Financial Statement Analysis

Dr. Vrajlal K. Sapovadia

Necessary to understand
Nature of a Business The Role of Accounting in Business Score Keeping Attention Directing Management Decisions Business Transactions GAAPs Basics/Glossary Profit Loss Assets Liabilities Equity Reserve Provision Income Expense

Dr. V. K. Sapovadia

Financial Statements

Balance Sheet Profit & Loss Statement Cash Flow statement Statement of change in equity (Not popular in India)
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FINANCIAL STATEMENT
Balance Sheet Describes the overall position of company at the end of period Provide information about the overall assets and liabilities of company applied in the business Income Statement Describes the current year performance

Provide the current year net profit information while

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Balance Sheet It is snapshot" of the entity's financial condition at a specific point in time

Income Statement Also known as Profit & Loss Account and details the entity's income and expenses during specific period of time Revenue/Expenses P (L) = R - E

Resources/Sources Assets/Liabilities A=L

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Balance Sheet Separate Business Entity concept Revenue & Capital transaction affect

Income Statement Revenue Recognition/ matching concept Only revenue transaction affects

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Different nomenclature
Balance Sheet Statement of Financial Position Net Worth Statement An Assets and Liabilities Statement Profit & Loss Account Income Statement Statement of earning Statement of operation Top line Bottom Line

Cash Flow Statement

Measures movement of cash Revenue & Capital transactions Notional transaction not affecting CFS Accrual transaction not affecting CFS

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Diversities

The financial affairs of a business may be of interest to a number of different groups: management, creditors, investors, government agencies, etc. Depending on who the analyst is in relation to the business, he or she may use a variety of tools with which to evaluate the said business.
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Niceties

Net Income should not be the only basis for concluding that a business is healthy and successful. Net Income must not be viewed alone, but in relation to other items in the Financial Statements.
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What do you think Accounting is all about?

The business needs to know HOW MUCH MONEY DOES IT HAVE? The amount of or lack of money is probably the most important factor in financial decision making Keeping accurate financial information is vital to making good business decisions How is its performance

What do you think Accounting is all about

The business needs to know HOW MUCH MONEY IT NEED? When it need money? Why it need money? The appropriate allocation of amount/investment in an asset is very important factor in financial decision making What is performance of each asset/investment?

How much money it should keep?

Money it self does not generate any value, but loose value due to inflation Money has cost, investor expect return interest, dividend Higher the money involved in business, higher the cost Low volume of money may leads to dysfunction of business Optimize level of cash!

A Poem..

Some people cant see why business failures keep mounting, And I really must agree: Theres simply no accounting

Accounting is not in isolation

Companies Act Income Tax Act Accounting Standards SEBI Other legislations Banking Regulation Act, Electricity Act, Insurance Act

Organization is

An arrangement of resources (capital, human, natural etc.) in order to produce goods, to render services to customers or to create wealth for the society

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Accounting
For-profit organisation Topline (Gross Revenue) & Bottomline (Profit) Not-for-profit organisation Surplus, Expenditure & Benefits Government organisation Expenditure & Deficit Accounting is natural Accounting is simple Accounting is useful Accounting is ingredient of Management Accounting is an Art
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Finance Life Blood of any organization

Accounting is science
Dr. V. K. Sapovadia

Accounting is...
Language of business
Has its own grammar & rules

A support function of business A social science Dynamic For External as well as Internal users An information system
Measures Business Activities Processes Business Information Communicates Financial Information

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Accounting Defined
It is an art of recording, classifying, summarizing business transactions & events Transactions in terms of money Events of financial character Recording in Journal chronological order, from vouchers Classifying in Ledger on basis of commonality from Journal Summarizing in Trial Balance only live accounts from ledger

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Accounting Explained

Input

Processes

Output

Transactions & events: identified, measured & recorded

Debit/Credit rules, Classification

Performance P & L Account Status of Assets & Liability Balance Sheet Inflow & outflow of Cash Cash Flow Statement

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From the eyes of users

The process of identifying, measuring, analyzing, and communicating financial information needed by management to plan, evaluate, and control an

organization's operations
A service activity whose function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions - in making reasoned choices among

alternative courses of action

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AAA definition

American Accounting Association Accounting is the process of identifying, measuring, analyzing, and communicating economic information to permit informed judgments and decisions by users of the information

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Who are the users?

