CHAPTER 5 FINANCIAL PERFORMANCE APPRAISAL OF EASTERN COALFIELDS LIMITED: A FRAMEWORK OF TOOLS AND TECHNIQUES EMPLOYED FOR DATA ANALYSIS

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1 CHAPTER 5 FINANCIAL PERFORMANCE APPRAISAL OF EASTERN COALFIELDS LIMITED: A FRAMEWORK OF TOOLS AND TECHNIQUES EMPLOYED FOR DATA ANALYSIS Introduction In the previous chapter, we have described the historical background and profile of Eastern Coalfields Limited that has been selected for our research study. The company was declared sick on March 31, 1997 u/s 3(1) (o) of Sick Industrial Companies (Special Provisions) Act (SICA), It is still under the Board for Industrial and Financial Reconstruction (BIFR). Earlier, we have discussed there different revival strategies time to time adopted by the company for its survival and progress and also highlighted the prospect of turnaround of the company in near future. The present Chapter mainly describes in detail the selected tools and techniques that we have employed for analyzing the data germane to the financial performance appraisal of Eastern Coalfields Limited. The fundamental objective of this chapter is to provide an elaborate framework of tools and techniques employed for data analysis in order to lay the foundation for meaningful analysis and interpretation of financial data carried out in the next chapter. 5.1 Concept of Performance Appraisal Performance Appraisal of a company is a systematic method of evaluating the performance of that company to understand its present financial standing and its abilities for further growth and development. It is a process of obtaining, analyzing and recording information about the relative worth of a company. 1 The focus of the performance appraisal is to measure and improve the actual performance of the company and further to ascertain the prospects of the company. Performance appraisal of a company mainly is of two types: financial and non-financial. However, we are confining our discussion to the financial performance appraisal of the company, as this is the focal point of our research. We know, it would have been better had we adopted all the measures, including nonfinancial measures for performance appraisal of Eastern Coalfields Limited, but it would be impossible to manage such a huge affair at a time. Thus, considering our limitations, we have restricted our focus only to the financial performance appraisal of the company. 100

2 5.2 Concept of Financial Performance Appraisal Financial performance analysis, which is also known as financial statement analysis, is a process of measuring the results of a company s policies and operations in monetary terms. It can range from the assessment of the solvency and liquidity to efficiency and profitability to risk management of a company. This process helps to review and evaluate the relationship between component parts of financial statements to obtain a better understanding of the financial health and performance of a company that enables management to take effective decisions. 2 The analysis of the financial position of a company is essential for improving its competitive position in the market place. A careful analysis of the financial health of a company can identify opportunities to improve performances at different levels and in different departments. It is helpful in assessing corporate excellence, forecasting bond rating, judging creditworthiness, predicting bankruptcy, and assessing market risk. 3 Since ECL has been declared a sick company under the Sick Industrial Companies (Special Provisions) Act (SICA), 1985 and still under BIFR, we earnestly believe that enquiry into its financial performance over a period of ten years can bring out vital information that may prove crucial for the recovery and turnaround of the company in not so distant future. 5.3 Tools and The focus of financial performance analysis is on the crucial information given in the financial statements and the significant relationship that exists between them. The first task of the financial analyst is to select the information relevant to the decision-making from the total information contained in the financial statements. The second step is to analyze the relevant information. The final step is interpretation and drawing of inferences and conclusions. 4 Though there are different methods or measures of assessing the financial performance of a company, none of these measures of financial performance is self-reliant. Thus, for a thorough assessment of a company's performance it is necessary to consider more than one measure. 5 Further, the methods of financial performance appraisal may take into consideration various accounting tools and techniques such as Comparative Financial Statement Analysis, Common-size Financial Statement Analysis, Ratio Analysis, Trend Analysis, Funds Flow Analysis, Cash Flow Analysis, Cost Volume Profit (CVP) Analysis, Value Added Analysis, Balanced Scorecard etc. for proper evaluation of financial performance of a company. Again, some of the techniques, viz. Ratio Analysis, 101

3 Analysis of Trend Ratios, Comparative Financial Statement Analysis, Cash Flow Analysis, and Funds Flow Analysis etc. are traditional and more frequently used measures whereas Value Added Analysis and Balanced Scorecard as a measure of corporate performance appraisal are newly emerging tools. However, in view of the time and resource constraints we have used the ratio analysis as the main accounting technique for financial performance appraisal of the Eastern Coalfields Limited (ECL) during the period to It may be noted here that though we have mainly used the technique of Ratio Analysis for evaluating the financial performance of Eastern Coalfields Limited, we have also taken help of Trend Ratios and Cash Flow Analysis to make our study more effective. We have already stated in Research Methodology (Figure 1.1 in page no. 12), in our first Chapter, the concerned accounting and statistical tools and techniques which we have applied for analyzing the data related to financial performance appraisal of the company. These specific tools and techniques that we have used are divided in two groups. These are: Group A: Accounting Tools employed for Analyzing the Financial Performance Appraisal of Eastern Coalfields Limited: 1) Ratio Analysis In order to evaluate the financial performance of any business unit the financial analysts always take help of certain tools. One of the traditional and most frequently used powerful tools is ratio analysis. The term ratio refers to the numerical or quantitative relationship between two variables. The relationship can be expressed as (i) percentages (say 25% of sales), (ii) fractions (say one-fourth of sales), and (iii) proportion of numbers (say 1:4 or 0.25:1). 6 Ratio analysis involves the use of various financial ratios to analyze and assess the financial performance and current financial position of a company. As traditional measures, ratios can be used as the benchmark for evaluating the financial performance of a company. The absolute figures reported in the financial statements such as Trading and Profit &Loss Account and Balance Sheet do not provide a meaningful understanding of the performance and financial position of a firm. Ratios make related information comparable and help us present data in a way that enables the stakeholders and researchers to make qualitative judgment about the company s financial performance. 102

