Financial Statements are written records of a company that shows, its financial status on a particular date and for a financial year. It conveys financial performance of the company. Generally, in India Financial Year is a period starting from 1st April and end 31st March next year. A company has to prepare its financial statements according to the provisions of the Companies Act, 2013 as well as keeping provisions of the Income Tax Act, 1961. The legislature has prescribed format of financial statements for each type of companies.
Financial Statements of a company conveys pictures of the performance, capital position, cash flows and results of business during a particular time period.
These financial statements generally used by various stakeholders such as investors, government, exchequer, shareholders and even employees of the company.
Financial statements are a collection of summary-level reports about an organization’s financial results, financial position, and cash flows.
They are useful for the following reasons:
i) To determine the ability of a business to generate cash, and the sources and uses of that cash.
ii) To determine whether a business has the capability to pay back its debts.
iii) To track financial results on a trend line to spot any looming profitability
iv) To derive financial ratios from the statements that can indicate the condition of the business.
v) To investigate the details of certain business transactions, as outlined in the disclosures that accompany the statements.
Items Included in the Financial Statements
The standard contents of a set of financial statements are:
i) Balance sheet. Shows the entity’s assets, liabilities, and stockholders’ equity as of the report date. It does not show information that covers a span of time.
ii) Income statement. Shows the results of the entity’s operations and financial activities for the reporting period. It includes revenues, expenses, gains, and losses.
iii) Statement of cash flows. Shows changes in the entity’s cash flows during the reporting period.
iv) Supplementary notes. Includes explanations of various activities, additional detail on some accounts, and other items as mandated by the applicable accounting framework, such as GAAP or IFRS.
Since these Financial Statements are required to be prepared and submitted with the authorities within a period of 6(six) months from end of financial year they related. In this case the date received by various stakeholders through these Financial Statements are 6(six) months older the date on which they finalised.
These financial statements are so complex i.e. why not understandable by common person or a person not having financial knowledge. But it plays very important role for stakeholders to take appropriate decision related to company.
We need some quick data and some equation to quickly understand these financial statements. We need Ratio Analysis because it is concerned with the calculation of relationship, which after proper identification & interpretation may provide information about the operations and state of affairs of a business enterprise.
This Ratio Analysis reduces guesswork on financial soundness and performance of a company and provide a sound basis for judgement status of company on a particular date.
TYPES OF RATIOS
1. LIQUIDITY MEASUREMENT –
a) Current Ratio;
b) Quick Ratio.
2. PROFITABLITY INDICATORS-
a) Profit Margin Analysis Ratio;
b) Return on Assets Ratio;
c) Return on Equity Ratio;
d) Return on Capital Employed Ratio.
3. FINANCIAL LEVERAGE /GEARING
a) Equity Ratio;
b) Debt Ratio;
c) Debt-Equity Ratio;
d) Capitalisation Ratio;
e) Interest Coverage Ratio.
4. OPERATING PERFORMANCE
a) Fixed Assets Turnover Ratio;
b) Sale/Revenue Ratio;
c) Average Collection Period Ratio;
d) Inventory Turnover Ratio;
e) Total Assets Turnover Ratio.
5. INVESTMENT VALUATION
a) Price/Earnings Ratio;
b) Price/Earnings to Growth Ratio;
c) Price to Sales Ratio;
d) Price to Book Value Ratio.
LET’S US DISCUSS SOME IMPORTANT RATIOS
1. LIQUIDITY MEASUREMENT RATIOS Liquidity means the ability of firm to meet its short-term financial obligations when and as they fall due. The greater the overage of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming dur in the near future and still fund its ongoing operations. If lower coverage shows that the entity is struggling to fulfil its short-term financial commitments and it is a red-flag to the investors of the company.
a) CURRENT ASSTE/CURRENT LIABILITIES –
Current Assets: =Cash+ Marketable Securities + Accounts Receivables + Inventories
Current Liabilities = Accounts Payable + Short Term Notes Payable + Short Terms Loans+ Current Maturities of Long-Term debts+ Accrued Income Tax + Other Accrued Expenses.
The ratio show number to times short term asset covers its short-term liabilities. It means higher the ratios indicate that entity is able to pay its short-term debts and expenses of its ongoing transactions easily. But very high ratio also suggest that company is not able to utilise its resources properly.
2:1 is the ideal Current Ratio.
b) QUICK RATIO/ACID TEST RATIO-
[Cash + Cash Equivalents + Short Term Investments + Accounts Receivables]/Current Liabilities
In this ratio we generally consider most liquid assets or asset that can be converted into cash within a short period of time. Generally, Inventories and Other Current Assets do not include, while calculating this ratio.
