Financial Statement Analysis PDF

UNIVERSITY OF JAFFNA – SRI LANKA Handout 2 FACULTY OF MANAGEMENT STUDIES AND COMMERCE DEPARTMENT OF FINANCIAL MANAGEMENT BBAF 11043 FUNDAMENTALS OF FINANCE F...

UNIVERSITY OF JAFFNA – SRI LANKA Handout 2 FACULTY OF MANAGEMENT STUDIES AND COMMERCE DEPARTMENT OF FINANCIAL MANAGEMENT BBAF 11043 FUNDAMENTALS OF FINANCE Financial Statement Analysis Learning Outcomes: After completing this topic, you will be able to; Define financial statement Explain the purpose of analysis of financial statement Explain the types of financial statement analysis Define Ratio analysis and calculate the ratios Identify the limitations of the ratio analysis 1 INTRODUCTION A financial statement is an official document of the firm, which explores the entire financial information of the firm. The main aim of the financial statement is to provide information and understand the financial aspects of the firm. Therefore, the preparation of the financial statement is important as much as the financial decisions. 2 FINANCIAL STATEMENTS A firm communicates financial information to the users through financial statements and reports. The financial statements contain summarized information of the firm’s financial affairs, organized systematically. They are means to present the firm’s financial situation to users. As these statements are used by investors, and financial analysts to examine the firm’s performance in order to make investment decisions, they should be prepared very carefully and contain as much information as possible. Two basic financial statements are prepared for the purpose of external reporting are: (i) Balance sheet and (ii) Profit and loss account. 1  12 3 FINANCIAL STATEMENT ANALYSIS Financial Statement Analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit and loss account. Financial Statement Analysis can be undertaken by management of the firm or by parties outside the firm, viz, owners, creditors, investors and others. The nature of the analysis will differ depending on the purpose of the analyst. i. Trade creditors are interested in the firm’s ability to meet their claims over a very short period of time. Therefore, their analysis will confine to the valuation of the firm’s liquidity position. ii. The suppliers of long-term debt are concerned with firm’s long-term solvency and survival. They analyze the firm’s profitability over time, its ability to generate cash to be able to pay interest and repay principal. iii. Long term creditors do analyze the historical financial statements, but they place more emphasis on the firm’s projected or pro forma, financial statements to make analysis about its future solvency and profitability. iv. Similarly, investors who have invested their money in the firm’s shares, are most concerned about the firms, earnings and growth. v. Finally, management of the firm would be interested in every aspect of the financial analysis. It is their overall responsibility to see that the resources of the firm are used most effectively and efficiently, and that the firm’s financial condition is sound. 4 TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS: Financial statement analysis is interpreted mainly to determine the financial and operational performance of the business concern. A number of methods or techniques are used to analyze the financial statements. The following are the common methods or techniques, which are widely used by the organizations. 2  13 4.1 Comparative Statement Analysis Comparative Statement analysis is an analysis of financial statement at different period of time. This statement helps to understand the comparative position of financial and operational performance at different period of time. It is classified into two major parts such as comparative balance sheet analysis and comparative profit and loss account analysis. Example 1: Comparative Profit and loss account of ‘Zero’ Company for the years ended 31st December 2018 and 31st December 2019. Particulars 2018 2019 Change (+ / -) % Change (LKR) (LKR) (LKR) (+ / -) Net Sales 200,000 250,000 (+) 50,000 (+) 25% (-) Cost of sales 150,000 180,000 (+) 30,000 (+) 20% Gross Profit 50,000 70,000 (+) 20,000 (+) 40% Less: Administrative Expenses 25,000 30,000 (+) 5,000 (+) 20% Net Operating Profit 25,000 40,000 (+) 15,000 (+) 60% Other income 12,000 18,000 (+) 6,000 (+) 50% Earning before interest and tax 37,000 58,000 (+) 21,000 (+) 56.76% Less: Interest 17,000 18,000 (+) 1,000 (+) 5.88% Earnings before tax 20,000 40,000 (+) 20,000 (+) 100% Less: Tax 8,000 16,000 (+) 