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Analysis of Financial Statements
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Balance Sheet
The key financial statement showing the what
firm owns and what a firm owes.
The summary statement of assets and
liabilities of the firm.
The difference between the assets and the
liabilities gives us the owner equity.
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Components of Balance sheet
Total value of assets Total value of liabilities
and shareholders equity
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Current assets
Current
liabilities
Fixed assets
1.Tangible assets2. Intangible fixed
assets
Long term
debt
Shareholder
equity
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Relationship between components
Assets-Liabilities= Owner's equity(I)
Current liabilities and long term debt are themain components of the liabilities side of the
balance sheet. Shareholder equity, the difference between the
assets of the firm and its liabilities.
Finally, balance sheet reflects the facts that, if thefirm were sell all its assets and use the money topay off its debt then whatever residual valueremained would belong to the shareholders.
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Net working capital
The difference between current assets andcurrent liabilities of the firm is known as thenet working capital.
Net working capital is positive when itscurrent assets exceed the current liabilitiesand vice versa.
For example,Net working capital =Current assets-Current
liabilities.(ii)
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Balance sheet
Assets Amount Liabilities and Amount
shareholders'
Equity
Current assets 100 Current liabilities 80Net fixed assets 600 Long-term debt 200
Shareholders' equity 420
Total liabilities andTotal assets 700 shareholders' equity 700
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Debt versus Equity
Firm usually gives first claim to the firms cashflow to creditors.
Equity holder entitled to only the residual
value i.e. also known as the shareholdersequity.
The firm uses the debt in their capital
structure is called the levered firm. The more the firm use the debt more is the
degree of financial leverage to the firm.
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Debt versus Equity
So, financial leverage increases the potential
reward to shareholders, but it also increases
the potential forfinancial distress and
business failure.
Use of debt serve as a means of signalingit
may signal the firm positively or negatively.
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Market value vs. Book value
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Market value
The value of the assets in the market ratherthan the book of the company.
Market value is also called the economic value
of the firm. Managers and investors will frequently be
interested in knowing the value of the firm.
This information is not on the balance sheetbecause the balance sheet assets are listed incost term.
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Book value
The value shown on the balance sheet for the
firms asset are book values.
Assets are carried on the books at what the
firm paid for them, no matter how long they
were purchased or how much they are worth
today.
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Which is more important for financial
manager?
For the financial manager the accounting or
book value is not an especially important
concern.
But, the matter is the market value of the
firm.
So, when we discuss the value maximization
objective of the financial manager the market
value is the concern.
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Example
Balance sheet
Market value versus book value
Assets Liabilities and equities
Book Market Book Market
Net Working 500 600 Debt 600 500
Capital
Net fixed 800 1200 Equity 700 1300
assets 1300 1800 1300 1800
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In above example the market value of the
equity is almost double as much as what is
shown on the books.
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Income statement
The summary statement showing the revenue
and expenses is known as the income
statement.
Income statement is basically prepared for
some specific time period such as quarter, half
yearly, yearly and so on.
Revenue- Expenses=Income.(iii)
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Income statement
The revenue and expenses of the firms
principal operation is the major body of the
income statement.
The main goal of the income statement is to
find out the net income of the firm.
Performance of the firm can be evaluated
from the income statement.
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Example
Income statementNet sales 2500
Cost of goods sold(COGS) 800
Depreciation 100Earning before interest and taxes 1600
Interest paid 400
Taxable income 1200
Tax 300
Net income 9008/19/2013 Hari Pd. Wagle M.Phil,Kusom 17
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Income statement
Out of the net income 450 is distributed among theshareholder as a divided and rest of the net income isretained by the firm.
The difference between the net income and divided is
the addition to retained earning. Net income and dividend can also be expressed as per
share basis.
Earning per share=Net income/Total shareoutstanding..(IV)
Dividend per share= Total dividend/ Total shareoutstanding(V)
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GAAP
An income statement prepared using GAAP
will show revenue when it accrues.
It is not necessary the actual cash flow.
In practices, this principle means that revenue
is recognized at the time of sale, which need
not be the same as the time of collection.
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Ratio analysis
Key analysis based on the financial
information of the firm.
Ratio analysis helps to determine the
relations from a firms financial information
and used for comparison.
Industry average is the benchmark for
comparison.
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Liquidity Ratio
Liquidity ratio measure the short term
solvency of the firm. So it is also called the
short-term solvency ratio.
The primary concern is the firms ability to pay
its bills over the short run without undue
stress.
Liquidity ratio focus on current assets and
current liabilities of firm.
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Liquidity ratios
Two common ratios used to evaluate the
solvency position of a firm are as follows:-
a) Current Ratio
b) Quick or Acid test ratio
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Current Ratio
Current ratio measure the short tem liquidity
of a firm.
The degree of liquidity reflects by the current
ratio.
It help to measure the firm ability to pay its
current liabilities by its current assets.
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Current
ratio=
=Times(i)
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Current ratio
Interpretation of ratio is very important to useit in practices.
For example if the calculated value of current
ratio is 1.5 the we can say that the firm haveRs.1.5 in current assets for every Rs.1 currentliabilities. Or we can also interpret as thecompany has its current liabilities covered 1.5times.
The standard of current ratio is 2:1.
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Quick Ratio
This ratio measure the very quick liquidity of
the firm.
This ratio omitted the inventory while
calculating the current assets.
Quick ratio can be calculated as follows.
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Current ratio=
=(ii)
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Quick Ratio
Quick ratio exclude the major part of the
current asset i.e. inventory.
Inventory is excluded because it is illiquid in
nature.
