Chap. 2-Analysis of Financial STMT and CFs-1

ANALYSIS OF FINANCIAL
STATEMENTS AND CASH

FLOWS
TOPIC 2
2011 Pearson Prentice Hall. All rights reserved.
Part A
1. The Income Statement
It is also known as Profit/Loss Statement
It measures the results of firms operation over a
specific period.
Income Statement for XYZ Co. for the period
ending 31st of August 2014
Income Statement for XYZ Co. for the year ended
31st of August 2014
(1st Sept 2013 31st Aug 2014)
The bottom line of the income statement shows the
firms profit or loss for a period.
2Sales 2011
Expenses
= All
Profits
or Loss
Pearson Prentice Hall.
rights reserved.
Income Statement Terms

Revenue (Sales)
Money derived from selling the companys product or service
Cost of Goods Sold (COGS)

The cost of producing or acquiring the goods or services to
be sold
Operating Expenses
Expenses related to marketing and distributing the product or
service and administering the business

Financing Costs
The interest paid to creditors
Tax Expenses
Amount of taxes owed, based upon taxable income
Figure 3-1
Figure 3-1 (cont.)
Table 3-1
2. The Balance Sheet

The balance sheet provides a snapshot of a firms
financial position at a particular date.
XYZ Co., Balance Sheet as at 31 August 2014
It includes three main items: assets, liabilities and
equity.
Assets (A) are resources owned by the firm

Liabilities (L) and owners equity (E) indicate how those
resources are financed

A = L + E
The transactions in balance sheet are recorded
historically at cost price, so the book value of a

firm may be very different from its current market
value.
Figure 3-3
Balance Sheet Terms: Assets

Current
assets comprise assets that are

relatively liquid, or expected to be converted into
cash within 12 months. Current assets typically
include:
Cash
Accounts Receivable (payments due from customers who
buy on credit)
Inventory (raw materials, work in process, and finished
goods held for eventual sale)
Other assets (ex.: Prepaid expenses are items paid for in
advance)
9
Balance Sheet Terms: Assets

Fixed Assets Include assets that will be used
for more than one year. Fixed assets typically

include:
Machinery and equipment
Buildings
Land
Other Assets Assets that are neither current
assets nor fixed assets. They may include longterm investments and intangible assets such as
patents, copyrights, and goodwill.
10
Balance Sheet Terms: Liabilities

Debt (Liabilities)
Money that has been borrowed from a creditor and must be repaid at
some predetermined date.

Debt could be current (must be repaid within twelve months) or longterm (repayment time exceeds one year).
Current Debt:
Accounts payable (Credit extended by suppliers to a firm when it
purchases inventories)
Accrued expenses (Short term liabilities incurred in the firms
operations but not yet paid for)
Short-term notes (Borrowings from a bank or lending institution due
and payable within 12 months)
Long-Term Debt
Borrowings from banks and other sources for more than 1 year
11
Balance Sheet Terms: Equity

Equity: Shareholders investment in the firm in the form of
preferred stock and common stock. Preferred stockholders

enjoy preference with regard to payment of dividend and
seniority at settlement of bankruptcy claims.
Treasury Stock: Stock that have been re-purchased by the
company.
Retained Earnings: Cumulative total of all the net income
over the life of the firm, less common stock dividends that
have been paid out over the years. Note retained earnings
are not equal to hard cash!
12
Balance Sheet: A = L + E
ASSETS (A)
Current Assets
Fixed Assets
Total Assets
LIABILITIES (L)
Current Liabilities
Long-Term Liabilities
Total Liabilities
OWNERS EQUITY
(E)
Preferred Stock
Common Stock
Retained earnings
Total Owners Equity

Total liabilities +
15
Equity
Table 3-3
14
Net Working Capital

Net Working Capital
= Current assets current liabilities
Larger the net working capital, better the firms ability
to repay its debt
Net working capital can be positive or zero or negative.
It is generally positive.
An increase in net working capital may not always be
good news. For example, if the level of inventory goes

up, current assets will increase and thus net working
capital will also increase. However, increasing inventory
level may well be a sign of inability to sell.
15
Debt Ratio
Debt ratio is the percentage of assets that are
financed by debt.
Debt
ratio is an indication of financial risk.

