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Module III

Understanding of FinancialStatements

WHAT IS AN ACCOUNTING?


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Accounting is a Language of Business

Accounting is an information processingsystem and the products of this process

are Financial Statements


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Sources of Information

Private Information Public Information

Annual Reports Quarterly Results Prospectus Others


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Quarterly Results

SEBI WHAT ? SEBI asks companies to mandatorily publish

and file quarterly results


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Prospectus

What is a Prospectus?

What is red herring prospectus?

What does it contain?

Examples, if any


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Prospectus

Examples, if any

Coal India Ltd (Sept. 2010) Muthoot Finance (April 2011)


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Question

What does an Annual Report

Consists of


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Financial Statements

Balance Sheet Profit and Loss Account

Cash Flow Statement


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Balance Sheet consists of Chairmans message

Key Financials Executive team profile Highlights & Objectives Driving sustained growth MDA or MAD Directors reports Report on Corporate Governance Auditors report Financial Statements Schedules Notes to Accounts

Consolidated Financial Statements


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Analysis of Financial Statement


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Analysis

Depends upon the need of the users andinformation available

Users Availability of information


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Analysis

Quantitative Analysis

Qualitative Analysis

Annual Reports/Quarterly results/Otherinformation


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Types of Quantitative Analysis

Cash Flow Statement Analysis Comparative Statement Analysis

Common size Statement Analysis Trend Analysis Ratio Analysis Dupont Analysis


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Cash Flow Statement Analysis

Cash from Operations activities (A)

Cash from Investments activities (B)

Cash from Financing activities (C)


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Relation and Comparison of Data

Accounting data in absolute terms do not provide muchmeaning the analysis involves comparison and relation

Ratio Whenever one item is expressed (as a fraction or adecimal fraction or an integer) in terms of another item

Example A firm earns a net profit of Rs. 20,000 on a sale ofRs. 500,000. We could express this relationship as ____?

4 percent or 4% profit margin Comparisons could be made

With Companys past performance With Competing Firms With an Absolute Standard With Industry/Economy trend With Budgets (Planning and Control)


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But In most cases, there are no standards against which a

particular ratio value could be tested We make relative conclusions bycomparing the ratios with

industry averages Thus, at best the conclusions could be better than or worse

than or average Possible pitfalls in these comparisons could be the different

accounting conventions Inventory valuation (LIFO vs. FIFO) Different methods of depreciation Typical items (eg. Retirement benefits)


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Ratio Analysis

1. Liquidity Ratios2. Profitability Ratios

3. Leverage Ratios4. Coverage Ratios5. Efficiency Ratios

6. Investors Ratios 7. Dupont Analysis


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S l R i


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Solvency Ratios

Short-term

Net Working Capital= Current Assets-Current Liabilities

Current Ratio= Current Assets/Current Liabilities

Acid Test Ratio or Quick Ratio=Quick Assets/Current liabilities[Quick Assets=CA-inventory-prepaid exp]

Accounts Receivable Turnover=Net Sales/Accounts Receivables

Collection Period= 365or12/Accounts Receivable turnover

Inventory Turnover= Cost of Sales/Inventory

Conversion Period= 365 or 12/Inventory turnover

Long-term

Total Debt to Total Capital = Total Debt/Total CapitalTotal Capital = Shareholders equity + LT debt

Long Term Debt to Total Capital= LTDebt /Total CapitalLong Term Debt to Fixed Assets= LT debt/Fixed Assets

Interest Cover= EBIT/interest

Times Fixed Charges Covered= EBIT/all fixed charges

Gearing or Leverage = Long term debt/Net Worth

Equity Multiplier = Total Assets / Net Worth


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Summary of RatiosNo. Name of Ratio Formula Results as

1 PE ratio MP per share / EPS Times2 ROA PAT + Interest (1-Tax rate)/

Total AssetsPercentage

3 ROIC or ROCE or RONA PAT + Interest (1-Tax rate)/Long-term liabilities +

Shareholders equity

Percentage

4 ROE PAT / Shareholders equity Percentage5 GP ratio/margin Gross margin / Net sales revenue Percentage6 Net profit margin/ratio PAT/Net Sales revenue Percentage7 EPS PAT/No. of shares outstanding Rupees8 Cash Realization Cash generated by operations /

Net income

Times

9 Asset Turnover Net Sales revenue / Total Assets Times10 Invested capital turnover Sales revenue / Long-term

liabilities + Shareholders equityTimes

11 Equity turnover Sales revenue / Shareholders equity Times12 Capital intensity Sales revenue / FA Times

13 Days cash Cash / Cash expenses 365 Days


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Summary of Ratios (Cont) 14 Accounts receivables

collection period or Daysreceivables

Accounts receivables / Sales 365 Days

15 Inventory storage period orDays inventory

Inventory / Cost of sales 365 Days

16 Inventory turnover Cost of sales / Inventory Times17 Working capital turnover Sales revenue / Working capital Times18 Current ratio CA/CL Ratio19 Quick ratio or Acid-test ratio CA inventory and prepaid exp /

