Analysis of Financial Statements

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Analysis of Financial Statements

  1. 1. Analysis of Financial Statements (Revised November 2004) The financial position of a firm is important to understand because it determines to a large extent the availability of capital and the desirability of future investments in new plants and equipment. Basic Financial Statements: The two basic financial statements of a firm are the balance sheet and the income statement or the statement of profit and loss. The balance sheet is a statement of the financial position of a firm as of a specific point in time. The basic balance sheet equation is: Assets = Liabilities + Net Worth. The assets are generally listed on the left side of a balance sheet. Assets are listed in decreasing order of liquidity, where liquidity refers to an assets capability for being converted to cash. For example, cash the most liquid asset is generally listed at the top of the assets column on a balance sheet. Other assets in order of decreasing liquidity would be marketable securities, accounts receivable and inventories. These assets are listed under current assets in Figure 1 because they are convertible to cash in less than one year. Other assets include investments not convertible to cash within one year, plant and equipment, prepaid expenses and deferred charges. Prepaid expenses might include prepaid insured premiums or rents whereas deferred charges refer to expenses to be recovered over an extended business period. An example of a deferred charge might be the cost to set up the organization which might be recovered over the life of the firm. The claims on the assets of a firm include the liabilities and the net worth. Liabilities are claims of creditors and have precedence on rights to the assets before the owners. Net worth refers to the portion of the assets of a firm, which are paid for by the owners. Liabilities are separated into current and other liabilities. Current liabilities are those debts which are payable within one year. Examples of current liabilities include accounts and notes payable within one year and taxes and other expenses which have accrued and are payable within one year. Net Working capital is defined as the current assets minus current liabilities. The Owner's Equity or Net Worth is generally made up of preferred and common stock, capital surplus and retained earnings. Capital surplus is the amount of money received from the sale of stock in excess of the face value of the stock. Retained earnings are the accumulated net operating income after taxes less the dividends paid to stockholders. The Income Statement or Statement of Profit and Loss (Figure 2) shows the financial performance of the firm over an interval of time. Net Sales are gross sales less returns. Gross Profit is net sales less the cost of goods sold excluding certain cost such as selling, general and administrative expenses and lease payments which cannot be directly attributed to the acquisition or manufacture of the goods sold. Gross operating income is gross profit less the above mentioned operating expenses which are not directly attributed to the cost of the goods sold.
  2. 2. Manhan Manufacturing Company Balance Sheet as of: Assets Dec. Dec.2004 2003 Current Assets (X 1000) (X 1000) Cash 5,500 7,500 Marketable Securities 5,000 3000 Accounts Receivable 17,000 20,000 Notes Receivable 2,500 3,700 Finished Goods 22,700 21,400 Inventory Other Inventory 7,700 8,000 Other Current Assets 9,400 8,300 Total Current Assets 69,800 71,900 Other Investments 5,000 4,000 Plant and Equipment 140,000 150,000 Less Depreciation (50,000) 90,000 (70,000) 80,000 Prepaid Expenses 1 1,500 2,000 Deferred Charges 2 3,000 2,500 Total Assets 169,300 160,400 Liabilities Current Liabilities Accounts payable 26,000 15,000 Notes payable (within 15,000 10,000 1 year) Accrued taxes & other 3,500 3,000 expenses Total Current Liabilities 44,500 28,000 First Mortgage bonds 22,000 20,000 8% Debentures 8% 10,000 10,000 Total Liabilities 76,500 58,000 Owner's Equity (Net Worth) Preferred stock 10,000 10,000 Common Stock 40,000 40,000 Capital surplus 4 10,000 10,000 Retained earnings 5 32,800 42,400 Total Owner's Equity 92,800 102,400 (Net Worth) Total Claims on Assets 169,300 160,400 Figure 1 Manhan Corporation Balance Sheet 1 An example could be a prepaid insurance premium.
  3. 3. 2 Deferred charges refer to expenses which are recovered over an extended period of the business operation. Ex. cost to incorporate, legal fees. 3 Includes federal income taxes, FICA, etc. 4 Capital surplus = Amount received from sale of the stock less face value of stock. 5 Retained earnings = Net operating income after taxes less dividends.
  4. 4. Net operating income is gross operating income less the depreciation charge for the period covered by the statement. Net income before taxes is net operating income less non operating expenses such as interest on notes and secured loans. Net income after taxes is net income before taxes less federal and state income taxes. The Statement of Retained Earnings (Figure 3) indicates how the retained earnings changes from one balance sheet to the next. The prior balance sheet retained earnings is adjusted by adding net income after taxes from the income statement and subtracting dividends paid to stockholders to obtain retained earnings for the new balance sheet. The retained earnings represents the additional investment in the company by the owners in addition to the initial investment made when their stock was purchased. Manhan Manufacturing Company Income Statement (For Year Ended Dec. 31, 2004) Net sales 300,000 Cost of goods sold 188,000 Gross profit 112,000 Less operating expenses Selling 15,000 General & admin. 20,000 Lease payments 14,000 49,000 Gross operating income 63,000 Less depreciation 20,000 Net operating income 43,000 Less other expenses Interest in notes payable 3,000 Interest on first mortgage 1,400 Interest on debentures 800 5,200 Net Income before income taxes 37,800 Federal income tax 18,144 Net income after income taxes 19,656 Figure 2 Manhan Corporation Income Statement Manhan Manufacturing Company Statement of Retained Earnings (For Year Ended Dec. 31, 2004) Balance of retained earning 1/1/04 32,800 Add: Net income 2004 19,656 52,456 Less: Dividends to stockholders 10,056 Balance of retained earnings 12/31/04 42,400 Figure 3 Manhan Corporation Statement of Retained Earnings
