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> > > > > > > > Lecture 13

Finance for Non Finance Professionals

Agenda
• • • Objective of the Webinar Key takeaways Purpose of existence of an economic entity


• • • • • •

Financial statements – construction and purpose
Understanding and interpreting Financial Statements Financial analysis as a measurement tool Purpose of analysis – equity perspective, debt perspective Ratio analysis Explaining simple terms in Finance - ROI, IRR, Time Value of Money Q&A

Objective • The webinar will help the participants – To gain an understanding of the basic principles of finance – To evaluate decisions related to finance more knowledgeably – To participate effectively in finance related discussions in their respective organisations – To gain basic understanding to pursue higher education / career in the field of finance – To follow recent economic events and its impact on corporate performance – To take informed decision related to personal finance and investing – To interact with financial department / finance professionals more knowledgeably .

to take well-informed investment decisions – Read / follow business newspapers / business channels with better understanding .Key Take Aways – Basic understanding of various forms of economic entities – Understanding financial statements and perform ratio analysis on published statements – Evaluate a corporate investing or financing decision meaningfully – Track financial performance of listed companies closely.

To do ‘business’ is to create an economic entity with the purpose of  Wealth creation  Wealth management. and  Wealth distribution Objective of an enterprise – To create the best possible values and share them in the equitable manner among all the stakeholders .

Business as an economic entity exists to make profits: – Trading activity Selling price > Cost of purchase Buying Selling – Manufacturing activity: Selling price > Cost of purchase + conversion costs Buying – Services Servicing Processing Selling Price for service > Cost of providing the service .

Who are the stakeholders in a business? – Investors  Equity holders – majority holders. Taxman . We need various entities to come together to run an enterprise and generate returns. minority shareholders  Debt holders including banks and financial institutions – – – – – Management Employees Suppliers Customers Community.

which are determined based on prudent accounting practices  Employees are typically rewarded based on their individual performance as well as the performance of the enterprise  Minority shareholders get equal treatment compared to majority owners (equal dividend distribution)  Debt holders are paid their due for contributing debt capital to the business (interest payment and principal repayment) Key to understanding accounting principles is to view an enterprise as a separate legal entity. labour or resources. and all stakeholders as those contributing capital.    Accounting forms the basis for measuring the performance of an enterprise The performance determines which stakeholder gets what share of the business Accounting also ensures ‘equitable’ distribution of wealth generated. . based on each person’s contribution to the business Few examples:  Taxman gets his share of the profits (currently 35% in India).

Enterprise Proprietary Partnership Company Private Ltd. Closely held Publicly held . Public Ltd.

 Partnership firm – owned by two or more owners – No difference between the obligations of the business and the obligations of the individual partners except when it is Limited Liability Partnership (Registered)  Company is an artificial person. Proprietary business – owned by single owner – No difference between the obligations of the business and the obligations of the individual. – Private limited company    Not more than 50 members Shares are not freely transferable. created by law and has perpetual existence. – Public limited company   Closely held public limited company (Deemed) Publicly held public limited company (Listed) . Obligations of the company are separate from those of promoters and management. No invitation to public for subscription.

com and www.in ) • Three key financial statements are – Balance Sheet – Profit & Loss Account and – Cash flow statement . the financial statements are reported to the Ministry of Company Affairs – Some of these are available for public viewing (both online as well as physically) for a small fee.bseindia.gov.• • • Financial statements report the state of financial affairs of an enterprise These are made publicly available for widely held companies. (http://www. usually free of cost (www.mca.nseindia.com ) For closely held public companies and private companies.

etc.Liabilities  Assets Fixed Assets  Land and building  Plant and Machinery Investments  Investment made in shares.    Owners’ capital  Equity Capital  Reserves and Surplus Borrowed funds  Long term debt  Short term debt  Working capital  Creditors  Current liabilities and Provisions  Working Capital  Raw Material  Work in progress  Finished goods  Debtors  Cash . government securities. bonds.

2008. say as at March 31.• The Liability side represent the various sources of funds for an enterprise – These are the liability of the enterprise to the providers of these funds • The Asset side represent the various uses of funds by an enterprise – These are the assets held by the enterprise. that are needed to operate the business (e. . the portfolio mix of the own funds and borrowed funds is called the Capital Structure of the company • Balance sheet is always presented as on a given day. Office space. It presents a static picture of the assets and liabilities of the enterprise as on that date. factory. etc. raw material. • In the Liability side.g.) • The Assets and Liabilities should ALWAYS match.

long term uses must always be funded with long term funds. current liability and short term debt • • Ideally.• Another way to look at the balance sheet is to match the sources and uses of funds. based on business managers’ preference. Short term investments may be financed by a combination of long term and short term funds. long term sources are • Equity capital • Reserves and Surplus • Long term borrowings – In Asset side. Financing long term assets with the short term funds creates risks (mainly refinancing risk). based on their tenure. – In Liability side. long term uses are • Fixed Assets • Investments – The rest are short term on both sides viz. Current assets. .

Depreciation & Amortization(EBITDA) Less Less Less Less Depreciation Interest payment Taxes Dividend Earning before interest and taxes (EBIT) Profit before taxes (PBT) Profit after tax (PAT) Retained earnings . taxes.Revenues from the business Less Raw material consumed Employee expenses Other manufacturing expenses Administrative expenses Selling expenses Sub total: Cost of Sales Earning before interest.

