents the accountant’s attempt to measure the change in the wealth of shareholders.

Accounting income, however, diverges from economic income due to the following
reasons:
Use of the Accrual Principle The accountant uses the accrual principle and not the cash
principle. Hence the computation of accounting income is not based on cash flows, even
though it is cash that really matters in the determination of economic income.
Omission of Changes in Value The accountant records only those changes in value which
arise from definite transactions. He does not bother about things like development of
new products, emergence of competition, and changes in regulation that significantly
alter the future revenues and costs of the firm and, hence, its value.
Depreciation Economic depreciation represents the decline in the value of asset during
the year. Since it is difficult to measure economic depreciation, the accountant often
follows a fairly straight forward method for allocating the historical cost of the assets
over its useful life. For example, under the straight line method - a commonly adopted
method - the historical cost of the asset is allocated evenly over its life. Understandably,
there is often a discrepancy between economic depreciation (loss of economic value) and
accounting depreciation (allocation of historical cost using some arbitrary rule).
Treatment of R&D and Advertising Expenditures R&D expenditures increase a firm’s
technical know-how which enhances revenues and lowers costs in the future; likewise,
advertising expenditures that build brand equity, benefit the firm over a period of
time. Hence these expenditures are akin to capital expenditures. Yet, for purposes of
accounting, these expenditures are typically written off in the year in which they are
incurred. This naturally causes a discrepancy between accounting income and economic
income.
Inflation Inflation raises the market value of the firm’s assets. However, under historical
cost accounting this is not acknowledged. Hence, the depreciation charge is based on
the historical cost, and not the replacement cost, of assets. This leads to a divergence
between accounting income and economic income.
Creative Accounting Firms may manage their accounting income by resorting to various
creative accounting techniques like change in the method of stock valuation, change in
the method and rate of depreciation, and sale and leaseback arrangement. Generally, the
motive for creative accounting is to artificially boost the reported income. Obviously,
such tactics cause a discrepancy between accounting income and economic income.
Statement of Cash Flow
From a financial point of view, a firm basically generates cash and spends cash. It
generates cash when it issues securities, raises a bank loan, sells a product, disposes an
asset, so on and so forth. It spends cash when it redeems securities, pays interest and
dividends, purchases materials, acquires an asset, so on and so forth. The activities that
generate cash are called sources of cash and the activities that absorb cash are called
uses of cash.

To understand how a firm has obtained cash and how it has spent cash during a given
period, we need to look at the changes in each of the items in the balance sheet over that
period. As an illustration, Exhibit 6.3 shows the balance sheets of Horizon Limited as on
31.3.20X0 and 31.3.20X1. The changes in various items of the balance sheet are noted in
the last two columns of that exhibit.
Looking at the exhibit we find that a number of things have changed over the year.
For example, long-term borrowings increased by Rs 20 million and fixed assets (net)
increased by Rs 50 million. Which of these changes represents a source of cash and which
a use of cash? Our common sense tells us that a firm generates cash when it increases its
liabilities (as well as owners’ equity) or disposes assets; on the other hand it uses cash
when it buys assets or reduces its liabilities (as well owners’ equity). Thus, the following
picture emerges.
Sources of Cash Uses of Cash
Increase in liabilities and owners’ equity Decrease in liabilities and owners’ equity
Decrease in assets (other than cash) Increase in assets (other than cash)
Exhibit 6.3 Changes in Balance Sheet Items
Rs. in million
Equity and Liabilities March 31 March 31
20 x 1 20 x 0 Increase Decrease
Shareholders’ Funds 500 450 -
Share capital 100 100 - -
Reserves and surplus 400 350 50 -
Non-current Liabilities 300 270 -
Long-term borrowings 200 180 20
Deferred tax liabilities (net) 50 45 5
Long-term provisions 50 45 5
Short-term borrowings 40 30 10
Trade payables 120 110 10
Other current liabilities 30 30 -
Short-term provisions 10 10 -
1,000 900
Assets
Fixed assets 500 450 50
Non-current investments 50 40 10
(Contd).

Equity and Liabilities March 31 March 31
Long-term loans and advances 50 60 10
Current investments 20 20 -
Inventories 160 140 20
Trade receivables 140 120 20
Cash and cash equivalents 60 50 10
Short-term loans and advances 20 20 -
1000 900
Using the above framework we can summarise the sources and uses of cash from the
balance sheet data as follows:
Sources Uses
Increase in reserves and surplus 50 Increase in fixed assets (net) 50
Increase in long-term borrowings 20 Increase in non-current investments 10
Increase in deferred tax liabilities 5 Increase in inventories 20
Increase in long-term provisions 5 Increase in trade receivables 20
Increase in short-term borrowings 10
Increase in trade payables 10
Decrease in long-term loans and advances 10
Total sources 110 Total uses 100
Net addition to cash 10
Note that the net addition to cash is Rs. 10 million and it tallies with the Rs 10 million change
shown on the balance sheet.
This simple statement tells us a lot about what happened during the year, but it
does not convey the full story. For example, the increase in reserves and surplus is
equal to: profit after tax – dividends. If these are reported separately it would be more
informative. Likewise, it would be more illuminating to know the break-up of net fixed
asset acquisition in terms of gross assets acquisition and depreciation charge.
To get these details, we have to draw on the profit and loss account of Horizon
Limited shown in Exhibit 6.2. The amplified sources and uses of cash statement is given
below:
Sources Uses
Net profit 130 Dividend payment 80
Depreciation and amortisation 50 Purchase of fixed assets 100
Increase in long-term borrowings 20 Increase in non-current investments 10
Increase in deferred-tax liabilities 5 Increase in inventories 20
Increase in long-term provisions 5 Increase in trade receivables 20
(Contd.)

Increase in trade payables 10
Decrease in long-term loans and
advances
10
Classified Cash Flow Statement The statement presented above lumped together all
sources of cash and uses of cash. To understand better how cash flows have been
influenced by various decisions, it is helpful to classify cash flows into three classes viz.,
cash flows from operating activities, cash flows from investing activities, and cash flows
from financing activities as shown in Exhibit 6.4.
Operating activities involve producing and selling goods and services. Cash inflows
from operating activities include monies received from customers for sales of goods
and services. Cash outflows from operating activities include payments to suppliers for
materials, to employees for services, and to the government for taxes.
Investing activities involve acquiring and disposing fixed assets, buying and selling
financial securities, and disbursing and collecting loans. Cash inflows from investing
activities include receipts from the sale of assets (real as well financial), recovery of
loans, and collection of dividend and interest. Cash outflows from investing activities
include payments for the purchase of assets (real and financial) and disbursement of
loans.
Exhibit 6.4 Components of Cash Flows
Operating =
+ –
Investing =
Financing =
=
Cash inflows
from operations
Cash outflows
from operations
Cash flow from
operations
Cash inflows
from investing
activities
Cash outflows
from investing
activities
Cash flow from
investing
activities
Cash inflows
from financing
activities
Cash outflows
from financing
activities
Cash flow from
financing
activities
Net cash flow
for the period
+ –

Exhibit 6.5 Cash Flow Statement
A. Cash Flow From Operating Activites
Profit Before Tax 180
Adjustments for:
Depreciation and amortisation 50
Finance costs 30
Interest income1
(10)
Operating Profit Before Working Capital Changes 250
Adjustments for Changes in Working Capital :
Trade receivables and short-term loan and advances (20)
Inventories (20)
Trade payables, short-term provisions, and other current
liabilities
10
Cash Generated From Operations 220
Direct taxes paid (50)
Net Cash From Operating Activities 170
B. Cash Flow from Investing Activities
Purchase of fixed assets (100)
Increase of non-current investments (10)
Reduction in long-term loans and advances 10
Interest income 10
Net Cash Used In Investing Activities (90)
C. Cash Flow From Financing Activities
Increase in long term borrowings 20
Increase in deferred tax liabilities 5
Increase in long-term provisions 5
Dividend paid (80)
Finance costs (30)
Net Cash From Financing Activities (70)
Net Cash Generated (A+B+C) 10
Cash and Cash Equivalents at the beginning of Period 50
Cash and Cash Equivalents at the End of Period 60
Financing activities involve raising money from lenders and shareholders, paying
interest and dividend, and redeeming loans and share capital. Cash inflows from
financing activities include receipts from issue of securities and from loans and deposits.
Cash outflows from financing activities include payment of interest on various forms
of borrowings, payment of dividend, retirement of borrowings, and redemption of
capital.
1
It is assumed that the entire other income is interest income

Exhibit 6.5 shows the cash flow statement of Horizon Limited for the period 1.4.20X0
to 31.3.20X1 prepared in conformity with the format prescribed by the Accounting
Principles Board of the Institute of Chartered Accountants of India.
Stand – Alone and Consolidated Financial Statements
Clause 32 of the listing agreement with the stock exchange(s) requires a company
to provide consolidated financial statements in addition to the stand-alone financial
statements. The consolidated financial statements are prepared by consolidating the
accounts of the parent company with those of its subsidiaries in accordance with
generally accepted accounting principles and in consonance with Accounting Standard
21 entitled “Consolidated Financial Statements”, issued by the Institute of Chartered
Accountants of India.
The consolidation of the financial statements has to be done on a line by line basis by
adding together like items of assets, liabilities, income, and expenses after eliminating
intra-group balances/transactions and resulting unrealised profits/losses in full. The
amount shown in respect of reserves comprise the amount of the relevant reserves as per
the balance sheet of the parent company and its share in the post-acquisition increase in
the relevant reserves of the consolidated entities.
The consolidated financial statements are prepared using uniform accounting policies
for like transactions and other events in similar circumstances. The consolidated financial
statements are presented, to the extent possible, in the same format as that adopted by
the parent company for its stand-alone financial statements.
Alternative Measures of Cash Flow
As an analyst, you can use the following measures of cash flow to determine the
financial health of a company: cash flow from operations and free cash flow.
Cash Flow from Operations When we looked at the profit and loss account, the emphasis
was on profit after tax (also called the bottom line). In finance, however, the focus is on
cash flow.
A firm’s cash flow generally differs from its profit after tax because some of the
revenues/expenses shown on its profit and loss account may not have been received/
paid in cash during the year. The relationship between net cash flow and profit after tax
is as follows:
Net cash flow = Profit after tax – Noncash revenues + Noncash expenses
An example of noncash revenue is accrued interest income that has not yet been
received. It increases the bottom line but is not matched by a cash inflow during the
accounting period – the cash inflow would occur in a subsequent period. An example
of a noncash expense is depreciation.
In practice, analysts define the net cash flow as:
Net cash flow = Profit after tax + Depreciation + Amortisation

