ACKNOWLEDGEMENT
We feel indebted to several early-stage authors whose works have inspired us, including Paul F. Grady, David F. Hawkins, Spicer and Pegler, SK Bhattacharya and John Dearden, Frank Wood as well as the professional accounting bodies such as ICAI (India) and ACCA (UK) for decades of professional excellence. The authors would like to express their gratitude to a number of present and former colleagues from academia, industry as well as thousands of former students for their support and encouragement. Thanks are due to Dr. Bibek Banerjee, Dr. Sachin Choudhry, Dr. SK Ganguli, Dr. Ashish Varma, Ms. Puja Agarwal, Dr. SR Dash, Dr. R. Arrawatia, Dr. AK Chauhan, Dr. A. Kastia and Dr. D. Maitra (IMT Ghaziabad), Dr. LC Gupta, Dr. SP Parashar and Bhavesh Patel (XLRI Jamshedpur), Dr. Nand Dhameja (MDI Gurgaon), Dr. Avinash Chander and Dr. Vijay Kapur (ICAI), Dr. SK Chakraborty, Prof. KK Bhattacharya and Prof. NK Rao (IIMC), Dr. Madhu Vij, Dr. SK Tuteja and Dr. Anjali Kalsie (FMS Delhi University), Dr. Deepak Chawla, Dr. VK Seth and Dr. Barnali Chakladar (IMI New Delhi), Prof. S. Sundararajan (IIMB), Dr. P.K. Jain (IIT-D), Dr. Sweta Agarwal and Dr. Gunjan Mittal (IILM), Ms. Bhavna Ranjan Ahuja (Alliance, Bangalore), Dr. GL Sharma (LBSIM), Dr. Raj Agrawal (AIMA), Dr. Girish Tripathi (NTPC), Arit Chaudhury and Rohit Tandon (Max Life), Mandeep S. Manihani (JP Morgan), Hitesh Goel (Kotak) and many others. In particular, our thanks are due to Ms. Prerna Jain [IMI alumni and co-editor of “Financial Sector Reforms in India” (2010)] for valuable inputs for several early chapters of the book. We are also grateful to the publisher Taxmann Publications Pvt. Ltd. for the unstinted support and timely execution of this textbook. We would urge our colleagues, students and readers to continue their valuable support in future too. Any constructive suggestions to improve the book are most welcome.
I-9
NARENDER L. AHUJA VARUN DAWAR
CHAPTER-HEADS
I-11
PAGE AbouttheAuthorsI-5 PrefaceI-7 AcknowledgementI-9 ContentsI-13 CHAPTER 1: INTRODUCTION TO ACCOUNTING 1 CHAPTER 2: ACCOUNTING CONCEPTS, CONVENTIONS AND POLICIES 20 CHAPTER 3: RECORDING TRANSACTIONS IN THE JOURNAL AND THE LEDGER 42 CHAPTER 4: TRIAL BALANCE TO FINANCIAL STATEMENTS 76 CHAPTER 5: INVENTORY, DEPRECIATION AND ACCOUNTING ERRORS 114 CHAPTER 6: THE ANNUAL REPORT : QUALITATIVE AND QUANTITATIVE DISCLOSURES 155 CHAPTER 7: ANALYZING FINANCIAL STATEMENTS-I FINANCIAL RATIOS ANALYSIS 186 CHAPTER 8: ANALYZING FINANCIAL STATEMENTS – II HORIZONTAL, COMMON-SIZE AND TREND ANALYSIS 215 CHAPTER 9: STATEMENT OF CASH FLOWS 245 CHAPTER 10: CONSOLIDATED FINANCIAL STATEMENTS – I: INTRODUCTION AND BALANCE SHEET CONSOLIDATION 288 CHAPTER 11: CONSOLIDATED FINANCIAL STATEMENTS - II CONSOLIDATED PROFIT & LOSS STATEMENT AND FURTHER ASPECTS 338 CHAPTER 12: CONSOLIDATED FINANCIAL STATEMENTS - III VERTICAL & MIXED GROUPS, PIECEMEAL ACQUISITION AND ASSOCIATES 390 CHAPTER 13: CONVERGENCE OF INDIAN ACCOUNTING STANDARDS WITH IFRS 442
APPENDICES
APPENDIX
OF
AND
OF
COMPANY 479
B: SCHEDULE II OF COMPANIES ACT, 2013 : USEFUL LIVES TO COMPUTE DEPRECIATION 496 KEY WORDS 503 GLOSSARY 513 PAGE I-12 CHAPTER-HEADS
A: SCHEDULE III OF COMPANIES ACT, 2013 : GENERAL INSTRUCTIONS FOR PREPARATION OF BALANCE SHEET AND STATEMENT
PROFIT
LOSS
A
APPENDIX
CONTENTS PAGE AbouttheAuthorsI-5 PrefaceI-7 AcknowledgementI-9 Chapter-headsI-11 1.1 Defining accounting 2 1.2 Evolution of accounting 4 1.3 The main forms of business organization 5 1.4 Users of Financial Statements and their information needs 9 1.5 The main Financial Statements 10 1.6 Branches of Accounting 11 1.7 Bookkeeping and Accounting 12 1.8 Auditing of Accounts and Financial Statements 13 1.9 Limitations of Financial Accounting 13 1.10 Can one set of Financial Statements satisfy information needs of all users? 15 RESEARCHABLE ISSUES 15 POINTS TO REMEMBER 16 MULTIPLE CHOICE QUESTIONS (MCQs) 16 REVIEW QUESTIONS 17 ANSWERS 19 2.1 Introduction 20 I-13
