Financial Understanding


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Presentation on Balance sheet, P&L and Financial rations

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Financial Understanding

  1. 1. Financial Appraisal
  2. 2. Balance Sheet <ul><li>Balance sheet reveals the financial position of a concern at a particular point of time (usually the closing date of the operating year). </li></ul><ul><li>Balance sheet is generally prepared on the basis of 'business entity ' concept under which the concern is taken as a separate entity than its promoter and will have its separate assets and liabilities. </li></ul><ul><li>The balance sheet gives particulars of assets and liabilities of a concern as on the date of closing and must also reveal the manner in which these are distributed. </li></ul><ul><li>Total assets of any concern will be matched by its total liabilities at all the times. </li></ul> of 19
  3. 3. Profit & Loss Statement <ul><li>Profit and loss statement is the summary of operations during the operating year. </li></ul><ul><li>Profit and loss account is the statement of working results of the concern for its operations during the year and is an important indicator of the way the business is being conducted by the concern and its financial results. </li></ul> of 19
  4. 4. Form of Balance sheet and P&L statement <ul><li>Except for limited companies, no specific form in which the Balance Sheet and P & L a/c of a concern is to be presented has been prescribed. </li></ul><ul><li>Limited companies have to draw their balance sheet in the format prescribed in Schedule VI under section 211 of Companies Act, 1956. </li></ul><ul><li>The first step for rearrangement starts with grouping of individual items of assets and liabilities into major groups. </li></ul> of 19
  5. 5. Basic Form of Balance Sheet: of 19
  6. 6. Term Explanation: <ul><li>Capital and Reserves : Representing contribution of the promoters/owners of the concern towards business. It is also known as the 'net worth' of the concern. </li></ul><ul><li>Term Liabilities : Representing those liabilities which are payable after one year. </li></ul><ul><li>Current Liabilities : Representing those liabilities which are generally payable within one year. </li></ul><ul><li>Fixed Assets : Representing assets of fixed nature such as land, building, plant and machinery etc. permanently required by the concern to carry out its business. </li></ul><ul><li>Intangible Assets : Representing assets such as goodwill, patents, preliminary expenses etc. </li></ul><ul><li>Current Assets : Representing those assets which are likely to be converted to cash within an operating period. </li></ul><ul><li>Other Non‑current Assets : Which represent miscellaneous assets not realisable during the current operating period such as non‑consumable stores & spares. </li></ul> of 19
  7. 7. Capital & Reserve (Net Worth) <ul><li>Net worth is a measure of financial stake of the promoters/owners in the business and is also referred to as 'owned funds'. </li></ul><ul><li>This is an important indicator of intrinsic financial strength of' the concern and is generally compared to the total outside liabilities of the concern. </li></ul><ul><li>The following items of the liability side of the balance sheet are added up to find out the net worth: </li></ul><ul><ul><li>Ordinary share capital. </li></ul></ul><ul><ul><li>Preference share capital (redeemable after 12 years). </li></ul></ul><ul><ul><li>General reserve. </li></ul></ul><ul><ul><li>Share premium </li></ul></ul><ul><ul><li>Development rebate reserve. </li></ul></ul><ul><ul><li>Investment allowance reserve. </li></ul></ul><ul><ul><li>Other reserves (excluding provisions). </li></ul></ul><ul><ul><li>Surplus in profit a n d loss account. </li></ul></ul> of 19
  8. 8. Capital & Reserve (Net Worth) <ul><li>However, if there is any deficit (carry forward loss) in profit and loss a/c on assets side of the balance sheet, the same should be deducted to find out the net worth of the concern. </li></ul><ul><li>The value of any intangible assets is also deducted to arrive at the tangible net worth. </li></ul><ul><li>The revaluation reserve, if any, is generally not counted for the purpose of determining the net worth. </li></ul><ul><li>Capital investment in subsidiary/other group companies may also be sometimes deducted from the net worth/net owned funds to arrive at the correct status of the stake of owners in the business. </li></ul><ul><li>In case of partnership & proprietary concerns any debit balance in the current accounts of the partners/proprietor shall also be deducted from partners' capital while computing the net worth. </li></ul> of 19