However, note that the above expression will not reflect net cash flow accurately if
there are significant noncash items other than depreciation and amortisation.
Free Cash Flow The cash flow from operations does not recognise that the firm has to
make investments in fixed capital and net working capital for sustaining operations. So,
a measure called free cash flow is considered.
The free cash flow is the post-tax cash flow generated from the operations of the firm
after providing for investments in fixed capital and net working capital required for
the operations of the firm. It is the cash flow available for distribution to shareholders
(by way of dividend and share buyback) and lenders (by way of interest and debt
repayment.)
6.2 ACCOUNTING STANDARDS
It is important that the information in financial statements is reliable and comparable
over time and across firms. To ensure this, companies are required to conform to a set of
accounting standards and principles .
Globally, the US Generally Accepted Accounting Principles (US GAAP) and the
International Financial Reporting Standards (IFRS) dominate. In India, Accounting
Standards (AS) are notified by the central government.
A paradigm shift in the economic environment in India in recent years has led to
greater attention being devoted to accounting standards. Further, increase in the volume
of cross-border financing and mergers and acquisitions has stimulated considerable
interest in common internationally accepted accounting principles. Initiatives taken
by International Organisation of Securities Commission(IOSCO) towards promoting
International Accounting Standards (IAS) and International Financial Reporting
Standards (IFRS) issued by the International Accounting Standards Board (IASB) have
created a momentum for harmonising Indian Accounting Standards with IFRS.
Indian GAAP
In India, Accounting Standards (AS) are notified by the central government in exercise
of powers under Section 211 (3C) of the Companies Act, 1956. The central government
notifies AS on the recommendations of the National Advisory Committee of Accounting
Standards (NACAS) constituted under Section 210 A of the Companies Act, 1956. Before
the establishment of NACAS, the Accounting Standards Board (ASB) of the Institute of
Chartered Accountants of India used to issue AS for its members to follow.
The NACAS has representatives from the Ministry of Company Affairs (MCA), the
Central Board of Direct Taxes (CBDT), the Controller and Auditor General of India (C
& AG), the Reserve Bank of India (RBI), the Securities Exchange Board of India (SEBI),
the Institute of Chartered Accountants of India(ICAI), the Institute of Cost and Works
Accountants of India (ICWAI), the Institute of Companies Secretaries of India (ICSI),
chambers of commerce (two), and a recognised academic institution.

The NACAS examines recommendations made by ICAI regarding accounting
standards in the light of international practices and their relevance in the Indian context
before making its recommendations to the central government. The central government
notifies the AS taking into account IAS/IFRS issued by IASB.
MoveToward IFRS In a bid to align Indian GAAP with IFRS, in February 2011, the MCA
notified Indian Accounting Standards (Ind AS) converged with IFRS. The effective date
of Ind AS, which was previously announced to be April 1, 2011, has been deferred. The
MCA is yet to notify the revised effective date.
Though very similar to the IFRS, the IndAS have some carve outs meant to tailor these
standards to the needs of the Indian environment.
Global Situation
Globally, the US GAAP and IFRS dominate. In the US there is no federal company law
that defines statutory provisions for corporate accounting. The Financial Accounting
Standards Board (FASB), a non-governmental body, issues accounting standards that
form the US GAAP. The FASB standards are supported by the Securities Exchange
Commission in the US.
The International Accounting Standards Board (IASB) is an independent, privately
funded body having members from nine countries with varied functional backgrounds.
It is based in London. Committed to developing a single set of high-quality, global
accounting standards, the IASB publishes its standards in the form of pronouncements
called “International Financial Reporting Standards” (IFRS). IASB has also adopted
the standards issued by the Board of the International Accounting Committee, which
continue to be called “International Accounting standards.”
IFRS and the US GAAP The key differences between IFRS (formulated by the
International Accounting Standards Board or IASB) and the US GAAP (formulated by
the Financial Accounting Standards Board or FASB) are as follows:
IFRS is a more principle-based accounting system whereas the US GAAP is a more
rule-based accounting system.
IFRS permits a company to revalue its fixed assets like land and buildings whereas
the US GAAP does not.
IFRS allows a company to amortise certain expenses like R & D expenses over
several years, whereas the US GAAP does not.
IFRS has a less elaborate format for the accounting of derivatives, whereas the US
GAAP requires a detailed mention of various kinds of exposures and liabilities
arising from derivative contracts.
IFRS permits separate accounting in unusual circumstances such as a
hyperinflationary situation whereas the US GAAP does not.
Key Trends in Accounting Standards While presently there are substantial differences
between accounting standards in different countries, accounting bodies have been
working to evolve common standards. Here are some pointers:

OnJanuary1,2005,Europe’s7000listedcompaniesadoptedInternationalFinancial
Reporting Standards (IFRS), replacing 25 different local accounting regimes with
one set of rules.
IFRS formulated by the International Accounting Standards Board (IASB) has
been gaining in popularity. It has been adopted or will be adopted by nearly 100
countries. India too is moving in the direction of IFRS.
In June 2007, SEC decided to allow foreign companies listed in the US to issue
their financial reports using the English version of IFRS.
6.3 FINANCIAL RATIOS
The financial statements of Horizon Limited are given in Exhibits 6.1 and 6.2. If you want
to compare the financial statements of Horizon Limited with those of other companies,
you would have a problem because of differences in size. One way of avoiding this
problem is to calculate and compare financial ratios – remember a ratio eliminates the
size problem as the size effectively divides out.
A ratio is an arithmetical relationship between two figures. Financial ratio analysis
is a study of ratios between various items or groups of items in financial statements.
Financial ratios have been classified in several ways. For our purposes, we divide them
into five broad categories as follows:
Liquidity ratios
Leverage ratios
Turnover ratios
Profitability ratios
Valuation ratios
To facilitate the discussion of various ratios, the financial statements of Horizon
Limited, shown in Exhibits 6.1 and 6.2, will be used.
Liquidity Ratios
Liquidity refers to the ability of a firm to meet its obligations in the short run, usually
one year. Liquidity ratios are generally based on the relationship between current assets
(the sources for meeting short-term obligations) and current liabilities. The important
liquidity ratios are: current ratio, acid-test ratio, and cash ratio.
Current Ratio A very popular ratio, the current ratio is defined as:
Current assets
Current liabilities
Current assets include cash, current investments, debtors, inventories (stocks),
loans and advances, and pre-paid expenses. Current liabilities represent liabilities that
are expected to mature in the next twelve months. These comprise (i) loans, secured
or unsecured, that are due in the next twelve months and (ii) current liabilities and
provisions.

Horizon Limited’s current ratio for 20X1 is 400/200 = 2.00
The current ratio measures the ability of the firm to meet its current liabilities - current
assets get converted into cash during the operating cycle of the firm and provide the funds
needed to pay current liabilities. Apparently, the higher the current ratio, the greater
the short-term solvency. However, in interpreting the current ratio the composition of
current assets must not be overlooked. A firm with a high proportion of current assets in
the form of cash and debtors is more liquid than one with a high proportion of current
assets in the form of inventories even though both the firms have the same current
ratio.
The general norm for current ratio in India is 1.33. Internationally it is 2.
Acid-test Ratio Also called the quick ratio, the acid-test ratio is defined as:
Quick assets
Current liabilities
Quick assets are defined as current assets excluding inventories.
Horizon’s acid-test ratio for 20 1 is: (400 – 160)/200 = 1.20
The acid-test ratio is a fairly stringent measure of liquidity. It is based on those current
assets which are highly liquid - inventories are excluded from the numerator of this ratio
because inventories are deemed to be the least liquid component of current assets.
Cash Ratio Because cash and bank balances and short term marketable securities are
the most liquid assets of a firm, financial analysts look at cash ratio, which is defined
as:
Cash ratio =
Cash and bank balances + Current investments
Current liabili
ities
Horizon Limited’s cash ratio for 20 1 is: (60 + 20)/200 = 0.40
Clearly, the cash ratio is perhaps the most stringent measure of liquidity. Indeed, one
can argue that it is overly stringent. Lack of immediate cash may not matter if the firm
can stretch its payments or borrow money at short notice. Aren’t financial managers
quite skillful at these things?
Leverage Ratios
Financial leverage refers to the use of debt finance. While debt capital is a cheaper source
of finance, it is also a riskier source of finance. Leverage ratios help in assessing the risk
arising from the use of debt capital.
Two types of ratios are commonly used to analyse financial leverage: structural ratios
and coverage ratios. Structural ratios are based on the proportions of debt and equity
in the financial structure of the firm. The important structural ratios are: debt-equity
ratio and debt-assets ratio. Coverage ratios show the relationship between debt servicing
commitments and the sources for meeting these burdens. The important coverage ratios
are: interest coverage ratio, fixed charges coverage ratio, and debt service coverage
ratio.

