2. Chapters 2 & 3 Financial Statements and Analysis

3. 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

4. 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

5. 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

6. 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

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

8. 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

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

10. 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

11. 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)

12. Financial strength - Liquidity  Liquidity – likelihood of the firm to meet its short-term obligations  Current ratio = current assets/current liabilities = 800000/300000 = 2.67  Quick ratio = (current assets – inventories)/current liabilities = (8000000- 370000)/300000 = 1.43

13. Financial strength - Solvency  Solvency – ability of the firm to satisfy its long- term obligations  Debt-equity ratio = long-term debt/equity = 300000/1000000 = 0.3  Total debt to total assets = total debt/total assets = 600000/1600000 = 0.375  Times interest earned = income before interest and taxes/interest = 550000/50000 = 11

14. Management performance - profitability  Profits gained in using the equity or assets  Return on equity = net income/equity = 200000/1000000 = 0.2  Return on assets = net income/total assets = 200000/1600000 = 0.125  Profit margin = net income/sales = 200000/4000000 = 0.05

15. Management performance – assets utilization  Measure the turn-over speed of the firm’s assets  Receivable turnover = Sales/receivables = 4000000/350000 = 11.4  Average collection period = receivables/average daily credit sales = 350000/(4000000/365) = 32

16. Assets Utilization cont’  Inventory turnover = COGS/Inventory = 3000000/370000 = 8.1  Capital asset turnover = Sales/Capital asset = 4000000/800000 = 5  Total asset turnover = Sales/Total assets = 4000000/1600000 = 2.5

17. 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

18. 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

19. 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

20. 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