chapter 03 {final energy financial management}.doc

8/14/2019 Chapter 03 {Final Energy Financial Management}.Doc

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Chapter - 3Analysis of Financial statements

3.1 Introduction

As observed in the previous chapter, a basic limitation of the tradition financialstatements comprising the balance sheet and the profit and loss account is that theydo not give all the information related to the financial operations of a firm.Nevertheless, they provide some extremely useful information to the extent that thebalance sheet mirrors the financial position on a particular date in term of thestructures of assets, liabilities and owners equity, and so on and the profit and lossaccount shows the results of operations during a certain period of time in term of the revenues obtained and the cost incurred during the year. Thus, the financialstatements provide a summarized view of the financial position and operation of afirm. Therefore, much can be learnt about a firm from a careful examination of itsfinancial statements as invaluable documents/performance reports. The analysis of financial statements is, thus, an important aid to financial analysis.

The focus of financial analysis is on key figure in the financial statements and thesignificant relationship that exits between them. The analysis of financial statementsis a process of evaluating the relationship between components parts of financialstatements to obtain a better understanding of the firms position and performance.The first task of the financial analyst is to select the information relevant to thedecision under consideration from the total information contained in the financialstatements. The second step is to arrange the information in a way to highlightsignificant relationships. The final step is interpretation and drawing of inferencesand conclusions. In brief financial analysis is the process of selection and evaluation.

3.2 Financial Ratios Meaning and Rationale

Ratio analysis is widely-used tool of financial analysis. It can be used to compare therisk and return relationship to firm of different sizes. It is defined as the systematicuse of ratio to interpret the financial statements so that the strength and weaknessesof a firm as well as its historical performance and current financial condition can bedetermined. The term ratio refers to the numerical or quantitative relationshipbetween two items/variables.

This relationship can be expressed as

(i) Percentage, say, net profits are 25 percent of sales (assuming netprofits of Rs 25,000 and sales of Rs 1,00,000,

(ii) Fraction (net profits is one-fourth of sales) and(iii) Proportion of numbers (the relationship between net profits and sales

is 1:4).


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These alternative methods of expressing items which are related to each other are,for purpose of financial analysis, referred to as ratio analysis. It should be notedthat computing the ratios does not add any information not already inherent in theabove figure of profits and sales. What the ratios do is that they reveal therelationship in a more meaningful way so as to enable equity investors, management

and lenders made better investment and credit decisions.The rationale of ratio analysis lies in the fact that it makes related informationcomparable. A single figure by itself has no meaning but when expressed in term of a related figure, it yields significant inferences. For instance, the fact that the netprofits of a firm amount to, say, Rs 10 lakhs throws no light on its adequacy orotherwise. The figure of net profit has to be considered in relation to other variables.How does it stand in relation to sales? What does it represents by way of return ontotal assets used or total capital employed? If, therefore, net profits are shown interms of their relationship with items such as, assets, capital employed, equity andso on, meaningful conclusion can be drawn regarding their adequacy. To carry the

above example further, assuming the capital employed to be Rs 50 lakh and Rs 100lakh, the net profits are 20 per cent and 10 per cent respectively. Ratio analysis,thus, as quantitative tool, enables analysis to draw quantitative answers to questionssuch as: Are the net profits adequate? Are the assets being used efficiency? Is thesolvent? Can the firm meet its current obligations and so on?

Ratio analysis is one of the techniques of financial analysis where ratios are used asa yardstick for evaluating the financial condition and performance of a firm.Analysis and interpretation of various accounting ratios gives skilled andexperienced analysts a better understanding of the financial condition andperformance of the firm than what he could have obtained only through a perusal of

financial statements.3.3 Financial Ratio Analysis

The ratio is an arithmetical between two figures. Financial ration analysis is a studyof ratios between various items or groups of items in financial statements. Financialratios have been classified in several ways. For our purpose, we divide them into fivebroad categories as follows:


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Liquidity ratios Leverage ratios Turnover ration Profitability ration Valuation ratio

To facilitate the discussion of various ratios the financial statements of HorizonLimited shown in the following statements will be used.

Horizon Limited: Profit and Loss Account for the year Endings 31 st March 2001

(Rs in Million)

Items 2001 2000Net sales 701 623Cost of goods sold 552 475

Stocks 421 370Wages and salaries 68 55Other manufacturing expanses 63 50

Gross profit 149 148Operating expanses 56 49

Depression 30 26General administration 12 11Selling 14 12

Operating profit 93 99Non- operating surplus/deficit (4) 6Profit before interest and tax (PBIT) 89 105Interest 21 22Profit before tax (PBT) 68 83Tax 34 41Profit after tax (PAT) 34 42Dividends 28 27Retained earnings 6 15Per share data(in rupees)

Earning per share 2.3 2.8Dividend per share 1.8 1.8Market Price per share 21.00 20.0Book value per share 17.47 17.07

Horizon Limited: balance Sheet as on 31 st March 2001

(Rs in Million)

2001 2000I Sources of Funds

1. Shareholders Funds 262 256(a) Share Capital 150 150(b) Reserves & Surplus 112 106

2. Loans Funds 212 156(a) Secured Loans 143 131

(i) Due after 1 year 108 29


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(ii) Due within 1 year 35 40(b) Unsecured Loans 69 25

