Financial Statements and Analysis IIMB

Financial Statements and Analysis
M S Narasimhan
Professor Finance & Control Area Indian Institute of Management Bangalore Bannerghatta Road, Bangalore 560076
March 2009
Content
1. Introduction
2. Balance Sheet
29
3. Income Statement
63
4. Cash Flow Statement
86
5. Analysis of Financial Statements
107
Preface The motivation for this material/book is to explain the financial statements in a simple and reader-friendly language and build reasonable confidence in dealing with financial numbers for nonfinancial managers. As I started teaching this module in many management development programmes, I realized that many organizations want to provide this financial input for their managers and many managers also expressed their aversion in dealing with financial matters. Among different finance topics, the aversion is more on accounting numbers. I initially started using the book titled Understanding Financial Statements by Fraser and Ormiston, which was generally received well by the managers. However, there is a general feeling that the book is in the U.S. context and the need for Indian version was felt by many of these managers. Though I personally like the Fraser and Ormiston book and would love to use the same, I decided to write Indian version following similar approach. I strongly recommend the readers to go through the Fraser and Ormiston book in addition to going through this book to get further insight on the subject. Throughout this book, I used one of the best known companies in India, Asian Paints to explain principal financial statements and how one can use such statements for analyzing the financial performance of a company or division of a company. Many managers who have gone through the earlier version of the book were positive and confirmed that the book is reasonably simple to read, comprehend and provide confidence on the subject. I have also prepared a Microsoft Excel Template for the analysis and I would be happy to share the template with all my readers of this book. This book and template is available free of cost. My future projects include developing a similar material on management accounting, finance, valuation and many other finance topics that I teach. Also, I am trying to get a video of my teachings using these materials for those who have not attended my lectures but interested in listening my lectures. I would be happy if you could give me your feedback on how best I can improve this material and also point out the errors of the book. Please also feel free to share this material with your friends and other managers.
M S Narasimhan Email: msn@iimb.ernet.in
Chapter 1
Introduction
1.1
INTRODUCTION
There are several business and social organisations around us. All these organisations have been started with an objective and goal. Many business organisations pursue the goal of maximising the wealth of the shareholders whereas social organisations pursue the goal of maximising the welfare of the targeted users. Setting the objective or goal is the beginning of a long journey for the promoters of the organisations. They need to raise resources or capital to perform activities to achieve their goals. Once resources are obtained they need to be invested in creating certain infrastructure and perform operations. At the end of each period, the performance of the operations is measured to understand whether the primary objective of the organisation was achieved or not. Accounting plays a critical role in measuring performance of the operations. Accounting records all monetary transactions and summarises the same at the end of the period to produce financial statements. There are several non-monetary performance measures like quality, customer service, cutting-edge technology, environment-friendly, etc., which are also highly important in measuring performance. While these measures are relatively easier to understand, most users find financial statements are often difficult to understand. The primary purpose of this book is to explain financial statements in a non-technical manner using financial statements of an Indian company throughout the book. Financial statements per se are simple to read and easy to understand. However, most readers of financial statements consider these as complex statements because financial statements are the output of accounting process. The problem is mostly on account of their experience with the accounting system. For example, a mechanical
engineer managing shop floor that consists of some 20 machines is comfortable in his job since he is familiar with the operation and maintenance of machines. For him, accounting is a black box. Suppose, he finds that a few machines are not giving good productivity and hence changed those machines with new ones that are slightly costlier than earlier machines. Though he would be expecting some increase in departmental expenditure, he would be shocked to see that the cost of operations of the shop floor has gone up several times more than the departmental cost of last period. Accountant explains that the higher cost is on account of increase in depreciation value due to written down value method followed by the company. Under this method of depreciation, depreciation value will be higher during the initial life of the machine and declines over a period of time. Since he has replaced old machines with new machines, depreciation values have gone up. Accounting department often handles taxation related issue like exercise, customs and income tax and that is another area that many of the readers would be uncomfortable. The result is a kind of perception that anything comes out of accounting process is difficult to follow. To add such feelings, there were major accounting frauds, which resulted in the loss of several jobs and billions of dollars in the United States and other developed nations. If a wrong accounting entry or treatment has the potential to impact someone's job in the operations, the level of fear on understanding the accounting process increases several times. Fortunately, accounting is not that much a complex subject and many of these accounting frauds are basically violation of established principles. Whether one likes it or not, understanding accounting process and financial statements are critical in managing organisations or a part of the organisation.
1.2
FINANCIAL ACCOUTNTING
Accountants record all monetary transactions that take place in the organisation. Normally such recording is done as and when transactions take place. For the purpose of recording, accountants create necessary accounting heads. For instance if the company takes loan from a bank, the accountant records this under the accounting head "Loans". Similarly, if the company buys a machine and some materials, accountant records the amount spent on machine under "Plant and Machinery" and materials under "Raw Materials". Suppose the sales representative travels to New Delhi to complete a sale. Travel expenditure incurred by the sales representative is recorded under the accounting head "Travel Expenditure". Accountants create a large number of accounting heads and they can be broadly classified under five headings namely equity, liability, asset, income and expenses. Recording accounting transactions is not a complex job and today they are mostly done by computers. For the purpose of recording, accountants use a system called 'double entry book keeping', which is also fairly simple to understand.
Chapter 1 Introduction 1.2.1 Double-entry book-keeping
Each transaction that qualifies for recording in accounting system affects the company in two ways. For example, if a company borrows loan from a bank, the company gets cash and at the same time is liable to repay the loan. It is necessary for the accounting system to record that the company has received cash and also the company is liable to pay the amount to the bank. Suppose, the company buys machine by paying cash. Again, accounting system records that the cash has come down by the cost of the machine and also, increases the value of machines owned by the company. In other words, each transaction (e.g. borrowing money from bank, buying a machine, etc.) causes two entries in the accounting system and hence it is called double entry book keeping system. This double entry book keeping system can be expressed in the form of an accounting equation shown below.
Assets = Shareholders' Equity + Liabilities

The above accounting equation expresses a simple fact. The business unit raises money from shareholders and lenders and invests the same in assets. All accounting transactions are recorded in such a manner that the above equation is always balanced. We will revisit this equation and discuss more on the same.
1.2.2 Internal Control System

Accounting department deals with monetary transactions and also records them. There is a need for proper control systems before dispersing money. For example, when the accounting department makes payment for an Invoice, it has to make sure that the goods have been actually received by the company. Otherwise, someone will print several invoices without any supply of goods and take away the money. Normally the accounting department verifies a few things like purchase order and goods receipt cum inspection note prepared and certified by stores and inspection department before making payment. Suppose someone in the company submits a travel bill, the accounting department would looks for proper authorisation for such travel. Internal control system normally expects at least more than one person and often more than two peoples involvement before making payments. Normally, organisations prepare accounting manual to describe such internal control systems along with listing accounting heads and procedure for recording transactions. Though more than one person is involved in monetary transactions, it is still possible that there may be collusion of people involved in such transactions. Some of the major accounting frauds involve more than one executives of the company. Agency problem exists everywhere when there is a separation of ownership and management. A simple example is political system under democracy where conflict of interest exists between people, politician/ministry and bureaucracy. Among the people also there are different classes like the upper, middle and lower or different sectors like north, west, south and east or within the state, various caste-based divisions, etc. Agency problem in political system is thus much more complex than agency problem
prevalent in business organisations. Once the agency problem is recognised, then the issue is how to reduce the problem. There are several ways or levels at which such problems are handled. In accounting system, it is handled through internal control system and auditing.
1.2.3 Internal and External Auditing

Internal auditing aims to resolve some of the conflicts between top management and other levels of management. Internal auditing examines all or substantial parts of the accounting transactions independently to make sure that internal control system works effectively. It also examines whether accounting transactions are properly recorded in the books of accounts. In many government organisations, there is concurrent audit in which internal audit department's clearance is required before the accounting department processing the bills for payment. Internal auditing can be done by full-time employees of the organisations or independent accounting firms. Internal auditors submit their report to top management. Nowadays, internal audit reports are also discussed by the Audit Committee, which consists of a few members of the Board of Directors. In addition to internal auditing, accounting records and internal control system are examined by independent external auditing firms. This is also called statutory auditing because such independent auditing is a mandatory requirement of the Companies Act that governs the company form of organisations. In company form of business organisation, statutory auditors are appointed by the shareholders in the Annual General Meeting (AGM). Statutory auditors in their report to the shareholders must state whether there are adequate internal control systems and whether the financial statements reflect the true and fair view of the company's financial position.
1.3
FINANCIAL ACCOUNTING REGULATIONS
The primary role of accounting is to record the transactions and present a summary of such transactions at the end of the period. Through such summarised statements, the management is communicating the companys performance to shareholders and others. In that sense, accounting is often called the language of business. Since accounting is a language to communicate something, it requires some rules and regulations. Rules and regulations are defined so that an accounting statements prepared by applying such rules and regulations are meant the same thing to both who prepare such statements and those who read or use such statements. Accounting rules and regulations can be broadly classified into two categories namely accounting concepts and conventions and accounting standards.
1.3.1 Accounting Concepts

Accounting concepts and conventions generally have no regulatory backing but accounting standards that are prepared by the regulating agencies use such concepts and conventions. If there is no accounting standard clearly laid down on a particular
Chapter 1 Introduction
issue, it is expected that such accounting transactions be treated in the books of accounts in consistent with basic accounting concepts and conventions. In other words, accounting concepts and conventions are evolved over a long period of time and are fundamental to accounting system. The following are few such important concepts and conventions which are used in preparing accounting statements.
1.3.2 The Entity concept

This concept emphasis that a business entity is separate and distinct from its owners. The accounts and financial statements should show the affairs of the business not that of the owner. In other words, even if there is any transaction between owners and the business unit or any transactions performed by the business unit on behalf of owners, it should be reflected in the account as if owner is different from business unit. For instance, if the company pays for personal air-travel cost of the owners, it should be shown as receivables from the owners. In the company form of business organization, such distinction is obvious because the law itself defines company as a separate legal entity. Even in other forms of organisations, though there is no such legal distinction, the owners and firm are treated two separate entity for accounting purpose so that the performance of the business can be measured better.
1.3.3 The Going Concern concept

The company or business is presumed to be healthy and likely to continue in business for the foreseeable future. This concept assumes importance in recognising assets and liabilities. If the assumption fails to hold, then all expenses including expenses incurred for purchase of fixed assets are to be shown expenses. Suppose the company pays insurance premium for period beyond accounting year. It is not possible to defer the expenditure and hence the entire expenditure has to be treated as that period expense. Similar is the case for valuation of work-in-progress. All assets are to be shown on liquidation value as if the company will be liquidated at the end of the period. By applying going concern concept, one can reasonably spread the expenditure over a period of time if the benefit of such expenditure also spreads over a time period. In certifying financial statements, auditors need to satisfy themselves whether the going concern concepts hold good or not.
1.3.4 The Money measurement concept:

Money measurement concept requires accounting system to record transactions only if such transactions can be measured on monetary basis. In other words, those events that cannot be measured in money terms cannot be entered in the books. There is no way to measure customers' satisfaction or production excellence or human resources value in accounting. In that sense, accounting is not integrating itself with other functions and today a typical performance measurement includes several other non-monetary measurements. However, it can be counter argued that if a firms production facility is
excellent or customer satisfaction levels are high, then they will be reflected in the form of additional revenue. Though it is true that ultimately they will be reflected in incremental revenue or profit, there could be considerable time gap. Another example is when a merger takes place between two companies, a number transactions are recorded as the company has to merge two financial statements into one. However, during the course of merger, the events like employees' dissatisfaction of the merger, if any, cannot be measured in monetary terms and hence not relevant for the financial statements. They may ultimately cost more for the company and reflected in the financial statement. Until then accounting statements will not capture such developments.
1.3.5 The Historical Cost concept

This concept explains how the value of any transaction should appear in the books. Suppose the business has acquired an asset for Rs. 10 lakh at the beginning of the accounting year and its value at the end of the year is Rs. 12 lakhs. What should be the value of the asset shown in balance sheet? If we assume that the company is going to be there for a long time (going concern concept), we should not bother year to year changes in value and hence the capital appreciation is not relevant. In accordance with this going concern concept, the historical cost concept says the assets or any transaction has to be entered initially at historical cost. Similarly, when a company buys some machines say computers in bulk, it might get a price different from the normal price. Here again the company can recognise only the price it has paid to the seller of asset. This concept is violated in certain cases where the concept itself requires the users to use such lower value.
1.3.6 The Conservatism concept

The conservatism convention suggests that the profits should not be realised and recorded until it occurs or should not be anticipated. The profits should be earned and accrued. However, losses can be anticipated and provided in the books. For instance, if the company believes some of its credit sales are not realisable, then it should provide for them as bad debts from the profits. Similarly, the value of inventory or short-term investments may have to be reduced and losses be recognised if the market price of inventory or short-term investments decline from the cost of acquisition. Here the cost concept is given up because these short-term assets are held for sale and when there is a loss even before the sale, they need to be recognised. It may look arbitrary to you as a manager that profit should not be recognised before sale whereas potential losses have to be recognised even before sale takes place. However, shareholders and other would like to have true and fair view of the company though financial statements and hence would expect the company to provide for known losses.
Chapter 1 Introduction 1.3.7 The Matching Concept
The matching concept requires revenue and expenses be matched to derive a reasonable value of profit1. Usually, the matching concept is applied by first determining revenue for the period, and then matching items of expenses that gave rise to these revenues. For example, if a firm sold 5000 units of finished products, then costs related to manufacturing and selling of 5000 units is to be identified and matched. This concept has to be applied along with conservatism concept and materiality concept. It may not be possible in many cases that the expenditure will actually relate to earning of the revenue but still will be deducted from the revenue to derive profit. These expenses are in the nature of period cost, that is whether there is a revenue or not, they may have to be incurred. For instance, the normal expenditure for maintenance will be Rs. 10 lakhs and the normal production is Rs. 500 lakhs. One can reasonably assume that Rs. 10 lakhs of maintenance is required to produce Rs. 500 lakhs worth of goods. Suppose in a year, due to strike or lock out, the actual production was Rs. 20 lakhs but the maintenance expenditure was still about Rs. 6 lakhs. We will presume that Rs. 6 lakhs was necessarily spent to earn Rs. 20 lakhs though the actual reason could be Rs. 5 lakhs worth of maintenance is required whether there is a production or not.
1.3.8 The Materiality concept

All monetary transactions are to be recorded and reported in the accounting system. However, the treatment of an item depends on the importance of the item. The treatment is normally related to recognising the expenditure as capital and revenue. For instance, an airline buys coat hangers or, your company purchasing pens to be used by the employees. Are they assets or expenses? Applying the definition of assets, they are actually assets since they are not held for sale and used in the process of manufacturing a product or service. However, they are not treated as assets and treated as expenditure for the period. That is, they are treated as if they are consumed and do not exist in the next accounting period, which however, is not true. But, such treatment is justified because for an airline company, it is not worth to record coat hangers as assets and providing depreciation year after year. For more understanding on definition of assets and expense refer section 1.4.
1.3.9 The Accrual concept

Accounting transactions generally end up with cash. That is, a sale is ultimately realised and expenses are generally paid. The question is should accounting system
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The only exception is when conservatism concept required to be applied. In such a situation, expenses are to be reported even though there is no income. For example, when the firm spends money on research, the benefit may arise in the future but the conservatism concept requires the firm to recognise this as expenditure for the period in view of uncertainty associated with the outcome of such research efforts.
wait for the cash part to complete before recording the same. It is not normally treated that way. Accounting transactions are recorded without waiting for cash part to complete. The reason is accrual concept. When it comes to revenue or expenses, accrual concept is consistent with matching concept. If a sale is made, whether expenses on account of sale is paid or not, they are to be recognised. For instance, an advertisement was released on December 25 but the amount was paid on 4th April. Since the expenses have been accrued, they need to be recognised in the accounts. Similarly, if a loan is taken in January and next interest has to be paid at the end of June, interest expenses for the period of January to March are to be recognised when closing the books of accounts in the month of March.
1.3.10 The Consistency concept

Consistency concept indicates that the company cannot keep changing its accounting policies quite often. If a company decides to depreciate its assets on a straight-line basis of accounting, then it is expected to continue the same for few years. A Company cannot depreciate an asset on straight-line basis in year 1 and adopt written-down value in year 2. So once a firm has chosen a particular method of accounting, it should adhere to that method in the future, so as to allow for the most meaningful comparisons on a year-on-year basis. Only when there are compelling reasons, they should go for a change and that change should be reported in the notes to accounts along with the financial impact of the same. However, with regard to different accounting methods, a company can adopt straight-line method of depreciation for reporting purposes and written-down value for tax purposes.
1.3.11 Accounting Standards

While accounting principles, concepts and conventions are general in nature, accounting standards are far more specific. Accounting standards in general discuss how a particular accounting transaction should be treated in the books of accounts. Wherever alternative treatments are possible, accounting standards generally allow such alternative treatments subject to the condition that the same is disclosed so that users will understand the consequence of following such treatment. For example, in valuing inventory, firms can follow one of the several methods allowed under the regulation but they need to be disclosed in the financial statements. Some accounting standards also deal with disclosure of information to the readers. Some of the recent accounting standards require segment report, disclosure of related party transactions, etc. As stated earlier, accounting standards have the backing of some organisations. Accounting Standards are framed by the Accounting Standard Board (ASB) of the Institute of Chartered Accountants of India (ICAI). So far, ASB has framed 28 Accounting Standards2. Companies Act, 1956 requires companies to comply with the Accounting Standards prescribed by the ICAI. Non-compliance with Accounting
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Details on the accounting standards can be obtained from www.icai.org
Standards requires reporting the reason along with the financial impact for such noncompliance. The Act also requires both the Board of Directors and auditors to inform whether the financial statements are prepared in accordance with accounting standards. In addition to generally accepted accounting principles, concept, conventions and accounting standards, there are other agencies, which regulate accounting systems and financial statements. Companies Act, 1956 prescribes the books that are to be maintained by the companies. It also gives the format for the balance sheet and information to be provided in profit and loss account. Securities and Exchange Board of India (SEBI) also lists down few statements that are to be given to the shareholders by the listed companies and they are mostly disclosure related statements. SEBI brings such regulations by requiring the stock exchanges to amend the listing agreement. The reasons behind the regulatory interference in preparation and disclosure of accounting statements are attributable to agency problem. The government, through Companies Act, allows the company form of organisation in which millions of shareholders invest money and also vest the management to select people. Management and the shareholders, who control the management, have incentive to misrepresent the accounting statements for certain short-term gains. Many accounting transactions are amenable for such misrepresentation. The government has some responsibility towards such millions of minority shareholders. Hence, the Companies Act requires the companies to appoint auditors and provide audited financial statements in accordance with accounting standards to the shareholders. Accounting bodies in turn develop set of standards to make sure that the accounting statements that they certify are standardised to an extent.
1.4 FUNDAMENTAL ACCOUNTING TERMS

There are five fundamental accounting terms, which are used in financial statements. They are discussed briefly in the following pages. Asset: Assets are economic resources that are capable of generating future revenue or required for creating future revenue. Examples of assets include plant and machinery, furniture, raw material, investments (in bonds and equity shares), cash, etc. Assets are normally tangible and also owned by the company but there are exceptions. Technical know-how, patent, trademark, etc. are also assets though they are intangible. However, they play a role in the process of generating future income. Assets that appear in the financial statements are normally owned by the company but here too there are few exceptions like assets acquired and used by the company on financial lease or hire purchase. Some large expenditure, whose benefit is likely to be realised in the future, is also treated as assets. Examples of such assets are research and development expenditure, major expenditure on information technology, business restructuring expenses, etc. Though these are exceptions, most items shown as asset are owned by the company and also tangible. We will discuss more on different kinds of assets in Chapter 2.
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Liabilities: Liabilities are financial obligations of the firm to non-owners or outsiders. There is no necessity for a company to have liabilities but many companies acquire resources through loans or on credit. Bank loan is something very common in most companies. Similarly, materials are acquired through credit purchases. There are several reasons for companies to acquire resources through liabilities. For instance it may not be possible to raise equity always and equity finance is also costlier than other sources of finance3. Some of the liabilities are known and fixed whereas sometime liabilities are estimated and provided in the accounting statement. For instance, liability for retirement benefit of employees is known for certain only at the time of retirement of employees. However, such liabilities can be estimated based on the service details of employees. They are estimated and provided because without such liabilities, users of financial statements may tend to overvalue the owners' wealth. Liabilities are of several types. Some of them are long-term and others short term. Those that are to be discharged over one year are mostly classified as long term in nature. And apparently, those to be discharged with in one year are classified as short-term liabilities. Equity: Equity represents owners' wealth. In the company form of organisations, owners are referred to as shareholders. Shareholders bring equity share capital at the initiation of the business and also periodically as and when major growth takes place. On a year to year basis, they contribute fresh capital in the form of allowing the management to retain part of the profit available to them. Such retained profit is called retained earnings or reserves and surplus. Equity or shareholders' wealth or shareholders' fund can be defined as owners claim against or interest in the assets of the company. Naturally, they can claim the assets only after discharging of all liabilities including estimated liabilities. It again gives us basic accounting equation.
Shareholders' Equity = Assets - Liabilities

Revenue: Revenues are income generated when the firm sells goods or services and such revenues increase the shareholders' wealth. Revenues need not be realised in the form of cash immediately since accounting transactions are recorded or recognised on accrual basis. Recognising revenue is one of the challenging tasks for accounting managers in certain cases. For instance, a software company undertaking a large project running for 3 years or a construction company building an irrigation dam or power project. These are special cases and accounting standards or in the absence of accounting standards, accounting concepts and conventions help the accountant to recognise some reasonable value as revenue based on the completion of work. Expenses: Expenses are incurred in the process of generating the revenues. These could be on account of manufacturing, selling, general or administrative.
3
Many readers may feel equity finance is less costly than loan, but unfortunately such a notion is not correct. Equity holders take more risk in the business and hence they will invest money only when they see returns are higher than what is available to them if they invest the same money in debt funds that has less risk.
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Manufacturing expenses are incurred to produce the goods. Assets when used become expenses. One good example would be depreciation. As and when the assets are used, the company charges depreciation, based on the usage of the asset. They reduce owners' wealth. Expenses need not always lead to increase in liabilities and often it may cause reduction in the value of the assets and hence reduce the owners' wealth. A simple case is paying cash to a firm, which performs repairs to machine. The value of assets (cash) decline when the firm effects payment for availing service.
1.5 FINANCIAL STATEMENTS

Financial statements are summary of accounting transactions and presented in such a manner that users can know the operating performance of the organisation and also its impact on the overall value of the organisation. Financial Statements generally refer to three principal financial statements namely Balance Sheet, Profit and Loss Account or Income Statement and Cash Flow Statement. These statements have schedules and explanatory notes that generally form part of financial statements. In the next three chapters, we will be discussing these statements in detail and here is a brief overview of these statements. Throughout the book, we will be discussing these statements with the help of financial statements of Asian Paints (India) Ltd. given in Exhibit 1.1 through 1.4 that provide some basic details of the company along with the three principal financial statements.
1.5.1 Balance Sheet

Balance sheet summarises assets, liabilities and shareholders equity as on a particular day and normally as on the last day of the accounting year. Exhibit 1.1 shows the balance sheet of Asian Paints (India) Ltd. as at 31st March 2008. The format of annual reports of companies in different countries differs to an extent. Companies in the U.S. and U.K. and a few other European countries provide assets value first and then liabilities and shareholder equity. Companies in the U.S. start with most liquid assets (cash) and end with least liquid assets (equipment), whereas companies in the U.K. start with less liquid assets and end with most liquid asset. Both U.S. and U.K. companies start with liabilities and end with equity with one exception. Companies in the U.K. deduct liabilities, which are payable within a year (current liabilities) from current assets (assets which are converted into cash within a year) whereas U.S. companies show current liabilities as a separate item of liabilities. Indian companies follow a mix of the above formats. It differs from other format on the sequence. Indian companies Balance sheet begins by providing equity first, then liabilities and finally assets. Liabilities are primarily those that arise due to borrowings. Borrowings of both long-term and short-term are shown under liabilities. Equity and liabilities together are called sources of funds. Asset side begins with most illiquid assets namely fixed assets and end with cash. Current liabilities are deducted from current assets as in the case of U.K. companies. Indian companies format reflects how much money that the company has raised (externally and internally) and where
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they have been used. Though the format of balance sheet differs in some respect, all balance sheets show assets, liabilities and shareholders' equity and consistent with the accounting equation discussed earlier.
Exhibit 1.1 Asian Paints (India) Ltd. - A Profile

Asian Paints (India) Ltd (APIL), promoted in 1942, is the largest paint company in India and one of the top ten decorative coatings companies in the world. The company has grown to become a truly international player in the global paint industry with presence in almost 50 overseas market. The company has presence in both Decorative and Industrial Coating segment of the Paint business. APIL's product range includes Wall paints, Metal paints, Wood Finishes, Primers and others. Vertical integration has seen it diversify into specialty products such as Pentaerythritol and Phthalic Anhydride. Apart from offering the customers a wide range of decorative and industrial paints, it even custom-creates products to meet specific needs. APIL's brands, Royal in the premium segment, Apcolite in the middle segment, Gattu, Tractor, Utsav, 3-Mango, etc, in the lower segment, are all well-established brands in their respective segments. Its one-stop colour shop has software to choose and select 1,511 combinations of various colours. The company enjoys the market share of 27% in the overall market. The company boasts four state-of-the-art manufacturing plants (for paints) at Bhandup(Maharashtra), Ankleshwar(Gujarat), Patancheru (Andhra Pradesh), and Kasna(Uttar Pradesh) with an combines installed capacity of 2,30,900 MT per annum. The company is setting up its fifth and its largest paint plant at Pondicherry with an installed capacity of 100000 TPA. It is also planning to establish a new plant with a capacity of 1,00,000 tonnes at Sriperumbudur near Chennai in Tamil Nadu. It is expected to be operational by March, 2005. Asian Paints in its pursuit to become a top five player in the global decorative paints market is following both organic and inorganic growth. During FY 2000-2001, APIL has set up two units each in Oman and Mauritius and acquired controlling stake in Delmege Forsyth & Company (Paints), the second largest paint company in Sri Lanka. APIL is also in the process of setting up a manufacturing unit in Bangaladesh. Further it has made two significant overseas acquisitions in 2002. APIL acquired 50.1% stake in loss making Berger International Ltd., a listed company in Singapore Stock Exchange in Nov 2002. Berger Internatioanl has manufacturing operations in 11 countries spread across the globe but does not have any operation in India. Sixty percent stake in SCIB Chemical SAE, Egypt, the fifth largest paints company in Egypt has also been acquired in 2002. Recently, the company has also acquired minority stake at ICI (India) Ltd. .
Chapter 1 Introduction 1.5.2 Profit and Loss Account
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Profit and loss account or income statement shows the operating results of the organisation during the period. While balance sheet states financial positions of the organisation at a particular point of time, income statement reports the operations that have been performed during the period. The period can be a year or quarter or halfyear. Listed Indian companies have to give quarterly results and such results are provided in the form of profit and loss account. Though several line items of Profit and loss account might confuse the readers, it primarily provides the details of sales, other income, operating expenses broadly classified into few categories, depreciation, interest, tax, profit and finally how much of the profit is distributed and how much is retained.
1.5.3 Cash Flow Statement

Cash flow statement shows how much cash that the company has received during the period and how the cash was spent. It gives sources and uses of cash under three broad groups namely, cash flow from operating activities, cash flow from financing activities and cash flow from investing activities. Normally, investors and analysts compare profit shown in profit and loss account and cash flow from operations shown in cash flow statements to get some insight on the quality of profit reported in the profit and loss account. ,
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Exhibit 1.2 BALANCE SHEET as at 31st March 2008 of Asian Paints (India) Ltd. (Rs. in Crores)
Schedules FUNDS EMPLOYED Shareholders Funds Share Capital Reserves and Surplus Loan Funds Secured Loans Unsecured Loans Deferred tax liability - (Note B - 21 in Schedule M) Total APPLICATION OF FUND Fixed Assets Gross Block Less : Depreciation Net Block Capital Work in Progress Investments Current Assets, Loans and Advances Interest accrued Inventories Sundry debtors Cash and Bank Balances Other receivables Loans and Advances As at As at 31.03.2008 31.03.2007
A B C
95.92 832.58 928.50 36.70 58.00 94.70 31.52 1054.72
95.92 648.16 744.08 66.90 58.77 125.67 22.15 891.90
D 937.89 509.06 428.83 110.39 E F 0.09 538.97 251.90 41.35 33.09 178.82 1044.22 539.22 422.88 806.20 471.29 334.91 11.62 346.53 334.39 0.03 434.07 235.96 42.49 31.23 115.45 859.23 594.10 54.15 648.25 92.62 1054.72 210.98 891.90
Less: Current Liabilities and Provisions Current Liabilities Provisions
G 785.11 166.49 951.60
Net Current Assets [(F) - (G)] Total
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Exhibit 1.3 ' st PROFIT AND LOSS ACCOUNT for the year ended 31 March 2008 of Asian Paints (India) Ltd. (Rs. in Crores)
Schedules INCOME Sales and operating income (Net of discounts) Less: Excise Duty Sales & operating income (Net of discounts & excise) Other Income EXPENDITURE Materials Consumed Employees' remuneration and benefits Manufacturing, admin., selling & distribution Exp. Profit Before Interest, Depreciation and Tax Less: Interest (Refer Note B - 17 in Schedule M) Less: Depreciation (Refer Note B-197 in Schedule M) Profit Before Tax Less: Provision for Current Tax Less: Provision for Deferred Tax (Refer Note B - 27 in Schedule M) Less: Fringe Benefit Tax Less: Short/(Excess) tax provisions for earlier years Profit After Tax Before Prior Period Items Add: Prior period items Profit After Tax and Prior Period Items Add: Balance Brought forward from previous year DISPOSABLE PROFIT DISPOSAL OF ABOVE PROFIT Dividend Equity Shares - Interim Dividend 1 - Interim Dividend 2 - Proposed Final Dividend Tax on Dividend Transfer to General Reserve Balance carried to Balance Sheet Earnings per share (Basic & diluted) (Note B-25 in Schedule M) Year 2007-2008 3911.96 495.80 3416.16 62.58 3478.74 1956.13 194.67 711.35 2862.15 616.59 8.27 43.77 564.55 171.32 9.38 5.96 1.30 376.59 -1.39 375.20 150.00 525.20 Year 2006-2007 3244.57 423.28 2821.29 40.45 2861.74 1660.71 157.11 581.71 2399.53 462.21 6.87 45.42 409.92 137.90 -2.37 4.46 0.00 269.93 2.12 272.05 110.00 382.05
J K L
62.35 100.71 27.72 134.42 200.00 525.20 39.12
52.76 62.35 9.59 17.77 89.58 150.00 382.05 28.36
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Exhibit 1.4 ' st CASH FLOW STATEMENT for the year ended 31 March 2008 of Asian Paints (India) Ltd. (Rs. in Crores)
2007-2008 A. Cash Flow From Operating Activities Profit before prior period item and tax Adjustments for: Depreciation Interest Income Dividend Income Interest Expense Prior Period adjustments Loss/(Profit) on Sale of Long Term Investments Loss/(Profit) on Sale of Short Term Investments Loss/(Profit) on Sale of Assets Operating Profit before working capital changes Trade Receivables Other Receivables Inventories Trade and other payables Cash generated from Operations Income Tax Paid net of refund Net Cash generated from Operating Activities (A) B. Cash Flow From Investing Activities Adjustments for: Purchase of Fixed Assets Sale of Fixed Assets Loans to subsidiaries Repayment of loan to subsidiaries Purchase of Investments Sale of Investments Interest Received Dividend Received Net Cash used in Investing Activities (B) C. Cash Flow From Financing Activities Proceeds from long term borrowings Proceeds from Short term borrowings Repayment of Long term borrowings Repayment of Short term borrowings Interest paid Dividend and Dividend tax paid Net Cash used in Financing Activities (C) Net increase/decrease in Cash [(A) + (B) + (C)] Note: Figures in brackets are negative values 564.55 43.77 (3.71) (25.01) 8.27 (1.39) 0.00 (0.96) (0.93) 584.59 (15.94) (31.10) (104.90) 199.86 632.51 (175.22) 457.29 (258.28) 1.57 (18.60) 2.28 (202.71) 115.18 3.64 25.01 (331.91) 5.07 0.00 (0.94) (35.10) (8.28) (87.27) (126.52) (1.14) 4.64 30.38 (0.45) 0.00 (6.91) (214.88) (187.22) 14.10 (67.73) 2.09 (1.91) 1.51 (116.33) 56.86 1.41 13.17 (110.93) 2006-2007 409.92 45.42 (1.44) (13.17) 6.87 2.12 (0.31) (0.06) (1.36) 447.99 (50.85) (14.17) (84.36) 162.23 460.84 (148.59) 312.25
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1.6 PREPARING FINANCIAL STATEMENTS

