UNIT_2.-_Accounting_and_financial_analysis.pdf

UNIT 2
Accounting and financial analysis
BUSINESS: COMPANY FUNDAMENTALS
1st Course
Degree in Telecommunications Technology Engineering
Business Fundamentals 1

2.1. Economic and financial structure of the company:
Assets, liabilities and Net worth
2.2. Working Capital
2.3. Operating Cycle. Breaking down average Cash Conversion Cycle.
2.4. Company´s results
2.5. Profitability
2.6. Solvency and liquidity
Contents
Business Fundamentals

• The economic-financial structure of the company is included
in its Balance Sheet.
• The balance sheet is an accounting document that reflects the
financial situation of the company at a given time.
• Three main kinds of components are distinguished:
2.1. Economic and financial structure of the company
ASSETS NET WORTH LIABILITIES
ECONOMIC STRUCTURE
(Investments)
FINANCIAL STRUCTURE
(Financial sources)

ASSETS
NET WORHT AND
LIABILITIES
A) NON CURRENT ASSETS
B) CURRENT ASSETS
A) NET WORTH
B) NON CURRENT
LIABILITIES
C) CURRENTS LIABILITIES

Asset
DEFINITION
Assets, rights and other resources
owned by the company, from
which it expects to obtain a
benefit in the future.

• Are the following elements
assets?
• Can the company account for
them?

 Not all of the company's resources are included in
the analysis of assets.
 Some intangible resources do not appear in the
analysis of assets.
 Perhaps the most important are the people, even
though they are one of the main resources of a
company, they do not appear in the assets. This is
one of the deficiencies of the balance sheet: not
collecting the knowledge and skills of the people
who work in the company.

NON CURRENT ASSETS
Assets that will remain linked to the company for
a period of time exceeding 1 year.
CURRENT ASSETS
Assets whose maturity, sale or realization is
expected to occur within 1 year.

Elements without physical appearance (patents,
trademarks, software, research and development
expenses, etc.)
Tangible elements, affected by the activity, to be
used for more than 1 year (machinery, vehicles,
facilities, etc.)
Real estate (land or buildings), not affected by the
activity, acquired to obtain a profit from its sale.
Shares of other companies, deposits in banks and
loans granted to other companies.
NON CURRENT ASSETS

It records the depreciation experienced (by use or
time) of intangible and tangible assets, and real
estate investments (excluding land). From the
moment they have been purchased until the
moment in which the balance is drawn up.
Note: It is included in the NON-CURRENT
ASSETS with a negative sign because it
reduces the value of the fixed assets.

Depreciable value: Loss of value that the asset will experience
throughout its useful life.
Acquisition price: Price by which the asset is acquired plus, if any, the
associated expenses (postage, customs, insurance, start-up expenses, etc.)
Residual value: Value that is expected to have the asset at the end of
its useful life.
Useful life: Number of years that the asset provides a service to the
company.

• At the end of each financial year (usually 1 year), the Annual
Depreciation (AD) of the assets is calculated (intangible and
tangible assets, and real estate investments). That is, the loss
of value that asset has experienced during that fiscal year.
• The most common method of calculation is the Linear
Depreciation Method:
years
life
useful
of
number
Value
Residual
-
price
n
Acquisitio
AD =

A company has acquired a machine for 60,000 euros
on January 1, 2018.
That price includes transport and assembly. The
company expects that this machine at the end of its
useful life (5 years) will have a residual value of 6,000
euros.
What is the depreciable value?
And the annual depreciation charge?
Exercise 2.1.

Products purchased (raw materials) or
manufactured for the purpose of being sold
(finished products) or used in the production
process (products in process).
Loans granted to customers for products invoiced
with a maturity of less than 1 year. And, in
general, any debt that someone has with the
company (workers, Public Administration, ...)
Shares acquired for the purpose of selling them
and obtaining short-term profits. And, in general,
any other financial investment, including loans to
companies with short-term maturities.
Money owned by the company in cash and bank
current accounts.
CURRENTS ASSETS

Net Worth and liabilities
DEFINITION
It includes the sources of financing
used by the company. That is, the
different means used to get the
money that the company needs.
ASSET = NET WORTH + LIABILITIES

Net Worth
Financing from the company itself (called own funds) and subsidies
obtained from different agencies.
NON CURRENT LIABILITIES
Financing from outside the company and to be repaid within a
period of> 1 year.
CURRENT LIABILITIES
Financing from outside the company and to repay within a period <1
year.
Net Worth and liabilities

NET WORTH
Financing from the contributions made
by the owners of the company. They can
be money or not.
Benefits from previous years not
distributed among the owners of the
company.
Profit or loss obtained by the company at
the end of the year pending application.
perceived by the company
and not required

