Module 5:

Financial
Analysis
• Ratio Analysis

• Cash Flow Analysis

• Balance Score Card (BSC)

• Economic Value Added (EVA)

• Cash Value Added (CVA)

 Financial
Analysis
Definition and Purpose
•Financial Analysis: Identifies financial strengths and weaknesses by establishing relationships
between balance sheet items and profit and loss accounts.
•Users: Can be internal (management) or external (owners, creditors, investors).

Users Focus Concern

Trade Creditors Short-term liquidity Firm’s ability to meet short-term claims

Firm’s profitability over time, cash

generation for interest and principal
Long-term Debt Long-term solvency and repayment, and capital structure
Suppliers survival relationships

Present and future profitability, steady

growth in earnings, and financial structure
Investors Earnings and profitability impacting earnings and risk

Comprehensive financial Effective and efficient use of resources,

Management health overall financial condition of the firm
 Ratio Analysis

Definition and Importance

 Ratio Analysis: A powerful tool for financial analysis, involving the
relationship between two or more financial figures.
 Objectives
Purpose: of Serves as Analysis
Accounting a benchmark for evaluating the financial position and
performance of a firm.
 Example: Net profit related to investment, current ratio (current assets
divided by current liabilities).

Characteristics of Ratios
 Quantitative Relationship: Ratios summarize large quantities of financial
data.
 Qualitative Judgment: Ratios help form qualitative assessments of
financial performance, such as liquidity or profitability.

Standards of Comparison
 Past Ratios: Historical ratios of the same firm.
 Competitors’ Ratios: Ratios of selected competing firms at the same point
Types of Ratios

4
3 Did you check
2 your
1 profitability?
What about your
funding situation?
What about your – Debt and Equity
The current efficiency ?
obligation status?
– Assets and
Liabilities

Leverage Ratio
Current Ratio Activity Ratio Profit Ratio
Current/Liquidity
Ratios

Liquidity Ratios measure a firm's ability to meet its current obligations as they become due.
These ratios provide a quick measure of liquidity by establishing a relationship between current
assets and current liabilities. Ensuring proper liquidity is crucial as insufficient liquidity can lead
Objectives of Accounting Analysis
to poor creditworthiness, loss of creditors' confidence, or even legal issues, while excess liquidity
indicates idle assets that earn nothing.

Common Liquidity Ratios:

1. Net Working Capital Measure

Particulars Amount (A) Amount (B)
2. Current Ratio Particulars Year 1 Year 2
Current Assets 180 30
Current Assets 150 300
3. Quick Ratio
Current Liabilities 120 10
4. Cash Ratio
NWC 60 20 Current Liabilities 75 200
5. Interval Measure NWC 75 100
LEVERAGE RATIOS

Purpose: Measure long-term financial strength and risk Types of Leverage Ratios:
· Focus: Mix of funds from owners (equity) and lenders (debt) 1. Debt-to-Equity Ratio: Measures the proportion of debt
· Importance: and equity in financing the firm's assets.
• Indicate financial risk level 2. Interest Coverage Ratio: Assesses the firm's ability to
Objectives of Accounting Analysis
• Show ability to use debt advantageously
cover interest payments with operating profits.
· Implications of Debt Financing: 3. Debt Ratio: Calculates the percentage of total assets
• Higher risk for the firm
• Legal obligation to pay interest financed by debt.
• Potential for legal action by creditors
Financial Metric Company A Company B
·
Assets $1,000,000 $1,000,000
Debt $500,000 $900,000
Equity $500,000 $100,000
Net Income $100,000 $100,000
Interest Expense $25,000 $45,000
Activity Ratios

•Purpose: Evaluate how efficiently a firm

manages and utilizes its assets to generate
sales.
Objectives of Accounting Analysis
•Also known as: Turnover ratios, as they
measure how quickly assets are converted into
sales.
•Key Relationship: They reflect the
Types of Activity Ratios
relationship between sales and various types of
assets.
• Inventory Turnover
• Debtors (Accounts Receivable) Turnover
• Assets Turnover Ratios
 PROFITABILITY RATIOS

Purpose of Profits:
 Profits are crucial for the survival and growth of a company over the long term.

 They enable businesses to attract investment for expansion and contribute to societal welfare.
Objectives of Accounting
 Profitability Analysis
is essential but should not be pursued at the expense of stakeholders' interests (e.g., customers,
employees, suppliers).

Measurement of Profit:
 Gross Profit Margin: Represents the difference between sales revenue and the cost of goods sold.