Preparation of financial statements is not a difficult task. It is a complex task when it comes to treatment of certain transactions but they can be resolved with the help of accounting standards and in the absence of accounting standards by applying accounting principles, concepts and conventions. If there are still some problems, they can be resolved through better disclosure. In this section, we illustrate how accounting statements can be prepared with the help of few transactions. We have attempted to avoid using debit and credit and in its place used accounting equation to explain the process of accounting.
1.6.1 Accounting Equation Illustration

1. Suppose a few of us jointly promote a trading company on January 1, 2008 to buy and sell few consumer durable items. We contribute Rs. 1 lakh per person and totally 30 of us have contributed to the share capital. Our accounting equation now is as follows. Assets Cash (30 lakhs) = = Liabilities + Shareholders' Equity 0 + Equity share capital (30 lakhs)
2. We approached a bank for a loan and the bank, based on assessing our requirement, has given us a loan of Rs. 20 lakhs. But our banker says we have to pay interest at the rate of 1% per month before 5th of next month. Our accounting equation immediately after this loan is as follows. , Assets Cash (50 lakhs) = Liabilities + Shareholders' Equity = Loan (20 lakhs) + Equity share capital (30 lakhs)
3. Now we found a place for showroom and paid Rs. 5 lakhs towards refundable advance. The rent for the show room is Rs. 1 lakh per month and payable by 5th of following month. While we need to record showroom rent advance, we don't need to record the agreement to pay rent of Rs. 1 lakh at this point of time. Advance is treated as asset since it is refundable. Advance (5) + Cash (45) = Loan (20) + Equity share capital (30) 4. We spent another 5 lakhs towards furniture for the show room. Furniture is asset. Our accounting equation now is as follows. Furniture (5) + Advance (5) + Cash (40) = Loan (20) + Equity share capital (30)
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Note cash value is coming down as we spend money. 5. Let us now do some business. We purchased consumer durable worth of Rs. 60 lakhs. We paid Rs. 30 lakhs and agreed to pay the balance in 60 days time. Our accounting equation now is as follows. Furniture (5) + Stock (60) + Advance (5) + Cash (10) = Loan (20) + Creditors (30) + Equity share capital (30) 6. We are able to sell Rs. 40 lakhs worth of goods for Rs. 50 lakhs. Of this we have made cash sales of Rs. 30 lakhs and remaining Rs. 20 lakhs is on credit basis to few institutional customers. Our accounting equation is now bit lengthy. Furniture (5) + Stock (20) + Debtors (20) + Advance (5) + Cash (40) = Loan (20) + Creditors (30) + Equity share capital (30) + (Sales (50) Cost of goods sold (40)) The equation underwent few changes. Stock has come down from Rs. 60 lakhs to Rs. 20 lakhs because we have sold Rs. 40 lakhs worth of goods. Cash is increased by Rs. 30 lakhs because we made cash sales of Rs. 30 lakhs. We have new entry called 'debtors' because we sold Rs. 20 lakhs to some institutional customers on credit basis. Since we can claim the amount at the end of due period, it is our asset. Since sales of Rs. 50 lakhs increase our wealth, it is shown along with shareholders equity and since Rs. 40 lakhs is expense incurred for this sales and it reduces our wealth, and hence reduced from the revenue or sales. 7. Our manager informs that we have to pay Rs. 2 lakhs as salary by 7th of next month, Rs. 2 lakhs for advertisement by 3rd of next month, Rs. 20000 towards interest by 5th of next month and Rs. 1 lakhs towards rent by 2nd of next month. Suppose we need to prepare a profit statement, we need to consider the above liabilities. None of our existing accounting heads in the accounting equation will be affected but on the right hand side of the equation, we have to add a new head called 'expenses payable (Rs. 5.2 lakhs) and also place a minus value of the same amount as expenses next to cost of good sold. Our accounting equation will be as follows. Furniture (5) + Stock (20) + Debtors (20) + Advance (5) + Cash (40) = Loan (20) + Creditors (30) + Expenses Payable (5.2) + Equity share capital (30) + (Sales (50) - Cost of goods sold (40) - Expenses (5.2))
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8. On the right hand side after Equity share capital, we have four items and all of them can be netted out to get profit for the period. The profit for the period is Rs. 4.80 lakhs. 9. Since many of us have borrowed money to invest money, we felt we can take some amount out of the profit to pay part of our interest. We took Rs. 1 lakh as dividend. Our cash holding declining by Rs. 1 lakh and we get a new accounting head called dividend on the right side. Our accounting equation now is as follows. Furniture (5) + Stock (20) + Debtors (20) + Advance (5) + Cash (39) = Loan (20) + Creditors (30) + Expenses Payable (5.2) + Equity share capital (30) + Sales (50) - Cost of goods sold (40) - Expenses (5.2) Dividend (1)
1.6.2 From Accounting Equation to Financial Statements

We can now prepare principal financial statements with the help of our accounting equations. Profit and loss account similar to the one shown in Exhibit 1.3 is shown in Exhibit 1.5. Balance sheet can be prepared using the rest of the accounting head available in our last accounting equation. Balance Sheet like the one shown in Exhibit 1.2 is shown in Exhibit 1.6. The profit and loss account and balance sheet that we prepared are fairly simple and there are complex transactions in the real word. However, we demonstrated the fact that preparation of these statements is fairly simple once the complex transactions are translated into accounting equation. Cash flow statement preparation is slightly complicated in a sense that it can't be prepared by just looking into the last equation. We need to look into all transactions and trace cash part of it. Since the number of transactions is relatively few, it is possible for us to work from our memory. We started our business with zero cash and we end our business with Rs. 39 lakhs. In cash flow statement, we have to find out how this change has taken place and group the cash flows into three major sources/uses namely operating activities, investment activities and financing activities. In doing this we should consider only cash transactions. Using all the cash transactions and summarising the same, we get a cash flow statement as shown in Exhibit 1.7.
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Exhibit 1.5: Profit and Loss Account for the month ending 31st January 2008 In Indian Rs. Income Sales 50,00,000 Other Income Total Income 50,00,000 Expenditure Cost of Good Sold Salary and wages Advertisement Rent Profit before depreciation, interest and tax Depreciation Interest Profit Before Tax Tax Profit after Tax/Disposable Profit Less: Dividend Balance Profit carried to Balance Sheet
40,00,000 2,00,000 2,00,000 1,00,000 45,00,000 5,00,000 20,000 4,80,000 4,80,000 1,00,000 3,80,000
Exhibit 1.6: Balance Sheet as at 31st January 2008 In Indian Rs. FUNDS EMPLOYED Shareholders' Fund Equity Share Capital 30,00,000 Reserves and Surplus (see P&L account) 3,80,000 Loans Loans from Bank Total APPLICATION OF FUNDS Fixed Assets (Furniture)4 Current Assets, Loans and Advances Stock 20,00,000 Debtors or Receivables 20,00,000 Rent Advance 5,00,000 Cash 39,00,000 84,00,000 Current Liabilities and Provisions Creditors or Suppliers' Due 30,00,000 Expenses Payable 5,20,000 35,20,000 Net Current Assets (84,00,000 - 35,20,000) Total
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In Indian Rs. 33,80,000 20,00,000 53,80,000 5,00,000
48,80,000 53,80,000
Exhibit 1.7: Cash Flow Statement for the month ending 31st January 2008 Nil Cash at the beginning (January 1, 2006) Cash flow from operating activities Cash received from customers 30,00,000 Cash paid to suppliers (30,00,000) Cash paid for Rent Advance (5,00,000) Net Cash Flow from Operating activities (5,00,000) Cash flow from investing activities Cash paid for the purchase of furniture (5,00,000) Cash flow from financing activities Cash from fresh equity 30,00,000 Cash from bank loan 20,00,000 Cash paid for dividend (1,00,000) Net Cash Flow from Financing Activities 49,00,000 Cash at the closing of the month (January 31, 2006) 39,00,000
4
We haven't provided depreciation for the asset for the sake of simplicity. We will discuss those concepts in Chapters 2 and 3.
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Computers today generate accounting statements and the job of the managers is to specify the right account head and decide on nature of treatment of certain items. The discretionary powers with accountants are coming down because of multiple regulating agencies trying to plug such discretionary powers. The purpose of the above illustration is not to teach accounting process or preparation of financial statement but to demonstrate that they are simple and easy to follow. Readers can continue our business for one more month, record the transactions in the accounting equation and prepare three principal financial statements. They can show previous month figure in the financial statement as we see in Exhibit 1.2 to 1. 4. Many of you will find it exciting to see that your balance sheet had 'balanced' in the end.
1.7 ANNUAL REPORT

Many of the readers of this book would have come across annual report of a company in which you are employed or invested your money5. Annual reports contain several details in addition to financial statements. Most annual reports contain the following details.
1.7.1 Board of Director, Bankers, Auditors and Top Management

The names of the board of directors, bankers, auditors, solicitor, and executives of top management are normally provided at the beginning of the annual report.
1.7.2 Chairman's and Director Report

Chairman's and/or directors' report highlight the operations and other important developments like issue of shares, mergers or acquisition, etc. that have taken place during the period. Directors' report normally has few annexure that highlight steps taken by the company for conservation of energy, research and development effort and expenditure, foreign exchange earning and outflow and salary details of some of the key employees. Many of these requirements were required when the country was in a closed economy mode and now there is a serious pressure from the industry associations to withdraw these requirements.
1.7.3 Management Discussion and Analysis (MD&A)

This is relatively a recent addition in the annual report. The purpose of this section is to review the operations of the company, major segments of the company, important developments in the market and their impact on the company and discuss the future of the company. Management is expected to provide 'forward looking statement' to reduce the information gap between the insiders and outsiders. While some companies perform good analysis and discussion, several companies report historical information
5
You can download the annual reports of many companies from the website of the company. For instance, you can download the annual report of Asian Paints (India) Ltd. from the company's website www.asianpaints.com
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and make confused statements. A good analysis and discussion should link what was discussed and forecasted in the previous report to the current one and explain deviations.
1.7.4 Corporate Governance Report

Corporate governance report discusses board's initiatives to protect the interest of investors and also how the board members are active in deliberating the issues in the board meeting. It reports how many board meeting have been held and attendance details of the members of the board. Similarly, it also reports the details of members of various subcommittees of the board like audit committee, remuneration committee, shareholders/investor grievance committee, etc. and meetings of such subcommittees. It also provides details of remuneration to board members.
1.7.5 Shareholders Information

This section provides financial calendar of the company. It gives important dates like AGM, book closure, record dates, etc. Details relating to stock exchanges in which shares are listed, monthly price movements of the stock, distribution of shareholding, registrar and share transfer agent and their addresses, etc. are also provided.
1.7.6 Auditors Report

Financial statements are required to be certified by the independent auditors to mitigate agency problem between the management and shareholders. Since management prepares financial statements, they have incentive to prepare the statements that suits their interest best than fair reporting. For example, showing loss may warrant revision of credit rating with consequential pressure from lenders and also ultimately increased interest rates for any additional borrowings. The last paragraph of typical audit report reads as follows. "In our opinion and as per the information and according to the explanation given to us, the said financial statements give the information required by the Act, in the prescribed manner and give a true and fair view in conformity with the accounting principle generally accepted in India: (i) in the case of Balance Sheet, of the state of affair of the company as on 31st March 2008; (ii) in the case of the Profit and Loss Account, of the profit of the company for the year ended on that date; and (iii) in the case of Cash Flow Statement, of the cash flows for the year ended on that date" The above kind of audit report is called unqualified report where the auditor certifies that the financial statements based on the evidence available reflects true and fair view. Suppose, the auditor finds some problem on management's treatment of certain transactions, the report may not be as clean as above. Then the auditor may say
24
that the financial statements reflect true and fair view except on those items. The certification may also be adverse in nature if the auditor finds that the financial statements fail to reflect true and fair view of the financial positions of the firm. In an extraordinary situation, if the management fails to co-operate with the auditors, auditor may refuse to give opinion and report the same to shareholders. In theory, auditors are independent and hence their report is expected to be an independent report. But in practice, many point out the kind of moral hazard6 affecting such independent role. The management identifies the auditor though their appointment and remuneration are approved by the shareholders in the AGM. It may be difficult for the management to dismiss the auditor because the outgoing auditors have right to issue a statement to the shareholders but auditor with such reputation may not be a preferred auditor by the management of other firms. Hence, auditor would like to have some normal working relationship with clients and that is the area of potential conflict of interests between auditor and shareholders. The role of auditing in such a situation where auditing firms align their interests with management even for temporary period or only to a small extent is questionable. Why should shareholders pay to auditors who align their interest with management whose performance they need to look into? Regulatory pressure like Sarbanes-Oxley Act, improvement of standards by the auditing profession as a whole, audit committee consisting of independent directors interacting with auditors, etc., are few recent steps to restore the positive role of auditing in company form of organisation.
1.7.7 Balance Sheet

As discussed earlier, Balance Sheet is the very first statement of group of statements called financial statements. It presents the financial position of the firm as on a particular date. Balance sheet reports the sources of capital and how such capital has been used in generating various forms of assets. All balance sheet values are reported for two-year period. Many developed markets require one more statement called Shareholders' Equity, which primarily reports changes in equity value from one period to another. There is no requirement for Indian companies but normally a reading of Schedules relating to equity share capital and reserves and surplus will provide such details.
1.7.8 Profit and Loss Account

Profit and loss account reports the operations (income, expenses and profit) of the firm during the year. Again, two-year figures are provided.
'moral hazard' refers to the risk that one party to a contract can change their behaviour to the detriment of the other party once the contract has been concluded.
Chapter 1 Introduction 1.7.9 Cash Flow Statement
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Cash flow statement shows how cash has moved in and moved out during the period and summarises the same under three broad headings namely cash flow from operating activities, investing activities and financing activities.
1.7.10 Schedules
Balance Sheet and Profit and Loss Account are in summary form but the details are provided in Schedules forming part of the two statements. Each major item or value of balance sheet and profit and loss account has a schedule to provide more details. Normally schedules are given for items like share capital, reserves and surplus, fixed assets, investments, current assets, current liabilities, sales, other income, expenditure, depreciation, and tax.
1.7.11 Consolidated Financial Statements

If a company has subsidiary companies, then they need to provide one more statement called consolidated financial statements by incorporating the results of subsidiary companies also. Earlier, Indian companies were required to provide the annual reports of all subsidiary companies and many companies come out with additional volume of annual reports exclusively for subsidiary companies. This requirement has been now been discontinued and companies having subsidiary companies have to give consolidated financial statements where the subsidiary companies financials are combined with the holding companies and shown as consolidated statements. Consolidated financial statements include balance sheet, profit and loss account, cash flow statement and schedules and notes forming part of financial statement.
1.8 FINANCIAL STATEMENTS AND INFORMATION GAP

Financial statements provide wealth of information to investors and others but they do not guarantee that there is no information gap. Information gap arises on two counts - one, on the amount of information available with insiders and outsider and two, on the timing of information availability. It may not be possible or feasible for the management to tell every information available with them. For example, Asian Paints (India) Ltd. may not be interested to tell brand-wise sales and profit margin though persons in the paint industry might know popular brands and guess on profit margin. The management may feel that the competitor might find potential use of such information. When segment reporting was introduced in the developed markets, many companies were reluctant to provide information. In India too, many companies justify that they are in single segment despite the fact that their products and consumers segments are different. Similarly, management may not be willing to part with information relating to contracts with suppliers and customers. Suppose the prices of raw materials and finished products are volatile. Investors would be very happy to get the details of long-term contracts that the company has signed along with price details since they can forecast the future profitability reasonably. Management may not be
26
willing to part with such information since competitors may come out with alternative strategies. While the demand for information by the investors is endless, management would like to part with as little information as possible. It is tough task for regulatory authorities to identify information that can be allowed to pass on without affecting the overall competitive position of companies. The second level of information gap is the time at which information is made available. Insiders have access to information as and when it flows whereas outsiders get consolidated information at different points of time. In India and in several other countries, unaudited / audited quarterly earnings statements are to be provided by the listed companies. Such quarterly earnings reports are also normally available after a month. In addition to this, regulating agencies insist the companies to report any information that has a major impact on earnings within a reasonable time. In addition, companies also come out with profit guidance statements if there is any major change in the operating performance. While efforts made so far on reducing the timing gap are considerable, there are still gaps on the timing issue.
1.9 USERS OF FINANCIAL STATEMENTS

The corporate form of business organisation uses the financial statements as a means of communication to the various stakeholders. The different stakeholders of an organisation are the shareholders, lenders, creditors, employees, potential investors and finally, the Government and the government agencies like tax departments. Basically, the demand for corporate information comes from the shareholders and investors, managers, employees, customers, lenders and other suppliers, security analysts, policy makers, regulators and government. The information demanded as well the purpose for which the information is demanded varies to a great extent among these groups. For instance, the government seeks financial information of the company mainly to check if the companies pay the right amount of taxes. Further they also examine the business and operations of the company to check if they dont violate licences granted, exportimport policies etc. The suppliers would be demanding financial information basically to be assured of the fact that the company would be in business for sufficiently long period of time, to enable them to have business with them. Also, checking on the fact that the company would be able to pay their dues. Similar is the position of the lenders. The managers within the company would also be demanding for information. Of course the information supplied to the managers within the firm may be much more in detail and confidential compared to the information provided to the outsiders. The managers basically seek information for decision making purposes and managing the firm. The customers, particularly the consumers of durable goods or vehicles or IT products would be interested in knowing whether the company would exist in near future to provide them the service for the product they purchased. So they would be constantly watching the company performance for the same. The employees would be interested in the company information because they would want to know if they would
27
get better wages or salaries for the coming years. Because if the firm is not doing well, the chances are that they might loose their jobs and also loose wages. So they keep a watch on the performance of the company. The analysts demand for information to publish reports on the performance of the companies. They also rate the debt payment capacity of the companies. They continuously track the company for information and analyse the company accordingly and inform the public on buy and hold strategies. On the other hand the demand for information by small and retails investors differ from that of the experienced analysts. The small investors simply do not have the full-fledged time to keep track of the companies' latest information. This is because small investors invest in a lot of companies and it is difficult for them to keep track of the information of all these companies. More over they would not be able to analyse effective as the experienced analysts do. They basically face problem of assessing the risk, expected return, and liquidity of the firms securities they hold. Based on the assessment of these factors, they make their investment decision on what securities to buy (sell) and when to buy (sell), which maximises their expected utility or wealth. Once the investment decision is made, shareholders and investors demand information for the purpose of safeguarding their interest in the corporate firm. This involves control of managerial behaviour so as to guide managerial activities towards the maximisation of shareholders wealth. Shareholders and investors require information to help them in making the investment decision, as also to design contracts and mechanisms for controlling the behaviour of managers, and orient the managerial behaviour towards realising the objectives of a firm. Accordingly, they demand all information that is non-proprietary, i.e. information whose disclosure does not affect the firms future cash flows.
1.10 SUMMARY
Every organisation has some objective to fulfil. They raise resources and deploy the same to pursue the objectives. They also measure the operations periodically to check whether objectives are fulfilled. Balance sheet shows how resources are mobilised and how are they used. Profit and loss account summarises the performance of the operations during the period. Financial statements are then analysed to examine whether objectives that are in financial nature are achieved or not. Financial statements and analysis of financial statement thus play critical role in the management of organisations. Financial statements are prepared based on large number of accounting transactions. Accounting transactions are recorded under relevant head as and when transactions take place. They are summarised at the end of the period to prepare financial statements. Recording accounting transactions in most cases are simple and straightforward but quiet a few transactions might create complications and hence affect the financial statements. Accountants follow some of the basic accounting principles, concepts and conventions to ensure some consistency in treatment of accounting transactions. There are Accounting Standards for the same purpose. In other
28
words, one can reasonably expect that a firm, which followed these basic principles, concepts and conventions and also accounting standards in preparation of financial statements, such statements, are comparable from one period to another period and one firm with another firm. In other words, over the years, accounting profession and regulating agencies are consciously making efforts to harmonise the variations in treatment of accounting transactions and moving towards achieving uniformity across several countries. To ensure compliance of accounting principles and standards, financial statements are audited and certified by independent audit firms. Annual reports contain more than financial statements. Over the years, the nonaccounting part of annual reports has gone up substantially since financial statements fail to satisfy the appetite of investors and other users of financial statements. Management Discussion and Analysis and Corporate Governance Report are two such new additions in the annual reports of Indian companies. The level of disclosure by Indian companies today is comparable with many developed markets. On certain aspects, the disclosure of Indian companies is more than information provided by companies in the developed market. While on the one hand management prefer to disclose less, they also compete with other companies in the capital market for capital where suppliers of capital prefer companies with better disclosure. Like regulating agencies, management also need to optimise the level of disclosure. It is difficult to say whether quality brings additional revenue but poor quality cost more to firm. Today, it applies equally to level of disclosure and quality of financial statements. Management all over the world is slowly learning that cost of poor disclosure level and quality of financial statements is much more today than it used to be in the past.
Chapter 2
The Balance Sheet
2.1
INTRODUCTION
The Balance Sheet represents all the assets owned by a company at a particular point of time and the claims of the owners and the outsiders against those of assets at that time. It can be called statement of wealth since it provides details of assets that the company owns and outstanding loans and other claims against the company. The difference between the two is shareholders' wealth. We often prepare statement of wealth in our personal life particularly when we borrow money from banks or other financial institutions. The lending institutions ask us to provide the details of assets like house, agriculture land, car and other vehicles, gold, deposits, shares and bonds, etc. and also outstanding loans and other commitments standing against such assets. The difference is our wealth and lenders use this information while taking lending decision. The wealth of the shareholders can be computed with the help of balance sheet equation
Asset - Liabilities = Shareholders' Equity or Wealth.

