Presentation on theme: "Finance for Non Finance Professionals"— Presentation transcript:
1 Finance for Non Finance Professionals N. MuthuramanDirectorRiverBridge Investment Advisors Pvt. Ltd.Disclaimer: This session does not aim to provide any investment advice. Participants mayseek advise of professional investment advisors for taking any investment decisions.
2 Agenda Objective of the Webinar Key takeaways Purpose of existence of an economic entityFinancial statements – construction and purposeUnderstanding and interpreting Financial StatementsFinancial analysis as a measurement toolPurpose of analysis – equity perspective, debt perspectiveRatio analysisExplaining simple terms in Finance - ROI, IRR, Time Value of MoneyQ&A
3 Objective The webinar will help the participants To gain an understanding of the basic principles of financeTo evaluate decisions related to finance more knowledgeablyTo participate effectively in finance related discussions in their respective organisationsTo gain basic understanding to pursue higher education / career in the field of financeTo follow recent economic events and its impact on corporate performanceTo take informed decision related to personal finance and investingTo interact with financial department / finance professionals more knowledgeably
4 Key Take Aways Key takeaways Basic understanding of various forms of economic entitiesUnderstanding financial statements and perform ratio analysis on published statementsEvaluate a corporate investing or financing decision meaningfullyTrack financial performance of listed companies closely, to take well-informed investment decisionsRead / 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 ofWealth creationWealth management, andWealth distributionObjective of an enterprise – To create thebest possible values and share them in theequitable manner among all the stakeholders
6 Purpose of an enterprise Business as an economic entity exists to make profits:Trading activitySelling price > Cost of purchaseManufacturing activity:Selling price > Cost of purchase + conversion costsServicesPrice for service > Cost of providing the serviceBuyingSellingBuyingProcessingSellingServicing
7 StakeholdersWe need various entities to come together to run an enterprise and generate returns. Who are the stakeholders in a business?InvestorsEquity holders – majority holders, minority shareholdersDebt holders including banks and financial institutionsManagementEmployeesSuppliersCustomersCommunity, Taxman
8 Why Accounting?Accounting forms the basis for measuring the performance of an enterpriseThe performance determines which stakeholder gets what share of the businessAccounting also ensures ‘equitable’ distribution of wealth generated, based on each person’s contribution to the businessFew examples:Taxman gets his share of the profits (currently 35% in India), which are determined based on prudent accounting practicesEmployees are typically rewarded based on their individual performance as well as the performance of the enterpriseMinority 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 ProprietaryPartnershipCompanyPrivate Ltd.Public Ltd.Closely heldPublicly held
10 Various forms of enterprise Proprietary business – owned by single ownerNo difference between the obligations of the business and the obligations of the individual.Partnership firm – owned by two or more ownersNo 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 companyNot more than 50 membersShares are not freely transferable.No invitation to public for subscription.Public limited companyClosely held public limited company (Deemed)Publicly held public limited company (Listed)
11 Financial statementsFinancial statements report the state of financial affairs of an enterpriseThese are made publicly available for widely held companies, usually free of cost (www.bseindia.com and )For closely held public companies and private companies, the financial statements are reported to the Ministry of Company AffairsSome 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 areBalance SheetProfit & Loss Account andCash flow statement
12 Construct of a Balance Sheet LiabilitiesOwners’ capitalEquity CapitalReserves and SurplusBorrowed fundsLong term debtShort term debtWorking capitalCreditorsCurrent liabilities and ProvisionsAssetsFixed AssetsLand and buildingPlant and MachineryInvestmentsInvestment made in shares, bonds, government securities, etc.Working CapitalRaw MaterialWork in progressFinished goodsDebtorsCash
13 Some observations on Balance Sheet The Liability side represent the various sources of funds for an enterpriseThese are the liability of the enterprise to the providers of these fundsThe Asset side represent the various uses of funds by an enterpriseThese 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 companyBalance sheet is always presented as on a given day, say as at March 31, 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 areEquity capitalReserves and SurplusLong term borrowingsIn Asset side, long term uses areFixed AssetsInvestmentsThe rest are short term on both sides viz. Current assets, current liability and short term debtIdeally, 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 businessLess Raw material consumedEmployee expensesOther manufacturing expensesAdministrative expensesSelling expensesSub total: Cost of SalesEarning before interest, taxes, Depreciation & Amortization(EBITDA)Less DepreciationEarning before interest and taxes (EBIT)Less Interest paymentProfit before taxes (PBT)Less TaxesProfit after tax (PAT)Less DividendRetained earnings
16 Inside the P&L Account Typical items under ‘Revenue from business’ Sales revenueOther related incomeScrap sales, Duty drawbackNon-operating incomeDividends and interestRent receivedExtra-ordinary incomeProfit on sale of assets / investmentsPrior-period items
17 Inside the P&L Account Typical items under ‘Cost of Sales’ Cost of goods soldDirect materialDirect laborDirect manufacturing overheadsAdministrative costsOffice rentSalariesCommunication costsOther costsSelling and distribution costsSalaries of sales staffCommissions, promotional expensesAdvertisement expenses etc.
