Intro & Basics of Financials
Understanding the 3 financial statements and other basic concepts of finance
The three financial statements are: (1) Income statement, (2) Balance sheet, and (3) Cash flow statement. Each of the financial statements provides important financial information for both internal and external stakeholders of a company.
The income statement illustrates the profitability of a company under accrual accounting rules. The balance sheet shows a company’s assets, liabilities, & shareholders’ equity at a particular point in time. The cash flow statement shows cash movements from operating, investing, and financing activities.
If you don’t have a hold on each of the financial statements, we would suggest the following articles as a refresher on the basics:
Let’s start with a summary of the three financial statements and what they look like, and then we will discuss the important highlights:
Profit & Loss Statement
COGS includes all the direct costs attributable to the production of a finished good, which includes the following costs: a) Raw Materials b) Labour Costs c) Freight Charges, and d) Other overhead charges
Consolidated vs Standalone Statements: Usually Consol statement is used for Analysis. But if the Subsidiary is large or is in a different business segment, then both Standalone Entity and subsidiary are to be analyzed separately.
Balance Sheet
Can Equity be negative or very low: Yes, but as per books of account. Consistently loss-making startups generally have a negative equity balance; Companies with >100% dividend payout might have very low equity
Cash Flow Statement
We can also summarize the CFS into sources and usage of funds, as follows:
Cash vs Accrual
Cash flows are given priority over Income Statement items >>>
EBITDA is used as a proxy for Cash Income, but it doesn’t reflect WC Changes, Capex & Debt related outflows
Real proxy for cash flows can be FCFF/FCFE, thus they are used while computing the valuation of a company
Why do some companies sit on huge cash in their books?
Cue to cash advances from customers (e.g. IndiaMart)
Conservatism due to cyclical business and need cash to tide over tough times (e.g. Indigo)
or because they might be generating huge amounts of cash flow and are still left with excess cash after paying out huge dividends (e.g. IT Companies)
Optimum Capital Structure
Capital Structure refers to the mix of Equity and debt funding in a company’s balance sheet:
Why Equity? No fixed payment obligations as in Debt borrowings; Listing also generates goodwill and investor oversight
Why Debt? No dilution of ownership; Interest payment is tax deductible, thus effectively this is cheaper than equities
The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital.
In theory, debt financing offers the lowest cost of capital due to its tax deductibility, but debt levels higher than the optimum capital structure increase the risk of insolvency
When should a company prefer issuing Equity instead of Debt? When the valuations are over-stretched; a New project/capex has some risk involved
Corporate Actions
Dividends vs. Buybacks: Companies reward their shareholders in two main ways—by paying dividends or by buying back shares. The dividends will flow out of retained earnings, but the shares outstanding will remain the same. A buyback will reduce the share capital account and reduce the number of shares outstanding
Basic vs. Diluted EPS: Diluted EPS is a calculation used to gauge the quality of a company's earnings per share (EPS) if all convertible securities (outstanding stock options, warrants, convertible preferred shares, convertible debentures etc.) were exercised
Stock price cum-dividend vs. ex-dividend: When the company declares a dividend, the price is called cum-dividend. On the record date (freezing of the list of shareholders who would be receiving a dividend) the price changes from cum- to ex-dividend
Bonus Shares: Bonus share are given out to increase the liquidity of stock; It is a cashless transaction (out of Reserves and surplus) and doesn’t impacts the total fair value of the company
Stock Split: It has a similar impact as Bonus Shares; A bonus issue is an additional share given to existing shareholders while a stock split is the same share divided into two or more as per the split ratio. Bonus shares are benefiting to existing shareholders while both existing shareholders and potential investors can benefit from the stock split.
Time Value of Money
Why is NPV preferred over IRR?
A company’s objective is maximizing shareholder wealth, and the best way to do that is by choosing a project that comes with the highest net present value. Such a project exerts a positive effect on the price of shares and the wealth of shareholders. So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are mutually exclusive. Actually, NPV is considered the best criterion when ranking investments.
IRR assumes the reinvestment happening at the same rate
In NPV you are using the opportunity cost as a discount rate so here you can assume that intermittent cashflows can be reinvested at that rate
In terms of profits, we always want to evaluate the absolute profit of a project, which is calculated using NPV
Thus, IRR is preferred when deciding whether a single project is worth investing in. For deciding between multiple projects NPV is a more preferred measure.