Financial Reporting, Analysis and Valuation

Prof. V K Gupta

Individual Term PaperSubmitted by

Tanoy Paul (2014PGP399)PGP2

Session 1

Financial Statements are essential documents of business which managers use to assess performance and identify the area where special care need t be provided.

Accounting is an art of

of resultRecording Classifying Summarizing Interpreting

Journal Ledger Trial Balance

Balance Sheet Income Statement

Analysis Projection

Purpose of accounting is o Planning, controlling and decision making for Shareholders ( Investors, Government,

Income Tax Dept, Customer etc.)o Maximizing Shareholders’ valueo Valuation of the Companyo Projection for the future positions

• Whatsoever has happened and recording on actual basis • Outcome is Annual Report

Financial Accounting

• When the recording happens based on estimation• Outcome is Business Plan

Cost Accounting

Financial Accounting

• Reports for Internal Users

Financial Reporting

• Reports for External users as per rules and regulations

Accounting Standards are rules and regulation governed by Indian Competent Authority

Accounting Policy are norms framed by management when Accounting Standards are not

mandatory

To prepare Indian Accounting Standards, USGAP has been considered as Benchmark

Financial Reporting includes Financial Accounting

Analysis is based on Reporting

Valuation is based on Analysis

Session 2

1 • Promoter (Idea Generator)

2 • Memorandum of Association

3 • Article of Association

4 • Registration

5 • Certificate of incorporation

6 • Prospectus (for public companies)

7 • Invitation for Share

8 • Issued Capital

Steps to open a Startup

Includes details about Authorized

Capital as per MOA

If Shares Application > Issued Capital Over Subscription If Shares Application < Issued Capital Under Subscription Called up Capital = (Issued Capital – Subscribed Capital) Paid up capital Paid by Shareholders and accounting will be done on this .

PAT = Reserve + Retained Earnings + Distributed to Shareholders

Organization Owner Liability PAT will go

Company Shareholders Limited To Shareholders

Partnership Partners Unlimited To Partners

Individual Traders Unlimited To Trades

Whatever was kept aside from this is Reserved

Internal Source of Financing = Depreciation + Retained Earnings (for Reinvestment purpose) Shareholders’ Fund = Reserved + Retained Earnings + Paid up capital Book value per share = (Shareholders’ Fund )/ No. of Shares issued Market Value per share should always be greater than Book value per share Market Value added = Market Value – Book Value Price of the share depends on the Supply and Demand Important Financial Ratios:

Liquidity ratio

• Current Ratio• Quick Ratio or acid

test

Solvency ratio

• Debt to Equity• Liabilities to Asset• Interest Coverage

Funds management ratio

• Account receivable Turnover

• Inventory Turnover• Accounts payable

turnover• Asset turnover• Days receivables

outstanding• Days inventory

Outstanding• Days payable

outstanding

Profitability ratio

• Return on asset• Return on Equity• Profit margin• Financial Leverage

Session 3&4

Total funds deployed in the Organization = Capital Employed Capital Employed = Shareholders’ Equity + Loan Fund Total Funds on book value can be obtained from Balance Sheet Total Funds on Market value can be obtained from market value of equity and debt Cash is an important component for valuation

Cash Flow statement if only on cash basis Direct Method Cash Flow statement if on accrual basis Indirect Method Indirect Method + (add) Non Cash Expense/(less) Non Cash Income = Direct Method Profit = (Cash Sale + Credit Sale) – (Cash Expense + Payable Expense) Operating Activities = Cash Purchase + Cash Sales + Cash Expenses Gross Margin = Trade Margin – Sales & Administrative Cost

Shareholders’ Equity+

Loan Fund

Fixed Asset+

Investment+

Working Capital

Investing Activity

Operating Activity

Financing Activity

Sales

ProfitTop

to B

ottom

Bott

om to

Top

Indirect Method

Direct Method

Asset Increase Negative Cash flow Outflow

Asset Decrease Positive Cash flow Inflow

Liabilities Increase Positive Cash Flow Inflow

Liabilities Decrease Negative Cash Flow outflow

Example:

Equity/Debt increase/decrease Financing Activity

Working Capital increase/decease Operating Activity

Fixed asset/investment increase/decrease Investment Activity

Session5&6

Book Value On Shareholders’ Fund Market value On market value of shares If Book Value < market Value Investor’s interest is not satisfied Profitability is assessed either on Sales or on Capital

ROC is of major interest of CEO whereas Shareholders are more interested on ROE

An Overview of Financial Statement Analysis: The Mechanics Historical Ratio Analysis:

Studying the components of a company’s balance sheets, income statements and Cash flow statement in historical perspective

