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Financial Reporting, Analysis and Valuation
Prof. V K Gupta
Individual Term PaperSubmitted by
Tanoy Paul (2014PGP399)PGP2
Session 1
Financial Statements are essential documents of business which managers use to assess performance and identify the area where special care need t be provided.
Accounting is an art of
of resultRecording Classifying Summarizing Interpreting
Journal Ledger Trial Balance
Balance Sheet Income Statement
Analysis Projection
Purpose of accounting is o Planning, controlling and decision making for Shareholders ( Investors, Government,
Income Tax Dept, Customer etc.)o Maximizing Shareholders’ valueo Valuation of the Companyo Projection for the future positions
• Whatsoever has happened and recording on actual basis • Outcome is Annual Report
Financial Accounting
• When the recording happens based on estimation• Outcome is Business Plan
Cost Accounting
Financial Accounting
• Reports for Internal Users
Financial Reporting
• Reports for External users as per rules and regulations
Accounting Standards are rules and regulation governed by Indian Competent Authority
Accounting Policy are norms framed by management when Accounting Standards are not
mandatory
To prepare Indian Accounting Standards, USGAP has been considered as Benchmark
Financial Reporting includes Financial Accounting
Analysis is based on Reporting
Valuation is based on Analysis
Session 2
1 • Promoter (Idea Generator)
2 • Memorandum of Association
3 • Article of Association
4 • Registration
5 • Certificate of incorporation
6 • Prospectus (for public companies)
7 • Invitation for Share
8 • Issued Capital
Steps to open a Startup
Includes details about Authorized
Capital as per MOA
If Shares Application > Issued Capital Over Subscription If Shares Application < Issued Capital Under Subscription Called up Capital = (Issued Capital – Subscribed Capital) Paid up capital Paid by Shareholders and accounting will be done on this .
PAT = Reserve + Retained Earnings + Distributed to Shareholders
Organization Owner Liability PAT will go
Company Shareholders Limited To Shareholders
Partnership Partners Unlimited To Partners
Individual Traders Unlimited To Trades
Whatever was kept aside from this is Reserved
Internal Source of Financing = Depreciation + Retained Earnings (for Reinvestment purpose) Shareholders’ Fund = Reserved + Retained Earnings + Paid up capital Book value per share = (Shareholders’ Fund )/ No. of Shares issued Market Value per share should always be greater than Book value per share Market Value added = Market Value – Book Value Price of the share depends on the Supply and Demand Important Financial Ratios:
Liquidity ratio
• Current Ratio• Quick Ratio or acid
test
Solvency ratio
• Debt to Equity• Liabilities to Asset• Interest Coverage
Funds management ratio
• Account receivable Turnover
• Inventory Turnover• Accounts payable
turnover• Asset turnover• Days receivables
outstanding• Days inventory
Outstanding• Days payable
outstanding
Profitability ratio
• Return on asset• Return on Equity• Profit margin• Financial Leverage
Session 3&4
Total funds deployed in the Organization = Capital Employed Capital Employed = Shareholders’ Equity + Loan Fund Total Funds on book value can be obtained from Balance Sheet Total Funds on Market value can be obtained from market value of equity and debt Cash is an important component for valuation
Cash Flow statement if only on cash basis Direct Method Cash Flow statement if on accrual basis Indirect Method Indirect Method + (add) Non Cash Expense/(less) Non Cash Income = Direct Method Profit = (Cash Sale + Credit Sale) – (Cash Expense + Payable Expense) Operating Activities = Cash Purchase + Cash Sales + Cash Expenses Gross Margin = Trade Margin – Sales & Administrative Cost
Shareholders’ Equity+
Loan Fund
Fixed Asset+
Investment+
Working Capital
Investing Activity
Operating Activity
Financing Activity
Sales
ProfitTop
to B
ottom
Bott
om to
Top
Indirect Method
Direct Method
Asset Increase Negative Cash flow Outflow
Asset Decrease Positive Cash flow Inflow
Liabilities Increase Positive Cash Flow Inflow
Liabilities Decrease Negative Cash Flow outflow
Example:
Equity/Debt increase/decrease Financing Activity
Working Capital increase/decease Operating Activity
Fixed asset/investment increase/decrease Investment Activity
Session5&6
Book Value On Shareholders’ Fund Market value On market value of shares If Book Value < market Value Investor’s interest is not satisfied Profitability is assessed either on Sales or on Capital
ROC is of major interest of CEO whereas Shareholders are more interested on ROE
An Overview of Financial Statement Analysis: The Mechanics Historical Ratio Analysis:
Studying the components of a company’s balance sheets, income statements and Cash flow statement in historical perspective
Two complementary techniques: Analyzing proportion of an account relative to other accounts Analyzing the growth in an account across periods
Basic tools: Common size statement of balance sheets & income statements Percentage change statements of balance sheets, income statements and Cash Flow
Gross Profit Operating profit Profit before/after tax
On CapitalOn Sales Working Capital Shareholders’ Fund
Pro forma forecasting Steps for doing forecasting for the conventional financial statement include:
