Description
Comprehensive list of all Financial Ratios.Useful for Students,Aspirants and Business Professionals.
STUDY. LEARN. SHARE. FINANCIAL RATIOS GLOSSARY
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Important types of ratios and their significance: ? Liquidity ratios ? Turnover ratios ? Profitability ratios ? Investment on capital/return ratios ? Leverage ratios ? Coverage ratios Liquidity ratios: o Current ratio: Formula = Current assets/Current liabilities. Min. Expected even for a new unit in India = 1.33:1. Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital. Range – No fixed range is possible. Unless the activity is very profitable and there are no immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see “quick asset ratio” or “acid test ratio”.
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o Acid test ratio or quick asset ratio: Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This assumes that all other current assets like receivables can be converted into cash easily. This ratio examines whether the quick assets are sufficient to cover all the current liabilities. Some of the authors indicate that the entire current liabilities should not be considered for this purpose and only quick liabilities should be considered by deducting from the current liabilities the short-term bank borrowing, as usually for an on going company, there is no need to pay back this amount, unlike the other current liabilities. Significance = coverage of current liabilities by quick assets. As quick assets are a part of current assets, this ratio would obviously be less than current ratio. This directly indicates the degree of excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost associated with high level of liquidity could also be high. What is working capital gap? The difference between all the current assets known as “Gross working capital” and all the current liabilities other than “bank borrowing”. This gap is met from one of the two sources, namely, net working capital and bank borrowing. Net working capital is hence defined as medium and long-term funds invested in current assets. Turn over ratios: Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system. o Debtors turn over ratio – this indicates the efficiency of collection of receivables and contributes to the liquidity of the system. Formula = Total credit sales/Average debtors
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outstanding during the year. Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of industry like capital goods, consumer goods – capital goods, this would be less and consumer goods, this would be significantly higher; Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and competitive it would be less as you are forced to give credit; Whether new enterprise or established – new enterprise would be required to give higher credit in the initial stages while an existing business would have a more fixed credit policy evolved over the years of business; Hence any deterioration over a period of time assumes significance for an existing business – this indicates change in the market conditions to the business and this could happen due to general recession in the economy or the industry specifically due to very high capacity or could be this unit employs outmoded technology, which is forcing them to dump stocks on its distributors and hence realisation is coming in late etc. Average collection period = inversely related to debtors turn over ratio. For example debtors turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90 days. In case the debtors turn over ratio increases, the average collection period would reduce, indicating improvement in liquidity. Formula for average collection period = 360/receivables turn over ratio. The above points for debtors turn over ratio hold good for this also. Any significant deviation from the past trend is of greater significance here than the absolute numbers. No minimum and no maximum. o Inventory turn over ratio – as said earlier, this directly contributes to the profitability of the organisation. Formula = Cost of goods sold/Average inventory held during the year. The inventory should turn over at least 4 times in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle and in such cases, the ratio would be low. While receivables turn over contributes to liquidity, this contributes to profitability due to higher turn over. The production cycle and the corporate policy of keeping high stocks affect this ratio. The less the production cycle,
o
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the better the ratio and vice-versa. The higher the level of stocks, the lower would be the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges. o Current assets turn over ratio – not much of significance as the entire current assets are involved. However, this could indicate deterioration or improvement over a period of time. Indicates operating efficiency. Formula = Cost of goods sold/Average current assets held in business during the year. There is no min. Or maximum. Again this depends upon the type of industry, market conditions, management’s policy towards working capital etc. o Fixed assets turn over ratio Not much of significance as fixed assets cannot contribute directly either to liquidity or profitability. This is used as a very broad parameter to compare two units in the same industry and especially when the scales of operations are quite significant. Formula = Cost of goods sold/Average value of fixed assets in the period (book value). Profitability ratios -Profit in relation to sales and profit in relation to assets: o Profit in relation to sales – this indicates the margin available on sales; o Profit in relation to assets – this indicates the degree of return on the capital employed in business that means the earning efficiency. Please appreciate that these two are totally different. For example, we will study the following; Units A and B are in the same type of business and operate at the same levels of capacities. Unit A employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and profits are as under: Parameter Sales Unit A 1000lacs Unit B 1000lacs
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Profits Profit margin on sales Return on capital employed
100lacs 10% 40%
90lacs 9% 45%
While Unit A has higher profit margins, Unit B has better returns on capital employed. o Profit margin on sales: Gross profit margin on sales and net profit margin ratio – Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges. Net sales = Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with another unit in the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs. Parameter Sales Cost of production Gross profit Deduct: Selling general, Administrative expenses and interest Net profit 35lacs 5lacs 30lacs 5lacs Unit A 100lacs 60lacs 40lacs Unit B 100lacs 65lacs 35lacs
While both the units have the same net profit to sales ratio, the significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses. This ratio helps in controlling either production costs if cost of production is high or selling and administration costs, in case these are high.