18 Inside the P&L Account Depreciation Straight line method Written Down Value methodDeferred revenue expenditureR&D expensesAdvertisement expensesProduct promotion expenses(expenses are charged as capital expenses and amortized over the period of time)
19 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 dateP&L Account can provide great insights into the functioning of an enterprise. Let us look at a few:Variable costs Vs. Fixed costsBreak even point is the point where there is ‘no profit, no loss’Cash expenses Vs. Non-cash expensesRaw material, salary and other administrative expenses are cash expensesDepreciation is typically the only non-cash expenseRecurring income Vs. one-time incomeIncome from ordinary activities are typically recurring in natureExtraordinary income / expenses are typically one-time in natureFew examples: Sale of office space, disposal of a factory unit, VRS
20 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 dateA statement that segregates cash generated and cash used based on the source/end use of the cashWhat are its components?Three key components of Cashflow Statement areCashflow from Operating ActivitiesRepresents the cash generated from the operations of the enterprise – a measure of ‘cash profit’ from the operationsCashflow in Investing ActivitiesRepresents the deployment of cash in various assets such as fixed assets, investments, etc.Cashflow from Financing ActivitiesRepresents 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 ActivitiesProfit Before TaxLess Non-operating income (e.g. Interest income, profit on sale of assets)Add Interest expenseAdd DepreciationLess Other cash adjustments (e.g. Unrealised foreign exchange loss)= Operating Profit before Working Capital ChangesLess Increase in DebtorsLess Increase in InventoryLess Increase in other current assets (e.g. Loans and Advances)Add Increase in CreditorsAdd Increase in other Current liabilities and Provisions= Cash generated from OperationsLess Taxes= Net Cash from Operating Activities
22 Construct of a Cash flow Statement Cash flow from Investing ActivitiesPurchase of Fixed Assets (negative because it is cash outgo)Add Purchase of Long term investmentsLess Proceeds from Sale of Fixed Assets or Investments (if any)Add Interest and Dividend Income= Net Cash used in Investing ActivitiesCash flow from Financing ActivitiesProceeds from issue of share capitalAdd Proceeds from raising fresh loansLess Repayment of existing loansLess Interest expenseLess Dividend paid= Net Cash Generated from Financing ActivitiesOpening Balance: Cash and Cash EquivalentsAdd Net Cash from Operating ActivitiesLess Net Cash used in Investing ActivitiesAdd Net Cash Generated from Financing Activities= Closing Balance: Cash and Cash Equivalents
23 Some observations on Cash flow statement Cash flow statement provides the reference check for the quality of ‘profits’ generated by a companyFor 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 goesDisproportionate 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 pointOpening 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 analysisSome important ratios for analysing performance of a company:Operating profit marginNet profit marginReturn on Capital EmployedCurrent RatioDebt:Equity ratioInterest coverage ratioEarnings per sharePrice Earnings ratioReturn on Networth
25 Ratio analysis Operating profit margin Net profit margin Indicates the business profitabilityOPM = EBITDA / Operating Income (or Net Sales)Depending on the industry, for healthy companies, OPM ranges from 15% - 50%Net profit marginIndicates the returns generated by the business for its ownersNPM = 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 enterpriseThe 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 / ownersThe 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:Debt:Equity ratioThe ratio of borrowed funds to owners’ fundsD: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 lendersCompany 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 coverageThe ratio indicates the cushion the company has, to service its interestInterest coverage = EBITDA / Interest costHigher the ratio, better it is for the lendersFor healthy companies, Interest coverage ranges from 2.0x to 8.0x.Interest coverage < 1.0x indicates high stress, and probably default on interest payments.
29 Ratio analysis – Lenders’ perspective Current ratioThis is a commonly used ‘liquidity ratio’, used by banks that lend for ‘working capital’Current ratio = Current AssetsCurrent liabilities + Short term debtThe 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 2.0xCurrent 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:
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 enterpriseEPS = Profit After TaxNumber of Equity shares outstandingEPS 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 EPSBasic EPS is computed based on no. of shares outstanding currentlyFully 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 sharePE = Current Market Price per shareEarnings 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) PEForward PE is computed using EPS of the next financial yearTTM PE is computed using EPS of last 4 quartersPE ratio has no meaning for unlisted companies as there is no ‘market price’ for these sharesBroadly 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.