Monday, January 31, 2011

What is the objective behind analysis of financial statements?

Objective (To know about)
Relevant indicator/Remarks

1.       Financial position of the company

Net worth, i.e., share capital, reserves and unallocated surplus in balance sheet carried down from profit and loss appropriation account.  For a healthy company, it is necessary that there is a balance struck between dividend paid and profit retained in business so much the net worth keeps on increasing.

2.     Liquidity of the company, i.e., whether the company is in a position to meet all its short-term liabilities (also called “current liabilities”) with the help of its current assets

Current ratio and quick ratio or acid test ratio.  Current ratio = Current assets/current liabilities.  Quick ratio = Current assets (-) inventory/ current liabilities. Current ratio should not be too high like 4:1 or 5:1 or too low like less than 1.5:1.  This means that the company is either too liquid thereby increasing its opportunity cost or not liquid at all, both of which are not desirable. Quick ratio could be at least 1:1. Quick ratio is a better indicator of liquidity position.

3.     Whether the company has acquired new fixed assets during the year and if so, what are the sources, besides internal accruals to finance the same?

Examination of increase in secured or unsecured loans for this purpose.  Without adequate financial planning, there is always the risk of diverting working capital funds for fixed assets. This is best assessed through a funds flow statement for the period as even net cash accruals (Retained earnings + depreciation + amortisation) would be available for fixed assets.

4.     Profitability of the company in general and operating profits in particular, i.e., whether the main operations of the company like manufacturing have been in profit or the profit of the company is derived from other income, i.e., income from investment in shares/debentures etc.

Percentage of profit before tax to total income including other income, like dividend or interest income.  Operating profit, i.e., profit before tax (-) other income as above as a percentage of income from the main operations of the company, be it manufacturing, trading or services.


5.     Relationship between the net worth of the company and its external liabilities (both short-term and long-term). What about only medium and long-term debts?

Debt/Equity ratio, which establishes this relationship.  Formula = External liabilities + preference share capital /net worth of the company (-) preference share capital (redeemable kind).  From the lender’s point of view, this should not exceed 3:1.  Is there any sharp deterioration in this ratio?  Is so, please be on guard, as the financial risk for the company increases to that extent.
For only medium and long-term debts, it cannot exceed 2:1.

6.     Has the company’s investments in shares/debentures of other companies reduced in value in comparison with last year?

Difference between the market value of the investments and the purchase price, which is theoretically a loss in value of the investment.  Actual loss is booked upon only selling.  The periodic reduction every year should warn us that at the time of actual sales, there would be substantial loss, which immediately would reduce the net worth of the company. Banks, Financial Institutions, Investment companies or NBFCs would be required to declare their investment every year in the balance sheet at cost price or market price whichever is less.

7.     Relationship between average debtors (bills receivable) and average creditors (bills payable) during the year.

Average debtors in the year/average creditors in the year.  This should be greater than 1:1, as bills receivable are at gross value {cost of development (+) profit margin}, whereas; creditors are at purchase price for software or components, which would be much less than the final sales value.  If it is less than 1:1, it shows that while receivable management is quite good, the company is not paying its creditors, which could cause problems in future.  Too high a ratio would indicate that receivable management is very poor.

8.     Future plans of the company, like acquisition of new technology, entering into new collaboration agreement, diversification programme, expansion programme etc.

Directors’ report.  This would reveal the financial plans for the company, like whether they are coming out with a public issue/Rights issue etc.

9.     Has the company revalued its fixed assets during the year, thereby creating revaluation reserves, without any inflow of capital into the company, as this is just an entry passed in the books?

Auditors’ comments in the “Notes to Accounts” relevant for this.  Frequent revaluation is not desirable and healthy.

10.  Whether the company has increased its investment and if so, what is the source for it?  What is the nature of investment?  Is it in tradable securities or long-term
     Securities, which can have a lock-in-period and cannot be liquidated in the near future?

