From Business Activities to Financial Statements

Four key components of effective financial statement analysis

Business strategy analysis Accounting analysis Financial analysis Prospective analysis

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ICFAI Business School

Business Strategy Analysis

Business strategy analysis

Prerequisite for grounding the subsequent accounting and financial analysis in business reality Allows identification of the firms profit drivers and key risks Enables analyst to assess the sustainability of the firms current performance and Make realistic forecasts of future performance

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ICFAI Business School

Business Strategy Analysis

Value is created when a firm earns a return on its investment in excess of the cost of capital What determines whether a firm can accomplish its goal of earning ROI > COC? 1. Choice of industry/industries in which the firm operates (industry analysis) 2. Manner in which the firm intends to compete with other firms in the industry/industries (competitive strategy analysis) 3. The way in which the firm expects to create and exploit synergies across the range of businesses in which it operates (corporate strategy analysis)

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ICFAI Business School

Accounting Analysis
Objective is to evaluate the degree to which a firms accounting captures its underlying business reality. Steps involved 1.Identify key accounting policies 2.Assess accounting flexibility 3.Evaluate accounting strategy 4.Evaluate the quality of disclosure 5.Identify potential red flags 6.Undo accounting distortions
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The signs

When companies are in danger of showing slightly negative earnings, They locate enough discretionary items To squeeze out marginally improved results. If a company suffered too big a decline in profits, It has an incentive to take a big bath i.e Take the hit entirely in one go
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Identify Potential Red Flags

Unexplained changes in accounting, especially when performance is poor. Unexplained transactions that boost profits. Disproportionate increases in accounts receivables in relation to sales. Disproportionate increases in inventories in relation to sales. An increasing gap between a firms reported income and its cash flow from operating activities.
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Identify Potential Red Flags

An increasing gap between a firms reported income and its tax income. Large fourth quarter adjustments Related party transactions or transactions between related entities.

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ICFAI Business School

Financial Analysis
Two principal tools 1. Ratio Analysis Involves assessing how various line items in the firms financial statements relate to one another. 2. Cash Flow Analysis Involves assessing the firms liquidity and how the firm is managing its operating, investing and financing cash flows.
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Drivers of a firms profitability and growth

Growth and Profitability

Product market strategies

Operating Management Investment Management Managing Working Capital & Fixed Assets
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Financial market Policies

Financing Decisions Dividend Policy

Managing Revenue & Expenses

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Managing Liabilities & equity

Managing payout

Measuring Overall Profitability

Starting point is Return On Equity (ROE) ROE = Net income Shareholders funds ROE - a comprehensive indicator of a firms performance Indicates how well managers are employing shareholders funds to generate returns

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ICFAI Business School

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Measuring Overall Profitability

A comparison of ROE with cost of capital gives an understanding of value of the firm and the path of future profitability Over time, ROE tends to be driven to normal level by competitive forces

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ICFAI Business School

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Decomposing Profitability

Traditional approach
ROE = ROA x Financial Leverage = Net income x Assets Assets Equity

How much profit the company is able to generate for each rupee of assets invested

How many rupees of assets the firm is able to deploy for each rupee invested by Its shareholders

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ICFAI Business School

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Decomposing Profitability
Decomposing Return On Assets ROA = Net income x Sales Sales Assets

How much profit the co. is able to generate for each rupee of sales Therefore, ROE = Net Income Sales
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How many rupees of sales the firm is able to generate for each rupee of its assets
Sales Assets x Assets Equity
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Decomposing Profitability

Illustration
Comparative analysis of Firm A with Industry Average Firm A Industry Average Current Ratio 2.43 2.60 Debt Equity Ratio 1.94 2.00 Avg.Collection Period 45 days 40 days Total Asset Turnover 1.33 1.52 Net Profit Margin 5% 5% ROE 19.6% 16.5% To what would you attribute the higher ROE Performance of Firm A?
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Decomposing Profitability
Illustration (Contd) Firm A ROE = NPM x NS x TA NS TA E 19.60 = 5 x 1.33 x 2.94 Industry 16.50 = 5 x 1.52 x 2.17

The better ROE is largely because of higher financial leverage. It could have been even better had the asset turnover also been on par with industry.
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Three drivers of ROE

Net Profit Margin (NPM) Asset Turnover Financial Leverage Ratio Co. A 2001 4.1% 1.61 6.6% 2.37 15.6% Co. A 2000 3.85% 1.68 6.5% 1.95 12.6% Co. B 2001 5.3% 2.89 15.3% 2.25 34.5%
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Illustrative data for two companies

NPM X Asset Turnover =Return on Assets X Financial Leverage =Return on Equity

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ICFAI Business School

Decomposing Net Profit Margins

Net Profit Margin (NPM) shows the profitability of the companys operating activities. Further decomposition of NPM helps to

Assess the efficiency of the firms operating management

Popular

tool used in this analysis is

Common sized income statement in which All line items are expressed as a % of sales.

