1. CDA COLLEGE ACC101: INTRODUCTION TO ACCOUNTING Lecture 11 Lecture 11 Lecturer: Kleanthis Zisimos

2. Chapter Topic List Evaluation of financial statements using ratios Evaluation of financial statements using ratios Cash management Cash management Bank reconciliation Bank reconciliation Cash flow statement Cash flow statement

3. Analysis of financial statements Financial statement analysis applies analytical tools to financial statements and transforms accounting data to useful information. It provides us an effective and systematic basis for making business decisions. Financial statement analysis applies analytical tools to financial statements and transforms accounting data to useful information. It provides us an effective and systematic basis for making business decisions. The analysis focuses on four elements of a company’s financial condition of performance, which are the following: The analysis focuses on four elements of a company’s financial condition of performance, which are the following: 1. Liquidity and efficiency 2. Solvency 3. Profitability 4. Market prospects

4. Analysis of financial statements (continued) The benchmarks of comparison which help us compute and interpreter our data are based on the a) Direct competitors, b) Industry statistics, c) Guidelines from past experience and d) intracompany data from prior financial years The benchmarks of comparison which help us compute and interpreter our data are based on the a) Direct competitors, b) Industry statistics, c) Guidelines from past experience and d) intracompany data from prior financial years The most common tools for financial statement analysis are The most common tools for financial statement analysis are 1. Horizontal analysis. Comparison of a company’s financial statements across time 2. Vertical analysis. Comparison of a company’s financial condition to a base amount 3. Ratio analysis. Measurement of key relations between financial statements items

5. Analysis of financial statements (continued) The ratio analysis. Ratio analysis is very popular because it identifies areas requiring further investigations and helps uncover conditions and trends difficult to detect by inspecting individual components making up the ratio. We will use ratios to analyze the company’s liquidity, efficiency, solvency, market prospects and profitability

6. Analysis of financial statements (continued) Liquidity and efficiency ratios. Liquidity refers to the availability of recourses to meet short term cash requirements and the efficiency refers to how productive a company is in using its assets. Liquidity and efficiency ratios. Liquidity refers to the availability of recourses to meet short term cash requirements and the efficiency refers to how productive a company is in using its assets. Current ratio= current assets current liabilities current liabilities It measures short term debt paying ability. A 2:1 current ratio is thought to be good Acid test ratio = Cash +short term investments+ current receivables current liabilities current liabilities It measures immediate short term debt paying ability A 1:1 acid test ratio is thought to be good

7. Analysis of financial statements (continued) Liquidity and efficiency ratios Accounts receivable turnover= Net sales Average accounts receivable Average accounts receivable It measures the efficiency of collections. Usually a high turnover is favorable Inventory Turnover = Cost of goods sold average inventory average inventory It measures the efficiency of inventory management Usually a high turnover is favorable Day sales uncollected = Accounts receivables X 365 Net sales Net sales It measures the liquidity of receivables

8. Analysis of financial statements (continued) Liquidity and efficiency ratios Day sales in inventory= Ending inventory X 365 Cost of goods sold Cost of goods sold It measures the liquidity of inventory Total asset Turnover= Net Sales average total assets average total assets It measures the efficiency of assets in producing sales

9. Analysis of financial statements (continued) Solvency ratios. Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations Debt ratio= Total Liabilities It measures creditor financing Total Assets Total Assets It is desirable equity ratio to be higher than debt ratio It is desirable equity ratio to be higher than debt ratio Equity ratio= Total Equity It measures Owner financing Total Assets Total Assets Times interest earned= Income before interest and taxes interest expense interest expense It measures the protection in meeting interest payments. The larger the ratio the less risky is the company for lenders

10. Analysis of financial statements (continued) Profitability ratios. Profitability refers to a company’s ability to generate an adequate return on invested capital Profit Margin ratio= Net income x 100 Net Sales Net Sales Gross Margin ratio= Net sales-cost of goods sold x 100 Net Sales Net Sales Return on total assets= net income average total assets average total assets It measures the overall profitability of assets

11. Analysis of financial statements (continued) Profitability ratios. Return on equity= Net income – preferred dividends Average common stock equity Average common stock equity It measures the profitability of owners equity Basic earnings per share= Net income – preferred dividends weighted average common shares outstanding weighted average common shares outstanding It measures the net income on each common share Book value per common share= Shareholders equity applicable to comm. s Number of common shares outstanding Number of common shares outstanding It measures the liquidation at reported amounts

12. Analysis of financial statements (continued) Market prospects ratios. They are useful for public Companies (C. register in stock exchange market) Price earnings ratio= Market price per share Earning per share Earning per share It measures the market value relative to earnings Dividend yield= Annual cash dividends per share Market price per share Market price per share It measures the cash return to each common share

13. Purpose of Internal Control Managers or owners use an internal control system to monitor and control business activities. An internal control system consists of the policies and procedures managers use to: Managers or owners use an internal control system to monitor and control business activities. An internal control system consists of the policies and procedures managers use to: Protect assets. Protect assets. Ensure reliable accounting. Ensure reliable accounting. Promote efficient operations. Promote efficient operations. Urge adherence to company policies. Urge adherence to company policies.

