Understanding Financial

Statements

Dr. M.V.S. Kameshwar Rao

Associate Professor, XIMR, Mumbai
The Flow of Presentation
• The Genesis of Finance & Accounting
• Increasing scale and scope of economic exchanges
• The Finance Sense
• The Wealth and Cash Thinking
• Presenting Financial Well-Being of Individuals
• The W I L E S C Framework
• Presenting Financial Well-Being of Business Entities
• Statements of Scale, Model, Leverage, Performance, and Cashflows
• The Double Entry System
• The Philosophy of Insightful Accounting
 The Genesis of
Finance &
Accounting
Increasing Scale and Scope of Economic Exchanges
Fear of Survival &
Welfare of Family
Survival is at the core of any Life
Same for Humans

Humans added another aspect;

Ensuring a Safe
and
Comfortable Future of Family

May be out of
Love, Perhaps!
Resourceful
Activities
Hunting

Growing

Storing

Known to humans for ages

Generating - Preserving
- Growing
Exchanging Resources
for Mutual Benefit

Every one can’t have everything

Exchanging resources
could satisfy
mutual wants;
and it made sense

Birth of Enterprising Spirit

 Recording Resource
Exchanges
Human Mind couldn’t register volumes of
exchanges

Mighty & Wealthy wanted to keep track of

exchanges

The Kings and Ministers wanted to be fair in

their judgements

Birth of Record Keeping and Accounting

Top: Accounting Tokens in 3300 BC in Sumerian Uruk period

Bottom: A cuneiform tablet depicting “A Contract of Sale of field and a House
2600 BC, Sumerian Culture
The Finance Sense
The Wealth and Cash Thinking
Jargon First!
• Money
• A medium of Exchange
• Cash
• Authorised Printed Paper and Metal Currency of a Country
• Capital
• Any form of wealth that is committed for an enterprising activity
• Investment
• The act of Committing Wealth with an expectation of Appreciation, Income, and Safe
Return
• Savings
• The excess of Recurring Income over Recurring Expenses
• Finance
• Cash, Bank Loans, Lines of Credit, Guarantees, Cash Equivalents treated as source for
CAPEX and OPEX in business
 What is Wealth?

Any existing ownership

of a
Resource
which generates
One time
or
Sustained benefits
or
A claim for future ownership
How to deal Wealth
Generate it -
-by engaging in value adding activities
Preserve It -
-by investing in risk less avenues
-from diminution of value
Grow It -
-by investing
-to beat inflation
-to spend it on a Rainy Day
-to pass it to your loved ones
Keep it Handy –
- by investing some % in liquid assets
What about Business? – Focus on Profits or Wealth?
Bank Fixed Deposit
Today Amount
Chocolate Vending Business
Today Amount
You have CASH as Wealth $ 1 Mn
You have CASH as Wealth $ 1 Mn
You invest in Bank FD @ 8% p.a. $ 1 Mn
You Buy Stock of Chocolates (Life 1 Year) $ 0.9 Mn
At Maturity After 1 Year Amount
You spent for Business Startup Expenses $ 0.02 Mn
You Receive CASH & Your Wealth $ 1.08 Mn
After 1 Year Amount
Your Wealth grew By (1.08 – 1) / 1 Mn 8% p.a.
You Sold Chocolates worth $ 0.8 Mn in Cash $ 1.1 Mn
Equity Share You spent for various expenses $ 0.05 Mn
Today Amount
You make a Profit (1.1 – 0.8 – 0.05 – 0.02) $ 0.23 Mn
You have CASH as Wealth $ 1 Mn
Your Profit on Investments (0.23 Mn / 1 Mn) 23% p.a.
Bought 10,000 equity shares @ $ 100 $ 1 Mn
Balance of CASH (1 - 0.9 - 0.02 + 1.1 - 0.05) $ 1.13 MN
After 1 Year Amount
Stock of Chocolates ( 0.9 – 0.8) $ 0.1 Mn
You Receive Dividend in CASH $ 0.08 Mn
Your Wealth after 1 Year (1.13 + 0) $ 1.13 Mn
Sold shares @ $110 received CASH $ 1.1 Mn
Your Wealth grew By (1.13 + 0 – 1) / 1 Mn 13% p.a.
Your Wealth after 1 Year (1.1 + 0.08) $ 1.18 Mn
Your Wealth grew By (1.1+0.8-1) / 1 Mn 18% p.a.
Let’s think bigger in Business – The Travel Saga
Today Amount
You have CASH as Wealth $ 4 Mn
You borrow CASH to do business, showing your $ 1 Mn Cash @ 10% p.a. $ 6 Mn
You Purchase 6 SUVs @ $ 1.5 Mn $ 9 Mn
After 1 Year Amount
Your travel business generated Revenue in CASH $ 2.5 Mn
You incurred expenses for travel business in CASH $ 1.5 Mn
You earn a profit in your travel business $ 1 Mn
Your Profit Margin on each $ of Revenue collected from Customers (1 Mn / 2.5 Mn) 40%
You pay interest on $ 6 Mn Loans @ 10% p.a. in CASH $ 0.6 Mn
Balance of Profit Left for you ( 1 Mn – 0.6 Mn) $ 0.4 Mn
Your CASH BALANCE (4 + 6 – 9 + 2.5 – 1.5 – 0.6) $ 1.4 Mn
You sell your SUVs at the end of 1 year and realise CASH $ 7.5 Mn
You need to repay Loan taken for the business in CASH $ 6 Mn
Your Wealth after 1 Year (1.4 + 7.5 – 6 ) $ 2.9 Mn
Key Learnings
• Don’t Chase only Profits in Business

