Understanding and Analyzing

Financial Statements

School of Inspired Leadership

Session Objectives

1. Why are financial reports and accounting information important?

2. Who uses them?

3. Understanding the relationship between the basic financial statements

4. Learn techniques to better understand financial statements

SOIL
Business is an economic activity
There are various stakeholders in any business

Will I
be paid?

How Creditors
good is our
investment?
How are we
Shareholders performing?

Management

SOIL
Users of Financial Statements

Equity Shareholders
Banks and Financial Creditors
Customers and Suppliers
Potential Investors
Management and Board

Financial statements provide information about the financial position,

performance and changes in financial position of an entity that is used by a
wide range of users in making economic decisions

Assessment of the firm’s
past, present and future
financial conditions
Primary Tools:
Done to find firm’s
- Balance Sheet; P&L
financial strengths and
- Cash Flow Analysis
weaknesses
- Financial ratios
SOIL
Annual Reports of a company provide relevant information

Financial statements & footnotes Director’s Report

Management Discussions and Analysis Financial highlights table

Corporate Governance Report Independent Auditor’s report

Other sources of information: Independent advisors, rating agencies, newspapers etc.

Crisil ICRA ICICI Direct

Indiabulls Capitaline Rediffmoney

SOIL
The Balance Sheet - Components

Liabilities Assets

Equity Capital Land & Buildings

Long Term Reserves & Surplus Plant & Machinery
Long Term Debt less Depreciation

Accounts Payable Inventories

Short Term
Short Term Borrowings Accounts Receivable
Working Capital Loans Cash & Bank Balances

SOIL
The Profit & Loss Account - Components

Sales / Salaries, selling &

Income
Less administration expenses

COGS
(RM + Wages)
= Gross Profit

Operating
Less Expenses
= EBITDA

Depreciation
PAT = Tax - Interest - Amortization
- EBITDA

PAT / Shares Dividend

= EPS Retained Earning

SOIL
Financial Analysis - Approaches

Trend analysis

Ratio analysis
SOIL
Trend Analysis

Trend analysis: The study of

percentage changes in financial
statement items over a period of time.

Trend analysis provides a simple

forecasting method.

But predictions yielded by trend

analysis are “soft.”

For more reliability, try regression

analysis.

SOIL
Ratio Analysis

An analytical technique that typically involves a

comparison of the relationship between two financial
items.
Can be applied Inter-firm or Intra-firm and adjust for
size differences. Leverage

Ratios help to: Liquidity Activity

•Evaluate performance
•Structure analysis
•Show the connection between activities and
Profitability Market
performance

Benchmark with
•Past performance of company (Trend or time Series
Analysis)
• Competitors/ Industry (Cross Sectional Analysis)
•Common Size statements: take base as 100
(revenues for P&L, Assets/ Liabilities for B/S)
SOIL
Liquidity Ratios

Current Ratio: Current Assets / Current Liabilities

Measures a firm’s ability to pay its current liabilities from its current assets.
Ideal level – 2 : 1
Too high – Might suggest that too much of its assets are tied up in unproductive
activities. Too low - risk of not being able to pay your way

Quick Ratio / Acid Test: Quick Assets / Current Liabilities

Measures a firm’s ability to pay its current liabilities without relying on the sale of its
inventory.
The omission of inventory gives an indication of the cash the firm has in relation to its
liabilities (what it owes)

SOIL
Leverage Ratios

Long-term debt = Long-term debt

to equity ratio Stockholders’ equity
Measures a firm’s financial leverage. The higher the ratio the more the business is
exposed to interest rate fluctuations and to having to pay back interest and loans
before being able to re-invest earnings.

Times interest Earned (TIE) or Interest Coverage ratio = ____EBIT___

Interest expense
Indicates the number of times that a firm’s interest expense is covered by earnings

SOIL
Activity Ratios

A/R turnover ratio = Net credit sales

Average accounts receivable

Indicates the number of times that a firm collects its accounts receivable each year.

Age of receivables (ACP) = 360 days

A/R turnover ratio

Indicates the length of time normally required to collect a receivable resulting from a
credit sale.

Inventory turnover ratio = Cost of goods sold

Average inventory

Indicates the number of times that a firm sells its inventory each year.

SOIL
Profitability Ratios

Net Profit (PAT) margin = Net income

Net sales
Indicates the percentage of each sales Rupee that contributes to net income

Return on assets (ROA) = NOPAT_____

Average total assets

Measures the rate of return a firm realizes on its investment in assets.

Return on equity (ROE) = Net income(PAT) – Preferred dividends

Average common stockholders’ equity

Measures the rate of return on a firm’s stockholders’ equity.

SOIL
Market Strength (Valuation) Ratios

Price-earnings ratio = Current market price of common stock (MPS)

Earnings per share for most recent 12 months (EPS)

Indicates the amount investors are willing to pay for each Rs.1 of a firm’s earnings.

Market price to book value ratio = Current market price of common stock (MPS)
Book value per share (BVS)

Indicates the amount investors are willing to pay for each Rs.1 of a firm’s net assets

SOIL
DuPont Analysis

DuPont System of Analysis is an integrative approach used to dissect a firm's

financial statements and assess its financial condition

It ties together the income statement and balance sheet to determine two
summary measures of profitability, namely ROA and ROE

The firm's return is broken into three components:

•A profitability measure (net profit margin)

•An efficiency measure (total asset turnover)
•A leverage measure (financial leverage multiplier)

ROE  Profit Margin  Total Asset Turnover  Equity Multiplier

Net Income Sales Total Assets

  
Sales Total Assets Common Equity
SOIL
Ratios and Forecasting

Share valuations are based on:

•Expected cash flows to shareholders
•ROE and ROA are major determinants of cash flows to shareholders

Ratios influence expectations by

•Showing where firm is now
•Providing context for current performance

Limitations of Ratios

-A firms industry category usually difficult to identify

-Published industry averages are only guidelines
-Accounting practices may differ across firms
-It is sometimes difficult to interpret deviations in ratios
-Industry ratios may not be desirable targets
-Seasonality affects ratios

SOIL