Analysis of Financial Statements

Module 1

Dr. Gagandeep Sharma, SJIM

Analysis of Financial Statements 1

Introduction

Analysis of Financial Statements 2

 About the Course
 Title: Analysis of Financial Statements
 Text book: Financial Statement Analysis by K.R. Subramanyam
 Assessment:
• Term Exams: 60%
• Assignment: 20%
• Group Project: 20%
 Class Timings: Follow the scheduled class timings strictly
 Mobile Phones: Mobile phones are strictly prohibited during class
 Communication:
• Email: gagandeep@[Link]
• For common information approach through your class representative
• For discussion, email for appointment with the agenda
• Room – 216A; second floor
 Non-negotiable: case readings and assignments!

Analysis of Financial Statements 3

Business Analysis
 Evaluates risks and prospects of business for
decision making:
• equity and debt valuation, credit risk assessment,
earnings predictions, audit testing,
compensation negotiations etc.

Analysis of Financial Statements 4

Business Analysis – Why?

Credit Analysis
• Determine credit value
• Trade creditors
• Debt holders
• Creditworthiness?
• Focus on Risk of default?

Equity/ Prospective Analysis

• Determine intrinsic value of company/stock
• Fundamental vs. technical analysis
• Concerned with upside and downside

Analysis of Financial Statements 5

Credit analysis

Liquidity
• Ability to meet short-term obligations
• Focus:
• Current cash flows
• Composition of current assets and
liabilities
• Liquidity of assets
Solvency
• Ability to meet long-term obligations
• Focus:
• Long-term profitability
• Capital structure

Analysis of Financial Statements 6

Prospective Analysis

Analysis of Financial Statements 7

Business Analysis – Why?

Managers

Mergers, acquisitions & divestitures

Financial management

Labour negotiations

Regulations

Director oversight

External auditing

Analysis of Financial Statements 8

Business Analysis - Components

Analysis of Financial Statements 9

 Business Environment and Strategy Analysis
 Analysis of company’s economic and industry circumstances:
• SWOT
 Two main parts:
• Industry analysis
 Porter's 5 forces model
 Comments on prospects as well as actual and prospective competition
• Strategy Analysis
 How will you establish competitive advantage?
 Evaluates responses to changes in environment
• Product mix, cost structure, differentiation
• It is more inte-functional and requires knowledge of:
 Economic and industry forces
 Strategic management
 Business policy
 Production,
 Logistics management
 Marketing, etc.

Analysis of Financial Statements 10

Accounting Analysis
 Does a company’s accounting statements reflect its economic reality?
• Adjust statements accordingly – recasting or reformulation
• Especially required for comparability problems:
 Comparison across firms in industry and across time – comparative analysis
• Accounting distortions leads to accounting risk:
 Manager estimation error
 Earnings management
 Accounting standards
 Regardless of the purpose / user unearthing earnings management is a key aim of accounting
analysis
• Evaluating earnings quality requires analysis of:
 company’s business, its accounting policies, the quantity and quality of information disclosed, the
performance and reputation of management, and the opportunities and incentives for earnings
management.

Analysis of Financial Statements 11

 Financial Analysis
 Answers questions that are:
• Future oriented
• Past/ track record
 Profitability analysis:
• Source: margin vs. capacity
utilization
 Role of non-operating income
 Risk analysis:
• Solvency and liquidity
 Cash flow analysis
• Accrual vs. cash profits
 Future financing/ payouts

Analysis of Financial Statements 12

 Basis of analysis: Business Activities
 Planning activities sources:
• Letter to shareholders
• Management’s discussion and analysis Planning
 Financing activities:
• Internal vs. external (equity vs. debt)
• Earnings distribution, dividend payout etc.
 Investing activities:
• Type (operating vs. financial), amount Operating
required, timing of acquisition, location etc. Activities
 Operating activities:
• Research and development, procurement, Financing Investing
production, marketing, and administration

Analysis of Financial Statements 13

 Financial Statements
 Balance Sheet
 Income Statement
 Statement of Shareholder’s equity
 Statement of Cash Flows

Analysis of Financial Statements 14

 Balance Sheet
 Balance Sheet (pg. 118)
• Financial position at a point-in-time
• Reflects accounting equation
 Assets = Liabilities + Equity
 Total investing = Total financing (creditor + owner)
 Uses = Sources of funds

Analysis of Financial Statements 15

 Income Statement / Profit & Loss Account
 Operations over the accounting period (Pg. 127)
• Gross profit = Revenues – COGS
• Operating profit = Gross profit – operating expenses
• Net profit = Operating profit adjusted for non-operating incomes and expenses