External
Shareholders Investors Lenders Bankers Employees Suppliers Customers Government Researchers

Internal
Management Executives

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Internal users

Financial Accounting (profit/status for the whole organisation) Cost Accounting (for product, process, people) Management Accounting Responsibility Accounting - Cost center, what is cost incurred? As planned? - Revenue Center - Profit Center - Investment Center Management Reporting, MIS

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External Users

Financial Accounting Why more rules? Balance Sheets (static, snap shot, status report, at particular point of time) Profit & Loss Account (flow reports, during the period) Difference between two B/s! Cash Flow Statement - (flow reports, during the period)

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Profit Vs. Income

Profit (accounting term) Objective is to measure performance Real Revenue surplus Accounting prescription Income (defined by Income Tax Act) Objective is to tax Real or Notional Revenue or capital gain National priority for tax vs. exemption

Tools Of Analysis

Cross-Sectional Analysis involves the comparison of different firms financial ratios at the same point in time. This is useful in terms of comparing the firm to other firms within the industry. This is sometimes called Benchmarking where the company compares itself to the benchmark company so it to identify areas in which it excels and areas for improvement.
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Financial Ratios

Analyzing Liquidity

The Liquidity of a business is measured by its ability to satisfy its short-term obligations as they come due. Liquidity refers to the solvency of the firm s overall financial position the ease with which it can pay its bills.
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Net Working Capital, although not actually a ratio, is a common measure of the firm s overall liquidity. Net Working Capital = Current Assets Current Liabilities
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The Current Ratio, one of the most commonly cited financial ratios, measures the firms ability to meet its short term obligations. It is expressed as follows: Current Ratio = Current Assets Current Liabilities

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The current assets are: Cash, Marketable Securities, Accounts Receivable, Inventory and Prepaid Expenses. A CR of 2.0 is occasionally cited as acceptable, but a values acceptability depends on the industry in which the firm operates. It is useful to note that when a firms CR is 1.0, its NWC is zero. If a firm has a CR of less than 1.0, it will have negative NWC

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The Quick Ratio or Acid-Test Ratio is similar to the current ratio except that it excludes inventory because some inventory cannot be sold easily as works in progress or special-purpose items. Prepaid expenses are also excluded because these are not converted to cash anymore but merely represent advanced disbursements of cash. The Quick Ratio is computed as follows:

Quick Ratio = Quick Assets Current Liabilities

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The current assets are: Cash, Marketable Securities, Accounts Receivable, Inventory and Prepaid Expenses. A CR of 2.0 is occasionally cited as acceptable, but a values acceptability depends on the industry in which the firm operates. It is useful to note that when a firms CR is 1.0, its NWC is zero. If a firm has a CR of less than 1.0, it will have negative NWC.
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Analyzing Activity


Activity Ratios measure the speed with which accounts are converted into sales or cash. With regard to current accounts, measures of liquidity are generally inadequate because differences in the composition of a firms current accounts can significantly affect its true liquidity.
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Inventory Turnover commonly measures the activity or liquidity of a firms inventory. It is calculated as follows:

Inventory Turnover =

Cost of Goods Sold Inventory or Average Inventory

The resulting turnover is meaningful only when it is compared to other firms in the same industry or to the firms past inventory turnover.

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Days Inventory is the number of days required to sell the inventory. This is computed as follows:

Theses ratios help the firm identify which of its inventories are bestsellers and which do not sell well.