Generally, higher the ratio, the more risky the firm
is, as firms have to pay interest on debt regardless
of the earnings or cash flow situation.
16
What Is the Difference Between

"Source" & "Use of cash
3-17
Source
Source is a term used to refer to the
receipt of an economic resource in
a transaction.
3-18
Use
Use is a term used to refer to the
spending of an economic resource
in a transaction.
3-19
3-20
An increase in an asset - a use of cash

An increase in liability - a source of cash
An increase in equity - a source of cash
A decrease in asset - a source of cash
A decrease in liability - a use of cash
A decrease in equity - a use of cash
The Cash Flow Statement

The Cash Flow Statement is the third
report in the Financial Statement
package
3-21
3. Measuring Cash Flows

Profits in the financial statements are
calculated on accrual basis rather than

cash basis (see next slide for accrual
basis accounting).
Thus profits are not equal to cash.
22
Accrual Accounting
3-23
Definition: Accounting method

that records revenues and
expenses when they are incurred,
regardless of when cash is
exchanged. The term "accrual"
refers to any individual entry
recording revenue or expense in
the absence of a cash transaction
Accrual Basis Accounting &

Free cash flows
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 as assets in balance sheet) but are written off every year as
depreciation expense.
Free cash flows:
- the amount of cash available for operation after the firm pays for
the investment it has made in operating working capital and fixed
assets.
- this cash is available to distribute to the firms creditors and
owners.
24
Figure 3-6
How to measure a firms cash flows
25
Three sources of cash

flows
Cash flows from Operations

(ex. Sales revenue, labor expenses)
Cash flows from Investments

(ex. Purchase of new equipment)
Cash flows from Financing

(ex. Borrowing funds, payment of dividends)
If we know the cash flows from operations, investments

and financing, we can understand the firms cash flow
position better, that is, how cash was generated and how
it was used.
26
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)
27
Figure 3-7
28
Table 3-5
29
4. Income Taxes and

Finance
Computing Taxable Income for
Corporation
Gross Income
Dollar sales from a product or service less cost of
production or acquisition
Taxable Income
Gross income less tax deductible expenses, plus
interest income received and dividend income received
Tax Deductible Expenses
Include Operating expenses (marketing, depreciation,
administrative expenses) and interest expense
Dividends paid are not deductible
30
Table 3-6
Computing Taxable Income ($000s)
31
Figure 3-4
32
Part B: Financial Ratio Analysis

The Purpose of Financial Ratio
Analysis
Financial Analysis using Ratios
A
popular way to analyze the financial

statements is by computing ratios. A ratio is a
relationship between two numbers, e.g. If ratio
of A: B = 30:10 ==> A is 3 times B.
A ratio by itself may have no meaning. Hence,
a given ratio is compared to:

(a) ratios from previous years
(b) ratios of other firms and/or leaders in the same
industry
33
Uses of Financial Ratios:

Within the Firm
Identify deficiencies in a firms 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.
Understand the financial performance of the
firms competitors.
Evaluate the financial condition of a major
supplier.
34
Uses of Financial Ratios:

Outside the Firm
Financial ratios are used by:
Lenders in deciding whether or not to make a
loan to a company.
Credit-rating agencies in determining a firms
credit worthiness.
Investors (shareholders and bondholders) in
deciding whether or not to invest in a company.
Major suppliers in deciding to whether or not to
grant credit terms to a company.
35
The Limitations of Financial

Ratio Analysis
It is sometimes difficult to identify industry
categories or comparable peers.
The published peer group or industry averages
are only approximations.
Industry averages may not provide a desirable
target ratio.
Accounting practices differ widely among firms.