2.2 Accounting principles 21 2.3 Accounting conventions 23 2.4 Main Accounting Concepts 25 2.5 Qualitative Characteristics of Financial Statements 30 2.6 Accountants’ dilemma 31 2.7 Disclosure of Accounting Policies 32 2.8 Accrual versus cash accounting systems 32 2.9 Determination of Indian GAAPs 34 RESEARCHABLE ISSUES 38 POINTS TO REMEMBER 38 MULTIPLE CHOICE QUESTIONS (MCQs) 38 ANSWERS TO MCQs 40 REVIEW QUESTIONS 40 3.1 Importance of the Business-Entity Concept 43 3.2 The Accounting Equation 44 3.3 Dual Aspect 45 3.4 The need for Detailed Accounting Records 48 3.5 The Accounting Cycle 48 3.6 The Journal and the Source Documents 49 3.7 The Ledger 50 3.8 Debit-credit Sides of Ledger Accounts 50 3.9 Double Entry System for Assets and Liabilities 51 3.10 Journalizing Transactions 53 3.11 Posting Information to Ledger Accounts 55 3.12 Trade Debtors and Creditors 56 3.13 The Asset of Stock of Goods 57 3.14 Specific Meaning of Sales and Purchases 58 3.15 Accounting for Expenses and Revenues 59 3.16 Difference Between Assets and Expenses 60 3.17 Drawings by the Proprietor/Owners 61 3.18 The Golden Rules of Accounting 62 3.19 Division of Journals and Ledgers 63 3.20 Comprehensive Example 63 PAGE I-14 CONTENTS
RESEARCHABLE ISSUES 67 POINTS TO REMEMBER 67 MULTIPLE CHOICE QUESTIONS (MCQs) 68 REVIEW QUESTIONS 69 ANSWERS TO MCQs: 74 ANSWERS TO REVIEW QUESTIONS 74 4.1 Introduction 76 4.2 Balancing-off the Ledger Accounts 77 4.3 Trial balance 84 4.4 Profit and Loss Account 85 4.5 Presentation of the Profit and Loss Account 87 4.6 Balance Sheet 88 4.7 Balance Sheet layout 89 4.8 Accrued Expenses and Incomes 92 4.9 Prepaid Expenses and Revenues 93 4.10 Provision for depreciation 96 4.11 Provision for Doubtful Debts 97 4.12 Carriage Expenses 99 4.13 Capital and Revenue Expenditure 100 4.14 Comprehensive Example 100 RESEARCHABLE ISSUES 104 POINTS TO REMEMBER 104 MULTIPLE CHOICE QUESTIONS (MCQs) 104 REVIEW QUESTIONS 106 ANSWERS TO MCQs AND SELECTED REVIEW QUESTIONS 109 5.1 Introduction 115 5.2 Valuation of Closing Inventory 115 5.2.1 Types of Inventory 116 5.2.2 Main Principle : Lower of Cost and Net Realizable Value 117 PAGE CONTENTS I-15
5.2.3 Cost of Inventories 118 5.2.4 Cost Formulas for Valuation of Inventory 121 5.2.5 Difference between the Indian GAAP and IFRS 125 5.2.6 Disclosure in Financial Statements 126 5.2.7 Comprehensive Example : Comparison of Cost and NRV 127 5.3 Fixed (Non-current) Assets and Depreciation 128 5.3.1 When to Recognize Fixed Assets 129 5.3.2 Measuring the Initial Cost of Depreciable Assets 129 5.3.3 Why is it Necessary to Carefully Determine the Cost 130 5.3.4 Costs that should be excluded from initial cost 131 5.3.5 Subsequent Costs of Improvements and Repairs 131 5.4 Depreciation : A Systematic Allocation of Cost 132 5.4.1 Methods of Calculating Depreciation 133 5.4.2 How to Choose the Right Method of Depreciation 135 5.4.3 Revaluation of Fixed Assets 136 5.4.4 Reporting Depreciation in P&L and Balance Sheet 137 5.4.5 Consistency Concept and Change in Method of Depreciation 138 5.4.6 Sale or Disposal of Fixed Assets 139 5.4.7 Amortization of Intangible Assets like Goodwill 141 5.4.8 Main excerpts from the 2011-12 Annual report of Britannia Industries Limited regarding accounting policy on fixed assets are given below 142 5.5 Correction of Errors and the Suspense Accounts 142 5.5.1 Correction of Errors that do not affect Trial Balance 143 5.5.2 Suspense Account 144 5.5.3 Example on Correction of Errors 146 RESEARCHABLE ISSUES 147 POINTS TO REMEMBER 147 MULTIPLE CHOICE QUESTIONS (MCQs) 148 REVIEW QUESTIONS 149 ANSWERS TO MCQs AND SELECTED REVIEW QUESTIONS 152 PAGE I-16 CONTENTS
6.1 Requirements as per the Listing Agreement with Stock Exchanges 156 6.1.1 Management Discussion and Analysis (MD&A) 156 6.1.2 Corporate Governance Report 162 6.2 Requirements as per the Companies Act, 2013 166 6.2.1 Director’s Report 166 6.2.2 Directors’ Responsibility Statement 167 6.2.3 Auditor’s Report 167 6.2.4 Financial Statements and Notes to Accounts (Schedule III) 171 6.3 Additional disclosures in an Annual Report 175 6.3.1 Revenue Recognition (AS 9) 175 6.3.2 Segment reporting (AS 17) 175 6.3.3 Related Party Disclosures (AS 18) 177 6.4 Voluntary Disclosures 178 6.4.1 Human Resource Accounting 178 6.4.2 Value Added Statement 180 6.4.3 Economic Value Added (EVA) 181 RESEARCHABLE ISSUES 182 POINTS TO REMEMBER 182 MULTIPLE CHOICE QUESTIONS (MCQs) 183 REVIEW QUESTIONS 184 7.1 Introduction 187 7.2 Groups of financial ratios 190 7.3 Liquidity ratios 190 7.4 Working capital ratios 193 7.5 Profitability ratios 195 7.6 Capital structure ratios 197 7.7 Turnover ratios 199 PAGE CONTENTS I-17
