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2 financial statements_and_cash_flows_slides - Basic Finance 2 financial statements_and_cash_flows_slides - Basic Finance Presentation Transcript

  • ANALYSIS OF FINANCIALSTATEMENTS AND CASH FLOWS TOPIC 2
  • Learning Objectives1. Understand the needs of financial statements.2. Distinguish between income statement, balance sheet and statement of cash flows and identify the items in those statements.3. Explain the usage of financial ratio analysis in financial statements analysis.4. Calculate liquidity ratio, asset management ratio, profitability ratio, leverage ratio and market value ratio to evaluate a company’s performance.5. Describe the limitations of financial ratio analysis. WRMAS 2
  • 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- persons employed by the firm • External users- potential investors, the Government, lenders, the public etc... WRMAS 3
  • 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. WRMAS 4
  • 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 WRMAS 5
  • Income Statement Form 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) WRMAS 6
  • Example of Income Statement WRMAS 7
  • Three additional important issues:• Operating income is NOT affected by how the firm is financed.• Interest expense (financing cost) is subtracted from income before computing the firm’s tax liability. i.e Interest is not taxable expenses.• Firm that has a positive net income does NOT necessarily mean it has any cash WRMAS 8
  • 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 how those resources are  Equity (E) - Owner claim financed A=L+E• The items are recorded at historical cost, so the book value of a firm may be very different from its market value. WRMAS 9
  • 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 WRMAS 10
  • 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 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. Balance Sheet Terms: Liabilities (Debt)• LIABILITIES are money borrowed and must be repaid at predetermined date. current liabilities (must be repaid within twelve months) long-term liabilities (repayment time exceeds one year). WRMAS 11
  • Balance Sheet Terms: Liabilities (Debt)• 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) WRMAS 12
  • Balance Sheet Terms: Equity• 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) WRMAS 13
  • Balance Sheet A = L + E Assets Liabilities (Debt) & EquityCurrent Assets Current Liabilities Cash Accounts Payable Accounts Receivable Accrued Expenses Short-term notes Inventories Long-Term Liabilities Prepaid Expenses Long-term notesFixed Assets Mortgages Machinery & Equipment Equity Buildings and Land Preferred StockOther Assets Common Stock (Par value) Paid in Capital Copyrights, Goodwill & Retained Earnings patents Treasury Stock TOTAL ASSETS TOTAL LIABILITIES + EQUITY WRMAS 14
  • Example of Balance Sheet WRMAS 15
  • STATEMENT OF CASH FLOWS• Definition: Shows the changes of cash for the company in certain period of time.• 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. WRMAS 16
  • Statement Of Cash Flows 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) WRMAS 17
  • Income Statement Conversion: From Accrual to Cash Basis• Two steps: – Add back depreciation (as it is a non-cash expense) to net income – Subtract any uncollected sales (i.e. increase in accounts receivable) and cash payment for inventories (i.e. increase in inventories less increase in accounts payables) WRMAS 18
  • Example: Statement Of Cash Flows WRMAS 19
  • USES OF FINANCIAL RATIO: 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.• Prepare, at both firm and division levels, financial projections.• Compare performance against other firms (competitors) or industry standards• Evaluate the financial condition of a major supplier WRMAS 20
  • USES OF FINANCIAL RATIO: Outside the Firm 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 whether or not to grant credit terms to a company. WRMAS 21
  • Types of Analysis 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. WRMAS 22
  • Analyzing Financial Performance: Ratio 1. Liquidity Ratio 2. Asset Management/Activity Ratio 3. Profitability Ratio 4. Leverage Ratio 5. Market Value Ratio WRMAS 23
  • Balance Sheet (For Ratios) WRMAS 24
  • Income Statement (For Ratios) WRMAS 25
  • LIQUIDITY RATIO How liquid is the firm? Liquidity shows the ability of the firm to pay its short term debt in the time given. It indicates the ease with which non- cash assets can be converted to cash to meet the financial obligations. Generally, bigger liquidity ratios, give a better position of the firm’s liquidity. WRMAS 26
  • Liquidity RatioWorking capital uses to measure the ability of a business to payit short term debt by current assets and shows the amount ofleaved current assets after current liabilities has been paid. Working Capital = Current Assets – Current Liabilities Davies Example? The bigger the value the better the business because it is able to pay its short term debt and it has higher current assets for its operation. WRMAS 27
