Financial statement Analysis

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You can manage only what you can measure

Session Plan
Understanding the financial statements Financial statement Analysis

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ACCOUNTING SYSTEM
Input
Identification

Process
Accounting Reports

Output
Communication

Recording

FILT ERS

Accounting reports
SOFTBYTE

Select economic events And Monetary Business transactions

Monetary

Record, classify and summarize Based on certain rules

Annual Report

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Audit

Analyze and interpret for users

FIRMS GENERATES REPORTS !!

Accounting system generates 3 reports giving the status and performance of the firm

The

Balance sheet /status report

The Profit and loss account (Income statement) The Cash flow statement

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BALANCE SHEET/STATUS REPORTS

It is the status report at a particular point of time Statement giving the position of assets and liabilities (claimants) Snap shot view of the continuously changing enterprise

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PROFIT AND LOSS ACCOUNT

Gives the profit (income less expenses) for a time period It gives all the incomes and expenses and gains and losses made by a firm
Revenues or Incomes arise from selling of goods or services to customers. Expenses related to earnings are deducted from revenues
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CASH FLOW STATEMENT

Why the status changed during the period Cash flow from financing activities Cash from investing activities Cash flow from operations

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Balance Sheet: ASSETS

Resources owned by a firm Capable of giving future cash flows (by use or disposal value) Objectively verifiable

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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

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

Sources of Funds (Liabilities)

Share Capital Reserves and Surplus Borrowings: Secured Unsecured Current Liabilities and Provision

Uses of Funds
Fixed Assets Investments Current Assets, Loans and Advances

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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

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FIXED ASSETS
Depreciation is treated as Expenses and is charged to the profit and loss account Accumulated Depreciation its the sum of depreciation charged to the profit and loss account till the end of the current financial year

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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

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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

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LIABILITIES
They are present obligations a firm owes.

They are claims against the assets the firm. Liabilities may be to the owners or to an outsider Discharging the liability will result in the decline of the assets Classified: Current and Long Secured/ Unsecured

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OWNERS EQUITY
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

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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

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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

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

SALES Expenses
RAW MATERIALS WAGES & SALARIES OTHER Overheads Depreciation 700 374 100 100

1579

SAD Expenses PBIT (Operating Profit) INTEREST PBT INCOME TAX PROFIT AFTER TAX

100 205 38 167 59 108

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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. Its a charge of the asset over the useful life of an asset
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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)
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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

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Depreciation

Straight Line Method

Formula: Cost -Residual Value Useful life

Reducing Balance Method

Formula for computation of rate

1 -

Residual value n Cost n= useful life in years

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Straight Line Method

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 %

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Straight line method

Year Gross Block 1 650000
2 3 650000 650000

Depr
200000 200000 200000

Acc. Depr Net Block 200000 450000

400000 600000 250000 50000

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Written down value method

Initial years the depreciation should be high as subsequently the Asset will incur higher repair expenses. Hence over the years the Repairs and depreciation together will even out Rate 1- n s /c n = useful life, s=scrap value c= cost 57.5%

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Written Down value method

GBV DepreciationNet Book 650000 373750 276250 276250 158843.75 117406.3 117406.3 67508.594 49897.66

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Financial Statement Analysis

(Analysis of Financial Performance)

From Business Activities to Financial Statements

Business Environment Labor Market Capital Market Product Market: Suppliers Customers

Business Activities Operating Investment Financing

Business Strategy Key factors And Risk

Accounting Environment Capital Market Structure, GAAP,Audit, &Legal system

Accounting System Measurement & Reporting

Accounting Strategy Choice of: Accounting Policy Reporting Format SupplementaryDisclosures

Story So far ..

Financial Statements
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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 SBUs and departments Credit rating
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Where to look for data

The Annual reports

(An annual report and financials therein represents a snapshot at a given moment. By the time it is mailed, an annual report is more history than news. ) 1. Directors Report - Working of the Company 2. Auditors Report 3. Management Discussion &Analysis Profit and loss account Balance Sheet Cash Flow statements Supplementary schedules and Notes Accounting Policies Subsidiary Company Information
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Other Data Sources

Forms filed with the ROC (In the US 10K and 10Q reports filed with SEC) Computerized data bases Info on industry norms/ratios Info on particular company/industries Articles in press Ever-expanding websites

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4 Step Analysis Process

Business Strategy Analysis Accounting Analysis Financial Analysis Prospective Analysis (Also do a SWOT analysis )

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TOOLS FOR EVALUATION

COMMON SIZE STATEMENTS HORIZONTAL ANALYSIS RATIO ANALYSIS CASH FLOW ANALYSIS

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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

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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

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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

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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
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FSA-Basic Structure
R Return on Equity E Leverage or Financial risk Return on Total Assets (ROI) Asset Turnover ratios Profit Margins Raw material/Sales Other expenses / Sales Interest / Sales

Fixed Asset Turnover

Current Ratio

Current Asset TOR

Inventory Turnover Debtors Turnover or Collection Period
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Financial Ratio Analysis

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

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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

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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
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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 firms ability to translate sales into profits

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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

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Fixed Assets Turn Over Ratio

Sales / Avg Fixed Assets Assess the effectiveness of the fixed assets to generate sales Also reflects the investment strategies

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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)
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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 firms ability to collect fast Helps gauge liquidity of accounts receivable (ability to collect cash from customers)
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Financial Leverage

It Pays to have Debt in your Capital Structure

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Financing Pattern

Leverage Ratios
measure the extent of a firms 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
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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 firms financing with debt and the financial risk
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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

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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

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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
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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.
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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 Padmini Srinivasan - iimb

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

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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

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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.

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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
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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.

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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!

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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 ?
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Operating Results: Transaction analysis

1. 2. 3.

4. 5.

BS: Capital 50000 = Cash 50000 Capital 50000 + Crs 20000 = Inventory 50000 + Cash 20000 OE 50000+ Profit 60000+ Crs 20000 = Drs 100000 + Inv 10000 + Cash 20000 OE 50000+ Profit 60000+Crs 20000 = Eqpt 15000+DRs 100000+ Inv 10000+Cash 5000 OE 50000+ Profit 57000+Crs 20000 = Eqpt 12000+DRs 100000+ Inv 10000+Cash 5000

There is profit of 57000 after depreciation but no cash ?

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Cash Flow (Direct Method)

1.

CFO: Paid Creditors

CFF Capital CFI Equipment Ending Cash Balance

(30000)

+50000 (15000) 5000

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Cash Flow (Indirect Method)

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
1.
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ACE Inc produced and sold Cassette Tapes. The cost of the Cassettes was Rs. 8 and were sold at Rs.10/- The company had a policy of keeping inventory for 30 days. It also paid its suppliers by the due dates. The company gave a credit of 30 days to its customers. The company had an opening inventory of Rs. 80000, Cash of Rs. 100000 and Equity of Rs. 280000 and Receivable Rs 1lac. The MD was happy with a whopping profit of Rs. 210000, but the conservative accountant predicted a crisis at this rate.

Particulars Apr May June July Aug Sep

Sales Production 100000 12000 units 120000 16000 160000 18000 180000 24000 240000 25000 Padmini Srinivasan - iimb 250000 28000

Ways to minimize cash holdings

Synchronize inflows and outflows. Use a remote disbursement account. Increase forecast accuracy to reduce need for safety stock of cash. Hold marketable securities (also reduces need for safety stock). Negotiate a line of credit (also reduces need for safety stock).
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