7.8 Return on investment ratios 200 7.9 Inter-firm Comparison: Maruti Suzuki and Tata Motors 202 MULTIPLE CHOICE QUESTIONS (MCQs) 212 REVIEW QUESTIONS 213 8.1 Horizontal, Common-size and Trend Analysis 216 8.2 Horizontal analysis 216 8.3 Common-size Analysis 218 8.4 Trend analysis 220 8.5 Corporate Illustration : Britannia Industries 220 8.6 Dabur India: Liquidity and working capital analysis 235 9.1 Introduction 245 9.2 Meaning of cash flow 246 9.3 What is a statement of cash flows 248 9.4 The main parts of a statement of cash flows 249 9.5 Information for preparing Cash flow statement 252 9.6 Methods of preparing the statement of cash flows 253 9.7 Preparing Statement of cash flows: the Direct Method 254 9.8 Preparing Statement of cash flows: the Indirect Method 259 9.9 What figure of profit to begin with? 261 9.10 Purpose and Importance of the Statement of Cash flows 264 9.11 Difference between profit & loss account and the statement of cash flows 267 9.12 Corporate illustration: The statement of cash flows of Dabur India Limited 267 9.13 Gain on sale of assets or investments 270 9.14 Treatment of miscellaneous items 271 9.15 Foreign currency cash flows 272 9.16 Disclosures 272 PAGE I-18 CONTENTS
9.17 Difference between IAS-7 and Indian AS-3 272 9.18 Limitations of the Statement of Cash Flows 273 POINTS TO REMEMBER 282 QUESTIONS 283 10.1 Introduction 289 10.2 When does the parent-subsidiary relationship arise 289 10.3 Meaning of consolidated Financial Statements 290 10.4 Objectives of consolidated Financial Statements 290 10.5 Meaning and definitions 291 10.6 Are Consolidated Financial Statements Mandatory in India? 292 10.7 The Nature of Consolidated Financial Statements 292 10.8 Balance Sheet Consolidation: Basic Mechanics 295 10.9 Balance sheet consolidation immediately after acquisition 295 10.10 Less than 100% acquisition and minority interest 303 10.11 Goodwill calculation on less than 100% acquisition 305 10.12 Acquisition for consideration other than cash 306 10.13 Treatment of pre-acquisition and post acquisition profits 308 10.14 Distribution of dividends by the subsidiary 311 10.15 Comprehensive exercise on consolidation of balance sheet 317 10.16 Consolidated balance sheet with preference capital 319 10.17 Intra-group investment in debentures 324 POINTS TO REMEMBER 327 MULTIPLE CHOICE QUESTIONS 328 11.1 Introduction 339 11.2 Consolidated income (Profit and Loss) Statement 339 11.3 Basic principles 340 11.4 Format of the Consolidated Profit and Loss Statement 341 PAGE CONTENTS I-19
11.5 Inter-company Trading 343 11.6 Inter-company dividends 348 11.7 Consolidated P&L Statement with Preference Capital 350 11.8 Pre-acquisition and Post-acquisition Profits 353 11.9 Comprehensive Example on Profit and Loss Consolidation 356 11.10 Sale of fixed assets 357 11.11 Revaluation of fixed assets 359 11.12 Miscellaneous inter company balances 362 11.13 Comprehensive Exercise: Consolidation of P&L Account and Balance Sheet 365 POINTS TO REMEMBER 369 MULTIPLE CHOICE QUESTIONS 370 QUESTIONS 374 PROBLEMS 375 12.1 Introduction 391 12.2 Consolidation of vertical groups 391 12.3 Direct and indirect methods for vertical group’s consolidation 392 12.3.1 The direct method 392 12.3.2 Example 1: Vertical groups consolidation by direct method 393 12.3.3 Example 2: Vertical groups consolidation by direct method when acquisitions are made at different dates 396 12.3.4 Example 3: Vertical groups consolidation by direct method when sub-subsidiary was acquired before the subsidiary 397 12.3.5 Consolidation of vertical groups with preference sharesDirect method 399 12.3.6 Example-4: Preference shares in vertical group - Direct method 400 12.4 Consolidation of vertical groups: The indirect method 402 12.4.1 Determination of Goodwill/Capital Reserve 403 12.4.2 Example 5: Vertical groups consolidation by indirect method 404 12.4.3 What if S2 was acquired before S1 408 12.4.4 Preference shares in vertical groups: Indirect method 410 PAGE I-20 CONTENTS
