Analysis of Financial Statements Part 2

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After going through Part 1, now let's discuss, whether bank should undertake analysis of financial statement of its credit customers? are ratios useful? Consider the following:-

1) An automobile manufacturer has stocks of cars and other current assets valued at Rs 100 cr and he has payables and other current liabilities worth Rs 80cr.

2) A retailer has stocks in show room and other assets worth Rs 25 lacs and has dues to his creditors and other current liabilities valued at Rs 12.5 lacs.

Which Customer is better?

Banks analysis will show that in absolute terms the first borrower has lots more money available than the retailer. But when the banker calculates the current ratios, he will find that the automobile seller has CR is (Current Ratio=CA/CL) i.e 100/80= 1.25 and the retailer has 25/12.5= 2. The banker knows that he has to examine the first borrower's financials with reference to industry standards before deciding if the CR is low and is a cause for concern. In te second case, on the face of it a CR of 2 shows good cash flow management and current assets are being partly funded out of long term funds which is a good position. Of course here again industry comparison is needed. Ratios do not tell the full story!

Use of Ratios give a better understanding of the performance of the company/ firm. It helps us to understand how current assets or long term assets have been funded, how the debt is being serviced, what kind of debt servicing ability is reflected in the numbers and how the firm's profitability compares with the industry average etc.

Let's try an example for better understanding of the Ratio's usefulness-

Suppose there are 2 companies

Company A--------> Profit -10 CR

Company B--------> Profit -5 CR

Which company looks profitable? 

If you look at the above figure you will jump to the conclusion that Company A is profitable.

Now if we go for Profitability or Profit Margin we will conclude that Company B is more profitable.
Another Example to know Profitability by going through CR:-
Now wait for 3rd part to explore more.

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