NON CURRENT LIABILITIES
CURRENT LIABILITIES
Debts of the company with a maturity of
more than 1 year
Debts of the company with a maturity of
1 year or less

ACTIVO NET WORTH
NON CURRENT ASSETS
• Intangible Fixed Assets
*Accumulated Amortization (-)
• Tangible Fixed Assets
• Accumulated Depreciation (-)
• Investment Property
*Accumulated Depreciation (-)
• Long-term Financial Investments
CURRENT ASSETS
• Inventories
• Trade and other receivables
• Short-term financial Investments
• Cash and cash equivalents
OWN FUNDS
• Social Capital
• Reserves
• Profit and loss of the period
SUBSIDIES, DONATIONS AND
LEGACIES
LIABILITIES
NON CURRENT LIABILITIESTE
• Long-term liabilities
CURRENT LIABILITIES
• Short-term liabilities

Exercise 2.2.: Prepare the Balance Sheet based on the following data
corresponding to December 31, 201X :
The elements of depreciable property, plant and equipment were acquired 4 years ago, have a
useful life of 20 years and a residual value of 50,000 euros. As regards intangible assets, the
accumulated amortization is 40,000 euros.
1) Contributions from the owners of the company ......................................
2) Benefits from previous years not distributed among the owners ..............
3) Benefit of the pending application year .......................................
4) Equipment assets ...................................................................................
5) Short-term credits granted by raw material suppliers.
6) Credits granted to short-term clients .............................................
7) Loans granted to long-term group companies ............................
8) Short-term debts with the Public Treasury ........................................
9) Money in current accounts in a Savings Bank ...............................
10) Investment in shares of other companies in the short term
11) Raw materials in the warehouse ............................................................ ..
12) Office furniture ........................................................................... ..
13) Industrial building .................................................................................... ..
14) Land (not affected by the activity: inv. Speculative) .............................................
15) Patent ............................................................................................. ..
16) Loan granted by a long-term bank ................................. ..
17) Finished products in the warehouse ................................................... ..
18) Computer software ............................................................................
19) Subsidies granted by the Xunta de Galicia ....................................
20) Industrial vehicles ............................................................................
500.000
85.000
143.000
300.000
69.000
72.500
250.000
10.000
40.000
35.000
150.000
6.000
300.000
194.500
80.000
440.000
25.000
10.000
100.000
44.000

NON CURRENT
ASSETS
CURRENT ASSETS
PATRIMONIO NETO
CURRENT
LIABILITIES
PASIVO NO
CORRIENTE
PERMANENT
FINANCIAL
RESOURCES
(Net Worth + Non
Current Liabilities)
Liquidity
degree
—
+
Enforceability
degree
—
+
degree of approach to
conversion in money
expiration of the debt

There must be some correspondence between the liquidity of the
asset and the enforceability of the Net worth + Liability, to ensure that
the company can meet its payments at all times.
Therefore, as a general rule:
• non-current assets must be financed with permanent resources, and
• current assets must be financed with current liabilities, but
to avoid the risk of a gap between the pace of collections generated
by current assets and the rhythm of payments derived from current
liabilities, a portion of current assets must be financed with permanent
resources. That part of the current assets financed with permanent
resources is what is called Working Capital

NON CURRENT
ASSETS
CURRENT ASSETS
PATRIMONIO NETO
CURRENT
LIABILITIES
PASIVO NO
CORRIENTE
PERMANENT
FINANCIAL
RESOURCES
(Net Worth + Non
Current Liabilities)
Liquidity
degree
—
+
Enforceability
degree
—
+
conversion in money
expiration of the debt
Working
Capital

• Two way to calculate Working Capital (WC):
WC PR NCA
PR: Permanent Resources
NCA: Non Current Assets
CA: Current Assets
CL: Current Liabilities
WC CA CL

a) Maximum stability
Non Current
Assets
Net Worth
Current
Assets
b) Normal
Non Current
Assets
Net Worth
Current
Assets
Non Current
Liabilities
Current
Liabilities
WC>0
c) Financial instability
Non Current
Assets
Net Worth
Current
Assets
Non Current
Liabilities
Current
Liabilities
WC<0
d) Bankruptcy
Non Current
Assets
Accumulated
losses
Non Current
Liabilities
Current
Liabilities
Current
Assets

 How much is the Working Capital of the company in
the previous example?
 What is the financial situation of the company?
Exercise 2.3.

Purchase of raw
materials
Production Finished Products
Sale to the
supermarket
Payment
Example: Canned food manufacturer
they are stored until they are
incorporated into the production
system
They are stored until they
are sold to customers:
supermarkets and
hypermarkets
2.3. Operating Cycle. Breaking down Average
Cash Conversion Cycle.

