_OceanofPDF.com_Financial_Statement_Analysis_-_Zebra_Learn

FSA.

First Published by ZebraLearn 2023 Copyright © Anurag Sundarka All Rights Reserved www.zebralearn.com The right of Anurag Sundarka to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act, 1988. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of the publisher. This publication is designed to provide accurate and authoritative information. It is sold under the express understanding that any decisions or actions you take as a result of reading this book must be based on your judgement and will be at your sole risk. The author or publisher will not be held responsible for the consequences of any actions and/ or decisions taken as a result of any information given or recommendations made. ISBN: 978-81-958950-7-6.

While every effort has been made to avoid any mistake or omission, this publication is being sold on the condition and understanding that ZebraLearn Pvt. Ltd. would not be liable in any manner, to any person, by reason of any mistake or omission in this publication or for any action taken or committed to be taken or advice rendered or accepted on the basis of this work. For any defect in printing or binding the publishers will be liable only to replace the defective copy with another copy of this work then available. This book is intended for educational purposes only. The discussions and interpretations presented in this book should not be used to draw any conclusions or any financial decisions. An example of a real company is used in this book solely for educational purposes and should not be taken as an indication of the value or potential of that company. The reader should conduct their own primary analysis before making any financial decisions. ZebraLearn Pvt. Ltd. is not responsible for any decisions or actions that are taken as a result of reading this book. The assumptions and examples presented in this book are hypothetical in nature and are not intended as a conclusion or recommendation. Therefore, readers should conduct their own analysis and form their own opinions. Disclaimer Disclaimer.

Contents Contents 1. Introduction 2. Getting started with Financial Statement Analysis 3. Understanding Annual Report - Important Terms & Concepts 4. Entering Data in Spreadsheets 5. Common-Size Analysis and Cash Flow Analysis 2.1 What is Financial Statement Analysis? 2.2 What are the different Financial Statements? 13 16 24 26 29 39 45 51 58 66 69 73 77 81 88 120 133 137 144 157 159 167 175 185 8 3.1 Data Subscription Services 3.2 Different Parts of Annual Reports 3.3 Standalone vs Consolidated Financial Statements 3.4 Auditor’s Report 3.5 Accounting Policies 3.6 Operating vs Non-Operating Items 3.7 Understanding Float 3.8 Reverse Float 3.9 Understanding Fixed Assets 3.10 Understanding Intangible Assets 3.11 Major Business Segments 3.12 Employee Benefit Expenses 4.1 Filling the Annual Inputs Sheet 4.2 Filling the Income Statement 4.3 Filling the Balance Sheet (Liabilities side) 4.4 Filling the Balance Sheet (Asset side) 4.5 Filling the Cash Flow Statement 5.1 Introduction to Analysis 5.2 Common Size Analysis 5.3 Cash Flow Statement Analysis 5.4 Cash flow from Investing Activities 5.5 Cash flow from Financing Activities.

6. Analysis of Balance Sheet - Working Capital & Short-Term Items 7. Analysis of Balance Sheet - Long term Assets 8. Analysis of Balance Sheet - Equity and Long Term Liabilities 9. Analysis of Income Statement - Revenue and Expenses 10. Analysis of Other Critical Sections - ESOPs, Leases, Related Party Transactions, etc. 189 217 244 249 255 259 263 269 273 278 286 290 294 298 305 313 316 322 329 332 335 338 340 342 348 356 362 6.1 Operating Working Capital 6.2 Financial/Non-Operating Working Capital 7.1 Operating Assets and Non Operating Assets 7.2 Fixed Assets 7.3 Fixed Assets - CAPEX 7.4 Intangible Assets 7.5 Capital Work in Progress 7.6 Long Term Investments 7.7 Other Non Current Assets 8.1 Long Term Borrowings 8.2 Long Term Provisions 8.3 Other Long Term Liabilities 8.4 Equity 8.5 Return On Equity (ROE) Analysis 8.6 Reserves and Surplus 9.1 Revenue Growth 9.2 Operating Asset Turnover Ratio 9.3 Cost of Goods Sold 9.4 Employee Benefit Expenses 9.5 Depreciation and Amortization 9.6 Other Operating Expenses 9.7 Non-Operating Expenses 9.8 Exceptional Items 9.9 Margin and Growth Rates 9.10 Taxes 10.1 ESOPs 10.2 Leases.

