OMTEX CLASSES: FINANCIAL STATEMENT ANALYSIS:

### FINANCIAL STATEMENT ANALYSIS:

Learning Objectives:

After studying the lesson, students will be able to:
Ø  Understand the meaning of financial statements and their objectives.
Ø  Identify the parties interested in the financial statements.
Ø  Understand the meaning of financial analysis and its objectives
Ø  Understand the parties interested in financial Analysis
Ø  Analyse the limitation of financial analysis
Ø  Prepare comparative Income statement and Position Statement.
Ø  Prepare Common Size Statements
Ø  Understand the tools of Financial Analysis.

SALIENT POINTS:-
·       Analysis of Financial statement is the systematic process of identifying the financial strength and weaknesses of the firm by establishing the relationship between the items of the Balance Sheet and income statement.
·       The information available from the Analysis, serves the interest of different sections like Management, shareholders, workers, creditors, government, Potential Investors, Economist and Researchers and Stock Exchange.
·       Financial analysis can be External Analysis and Internal Analysis, Horizontal analysis and Vertical Analysis.
·       External Analysis: when analysis is made on the basis of Published statements, reports and information then this is known as External analysis.
·       Internal Analysis: This analysis is based upon the information available to the business only.
·       Horizontal Analysis: This analysis is based on the financial statements of different years of the same business unit or financial statements of a particular year of different business units.
·       Vertical Analysis: According to this analysis financial statement of the same period or different items of the same financial statements are compared.
·       Comparative statements, Common Size statements, Trend Analysis, Ratio Analysis, Fund Flow Statement, Cash flow statement are the Tools of financial statement analysis.
·       Comparative Statements: it helps in ascertaining change in the items of income statement and Position Statement of different years in terms of figures and percentage.
1.     Comparative Income statement:(4 Marks)
 Particular P.Y amount C.Y. amount Change in amount Change in Percentage Gross sales Less:    Sales return Xxx xxx Xxx Xxx C.Y –P.Y. C.Y-P.Y   X 100   P.Y. Net Sales Less:      C.O.G.S. Xxx xxx Xxx Xxx do do Gross Profit Less:        Indirect Expenses/       Operating expense Xxx xxx Xxx xxx do do Operating Profit Add:     Non-operating income Less:  non-operating expenses Xxx Xxx xxx Xxx Xxx xxx do do Profit before tax Less: tax Xxx xxx Xxx xxx do do Profit after tax xxx xxx do do

2. Comparative Balance Sheet: - (4 Marks)

 Particular P.Y. amount C.Y. Amount Change in amount Change in Percentage 1. Share Capital xxx Xxx C.Y –P.Y C.Y-P.Y   X 100   P.Y. 2. Reserve and surplus Xxx xxx do do 3.Secured loan Xxx xxx do do 4. Unsecured Loan Xxx Xxx do do 5. Current liabilities & Provision Xxx Xxx do do Total Xxx Xxx C.Y –P.Y C.Y-P.Y   X 100   P.Y. 1. Fixed Assets Xxx Xxx do do 2. Investments Xxx Xxx do do 3. Current assets and Loans & Advances Xxx Xxx do do 4. Miscellaneous Expenditure Xxx Xxx do do 5. P&L(Debit balance) Xxx Xxx do do Total xxx Xxx C.Y –P.Y C.Y-P.Y  X 100   P.Y.

