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Financial Statement Analysis

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Financial reporting provides information about performance, financial position, andchanges in financial position

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Food for thought

Suppose you were working with Satyam in 2008. If you had analyzed the previous 3years financial statements, would you have discovered that cash was diverted fromthe company?

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The objective of an audit of financial statements is to enable the auditor to express anopinion whether the financial statements are prepared, in all material respects, inaccordance with an applicable financial reporting framework.

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Why FSA

Evaluating equity investment

va ua ng

Assigning credit rating

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Accounting principles

Historical cost basis

Going-concern rule Matching principle

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Accounting principles

Consistency rule

Conservative principleMateriality rule

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Liquidity Vs Solvency

Liquidity refers to the ability to meet short-term obligations

Solvency refers to the ability to meet long-term obligations

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Accounting Process

Voucher

(Documentation)

Journal(Day book)

Ledger(Classification)

Trial Balance

(Summarizing)

Financial Statements

(Bifurcation) 9


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Documentation and Recording

Three rules of accounting

Debit the receiver Debit what comes in Debit all expenses and losses

Credit the giver Credit what goes out Credit all incomes and gains

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Whats relevant for whom?

Particulars Amount

Net Sales/Income from Operations 460233.00

Other Operating Income 5800.00

Other Income 40945.00

Interest 5077.00

Lenders?Owners?

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Net Profit (+) / Loss (-) for the period 211809.00

Dividend (%) -

Face Value (in Rs.) 1.00

Paid-up Equity Share Capital 8310.00

Reserves excluding RevaluationReserves

712561.00

Diluted EPS after Extraordinaryitems (in Rs.)

25.31

Public Shareholding (%) 42.97

OwnersEmployeesPublic-at-large?

Lenders?

Owners?

LendersOwnersEmployeesPublic-at-large?


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Balance Sheet

Report format

Account format

Income statement

Cash flow statement

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Balance Sheet

What are assets? Resources from which future economic benefitsare expected to flow to the enterprise

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Typical Assets

Cash and cash equivalents

Inventories

Receivables

Prepaid expenses

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Property, plant, and equipment

Intangible assets

Investments


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Statement of financial position at the end of the period

Statement of comprehensive income for the period (presented as either a singlestatement or an income statement with a statement of recognized gains and losses)

Statement of changes in equity for the period

Statement of cash flows for the period

Notes, including a summary of significant accounting policies

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Food for thought

Physical form? Patents, copyrights?

Legal rights? Hire-purchase?

Purchased/produced?

Government granted land?

Expenses incurred? Unsuccessful digging of oil wells?

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Balance Sheet

What are liabilities? Present obligation likely to be settled in the future

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Typical Liabilities

Borrowings

Payables

Provisions

Unearned revenues

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Financial liabilities

Accrued liabilities

Deferred tax liabilities


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Food for thought

Rectifying defects beyond

warranty period?

Maintaining good business relation,liability

Estimating liability? Provisions. Retirement benefits?

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Balance Sheet

What is equity? Assets less Liability?

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Food for thought

Decision needs of users?Owners capital, General Reserve,Capital Reserve

Creditor rotection? Debenture redemption reserve

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Points to Ponder

How should firm fund their assets?

Corporate finance decision

Why is equity capital important

Financial distress, optimal capital structure

Corporate strategy

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Special Note- Inventories

Lower of cost or NRV

What is dating?

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Points to Ponder

Should firms carry all its assets on historical cost basis?

Relevance of Price-to-book multiple in firm valuation

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Special note- Intangibles

Identifiable intangible

Unidentifiable intangible

Amortized over estimated useful life

Tested for impairment every year

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Is goodwill same as control premium?


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Income Statement

What is Income? Increase in economic benefitduring a year

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Income Statement

Net Income or Net profit = Revenue - Expenses

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Income statement

Function of expense method

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Eh-Bit-Duh?


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Classification using nature of expense method

Revenue

Other income

Changes in inventories of finished goods and work in progress

Raw materials and consumable used

Employee expenses

Depreciation and amortization expense

Other expenses

Total expenses

Profits before tax

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Food for thought

Does Sales have the same meaning as Revenue?

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Revenue Recognition- Goods

Evidence of an arrangement between buyer and seller

Disallows practice of recognizing revenue by delivering the product justbefore the end of an accounting period and then completing a salescontract after the period end

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,

Precludes revenue recognition when the product has been shipped but risksand rewards of ownership have not actually passed to the buyer


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Revenue Recognition- Goods

Price is determined or determinable

Precludes firms from recognizing revenue based on contingency

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Seller reasonably sure of collecting money

Preclude firms from recognizing revenue when the customer is unlikely to pay


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Revenue Recognition- Services

Outcome of a transaction involving the rendering of services can be estimated reliably

Amount can be measured reliably

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Probable that economic benefits will flow to the entity

Stage of completion of transaction can be measured reliably

Costs incurred can be measured reliably


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From Annual Report: Revenue Recognition

1. Revenue on time-and-material contracts are recognized as the related services areperformed and revenue from the end of the last billing to the Balance Sheet date isrecognized as unbilled revenues.