A high or low ratio does not automatically lead to
a specific conclusion.
Seasons may bias the numbers in the financial
statements.
36
1)Liquidity Ratios:
1) Current ratio = Current assets/Current liabilities
This ratio measures the degree of liquidity by comparing
its current assets to its current liabilities. Higher figure
means that the business financial condition is better as it
has enough liquid assets for its operation.
2) Quick ratio = (current assets-inventory/current liabilities)
This ratio is a more stringent measure of liquidity than the
current ratio. It excludes inventories and other current
assets that are least liquid from current assets. Higher ratio
shows that the business has enough quick assets or liquid
assets to cover its short term debt immediately.
37
2)ASSET
MANAGEMENT/ACTIVITY/EFFICIENCY
RATIOS
1)
2)
3)
38
Average collection periods (ACP)= Accounts receivable/(Annual credit

sales/365)
ACP = Accounts receivable/Daily sales
The ratio measures how long a firm takes to collect its credit
accounts. The lower the figure is better.
Account receivable turnover = sales/accounts receivables
This ratio measures how often accounts receivables are rolled over
during a year. Higher ratio illustrates that the firm can collect its
debt more frequent and thus has few bad debts.
Inventory turnover = costs of good sold/inventory
It measures the number of times a firms inventories are sold and
replaced during the year. Higher ratio indicates that inventory can be
sold and replaced more frequently.
4) Fixed asset turnover = sales/net fixed assets
This ratio is an overall measure of asset

efficiency based on the relation between
firms sales and the total assets. Higher
ratio indicates that firm is managing its
assets more effectively.
5) Total asset turnover = sales/total assets
Higher ratio is favored because it indicates
the effectiveness of the firm in generating
sales from its total assets.
39
3)PROFITABILITY RATIOS
1) Gross profit margin= gross profit/ sales
The gross profit margin is a measure of the gross profit earned on

sales. The gross profit margin considers the firm's cost of goods
sold, but does not include other costs. Higher ratio is better.
2) Net profit margin = Net income/sales
A higher profit margin indicates a more profitable company
thathas better control overits costs compared toits competitors.
3) Operating Profit Margin(OPM) = Operating profit/Sales
OPM examines how effective the company is in managing its
cost of goods sold and operating expenses that determine the
operating profit.
40
4)
Return on assets (ROA) = Net income/total assets

This evaluates how effectively the company
employs its assets to
generate a return. It measures efficiency. Higher
ratio is better.
5) Return on equity (ROE) = Net income/ common
equity
Return on equity is the bottom line measure for the
shareholders, measuring the profits earned for each
dollar invested in the firm's stock. Higher ratio is
favored because the firm can generate better return
to the owner of the firm.
41
4)LEVERAGE RATIOS
1)
Debt ratio = total debt/total assets
This ratio measures the extent to which a firm has been financed
with debt. More debt financing results in more financial risk.
2)
Times interest earned= EBIT/interest
The times interest earned ratio indicates how well the firm's
earnings can cover the interest payments on its debt. Higher ratio
shows better ability in meeting interest payment.
3)
Debt to equity ratio = total debt/total equity
This ratio indicates what proportion of equity and debt the
company is using
to finance its assets. A high debt to equity ratio could indicate
that the
company may be over-leveraged, and should look for ways to
reduce its debt.
42
5)MARKET VALUE RATIOS

1)
Earning per share (EPS) = Net income/number of shares outstanding

It represents the portion of a firm's earnings that is allocated to each
share of common stock.
2)
Price earning ratio (PE) = price per share/earnings per share

The ratio indicates how much investors are willing to pay per dollar of
current earnings. As such, high P/E Ratios are associated with growth
stocks. The most common measure of how expensive a stock is.
3)
Price (market) to book ratio=price per share/book value per share

This ratio measures how much a company worth at present, in
comparison with the amount of capital invested by current and past
shareholders into it.
4)
Book value per share= Total equity/Number of shares outstanding