·       Common Size Statements: In common size statements every item of the statement is presented in the form of percentage of its important heading i.e  Net Sales( in case of Common Size income Statement) and Total of Assests and Liabilities(in case of Common Size Balance Sheets)

1. Common Size Income statement: (4 Marks)

 Particular P.Y amt. C.Y. amt. Percentage of Net sales in P.Y. Percentage of Net sales in C.Y. Gross sales Less:    Sales return Xxx xxx Xxx Xxx P.Y. Amount      X 100 P.Y. net sales C.Y. Amount   X 100 C.Y. net sales Net Sales Less:      C.O.G.S. Xxx xxx Xxx Xxx 100% P.Y. Amount  X 100 P.Y. net sales 100% C.Y. Amount   X 100 C.Y. net sales Gross Profit Less:    Indirect Expense/   Operating expense Xxx xxx Xxx xxx do do Operating Profit Add:  Non-operating income Less:  non-operating expenses Xxx Xxx xxx Xxx Xxx xxx do do Profit before tax Less: tax Xxx xxx Xxx xxx do do Profit after tax xxx xxx do do

2. Common Size Balance Sheet:- (4 Marks)
 Particular P.Y. amount C.Y. Amount % of total in P.Y. % of total in C.Y. 1. Share Capital xxx Xxx P.Y amount X 100 Total of P.Y. C.Y. amount X 100 Total of C.Y. 2. Reserve and surplus Xxx xxx do do 3.Secured loan Xxx xxx do do 4. Unsecured Loan Xxx Xxx do do 5. Current liabilities & Provision Xxx Xxx do do Total Xxx Xxx 100 % 100% 1. Fixed Assets Xxx Xxx P.Y amount X 100 Total of P.Y. C.Y. amount X 100 Total of C.Y. 2. Investments Xxx Xxx do do 3. Current assets and Loans & Advances Xxx Xxx do do 4. Miscellaneous Expenditure Xxx Xxx do do 5. P&L(Debit balance) Xxx Xxx do do Total xxx Xxx 100% 100%

QUESTIONS 01 MARKS

1.  How will you show the following items in the Balance sheet of a
Company.                                                                                                                    (1)
(i) Calls in Arrears       (ii) Calls in Advance.

Ans (i) Calls in Arrears: It is deducted from the subscribed capital.
(ii) Calls in Advance: It is shown separately under the subscribed
capital.

2.     Under what heads the following items on the Liabilities side of the
Balance sheet of a company will be presented                                                                (1)
(i)              Proposed Dividend.
(ii)            Unclaimed Dividend.
Ans:

Proposed dividend          Current Liabilities                   Provisions
&
Provisions

Unclaimed dividend          Current Liabilities        Current Liabilities
&
Provisions

3. State any two items which are shown under the head ‘Investment’
in a company balance sheet.                                                                                          (1)
Ans. (i) Government Securities.
(ii) Sinking Fund Investment.
4.  List any two information required to be given in the balance sheet
of a company or by way of foot Notes.                                                                          (1)
Ans.  (i) Uncalled Liability on share partly paid up .
(ii) Arrears of fixed Cumulative Dividend.

5. Which part of Schedule VI to the Companies Act.1956 prescribes   the forms of the balance sheet ?                                                                                                                         (1)
Ans. Part I of Schedule VI to the Companies Act.1956.

6. How is analysis of Financial statements suffered from the limitation  of window     dressing ?                                                                                                                             (1)
Ans. Analysis of financial statements is affected from the limitation of window dressing as companies hide some vital information or   show items at incorrect value to portray better profitability and financial Position of the business, for example the company may            overvalue closing stock to show higher profits.

7. What is the interest of Shareholders in the analysis of Financial Statements?             (1)

Ans. (i) They want to judge the present and future earning capacity of  the business.
(ii) They want to judge the safety of their investment.

8. Name two tools of Financial Analysis?                                                                           (1)
Ans. (i) Comparative Financial Statements.
(ii) Ratio Analysis etc.
9. What is Horizontal Analysis?                                                                                          (1)
Ans: The analysis which is made to review and compare the financial  statements of two or more then two Years is called Horizontal Analysis.
10. Give the example of Horizontal Analysis.                                                                     (1)
Ans. Comparative Financial Statement.

11.   What is Vertical Analysis?                                                                                           (1)
Ans:11  The Analysis which is made to review the financial statements  of one particular year only is called Vertical Analysis.