Secondly, book value of inventory is different
from the market value.
For example Quick ratio 1.2 means the firm
has 1.2 times quick assets than liabilities.
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Other liquidity Ratio
Cash Ratio: The relation between the cash and
current liabilities of the firm.
Net working capital to total asset ratio:
Measure the amount of short term liquidity of
the firm with the total assets.
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Cash ratio=
= (iii)
Net working capital to total assets ratio=
=
(iv)
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Asset Management ratio
This ratio measure the efficiency of the firm to
use the assets.
It is also called turnover ratio.
This ratio concern how efficiently firm uses
their assets to generate the sales.
Now, we are going to discuss the following
asset management ratio.
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Asset Management ratio
Inventory turnover
Days sales in inventory
Receivable turnover Days sales in Receivable
Net working capital turnover ratio
Fixed assets turnover
Total assets turnover
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Inventory turnover
Inventory turnover measure how many times
firm is turns out its inventory in to sales.
Higher this ratio means the greater the
efficiency of managing the inventory.
Inventory turnover can be calculated as
follows.
Inventory turnover=Cost of goods
sold/Inventory.(V)
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Days sales in inventory
Days sales in inventory measure the time
required to turnout inventory.
Days sales in inventory can be calculated as
follows.
Days sales in inventory=Days in year/Inventory
turnover(VI)
(Note: Days in year is 365 and we use sales
instead of COGS if COGS is not given)
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Receivable Turnover Ratio
Receivable turnover ratio measure the
efficiency of the firm to collect the cash from
the market.
Receivable turnover ratio=Sales/Account
receivable.(VII)
This ratio gives us the indication of an ability
of firm to reloaded the money form the
market.
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Days sales in Receivable
Receivable turnover ratio makes more sense if
we convert it to days.
Receivable turnover ratio measure the days
required to collect credit sales from the
market.
Days sales in Receivable can be calculated as
follows.
=Days in year/Receivable turnover.(viii)
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Other turnover ratio
Net working capital turnover ratio measurethe efficiency of working capital to generatethe sales
Net working capitalturnover=Sales/NWC..(ix)
Fixed asset turnover ratio measure theefficiency of mobilizing the fixed assets.
Fixed asset turnover=Sales/Net fixedassets(x)
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Other turnover ratio
Total assets turnover ration measure the
efficiency of the firm to utilize the fixed asset
of the firm.
Total assets turnover ratio=Sales/Total
assets(xi)
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Debt Management Ratio
Debt management ratio measure the long
term solvency of the firm.
Mainly following ratio will be discussed
Total debt ratio
Debt equity ratio
Equity Multiplier
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Total Debt Ratio
Total debt ratio measure the percentage of
debt in a capital structure of the firm.
Total debt ratio can be calculated as follows;-
Total debt ratio=Total assets-Total equity/Total
assets(xii)
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Debt-Equity Ratio
The ratio between debt and equity of the firm.
Debt-equity ratio=Total debt/Total
equity.(xiii)
Generally, debt equity ratio express in times.
We can also calculate the Equity multiplier(EM)
from the help of Debt and equity.
EM=Total assets/Total equity(xiv)
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Profitability Ratio
Profitability ratio measure the profit in terms
of sales, total assets and equity employed.
Three generally used ratio for measuring
profitability are as follows;-
Profit margin
Return on assets (ROA)
Return on Equity (ROE)
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Profit Margin
Profit margin measure the profit in every
rupees sales.
Profit margin=Net income/Sales(xv)
If other things remain constant then a
relatively high profit margin is preferable.
This situation means low expenses ration in
relation to sales.
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Return on Assets (ROA)
Return on assets is profit per rupees of assets
employed by the firm.
ROA=Net income/Total assets=%...............(xvi)
Higher the ROA better the performance of the
company.
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Return of Equity (ROE)
ROE measure how the shareholder benefiting
from the company.
ROE=Net Income/Total equity=%........(xvii)
If the other thing same, the higher ROE is
desirable for a firm.
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Market Value Measures
Market value measures used the information
from the market.
Price earning ratio(PE ratio)
Market-to-book ratio
Price-sales ratio
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Price Earning Ratio
P/E ratio gives us the idea that how many
times the market value from its earnings.
P/E ratio can be calculated as follows;-
P/E=Price per share/Earnings per share(xviii)
Earning per share=Price per share/Earnings per
share(xix)
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Market to book Ratio
The ratio between market value per share and
book value per share.
The market to book Ratio can be calculated as
follows.
Market-to-book Ratio=Market value per
share/Book value per share.(xx)
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Price-sales Ratio
The ratio based on price per share and sales
per share.
Price sales Ratio=Price per share/Sales per
share.(xxi)
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Du Pont Equation
The relation between profit margin, total assets
turnover and equity multiplier is known as the Du
Pont equation.
ROE=PM x TAT x EM(xxii)
Where,
ROE=Return on equity
PM=Profit Margin
TAT=Total assets turnover EM=Equity Multiplier
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Uses and limitation of Ratio analysis
Uses of Ratio Analysis
To evaluate the performance of the firm.
To facilitate the comparison of the ratio.
Uses for creditors and shareholder.
Uses for identification of the relative position
of the firm. Uses for arriving decision making.
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Limitation of the ratio
Required basis of comparison
Different in interpretation
Different in situation of two firm.
Changes in price level
Short-term changes
No indication of the future
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Homework-1
1) Solve problem No. 2,3,5,6,10,18,19,21,24
2) How can you define ratio analysis? What are
the limitation of ratio analysis?
3) Define Du Pont identity with suitable
example.
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Quiz
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