Finance for Non Finance Professionals
N. Muthuraman Director
RiverBridge Investment Advisors Pvt. Ltd.
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 activity
Selling price > Cost of purchase
Manufacturing activity:
Selling price > Cost of purchase + conversion costs
Services
Price for service > Cost of providing the service
Buying Selling
Selling Processing
Buying
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
Company Proprietary
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 business
Less Raw material consumed Employee 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
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
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 Activities
Profit Before Tax
Less Non-operating income (e.g. Interest income, profit on sale of assets) Add Interest expense
Add Depreciation
Less Other cash adjustments (e.g. Unrealised foreign exchange loss)
= Operating Profit before Working Capital Changes Less Increase in Debtors
Less Increase in Inventory
Less Increase in other current assets (e.g. Loans and Advances) Add Increase in Creditors
Add Increase in other Current liabilities and Provisions
= Cash generated from Operations Less Taxes
= 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 investments
Less 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 capital Add Proceeds from raising fresh loans Less Repayment of existing loans
Less Interest expense Less Dividend paid
= Net Cash Generated from Financing Activities Opening Balance: Cash and Cash Equivalents
Add Net Cash from Operating Activities Less Net Cash used in Investing Activities
Add 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
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
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
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
Thank you!
