Professional Documents
Culture Documents
Financial Statements and Analysis IIMB
Financial Statements and Analysis IIMB
and
Analysis
M S Narasimhan
Professor – Finance & Control Area
Indian Institute of Management Bangalore
Bannerghatta Road, Bangalore 560076
March 2009
Content
1. Introduction 1
2. Balance Sheet 29
3. Income Statement 63
M S Narasimhan
Email: msn@iimb.ernet.in
Chapter 1
Introduction
1.1 INTRODUCTION
There are several business and social organisations around us. All these organisations
have been started with an objective and goal. Many business organisations pursue the
goal of maximising the wealth of the shareholders whereas social organisations pursue
the goal of maximising the welfare of the targeted users. Setting the objective or goal is
the beginning of a long journey for the promoters of the organisations. They need to
raise resources or capital to perform activities to achieve their goals. Once resources
are obtained they need to be invested in creating certain infrastructure and perform
operations. At the end of each period, the performance of the operations is measured to
understand whether the primary objective of the organisation was achieved or not.
Accounting plays a critical role in measuring performance of the operations.
Accounting records all monetary transactions and summarises the same at the end of
the period to produce financial statements. There are several non-monetary
performance measures like quality, customer service, cutting-edge technology,
environment-friendly, etc., which are also highly important in measuring performance.
While these measures are relatively easier to understand, most users find financial
statements are often difficult to understand. The primary purpose of this book is to
explain financial statements in a non-technical manner using financial statements of an
Indian company throughout the book.
Financial statements per se are simple to read and easy to understand. However,
most readers of financial statements consider these as complex statements because
financial statements are the output of accounting process. The problem is mostly on
account of their experience with the accounting system. For example, a mechanical
2 Financial Statements and Analysis
engineer managing shop floor that consists of some 20 machines is comfortable in his
job since he is familiar with the operation and maintenance of machines. For him,
accounting is a black box. Suppose, he finds that a few machines are not giving good
productivity and hence changed those machines with new ones that are slightly costlier
than earlier machines. Though he would be expecting some increase in departmental
expenditure, he would be shocked to see that the cost of operations of the shop floor
has gone up several times more than the departmental cost of last period. Accountant
explains that the higher cost is on account of increase in depreciation value due to
written down value method followed by the company. Under this method of
depreciation, depreciation value will be higher during the initial life of the machine and
declines over a period of time. Since he has replaced old machines with new machines,
depreciation values have gone up.
Accounting department often handles taxation related issue like exercise, customs
and income tax and that is another area that many of the readers would be
uncomfortable. The result is a kind of perception that anything comes out of accounting
process is difficult to follow. To add such feelings, there were major accounting frauds,
which resulted in the loss of several jobs and billions of dollars in the United States and
other developed nations. If a wrong accounting entry or treatment has the potential to
impact someone's job in the operations, the level of fear on understanding the
accounting process increases several times. Fortunately, accounting is not that much a
complex subject and many of these accounting frauds are basically violation of
established principles. Whether one likes it or not, understanding accounting process
and financial statements are critical in managing organisations or a part of the
organisation.
prevalent in business organisations. Once the agency problem is recognised, then the
issue is how to reduce the problem. There are several ways or levels at which such
problems are handled. In accounting system, it is handled through internal control
system and auditing.
excellent or customer satisfaction levels are high, then they will be reflected in the form
of additional revenue. Though it is true that ultimately they will be reflected in
incremental revenue or profit, there could be considerable time gap. Another example
is when a merger takes place between two companies, a number transactions are
recorded as the company has to merge two financial statements into one. However,
during the course of merger, the events like employees' dissatisfaction of the merger, if
any, cannot be measured in monetary terms and hence not relevant for the financial
statements. They may ultimately cost more for the company and reflected in the
financial statement. Until then accounting statements will not capture such
developments.
1
The only exception is when conservatism concept required to be applied. In such a situation,
expenses are to be reported even though there is no income. For example, when the firm spends
money on research, the benefit may arise in the future but the conservatism concept requires the
firm to recognise this as expenditure for the period in view of uncertainty associated with the
outcome of such research efforts.
8 Financial Statements and Analysis
wait for the cash part to complete before recording the same. It is not normally treated
that way. Accounting transactions are recorded without waiting for cash part to
complete. The reason is accrual concept. When it comes to revenue or expenses,
accrual concept is consistent with matching concept. If a sale is made, whether
expenses on account of sale is paid or not, they are to be recognised. For instance, an
advertisement was released on December 25 but the amount was paid on 4th April.
Since the expenses have been accrued, they need to be recognised in the accounts.
Similarly, if a loan is taken in January and next interest has to be paid at the end of
June, interest expenses for the period of January to March are to be recognised when
closing the books of accounts in the month of March.
2
Details on the accounting standards can be obtained from www.icai.org
Chapter 1 Introduction 9
Standards requires reporting the reason along with the financial impact for such non-
compliance. The Act also requires both the Board of Directors and auditors to inform
whether the financial statements are prepared in accordance with accounting standards.
In addition to generally accepted accounting principles, concept, conventions and
accounting standards, there are other agencies, which regulate accounting systems and
financial statements. Companies Act, 1956 prescribes the books that are to be
maintained by the companies. It also gives the format for the balance sheet and
information to be provided in profit and loss account. Securities and Exchange Board
of India (SEBI) also lists down few statements that are to be given to the shareholders
by the listed companies and they are mostly disclosure related statements. SEBI brings
such regulations by requiring the stock exchanges to amend the listing agreement.
The reasons behind the regulatory interference in preparation and disclosure of
accounting statements are attributable to agency problem. The government, through
Companies Act, allows the company form of organisation in which millions of
shareholders invest money and also vest the management to select people.
Management and the shareholders, who control the management, have incentive to
misrepresent the accounting statements for certain short-term gains. Many accounting
transactions are amenable for such misrepresentation. The government has some
responsibility towards such millions of minority shareholders. Hence, the Companies
Act requires the companies to appoint auditors and provide audited financial statements
in accordance with accounting standards to the shareholders. Accounting bodies in turn
develop set of standards to make sure that the accounting statements that they certify
are standardised to an extent.
3
Many readers may feel equity finance is less costly than loan, but unfortunately such a notion
is not correct. Equity holders take more risk in the business and hence they will invest money
only when they see returns are higher than what is available to them if they invest the same
money in debt funds that has less risk.
Chapter 1 Introduction 11
Manufacturing expenses are incurred to produce the goods. Assets when used become
expenses. One good example would be depreciation. As and when the assets are used,
the company charges depreciation, based on the usage of the asset. They reduce
owners' wealth. Expenses need not always lead to increase in liabilities and often it
may cause reduction in the value of the assets and hence reduce the owners' wealth. A
simple case is paying cash to a firm, which performs repairs to machine. The value of
assets (cash) decline when the firm effects payment for availing service.
they have been used. Though the format of balance sheet differs in some respect, all
balance sheets show assets, liabilities and shareholders' equity and consistent with the
accounting equation discussed earlier.
Exhibit 1.2
BALANCE SHEET as at 31st March 2008
of Asian Paints (India) Ltd.
(Rs. in Crores)
As at As at
Schedules
31.03.2008 31.03.2007
FUNDS EMPLOYED
Shareholders’ Funds
Share Capital A 95.92 95.92
Reserves and Surplus B 832.58 648.16
928.50 744.08
Loan Funds C
Secured Loans 36.70 66.90
Unsecured Loans 58.00 58.77
94.70 125.67
Deferred tax liability - (Note B - 21 in Schedule M) 31.52 22.15
Total 1054.72 891.90
APPLICATION OF FUND
Fixed Assets D
Gross Block 937.89 806.20
Less : Depreciation 509.06 471.29
Net Block 428.83 334.91
Capital Work in Progress 110.39 11.62
539.22 346.53
Investments E 422.88 334.39
Current Assets, Loans and Advances F
Interest accrued 0.09 0.03
Inventories 538.97 434.07
Sundry debtors 251.90 235.96
Cash and Bank Balances 41.35 42.49
Other receivables 33.09 31.23
Loans and Advances 178.82 115.45
1044.22 859.23
Less: Current Liabilities and Provisions G
Current Liabilities 785.11 594.10
Provisions 166.49 54.15
951.60 648.25
2. We approached a bank for a loan and the bank, based on assessing our
requirement, has given us a loan of Rs. 20 lakhs. But our banker says we have
to pay interest at the rate of 1% per month before 5th of next month. Our
accounting equation immediately after this loan is as follows.
,
Assets = Liabilities + Shareholders' Equity
Cash (50 lakhs) = Loan (20 lakhs) + Equity share capital (30 lakhs)
3. Now we found a place for showroom and paid Rs. 5 lakhs towards refundable
advance. The rent for the show room is Rs. 1 lakh per month and payable by
5th of following month. While we need to record showroom rent advance, we
don't need to record the agreement to pay rent of Rs. 1 lakh at this point of
time. Advance is treated as asset since it is refundable.
Advance (5) + Cash (45) = Loan (20) + Equity share capital (30)
4. We spent another 5 lakhs towards furniture for the show room. Furniture is
asset. Our accounting equation now is as follows.
Furniture (5) + Advance (5) + Cash (40) = Loan (20) + Equity share
capital (30)
18 Financial Statements and Analysis
Furniture (5) + Stock (60) + Advance (5) + Cash (10) = Loan (20) +
Creditors (30) + Equity share capital (30)
6. We are able to sell Rs. 40 lakhs worth of goods for Rs. 50 lakhs. Of this we
have made cash sales of Rs. 30 lakhs and remaining Rs. 20 lakhs is on credit
basis to few institutional customers. Our accounting equation is now bit
lengthy.
Furniture (5) + Stock (20) + Debtors (20) + Advance (5) + Cash (40) =
Loan (20) + Creditors (30) + Equity share capital (30) + (Sales (50) -
Cost of goods sold (40))
The equation underwent few changes. Stock has come down from Rs. 60 lakhs
to Rs. 20 lakhs because we have sold Rs. 40 lakhs worth of goods. Cash is
increased by Rs. 30 lakhs because we made cash sales of Rs. 30 lakhs. We
have new entry called 'debtors' because we sold Rs. 20 lakhs to some
institutional customers on credit basis. Since we can claim the amount at the
end of due period, it is our asset. Since sales of Rs. 50 lakhs increase our
wealth, it is shown along with shareholders equity and since Rs. 40 lakhs is
expense incurred for this sales and it reduces our wealth, and hence reduced
from the revenue or sales.
7. Our manager informs that we have to pay Rs. 2 lakhs as salary by 7th of next
month, Rs. 2 lakhs for advertisement by 3rd of next month, Rs. 20000 towards
interest by 5th of next month and Rs. 1 lakhs towards rent by 2nd of next month.
Suppose we need to prepare a profit statement, we need to consider the above
liabilities. None of our existing accounting heads in the accounting equation
will be affected but on the right hand side of the equation, we have to add a
new head called 'expenses payable (Rs. 5.2 lakhs) and also place a minus
value of the same amount as expenses next to cost of good sold. Our
accounting equation will be as follows.
Furniture (5) + Stock (20) + Debtors (20) + Advance (5) + Cash (40) =
Loan (20) + Creditors (30) + Expenses Payable (5.2) + Equity share
capital (30) + (Sales (50) - Cost of goods sold (40) - Expenses (5.2))
Chapter 1 Introduction 19
8. On the right hand side after Equity share capital, we have four items and all of
them can be netted out to get profit for the period. The profit for the period is
Rs. 4.80 lakhs.
9. Since many of us have borrowed money to invest money, we felt we can take
some amount out of the profit to pay part of our interest. We took Rs. 1 lakh as
dividend. Our cash holding declining by Rs. 1 lakh and we get a new
accounting head called dividend on the right side. Our accounting equation
now is as follows.
Furniture (5) + Stock (20) + Debtors (20) + Advance (5) + Cash (39) =
Loan (20) + Creditors (30) + Expenses Payable (5.2) + Equity share
capital (30) + Sales (50) - Cost of goods sold (40) - Expenses (5.2) -
Dividend (1)
Exhibit 1.5: Profit and Loss Account for the month ending 31st January 2008
Income In Indian Rs.
Sales 50,00,000
Other Income -
Total Income 50,00,000
Expenditure
Cost of Good Sold 40,00,000
Salary and wages 2,00,000
Advertisement 2,00,000
Rent 1,00,000
45,00,000
Profit before depreciation, interest and tax 5,00,000
Depreciation -
Interest 20,000
Profit Before Tax 4,80,000
Tax -
Profit after Tax/Disposable Profit 4,80,000
Less: Dividend 1,00,000
Balance Profit carried to Balance Sheet 3,80,000
Chapter 1 Introduction 21
Exhibit 1.7: Cash Flow Statement for the month ending 31st January 2008
Cash at the beginning (January 1, 2006) Nil
Cash flow from operating activities
Cash received from customers 30,00,000
Cash paid to suppliers (30,00,000)
Cash paid for Rent Advance (5,00,000)
Net Cash Flow from Operating activities (5,00,000)
Cash flow from investing activities
Cash paid for the purchase of furniture (5,00,000)
Cash flow from financing activities
Cash from fresh equity 30,00,000
Cash from bank loan 20,00,000
Cash paid for dividend (1,00,000)
Net Cash Flow from Financing Activities 49,00,000
Cash at the closing of the month (January 31, 2006) 39,00,000
4
We haven't provided depreciation for the asset for the sake of simplicity. We will discuss those
concepts in Chapters 2 and 3.
22 Financial Statements and Analysis
Computers today generate accounting statements and the job of the managers is to
specify the right account head and decide on nature of treatment of certain items. The
discretionary powers with accountants are coming down because of multiple regulating
agencies trying to plug such discretionary powers. The purpose of the above illustration
is not to teach accounting process or preparation of financial statement but to
demonstrate that they are simple and easy to follow. Readers can continue our business
for one more month, record the transactions in the accounting equation and prepare
three principal financial statements. They can show previous month figure in the
financial statement as we see in Exhibit 1.2 to 1. 4. Many of you will find it exciting to
see that your balance sheet had 'balanced' in the end.
5
You can download the annual reports of many companies from the website of the company.
For instance, you can download the annual report of Asian Paints (India) Ltd. from the
company's website www.asianpaints.com
Chapter 1 Introduction 23
and make confused statements. A good analysis and discussion should link what was
discussed and forecasted in the previous report to the current one and explain
deviations.
that the financial statements reflect true and fair view except on those items. The
certification may also be adverse in nature if the auditor finds that the financial
statements fail to reflect true and fair view of the financial positions of the firm. In an
extraordinary situation, if the management fails to co-operate with the auditors, auditor
may refuse to give opinion and report the same to shareholders.
In theory, auditors are independent and hence their report is expected to be an
independent report. But in practice, many point out the kind of moral hazard6 affecting
such independent role. The management identifies the auditor though their appointment
and remuneration are approved by the shareholders in the AGM. It may be difficult for
the management to dismiss the auditor because the outgoing auditors have right to issue
a statement to the shareholders but auditor with such reputation may not be a preferred
auditor by the management of other firms. Hence, auditor would like to have some
normal working relationship with clients and that is the area of potential conflict of
interests between auditor and shareholders.
The role of auditing in such a situation where auditing firms align their interests
with management even for temporary period or only to a small extent is questionable.
Why should shareholders pay to auditors who align their interest with management
whose performance they need to look into? Regulatory pressure like Sarbanes-Oxley
Act, improvement of standards by the auditing profession as a whole, audit committee
consisting of independent directors interacting with auditors, etc., are few recent steps
to restore the positive role of auditing in company form of organisation.
6
'moral hazard' refers to the risk that one party to a contract can change their behaviour to the
detriment of the other party once the contract has been concluded.
Chapter 1 Introduction 25
1.7.10 Schedules
Balance Sheet and Profit and Loss Account are in summary form but the details are
provided in Schedules forming part of the two statements. Each major item or value of
balance sheet and profit and loss account has a schedule to provide more details.
Normally schedules are given for items like share capital, reserves and surplus, fixed
assets, investments, current assets, current liabilities, sales, other income, expenditure,
depreciation, and tax.
willing to part with such information since competitors may come out with alternative
strategies. While the demand for information by the investors is endless, management
would like to part with as little information as possible. It is tough task for regulatory
authorities to identify information that can be allowed to pass on without affecting the
overall competitive position of companies.
The second level of information gap is the time at which information is made
available. Insiders have access to information as and when it flows whereas outsiders
get consolidated information at different points of time. In India and in several other
countries, unaudited / audited quarterly earnings statements are to be provided by the
listed companies. Such quarterly earnings reports are also normally available after a
month. In addition to this, regulating agencies insist the companies to report any
information that has a major impact on earnings within a reasonable time. In addition,
companies also come out with profit guidance statements if there is any major change
in the operating performance. While efforts made so far on reducing the timing gap are
considerable, there are still gaps on the timing issue.
get better wages or salaries for the coming years. Because if the firm is not doing well,
the chances are that they might loose their jobs and also loose wages. So they keep a
watch on the performance of the company.
The analysts demand for information to publish reports on the performance of the
companies. They also rate the debt payment capacity of the companies. They
continuously track the company for information and analyse the company accordingly
and inform the public on buy and hold strategies. On the other hand the demand for
information by small and retails investors differ from that of the experienced analysts.