Debt-equity Ratio The debt-equity ratio shows the relative contributions of creditors
and owners. It is defined as:
Total liabilities (Debt)
Shareholders’ funds (Equity)
The numerator of this ratio consists of all liabilities2
, non-current and current, and the
denominator consists of share capital and reserves and surplus3
.
Horizon’s debt-equity ratio for the 20X1 year-end is:
(300 + 200) / 500 = 1.0
In general, the lower the debt-equity ratio, the higher the degree of protection enjoyed
by the creditors. In using this ratio, however, the following points should be borne in
mind:
The book value of equity often understates its market value. This happens because
tangible assets are carried at their historical values less depreciation and many
highly valuable intangible assets are not recorded on the balance sheet.
Some forms of debt (like term loans, secured debentures, and secured short-term
bank borrowing) are usually protected by charges on specific assets and hence
enjoy superior protection.
Debt-asset Ratio The debt-asset ratio measures the extent to which liabilities support
the firm’s assets. It is defined as:
Total liabilities (Debt)
Total assets
The numerator of this ratio includes all liabilities (non-current and current) and the
denominator of this ratio is the total of all assets (the balance sheet total).
Horizon’s debt-asset ratio for 20X1 is:
500/1000 = 0.5
This ratio is related to the debt-equity ratio as follows:
Debt
Assets
=
Debt/Equity
1 + Debt/Equity
(6.1)4
2
Alternatively, the ratio of non-current liabilities to equity may be calculated. What is important
is that the same ratio is used consistently when comparisons are made.
3
For the sake of simplicity, preference capital is subsumed under equity, since preference
capital is usually a very minor source of finance, its inclusion or exclusion hardly makes any
difference.
4
Equation (6.1) is derived as follows:
Debt/Assets = Debt/(Equity+Debt)
Dividing both the numerator and the denominator of the right-hand side of this equation by
equity, we get
Debt/Assets = {Debt/Equity} / {(Equity/Equity) + (Debt/Equity)}
= {Debt/Equity} / {1+ (Debt/Equity)}

Interest Coverage Ratio Also called the times interest earned, the interest coverage
ratio is defined as:
Profit before interest and taxes
Interest
Horizon’s interest coverage ratio for 20X1 is: 210/30 = 7.0
Note that profit before interest and taxes is used in the numerator of this ratio because
the ability of a firm to pay interest is not affected by tax payment, as interest (or finance
costs) on debt funds is a tax-deductible expense. A high interest coverage ratio means
that the firm can easily meet its interest burden even if earnings before interest and
taxes suffer a considerable decline. A low interest coverage ratio may result in financial
embarrassment when earnings before interest and taxes decline. This ratio is widely
used by lenders to assess a firm’s debt capacity. Further, it is a major determinant of
bond rating.
Though widely used, this ratio is not a very appropriate measure of interest coverage
because the source of interest payment is cash flow before interest and taxes, not profit
before interest and taxes. In view of this, we may use a modified interest coverage
ratio:
Profit before interest and taxes + Depreciation and amortis
sation
Interest
For Horizon Limited, this ratio for 20X1 is: (210 + 50)/30 = 8.67
Fixed Charges Coverage Ratio This ratio shows how many times the cash flow before
interest and taxes covers all fixed financing charges. It is defined as:
Profit before interest and taxes + Depreciation and amortisation
Interest +
Repayment of loan
1 Tax rate
In the denominator of this ratio the repayment of loan alone is adjusted upwards for
the tax factor because the loan repayment amount, unlike interest, is not tax deductible.
Horizon’s tax rate has been assumed to be 30 per cent.
Horizon’s fixed charges coverage ratio5
for 20X1 is:
210 + 50
30 +
50
(1-0.3)
= 2.56
In view of the above relationship, the interpretation of the debt ratio is similar to that of the
debt-equity ratio.
5
From the balance sheet we ind that Rs.50 million loans are repayable within one year.

This ratio measures debt servicing ability comprehensively because it considers both
the interest and the principal repayment obligations. The ratio may be amplified to
include other fixed charges like lease payment and preference dividends6
.
Debt Service Coverage Ratio Used by financial institutions in India, the debt service
coverage ratio is defined as:
Profit after tax + Depreciation + Other non-cash charges + Interest on
term loan + Lease rentals
Interest on term loan + Lease rentals + Repayment of term loan
Financial institutions calculate the average debt service coverage ratio for the period
during which the term loan for the project is repayable. Normally, financial institutions
regard a debt service coverage ratio of 1.5 to 2.0 as satisfactory.
Turnover Ratios
Turnover ratios, also referred to as activity ratios or asset management ratios, measure
howefficientlytheassetsareemployedbyafirm.Theseratiosarebasedontherelationship
between the level of activity, represented by revenues or cost of goods sold, and levels of
various assets. The important turnover ratios are: inventory turnover, average collection
period, receivables turnover, fixed assets turnover, and total assets turnover.
Inventory Turnover The inventory turnover, or stock turnover, measures how fast the
inventory is moving through the firm and generating sales. It is defined as:
Revenues from operations
Average inventory
Horizon’s inventory turnover for 20X1 is:
1290
(160 + 140)/2
= 8.6
The inventory turnover reflects the efficiency of inventory management. The higher
the ratio, the more efficient the management of inventories and vice versa. However,
this may not always be true. A high inventory turnover may be caused by a low level
of inventory which may result in frequent stockouts and loss of sales and customer
goodwill.
Notice that as inventories tend to change over the year, we use the average of the
inventories at the beginning and the end of the year. In general, averages may be used when
a flow figure (revenues from operations) is related to a stock figure (inventories).
6
A ratio along these lines is:
Profit before depreciation interest and lease payments/{ Debt interest + Lease payments +
(Loan repayment installment/1-Tax rate) +
(Preference dividends/1-Tax rate)}

Debtors’Turnover This ratio shows how many times trade receivables turn over during
the year. It is defined as:
Net credit sales
Average trade receivables
If the figure for net credit sales is not available, one may have to make do with the
revenues from operations.
Horizon’s debtors’ turnover for 20X1 is:
1290 ÷ [(140+120)/2] = 9.92
Obviously, the higher the debtors’ turnover the greater the efficiency of credit
management.
Average Collection Period The average collection period represents the number of
days’ worth of credit sales that is locked in trade receivables. It is defined as:
Average daily credit sales
If the figure for credit sales is not available, one may have to make do with the revenue
from operations.
Horizon’s average collection period for 20X1 is:
[(140 + 120)/2]
(1290/365)
= 36.8 days
Note that the average collection period and the debtors’ turnover are related as
follows:
Average collection period =
365
Debtors’ turnover
The average collection period may be compared with the firm’s credit terms to judge
the efficiency of credit management. For example, if the credit terms are 2/10, net 45,
an average collection period of 85 days means that the collection is slow and an average
collection period of 40 days means that the collection is prompt. An average collection
period which is shorter than the credit period allowed by the firm needs to be interpreted
carefully. It may mean efficiency of credit management or excessive conservatism in
credit granting that may result in the loss of some desirable sales.
Fixed AssetsTurnover This ratio measures sales per rupee of investment in fixed assets.
It is defined as:
Average net fixed assets
Horizon’s fixed assets turnover ratio for 20X1 is:
1290 ÷ [(500+450)/2] = 2.72
This ratio is supposed to measure the efficiency with which fixed assets are employed
- a high ratio indicates a high degree of efficiency in asset utilisation and a low ratio

reflects inefficient use of assets. However, in interpreting this ratio, one caution should
be borne in mind. When the fixed assets of the firm are old and substantially depreciated,
the fixed assets turnover ratio tends to be high because the denominator of the ratio is
very low.
Total Assets Turnover Akin to the output-capital ratio in economic analysis, the total
assets turnover is defined as:
Total revenues
Average total assets
Horizon’s total assets turnover ratio for 20X1 is:
1300 ÷ [(1000+900)/2] = 1.37
This ratio measures how efficiently assets are employed, overall.
Profitability Ratios
Profitability reflects the final result of business operations. There are two types of
profitability ratios: profit margins ratios and rate of return ratios. Profit margin ratios
show the relationship between profit and sales. Since profit can be measured at different
stages, there are several measures of profit margin. The most popular profit margin
ratios are: gross profit margin ratio and net profit margin ratio. Rate of return ratios reflect
the relationship between profit and investment. The important rate of return measures
are: return on assets, earning power, return on capital employed, and return on equity.
Gross Profit Margin Ratio The gross profit margin ratio is defined as:
Gross profit
Gross profit is defined as the difference between revenues from operations and cost of
goods sold. Cost of goods sold is the sum of manufacturing costs relating to the operating
revenues of the period. Manufacturing costs include material costs, employee benefit
costs for manufacturing personnel, and manufacturing expenses. Since the published
financial statements lump together employee benefit expenses for manufacturing
personnel and non-manufacturing personnel and subsume manufacturing expenses
under other expenses (a catch-all category that includes a lot of expenses relating to
sales and general administration), it is not possible for the external analyst to estimate
accurately the cost of goods sold. For our purposes, we will assume that one-half of
employee benefit expenses and one-half of other expenses relate to manufacturing – this
is indeed a heroic assumption. So, the estimated manufacturing costs are Rs.820 million
– material cost (600) + employee benefit cost (100) + other expenses (120). This means
that the gross profit for 20 1 is : 1290 – 820 = Rs. 470 million. Hence, Horizon’s gross
profit margin ratio for 20 1 is:
470/1290 = 0.36 or 36 percent

This ratio shows the margin left after meeting manufacturing costs. It measures the
efficiency of production as well as pricing. To analyse the factors underlying the variation
in gross profit margin the proportion of various elements of cost (labour, materials, and
manufacturing overheads) to sales may be studied in detail.
Net Profit Margin Ratio The net profit margin ratio is defined as:
Net profit
Total revenues
Horizon’s net profit margin ratio for 20X1 is:
130/1300 = 0.10 or 10 percent
This ratio shows the earnings left for shareholders (both equity and preference)
as a percentage of total revenues. It measures the overall efficiency of production,
administration, selling, financing, pricing, treasury, and tax management. Jointly
considered, the gross and net profit margin ratios provide a valuable understanding of
the cost and profit structure of the firm and enable the analyst to identify the sources of
business efficiency/inefficiency.
Return on Assets The return on assets (ROA) is defined as:
ROA =
Profit after tax
Horizon’s ROA for the year 20X1 is:
130 [(1000 + 900) / 2] = 13.7 percent
Though widely used, ROA is an odd measure because its numerator measures the
return to shareholders (equity and preference) whereas its denominator represents the
contribution of all investors (shareholders as well as lenders).
Earning Power The earning power is defined as:
Earning power =
Profit before interest and tax
Horizon’s earning power for the year 20X1 is:
210 [(1000 + 900) / 2] = 22.1 percent
Earning power is a measure of business performance which is not affected by interest
charges and tax burden. It abstracts away the effect of capital structure and tax factor
and focuses on operating performance. Hence it is eminently suited for inter-firm
comparison. Further, it is internally consistent. The numerator represents a measure of
pre-tax earnings belonging to all sources of finance and the denominator represents total
financing.
Return on Capital Employed The return on capital employed is defined as:
ROCE =
Profit before interest and tax (1 - Tax rate)
Average total
l assets