10.3 Forwards/Derivatives 10.4 Related Party Transactions 10.5 Consolidation - Subsidiaries, Associates and JVs 10.6 Segmental Analysis 10.7 Discontinued Operations 10.8 Conclusion 10.9 Adding Sector - Specific KPIs Disclaimer Credits 11. Identifying Red Flags in Financial Reports 12. Practice, Patience and Persistence 366 371 378 384 388 393 394 416 417 396 412.

Financial statement analysis is a complex topic that requires a deep understanding of accounting principles, financial metrics, and analytical techniques. While reading or listening about the topic can be useful, the best way to master it is through hands-on practice. That is why this book has been designed in a hands-on manner, with practical templates and a detailed case study that will help you apply what you learn to real-life scenarios. To get the maximum value out of this book, it is essential that you practice along with the examples provided. This will help you to develop a better understanding of financial statement analysis, as well as to refine your analytical skills. By working through the templates and case study, you will be able to see how the different metrics and techniques can be applied to analyze financial statements, identify trends, and make informed decisions. Remember that practice is the key to success when it comes to financial statement analysis. The more you practice, the more confident and proficient you will become in analyzing financial statements. So, make sure you take the time to work through the examples provided in this book, and don't be afraid to experiment with different scenarios and techniques. With practice, you will soon be able to apply your knowledge of financial statement analysis to real-world situations, and make informed decisions that can help you achieve your financial goals. How to use this book? How to use this book?.

Introduction 1 8 Financial Statement Analysis.

Welcome to this book on Financial Statement Analysis by Zebra Learn, where we start with absolute basics and build on it one step at a time to reach a position where we are able to understand a company’s financial position and its performance by analyzing its financial statements. 9 Introduction.

We look at different financial statements like the Balance Sheet, the Profit and Loss Statement, the Changes in Equity, the Cash Flow Statement, and notes to different accounts. This book aims to understand financial health for any given company. This is critical for all sorts of financial activity like banking, investments, etc. Experienced analysts can understand the health of different companies by looking at the above statements. This helps them make decisions about investments, lending, general corporate finance etc., by analyzing the company’s data. The above statements together are known as the Financial Statements. Each line item will be analyzed so that the strengths and weaknesses of any given company can be understood. strengths Company Different Financial Statments Analyzing Company's Data weaknesses Balance Sheet, P&L Statement, Changes in Equity, Cash Flow Statemen, Notes to Different Accounts. 10 Financial Statement Analysis.

In this book, we will start with Financial Statements and getting to know the basics of the same. We will then jump on to obtaining data for our analysis. After that, we will move forward and learn about how to analyse each line item in the financial statements to understand the company better. Going ahead, we will use an excel template like this- NOTES TO ACCOUNTS This will help us break down the entire financial statement into multiple parts: Income Statements, Balance Sheet, Statement of Changes in Equtiy, Cash Flow Statement. Then we will understand every line item and the things that need to be kept in mind. We aim to have a complete understanding of the company’s performance. This book will be super fun, exciting, and useful, and we will practice along so that we learn along with the chapters. Remember, the real value is in the practice. You will be able to extract most from this book, if you practice along as well. In the next chapter of this book, we start by answering the question What is financial statement analysis, and why is it needed? We will start with the basics of financial statement analysis in the next chapter. Income Statement Statement Changes in Equity Balance Sheet Cash Flow Statement Financial Statements 11 Introduction.

Financial Statement 2 Analysis Getting Started with Getting Started with ₹ ₹ 12 Financial Statement Analysis.

What is financial statement analysis? We start our journey by understanding what exactly financial statement analysis is, where is financial statement analysis used and what is its importance. The definition of financial statement analysis can be broken down into three parts: Financial statement analysis means Borrowing Investment Decision The ultimate goal of this analysis is to make key decisions - A detailed investigation of Company’s financials To understand its performance in detail 2.1 Lending ₹ ₹ ₹ ₹₹₹ 13 Getting Started with Financial Statement Analysis.

