Dr. Padmini Srinivasan Indian Institute of Management...
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Financial statement analysis
Dr. Padmini Srinivasan Indian Institute of Management Bangalore
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Accounting Principles
Monetary transactions and Events enter the system Process Using an Accounting Mechanism Follow certain rules or principles of Accounting called as ‘GAAP’ (Generally Accepted Accounting Principles) or Accounting standards Audit to lend credibility to the reports
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Primary Financial Statements
Balance Sheet Statement of
Financial Position
Profit and Loss A/c
(Income Statement)
Cash Flow Statement
The financial statements reports on status & performance of the company in financial terms
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The Balance sheet
The Balance sheet is a status report giving the Financial Position of the Company at a particular point of time
Resources owned and
amounts owed
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The Profit and Loss Account Measures Operating Performance
The profit and loss account or the Income statement, reports the company’s revenues, expenses, and net income or net loss for the period. Revenues or Incomes arise from selling of goods or services to customers Expenses related to earnings are deducted from revenues
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The Statement of Cash Flows
The statement of cash flows reports the company’s cash inflows and
Outflows from its various activities.
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Balance Sheet
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Balance Sheet
Assets.
Liabilities
Owners’ equity
•Gives the resources owned and their funding •The “assets” owned and the claimants against the assets
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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 arising from a past identifiable event
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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
Uses of Funds Fixed Assets Investments
• Current Assets, Loans and Advances
Sources of Funds (Liabilities)
Share Capital Reserves and Surplus Borrowings:
Secured Unsecured
Current Liabilities and Provision
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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 it’s 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 Trade Investments
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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. Discharging the liability will result in the decline of the assets
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Shareholders Funds
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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Two other items
Deferred tax Misc Expenditure and Losses
(to the extent not written off)
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Profit and Loss Account
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PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31/3/2006
SALES 1579 Other Income 100 Total income Expenses RAW MATERIALS 700 WAGES & SALARIES 374 OTHER Overheads 100 Depreciation 100 Administration and Selling Exp 100 PBIT (Operating Profit) 305 INTEREST 38 PBT 267 INCOME TAX 59 PROFIT AFTER TAX 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. It’s 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 Cost n= useful life in years
n
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Straight Line Method
Compute Depreciation Cost of asset Rs. 650,000 Salvage value Rs. 50,000 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
Depr Acc. Depr Net Block
1 650000 200000 200000 450000
2 650000 200000 400000 250000
3 650000 200000 600000 50000
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Reducing Balance method
Year Gross Block
Depr Acc. Depr
Net Block
1 650000 373,750 373,750 276250
2 650000 158,843 532,593 117,407
3 650000 67,507 600000 50000
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Financial Statement Analysis (Analysis of Financial Performance)
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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 SBU’s 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. Directors Report - Working of the Company Auditors Report 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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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
Leverage or Financial risk
Fixed Asset Turnover
Debtors Turnover or Collection Period
Inventory Turnover
Current Asset TOR
Asset Turnover ratios
Interest / Sales
Other expenses / Sales
Raw material/Sales
Profit Margins
Return on Total Assets (ROI)
R Return on Equity E
Current Ratio
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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 firm’s 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 firm’s 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 firm’s 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 firm’s 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
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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. BS: Capital 50000 = Cash 50000 2. Capital 50000 + Crs 20000 = Inventory 50000 +
Cash 20000 3. OE 50000+ Profit 60000+ Crs 20000 = Drs 100000 + Inv 10000 + Cash 20000 4. OE 50000+ Profit 60000+Crs 20000 =
Eqpt 15000+DRs 100000+ Inv 10000+Cash 5000 5. 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 (30000)
2 CFF Capital +50000 CFI
Equipment (15000)
Ending Cash Balance 5000
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Cash Flow (Indirect Method)
1. 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
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Forward Contracts
Used for hedging open positions Its contract to deliver or receive at a specified rate &date a certain amount of foreign currency. Open positions hedged like foreign currency assets/liabilities or commitments eg : Receivable /Payables / loans