Understanding And Analysing Financial Statements

UNDERSTANDING AND ANALYSING FINANCIAL STATEMENTS

By ARCHANA SINGH

1

What are Financial Statements? F B

A

L

I N

A

A P N R C O E F

N

C

I A

L

SI T C H AA E SN E H DT

2

The “HOW” of Financial Decision Making 

To make the three basic decisions Financial statements are analyzed compared interpreted Analysis – reclassification of given data into homogenous and comparable groups Comparison – relative magnitude is ascertained Interpretation – drawing proper conclusions for future decisions.

3

Balance sheet  Prepared

from the point of view of the

firm  Relates to a point of time not a period  Is in terms of money  Is always balanced  Reflects the health of the firm at that moment

4

Profit & Loss account Shows the financial results for a period  The period is normally a year 

Both the financial statements are analyzed by tools like: - Ratio Analysis - Funds flow statements - Cash flow statements

5

Balance Sheet – common entries SHARE CAPITAL – capital provided by the owners  RESERVES & SURPLUS – capital belonging to owners - share-premium reserve - general reserve - dividend capitalization reserve Together share capital + reserves = NET WORTH 

6

LONG TERM LOANS – major part of the liabilities can be raised from - banks - FI’s - public deposits CURRENT LIABILITIES – short term source e.g.- wages/interest payable, sundry creditors etc

7

 FIXED

ASSETS – Are not normally traded for liquidity, do not change in form or quantity thus gross fixed assets are depreciated

 DEPRECIATION

is the process of allocating the original purchase price of a fixed asset over the course of its useful life.  All Fixed assets except land are depreciated

8

 CURRENT

ASSETS continually change in form & quantity and follow a sequence of change such as- cash &marketable securities - bank balance - loans advances & prepaid expenses - receivables & sundry debtors - inventory

9

 INVESTMENTS

– after fulfilling the need of FA & CA ‘the financial manager uses the surplus cash towards investments (as cash is dead & decaying asset). Investments are in - outside/firm’s securities - other businesses - subsidiary companies The investments are valued at actual cost or market value or the lesser of the two depending on the firm’s policy

10

Flowchart of a balance sheet Capital & Liabilities  Where the funds come from Share Capital Reserves&Surplus Long term loans Short term debt 

Assets  Where the funds are deployed Fixed assets Investments Current assets 

11

Profit & Loss Account Shows the financial results for a period. List of all revenues/sales ----------X  List of all expenses (only expenses for current year) ----------Y If X>Y then profit if X
12

Gross Profit = Sales – COGS  Operating Profit/EBIT = Gross Profit – Operating Expenses (administrative and selling & distribution expenses)  EAIBT = Operating Profit + Non-operating Income – Non Operating Expenses (Interest, Depreciation incl. Amortization schedule)  EAT/Net Profit = EAIBT – Tax 

The Net Profit is either to be distributed as dividend amongst shareholders or kept back in the firm as retained earnings.

13

Schedules & Notes to Accounts  Schedules

give a break-up of items in the balance sheet and P & L account  Note to Accounts are meant for qualitative explanation of certain items as well as disclosure of offbalance sheet items 14

Evaluation of financial performance  Comparison

is essential

The comparison can be of the ratio of the same company over several successive years Comparison with similar figures of other firms and units in the same industry Comparison with similar figures of other firms and units in different industries 15

Fundamental Question  1)

How is the business doing?  (2) How is the business placed at present?  (3) What are the future prospects of the business?

16

 We 

can use

Ratio Analysis Trend Analysis Inter firm Comparison Comparative statements Common size statements Fund flow analysis Cash Flow analysis Benchmarking

17

Performance Area Profitability Efficiency

Liquidity

Key Issues Is the business making a profit? Is it enough? Is the business making best use of its resources? Is it generating adequate sales from its investment in equipment and people? Is it managing its working capital properly? Is the business able to meet its short-term obligations as they fall due from cash resources immediately available to it? 18

Performance Key Issues Area Stability What about the long-term prospects of the business? Is the business generating sufficient resources to repay long-term liabilities and re-invest in required new technology? What is the overall structure of the businesses' finance - does it place a burden on the business? 19

Performance Area Investment Return

Key Issues

What return can investors or lender expect to get out of the business? How does this compare with similar, alternative investments in other businesses?

