Analysis of Financial Statements- Balance Sheet and Profit & Loss Account

The Balance Sheet and Profit & Loss Account is the most important documents for any business. These documents give a mirror impression of the financial health of any organisation. These statements are analysed differently by the bankers, credit rating agencies, investment bankers, equity analysts, private investors ,stock exchanges, SEBI , income tax dept etc. to understand the business as per their requirements. We now deal with their analysis with a view to have perception of lending agencies/banks.

PROFIT AND LOSS ACCOUNT.

The Profit and Loss Account is one of the main financial statement along with the Balance Sheet. The Profit and Loss account contains both the top line and the bottom line growth/decline. It contains statement of income and expenses and the bottom line shows the net income for a period of time(one year, six months, three months etc.) It is very essential for the businessmen and/or business entity to constantly evaluate the performance over a period of time to know where the business is heading i.e. whether the business is making profit or loss during a particular period, since the P&L contains total revenues, other income, total expenses and the bottom line showing net income and/or loss made over a period of time. This will help to initiate remedial measures if the bottom line very thin or in red i.e. loss incurred over certain period. The profit and loss ratios which are useful for the lenders/banks are the following -

Net Profit ratio – This can be obtained by dividing the net income by top line/sales. This indicates the net profit margin of any business. The percentage of net profit margin varies from business to business. It can be as high as 15 to 20% in IT industry to less than 1% in case of traders.

1. Profit Before Tax ratio – This can be obtained by dividing the profit before tax by top line/sales. This ratio indicates the profitability before tax.

2. Interest coverage ratio – This can be obtained by adding the net profit + depreciation + interest which is divided by interest. This ratio indicates the capacity of the business to service interest obligations of borrowed funds. If the ratio is less than 2, the capacity of the business to service its obligations is considered weak and if the sensitivity of the market is taken into account of say 5% to 10% of increase in expenditure/decrease in selling price, the capacity of the unit to meet its interest obligations is weak.

3. Debt Service Coverage Ratio – This ratio could be obtained by adding the net profit + Depreciation + Interest on long term funds(excluding working capital) which is divided by Interest + Instalments on long term loans. If the ratio is less than 1.40 to 1.60 the same will indicate that the capacity of the business to service its obligations on long term borrowed funds is weak. At the same time if the ratio is more than 2, the same will indicate that the business could repay the long term borrowed funds at a shorter period than estimated.

4. Operating Profit Ratio(before interest): This ratio can be obtained by dividing the operating profit before interest by sales/top line. This is useful to understand the business entity’s capacity to service the interest obligations.

5. Operating profit after interest ratio – This ratio is obtained by dividing the profit after interest by sales/top line and denotes the net earnings percentage after interest payment, before adding the other income like interest on Term Deposits placed with the banks, income tax refund, commission earned etc and subtracting the miscellaneous expenses if any(not directly related to business).

BALANCE SHEET

The Balance Sheet has two sides. One is the liabilities side which contains owner’s stake in the business, Long Term funds from sources like borrowed funds, funds obtained from others like directors/ friends and relatives etc., short term liabilities like creditors and other liabilities and short term borrowings.

The other side contains the assets side which contains the assets like current assets i.e. cash and bank balance(including amount in fixed deposits), Debtors relating sales, inventory like raw materials, semi-finished and finished goods, advance paid to suppliers and other current assets which is realisable within a year. Other than current assets, the assets side also contains the fixed assets like land and buildings, plant and machineries, vehicles etc., which is generally permanent assets of the business which is required for a longer period to run the business. The asset side also contains other non-current assets which may not be realisable within a year. This includes capital work in progress which is not capitalised(not transferred to fixed assets), deposits with electricity boards/statutory authorities, long term investments, deferred receivables etc. If there are intangible assets like preliminary expenses to the extent not written-off), deferred tax assets, the same will form part of asset side and is shown separately.

The balance sheet ratios which are useful for the lenders/banks are as under –

1. Current ratio – After classifying the balance sheet items as above, this ratio is obtained by dividing the current assets by current liabilities. In any business the lenders expect a minimum contribution of 25% by the company/business entity as its own contribution towards current assets and the balance amount of 75%, the lenders are ready to lend for supporting to build up of current assets. If the current ratio is a minimum of 1.33, it denotes that the business entity has its own contribution of minimum 25% towards the build up of current assets. If the current ratio is less than 1.33 the same indicates lower than 25% contribution by the business entity. If the current ratio is more than 1.33, it denotes higher than 25% contribution by the business entity towards build up of current assets.

2. Debt Equity Ratio – The debt equity ratio is obtained by dividing the total out-side liability by the capital(promoters/company’s own funds). This ratio is generally expected to be 3 : 1, which denotes that for every Rs.3 of outside liability is supplemented by capital of Rs.1. If the debt equity ratio is more 3 : 1, the same denotes that promoter’s contribution is lower and if the debt equity is lower than 3 : 1, the promoters contribution is higher, giving higher level of comfort to the lenders to fund the business.

3. Debt : Quasi Equity Ratio – The same is obtained by adding the capital and unsecured loans from promoters and directors and also friends and relatives of partners/proprietor and then dividing the same by subtracting the unsecured loans from total outside liability. If this ratio is atleast 3 : 1, the same denotes that the business is supplementing its contribution of Rs.1 for every outside liability of Rs.3 with the help of unsecured loans.

4. Quick Ratios – This is obtained by dividing the cash + Account Receivables by current liabilities. This explains the number of rupees in cash and receivables to every rupee payable by way of current liabilities.

5. Return on investment – This ratio is obtained by dividing the net profit before tax by net worth. This ratio indicates the efficiency of the business to generate net income for every rupee invested in the business.

6. Return on assets – This ratio is obtained by dividing the net profit before tax by total assets. This ratio denotes the efficiency of total assets in generating the income.