We shall start with defining a few important terms in finance. What is a financial transaction ?

A financial transaction is an event or condition under a contract/ agreement between a buyer and seller to exchange an asset for payment. Example A buys land worth Rs 15 lacs from B. In this case the land is exchanged for cash ( payment for the asset ). This is a financial transaction. Why do we record financial transactions ? We record financial transactions because it affects the financial position of an individual/ entity and it is necessary to record these transactions to arrive at the financial position of an individual/ entity as on a particular date. In the above example, A bought land by paying Rs 15 lacs and in this process his cash has been converted into another asset ie., land. Apart from this , the transactions, in many instances, also result in profit or loss. In the above case , if the land is worth Rs 16 lacs, A makes a profit of Rs 1 lac Hence the recording of transactions help in arriving at the profit or loss. What is an asset ? An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow. The economic benefits are measured through the cash flows generated by these assets. In other words, an asset generates cash flows and inversely prevents a cash flow. Let us a take a simple example of A buying a house property. A may use the property either for living in which case he saves payment of rent ( preventing a cash out flow ) or he may choose to rent out the property in which case he may receive rentals ( generating cash flow ) What is a liability ? A liability is a present obligation arising past events, the settlement of which is expected to result in an out flow of cash. Example A borrows money to buy a house property. This a liability as the loan has to be repaid which results in out flow of cash. Where are the assets and liabilities recorded ? The assets and liabilities are presented in the Balance Sheet. What do we understand by the term capital ? The term capital refers to the money brought into business. The capital can be own capital or borrowed capital. Own capital is known as equity and borrowed capital is known as debt.

How does one classify an item as debt or equity ? The defining characteristics of equity and debt are : Equity 1. 2. 3. 4. 5. Debt 1. 2. 3. 4. 5. Repayable as per terms Interest and repayment to be made irrespective of the entity earns profit or not Risk lower as compared to equity Typically , npo right to participate in the management The entity enjoys tax benefits on the interest paid Typically, repaid only when the entity ceases to do business Dividend ( return ) is paid only if the entity earns profit Risk is higher Has a right to participate in the management The entity will not enjoy any tax benefits

When one one refers to the term Financial Statements , what are the statements which are relevant ? A : The term Financial Statements means three statements viz., Balance sheet, Income statement and Cash flow statement. These three statements are complementary to each other as one would need all these three to analyse the financial standing of an entity. Why these documents are relevant for a financial analyst ? A : These are important statements giving full information on the entitys working and financial status. The Balance sheet contains information on the assets and liabilities of an entity as on a specified date date ( quarterly, half yearly, yearly, example, Balance Sheet as on 31st Mar 2010 ) It also shows how the resources of the entity are deployed . The resources deployed in various assets are called Assets in Place. For example, the resources deployed in Plant, Property and Equipments, Investments, etc., are all called Assets in Place.

The Income statement contain details regarding the business income generated and expenditure incurred for generating the income during a specified period ( typically yearly, quarterly, half yearly ) .The income statement, therefore , covers details for a specific period ( example , Income statement for the year ended 31st Mar 2010 ). Hence, one can read the business performance of an entity through this statement for the period . The cash flow statement gives details of cash flow during a specific period, example Cash flow statement for the year ending 31st mar 2010. Cash flow is important as the entity should have adequate liquidity to meet the business obligations. This statement enables us to know the liquidity position of the entity. If the entity does not have liquidity , obviously, it will default in payments even if it generates adequate profits. Who are all interested in reading financial statements ? and why ? Typically , the stake holders are interested in reading these financial statements. Stake holders would mean the owners, employees, investors, lenders, govt., financial analysts and ,suppliers. However, the purpose for which these stake holders would analyse statements may differ. For example, the employees would look at the long term stability or sustainability , shareholders would like to know if the entity is generating adequate returns, investors would analyse to know the right price for investing or disinvesting, govt would analyse to ensure that the entity discloses the riht numbers from taxation point of view and the analysts would analyse to correctly value the entity. Thus, typically almost all of them are looking at the fundamentals which would indicate the health of the entity These statements are also used for interentity comparison or peer comparison which would indicate where the entity stands vis a vis the peers What is the format of these statements ? Basically the purpose of the format is to have a uniform presentation so that the peer comparison is easy. While in most of the cases these formats are dictated by the regulators. For example, Companies act prescribe the format for Indian companies, Banking Regulation Act prescribes for banking companies, Insurance Act, Electricity Act prescribe for their respective sectors, etc. However, fundamentally , the contents and substance in all the cases are the same, only presentation format changes as per the needs of the regulators. Balance sheets can be presented in a horizontal format or a vertical format. The industry prefers vertical format.

What are the typical components of a Balance sheet ? The typical components are, Sources of Funds Under this heading the shareholders equity, reserves and surplus and loan funds ( borrowed funds ) are shown. Application of funds- Under this, the uses of funds, viz., where these funds are invested are given, they would consist of Fixed assets, investments, and current assets The current assets are shown net of current liabilities .This is basically to indicate the liquidity of the indicate in broad terms Th sequencing of items in the balance sheet follow a descending order of liquidity and ascending order of returns on the asset side and an ascending order of returns and descending order of maturity on the liability side.