12.5 Current liabilities due to minority shareholders 412 12.6 The consolidation of mixed groups 413 12.7 Eventual control by piecemeal acquisition 416 12.8 Additional acquisitions in existing subsidiary 418 12.9 Sale of shares by the parent (holding) company 420 12.10 Accounting standard on treatment of profit or loss on the disposal 423 12.11 Miscellaneous aspects of consolidation of subsidiaries 423 12.12 Consolidation of associates 424 12.12.1 Meaning of associate 424 12.12.2 Consolidation procedures 425 12.12.3 The equity method 425 12.12.4 Equity method vs. Cost method 426 12.12.5 Consolidated Profit and Loss Account 427 12.12.6 Consolidated Balance Sheet 427 POINTS TO REMEMBER 431 QUESTIONS 432 MCQs 433 PROBLEMS 435 13.1 Introduction 442 13.2 Calculation of Qualifying Net Worth of Companies 444 13.3 Voluntary Adoption 444 13.4 Comparison of Indian GAAP, IFRS and Ind AS 445 RESEARCHABLE ISSUES 474 POINTS TO REMEMBER 474 MULTIPLE CHOICE QUESTIONS (MCQs) 474 REVIEW QUESTIONS 475 PAGE CONTENTS I-21
PAGE APPENDICES GENERAL INSTRUCTIONS FOR PREPARATION OF BALANCE SHEET AND STATEMENT OF PROFIT AND LOSS OF A COMPANY 479 USEFUL LIVES TO COMPUTE DEPRECIATION 496 KEY WORDS 503 GLOSSARY 513 I-22 CONTENTS
ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE AND TREND ANALYSIS
LEARNING OBJECTIVES:
After studying this chapter, you should be able to:
➢ Explain the meaning and importance of the horizontal, common-size and trend analysis
➢ Identify the steps involved in preparing the common-size financial statements
➢ Prepare common-size financial statements
➢ Use horizontal and trend analysis for comparing performance
➢ Carry out inter-firm and inter-period comparison of performance using ratios.
INTRODUCTION
In this chapter we discuss the important yet simple techniques of horizontal, common-size and trend analysis which are used as an integral part of ratios analysis. After introducing these techniques, we integrate them with the ratios explained in the previous chapter with the help of a detailed study of Britannia Industries Limited.
215
8.1 Horizontal, Common-size and Trend Analysis
These simple techniques use percentages to analyze changes taking place in the financial performance and financial condition of firms, either over time or in comparison to other competing firms. The beauty of these techniques lies in the fact that they are very simple to understand and require little financial training to calculate and interpret. They can supplement financial ratios analysis or used on a stand-alone basis depending on the desired depth of analysis. These techniques are horizontal analysis, common-size analysis and trend analysis.
8.2 Horizontal analysis
Horizontal analysis involves comparing the same entity’s financial statements of two (or more) periods to analyze changes that have taken place over the period. Such analysis may be carried out both for items of profit & loss account as well as the balance sheet. A comparison of items in the profit & loss account would reveal the increase or decrease in incomes and expenses, while analysis of balance sheet items would reveal the changes in assets, capital and liabilities that have taken place in the current period as compared to the previous one.
The changes between the two periods may be calculated in absolute amounts as well as in percentages. Between the two, differences reported in percentages are sometimes considered more useful as they highlight the relative extent or magnitude of change that has occurred during the period. However, differences in both amounts and percentages have their own usefulness and percentage changes should not be considered in isolation as they may sometime present a misleading picture, particularly when the previous year figure, used as base, is small or nil.
Horizontal analysis is a basic and simple technique which can bring out very useful information without requiring complex formulae or calculations. For example, if a horizontal analysis of profit & loss account shows that sales increased by 10% over the previous year, but selling expenses rose by 25%, it may be a cause of concern to the management and may highlight an area that needed investigation.
ILLUSTRATION: The financial statements of MegaNuts Limited for two years are given below. The last two columns have been added to show changes that has taken place between the two years: in absolute amounts and in percentage.
