CHAPTER 02 L. J. Gitman CHAPTER 02 L. J. Gitman ANALYSISOF FINANCIAL STATEMENTS

What is Financial Statements? A structured financial representation of the financial position of and the transactions undertaken by an enterprise/firm.A structured financial representation of the financial position of and the transactions undertaken by an enterprise/firm. A complete set of financial statements includes:A complete set of financial statements includes: a) Income statements: which presents the revenues and expenses and resulting net income or net loss for a specific period of time. a) Income statements: which presents the revenues and expenses and resulting net income or net loss for a specific period of time. For example:

ABC Corporation Income Statement for the Year Ended December 31, 2008 Sales Revenue- Cost of Goods Sold= Gross Profits Gross Pro.- Operating Exp.= Operating Profit (EBIT) Operating Pro.- Int. Exp.= Net Profit b4 Taxes (EBT) Net Pro. b4 Taxes- Taxes= Net Profit after Taxes Net Pro. after Taxes- Preferred Stocks= Earnings Available to Common Stock holders Earning Per Share (EPS)= Dividend Per Share (DPS)=

What is Financial Statements? b) Balance Sheet: A balance sheet reports the assets, liabilities, and owners equity at a specific date. Estimates the firm’s worth on a given date; built in the accounting equation: Assets = Liabilities + Owner’s Equity Assets = Liabilities + Owner’s Equity c) An owner’s Equity Statement: Summarizes the changes in owner’s equity for a specific period of time.

ABC Company Balance Sheet as of Dec. 31, 2008 Assets = Liabilities + Stockholder’s Equity Assets = Current Assets + Net Fixed Assets C/A = Cash + Marketable Securities + Accounts Receivable + Inventories Net Fixed Assets = Gross Fixed Assets – Accumulated Depreciation Gross F/A = Land & Buildings + Machinery & Equipments + Furniture + Vehicles

ABC Company Balance Sheet as of Dec. 31, 2006 Liabilities = Current Liabilities + Long term Debt C/L = Accounts payable + Notes payable + Accruals Stockholders’ Equity = Preferred Stocks + Common Stocks + Paid-in Capital in Access of Par on Common Stock + Retained Earnings

What is Financial Statements? d) Cash Flow Statement: Summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time. (Shows the changes in the firm’s working capital over a period of time by listing the sources of funds and uses of these funds) e) Accounting Policies and Explanatory Notes.

Objectives of Financial Statements  To provide information about the financial position, performance and cash flows of an enterprise that is useful to a wide range of users in making economic decisions;  To shows the results of management’s stewardship of the resources entrusted to it.

Analysis Techniques The basic techniques to extract information from financial statements are: The basic techniques to extract information from financial statements are: Examination of comparative financial statements; Examination of comparative financial statements; Ratio Analysis. Ratio Analysis.

Analysis Techniques  Both techniques are based on: Comparison of performance of period with another period: time series analysis, or Comparison of performance of period with another period: time series analysis, or Comparison of performance of one business with that of similar business, in either current or past period: cross-sectional analysis. Comparison of performance of one business with that of similar business, in either current or past period: cross-sectional analysis.

Examination of Comparative Financial Statements  Comparative financial statements are side by side presentations of consecutive financial statements of the same type (balance sheets, income statements, and so forth).  They permit period-to-period comparisons of important accounts and account group.  Thus they help statement users to identify the causes of changes in a business’ future profitability and financial position.

Ratio Analysis  Ratio is the relationship between two or more aspects of a particular data.  In financial analysis, a ratio is used as a benchmark for evaluating the financial position and performance of a firm.  Ratio analysis is an examination of financial statements conducted by preparing and evaluating a series of ratios.

Ratio Analysis Interested Parties:Interested Parties:  Management should be the most interested parties.  Both present and prospective shareholders are interested.  The firm’s creditors are also interested.  Government and regulatory bodies.

Types of Ratio: Four types of ratios are used in analyzing the financial position of a company: Four types of ratios are used in analyzing the financial position of a company: 1.Liquidity ratios indicate the company’s capacity to meet short-run obligations. 2.Activity ratios indicate how effectively the company is using its assets. 3.Leverage ratios indicate the company’s capacity to meet its long term and short term debt obligations. 4.Profitability ratios indicate the net returns on sales and assets.

