PPT-1 (Financial Statements)

8/11/2019 PPT-1 (Financial Statements)

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Financial Statements are compilation of financial data.

arranged and organised in a systematic and summarised manner according to accounting

principles. to assess financial position of an enterprise.

as regards its profitability, operational efficiency,

long and short-term solvency and growth potential.

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FINANCIAL STATEMENTS


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Financial Statements


IncomeStatement Balance Sheet

Statement of Changes in Financial Position

Fund Flow Statement Cash Flow Statement

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Income Statement

Its a statement/account (Profit and Loss A/c)prepared at the end of every accounting period.

To ascertain revenue profit earned (or revenue loss incurred) for that accounting period.

Profit (or loss) is ascertained by matching totalrevenue expenses incurred with revenue incomes earned during that accounting period.

Therefore it exhibits profit-earning capacity and operating performance of a concern.

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INCOME STATEMENT


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Balance Sheet

A summarised statement, generally prepared at the end of every accounting period .

Shows the values of assets and liabilities to exhibit the financial position of the concern.

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BALANCE SHEET


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Statement of Changes inFinancial Position

Financial statement is needed to disclose more financial information.

For different users of the Financial Statements.

Some other statements are required to exhibit changes in financial position of an entity.

Exhibition between two accounting period is

necessary.

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STATEMENT OF CHANGES IN FINANCIAL STATEMENTS

CONTD


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. contdFund Flow Statement

Shows inflows and outflows of funds of an entity at the end of accounting period.

Fund refers working capital and the statement exhibits various sources and uses of that.

Cash Flow Statement

Shows inflows and outflows of cash of an entity at the end of accounting period.

Cash refers cash-in-hand, cash-at-bank and short-term investments (i.e. cash and cash equivalents)

the statement exhibit various sources and uses of cash & cash equivalents.

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Financial Statement Analysis

It involves a systematic and critical examination of the information.

Contained in the Financial Statements with a view to provide effective and more meaningful

information to its different users. It is basically a postmortem of the transactional activity .

to judge the operational ability, profitability,

solvency, managerial efficiency and overall performance of the entity.

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.contd Overview of Financial Statement Analysis

Business Analysis

-Types-Components

Financial Statements - Basis of Analysis

-Business Activities

-Financial Statements and Business Activities

-Additional Information

Financial Statement Analysis Preview

-Basic valuation models-Analysis in an efficient market-Analysis tools

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Business Analysis Financial Statement Analysis is an integral and important

part of Business Analysis. Business Analysis is a process of evaluating a companys economic prospects and risks.

Types (1) Credit Analysis In pure credit financing,

creditors bears the risk of default.This asymmetric relation of a creditors risk and return has a major impact on creditors perspective.

(2) Equity Analysis Unlike credit analysis, equity

analysis is symmetric in that it must assess both downside risk and upside potential.

Equity investors are affected by all aspects of acompanys financial condition and performance.

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Components of Business Analysis

Business Environment and Strategy Analysis

Accounting Analysis

Financial Analysis

Prospective Analysis and Valuation.

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- Basis of Analysis

Business Activities It consist of

Planning Activities,Financing Activities,

Investing Activities and

Operating Activities.

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.contd Financial Statements and Business Activities

At the end of a period - typically a quarter or a year - financial statements are prepared.to report on financing and investing activities at that point in time.to summarize operating activities for the preceding period.The financial statements used here are Balance

Sheet, Income Statement, Statement of

Shareholders Equity, Statement of Cash Flowsetc.

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.contd Additional Information

A thorough financial statement analysis involves examining the additional informations.

Informations such as Managements Discussion & Analysis, Management Report, Auditor Report, Explanatory Notes etc.

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l l


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Financial tatement AnalysisPreview

Valuation Models (Preview 1) It normally refers to

estimating the intrinsic value of a company or its stock. The basis of valuation is present value theory.

To value a security an investor needs - (1) expected future payoffs over the life of the security and (2) discount rate.