• Generate - As much Income Over Expenses

So that you

• Preserve – your Initial Wealth (Recover lost Value)

Only then Check whether you have

• Grown it through Profits

Presenting Financial
Well-Being of Individuals
The W I L E S C Framework
Frugal Families
Wealth
1) 2 BHK Apartment - $ 2.5 Mn
2) Two Wheeler – 0.02 Mn
Insurance
3) $ 0.5 Mn
Loans
4) Housing, Vehicle, Educational
– upto $ 3 Mn
Earnings
5) Entry Level Jobs – upto $.6 Mn
p.a.
Savings
6) $ 0.6 Mn – $ 0.54 Mn = 0.06 Mn
Cash – 0.06 Mn
Affluent Families
Wealth
1) 6 BHK Duplex House - $ 20 Mn
2) Two SUVs – $ 2 Mn
Insurance
3) $ 5 Mn
Loans
4) Housing – upto $ 10 Mn
Earnings
5) Business & C – Suite Job
- upto $ 6 Mn p.a.
Savings
6) $ 6 Mn – $ 4.8 Mn = $ 1.2 Mn
p.a.
Cash – $ 0.5 Mn
How do we Measure and Interpret Financial Well Being?
• Add up Wealth Forms – CAPACITY TO EARN
• To judge the Capacity to Generate Future Benefits

• Deduct Loans - INDEBTEDNESS

• To appreciate how much of Wealth is truly OWNED

• Assess quantum of Insurance – ABILITY TO MANAGE RISKS

• To be assured of bearing Income and Life Shocks

“What do you OWN - What do you OWE”

The Long Term Well Being
How do we Measure and Interpret Financial Well Being?

• Observe Channels of Recurring Income – ACTUAL EARNING

• To increase regular Inflows for Sustenance and Savings

• Track Recurring Expenses – EFFORT TO EARN

• To reduce wasteful expenses

• Ascertain Saving – EFFICIENCY IN EARNING

• To measure annual additions to Wealth

“What did you Earn - How much did you Spend for it”
The Nurturing of your Well Being
How do we Measure and Interpret Financial Well Being?

• Check out Cash balances – ABILITY TO MEET IMMEDIATE NEEDS

• To feel confident of meeting day to day needs

“What do you have for immediate needs”

The Short Term Well Being
Key Learnings

• When measuring Financial Well – being we want to know

• How much do you Own & How Much do you Owe

• How much do you Earn & How Much do you Spend to Earn it

• What do you have to meet the immediate financial needs

 Presenting Financial
Well Being of
Business Entities
Statements of Scale, Model, Solvency, Performance and Cashflows
Does the Spirit of Presentation change? NO!

Individual Business
Wealth Equity
Insurance Reserves
Loans Liabilities
Earnings Revenues
Expenses Expenses
Savings Profits
Cash Cash
Accounting Jargons First !
• Capital
• Amounts of money provided by owners and lenders to the business
• Asset
• Wealth, Endowments of Resource
• owned and controlled by Business
• which has future income generating capacity
• Liability
• Indebtedness, Loans of business
• due to past actions
• Equity
• Funds invested by and belonging to the Owners
• All accumulated profits and Reserves over the years
Accounting Jargons First !
• Income
• Recurring inflow of resources (usually Cash)
• due to core operations of business
• Expense
• Recurring outflow of resources (usually Cash)
• to arrange goods and services consumed by business
• Gain
• Once in a while excess of Value realised over cost incurred
• Arising in transactions related to non core operations
• Loss
• Once in a while excess of expenses over revenue
• due to core operations of business or
• due to outflow of any resource
• without enjoying any benefit from it
Rules of the Game of Accounting!
• Financial statements are written in an Accounting Language
• Only economic transactions are recorded in the books of accounts
• The Goal is to present a “true and fair view” of financial well being of a firm
• Losses yet to happen to be provided for, Gains to be recorded only when
realised
• Transactions are recorded
• When there is flow of CASH – Cash Basis and
• Also When there is no flow of CASH – Accrual Basis
• Transactions are recorded from
• the perspective of the Business and
• NOT from that of THE OWNER OR LENDER
• Don’t think Financial Statements show only FACTS, there are OPINIONS also
The Accounting Cycle – The Path to Presentation