The ratio of stockholder equity to the number of common stocks. Book
value per share should not be thought of as an indicator of economic worth,
since it reflects accounting valuation (and not necessarily market valuation).
(NEW DEFINITION-PLS WRITE DOWN)
43
Table 4-1
44
Table 4-2
45
1) LIQUIDITY RATIO
RATIO
1) Current ratio
2) Quick ratio
46
FORMULA
DAVIES INC.
PEER GROUP
Current
assets/current
liabilities
$143m/
$64m=2.23
1.80
(current assetsinventory/curren
t liabilities)
($143m-$84m)/
$64m =0.92
0.89
2)ASSET
MANAGEMENT/ACTIVITY/EFFICIENCY
RATIOS
RATIO
FORMULA
DAVIES INC.
PEER GROUP
1) Average
collection
periods (ACP)
Accounts
receivable/
(Annual credit
sales/365)
$36m/
($600m/365)
= 21.90 days
25 days
2)Account
receivable
turnover
sales/accounts
receivables
$600m/$36m
=16.67x
14.6x
3)Inventory
turnover
costs of good
sold/inventory
$460m/$84m
=5.48x
7.00x
4)Fixed asset
turnover
sales/net fixed
assets
$600m/$295m
=2.03x
1.75x
47
5)Total asset
sales/total
$600m/$438m
1.15x
3)PROFITABILITY RATIOS
RATIO
FORMULA
DAVIES INC.
PEER GROUP
gross
profit/sales
$140m/$600m
=0.233=23.3%
25%
Net
income/sales
$42m/$600m
=0.07=7%
6.5%
3)Operating
Profit
Margin(OPM)
Operating
profit/Sales
$75m/$600m
=0.125=12.5%
15.5%
4)Return on
assets (ROA)
Net
income/total
assets
$42m/$438m
=0.096=9.6%
10%
1)Gross profit
margin
2)Net profit
margin
5)Return on
Net income/
$42m/$203m
(ROE)
common
equity
2011
Pearson Prentice
Hall. All rights
reserved.=0.207=20.7%
48 equity
18%
4)LEVERAGE RATIOS
RATIO
1)Debt ratio
2)Times
interest earned
3)Debt to
equity ratio
49
FORMULA
DAVIES INC.
total debt/total $235m/$438m

assets
=0.537=53.7%
PEER GROUP
35%
EBIT/interest
$75m/$15m
=5.0x
7.0x
total debt/total
equity
$235m/$203m
=1.16x
2.05x
5)MARKET VALUE RATIOS

RATIO
1)Earning per
share (EPS)
2) Price earning
ratio (PE)
FORMULA
DAVIES INC.
PEER GROUP
Net
income/number
of shares
outstanding
$42m/20m=$2.
10
$1.89
price per
share/earnings
per share
$32/$2.10=15.2
4x
19.0x
(assume the
market price for
Davies stock
was $32 per
share)
50
3)Price (market)
price per
$32/$10.15=3.1
to book
ratio
share/book
5x
value per share
3.7x

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ANALYSIS OF FINANCIAL

STATEMENTS AND CASH

2011 Pearson Prentice Hall. All rights reserved.

Income Statement for XYZ Co. for the period

ending 31st of August 2014

Income Statement for XYZ Co. for the year ended

31st of August 2014

(1st Sept 2013 31st Aug 2014)

The bottom line of the income statement shows the

firms profit or loss for a period.

Income Statement Terms

Cost of Goods Sold (COGS)

service and administering the business

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2011 Pearson Prentice Hall. All rights reserved.

Figure 3-1 (cont.)

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2011 Pearson Prentice Hall. All rights reserved.

2. The Balance Sheet

financial position at a particular date.

XYZ Co., Balance Sheet as at 31 August 2014

It includes three main items: assets, liabilities and

Assets (A) are resources owned by the firm

resources are financed

The transactions in balance sheet are recorded

historically at cost price, so the book value of a

2011 Pearson Prentice Hall. All rights reserved.

2011 Pearson Prentice Hall. All rights reserved.

Balance Sheet Terms: Assets

assets comprise assets that are

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Balance Sheet Terms: Assets

for more than one year. Fixed assets typically

Other Assets Assets that are neither current

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Balance Sheet Terms: Liabilities

some predetermined date.

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Balance Sheet Terms: Equity

preferred stock and common stock. Preferred stockholders

Treasury Stock: Stock that have been re-purchased by the

Retained Earnings: Cumulative total of all the net income

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Total Owners Equity

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2011 Pearson Prentice Hall. All rights reserved.

Net Working Capital

to repay its debt

Net working capital can be positive or zero or negative.

An increase in net working capital may not always be

good news. For example, if the level of inventory goes

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ratio is an indication of financial risk.

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What Is the Difference Between

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2011 Pearson Prentice Hall. All rights reserved.

2011 Pearson Prentice Hall. All rights reserved.

An increase in an asset - a use of cash

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The Cash Flow Statement

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3. Measuring Cash Flows