Analysis of financial statements prof rishi

Prof. Rishi Chourasia
Management Vikalp

www.managementvikalp.co.in 1

Accounting
Accounting is the process of measuring, interpreting, and
communicating financial information to support internal and external
business decision making.


Business Activities Involving Accounting
 Financing activities provide necessary funds to
start a business and expand it after it begins
operating.
 Investing activities provide valuable assets
required to run a business.
 Operating activities focus on selling goods and
services, but they also consider expenses as
important elements of sound financial
management.


The Foundation of Accounting Systems
• Generally accepted accounting principles ( GAAP) encompass the
conventions, rules, and procedures for determining acceptable
accounting practices at a particular time.

• Financial Accounting Standards Board ( FASB) is primarily
responsible for evaluating, setting, or modifying GAAP in the U.S.

• Sarbanes-Oxley Act responded to cases of accounting fraud.
– Created the Public Accounting Oversight Board , which sets audit
standards and investigates and sanctions accounting firms that certify the
books of publicly traded firms.
– Senior executives must personally certify that the financial information
reported by the company is correct.
– Resulted in increase in demand for accountants.


The Accounting Cycle
Accounting process - set of activities involved in converting information
about transactions into financial statements.


The Accounting Equation
• Assets - anything of value owned or leased by a business.
• Liability - claim against a firm’s assets by a creditor.
• Owner’s equity - all claims of the proprietor, partners, or
stockholders against the assets of a firm, equal to the excess of
assets over liabilities.
• Basic accounting equation - relationship that states that
assets equal liabilities plus owners’ equity.

• Double-entry bookkeeping - process by which accounting
transactions are entered; each individual transaction always has an
offsetting transaction.


Business Entity Concept
 Money Measurement concept
 Going concern concept
 Historical cost Concept
 Matching concept
 Conservatism
 Consistency
 Disclosure


 Financial analysis refers to an assessment and evaluation of the viability, stability
and profitability of a business, sub-business or project.
 Financial analysis is to evaluate & assess enterprises for its net worth, profitability
and viability; more particularly financial condition and performance
 Done to find firm’s financial strengths and weaknesses
 Primary Tools:
 Financial Statements
 Comparison of financial ratios to past, industry, sector and all firms
 Financial analysis process/ applications
 Planning
 Budgeting
 Monitoring (MIS)
 Forecasting
 Ratio Analysis


 Balance Sheet
 Profit & Loss Account
 Cash flow Statement (AS-3)
 Notes to Account and Accounting Policies

Presentation
Conventional – (now obsolete)
Vertical form


 Annual reports
◦ Company websites, Stock exchanges, Financial websites
 Published collections of data
◦ e.g., Dun and Bradstreet or Robert Morris
 Investment sites on the web
◦ Examples
 http://www.moneycontrol.com
 http://www.reuters.com and many others


Traditional / Conventional

Liabilities  Assets
 Share Capital & Reserves  Fixed Assets
 Loan Funds  Tangible Assets
 Current Liabilities
 Intangible Assets
 Investments
 Current Assets
 Debtors
 Inventories
 Cash/ Bank
 Loans & Advances

SOURCES OF FUNDS
Shareholders Funds
I) Equity Share Holders Fund
Equity Share Capital xx
Reserves & Surplus xx
xx
Less: - P& L A/c xx
Misc Exp not w/off xx (xx) xx
II) Borrowed Fund:
(i) Debentures
(ii) Institutional Borrowing xx
TOTAL SOURCES OF FUNDS XXX

APPLICATION OF FUNDS
I) Fixed Asset (Cost) Gross Block XX
Less: - Depreciation (XX)
Net Block XXX
II) Investment XXX
III) Current Assets
(1) Accrued Incomes/ Stores XX
(2) Sundry Debtors (Net) XX
(3) Stock/Inventory XX
(4) Cash/ Bank Balance XX
(5) Advances / Deposits XX XXX
IV) Less: - Current Liabilities/ Provisions:
(1) Current Liabilities XX
(2) Provisions XX (XXX)
TOTAL APPLICATION OF FUNDS XXXX

 Gross Profit
 Gross Profit = Sales - Costs of Goods Sold
 EBITDA (Earnings before Interest, Tax, Depreciation &
Amortization)
 = Gross Profit - Cash Operating Expenses
 EBIT = EBDIT - Depreciation – Amortization
 PBT = EBIT - Interest
 PAT = PBT- Taxes
 PAT (or Net Income) is a primary determinant of the firm’s
earnings and, thus, the value of the firm’s shares

