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Analysis of Financing Liabilities(Financial Statement Analysis) : Analysis of Financing Liabilities(Financial Statement Analysis) Prepared by: CA Tarun Mahajan Presented by: CA Tarun Mahajan

Slide 2 : Presented by: CA Tarun Mahajan

Slide 3 : A shift from Operating liabilities to Financing Liabilities indicates beginning liquidity crises Presented by: CA Tarun Mahajan

BONDS : BONDS It is a contract between the borrower and the lender that obligates the bond issuer to make payment to the bondholder over the life of the bond. Periodic payment of Interest and repayment of principle at the time of maturity. Coupon rate payment = Coupon rate x Face value of the bond. Presented by: CA Tarun Mahajan

Effect due to changes in market rates : Effect due to changes in market rates When market rates rise = Bond value decreases. When market rates Fall = Bond value increases. When market rate equals the coupon rate = Bond trades at par. Presented by: CA Tarun Mahajan

Slide 6 : CR = Coupon Rate MR = Market Rate Presented by: CA Tarun Mahajan

Slide 7 : Presented by: CA Tarun Mahajan

Slide 8 : Note that Zero coupon bond will highly overstate Cash flows from operations Presented by: CA Tarun Mahajan

Other issues : Other issues Convertible bonds: if the market value of equity shares is higher than the conversion price than treat these as equity for analysis purpose Exchangeable bonds: debt value ratio reduces after exchange For the purpose of analysis market value of debts is better then book value. Note that All the US firms are required to disclose market value of their debts. Presented by: CA Tarun Mahajan

LEASES & OFF-BALANCE SHEET DEBT : LEASES & OFF-BALANCE SHEET DEBT Presented by: CA Tarun Mahajan Presented by: CA Tarun Mahajan

What is lease? : What is lease? A lease is an agreement whereby, owner of an asset (Lessor) transfers the right to use his asset in favour of another person (lessee) for periodic consideration (lease rent). Presented by: CA Tarun Mahajan

TYPES OF LEASES : TYPES OF LEASES L E A S E Operating Capital/Finance Lease Lease Presented by: CA Tarun Mahajan

Slide 13 : Finance lease: It is a lease under which lessor charges lease rent in such manner the over the life of the asset, he is able to recover the entire cost of the asset plus a reasonable return. Hence it is more a finance (loan) and less a lease Operating lease: it is lease which is not a finance lease. Presented by: CA Tarun Mahajan

Criteria to classify Lease : Criteria to classify Lease The title of the leased asset is transferred to the lessee at the end of the lease term. Presence of bargain purchase option, which would enable the lessee to purchase the asset at cost lower than the fair market value, once the option becomes exercisable. The lease period is at least 75% of the asset’s economic life. The present value of the minimum lease payment is equal to or greater than 90% of fair value of the asset. (The discounting rate used is lower of interest rate implicit in the lease or lessee’s borrowing rate ) If any one of the above mentioned condition is met then lease is a capital lease or else a operating lease. Presented by: CA Tarun Mahajan

Leasing vs. Purchasing : Leasing vs. Purchasing Presented by: CA Tarun Mahajan

Reporting by Lessee : Reporting by Lessee Operating Lease: At the inception of the lease, no entry is made. During the term of the lease rent expense is charged to the income and to cash flow from operations. Foot note disclosure of the lease payments for each of the next five years is required. Presented by: CA Tarun Mahajan

Capital Lease : Capital Lease At the inception of the lease the present value of the minimum lease payment is recognized as an asset and as a liability on the lessee’s balance sheet. During the term of the lease, the leased asset is depreciated on the income statement. The lease payment is separated into interest expense and principle payments on the lease liability. Cash flow from operations is reduced by the interest expense and cash flow from financing is reduced by the principle payment on the lease liability. (We can conclude that we have to treat it as an purchase of asset out of borrowed amount) Presented by: CA Tarun Mahajan

Slide 18 : Capital lease presents a brighter picture of financal statements as compared to operating lease. Presented by: CA Tarun Mahajan

Effects of Lease method on Financial statements : Effects of Lease method on Financial statements Presented by: CA Tarun Mahajan

