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Financial statement analysis

Dr. Padmini Srinivasan Indian Institute of Management Bangalore

Accounting Principles

Monetary transactions and Events enter the system Process Using an Accounting Mechanism Follow certain rules or principles of Accounting called as ‘GAAP’ (Generally Accepted Accounting Principles) or Accounting standards Audit to lend credibility to the reports

Primary Financial Statements

Balance Sheet Statement of

Financial Position

Profit and Loss A/c

(Income Statement)

Cash Flow Statement

The financial statements reports on status & performance of the company in financial terms

The Balance sheet

The Balance sheet is a status report giving the Financial Position of the Company at a particular point of time

Resources owned and

amounts owed

The Profit and Loss Account Measures Operating Performance

The profit and loss account or the Income statement, reports the company’s revenues, expenses, and net income or net loss for the period. Revenues or Incomes arise from selling of goods or services to customers Expenses related to earnings are deducted from revenues

The Statement of Cash Flows

The statement of cash flows reports the company’s cash inflows and

Outflows from its various activities.

Balance Sheet

Balance Sheet

Assets.

Liabilities

Owners’ equity

•Gives the resources owned and their funding •The “assets” owned and the claimants against the assets

© Padmini Srinivasan - iimb

Balance Sheet: ASSETS

Resources owned by a firm Capable of giving future cash flows (by use or disposal value) Objectively verifiable arising from a past identifiable event


LIABILITIES

Liabilities are Debts They are present obligations a firm owes. They are claims against the assets the firm. Liabilities may be to the owners or to outsiders


Balance Sheet of ABC LTD as on 31ST MARCH, 2005

Uses of Funds Fixed Assets Investments

• Current Assets, Loans and Advances

Sources of Funds (Liabilities)

Share Capital Reserves and Surplus Borrowings:

Secured Unsecured

Current Liabilities and Provision


FIXED ASSETS

Used for producing goods / services for renting out or for administrative uses Useful life of more than 1 year Not held for sale in the ordinary course of the business Disclosed : Gross book value

As less: Accumulated Depreciation

Net book value


FIXED ASSETS

Depreciation is treated as Expenses and is charged to the profit and loss account Accumulated Depreciation it’s the sum of depreciation charged to the profit and loss account till the end of the current financial year


INVESTMENTS

Are assets held as stores of value with a view to get interest, dividend or capital

appreciation TYPES: Long Term/ Current (holding period)

Quoted / Not Quoted Trade Investments


CURRENT ASSETS, LOANS AND ADVANCE

Current assets are assets that form part of the operating cycle and take interrelated form Expected to be converted into cash in next 12 months Consists of :

Cash Sundry Debtors Inventory Others


LIABILITIES

They are present obligations a firm owes. They are claims against the assets the firm. Discharging the liability will result in the decline of the assets


Shareholders Funds

Share Capital Amount contributed by owners towards the capital of the firm They are divided into units called share Have a face Value RESERVES AND SURPLUS They are the accumulated profits or retained earnings not distributed and owed by the business to the equity share holders

Share Capital + R & S is called Net Worth


LOANS

Are borrowing to be repaid as per agreed terms on which interest needs to be paid irrespective of availability of profits.

TYPES: SECURED LOAN OR UNSECURED LOANS LONG TERM OR SHORT TERM


Current liabilities and Provisions

Arising on account of acquiring goods/services on credit or incurring expenses which are paid for later Normally they are to be settled within a period of 12 months

Two other items

Deferred tax Misc Expenditure and Losses

(to the extent not written off)

Profit and Loss Account


PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31/3/2006

SALES 1579 Other Income 100 Total income Expenses RAW MATERIALS 700 WAGES & SALARIES 374 OTHER Overheads 100 Depreciation 100 Administration and Selling Exp 100 PBIT (Operating Profit) 305 INTEREST 38 PBT 267 INCOME TAX 59 PROFIT AFTER TAX 108


Depreciation

Some Myths about Depreciation It is a process of valuation It generates cash It helps in replacement to new machine

Truths ..