The numerator of this ratio viz., profit before interest and tax (1-tax rate) is also called
net operating profit after tax (NOPAT).
Horizon’s ROCE for the year 20X1 is:
210 (1 – 0.3) [(1000 + 900 ) / 2 ] = 15.5 percent
ROCE is the post-tax version of earning power. It considers the effect of taxation, but not
the capital structure. It is internally consistent. Its merit is that it is de ined in such a way
that it can be compared directly with the post-tax weighted average cost of capital of the
irm. ROCE is also referred to as ROIC (return on invested capital).
Return on Equity A measure of great interest to equity shareholders, the return on equity
is de ined as:
Equity earnings
Average equity
The numerator of this ratio is equal to profit after tax less preference dividends. The
denominator includes all contributions made by shareholders (paid-up capital + reserves
and surplus). This ratio is also called the return on net worth or return on shareholders’
funds. For our purpose equity, net worth, and shareholders’ funds are synonymous.
Horizon’s return on equity for 20X1 is:
130 ÷ [(500 + 450)/2] = 27.4 percent
The return on equity measures the profitability of equity funds invested in the firm.
It is regarded as a very important measure because it reflects the productivity of the
ownership (or risk) capital employed in the firm. It is influenced by several factors:
earning power, debt-equity ratio, average cost of debt funds, and tax rate.
In judging all the profitability measures it should be borne in mind that the historical
valuation of assets imparts an upward bias to profitability measures during an
inflationary period. This happens because the numerator of these measures represents
current values, whereas the denominator represents historical values.
Valuation Ratios
Valuation ratios indicate how the equity stock of the company is assessed in the capital
market. Since the market value of equity reflects the combined influence of risk and
return, valuation ratios are the most comprehensive measures of a firm’s performance.
The important valuation ratios are: price-earnings ratio, EV-EBITDA ratio, market value
to book value ratio, and Q ratio.
Price-earnings Ratio Perhaps the most popular financial statistic in stock market
discussion, the price-earnings ratio is defined as:
Market price per share
Earnings per share
The market price per share may be the price prevailing on a certain day or the average
price over a period of time. The market price per share of Horizon as on 31st March 20
1 is Rs. 200. The earnings per share is simply: profit after tax less preference dividend
divided by the number of outstanding equity shares.

Horizon’ price-earnings ratio at the end of 20 1 is:
200/13 = 15.4
The price-earnings ratio (or the price-earnings multiple as it is commonly referred to)
is a summary measure which primarily reflects the following factors: growth prospects,
risk characteristics, shareholder orientation, corporate image, and degree of liquidity.
EV-EBITDA Ratio A widely used multiple in company valuation, the EV-EBITDA ratio
is defined as:
Enterprise value (EV)
Earnings before interest, taxes, depre
eciation, and amortisation (EBITDA)
EV is the sum of the market value of equity and the market value of debt. The market
value of equity is simply the number of outstanding equity shares times the price per
share. As far as debt is concerned, its market value has to be imputed. Generally, a rupee
of loan is deemed to have a rupee of market value.
Horizon’s EV-EBITDA ratio for 20X1 is:
= 10 200 + 500
260
=
2500
260
= 9.62
EV-EBITDA is supposed to reflect profitability, growth, risk, liquidity, and corporate
image.
Market Value to Book Value Ratio Another popular stock market statistic, the market
value to book value is defined as:
Market value per share
Book value per share
Horizon’s market value to book value ratio at the end of 20X1 was:
200/50 = 4.00
In a way, this ratio reflects the contribution of a firm to the wealth of society. When
this ratio exceeds 1 it means that the firm has contributed to the creation of wealth in
the society - if this ratio is, say, 2, the firm has created a wealth of one rupee for every
rupee invested in it. When this ratio is equal to 1, it implies that the firm has neither
contributed to nor detracted from the wealth of society.
It may be emphasised here that if the market value to book value ratio is equal to 1,
all the three ratios, namely, return on equity, earnings-price ratio (which is the inverse
of the price-earnings ratio), and total yield, are equal7
.
7
The following analysis proves this point:
Let B0 = book value per share at the beginning of the year
E1 = earnings per share for the year
D1 = dividends per share for the year
R1 = retained earnings per share for the year = E1 – D1
B1 = book value per share at the end of the year = B0 + E1 – D1

Q Ratio Proposed by James Tobin, the q ratio is defined as:
Market value of equity and liabilities
Estimated replacement
t cost of assets
The q ratio resembles the market value to book value ratio. However, there are two
key differences: (i) The numerator of the q ratio represents the market value of equity
as well as debt, not just equity. (ii) The denominator of the q ratio represents all assets.
Further these assets are reckoned at their replacement cost, not book value.
Comparison with Industry Averages
We have discussed a long list of financial ratios. For judging whether the ratios are high
or low, one has to make a comparative analysis such as a cross-section analysis (in
which the industry averages may be used as benchmarks) or time series analysis (in
which the ratios of the firm are compared over time).
Exhibit 6.6 shows the ratios of Horizon Limited along with industry averages. The
industry averages often provide useful benchmarks for comparisons. Sometimes the
ratios of a few competitor firms may be used as benchmarks.
Comparing the ratios of Horizon Limited with industry averages we find that:
Horizon Limited has a favourable liquidity position. All the liquidity ratios of
Horizon Limited are higher than the industry average.
Leverage ratios of Horizon Limited are a shade better than the industry
average.
Turnover ratios of Horizon Limited are more or less comparable with the industry
average.
Profit margin ratios of Horizon Limited are somewhat higher than the industry
average. The rate of return measures of Horizon Limited are also higher than the
industry average.
The valuation ratios of Horizon Limited compare slightly favourably in relation
to industry average.
Time Series of Financial Ratios
Besides looking at the ratios for one year, one would like to look at the ratios for several
years.Thiswillhelpinthedetectionofsecularchangesandavoidanceofthebiasintroduced
by transitory forces. Exhibit 6.7 presents certain selected ratios for Horizon Limited for a
period of five years (year 5 corresponds to 20X1). Looking at this exhibit we find that:
M0 = market price per share at the beginning of the year = B0
M1 = market price per share at the end of the year = B1
Return on equity = E1/B0
Earnings-price ratio = E1/M0 = E1/B0
Total yield = (D1 + M1 – M0)/M0 = (D1 + B1 – B0)/B0
= [ D1 + (B0 + E1 – D1) – B0]/B0 = E1/B0

The debt-equity ratio improved steadily for three years and increased slightly in
the last year.
The total assets turnover ratio remained more or less flat with minor
fluctuations.
The net profit margin improved steadily for three years but dipped marginally in
the last year.
The return on equity followed the pattern of the net profit margin.
The price-earnings ratio improved steadily over time.
Exhibit 6.6 Comparison of Ratios of Horizon Limited with Industry Average
Ratio Formula Horizon Industry
Limited Average
Liquidity
Current ratio Current assets
Current liabilities
2.00 1.80
Acid-test ratio Quick assets
Current liabilities
1.20 1.05
Leverage
Debt-equity ratio Total liabilities
Shareholders' funds
1.00 1.10
Debt-ratio Total liabilities
Total assets
0.50 0.55
Interest coverage ratio PBIT
Interest
7.0 5.0
Turnover
Inventory turnover Revenues from operations
Average inventory
8.6 8.4
Debtors’ turnover Net credit sales
9.92 10.1
Fixed assets turnover Revenues from operations
Average net fixed assets
2.72 2.75
(Contd).

Total assets turnover Total revenues
1.37 1.40
Profitability
Gross profit margin ratio Gross profit
36.4% 25.0%
Net profit margin ratio Net profit
Total revenues
10.0% 8.5%
Return on assets Profit after tax
13.7% 12.5%
Earning power PBIT
22.1% 19.3%
Return on capital
employed
PBIT (1-T)
15.5% 13.8%
Return on equity Equity earnings
Average equity
27.4% 23.2%
Valuation
Price-earnings ratio Market price per share
Earnings per share
15.4 12.00
Yield Dividend + Price change
Initial price
14.0% 14.1%
Market value to book value
ratio
Market price per share
Book value per share
4.00 3.2
Exhibit 6.7 Time Series of Certain Financial Ratios
1 2 3 4 5
Debt-equity ratio 1.3 1.2 1.0 0.9 1.0
Total asset turnover ratio 1.34 1.41 1.35 1.39 1.37
Net profit margin (%) 8.0 9.0 10.2 10.5 10.0
Return on equity (%) 20.1 22.0 26.0 27.6 27.4
Price-earnings ratio 12.5 13.2 13.8 14.9 15.4

6.4 DU PONT ANALYSIS
The Du Pont Company of the US pioneered a system of financial analysis which has
received widespread recognition and acceptance. A useful system of analysis, which
considers important inter-relationships based on information found in financial
statements, it has been adopted by many firms in some form or the other. Exhibit 6.8
shows the Du Pont chart as applied to Horizon Limited.
Exhibit 6.8 Du Pont Chart Applied to Horizon Limited
Exhibit 6.9 Extension of Du Pont Chart