 Net Profit Margin: Indicates the percentage of revenue that translates into profit after all expenses, including
taxes.
 Operating Profit: Also known as EBIT (Earnings Before Interest and Taxes), it reflects earnings from core
business operations before interest and taxes are deducted.
 Net Operating Profit After Tax (NOPAT): Represents the profit available to all investors (lenders and
owners) after accounting for taxes. It is calculated as EBIT adjusted for taxes.
 Types of Profitability Ratios:

Profitability in relation to sales:

 Measures how effectively a company generates profits from its
sales revenue.
• Gross Profit Margin
Objectives of Accounting
• Net Profit Margin Analysis
• Operating Expense Ratio

Profitability in relation to investment:

 Evaluates the return on investment for shareholders and

creditors.
 Return on Investment (ROI)
 Return on Equity (ROE)
 Earnings per Share (EPS)
 Dividend per Share (DPS or DIV)
 Dividend-Payout Ratio
 Price–Earnings Ratio
 Dividend Yield and Earnings Yield

 Some cautions

• Different Industries, Different Benchmarks • Non-Recurring Items Skew Ratios

• Liquidity vs. Efficiency Trade-Off
• Seasonal Variations Can Skew Results
• High Dividend Payout Ratios Can Signal Weak
• The Impact of Accounting Methods Growth Prospects

• Leverage Can Inflate ROE • Interest Coverage Ratio Can Be Misleading in

Low-Interest Environments
• Profitability Ratios Don’t Equal Cash Flow
• Price-to-Sales Ratio May Be Better for Growth
• Liquidity Ratios Can Be Misleading Without Companies

Context • A High Quick Ratio May Signal Over-

Cautiousness
• High P/E Doesn’t Always Mean Overvaluation

• Inventory Turnover Ratio Can Reflect Both

Demand and Supply Chain Efficiency

• Debt Ratios Are More Meaningful in

Combination
Limitations of Ratio Analysis:
 Difficulty in comparison: Choosing the right basis for comparison · Impact of Price Level Changes:
among companies or over different periods can be challenging due to  Inflation affects ratio analysis by altering the value of money
varying circumstances.
 Changes in price levels: Fluctuations in the general price level can over time, impacting inventory valuation, asset values, and
Objectives
distort ratioof Accounting especially
interpretations, Analysis in terms of inventory valuation borrowing costs.
and asset depreciation.
 Differences in definitions: Varied definitions of items in financial  This leads to discrepancies in accounting profits, as financial
statements (e.g., assets, liabilities) complicate ratio analysis across statements are based on historical cost rather than current
companies or industries.
market values.
 Static nature of ratios: Ratios calculated at a single point in time
may not provide a comprehensive view due to short-term fluctuations · Use of Historical Data:
and changes.
 Historical focus: Ratios are based on historical financial statements  While ratios are derived from historical financial statements,
and may not predict future performance accurately. they provide a retrospective view and may not accurately reflect
· Standards for Comparison: future financial outcomes.
 Ratios gain meaning when compared against standards such as
 Management has insights into future plans and policies that are
industry averages. However, obtaining reliable industry data can be
challenging. not reflected in historical ratios, posing a challenge for external
 Differences in company situations and economic factors over time analysts relying on past data.
make meaningful comparisons difficult.
Cash Flow Analysis

· Purpose of Cash Flow Analysis:

 Cash flow analysis is crucial for short-term planning, ensuring a firm has enough
cash to meet immediate obligations such as debt payments, expenses, and
Objectives of Accounting Analysis
dividends.

· Historical Analysis for Projections:

 Historical cash flow analysis provides insights to prepare reliable projections for
the near future, helping management anticipate cash needs and surpluses.

· Comparison with Funds Flow Statement:

 The Cash Flow Statement focuses specifically on cash movements, contrasting
with the Funds Flow Statement that emphasizes changes in working capital and
long-term funds.

· Preparation Methods:
 The direct method

 Indirect method
Direct Method Indirect
(A) Sales Revenues
Method
(B) Less: Expenses Using Working Capital (A) Net Income (or Loss) as Shown by Profit and Loss
•Cost of raw materials used (or cost of goods sold) Account
(B) Add:
•Wages and salary expenses •Depreciation expenses
•Other manufacturing expenses (excluding depreciation) •Amortisation of goodwill, patents, and other intangible
assets
•Office expenses
•Amortisation of discount on debentures or share issue
•Selling and distribution expenses expenses
•Interest •Amortisation of extraordinary losses incurred in previous
years
•Income tax •Loss on sale of non-current assets
(C) Working Capital from Business Operations (C) Less:
•Amortisation of premium received on debentures
(D) Adjustments to Convert to Cash Basis
•Profit on sale of equipment (already included under
[Link]: Decrease in Working Capital (–CA or +CL) sources)
[Link] in current assets other than cash (item-wise) •Profit on revaluation of non-current assets (does not
contribute to working capital)
[Link] in current liabilities (item-wise)
•Dividends and interest received on investments (reported
[Link]: Increase in Working Capital (+CA or –CL) separately)
[Link] in current assets other than cash (item-wise) (A + B – C) = Working Capital from Business
Operations
[Link] in current liabilities (item-wise) (D) Adjustments to Convert to Cash Basis
(E) Cash Flow from Business Operations [Link]: Decrease in Working Capital (–CA or +CL)
 The Flow of Accounting – From Entry to Final Statements

