Ff topic2 analysis_of_financial_statement_and_cash_flow


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Ff topic2 analysis_of_financial_statement_and_cash_flow

  1. 1. Topic 2 Analysis of financial statements and cash flows
  2. 2. 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.
  3. 3. 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.
  4. 4. 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.
  5. 5. 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
  6. 6. Figure 2-1
  7. 7. Figure 2-1 (cont.)
  8. 8. Table 2-2
  9. 9. 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.
  10. 10.  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
  11. 11.  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
  12. 12.  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
  13. 13.  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
  14. 14.  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
  15. 15. Balance Sheet Assets Liabilities (Debt) & Equity Current Assets Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses Fixed Assets Machinery & Equipment Buildings and Land Other Assets Investments & patents Current Liabilities Accounts Payable Accrued Expenses Short-term notes Long-Term Liabilities Long-term notes Mortgages Equity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings
  16. 16. Balance Sheet
  17. 17. 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.
  18. 18. Cash inflows and outflows
  19. 19. Figure 2-2
  20. 20. Table 2-4
  21. 21. 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.
  22. 22. 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.
  23. 23. 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. Benchmarking Compare the company’s financial position with other competitors. Types of Analysis
  24. 24. 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)
  25. 25.  Liquidity is measured by two approaches: 1. Comparing the firm’s current assets and current liabilities 2. 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 1. Liquidity ratios
  26. 26.  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…)
  27. 27.  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…)
  28. 28. 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.
  29. 29. 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.
  30. 30.  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…)
  31. 31.  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…)
  32. 32.  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…)
  33. 33.  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…)
  34. 34. 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.
  35. 35. 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.
  36. 36. 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.
  37. 37. 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.
  38. 38. 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.
  39. 39.  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
  40. 40. 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.
  41. 41.  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….)
  42. 42. 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.