  9. 9. Term Liabilities <ul><li>The liabilities which are not payable within one year are grouped as ‘term liabilities’ and will generally include the following items in the balance sheet: </li></ul><ul><ul><li>Debentures (not maturing within one year). </li></ul></ul><ul><ul><li>The part of debentures which is compulsorily convertible to share capital should be shown as a part of equity capital forming net worth of the concern. The balance amount only need he shown under this head and included in the term liabilities. </li></ul></ul><ul><ul><li>Redeemable preference shares (not maturing within one year, but of maturity not exceeding 12 years). </li></ul></ul><ul><ul><li>Term loans (exclusive of instalments payable within one year and overdue instalments, if any). </li></ul></ul><ul><ul><li>Deferred payment credits (exclusive of instalments payable within one year). </li></ul></ul><ul><ul><li>Term deposits repayable after one year. </li></ul></ul><ul><ul><li>Deposits from dealers/selling agents irrespective of their tenure if such deposits are accepted to be repayable only, when the dealership/agency is terminated. </li></ul></ul><ul><ul><li>Other such liabilities, which are repayable after one year </li></ul></ul> of 19
  10. 10. Current Liabilities <ul><li>All liabilities which are of short‑term nature and are generally payable within a period of' one year are taken as current liabilities. </li></ul><ul><li>Current liabilities also include estimated or accrued amounts which are anticipated to cover expenditure within the year for known obligations such as provisions for bonus payments, taxation etc. </li></ul><ul><li>The following items are included in current liabilities: </li></ul><ul><ul><li>Short‑term borrowing (including bills purchased and discounted) from banks and others. </li></ul></ul><ul><ul><li>Unsecured loans. </li></ul></ul><ul><ul><li>Public deposits maturing within one year. </li></ul></ul><ul><ul><li>Sundry creditors (trade) for raw materials and consumable stores and spares. </li></ul></ul><ul><ul><li>Interest and other charges accrued but not due for payment. </li></ul></ul><ul><ul><li>Advances/progress payments from customers. </li></ul></ul><ul><ul><li>Instalments of term loans, deferred payment credits, debentures, long‑term deposits payable within one year. </li></ul></ul> of 19
  11. 11. Current Liabilities - cont. <ul><ul><li>Redeemable preference shares maturing within one year. </li></ul></ul><ul><ul><li>Lease rentals payable during the year in respect of leased assets, if any. </li></ul></ul><ul><ul><li>Provident Fund dues. </li></ul></ul><ul><ul><li>Provision for taxation. </li></ul></ul><ul><ul><li>Sales tax, excise duty etc. </li></ul></ul><ul><ul><li>Other Provisions </li></ul></ul> of 19
  12. 12. Misc. Current Liabilities <ul><li>Dividends </li></ul><ul><li>Liabilities for expenses. </li></ul><ul><li>Gratuity payable within one year. </li></ul><ul><li>Other provisions </li></ul><ul><li>Any other payments due within one year. </li></ul> of 19
  13. 13. Fixed Assets <ul><li>Fixed assets are generally shown in the balance sheet on the gross value termed as 'gross block‘. </li></ul><ul><li>Fixed Assets would generally include land and building, plant and machinery, construction in progress, furniture and fixtures, vehicles, etc. </li></ul><ul><li>The depreciation on fixed assets is provided annually and credited to a separate depreciation reserve fund. </li></ul><ul><li>The 'net block' of fixed assets which is actually taken into the balance sheet would he obtained by deducting depreciation reserve fund from the 'Gross block'. </li></ul><ul><li>'Capital work in progress' if shown separately in the balance sheet is also to be classified under ‘Fixed Assets’. </li></ul> of 19
  14. 14. Current Assets <ul><li>The item is of current assets include cash and bank balances and such assets which are realisable into cash within an operating period of one year. </li></ul><ul><li>The items to be included in Current Assets are: </li></ul><ul><ul><li>Cash and bank balance. </li></ul></ul><ul><ul><li>Receivables arising out of sales including exports other than deferred receivables including bills purchased and discounted by banks </li></ul></ul><ul><ul><li>Instalments of deferred receivables due within one year. </li></ul></ul><ul><ul><li>Advance payment for taxes. </li></ul></ul><ul><ul><li>Prepaid expenses </li></ul></ul><ul><ul><li>Inventory/stock of goods consisting of </li></ul></ul><ul><ul><ul><li>Raw materials and components used in the process of manufacture including those in the transit. </li></ul></ul></ul><ul><ul><ul><li>Stocks in process including semi‑finished goods. </li></ul></ul></ul><ul><ul><ul><li>Finished goods including goods in transit. </li></ul></ul></ul><ul><ul><ul><li>Other consumable spares. </li></ul></ul></ul> of 19