  • Liquidity RatioCurrent ratio- compares cash and current assets that should beconverted into cash during the year with the liabilities thatshould be paid within the year. Current asset = X Times Current ratio = Current liability Davies Example?Davies has ____ in current assets for every $1 in currentliabilities. The higher of this ratio means the business financial is better where it has enough liquid asset of its operation. WRMAS 28
  • Liquidity RatioQuick ratio (known also as asid test) -Compares cash and currentassets (minus inventory) that should be converted into cash duringthe year with the liabilities that should be paid within the year. What is the rationale for excluding inventories? Current asset - Inventory = X TimesQuick ratio = Current liabilityDavies Example?Davis has ____ in quick assets for every $1 in current liabilities. The higher the ratio shows the business has enough quick assets to pay its short term debt immediately. WRMAS 29
  • ASSET MANAGEMENT RATIO• How efficiently and effectively a company is using its assets in the generation of revenues? It uses 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. The firm is responsible to use the assets efficiency and effectively. WRMAS 30
  • Asset Management RatioAverage collection period determines the average days for thefirm to collect its accounts receivable from customers in certainperiod. How long does it take to collect the firm’s receivables? 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝒓𝒆𝒄𝒊𝒆𝒗𝒂𝒃𝒍𝒆 𝑨𝑪𝑷 = = 𝒅𝒂𝒚𝒔 𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔 /𝟑𝟔𝟓Davies Example?On average, Davies needs ____ days to collect payment onaccounts receivable. A lower number of days is better because this means that the company gets its money more quickly. WRMAS 31
  • Asset Management RatioAccount Receivable Turnover determines the ability of thebusiness to collect debt from its customers. It shows the numberof account receivable turn in a year. A turn covers the startingperiod of account receivable until the due of the account. ARTO = Credit sales = Times Accounts receivable Davies Example? Higher is better because it shows the business can collect its credit accounts immediately. If low, firms needs to take a look at its credit and collections policy and be sure they are on target. WRMAS 32
  • Asset Management RatioInventory Turnover shows how many times per year the inventorywill be sold and replaced. How many times is inventory rolled over per year?Inventory Cost of goods sold = TIMES =turnover Inventory Davies Example?On average, ____ times passed between the acquisition and saleof inventory. 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. WRMAS 33
  • Asset Management RatioFixed Asset Turnover shows the efficiency of the firm in using fixedasset in generating sales. SalesFixed asset turnover = = TIMES Total fixed assetsDavies Example?Davies generates ____ in sales for every $1 invested in fixed assets. The higher is better because it shows the effectiveness of the firm to produce sales from its fixed assets. WRMAS 34
  • Asset Management RatioTotal Asset Turnover shows the efficiency of the firm to use itsassets to generate sales. Sales Total asset turnover = = TIMES Total assets Davies Example?Davies is generating ____ in sales for every $1 invested in assets. The higher is better because it shows the effectiveness of the firm to use its assets to generate sales. WRMAS 35
  • PROFITABILITY RATIO Are a company has an ability to generate profits relative to sales, assets and equity? It shows a companys overall efficiency and performance. When these ratios are higher than a competitors ratio or than the companys ratio from a previous period, this is a sign that the company is doing well. WRMAS 36
  • Profitability RatioGross Profit Margin looks at cost of goods sold as a percentageof sales. It shows firms ability to turn a dollar of sales into profitafter the cost of goods sold has been accounted for. Gross Profit Gross profit margin = = % Sales Davies Example? For every $1 of sales, ____ of gross profit was made OR costs of goods sold consumed ____ of every sales dollar. Higher ratio is better because it indicates that the firm is operating efficiently after sales costs are subtracted. WRMAS 37
  • Profitability RatioOperating Profit Margin examines how effective the company isin managing its cost of goods sold and operating expenses thatdetermine the operating profit (EBIT). EBIT Operating profit margin = = % Sales Davies Example? For every $1 of sales, ____of EBIT was generated. Higher ratio is better because it indicates that the firm is managing its operating expenses efficiency WRMAS 38
  • Profitability RatioNet Profit Margin determines profit earns from every dollar ofsales after all expenses, including cost of good sold, salesexpenses, general and admin cost, depreciation, interest and taxcompletely paid. Net income = %Net profit margin = Sales Davies Example? For every $1 of sales, ____of profit was generated. The higher of this ratio is better because it shows the reducing in expenses or cost in producing sales WRMAS 39
