financial analysis introduction 5.6 1. how accounting helps analysis of financial statement helps...

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Financial analysis

Introduction

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How accounting helps

• Analysis of financial statement helps provide right information of the strength and weakness

• Helps companies manage business efficiently

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What financial statements contain?

• Contains financial information of the company’s operation during the period

• Contains comparative figures• Also contains qualitative information about

the management and key decisions

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Uses of financial statements

• Legal obligation• Balance sheet and profit and loss account

can be studied to ascertain the status• Stakeholders like investors, regulators,

stakeholders use the statements to study performance

• Organisation uses the data to study internal performance like cost of operations, liquidity etc.,

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Helps in management decisions

• Budgeting and profit planning• Management of cash flow• Operations management and control• Major decisions– Trade off between buying and leasing– Helps choice of products and product lines– Marketing techniques to be adopted– Choosing the right operations

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Why we need to understand

• Our competitors run the business as a commercial organisation

• For evaluation of performance we need to understand how industry works and the standards

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Reading financial statements

Overview

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Balance sheet - Introduction

• A snapshot of financial position of a company

• Reveals– Company’s assets– Liabilities– Owner’s equity (net worth)

• FormulaAssets = Liabilities + Shareholder’s equity

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Assets

• Things that a company owns• Assets have a value, can be sold• Used by companies to make products or provide

services that can be sold• They include

– Plant and machinery– Other equipments– Inventory (stock of raw material, work-in-progress and finished

goods)– Cash and its equivalent

• Can be classified as current, non current and intangible

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Liabilities

• Money that company owes to others• Includes all kinds of obligations• Categorised as long term and short term

(current) liabilities• Long tem liabilities include debt and other

non-debt financial obligations• Current liabilities are those that are short

term borrowings and other payments due for payment within one year

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Shareholder’s equity

• This is the initial investment into business by investors

• It may also include the retained earnings• Together it is called networth of a

company

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Balancing

• The left side of the balance sheet has the liabilities and net worth

• The right side has the assets• For the balance sheet to balance, total

assets on the right side has to equal total liabilities plus net worth

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Sample balance sheet

•Balance sheet of Dabur India Limited•Shows in the form of Sources and Uses of funds

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Financial statement

• Balance sheet• Income statement• Cash flow statement

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Balance sheet analysis

• Sources of funds– Capital– Reserves & Surplus– Term Liabilities– Current Liabilities

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• Uses of funds– Fixed Assets– Intangible assets– Non current assets– Current assets

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• Capital– Authorised capital– Issued capital– Subscribed capital– Paid up capital

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• Reserves– General reserves– Revaluation of fixed assets– Issue of shares at premium

• Surplus– The credit balance in Profit and loss account

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• Tangible net worth– Refers to total funds arrived at adding up capital,

reserves and surplus less intangible assets

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• Long term liabilities– Redeemable preference shares– Debentures– Deferred payment guarantees– Public Deposits(Repayable after 12 months)– Term loans and unsecured loans from friends,

relatives, directors repayable over a period of time

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• Current liabilities– Working capital bank borrowings– Term loans deferred credit installments falling due in 12

months– public deposits maturing within 12 months– unsecured loans, unless the repayment is on deferred terms– sundry creditors– advances from dealers and customers– interest accrued but not paid– tax provisions– Dividend declared and payable

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• Contingent liabilities– Tax disputes– Legal litigations– Bills and cheques discounted with banks– Claims against the company not acknowledged

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• Fixed Assets– Infrastructure like land & building– plant & machinery– Vehicles– Furniture & fixtures

• Depreciation– Straight line method– Written down Value Method

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• Investments– Shares And Securities– Associate Companies– Fixed deposits with banks/finance companiesRemarks– While analysing bal sheet we can analyse necessity

of such investments– While fixed deposits with banks are considered as

fixed assets, the investments in associate concerns are treated as non current assets.