Identifying & Recording & Presenting

Classifying Summarising • P & L Account
• Transactions • Ledgers • Balance Sheet
• Asset, Liability, • Trial Balance • Cashflow
Income, Statement
Expense
What are Business Transactions?

1. Exchange of Resources or Claims on Resources between Business and Others

2. Recognising Consumption of Resources by business

Liabilitie Expenses
s
Adjustment
Assets Equity Revenues
s

Balance Short Term P&L

Well Being Account
Long Term
Sheet
Nurturing
Well Being Cash Flow Well Being
Statement
Interpreting Business Transactions
• Say an individual brings in Capital $ 10 Mn to start a business
• One can interpreted this from two perspectives – Individual’s and
Business’s
• From the Individual’s Perspective?
• Cash Balance Decreased by $ 10 Mn or Assets Decreased
• A New Asset called Business created by $ 10 Mn
• From the Business’s Perspective?
• It’s Cash Balance Increased by $ 10 Mn and – A new Asset is Created
• This $ 10 Mn belongs to the owner – A new Liability is Created
• Each One had two perspectives. Which one to Record?
• Who Decides? Forms of Business Organisation
 Let’s Record only One Side
Transaction Transactions Cash
Owner Brings in Capital into business in Cash – 10 Mn Capital Brought In + 10 Mn
Buys Furniture using Cash – 1 Mn Furniture Purchased - 1 Mn
Loan to construct a plant – 10 Mn Loan from Bank + 10 Mn
Sells goods for Cash – 4 Mn Sales received in Cash + 4 Mn
Expenses to sell the goods – 4 Mn Expenses Incurred - 4 Mn
Repays loans with Interest – 5 Mn Business Repays Loan - 5 Mn
Pays dividends to Owners – 1 Mn Dividends paid to Owners - 1 Mn
Accrued Interest on Bank Deposit – 2 Mn Year End Extractions
Buys goods for resale on Credit – 1 Mn Balance of Cash 13 Mn
Received Land on Donation and partly as a Loan – (3 + 2 = 5 Mn) Balance of Loan 7 Mn
Assets = (13 + 5 + 1) = 19; Income – 4 ; Expenses – (4 + 1) = 5 Furniture 1 Mn
Liabilities = (7 + 1) = 8; Profit = (4 – 5) = -1 paid out as dividends -1 Land 5 Mn
Net Ending Wealth = (19 – 8) = 11; Beginning Wealth = 10 Mn; Increase = 1 Payable to Supplier 1 Mn
The Double Entry
System
Philosophy of Insightful Accounting
Rationale of Recording Both Aspects
• Can’t be appreciated from an Individual’s perspective
• Fits very well from the perspective of Corporate Businesses because
• It is a life less entity and
• It should recognise and depict the FACT that
• Assets at its disposal are in fact
• Claimed by Owners and Lenders
• who provided the Capital to buy them
• Good to recognise! But why record?
• Ensures Cross Check for Arithmetic Accuracy of Recording
• Ensures accountability of managers, when owners are not running the show
• Forms documentary evidence for litigation, due to visibility
• Improves information to every stakeholder
• Facilitates analysis for successful management with granular data
• Rewarded by Stock markets for Good quality information
• Mandated by Accounting Standards

