Finance for Non Finance Professionals N. Muthuraman Director RiverBridge Investment Advisors Pvt. Ltd. Disclaimer: This session does not aim to provide any investment advice. Participants may seek advise of professional investment advisors for taking any investment decisions. Agenda Objective of the Webinar Key takeaways Purpose of existence of an economic entity Financial statements – construction and purpose Understanding and interpreting Financial Statements Financial analysis as a measurement tool Purpose of analysis – equity perspective, debt perspective Ratio analysis Explaining simple terms in Finance - ROI, IRR, Time Value of Money Q&A Objective The webinar will help the participants To gain an understanding of the basic principles of finance To evaluate decisions related to finance more knowledgeably To participate effectively in finance related discussions in their respective organisations To gain basic understanding to pursue higher education / career in the field of finance To follow recent economic events and its impact on corporate performance To take informed decision related to personal finance and investing To interact with financial department / finance professionals more knowledgeably Key Take Aways Key takeaways Basic understanding of various forms of economic entities Understanding financial statements and perform ratio analysis on published statements Evaluate a corporate investing or financing decision meaningfully Track financial performance of listed companies closely, to take well-informed investment decisions Read / follow business newspapers / business channels with better understanding Purpose of an economic entity To do ‘business’ is to create an economic entity with the purpose of Wealth creation Wealth management, and Wealth distribution Objective of an enterprise – To create the best possible values and share them in the equitable manner among all the stakeholders Purpose of an enterprise Business as an economic entity exists to make profits: Trading activity Selling price > Cost of purchase Buying Selling Selling price > Cost of purchase + conversion costs Manufacturing activity: Buying Processing Selling Price for service > Cost of providing the service Services Servicing Stakeholders We need various entities to come together to run an enterprise and generate returns. Who are the stakeholders in a business? Investors Management Employees Suppliers Customers Community, Taxman Equity holders – majority holders, minority shareholders Debt holders including banks and financial institutions Why Accounting? Accounting forms the basis for measuring the performance of an enterprise The performance determines which stakeholder gets what share of the business Accounting also ensures ‘equitable’ distribution of wealth generated, based on each person’s contribution to the business Few examples: Taxman gets his share of the profits (currently 35% in India), which are determined based on prudent accounting practices Employees are typically rewarded based on their individual performance as well as the performance of the enterprise Minority shareholders get equal treatment compared to majority owners (equal dividend distribution) Debt holders are paid their due for contributing debt capital to the business (interest payment and principal repayment) Key to understanding accounting principles is to view an enterprise as a separate legal entity, and all stakeholders as those contributing capital, labour or resources. Various forms of enterprise Enterprise Proprietary Partnership Company Private Ltd. Public Ltd. Closely held Publicly held Various forms of enterprise Proprietary business – owned by single owner No difference between the obligations of the business and the obligations of the individual. Partnership firm – owned by two or more owners No difference between the obligations of the business and the obligations of the individual partners except when it is Limited Liability Partnership (Registered) Company is an artificial person, created by law and has perpetual existence. Obligations of the company are separate from those of promoters and management. Private limited company Not more than 50 members Shares are not freely transferable. No invitation to public for subscription. Public limited company Closely held public limited company (Deemed) Publicly held public limited company (Listed) Financial statements Financial statements report the state of financial affairs of an enterprise These are made publicly available for widely held companies, usually free of cost (www.bseindia.com and www.nseindia.com ) For closely held public companies and private companies, the financial statements are reported to the Ministry of Company Affairs Some of these are available for public viewing (both online as well as physically) for a small fee. (http://www.mca.gov.in ) Three key financial statements are Balance Sheet Profit & Loss Account and Cash flow statement Construct of a Balance Sheet Liabilities Owners’ capital Assets Borrowed funds Equity Capital Reserves and Surplus Fixed Assets Land and building Plant and Machinery Investments Working capital Long term debt Short term debt Creditors Current liabilities and Provisions Investment made in shares, bonds, government securities, etc. Working Capital Raw Material Work in progress Finished goods Debtors Cash Some observations on Balance Sheet The Liability side represent the various sources of funds for an enterprise These are the liability of the enterprise to the providers of these funds The Asset side represent the various uses of funds by an enterprise These are the assets held by the enterprise, that are needed