Journal Entry: This is where transactions are first recorded chronologically in

the journal (e.g., purchases, sales). Each transaction involves at least one debit
and one credit entry.

Ledger: The entries from the journal are posted to the ledger, where individual
accounts (e.g., Purchases, Cash, Sales) show all debits and credits related to
them. Each account shows the ongoing balance of a specific type of
transaction.

Trial Balance: After posting all entries to the ledger, the balances of each
ledger account are listed in the trial balance. This is used to check if the total
debit balances equal the total credit balances, ensuring that the double-entry
system is followed correctly.

Final Accounts: Once the trial balance is verified, the financial statements
(final accounts) are prepared:

Trading Account: Calculates gross profit (Sales - Cost of Goods Sold).

Profit & Loss Account: Calculates net profit (Gross Profit - Expenses).
Balance Sheet: Shows the company's financial position by listing all assets
 From the following information, determine cash
received from debtors during current year:
Debtors in the beginning of current year 100

Total sales
2,000

Cash sales
500

Debtors at the end of current year 300

From the following
Determine cash paid to suppliers/creditors from the
(i) determine the gross amount of plant and machinery
following data during current year:
purchased and
Cost of goods sold: (ii) depreciation charged during the current year.
Rs 480 lakh Plant assets (net of depreciation) at year-end Rs 285 lakh and at
Opening stock: the year-beginning Rs 127 lakh.
Rs 30 lakh Gross plant assets increased by Rs 186 lakh even though machine
Closing stock: costing initially Rs 58 lakh with book value of Rs 38 lakh was sold
at loss of Rs 25 lakh.

Rs 50 lakh
 Usefulness

Analysts:
· Investors and Shareholders:  How do cash flows compare to reported earnings?
 Is the company generating enough cash from operations?  What are the trends in operating, investing, and financing cash
 How effectively is the company using its cash? flows?
 Can theofcompany
Objectives sustain
Accounting or increase dividends?
Analysis  Is the company's cash flow sustainable?
 Is the company relying too heavily on external financing? · Suppliers:
· Creditors and Lenders:  Can the company pay its bills on time?
 Can the company meet its debt obligations?  Is the business financially stable enough for long-term
 Is the company generating sufficient cash to cover interest partnerships?
payments? · Employees:
 What is the quality of the company's earnings?  company financially healthy enough to provide job security?
· Management:  Can the company afford salary increases or bonuses?
 Are current operations providing enough cash for future · Regulators:
growth?  Is the company complying with financial regulations?
 Which activities are generating or consuming the most  Are there any unusual cash flow patterns that warrant
cash? investigation?
 Is there a need to adjust business strategy or operations? · Competitors:
 Is there enough cash for capital expenditures or  cash management compare to industry standards?
acquisitions?  What investment or financing strategies is the company using?
 Cash from Operating
Activities
• Cash receipts from the sale of goods and the rendering of services

• Cash receipts from royalties, fees, commissions, and other revenues

• Cash payments to suppliers for goods and services

• Cash payments to and on behalf of employees

• Cash receipts and cash payments of an insurance enterprise for premiums and

claims, annuities and other policy benefits

• Cash payments or refunds of income taxes unless they can be specifically identified

with financing and investing activities

• Cash receipts and payments relating to futures contracts, forward contracts, option

contracts, and swap contracts when the contracts are held for dealing or trading

purpose
 Cash from Investing
Activities
• Cash payments to acquire fixed assets (including intangibles). These

payments include those relating to capitalised research and

development costs and self-constructed fixed assets

• Cash receipts from disposal of fixed assets (including intangibles)

• Cash payments to acquire shares, warrants or debt instruments of other

enterprises and interests in joint ventures

• Cash receipts from disposal of shares, warrants, or debt instruments of

other enterprises and interests in joint ventures

• Cash advances and loans made to third parties

• Cash receipts from the repayment of advances and loans made to third

parties
Cash from Financing
Activities

• Cash proceeds from issue of shares or other similar instruments

• Cash proceeds from issue of debentures, loans, notes, bonds and

other short-term or long-term borrowings

• Cash repayments of amounts borrowed

• Buy-back of shares

• Redemption of preference shares

• Dividend/interest paid
Particulars April 1, 2009 March 31, 2010
Sundry debtors 30,000 40,000
Stock in trade 55,000 60,000