8,000 (+) 100% Net Profit 12.000 24,000 (+) 12,000 (+) 100% 3  14 Comparative Balance Sheet of ‘‘Zero’ Company as on 31st December 2018 and 31st December 2019. Particulars 2018 2019 Change % Change (LKR) (LKR) (+ / -) (LKR) (+ / -) Current Assets: Cash and Bank 23,600 2,000 (-) 21,600 (-) 91.50 Debtors 41,800 38,000 (-) 3,800 (-) 9.10 Inventory 32,000 26,000 (-) 6,000 (-) 18.80 Other Current Assets 6,400 2,600 (-) 3,800 (-) 59.40 (A) 103,800 68,000 (-) 35,200 (-) 33.90 Fixed Assets: Land and Building 54,000 34,000 (-) 20,000 (-) 37.00 Plant and Machinery 67,800 166,800 (+) 99,000 (-) 146.02 (B) 121,800 200,800 (+) 79,000 (+) 64.90 Long Term Investment (C) 9,200 11,800 (+) 2,600 (+) 28.30 Total Assets (A+B+C) 234,800 281,200 (+) 46,400 (+) 19/80 Current Liabilities (D) 52,400 25,400 (-) 27,000 (-) 51.50 Long-Term Debt (E) 40,000 65,000 (+) 25,000 (+) 62.50 Owner’s Equity: Equity Share Capital 80,000 120,000 (+) 40,000 (+) 50.00 Reserves and Surplus 62,400 70,800 (+) 8,400 (+) 13.50 (F) 142,400 190,800 (+) 48,400 (+) 34.00 Total Liabilities and Capital 234,800 281,200 (+) 46,400 (+) 19.80 4.2 Trend Analysis The financial statements may be analyzed by computing trends of series of information. It may be upward or downward directions which involve the percentage relationship of each and every item of the statement with the common value of 100%. Trend analysis helps to understand the trend relationship with various items, which appear in the financial statements. These percentages may also be taken as index number showing relative changes in the financial information resulting with various period of time. In this analysis, only major items are considered for calculating the trend percentage. 4  15 Example 2: Calculate the trend analysis from the following information of ‘‘Zero’ Company taking 2014 as a base year. Year Current Assets Fixed Assets Total Assets 2014 100,000 125,000 200,000 2015 125,000 120,000 225,000 2016 115,000 110,000 240,000 2017 112.800 108,000 250,000 2018 103,800 121,800 234,800 2019 68,000 200,800 282.200 Trend Analysis (Base Year 2014 = 100) Year Current Assets Fixed Assets Total Assets Amount Trend Amount Trend Amount Trend (Rs) Percentage (Rs) Percentage (Rs) Percentage 2014 100,000 100.0 125,000 100.0 200,000 100.0 2015 125,000 125.0 120,000 96.0 225,000 112.5 2016 115,000 115.0 110,000 88.0 240,000 120.0 2017 112,800 112.8 108,000 86.4 250,000 125.0 2018 103,800 103.8 121,800 97.4 234,800 117.4 2019 68,000 68.0 200,800 160.6 282,200 141.1 4.3 Common Size Analysis Another important financial statement analysis technique is common size analysis in which figures reported are converted into percentage to some common base. In the balance sheet the total assets figures is assumed to be 100 and all figures are expresses as a percentage of this total. It is one of the simplest methods of financial statement analysis, which reflects the relationship of each and every item with the base value of 100%. Example 3: Common size balance sheet of ‘‘Zero’ Company as on 31st December 2018 and 31st December 2019 5  16 Particulars 2018 (LKR) % 2019 (LKR) % Current Assets: Cash and Bank 23,600 10.05 2,000 0.71 Debtors 41,800 17.80 38,000 13.51 Inventory 32,000 13.63 26,000 9.25 Other Current Assets 6,400 2.73 2,600 0.92 (A) 103,800 44.21 68,000 24.18 Fixed Assets: Land and Building 54,000 23.0 34,000 12.09 Plant and Machinery 67,800 28.87 166,800 59.32 (B) 121,800 51.87 200,800 71.40 Long Term Investment (C) 9,200 3.92 11,800 4.20 Total Assets (A+B+C) 234,800 100 281,200 100 Current Liabilities (D) 52,400 22.32 25,400 9.03 Long-Term Debt (E) 40,000 17.04 65,000 23,12 Owner’s Equity: Equity Share Capital 80,000 34.07 120,000 42.67 Reserves and Surplus 62,400 26.57 70,800 25.18 (F) 142,400 60.64 190,800 67.85 Total Liabilities and Capital 234,800 100 281,200 100 4.4 Funds flow and Cash flow Statement Funds flow statement is one of the important tools, which is used in many ways. It helps to understand the changes in the financial position of a business enterprise between the beginning and ending financial statement dates. It is also called as statement of sources and uses of funds. Cash flow statement is a statement which shows the sources of cash inflow and uses of cash out-flow of the business concern during a particular period of time. It is the statement, which involves only short-term financial position of the business concern. Cash flow statement provides a summary of operating, investment and financing cash flows and reconciles them with changes in its cash and cash equivalents such as marketable securities. These will be considered later. 