Depreciation is the allocation of cost (depreciable value) of an asset to the periods that benefit from its use. It’s a charge of the asset over the useful life of an asset


Depreciation

Some Terms: Original cost (OC) of the asset Expected Useful life of the asset (This is not the physical life) Residual Value (RV) at the end of the useful life Depreciable Value of the asset (OC-RV)


Depreciation

Methods of Charging Depreciation Straight Line Method Reducing Balance Method

Which ever method you use the total depreciation to be charged over the useful life will be the same


Depreciation

Straight Line Method Formula: Cost -Residual Value Useful life

Reducing Balance Method Formula for computation of rate

1 - Residual value Cost n= useful life in years

n


Straight Line Method

Compute Depreciation Cost of asset Rs. 650,000 Salvage value Rs. 50,000 Depreciable Value = 6,50,000 – 50,000

= 600,000 Depreciation = 600,000 / 3 Rs.200,000 p.a. =200,000/650,000 * 100 30.6 %


Straight line method

Year Gross Block

Depr Acc. Depr Net Block

1 650000 200000 200000 450000

2 650000 200000 400000 250000

3 650000 200000 600000 50000


Reducing Balance method

Year Gross Block

Depr Acc. Depr

Net Block

1 650000 373,750 373,750 276250

2 650000 158,843 532,593 117,407

3 650000 67,507 600000 50000

Financial Statement Analysis (Analysis of Financial Performance)


Need for Financial statement analysis

•How has the business performed during the year

•How is the financial condition of the company

•How investment activities have performed during the year

•How does the unit stand in comparison to the industry

•Preparation of Forecasts

•Evaluation of SBU’s and departments

•Credit rating


Where to look for data

The Annual reports (An annual report and financials therein represents a

snapshot at a given moment. Directors Report - Working of the Company Auditors Report Management Discussion &Analysis Profit and loss account Balance Sheet Cash Flow statements Supplementary schedules and Notes Accounting Policies Subsidiary Company Information


TOOLS FOR EVALUATION

COMMON SIZE STATEMENTS HORIZONTAL ANALYSIS RATIO ANALYSIS CASH FLOW ANALYSIS’


Common Size Statements

Common size income statement Expresses each income statement category as a percentage of net sales

Common size balance sheet Expresses each item on balance sheet as a percentage of total assets or equities

Both statements facilitate structural analysis of the firm


HORIZONTAL ANALYSIS

Year to year changes Changes in amounts and percentages Reveals a trend & direction

For long term trends prepare a index number trend series


RATIO ANALYSIS

GIVES THE LINK BETWEEN INVESTMENT, FINANCING AND OPERATING ACTIVITY

i.e. how various items in the financial statements relate to one and another Analysis of Past performance helps in forecasting the future performance


Financial Statement Analysis

PROFITABILITY LIQUIDITY SOLVENCY

Note: Different authors take slightly different approach (formulas) for eg: PBIT instead of PAT etc.,

PBIT (NOPAT) is a good measure for inter divisions evaluation


FSA-Basic Structure

Leverage or Financial risk

Fixed Asset Turnover

Debtors Turnover or Collection Period

Inventory Turnover

Current Asset TOR

Asset Turnover ratios

Interest / Sales

Other expenses / Sales

Raw material/Sales

Profit Margins

Return on Total Assets (ROI)

R Return on Equity E

Current Ratio


Financial Ratio Analysis

Profitability Ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity


Return Ratios

Return on Equity PAT/ AVG Stockholders’ Equity

Measure overall efficiency of the firm in managing investment in assets and generating return to stockholders


Return Ratios

Return on Total Assets (ROCE) PAT /Avg Total Assets or - PBIT/ AVG Total Assets* - NOPAT / Total Assets

The ratio measures the overall efficiency of the firm in managing investment in assets and generating return to stockholders


Profitability Ratios

Net Profit Margin Net Profit After Tax/Net Sales

Operating Profit Margin PBIT (Profit before interest and tax) /Net Sales

Various Expenses to Sales Salary/Net Sales

All measure firm’s ability to translate sales into profits


Turn Over Ratios(Resource Utilization)

The Ability of different assets like Fixed Assets, current assets and both to generate sales (turnover)

Total Asset Turn over Ratio Sales / average Total Assets


Fixed Assets Turn Over Ratio

Sales / Avg Fixed Assets

Assess the effectiveness of the fixed assets to generate sales

Also reflects the investment strategies


Inventory Turnover Ratio (Not Relevant)

Cost of Goods Sold (Sales) / AVG Inventory

Number of Days Stock Avg Inventory / Sales(COGS) per day (Measures efficiency of inventory

management (not the inventory policy of the management)


Debtors Turnover Ratio

Debtors Turnover Ratio Net Sales/ Average Debtors

Average Collection Period Accounts Receivable/Average Daily Sales

(Avg daily sales = Credit sales/365) Another measure of efficiency of firm’s ability to

collect fast Helps gauge liquidity of accounts receivable (ability

to collect cash from customers)


Financial Leverage

It Pays to have Debt in your Capital Structure


Financing Pattern

Leverage Ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges also called as the Solvency ratios

Liquidity Ratios Measures the firms ability to meet cash needs as they arise


Leverage: Debt Ratios (!!)