The focus during Financial statement analysis is on the company's financial performance and reporting alone. Qualitative or Subjective data like Management Commentary and Industry Reports are given secondary preference -just to understand the financial numbers better. Remember, the ultimate aim of FSA is to make key decisions. However, if the statements are incorrect, the decisions made based on them will also be inaccurate. Apart from understanding the performance, FSA also helps us identify: If the company's financial statements are manipulated. Do they make economic sense?? Here is where forensic accounting comes into the picture. It is a separate branch of analysis that determines if the financials are manipulated. It involves detailed breakdown of every component to gain an in-depth understanding. Forensic Accounting is a completely different subject and that is beyond the scope of this book. However, we will discuss certain red flags that help us identify potential manipulation. 14 Financial Statement Analysis.

Now that you know what is financial statement analysis, it is also essential to know its importance. Why do so many people across financial domain stress on this? Well, Financial statement analysis helps decision makers understand three key aspects: IMPORTANCE OF FSA The past performance of the entity: Detailed breakdown of company's financial metrics and KPIs and its performance over time. Indicators about the company’s future performance 1 2 3 2 1 3 The past performance of the entity: Detailed breakdown of company's financial metrics and KPIs and its performance: Each important financial metric is broken into detailed finer parts. This helps entities understand the root cause of problems if any. Financial data is always viewed in comparison to past data. This helps us understand how the company and its numbers have changed and evolved over time. Comparision Present Data Past Data 1. 2. 3. FSA forms the base of activities like forecasting and valuations. We can build on top of such Financial Statement analysis to forecast the company's future performance and even go on to build a complete financial model with forecasting. Indicators about the company’s future performance This helps you understand the past, present and future of the business. 15 Getting Started with Financial Statement Analysis.

Profit & Loss Statement Income Expense Profit Loss Cash Flow Statement Operating Financing Investing Balance Sheet Capital Liability Assets What are the different financial statements? Now that you understand what financial statement analysis is, we also need to understand what financial statements are. To understand company financial statement there are three financial statements that we will be analysing along with the notes to accounts: These three reports help in evaluating two things: 2.2 Balance Sheet is a presentation of everything that the company owns(assets) and owes(liabilities). Profit and Loss Statement shows total sales that a company has minus all the expenses that it has incurred in a given time frame. Company's Past Performance Future Decisions Cash flow Statement shows all the cash inflow and outflow - for operations, investing and financing, by the company in a given time frame. 0 2018 2019 2020 2021 2022 2023 16 Financial Statement Analysis.

1. The company does not need a lot of trade receivables. 2. It’s Property, Plant and Equipment is around Rs. 1500 Cr, out of total assets of Rs. 7500 Cr. This also means that the company has enough fixed assets. These are general things you can understand with just a glance. However, if you dig deeper, you will learn more comprehensively. Multiple entities use these financial statements to understand the past performance of a company to arrive at important decisions. If you look at the financials of Britannia Industries Limited, you can conclude things like: EXAMPLE EXAMPLE Financials of Britannia Industries Limited Balance Sheet Cashflow Statement Auditor's Report Profit & Loss Statement 17 Getting Started with Financial Statement Analysis.

Apart from the three reports above, you will also find several notes to accounts. Do not get overwhelmed by these. These notes are just a detailed breakdown and explanation of figures mentioned in the financial statements. This can help you understand the financial statements better. This is an example of Notes to accounts. It is suggested that you open a company's annual report and go through the Notes to Accounts section if you are already not familiar with the same. N O T E S NOTES TO ACCOUNTS 18 Financial Statement Analysis.

Banks and other financial institutions involved in the lending business must understand a company’s past performance. They need to determine whether a company can be lent money or not. For this, they rely on financial statement analysis. Certain parameters, such as Sometimes, banks may offer a loan if the core health of the business is solid, even if it is not backed by enough assets. This generally happens when the company is generating enough cash. Investment decisions by private equity players are also based on financial statement analysis. However, this is a little tricky as there is not enough past data. Interest coverage ratio = Private Equity/Venture Capital: Banks Asset Volume Earnings Before Interest And Taxes Interest Expenses Debt Equity ratio = Total Debt Total Equity Private equity investing in startup company’s can become a challenging task since the financials would change dramatically. Relatively old companies have more operating history to show and are relatively more stable as well. VS VS Who uses financial statement analysis? 19 Getting Started with Financial Statement Analysis.

