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