ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement

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Financial Management MGT201

Lesson 03

ANALYSIS OF FINANCIAL STATEMENTS

Learning Objectives:

After going through this lecture, you would be able to have a better understanding of the following

concepts.

· Analysis of Financial Statements

· Key Financial Ratios

· Limitation of Financial Statements Analysis

· Market value added & Economic value added.

You have studied in previous lecture

· Objective of Economics:

The objective of economics is profit maximization, however, for whom the profit is to be

maximized and for what duration may vary.

· Objective of Financial Accounting (FA):

The objective of financial accounting is to record accurate, timely, consistent, and

generalized collection of financial data, consolidating the information and reporting it to the

management for decision-making. Nevertheless, the decision-makers use financial

management techniques for a useful interpretation of the consolidated financial data.

· Objective of Financial Management (FM):

The objective of financial management is to maximize the wealth of the

shareholders/owners. One way of increasing shareholders' wealth is by maximizing the

stock price. In financial management when we talk about the profit maximization, we

actually imply profit maximization for the shareholders of the company. We can simply

measure it from the share price of the company in the market.

Another way is to find the best investment and financing opportunities in order to maximize

the value of the company. As we will see in the later lectures, the two ways are closely

related to each other. Financial statements are used to assess the financial position as well as

performance of the company, so that the financing and investing decisions could be taken

accordingly.

Analysis of Financial Statements:

A company's financial statements need to be studied for signs of financial strengths and

weaknesses and then compared to (or benchmarked against) the industry. Before getting

into the details of the financial management techniques, we would briefly revise some of the

accounting concepts, which are going to help us in comprehending those analysis

techniques.

Basic Financial Statements:

There are four basic financial statements that are prepared by the financial accountants for the

use of the managers, creditors and investors of the company. These statements are

a. Balance Sheet

b. P/L or Income Statement

c. Cash Flow Statement

d. Statement of Retained Earnings (or Shareholders' Equity Statement)

The concepts that we are going to discuss here in reviewing financial accounting concepts are

Fundamental Accounting Equation and Double Entry Principle.

· Assets +Expense = Liabilities + Shareholders' Equity + Revenue

(Note: Expense & Revenue are Temporary P/L accounts the others are Permanent Balance Sheet

Accounts)

· Left Hand Items increase when debited. Right Hand items increase when credited.

· For every journal entry, the Sum of Debits = the Sum of Credits

Balance Sheet:

The following facts about balance sheet are also going to help us in understanding the

financial statements analysis process.

A balance sheet is a `static snapshot' at one point in time (therefore the consolidated

data available is vulnerable to inventory and cash swings, i.e., if the balance sheet of a

firm is showing low inventory and high cash position at the year ending when the

Financial Management MGT201

balance sheet is prepared, the company may buy excessive inventory against cash the

very next day. The balance sheet prepared a day earlier would not report the new

transaction and the latest financial position of the company would not be known to the

analyst, unless the company updates him on that.)

Balance sheet items or accounts are `permanent accounts' that continue to accumulate

from one accounting cycle to the next.

Balance sheet items are recorded on historical cost basis, i.e., the balance sheet neglects

any increase in value of assets resulting from inflation and reports assets and liabilities

at their book value. It is a big limitation for financial analysts, since a useful analysis

could only be made by considering the assets and liabilities at their market value rather

than book value. Nevertheless, there are some approaches by which we can solve this

problem. Constant rupee approach is one such remedy.

Constant Rupee Approach: In constant rupee approach, two balance sheets of the same

company for different times are compared at a specific time and inflationary

adjustments are made.

· Assets (Left Hand Side):

Having revised certain concepts and limitations of financial accounting process and

financial statements, we would now have a brief overview of the items that appear on the left-hand

side of the balance sheet, known as assets.

Assets are economic and business resources that are used in generating revenue for the

organization: They can be tangible (inventory) or intangible (patent, brand value,

license). Some assets are classified as current (cash, accounts receivable) and others are

fixed (machinery, land, and building). There are also long-term assets (property, loans

given) and contingent assets, the value of which can only be assessed in future (legal

claim pending, option).

Current Assets = Cash + Marketable Securities + Accounts Receivable + Pre-Paid

Expenses + Inventory

The accounts receivable aging schedule is a listing of the customers making up total

accounts receivable balance. Most businesses prepare an accounts receivable aging

schedule at the end of each month. Analyzing your accounts receivable aging schedule

may help you identify potential cash flow problems.

