FINANCE

Financial (statement) analysis

The art of transforming data from financial statements into
information that is useful for informed decision making.

Dr. Varsha BN

Section : 8C
Topics/Terminologies
 Income statement
 Financial statements
 Appraisal through financial statements-ratio’s analysis
 Capital budgeting
 Working capital management
 Construction accounting
 Case studies

Working Capital = Current Assets – Current Liabilities

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https://www.sec.gov/reportspubs/investor-publications/investorpubsbegfinstmtguidehtm.html

Financial statements
 They show you where a company’s money came from, where
it went, and where it is now. There are four main financial
statements.
 balance sheets;
 income statements
 cash flow statements
 statements of shareholders’ equity
 Balance sheets show what a company owns and what it owes
at a fixed point in time.
 Income statements show how much money a company made
and spent over a period of time.
 Cash flow statements show the exchange of money between a
company and the outside world also over a period of time.
 “statement of shareholders’ equity,” shows changes in the
interests of the company’s shareholders over time.
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Balance sheet
 Balance sheet is a summary of a firm’s financial position
on a given date and includes the following :

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Income statement

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Cash flow statement
 Cash flow statements report a company’s inflows and outflows
of cash. This is important because a company needs to have
enough cash on hand to pay its expenses and purchase assets.
 A cash flow statement shows changes over time rather than
absolute amounts at a point in time. It uses and reorders the
information from a company’s balance sheet and income
statement.
 The bottom line of the cash flow statement shows the net
increase or decrease in cash for the period.
 Generally, cash flow statements are divided into three main
parts. Each part reviews the cash flow from one of three types
of activities: (1) operating activities; (2) investing activities; and
(3) financing activities.

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Cost of goods sold
 The cost of goods sold is an important accounting term
for a manufacturing company. It represents the net cost of
producing the product marketed by the firm.

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Business ratios
 Financial ratios are created with the use of numerical values
taken from financial statements to gain meaningful information
about a company.
 The numbers found on a company’s financial statements –
balance sheet, income statement, and cash flow statement –
are used to perform quantitative analysis and assess a
company’s liquidity, leverage, growth, margins, profitability, rates
of return, valuation, and more.
 Analysis of financial ratios serves two main purposes:
 Track company performance
 Make comparative judgments regarding company performance

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 https://corporatefinanceinstitute.com/resources/knowledge/finance/financial-ratios/
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 https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp

Capital budgeting
 CAPITAL INVESTMENTS are long-term investments in
which the assets involved have useful lives of multiple
years.
 CAPITAL BUDGETING is a method of estimating the
financial viability of a capital investment over the life of the
investment. The capital budgeting process can involve almost anything
including acquiring land or purchasing fixed assets like a new truck or machinery.

Capital budgeting methods include adjustments for the time value of money. Capital
investments create cash flows that are often spread over several years into the future. To
accurately assess the value of a capital investment, the timing of the future cash flows are
taken into account and converted to the current time period (present value).

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A capital budgeting decision is both a financial commitment and an investment. By taking on a project, the
business is making a financial commitment, but it is also investing in its longer-term direction that will likely
have an influence on future projects the company considers.

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IMPORTANCE OF CAPITAL BUDGETING
• Long term investments involve risks: Capital expenditures are long term
investments which involve more financial risks.
• Huge investments and irreversible ones: As the investments are huge but the
funds are limited, proper planning through capital expenditure is a pre-requisite. Also,
the capital investment decisions are irreversible in nature, i.e. once a permanent asset
is purchased its disposal shall incur losses.
• Long run in the business: Capital budgeting reduces the costs as well as brings
changes in the profitability of the company.

SIGNIFICANCE OF CAPITAL BUDGETING

• Capital budgeting provides a wide scope for financial managers to evaluate different
projects in terms of their viability to be taken up for investments
• It helps in exposing the risk and uncertainty of different projects
• It helps in keeping a check on over or under investments
• The management is provided with an effective control on cost of capital expenditure
projects
• Ultimately the fate of a business is decided on how optimally the available resources
are used

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Payback Period
 The payback period calculates the length of time required to
recoup the original investment.

 The analysis does not include cash flow payments beyond the
payback period
 Payback Period method is most useful for comparing projects with
nearly equal lives
 The Payback Period analysis does not take into account the time
value of money

 For example, assume that an investment of $600 will generate annual cash flows of $100 per
year for 10 years.The number of years required to recoup the investment is six years.
 If the investment generates cash flows for an additional four years beyond the six year
payback period. The value of these four cash flows is not included in the analysis. Suppose the
investment generates cash flow payments for 15 years rather than 10. The return from the
investment is much greater because there are five more years of cash flows. However, the
analysis does not take this into account and the Payback Period is still six years.

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Discounted Payback Period
 Discounted PB period factors in TVM and allows one to
determine how long it takes for the investment to be
recovered on a discounted cash flow basis.
 The discount rate for a company may represent its cost
of capital or the potential rate of return from an
alternative investment.
 It takes longer to repay the investment when the cash
flows are discounted

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 Another drawback is that both payback periods and
discounted payback periods ignore the cash flows that
occur towards the end of a project's life, such as
the salvage value. Thus, the PB is not a direct measure of
profitability.

