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Financial Statement Analysis

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Financial reporting provides information about performance, financial position, and
changes in financial position

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Food for thought

Suppose you were working with Satyam in 2008. If you had analyzed the previous 3
years financial statements, would you have discovered that cash was diverted from
the company?

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The objective of an audit of financial statements is to enable the auditor to express an
opinion whether the financial statements are prepared, in all material respects, in
accordance with an applicable financial reporting framework.

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Why FSA

Evaluating equity investment

Evaluating M&A

Assigning credit rating

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Accounting principles

Historical cost basis

Accrual concept

Going-concern rule Matching principle

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Accounting principles

Consistency rule

Materiality rule Conservative principle

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Liquidity Vs Solvency

Liquidity refers to the ability to meet short-term obligations

Solvency refers to the ability to meet long-term obligations

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Accounting Process

Voucher
(Documentation)

Journal
(Day book)

Ledger
(Classification)

Trial Balance
(Summarizing)

Financial Statements
(Bifurcation)
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Documentation and Recording

Three rules of accounting

Debit the receiver Debit what comes in Debit all expenses and losses

Credit the giver Credit what goes out Credit all incomes and gains

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What’s relevant for whom?

Particulars Amount
Net Sales/Income from Operations 460233.00
Lenders?
Other Operating Income 5800.00 Owners?

Other Income 40945.00

Interest 5077.00
Lenders
Net Profit (+) / Loss (-) for the period 211809.00 Owners
Employees
Dividend (%) -
Public-at-large?
Face Value (in Rs.) 1.00

Paid-up Equity Share Capital 8310.00 Lenders?


Owners?
Reserves excluding Revaluation
712561.00
Reserves
Lenders
Diluted EPS after Extraordinary Owners
25.31
items (in Rs.) Employees
Public Shareholding (%) 42.97 Public-at-large?
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Financial Statements

Report format

Balance Sheet
Account format

Income statement

Cash flow statement

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Balance Sheet

What are assets? Resources from which future economic benefits


are expected to flow to the enterprise

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Typical Assets

Cash and cash equivalents

Inventories

Receivables

Prepaid expenses

Property, plant, and equipment

Intangible assets

Investments

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Financial Statements

Statement of financial position at the end of the period

Statement of comprehensive income for the period (presented as either a single


statement or an income statement with a statement of recognized gains and losses)

Statement of changes in equity for the period

Statement of cash flows for the period

Notes, including a summary of significant accounting policies

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Food for thought

Physical form? Patents, copyrights?

Legal rights? Hire-purchase?

Purchased/ Government granted land?


produced?

Expenses incurred? Unsuccessful digging of oil wells?

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Balance Sheet

What are liabilities? Present obligation likely to be settled in the future

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Typical Liabilities

Borrowings

Payables

Provisions

Unearned revenues

Financial liabilities

Accrued liabilities

Deferred tax liabilities

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Food for thought

Rectifying defects beyond Maintaining good business relation,


warranty period? liability

Future rebates? Past transaction leads to liability

Estimating liability? Provisions. Retirement benefits?

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Balance Sheet

What is equity? Assets less Liability?

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Food for thought

Decision needs of users? Owner’s capital, General Reserve,


Capital Reserve

Creditor protection? Debenture redemption reserve

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Points to Ponder

How should firm fund their assets? Why is equity capital important

Corporate finance decision

Financial distress, optimal capital structure

Corporate strategy

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Special Note- Inventories

Lower of cost or NRV

What is dating?

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Points to Ponder

Should firms’ carry all its assets on historical cost basis?

Relevance of Price-to-book multiple in firm valuation

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Special note- Intangibles

Identifiable intangible Amortized over estimated useful life

Unidentifiable intangible Tested for impairment every year

Is goodwill same as control premium?

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Income Statement

What is Income? Increase in economic benefit


during a year

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Income Statement

Net Income or Net profit = Revenue - Expenses

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Income statement

Function of expense method

Eh-Bit-Duh?

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Classification using nature of expense method

Revenue

Other income

Changes in inventories of finished goods and work in progress

Raw materials and consumable used

Employee expenses

Depreciation and amortization expense

Other expenses

Total expenses

Profits before tax

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Food for thought

Does Sales have the same meaning as Revenue?

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Revenue Recognition- Goods

Evidence of an arrangement between buyer and seller

Disallows practice of recognizing revenue by delivering the product just


before the end of an accounting period and then completing a sales
contract after the period end

Product delivered, or service rendered

Precludes revenue recognition when the product has been shipped but risks
and rewards of ownership have not actually passed to the buyer

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Revenue Recognition- Goods

Price is determined or determinable

Precludes firms from recognizing revenue based on contingency

Seller reasonably sure of collecting money

Preclude firms from recognizing revenue when the customer is unlikely to pay

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Revenue Recognition- Services
Outcome of a transaction involving the rendering of services can be estimated reliably

Amount can be measured reliably

Probable that economic benefits will flow to the entity

Stage of completion of transaction can be measured reliably

Costs incurred can be measured reliably

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From Annual Report: Revenue Recognition

1. Revenue on time-and-material contracts are recognized as the related services are


performed and revenue from the end of the last billing to the Balance Sheet date is
recognized as unbilled revenues.