216 CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE
SUMMARISED BALANCE SHEETS AS AT 31 DECEMBER
(At
PROFIT & LOSS ACCOUNTS FOR THE YEAR ENDED 31 DECEMBER:
20X6 20X7 Change Change % Net Fixed assets 49000620001300026.53
cost less depreciation) Current Assets Stocks 40000650002500062.5 Debtors 420004600040009.52 Cash at bank 100006000-4000-40 920001170002500027.17 Current Liabilities: Trade creditors 3200037000500015.63 Bills payable 40003000-1000-25 3600040000400011.11 Net current assets 5600062000600010.71 Total net assets 1050001390003400032.38 Capital and reserves: Equity share capital 55000815002650048.18 Retained earnings 3000037500750025.00 Net worth 850001190003400040.00 Long term liabilities: 10% Debentures 200002000000.00 1050001390003400032.38
20X6 20X7 Change Change % Turnover 48000060000012000025.00 Manufacturing cost 28800039000010200035.42 Sales & Administration expenses 1660001830001700010.24 Interest expense 2000200000.00 Profit before taxation 240002500010004.17 Tax on profit 720075003004.17 Profit for the financial year 16800175007004.17 Dividends 100001000000.00 Retained profit for the year 6800750070010.29 Retained profit brought forward 2320030000680029.31 Retained profit carried forward 3000037500750025.00
HORIZONTAL, COMMON-SIZE 217
CH. 8 : ANALYZING FINANCIAL STATEMENTS-II
The percentage change has been calculated as follows:
Change % = (20X7 figure – 20X6 figure)*100/20X6 figure. For example, percentage change in net fixed assets = (62000 – 49000)*100/49000 = 26.53%.
The calculations shown in the ‘change’ columns reveal several interesting findings. Sales increased by 25% but manufacturing cost increased by a whopping 35.42%, putting a huge pressure on profit margins. However, a less than proportionate rise in sales & administration expenses helped the company in reporting a small increase in profits.
Changes in balance sheet items show that fixed assets increased by 26.53% while sales rose by only 25%, which meant a little less efficient use of fixed assets than previous year. But more striking was the huge increase in inventory by 62.5%, which would normally be difficult to justify. Debtors management was relatively better which rose by 9.52% only.
8.3 Common-size Analysis
Common-size analysis, also called vertical analysis, is another simple way of making a comparative analysis of two companies for the same period or of two periods of the same organization. This analysis is performed by expressing each line in the financial statement as a percentage of a total value. In a common-size profit & loss account, each line is expressed as a percentage of the total net sales, while in a common-size balance sheet, each line is expressed as a percentage of the total assets (which would be same as the total of capital plus liabilities).
Information in absolute amounts provided in the financial statement is difficult to compare but the same information converted into percentages of a base value lends itself to easy and more meaningful comparisons. For example, consider the normal and common-size balance sheets of MegaNuts Limited for two years, given below:
SUMMARISED
BALANCE SHEETS
DECEMBER NORMAL BALANCECOMMON-SIZE SHEETBALANCE SHEET 20X620X720X620X7 Tangible fixed asests 490006200034.7534.64
cost
depreciation) Current Assets: Inventory400006500028.3736.31 Debtors 420004600029.7925.70 Cash at bank 1000060007.093.35 Total assets 141000179000100.00100.00 Capital and reserves: Equity share capital 550008150039.0145.53
AS AT 31
(At
less
218 CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE
All line items in the common-size balance sheets are stated in terms of a percentage of the total assets of the respective years (each asset and liability item is divided by total assets and multiplied by 100). A comparison of the two years’ common-size balance sheets reveals changes in the relative composition of assets, as well as the changes in the relative mix of equity and debt financing. On the assets side, the relative investment in inventory has increased from 28.37% to 36.31% of total assets, but the investment in debtors and particularly cash has significantly reduced. The relative size of net fixed assets remained almost stable at about 34% of the total assets. On the capital & liabilities side, the proportional financing from equity has increased from 39.01% to 45.53% of total assets, while the relative extent of financing from long term debt (debentures) and current liabilities has reduced.
It is clear from the common-size analysis of MegaNuts Limited that the management needs to pay greater attention to management of inventory and cash among assets, and review its equity-focused financing policy on the other side of the balance sheet. Similarly, a common-size profit & loss account may reveal significant changes in the cost of goods sold, expenses and profit margins between the two periods. For example, consider the normal and common-size profit & loss accounts of MegaNuts Limited given below:
MEGANUTS’ NORMAL AND COMMON-SIZE PROFIT & LOSS ACCOUNTS:
Retained earnings 300003750021.2820.95 Net worth 8500011900060.2866.48 Long term liabilities : 10% Debentures 200002000014.1811.17 Current Liabilities : Trade creditors 320003700022.7020.67 Bills payable 400030002.841.68 141000179000100.00100.00
NORMAL PROFITCOMMON-SIZE & LOSS ACCOUNTPROFIT & LOSS ACCOUNT 20X620X720X620X7 Turnover 480000600000100.00100.00 Manufacturing expenses 28800039000060.0065.00 Sales & Administration expenses 16600018300034.5830.50 Interest expense 200020000.420.33 Profit before taxation 24000250005.004.17 Tax on profit 720075001.501.25 NORMAL BALANCECOMMON-SIZE SHEETBALANCE SHEET 20X620X720X620X7 CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE 219
The common-size profit & loss account is prepared by reporting each line item as a percentage of the total net sales (each line item is divided by net sales and multiplied by 100). MegaNuts’ common-size profit & loss accounts clearly show why the company’s profitability declined in 20X7 as compared to 20X6. Manufacturing expenses increased significantly from 60% to 65% of the sales value, putting heavy pressure on profit margins. The situation was largely saved by a decline in sales and administrative expenses, but still the pre-tax profit margin declined from 5.0% to 4.17% of sales.