 Since the payback period does not reflect the added value
of a capital budgeting decision, it is usually considered the
least relevant valuation approach. However, if liquidity is a
vital consideration, PB periods are of major importance.

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Internal Rate of Return (IRR)
 The Internal Rate of Return is the rate of return from the
capital investment. In other words, the Internal Rate of
Return is the discount rate that makes the Net Present
Value equal to zero.
 Since the NPV of a project is inversely correlated with the discount rate—if the
discount rate increases then future cash flows become more uncertain and thus
become worth less in value—
 The IRR will usually produce the same types of decisions as net present value
models and allows firms to compare projects on the basis of returns on invested
capital.

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Net Present Value

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 The profitability index is calculated by dividing the present value of future
cash flows by the initial investment.
 A PI greater than 1 indicates that the NPV is positive while a PI of less than
1 indicates a negative NPV.

Profitability Index = PV of future cash flows / PV of initial investment

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Working Capital Management
 The term ‘working capital management’ primarily refers to the efforts of
the management towards effective management of current assets and
current liabilities.
 In other words, an efficient working capital management means ensuring
sufficient liquidity in the business to be able to satisfy short-term expenses
and debts.
 Working capital management is a day to day activity, unlike capital
budgeting decisions. Most importantly, inefficiencies at any levels of
management have an impact on the working capital and its management.
 The two main factors that decide the quantum of working capital that a
business should maintain, are liquidity and profitability. (the relation between
liquidity and profitability is inverse)

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Liquidity is a measure companies uses to examine their ability to
cover short-term financial obligations. It's a measure of
your business's ability to convert assets—or anything your
company owns with financial value—into cash. Liquid assets can be
quickly and easily changed into currency.

The trade-off is perhaps most obvious with regards to the holding

of cash. Although cash obviously provides liquidity it generates
little return, even if held in the form of cash equivalents .This is
particularly true in an era of low interest rates

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Following are the main points that signify why it is important to take the
management of working capital seriously.
• Ensures Higher Return on Capital
• Improvement in Credit Profile & Solvency
• Increased Profitability
• Better Liquidity
• Business Value Appreciation
• Most Suitable Financing Terms
• Interruption Free Production
• Readiness for Shocks and Peak Demand
• Advantage over Competitors

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The primary objectives of working capital management include the following:

Smooth Operating Cycle: The key objective of working capital management is to

ensure a smooth operating cycle. It means the cycle should never stop for the lack of
liquidity whether it is for buying raw material, salaries, tax payments etc.

Lowest Working Capital: For achieving the smooth operating cycle, it is also
important to keep the requirement of working capital at the lowest. This may be achieved
by favorable credit terms with accounts payable and receivables both, faster production
cycle, effective inventory management etc.

Minimize Rate of Interest or Cost of Capital: It is important to understand that

the interest cost of capital is one of the major costs in any firm. The management of the
firm should negotiate well with the financial institutions, select the right mode of finance,
maintain optimal capital structure etc.

Optimal Return on Current Asset Investment: In many businesses, you have a

liquidity crunch at one point of time and excess liquidity at another. This happens mostly
with seasonal industries. At the time of excess liquidity, the management should have
good short-term investment avenues to take benefit of the idle funds.

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Theoretically, following three types of policies are explained whereas they can be n
number of policies depending on where the tradeoff is stricken between the
liquidity and profitability.

• Relaxed Policy / Conservative policy – This policy has a high level of

current assets maintained to honor the current liabilities. Here, the liquidity is
very high and the direct impact on profitability is also high.
• Restricted Policy / Aggressive policy – This policy has a lower level of
current assets. Here, the liquidity levels are very low, therefore, the direct
impact on profitability is also low.
• Moderate Policy – It lies between the conservative and aggressive policy.

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Working capital cycle
 The cash operating cycle (also known as the working capital cycle or the
cash conversion cycle) is the number of days between paying suppliers and
receiving cash from sales.
 The operating cycle of a company consists of time period between the
procurement of inventory and the collection of cash from receivables. The
operating cycle is the length of time between the company’s outlay on raw
materials, wages and other expenses and inflow of cash from sale of goods.

 Cash operating cycle = Inventory days + Receivables days – Payables days.

 The longer the operating cycle the greater the level of resources ‘tied up’ in
working capital.

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 Although it is desirable to have as short a cycle as possible, there may be
external factors which restrict management’s ability to achieve this:
 Nature of the business – a supermarket chain vs construction company
 Industry norms / common practices – what key competitors offer
 Power of suppliers – style of payment

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Construction accounting
 Construction accounting is more complex than it is for
most businesses due to the nature of the work, per-
project pricing, fluctuating operating costs, and more.
 Construction companies need to be able to track and
report expenses, bid on projects, manage payroll, and a
slew of other accounting responsibilities.
 Challenges are :
 Project-based accounting
 Services and vendors
 Mobile work and production
 Irregular contracts
 Fluctuating overhead costs

https://www.foundationsoft.com/construction-accounting-101/
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 Methods of Construction accounting

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Questions from Previous papers

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