At the apex of the Du Pont chart is the return on assets (ROA), defined as the product
of net profit margin (NPM) and the total assets turnover ratio (TAT):
Net profit
ROA
=
Net profit
Total revenues
Total revenues
Average t
NPM
o
otal assets
TAT
(6.2)
Such a decomposition helps in understanding how return on assets is influenced by
net profit margin and the total assets turnover.
The upper side of the Du Pont chart shows the details underlying the net profit
margin ratio. An examination of this side may indicate areas where cost reductions may
be effected to improve the net profit margin. If this is supplemented by comparative
common size analysis, it becomes relatively easier to understand where cost control
efforts should be directed.
The lower side of the Du Pont chart throws light on the determinants of the assets
turnover ratio. If this is supplemented by a study of component turnover ratios (inventory
turnover, debtors’ turnover, and fixed assets turnover), a deeper insight can be gained
into efficiencies/inefficiencies of asset utilisation.
The basic Du Pont analysis may be extended to explore the determinants of return on
equity (ROE).
Net profit
Average Equity
ROE
=
Net profit
Total revenue
Total revenues
Average to
NPM
t
tal assets
Average equi
TAT
t
ty
LM
(6.3)
Note that the third component on the right hand side of Eq (6.3) is referred to as the
leverage multiplier (LM).
The extension of Du Pont chart as applied to Horizon Limited is shown in Exhibit
6.9.
6.5 STANDARDISED FINANCIAL STATEMENTS
As an analyst, you would like to compare the financial statements of Horizon Limited
to those of other companies. You would have a problem, however, because companies
often differ considerably in size. For example, Hindustan Unilever and Nirma are very
different in size, so it is difficult to compare their financial statements directly. Even
for the same company, if its size changes over time, it is difficult to compare financial
statements at different times.
For meaningful comparison, you can standardise the financial statements. A simple
way to do this is to work with percentages, rather than rupees. We discuss below some
ways of doing this.
Common Size Statements A useful and convenient way of standardising financial
statements is to express each item on the profit and loss statement as a percentage of
sales and each item on the balance sheet as a percentage of total assets. The resulting
financial statements are called common size statements.

The common size profit and loss statement and the common size balance sheet of
Horizon Limited are shown in Part A and Part B of Exhibit 6.10.
Exhibit 6.10 Common Size Statements
Part A: Profit and Loss Statement
Regular (in million) Common Size (%)
20X1 20X0 20X1 20X0
Total revenues Rs. 1300 Rs. 1180 100 100
Total expenses other than
finance cost
1090 995 84 84
PBIT 210 185 16 16
Interest (Finance costs) 30 25 2 2
PBT 180 160 14 14
Tax 50 40 4 4
PAT 130 120 10 10
Part B: Balance Sheet
20X1 20X0 20X1 20X0
Shareholders’ funds 500 450 50 50
Non-current liabilites 300 270 30 30
Current liabilities 200 180 20 25
Total 1000 900 100 100
Non-current assets 600 550 60 61
Current assets 400 350 40 39
Total 1000 900 100 100
Common Base Year Financial Statements Suppose you are looking at the financial
statements of a company over a period of time and trying to figure out trends in revenues,
profits, net worth, debt, and so on. A useful way of doing this is to select a base year and
then express each item relative to the amount in the base year. The resulting statements
are called common base year statements.
Exhibit 6.11 presents the common base year profit and loss statement and balance
sheet of Horizon Limited. For example, the common base year value for net sales for
year 20X1 is 110. This means that net sales have increased 10 percent over their base-year
(20X0) value. Other numbers can be similarly interpreted.

Exhibit 6.11 Common Base Year Financial Statements
Part A: Profit and Loss Statement
20X1 20X0 20X1 20X0
Total revenues Rs. 1300 Rs. 1180 110 100
Total expenses other than
finance cost
1090 995 110 100
PBIT 210 185 114 100
Interest (Finance costs) 30 25 120 100
PBT 180 160 113 100
Tax 50 40 125 100
PAT 130 120 108 100
Part B: Balance Sheet
20X1 20X0 20X1 20X0
Shareholders’ funds 500 450 111 100
Non-current liabilites 300 270 111 100
Current liabilities 200 180 111 100
Total 1000 900 111 100
Non-current assets 600 550 109 100
Current assets 400 350 114 100
Total 1000 900 111 100
6.6 APPLICATIONS OF FINANCIAL STATEMENT ANALYSIS
Having learnt how to compute and interpret a number of financial ratios, let us now
examine how a set of financial ratios may be combined to answer some questions that
are commonly raised by financial managers and others.
Assessing Corporate Excellence Every year, the Economic Times gives corporate
excellence award for the Company of the Year and the Emerging Company of the
Year. The Economic Times considers the following financial indicators in its quantitative
evaluation for judging corporate excellence:
Increase in market capitalisation over the 12-month period on the date of
calculation.
Increase in revenues over one accounting year.
Increase in profit after tax over one accounting year.
Return on net worth.

Compound annual growth in EPS over the past three years.
Price-earnings ratio.
Market capitalisation as on July 15.
Sales for the latest financial year.
Profit after tax for the latest financial year.
The determination of the top 20 companies in each category is based on a combined
ranking over the nine indicators which are equally weighted. To judge corporate
excellence, other studies have employed different sets of financial indicators.
Judging Creditworthiness For judging credit worthiness of a potential customer or
client a number of ad hoc scoring models employing several financial variables have
been used. One such model is shown in Exhibit 6.12. In this model you assess a client
on various factors by assigning points in the range 0-15. By looking at the total points
you judge the creditworthiness of the client.
Forecasting Bankruptcy A multivariate model of the kind displayed in Exhibit 6.12
representsadistinctimprovementoverasingleratioanalysis.Itseemstocomprehensively
consider almost all the key factors relevant for credit evaluation. A critical look at this
model, however, raises several issues: Why should the model have eleven factors? What
is the sanctity about the scale of rating? Why should the factors be regarded equally
important? Is there any conceptual framework or theory that supports such scoring? In
sum, the approach seems to be ad hoc.
To overcome some of these limitations, the modern approach to financial analysis
employs multivariate statistical techniques. What is the key difference between scientific
multivariate analysis and ad hoc multivariate analysis? In scientific multivariate analysis,
the selection of variables, the form of the model, the scheme of weighting, and the
determination of cut off levels (wherever it is done) are guided largely by objective
statistical methodology, not subjective managerial judgment.
A widely cited example of scientific multivariate analysis is the classic study by
Altman8
on prediction of corporate bankruptcy. In this study Altman examined a sample
of 33 bankrupt firms with a pair of 33 non-bankrupt firms. He considered 22 accounting
and non-accounting variables in various combinations as predictors of failure. He found
that the following function discriminated best between the bankrupt and non-bankrupt
firms:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 (6.4)
where X1 is the working capital/total assets (a liquidity measure), X2 is the retained
earnings/total assets (a measure for reinvestment of earnings), X3 is the earnings before
interest and taxes/total assets (a profitability measure), X4 is the market value of equity/
book value of total debt (a leverage measure), and X5 is the sales/total assets (a turnover
measure).
8
Edward I. Altman, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate
Bankruptcy”, Journal of Finance (September 1968)

Altman found that firms which had a Z score below 1.81 almost went bankrupt, firms
which had a Z score value above 2.99 remained healthy, and firms which had a Z score
between 1.81 and 2.99 fell in a grey area.
Valuing Equity Shares Prasanna Chandra9
tried to study the manner in which the stock
market in India weights and combines certain fundamental factors in determining share
prices. One of the equations estimated by him is given below
Y = 0 D 1
G 2
O 3
F 4
S 5
(6.5)
On logarithmic transformation this becomes:
ln Y = ln 0 + 1lnD + 2lnG + 3lnO + 4lnF + 5lnS + ln (6.6)
where Y is the share price, D is the dividend per share, G is the growth rate, O is the
operating risk, F is the financial risk, S is the company size, and is the error term.
The estimated relationship for one of the samples in 1970 was as follows:
ln Y = 10.65 + 0.926 ln D + 3.85 ln G - 0.044 ln O – 0.063 ln F + 0.093 ln S (6.7)
Exhibit 6.12 A Credit Scoring Model
Points
Character
Average past payment On time Up to 30 Up to 60
days late days late - - - -
Capacity
Profit margin 0-5% 6-10% >10% - - - -
Quick ratio < 0.75 0.75 - 1.25 > 1.25 - - - -
Cash flow Low Average High - - - -
Capital
Current ratio < 1 1 - 1.5 > 1.5 - - - -
Debt-equity ratio < 1 1 - 2 > 2 - - - -
Interest earned < 2X 2X - 3X > 3X - - - -
Collateral
Net worth Low Average High - - - -
Per cent assets free Low Average High - - - -
Market value to net worth Low Average High - - - -
Conditions Recession Average Prosperity - - - -
Total - - - -
Predicting Bonds Ratings In the US Moody’s bond ratings and Standard and Poor’s
bond ratings are most widely used. Naturally, financial managers are interested in
9
Prasanna Chandra, Valuation of Equity Shares in India, New Delhi, Sultan Chand & Sons,
1978.

guessing the ratings the bonds of their firms would get from these agencies. Hence, a
question that concerns them is: Can financial ratios be used for predicting bond ratings?
Empirical research suggests that the answer to this question is a ‘yes’. We will look at
two illustrative studies.
In a path breaking study Kalpan and Urwitz10
found that, in general, a lower debt
ratio, a higher interest coverage ratio, a higher return on assets ratio, a larger size, a
lower market risk, and a lower unique risk had a favourable influence on bond ratings.
They combined these variables into a single measure of bond quality and examined how
well it could predict Moody’s ratings. As Exhibit 6.16 shows, they found a very close
correspondence between predicted ratings and actual ratings for a sample of newly
issued bonds.
Exhibit 6.13 Predicted Ratings and Actual Ratings for a Sample of Newly
Issued Bonds
Predicted Ratings
Actual Ratings Aaa Aa A Baa Ba B Total
Aaa 2 2
Aa 2 2 5 9
A 1 33 2 36
Baa 8 7 15
Ba 1 1
B 1 1
Total 4 3 46 10 1 64
Source R.S.Kaplan and G.Urwitz, “Statistical Models of Bond Ratings: AMethodological Inquiry,”
Journal of Business, Vol.52, (April 1979).
In an interesting study conducted in 1983, Belkaoui11
analysed bond ratings for an
estimation sample of 266 industrial bonds, all with a rating of B or above by Standard
and Poor’s in 1981. He employed a linear multiple discriminant analysis model in which
the following nine independent variables were considered: (i) total assets, (ii) total
debt, (iii) long-term debt-total invested capital, (iv) current assets/current liabilities, (v)
fixed charge coverage ratio, (vi) five-year cash flow divided by five-year sum of capital
expenditure, (vii) common dividends, (viii) stock price/common equity per share, and
(ix) subordination status (represented by a dummy variable). Belkaoui selected status
variables after analysing variables which are supposed to determine the investment
quality of bond.
10
R.S. Kalpan and G. Urwitz “Statistical Models of Bond Ratings: A Methodological Inquiry,”
Journal of Business, Vol. 52, (April 1979), 232-261.
11
Ahmed Belkaoui, Industrial Bonds and the Rating Process, Westport CT: Quorum Books, 1983.