6  17 5 FINANCIAL RATIO ANALYSIS Ratio analysis is a powerful tool of financial analysis. A ratio is defined as “the indicated measure of two mathematical expressions” and as “the relationship between two or more things”. In financial analysis, a ratio is used as an index or yardstick for evaluating the financial position and performance of a firm. The absolute accounting figures reported in the financial statements do not provide a meaningful understanding of the performance and financial position of a firm. An accounting figure conveys meaning when it is related to some other relevant information. The relationship between two accounting figures, expressed mathematically, is known as a financial ratio (or simply as a ratio). Ratios help to summarize the large quantities of financial data and to make qualitative judgement to be formed about the firm’s financial performance. The ratio indicates a relationship – a quantified relationship between current assets and current liabilities. This relationship is an index or yardstick which permits a qualitative judgment to be formed about the firm’s ability to meet its current obligations. It measures the firm’s liquidity. The greater the ratio is the greater the firm’s liquidity and vice versa. Based on the above standards, we can identify two type of analysis: 1. Trend Analysis 2. Cross sectional analysis 5.1 Trend Analysis: (Time-Series Analysis) In trend analysis, the analyst can compare a present ratio with past and expected future ratios for the same company. When financial ratios are arranged on a spreadsheet over a period of years, the analyst can study the composition of change and determine whether there has been an improvement or deterioration in the financial condition and the performance over time. Financial ratios also can be computed from projected or pro forma statements and compared with present and the past ratios. 5.2 Cross Sectional Analysis In this analysis, the ratios of one firm are compared with those of similar firms or with industry averages at the same point in time. Such a comparison gives insight into the relative financial condition and performance of the firm. The main advantage of using ratios in cross 7  18 sectional analysis is the complexity of the financial statements can be reduced to a small number of key variables, and the comparison permitted between large and small firms. 5.3 Classification, Calculation and Interpretation of Financial Ratios Several ratios can be calculated from accounting data contained in financial statements. These ratios can be grouped into the following categories. 1. Liquidity ratios 2. leverage ratios 3. Activity ratios 4. Profitability ratios Liquidity ratios measure the firm’s ability to meet current obligations, leverage ratios show the proportions of debt and equity in financing the firm’s assets, activity ratios reflect the firm’s efficiency in utilizing its assets and profitability ratios measure the overall performance and effectiveness of the firm. 5.3.1 Liquidity Ratios Liquidity ratios measure the ability of a firm to meet its current obligations. It needs the preparation of the cash budget and the cash flows statement, but liquidity ratios provide a quick measure of liquidity. A firm should ensure that it does not suffer from lack of liquidity and also that it is not too much highly liquid. A very high degree of liquidity is bad since idle assets earn nothing. Therefore, it is necessary to strike a proper balance between liquidity and lack of liquidity. i. Current Ratio The current ratio compares a company’s total current assets with its total current liabilities. The current ratio is a measure of the firm’s short-term solvency. It indicates the availability of current assets in rupees for every one rupee of current liability. A ratio of greater than one means that the firm has more current assets than current claims against them. This ratio is calculated as: Current Ratio = Current Assets / Current Liabilities ii. Quick Ratio It is called as acid-test ratio establishes a relationship between quick, or liquid, assets and current liabilities. Cash is the most liquid asset. Other assets that are considered to be relatively liquid and included in quick assets are debtors and bills receivable, and marketable 8  19 securities. Inventories are considered to be less liquid. Quick Ratio = Current Assets – Inventories / Current Liabilities iii. Cash Ratio Since cash is the most liquid asset, a financial analyst may