14. Principles of Internal Control The principles of internal control depend on factors such as the nature of the business and its size. The basic principles however are: The principles of internal control depend on factors such as the nature of the business and its size. The basic principles however are: 1. Establish responsibilities. 2. Maintain adequate records. 3. Insure assets and bond key employees. 4. Separate recordkeeping from custody of assets. 5. Divide responsibility for related transactions. 6. Apply technological controls. 7. Perform regular and independent reviews.

15. Limitations of Internal Control All internal control policies have limitations due to human elements and costs. The Human Element is caused by human error and human fraud. All internal control policies have limitations due to human elements and costs. The Human Element is caused by human error and human fraud.

16. Bank Reconciliation Bank reconciliation is a method of controlling cash. When a company deposits all cash receipts and makes all cash payments (except petty cash) by check, it can use the bank statement for providing the accuracy of its cash records. Bank reconciliation is a method of controlling cash. When a company deposits all cash receipts and makes all cash payments (except petty cash) by check, it can use the bank statement for providing the accuracy of its cash records. The purpose of bank reconciliation is to match the bank a/c in our books with the bank statement provides by our bank. The purpose of bank reconciliation is to match the bank a/c in our books with the bank statement provides by our bank.

17. Bank Reconciliation When you compare the bank statement with the bank a/c some differences may occur due to: When you compare the bank statement with the bank a/c some differences may occur due to: 1. Outstanding checks. Checks paid but not yet shown to the bank statement 2. Deposits in transit. Deposits which are not yet cleared in the bank 3. Deductions for services fees like cheque book charges. 4. Additions for collections and for interest fees. 5. Errors.

18. Bank reconciliation statement The bank reconciliation statement is computed for the correction of errors and adjustment of the differences. It has the following form The bank reconciliation statement is computed for the correction of errors and adjustment of the differences. It has the following form PART 1 Bank statement amount X Less: Unpresented checks (X) Add. Uncleared deposits X X

19. Bank reconciliation statement The results from part 1 should be equal with the results of part 2 The results from part 1 should be equal with the results of part 2 PART 2 Bank account amount X Less: Bank charges or interests (X) Adjustment of errors X X

20. Bank Reconciliation Example. VideoBuster ltd has gathered the following data” Bank balance from bank statement € 2000 Bank balance from bank statement € 2000 Bank balance form books € 2540 Bank balance form books € 2540 A € 200 deposit is not yet recorded in the bank statement A € 200 deposit is not yet recorded in the bank statement Outstanding check from bank statement € 300 Outstanding check from bank statement € 300 Bank charges of € 40 for bank transfer not recorded in the books Bank charges of € 40 for bank transfer not recorded in the books Interest on loan € 600 not yet recorded in the books of the company Interest on loan € 600 not yet recorded in the books of the company Prepare the Bank reconciliation to record the data

21. Bank Reconciliation Bank reconciliation Bank reconciliation Bank Statement b/ce 2000 Book b/ce 2540 Add Deposit 200 Less Bank charges - 40 Less Unclear Check -300 Less Loan Interest -600 1900 1900 1900 1900

22. Discussion Exercise On 31 March 2010 the company’s bank account showed a debit balance of € 5000. The bank statement of March which was sent by the bank had a credit balance of 5600. Make the bank reconciliation statement noting the following points On 31 March 2010 the company’s bank account showed a debit balance of € 5000. The bank statement of March which was sent by the bank had a credit balance of 5600. Make the bank reconciliation statement noting the following points 1. Bank charges € 200 were not recorded in the books 2. A check for € 1000 was not shown in the bank statem. 3. A check deposit was not cleared in the bank for 500 4. A check for € 400 was not shown in the bank statem. 5. A check payment of 100 to a supplier was wrongly recorded to the books of the company as a cash payment

23. Cash Flow Statement The purpose of the cash flow statement is to report all major cash receipts (inflows) and cash payments (outflows) The purpose of the cash flow statement is to report all major cash receipts (inflows) and cash payments (outflows) A lot of profitable companies bankrupt because they have a deficit in the cash flow so is very import to compute it correctly and timely. A lot of profitable companies bankrupt because they have a deficit in the cash flow so is very import to compute it correctly and timely. Positive income statement and negative cash flow happens because the company has credit sales, capital expenditure and much more. Positive income statement and negative cash flow happens because the company has credit sales, capital expenditure and much more.

24. Cash Flow Statement Cash Flow Computation Net Profit after Taxes X Plus: Interest Expense X Plus: Depreciation (Book) X Less: Capital Expenditures X Less: Working Capital Investment Increase X Available Cash Flow X

25. Notes on the Net cash flow from operating activities Depreciation and loss on sales are not cash payment so we add them back to the profit Depreciation and loss on sales are not cash payment so we add them back to the profit An increase in stocks means less cash because we spent money on buying the stock. An increase in stocks means less cash because we spent money on buying the stock. A decrease in debtors means more cash because we received money from them A decrease in debtors means more cash because we received money from them A decrease in creditors means les cash because we pay them A decrease in creditors means les cash because we pay them

26. Capital Expenditure Cash outflows include Cash outflows include 1. Payments to acquire a fixed asset 2. Loans to other companies made by the reporting entity Cash inflows include Cash inflows include 1. Receipts from sales of fixed assets 2. Receipts from the repayment of the reporting entity’s loan