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Financial Statement Analysis MGT-537 Dr. Hafiz Muhammad Ishaq 32

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1 Financial Statement Analysis MGT-537 Dr. Hafiz Muhammad Ishaq 32
Course Title: Financial Statement Analysis Course Code: MGT-537 Course Instructor: Dr. Hafiz Muhammad Ishaq Total Lectures: 32

2 Previous Lecture Summary
Practical Problems Related to: Common Size Analysis, Vertical Analysis, Horizontal Analysis Trend Analysis,

3 Today's Lecture Topics Liquidity of Short-Term Assets
Related Debt Paying Ability Current Assets Current Liabilities Operating Cycle Cash, Marketable Securities, Receivable, Inventories, Prepayments, Other Current Assets,

4 Current Assets Current assets Typical examples
In the form of cash or will be realized in cash or conserve the use of cash within the operating cycle, or one year, whichever is longer Typical examples Cash – Marketable securities Receivables – Inventories Prepayments

5 Operating Cycle The time period between the acquisition of goods and the final cash realization from sales Retail and Wholesale Manufacturing Purchase inventory Cash sale to customer Purchase material Produce finished product Sell to customer on credit Collect amount due from customer

6 Current Assets: Cash (cont’d)
Compensating balance A portion of loan proceeds required to be retained on deposit Increases effective interest rate Against current liability Part of current assets; disclosure Against noncurrent liability Reported as noncurrent asset

7 Current Assets: Cash Unrestricted Restricted
Available to pay creditors Report as current asset Restricted May report as current but disclose restrictions Eliminate cash and related current liability when measuring short-term debt-paying ability

8 Current Assets: Marketable Securities
Any equity or debt instrument that it readily saleable and can be converted into cash, or exchanged with ease. Stocks, bonds, short-term commercial paper and certificates of deposit are all considered marketable securities because there is a public demand for them and because they can be readily converted into cash. Debt and equity securities Readily marketable Managerial intent to convert to cash within the year or the operating cycle, whichever is longer Carried at fair value Analysis: Reclassify continuing investments as noncurrent

9 Current Assets: Receivables
Sales made but not paid-for by the customers (trade debtors).  Accounts receivables are shown as current (short- term) assets in a balance sheet and are, in fact, unsecured promises by customers to pay in the future. These sums are a key factor in determining a firm's liquidity and may be discounted used in raising a short-term bank loan, or sold to a factor. A provision is usually made in the accounts of a firm to offset uncollectible accounts receivable (bad debts) as losses. Claims to future cash inflows Arise from sales to customers Trade (account) receivables Notes receivable Other current receivables

10 Current Assets: Receivables (cont’d)
Valuation Ignore cost of fund use for delayed collection Assume rate of interest is reasonable Notes that are noninterest-bearing carry an unreasonable rate, or are for an amount different from value of transaction are recorded at present value Impairment Uncollectibility Allowed discounts Allowances given Returns

11 Current Assets: Receivables (cont’d)
Impairment: Accrue (allowance method) Based on estimate of receivables’ realizable value Set up allowance Expense recognized on income statement Asset reduced by contra account “Allowance” Expense on income statement before deducted on tax return Charge-off of a specific receivable Reduces accounts receivable and allowance for doubtful accounts No impact on financial income or net assets Deductible event for income taxes

12 Current Assets: Receivables (cont’d)
Impairment: Direct write-off Alternative to accrual method when Receivables are not material or Amount for accrual cannot be reasonably estimated Charge-off of a specific receivable Recognize expense Reduce asset Bad debt expense likely to be recognized in a year subsequent to the sale Does not match expense with revenue

13 Current Assets: Receivables (cont’d)
Trade receivables Typically collected within 30 days Installment receivables May be carried as a current asset yet collection may be significantly longer than trade receivables Usually considered to be lower quality than trade receivables

14 Current Assets: Receivables (cont’d)
Customer concentration May impair the quality of receivables if a large portion of receivables is from a few customers Liquidity Number of days’ sales in receivables Accounts receivable turnover