Current Liabilities

Ratio

20 Financial Leverage Ratio Assets / Shareholders equity Times21 DE ratio Long-term liabilities / Shareholders

equityOrTotal liabilities / Shareholdersequity

Percentage

22 Debt/capitalization Long-term liabilities /

Long-term liabilities +Shareholders equity

Percentage

23 Times interest earned Pretax operating profit + interest /Interest

Times

24 Cash flow/debt Cash generated operations / Totaldebt

Percentage

25 Dividend yield DPS / MP price share Percentage26 Dividend payout DPS/EPS

Or Dividend s/PAT

Percentage


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In Class Exercises


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Types of Analysis Horizontal Analysis

Comparative Statement Analysis

Trend Analysis

Vertical Analysis Common size Statement Analysis

Ratio Analysis


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Refer Handouts and omment


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2004 2003IncomeSales 110 80 Less: Excise Duty 10 8 Net Sales 100 72 Other Income 20 18

120 90 ExpenditureMaterials 50 40 Other Expenses 30 25 Interest 5 10 Depreciation 10 10

95 85 Compensation paid under VRS 20 -

115 85 Profit for the year before tax 5 5

Tax 2 2 Profit for the year 3 3


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Vertical AnalysisCommon Size Financial Statements

A financial statement presented by representing each item as apercentage to the total amount of which it is a part

Example X had a sale of Rs 15 mn during the year and cost of goods sold

of Rs 12 mn whereas Y has a sale of Rs 8 mn and cost of goodssold of Rs 4.8 mn

The above is not amenable to direct understanding. Cost of goods sold of X is 80% of sales and for Y it is 60% of

sales This is more lucid and meaningful. Useful while dealing with

many companies in the same industry Format


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Vinyl Chemicals Limited


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Common Size AnalysisVCL is having less leverage

than competitorsDuring the year VCL has aincrease in its long-termliabilities

Current Liabilities across theindustries seem to be stableWhat could be the reasons forsuch changes? What are thebroad implications?


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Common Size AnalysisWhat could be the reasons for the

companies turnaround?Is it a decrease in raw materialsor increase in the sale prices orincrease in the sales volumesWhy is the company still laggingbehind?What could be the reason for thecompany declaring dividend?


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RATIO ANALYSIS


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Liquidity Ratios

Current Ratio

Quick Ratio or Acid Test Ratio

Super Quick Ratio

Net Working Capital


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Leverage Ratios

Debt Equity Ratios

Debt to Capital Employed

Financial Leverage or Equity Multiplier

Interest coverage ratio


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Efficiency Ratios/Turnover Ratios

Receivables or Debtors Turnover Receivables collection period

Inventory or Stock Turnover Inventory holding or conversion period

Assets Turnover Working capital turnover


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Investors Ratios

EPS PE multiple DPS Payout ratio DY Ratio

EY Ratio Book value per share Market price to book value per share


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Implied growth rate equation

Also called sustainable growth rate = Return on Shareholders equity X Profit

retention rate g = r X b Where

g= sustainable growth rate r= ROE b= retention ratio i.e. (1-payout ratio)


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Du Pont Analysis

Read the note It is an integrated ratio Like any other ratio, but helps to investigate

the source of contribution


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Du Pont Analysis

A combination of margin on sales ratio, efficiency ratio, andlong-term solvency ratio is popularly known as the DuPontanalysis

Return on Equity (ROE) =Net Profit Margin (defined as Net Profit/Sales) x AssetUtilization Ratio (defined as Sales/Total Asset) x EquityMultiplier Ratio (Total Assets/Owners Equity)

The DuPont analysis approach helps in identifying andpinpointing the reasons behind high or low profitability of afirm vis--vis its competitors


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Dupont Analysis

Return = Profitability X Efficiency X Leverage

ROE = NPM X Asset Turnover X Leverage


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Qualitative Analysis

Look at the handout on questions to be asked


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Comments on Ratio Analysis

Helps to start the diagnose and proceed fortreatment

Try to overcome tendency to look at numbersrather than underlying reasons.

Starting point; identify questions notanswers.


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The way forward

Finance minister cautions against windowdressing by accountantsET Bureau Jan 5, 2011, 07.10am ISTPranab Mukherjee |International Financial Reporting Standards NEW DELHI: Finance minister Pranab Mukherjee has asked the country's auditingfraternity to be vigilant against "window dressing" of financials by companies, andhighlighted the need for stringent disclosure norms on complex financial instruments."Accountants have a critical role in guarding against window dressing of balance sheetsthat encourages entities to take more and more risk until they are dangerouslyleveraged," Mr Mukherjee said on Tuesday at a conference organised by the Institute ofChartered Accountants of India.

"We need to craft credible and consistent rules and regulations for financial markets toprevent a race to the bottom where capital leaks out to the areas with the weakestregulation. We must encourage stronger disclosure standards for systematicallyimportant financial institutions as well as complex and sophisticated financial products,"he said.
http://economictimes.indiatimes.com/topics.cms?query=Pranab%20Mukherjeehttp://economictimes.indiatimes.com/topics.cms?query=International%20Financial%20Reporting%20Standardshttp://economictimes.indiatimes.com/topics.cms?query=International%20Financial%20Reporting%20Standardshttp://economictimes.indiatimes.com/topics.cms?query=Pranab%20Mukherjeehttp://economictimes.indiatimes.com/topics.cms?query=Pranab%20Mukherjeehttp://economictimes.indiatimes.com/topics.cms?query=Pranab%20Mukherjee


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Q i


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Questions

Thank you

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