The common-size analysis is simple to understand and easy to perform. It is frequently used to compare changes in financial statements of two (or more) periods of an organization, for inter-firm comparisons or comparing a company’s performance with the rest of the industry. It is particularly helpful when comparing companies of different sizes.
8.4
Trend analysis
The trend analysis is an extension of the horizontal analysis and is useful in studying changes that have taken place in the business over a longer period than just two years. Therefore, trend analysis would require comparable data for at least three years, though 5 to 10 years’ trend analysis is more common and perhaps more useful.
To perform a trend analysis, a past year (normally the first year of the period under consideration) is chosen as the ‘base year’ and all items in the financial statement of the base year are assigned a value of 100%. Then, items in the subsequent years are expressed as a percentage of the base year value, using the following formula:
Trend % for any year = (Current year value/Base year value)* 100
If the trend percentage for any item in a subsequent year is greater than 100%, it indicates an increase over the base year, and if the trend analysis percentage is lesser than 100%, it would mean a decrease over the base year.
8.5
Corporate Illustration : Britannia Industries
Given below are the balance sheet and profit and loss account of the company for two
Profit after tax for the year 16800175003.502.92 Dividends 10000100002.081.67 Retained profit for the year 680075001.421.25 Retained profit brought forward 23200300004.835.00 Retained profit carried forward 30000375006.256.25
220 CH. 8 : ANALYZING FINANCIAL STATEMENTS-II
COMMON-SIZE
NORMAL PROFITCOMMON-SIZE & LOSS ACCOUNTPROFIT & LOSS ACCOUNT
HORIZONTAL,
years. Calculate relevant ratios related to liquidity, profitability, working capital, turnover and capital structure and return on investment for the two years. Comment on the company’s financial performance in the year 2010 as compared to the previous year.
BRITANNIA ANNUAL REPORT 2010 Profit
and loss account for the year ended 31st March ( in ’000) Schedule 20102009 INCOME Gross sales 3424579331428919 Less: Excise duty 231765306778 Net sales 3401402831122141 Other income N 561157398948 3457518531521089 EXPENDITURE Cost of materials O 2168906419103947 Staff cost P 995201960172 Expenses Q 96969618430867 Depreciation and amortisation D 375434334560 Financial expenses R 82059160071 3283871928989617 Profit before tax and exceptional items 17364662531472 Exceptional items (Profit/loss) S 528695206295 Profit before taxation 12077712325177 Income tax expenses -Current income tax 220490343799 -Minimum alternative tax credit -13827 -Fringe benefit tax——— 52973 -Wealth tax 12241224 -Deferred income tax, net -165226 123180 Profit after taxation 11651101804001 Profit brought forward 1095989600000 Profit available for appropriation 22610992404001 Appropriations Transfer to general reserve 117000190000 Proposed dividends 597254 Interim dividends———— 955607
CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE 221
222 CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE
Note: Schedules stated above included in the Annual Report of the company provide detailed information. They are not included here.
Tax on interim/proposed dividend99196162405 Profit carried forward 14476491095989 22610992404001
ANNUAL REPORT 2009-10 ( in ‘000) BALANCE SHEETAs at 31st March 20102009 SOURCES OF FUNDS Shareholder’s funds Share capital 238902238902 Reserves and surplus 37236208006510 39625228245412 Loans funds Secured 4081019 21972 Unsecured 215149229651 4296168251623 Deferred Tax Liability, net—— 99421 82586908596456 APPLICATIONS OF FUNDS Fixed assets Gross block 54783315115047 Less: Accumulated depreciation and amortisation 26633232336654 Net block 28150082778393 Capital work-in-progress and advances 11639360203 29314012838596 Investments 49063894230969 Deferred tax asset, net65805——Current assets, loans and advances Inventories 26834352536331 Sundry debtors 394868496143 Cash and bank balances 233607407978 Other current assets 144649137085 ( in ’000) Schedule 20102009
BRITANNIA
ANSWER: BRITANNIA INDUSTRIES LIMITED RATIOS ANALYSIS
Financial Ratios Analysis of the company’s performance for the year 2010.
1. RETURN ON NET WORTH [RETURN ON EQUITY] %
= (PAT – Preference Dividend) x 100/Net Worth
Where:
a. PAT (profit after taxes) must be adjusted for extraordinary or exceptional items of incomes and expenses as such items are not likely to recur on a regular basis. To make this adjustment, extraordinary incomes are deducted (to cancel their previous inclusion) and extraordinary expenses are added back (because earlier they were deducted in the calculation of profits);
b. Net worth = Equity capital + reserves & surplus – Miscellaneous Expenditure Not yet written off. The reason for deducting the “Miscellaneous Expenditure Not yet written off” is that such expenditure would be a charge against the claims of equity holders in the case of winding up of the company.
c. If the company had any preference capital during the period under consideration, preference dividends should be deducted from PAT, and also, the amount of preference capital should be excluded to calculate net-worth or equity.
Britannia Industries Limited’s RONW for 2010 and 2009 are calculated below:
BASIC FORMULA: RONW % = (PAT/Net worth) x 100
Explanation : Before calculating the ratio, following adjustments would be required:
a. PAT here will have to be adjusted for ‘extraordinary items’ (profit/losses).
b. Net worth (shareholders’ funds) has to be adjusted for ‘miscellaneous expenditure not yet written off’.