to operate the business (e.g. Office space, factory, raw material, etc.) The Assets and Liabilities should ALWAYS match. In the Liability side, the portfolio mix of the own funds and borrowed funds is called the Capital Structure of the company Balance sheet is always presented as on a given day, say as at March 31, 2008. It presents a static picture of the assets and liabilities of the enterprise as on that date. Some observations on Balance Sheet Another way to look at the balance sheet is to match the sources and uses of funds, based on their tenure. In Liability side, long term sources are Equity capital Reserves and Surplus Long term borrowings Fixed Assets Investments In Asset side, long term uses are The rest are short term on both sides viz. Current assets, current liability and short term debt Ideally, long term uses must always be funded with long term funds. Financing long term assets with the short term funds creates risks (mainly refinancing risk). Short term investments may be financed by a combination of long term and short term funds, based on business managers’ preference. Construct of a Profit & Loss account Revenues from the business Less Raw material consumed Employee expenses Other manufacturing expenses Administrative expenses Selling expenses Sub total: Cost of Sales Earning before interest, taxes, Depreciation & Amortization(EBITDA) Less Less Less Less Depreciation Interest payment Taxes Dividend Earning before interest and taxes (EBIT) Profit before taxes (PBT) Profit after tax (PAT) Retained earnings Inside the P&L Account Typical items under ‘Revenue from business’ Sales revenue Other related income Scrap sales, Duty drawback Dividends and interest Rent received Profit on sale of assets / investments Prior-period items Non-operating income Extra-ordinary income Inside the P&L Account Typical items under ‘Cost of Sales’ Cost of goods sold Direct material Direct labor Direct manufacturing overheads Administrative costs Office rent Salaries Communication costs Other costs Selling and distribution costs Salaries of sales staff Commissions, promotional expenses Advertisement expenses etc. Inside the P&L Account Depreciation Straight line method Written Down Value method Deferred revenue expenditure R&D expenses Advertisement expenses Product promotion expenses (expenses are charged as capital expenses and amortized over the period of time) Some observations on P&L Account P&L Account presents a snapshot of the performance of an enterprise over a given period (a year, half-year, quarter, etc.) Unlike Balance Sheet, which presents a static picture on a given date P&L Account can provide great insights into the functioning of an enterprise. Let us look at a few: Variable costs Vs. Fixed costs Break even point is the point where there is ‘no profit, no loss’ Raw material, salary and other administrative expenses are cash expenses Depreciation is typically the only non-cash expense Income from ordinary activities are typically recurring in nature Extraordinary income / expenses are typically one-time in nature Few examples: Sale of office space, disposal of a factory unit, VRS Cash expenses Vs. Non-cash expenses Recurring income Vs. one-time income Cashflow Statement What is a Cashflow Statement? What are its components? A statement that links the P&L generated based on ‘accrual’ principle and the Balance Sheet which represents the snapshot on a given date A statement that segregates cash generated and cash used based on the source/end use of the cash Three key components of Cashflow Statement are Cashflow from Operating Activities Cashflow in Investing Activities Represents the cash generated from the operations of the enterprise – a measure of ‘cash profit’ from the operations Represents the deployment of cash in various assets such as fixed assets, investments, etc. Represents the net cash raised in the form of capital such as equity capital, borrowed funds, etc. Cashflow from Financing Activities Construct of a Cash flow Statement Cashflow from Operating Activities Less Add Add Less = Less Less Less Add Add = Less = Profit Before Tax Non-operating income (e.g. Interest income, profit on sale of assets) Interest expense Depreciation Other cash adjustments (e.g. Unrealised foreign exchange loss) Operating Profit before Working Capital Changes Increase in Debtors Increase in Inventory Increase in other current assets (e.g. Loans and Advances) Increase in Creditors Increase in other Current liabilities and Provisions Cash generated from Operations Taxes Net Cash from Operating Activities Construct of a Cash flow Statement Cash flow from Investing Activities Add Less Add = Purchase of Fixed Assets (negative because it is cash outgo) Purchase of Long term investments Proceeds from Sale of Fixed Assets or Investments (if any) Interest and Dividend Income Net Cash used in Investing Activities Cash flow from Financing Activities Add Less Less Less = Proceeds from issue of share capital Proceeds from raising fresh loans Repayment of existing loans Interest expense Dividend paid Net Cash Generated from Financing Activities Opening Balance: Cash and Cash Equivalents Add Net Cash from Operating Activities Less Net Cash used in Investing Activities Add Net Cash Generated from Financing Activities = Closing Balance: Cash and Cash Equivalents Some observations on Cash flow statement Cash flow statement provides the reference check for the quality of ‘profits’ generated by a company For instance, if the company reports profits, most of which remain uncollected in the form of ‘debtors’, cashflow from operations will be negative, which should prompt an analyst to probe