Bills receivable 10,000 12,000

Prepaid expenses 3,000 2,000
Total Assets 108,000 114,000
Sundry creditors 48,000 30,000
Outstanding expenses 3,000 6,000
Bills payable 8,000 6,000
Dividends payable 0 3,000
Provision for doubtful accounts 1,500 2,000
Accumulated depreciation 50,000 60,000
Total Liabilities 110,500 107,000
Net Income (as per profit and loss
account) 0 80,000
The following information is available for XYZ Company for the year ended December 31,
2023. Using this information, prepare a Cash Flow Statement following the indirect method.
Income Statement Information:
 Net Income: $50,000
Additional Information:
o Depreciation: $10,000
o Amortization: $5,000
o Loss on Sale of Equipment: $2,000
o Increase in Accounts Receivable: $3,000
o Decrease in Inventory: $4,000
o Increase in Accounts Payable: $7,000
o Increase in Prepaid Expenses: $2,000
o Purchase of Equipment: $15,000
o Proceeds from Sale of Equipment: $5,000
o Issuance of Common Stock: $20,000
o Repayment of Long-term Debt: $10,000
o Dividends Paid: $5,000
Extraordinary Items

• Interest

• Dividends
Objectives – Paid or received?
of Accounting Analysis

• Taxes on Income – Operating or Financing?

• Deferred Taxes -??

• Investment in Subsidiaries, Associates and Joint Ventures

• Acquisitions and Disposal of Subsidiaries and other Business Units

• Non-Cash Transaction
 March 31, Previous Liabilities & March 31, Current March 31, Previous
Assets March 31, Current Year Year Equities Year Year
Cash 2 10 Current Liabilities 105 30
Receivables (net) 60 30 Long-term Debt 150 —
Stockholder’s
Inventories 100 50 Equity 207 160
Plan Assets (net of
accumulated
depreciation) 300 100
Total Assets 462 190 Total Equities 462 190

Additional Information
• Net income before taxes, Rs 81 lakh.
• Taxes paid are Rs 27 lakh.
• Net income was Rs 54 lakh.
• Cash dividend
• paid were Rs 7 lakh.
• Depreciation was Rs 20 lakh.
• Fixed assets were purchase for Rs 220 lakh, Rs 150 lakh
• of which was financed via the issuance of long-term debt
 Balanced Scorecard (BSC)

A Balanced Scorecard (BSC) is a strategic planning and management system used by organizations to
align business activities with their vision and strategy, improve internal and external communications,
and monitor organizational performance against strategic goals. It was developed by Robert Kaplan and
Objectives of Accounting
David Norton Analysis
in the early 1990s.
The Balanced Scorecard approach suggests viewing the organization from four key perspectives:
1. Financial Perspective – Sales, profit, growth rate
2. Customer Perspective – CLV, NPS, CSAT
3. Internal Business Processes Perspective – waste management, cycle time
4. Learning and Growth Perspective – Training hours, R&D, Employee happiness

For each perspective, the organization defines:

 Objectives: What the organization wants to achieve
 Measures: How progress will be tracked
 Targets: The specific level of performance to reach
 Initiatives: Actions to be taken to meet the objectives
 Mission
“Bring inspiration and innovation to every athlete* in the
world. *If you have a body, you are an athlete.”

“Connect the world’s professionals to make them more productive

and successful.”

Consistent with the vision and values of the founder Jamsetji

Tata, Tata Steel strives to strengthen India’s industrial base
through effective utilisation of staff and materials. The means
envisaged to achieve this are cutting-edge technology and high
productivity, consistent with modern management practices.
Vision
“To become the world’s most
trusted company.”

We aspire to be the global steel industry benchmark for Value Creation

and Corporate Citizenship.
Perspect
ive Objective Measure Target Initiative
Year-over-year Launch new product
Increase revenue growth Or 10% annual lines and expand
Financial revenue RoI/ RoA growth into new markets
Implement a new
Improve customer feedback
Custome customer Customer Achieve a score of system and improve
r satisfaction satisfaction score 4.5/5 response times
Implement lean
Internal manufacturing
Business Reduce principles and
Processe production Average time from Reduce cycle time upgrade production
s cycle time order to delivery by 20% equipment
Develop a
comprehensive
40 hours of training program and
Learning Enhance training per partner with
and employee Number of training employee educational
Growth skills hours per employee annually institutions