GROSS PROFIT
(I) Sales xx
(II) Other Income xx
Total Receipts xxx
Less: - (I) Purchases xx
(II) Increase / Decrease In Inventory xx
Raw Materials Consumed xxx
(III) Manufacturing Expenses (xx) (xxx)
Gross Profit xxx
Less: - (I) Admin Exp (Excluding Depreciation) xx
(II) Selling Exp xx
(III) Financial Exp (Excluding Int) xx
Operating Expenses (xxx)
(IV) Profit Before Dep / Int/ Tax xxxx EBITDA
(V) Depreciation (xxx)
Profit Before Int / Tax xxxx EBIT

Less: - Interest (XXX)
Net Profit Before Tax (NPBT) XXX
Less: - Provision For Tax (XXX)
Net Profit After Tax (NPAT) XXX
Deffered Tax Adjustments
Balance b/f XXX
Profits Available For Appropriation XXX
Less: - Appropriations / Transfers XXX
Profit available for distribution XXX
Less: - Dividend / Interim Dividend XXX
Dividend Tax XXX XXX
Balance c/f to Balance Sheet XXXX


Balance Sheet as at _____

ITEM C. Y P. Y. Inc Dec rease % Change
rease



Particulars CO A CO B In . % In % Change %
CO A CO B

XXX XXX

XXX XXX

Trend Analysis
ITEM Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
% % % % %
Eq. Share
Capital
Pref Sh cap
Res. & Surplus
Borrowings

Total of Sources 100 100 100 100 100


Assets are the Resources Owned and controlled by the enterprise.
 Assts enable an Enterprise to exploit and get economic benefits in future. The
economic benefit from the assets can be derived in any of the following ways:
 .Used to produced goods and services, which the enterprise can sell.
 .Used to Exchange the asset for another asset.
 .Used to settle a Liability.
 .Used to distribute amongst the owners.

 Assets arise due to spending/giving economic benefit in the past and would
be realized by harvesting economic benefit in the future.

 Most Assets are Reported at Historical Cost
 Historical Cost is
 Objective & Verifiable
 Therefore, not subject to bias
 However, historical cost is not particularly “relevant” to most readers of the
balance sheet
 “Relevance vs. Reliability” is an important issue with accountants.


 Release of assets would result in to cash inflows.

 Asset can either be in Physical form or Intangible (Non-Physical) form.
Land, Building, Plant and Machinery, Goods, Receivables etc. are the
examples of Tangible/Physical Assets. Patents, Copyrights, Licenses,
Goodwill etc. are the examples of Intangible assets.

 To acquire any asset that enterprise has to incur expenditure/payment,
but all expenses/payments need not necessarily result in to generation
of an asset.

 An asset is recognized in the Balance Sheet when it is sure to generate
economic benefit in future and that such cost of asset and value of
future economic benefit is measurable.


Liabilities are the obligation of the enterprise. They are what the enterprise Owes to
others i.e. the debts of the enterprise.

 Liabilities arise on account of the benefits availed by the enterprise in the past.
 Liabilities are settled / paid off by giving economic benefits in future. Examples of
Liabilities are Creditors, Secured and Unsecured Lenders, Owners Fund.
 Liabilities can be settled in any of the following ways:

 .Cash Payment
 .Adjustment/Barter with other asset.
 .Providing goods and services.
 .Exchange of one liability with another liability.
 .Extinguishments/Waiver of liability.

 Discharge of liability would result in to cash outflow.
 A liability is recognized in the balance sheet only when it has crystallized and
ascertained. Contingent liabilities are not recognized in the balance sheet but are
disclosed as a footnote.


Incomes are the revenue that arises to the enterprise in the
ordinary course of business by providing goods and services.

 Income arises by use of the Assets of the Enterprise as also
due to incurring expenses to earn such incomes.

 Income results in to increase in the economic benefit to the
enterprise either by way of increase in assets or decrease
in liabilities.

 It would also include those gains that may arise to the
enterprise from non core business activity such as Rent
income, Interest receipts, profit on sale of investments etc.


Expenses are the losses or outflows that arise during the
ordinary course of business.

 Expenses result in to outflow and reduction in assets.