2. Revenue from fixed-price, fixed-timeframe contracts, where there is no uncertainty as


to measurement or collectability of consideration, is recognized based upon the
percentage-of-completion.

3. When there is uncertainty as to measurement or ultimate collectability, revenue


recognition is postponed until such uncertainty is resolved.

4. Cost and earnings in excess of billings are classified as unbilled revenue while
billing in excess of cost and earnings is classified as unearned revenue.

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Revenue Recognition- Special Cases

Long-term contracts

Percentage of Completion Method Completed Contract Method

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Expense Recognition

Matching Cost Principle

Period Cost

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Issues In Expense Recognition

Warranty on sales

Depreciation and Amortization

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Points to Ponder

What if accumulated depreciation is a large percentage of total fixed assets?

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Accounting equations

Assets= Liabilities + Owners’ equity

Assets - Liabilities = Owners’ equity

Owners’ equity = Contributed capital + Retained earnings

Revenue - Expenses = Net income (loss)

Ending retained earnings = Beginning retained earnings + Net income


- Dividends

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Why Cash Flow Statement

Provides information about cash receipts and cash payments during an accounting
period

Shows cash flow linkage between ending cash balance and beginning balance

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Cash Flow Statement

Disclosing sources and uses of cash helps statement users evaluate the company’s
liquidity, solvency, and financial flexibility

CFO CFI CFF

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Bond Issue

Actual interest rate Vs Effective interest rate

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Accounting for Carbon Credits
Clean Development Mechanism

Certified Emission Reduction

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Accounting for Leases

Operating Lease
Ownership of leased asset transfers to lessee at end of lease

Lease contains option for lessee to purchase leased asset cheaply

Financial Lease Lease term is 75 percent or more of useful life of leased asset.

PV of lease payments is 90 percent or more of FV of leased asset.

Recent ED

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Deferred Taxes

Taxable profits Vs Accounting Profits

Temporary Differences

Tax Asset, Tax Liability

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Corporate Frauds

Financial statement fraud

Asset misappropriation

Corruption

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Financial Statement Fraud

Misuse of materiality concepts

Understating liabilities

Overstating revenue

Overstating assets

Understating expenses
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Red Flags: Overstating Income

Increased revenues without corresponding increase in cash flow

Unusual growth in days receivables

Significant, unusual or highly complex transactions, particularly those that are


closed near the end of a financial reporting period

Strong revenue growth when peer companies are experiencing weak sales

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Red Flags: Understating expenses

Significant unexplained increases in fixed assets

Recurring negative CFO despite positive earnings and earnings growth

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Cookie Jar Reserves

Smoothing of earnings, overestimating liabilities during “good” times

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Ratio Analysis- Asset Utilization Measurement

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Ratio Analysis

Sales-to-Working Capital Ratio

Annualized net sales


———————————————————————
(Accounts receivable + Inventory – Accounts payable)

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Ratio Analysis

Sales-to-Fixed Asset Ratio

Annualized net sales


—————————
Total fixed asset

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Ratio Analysis

Accumulated Depreciation to Fixed Assets Ratio

Accumulated depreciation
———————————
Total fixed assets

Is company strapped for cash? Analysis of Cash Flow Statement

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Ratio Analysis

Investment Turnover

Sales
——————————————————
Equity + Long-term liabilities

Read with Debt-Equity Ratio


Optimal capital structure

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Ratio Analysis

Break-even Point

Total operating expenses


——————————————
Average gross margin percentage

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Ratio Analysis

Margin of Safety

Current sales level – Break-even point


———————————————
Current sales level

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Ratio Analysis- Operating Performance Measurement

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Ratio Analysis

Gross Profit Index


Gross profit in period two
———————————
Sales in period two
———————————
Gross profit in period one
———————————
Sales in period one

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Gross Profit Index: Red Flags

Accounting changes

Business issues

Corporate strategy

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Ratio Analysis- Cash Flow Measurement

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Ratio Analysis

Cash Flow From Operations

Net Income + Noncash expenses – Noncash sales


——————————————————————————
Net Income

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Ratio Analysis

Cash Flow Coverage Ratio

Total debt payments + Dividend payments + Capital expenditures


———————————————————————————
Net income + Noncash expenses – Noncash sales

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Ratio Analysis

Cash Flow to Fixed Assets Ratio

Net income + Noncash expenses – Noncash sales- ?


————————————————————
Capex

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Points to Ponder

What if the Cash Flow to Fixed Assets Ratio is one?

Pecking Order Hypothesis?

Read with Return on Equity?

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Ratio Analysis- Liquidity Measurement

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Ratio Analysis

Average Receivables Collection Period

Average accounts receivable


————————————
Annual sales / 365

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Points to Ponder

Is annualizing monthly sales acceptable?

How about annualizing sales for the period covered by the existing accounts receivable?

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Ratio Analysis

Inventory Turnover/Days Inventory

Cost of goods sold


————----——
Inventory

365/Inventory Turnover Ratio

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Ratio Analysis- Capital Structure and Solvency

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Ratio Analysis

Times Interest Earned

Average cash flow


———————————
Average interest expense

What about principal repayments?

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Ratio Analysis

Debt Service Coverage Ratio

Earnings before interest and taxes


————————–—————————
Scheduled principal payments
Interest + —————————————
(1 – Tax rate)

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