  5. 5. Ratio Analysis of Financial Statements: The four types of ratios are: liquidity ratios, leverage ratios, activity ratios V and profitability ratios. Liquidity ratios are most important when accessing a firm ability to meet its' short term debts. A creditor considering making a short term loan to a firm would be most interested in the firm's liquidity ratios. Leverage ratios measure the extent which a firm's assets are financed by creditors as compared with owners. High leverage ratios generally mean high risk for creditors. Activity ratios measure the firm’s ability to effectively manage its resources, such as inventory, and fixed assets. Profitability ratios measure the firm's ability to achieve returns on sales and investment. Activity and profitability ratios are most important when measuring the firm's long term financial position. Table 1 presents the ratio, its calculation formula, and the application of the formula to the 2004 Manhan Corporation data presented in its balance sheet and income statement. In order to gage the financial condition of the Manhan Corporation the analyst must compare the ratios obtained with industry averages for its industry. In order to obtain a picture of the firm’s progress over the past several years, it is often helpful to plot key ratios for the corporation and the industry average on the same time scaled graph as shown in Figure 4. Comparative ratios for major corporations and industry groups may be obtained from a wide variety of sources. Perhaps the most complete source is compiled by Dun & Bradstreet, Inc. Other sources of comparative ratios include Robert Morris Associate; the National Association of Bank Loan Officers; the Quarterly Financial Report for Manufacturing Corporations published jointly by the Federal Trade Commission (FTC) and the Securities and Exchange Commission (SEC); Forbes, Annual Report on American Industry, vital facts and ratios for 500 largest corporations, published annually in the January issue; Fortune, Fortune 500 annual report on costs and ratios, June issue and Standards and Poor's Industry Surveys for all major industries, includes ratios for each major company in each major industry.
  6. 6. Table 1 Manhan Corporation Financial Ratios Ratio Formula Manhan Corp. 04 I Liquidity Ratios 1. Current Ratio Current Assets / Current Liabilities 71,900 / 28,000 = 2.57 2. Quick or acid test Current Assets-inventory / Current 42,500 / 28,000 = Liabilities 1.52 II Leverage Ratios 3. Debt to total Total liabilities / Total Assets 58,000 / 160,400 = assets 0.36 4. Times interest Gross operating income* / Interest 63,000 / 5,200 = earned charges* 12.12 III Activity Ratios 5. Inventory turnover Net sales* / Inventory 300,000 / 29,400 = 10.20 6. Fixed assets Net sales* / Fixed assets 300,000 / 80,000 = turnover 3.75 7. Total assets Net sales* / Total assets 300,000 / 160,400 = turnover 1.87 8. Average collection Receivables / Sales per day* 23,700 / 822 = 28.8 period IV Profitability Ratios 9. Return on Total Net income after taxes* / Total assets 19,656 / 160,400 = Assets 12.3% 10. Profit margin Net income after taxes* / Net Sales* 19,656 / 300,000 = on sales 6.6% 11. Return on Net Net income after taxes* / Net Worth 19,656 / 102,400 = Worth or Return on 19.2% Equity * This comes from the income statement Figure 4 Comparison over time of Manhan Corporation ratios with industry averages.
  7. 7. A funds flow chart is presented in Figure 5. The chart depicts the impact of various costs, sales, and assets on total return on investment. The cost data appearing under each rectangular block of Figure 5 was taken from Figures 1 and 2. Manhan Corporation Funds Flow chart Cash & Marketable Securities 1050 + Accounts & Notes Receivable Net Sales 23700 Working ═ 300000 Capital ═ + Turn Over ÷ Inventories 1.87 Total ═ + 63600 29400 Investment Other 160400 Assets * Cost of Goods Sold Return on ═ x 96800 188000 Investment 12.25 Net Sales + * Selling Expenses Net income ═ - 300000 after Taxes 15000 Total Net income as ═ ═ 19656 Cost of + * General & Admin. a % of sales ÷ operation 12.29 Expenses 6.55% 280344 20000 Net Sales + * Other Operating 300000 Expenses 14000 * This comes from the income statement. Depreciation, + Interest & Taxes 43344 Figure 5 Manhan Corporation Funds flow chart Exercise: Select a company of interest and perform a financial analysis of that company by obtaining data from one of the sources mentioned in this section. References: 1. Forbes Magazine, “Annual Report on American Industry”, Presents vital facts and ratios for 500 largest corporations, January of each year 2. Forbes Magazine, “Annual Report - Fortune 500", Costs and ratios for 500 corporations, June 3. Foulke, Roy A., "Practical Financial Statement Analyses," N.Y. - McGraw-Hill, 1961. 4. "Standard and Poor's Basic Industry Surveys for Major Industries," includes financial ratios for each major company in each major industry. 5. "Quarterly Financial Report for Manufacturing Corporations," issued jointly by the Federal Trade Commission, Washington, U.S. Govt. Printing Office. 6. Johnson, Arnold W., "The Interpretation of Financial Statements," Financial Analyst Journal, Nov. - Dec., 1968, pp. 75-84.

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