The small investors simply do not have the full-fledged time to keep track of the
companies' latest information. This is because small investors invest in a lot of
companies and it is difficult for them to keep track of the information of all these
companies. More over they would not be able to analyse effective as the experienced
analysts do. They basically face problem of assessing the risk, expected return, and
liquidity of the firm’s securities they hold. Based on the assessment of these factors,
they make their investment decision on what securities to buy (sell) and when to buy
(sell), which maximises their expected utility or wealth.
Once the investment decision is made, shareholders and investors demand
information for the purpose of safeguarding their interest in the corporate firm. This
involves control of managerial behaviour so as to guide managerial activities towards
the maximisation of shareholders’ wealth. Shareholders and investors require
information to help them in making the investment decision, as also to design contracts
and mechanisms for controlling the behaviour of managers, and orient the managerial
behaviour towards realising the objectives of a firm. Accordingly, they demand all
information that is non-proprietary, i.e. information whose disclosure does not affect
the firm’s future cash flows.
1.10 SUMMARY
Every organisation has some objective to fulfil. They raise resources and deploy
the same to pursue the objectives. They also measure the operations periodically to
check whether objectives are fulfilled. Balance sheet shows how resources are
mobilised and how are they used. Profit and loss account summarises the performance
of the operations during the period. Financial statements are then analysed to examine
whether objectives that are in financial nature are achieved or not. Financial statements
and analysis of financial statement thus play critical role in the management of
organisations. Financial statements are prepared based on large number of accounting
transactions.
Accounting transactions are recorded under relevant head as and when transactions
take place. They are summarised at the end of the period to prepare financial
statements. Recording accounting transactions in most cases are simple and
straightforward but quiet a few transactions might create complications and hence
affect the financial statements. Accountants follow some of the basic accounting
principles, concepts and conventions to ensure some consistency in treatment of
accounting transactions. There are Accounting Standards for the same purpose. In other
28 Financial Statements and Analysis
words, one can reasonably expect that a firm, which followed these basic principles,
concepts and conventions and also accounting standards in preparation of financial
statements, such statements, are comparable from one period to another period and one
firm with another firm. In other words, over the years, accounting profession and
regulating agencies are consciously making efforts to harmonise the variations in
treatment of accounting transactions and moving towards achieving uniformity across
several countries. To ensure compliance of accounting principles and standards,
financial statements are audited and certified by independent audit firms.
Annual reports contain more than financial statements. Over the years, the non-
accounting part of annual reports has gone up substantially since financial statements
fail to satisfy the appetite of investors and other users of financial statements.
Management Discussion and Analysis and Corporate Governance Report are two such
new additions in the annual reports of Indian companies. The level of disclosure by
Indian companies today is comparable with many developed markets. On certain
aspects, the disclosure of Indian companies is more than information provided by
companies in the developed market. While on the one hand management prefer to
disclose less, they also compete with other companies in the capital market for capital
where suppliers of capital prefer companies with better disclosure. Like regulating
agencies, management also need to optimise the level of disclosure. It is difficult to say
whether quality brings additional revenue but poor quality cost more to firm. Today, it
applies equally to level of disclosure and quality of financial statements. Management
all over the world is slowly learning that cost of poor disclosure level and quality of
financial statements is much more today than it used to be in the past.
Chapter 2
2.1 INTRODUCTION
The Balance Sheet represents all the assets owned by a company at a particular
point of time and the claims of the owners and the outsiders against those of assets at
that time. It can be called statement of wealth since it provides details of assets that the
company owns and outstanding loans and other claims against the company. The
difference between the two is shareholders' wealth. We often prepare statement of
wealth in our personal life particularly when we borrow money from banks or other
financial institutions. The lending institutions ask us to provide the details of assets like
house, agriculture land, car and other vehicles, gold, deposits, shares and bonds, etc.
and also outstanding loans and other commitments standing against such assets. The
difference is our wealth and lenders use this information while taking lending decision.
The wealth of the shareholders can be computed with the help of balance sheet
equation
possible to see overall growth of the business over the last period. A comparison with
other firms in the industry shows the relative position of the company in the industry.
Composition of Assets: Assets are of different types. Indian companies are required to
list the assets under three broad categories namely Fixed Assets, Investments and
Current Assets, Loans and Advances. While fixed assets generate revenue, investments
in current assets increase cost. Understanding composition is useful to asses the
efficiency of managing current assets.
Liabilities to outsiders: Assets can be acquired by borrowing funds or with own funds.
Balance Sheet provides the details of how much the company has to pay to outsiders.
The liability to outsiders can be in the form of unpaid loan or unpaid suppliers' dues or
other expenses. It is also possible to see the growth of liabilities to outsiders by
comparing the two years liabilities. Further, the extent to which the company uses
outsiders' liability in creating assets can be seen by comparing liabilities and assets.
Shareholders' Fund or Equity or Wealth: The owners' stake on the assets can be
assessed by comparing the total assets and shareholders' fund. If the shareholders' fund
is small compared to outsiders' liability, it means that the company is heavily relying on
outsiders' liability. This may cause some potential problem for the solvency of the
company in the future particularly when the business slows down temporarily and at
the same time interest and other liabilities are difficult to be deferred.
Exhibit 2.1
BALANCE SHEET as at 31st March 2008
of Asian Paints (India) Ltd.
(Rs. in Crores)
As at As at
Schedules
31.03.2008 31.03.2007
FUNDS EMPLOYED
Shareholders’ Funds
Share Capital A 95.92 95.92
Reserves and Surplus B 832.58 648.16
928.50 744.08
Loan Funds C
Secured Loans 36.70 66.90
Unsecured Loans 58.00 58.77
94.70 125.67
Deferred tax liability - (Note B - 21 in Schedule M) 31.52 22.15
Total 1054.72 891.90
APPLICATION OF FUND
Fixed Assets D
Gross Block 937.89 806.20
Less : Depreciation 509.06 471.29
Net Block 428.83 334.91
Capital Work in Progress 110.39 11.62
539.22 346.53
Investments E 422.88 334.39
Current Assets, Loans and Advances F
Interest accrued 0.09 0.03
Inventories 538.97 434.07
Sundry debtors 251.90 235.96
Cash and Bank Balances 41.35 42.49
Other receivables 33.09 31.23
Loans and Advances 178.82 115.45
1044.22 859.23
Less: Current Liabilities and Provisions G
Current Liabilities 785.11 594.10
Provisions 166.49 54.15
951.60 648.25
2.3 CONSOLIDATION
Indian companies are required to give two sets of Balance Sheet. The first
statement given in Exhibit 2.1 is the Balance Sheet pertaining to Asian Paints (India)
Limited, which is a separate legal entity. In addition to this balance sheet, companies
are required to give another Balance Sheet called Consolidated Balance Sheet if they
have subsidiaries. If Company 'A' has more than 50% shares of Company 'B', then
Company 'B' becomes a subsidiary of Company 'A' and Company 'A' is called the
holding company. The financial statements of the holding company and subsidiary
companies are consolidated by the holding company in its financial statements to the
extent its interest in subsidiary companies and present them separately as Consolidated
Balance Sheet, Consolidated Profit and Loss Account and Consolidated Cash Flow
Statements.
The objective of such consolidation as per Accounting Standard 21 is that -
"consolidated financial statements are presented by a parent (also known as holding
enterprise) to provide financial information about the economic activities of its group.
These statements are intended to present financial information about a parent and its
subsidiary(ies) as a single economic entity to show the economic resources controlled
by the group, the obligations of the group and results the group achieves with its
resources". Consolidation is required even when a company is not a subsidiary
company but the parent company controls the composition of the board of directors in
the case of a company or the composition of the corresponding governing body in case
of any other enterprise so as to obtain economic benefits from its activities. Exhibit 2.2
presents Consolidated Balance Sheet of Asian Paints (India) Limited as at 31st March
2008.
Exhibit 2.2 .
CONSOLIDATED BALANCE SHEET AS AT 31st March 2008
of Asian Paints (India) Ltd.
(Rs. In Crores)
As at As at
31.03.200
Schedules 8 31.03.2007
FUNDS EMPLOYED
Shareholders’ Funds
Share Capital A 95.92 95.92
Reserves and Surplus B 886.45 681.87
982.37 777.79
Loan Funds C
Secured Loans 145.14 121.10
Unsecured Loans 130.07 185.07
275.21 306.17
Deferred tax liability - (Note B-11 in Schedule M) 39.08 26.79
Minority Interest 57.37 60.08
Total 1354.03 1170.83
APPLICATION OF FUND
Goodwill on Consolidation 44.35 46.86
Fixed Assets D
Gross Block 1211.22 1083.15
Less : Depreciation 633.66 603.77
Net Block 577.56 479.38
Capital Work in Progress 114.18 13.78
691.74 493.16
Investments E 276.65 192.72
Current Assets, Loans and Advances F
Interest accrued 0.09 0.03
Inventories 714.01 598.01
Sundry debtors 460.33 420.61
Cash and Bank Balances 110.71 105.39
Other receivables 73.27 69.36
Loans and Advances 153.07 97.93
1511.48 1291.33
Less: Current Liabilities and Provisions G
Current Liabilities 992.30 787.04
Provisions 177.89 66.20
1170.19 853.24
Net Current Assets [(F) - (G)] 341.29 438.09
Total 1354.03 1170.83
34 Financial Statements and Analysis
for the next 10 years or so. Authorised capital can be changed but it requires elaborate
procedure. At the same time, if the authorised capital is very large, then they may end
up in paying more fees to government since some of the regulatory fees are related to
authorised capital.
Issued and Subscribed: This is the amount of share capital that has actually been
issued by the company to the shareholders. The first column shows the number of
shares issues. The value of issued capital is equal to the number of shares issued
multiplied by the nominal value of each share. Subscribed capital is the amount of
share capital that has been bought by the shareholders. It is equal to the number of
shares subscribed by the nominal value of each share. Asian Paints (India) Ltd. has
issued 93,989,940 shares and all of them have been subscribed and hence the Issued
and Subscribed share capital value is Rs. 95.92 crores.
Called: In certain cases, the company might have asked shareholders to pay only a part
of the face value. In such an event, the called up value will be lower than subscribed
value. For fully paid up shares, the amount of Called up Share Capital should be equal
to the amount of Subscribed Share Capital.
Paid up: This is the amount, which the shareholders of the company have actually paid
on their shares. Unless any shareholder has defaulted in payment of the calls, this
amount should equal the “Called” value above. In the case of Asian Paints (India) Ltd.
no such complexities is visible in the reported balance sheet. Normally, these details
appear during the initial life of the company.
Bonus Shares: In describing subscribed and paid-up share capital, Asian Paints (India)
Ltd. mentioned that it has issued 94,199,443 bonus shares by capitalising share
premium and general reserve. Bonus shares are issued to the existing shareholders
Chapter 2 The Balance Sheet 37
without collecting any money from the shareholders. When the bonus shares are issued,
the equity share capital increase without any corresponding increase on the asset side of
the balance sheet since there is no cash flow to the company. The balance sheet
equation (Asset = Liabilities + Shareholders' Equity) gets affected in that process.
Thus, when companies issue bonus shares, they increase share capital value but they
reduce Reserves and Surplus value to an extent. This is called capitalisation of General
Reserve or transferring figures from Reserves and Surplus to Share Capital. It should
be noted that the company is not increasing the value by issue of bonus shares. Even
the shareholders fund (sum of share capital and reserves and surplus) is not undergoing
any change.
Why should company issue bonus shares and what investors get in turn by
collecting pieces of additional paper or one more electronic entry in their share
depository account? Some people believe that companies try to convey good future
prospects through bonus issues. Normally, bonus issues are made when managers
believe that the future prospects are good.
Another reason for issue of bonus is liquidity consideration. If the market price of
the shares increases to a large value, many small prospective investors may not be able
to buy such shares in view of huge investment requirement. For example, if the Infosys
stock price is Rs. 40000, very few people would be in a position to buy 1 share of
Infosys. The liquidity of the shares is likely to be affected in that process. Hence the
companies can issue bonus shares and bring down the share price within a range. The
fall in price will not affect the shareholders wealth since they have more shares now.
For instance if the pre-bonus price is Rs. 240 and if the company issues 1:1 bonus, the
price will be around 120. Suppose the price decline to Rs. 122 immediately after the
bonus issue. If you have 10 shares of the company prior to bonus issue, you will now
have additional 10 shares and totally 20 shares. The market value of your share prior to
bonus issue was Rs. 2400 (10 shares x Rs. 240) and now it will be Rs. 2440 (20 shares
x Rs. 122). At Rs. 122, the shareholder of the company can expect better liquidity
compared to liquidity prevailing when the price was Rs.240.
Stock Split: Stock split is similar to bonus issue and has same implication. That is, the
number of shares increases after the stock split or bonus issue. The difference is stock
split doesn't require capitalisation or transferring amount from Reserves and Surplus to
Share Capital. Stock split reduces the face value. Suppose the face value now is Rs. 10.
The company decides to have a stock split of 1:1 instead of bonus issue of 1:1. In stock
split case, the number of shares will increase but the face value is now reduced to Rs. 5.
Remember, companies need to send fresh certificates or pass a fresh entry in electronic
depository under both methods and also remember, there is no increase in shareholders'
fund or value of the assets under both methods. While some companies prefer bonus
shares and others prefer stock split. The current fashion is stock split though Asian
Paints (India) Ltd. has so far not made any stock split.
During the last two decades, Asian Paints has issued 6 bonus shares as detailed
below. In other words, if you had 500 shares of the company in 1985, you would now
have about 9216 shares! Your investment in 500 shares in 1985 would have costed Rs.
38 Financial Statements and Analysis
10000 to Rs. 15000 and its value at a price of Rs. 1200 as on March 31,2008 is Rs.
110.59 lakhs. The initial investment has grown at an average compound rate of 34%
per year for the last 23 years. Asian Paints (India) Ltd. rewarded the investors by
focusing its core business and expanding globally despite competition from
multinationals and unorganised sectors, which enjoy considerable tax benefit. We are
fascinated with the achievement of the company and that is one reason we have chosen
the company for illustrating financial analysis. Of course, many of you would have
fascinated with the television advertisement of Asian Paints (India) Ltd.
shareholders. Why should the company set aside a part of the profit? Normally, it is
governed by the law or agreement or practice. For example, if the company issues
debentures, the debenture holders would like to restrict the company in paying dividend
out of profit. Once dividend is paid, it is not possible to ask the shareholders to pay the
amount back to meet the liability towards repayment of debenture amount. It is
possible that debenture holders put a blanket prohibition for distribution of profit but
normally shareholders will not like such restrictions or dictations. Alternatively,
debenture holders can demand to set aside some specified amount, say 20% of
debenture value every year for 5 years and shareholders might agree for the same. A
feel good factor for both the parties involved. This condition creates a new account
called 'Debenture Redemption Reserve" and the company transfer the agreed amount
from the Profit and Loss account to this account every year till debenture are repaid.
Often, non-accounting students and managers tend to believe that the amount is in
form of cash. This confusion is mainly because the normal understanding of the word
'reserve'. It should be noted that the agreement between the shareholders and debenture
holders in this case is the available profit for payment of dividend will be determined
after setting aside some amount and not by depositing the amount in a bank account.
The purpose of such agreement is to prevent money going out from the company to
shareholders rather than preserving cash for repayment. In other words, reserve is part
of retained profit and it is upto the managers to decide how to use the retained profit. It
can be used for the purchased of fixed assets or current assets or investments or simply
repaying some of the existing loans or dues. The Schedule B of Asian Paints (India)
Ltd. gives the details of Reserves and Surplus (Exhibit 2.4).
Capital Reserve and Revenue Reserve: Reserves and surplus can be broadly
classified into two types. Reserves created out of profit or surplus arising out of
revenue transactions are revenue reserves and surplus. Surplus arising out of capital
transactions is capital reserves and surplus. For example, when companies issue shares
at a premium, the face value will be shown under share capital and premium part will
be shown under reserves and surplus. This surplus is not arising out of profit but as a
result of raising capital at a price greater than the face value. Why should companies
issue share at a premium? Suppose you are a shareholder of Asian Paints (India) Ltd.,
whose current market price is Rs. 390 (March 2008) and your company is coming out
with a public issue. Would you like your company to issue shares at Rs. 10 to the
public? Existing shareholders will object because the moment another shareholder gets
1 share at Rs. 10, she or he will share the future profit of the company equally along
with you. Existing shareholders will feel such an issue of shares at par is unfair deal to
them and block the company to issue shares at part. Existing shareholders will be
happy if the company issues shares at premium since they expect new shareholders to
pay the 'price' or 'premium' before acquiring the right to participate on the fortunes of
the company that have not been distributed. Actually, the expected premium will also
include passing on the right to share future income if the business is doing well. In a
few cases like American Depository Receipt (ADR) it is possible for the companies to
issue shares at a price more than current market price.