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Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula = Net profit/net sales. Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency. In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well. Investment on capital ratios/Earnings ratios: o Return on net worth Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds including Preference Share capital. Hence Preference Share capital is not deducted. There is no standard range for this ratio. If it reduces it indicates less return on the net worth. o Return on equity Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share capital. Although reference is equity here, all equity shareholders’ funds are taken in the denominator. Hence Preference dividend and Preference share capital are excluded. There is no standard range for this ratio. If it comes down over a period it means that the profitability of the organisation is suffering a setback. o Return on capital employed (pre-tax) Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives return on long-term funds employed in business in pre-tax terms. Again there is no standard range for this ratio. If it reduces, it is a cause for concern. o Earning per share (EPS) Dividend per share (DPS) + Retained earnings per share (REPS). Here the share refers to equity share and not preference share. The formula is = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares. This is an important indicator about the return to equity shareholder. In fact P/E
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ratio is related to this, as P/E ratio is the relationship between “Market value” of the share and the EPS. The higher the PE the stronger is the recommendation to sell the share and the lower the PE, the stronger is the recommendation to buy the share. This is only indicative and by and large followed. There is something known as industry average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and growth prospects are quite good, it is the time for buying the shares, unless we know for certain that the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time for us to sell unless we expect further increase in the near future. Leverage ratios Leverages are of two kinds, operating leverage and financial leverage. However, we are concerned more with financial leverage. Financial leverage is the advantage of debt over equity in a capital structure. Capital structure indicates the relationship between medium and long-term debt on the one hand and equity on the other hand. Equity in the beginning is the equity share capital. Over a period of time it is net worth (-) redeemable preference share capital. It is well known that EPS increases with increased dose of debt capital within the same capital structure. Given the advantage of debt also, as even risk of default, i.e., nonpayment of interest and non-repayment of principal amount increases with increase in debt capital component, the market accepts a maximum of 2:1 at present. It can be less. Formula for debt/equity ratio = Medium and long-term loans + redeemable preference share capital / Net worth (-) Redeemable preference share capital. From the working capital lending banks’ point of view, all liabilities are to be included in debt. Hence all external liabilities including current liabilities are taken into account for this ratio. We have to add redeemable preference share capital and reduce from the net worth the same as in the previous formula.
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Coverage ratios o Interest coverage ratio This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest payment on all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1. Less than that is not desirable, as after paying interest, tax has to be paid and afterwards dividend and dividend tax.
o Asset coverage ratio This indicates the number of times the medium and long-term liabilities are covered by the book value of fixed assets. Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. Accepted ratio is minimum 1.5:1. Less than that indicates inadequate coverage of the liabilities. o Debt Service coverage ratio This indicates the ability of the business enterprise to service its borrowing, especially medium and long-term. Servicing consists of two aspects namely, payment of interest and repayment of principal amount. As interest is paid out of income and booked as an expense, in the formula it gets added back to profit after tax. The assumption here is that dividend is ignored. In case dividend is paid out, the formula gets amended to deduct from PAT dividend paid and dividend tax. Formula is: (Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue Expenditure written off (+) Interest on medium and long-term borrowing (Denominator) Interest on medium and long-term borrowing (+) Installment on medium and long-term borrowing.
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This is assuming that dividend is not paid. In the case of an existing company dividend will have to be paid and hence in the numerator, instead of PAT, retained earnings would appear. The above ratio is calculated for the entire period of the loan with the bank/financial institution. The minimum acceptable average for the entire period is 1.75:1. This means that in one year this could be less but it has to be made up in the other years to get an average of 1.75:1.
What is the objective behind analysis of financial statements? Objective (To know about) 1. Financial position of the company Relevant indicator/Remarks 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 Current ratio and quick ratio or acid test the company is in a position to meet all ratio. Current ratio = Current assets/current its short-term liabilities (also called liabilities. Quick ratio = Current assets (-) “current liabilities”) with the help of its inventory/ current liabilities. Current ratio current assets 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
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better indicator of liquidity position.
3. Whether the company has acquired new Examination of increase in secured or fixed assets during the year and if so, unsecured loans for this purpose. Without what are the sources, besides internal adequate financial planning, there is always accruals to finance the same? 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 Percentage of profit before tax to total and operating profits in particular, i.e., income including other income, like dividend whether the main operations of the or interest income. Operating profit, i.e., company like manufacturing have been profit before tax (-) other income as above in profit or the profit of the company is as a percentage of income from the main derived from other income, i.e., income operations etc. of the company, be it from investment in shares/debentures manufacturing, trading or services.