Effect on Ratios : Effect on Ratios Presented by: CA Tarun Mahajan

Off-Balance sheet Items : Off-Balance sheet Items Operating lease is the most prevalent type of off-balance sheet financing. Take-or-pay contract or throughput arrangement: Here the purchasing firm commits to buy a minimum amount of input over time. Neither the asset or the borrowings are recognized on the balance sheet. Sale of receivables with recourse: Here the firm will sell its receivables but will continue to service its receivables & transfer any collections to the new owner of those receivables. These transactions are recorded as sales. This will decrease receivables and increase operating cash flow. Presented by: CA Tarun Mahajan

Off-Balance sheet Items : Off-Balance sheet Items Operating lease is the most prevalent type of off-balance sheet financing. Take-or-pay contract or throughput arrangement: Here the purchasing firm commits to buy a minimum amount of input over time. Neither the asset or the borrowings are recognized on the balance sheet. Sale of receivables with recourse: Here the firm will sell its receivables but will continue to service its receivables & transfer any collections to the new owner of those receivables. These transactions are recorded as sales. This will decrease receivables and increase operating cash flow. Presented by: CA Tarun Mahajan

Off-Balance sheet items (cont..) : Off-Balance sheet items (cont..) Financial subsidiaries: Parent companies with less than 50% control over the subsidiaries are not consolidated. Investments in affiliated firms: Firms may get operating control by this. Joint ventures: They provide economies of scale and disperse risks. Presented by: CA Tarun Mahajan

Classification of lease by Lessor : Classification of lease by Lessor The lessor must classify the lease as capital lease if any of the previous four criteria hold and additional two conditions. The collectability of lease payment is predictable. There are no significant uncertainties about the amount of unreimbursable costs yet to be incurred by the lessor. Presented by: CA Tarun Mahajan

Sales Type Lease : Sales Type Lease If this lease is the capital lease an the lessor is the dealer or the seller of leased equipment, then the lease is a sales type lease on the books of the lessor. It means that the implicit interest rate is such that the present value of the minimum lease payments is the selling price of the leased asset. Interest revenue is equal to the implicit interest rate times the net lease receivable at the beginning of the period. Presented by: CA Tarun Mahajan

Accounting for Sales type Lease : Accounting for Sales type Lease First the sale is recorded as the present value of the lease payments, with cost of goods sold being equal to the net difference between the cost of the asset & the present value of the estimates salvage value. Profit is shown in the Income statement. The same amount is reported as operating cash inflow and investment cash outflow. Next the asset account called the “net investment in the lease” Which is the present value of all future lease payments and estimated salvage value. Presented by: CA Tarun Mahajan

Accounting for Direct financing lease : Accounting for Direct financing lease There is no sale or manufacturing profit in a direct financing type lease, so the only type of profit reported is interest income. Compared to a sales type lease, direct financing lease will result in lower Net Income, lower retained earning and lower equity by the amount of profit on sale that is recorded for sales type lease. Presented by: CA Tarun Mahajan

ANALYSIS OF FINANCIAL STATEMENTS : ANALYSIS OF FINANCIAL STATEMENTS Presented by: CA Tarun Mahajan

Common size Income statement & Balance sheet : Common size Income statement & Balance sheet Common size Income statement – Each income statement variable is taken as a percentage of “sales” Common size Balance Sheet – Each Balance sheet item is taken as a percentage of “total assets” The benchmark variable in each case is taken as 100% and the other comparative variables as a proportion to the total value. Presented by: CA Tarun Mahajan

Example of comparative statements : Example of comparative statements Income statement: Balance Sheet: Sales - $10000 Total assets $20000 Purchases - $6500 Current liabilities - $4500 Inventory - $3000 Equity - $12000 Administration expenses - $2500 Debt - $8000 Sales = 100% Total Assets = 100% Purchases = 65% Current Liabilities = 22.5% Inventory = 30% Equity = 60% Admn Exps. = 25% Debt = 40% Presented by: CA Tarun Mahajan

What is Ratio Analysis? : What is Ratio Analysis? Ratio = One Variable Other Variable Ratio is a meaningful comparision of two data. It is used to evaluate the potential areas of strength and weakness of the company. It serves to make a comparative assessment among different companies on various parameters. Ratios’ may be pure Balance sheet ratios, Income statement ratios or Mixed ratios. Presented by: CA Tarun Mahajan