Debt to Equity Ratio Long Term Debt/Equity

Debt Asset Ratio Total Outside Liability / Total Assets

Interest Cover Ratio Operating Profit/Interest Expense

Indicates how well operating earnings cover fixed interest charges

They measure the extent of firm’s financing with debt and the financial risk


Liquidity Ratios

Current Ratio Current Assets/Current Liabilities Measures ability to meet short-term cash needs

Quick or Acid Test Ratio Current Assets-Inventory/Current Liabilities Measure ability to meet short-term cash needs more rigorously


Other Ratios : For the Investor

Earnings per Share PAT /Average Equity Shares Indicates return on a per share basis

Book Value of the Share Net worth / Number of shares


CASH FLOW STATEMENT

CASH IS CASH REST IS ACCOUNTING!!! Accounting profits do not help in assessing the firms ability to meet its debts

As they are based on accrual concept As they are based on subjective judgements like depreciation


CASH FLOW STATEMENT

Cash flow statement can be taken as a summary of the cash book Need for cash flow statement arises from the deficiencies in the profit and loss a/c and the balance sheet, as these numbers are influenced by the accounting policies etc

Cash flow statement helps in forecasting future value.


Objectives of a CFS

Provide information to the user on: - - ability of the enterprise to

generate cash and cash equivalents and the timing and certainty of their generation.

- the manner in which the enterprise puts cash and cash equivalents to use.

- financial structure, liquidity, solvency,net assets and adaptability of the enterprise

-


CASH FLOW STATEMENTS

Provides information on cash flow related to operation financing and investing activities Firms follow the accrual and matching principle to record transactions and hence the company's incomes/ expenses are not related to cash


CASH FLOW STATEMENTS

CASH FLOWS ARE DIVIDED INTO 3 SEGMENTS AS : CASH FLOW FROM OPERATING ACTIVITY CASH FLOW FROM INVESTING ACTIVITY CASH FLOW FROM FINANCING ACTIVITY


OPERATING ACTIVITIES

Includes the cash flows derived from principal revenue –producing activities of enterprise. Cash receipts from main business of company. Cash receipts from royalties, fees, etc. Cash payment to supplier. Cash payment to and behalf of employees. Cash payments or refunds of income tax.


INVESTMENT ACTIVITIES

Shows the expenditure that have been made to generate future income and cash flows.

Cash payment to acquire fixed assets. Cash receipts from disposal of fixed assets (including intangibles) Cash payment to acquire shares ,warrants or debt instrument of other firms. Cash receipts from disposal of shares etc


FINANCING ACTIVITIES

Cash proceeds from issuing shares or other similar instruments Cash received from debentures,loans bonds and other borrowings Cash repayments of amount borrowed.


Profitable, yet in Trouble?

A firm is defined as “profitable if it has a positive net income A positive net income results from revenues exceeding expenses A firm may have a positive net income, but this does not guarantee that the firm has the CASH to meet its obligations!


Cash Flow from operations

1.Started business with share capital of Rs.50000 2. Purchased goods for Rs. 50000 paid 60 % in

cash, balance payable 3. Sold goods costing Rs. 40000 for Rs. 100000

on one month credit. 4. Purchased equipment for Rs. 15000 5. Depreciation of Eqpt. Rs. 3000 The month end. Prepare the Financial

Statements The company wants to declare dividends of Rs.

40000 ?


Operating Results: Transaction analysis

1. BS: Capital 50000 = Cash 50000 2. Capital 50000 + Crs 20000 = Inventory 50000 +

Cash 20000 3. OE 50000+ Profit 60000+ Crs 20000 = Drs 100000 + Inv 10000 + Cash 20000 4. OE 50000+ Profit 60000+Crs 20000 =

Eqpt 15000+DRs 100000+ Inv 10000+Cash 5000 5. OE 50000+ Profit 57000+Crs 20000 =

Eqpt 12000+DRs 100000+ Inv 10000+Cash 5000

There is profit of 57000 after depreciation but no cash ?


Cash Flow (Direct Method)

1. CFO: Paid Creditors (30000)

2 CFF Capital +50000 CFI

Equipment (15000)

Ending Cash Balance 5000


Cash Flow (Indirect Method)

1. CFO:PAT 57000 Add: Depreciation 3000 Cash flow before WC Changes 60000 Increase Creditors 20000 Increase in Drs - 100000 Increase in Inv - 10000 -90000 Net outflow -30000

2 CFF Capital +50000 3 CFI

Equipment (15000) Ending Cash Balance 5000

Forward Contracts

Used for hedging open positions Its contract to deliver or receive at a specified rate &date a certain amount of foreign currency. Open positions hedged like foreign currency assets/liabilities or commitments eg : Receivable /Payables / loans

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