Analysis of Financial Statements

The basic question

What do we finance ?

Cost ? or Asset ?

We finance Cost

Asset is a Security Cover guaranteed by legal rights or charges

The corollary

Two principles of financing Cash flow backed financing

Lender gets a legal charge on the cash flow

Asset backed financing

Lender gets a legal charge on the assets created

Asset backed financing

The concept of security

Primary security

Assets created out of bank finance

Collateral security

Any other asset charged to the bank against the loan

The basic question

Whom do we finance ?

Borrower
The 3 Cs Capital, Capacity & Character

How do we judge him ?

The judgment requires and makes use of Prudence, Due diligence & Analysis

Credit Appraisal
The process of decision making in Credit by undertaking Informed Analysis using Prudence, Due diligence & Conservatism

Informed Analysis

Attribute based

Financial statements based

Please count every F in the following text

FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY COMBINED WITH THE EXPERIENCE OF YEARS

Financial Analysis

We see things but do not observe

We write things but do not say

Financial Analysis

Why Analysis ?

To get a true & fair view ?? Perspectives may vary with the user Analysis is a prerogative of the decision maker Analysis for decision making
Objective Meaningful

The approach for analysis ?

The BALT approach to Financial Analysis

BANKING ACCOUNTING LEGAL

TAXATION

Financial Statements - the components

Statement of profit & loss (P&L account) Statement of assets and liabilities (Balance Sheet), Cash flow statements Explanatory schedules or notes forming part of these statements Earnings per Share (EPS) statements Report by the Board of Directors Directors Responsibility Statements

Financial Statements - the components

Auditors Report

Notes to Accounts Observations & Qualifications, if any Report as per CARO 2003

CARO 2003
Company Auditors Report Order, 2003 Applicable to all companies except

Banking Companies Insurance Companies Section 25 companies Private companies with

PUC

+ Reserves <= Rs.50 lakh Public Deposits - NIL Loan from Bank/FIs <= Rs.10 lakh Annual sales turnover <= Rs. 5 Cr.

CARO 2003 - relevance for banks

Disposal of fixed assets Has it affected the going concern ? Records of inventory & physical verification Conducted ? Properly accounted for ? Loans (secured / unsecured) taken / granted ? Interest, Repayment, Conduct, Transactions - Regular? Accepted deposits from public ? Provision of sec. 58A & 58AA complied with ? Deposit of undisputed statutory dues Regular in payment ? Arrears ? Is it a sick company under SICA ? Provision of sec. 58A & 58AA complied with ? Whether defaulted in repayments to banks / FIs ?

Extent & period ?

Financial Statements
Other important information

Contingent liabilities Off balance sheet items

Market information

Building Blocks of Financial Statements

Fundamental concepts Local Accounting Standards International Accounting Standards US GAAP

Structure of presentation of Balance Sheet

Liabilities Capital & Reserves Secured Loan Unsecured Loan Current Liabilities & Provisions Total Assets Fixed Assets Investments Current Assets, Loans & Advances Miscellaneous expenses to the extent not written off Total

Structure of presentation of Balance Sheet (as required for analysis)

Liabilities

Assets
Inventories, Receivables etc. (assets chargeable to Bank) Other Current Assets

Short term Bank borrowing Cash & Bank balance Other Current Liabilities (incldg. Trade Creditors, Provisions etc.) Term Liabilities

Net Worth

Total

Net Block (Fixed Assets less Depreciation) Intangible Assets Total

What is the difference between the styles of presentation ?

From the promoters perspective

Permanency of liabilities and assets

From the bankers perspective

Currency of liabilities and assets

This is the reason why from the point of view of a Credit Analyst :

classification of Assets and Liabilities as Current and non-Current assumes considerable importance.

The Credit Analyst may therefore have to restructure the financial statements

according to his needs i.e. making a meaningful analysis of the figures for his decision making

To make the analysis meaningful, it may be necessary to :

include delete, or reclassify

some items of expenses, assets or liabilities

We may call it recasting, reclassification or restructuring of the financial statements

Current Assets
Current Assets are assets like Cash, Bank balances and other resources that are reasonably expected to be realized or consumed within one year of the date of the Balance sheet. Thus, Current Assets include : Cash Bank balances Inventory holding comprising of Raw Material, Semi - Finished goods, Finished goods, consumables etc. Advance payment made Prepaid expenses Advance Tax etc. Margin deposited against BG for WC purposes etc.

Current Liabilities
Similarly, Current Liabilities are those obligations of the enterprise that are reasonably expected to be liquidated within one year from the date of the Balance sheet, either through the resources classed as Current Assets, or through the creation of other Current Liabilities. Accordingly, Current Liabilities include : Bank borrowings for Working capital purposes Other short term credits Trade Credits Expenses due but not paid Provisions made for expenses / losses Advance payment received Instalment of Term Loan due within a year etc.

However, there may be cases where :

The maturity period of any of the Current assets and Current Liabilities may be more than a year Thus, the one year temporal standard to determine the validity of Current-ness may not be universally valid Therefore, what may be Current or non-Current also depends on the core business activity marked by technological requirements and trading practices

Tips for re-classification

Value of an asset lower of the market value or reported value Assessed value < reported value ?? Create provision New provision carved out of Net worth i.e. Capital and Reserves.