Balance Sheet provides the following information to the users of financial statements:
Size of the company: The total of the assets gives some idea about the size of the
company. Since the details of balance sheet items are provided for two years, it is
30
possible to see overall growth of the business over the last period. A comparison with other firms in the industry shows the relative position of the company in the industry. Composition of Assets: Assets are of different types. Indian companies are required to list the assets under three broad categories namely Fixed Assets, Investments and Current Assets, Loans and Advances. While fixed assets generate revenue, investments in current assets increase cost. Understanding composition is useful to asses the efficiency of managing current assets. Liabilities to outsiders: Assets can be acquired by borrowing funds or with own funds. Balance Sheet provides the details of how much the company has to pay to outsiders. The liability to outsiders can be in the form of unpaid loan or unpaid suppliers' dues or other expenses. It is also possible to see the growth of liabilities to outsiders by comparing the two years liabilities. Further, the extent to which the company uses outsiders' liability in creating assets can be seen by comparing liabilities and assets. Shareholders' Fund or Equity or Wealth: The owners' stake on the assets can be assessed by comparing the total assets and shareholders' fund. If the shareholders' fund is small compared to outsiders' liability, it means that the company is heavily relying on outsiders' liability. This may cause some potential problem for the solvency of the company in the future particularly when the business slows down temporarily and at the same time interest and other liabilities are difficult to be deferred.
2.2
BALANCE SHEET FORMAT
The Balance Sheet shows different classification of assets and liabilities arranged in a particular order, depending on the conventions or rules prevailing in different countries. The two most commonly used forms of presenting the Balance Sheet are the Vertical Form and the Horizontal Form. In the vertical form of classification, the assets, liabilities and shareholders funds are shown one below the other but the sequence differ across countries. Indian companies which follow the vertical form of classifying its assets, lists Shareholders Fund first, then Liabilities and finally the Assets side of the balance sheet. In horizontal format, the Assets are shown on one side and Shareholders' Fund and Liabilities are shown on the other side. Companies Act, 1956 lays down the acceptable formats of the Balance Sheet for companies registered under the Act. Though both the formats are allowed by the Act, of late, the Vertical Form is being commonly used. Asian Paints (India) Limited has presented its Balance Sheet in the Vertical Form as shown in Exhibit 2.1. Assets and liabilities are arranged in descending order of permanence the most permanent or long-term item is placed at the top. The format of Indian balance sheet is bit unique in a sense, sources of funds or liabilities and equity are shown first before application of funds or assets while most common practice in other countries is assets are shown first and then liabilities and equity. The logic for Indian format can be attributed to sequence of operations that a business units typically perform - first acquire equity, then raise loan, use the funds available to first buy fixed assets and then finally current assets. The logic of other formats is first find out the assets owned by the company, then identify liabilities against the assets and finally show the difference as owners wealth.
Chapter 2
The Balance Sheet
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A B C
95.92 832.58 928.50 36.70 58.00 94.70 31.52 1054.72
95.92 648.16 744.08 66.90 58.77 125.67 22.15 891.90
D 937.89 509.06 428.83 110.39 E F 0.09 538.97 251.90 41.35 33.09 178.82 1044.22 539.22 422.88 806.20 471.29 334.91 11.62 346.53 334.39 0.03 434.07 235.96 42.49 31.23 115.45 859.23 594.10 54.15 648.25 92.62 1054.72 210.98 891.90
G 785.11 166.49 951.60
32 2.3 CONSOLIDATION
Indian companies are required to give two sets of Balance Sheet. The first statement given in Exhibit 2.1 is the Balance Sheet pertaining to Asian Paints (India) Limited, which is a separate legal entity. In addition to this balance sheet, companies are required to give another Balance Sheet called Consolidated Balance Sheet if they have subsidiaries. If Company 'A' has more than 50% shares of Company 'B', then Company 'B' becomes a subsidiary of Company 'A' and Company 'A' is called the holding company. The financial statements of the holding company and subsidiary companies are consolidated by the holding company in its financial statements to the extent its interest in subsidiary companies and present them separately as Consolidated Balance Sheet, Consolidated Profit and Loss Account and Consolidated Cash Flow Statements. The objective of such consolidation as per Accounting Standard 21 is that "consolidated financial statements are presented by a parent (also known as holding enterprise) to provide financial information about the economic activities of its group. These statements are intended to present financial information about a parent and its subsidiary(ies) as a single economic entity to show the economic resources controlled by the group, the obligations of the group and results the group achieves with its resources". Consolidation is required even when a company is not a subsidiary company but the parent company controls the composition of the board of directors in the case of a company or the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities. Exhibit 2.2 presents Consolidated Balance Sheet of Asian Paints (India) Limited as at 31st March 2008.
2.4
BALANCE SHEET DATE
As stated earlier and can be seen in the title of Balance Sheet, it is a statement prepared at a point of time. Thus title of the Balance Sheet should always mention the date of preparation like As at 31 March 2008. Balance Sheet of Asian Paints (India) Ltd. as at March 31, 2008 refers to assets, liabilities and shareholders' fund position of the company on that particular date and more precisely at the normal closing business hours of the company. Normally, Balance Sheet is finalised and received by the investors and others sometime between June to September of the year. It means that the assets, liabilities and shareholders' fund of the company on the day in which balance sheet is received by the investors can be significantly different from what is mentioned in the balance sheet. The value of accounting statements is often questioned on this account. Though companies listed in stock exchanges are required to provide quarterly earnings report, there is no mandatory requirement to provide Balance Sheet on quarterly basis. The gap of six month was required earlier for finalisation of accounting statement when the computing and telecommunication facilities were not so sophisticated in this country.
Chapter 2
The Balance Sheet
33
.
Exhibit 2.2
CONSOLIDATED BALANCE SHEET AS AT 31st March 2008 of Asian Paints (India) Ltd. (Rs. In Crores)
Schedules FUNDS EMPLOYED Shareholders Funds Share Capital Reserves and Surplus Loan Funds Secured Loans Unsecured Loans Deferred tax liability - (Note B-11 in Schedule M) Minority Interest Total APPLICATION OF FUND Goodwill on Consolidation Fixed Assets Gross Block Less : Depreciation Net Block Capital Work in Progress Investments Current Assets, Loans and Advances Interest accrued Inventories Sundry debtors Cash and Bank Balances Other receivables Loans and Advances Less: Current Liabilities and Provisions Current Liabilities Provisions Net Current Assets [(F) - (G)] Total As at 31.03.200 8 As at 31.03.2007
A B C
95.92 886.45 982.37 145.14 130.07 275.21 39.08 57.37 1354.03 44.35
95.92 681.87 777.79 121.10 185.07 306.17 26.79 60.08 1170.83 46.86 1083.15 603.77 479.38 13.78 493.16 192.72 0.03 598.01 420.61 105.39 69.36 97.93 1291.33 787.04 66.20 853.24 438.09 1170.83
D 1211.22 633.66 577.56 114.18 691.74 276.65 0.09 714.01 460.33 110.71 73.27 153.07 1511.48 G 992.30 177.89 1170.19 341.29 1354.03
E F
34
Since these facilities are substantially improved, it is possible for companies to release balance sheet much earlier but often companies take maximum allowed time before finalising the accounts.
2.5
FUNDS EMPLOYED
Capital is critical for starting and running business units. Such capital is raised broadly from three sources. Shareholders bring equity capital at the beginning of the business venture and further equity capital when major investments are made. As the firm starts earning profit, the shareholders allow the management to retain part of the profit and such 'Retained Capital' forms second major source of capital. The third and most important source of capital is borrowing from financial institutions or banks and market. This is called Borrowed Capital or Loan Funds. Financial Engineering has helped to develop several new ways to raise capital, which are mostly hybrid or a variation of the above mentioned forms of capital. For example, leasing is another source of borrowed capital and preference share capital is a source of equity capital. Since this part of Balance Sheet shows how much of funds that the business unit employed as on the date of balance sheet, it is given the title of "Funds Employed". Sometime, this section is also titled as "Sources of Funds" since the user can know the sources from which the business unit has raised capital or funds. Sources of Funds are also arranged in the order of permanence, with the most permanent being shown at the top. Balance Sheet normally has four columns. First column describes the details of balance sheet item. Each item of the balance sheet is normally represents consolidated figures of several sub-items. Schedules forming part of the balance sheets provide the details. The second column gives the Schedule Number. The third and fourth column gives balance sheet values of the current year and previous year respectively. As we discuss various items of balance sheet, we will also discuss the related schedules.
2.6
SHAREHOLDERS' FUNDS
This represents the funds or capital provided by the shareholders for the business. Shareholders provide funds in two forms. They can bring fresh capital as and when required or allow the company to retain a part of the profit. There is no real distinction between contributed capital and retained capital as far as the shareholders are concerned and they would expect the company to use the entire amount to their benefit. Though accounting statements provide the details of contributed capital and retained capital, this distinction is rarely used in analysis. Shareholders of Asian Paints (India) Ltd. have contributed Rs. 959.20 million in the form of share capital and Rs. 4763.00 million in the form of retained capital or Reserves and Surplus for the year ending March 2008 (Refer Exhibit 2.1). Share capital contribution of Rs. 959.20 million need not be in the form of cash and this issue is discussed more in detail in subsequent sections.
Chapter 2 2.7
The Balance Sheet
35
SHARE CAPITAL
At the time of forming the company or registering the company under the Companies Act, 1956, a group of people loosely called promoters or technically the signatories of Memorandum of Association contributes to share capital. Memorandum of Association is a document which contains various details of the company like the name of the company, registered office, purpose of business, etc. and serves as a basis for registering the company. The company can then raise fresh capital as and when required subject to certain formalities required under law and regulations. When the company first raises capital from public after its formation, it is called 'Initial Public Offering' or simply IPO. Subsequently, the company can raise fresh capital by issuing shares and they are called 'seasoned offerings'. If seasoned offerings are restricted to existing shareholders, it is called 'rights offering'. Share Capital can be in two forms. Equity Share Capital and Preference Share Capital. Equity share capital or common stock represents ownership of the company. These are permanent capital and also carry high risk. There is no assurance that the company performs well and reward the equity shareholders. The only good thing is the liability of the shareholders is limited. The concept of limited liability enabled formation of large companies with the help of several millions of small shareholders and hence contributes for industrial development of nations. Preference Shares carry a certain fixed rate of dividend, which must be paid by the company to the Preference Shareholders before any dividend is paid to the Equity Shareholders, in case the company makes profits. In case the company does not make enough profits, it would not pay the Preference Dividend. However, in such case, the unpaid dividend would need to be paid in the subsequent years (in case of Cumulative Preference Shares) before any dividend is paid to the Equity Shareholders. In the event of liquidation of the company, after meeting all external liabilities and if there is a surplus funds, preference shareholders' due are first met before sharing the residual funds for equity shareholders. Their liability is also limited. In that sense, preference shareholders are slightly better off than the equity shareholders but they also carry certain amount of risk. Preference share capital is normally redeemed after some point of time. Though Asian Paints (India) Ltd. is authorised to issue preference share capital, there is no outstanding value on preference share capital. The Schedule A provides the details of Share Capital (Exhibit 2.3) Authorised: This is the maximum amount of share capital that the company can issue. A company can increase its Authorised Capital by amending the Memorandum of Association in terms of the procedure laid down in the Companies Act, 1956. The number of shares issued is given in the first column and description of the share is stated in the second column. 'Equity shares of Rs. 10 each' means the face value of each equity share is Rs. 10. Similarly, the face value of preference share is Rs. 100. Face value can be any thing but normally it is Rs. 10 or Rs. 100. However, many Indian companies have now face value of Rs. 5, Rs. 2 and Rs. 1. The Authorised Share Capital of Asian Paints (India) Ltd. as on 31st March 2008 is Rs. 100 cores. Authorised capital is normally set keeping in mind the kind of growth that the company will have
36
for the next 10 years or so. Authorised capital can be changed but it requires elaborate procedure. At the same time, if the authorised capital is very large, then they may end up in paying more fees to government since some of the regulatory fees are related to authorised capital.
Exhibit 2.3
SCHEDULE A: SHARE CAPTIAL Authorised 99,500,000 Equity shares of Rs. 10 each 11% Redeemable Cumulative Preference shares of Rs. 100 each 50,000 Issues and Subscribed 95,919,779 Equity Shares of Rs. 10 each fully paid: a) 93,989,940 Bonus Shares issued on capitalization of Share Premium and General Reserves and b) 294,000 shares issued as fully paid up pursuant to the scheme of Rehabilitation / Amalgamation of Pentasia Chemicals Ltd, without payments received in cash;
(Rs. in Crores)
As at As at 31.03.2008 31.03.2007 99.50 0.50 100.00 99.50 0.50 100.00
95.92 95.92
95.92 95.92
Issued and Subscribed: This is the amount of share capital that has actually been issued by the company to the shareholders. The first column shows the number of shares issues. The value of issued capital is equal to the number of shares issued multiplied by the nominal value of each share. Subscribed capital is the amount of share capital that has been bought by the shareholders. It is equal to the number of shares subscribed by the nominal value of each share. Asian Paints (India) Ltd. has issued 93,989,940 shares and all of them have been subscribed and hence the Issued and Subscribed share capital value is Rs. 95.92 crores. Called: In certain cases, the company might have asked shareholders to pay only a part of the face value. In such an event, the called up value will be lower than subscribed value. For fully paid up shares, the amount of Called up Share Capital should be equal to the amount of Subscribed Share Capital. Paid up: This is the amount, which the shareholders of the company have actually paid on their shares. Unless any shareholder has defaulted in payment of the calls, this amount should equal the Called value above. In the case of Asian Paints (India) Ltd. no such complexities is visible in the reported balance sheet. Normally, these details appear during the initial life of the company. Bonus Shares: In describing subscribed and paid-up share capital, Asian Paints (India) Ltd. mentioned that it has issued 94,199,443 bonus shares by capitalising share premium and general reserve. Bonus shares are issued to the existing shareholders
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The Balance Sheet
37
without collecting any money from the shareholders. When the bonus shares are issued, the equity share capital increase without any corresponding increase on the asset side of the balance sheet since there is no cash flow to the company. The balance sheet equation (Asset = Liabilities + Shareholders' Equity) gets affected in that process. Thus, when companies issue bonus shares, they increase share capital value but they reduce Reserves and Surplus value to an extent. This is called capitalisation of General Reserve or transferring figures from Reserves and Surplus to Share Capital. It should be noted that the company is not increasing the value by issue of bonus shares. Even the shareholders fund (sum of share capital and reserves and surplus) is not undergoing any change. Why should company issue bonus shares and what investors get in turn by collecting pieces of additional paper or one more electronic entry in their share depository account? Some people believe that companies try to convey good future prospects through bonus issues. Normally, bonus issues are made when managers believe that the future prospects are good. Another reason for issue of bonus is liquidity consideration. If the market price of the shares increases to a large value, many small prospective investors may not be able to buy such shares in view of huge investment requirement. For example, if the Infosys stock price is Rs. 40000, very few people would be in a position to buy 1 share of Infosys. The liquidity of the shares is likely to be affected in that process. Hence the companies can issue bonus shares and bring down the share price within a range. The fall in price will not affect the shareholders wealth since they have more shares now. For instance if the pre-bonus price is Rs. 240 and if the company issues 1:1 bonus, the price will be around 120. Suppose the price decline to Rs. 122 immediately after the bonus issue. If you have 10 shares of the company prior to bonus issue, you will now have additional 10 shares and totally 20 shares. The market value of your share prior to bonus issue was Rs. 2400 (10 shares x Rs. 240) and now it will be Rs. 2440 (20 shares x Rs. 122). At Rs. 122, the shareholder of the company can expect better liquidity compared to liquidity prevailing when the price was Rs.240. Stock Split: Stock split is similar to bonus issue and has same implication. That is, the number of shares increases after the stock split or bonus issue. The difference is stock split doesn't require capitalisation or transferring amount from Reserves and Surplus to Share Capital. Stock split reduces the face value. Suppose the face value now is Rs. 10. The company decides to have a stock split of 1:1 instead of bonus issue of 1:1. In stock split case, the number of shares will increase but the face value is now reduced to Rs. 5. Remember, companies need to send fresh certificates or pass a fresh entry in electronic depository under both methods and also remember, there is no increase in shareholders' fund or value of the assets under both methods. While some companies prefer bonus shares and others prefer stock split. The current fashion is stock split though Asian Paints (India) Ltd. has so far not made any stock split. During the last two decades, Asian Paints has issued 6 bonus shares as detailed below. In other words, if you had 500 shares of the company in 1985, you would now have about 9216 shares! Your investment in 500 shares in 1985 would have costed Rs.
38
10000 to Rs. 15000 and its value at a price of Rs. 1200 as on March 31,2008 is Rs. 110.59 lakhs. The initial investment has grown at an average compound rate of 34% per year for the last 23 years. Asian Paints (India) Ltd. rewarded the investors by focusing its core business and expanding globally despite competition from multinationals and unorganised sectors, which enjoy considerable tax benefit. We are fascinated with the achievement of the company and that is one reason we have chosen the company for illustrating financial analysis. Of course, many of you would have fascinated with the television advertisement of Asian Paints (India) Ltd. Year Bonus Ratio 1985 3:5 1987 1:2 1992 3:5 1995 1:1 2000 3:5 2003 1:2
Shares issued on mergers Schedule A also mentioned that the company has issued 294,000 shares as fully paid without payment received in cash to shareholder of Pentasia Chemicals Ltd pursuant to the scheme of rehabilitation/amalgamation. When a company merged with another company, the shareholders of the company, which is merging with another company will have to get either cash or the shares of the other company since shares of their company is no more traded in the market. At the time of merger, based on relative valuation of two companies, the companies will announce the swap ratio. Suppose if the swap ratio is 1 share of Asian Paints (India) Ltd. for every 25 shares of Pentasia Chemicals Ltd., the shareholders holding 100 shares of Pentasia will get 4 shares of Asian Paints (India) Ltd. Other than bonus shares and stock split, companies might issue shares without getting cash for these reasons. One more example is allotting shares to a collaborator, who provides technology. Here the company gives shares to get the technology instead of paying cash. Cancellation of Shares Share capital may also be reduced in certain cases. One prominent case is repurchase of shares or buyback of shares. Companies are allowed to buy back their own shares after following certain procedure and subject to certain conditions. Buyback is normally done when the company has surplus cash and believes that the share prices are traded at a price below its real value, then such additional cash may be used. Alternatively, companies may want to have capital restructuring for various reasons. Under Indian regulations, shares purchased back have to be cancelled and this will lead to reduction in share capital. Asian Paints (India) Ltd. has not done any share repurchase so far since the same has not been reported. Another instance for cancellation of shares is shares held by another company, which got merged with this company. Pentasia Investments Ltd. was merged with Asian Paints (India) Ltd. during the year.
2.8
RESERVES AND SURPLUS
The term 'Reserve' denotes amount or funds set aside to meet certain objectives. Reserves are created out of profit. It means out of profit earned, the company sets aside some part and uses the balance only for distribution in the form of dividend to
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The Balance Sheet
39
shareholders. Why should the company set aside a part of the profit? Normally, it is governed by the law or agreement or practice. For example, if the company issues debentures, the debenture holders would like to restrict the company in paying dividend out of profit. Once dividend is paid, it is not possible to ask the shareholders to pay the amount back to meet the liability towards repayment of debenture amount. It is possible that debenture holders put a blanket prohibition for distribution of profit but normally shareholders will not like such restrictions or dictations. Alternatively, debenture holders can demand to set aside some specified amount, say 20% of debenture value every year for 5 years and shareholders might agree for the same. A feel good factor for both the parties involved. This condition creates a new account called 'Debenture Redemption Reserve" and the company transfer the agreed amount from the Profit and Loss account to this account every year till debenture are repaid. Often, non-accounting students and managers tend to believe that the amount is in form of cash. This confusion is mainly because the normal understanding of the word 'reserve'. It should be noted that the agreement between the shareholders and debenture holders in this case is the available profit for payment of dividend will be determined after setting aside some amount and not by depositing the amount in a bank account. The purpose of such agreement is to prevent money going out from the company to shareholders rather than preserving cash for repayment. In other words, reserve is part of retained profit and it is upto the managers to decide how to use the retained profit. It can be used for the purchased of fixed assets or current assets or investments or simply repaying some of the existing loans or dues. The Schedule B of Asian Paints (India) Ltd. gives the details of Reserves and Surplus (Exhibit 2.4). Capital Reserve and Revenue Reserve: Reserves and surplus can be broadly classified into two types. Reserves created out of profit or surplus arising out of revenue transactions are revenue reserves and surplus. Surplus arising out of capital transactions is capital reserves and surplus. For example, when companies issue shares at a premium, the face value will be shown under share capital and premium part will be shown under reserves and surplus. This surplus is not arising out of profit but as a result of raising capital at a price greater than the face value. Why should companies issue share at a premium? Suppose you are a shareholder of Asian Paints (India) Ltd., whose current market price is Rs. 390 (March 2008) and your company is coming out with a public issue. Would you like your company to issue shares at Rs. 10 to the public? Existing shareholders will object because the moment another shareholder gets 1 share at Rs. 10, she or he will share the future profit of the company equally along with you. Existing shareholders will feel such an issue of shares at par is unfair deal to them and block the company to issue shares at part. Existing shareholders will be happy if the company issues shares at premium since they expect new shareholders to pay the 'price' or 'premium' before acquiring the right to participate on the fortunes of the company that have not been distributed. Actually, the expected premium will also include passing on the right to share future income if the business is doing well. In a few cases like American Depository Receipt (ADR) it is possible for the companies to issue shares at a price more than current market price.
40
Exhibit 2.4
SCHEDULE B: RESERVES AND SURPLUS Capital Reserve Capital Redemption Reserve General Reserve As per Last Balance Sheet Add: Transfer from Profit and Loss Account Add: Adjustment on account of adoption of AS 15 (revised) Profit and Loss Account
(Rs. in Crores)
As at As at 31.03.2008 31.03.2007 0.50 0.50 497.66 134.42 632.08 200.00 832.58 415.86 89.58 (7.78) 200.00 648.16
Note: AS 15 (Revised) related to providing future liability of employee related liabilities (like Pension) at the current estimated value.
Surplus arising out of revaluation of assets is also capital in nature. Similarly, when a company set aside some amount for repayment of capital, they are also called capital reserve. For example, if a company issues preference share capital with an agreement that it will be redeemed at the end of 7 years, the company may have to set aside some amount every year out of profit. The reserve is mainly created to repay preference share capital and hence called Capital Redemption Reserve. These capital reserves and surplus are not available for distribution of dividend. Since dividends are to be distributed out of profit, any dividend distribution out of capital surplus and reserve amounts to distribution out of capital, which is generally disallowed under the Companies Act7. They can be transferred to share capital account through bonus issues or write off expenses or losses. Asian Paints (India) Ltd. has Rs. 5 million under capital redemption reserve, which was created, for repayment of preference shares. Though there are no outstanding preference shares for the company, the company has not transferred to share capital through issue of bonus shares and allowed it to remain as capital reserve8. General Reserve: General reserve is revenue reserve since it is created out of surplus in the profit and loss account. General reserve to an extent demonstrates the past performance of the company and the amount that the shareholders have left inside the company. Shareholders, who are not confident on the future of the company, would have taken substantial part of the profit available for dividend instead of leaving the amount inside the company. The General Reserve value of Asian Paint (India) Ltd. as at March 31, 2008 is Rs. 632.08 crores. Such a huge reserve, which accounts for about 80% of the total funds, demonstrates the shareholders confidence on the future of the company. It is also a reflection of the company's glorious past, which enabled the company to retain such a huge amount. It may be noted that the company has not
7
As a non-accounting student or manager, this much understanding on capital reserve and surplus is adequate. 8 The company might be thinking of issuing preference shares again in the future.
Chapter 2
The Balance Sheet
41
retained the amount at the cost of dividend. The company has distributed nearly Rs. 800 cr. in the last ten years as dividend and added Rs. 600 cr. to reserves and surplus. The break up of general reserve of Rs. 632.08 Cr. might confuse several readers. The first line is the amount of general reserve at the beginning of the period. The company has earned a profit of Rs. 375.20 Cr. during the year (refer Exhibit 1.3 of Chapter 1) as per Profit and Loss Account and the company transfers Rs. 134.42 Cr. to general reserve. Hence this amount is added here. Profit and Loss Account: The profit and loss account value shown in the Balance Sheet under Reserves and Surplus represents profit retained after transfers to various reserves and payment of dividend. Though it is part of retained earnings, the value of retained earning is significantly larger than the value shown against P&L account. The break-up of Reserves and Surplus is partly technical and hence one need not worry too much on such details. As a non-accounting student/manager, you should be in a position to find out the capital reserve and revenue reserve to understand the source and purpose of such reserves. Capital Reserve is a reserve created out of capital transactions resulting surplus or created for the purpose of repaying capital. Revenue reserves are created out of surplus arising from revenue transactions or profit. A related term often used in this context is 'free reserve'. Free reserve refers to that part of revenue reserves without any specific objective. For computing free reserves, reserves like debenture redemption reserve are excluded. The free reserve of Asian Paints (India) Ltd. is Rs. 832.08 Cr., which is the sum of General Reserve and P&L Account.
2.9
DEFERRED TAX LIABILITIES
This amount represents the tax liability which is expected to arise in the future and would therefore be payable by the company in the future years. This liability has arisen because of timing differences between taxable income and accounting income. Many of you might wonder how such timing differences arise and allowed. Business units are required to prepare accounting statements and draw profit and loss account following certain rules and regulation (like Accounting Standards) and submit the same to shareholders. For income tax purpose, business units are legally allowed to recast their profit and loss account by following certain liberal provisions available under the Income Tax Act and pay less. Such liberal provisions are of two types. Some provisions permanently allow the taxpayers to enjoy the benefit of lower tax. For example, profit arising out of certain exports or business units set up in certain backward districts qualifies for such liberal tax provision9. On the other hand, certain provisions allow the taxpayers to defer or postpone the tax payment. One such prominent provision is provision relating to depreciation. It may be too early to discuss different types of depreciation and hence we will discuss the concept without introducing types of depreciation.
The income-tax provisions changes rapidly. Hence, these concessions need not be applicable in the future.
42
Suppose the company has shown Rs. 100 million as depreciation under the regular account book. It has also reported a profit of Rs. 400 million. The company is expected to pay a tax of Rs. 140 million (at the rate of 35%). Suppose income tax department allows the company to show a depreciation of Rs. 200 million. Since the expense has now increased from Rs. 100 million to Rs. 200 million, the profit will decline from Rs. 400 million to Rs. 300 million. The company now has to pay a tax of Rs. 105 million and thus deferring Rs. 35 million. It is not possible for the company to completely escape from paying this Rs. 35 million tax. Since the total depreciation allowed over a period of time under both company's account and income tax account should not exceed the value of the asset, the depreciation value will be zero for income tax purpose at a later of point of time and hence the company has to pay the deferred tax. For the sake of clarity let us continue the example. Assume the value of the asset is Rs. 600 million and year to year profit before depreciation is Rs. 500 million. The following Table (Exhibit 2.5) shows the profit under company's book and income tax purpose and the tax deferred. While the tax is deferred during the first three years, the company ends up paying the amount from year 4 to 6. The net savings is zero but there is a time value of money in such deferment10. The balance sheet of Asian Paints (India) Ltd. has shown a deferred tax liability of Rs. 305.38 million and also asks the readers to refer Note B-27 of Schedule M for details. This note gives the break up reasons for deferred tax (Exhibit 2.6). Like depreciation, there are other reasons causing distortion between tax payable as per company's account and income tax account. While depreciation will normally cause deferred tax, there are items, which force the company to pay tax in advance. For example, the company will show some amount as bad debts but income tax authorities may disallow such expenditure until it is proved that there is no scope for collecting the due. In such case, profit as per company's book will be lower whereas profit as per income tax purpose will be higher. However, depreciation related deferred tax will normally be a major item. The statement of deferred tax of Asian Paints (India) Ltd. shows five items. Of this one item cause tax deferment whereas the remaining four items cause advance payment of tax (called deferred tax asset). Some companies show the two values separately where the deferred tax is shown as a part of liability side and deferred tax asset is shown on the asset side. As stated earlier, the depreciation related deferred tax is the single major contributory for the net value.
10
What is the wisdom of Income Tax allowing such deferment? A full discussion on this issue is beyond the scope of this book. Government believes that such deferment gives an incentive for firms to invest in fresh projects and thus enable capital formation for the country. But we don't know whether companies create fresh assets mainly to capture such tax incentives.
Chapter 2
The Balance Sheet
43
.
Exhibit 2.5: Deferred tax computation and its impact

Year Under Company's Book Profit before depreciation Depreciation Taxable Profit Tax @35% of Taxable Profit Under Income Tax Book Profit before depreciation Depreciation Taxable Profit Tax @35% of Taxable Profit Tax Deferred 1 500 100 400 140 2 500 100 400 140 3 500 100 400 140 4 500 100 400 140 5 500 100 400 140 6 500 100 400 140
500 200 300 105
500 200 300 105
500 200 300 105
500 0 500 175
500 0 500 175
500 0 500 175
35
35
35
-35
-35
-35
Exhibit 2.6: Schedule M (Note B-21) of Asian Paints (India) Ltd.

The major components of Deferred tax assets/(liabilities) arising on account of timing differences as at 31st March, 2008 are as follows: As at As at 31.3.2008 31.3.2007 Difference between the Written Down Value of assets as per books of accounts and Income Tax Act, 1961. (36.85) (48.38) Expenses allowed for tax purpose on payment basis 13.49 10.45 Provision for doubtful debts 1.07 1.55 Voluntary Retirement Scheme (VRS) expenditure debited to Profit and Loss Account but allowed in Income tax over five years 0.71 1.01 1.69 Capital Losses carried forward under the Income Tax Act, 1961 1.58 3.95 Deferred tax asset on employee benefit obligations on account AS15 Deferred tax benefit/(expenses) for the year (9.38) 2.37 Note: Figures in brackets are negative values; other than depreciation difference, all other values are insignificant.
Another interesting observation is the balance in deferred tax liability has increased from Rs. 22.15 Cr. to Rs. 31.52 Cr. The increase in liability is attributed to (a) tax saving on account of depreciation and (b) tax paid in advance on account of certain expenses are allowed on payment basis. The company is in expansion mode and hence able to do some tax planning. The trend may change over the years if the company stops in taking up major project. As a user of accounting statement, you need not concern too much as long as the changes in deferred tax balance are relatively smaller compared to the overall size of the company. At the same time, users of accounting statement need to be clear that any large increase in deferred tax means likely increase
44
of tax cash outflow in the future. Though many of you would be relatively comfortable with the concept of deferred tax, you may still wonder why it appears under the source of funds. Suppose the law does not allow the companies to follow different depreciation methods11. The company would end up paying the tax and hence there is no deferment. The value of deferred tax is nothing but the funds of the government used by the company for temporary period. Hence it is a source of funds and such funds are provided by the government without any interest.
2.10
LOAN FUNDS
Loan is an important source of funds. Loans are broadly classified as secured and unsecured and further long-term and short-term. Secured loans are those loans for which the company has provided security and such securities are normally in the form of assets of the company. In the event of non-payment of interest or principal, the lender can take the possession of the assets secured for their loans and dispose the assets to meet their dues. The details of secured and unsecured loans of Asian Paints (India) Ltd. are given in Exhibit 2.7. The company has taken Rs. 36.70 cr. of secured loan primarily from two sources namely sales tax deferral and working capital loan from banks (cash credit account). The details of security are given in the notes appearing below the schedule. The securities provided are mainly plant, commercial properties, movable assets and inventory. The company has also borrowed through unsecured loans (Rs. 58.00 Cr.) in the form of trade deposits and loans availed under sales tax deferment scheme. Sales Tax deferment is a scheme under which a company can collect sales tax but need not deposited with the government for some period. It should be deposited with the government after the period. It is an incentive system in which many state governments are motivating companies to set up business operations in their state. There are several other forms of borrowing. Though Asian Paints (India) Ltd. has not used commercial papers, many Indian companies raise money through commercial papers for working capital. Some companies also raise money through inter-corporate deposits and use financial lease to acquire assets. Though financial lease is strictly not a loan, accounting standard now (w.e.f. 1-4-2001) requires companies to recognise the future lease obligations as loan and report the same on the liability side. Asian Paints (India) Ltd. has not taken any such assets on lease after the implementation of this Accounting Standard (AS-19).
11
Many European countries disallow such practice.
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The Balance Sheet
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Exhibit 2.7: SCHEDULE C: SECURED AND UNSECURED LOANS Secured Loans Long Term: Loans and advances Financial Institutions (Note No. 1) Short Term: Loans and advances from banks Cash Credit Accounts (Note No. 2) Foreign Currency Loan Total of Secured Loan Unsecured Loans Fixed Deposits Interest accrued and due Trade deposits Interest free Sales Tax Department State of AP (Note No. 3) Total of Unsecured Loan Total of Secured and Unsecured Loan
(Rs. in Crores) As at As at 31.03.2008 31.03.2007
23.13 23.13
18.23 18.23
13.57 36.70
48.67 66.90
17.30 40.70 58.00 94.70
18.07 40.70 58.77 125.67
In addition to the feature of security, the terms of loans and advances vary significantly between different types of loan and such variation will also have significant bearings on the future prospects of the company. A foreign currency loan may carry a low interest rate but it might be much riskier and costlier when the exchange rates move against the company's favour. Similarly fixed interest rate borrowing may be cheaper today but turns costly over the years when the interest rate declines in the economy. Many public borrowings of long-term duration these days contain call and put options to safeguard the interests of both borrowers and lenders/investors of such bonds. However, such options come with a price and add cost to the company.
2.11
ASSETS
Assets are classified as tangible and intangible, owned by the company. Land, Building, Machinery and Finished Products of the company are tangible items. Patents, Technical know-how and Goodwill are examples of intangible items. These represent the various forms in which the funds of the business have been invested. Hence, this part of Balance Sheet is also titled as Application of Funds. The term owned by the company is emphasised here because sometimes companies that use
46
assets may not own it and so may not show them on the balance sheet12. One such example is acquiring asset under lease arrangements. Assets are broadly grouped as Fixed Assets and Current Assets. This distinction arises because accounts are prepared at the end of certain periods, usually at the end of every year. Assets, which get fully consumed or utilised within one accounting period, are called Current Assets. Assets whose useful life exceeds one year are called Fixed Assets.
2.12
FIXED ASSETS
Fixed Assets are the long-lived assets of a company. Accounting Standard 10 defines fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business. Examples of fixed assets are land, building, plant and machinery. As fixed assets would have some useful life left at the end of the accounting period, they are shown in the Balance Sheet. Exhibit 2.8 shows the fixed assets schedule of Asian Paints (India) Ltd. Fixed Assets can be tangible (i.e. capable of being touched, felt and seen), or intangible. Intangible asset is an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes. Examples of intangible assets include patents, trademarks, and copyrights. Asian Paints (India) Ltd. reports two such intangible assets namely trade mark and software licence fees. As the Fixed Assets are used for a long period of time, spreading over accounting periods, it is necessary to spread the cost of acquiring these fixed assets over their useful life. This spreading of cost of the fixed asset over several accounting periods is known as Depreciation. The "Net Block" value of the fixed assets reported in the Balance Sheet shows the part of the cost of that asset which has not yet been written off as Depreciation and has to be written off in the future accounting periods as depreciation. The Balance Sheet of Asian Paints (India) Ltd. shows four line items under Fixed Assets heading. They are Gross Block, Depreciation, Net Block and Capital Work in Progress. There is a substantial difference between gross block and net block and the difference is on account of depreciation. Gross Block: Gross Block represents the "Original Cost or historical cost of the Fixed Assets. Here, Original Cost means the total expenditure incurred by the company in acquiring the asset, and bringing it to a stage when it is ready for commercial production. Hence, Original Cost should include the freight inward, installation expenses, customs duty (if any), cost of trial runs, etc. AS-10 explains the cost as follows:
12
Accounting Standards now require those assets to be shown by the company as assets even though they are not owned by them.
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The cost of an item of fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price. Examples of directly attributable costs are: i. site preparation; ii. initial delivery and handling costs; iii. installation cost, such as special foundations for plant; and iv. professional fees, for example fees of architects and engineers. Accumulated Depreciation (Balance Sheet figure): The depreciation value shown in the balance sheet (in the case of Asian Paints Rs. 469.41 Cr.) is called accumulated depreciation. As mentioned earlier, the cost of the fixed assets has to be spread over the years and charged to the profit and loss account. The reason for charging depreciation to profit and loss account as expense is obvious. Without charging depreciation, the profit derived may not be a fair value. All expenses whether purchase of plant or chemical should be charged to profit and loss account. While expenses incurred on the purchase of chemical is charged immediately (assuming it is consumed in the production process), expenses incurred on the purchase of plant and machinery is charged over the years because these assets are used for the production over the years. Since they are 'used' for production, the output or the product should bear some portion of the cost of the fixed assets. Through depreciation, this purpose is achieved. Accumulated depreciation is equal to the amount, which has already been charged in the profit and loss account for the assets that the company owns as on that date. Suppose the company owns some 300 assets as on March 31, 2008. The original value of these 300 assets is called Gross Block. The sum of depreciation of these 300 assets, which has already been charged to profit and loss account, is called accumulated depreciation. Companies maintain asset register in which the original value of the asset and depreciation charged every year are recorded. It is possible to find out at any given point of time how much depreciation has been already charged for each asset from this register. Asian Paints (India) Ltd. would have large number of assets spread all over the country at their plants and sales offices. The original cost of these assets, which are in possession with Asian Paints (India) Ltd. as on March 31, 2008, was Rs. 937.89 Cr. It is called Gross Block. The depreciation charged over the years against these assets was Rs. 469.41 Cr. and this is called accumulated depreciation. Net Block: The difference between the Gross Block and Accumulated Depreciation is called Net Block. Net Block value of the assets of Asian Paints (India) Ltd. as on March 31, 2008 was Rs. 428.83 Cr. It is also equal to the amount of the assets, which are yet to be charged to profit and loss account and will be charged over the years in the future. Capital Work in Progress: This item represents the expenditure incurred till date on the creation of a new fixed asset. But the asset is not complete and is not capable of being commercially used. Hence, the amount of expenditure incurred thereon is shown separately under this head. Any additional expenditure incurred to bring such assets to
48
a stage where they can be commercially exploited during the subsequent accounting periods would be added thereto. Once the asset is ready for commercial use, the amount is transferred from this account to the relevant account of the Fixed Asset (eg: Plant & Machinery, Building, etc.) and depreciation is charged on it in the usual manner. The value of Capital Work in Progress of Asian Paints (India) Ltd. as on 31st March 2008 is Rs. 110.39 Cr. (Refer Exhibit 2.1). The Net Block is often referred to as the Book value. A question may arise as to whether the book value of fixed assets is representative of their fair market value. It is often the case that the book value may be quite different from the market value. Despite this, these assets are still not shown at market value, as they are not meant to be sold in the market, but to be utilised by the company in running its operations. However, the Accounting Standards do allow the fixed assets to be revalued (i.e., both increase and decrease in value), in order to bring the book value in line with the market value. However, such revaluations, particularly the upward revaluation, are not frequently resorted. Even if a company does revaluation and increases the value of the assets, it should disclose the fact every time when it reports fixed assets value and also value of the fixed assets without such revaluation. The details of fixed assets are given in Schedule D (see Exhibit 2.8) of the Annual Report. This is the most complex schedule, which creates considerable confusion to the non-accounting students and mangers. The first column shows the description of the assets. Asian Paints (India) Ltd. classified its total assets into 11 broad categories. Since the company is in the manufacturing industry, more than half of its assets are tangible and in the form of plant and machinery. Columns 2 to 5 relate to gross block or original value of the assets. Column 2 shows the original value of assets that are in possession with the company as on 1st April 2007. During the year, the company has purchased some assets, whose original value was Rs. 138.33 Cr. and the details are given in column 3. The company could have sold some of the assets during the year or transferred to some other companies. In other words, a few assets have gone out of the company. The original value of these assets that have been sold or transferred was Rs. 6.64 Cr. and the details are reported in column 5. It should be noted that this value is neither sale value of those assets nor book value (original value less accumulated depreciation). It is just original value of the asset (invoice value plus direct expenses incurred on these assets). The values in column 6 to 9 are related to the accumulated depreciation. The accumulated depreciation as on March 31, 2007 is reported in column 6. The difference of values in column 2 and column 6 is the net block value (or book value) of the assets as on March 31, 2007 and you can see this value in the last column of the table. Column 7 is related to depreciation provided for the assets during the year, which are used by the company. This value is equal to Rs. 43.70 Cr. This is the value that will be shown as expenses for the year 2007-08 in the Profit and Loss Account. Column 8 is critical for understanding the whole table. In column 4, the company provided the details of assets which have been sold or transferred and deducted the original value of the assets. Since the assets itself are not with the company, the
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accumulated depreciation should also be removed. The accumulated depreciation of these assets are identified and reported in column 8. They are deducted to derive the accumulated depreciation as on March 31, 2008. In other words, the gross block value shown in column 5 and accumulated depreciation value shown in column 9 are related to only for the assets, which the company owns as on March 31, 2008. The company has also deducted about Rs. 39.65 million towards impairment of assets. Assets which are in possession but not useful for the purpose for which it was acquired or useful only to a small extent should not be shown at normal value (purchase value less depreciation). Since the value of the asset is much below its book value, it should be further reduced and such mechanism is called impairment of assets. The net block value of the asset is equal to gross block less accumulated depreciation less impairment of assets. The various items of Fixed Assets are described below: Land and Building: This item shows the value of the Land and Buildings owned or leased by the company. While freehold land is the land owned by the company, the leasehold land is land taken on long-term lease normally from the state government. There is no depreciation for land. Plant and Machinery: These are the assets used in the manufacturing process. It may be a new machine or second hand machine. It can be purchased machine or self constructed machine. Scientific Research Equipment and Building: This is shown separately since accounting standard on treatment of such assets and depreciation rates differ for the assets used for research and development. Electric Pipe and Fittings: These include transformers, air-conditioner, fans, etc. Furniture and office equipment: These include table and chairs, computers, photocopying, etc. Vehicles: It includes heavy vehicles used for distribution, movement of materials within the plant, cars, etc. Leased Assets: Leased assets are assets given on lease to others. Asian Paints (India) Ltd. is leasing 'tinting systems' to dealers. Goodwill: There is no value called Goodwill in fixed asset schedule of Asian Paints (India) Ltd. but it doesn't mean there is no goodwill for the company. Goodwill, in general, is recorded in the books only when some consideration in money or moneys worth has been paid for it. Whenever a business is acquired for a price (payable either in cash or in shares or otherwise), which is in excess of the value of the net assets of the business taken over, the excess is termed as goodwill. Goodwill arises from business connections, trade name or reputation of an enterprise or from other intangible benefits enjoyed by an enterprise. As a matter of financial prudence, goodwill is written off over a period.
Exhibit 2.8: SCHEDULE D: FIXED ASSETS

