How

Read Financial Statements

Professor .V.RAMACHANDRAN. SIESCOMS, NERUL, NAVI MUMBAI.

Three Categories of Statements

Each shareholder gets an Annual Report Statement from Chairman/President/MD Firms operating results for the last financial year in qualitative terms, future outlook Quantitative statements
 Balance Sheet  Profit and Loss Statement (Income Statement)  Cash Flow Statement

Balance Sheet

It is actually a snap shot at the instant it is prepared Shows the companys financial position what the company owns and owes Shows the sources and applications of funds It is not duration specific like P&L statement . Can be prepared even every day; Companies in India usually Prepare on a Quarterly/Annual basis. Numbers by themselves are not important; ratios are.

Balance Sheet continued

As per Double entry accounting system: The Assets and Liabilities must balance Every transaction gets entered at two places under different heads so that accounts are balanced. Credit / Debit or Assets / Liabilities Compare the movement across the quarters or years Scope for manipulation: Asset valuation, payment realization (GAAP)

Balance Sheet Structure & Financial Management Decisions

Liabilities Long Term Liabilities
Capital Structure Decisions

Assets Fixed Assets Land,Buildings,Vehicles, Equipments Current Assets Cash, Account receivables Inventory,WIP,Finished Goods
Capital budgeting Decisions

Equity,Term Loans,Debentures Current Liabilities Accounts payables Short Term Loans

Operating policy Decisions

Assets

You pay for them to acquire them and so you own them They can be tangible or intangible (goodwill, monopoly) They generate revenues in short or long term Liquidity of an asset: Length of the time it takes to generate revenue Their value generally depreciates over time They can be revalued on some events

Examples of Assets
Current Assets Cash in bank and in hand (bank balance, physical cash) Marketable Securities (parked funds) Accounts Receivables Inventory (Raw Materials, Work In Progress Finished goods) Fixed Assets Land, Building, Plants, Offices, Vehicles Equipment (PCs, Office equipment, Test jigs) Patents, Copyrights, Trademarks Goodwill, Brand Position

Liabilities

Money received from outside sources that has been made available to the firm The firm owes them to outside agents including the shareholders Liabilities can be with short term, long term, or no term repayment schedules

Examples of Liabilities
Current Liabilities Accounts payable (supplier credit) Accrued corporate tax Short term loans Long Term Liabilities Debentures Long term loans Equity (common stock + preferred stock) Retained earnings

A Typical Manufacturing Company Starts Operation

Two promoters deposit Rs 5 lakhs in the company account as equity XYZ Private Limited Balance Sheet at April 1, 2001

Liabilities Equity Total 5,00,000 5,00,000

Assets Cash Total 5,00,000 5,00,000

A lathe is bought on cash basis

Owner pays Rs 3 lakhs from the bank acount

Liabilities Equity 5,00,000

Assets Cash Plant 2,00,000 3,00,000 5,00,000

Total

5,00,000

Total

Raw material worth Rs 80,000 bought on a 60 day credit basis

No payment is done so cash position does not change

Liabilities Equity
Account Payable

Assets 5,00,000 80,000 Cash Plant Inventory 2,00,000 3,00,000 80,000 5,80,000

Total

5,80,000

Total

Raw material worth Rs 40,000 processed and sold for Rs 50,000 with a 30 day credit
No payment is done so cash position does not change, but inventory is reduced

Liabilities Equity
Accounts Payable

Assets 5,00,000 80,000 10,000 Cash Plant Inventory

Accounts Receivable

2,00,000 3,00,000 40,000 50,000

Retained Earnings

Total 5,90,000

Total 5,90,000

Customer pays up after 20 days

Payment deposited in bank so cash position changes
Liabilities Equity
Accounts Payable

Assets 5,00,000 80,000 10,000 Cash Plant Inventory

Accounts Receivable

2,50,000 3,00,000 40,000 00,000 5,90,000

Retained Earnings

Total

5,90,000

Total

Supplier credit period is over and raw material is paid for after 60 days
Payment done from bank so cash balance reduces

Liabilities Equity
Accounts Payable

Assets 5,00,000 00,000 10,000 Cash Plant Inventory

Accounts Receivable

1,70,000 3,00,000 40,000 00,000

Retained Earnings

Total 5,10,000

Total 5,10,000

A new promoter buys 10,000 shares of Rs 10 face value at a premium of Rs 20

Payment done to bank so cash balance increases

Liabilities Equity
Accounts Payable

Assets 6,00,000 00,000 Cash Plant Inventory

Accounts Receivable

4,70,000 3,00,000 40,000 00,000

Retained 10,000 Earnings Share Premium 2,00,000 a/c Total 8,10,000

Total 8,10,000

Profit & Loss Account (Income Statement)

Sales Revenues Other Revenues Total Revenues Cost of Goods Sold Gross Profit Operating Expenses PBITD Interest + Tax + Depreciation Net Profit

4,00,000 1,00,000 5,00,000 2,00,000 3,00,000 1,50,000 1,50,000 25,000 1,25,000

100 % 40 % 60 % 30 % 30 % 5% 25 %

Cash Flow / Funds Flow Statement

Differences in successive balance sheets Sources of Funds

 Net profit  Issue of new share capital  Sale of fixed assets  New loans

Use of Funds
 Payment of dividends  Purchase of fixed assets  Repayment of loans

Ratio Analysis

Compare the performance of the company for three/five successive years The absolute numbers change so compare ratios Compare two companies of differing size but from the same industry, e.g, Infosys and Mastek Calculate industry-wide numbers (net profit margins for automobile companies)

Liquidity Ratios

Measure a firms ability to meet its short term obligations Show trends early and so corrective actions can be taken in the working capital management

Current Ratio: Current Assets / Current Liabilities Acid Test Ratio or Quick Ratio: (Current Assets Inventory) / Current Liability (Cash or cash equivalent) / Current Liability A firm is solvent if its assets are greater than outside liabilities. A firm is liquid if its current assets are greater than its current liabilities

Gearing Ratios

Leverage of a firm: Proportion of its long term liabilities that are debts

Long term liabilities = Debts + Equity Debt/Equity ratio Loan Capital / Share holders funds

Gears, Leverage: Mechanical Engg terms

Asset Utilization Ratios

Return on Total Investment: managements skill in exploiting the funds made available
ROI = PBT / (Shareholders funds + Long term loans)

Return on Shareholders Equity ROE =

PAT / (Shareholders funds) Sales / Total Capital Employed

Profitability Ratios

Net Profit Margin = NP / Sales

Gross Profit Margin = GP / Sales

Market Value related Ratios

EPS (Earning Per Share) :

NP / Total outstanding shares

P/E : Market Price / Earning Per Share Revenue Multiple: Revenues / Assets Market to Book: Market Value / Book Value

Limitations of Financial Statements

They are backward looking: Accrued results of the past year / quarter Companys value depends on its future profitability which depends on many factors not reflected in the balance sheet, which are non-monetary
Nature and innovativeness of it products Technology landscape (product obsolescence) Competitors Economic conditions (recession / boom), government policies  Staff and management morale
   

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