Belkaoui’s principal findings were as follows: (i) In the estimation sample, 72.9 percent
(194/266) of the bond ratings were correctly classified and 24.4 percent (65/266) of the
bond rating were within one rating of the actual ones. (ii) In the validation sample 67.8
percent (78/115) of the bond ratings were correctly classified and 23.5 percent (27/115)
of the bond ratings were within one rating of the actual ones. Belkaoui’s percentages
of correct classification compare favourably with those reported in previous studies of
industrial bond ratings.
Estimating Market Risk The market risk of a company’s stock, as measured by beta12
, is
an important determinant of the return required by investors. To estimate a stock’s beta
you need sufficient history of stock price data. Since this may not always be available,
financial economists examined whether accounting data can be used to get a handle
over equity beta. For example, economic logic tells us that if the debt-equity ratio is
high, other things being equal, equity beta is also high. No wonder, empirical evidence
supports such a relationship.
You can also calculate the “accounting beta” of a firm. It reflects the sensitivity of the
firm’s earnings changes to changes in the aggregate earnings of all firms.
Instead of looking at one measure at a time, you can look at a combination of several of
them. For example, Hochman found that the debt ratio, dividend yield, and accounting
beta when combined provide an estimate of a stock’s equity beta which is as good as
that obtained from stock’s price history.
6.7 USING FINANCIAL STATEMENT ANALYSIS
Financial statement analysis can be a very useful tool for understanding a firm’s
performance and condition. However, there are certain problems and issues encountered
in such analysis which call for care, circumspection, and judgment.
Shortcomings of Financial Statements
Financial statements have serious shortcomings arising out of the following
The Annual Reporting Requirement The need to produce financial statements on
a 12-month cycle forces management and its auditors to make a series of difficult
estimates about the eventual outcome of some highly uncertain long-term projects and
liabilities.
Inability of Management to Report Objectively on Itself This is a more fundamental
dilemma. Since management is responsible for preparing financial statements,
management, in effect, reports on itself. Within the framework of GAAP, the auditors
only opine on the financial statements. While GAAP imposes a lot of restrictions, it
does provide management with a great deal of freedom. Such freedom would typically
be used by management to write a more glowing report card. Why? Louis Lowenstein
12
Beta is discussed in Chapter 8.

explains : “If we could psychoanalyze the CEOs of America, we could find, I believe,
that the most important explanation of the tendency to window-dress the annual report
is their own reluctance to recognize bad news.”
Choice Between Flexibility and Consistency It is extremely difficult to write a set of
rules that can be applied across the board. For example, the historical cost rule has a
different meaning across sectors like oil exploration, banking, and software. If a single
set of rules is applied to all of them, it is bound to be an awkward fit.
Problems in Financial Statement Analysis
You have to cope with the following problems while analysing financial statements.
Lack of an Underlying Theory The basic problem in financial statement analysis is that
there is no theory that tells us which numbers to look at and how to interpret them. In
the absence of an underlying theory, financial statement analysis appears to be ad hoc,
informal, and subjective.As James Horrigan put it: “From a negative viewpoint, the most
striking aspect of ratio analysis is the absence of an explicit theoretical structure…… As a
result the subject of ratio analysis is replete with untested assertions about which ratios
should be used and what their proper levels should be.”
Conglomerate Firms Many firms, particularly the large ones, have operations spanning
a wide range of industries. Given the diversity of their product lines, it is difficult to find
suitable benchmarks for evaluating their financial performance and condition. Hence,
it appears that meaningful benchmarks may be available only for firms which have a
well defined industry classification.
Window Dressing Firms may resort to window dressing to project a favourable financial
picture. For example, a firm may prepare its balance sheet at a point when its inventory
level is very low. As a result, it may appear that the firm has a very comfortable liquidity
position and a high turnover of inventories. When window dressing of this kind is
suspected, the financial analyst should look at the average level of inventory over a
period of time and the not the level of inventory at just one point of time.
Price Level Changes Financial accounting, as it is currently practised in India and most
other countries, does not take into account price level changes. As a result, balance sheet
figures are distorted and profits misreported. Hence, financial statement analysis can
be vitiated.
Variations in Accounting Policies Business firms have some latitude in the accounting
treatment of items like depreciation, valuation of stocks, research and development
expenses, foreign exchange transactions, installment sales, preliminary and pre-
operative expenses, provision of reserves, and revaluation of assets. Due to diversity
of accounting policies found in practice, comparative financial statement analysis may
be vitiated.
Interpretation of Results Though industry averages and other yardsticks are commonly
used in financial ratios, it is somewhat difficult to judge whether a certain ratio is ‘good’

or ‘bad’. A high current ratio, for example, may indicate a strong liquidity position
(something good) or excessive inventories (something bad). Likewise, a high turnover of
fixed assets may mean efficient utilisation of plant and machinery or continued flogging
of more or less fully depreciated, worn out, and inefficient plant and machinery.
Another problem in interpretation arises when a firm has some favourable ratios
and some unfavourable ratios – and this is rather common. In such a situation, it
may be somewhat difficult to form an overall judgement about its financial strength or
weakness. Multiple discriminant analysis, a statistical tool, may be employed to sort
out the net effect of several ratios pointing in different directions.
Correlation among Ratios Notwithstanding the previous observation, financial ratios
of a firm often show a high degree of correlation. Why? This is because several ratios
have some common element (sales, for example, is used in various turnover ratios) and
several items tend to move in harmony because of some common underlying factor. In
view of ratio correlations, it is redundant and often confusing to employ a large number
of ratios in financial statement analysis. Hence it is necessary to choose a small group
of ratios from a large set of ratios. Such a selection requires a good understanding of
the meaning and limitations of various ratios and an insight into the economics of the
business.
Potential Red Flags
As an analyst, you should learn to identify potential red flags. Here is a list of common
red flags.
A qualified audit opinion.
A change in accounting policy that is not satisfactorily explained.
An unusual increase in accruals.
A widening gap between reported income and cash flow from operations.
Large adjustments in the fourth quarter.
An abrupt change in external or internal auditor.
An increase in transactions with related parties.
An unusual increase in short-term financing or lending.
Guidelines for Financial Statement Analysis
From the foregoing discussion, it is clear that financial statement analysis cannot be
treated as a simple, structured exercise. When you analyse financial statements bear in
mind the following guidelines.
1. Use ratios to get clues to ask the right questions By themselves ratios rarely provide
answers, but they definitely help you to raise the right questions.
2. Be selective in the choice of ratios You can compute scores of different ratios and
easily drown yourself into confusion. For most purposes a small set of ratios –
three to seven – would suffice. Few ratios, aptly chosen, would capture most of
the information that you can derive from financial statements.

3. Employ proper benchmarks It is a common practice to compare the ratios (calculated
from a set of financial statements) against some benchmarks. These benchmarks
may be the average ratios of the industry or the ratios of the industry leaders or
the historic ratios of the firm itself.
4. Know the tricks used by accountants Since firms tend to manipulate the reported
income, you should learn about the devices employed by them.
5. ReadthenotestoaccountsNotestoaccountssometimescontainvaluableinformation.
They may reveal things that management may try to hide. The more difficult it
is to read a footnote, the more information – laden it may be.
6. Remember that financial statement analysis is an odd mixture of art and science
Financial statement analysis cannot be regarded as a simple, structured exercise.
It is a process requiring care, thought, common sense, and business judgment – a
process for which there are no mechanical substitutes.
6.8 GOING BEYOND THE NUMBERS
The tools of analysis discussed in this chapter are helpful in making investment decisions,
evaluating performance, and forecasting future developments.
Comprehensive business analysis, however, calls for going beyond the conventional
financial measures to consider qualitative factors relevant for evaluating the performance
and prospects of a company. The American Association of Individual Investors (AAII)
has summarised these factors as follows:
1. Are the company’s revenues tied to one key customer? If so, the company’s performance
may decline dramatically if the customer goes elsewhere. On the other hand, if
the relationship is firmly entrenched, this might actually stabilise sales.
2. To what extent are the company’s revenues tied to one key product? Companies that rely
on a single product may be more efficient and focused, but a lack of diversification
increases risk. If revenues come from several different products, the overall
bottom line will be less affected by a drop in the demand for any one product.
3. To what extent does the company rely on a single supplier? Depending on a single
supplier may lead to unanticipated shortages, which investors and potential
creditors should consider.
4. What percentage of the company’s business is generated overseas? Companies with a
large percentage of overseas business are often able to realise higher growth and
larger profit margins. However, firms with large overseas operations find that the
value of their operations depends in large part on the value of the local currency.
Thus, fluctuations in currency markets create additional risks for firms with large
overseas operations. Also, the potential stability of the region is important.
5. Competition. Generally, increased competition lowers prices and profit margins.
In forecasting future performance, it is important to assess both the likely actions
of the current competition and the likelihood of new competitors in the future.
6. Future prospects. Does the company invest heavily in research and development?
If so, its future prospects may depend critically on the success of new products