40 Financial Statements and Analysis
Surplus arising out of revaluation of assets is also capital in nature. Similarly, when
a company set aside some amount for repayment of capital, they are also called capital
reserve. For example, if a company issues preference share capital with an agreement
that it will be redeemed at the end of 7 years, the company may have to set aside some
amount every year out of profit. The reserve is mainly created to repay preference
share capital and hence called Capital Redemption Reserve. These capital reserves and
surplus are not available for distribution of dividend. Since dividends are to be
distributed out of profit, any dividend distribution out of capital surplus and reserve
amounts to distribution out of capital, which is generally disallowed under the
Companies Act7. They can be transferred to share capital account through bonus issues
or write off expenses or losses. Asian Paints (India) Ltd. has Rs. 5 million under capital
redemption reserve, which was created, for repayment of preference shares. Though
there are no outstanding preference shares for the company, the company has not
transferred to share capital through issue of bonus shares and allowed it to remain as
capital reserve8.
General Reserve: General reserve is revenue reserve since it is created out of surplus
in the profit and loss account. General reserve to an extent demonstrates the past
performance of the company and the amount that the shareholders have left inside the
company. Shareholders, who are not confident on the future of the company, would
have taken substantial part of the profit available for dividend instead of leaving the
amount inside the company. The General Reserve value of Asian Paint (India) Ltd. as
at March 31, 2008 is Rs. 632.08 crores. Such a huge reserve, which accounts for about
80% of the total funds, demonstrates the shareholders confidence on the future of the
company. It is also a reflection of the company's glorious past, which enabled the
company to retain such a huge amount. It may be noted that the company has not
7
As a non-accounting student or manager, this much understanding on capital reserve and
surplus is adequate.
8
The company might be thinking of issuing preference shares again in the future.
Chapter 2 The Balance Sheet 41
retained the amount at the cost of dividend. The company has distributed nearly Rs.
800 cr. in the last ten years as dividend and added Rs. 600 cr. to reserves and surplus.
The break up of general reserve of Rs. 632.08 Cr. might confuse several readers.
The first line is the amount of general reserve at the beginning of the period. The
company has earned a profit of Rs. 375.20 Cr. during the year (refer Exhibit 1.3 of
Chapter 1) as per Profit and Loss Account and the company transfers Rs. 134.42 Cr. to
general reserve. Hence this amount is added here.
Profit and Loss Account: The profit and loss account value shown in the Balance
Sheet under Reserves and Surplus represents profit retained after transfers to various
reserves and payment of dividend. Though it is part of retained earnings, the value of
retained earning is significantly larger than the value shown against P&L account. The
break-up of Reserves and Surplus is partly technical and hence one need not worry too
much on such details. As a non-accounting student/manager, you should be in a
position to find out the capital reserve and revenue reserve to understand the source and
purpose of such reserves. Capital Reserve is a reserve created out of capital
transactions resulting surplus or created for the purpose of repaying capital. Revenue
reserves are created out of surplus arising from revenue transactions or profit. A related
term often used in this context is 'free reserve'. Free reserve refers to that part of
revenue reserves without any specific objective. For computing free reserves, reserves
like debenture redemption reserve are excluded. The free reserve of Asian Paints
(India) Ltd. is Rs. 832.08 Cr., which is the sum of General Reserve and P&L Account.
9
The income-tax provisions changes rapidly. Hence, these concessions need not be applicable
in the future.
42 Financial Statements and Analysis
Suppose the company has shown Rs. 100 million as depreciation under the regular
account book. It has also reported a profit of Rs. 400 million. The company is expected
to pay a tax of Rs. 140 million (at the rate of 35%). Suppose income tax department
allows the company to show a depreciation of Rs. 200 million. Since the expense has
now increased from Rs. 100 million to Rs. 200 million, the profit will decline from Rs.
400 million to Rs. 300 million. The company now has to pay a tax of Rs. 105 million
and thus deferring Rs. 35 million. It is not possible for the company to completely
escape from paying this Rs. 35 million tax. Since the total depreciation allowed over a
period of time under both company's account and income tax account should not
exceed the value of the asset, the depreciation value will be zero for income tax
purpose at a later of point of time and hence the company has to pay the deferred tax.
For the sake of clarity let us continue the example. Assume the value of the asset is
Rs. 600 million and year to year profit before depreciation is Rs. 500 million. The
following Table (Exhibit 2.5) shows the profit under company's book and income tax
purpose and the tax deferred. While the tax is deferred during the first three years, the
company ends up paying the amount from year 4 to 6. The net savings is zero but there
is a time value of money in such deferment10.
The balance sheet of Asian Paints (India) Ltd. has shown a deferred tax liability of Rs.
305.38 million and also asks the readers to refer Note B-27 of Schedule M for details.
This note gives the break up reasons for deferred tax (Exhibit 2.6). Like depreciation,
there are other reasons causing distortion between tax payable as per company's
account and income tax account. While depreciation will normally cause deferred tax,
there are items, which force the company to pay tax in advance. For example, the
company will show some amount as bad debts but income tax authorities may disallow
such expenditure until it is proved that there is no scope for collecting the due. In such
case, profit as per company's book will be lower whereas profit as per income tax
purpose will be higher. However, depreciation related deferred tax will normally be a
major item. The statement of deferred tax of Asian Paints (India) Ltd. shows five items.
Of this one item cause tax deferment whereas the remaining four items cause advance
payment of tax (called deferred tax asset). Some companies show the two values
separately where the deferred tax is shown as a part of liability side and deferred tax
asset is shown on the asset side. As stated earlier, the depreciation related deferred tax
is the single major contributory for the net value.
10
What is the wisdom of Income Tax allowing such deferment? A full discussion on this issue
is beyond the scope of this book. Government believes that such deferment gives an incentive
for firms to invest in fresh projects and thus enable capital formation for the country. But we
don't know whether companies create fresh assets mainly to capture such tax incentives.
Chapter 2 The Balance Sheet 43
of tax cash outflow in the future. Though many of you would be relatively comfortable
with the concept of deferred tax, you may still wonder why it appears under the source
of funds. Suppose the law does not allow the companies to follow different
depreciation methods11. The company would end up paying the tax and hence there is
no deferment. The value of deferred tax is nothing but the funds of the government
used by the company for temporary period. Hence it is a source of funds and such
funds are provided by the government without any interest.
11
Many European countries disallow such practice.
Chapter 2 The Balance Sheet 45
2.11 ASSETS
Assets are classified as tangible and intangible, owned by the company. Land,
Building, Machinery and Finished Products of the company are tangible items.
Patents, Technical know-how and Goodwill are examples of intangible items. These
represent the various forms in which the funds of the business have been invested.
Hence, this part of Balance Sheet is also titled as “Application of Funds”. The term
owned by the company is emphasised here because sometimes companies that use
46 Financial Statements and Analysis
assets may not own it and so may not show them on the balance sheet12. One such
example is acquiring asset under lease arrangements.
Assets are broadly grouped as “Fixed Assets” and “Current Assets”. This
distinction arises because accounts are prepared at the end of certain periods, usually at
the end of every year. Assets, which get fully consumed or utilised within one
accounting period, are called Current Assets. Assets whose useful life exceeds one year
are called Fixed Assets.
12
Accounting Standards now require those assets to be shown by the company as assets even
though they are not owned by them.
Chapter 2 The Balance Sheet 47
The cost of an item of fixed asset comprises its purchase price, including import
duties and other non-refundable taxes or levies and any directly attributable cost of
bringing the asset to its working condition for its intended use; any trade discounts and
rebates are deducted in arriving at the purchase price. Examples of directly attributable
costs are:
i. site preparation;
ii. initial delivery and handling costs;
iii. installation cost, such as special foundations for plant; and
iv. professional fees, for example fees of architects and engineers.
Accumulated Depreciation (Balance Sheet figure): The depreciation value shown in
the balance sheet (in the case of Asian Paints Rs. 469.41 Cr.) is called accumulated
depreciation. As mentioned earlier, the cost of the fixed assets has to be spread over the
years and charged to the profit and loss account. The reason for charging depreciation
to profit and loss account as expense is obvious. Without charging depreciation, the
profit derived may not be a fair value. All expenses whether purchase of plant or
chemical should be charged to profit and loss account. While expenses incurred on the
purchase of chemical is charged immediately (assuming it is consumed in the
production process), expenses incurred on the purchase of plant and machinery is
charged over the years because these assets are used for the production over the years.
Since they are 'used' for production, the output or the product should bear some portion
of the cost of the fixed assets. Through depreciation, this purpose is achieved.
Accumulated depreciation is equal to the amount, which has already been charged
in the profit and loss account for the assets that the company owns as on that date.
Suppose the company owns some 300 assets as on March 31, 2008. The original value
of these 300 assets is called Gross Block. The sum of depreciation of these 300 assets,
which has already been charged to profit and loss account, is called accumulated
depreciation. Companies maintain asset register in which the original value of the asset
and depreciation charged every year are recorded. It is possible to find out at any given
point of time how much depreciation has been already charged for each asset from this
register. Asian Paints (India) Ltd. would have large number of assets spread all over the
country at their plants and sales offices. The original cost of these assets, which are in
possession with Asian Paints (India) Ltd. as on March 31, 2008, was Rs. 937.89 Cr. It
is called Gross Block. The depreciation charged over the years against these assets was
Rs. 469.41 Cr. and this is called accumulated depreciation.
Net Block: The difference between the Gross Block and Accumulated Depreciation is
called Net Block. Net Block value of the assets of Asian Paints (India) Ltd. as on
March 31, 2008 was Rs. 428.83 Cr. It is also equal to the amount of the assets, which
are yet to be charged to profit and loss account and will be charged over the years in
the future.
Capital Work in Progress: This item represents the expenditure incurred till date on
the creation of a new fixed asset. But the asset is not complete and is not capable of
being commercially used. Hence, the amount of expenditure incurred thereon is shown
separately under this head. Any additional expenditure incurred to bring such assets to
48 Financial Statements and Analysis
a stage where they can be commercially exploited during the subsequent accounting
periods would be added thereto. Once the asset is ready for commercial use, the
amount is transferred from this account to the relevant account of the Fixed Asset (eg:
Plant & Machinery, Building, etc.) and depreciation is charged on it in the usual
manner. The value of Capital Work in Progress of Asian Paints (India) Ltd. as on 31st
March 2008 is Rs. 110.39 Cr. (Refer Exhibit 2.1).
The Net Block is often referred to as the Book value. A question may arise as to
whether the book value of fixed assets is representative of their fair market value. It is
often the case that the book value may be quite different from the market value.
Despite this, these assets are still not shown at market value, as they are not meant to be
sold in the market, but to be utilised by the company in running its operations.
However, the Accounting Standards do allow the fixed assets to be “revalued” (i.e.,
both increase and decrease in value), in order to bring the book value in line with the
market value. However, such revaluations, particularly the upward revaluation, are not
frequently resorted. Even if a company does revaluation and increases the value of the
assets, it should disclose the fact every time when it reports fixed assets value and also
value of the fixed assets without such revaluation.
The details of fixed assets are given in Schedule D (see Exhibit 2.8) of the Annual
Report. This is the most complex schedule, which creates considerable confusion to the
non-accounting students and mangers. The first column shows the description of the
assets. Asian Paints (India) Ltd. classified its total assets into 11 broad categories.
Since the company is in the manufacturing industry, more than half of its assets are
tangible and in the form of plant and machinery. Columns 2 to 5 relate to gross block
or original value of the assets. Column 2 shows the original value of assets that are in
possession with the company as on 1st April 2007. During the year, the company has
purchased some assets, whose original value was Rs. 138.33 Cr. and the details are
given in column 3. The company could have sold some of the assets during the year or
transferred to some other companies. In other words, a few assets have gone out of the
company. The original value of these assets that have been sold or transferred was Rs.
6.64 Cr. and the details are reported in column 5. It should be noted that this value is
neither sale value of those assets nor book value (original value less accumulated
depreciation). It is just original value of the asset (invoice value plus direct expenses
incurred on these assets).
The values in column 6 to 9 are related to the accumulated depreciation. The
accumulated depreciation as on March 31, 2007 is reported in column 6. The difference
of values in column 2 and column 6 is the net block value (or book value) of the assets
as on March 31, 2007 and you can see this value in the last column of the table.
Column 7 is related to depreciation provided for the assets during the year, which are
used by the company. This value is equal to Rs. 43.70 Cr. This is the value that will be
shown as expenses for the year 2007-08 in the Profit and Loss Account.
Column 8 is critical for understanding the whole table. In column 4, the company
provided the details of assets which have been sold or transferred and deducted the
original value of the assets. Since the assets itself are not with the company, the
Chapter 2 The Balance Sheet 49
Leasehold land and major leasehold improvements are amortised over the primary
period of lease.
Purchase cost, User licence fees and consultancy fees for major software are amortised
over a period of four years. Acquired Trade Mark is amortised over a period of five
years.
(d) At Balance Sheet date, an assessment is done to determine whether there is any
indication of impairment in the carrying amount of the Company's fixed assets. If any
such indication exists, the asset's recoverable amount is estimated. An impairment loss
is recognised whenever the carrying amount of an asset exceeds its recoverable
amount.
An assessment is also done at each Balance Sheet date whether there is any indication
that an impairment loss recognised for an asset in prior accounting periods may no
longer exist or may have decreased. If any such indication exists the asset's recoverable
amount is estimated. The carrying amount of the fixed asset is increased to the
revised estimate of its recoverable amount but so that the increased carrying
amount does not exceed the carrying amount that would have been determined
had no impairment loss been recognised for the asset in prior years. A reversal of
impairment loss is recognised in the Profit and Loss Account.
2.13 INVESTMENTS
Investments represent any amount spent on acquiring assets, which are not directly
related to the business of the company. Investments are assets held by an enterprise for
earning income by way of dividends, interest, and rentals, for capital appreciation, or
for other benefits to the investing enterprise. For example if a company may acquire
shares or debentures in other Indian companies. As the acquisition of these securities is
not the main business of APL, such assets are shown separately as “Investments”.
However assets held as stock-in-trade are not ‘investments’. The Total Value of
Investments made by Asian Paints (India) Ltd as on 31st March 2008 is Rs. 422.88
Crores. The details are investments are given in Schedule E (Exhibit 2.9). If the
Chapter 2 The Balance Sheet 53
company has numerous investments, the schedule will run into several pages because
the companies are expected to give complete details.
The company has reported the following Accounting Policy related to Investments:
(a) Long term investments are carried at cost. Provision for diminution in the value
of long term investments is made only if such a decline is not temporary in the
opinion of the management. Current investments are carried at lower of cost and
fair value. The comparison of cost and fair value is done separately in respect of
each category of investments.
(b) Profit and loss on sale of investments is determined on a first in first out (FIFO)
basis.
Investments can mainly be of two types - Short Term and Long Term. Short Term
investments are meant to be sold off or liquidated within the next accounting period.
Hence, these are shown at market value. But in case their cost of acquisition is less than
the market value, then they are shown at the cost. This is to prevent the company from
booking any profits, which have not yet been realised in cash. Thus, the rule to value
such investments is “Cost or Market Value, whichever is lower”. Long Term
investments are meant to be held beyond one accounting period. As these are not meant
54 Financial Statements and Analysis
for disposal within the accounting period, they are shown at their original cost.
However, in case there is any permanent diminution in value, then they are to be shown
at the reduced value, in order to reflect the fair value. Investments are to be classified
under the following heading with complete details under each heading for the reporting
purpose.
Long Term and Short Term Investments: Investments which are expected to be held
for more than one year are grouped under long term investments. Other investments are
grouped under short-term investments.
Quoted and Unquoted Investments: If the investments are quoted in the stock
exchanges, they are grouped separately and listed. Aggregate market value of the
quoted investments is to be reported at the end of the schedule. Unquoted investments
are investments in unlisted companies.
Trade and Non-trade investments: Trade investments are investments made by the
company in the ordinary course of business. They are business-related investments.
The objective is not just investing the temporary surplus cash but with an objective of
developing long-term association with the investing company. Investments in joint
venture or subsidiary companies are trade investment. Non-trade investments are
investment in the nature of cash or treasury management. They are made to park
temporary surplus funds to earn some return. Exhibit 2.9 provides investment of Asian
Paints (India) Ltd. under the above broad heading. Investments of the company are
substantially for long-term purpose and that too investment in subsidiary companies.
Investments in subsidiary companies are cancelled out under consolidated balance
sheet. Exhibit 2.2 (Consolidated Balance Sheet) shows an investment of Rs. 276.65
crores compared to Rs. 422.88 crores shown in Exhibit 2.1. Investments worth of Rs.
132.19 crores in subsidiary companies has been removed.
Current Assets are those assets, which get used up, consumed, or whose benefit is
realised within the accounting period (i.e., within one year). So, unlike fixed assets,
their useful life is normally less than one year. Hence, they are called “current” assets.
Major items of currents assets are inventories, sundry debtors (customers' due) and
cash. Exhibit 2.10 presents the Schedule F, which provides additional details on current
assets, loans and advances.
Interest Accrued: Interest accrued on investments and loans and advances for the
accounting period are expected to be received are recorded as income for the period.
Since such interest is recorded as income, it has a positive impact on shareholders'
equity part of the balance sheet equation. There should be a corresponding increase in
the other part of the equation to ensure the equation gets balanced. If the interest is
realised in cash, it will add to cash and bank balances. Since the amount has not
received, it will be treated as receivables or interest accrued but not received.