Gross Block
Total As at 1/4/2007 Additions during the year Deductions and/or transfers As at 31-308
Upto 31.3.07
(Rs. in Crpres)
Depreciation
Total During the year Deductions and/or transfers as at 31-308 As at 1/4/2007 As at 31-308 As at 31-308 As at 31-307
Impairment
Net Block
Tangible Assets Freehold Land Leasehold Land Buildings Plant and Machinery Scientific Research: Equipment Building Furniture and Office Equipment Vehicles Leased Assets: Equipment Intangible Assets Trademark Software - License fees Total Previous Year
5.91 13.35 152.23 467.02 11.51 3.11 21.74 3.35 97.31 11.92 18.75 806.20 736.14
80.16 0.85 6.81 44.78 0.50 2.52 0.17
0.06 3.48 -0.14 0.55 0.68 1.93
86.07 14.20 158.98 508.32 12.15 3.11 23.71 2.67 95.55 11.92 21.21 937.89 806.20
0.82 36.07 281.10 7.43 0.67 15.35 1.76 59.98 11.92 15.82 430.92 393.89
0.15 4.61 28.99 0.74 0.10 1.84 0.35 5.35
0.03 2.97 -0.01 0.37 0.65 1.13
0.97 40.65 307.12 8.18 0.77 16.82 1.46 64.20 11.92 17.32 469.41 430.92
13.73 0.50 1.83 24.31
13.58 0.50 1.65 23.92
86.07 13.23 118.33 187.62 3.47 2.34 5.24 1.21 7.43
5.91 12.53 116.15 172.19 3.59 2.44 4.56 1.58 13.02
2.54 138.33 80.63
0.08 6.64 10.57
1.57 43.70 45.06
0.07 5.21 8.03
40.37 41.82
39.65 40.37
3.89 428.83 334.91
2.94 334.91 300.43
Trademarks, Copyrights and Patents: These assets are normally acquired in two ways: (i) by purchase, in which case they are valued at the purchase cost including incidental expenses, stamp duty, etc. and (ii) by development within the enterprise, in which case identifiable costs incurred in developing the assets are capitalised. They are normally written off over their legal term of validity or over their working life, whichever is shorter. Asian Paints (India) Ltd. reported that is writes of trademarks over a period of five years. Assets acquired under financial lease: Asian Paints (India) Ltd. has not acquired any assets under financial lease. However when companies acquire assets under financial lease after 1-4-2001, they need to report the same as assets under this schedule. Accounting Policies related to Fixed Assets The company has reported the accounting policies related to fixed assets and depreciation as follows to make the matter clear. (a) Fixed Assets are carried at the cost of acquisition or construction, less accumulated depreciation. The cost of fixed assets include taxes (other than those subsequently recoverable from tax authorities), duties, freight, and other incidental expenses related to the acquisition and installation of the respective assets. Interest on borrowed funds directly attributable to the qualifying assets up ot the period such assets are put to use, is included in the cost. (b) Know-how related to plans, designs and drawings of buildings or plant and machinery is capitalized under relevant asset heads. (c) Depreciation on all fixed assets is provided under Straight Line Method. The rates of depreciation prescribed under Schedule XIV of the Companies Act, 1956 are considered as the minimum rates. If the managements estimate of the useful life of a fixed asset at the time of acquisition of the asset or of the remaining useful life on a subsequent review is shorter than that envisaged in the aforesaid schedule, depreciation is provided at a higher rate based on the managements estimate of the useful life/remaining useful life. Pursuant to this policy, depreciation of the following assets has been provided at rates which are higher than the corresponding rates prescribed in Schedule XIV. Information Technology Assets Scientific Research Equipment Furniture and Fixtures Office Equipment and Vehicles : 4 years : 8 years : 8 years : 5 years
For Phthalic Anhydride and Pentaerythritol plants, depreciation is provided on all eligible plant and machinery at rates applicable for continuous process plants and for other eligible plant and machinery depreciation is provided on triple shift basis.
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Depreciation on tinting systems except computers leased to dealers is provided under Straight Line Method over the estimated useful life of nine years as per technical evaluation. Depreciation on computers given on lease is provided under Straight Line Method and at rates specified under Schedule XIV to the Companies Act, 1956. Leasehold land and major leasehold improvements are amortised over the primary period of lease. Purchase cost, User licence fees and consultancy fees for major software are amortised over a period of four years. Acquired Trade Mark is amortised over a period of five years. (d) At Balance Sheet date, an assessment is done to determine whether there is any indication of impairment in the carrying amount of the Company's fixed assets. If any such indication exists, the asset's recoverable amount is estimated. An impairment loss is recognised whenever the carrying amount of an asset exceeds its recoverable amount. An assessment is also done at each Balance Sheet date whether there is any indication that an impairment loss recognised for an asset in prior accounting periods may no longer exist or may have decreased. If any such indication exists the asset's recoverable amount is estimated. The carrying amount of the fixed asset is increased to the revised estimate of its recoverable amount but so that the increased carrying amount does not exceed the carrying amount that would have been determined had no impairment loss been recognised for the asset in prior years. A reversal of impairment loss is recognised in the Profit and Loss Account. After recognition of impairment loss or reversal of impairment loss as applicable, the depreciation charge for the asset is adjusted in future periods to allocate the asset's revised carrying amount, less its residual value (if any), on straight line basis over its remaining useful life.
2.13
INVESTMENTS
Investments represent any amount spent on acquiring assets, which are not directly related to the business of the company. Investments are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. For example if a company may acquire shares or debentures in other Indian companies. As the acquisition of these securities is not the main business of APL, such assets are shown separately as Investments. However assets held as stock-in-trade are not investments. The Total Value of Investments made by Asian Paints (India) Ltd as on 31st March 2008 is Rs. 422.88 Crores. The details are investments are given in Schedule E (Exhibit 2.9). If the
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company has numerous investments, the schedule will run into several pages because the companies are expected to give complete details. Exhibit 2.9
SCHEDULE E: INVESTMENTS Long Term Investments Unquoted (i) In Government Securities (ii) Trade Investments (iii) Non-trade Investments (iv) Investments in subsidiary companies Total (Unquoted - Long Term) Quoted (i) Trade Investments (ii) Other Investments Total (Quoted - Long Term) Short Term Investments Non-Trade Investments Total Investments (Long-term Unquoted + quoted + Short-term) Aggregate market value of Quoted Investments Long Term Quoted Investments Short Term Quoted Investments
(Rs. in Crores)
As at As at 31.03.2008 31.03.2007
15.15 0.50 132.19 147.84 77.25 0.13 77.38 197.66 422.88 254.26 -
15.15 0.50 127.14 142.79 77.25 0.13 77.38 114.22 334.39 183.02 -
The company has reported the following Accounting Policy related to Investments: (a) Long term investments are carried at cost. Provision for diminution in the value of long term investments is made only if such a decline is not temporary in the opinion of the management. Current investments are carried at lower of cost and fair value. The comparison of cost and fair value is done separately in respect of each category of investments. (b) Profit and loss on sale of investments is determined on a first in first out (FIFO) basis. Investments can mainly be of two types - Short Term and Long Term. Short Term investments are meant to be sold off or liquidated within the next accounting period. Hence, these are shown at market value. But in case their cost of acquisition is less than the market value, then they are shown at the cost. This is to prevent the company from booking any profits, which have not yet been realised in cash. Thus, the rule to value such investments is Cost or Market Value, whichever is lower. Long Term investments are meant to be held beyond one accounting period. As these are not meant
54
for disposal within the accounting period, they are shown at their original cost. However, in case there is any permanent diminution in value, then they are to be shown at the reduced value, in order to reflect the fair value. Investments are to be classified under the following heading with complete details under each heading for the reporting purpose. Long Term and Short Term Investments: Investments which are expected to be held for more than one year are grouped under long term investments. Other investments are grouped under short-term investments. Quoted and Unquoted Investments: If the investments are quoted in the stock exchanges, they are grouped separately and listed. Aggregate market value of the quoted investments is to be reported at the end of the schedule. Unquoted investments are investments in unlisted companies. Trade and Non-trade investments: Trade investments are investments made by the company in the ordinary course of business. They are business-related investments. The objective is not just investing the temporary surplus cash but with an objective of developing long-term association with the investing company. Investments in joint venture or subsidiary companies are trade investment. Non-trade investments are investment in the nature of cash or treasury management. They are made to park temporary surplus funds to earn some return. Exhibit 2.9 provides investment of Asian Paints (India) Ltd. under the above broad heading. Investments of the company are substantially for long-term purpose and that too investment in subsidiary companies. Investments in subsidiary companies are cancelled out under consolidated balance sheet. Exhibit 2.2 (Consolidated Balance Sheet) shows an investment of Rs. 276.65 crores compared to Rs. 422.88 crores shown in Exhibit 2.1. Investments worth of Rs. 132.19 crores in subsidiary companies has been removed.
2.14
CURRENT ASSETS, LOANS AND ADVANCES
Current Assets are those assets, which get used up, consumed, or whose benefit is realised within the accounting period (i.e., within one year). So, unlike fixed assets, their useful life is normally less than one year. Hence, they are called current assets. Major items of currents assets are inventories, sundry debtors (customers' due) and cash. Exhibit 2.10 presents the Schedule F, which provides additional details on current assets, loans and advances. Interest Accrued: Interest accrued on investments and loans and advances for the accounting period are expected to be received are recorded as income for the period. Since such interest is recorded as income, it has a positive impact on shareholders' equity part of the balance sheet equation. There should be a corresponding increase in the other part of the equation to ensure the equation gets balanced. If the interest is realised in cash, it will add to cash and bank balances. Since the amount has not received, it will be treated as receivables or interest accrued but not received.
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Exhibit 2.10
SCHEDULE F: CURRENT ASSETS, LOANS AND ADVANCES Current Assets (i) Interest Accrued (ii) Inventories - valued and certified by the Management (a) Raw materials (b) Packing materials (c) Finished goods (d) Work-in-process (e) Stores, spares and fuel (f) Other traded items (iii) Sundry debtors (unsecured) (a) Outstanding for more than six months Considered good Considered doubtful Less: Provision for doubtful debts (b) Other debts (considered good) (iv) Cash and Bank Balances (a) Cash on hand (b) Balances with Scheduled Banks (i) Current Account (ii) Term Deposits (iii) Cash Credit Accounts (v) Other Receivables Loans and Advances (A) Wholly owned subsidiaries (B) Company in which directors are interested (C) Other Loans and Advances (D) Advance Payment of Taxes Total
(Rs. in Crores)
As at As at 31.03.2008 31.03.2007 0.09 190.82 15.48 287.16 29.95 13.8 1.76 538.97 0.03 124.97 13 256.35 25.73 11.14 2.88 434.07
4.42 3.23 7.65 3.23 4.42 247.48 251.90 0.12 41.21 0.02 41.35 33.09 43.79 130.50 4.53 1044.22
4.34 4.54 8.88 4.54 4.34 231.62 235.96 0.14 42.33 0.02 42.49 31.23 27.47 80.10 7.88 859.23
Inventories: This item represents the value of materials which are used in the production (e.g. chemicals, pigments), materials which are in the process of being manufactured or work-in-progress and completed goods ready for sale or finished goods. Accounting Standard 2 states inventories as assets (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the
56
form of materials or supplies to be consumed in the production process or in the rendering of services. The general rule for valuing these is the same as that of shortterm investments i.e. they are valued at Cost or Net Realisable Value, whichever is lower. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. The principle followed is conservatism. Suppose the net realisable value is less than the cost, then it is necessary to record the loss immediately. This is achieved by valuing the inventory at net realisable value instead of cost value. On the other hand, if the net realisable value is above the cost value, then the profit should not be recorded unless the inventory is sold. While the principle may be clear to many of you, how this is achieved may still be a source of confusion. The following example will be useful to understand how this inventory valuation rule achieves the principle. Suppose a trading company purchases 1000 pieces of Television at an average cost of Rs. 12000 per piece. During the year, the company has sold 900 units at an average price of Rs. 12500. Assume the price of television has come down substantially and it is estimated that the remaining 100 units can be sold only at Rs. 11800. During the period, the company has incurred expenses towards salary, rent, electricity, etc. for Rs. 150000. Accountant prepares the profit and loss account as follows: Sales Rs. 12500 x 900 11,250,000 Closing Stock Rs. 11800 x 100 1,180,000 Total 12,430,000 Less: Purchases Rs. 12000 x 1000 12,000,000 Expenses (Salary, rent, etc.) 150,000 12,150,000 Profit 280,000 The profit can also be explained as follows: Profit realised on selling 900 TVs at the rate of Rs. 500 per TV is Rs. 450,000; Less: Expenses of Rs. 150000 and Prospective Loss of Rs. 20,000 related to 100 unsold TV (inventory) at the rate of Rs. 200 per unit. In computing the profit, the company considers the prospective loss. Suppose the price of TV has not come down. It is possible for the company to sell the 100 TV next year at a price more than Rs. 12000. The profit will be Rs. 300,000. The closing stock value in the above table will be Rs. 1,200,000 (Rs. 12,000 x 100 units). In this case, the future potential profits are not recorded in computing the profit for the period. Inventory Accounting Method: Inventories are valued at cost or net realisable value. There are complexities in computing the cost particularly when the materials are procured in different periods. In the above example, suppose 1000 pieces of TVs are purchased 12 times at the rate of one consignment per month. Each consignment is for a quantity ranging from 80 to 90. Though the average price is Rs. 12000, the actual price between consignments is in the range of Rs. 11800 to Rs. 12200. Suppose the selling price or net realisable value of the remaining 100 units will not be less than Rs. 12500. For valuation of inventory, the company needs cost value. The issue is what is the cost value of the remaining 100 units. There are several possible ways through
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which one can compute the cost value. In this case the goods are identifiable in nature and hence one can find out the exact prices at which the 100 unsold goods are with the company. However, this practice may not be feasible for a chemical company or steel company. There are broadly three methods used for finding the cost of inventory and each method is based on an assumption. Method 1 called first-in-first-out method or FIFO assumes goods received first are consumed or sold and hence the closing stock consists of goods purchased during the last few days or weeks or months. The value of closing stock is found by applying the last few rates. Method 2 called last-in-first-out method or LIFO assumes exactly opposite way. It assumes goods last received are used or sold first and the closing stock consists of units purchased earlier. Accordingly, consumption or sales are valued at the last invoice price and closing stock is computed by deducting the cost of consumption or sales from total purchase cost. LIFO is not allowed under Indian Accounting Standard. Method 3 called weighted average cost method updates the stock value every time when a purchase is made taking into account the value of stock available at that point of time. Suppose on day 1, 100 units are purchased at a price of Rs. 10 per unit. Day 2, 80 units are consumed. The weighted average cost of closing stock of 20 units is Rs. 10 per unit. Day 3, 80 units are purchased at a price of Rs. 12 per unit. The weighted average cost of the stock of 100 units (20 old units and 80 new units) is Rs. 11.60 (200+960 divided by 100). The process of updating the value of the stock continues and closing stocks are valued at this weighted average rate. Among the three methods, weighted average cost method is widely used by Indian companies. Asian Paints (India) Ltd. has classified the inventory into six categories namely Raw materials, Packing materials, Finished goods, Work-in-process, Stores, spares and fuel and Other traded items. Among these six items, finished goods and raw material account for substantial part of inventory value. In the notes on balance sheet section, the company has stated the inventory valuation policy as follows: Accounting Policy on Inventory Valuation
a) Raw materials, work in progress, finished goods, packing materials, stores, spares, traded goods and consumables are carried at the lower of cost and net realizable value. The comparison of cost and net realizable value is made on an item-by-item basis. Damaged, unserviceable and inert stocks are suitably depreciated. b) In determining cost of raw materials, packing materials, traded goods, stores, spares and consumables, weighted average cost method is used. Cost of inventory comprises all costs of purchase, duties, taxes (other than those subsequently recoverable from tax authorities) and all other costs incurred in bringing the inventory to their present location and condition. c) Cost of finished goods and work-in-process includes the cost of raw materials, packing materials, an appropriate share of fixed and variable production overheads, excise duty as applicable and other costs incurred in bringing the inventories to their present location and condition. Fixed production overheads are allocated on the basis of normal capacity of production facilities.
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Sundry Debtors: Business practice requires companies to sell goods or provide services on credit. The period of credit ranges from 15 days to 180 days. The amount outstanding on customers' account is called sundry debtors or accounts receivables. They are part of current assets since these dues are normally collected within one year. Sundry debtors outstanding for more than six months are to be shown separately. It is also necessary for the company to identify the receivables, which are considered doubtful and disclose the same. For doubtful debts, it is necessary to make provision in the accounts. Since they are doubtful debts and potential future loss, such provisions are made out of the profits of the current year. Auditors require the company to get a certificate from the customers who are yet to pay the bills to confirm whether the values match what is shown in company's book. Also, doubtful debts are identified through other checks like number of days outstanding, dispute on the supply terms, litigation, etc. It is also possible for the management to forecast the percentage of debt will turn doubtful based on the past records and experience. Asian Paint (India) Ltd. considered dues worth of Rs. 3.23 Crores as doubtful out of total sundry debtors of Rs. 251.90 Crores as on March 31, 2008. Considering the scale of operation of the company, the percentage of doubtful debts is just about 0.10% of sales, which is not a figure to worry about. Provision for doubtful debt is not a loss and it is only a provision for estimated loss. Provisions can be shown below the heading "current liabilities and provisions" or deducted from the asset items related to the provision. Normally, provision for doubtful debt is deducted from the sundry debtors to get the net value of the sundry debtors. This kind of presentation gives a better picture about the receivables than showing gross sundry debtors under the asset side and provisions for doubtful debts on the liability side. It may be recalled that Provision for Depreciation on Fixed Assets is also shown as a negative value below Fixed Assets to derive net block instead showing the same under liability side. Cash and Bank Balances: This represents the amount of cash held by the company in its offices and credit balance in the bank accounts. Cash and bank balances are required to meet the day-to-day operations of the company. However, any excess holding will be costly for the company since there is an opportunity cost for the cash and balances in current account of the bank. Companies need to find optimum cash level like optimum inventory level and hold such amount. The cash holding depends on monthly expenses, credit policy and other commitments. Normally monthly or weekly cash budget is prepared to find out the cash requirement. Asian Paints (India) Ltd. has classified cash and bank balances under three categories - cash on hand, balances with banks and term deposits. The total value of cash and bank balance as on March 31, 2008 was Rs. 41.35 Crores. The company has incurred a total expenditure of Rs. 2862.15 Crores for the year 2007-08 or Rs. 51.58 Crores per week. The cash and bank balance holding of Rs. 41.35 Crores roughly covers expenditure for about one-week. Loans and Advances: In the normal course of business, companies may have to give temporary loans and advances to other entities. For example, companies may provide loans and advances to employees, which may be recoverable in 10 or 12 installments.
Chapter 2
The Balance Sheet
59
Sometime, it may be necessary to pay deposits with various government agencies for electricity, telephone, water, etc, or pay advance tax. Since all these are either recoverable or adjustable against future liabilities, they are treated as a part of asset. Companies generally classify the loans and advances under four broad heads for the purpose of disclosure. They are (a) Loans and advances to wholly owned subsidiaries (b) Loans and advances to companies in which directors of Asian Paints are interested, (c) Loans and advances to others and (d) Advance tax paid. This disclosure will help the readers to understand whether the directors of the company use their association with the company for certain personal benefit. Advance Payment of Taxes (Net of provision for tax): A company is often required to make the payment of Income Tax during the accounting period itself, based on an estimate of the likely profits during the year. This is called Advance Tax, as it is paid before the end of the accounting period. The amount and timing of such payments is determined by the Income Tax Act. Any such Advance Tax paid is shown under this head.
2.15
CURRENT LIABILITIES AND PROVISIONS
These items are financial claims against the company which are payable within the next accounting year. The main items are: Acceptances: When goods are purchased on credit basis, sometime the supplier might insist the buyer to sign the bills payable. By signing this, the buyer formally agrees to pay the dues to the holder of the bill on the due date. The suppliers can submit such bills payable to their banks and raise money against such bills. This process is called discounting bills. Sundry Creditors: This item represents the amount payable by the company on account of purchases made by it in the ordinary course of its operations, i.e., the company may have purchased some raw materials, but has not yet paid for them. Or it might have used the services of its personnel, but their wages / salaries would be paid in the subsequent month. Sundry Creditors includes all such amounts. These are obligations that a firm expects to pay or discharge during the normal operating cycle, usually less than a year. Sundry creditors value is normally shown under two subheadings namely 'Trade' and 'Others'. Current Portion of Long Term Debt: This item represents that portion of the Long Term Debt taken by the company, which must be paid by it within the next accounting period. It includes both, the amount of principal to be repaid as well the interest which has become due. Interest accrued but not due: This refers to interest on borrowing accrued but not required to be paid. For example, as per the borrowing terms, if the interest for the period January to June is due on 30th June, 2008, the interest for the months of January to March will be recorded as expenses and liability for the year ending March 31, 2007.
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Provisions: These are cash expenses likely to happen in the near futures. Examples of provisions are provision for dividend, tax, bonus, etc. These items are not like provision for doubtful debt or depreciation where there is no immediate liability. The details of current liabilities and provisions given in schedule G of Asian Paints (India) Ltd. is given in Exhibit 2.11. Exhibit 2.11
SCHEDULE F: CURRENT LIABILITIES AND PROVISIONS Current Liabilities (i) Acceptances (ii) Sundry Creditors Due to Micro and small enterprises Others (iii) Investor Education and Protection Fund (iv) Interest accrued but not due (v) Other Liabilities Provisions (i) Provision for Final Dividend (ii) Provision for tax on Final Dividend (iii) Provision for accrued leave (iv) Defined Benefit Obligations (v) Other provisions
(Rs. in Crores)
As at As at 31.03.2008 31.03.2007 214.47 0.80 374.93 375.73 3.17 191.74 785.11 100.71 17.12 39.31 5.09 4.26 166.49 951.60 165.09
267.35 432.44 6.29 155.37 594.10 9.59 1.63 35.93 2.74 4.26 54.15 648.25
2.16
NET CURRENT ASSETS
This is the difference between Current Assets, Loans and Advances and Current Liabilities and Provisions. Current assets are partly funded by the suppliers (current liabilities). The difference between the two represents the company's contribution towards purchase of current assets. Under the format used by Indian companies, supplier credit (current liabilities) is not considered as sources of funds since there is no explicit funds transaction when goods are purchased on credit. Hence, current liabilities and provision are treated as a source of funds for the purchase of current assets, loans and advances and the balance is shown as net current assets or uses of funds for the purchase of current assets. The Net Current Assets of Asian Paints (India) Ltd. as on 31st March 2008 is Rs. 92.62 Crores. It is purely a matter of convenient way of presenting the summary of accounts. However, in other countries like the U.S., the current liabilities are shown as a part of liabilities in the balance sheet drawn by companies.
Chapter 2
The Balance Sheet
61
2.17 DEFERRED
REVENUE EXPENDITURE (To the extent not written off):
This item is neither a fixed asset nor a current asset. It represents a different category of expenditure altogether. Often, a company incurs a substantial expenditure, say on a large advertisement campaign or major information technology expenses. The expenditure is, truly speaking, a revenue expenditure, and hence should appear in the profit and loss account. However, if the benefit of the expenditure is realised over the next few years, it is only logical to write off the expenditure over the years. Suppose a company incurs Rs. 100 million in supply chain management system and the benefit is fully realised during the next four years period. In such an event, Rs. 25 million is charged in the profit and loss account for the period 1 and the remaining Rs. 75 million is shown in the balance sheet as asset. The description used for such asset is Deferred Revenue Expenditure (to the extent not written off). In year 2, another Rs. 25 million will be charged in the profit and loss account but the balance sheet asset value will be reduced to Rs. 50 million. At the end of year 4, the expenditure will not appear in the balance sheet. In many balance sheets including the Balance Sheet of Asian Paints for the year ended 31st March 2005, we may not see any figures on this heading. Earlier Asian Paints (India) Ltd. was showing such IT related expenditure as deferred expenditure but in 2004-05, it has shown the same as intangible fixed assets and mentioned the same in notes to accounts as follows: Hitherto, user licence fees for major software was classified as Deferred Revenue Expenditure. Pursuant to Accounting Standard (AS 26) - Intangible Assets, the same has now been reclassified as Intangible Assets under "Schedule D-Fixed Assets". Other software expenditure is written off to the Profit and Loss Account in the year of purchase.
2.18
CONTINGENT LIABILITIES
Contingent Liabilities are, in a true sense, not liabilities, as the company has no obligation to pay them as at the Balance Sheet date. They reflect certain sum of money, which may become payable by the company, based on the happening of an uncertain event. Thus, these are hypothetical claims against the company, and so are not reflected in the Balance Sheet, but are shown in the footnotes of the Balance Sheet or as a part of Notes to Balance Sheet. They give useful information about some potential losses, which the company may have to incur in the future. These losses may arise because of disputed tax liabilities, dishonour of bills discounted by the company, invoking on guarantees issued by the company, etc. Though Asian Paints (India) Ltd. has not given a separate disclosure under the caption 'Contingent Liability', the Note B of Schedule M provides some details. (a) Guarantee given on behalf of Company's dealers in respect of loans granted to them by a bank for acquiring dealer tinting systems 2007-08 34.72 2006-07 34.83
62

75.16 77.32
(b) Corporate guarantees issued by the Company to certain banks on behalf of some of its subsidiaries (c) Claims against the Company not acknowledged as debts: i. Tax matters in dispute under appeal ii. Others
33.72 3.36
46.09 2.92
The total value of such liabilities as on March 31, 2008 is Rs. 146.96, which is about 20% of the reserves and surplus.
2.19
SUMMARY
Balance Sheet is normally the first financial statement of the annual report, which consists of several other financial statements. Balance sheet is a statement of wealth. It also provides wealth of information to the users of financial statement. The statement lists the assets owned by the company and claims against the company as on the date on which the balance sheet is prepared. Balance sheet can also be viewed as a statement, which shows the sources of funds and their uses. Funds are provided by shareholders and lenders. Shareholders can bring fresh equity or allow the company to retain part of the profit as their contribution. Lenders can provide funds in the form of secured loan or unsecured loan or for long period or short period. Funds raised from shareholder and lenders are mainly used for purchase of fixed assets, investments and net current assets. A reading of balance sheets shows the composition of sources of funds and the assets. A comparison with previous year's values highlights the growth of the company and how such growth is funded. Balance Sheet always balances due to double entry bookkeeping principle, which can be stated as balance sheet equation. A simple balance sheet equation isAssets = Liabilities + Shareholders Equity An expanded version of the balance sheet equation isFixed Asset + Investments + Current Asset - Current Liability = Secured Loan + Unsecured Loan + Deferred Tax + Shareholders' Equity The equation can be expanded further to reflect several components of assets and liabilities. Indian companies provide the principal items of balance sheet in a single page statement and provide large amount of details in schedules and notes forming part of balance sheet.
Chapter 3
Income Statement
3.1
INTRODUCTION
The shareholders of companies like Asian Paints (India) Ltd. would expect the managers of their companies to work towards earning profit for them. They would not be satisfied if the management just informs them that the company has made so many millions of profit. They would expect the company to give the details of revenue and expenditure under few broad headings and then the resulting profit. Tax authorities would also expect the company to produce a detailed statement showing income and expenditure while paying tax. Though profit is important figure, the users of financial statements would expect more details about the operations along with the details of profit. Members of not-for-profit organisations would also expect their organisations to report the operating details by giving major income and expenditure details. Organisations with profit as objective prepare a statement called profit and loss account. The profit and loss account is a formal financial statement, which summarises the results of a company's operations (revenues and expenses) for a specific period of time. Not-for-profit organisations prepare a statement called income and expenditure account and show whether the organisation has earned surplus or incurred deficit during the period. These statements show the results of operations in a manner such that the reader can understand the results from normal operating activities of the organisation, and also the result of any extraordinary or one-shot items. Such presentation allows a better understanding of the performance of the organisation. Expenditure split in this manner can really help us see how well the business is performing and where it needs to make changes if it wants to stay in business or improve its performance.
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Profit and loss account helps us to analyse the profitability of a company over a particular time period. Unlike a Balance Sheet, it cannot tell us how much assets the company owns, but it can help us work out where the company is making and losing money by using such assets. After all, assets are held to generate profit. Profit and loss account is also required to be prepared on shorter intervals. Under the listing agreement of stock exchanges, listed companies in India have to give quarterly statement of profit in a summarised form in addition to detailed profit and loss account at the end of each accounting year. Profit and Loss account is relatively simpler than balance sheet in terms of understanding the concepts. It provides the following information to the users of financial statements. Sources of Income or Revenue: Broadly, there are two sources of income - income from main operation and other income. Other income may be recurring or one-time non-recurring income. It is possible for companies to show major increase in profit by reporting an improvement in other income. Since other income is generally volatile on a year to year basis, users of financial statements mostly give less importance for other income. Trends in Expenditure: The ability to contain the cost is critical for the long-term solvency of the company. By comparing expenditure item with sales for two or more years, it is possible to assess the ability of the firm in controlling cost. It is also possible for the users to make inter-firm comparison on expenditure. Different Types of Profit: The term profit is open for misinterpretation without proper prefix or suffix. Profit before depreciation, interest and taxes (PBDIT), Profit before interest and taxes (PBIT), Profit before tax (PBT), Profit after tax (PAT), Profit before extra-ordinary items are few categories of profit and each one conveys some additional information. Similarly, profits are reported as operating profit, gross profit, net profit, cash profit, disposable profit, etc. Profit and Loss statement provides the details of these different types of profit.
3.2
ACCOUNTING PERIOD
The period of time for which a profit and loss account is prepared is known as an Accounting Period, usually twelve months. Therefore the caption of Profit and Loss Account ends with 'for the period ended'. Indian companies generally use April March as accounting period, although some companies prefer to use the international standard and follow the calendar year (January-December) as their accounting period. Many multinational companies have January to December as accounting period to align their accounting cycle with their parent companies. Some companies also choose a different accounting period such as July - June or November to October to align their business cycle with accounting cycle. For example, Pharmasia Healthcare Ltd. has December to November and Thomas Cook (India) Ltd has November to October as accounting period. In a few rare occasions, companies may have accounting period more than or less than 12 months and they happen when they change the accounting cycle. For instance a company having accounting period of July to June wants to change to April to March, has to either increase one accounting period for 18 months or reduce one accounting period to 6 months to move to the new cycle.
Chapter 3 3.3
The Income Statement
65
PROFIT AND LOSS ACCOUNT FORMAT
Unlike Balance Sheet, there is no prescribed format given by the Companies Act, 1956. However, the Act requires the companies to prepare the profit and loss account to reflect the true and fair view of the operations of the company for the accounting period. Further, the Act also requires the profit and loss account to show information listed in Schedule IV. The profit and loss account of Asian Paints (India) Ltd. for the year ending March 31, 2008 is given in Exhibit 3.1. While important items are summarised in one page, additional details are provided in the schedules forming part of Profit and Loss account. If the company has subsidiaries, like consolidated balance sheet, the company should also give consolidated profit and loss account. The purpose of consolidation is to show the overall profitability of the group, which includes holding company and its subsidiaries. It is quiet possible that the profit and loss account shows a healthy picture but the consolidated profit and loss account may show an entirely different or at times even gloomy future. This happens when any of the subsidiaries are incurring loss. So on a consolidated basis, the company may not be doing better. This is one reason why de-mergers occur and companies spin off their not so well performing subsidiaries. However, for various reasons (good as well as wrong reasons), companies create highly complex and nested business organisation structure. It would be difficult to assess the financial position of such companies without looking into consolidated profit and loss account. Exhibit 3.2 presents Consolidated Profit and Loss Account of Asian Paints (India) Ltd. for the year ended March 31, 2008.
3.4
THE MATCHING AND ACCRUAL CONCEPTS
Before we begin explaining the different components of a Profit and Loss Account, it is important to understand the matching and accrual concepts13. These are fundamental concepts upon which profit is determined. Accounting Standard 1 (AS-1) sets out several concepts including the matching and accrual concept, which accountants are required to follow while preparing financial statements. The Matching Concept requires expenditure must be matched with revenues earned. The Accrual Concept requires the organisations to record transactions as and when they occur, and not based on when cash is actually received or paid. The following examples will clarify this concept.
13
We have discussed these concepts briefly in Chapter 1.
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J K L
62.35 100.71 27.72 134.42 200.00 525.20 39.12
52.76 62.35 9.59 17.77 89.58 150.00 382.05 28.36
Chapter 3
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Exhibit 3.2 ' CONSOLIDATED PROFIT AND LOSS ACCOUNT for the year ended 31st March 2008 of Asian Paints (India) Ltd.
(Rs. in Crores)
Schedu les INCOME Sales and operating income (Net of discounts) Less: Excise Duty Sales and operating income (Net of discounts and excise) Other Income EXPENDITURE Materials Consumed Employees' remuneration and benefits Manufacturing, administrative, selling & distribution Exp. Profit Before Interest, Depreciation and Tax Less: Interest (Refer Note B - 17 in Schedule M) Less: Depreciation (Refer Note B - 197 in Schedule M) Less: Profit/Loss from Associate Company Profit Before Tax and Extraordinary Items Extraordinary Items (Refer Note B-6 and B-8 in Schedule M) Profit Before Tax and Prior Period Items Less: Provision for Current Tax Less: Provision for Deferred Tax Less: Fringe Benefit Tax Less: Short/(Excess) tax provisions for earlier years Profit After Tax Before Prior Period Items Add: Prior period items Profit After Tax and Prior Period Items Less: Minority Interest Attributable to shareholders Add: Balance Brought forward from previous year DISPOSABLE PROFIT
Earnings per share (Basic & diluted) (Note B-25 in Schedule M)
Year 2007-2008 4935.66 531.33 4404.33 61.95 4466.28 2577.64 306.66 861.80 3746.10 720.18 21.16 59.17 639.85 6.84 633.01 184.79 10.56 6.43 1.59 429.64 -1.59 428.05 18.87 409.18 150.00 559.18 42.66
Year 2006-2007 4133.52 463.55 3669.97 37.25 3707.22 2199.40 262.04 730.47 3191.91 515.31 18.91 61.14 0.40 434.86 7.76 427.10 148.31 -2.88 4.81 -3.58 280.44 2.65 283.09 2.06 281.03 110 391.03 29.30
J K L
68
Revenue as recorded at the top of the Profit and Loss Account is the total value of sales invoices raised for goods and services provided during the accounting period. If the accounting period is from 1 January to 31 December, then all invoices for goods and services provided in the accounting period are included irrespective of the fact whether cash has been received from customers or not. It is a normal trading practice for customers to buy goods on credit terms. This means actual payment for the invoices raised during the period may be received after the accounting period. The reason for considering such unpaid invoices also in sales is accrual concept. The impact of this accrual concept is a part of the profit stated in the profit and loss account is yet to be realised in cash. In other words, the profit derived based on accrual concept is also profit accrued but not necessarily received or realised in cash. Sales invoices raised for goods and services provided outside of this period are not to be included in the sales figure for the period because accrual concept requires to exclude transactions not occurred during the period. The matching concept requires all costs incurred in achieving sales for an accounting period to be matched against those sales again irrespective of the fact whether they are paid or not. For example if a company sold 1000 pieces during the year and of this 200 units were purchased in the previous year and the remaining 800 during the current year, the expense should reflect all the 1000 units cost of purchase. Similarly, for the accounting period ended 31 March 2008, fixed expenses incurred between 1 April 2007 and 31 March 2008 are to be matched against sales. It means that if the company paid rent or insurance on 1st January 2008 for six months (January to June), it should consider only half of this amount as expense for the period (January to March). The value of the 3 months rent or insurance paid in advance for April to June will appear in the Balance Sheet under Current Assets as a prepayment. There are few cases in which the company may have to recognise the expense even though they are not due for payment. Interest on borrowing for the period whether it is due or not should be shown as expense of the period. Normally, interest on borrowings is paid twice in a year, 30th June and 31st December. When the books of accounts are prepared for the period of April to March, interest for the period of January to March is to be included though they are due and payable only on 30th June. There are several such situations in which matching principle sets the decision rule whether to recognise the expenditure or not. In other words, matching concept requires the accountants to consider all expenses of the period and expenses incurred for earning the revenue. The entries found in a typical Profit and Loss Account can be divided into four broad categories namely, income, expenses, profits or losses and appropriation of profits.
3.5
INCOME
Income or revenue is outcome of operations. Accounting Standard 9 (AS-9) defines revenue as "the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding
Chapter 3
69
interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration." Earlier in our discussion on accrual concept, we mentioned that credit sales should be included as revenue. While this is a general principle, as per Accounting Standard 9, a sale is recognised as revenue only when i. the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and ii. no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods. There are various sources of revenues for a company. Sales, also referred to as turnover, represent the total income of a business from its normal trading activities. The value of turnover that appears in the Profit and Loss Account includes the total value of all goods or services for which invoices have been issued, even if payment has not yet been received for some of these invoices. Some companies report sales excluding excise duty and others show including excise duty and then deduct the excise duty to derive net sales. The first line item of Asian Paints (India) Ltd. is sales and operating income but it includes excise duty. It was Rs. 3911.93 crores as given in Exhibit 3.1 and the company has paid Rs. 495.80 crores as excise duty. Sales and operating income excluding excise duty was Rs. 3416.16 crores. Trade discounts are excluded in computing the sales. Trade discounts are given for bulk purchases. There is another discount called cash discount which are given when buyers make payment before due date but they are to be recorded in the books of accounts. The Profit and Loss Account draws the attention of the reader to Schedule H to get more details about the sales and other income. The details of the schedule are given in Exhibit 3.3 The first section of Schedule H provides the break up of sales - home or domestic market, exports and inter-division transfers. Inter-division transfers are strictly not sales but many companies include for the purpose of accounting convenience. Such transfers are also reflected under the expenses and hence normally there should not be any impact on profit14. The details of good returned is also reported in the schedule. Some of these items may be actually sold in previous accounting period or year but still accounted as negative sales for the current period. One need to worry if the value of such good returned is large and significantly different from the previous year. Sometime, it may be necessary to look into the good returned value of other companies in the industry to assess the quality of the product or company's ability to fulfil the
There is a scope for window dressing but we will presume that accounting, auditing and corporate governance practices will prevent such window dressing. Discussion on window dressing or accounting manipulation is beyond the scope of this book and hence we make a sweeping assumption that unless stated specifically, the companies we will be analysing in this book are good companies.
14
70
customers' specification. Duty drawback and export subsidy are money received from government either in the form of return of duties paid or subsidy for exporting the good. Government has some such schemes to promote export. Trade discounts values are also shown in the schedule and deducted from the sales to derive Sales net of discount.
Exhibit 3.3
SCHEDULE H: SALES AND OPERATING INCOME
(Rs. in Crores)
Year 2007-2008 Year 2006-2007
Sales Home Market Exports Turnover Less: Discounts Sales (Net of discounts) Processing charges Lease Rent Revenue from Home Solutions operations
4042.63 17.30 4059.93 170.73 3889.20 12.38 0.59 9.79 3911.96
3343.42 17.27 3360.69 136.42 3224.27 11.52 1.73 7.05 3244.57
Note: B-7 of Schedule M provides quantitative information on finished good.
In addition to sales, Asian Paints (India) Ltd. has earned income from three other sources. Since they are related to main business, they are shown as a part of operating income. Processing charges are income earned by the company for processing third party material on contract basis. Lease rent is related to rental income received by leasing tinting systems to dealers on an operating lease basis. 'Home Solution Operations' provide painting services to the customers on turnkey basis. This will enable the company to move closer to the customers. According to company's websiteAsian Paints Home Solutions is the worlds first painting service. Once you become a Home Solutions customer you can just sit back and relax because we will take over the complete job of painting your home from start to a smooth finish. Remove the pain out of painting.Call for Asian Paints Home Solutions today! The sales and operating income of the company has increased by 20% during the year and such growth is substantially contributed by the domestic sales. Though export sales is stagnant, the company has overseas subsidiary companies to cater domestic market of those countries. As per Schedule H of Consolidated Profit and Loss Account for the year ending March 31, 2008, the sales is Rs. 4887.96 Crores. Since the domestic sales in India is Rs. 3889.20Crores, the additional Rs. 998.76 Crores is on account of sales that have taken place through subsidiaries located outside India. Sales outside India were Rs. 855.41 Crores for the year 2006-07. The operations outside India had grown only at the rate of 17% against the domestic sales growth of 20%. It is important to realise that increasing turnover does not necessarily mean increasing prosperity - if the costs are rising faster than turnover, the profits will shrink.
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Sometime back sugar companies in India was complaining that due to price and quantity control along with import polices, they were incurring loss by crushing sugarcane. Unfortunately, they may not be able turn away the farmers because farmers have grown the sugarcane with a belief that sugar companies will buy the sugarcane. Normally, sugar companies also give loan to farmers for growing sugarcane and failure to buy sugarcane may lead to bad debts. Such loss may be more than crushing loss. Some industries might get into such problem due to government polices and intervention.
3.6
OTHER INCOME
In addition to manufacturing and selling the main products, business units get income from other sources, which are not related to main activity of the company. The best example is interest income from bonds and other investments, which are made by the company to use surplus cash. They are reported separately because they are more volatile than income from the core activity of the company. Normally, analysts give less importance to other income in valuation of the company because of the smaller value and uncertainty associated with the income. The following graph highlights the level of fluctuation or volatility of other income compared to orderly growth of sales and profit after tax of Asian Paints during 1994 to 2003. The values are indexed at 1993-94 level. The other income component has achieved some stability since 2004 and growing constantly since then. This is mainly on account of consisted positive performance of investment portfolio that the company is maintaining.
Sales, Profit after tax and other incom e of Asian Paints (India) Ltd.
600
500
Sales Profit after tax Other Income

