Analysis Of Financial Statements 2h4j1p
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Analysis of Financial Statements
The basic question
What do we finance ?
Cost ? or Asset ?
We finance Cost
Asset is a Security Cover guaranteed by legal rights or charges
The corollary
Two principles of financing
Cash flow backed financing
Lender gets a legal charge on the cash flow
Asset backed financing
Lender gets a legal charge on the assets created
Asset backed financing The concept of security
Primary security
Assets created out of bank finance
Collateral security
Any other asset charged to the bank against the loan
The basic question
Whom do we finance ?
How do we judge him ?
Borrower The 3 ‘C’s Capital, Capacity & Character
The judgment requires and makes use of Prudence, Due diligence & Analysis
Credit Appraisal The process of decision making in Credit by undertaking Informed Analysis using Prudence, Due diligence & Conservatism
Informed Analysis
Attribute based
Financial statements based
Please count every ‘F’ in the following text FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY COMBINED WITH THE EXPERIENCE OF YEARS
Financial Analysis
We ‘see’ things but do not ‘observe’
We ‘write’ things but do not ‘say’
Financial Analysis
Why Analysis ?
To get a true & fair view ?? Perspectives may vary with the Analysis is a prerogative of the decision maker Analysis for decision making
The approach for analysis ?
Objective Meaningful
The BALT approach to Financial Analysis
BANKING
ING
LEGAL
TAXATION
Financial Statements - the components
Statement of profit & loss (P&L ) Statement of assets and liabilities (Balance Sheet), Cash flow statements Explanatory schedules or notes forming part of these statements Earnings per Share (EPS) statements Report by the Board of Directors Directors’ Responsibility Statements
Financial Statements - the components
Auditors’ Report
Notes to s Observations & Qualifications, if any Report as per CARO 2003
CARO 2003 Company Auditors Report Order, 2003 Applicable to all companies except
Banking Companies Insurance Companies Section 25 companies Private companies with PUC
+ Reserves <= Rs.50 lakh Public Deposits - NIL Loan from Bank/FIs <= Rs.10 lakh Annual sales turnover <= Rs. 5 Cr.
CARO 2003 - relevance for banks
Disposal of fixed assets Has it affected the going concern ? Records of inventory & physical verification Conducted ? Properly ed for ? Loans (secured / unsecured) taken / granted ? Interest, Repayment, Conduct, Transactions - Regular? Accepted deposits from public ? Provision of sec. 58A & 58AA complied with ? Deposit of undisputed statutory dues Regular in payment ? Arrears ? Is it a sick company under SICA ? Provision of sec. 58A & 58AA complied with ? Whether defaulted in repayments to banks / FIs ?
Extent & period ?
Financial Statements Other important information
Contingent liabilities
Off balance sheet items
Market information
Building Blocks of Financial Statements
Fundamental concepts
Local ing Standards
International ing Standards
US GAAP
Structure of presentation of Balance Sheet Liabilities
Assets
Capital & Reserves
Fixed Assets
Secured Loan Unsecured Loan
Investments Current Assets, Loans & Advances Miscellaneous expenses to the extent not written off Total
Current Liabilities & Provisions Total
Structure of presentation of Balance Sheet (as required for analysis) Liabilities
Assets
Short term Bank borrowing Cash & Bank balance Other Current Liabilities (incldg. Trade Creditors, Provisions etc.) Term Liabilities
Inventories, Receivables etc. (assets chargeable to Bank)
Net Worth
Net Block (Fixed Assets less Depreciation) Intangible Assets Total
Total
Other Current Assets
What is the difference between the styles of presentation ?
From the promoter’s perspective
Permanency of liabilities and assets
From the banker’s perspective
Currency of liabilities and assets
This is the reason why from the point of view of a Credit Analyst :
classification of Assets and Liabilities as Current and non-Current assumes considerable importance.
The Credit Analyst may therefore have to restructure the financial statements
according to his needs i.e. making a meaningful analysis of the figures for his decision making
To make the analysis meaningful, it may be necessary to : include delete, or reclassify
some items of expenses, assets or liabilities
We may call it recasting, reclassification or restructuring of the financial statements
Current Assets
Current Assets are assets like Cash, Bank balances and other resources that are reasonably expected to be realized or consumed within one year of the date of the Balance sheet. Thus, Current Assets include : Cash Bank balances Inventory holding comprising of Raw Material, Semi - Finished goods, Finished goods, consumables etc. Advance payment made Prepaid expenses Advance Tax etc. Margin deposited against BG for WC purposes etc.