Analysis of Financial Statements 16

 Statement of changes in Shareholder’s Equity
 Statements of retained earnings, comprehensive income and changes in capital accounts are often
called the statements of changes in shareholders’ equity. (119, 180)
• EPS (basic vs. diluted)
 Comprehensive income –
• Account for changes like
 MTM on available for sale securities / forex
 Cash flows from derivatives
 Revaluation of pension plans
 Revaluation of assets

Analysis of Financial Statements 17

Link Between Financial Statements

Analysis of Financial Statements 18

Additional Information

Management’s Discussion and analysis

Management report

Auditor Report

Explanatory Notes

Supplementary Information

Proxy statements

Analysis of Financial Statements 19

 Analysis Preview
 Analysis Tools
1. Comparative financial statement analysis
2. Common-size financial statement analysis
3. Ratio analysis
4. Cash flow analysis
5. Valuation

Analysis of Financial Statements 20

 Analysis Preview
 Analysis Tools
1. Comparative financial statement analysis
2. Common-size financial statement analysis
3. Ratio analysis
4. Cash flow analysis
5. Valuation

Analysis of Financial Statements 21

 Comparative Financial Statement Analysis
 Evaluation of consecutive years’ financial statements
• Horizontal Analysis
 Output: trends in sales, expenses, profits, assets, liabilities etc.
 Types:
• Year-year change analysis
• Index-number trend analysis
 Current yr. *100/ previous yr.
 Issues
• -ve figures
• Long-period comparison
• Base effect
 Report median / mean
 Only focus on significant items!

Analysis of Financial Statements 22

 Common-size Financial Statement Analysis
 Analysis of proportions in a statement
 Express all items as a %age of some common item
• Balance Sheet: Total assets/liabilities
• Income Statement: Net/gross sales
 Vertical analysis
 Focus is on make-up of items:
• Sources of financing
• Composition of assets
• Proportion of revenues and expenses
 Usually more detailed than trend analysis
 Facilitates inter-firm comparison

Analysis of Financial Statements 23

Common-size Financial Statement Analysis

Analysis of Financial Statements 24

 Ratio Analysis
 Establish relationship between two or more economically important items
 Factors affecting ratios:
• Economic events
• Industry factors
• Management policies
• Accounting methods
 Prior accounting analysis is important e.g. LIFO usage or contingent liabilities like leases
 It is all about interpretation!
• What's causing change?
• Benchmarking
• Comparisons with past
• Budgets

Analysis of Financial Statements 25

 Ratio Analysis
 Categories of ratios
• Overall performance and profitability
• Efficiency and investment utilization
• Leverage and financial condition
• Market ratios and dividend

Analysis of Financial Statements 26

 Overall Performance and Profitability
 Return on equity (ROE) = Net income / Avg. Shareholders’ equity
• 𝑅𝑂𝐸 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 × 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 (equity multiplier)
• 𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒/𝑆𝑎𝑙𝑒𝑠 × 𝑆𝑎𝑙𝑒𝑠/𝐴𝑠𝑠𝑒𝑡𝑠 × 𝐴𝑠𝑠𝑒𝑡𝑠/𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟’s 𝐸𝑞𝑢𝑖𝑡𝑦
 This decomposition is DuPont Analysis
 Return on invested capital (ROIC) =
[EBIT (1- Tax Rate)] / 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑑𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 – non operating assets
 Return on capital employed (ROCE) = EBIT / Average Capital Employed
 Where Average Capital Employed = TNW + tern liabilities + current liabilities
 Return on assets (ROA) = Net income / Avg. total assets or EBIT (1 – Tax rate) / Avg. total assets
• ROA = [Net income/ Avg. Equity] * Av.g Equity / Avg. total assets]
• ROA = ROE / Equity Multiplier

 Profitability
• Gross Profit Margin= Gross Profit/Net Sales; where gross profit = sales - COGS
• EBITDA Margin = EBITDA/Net Sales
• Operating Profit Margin = Operating Profit/Net Sales; where operating profit = gross profit – operating expenses
• Net Profit Margin = Net Income /Net Sales
• Expense Ratio = Expenses / Net Sales

Analysis of Financial Statements 27

 Efficiency and Investment Utilization
 Total asset turnover = Sales/Total Assets
 Fixed asset turnover = Sales /PPE
 Working capital turnover = Sales / Working Capital
 CA turnover = Sales / Current Assets
 AR turnover = Credit Sales/ Av. AR
• Collection period or Days sales outstanding (DSO) = Accounts receivables / Credit sales per day
 Inventory turnover = COGS / Av. Inventory
• Days’ sales in inventory (DSI) or days inventory outstanding = Ending inventory / (COGS / 365)
 Payables period: Av. no of days to pay AP= Accounts payables/ Credit purchases per day
• Days’ payable outstanding (DPO) = Accounts Payable / (COGS / 365)

