Topic 2Analysis of financial statements and cash

flows

Learning Objectives

Distinguish between balance sheet, income statements and statement of cash flow.

Indentify the items in those statements

Explain the need of financial statements.

Explain the usage of the ratios in financial statement analysis.

Calculate those ratios based on formulas given. Identify the limitations of ratio analysis.

Financial statements needs

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... Analyzing a firm’s financial statement can help

managers carry out three important tasks:• Assess current performance through financial

statement analysis,• Monitor and control operations, and• Forecast future performance.

The Income Statement

It is also known as Profit/Loss Statement

It measures the results of firm’s operation over a specific period.

The bottom line of the income statement shows the firm’s profit or loss for a period.

Sales – Expenses = Profits

Usefulness of income statement:

Evaluate the past performance of the firm.

Provide a basis for predicting future performance.

Income Statement Terms Revenue (Sales)

Money derived from selling the company’s product or service

Cost of Goods Sold (COGS) The cost of producing or acquiring the goods or services

to be sold

Operating Expenses Expenses related to marketing and distributing the

product or service and administering the business

Financing Costs The interest paid to creditors

Tax Expenses Amount of taxes owed, based upon taxable income

Figure 2-1

Figure 2-1 (cont.)

Table 2-2

1. The Balance Sheet The balance sheet provides a snapshot of a firm’s

financial position at a particular date.

It includes three main items: assets, liabilities and equity. Assets (A) are resources owned by the firm Liabilities (L) and owner’s equity (E) indicate how

those resources are financed A = L + E

The transactions in balance sheet are recorded historically at cost price, so the book value of a firm may be very different from its current market value.

Current assets comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include: Cash Marketable security–investment on short term financial

assets with high liquidity. Example: T-bill. Accounts Receivable (payments due from customers who

buy on credit) Inventory (raw materials, work in process, and finished

goods held for eventual sale) Other assets (ex.: Prepaid expenses are items paid for in

advance)

Balance Sheet Terms: Assets

Fixed Assets – Include assets that will be used for more than one year. Fixed assets typically include: Machinery and equipment Buildings Land

Other Assets – Assets that are neither current assets nor fixed assets. They may include long-term investments and intangible assets such as patents, copyrights, and goodwill.

Balance Sheet Terms: Assets

Debt (Liabilities) Money that has been borrowed from a creditor

and must be repaid at some predetermined date. Debt could be current (must be repaid within

twelve months) or long-term (repayment time exceeds one year).

Balance Sheet Terms: Liabilities

Current Debt: 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 Debt Borrowings from banks and other sources for more than 1

year

Balance Sheet Terms: Liabilities

Equity: Shareholder’s investment in the firm in the form of preferred stock and common stock.

Preferred stock: Preferred stockholders enjoy preference with regard to payment of dividend and seniority at settlement of bankruptcy claims.

Retained Earnings: Cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years.

Paid in Capital: (money that a company gets from potential investors in addition to the stated value of the stock).

Balance Sheet Terms: Equity

Balance SheetAssets Liabilities (Debt) & Equity

Current Assets Cash

Marketable Securities

Accounts Receivable

Inventories

Prepaid Expenses

Fixed Assets Machinery & Equipment

Buildings and Land

Other AssetsInvestments & patents

Current Liabilities Accounts Payable Accrued Expenses Short-term notes

Long-Term Liabilities Long-term notes

MortgagesEquity

Preferred Stock Common Stock (Par

value) Paid in Capital

Retained Earnings

Balance Sheet

Cash Flows Statement

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 operating activities

Cash flow from investment activities

Cash flow from financing activities

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

Cash inflows and outflows

Figure 2-2

Table 2-4

Uses of Financial Ratios: 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.

Uses of Financial Ratios: Outside the Firm

Financial ratios are 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 to whether or not to grant credit terms to a company.

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. BenchmarkingCompare the company’s financial position with other

competitors.

Types of Analysis

2. Measuring Key Financial Relationships: Five Key Questions

1. How liquid is the firm? (Liquidity)

2. Is management generating adequate operating profits on the firm’s assets?(Profitability)

3. Is management providing a good return on the capital provided by the shareholders? (Asset Management)

4. How is the firm financing its assets? (Leverage)

5. Is the management team creating shareholder value? (Market-Value)

Liquidity is measured by two approaches:1. Comparing the firm’s current assets and current liabilities2. Examining the firm’s ability to convert accounts receivables

and inventory into cash on a timely basis

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.

Formula: Working capital = Current assets – current liabilities

Larger the net working capital, better the firm’s ability to repay its debt.

