Chapter 14


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Chapter 14

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