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5. Relationship between the net worth of Debt/Equity ratio, which establishes this the company and its external liabilities relationship. Formula = External liabilities + (both short-term and long-term). What preference share capital /net worth of the about only medium and long-term company debts? (-) 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 Difference between the market value of the shares/debentures of other companies investments and the purchase price, which is reduced in value in comparison with last theoretically year? 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.
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7. Relationship between average debtors Average (bills payable) during the year.
debtors
in
the
year/average
(bills receivable) and average creditors 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 Directors’ report. into new collaboration agreement, they are coming
This would reveal the out with a public
acquisition of new technology, entering financial plans for the company, like whether diversification programme, expansion issue/Rights issue etc. programme etc.
9. Has the company revalued its fixed Auditors’ comments in the “Notes to assets during the year, thereby creating Accounts” relevant for this. of capital into the company, as this is just an entry passed in the books? Frequent revaluation reserves, without any inflow revaluation is not desirable and healthy.
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10. Whether the company has increased its Increase in amount of investment in investment and if so, what is the source shares/debentures/Govt. securities etc. in for it? What is the nature of investment? comparison Is it in tradable securities or long-term with last year and any investment within group companies? Any
Securities, which can have a lock-in- undue increase in investment should put us period and cannot be liquidated in the on guard, as working capital funds could near future? have been diverted for it.
11. Has the company during the year given Any increase in unsecured loans. If the loans any unsecured loans substantially other are to group companies, then all the more than to employees of the company? reason to be cautious. Hence, where the figures have increased, further probing is called for.
12. Are the company’s unsecured loans Any comments to this effect in the notes to (given) not recoverable and very old? 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 Any comments about over dues as in the payment of its dues on account of loans “Notes to Accounts” should be looked into. or periodic interest on its liabilities? Any serious default is likely to affect the “credit rating” of the company with its lenders, thereby increasing its cost of borrowing in future.
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14. Has the company defaulted in providing Any comments about this in the “Notes to for bonus liability, P.F. liability, E.S.I. Accounts” should be looked into. liability, gratuity liability etc?
15. Whether the company is holding very Cash balance together with bank balance in huge cash, as it is not desirable and current account, if any, is very high in the increases the opportunity cost? current assets.
16. How many times the average inventory Relationship between cost of goods sold and has turned over during the year? 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 Increase in paid-up capital in the balance capital during the period and what is the sheet and share premium reserves in case purpose for which it has raised equity the issue has been at a premium. capital? If it was a public issue, how did it fare in the market?
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18. Has the company issued any bonus Increase in paid-up capital and simultaneous shares during the year? 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 Increase in paid-up capital and share in the period and what is the purpose of premium reserves, in case the issue has been the issue? If it was a public issue, how at a premium. did it fare in the market?
20. What is the proportion of marketable Percentage of marketable investment to investment to total investment and total investment and comparison with whether this has decreased in 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. comparison with the previous year?
21. What is the increase in sales income over Comparison with previous year’s sales last year in % terms? Is it due to increase income and whether the growth has been in numbers or change in product mix or more or less than the estimate. increase in prices of finished products only?
22. What is the amount of provision for bad In percentage terms, how much is it of total and doubtful debts or advances debts outstanding and what are the reasons
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outstanding?
for such provision in the notes to accounts by the auditors?
23. What is the amount of work in progress Is there any comment about valuation of as shown in the Profit and Loss Account? 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 Examination of expenses schedule would lease rentals and if so what is the show this. What is the comment in notes to amount of lease liability outstanding? accounts about this? Lease liability is an offbalance sheet to item and hence the this examination, ascertain 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 Auditors’ depreciation on fixed assets, due to policies. of the company?
comments
on
“Accounting”
Change over from straight-line
which, there is an impact on the profits method to written down value method or vice-versa does affect the deprecation charge for the year thereby affecting the
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profits during the year of change.
26. If it is a manufacturing company, Relationship between materials consumed whether the % of materials consumed is during the year and the sales. increasing in relation to sales?
27. Has the company changed its method of Auditors’ valuation of inventory, due to which policies. there is an impact of the profits of the company?
comments
on
“Accounting”
28. Whether the % of administration and Relationship the year under review?
between
general
and
general expenses has increased during 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 Interest coverage ratio = earnings before income to pay the interest charges? interest and tax/total interest on all shortterm and long-term liabilities. not satisfactory. Minimum should be 3:1 and anything less than this is
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30. Whether the finance charges have gone Relationship between interest charges and up disproportionately as compared with sales income – whether it is consistent with the increase in sales income during the the previous year or is there any spurt? same period? 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 Relationship between “payment to and sales has increased? 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 Relationship relation to sales has gone up?
between
“selling
and Any
marketing” expenses and the sales.
