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Module 1: Ratio and Financial Statement Analysis

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Namaste.To all of you, I am very happy that we have reached the last 40th lecture of this course.So, we were meeting regularly for last 2 months, I am hoping that you would have found thelectures as well as the assignments very much useful for your learning process.Now, this being a last lecture we will take a brief recap of whatever we have discussedwhatever you have learnt in the course, we would also think of what can be done furtherfor strengthening the learning and also what are the avenues for future learning.I know it is a mix of variety of students or participants of different type, becausethis course has registration of students from different faculties; there are engineeringstudents, there are management students, there are non-commerce students like art or sciences,there are also few commerce students, there are some entrepreneurs or housewives and soon.So, it is going to be useful for almost everybody in the society if you have a basic knowledgeof accounting, which we have tried to discuss in the class.So, we started with discussion on what is meant by accounting.If you remember we discussed that accounting is a language of business.So, we come out with financial statements based on transactions.First we record transactions then we summarize and the reports which are available are knownas financial transactions giving us the financial reports.It is not only restricted to business entities it is equally useful for non-profit organizations,for government organizations.In fact, they are also useful for households.Just to know the expenses and income of a household also if proper financial statementsare prepared then that that becomes advantageous.Then we went on to discuss three important financial statements we started with balancesheet.So, balance sheet is a statement which gives the financial position as at a particulardate.We can make balance sheet as on any date, but normally it is prepared at the end ofthe quarter may be at the end of 3 months or sometimes at the end of 1 year.There is a specific format for the balance sheet.So, you have got assets and liabilities; assets represents the resources which we use forbusiness like cash, like land and building, like patents like software or hardware andso, on they are required to be funded by somebody those are the sources of funds which we callthem as liabilities.There are two major types of liabilities in the category of NCL that is noncurrent liabilitiesor long term liabilities and then there are current liabilities.The non-current liabilities in turn can be of two types you have owners funds which isalso known as equity or net worth and then you will have variety of other non-currentliabilities which mainly consist of borrowings of debt.So, we discussed about the balance sheet.Now, analysis of balance sheet is very much useful because we come to know the strengthsand the weaknesses of the business in the form of assets and liabilities.Though I am using the term business it is not just for business entities, if you studythe balance sheet for a new organization say a trust or a school or for government organizationsalso, you come to know: what are the resources which are being used for running those activitiesand who are funding those resources.So, we have seen first the basic formats, we have also seen the format of balance sheetas per company law.Next we moved to profit and loss account.We all know profit and loss account or income statement is an important statement becauseit list out all the incomes.So, the revenues generated from where the money is coming and then we relate it withthe expenses; in the expenses all category of expenses will be listed.So, first you will have operating expenses like purchases, like manufacturing expenses,then you may have something like rent, advertising, marketing expenses, you will also have financecost, then non-cash cost like depreciation, that give you the first level of profit whichcan be called as a operating profit.If you do not consider finance cost, then from operating profit you deduct finance costthen what operating profit you is also known as PBIT.After you deduct finance cost you get PBT.From PBT or Profit Before Tax you deduct taxes to get PAT, this is the profit available tothe owners from that some profit may be distributed to the owners in the form of dividends andthen the remaining profits are called as retained earnings which are transferred to balancesheet.Because they get added to the owners funds normally we show it under the category asreserves and surplus in the balance sheet.Then we move to the third important statement that is known as cash flow statement.Cash flow statement as the name suggest talks about the flows of cash.Now the cash flow statement evolved because though profit and loss account makes us tounderstand the profitability of the business, it may not tell us what is the cash comingin and in what way the cash is being utilized that is why a cash flow statement was developed.And, all the cash flows are categorized under three heads so, that users of the statementunderstand purposes for which the cash is being raised and is being utilized.So, there are three headings.Do you remember the headings?The first one is operating cash flows.So, this is the normal business activity of the entity or the day to day activities ofthe entity.All the money is coming in and out for normal course of activities are listed under thecash flow from operating activities, usually we use indirect method for the same.So, we start with profit before tax and we make adjustments for those items which arenon-cash in nature.So, what are those non-cash items?We will add depreciation, we will add any particular amounts which are written off whichare non cash in nature.Now why do we add depreciation?I think you all know, but I am just revising because here is where many get confused.On one hand when we prepare P and L account we deduct depreciation, but in cash flow weadd depreciation.What is the reason?Because it is a non cash expense and we have not paid any cash for the same, but it hasbeen deducted for calculating profits or PBT.So, here what we do is, we take PBT we add depreciation, we also make adjustment fornon operating items.For example, if there is any profit on sale of shares we will take in cash flow statement,will we add this profit or deduct the profit?Just think over most of you are right we will deduct the profit.Again a point of confusion because many times when the word profit comes we feel it shouldbe added, but in reality it should be deducted because it has already been considered forcalculation of profit and it is not an operating item.So, we