  15. 15. Current Assets <ul><ul><li>Advances for purchase of raw materials, components and consumable stores. </li></ul></ul><ul><ul><li>Deposits kept with public bodies etc. for normal business operations such as earnest deposits kept by construction companies etc. maturing within the normal operating cycle. </li></ul></ul><ul><ul><li>Monies receivable from contracted sale of fixed assets during the next one year. </li></ul></ul> of 19
  16. 16. Other Non-current Assets <ul><li>This category includes such tangible miscellaneous assets which are not current in nature and are also not classified as fixed assets. It may be taken as residual category of tangible assets with a concern and will consist of: </li></ul><ul><ul><li>Investments/book debts/advances/deposits to subsidiary companies/ affiliates and others inter corporate deposits/investment in units of Unit Trust of India & other Mutual Funds. </li></ul></ul><ul><ul><li>Investment for long term purposes e.g. sinking fund, gratuity fund etc. </li></ul></ul><ul><ul><li>Advances to suppliers of capital goods/spares and contractors for capital expenditure. </li></ul></ul><ul><ul><li>Deferred receivables excluding those which are maturing within one year and have been included in current assets. </li></ul></ul><ul><ul><li>Dead inventory including non‑consumable stores and spares. Other miscellaneous assets including dues from directors. Security deposits/ tender deposits. </li></ul></ul><ul><ul><li>Fixed deposits with banks as margin for non‑fund based credit facilities. </li></ul></ul><ul><ul><li>Receivables outstanding for more than 6 months. </li></ul></ul> of 19
  17. 17. Intangible Assets <ul><li>The items under this head would generally consist of. </li></ul><ul><ul><li>Goodwill </li></ul></ul><ul><ul><li>Patents </li></ul></ul><ul><ul><li>Preliminary and formation expenses not written off </li></ul></ul><ul><ul><li>Bad and doubtful debts not provided for. </li></ul></ul>
  18. 18. Ratio Analysis
  19. 19. Why Ratio Analysis? <ul><li>It is a tool which enables the banker or lender to arrive at the following factors: </li></ul><ul><ul><li>Liquidity position </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Solvency </li></ul></ul><ul><ul><li>Financial Stability </li></ul></ul><ul><ul><li>Quality of the Management </li></ul></ul><ul><ul><li>Safety & Security of the loans & advances to be or already been provided </li></ul></ul> of 19
  20. 20. Classification of Ratio <ul><li>Liquidity Ratio </li></ul><ul><ul><li>These ratios include the ability of the company to discharge the liabilities as and when they mature, generally the next 1 year. </li></ul></ul><ul><li>Efficiency Ratio </li></ul><ul><ul><li>Profitability is the measure of earning ability of the business. They are generally measured in percentages. </li></ul></ul><ul><li>Turnover Ratio </li></ul><ul><ul><li>Turnover ratios are basically productivity ratios which measure the output produced from the given inputs deployed. </li></ul></ul><ul><li>Finance structure Ratio </li></ul><ul><ul><li>These ratios indicate the relative mix or blending of owner’s funds and outsider’s debt funds in the total capital employed in the business. </li></ul></ul><ul><li>Valuation Ratio </li></ul><ul><ul><li>These ratios are the result of the management of above four categories of the functional ratio. These are presented on a per share basis and thus are more useful to the equity investors. </li></ul></ul> of 19
  21. 21. Classification of Ratio of 19 Liquidity Efficiency Turnover Leverage Valuation Current Ratio Quick Ratio GP margin NP margin ROI RONW Fixed Asset Turnover Ratio, Inventory Turnover Ratio, Debtor’s Turnover Ratio. Creditor’s Turnover Ratio Debt – Equity Debt Ratio, Indebtedness Ratio, Interest Coverage Ratio, DSCR EPS D/P Ratio MV to BV Ratio