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 Debt service coverage ratio = Internal internal accruals {Profit after tax (-) accruals (+) interest on medium and long-
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dividend (+) any non-cash expenditure term external liabilities/interest on medium like depreciation, preliminary expenses and long-term liabilities (+) repayment of write-off etc.} to meet repayment medium and long-term external liabilities. 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. obligation of principal amount of loans, The term-lending institution or bank looks debentures etc.?
34. Return on investment in business to Earnings before interest and tax/average compare it with return on similar total invested capital, i.e., net worth (+) debt investment elsewhere. 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 Profit after tax (-) dividend on preference surplus) 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? Profit after tax (-) dividend on preference (EPS) 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.
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37. Whether the company has reduced its Relationship between amount of dividend dividend payout in comparison with last payout and profit after tax last year and this year? 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 “Notes on Accounts” as given at the end of contingent liabilities due to any of the the accounts. following? Any substantial increase especially in Disputed central excise duty, customs disputed amount of duties should put us on duty, income tax, octroi, sales tax, guard. 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.
39. Has the company changed its policy of Substantial change in vendor charges, or outsourcing its work from vendors and if subcontracting charges. so, what are the reasons?
40. Is there any substantial increase in Increase in consultancy charges. charges paid to consultants?
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41. Has the company opened any branch Directors’ Report or sudden spurt in general office in the last year? and administration expenses.
The principal tools of analysis are: ? Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play. ? Comparison with past trend within the same company is one type of analysis and comparison with the industrial average is another analysis
Some of the limitations of the financial statements are given below :
? Analysis and understanding of financial statements is only one of the tools in understanding of the company ? The annual statements do have great limitations in their value, as they do not speak about the following? Management, its strength, inadequacy etc. ? Key personnel behind the activity and human resources in the organisation. ? Average key ratios in the industry in the country, of which the company is an integral part. This information has to be obtained separately. ? Balance sheet is as on a particular date and hence it does not indicate about the average for the entire year. Hence it cannot indicate the position with 100% reliability. (Link it with fundamental analysis.)
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? The auditors’ report is based more on information given by the management, company personnel etc. ? To an extent at least, there can be manipulation in the level of expenditure, level of closing stocks and sales income to manipulate profits of the organisation, depending upon the requirement of the management during a particular year. ? One cannot come to know from study of financial statements about the tax planning of the company or the basis on which the company pays tax, as it is not mandatory under the provisions of The Companies’ Act, 1956, to furnish details of tax paid in the annual statement of accounts.
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doc_422136673.pdf
Comprehensive list of all Financial Ratios.Useful for Students,Aspirants and Business Professionals.
STUDY. LEARN. SHARE. FINANCIAL RATIOS GLOSSARY
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Important types of ratios and their significance: ? Liquidity ratios ? Turnover ratios ? Profitability ratios ? Investment on capital/return ratios ? Leverage ratios ? Coverage ratios Liquidity ratios: o Current ratio: Formula = Current assets/Current liabilities. Min. Expected even for a new unit in India = 1.33:1. Significance = Net working capital should always be positive. In short, the higher the net working capital, the greater is the degree of overall short-term liquidity. Means current ratio does indicate liquidity of the enterprise. Too much liquidity is also not good, as opportunity cost is very high of holding such liquidity. This means that we are carrying either cash in large quantities or inventory in large quantities or receivables are getting delayed. All these indicate higher costs. Hence, if you are too liquid, you compromise with profits and if your liquidity is very thin, you run the risk of inadequacy of working capital. Range – No fixed range is possible. Unless the activity is very profitable and there are no immediate means of reinvesting the excess profits in fixed assets, any current ratio above 2.5:1 calls for an examination of the profitability of the operations and the need for high level of current assets. Reason = net working capital could mean that external borrowing is involved in this and hence cost goes up in maintaining the net working capital. It is only a broad indication of the liquidity of the company, as all assets cannot be exchanged for cash easily and hence for a more accurate measure of liquidity, we see “quick asset ratio” or “acid test ratio”.