(i) Due after 1 year 29 10(ii) Due within 1 year 40 15

--------- ----------474 412

II Application of Funds1. Fixed Assets 330 3222. Investments 15 15

(i) Long term investments 12 12(ii) Current investments 3 3

3. Current Assets, loans, Advances 234 156a. Inventories 105 72b. Sundry Debtors 114 68c. Cash & bank balance 10 6d. Loans & advances 5 10

less: Current Liabilities and Provision 105 81Net Current Assets 129 75

-------- ----------Total 474 412

3.3.1 Liquidity Ratios

Liquidity refers to the ability of a firm to meet its obligations in the short run,usually one year. Liquidity ratios are generally based on the relationship betweencurrent assets (the sources for meeting short-term obligations) and currentliabilities. The important liquidity ratios are

Current ratio: - A very popular ratio, current ratio is defined as:

Current AssetsCurrent Liabilities

Current assets include cash, current investments, debtors, inventories (stocks), loansand advances, and pre-paid expanses. Current liabilities represent liabilities that areexpected to mature in the next twelve months. These comprise (i) loans, secured orunsecured, that are due in the next twelve months and (ii) current liabilities andprovisions.

Horizon Limiteds current ration is: 237/180 = 1.32

The current ration measures the ability of the firm to meet its current liabilities current assets converted into cash in the operating cycle of the firm and provide thefunds needed to pay current liabilities. Apparently, higher the current ratio, thegreater the short-term solvency. However, in interpreting the current ratio thecomposition of current assets must not be overlooked. A firm with a higherproportion of current assets in the form of cash and debtors is more liquid than onewith a high proportion of current assets in the form of inventories even though boththe firms have the same current ratio.


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The general norm for current ratio in India is 1.33. Internationally it is 2

Acid-test ratio: - A lso called the quick ratio, the acid test ratio is defined as:

Quick Assets

Current Liabilities

Quick assets are defined as current assets excluding inventories.

Horizons acid-test ratio for 2001 is: (237-105)/180 = 0.73

The acid test ratio is a fairly stringent measure of liquidity. It is based on thosecurrent assets which are highly liquid inventories are excluded from thenumerator of this ratio because inventories are deemed to be least liquid componentof current assets.

Cash ratio:- Because cash and bank balance and short term marketable securitiesare the most liquid assets of a firm, financial analysts look at cash ratio, which isdefined as:

cash and bank balance Current investmentsCurrent liabilities

+

Horizons cash ratio for 2001 is: (10+3)/180 = 0.07

Clearly, the cash ratio is perhaps the most stringent measure of liquidity. Indeed,

one can argue that it is outlay stringent. Lack of immediate cash may not matter if the firm can stretch its payments or borrows money at short notice.

3.3.2 Leverage Ratios

Financial leverage refers to the use of debt finance. While debt capital is a cheapersource of finance, it is also a riskier source of finance. Leverage ratios help inassessing the risk arising from the use of dept capital. Two types of ratios arecommonly used to analyze financial leverage: structure ratios and coverage ratios.Structure ratios are based on the proportions of dept and equity in the financialstructure of the firm. The important structure ratios are: debt-equity ratio anddept-assets ratio. Coverage ratios show the relationship between debt servicingcommitment and the sources for meeting these burdens. The important coverageratios are: interest coverage ratio, fixed charges coverage ratio, and debt servicescoverage ratio.

Debt equity Ratio:- The debt-equity ratio shows the relative contributions of creditors and owners. It is defined as:


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Debt Equity

a

The numerator of this ratio consists of all debt, short-term as well long-term, andthe denominator consists of net worth plus preference capital.

Horizons debt-equity ratio for the 2001 year-end is: 212/262 = 0.809

In general, the lower the debt-equity ratio, the higher the degree of protectionenjoyed by the creditors. In using this ratio, however, the following points should beborne in mind:

1. The book value of equity may be an understanding of its true value in aperiod of rising prices. This happens because assets are carried at theirhistorical values less depreciation, not at current value.

2. Some forms of debt (like term loans, secured debentures, and secured short-term bank borrowing) are usually protected by specific collateral and enjoysuperior protection.

Debt-assets ratio: - The debt-assets ratio measure the extant to which borrowedfunds supports the firms assets. It is defined as:

Debt Assets

The numerator of this ratio includes all debt, short-term as well as long-term, andthe denominator of this ratio is the total of all assets (the balance sheet total).

Horizons debt-assets ratio for 2001 is: 212/474 = 0.45

Interest coverage Ratio Also called the times interest earned, the interestcoverage ratio is defined as:

intint

Profit before erest and taxeserest

Horizons interest coverage ratio for 2001 is: 89/21 = 4.23

Note that profit interest and taxes is used in the numerator of this ratio because theability of a firm to pay interest is not affected by tax payment, as interest on debtfunds is a tax-deductible expanse. A high interest coverage ratio means that the firmcan easily meet its interest burden even if profit before interest and taxes suffer aconsiderable decline. A low interest coverage ratio may result is widely in financialembarrassment when profit before interest and taxes decline. This ratio is widelyused by lenders to assess a firms debt capacity. Further, it is major determine of


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bond rating. Though widely used, this ratio is not very appropriate measure of interest coverage because the source of interest payment is cash flow before interestand taxes, not profit before interest and taxes. In view of this, we may use amodified interest coverage ratio:

intint

profit before erest and taxes Depreciation Debt erest

+

For horizons Limited, this ratio for 2001 is: 119/21 = 5.67

Fixed charges Coverage Ratio:- This ratio shows how many times the cashflow before interest and taxes covers all fixed financing charges. It is defined as:

intRe

1

profit before erest and taxes Depreciation payment of loan

Interest Tax rate

+

+

In the denominator of this ratio only the repayment of loan is adjusted upwards forthe tax factor because the loan repayment amount, unlike interest, is not taxdeductible.

