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Chapter 14

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  • 1.  
  • 2. CHAPTER 14 ACCOUNTING & FINANCIAL ANALYSIS
  • 3. LEARNING OBJECTIVES
        • Explain how firms use accounting.
        • Explain how to interpret financial statements.
        • Explain how to evaluate a firm’s financial condition.
    Ratio Analysis Balance Sheet Income Statement The Importance of Financial Statements Main Resources
  • 4. INTRODUCTION
    • Accounting is the summary of a company’s financial activities
    • The process of accounting ends with a set of financial statement
    • Financial statement provides detailed information about a company’s recent performance and its financial condition.
    • Managers use this information to evaluate the company’s strengths and weaknesses so that it can capitalize the strengths and make corrective actions if there are deficiencies.
    • This chapter focuses on how the accounting and the financial analysis functions can be used by companies to maximise its value
    Ratio Analysis Balance Sheet Income Statement The Importance of Financial Statements Main Resources
  • 5. THE IMPORTANCE OF ACCOUNTING
    • Accounting provides financial information of an organization.
    • The process starts with bookkeeping where daily or weekly transactions are recorded.
    • The end product of accounting cycle is the production of financial statements
    • The financial statements are important for:
      • Reporting
      • Decision making
      • Controlling.
    Ratio Analysis Balance Sheet Income Statement The Importance of Financial Statements Main Resources
  • 6. REPORTING
    • Firms need to report all relevant financial activities accurately in accordance with “generally accepted accounting principles” (GAAP), Malaysia Accounting Standard Board (MASB) and International Accounting Standards (IAS).
    • The use of common set guidelines allows for more consistency in reporting practices among firms and consequently meaningful comparison can be made between firms.
    Ratio Analysis Balance Sheet Income Statement The Importance of Financial Statements Main Resources
  • 7. DECISION MAKING
    • Accounting data provides financial information to support decision making.
    • Eg: financial manager uses past data for budgeting decisions and anticipate future financing needs.
  • 8. CONTROLLING
    • Financial information helps managers to monitor and control the performance of individuals, departments and products.
    • This is done by evaluating and reviewing the financial statements.
  • 9. UNDERSTANDING FINANCIAL STATEMENTS
    • Main components of financial statement
    •  Income statement
    •  Balance sheet
    • Before analysing and interpreting the financial statement, it is important to understand the information reported in both income statements and balance sheet.
  • 10. INCOME STATEMENT
    • Reports revenue, expenses and income or loss made during the accounting period which is usually one year.
      • Net sales
      • Cost of goods sold
      • Gross profit
  • 11. INCOME STATEMENT
      • Operating expenses
      • Interest expense
      • Earning before interest and tax
      • Net income
  • 12. BALANCE SHEET
    • Reports asset, liability and equity of firms.
    • Assets = Liabilities + Owner’s Equity
    • Assets
      • Current assets
      • Fixed assets
  • 13. BALANCE SHEET
    • Liabilities
      • Short term liabilities
      • Long term liabilities
    • Owner’s equity
  • 14. RATIO ANALYSIS
    • One of the tools that is used by financial managers to assess the financial condition of the firm.
    • It evaluates the relationship between financial statement variables.
    • It is used to compare current performance with past performance to evaluate the impact of any financial decision implemented (internal analysis).
    • It is also used to compare the current performance within the industry to evaluate the standing of a particular firm to the ratios of industry average.
  • 15. RATIO ANALYSIS (cont.)
    • Ratio can be categorized into four main categories as follows:
      • Liquidity
      • Efficiency
      • Financial leverage
      • Profitability
    • The following is the financial statement of Kayu Kayan Bhd.
  • 16. Kayu Kayan Bhd Income Statement for the year ended 31 December 2007
    • RM
    • Net sales 700,000
    • Cost of goods sold ( 500,000)
    • Gross profit 200,000
    • Selling expenses 100,000
    • General & administrative expenses 30,000
    • Total operating expenses ( 130,000)
    • Earning before interest & taxes (EBIT) 70,000
    • Interest expenses 10,000
    • Earning before taxes 60,000
    • Income taxes (27%) 16,200
    • Net income 43,800
  • 17. Kayu Kayan Bhd Balance Sheet as at 31 December 2007
    • RM
    • Assets
    • Current assets:
    • Cash 17,000
    • Marketable securities 7,200
    • Accounts receivables 38,000
    • Inventory 93,000
    • Total current assets 155,200
    • Fixed Assets:
    • Net plant & equipment 290,000
    • Less: Accumulated depreciation 29,000
    • Net fixed asset 261,000
    • Total Assets 416,200
  • 18. Kayu Kayan Bhd Balance Sheet as at 31 December 2007 (cont.)