2. Revenue from fixed-price, fixed-timeframe contracts, where there is no uncertainty asto measurement or collectability of consideration, is recognized based upon the

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percentage-of-completion.

3. When there is uncertainty as to measurement or ultimate collectability, revenuerecognition is postponed until such uncertainty is resolved.

4. Cost and earnings in excess of billings are classified as unbilled revenue while

billing in excess of cost and earnings is classified as unearned revenue.


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Revenue Recognition- Special Cases

Long-term contracts

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Expense Recognition

Matching Cost Principle

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er o os


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Issues In Expense Recognition

Warranty on sales

Depreciation and Amortization

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Points to Ponder

What if accumulated depreciation is a large percentage of total fixed assets?

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Accounting equations

Assets= Liabilities + Owners equity

Assets - Liabilities = Owners equity

Owners equity = Contributed capital + Retained earnings

Revenue - Expenses = Net income (loss)

Ending retained earnings = Beginning retained earnings + Net income- Dividends

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Why Cash Flow Statement

Provides information about cash receipts and cash payments during an accountingperiod

Shows cash flow linkage between ending cash balance and beginning balance

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Cash Flow Statement

Disclosing sources and uses of cash helps statement users evaluate the companysliquidity, solvency, and financial flexibility

CFO CFFCFI

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Bond Issue

Actual interest rate Vs Effective interest rate

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Accounting for Carbon Credits

Clean Development Mechanism

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Certified Emission Reduction


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Accounting for Leases

Operating Lease

Financial Lease

Ownership of leased asset transfers to lessee at end of lease

Lease contains option for lessee to purchase leased asset cheaply

Lease term is 75 percent or more of useful life of leased asset.

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Recent ED

PV of lease payments is 90 percent or more of FV of leased asset.


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Deferred Taxes

Taxable profits Vs Accounting Profits

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Tax Asset, Tax Liability


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Corporate Frauds

Financial statement fraud

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Corruption


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Financial Statement Fraud

Understating liabilities

Misuse of materiality concepts

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Overstating revenue

Understating expenses

Overstating assets


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Red Flags: Overstating Income

Increased revenues without corresponding increase in cash flow

Unusual growth in days receivables

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Significant, unusual or highly complex transactions, particularly those that areclosed near the end of a financial reporting period

Strong revenue growth when peer companies are experiencing weak sales


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Red Flags: Understating expenses

Significant unexplained increases in fixed assets

Recurring negative CFO despite positive earnings and earnings growth

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Cookie Jar Reserves

Smoothing of earnings, overestimating liabilities during good times

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Ratio Analysis- Asset Utilization Measurement

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Ratio Analysis

Sales-to-Working Capital Ratio

Annualized net sales(Accounts receivable + Inventory Accounts payable)

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Ratio Analysis

Sales-to-Fixed Asset Ratio

Annualized net sales

Total fixed asset

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Ratio Analysis

Accumulated Depreciation to Fixed Assets Ratio

Accumulated depreciation

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Total fixed assets

Is company strapped for cash? Analysis of Cash Flow Statement


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Ratio Analysis

Investment Turnover

Sales

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Equity + Long-term liabilities

Read with Debt-Equity RatioOptimal capital structure


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Ratio Analysis

Break-even Point

Total operating expenses

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verage gross marg n percentage


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Ratio Analysis

Margin of Safety

Current sales level Break-even point

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Current sales level


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Ratio Analysis- Operating Performance Measurement

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R ti A l i


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Ratio Analysis

Gross Profit Index

Gross profit in period two

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Gross profit in period one

Sales in period one

G P fit I d R d Fl


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Gross Profit Index: Red Flags

Accounting changes

Business issues

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Corporate strategy


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Ratio Analysis- Cash Flow Measurement

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Ratio Analysis


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Ratio Analysis

Cash Flow From Operations

Net Income + Noncash ex enses Noncash sales

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Net Income

Ratio Analysis


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Ratio Analysis

Cash Flow Coverage Ratio

Total debt payments + Dividend payments + Capital expenditures

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Net income + Noncash expenses Noncash sales

Ratio Analysis


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Ratio Analysis

Cash Flow to Fixed Assets Ratio

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+ -

Capex

Points to Ponder


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Points to Ponder

What if the Cash Flow to Fixed Assets Ratio is one?

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Read with Return on Equity?


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Ratio Analysis- Liquidity Measurement

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Ratio Analysis


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Ratio Analysis

Average Receivables Collection Period

Average accounts receivable

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Annual sales / 365

Points to Ponder


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Points to Ponder

How about annualizing sales for the period covered by the existing accounts receivable?

Is annualizing monthly sales acceptable?

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Ratio Analysis


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Ratio Analysis

Inventory Turnover/Days Inventory

Cost of goods sold

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----Inventory

365/Inventory Turnover Ratio


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Ratio Analysis- Capital Structure and Solvency

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Ratio Analysis


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Ratio Analysis

Times Interest Earned

Average cash flow

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Average interest expense

What about principal repayments?

Ratio Analysis


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y

Debt Service Coverage Ratio

Earnings before interest and taxes

Scheduled rinci al a ments

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Interest +

(1 Tax rate)

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