Analysis of

Financial
Statements
PPT – 1
AFS Overview
 AFS Overview
• Business Analysis is the process of evaluating a
Company’s economic prospects and risks
– Includes analysing Company’s business environment, its
strategies, its financial position and performance
– Whether to invest in equity or in debt securities, whether to
extend credit through short or long term loans, how to
value an IPO, how to value restructurings including
mergers, acquisitions and divestitures
• Financial Statement Analysis is the application of
analytical tools and techniques to general purpose
financial statements and related data to derive
estimates and inferences useful in business analysis
– Reduces reliance on hunches, guesses and intuition for
business decisions
– Decreases uncertainty of Business Analysis
 Tools for Financial Analysis
• Comparative Financial Statement Analysis
• Common-size Financial Statement Analysis
• Ratio Analysis
• Cash Flow Analysis
• Valuation
Manipulations in Financial Statements
 Manipulations in Financial Statements
• Inflate sales of current year by advancing sales from the
following year
• Alter ‘other income’ figure by playing with non-operational
items like sale of fixed assets
• Fiddle with method and rate of depreciation
• Change method of stock valuation
• Capitalise expenses
• Defer discretionary expenses
• Make inadequate provision for known liabilities, treat
certain liabilities as contingent
• Make extra provision during prosperous years and write
them back in lean years
• Revalue assets to create impression of substantial reserves
• Lengthen Accounting Year in an attempt to cover poor
performance
• Off Balance Sheet Financing
Why Companies manipulate earnings?
• To project that the company is a low risk company
• To enhance managerial compensation if it is linked to
reported earnings
• To promote a perception that the management of the firm
is competent
• To communicate more meaningfully about the long term
prospects of the firm
 How to read between the lines?
• Acquire greater knowledge of how accountants
prepare financial statements
• Read the notes to accounts minutely to discover
changes in accounting policies and the nature and
magnitude of contingent liabilities
• Read Auditor’s report and understand the
implications of the qualifications
• Look at performance of the company over a
period of time
 Going beyond the numbers
• Are company’s revenues tied to one key customer?
• To what extent are the company’s revenues tied to one key
product?
• To what extent does the company rely on a single supplier?
• What percentage of the company’s business is generated
overseas?
• State of Competition
• Future prospects
• Legal and regulatory environment
 A Healthy Balance Sheet?
LIABILITIES Rs. Rs. ASSETS Rs. Rs.
Share Capital 29 Fixed Assets 90
Reserves & Surplus 319 Investments 495
Net Worth 348 Current Assets, Loans &
Advances
Secured Loans 208 - Inventory 43
Unsecured Loans 49 - Debtors 26
Debt 257 - Cash & Bank 3
- Loans & Advances 59
TOTAL 131
Current Liabilities
- Current Liabilities 97
- Provisions 14
TOTAL 111
Net Current Assets 20

TOTAL 605 TOTAL 605

Observations on the ‘Healthy Balance Sheet’
• Investment worth Rs. 475 is in a Associate company whose
Net Worth is negative
• Loans and Advances include Rs. 33 given to the Associate
Company
• Secured loans contain Rs. 58 finance obtained from Bank
towards stock and debtors
• Unsecured loans of Rs. 49 is short term borrowings from
directors
 Re-Cast Balance Sheet
LIABILITIES Rs. Rs. ASSETS Rs. Rs.
Share Capital 29 Fixed Assets 90
Reserves & Surplus 319 Investments 20
TOTAL 348 Current Assets, Loans &
Advances
Less : - Inventory 43
Investment in Associate -475 - Debtors 26
Loan to Associate -33 - Cash & Bank 3
Adjusted Net Worth -160 - Loans & Advances 26
TOTAL 98
Secured Loans 208 Current Liabilities
Less : Bank Finance 58 - Current Liabilities 97
- Provisions 14
- Unsecured Loans 49
Term Finance 150 - Bank Finance 58
TOTAL 218
Net Current Assets -120

TOTAL -10 TOTAL -10

 ALM – Example 1

LIABILITIES Rs. ASSETS Rs.