in the pipeline. For example, the market’s assessment of a computer company
depends on how next year’s products are shaping up. Likewise, investors in
pharmaceutical companies are interested in knowing whether the company has
developed any potential blockbuster drugs that are doing well in the required
tests.
7. Legal and regulatory environment. Changes in laws and regulations have important
implications for many industries. For example, when forecasting the future of
tobacco companies, it is crucial to factor in the effects of proposed regulations and
pending or likely lawsuits. Likewise, when assessing banks, telecommunications
firms, and electric utilities, analysts need to forecast both the extent to which these
industries will be regulated in the years ahead, and the ability of individual firms
to respond to changes in regulation.
SUMMARY
The balance sheet shows the financial position (or condition) of a firm at a given
point of time. It provides a snapshot and may be regarded as a static picture. The
income statement (referred to in India as the statement of profit and loss) reflects
the performance of a firm over a period of time. The cash flow statement portrays
the flow of cash through the business during a given accounting period.
To understand how cash flows have been influenced by various decisions, it is helpful
to classify cash flows into three categories: cash flows from operating activities, cash
flows from investing activities, and cash flows from financing activities.
Corporate managements have discretion in influencing the occurrence, measurement
and reporting of revenues, expenses, assets, and liabilities. They may use this latitude
to manage the bottom line.
Financial ratio analysis, the principal tool of financial statement analysis, is a study
of ratios between items or groups of items in financial statements.
Financial ratios may be divided into five broad types: liquidity ratios, leverage
ratios, turnover ratios, profitability ratios, and valuation ratios.
Liquidity refers to the ability of the firm to meet its obligations in the short run,
usually one year. Current ratio and acid-test ratio are the important liquidity
ratios.
Leverage refers to the use of debt finance. Debt-equity ratio, interest coverage ratio,
and fixed charges coverage ratio are the important leverage ratios.
Turnover refers to the efficiency of asset use. Inventory turnover ratio, receivables
turnover ratio, fixed assets turnover ratio, and total assets turnover ratio are the
important turnover ratios.
Profitability reflects the final result of business operations. Gross profit margin
ratio, net profit margin ratio, return on assets, earning power, return on capital
employed, and return on equity are the most important profitability ratios.
Valuation refers to the assessment of the firm by the capital market. Price-earnings
ratio and market value – book value ratio are the most important valuation ratios.

For judging whether the ratios are high or low, cross-section analysis and time-
series analysis are used.
In common size analysis, the items in the balance sheet are stated as percentages of
total assets and the items in the statement of profit and loss are stated as percentages
of sales.
According to Du Pont analysis, return on equity is expressed as a product of net
profit margin, total asset turnover, and asset-equity ratio.
Properly combined, financial ratios may be used to assess corporate excellence, judge
creditworthiness, predict bankruptcy, value equity shares, predict bond ratings, and
measure market risk.
While financial statement analysis can be a very useful tool, there are certain
problems and issues encountered in such analysis that call for care, circumspection,
and judgment.
Comprehensive business analysis calls for going beyond conventional financial
measures to consider qualitative factors relevant for evaluating the performance and
prospects of a company.
QUESTIONS
1. State the basic accounting identity.
2. Describe the various asset accounts and liability accounts found on a company’s balance
sheet.
3. “Accounting and economic values tend to differ”. Why?
4. Discuss the important items found on the statement of profit and loss.
5. Explain the sources of divergence between accounting income and economic income.
6. What are the sources of cash and what are the uses of cash?
7. Give the format for the cash flow statement.
8. What is cash flow from operations? What is free cash flow?
9. Write a note on accounting standards.
10. What are the different types of financial ratios?
11. Discuss the important liquidity ratios.
12. Define and evaluate various leverage ratios.
13. Discuss the important turnover ratios.
14. Explain the important profit margin ratios.
15. Compare the following rate of return ratios: return on assets, earning power, return on
capital employed, and return on equity.
16. Discuss the key valuation ratios.
17. “If the market price per share is equal to the book value per share, the following are equal:
return on equity, earnings price ratio, and total yield.” Prove.
18. What are common size financial statements and common base year financial statements?
19. Why is it important to do time-series analysis and common size financial statements ?
20. Discuss the Du Pont analysis.
21. Carry out the Du Pont analysis for a company of your choice.

22. List the financial indicators used by the Economic Times.
23. Describe the Altman model for predicting corporate bankruptcy.
24. Discuss the problems and issues faced in financial statement analysis.
25. What guidelines would you follow in financial statement analysis?
26. Discuss the issues considered important by the American Association of Individual
Investors.
SOLVED PROBLEMS
1. The financial statements of Matrix Limited are shown below:
Rs. in million
Statement of Profit and Loss for Matrix Limited for the Year Ended March 31, 20X1
Current
Period
Previous Period
Revenues from operations 1065 950
Other income@ 35 28
Total revenues 1100 978
Expenses
Material expenses 600 520
Employee benefits expenses 120 110
Finance costs 35 30
Depreciation and amortisation expenses 50 40
Other expenses 10 12
Total expenses 815 712
Profit before exceptional and extraordinary items and tax 285 266
Exceptional items ----- -----
Profit before extraordinary items and tax 285 266
Extraordinary items ----- -----
Profit before tax 285 266
Tax expense 95 82
Profit( loss) for the period 190 184
Dividends 25 25
@ The entire other income consists of interest received.

Balance Sheet of Matrix Limited as at March 31, 20X1
Rs. in million
20X1 20X0
EQUITY AND LIABILITIES
Share capital * 125 125
Non-current Liabilities 300 295
Long-term borrowings ** 196 205
Deferred tax liabilities(net) 92 80
Short-term borrowings 90 75
Total 1052 863
ASSETS
Inventories 165 138
Total 1052 863
* Face value per share is Rs.10
**Rs.50 million of long-term loans are repayable within a year
i. Prepare a sources and uses of cash statement
ii. Prepare the cash flow statement.
iii. Calculate the following ratios for the year 20X1 : Current ratio, acid-test ratio, cash ratio,
debt-equity ratio, interest coverage ratio, fixed charges coverage ratio ( assume a tax rate of
30 percent), inventory turnover ratio(assume that the cost of goods sold is Rs 750 million),
debtor turnover ratio, average collection period, total assets turnover, gross profit margin,
net profit margin, return on assets, earning power, return on equity.
iv. Set up the Dupont equation.
Solution
The sources and uses of cash statement for Matrix Limited for the year ending 31st
March
20X1 is given below:

Rs. in million
Sources Uses
Net profit 190 Dividend payment 25
Depreciation and amortisation 50 Decrease in long-term borrowings 9
Increase in deferred tax liabilities 12 Decrease in trade payables 4
Increase in long-term provisions 2 Purchase of fixed assets 155
Increase in other current liabilities 2 Increase in current investments 12
Increase in short-term provisions 6 Increase in inventories 27
Decrease in long-term loans and
advances
10 Increase in trade receivables 60
Decrease in short-term loans and
advances given
10
(ii)
Cash Flow Statement
Rs. in million
A. Cash Flow From Operating Activities
Profit Before Tax 285
Adjustments for:
Depreciation and amortisation 50
Finance costs 35
Interest income (35)
Operating Profit Before Working Capital Changes 335
Adjustments for changes in working capital:
Trade receivables and short-term loans and advances (50)
Inventories (27)
Current investments (12)
Trade payables, short-term provisions, and other current liabilities 4
Cash Generated From Operations 250
Direct taxes paid (95)
Net Cash From Operating Activities 155
B. Cash Flow From Investing Activities
Purchase of fixed assets (155)
Interest income 35
Net Cash Used In Investing Activities (120)
C. Cash Flow From Financing Activities
Decrease in long- term borrowings (9)
Decrease in long-term loans and advances given 10
Increase in deferred tax liabilities 12
(Contd.)

Increase in long-term provisions 2
Dividend paid (25)
Finance costs (35)
Net Cash From Financing Activities (30)
Net Cash Generated (A+B+C) 5
Cash and Cash Equivalents at the Beginning of Period 20
Cash And Cash Equivalents at the End of Period 25
(iii)
Current ratio =
402
132+ 50
= 2.21
Acid-test ratio =
402 165
132+50
= 1.30
Cash ratio =
25 + 17
182
= 0.23
Debt-equity ratio = 432 / 620 = 0.70
Interest coverage ratio =
285 + 35
35
= 9.14
Fixed charges coverage ratio =
(285 +35) + 50
35 + 50/(1 0.3)
= 3.48
Inventory turnover ratio =
750
(165+138)/2
= 4.95
Debtors turnover =
1065
(175 + 115)/2
= 7.34
Average collection period =
365
7.34
= 50 days
Total assets turnover ratio =
1100
(1052+863)/2
= 1.15
Gross proﬁt margin =
(1065 750)
1065
–
= 29.58 %
Net proﬁt margin =
190
1100
= 17.27 %
Return on assets =
190
(1052+863)/2
= 19.84 %
Earning power =
285+ 35
(1052+863)/2
= 33.42 %