12. Give the example of Vertical Analysis?                                                                        (1)
Ans. Ratio Analysis.

QUESTIONS 03 MARKS

1. Give the format of the Balance sheet of a company (main headings only) as per the requirement of  Schedule VI of the companies Act.1956.

Liabilities                         Rs.                     Assets                     Rs.

1.  Share capital                                         1.Fixed Assets
2.Reserve & surplus                                  2.Investment
3.Secured Loans                                        3. Current Assets,
(a) Current Assets
5.Current Liabilities & Provision                4. Miscellaneous
Expenditure
(a)   Current Liabilities                              5.  P &L A/c (Dr. Balance)
(b)  Provision
[
2. Give the heading under which the following items will be shown in
a company’s Balance sheet:
(i)              Goodwill.
(ii)            Preliminary Expenses
(iii)          Loose Tools
(iv)          Capital Redemption Resave.
(v)            Live Stock.
(vi)          Patent

Ans  (i) Fixed Assets.
(ii) Miscellaneous Expenditures
(iii)Current Assets Loans & Advance under Current Assets.
(iv)Reserve and Surplus.
(v)Fixed Assets.
(vi)Fixed Assets

3. The following balance have been from the book of Sahara Ltd.  Share capital Rs.10,00,000, securities Premium Rs. 1,00,000, 9%   Debentures Rs. 500,000, Creditors Rs. 200,000., Proposed Dividend  Rs. 50,000. , Freehold property RS. 9,00,000, share of Reliance
Industries Rs. 4,50,000, Work-in- Progress Rs. 4,00,000, Discount  on Issue of debentures Rs. 1,00,000. Prepare the balance sheet of    the company as per schedule VI part 1 of the companies Act.1956.

Ans.
BALANCE SHEET of Sahara Ltd.
(as on___________)
As per Schedule VI Part I of Company Act, 1956

 Liabilities Amount (Rs.) Assets Amount (Rs.) 1. Share Capital 2. Reserve & Surplus: Securities Premium 3. Secured Loan: 9% Debentures 4. Unsecured Loan: 5. Current Liabilities & Provisions: A. Current Liabilities: Creditors B. Provisions: Proposed Dividend 10,00,000 1,00,000 5,00,000 2,00,000 50,000 1. Fixed Assets: Freehold property 2. Investment: share of Reliance Industries 3. Current Assets, Loans & Advances: A. Current Assets: Work-in- Progress B. Loans & Advances: 4. Miscellaneous Expenditure: Discount on Issue of Debentures 5. P&L A/c(Dr. Balance) 9,00,000 4,50,000 4,00,000 ---------- 1,00,000 ------------- Total 18,50,000 18,50,000

4.  List any three items that can be shown as contingent Liabilities in a company’s Balance sheet.
Ans:  (i) Claims against the Company not acknowledged as debts.
(ii) Uncalled Liability on partly paid shares.
(iii)Arrears of Dividend on Cumulative preference shares.

5.  How is a Company’s balance sheet different from that of a Partnership firm? Give Two point only
Ans. (i) For company’s Balance Sheet there are two standard forms  prescribed under the companies Act.1956 .Whereas, there is no standard form prescribed under the Indian partnership Act,1932 for a partnership Firms balance sheet.
(ii) In case of a company’s Balance sheet previous year’s figures  are required to be given whereas it is not so in the case of a   partnership firms balance sheet.

QUESTIONS 04 MARKS

1. Prepare Comparative and Common Size income statement from   the following information for the year’s ended march 31, 2008 and 2009.