need to remove it that is why we deduct it. So, we deduct profit from operation something like profit from sale of shares, if there is any loss due to some non operating item let us say loss on sale of old machinery, then because it is a loss we will add it. So, we after making the adjustments for non-cash and non operating items, we get a figure which is known as funds from operations. Now in funds from operations we will make adjustment for working capital items. So, any moment in inventory, any moment in debtors, any moment in creditors will be adjusted in cash flow statement because, it affects the availability of cash to me. For example, if the amount of debtors or receivables has gone down during the year, it means tha tour collection efforts were good and debtors have paid more amount from their last yearsoutstanding they have reduced their outstanding, they have paid that amount to us.So, decreasing debtors is a plus item in the cash flow statement ok.So, I think keep only this in mind that decrease in debtor is a addition to cash, automaticallythe same rule will be applicable to inventory.When it comes to creditors it will be exactly opposite because, for a current asset decreaseis going to be added, but for a current liability decrease will be deducted getting it.So, we will adjust working capital items at this stage we will get cash flow from operatingactivities before tax, then we will deduct the taxes paid, then we will get the cashflow from operating activities.This is the first part of cash flow statement which is comparatively complicated to calculateand it is a lengthier part.After that there are two more headings; the second one is cash from investing activitiesas the name suggests it includes long term investments, it also includes any other NCAlike fixed assets.So, if you have purchased or sold these items, any cash going out or coming in would be shownunder cash from investing activities.The third one is cash from financing activities; so, any money which we have raised for thebusiness or if you have gone for repayment, then that will be included under this.For example, issue of shares or buy back of shares, issue of debentures or redemptionof debenture, taking loan returning or repaying loan all these transactions would be in thefinancing item.There is some special need to note about interest and dividend.Whenever interest is received because it is received from investments, it will be categorizedas investing item same thing is true for dividend received.Whenever interest is paid or dividend it paid it will be categorized as a financing item.So, we will make total of operating plus investing plus financing, that will be the total cashgenerated by the company or entity during the year, we will add opening balance andthat will be matching with the closing balance of cash.In the note we will show any non cash transactions which we have not included in the cash flowstatement.What are such non-cash transactions?For example, if there is a share swap.Now what is a share swap?Suppose we have acquired other company, for acquiring other company we have issued ourshares and in return we have got shares of that company from that their shareholders,then it is called as a share swap deal; no cash payment is involved.So, it is not coming in the cash flow statement it will be shown as a note or as a footnote.Like that there can be more transactions for example, if we have some outstanding loanwhich is payable to the bank, but instead of paying the loan amount we issued shares.So, our capital balance has increased and the loan balance has decreased without involvementof any cash, then again it becomes a non cash transaction.So, we will not show it in the cash flow, but we will show it as a footnote.So, have you got it?I have just gone a little in detail because cash flow statement is one important statementand many times the participants get confused in that.So, we discussed about all the three financial statements.At this point of time I had told you in the sessions earlier and again I am repeatingthat it is very important for you to have a hands on view of the actual statements,just what we discussed in the class is not enough.So, you were asked in the first 2-3 sessions itself, that you need to choose your company,download the annual report read the annual report carefully particularly the financialstatement part of it.I hope you have completed that assignment and you have submitted the required details,but going beyond required details I will request you to many times read their P and L, balancesheet, cash flows.And, you can also check with the other companies financial statements so, that you know thepeculiarities how different financial statements are prepared by different companies.Apart from financial statements there will be many other useful information in the annualreport, that also we have discussed in the class and by now you would have seen it inthe annual report do you remember what else is there?There will be corporate governance report, there will be sustainability report, therewill be list of employees which are who are getting high level of salary, there wouldbe directors report, there will be auditor’s report like that a variety of informationabout that company and sometimes about that industry is available.So, please go through that information also.In the class particularly after discussing the financial statements, we have gone intosome of the conceptual parts.Now, many times in the traditional system the accounting its taught from journal entriesthen we go to ledger account.From ledger we come to trial balance, from trial balance students are taught to prepareP and L and balance sheet.But I have gone in a reverse way first we have learnt: what is the output in the formof balance sheet, then income statement, then cash flow and then you have been introducedto the steps which are taken for preparation of those statements.Because this is not a hard core class meant for accounting students, this is mainly meantfor non accounting professionals who have lesser time.So, we have tried to cover the whole course in 20 hours to discuss important part of accountingok.Now, at this stage we had discussed two important topics one was depreciation, methods of depreciation,how the depreciation is provided, next was inventory methods like FIFO or method likeweighted average we had discussed, then we went to some conceptual discussion in conceptualdiscussion we have learnt about corporate governance; what is corporate governance,what are the important principles of governance, what happens due to failure of governanceit leads to variety of frauds malpractices.So, we discussed an example of Enron which is one of the biggest global fraud, then wealso discussed global models of corporate governance the Anglo