4 We can calculate these financial performance ratios from the balance sheet and income statement. However, performance ratios need to be compared against some benchmarks. These benchmarks may be the past ratios, i.e. the historical ratios of the firm itself (time series analysis) or the competitors ratios, i.e. the ratios of some successful competitors (crosssection analysis) or industry ratios, i.e. average ratios of the industry to which the firm belongs (industry analysis) to get a better idea of the financial health of the selected company. Time series analysis gives an indication of the direction of change in financial performance of the firm over time, cross-sectional analysis indicates the relative financial position and performance of the firm whereas industry analysis helps to ascertain the financial standing and capability of the firm vis-à-vis other firms. 7 The rationale of ratio analysis lies in the fact that it makes related information comparable. A single figure by itself has no meaning but when expressed in terms of a related figure, it yields significant inferences. Ratio analysis thus, as a quantitative tool, enables analysts to draw quantitative answers to different questions, viz. Are the net profits adequate? Are these assets being used efficiently? obligations? And so on. 8 Is the firm solvent? Can the firm meet its current In our study, we have judiciously chosen and computed financial ratios for the period of ten years, i.e. from to to achieve a meaningful analysis of financial performance of Eastern Coalfields Limited. We have chosen this period considering the fact that the company has put tremendous efforts during that period for its turnaround. For the purpose of our study and analysis of the financial performance of the Eastern Coalfields Limited, we have first aptly chosen some important ratios, which, we hope, would capture most of the information that we can derive from financial statements. Then these ratios are classified into four broad categories. These are: a) Liquidity Ratios; b) Leverage Ratios; c) Efficiency Ratios; and d) Profitability Ratios. Liquidity ratios measure the firm s ability to meet current obligations; leverage ratios show the proportions of debt and equity in financing the firm s assets; activity ratios reflect the firm s efficiency in utilizing its assets, and profitability ratios measure overall performance and effectiveness of the firm. 9 Moreover, we would like to mention here that in the standard textbook on Financial Management, some of the ratios have different formulas for calculation. Thus, considering this diversity and to arrive at reliable and 103

5 logical findings we have preferred the formulas that appeared us as the most appropriate one bearing in mind the nature, purpose and position of the company as well the objectives and hypotheses of the study. Now each of these ratios is discussed below: a) Liquidity Ratios: Liquidity ratios are also termed as Short-term Solvency Ratios. Liquidly refers to the ability of a concern to meet its obligations in the short run, usually one year and to test its ability to maintain positive cash flow, while satisfying immediate obligations. 10 In fact, liquidity is a pre-requisite for the very survival of the company. However, liquidity should be neither excessive nor inadequate. The failure of a company to meet current obligations due to lack of sufficient liquidity will result in a poor credit worthiness and loss of creditors confidence. Again, a very high degree of liquidity indicates idle assets that earn nothing. Thus, it is necessary to strike a proper balance between the two, i.e. high liquidity and lack of liquidity for efficient financial management and to optimize profit. 11 The following important ratios we have included under the group Liquidity Ratios: i) Current Ratio (CR): Current Ratio expresses a relationship between current assets and current liabilities. The formula is calculated below: Current Ratio = Current Assets / Current Liabilities. This ratio is also known as working capital ratio, and is widely used to analyze the shortterm solvency position or liquidity position of a firm. The current assets of a firm represents those assets which can be, in the ordinary course of business, converted into cash within a short period of time, normally one year, whereas current liabilities are defined as liabilities which are short-term maturing obligations to be made within a year. The higher the current ratio, the larger is the amount of rupees available per rupee of current liability, the more is the firm s ability to meet current obligations. Conventionally, a current ratio of 2:1 is considered an ideal one. However, there is no hard and fast rule and further the rule of thumb can not be applied mechanically. An ideal ratio may differ depending on the development of the capital market, the availability of long-term funds to finance current assets and nature of the industry. For instance, for a public sector undertaking like ECL, the current ratio of 1:1 may be acceptable. This is because ECL is a government company enjoying the financial backing and support of the Government of India. 104