• Operation cycle
Definition: Time that, on average, it takes to recover
1 € invested in the exploitation cycle.
• Two cases:
– Industrial business
– Trading companies
28
2.3. Operating Cycle. Breaking down Average
Cash Conversion Cycle.

29
Operating Cycle = APRMi + APMf + APFPs + APCc = X days
Case 1: INDUSTRIAL COMPANIES
Purchase of
Raw Material
Entry into production
of raw materials
Sale of the
finished product
Collection
from clients
Obtaining the
finished product
APRMi APCc
APFPs
APMf
 APRMi= Average Period of Raw Materials in Inventory before entering production process.
 APMf= Average period of manufacturing
 APFPs= Average period of storage of the finished product before its sale.
 APCc= Average period of collection from clients
2.3. Operating Cycle. Breaking down
Average Cash Conversion Cycle.
Days of Inventory Outstanding (DIO) Days of Sales Outstanding (DSO)

30
Purchase of
Raw Material
Sale of the
finished product
Cash Conversion Cycle
DPO
Collection
from clients
Payment to suppliers
of raw materials
Cash Conversion Cycle = Operating Cycle – DPO = Y days
DPO = Days of Payables Outstanding
Operating Cycle

31
Operating Cycle = DIO + DSO = X days
Case 2: TRADING COMPANIES
Purchase of
Goods for resale
Sale of Goods
for resale
DIO = Average period of storage of the merchandise before its sale.
DSO = Average collection period for clients.
DPO= Average period of payment to merchandise suppliers.
Cash Conversion Cycle = Operating Cycle — DPO
Days of Inventory Outstanding (DIO) Days of Sales Outstanding (DSO)
Collection
from clients
DPO

• The results of the company are included in the Profit
and Loss Account.
• The Profit and Loss Account is an accounting
document that includes:
INCOMES
EXPENSES
PROFIT/LOSS

INCOMES ≠ COLLECTIONS
EXPENSES ≠ PAYMENTS
The Profit and Loss Account includes only
income and expenses

INCOMES ≠ COLLECTIONS
Suppose a company makes a sale of 1,000 units of its product at 10 euros per
unit. This company records an income of 10,000 euros. Suppose now that the
company only receives 50% of the amount at the time of sale, leaving the
other 50% outstanding. This company then has a charge of 5,000 euros. So
this company has an income of 10,000 euros and a charge of 5,000 euros.
34
EXPENSES ≠ PAYMENTS
Suppose that a company acquires raw materials worth 5,000 euros. This
company then records an expense of 5,000 euros. Suppose that the
company at the time of purchase pays 50%, then you have a payment of
2,500 euros. Therefore, this company has an expense of 5,000 euros and a
payment of 2,500 euros.
The Profit and Loss Account includes only
income and expenses

+ Sales and other operating incomes
- Operating expenses
A.1) OPERATING PROFIT (EBIT: Earnings Before Interests and Taxes)
+ FinanciaI Incomes
- Financial Expenses
A.2) FINANCIAL PROFIT
A.3) EBT (Earnings Before Taxes)
- Corporate Taxes
A.4) NET PROFIT

LOSS AND PROFIT ACCOUNT SCHEME
Operating
Incomes
Operating
Expenses
Financial
Incomes
Financial
Expenses
Operating Profit Financial Profit
EBT
(Earnings Before Taxes)
Net Profit
Corporate Taxes

Operating Profit
Difference between income and expenses due to the usual
activity of the company
Financial Profit
Difference between interest earned on financial investments
(financial income) and interest paid on debts (financial
expenses).
Earnings Before Taxes (EBT)
Sum of the EXPLOITATION RESULT and the FINANCIAL RESULT.
Net Profit
Difference between RESULT BEFORE TAXES and the tax on profits.

Exercise 2.4. Prepare the Profit and Loss Account based on the
following data corresponding to December 31, 201X:
1) Consumption of raw materials: 28,000,000 euros.
2) Contributions to Social Security by the company: 1,650,000 euros.
3) Annual amortization fee for fixed assets: 50,000 euros
4) Dividends received for the shares of another company: 4,000 euros.
5) Fuel expenditure: 550,000 euros.
6) Expenditure on repair and maintenance of machinery: 600,000 euros.
7) Tax on economic activities (IAE) and other taxes: 1,000 euros.
8) Tax on profits: 1,500 euros.
9) Income received for the rental of some industrial buildings that do not use: 15,000 euros.
10) Income received from the sale of its products: 43,300,000 euros.
11) Interests paid for debts contracted with third parties: 40,000 euros.
12) Interest received for a loan granted to another company: 20,000 euros.
13) Other operating expenses: 5,000 euros
14) Prize received for good environmental conduct: 100,000 euros.
15) Services provided by other companies (advertising, consulting, cleaning, gardening, etc.):
725,000 euros
16) Salaries paid to staff: 11,813,000 euros.