 Particulars 2008(Rs.) 2009(Rs.) 1.Net Sales 2.Cost of Goods Sold 3.Indirect Expenses 4.Income Tax rate 8,00,000 60% of sales 10% of Gross profit 50% 10,00,000 60% of sales 10% of Gross Profit 60%
Ans.1.a
Comparative Income statement:
 Particular 2008 amount 2009 amount Change in amount Change in Percentage Net Sales Less:   C.O.G.S. 8,00,000 4,80,000 10,00,000   6,00,000 2,00,000 1,20,000 25% 25% Gross Profit Less: Indirect Expenses 3,20,000    32,000 4,00,000     40,000 80,000     8,000 25% 25% Operating Profit/ PBT Less: tax 2,88,000 1,44,000 3,60,000  2,16,000 72,000  72,000 25% 50% Profit after tax 1,44,.000 1,44,000 ---------- ------------

Common Size Income statement

 Particular 2008 amount 2009 amount Percentage of Net sales in P.Y. Percentage of Net sales in C.Y. Net Sales Less:   C.O.G.S. 8,00,000 4,80,000 10,00,000   6,00,000 100% 60% 100% 60% Gross Profit Less: Indirect Expenses 3,20,000    32,000 4,00,000     40,000 40% 4% 40% 4% Operating Profit/ PBT Less: tax 2,88,000 1,44,000 3,60,000  2,16,000 36% 18% 36% 21.6% Profit after tax 1,44,.000 1,44,000 18% 14.4%

RATIO AND ANALYSIS

Learning outcomes:
·       Explain the meaning of accounting ratios.
·       Understand the objectives and limitation of accounting ratios.
·       Classify the ratios as profitability, activity and solvency.
·       Compute various profitability, activity and solvency ratios.
·       Express your views about the operational efficiency and financial soundness of the company.
·       Comment upon the performance of the enterprise.
·       Recommend financial measures to be adopted to strengthen financial structure of the company

IMPORTANT FORMULAE OF RATIO ANALYSIS

Profitability ratio
1.     Gross Profit Ratio = Gross profit/Net sales*100      {gross profit=Net sales- cost of goods sold}
2.     (a) Net profit ratio= Net Profit/Net sales*100      {Net Profit=Gross profit+operating and non operating income-operating and non operating expenses.}
(b)Operating Net profit ratio =Operating Net profit/Net sales*10
 3 Operating Ratio= (Cost of goods sold + Operating expenses)  x 100 Net Sales 4 Return on investment ( ROI)= Net Profit before interest,tax and dividend  X  100 Capital Employed Capital employed= Share Capital+Undistributed profit+long term loans- (fictitious assets like underwriting commission, preliminary expenses, discount or loss on issue of shares and non-operating assets like Investments). or Net fixed assets+Working capital working capital= Current assets-current liabilities. 5 Earning per share= Net Profit-Preference dividend No.of Equity shares 6 Dividend per share=Net Profit after interest, taxes and preference dividend Number of equity shares 7 Price Earning Ratio=Market price of a share Earning per share

 (B) TURNOVER OR ACTIVITY OR PERFORMANCE RATIOS: 1 Working capital turnover ratio=Net Sales working capital Working Capital= Current assets- current Liabilities 3 Debtors turnover ratio= Net credit sales Average Debtors Average Debtors=Debtorsin the beginning+Debtors at the end 2 Receivables= Debtors+Bills receivable 4 Payable turnover ratio= Net credit purchases Account Payable 5 Fixed Assets Turnover ratio= Sales or cost of goods sold Net fixed assets 6 Current  assets Turnover Ratio=Net sales or cost of goods sold current Assets LIQUIDITY RATIOS: 1 Current ratio= current Assets current liabilities 2 Liquid or quick or acid test ratio= liquid assets current liabilities Solvency ratios 1 Debt to equity ratio= Long term loans Shareholder's funds 2 Total assets to debt ratio= Total assets Long term debts 3 Proprietary ratio= Proprietors fund or shareholders fund Total Assets 4 Current asset turnover ratio= Net sales/cost of goods sold current assets 5 Fixed assets turnover ratio= Net sales Net fixed assets

Ratio Analysis

Questions for 1 mark
1)     X Ltd has a debt Equity Ratio at 3:1. According to the Management, it should be maintained at 1;1. What are the two choices to do so ?
Ans : The Two choices to maintain Debt Equity ratio at 1:1 are:
a)     To increase the Equity
b)     To reduce the debt

2)     Assuming that the Debt equity ratio is 1:2, state giving reason whether the ratio will improve, decline or will have no change if equity shares are issued for cash.
Ans It will decrease the ratio as Equity increases without change in the debt.

