Transcript Business Plan 2008

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
Manufacturing activity:
Selling price > Cost of purchase + conversion costs
Buying

Services
Processing
Selling
Price for service > Cost of providing the service
Servicing
Stakeholders

We need various entities to come together to
run an enterprise and generate returns. Who
are the stakeholders in a business?

Investors







Equity holders – majority holders, minority shareholders
Debt holders including banks and financial institutions
Management
Employees
Suppliers
Customers
Community, Taxman
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
Private Ltd.
Partnership
Company
Public Ltd.
Closely held
Publicly held
Various forms of enterprise

Proprietary business – owned by single owner


Partnership firm – owned by two or more owners


No difference between the obligations of the business and the obligations of the
individual.
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



Borrowed funds



Equity Capital
Reserves and Surplus

Long term debt
Short term debt

Creditors
Current liabilities and Provisions
Fixed Assets

Land and building

Plant and Machinery
Investments

Working capital

Assets

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


The Asset side represent the various uses of funds by an
enterprise




These are the liability of the enterprise to the providers of these
funds
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




In Asset side, long term uses are





Equity capital
Reserves and Surplus
Long term borrowings
Fixed Assets
Investments
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
Depreciation
Earning before interest and taxes (EBIT)
Less
Interest payment
Profit before taxes (PBT)
Less
Taxes
Profit after tax (PAT)
Less
Dividend
Retained earnings
Inside the P&L Account
Typical items under ‘Revenue from business’
 Sales revenue
 Other related income


Non-operating income



Scrap sales, Duty drawback
Dividends and interest
Rent received
Extra-ordinary income


Profit on sale of assets / investments
Prior-period items
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


Cash expenses Vs. Non-cash expenses



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
Recurring income Vs. one-time income



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
Cashflow Statement

What is a Cashflow Statement?



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
What are its components?

Three key components of Cashflow Statement are
Cashflow from Operating Activities

Represents the cash generated from the operations of the enterprise – a
measure of ‘cash profit’ from the operations
Cashflow in Investing Activities

Represents the deployment of cash in various assets such as fixed
assets, investments, etc.
Cashflow from Financing Activities

Represents the net cash raised in the form of capital such as equity
capital, borrowed funds, etc.
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


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.
Cash flow statement, like balance sheet, provides a self-check point


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.
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.
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




Net 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%
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




Forward PE is computed using EPS of the next financial year
TTM PE is computed using EPS of last 4 quarters
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.

The ratio is also related to the growth in earnings that the company
can generate in the next few years.
Thank you!