Please note that if Current Ratio is greater than Quick Ratio, then it indicates that the company’s current asset is dependent of inventory and this is a not good indication of soundness of company. It means that company is slow in converting its inventory into finished goods and finally we can say that into cash and cash equivalents.
1:1 Quick Ratio is ideal one.
2. PROFITABILITY INDICATORS RATIOS; the overall measure of success of a business is the profitability which results from the effective use of resources. Profitability for a company is its ability to earn profit during a given period of time. The profitability ratios show the combined effect of liquidity, asset management, use of resources by the company for earning profit.
a) GROSS PROFIT MARGIN RATIO= [GROSS PROFIT/NET SALES] *100 this ratio is used to analyse how efficiently a company is using its raw material, labour and manufacturing related fixed asset to generate profit.
Note: Higher the ratio, the higher is the profit earned on sales.
b) OPERATING PROFIT MARGIN RATIO= [ OPERATING PROFIT/NET SALES] *100
OPERATING INCOME= GROSS PROFIT- Selling, General & Administrative Expenses.
Note: Lower the ratio, lower the expense related to sales.
c) NET PROFIT MARGIN RATIO= [NET PROFIT/NET SALES] *100
Note: Higher Profit Ration means more profitable is the sales.
d) RETURN ON EQUITY RATIO= [ NET INCOME/AVERAGE SHAREHOLDERS EQYUITY] *100 It measures how much the shareholders earned for their investment in the company.
Note: Higher Percentage indicates the management is utilizing its equity base and the better return is to investor.
e) RETURN ON CAPITAL EPMLOYED RATIO= [NET INCOME/CAPITAL EMPLOYED]
Capital Employed= Average Debt Liabilities + Average Shareholders’ Equity
This ratio complements the return on equity ratio by adding a company’s debt liabilities, or funded debt to equity to reflect a company’s total “Capital Employed”. This measure narrows the focus to gain a better understanding of a company’s ability to generate returns from its available capital base.
Note: it is a more comprehensive profitability indicator because it gauges management’s ability to generate earnings from a company’s total pool of capital.
3. FINANCIAL LEVERAGE/GEARING RATIO;
These ratios indicate the degree to which the activities of a firm are supported by creditors’ funds as opposed to owners as the relationship of owner’s equity to borrowed funds is an important indicator of financial strength. The debts require fixed payment of interest as well as principal amount and legal action may be taken in case of default, which bent the image and financial strength of a company.
Financial Leverage will be to the advantage of the ordinary shareholders as long as the rate of earning on Capital Employed is greater than the rate on borrowed funds.
a) EQUITY RATIO= [ ORDINARY SHAREHOLDERS’ INTEREST/TOTAL ASSETS] *100 This measures the strength of the Financial Structure of the Company.
Note: a high ratio indicates a strong financial structure of the company. Relatively low equity ratio reflects a more speculative situation because of the effect of high leverage and the greater possibility of financial difficulty arising from excessive debt burden. Low ratio means the company is running on external debts rather than investment from shareholders.
b) DEBT-EQUITY RATIO= [ TOTAL LIABILITIES/TOTAL EQUITY]
This ratio measures how much suppliers, lenders creditors and obligers have committed to the company versus what the shareholder have committed. This ratio indicates the extent to which debt is covered by shareholder’s funds.
Note: a lower ratio is always safer. But a too lower ratio suggests that there is inefficiency in utilisation of shareholder’s funds. The higher ratio indicates that the company is running on external debts rather on shareholders’ fund.
c) CAPITALISATION RATIO= [ LONG TERM DEBT/ (LONG TERM DEBT+ SHAREHOLDER’S EQUITY)]
This ratio measures the debt component of a company’s capital structure of capitalisation to support a company’s operations and growth.
Note: We know that a low level of debt and sizable proportion of equity in the capital structure of a company is an indication of financial fitness of the company. A high level of external debt poses always restriction on progress of a company. It is better to have low level of external debt for better performance of a company.
d) INTEREST COVERAGE RATIO= [EBIT/INTEREST ON LONG TERM DEBT]
This ratio indicates the number of times a company meets its interest expense liability.
Note: lower the ratio means there is danger in performance of company and may be future company will not able to serve its interest liabilities.
4. OPERATING PERFORMANCE RATIOS; These ratios indicate how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash, i.e. how efficiently and effectively a company is using its resources to generate sales and increase shareholder value.
a) FIXED ASSETS TRUNOVER RATIO= [ SALES/NET FIXED ASSETS]
It measures productivity of a company’s fixed asset with respect to generating sales.
Note: generally higher ratio preferred because it indicates a better utilisation of fixed assets in generation of sales.
b) INVENTORY TURNOVER RATIO= [ SALES/AVERAGE INVENTORY]
It indicates efficiency of a company in selling its products. It measures the stock in relation to turnover in order to determine how often the stock turns over in the business.
