Finance for Non Finance

Professionals - II
FUNDAMENTALS OF ACCOUNTING STATEMENTS & RATIOS
 Agenda
1. Objectives of the session
7. Purpose of analysis – equity perspective, debt
2. Key takeaways perspective

3. Purpose of existence of an economic entity 8. Ratio analysis

4. Financial statements – construction and purpose 9. Explaining simple terms in Finance - ROI, IRR, Time
Value of Money

5. Understanding and interpreting Financial Statements

10. Q&A

6. Financial analysis as a measurement tool

 Objective

The session 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 organizations
◦ 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
 Key Take Aways

Key takeaways
◦ 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 take well-
informed investment decisions
◦ Read / follow business newspapers / business channels with better
understanding
Purpose of an economic entity
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
Purpose of an enterprise
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 Processing Selling

◦ Services
Price for service > Cost of providing the service
Servicing
Stakeholders
We need various entities to come together to run an enterprise and
generate returns. Who are the stakeholders in a business?
◦ Investors
 Equity holders – majority holders, minority shareholders
 Debt holders including banks and financial institutions
◦ Management
◦ Employees
◦ Suppliers
◦ Customers
◦ Community, Taxman
Why Accounting?
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), 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,

and all stakeholders as those contributing capital, labour or resources.
Various forms of enterprise
Enterprise

Proprietary Partnership Company

Private Ltd. Public Ltd.

Closely held Publicly held

Various forms of enterprise
Proprietary business – owned by single owner
◦ No difference between the obligations of the business and the obligations of the individual.

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, created by law and has perpetual existence. Obligations of the company are separate
from those of promoters and management.

◦ Private limited company

 Not more than 50 members
 Shares are not freely transferable.
 No invitation to public for subscription.

◦ Public limited company

 Closely held public limited company (Deemed)
 Publicly held public limited company (Listed)
 Financial statements

Financial statements report the state of financial affairs of an enterprise

These are made publicly available for widely held companies, usually free
of cost (www.bseindia.com and www.nseindia.com )
For closely held public companies and private companies, 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. (http://www.mca.gov.in )

Three key financial statements are

◦ Balance Sheet
◦ Profit & Loss Account and
◦ Cash flow statement
Construct of a Balance Sheet
Liabilities Assets
Fixed Assets
 Land and building
Owners’ capital  Plant and Machinery
 Equity Capital
 Reserves and Surplus
Investments
Borrowed funds  Investment made in shares, bonds, government securities, etc.
 Long term debt
 Short term debt Working Capital
Working capital  Raw Material
 Creditors  Work in progress
 Finished goods
 Current liabilities and Provisions
 Debtors
 Cash
 Some observations on Balance Sheet

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.g. Office space, factory, raw material, etc.)

The Assets and Liabilities should ALWAYS match.

In the Liability side, 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, say as at March 31,
2008. It presents a static picture of the assets and liabilities of the
enterprise as on that date.
 Some observations on Balance Sheet

Another way to look at the balance sheet is to match the sources and uses of
funds, based on their tenure.
◦ In Liability side, long term sources are
◦ Equity capital
◦ Reserves and Surplus
◦ Long term borrowings
◦ In Asset side, long term uses are
◦ Fixed Assets
◦ Investments
◦ The rest are short term on both sides viz. Current assets, current liability and short term
debt

Ideally, long term uses must always be funded with long term funds. Financing
long term assets with the short term funds creates risks (mainly refinancing risk).
Short term investments may be financed by a combination of long term and short
term funds, based on business managers’ preference.
Construct of a Profit & Loss account
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, taxes, Depreciation & Amortization(EBITDA)
Less Depreciation
Earning before interest and taxes (EBIT)
Less Interest payment
Profit before taxes (PBT)
Less Taxes
Profit after tax (PAT)
Less Dividend
Retained earnings
Inside the P&L Account
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
 Inside the P&L Account

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, promotional expenses
◦ Advertisement expenses etc.
 Inside the P&L Account

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)
 Some observations on P&L Account

P&L Account presents a snapshot of the performance of an enterprise over

a given period (a year, half-year, quarter, etc.)
◦ Unlike Balance Sheet, which presents a static picture on a given date

P&L Account can provide great insights into the functioning of an

enterprise. Let us look at a few:
◦ Variable costs Vs. Fixed costs
◦ Break even point is the point where there is ‘no profit, no loss’
◦ Cash expenses Vs. Non-cash expenses
◦ Raw material, salary and other administrative expenses are cash expenses
◦ Depreciation is typically the only non-cash expense
◦ Recurring income Vs. 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, disposal of a factory unit, VRS
 Cashflow Statement

What is a Cashflow Statement?

◦ A statement that links the P&L generated based on ‘accrual’ principle and the
Balance Sheet which represents the snapshot on a given date
◦ A statement that segregates cash generated and cash used based on the
source/end use of the cash
What are its components?
◦ Three key components of Cashflow Statement are
Cashflow from Operating Activities
◦ Represents the cash generated from the operations of the enterprise – a measure of
‘cash profit’ from the operations
Cashflow in Investing Activities
◦ Represents the deployment of cash in various assets such as fixed assets, investments,
etc.
Cashflow from Financing Activities
◦ Represents the net cash raised in the form of capital such as equity capital, borrowed
funds, etc.
Construct of a Cash flow Statement
Cashflow from Operating Activities
Profit Before Tax
Less Non-operating income (e.g. Interest income, profit on sale of assets)
Add Interest expense
Add Depreciation
Less Other cash adjustments (e.g. Unrealised foreign exchange loss)
= Operating Profit before Working Capital Changes
Less Increase in Debtors
Less Increase in Inventory
Less Increase in other current assets (e.g. Loans and Advances)
Add Increase in Creditors
Add Increase in other Current liabilities and Provisions
= Cash generated from Operations
Less Taxes
= Net Cash from Operating Activities
Construct of a Cash flow Statement
Cash flow from Investing Activities
Purchase of Fixed Assets (negative because it is cash outgo)
Add Purchase of Long term investments
Less Proceeds from Sale of Fixed Assets or Investments (if any)
Add Interest and Dividend Income
= Net Cash used in Investing Activities