Inventory value (at any instant in time) is a very controversial figure which depends on

inventory valuation methodology (i.e. FIFO, LIFO, Average Cost) and Depreciation

Method (i.e. Straight Line, Double Declining, Accelerated). Companies have the

flexibility that they can use one methodology for preparing the financial statements &

the different methodology for tax purposes.

· Liabilities (Right Hand Side):

The right hand side of the balance sheet represents liabilities.

Liabilities are sources which are use to acquire the resources or liabilities are

obligations of two types:

1) Obligations to outside creditors and

2) Obligations to shareholders known as Equity.

Liabilities can be short term debts, long term debt, equity, retained earnings, contingent,

unrealized gain on holding of marketable securities

Current Liabilities = Account Payables + Short Term Loans + Accrued Expenses

Net Working Capital = Current Assets Current Liabilities

Total Equity = Common Equity + Paid In Capital + Retained Earnings (Retained

Earnings is NOT cash always)

Total Equity represents the residual excess value of Assets over Liabilities: Assets

Liabilities = Equity = Net Worth

Only cash account represents real cash which can be used to pay your bills!!

Profit & Loss account or Income Statement:

An income statement is a "flow statement" over a period of time matching the operating

cycle of the business, which reports the income of the firm.

Generally, Revenue Expense = Income

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Right hand side receipts (revenues) are added. Left hand side payments (expenses) are

subtracted.

P/L Items or Accounts are `temporary' accounts that need to be closed at the end of the

accounting cycle.

Sales revenue Cost of Goods Sold = Gross Profit (Revenue)

Cost of Goods Sold is a very controversial figure that varies depending on Inventory

Valuation Method (i.e., FIFO, LIFO, Average Cost) and Depreciation Method (Straight

Line, Double Declining, Accelerated). Depreciation is treated as an expense (although

it is non-cash)

Gross Revenue Admin & Operating Expenses = Operating Revenue

Operating Revenue Other Expenses + Other Revenue = EBIT

EBIT Financial Charges & Interest = EBT Note: Leasing Treatment

EBT Tax = Net Income

Net Income Dividends = Retained Earnings

Net Income is NOT cash (it can't pay for bills)

P/L Statement of Company XYZ

Year Ending June 30th 2002)

(`000 Rs.)

(`000 Rs)

Net Sales

1000

Cost of Goods Sold

(500)

Gross Profit

500

Administration Expenses

(200)

Depreciation Expense

(0)

Operating Profit

300

Other Expenses

(180)

Other Income (interest)

(0)

(180)

EBIT

120

Tax

(20)

Net Income

100

Cash Flow Statement:

A cash flow statement shows the cash position of the firm and the way cash has been

acquired or utilized in an accounting period.

A cash flow statement separates the activities of the firm into three categories, which are

operating activities, investing activities and financing activities.

· Operating Cash Flow Statement can be obtained by using two approaches:

1) Direct

2) Indirect.

A cash flow statement can be derived from P/L or Income Statement and two consecutive year Balance

Sheets.

· A cash flow statement is not prepared on accrual basis but rather on cash basis: Actual

cash receipts and cash payments.

· The net income is obtained from the Income Statement of a period of time matching

the operating cycle of the business. Generally:

Revenue Expense = Income

In order to arrive as the cash flows resulting from operating activities Increases in current assets

are cash payments (-), i.e., cash outflow

Increases in current liabilities are cash receipts (+), i.e., cash inflow

Right Hand Side Receipts are added.

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Left Hand Side payments are subtracted

Statement of Retained Earnings or Shareholders' Equity Statement

Total Equity = Common Par Stock Issued + Paid In Capital + Retained Earnings

(Retained Earnings is the cumulative income that is not given out as Dividend it is NOT cash)

XYZ

Cash Flow Statement

(June 30th 2001 June 30th 2002)

(`000 Rs)

Net Income

400

Add Depreciation Expense

100

Subtract Increase in Current Assets:

Increase in Cash

(400)

Increase in Inventory

(700)

(1100)

Add Increase in Current Liabilities:

Increase in A/c Payable

500

Cash Flow from Operations

(100)

Cash Flow from Investments

Cash Flow from Financing

500

Net Cash Flow from All Activities

400

Note 1:

Indirect Cash Flow Approach using Income Statement and two consecutive Balance

Sheets

Note 2:

Final Net Cash Flow from All Activities should match the difference in the difference in

the closing balances in the Balance Sheets from June 30th 2001 and June 30th 2002

Note 3:

Investments include all cash sale and purchases of non-current assets and marketable

securities

Note 4:

Financing includes all cash changes in loans, leasing, and equity etc.