  22. 22. Debt – Equity Ratio <ul><li>It is a measurement of long‑term solvency of concern. The ratio gives an indication of the dependence of the concern on borrowed funds. </li></ul><ul><li>Any increase in debt equity ratio over successive years would mean erosion in the net worth either due to losses or withdrawals from capital or reserve. The other reason for such reduction maybe due to heavy borrowings without corresponding additions to capital. </li></ul><ul><li>The change in debt ratio also throws light on the policy of management for distribution/retention of profits. </li></ul><ul><li>With good profitability not showing improvement in debt equity ratio over a period of time would reveal that most of the profits are being distributed to shareholders. </li></ul><ul><li>All these aspects need to be probed and suitable explanatory notes would be necessary if there is any adverse movement in debt equity ratio as compared to earlier years. </li></ul> of 19 Debt – Equity Ratio Total Term Liabilities Tangible Net Worth =
  23. 23. Indebtedness Ratio <ul><li>Thi s ratio is in fact an extension of debt equity ratio and is also sometimes referred to as 'leverage ratio'. </li></ul><ul><li>The calculation of this ratio thus takes into consideration the term liabilities as well as the current liabilities of the concern and may be considered as a better indicator of solvency of the concern. </li></ul><ul><li>There is no ideal ratio prescribed under this category and ratios generally ranging from 4:1 to 6:1 are acceptable. Higher ratio would indicate excessive dependence on outside funds and may be considered as a -ve factor. </li></ul><ul><li>The study of movement in this ratio over successive years also gains importance as any increase in the ratio over the successive period means deterioration in the financial stake of the promoter in the project and may be another -ve factor. </li></ul> of 19 Indebtedness Ratio Total Outside Liabilities Tangible Net Worth =
  24. 24. Current Ratio <ul><li>Current Ratio indicates the firm’s ability to meet its obligation maturing within one year. </li></ul><ul><li>Generally, the current ratio should be 2:1. This is a precautionary provision because some cash inflows like cash sales and collections from the customers are highly uncertain. </li></ul><ul><li>The other important aspect to be examined in this regard is to study the trend in the movement of current ratio over a period of time. </li></ul><ul><li>An increasing ratio is an indicator of improving position of a concern while a decrease in the current ratio may raise doubts about the overall functioning of the concern. </li></ul><ul><li>A deteriorating current ratio will either mean successive losses being suffered by the concern or diversion of short term funds for long term uses. Both these factors will have a negative influence on the decision making and would require suitable explanation being given for adverse change in the current ratio. </li></ul> of 19 Current Ratio Total Current Assets Total Current Liabilities =
  25. 25. Quick Ratio <ul><li>In practice, all Current Assets are not so realisable. For example, inventory of finished goods etc. and stock in process may take a long time before these can be converted to cash and may thus not be available to meet the current dues of the firm. This may sometimes lead to erroneous conclusion regarding the real liquidity of the concern. Assets of such nature are thus excluded to find out the real liquidity position of the concern on a very short term basis. </li></ul><ul><li>While calculating this ratio sometimes total current liabilities are not taken into consideration and bank borrowing is which are generally available against the stocks of inventory are excluded from the current liabilities </li></ul><ul><li>This ratio shows the real liquidity position. No fixed norms have been prescribed for this ratio but a ratio of 1:1 should be considered as adequate. </li></ul> of 19 Quick Ratio Total Current Assets - Inventory Total Current Liabilities – Bank borrowings against stock inventory =
  26. 26. Gross Profit Margin <ul><li>There cannot be any norms for minimum or maximum percentage of gross profit earned by any project. </li></ul><ul><li>The more important aspect is, the change in the ratio on year to year basis. An increasing gross profit ratio would mean stabilisation of production, effective management of inventory besides marketing efficiency and better production management. </li></ul><ul><li>The lower gross profit ratio on the other hand may mean a strain on the margins due to increase in the cost of raw materials and other production costs without a corresponding increase in sales realisation. </li></ul> of 19 Gross Profit Margin Gross Profit Sales =