Business Owners Entrepreneurs Business owners must make key decisions at all times. This might include decisions of raising further capital, investment decisions, choosing a project to invest in and others. These are similar to business owners but they might not have much past data to analyze. Moreover, there might not be stable economic or financial information to make a decision. However, with whatever limited information they have, they need to take decisions. Capital Investment decisions Choosing a project to invest in For this, they must do a thorough financial statement analysis to understand the company’s past performance. Owners might even look at competitors’ data to understand their strengths and weaknesses, and make decisions. understand the entity’s performance make decisions and project the future 20 Financial Statement Analysis.

Credit Rating Agencies These are agencies that assign ratings to companies based on their creditworthiness. Ratings such as AAA, AA, A, B, BBB and so on can be assigned. These ratings show how creditworthy a company is. Thus, these agencies must analyse financial statements to assign appropriate ratings. These ratings can affect the borrowing rates of a borrower. Therefore, it is important that these ratings are correct and reflect the reality. Suppose a company's Return on Capital (ROE) was 20% three years ago, and now it is 15%, which is a good ROE on a stand-alone basis. However, if compared to previous years, we can observe that the company is facing a slight decline. Rating agencies need to reflect such changes in their ratings for the company. The above are some entities and users that analyze financial statements on a day to day to basis. They can then go on and build financial models with different objectives on this detailed analysis of financial statements. Now you know why Financial statement analysis is such a critical skill in multiple finance domains. RISK METER 21 Getting Started with Financial Statement Analysis.

22 Financial Statement Analysis.

In this chapter, we will understand about the raw sources of data. We will use Annual reports and quarterly results – the primary data sources. Also, we will enter the data manually. It is important to get used to different statements and notes to accounts. In this chapter, we will understand the different terms to get us started with the analysis of financial analysis. Welcome!!! Understanding Annual Report & important terms and concepts & important terms and concepts 3 23 Understanding Annual Report - Important Terms & Concepts.

Data Subscription Services To begin with, we will be entering numbers manually and conducting most of our analysis with the help of an excel. This is particularly useful for those who are not already comfortable with Financial Statements. Going ahead, you will switch to paid data sources to get past data. These services provide financial data in a standard form for last 5-15 years. When you become a professional, you will not have time to manually enter every data. Thus, you will have to rely on various subscription services These services can provide you with past data of 5,7 or 10 years to analyze. Some popular services are Capitaline and Ace Equity. It would save a lot of your time You can analyze more companies when data is readily available You can automate and embed this data into financial models or excel sheets you have created. Wondering how it can help you? 3.1 24 Financial Statement Analysis.

Free Sources of Data If you are just starting, you might not have enough to pay for subscription services. Do not worry. You can use multiple free sources to start with financial analysis. For example, you can use screener.in, which fetches data in a simplistic manner. You just need to create an account and log in to the platform. At times, you might not be able to find data in best form. You can convert original balance sheet to excel format. This might take time. But, it is the closest free substitute for free data. This is not the most ideal way to get data, but this is where you can start as a learner. Going ahead you should use paid subscription to get data as you would be taking high stakes decisions based on them. Suppose you want to download the Balance sheet of Pidilite Industries. Balance Sheet Download Balance sheet screenshot 1. You may get little inaccuracies, with a few lines being up or down. You can adjust it to get your free data. 4. 2. 3. Use an image to excel online converter to convert this image into excel. Download the Balance Sheet as an image. Simply open the Balance Sheet on any website or company's annual report. EXAMPLE EXAMPLE FREE FREE SOURCE SOURCE FREE FREE SOURCE SOURCE FREE FREE SOURCE SOURCE 25 Understanding Annual Report - Important Terms & Concepts.

Annual Reports refer to yearly documents by the company where the company updates its investors about its performance and financial statements. Annual reports include various sections such as Letter by the chairman, letter by the CEO, management discussions and others. However, we are only concerned with one section - the financial statements, both consolidated and standalone. It is important to get used to these financial statements as there are a lot of data points to understand. These elements together form company’s financial statements. Together, these tell us about the company’s financial position- present and past. These are the raw data that we will use as inputs to draw various inferences. It is essential to understand each line item. As we saw in the previous section too, we will enter data into our Excel templates manually to begin with. This is particularly important to get comfortable with the financial statements. Once we are comfortable, we can switch to the different paid subscriptions that we saw in the previous section. Annual reports are the most authentic source for financial data for any given company because that builds level playing field for all analysts and softwares too. Financial statement includes various components such as: Financial Statement Letter by Chairman Management Discussions 3.2 Auditor’s reports Balance Sheet Statement of Profit and Loss Note to Accounts Statement of changes in equity Cash Flow Statement Accounting Policy Different Parts of Annual Report 26 Financial Statement Analysis.