Project sales growth Project operating costs before depreciation, amortization and interest Project the balance sheet Project depreciation, amortization and interest Project the statement of cash flow
Valuation The value of any investment depends on two critical factors
The future nominal dollar returns the investment will generate The required percentage return demanded by the investor for the use of capital,
which is cost of capital In this article they have introduced about the basic input mechanics used in most
popular valuation models--- Discounted Cash Flow. The several steps includes are: Forecasted free cash flow (FCF) over the time horizon in consideration Forecasted aggregate FCF for the years beyond that horizon, called the Terminal
value (TV) calculation Discount all future cash flows using the appropriate discount rate Subtract any non-operating liabilities to yield total equity value. Dividing by shares
yields share price TV = FCF (1+g)/(WACC-g)
where g= expected average long term growth rate in FCFWACC= Weighted average cost of capital
Assessing a Company’s Future Financial Health
Assessing the long term financial health of a company is very important task for management
perspective as it formulates goals and strategies and for outsiders also it plays important role
as they consider the extension of credit, long term supplier agreements or investment in
company’s equity
The basic steps include:
Analyze Fundamentals
Analyze investments to support the business unit’s Strategy
Assess Future profitability and Competitive performance
Assess future External Financing needs
Ensure Access to target sources of external finance
Assess viability of the 3-5 years plan
Perform stress test under Scenarios of adversities
Formulate current financing plan
Session 7&8
Sustainable Growth and the Interdependence of financial goals and policies
Financial Goals Financial Policies
Return on total capital
(ROTC)
Return on Equity(ROE)
Growth Rate
Debt Policy:Debt to Equity ratio
Dividend Policy: Payout ratio(po)
Financial Leverage Equation: ROE = ROTC+[ROTC-KD](D/E) Sustainable Growth Equation: Growth Rate = (1-po)ROE
ABC Learning Centres Limited Case Study The following are the steps that were carried out in order to evaluate company’s performance
Business Analysis Financial Analysis Accounting Analysis Valuation
Value Chain activities performed by the company Evidences of success (in terms of Revenue, expansion, operating leverage, profitability etc.) Evaluating Growth in terms of Revenue, PAT, Total asset, Borrowings, No. of centres etc. Evaluating companies financial ratios from the Common size balance sheet and Income
Statement Using CAPM Model to find out cost of Equity. If ROE is more than cost of equity then it is
sustainable.
Understanding Economic Value Added
EVA aims to measure the firm’s ability to generate profits in excess of the cost of capital
employed to generate those profits
Value is created only when return on capital is greater than the cost of capital. Any project
should be accepted only if it has a Positive NPV(Net present value)
EVA = NOPAT – Cost of Capital*Capital
NOPAT= EBIT*(1-tax rate)
Cost of Capital= WACC= [D/(D+E)]*(1-t)*rD + [E/(D+E)]*rE
EVA metrics provide managers with a powerful tool to weigh investment and spending
decisions against Capital requirements and investor’s expectation
Session 9
Sustainable EVA Value Drivers
NOPAT
=Sales – COGS=Gross Profit - Operating Expenses=Operating Profit - Tax & Interest=PAT
Price
Quantity Opening Stock
Closing Stock
Purchase
• Bulk order• Annual Contract• Purchase from original
point• EOQ to reduce
holding/carrying cost
Control
• Capital structure designing to get optimum cost structure• Sensitivity Analysis
Cost of Capital
Cost of Equity
Cost of debtCapital
employed
Fixed Asset
Investment
Net current asset
• Maximum utilization of asset
Debt
Equity
Current asset Current Lability
Several other value drivers for sustainable EVA are as follows:
Differentiating the product
Retaining existing customer by delighting the customers with
o Best Product
o Best Price
o Best Service
Cost Creation Program to cut/reduce cost
Increasing the market share
Strengthening Credit policy
External Drivers
o Inflation
o Govt. Policy
Quality of Earnings Quality Earning is a common statement analysis made to describe a company’s earnings It is used by those within and outside of the investment field to identify accounting red flags
which may suggest that the company’s character is changing or that its accounting figures are potentially are potentially misleading and extra care should be taken in analyzing its statements
The determinants of Quality of Earnings are as follows:
Quality Earnings are used in several applications such as: Management Appraisal Relative Quality Dividend and reinvestment Volatility and Risk
Economic Environment impact Volatility Cash Flow One time Events Recurring Economic Activities Financial status Accounting Policy
Tax Policy Production Asset Quality Users’ Objective
For valuation of Company, Quality profit should be considered Assessing Earning Quality
Reported Earnings and Non recurring items analysis Accounts Receivable Analysis Inventory Analysis
Session 10
Valuation
Approaches to Valuation Discounted cash flow valuation- relating the value of an asset to the present value of
expected future cash flows on that asset Relative Valuation- Estimating the value of an asset by looking at the pricing of
comparable assets relative to a common variable like earnings, cash flows, book value etc.