Chapter 2 The Balance Sheet 55
Inventories: This item represents the value of materials which are used in the
production (e.g. chemicals, pigments), materials which are in the process of being
manufactured or work-in-progress and completed goods ready for sale or finished
goods. Accounting Standard – 2 states “inventories as assets (a) held for sale in the
ordinary course of business; (b) in the process of production for such sale; or (c) in the
56 Financial Statements and Analysis
which one can compute the cost value. In this case the goods are identifiable in nature
and hence one can find out the exact prices at which the 100 unsold goods are with the
company. However, this practice may not be feasible for a chemical company or steel
company. There are broadly three methods used for finding the cost of inventory and
each method is based on an assumption.
Method 1 called first-in-first-out method or FIFO assumes goods received first are
consumed or sold and hence the closing stock consists of goods purchased during the
last few days or weeks or months. The value of closing stock is found by applying the
last few rates. Method 2 called last-in-first-out method or LIFO assumes exactly
opposite way. It assumes goods last received are used or sold first and the closing stock
consists of units purchased earlier. Accordingly, consumption or sales are valued at the
last invoice price and closing stock is computed by deducting the cost of consumption
or sales from total purchase cost. LIFO is not allowed under Indian Accounting
Standard. Method 3 called weighted average cost method updates the stock value
every time when a purchase is made taking into account the value of stock available at
that point of time. Suppose on day 1, 100 units are purchased at a price of Rs. 10 per
unit. Day 2, 80 units are consumed. The weighted average cost of closing stock of 20
units is Rs. 10 per unit. Day 3, 80 units are purchased at a price of Rs. 12 per unit. The
weighted average cost of the stock of 100 units (20 old units and 80 new units) is Rs.
11.60 (200+960 divided by 100). The process of updating the value of the stock
continues and closing stocks are valued at this weighted average rate. Among the three
methods, weighted average cost method is widely used by Indian companies.
Asian Paints (India) Ltd. has classified the inventory into six categories namely Raw
materials, Packing materials, Finished goods, Work-in-process, Stores, spares and fuel
and Other traded items. Among these six items, finished goods and raw material
account for substantial part of inventory value. In the notes on balance sheet section,
the company has stated the inventory valuation policy as follows:
a) Raw materials, work in progress, finished goods, packing materials, stores, spares, traded
goods and consumables are carried at the lower of cost and net realizable value. The
comparison of cost and net realizable value is made on an item-by-item basis. Damaged,
unserviceable and inert stocks are suitably depreciated.
b) In determining cost of raw materials, packing materials, traded goods, stores, spares and
consumables, weighted average cost method is used. Cost of inventory comprises all
costs of purchase, duties, taxes (other than those subsequently recoverable from tax
authorities) and all other costs incurred in bringing the inventory to their present location
and condition.
c) Cost of finished goods and work-in-process includes the cost of raw materials, packing
materials, an appropriate share of fixed and variable production overheads, excise duty
as applicable and other costs incurred in bringing the inventories to their present
location and condition. Fixed production overheads are allocated on the basis of normal
capacity of production facilities.
58 Financial Statements and Analysis
Sometime, it may be necessary to pay deposits with various government agencies for
electricity, telephone, water, etc, or pay advance tax. Since all these are either
recoverable or adjustable against future liabilities, they are treated as a part of asset.
Companies generally classify the loans and advances under four broad heads for the
purpose of disclosure. They are (a) Loans and advances to wholly owned subsidiaries
(b) Loans and advances to companies in which directors of Asian Paints are interested,
(c) Loans and advances to others and (d) Advance tax paid. This disclosure will help
the readers to understand whether the directors of the company use their association
with the company for certain personal benefit.
Advance Payment of Taxes (Net of provision for tax): A company is often required
to make the payment of Income Tax during the accounting period itself, based on an
estimate of the likely profits during the year. This is called “Advance Tax”, as it is paid
before the end of the accounting period. The amount and timing of such payments is
determined by the Income Tax Act. Any such Advance Tax paid is shown under this
head.
Provisions: These are cash expenses likely to happen in the near futures. Examples of
provisions are provision for dividend, tax, bonus, etc. These items are not like
provision for doubtful debt or depreciation where there is no immediate liability.
The details of current liabilities and provisions given in schedule G of Asian Paints
(India) Ltd. is given in Exhibit 2.11.
2.17 DEFERRED REVENUE EXPENDITURE (To the extent not written off):
This item is neither a fixed asset nor a current asset. It represents a different
category of expenditure altogether. Often, a company incurs a substantial expenditure,
say on a large advertisement campaign or major information technology expenses. The
expenditure is, truly speaking, a revenue expenditure, and hence should appear in the
profit and loss account. However, if the benefit of the expenditure is realised over the
next few years, it is only logical to write off the expenditure over the years. Suppose a
company incurs Rs. 100 million in supply chain management system and the benefit is
fully realised during the next four years period. In such an event, Rs. 25 million is
charged in the profit and loss account for the period 1 and the remaining Rs. 75 million
is shown in the balance sheet as asset. The description used for such asset is Deferred
Revenue Expenditure (to the extent not written off). In year 2, another Rs. 25 million
will be charged in the profit and loss account but the balance sheet asset value will be
reduced to Rs. 50 million. At the end of year 4, the expenditure will not appear in the
balance sheet. In many balance sheets including the Balance Sheet of Asian Paints for
the year ended 31st March 2005, we may not see any figures on this heading. Earlier
Asian Paints (India) Ltd. was showing such IT related expenditure as deferred
expenditure but in 2004-05, it has shown the same as intangible fixed assets and
mentioned the same in notes to accounts as follows:
Hitherto, user licence fees for major software was classified as Deferred Revenue
Expenditure. Pursuant to Accounting Standard (AS 26) - Intangible Assets, the same
has now been reclassified as Intangible Assets under "Schedule D-Fixed Assets".
Other software expenditure is written off to the Profit and Loss Account in the year of
purchase.
The total value of such liabilities as on March 31, 2008 is Rs. 146.96, which is about
20% of the reserves and surplus.
2.19 SUMMARY
Balance Sheet is normally the first financial statement of the annual report, which
consists of several other financial statements. Balance sheet is a statement of wealth. It
also provides wealth of information to the users of financial statement. The statement
lists the assets owned by the company and claims against the company as on the date
on which the balance sheet is prepared. Balance sheet can also be viewed as a
statement, which shows the sources of funds and their uses. Funds are provided by
shareholders and lenders. Shareholders can bring fresh equity or allow the company to
retain part of the profit as their contribution. Lenders can provide funds in the form of
secured loan or unsecured loan or for long period or short period. Funds raised from
shareholder and lenders are mainly used for purchase of fixed assets, investments and
net current assets. A reading of balance sheets shows the composition of sources of
funds and the assets. A comparison with previous year's values highlights the growth of
the company and how such growth is funded. Balance Sheet always balances due to
double entry bookkeeping principle, which can be stated as balance sheet equation. A
simple balance sheet equation is-
The equation can be expanded further to reflect several components of assets and
liabilities. Indian companies provide the principal items of balance sheet in a single
page statement and provide large amount of details in schedules and notes forming part
of balance sheet.
Chapter 3
Income Statement
3.1 INTRODUCTION
The shareholders of companies like Asian Paints (India) Ltd. would expect the
managers of their companies to work towards earning profit for them. They would not
be satisfied if the management just informs them that the company has made so many
millions of profit. They would expect the company to give the details of revenue and
expenditure under few broad headings and then the resulting profit. Tax authorities
would also expect the company to produce a detailed statement showing income and
expenditure while paying tax. Though profit is important figure, the users of financial
statements would expect more details about the operations along with the details of
profit. Members of not-for-profit organisations would also expect their organisations to
report the operating details by giving major income and expenditure details.
Organisations with profit as objective prepare a statement called profit and loss
account. The profit and loss account is a formal financial statement, which summarises
the results of a company's operations (revenues and expenses) for a specific period of
time. Not-for-profit organisations prepare a statement called income and expenditure
account and show whether the organisation has earned surplus or incurred deficit
during the period. These statements show the results of operations in a manner such
that the reader can understand the results from normal operating activities of the
organisation, and also the result of any extraordinary or one-shot items. Such
presentation allows a better understanding of the performance of the organisation.
Expenditure split in this manner can really help us see how well the business is
performing and where it needs to make changes if it wants to stay in business or
improve its performance.
64 Financial Statements and Analysis
Profit and loss account helps us to analyse the profitability of a company over a
particular time period. Unlike a Balance Sheet, it cannot tell us how much assets the
company owns, but it can help us work out where the company is making and losing
money by using such assets. After all, assets are held to generate profit. Profit and
loss account is also required to be prepared on shorter intervals. Under the listing
agreement of stock exchanges, listed companies in India have to give quarterly
statement of profit in a summarised form in addition to detailed profit and loss account
at the end of each accounting year. Profit and Loss account is relatively simpler than
balance sheet in terms of understanding the concepts. It provides the following
information to the users of financial statements.
Sources of Income or Revenue: Broadly, there are two sources of income - income
from main operation and other income. Other income may be recurring or one-time
non-recurring income. It is possible for companies to show major increase in profit by
reporting an improvement in other income. Since other income is generally volatile on
a year to year basis, users of financial statements mostly give less importance for other
income.
Trends in Expenditure: The ability to contain the cost is critical for the long-term
solvency of the company. By comparing expenditure item with sales for two or more
years, it is possible to assess the ability of the firm in controlling cost. It is also possible
for the users to make inter-firm comparison on expenditure.
Different Types of Profit: The term profit is open for misinterpretation without proper
prefix or suffix. Profit before depreciation, interest and taxes (PBDIT), Profit before
interest and taxes (PBIT), Profit before tax (PBT), Profit after tax (PAT), Profit before
extra-ordinary items are few categories of profit and each one conveys some additional
information. Similarly, profits are reported as operating profit, gross profit, net profit,
cash profit, disposable profit, etc. Profit and Loss statement provides the details of
these different types of profit.
13
We have discussed these concepts briefly in Chapter 1.
66 Financial Statements and Analysis
Earnings per share (Basic & diluted) (Note B-25 in Schedule M) 42.66 29.30
68 Financial Statements and Analysis
Revenue as recorded at the top of the Profit and Loss Account is the total value of
sales invoices raised for goods and services provided during the accounting period. If
the accounting period is from 1 January to 31 December, then all invoices for goods
and services provided in the accounting period are included irrespective of the fact
whether cash has been received from customers or not. It is a normal trading practice
for customers to buy goods on credit terms. This means actual payment for the invoices
raised during the period may be received after the accounting period. The reason for
considering such unpaid invoices also in sales is accrual concept. The impact of this
accrual concept is a part of the profit stated in the profit and loss account is yet to be
realised in cash. In other words, the profit derived based on accrual concept is also
profit accrued but not necessarily received or realised in cash. Sales invoices raised for
goods and services provided outside of this period are not to be included in the sales
figure for the period because accrual concept requires to exclude transactions not
occurred during the period.
The matching concept requires all costs incurred in achieving sales for an
accounting period to be matched against those sales again irrespective of the fact
whether they are paid or not. For example if a company sold 1000 pieces during the
year and of this 200 units were purchased in the previous year and the remaining 800
during the current year, the expense should reflect all the 1000 units cost of purchase.
Similarly, for the accounting period ended 31 March 2008, fixed expenses incurred
between 1 April 2007 and 31 March 2008 are to be matched against sales. It means that
if the company paid rent or insurance on 1st January 2008 for six months (January to
June), it should consider only half of this amount as expense for the period (January to
March). The value of the 3 months rent or insurance paid in advance for April to June
will appear in the Balance Sheet under Current Assets as a prepayment.
There are few cases in which the company may have to recognise the expense even
though they are not due for payment. Interest on borrowing for the period whether it is
due or not should be shown as expense of the period. Normally, interest on borrowings
is paid twice in a year, 30th June and 31st December. When the books of accounts are
prepared for the period of April to March, interest for the period of January to March is
to be included though they are due and payable only on 30th June. There are several
such situations in which matching principle sets the decision rule whether to recognise
the expenditure or not. In other words, matching concept requires the accountants to
consider all expenses of the period and expenses incurred for earning the revenue.
The entries found in a typical Profit and Loss Account can be divided into four
broad categories namely, income, expenses, profits or losses and appropriation of
profits.
3.5 INCOME
Income or revenue is outcome of operations. Accounting Standard 9 (AS-9) defines
revenue as "the gross inflow of cash, receivables or other consideration arising in the
course of the ordinary activities of an enterprise from the sale of goods, from the
rendering of services, and from the use by others of enterprise resources yielding
Chapter 3 The Income Statement 69
interest, royalties and dividends. Revenue is measured by the charges made to
customers or clients for goods supplied and services rendered to them and by the
charges and rewards arising from the use of resources by them. In an agency
relationship, the revenue is the amount of commission and not the gross inflow of cash,
receivables or other consideration." Earlier in our discussion on accrual concept, we
mentioned that credit sales should be included as revenue. While this is a general
principle, as per Accounting Standard 9, a sale is recognised as revenue only when
i. the seller of goods has transferred to the buyer the property in the goods for a
price or all significant risks and rewards of ownership have been transferred to
the buyer and the seller retains no effective control of the goods transferred to a
degree usually associated with ownership; and
ii. no significant uncertainty exists regarding the amount of the consideration that
will be derived from the sale of the goods.
There are various sources of revenues for a company. Sales, also referred to as
turnover, represent the total income of a business from its normal trading activities. The
value of turnover that appears in the Profit and Loss Account includes the total value of
all goods or services for which invoices have been issued, even if payment has not yet
been received for some of these invoices. Some companies report sales excluding
excise duty and others show including excise duty and then deduct the excise duty to
derive net sales. The first line item of Asian Paints (India) Ltd. is sales and operating
income but it includes excise duty. It was Rs. 3911.93 crores as given in Exhibit 3.1
and the company has paid Rs. 495.80 crores as excise duty. Sales and operating income
excluding excise duty was Rs. 3416.16 crores. Trade discounts are excluded in
computing the sales. Trade discounts are given for bulk purchases. There is another
discount called cash discount which are given when buyers make payment before due
date but they are to be recorded in the books of accounts. The Profit and Loss Account
draws the attention of the reader to Schedule H to get more details about the sales and
other income. The details of the schedule are given in Exhibit 3.3
The first section of Schedule H provides the break up of sales - home or domestic
market, exports and inter-division transfers. Inter-division transfers are strictly not sales
but many companies include for the purpose of accounting convenience. Such transfers
are also reflected under the expenses and hence normally there should not be any
impact on profit14. The details of good returned is also reported in the schedule. Some
of these items may be actually sold in previous accounting period or year but still
accounted as negative sales for the current period. One need to worry if the value of
such good returned is large and significantly different from the previous year.
Sometime, it may be necessary to look into the good returned value of other companies
in the industry to assess the quality of the product or company's ability to fulfil the
14
There is a scope for window dressing but we will presume that accounting, auditing and
corporate governance practices will prevent such window dressing. Discussion on window
dressing or accounting manipulation is beyond the scope of this book and hence we make a
sweeping assumption that unless stated specifically, the companies we will be analysing in this
book are good companies.
70 Financial Statements and Analysis
customers' specification. Duty drawback and export subsidy are money received from
government either in the form of return of duties paid or subsidy for exporting the
good. Government has some such schemes to promote export. Trade discounts values
are also shown in the schedule and deducted from the sales to derive Sales net of
discount.
Sales, Profit after tax and other incom e of Asian Paints (India) Ltd.
600
500
Sales
Profit after tax
Other Income
400
300
200
100
0
March, 1994 March, 1995 March, 1996 March, 1997 March, 1998 March, 1999 March, 2000 March, 2001 March, 2002 March, 2003
72 Financial Statements and Analysis
The Schedule I of the Asian Paints (India) Ltd. lists the details of other income.
They are shown in Exhibit 3.4.
3.8 EXPENDITURE
Expenditure incurred in earning revenue is deducted to derive profit. Any amount
spent by the business unit is expenditure but the nature of expenditure may differ.
Expenditure incurred to earn revenue is called Revenue Expenditure and expenditure
incurred to buy an asset is called capital expenditure. While revenue expenditure like
material purchased, salary and wages, etc. are charged in full, capital expenditure is
charged over the years based on the usage of the asset. The basis for writing off such
capital expenditure varies based on the nature and the type of expenditure involved. For
instance, if it’s a tangible physical machinery purchased for production, this asset is
written off in the form of depreciation. Revenue Expenditure are normally grouped
under three heads namely materials, salaries and wages and manufacturing,
administrative, selling and distribution expenses for the purpose of disclosure and the
details are reported in the schedules. In addition, finance charges (interest expenditure)
and depreciation are disclosed separately.
15
Asian Paints (India) Ltd. adjust the stocks when computing material consumed.
74 Financial Statements and Analysis
purchased is added to the value of open stock of material and then value of closing
stock is deducted to find the material consumption. That is material consumed is equal
to open stock of material plus material purchased less closing stock of material.
Though this computation looks simple there are several complications. The material
consumed just arrived using the above equation is not material consumed for goods
sold but material consumed for goods produced during the period. Therefore the value
of closing stock of finished goods has to be separated.