Horizons fixed charge coverage ratio for 2001 is:( )

70.05.07521

119=

+

This ratio measures debt servicing ability comprehensive because it considers boththe interest and the principle repayment obligations. The ratio may be amplified toinclude other fixed charge like lease payment and preference dividends.

Debt Service Coverage Ratio:- Used by term-lending financial institution inIndia, the debt service coverage ratio is defined as:

Pr arg intRe

ofit after tax Depreciation Other non cash ch e erest on term loan Interest on term loan payment of term loan

+ + +

+

Financial institutions calculate the average debt service coverage ratio for theperiod during which the term loan for the project is repayable. Normally, financialinstitutions regard a debt service coverage ratio of 1.5 to 2.0 satisfactory.

3.3.3 Turnover Ratios

Turnover ratios, also refereed to as activity ratios or assets management ratiosmeasure, how efficiently the assets are employed by a firm. These ratios are basedon the relationship between the level of activity, represented by sales or cost of goods sold, and levels of various assets. The important turnover ratios are:


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inventory turnover, average collection period, receivable turnover, fixed assetsturnover, and assets turnover.

Inventory turnover: - The inventory turnover, or stock turnover, measure howfast the inventory is moving through the firm and generating sales. It is defined as:

Cost of goods sold Average inventory

Horizons inventory turnover for 2001 is:( )

5526.24

105 72 2=

+

In inventory turnover reflects the efficiency of inventory management. The higherthe ratio, the more efficient the management of inventories and vice verse. However,this may not always be true. A high inventory turnover may be caused by a low level

of inventory which may result in frequent stockouts and loss of sales and customersgoodwill.

Notice that as inventories tend to change over the year, we use the average of theinventories at the beginning and end of the year. In general, average may be usedwhen a flow figure (in this case, cost of goods sold) is related to a stock figure(inventories).

Debtors turnover: - This ratio shows how many accounts receivable (debtors)turn over during the year. It is defined as:

Average Accounts Receivable (debtors) Net credit sales

If the figure for net credit sales is not available, one may have to make do with netsales figure.

Horizons debtors turnover for 2001 is:( )

7017.70

114 68 2=

+

Obviously, the higher the debtors turnover the greater the efficiency of credit

management.

Average Collection Period : - The average collection period represents thenumber of days worth of credit sales that is locked in debtors (accounts receivable).It is defined as:


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Average Debtors Average daily credit sales

If the figure for credit sales is not available, one may have to make do with the netsales figure.

Horizons average collection period for 2001 is:( )114 68 2

47.4701 365

days+

=

Note that the average collection period and the accounts receivable turnover arerelated as follows:

365average collection period=

accounts receivable (debtors) turn over

The average collection period may be compared with the firms credit terms to judge the efficiency of credit management. For example, if the credit terms are 2/10,net 45, an average collection period of 85 days means that the collections is slow andan average collection period of 40 days means that the collection is prompt. Anaverage collection period which is shorter than the credit period allowed by the firmneeds to be interpreted carefully. It may mean efficiently of credit management orexcessive conservation in credit granting that may result in the loss of somedesirable sales.

Fixed Assets Turnover: - this ratio measure sales per rupee of investment infixed assets. It is defined as:

Net SalesAverage net fixed assets

Horizons fixed Asserts turnover ratio for 2001 is:( )

7012.15

330+322 2=

This ratio is supposed to measure the efficiency with which fixed assets areemployed- a high ratio indicates a high degree of efficiency in assets utilization andhow a low ratio reflects inefficient use of assets. However, in interpreting this ratio,one caution should be borne in mind. When the fixed assets of the firm are old andsubstantially depreciated, the fixed assets turnover ratio tends to be high becausethe denominator of the ratio is very low.

Total Assets Turnover:- Akin to the output-capital ratio in economic analysis,the total asserts turnover is defined as:


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AssetsTotal AverageSales Net

Horizons total assets turnover ratio for 2001 is:( )

7011.58

474+412 2=

This ratio measure how efficiently assets are employed, overall.

3.3.4 Profitability ratio

Profitably reflects the final results of business operation.

There are two types of profitability

(i) Profit margins ratio show the relationship between profit and sales.

Gross profit margin ratio and

Net profit margin ratio

(ii) Rate of return ratios reflects the relationship between profit andinvestment.

Return on total assets,

Earning power, and

Return on equity.

Gross Profit Margin Ratio: - The gross profit margin ratio is defined as:

PrGross ofit Net Sales

Gross profit is defined as the difference between net sales and cost of goods sold.

Horizons gross profit margin ratio for 2001 is: 149/701=0.21 or 21 Per cent

This ratio shows the margin left after meeting manufacturing costs. It measure theefficiently of production as well as pricing.