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Accounts Receivable Turnover is used in determining how quickly accounts receivable are converted to cash. It is computed as follows:

Accounts Receivable Turnover =

Net Sales A/R or Average A/R

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Average Collection Period or Days A/R is the number of days required (on average) to collect A/R. This is computed as follows:

Both these ratios are meaningful only in relation to the firms credit terms. For example, if the company grants 30day credit terms and its ave. collection period is 41 days, this means that collections are done inefficiently.
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The Operating Cycle tells how quickly a firm converts is inventory to cash; that is, from inventory to A/R and then from A/R to cash. This is computed as:

Operating Cycle = Days Inventory + Days A/R

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Total Asset Turnover indicates the efficiency with which the firm uses its assets to generate sales. Generally, the higher a firms total asset turnover, the more efficiently its assets have been used. This measure is probably of greatest interest to management because it indicates whether the firms operations have been financially efficient. This is calculated as follows:

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Analyzing Solvency and Debt



The Solvency of a business is measured by its ability to satisfy its long-term obligations. This is significant in relation to the firms Debt Position which indicates the amount of other peoples money being used in generating profits.

In general, analysts are more concerned with long-term debts because these commit the firm to paying interest, and eventually the principal, over the long run.

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The more debt a firm uses in relation to its total assets, the greater its Financial Leverage, which is the magnification of risk and return introduced through the use of fixed-cost financing such as debt and (cumulative) preferred stock. Incidentally, the more financial leverage a firm uses, the greater will be its risk and its expected return.
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The Debt Ratio measures the proportion of total assets financed by the firms creditors. The higher this ratio, the greater the amount of other peoples money being used to generate profits. This is computed as follows: Debt Ratio = Total Liabilities Total Assets

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The Debt-to-Equity Ratio measures the proportion of debt financing to equity financing; that is, the amount of the creditors money as a proportion of the firms owners money. This is computed as follows:

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The Times Interest Earned Ratio or the Interest Coverage Ratio measures the firms ability to make contractual interest payments. Because interest on longterm debt is a fixed cost every period, this ratio indicates whether there will be sufficient earnings (before interest and taxes) generated in order to cover the interest, however many times over. This is computed as follows:

Times Interest Earned Ratio = Earnings before Interest and Taxes Interest Expense

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Analyzing Profitability


Profits are the lifeblood of the firm and all its stakeholders are concerned with its Profitability or the ability to generate profits. However, in the same way that there are many ways of computing income or profit, so too is profitability measured in different ways.
Percentage Change or Growth Rate is the rate at which a key measure (Net Sales, Net Income, etc.) is increasing or decreasing. This is a manner of comparing a firms performance for the current period as versus its performance in the 47 preceding period.

Growth rate

Percentage Change = Rupees Amount of Change Financial Statement amount in the previous or base year

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Percentage analysis may be used over the span of several years. In order to do this, the Base Years financial statement amount is used as a denominator for the dollar amount of change for every year. The Gross Profit Margin measures the percentage change of each sales dollar remaining after the firm has paid for its goods. The higher the gross profit margin, the better because this means that the relative cost of merchandise sold is lower.

Gross Profit Margin = Net Sales COGS = Gross Profit Net Sales Net Sales
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The Operating Profit Margin measures the percentage change of each sales dollar remaining after all costs and expenses other than interest and taxes are deducted. It represents the pure profits earned on each sales dollar. Operating profits are pure because they measure only the profits earned on operations and ignore any financial and government charges (interest and taxes). This is computed as follows: Operating Profit Margin = Operating Profit Net Sales
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The Net Profit Margin measures the percentage of each sales dollar after all costs, including interest and taxes. This is computed as follows:

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The higher the firms net profit margin, the better. The net profit margin is a commonly cited measure of the firms success with respect to earnings on sales. Good net profit margins differ considerably across industries. The Return on Total Assets or the Return on Investment measures the firms overall effectiveness in generating profits with its available assets. The higher the firms ROA, the better. This is computed as follows:

Return on Assets = Net Income Total Assets

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The Return on Equity measures the return earned on the owners investment in the firm. Generally, the higher this return, the better off are the owners. This is computed as follows:

