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Financial Statement Analysis
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Financial reporting provides information about performance, financial position, andchanges in financial position
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Food for thought
Suppose you were working with Satyam in 2008. If you had analyzed the previous 3years financial statements, would you have discovered that cash was diverted fromthe company?
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The objective of an audit of financial statements is to enable the auditor to express anopinion whether the financial statements are prepared, in all material respects, inaccordance with an applicable financial reporting framework.
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Why FSA
Evaluating equity investment
va ua ng
Assigning credit rating
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Accounting principles
Historical cost basis
Going-concern rule Matching principle
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Accounting principles
Consistency rule
Conservative principleMateriality rule
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Liquidity Vs Solvency
Liquidity refers to the ability to meet short-term obligations
Solvency refers to the ability to meet long-term obligations
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Accounting Process
Voucher
(Documentation)
Journal(Day book)
Ledger(Classification)
Trial Balance
(Summarizing)
Financial Statements
(Bifurcation) 9
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Documentation and Recording
Three rules of accounting
Debit the receiver Debit what comes in Debit all expenses and losses
Credit the giver Credit what goes out Credit all incomes and gains
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Whats relevant for whom?
Particulars Amount
Net Sales/Income from Operations 460233.00
Other Operating Income 5800.00
Other Income 40945.00
Interest 5077.00
Lenders?Owners?
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Net Profit (+) / Loss (-) for the period 211809.00
Dividend (%) -
Face Value (in Rs.) 1.00
Paid-up Equity Share Capital 8310.00
Reserves excluding RevaluationReserves
712561.00
Diluted EPS after Extraordinaryitems (in Rs.)
25.31
Public Shareholding (%) 42.97
OwnersEmployeesPublic-at-large?
Lenders?
Owners?
LendersOwnersEmployeesPublic-at-large?
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Financial Statements
Balance Sheet
Report format
Account format
Income statement
Cash flow statement
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Balance Sheet
What are assets? Resources from which future economic benefitsare expected to flow to the enterprise
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Typical Assets
Cash and cash equivalents
Inventories
Receivables
Prepaid expenses
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Property, plant, and equipment
Intangible assets
Investments
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Financial Statements
Statement of financial position at the end of the period
Statement of comprehensive income for the period (presented as either a singlestatement or an income statement with a statement of recognized gains and losses)
Statement of changes in equity for the period
Statement of cash flows for the period
Notes, including a summary of significant accounting policies
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Food for thought
Physical form? Patents, copyrights?
Legal rights? Hire-purchase?
Purchased/produced?
Government granted land?
Expenses incurred? Unsuccessful digging of oil wells?
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Balance Sheet
What are liabilities? Present obligation likely to be settled in the future
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Typical Liabilities
Borrowings
Payables
Provisions
Unearned revenues
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Financial liabilities
Accrued liabilities
Deferred tax liabilities
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Food for thought
Rectifying defects beyond
warranty period?
Maintaining good business relation,liability
Estimating liability? Provisions. Retirement benefits?
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Balance Sheet
What is equity? Assets less Liability?
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Food for thought
Decision needs of users?Owners capital, General Reserve,Capital Reserve
Creditor rotection? Debenture redemption reserve
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Points to Ponder
How should firm fund their assets?
Corporate finance decision
Why is equity capital important
Financial distress, optimal capital structure
Corporate strategy
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Special Note- Inventories
Lower of cost or NRV
What is dating?
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Points to Ponder
Should firms carry all its assets on historical cost basis?
Relevance of Price-to-book multiple in firm valuation
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Special note- Intangibles
Identifiable intangible
Unidentifiable intangible
Amortized over estimated useful life
Tested for impairment every year
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Is goodwill same as control premium?
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Income Statement
What is Income? Increase in economic benefitduring a year
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Income Statement
Net Income or Net profit = Revenue - Expenses
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Income statement
Function of expense method
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Eh-Bit-Duh?
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Classification using nature of expense method
Revenue
Other income
Changes in inventories of finished goods and work in progress
Raw materials and consumable used
Employee expenses
Depreciation and amortization expense
Other expenses
Total expenses
Profits before tax
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Food for thought
Does Sales have the same meaning as Revenue?
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Revenue Recognition- Goods
Evidence of an arrangement between buyer and seller
Disallows practice of recognizing revenue by delivering the product justbefore the end of an accounting period and then completing a salescontract after the period end
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,
Precludes revenue recognition when the product has been shipped but risksand rewards of ownership have not actually passed to the buyer
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Revenue Recognition- Goods
Price is determined or determinable
Precludes firms from recognizing revenue based on contingency
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Seller reasonably sure of collecting money
Preclude firms from recognizing revenue when the customer is unlikely to pay
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Revenue Recognition- Services
Outcome of a transaction involving the rendering of services can be estimated reliably
Amount can be measured reliably
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Probable that economic benefits will flow to the entity
Stage of completion of transaction can be measured reliably
Costs incurred can be measured reliably
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From Annual Report: Revenue Recognition
1. Revenue on time-and-material contracts are recognized as the related services areperformed and revenue from the end of the last billing to the Balance Sheet date isrecognized as unbilled revenues.