Return on equity =
190
(620+455)/2
= 35.35 %
(iv) Dupont equation
Net profit
Average equity
=
Net profit
Total revenues
Total revenues
Average equity
190
(620+455)/2
=
190
1100
1100
(1052+863)/2
(1052+863)/2
(620+455)/2
35.35% = 17.27% x 1.15 x 1.78
2. A firm’s current assets and current liabilities are 1,600 and 1,000 respectively. How much
can it borrow on a short-term basis without reducing the current ratio below 1.25.
Solution
Let the maximum short-term borrowing be B. The current ratio with this borrowing should
be 1.25.
1,600 + B
1,000 + B
= 1.25
Solving this equation, we get B = 1,400. Hence the maximum permissible short-term bor-
rowing is 1,400.
3. Determine the sales of a firm given the following information:
Current ratio = 1.4
Acid-test ratio = 1.2
Current liabilities = 1,600
Inventory turnover ratio = 8
Solution
The sales figure may be derived as follows :
Current assets = Current liabilities x Current ratio
= 1,600 x 1.4 = 2,240
Current assets – Inventories = Current liabilities x Acid-test ratio
= 1,600 x 1.2 = 1,920
Inventories = 2,240 – 1,920 = 320
Sales = Inventories x Inventories turnover ratio
= 320 x 8 = 2,560
4 The following ratios are given for Mintex Company
Net profit margin ratio 4 per cent
Current ratio 1.25
Return on net worth 15.23 per cent
Total debt to total assets ratio 0.40
Inventory turnover ratio 25

Complete the following statements
Profit and Loss Statement
Rs.
Sales ………….
Cost of goods sold ………….
Operating expenses 700
PBIT ………….
Interest 45
Profit before tax ………….
Tax provision (50 per cent) ………….
Profit after tax ………….
Balance Sheet
Net worth …………. Fixed assets ………….
Long-term debt …………. Current assets 180
(15 per cent interest)
Cash ………….
Accounts payable …………. Receivables 60
Inventory ………….
Solution
The blanks in the above statements may be filled as follows :
(a) Accounts payable The value of accounts payable – the only current liabilities – is derived
as follows.
Current ratio =
Current assets
Current liabilities
= 1.25
Current liabilities =
Current assets
1.25
=
180
1.25
= 144
So accounts payable are 144
(b) Long-term debt The only interest-bearing liability is the long-term debt which carries 15 per
cent interest rate. Hence the long-term debt is equal to
Interest
0.15
=
45
0.15
= 300
(c) Total assets As the ratio of total debt to total assets is 0.4, total assets (the total of the balance
sheet) is simply :
Total debt
0.4
=
144 + 300
0.4
= 1110
(d) Net worth The difference between total assets and total debt represents the net worth.
Hence, it is equal to :
1100 – (444) = 666
(e) Fixed assets The difference between total assets and current assets represents fixed assets.
So,
Fixed assets = 1110 – 180 = 930
(f) Profit after tax This is equal to :
(Net worth) (Return on net worth) = (666) (0.1523) = 101.4

(g) Tax As the tax rate is 50 per cent, the tax provision is simply equal to the profit after tax,
i.e., 101.4.
(h) Profit before tax The sum of the profit after tax and the tax provision is equal to the profit
before tax. So, it is equal to :
101.4 +101.4 = 202.8
(i) PBIT This is equal to the profit before tax plus the interest payment. Hence, it is equal to :
202.8 + 45 = 247.8
(j) Sales The figure of sales may be derived as follows :
= = 2535
(j) Cost of goods sold This figure of cost of goods sold may be derived from the following ac-
counting identity :
Sales – cost of goods sold – operating expenses = PBIT
2535 – cost of goods sold – 700 = 247.8
Hence the cost of goods sold figure is 1587.2
(i) Inventory This is equal to :
= =101.4
(m) Cash This may be obtained as follows :
Current assets – receivables – inventory = 180 – 60 – 101.4 = 18.6
PROBLEMS
1 At the end of 20X1 the balances in the various accounts of Mahaveer Limited are as fol-
lows:
Rs. in million
Accounts Balance
Equity capital 90
Preference capital 20
Fixed assets (net) 150
Reserves and surplus 50
Cash and bank 20
Debentures (secured) 60
Marketable securities 10
Term loans (secured) 70
Receivables 70
Short-term bank borrowing (unsecured) 40
Inventories 110
(Contd.)

Rs. in million
Accounts Balance
Trade creditors 30
Provisions 10
Pre-paid expenses 10
Required: Classify the accounts into assets and liabilities. Prepare the balance sheet of
Mahaveer Limited as per the format speciﬁed by the Companies Act.
2. The comparative balance sheets and statements of proﬁt and loss of Saraswati Company
are given below:
Balance Sheet of Saraswati Limited Rs. in million
20X1 20X0
Equity And Liabilities
Share capital * 200 200
Non-Current Liabilities 430 420
Long-term borrowings** 260 280
Deferred tax liabilities(net) 80 60
Short-term borrowings 132 120
Total 1258 1108
Assets
Non-Current Assets 584 492
Inventories 320 314
Total 1258 1108

* Par value of share Rs. 10
** Out of which Rs.80 million is payable within 1 year
Statement of Profit and Loss for Saraswati Limited for the year ended March 31, 20 1
Rs. in million
Revenue from operations 860
Other income@ 50
Total revenues 910
Expenses
Material expenses 380
Employee benefits expenses 210
Finance costs 48
Depreciation and amortization expenses 48
Other expenses 25
Total expenses 711
Profit before exceptional and extraordinary items
and tax 199
Exceptional items ------
Profit before extraordinary items and tax 199
Extraordinary items ------
Profit before tax 199
Tax expenses 35
Current tax 17
Deferred tax charge 18
Profit( loss for the period) 164
Dividends 50
@ Consists entirely of interest income.
Required: (a) Prepare the sources and uses of cash statement for the period 1-4-20 0 to
31-3-20 1
(b) Prepare the cash flow statement for the period 1-4-20 0 to 31-3-20 1
(c) Calculate the following ratios for the year 20X1
Current ratio, acid-test ratio, cash ratio, debt-equity ratio(consider deferred tax liability as
forming part of debt), interest coverage ratio, fixed charges coverage ratio ( assume a tax
rate of 33 percent), inventory turnover ratio (assume the cost of goods sold to be Rs.680
million), debtor turnover ratio, average collection period, total assets turnover, gross profit
margin, net profit margin, return on assets, earning power, return on equity
3. Premier Company’s net profit margin is 5 percent, total assets turnover ratio is 1.5 times,
debt to total assets ratio is 0.7. What is the return on equity for Premier?
4. McGill Inc. has profit before tax of Rs.40 ml. If the company’s times interest earned ratio
is 6, what is the total interest charge?
5. The following data applies to a firm :

Interest charges Rs.150,000
Total revenues Rs.7,000,000
Tax rate 60 percent
Net profit margin 6 percent
What is the firm’s times interest earned ratio?
6 . Afirm’s current assets and current liabilities are 600 and 1,500 respectively. How much can
it borrow (short-term) from bank without reducing the current ratio below 1.5?
7. A firm has total annual sales (all credit) of 1,000,000 and accounts receivable of 160,000.
How rapidly (in how many days) must accounts receivable be collected if management
wants to reduce the accounts receivable to 120,000?
8. Determine the sales of a firm with the following financial data :
Current ratio = 1.5
Current liabilities = 800,000
Inventory turnover ratio = 5 times
9. Complete the balance sheet and sales data (fill in the blanks) using the following financial
data :
Debt/equity ratio = 0.60
Total assets turnover ratio = 1.5
Days’ sales outstanding in
Accounts receivable = 40 days
Gross profit margin = 20 percent
Inventory turnover ratio = 5
Balance sheet
Equity capital 50,000 Plant and equipment . . . .
Retained earnings 60,000 Inventories . . . .
Debt . . . . Accounts receivable . . . .
Cash . . . .
. . . . . . . .
Sales . . . .
Cost of goods sold . . . .
MINICASE
The balance sheet and profit and loss account of GNL Limited for the years 20X4
and 20X5 are given below:
Balance Sheet of GNL Limited
(Rs.in million)
20X4 20X5
Equity and Liabilities
Shareholders’ Funds 43.6 46.7
(Contd.)

20X4 20X5
Share capital 18.0 18.0
Reserves and surplus 25.6 28.7
Non-current Liabilities 46.6 51.7
Long-term borrowings 29.4 32.5
Deferred tax liabilities(net) 6.4 7.2
Long-term provisions 10.8 12.0
Current Liabilities 31.2 36.6
Short-term borrowings 15.6 18.4
Trade payables 7.5 9.4
Other current liabilities 5.8 5.0
Short-term provisions 2.3 3.8
Total 121.4 135.0
Assets
Non-current Assets 73.9 84.2
Fixed assets 52.6 58.6
Non-current investments 12.8 18.5
Long-term loans and advances 8.5 7.1
Current Assets 47.5 50.8
Current investments 4.2 6.8
Inventories 18.2 22.0
Trade receivables 20.5 18.2
Cash and cash equivalents 1.8 1.4
Short-term loans and advances 2.8 2.4
Total 121.4 135.0
Statement of Profit and Loss for GNL Limited for the year 20X5
(Rs.in million)
20X4 20X5
Revenue from operations 82.4 98.5
Total expenses 67.8 81.4
Material expenses 38.2 45.0
Employee benefits expenses 12.5 15.6
Finance costs 8.6 10.2
Depreciation and amortisation expenses 6.5 7.4
Other expenses 2.0 3.2
Profit before tax 14.6 17.1
Tax expense 8.4 9.0
Profit(loss for the period) 6.2 8.1
Dividends 5.00 5.00

Required:
a. Calculate the following ratios for the year 20X5:
Current ratio, acid-test ratio, cash ratio, debt–equity ratio interest coverage ratio,
inventory turnover ratio (assume the cost of goods sold to be 70), debtor turnover
ratio, average collection period, total assets turnover, gross profit margin, net
profit margin, return on assets, earning power, return on equity
b. Prepare the Du Pont Chart for the year 20X5
c. Prepare the common size and common base financial statements for GNL.
d. Identify the financial strengths and weaknesses of GNL Limited.
e. What are the problems in analysing financial statements ?
f. Discuss the qualitative factors relevant for evaluating the performance and
prospects of a company.
Assume that (i) Rs. 3 million of long-term debt is payable within a year, (ii) the
income tax rate is 30 percent, (iii) the market value of equity share at the end of
20X is Rs. 72.

Unit I Financial Modelling description and details

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