Basics of Finance _ 2

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Finance for Non FinanceProfessionals

Lecture 13


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Agenda

Objective of the Webinar

Key takeaways

Purpose of existence of an economic entity

Financial statementsconstruction and purpose

Understanding and interpreting Financial Statements

Financial analysis as a measurement tool

Purpose of analysisequity perspective, debt perspective

Ratio analysis

Explaining simple terms in Finance - ROI, IRR, Time Value of Money

Q&A


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Objective

The webinar will help the participants To gain an understanding of the basic principles of finance

To evaluate decisions related to finance moreknowledgeably

To participate effectively in finance related discussions intheir respective organisations

To gain basic understanding to pursue higher education /career in the field of finance

To follow recent economic events and its impact oncorporate performance

To take informed decision related to personal finance andinvesting

To interact with financial department / finance professionalsmore knowledgeably


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Key Take Aways

Basic understanding of various forms of economicentities

Understanding financial statements and performratio analysis on published statements

Evaluate a corporate investing or financingdecision meaningfully

Track financial performance of listed companies

closely, to take well-informed investment decisions

Read / follow business newspapers / businesschannels with better understanding


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To do business is to create an economic entity with the

purpose of Wealth creation

Wealth management, and

Wealth distribution

Objective of an enterpriseTo create the

best possible values and share them in the

equitable manner among all the stakeholders


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Business as an economic entity exists to make profits: Trading activitySelling price > Cost of purchase

Manufacturing activity:Selling price > Cost of purchase + conversion costs

ServicesPrice for service > Cost of providing the service

Buying Selling

SellingProcessingBuying

Servicing


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We need various entities to come together torun an enterprise and generate returns. Whoare the stakeholders in a business? Investors

Equity holdersmajority holders, minority shareholders Debt holders including banks and financial institutions

Management

Employees

Suppliers

Customers

Community, Taxman


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Accounting forms the basis for measuring the performance of an enterprise

The performance determines which stakeholder gets what share of thebusiness

Accounting also ensures equitable distribution of wealth generated, basedon each persons contribution to the business

Few examples: Taxmangets his share of the profits (currently 35% in India), which are

determined based on prudent accounting practices

Employeesare typically rewarded based on their individual performance aswell as the performance of the enterprise

Minority shareholdersget equal treatment compared to majority owners(equal dividend distribution)

Debt holdersare paid their due for contributing debt capital to the business

(interest payment and principal repayment)

Key to understanding accounting principles is to view an enterprise as a separatelegal entity, and all stakeholders as those contributing capital, labour orresources.


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Partnership

Enterprise

Closely held

CompanyProprietary

Public Ltd.Private Ltd.

Publicly held


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Proprietary businessowned by single owner

No difference between the obligations of the business and the obligations of the

individual.

Partnership firmowned by two or more owners

No difference between the obligations of the business and the obligations of the

individual partners except when it is Limited Liability Partnership (Registered)

Companyis an artificial person, created by law and has perpetual existence.

Obligations of the company are separate from those of promoters and

management.

Private limited company Not more than 50 members

Shares are not freely transferable.

No invitation to public for subscription.

Public limited company

Closely held public limited company (Deemed)

Publicly held public limited company (Listed)


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Financial statements report the state of financial affairs of an enterprise

These are made publicly available for widely held companies, usuallyfree of cost (www.bseindia.comand www.nseindia.com)

For closely held public companies and private companies, the financialstatements are reported to the Ministry of Company Affairs

Some of these are available for public viewing (both online as well asphysically) for a small fee. (http://www.mca.gov.in)

Three key financial statements are

Balance Sheet Profit & Loss Account and

Cash flow statement
http://www.bseindia.com/http://www.nseindia.com/http://www.mca.gov.in/http://www.mca.gov.in/http://www.nseindia.com/http://www.bseindia.com/


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Liabilities

Owners capital Equity Capital

Reserves and Surplus

Borrowed funds Long term debt Short term debt

Working capital Creditors

Current liabilities and Provisions

Assets Fixed Assets

Land and building

Plant and Machinery

Investments Investment made in shares,

bonds, government securities, etc.

Working Capital

Raw Material

Work in progress

Finished goods Debtors

Cash


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The Liability side represent the various sources of funds for an

enterprise

These are the liability of the enterprise to the providers of these

funds

The Asset side represent the various uses of funds by an

enterprise

These are the assets held by the enterprise, that are needed to

operate the business (e.g. Office space, factory, raw material, etc.)

The Assets and Liabilities should ALWAYS match.

In the Liability side, the portfolio mix of the own funds and

borrowed funds is called the Capital Structure of the company Balance sheet is always presented as on a given day, say as at

March 31, 2008. It presents a static picture of the assets andliabilities of the enterprise as on that date.


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Another way to look at the balance sheet is to match the sources anduses of funds, based on their tenure.

In Liability side, long term sources are

Equity capital

Reserves and Surplus

Long term borrowings

In Asset side, long term uses are

Fixed Assets

Investments

The rest are short term on both sides viz. Current assets, current liability

and short term debt

Ideally, long term uses must always be funded with long term funds.

Financing long term assets with the short term funds creates risks

(mainly refinancing risk).

Short term investments may be financed by a combination of long term

and short term funds, based on business managers preference.