Expenses would also include losses, which are not in normal
course of business e.g. Loss by Fire, Flood or natural
calamity, Loss by theft, loss on account of foreign exchange
fluctuations etc.

 Expenses would also include such expenses where there is no
physical flow of cash but on account of fall in value of assets
e.g. Depreciation.


Capital is the amount invested by the Owners in the Enterprise.

 It would include the amount invested at the starting of the business, as
also the additional amount invested from time to time and the retained
profits in the business.

 Anybody who invests money in a business enterprise does so primarily
with the intention to earn profits on his investment. This results in to
the concept of CAPITAL MAINTENANCE.

 FINANCIAL CAPITAL MAINTENANCE is the financial/monitory
profits, which the enterprise has earned over a period of time. In
simple terms it is the net profit for the year arising due to
difference between the income and expenses of the enterprise.

 PHYSICAL CAPITAL MAINTENANCE is something, which is not
immediate and apparent. It is the sustenance or advancement in the
future profit earning ability of an enterprise.


A fixed asset is an asset of a business intended for continuing use
which includes:
 Tangible Assets
 Infrastructure like land & building
 plant & machinery
 Vehicles
 Furniture & fixtures
 Intangible Assets
 Preliminary & Preoperative expenses
 Deferred Revenue Expenditure
 Goodwill
 Trade mark
 Patents


 DETERMINES THE REVENUE GENERATING CAPACITY
 Examines the age and condition of each major asset category
 The costs of replacing old assets to determine the output levels,
downtime and temporary discontinuance.
 Depreciation is a key concept analysts use when analyzing fixed
assets and the examination of depreciation helps to clarify the useful life
of assets.
 Companies benefit from fixed asset analysis by taking control of their
fixed assets and maintaining their condition in order to ensure proper
operation


What Does Inventory Mean?
 The raw materials, work-in-process goods and completely finished
goods that are considered to be the portion of a business's assets that
are ready or will be ready for sale.
 Inventory represents one of the most important assets that most
businesses possess, because the turnover inventory represents one of
the primary sources of revenue generation and subsequent earnings
for the company‘s shareholders/owners


 Possessing a high amount of inventory for long periods of time is not
usually good for a business because of inventory storage, obsolescence
and spoilage costs
 However, possessing too little inventory isn't good either, because the
business runs the risk of losing out on potential sales and potential
market share as well
 Inventory management forecasts and strategies, such as a just-in-time
inventory system, can help minimize inventory costs because goods are
created or received as inventory only when needed
 Inventory Carrying cost
◦ High Inventory
◦ Low Inventory
◦ Just in Time (JIT) Inventory


 Investments consist of
◦ Shares And Securities of
 Subsidiary Companies
 Associates Companies
◦ Marketable securities-listed securities (shares and units)
◦ Treasury bills, Government securities
 Analysis
◦ While analyzing balance sheet we can analyze necessity of such
investments
◦ Also movement in investments helps us to understand the fund
requirements of a company
◦ Helps us to understand how much liquidity a company has
◦ Holding company structure


 Reports the value of a company's assets that are
cash or can be converted into cash immediately
 Examples

◦ Cash on hand
◦ Term deposits with banks/finance companies
◦ bank accounts
 Analysis
◦ Helps us to understand how much liquidity a company has
◦ Fund requirements of a company
◦ Money kept as margin money – will not be available as free
cash to the company


 An individual or organization that owes a debt or has an
obligation to another party
 Debtor Ageing Analysis
◦ A listing of debtors' accounts , usually produced monthly, which analyses
the age of the debts by splitting them into such categories as those up to
one month old, two months old, and more than two months old. The
debtor ageing ratio indicates the average time it takes your business to
collect its debts
◦ Need- As a basic part of the credit control system, the analysis should be
regularly examined so that any appropriate follow-up action may be
taken
◦ Important determinant of Pricing policy
◦ It's worth looking at this ratio over a number of financial years to monitor
performance trends.
◦ Risk Factors

 Creditors Ageing Analysis
◦ Similar to debtors ageing analysis, only with
Creditors
◦ Need
◦ Indirect financing of business
◦ Cash flow can be eased
 This could be a useful tool to schedule your

payments to your creditors
 Credit negotiation

 Ability to bargain for discounts


 A firm has resources. It converts resources into profits
through
production of goods and services
sales of goods and services
 Ratios
Measure relationships between resources and financial flows
Show ways in which firm’s situation deviates from
Its own past
Other firms
The industry
All firms