Should we carry an asset which is no more relevant ?? Take out of the Balance Sheet Make adjustments against Net Worth.

Revaluation company perspective

Balance Sheet Liabilities Capital & general reserve Revaluation reserve Other liabilities (including bank loan) Total Year 1 500 500 1000 2000 Amount in Rs. Lakh Year 2 Assets 700 Fixed assets (including revaluation) 400 1000 Other assets 2100 Year 1 1700 Year 2 1400 (1700300) 700 2100

300 2000

(Note : year 1 on revaluation ; year 2 one year after revaluation)

Revaluation Bank perspective

Profit & Loss account Profit before depreciation Less depreciation Profit after depreciation (Rs. lakh) 400 200 200

Liabilities Capital & general reserve Other liabilities (including bank loan) Total

Year 1 500 1000 1500

Year 2 Assets 700 Fixed assets 1000 Other assets 1700

Year 1 1200 300 1500

Year 2 1000 700 1700

Deferred Tax issues

Stems from a difference in approach in Accounting vs. Taxation accounting Deferred Tax Liabilities

Mostly from depreciation Mostly from VRS issues

Deferred Tax assets

Example A company has purchased an instrument for use in the Research & Development department at a cost of Rs.10 Cr. The company would use SLM rate of depreciation @ Rs.2 Cr. per annum. The Income Tax laws however permit full depreciation during the first year for such instruments. How would the company treat this from the point of view of Deferred Tax liability ?

Deferred Tax Issues

Sl. No. Year end 1. 2. 3. 4. 5 6. 7. 8. 9. 10. PBDT (say) Depreciation (as per Companies Act) PBT Provision for Tax (@ 40%) PBDT Depreciation (as per Income Tax Act) PBT Provision for Tax (@ 40%) Deferred Tax liability created Balance of DTL as appearing in the BS I 12 2 10 4 II 12 2 10 4 III 12 2 10 4 IV 12 2 10 4 V 12 2 10 4

12 12 12 12 12 10 0 0 0 0 2 12 12 12 12 0.8 4.8 4.8 4.8 4.8 3.2 ( 4 0.8) 3.2 2.4 1.6 0.8 0

Analysis of Financial Statements

Analysis of financial statements is necessary to gauze the financial health of a unit. Analysis can be done by means of : Percent of Sales method Trend analysis Ratio analysis Funds flow analysis Cash flow analysis Break even analysis etc.

Ratio Analysis

Most important generic ratios of relevance in credit analysis Liquidity ratios / indicators Gearing levels Profitability ratios Coverage ratios Return on Capital / Investments / Assets Turnover / Holding ratios

Liquidity Indicators

Current ratio Acid test / Quick ratio NWC (Net Working Capital) Cash Generation

The rationale of Current Ratio

How Current is the Current Ratio ?

Does it indicate Liquidity ? the concept of recovery by disposal of the concept of Current-ness of liabilities The conflict between Prescriptive & definitions The conflict between Operating Funding concept Does not take care of recent developments

CA assets and Conceptual Cycle vs. accounting

Deferred tax CENVAT receivables

Net Working Capital

Current Liabilities Current Assets Net Working Capital Other Liabilities Other Assets

Gearing ratio

Indicates stability
TOL / TNW Debt Equity ratio (TTL / TNW)

Consider the following

A business enterprise has submitted the following projected estimates with a request to provide short-term (cash credit) and term loan facilities of Rs.3.00 lakh and Rs.4.00 lakh respectively. The B/S and ratios looks like the following
Liabilities
Capital Amount

Assets Fixed assets Current assets

Amount

100 150 400 50 300 1000

500 500

Unsecured loan Term loan Trade credit Cash credit Total

Total

1000

Total Debt / Equity Ratio Long Term Debt / Equity Current Ratio

(TOL / TNW) (TTL / TNW) CA / CL

900 / 100 400 / 100 500 / 500

9:1 4:1 1:1

You refuse the proposal

The entrepreneur comes back with a proposal that the fixed assets would be acquired on lease by arrangement with an NBFC. Resubmits the proposal for WC credit facilities only.
Liabilities
Capital Amount

Assets Current Assets

Amount

100 50 50 300 500

500

Unsecured loan Trade credit Cash credit Total

Total Debt / Equity Ratio

Total
(TOL / TNW) 400 / 100

500
4:1

Long Term Debt / Equity

(TTL / TNW)

NA

NA

Current Ratio

CA / CL

500 / 400

1.25 : 1

Gearing ratio - stability

TOL

TOL

TNW Stable

TNW

Unstable

Coverage Ratios

Cash Accrual Repayment Obligations

Important Coverage ratios

Debt Service Coverage ratio Interest Coverage ratio

Ratio Analysis (contd..)

Although any number of ratios can be taken out, at least the following ratios should be calculated and interpreted for the purpose of Decision Making and Pricing :

Working Capital facilities

Current ratio TOL / TNW (Total Debt / Equity ) ratio PAT / Net Sales ( Total profitability ratio) PBDIT / Interest ( Interest Coverage ratio) PBDIT / Total Assets ( ROCE or ROA) ratio (Inventory + Receivables) / Net sales (in days) ratio

Ratio Analysis (contd..)

Term loan facilities

Project Debt / Equity ratio TOL / TNW Gross Debt Service Coverage ratio

THANK YOU