TOPIC 2

ANALYSIS OF FINANCIAL STATEMENTS AND CASH FLOWS

CONTENTS

Needs of financial statements Financial statements

› Income Statement› Balance Sheet› Statement of Cash Flows

Financial statement analysis› Liquidity ratios› Profitability ratios› Asset management ratios› Leverage ratios› Market value ratios› Limitations of ratio analysis

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• External users

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.

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

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: Basic Structure

Financing Activities

Operating Activities

Example of Income Statement

Three additional important issues

Operating income (EBIT) is NOT affected by how the firm is financed.

Interest expense is subtracted from income before computing the firm’s tax liability, i.e. Interest is not taxable expenses.

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

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* Liabilities and Equity indicate how those resources are financed

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

Balance Sheet : Basic Structure

Assets Liabilities (Debt) & Equity

Current Assets Cash

Accounts Receivable Inventories

Prepaid ExpensesFixed Assets Machinery & Equipment Buildings and LandOther Assets

Copyrights, Goodwill & patents

TOTAL ASSETS

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

TOTAL LIABILITIES + EQUITY

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

Balance Sheet Terms: Assets

• FIXED ASSETS The assets are held for more than one year. Fixed assets typically include: plant and machinery, building and land.

• OTHER ASSETSAssets 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.

Balance Sheet Terms: Liabilities (debt)

LIABILITIES are money borrowed and must be repaid at predetermined date.

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/DEBTSCovers 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)

Balance Sheet Terms: Equity

• EQUITYShareholder’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)

Example of Balance Sheet

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

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)

Increasing(decreasing) of net cash is total cash flow from operating, investing and financing activities. This changes will be added with to get ending cash balance

Beg. Cash balance + Net changes in cash= ending cash balance.

STATEMENT OF CASH FLOWS

Statement Of Cash Flows

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

Financial Statement Analysis

What is our decision?

Maximize shareholders wealth

or

Maximize profit?

Financial Statement Analysis

Ratios are used to analyze performance and financial position of a business organization

Can be used to identify strengths and weaknesses of financial situation for a company.

Comparison analysis can be done with these following method: Trend analysis, comparison analysis, Benchmarking

Financial Statement Analysis

Trend analysis› Compare current ratios in previous year› Covers some time period so the analyst can see the

achievement flow for the company in longer period. Comparison analysis

› Compare the company ratios with other 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

Financial Statement Analysis

Ratio can be used to answer four important questionsabout the firm operations:1. How liquid the firm? 2. Is the management generate enough

operating profits from firms’ asset? 3. Is the shareholders get the worth return on

their investment? 4. How is the firm financing its asset?

1. LIQUIDITY RATIO

Liquidity is the ability to have cash available when needed to meet its short term financial obligations

Measured by two approaches: Current Ratio Quick Ratio or Acid Test Ratio

Current Ratio

a. Current Ratio measure the relationship between current assets and

current liabilities The higher of this ratio, it means the business is better

where it has enough liquid asset of its operation Formula: Current Ratio = CA / CL Davies Example: CR = $143m / $64m = 2.23 times Davies has $2.23 in current assets for every $1 in current

liabilities

Quick Ratio or Acid Test Ratio

b. Quick Ratio or Acid Test Ratio Calculated by deduct the inventory from the current

assets and divided the amount with current liabilities The higher the answer, the business has enough quick

assets to pay its short term immediately Formula: Quick Ratio = (CA – Inventory)/ CL Davies Example: QR = ($143m - $84) / $64m = 0.92 times IDavies has $0.92 in quick assets for every $1 in current

liabilities

2. ASSET MANAGEMENT RATIO

Use to identify efficiencies and effectiveness of firm in managing its asset

Firm should make basic decision about total investment in account receivable, inventories and fixed asset Average Collection Period Accounts Receivable Turnover Inventory Turnover Fixed asset turnover Total asset turnover