Debt Valuation

Valuation Models

Equity Valuation

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Debt Valuation The value of security is equal to the present value of its

future payoffs discounted at an appropriate rate . The future payoffs from a debt security are its interest

and principal payments.

The value of a bond at time t, or B t is computed as

Where I is the interest payment in period

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1 (1 ) (1 )

n

t i ni

I F B

r r


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. contd F is the principal payment (usually the debts face

value) and

r is the investors required interest rate , or yield to maturity.

When valuing bonds, we determine the expected (or desired) yield based on factors such as current

interest rates , expected inflation and risk of default .

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Equity Valuation

Equity valuation is more complex than debt valuation.

With a bond, the future payoffs are specified .

with equity, the investor has no claim on predetermined payoffs .

Equity investors look for dividend payments and capital appreciation .

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. contd The value of an equity security at time t, or V

determined by the following methods As per Dividend Discount Model

D

t is

Where t+1 is dividend in period t+1, and

k is the cost of capital].g is the sustainable growth rate

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1t t DV k g


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. contdAs per Free Cash Flow to Equity Model

Where FCFE is free cash flow to equity in period t+1

k is the cost of capital.

Free Cash Flow to Equity = Net Income - (Capital Expenditure Depreciation) Working capital Accruals+ (New debt issued - Debt Repayment)

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1t t

FCFE V

k g


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. contd

As per Residual Income Model

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Residual Income = Comprehensive Income Cost of Equity Capital * Book Value of Equity

0 01

10 0

1

RI(1 )

(1 )

t

t t

t t

t t

V Br

E rBV B

r


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Analysis Tools

Comparative

ProfitabilityAnalysis

GrowthAnalysis

Cash

FlowAnalysis

FinancialStatementAnalysis

AnalysisTools

Common-Size

FinancialStatement

Analysis

TrendAnalysis

RatioAnalysis

Balance IncomeSheet Statement

Analysis Analysis

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Ratio Analysis

A financial ratio is a relationship between two or more

accounting data expressed in mathematical terms. Accounting Ratio calculated from different

accounting data for exhibiting a meaningful anduseful relationship between them.

The process of comparative analysis and interpretation of all these Accounting Ratios are called Ratio Analysis.

It is a tool adopted for determining the quantitative relationship between two or more financial data as obtained from Financial Statement.

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. contd Usefulness of Ratios depends on our skillful

application and interpretation of them.

Internal operating activities affect a companys ratios.

We should be aware of the effects of economic events, industry factors, management policies and Accounting methods .

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Analysing a Ratio

Selection of relevant various Accounting data from the Financial Statements.

Computation of related Accounting Ratios in a very significant, logical and useful manner.

Computed Ratios are generally compared with some predetermined standards.

To obtain some conclusive financial information of

the enterprise.

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.contd

LiquidityRatios

SolvencyInvestmentRatios Ratios

AccountingRatios

Leverage ProfitabilityRatios Ratios

TurnoverRatios

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Liquidity Ratio

Current Ratio

Liquidity Ratio Liquid Ratio

Cash to Current AssetsRatio

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Current Ratio

Formula = The ratio is connected with the working capital (current assets

less current liabilities), so it is called Working Capital Ratio .

This ratio is the indicator of the short-term liquidity position of a firm.

The conventional ratio is taken at 2:1 (every current liability of Re.1 should be backed by a current asset of `2).

If higher the ratio, the larger is the amount of rupees available for per rupee of current liability.

Accordingly the greater is the safety of funds of short-term creditors.

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Current Assets

urrent LiabilitC ies


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Liquid or Acid Test Ratio

Formula =

Here Quick Assets = Current Assets less Stock and Quick Liabilities = Current Liabilities less Bank Overdraft.

Stocks are excluded because they take more time for conversion.

Overdraft is a method of financing an enterprise and not likely to be called in on demand.

Conventional ratio is 1:1 . If the ratio is less than 1, then some portion of the short-term liabilities must be met from outsidefunds which are not desirable.

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Quick AssetsQuick Liabilities


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Cash to Current Assets Ratio

Formula =

There is no standard ratio.

