Topic 2 2_ (2) finance


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Topic 2 2_ (2) finance

  1. 1. 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
  2. 2.  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
  3. 3. • 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.
  4. 4. 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 
  5. 5. SALES - Cost of Goods Sold (COGS) - - GROSS PROFIT Operating Activities Operating Expenses OPERATING INCOME (EBIT) Interest Expense EARNINGS BEFORE TAXES (EBT) Income Taxes Financing EARNINGS AFTER TAXES (EAT) Activities Preferred Stock Dividends (if any) NET INCOME (EARNING AVAILABLE FOR STOCKHOLDERS)
  6. 6.  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
  7. 7.   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.
  8. 8. Assets Liabilities (Debt) & Equity Current Assets Cash Accounts Receivable Inventories Prepaid Expenses Fixed Assets Machinery & Equipment Buildings and Land Other Assets Copyrights, Goodwill & 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 Treasury Stock TOTAL ASSETS TOTAL LIABILITIES + EQUITY
  9. 9. • 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
  10. 10. • FIXED ASSETS The assets are held for more than one year. Fixed assets typically include: plant and machinery, building and land. • OTHER ASSETS Assets 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.
  11. 11.  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/DEBTS Covers 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)
  12. 12. • EQUITY Shareholder’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)
  13. 13. Example of Balance Sheet
  14. 14. STATEMENT OF CASH FLOWS  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. 
  15. 15. 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. 
  16. 16. What is our decision?  Maximize shareholders wealth or  Maximize profit?
  17. 17. 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 
  18. 18.    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
  19. 19. Ratio can be used to answer four important questions about 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?
  20. 20. 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 
  21. 21. Current Ratio a.      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
  22. 22. Quick Ratio or Acid Test Ratio b.      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
  23. 23. 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
  24. 24.     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
  25. 25.    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
  26. 26.  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
  27. 27. 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 
  28. 28. 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 
  29. 29.  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
  30. 30.  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%
  31. 31.  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%
  32. 32.  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%
  33. 33. 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% 
  34. 34.     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%
  35. 35. How firms financed its asset? Shows the ability of firm to suit its responsibility or obligation to their debtors Determine the effectiveness of management in using and managing capital     Debt Ratio Equity Ratio Debt to Equity Ratio Time Interest Earned
  36. 36. Debt ratio shows the percentage of firm’s assets that are financed by debt  Formula: Debt Ratio = Total Debt / Total Asset 
  37. 37. What percentage of the firm’s assets are financed by owner?  Formula: Equity ratio = Total owners’ equity Total assets 
  38. 38. It measures the percentage of liability covers by equity  Formula: DTER = Total Debt / Total Owner’s Equity 
  39. 39. 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 
  40. 40.           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