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o Acid test ratio or quick asset ratio: Quick assets = Current assets (-) Inventories which cannot be easily converted into cash. This assumes that all other current assets like receivables can be converted into cash easily. This ratio examines whether the quick assets are sufficient to cover all the current liabilities. Some of the authors indicate that the entire current liabilities should not be considered for this purpose and only quick liabilities should be considered by deducting from the current liabilities the short-term bank borrowing, as usually for an on going company, there is no need to pay back this amount, unlike the other current liabilities. Significance = coverage of current liabilities by quick assets. As quick assets are a part of current assets, this ratio would obviously be less than current ratio. This directly indicates the degree of excess liquidity or absence of liquidity in the system and hence for proper measure of liquidity, this ratio is preferred. The minimum should be 1:1. This should not be too high as the opportunity cost associated with high level of liquidity could also be high. What is working capital gap? The difference between all the current assets known as “Gross working capital” and all the current liabilities other than “bank borrowing”. This gap is met from one of the two sources, namely, net working capital and bank borrowing. Net working capital is hence defined as medium and long-term funds invested in current assets. Turn over ratios: Generally, turn over ratios indicate the operating efficiency. The higher the ratio, the higher the degree of efficiency and hence these assume significance. Further, depending upon the type of turn over ratio, indication would either be about liquidity or profitability also. For example, inventory or stocks turn over would give us a measure of the profitability of the operations, while receivables turn over ratio would indicate the liquidity in the system. o Debtors turn over ratio – this indicates the efficiency of collection of receivables and contributes to the liquidity of the system. Formula = Total credit sales/Average debtors
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outstanding during the year. Hence the minimum would be 3 to 4 times, but this depends upon so many factors such as, type of industry like capital goods, consumer goods – capital goods, this would be less and consumer goods, this would be significantly higher; Conditions of the market – monopolistic or competitive – monopolistic, this would be higher and competitive it would be less as you are forced to give credit; Whether new enterprise or established – new enterprise would be required to give higher credit in the initial stages while an existing business would have a more fixed credit policy evolved over the years of business; Hence any deterioration over a period of time assumes significance for an existing business – this indicates change in the market conditions to the business and this could happen due to general recession in the economy or the industry specifically due to very high capacity or could be this unit employs outmoded technology, which is forcing them to dump stocks on its distributors and hence realisation is coming in late etc. Average collection period = inversely related to debtors turn over ratio. For example debtors turn over ratio is 4. Then considering 360 days in a year, the average collection period would be 90 days. In case the debtors turn over ratio increases, the average collection period would reduce, indicating improvement in liquidity. Formula for average collection period = 360/receivables turn over ratio. The above points for debtors turn over ratio hold good for this also. Any significant deviation from the past trend is of greater significance here than the absolute numbers. No minimum and no maximum. o Inventory turn over ratio – as said earlier, this directly contributes to the profitability of the organisation. Formula = Cost of goods sold/Average inventory held during the year. The inventory should turn over at least 4 times in a year, even for a capital goods industry. But there are capital goods industries with a very long production cycle and in such cases, the ratio would be low. While receivables turn over contributes to liquidity, this contributes to profitability due to higher turn over. The production cycle and the corporate policy of keeping high stocks affect this ratio. The less the production cycle,
o
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the better the ratio and vice-versa. The higher the level of stocks, the lower would be the ratio and vice-versa. Cost of goods sold = Sales – profit – Interest charges. o Current assets turn over ratio – not much of significance as the entire current assets are involved. However, this could indicate deterioration or improvement over a period of time. Indicates operating efficiency. Formula = Cost of goods sold/Average current assets held in business during the year. There is no min. Or maximum. Again this depends upon the type of industry, market conditions, management’s policy towards working capital etc. o Fixed assets turn over ratio Not much of significance as fixed assets cannot contribute directly either to liquidity or profitability. This is used as a very broad parameter to compare two units in the same industry and especially when the scales of operations are quite significant. Formula = Cost of goods sold/Average value of fixed assets in the period (book value). Profitability ratios -Profit in relation to sales and profit in relation to assets: o Profit in relation to sales – this indicates the margin available on sales; o Profit in relation to assets – this indicates the degree of return on the capital employed in business that means the earning efficiency. Please appreciate that these two are totally different. For example, we will study the following; Units A and B are in the same type of business and operate at the same levels of capacities. Unit A employs capital of 250 lacs and unit B employs capital of 200lacs. The sales and profits are as under: Parameter Sales Unit A 1000lacs Unit B 1000lacs
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Profits Profit margin on sales Return on capital employed
100lacs 10% 40%
90lacs 9% 45%
While Unit A has higher profit margins, Unit B has better returns on capital employed. o Profit margin on sales: Gross profit margin on sales and net profit margin ratio – Gross profit margin = Formula = Gross profit/net sales. Gross profit = Net sales (-) Cost of production before selling, general, administrative expenses and interest charges. Net sales = Gross sales (-) Excise duty. This indicates the efficiency of production and serves well to compare with another unit in the same industry or in the same unit for comparing it with past trend. For example in Unit A and Unit B let us assume that the sales are same at Rs.100lacs. Parameter Sales Cost of production Gross profit Deduct: Selling general, Administrative expenses and interest Net profit 35lacs 5lacs 30lacs 5lacs Unit A 100lacs 60lacs 40lacs Unit B 100lacs 65lacs 35lacs
While both the units have the same net profit to sales ratio, the significant difference lies in the fact that while Unit A has less cost of production and more office and selling expenses, Unit B has more cost of production and less of office and selling expenses. This ratio helps in controlling either production costs if cost of production is high or selling and administration costs, in case these are high.