6 However, it is a quantitative index of liquidity and thus fails to give the qualitative aspect. A qualitative measure, on the other hand, takes into account the proportion of various types of current assets. ii) Quick Ratio (QR): This ratio is also known as Liquid Ratio or Acid Test Ratio. The quick ratio expresses a relationship between quick assets and current liabilities. The ratio is calculated below: Quick Ratio = Quick Assets / Current Liabilities. An asset is said to be liquid or quick only if it can be converted into cash immediately or at a short notice without losing its value. Usually a high quick ratio indicates that the firm has ability to meet current or short-term liabilities in time and, on the other hand, a low quick ratio represents the opposite. The ratio is widely accepted as the best available test of the liquidity position of a firm 12. As a rule of thumb, a quick ratio of 1:1 is considered satisfactory because of its immediate ability to meet the short-term obligations. iii) Super Quick Ratio (SQR): A variation of the Quick Ratio is known as Super Quick Ratio. This is also called Absolute Liquidity Ratio or Cash Ratio. This ratio is the most rigorous and conservative tests of a firm s liquidity position. The ratio is computed by dividing the super-quick assets by current liabilities of a firm. 13 Thus, the formula of this ratio is: Super Quick Ratio = Super-Quick assets / Current Liabilities. Super quick assets include here only cash and bank balances, as there is no marketable security. Normal standard of this ratio is 0.5:1. b) Leverage Ratios: These Ratios are also known as Capital Structure Ratios or Long-term Solvency Ratios. These financial ratios throw light on long-term solvency or financial potency of a firm. Leverage ratios show the ability of a firm to assure the long term lenders/ creditors with regard to (i) repayment of the principal amount of loan on maturity or installments in due dates; and (ii) periodic payment of interest during the period of the loan. Accordingly, there are two types of leverage ratios: structural ratios and coverage ratios. Structural ratios are based on the proportion of debt and equity in the financial structure of the firm. Coverage ratios show the relationship between debt serving commitments and the sources for meeting these burdens

7 However, we have considered the following ratios under this group: i) Debt-Equity Ratio: In this ratio, the relationship between borrowed funds and owners equity is measured to test the long-term financial solvency of the company. This is perhaps the most widely used measure of a company's leverage. This ratio reflects the relative contribution of creditors and shareholders of a company in financing its assets. It is an important tool of financial analysis to appraise the financial structure of a firm. 15 A high ratio shows a large share of financing by the creditors of the firm whereas a low ratio implies a smaller claim of creditors. This ratio hence indicates the margin of safety to the creditors. A ratio above 1 (or 100%) would show that the firm has taken more debt than equity that is a risky matter. However, it is essential to compare this ratio with other firms in the same industry to have a better idea of the solvency of the selected company. The usual formula of this ratio is: Debt to Net worth Ratio = Long-term debt / Net worth. Where Net worth = Equity Share Capital + Reserves ± Past Accumulated Profits /Losses. The standard norm of this ratio is usually 2:1 for private sector enterprises whereas for public sector it is 1:1. 16 However, in our study we have computed this ratio as Net worth to Debt Ratio in place of Debt to Net worth Ratio because of the negative net worth of the company. 17 If we consider the usual ratio, it would give an inexpressible value of this ratio. Therefore, in our case the formula is: Net worth to Debt Ratio = Net worth / Long-term Debt. i) Net worth to Net Fixed Assets Ratio (NWFAR): This ratio reveals the owner s contribution to the net value of fixed assets. Net worth to Net Fixed Assets Ratio is used as an alternative to Fixed Assets to Net worth Ratio because of the negative net worth of the company as we have mentioned earlier. If we consider the usual ratio, i.e. Fixed Assets to Net worth Ratio, it would give an inexpressible value of this ratio. Usually a part of net worth (owners fund) around 60 % to 75 % should be used for investment in fixed assets and the balance part should be used for investment in working capital. Thus, the very objective of this ratio fails in case the company does not have positive net worth, the case we observe for ECL. This ratio is calculated below: Assets. Net worth to Fixed Assets Ratio = Net worth / Closing balance of Net Fixed 106

8 ii) Long Term Debt to Total Debt Ratio (LDTDR): This ratio is calculated below: Long Term Debt to Total Debt Ratio = Long Term Debt / Total Debt. This ratio indicates the proportion of long-term debt to total debt of a company at a point of time. Usually long-term debt should be used mainly for long-term investment purpose though a part of it may be used for working capital purpose also. Thus, when a company uses short-term debt for long-term investment purpose or depends on short-term debt for running its day-to-day activities, it will hamper smooth running of the company. It will give very bad impression on its image and create an unrest state. This situation will give an alarm to the long-term solvency of the company. Therefore, there should be a balance between the two. c) Activity Ratios Activity Ratios are also known as Turnover Ratios or Efficiency Ratios. As activity ratios are concerned with assessing the efficiency of a company in managing its assets, these are also called efficiency ratios or asset utilization ratios. Usually, the greater is the rate of turnover or conversion, the more efficient is the utilization of assets, other things remaining the same. For this reason, such ratios are also called as turnover ratios. An activity ratio thus is a measure to test the relationship between sales (or cost of sales) and the various assets of a firm. 18 Further, these ratios indicate whether the firm s investment in current assets and long-term assets are too large or to small. Here, we have considered the following important ratios under this group that are more relevant to our study: i) Current Assets Turnover Ratio (CATR): Current assets are also called gross working capital whereas excess of current assets over current liabilities is called net working capital. Here, we have used current assets turnover ratio as a substitute for usual working capital turnover ratio or net working capital turnover ratio because of the negative working capital of the company. In case we calculate the usual ratio, i.e. net working capital ratio, it would give an absurd result because of the excess of current liabilities over current assets. Current Assets Turnover Ratio has a direct relationship with sales. This ratio is calculated by dividing net sales by average current assets. Thus, the formula of this ratio is: Current Assets Turnover Ratio = Net Sales / Average Current Assets. 107

