Financial Reporting and Analysis – Session 5 & 6

Financial Statements Analysis

(Chapter No 22)
Analysis + Financial Statements

2
What is the trend that you read?

Sales Growth (%)

What are the key dimensions of the trend?

3
Does your reading change in #2? Why?

Hike
Sales in Salary(%)
Growth

Sales Growth
Hike in Salary(%)

4
How about 1 versus 3?

Sales Growth
Hike in Salary(%)

Hike in Salary
SalesofGrowth
No. km run(%)

No. of km run

5
How about 3 versus 4?

Hike in Salary

Hike in Salary
SalesofGrowth
No. km run(%)

Sales Growth (%)

6
Spot the difference …60 Seconds

3 differences in 60 seconds is a genius in making

2 differences in 60 seconds is an extraordinary mind
1 differences in 60 seconds is above average
0 differences in 60 seconds is…

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Perceptions about Financial Analysis
Why do we analyze at all?

Information Analysis Inference Decision

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Stakeholders (Who) interested in FSA

Stakeholders Objective (Decision)

Lender Credit worthiness

Promoter Basic viability of business
Investor Returns from the investment
Supplier Liquidity Position
Customer Sustainability of operations
Capital Markets Corporate Governance

Government Revenue generation ability

Employees Impact on wages/salaries

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Process (How) of Analysis

1. Determine
2. Gather
the Objective
Data
and Context

6. Update the 3. Process

Analysis the Data

5. Report the
4. Analyze and
Conclusions or
interpret the
Recommendation
data
s

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Sources of Information for an Analyst

1. Financial Statement
2. Auditor Reports
3. Notes to Financial Statement
4. Directors’ Report / Corporate Governance Report / MDA
5. Quarterly or semiannual reports (not audited)
6. Proxy Statements
7. Corporate Reports and Press Releases
8. Industry reports – CII, SIAM, FICCI
9. Newspapers / Magazine / Social Media

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5 Contours (What) of FSA (Excl. Qualitative Aspects)

Activity Liquidity

Solvency

Profitability
(Management + Capital Valuation/Investment
Ratios
Provider)

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 Is there any relationship?

Liquidity

Profitability Solvency

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Techniques of Financial Analysis

• Under the framework of the financial analysis, step #3 was to Process the data after
gathering it from different sources

• We use the following techniques:

Ratio Analysis Common Sizing

Time Series Analysis Graph / Charting

• Make sure that reported FS are converted into Adjusted FS before applying any of these
(removal of Non sustainable items, Difference in AS, variation in A/c policies and
Assumptions)

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Importance of the reference point

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What can be a suitable reference point?

Peer Group Industry Average

Best?

Specific Competitor Own Historical

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Ratio Analysis

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Ratio Analysis
• Ratio is a combination of two variables where one variable (Numerator) is expressed
as X of the other (denominator)
• Numerator is called as the driver of the ratio and Denominator a base (brake)
• It is used to describe relationships between different variables used in financial
accounts
• Some commonly used ratios
1. Exam Pass Rate
2. Inflation (WPI or CPI)
3. Gender Ratio

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 Directional Interpretation
Change in parameters Final Impact on the Ratio

1. Nr increases, Dr decreases 1.
2. Nr decreases, Dr increases 2.
3. Nr is constant, Dr changes (Inc or Dec) 3.
4. Dr is constant, Nr changes (Inc or Dec) 4.
5. Nr and Dr both increases 5.
a) Ratio >1 a)
b) Ratio <1 b)
6. Nr and Dr both decreases 6.
a) Ratio >1 a)
b) Ratio <1 b)

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 Solvency Ratios

• What constitutes Debt?

• What is Equity?
• Which Assets to be taken?
• Should we take accrual interest or cash interest?

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22
 Liquidity Ratios

• What are different Current Assets?

• How are CA different than QA? And Cash
Assets?
• How are CL related to Debt?

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 Activity Ratios

• Mix ratio versus Pure Ratio

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25
Profitability Ratios

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Return on Equity: The most important ratio = Net Profits / Equity

Profitability Activity Solvency

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Limitations of Return of Equity

1. It does not capture the liquidity theme. It is based on profits and hence accrual, not
cash

2. R stands for Return, and does not capture the risk involved in getting Debt on the
capital structure.

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 Valuation / Investment Ratios

• Where should we source share price from?

• Leading and Lagging PE?
• Is P/B a pure ratio or mixed ratio?

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Limitations of Ratio Analysis

1. Lack of comparability across industries

2. Accounting policies / Accounting estimates may differ across companies

in the same industry (FIFO vs AVCO | SLM vs WDV)

3. It is suggestive, not conclusive on most occasion

4. Figures from the Financial Statements (FS) may not be representative of

the true picture on the ground due to limitations of FS

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Multivariate Ratio Analysis

• A number of key ratios are weighted and combined to produce a single

"index number" which represents the financial health of the company.

• Advanced Statistical Tools such as Determinant Analysis are used

• Altman’s Z model is the most prevalent example: used to predict

corporate failure

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The Altman Model

Z score = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5

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The Altman Z-Model on Ricoh (India) Limited

Z-Score Over a Period of Time

5.00

4.00

3.00

2.00

1.00

0.00
FY98
FY99
FY00
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15
FY16
FY17
FY18
-1.00

-2.00

-3.00

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Common Sizing

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Common-sized financial statements

• Where each figure is expressed as a % of some figure of the same year

• This helps in comparison of companies with different sizes

35
Case Practice: Hypothetical Limited

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Time Series Analysis
(Trend Analysis)

337
Trend Analysis
• Where respective figures of the first period are treated as the base value and corresponding
figures for all the future years is indexed over the base value
Balance Sheet 2017 2018 2019

Cash 800 1,000 1,200

Inventory 1,500 900 1,350
PPE 6,000 7,500 7,200

Indexed 2017 2018 2019

Cash 1 1.25 1.5

Inventory 1 0.6 0.9
PPE 1 1.5 1.2

• The idea is not to compare Cash with Inventory, but to track cash values over a period of time

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Case Practice: Hypothetical Limited

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 Hypothetical Limited
Manufacturing Firm |Small Size | Private Limted

Company needs a Working Capital loan for INR 5Cr.

Stakeholders Objective (Decision)

Lender = Bank Credit worthiness

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Questions (1/2)
1. Do you think it is important for you to enquire about the industry and economy before deciding?
2. The promoter tells you that the company is getting the orders beyond expectations. What
parameters should you focus on to verify his claim?
3. Is asset utilisation an issue for the company? Verify your opinion after checking both kinds of
business assets.
4. What is the trend in the collection period? What do you think may be the reason?
5. The CEO is looking for a bigger inventory warehouse. What do you read from the inventory
values?
6. The CEO is proud of a increasing the supplier payment period, as a sign of market dominance.
Critically argue the above hubris.

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Questions (2/2)
7. Is the company facing any production cost over-run?
8. Rs. 16,000 in FY19 from Rs. 9,840 in FY18, CEO claims that the company is making
good profits. Do you agree?
9. Which expenses are responsible for fall in the profitability?
10.Why do you think depreciation is increasing so much? How is this related to the working
capital problem?
11.Is owners’ stake thinning over a period of time? What is the cause? What are the
implications?
12.Is interest payment a challenge for the company?

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