Another complication is the method to be used for valuation of material issued over
a period of time due to continuous change in the purchase price. In the previous
chapter, we discussed couple of methods of inventory valuation and the company has
to select one that is most suitable given the price movements of the material. Finally, if
the market price of the material is lower than the cost of the material, then closing stock
is valued at cost and the implication of such valuation is increase in material
consumption value. In other words, material consumption value gets distorted due to
these factors and this in turn will impact on the profit. Hopefully, if the closing stock
value is relatively small compared to profit of the company, then such distortions will
not have any major impact on the profit value. On the other hand, if the closing stock
value is as high as the profit or if, more than the profit, any valuation error would have
major impact on the value of profit. The following table illustrates the point.
Company A Company B
Sales 1000 1000
Opening Stock 150 20
Purchases 460 500
Closing Stock 100 10
Material Consumed 510 510
Other Expenses 390 390
Profit 100 100
Revised profit if the closing stock is 90 99
overvalued by 10%
Percent change in profit due to 10% 1%
valuation error
Cost of finished goods and work-in-process includes the cost of raw materials,
packing materials, an appropriate share of fixed and variable production overheads,
excise duty as applicable and other costs incurred in bringing the inventories to their
present location and condition. Fixed production overheads are allocated on the basis
of normal capacity of production facilities.
76 Financial Statements and Analysis
Companies adopt various formats in presenting the same information for better
understanding. The income statement of Asian Paints can be presented as follows:
Year Year
2007-2008 2006-2007
INCOME
Sales and Other income 3478.74 2861.74
EXPENDITURE
Opening stock of Raw material and packing material 137.97 129.33
Add: Raw material and packing material purchased 2001.27 1673.28
Less: Closing stock of Raw material and packing material 206.30 137.97
Cost of Materials consumed 1932.94 1664.64
Employees' remuneration and benefits 194.67 157.11
16
The figure is revised periodically considering the inflation and general trend in the managerial
remuneration. Some of the industry associations are against this disclosure and putting pressure
on the government to withdraw this requirement. Many companies including Asian Paints
stopped giving this information but inform the shareholders that they can get this information by
writing to Company Secretary of the company. Some of you can compare your salary with
your counterpart in other companies by going through this table!
78 Financial Statements and Analysis
have discussed the provision for bad and doubtful debts. The value of provision was
Rs. 3.23 Cr. as on March 31, 2008 and Rs. 4.54 Cr. as on March 31, 2007. The
difference can be explained as follows.
Provision for Bad and doubtful debts (March 31, 2007) Rs. 4.54 Cr.
Add: Additional provision made during the year 2007-08 Rs. 1.18 Cr.
Rs. 5.72 Cr.
Less: Bad debts recognized and written off during the year 2007-08 Rs. 2.49 Cr.
Provision for Bad and doubtful debts (March 31, 2008) Rs. 3.23 Cr.
3.13 INTEREST
Interest or finance charges are related to short-term and long-term loan taken by the
company. They are by and large fixed in nature. As part of the notes to accounts,
companies normally give the break up of the interest expenses.
3.14 DEPRECIATION
Capital expenditure is incurred to generate revenue over a period of time. Hence
the cost of incurred in buying capital assets are spread over a period of time. This
Chapter 3 The Income Statement 81
process of spreading the expenditure is achieved through depreciation. The reason for
providing depreciation can be seen from another angle. We discussed matching
principle in deriving profit for the period. According to matching principle, expenses
incurred to earn revenue are to be matched. When we use a machine or building or
vehicle to generate a product or sell a product, it should bear expenditure related to
usage of machine or building or vehicle. If it is a hired machine or rented building, it is
easy to match the expenditure with revenue. For the owned assets, depreciation is the
process through which matching take place.
The need for charging depreciation is fairly easy to understand but the debate often
is on how much should be charged. It is normally a technical issue - how much of the
asset value depreciated during the year because of production department using the
asset? Instead of finding machine wise such details, which may be impractical,
normally the life of the assets are estimated and depreciation rates are worked out on
that basis. Companies Act, 1956 provides the minimum rates of Depreciation for
different categories of Assets17. Income Tax Act also provides depreciation rates
applicable to business units. Once the life of the asset is fixed, companies need to
decide the method of depreciation.
There are two widely practised methods of depreciation. Under 'straight line
method' (SLM), it is assumed that wear and tear of the asset takes place uniformly over
the years. Hence the value of depreciation is constant for that machinery year after
year. The value of depreciation under this method is equal to value of the asset minus
salvage value of the asset divided by estimated life of the machine. SLM is normally
used in preparing accounts for the shareholders. The second method widely used in
casting profit and loss account for income-tax purpose is called 'reducing balance
method' or 'written down value (WDV) method'. Under WDV method, the value of
depreciation is equal to value of the asset at the beginning of the period multiplied by
the depreciation rate. Hence the value of depreciation declines year after year.
There are several justifications for this method. The productivity of the assets is
normally high during the initial years and hence value of the asset depreciates more
during the initial year. It is also believed as the time pass, new machines will come into
the market which in turn will reduce the value of the machine. Hence, it is better to
depreciate the asset during the early phase of life. Since the purpose of depreciation is
to recover the cost of machine, it is better to recover the cost during the initial stages
since future is uncertain. This method is also preferred because repairs and
maintenance expenses will go up over the years and hence it is better to match them by
charging high depreciation during the initial years and then less depreciation in
subsequent years.
Like bad and doubtful debts, the depreciation figure that appears in the Profit and
Loss account is provision set aside for the current year for depreciation. Details of the
same are reported under Fixed Assets Schedule. The fixed asset schedule of Asian
17
Companies Act prescribes depreciation and insists that profit should be derived only after
providing depreciation. The reason is profit without providing depreciation and disposal of such
profit amount to distribution of capital.
82 Financial Statements and Analysis
Paints (India) Ltd. gives the following details, which is useful to understand the linkage
between depreciation value shown in Profit and Loss Account and Balance Sheet.
Provision for Depreciation (upto 31-3-2007) (opening balance) Rs. 430.92 Cr.
Add: Additional provision made during the year 2007-08 Rs. 43.70 Cr.
Rs. 474.62 Cr.
Less: Provision for depreciation withdrawn due to sale or transfer of
assets Rs. 5.21 Cr.
Provision for Depreciation (March 31, 2008) (closing balance) Rs. 469.41 Cr.
additional shares at a value less than fair value. For instance, if the fair value or
current market price is Rs. 100 but the company agrees to convert the debt and issue
shares for Rs. 40, then 0.60 shares is added to the existing number of shares to
compute diluted earnings per share. In other words, if there is no discount price to
fair value, then there will not be any difference between the basic earning per share
and diluted earnings per shares, other things remaining constant18.
Asian Paints (India) Ltd. has reported basic and diluted earnings per share of Rs.
39.12. The computation details as shown in the Schedule M are as follows.
3.21 SUMMARY
Business units operate with a goal of generating profit. Though they may pursue
various other goals, profit is always bottom line for any business unit and society also
recognises the need for firms making profit. The task of arriving at the profit / loss
figure is really complex in view of number of assumptions to be made in preparing
profit and loss account. It is difficult to detect accounting frauds fairly for a long period
of time and profit and loss account is vulnerable for such frauds. Companies normally
follow accrual and matching principles in preparing profit and loss account. In
addition, there are number of Accounting Standards to ensure some level of uniformity
and consistency in preparation of profit and loss account.
Indian companies provide large amount of details of income and expenditure either
in the schedules or directors' report. The profit derived is only notional. It is not
realised profit. A significant part of the profit may be still in the form of debtors and
such profits are realised only when the debtors pay the dues. Many companies speed up
the sales towards the end of the year to improve the profitability and in that process, it
might even result in accepting some bad and doubtful customers. In view of this as well
as unfriendly format, many users of accounting statements started demanding
additional reader-friendly disclosures. Companies are now required to provide cash
18
For a set of illustration on the computing the diluted earnings per share, please refer
Accounting Standard 20. All Accounting Standards are available in ICAI web site,
http://www.icai.org.in
Chapter 3 The Income Statement 85
low statement to satisfy this demand. Cash Flow Statement is the third important
financial statement and we discuss more about this in the next chapter.
Chapter 4
4.1 INTRODUCTION
The two principal financial statements discussed in the last two chapters differ on one
important aspect. While income statement is period statement, balance sheet is
prepared at a particular point of time. Balance sheet normally provides values for two
periods but the values are at two different points of time. What is the link between the
two balance sheet values? Initially companies were preparing and producing funds flow
statement to show the link between two balance sheet dates19. Since many users started
complaining that there is little value addition coming out of funds flow statements and
started demanding cash flow statements, regulating agencies all over the world has
moved to cash flow statements. Since 1994-95, all listed companies in India were also
required to disclose the statement of cash flows in addition to balance sheet and profit
and loss statements.
19
Though earlier Accounting Standard AS-3 allowed companies to provide Funds Flow
Statement, a very few companies and most public sector companies were giving funds flow
statement since AS 3 was not mandatory in those days.
Chapter 4 Statement of Cash Flows 87
4.2 NEED FOR CASH FLOW STATEMENT
The primary objective of the statement of cash flows is to provide information about an
entity's cash receipts and cash payments during a period. The net effect of cash flow is
provided under different heads namely cash flow from operating, investing and
financing activities. It helps users to find answers to the following important questions:
(a) Where did the cash come from during the period?
(b) What was the cash used for during the period?
(c) What was the change in the cash balance during the period?
The AS-3 identifies two important uses of cash flow statement as follows:
(a) A cash flow statement, when used in conjunction with the other financial
statements, provides information that enables users to evaluate the changes in net
assets of an enterprise, its financial structure (including its liquidity and solvency)
and its ability to affect the amounts and timing of cash flows in order to adapt to
changing circumstances and opportunities. Cash flow information is useful in
assessing the ability of the enterprise to generate cash and cash equivalents and
enables users to develop models to assess and compare the present value of the
future cash flows of different enterprises. It also enhances the comparability of the
reporting of operating performance by different enterprises because it eliminates
the effects of using different accounting treatments for the same transactions and
events.
(b) Historical cash flow information is often used as an indicator of the amount,
timing and certainty of future cash flows. It is also useful in checking the accuracy
of past assessments of future cash flows and in examining the relationship
between profitability and net cash flow and the impact of changing prices.
Since the cash flow statement primarily assesses the liquidity position of the firm,
the demand for such statement stems from banking and financial institutions. Robert
Morris Associates, a national association of bank loan and credit officers, advocates the
use of cash flow analysis as a tool necessary to evaluate, understand, and accurately
determine a borrower’s ability to repay loans.
"Banks lend cash to their clients, collect interest in cash, and require debt
repayment in cash. Nothing less, just cash. Financial statements, however,
usually are prepared on an accrual basis, not on a cash basis. And
projections? Same thing. Projected net income, not projected cash income.
Yet, cash repays loans. Therefore, we are compelled to shift our focus if we
truly wish to assess our client’s ability to pay interest and repay debt. We must
turn our attention to cash, working through the roadblocks thrown up by
accrual accounting, to properly evaluate the creditworthiness of our client".
(RMA Uniform Credit Analysis, Philadelphia, Robert Morris Associates,
1982).
88 Financial Statements and Analysis
Cash flow from operating activities for instance tells how much cash that the
business has generated through operations. The figure is derived by deducting cash
paid to suppliers, employees and other operating expenses from cash received from
customers and cash sales. Every investor would like to see the profit in the form of cash
because profit is realised only when cash is received from the customers. During USSR
collapse, many Indian companies have suffered a lot because of considerable delay in
collecting the dues. If cash part of profit is so important, what is the justification for
reporting accounting profit?
Accounting profit is prepared based on accrual principle and going concern
assumption. Hence it reflects the long-term operational efficiency of the business.
Since some management may use these assumptions and principles to report higher
profit in the short run, cash flow statement supplements. At least, it enables people to
ask right questions. For instance, if a firm reports significant improvement in sales and
profit but there is no change in cash flow from operations. One possible reason would
be the high level of receivables. Users of financial statements may raise a right question
whether these sales are genuine or whether such increase in receivables is seen in other
business units of the industry. Auditors of such firms, while certifying the profit and
receivables figures may also insist the company to demonstrate whether such sales are
genuine.
Chapter 4 Statement of Cash Flows 89
Cash flows are also difficult to fudge or manipulate and hence often used to
examine whether the reported profit is outcome of any abnormal changes or
developments20. For instance, if a company approaches a bank for a loan, the company
would normally highlight the profitability of the business. But with lot of accounting
scams around, the credit appraiser will be cautious in believing the profit figure. The
credit appraiser would be interested in looking into cash flows of the business and
particularly, cash flow from operations. The operating cash flows should be adequate to
meet fixed interest and other liabilities and also the repayment schedule. Though
Accounting Standard setting bodies have provided guidelines for the preparation for
cash flow statement, one can choose the format to suit particular requirement. Suppose
a company capitalised some of the revenue expenditure (deferred revenue expenditure).
Though it increases the profit and also cash flow from operations, the user of cash flow
statement can reduce the cash flow from operation based on her/his judgement on the
expenditure.
Cash Flow Statement is useful to examine whether the profits are realised and if so,
what percentage of profit a firm has realised. In other words, a company that shows
high level of profit need not be liquid in cash. Suppliers of goods will also be
interested to examine the cash flow position of the company before supplying goods on
credit. Investors, who have no control on management, will also be interested in
examining the cash flow to supplement her/his analysis on profitability of the business.
The cash flow statement is different from other principal financial statements in many
different ways.
Financial statements like P&L account and Balance Sheet are prepared using
accrual accounting principle. For instance, when a firm sells its products, it is assumed
that profit is realised. Similarly, the expenses incurred against the sale are assumed to
have been incurred or paid irrespective of the fact whether cash is paid or not. Interest
expenses are charged against profit though it is an outcome of financing decision.
Several non-cash expenses like depreciation are also charged against profit. On the
other hand, cash flow statement is prepared on the principle of cash accounting
concept. It is simply a summary of cash book classified under three major headings
namely cash flow from operating, investing and financing activities.
In a broad context, the cash flow from operating activities culls out all Profit and
Loss Account entries of the cash book (like sales, material, wages, etc.,) and summarise
the same. The cash flow from investing activities summarises all the entries affecting
asset side of balance sheet like purchase of fixed assets, sale of fixed assets, etc., of
cash book. Finally, the cash flow from financing activities summarises all the liability
side entries like borrowing, repayment, fresh equity, etc. of cash book. Exhibit 4.2
shows the Cash Flow Statement of a company,, which summarises the cash book
entries under different headings, which are easily readable.
20
There is a limit for the cash flow statement in examining reported profit. Suppose the
company processed a material by using a vendor and consumed the same in manufacturing. The
vendor sends the bill but the accounts department fails to record this as expense and has also not
paid the cash. Both profit and cash flow from operations will be overstated.
90 Financial Statements and Analysis
The Profit and Loss account is also equally readable but the problem is that it may
be confusing too. For example, many companies as a part of expenditure, put an
additional entry titled "changes in stocks" or "increase/decrease in stocks" and
sometime add and sometime deduct the value from sales. Many non-accounting readers
will get confused and give up further reading. After couple of major accounting scams,
non-accounting readers would tend to see every reported profit as contaminated figure.
Many readers are not aware of the meaning of depreciation and also "Balance in Profit
and Loss Account Brought Forward". Starting from the year 2001-02, the P&L
account has one more confusion for ordinary readers namely "Deferred Tax". To add
further confusion, in the Balance Sheet, it has both Deferred Tax Asset and Deferred
Tax Liability. The mismatch between the depreciation value and deferred tax value
shown in P&L account and Balance Sheet is further confusion to naive readers. As an
accounting person, one may be familiar with all the jargons learnt by heart by practice,
but it could really be a puzzle for naive readers. They might give up further reading
after a couple of pages.
These two methods differ mainly on the methodology used for computing the cash
from operating activities. It may be noted that AS-3, IAS-7 and also FASB Statement
Chapter 4 Statement of Cash Flows 93
No. 95 all recommend presentation of the direct method in the primary statement
though firms are allowed to use either of the methods. However, companies normally
provide the statement in indirect format. While direct method logically summarises
cash flow movement under broad operating heads, indirect method works backward
from Net profit and remove all non-cash income and expenses to get cash from
operating activities.
confusing and hence requires some discussion. In preparing the cash flow from
operating activities, the company is working backward from accrual profit figure to
cash flow from operation. Cash flow from operations is arrived after making three
types of adjustments.
It first removes all non-cash income and expenditure that was included in the profit
figure. Depreciation being a non-cash expense should not be reduced from the profit.
Since Profit and loss account has already reduced the depreciation, now in preparing
operating cash flow, it is added back.
It also removes income and expenses (cash or non-cash) not related to operating
activities. Interest income, dividend income, interest expense, prior period adjustments
and extra-ordinary item are cash and non-cash items not related to operations. Interest
and dividend income are part of other income and hence increased the profit value.
Now they are deducted to get operating cash flow. Prior period adjustments and extra-
ordinary items are earlier deducted in computing profit based on certain accounting
principles but they have no cash impact during the current year and hence they are
added back. In other words, these figures take exactly opposite sign now compared to
the sign used earlier in computing profit under P&L account.
It finally adjusts changes in receivables, payables and inventory, which are result of
operating activities and have an impact on cash flow from operation. This is slightly
complex to understand. Let us take a simple example. Suppose a firm has an opening
inventory of Rs. 1000. During the current period it has not made any fresh purchase but
sold half of the opening inventory for Rs. 550. The closing inventory at the end of the
period is Rs. 500 (since half of Rs. 1000 is sold). Assume there is no other expenditure
during the period. The Profit and Loss account will show Rs. 50 has profit. Our
common sense suggests that the cash flow from operation is Rs. 550. This Rs. 550 can
be derived by adding profit (Rs. 50) with changes in inventory (Rs. 1000-500). Let us
take another situation.
