Financial analysis Introduction 5.6 1

How accounting helps Analysis of financial statement helps provide right information of the strength and weakness Helps companies manage business efficiently 5.6 2

What financial statements contain? Contains financial information of the company’s operation during the period Contains comparative figures Also contains qualitative information about the management and key decisions 5.6 3

Uses of financial statements Legal obligation Balance sheet and profit and loss account can be studied to ascertain the status Stakeholders like investors, regulators, stakeholders use the statements to study performance Organisation uses the data to study internal performance like cost of operations, liquidity etc., 5.6 4

Helps in management decisions Budgeting and profit planning Management of cash flow Operations management and control Major decisions – Trade off between buying and leasing – Helps choice of products and product lines – Marketing techniques to be adopted – Choosing the right operations 5.6 5

Why we need to understand Our competitors run the business as a commercial organisation For evaluation of performance we need to understand how industry works and the standards 5.6 6

Reading financial statements Overview 5.6 7

Balance sheet - Introduction A snapshot of financial position of a company Reveals – Company’s assets – Liabilities – Owner’s equity (net worth) Formula Assets = Liabilities + Shareholder’s equity 5.6 8

Assets Things that a company owns Assets have a value, can be sold Used by companies to make products or provide services that can be sold They include – Plant and machinery – Other equipments – Inventory (stock of raw material, work-in-progress and finished goods) – Cash and its equivalent Can be classified as current, non current and intangible 5.6 9

Liabilities Money that company owes to others Includes all kinds of obligations Categorised as long term and short term (current) liabilities Long tem liabilities include debt and other non-debt financial obligations Current liabilities are those that are short term borrowings and other payments due for payment within one year

Shareholder’s equity This is the initial investment into business by investors It may also include the retained earnings Together it is called networth of a company

Balancing The left side of the balance sheet has the liabilities and net worth The right side has the assets For the balance sheet to balance, total assets on the right side has to equal total liabilities plus net worth

Sample balance sheet Balance sheet of Dabur India Limited Shows in the form of Sources and Uses of funds

Financial statement Balance sheet Income statement Cash flow statement

Balance sheet analysis Sources of funds – Capital – Reserves & Surplus – Term Liabilities – Current Liabilities

Balance sheet analysis Uses of funds – Fixed Assets – Intangible assets – Non current assets – Current assets

Balance sheet analysis Capital – Authorised capital – Issued capital – Subscribed capital – Paid up capital

Balance sheet analysis Reserves – General reserves – Revaluation of fixed assets – Issue of shares at premium Surplus – The credit balance in Profit and loss account

Balance sheet analysis Tangible net worth – Refers to total funds arrived at adding up capital, reserves and surplus less intangible assets

Balance sheet analysis Long term liabilities – Redeemable preference shares – Debentures – Deferred payment guarantees – Public Deposits(Repayable after 12 months) – Term loans and unsecured loans from friends, relatives, directors repayable over a period of time

Balance sheet analysis Current liabilities – Working capital bank borrowings – Term loans deferred credit installments falling due in 12 months – public deposits maturing within 12 months – unsecured loans, unless the repayment is on deferred terms – sundry creditors – advances from dealers and customers – interest accrued but not paid – tax provisions – Dividend declared and payable

Balance sheet analysis Contingent liabilities – Tax disputes – Legal litigations – Bills and cheques discounted with banks – Claims against the company not acknowledged

Balance sheet analysis Fixed Assets – Infrastructure like land & building – plant & machinery – Vehicles – Furniture & fixtures Depreciation – Straight line method – Written down Value Method

Balance sheet analysis Investments – Shares And Securities – Associate Companies – Fixed deposits with banks/finance companies Remarks – While analysing bal sheet we can analyse necessity of such investments – While fixed deposits with banks are considered as fixed assets, the investments in associate concerns are treated as non current assets

Balance sheet analysis Non Current Assets – Deferred receivables/Overdue receivables(like disputed amounts and overdue > 6 months) – Non moving stocks/inventory/unusable spares – Investment/Lending to associate concern – Borrowing of the directors from the company – Telephone deposits/ ST deposits etc

Balance sheet analysis Intangible Assets – Preliminary & Preoperative expenses – Deferred Revenue Expenditure – Goodwill – Trade mark – Patents