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• Non Current Assets– Deferred receivables/Overdue receivables(like

disputed amounts and overdue > 6 months)– Non moving stocks/inventory/unusable spares – Investment/Lending to associate concern– Borrowing of the directors from the company– Telephone deposits/ ST deposits etc

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• Intangible Assets– Preliminary & Preoperative expenses– Deferred Revenue Expenditure– Goodwill– Trade mark– Patents

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• Current Assets– Raw materials, work-in-progress,finished

goods,spares and consumables– Sundry debtors and receivables < 6 mths– Advances paid to suppliers of raw materials– Cash and bank balances– Interest receivables– Other current assets such as Government

securities, Bank deposits ..etc

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• Notes– Management competence– Investment decision– Resorting to window dressing– experience of the promoters– Board comprises of only family members– The key personnel of the company– The structure of the organisation– The authority and decision making are decentralised

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• Notes– The state of industrial relations– Financial systems and procedures– management control– planning, budgeting, forecasting– capacity utilisation– status of the technology– awareness of the market, competitions ..etc– for listed co: share prices, EPS, book value, dividend

record, public response ..etc5.6

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• Exercise 1

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Profit and loss account

• It is a summary of revenue earned and expenses incurred which ultimately results in profit or loss of to the company

• No defined format in law• Operating revenue = Sales revenue• Non-operating revenue = Other income ( out of

sale of investments, interest, commission and discount etc)

• Hence operating profit is a yard stick for operating profit of the company

• Operating profit = Sales Revenue- Operating Cost

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• Gross Sales– Gross sales includes excise duty to be charged to

the customer, central sales tax applicable, state sales tax applicable, the discount o be allowed to distributors/dealers/customers. The gross sales appears in the P&L account comprises of all the above part from the basic unit price.

• Net Sales– The sales figure excluding all the factors explained

above are the net sales

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• Cost of production– This is the cost incurred right from the procurement of raw

material to the finished good.– For ex in a garment firm following cost is incurred while

production• cost of raw material cloth, buttons, canvas, hooks, zips etc• Maintenance of sewing machines• payment of wages to workers• Power• Washing, ironing, packing etc.

• Cost of Production excludes selling & admin exp & interest cost

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• Selling And General Administrative Expenses– Maintaining office staff for admin & accounting– marketing effort– payment of salaries/Allowances to marketing

personnel– All the expenses which are not directly connected

to manufacturing are classified as selling and/or general expenses

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• Cost of goods sold– Cost of goods sold includes all manufacturing

expenses and the adjustments for opening and closing stock

– Cost of Goods sold = Opening stock + Purchases + Manufacturing expenses - Closing stock

• Gross Profit – arrived deducting figure of cost of goods sold from

the sales figure• Gross profit = Sales - Cost of goods sold.5.6

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• Operating Profit is arrived deducting selling, administrative and general expenses , provision for bad debts, interest and miscellaneous expenses from the gross profit.

• ie Op Profit = Gr Prof - (Sel & adm exp + Prov bad debt + mis exp )

• Profit Before Tax When other income is added and other expenses are deducted from the operating profit we get profit before Tax

• ie PBT = Op Profit + oth Inc - oth exp • Net Profit When provision for taxes is deducted from

the Profit Before Tax we get Net profit• ie Net Profit = PBT - taxes

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• Non Operating Income/Expenses – The income earned by the unit from other than

manufacturing and selling operations is classified under this head . i.e • Interest earned on fixed deposits• Dividends and profit earned by sale of assets and share.

– All those expenses which are not directly connected with operations of the unit are classified under this head. i.e • Preliminary expenses written off• Loss suffered due to sale of assets & share

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Ratio analysis

• Standardize numbers across industry – facilitate comparison

• Used to highlight weaknesses and strengths

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Categories of ratios

• Liquidity – Can the business make required payments as they fall due?

• Asset management – Does the organisation have the right amount of assets for the level of shares

• Debt management – Does the company have the right mix of debt and equity

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Categories of ratios

• Profitability – Do the sale prices exceed the unit cost

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Debt to equity ratio

• Compares company’s total debt to shareholder’s equity

• Data for calculation can be found in company’s balance sheet

• To calculate the ratio, divide the company’s total liabilities by the shareholders’ equity

Debt-to-equity ratio = Total liabilities/shareholders’ equity• If the ratio is 1.5:1, the company has a debt

of Rs. 1.50 for every Re 1/- of the equity

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Inventory turnover ratio

• Compares the company’s cost of sales to the inventory for a given period

Inventory turnover = Sales/Inventories• A higher ratio indicates quick movement of

stock• A low ratio indicates slow movement and

accumulation of old stock

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Operating margin

• Compares company’s operating income (before interest and taxes) to revenues

• Expressed as a percentage of revenue• Shows the amount of income for every

rupee of sale• Indicator of the profit margin

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Price/Earning ratio

• Compares company’s common stock price with its earning per share

P/E Ratio = Price per share/Earnings per share

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Working capital

• Working capital is the money left after paying the current liabilities

Working capital = Current assets – Current liabilities

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Exercise 2

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