The firm has receivables of Rs. 5000. During this period, the company has not
done any operations but collected Rs. 3000. The profit and loss account will show a
zero profit but we know the firm got Rs. 3000 through operations. The operating cash
flow now is profit (zero) plus changes in receivables. The same logic applies for
payables. Exhibit 4.5 lists the adjustment generally made in deriving operating cash
flow under indirect method.
Chapter 4 Statement of Cash Flows 95
Exhibit 4.5 Cash flow from operating activities - Indirect Method '
Net Income before extraordinary items
I Non-cash revenue and expenses included in income
Eg. + Depreciation
+ Deferred Revenue Expenditure written off during the period
+ Increase in Deferred Tax Liability
- Decrease in Deferred Tax Liability
+ Increase in Deferred Revenue
- Decrease in Deferred Revenue
II Non-operating revenue and expenses included in income
(Cash as well as non-cash income and expenses)
Eg. + Interest Expense
- Interest Income
- Dividend Income
- Gain on sale of assets
+ Loss on sale of assets.
III Cash Provided (used) by current assets and liabilities
Eg. + Decrease in current assets items (excluding cash)
- Increase in current assets (excluding cash)
- Increase in current liabilities
+ Decrease in current liabilities
Net Cash from Operating activities
Preparing cash flow from operating activities under direct method is relatively
simple if one has access to cash book. It is also possible to prepare the same using the
Balance Sheet and Profit and Loss account values. Refer Exhibit 4.2, where the format
for direct method is shown. The first line item is Cash receipt from customers. This can
be derived if we have the details of sales, receivable at the beginning of the year and
receivables at the end of the year. These values are available in P&L account and
Balance Sheet.
Sales and operating income of Asian Paints (India) Ltd. for the year ending March
31, 2008 was Rs. 3478.74 Cr. Sundry debtors value for the previous year ended (March
31, 2007) was Rs. 420.61 Cr. and at the end of March 31, 2008 was Rs. 460.33 Cr. Let
us assume all sales are initially credit basis and if so, the debtors should have increased
from Rs. 420.61 Cr. to Rs. 3899.35 Cr. Since the debtors' value as on March 31, 2008
is only Rs. 460.33 Cr., it means Rs. 3439.32 Cr. (Rs. 3899.35 - Rs. 460.33) should have
been collected from the debtors21. Similarly, it is possible to trace the cash part of
several operating income and expenses. It might be confusing to some of the readers
21
It is not so simple often. Even in this case, the schedule shows that the sale value includes
inter-division sales. There are several ways thorough which the accounting of inter-division
sales is done. It is always simple and straightforward if direct method of cash flow statement is
prepared using cash book.
96 Financial Statements and Analysis
but understanding the logic is adequate to develop some confidence on these numbers
and statements and will be useful when you start using these statements for decision
making. Exhibit 4.6 lists the computation mechanism to find out the cash flows on
several line items that goes into direct method preparation of cash flow statement.
Exhibit 4.6 Cash flow from operating activities - Direct Method '
Cash Flow Item Methodology
Cash collection from Sales
customers - Increase in accounts receivables
+ Decrease in accounts receivables
Cash Paid to suppliers Cost of Goods Sold
- Decrease in Inventory
+ Increase in Inventory
Cash Paid to Employees Salary Expenses
- Increase in accrued/outstanding salaries payable*
+ Decrease in accrued/outstanding salaries payable
Cash Paid for Other Other operating expenses
operating expenses - Depreciation and other non-cash expenses
- Decrease in prepaid expenses
- Increase in outstanding operating expenses
+ Increase in prepaid expenses
+ Decrease in outstanding operating expenses
Cash paid/received for Net Interest Expenses (expense-income)
interest - Increase in outstanding interest
+ Decrease in outstanding interest
- Increase in interest receivable
+ Decrease in interest receivable
Cash from dividend or Dividend or Other Income
other sources + Decrease in other income receivable
- Increase in other income receivable
Cash Paid for Taxes Tax Expense
- Increase in deferred tax liability
+ Decrease in deferred tax liability
- Decrease in deferred tax asset
+ Increase in deferred tax asset
- Increase in taxes payable
+ Decrease in taxes payable
- Decrease in prepaid taxes
+ Increase in prepaid taxes.
Note: * Some of these items may not be available readily in the Balance sheet and often
clubbed with other items.
If the purpose of cash flow is to give the details of cash movement during the
period, preparing cash flow statement through indirect method defeats the purpose.
Chapter 4 Statement of Cash Flows 97
While the details of cash flow from investment and financing activities are easy to
understand under both methods, details provided under cash flow from operating
activities fail to add any value to the readers22. On the other hand, the details or break-
up provided on cash flow from operating activities under direct method add some value
to the readers. Clause 19 of Accounting Standard 3 states, "the direct method provides
information which may be useful in estimating future cash flows and which is not
available under the indirect method and is, therefore, considered more appropriate
than the indirect method". Accounting Standards also require those who provide cash
flow statement under direct method to provide a reconciliation statement to explain the
difference between accounting profit and cash flow from operating activities. While
many accounting bodies entrusted with standard setting encourage the companies to
use direct format, countries like Australia and New Zealand requires the companies to
provide direct method of cash flow statement. Exhibit 4.7 shows cash flow statement of
an Australian company under direct method
Exhibit 4.7 Cash Flow Statement for the year ended 30 September 2003 .
Orica Limited.
($ in Millions)
Consolidated
2003 2002
Cash from operating activities
Receipt from customers 4471.60 4482.90
Payment to suppliers and employees (3877.50) (4084.70)
Interest received 8.90 9.10
Borrowing costs (72.10) (75.40)
Dividend received 8.40 15.60
Royalty and other trading revenue received 23.70 42.70
Net income taxes paid (62.60) (47.50)
Net Cash from operating activities 500.40 342.70
Cash flows from investing activities
Payment for property, plant and equipment (119.70) (100.20)
Payments for purchase of investments (0.10) (1.30)
Payments for purchase of businesses and controlled entities (415.70) -
Proceeds from sale of property, plant and equipment 76.10 84.90
Proceeds from sale of investments 1.00 0.30
Proceeds from share buy-back by subsidiaries - -
Proceeds for purchase of businesses and controlled entities 73.00 28.30
Net cash flow (used in)/from investing activities (385.40) 12.00
Cash flow from financing activities
22
Companies could give simply cash flow from operating activities without any details since
such details under indirect method confuse naïve readers and fail to add value to informed
readers.
98 Financial Statements and Analysis
23
Cash flows from interest and dividends received and paid should each be disclosed separately.
Cash flows arising from interest paid and interest and dividends received in the case of a
financial enterprise should be classified as cash flows arising from operating activities. In the
case of other enterprises, cash flows arising from interest paid should be classified as cash flows
from financing activities while interest and dividends received should be classified as cash
flows from investing activities. Dividends paid should be classified as cash flows from
financing activities - Clause 30 of AS 3.
100 Financial Statements and Analysis
The company has repaid some part of long-term and short-term loans during the
year. The schedule on Loan Funds shows that substantial part of long-term borrowings
is interest-free loan under Sales Tax Deferment Schemes of various state governments.
Dividend outflow is the major expenditure for the company under this head. The
company is distributing about one-third of its cash flow from operations towards
dividend during the last two years.
Exhibit 4.11: Comparison of Accounting Profit and Cash Flow from Operations
(Rupees in Crores)
Mar Mar Mar Mar Mar Mar
08 07 06 05 04 03
PBDIT less Tax 384.35 288.03 207.52 194.57 178.17 188.76
Cash Flow from Operating
Activities 457.29 312.25 218.69 156.45 243.43 191.25
The figures in Exhibit 4.11 are comparable except for March 2005 where there is
an increase in PBDIT less Tax whereas cash flow from operating activities has gone
down. A further analysis shows that the inventory level has gone up significantly
during 2005 compared to 2004 figures. It is quiet possible that the company would
have made wrong forecast of sales and produced more than potential sales. The
inventory levels had gone up from Rs. 211 cr. In 2003-04 to Rs. 330 cr. in 2004-05 (an
increase of Rs. 119 cr.) against an increase in sales of Rs. 1798 cr. to Rs. 2048 cr. In
other words, inventory as a percentage of net sales had increased from 11.76% to
16.14% in 2004-05.
Lenders and suppliers would be interested to examine whether the firm is liquid
and where from the firm generated cash to pay their liabilities. For instance, if a firm
repaid a part of institutional loan by raising fresh loan or equity, institutions will be
naturally worried whether they will continue to get subsequent instalments since there
is a fair chance that the company may not be able to repeat this process year after year.
They would be interested whether the firm's cash flow from operation is adequate to
meet their liabilities. It is not that the firms should not borrow money subsequently, but
such borrowings should be for creation for fresh assets.
Employees are also equally interested whether the firm's cash flow from operation
is adequate so that they will get their salary and other benefits on time24. Managers are
also interested on cash flow from operations value since it is the source of strength for
them to take up challenging tasks in the competitive market. Cash gives strength to
organisation and cash rich doesn't mean the cash is kept idle. Such cash are eventually
used for other activities. Today, many companies talk of financial flexibility as one of
24
If you are in government service and if you are able to prepare such statements for
government, you will be really worried how the government would be meet such liabilities in
the future. Many State Governments and local bodies often fail to pay salary on time.
104 Financial Statements and Analysis
the desired goal, as in a competitive environment, the firm needs to survive and exploit
fresh opportunities with its own capital (See Exhibit 4.12). A cash starved company
will not only miss such opportunities but also create internal uncertainty for survival.
While many key employees will quit, suppliers stop supplying goods and customers
hesitate to deal with such companies, the life turns miserable for such organisations.
4.11 SUMMARY
Cash Flow Statement and cash flow analysis have assumed importance particularly
when many companies have started adopting creative accounting and earnings
management. Realising the needs of naïve users as well as others, regulating agencies
have made reporting of cash flow statements mandatory. Cash flow statement is easy
to understand and to an extent difficult to fudge. It provides three important pieces of
information on cash flow movements of the firm - how much cash is generated through
operation, financing and how much cash is spent for investment? It gives a clear and
real picture about the internal activities of the firm.
There are two methods of preparation of cash flow statements, namely direct and
indirect method. While direct method gives more details on cash flow from operating
activities and also reader-friendly, indirect method is more accounting oriented and
fails to provide any additional information. Unfortunately, many companies use
indirect method though the accounting standards allow both methods. This indirectly
shows the eagerness of management to withhold information unless it is required by the
regulation. Fortunately, the final figure is adequate to get good insight though
additional information will always be useful.
Cash flow analysis is typically done by comparing the changes in cash flow from
operating activities from period to period with the changes in profit levels of the firm.
Such comparison is useful to understand the quality of reported profit. Also, the cash
flow from operating activities is used to compare whether they are sufficient to meet
the liabilities of lenders and also contribute for further investments. Cash Flow
Statement of Asian Paints (India) Ltd. shows that the company is generating adequate
cash from operations to meet investment requirement and also meet the interest and
repayment liability on loan. Its accrual based reported profit is consistent with cash
flow from operations.
Exhibit 4.12: Excerpt from 2001-02 Annual Report of Infosys Ltd. (pages. 8-9)
“……A key element of a strategy for survival and even rejuvenation in a downturn is a flexible
financial framework within which a company operates. In bad times, a company needs to cut its
costs, protect its revenues, and also have a cushion to fall back on to weather the vicissitudes of
the downturn. Indeed, the most flexible and nimble players may gain a competitive edge over
their less agile rivals in such times.
Although these factors are not all completely within the control of a company, corporate
managers enjoy considerable latitude in structuring their business to maximize financial
flexibility on each of these fronts.
How do these factors contribute to the financial flexibility of a corporation, and how can
managers improve their performance on each of these dimensions?
Low operating leverage. If this ratio is high, the fixed payout burden is relatively large, and the
corporation will face a greater adverse impact in the event of a downturn. To illustrate the
importance of this factor, consider the steel industry, which has a high fixed cost component due
to large capital requirements. In the current recession, most steel makers are getting hurt not
only because their revenues do not cover their costs, but also due to their limited ability to
reduce these fixed costs. In contrast, POSCO of Korea reduced its operating leverage by sub-
contracting part of its manufacturing, and building on substantial economies of scale in its key
operations. It continues to be profitable, and has even increased its earnings in the current
recession.
Low financial leverage. The higher the financial leverage, the greater is the fixed burden of
servicing the debt. A corporation that is already burdened by the stresses of reduction in
revenues is affected even more adversely, because of the need to meet the pre-committed debt
payments of interest and principal. A combination of high
operating and financial leverage makes it a “double-whammy.” This is what has badly affected
most large companies in the global telecommunications sector such as France Telecom and
Deutsche Telekom. Global Crossings is an extreme version of this problem, and had filed for
bankruptcy earlier this year. In contrast, Hutchison Whampoa, the Hong Kong conglomerate
with extensive telecommunications holdings, is using its low leverage to pick up
technologically-valuable assets at bargain-basement prices.
High liquidity. Companies that carefully husband their cash resources – in essence create
negative financial leverage – have a much better safety net to face a downturn. The networking
106 Financial Statements and Analysis
giant, Cisco Systems, is feeling the pinch of the recession like every other technology company,
but with over US$20 billion in cash and marketable securities, it is well equipped to last out a
prolonged recession. It may even be able to buy assets and companies at attractive prices.
Hence, high liquidity combined with low financial leverage becomes an important strategic tool
when times are hard.
High operating margin. While the first three factors affect the cost side of the equation, this
fourth feature deals with the cushion between the revenues and the costs. An example of high
operating margins is the Indian IT services industry, which has demonstrated its financial
flexibility in the current recession. The best companies in this industry have been relatively
better equipped to weather the storm because they can face the dip in revenue growth without
digging too deeply into their cash reserves.
High agility in augmenting revenues. When business conditions are adverse, there is
tremendous pressure to maintain and even augment revenues. This involves all the tools of
marketing, including aggressive pricing, brand loyalty augmentation, and customer relationship
management. Wal-Mart Stores, the giant retailer, has managed to grow by double-digit
percentages through a combination of these strategies, even in the current period.
Total transparency in financial transactions. When times are good – as they were during the
dot-com boom only three years ago – very few questions are raised about the financial practices
of corporations. In downturns, the capital market becomes much more demanding, and it
becomes more difficult for companies to raise external finance. Firms that adhere to the best
practices of corporate governance and follow transparent processes in all their financial dealings
are more likely to be able to raise capital, should they need it, in a down market. This factor is
very much at work even in the ability of countries to raise external finance: witness the
problems faced by Argentina, and the downgrading of Japan, an erstwhile strong economy.
Recent accounting scandals in the United States and elsewhere, involving companies such as
Enron, highlight the importance of this factor. And, it could be argued that even companies that
have a viable long-term model may be dragged into default and even bankruptcy, because their
financial dealings are under a cloud. Berkshire Hathaway, on the other hand, enjoys a
substantial premium over the value of its portfolio holdings, in large part, due to the “clean”
reputation it enjoys under Warren Buffet.
How can a corporation improve its performance in each of these dimensions and hence its
financial flexibility?
While there are constraints imposed by technology and the market in certain industries, most
firms can still undertake actions to improve their flexibility. For example, a company can reduce
its operating leverage by outsourcing services where it has little or no competitive advantage. It
can improve its operating margin by moving to lower cost locations, as the apparel industry has
done successfully in the past decade. Firms in industries with intrinsically high operating
leverage can use debt more judiciously, so as not to exacerbate the overall fixed commitments
they make. Lastly, all firms can improve their performance by being more transparent in their
financial transactions – so that investors respond favorably when they need to tap the capital
market.
---- Marti G. Subrahmanyam
Independent Director”
CHAPTER 5 Analysis of Financial Statements 107
Chapter 5
Analysis of Financial
Statements
5.1 INTRODUCTION
Organisations have a purpose and it is generally stated in the mission or vision
statement. To achieve the purpose, organisations need finance, which is raised from the
capital market through debt or equity. Finance or capital is raised either directly from
the investors or through intermediary institutions like banks. Once capital is raised, the
capital is invested in assets, which can be broadly classified into fixed and current
assets. Several factors determine the choice of assets and proportion of investments in
different types of assets. A trading company or service company may not invest much
on fixed assets whereas manufacturing company like automobile company would
invest large amount in fixed assets. Some manufacturing industries may require more
working capital, if the materials used by them are available only in certain seasons.
After raising capital and acquiring assets, the business unit runs the operations and
generates revenue. Since most business units are started with an objective of making
profit, many of them report profit. Accounting statements typically reflect the above
activities and allow the managers to examine whether their plan or strategy has resulted
in positive impact on the company.
