Chapters 2 & 3 Financial Statements and Analysis

Introduction  Financial statements reflect the performance of a firm from a financial perspective  They are very often used in getting finance from outside sources e.g. bank loan, bond market, stock market, etc  In merger and acquisition, the manager will inspect the financial statements of the firm to be acquired  Agenda today - to understand and analyze financial statements

Types of Financial Statements  Income Statement -Provides a summary of the firm’s financial transactions for a period of time  Balance Sheet -Reviews the firm’s financial position at a particular point in time  Statement of Cash Flow -Indicates the cash flow of the firm at a point in time

Income Statement  Begins with the aggregate amount of sales for a specific period of time (e.g.fiscal year)  Subtract the expenses according to their relative importance in producing the sales  The final outcome is Net Income which can be used to generate the earnings per share (EPS) value and price/earning (P/E) ratio

Balance Sheet  Left hand side shows the Assets employed in the operation of the firm (capital budgeting)  Right hand side reviews the liabilities and shareholders’ equity (sources of financing)  Assets are listed in their order of liquidity  Sources of financing are listed in their order of maturity

Statement of Cash Flows  Emphasizes the critical nature of cash flow  Reviews cash flows  From operating activities  From investing activities  From financing activities

Tax Consideration  It affects the income after-tax; hence it affects earnings & earnings growth  In making investment decision, it is the after-tax cash flows that matter

Financial Statement Analysis  Analysis of the firm’s financial strength -Liquidity -Solvency (debt utilization)  Analysis of management performance -Profitability -Asset utilization

Tool for financial analysis  Financial ratios  Ratio of two values from balance sheet e.g. current assets/current liabilities  Ratio of two values from income statement e.g. net income/sales  Ratio of one value from balance sheet and one value from income statement e.g. net income/shareholders’ equity

Advantages in using financial ratios  Facilitates comparison across firms  Facilitates comparison of firms of different sizes  Enables comparison to industry norm  Enables comparison of results from different years (trend analysis)

Financial strength - Liquidity  Liquidity – likelihood of the firm to meet its short-term obligations  Current ratio = current assets/current liabilities = / = 2.67  Quick ratio = (current assets – inventories)/current liabilities = ( )/ = 1.43

Financial strength - Solvency  Solvency – ability of the firm to satisfy its long- term obligations  Debt-equity ratio = long-term debt/equity = / = 0.3  Total debt to total assets = total debt/total assets = / =  Times interest earned = income before interest and taxes/interest = /50000 = 11

Management performance - profitability  Profits gained in using the equity or assets  Return on equity = net income/equity = / = 0.2  Return on assets = net income/total assets = / =  Profit margin = net income/sales = / = 0.05

Management performance – assets utilization  Measure the turn-over speed of the firm’s assets  Receivable turnover = Sales/receivables = / = 11.4  Average collection period = receivables/average daily credit sales = /( /365) = 32

Assets Utilization cont’  Inventory turnover = COGS/Inventory = / = 8.1  Capital asset turnover = Sales/Capital asset = / = 5  Total asset turnover = Sales/Total assets = / = 2.5

Norm Comparison  Profit margin of the firm = 5%  Industry norm = 6.5%  Below average  Average collection period of the firm = 32 days  Industry norm = 36 days  Above average

Trend Comparison  Profit margins in 1998, 1999 & 2000 are 3%, 4% & 5% respectively  Profit margins are growing – good sign  Average collection days in 1998, 1999 & 2000 are 28 days, 30 days & 32 days  Collection time is increasing – bad sign

Limitations of Ratio Analysis  Different accounting methods across different firms  Ratios may change as a result of changes in accounting method e.g. change in inventory valuation, revenue recognition, etc  Ratios are based on historical information and may change in the future

Summary  Three types of financial statements – Income Statement, Balance Sheet and Statement of Cash Flows  Four categories of financial ratios – Liquidity, Solvency, Profitability & Asset Utilization  Advantages in using ratios – norm & trend analysis  Limitations in using ratios