ive ofa business is to earn a satisfactory return on the sted in it. Financial analysis helps in ascertaining whether juate profits are being earned on the capital invested in the business ‘not, It also helps in knowing the capacity to pay the interest and ividend. 2. Indicating the trend of Achievements Financial statements of the previous years can be compared and the trend regarding various expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value of assets and liabilities can be compared and the future prospects of the business can be envisaged. 3. Assessing the growth potential of the business The trend and other analysis of the business provides sufficient information indicating the growth potential of the business. 4, Comparative position in relation to other firms The purpose of financial statements analysis is to help the management to make a comparative study. of the profitability of various firms engaged in similar businesses. Such comparison also helps the management to study the position of their firm in respect of sales, expenses, profitability and utilizing capital, ete. 5. Assess overall financial strength The Purpose of financial analysis is to assess the financial strength of 7 the business. Analysis also helps in taking decisions, whether funds‘wellbeing of the business. They like to know the earning __ capacity of the business and its prospects of future growth. (ii) Management: The management is interested in the financial position / and performance of the enterprise as a whole and of its various divisions, It helps them in preparing budgets and assessing the performance of various departmental heads. (iii) Trade unions: They are interested in financial statements for negotiating the wages or salaries or bonus agreement with the management. (iv) Lenders: Lenders to the business like debenture holders, suppliers of loans and lease are interested to know short term as well as long term solvency position of the entity. (v) Suppliers and trade creditors: The suppliers and other creditors are interested to know about the solvency of the business i.e. the ability of the company to meet the debts as and when they fall due. Tax authorities: Tax authorities are interested in financial statements for determining the tax liability. (vii) Researchers: They are interested in financial statements in undertaking research work in business affairs and practices. (viii) Employees: They are interested to know the growth of profit. As a result of which they can demand better remuneration and congenial working environment.res expenses and profit and loss of an enterprise. They r understandable to interested Parties like creditors, shareholders, __ Investors etc. Thus, various techniques are employed for analyzing and interpreting the financial statements. Techniques of analysis of financial Statements are mainly classified into three categories: ji) Cross-sectional analysis It is also known as inter firm comparison, This analysis helps in analyzing financial characteristics of an enterprise with financial characteristics of another similar enterprise in that accounting period. For example, if company A has earned 15% profit on capital invested. This does not say whether it is adequate or not. If we analyze further and find that a similar company has earned 16% during the same period, then we can only make a conclusion that company B is better. Thus, it turns into a meaningful analysis. (ii) Time series analysis It is also called an intra-firm comparison. According to this method, the relationship between different items of financial statement is established, comparisons are made and results obtained. The basis of comparison may be: © Comparison of the financial statements of different years of the same business unit. ¢ Comparison of financial statement of a particular year of different business units, (iii) Cross-sectional cum time series analysis This analysis is intended to compare the financial characteristics of two a> mparative financial statements _ Common size statements © Trend analysis * Ratio analysis . ° Funds flow analysis Cash flow analysis Comparative financial statements In brief, comparative study of financial statements is the comparison of the financial statements of the business with the Previous year’s financial Statements. It enables identification of weak points and applying corrective measures. Practically, two financial statements (balance sheet and income Statement) are prepared in comparative form for analysis purposes, 1. Comparative Balance Sheet The comparative balance sheet shows the different assets and liabilities of the firm on different dates to make comparison of balances from one date to another. The comparative balance sheet has two columns for the data of original balance sheets. A third column is used to show change (inerease/decrease) in figures. The fourth column may be added for giving percentages of increase or decrease. While interpreting comparative Balance sheet the interpreter is expected to study the following aspects: (i) Current financial position and Liquidity position. By studying current financial positio liquidity position of a concern, one should examine the working capital in both the years. Working capital is the excess of current assets over current liabilities. (ii) Long-term financial