Net Profit Margin Ratio: - The net profit margin ratio is defined as:


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Pr Net ofit Net Sales

Horizons net profits margin ratio for 2001 is: 34/701 = 0.049 or 4.9 percent

This ratio shows the earning left for shareholders (both equity and preference) aspercentage of net sales. It measures the overall efficiency of production,administrations, selling, financing, pricing and tax management. Jointly consider,the gross and net profit margin ratios provides a valuables understanding of the costand profit structure of the firm and enable the analysis to identify the sources of business efficiency / inefficiency.

Return on Total Assets: - A commonly used tare of return measure, the returnon total assets (also called return on capital employed or return on investment) isdefined as:

( )Pr Net Income ofit Average Total Assets

Horizons return on total assets for 2001 is:

( )34

0.077 7.7%474 412 2

or =+

The net income to total assets ratio is supposedly a measure of how efficiently thecapital is employed. Though widely used, this is an odd measure because thenumerator measures the return to shareholders (equity and preference) and thedenominator represents the contribution of shareholders as well as creditors.

To ensure internal consistency, the following variants of return on total assets maybe employed:

Net Income Interest Average Total Assets

+

Horizons return on total assets modified measure for 2001 is:

( )( )

34 210.124 12.4%

474 412 2or

+=

+

Earning Power: - A measure of operating profitability, the earning power isdefined as:


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Pr ofit before Interest and Taxs Average Total assets

Horizons earning power for 2001 is:

( )89 0.201 20.1 %

474 412 2or =

+

The earning power is a measure of business performance which is not affected byinterest charges and tax payments. It abstracts away the effects of financialstructure and tax rate and focus on operating performance. Hence, it is eminentlysuited for inter-firm comparisons. Further, it is internally consistent. Thenumerator represents a measure of pre-tax earning belonging to all sources of finance and the denominator represents total financing.

Return on Equity: - A measure of greater interest to equity shareholder, thereturn on equity is defined as:

arg Equity earning

Ave e Net worth

The numerator of this ratio is equal to profit after tax less preference dividends. Thedenominator includes all contributions made by equity shareholders (paid-upcapital + reserves and surplus). This ratio is also called the return on net worth.

Horizons return on equity for 2001 is: ( )34

0.131 13.1 %262 256 2 or =+

The return on equity measures the profitability of equity funds invested in the firm.It is regarded as a very important measure because it reflects the productively of theownership (or risk) capital employed in the firm. It is influenced by several factors:earning power, debt-equity ratio, average cost of debt funds, and tax rate.

In judging all the profitability measures it should be borne in mind that thehistorical valuation of assets imparts an upwards bias to profitability measuresduring an inflationary period. This happens because the numerator of these

measures represents current values, whereas the denominator represents historicalvalues.

3.3.5 Valuations Ratios

Valuation ratios indicate how the equity stock of the company is assessed in thecapital market. Since the market value of equity reflects the combined influence of risk and return, valuation ratios are the most comprehensive measure of a firms


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performance. The important valuation ratios are: price-earning ratios, yield, andmarket value to book value ratio.

Price earning ratio: - Perhaps the most popular financial statistic in stockmarket discussion, the price-earning ratio is defined as:

Market price per share Earnings per share

The market price per share may be the price prevailing on a certain day or theaverage price over a period of time. The earnings per share is simply: profit aftertax less preference dividend divided by the number of outstanding equity shares.

Harizons price-earning ratio at the end of 2001 is :

219.132.3 =

The price-earning ratio (or the price-earnings multiple as it is commonly referredto) is a summary measure which primarily reflects the following factors: growthprospects, risk characteristics, shareholders orientations, corporation image, anddegree of liquidity.

Yield: - This is a measure of the rate of return earned by shareholders. It is definedas:

PrPr

Dividend ice Change Initial ice

+

This may be split into two parts:

PrPr Pr

Dividend ice Change Initial ice Initial ice

+ .i.e. Dividend yield + Capital gains/Losses yield

For Horizons the dividend yield and the capital gains yield for 2001 are as follows:

Dividend yield = 1.8/20.0 = 9% and Capital gains yield = 1.0/20.0 = 5 %.Hence, the total yield for 2001 was 14 Percent. Generally companies with lowgrowth prospects offer a high dividend yield and a low capital gains yield. On theother hand, companies with superior growth prospects offer a low dividend yieldand a high capital gains yield.


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Market value to Book value ratio: - Another popular stock market statistic,the market value to book value is defined as:

Market value per share Book value per share

Horizons market value to book value ratio at the end of 2001 was:

= 21.00/17.47 = 1.20

In a way, this ratio reflects the contribution of a firm to the wealth of society. Whenthis ratio exceeds 1 it means that the firm has contributed to the creation of wealthin the society if this ratio is, say, 2, the firm has created a wealth of one rupee forevery rupee invested in it. When this ratio is equal to 1, it implies that the firm hasneither contributed to nor detracted from the wealth of society.

It may be emphasized here that if the market value to book value ratio is equal to 1,all the three ratios, namely, return on equity, earning-price ratio (which is theinverse of the price earning ratio), and total yield, are equal.

3.4 Common size statements

Ratio analysis apart, another useful way of analyzing financial statements is toconvert them into common size statements by expressing absolute rupee amountsinto percentage. When this method is pursued, the income statement exhibits eachexpanse item or group of expense items as a percentage of net sales, and net salesare taken at 100 per cent. Similarly, each individual assets and liability classificationis shown as a percentage of total assets and liabilities respectively. Statementsprepared in this way are referred to as Common-Size statements.