Two complementary techniques: Analyzing proportion of an account relative to other accounts Analyzing the growth in an account across periods

Basic tools: Common size statement of balance sheets & income statements Percentage change statements of balance sheets, income statements and Cash Flow

Gross Profit Operating profit Profit before/after tax

On CapitalOn Sales Working Capital Shareholders’ Fund

Pro forma forecasting Steps for doing forecasting for the conventional financial statement include:

Project sales growth Project operating costs before depreciation, amortization and interest Project the balance sheet Project depreciation, amortization and interest Project the statement of cash flow

Valuation The value of any investment depends on two critical factors

The future nominal dollar returns the investment will generate The required percentage return demanded by the investor for the use of capital,

which is cost of capital In this article they have introduced about the basic input mechanics used in most

popular valuation models--- Discounted Cash Flow. The several steps includes are: Forecasted free cash flow (FCF) over the time horizon in consideration Forecasted aggregate FCF for the years beyond that horizon, called the Terminal

value (TV) calculation Discount all future cash flows using the appropriate discount rate Subtract any non-operating liabilities to yield total equity value. Dividing by shares

yields share price TV = FCF (1+g)/(WACC-g)

where g= expected average long term growth rate in FCFWACC= Weighted average cost of capital

Assessing a Company’s Future Financial Health

Assessing the long term financial health of a company is very important task for management

perspective as it formulates goals and strategies and for outsiders also it plays important role

as they consider the extension of credit, long term supplier agreements or investment in

company’s equity

The basic steps include:

Analyze Fundamentals

Analyze investments to support the business unit’s Strategy

Assess Future profitability and Competitive performance

Assess future External Financing needs

Ensure Access to target sources of external finance

Assess viability of the 3-5 years plan

Perform stress test under Scenarios of adversities

Formulate current financing plan

Session 7&8

Sustainable Growth and the Interdependence of financial goals and policies

Financial Goals Financial Policies

Return on total capital

(ROTC)

Return on Equity(ROE)

Growth Rate

Debt Policy:Debt to Equity ratio

Dividend Policy: Payout ratio(po)

Financial Leverage Equation: ROE = ROTC+[ROTC-KD](D/E) Sustainable Growth Equation: Growth Rate = (1-po)ROE

ABC Learning Centres Limited Case Study The following are the steps that were carried out in order to evaluate company’s performance

Business Analysis Financial Analysis Accounting Analysis Valuation

Value Chain activities performed by the company Evidences of success (in terms of Revenue, expansion, operating leverage, profitability etc.) Evaluating Growth in terms of Revenue, PAT, Total asset, Borrowings, No. of centres etc. Evaluating companies financial ratios from the Common size balance sheet and Income

Statement Using CAPM Model to find out cost of Equity. If ROE is more than cost of equity then it is

sustainable.

Understanding Economic Value Added

EVA aims to measure the firm’s ability to generate profits in excess of the cost of capital

employed to generate those profits

Value is created only when return on capital is greater than the cost of capital. Any project

should be accepted only if it has a Positive NPV(Net present value)

EVA = NOPAT – Cost of Capital*Capital

NOPAT= EBIT*(1-tax rate)

Cost of Capital= WACC= [D/(D+E)]*(1-t)*rD + [E/(D+E)]*rE

EVA metrics provide managers with a powerful tool to weigh investment and spending

decisions against Capital requirements and investor’s expectation

Session 9

Sustainable EVA Value Drivers

NOPAT

=Sales – COGS=Gross Profit - Operating Expenses=Operating Profit - Tax & Interest=PAT

Price

Quantity Opening Stock

Closing Stock

Purchase

• Bulk order• Annual Contract• Purchase from original

point• EOQ to reduce

holding/carrying cost

Control

• Capital structure designing to get optimum cost structure• Sensitivity Analysis

Cost of Capital

Cost of Equity

Cost of debtCapital

employed

Fixed Asset

Investment

Net current asset

• Maximum utilization of asset

Debt

Equity

Current asset Current Lability

Several other value drivers for sustainable EVA are as follows:

Differentiating the product

Retaining existing customer by delighting the customers with

o Best Product

o Best Price

o Best Service

Cost Creation Program to cut/reduce cost

Increasing the market share

Strengthening Credit policy

External Drivers

o Inflation

o Govt. Policy

Quality of Earnings Quality Earning is a common statement analysis made to describe a company’s earnings It is used by those within and outside of the investment field to identify accounting red flags

which may suggest that the company’s character is changing or that its accounting figures are potentially are potentially misleading and extra care should be taken in analyzing its statements

The determinants of Quality of Earnings are as follows:

Quality Earnings are used in several applications such as: Management Appraisal Relative Quality Dividend and reinvestment Volatility and Risk

Economic Environment impact Volatility Cash Flow One time Events Recurring Economic Activities Financial status Accounting Policy

Tax Policy Production Asset Quality Users’ Objective

For valuation of Company, Quality profit should be considered Assessing Earning Quality

Reported Earnings and Non recurring items analysis Accounts Receivable Analysis Inventory Analysis

Session 10

Valuation

Approaches to Valuation Discounted cash flow valuation- relating the value of an asset to the present value of

expected future cash flows on that asset Relative Valuation- Estimating the value of an asset by looking at the pricing of

comparable assets relative to a common variable like earnings, cash flows, book value etc.