 Diagnostic tool for financial health
 Standardize financial information for comparisons
 Evaluate current operations
 Compare performance with past performance
 Compare performance against other firms or industry
standards
 Study the efficiency of operations
 Study the risk of operations


 A firm’s industry category is often difficult to identify
 Published industry averages are only guidelines
 Accounting practices differ across firms
 Sometimes difficult to interpret deviations in ratios
 Industry ratios may not be desirable targets
 Seasonality affects ratios
 Relative, not absolute


The important ratios that arise from the Balance
Sheet include
Liquidity ratios

-Current ratio
-Quick ratio
Debtors turnover ratio

Creditors turnover ratio

Return on assets ratio

Return on equity ratio

Return on investment ratio


Objective of Analysis Ratio Formula Standard Ratio

Immediate Liquidity Quick Ratio Quick Assets / Quick Liabilities 1:1

Short Term Current Ratio Current assets / Current Liabilities 2:1
Liquidity

Liquidity of Stock Stock Working Stock *100 / Working Capital 100%
Capital

Stock COGS / Average Stock Company Standard
Turnover

Average Stock = (Op. St+ Cl St )/ 2

Liquidity of Debtors Debtors (Debtors +B. R.) / Daily Credit Sales Normal Credit
Turnover Allowed

Liquidity of Creditors (Creditors +B.P)/ Daily Credit Purchases Company Standard
Creditors Turnover

Long Term Proprietary Proprietors Funds *100/ Total Assets 65% to 75%
Solvency & Stability Ratio

Debt-Equity Borrowed Funds/ Proprietors Funds 2:1
Ratio


Operating or trading Gross Profit GP * 100 Company
efficiency Ratio Net sales Standard
Operating (COGS+ Operating Exp) * 100 Company
Ratio Net Sales Standard
Operating Net Operating Net Profit * 100 Company
Profit Ratio Net Sales Standard
Expenses Expenses * 100 Company
Net Profit Net Profit * 100 Company
Overall Profitability Return on NP (before int. & Tax) *100 Company
Capital Capital Employed Standard
Employed
Return on NP (after tax) * 100 Company
Propreitors Proprietors Funds Standard
Funds
Return on NP (after tax & Pref Div) * 100 Company
Equity (Equity Cap + Reserves) Standard
Capital Structure Capital (Pref Capital + Debn+Loan) Company
Gearing (Equity + Reserves) Standard
Debt-Equity Debt
Ratio Equity
Proprietory Proprietors Funds *100 65% to 75%
Ratio Total Assets

Overtrading or Proprietory Ratio Proprietors Funds *100 Low Ratio:
undertrading / Total Assets Overtrading,
High Ratio:
undertrading

Stock Cost of Goods Sold *100/ Average Stock High Ratio:
Turnover Overtrading,
Low
Ratio:undertradi
ng

Current Ratio Current assets/ Current Liabilities Low Ratio:
Overtrading,
High
Ratio:undertradi
ng

Coverage Dividend Equity dividend * 100/ Profit for Equity Company Standard
Payout Shareholders