A company financial statement that displays all items as percentages of a commonbase figure. This type of financial statement allows for easy analysis betweencompanies or between time periods of a company.

The values on the common size statement are expressed as percentages of astatement component such as revenue. While most firms don't report theirstatements in common size, it is beneficial to compute if you want to analyze two ormore companies of differing size against each other.

Formatting financial statements in this way reduces the bias that can occur whenanalyzing companies of differing sizes. It also allows for the analysis of a companyover various time periods, revealing, for example, what percentage of sales is cost of goods sold and how that value has changed over time.


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3.4.1 What are common-size financial statements?

Common-size financial statements usually involve the balance sheet and the incomestatement. These two financial statements become common-size when their dollaramounts are expressed in percentages.

For example, a common-size balance sheet will report all of the balance sheetamounts as a percentage of the Total Assets amount. If Cash was $80,000 andTotal Assets were $1,000,000 then Cash will appear as 8% and Total Assets willappear as 100%. If the Current Assets were $350,000 they will appear as 35%. If Current Liabilities were $180,000 then on the common-size statement they willappear as 18%. By having all of the balance sheet amounts as a percentage of TotalAssets, you can compare your companys current asset percentage (and all otherline items) to your industrys percentage or to any other companys percentages. Itdoesnt matter if the other company is larger or smaller than your company,because all amounts are in percentages of Total Assets. Hence, the name common-

size.

A common-size income statement will show all of the income statement amounts as apercentage of net sales. If net sales are $10,000,000 and the cost of goods sold is$7,800,000, the common-size income statement will report net sales as 100% and thecost of goods sold as 78%. If SG&A expenses are $1,300,000 they will appear as13%. Having the income statement in percentages of net sales allows you to compareyour companys SG&A expenses and its gross profit to your industry percentagesand to other companies regardless of size.

An easy way to spot trends in your balance sheet and income statement data from a

number of years, or to compare your information with that of another company orindustry group, is to use "common size" financial statements.

To create common size statements, you simply take the information from yourregular statements, and express it as percentages rather than as absolute dollars.This makes it much easier to pinpoint differences from year to year, and to compareyour data with that of one or more companies that may be considerably larger orsmaller than yours. Moreover, if you get industry data or financial data on yourcompetitors from a commercial service, the best way to compare the data is toexpress all financials in the common-size, percentage, and format.

Here's an example of an income statement that shows both absolute dollar valuesfor four years, and also common size percentages for the same four years. Note thatall items on the common size part of the statement are expressed in terms of apercentage of sales. To arrive at the common size percentage for an item, we simplydivided the dollar value of that item by the dollar value of sales for the period.

Dollars, in Thousands Common Size Percentage


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1 2 3 4 Years 1 2 3 4

$525 $595 $630 $724 Sales 100 100 100 100

158 190 208 217 Gross Margin 30 32 33 30

79 95 95 101 Selling Exp. 15 16 15 14

31 31 32 32 Gen. & Admin. 6 5 5 4

$ 48 $ 64 $ 81 $ 84 Operating Inc. 9 11 13 12

6 6 6 8 Interest 1 1 1 1

$ 42 $ 58 $ 75 $ 76 Pretax Income 8 10 12 10

14 20 26 26 Fed. Inc. Tax 3 3 4 4

$ 28 $ 38 $ 49 $ 50 Net Income 5 6 8 7

Here's an example of a balance sheet that shows both absolute dollar values for fouryears, and common-size percentages for the same four years. Notice that items

normally appearing on the asset side of the balance sheet are presented as apercentage of total assets. Items normally on the liabilities and equity side of thesheet are presented as a percentage of total liabilities and equity.

Dollars, in Thousands Common Size Percentage

1 2 3 4 Years 1 2 3 4

$ 50 $ 40 $ 45 $ 70 Cash 6 4 5 7

230 250 175 225 Accts. Rec. 26 27 19 22

175 180 195 185 Inventory 20 19 21 18

10 15 10 310 Other Current Assets 1 2 1 1


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$465 $485 $425 $490 Total Current Assets 53 52 46 48

400 425 500 515 Plant & Equip. 45 46 54 51

15 20 5 10 Other Non-Current Assets 2 2 1 1

$880 $930 $930 $1015 Total Assets 100 100 100 100

200 225 220 210 Accts. Pay. 23 24 24 21

50 45 20 80 Bank Debt 6 5 2 8

$ 250 $ 270 $ 240 $ 290 Total Current Liabs. 28 29 26 29

150 100 60 250 Long-Term Debt 17 11 6 25

$ 400 $ 370 $ 300 $ 540 Total Liabs. 45 43 32 53

480 560 630 475 Owner's Equity 54 52 68 47

$ 880 $ 930 $ 930 $ 1015 Total Liabs. & Equity 100 100 100 100

Common Size Income Statements Industry

1997 1998 1998 Net Sales 100.0% 100.0% 100.0%Costs excluding depreciation 87.6 87.2 87.6Depreciation 3.2 3.3 2.8

Total Operating Costs 90.8 90.5 90.4Earnings before interest & taxes 9.2 9.5 9.6

Less interest 2.1 2.9 1.3Earnings before taxes 7.1 6.5 8.3

Taxes (40%) 2.8 2.6 3.3Net income before preferred dividends 4.3 3.9 5.0

Preferred dividends 0.1 0.1 0.0Net income available to common stockholders 4.1 3.8 5.0