Average Collection Period

How long does it take to collect the firm’s receivables? Comparison of this ratio with credit period will measure the

efficiency of the firm to collect its debt Formula: ACP = Account Receivable

Annual credit sales /365 Davies Example: ACP = $36M / ($600M/365) = 21.95 days

Accounts Receivable Turnover

How many times accounts receivable are “rolled over” during a year. It determine the ability of the business to collect debt from its customers

The higher ART is better because it shows the business can collect its debt immediately and has a few bad debt

Formula: ART = Credit sales / Accounts receivable

Inventory Turnover

How many times is inventory rolled over per year? The higher the Inventory turnover means the firm in better

position because it shows the quick inventory movement Formula: Inventory Turnover = Cost of goods sold/Inventory Davies Example: IT = $460M / $84M = 5.48 times # of days = 365/Inventory turnover = 365/5.48 = 67 days

Fixed Asset Turnover

Examines efficiency in generating sales from investment in “fixed assets”

The higher FAT is better because it shows the effectiveness of the firm to produce sales from its fixed assets

Formula: FAT = Sales/Fixed assets Davies Example: FAT = $600M / $295M = 2.03 times Davies generates $2.03 in sales for every $1 invested in fixed

assets

Total Asset Turnover

This ratio measures how efficiently a firm is using its assets in generating sales.

The higher of this ratio is better because it shows the effectiveness of the firm in managing its assets.

Formula: Total Assets Turnover = Sales/Total assets Davies Example: TAT = $600M / $538M = 1.37 times Davies is generating $1.37 in sales for every $1 invested in

assets

3. PROFITABILITY RATIO

Measures a firm’s ability to generate profits relative to sales, assets and equity Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Assets Return on Equity

Gross Profit Margin

It 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.

Formula: GPM = Gross profit/Sales Davies Example: GPM = $140m / $600m = 0.2333 or 23.33%

Operating Profit Margin

OPM examines how effective the company is in managing its cost of goods sold and operating expenses that determine the operating profit.

Formula: OPM = Operating profit/Sales Davies Example: OPM = $75M / $600M = 0.125 or 12.5%

Net Profit Margin

NPM 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, the better because it shows reducing in expenses or cost in producing sales

Formula: NPM = Net Income /Sales Davies Example: NPM = $42m / $600m = 0.07 or 7%

Return on Asset

Return on Asset determine the effectiveness of management in using their asset to generate income

The higher of this ratio, the better because it shows the firm is more effective in using their assets

Formula: ROA = Net income / Total Asset Davies Example: ROA = $42m / $438m = 0.0959 or 9.59%

Return on Equity

Return on Equity determine the effectiveness of efficiency of the firm to generate income for its shareholder. It is profitability measurement to equity investment in the firm

The higher of this ratio, the better because it shows the firm is able to produce higher profits to its owners

Formula: ROE = Net income / Total Equity Davies Example: ROE = $42m / $203m = 20.69%

4. LEVERAGE RATIO

How firms financed its asset?Shows the ability of firm to suit its

responsibility or obligation to their debtorsDetermine the effectiveness of management in

using and managing capital Debt Ratio Equity Ratio Debt to Equity Ratio Time Interest Earned

Debt Ratio

Debt ratio shows the percentage of firm’s assets that are financed by debt

Formula: Debt Ratio = Total Debt / Total Asset

Equity Ratio

What percentage of the firm’s assets are financed by owner?

Formula: Equity ratio = Total owners’ equity Total assets

Debt to Equity Ratio

It measures the percentage of liability covers by equity

Formula: DTER = Total Debt / Total Owner’s Equity

Times Interest Earned

Examines 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

Formula: TIE = EBIT / Interest

Limitation of Ratio Analysis

Difficulty in identifying industry categories or finding peers Published peer group or industry averages are only

approximations Accounting practices differ among firms Financial ratios can be too high or too low Industry averages may not provide a desirable target ratio or norm Difficulty in identifying industry categories or finding peers Published peer group or industry averages are only

approximations Accounting practices differ among firms Financial ratios can be too high or too low Industry averages may not provide a desirable target ratio or norm