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Net profit/sales ratio – net profit means profit after tax but before distribution in any form = Formula = Net profit/net sales. Tax rate being the same, this ratio indicates operating efficiency directly in the sense that a unit having higher net profitability percentage means that it has a higher operating efficiency. In case there are tax concessions due to location in a backward area, export activity etc. available to one unit and not available to another unit, then this comparison would not hold well. Investment on capital ratios/Earnings ratios: o Return on net worth Profit After Tax (PAT) / Net worth. This is the return on the shareholders’ funds including Preference Share capital. Hence Preference Share capital is not deducted. There is no standard range for this ratio. If it reduces it indicates less return on the net worth. o Return on equity Profit After Tax (PAT) – Dividend on Preference Share Capital / Net worth – Preference share capital. Although reference is equity here, all equity shareholders’ funds are taken in the denominator. Hence Preference dividend and Preference share capital are excluded. There is no standard range for this ratio. If it comes down over a period it means that the profitability of the organisation is suffering a setback. o Return on capital employed (pre-tax) Earnings Before Interest and Tax (EBIT) / Net worth + Medium and long-term liabilities. This gives return on long-term funds employed in business in pre-tax terms. Again there is no standard range for this ratio. If it reduces, it is a cause for concern. o Earning per share (EPS) Dividend per share (DPS) + Retained earnings per share (REPS). Here the share refers to equity share and not preference share. The formula is = Profit after tax (-) Preference dividend (-) Dividend tax both on preference and equity dividend / number of equity shares. This is an important indicator about the return to equity shareholder. In fact P/E
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ratio is related to this, as P/E ratio is the relationship between “Market value” of the share and the EPS. The higher the PE the stronger is the recommendation to sell the share and the lower the PE, the stronger is the recommendation to buy the share. This is only indicative and by and large followed. There is something known as industry average EPS. If the P/E ratio of the unit whose shares we contemplate to purchase is less than industry average and growth prospects are quite good, it is the time for buying the shares, unless we know for certain that the price is going to come down further. If on the other hand, the P/E ratio of the unit is more than industry average P/E, it is time for us to sell unless we expect further increase in the near future. Leverage ratios Leverages are of two kinds, operating leverage and financial leverage. However, we are concerned more with financial leverage. Financial leverage is the advantage of debt over equity in a capital structure. Capital structure indicates the relationship between medium and long-term debt on the one hand and equity on the other hand. Equity in the beginning is the equity share capital. Over a period of time it is net worth (-) redeemable preference share capital. It is well known that EPS increases with increased dose of debt capital within the same capital structure. Given the advantage of debt also, as even risk of default, i.e., nonpayment of interest and non-repayment of principal amount increases with increase in debt capital component, the market accepts a maximum of 2:1 at present. It can be less. Formula for debt/equity ratio = Medium and long-term loans + redeemable preference share capital / Net worth (-) Redeemable preference share capital. From the working capital lending banks’ point of view, all liabilities are to be included in debt. Hence all external liabilities including current liabilities are taken into account for this ratio. We have to add redeemable preference share capital and reduce from the net worth the same as in the previous formula.
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Coverage ratios o Interest coverage ratio This indicates the number of times interest is covered by EBIT. Formula = EBIT / Interest payment on all loans including short-term liabilities. Minimum acceptable is 2 to 2.5:1. Less than that is not desirable, as after paying interest, tax has to be paid and afterwards dividend and dividend tax.
o Asset coverage ratio This indicates the number of times the medium and long-term liabilities are covered by the book value of fixed assets. Formula = Book value of Fixed assets / Outstanding medium and long-term liabilities. Accepted ratio is minimum 1.5:1. Less than that indicates inadequate coverage of the liabilities. o Debt Service coverage ratio This indicates the ability of the business enterprise to service its borrowing, especially medium and long-term. Servicing consists of two aspects namely, payment of interest and repayment of principal amount. As interest is paid out of income and booked as an expense, in the formula it gets added back to profit after tax. The assumption here is that dividend is ignored. In case dividend is paid out, the formula gets amended to deduct from PAT dividend paid and dividend tax. Formula is: (Numerator) Profit After Tax (+) Depreciation (+) Deferred Revenue Expenditure written off (+) Interest on medium and long-term borrowing (Denominator) Interest on medium and long-term borrowing (+) Installment on medium and long-term borrowing.
