Module III

Understanding of Financial
Statements
WHAT IS AN ACCOUNTING?
Accounting is a Language of Business

Accounting is an information processing
system and the products of this process
are Financial Statements
Sources of Information
Private Information
Public Information
Annual Reports
Quarterly Results
Prospectus
Others
Quarterly Results
SEBI WHAT ?
SEBI asks companies to mandatorily publish
and file quarterly results

Prospectus
What is a Prospectus?

What is red herring prospectus?

What does it contain?

Examples, if any
Prospectus

Examples, if any

Coal India Ltd (Sept. 2010)
Muthoot Finance (April 2011)
http://www.sebi.gov.in/sebiweb/home/list/3/15/11/0/Red-
Herring-Documents-filed-with-ROC
SEBI
Sources of red herring prospectus
and final prospectus
Question

What does an Annual Report
Consists of
Financial Statements
Balance Sheet
Profit and Loss Account
Cash Flow Statement
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
AGM invitations etc.

Analysis of Financial Statement
Analysis
Depends upon the need of the users and
information available
Users
Availability of information

Analysis
Quantitative Analysis

Qualitative Analysis

Annual Reports/Quarterly results/Other
information
Financial Statements
Balance Sheet
The entity in order to achieve its objectives has arrived at a
decision to apportion the resources and deployed it in fixed
assets and in current assets-Assets side
The proportions of funds that are borrowed on short term, on
long term as well as what is the contribution of owners towards
the total financial requirement of the entity-Liability side
Profit & Loss Account
Gives the cost structure of the business and the relationship of
costs to the revenues
It gives the information relating to margin available on the sales
Types of Quantitative Analysis
Cash Flow Statement Analysis
Comparative Statement Analysis
Common size Statement Analysis
Trend Analysis
Ratio Analysis
Dupont Analysis
Cash Flow Statement Analysis
Cash from Operations activities (A)

Cash from Investments activities (B)

Cash from Financing activities (C)
Relation and Comparison of Data
Accounting data in absolute terms do not provide much
meaning the analysis involves comparison and relation
Ratio Whenever one item is expressed (as a fraction or a
decimal fraction or an integer) in terms of another item
Example A firm earns a net profit of Rs. 20,000 on a sale of
Rs. 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)
But
In most cases, there are no standards against which a
particular ratio value could be tested
We make relative conclusions by comparing 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)
Ratio Analysis
1. Liquidity Ratios
2. Profitability Ratios
3. Leverage Ratios
4. Coverage Ratios
5. Efficiency Ratios
6. Investors Ratios
7. Dupont Analysis

Profitability Ratios

Margin
on sales
Gross Profit Margin = Gross profit/Nest Sales *100
Operating Profit Margin=Operating profit/Net Sales
Earnings Before Interest & Tax=EBIT/Net Sales
Profit before tax=PBT/Net Sales
Net Profit Margin (i.e., Profit after tax)=PAT/Net Sales
Return on
Investment
Operating Profit to Operating Assets
=PBIT/Current +Non-Current Assets(FA)
Net Income to Total Assets=PAT/Total Assets
Return on Equity=PAT-Pref. dividends/Shareholders Equity

Efficiency
Total Asset Turnover=Net Sales/Total Assets
Operating Asset Turnover=Net Sales/Operating Assets
Working Capital Turnover=Net Sales/Working capital
Shareholder Equity Turnover=Net Sales/Net Worth
Return
per share
Earnings per share=PAT/no. of outstanding shares
Price to Earnings=Market price per share/EPS
Dividends per share=dividends/no. of outstanding shares
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 Capital
Total Capital = Shareholders equity + LT debt
Long Term Debt to Total Capital=LTDebt /Total Capital
Long 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
Summary of Ratios
No. Name of Ratio Formula Results as
1 PE ratio MP per share / EPS Times
2 ROA PAT + Interest (1-Tax rate)/
Total Assets
Percentage
3 ROIC or ROCE or RONA PAT + Interest (1-Tax rate)/
Long-term liabilities +
Shareholders equity
Percentage
4 ROE PAT / Shareholders equity Percentage
5 GP ratio/margin Gross margin / Net sales revenue Percentage
6 Net profit margin/ratio PAT/Net Sales revenue Percentage
7 EPS PAT/No. of shares outstanding Rupees
8 Cash Realization Cash generated by operations /
Net income
Times
9 Asset Turnover Net Sales revenue / Total Assets Times
10 Invested capital turnover Sales revenue / Long-term
liabilities + Shareholders equity
Times
11 Equity turnover Sales revenue / Shareholders equity Times
12 Capital intensity Sales revenue / FA Times
13 Days cash Cash / Cash expenses 365 Days

Summary of Ratios (Cont)
14 Accounts receivables
collection period or Days
receivables
Accounts receivables / Sales 365 Days
15 Inventory storage period or
Days inventory
Inventory / Cost of sales 365 Days
16 Inventory turnover Cost of sales / Inventory Times
17 Working capital turnover Sales revenue / Working capital Times
18 Current ratio CA/CL Ratio
19 Quick ratio or Acid-test ratio CA inventory and prepaid exp /
Current Liabilities
Ratio
20 Financial Leverage Ratio Assets / Shareholders equity Times
21 DE ratio Long-term liabilities / Shareholders
equity
Or
Total liabilities / Shareholders
equity
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 / Total
debt
Percentage
25 Dividend yield DPS / MP price share Percentage
26 Dividend payout DPS/EPS
Or Dividend s/PAT
Percentage

