Finance for Non Finance Professionals

Agenda

Objective of the Webinar

Key takeaways

Purpose of existence of an economic entity

Financial statements – construction and purpose

Understanding and interpreting Financial Statements

Financial analysis as a measurement tool

Purpose of analysis – equity perspective, debt perspective

Ratio analysis

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

Q&A

Objective

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

finance To evaluate decisions related to finance more

knowledgeably To participate effectively in finance related discussions

in their respective organisations To gain basic understanding to pursue higher

education / career in the field of finance To follow recent economic events and its impact on

corporate performance To take informed decision related to personal finance

and investing To interact with financial department / finance

professionals more knowledgeably

Key Take Aways

Key takeaways Basic understanding of various forms of

economic entities Understanding financial statements and

perform ratio analysis on published statements

Evaluate a corporate investing or financing decision meaningfully

Track financial performance of listed companies closely, to take well-informed investment decisions

Read / follow business newspapers / business channels with better understanding

Purpose of an economic entity

To do ‘business’ is to create an economic entity with the purpose of

Wealth creation Wealth management, and Wealth distribution

Objective of an enterprise – To create the best possible values and share them in the

equitable manner among all the stakeholders

Purpose of an enterprise

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

Stakeholders

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

Equity holders – majority holders, minority shareholders

Debt holders including banks and financial institutions

Management Employees Suppliers Customers Community, Taxman

Why Accounting?

Accounting forms the basis for measuring the performance of an enterprise

The performance determines which stakeholder gets what share of the business

Accounting also ensures ‘equitable’ distribution of wealth generated, based on each person’s contribution to the business

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

are determined based on prudent accounting practices Employees are typically rewarded based on their individual

performance as well as the performance of the enterprise Minority shareholders get equal treatment compared to majority

owners (equal dividend distribution) Debt holders are 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 separate legal entity, and all stakeholders as those contributing capital, labour or resources.

Various forms of enterprise

Partnership

Enterprise

Closely held

CompanyProprietary

Public Ltd.Private Ltd.

Publicly held

Various forms of enterprise

Proprietary business – owned by single owner No difference between the obligations of the business and the obligations of the

individual.

Partnership firm – owned 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)

Company is 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)

Financial statements

Financial statements report the state of financial affairs of an enterprise

These are made publicly available for widely held companies, usually free of cost (www.bseindia.com and www.nseindia.com )

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

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

Three key financial statements are Balance Sheet Profit & Loss Account and Cash flow statement

Construct of a Balance Sheet

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

Some observations on Balance Sheet

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 and liabilities of the enterprise as on that date.

Some observations on Balance Sheet

Another way to look at the balance sheet is to match the sources and uses 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.

Construct of a Profit & Loss account

Revenues from the businessLess Raw material consumed

Employee expensesOther manufacturing expensesAdministrative expensesSelling 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

Inside the P&L Account

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

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.

Inside the P&L Account

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)

Inside the P&L Account

Some observations on P&L Account

P&L Account presents a snapshot of the performance of an enterprise 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

Cashflow Statement

What is a Cashflow Statement? A statement that links the P&L generated based on ‘accrual’

principle and the Balance Sheet which represents the snapshot on a given date

A statement that segregates cash generated and cash used based on the source/end use of the cash

What are its components? Three key components of Cashflow Statement are

Cashflow from Operating Activities Represents the cash generated from the operations of the

enterprise – a measure of ‘cash profit’ from the operations Cashflow in Investing Activities

Represents the deployment of cash in various assets such as fixed assets, investments, etc.

Cashflow from Financing Activities Represents the net cash raised in the form of capital such as

equity capital, borrowed funds, etc.