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============================================================Common Size Balance Sheets

Industry1997 1998 1998

Assets

Cash & Marketable securities 4.8% 0.5% 3.2%Accounts receivable 18.8 18.8 17.8Inventories 24.7 30.8 19.8

Total Current Assets 48.2 50.0 40.8Net plant & equipment 51.8 50.0 59.2Total Assets 100.0 100.0 100.0

Liabilities & EquityAccounts payable 1.8% 3.0% 1.8%Notes payable 3.6 5.5 4.4Accruals 7.7 7.0 3.6

Total current liabilities 13.1 15.5 9.8Long term bonds 34.5 37.7 30.2Total Debt 47.6 53.2 40.0

Preferred equity 2.4 2.0 0.0Common equity 50.0 44.8 60.0Total Liab. & Equity 100.0 100.0 100.0

Common size comparative statements prepared for one firm over the year wouldhighlights the relative changes in each group of expanses, assets and liabilities.These statements can be equally useful for inter-firm comparisons, given the factthat absolute figure of two firms of the same industry are not comparable. Financial

statements and common-size statements of the Hypothetical Ltd are presented inExample 7.10.

The accompanying balance sheet and profit and loss account relate to HypotheticalLtd. Convert these into common-size statements.

Balance Sheet as at March 31 (Amount in lakh of rupees)

Particular Previous Year Current Year


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Liabilities

Equity share capital (of Rs 10 each)

General Reserves

Long-term loans

Creditors

Outstanding expanses

Other current liabilities

Assets

Plant (net of accumulated depreciation)

Cash

Debtors

Inventories

240

96

182

67

6

9

600

402

54

60

84

600

240.0

182.0

169.5

52.0

---

6.5

650.0

390

78

65

117

650

Income Statements for the Year Ended March 31 (Amount in lakh of rupees)

Particular Previous Year Current yearGross sales

Less: Return

Net Sales

Less: Cost of Goods Sold

Gross Profit

Less: Selling, general, and administrative cost

Operating Profit

Less: Interest expanses

Earning before taxes

370

20

350

190

160

50

110

20

90

480

30

450

215

235

72

163

17

146


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Less: Taxes

Earning after taxes

31.5

58.5

51.5

94.9

Solution

Balance Sheet as at March 31 (Amount in lakh of rupees)

Particular Previous Year Current YearOwners Equity:

Equity share capital (of Rs 10 each)

General Reserves

Long-term borrowings:

Loans

Current liabilities:

Creditors

Outstanding expanses

Other current liabilities

Total liabilities

Fixed Assets:

Plant (net of accumulated depreciation)

Current assets:

Cash

40.0

16.0

56.0

30.3

11.2

1.0

1.5

13.7

100

67.0

9.0

36.9

28.0

64.9

26.1

8.0

---

1.0

9.0

100

60.0

12.0

10.0


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Debtors

Inventories

10.0

14.0

33.0

100

18.0

40.0

100

Income Statements for the Year Ended March 31 (Percentage)

Particular Previous Year Current yearNet sales

Less: Cost of Goods Sold

Gross Profit

Selling, general, and administrative cost

Operating Profit

Interest

Earning before taxes

Taxes

100.0

54.3

45.7

14.3

31.4

5.7

25.7

9.0

16.7

100.0

47.8

52.2

16.0

36.2

3.8

32,4

11.4

21.0

These percentages figures bring out clearly the relative significance of each group of items in the aggregate position of the firm. For instance, in the current year theEAT of Hypothetical Ltd has increased to 21 percent from 16.7 percent in theprevious year. This improvement inn profitability can mainly be traced to thedecreases of 6.5 percent in the cost of goods sold, reflecting improvement inefficiency of manufacturing operations. The decreases in financial overheads(interest) by 1.9 percent during the current year can be traced to the repayment of apart of long-term loans. Further analysis indicates that profitability would havebeen more but for an increase in operating expanses ratio by 1.7 percent.

The common-size balance sheets shown that current assets as a percentage of totalassets have increased by 7 percent over previous year. This increase was shared byinventories (4 percent) and cash (3 percent); the share of debtors remainedunchanged at 10 percent. The proportion of current liabilities (mainly due tocreditors) was also lower at 9 percent in the current year compared to 13.7 percentin the previous year. These facts signal overall increase in the liquidity position of the firm. Further, the share of long-term debt has also declined and owners equityhas gone up from 56 percent in the precious year to 64.9 percent in the current year.


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3.5 Projected Financial Statements

Understanding the Role of Financial Statement Projections

Financial projections are an integral part of any comprehensive business plan. But,

just what are they and what benefit can they provide to your business?

Most businesses are accustomed to traditional financial statements which are"historical" in nature. That is to say that they measure income or present afinancial position for past events. The information as reported in historical financialstatements is a summarized presentation of the operations of the business during aspecific period of time.

While it is certainly important to know where you have been, it is equally importantto know where you are going. Thus, the purpose of "projected" financial statementsis to show what is likely to occur in the future based on key financial and business

assumptions of the present.