In a comfortably financed firm, it will not less than 5% to 10% of the current assets.

Sometimes debtors and cash are taken together in relation to the current assets.

In such a case, cash and debtors together should constitute 50% and the stock and others , the balance 50% of the total current assets.

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CashCurrent Assets


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Solvency Ratio

Debt to Total Assets Ratio

Debt Service Coverage Ratio

Solvency RatioInterest Coverage Ratio

Debt Equity Ratio

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Debt to Total Assets Ratio

Formula =

From creditors point of view, a low ratio is desirable.

Firms with stable earnings may go for a higher proportion of debt to finance total assets than those with relatively less stable earnings.

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Debt

Total Assets


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Debt Service Coverage Ratio

Formula =

This measures the ability of the firm to make committed payments, interest and loan installment in time.

Generally, a ratio of 2 and more is consideredsatisfactory.

Higher the ratio the better is the debt-servicing capacity of the firm.

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EBIT/ Operating IncomeTotal Fixed charges


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Interest Coverage Ratio

Formula =

It measures the ability of the firm to meet its interest payments as they become due.

The ratio should be at least 5 .

From the creditors point of view, a higher ratio is more desirable to cover up the interest expense of the firm even under the worst situation.

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EBITInterest


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Debt Equity Ratio

Formula =

It measures the relation between debt and equity .

signals the extent of financial risk involved.

From creditors point of view, a low ratio is desirable.

From shareholders point of view, the higher the ratio, the greater is the possibility of increasing the rate of

return to equity . The cost of debt is lower than the rate of return from

the investment.

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Long Term DebtShareholders Equity


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.contd In India, private sector enterprises are expected to

have a 2:1 ratio.

For public sector enterprises the norm is of 1:1 .

The average profitability of a private sector

enterprise is better .

Private sector enterprise is expected to bear greater financial risk than a public sector enterprise.

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Profitability RatioProfitability

Ratio

GrossProfitRatio

P/V Operating Net ProfitRatio Ratio Ratio

Return onCapital

Employed

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Gross Profit Ratio

Formula =

This ratio shows the amount of gross profit made out of the total net sales.

If there are several products the ratio should preferably be found out for each product separately .

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Gross Profit Net Sales


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P/V Ratio

Formula =

Or,

Or,

Under normal circumstances, it is an indicator of the relative profitability of different products, processes or

departments. This ratio can be used for determining the break-even

point and margin of safety .

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ContributionSales

Fixed Cost + ProfitSales

Change in Profit or ContributionChange in Sales


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Operating Ratio

Formula =

This ratio indicates the percentage of the total operating expenses included in the sales.

It is an indicator of the total operating expenses incurred for production and sales of goods with

respect to the selling price of those goods.

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Cost of Goods Sold + Other Expenses Net Sales


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Net profit Ratio

Formula =

This ratio indicates the portion of the sales that is left to the firm after all costs, charges and expenses have been deducted.

It is very useful to the firm as it is an indicator of cost

control and sales promotion .

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Net Profit after interest After Tax Net Sales


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Return on Capital Employed

Formula =

This ratio reveals the overall efficiency or otherwise with which the firm is operating.

It is the multiple of product profitability and capital turnover.

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Net Profit before InterestTotal Capital employed


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Turnover Ratio

StockTurnover Ratio

CapitalTurnover

Ratio

TurnoverRatio

CreditorsTurnover

Ratio

DebtorsTurnover

Ratio

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Stock Turnover Ratio

Formula =

This ratio indicates the movement of stock during a particular period.

The higher the ratio , the shorter is the average time between investment in stock and the sales.

The rate of stock turnover is greatly influenced by the

nature of the business. Example , the stock turnover in food stores will be

much higher than in the motor or engineering industry.

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Cost of Goods SoldAverage Inventory


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Debtors Turnover Ratio

Formula =

This ratio shows the number of days for which credit is outstanding in the value of the amounts owed by the debtors.

It gives an indication of the efficiency or otherwise

of the credit or collection system.

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Net Credit SalesAverage Receivables


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Capital Turnover Ratio

Formula =

This ratio indicates the extent of utilization of the

capital employed in the business in its operating activity.

