Parth Verma I The Valuation School

CHAPTER 8

COMPANY ANALYSIS - FINANCIAL ANALYSIS

Learning objectives

• Role of financial analysis in fundamental analysis

• Consolidated and stand-alone results of a company
• How to read a balance sheet
• How to read a profit and loss account statement
• How to read a cash flow statement
• Importance of reading audit report and notes to accounts
• Financial statement analysis using ratios and commonly used
ratios
• Computation of Dupont analvsis
• Importance of peer comparison
• Need to track the equity expansion, dividend and earnings
history of the company
• Importance of studying the ownership structure and insider
transactions

INTRODUCTION TO FINANCIAL STATEMENTS

.

As per IndAS1, financial statements of listed companies need to include the following:

- Balance Sheet
- Profit and Loss Account Statement
- Statement of changes in shareholder's equity
- Cash flow statement
- Detailed Notes
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Companies have to provide comparable information for at least one prior period.

1. Standalone financial statements

represent the financial performance of an individual company without considering the

financials of its subsidiaries or related entities.

2. Consolidated financial statements

have a combined financial performance group of entities incorporating the financials of

the parent company and its subsidiaries.

BALANCE SHEET

• The balance sheet is a financial statement that shows a company's financial

position at a particular point in time.

• The balance sheet follows the fundamental accounting equation:

Assets = Liabilities + Shareholder's Equity

• It shows the company's financial health, liquidity, solvency, and ability to meet its
short-term and long-term debt.

BALANCE SHEET ITEMS

ASSETS :

• Assets are the B/S items that are expected to provide future benefits.
• Two types:

1) Non-Current Assets:

- Noncurrent assets are a company's long-term investments that have a useful life of
more than one year.
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• Examples: Property, Plant, and Equipment (PPE), under-construction assets, goodwill

from business acquisitions, intangible assets like copyrights and patents, joint venture
investments, and long-term financial assets.

2. Current Assets:

• Current assets are resources used for daily operations and expenses and can be
convertible to cash within a year.

• Examples: Inventory which is goods for sale or production, Cash and cash equivalents,
Receivables from the sale of goods, other current such as prepaid expenses, and short-
term investments.

LIABILITIES

• A liability is a financial obligation or debt that a company owes to others.

• Two types:

1) Non-Current Liabilities:

• Noncurrent liabilities are a company's long-term debt that has been fulfilled after one
year.
• Examples:

Long-Term Debt:
Debt repayable after a year including loans and bonds.

Lease liability:
Amount owed from leasing assets over a year.

Derivative instruments:
Derivative contract losses that are settled after a year.

Other non-current liabilities:

Obligations that do not fall into the other categories.

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2) Current Liabilities:

• Current liabilities are a company's financial obligations or debts that must be paid
within a year.
• Examples:

Payables: Deferred revenue:

Owed to suppliers for goods/services. Earned but not received revenue.

Short-term debt: Advanced from customers:

Repayable within a year. Prepayments by customers.

Short-term provisions: Unpaid & accrued expenses:

Expected within a year. Incurred but unpaid expenses.

Current portion of long-term liability:

Long-term debt due in a year.

EQUITY

• Equity is the ownership stake held by shareholders after deducting all the liabilities
from total assets.

• Equity = Assets - Liability

• Components of Equity:

Share capital: Capital and revaluation reserve:

Face value of the company's issued shares. Surplus from asset value increase, not
for dividends.
Share premium:
Amount paid over share face value. Minority interest:
Subsidiary equity owned by non-
Retained earnings: parent shareholders, seen in
Total undistributed company earnings. consolidated statements only.

General reserve:
reserved funds for future use.
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BALANCE SHEET METRIC

The balance sheet may not reflect the true value of assets due to accounting conventions.
Analysts need to calculate additional following metrics:

1) Total Debt:

• Total debt = Long-term debt + Current portion of long-term debt + Short-term debt +
Financial lease obligations + Accrued interest.

2) Working Capital:

• Represents the funds available for day-to-day operations.

• WC= Current Assets - Current Liabilities

3) Core Working Capital:

• It is an adjusted working capital calculated using assets and liabilities from core
operations only.

• Core working capital = Inventory + Trade Receivables - Trade Payables.

PROFIT & LOSS ACCOUN T (P/L)

• The Profit and Loss (P/L) statements provide a company's financial performance within
a specific period.

• In India, the format is prescribed by the Companies Act, 2013 under Schedule III.
However, under IndAS 1, it should include other comprehensive income.

P/l lINE ITEMS :

1) Revenue:
Revenue is the income earned from selling goods and services from core operations or related
sources.
2) Other income:
Other income covers non-operating earnings like investment returns or asset sales.

3) Expenses:
Expenses include operational costs like employee expenses, depreciation and amortization,
raw materials costs, finance costs, stock-in-trade purchases, and changes in finished
goods inventory.

4) Income from equity-accounted entities:

This refers to the company's share of profit of an entity which is accounted under the
equity method.

5) Exceptional items / non-recurring items:

These are unusual income or expenses not part of regular business operations, like losses
due to natural disasters or one-time regulatory fees.

6) Tax:
Tax expenses in an Indian company include Current tax, Minimum Alternate Tax (MAT), and
Deferred tax.

7) Minority interest:
This refers to the amount of profits of a subsidiary company that belongs to external
shareholders of the subsidiary.

8) Earnings per share (EPS):

EPS is the net income divided by the average number of outstanding shares. There are two
types of EPS Basic EPS and Diluted EPS.

9) Other comprehensive income (OCI):

Income or expenses that are excluded from the profit and loss account.