In Class Exercises
Types of Analysis
Horizontal Analysis
Comparative Statement Analysis

Trend Analysis

Vertical Analysis
Common size Statement Analysis

Ratio Analysis
Horizontal Analysis
Comparative Statement Analysis
Present the accounting information of the
same business unit for two or more
accounting periods

It shows the changes and trends of accounting
data in detail

Format


Refer Handouts and Comment
2004 2003
Income
Sales 110 80
Less: Excise Duty 10 8
Net Sales 100 72
Other Income 20 18
120 90
Expenditure
Materials 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
Vertical Analysis
Common Size Financial Statements
A financial statement presented by representing each item as a
percentage 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 goods
sold 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
Common Size Financial Statements
Profit & Loss Account
Here we show the net sales as 100% and each of the
components of expenses and profits as a percentage of net
sales
Balance Sheet
Constructed by showing each item of asset as a percentage of
total assets, similarly each item of liability and owners equity is
shown as a percentage of total liabilities and owners equity
The common-size financial statements could either be prepared
in summary or in details
Vinyl Chemicals Limited
Vinyl Chemicals Ltd. is a mid
sized organic chemicals
manufacturer owned by the
Pidilite Parekh group
Common Size Analysis
VCL is more fixed asset intensive
VCL has less inventory levels
than its competitors
At VCL, there a decrease in the
inventory levels and increase in the
receivables
At VCL, there is a decrease in
the investments of the company
What could be the reasons for such
changes? What are the broad
implications?
Vinyl Chemicals Limited
Common Size Analysis
VCL is having less leverage
than competitors
During the year VCL has a
increase in its long-term
liabilities
Current Liabilities across the
industries seem to be stable
What could be the reasons for
such changes? What are the
broad implications?
Vinyl Chemicals Limited
Common Size Analysis
What could be the reasons for the
companies turnaround?
Is it a decrease in raw materials
or increase in the sale prices or
increase in the sales volumes
Why is the company still lagging
behind?
What could be the reason for the
company declaring dividend?
RATIO ANALYSIS
Liquidity Ratios
Current Ratio

Quick Ratio or Acid Test Ratio

Super Quick Ratio

Net Working Capital
Profitability Ratios
Gross margin or Operating Profit Ratio

Net Profit Ratio

ROCE/ROI/ROA

ROE
Leverage Ratios
Debt Equity Ratios

Debt to Capital Employed

Financial Leverage or Equity Multiplier

Interest coverage ratio
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
Investors Ratios
EPS
PE multiple
DPS
Payout ratio
DY Ratio
EY Ratio
Book value per share
Market price to book value per share



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)
Du Pont Analysis

Read the note
It is an integrated ratio
Like any other ratio, but helps to investigate
the source of contribution
Du Pont Analysis
A combination of margin on sales ratio, efficiency ratio, and
long-term solvency ratio is popularly known as the DuPont
analysis
Return on Equity (ROE) =
Net Profit Margin (defined as Net Profit/Sales) x Asset
Utilization Ratio (defined as Sales/Total Asset) x Equity
Multiplier Ratio (Total Assets/Owners Equity)
The DuPont analysis approach helps in identifying and
pinpointing the reasons behind high or low profitability of a
firm vis--vis its competitors
Dupont Analysis

Return = Profitability X Efficiency X Leverage

ROE = NPM X Asset Turnover X Leverage
1-48
Bases for comparison
Experience. A feel for what is right or reasonable.
Budget. A target developed within the company.
Factors to be considered:
How carefully was budget constructed?
What circumstances are different now?
Historical standards. Prior periods results
adjusted for changes in accounting methods.
External benchmarks. Competitor, industry
average
Qualitative Analysis


Look at the handout on questions to be asked
1-50
Comments on Ratio Analysis
Helps to start the diagnose and proceed for
treatment

Try to overcome tendency to look at numbers
rather than underlying reasons.
Starting point; identify questions not
answers.

The way forward
Finance minister cautions against window
dressing by accountants
ET Bureau Jan 5, 2011, 07.10am IST
Pranab Mukherjee|
International Financial Reporting Standards
NEW DELHI: Finance minister Pranab Mukherjee has asked the country's auditing
fraternity to be vigilant against "window dressing" of financials by companies, and
highlighted the need for stringent disclosure norms on complex financial instruments.
"Accountants have a critical role in guarding against window dressing of balance sheets
that encourages entities to take more and more risk until they are dangerously
leveraged," Mr Mukherjee said on Tuesday at a conference organised by the Institute of
Chartered Accountants of India.
"We need to craft credible and consistent rules and regulations for financial markets to
prevent a race to the bottom where capital leaks out to the areas with the weakest
regulation. We must encourage stronger disclosure standards for systematically
important financial institutions as well as complex and sophisticated financial products,"
he said.
MANAC I

Understanding


Analyzing

Questions



Thank you