Return on Equity = Net Income Total Stockholders Equity

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The firms Earnings Per Share are generally of interest to present or prospective stockholder and to management. The earning per share represent the number of dollars earned on behalf of each outstanding share of common stock. This is computed as follows:

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Though not a true measure of profitability, the Price/Earnings Ratio is commonly used to assess the owners appraisal of share value. The P/E ratio measures the amount investors are willing to pay for each Rupee of the firms earnings. This ratio indicates the degree of confidence that investors have on the firms future performance. The higher the P/E ratio, the greater the investor confidence. This is computed as follows: Price/Earnings Ratio = Market Price per share of Common Stock Earnings per Share

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Business
Business needs money Assets Owners, investors, Lenders, bankers (money provider) Business uses money Purchase assets, incur expenses (consume money) Business create liability Business create assets Business transforms assets: RM Finished Goods Transformation add value Customer perceives benefit in purchase goods/service for which he pay price Business also perceive benefit profit & return

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How business runs?

Owners Capital Return Outsiders funds Assets

Transformed sacrificing labor and natural resources

Goods & services Price

Customer

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How business works?

Non-Recurring Transactions
Owner give capital to business known as EQUITY Debt is raised for shortfall known as LIABILITY Assets are created on which business runs - known as FIXED ASSETS

Recurring Transactions
Purchase goods & services Convert goods & services to Product/Service for the customers both known as CURRENT ASSETS Incur expenses Sales the goods/provide service to customers Income rent/interest/ Royalty received etc.
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What Accounting records?

Transactions (Sale, Purchase, salary paid etc.)
It is always with the third party They are objective in nature, resulting from negotiation & contract Supported by documents Occurring throughout the year Primarily creates or converts equity, liability or assets It occurs after transactions, result into increase or decrease equity, liability or assets Events (Depreciation, Bad debt, Amortization etc.) Internally generated Subjective/estimated No legal documentation Generally recorded on the last day of accounting year

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Transaction & Payment

Purchase of goods/services Transaction is done and paid at a time CASH Transaction is done but payment be made later, CREDIT

Sale of goods/service Transaction is done and received amount at a time CASH Transaction is done but receipt will be made later, CREDIT
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Method of Accounting
Transaction is required to be recorded at the earliest Purchase transaction is done and paid at a time Goods comes in & cash goes out Purchase on credit
Goods comes in, liability towards supplier is created Creditor

Sale transaction is done and payment is received Goods goes out & cash comes in Sale on credit
Goods goes out, right towards buyer is created Debtor
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Cash v/s Accrual Method

Cash method records transaction, when cash is paid or received

Accrual method records transaction, when liability to pay is created & right to recover is obtained Accrual method is also known as Mercantile method

In India, Company has to follow Accrual method only, unless law specifically provides otherwise e.g. NPA a/c of bank etc.

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Business needs information

For normal working, survival, growth Sharing profit & loss Regulatory requirement To share with Stakeholders For managerial decisions Quantitative- Qualitative Accounting vs. Non-accounting

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Accounting Information
Operating (Purchase/sold on credit, whom to pay? How much to pay?) Financial (My liquidity?) Management (Operations efficient?) Tax (How much tax to pay?)
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The way of understanding Accounting

Forward Approach how input processed to output (Accountant s approach)

Emphasize the concepts & techniques involved in collecting, processing, summarizing & reporting accounting information

Backward Approach (Users approach)

Emphasize what the user needs to know, what accountants did?
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Balance Sheet
Sources Resources

Liabilities
Internal capital supplied by owner, Reserve External loan, deposit, credit Long term Short term

Assets
Fixed Current Fictitious

SOURCE OF FUND

USE OF FUND

Accounting terms
Equity: Residual claim of owners over business, capital provided by owners, risk & return belongs to owners Liability: current obligation of business toward third party, discharge of liability require sacrifice of assets Asset: resources owned/controlled by business, created by result of liability, intended to use for business Profit: surplus of revenue over expenses Loss: short of revenue over expenses Income: inflow of revenue Expense: sacrifice of assets Equities = Equity + Liability

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Basic equations

Balance Sheet equation Assets = Equities Assets = Equity + Liability Assets = owner s equity + third party liability Profit & Loss Equation Revenue Expenses = Net Income (Profit)

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Balance Sheet (Any format?)