Balance Sheet, Profit and Loss Account and Cash Flow Statements are three
principal financial statements and they reflect the above activities. Balance Sheet
explains where from the organisation has raised money and where they have invested
108 Financial Statements and Analysis
the money. Profit and Loss Account explains how efficiently the assets of the
organisation have been used and what has been the net outcome of the operations. Cash
Flow Statement shows operational outcome, capital raised and invested but all in terms
of cash. While the principal financial statements provide wealth of information to
investors and others, there is no ready answer to a question whether the organisation
has achieved the goal or mission. Financial Statements are analysed further to get such
an insight on the performance of the organisation and various parts or divisions of the
organisation.
In the last three chapters, principal financial statements namely balance sheet,
profit and loss account and statement of cash flows are discussed. While explaining
various items of these statements, we also analysed them briefly but our analyses were
restricted to items within the statements. In this chapter we analyse financial statements
together to understand long-term and short-term financial health of the firm25. Financial
analysis today is performed by various users of financial statements. Investors and
management perform the financial analysis to understand how productive the assets
were in generating profit during the period. Lenders and suppliers of goods will look
for ability of the firm in repaying the dues on time. Financial managers not only
prepare financial statements but also analyse the same to get further insight on the
performance of the organisation. They need to examine the organisation from the
perspective of several users so that they can fulfil the needs of many of them.
While financial analysis is often used for evaluating current or historical
performance, management uses the input of such analysis for planning exercise. In
preparing budgets, the inputs of financial analysis are extensively used. Financial
analysis provides linkage between operating activities and funding activities. Normally,
top management sets the goal and operational managers then determine the level of
operations required in achieving the goal. It would be difficult to increase the level of
operations without any investments unless there is a huge idle capacity. Thus increased
activity demands more addition to assets and this in turn increase the demand for
capital. The first step in this process is to know how much of additional assets we need
and how much of capital we need to mobilise from various sources. Financial analysis,
which provides historical linkage between various financial components, is useful.
Suppose the top management fixes a goal to increase the net income by another 20%
for the coming year. Using profit to sales linkage, managers can estimate additional
turnover required in achieving the goal. Once additional turnover is estimated, it is
possible to assess the investment requirement for additional assets (fixed and current
assets in the case of manufacturing companies) and then additional funds required to
buy such assets. Thus financial analysis is prerequisite for financial planning.
25
Some of the discussions of this chapter are understood better if the readers have gone through
the earlier four chapters.
CHAPTER 5 Analysis of Financial Statements 109
5.2 TECHNIQUES OF FINANCIAL ANALYSIS
Financial statements are analyzed to answer several questions and different techniques
are followed for analysing financial statements. Some of the usual questions are:
(a) How my company is comparable with others in the industry in terms of overall
business?
(b) How my company is growing over the years?
(c) How is the overall financial health of my company? What are the strong and weak
areas of performance?
(d) Compared to industry or bench marked company, how is the performance of my
company?
(e) Is the company pursuing the financial performance and policies consistent with the
strategy?
Analysts use several techniques to answer such questions. The details available in
financial statements are converted into certain formats to facilitate such analysis. The
most popular and often used techniques include preparing common size financial
statements, statement showing growth of financial variables over the years, ratio
analysis and inter-firm comparison.
the debt level will approach to zero in next few years once the company retires the
sales tax deferment loan of Rs. 64 crores. The financial risk of the company in that
process is considerably reduced and also, the company's debt capacity is very high
compared to other firms in the industry. Is this financial policy consistent with
company's current strategy of pursuing the growth through acquisition? It is quiet
possible that the company believes in acquisition through cash deals and low debt will
allow the company to tap the resources at any time. Further, if the acquired firm is a
sick firm and comes with some debt level, it is desirable to have low debt so that
servicing of debt of sick firm in addition to bearing the cash loss of sick firm during
initial period is feasible with low debt. In other words, it would be difficult for a highly
levered firm to buy another sick and levered firm and bear the cash loss of the sick firm
as well as servicing the debt of the sick firm.
Exhibit 5.1(a) .
Asian Paints (India) Ltd.
COMMON SIZE BALANCE SHEET
As at As at
31.03.2008 31.03.2007
FUNDS EMPLOYED
Shareholders’ Funds 88.03 83.43
Loan Funds 8.98 14.09
Deferred Tax Liability (Net) 2.99 2.48
Total 100.00% 100.00%
APPLICATION OF FUND
Fixed Assets 51.12 38.85
Investments 40.09 37.49
Current Assets, Loans and Advances 99.00 96.34
Less: Current Liabilities and Provisions (90.22) (72.68)
Net Current Assets 8.78 23.66
Total 100.00% 100.00%
There are major changes on the composition of assets. Net investment in fixed
assets has increased significantly mainly on account of purchase of freehold land (Rs.
80.16 cr.) and plant and machinery (Rs. 44.78 cr.). Investments have gone up
marginally on account of increased surplus cash available for treasury activities. The
level of current assets has gone up marginally but current liabilities have gone up
significantly leading to significant drop in the net current assets. In absolute value, the
net current assets has dropped from Rs. 210.98 Cr. to Rs. 92.62 Cr. With increased
brand image and third party sourcing, it is possible for the company to achieve negative
working capital in the near future.
Common size profit and loss account shows composition of income and
expenditure over the two years period or between firms. Analysis of common size
profit and loss account of Asian (Paints) India Ltd.(Exhibit 5.1 (b)) shows no major
CHAPTER 5 Analysis of Financial Statements 111
change in the composition of income. On the expenditure side, material cost has gone
down but there is a marginal increase in other cost elements. The management of the
company observes in the Management Discussion and Analysis that “…prices of raw
materials had increased sharply in second and third quarter of the previous year 2006-
07. In the year under review, prices of raw materials were soft compared to the
previous year especially during first half. This was largely due to strong Rupee and
good supply situation which negated the impact of rising crude oil prices in the
international market. Accordingly, your company benefited considerably”
Material constitutes an important cost item and a decline in the cost has a positive
impact on the profitability of the firm. Since all other cost items by and large remained
at the same level, the decline in raw material cost has positively contributed on profit
margin from 9.43% to 10.83% for the year ending March 31, 2008.
Total Liabilities 196 167 137 127 115 111 100 122 102 100
Gross Block 228 196 179 174 159 154 145 133 114 100
Less: Accumulated
Depreciation 404 371 339 306 267 229 184 148 121 100
Net Block 159 128 116 121 116 124 130 127 111 100
CHAPTER 5 Analysis of Financial Statements 113
Investments 849 672 552 519 487 297 127 89 81 100
Inventories 335 270 217 206 131 129 97 124 116 100
Sundry Debtors 315 295 232 186 173 147 149 152 108 100
Cash and Bank 185 190 127 115 110 122 99 53 85 100
Loans and Advances 305 211 174 132 125 116 114 180 149 100
Total Current Assets 314 258 206 179 139 130 113 138 119 100
Current Liabilities 586 399 333 298 245 190 152 150 147 100
Total Assets 196 167 137 127 115 111 100 122 102 100
The year 1999 has been used as the base year for computing the percentages. The
company was following the capital structure policy of fifty per cent equity and fifty per
cent debt till 2001 but then moving towards zero debt policy. How Asian Paint has
achieved such a major reduction in debt? It could be due to issue of fresh equity shares
or changes in dividend policy or changes on the assets side of balance sheet like selling
out some of the divisions. In this 10-year period, the company has not issued any fresh
equity (except bonus shares). There is no major change in the dividend policy and the
company on average pays out is about 40 per cent of profit after tax as dividend. One
possible explanation could be major decline in net current assets, which has come
down from 100 to 54 during this period. A decline in current assets releases capital
invested in current assets, which in turn can be used for repaying debt.
In Asian Paint (India) Ltd., all components of current assets have gone up over the
years. An analysis of current liabilities shows a major increase and it has grown about 9
times during this period particularly since 2002. In other words, while the company is
moving towards zero debt, it has also increased considerable credit from the suppliers.
If the justification for reducing the debt is high cost attached with such debts, then one
has to examine implicit cost attached with current liabilities26. The trend analysis of
balance sheet also reveals a slow down in investment in fixed assets during the last
three years but at the same time an increase in investments during the same period.
Exhibit 5.2(b) compares major items of profit and loss account over the years.
Though the growth rate of income is not uniform, it is moving upward over the years
and increased nearly 3 times. There is not even a single year in which the income has
shown a negative growth. In this restricted context, the business risk is not very high
for the company. Barring selling and expenditure, all cost items are showing growth
rate of less than or equal to income growth. Surprisingly, the profit is growing are at
26
It is possible to argue that there is no cost attached with suppliers' credit or liabilities. It need
not always be true since supplier would expect compensation for giving credit period or facility.
Borrowing through suppliers makes sense if the interest rates are distorted between different
segments of the economy. Suppose, interest rate for SSI is lower compared to large industries,
one can arbitrage such differential interest rates.
114 Financial Statements and Analysis
higher rate than the sales. The reason for profit growth is declining trend in excise duty
whose growth rate is significantly lower than income growth. The sales has gone up by
three and half times over the years but the exercise duty has gone up only by three
times during the same period. The interest expenditure has also come down over the
years. An interesting observation is significant increase in selling and administration
expenses. With increased competition, the investment in advertisement and other
promotional expenses have gone up significantly to protect and nurture the brand. The
company was spending Rs. 26.75 Cr. towards advertisement in 1998-99. In 2007-08,
expenditure on account of advertisement was Rs. 164.85 Cr. Analysts would like to
check how other companies are managing the cost and revenue to get more insight on
competitive advantage of Asian Paints in the industry.
Exhibit 5.2(b) '
Asian Paints (India) Ltd.
PROFIT AND LOSS ACCOUNT TREND ANALYSIS
Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar
08 07 06 05 04 03 02 01 00 99
Sales Turnover 362 300 248 209 182 167 147 135 119 100
Excise Duty 308 271 223 195 159 146 123 118 108 100
Net Sales 371 305 253 212 186 171 151 138 121 100
Other Income 284 193 163 143 98 57 67 42 62 100
Total Income 372 309 250 217 184 171 145 137 121 100
EXPENDITURE
Raw Materials 367 318 249 219 176 163 133 131 120 100
Power & Fuel Cost 197 182 151 141 127 128 135 123 114 100
Employee Cost 362 296 258 237 204 216 188 148 118 100
Other Mfg Expenses 255 217 240 207 170 154 132 123 112 100
Selling & Admin Exp 522 418 285 235 219 190 172 157 129 100
Miscellaneous Exp 126 104 203 123 135 96 119 147 109 100
Total Expenditure 362 307 251 216 182 167 142 135 119 100
Operating Profit 425 321 245 223 197 196 163 144 131 100
Interest 60 53 37 29 39 56 65 99 91 100
Gross Profit 490 369 283 258 226 221 181 152 138 100
Depreciation 189 196 201 210 212 214 184 139 123 100
Profit Before Tax 558 408 301 268 229 223 180 155 142 100
Tax 719 575 475 412 367 352 249 206 191 100
Reported Net Profit 488 354 243 226 192 186 150 138 127 100
CHAPTER 5 Analysis of Financial Statements 115
5.5 RATIO ANALYSIS
In common size and trend analysis, financial statements are examined independently.
Financial statements provide additional insight if the analysts link these financial
statements and such linking is achieved through ratio analysis. Ratios are aimed to
assess profitability, productivity of assets or capital and risk associated with operations.
Though one can get some basic idea about the company while evaluating common size
statement and trend analysis, the level of comparison is however restricted. Ratio
analysis integrates financial statements to assess financial health of the firm. Some of
the important ratios are discussed below. Exhibit 5.3 and 5.4 presents Balance Sheet
and Profit and Loss Account of Asian Paints (India) Ltd.
Exhibit 5.3
BALANCE SHEET as at 31st March 2008
of Asian Paints (India) Ltd.
(Rs. in Crores)
As at As at
Schedules
31.03.2008 31.03.2007
FUNDS EMPLOYED
Shareholders’ Funds
Share Capital A 95.92 95.92
Reserves and Surplus B 832.58 648.16
928.50 744.08
Loan Funds C
Secured Loans 36.70 66.90
Unsecured Loans 58.00 58.77
94.70 125.67
Deferred tax liability - (Note B - 21 in Schedule M) 31.52 22.15
Total 1054.72 891.90
APPLICATION OF FUND
Fixed Assets D
Gross Block 937.89 806.20
Less : Depreciation 509.06 471.29
Net Block 428.83 334.91
Capital Work in Progress 110.39 11.62
539.22 346.53
Investments E 422.88 334.39
Current Assets, Loans and Advances F
Interest accrued 0.09 0.03
Inventories 538.97 434.07
Sundry debtors 251.90 235.96
Cash and Bank Balances 41.35 42.49
Other receivables 33.09 31.23
Loans and Advances 178.82 115.45
1044.22 859.23
Less: Current Liabilities and Provisions G
Current Liabilities 785.11 594.10
Provisions 166.49 54.15
951.60 648.25
Return on total assets (ROTA) of Asian Paints (India) Ltd. for the year 2007-08
was 54.31% compared 47% for the previous year. It shows that the company is
generating Rs. 54.31 for every Rs. 100 of capital invested, for the suppliers of capital
on pre-tax basis. This improvement is wiped out once we consider the suppliers' credit
in our analysis. Return on investments has marginally increased from 27% to 29%
during the year27. However, this ROI definition has inherent flaw since numerator of
the equation fails to reflect the reward for suppliers' credit. In other words, when we
add suppliers' credit as a source of capital, the reward part associated with such capital
should be added in numerator. Since the reward associated with the suppliers’ credit is
difficult to measure, it is better to use ROTA for evaluation. ROTA is generally used
for business level evaluation and can be applied for a plant or a SBU or a department.
It simply measures that the business unit or a division has taken some resources or
capital of the organization and hence measures the benefit contributed by the resource
to the organization. There is no colour for this capital (debt or equity) and hence
whatever the division or SBU generate out of this capital (without any concern on who
will be the ultimate recipient of the return – equity holder, debt holder or government)
is relevant for performance measurement. In measuring performance through ratio
analysis, there are two aspects, which are important – consistency across the years and
numerator – denominator issue.
There are four drivers for the profitability of a business organization. They are (a)
Asset Management (b) Cost Management (c) Leverage or Debt Management and (d)
Tax Management. The leverage and tax management are discussed first before taking
up asset management and cost management.
27
Here is a word of caution. It is not difficult to mislead with financial ratios by changing
definition and hence one has to be very careful in both computing the ratio and also in its
interpretation.
CHAPTER 5 Analysis of Financial Statements 119
Return on Equity or Net Worth or Shareholders' Funds28
The previous ratio (Return on Total Assets) combines all sources of capital but
shareholders would be interested to know how much of return that the company has
generated for them. This ratio is called return on equity (ROE) or return on net worth
(RONW). Here equity or net worth means equity share capital and reserves and
surplus. The definition of 'return' is profit before tax.
Return on Equity or Return on Net Worth
2007-08 2006-07
Profit before taxes 564.55 409.92
Shareholders' Fund 928.50 744.08
Return on Equity or Net Worth 60.80% 55.09%
Return on Equity is higher than return on investments on both periods. It is
important to understand the source of additional earnings. Suppose the company has no
borrowings. Then PBIT and PBT will be the same and also the sum of the debt and
equity will be equal to equity. Under such a situation, both return on total assets and
return on equity will be one and the same. The moment debt is introduced the ROE is
affected. ROE is positively affected when the company borrows money at a rate lower
than return on total assets. Under this condition, the company borrows capital, uses to
earn a higher ROTA, pays lower interest and adds the balance (or surplus) to the
shareholders. On the other hand if the ROTA is lower than interest rate, equity holders
have to bear the difference and hence the ROE is negatively affected. The difference
between ROTA and ROE can be explained as follows:
ROE - ROTA = (ROTA - Interest Rate) x (Debt/Net Worth)
The difference between ROE and ROTA is positive only when (a) ROTA is greater
than interest rate and (b) debt/net worth is positive. If one applies the above equation
for Asian Paints (India) Ltd., the results might show some inconsistent value. The
reason is deferred tax liability. In our earlier discussion, we have only two sources of
funds namely debt and equity. However, the balance sheet shows three figures namely
shareholders' funds, loan funds and deferred tax liability (net). The question is on the
treatment of deferred tax liability. One possibility is treating the liability as interest-
free loan given by the government. With this assumption, it is possible to show the
relationship between ROE and ROTA under the above equation. Before that, it is
necessary to find out the cost of debt or interest rate. There may be some problems here
too. While interest value given in profit and loss account is equal to interest for loan of
the period, loan funds shown in balance sheet is loan outstanding as on that date.
Suppose the company has repaid substantial part of the loan towards the end of the
year. It will reduce the loan outstanding but interest expense will include interest on
such loans. It might give some abnormal interest rate if one divides interest expenses
28
Equity, net worth and shareholders' fund all refers to the same thing. It is equal to equity share
capital plus Reserves and Surplus.
120 Financial Statements and Analysis
Company A Company B
Equity 300 300
Debt 200 200
Total Capital 500 500
Profit Before Tax 100 100
Tax 35 10
Profit After Tax 65 90
Return on Equity (pre-tax) 33.33% 33.33%
Return on Equity (post-tax) 21.66% 30.00%
There are several reasons for the differences in tax paid. It could be due to
differences in depreciation or inventory policies used by the two companies for
accounting and tax purpose. It is also possible due to revenue mix (tax-exempted
earning like export earning and domestic earning) or location of the plant where some
tax incentives are given. The level of distortions have come down now to a great extent
29
ROE before extraordinary items
30
When financial leverage concept is used for solvency purpose, deferred tax liability need not
be considered as debt.