Analysis of Financial Statements 28

 Operating and cash cycle

 Operating cycle = Inventory Holding Period + Collection Period

 Cash Conversion Cycle = (DSO + DSI – DPO)
Days sales outstanding + Days sales in inventory – days payables outstanding
How long to collect cash from customers + how long inventory sits in before being sold – how long to pay
suppliers

Analysis of Financial Statements 29

 Leverage and Financial Condition Ratios
 Liquidity: meet short term obligations
• Current ratio = Current Assets/Current Liabilities
• Quick / Acid-test ratio = (Current Assets-Inventory)/Current Liabilities
 Solvency: meet long term interest costs and repayment obligations
• Debt-to-assets ratio = Total Liabilities/Total Assets
• Debt-to-equity ratio = Total Liabilities/Equity
• Interest coverage ratio = EBIT/ Interest Paid

Analysis of Financial Statements 30

 Market Value and Dividend Policy
 EPS = PAT/ Number of shares
 Price to Earnings (PE) = Market price per share / EPS
• How market judges the future prospects of the company
 Dividend Yield = Dividend per share / Market price per share
 Dividend payout rate = Dividends / Net income
• More retention is a good sign
 Price-to-book = Market price per share / Book value per share

Analysis of Financial Statements 31

Financial Reporting and
Accounting Standards
Financial Reporting – Rules?
 Accounting standards (AS) are a set of principles,
standards, and procedures that serve as the foundation
for financial accounting policies and practices.
 Variety of standards
• GAAP – FASB
• IFRS (18) – International Accounting Standards
Board
• IAS (41) – International Accounting Standards
Committee (IASC) (till 2001)
• Ind AS - ICAI
 Ind AS is in confirmation to international standards
• A set of 39 standards
• ([Link]
• Naming convention depends on the source of
conformity
• Notified in 2015 by MCA – the Companies (Indian
Accounting Standard Rules), 2015
• Staggered applicability post 2016-17

Analysis of Financial Statements 33

Financial Reporting – SEBI Rules
 The SEBI (Listing Obligations
and Disclosure Requirements)
Regulations, 2015 (“LODR
Regulations” or “LODR”)

Analysis of Financial Statements 34

IndAS, IFRS, GAAP – key differences
 Indian companies cannot use IFRS and GAAP for statutory reporting
 US GAAP reporting is required if:
• Mergers and acquisitions and capital-raising ([Link]
filings/quarterly-results/2000-2001/q1/[Link])
• Foreign businesses
• Foreign stakeholders
 Under GAAP companies require:
• A statement of financial position;
• A statement of profit or loss and other comprehensive income;
• A statement of changes in equity;
• A statement of cash flows; and
• Notes comprising significant accounting policies and other explanatory information
IndAS, IFRS – key differences
 Ind AS and IFRS have converged but minor
differences are there:
[Link]
• Some IFRS/IAS haven’t been notified
• Carve-outs (carve-ins) which are due to differences in
application of accounting principles and practices and
economic conditions prevailing in India.
• Other changes in Indian Accounting Standards vis-a-vis
IFRS not resulting in carve-outs
Accounting Analysis
 Why know about accounting standards?
 Accounting analysis
• Adjust for accounting distortions – accrual accounting
• Adjust general-purpose financial statements to meet end-users’ objectives
Desirable Qualities of Accounting Information
 Relevance – the capacity of information to affect a decision
• Timeliness, materiality
 Reliability: contingent liabilities?
• Verifiability
• Faithfulness
• Neutrality
• Substance over form (what’s the transaction about?)
• Prudence
• Completeness
Financial Reporting - India
 Ind AS1 Presentation of Financial Statements
 Six sets of statements are required
• A complete set of financial statements, which should be presented, including comparatives, at least
annually consists of:
1. A balance sheet as at the end of the period;
2. a statement of profit and loss for the period;
3. a statement of changes in equity for the period;
4. a statement of cash flows for the period;
5. notes, comprising significant accounting policies and other explanatory information;
6. comparative information in respect of the preceding period.

Analysis of Financial Statements 39

Framework
 ICAI lays down a “Framework for the Preparation and Presentation of Financial Statements in accordance
with Indian Accounting Standards”
 Deals with:
• Objectives
• Qualitative characteristics that determine the usefulness of the information;
• the definition, recognition and measurement of the elements from which financial statements are constructed;
and
• concepts of capital and capital maintenance
 Users
• Investors
• Employees
• Lenders
• Suppliers and trade creditors
• Customers
• Government and their agencies
• Public

Analysis of Financial Statements 40

Important principles
 Accruals
 Historical cost and fair value
 Materiality
 Conservatism
• Delay good news!

Analysis of Financial Statements 41

Limitations of accounting information
 Timeliness
 Frequency
 Forward looking

Analysis of Financial Statements 42