15 Days’ Sales in Receivables
Should mirror the company’s credit terms Reading reflects end-of-year status of receivables Use of the natural business year (lower sales at year-end) can understate result Compare Firm data for several years Other industry firms and industry averages

16 Days’ Sales in Receivables (cont’d)
Causes for overstatement Sales volume expands materially late in the year Receivables are uncollectible and should have been written off The company seasonally dates invoices A large portion of receivables are on the installment basis Causes for understatement Sales volume decreases materially late in the year A material amount of sales are on a cash basis The company has a factoring arrangement in which a material amount of the receivables is sold to an outside party

17 Accounts Receivable Turnover
Indicates the liquidity of receivables Determining average gross receivables End of year and beginning of year base points for average mask seasonal fluctuations Internal analysis: use monthly or weekly amounts External analysis: use quarterly data

18 Accounts Receivable Turnover in Days
Similar to Number of Days’ Sales in Receivables except average receivables are used Should reflect firm’s credit and collection policies

19 Practical Exercise The Hawk Company wants to determine the liquidity of its receivables. It has supplied you with the following data regarding accounts for December 31, 2003 and 2002. Net sales $1,180,178 $2,200,000 Receivables, less allowance for losses and discounts: Beginning or year (allowance for losses and discounts 2003 -$12,300; $ 7180) 240, ,180 End Of year (allowance for losses and discounts 2003-$11180, 2002-$12300) 220, ,360 Required: Compute the number of days sales in receivables at December 31st 2003 and 2002 Compute the accounts receivable turnover for 2003 and 2002 (Use year- end gross receivables.) Comment on the liquidity of Hawk Company receivables



22 The Hawk Company receivables have been much less liquid in 2003 in comparison with 2002.
The days' sales in receivables at the end of the year have increased from days in 2002 to days in 2003. The accounts receivable turnover declined in 2003 to 4.87 from a turnover of 8.98 in 2002. These figures represent a major deterioration in the liquidation of receivables. The reasons for this deterioration should be determined. Some possible reasons are a major customer not paying its bills, a general deterioration of all receivable accounts, or a change in the Hawk Company credit terms.

23 Practical Exercise Mr. Williams, the owner of Williams produce, wants to maintain control over accounts receivable. He understands that day’s sales in receivables and accounts receivable turnover will give a good indication of how well receivables are being managed. Williams produce does 60% of its business during June July and August. Mr. Williams provided the pertinent data. Compute the day’s sales in receivables for July 31, 2003 and December 31, 2003, based on the accompanying data. Compute the accounts receivable turnover for the period ended July 31, 2003, and December 31, (Use year- end gross receivables) Comment on the results from (a) and(b) For Year For Year Ended Ended December 31, July 31, Net sales $800,000 $790,000 Receivables, less allowance for doubtful accounts: Beginning of period (allowance January 1, $,3,000, August, 1, $4,000) ,000 $89,000 End of period (allowance December 31, $3,500; July 31, $4,100) , ,150


25 This company appears to have a seasonal business because of the materially different days' sales in receivables and accounts receivable turnover when computed at the two different dates. The ratios computed will not be meaningful in an absolute sense, but they would be meaningful in a comparative sense when comparing the same dates from year to year. They would not be meaningful when comparing different dates.

26 Practical Exercise The following inventory and sales data for this year for G.Rabbit Company are: End of Year Beginning of Year Net sales $ 3,150,000 Gross receivables , $ 160,000 Inventory , ,000 Cost of goods sold ,250,000 Required Using the above data from the G Rabbit Company, compute: a. The account receivable turnover in days b. The inventory turnover in days c. The operating cycle


28 Practical Exercise The Anna Banana Company would like to estimate how long it will take to realize cash from its ending inventory. For this purpose, the following data are submitted: Account receivable, less allowance For doubtful accounts of $30,000 $560,000 Ending inventory ,000 Net sales ,350,000 Cost of Goods Sold 3,600,000 Required: Estimate how long it will take to realize cash from ending inventory


30 Lecture Summary Liquidity of Short-Term Assets; Related Debt Paying Ability Current Assets , Current Liabilities and the Operating Cycle Cash, Marketable Securities, Receivable, Inventories, Prepayments, Other Current Assets,

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