Higher the ratio, larger is the return on the capital employed in the trading or operating activity.

A low ratio signifies that the firm has not efficiently utilized the capital employed by it.

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Net Sales/ Cost of Goods SoldAverage Capital Employed


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Leverage Ratio

CapitalGearing

CashFlow to

Debt

CurrentAssets to

NetWorth

Fixed

RatioDebt

EquityRatio

LeverageRatio Debt to

TotalCapital

Ratio

ProprietaryAssets toRatioNet

Worth

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Capital Gearing Ratio

Formula =

Low equity base represents highly geared structure

High equity base represents low geared structure.Capital gearing ratio is the measure of capital structure analysis and financialstrength of the company and is of great importance for actual and potentialinvestors.Borrowing is a cheap source of funds for many companies but a highly gearedcompany is considered a risky investment by the potential investors because sucha company has to pay more interest on loans and dividend on preferred stock and,therefore, may have to face problems in maintaining a good level of dividend forcommon stockholders during the period of low profits.Banks and other financial institutions reluctant to give loans to companies that are

already highly geared.

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Common Stockholders EquityFixed Interest Bearing Funds


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. contd This ratio may be considered from two point of

views long-term solvency and profitability .

From solvency point of view, a high equity base (low geared ) more desirable.

The risk of liquidating long-term debt is comparatively less .

Under profitable condition, a low equity base ( high geared ) may be preferable.

The rate of return to small equity will be comparatively high .

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b


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Debt Equity Ratio

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Formula = Total DebtStockholders Equity

Debt to equity ratio is a long term solvency ratio that indicates the

soundness of long-term financial policies of the company. It shows therelation between the portion of assets provided by the the stockholdersand the portion of assets provided by creditors. It is calculated bydividing total liabilities by stockholders equity.

Debt to equity ratio is also known as external -internal equity ratio.

The numerator consists of the total of current and long term liabilitiesand the denominator consists of the total stockholders equity includingpreferred stock.

D b T l C i l R i


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Debt to Total Capital Ratio

Formula =

This is a variant of D/E Ratio .

It expresses outside liabilities (both long-term and short- term) in relation to the total capitalization of the firm.

Generally the creditors prefer the low debt ratio as the greater is the safety against creditors losses in the event of liquidation .

The owners may prefer high debt ratios to magnify earnings or giving up some degree of control in the event of new shares issue .

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Total DebtCapital Employed


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Proprietary Ratio

Formula =

This ratio is a test of long-term financial position as also test of capitalization .

The higher the ratio the stronger is the long-term financialposition.

This ratio is also a test of credit strength .

If the amount of the proprietors equity decreases in relation to theamount of debt capital, a business becomes more dependent upon creditors to supply its working capital.

Some Analyst use Total Assets Intangible Assets in the denominator71

Stockholders Equity 100Total Assets

Fi d A N W h


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Fixed Assets to Net Worth

Formula =

This ratio indicates the extent to which fixed assets are being financed by equity interest.

If the ratio exceeds 1 or 100 percent , it shows that a portion of the fixed assets is being financed by long-term debt capital.

If the ratio is less than 100 percent , it may mean the non- existence of any long-term fixed interest bearing finance in

the firm. But normally the ratio may be more than 100 percent

because there should be some fixed interest bearing capital in the firms financial structure.

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Fixed Assets Net Worth

C A N W h


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Current Assets to Net Worth

Formula =

A higher proportion of the current assets than fixed

assets to proprietorship is considered to be an indication of financial strength .

If the ratio of fixed assets to shareholders equity is unduly high then current assets to net worth is bound

to be low in such a case. The firm may not work properly due to too much

capital is tied up in fixed assets.

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Current Assets Net Worth

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Cash Flow to Debt

Formula =

This ratio is used for assessing the long-term liquidity

position of the firm. Cash flows are considered to be more appropriate

than traditional profit .

Any measure that uses cash flows is regarded to be a superior one in predicting the financial health of a company.