Typical items under ‘Revenue from business’  Sales revenue  Other related income  Scrap sales. Duty drawback  Non-operating income – Dividends and interest – Rent received  Extra-ordinary income – Profit on sale of assets / investments – Prior-period items .

promotional expenses – Advertisement expenses etc.Typical items under ‘Cost of Sales’  Cost of goods sold – Direct material – Direct labor – Direct manufacturing overheads  Administrative costs – Office rent – Salaries – Communication costs – Other costs  Selling and distribution costs – Salaries of sales staff – Commissions. .

 Depreciation – Straight line method – Written Down Value method  Deferred revenue expenditure – R&D expenses – Advertisement expenses – Product promotion expenses (expenses are charged as capital expenses and amortized over the period of time) .

one-time income • Income from ordinary activities are typically recurring in nature • Extraordinary income / expenses are typically one-time in nature • Few examples: Sale of office space. half-year. quarter. which presents a static picture on a given date • P&L Account can provide great insights into the functioning of an enterprise. disposal of a factory unit. Let us look at a few: – Variable costs Vs. Non-cash expenses • Raw material. VRS . salary and other administrative expenses are cash expenses • Depreciation is typically the only non-cash expense – Recurring income Vs. etc.) – Unlike Balance Sheet. no loss’ – Cash expenses Vs.• P&L Account presents a snapshot of the performance of an enterprise over a given period (a year. Fixed costs • Break even point is the point where there is ‘no profit.

Some important ratios for analysing performance of a company: – Operating profit margin – Net profit margin – – – – Return on Capital Employed Current Ratio Debt:Equity ratio Interest coverage ratio – Earnings per share – Price Earnings ratio – Return on Networth .

e.) but the above two are most commonly used.50% – Net profit margin • Indicates the returns generated by the business for its owners • NPM = PAT / Operating Income (or Net Sales) • For healthy companies.12% – Several other ‘profitability’ measures are there (Gross margin.– Operating profit margin • Indicates the business profitability • OPM = EBITDA / Operating Income (or Net Sales) • Depending on the industry. for healthy companies. comparing with other companies in same industry) . – The profitability margins are very useful for peer comparison (i. NPM ranges from 3% . OPM ranges from 15% . Contribution margin. etc.

30% • If ROCE is less than Interest rate for a company consistenty. capital structure or asset intensity. long term debt and short term debt. the company is destroying value for its equity investors / owners – The owners are better off dissolving the company and parking their money in bank fixed deposits and earn interest!!! . ROCE ranges from 15% .– Return on Capital Employed • Indicates true measure of performance of an enterprise • The capital employed in business is Equity capital. • ROCE = EBIT / (‘Networth’ + ‘Total Debt’) • The ratio is independent of the industry. • For healthy companies. • Returns generated for all these providers of capital is EBIT. reserves and surplus.

Lenders. may use the following ratios: – Debt:Equity ratio • The ratio of borrowed funds to owners’ funds • D:E ratio is also known as ‘gearing’. more risky for lenders – Company has to service higher interest cost if it borrows more. but at the same time. ‘leverage’ or ‘capital structure’ • Gearing = (Long term debt + Short Term debt) (Equity capital + Reserves & Surplus) • For most manufacturing companies. . or a Mutual Fund investing in bonds or debentures of a company. the company may be more vulnerable to default on its interest. D:E less than 2. better it is for owners. • Higher the ratio.0x is considered healthy. in a recession. such as a bank giving loan.

.0x. and probably default on interest payments.– Interest coverage • The ratio indicates the cushion the company has.0x to 8. better it is for the lenders • For healthy companies.0x indicates high stress. to service its interest • Interest coverage = EBITDA / Interest cost • Higher the ratio. Interest coverage ranges from 2. • Interest coverage < 1.

com/Ratings/Commentary/CommentaryDocs/Commo n-myths-about-current-ratio_Dec05.– Current ratio • This is a commonly used ‘liquidity ratio’. than the current assets that are maturing in the same period.0x • Current ratio of < 1. current ratio ranges between 1. Please read the commentary: http://www. – Indirectly.pdf .crisil. the ratio also indicates the proportion of long term assets funded by long term liabilities. as more current liabilities / short term debt are maturing in the next one year. used by banks that lend for ‘working capital’ • Current ratio = Current Assets Current liabilities + Short term debt • The ratio indicates the ratio of short term assets to short term liabilities.0x indicates that the company may face liquidity problems.2x to 2. • For solvent companies.

or an individual investor. for the relevant period (one year. .) • Two common sub-classification are Basic EPS and Fully Diluted EPS – Basic EPS is computed based on no. one quarter. of shares outstanding currently – Fully Diluted EPS is computed assuming all ‘convertibles’ and ‘options’ are exercised fully. may use the following ratios: – Earnings Per Share (EPS) • The Profit earned by the company for each share in the share capital of the enterprise • EPS = Profit After Tax Number of Equity shares outstanding • EPS is expressed in Rupees. etc. or a Private Equity investor.Equity investors. • This represents each shareholder’s claim in the profits of the company. such as a Mutual Fund investing in shares.

• When EPS is negative. – The ratio is also related to the growth in earnings that the company can generate in the next few years. PE ratio is in the range of 5-12x during recession times and 10-25x during boom times. . PE is meaningless. • Two common sub-classification are Forward PE and Trailing Twelve Months (TTM) PE – Forward PE is computed using EPS of the next financial year – TTM PE is computed using EPS of last 4 quarters • PE ratio has no meaning for unlisted companies as there is no ‘market price’ for these shares • Broadly speaking.– Price .Earnings Ratio (PE) • The ratio of current market price of the equity share to the annual earnings per share • PE = Current Market Price per share Earnings Per Share (EPS) • PE is expressed in ratio or times.

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