Interest PBIT / Interest Company Standard
Coverage


Objective of Ratio to be computed Formula Standard Ratio
Analysis
Immediate Liquidity Quick Ratio Quick Assets/ Quick Liabilities 1:1
Short Term Liquidity Current Ratio Current assets/ Current Liabilities 2:1
Liquidity of Stock Stock Working Capital Stock *100/ Working Capital 100%
Stock Turnover COGS/ Average Stock Company Standard
Average Stock = (Op. St+ Cl St)/2
Liquidity of Debtors Debtors Turnover (Debtors +Bills Receivable)/ Daily Credit Sales Normal Credit Allowed
Liquidity of Creditors Creditors Turnover (Creditors +Bills Payable)/ Daily Credit Purchases Company Standard
Long Term Solvency Proprietary Ratio Proprietors Funds *100/ Total Assets 65% to 75%
& Stability
Debt-Equity Ratio Borrowed Funds/ Proprietors Funds 2:1
Operating or trading Gross Profit Ratio GP * 100/ Net Sales Company Standard
efficiency
Operating Ratio (COGS+ Operating Exp) * 100/ Net Sales Company Standard
Operating Net Profit Ratio Operating Net Profit * 100/ Net Sales Company Standard
Expenses Ratio Expenses * 100/ Net Sales Company Standard
Net Profit Ratio Net Profit * 100/ Net Sales Company Standard
Overall Profitability Return on Capital Employed NP (before int. & Tax) *100/ Capital Employed Company Standard
Return on Propreitors Funds NP (after tax) *100/ Proprietors Funds Company Standard
Return on Equity NP (after tax & Pref Div) *100/ (Equity Cap + Reserves) Company Standard
Capital Structure Capital Gearing (Pref Capital + Debn+Loan)/ (Equity + Reserves) Company Standard
Debt-Equity Ratio Debt/ Equity
Proprietory Ratio Proprietors Funds *100/ Total Assets 65% to 75%
Overtrading or Proprietory Ratio Proprietors Funds *100/ Total Assets Low Ratio: Overtrading,
undertrading High Ratio:undertrading
Stock Turnover Cost of Goods Sold *100/ Average Stock High Ratio: Overtrading,
Low Ratio:undertrading
Current Ratio Current assets/ Current Liabilities Low Ratio: Overtrading,
High Ratio:undertrading
Coverage Dividend Payout Equity dividend * 100/ Profit for Equity Shareholders Company Standard
Interest Coverage PBIT / Interest Company Standard


Objective of Analysis Ratio Formula Standard Ratio

PROFITABILITY Return on = NPAT Du Pont
Equity (ROE) Capital + Reserves- (def Exp) analysis
Earnings Per Net Profit- (Pref Div)   ERR
Share(EPS) No of Equity shares
Price Earning Av. Market price per share Industry
Ratio(EPS) Earnings per share standard

Return on P B T /       X   100 ERR Industry
Investemnts( Capital Employed standard
ROI)

Return on N PA T                X  100
Assets(ROA) Av. Total Assets
Credit Risk Debt service Earnings Availble for service of debt (EBITDA)
Ratio  (DSR) Interest + Instalments


 A class of financial metrics that is used to determine a company's ability to pay off
its short-terms debts obligations.
 Generally, the higher the value of the ratio, the larger the margin of safety that the
company possesses to cover short-term debts
 Current ratio
◦ A liquidity ratio that measures a company's ability to pay short-term obligations.
The Current Ratio formula is:
Current ratio= Current assets
Current liabilities
 Quick ratio/ Acid Test Ratio
◦ The quick ratio measures a company's ability to meet its short-term obligations
with its most liquid assets. The higher the quick ratio, the better the position of
the company.
◦ The quick ratio is calculated as= Current assets -Inventories
Current Liabilities


 It is also known as receivables turnover ratio.
 An accounting measure used to quantify a firm's effectiveness in extending credit as
well as collecting debts. The receivables turnover ratio is an activity ratio, measuring
how efficiently a firm uses its assets.
 Formula:
Accounts receivable turnover= Net credit sale
Average accounts receivable
 Some company report only Total Sales. This can affect the ratio depending on the size
of the cash sales
 This ratio indicates how well debtors are being collected. If debtors are not collected
reasonably in accordance with their terms, you should rethink your collection policy.
 If debtors are excessively slow in being converted to cash, liquidity will be severely
affected.
 It may also be calculated as
Debtors turnover (in days) = Debtors* 365 days
Net credit sales


 It is also known as Accounts Payable Turnover Ratio.
 A short-term liquidity measure used to quantify the rate at which a
company pays off its suppliers.
 Accounts payable turnover ratio is calculated by taking the total
purchases made from suppliers and dividing it by the average accounts
payable amount during the same period.
 Formula
Accounts payable turnover = Total credit purchases
Average accounts payable
It may also be calculated as,
Creditors turnover (in days) = Creditors*365 days
Net credit purchases


What Does Return On Total Assets (ROA) Mean?
 It measures a company's earnings before interest and taxes (EBIT)
against its total net assets.
 The ratio is considered an indicator of how effectively a company is using its
assets to generate earnings before contractual obligations must be paid.
 ROA= EBIT_____
Total net assets
 This measures how efficiently profits are being generated from the assets
employed in the business, when compared with the ratio of firms in a similar
business.
 A low ratio in comparison with the averages in the industry indicates
inefficient use of the business assets.
 The return on assets ratio is also calculated as follows:
Return on assets = Net profit before tax
Total Assets

 What Does Operating Margin Mean?
 A ratio used to measure a company's pricing strategy and
operating efficiency.
 Calculated as:
Operating margin = Operating income
Net sales
 Operating margin is a measurement of what proportion of a
company's revenue is left over after paying for variable
costs of production such as wages, raw materials, etc.
 A healthy operating margin is required for a company to be
able to pay for its fixed costs, such as interest on debt.