Cash flow from Financing Activities

Proceeds from issue of share capital
Add Proceeds from raising fresh loans
Less Repayment of existing loans
Less Interest expense
Less Dividend paid
= Net Cash Generated from Financing Activities

Opening Balance: Cash and Cash Equivalents

Add Net Cash from Operating Activities
Less Net Cash used in Investing Activities
Add Net Cash Generated from Financing Activities
= Closing Balance: Cash and Cash Equivalents
 Some observations on Cash flow statement

Cash flow statement provides the reference check for the quality of ‘profits’ generated by a
company
◦ For instance, if the company reports profits, most of which remain uncollected in the form of ‘debtors’,
cashflow from operations will be negative, which should prompt an analyst to probe debtors further.

Cash flow statement provides a snapshot of where the cash comes and where the cash goes
◦ Disproportionate cash going into investing activities on a continuous basis could provide a clue on
‘unproductive’ assets in a company.

Cash flow statement, like balance sheet, provides a self-check point

◦ Opening and Closing Cash balances should tie in with the actual balance in the bank account as on the
opening and closing dates. Acts as a good reference check point.

Negative cashflow from operations is not necessarily a sign of distress, especially for a growing
company.
◦ Typically, increase in working capital could be more than the cash profit generated by a growing
company
 Ratio analysis

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
 Ratio analysis

◦ Operating profit margin

◦ Indicates the business profitability
◦ OPM = EBITDA / Operating Income (or Net Sales)
◦ Depending on the industry, for healthy companies, OPM ranges from 15% - 50%

◦ Net profit margin

◦ Indicates the returns generated by the business for its owners
◦ NPM = PAT / Operating Income (or Net Sales)
◦ For healthy companies, NPM ranges from 3% - 12%

◦ Several other ‘profitability’ measures are there (Gross margin,

Contribution margin, etc.) but the above two are most commonly used.
◦ The profitability margins are very useful for peer comparison (i.e.
comparing with other companies in same industry)
 Ratio analysis

◦ Return on Capital Employed

◦ Indicates true measure of performance of an enterprise
◦ The capital employed in business is Equity capital, reserves and surplus, long
term debt and short term debt.
◦ Returns generated for all these providers of capital is EBIT.
◦ ROCE = EBIT / (‘Networth’ + ‘Total Debt’)
◦ The ratio is independent of the industry, capital structure or asset intensity.
◦ For healthy companies, ROCE ranges from 15% - 30%
◦ If ROCE is less than Interest rate for a company consistenty, 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!!!
 Ratio analysis – Lenders’ perspective

Lenders, such as a bank giving loan, or a Mutual Fund investing in bonds or

debentures of a company, may use the following ratios:
◦ Debt:Equity ratio
◦ The ratio of borrowed funds to owners’ funds
◦ D:E ratio is also known as ‘gearing’, ‘leverage’ or ‘capital structure’
◦ Gearing = (Long term debt + Short Term debt)
(Equity capital + Reserves & Surplus)
◦ For most manufacturing companies, D:E less than 2.0x is considered healthy.
◦ Higher the ratio, better it is for owners; but at the same time, more risky for
lenders
◦ Company has to service higher interest cost if it borrows more; in a recession, the
company may be more vulnerable to default on its interest.
 Ratio analysis – Lenders’ perspective

◦ Interest coverage
◦ The ratio indicates the cushion the company has, to service its interest
◦ Interest coverage = EBITDA / Interest cost
◦ Higher the ratio, better it is for the lenders
◦ For healthy companies, Interest coverage ranges from 2.0x to 8.0x.
◦ Interest coverage < 1.0x indicates high stress, and probably default on interest payments.
 Ratio analysis – Lenders’ perspective

◦ Current ratio
◦ This is a commonly used ‘liquidity ratio’, 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.
◦ Indirectly, the ratio also indicates the proportion of long term assets funded by long term liabilities.
◦ For solvent companies, current ratio ranges between 1.2x to 2.0x
◦ Current ratio of < 1.0x indicates that the company may face liquidity problems, as more
current liabilities / short term debt are maturing in the next one year, than the current
assets that are maturing in the same period.

Please read the commentary:

http://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-a
bout-current-ratio_Dec05.pdf
 Ratio analysis – Equity investors’ perspective

Equity investors, such as a Mutual Fund investing in shares, or an individual

investor, or a Private Equity investor, 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.
◦ This represents each shareholder’s claim in the profits of the company, for the
relevant period (one year, one quarter, etc.)
◦ Two common sub-classification are Basic EPS and Fully Diluted EPS
◦ Basic EPS is computed based on no. of shares outstanding currently
◦ Fully Diluted EPS is computed assuming all ‘convertibles’ and ‘options’ are exercised
fully.
 Ratio analysis – Equity investors’ perspective

◦ 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.
◦ When EPS is negative, 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, PE ratio is in the range of 5-12x during recession times and
10-25x during boom times.
◦ The ratio is also related to the growth in earnings that the company can generate in the
next few years.
Thank you!