examine cash ratio and its equivalent to current liabilities. Trade investment or marketable securities are equivalent of cash, therefore, they may be included in the computation of cash ratio. Cash ratio = Cash + Marketable securities / Current liabilities iv. Interval Measure Interval measure assesses a firm’s ability to meet its regular cash expenses. Interval measure relates liquid assets to average daily operating cash outflows. The daily operating expenses will be equal to the cost of goods sold plus selling, administrative and general expenses less depreciation divided by number of days in the year. Interval measure may be refined further. Instead of calculating only the daily operating expenditures, one may also include expenditures required for paying interest, acquiring assets and repaying debt. Interval measure = Current assets – Inventory / Average daily operating expenses iv. Networking Capital Ratio The difference between current assets and current liabilities excluding short-term bank borrowing is called net working capital (NWC) or net current assets (NCA). NWC is sometime used as a measure of a firm’s liquidity. It is considered that, between two firms, the one having the larger NWC has the greater ability to meet its current obligations. This is not necessarily so the measure of liquidity is a relationship, rather than the difference between current assets and current liabilities. However, NWC measures the firm’s potential reservoir of funds. It can be related to net assets (or capital employed). NWC ratio = Net working capital (NWC) / Net assets (NA) Activity 1: The following information is available from Alpha Company. Particulars Amount LKR (000’) Cash and Cash equivalent 2188 Short term investment 65 Receivables 1072 Inventory 8338 Other Current Assets 254 9  20 Total Current Assets 11917 Accounts Payable 4560 Outstanding expenses 809 Taxes Payable 307 Deferred Revenue 998 Income Tax Payable 227 Other outstanding expenses 1134 Total current liability 8035 Additional Details are (in 000’): 1. Cost of sales during the year is 11215. 2. Sales and Administrative costs during the years is 25. 3. Depreciation for the year is 1913. 4. Total (Net) Assets 25,000. You are required to calculate the liquidity ratios by using the above information. 5.3.2 Leverage Ratios The short-term creditors, like bankers and suppliers of raw material are more concerned with the firm’s current debt-paying ability. On the other hand, long term creditors, like debenture holders, financial institutions etc., are more concerned with the firm’s long-term financial strength. A firm should have a strong short as well as long term financial position. To judge the long-term financial position of the firm, financial leverage, or capital structure ratios are calculated. This is called as solvency ratio, which measures the long-term obligation of the business concern. Some of the leverage ratios are given below: i. Debt Ratio\ Debt to Asset Ratio Several debt ratios may be used to analyse the long-term solvency of a firm. The firm may be interested in knowing the proportion of the interest bearing debt in the capital structure. Debt ratio = Total debt (TD) / Total debt (TD) + Net worth (NW) = Total debt (TD) / Capital employed (CE) ii. Debt – Equity Ratio This relationship describing the lenders’ contribution for each rupee of the owners’ contribution is called debt-equity ratio. Debt-equity (DE) ratio is directly computed by 10  21 dividing total debt by net worth. Debt – Equity ratio = Total debt (TD) / Net Worth (NW) iii. Capital employed to Net Worth Ratio / Debt to Capital Ratio To express the basic relationship between debt and equity is another way. How much funds are being contributed together by lenders and owners for each rupee of the owners’ contribution? Calculating the capital employed ratio or net assets to net worth can find this. CE to NW ratio = Capital employed (CE) / Net Worth (NW) or NA to NW ratio = Net Assets (NA) / Net Worth (NW) Note that CE / NW ratio is simply one plus debt-equity ratio CE / NW = NW + TD / NW = 1 + TD / NW iv. Other Debt ratios TL to LF ratio = Total Liabilities (TL) / Total assets (TA) LT to NW ratio = Long term debt (LD) / Net Worth (NW) v. Coverage ratio Debt ratios described above are static in nature, and fail to indicate the firm’s ability to meet interest (and other fixed charges) obligations. This ratio is used to test the firm’s debt servicing capacity. The interest coverage ratio is computed by dividing earnings before interest and taxes (EBIT) by interest charges. Interest coverage = EBIT / Interest Activity 2: Imagine a business with the following financial information: LKR 50 million of assets. LKR 20 million of Debt. LKR 25 million of equity. LKR 5 million of annual EBITD. LKR 2 million of annual depreciation expense. Interest charges LKR 0.5M You are required to calculate the leverage ratios. 