Slide 32 : Types of Ratios Activity Ratios Liquidity Ratios Other Ratios Solvency Ratios Profitability Ratios Presented by: CA Tarun Mahajan

Activity Ratios : Activity Ratios These are also known as Turnover ratios. These are Mixed ratio. In the numerator of any turnover ratio we put either the sales or any equivalent term. While in the denominator we put some balance sheet item. In any mixed ratio B/s items are kept average, i.e., (opening+closing)/2. These ratios measure performance of a company. Very Higher ratio indicates overutilization of assets and vice versa. Presented by: CA Tarun Mahajan

TURNOVER RATIOS : TURNOVER RATIOS Turnover ratios are measured on basis of times. Presented by: CA Tarun Mahajan

CALCULATION OF PERIODS : CALCULATION OF PERIODS Receivables collection period = 365 receivables turnover Indicates average no. of days that customers take make the payment. Inventory processing period = 365 inventory turnover Indicates the amount of time the capital gets tied up in inventory.# Payables payment period = 365 payables turnover Indicates time available to us for making payment to creditors/suppliers of materials. Presented by: CA Tarun Mahajan

CASH CONVERSION CYCLE : CASH CONVERSION CYCLE Receivables Collection period Inventory Collection period Payables payment period This cycle shows us the amount of time it takes for our raw materials/inputs to get converted in to cash. Presented by: CA Tarun Mahajan

LIQUIDITY RATIO : LIQUIDITY RATIO Current Ratio = Current Assets Current Liabilities Quick Ratio = Current assets – inventory Current Liabilities Numerator for quick ratio would generally include: Cash, marketable securities & account receivables. Cash Ratio = Cash + Marketable Securities Current Liabilities Defensive Interval = Cash + Marketable Securities + Receivable Average Daily Expenditures The higher these ratios, it is more likely that the company will be able to pay its short term obligations. Presented by: CA Tarun Mahajan

SOLVENCY RATIOS : SOLVENCY RATIOS Debt to equity ratio = Total debt Total equity Here total debt may include long term debt plus interest bearing short term debt. Some analyst also include non interest bearing current liabilities also. Debt to capital = Total debt Total Debt + Total Shareholders’ equity Debt to Asset = Total Debt Total Assets Higher the above ratios higher the financial risk. But lower than optimum ratio may result in lost opportunity of trading on equity. Presented by: CA Tarun Mahajan

SOLVENCY RATIOS : SOLVENCY RATIOS Financial Leverage = Average Total Assets Average Total equity Interest Coverage Ratio = Earning before interest & Tax Interest Payment Fixed Charge Coverage Ratio = EBIT + Lease Payment Interest + Lease Payment This ratio is more meaningful for the companies that lease a large portion of their assets. Poor coverage ratios may lead to insolvancy. Presented by: CA Tarun Mahajan

PROFITABILITY RATIOS : PROFITABILITY RATIOS Gross margin ratio = gross profit sales Net margin ratio = Net profit sales Operating margin ratio = Operating profit sales Return on equity ratio = Net income equity Return on Common Equity = Net income – Preferred Dividend Common Equity Presented by: CA Tarun Mahajan

Profitability Ratios : Profitability Ratios Return on Assets (ROA) = Net Income + Interest expense (1-t) Average Total Assets Return on Total capital = EBIT Average Capital Employed Profitability ratios are preferable on higher side. Higher ratios means better performance of the company hence higher stock price. Presented by: CA Tarun Mahajan

DUPONT ANALYSIS : DUPONT ANALYSIS The Dupont method is used to decompose the return on equity (ROE) formulae, It helps us to find exactly what factors are driving ROE and thereby take suitable measures to rectify them. There are 2 approaches for Dupont analysis: traditional approach & the extended version. Traditional approach: ROE = net income sales assets sales assets equity i.e. (net profit margin) (asset turnover) (equity multiplier) Example: Assets 300, equity 100, sales 600, net income 48. ROE = 8% x 2 x 3 = 48% Presented by: CA Tarun Mahajan