Ratio Analysis: Analyzing Liquidity Liquidity Ratios- Tell whether or not the business will be able to meet its maturing obligations as they come due.Liquidity Ratios- Tell whether or not the business will be able to meet its maturing obligations as they come due. 1.Current Ratio- Measures solvency by showing the firm’s ability to pay current liabilities out of current assets. Suppose Industry Average Current Ratio = 1.50 CR = Example: 2-11

Ratio Analysis: Analyzing Liquidity Interpretation:Interpretation: The higher the ratio, more liquid the firm is. As a norm a CR of 2 is cited as acceptable. The company’s current ratio is above the industry average by a significant amount and equal as standard. The company should have no problem meeting short-term debts as they come due. The higher the ratio, more liquid the firm is. As a norm a CR of 2 is cited as acceptable. The company’s current ratio is above the industry average by a significant amount and equal as standard. The company should have no problem meeting short-term debts as they come due.

Ratio Analysis: Analyzing Liquidity 2. Quick Ratio- Shows the extent to which the firm’s most liquid assets cover its current liabilities. Quick Ratio = Suppose Industry Average Quick Ratio =.80 The quick ratio of this company is satisfactory as compare with industry average. Standard recommended here 1.0. The quick ratio of this company is satisfactory as compare with industry average. Standard recommended here 1.0.

Ratio Analysis: Analyzing Activity Evaluate the firm’s overall performance and show how effectively it is putting its funds to work.Evaluate the firm’s overall performance and show how effectively it is putting its funds to work. 1.Inventory Turnover Ratio: Measures the activity, or liquidity, of a firm’s inventory. Inventory Turnover =

Ratio Analysis: Analyzing Activity  Average inventory for year Beginning inventory + Ending inventory 2 Beginning inventory + Ending inventory 2 A low inventory turnover implies a large investment in inventories relative to the amount needed to services sales. Excess inventory ties up resources unproductively.A low inventory turnover implies a large investment in inventories relative to the amount needed to services sales. Excess inventory ties up resources unproductively.

Ratio Analysis: Analyzing Activity Average Collection Period Ratio/Days Sales Outstanding (DSO): Tells how long it takes from the time the sales is made to the time the cash is collected from the customer from its accounts receivable.Average Collection Period Ratio/Days Sales Outstanding (DSO): Tells how long it takes from the time the sales is made to the time the cash is collected from the customer from its accounts receivable. Average Collection Period=

Ratio Analysis: Analyzing Activity It indicates the firm’s efficiency in collecting on its sales. It may also reflects the firm credit policy. If customers are given more time to pay, then the collection period will generally be greater.

Ratio Analysis: Analyzing Activity Fixed Assets turnover ratio: This ratio indicates how intensively the fixed assets of the firm are being used.Fixed Assets turnover ratio: This ratio indicates how intensively the fixed assets of the firm are being used. Fixed Asset Turnover = An inadequately low ratio implies excessive investments in plant and equipment relative to the value of the output being produced.

Ratio Analysis: Analyzing Activity Total Assets Turnover- reflects how well the company’s assets are being used to generate sales.Total Assets Turnover- reflects how well the company’s assets are being used to generate sales. Total Asset Turnover =

Ratio Analysis: Analyzing Leverage Leverage: Simply the degree of the firm’s borrowing or, the use of fixed costs in an attempt to increase (or lever up) profitability.Leverage: Simply the degree of the firm’s borrowing or, the use of fixed costs in an attempt to increase (or lever up) profitability. Leverage ratio measure the extent of the firm’s total debt burden. They reflect the company’s ability to meet its short-term and long-term debt obligations.Leverage ratio measure the extent of the firm’s total debt burden. They reflect the company’s ability to meet its short-term and long-term debt obligations.

Ratio Analysis: Analyzing Leverage Leverage ratios are important to creditors, since they indicate whether or not the firm’s revenues can support interest and other fixed charges, as well as whether or not there are sufficient assets to pay off the debt if the firm liquidatesLeverage ratios are important to creditors, since they indicate whether or not the firm’s revenues can support interest and other fixed charges, as well as whether or not there are sufficient assets to pay off the debt if the firm liquidates Share holders, too, are concerned with leverage, since interest is a company expense that increase with greater debt. If borrowing and interest are excessive, the company may become bankrupt.Share holders, too, are concerned with leverage, since interest is a company expense that increase with greater debt. If borrowing and interest are excessive, the company may become bankrupt.