Construct of a Cash flow Statement

Cashflow from Operating ActivitiesProfit Before Tax

Less Non-operating income (e.g. Interest income, profit on sale of assets)Add Interest expenseAdd DepreciationLessOther cash adjustments (e.g. Unrealised foreign exchange loss) = Operating Profit before Working Capital ChangesLessIncrease in DebtorsLessIncrease in InventoryLess Increase in other current assets (e.g. Loans and Advances)Add Increase in CreditorsAdd Increase in other Current liabilities and Provisions= Cash generated from OperationsLessTaxes= Net Cash from Operating Activities

Construct of a Cash flow Statement

Cash flow from Investing Activities

Purchase of Fixed Assets (negative because it is cash outgo)Add Purchase of Long term investmentsLess Proceeds from Sale of Fixed Assets or Investments (if any)Add Interest and Dividend Income= Net Cash used in Investing Activities

Cash flow from Financing Activities

Proceeds from issue of share capitalAdd Proceeds from raising fresh loans Less Repayment of existing loansLess Interest expenseLess Dividend paid= Net Cash Generated from Financing Activities

Opening Balance: Cash and Cash EquivalentsAdd Net Cash from Operating ActivitiesLess Net Cash used in Investing ActivitiesAdd Net Cash Generated from Financing Activities= Closing Balance: Cash and Cash Equivalents

Some observations on Cash flow statement

Cash flow statement provides the reference check for the quality of ‘profits’ generated by a company

For instance, if the company reports profits, most of which remain uncollected in the form of ‘debtors’, cashflow from operations will be negative, which should prompt an analyst to probe debtors further.

Cash flow statement provides a snapshot of where the cash comes and where the cash goes

Disproportionate cash going into investing activities on a continuous basis could provide a clue on ‘unproductive’ assets in a company.

Cash flow statement, like balance sheet, provides a self-check point Opening and Closing Cash balances should tie in with the actual balance in

the bank account as on the opening and closing dates. Acts as a good reference check point.

Negative cashflow from operations is not necessarily a sign of distress, especially for a growing company.

Typically, increase in working capital could be more than the cash profit

generated by a growing company

Ratio analysis

Some important ratios for analysing performance of a company:

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

Ratio analysis

Operating profit margin Indicates the business profitability OPM = EBITDA / Operating Income (or Net Sales) Depending on the industry, for healthy companies, OPM

ranges from 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 commonly used.

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

Ratio analysis

Return on Capital Employed Indicates true measure of performance of an enterprise The capital employed in business is Equity capital, reserves

and surplus, 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 equity investors / owners

The owners are better off dissolving the company and parking their money in bank fixed deposits and earn interest!!!

Ratio analysis – Lenders’ perspective

Lenders, such as a bank giving loan, or a Mutual Fund investing in bonds or debentures of a company, may use the following ratios:

Debt:Equity ratio The ratio of borrowed funds to owners’ funds D:E ratio is also known as ‘gearing’, ‘leverage’ or ‘capital

structure’ Gearing = (Long term debt + Short Term debt)

(Equity capital + Reserves & Surplus) For most manufacturing companies, D:E less than 2.0x is

considered healthy. Higher the ratio, better it is for owners; but at the same

time, more risky for lenders Company has to service higher interest cost if it borrows

more; in a recession, the company may be more vulnerable to default on its interest.

Ratio analysis – Lenders’ perspective

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

ranges from 2.0x to 8.0x. Interest coverage < 1.0x indicates high

stress, and probably default on interest payments.

Ratio analysis – Lenders’ perspective

Current ratio This is a commonly used ‘liquidity ratio’, used by banks that lend

for ‘working 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

liquidity problems, as more current liabilities / short term debt are maturing in the next one year, than the current assets that are maturing in the same period.

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

Ratio analysis – Equity investors’ perspective

Equity investors, such as a Mutual Fund investing in shares, or an individual investor, or a Private Equity investor, may use the following 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 shareholder’s claim in the profits of the

company, for the relevant period (one year, one quarter, etc.) Two common sub-classification are Basic EPS and Fully

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

currently Fully Diluted EPS is computed assuming all ‘convertibles’ and

‘options’ are exercised fully.

Ratio analysis – Equity investors’ perspective

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

Trailing Twelve 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.

Thank you!