3) State the satisfactory ratio of Current ratio and Liquid Ratio
Ans The Standard Current ratio is 2:1 whereas Ideal Liquid ratio is 1:1.
4) Current ratio of a firm is 2:1. State whether ‘Purchase of goods for  cash” will improve, decrease or will not have any change in the ratio
Ans. It will not change the ratio as stock increases and cash decreases.
5)  Define “ratio Analysis”
Ans  Ratio Analysis refers to the process of computing, determining and explaining the relationship between the component items of financial statements in terms of ratios.

2-3 MKS
6) A company has a current ratio of 4:1 and Quick ratio is 2.5;1. Assuming that the inventories are Rs 22500, find out total current assets and current liabilities.
Ans   Current ratio ---4:1
Quick ratio ---2.5:1
Inventory =4-2.5=1.5
If inventory is 1.5, then Current assets =4
If inventory = 22500, then current assets = 4X 22500/1.5 =60,000
Current Liabilities = 60,000/4 = Rs  15000.
7) From the following, calculate stock turnover ratio—
Net Sales –Rs 2,00,000           Gross Profit = 25%              Opening stock = 5000
Closing stock : 15000
Ans – Stock Turnover ratio = Cost of goods sold/Average stock
Cost of sales= sales-gross profit
Cost of sales = 2,00,000 – 50,000 = 1,50,000
Average stock = Opening stock + closing stock   =     20,000/2 =10,000
2
1,50,000/10,000 = 15 times.
8) Calculate Gross profit and sales—
Average stock = Rs 80,000
Stock turnover ratio =  6 times
Selling price = 25% above cost
Ans. Stock Turnover ratio = cost of sales/average stock
6 = cost of sales/80,000
Cost of sales = 80,000X 6 = 4,80,000
Gross profit = 4,80,000 X 25/100 = 1,20,000
Sales = Cost of sales + Gross Profit
4,80,000 + 1,20,000 = Rs 6,00,000
9)  A  Company made credit sales of Rs 7,20,000 during the year. If the collection period is 50 days and the year is assumed to be of 360 days. Calculate –
a) Average Debtors  b) Debtors Turnover ratio c)Opening and Closing Debtors if the closing Debtors are Rs 10,000 more than the opening Debtors.
Ans   Credit sales per day = 7,20,000/360 = Rs 2000 per day.
Average Debtors = 2000 X 50 days = Rs 1,00,000
Debtors Turnover ratio = Net credit sales/Average Debtors
= 7,20,000/1,00,000 = 7.2 times.
Let the Opening Debtors be “x”
Closing Debtors = “x + 10,000”
Total Debtors = x + x + 10,000 = 2,00,000
= 2x+ 10,000 = 2,00,000
= 2x = 1,90,000
x = 95,000 ( Opening Debtors = 95000)
Closing Debtors = 95000 + 10000 = Rs 1,05,000

10) Calculate Operating ratio—                                       Rs
Net Sales =                                                            5,40,000
Net Purchases                                                        3,10,000
Opening Stock                                                          75,000
Direct expenses                                                        32,000
Closing Stock                                                           50,000
Selling expenses                                                       25,000
Distribution expenses                                               15,000

Operating ratio =  Cost of sales +Operating expenses/Net sales *100
Cost of sales = Opening stock + Net purchases + direct expenses-closing stock
= 75000+3,10,000+32,000-50,000 = 3,67,000
Operating expenses = Selling expenses + Distribution expenses
= 25000+15000 = 40,000
Operating ratio = 3,67,000+40,000/5,40,000 X 100 = 75.37%