DUPONT ANALYSIS (Extended Version) : DUPONT ANALYSIS (Extended Version) ROE = (Operating Profit Margin x Asset Turnover – Interest Expense) x Financial Leverage x Tax Retention rate Presented by: CA Tarun Mahajan

DUPONT ANALYSIS (Another Extended Version) : DUPONT ANALYSIS (Another Extended Version) ROE = 0.70 x 0.70 x 0.20 x 2 x 1.25 ROE = 24.5% Presented by: CA Tarun Mahajan

CASH FLOW RATIOS : CASH FLOW RATIOS Cash flow to long term debt ratio: CFO Long term debt + PV of operating leases. Cash flow to total interest bearing debt: CFO long term debt + current interest bearing liabilities Where: CFO = cash flow from operations. Presented by: CA Tarun Mahajan

Ratios measuring Business Risk : Ratios measuring Business Risk CV Sales = Standard Deviation of Sales Means Sales CV Operating Income = Standard Deviation of Operating Income Mean Operating Income CV Net Income = Standard Deviation of net Income Mean Net Income Higher the ratios, higher the business risk and vice versa. Hence this ratios are preferable on lower side. Presented by: CA Tarun Mahajan

GROWTH RATIO : GROWTH RATIO Retention ratio = profits retained OR 1 – payout ratio Net profit Dividend payout ratio = dividend declared OR 1 – retention ratio Net profit Sustainable growth rate = retention ratio x ROE Where, ROE = return on equity. Presented by: CA Tarun Mahajan

LIMITATIONS OF RATIO ANALYSIS : LIMITATIONS OF RATIO ANALYSIS Ratios only make sense when they are compared to some other variable and not on isolated basis. Different companies may be using different accounting conventions which make ratio comparison a difficult job. Difficult to find comparable industry ratios when analyzing companies that operate in multiple industries. Window dressing of financial statement data. Presented by: CA Tarun Mahajan

Slide 49 : Evaluating Accounting Policies Accounting Policies Conservative Aggressive Revenue recognition After sale, when risk has At sale, although risk passed to buyer remains Depreciation choice Accelerated over shorter Straight-line over longer period period Inventory method LIFO (assuming prices are FIFO (assuming prices are rising) rising) Amortization of Over a shorter period Over 40 years goodwill Estimation of warranty High estimate Low estimate / bad debt expense Treatment of Expense Capitalize advertising Loss contingencies Accrue loss Footnote only 2 8.38.b Presented by: CA Tarun Mahajan

INTERNATIONAL STANDARD CONVERGENCE : INTERNATIONAL STANDARD CONVERGENCE Presented by: CA Tarun Mahajan

Objective of Convergence : Objective of Convergence Worldwide financial statements are prepared using different accounting standards. For example US uses US GAAP while others use IFRS and so on. So that every financial statement is comparable on a global basis there has to be a common standard to regulate preparation and presentation of financial statements. Accordingly there is a severe need to converge international standards to facilitate comparability of financial statements of different companies in different part of the world. Presented by: CA Tarun Mahajan

International framework : International framework Process followed by FASB in developing standards: Advisory task force of experts studies problem and comes up with a discussion document Public hearing is held and comments are collated FASB analyzes comments FASB board meets in public view to discuss the issue Proposed solution is drafted and additional comments are invited FASB board discussed comments Final statement of FASB standards are released outlining the new standard International considerations: International organization of security commissions – listings, technical issues on securities transactions International accounting standards board – non-governmental; IAS standards EEC directives for harmonizing standards in Europe SEC’s influence in setting international standards due to the listing of international companies on US stock exchanges Multi-jurisdictional disclosure system: agreement between US and Canada to issues securities in each other’s countries when compliant with domestic GAAP Presented by: CA Tarun Mahajan

Remarkable differences under US GAAP and IFRS : Remarkable differences under US GAAP and IFRS Presented by: CA Tarun Mahajan

Remarkable differences under US GAAP and IFRS : Remarkable differences under US GAAP and IFRS Presented by: CA Tarun Mahajan

Classification & Treatment of investments : Classification & Treatment of investments Presented by: CA Tarun Mahajan