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  1. 1. Chapters 2 & 3 Financial Statements and Analysis
  2. 2. Introduction <ul><li>Financial statements reflect the performance of a firm from a financial perspective </li></ul><ul><li>They are very often used in getting finance from outside sources e.g. bank loan, bond market, stock market, etc </li></ul><ul><li>In merger and acquisition, the manager will inspect the financial statements of the firm to be acquired </li></ul><ul><li>Agenda today - to understand and analyze financial statements </li></ul>
  3. 3. Types of Financial Statements <ul><li>Income Statement </li></ul><ul><li>Provides a summary of the firm’s financial transactions for a period of time </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Reviews the firm’s financial position at a particular point in time </li></ul><ul><li>Statement of Cash Flow </li></ul><ul><li>Indicates the cash flow of the firm at a point in time </li></ul>
  4. 4. Income Statement <ul><li>Begins with the aggregate amount of sales for a specific period of time (e.g.fiscal year) </li></ul><ul><li>Subtract the expenses according to their relative importance in producing the sales </li></ul><ul><li>The final outcome is Net Income which can be used to generate the earnings per share (EPS) value and price/earning (P/E) ratio </li></ul>
  5. 5. Balance Sheet <ul><li>Left hand side shows the Assets employed in the operation of the firm (capital budgeting) </li></ul><ul><li>Right hand side reviews the liabilities and shareholders’ equity (sources of financing) </li></ul><ul><li>Assets are listed in their order of liquidity </li></ul><ul><li>Sources of financing are listed in their order of maturity </li></ul>
  6. 6. Statement of Cash Flows <ul><li>Emphasizes the critical nature of cash flow </li></ul><ul><li>Reviews cash flows </li></ul><ul><li>From operating activities </li></ul><ul><li>From investing activities </li></ul><ul><li>From financing activities </li></ul>
  7. 7. Tax Consideration <ul><li>It affects the income after-tax; hence it affects earnings & earnings growth </li></ul><ul><li>In making investment decision, it is the after-tax cash flows that matter </li></ul>
  8. 8. Financial Statement Analysis <ul><li>Analysis of the firm’s financial strength </li></ul><ul><li>Liquidity </li></ul><ul><li>Solvency (debt utilization) </li></ul><ul><li>Analysis of management performance </li></ul><ul><li>Profitability </li></ul><ul><li>Asset utilization </li></ul>
  9. 9. Tool for financial analysis <ul><li>Financial ratios </li></ul><ul><li>Ratio of two values from balance sheet e.g. current assets/current liabilities </li></ul><ul><li>Ratio of two values from income statement e.g. net income/sales </li></ul><ul><li>Ratio of one value from balance sheet and one value from income statement e.g. net income/shareholders’ equity </li></ul>
  10. 10. Advantages in using financial ratios <ul><li>Facilitates comparison across firms </li></ul><ul><li>Facilitates comparison of firms of different sizes </li></ul><ul><li>Enables comparison to industry norm </li></ul><ul><li>Enables comparison of results from different years (trend analysis) </li></ul>
  11. 11. Financial strength - Liquidity <ul><li>Liquidity – likelihood of the firm to meet its short-term obligations </li></ul><ul><li>Current ratio = current assets/current liabilities = 800000/300000 = 2.67 </li></ul><ul><li>Quick ratio = (current assets – inventories)/current liabilities = (8000000-370000)/300000 = 1.43 </li></ul>
  12. 12. Financial strength - Solvency <ul><li>Solvency – ability of the firm to satisfy its long-term obligations </li></ul><ul><li>Debt-equity ratio = long-term debt/equity = 300000/1000000 = 0.3 </li></ul><ul><li>Total debt to total assets = total debt/total assets = 600000/1600000 = 0.375 </li></ul><ul><li>Times interest earned = income before interest and taxes/interest = 550000/50000 = 11 </li></ul>
  13. 13. Management performance - profitability <ul><li>Profits gained in using the equity or assets </li></ul><ul><li>Return on equity = net income/equity = 200000/1000000 = 0.2 </li></ul><ul><li>Return on assets = net income/total assets = 200000/1600000 = 0.125 </li></ul><ul><li>Profit margin = net income/sales = 200000/4000000 = 0.05 </li></ul>
  14. 14. Management performance – assets utilization <ul><li>Measure the turn-over speed of the firm’s assets </li></ul><ul><li>Receivable turnover = Sales/receivables = 4000000/350000 = 11.4 </li></ul><ul><li>Average collection period = receivables/average daily credit sales = 350000/(4000000/365) = 32 </li></ul>
  15. 15. Assets Utilization cont’ <ul><li>Inventory turnover = COGS/Inventory = 3000000/370000 = 8.1 </li></ul><ul><li>Capital asset turnover = Sales/Capital asset = 4000000/800000 = 5 </li></ul><ul><li>Total asset turnover = Sales/Total assets = 4000000/1600000 = 2.5 </li></ul>
  16. 16. Norm Comparison <ul><li>Profit margin of the firm = 5% </li></ul><ul><li>Industry norm = 6.5% </li></ul><ul><li>Below average </li></ul><ul><li>Average collection period of the firm = 32 days </li></ul><ul><li>Industry norm = 36 days </li></ul><ul><li>Above average </li></ul>
  17. 17. Trend Comparison <ul><li>Profit margins in 1998, 1999 & 2000 are 3%, 4% & 5% respectively </li></ul><ul><li>Profit margins are growing – good sign </li></ul><ul><li>Average collection days in 1998, 1999 & 2000 are 28 days, 30 days & 32 days </li></ul><ul><li>Collection time is increasing – bad sign </li></ul>
  18. 18. Limitations of Ratio Analysis <ul><li>Different accounting methods across different firms </li></ul><ul><li>Ratios may change as a result of changes in accounting method e.g. change in inventory valuation, revenue recognition, etc </li></ul><ul><li>Ratios are based on historical information and may change in the future </li></ul>
  19. 19. Summary <ul><li>Three types of financial statements – Income Statement, Balance Sheet and Statement of Cash Flows </li></ul><ul><li>Four categories of financial ratios – Liquidity, Solvency, Profitability & Asset Utilization </li></ul><ul><li>Advantages in using ratios – norm & trend analysis </li></ul><ul><li>Limitations in using ratios </li></ul>