Analysis of Financial Statements

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 ? Borrower

How do we judge him ? 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 SCIENTI-

FIC 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 user 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

ACCOUNTING

LEGAL

TAXATION

Financial Statements - the components Statement of profit & loss (P&L account) 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 Accounts 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 - NILLoan from Bank/FIs <= Rs.10 lakhAnnual 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 accounted 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 Accounting Standards

International Accounting Standards

US GAAP

Structure of presentation of Balance Sheet

Liabilities Assets

Capital & Reserves Fixed Assets

Secured Loan Investments

Unsecured Loan Current Assets, Loans & Advances

Current Liabilities & Provisions

Miscellaneous expenses to the extent not written off

Total Total

Structure of presentation of Balance Sheet (as required for analysis)

Liabilities AssetsShort term Bank borrowing Cash & Bank balance

Other Current Liabilities (incldg. Trade Creditors, Provisions etc.)

Inventories, Receivables etc. (assets chargeable to Bank)

Term Liabilities Other Current Assets

Net Worth Net Block (Fixed Assets less Depreciation)

Intangible Assets

Total Total

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 AssetsCurrent 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 LiabilitiesSimilarly, 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-classificationValue 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 Amount in Rs. Lakh Liabilities Year 1

Year 2 Assets Year 1 Year 2

Capital & general reserve

500 700 Fixed assets (including revaluation)

1700 1400 (1700-300)

Revaluation reserve

500 400

Other liabilities (including bank loan)

1000 1000 Other assets 300 700

Total 2000 2100 2000 2100 (Note : year 1 – on revaluation ; year 2 – one year after revaluation)

Revaluation – Bank perspective

Profit & Loss account (Rs. lakh)

Profit before depreciation 400

Less depreciation 200

Profit after depreciation 200

Liabilities Year 1

Year 2 Assets Year 1 Year 2

Capital & general reserve

500 700 Fixed assets 1200 1000

Other liabilities (including bank loan)

1000 1000 Other assets 300 700

Total 1500 1700 1500 1700

Deferred Tax issues Stems from a difference in approach in Accounting

vs. Taxation accounting 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 I II III IV V

1. PBDT (say) 12 12 12 12 12 2. Depreciation (as per Companies Act) 2 2 2 2 2 3. PBT 10 10 10 10 10 4. Provision for Tax (@ 40%) 4 4 4 4 4 5 PBDT 12 12 12 12 12 6. Depreciation (as per Income Tax Act) 10 0 0 0 0 7. PBT 2 12 12 12 12 8. Provision for Tax (@ 40%) 0.8 4.8 4.8 4.8 4.8 9.

Deferred Tax liability created 3.2 ( 4 – 0.8)

10. Balance of DTL as appearing in the BS 3.2 2.4 1.6 0.8 0

Analysis of Financial StatementsAnalysis 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 AnalysisMost 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 CA the concept of ‘Current-ness’ of assets and

liabilities The conflict between Prescriptive & Conceptual

definitions The conflict between ‘Operating Cycle’ vs.

‘Funding’ concept Does not take care of recent accounting

developments Deferred tax CENVAT receivables

Net Working Capital

Current AssetsCurrent Liabilities

Net Working Capital

Other

Liabilities Other

Assets

Gearing ratio

Indicates stability

TOL / TNW

Debt Equity ratio (TTL / TNW)

Consider the followingA 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 50

Cash credit 300

Total 1000 Total 1000

Total Debt / Equity Ratio (TOL / TNW) 900 / 100 9 : 1

Long Term Debt / Equity (TTL / TNW) 400 / 100 4 : 1

Current Ratio CA / CL 500 / 500 1 : 1

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 Amount Assets Amount

Capital 100 Current Assets 500

Unsecured loan 50

Trade credit 50

Cash credit 300

Total 500 Total 500

Total Debt / Equity Ratio (TOL / TNW) 400 / 100 4 : 1

Long Term Debt / Equity (TTL / TNW) NA NA

Current Ratio CA / CL 500 / 400 1.25 : 1

Gearing ratio - stability

TOL

TNW

TOL

TNW

Stable 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

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