2 financial statements_and_cash_flows_slides - Basic Finance

ANALYSIS OF FINANCIAL STATEMENTS AND CASH FLOWS

TOPIC 2

Learning Objectives

1. Understand the needs of financial statements.

2. Distinguish between income statement, balance sheet and statement of cash flows and identify the items in those statements.

3. Explain the usage of financial ratio analysis in financial statements analysis.

4. Calculate liquidity ratio, asset management ratio, profitability ratio, leverage ratio and market value ratio to evaluate a company’s performance.

5. Describe the limitations of financial ratio analysis.

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Needs of Financial Statements • In Malaysia, Company Act 1965 required companies to

expose their annual report to Company Registrar.

• Among the content of the report is financial statement, covers, income statement, balance sheet, cash flow statement, and explanation notes about those accounts.

• Financial statements users can be classified into 2 types:

• Internal users- persons employed by the firm

• External users- potential investors, the Government, lenders, the public etc...

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INCOME STATEMENT • Also known as Profit and Loss Statement. • It measures the results of a firm’s operation over a specific

period. • The bottom line of the income statement shows the firm’s profit

or loss for a period. • Usefulness of income statement: -Evaluate the past performance of the firm. -Provide a basis for predicting future performance.

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Income Statement Terms

• Revenue (Sales)-Income from sales of products or services

• Cost of Goods Sold (COGS)-Cost of producing the goods/services to be sold

• Operating Expenses-Expenses related to marketing and distributing the product or service and administration cost

(Example: marketing & selling, general & administrative, depreciation expenses)

• Financing Costs-The interest paid to creditors/bondholders

• Tax Expenses-Amount of taxes owed, based upon taxable income

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SALES

- Cost of Goods Sold (COGS)

GROSS PROFIT

- Operating Expenses

OPERATING INCOME (EBIT)

- Interest Expense

EARNINGS BEFORE TAXES (EBT)

- Income Taxes

EARNINGS AFTER TAXES (EAT)

- Preferred Stock Dividends (if any)

NET INCOME (EARNING AVAILABLE FOR STOCKHOLDERS)

Income Statement Form

Financing

Activities

Operating Activities

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Example of Income Statement

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Three additional important issues:

• Operating income is NOT affected by how the firm is financed.

• Interest expense (financing cost) is subtracted from income before computing the firm’s tax liability. i.e Interest is not taxable expenses.

• Firm that has a positive net income does NOT necessarily mean it has any cash

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BALANCE SHEET • Provides a snapshot of firm’s financial position at a particular date. • It includes three main parts: assets, liabilities and equity.

Assets (A) -Productive sources that give return to the company. Liabilities (L) - Creditors claim Equity (E) - Owner claim A = L + E

• The items are recorded at historical cost, so the book value of a firm may be very different from its market value.

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how those resources are financed

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Balance Sheet Terms: Assets • CURRENT ASSETS The assets will not stay in the business for long (relatively

liquid), or expected to be converted into cash within 12 months. Cash – currency or coins owned by company either in bank

account or hand. Marketable security – investment on short term financial

assets with high liquidity. Example: T-bill, bankers acceptance, etc.

Accounts receivable – payments due from customers who buy on credit.

Inventory – raw materials, working in process and final products that will be sold.

Prepaid expenses – Items paid for in advance

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• FIXED ASSETS The assets are held for more than one year. Fixed assets

typically include: plant and machinery, building and land. • OTHER ASSETS Assets that are neither current assets nor fixed assets. They

may include intangible assets that can’t be touched or saw physically such as pattern, right and goodwill.

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Balance Sheet Terms: Assets

Balance Sheet Terms: Liabilities (Debt) • LIABILITIES are money borrowed and must be repaid at

predetermined date.

current liabilities (must be repaid within twelve months)

long-term liabilities (repayment time exceeds one year).

• CURRENT LIABILITIES (Short-term Liabilities)

Liability that must be paid within 12 months.