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This is assuming that dividend is not paid. In the case of an existing company dividend will have to be paid and hence in the numerator, instead of PAT, retained earnings would appear. The above ratio is calculated for the entire period of the loan with the bank/financial institution. The minimum acceptable average for the entire period is 1.75:1. This means that in one year this could be less but it has to be made up in the other years to get an average of 1.75:1.
What is the objective behind analysis of financial statements? Objective (To know about) 1. Financial position of the company Relevant indicator/Remarks 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 Current ratio and quick ratio or acid test the company is in a position to meet all ratio. Current ratio = Current assets/current its short-term liabilities (also called liabilities. Quick ratio = Current assets (-) “current liabilities”) with the help of its inventory/ current liabilities. Current ratio current assets 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
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better indicator of liquidity position.
3. Whether the company has acquired new Examination of increase in secured or fixed assets during the year and if so, unsecured loans for this purpose. Without what are the sources, besides internal adequate financial planning, there is always accruals to finance the same? 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 Percentage of profit before tax to total and operating profits in particular, i.e., income including other income, like dividend whether the main operations of the or interest income. Operating profit, i.e., company like manufacturing have been profit before tax (-) other income as above in profit or the profit of the company is as a percentage of income from the main derived from other income, i.e., income operations etc. of the company, be it from investment in shares/debentures manufacturing, trading or services.
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5. Relationship between the net worth of Debt/Equity ratio, which establishes this the company and its external liabilities relationship. Formula = External liabilities + (both short-term and long-term). What preference share capital /net worth of the about only medium and long-term company debts? (-) 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 Difference between the market value of the shares/debentures of other companies investments and the purchase price, which is reduced in value in comparison with last theoretically year? 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.
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7. Relationship between average debtors Average (bills payable) during the year.
debtors
in
the
year/average
(bills receivable) and average creditors 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 Directors’ report. into new collaboration agreement, they are coming
This would reveal the out with a public
acquisition of new technology, entering financial plans for the company, like whether diversification programme, expansion issue/Rights issue etc. programme etc.
9. Has the company revalued its fixed Auditors’ comments in the “Notes to assets during the year, thereby creating Accounts” relevant for this. of capital into the company, as this is just an entry passed in the books? Frequent revaluation reserves, without any inflow revaluation is not desirable and healthy.
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10. Whether the company has increased its Increase in amount of investment in investment and if so, what is the source shares/debentures/Govt. securities etc. in for it? What is the nature of investment? comparison Is it in tradable securities or long-term with last year and any investment within group companies? Any
Securities, which can have a lock-in- undue increase in investment should put us period and cannot be liquidated in the on guard, as working capital funds could near future? have been diverted for it.
11. Has the company during the year given Any increase in unsecured loans. If the loans any unsecured loans substantially other are to group companies, then all the more than to employees of the company? reason to be cautious. Hence, where the figures have increased, further probing is called for.
12. Are the company’s unsecured loans Any comments to this effect in the notes to (given) not recoverable and very old? 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 Any comments about over dues as in the payment of its dues on account of loans “Notes to Accounts” should be looked into. or periodic interest on its liabilities? Any serious default is likely to affect the “credit rating” of the company with its lenders, thereby increasing its cost of borrowing in future.
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14. Has the company defaulted in providing Any comments about this in the “Notes to for bonus liability, P.F. liability, E.S.I. Accounts” should be looked into. liability, gratuity liability etc?
15. Whether the company is holding very Cash balance together with bank balance in huge cash, as it is not desirable and current account, if any, is very high in the increases the opportunity cost? current assets.
16. How many times the average inventory Relationship between cost of goods sold and has turned over during the year? 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 Increase in paid-up capital in the balance capital during the period and what is the sheet and share premium reserves in case purpose for which it has raised equity the issue has been at a premium. capital? If it was a public issue, how did it fare in the market?
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18. Has the company issued any bonus Increase in paid-up capital and simultaneous shares during the year? 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 Increase in paid-up capital and share in the period and what is the purpose of premium reserves, in case the issue has been the issue? If it was a public issue, how at a premium. did it fare in the market?
20. What is the proportion of marketable Percentage of marketable investment to investment to total investment and total investment and comparison with whether this has decreased in 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. comparison with the previous year?