9 This ratio explains the liquidity or illiquidity position of the company. It also indicates the velocity of the utilization of current assets. The ratio measures the efficiency with which a firm utilizes its current assets. A higher ratio indicates an efficient utilization of current assets and a low ratio indicates otherwise. However, a very high current assets turnover ratio is not good for a firm, which implies an inadequate investment in current assets that would affect profitability. 19 ii) Stock Turnover Ratio (STR): This ratio is computed by dividing the cost of goods sold by the average stock of coal and coke. The formula is given below: Stock Turnover Ratio = Cost of Goods Sold / Average Stock. This ratio indicates how fast stock is sold. A high ratio is good from the viewpoint of liquidity. It shows higher efficiency of management of stock because more frequently the stock is sold the lesser amount of money is required to finance it. In standard practice, stock turnover ratio of 5 to 6 times of the average stock is considered good. A low ratio, on the other hand, shows the inefficiency of the management. However, a high stock turnover ratio that is far above the industry average would create an unrest situation and affect profitability of the company, which indicates inadequate investment in stock resulting frequent stockouts and loss of sales and customer goodwill. 20 iii) Debtors Turnover Ratio (DTR): It is determined by dividing the net credit sales by average debtors. Here net sale is considered for net credit sale. Thus, the formula is: Debtors Turnover Ratio = Net Sales / Average Debtors. This ratio is a vital tool to analyze the liquidity position of a company, which considerably depends upon the quality of the debtors. The ratio signifies the credit and collection policy followed by a company. A high debtors turnover ratio indicates prompt payments made by the debtors and vice-versa. A shorter collection period implies better quality of the debtors and indicates an efficient management of credit policy. Similarly, a higher collection period indicates an inefficient collection performance, which adversely affects the liquidity position of a company and may result in more bad debts. However, excessive conservatism in credit granting may cause in the loss of some desirable sa les. 21 iv) Fixed Assets Turnover Ratio (FATR): This ratio is computed by dividing net sales by average net fixed assets. Thus, the formula is given below: Fixed Assets Turnover Ratio = Net Sales / Average Net Fixed Assets. 108

10 This ratio is a vital tool to assess the efficiency of a company in utilizing its fixed assets to boost sales and profitability, which considerably depends upon the quality of the fixed assets. Unutilized or underutilized fixed assets affect production and profitability and further increase expenses for maintenance and upkeep. A firm s ability to produce a large volume of sales for a given amount of net assets is the most important aspect of its operating performance. A higher ratio indicates an efficient utilization of fixed assets and a low ratio indicates otherwise, but very high fixed assets turnover ratio is also not good for a firm, which implies that fixed assets are inadequately invested or fixed assets are very old and substantially depreciated that would affect profitability. 22 v) Stores to Consumption Ratio (in months): This ratio here indicates stock of stores as a number of months consumption, i.e. holding of stores in advance for certain months consumption. The formula of this ratio is: Stores to Consumption Ratio = Closing Stock of Stores / Average Consumption Per month. Increase in sales with same or lesser investment in stores and spare parts indicates an improvement in efficiency of utilization of these assets and in reducing slow moving or non-moving items if any. Conversely, a large holding of these assets indicates inefficiency. 23 d) Profitability Ratios / Profit inability Ratios : Profitability is the ability of a firm to earn income and sustain growth in both short-term and long-term. Profit inability refers to the lack of ability of a firm to earn profit and sustain growth in the both short-term and long-term perspectives. A company should earn sufficient profits to survive and grow in the long-run. Profits are essential and every stakeholder of a company is interested to see its financial soundness and profitability. When management of a company is keen to measure its operating efficiency through profitability, the shareholders invest their funds in the expectation of reasonable returns. Thus, the operating efficiency of a company and its ability to ensure adequate return to its shareholders depend ultimately on the profits earned by it. 24 When a company fails to earn profit over a long period resulting in sickness, the most of the profitability ratios become negative. This is the situation with the ECL. Based on our own thinking and analysis coupled with knowledge from the relevant literature, we prefer to call the negative profitability ratios as profit inability ratios. The term profit inability ratio is our 109