position. By studying the long-term financial position of the conc one should examine the changes in fixed assets, long-term liabilities and capital. pect to be studied in a comparative balance sh iii) Profitability of the concern, The next as; rease in profit will help the the profitability of the concern. The study of increase or deci interpreter to observe whether the profitability has improved or not. After studying various assets and liabilities, an opinion should be 3 formed about the financial position of the concern,igher than the costs of borrowing, ROCE also shows how effi ae s iciently a business is using its resources. If the return very low, the business may be better off realizing its assets and investing the Proceeds in a higher interest bank account. Large cash balances are not contributing to profits and some analysts therefore educt | employed. However, it is usually acceptable not to make this adjustment as ROCE is a performance measure and management have decided to operate with that large balance. 2.Gross profit Margin ross Profit X100 Sales revenue This is a margin that the company makes on its sales and would be expected to remain reasonably constant. However, this ratio could be affected by: a) Selling price because of competition b) Sales mix which is always deliberate c) Purchase costs including carriage or discounts d) Production costs like materials, labour or production overheads e) Inventory like errors in counting valuing or inventory shortages ete. Comparing Gross Profit margin overtime. Gross profit Margin: If gross profit has not increased in line with sales revenue, one needs to establish why and find what caused the discrepancy. The like cause of the discrepancy includes; Increased purchase costs. If so are the costs under the company’s control? Inventory write-offs or other costs being allocated to cost of sales for example research and development expenditure. f Low margins usually suggest poor performance but may be due to expansion costs for example launching a new product or trying to increase market share,Uns is & measure of how well the assets of a business are being used to ger Net assets turn over= Sales : ee . Total Assets-Current liabilities This ratio is measured in terms of times. This ratio measures management’s efficiency in generating revenue from the net assets at its disposal. The higher the number of times the more efficient. WARNING ABOUT COMMENTS ON PROFIT MARGIN AND ASSETS TURNOVER It might be tempting to think that a high profit margin is good and a low asset turnover means sluggish in trading. To reach this conclusion there could be a tradeoff between profit margin and asset turnover and you cannot look at one without looking at the other. A higher profit margin means a high profit per one shilling of sales but if this also means that sales prices are high, there is a strong possibility that sales revenue will be depressed and assets turnover will be low. A high assets turnover means that the company is generating a lot of sales but to do this it might have to keep its prices down and so accept a low profit margin per one shilling of sales. B. LIQUIDITY RATIOS (SHORT TERM SOLVENCY) Liquidity is the amount of cash a company can put its hands on quickly to settle its debt and meet other unforeseen demands for cash payments. Liquid funds consist of the following; ¢ Cash Short-term investments for which there is ready market Fixed term deposits with a bank or other financial institutions e.g. si months high interest deposits with a bank aof non-current assets Sales revenue from sale of goods or services © Profits _ CURRENT RATIO. ‘Current ratio=Current Assets Current liabilities The idea behind this ratio is that the company should have enough current assets ° that give a promise of “Cash to come” to meet its future commitments to pay off its current liabilities. A ratio in excess of 1 should be expected. QUICK RATIO Quick ratio=Current Assets-Inventory Current Liabilities This ratio should be at least one for companies with a slow inventory turnover. For companies with fast inventory turnover a quick ratio can be comfortably less than one without suggesting that the company could be in cash flow trouble. Both the current ratio and the quick ratio offer an indication of the company’s liquidity position. A smaller current ratio or quick ratio may or may not be desirable depending on the business in which in which one is trading for example supermarket or manufacturing firm. Alternatively, a current ratio and a quick ratio can get bigger than they need to be for example a company that has large volumes of inventories and receivables might be over investing in working capital and tying up more funds in the business than it needs to. This would suggest poor management of receivables or inventories by the company. EFFICIENCY/ACTIVITY RATIOS Activity ratios are measures of how well assets are used which are in most cases called turnover ratios. These ratios can be used to evaluate the benefits pro due specific assets such as inventory and accounts receivable.yee Inventory X 365 “ah Cost of sales A ing inventory turnover period from one year to another in¢ A slowdown in trading b) A build up in inventory levels perhaps suggesting that the investment in inventories is becoming excessive. Generally, the