Loans and advances 17536111815878 52107105393415 Less: Current liabilities and provisions Liabilities 32048722658062 Provisions 16502031474836 48550754132898 Net current assets 3550951260517 Miscellaneous expenditure (to the extent not written off or adjusted)—— 266374 82586908596456
( in ‘000) 20102009
CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE 223
EXPANDED FORMULA:
PROFIT AFTER TAXES BUT ‘BEFORE’ EXTRAORDINARY ITEMS X 100 RONW = SHAREHOLDERS’ FUNDS - MISCELLANEOUS EXPENDITURE NOT YET WRITTEN OFF
RONW for Britannia Industries is calculated below.
20102009
NET PROFIT AFTER TAX11651101804001
ADD EXTRAORDINARY ITEMS (LOSS)528695206295
NET PROFIT ‘BEFORE’ EXTRAORDINARY ITEMS16938052010296
SHAREHOLDERS’ FUNDS39625228245412
LESS: MISCELLANEOUS EXPENSES
[NOT YET WRITTEN OFF]0266374
NET WORTH39625227979038
RETURN ON NET WORTH %42.7525.19
The RONW of the company showed a remarkable increase in 2010 as compared to 2009, mainly because of the reduction in the net worth caused by issue of bonus debentures out of the general reserves of the company.
2. EARNING PER SHARE (EPS)
Formula: PAT – Preference Dividend
Weighted average number of Equity Shares
Britannia Industries’ EPS is calculation:
PAT : as calculated for the RONW ratio for the two years.
Weighted number of equity shares: The number of equity shares outstanding during 2008, 2009 and 2010 was same = 23890163 or 23890.16 thousands. Note that since PAT figure is ‘000, the number of equity shares outstanding should also be in ‘000 to calculate EPS.
20102009
NET PROFIT AFTER TAX ( ‘000)11651101804001
ADD EXTRAORDINARY ITEMS (LOSS)528695206295
NET PROFIT ‘BEFORE’ EXTRAORDINARY ITEMS16938052010296
EQUITY SHARES OUTSTANDING (‘000)23890.1623890.16
EARNINGS PER SHARE70.9084.15
There was a decline in the company’s earnings per share in 2010 as compared to 2009, as a result of a lower PAT in 2010.
224 CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE
3. CASH EARNINGS PER SHARE (CEPS)
As compared to the EPS which is calculated using the accrual basis of accounting, the CEPS reports cash profits earned per share. CEPS derives its importance from the fact that it is cash and liquid resources that would be required to settle outside liabilities such as paying the creditors and repaying bank loans. No doubt then that the CEPS is given more importance by lending institutions in appraisal of creditworthiness of their clients.
The CEPS is considered more relevant for one more reason. In many capital intensive projects with long gestation period, the annual income in initial years could be small while the depreciation charge might be relatively huge, forcing the company to show nil or little net profits. The CEPS calculation indicates to the analysts how the EPS could be expected to rise as fixed assets get depreciated over time and true earning potential of the project surfaces. The CEPS is calculated as follows:
(PAT – Preference Dividend) + Non cash charges
CEPS = Weighted Average Number of Equity Shares Outstanding Britannia Industries’ CEPS calculation follows: PAT : as calculated for the RONW ratio for the two years.
Weighted number of equity shares: The number of equity shares outstanding during 2008, 2009 and 2010 was same = 23890163 or 23890.16 thousands. Note that since PAT figure is ‘000, the number of equity shares outstanding should also be in ‘000 to calculate EPS.
Non-cash charges = depreciation and amortization of 375434 thousands and 334560 thousands in 2010 and 2009 respectively.
There was a decline in the company’s cash earnings per share in 2010 as compared to 2009, mainly as a result of a lower PAT in 2010.
BRITANNIA RATIOS MEASURING PROFITABILITY IN RELATION TO SALES
It is absolutely necessary for the success of a business that its sales should be profitable. Sales are profitable when the selling price of a product or service not only covers its cost, but also leaves a profit margin. The higher the profit margin, more viable and sustainable the business.
Therefore, it is helpful to analyse how various cost elements and profit margins are changing over time or in relation to other companies in the same industry.
NET PROFIT AFTER TAX ( ‘000)11651101804001 ADD EXTRAORDINARY ITEMS (LOSS)528695206295 NET PROFIT ‘BEFORE’ EXTRAORDINARY ITEMS16938052010296 ADD DEPRECIATION & AMORTIZATION EXP.375434334560 NET PROFIT + NON-CASH CHARGES20692392344856 EQUITY SHARES OUTSTANDING (‘000)23890.1623890.16 EARNINGS PER SHARE86.6198.15
20102009
CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE 225
Analysts normally carry out two types of ratios analysis for this purpose:
A. Ratios of individual items of costs and expenses to sales, and
B. Multi-step profit margin ratios in relation to sales.
A. Ratios of individual items of costs and expenses to sales: The ratios of individual costs and expenses to sales can be measured by preparing a common-size profit & loss account where all line items are expressed as a percentage of the annual net sales. Such analysis would highlight which costs and expenses are rising rapidly and need to be given attention, and controlled before they eat into the profit margins. The common-size profit & loss account for Britannia Industries for the years 2009 and 2010 are given below.