Therefore, along with What has happened, Why it has happened is also important
How does Double Entry System solve?
• It believes all business transactions involve only Asset, Liability, or Equity
• It proposes the fundamental Accounting Equation
• Assets = Liabilities + Equity
• It is a philosophical depiction that
• A Business cannot own anything, more than it owes
• A Business is born without anything, and at the end it is left without anything
• To be true, fair, and informative
• every transaction
• has to be recorded TWICE,
• Recognising Asset, Liability, or Equity aspects AND
• Check that “Assets = Liabilities + Equity” is always VALIDATED
• Incomes and Expenses are to be netted each quarter / year
• Profit or Loss arising out of netting to be adjusted into Equity
 Double Entry in Action
Transaction Asset Liability Equity Income Expense
Owner Brings Capital in Cash - 10 mn Cash + 10 Owner’s +10
Bought Furniture using Cash - 1 Mn Furniture + 1
Cash - 1
Loan to buy construct plant - 10 mn Bank + 10 Loan +10
Sells goods for Cash - 4 mn Cash + 4 Sales + 4
Incurs expenses to sell the goods – 4 mn Cash - 4 Expenses + 4
Repays loans – 5 mn Cash - 5 Loan - 5
Interest Accrued – 2 mn Receivable + 2 Interest + 2
Buys goods for resale on Credit – 1 mn Payables +1 Expenses - 1
Land on Donation and partly as Loan – 5 mn Land + 5 Loan + 2 Donation + 3
Net Profit (Net Loss) (Inc – Exp) = 6 – 5 Net Profit + 1 6 5
Pays dividends to Owners Cash - 1 Dividends - 1
Total 21 8 13
Increase in Wealth 3
Balance Sheet – Statement of Assets & Liabilities - $ Mn
Liabilities Amount Assets Amount
Equity Share Capital Owners Wealth Tangible Assets CAPEX invested in
Number of Shares Paid up at Face Value Stay’s Forever Property Plant Equipment the business
Generates
Revenues, Creates
Reserves and Surpluses Need to repaid Intangible Assets Expenses over Long
Accumulated Profits, Reserves in > 1 Year Goodwill, Patents, Licenses Time. Needs
Replacements in
Unsecured Long Term Liabilities Financial Assets Medium to L-Term
Preference Shares Investment in Subsidiaries

Secured Long Term Liabilities Current Assets Inventory Will Realise into
Bonds, Bank Term Loans Receivables Cash < 1 Year
Cash

Current Liabilities Need to paid in Miscellaneous Assets Losses to be Written

Payables, Bank OD, < 1 Year Preliminary Expenses, Pre-Operative Off
Unpaid Expenses, Provisions Expenses, Failed R&D Expenses

This is a Cumulative Statement from the inception of Business to understand Business’s Capacity and Solvency
P & L Account – Statement of Income - $ Mn
Items Description
Sales / Revenue + Other Income Core Business Income + Other Incomes
Less Direct Operating Expenses (OPEX1) Material+ Energy+ Manpower
Gross Profit Margin left to meet other Overheads
Less Admin, Selling, and Distribution Overheads (Fixed Costs) (OPEX2) Generally Fixed Indirect Expenses
Profits before Interest Tax Depreciation & Profits left after all cash OPEX
Amortisation(PBITDA)
Less Depreciation and Provisions for NPAs (50 + 14,950) Allocation of CAPEX Recovery; NON-CASH
OPEX
Profits Before Interest and Tax (PBIT) Profits left after all business related OPEX
Less Interest on Loans Regular Debt Servicing
Profits Before Tax (PBT) Taxable Profits to belonging to the Owners
Less Corporate Taxes Corporate Taxes to be paid to Government
Profits After Tax (PAT) Net Profits after all deductions left for Owners
Dividends Part of Profits Taken out of Business
Retained Earnings Part of Profits Re-Invested in Business
This is a Annual Statement Prepared Every Year to understand Business Performance
Balance Sheet – Statement of Assets & Liabilities
Liabilities STEEL IT BANK
Equity Share Capital 1,150 2,000 500
Reserves and Surpluses 69,300 60,000 1,80,000
Unsecured Long Term Liabilities 0 0 1,45,000
Secured Long Term Liabilities 29,000 3000 5,50,000
Current Liabilities Deposits 5,50,000
Provisions 65,500
38,000 15,000 0
Others
Total 1,37,450 80,000 14,91,000

Assets STEEL IT BANK

Tangible Assets 76,500 12,000 4,500
Intangible Assets 150 1,000 54,500
Financial Assets 39,500 22,000 14,54,000
Current Assets Inventory 12,000 0
Receivables 8,450 16,000
Cash 700 14,000 72000
Others 0 15,000 15000