400
300
200
100
0 March, 1994 March, 1995 March, 1996 March, 1997 March, 1998 March, 1999 March, 2000 March, 2001 March, 2002 March, 2003
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The Schedule I of the Asian Paints (India) Ltd. lists the details of other income. They are shown in Exhibit 3.4.
Exhibit 3.4
SCHEDULE I: OTHER INCOME
(Rs. in Crores)
Year 2007-2008 3.71 Year 2006-2007 1.44
Interest Claims received Dividends from subsidiary companies Dividend from long term investments Dividend from short term investments Royalty Sundry balances written back Profit on sale of long term investments (Net) Profit on sale of short term investments (Net) Profit on sale of assets (Net) Exchange difference (Net) Miscellaneous Income
0.23 0.68 10.35 13.98 9.67 0.09 0.96 0.93 21.98 62.58
0.07 0.51 4.69 7.97 8.8 0.68 0.31 0.06 1.36 0.33 14.23 40.45
While most of the items are self explanatory, there are few items, which require some explanation. 'Claims received' could be related to insurance claims, railway claims, etc., pertaining to past years but realised during this year. The company would have expensed or taken into account the loss in those years since normally these claims take long processing time and there are considerable uncertainties associated with the success of such claims. 'Sundry balances written back' relates to closing out small balances in creditors, provisions, etc., which the company felt no more to be paid or required to continue such accounts. 'Exchange fluctuations' relate to additional Rupee value received when some of the foreign exchange values are converted into Indian Rupees (INR). The company could have used a particular exchange rate while converting an export bill denominated in US dollar or other currencies last year. The receipt of the same might have taken place during the current year and when the foreign exchange is converted into INR, the Rupee value realised could have been more than the amount considered earlier. In some transactions, this could be positive and in some other transactions, there could be loss due to fluctuations in foreign exchange rates. Though the basic transaction is related to main activity, this additional income is on account of the unforeseen development in foreign exchange market and hence treated as other income. Despite this lengthy classification, there are several other sources of income, which are clubbed together as miscellaneous. Some of these items are rent received from the properties let out by the company, sale of old newspapers, sale of scrap, etc.
Chapter 3 3.7
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CHANGE IN STOCKS
Some companies might report 'changes in stock' either on the income side or on the expense side. Some companies adjust such changes in stocks for computing material consumed and disclose the same in the schedule15. Often non-accounting readers get confused when they see an item with description 'changes in stock' or 'increase/ (decrease) in stocks' either under income or expenditure headings. They are simple concepts and the following example explains the same. Suppose a trader purchased 1000 units of toys at an average cost of Rs. 10 and sold 800 units in period 1 at an average price of Rs.12. In period 2, he purchased another 900 units at an average price of Rs.10 but sold 1000 units at an average price of Rs. 11. Common sense suggests that the profit for period 2 should be Rs. 1000 because the selling price was Rs. 11 and cost was Rs.10 and hence per unit profit is Re 1. Some Accountants prepare the same in the following manner though it confuses non-accounting users. Sales 1000 x 11 11000.00 Closing Stock 100 x 10 : 1000.00 Less: Opening Stock 200 x 10 : 2000.00 Changes in Stock - 1000.00 Less: Purchases during the period 900 x 10 9000.00 Profit/Loss 1000.00 Note: Many times, opening stock and closing stock values are not reported here but the net impact is reported in the form of changes in stock.
3.8
EXPENDITURE
Expenditure incurred in earning revenue is deducted to derive profit. Any amount spent by the business unit is expenditure but the nature of expenditure may differ. Expenditure incurred to earn revenue is called Revenue Expenditure and expenditure incurred to buy an asset is called capital expenditure. While revenue expenditure like material purchased, salary and wages, etc. are charged in full, capital expenditure is charged over the years based on the usage of the asset. The basis for writing off such capital expenditure varies based on the nature and the type of expenditure involved. For instance, if its a tangible physical machinery purchased for production, this asset is written off in the form of depreciation. Revenue Expenditure are normally grouped under three heads namely materials, salaries and wages and manufacturing, administrative, selling and distribution expenses for the purpose of disclosure and the details are reported in the schedules. In addition, finance charges (interest expenditure) and depreciation are disclosed separately.
3.9
MATERIAL CONSUMED
Matching concept requires the accountants to find out how much of material is consumed for the goods sold. It requires elaborate computation. The value of material
15
Asian Paints (India) Ltd. adjust the stocks when computing material consumed.
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purchased is added to the value of open stock of material and then value of closing stock is deducted to find the material consumption. That is material consumed is equal to open stock of material plus material purchased less closing stock of material. Though this computation looks simple there are several complications. The material consumed just arrived using the above equation is not material consumed for goods sold but material consumed for goods produced during the period. Therefore the value of closing stock of finished goods has to be separated. Another complication is the method to be used for valuation of material issued over a period of time due to continuous change in the purchase price. In the previous chapter, we discussed couple of methods of inventory valuation and the company has to select one that is most suitable given the price movements of the material. Finally, if the market price of the material is lower than the cost of the material, then closing stock is valued at cost and the implication of such valuation is increase in material consumption value. In other words, material consumption value gets distorted due to these factors and this in turn will impact on the profit. Hopefully, if the closing stock value is relatively small compared to profit of the company, then such distortions will not have any major impact on the profit value. On the other hand, if the closing stock value is as high as the profit or if, more than the profit, any valuation error would have major impact on the value of profit. The following table illustrates the point. Company A 1000 150 460 100 510 390 100 90 10% Company B 1000 20 500 10 510 390 100 99 1%
Sales Opening Stock Purchases Closing Stock Material Consumed Other Expenses Profit Revised profit if the closing stock is overvalued by 10% Percent change in profit due to valuation error
The impact of valuation error on profit is high in company A in comparison to company B. Hence, the accountant and auditors of the company A, need to be more cautious in valuation of closing stock and go through inventory records and perform physical verification more carefully. The details of materials consumed are given in Exhibit 3.5. The details of material consumed are arranged under five heads. Raw materials consumed and packing material consumed are related to material consumed in the production process. A part of this expense is related to stocks not sold (closing stock of finished goods) and hence has to be separated. This separation is done under the last heading of the Schedule J. Purchase of paints for resale is related to outsourcing, which is prominent in many industries. Cost of other goods sold is related to cost related to miscellaneous sales or income included under Other Income (See
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Exhibit 3.3). The details of opening stock and closing stock of finished and semifinished goods are also reported. Though change in finished goods stock is not strictly material cost, they are clubbed with material cost for simplicity. Cost Accountants would treat such change in finished goods outside cost of goods manufactured to derive cost of goods sold. Since the value of changes in finished goods is not significant, there is no material impact on this treatment.
Exhibit 3.5
SCHEDULE J: MATERIAL CONSUMED Raw Materials Consumed Opening Stock Add: Purchases and expenses Less: Closing Stock Packing Material Consumed Opening Stock Add: Purchases and expenses Less: Closing Stock Purchase of Paints for resale (Quantity 10231 MT/PY-11549 MT) Cost of other goods sold Add/Less:Decrease/(Increase) in finished and semi-finished stocks Opening Stock Less: Closing Stock Increase in Excise duty on finished goods
(Rs. in Crores)
Year 2007-2008 124.97 1659.52 1784.49 190.82 1593.67 13.00 341.75 354.75 15.48 339.27 31.50 26.88 277.86 314.08 1.03 1956.13 Year 2006-2007 107.97 1391.94 1499.91 124.97 1374.94 21.36 281.34 302.70 13.00 289.70 26.20 28.01 206.58 277.86 13.14 1660.71
The following notes on accounting policies related to valuation of closing stock of finished goods and semi-finished goods explain items included in valuation of closing stock.
Cost of finished goods and work-in-process includes the cost of raw materials, packing materials, an appropriate share of fixed and variable production overheads, excise duty as applicable and other costs incurred in bringing the inventories to their present location and condition. Fixed production overheads are allocated on the basis of normal capacity of production facilities.
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Companies adopt various formats in presenting the same information for better understanding. The income statement of Asian Paints can be presented as follows:
Year 2007-2008 INCOME Sales and Other income EXPENDITURE Opening stock of Raw material and packing material Add: Raw material and packing material purchased Less: Closing stock of Raw material and packing material Cost of Materials consumed Employees' remuneration and benefits Manufacturing Expenses (See Note) Cost of Goods Manufactured 3478.74 137.97 2001.27 206.30 1932.94 194.67 287.71 2415.32 Year 2006-2007 2861.74 129.33 1673.28 137.97 1664.64 157.11 253.31 2075.06
Administration, Selling and Distribution Expenses (See Note) 423.64 328.40 Add: Purchase of Paints for resale 31.50 26.20 26.88 28.01 Cost of other goods sold 277.86 206.58 Opening stock of Finished Goods (See Note) 314.08 277.86 Less: Closing stock of Finished Goods (See Note) 2861.12 2386.39 Cost of Goods Sold Profit Before Interest, Depreciation and Tax 617.62 475.35 Note: Manufacturing, administrative, selling and distribution expenses are separated on some ad hoc basis based on the details given in Schedule L; Value of semi-finished stock is assumed as zero in the absence of information. If it is available, it should be shown below raw materials consumed.
The above format is sometime preferred as it gives better information of the cost of goods manufactured. It should be noted that it is difficult to get accurate information on cost of goods manufactured unless the company is willing to give such information. For instance, in the above format, the employee remuneration figure contains salary and wages paid to administration and marketing employees and to that extent the cost of good manufactured is distorted. Some analysts while reviewing the performance of the company would prefer to assess manufacturing efficiency separately and compare the same with previous years and other companies in the industry.
3.10 EMPLOYEES REMUNERATION AND BENEFITS

The details of salaries and wages to employees are reported separately in the form of schedule. Schedule K of Asian Paints (India) Ltd. provides the details under three major heads.
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Exhibit 3.6
SCHEDULE K: EMPLOYEES' REMUNERATION AND BENEFITS Salaries, wages, allowances, commission and provisions for bonus and accrued leave salary Staff Welfare Expenses Contribution to Provident Fund, Gratuity and other funds Defined Benefit Plans (Gratuity and other plans)
(Rs. in Crores)
Year 2007-2008 167.66 8.78 10.19 8.14 194.67 Year 2006-2007 134.49 7.74 10.04 4.84 157.11
Companies are required to give two more information relating to employees' remuneration and benefits. Under Section 217 (2A) of the Companies Act and Companies (Particulars of Employees) Rules, 1975, companies are required to give the details of employees who are drawing a total salary of more than Rs. 24 lakhs16. The disclosure includes name of the employees, age, designation, remuneration, qualification, date of commencement of employment, number of years of experience and details of last employment including the company employed and designation. This report appears as a part of Directors' Report. The objective or the requirement for reporting is to provide information to the shareholders about the profile of such high paid employees involved in managing the company. And also to indicate that there is no siphoning of funds in the name of salary to some employees. Some companies provide this information as a separate loose sheet or as a small binder instead of printing the same in the annual report. There is also a provision, which states that the companies can send it to shareholders upon request. Hence, some companies do not disclose them along with the annual report, but state that the same will be posted to the interested shareholders when requested. The details of managerial remuneration to the directors of the company are also to be disclosed and this detail is provided in the Notes to accounts, which is normally the last but one schedule of the Balance Sheet and Profit and Loss Account. The details of managerial remuneration of Asian Paints (India) Ltd. are as follows:
16
The figure is revised periodically considering the inflation and general trend in the managerial remuneration. Some of the industry associations are against this disclosure and putting pressure on the government to withdraw this requirement. Many companies including Asian Paints stopped giving this information but inform the shareholders that they can get this information by writing to Company Secretary of the company. Some of you can compare your salary with your counterpart in other companies by going through this table!
78 Exhibit 3.7
Financial Statements and Analysis (Rs. in Crores)

Year 2006-2007 1.10 2.55 0.90 0.37 0.09 0.65 5.66
Year Managerial Remuneration under Section 198 of the Companies Act, 1956 2007-2008 1.29 Salaries and allowances 3.00 Commission on profit to executive directors 1.06 Contribution to Provident and Superannuation funds 0.43 Perquisites 0.10 Sitting fees to non-executive directors 0.87 Commission to non-executive directors 6.75
The details of salary, perquisites and commission paid to individual directors are also reported as a part of Corporate Governance Report. Another recent requirement is appointment of Remuneration Committee, which consists of non-executive and independent directors, to decide remuneration of top management. Normally, the Corporate Governance Report also discloses the number of meetings of the committee and members attendance in such meetings. For the year ending 2007-08, the company has provided details on the number of meetings held and number of members who attended those meetings. Mostly the issues that were handled are broadly hinted as part of the corporate governance report.
3.11 MANUFACTURING, ADMINISTRATIVE, SELLING AND DISTRIBUTION EXPENSES