KEY METRIC FROM P/L :

1) Gross Profit:
It is calculated by reducing the cost of goods sold from revenue and refers to the surplus
that a company can use to meet its fixed expenses.

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2) Earnings Before Interest Tax Depreciation and Amortization (EBITDA):
It measures a company's earnings from its core operations before considering the impact of
interest expenses, taxes, depreciation, and amortization.

3) Earnings Before Interest and Taxes (EBIT):

It reflects a company's profitability from its core operations by excluding the impact of
interest expense and income tax from its earnings.

4) Adjusted profit after tax:

It represents the company's net profit adjusted for exceptional or non-recurring items.

5) Effective tax rate:

It is the actual rate of tax a company pays on its taxable income.

STATEMENT OF CHANGES IN SHAREHOLDER’S EQUITY

It tracks how a company's ownership has changed over time due to various transactions
such as share issuances, dividends, and profits.

BASICS OF CASH FLOW

Cash flow refers to the movement of money into and out of a business.

1. Operating cash flows:

Day-to-day cash from business activities.

2. Investing cash flows:

Cash from buying/selling assets.

3. Financing cash flows:

Cash from raising/paying off capital or debts.

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NOTES TO ACCOUN TS

It provides details of the accounting policies used by the company and additional information
about the items reported in financial statements. few things to look for in notes to accounts:

1. Accounting policies:
Details how a company treats items in financial statements.

2. Contingent liabilities:
Potential liabilities arising from uncertain future events.

3. Off-Balance Sheet Items:

Assets or liabilities not on the balance sheet, like operating leases or derivative contracts.

IMPORTANT POINTS TO KEEP IN MIND WHILE LOOKING AT FINANCIALS

• Understanding terminology makes numbers more understandable.

• Numbers can be manipulated with assumptions or creative accounting.
• Changes in accounting periods can confuse comparisons.
• One-off items can significantly impact profits, altering analysis.
• Consistent performance over time is ideal for investors.

READING AUDIT REPORTS TO UNDERSTAND THE QUALITY OF ACCOUN TING

• Auditors verify accuracy but can't guarantee it due to high transaction volume.

• They assess control systems and adherence to accounting standards.

• Reports can be clean (no issues), disclaimer (missing info), or qualified (lack of accuracy).

• Analysts must check the auditor's report for concerns while reviewing financial
statements.

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FINANCIAL STATEMENT ANALYSIS USING RATIOS

Comm'only used ratios:

1) Profitability Ratios:

EBITDA MARGINS

• This ratio is useful in finding out the profitability of the company purely based on its
operations and direct costs.

• EBITDA Margin = EBITDA / Net Sales

PAT MARGINS

• Measures a company's ability to convert sales into profits after accounting for all expenses
and taxes.

• PAT Margin = PAT/ Net Sales

2) Return Ratios:

RETURN ON EQUITY (ROE)

• Measures a company's efficiency in generating profits from shareholders' equity.

• ROE = PAT/ Net-worth

w

(Networth = Equity Capital + Reserves & Surplus)

RETURN ON CAPITAL EMPLOYED (ROCE)

• Measures a company's profitability and efficiency in utilizing its capital.

• ROCE = EBIT/ Capital Employed

~

(Capital Employed = Total Assets – Current Liabilities or Total Equity + Total Debt)
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3) Leverage Ratios:

DEBT TO EQUITY (D/E RATIO)

• measures a company's leverage by comparing its total debt to its shareholders' equity.

• D/E Ratio = Long-Term Debt / Net-worth

INTEREST COVERAGE RATIO

• measures a company's ability to pay interest from its earnings.

• ICR = EBIT / Interest Expense

4) Liquidity Ratios:

CURRENT RATIO

• measures the company's liquidity.

• Current Ratio = Current Assets / Current Liabilities

QUICK RATIO

• assesses a company's ability to cover short-term liabilities with its most liquid assets,
excluding inventory.

• Quick Ratio = (Current Assets – Inventories) / current liabilities

5) Efficiency Ratios:

ACCOUNTS RECEIVABLE TURNOVER

• This indicates how fast a company converts its sales into cash.

• Accounts Receivable Turnover = Revenue / Accounts Receivable

 ACCOUNTS PAYABLE TURNOVER

• This indicates how much of a company's purchases are on credit.

Accounts Payable Turnover = Purchases / Accounts Payable

ASSET TURNOVER

• This indicates how many times the assets are put to use to generate revenues for the
business.

Asset Turnover = Net Sales / Total Assets

INVENTORY TURNOVER

• This ratio gives the number of times inventory is rolled over by a company.

Inventory Turnover = Sales / Inventory

DUPONT ANALYSIS

It is a financial technique that spits a company's return on equity (ROE) into various
components to understand its drivers of profitability.

FORECASTING USING RATIO ANALYSIS

• Analyzing ratios helps understand financial metrics' behavior and forecast the future but
past performance doesn't guarantee future results.

• Analysts need to adjust forecasts based on changing scenarios.

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PEER COMPARISIONS

Peer comparison assesses a company's financials against its industry rivals.

• Ratios like profit margins, asset turnover, and leverage are used.
• It aids investors in gauging a company's performance and spotting investment
chances.

OTHER ASPECTS TO STUDY FROM FINANCIAL REPORTS

• Equity History: Analyze fund-raising, impact on shareholder value, and dilution via
equity models.

• Dividend & Earnings: Check dividend policy, profit distribution, yield, and stability for
investment insight

• Corporate Actions: Track dividends, bonuses, splits, and rights issues affecting share
prices.

• Insider Trades: Monitor insider buying/selling; insider buying often signals future
profits.

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