    • RM
    • Liabilities & Shareholders’ Equity
    • Current liabilities:
    • Accounts payable 55,000
    • Notes payable 13,000
    • Total current liabilities 68,000
    • Long-term debt 100,000
    • Owners’ equity:
    • Common stock 200,000
    • Retained earnings 48,200
    • Total owners’ equity 248,200
    • Total liabilities & owner’s equity 416,200
  • 19. Required
    • Calculate all four categories of ratio (ie: liquidity, efficiency, leverage and profitability).
    • Evaluate the overall financial performance of Kayu Kayan Bhd
  • 20. Liquidity Ratios
    • Current ratio
        • = current assets
        • current liabilities
    • = 155,200
        • 68,000
        • = 2.28
        • Industry average = 3.00
  • 21. Liquidity Ratios
    • Quick ratio
      • = current assets - inventories
      • current liabilities
      • = 155,200 – 93,000
      • 68,000
      • = 0.91
      • Industry average = 1.50
  • 22. Efficiency Ratios
    • Inventory turnover
    • = cost of goods sold
    • inventory
    • = 500,000
    • 93,000
    • = 5.37
    • Industry average = 6.50
  • 23. Efficiency Ratios
    • Average collection period
      • = accounts receivable
      • daily credit sales
      • = 38,000
      • 700,000/360 days
      • = 19.55 days
      • Industry average = 15 days
  • 24. Efficiency Ratios
    • Fixed asset turnover
    • = Net sales
    • Fixed assets
    • = 700,000
    • 261,000
    • = 2.68
    • Industry average = 2.8
  • 25. Efficiency Ratios
    • Total assets turnover
    • = Net sales
    • Total assets
    • = 700,000
    • 416,200
    • = 1.68
    • Industry average = 1.5
  • 26. Financial Leverage Ratios
    • Debt ratio
    • = total debt
    • total assets
    • = 168,000
    • 416,200
    • = 0.40
    • Industry average = 0.30
  • 27. Financial Leverage Ratios
    • Times interest earned
    • = Earnings before interest & taxes (EBIT)
    • Annual interest expense
    • = 70,000
    • 10,000
    • = 7 times
    • Industry average = 7.5 times
  • 28. Profitability Ratios
    • Net profit margin
    • = Net income x 100
    • Net sales
    • = 43,800 x 100
    • 700,000
    • = 6.26%
    • Industry average = 7%
  • 29. Profitability Ratios
    • Return on assets
    • = Net income x 100
    • Total assets
    • = 43,800 x 100
    • 416,200
    • = 10%
    • Industry average = 10.5%
  • 30. Profitability Ratios
    • Return on equity
    • = Net income x 100
    • Owners’ equity
    • = 43,800 x 100
    • 248,200
    • = 18%
    • Industry average = 15%
  • 31. Summary
    • Liquidity Ratios
      • Current ratio
      • Quick ratio
    • Efficiency Ratios
      • Inventory turnover
      • Average collection period
      • Fixed asset turnover
      • Total assets turnover
    • Financial Leverage Ratios
      • Debt ratio
      • Times interest earned
    • Profitability Ratios
      • Net profit margin
      • Return on assets
      • Return on equity
  • 32. LIMITATIONS OF RATIO ANALYSIS
    • Comparison with industry average is difficult for firms with various kind of industries.
    • Different operating and accounting practices among firms make comparison difficult.
    • Seasonal factors may distort ratios.
  • 33. SUMMARY
    • In this chapter we have:
      • Discussed the importance of accounting and financial statements to a company.
      • Discussed how to evaluate the performance of a firm using ratio analysis.
      • Discussed the limitations of ratio analysis