Accounts payable (Credit extended by suppliers to a firm when it purchases inventories)

Accrued expenses (Short term liabilities incurred in the firm’s operations but not yet paid for)

Short-term notes (Borrowings from a bank or lending institution due and payable within 12 months)

• LONG-TERM LIABILITIES/DEBTS Covers loan from bank or other sources that provide capital for

liability term more than 1 year. (Example: buying machinery and building for period of 25 to 30

years using bank loan)

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Balance Sheet Terms: Liabilities (Debt)

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• EQUITY Shareholder’s investment in the firm in the form of preferred

stock and common stock. Preferred Stock (received dividend in fixed amount) Common Stock Treasury Stock (stock that has been re-purchased by the firm) Retained Earnings (earnings retained and will be reinvest in

the firm) Paid in Capital (money that a firm gets from potential

investors in addition to the stated value of the stock)

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Balance Sheet Terms: Equity

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Balance Sheet A = L + E Assets Liabilities (Debt) & Equity

Current Assets

Cash

Accounts Receivable

Inventories

Prepaid Expenses

Fixed Assets

Machinery & Equipment

Buildings and Land

Other Assets

Copyrights, Goodwill & patents

TOTAL ASSETS

Current Liabilities Accounts Payable Accrued Expenses Short-term notes Long-Term Liabilities Long-term notes Mortgages Equity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings Treasury Stock

TOTAL LIABILITIES + EQUITY 14 WRMAS

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Example of Balance Sheet

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• Definition: Shows the changes of cash for the company in certain period of time.

• Profits in the income statement are calculated on “accrual basis” rather than “cash basis”.

• Thus profits are not equal to cash.

• Accrual basis is the principle of recording revenues when earned and expenses when incurred, rather than when cash is received or paid.

– Thus sales revenue recorded in the income statement includes both cash and credit sales.

• Treatment of long-term assets: Asset acquisitions (that will last more than one year, such as equipment) are not recorded as an expense but are written off every year as depreciation expense.

STATEMENT OF CASH FLOWS

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Divided sources and uses of cash into THREE components: Cash flow from operations (ex. Sales revenue, labor expenses) Cash flow from investment (ex. Purchase of new equipment) Cash flow from financing (ex. Borrowing funds, payment of div)

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Statement Of Cash Flows

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Income Statement Conversion: From Accrual to Cash Basis

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• Two steps: – Add back depreciation (as it is a non-cash expense) to net income – Subtract any uncollected sales (i.e. increase in accounts receivable)

and cash payment for inventories (i.e. increase in inventories less increase in accounts payables)

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Example: Statement Of Cash Flows

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USES OF FINANCIAL RATIO: Within the Firm

• Identify deficiencies in a firm’s performance and take corrective action.

• Evaluate employee performance and determine incentive compensation.

• Compare the financial performance of different divisions within the firm.

• Prepare, at both firm and division levels, financial projections.

• Compare performance against other firms (competitors) or industry standards

• Evaluate the financial condition of a major supplier

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USES OF FINANCIAL RATIO: Outside the Firm used by

• Lenders in deciding whether or not to make a loan to a company.

• Credit-rating agencies in determining a firm’s credit worthiness.

• Investors (shareholders and bondholders) in deciding whether or not to invest in a company.

• Major suppliers in deciding whether or not to grant credit terms to a company.

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Types of Analysis

Trend analysis

Compare the current ratios with ratios in previous year. It covers some time period so the analyst can see the achievement flow for the company in longer period.

Comparison analysis

Compare the company’s ratios with ratios of other equivalent companies. If there is industry ratios, it can be used as a guide to evaluate the position of the company in the industry.

Benchmarking

Compare the company’s financial position with other competitors.

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Analyzing Financial Performance: Ratio

1. Liquidity Ratio 2. Asset Management/Activity Ratio 3. Profitability Ratio 4. Leverage Ratio 5. Market Value Ratio

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Balance Sheet (For Ratios)

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Income Statement (For Ratios)

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LIQUIDITY RATIO

How liquid is the firm?

Liquidity shows the ability of the firm to pay its short term debt in the time given. It indicates the ease with which non-cash assets can be converted to cash to meet the financial obligations.

Generally, bigger liquidity ratios, give a better position of the firm’s liquidity.

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Liquidity Ratio

Working capital uses to measure the ability of a business to pay it short term debt by current assets and shows the amount of leaved current assets after current liabilities has been paid.

Working Capital = Current Assets – Current Liabilities

Davies Example?

The bigger the value the better the business because it is able to pay its short term debt and it has higher current

assets for its operation.

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Current ratio- compares cash and current assets that should be converted into cash during the year with the liabilities that should be paid within the year. Davies has ____ in current assets for every $1 in current liabilities. The higher of this ratio means the business financial is better

where it has enough liquid asset of its operation.

Current ratio = Current asset

Current liability = X Times

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Liquidity Ratio

Davies Example?