  • Profitability RatioReturn on Asset (ROA) determines the effectiveness ofmanagement in using their assets to generate income. Net incomeReturn on asset= = % Total assetsDavies Example?For every $1 of assets, ____ cents of profit was generated ORDavies has a NI of ____ for each dollar of total assets. The higher of this ratio is better because it shows the firm is more effective in using their assets to generate sales. WRMAS 40
  • Profitability RatioReturn on Equity (ROE) determines the efficiency of the firm togenerate income for its shareholder. Are the Firm’s managers providing a good return on the capital provided by the shareholders? Net income = %Return on equity = Total equity Davies Example? For every $1 invested by shareholders, ____ of additional wealth (profit) was generated OR Davies has a NI of ____ for each dollar of total equity. Higher of this ratios is better because it shows the firm is able to produce higher profit to its owners. WRMAS 41
  • 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 creditors. This ratio determines the effectiveness of management in using and managing capital. WRMAS 42
  • Leverage RatioDebt Ratio shows the percentage of firm’s assets that financed bydebt (implying the balance is financed by equity). Debt ratio = Total debt Total assets = % Davies Example? Davies finances ____ of firm’s assets by debt and ____by equity.The lower is better because the less total debt the business has in comparison to its asset base (high ratio-in danger of becoming insolvent and/or going bankrupt) WRMAS 43
  • Leverage Ratio Debt to Equity Ratio measures the percentage of liability covers by equity. Total debt DOE = = % Total equity Davies Example?Davies finances ____ of firm’s equity by debt OR For every dollar ofDavies owned by the shareholders, Davies owes ____ to creditors. The lower of this ratio is better because it indicates a safer investment to potential owners of the company. WRMAS 44
  • Leverage RatioTimes Interest Earned (TIE) measures how many times the firmhas profit to pay interest expenses. This ratio indicates theamount of operating income available to service interestpayments.TIE = Operating profit (EBIT) = TIMES Interest expenseDavies Example?Davies operating income are ____ the annual interest expenseOR ____% of the operating profits goes towards servicing thedebt.The higher of this ratio is better because it shows the firm is able to pay the interest expenses. WRMAS 45
  • MARKET VALUE RATIO Are the firm’s managers creating shareholder value? Ratios relate an observable market value, the stock price, to book values obtained from the firms financial statements.Earning Per Share represents the portion of a firmsearnings, that is allocated to each share of common stock. Net income = $Earning Per Share= No. of Share outstandingDavies Example?Davies generated profits of ____ for each share issued. A high EPS is better because it is capable of generating a significant dividend for investors WRMAS 46
  • Market Value RatioPrice-Earning Ratio (P/E) indicates how much investors arewilling to pay for $1 of reported income.Price-Earning = Price per share = TIMES Ratio Earning per shareDavies Example?To buy one share investors are prepared to pay ____ the profitearned per share. A high P/E ratio is better because it shows that investors are anticipating higher growth in the future. WRMAS 47
  • Market Value RatioPrice (Market)-to-book-Ratio measures how much a companyworth at present, in comparison with the amount of capitalinvested by current and past shareholders into it. It showsfirms success in creating value for its stockholders.Price-to-book Ratio = Price per share Book value per sharewhereBook Value Per Share = Total Equity No. of share outstandingDavies Example?A ratio greater than 1 indicates that the shares are more valuable than what the shareholders originally paid. WRMAS 48
  • LIMITATIONS OF FINANCIAL RATIO ANALYSISRatios can provide meaningful comparisons of companies insimilar industries. Also, keep in mind that ratio analysis does nottell the entire story. Why?1) Many large firms operate in multiple lines of business. It is difficult to find a meaningful set of industry-average ratios.2) Seasonal factors can also distort ratio analysis.3) Industry averages may not provide a desirable target ratio. WRMAS 49
  • 4) A company may have some good and some bad ratios, making it difficult to tell if its a good or weak company. A high or low ratio does not automatically lead to a specific favorable or unfavorable conclusion.5) Different accounting method among the firm results different calculation of ratios. For example, in calculating inventory and depreciation.6) Industry average is only estimation and guidelines. Industry average is not necessarily a desirable target and required ratio. It only illustrates the firm position in industry. WRMAS 50
  • Bonus Questions1. You know that the return on equity (ROE) is 18%. If sales were $4 million, the debt ratio was 0.40 and the total debt is $2 million, What is return on assets (ROA)?2. You are given the following information: Stockholders’ equity=$1,250; Shares outstanding=25; Market/Book ratio=1.5. Calculate the market price. WRMAS 51