Increase in amount of investment in shares/debentures/Govt. securities etc. in comparison with last year and any investment within group companies?  Any undue increase in investment should put us on guard, as working capital funds could have been diverted for it.

11.   Has the company during the year given any unsecured loans substantially other than to employees of the company?

Any increase in unsecured loans.  If the loans are to group companies, then all the more reason to be cautious.  Hence, where the figures have increased, further probing is called for.

12.  Are the company’s unsecured loans (given) not recoverable and very old?

Any comments to this effect in the notes to accounts should put us on caution.  This examination would indicate about likely impact on the future profits of the company.

13.  Has the company been regular in payment of its dues on account of loans or periodic interest on its liabilities?

Any comments about over dues as in the “Notes to Accounts” should be looked into.  Any serious default is likely to affect the “credit rating” of the company with its lenders, thereby increasing its cost of borrowing in future.

14.  Has the company defaulted in providing for bonus liability, P.F. liability, E.S.I. liability, gratuity
     liability etc?

Any comments about this in the “Notes to Accounts” should be looked into.

15.  Whether the company is holding very huge cash, as it is not desirable and increases the opportunity cost?

Cash balance together with bank balance in current account, if any, is very high in the current assets.

16.  How many times the average inventory has turned over during the year?

Relationship between cost of goods sold and average inventory during the year (only where cost of goods sold cannot be determined, net sales can be taken as the numerator).  In a manufacturing company, which is not in capital goods sector, this should not be less than 4:1 and for a consumer goods industry, this should be higher even.  For a capital goods industry, this would be less.

17.  Has the company issued fresh share capital during the period and what is the purpose for which it has raised equity capital?  If it was a public issue, how did it fare in the market?

Increase in paid-up capital in the balance sheet and share premium reserves in case the issue has been at a premium.

18.  Has the company issued any bonus shares during the year?

Increase in paid-up capital and simultaneous reduction in general reserves. Enquiry into the company’s ability to keep up the dividend rate of the immediate past.

19.  Has the company made any rights issue in the period and what is the purpose of the issue?  If it was a public issue, how did it fare in the market?

Increase in paid-up capital and share premium reserves, in case the issue has been at a premium.

20.What is the proportion of marketable investment to total investment and whether this has decreased in comparison with the previous year?

Percentage of marketable investment to total investment and comparison with previous year.  Any decrease should put us on guard, as it reduces liquidity on one hand and increases the risk of non-payment on due date, especially if the investment is in its own subsidiary or group companies, thereby forcing the company to provide for the loss.

21.  What is the increase in sales income over last year in % terms? Is it due to increase in numbers or change in product mix or increase in prices of finished products only?

Comparison with previous year’s sales income and whether the growth has been more or less than the estimate.

22.What is the amount of provision for bad and doubtful debts or advances outstanding?

In percentage terms, how much is it of total debts outstanding and what are the reasons for such provision in the notes to accounts by the auditors?

23.What is the amount of work in progress as shown in the Profit and Loss Account?

Is there any comment about valuation of work in progress by the auditors?  It can be seen that profit from operations can be manipulated by increase/decrease in closing stocks of both finished goods and work in progress.

24.Whether the company is paying any lease rentals and if so what is the amount of lease liability outstanding?

Examination of expenses schedule would show this.  What is the comment in notes to accounts about this?  Lease liability is an off-balance sheet item and hence this examination, to ascertain the correct external liability and to include the lease rentals in future also in projected income statements; otherwise, the company may be having much less disclosed liability and much more lease liability which is not disclosed.  This has to be taken into consideration by an analyst while estimating future expenses for the purpose of estimating future profits.

25.Has the company changed its method of depreciation on fixed assets, due to which, there is an impact on the profits of the company? 

Auditors’ comments on “Accounting” policies.  Change over from straight-line method to written down value method or vice-versa does affect the deprecation charge for the year thereby affecting the profits during the year of change.