11)  Net profit after Interest but before tax Rs 1,40,000
15% Long term debt : Rs 4,00,000
Shareholders fund : Rs 2,40,000
Tax rate : 50%  , Calculate Return on capital employed.
Return on capital employed = Net profit before interest and tax/Capital employed X 100
Interest on long term debt = 15/100 X 4,00,000
= 60,000
Net Profit before Interest = 1,40,000 + 60,000 = 2,00,000
Capital employed = Debt + Shareholders fund
= 4,00,000 + 2,40,000 = 6,40,000
Return on Capital employed = 2,00,000/6,40,000 X 100 = 31.25%
12) Calculate Inventory Turnover Ratio—
Sales = Rs 4,00,000      Average stock – Rs 55,000      Gross Loss ratio =10%
Inventory Turnover ratio = Cost of sales/Average stock
=4,40,000/55000 = 8 times .
13) Calculate Fixed Assets turnover ratio-
Cost of goods sold : Rs 16,80,000
Gross profit = Rs 5,60,000
Capital employed = Rs43,00,000
Working capital = Rs 80,000
Fixed assets turnover ratio = Net sales/ Net fixed assets
Net sales = Cost of goods sold + Gross profit
= 16,80,000 + 5,60,000
= 22,40,000
Capital employed = Net fixed assets + Net working Capital
4,00,000   = Net Fixed assets + 80,000
Net Fixed assets = 3,20,000
Fixed assets turnover ratio = 22,40,000/3,20,000 = 7 times

14) Calculate Current Asset Turnover ratio if –
Cost of goods sold = Rs 7,50,000
Gross profit = Rs 2,10,000
Total Assets = Rs 3,00,00
Capital employed = Rs 3,00,000
Working capital : Rs 60,000

Current Assets Turnover ratio = Net Sales/ Net Current assets
Net sales = Cost of sales + Gross Profit
= 7,50,000 + 2,10,000
= 9,60,000
Capital Employed  = Net Fixed +Net Working Capital
Net Fixed Assets = Capital employed – Net working Capital
= 3,00,000 – 60,000
= 2,40,000.
Total Assets = Rs 3,00,000
Current Assets = Total assets – Fixed assets
= 3,00,000 – 2,40,000
= 60,000
Current Assets turnover ratio = Net Sales/Net current Assets
= 9,60,000/60,000 = 16 times.

15) From the following information calculate =
a) Debt equity ratio          b) Total Assets to Debt ratio        c)  Proprietary ratio

Equity share capital = Rs 20,00,000
Reserves and Surplus = Rs 12,00,000
12% Debentures = Rs 10,00,000
Bank Loan  = Rs 8,00,000
Current Liabilities = Rs 5,00,000
Fixed Assets = Rs 25,00,000
Goodwill = Rs 4,00,000
Current Assets = Rs 18,00,000

a)     Debt Equity Ratio = Debt/Equity
Debt = 12% Debentures + Bank Loan
= 10,00,000 + 8,00,000
= 18,00,000
Equity = Equity share capital + Reserves and Surplus
= 20,00,000+12,00,000
= Rs 32,00,000
Debt / Equity = 18,00,000/32,00,000 = 0.56:1
b)     Total Assets to Debt ratio = Total Assets/Long term Debt
Total Assets = Fixed assets + Goodwill + Current assets
= 25,00,000 + 4,00,000 + 18,00,000
=Rs 47,00,000
Long Term Debt = 12% Debentures + Bank Loan
= 18,00,000
Total Assets to Debt Ratio = 47,00,000/18,00,000 = 2.6:1

c)     Proprietory Ratio = Equity/Total Assets

=  32,00,000/47,00,000 = 0.68 or 68%