21. What is the increase in sales income over Comparison with previous year’s sales last year in % terms? Is it due to increase income and whether the growth has been in numbers or change in product mix or more or less than the estimate. increase in prices of finished products only?
22. What is the amount of provision for bad In percentage terms, how much is it of total and doubtful debts or advances debts outstanding and what are the reasons
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outstanding?
for such provision in the notes to accounts by the auditors?
23. What is the amount of work in progress Is there any comment about valuation of as shown in the Profit and Loss Account? 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 Examination of expenses schedule would lease rentals and if so what is the show this. What is the comment in notes to amount of lease liability outstanding? accounts about this? Lease liability is an offbalance sheet to item and hence the this examination, ascertain 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 Auditors’ depreciation on fixed assets, due to policies. of the company?
comments
on
“Accounting”
Change over from straight-line
which, there is an impact on the profits method to written down value method or vice-versa does affect the deprecation charge for the year thereby affecting the
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profits during the year of change.
26. If it is a manufacturing company, Relationship between materials consumed whether the % of materials consumed is during the year and the sales. increasing in relation to sales?
27. Has the company changed its method of Auditors’ valuation of inventory, due to which policies. there is an impact of the profits of the company?
comments
on
“Accounting”
28. Whether the % of administration and Relationship the year under review?
between
general
and
general expenses has increased during 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 Interest coverage ratio = earnings before income to pay the interest charges? interest and tax/total interest on all shortterm and long-term liabilities. not satisfactory. Minimum should be 3:1 and anything less than this is
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30. Whether the finance charges have gone Relationship between interest charges and up disproportionately as compared with sales income – whether it is consistent with the increase in sales income during the the previous year or is there any spurt? same period? 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 Relationship between “payment to and sales has increased? 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 Relationship relation to sales has gone up?
between
“selling
and Any
marketing” expenses and the sales.
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 Debt service coverage ratio = Internal internal accruals {Profit after tax (-) accruals (+) interest on medium and long-
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dividend (+) any non-cash expenditure term external liabilities/interest on medium like depreciation, preliminary expenses and long-term liabilities (+) repayment of write-off etc.} to meet repayment medium and long-term external liabilities. 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. obligation of principal amount of loans, The term-lending institution or bank looks debentures etc.?
34. Return on investment in business to Earnings before interest and tax/average compare it with return on similar total invested capital, i.e., net worth (+) debt investment elsewhere. 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 Profit after tax (-) dividend on preference surplus) 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? Profit after tax (-) dividend on preference (EPS) 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.
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37. Whether the company has reduced its Relationship between amount of dividend dividend payout in comparison with last payout and profit after tax last year and this year? 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 “Notes on Accounts” as given at the end of contingent liabilities due to any of the the accounts. following? Any substantial increase especially in Disputed central excise duty, customs disputed amount of duties should put us on duty, income tax, octroi, sales tax, guard. 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.
39. Has the company changed its policy of Substantial change in vendor charges, or outsourcing its work from vendors and if subcontracting charges. so, what are the reasons?
40. Is there any substantial increase in Increase in consultancy charges. charges paid to consultants?
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41. Has the company opened any branch Directors’ Report or sudden spurt in general office in the last year? and administration expenses.
The principal tools of analysis are: ? Ratio analysis – i.e. to determine the relationship between any set of two parameters and compare it with the past trend. In the statements of accounts, there are several such pairs of parameters and hence ratio analysis assumes great significance. The most important thing to remember in the case of ratio analysis is that you can compare two units in the same industry only and other factors like the relative ages of the units, the scales of operation etc. come into play. ? Comparison with past trend within the same company is one type of analysis and comparison with the industrial average is another analysis
Some of the limitations of the financial statements are given below :
? Analysis and understanding of financial statements is only one of the tools in understanding of the company ? The annual statements do have great limitations in their value, as they do not speak about the following? Management, its strength, inadequacy etc. ? Key personnel behind the activity and human resources in the organisation. ? Average key ratios in the industry in the country, of which the company is an integral part. This information has to be obtained separately. ? Balance sheet is as on a particular date and hence it does not indicate about the average for the entire year. Hence it cannot indicate the position with 100% reliability. (Link it with fundamental analysis.)
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? The auditors’ report is based more on information given by the management, company personnel etc. ? To an extent at least, there can be manipulation in the level of expenditure, level of closing stocks and sales income to manipulate profits of the organisation, depending upon the requirement of the management during a particular year. ? One cannot come to know from study of financial statements about the tax planning of the company or the basis on which the company pays tax, as it is not mandatory under the provisions of The Companies’ Act, 1956, to furnish details of tax paid in the annual statement of accounts.
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doc_422136673.pdf