When preparing projected financial statements for a company, we begin the processby developing a computer spreadsheet model. These models consist of aninterrelated set of equations, formulas and linking expressions that define the keyassumptions used in the projections. A full projection will consist of an incomestatement, balance sheet, cash flow statement, various supporting schedules andnotes explaining the key assumptions used to develop the projected statements.Although projections may extend out to five years or more, usually several monthsto a year is more common due to the decreasing reliability of predicting futureevents.

Historical financial statements typically provide the starting point to develop theprojected reports. By studying the results of past operations we can identify keyrelationships within the financial results of the company. This information, alongwith interviews with the business owners, allows us to define the values andcalculations that will be used in the projected financial statements.

Developing these financial models can become rather complex. However, oncecompleted, these financial models can be used to run various "what if analysis"whereby a given value change can be entered in the model to see what effect it willhave on the results of business operations throughout all the reports.

Financial projections can be used as a "compass" to steer your company toward thefuture using a variety of possible scenarios. For example, projections can help tohighlight and answer such questions as:

How will my projected growth rate in revenues affect my variable and fixedcosts?

At what level of revenues does my break even point occur?


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What will be the impact of expanding or discontinuing a product line? In order to grow revenues by X% per year, what will be the required

increase in inventory? How will I finance this inventory increase? To achieve my projected growth, what new machinery acquisitions will be

required? What is the best means to finance it?

What would be the financial impact of leasing the equipment rather thanpurchasing it? What impact will inflation have on my business operations? How will our key financial ratios change given our expected projected

results? Will we be able to service our existing debt?

A comprehensive projection is like a road map. It shows you the best course to plotin managing the growth of your business and gives you a clearer vision of yourdestination.

Our firm has extensive experience in preparing projected financial statements forvarious industries and purposes. If youre applying for a bank loan, seekinginvestment capital or planning a business expansion we are available to answer anyquestions you might have with regard to preparing financial projections.

3.5.1 Preparing Monthly Projected Financial Statements for a Valuation

There are many things more interesting than the subject of monthly financialprojections or forecasts. But if you are called upon to prepare them, you will quicklydiscover that there is very little guidance available on the subject.

This article provides an overview of the reasons for including monthly projections ina valuation; the issues to be considered by an analyst when including them andconsiderations that will help an analyst prepare a more diligent set of projections.

There are three primary reasons that an analyst would want to include monthlyprojections as part of a valuation.

1. There are interim financial statements that are closer to the valuation dateand the analyst wants to project earnings and financial position from theinterim date until the end of the fiscal year (sometimes referred to as anannualization).

2. The interim statements reflect substantial changes to the structure of thefinancial statements thus making them a more reliable base for projectingforward.

3. The analyst is concerned about the changes in a companys financialperformance and position on a short-term (month-to-month) basis.

The process of preparing monthly statements requires a deeper look into the variouscyclical, seasonal and operational assumptions that impact the company. In addition


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to estimating monthly earnings, monthly financial statements can provide insightinto:

1. The liquidity and ability to meet its financial obligations.2. The adequacy of a companys working capital in light of growth.

3. The impact of capital expenditures and related financing activities.

3.5.2 Interim versus Annual Financial Statements

Interim Financial Statements are statements prepared at any time other than theend of the companys fiscal year. The usefulness of Interim Statements is largelydetermined by the proximity to the valuation date and the reliability of thenumbers. If the companys business cycle(s) is seasonal or the statements suggest asignificant change in financial performance, it may be useful to include them as partof a valuation.

There is an important difference between Annual (Year-End) and InterimFinancials. In privately owned companies, interim statements are prepared in-houseand, unless required by funding sources, are usually intended only for internalpurposes. Interim Statements may not be as complete or accurate as the Year-Endstatements. In some companies, certain adjustments typically addressed in theAnnual Statements might not be included in the Interim Statements. Suchadjustments include account receivable write-offs, reconciliation of inventory (bookversus physical), accrual accounts (interest, depreciation & amortization), prepaidexpenses, dividends, retirement contributions, contracts-in-process, and thetreatment of disbursements to owners and shareholders. Interim Statements seldominclude Accountants Notes and other appropriate disclosures further complicating

the analysts job. Therefore, an analyst will need to obtain the needed informationfrom management.

An analyst who wants to include monthly projections (whether from an interimperiod or year-end) can either obtain them from the company being valued orprepare them on his/her own. Projections prepared by the company may be morereliable because the preparer has access to accounting information and access toplans and budgets.

3.5.3 Key Components of Monthly Projections

If an analyst decides to proceed with monthly projections, its advisable to projectthe Income Statement, Balance Sheet, and Statement of Cash Flows. It is a mistaketo just project the Income Statement. Revenues and earnings impact AccountsReceivable, Accounts Payable, and Inventory balances as well as potentiallynecessitating the acquisition and disposals of Fixed Asset. Increases in revenues andearnings can easily be absorbed by the Balance Sheet sometimes, counter-intuitively,reducing bank balances.


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There are four basic approaches that an analyst can use to prepare monthlyprojected financial statements:

1. Use all or part of projections prepared by the client or company.2. Prepare projections using the Top-Down approach. In the Top-Down

approach, the analyst prepares the projection on an annual basis and thenallocates the numbers for each line item into the monthly projections.3. Prepare projections using the Bottom-Up approach. When using the Bottom

Up approach, the analyst projects each line item for every individual monthwith the sum of the months equaling the annual amount.