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Revenues from the businessLess Raw material consumedEmployee expenses

Other manufacturing expenses

Administrative expenses

Selling expenses

Sub total: Cost of Sales

Earning before interest, taxes, Depreciation &

Amortization(EBITDA)

Less Depreciation

Earning before interest and taxes (EBIT)

Less Interest payment

Profit before taxes (PBT)

Less Taxes

Profit after tax (PAT)

Less Dividend

Retained earnings


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Typical items under Revenue from business

Sales revenue

Other related income

Scrap sales, Duty drawback

Non-operating income

Dividends and interest

Rent received

Extra-ordinary income

Profit on sale of assets / investments

Prior-period items


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Typical items under Cost of Sales Cost of goods sold

Direct material

Direct labor

Direct manufacturing overheads

Administrative costs Office rent

Salaries

Communication costs

Other costs

Selling and distribution costs Salaries of sales staff

Commissions, promotional expenses

Advertisement expenses etc.


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Depreciation

Straight line method

Written Down Value method

Deferred revenue expenditure

R&D expenses

Advertisement expenses

Product promotion expenses

(expenses are charged as capital expenses and

amortized over the period of time)


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P&L Account presents a snapshot of the performance of anenterprise over a given period (a year, half-year, quarter, etc.)

Unlike Balance Sheet, which presents a static picture on a given

date

P&L Account can provide great insights into the functioning of an

enterprise. Let us look at a few: Variable costs Vs. Fixed costs

Break even point is the point where there is no profit, no loss

Cash expenses Vs. Non-cash expenses

Raw material, salary and other administrative expenses are cash

expenses

Depreciation is typically the only non-cash expense

Recurring income Vs. one-time income

Income from ordinary activities are typically recurring in nature

Extraordinary income / expenses are typically one-time in nature

Few examples: Sale of office space, disposal of a factory unit, VRS


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Some important ratios for analysing performance of acompany:

Operating profit margin Net profit margin

Return on Capital Employed Current Ratio Debt:Equity ratio Interest coverage ratio

Earnings per share Price Earnings ratio Return on Networth


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Operating profit margin Indicates the business profitability

OPM = EBITDA / Operating Income (or Net Sales)

Depending on the industry, for healthy companies, OPM rangesfrom 15% - 50%

Net profit margin Indicates the returns generated by the business for its owners

NPM = PAT / Operating Income (or Net Sales)

For healthy companies, NPM ranges from 3% - 12%

Several other profitability measures are there (Gross margin,Contribution margin, etc.) but the above two are most commonlyused.

The profitability margins are very useful for peer comparison(i.e. comparing with other companies in same industry)


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Return on Capital Employed

Indicates true measure of performance of an enterprise

The capital employed in business is Equity capital, reserves andsurplus, long term debt and short term debt.

Returns generated for all these providers of capital is EBIT.

ROCE = EBIT / (Networth + Total Debt) The ratio is independent of the industry, capital structure or

asset intensity.

For healthy companies, ROCE ranges from 15% - 30%

If ROCE is less than Interest rate for a company

consistenty, the company is destroying value for its equityinvestors / owners

The owners are better off dissolving the company andparking their money in bank fixed deposits and earninterest!!!


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Interest coverage The ratio indicates the cushion the company has,

to service its interest

Interest coverage = EBITDA / Interest cost

Higher the ratio, better it is for the lenders

For healthy companies, Interest coverage rangesfrom 2.0x to 8.0x.

Interest coverage < 1.0x indicates high stress,

and probably default on interest payments.


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Current ratio

This is a commonly used liquidity ratio, used by banks that lend forworking capital

Current ratio = Current Assets

Current liabilities + Short term debt

The ratio indicates the ratio of short term assets to short term liabilities. Indirectly, the ratio also indicates the proportion of long term assets funded by

long term liabilities.

For solvent companies, current ratio ranges between 1.2x to 2.0x

Current ratio of < 1.0x indicates that the company may face liquidityproblems, as more current liabilities / short term debt are maturing in thenext one year, than the current assets that are maturing in the sameperiod.

Please read the commentary:http://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdf
http://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdfhttp://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdf


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Equity investors, such as a Mutual Fund investing in shares, oran individual investor, or a Private Equity investor, may use thefollowing ratios:

Earnings Per Share (EPS)

The Profit earned by the company for each share in the share

capital of the enterprise EPS = Profit After Tax

Number of Equity shares outstanding

EPS is expressed in Rupees.

This represents each shareholders claim in the profits of thecompany, for the relevant period (one year, one quarter, etc.)

Two common sub-classification are Basic EPS and Fully DilutedEPS

Basic EPS is computed based on no. of shares outstanding currently

Fully Diluted EPS is computed assuming all convertibles andoptions are exercised fully.


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Price - Earnings Ratio (PE) The ratio of current market price of the equity share to the annual

earnings per share

PE = Current Market Price per share

Earnings Per Share (EPS)

PE is expressed in ratio or times.

When EPS is negative, PE is meaningless.

Two common sub-classification are Forward PE and TrailingTwelve Months (TTM) PE

Forward PE is computed using EPS of the next financial year

TTM PE is computed using EPS of last 4 quarters

PE ratio has no meaning for unlisted companies as there is no

market price for these shares Broadly speaking, PE ratio is in the range of 5-12x during

recession times and 10-25x during boom times. The ratio is also related to the growth in earnings that the company

can generate in the next few years.


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Basics of Finance _ 2