Balance sheet analysis Current Assets – Raw materials, work-in-progress,finished goods,spares and consumables – Sundry debtors and receivables < 6 mths – Advances paid to suppliers of raw materials – Cash and bank balances – Interest receivables – Other current assets such as Government securities, Bank deposits..etc

Balance sheet analysis Notes – Management competence – Investment decision – Resorting to window dressing – experience of the promoters – Board comprises of only family members – The key personnel of the company – The structure of the organisation – The authority and decision making are decentralised

Balance sheet analysis Notes – The state of industrial relations – Financial systems and procedures – management control – planning, budgeting, forecasting – capacity utilisation – status of the technology – awareness of the market, competitions..etc – for listed co: share prices, EPS, book value, dividend record, public response..etc

Exercise

Profit and loss account It is a summary of revenue earned and expenses incurred which ultimately results in profit or loss of to the company No defined format in law Operating revenue = Sales revenue Non-operating revenue = Other income ( out of sale of investments, interest, commission and discount etc) Hence operating profit is a yard stick for operating profit of the company Operating profit = Sales Revenue- Operating Cost

Profit and loss account Gross Sales – Gross sales includes excise duty to be charged to the customer, central sales tax applicable, state sales tax applicable, the discount o be allowed to distributors/dealers/customers. The gross sales appears in the P&L account comprises of all the above part from the basic unit price. Net Sales – The sales figure excluding all the factors explained above are the net sales

Profit and loss account Cost of production – This is the cost incurred right from the procurement of raw material to the finished good. – For ex in a garment firm following cost is incurred while production cost of raw material cloth, buttons, canvas, hooks, zips etc Maintenance of sewing machines payment of wages to workers Power Washing, ironing, packing etc. Cost of Production excludes selling & admin exp & interest cost

Profit and loss account Selling And General Administrative Expenses – Maintaining office staff for admin & accounting – marketing effort – payment of salaries/Allowances to marketing personnel – All the expenses which are not directly connected to manufacturing are classified as selling and/or general expenses

Profit and loss account Cost of goods sold – Cost of goods sold includes all manufacturing expenses and the adjustments for opening and closing stock – Cost of Goods sold = Opening stock + Purchases + Manufacturing expenses - Closing stock Gross Profit – arrived deducting figure of cost of goods sold from the sales figure Gross profit = Sales - Cost of goods sold

Profit and loss account Operating Profit is arrived deducting selling, administrative and general expenses, provision for bad debts, interest and miscellaneous expenses from the gross profit. ie Op Profit = Gr Prof - (Sel & adm exp + Prov bad debt + mis exp ) Profit Before Tax When other income is added and other expenses are deducted from the operating profit we get profit before Tax ie PBT = Op Profit + oth Inc - oth exp Net Profit When provision for taxes is deducted from the Profit Before Tax we get Net profit ie Net Profit = PBT - taxes

Profit and loss account Non Operating Income/Expenses – The income earned by the unit from other than manufacturing and selling operations is classified under this head. i.e Interest earned on fixed deposits Dividends and profit earned by sale of assets and share. – All those expenses which are not directly connected with operations of the unit are classified under this head. i.e Preliminary expenses written off Loss suffered due to sale of assets & share

Ratio analysis Standardize numbers across industry – facilitate comparison Used to highlight weaknesses and strengths

Categories of ratios Liquidity – Can the business make required payments as they fall due? Asset management – Does the organisation have the right amount of assets for the level of shares Debt management – Does the company have the right mix of debt and equity

Categories of ratios Profitability – Do the sale prices exceed the unit cost

Debt to equity ratio Compares company’s total debt to shareholder’s equity Data for calculation can be found in company’s balance sheet To calculate the ratio, divide the company’s total liabilities by the shareholders’ equity Debt-to-equity ratio = Total liabilities/shareholders’ equity If the ratio is 1.5:1, the company has a debt of Rs for every Re 1/- of the equity

Inventory turnover ratio Compares the company’s cost of sales to the inventory for a given period Inventory turnover = Sales/Inventories A higher ratio indicates quick movement of stock A low ratio indicates slow movement and accumulation of old stock

Operating margin Compares company’s operating income (before interest and taxes) to revenues Expressed as a percentage of revenue Shows the amount of income for every rupee of sale Indicator of the profit margin

Price/Earning ratio Compares company’s common stock price with its earning per share P/E Ratio = Price per share/Earnings per share

Working capital Working capital is the money left after paying the current liabilities Working capital = Current assets – Current liabilities

Exercise