Financial Statement Analysis

Financial Statement Analysis

Financial statement is simply keeping the accounts.

One would usually find me do some kind of accounting every month end after I receive my salary:

Lets me take you through my 3 month accounting

This is done to check how much money I have spent during the month and how much I could save. The above table is a representation of an Income statement.

My monthly saving would change depending on how prudently I spend my money. There are months I am reckless while spending (Jul’09) and have borrowed money, used credit card extensively and there are months where I have a surplus (May’09).

Having completed one year with SBI I now wanted to check how I have spent the money, how much have I invested, how much I have borrowed, how much do others owe me, how much do I owe them. Just to know how much was I worth.

So I set out to scrabble for each investment made, money spent. Finally I prepare a statement which turns out be the following:

I have received Rs. 384000 as monthly salary and got a bonus of Rs. 180000

This calculation immediately made me realize I needed to be worth another Rs. 9,99,99,79,000 to be called a billionaire.

So what is an asset?

Asset is anything which you own (liable to own) and has monetary value (quantified in rupees). If I have lent money to you, it is still my asset as you have an obligation to pay me back that sum.

What is a Liability?

Liability is anything which I have borrowed has monetary value and has an obligation to repay. I have Vodafone post paid mobile connection and have an obligation to pay for the services (call, sms, caller tune) provided.

Portfolio Management '

Portfolio Management

Portfolio management is all about money management. When you receive your salary you plan how to manage your savings and investments. This planning is what can be simply understood as portfolio management.

Let us take an example. I recently received a bonus of Rs. 1,40,000. Now I was planning how to manage the investments.

The options I have are:

1. Investing in G-sec 3 year paper offering a 6.5% return ( No credit risk as it has sovereign backing i.e. it is the risk free rate)
2. Investing in Term Deposits of 3 years in Nationalized Bank offering 8.5% return (Small risk at all as the bank is Government owned – trust factor high)
3. Investing in Term Deposits of 3 years in Private Banks offering 9.00% return (Medium risk as the bank is privately held – trust factor lower)
4. Invest in a 3 year rated NCD (bond) of a pharmaceutical company offering 9.15% annual coupon - return ( Moderate high risk)
5. Investing in Equity Mutual Fund that has offered a CAGR return of 20% last 5 years, though last year it gave a negative return of -15%. ( High Risk)
6. Investing in Direct Equity where returns can vary from -100% to 400% (Very high risk)

We observe that investment with higher risk offer higher returns.

But I also observe the inflation in current period is 3% i.e. the prices of the commodities are increasing at 3%. So the real interest I would receive on my investments would be much less.

How?

Suppose I am considering whether to Spend Rs. 10000 and buy a mobile this year or invest the money at 6.5% G-sec (nominal risk free rate) and postpone the purchase for the next year.

If I invest in G-sec I would receive Rs.10650 after year 1. But the inflation level is at 3%. So the same mobile phone would be available for Rs. 10300.

So effectively I have gained Rs. 350 by postponing my purchase.

What is the real risk free rate?

At the first look one would say the risk free rate is 3.5% (Nominal risk free rate – inflation). But it is normally a little less than 3.5%.

What is the risk?

The risk is danger of losing money (Capital Erosion). This could happen due to many of the following reasons. I would do a quick SWOT analysis of the alternatives.

1. Counterparty Risk: Here the level of trustworthiness matters. We believe the government for sure would not default on its obligations. Here the Counterparty risk is almost zero.
2. Business Risk: When I am consider buying the NCD of pharmaceutical firm I have to look into its business model, future growth and industry outlook.
3. Exchange rate risk: If the pharmaceutical company has major business abroad, the currency fluctuations would impact its earnings.
4. Liquidity Risk: If I make the investment in the NCD whether I would be able to sell the same in the secondary market. This risk is also is relevant to stocks. Stocks with high liquidity (i.e. no. of shares that get traded in a day) could be sold easily at the exchange.
5. Political Risk: If a government abroad where the pharmaceutical company has operations intends to impose heavy duties on imports, it is a political risk.
6. Financial risk: If the pharmaceutical company is increasing its Debt exposure to 80% from 50% there will be significant increase in interest expense (the amount to service the 9.15% interest offered). This will heavily impact its net earnings. This reduction in earnings is a financial risk.

What is security market line? (The high risk - high return game)

From the above example each alternative offers a return at a level of risk. If we plot it, then the line representing the same is called Security market line.














The slope of this line would change with the return expected for a given level of risk.


Level of risk

The level of risk taking ability differs from person to person.

1. Usually people who are young with fewer responsibilities (No spouse, no children) on their shoulders would look at riskier investments. (Age is a factor)
2. If I have surplus funds at my disposal I would look to invest in riskier assets. (Income / wealth matters)
3. I belong to a risk-averse south Indian family and would invest in less riskier assets than a member from Business family. (Family matters)
4. The last year stock market debacle saw me lose large chunk of my wealth. I am psychological dis-inclined to invest in stock markets (Psychology also matters)

My investment objectives

The investment objectives would depend on whether

1. If I look to preserve my wealth I would invest in least risky assets (G-sec papers).
2. I look to make some quick fast money I would invest in stocks.
3. If I look to earn moderate returns and generate income of my investment I would invest in Pension Funds (I am associated with the India’s largest pension fund company as on 30th july 2009).
4. My investment objective could also be a combination of all the above three.