5.3.3 Activity Ratios This ratio measures the efficiency of the current assets and liabilities in the business concern during a particular period. This ratio is helpful to understand the performance of the business 11  22 concern. These ratios are called as turnover ratios because they indicate the speed with which assets are being converted or turned over into sales. Some of the activity ratios are given below. i. Inventory Turnover Inventory turnover indicates the efficiency of the firm in producing and selling its product. It is calculated by dividing the cost of goods sold by the average inventory: Inventory turnover = Cost of goods sold / Average inventory After calculating the Inventory turnover, it could be calculated the days of Inventory Holding (DIH). The reciprocal of inventory turnover gives average inventory holdings in percentage term. When the numbers of days in a year (360) are divided by inventory turnover, we obtain days of inventory holdings. DIH = Average inventory / Cost of goods sold X 360 = 360 / Inventory turnover. When the cost of goods sold figure is not be available from the published annual accounts, to compute inventory turnover as sales divided by the average inventory or the year end inventory. Inventory turnover = Sales / Inventory DIH = Inventory / sales X 360 ii. Debtors (Accounts receivable) turnover Debtors are convertible into cash over a short period. The liquidity position of the firm depends on the quality of debtors to a great extent. Three ratios are used to judge the quality or liquidity of debtors. Debtors turnover = Credit Sales / Average debtors Debtors turnover indicates the number of times debtors turnover each year. Generally, the higher the value of debtor’s turnover, the more efficient is the management of credit. When the information about credit sales and opening and closing balances of debtors are not available the debtor’s turnover can be calculated as: Debtors turnover = Sales / Debtors iii. Collection period The average number of days for which debtors remain outstanding is called the average collection period (ACP) and can be computed as follows: ACP = 360 / Debtors turnover = Debtors / sales X 360 12  23 iv. Aging Schedule The aging schedule breaks down debtors according to the length of time for which they have been outstanding. The aging schedule is given in the following table. Outstanding period (days) Outstanding amount of debtorsPercentage of total debtors 0 – 25 2,00,000 50.0 26 - 35 1,00,000 25.0 36 - 45 50,000 12.5 46 - 60 30,000 7.5 over 60 20,000 5.0 4,00,000 100.00 In the above table, 50 percent of its debtors are overdue. It reveals that some of the accounts of the firm have serious problems of collection. The aging schedule gives more information than the collection period, and very clearly spots out the slow-paying debtors. v. Assets turnover ratio Assets are used to generate sales. So, a firm should manage its assets efficiently to maximize sales. The relationship between sales and assets is called as assets turnover. It could be calculated as follows. Net assets turnover = Sales / Net assets Net assets include net fixed assets and net current assets (Current assets – current liabilities). Since net assets are equal to capital employed, net assets turnover may also be called as capital employed turnover. vi. Total assets turnover This ratio shows the firm’s ability in generating sales from all financial resources committed to total assets. Total assets turnover = Sales / Total Assets vii. Fixed and current assets turnover The firm may wish to know its efficiency of utilizing fixed assets and current assets separately. Fixed assets turnover = Sales / Net fixed assets Currents assets turnover = Sales / Currents assets 13  24 viii. Working Capital turnover: This is calculated as follows: Net current assets turnover = Sales / Net current assets. Activity 3: Below shows some values of draft Balance sheet and income statement of Widget Manufacturing Company. From Balance Sheet From Income Statement Current Assets: LKR 000’ LKR 000’ Cash 2,550 Sales 112,500 Marketable securities 2,000 Cost of Goods Sold 85,040 Accounts Receivable (Net) 16,675 Gross Margin 27,460 Inventories 26,470 Total Current Assets 47,695 Using the above figures, calculate the relevant activity ratios. (Assume the company’s beginning inventory on January 1 is value at LKR 22,500,000). 