Contingent claim valuation- Using option pricing models to measure the value of assets that share option characteristics

Discounted Present value Method

Value of an asset = +………………..+

Where CFt =expected cash flow in period t r =discount rate

n =life of the asset Methods

Equity Valuation: The value of equity is obtained by discounting expected cash flows to equity, i.e. the residual cash flows after meeting all expenses, tax obligation and interest and principal payments at the cost of equity. In this method

CF= Expected Cash flow to equity r= Cost of equity

Session 11to18

Firm Valuation: The value of equity is obtained by discounting expected cash flows to the firm, i.e. the residual cash flows after meeting all expenses, tax obligation but prior to debt payment at the weighted average cost of Capital. In this method

CF= Expected Cash flow to firm r= WACC= Weighted average cost of capital

Free Cash flow = Revenue (-) Operating Expense(-) tax(+) Non cash items(-) change in WC(-) Investment in Capex

Firm Value= Equity value + all debt + all Non equity claims to firm Cash flow to Firm = FCFF= EBIT (1-t) - (Capital Expenditure - Depreciation) - Change in

Working Capital Cash flow to Equity = FCFE = Net Income - (Capital Expenditure - Depreciation) (1- Debt Ratio)

- Change in Working Capital (1-Debt Ratio) Cost of Equity =rE =Risk free rate + Beta * Risk Premium Cost of Capital= WACC= [D/(D+E)]*(1-t)*rD + [E/(D+E)]*rE

Terminal Value = FCFn+1 /(r-g)

Valuation using residual earnings

Following are the steps to do valuation using residual earnings:

Finding the average book value equity from the given data of Book value equity

ROCE= Return on capital employed = Earnings/ Average Book value of equity

Residual Earning= Earning – Cost of Equity * Average Book value of equity

Value of equity = (Book value of Equity of Current year) + (Projected Residual Earning of

Next year)*(1+ Growth)/(Capital Charge or Cost of equity –Growth)

If growth = 0 then,

Value of equity = (Book value of Equity of Current year) + (Projected Residual

Earning of Next year)*/(Capital Charge or Cost of equity )

Relative valuation

The value of any asset can be estimated by looking at how the market prices “similar” or

“comparable” assets. The method follows the below mentioned procedure to value the firm

Choices with multiples:

Equity or Firm: Multiples can be scaled to equity value, to firm value or to value of

operating assets

Scaling variable: The market value can be scaled to

o Earnings: The choices can range from equity earnings to operating income

o Book Value: The choice can include book value of equity or book value of capital

o Revenues

Choosing the Comparable firms

Making the comparison

Value at Risk

Value at risk (VaR) is a probabilistic measure of the range of values a firm’s portfolio could lose

due to market volatility This volatility includes effects from changes in interest rates, exchange

rates, commodities prices and other general market risks.

Different methods of calculating VaR:

Correlation: This method attempts to calculate the variance of the entire portfolio based

on the variances of each asset in the portfolio and the relationship between risk factors.

The following steps need to be performed to calculate VaR

o Calculating mean, variance and correlation of each asset using historical data

o Providing weights to the assets in the portfolio

o Calculating the expected portfolio return

o Calculating the portfolio variance

o Finally, assume the return on the portfolio to be normally distributed with mean

and variance calculated above. The value of the portfolio at the chosen probability

level is the VaR

Session 19

Historical simulation: Historical simulation uses actual historic values to predict the

returns of the risk factors instead of assuming risk factor returns have a normal

distribution . The following steps need to be performed to calculate VaR

o Gather market data for each asset over the historical period. Measure the

percentage change in interest rate from day to day

o Value the portfolio for the change that would occur if history repeats itself

o Amount of loss due to market risk can be got by subtracting future portfolio value

from present value

o Repeat the analysis to create a distribution of possible outcomes

o Rank all the possible outcomes and choose a confidence interval. The value at

that percentile in the distribution represents VaR

Monte carlo Simulation: It is much more comprehensive and rigorous than historical

simulation. It takes greater account of the potential for market shocks and uses

mathematical model t predict future shocks.

Thank You Sir