2. Revenue from fixed-price, fixed-timeframe contracts, where there is no uncertainty asto measurement or collectability of consideration, is recognized based upon the
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percentage-of-completion.
3. When there is uncertainty as to measurement or ultimate collectability, revenuerecognition is postponed until such uncertainty is resolved.
4. Cost and earnings in excess of billings are classified as unbilled revenue while
billing in excess of cost and earnings is classified as unearned revenue.
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Revenue Recognition- Special Cases
Long-term contracts
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Expense Recognition
Matching Cost Principle
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er o os
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Issues In Expense Recognition
Warranty on sales
Depreciation and Amortization
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Points to Ponder
What if accumulated depreciation is a large percentage of total fixed assets?
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Accounting equations
Assets= Liabilities + Owners equity
Assets - Liabilities = Owners equity
Owners equity = Contributed capital + Retained earnings
Revenue - Expenses = Net income (loss)
Ending retained earnings = Beginning retained earnings + Net income- Dividends
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Why Cash Flow Statement
Provides information about cash receipts and cash payments during an accountingperiod
Shows cash flow linkage between ending cash balance and beginning balance
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Cash Flow Statement
Disclosing sources and uses of cash helps statement users evaluate the companysliquidity, solvency, and financial flexibility
CFO CFFCFI
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Bond Issue
Actual interest rate Vs Effective interest rate
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Accounting for Carbon Credits
Clean Development Mechanism
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Certified Emission Reduction
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Accounting for Leases
Operating Lease
Financial Lease
Ownership of leased asset transfers to lessee at end of lease
Lease contains option for lessee to purchase leased asset cheaply
Lease term is 75 percent or more of useful life of leased asset.
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Recent ED
PV of lease payments is 90 percent or more of FV of leased asset.
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Deferred Taxes
Taxable profits Vs Accounting Profits
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Tax Asset, Tax Liability
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Corporate Frauds
Financial statement fraud
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Corruption
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Financial Statement Fraud
Understating liabilities
Misuse of materiality concepts
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Overstating revenue
Understating expenses
Overstating assets
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Red Flags: Overstating Income
Increased revenues without corresponding increase in cash flow
Unusual growth in days receivables
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Significant, unusual or highly complex transactions, particularly those that areclosed near the end of a financial reporting period
Strong revenue growth when peer companies are experiencing weak sales
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Red Flags: Understating expenses
Significant unexplained increases in fixed assets
Recurring negative CFO despite positive earnings and earnings growth
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Cookie Jar Reserves
Smoothing of earnings, overestimating liabilities during good times
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Ratio Analysis- Asset Utilization Measurement
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Ratio Analysis
Sales-to-Working Capital Ratio
Annualized net sales(Accounts receivable + Inventory Accounts payable)
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Ratio Analysis
Sales-to-Fixed Asset Ratio
Annualized net sales
Total fixed asset
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Ratio Analysis
Accumulated Depreciation to Fixed Assets Ratio
Accumulated depreciation
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Total fixed assets
Is company strapped for cash? Analysis of Cash Flow Statement
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Ratio Analysis
Investment Turnover
Sales
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Equity + Long-term liabilities
Read with Debt-Equity RatioOptimal capital structure
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Ratio Analysis
Break-even Point
Total operating expenses
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verage gross marg n percentage
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Ratio Analysis
Margin of Safety
Current sales level Break-even point
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Current sales level
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Ratio Analysis- Operating Performance Measurement
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R ti A l i
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Ratio Analysis
Gross Profit Index
Gross profit in period two
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Gross profit in period one
Sales in period one
G P fit I d R d Fl
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Gross Profit Index: Red Flags
Accounting changes
Business issues
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Corporate strategy
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Ratio Analysis- Cash Flow Measurement
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Ratio Analysis
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Ratio Analysis
Cash Flow From Operations
Net Income + Noncash ex enses Noncash sales
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Net Income
Ratio Analysis
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Ratio Analysis
Cash Flow Coverage Ratio
Total debt payments + Dividend payments + Capital expenditures
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Net income + Noncash expenses Noncash sales
Ratio Analysis
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Ratio Analysis
Cash Flow to Fixed Assets Ratio
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+ -
Capex
Points to Ponder
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Points to Ponder
What if the Cash Flow to Fixed Assets Ratio is one?
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Read with Return on Equity?
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Ratio Analysis- Liquidity Measurement
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Ratio Analysis
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Ratio Analysis
Average Receivables Collection Period
Average accounts receivable
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Annual sales / 365
Points to Ponder
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Points to Ponder
How about annualizing sales for the period covered by the existing accounts receivable?
Is annualizing monthly sales acceptable?
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Ratio Analysis
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Ratio Analysis
Inventory Turnover/Days Inventory
Cost of goods sold
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----Inventory
365/Inventory Turnover Ratio
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Ratio Analysis- Capital Structure and Solvency
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Ratio Analysis
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Ratio Analysis
Times Interest Earned
Average cash flow
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Average interest expense
What about principal repayments?
Ratio Analysis
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y
Debt Service Coverage Ratio
Earnings before interest and taxes
Scheduled rinci al a ments
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Interest +
(1 Tax rate)