SOME FINANCIAL RATIOS:

LIQUIDITY & SOLVENCY RATIOS:

Current Ratio: Current ratio is a ratio between current assets and liabilities, which tells that for every

dollar in current liabilities, how many current assets do the company possess. Since the current

liabilities are usually paid out of current assets, it makes sense to compare the two figures to assess the

liquidity of the firm. Liquidity implies the ease with which the current liabilities can be paid off.

Generally, the higher the ratio, the better it is considered, but too high a ratio may imply less productive

use of current assets. A ratio of two to one (2:1) is considered ideal.

= Current Assets / Current Liabilities

Quick/Acid Test ratio: Quick ratio is relatively a stringent measure of liquidity. The ratio is obtained

by subtracting inventory from current assets and dividing the result by current liabilities. Inventory is

the least liquid of all current assets. By subtracting inventory from current assets, we are actually

comparing more liquid assets with current liabilities. This ratio not only helps in gauging the solvency

of the company, it may also show if the inventories are piling up. A desirable quick ratio can range from

(0.8:1) to (1.5:1) depending on the nature of the business.

= (Current Assets Inventory) / Current Liabilities

Financial Management MGT201

Average Collection Period: Also known as Days Sales Outstanding, average collection period shows in

how many days the Accounts receivables of the company are converted into cash. Most of the

companies sell most of their products/services on credit basis, hence it is critical for the company to

know in how much time these receivables could be converted to cash in order to ensure liquidity at all

times. Average collection period is calculated using the following formula

= Average Accounts Receivable /(Annual Sales/360)

Note: Average collection period is usually expressed in terms of days. If you find a decimalized answer,

you should round it off to the next integer.

PROFITABILITY RATIOS:

The profitability ratios show the combine effects of liquidity, asset management, and debt

management on operating result.

Profit Margin (on sales): One of the most commonly used ratios is profit margin on sales. This ratio

tells the percentage of profit for every dollar of revenue earned. This ratio is usually expressed in terms

of percentage and the general rule is , the higher the ratio, the better it is. Most of the companies

compare this ratio to the previous years' ratios to assess if the company is better off.

= [Net Income / Sales] X 100

Return on Assets: Return on assets is another profitability ratio, which shows the profitability of the

company against each dollar invested in total assets. We can obtain this figure by simply by dividing the

net profit with total assets. Since the assets are economic resources that are used to earn profit, it is

logical to assess if the assets have been used efficiently enough to generate profits. This ratio is also

expressed in percentage terms.

= [Net Income / Total Assets] X 100

Return on equity:

Return on equity is of special interest to the shareholders, since equity

represents the owners' share in the business. Return on equity can be obtained by dividing the net

income with the total equity. This ratio shows that for each dollar in equity how much profit is

generated by the company.

= [Net Income/Common Equity]

ASSET MANAGEMENT RATIOS

These measures show how effectively the firm has been managing its assets.

Inventory Turnover:

Inventory turnover shows the number of times the inventories are replenished within one

accounting cycle. The ratio can be obtained by dividing the sales by inventory. While the quick ratio

measures the liquidity and points out the inventory piling problem, the inventory turnover confirms

whether or not the major portion of the current assets of the firm are tied up in inventory. This ratio is

also used in measuring the operating cycle and cash cycle of the firm. A higher turnover is desirable as

it reflects the liquidity of the inventories.

= Sales / inventories

Total Assets Turnover:

An effective use of total assets held by a company ensures greater

revenue to the firm. In order to measure how effectively a company has used its total assets to generate

revenues, we compute the total assets turnover ratios, dividing the sales by total assets.

= Sales / Total Assets

An increasing ratio over the years may show that with an addition of assets, the company has

been able to generate incremental sales in greater proportion.

DEBT (OR CAPITAL STRUCTURE) RATIOS:

Debt-Assets: A commonly used ratio to measure the capital structure of the firm is debt to assets ratio.

Capital structure refers to the financing mix (proportion of debt and equity) of a firm. The greater the

proportion of debt in the financing mix, the less willing creditors, and investors would be to provide

more finances to the company. In Pakistan, the debt to assets ratio is prescribed in prudential regulations

by the State Bank of Pakistan as a guideline for the banks (creditors). A ratio greater than 0.66 to 1 is

considered alarming for the providers of funds.

