> > > > > > > > Lecture 13

Finance for Non Finance Professionals

Agenda
Objective of the Webinar Key takeaways Purpose of existence of an economic entity

Financial statements construction and purpose

Understanding and interpreting Financial Statements Financial analysis as a measurement tool Purpose of analysis equity perspective, debt perspective Ratio analysis Explaining simple terms in Finance - ROI, IRR, Time Value of Money Q&A

Objective
The webinar will help the participants
To gain an understanding of the basic principles of finance To evaluate decisions related to finance more knowledgeably To participate effectively in finance related discussions in their respective organisations To gain basic understanding to pursue higher education / career in the field of finance To follow recent economic events and its impact on corporate performance To take informed decision related to personal finance and investing To interact with financial department / finance professionals more knowledgeably

Key Take Aways

Basic understanding of various forms of economic entities Understanding financial statements and perform ratio analysis on published statements Evaluate a corporate investing or financing decision meaningfully

Track financial performance of listed companies closely, to take well-informed investment decisions
Read / follow business newspapers / business channels with better understanding

To do business is to create an economic entity with the purpose of

Wealth creation Wealth management, and Wealth distribution

Objective of an enterprise To create the best possible values and share them in the equitable manner among all the stakeholders

Business as an economic entity exists to make profits: Trading activity

Selling price > Cost of purchase

Buying

Selling

Manufacturing activity:
Selling price > Cost of purchase + conversion costs

Buying Services Servicing

Processing

Selling

Price for service > Cost of providing the service

 We need various entities to come together to run an enterprise and generate returns. Who are the stakeholders in a business?
Investors
Equity holders majority holders, minority shareholders Debt holders including banks and financial institutions

Management Employees Suppliers Customers Community, Taxman

Accounting forms the basis for measuring the performance of an enterprise The performance determines which stakeholder gets what share of the business Accounting also ensures equitable distribution of wealth generated, based on each persons contribution to the business Few examples:
Taxman gets his share of the profits (currently 35% in India), which are determined based on prudent accounting practices Employees are typically rewarded based on their individual performance as well as the performance of the enterprise Minority shareholders get equal treatment compared to majority owners (equal dividend distribution) Debt holders are paid their due for contributing debt capital to the business (interest payment and principal repayment) Key to understanding accounting principles is to view an enterprise as a separate legal entity, and all stakeholders as those contributing capital, labour or resources.

Enterprise

Proprietary

Partnership

Company

Private Ltd.

Public Ltd.

Closely held

Publicly held

Proprietary business owned by single owner

No difference between the obligations of the business and the obligations of the individual.

Partnership firm owned by two or more owners

No difference between the obligations of the business and the obligations of the individual partners except when it is Limited Liability Partnership (Registered)

Company is an artificial person, created by law and has perpetual existence. Obligations of the company are separate from those of promoters and management.
Private limited company
Not more than 50 members Shares are not freely transferable. No invitation to public for subscription.

Public limited company

Closely held public limited company (Deemed) Publicly held public limited company (Listed)

Financial statements report the state of financial affairs of an enterprise These are made publicly available for widely held companies, usually free of cost (www.bseindia.com and www.nseindia.com ) For closely held public companies and private companies, the financial statements are reported to the Ministry of Company Affairs
Some of these are available for public viewing (both online as well as physically) for a small fee. (http://www.mca.gov.in )

Three key financial statements are

Balance Sheet Profit & Loss Account and Cash flow statement

Liabilities

Assets
Fixed Assets Land and building Plant and Machinery
Investments
Investment made in shares, bonds, government securities, etc.

Owners capital
Equity Capital Reserves and Surplus

Borrowed funds
Long term debt Short term debt

Working capital
Creditors Current liabilities and Provisions

Working Capital Raw Material Work in progress Finished goods Debtors Cash

 The Liability side represent the various sources of funds for an enterprise
These are the liability of the enterprise to the providers of these funds

The Asset side represent the various uses of funds by an enterprise

These are the assets held by the enterprise, that are needed to operate the business (e.g. Office space, factory, raw material, etc.)

The Assets and Liabilities should ALWAYS match. In the Liability side, the portfolio mix of the own funds and borrowed funds is called the Capital Structure of the company Balance sheet is always presented as on a given day, say as at March 31, 2008. It presents a static picture of the assets and liabilities of the enterprise as on that date.

Another way to look at the balance sheet is to match the sources and uses of funds, based on their tenure.
In Liability side, long term sources are
Equity capital Reserves and Surplus Long term borrowings

In Asset side, long term uses are

Fixed Assets Investments

The rest are short term on both sides viz. Current assets, current liability and short term debt

Ideally, long term uses must always be funded with long term funds. Financing long term assets with the short term funds creates risks (mainly refinancing risk). Short term investments may be financed by a combination of long term and short term funds, based on business managers preference.

Revenues from the business

Less Raw material consumed Employee expenses Other manufacturing expenses Administrative expenses Selling expenses Sub total: Cost of Sales

Earning before interest, taxes, Depreciation & Amortization(EBITDA)

Less Less Less Less Depreciation Interest payment Taxes Dividend

Earning before interest and taxes (EBIT)

Profit before taxes (PBT)

Profit after tax (PAT)

Retained earnings

Typical items under Revenue from business Sales revenue Other related income
Scrap sales, Duty drawback

Non-operating income
Dividends and interest Rent received

Extra-ordinary income
Profit on sale of assets / investments Prior-period items

Typical items under Cost of Sales

Cost of goods sold Direct material Direct labor Direct manufacturing overheads Administrative costs Office rent Salaries Communication costs Other costs Selling and distribution costs Salaries of sales staff Commissions, promotional expenses Advertisement expenses etc.