5.3.4 Profitability Ratio A firm should earn profits to survive and grow over a long period of time. Profitability ratio helps to measure the profitability position of the business concern. Generally, two major types of profitability ratios are calculated. i. profitability in relation to sales. ii. profitability in relation to investment. Some of the major profitability ratios are given below. i. Gross profit margin = Sales – Cost of goods sold / sales = Gross profit / Sales ii. Net profit margin Net profit is obtained when operating expenses, interest and taxes are subtracted from the gross profit. The net profit margin ratio is measured by dividing profit after tax by sales. Net profit margin = Profit after tax / Sales Net profit margin ratio establishes a relationship between net profit and sales and indicates management’s efficiency in manufacturing, administering and selling the products. And also, it indicates the firm’s capacity to withstand adverse economic conditions. 14  25 Net margin based on NOPAT The profit after tax (PAT) excludes interest on borrowing. Interest is tax deductible, and therefore, a firm that pays more interest pays less tax. Tax saved on account of payment of interest is called interest tax shield. Net profit margin = EBIT (1-T) / Sales = NOPAT / Sales. Taxes are not controllable by a firm, and also one may not know the marginal corporate tax rate while analysing the published data. Therefore, the margin ratio may be calculated on before tax basis. Profit margin = EBIT / Sales iii. Operating Expense Ratio It explains the changes in the profit margin (EBIT to sales) ratio. Operating expenses ratio = Operating expenses / Sales Cost of goods sold ratio = Cost of goods sold / Sales iv. Other operating expense ratio Other operating expense ratio = Other operating expenses / Sales Profitability in relation to investment i. Return on Investment (ROI) The term investment may refer to total assets or net assets. The funds employed in net assets are known as capital employed. ROI = ROTA = EBIT (1-T) / Total assets = EBIT (1-T) / TA ROI = RONA = EBIT (1- T) / Net assets = EBIT (1 – T) / NA Where, ROTA and RONA are respectively, return on total assets and return on net assets. RONA is equivalent of return on capital employed. i.e ROCE. Since taxes are not controllable by management and since firm’s opportunities for availing tax incentives differ, it may be more prudent to use before tax measure of ROI. ROI = ROTA = EBIT / TA ROI = RONA = EBIT / NA ii. Return on Equity Common or ordinary shareholders are entitled to the residual profits. The rate of dividend is not fixed. A return on shareholders’ equity is calculated to see the profitability of owners’ investment. 15  26 ROE = Profit after taxes / Net worth (Equity) = PAT / NW ROE indicates how well the firm has used the resources of owner. In fact this ratio is one of the most important relationships in financial analysis. iii. Earnings per Share (EPS) The profitability of the shareholders’ investment can also be measured in many other ways. One such measure is to calculate the earnings per share. The earnings per share (EPS) is calculated by dividing the profit after taxes by the total number of ordinary shares outstanding. EPS = Profit after tax / Number of shares outstanding iv. Dividend per Share (DPS) Net profit after taxes belongs to shareholders. But the income, which they really receive, is the amount of earnings distributed as cash dividends. So, a large number of present and potential investors may be interested in DPS. DPS is calculated by dividing ordinary dividend from number of ordinary shares ranking for dividend. DPS = Earnings paid to shareholders (dividend) / Number of Ordinary Shares outstanding v. Dividend Payout Ratio Payout ratio = Equity dividends / Profit after tax =Dividends per share / Earnings per share = DPS / EPS Activity 4: From the following balance sheet of Aravind Industries Ltd., as at 31st March 2018 calculate the relevant ratios. Liabilities LKR 000’ Assets LKR 000’ Equity Share Capital 10,000 Fixes Assets (less depreciation 26,000 LKR 10,000 7% Preference Share Capital 2,000 Currents Assets: Reserves and Surplus 8,000 Cash 1,000 6% Mortgage Debentures 14,000 Investments (10%) 3,000 Current Liabilities Sundry debtors 4,000 Creditors 1,200 Stock 6,000 16  27 Bills Payable 2,000 Outstanding expenses 200 Tax Provision 2,600 40,000 40,000 Other Information 1. Net Sales LKR 60,000,000 2. Cost of good sold LKR 51,600,000 3. Net income before tax LKR 4,000,000 4. Net income after tax LKR 2,000,000 Calculate the appropriate ratios. 