One-offs are non-recurring events or events that do not happen every year. These events can make the company’s financials look very good or bad in a particular year. However, our focus is on making decisions about the future based on past data. Since these events will not repeat every year, we must remove these one-offs from financial statements. When we are manually entering data in the spreadsheets that we are using, we will have to "normalize" data. So normalizing financials basically means that we make few changes to the numbers so that it reflects the reality even more closely. We will mainly do two things to normalize Financial numbers- Let us understand it with a few examples: 1. 2. 3. 1. Remove one-offs How to normalize the data? Thus, it is important to understand these items and associated notes. Suppose a company had to pay 25% more on exports due to the Russia-Ukraine war. Again, this is a one-off event and will not happen every year. All these one-offs must be normalized. Only then can you understand the financial statements in a true manner. If such one-offs are not removed from our analysis, the numbers will not show the reality. In such cases, you may end up making wrong decisions about the future. Huge profits on trading Loss due to fire Fire is an accident that will not happen every year unless it is a very fire-prone business. Thus, losses due to such fires are on offs and must be removed. If the company has made one-time profits from trading activities, it should also be removed before analyzing financial statements. Unless it is a trading company, these profits will not happen every year. Similarly, any profit or loss on sale of any subsidiary should also be removed as it is non-recurring. Profit or loss on sale of subsidiaries Due to huge profit on trading Loss due to fire Average Profit FY2017 2018 2019 2020 2021 2022 27 Understanding Annual Report - Important Terms & Concepts.

2. Discontinued activities These are the company's business activities that have been stopped or sold off. We must remove them from income statements and cash flows since we want to make decisions that impact the future. Since these activities have been stopped, they have no impact on the future. Thus, we will not study these and also remove the impact of such discontinued activities from the numbers. Company A was in two businesses: Shoes and TV. Now, the company has decided to discontinue the TV division. The past data and margins will include numbers from shoe and TV businesses. However, in the future, the numbers will be based only on the Shoe business. Thus, we must remove all TV-related numbers from past data, such as sales, expenses, and profits. After that, we must make a decision based only on the shoe business numbers. 2010 2012 2014 COMPANY 2016 COMPANY Thus, these are two things we need to keep in mind when we fill out our raw data.These are one-offs that do not occur yearly and discontinued activities that will not affect future business. So far, we understand the sources of raw data, and how to enter them into our spreadsheet. We understand how to normalize them. Lets now move forward and build further on this by understanding the difference between Standalone and Consolidated Statements and which numbers to use. Discontinued EXAMPLE EXAMPLE 28 Financial Statement Analysis.

So the only companies that have subsidiaries, joint ventures etc report two sets of Financial Statements. Companies that own no subsidiary report only one set of Financial Statements. Many companies report two sets of Financial Statements in their Annual Reports - Standalone and Consolidated Financial Statements. First, lets understand the difference between the two of them. We may ask, why will a company need two different financial statements? Let us learn more about them. 3.3 Consolidated Financial Statement All other businesses + + Standalone Financial Statement Standalone Financial Statement Consolidated Financial Statement Standalone Financial Statement Consolidated Financial Statement Standalone vs Consolidated Financial Statements 29 Understanding Annual Report - Important Terms & Concepts.

A Standalone financial statement includes the profit and loss and assets and liabilities of only the core company. Taking the example of Pidilite Industries Limited, only the profit that the parent company generates by itself can be included in the standalone financial statement. Standalone Financial Statements Standalone Financial Statements 30 Financial Statement Analysis.

31 Understanding Annual Report - Important Terms & Concepts.

However, when we are talking about the consolidated statement, we don’t just consider the parent company i.e. Pidilite Industries Ltd. The company will have subsidiaries, joint ventures, majority shareholding, etc. In this case, we will have to consider the sales, revenue, and profit generated by all these entities put together and not just the parent company- Pidilite industries ltd. Consolidated Financial Statements Consolidated Financial Statements 32 Financial Statement Analysis.

