Finance for Non Finance Professionals

1
Finance for Non Finance Professionals

• N. Muthuraman
• Director
• RiverBridge Investment Advisors Pvt. Ltd.

Disclaimer This session does not aim to provide
any investment advice. Participants may seek
advise of professional investment advisors for
taking any investment decisions.
2
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
• QA

3
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

4
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

5
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
6
Purpose of an enterprise

• Business as an economic entity exists to make
  profits
• Trading activity
• Selling price gt Cost of purchase
• Manufacturing activity
• Selling price gt Cost of purchase conversion
  costs
• Services
• Price for service gt Cost of providing the service

Selling
Buying
Processing
Buying
Selling
Servicing
7
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

8
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 persons
  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.

9
Various forms of enterprise
Enterprise
Proprietary
Partnership
Company
Public Ltd.
Private Ltd.
Publicly held
Closely held
10
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)

11
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

12
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

13
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.

14
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.

15
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

16
Inside the PL 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

17
Inside the PL Account

• 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.

18
Inside the PL Account

• Depreciation
• Straight line method
• Written Down Value method
• Deferred revenue expenditure
• RD expenses
• Advertisement expenses
• Product promotion expenses
• (expenses are charged as capital expenses and
  amortized over the period of time)

19
Some observations on PL Account

• PL 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
• PL 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

20
Cashflow Statement

• What is a Cashflow Statement?
• A statement that links the PL 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.

21
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

22
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

23
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

24
Ratio analysis

• Some important ratios for analysing performance
  of a company
• Operating profit margin
• Net profit margin
• Return on Capital Employed
• Current Ratio
• DebtEquity ratio
• Interest coverage ratio
• Earnings per share
• Price Earnings ratio
• Return on Networth

25
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)

26
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!!!

27
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
• DebtEquity ratio
• The ratio of borrowed funds to owners funds
• DE 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, DE 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.

28
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 lt 1.0x indicates high stress,
  and probably default on interest payments.

29
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 lt 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-abo
  ut-current-ratio_Dec05.pdf

30
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 shareholders 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.

31
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.

32
Thank you!