26.If it is a manufacturing company, whether the % of materials consumed is increasing in relation to sales?

Relationship between materials consumed during the year and the sales.

27.Has the company changed its method of valuation of inventory, due to which there is an impact of the profits of the company?

Auditors’ comments on “Accounting” policies.

28.Whether the % of administration and general expenses has increased during the year under review?

Relationship between general and administrative expenses during the year and the sales.  In case there is any extraordinary increase, what are the reasons therefore?

29.Whether the company had sufficient income to pay the interest charges?

Interest coverage ratio = earnings before interest and tax/total interest on all short-term and long-term liabilities.  Minimum should be 3:1 and anything less than this is not satisfactory.

30.Whether the finance charges have gone up disproportionately as compared with the increase in sales income during the same period?

Relationship between interest charges and sales income – whether it is consistent with the previous year or is there any spurt?
Is there any explanation for this, like substantial expansion or new project or diversification for which the company has taken financial assistance?  While a benchmark % is not available, any level in excess of 6% calls for examination.                         

31.  Whether the % of employee costs to sales has increased?

Relationship between “payment to and provision for employees” and the sales.  In case any undue increase is seen, it could be due to expansion of activity etc. that would be included in the Directors’ Report.

32.Whether the % of selling expenses in relation to sales has gone up?

Relationship between “selling and marketing” expenses and the sales.  Any undue increase could either mean that the company is in a very competitive industry or it is aggressive to increase its market share by adopting a marketing strategy that would increase the marketing expenses including offer of higher commission to the intermediaries like agents etc.

33.Whether the company had sufficient internal accruals {Profit after tax (-) dividend (+) any non-cash expenditure like depreciation, preliminary expenses write-off etc.} to meet repayment obligation of principal amount of loans, debentures etc.?

Debt service coverage ratio = Internal accruals (+) interest on medium and long-term external liabilities/interest on medium and long-term liabilities (+) repayment of medium and long-term external liabilities.  The term-lending institution or bank looks for 1.75:1 on an average for the loan period.  This is a very critical ratio to indicate the ability of the company to take care of its obligation towards the loans it has taken both by way of interest as well as repayment of the principal.

34.Return on investment in business to compare it with return on similar investment elsewhere.

Earnings before interest and tax/average total invested capital, i.e., net worth (+) debt capital.  This should be higher than the average cost of funds in the form of loans, i.e., interest cost on loans/debentures etc.

35.Return on equity (includes reserves and surplus)

Profit after tax (-) dividend on preference share capital/net worth (-) preference share capital (return in percentage).  Anything less than 15% means that our investment in this company is earning less than the average return in the market.

36.How much earning has our share made? (EPS)

Profit after tax (-) dividend on preference share capital/number of equity shares.  In terms of percentage anything less than 40% to 50% of the face value of the shares would not go well with the market sentiments.

37.Whether the company has reduced its dividend payout in comparison with last year?

Relationship between amount of dividend payout and profit after tax last year and this year.  Is there any reason for this like liquidity crunch that the company is experiencing or the need for conserving cash for business activity, like purchase of fixed assets in the immediate future?

38.Is there any significant increase in the contingent liabilities due to any of the following?
     Disputed central excise duty, customs duty, income tax, octroi, sales tax, contracts remaining unexecuted, guarantees given by the banks on behalf of the company as well as the guarantees given by the company on behalf of its subsidiary or associate company, letter of credit outstanding for which goods not yet received etc.

“Notes on Accounts” as given at the end of the accounts. 
Any substantial increase especially in disputed amount of duties should put us on guard.

39.               Has the company changed its policy of outsourcing its work from vendors and if so, what are the reasons?

Substantial change in vendor charges, or subcontracting charges.

40.               Is there any substantial increase in charges paid to consultants?

Increase in consultancy charges.

41.     Has the company opened any branch office in the last year?

Directors’ Report or sudden spurt in general and administration expenses.


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