= Total Debt / Total Assets

Debt-Equity: Another commonly used ratio, debt to equity, explicitly shows the proportion to debt to

equity. A ratio of 60 to 40 is used for new projects, i.e., for a project it is permitted to raise its finances

60 percent from the debt and 40 percent from equity. Debt to equity is computed by the following

formula.

Financial Management MGT201

= Total Debt / Total Equity

Times-Interest-Earned: Times-interest-earned reflects the ability of a company to pay its financial

charges (interest). This ratio is obtained by dividing the operating profit by the interest charges.

Conceptually, the interest charges are to be paid from the earnings before interest and taxes. A ratio of 4

to 1 shows that the company covers the interest charges 4 times, which is generally considered

satisfactory by the management, however, a ratio higher than that, may be more desirable. A high time-

interest-earned ratio is a good sign, especially for the creditors.

= EBIT / Interest Charges

Market Value Ratios:

Market value ratios relate the firm's stock price to its earnings & book value per share. These

ratios give management an indication of what equity investors think of the company's past performance

& future prospects

Price Earning Ratio:

It shows how much investors are willing to pay per rupee of reported profits. This ratio reflects

the optimism, or lack thereof, investors have about the future performance of the company.

= Market Price per share / *Earnings per share

Market /Book Ratio:

Market to book ratio gives an indication how equity investors regard the company's value. This

ratio is also used in case of mergers, acquisition or in the event of bankruptcy of the firm.

= Market Price per share / Book Value per share

*Earning Per Share (EPS):

= Net Income / Average Number of Common Shares Outstanding

Ratios help us to compare different businesses in the same industry and of a similar size.

Limitations of Financial Statement Analysis:

Despite the fact that ratios are a useful analysis tool, there are certain limitations, which are

important for an analyst to understand before applying this tool, in order to make his analysis more

meaningful.

· FSA is generally an outdated (because of Historical Cost Basis) post-mortem of what has

already happened. It is simply a common starting point for comparison. Use Constant Rupee /

Dollar analysis to account for inflation.

· FSA is limited by the fact that financial statements are "window dressed" by creative

accountants. Window dressing refers to the understatement or overstatement of financial facts.

· Different companies use different accounting standards for Inventory, Depreciation, etc.

therefore comparing their financial ratios can be misleading

· FSA just presents a few static snapshots of a business' financial health but not the complete

moving picture.

· It's difficult to say based on Financial Ratios whether a company is healthy or not because that

depends on the size and nature of the business.

Difference in Focus:

Financial Statements are prepared by financial accountants with a certain perspective,

however the financial managers--the end users of these financial statements, have a different focus to

draw meaningful conclusions out of these statements. These differences are listed below

· Financial Accounting (FA) Focus:

· Use Historical Value (assets are booked at original purchase price)

· Follow Accrual Principle (calculate Net Income based on accrued expense and accrued

revenue)

· How to most logically, clearly, and completely represent the financial data.

· Financial Management (FM) Focus:

· Use Market Value (assets are valued at current market price)

· Follow Incremental Cash Flows because an Asset's (and a Company's) Value is

determined by the cash flows that it generates.

· How to pick the best assets and liabilities portfolios in order to maximize shareholder

wealth.

Financial Management MGT201

FM Measures of Financial Health:

The financial management measures that are used for assessing the financial health of a company

primarily focus on the basic objective of financial management, i.e., to increase the wealth of the

shareholders. Given below are the two important measures of financial health.

M.V.A (Market Value Added):

Market Value Added is a measure of wealth added to the amount of equity capital provided by

the shareholders. It can be determined by the following equation

MVA (Rupees) = Market Value of Equity Book Value of Equity Capital

Following are the characteristics of MVA

· It is a cumulative measure, i.e., it is measured from the inception of the company to

date. Market Value is based on market price of shares.

· It shows how much more (or less) value the management has succeeded in adding (or

reducing) to the company in the eyes of the general public / market.

· It is used for incentive compensation packages for CEO's and higher level

management.

· E.V.A (Economic Value Added):

Economic Value Added, on the other hand, focuses on the managerial effectiveness in a

given year. It can be obtained by subtracting the cost of total capital from the operating profits of a

company

EVA (Rupees) = EBIT (or Operating Profit) Cost of Total Capital

EVA has the following characteristics

· It is measured for any one year.

· It is relatively difficult to calculate because Operating Profit depends on

Depreciation Method, Inventory Valuation, and Leasing Treatment, etc. Also, a

combined Cost of Total Capital (Debt and Equity) is difficult to compute.

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