How are they different in IFRS ? IFRS does not prescribe a particular format. A current/ non current presentation of assets and liabilities is used. Certain minimum items are presented on the face of balance sheet What are the schedules to the balance sheet ? The schedules to the balance sheet give detailed break down of items. This enables one to know the detailed components of items shown in the balance sheet . For example, schedule A to share capital would give details such as the face value of shares ,authorised capital, Issued, subscribed and paid- up capital , shares issued as bonus shares, shares issued as part of restructuring, shares issued as part of amalgamation,etc. How are these details useful for an analyst ? The analysts can analyse the components and measure the health of the entity. For example, if the entity shows shares issued as part of the restructuring, it indicates that the entity was in financial difficulties in the past and further analysis of the restructuring would give valuable information on the future growth of the firm and the sustainability of the profits. We shall discuss more on this as we go along.

Is there any format for Income statement or Profit and loss account ? There is no prescribed standard format .However, certain income and expenditure items are disclosed in accordance with the accounting standards and the Companies Act. Industry specific formats are prescribed by regulators . Is it different in IFRS ? IFRS does not prescribe any format in this case also. However, expenditure is presented in one of the formats ( function/ nature ) What are the components in Profit and Loss account ? The components are , Income ---includes sales turnover/ income ( revenue ), variation in stocks (variation between the opening and closing stocks ), and other business income Expenditure ---- includes all revenue expenditure such as cost of purchases, manufacturing expenses, interest and other finance charges ( bill discounting charges), depreciation,etc. The difference the above two items will be either operating profit or operating loss , depending on the surplus or deficit. The Profit and Loss account would also show items like provisioning, tax liability, appropriations, etc. The profit after these is available for distribution as dividend or are available for investing in business , which is typically termed as plough back of profits. The Profit and Loss account also has schedules to explain break down of items. For example, other income break downs could be interst received from debt securities/ deposits from banks, dividend income, profit on sale of investments, profit on sale of assets, etc. The break down enables one to understand whether any of the items are one time income or they will be received in continuum. For example if the income include an item like sale of fixed assets, it is a one time income which is of capital nature and hence not available for distribution as dividends. Hence, the schedules give details of the items which would enable an analyst to infer useful information on the working of the firm and the sustainability of income.

What are the components of Cash flow statement ? The cash flow statement is primarily divided into three parts a. cash flow from operating activities b. cash flow from investing activities c. cash flow from financing activies

Cash flow from operating activities indicates the cash inflow and out flow from operating activities of the firm. Operating cash flow basically indicates that if the firm is generating positive cash flow from the operations. Operating cash flows generated by the firm primarily indicates that the firms operations are generating cash surplus which is a positive indicator of the firms business operations. If the firm is not generating operating cash flows, it means that the firm depends on further investments to meet the cash out flow of its operations which is not a healthy indicator. However, the during initial stages , a firm may show negative operating cash flow as the business may not have reached break even level. Hence, while reading the cash flow statements, one has to also analyse the reasons for the state of affairs as disclosed by these cash flow to form an opinion. Cash flow from investing activities indicates the cash inflows and out flows arising out of investing activities. Investing activities mean the investments made by the firm in fixed assets, and other assets which are needed to run the business whether it is manufacturing activities, servicing activities or trading activities. These assets are used for running the business and generate profits.The investing cash flow also give details of the investments made in acquiring assets and cash flow received by sale of assets, income received on investments , cash flow arising out of sale of investments and cash outflow on account of investments. For example, if the cash flow of a manufacturing company like Hindustan Unilever, shows large out flow in investing cash flow under the head investments, it would indicate that Unilver does not have business expansion opportunities and hence, are using the cash flows for investment in securities. One need to further probe whether the investment is short term or long term If short term, obviously the co has plans to expand and is waiting for the opportunity and if long term, they do not forsee any expansion plan and accordingly the co will take a decision how to use the cash generated optimally, ie., if it should return the cash to share holders, should go for an acquisition of another company , etc.

Cash flow from financing activities relate to inflow and out flow of cash arising out of financing activities. The financing activities mean raising of resources. Resources can be owners resources and borrowed resources. The former is called equity and the latter debt. Therefore, the items of cash inflow and out flow relate to equity and debt raised, repayment of debt and servicing of interest on debt, payment of dividend etc. Financing cash flow will indicate how the funding of the firm as also the nature/ type viz., short- term or long term. If the firm has raised short term resources , it would mean that the funds have been used for meeting temporary liquidity needs. The long term borrowing would indicate resources needed for expansion/ growth, etc.