higher the inventory turnover the better. The lower the tumover period, the better but several aspects of inventory holding policy have to be balanced e.g. Lead time Seasonal fluctuations in orders Alternative uses of warehouse space Bulk buying discounts Likelihood of inventory perishing or becoming obsolete. ‘Also an increase in number in a number of days implies that inventory is turning Over Jess quickly which could be regarded as a bad sign and may indicate © Lack of demand for the goods Poor inventory control e Anincrease in costs e.g. storage, obsolescence, insurance, damages etc. However, it may not necessarily be bad where management are; e Buying inventory in large quantities to take advantage of trade discounts or ‘Increasing inventory levels to avoid stock outs ACCOUNTS RECEIVABLE TURNOVER les to accounts receivable. This ratio indicates how many This is a ratio of net credit sal been created and collected. times in the period sales have Sales on credit Accounts receivable receivable collection period= Accounts receivable X 365 Credit sales Accounts receivable turnover=:L ASSETS TURNOVER his is a ratio of sales to total assets. This ratio indicates the extent that the investn total assets results in sales. oe Total Assets turnover=Sales Total Assets-Current liabilities FIXED ASSETS TURNOVER This is a ratio of sales to fixed assets. This ratio indicates the ability of the company’s management to put the fixed assets to work to generate sales. Fixed Assets Turnover=Sales Fixed assets TMENT RATIOS SHAREHOLDERS | These ratios help equity shareholders and other investors to assess the value and quality of an investment in ordinary share of a company. These include; Earnings per share Dividends per share Dividend Cover P/E ratio Dividend yield EARNINGS PER SHARE This i is the amount of net profit for the period that is attributable to each ordinary i is outstanding during all or part of the period. Earnings are profits afterolder standing, lend Cover= Earnings per share Dividend per ordinary share A dividend cover of 2 times would indicate that the company had paid 50% of its distributable profits as dividends and retained 50% in the business to help. to finance future operations. Retained profits are important sources of funds for most companies and so the dividend cover ean in some cases be quiet high. * A significant change in the dividend cover from one year to the next would be worth looking at closely.E.g. if a company’s dividend cover were to fall sharply between one year and the next it could be that its profits had fallen but the directors wished to pay at least the same amount of dividends as in the Previous year so as to keep the shareholders expectations satisfied, PRICE/EARNINGS (P/E) RATIO e The P/E ratio is the ratio of the company’s current share price to the earnings per share. A higher P/E ratio indicates strong shareholder’ s confidence in the company and its future like profits, growth etc. A lower P/E ratio indicates lower confidence of shareholders in the company P/E ratio of one company can be compared with the P/E ratios of other companies in the same business sector or other companies generally. P/E ratio is very important and useful in stock exchange reporting where prices are readily available. Price earnings ratio=Current Market Price per Share Earnings per Share DIVIDEND YIELD This is a return a shareholder is currently expecting on the shares of the company. We often describe a company’s dividend policy in termsinvolves risk because d 0 2st and to repay the princip incing does not obligate the company to pay a ds are paid at the discretion of the board of directors. ys same risk which we refer to as business risk inherent in any ‘operating segment of a business. ‘ How a company chooses to finance its operations, the particular mix of debt and equity may add financial risk on top of business risk. Financial risk is the extent that debt financial is used relative to equity. ‘When a company is heavily in debt, banks and other potential lenders may be unwilling to advance further funds. When a company is earning only a modest profit before interest and taxes and has a heavy debt burden, there will be very little profit left for shareholders after interest charges have been paid, if interest rates were to go up on bank overdrafts and other loans or if the company is to borrow more it might be incurring interest charges excess of profit before interest and taxes. This may eventually lead to liquidation of the company. Because of these two reasons companies should keep their debt burden under control. The following ratios have to be looked at to monitor the debt burden a) Total debt to assets ratio b) Long term debt to assets ratio c) Gearing ratio d) Interest cover TOTAL DEBT TO ASSETS RATIO This indicates the proportion of assets that are financed with debt (Both short term and long term debt). Total debt to assets ratio=Total debt Total assets Note that total assets are equal to the sum of total debt and equity.Non redeemable preference shares Long term debt including redeemable preference share. The capital gearing ratio is a measure of the proportion of a company’s eapital that is debt. Gearing=Interest bearing debt Shareholders equity+interest bearing debt. OR Gearing=Total long term Debt Total shareholders’ equity As with the debt ratio there is no absolute limit to what gearing ratio ought to be. A company with a gearing ratio of more than 50% is said to be highly geared Whereas low gearing means a gearing ratio less than 50%. When a company is highly geared it may be difficult for it to borrow more money unless it can also boost its shareholder’s capita either with retained profits or be new share issue. Leverage or gearing can be looked at also by calculating the proportion of total assets financed by equity. This is called Equity: Assets ratio. Equity to Asset’s ratio =Shareholders Equity X100 Total Assets-Current liabilities INTEREST COVER This ratio shows whether a company is earning enough profits before interest and tax to pay interest costs comfortably or whether its interest costs are high in relation to the size of its profits so that a fall in PBIT would then have a significant effect on profits available for ordinary shareholders, Interest cover=PBIT Interest chargesane "are several possible ways of setting out a report. Usually a 0 basic sections, Main body including conclusions arrived at Statistical appendices and supplementary statements which backup the comments or conclusions in the main body text, The following is a suitable approach to setting out a report. ° Index to the report ° Addressee date and title who the report is written to Introduction. Introduce the readers to the aim or purpose of the report. For example, analysis of the financial statements of X Ltd for the two years ended 31% -Dec.20.... State assumptions if any to be used in the report in the report. State key assumptions State the source of information used e.g the financial information included in the teport. Mention the extent to which the report was limited by specific instructions. Conclusion. The conclusion should be as clearer as possible Appendices. Attach appendices containing detailed figures and calculations of ratios that have been used. EXAMPLE ONE The following information relates to the final accounts of TAAKA Ltd published in the years 2019 and 2020. EXTRACT FROM THE STATEMENT OF PROFIT AND LOSS TO 30,04, 2020 2019 $000 $000 $000 $ 000 [Sales 11,200 9,750 Cost of sales 8.460, 6.825 ; Net profit before tax 465 320 This is after charging Sail 45230 80 1,950 3,800 2020 2019 r. = Equity and Liabilities $000 $000 $000 $ 000 Equity Ordinary share capital 800 800 Retained earnings 1,310 2,110 930 1,730 Non current Liabilities 10% Loan stock 800. 600 Current Liabilities Bank overdraft 110 80 | Payables 750) 690 Taxation 30 890 20 790 Total Equity &Liabilities | [3,800 3,120 The following ratios are those calculated for TAAKA Ltd based on its published accounts for the previous year and also the latest industrial average ratios. TAAKA Ltd Industrial i __| 30.4.2019 average ROCE 16.30% 18.50% Profit/Sales 3.90% 4.73% Assets Turnover 4.19 3.91 Current Ratio 2.14 1.90 Quick Ratio 152) L2G G.P Margin 30.00% 35.23% A/Cs Receivable collection Period 40 Days 52 Days [ACs Payable Payment period 37 days 49 days | Inventory Turnover 13.9 Times 18.3 Times earii 26.75% 32.11%s margin however is considerably lower than the previ than the industrial average. This Suggests either that there has | change in the cost structure of the company or that there has been a cl the method of cost allocation between periods which has affected the cost goods sold. Either way this is a marked change that requires further investigation. The company may be in a period of transition because sales have increased by nearly 15% over the year. Also new non current assets have: been purchased. Assets turnover has declined between the periods although the 2020 figure is in line with the industrial average. This reduction might indicate that the efficiency with which assets are used has deteriorated or it might indicate that the assets acquired in 2020 have not yet fully contributed to the business. A longer trend analysis would clarify the pictures. 2. Liquidity and working capital The current ratio has improved slightly over the year and is marginally higher than the industrial average. It is also in line with what is generally as satisfactory (2:1). The quick ratio has declined marginally but it is still better than the industrial average. This suggests that TAAKA Ltd has no short term liquidity problems and should have no difficulty in paying its debts as they fall due. 3. Activity/Efficiency Receivables as a proportion of sales is unchanged from 2019 and are considerably lower than the industrial average. Consequently, there is probably little opportunity to reduce this further and there may be pressure in future from customers the period of credit given.The level of gearing has increased slightly over the year and it is below the _ industrial average. Since the return on capital employed is nearly twice the rate of interest on the loan stock. Profitability is likely to be increased by a modest increase in the level of gearing. Also it is in line with what is generally regarded as satisfactory (50:50) Accountant EXAMPLE TWO The accountant of ABC manufacturing company Ltd requires a loan to finance current assets and repay a bank overdraft. It is intended that the loan be repaired in one year. The bank is provided with the following financial statements which accompanied the loan request;