Current Liabilities
Similarly, Current Liabilities are those obligations of the enterprise that are reasonably expected to be liquidated within one year from the date of the Balance sheet, either through the resources classed as Current Assets, or through the creation of other Current Liabilities. Accordingly, Current Liabilities include : Bank borrowings for Working capital purposes Other short term credits Trade Credits Expenses due but not paid Provisions made for expenses / losses Advance payment received Instalment of Term Loan due within a year etc.
However, there may be cases where :
The maturity period of any of the Current assets and Current Liabilities may be more than a year
Thus, the one year temporal standard to determine the validity of “Current-ness” may not be universally valid
Therefore, what may be Current or non-Current also depends on the core business activity marked by technological requirements and trading practices
Tips for re-classification Value of an asset – lower of the market value or reported value Assessed value < reported value ?? Create provision New provision carved out of Net worth i.e. Capital and Reserves.
Should we carry an asset which is no more relevant ?? Take out of the Balance Sheet Make adjustments against Net Worth.
Revaluation – company perspective Balance Sheet Liabilities
Year 1
Capital & general reserve
500
Revaluation reserve
500
Amount in Rs. Lakh Year 2 Assets 700 Fixed assets (including revaluation) 400
Other liabilities (including bank loan)
1000
1000 Other assets
Total
2000
2100
(Note : year 1 – on revaluation ; year 2 – one year after revaluation)
Year 1 1700
Year 2 1400 (1700300)
300
700
2000
2100
Revaluation – Bank perspective Profit & Loss
(Rs. lakh)
Profit before depreciation
400
Less depreciation
200
Profit after depreciation
200
Liabilities Capital & general reserve Other liabilities (including bank loan) Total
Year 1
Year 2 Assets
Year 1
Year 2
500
700 Fixed assets
1200
1000
1000
1000 Other assets
300
700
1500
1700
1500
1700
Deferred Tax issues
Stems from a difference in approach in ing vs. Taxation ing Deferred Tax Liabilities
Mostly from depreciation
Deferred Tax assets
Mostly from VRS issues
Example A company has purchased an instrument for use in the Research & Development department at a cost of Rs.10 Cr. The company would use SLM rate of depreciation @ Rs.2 Cr. per annum. The Income Tax laws however permit full depreciation during the first year for such instruments. How would the company treat this from the point of view of Deferred Tax liability ?
Deferred Tax Issues Sl. No. Year end 1. 2. 3. 4.
PBDT (say) Depreciation (as per Companies Act) PBT Provision for Tax (@ 40%)
5 6. 7. 8. 9.
PBDT Depreciation (as per Income Tax Act) PBT Provision for Tax (@ 40%) Deferred Tax liability created
10.
Balance of DTL as appearing in the BS
I
II
III
IV
V
12 2 10 4
12 2 10 4
12 2 10 4
12 2 10 4
12 2 10 4
12 12 12 12 12 10 0 0 0 0 2 12 12 12 12 0.8 4.8 4.8 4.8 4.8 3.2 ( 4 – 0.8) 3.2
2.4 1.6 0.8
0
Analysis of Financial Statements
Analysis of financial statements is necessary to gauze the financial health of a unit. Analysis can be done by means of : Percent of Sales method Trend analysis Ratio analysis Funds flow analysis Cash flow analysis Break even analysis etc.
Ratio Analysis
Most important generic ratios of relevance in credit analysis Liquidity ratios / indicators Gearing levels Profitability ratios Coverage ratios Return on Capital / Investments / Assets Turnover / Holding ratios
Liquidity Indicators
Current ratio
Acid test / Quick ratio
NWC (Net Working Capital)
Cash Generation
The rationale of Current Ratio
How Current is the Current Ratio ?