Thus the cash flow indicates inflow and outflow of cash in the business operations divided into three typical categories to understand and disseminate the business implications . We shall learn more when we proceed further. However, before we proceed to the next topic, one should know that cash flows can be prepared in two formats. They are a. direct method b. indirect method In direct method, cash flows are derived from aggregating cash receipts and payments associated with operating activities. In the case of indirect method, cash flows are derived from adjusting net income for transactions of no-cash nature like depreciation. The indirect method is most common in use as it is more convenient to compute. The results of both these methods are the same. Is cash flow statement mandatory ? It is compulsory for the firms which are listed or in the process of listing, insurance companies, financial institutions or enterprises whose turnover exceeds Rs 500 million or borrowing in excess of Rs 100 million. Is it different in IFRS ? In IFRS there are no exemptions like Indian GAAP

Explain the terms cash and cash equivalents Cash is cash on hand, demand deposits, and cash equivalents are investments which are highly liquid that are readily convertible to known amounts of cash and which are subject to insignificant risk of changes in value. An investment typically qualifies to be categorised as cash equivalent only when it has a remaining maturity of 3 months or less from the date of acquisition. Thus a treasury bill purchased on 15th of March 2010, can be classified as cash equivalent in the balance sheet as at 31st mar 2010, only if its maturity is on or before 15th June 2010. Is it different in IFRS? In IFRS, bank overdrafts payable on demand are also included as cash and cash equivalent. Is cash flow format different in IFRS ? The format is the same as in Indian GAAP What are the other items in an Annual report of a company ? The other major items in an annual report are, A .Company information which contains details regarding the registered office,Board, management team, line of activies, financial high lights and key indicators like EPS, EBITDA, Book value, etc. Typically, a few years data are given to facilitate comparative performance. B.Management Discussions this an important part containing the overview of the operations, details of future plans, resources planned, business review division wise or business wise, and all factors which would have an impact on the companys operations in future. C. Report on Corporate Social responsibility Gives details on the social responsibilty initiatives of the company D. Report on corporate governance This contains details regarding the compliance of the prescibed guidelines on corporate governance such as Board composition, audit committee and other committee compositions and observations, if any, and comments on mandatory compliance of SEBI guide lines.

E. Directors report This gives brief of financial results, operational results, analysis of results, discussion on auditors report , etc. F. Auditors report giving their opinion on the financial statements. An important point to be seen in Auditors report is regarding the qualifications, if any. Qualification in an Audit report would mean that the companys financial do not represent true and fair view for reasons explained. For an analyst, such a qualifications have important implications which we shall discuss later. Accounting Standards What are accounting standards and why are they important for an analyst ? The financial statements are computed on the basis of certain guidelines. The Institute of Chartered Accountants of India , the Indian accounting body, has brought out 32 accounting standarads . These standards are guidelines for preparation of Financial statements. The standard lays down following parameters which each standard will address so that the financial statements prepared depict a fair and true picture . a. Identification of financial transactions--- standard will lay down how to identify if a transaction is financial transaction requiring financial recording . For example, a transaction not having any financial implications for the period under report will not need to be a part of statements. Eg., a liability which is disputed but chances of its becoming a liability is remote will not be accounted for as liability. b. Measuring of transactions--- the standard will enumerate how the financial transactions are to be measured. This is important because if there are measuring errors , it can impact the financial results. For example, if inventory is to be valued, at what price it should be valued,/ at the price acquired, at the average price, or at the price bought last, or at the price bought first or at market price? The methodology adopted to value will give different financial results. Hence, the need for guidelines c. Treating the transactionsthe standard lays down the methodology or principles to treat a transaction as a revenue item or capital item since these classifications have significant impacts on the financial results. d. Presenting the transactions- the accounting transactions do get presented in the financial statements and the standards prescribe in what format these are to be presented so that the statements contain all that is required and are user friendly without being cumbersome and complex.closuresthe standards also prescribe the rules for different disclosures in the financial statements. These disclosures are needed to understand the methodology adopted by the firm in the preparation of statements since standards also give options to follow any of the guidelines, for example, again taking the example of inventory valuation, the firm has a choice of adopting any one of the methods of valuation like, FIFO, LIFO,etc. These methods give different valuations and hence impact the statements differently. The disclosures also mention whenever there is a change effected in the methodology adopted by the firm .

In such cases, the impact on account of change in the methodology is also required to be disclosed. For example, if theTata Steel has changed method of valuation of inventory from LIFO to FIFO and as a result the profit of the firm has increased , say, by Rs 12 crores, the fact that the profit would have been lower by Rs 12 crores had not the firm changed the valuation methodology , has to be disclosed The objective of accounting standards is to bring about uniformity or a common standard in the preparation of financial statements so that these statements are represent true and fair view and therefore, comparable. How are IFRS standards different from Indian Standards ? The objective of IFRS is to make financial reporting more relevant to the most important users, analysts and investors by enabling the financial statements to explain what the business is doing and what the key business drivers are . Therefore, fundamentally the IFRS standards do not differ from Indian standards significantly , but at the same time move towards achievement of the objective of the statements making more relevant to users through a principle- based standards. We shall explain specific variances as when they are discussed.