US model which is verymuch dependent on CEO and on the capital markets, then the banking dominated model of Japanand Germany, government dominated model in China and ethical model in India.We have also discussed various ethical aspects or moral aspects which we get from indianculture (bharateeya sanskriti) and which are very important for proper functioning of anyorganization.Then from corporate governance we have also discussed about evolution of accounting, howaccounting is related to Deevali, how various shreni types of organizations existed in ancientIndia.So, we have learnt about the history of accounting, then again we went to statements because bynow I had hope that you would have familiarize yourself about the financial statements.So, we have may we have then gone for 2-3 exercises or cases taking real life companiesand we had made in the class various financial statements like P and L balance sheet andcash flow.From that if you remember we had done a case of Hindalco and in detail all the three statementswere made after that we went to analysis of financial statements in the analysis we takeready statements sometimes we take some extra data and study the statements so, that wecan analyze it and we can draw some interpretations from the statement.We saw that from a portfolio management angle this is a part of fundamental analysis.In fundamental analysis there are three components company analysis, economy analysis and industryanalysis we had focused on company analysis which is related to what we are learning thatis financial statements.So, varieties of ratios were calculated.Do you remember important categories of ratios?From the balance sheet we started with liquidity ratios like current ratio then financial statementstability related ratios like debt equity or capital gearing ratio, then from incomestatement we can calculate profitability ratio like net profit or operating profit ratio,we can also calculate expense ratios like cost of good sales, to sales or material consumedto revenue these types of ratios.Then we can calculate variety of return ratios.So, in return ratios we link the profitability to amount invested.The most important return ratio is ROI Return On Investment or sometimes it is called asreturn on invested capital; it can be calculated for the whole company, it can also be calculatedfor a particular project or for a particular SBU or division of the company it becomesa very important criteria for evaluation of projects.There can also be return on equity share holders funds known as ROE or return on owners fund,then there can be other type of ratios which are known as turnover or activity ratios orefficiency ratios.For example, total asset turnover or inventory turnover or debtors turnover or fixed assetturnover these ratios measure the efficiency in use of that asset, we have also seen thatinventory turnover you can convert it into number of days.So, we know that how many days of inventory or how many days of receivables are in thebalance sheet.So, we these were the ratios related to financial statements there can be other ratios whichare useful for stock market like earning per share or dividend yield or for example, PEratio this becomes very important for stock market investors.You can also have other ratios for example, for employees important ratio can be revenueper employee or profit per employee.So, like that you can also take some outside data and link it to financial statements tocalculate other types of ratios.So, this was the almost the last part of our discussion.Now going ahead there can be a few concepts which we have not discussed, but those whohave developed interest now in accounting or in finance, I would request you to studythem further.One of them is environmental accounting or green accounting at is as it is known as wherewe try to measure the environmental impact for a particular project or for a company.So, you can have environment accounting, there is another concept called as inflation accountingwhich tries to measure the impact of inflation, another important aspect of accounting ishuman resources accounting.We have seen that human resources are one of the most important assets for the business,but we cannot show it in the balance sheet because they are not owned by the organization.But now there are concepts like HRA or Human Resource Accounting where some efforts aremade to evaluate and value the human resources and put them in the form of a particular figure.So, there are variety of contemporary or new concepts which are coming in accounting.In our major discussion we have also discussed about accounting standards or GAAP, but wehave discussed it in short you can go more in detail about various financial standardsor accounting standards which are issued by various bodies why they are issued and howthey are applied by variety of companies.So, there are number of aspects which can be studied in accounting.I hope you have developed now more and more interest.There are a few more concepts like investment accounting, departmental accounting, branchaccounting.So, what I would request you is, now if you have developed some basic understanding gofor a detail accounting book or some other web courses in accounting, wherein more aspectswould be detailed would be discussed and you can learn more and more aspects of accounting.As far as our course is concerned various sheets have been shared with you they includefirst was about our assignment on annual report, there are variety of cases, there are alsosome conceptual aspects which have been shared with you.If you have not downloaded a few of them I would request you to download go through themand for any queries which you have, our discussion forums are always active and research scholarsand professors from IIT are also participating in it to respond to your queries.So, keep on raising the queries discuss it amongst the peer group also discuss it withour research scholars and that will help continuous learning for you and we are also of course,going to have a proctored exam.And, I hope you are preparing well for the exam, and best wishes to all of you not onlyfor the exam, but also for grasping the learning which would have happen.You would have learned many things and I hope they would be very much useful for your dayto day life.It can be for your corporate life, for your career because you will be evaluated on financialperformance, it will be also useful for entrepreneurs.If you are doing business the knowledge of finance is very important; if you are wantingto study further let us say wanting to do MBA or PhD or wanting to learn further somemore aspects of accounting or finance for that also this course is very going to bevery much useful.So, all the best for exam as well as for further learning keep in touch.Namaste.