Liabilities Equity Reserve (capital, revenue..) Debenture Secured loan Unsecured loan Creditors Provision Contingent Liability Assets Goodwill Land Building Machinery Electrical etc. Vehicle Investments Debtors Inventory Cash

Performance
Money goes out of the firm Outflow Expenses Money comes into the firm Inflow Revenue

If expenses are higher than revenue LOSS

If revenue is higher than expenses PROFIT

Objectives of Accounting

It should fairly reflect the true "substance" of the business and the results of its operation.
The theory of accounting has, therefore, developed the concept of a "true and fair view". The true and fair view is applied in ensuring and assessing whether accounts do indeed portray accurately the business' activities. To support the application of the "true and fair view", accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently Accounting is not pure science, its result of professional judgment

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Objectives
Useful to potential & present investor/ creditors to make rational decision Understandable & useful to willing & reasonably known person Depict detail of economic resources & claim against it Balance Sheet, effect of transaction & event on resources & claim Give picture of financial performance P & L Account Provide assessment base for the amounts, timing & uncertainty of cash flow Cash Flow Statement

Nature of framework (principles)

Accounting Concepts Accounting Convention Accounting Postulates Accounting Principles Accounting Standards Accounting Rules

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Accounting Concepts
Social Science- Applied science Evolved through observations, experiences & consensus Accounting Concepts- Ideas, Notions, Thoughts, Perceptions
Separate Legal Entity Concept Going Concern Concept Money Measurement Concept Accounting Period Concept Dual Aspect Concept Matching Concept Cost Concept, Realization Concept Accrual Concept
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Accounting Concepts..
Are generic ideas generalized from particular instances Are not part of the formal theory formulation Evolved by experience It is to bring quality (?) of Financial Statements

Accounting Convention
Conventions = Habits, Practices, Tradition, Custom Likely Behavior Provide convenience No absolute scientific base Subjective person, place, time
Convention of Disclosure Convention of Materiality Convention of Consistency Convention of Conservatism
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Accounting Postulates
Basic assumption or fundamental proposition regarding the economic, political, or social environment that accounting operates in. A postulate is pertinent to developing an Accounting Principle. Theoretical assumptions on which modern accounting principles are based. Accounting postulates may relate to the environment of accounting, accounting entity, measurement process, and accounting objectives. Examples of postulates are accounting entity and continuity.
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Why Postulates?
Basic assumptions that can not be verified Sometimes called axioms in formal logical systems Postulates stemming from the economic and political environment Postulates stemming from the field of accounting itself The imperatives

Accounting Principles

Verifiable concepts Like pure science (Debit Credit rules) Dual Aspect principle Matching principle Basic Equations (Balance Sheet/Profit & Loss A/c) Principles are, Rules that empirically tested can become laws General approaches used in the recognition and measurement of accounting events
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The linkages..
Postulates are basic assumptions that can not be verified Principles are general approaches used in the recognition and measurement of accounting events Principles are postulates derived from experience and reason that have proved useful Principles are postulates that have been successful in practice

Criteria

Relevance what is objective of accounting?, meaningful, useful? Objectivity not influenced by personal bias, supported by documents, connotes reliability, trust Feasibility implementable without much difficulty, cost/benefit/time?

Linkages between B/s & P& L A/c

Revenue Receipt & Payment Capital Receipt & Payment Gross vs. Net Profit Income Common items profit, closing inventory

Reason of linkages.
P & L A/c record revenue transaction to measure performance Cumulative net result transferred to Balance Sheet Risk & return belongs to owner!!