 Depreciation Straight line method Written Down Value method Deferred revenue expenditure R&D expenses Advertisement expenses Product promotion expenses (expenses are charged as capital expenses and amortized over the period of time)

 P&L Account presents a snapshot of the performance of an enterprise over a given period (a year, half-year, quarter, etc.)
Unlike Balance Sheet, which presents a static picture on a given date

P&L Account can provide great insights into the functioning of an enterprise. Let us look at a few:
Variable costs Vs. Fixed costs
Break even point is the point where there is no profit, no loss

Cash expenses Vs. Non-cash expenses

Raw material, salary and other administrative expenses are cash expenses Depreciation is typically the only non-cash expense

Recurring income Vs. one-time income

Income from ordinary activities are typically recurring in nature Extraordinary income / expenses are typically one-time in nature Few examples: Sale of office space, disposal of a factory unit, VRS

Some important ratios for analysing performance of a company: Operating profit margin Net profit margin Return on Capital Employed Current Ratio Debt:Equity ratio Interest coverage ratio

Earnings per share Price Earnings ratio Return on Networth

 Operating profit margin

Indicates the business profitability OPM = EBITDA / Operating Income (or Net Sales) Depending on the industry, for healthy companies, OPM ranges from 15% - 50%

Net profit margin

Indicates the returns generated by the business for its owners NPM = PAT / Operating Income (or Net Sales) For healthy companies, NPM ranges from 3% - 12%

Several other profitability measures are there (Gross margin, Contribution margin, etc.) but the above two are most commonly used. The profitability margins are very useful for peer comparison (i.e. comparing with other companies in same industry)

 Return on Capital Employed

Indicates true measure of performance of an enterprise The capital employed in business is Equity capital, reserves and surplus, long term debt and short term debt. Returns generated for all these providers of capital is EBIT. ROCE = EBIT / (Networth + Total Debt)

The ratio is independent of the industry, capital structure or asset intensity. For healthy companies, ROCE ranges from 15% - 30% If ROCE is less than Interest rate for a company consistenty, the company is destroying value for its equity investors / owners
The owners are better off dissolving the company and parking their money in bank fixed deposits and earn interest!!!

Lenders, such as a bank giving loan, or a Mutual Fund investing in bonds or debentures of a company, may use the following ratios: Debt:Equity ratio
The ratio of borrowed funds to owners funds D:E ratio is also known as gearing, leverage or capital structure Gearing = (Long term debt + Short Term debt) (Equity capital + Reserves & Surplus) For most manufacturing companies, D:E less than 2.0x is considered healthy. Higher the ratio, better it is for owners; but at the same time, more risky for lenders
Company has to service higher interest cost if it borrows more; in a recession, the company may be more vulnerable to default on its interest.

 Interest coverage
The ratio indicates the cushion the company has, to service its interest Interest coverage = EBITDA / Interest cost Higher the ratio, better it is for the lenders For healthy companies, Interest coverage ranges from 2.0x to 8.0x. Interest coverage < 1.0x indicates high stress, and probably default on interest payments.

 Current ratio
This is a commonly used liquidity ratio, used by banks that lend for working capital Current ratio = Current Assets Current liabilities + Short term debt The ratio indicates the ratio of short term assets to short term liabilities.
Indirectly, the ratio also indicates the proportion of long term assets funded by long term liabilities.

For solvent companies, current ratio ranges between 1.2x to 2.0x Current ratio of < 1.0x indicates that the company may face liquidity problems, as more current liabilities / short term debt are maturing in the next one year, than the current assets that are maturing in the same period.

Please read the commentary: http://www.crisil.com/Ratings/Commentary/CommentaryDocs/Commo n-myths-about-current-ratio_Dec05.pdf

Equity investors, such as a Mutual Fund investing in shares, or an individual investor, or a Private Equity investor, may use the following ratios: Earnings Per Share (EPS)
The Profit earned by the company for each share in the share capital of the enterprise EPS = Profit After Tax Number of Equity shares outstanding EPS is expressed in Rupees. This represents each shareholders claim in the profits of the company, for the relevant period (one year, one quarter, etc.) Two common sub-classification are Basic EPS and Fully Diluted EPS
Basic EPS is computed based on no. of shares outstanding currently Fully Diluted EPS is computed assuming all convertibles and options are exercised fully.

 Price - Earnings Ratio (PE)

The ratio of current market price of the equity share to the annual earnings per share PE = Current Market Price per share Earnings Per Share (EPS) PE is expressed in ratio or times. When EPS is negative, PE is meaningless. Two common sub-classification are Forward PE and Trailing Twelve Months (TTM) PE
Forward PE is computed using EPS of the next financial year TTM PE is computed using EPS of last 4 quarters

PE ratio has no meaning for unlisted companies as there is no market price for these shares Broadly speaking, PE ratio is in the range of 5-12x during recession times and 10-25x during boom times.
The ratio is also related to the growth in earnings that the company can generate in the next few years.

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