Does it indicate ‘Liquidity’ ? the concept of recovery by disposal of the concept of ‘Current-ness’ of liabilities The conflict between Prescriptive & definitions The conflict between ‘Operating ‘Funding’ concept Does not take care of recent developments
Deferred tax CENVAT receivables
CA assets and Conceptual Cycle’ vs. ing
Net Working Capital Current Liabilities
Current Assets Net Working Capital
Other Liabilities
Other Assets
Gearing ratio
Indicates stability
TOL / TNW
Debt Equity ratio (TTL / TNW)
Consider the following A business enterprise has submitted the following projected estimates with a request to provide short-term (cash credit) and term loan facilities of Rs.3.00 lakh and Rs.4.00 lakh respectively. The B/S and ratios looks like the following Liabilities
Amount
Assets
Amount
Capital
100
Fixed assets
500
Unsecured loan
150
Current assets
500
Term loan
400
Trade credit Cash credit Total
50 300 1000
Total
1000
Total Debt / Equity Ratio
(TOL / TNW)
900 / 100
9:1
Long Term Debt / Equity
(TTL / TNW)
400 / 100
4:1
CA / CL
500 / 500
1:1
Current Ratio
You refuse the proposal The entrepreneur comes back with a proposal that the fixed assets would be acquired on lease by arrangement with an NBFC. Resubmits the proposal for WC credit facilities only. Liabilities Capital
Amount
100
Unsecured loan
50
Trade credit
50
Cash credit
300
Total Total Debt / Equity Ratio
Long Term Debt / Equity
Current Ratio
500
Assets
Amount
Current Assets
500
Total
500
(TOL / TNW)
400 / 100
4:1
(TTL / TNW)
NA
NA
CA / CL
500 / 400
1.25 : 1
Gearing ratio - stability
TOL
TNW Stable
TOL
TNW
Unstable
Coverage Ratios
Cash Accrual Repayment Obligations
Important Coverage ratios
Debt Service Coverage ratio Interest Coverage ratio
Ratio Analysis (contd..) Although any number of ratios can be taken out, at least the following ratios should be calculated and interpreted for the purpose of Decision Making and Pricing :
Working Capital facilities
Current ratio TOL / TNW (Total Debt / Equity ) ratio PAT / Net Sales ( Total profitability ratio) PBDIT / Interest ( Interest Coverage ratio) PBDIT / Total Assets ( ROCE or ROA) ratio (Inventory + Receivables) / Net sales (in days) ratio
Ratio Analysis (contd..) Term loan facilities
Project Debt / Equity ratio
TOL / TNW
Gross Debt Service Coverage ratio
THANK YOU
The basic question
What do we finance ?
Cost ? or Asset ?
We finance Cost
Asset is a Security Cover guaranteed by legal rights or charges
The corollary
Two principles of financing
Cash flow backed financing
Lender gets a legal charge on the cash flow
Asset backed financing
Lender gets a legal charge on the assets created
Asset backed financing The concept of security
Primary security
Assets created out of bank finance
Collateral security
Any other asset charged to the bank against the loan
The basic question
Whom do we finance ?
How do we judge him ?
Borrower The 3 ‘C’s Capital, Capacity & Character
The judgment requires and makes use of Prudence, Due diligence & Analysis
Credit Appraisal The process of decision making in Credit by undertaking Informed Analysis using Prudence, Due diligence & Conservatism
Informed Analysis
Attribute based
Financial statements based
Please count every ‘F’ in the following text FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY COMBINED WITH THE EXPERIENCE OF YEARS
Financial Analysis
We ‘see’ things but do not ‘observe’
We ‘write’ things but do not ‘say’
Financial Analysis
Why Analysis ?
To get a true & fair view ?? Perspectives may vary with the Analysis is a prerogative of the decision maker Analysis for decision making
The approach for analysis ?
Objective Meaningful
The BALT approach to Financial Analysis
BANKING
ING
LEGAL
TAXATION
Financial Statements - the components
Statement of profit & loss (P&L ) Statement of assets and liabilities (Balance Sheet), Cash flow statements Explanatory schedules or notes forming part of these statements Earnings per Share (EPS) statements Report by the Board of Directors Directors’ Responsibility Statements
Financial Statements - the components
Auditors’ Report
Notes to s Observations & Qualifications, if any Report as per CARO 2003
CARO 2003 Company Auditors Report Order, 2003 Applicable to all companies except
Banking Companies Insurance Companies Section 25 companies Private companies with PUC
+ Reserves <= Rs.50 lakh Public Deposits - NIL Loan from Bank/FIs <= Rs.10 lakh Annual sales turnover <= Rs. 5 Cr.