A large number of operating expenses are pooled and presented under this heading but the details are given in a separate schedule. When inter-firm analysis is made, often you find substantial difference on this expenditure between the firms. Ability to contain cost offers significant competitive advantage. While the scope for containing cost is limited on material and labour, these expenses offer tremendous scope for cost saving. Under costing terminology, these expenses are called indirect cost or overhead. Schedule L of the Annual Report of Asian Paints (India) Ltd. shows the details of expenses incurred under this expenditure item (Exhibit 3.7).
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(Rs. in Crores)
Year Year 2007-2008 2006-2007 14.37 14.21 35.86 33.29 25.03 19.39 151.60 128.39 22.78 19.69 25.68 21.24 8.76 13.52 3.63 3.58 164.85 110.98 158.96 132.59 18.02 14.10 25.60 22.02 0.44 0.49 1.60 1.58 0.53 27.35 23.23 0.87 0.65 0.10 0.09 1.18 1.87 0.97 0.52 5.19 5.05 8.77 7.13 4.75 4.40 4.46 3.70 711.35 581.71
Exhibit 3.8
SCHEDULE L: MANUFACTURING, ADMINISTRATIVE, SELLING AND DISTRIBUTION EXPENSES Stores and Spares Power and fuel Processing charges Freight and handling charges Repairs and Maintenance Rent Rates and taxes Insurance Advertisement and Sales Promotional expenses Cash and Payment Performance Discount Printing, stationery and communication expenses Travelling expenses Commission on sales Donations Exchange difference (net) Miscellaneous expenses Commission to Non-Executive Directors Directors sitting fees Bad and doubtful debts Auditors' remuneration Financial Charges Information Technology Charges Legal and Professional expenses Training and Recruitment Total
The expenditure on manufacturing and others have gone up by twenty-two percent and increase in marketing and selling expenses is the main reason for significant increase in the expenditure. While most of the items are simple to understand, a few items might not seem obvious while reading the schedule. Sundry balances written off relate to accounts with small debit balances, which are not worth to keep any more are written off. For example, if the company raises a bill or invoice to a customer for Rs. 15.180 lakhs. For some reasons, the customer sends a cheque for Rs. 15.175 lakhs. The difference could be on sales tax computation, freight expenses, etc. Though the company will pursue the matter for some more time, there is no point in keeping the amount in the account beyond certain period if the dispute continues or the customer discontinued doing business with the company. Bad and doubtful debts (Rs. 1.18 Cr.) are provision for bad and doubtful debt setaside for the current year. In discussing the sundry debtors in the previous chapter, we
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have discussed the provision for bad and doubtful debts. The value of provision was Rs. 3.23 Cr. as on March 31, 2008 and Rs. 4.54 Cr. as on March 31, 2007. The difference can be explained as follows.
Provision for Bad and doubtful debts (March 31, 2007) Add: Additional provision made during the year 2007-08 Less: Bad debts recognized and written off during the year 2007-08 Provision for Bad and doubtful debts (March 31, 2008) Rs. 4.54 Cr. Rs. 1.18 Cr. Rs. 5.72 Cr. Rs. 2.49 Cr. Rs. 3.23 Cr.
Financial charges refer to the expenditure incurred in connection with financial transactions like payment of commission and other expenses to bank of cheque clearing, letter of credit, guarantee, etc.
3.12
RESEARCH AND DEVELOPMENT EXPENDITURE
While some companies show this as a separate line item under the heading 'manufacturing, administrative, selling and distributions expenses', others include them under the respective accounting heads. However, all companies are expected to give the details as part of directors' report. The Directors' Report of Asian Paints (India) Ltd. shows that the company has incurred Rs. 34.19 Cr. (previous year: Rs. 1.83 Cr.) towards purchase of capital equipment for R&D purpose and Rs. 17.66 Cr. (previous year: Rs.12.90 Cr.) towards recurring R&D expenditure. The accounting policy of the company shows that its capital R&D expenditure is shown separately under respective heads of fixed assets. Similarly, the revenue expenses including depreciation are included under the respective heads of expenses. The R&D expenditure as a percentage of turnover has increased from 0.52% in 2006-07 to 1.52% of the turnover in 2007-08.
3.13
INTEREST
Interest or finance charges are related to short-term and long-term loan taken by the company. They are by and large fixed in nature. As part of the notes to accounts, companies normally give the break up of the interest expenses.
Exhibit 3.9
Interest Expenses
On Bank Borrowings On Bill Discounting Other interest
(Rs. in Crores)
Year 2007-2008 0.27 7.39 0.61 8.27 Year 2006-2007 0.18 5.95 0.74 6.87
Total
3.14
DEPRECIATION
Capital expenditure is incurred to generate revenue over a period of time. Hence the cost of incurred in buying capital assets are spread over a period of time. This
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process of spreading the expenditure is achieved through depreciation. The reason for providing depreciation can be seen from another angle. We discussed matching principle in deriving profit for the period. According to matching principle, expenses incurred to earn revenue are to be matched. When we use a machine or building or vehicle to generate a product or sell a product, it should bear expenditure related to usage of machine or building or vehicle. If it is a hired machine or rented building, it is easy to match the expenditure with revenue. For the owned assets, depreciation is the process through which matching take place. The need for charging depreciation is fairly easy to understand but the debate often is on how much should be charged. It is normally a technical issue - how much of the asset value depreciated during the year because of production department using the asset? Instead of finding machine wise such details, which may be impractical, normally the life of the assets are estimated and depreciation rates are worked out on that basis. Companies Act, 1956 provides the minimum rates of Depreciation for different categories of Assets17. Income Tax Act also provides depreciation rates applicable to business units. Once the life of the asset is fixed, companies need to decide the method of depreciation. There are two widely practised methods of depreciation. Under 'straight line method' (SLM), it is assumed that wear and tear of the asset takes place uniformly over the years. Hence the value of depreciation is constant for that machinery year after year. The value of depreciation under this method is equal to value of the asset minus salvage value of the asset divided by estimated life of the machine. SLM is normally used in preparing accounts for the shareholders. The second method widely used in casting profit and loss account for income-tax purpose is called 'reducing balance method' or 'written down value (WDV) method'. Under WDV method, the value of depreciation is equal to value of the asset at the beginning of the period multiplied by the depreciation rate. Hence the value of depreciation declines year after year. There are several justifications for this method. The productivity of the assets is normally high during the initial years and hence value of the asset depreciates more during the initial year. It is also believed as the time pass, new machines will come into the market which in turn will reduce the value of the machine. Hence, it is better to depreciate the asset during the early phase of life. Since the purpose of depreciation is to recover the cost of machine, it is better to recover the cost during the initial stages since future is uncertain. This method is also preferred because repairs and maintenance expenses will go up over the years and hence it is better to match them by charging high depreciation during the initial years and then less depreciation in subsequent years. Like bad and doubtful debts, the depreciation figure that appears in the Profit and Loss account is provision set aside for the current year for depreciation. Details of the same are reported under Fixed Assets Schedule. The fixed asset schedule of Asian
Companies Act prescribes depreciation and insists that profit should be derived only after providing depreciation. The reason is profit without providing depreciation and disposal of such profit amount to distribution of capital.
17
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Paints (India) Ltd. gives the following details, which is useful to understand the linkage between depreciation value shown in Profit and Loss Account and Balance Sheet.
Provision for Depreciation (upto 31-3-2007) (opening balance) Add: Additional provision made during the year 2007-08 Less: Provision for depreciation withdrawn due to sale or transfer of assets Provision for Depreciation (March 31, 2008) (closing balance) Rs. 430.92 Cr. Rs. 43.70 Cr. Rs. 474.62 Cr. Rs. 5.21 Cr. Rs. 469.41 Cr.
3.15
EXTRAORDINARY ITEM
Income and expenses or profit and loss arising out of events that are not generally performed or occurred in the ordinary course of business are to be reported separately. They are normally one time income or expenses. Analysts while valuing the business units give different treatments for profit or loss arising out of ordinary course of business and profit or loss of extraordinary nature. Extraordinary items are less relevant for forecasting future cash flows. Some of the examples of extraordinary items relating to loss are loss arising out of major fire, earthquake, etc., major value loss on long-term investments, loss arising out of sale of division, compensation provided for voluntary retirement scheme, etc. Asian Paint (India) Ltd. has not reported any profit or loss under this accounting head but a loss of Rs. 68.06 million as extraordinary item was recognized in 2004-05 and Note B-23 of Schedule M reports that this is on account of provision made for permanent diminution in the value of investments made in the company's subsidiary Asian Paints (Mauritius) Ltd. The company has made a sale of its investment in the subsidiary and recorded the profit earned to the tune of Rs. 42.31 million in the profit and loss account of the year ending March 2005.
3.16
PROVISION FOR CURRENT TAX AND DEFERRED TAX
As discussed in the last chapter on Balance Sheet, companies are now required to show how much of tax is actually paid and how much being deferred. Since companies resort several tax planning measures to defer the tax to future, profit after tax figure often gets distorted. With the new accounting standard in place (AS 22), it is not possible to for the companies to distort the profit after tax using tax planning. The first provision is related to the tax to be paid shortly and hence such provisions are shown as current liability. Since the timing of payment of deferred tax is uncertain, the 'provision for deferred tax' is shown separately in the Balance Sheet. Like any provision account (e.g. provision for bad and doubtful debt, provision for depreciation), provision for tax and deferred tax are also created from the profit. For a more detailed discussion on provision for deferred tax, the readers may refer the chapter on Balance Sheet.
3.17
PRIOR PERIOD ITEMS OR ADJUSTMENT
Matching concept requires some of the items not related to the current period and expenditure spent to earn current year revenue to be excluded in preparing profit for the
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year. However, if any expenditure related to previous accounting year is incurred, it should be charged to profit and loss account. Those expenses are grouped and deducted from the profit at this stage. They are normally small amount and sometime may even be positive.
3.18
BALANCE BROUGHT FORWARD FROM PREVIOUS YEAR
Profit and Loss account is continuous account and there will be some value left over at the end of year after paying dividend and transferring some values to specified reserves account. The profit value derived so far is related to profit generated during the year. The opening balance of the profit is added with the profit generated during the year to get profit available for disposal. The disposal profit of Asian Paints (India) Ltd. is Rs. 525.20 Crores as on March 31, 2005.
3.19
DISPOSAL PROFIT
Disposal profit is used to create any special reserves like debenture redemption reserve, general reserve and pay dividend. Some companies pay dividend only one time whereas other may pay two or more times in a year. While last dividend paid in a year is called 'Final Dividend', others are called 'Interim Dividend'. Dividends are not taxed in the hands of the recipients in India but companies, which distribute dividend, are required to pay dividend tax. The value is shown separately as Tax on Dividend. After setting aside money for payment of dividend, dividend tax, special reserves and general reserves, the balance amount of the Profit and Loss Account is shown as a separate item under 'Reserves and Surplus' of the Balance Sheet since the balance represents surplus value added / reduced from the year's operations.
3.20
EARNINGS PER SHARE (EPS) AND DILUTED EPS
Companies are now required to report Earnings per Share. Earlier, there was no uniformity on reporting EPS and companies use to choose such reporting whenever it is convenient to them and also by following convenient method. Since EPS is widely used by the investor, such kind of reporting is not desirable. Hence, Accounting Standard Board of Institute of Charted Accountants of India has prescribed Accounting Standard 20 - Earnings Per Share and made it mandatory for companies listed in any of the Indian Stock Exchanges. Companies are now required to report basic earnings per share and also diluted earnings per share if the share capital of the company is likely to increase in the future for which some commitment has already been made. Basic earnings per share is calculated by dividing the net profit or loss for the period by the weighted average number of equity shares outstanding during the period. If the company has already committed additional issue of shares through convertible debentures, employees' stock option, etc., then in addition to basic earning per share, companies have to report diluted earnings per share after taking into account the effect of such additional shares. The diluted earnings per share will be lower than basic earnings per share if the company has committed to issue such
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additional shares at a value less than fair value. For instance, if the fair value or current market price is Rs. 100 but the company agrees to convert the debt and issue shares for Rs. 40, then 0.60 shares is added to the existing number of shares to compute diluted earnings per share. In other words, if there is no discount price to fair value, then there will not be any difference between the basic earning per share and diluted earnings per shares, other things remaining constant18. Asian Paints (India) Ltd. has reported basic and diluted earnings per share of Rs. 39.12. The computation details as shown in the Schedule M are as follows.
Exhibit 3.10
Earnings per share
(Rs. in Crores)
Year 2007-2008 Year 2007-2008 28.36 272.05 95,919,779
39.12 b) Profit after tax and prior period items as per Profit and Loss A/C (Rs. in Crores) 375.20 95,919,779 c) Weighted Average number of equity shares outstanding
a) Basic and diluted earnings per share in Rupees (face value - Rs. 10 per share)
3.21
SUMMARY
Business units operate with a goal of generating profit. Though they may pursue various other goals, profit is always bottom line for any business unit and society also recognises the need for firms making profit. The task of arriving at the profit / loss figure is really complex in view of number of assumptions to be made in preparing profit and loss account. It is difficult to detect accounting frauds fairly for a long period of time and profit and loss account is vulnerable for such frauds. Companies normally follow accrual and matching principles in preparing profit and loss account. In addition, there are number of Accounting Standards to ensure some level of uniformity and consistency in preparation of profit and loss account. Indian companies provide large amount of details of income and expenditure either in the schedules or directors' report. The profit derived is only notional. It is not realised profit. A significant part of the profit may be still in the form of debtors and such profits are realised only when the debtors pay the dues. Many companies speed up the sales towards the end of the year to improve the profitability and in that process, it might even result in accepting some bad and doubtful customers. In view of this as well as unfriendly format, many users of accounting statements started demanding additional reader-friendly disclosures. Companies are now required to provide cash
18
For a set of illustration on the computing the diluted earnings per share, please refer Accounting Standard 20. All Accounting Standards are available in ICAI web site,
http://www.icai.org.in
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low statement to satisfy this demand. Cash Flow Statement is the third important financial statement and we discuss more about this in the next chapter.
Chapter 4
Statement of Cash Flows
4.1
INTRODUCTION
The two principal financial statements discussed in the last two chapters differ on one important aspect. While income statement is period statement, balance sheet is prepared at a particular point of time. Balance sheet normally provides values for two periods but the values are at two different points of time. What is the link between the two balance sheet values? Initially companies were preparing and producing funds flow statement to show the link between two balance sheet dates19. Since many users started complaining that there is little value addition coming out of funds flow statements and started demanding cash flow statements, regulating agencies all over the world has moved to cash flow statements. Since 1994-95, all listed companies in India were also required to disclose the statement of cash flows in addition to balance sheet and profit and loss statements.
19
Though earlier Accounting Standard AS-3 allowed companies to provide Funds Flow Statement, a very few companies and most public sector companies were giving funds flow statement since AS 3 was not mandatory in those days.
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87
NEED FOR CASH FLOW STATEMENT
The primary objective of the statement of cash flows is to provide information about an entity's cash receipts and cash payments during a period. The net effect of cash flow is provided under different heads namely cash flow from operating, investing and financing activities. It helps users to find answers to the following important questions: (a) Where did the cash come from during the period? (b) What was the cash used for during the period? (c) What was the change in the cash balance during the period? The AS-3 identifies two important uses of cash flow statement as follows: (a) A cash flow statement, when used in conjunction with the other financial statements, provides information that enables users to evaluate the changes in net assets of an enterprise, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises. It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events. (b) Historical cash flow information is often used as an indicator of the amount, timing and certainty of future cash flows. It is also useful in checking the accuracy of past assessments of future cash flows and in examining the relationship between profitability and net cash flow and the impact of changing prices. Since the cash flow statement primarily assesses the liquidity position of the firm, the demand for such statement stems from banking and financial institutions. Robert Morris Associates, a national association of bank loan and credit officers, advocates the use of cash flow analysis as a tool necessary to evaluate, understand, and accurately determine a borrowers ability to repay loans. "Banks lend cash to their clients, collect interest in cash, and require debt repayment in cash. Nothing less, just cash. Financial statements, however, usually are prepared on an accrual basis, not on a cash basis. And projections? Same thing. Projected net income, not projected cash income. Yet, cash repays loans. Therefore, we are compelled to shift our focus if we truly wish to assess our clients ability to pay interest and repay debt. We must turn our attention to cash, working through the roadblocks thrown up by accrual accounting, to properly evaluate the creditworthiness of our client". (RMA Uniform Credit Analysis, Philadelphia, Robert Morris Associates, 1982).
88 4.3
Financial Statements and Analysis CASH FLOW VS. OTHER FINANCIAL STATEMENTS
Cash Flow Statement is reasonably simple and easy to understand. Exhibit 4.1 provides a summary of Cash Flow Statement of Asian Paints (India) Ltd. In simple term it shows that the company has received Rs. 457.29 Cr. cash from its operations and spent this cash for fresh investment to an extent of Rs. 331.91 Cr. and Rs. 126.52 Cr. for repayment of debt and payment of interest and dividend. The excess spending worth of Rs. 1.14 cr. was drawn from cash available with the company at the beginning of the year. The statement shows that the company is getting enough cash from its operations and it is not depending on outside money for fresh investments. While this statement may not tell whether such strategy is right (investing only to the extent of cash generated by operations), it definitely gives some amount of comfort to the readers on the financial health of the company.
Exhibit 4.1 Cash Flow Statement (Summary) Asian Paints (India) Ltd. (Rs. in Crores)
'
Net Cash generated from Operating Activities Net Cash used in Investing Activities Net Cash used in Financing Activities Cash added to (drawn from) Opening Cash Balance
Year Year 2007-2008 2006-2007 457.29 312.25 (331.91) (110.93) (126.52) (187.22) (1.14) 14.10
Cash flow from operating activities for instance tells how much cash that the business has generated through operations. The figure is derived by deducting cash paid to suppliers, employees and other operating expenses from cash received from customers and cash sales. Every investor would like to see the profit in the form of cash because profit is realised only when cash is received from the customers. During USSR collapse, many Indian companies have suffered a lot because of considerable delay in collecting the dues. If cash part of profit is so important, what is the justification for reporting accounting profit? Accounting profit is prepared based on accrual principle and going concern assumption. Hence it reflects the long-term operational efficiency of the business. Since some management may use these assumptions and principles to report higher profit in the short run, cash flow statement supplements. At least, it enables people to ask right questions. For instance, if a firm reports significant improvement in sales and profit but there is no change in cash flow from operations. One possible reason would be the high level of receivables. Users of financial statements may raise a right question whether these sales are genuine or whether such increase in receivables is seen in other business units of the industry. Auditors of such firms, while certifying the profit and receivables figures may also insist the company to demonstrate whether such sales are genuine.
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Cash flows are also difficult to fudge or manipulate and hence often used to examine whether the reported profit is outcome of any abnormal changes or developments20. For instance, if a company approaches a bank for a loan, the company would normally highlight the profitability of the business. But with lot of accounting scams around, the credit appraiser will be cautious in believing the profit figure. The credit appraiser would be interested in looking into cash flows of the business and particularly, cash flow from operations. The operating cash flows should be adequate to meet fixed interest and other liabilities and also the repayment schedule. Though Accounting Standard setting bodies have provided guidelines for the preparation for cash flow statement, one can choose the format to suit particular requirement. Suppose a company capitalised some of the revenue expenditure (deferred revenue expenditure). Though it increases the profit and also cash flow from operations, the user of cash flow statement can reduce the cash flow from operation based on her/his judgement on the expenditure. Cash Flow Statement is useful to examine whether the profits are realised and if so, what percentage of profit a firm has realised. In other words, a company that shows high level of profit need not be liquid in cash. Suppliers of goods will also be interested to examine the cash flow position of the company before supplying goods on credit. Investors, who have no control on management, will also be interested in examining the cash flow to supplement her/his analysis on profitability of the business. The cash flow statement is different from other principal financial statements in many different ways. Financial statements like P&L account and Balance Sheet are prepared using accrual accounting principle. For instance, when a firm sells its products, it is assumed that profit is realised. Similarly, the expenses incurred against the sale are assumed to have been incurred or paid irrespective of the fact whether cash is paid or not. Interest expenses are charged against profit though it is an outcome of financing decision. Several non-cash expenses like depreciation are also charged against profit. On the other hand, cash flow statement is prepared on the principle of cash accounting concept. It is simply a summary of cash book classified under three major headings namely cash flow from operating, investing and financing activities. In a broad context, the cash flow from operating activities culls out all Profit and Loss Account entries of the cash book (like sales, material, wages, etc.,) and summarise the same. The cash flow from investing activities summarises all the entries affecting asset side of balance sheet like purchase of fixed assets, sale of fixed assets, etc., of cash book. Finally, the cash flow from financing activities summarises all the liability side entries like borrowing, repayment, fresh equity, etc. of cash book. Exhibit 4.2 shows the Cash Flow Statement of a company,, which summarises the cash book entries under different headings, which are easily readable.
There is a limit for the cash flow statement in examining reported profit. Suppose the company processed a material by using a vendor and consumed the same in manufacturing. The vendor sends the bill but the accounts department fails to record this as expense and has also not paid the cash. Both profit and cash flow from operations will be overstated.
20
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The Profit and Loss account is also equally readable but the problem is that it may be confusing too. For example, many companies as a part of expenditure, put an additional entry titled "changes in stocks" or "increase/decrease in stocks" and sometime add and sometime deduct the value from sales. Many non-accounting readers will get confused and give up further reading. After couple of major accounting scams, non-accounting readers would tend to see every reported profit as contaminated figure. Many readers are not aware of the meaning of depreciation and also "Balance in Profit and Loss Account Brought Forward". Starting from the year 2001-02, the P&L account has one more confusion for ordinary readers namely "Deferred Tax". To add further confusion, in the Balance Sheet, it has both Deferred Tax Asset and Deferred Tax Liability. The mismatch between the depreciation value and deferred tax value shown in P&L account and Balance Sheet is further confusion to naive readers. As an accounting person, one may be familiar with all the jargons learnt by heart by practice, but it could really be a puzzle for naive readers. They might give up further reading after a couple of pages.
Exhibit 4.2
Cash Flow Statement under Direct Method (A) Operating Activities Cash Collection from Sales Less: Cash Paid for: Raw Materials Direct Labour Overhead Less: Cash Paid for Non-factory Costs Salaries and Wages Other Sales and Administration Cash Generated from Operation Add: Interest Earned Net Cash from Operating Activities (X) (B) Investment Activities Purchase of Plant Assets Short-term investments Net Cash Flow from Investing Activities (Y) (C) Financing Activities Dividends paid Net Cash Flow from Financing Activities (Z) (D) Net Change in Cash (X+Y+Z) Cash at the Beginning of the year Cash at the End of the Year 115716 (18478) (13452) (8758) (14625) (413)
'
(40688) (15038) 59990 390 60380 (23000) (12000) (35000) (25000) (25000) 380 6000 6380
The Balance Sheet is also equally a puzzle to investors. Many students and even executives ask us if the company has huge reserves and surplus, does it mean the company has such amount of cash? These are really genuine doubts to ordinary readers
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of financial statements. To a great extent, cash flow statement is free of this kind of confusion. The statement of cash flows, required by the Accounting Standard-3, is a major development in accounting measurement and disclosure because of it relevance to financial statement users.
4.4
REGULATIONS RELATING TO CFS
Though International Accounting Standard Committee has revised the International Accounting Standard-7 (IAS-7) in 1992 and switched over to cash flow statement, Accounting Standard-3 (AS-3) of Accounting Standard Board (ASB), which is equivalent to earlier IAS-7, was not revised till 1997. In 1997, ASB revised the AS-3 in line with revised IAS-7 and issued an accounting standard on reporting cash flow information. However, AS-3 was made mandatory for the accounting period starting on or after 1st April 2001 for the following enterprises: i. Enterprises whose equity or debt securities are listed on a recognised stock exchange in India, and enterprises that are in the process of issuing equity or debt securities that will be listed on a recognised stock exchange in India as evidenced by the board of directors resolution in this regard. ii. All other commercial, industrial and business reporting enterprises, whose turnover for the accounting period exceeds Rs. 50 crore. Since ASB of ICAI took a long time for the introduction of cash flow statement, the Securities and Exchange Board of India (SEBI) following the recommendation of the group constituted for this purpose has instructed the Governing Board of all the Stock Exchanges to amend the Clause 32 of the Listing Agreement and required all listed entities to provide Cash Flow Statement from the financial year 1994-95.
4.5
CASH FLOW STATEMENT FORMATS
The statement of cash flow requires restating of the information presented on a balance sheet but in flow format. The balance sheet is prepared by measuring the assets and liabilities at a point of time, usually as on March 31st of the year. In flow statements, we measure the changes in assets and liabilities during the period. For example, the liability side of the balance sheets contains so many items, which essentially brought in funds for the company. How much of cash is received under each item or how much cash was given back on each item constitutes one part of the cash flow statement. Similarly, cash flows on the assets sides are also computed. The changes in retained earning part of the Balance Sheet actually reflect Profit and Loss Account. Cash Flow statement separately computes cash generated from and paid for various operating activities. Cash flow statement thus shows three important values: Net Cash generated through operating activities, Net Cash spent for investing activities and finally, net cash generated through financing activities. Cash Flow Statement can be prepared in two ways. They are called direct and indirect method. The format used under these two methods is shown in Exhibit 4.3.
92 Exhibit 4.3
Financial Statements and Analysis '
Cash Flow Statement Under Listing Agreement and IAS-7 IAS-7 (Indirect Method)/SEBI Format IAS-7 (Direct Method) A. Cash flow from operating activities A. Cash flow from operating activities Net profit before tax & extraordinary Cash receipt from customers items Adjustments for: Less: Cash paid to suppliers & other Depreciation operating expenses Foreign Exchange Investments Operating Profit before working capital changes Adjustments for: Trade and other receivables Inventories Trade Payables Cash generated from operations Cash generated from operation Less: Interest paid Less: Interest paid Direct tax paid Income tax paid Cash flow before extraordinary items Cash flow before Extraordinary items Extraordinary items Less: Extraordinary items Net Cash from / (used in) operating Net Cash from / (used in) operating activities activities B. Cash flow from investing activities B. Cash flow from investment activities Purchase of fixed assets Purchase of fixed assets Sale of fixed assets Proceeds from sale of fixed assets Acquisition of companies Investment in subsidiaries Purchase of investments Investment in trade investment Sale of investments Loans and Advances Taken/(returned) Interest Received Current investments made Dividend Received Interest/Dividend Received Net cash used in investing activities Net cash used in investing activities C. Cash flows from financing activity C. Cash flows from financing activity Proceeds from issue of share capital Proceeds from issue of share capital Proceeds from long-term borrowings(net) Proceeds from long-term borrowings Repayment of financial lease liabilities Repayment of Loans Dividend paid Dividend paid Net Cash used in financing activities Net Cash used in financing activities Net Increase in cash & cash equivalents Net Increase in cash & cash equivalents These two methods differ mainly on the methodology used for computing the cash from operating activities. It may be noted that AS-3, IAS-7 and also FASB Statement
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No. 95 all recommend presentation of the direct method in the primary statement though firms are allowed to use either of the methods. However, companies normally provide the statement in indirect format. While direct method logically summarises cash flow movement under broad operating heads, indirect method works backward from Net profit and remove all non-cash income and expenses to get cash from operating activities.
4.6
CASH FLOW FROM OPERATING ACTIVITIES
Cash flow from operation arises when the firm produce and sell at a profit. Thus, this part of statement is summary of cash received from main line of business activities and cash incurred to generate such revenue. As stated earlier, this part of cash flow statement can be prepared in two ways. Under indirect method net profit is adjusted to derive this value. Exhibit 4.4 shows the cash flow from operating activities of Asian Paints (India) Ltd.
Exhibit 4.4 Asian Paints (India) Ltd.
' (Rs. in Crores)
Year Year 2007-2008 2006-2007 Profit before prior period item, tax and after extraordinary item 564.55 409.92 Adjustments for: 43.77 45.42 Depreciation Interest Income (3.71) (1.44) (25.01) (13.17) Dividend Income 8.27 6.87 Interest Expense Prior Period adjustments (1.39) 2.12 Loss/(Profit) on Sale of Long Term Investments 0.00 (0.31) Loss/(Profit) on Sale of Short Term Investments (0.96) (0.06) (0.93) (1.36) Loss/(Profit) on Sale of Assets 584.59 447.99 Operating Profit before working capital changes Adjustments for: (15.94) (50.85) Trade Receivables (31.10) (14.17) Other Receivables Inventories (104.90) (84.36) 199.86 162.23 Trade and other payables Cash generated from Operations 632.51 460.84 Income Tax Paid net of refund (175.22) (148.59) 457.29 312.25 Net Cash generated from Operating Activities Note: Figures in brackets are negative values
CASH FLOW FROM OPERATING ACTIVITIES
Asian Paints (India) Ltd. has generated Rs. 457.29 Cr. cash from operations during 2007-08 against Rs. 312.25 Cr. in 2006-07. The above statement is obviously
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confusing and hence requires some discussion. In preparing the cash flow from operating activities, the company is working backward from accrual profit figure to cash flow from operation. Cash flow from operations is arrived after making three types of adjustments. It first removes all non-cash income and expenditure that was included in the profit figure. Depreciation being a non-cash expense should not be reduced from the profit. Since Profit and loss account has already reduced the depreciation, now in preparing operating cash flow, it is added back. It also removes income and expenses (cash or non-cash) not related to operating activities. Interest income, dividend income, interest expense, prior period adjustments and extra-ordinary item are cash and non-cash items not related to operations. Interest and dividend income are part of other income and hence increased the profit value. Now they are deducted to get operating cash flow. Prior period adjustments and extraordinary items are earlier deducted in computing profit based on certain accounting principles but they have no cash impact during the current year and hence they are added back. In other words, these figures take exactly opposite sign now compared to the sign used earlier in computing profit under P&L account. It finally adjusts changes in receivables, payables and inventory, which are result of operating activities and have an impact on cash flow from operation. This is slightly complex to understand. Let us take a simple example. Suppose a firm has an opening inventory of Rs. 1000. During the current period it has not made any fresh purchase but sold half of the opening inventory for Rs. 550. The closing inventory at the end of the period is Rs. 500 (since half of Rs. 1000 is sold). Assume there is no other expenditure during the period. The Profit and Loss account will show Rs. 50 has profit. Our common sense suggests that the cash flow from operation is Rs. 550. This Rs. 550 can be derived by adding profit (Rs. 50) with changes in inventory (Rs. 1000-500). Let us take another situation. The firm has receivables of Rs. 5000. During this period, the company has not done any operations but collected Rs. 3000. The profit and loss account will show a zero profit but we know the firm got Rs. 3000 through operations. The operating cash flow now is profit (zero) plus changes in receivables. The same logic applies for payables. Exhibit 4.5 lists the adjustment generally made in deriving operating cash flow under indirect method.
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'
Exhibit 4.5 Cash flow from operating activities - Indirect Method

Net Income before extraordinary items I Non-cash revenue and expenses included in income Eg. + Depreciation + Deferred Revenue Expenditure written off during the period + Increase in Deferred Tax Liability - Decrease in Deferred Tax Liability + Increase in Deferred Revenue - Decrease in Deferred Revenue II Non-operating revenue and expenses included in income (Cash as well as non-cash income and expenses) Eg. + Interest Expense - Interest Income - Dividend Income - Gain on sale of assets + Loss on sale of assets. III Cash Provided (used) by current assets and liabilities Eg. + Decrease in current assets items (excluding cash) - Increase in current assets (excluding cash) - Increase in current liabilities + Decrease in current liabilities Net Cash from Operating activities
Preparing cash flow from operating activities under direct method is relatively simple if one has access to cash book. It is also possible to prepare the same using the Balance Sheet and Profit and Loss account values. Refer Exhibit 4.2, where the format for direct method is shown. The first line item is Cash receipt from customers. This can be derived if we have the details of sales, receivable at the beginning of the year and receivables at the end of the year. These values are available in P&L account and Balance Sheet. Sales and operating income of Asian Paints (India) Ltd. for the year ending March 31, 2008 was Rs. 3478.74 Cr. Sundry debtors value for the previous year ended (March 31, 2007) was Rs. 420.61 Cr. and at the end of March 31, 2008 was Rs. 460.33 Cr. Let us assume all sales are initially credit basis and if so, the debtors should have increased from Rs. 420.61 Cr. to Rs. 3899.35 Cr. Since the debtors' value as on March 31, 2008 is only Rs. 460.33 Cr., it means Rs. 3439.32 Cr. (Rs. 3899.35 - Rs. 460.33) should have been collected from the debtors21. Similarly, it is possible to trace the cash part of several operating income and expenses. It might be confusing to some of the readers
It is not so simple often. Even in this case, the schedule shows that the sale value includes inter-division sales. There are several ways thorough which the accounting of inter-division sales is done. It is always simple and straightforward if direct method of cash flow statement is prepared using cash book.
21
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but understanding the logic is adequate to develop some confidence on these numbers and statements and will be useful when you start using these statements for decision making. Exhibit 4.6 lists the computation mechanism to find out the cash flows on several line items that goes into direct method preparation of cash flow statement.
Exhibit 4.6 Cash flow from operating activities - Direct Method

Cash Flow Item Cash collection from customers Cash Paid to suppliers Methodology Sales - Increase in accounts receivables + Decrease in accounts receivables Cost of Goods Sold - Decrease in Inventory + Increase in Inventory Salary Expenses - Increase in accrued/outstanding salaries payable* + Decrease in accrued/outstanding salaries payable Other operating expenses - Depreciation and other non-cash expenses - Decrease in prepaid expenses - Increase in outstanding operating expenses + Increase in prepaid expenses + Decrease in outstanding operating expenses Net Interest Expenses (expense-income) - Increase in outstanding interest + Decrease in outstanding interest - Increase in interest receivable + Decrease in interest receivable Dividend or Other Income + Decrease in other income receivable - Increase in other income receivable Tax Expense - Increase in deferred tax liability + Decrease in deferred tax liability - Decrease in deferred tax asset + Increase in deferred tax asset - Increase in taxes payable + Decrease in taxes payable - Decrease in prepaid taxes + Increase in prepaid taxes.
'
Cash Paid to Employees
Cash Paid for Other operating expenses
Cash paid/received for interest
Cash from dividend or other sources Cash Paid for Taxes
Note: * Some of these items may not be available readily in the Balance sheet and often clubbed with other items.
If the purpose of cash flow is to give the details of cash movement during the period, preparing cash flow statement through indirect method defeats the purpose.
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While the details of cash flow from investment and financing activities are easy to understand under both methods, details provided under cash flow from operating activities fail to add any value to the readers22. On the other hand, the details or breakup provided on cash flow from operating activities under direct method add some value to the readers. Clause 19 of Accounting Standard 3 states, "the direct method provides information which may be useful in estimating future cash flows and which is not available under the indirect method and is, therefore, considered more appropriate than the indirect method". Accounting Standards also require those who provide cash flow statement under direct method to provide a reconciliation statement to explain the difference between accounting profit and cash flow from operating activities. While many accounting bodies entrusted with standard setting encourage the companies to use direct format, countries like Australia and New Zealand requires the companies to provide direct method of cash flow statement. Exhibit 4.7 shows cash flow statement of an Australian company under direct method
Exhibit 4.7 Cash Flow Statement for the year ended 30 September 2003 . Orica Limited. ($ in Millions)
Consolidated 2003 2002 Cash from operating activities Receipt from customers Payment to suppliers and employees Interest received Borrowing costs Dividend received Royalty and other trading revenue received Net income taxes paid Net Cash from operating activities Cash flows from investing activities Payment for property, plant and equipment Payments for purchase of investments Payments for purchase of businesses and controlled entities Proceeds from sale of property, plant and equipment Proceeds from sale of investments Proceeds from share buy-back by subsidiaries Proceeds for purchase of businesses and controlled entities Net cash flow (used in)/from investing activities Cash flow from financing activities
22
4471.60 (3877.50) 8.90 (72.10) 8.40 23.70 (62.60) 500.40 (119.70) (0.10) (415.70) 76.10 1.00 73.00 (385.40)
4482.90 (4084.70) 9.10 (75.40) 15.60 42.70 (47.50) 342.70 (100.20) (1.30) 84.90 0.30 28.30 12.00
Companies could give simply cash flow from operating activities without any details since such details under indirect method confuse nave readers and fail to add value to informed readers.
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154.60 (4.20) (120.10) (0.20) (38.90) 1.90 (159.50) (166.40) (51.40) 143.20 (6.70) 85.10 (100.00) (152.30) (0.40) (77.20) (329.90) 24.80 121.80 (3.40) 143.20
Proceeds from long-term borrowings Repayment of long-term borrowings Net movement of short-term financing Principal repayment under financial leases Proceeds from issue/(buyback) of shares Proceeds from issue of share to outside equity interests Dividends paid Net cash flow (used in)/from financing activities Net (decrease)/increase in cash held Cash at the beginning of the financial year Effect of exchange rate changes on cash Cash at the end of financial year
4.7
CASH FLOW FROM INVESTING ACTIVITIES
Measuring cash flow from investing and financing activities is simple. Any amount spent on purchase of fixed assets forms part of investing activities. For instance if a firm spends Rs. 20 lakhs to buy new assets and also sold Rs. 3 lakhs worth of assets for Rs. 8 lakhs, the net cash flow on investing activities is Rs. 12 lakhs (Cash outflow of Rs.20 lakhs less Cash inflow Rs. 8 lakhs). Exhibit 4.8 shows cash flow from investing activities of Asian Paints (India) Ltd.
Exhibit 4.8 Cash Flow from Investing Activities Asian Paints (India) Ltd.
B. CASH FLOW FROM INVESTING ACTIVITIES
Purchase of Fixed Assets Sale of Fixed Assets Loans to subsidiaries Repayment of loan to subsidiaries Purchase of Investments Sale of Investments Interest Received Dividend Received Net Cash used in Investing Activities (B)
' (Rs. in Crores)

Year Year 2007-2008 2006-2007 (258.28) (67.73) 1.57 2.09 (18.60) (1.91) 2.28 1.51 (202.71) (116.33) 115.18 56.86 3.64 1.41 25.01 13.17 (331.91) (110.93)
The company has invested Rs. 331.91 Cr. and the break up shows substantial investments are towards purchase of fixed assets and investments. The schedule, which provides the details of investments shows that Asian Paints is very active in treasury transactions and buys and sells equity shares and mutual funds aggressively. One of the significant part of investment is investments in ICI Ltd. shares for Rs. 772.46
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million and the Directors' report of 2004-05 informed the shareholders that it acquired 9.2% stake of ICI (India) Ltd. The average acquisition price is Rs. 205 per share and it should have been acquired about 30 to 40 percent premium. By classifying this investment as trade investments, Asian Paints (India) Ltd. informed the shareholders that it is a long-term commitment. Since the foreign promoter of ICI (India) Ltd. namely Imperial Chemical Industries, UK is holding 50.83 percent state in ICI (India) Ltd. it would be difficult for the Asian Paints (India) Ltd. to make any hostile bid. However, the company might look for some association or acquisition of part of the company in the event of any restructuring by the ICI (India) Ltd. The company during the last few years is trying to expand its operations, particularly international operations through acquisitions.
4.8
CASH FLOW FROM FINANCING ACTIVITIES
Cash flow from financing activities shows the amount of fresh equity and loan that the company has raised during the period and the loan amount repaid. In addition to this, dividend is also deducted since dividend is the outcome of financing activities. As far as interest is concerned, it depends on how interest was treated under Operating Cash Flow section. If interest is not considered as an item of operating cash out flow, then it should be shown as outflow under Cash Flow from Financing Activities. If it has already been shown as operating cash outflow, then it should not be shown here again. International Accounting Standard (IAS)-7 requires that interest expenses should be treated as cash flow from operating activities whereas Accounting Standard-3 of India requires that it should be treated as cash outflow of financing activity23. Since Indian companies follow AS-3, interest paid is normally shows as cash outflow of financing activities. Exhibit 4.9 shows cash flow from investing and financing activities.
Exhibit 4.9 Cash Flow from Financing Activities Asian Paints (India) Ltd.
' (Rs. in Crores)
CASH FLOW FROM FINANCING ACTIVITIES

Proceeds from long term borrowings Proceeds from Short term borrowings Repayment of Long term borrowings
23
Year Year 2007-2008 2006-2007 5.07 4.64 0.00 30.38 (0.94) (0.45)
Cash flows from interest and dividends received and paid should each be disclosed separately. Cash flows arising from interest paid and interest and dividends received in the case of a financial enterprise should be classified as cash flows arising from operating activities. In the case of other enterprises, cash flows arising from interest paid should be classified as cash flows from financing activities while interest and dividends received should be classified as cash flows from investing activities. Dividends paid should be classified as cash flows from financing activities - Clause 30 of AS 3.
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Repayment of Short term borrowings Interest paid Dividend and Dividend tax paid Net Cash used in Financing Activities (C)

(35.10) (8.28) (87.27) (126.52) 0.00 (6.91) (214.88) (187.22)
The company has repaid some part of long-term and short-term loans during the year. The schedule on Loan Funds shows that substantial part of long-term borrowings is interest-free loan under Sales Tax Deferment Schemes of various state governments. Dividend outflow is the major expenditure for the company under this head. The company is distributing about one-third of its cash flow from operations towards dividend during the last two years.
4.9
PREPARATION OF CASH FLOW STATEMENT
Cash flow statement can be prepared with the help of balance sheet and profit and loss account. A reading of schedules and notes will be desired to get better picture while preparing the cash flow statement. Exhibits 4.6 and 4.7 will be useful when you prepare cash flow statement by yourself in case the company has not reported such statement. The mechanics of preparing cash flow statement is illustrated in Exhibit 4.10. Exhibit 4.10: Preparation of Cash Flow Statement: An Illustration Profit and Loss Account for the year ended 31st March 200X (Rs. in thousands) Previous year Current year Sales 111780 98050 Other Income 390 220 Cost of Good Sold 41954 39010 Selling and Administrative Expenses 16178 12500 Profit Before Tax 54038 46760 Less: Income Tax 21615 18704 Profit After Tax 32423 28056 (b) Balance Sheet as on 31st March, 200X Liabilities and Shareholder Equity Equity Share Capital Retained Earnings Current Liabilities Accounts Payable Income Tax Payable Dividend Payable Total Liabilities Assets Fixed Assets 393000 (370000) Current year 180000 134045 3526 21615 339186 (Rs. in thousands) Previous year 180000 101622 4330 25000 310952
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300600 6380 19092 516 598 12000 339186
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280000 6000 23568 636 748 310952
Less: Depreciation 92400 (90000) Current Assets Cash Accounts Receivable: 20064 Less: Provision - 972) Inventory: Raw Materials Finished Good Investments Total Assets (A) Operating Activities Profit After Tax or Net Income Adjustments for: Depreciation Decrease in Trade Receivables Decrease in Inventories Income Tax Decrease in Accounts Payable Net Cash from Operating Activities (B) Investment Activities Purchase of Plant Assets Short-term investments Net Cash Flow from Investing Activities (C) Financing Activities Dividends paid Net Cash Flow from Financing Activities (D) Net Change in Cash Cash at the Beginning of the year Cash at the End of the Year (A) Operating Activities Cash Collection from Sales Less: Cash Paid for: Raw Materials Direct Labour Overhead Less: Cash Paid for Non-factory Costs Salaries and Wages Other Sales and Administration Cash Generated from Operation Add: Interest Earned Net Cash from Operating Activities (B) Investment Activities
Cash Flow Statement Under Indirect Method/as per Listing Agreement 32423 2400 4476 270 21615 (804)
27957 60380 (23000) (12000) (35000) (25000) (25000) 380 6000 6380
Cash Flow Statement Under Direct Method 115716 (18478) (13452) (8758) (14625) (413)
(40688) (15038) 59990 390 60380
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(23000) (12000) (35000) (25000) (25000) 380 6000 6380
Purchase of Plant Assets Short-term investments Net Cash Flow from Investing Activities (C) Financing Activities Dividends paid Net Cash Flow from Financing Activities (D) Net Change in Cash Cash at the Beginning of the year Cash at the End of the Year
4.10 ANALYSING CASH FLOW STATEMENT