11 new coinage, which will hopefully find acceptance to the academic world. Now this strength of profitability can be measured through profitability ratios. Profitability ratios are based either on sales or on investments. Profitability ratios in relation to sales are: (a) Profit margin (gross and net) and (b) Expenses ratio. On the other hand, profitability ratios in relation to investments are measured by (a) Return on assets, (b) Return on capital employed and (iii) Return on shareholders equity. 25 Now, we would like to note here that due to negative net worth and negative capital employed we are unable to compute all the normal profitability ratios like Return on Capital Employed (ROCE), Return on Equity (ROE), and Return on Networth (RONW) etc. Thus, we have limited ourselves only to the following relevant ratios that are suitable for our study: i) Gross Profit Ratio: It is calculated by dividing gross profit by net sales. Thus, Gross Profit Ratio = (Gross Profit / Net Sales). Gross Profit is the result of the relationship between price, sales volume, and costs. Thus, a change in these factors would bring change in the gross profit margin. A high ratio of gross profit to sales is a sign of good management, which implies that cost of production of the firm is relatively low whereas a relatively low gross profit margin is certainly a danger signal, which demands a careful and detailed analysis of the factors responsible for it. 26 However, here for calculation of gross profit we have adjusted Profit/loss for the Year by adding up provision for bad debt, bad debt written off, interest paid on long-term loan etc. and deducing interest received from Term Deposit etc. to find out gross profit mainly from production activities. We have followed this logic in our analysis chapter also. ii) Net Profit Ratio: It is calculated here by dividing net profit before tax by net sales. Thus, the formula of this ratio is: Net Profit Ratio= (Net Profit before Tax / Net Sales) Here we have considered Net Profit before Tax (PBT) instead of Net Profit after Tax (PAT) in the denominator. Reason is that for ECL, PBT and PAT are more or less same because the company during our study period has mostly incurred losses and again there is huge balance of accumulated losses for adjustment and hence has not paid any income tax on profit. Further, Profit before Tax can highlight on the operating efficiency of the 110

12 company which is very important for a sick company like ECL. Further this formula is followed by the industry and hence it is useful for comparing its performance with the industry. The net profit margin is an indicator of management s ability to operate business with sufficient surplus not only to recover the cost of merchandise or services, operating expenses and the cost of the borrowed funds but also to leave a margin of reasonable return to the owners for providing their capital at risk and a margin for growth. A high net profit margin would ensure adequate return to the owners and enable a firm to resist adverse economic conditions when either selling price is declining or cost of production is rising or demand is falling. On the other hand, a lower net profit margin has adverse implications. 27 iii) Cash profit Ratio: We know, net profit of a firm is affected by the amount of depreciation which is a non-cash expense and this depreciation being an allocation of historical cost has little role in present decision making. Thus, it is essential for an enterprise to earn cash profit (i.e. Net Profit + Depreciation) from operations and net sales for the survival and smooth running of its day-to-day operating activities. Cash profit ratio, in this respect, is more reliable indicator of performance and evaluates the efficiency of operation of a firm in terms of cash generation and is not affected by the methods of depreciation. Cash profit ratio measures the relationship between cash generated from operations and the net sales. 28 The formula is calculated below: Cash Profit Ratio = (Cash Profit / Net Sales). iv) Return on Total Assets (ROTA): The return on total assets is an important measure of the overall profitability and operational efficiency of a firm. This ratio is considered to be the best alternative to Return on Capital Employed (ROCE) which can not be computed here because of negative capital employed of the company. This ratio shows an interaction between profitability ratio and activity ratio. This ratio is also called Earning Power Ratio. The ratio is calculated below: Return on Total Assets Ratio = Net profit margin x Assets Turnover. Alternatively, ROTA = (PBT /Net sales) x (Net Sales / Total assets) = Profit before tax / Total assets. 29 It implies that the performance of a firm can be improved either by generating more sales volume per rupee of investment or by increasing the profit margin per rupee of sales. 111

13 In addition, before assessing the financial performance of the company under study we would like to mention here that there can be no ratio which may be treated as ideal or standard for all firms in an industry or for similar firms in different industries. This is due to a number of reasons. First, the nature of business, competition, risk involved, etc. may vary from firm to firm or industry to industry. Consequently, the same standard may not be applicable to all. Second, the position depends on the items making up the ratio and these are bound to vary unit to unit. Therefore, any conclusion drawn without regard to the constituent items in detail is likely to lose much of its significance. Third, a poor ratio may be the result of either financial incompetence or financial wizardry. It, therefore, follows that the ideal or conventional ratios should not be taken as a rigid standard for purposes of analysis; at best they may be treated as guides in the hands of the analysts. Each firm must build up its own standard under its own operating conditions. However, a good financial statement analyst requires a combination of common sense and sound financial judgment, neither of which can be reduced to a set of rigid standards. 30 While financial statement analysis can be a very useful tool, there are certain problems that call for care, alertness, and judgment. 31 2) Cash Flow Analysis In addition to ratio analysis, cash flow analysis is an important technique for appraisal of financial performance with regard to the short-term solvency of the company, i.e. for assessing the liquidity position of the company. Cash flow statement provides information about the cash inflow and outflow of an enterprise for a given period and enables management to ascertain the availability of cash to meet business obligations when required. Further, it has a special importance for a sick company like ECL to identify whether the company has been improving its strength to generate cash to run its business without depending on external sources of funds and been able to stop cash losses, i.e. losses before charging depreciation. It depicts the changes in cash position resulting from operating, investing and financing activities of an enterprise during a particular period. An enterprise that consistently fails to pay interest and loans from operating cash flow approaches towards insolvency. A weak or negative cash flow means that a company has to turn to external sources to fund future investments. Generally, companies in stronggrowth industries often find themselves in a poor cash flow position because of their substantial investment needs. Thus, a cash flow statement gives a true picture of a firm s liquidity as well as solvency position