So, the standalone financial statement only accounts for the parent company, while the consolidated financial statement considers all the subsidiaries, joint ventures, and all else. 33 Understanding Annual Report - Important Terms & Concepts.

Notes 34 Financial Statement Analysis.

As we know, Reliance has three main businesses among multiple businesses: Consolidated Fianancial Statement Standalone Standalone Standalone Now, the parent company, Reliance Industries Ltd., only deals with the Petroleum business. It doesn’t include Jio or the retail business by itself. For a standalone statement, only the numbers from the petroleum business will be calculated. However, for the consolidated financial statement, we shall consider the profits, losses, and assets for subsidiaries of Reliance industries Ltd. like Jio platforms Ltd. and Reliance retail. The numbers of these subsidiaries will be included in the consolidated financials but not in the standalone one. AN EXAMPLE AN EXAMPLE 35 Understanding Annual Report - Important Terms & Concepts.

So, whenever we talk about the sales and profits of a company, we always refer to the consolidated financial statement. It includes all the parts a company owns. In contrast, the standalone statement shows the figures for the parent company. It doesn’t show the complete picture that is shown by the consolidated statement by accounting for everything that the parent company owns. And it also makes a lot more sense to look at the total numbers rather than just how the business ownership is distributed. Consolidated Financial Statements must be used at all times to enter raw numbers for past performance unless otherwise stated. We will use Standalone under very few instances, for most analysis Consolidated statements will be used. If you are looking for details like the debt-to-equity ratio, you must use consolidated numbers to calculate the same. If, however, a company does not have any subsidiaries, then it will not disclose two different sets of statements. Consolidated and standalone statements are one and the same in this case. Thus, if you find companies that have released just one set of statements, you can be assured that the company does not have any subsidiaries. If there are no subsidiaries then, Standalone Financial Statement Consolidated Financial Statement Conslidated financial statement Conslidated financial Conslidated financial statement statement = ALWAYS GO FOR CONSOLIDATED STATEMENT 36 Financial Statement Analysis.

There are some cases where the larger chunk of the business is owned by a subsidiary. The details can be found as part of the notes of the consolidated statement. As an example, if a company has a total turnover of 1000 cr with only one subsidiary accounting the 900 cr. In this case, the standalone statement will only be worth 100cr as revenue. We must be careful in such cases where the major value of the company resides in one of its subsidiaries. We must identify the subsidiaries that hold majority of the value and dig deeper into them. A company’s consolidated statement will give us a list of its subsidiaries and their details, including shares, profits, and assets. The list will have details for the following under notes to accounts: Fully owned (100%) subsidiaries Partially owned subsidiaries, which are not 100% owned by the company Joint ventures This will help us understand things like Revenue, Profit After Tax, Net assets, liabilities, ownership percentage and so on for each subsidiary. Major Value Composition of Consolidation Parent Company Subsidiaries 48.17% 20.09% 17.91% 8.44% 5.24% 0.16% 37 Understanding Annual Report - Important Terms & Concepts.

Again, to sum up, the standalone statement only refers to a company's parent business and is not its accurate reflection. While, consolidated numbers will include not only the parent company but all its subsidiaries, joint ventures, etc. It will also help us understand the different subsidiaries owned by the parent company and which are the most valuable ones.We shall always look at the consolidated numbers unless specified otherwise. In the next unit, we will get started with annual reports and different items of financial statements. S U M M I N G U P A detailed break-down also helps us focus only on the major subsidiaries rather than all of them. For a company like Reliance industries which has hundreds of subsidiaries. We can figure out the 4-5 significant subsidiaries based on the detailed numbers, including sales, profits, return on assets, and return on equity. We can then focus most of our time and energy on understanding the selected subsidiaries rather than all of them. Numbers for Major Subsidiaries 38 Financial Statement Analysis.

So far, we have learned about standalone and consolidated statements. Now, we must look into another important aspect of financial statements - an independent auditor’s report. It is one of the first things we check while studying a company’s financials. 3.4 It is compulsory that whenever any company prepares financial statements, they must get it audited or checked. This checking is called an audit. An audit is done by an independent third party who is compulsorily a Chartered Accountant. Every single financial statement must be verified every single financial year during the audit. This is basically like a third party approval that the accounting reported by the company is true. CA After the audit is over, the auditor submits a report which is attached with the income statement and balance sheet by the company. Auditor's Report Every company compulsorily needs to disclose the Auditor’s report. 39 Understanding Annual Report - Important Terms & Concepts.