My investment constraints

When I am planning an investment I also have some constraints

1. First is limited money to invest ( Only Rs. 1,40,000)
2. For what time period I am planning to lock in my amount before I use it for my consumption
3. Whether I would get tax-exemption under 80C and if yes how much for my choice of investments.
4. Does the government/ law mandate I make donations to PM relief fund every year.
5. Whether I personally approve of my investments in tobacco, Casino running, Liquor producing company or I follow the shariah norms

So what do I do?
I remember Mr. Markowitz who developed the portfolio modeling technique. His golden words were:

1. If A and B offer the same return but B is riskier then please choose A. It maximizes your fund utility.
2. If C offers a return in the range of -10% to 20% and D offer -30% to 50% then please choose according to your risk aversion levels taking variance and standard deviation into account.
3. Please calculate the return you expect out of your investment and probability that such a return would get generated.
4. All the points are nothing but weighing the Risk Reward on your investment alternatives and by following these you would be able to develop an optimal portfolio on efficient frontier (nothing but a set of optimal portfolio according to risk appetite of investors).

Economics

What is Economics?
Economics is a science. It deals with the what, how, when of resource utilization by the humans.

What is Price Elasticity?
Price elasticity is reflects the price one is ready to pay for a quantity of good.

Now let us suppose for example, how much would I pay for a shirt

When I enter the UCB (United Colors of Benetton) shop. Normally the price range a one shirt is Rs. 2800-Rs 3000. Given the price of shirts I would have normally purchased only 1 shirt. But that particular day the shop announces a discount of 25% on each shirt. I make a quick calculation and think that the offer is attractive and hence I can purchase 2 shirts instead of 1.
Now the shop keeper tells me if I buy 3 shirts I can avail a discount of 35% on each shirt. This seems even more attractive. I finally make a purchase of 3 shirts instead of 1.
So price elasticity is simply the price I am ready to pay for a quantity of good.













Usually the classification goes as products that are elastic (the example above) and some that are inelastic and unit elastic.

Salt is inelastic because even if the Rs 15 per KG bag is offered to me at Rs. 5 I would not purchase extra bags of salt.

Unit elastic is when normally I pay Rs. 100 for 1 kilo of basmati rice but if the same is available for Rs. 80 per kilo I would buy 1.2 kilos of the rice.

Derivative

What are Derivatives?

It had always been one of the toughest topics while I was in my twelfth standard. But I guess this topic is much different. Here we talk about financial derivatives.

Derivative is simply a thing which derives its value out of something else.

Let us suppose I have a piece of land in Chennai. Now the price of the land would depend on a lot of things situated around it.
If a huge mall, a residential complex and an IT SEZ surround my piece of well developed land the market price of the piece of land would be high.
If the same piece of land had been ill developed surrounded by Garbage dumping ground it would have been available for cheap.

So the price of the land is a derivative of the development in and around it. That is, when the price of local area increases the price of my land increases.

Here the underlying asset is the local area encompassing the land.

What are Swaps?

Now I get into lease contract with someone who has Rs. 10 lac with him. I tell him it would be a 10 year lease.
Since I want to avoid the risk of fluctuating prices I ask lessee to pay me Rs. 1 lac every year as part of the lease instead of yearly changing market related rent.

So I have transferred the risk of the price changes with a fixed payoff from the lessee.
The lessee expects the prices of properties to appreciate in the future and intends to make gains from yearly assumed rising prices from the use of the property.

This is called a swap in positions. How?

Instead of me charging the yearly changing market related rent (variable / flexible) I decide to take a fixed amount of Rs. 1 lac. (Fixed) i.e I have swapped my position from flexible to fixed.

Now the lessee who had a fixed amount Rs. 10 lac with him (Fixed) has shifted his position to flexible on the assumption that the trend of property rentals is upwards.

What are options?

Options are nothing but a choice offered to the buyer of the option.

If Iessee requests inclusion of a clause in the lease that we shall terminate the lease if the market rentals decrease by more than 10% from the current Rs. 1lac, at the end of 5 years. This is called a Call option with the lessee.

Why Call?

Call because lessee has been given the right to foreclose/ call back/buy back our existing agreed position. I am the call writer here.

I tell him to provide such a provision I would charge an extra sum of Rs. 25000 in the first year. This is the Option price which lessee would have to pay.

I request the lessee in return that I would like an inclusion of clause that we shall terminate the lease if the market rentals increase by more than 20% from the current Rs. 1 lac, at the end of 5 years. This is called put option.

Why Put?

Put because the lessee has offered the right to me to foreclose/ give back/ our existing agreed position. lessee is the put writer here.

Lessee tells me that such a provision would amount to a deduction of Rs. 15000 (Put option price) from the Call Option price of Rs. 25000.