4. Prepare projections using a hybrid of all of the above.

Even in cases where the client or company has prepared detailed monthlyprojections; there is still a good chance that the historic statements (annual andinterim) will require certain account adjustments (normalization or recasting)which will not be included in the clients projection. Accordingly, the hybrid

approach gives the analyst the flexibility to use the other three approaches asappropriate for each account.

3.5.4 Preparing Monthly Projected Financial Statements for a Valuation- 2

It can be tempting to prepare a nave annualization or monthly projection usingone of two different approaches. Under the first nave approach, the annualization ismade by dividing the interim numbers by the number of months covered and thenmultiplying by twelve. The other nave option is to apply a sales cycle expressed asa percentage of the total sales in relation to a given month. These monthlypercentages are then applied to all line items. Both of these produce very speciousresults because they ignore business realities.

Elements of Monthly Projections

The key elements of a projection (including monthlies) are the collection of data, theperiod covered, the base values for each line item, any observations about thebehavior of a given line item, determining the appropriate approach, and thevariables to be applied.

Collect and Organize Data: The analyst needs to obtain the informationnecessary to diligently prepare the projections. Information includesfinancial statements, budgets, sales forecasts, market studies and any otherreliable source. The degree of information provided by management is goingto depend upon the reasons for the valuation and the party on whose behalf it is being prepared.

Period Covered: Monthly projections are most useful in the short-term. Theyare useful to annualize an Interim Financial Statement and can provideinsights into the impact of seasonality, business cycles and growth patterns


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upon the companys earnings and financial position. Its pretty much anarticle of faith. Confidence in projections decreases as the number of projected months increase.

Base Values: Unless an analyst magically pulls numbers out of thin air(which is not diligent or ethical), projection assumptions should have

continuity with the past and present. The analyst starts with the last valuefor the line item and the changes to that value over the observable past. Thevalue could be as stated on the financial statement (historic or normalized) oradjusted.

Observing Line-Item Behavior and Relationships: A line-item value is not astatic number. It is the result of actions undertaken by the company. It has arelationship to the other accounts. A company can have multiple revenuesources each having its own cycle, inventory requirements, and the relatedline item expenses. Some expenses follow sales, some follow a set budget,some expenses are level or fixed. In addition, the companys chart of accounts is not set in stone and new accounts may need to be added. The

same applies to Balance Sheet line items. Determining the Appropriate Approach: The analyst next needs todetermine whether to use all or part of projections provided by the client, theTop-Down approach, the Bottom-Up approach or a hybrid thereof. Differentapproaches can be used for different line items based upon available data.

Variable Application: Once the analyst has determined the period covered,base values, the best approach and has a handle on the line items behaviorand relationship to the whole, it is appropriate to proceed to applying thevariable. The variable is usually a percentage (i.e., percentage of growth,percentage of sales or percentage of wages) or a turnover rate (i.e., accountreceivable turns, inventory turns and so on). Variables can change fromperiod-to-period.In addition, there are a number of accounts that are calculatedindependently such as depreciation, amortization, interest, and such.

Focus on Substance Instead of Process

The analyst can use a spreadsheet to prepare the monthly projections or a financialmodeling system like the one that is included with Corporate ValuationProfessional. Home-grown spreadsheets give the analyst maximum flexibility, butrequire formula writing, link management, print control and usually lack a cohesiveinterface. Every time a line item is added or deleted or a variable is changed,formulae need to be re-written and the entire spreadsheet should be checked tomake sure that any dependencies have also been updated. As an alternative, asystem like Corporate Valuation Professional provides all of the formulaemanagement and presentation formatting so the analyst can focus his or herattention on getting inside of the numbers and their implications.


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Closing Thoughts

Its worth keeping in mind that by annualizing the interim statement and/or usingmonthly projections, you are increasing the number of assumptions that can bechallenged by the opposing side of any controversy involving the valuation. In

addition, there may be an unspoken assumption that an analyst who preparesmonthly projections has exercised care and thought beyond the level required toprepare annual projections. For that reason, diligence and care in the gathering anduse of data is advised, plus the analyst wants to clearly disclose the limitations of theprojections.

Furthermore, the analyst wants to make certain that the projections are not used orconstrued to be representations or promises of any kind with respect to theperformance of the company. This is of special concern to brokers andintermediaries who include projections of any kind as part of a sellingmemorandum or presentation.

While monthly projections take additional time for data gathering, organizing andapplication, the benefits are a deeper understanding of the business and its moreimmediate financial ebb and flow. If properly prepared and used, monthlyprojections can be an important component of a quality valuation.

Key points

1. Projected financial statements include an opening-day balance sheet,projected income statements for at least three years, and a cash flowprojection.

2. Common accounting methods include the cash basis, the accrual basis, andthe completed-contract method.3. The balance sheet compares the possessions of a company and the debts that

it owes on a specific day.4. The opening-day balance sheet will closely correspond to the startup costs.5. The projected income statement estimates sales, cost of goods sold, expenses,

and profit.6. The calculation for cost of goods sold varies by industry.7. The income statement for a corporation and proprietorship are different

because the owners salaries are recorded differently.8. Cash flow projection estimates cash coming into the business and cash paid

out; profitable businesses may still have cash shortages due to seasonalfluctuations and amounts due from customers that have not been collected.

chapter 03 {final energy financial management}.doc

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