BRITANNIA ANNUAL REPORT 2010
Profit and loss account for the year ended 31st March
the year ended2010 % OF NET 2009 % OF ( ’000)( ’000) NET SALESSALES INCOME Gross sales 34245793100.6831428919100.99 Less: Excise duty 2317650.683067780.99 Net sales 34014028100.0031122141100.00 Other income 5611571.653989481.28 34575185101.6531521089101.28 EXPENDITURE Cost of materials 2168906463.771910394761.38 Staff cost 9952012.939601723.09 Expenses 969696128.51843086727.09 Depreciation and amortisation 3754341.103345601.07 Financial expenses 820590.241600710.51 3283871996.542898961793.15 Profit before tax and exceptional items 17364665.1125314728.13 Exceptional items (Profit/loss) 5286951.552062950.66 Profit before taxation 12077713.5523251777.47 Income tax expenses -Current income tax 2204900.653437991.10 -Minimum alternative tax credit -13827-0.04— ——-Fringe benefit tax——— 529730.17 -Wealth tax 12240.0012240.00 -Deferred income tax, net -165226-0.491231800.40 Profit after taxation 1165110 3.43 1804001 5.80
For
226 CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE
The common-size profit & loss account shows a relatively steep rise in the cost of materials, from 61.38% to 63.77% of the net sales, putting pressure on profit margins. In fact the net profit margin declined by almost the same extent as the rise in cost of materials, from 5.80% to 3.43% of the sales. The general business expenses and extraordinary items also need to be watched.
BRITANNIA LIQUIDITY RATIOS
CURRENT RATIO
Current Ratio=Current Assets/Current Liabilities
Current assets include inventory, sundry debtors, cash and bank balances, loans and advances, other current assets + short term marketable investments. Current Liabilities include current liabilities and provisions + short term loans repayable within 12 months.
The current ratio has declined in year 2010 as compared to year 2009 indicating lesser amount of current assets available per rupee of current liabilities. This by itself could be a cause of concern to the creditors of the company as a lower current ratio could increase chances of a default in making timely payment of day-to-day dues, unless the company has a standby arrangement with banks for overdraft or short term loans facility.
Banks and financial institutions normally expect a current ratio of at least 1.33 times. While interpreting the current ratio, the structure of current assets should also be studied. A firm with greater portion of current assets in the form of inventory and debtors would not be considered as liquid as a firm with greater portion of current assets in the form of cash and bank balances. This is because inventories and debtors would take more time before they are converted into spendable funds, while cash and bank balances represent ready purchasing power. In the case of Britannia Industries, the fact that inventories increased in 2010 as compared to 2009 while cash and bank balances declined during the same period, does not present a very positive picture about the company’s liquidity.
QUICK RATIO
CURRENT ASSETS + SHORT TERM INVESTMENTS – INVENTORIES
= CURRENT LIABILITIES + PROVISIONS + SHORT TERM LOANS
20102009 CURRENT ASSETS52107105393415 SHORT TERM INVESTMENTS00 TOTAL52107105393415 CURRENT LIABILITIES + PROVISIONS48550754132898
LOANS00 TOTAL48550754132898 CURRENT RATIO1.071.30
SHORT-TERM
CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE 227
20102009
CURRENT ASSETS52107105393415
SHORT TERM INVESTMENTS00
52107105393415
LESS: INVENTORIES26834352536331
TOTAL25272752857084
CURRENT LIABILITIES + PROVISIONS48550754132898
SHORT-TERM LOANS00
TOTAL48550754132898
QUICK RATIO0.520.69
Inventories are excluded from the current assets because they would normally take the longest period to convert themselves into spendable cash resources, and thus represent the least liquid of current assets. A lower quick ratio in year 2010 as compared to the previous year indicates that the company would have lesser liquid resources (cash, bank balances and other current assets except inventories) per rupee of current liabilities. This shows a lower margin of safety available to creditors and increased possible risk of default in meeting short term dues.
DEBTORS’ COLLECTION PERIOD (DAYS)
= Sundry Debtors × 365/Annual sales
Applying the above formula to Britannia Industries data, the ratio would be calculated as follows:
20102009
YEAR END SUNDRY DEBTORS394868496143
ANNUAL ‘GROSS’ SALES3424579331428919
DEBTORS DAYS4.215.76
Three comments need to be made about the calculation of this ratio.
➢ Firstly, the denominator in this ratio should ideally be the annual ‘credit’ sales because it is the credit sales that cause debtors or receivables. However, as credit sales are not disclosed in the published financial statements of companies, we have to manage with total annual sales.
➢ Secondly, note that we have used ‘gross’ sales rather than net sales for this ratio. The reason is that it is the gross sales revenue (i.e., the invoice price) that is to be collected from the customers. The difference between the gross and net sales is caused by excise duty payable by the company to the Government, but that is independent of the collection of dues from the customers. Hence for the purpose of this ratio, it is better to use gross sales value if there is a difference between the two on account of excise duties payable.
228 CH. 8 : ANALYZING FINANCIAL STATEMENTS-II HORIZONTAL, COMMON-SIZE
AUTHOR : NARENDER L. AHUJA, VARUN DAWAR