Share Capital 1,00,000 Fixed Assets 2,50,000
Reserves & Surplus 10,000 Sundry Debtors 50,000
Short Term Loans 2,00,000 Stock 50,000
Long Term Loans 50,000 Cash / Bank 10,000

TOTAL 3,60,000 TOTAL 3,60,000

 ALM – Example 2

LIABILITIES Rs. ASSETS Rs.

Share Capital 1,00,000 Fixed Assets 1,00,000
Reserves & Surplus 10,000 Sundry Debtors 1,50,000
Short Term Loans 50,000 Stock 1,00,000
Long Term Loans 2,00,000 Cash / Bank 10,000

TOTAL 3,60,000 TOTAL 3,60,000

Cash Flow Statements
 Objectives
• Earnings do not typically equal net cash flows, except over the life
time of the Company
• Providing users of financial statements with a basis to assess the
ability of the enterprise to generate cash and cash equivalents and
the needs of the enterprise to utilise those cash flows
– ability of an enterprise to generate cash and cash equivalents
– timing and certainty of their generation
• 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 flows classified as follows :
– Operating Activities
– Investing Activities
– Financing Activities
 Objectives
• Assess and compare the present value of the
future cash flows of different enterprises
• Comparability of the reporting of operating
performance by different enterprises
• Eliminates the effects of using different
accounting treatments for the same transactions
and events
 Operating, Investing & Financing Activities
• Operating activities are the principal revenue-producing
activities of the enterprise and other activities that are not
investing or financing activities
• Investing activities are the acquisition and disposal of
long-term assets and other investments not included in
cash equivalents
• Financing activities are activities that result in changes in
the size and composition of the owners’ capital (including
preference share capital in the case of a company) and
borrowings of the enterprise
• A single transaction may include cash flows that are
classified differently
– Payment of interest on a loan (Financing activity)
– Repayment of a loan (Investing activity)
 Cash & Cash Equivalents
• Cash flows are inflows and outflows of cash and cash
equivalents
• Cash equivalents are short term, highly liquid
investments that are readily convertible into known
amounts of cash and which are subject to an insignificant
risk of changes in value
• An investment normally qualifies as a cash equivalent only
when it has a short maturity of, say, three months or less
from the date of acquisition
• Cash flows exclude movements between items that
constitute cash or cash equivalents
 Cash Flow from Operating Activities
• Indicator of the extent to which the operations of the
enterprise have generated sufficient cash flows to maintain
the operating capability of the enterprise, pay dividends,
repay loans and make new investments without recourse to
external sources of financing
– Cash receipts from the sale of goods and the rendering of services
– Cash receipts from royalties, fees, commissions and other revenue
– Cash payments to suppliers for goods and services
– Cash payments to and on behalf of employees
– Cash receipts and cash payments of an insurance enterprise for
premiums and claims, annuities and other policy benefits
– Cash payments or refunds of income taxes unless they can be
specifically identified with financing and investing activities
– Cash receipts and payments relating to futures contracts, forward
contracts, option contracts and swap contracts when the contracts
are held for dealing or trading purposes
 Cash Flow from Investing Activities
• Extent to which expenditures have been made for
resources intended to generate future income
and cash flows
– Cash payments to acquire fixed assets (including
intangibles)
– Cash receipts from disposal of fixed assets (including
intangibles)
– Cash payments to acquire shares, warrants or debt
instruments of other enterprises and interests in joint
ventures
– Cash receipts from disposal of shares, warrants or debt
instruments of other enterprises and interests in joint
ventures
– Cash advances and loans made to third parties
– Cash receipts from the repayment of advances and
loans made to third parties
– cash payments or receipts towards futures contracts,
forward contracts, option contracts and swap contracts
 Cash Flow from Financing Activities
• Useful in predicting claims on future cash flows
by providers of funds (both capital and borrow
– Cash proceeds from issuing shares or other similar
instruments
– Cash proceeds from issuing debentures, loans, notes,
bonds and other short or long-term borrowings
– Cash repayments of amounts borrowed
 Cash Flow Statement – Methods
• Direct method
– major classes of gross cash receipts and gross
cash payments are disclosed
• Indirect Method
– net profit or loss is adjusted for the effects of
transactions of a non-cash nature, any
deferrals or accruals of past or future operating
cash receipts or payments, and items of
income or expense associated with investing or
financing cash flows