6 ADVANTAGES OF RATIO ANALYSIS Financial ratio analysis is a useful tool for users of financial statement. It has the following advantages. i. It simplifies the financial statements. ii. It helps in comparing companies of different size with each other. iii. It helps in trend analysis which involves comparing a single company over a period. iv. It highlights important information in simple form quickly. A user can judge a company by just looking at few numbers instead of reading the whole financial statements. 7 LIMITATIONS OF RATIO ANALYSIS i. Historical. All of the information used in ratio analysis is derived from actual historical results. This does not mean that the same results will carry forward into the future. ii. Inflation. If the rate of inflation has changed in any of the periods under review, this can mean that the numbers are not comparable across periods. For example, if the inflation rate was 100% in one year, sales would appear to have doubled over the preceding year, when in fact sales did not change at all. iii. Aggregation. The information in a financial statement line item that you are using for a ratio analysis may have been aggregated differently in the past, so that running the ratio analysis on a trend line does not compare the same information through the entire trend period. 17  28 iv. Operational changes. A company may change its underlying operational structure to such an extent that a ratio calculated several years ago and compared to the same ratio today would yield a misleading conclusion. v. Accounting policies. Different companies may have different policies for recording the same accounting transaction. This means that comparing the ratio results of different companies may be like comparing apples and oranges. vi. Business conditions. You need to place ratio analysis in the context of the general business environment. For example, 60 days of sales outstanding might be considered poor in a period of rapidly growing sales, but might be excellent during an economic contraction when customers are in severe financial condition and unable to pay their bills. vii. Interpretation. It can be quite difficult to ascertain the reason for the results of a ratio. viii. Company strategy. It can be dangerous to conduct a ratio analysis comparison between two firms that are pursuing different strategies. ix. Point in time. Some ratios extract information from the balance sheet. Be aware that the information on the balance sheet is only as of the last day of the reporting period. If there was an unusual spike or decline in the account balance on the last day of the reporting period, this can impact the outcome of the ratio analysis. SUMMARY Financial Statement is an official document which expresses the financial information to the users who needs the information. In this unit it was defined the financial statement and the purpose of analysis of financial statement. It has been explained the types of ratios and it has been analysed the types of ratios. and Also it has been identified the advantages and Limitations of ratios analysis. SELF-PRACTICE QUESTIONS 1. What do you mean by financial statement analysis? 2. Discuss various types of financial statement analysis. 3. What is ratio analysis? Explain its types. 4. The following information is given about ABC Ltd., for the year ending December 31, 2019. (i) Inventory turnover ratio 6 times. (ii) Gross profit ratio 20 percent on sales. 18  29 (iii) Sales for 2019 LKR. 300,000. (iv) Closing stock is LKR. 10,000 more than the opening stock. (v) Opening creditors LKR. 20,000. (vi) Closing creditors LKR. 30,000. (vii) Trade debtors at the end LKR. 60,000. (viii) Net working capital LKR. 50,000. You are required to calculate the following: (a) Average stock. (b) Purchases. (c) Creditors turnover ratio. (d) Working capital turnover ratio. 5. Using the following information, complete the balance sheet. Long term debt to equity 5:1 Total asset turnover 2.5 times Average collection period * 18days Inventory turnover 9 times Gross profit margin 10% Acid-test ratio 1:1 Assume a 360 day year and all sales on credit. Cash Notes and payables 100,000 Accounts receivable Long-term debt Inventory Common stock 100,000 Plant and equipment Retained earnings 100,000 Total assets Total liabilities and shareholders equity 19