  27. 27. Operating Profit Margin <ul><li>The absolute ratio is not important even in this case and comparison on year to year basis is to be made to draw some important conclusions on the working of the unit. </li></ul><ul><li>An increase in operating profit ratio would mean stabilisation of the products of concern and effective control on selling and administrative expenses. </li></ul><ul><li>The change in operating profit ratio is largely dependent on the, change in gross profit ratios though it is not necessary that both the ratios move, in the same direction and all types of combinations are possible. </li></ul> of 19 Operating Profit Margin Operating Profit Sales =
  28. 28. Scenarios combining both Ratio <ul><li>+ve change in Gross Profit Ratio & +ve change in Operating Profit </li></ul><ul><ul><li>This situation reveals all round improvement in working results of the unit and is a plus factor. It proves stabilisation of production and marketing arrangements by the unit and effective control over the overheads. </li></ul></ul><ul><ul><li>+ve change in Gross Profit Ratio & -ve change in Operating Profit. </li></ul></ul><ul><ul><li>+ve change in gross profit ratio points towards better control over cost of production which is, however, lost by increased selling and administrative costs resulting in -ve change in operating profits. The position in this regard is now to be rectified by exercising better control over the overheads eroding the profitability. </li></ul></ul> of 19
  29. 29. <ul><li>-ve change in Gross Profit ratio and -ve change in Operating Profit. </li></ul><ul><ul><li>This situation reveals an overall deterioration in the working of the unit. The change in gross profit ratio is due to increased cost of production while the change in operating profit may be either directly as a consequence of increase in cost of production or may also be contributed by increased overheads A very detailed investigation in the circumstances resulting in such a situation is necessary to rectify it in future. </li></ul></ul><ul><li>-ve change in Gross Profit ratio and +ve change in Operating Profit. </li></ul><ul><ul><li>The increase in the cost of production has been more than offset by savings in other overheads which indicates towards a stable marketing effort coupled with effective control over expenditure. The increase in production cost needs to be investigated and suitable remedial measures are required to be taken to improve the position. </li></ul></ul> of 19 Scenarios combining both Ratio
  30. 30. Net Profit Margin <ul><li>There can not be any norms regarding minimum or maximum percentage of net profit earned by any project. </li></ul><ul><li>The margin largely depends on the firm’s borrowing capacity, it’s accounting policy related to the depreciation of fixed assets as well as the tax planning. </li></ul><ul><li>Similar to the GP margin, the absolute no. of NP margin is not significant. The Y-o-Y comparison gives more insight about the company’s ability to earn the profit. </li></ul><ul><li>The net profit is available to the shareholders of the company. </li></ul> of 19 Net Profit Margin Net Profit Sales =
  31. 31. Return on Capital Employed <ul><li>The ratio indicates the earning power of any project in relation to the investment made and risks undertaken. It will also benefit to compare it with other projects to find out the relative strength of any project in terms of profitability. </li></ul><ul><li>This ratio is also found out for a number of successive years to establish the trend. Any deterioration would mean lower earning capacity of the project due to erosion in margins as a result of many factors which may include increase in cost of production, overheads and difficult competitive market. </li></ul><ul><li>A careful study of these factors may help to plan suitable strategies for improvement in future. </li></ul> of 19 Return on Capital Employed Profit before Tax + Interest on Term Liabilities (PBIT) Net Worth + Term Liabilities =
  32. 32. Return on Net Worth <ul><li>An attempt is made to find out return on the net worth which is a better indicator of the earning capacity of project in relation to the owned funds employed for the project. </li></ul><ul><li>This indicates the real amount available to owners as a return on their investment after all the claims on income including taxes have been satisfied. </li></ul> of 19 Return on Net Worth Net Profit after Tax Tangible Net Worth =