Net working capital can be positive or zero or negative. It is generally positive.

1. Liquidity ratios

Current ratio compares a firm’s current assets to its current liabilities.

Formula:

Current ratio = Current assets/Current liabilities = x Times

The higher of this ratio means the business financial is better where it has enough liquid asset of its operation.

Liquidity ratios (cont…)

Quick ratio compares cash and current assets (minus inventory) that can be converted into cash during the year with the liabilities that should be paid within the year.

Formula:

Quick Ratio = Current Assets – inventory / Current liabilities = x Times

This ratio is more stringent measure of liquidity than the current ratio in that it excludes inventories and other current assets (those that are least liquid) from current assets.

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

Liquidity ratios (cont…)

2. Asset management ratios

Is management generating adequate operating profits on the firm’s assets?

It use 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.

Asset management ratios (cont…)

Average Collection Period (ACP) determines the average days for the firm to collect its account receivable from customers in certain period.

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

Formula:

ACP = Accounts receivable/(Annual credit sales/365)= Days

= Accounts receivable/(Daily credit sales)= Days

Comparison of this ratio with credit period will measure the efficiency of the firm to collect its debt.

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.

Formula

Account Receivable Turnover =

Credit Sales/Accounts receivable = Times

Higher account receivable turnover is better because it shows the business can collect its debt immediately and has a few bad debt.

Asset management ratios (cont…)

Inventory Turnover measures the number of times a firm’s inventories are sold and replaced during the year.

Formula:

Inventory Turnover = Cost of goods sold/Inventory = Times

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. It also can reduce the number of cash in term of inventory. It also prevent the bad inventory.

Asset management ratios (cont…)

Fixed Asset Turnover indicates how efficiently the firm is using its fixed assets.

Formula:

Fixed Asset Turnover = Sales/Total fixed assets = Times

The higher this ratio is better because it shows the effectiveness of the firm to produce sales from its fixed assets. This ratio shows the sales generated from every dollar of fixed asset.

Asset management ratios (cont…)

Total Asset Turnover shows the assts efficiency based on the relation between firm’s sales and the total assets.

Formula:

Total Asset Turnover = Sales/Total Assets = Times

The higher of this ratio is better because it shows the effectiveness of the firm in managing its assets. It means how much of sales can be generated from every dollar of asset.

Asset management ratios (cont…)

3. Profitability Ratio Gross Profit Margin measures of the gross profit earned

on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs.

Formula:

Gross profit margin= Gross profit/Sales = %

The higher of this ratio is better because it means efficient purchase management and related cost with purchases is reduced.

Profitability Ratio (cont….) 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.

Formula:

Net profit margin= Net Income/Sales = %

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

Profitability Ratio (cont….) Return On Equity (ROE) measures the profits earned for

each dollar invested in the firm's stock

Formula:

ROA= Net income/Common Equity= Times

Higher ratio is favored because the firm can generate better return to the owner of the firm.

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

Formula:

ROA= Net income/Total Assets = Times

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

4. 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 debtors.

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

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

Formula:

Debt Ratio = Total debt/Total assets = %

The lower of this ratio means more coverage earn by debtors if the firm bankrupt.

Leverage Ratios (cont..)

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

Formula:

Debt to Equity (DOE)= Total debts/Total equity= %

The lower of this ratio is better because it shows the firm is able to add its debt/liability if it needs to do so.

Times Interest Earned indicates the amount of operating income available to service interest payments.

Formula:

Times Interest Earned = Operating profit (EBIT)/Interest= Times

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

Is the management team of the firm creating shareholder value?

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

Formula:

EPS = Net income/number of shares The higher the earnings per share, the higher each share

should be worth.

5. Market Value Ratios

Market Value Ratios (cont….)

Price/Earnings Ratio Indicates how much investors are willing to pay for $1 of reported earnings.

Formula:

P/E = Price per share/Earnings per share= Times

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

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.

Indicates the investor’s assessment of the firm.

Formula:

Market-to-Book Ratio = market value per share/ book value per share

Where: Book value per share= Equity/number of shares

The higher of this ratio is better because the investors believe the firm is more valuable than what they originally paid for the stock.

Market Value Ratios (cont….)

3. The Limitations of Financial Ratio Analysis

It is sometimes difficult to identify industry categories or comparable peers.

The published peer group or industry averages are only approximations.

Industry averages may not provide a desirable target ratio.

Accounting practices differ widely among firms.

A high or low ratio does not automatically lead to a specific conclusion.

Seasons may bias the numbers in the financial statements.