Company A
Profit = 1 mill. euros
Investment = 10 mill. euros
Company B
Profit = 2 mill. euros
Investment = 30 mill. euros
10%
0,1
10
1
ROAA →
=
= 7%
0,07
30
2
ROAB →
=
=
2.5. Profitability
Profitability
Indicator of the efficiency with which the company manages
its production factors

• Return on Assets (ROA)
• Return on Equity (ROE)
• Sales Margin (SM)
rs´equity
Shareholde
Income
Net
ROE =
Assets
Total
(EBIT)
Profit
Operating
ROA =
Sales
(EBIT)
Profit
Operating
SM =
40
2.5. Profitability

• Relathionship between ROA and ROE:
• Three strategies to achive a good ROA:
1ª) SM high y Asset Turnover low
2ª) SM low y Asset Turnover high
3ª) SM high y Asset Turnover high
Turnover
Asset
Margin
Sales
Asset
Total
Sales
Sales
EBIT
Asset
Total
(EBIT)
profit
Operating
ROA
×
=
×
=
=
=
Multiply and divide by "sales”
Asset Turnover is the number
of times that sales cover the
total assets
2.5. Profitability

2. 6. Solvency and liquidity
Solvency
The ability of the company to meet the
payment commitments acquired, both in the
short and long term.
Liquidity
The ability of the company to meet
the payment commitments in the
short term.

Solvency ratio = Total assets / Total liabilities: It indicates whether the
company's assets are sufficient to cover all the company's debt.
Financial Leverage Ratio = Total liabilities / Shareholders´s equity: It
indicates the proportion of the company's indebtedness for each euro of
own funds with which it has. If it is greater than 1 it means that the
company is financed primarily with debt. If it is less than 1, the company
is financed primarily with its own funds.
Interest Coverage Ratio = Operating income / Financial expenses: If its
value is greater than 1, it indicates that the operating result is sufficient
to cover the interest on debts. If it is less than 1 it can be said that the
company can present certain solvency problems.
Solvency Ratios

Current Ratio = Current assets / Current liabilities: It indicates the
proportion of current assets for each euro of short-term debt
contracted by the company. It is a first approximation to assess
liquidity. It is not precise since it does not take into account the
different liquidity of the elements of current assets.
A company that has most of its current assets in cash is more liquid
than another company that has most of its current assets in stock.
Quick Ratio (Acid-test) = (Current Asset-Inventory) / Current Liability:
Indicates the ability to have cash to meet short-term payment
commitments. The numerator includes the most liquid components of
the asset, that is, money or assets easily convertible into money.
Cash Ratio = Cash / Current liabilities: Indicates the availability of cash to
meet short-term payment commitments.
Liquidity Ratios

(*) These values are approximate and relative, since everything depends on the type of
company and the economic conjuncture.
Indicadores Lo deseable es… (*)
SOLVENCY
Solvency Ratio Between 1,5 y 2,5
Financial Leverage Ratio
Depends on company financing
policy
Interest Coverage Ratio > 1,0 and as high as possible
LIQUIDITY
Current Ratio Between 1,0 and 2,0
Quick Ratio (Acid-test) Between 0,75 and 1,0
Cash Ratio Between 0,2 and 0,3
Debts
Assets
Total
Equity
rs´
Shareholde
Debt
Total
Expense
Interest
(EBIT)
Profit
Operating
s
Liabilitie
Current
Assets
Current
s
Liabilitie
Current
s
Inventorie
-
Assets
Current
s
Liabilitie
Current
Cash

Exercise 2.5.
A company presents the following balance sheet (data in thousands of euros):
• The operating result obtained in the year was € 552,000 and the interest
paid on the debts was € 43,750.
Calculate and interpret all financial ratios.
ASSET OWNERS´EQUITY and LIABILITIES
NON CURRENT ASSETS 1.400€ OWNERS´EQUITY 1.310€
CURRENT ASSETS 835€ Social Capital 1.100€
Inventories 400€ Reserves 160€
Trade and other receivables 230€ Subsidies 50€
Short-term financial investments 70€ NON CURRENT LIABILITIES 425€
Cash and cash equivalents 135€ CURRENT LIABILITIES 500€
Total 2.235€ Total 2.235€

UNIT_2.-_Accounting_and_financial_analysis.pdf

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