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Operting Cash FlowTotal Debt

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Investment Ratio

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Di id d Yi ld


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Dividend Yield

Formula =

It measures the real rate of return on an investment

in shares.

Higher the yield more profitable is the investment and vice versa.

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Dividend Per ShareMarket Price per share

Di id d C f O di Sh


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Dividend Cover for Ordinary Shares

Formula =

A high ratio implies greater retention of profit.

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Earning Per ShareDividend per share

This indicates the amount of profit cover for an

ordinary dividend and amount of profit retained inthe business.

Di id d Yi ld


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Dividend Yield

Formula =

It measures the real rate of return on an investment

in shares.

Higher the yield more profitable is the investment and vice versa.

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Dividend Per ShareMarket Price per share

Earning per Equity Share


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Earning per Equity Share

Formula =

It is an indicator of profitability of investment .

Higher the ratio more profitable is the financingplans and vice-versa .

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Net Income - Preafrence Dividends Number of outstanding shares

Price Earning Ratio


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Price Earning Ratio

Formula = MarketPrice per Share (Equity) Earnings per Share (Equity)

It is an important indicator for evaluating a share . When a new issue of shares is due it shows the

earnings the market expects in relation to the current share prices.

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Market Capitalization


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Market Capitalization

It indicates the market value of a company from the investors perspective.

Thus market capitalization is a better measure of sizethan worth. That is, market capitalization is not the

same as market value, which can generally only beassigned when the company is actually sold.

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Market Capitalization = Current Stock Price x Shares Outstanding

Comparative Financial Statement


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pAnalysis

It is a form of horizontal analysis.

Financial statements of two or more years (in case of Inter-period Analysis )

Or of two or more different companies (in case of Inter-firm Analysis )

Or of a company and its industry are compared, analysed and interpreted.

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Nature of Comparative Financial


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pStatement Analysis

In case of Inter-period Analysis , uniformity in Accounting

Concepts and Conventions should be maintained during allthe years for comparison.

In case of Inter-firm Analysis , size of firms taken into consideration for comparison must be more or less the

same. The Statement exhibits absolute figures for two or more years of the items appearing in Financial Statements.

It exhibits the changes in absolute figures of the current year

as compared to the previous year taken as the base year. Percentage changes in absolute figures of the current year on the basis of the base year are ascertained.

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An Examp e o Comparative Income


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p pStatement of ABC Ltd.

2012-13 2011-12 Change Change(` million) ( ` million) ( ` million) (in %)

Revenues 49,205 41,444 7,761 18.7

Cost of goods sold 40,190 33,892 6,298 18.6

Gross profit 9,015 7,552 1,463 19.4

Operating expenses:

Selling, general and administrativeexpenses 4,298 3,544 754 21.3Research and development expenses 463 464 (1) -0.2Operating profit 4,254 3,544 710 20.0

Investment income 191 180 11 6.1

Pretax income 4,445 3,724 721 19.4

Income tax expenses 1,402 1,079 323 29.9

Net income 3,043 2,645 398 15.0

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Analysing the Table


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Analysing the Table The above table shows a year-to-year comparative

analysis using ABC Ltd.s income statements. First, both the revenues and cost of goods sold increased by approximately the same percentage(18.7% and

18.6% respectively).

However, gross profit increased at a higher percentage (19.4%) because of its lower base.

Selling, general and administrative expenses increased by 21.3%.

This increase in cost may be related to higher operating costs and increased cost of attracting and retaining personnel .

contd


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. contd The research and development costs remained at

approximately 2011-12 levels. Pretax income increased by 19.4% in 2012-13, but

tax expense increased by 29.9%, thus reducing theincrease in net income to 15%.

ABC Ltd. reports that the increased tax expense is primarily the result of a tax incentive which allowedthe company to repatriate a large amount of cashwith a lower tax rate.

In sum, ABC Ltd. is performing remarkably well in a tough competitive environment.

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ommon- ze nanc a


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Statement Analysis

Relative position of each item or elements of Financial Statements cannot be known through horizontal or comparative analysis .