CHAPTER 5 Analysis of Financial Statements 121
since companies have to show deferred tax liability separately. It is better to assess the
impact of tax planning on profitability separately instead of mixing them up with
operational efficiency.
If a company has improved its profitability due to better tax planning, it has to be
identified separately and those who have contributed to such additional profitability
have to be rewarded. The impact of tax planning on profitability can be assessed by
comparing pre-tax profitability and post-tax profitability separately. Suppose the pre-
tax return on equity of a company is 20%. If there is no tax planning and the tax rate is
35%, the post-tax return on equity should be 14% [20% x (1-35%)]. If the actual post-
tax return on equity of the company is more than 14%, then the difference is on account
of better tax planning. For instance, if the post-tax actual return on equity in the above
example is 16%, then the company is able to show additional 2% due to better tax
planning. In other words, the impact of tax planning on profitability can be defined as
follows.
Post-tax ROE - Pre-tax ROE x (1-tax rate)
31
This additional return is temporary until such time the company is in position to defer the tax.
An alternative way of assessing impact of tax planning is amount of tax not paid during the
current year (equal to deferred tax liability) multiplied cost of capital i.e. interest free funds.
122 Financial Statements and Analysis
improves the profitability by improving the profit margin. In the following pages, we
will discuss several components of Asset Management and Cost Management.
32
The company is not using capital work-in-progress and also the current liabilities and
provisions are not assets. Hence, it is possible to add up fixed assets, investments and current
assets, loans and advances and define the same as asset.
33
Wherever balance sheet values are used in computing ratios, it is possible to take average of
two period’s value and use the same instead of one-year end value. For the purpose of
simplicity, we will be using only year-end values here.
CHAPTER 5 Analysis of Financial Statements 123
Fixed Asset Turnover Ratio
2007-08 2006-07
Sales and operating income 3416.16 2821.29
Fixed Assets or Net Block 428.83 334.91
Fixed Asset Turnover Ratio 7.97 8.42
Note: Operating income is included since some fixed assets are used for generating
operating income like processing charges and lease rental.
Net Current Assets Turnover Ratio
2007-08 2006-07
Sales and operating income 3416.16 2821.29
Net Current Assets 92.62 210.98
Net Current Turnover Ratio 36.88 13.37
Investment Income to Investment
2007-08 2006-07
Interest, dividend and profit on 29.68 14.98
sale of investments
Investments 422.88 334.39
Investment income to Investments 7.02% 4.48%
Note: If average investments value is used, the percentage will be different.
The company is showing an improvement both on total assets turnover ratio, and
net current assets turnover ratio whereas fixed assets turnover ratio has declined to an
extent. An investment of Rs. 100 in total assets yielded revenue of Rs.321 in 2006-07
and the revenue increased to Rs. 330 in 2007-08. In other words, efficiency of asset
utilisation has improved in 2007-08 compared to the previous year. Analysts also
compare the ratios with other companies in the industry before judging the
performance of the company.
Investments in long-term and short-term are yielding poor return but it should be
noted that it is only a realised return. The dividend yield of many good investments is
generally low but such investments offer high capital appreciation over the years.
Investors’ in Asian Paints stocks today is likely to get a dividend of Rs. 17 per share
against an investment of Rs.1150 per share. This offers a dividend yield of 1.5% but
investors buy Asian Paints stocks mainly for capital appreciation. The capital gains
part of the income has not been recognised in computing the above return. For
example, an investment of Rs. 100 in a subsidiary company may generate a net income
of Rs. 30 but it might distribute only Rs. 5 as dividend. While the realised return is only
5% in this case, the unrealised return is 25%. Using information available in
Consolidated Profit and Loss Account, Investments Schedule and current market prices
of quoted investments, it is possible to evaluate the efficiency of the investments. The
market value of quoted investment is Rs. 254.26 Cr. against Rs.183.02 Cr. of market
value of last year (2006-07). It means during the year, the investments have
appreciated by Rs. 63 Cr. or nearly 33%. Though this figure is reasonably high, it is
lower than the company’s ROE. In addition, the company is holding Rs. 197.66 cr.
124 Financial Statements and Analysis
worth of mutual funds units (cost value) and the market value of such investments is
not available.
The net current asset consists of current assets and current liability and efficiency
analysis can be performed on each component of current assets. Such analysis is also
called 'liquidity analysis' or 'working capital cycle analysis'. Current assets are required
for running the business and there are several factors that influence the current assets.
Technology, distance, business practices and risk aversion determine the need and
amount of investment required for various current assets. Investments in current assets
consume cost and hence it is expected to bring additional benefit to justify such
investments. Following ratios are useful in this context.
Gross Current Asset Turnover Ratio
Current Assets consist of inventories, receivables or sundry debtors and cash and bank
balances34. These assets are called current assets because they are expected to be
liquidated within a year and change their form. For instance, dues from debtors as on
March 31, 2005 would be collected by March 31, 2006. Though the debtors value on
March 31, 2006 may be more than the value as on March 31, 2005, it should be noted
that such debtors are new debtors and finished goods after sales take the form of
debtors. Gross current assets turnover ratio and components of current assets turnover
ratio are used to assess the management's efficiency in using current assets.
Gross Current Assets Turnover Ratio
2007-08 2006-07
Sales and operating income 3416.16 2821.29
Current Assets (Inventory+Drs+Cash) 832.22 712.52
Current Assets Turnover Ratio 4.10 3.96
Since investments in current assets have gone up from Rs. 712.52 Crores to Rs.
832.22 Crores, it is expected to generate additional sales to justify such investments.
Since the gross current asset turnover ratio remains at 2006-07 level, it means
additional investments in current assets has brought additional sales but with the same
level of efficiency. The inverse of this ratio explains the amount required to be
invested in current assets to generate for every Re. 1 sales. In 2006-07, the company
required 25 paise for every Re. 1 sales and it has gone down marginally to 24 paise to
generate same Re. 1 sales in 2007-08.
34
Current assets, loans and advances are clubbed together and reported in the balance sheet.
Though loans and advances, interest accrued but not due, advance payment of tax, etc. which
form part of this group are also realised within one year, normally they are not part of working
capital cycle. Some analysts combine all the values to compute such ratio for the sake of
simplicity.
CHAPTER 5 Analysis of Financial Statements 125
Inventory turnover ratio has decreased from the previous year value. The inverse of
this ratio shows the investments in inventory per Rupee of cost of goods manufactured.
For every Rupee of cost of good manufactured, the company required an investment of
21 paise for inventory in 2006-07 but it has increased to 22 paise in 2007-08. It is also
possible to compute the number of days the inventory is maintained at different points
of time. This can be computed by taking a ratio of value of inventory to average daily
value of cost of goods manufactured. For computing average daily value of cost of
goods sold, the number of days in a year can be defined as total days (365 days) or
working days (300 days). An easy shortcut to compute number of days of inventory is
dividing 365 or 300 days by inventory turnover ratio. The number of days of inventory
35
This definition is also not prefect since manufacturing expenses are not directly given. For
instance, firms may consider depreciation relating to production facilities as part of
manufacturing expenses and hence allocate part of the depreciation to inventory. But this calls
for bifurcation of depreciation into production related and non-production related. For
simplicity, we exclude depreciation and arbitrarily compute manufacturing expenses from the
list of expenses given in Schedule L of the Financial Statements of Asian Paints (India) Ltd.
Please refer page number 14 of the Chapter 3 for details.
126 Financial Statements and Analysis
that the company was holding as on March 2008 was 81 days (365 divided by 4.48)
and for the previous year, it was 76 days.
Inventory turnover ratio can be further dividend into raw materials turnover ratio
and finished goods turnover ratio, the two major component of inventory in many
companies. Efficiency of managing raw materials and finished goods can be assessed
in the form of turnover ratio or amount invested to generate one Rupee of cost of good
manufactured or number of days of material or finished goods held by the company. In
the case of material related ratios, sometime raw materials consumed may be relevant
than cost of goods manufactured. It is possible to drill down these ratios further for
principal raw materials or finished good separately.
Current Ratio
Current ratio measures the amount of long funds used to procure current assets.
Suppose a firm requires total gross current assets of Rs. 1000 to run the business. A
part of it can be met through suppliers' credit and another part of it can be arranged
though short-term loans like working capital loan or commercial paper. Suppose credit
facility is available for Rs. 200 and another Rs. 200 is raised through short-term loan.
The balance amount of Rs. 600 has to come from long-term funds in the form of equity
or loan. In other words, sixty percent of current assets are funded by the long-term
funds. The same can be expressed in term of ratio called current ratio. Current ratio is
equal to current assets divided by current liabilities. Current liability in this example is
equal to supplier credit plus short-term loan.
In computing current ratio, some adjustments are required if one uses the Balance
Sheet of Indian companies. Normally, current liabilities value shown on the asset side
of the balance sheet as a reduction from the current assets, exclude short-term loans.
128 Financial Statements and Analysis
Such short-term loans are shown under ‘Loan Funds’ of Sources of Funds or Funds
Employed side of the Balance sheet. So it is necessary to find out the value of short-
term loans from the Loan Funds Schedule and add the same with sundry creditors and
current other liabilities. Another issue need to be handled is provisions. Since
provisions shown under the heading 'Current Liabilities and Provision' are expenses
and other payments to be paid within one year period, they should also be included in
computing the current ratio. The schedule on Loan Funds of the company shows that
the company has taken a short-term loan of Rs. 13.57 Cr. as on March 31, 2008 (Rs.
48.67 Cr. as on March 31, 2007). The current ratio is computed as follows.
Current Ratio
2007-08 2006-07
Current Assets 832.22 712.52
Current Liabilities & Provisions* 965.17 696.92
Current Ratio 0.86 1.02
* [Current Liabilities and Provision as per balance sheet plus Short Term Loan]
An increase in current ratio normally means increase of liquidity position.
Normally, current ratio of 2 is considered good since it means current assets are twice
that of current liabilities and hence even if there are temporary delays in collections,
still current liabilities can be met. At current ratio of 2, the company is bringing 50% of
long-term funds for acquiring current assets and only 50% is used through suppliers'
credit and short-term sources. A current ratio of 2 normally means that the firm will
honour the payments on due dates with a small delay even if 1 out of 2 customers pays
their dues. If the current ratio is 1, it is possible for the firm to meet current liability
provided current assets are realised on time. Any further delay in realisation of current
assets will affect liquidity. In the case of Asian Paints (India) Ltd. the current ratio was
not only low but gone down further in year 2008. Before concluding that the liquidity
position of Asian Paints (India) Ltd. has been deteriorated, one need to look into the
ability of the company in raising funds in short period when there is a delay in realising
current assets and also large investments that the company holding in the market. With
low debt level of both long-term and short-term in nature, it may not be difficult for the
company to get loans to meet such crisis. Also, the top management might want to
create such tight liquidity position to make sure prompt collection of dues.
Quick Ratio or Acid-test Ratio
This ratio compares liquid part of current assets with current liability to measure the
liquidity position of the company. Generally, inventories are less liquid. Hence, in
arriving at the quick ratio we need to remove the inventory from the current assets and
compare the same with current liabilities. Since some part of inventories may be more
liquid than other current assets, one has to apply judgement and identify illiquid part of
current assets in computing the ratio. Assuming the entire inventory is illiquid and all
other components of current assets are liquid for Asian Paints (India) Ltd. the quick
ratio is computed as follows.
Quick Ratio
CHAPTER 5 Analysis of Financial Statements 129
2007-08 2006-07
Current Assets - Inventory 293.25 670.03
Current Liabilities* 965.17 696.92
Quick Ratio 0.30 0.96
* [Current Liabilities and Provision as per balance sheet plus Short Term Loan]
Quick ratio has declined from 0.96 to 0.30. Normally a quick ratio of 1:1 is
accepted. The expectation is if most liquid assets of firm are equal to current liabilities,
then the firm would be in a position to meet such liabilities on time. Indian companies’
balance sheets call for one more adjustment in computing both current ratio and quick
ratio. Since investments are shown separately in the balance sheet, it is necessary to
identify investments which are liquid in nature and add the same with current assets.
Investment shown under short-term investments of the Investments Schedule can be
considered for this purpose. As on March 31, 2008, Asian Paints (India) Ltd. has Rs.
197.66 cr. investments in mutual funds and this can be added with current assets while
computing current ratio and quick ratio.
Profit margin has increased from 14.56% to 16.47%, which is a good sign. It shows the
company is successfully facing competitive pressure. The reasons for the change in
profit margin can be examined through cost ratios. Cost ratios are defined as elements
130 Financial Statements and Analysis
of cost divided by sales or cost of goods sold. Such cost ratios can be restricted to
selected major cost items or computed as many as possible using cost information
available in the Schedules of Profit and Loss account. The following are few major cost
ratios of Asian Paints (India) Ltd. expressed as a percentage of Cost of Goods Sold
(GOGS).
Cost Ratios
2007-08 2006-07
Material to COGS 68.37% 69.59%
Employee Cost to COGS 6.80% 6.58%
Manufacturing, administrative, selling 24.86% 24.38%
and distribution expenses to COGS*
Interest to COGS 0.29% 0.29%
Depreciation to COGS 1.81% 2.19%
* Since the break up of this expenditure is available, more cost ratios can be computed with the
help of Schedule L of Profit and Loss Account.
The cost ratios show a decrease in material cost and a marginal increase in other
costs.
Since loan and other fixed obligations are low, DSCR for Asian Paints (India) Ltd.
is very high. Suppose the preferred DSCR is 2 or more, then the borrowing capacity of
the company is several times of the current borrowing level.
In Exhibit 5.5, all the ratios are shown in a chart popularly called DuPont Chart.
Through DuPont chart, one can get quick insight on the health of the company,
compare the current year performance of the company with previous year and compare
the health of the company with industry average or competitor. Exhibit 5.6 summarises
the financial ratios of Asian Paints (India) Ltd. for the year 2007-08 and 2006-07 in
DuPont Chart.
A quick analysis of the Exhibit 5.6 shows that the company has shown
improvement in all areas of performance except profit margin and current assets
management. The primary reason for decline in profit margin is increase in raw
materials cost and employees cost. If the company maintained the profit margin of the
previous year (14.15%), then return on total assets would have increased marginally to
40.61%. In other words, a decline in profit margin of 0.07% has a marginal negative
impact on the overall profitability of the firm mainly on account of better asset
management by the company. Liquidity of the firm has improved compared to the
previous year but payment to suppliers takes longer period than earlier. Since the cost
of debt is significantly lower than return on total assets, leverage contributed positively
to the shareholders' return. However, the impact is not high since leverage is very low.
Impact of tax planning has no impact on profitability. Declining trend in deferred tax
indicates that the company has started paying of the tax deferred earlier. Unless growth
is restored, it will have an impact on future cash flows.
5.13 SUMMARY
Financial statement analysis completes our journey on understanding financial
statements. But yes, the interpretation and analysis of the statements begin. While
financial statements provide wealth of information to users reflecting various activities
of the organisations, financial statements integrates them and assess whether the
business has achieved the goal of maximising the wealth of the shareholders. Financial
statements are analysed in several ways depending on the objective of such analysis.
Common size analysis, trend analysis and financial ratio analysis are three important
methods. The analysis of financial statements consists of a mixture of steps that
interrelate and affect each other. It would lead to wrong conclusion and strategy if the
analysis were done on piecemeal basis. For instance, higher turnover ratio doesn't mean
good for the company since the company might aggressively be selling by cutting
down the price. Such aggressive selling could influence the collection or increase the
bad debts. An integrated analysis would be useful in this context.
The goal of wealth maximisation is achieved when the firm increases ROE without
increasing the financial and business risk. At the firm level, managers need to
maximise the return on total assets (ROTA). This profitability measure driven two
drivers namely, asset management and cost management. Asset management refers to
the ability of the firm to generate maximum revenue for a given level of assets. Cost or
profit management refers to ability of the firm in controlling the cost or maximising
profit margin. There are two possible strategies that firms can follow to improve cost
minimisation or profit maximisation.
Cost leadership requires the company to spend their efforts to reduce the cost and
then set competitive price to acquire larger volume or market share. Product
differentiation strategy would require the firm to move upward on value chain and get
premium price and profit. Companies generally pursue both strategies and develop
products for different segments. For instance, Asian Paints (India) Ltd., the company
we have analysed in this book, has developed a range of products and services over the
years to serve the needs of different segments of market. Managers, who have access to
134 Financial Statements and Analysis
more information, can measure profitability for each product or brand or division or
plant or region. The primary purpose of accounting and accounting information system
should enable the managers to get such details We conclude our book with one of the
most powerful statements that we have come across on this aspect.
Over the long-term, it is absolutely essential to be a lower cost supplier. To stay
competitive, inflation-adjusted cost of producing and supplying any product or
service must continuously trend downward. The true cost and profit picture for
each product/market segment, and for all key customers must always be known.
B. Charles Ames and James D. Hlavacek
Harvard Business Review, Jan-Feb, 1990
Exhibit 5.5: DuPont Chart - Financial Statement Analysis
Impact of Tax Planning Return on Equity* Impact of Tax Planning
Deferred Tax/Total Funds PAT / Net Worth Deferred Tax/Total Funds