Statement of cash flow is an important additional and support statement to examine the performance of the company. There are several users of the cash flow statement and each one analyses the cash flow statement in a way that achieves their requirements. Investors of equity shares use cash flow statement for two purposes. One, they would like to know how the cash has moved broadly and how the firm is able to use the cash. For instance, when the firm is in a major expansion activity, the equity holders would like to know how the growth is funded. Two, equity holders would like to use cash generated from operating activities to assess the quality of profit reported by the firm in the Profit and Loss account. Since window dressing is prevalent in many countries and managers have short-term incentives to pursue such window dressing, equity holders are worried how reliable the profit reported in the income statement. While investors react positively to such higher profit in the absence of any evidence of window dressing, a downtrend or negative cash flow from operating activities will trigger negative reaction. Since cash flow statement is difficult to fudge, investors compare whether the cash flow from operating activities is consistent with the reported profit. It is unfair to expect that both values are same since profit and loss account is normally prepared under accrual basis whereas cash flow statement is based on cash basis. Further income statement considers non-cash expenses like depreciation and notional expenses like tax and other expenses payable. One can adjust or add such non-cash expenses considered in the income statement with accounting profit for comparison. Normally, the Profit before interest, depreciation and taxes (PBDIT) less taxes can be compared with cash flow from operations. In addition, it is possible to compare the increase in PBDIT less tax with increase in cash flow from operations. If the two figures are consistent with each other, there is no prima facie evidence that there is fudging. On the other hand, if the cash flow from operations is significantly lower than PBDIT less tax, it is necessary to look into the accounting statements, directors report and auditors report carefully to understand why there is a delay in converting the profit into cash. It is also desirable to compare whether other companies in the industry also suffer with similar differences so that one can conclude that the delay in collecting the dues from customers is industry wide trend. If there is no satisfactory evidence, then we need to avoid relying on such financial statements for
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further analysis. Exhibit 4.11 provides the comparative figures for Asian Paints (India) Ltd. for the last few years. Exhibit 4.11: Comparison of Accounting Profit and Cash Flow from Operations (Rupees in Crores) Mar 08 384.35 457.29 Mar 07 288.03 312.25 Mar 06 207.52 218.69 Mar 05 194.57 156.45 Mar 04 178.17 243.43 Mar 03 188.76 191.25
PBDIT less Tax Cash Flow from Operating Activities Increase in PBDIT less Tax Increase in CF from Operating Activities
96.32 145.04
80.51 93.56
12.95 62.24
16.40 -86.98
-10.59 52.18
The figures in Exhibit 4.11 are comparable except for March 2005 where there is an increase in PBDIT less Tax whereas cash flow from operating activities has gone down. A further analysis shows that the inventory level has gone up significantly during 2005 compared to 2004 figures. It is quiet possible that the company would have made wrong forecast of sales and produced more than potential sales. The inventory levels had gone up from Rs. 211 cr. In 2003-04 to Rs. 330 cr. in 2004-05 (an increase of Rs. 119 cr.) against an increase in sales of Rs. 1798 cr. to Rs. 2048 cr. In other words, inventory as a percentage of net sales had increased from 11.76% to 16.14% in 2004-05. Lenders and suppliers would be interested to examine whether the firm is liquid and where from the firm generated cash to pay their liabilities. For instance, if a firm repaid a part of institutional loan by raising fresh loan or equity, institutions will be naturally worried whether they will continue to get subsequent instalments since there is a fair chance that the company may not be able to repeat this process year after year. They would be interested whether the firm's cash flow from operation is adequate to meet their liabilities. It is not that the firms should not borrow money subsequently, but such borrowings should be for creation for fresh assets. Employees are also equally interested whether the firm's cash flow from operation is adequate so that they will get their salary and other benefits on time24. Managers are also interested on cash flow from operations value since it is the source of strength for them to take up challenging tasks in the competitive market. Cash gives strength to organisation and cash rich doesn't mean the cash is kept idle. Such cash are eventually used for other activities. Today, many companies talk of financial flexibility as one of
24
If you are in government service and if you are able to prepare such statements for government, you will be really worried how the government would be meet such liabilities in the future. Many State Governments and local bodies often fail to pay salary on time.
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the desired goal, as in a competitive environment, the firm needs to survive and exploit fresh opportunities with its own capital (See Exhibit 4.12). A cash starved company will not only miss such opportunities but also create internal uncertainty for survival. While many key employees will quit, suppliers stop supplying goods and customers hesitate to deal with such companies, the life turns miserable for such organisations.
4.11 SUMMARY
Cash Flow Statement and cash flow analysis have assumed importance particularly when many companies have started adopting creative accounting and earnings management. Realising the needs of nave users as well as others, regulating agencies have made reporting of cash flow statements mandatory. Cash flow statement is easy to understand and to an extent difficult to fudge. It provides three important pieces of information on cash flow movements of the firm - how much cash is generated through operation, financing and how much cash is spent for investment? It gives a clear and real picture about the internal activities of the firm. There are two methods of preparation of cash flow statements, namely direct and indirect method. While direct method gives more details on cash flow from operating activities and also reader-friendly, indirect method is more accounting oriented and fails to provide any additional information. Unfortunately, many companies use indirect method though the accounting standards allow both methods. This indirectly shows the eagerness of management to withhold information unless it is required by the regulation. Fortunately, the final figure is adequate to get good insight though additional information will always be useful. Cash flow analysis is typically done by comparing the changes in cash flow from operating activities from period to period with the changes in profit levels of the firm. Such comparison is useful to understand the quality of reported profit. Also, the cash flow from operating activities is used to compare whether they are sufficient to meet the liabilities of lenders and also contribute for further investments. Cash Flow Statement of Asian Paints (India) Ltd. shows that the company is generating adequate cash from operations to meet investment requirement and also meet the interest and repayment liability on loan. Its accrual based reported profit is consistent with cash flow from operations.
Exhibit 4.12: Excerpt from 2001-02 Annual Report of Infosys Ltd. (pages. 8-9)
Creating a Flexible Financial Model A key element of a strategy for survival and even rejuvenation in a downturn is a flexible financial framework within which a company operates. In bad times, a company needs to cut its costs, protect its revenues, and also have a cushion to fall back on to weather the vicissitudes of the downturn. Indeed, the most flexible and nimble players may gain a competitive edge over their less agile rivals in such times. There are several determinants of such financial flexibility: 1. Low operating leverage 2. Low financial leverage 3. High liquidity 4. High operating margin 5. High agility in augmenting revenues 6. Total transparency in financial transactions Although these factors are not all completely within the control of a company, corporate managers enjoy considerable latitude in structuring their business to maximize financial flexibility on each of these fronts. How do these factors contribute to the financial flexibility of a corporation, and how can managers improve their performance on each of these dimensions? Low operating leverage. If this ratio is high, the fixed payout burden is relatively large, and the corporation will face a greater adverse impact in the event of a downturn. To illustrate the importance of this factor, consider the steel industry, which has a high fixed cost component due to large capital requirements. In the current recession, most steel makers are getting hurt not only because their revenues do not cover their costs, but also due to their limited ability to reduce these fixed costs. In contrast, POSCO of Korea reduced its operating leverage by subcontracting part of its manufacturing, and building on substantial economies of scale in its key operations. It continues to be profitable, and has even increased its earnings in the current recession. Low financial leverage. The higher the financial leverage, the greater is the fixed burden of servicing the debt. A corporation that is already burdened by the stresses of reduction in revenues is affected even more adversely, because of the need to meet the pre-committed debt payments of interest and principal. A combination of high operating and financial leverage makes it a double-whammy. This is what has badly affected most large companies in the global telecommunications sector such as France Telecom and Deutsche Telekom. Global Crossings is an extreme version of this problem, and had filed for bankruptcy earlier this year. In contrast, Hutchison Whampoa, the Hong Kong conglomerate with extensive telecommunications holdings, is using its low leverage to pick up technologically-valuable assets at bargain-basement prices. High liquidity. Companies that carefully husband their cash resources in essence create negative financial leverage have a much better safety net to face a downturn. The networking
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giant, Cisco Systems, is feeling the pinch of the recession like every other technology company, but with over US$20 billion in cash and marketable securities, it is well equipped to last out a prolonged recession. It may even be able to buy assets and companies at attractive prices. Hence, high liquidity combined with low financial leverage becomes an important strategic tool when times are hard. High operating margin. While the first three factors affect the cost side of the equation, this fourth feature deals with the cushion between the revenues and the costs. An example of high operating margins is the Indian IT services industry, which has demonstrated its financial flexibility in the current recession. The best companies in this industry have been relatively better equipped to weather the storm because they can face the dip in revenue growth without digging too deeply into their cash reserves. High agility in augmenting revenues. When business conditions are adverse, there is tremendous pressure to maintain and even augment revenues. This involves all the tools of marketing, including aggressive pricing, brand loyalty augmentation, and customer relationship management. Wal-Mart Stores, the giant retailer, has managed to grow by double-digit percentages through a combination of these strategies, even in the current period. Total transparency in financial transactions. When times are good as they were during the dot-com boom only three years ago very few questions are raised about the financial practices of corporations. In downturns, the capital market becomes much more demanding, and it becomes more difficult for companies to raise external finance. Firms that adhere to the best practices of corporate governance and follow transparent processes in all their financial dealings are more likely to be able to raise capital, should they need it, in a down market. This factor is very much at work even in the ability of countries to raise external finance: witness the problems faced by Argentina, and the downgrading of Japan, an erstwhile strong economy. Recent accounting scandals in the United States and elsewhere, involving companies such as Enron, highlight the importance of this factor. And, it could be argued that even companies that have a viable long-term model may be dragged into default and even bankruptcy, because their financial dealings are under a cloud. Berkshire Hathaway, on the other hand, enjoys a substantial premium over the value of its portfolio holdings, in large part, due to the clean reputation it enjoys under Warren Buffet. How can a corporation improve its performance in each of these dimensions and hence its financial flexibility? While there are constraints imposed by technology and the market in certain industries, most firms can still undertake actions to improve their flexibility. For example, a company can reduce its operating leverage by outsourcing services where it has little or no competitive advantage. It can improve its operating margin by moving to lower cost locations, as the apparel industry has done successfully in the past decade. Firms in industries with intrinsically high operating leverage can use debt more judiciously, so as not to exacerbate the overall fixed commitments they make. Lastly, all firms can improve their performance by being more transparent in their financial transactions so that investors respond favorably when they need to tap the capital market. ---- Marti G. Subrahmanyam Independent Director
CHAPTER 5 Analysis of Financial Statements
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Chapter 5
Analysis of Financial Statements
5.1
INTRODUCTION
Organisations have a purpose and it is generally stated in the mission or vision statement. To achieve the purpose, organisations need finance, which is raised from the capital market through debt or equity. Finance or capital is raised either directly from the investors or through intermediary institutions like banks. Once capital is raised, the capital is invested in assets, which can be broadly classified into fixed and current assets. Several factors determine the choice of assets and proportion of investments in different types of assets. A trading company or service company may not invest much on fixed assets whereas manufacturing company like automobile company would invest large amount in fixed assets. Some manufacturing industries may require more working capital, if the materials used by them are available only in certain seasons. After raising capital and acquiring assets, the business unit runs the operations and generates revenue. Since most business units are started with an objective of making profit, many of them report profit. Accounting statements typically reflect the above activities and allow the managers to examine whether their plan or strategy has resulted in positive impact on the company. Balance Sheet, Profit and Loss Account and Cash Flow Statements are three principal financial statements and they reflect the above activities. Balance Sheet explains where from the organisation has raised money and where they have invested
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the money. Profit and Loss Account explains how efficiently the assets of the organisation have been used and what has been the net outcome of the operations. Cash Flow Statement shows operational outcome, capital raised and invested but all in terms of cash. While the principal financial statements provide wealth of information to investors and others, there is no ready answer to a question whether the organisation has achieved the goal or mission. Financial Statements are analysed further to get such an insight on the performance of the organisation and various parts or divisions of the organisation. In the last three chapters, principal financial statements namely balance sheet, profit and loss account and statement of cash flows are discussed. While explaining various items of these statements, we also analysed them briefly but our analyses were restricted to items within the statements. In this chapter we analyse financial statements together to understand long-term and short-term financial health of the firm25. Financial analysis today is performed by various users of financial statements. Investors and management perform the financial analysis to understand how productive the assets were in generating profit during the period. Lenders and suppliers of goods will look for ability of the firm in repaying the dues on time. Financial managers not only prepare financial statements but also analyse the same to get further insight on the performance of the organisation. They need to examine the organisation from the perspective of several users so that they can fulfil the needs of many of them. While financial analysis is often used for evaluating current or historical performance, management uses the input of such analysis for planning exercise. In preparing budgets, the inputs of financial analysis are extensively used. Financial analysis provides linkage between operating activities and funding activities. Normally, top management sets the goal and operational managers then determine the level of operations required in achieving the goal. It would be difficult to increase the level of operations without any investments unless there is a huge idle capacity. Thus increased activity demands more addition to assets and this in turn increase the demand for capital. The first step in this process is to know how much of additional assets we need and how much of capital we need to mobilise from various sources. Financial analysis, which provides historical linkage between various financial components, is useful. Suppose the top management fixes a goal to increase the net income by another 20% for the coming year. Using profit to sales linkage, managers can estimate additional turnover required in achieving the goal. Once additional turnover is estimated, it is possible to assess the investment requirement for additional assets (fixed and current assets in the case of manufacturing companies) and then additional funds required to buy such assets. Thus financial analysis is prerequisite for financial planning.
25
Some of the discussions of this chapter are understood better if the readers have gone through the earlier four chapters.
CHAPTER 5 Analysis of Financial Statements 5.2 TECHNIQUES OF FINANCIAL ANALYSIS
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Financial statements are analyzed to answer several questions and different techniques are followed for analysing financial statements. Some of the usual questions are: (a) How my company is comparable with others in the industry in terms of overall business? (b) How my company is growing over the years? (c) How is the overall financial health of my company? What are the strong and weak areas of performance? (d) Compared to industry or bench marked company, how is the performance of my company? (e) Is the company pursuing the financial performance and policies consistent with the strategy? Analysts use several techniques to answer such questions. The details available in financial statements are converted into certain formats to facilitate such analysis. The most popular and often used techniques include preparing common size financial statements, statement showing growth of financial variables over the years, ratio analysis and inter-firm comparison.
5.3
COMMON SIZE STATEMENT ANALYSIS
Suppose an analyst would like to know how this company is different from other companies in the industry. One of the major problems when comparing different firms of the same industry is difference in size of the firm. It would be difficult to compare Asian Paints (India) Ltd. with Kansai Nerolac Paints Ltd. without adjusting the size since the Kansai Nerolac is less than half the size of Asian Paints (India) Ltd. In common size statement analysis, balance sheet or profit and loss account or cash flow statement are converted into percentage format. For balance sheet, the total value of the asset is treated as 100 and all sub-components of assets and liabilities are expressed as a percentage of total asses. In profit and loss account, the sales or total revenue is equated to 100 and all expenses are converted into as a percentage of revenue. For cash flow statement, the net cash flow of the year is treated as 100. When two firms are compared on this basis, it is possible to know how the assets, liabilities, expenses and component of cash flows are distributed among the various components. Common size statement analysis if performed across several years traces the changes in the allocation of assets or liabilities. Exhibit 5.1(a) to 5.1(c) shows common size statement of Asian Paints (India) Ltd. for two years period. An analysis of common size balance sheet improves the understanding of the readers on the distribution of assets and liabilities. Asian Paints (India) Ltd. has reduced its dependence on debt capital during the year 2007-08 compared to previous year. In 1999-2000, the company was depending on loan funds to an extent of 50% but over the years, it has come down to 8.98%. The company has reduced the cash credit borrowing (for working capital) significantly during the year. If this trend continues,
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the debt level will approach to zero in next few years once the company retires the sales tax deferment loan of Rs. 64 crores. The financial risk of the company in that process is considerably reduced and also, the company's debt capacity is very high compared to other firms in the industry. Is this financial policy consistent with company's current strategy of pursuing the growth through acquisition? It is quiet possible that the company believes in acquisition through cash deals and low debt will allow the company to tap the resources at any time. Further, if the acquired firm is a sick firm and comes with some debt level, it is desirable to have low debt so that servicing of debt of sick firm in addition to bearing the cash loss of sick firm during initial period is feasible with low debt. In other words, it would be difficult for a highly levered firm to buy another sick and levered firm and bear the cash loss of the sick firm as well as servicing the debt of the sick firm.
Exhibit 5.1(a)
Asian Paints (India) Ltd.

COMMON SIZE BALANCE SHEET
As at 31.03.2008 FUNDS EMPLOYED Shareholders Funds Loan Funds Deferred Tax Liability (Net) Total APPLICATION OF FUND Fixed Assets Investments Current Assets, Loans and Advances Less: Current Liabilities and Provisions Net Current Assets Total
88.03 8.98 2.99
As at 31.03.2007
83.43 14.09 2.48
100.00%
100.00%
51.12 40.09 99.00 (90.22) 8.78
38.85 37.49 96.34 (72.68) 23.66
100.00%
100.00%
There are major changes on the composition of assets. Net investment in fixed assets has increased significantly mainly on account of purchase of freehold land (Rs. 80.16 cr.) and plant and machinery (Rs. 44.78 cr.). Investments have gone up marginally on account of increased surplus cash available for treasury activities. The level of current assets has gone up marginally but current liabilities have gone up significantly leading to significant drop in the net current assets. In absolute value, the net current assets has dropped from Rs. 210.98 Cr. to Rs. 92.62 Cr. With increased brand image and third party sourcing, it is possible for the company to achieve negative working capital in the near future. Common size profit and loss account shows composition of income and expenditure over the two years period or between firms. Analysis of common size profit and loss account of Asian (Paints) India Ltd.(Exhibit 5.1 (b)) shows no major
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change in the composition of income. On the expenditure side, material cost has gone down but there is a marginal increase in other cost elements. The management of the company observes in the Management Discussion and Analysis that prices of raw materials had increased sharply in second and third quarter of the previous year 200607. In the year under review, prices of raw materials were soft compared to the previous year especially during first half. This was largely due to strong Rupee and good supply situation which negated the impact of rising crude oil prices in the international market. Accordingly, your company benefited considerably Material constitutes an important cost item and a decline in the cost has a positive impact on the profitability of the firm. Since all other cost items by and large remained at the same level, the decline in raw material cost has positively contributed on profit margin from 9.43% to 10.83% for the year ending March 31, 2008.
Exhibit 5.1(b)
'

COMMON SIZE PROFIT AND LOSS ACCOUNT
For the year ended March 2008 March 2007 INCOME Sales and operating income (Net of discounts) Less: Excise Sales and operating income (Net of discounts and excise) Other Income EXPENDITURE Materials Consumed Employees' remuneration and benefits Manufacturing, administrative, selling and distribution Exp. Less: Interest Less: Depreciation Profit Before Tax Less: Provision for Taxes Profit After Tax
112.45 (14.25) 98.20 1.80 113.38 (14.79) 98.59 1.41
100.00
56.23 5.60 20.45 0.24 1.26 16.23 (5.40) 10.83
100.00
58.03 5.49 20.33 0.24 1.59 14.32 (4.89) 9.43
Common size cash flow statement gives an idea about how the cash generated from the operations has been spent during the year and hence gives an idea about the direction of the firm. Exhibit 5.1(c) shows that the company was spending more on investment activities in 2007-08 compared to financing activities (repayment of debt) but in 2006-07, it has spent more amount on financing activities compared to investment activities.
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Exhibit 5.1(c)
'

COMMON SIZE STATEMENT OF CASH FLOWS
Net Cash generated from Operating Activities Net Cash used in Investing Activities Net Cash used in Financing Activities Cash added to (drawn from) Opening Cash Balance For the year ended March 2008 March 2007 100.00 100.00
72.58 27.66 -0.24 35.52 59.95 4.51
5.4
TREND ANALYSIS
Trend analysis shows the level of growth that the company has achieved over the years on each component of financial statements. Suppose the growth rate of sales is 20% but its cost has increased by 26%, then its profitability is affected. One can perform such analysis by observing the trends on each financial parameter. Normally a base year is selected and the values of base year are set to 100. Subsequent years' values are reported as a percentage of the base year value. Exhibit 5.2 (a) presents balance sheet values for the last 10 years. The trend analysis of balance sheet gives some ideas about the financial polices and strategies of the company.
Exhibit 5.2(a)
'

BALANCE SHEET TREND ANALYSIS
Mar 08 239 315 305 22 121 44 196 228 404 159 Mar 07 239 245 244 40 123 58 167 196 371 128 Mar 06 239 199 204 19 124 42 137 179 339 116 Mar 05 239 180 188 20 115 41 127 174 306 121 Mar 04 239 165 175 14 99 32 115 159 267 116 Mar 03 160 156 157 38 82 48 111 154 229 124 Mar 02 160 131 135 45 72 51 100 145 184 130 Mar 01 160 131 135 97 132 105 122 133 148 127 Mar 00 100 120 117 73 107 80 102 114 121 111 Mar 99 100 100 100 100 100 100 100 100 100 100
Share Capital Reserves Total Shareholders Funds Secured Loans Unsecured Loans Total Debt Total Liabilities Gross Block Less: Accumulated Depreciation Net Block

Investments Inventories Sundry Debtors Cash and Bank Loans and Advances Total Current Assets Current Liabilities Net Current Assets Total Assets 849 335 315 185 305 314 586 54 196 672 270 295 190 211 258 399 124 167 552 217 232 127 174 206 333 84 137 519 206 186 115 132 179 298 66 127 487 131 173 110 125 139 245 37 115 297 129 147 122 116 130 190 73 111 127 97 149 99 114 113 152 76 100 89 124 152 53 180 138 150 125 122 81 116 108 85 149 119 147 92 102
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100 100 100 100 100 100 100 100 100
The year 1999 has been used as the base year for computing the percentages. The company was following the capital structure policy of fifty per cent equity and fifty per cent debt till 2001 but then moving towards zero debt policy. How Asian Paint has achieved such a major reduction in debt? It could be due to issue of fresh equity shares or changes in dividend policy or changes on the assets side of balance sheet like selling out some of the divisions. In this 10-year period, the company has not issued any fresh equity (except bonus shares). There is no major change in the dividend policy and the company on average pays out is about 40 per cent of profit after tax as dividend. One possible explanation could be major decline in net current assets, which has come down from 100 to 54 during this period. A decline in current assets releases capital invested in current assets, which in turn can be used for repaying debt. In Asian Paint (India) Ltd., all components of current assets have gone up over the years. An analysis of current liabilities shows a major increase and it has grown about 9 times during this period particularly since 2002. In other words, while the company is moving towards zero debt, it has also increased considerable credit from the suppliers. If the justification for reducing the debt is high cost attached with such debts, then one has to examine implicit cost attached with current liabilities26. The trend analysis of balance sheet also reveals a slow down in investment in fixed assets during the last three years but at the same time an increase in investments during the same period. Exhibit 5.2(b) compares major items of profit and loss account over the years. Though the growth rate of income is not uniform, it is moving upward over the years and increased nearly 3 times. There is not even a single year in which the income has shown a negative growth. In this restricted context, the business risk is not very high for the company. Barring selling and expenditure, all cost items are showing growth rate of less than or equal to income growth. Surprisingly, the profit is growing are at
26
It is possible to argue that there is no cost attached with suppliers' credit or liabilities. It need not always be true since supplier would expect compensation for giving credit period or facility. Borrowing through suppliers makes sense if the interest rates are distorted between different segments of the economy. Suppose, interest rate for SSI is lower compared to large industries, one can arbitrage such differential interest rates.
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higher rate than the sales. The reason for profit growth is declining trend in excise duty whose growth rate is significantly lower than income growth. The sales has gone up by three and half times over the years but the exercise duty has gone up only by three times during the same period. The interest expenditure has also come down over the years. An interesting observation is significant increase in selling and administration expenses. With increased competition, the investment in advertisement and other promotional expenses have gone up significantly to protect and nurture the brand. The company was spending Rs. 26.75 Cr. towards advertisement in 1998-99. In 2007-08, expenditure on account of advertisement was Rs. 164.85 Cr. Analysts would like to check how other companies are managing the cost and revenue to get more insight on competitive advantage of Asian Paints in the industry.
Exhibit 5.2(b)
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PROFIT AND LOSS ACCOUNT TREND ANALYSIS
Sales Turnover Excise Duty Net Sales Other Income Total Income EXPENDITURE Raw Materials Power & Fuel Cost Employee Cost Other Mfg Expenses Selling & Admin Exp Miscellaneous Exp Total Expenditure Operating Profit Interest Gross Profit Depreciation Profit Before Tax Tax Reported Net Profit 367 197 362 255 522 126 362 425 60 490 189 558 719 488 318 182 296 217 418 104 307 321 53 369 196 408 575 354 249 151 258 240 285 203 251 245 37 283 201 301 475 243 219 141 237 207 235 123 216 223 29 258 210 268 412 226 176 127 204 170 219 135 182 197 39 226 212 229 367 192 163 128 216 154 190 96 167 196 56 221 214 223 352 186 133 135 188 132 172 119 142 163 65 181 184 180 249 150 131 123 148 123 157 147 135 144 99 152 139 155 206 138 120 114 118 112 129 109 119 131 91 138 123 142 191 127 100 100 100 100 100 100 100 100 100 100 100 100 100 100 Mar 08 362 308 371 284 372 Mar 07 300 271 305 193 309 Mar 06 248 223 253 163 250 Mar 05 209 195 212 143 217 Mar 04 182 159 186 98 184 Mar 03 167 146 171 57 171 Mar 02 147 123 151 67 145 Mar 01 135 118 138 42 137 Mar 00 119 108 121 62 121 Mar 99 100 100 100 100 100
CHAPTER 5 Analysis of Financial Statements 5.5 RATIO ANALYSIS
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In common size and trend analysis, financial statements are examined independently. Financial statements provide additional insight if the analysts link these financial statements and such linking is achieved through ratio analysis. Ratios are aimed to assess profitability, productivity of assets or capital and risk associated with operations. Though one can get some basic idea about the company while evaluating common size statement and trend analysis, the level of comparison is however restricted. Ratio analysis integrates financial statements to assess financial health of the firm. Some of the important ratios are discussed below. Exhibit 5.3 and 5.4 presents Balance Sheet and Profit and Loss Account of Asian Paints (India) Ltd.
5.6
PROFITABILITY RATIOS
Asian Paints (India) Ltd. has reported an increase in profit in 2007-08 compared to 2006-07. Its profit before depreciation, interest and tax (PBDIT) has increased from Rs. 462 Cr. to Rs. 616 Cr. Profit before tax (PBT) and Profit after tax have also increased. It is good to see positive number and that too growing value under the heading of profit in a competitive environment but it is not adequate. It is important to assess the profitability of the operations. The concept of profitability is something similar to productivity of the machine or employee. Profitability measures the productivity of the capital. Since capital is raised from various sources, profitability is measured in different ways at different levels. Return on Total Assets or Funds Employed Return on total assets or funds employed measures the profitability of the business unit without differentiating suppliers of funds. It simply explains how much income that the firm has generated for the capital it has taken or used during the year. Depending on the definition of total assets, this ratio is also referred to as Return on Investments or Return on Capital Employed. Suppose total asset is defined as sum of fixed assets, investments and net current assets. Return on total assets under this definition can be called Return on Capital Employed (ROCE). Here capital employed means capital supplied by equity holders and debt holders and it excludes suppliers' contribution on working capital in the form of suppliers' credit. On the other hand, if the total asset is defined as sum of fixed assets, investments and current assets, then this ratio is called Return on Investments (ROI). The 'return' part of the ratio is defined normally as profit before interest and taxes less tax. In other words, the profit before interest and tax less tax is the amount available to the suppliers of capital. For the purpose of clarity, we will explain the profitability ratio without considering tax initially and then show the impact of tax separately. We prefer this approach because the impact of tax polices on profitability might cause confusion while examining the profitability of two firms.
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A B C
95.92 832.58 928.50 36.70 58.00 94.70 31.52 1054.72
95.92 648.16 744.08 66.90 58.77 125.67 22.15 891.90
D 937.89 509.06 428.83 110.39 E F 0.09 538.97 251.90 41.35 33.09 178.82 1044.22 539.22 422.88 806.20 471.29 334.91 11.62 346.53 334.39 0.03 434.07 235.96 42.49 31.23 115.45 859.23 594.10 54.15 648.25 92.62 1054.72 210.98 891.90
G 785.11 166.49 951.60
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J K L
62.35 100.71 27.72 134.42 200.00 525.20 39.12
52.76 62.35 9.59 17.77 89.58 150.00 382.05 28.36
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Return on Total Assets or Funds Employed or Capital Employed 2007-08 2006-07 Return on Total Assets Profit before interest and taxes Total Assets Return on Total Assets Return on Investments Profit before interest and taxes FA + Investments + CA Return on Investment (ROI) 572.82 1054.72 54.31% 2007-08 572.82 2006.32 29% 416.79 891.90 46.73% 2006-07 416.79 1540.15 27%
Return on total assets (ROTA) of Asian Paints (India) Ltd. for the year 2007-08 was 54.31% compared 47% for the previous year. It shows that the company is generating Rs. 54.31 for every Rs. 100 of capital invested, for the suppliers of capital on pre-tax basis. This improvement is wiped out once we consider the suppliers' credit in our analysis. Return on investments has marginally increased from 27% to 29% during the year27. However, this ROI definition has inherent flaw since numerator of the equation fails to reflect the reward for suppliers' credit. In other words, when we add suppliers' credit as a source of capital, the reward part associated with such capital should be added in numerator. Since the reward associated with the suppliers credit is difficult to measure, it is better to use ROTA for evaluation. ROTA is generally used for business level evaluation and can be applied for a plant or a SBU or a department. It simply measures that the business unit or a division has taken some resources or capital of the organization and hence measures the benefit contributed by the resource to the organization. There is no colour for this capital (debt or equity) and hence whatever the division or SBU generate out of this capital (without any concern on who will be the ultimate recipient of the return equity holder, debt holder or government) is relevant for performance measurement. In measuring performance through ratio analysis, there are two aspects, which are important consistency across the years and numerator denominator issue. There are four drivers for the profitability of a business organization. They are (a) Asset Management (b) Cost Management (c) Leverage or Debt Management and (d) Tax Management. The leverage and tax management are discussed first before taking up asset management and cost management.
27
Here is a word of caution. It is not difficult to mislead with financial ratios by changing definition and hence one has to be very careful in both computing the ratio and also in its interpretation.
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Return on Equity or Net Worth or Shareholders' Funds28 The previous ratio (Return on Total Assets) combines all sources of capital but shareholders would be interested to know how much of return that the company has generated for them. This ratio is called return on equity (ROE) or return on net worth (RONW). Here equity or net worth means equity share capital and reserves and surplus. The definition of 'return' is profit before tax. Return on Equity or Return on Net Worth 2007-08 Profit before taxes Shareholders' Fund Return on Equity or Net Worth 564.55 928.50 60.80% 2006-07 409.92 744.08 55.09%
Return on Equity is higher than return on investments on both periods. It is important to understand the source of additional earnings. Suppose the company has no borrowings. Then PBIT and PBT will be the same and also the sum of the debt and equity will be equal to equity. Under such a situation, both return on total assets and return on equity will be one and the same. The moment debt is introduced the ROE is affected. ROE is positively affected when the company borrows money at a rate lower than return on total assets. Under this condition, the company borrows capital, uses to earn a higher ROTA, pays lower interest and adds the balance (or surplus) to the shareholders. On the other hand if the ROTA is lower than interest rate, equity holders have to bear the difference and hence the ROE is negatively affected. The difference between ROTA and ROE can be explained as follows: ROE - ROTA = (ROTA - Interest Rate) x (Debt/Net Worth) The difference between ROE and ROTA is positive only when (a) ROTA is greater than interest rate and (b) debt/net worth is positive. If one applies the above equation for Asian Paints (India) Ltd., the results might show some inconsistent value. The reason is deferred tax liability. In our earlier discussion, we have only two sources of funds namely debt and equity. However, the balance sheet shows three figures namely shareholders' funds, loan funds and deferred tax liability (net). The question is on the treatment of deferred tax liability. One possibility is treating the liability as interestfree loan given by the government. With this assumption, it is possible to show the relationship between ROE and ROTA under the above equation. Before that, it is necessary to find out the cost of debt or interest rate. There may be some problems here too. While interest value given in profit and loss account is equal to interest for loan of the period, loan funds shown in balance sheet is loan outstanding as on that date. Suppose the company has repaid substantial part of the loan towards the end of the year. It will reduce the loan outstanding but interest expense will include interest on such loans. It might give some abnormal interest rate if one divides interest expenses
28
Equity, net worth and shareholders' fund all refers to the same thing. It is equal to equity share capital plus Reserves and Surplus.
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by loan outstanding. Assuming there no such abnormality, interest rate is computed as follows. 2007-08 2006-07 Loan Funds 94.70 125.67 Deferred Tax Liability (Net) 31.52 22.15 147.82 Total Loan Funds 126.22 6.87 Interest 8.27 6.55% 4.65% Interest Rate or cost of debt Applying the above interest rates in the equation, the impact of borrowings on return on equity can be shown as follows: 60.80%29 - 54.31% = (54.31% - 6.55%) x (126.22/928.50) = 6.49% The impact of debt on return on equity is also called as impact of financial leverage. Financial leverage refers to use of debt and can be measured in several ways. In the above equation, financial leverage is equal to debt to equity value. The debt (which includes deferred tax liability) to equity value is 0.2230. Contribution of financial leverage has declined from 8.36% to 6.49% due to increase in equity.
5.7
IMPACT OF TAX ON PROFITABILITY
Tax distorts profitability to an extent. That is, two companies with same profit before tax and pre-tax profitability may have different post-tax profit and post-tax profitability. The following table explain the impact of tax on profitability. Company A 300 200 500 100 35 65 33.33% 21.66% Company B 300 200 500 100 10 90 33.33% 30.00%
Equity Debt Total Capital Profit Before Tax Tax Profit After Tax Return on Equity (pre-tax) Return on Equity (post-tax)
There are several reasons for the differences in tax paid. It could be due to differences in depreciation or inventory policies used by the two companies for accounting and tax purpose. It is also possible due to revenue mix (tax-exempted earning like export earning and domestic earning) or location of the plant where some tax incentives are given. The level of distortions have come down now to a great extent
ROE before extraordinary items When financial leverage concept is used for solvency purpose, deferred tax liability need not be considered as debt.
30 29
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since companies have to show deferred tax liability separately. It is better to assess the impact of tax planning on profitability separately instead of mixing them up with operational efficiency. If a company has improved its profitability due to better tax planning, it has to be identified separately and those who have contributed to such additional profitability have to be rewarded. The impact of tax planning on profitability can be assessed by comparing pre-tax profitability and post-tax profitability separately. Suppose the pretax return on equity of a company is 20%. If there is no tax planning and the tax rate is 35%, the post-tax return on equity should be 14% [20% x (1-35%)]. If the actual posttax return on equity of the company is more than 14%, then the difference is on account of better tax planning. For instance, if the post-tax actual return on equity in the above example is 16%, then the company is able to show additional 2% due to better tax planning. In other words, the impact of tax planning on profitability can be defined as follows. Post-tax ROE - Pre-tax ROE x (1-tax rate) Impact of Tax Planning on Profitability 2007-08 2006-07 Profit before taxes 564.55 409.92 Profit Before taxes less current year tax 393.23 272.02 Shareholders' Fund 928.50 744.08 60.80% 55.09% Return on Equity (pre-tax) 42.35% 36.56% Return on Equity (post-tax) 39.52% 35.81% Return on Equity (pre-tax) x (1-tax rate, 35%) 2.83% 0.75% Post-tax ROE - Pre-tax ROE x (1-tax rate) For Asian Paints (India) Ltd., the impact of tax planning on profitability is about 3%31. In addition, analysts can also compare the contribution of deferred tax liability on the sources of funds. Deferred tax liability contributes about 3% during 2007-08 (2.48% in 2006-07).
5.8
PROFITABILITY DRIVERS
Return on Total Assets or Return on Investments measures the profitability of the firm at business level. Profitability is influenced by several factors. Profitability drivers can be broadly classified into asset-related drivers and cost or profit-related drivers. Assetrelated drivers contribute to profitability by improving the efficiency of the assets. Cost-related profitability drivers improve the profitability by managing the cost better. In other words, firms need to manage asset and cost to improve the profitability. While asset management improve the profitability by increasing the sales, cost management
31
This additional return is temporary until such time the company is in position to defer the tax. An alternative way of assessing impact of tax planning is amount of tax not paid during the current year (equal to deferred tax liability) multiplied cost of capital i.e. interest free funds.
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improves the profitability by improving the profit margin. In the following pages, we will discuss several components of Asset Management and Cost Management.
5.9
ASSET MANAGEMENT
Firms employ set of assets to generate sales. Fixed assets are essential for converting the material into finished goods or providing services to the customers. Current Assets are used in the manufacturing process and some current assets are outcome of manufacturing process. Ideally fixed assets need to generate large volume and for that given volume, the firm should use very little investments in current assets. A set of ratios called turnover ratios measures the productivity of the assets. Total Asset Turnover Ratio The total asset turnover ratio measures the total income that the firm is able to generate using the assets. Since total assets include fixed assets, investments and current assets, it is desirable to use total income while computing this ratio. As we break the total assets into its components, we can also do the same for total income. It is important to note that some compatibility is always ensured between the numerator and denominator of the ratio. Asian Paints (India) Ltd. has reported total income of Rs. 3478.74 Crores by using assets worth of Rs. 1054.72 Crores in 2007-0832. Instead of using year end total assets value, some analysts recommend average value of total assets of two periods33. Total asset turnover ratio of Asian Paints (India) Ltd. is shown below. Total Asset Turnover Ratio 2007-08 Total Income 3478.74 Total Asset 1054.72 Total Asset Turnover Ratio 3.30 2006-07 2861.74 891.90 3.21
Total Assets consists of three types of assets namely fixed assets, investments and net current assets. It is possible to measure the efficiency of each type of assets. The numerator of the equation is changed according the denominator value. For instance, other income is not included in turnover when computing fixed assets turnover ratio and net current assets turnover ratio. Similarly, sales and operating income is excluded while computing efficiency of funds deployed for investments.
The company is not using capital work-in-progress and also the current liabilities and provisions are not assets. Hence, it is possible to add up fixed assets, investments and current assets, loans and advances and define the same as asset. 33 Wherever balance sheet values are used in computing ratios, it is possible to take average of two periods value and use the same instead of one-year end value. For the purpose of simplicity, we will be using only year-end values here.
32