CARO 2003 - relevance for banks
Disposal of fixed assets Has it affected the going concern ? Records of inventory & physical verification Conducted ? Properly ed for ? Loans (secured / unsecured) taken / granted ? Interest, Repayment, Conduct, Transactions - Regular? Accepted deposits from public ? Provision of sec. 58A & 58AA complied with ? Deposit of undisputed statutory dues Regular in payment ? Arrears ? Is it a sick company under SICA ? Provision of sec. 58A & 58AA complied with ? Whether defaulted in repayments to banks / FIs ?
Extent & period ?
Financial Statements Other important information
Contingent liabilities
Off balance sheet items
Market information
Building Blocks of Financial Statements
Fundamental concepts
Local ing Standards
International ing Standards
US GAAP
Structure of presentation of Balance Sheet Liabilities
Assets
Capital & Reserves
Fixed Assets
Secured Loan Unsecured Loan
Investments Current Assets, Loans & Advances Miscellaneous expenses to the extent not written off Total
Current Liabilities & Provisions Total
Structure of presentation of Balance Sheet (as required for analysis) Liabilities
Assets
Short term Bank borrowing Cash & Bank balance Other Current Liabilities (incldg. Trade Creditors, Provisions etc.) Term Liabilities
Inventories, Receivables etc. (assets chargeable to Bank)
Net Worth
Net Block (Fixed Assets less Depreciation) Intangible Assets Total
Total
Other Current Assets
What is the difference between the styles of presentation ?
From the promoter’s perspective
Permanency of liabilities and assets
From the banker’s perspective
Currency of liabilities and assets
This is the reason why from the point of view of a Credit Analyst :
classification of Assets and Liabilities as Current and non-Current assumes considerable importance.
The Credit Analyst may therefore have to restructure the financial statements
according to his needs i.e. making a meaningful analysis of the figures for his decision making
To make the analysis meaningful, it may be necessary to : include delete, or reclassify
some items of expenses, assets or liabilities
We may call it recasting, reclassification or restructuring of the financial statements
Current Assets
Current Assets are assets like Cash, Bank balances and other resources that are reasonably expected to be realized or consumed within one year of the date of the Balance sheet. Thus, Current Assets include : Cash Bank balances Inventory holding comprising of Raw Material, Semi - Finished goods, Finished goods, consumables etc. Advance payment made Prepaid expenses Advance Tax etc. Margin deposited against BG for WC purposes etc.
Current Liabilities
Similarly, Current Liabilities are those obligations of the enterprise that are reasonably expected to be liquidated within one year from the date of the Balance sheet, either through the resources classed as Current Assets, or through the creation of other Current Liabilities. Accordingly, Current Liabilities include : Bank borrowings for Working capital purposes Other short term credits Trade Credits Expenses due but not paid Provisions made for expenses / losses Advance payment received Instalment of Term Loan due within a year etc.
However, there may be cases where :
The maturity period of any of the Current assets and Current Liabilities may be more than a year
Thus, the one year temporal standard to determine the validity of “Current-ness” may not be universally valid
Therefore, what may be Current or non-Current also depends on the core business activity marked by technological requirements and trading practices
Tips for re-classification Value of an asset – lower of the market value or reported value Assessed value < reported value ?? Create provision New provision carved out of Net worth i.e. Capital and Reserves.
Should we carry an asset which is no more relevant ?? Take out of the Balance Sheet Make adjustments against Net Worth.
Revaluation – company perspective Balance Sheet Liabilities
Year 1
Capital & general reserve
500
Revaluation reserve
500
Amount in Rs. Lakh Year 2 Assets 700 Fixed assets (including revaluation) 400
Other liabilities (including bank loan)
1000
1000 Other assets
Total
2000
2100
(Note : year 1 – on revaluation ; year 2 – one year after revaluation)
Year 1 1700
Year 2 1400 (1700300)
300
700
2000
2100
Revaluation – Bank perspective Profit & Loss
(Rs. lakh)
Profit before depreciation
400
Less depreciation
200
Profit after depreciation
200
Liabilities Capital & general reserve Other liabilities (including bank loan) Total
Year 1
Year 2 Assets
Year 1
Year 2
500
700 Fixed assets
1200
1000
1000
1000 Other assets
300
700
1500
1700
1500
1700
Deferred Tax issues
Stems from a difference in approach in ing vs. Taxation ing Deferred Tax Liabilities
Mostly from depreciation
Deferred Tax assets
Mostly from VRS issues
Example A company has purchased an instrument for use in the Research & Development department at a cost of Rs.10 Cr. The company would use SLM rate of depreciation @ Rs.2 Cr. per annum. The Income Tax laws however permit full depreciation during the first year for such instruments. How would the company treat this from the point of view of Deferred Tax liability ?