What Does Return On Equity - ROE Mean?
The amount of net income returned as a percentage of
shareholders equity. Return on equity measures a
corporation's profitability by revealing how much profit a
company generates with the money shareholders have
invested.

ROE is expressed as a percentage and calculated as
= __Net income__
Share holders equity


What Does Return On Investment - ROI Mean?
A performance measure used to evaluate the efficiency of
an investment or to compare the efficiency of a number of
different investments. To calculate ROI, the benefit (return)
of an investment is divided by the cost of the investment;
the result is expressed as a percentage or a ratio
 The return on investment formula:

ROI = (Net Profit Before Tax )
Capital Employed
 This ratio tells you whether or not all the effort and time put

into the business has been worthwhile.


 If the ROI is less than the rate of return on an alternative
risk free investment, such as a bank savings account or
other secure bank investments, then you may be wiser to
sell the business and put the money into that investment
 The ROI is also calculated is follows:
Return on Investment = Net profit before tax
Net worth


 Every public limited co share calculate and disclose the
EPS in accordance with AS 20.
 EPS is a financial ratio indicating the amount of profit/ loss
for the period attributable to each equity share
 Basic EPS = Net Profit After Tax (Pref Dividend)
Wtd Average Eq. Share

 Diluted EPS = ___Diluted Earnings_____________
Wtd. Avg. of the Eq. Shares+ Wtd Avg. Addl Eq Shares


 The portion of a company's profit allocated to each
outstanding share of common stock. Earnings per
share serves as an indicator of a company's profitability.

 Calculated as:
= Net income- Dividends on preferred stock
Average outstanding shares

 Earnings per share is generally considered to be the single
most important variable in determining a share's price.

 It is also a major component used to calculate the price-to-
earnings valuation ratio.


Price-Earnings Ratio - P/E Ratio (Contd)

 A high P/E suggests that investors are
expecting higher earnings growth in the future
compared to companies with a lower P/E
 It's usually more useful to compare the P/E ratios of

one company to other companies in the same
industry, to the market in general or against the
company's own historical P/E.


 A valuation ratio of a company's current share price
compared to its per-share earnings.
Calculated as: = Market value per share
Earnings per share
 EPS is usually from the last four quarters (trailing P/E),

but sometimes it can be taken from the estimates of
earnings expected in the next four quarters (projected or
forward P/E).
 A third variation uses the sum of the last two actual

quarters and the estimates of the next two quarters
known as price multiple or earnings multiple


 What Does Debt/Equity Ratio Mean?

 A measure of a company's financial leverage calculated by
dividing its total liabilities by stockholders' equity. It
indicates what proportion of equity and debt the company
is using to finance its assets.
Calculated as= Total liabilities
Share holders equity
 Note: Sometimes only interest-bearing, long-term debt is
used instead of total liabilities in the calculation.


Du-Pont Analysis

 It is believed that measuring assets at gross book value
removes the incentive to avoid investing in new assets.
 New asset avoidance can occur as financial accounting
depreciation methods artificially produce lower ROEs in
the initial years that an asset is placed into service.
 If ROE is unsatisfactory, the DuPont analysis helps
locate the part of the business that is underperforming.


RO E

RO A E q u it y M u lt ip lie r

P r o f it M a r g in T o ta l A s s e t T u rn o v e r


R O E

R O A E q u it y M u lt ip lie r

P r o fit M a r g in T o ta l A s s e t T u rn o v e r

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier
Net Income Sales Total Assets
= × ×
Sales Total Assets Common Equity


 Method to breakdown ROE into:
◦ ROA and Equity Multiplier

 ROA is further broken down as:
◦ Profit Margin and Asset Turnover

 Helps to identify sources of strength and weakness
in current performance

 Helps to focus attention on value drivers


What Does Leverage Mean?

 The use of various financial instruments or borrowed capital,
such as margin, to increase the potential return of an
investment.

 The amount of debt used to finance a firm's assets. A firm
with significantly more debt than equity is considered to be
highly leveraged.