14 At present, the preparation of cash flow statement is mandatory from April 1, 2001 and shall be prepared in conformity with the revised Accounting Standard AS-3. This statement reconciles opening and closing balances of cash and cash equivalents for the reported accounting period. The cash flow statement relating to a particular period is classified into the following three main categories: i) Cash flow from operating activities. Operating activities are the principal revenue-producing activities of an enterprise, which affect those transactions and events that determine net profit or loss. ii) Cash flow from investing activities. Investing activities relate to the acquisition and disposal of long-term productive assets and other investments not included in cash equivalents. iii) Cash flows from financing activities. Financing activities relate to such activities that result in changing the quantum and composition of the owners capital and debt capital of the enterprise. In our study, we have used the technique of cash flow analysis for financial performance appraisal of ECL. The procedures used for the preparation of cash flow statement are as follows: a) Calculation of net increase or decrease in cash and cash equivalents. b) Calculation of the net cash provided or used by operating activities. c) Calculation of the net cash provided or used by investing activities. d) Calculation of the net cash provided or used by financing activities. e) Preparation of the cash flow statement by classifying all cash inflows and outflows in terms of operating, investing and financing activities and showing net cash flow from each of them separately. f) Ensuring that the aggregate of the cash flows from operating, investing and financing activities is equal to the net increase or decrease in cash and cash equivalents. g) Reporting of any significant investing and financing transactions that do not involve cash or cash equivalents in a separate schedule to the cash flow statements. The ratio analysis and cash flow analysis are based on the financial data for ten years taken from the Annual Reports of the companies. The original data in full form have been 113

15 provided in the Annexures given at the end of the thesis. However, the titles of the Annexures are presented below: Annexure I: Secondary Data collected from Annual Reports of Eastern Coalfields Ltd. for the period to ; Annexure II: Secondary Data collected from Annual Reports of CCL during to ; Annexure III: Secondary Data collected from Annual Reports of CIL during to ; Annexure IV: Balance Sheet Data of ECL for the period to ; Annexure V: Profit and Loss Data of ECL for the period to Group B: Statistical Tools and Techniques employed for Analyzing the Financial Performance Appraisal of Eastern Coalfields Limited 1) Trend Ratios Trend ratios are the index numbers of the movements of financial figures reported in the financial statements for more than one accounting period. It is a statistical technique adopted to reveal the trend of financial items that are used in analyzing the behavior of financial items and for preparation of projected financial statements. In preparation of trend ratios, first, the base accounting period is selected and the financial figures of that base period are given the index number of 100. Then the trend ratios are calculated for the selected financial items given in the financial statements for the successive accounting periods taking the base period trend ratio as 100 for comparison and to arrive at the conclusions for important changes. They help in making horizontal analysis of comparative statements. It also reflects the behaviour of selected financial items over a period. 33 2) Arithmetic Mean (A.M.) Arithmetic mean of a set of observations is defined as their sum, divided by the number of observations. Thus, if there is a set of n observations x 1, x 2, x 3 x n then A.M. of them is denoted by = (x 1 + x 2 + x x n ) = 114

16 Where is called Arithmetic Mean, is the sum of the total observations. A.M. is the simplest and easiest to understand and fulfills all the criteria of a satisfactory average. It is based on all observations and easy to calculate. It is also the most stable of all the measures of central tendency, as far as sampling fluctuations are concerned. If many samples are drawn from the same statistical population, arithmetic mean will be found to fluctuate less than any other measure of central tendency. 34 3) Standard Deviation (S.D.) It is defined as the square root of the A.M. of squares of deviations from A.M. It is also known as Root-Mean-Square Deviation from mean. Thus, if a set of n observations x 1, x 2, x 3 x n possesses a mean, then S.D. of them is denoted by and is defined as = 2. Where 2 is the sum of the squares of deviations from A.M. and is (x 1, x 2, x 3,, x n ). It is the most useful among all measures of dispersion because it possesses most of the characteristics of a good measure and is always taken to be positive. It is also the least affected by sampling fluctuations. Square of S.D. is known as the variance ( 2 ). 35 Further, when we compare two data, S.D. is the best measure to be used in the coefficient of variation for consistency or inconsistency of data. If two series of data is given with same mean, the mean itself will be the best representative of that series, which is having minimum value of S.D. Perhaps this is the most important role of standard deviation. 36 4) Coefficient of Variation (C.V.) All absolute measures of dispersion are expressed in the same unit in which the original observations are given and hence are unsuitable for comparing the dispersion of two or more sets of observations given in different units, e.g. heights in inches and weights in lbs. Thus, for that purpose a relative measure being a pure number may be used. Relative measures are obtained by expressing an absolute measure as a percentage of measure of central tendency and hence relative measures are independent of the units of measurement. They may also be used to compare the relative accuracy of data but absolute measures cannot be so used. Again, there are cases where it is found that although the unit of measurement is the same the averages differ widely and in such 115