Note: High ratio indicates that there is a little chance of the firm holding damaged or obsolete stock.
c) TOTAL ASSETS TURNOVER RATIO= [ SALES /TOTAL ASSETS]
This indicates the efficiency with which a firm utilises its all assets to generate sales.
Note: higher ratio indicates the company is utilising its assets more efficiently for generation of sales.
5. INVESTMENT VALUATION RATIOS;
Valuation is a quantitative process that determines the fair value of an asset or a firm. A company can be evaluated on an absolute basis on its own or a relative basis by comparing it to competitors. There are several methods and techniques to arrive at a valuation value and the most commonly used among them are ratios.
Investment valuation ratios highlight the relationship of a company or its equity’s market value with some fundamental financial metrics, such as earnings. Valuation ratios show the price you pay for some financial metrics such as earning streams, cash flow, and revenues.
Now we know that valuation is a financial process that determines a company’s worth, and that investment valuation ratios provide that insight into the context of the company’s financial share price, thus serving as a tool for evaluating investment potential.
a) PRICE TO EARNINGS RATIO
Price to Earnings (P/E) ratio, also known as price multiple or earnings multiple, is a valuing ratio that measures the firm’s current share price relative to its per-share earnings. It is employed by investors to determine the value of a firm’s share with an apple to apple comparison.
Note: If the P/E ratio is large, it indicates that investors expect earnings to increase in the future hence the company’s stock is overvalued. On the contrary, a low P/E ratio indicates that the current earnings are high compared with the current share price therefore the stock could be considered as undervalued. It is worth noting that a company without earnings or making a loss doesn’t have a P/E ratio, as there is nothing for the denominator.
P/E RATIO = MARKET VALUE PER SHARE/ EARNINGS PER SHARE
b) PRICE/EARNINGS TO GROWTH RATIO
PEG ratio is derived by dividing a stock’s price to earnings ratio to the growth rate of its earnings for a specific period. Thus, PEG enhances the P/E ratio by adding the expected growth earnings factor into the calculations. Like P/E ratio PEG is also used to determine the actual stock’s value.
Note: A lower PEG indicates that the company is undervalued. Keep in mind that one reported source’s PEG value can be highly differentiated from others as it depends on the growth estimate employed in calculation.
PEG RATIO = (PRICE/ EARNINGS PER SHARE) / EARNINGS PER SHARE GROWTH
c) PRICE TO SALES RATIO
Price to sales ratio, also known as a sales multiple or revenue multiple, is a valuation ratio that compares a company’s stock value to its revenues. It is an analysis and valuation tool that shows how much a person can willingly spend per rupee sale of a company’s stock.
The ratio is either derived by dividing a company’s market capitalization to the total sales within a specific time or by dividing stock price to the sales per share on a per-share basis.
Note: A lower ratio implies that stocks are undervalued and vice versa. One drawback of this ratio is that it doesn’t give any indication of whether the company is actually making earnings.
PRICE TO SALES RATIO= MARKET VALUE PER SHARE/ SALES PER SHARE
PRICE TO SALES RATIO = MARKET CAPITALIZATION / SALES
d) PRICE TO BOOK VALUE RATIO
This ratio compares the company’s stock price or market value to the book value per share. In contrast, book value is the net asset value of any company in the intangible assets and liabilities.
The ratio shows the amount that shareholders are paying for the net assets of any company. Remember that market value is generally higher than the book value.
Note: A p/b ratio of 1 is considered as a stable ratio.
P/B RATIO = MARKET PRICE PER SHARE/ BOOK VALUE PER SHARE.
Book value per share = (Total Common Shareholders Equity – Preferred Stock) /Common Shares
CONCLUSION: An investor should invest into any company after analysing financial statement of company. The financial statements of a company consist of various types of reports as prescribed by the legislature based on financial performance of the company during a particular period. It shows financial performance and profitability of company and its statement of assets and liabilities on a particular date. Generally, it is difficult for an investor to understand financial statement of a company. For better understanding of a financial statements, we can use ration analysis. Ratios provides us sound judgment on financial position of a company. Ratios are indicator of financial performance of company and indicates current and strength of company to carry on its business and projects. A good financial ratio indicates that company is earing profit and increasing shareholder’s capital.
Disclaimer: The entire contents of this document have been prepared on the basis of relevant provisions and as per the information existing at the time of the preparation. Although care has been taken to ensure the accuracy, completeness, and reliability of the information provided, author assume no responsibility, therefore. Users of this information are expected to refer to the relevant existing provisions of applicable Laws and take appropriate advice of consultants. The user of the information agrees that the information is not professional advice and is subject to change without notice. Author assume no responsibility for the consequences of the use of such information.