debtors further. Cash flow statement provides a snapshot of where the cash comes and where the cash goes Disproportionate cash going into investing activities on a continuous basis could provide a clue on ‘unproductive’ assets in a company. Opening and Closing Cash balances should tie in with the actual balance in the bank account as on the opening and closing dates. Acts as a good reference check point. Cash flow statement, like balance sheet, provides a self-check point Negative cashflow from operations is not necessarily a sign of distress, especially for a growing company. Typically, increase in working capital could be more than the cash profit generated by a growing company Ratio analysis Some important ratios for analysing performance of a company: Operating profit margin Net profit margin Return on Capital Employed Current Ratio Debt:Equity ratio Interest coverage ratio Earnings per share Price Earnings ratio Return on Networth Ratio analysis Operating profit margin Indicates the business profitability OPM = EBITDA / Operating Income (or Net Sales) Depending on the industry, for healthy companies, OPM ranges from 15% - 50% Net profit margin Indicates the returns generated by the business for its owners NPM = PAT / Operating Income (or Net Sales) For healthy companies, NPM ranges from 3% - 12% Several other ‘profitability’ measures are there (Gross margin, Contribution margin, etc.) but the above two are most commonly used. The profitability margins are very useful for peer comparison (i.e. comparing with other companies in same industry) Ratio analysis Return on Capital Employed Indicates true measure of performance of an enterprise The capital employed in business is Equity capital, reserves and surplus, long term debt and short term debt. Returns generated for all these providers of capital is EBIT. ROCE = EBIT / (‘Networth’ + ‘Total Debt’) The ratio is independent of the industry, capital structure or asset intensity. For healthy companies, ROCE ranges from 15% - 30% If ROCE is less than Interest rate for a company consistenty, the company is destroying value for its equity investors / owners The owners are better off dissolving the company and parking their money in bank fixed deposits and earn interest!!! Ratio analysis – Lenders’ perspective Lenders, such as a bank giving loan, or a Mutual Fund investing in bonds or debentures of a company, may use the following ratios: Debt:Equity ratio The ratio of borrowed funds to owners’ funds D:E ratio is also known as ‘gearing’, ‘leverage’ or ‘capital structure’ Gearing = (Long term debt + Short Term debt) (Equity capital + Reserves & Surplus) For most manufacturing companies, D:E less than 2.0x is considered healthy. Higher the ratio, better it is for owners; but at the same time, more risky for lenders Company has to service higher interest cost if it borrows more; in a recession, the company may be more vulnerable to default on its interest. Ratio analysis – Lenders’ perspective Interest coverage The ratio indicates the cushion the company has, to service its interest Interest coverage = EBITDA / Interest cost Higher the ratio, better it is for the lenders For healthy companies, Interest coverage ranges from 2.0x to 8.0x. Interest coverage < 1.0x indicates high stress, and probably default on interest payments. Ratio analysis – Lenders’ perspective Current ratio This is a commonly used ‘liquidity ratio’, used by banks that lend for ‘working capital’ Current ratio = Current Assets Current liabilities + Short term debt The ratio indicates the ratio of short term assets to short term liabilities. Indirectly, the ratio also indicates the proportion of long term assets funded by long term liabilities. For solvent companies, current ratio ranges between 1.2x to 2.0x Current ratio of < 1.0x indicates that the company may face liquidity problems, as more current liabilities / short term debt are maturing in the next one year, than the current assets that are maturing in the same period. Please read the commentary: http://www.crisil.com/Ratings/Commentary/CommentaryDocs/Comm on-myths-about-current-ratio_Dec05.pdf Ratio analysis – Equity investors’ perspective Equity investors, such as a Mutual Fund investing in shares, or an individual investor, or a Private Equity investor, may use the following ratios: Earnings Per Share (EPS) The Profit earned by the company for each share in the share capital of the enterprise EPS = Profit After Tax Number of Equity shares outstanding EPS is expressed in Rupees. This represents each shareholder’s claim in the profits of the company, for the relevant period (one year, one quarter, etc.) Two common sub-classification are Basic EPS and Fully Diluted EPS Basic EPS is computed based on no. of shares outstanding currently Fully Diluted EPS is computed assuming all ‘convertibles’ and ‘options’ are exercised fully. Ratio analysis – Equity investors’ perspective Price - Earnings Ratio (PE) The ratio of current market price of the equity share to the annual earnings per share PE = Current Market Price per share Earnings Per Share (EPS) PE is expressed in ratio or times. When EPS is negative, PE is meaningless. Two common sub-classification are Forward PE and Trailing Twelve Months (TTM) PE PE ratio has no meaning for unlisted companies as there is no ‘market price’ for these shares Broadly speaking, PE ratio is in the range of 5-12x during recession times and 10-25x during boom times. Forward PE is computed using EPS of the next financial year TTM PE is computed using EPS of last 4 quarters The ratio is also related to the growth in earnings that the company can generate in the next few years. Thank you!