17 cases, a relative measure provides a more useful measure of variability than standard deviation itself. In our data analysis, we have used Coefficient of Variation as a measure of relative dispersion for comparing two or more sets of ratios for financial performance appraisal of the company. It is a useful statistic in our case for comparing the degree of variation from one series of ratio to another even if the means are drastically different from each other. The coefficient of variation represents the ratio of the standard deviation to the mean. 37 The C.V. provides a benchmark for measuring a degree of variability. Usually lower the coefficient better is the accuracy of measurement of, and S.D. The formula of coefficient of variation is given below: Coefficient of Variation (C.V.) = x 100. As mean is the best measure of central tendency, standard deviation is the best measure of dispersion. So, coefficient of variation is the best measure of relative dispersion. 38 5) Correlation Analysis The word correlation is used to denote the degree of association between the variables. If two variables X and Y are so related that variations in the magnitude of one variable tend to be accompanied by variations in the magnitude of the other variable, they are said to be correlated. It shows the strength of linear relationships between two variables and is denoted by r. The statistic r is also referred to as the Pearson s product-moment coefficient of correlation. If Y tends to increase as X increases, the variables are said to be positively correlated. If Y tends to decrease as X increases, the variables are negatively correlated. If the values of Y are not affected by changes in the values of X, the variables are said to be uncorrelated. Alternatively, we say that positive r occurs when large values of X go with large values of Y or small values of X go with small values of Y. Negative r occurs when large values of X go with small values of Y or vice versa. Zero correlation means there exists no relation between X and Y. Thus, it tells us whether or not there exists a linear relationship between X and Y. Let (X 1, Y1), (X 2, Y2) (X n,y n ) be a given set of n pairs of observations on two variables X (dependent variable) and Y (independent variable). The correlation coefficient or coefficient of correlation, between X and Y (denoted by the symbol r XY ) is then defined as 116

18 r xy = Where, r xy = Pearson s Product -Moment Correlation Coefficient. X = value of independent variable. = mean of the values of the independent variable. Y = value of dependent variable. = mean of the values of the dependent variable. 39 In our analysis we have calculates Pearson s Product-Moment Correlation Coefficient to measure the degree of association between the variables. It measures here the magnitude and direction of linear relationships between two variables, X being the independent variables (all group ratios) and Y being the dependent variables (return on total assets). We have used the value of r for the following purposes: a) To find the strength of linear relationships between two variables. This helps us to know whether or not there exists a linear relationship between X (all group ratios) and Y (return on total assets). b) To measure the goodness of the fit between two sets of data. If r is close to zero we shall say that the fit is poor or weak or non-existent. If on the other hand, r is close to +1 or -1, we shall say that the fit is good and there is a strong correlation. If the r is positive and strong, it stands to reason that the variables are interrelated in a way that points to cause and effect relationship and we can then make predictions and generalizations. The range of r is between +1 and -1. The highest positive value of r is +1 and the highest negative value of r is -1. 6) Test for Significance of Observed Correlation Coefficient Or Testing of Hypothesis This test is necessary to make sure that the r value is not by chance, but real. If the r is spurious (i.e. by chance), no cause and effect relationship can be established. This statistic is used for testing the significance of r. Null hypothesis states that there is no correlation between X and Y, this means that ρ (Greek rho) =0. Alternative hypothesis states that there is relation between X and Y. This means that ρ 0. Suppose, we have a random sample of n pairs of observation (x 1, y 1 ), (x 2, y 2 ) (x n, y n ) from a bivariate normal 117

19 population and let r be the observed correlation coefficient in the sample. It is required to test if this sample correlation coefficient is significant of any correlation in the population (i.e., whether the value of the population correlation coefficient ρ is zero and the observed value of r has arisen due to fluctuation of sampling). R.A. Fisher has shown that when the Null Hypothesis H 0 (ρ=0) is true, the test statistic follows Student s t distribution with (n-2) degrees of freedom. 40 Though this test is based on a normal curve approximation and the assumption that n is large, it can be used even when n is small. Decision rule: Reject H 0 if observed t t n-2 or Accept H 0 otherwise at a given level of significance. If r tests significant we say that r is significant at a given level of significance. 7) Trend Analysis of different Financial Ratios: For determining trends of financial ratios, we have used the formula as suggested by H. Bhattacharya for the measurement of financial performance of Eastern coalfields limited. The formula recommended by H. Bhattacharya is very useful for computing quick estimate of the trend of financial ratios which is very easy to calculate and interpret. It gives the same result as can be calculated following regression equation or by semiaverage method. 41 The formula as followed by him for estimating trend of financial ratios is given bellow: LHS (Calculated value) RHS (Standard value) Where are the values of the ratio for the years 1, 2, 3, 4. n and N is the total no of years for which the ratio is calculated. The trend may be regarded as rising or flat or declining if the left hand side (LHS) of the equation is greater than or equal to or less than the right hand side (RHS) of the equation. In our analysis, the RHS will always be Where N = 10 (i.e. no of years) as period of our study is from to