What do you find in the Auditor’s report? The Auditor’s report includes an opinion about the given set of financial statements of a company. No Opinion Given Negative Opinion Unqualified Opinion Qualified Opinion Any auditor can give four different kinds of opinions. 40 Financial Statement Analysis.

Unqualified Opinion Qualified Opinion Clean and clear opinion given by the auditor about the practices of the company. It is the best opinion an auditor can give when they think that everything disclosed by the company is correct. This is proof of good accounting practices and shows good systems and processes are in place. This kind of opinion means one needs to be cautious before entering into an investment with the company. Qualified opinion is a red flag when it comes to any company's auditor report. The auditor opines that something might not be right. This kind of opinion falls somewhere between a negative and a positive opinion. Here the auditor refrains from giving an unqualified opinion, but at the same time is not giving a negative opinion as well. They cannot completely say if something is wrong but they can not confidently say that all systems in place are correct. 1 2 1 2 41 Understanding Annual Report - Important Terms & Concepts.

Negative Opinion No Opinion Given The auditor clearly says that something going on in the company is wrong. This implies that the disclosed financial statements does not provide a clear picture of the company’s practices. The auditor is not convinced that the numbers presented are a true picture of the health of the company. This can be the case when the auditor discontinues the audit or decides to not give an opinion. In this case, they are not happy with the financial statements or status of the particular company. Auditor's also refrain from giving an opinion when they do not receive proper justification or explanation from the company's management for their queries. 3 4 3 4 I am leaving 42 Financial Statement Analysis.

The given example shows the Auditor's Report of the Pidilite Company. The Auditor’s report says that the company discloses the required information, which provides a true and fair view according to the Indian Accounting Standards. Thus, we can clearly say that the Auditor gives an Unqualified Opinion in this example. This means that the auditor approves the working of the company, and there is no flaw in their accounting practices. There is no negative point mentioned in the opinion, that they could identify. The best opinion is the Unqualified opinion given by the auditor. Any other kind of opinion can imply there is something wrong with the company’s practices. It is thus important to look at the auditor’s opinion in order to understand the state of a company and their accounting practices. An unqualified opinion does not guarantee that the financial reports are free from any manipulation, but a lack of unqualified opinion increases chances of manipulative activities quite significantly. As a result, one may stay away from companies that do not have Unqualified Opinion. 43 Understanding Annual Report - Important Terms & Concepts.

Thus, it is important that a company gets an Unqualified Opinion from an auditor every financial year. We must start our analysis with the auditor's opinion for each financial year. If the opinion is unqualified, we can move ahead with other sections of the report. These include sections like: Management’s responsibility and auditor’s responsibility. Any other matters that need to be disclosed. The name and company of the Auditor. It is important to check who is the auditor that audits the company's financials. It should increase our trust on the numbers if the auditor is a reputed firm and not a local practice. For example, in the case of Pidilite, the auditor is Deloitte Haskins & Sells LLP, which is a well-reputed auditor. Reading different kinds of Auditor’s reports for different companies will give a clear understanding of Independent Auditor’s reports. Acquiring New company In the next unit, we will learn about accounting policies. For example, read auditor’s reports of a few companies which have reported frauds in the past. You will learn a lot about how red flags could be spotted in auditor's reports and other financial statements of these companies. It is important that the auditor is neutral and not related to the management. Key audit matters like the things taken care of and listed down. Also, if the company has acquired any other company, there is a mention in the auditor’s report. 44 Financial Statement Analysis.

In the previous unit, we discussed the Auditor’s Report. Now, we will look at an important set of disclosures in financial statements - Significant Accounting Policies. Every company has a set of guidelines or rules it must follow to draw up its finances. Some of these policies are governed by statutory laws. Other policies are decided by the company itself. Let us consider an example to understand things better. 3.5 For example, consider an e-commerce company like Amazon. Here are the stages where the company can consider an order as 'revenue': There are different stages when a company can consider something as revenue. Logically, the last stage - when the order has been delivered and the return window has closed, is when the company should book revenue. The stage at which the company considers something as revenue is called Revenue recognition policy. This way, company needs to have policies for when it counts something as an expense, as an asset, as a lease, as rent and so on. Together, these are called - Significant Account Policies of the Company. Order is received Order is dispatched Order has been delivered return/ refund window (say 7 days) is closed Order Confirmed! Order Delivered Return period is closed However, companies can decide their policies based on their line of business. Let’s consider another example. Order can be cancelled or returned. So, recognizing revenue at any other stage will be incorrect. Accounting Policies E-Commerce Company EXAMPLE EXAMPLE 45 Understanding Annual Report - Important Terms & Concepts.