  33. 33. Inventory Turnover Ratio <ul><li>This ratio is a measure of the fastness in the turnover of the inventory. </li></ul><ul><li>The higher ratio indicates that the enterprise is able to achieve higher turnover with low level of inventory thereby reducing the chances of inventory hold ups or carrying over of obsolete inventory. </li></ul><ul><li>The lower ratio indicates slow turnover with possible chances of carrying over of un-saleable inventory. </li></ul><ul><li>The increase in the ratio reveals a healthy trend where the firm may not be facing any selling problems. This would further mean low investment in inventories resulting in higher profits. </li></ul><ul><li>The declining trend in the ratio would point towards sluggishness in the demand of goods manufactured/traded by the enterprise with large carry over stocks demanding more investment with slow movement. This may also mean carry over of dead inventory. It is a negative feature and this trend is to be arrested as early as possible. </li></ul> of 19 Inventory Turnover Ratio Cost of Sale Average Inventory =
  34. 34. Creditors’ Turnover Ratio <ul><li>This ratio is determined to find out the average period of credit available to the concern for its purchases and its policy to pay its creditors. </li></ul><ul><li>This will give result in days and indicates average period taken by the concern to pay its creditors. Sometimes, separate figures for credit purchases may not be available and figures of total purchases may be taken in the denominator. </li></ul><ul><li>A longer repayment period would mean that the firm is not making prompt payment. </li></ul><ul><li>The increasing trend in this ratio would reveal that the concern is defaulting in making prompt payment to creditors and is an indicator of some financial difficulties being faced by it. </li></ul> of 19 Creditors’ Turnover Ratio Bills Payable + Sundry Creditors Total Credit Purchases = X 365
  35. 35. Debtors’ Turnover Ratio <ul><li>This ratio will give the result in number of days that are taken on the average to realise the sale proceeds. Where figures of credit sales are not separately available, the figures of total sales may be taken in the denominator. </li></ul><ul><li>Longer period in realisation of sales proceeds points towards the incapacity if the unit to realise its dues in time. </li></ul><ul><li>The trend in the ratio on year to year basis is also required to be studied. The increasing ratio would indicate that the concern is having difficulty in sales due to sluggishness in demand or has ended up with some bad debts which cannot be realised promptly. </li></ul><ul><li>Sometimes, the ratio may deteriorate due to the lack of efforts by the management to realise its dues promptly. This situation, therefore, needs very close. </li></ul> of 19 Debtors’ Turnover Ratio Bills Receivable + Sundry Debtors Total Credit Sales = X 365
  36. 36. Scenarios combining both Ratio <ul><li>A Low Creditor Ratio with Higher Debtor Ratio </li></ul><ul><ul><li>This means that a firm is prompt in making its payment but has to extend credit for its sales for a longer period. This may be due to adverse market conditions for the product in which the firm is dealing and in any case means large investment for financing its sales. </li></ul></ul><ul><li>A Low Debtor Ratio with Higher Creditor Ratio </li></ul><ul><ul><li>This means that the firm is able to get its supplies on credit but is not required to extend credit for its sales. From this situation it may be concluded that the product has a ready market and the firm is enjoying a good reputation enabling it to get goods on credit on its own terms. </li></ul></ul> of 19
  37. 37. Interest Coverage Ratio <ul><li>This ratio measures the ability of firm’s paying interest of the borrowed debt funds. </li></ul><ul><li>This ratio indicates the use of interest bearing funds in generating higher operating profits. </li></ul><ul><li>Higher is the ratio better is utilization of the debt funds. Higher interest coverage ratio, enhances the equity earnings because incremental earnings is passed over to equity financed portion of the capitalization. </li></ul> of 19 Interest Coverage Ratio EBITDA Interest & Finance charge =
  38. 38. Debt Service Coverage Ratio <ul><li>The DSCR is basic ratio for the financial institutions which measures “the debt-servicing” and “the debt-paying” ability of borrower. </li></ul><ul><li>It is a popular benchmark used in the measurement of an income-producing property’s ability to produce enough revenue to cover its monthly mortgage payments. </li></ul><ul><li>The higher this ratio is, the easier it is to borrow money for the property. </li></ul> of 19 Debt Service Coverage Ratio EBITDA + Non cash expenses Interest & Finance charge + Repayment of Term Loan =