Helps
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to compare trends over time and across firms in the industry.

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Decomposing Net Profit Margins

Allows the following questions to be asked Are the companys margins consistent with its stated competitive strategy? Are the companys margins changing? If so, what are the underlying causes?

Changes in competition? Changes in input costs? Poor overhead cost management? What are the business activities driving these costs? Are these activities necessary?
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Cash Flow Analysis

The purpose of cash flow analysis is to disentangle from financial statements based on historical accounting principles, the actual movements of cash, in terms of its sources and uses.

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Cash Flow Analysis

Cash flow analysis provides an indication of The quality of information in Income statement and balance sheet

Earnings can be manipulated by managements choice of accounting policies, whereas Cash flow cannot be changed by any accounting policy.

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Cash Flow Analysis

Cash flows are classified into three categories

Cash flow from Operations Cash generated from the sale of goods and services after paying for the cost of inputs and operations Cash flow related to investment activities Cash paid for capital expenditures, inter corporate investments, acquisitions and cash received from sale of fixed assets Cash flow related to financing activities Cash raised from or paid to shareholders and lenders.
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Cash Flow Analysis

Why does net income differ from operating cash flows? Because revenues and expenses are accounted on accrual basis. Two types of accruals embedded in net income

Current accruals e.g., credit sales, unpaid expenses which result in change in current assets Non current accruals e.g., depreciation Adjustments have to be made for both these accruals Non-operating gains included in net income eg., profits from sale of fixed assets.
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To derive cash flow from operations from net income

In addition, adjustments have to be made for

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Cash Flow Analysis

Cash flow analysis can be used to address questions like Is the cash flow from operations positive or negative? If negative, why?

Is it because the company is growing? Is it because the operations are unprofitable? Is it having difficulty managing its working capital properly?

Can the company meet its short term financial obligations such as interest payments, from its operating cash flow? Can it continue to meet these obligations without reducing its operating flexibility?
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Cash Flow Analysis

How much cash did the company invest in growth? Are these investments consistent with its business strategy? Did the company use internal cash flows to finance growth? Or Did it rely on external financing? Did the company pay dividends from internal free cash flow? Or did it have to rely on external financing? If the company had to fund its dividends from external sources Is the companys dividend policy sustainable?
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ICFAI Business School

Cash Flow Analysis

What type of external financing does the company rely on? Equity, short term debt or long term debt? Is the financing consistent with the companys overall business risk? Does the company have excess cash flow after making capital investments? Is it a long term trend? What plans does the management have to deploy the free cash flow?

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ICFAI Business School

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Cash Flow From Operations

Factors affecting firms ability to generate positive cash flow from operations Healthy firms, in steady state should generate more cash from customers than they spend on operating expenses Growing firms, esp. those investing cash in R&D, marketing and advertising may experience negative operating cash flow. Growing firms also invest additionally in working capital items

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Cash Flow From Operations

Net investments in working capital are a function of Firms credit policies (accounts receivables) Payment policies (payables, prepaid expenses and accrued liabilities) and Expected growth in sales (inventories)

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Cash Flow relating to Investments

Any positive operating cash flow

After making operating working capital investments Allows firm to pursue growth opportunities

If internal cash flows are not adequate firm has to rely on external funds Both costs and benefits exist in funding growth internally

Internal cash flows may be used for unprofitable investments Long term risky investments cannot be undertaken with external funds As it is difficult to communicate to the capital markets. The benefits from such investments

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ICFAI Business School

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Cash Flow relating to Financing

Any excess cash flow after long term investments

Is free cash flow available for both debt and equity holders Additional funds to meet interest and debt repayment obligations Or cut some of their investments in working capital or long term assets Or issue additional equity

Firms with negative free cash flow have to borrow

Such a situation is financially risky. Cash flow after payments to debt holders is

Free cash flow available to shareholders They are borrowing, which may not be prudent

If firms pay dividends despite negative free cash flow,

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ICFAI Business School

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Prospective Analysis

First step is forecasting Serves to summarize the forward looking view that emerges from

business strategy analysis, accounting analysis and financial analysis not just earnings forecast but also, cash flows and balance sheets

Best approach is to do it comprehensively,

Approach involves line by line analysis

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ICFAI Business School

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