Deferred Tax Issues Sl. No. Year end 1. 2. 3. 4.
PBDT (say) Depreciation (as per Companies Act) PBT Provision for Tax (@ 40%)
5 6. 7. 8. 9.
PBDT Depreciation (as per Income Tax Act) PBT Provision for Tax (@ 40%) Deferred Tax liability created
10.
Balance of DTL as appearing in the BS
I
II
III
IV
V
12 2 10 4
12 2 10 4
12 2 10 4
12 2 10 4
12 2 10 4
12 12 12 12 12 10 0 0 0 0 2 12 12 12 12 0.8 4.8 4.8 4.8 4.8 3.2 ( 4 – 0.8) 3.2
2.4 1.6 0.8
0
Analysis of Financial Statements
Analysis of financial statements is necessary to gauze the financial health of a unit. Analysis can be done by means of : Percent of Sales method Trend analysis Ratio analysis Funds flow analysis Cash flow analysis Break even analysis etc.
Ratio Analysis
Most important generic ratios of relevance in credit analysis Liquidity ratios / indicators Gearing levels Profitability ratios Coverage ratios Return on Capital / Investments / Assets Turnover / Holding ratios
Liquidity Indicators
Current ratio
Acid test / Quick ratio
NWC (Net Working Capital)
Cash Generation
The rationale of Current Ratio
How Current is the Current Ratio ?
Does it indicate ‘Liquidity’ ? the concept of recovery by disposal of the concept of ‘Current-ness’ of liabilities The conflict between Prescriptive & definitions The conflict between ‘Operating ‘Funding’ concept Does not take care of recent developments
Deferred tax CENVAT receivables
CA assets and Conceptual Cycle’ vs. ing
Net Working Capital Current Liabilities
Current Assets Net Working Capital
Other Liabilities
Other Assets
Gearing ratio
Indicates stability
TOL / TNW
Debt Equity ratio (TTL / TNW)
Consider the following A business enterprise has submitted the following projected estimates with a request to provide short-term (cash credit) and term loan facilities of Rs.3.00 lakh and Rs.4.00 lakh respectively. The B/S and ratios looks like the following Liabilities
Amount
Assets
Amount
Capital
100
Fixed assets
500
Unsecured loan
150
Current assets
500
Term loan
400
Trade credit Cash credit Total
50 300 1000
Total
1000
Total Debt / Equity Ratio
(TOL / TNW)
900 / 100
9:1
Long Term Debt / Equity
(TTL / TNW)
400 / 100
4:1
CA / CL
500 / 500
1:1
Current Ratio
You refuse the proposal The entrepreneur comes back with a proposal that the fixed assets would be acquired on lease by arrangement with an NBFC. Resubmits the proposal for WC credit facilities only. Liabilities Capital
Amount
100
Unsecured loan
50
Trade credit
50
Cash credit
300
Total Total Debt / Equity Ratio
Long Term Debt / Equity
Current Ratio
500
Assets
Amount
Current Assets
500
Total
500
(TOL / TNW)
400 / 100
4:1
(TTL / TNW)
NA
NA
CA / CL
500 / 400
1.25 : 1
Gearing ratio - stability
TOL
TNW Stable
TOL
TNW
Unstable
Coverage Ratios
Cash Accrual Repayment Obligations
Important Coverage ratios
Debt Service Coverage ratio Interest Coverage ratio
Ratio Analysis (contd..) Although any number of ratios can be taken out, at least the following ratios should be calculated and interpreted for the purpose of Decision Making and Pricing :
Working Capital facilities
Current ratio TOL / TNW (Total Debt / Equity ) ratio PAT / Net Sales ( Total profitability ratio) PBDIT / Interest ( Interest Coverage ratio) PBDIT / Total Assets ( ROCE or ROA) ratio (Inventory + Receivables) / Net sales (in days) ratio
Ratio Analysis (contd..) Term loan facilities
Project Debt / Equity ratio
TOL / TNW
Gross Debt Service Coverage ratio
THANK YOU
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