Fixed Asset Turnover Ratio 2007-08 Sales and operating income 3416.16 Fixed Assets or Net Block 428.83 Fixed Asset Turnover Ratio 7.97
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2006-07 2821.29 334.91 8.42
Note: Operating income is included since some fixed assets are used for generating operating income like processing charges and lease rental. Net Current Assets Turnover Ratio 2007-08 Sales and operating income 3416.16 Net Current Assets 92.62 Net Current Turnover Ratio 36.88 2006-07 2821.29 210.98 13.37
Investment Income to Investment 2007-08 2006-07 Interest, dividend and profit on 29.68 14.98 sale of investments Investments 422.88 334.39 Investment income to Investments 7.02% 4.48% Note: If average investments value is used, the percentage will be different. The company is showing an improvement both on total assets turnover ratio, and net current assets turnover ratio whereas fixed assets turnover ratio has declined to an extent. An investment of Rs. 100 in total assets yielded revenue of Rs.321 in 2006-07 and the revenue increased to Rs. 330 in 2007-08. In other words, efficiency of asset utilisation has improved in 2007-08 compared to the previous year. Analysts also compare the ratios with other companies in the industry before judging the performance of the company. Investments in long-term and short-term are yielding poor return but it should be noted that it is only a realised return. The dividend yield of many good investments is generally low but such investments offer high capital appreciation over the years. Investors in Asian Paints stocks today is likely to get a dividend of Rs. 17 per share against an investment of Rs.1150 per share. This offers a dividend yield of 1.5% but investors buy Asian Paints stocks mainly for capital appreciation. The capital gains part of the income has not been recognised in computing the above return. For example, an investment of Rs. 100 in a subsidiary company may generate a net income of Rs. 30 but it might distribute only Rs. 5 as dividend. While the realised return is only 5% in this case, the unrealised return is 25%. Using information available in Consolidated Profit and Loss Account, Investments Schedule and current market prices of quoted investments, it is possible to evaluate the efficiency of the investments. The market value of quoted investment is Rs. 254.26 Cr. against Rs.183.02 Cr. of market value of last year (2006-07). It means during the year, the investments have appreciated by Rs. 63 Cr. or nearly 33%. Though this figure is reasonably high, it is lower than the companys ROE. In addition, the company is holding Rs. 197.66 cr.
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worth of mutual funds units (cost value) and the market value of such investments is not available. The net current asset consists of current assets and current liability and efficiency analysis can be performed on each component of current assets. Such analysis is also called 'liquidity analysis' or 'working capital cycle analysis'. Current assets are required for running the business and there are several factors that influence the current assets. Technology, distance, business practices and risk aversion determine the need and amount of investment required for various current assets. Investments in current assets consume cost and hence it is expected to bring additional benefit to justify such investments. Following ratios are useful in this context. Gross Current Asset Turnover Ratio Current Assets consist of inventories, receivables or sundry debtors and cash and bank balances34. These assets are called current assets because they are expected to be liquidated within a year and change their form. For instance, dues from debtors as on March 31, 2005 would be collected by March 31, 2006. Though the debtors value on March 31, 2006 may be more than the value as on March 31, 2005, it should be noted that such debtors are new debtors and finished goods after sales take the form of debtors. Gross current assets turnover ratio and components of current assets turnover ratio are used to assess the management's efficiency in using current assets. Gross Current Assets Turnover Ratio 2007-08 Sales and operating income 3416.16 Current Assets (Inventory+Drs+Cash) 832.22 Current Assets Turnover Ratio 4.10 2006-07 2821.29 712.52 3.96
Since investments in current assets have gone up from Rs. 712.52 Crores to Rs. 832.22 Crores, it is expected to generate additional sales to justify such investments. Since the gross current asset turnover ratio remains at 2006-07 level, it means additional investments in current assets has brought additional sales but with the same level of efficiency. The inverse of this ratio explains the amount required to be invested in current assets to generate for every Re. 1 sales. In 2006-07, the company required 25 paise for every Re. 1 sales and it has gone down marginally to 24 paise to generate same Re. 1 sales in 2007-08.
34
Current assets, loans and advances are clubbed together and reported in the balance sheet. Though loans and advances, interest accrued but not due, advance payment of tax, etc. which form part of this group are also realised within one year, normally they are not part of working capital cycle. Some analysts combine all the values to compute such ratio for the sake of simplicity.
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Inventory Turnover Ratio Inventory Turnover Ratio and other inventory related ratios are used to check efficiency of the firm in managing inventory. The faster it turns around the inventory, it is good for the business. Efficiency of inventory management can be assessed in three forms namely, inventory turnover ratio, amount required to be invested in inventory to generate Re.1 sales and number of days of inventory. In the earlier turnover ratios, sales or income was used as the numerator. Since inventories are valued at cost, the numerator of inventory turnover ratio should exclude profit. Normally cost of goods sold (in case of trading company) or cost of goods manufactured (in case of manufacturing company) is used instead of sales value in the numerator of the equation. The definition of cost of good sold or cost of goods manufactured depends on inventory valuation policy. Sometime it may be difficult to get these values directly from the annual report and hence some analysts continue to use sales for computing all turnover or activity ratios. Since Asian Paints is a manufacturing company, we will use cost of good manufactured and we define cost of good manufactured as equal to the sum of material consumed, employees' remuneration and benefits and manufacturing expenses35. Inventory Turnover Ratio 2007-08 Cost of Good Manufactured* 2415.32 Inventories 538.97 Inventory Turnover Ratio 4.48
See page number 76 of Chapter 3 for details
2006-07 2075.06 434.07 4.78
Inventory turnover ratio has decreased from the previous year value. The inverse of this ratio shows the investments in inventory per Rupee of cost of goods manufactured. For every Rupee of cost of good manufactured, the company required an investment of 21 paise for inventory in 2006-07 but it has increased to 22 paise in 2007-08. It is also possible to compute the number of days the inventory is maintained at different points of time. This can be computed by taking a ratio of value of inventory to average daily value of cost of goods manufactured. For computing average daily value of cost of goods sold, the number of days in a year can be defined as total days (365 days) or working days (300 days). An easy shortcut to compute number of days of inventory is dividing 365 or 300 days by inventory turnover ratio. The number of days of inventory
35
This definition is also not prefect since manufacturing expenses are not directly given. For instance, firms may consider depreciation relating to production facilities as part of manufacturing expenses and hence allocate part of the depreciation to inventory. But this calls for bifurcation of depreciation into production related and non-production related. For simplicity, we exclude depreciation and arbitrarily compute manufacturing expenses from the list of expenses given in Schedule L of the Financial Statements of Asian Paints (India) Ltd. Please refer page number 14 of the Chapter 3 for details.
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that the company was holding as on March 2008 was 81 days (365 divided by 4.48) and for the previous year, it was 76 days. Inventory turnover ratio can be further dividend into raw materials turnover ratio and finished goods turnover ratio, the two major component of inventory in many companies. Efficiency of managing raw materials and finished goods can be assessed in the form of turnover ratio or amount invested to generate one Rupee of cost of good manufactured or number of days of material or finished goods held by the company. In the case of material related ratios, sometime raw materials consumed may be relevant than cost of goods manufactured. It is possible to drill down these ratios further for principal raw materials or finished good separately. Debtors Turnover Ratio Debtors constitute an important part of current assets. Credit is often used to attract more sales. Like other components of current assets, such increased sales come with a cost. Hence incremental debtor and incremental sales are also compared to understand the level of competition. For instance if the sales and debtors of period 1 are Rs. 1000 and Rs. 100 respectively and debtors value increased Rs. 120 in period 2, the expected sales for period 2 is Rs. 1200. In other words, additional investment of Rs. 20 on debtors is expected to bring 10 times of its value as additional sales (i.e. Rs. 200). On the other hand, if the additional sale is only Rs. 100, it might mean that the company is finding it hard to push additional units in the market. Management of debtors can also be evaluated in terms of number of days of debtors that the company is holding compared to others. It is called 'Average Collection Period' or 'Average Days Outstanding'. Debtors Turnover Ratio 2007-08 Sales 3416.16 Sundry Debtors 251.90 Debtors Turnover Ratio 13.56 Average Collection Period 2007-08 Sundry Debtors 251.90 Sales/365 days 9.36 Average collection period (days) 26.91
2006-07 2821.29 235.96 11.96
2006-07 235.96 7.73 30.53
Debtors turnover ratio has improved and collection period has decreased by 3 days. Collection period is expressed in terms of number days. Sometime the denominator is expressed in term of average monthly sales to avoid the complications relating to holidays and working days. Whenever balance sheet values are used in the form of ratio, one can expect marginal variation in ratios of one period to another period. On
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debtors, though the value has marginally increased, there is no abnormality on the collection mechanism. Assessing Short Term Liquidity Liquidity of firm refers to the ability of the company in meeting the short-term liabilities on time. Lack of liquidity often affects production since suppliers may reduce the supply unless old dues are cleared. In such illiquid environment, managerial time often is wasted in handling creditors or finding money. Liquidity can be assessed in two ways: Average time taken to pay the suppliers and proportion of long-term funds used in buying current assets. Average time taken to pay the dues can be computed by following the same logic used in computing average time taken to collect dues from the debtors. Two alternative methods are used in computing this ratio depending on the availability of data. Since sundry creditors are related to purchases, the ratio requires purchase value. If purchase value is not readily available, cost of good manufactured or sold is used as an approximation of this ratio. Since purchase values are normally provided by the Indian companies in the Schedule relating to materials consumed, this ratio is defined as follows. Time taken to pay suppliers' due 2007-08 Sundry Creditors & Acceptances 590.20 Average purchase per month* 163.01 Months taken to pay suppliers' due 3.62
* [Raw materials purchase + packing material purchase + purchase of paints]/12
2006-07 432.11 138.39 3.12
The company avails about 110 days credit from suppliers and during the current year, the company is taking slightly longer period of credit compared to previous years. The payment days increased from 60 days in 2002 to 110 days in 2008. Current Ratio Current ratio measures the amount of long funds used to procure current assets. Suppose a firm requires total gross current assets of Rs. 1000 to run the business. A part of it can be met through suppliers' credit and another part of it can be arranged though short-term loans like working capital loan or commercial paper. Suppose credit facility is available for Rs. 200 and another Rs. 200 is raised through short-term loan. The balance amount of Rs. 600 has to come from long-term funds in the form of equity or loan. In other words, sixty percent of current assets are funded by the long-term funds. The same can be expressed in term of ratio called current ratio. Current ratio is equal to current assets divided by current liabilities. Current liability in this example is equal to supplier credit plus short-term loan. In computing current ratio, some adjustments are required if one uses the Balance Sheet of Indian companies. Normally, current liabilities value shown on the asset side of the balance sheet as a reduction from the current assets, exclude short-term loans.
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Such short-term loans are shown under Loan Funds of Sources of Funds or Funds Employed side of the Balance sheet. So it is necessary to find out the value of shortterm loans from the Loan Funds Schedule and add the same with sundry creditors and current other liabilities. Another issue need to be handled is provisions. Since provisions shown under the heading 'Current Liabilities and Provision' are expenses and other payments to be paid within one year period, they should also be included in computing the current ratio. The schedule on Loan Funds of the company shows that the company has taken a short-term loan of Rs. 13.57 Cr. as on March 31, 2008 (Rs. 48.67 Cr. as on March 31, 2007). The current ratio is computed as follows. Current Ratio 2007-08 Current Assets 832.22 Current Liabilities & Provisions* 965.17 Current Ratio 0.86
* [Current Liabilities and Provision as per balance sheet plus Short Term Loan]
2006-07 712.52 696.92 1.02
An increase in current ratio normally means increase of liquidity position. Normally, current ratio of 2 is considered good since it means current assets are twice that of current liabilities and hence even if there are temporary delays in collections, still current liabilities can be met. At current ratio of 2, the company is bringing 50% of long-term funds for acquiring current assets and only 50% is used through suppliers' credit and short-term sources. A current ratio of 2 normally means that the firm will honour the payments on due dates with a small delay even if 1 out of 2 customers pays their dues. If the current ratio is 1, it is possible for the firm to meet current liability provided current assets are realised on time. Any further delay in realisation of current assets will affect liquidity. In the case of Asian Paints (India) Ltd. the current ratio was not only low but gone down further in year 2008. Before concluding that the liquidity position of Asian Paints (India) Ltd. has been deteriorated, one need to look into the ability of the company in raising funds in short period when there is a delay in realising current assets and also large investments that the company holding in the market. With low debt level of both long-term and short-term in nature, it may not be difficult for the company to get loans to meet such crisis. Also, the top management might want to create such tight liquidity position to make sure prompt collection of dues. Quick Ratio or Acid-test Ratio This ratio compares liquid part of current assets with current liability to measure the liquidity position of the company. Generally, inventories are less liquid. Hence, in arriving at the quick ratio we need to remove the inventory from the current assets and compare the same with current liabilities. Since some part of inventories may be more liquid than other current assets, one has to apply judgement and identify illiquid part of current assets in computing the ratio. Assuming the entire inventory is illiquid and all other components of current assets are liquid for Asian Paints (India) Ltd. the quick ratio is computed as follows. Quick Ratio

Current Assets - Inventory Current Liabilities* Quick Ratio 2007-08 293.25 965.17 0.30 2006-07 670.03 696.92 0.96
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* [Current Liabilities and Provision as per balance sheet plus Short Term Loan]
Quick ratio has declined from 0.96 to 0.30. Normally a quick ratio of 1:1 is accepted. The expectation is if most liquid assets of firm are equal to current liabilities, then the firm would be in a position to meet such liabilities on time. Indian companies balance sheets call for one more adjustment in computing both current ratio and quick ratio. Since investments are shown separately in the balance sheet, it is necessary to identify investments which are liquid in nature and add the same with current assets. Investment shown under short-term investments of the Investments Schedule can be considered for this purpose. As on March 31, 2008, Asian Paints (India) Ltd. has Rs. 197.66 cr. investments in mutual funds and this can be added with current assets while computing current ratio and quick ratio.
5.10 COST OR PROFIT MANAGEMENT

The second important profitability driver is cost or profit management. That is profitability can be improved by cutting cost or moving upward on value chain and selling high-end premium products. Efficiency of the firm in managing cost or profit is measured through profit margin and cost ratios. Profit Margin Since the term 'profit' may mean different things to different users, it is better to be specific in defining profit. Normally, some prefix or suffix is used to define profit. Examples are Operating profit, gross profit, net profit, profit before interest and depreciation, profit before tax and profit after tax, disposable profit, etc. As we are separating the decision on usage of debt and tax planning from operating performance, we define profit margin as Profit Before Interest and Taxes (PBIT) to Sales. This ratio shows profit before interest and taxes earned by the firm per Rupee of sales. Profit Margin (Profit before interest and taxes to Sales) 2007-08 2006-07 Profit before interest and taxes 572.82 416.79 Sales and other income* 3478.74 2861.74 Profit Margin (PBIT to Sales) 16.47% 14.56%
* Since numerator includes other income, denominator should also include other income. Alternatively, other income can be reduced from both numerator and denominator but it might call for further adjustments.
Profit margin has increased from 14.56% to 16.47%, which is a good sign. It shows the company is successfully facing competitive pressure. The reasons for the change in profit margin can be examined through cost ratios. Cost ratios are defined as elements
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of cost divided by sales or cost of goods sold. Such cost ratios can be restricted to selected major cost items or computed as many as possible using cost information available in the Schedules of Profit and Loss account. The following are few major cost ratios of Asian Paints (India) Ltd. expressed as a percentage of Cost of Goods Sold (GOGS). Cost Ratios Material to COGS Employee Cost to COGS Manufacturing, administrative, selling and distribution expenses to COGS* Interest to COGS Depreciation to COGS 2007-08 68.37% 6.80% 24.86% 0.29% 1.81% 2006-07 69.59% 6.58% 24.38% 0.29% 2.19%
* Since the break up of this expenditure is available, more cost ratios can be computed with the help of Schedule L of Profit and Loss Account.
The cost ratios show a decrease in material cost and a marginal increase in other costs.
5.11 LEVERAGE MANAGEMENT

In discussing Return on Total Assets and Return of Equity or Net worth, the importance of debt was highlighted. Debt brings positive effect to equity shareholders if the debt funds are used at a rate (ROI) more than cost of debt or interest rate. However, such positive difference should not be leveraged too much since the negative impact of debt is also high when the return declines and particularly below the cost of debt. In other words, debt adds risk to firm and such risk is called financial risk. The source of such risk is commitment on the part of management to pay fixed interest rate irrespective of profit or loss of the company. Financial institutions, banks and other lenders of long term debt are concerned about the financial leverage of the company. They expect the firm to manage the leverage such that it doesn't affect the solvency of the firm. Two ratios namely debt to total capital or debt to equity and debt service coverage ratios are normally used for this purpose. Debt to Total Capital or Debt to Equity Ratio Debt to total capital or debt to equity ratio measures the proportion of debt in the capital structure. If the proportion is very high, it shows that the equity holders transfer most part of the risk to debt holders. Prospective lenders would avoid such firms. Lenders work out debt capacity of the firm and then find out how much of debt capacity that the firm has already used before lending new debt. Debt capacity can be related to cash flows or simply a policy statement. Earlier, prior to 1990, development financial institutions and banks restrict the lending to an extent of 66.67% or two-thirds of total capital. Today with increased business risk, many companies are reluctant to have a debt to total capital of more than fifty per cent.
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Suppose the acceptable level of debt to total capital is 50%. If the firm's existing debt to total capital is 30%, the firm has additional debt capacity to an extent of 20% of the total capital for the given equity level. It can increase the debt capacity provided it is able to increase the equity. In computing debt capacity, normally long-term debt is considered. As stated earlier, Asian Paints (India) Ltd. has reduced the debt level significantly in recent years and hence improved its additional borrowing capacity. The debt to total capital and debt to equity ratio of the company are as follows. Long-term Debt to Total Capital Ratio 2007-08 Long-term Debt 94.70 Total Capital 1054.72 Long-term debt to total capital ratio 8.98% Long-term Debt to Equity Ratio 2007-08 Long-term Debt 94.70 Equity or Net Worth 928.50 Long-term debt to equity ratio 10.20% 2006-07 125.67 891.90 14.09% 2006-07 125.67 744.08 16.89%
Debt Service Coverage Ratio Debt service coverage ratio (DSCR) evaluates whether the firm has adequate cash to meet the pre-determined financial obligations. Financial obligations are mainly interest liability, lease rentals and amount payable during the year on debt (instalment due for the year). Such financial obligations are compared with profit before depreciation, interest and taxes (PBDIT) or cash flow from operations. Since lease rentals are deducted to compute PBDIT, such lease rentals are to be added back to maintain consistency between numerator and denominator. DSCR for Asian Paints (India) Ltd. is as follows. Debt Service Coverage Ratio (DSCR) 2007-08 616.59 PBDIT [Interest + Lease Rent + Installment ] 44.97 Debt Service Coverage Ratio 13.71 Debt Service Coverage Ratio (DSCR) 2007-08 [Cash Flow From Operations + Lease] 465.57 [Interest+Lease Rent+Short-term Loan] 44.97 Debt Service Coverage Ratio 10.35 2006-07
462.21
73.77 2.67 2006-07 319.16 73.77 4.33
* The company has no leased assets; short-term loan are considered as repayment obligations for the year; no part of long-term debt are due during the current year as per Schedule C.
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Since loan and other fixed obligations are low, DSCR for Asian Paints (India) Ltd. is very high. Suppose the preferred DSCR is 2 or more, then the borrowing capacity of the company is several times of the current borrowing level. In Exhibit 5.5, all the ratios are shown in a chart popularly called DuPont Chart. Through DuPont chart, one can get quick insight on the health of the company, compare the current year performance of the company with previous year and compare the health of the company with industry average or competitor. Exhibit 5.6 summarises the financial ratios of Asian Paints (India) Ltd. for the year 2007-08 and 2006-07 in DuPont Chart. A quick analysis of the Exhibit 5.6 shows that the company has shown improvement in all areas of performance except profit margin and current assets management. The primary reason for decline in profit margin is increase in raw materials cost and employees cost. If the company maintained the profit margin of the previous year (14.15%), then return on total assets would have increased marginally to 40.61%. In other words, a decline in profit margin of 0.07% has a marginal negative impact on the overall profitability of the firm mainly on account of better asset management by the company. Liquidity of the firm has improved compared to the previous year but payment to suppliers takes longer period than earlier. Since the cost of debt is significantly lower than return on total assets, leverage contributed positively to the shareholders' return. However, the impact is not high since leverage is very low. Impact of tax planning has no impact on profitability. Declining trend in deferred tax indicates that the company has started paying of the tax deferred earlier. Unless growth is restored, it will have an impact on future cash flows.
5.12 INTERFIRM COMPARISON

Kansai Nerolac Paints Ltd.(GNPL), the Indian subsidiary of Japan based Kansai Paint Co. Ltd, is manufacturing and selling decorative paints as well as industrial paints, marine paints, enamels, varnishes, coatings, resins etc. It is the market leader in the Industrial paints segment. The company markets its products under the brand names Nerolac, Glossolite, Goody, Allscapes, Excel. Though the company was started some twenty two years before Asian Paints (India) Ltd., it is roughly half the size of Asian Paints (India) Ltd. and is also the second largest paint company in India. In Exhibit 5.7, the financial performance of Asian Paints (India) Ltd. is compared with Kansai Nerolac Paints Ltd. An independent analysis on the performance of Kansai Nerolac Paints Ltd. shows that the company is doing well and particularly, it has shown major improvement in 2007-08 compared to previous years. However, the performance of Asian Paints (India) Ltd. is better on several segments. Asian Paints derives its strength particularly by managing the assets. Asian Paints improved return on assets is derived by higher level of asset turnover ratio when both companies have achieved a similar profit margin. A further analysis of asset management shows an interesting trend. While Kansai Nerolac has performed better on fixed asset management, Asian Paints has reported superior performance on current assets management. Kansais major problem is debtors
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management. Kansai Nerolac has narrowed down its gap with Asian Paints on profitability by having higher debt levels and better tax planning. Overall, Asian Paints is not only the market leader in paints industry but also shows superior financial performance. Such superior performance is also reflected in the stock prices of Asian Paints (India) Ltd. The price-earnings (P/E) ratio of Asian Paints (India) Ltd. as on March 2008, was about 75% more than Kansai Nerolac Paints Ltd. Asian Paints 1200 39.12 30.67 96.80 12.40 Kansai Nerolac 732 42.41 17.26 220.29 3.32
Market Price (31/03/2008) Earnings Per Share Price - Earnings Ratio Book Value per share Price Book Ratio
5.13 SUMMARY
Financial statement analysis completes our journey on understanding financial statements. But yes, the interpretation and analysis of the statements begin. While financial statements provide wealth of information to users reflecting various activities of the organisations, financial statements integrates them and assess whether the business has achieved the goal of maximising the wealth of the shareholders. Financial statements are analysed in several ways depending on the objective of such analysis. Common size analysis, trend analysis and financial ratio analysis are three important methods. The analysis of financial statements consists of a mixture of steps that interrelate and affect each other. It would lead to wrong conclusion and strategy if the analysis were done on piecemeal basis. For instance, higher turnover ratio doesn't mean good for the company since the company might aggressively be selling by cutting down the price. Such aggressive selling could influence the collection or increase the bad debts. An integrated analysis would be useful in this context. The goal of wealth maximisation is achieved when the firm increases ROE without increasing the financial and business risk. At the firm level, managers need to maximise the return on total assets (ROTA). This profitability measure driven two drivers namely, asset management and cost management. Asset management refers to the ability of the firm to generate maximum revenue for a given level of assets. Cost or profit management refers to ability of the firm in controlling the cost or maximising profit margin. There are two possible strategies that firms can follow to improve cost minimisation or profit maximisation. Cost leadership requires the company to spend their efforts to reduce the cost and then set competitive price to acquire larger volume or market share. Product differentiation strategy would require the firm to move upward on value chain and get premium price and profit. Companies generally pursue both strategies and develop products for different segments. For instance, Asian Paints (India) Ltd., the company we have analysed in this book, has developed a range of products and services over the years to serve the needs of different segments of market. Managers, who have access to
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more information, can measure profitability for each product or brand or division or plant or region. The primary purpose of accounting and accounting information system should enable the managers to get such details We conclude our book with one of the most powerful statements that we have come across on this aspect. Over the long-term, it is absolutely essential to be a lower cost supplier. To stay competitive, inflation-adjusted cost of producing and supplying any product or service must continuously trend downward. The true cost and profit picture for each product/market segment, and for all key customers must always be known. B. Charles Ames and James D. Hlavacek Harvard Business Review, Jan-Feb, 1990
Exhibit 5.5: DuPont Chart - Financial Statement Analysis

Impact of Tax Planning Deferred Tax/Total Funds Return on Equity* PAT / Net Worth Impact of Tax Planning Deferred Tax/Total Funds
Impact of Leverage (ROI - I) * Debt / NW
Return on Equity PBT/Net Worth Return on Total Assets PBIT / Total assets
Leverage or financial risk Debt to Net Worth
Asset Turnover Ratio (ATO) Sales / Total Assets Fixed Asset Turnover Sales / Fixed Assets Payment Days
Creditors/Purchase per month
Profit Margin PBIT / Sales
Current Asset Turnover Sales/Gr.Current Assets Inventory TO CGOS / Inventory Debtors Turnover Sales / Debtors Collection Period 365 or 12 / Debtors TO
Raw Materials Cost to COGS

Raw Materials Cost/ COGS Employee Cost to COGS Employee Cost/ COGS Operating Expenses to COGS Operating Expenses/ COGS
Current ratio CA/CL
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Exhibit 5.6: DuPont Chart - Asian Paints (India) Ltd.

2007-08 2006-07 2007-08 2006-07 2007-08 2006-07
Deferred Tax/Total Funds 2.99% 2.48% Return on Equity* 42.35% 36.56% Impact of Tax Planning 2.83% 0.75%
Impact of Leverage 6.49% 8.36%
Return on Equity 60.80% 55.09% Return on Total Assets 54.31% 46.73%
Leverage or financial risk 0.14 0.20
Asset Turnover Ratio (ATO) 3.30 3.21 Fixed Asset Turnover 7.97 8.42 Payment Days 3.62 mths 3.12 mths Current ratio 0.86 1.02 Current Asset Turnover 4.10 3.96 Inventory TO 4.48 4.78 Debtors Turnover 13.56 11.96 Collection Period 27 days 31 days
Profit Margin 16.47% 14.56%

68.37% 69.59%
Employee Cost to COGS 6.80% 6.58%
Manufacturing Exp to COGS 24.86% 24.38%
137 Exhibit 5.7: DuPont Chart - Asian Paints vs. Kansai Nerolac
CHAPTER 5 Analysis of Financial Statements Asian Paints Kansai Asian Paints Kansai Asian Paints Kansai
Deferred Tax/Total Funds 2.99% -1.53% Return on Equity* 42.35% 18.10% Impact of Tax Planning 2.83% -0.55%
Impact of Leverage 6.49% 3.48%
Return on Equity 60.80% 28.70% Return on Total Assets 54.31% 25.22%
Leverage or financial risk 0.14 0.15
Asset Turnover Ratio (ATO) 3.30 2.10 Fixed Asset Turnover 7.97 6.78 Payment Days 3.62 mths 2.42 mths Current Asset Turnover 4.10 3.35 Inventory TO 5.28
Profit Margin 16.47% 12.02%

68.37% 59.14%
4.45
Employee Cost to COGS 6.80% 5.34%
0.86
Current ratio 1.66
Debtors Turnover 13.56 6.59 Collection Period 27 days 55 days
Operating Expenses to COGS 24.86% 32.26%

Financial Statements and Analysis IIMB

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Financial Statements and Analysis IIMB

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Financial Statements and Analysis

4. Cash Flow Statement

5. Analysis of Financial Statements

M S Narasimhan Email: msn@iimb.ernet.in