20

RATIO ANALYSIS  Is

a primary tool for analyzing the firm’s financial position External analysis – by outsiders (creditors, stockholders, analysts):they have limited access to confidential information Internal analysis – by the finance & accounting departments. They have access to detailed (future) information and can do a SWOT analysis too

21

Ratio Analysis just indicates the SYMPTOMS of problems.  After locating symptom the cause has to be determined  Ratios point out the relationships which are not obvious from the raw data.  Ratios are used for: 

Comparing different industries Comparing different companies in the same industry (to reveal strong & weak companies) Comparing performance in different time periods (they indicate future success or failure)

22

There can be 1000s of different kinds of ratios based on financial statements, but different analysts require different kinds of Ratios:  ST Creditor : Liquidity ratios  LT Creditor : Liquidity & Profitability  Stockholders : Liquidity, Profitability & Policies of firm which affect market price.

23



LIQUIDITY RATIOS Current ratio Quick/acid test ratio



LEVERAGE RATIOS debt-equity ratio debt ratio



PROFITABILITY RATIOS

 P/E ratio  Market value to book value ratio  Gross profit ratio  Operating profit ratio  Net profit ratio  ROTA  ROE/-ROCE 24

 ACTIVITY

RATIOS

Total assets turnover ratio Fixed assets turnover ratio Current assets turnover ratio Interest coverage ratio Accounts receivable ratio Average collection period

25

Liquidity ratios  CR= CA/CL  QR= CA-Inventory/CL

Coverage ratios  EAIBT/Annual interest payment= Interest coverage  EAT + Depreciation/Annual amount of loan installment= loan repayment coverage ratio  EAT + Depreciation/Annual interest(1-tax rate)=Coverage for principal & interest loan repayment  EAT-Preference Dividend/Annual dividend payment=Dividend Coverage 26



Profitability ratios PBIT*100/Total capital employed=ROCE EAIT/Sales=Net Profit ratio EBIT/Sales=Gross Profit ratio

     

Turnover ratios Net sales/Total capital employed=Capital turnover ratio Net sales/Net FA= FA turnover ratio COGS/Average inventory=Inventory Turnover ratio Net sales/Gross CA=CA turnover ratio Annual credit sales/amt. of debtors at the end of the month=Debtors turnover ratio

27

 Capital

structure ratios

Total of LT liabilities/Total shareholders funds = Debt to Equity ratio Net worth to total assets shows stability of the firm Net worth to Fixed Assets shows extent to which FA have been financed out of owner’s funds.

28

Symptoms, Causes & Solutions revealed by Financial Ratios Symptoms Problem Solution A. Abnormal 1.Inadequate 1.Raise Liquidity Cash additional Ratio funds 2. Excessive 2. Restrict Receivables terms of trade: more aggressive collection policy

29

Symptoms

Problem

3.Excessive inventory

3.Improve inventory

4. Excessive financing

4.Obtain

Solution

mgmt. CL

LT

30

Symptoms

Problem Solution

2. Abnormal 1. High 1. Institute Profitability Production cost cutting Ratio costs measures 2. Idle 2. Sell excess assets assets 3. Inadequate 3. Increase sales size of sales & advertising 4. Inadequate 4. Raise SP selling price

force

31

Symptoms

Problem Solution

5. High 5.Reduce administrative them expenses 6. Excessive 6. Seek lower cost payments debt or shift equity financing

interest to

32

DU PONT Analysis  ROCE=

Net profit margin * capital turnover Ratio  N.P.(EAIT) Sales ---------------- * -------------------------Sales Capital employed

33

Sources & Uses of Funds Flow of funds in a firm is continuous.  Assets are the net use  Liabilities are the net sources  The fund flow is a method by which we study net fund flow between 2 points of time: we take the balance sheet of 2 consecutive periods and the P&L a/c for the period  Funds can be defined as Cash; Working Capital; Total funds 

34

THREE STEP PROCESS 1. Classify net B/S changes that occur between 2 times 2. Classify from P&L a/c (increase or decrease) 3. Consolidate this information into a source and use of funds.

35

 1. 2. 3. 4.

Sources A net decrease in any asset A net increase in any liability Sale of stock Fund From operation

 1. 2. 3.

4.

Uses A net increase in any asset A net decrease in any liability Retirement/ purchase of stock Cash dividends

36

 Funds

flow statement helps to alert the management to the problems that can later be analyzed in detail

 This

facilitates the proper action to be taken

 Helps

to evaluate the firm’s financing 37

THANK YOU

38