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= X Times

Quick ratio (known also as asid test) -Compares cash and current assets (minus inventory) that should be converted into cash during the year with the liabilities that should be paid within the year.

What is the rationale for excluding inventories? Davis has ____ in quick assets for every $1 in current liabilities.

The higher the ratio shows the business has enough quick assets to pay its short term debt immediately.

Quick ratio = Current asset - Inventory

Current liability

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Liquidity Ratio

Davies Example?

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ASSET MANAGEMENT RATIO

• How efficiently and effectively a company is using its assets in the generation of revenues?

It uses to identify the efficiency and effectiveness of the firm in managing its assets.

The firm should make basic decision about total investment in account receivable, inventory and fixed assets.

The firm is responsible to use the assets efficiency and effectively.

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Average collection period determines the average days for the firm to collect its accounts receivable from customers in certain period.

How long does it take to collect the firm’s receivables?

A lower number of days is better because this means that the company gets its money more quickly.

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Asset Management Ratio

Davies Example?

On average, Davies needs ____ days to collect payment on accounts receivable.

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𝑨𝑪𝑷 = 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝒓𝒆𝒄𝒊𝒆𝒗𝒂𝒃𝒍𝒆

𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔 /𝟑𝟔𝟓 = 𝒅𝒂𝒚𝒔

ARTO = Credit sales = Times

Accounts receivable

Account Receivable Turnover determines the ability of the business to collect debt from its customers. It shows the number of account receivable turn in a year. A turn covers the starting period of account receivable until the due of the account.

Higher is better because it shows the business can collect its credit accounts immediately. If low, firms needs to take a look at

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Asset Management Ratio

Davies Example?

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= TIMES

Inventory Turnover shows how many times per year the inventory will be sold and replaced.

How many times is inventory rolled over per year?

The higher turnover means the firm in better position because it shows the quick inventory movement. Inventory can be sold quickly and replace back immediately.

Inventory

turnover =

Cost of goods sold

Inventory

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Asset Management Ratio

Davies Example?

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On average, ____ times passed between the acquisition and sale of inventory.

Fixed Asset Turnover shows the efficiency of the firm in using fixed asset in generating sales.

Davies generates ____ in sales for every $1 invested in fixed assets.

The higher is better because it shows the effectiveness of the

firm to produce sales from its fixed assets.

= TIMES Fixed asset turnover = Sales

Total fixed assets

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Asset Management Ratio

Davies Example?

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Total Asset Turnover shows the efficiency of the firm to use its assets to generate sales.

Davies is generating ____ in sales for every $1 invested in assets.

= TIMES

The higher is better because it shows the effectiveness of the firm to use its assets to generate sales.

Total asset turnover = Sales

Total assets

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Asset Management Ratio

Davies Example?

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PROFITABILITY RATIO Are a company has an ability to generate profits relative to

sales, assets and equity?

It shows a company's overall efficiency and performance.

When these ratios are higher than a competitor's ratio or than the company's ratio from a previous period, this is a sign that the company is doing well.

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Gross Profit Margin looks at cost of goods sold as a percentage of sales. It shows firm's ability to turn a dollar of sales into profit after the cost of goods sold has been accounted for.

= %

Higher ratio is better because it indicates that the firm is operating efficiently after sales costs are subtracted.

Gross profit margin = Gross Profit

Sales

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Profitability Ratio

Davies Example?

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For every $1 of sales, ____ of gross profit was made OR costs of goods sold consumed ____ of every sales dollar.

Operating Profit Margin examines how effective the company is in managing its cost of goods sold and operating expenses that determine the operating profit (EBIT).

= %

Higher ratio is better because it indicates that the firm is managing its operating expenses efficiency

Operating profit margin = EBIT

Sales

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Profitability Ratio

Davies Example?

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For every $1 of sales, ____of EBIT was generated.

= %

Net Profit Margin determines profit earns from every dollar of sales after all expenses, including cost of good sold, sales expenses, general and admin cost, depreciation, interest and tax completely paid.

The higher of this ratio is better because it shows the reducing in expenses or cost in producing sales

Net profit margin = Net income

Sales

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Profitability Ratio

Davies Example?

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For every $1 of sales, ____of profit was generated.

= %

Return on Asset (ROA) determines the effectiveness of management in using their assets to generate income.

The higher of this ratio is better because it shows the firm is more effective in using their assets to generate sales.