20 5.4 Conclusion. We have mentioned that mainly there are two types of performance appraisal of a company: financial and non-financial. However, we have confined our study only to the financial performance appraisal and to the relevant tools and techniques only. We have described all these tools and techniques in two groups: Group A that includes Accounting Tools, viz. Ratio Analysis and Cash Flow Analysis and Group B that includes Statistical Tools viz. Trend Ratios, Arithmetic Mean, Standard Deviation, Coefficient of Variation, Pearson s Correlation Coefficient and Student t test. Moreover, Ratio analysis has been considered here main accounting tool for financial performance appraisal that is a traditional and widely accepted tool whereas Cash Flow Analysis and Trend Ratios are chosen for further refinement of our study. Again, Cash Flow Analysis is selected as it has become mandatory for a corporate sector from April 1, 2001 and has a special importance for a sick company like ECL where cash inflow is very important for the survival of the company. In addition, we have taken help of the selected statistical tools for proper analysis and interpretation of the data. However, though we cannot ignore the importance of other techniques of financial performance appraisal of a company as well as other methods of measuring the overall performance of the company, our main objective has been to describe only those relevant tools and techniques, which are more appropriate in our case. In the next chapter titled Analysis and Interpretation of Data we have applied these tools without any ambiguity to achieve our objectives meticulously. References: Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Chandra, P. (2011): Financial Management, Theory and Practice, Tata McGraw Hill Education Private Ltd., New Delhi, 8 th ed., p

21 4. Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Pandey, I. M. (2008): Financial Management, Vikas Pub. House Pvt. Ltd., Noida, 9 th ed. Reprint, p Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Pandey, I. M. (2008): Financial Management, Vikas Pub. House Pvt. Ltd., Noida, 9 th ed. Reprint, p Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Pandey, I. M. (2008): Financial Management, Vikas Pub. House Pvt. Ltd., Noida, 9 th ed. Reprint, p Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Paul, S. K. (2007): Management Accounting, New Central Book Agency (P) Ltd, Kolkata, 3 rd Revised ed. Reprint, p Chandra, P. (2011): Financial Management, Theory and Practice, Tata McGraw Hill Education Private Ltd., New Delhi, 8 th ed., p Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Banerjee, B. (2005): Financial Policy and Management Accounting, PHI Private Limited, New Delhi, 7 th ed., p Banerjee, B. (2005): Financial Policy and Management Accounting, PHI Private Limited, New Delhi, 7 th ed., p. 375 and Bhattacharya, H. (1995): Total Management by Ratios: An Integrated Approach, Sage Publications, New Delhi, 1 st ed., p Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., pp Kishore, R. M. (2007): Financial Management, Taxman Allied Services (P) Ltd, New Delhi, 6 th ed. Reprint, p

22 20. Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Ibid., Pandey, I. M. (2008): Financial Management, Vikas Publishing House Pvt. Ltd., Noida, 9 th ed. Reprint, p Annual Report & Accounts of Eastern Coalfields Limited ( ), p Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and 25. Ibid. Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., p Ibid., pp Ibid., p Kishore, R. M. (2007): Financial Management, Taxman Allied Services (P) Ltd., New Delhi, 6 th ed. Reprint, pp Khan, M.Y. & Jain, P.K. (2007): Financial Management, Text, Problems and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 4 th ed., pp Banerjee, B. (2005): Financial Policy and Management Accounting, PHI Private Limited, New Delhi, 7 th ed., p Chandra, P. (2011): Financial Management, Theory and Practice, Tata McGraw Hill Education Private Ltd., New Delhi, 8 th ed., p Kishore, R. M. (2007): Financial Management, Taxman Allied Services (P) Ltd., New Delhi, 6 th ed. Reprint, pp Ibid.,p Das, N.G. (2009): Statistical Methods, TMH, New Delhi, Vol I, p Ibid, pp Biswas, D. (2006): Probability and Statistics, New Central Book Agency, Kolkata, Vol I, 1 st ed., p Das, N.G. (2009): Statistical Methods, TMH, New Delhi, Vol I, pp Biswas, D. (2006): Probability and Statistics, New Central Book Agency, Kolkata, Vol I, 1 st ed., p Das, N.G. (2009): Statistical Methods, TMH, New Delhi, Vol I, p Das, N.G. (2009): Statistical Methods, TMH, New Delhi, Vol II, p Bhattacharya, H. (1995): Total Management by Ratios: An Integrated Approach, Sage Publications, New Delhi, 1 st ed., p