 Leverage is most commonly used in real estate transactions
through the use of mortgages to purchase a home.


1. Any ratio used to calculate the financial leverage of a company
to get an idea of the company's methods of financing or to
measure its ability to meet financial obligations. There are
several different ratios, but the main factors looked at include
debt, equity, assets and interest expenses.

2. A ratio used to measure a company's mix of operating costs,
giving an idea of how changes in output will affect operating
income. Fixed and variable costs are the two types of operating
costs; depending on the company and the industry, the mix will
differ.


 Cash flow statements shall disclose movements in Cash and Cash
equivalents. It reflects the inflow and out flow of cash equivalents.
 The Cash flow is reflected in 3 distinct areas of Activity

CASH FLOW AS 3

OPERATING INVESTING FINANACING
ACTIVITIES ACTIVITIES ACTIVITIES

Revenue Generating Acquisition and Disposal Increase decrease in
Activities of Capital
Sales, incomes royalties Long Term Assets Increase decrease in
fees. Borrowings
Payments Purchases, net Profit and loss
profit on sales of assets
NON CASH incomes to be excluded
credits/debits to be
excluded


Direct Method Cash Flow Statement (Rs. ‘000)

Cash Flows from Operating activities 2009
Cash receipts from customers 30,150
Cash paid to suppliers & employees -27,600
Cash generated from operations 2,550
Income Taxes paid -860
Cash flow before extraordinary items 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870
Cash flows from investing activities
Purchase of fixed assets -350
Proceeds from sale of equipment 20
Interest received 200
Dividends received 160
Net cash from investing activities 30
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long term borrowings 250
Repayment of long term borrowings -180
Interest paid -270
Dividends paid -1,200
Net cash used in financing activities -1,150
Net increase in cash and cash equivalents 750
Cash and cash equivalents at the beginning of the period 160
Cash and cash equivalents at the end of the period 910
Direct Method: Whereby major classes of gross cash receipts and gross cash payments are disclosed
1.Cash flow from operating activities
2.Cash flow from investing activities
3. Cash flow from financing activities www.managementvikalp.co.in 64

Indirect Method Cash Flow Statement (Rs. ‘000)
Cash flows from operating activities 2009
Net profit before tax and extraordinary items 3,350
Adjustments for:
Depreciation 450
Foreign exchange loss 40
Interest income -300
Dividend income -200
Interest expense 400
Operating profit before working capital changes 3,740
Increase in sundry debtors -500
Decrease in inventories 1,050
Decrease in sundry creditors -1,740
Cash generated from operations 2,550
Income taxes paid -860
Cash flow before extraordinary items 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870
Cash flows from investing activities
Purchase of fixed assets -350
Proceeds from sale of equipment 20
Interest received 200
Dividend received 160
Net cash from investing activities 30
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long term borrowings 250
Repayment of long term borrowings -180
Interest paid -270
Dividends paid -1,200
Net cash used in financing activities -1,150
Net increase in cash and cash equivalents 750
Cash and cash equivalents at the beginning of the 160
period
Cash and cash equivalents at the end of the period 910

Indirect Method: Whereby net profit or loss is adjusted for the effects of a transactions of a non-
cash nature, any deferral or accruals of past or future operating cash receipts or payments and
items of income or expense associated with investing of financing cash flows.

1) Window dressing is to present a bright picture of your
financial statement than what actually is.
2) Balance Sheet projects an “unfair view” of the state of
affairs.
3) “True” but not Fair
4) Figures are distorted
5) May comply with legal provisions in form but not in
Substance “Substance Over Form” – “In Essence”.


 Not providing for liabilities / expenses which exist.
 Deferment of expenses
 Over valuation / of assets.
 Under valuation/ over valuation of inventory.
 Excess provision for doubtful debts
 Fictitious / distress sales on approval
 Recall advances.
 Cheque in transit.


 Obligations that are contingent liabilities of a bank, and
thus do not appear on its balance sheet. In general, off-
balance sheet items include the following:
 direct credit substitutes in which a bank substitutes its own
credit for a third party, including standby letters of credit;
 irrevocable letters of credit that guarantee repayment of
commercial paper or tax-exempt securities;
 risk participations in bankers' acceptances;
 sale and repurchase agreements;
 asset sales with recourse against the seller;
 interest rate swaps;
 interest rate options and currency options


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