To study relative significance of every item in Financial Statements, vertical analysis or common- size statement analysis is necessary.

contd


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.contd

Common-SizeFinancial

Statement Analysis

Common-Size Common-Size

Income Statement Balance Sheet

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Nature of ommon- ize Financial


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Statement Analysis It exhibits absolute figures of the items appearing in

Financing Statements of two or more years or two or more

firms .

It also exhibit percentage figure of every item in Financial Statements as a percentage of the pre-selected base item.

Every item appearing in such income statement is represented as a percentage of base items (generally net sales). In case of Balance Sheet, generally total of Balance

Sheet is considered.

Here relative importance of each component of Financial Statements in whole is exhibited, but no comparative studyis done between the years.

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An Example of ommon- ize


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pIncome Statement of PQR Ltd.

Absolute Figures % of Net Sales

2011-12 ( `) 2012-13 ( `) 2011-12 2012-13

Net Sales 1,00,000 1,10,000 100 100

Less: Cost of goods sold 60,000 65,700 60 59.73

Gross profit 40,000 44,300 40 40.27

Less: Operating expenses:

Selling, general & administrativeexpenses 30,000 37,000 30 33.63Operating profit 10,000 7,300 10 6.64

Add: Interest income 2,000 3,300 2 3

Profit before Interest & Tax (PBIT) 12,000 10,600 12 9.64

Less: Interest 3,000 6,200 3 5.64Profit before Tax (PBT) 9,000 4,400 9 4

Less: Tax @50% on PBT 4,500 2,200 4.5 2

Net profit 4,500 2,200 4.5 2

Analysing the Table


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Analysing the Table

Both sales and cost of goods sold have been increased in

2012-13 as compared to 2011-12, Sales have been increased at a higher rate than the cost of goods sold.

Gross Profit for 2012-13 has been increased from 40% of

sales to 40.27% of sales indicating a marginal increase in profit.

Operating expenses have been increased from 30% of

sales to 33.63% of sales in 2012-13 as compared to 2011-12.

Decrease in Operating Profit from 10% to 6.64% of sales.

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Trend Analysis


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Trend Analysis

It indicates the trend of individual item of Financial

Statements over a period of time. It helps to analyse the trend of each such item.

A year (generally a normal year, i.e. a year where no abnormal incident has been occurred) is selected as the base year.

The figures appearing in Financial Statements of that base year are assigned as 100 .

Necessary adjustments for price level should be made in the figures of other years compared to the baseyear.

contd


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. contd Trend percentages are computed in the following

manner:

Conclusion can be drawn by analysing the trend patterns of various items and also taking intoaccount absolute values of the concerned items.

Current Year BalanceTrend Ratio = 100

Base Year Balance

Example of Trend Analysis


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Example of Trend Analysis

Cash balance of a company at 31 st March, Year 1

(the base year), is Rs 12,000. Its cash balance at 31 stMarch, Year 2, is Rs 18,000. Using 100 as the indexnumber for Year 1, the index number for Year 2 equals150 and is computed as

Current year balance

Base year balance X 100 = `18,000

`12,000X 100 =

150

The cash balance of the company at 31 st March, Year3, is `9,000. The index for Year 3 is 75 and is computedas `9,000

`12,00038

X 100 = 75

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Analysing the Example

The change in cash balance between Year 1 and

Year 2 for this example is 50% (150 - 100). It is easily inferred from the index number .

The change from Year 2 to Year 3 is not 75% (150-

75), as a direct comparison might suggest.

Instead, it is 50%, computed as`9,000

`18,000

This involves computing the Year 2 to Yearchange by reference to the Year 2 balance. 3

Contd


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.Contd

The percentage change is computable using index

numbers only. For example, in computing this change, we should

calculate 75/150=0.50, or a change of 50%.

We must exercise care in using index-number trend comparisons where changes might be due to economy or industry factor.

Interpretation of percentage changes using indexnumber trend series must be inconsistent ofapplication of accounting principles over time.

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PPT-1 (Financial Statements)

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Transcript of PPT-1 (Financial Statements)