Return on asset= Net income

Total assets

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Profitability Ratio

Davies Example?

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For every $1 of assets, ____ cents of profit was generated OR Davies has a NI of ____ for each dollar of total assets.

= %

Return on Equity (ROE) determines the efficiency of the firm to generate income for its shareholder.

Are the Firm’s managers providing a good return on the capital provided by the shareholders?

Higher of this ratios is better because it shows the firm is able to produce higher profit to its owners.

Return on equity = Net income

Total equity

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Profitability Ratio

Davies Example?

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For every $1 invested by shareholders, ____ of additional wealth (profit) was generated OR Davies has a NI of ____ for each dollar of total equity.

LEVERAGE RATIO

Does the firm finance its assets by debt or equity or both?

Leverage ratio shows the ability of the firm to fulfill its responsibility or obligation to their creditors.

This ratio determines the effectiveness of management in using and managing capital.

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Debt ratio = Total debt Total assets = %

Debt Ratio shows the percentage of firm’s assets that financed by debt (implying the balance is financed by equity).

The lower is better because the less total debt the business has in comparison to its asset base (high ratio-in danger of becoming

insolvent and/or going bankrupt) 43

Leverage Ratio

Davies Example?

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Davies finances ____ of firm’s assets by debt and ____by equity.

Debt to Equity Ratio measures the percentage of liability covers by equity.

Total debt DOE = Total equity

= %

The lower of this ratio is better because it indicates a safer investment to potential owners of the company.

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Leverage Ratio

Davies Example?

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Davies finances ____ of firm’s equity by debt OR For every dollar of Davies owned by the shareholders, Davies owes ____ to creditors.

TIE = Operating profit (EBIT)

Interest expense

= TIMES

Times Interest Earned (TIE) measures how many times the firm

has profit to pay interest expenses. This ratio indicates the

amount of operating income available to service interest

payments.

The higher of this ratio is better because it shows the firm is able to pay the interest expenses.

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Leverage Ratio

Davies Example?

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Davies operating income are ____ the annual interest expense OR ____% of the operating profits goes towards servicing the debt.

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MARKET VALUE RATIO Are the firm’s managers creating shareholder value? Ratios relate an observable market value, the stock price, to

book values obtained from the firm's financial statements.

Earning Per Share represents the portion of a firm's earnings, that is allocated to each share of common stock.

A high EPS is better because it is capable of generating a significant dividend for investors

Earning Per Share= Net income

No. of Share outstanding = $

Davies Example?

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Davies generated profits of ____ for each share issued.

Price-Earning = Price per share

Ratio Earning per share

= TIMES

Price-Earning Ratio (P/E) indicates how much investors are

willing to pay for $1 of reported income.

A high P/E ratio is better because it shows that investors are anticipating higher growth in the future.

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Market Value Ratio

Davies Example?

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To buy one share investors are prepared to pay ____ the profit earned per share.

Price-to-book Ratio = Price per share

Book value per share

where

Book Value Per Share = Total Equity

No. of share outstanding

Price (Market)-to-book-Ratio measures how much a company

worth at present, in comparison with the amount of capital

invested by current and past shareholders into it. It shows

firm's success in creating value for its stockholders.

A ratio greater than 1 indicates that the shares are more valuable than what the shareholders originally paid.

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Market Value Ratio

Davies Example?

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LIMITATIONS OF FINANCIAL RATIO ANALYSIS

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Ratios can provide meaningful comparisons of companies in similar industries. Also, keep in mind that ratio analysis does not tell the entire story. Why?

1) Many large firms operate in multiple lines of business. It is difficult to find a meaningful set of industry-average ratios.

2) Seasonal factors can also distort ratio analysis.

3) Industry averages may not provide a desirable target ratio.

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4) A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company. A high or low ratio does not automatically lead to a specific favorable or unfavorable conclusion.

5) Different accounting method among the firm results different calculation of ratios. For example, in calculating inventory and depreciation.

6) Industry average is only estimation and guidelines. Industry average is not necessarily a desirable target and required ratio. It only illustrates the firm position in industry.

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Bonus Questions

1. You know that the return on equity (ROE) is 18%. If sales were $4 million, the debt ratio was 0.40 and the total debt is $2 million, What is return on assets (ROA)?

2. You are given the following information: Stockholders’ equity=$1,250; Shares outstanding=25; Market/Book ratio=1.5. Calculate the market price.

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