Contingent claim valuation- Using option pricing models to measure the value of assets that share option characteristics
Discounted Present value Method
Value of an asset = +………………..+
Where CFt =expected cash flow in period t r =discount rate
n =life of the asset Methods
Equity Valuation: The value of equity is obtained by discounting expected cash flows to equity, i.e. the residual cash flows after meeting all expenses, tax obligation and interest and principal payments at the cost of equity. In this method
CF= Expected Cash flow to equity r= Cost of equity
Session 11to18
Firm Valuation: The value of equity is obtained by discounting expected cash flows to the firm, i.e. the residual cash flows after meeting all expenses, tax obligation but prior to debt payment at the weighted average cost of Capital. In this method
CF= Expected Cash flow to firm r= WACC= Weighted average cost of capital
Free Cash flow = Revenue (-) Operating Expense(-) tax(+) Non cash items(-) change in WC(-) Investment in Capex
Firm Value= Equity value + all debt + all Non equity claims to firm Cash flow to Firm = FCFF= EBIT (1-t) - (Capital Expenditure - Depreciation) - Change in
Working Capital Cash flow to Equity = FCFE = Net Income - (Capital Expenditure - Depreciation) (1- Debt Ratio)
- Change in Working Capital (1-Debt Ratio) Cost of Equity =rE =Risk free rate + Beta * Risk Premium Cost of Capital= WACC= [D/(D+E)]*(1-t)*rD + [E/(D+E)]*rE
Terminal Value = FCFn+1 /(r-g)
Valuation using residual earnings
Following are the steps to do valuation using residual earnings:
Finding the average book value equity from the given data of Book value equity
ROCE= Return on capital employed = Earnings/ Average Book value of equity
Residual Earning= Earning – Cost of Equity * Average Book value of equity
Value of equity = (Book value of Equity of Current year) + (Projected Residual Earning of
Next year)*(1+ Growth)/(Capital Charge or Cost of equity –Growth)
If growth = 0 then,
Value of equity = (Book value of Equity of Current year) + (Projected Residual
Earning of Next year)*/(Capital Charge or Cost of equity )
Relative valuation
The value of any asset can be estimated by looking at how the market prices “similar” or
“comparable” assets. The method follows the below mentioned procedure to value the firm
Choices with multiples:
Equity or Firm: Multiples can be scaled to equity value, to firm value or to value of
operating assets
Scaling variable: The market value can be scaled to
o Earnings: The choices can range from equity earnings to operating income
o Book Value: The choice can include book value of equity or book value of capital
o Revenues
Choosing the Comparable firms
Making the comparison
Value at Risk
Value at risk (VaR) is a probabilistic measure of the range of values a firm’s portfolio could lose
due to market volatility This volatility includes effects from changes in interest rates, exchange
rates, commodities prices and other general market risks.
Different methods of calculating VaR:
Correlation: This method attempts to calculate the variance of the entire portfolio based
on the variances of each asset in the portfolio and the relationship between risk factors.
The following steps need to be performed to calculate VaR
o Calculating mean, variance and correlation of each asset using historical data
o Providing weights to the assets in the portfolio
o Calculating the expected portfolio return
o Calculating the portfolio variance
o Finally, assume the return on the portfolio to be normally distributed with mean
and variance calculated above. The value of the portfolio at the chosen probability
level is the VaR
Session 19
Historical simulation: Historical simulation uses actual historic values to predict the
returns of the risk factors instead of assuming risk factor returns have a normal
distribution . The following steps need to be performed to calculate VaR
o Gather market data for each asset over the historical period. Measure the
percentage change in interest rate from day to day
o Value the portfolio for the change that would occur if history repeats itself
o Amount of loss due to market risk can be got by subtracting future portfolio value
from present value
o Repeat the analysis to create a distribution of possible outcomes
o Rank all the possible outcomes and choose a confidence interval. The value at
that percentile in the distribution represents VaR
Monte carlo Simulation: It is much more comprehensive and rigorous than historical
simulation. It takes greater account of the potential for market shocks and uses
mathematical model t predict future shocks.
Thank You Sir