Total 1,37,450 80,000 14,91,000

P & L Account – Statement of Income - $ Mn
Items STEEL IT BANK

Sales / Revenue 69000 80000 140,000

Less Direct Operating Expenses 30000 42000 70,000
Gross Profit 39000 38000 70,000
Less Admin, Selling, and Distribution Overheads (Fixed Costs) 20000 17000 22,000
Profits before Interest Tax Depreciation and 19000 21000 48,000
Amortisation(PBITDA)
Less Depreciation and Provisions for NPAs (50 + 14,950) 3800 2000 15,000
Profits Before Interest and Tax (PBIT) 15200 19000 33,000
Less Interest on Loans 2800 100 0
Profits Before Tax (PBT) 12400 18100 33,000
Less Corporate Taxes 6700 5000 10,000
Profits After Tax (PAT) 5700 13100 23,000
Dividends Paid to Shareholders 1145 7500 13,000
Earnings re-invested in the Business 4555 5600 10,000
Why Cash Flow Statement?
IT Bank Steel
Items Amount Items Amount Items Amount
Profits After Tax 13,100 Profits After Tax 23,000 Profits After Tax 5,700
Cash from Operations 14,000 Cash from Operations -57,000 Cash from Operations 15000
Cash from Investment -600 Cash from Investment -1,500 Cash from Investment -16350
Cash from Financing -14,000 Cash from Financing 16,000 Cash from Financing -3000
Net Increase/Decrease -600 Net Increase/Decrease -42,500 Net Increase/Decrease -4350
Most of my revenues are in Cash I made Profits! But Sorry I I made Cash Profits! Because I
and not much non-cash expenses can’t Pay Dividends hade many Non-Cash Expenses
and incomes! and Inventory Adjustments
Sorry! Most of my Income is in the
I bought Back Equity Books waiting for Customer’s to pay I made Huge CAPEX for Capital
Shares! Sorry! No Growth and is unrealised Work in Progress and repaid
Opportunities No CAPEX Loans
Since I have profits can I get Dividends? The company sold on Credit, did the customer’s pay? What is the CAPEX made this
year? The company repaid some loan and borrowed afresh, how much were these flows?
Profit & Loss Account is prepared on BOTH CASH AND NON-CASH BASIS.
BALANCE SHEEET IS A CUMULATIVE STATEMENT- We need to Juggle a Bit to Extract this year’s Additions and Deletions
 Cash Flow Statements – Statement of Cashflows
Items
Book Profits After Tax (from Income Statement)
+ All Non-Cash Expenses
- All Non-Cash Incomes
+ All Non-Operating Expenses
- All Non-Operating Incomes
+ Decrease or - Increase in Working Capital
= Cashflow from Operations (CFOPs)
Amount Items Amount
Cash inflow due to sale of Assets
+ Cash inflow due to Interest
and Dividends on Investments
- Cash outflow due to CAPEX
- Cash outflow due to
Financial Investments out of business
= Cashflow from Investment Activities
(CFIAs)

Items Amount
Cash Inflow due to raising Loans
+ Cash inflow due to raising fresh equity capital
- Repayment of Loans
- Buyback of Equity Shares
- Payment of Interest and Dividends
= Cashflow from Financial Activities (CFFAs)
 Cashflow Statements
Items $ Mn Items $ Mn
OP Bal of Cash 100 OP Bal of Cash 100
+ / - CFOPs 1000 + / - CFOPs 1500
+ / - CFIAs -3000 + / - CFIAs -100
+ / - CFFAs 2000 + / - CFFAs -1000
CL Bal of Cash 100 CL Bal of Cash 500

Growing Firm Items $ Mn Mature Firm

OP Bal of Cash 100
+ / - CFOPs -550
+ / - CFIAs 1000
+ / - CFFAs -500
CL Bal of Cash 50

Dying Firm
What to Look for in Financial Statements?
• Fixed Assets / Current Assets Ratio
• What is your business model?
• Current Assets / Current Liabilities Ratio – Current Ratio
• Can you meet the short term obligations?
• L.T. Liabilities/ Equity Ratio – Debt Equity Ratio
• Who has more stakes in the business?
• Long Term Liabilities / (Tangible + Intangible + Financial Assets)
• Do the owners really own the assets of the business?
• (Cash + Bank Balances) / Daily Operating Expenses – Cash Burn Ratio
• How many days can the company survive without Sales?
What to Look for in Financial Statements?
• Gross Profit / Revenue – Gross Profit Margin
• Are Cost Effective? Do you have the Brand Power?
• PBIT / Revenue – Operating Margin
• What is left for financiers and government after meeting business expenses?
• PAT / Revenue – Net Profit Margin
• What part of revenue did the owners get?
• PBIT / (LT Debt + Equity) – Return on Investment
• How much did the business give back to Fund Providers?
• Is it greater than what the lenders have to be given?
• PAT / Equity – Return on Equity
• How much did the business give back to the owners?
• Is it greater than what the lenders have got?
Taking an Integrated View
Total Assets
Turnover
Revenue
Total Assets Equity
Net Profit Multiplier
Margin
PAT / Revenue x x Total Assets
Equity
Return on
Equity
PAT
Equity
 Thanks for your
Patience!

Will Be Happy to
Interact on Questions