Examples of concepts..
Postulates Going Concern AS-1 Time Period Periodicity Concept Accounting Entity, Separate Business Entity Concept Monetary Unit, Money Measurement Concept
Input-Oriented Principles Rules of Operation Revenue Recognition, AS-9 Matching Concept Constraining Principles Concept of Conservation (Prudence) Concept of Disclosure, AS-1 Materiality Concept Objectivity Concept Output-Oriented Principles Applicable to users: Comparability Applicable to Preparers: Consistency & Uniformity

The pillars
Concepts Fundamental assumptions underlying the preparation of financial statements AS1: Going Concern, Accrual & Consistency Bases Methods developed to apply the concepts to specific transactions Monetary concept Policies Specific to a particular organization Chosen on the basis of suitableness Depreciation method, valuation of inventory etc.

. Accounting Policies specific to a firm

Accounting bases methods Accounting Concepts broad principles

Accounting Standards
Rules, To bring uniformity, objectivity, reliability, neutrality Governs current accounting practice and used as a reference to determine the appropriate treatment of complex transactions Each country have its own AS International AS/FASB In India, ICAI (30 AS) CBDT (2 AS) Accounting standards are rules according to which accounts have to be drawn up. They demand minimum levels of disclosure, lay down fundamental principles, define the meanings of terms and specify how numbers should be calculated
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Importance of Accounting Standard

Mandatory (Except AS 3 etc.) Section 211 of the Companies Act, 1956, requires that every profit & loss account and balance sheet of the company shall comply with the accounting standards. For the purpose of Section 211, the expression "accounting standards" means the standards of accounting recommended by the Institute of Chartered Accountants of India Responsibility of BoD
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USA vs. India

USA Sarbanes Oxley Act AICPA/FASB No mandate for AS No format of B/s & P & L Three years B/s Two years P & L Rule based INDIA Clause 49 of SEBI ICAI/CBDT Company Act AS mandatory Format of B/s prescribed Vertical & Horizontal Two Years B/s P & L Items are illustrated Two years P & L Principle based

Accounting Debit/Credit Rules

Basis of modern accounting Double entry system Sacrifice of one party vis--vis benefit of other party Personal Accounts Person/Individual/group of individual Nominal Accounts Income & Expense Real Accounts - Assets

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Debit - Credit
Debit Personal receiver Real when assets comes in Nominal - Expense Credit Personal giver Real when asset goes out Nominal - Income

Assets
Fixed Assets Creation stage of business Meant for business Life of asset is longer than accounting period Asset may be movable or immovable Asset may be tangible or intangible Current assets Running the business Meant for customers Assets are converted into other asset during accounting period Asset may be movable or immovable Asset may be tangible or intangible
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Characteristics of Asset
Assets, must be acquired in transaction (Goodwill?) Economic Resource Control of resource Cost fair value, objectively measurable May be cash or convertible to cash Goods that can be sold Items expected to be used in future to generate cash flow

Type of assets
Fixed may be movable or immovable asset Current Fictitious [it is really not an asset, even though shown on Tangible Balance Sheet] Intangible Movable (has nothing to do with fixed/current asset) Immovable

Capital vs. Revenue Expenditure

Capital Expenditure Outlay resulting in the increase or acquisition of an asset or INCREASE in the earning capacity of a business, increase life of the asset, improve quality of production Outlay create asset or enhance quality of asset Revenue Expenditure Outlay as is necessary for the MAINTENANCE of earning capacity including the upkeep of the fixed assets in a fully efficient state. Outlay does not create any asset

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Test of capital vis--vis revenue

Outlay of money Effect on Financial Statement P & L or B/S? Creating any asset? Long term benefit? Fixed or Current Asset? Increasing life Improving quality or productivity? Attached with which main asset?

Profit measurement exercise

Surplus revenue over expenses Business asset (Fixed Asset) should be intact Devaluation of Fixed Asset should be taken care of Tangible Fixed Asset Depreciation Intangible Fixed Asset Amortization Wasting asset, like mines etc. - Depletion

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Thank You! Q&A

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