Construction Company A company can have different accounting policies for different line items. Apart from revenue, the company needs accounting policies for: and so on. So, when does a construction company or a real estate developer book its revenue? Here are the instances: ◊� When a company accounts for the cost. ◊� When they account for rent ◊� How does a company account for investment in associ- ates and joint ventures ◊� When the construction of the project is complete ◊� When the real estate complex has been sold ◊� When the payment has been received ◊� When they hand over the project to the customer. Each company has a set of rules that they use to enter number into their accounting system. These are clearly mentioned in the accounting policies of the company. It is mandatory for every company to disclose its accounting policies along with the financial numbers. EXAMPLE EXAMPLE 46 Financial Statement Analysis.

Do you agree with the accounting policies of the company? 1 Depending on Order is placed Advertisement is delivered & & When payment is recieved Return window is closed Placed Each company has different accounting policies based on management discretion. The line of business, the nature of business, and the industry, different companies have different policies. A media company might book revenue in either of two cases - So you first need to check whether you agree with a company’s accounting policies. Compare the Changes The next important thing that you need to consider is to compare the changes in the current year and the previous year. However, the main reason behind this may be a change in accounting policies. We must check year on year if the company is changing any Accounting policy and if so, what is the change and what is the reason to make that change? Change in accounting policies leave the numbers incomparable. Let us assume, Let us assume, revenue grew by approximately 20% revenue grew by 50% 50% 20% The numbers might see to have improved. You might think that the company is doing exceptionally well. It's a revenue! While discussing accounting policies, we have to consider two important points. 2 47 Understanding Annual Report - Important Terms & Concepts.

Revenue is recognized when the company transfers control of goods to the customer and they no longer have any responsibilities or obligations to fulfill. This is generally on delivery. This is when the performance obligation is satisfied, and the seller has no control over the inventory. Depending on terms on delivery dispatch Advance recieved Contract liability is treated as formal customer acceptance Thus, “control” plays an important part. Revenue should be recognized when control is transferred, and the seller has fulfilled all obligations. Received Liabilty 1. Basis of Consolidation 2. Revenue Recognition - Sale of Goods This includes how the subsidiaries and the joint ventures are treated and how their accounting is done. With this, you will learn how the companies are creating or adding the various accounts of the subsidiaries. For business combinations, most companies use the acquisition method. FEW EXAMPLES ACCOUNTING POLICIES: of 48 Financial Statement Analysis.

Revenue from the sale of services includes: Fixed price contract Time and material contracts It is recognized as a sale as and when the services are performed, and the buyer certifies it. So revenue is considered only when the client accepts the sale. Thus, when the company gets an order, it will not immediately be considered revenue. Only when it is executed will the company report it as revenue. Services performed but not certified by the buyer are treated as unbilled revenue. Incomplete services are recorded at cost as Work in Progress (WIP). When services are delivered When services are rejected W.I.P. BUY Revenue Revenue Revenue 3. Revenue recognition - Sale of Services ACCEPTED REJECTED 49 Understanding Annual Report - Important Terms & Concepts.

It might be difficult to understand in the initial days as there are numerous points to consider. You also have to check for the quality of the accounting policies adopted by the company. Next, you must check for changes in the accounting policies from the previous year. As we can see, there are different accounting policies for every item, like Earlier, we analyzed the Auditor’s report and their opinions, and now we have discussed a company’s accounting policies. So this will help you understand where to start while working on any financial statement. In most cases, you won’t find any changes. However, there will be certain changes in some years, and you need to find them out. These are two of the most important things you must understand before Financial Statement Analysis - Auditor's Report and Accounting Policies. However, after some time, you will get used to it. You will get used to the terms and learn to focus on the important points crucial for the company. CURRENCIES CURRENCIES TAXATION TAXATION SHARES SHARES REVENUE REVENUE 50 Financial Statement Analysis.