Ratio Analysis: Analyzing Leverage 1.Debt to Total Assets Ratio: Measures the proportion of total assets financed by the firm’s creditors. Debt Ratio = Generally, creditors prefer a low debt ratio since it implies a greater protection of their position. A higher debt ratio generally means that the firm must pay a higher interest rate on its borrowing. Macro’s debt ratio of 0.4 is satisfactory in that it is less than the acceptable level of 0.45 for the firm indicated.

Ratio Analysis: Analyzing Leverage 2. Time Interest Earned Ratio: Measures the firm’s ability to make contractual interest payments. Times Interest Earned Ratio: Between 3-5 is suggested. Higher the ratio, better it is for the firm. Macro’s times interest earned ratio of 8.55 times means that Macro’s earning available to pay interest is 8.55 times the interest is due. This is more than the appropriate level for Macro of 6.5.

Ratio Analysis: Analyzing Profitability  Profitability ratios measure the success of the firm in earning a net return on sales or on investment.  Since profit is the indicator of firm’s good performance, poor ratio indicates here a basic failure that, if not corrected, would probably result in the firm’s going out of business. Common size income statement may be used to analyze the profitability of a firm. –Common-size income statement: Expressed as a percentage of sales. Example P. 62 –Common-size balance sheet: Expressed as a percentage of either total assets or total liabilities and owners equity.

Ratio Analysis: Analyzing Profitability Gross Margin Reflects the effectiveness of pricing policy and of production efficiency (that is how well the purchase or production cost of goods is controlled). By equation:Gross Margin Reflects the effectiveness of pricing policy and of production efficiency (that is how well the purchase or production cost of goods is controlled). By equation: Gross-Profit Margin =

Ratio Analysis: Analyzing Profitability Operating/Net Profit Margin measures the percentage of each sales taka remaining after all costs and expenses other than interest and tax are deducted. Example-2.4Operating/Net Profit Margin measures the percentage of each sales taka remaining after all costs and expenses other than interest and tax are deducted. Example-2.4 Operating Profit Margin = Net Profit Margin = Net Profit Margin = EPS =

Ratio Analysis: Analyzing Profitability Return on Total Assets (ROA), also called the return on investment (ROA), measures the firm’s overall effectiveness in generating profits with its available assets.Return on Total Assets (ROA), also called the return on investment (ROA), measures the firm’s overall effectiveness in generating profits with its available assets. ROA =

Ratio Analysis: Analyzing Profitability Return on Equity (ROE) measures the return earned on the owners’ investment in the firm. Generally, the higher this return, the better off are the owners.Return on Equity (ROE) measures the return earned on the owners’ investment in the firm. Generally, the higher this return, the better off are the owners. ROA =

Categories of Financial Ratios Market Ratios: measures a firm’s current market price measured by its current share price to certain accounting values.Market Ratios: measures a firm’s current market price measured by its current share price to certain accounting values. –P/E (Price/Earning) Ratio: measures the amount that the investors are willing to pay for each taka of a firm’s earnings. P/E Ratio = Market price per share/ EPS The higher the P/E ratio greater the investor’s confidence on the firm’s future performance. –M/B (Market/Book Value) Ratio: measures how much the investors are willing to pay for each dollar of the company’s stock. M/B Ratio = Market price per share/Book value per share Book Value per share = Common stock equity/No. of common share outstanding

Caution about Using Ratios Ratio analysis directs attention to potential areas of concern, not about the existence of a problem.Ratio analysis directs attention to potential areas of concern, not about the existence of a problem. Group of ratios are more conclusive than a single ratio.Group of ratios are more conclusive than a single ratio. Ratios should be calculated during the same period of the year.Ratios should be calculated during the same period of the year. Use only the audited financial statements.Use only the audited financial statements. Use identical accounting methods for calculating, specially for inventory and depreciation related figures.Use identical accounting methods for calculating, specially for inventory and depreciation related figures. Results such as the book value of inventory and depreciable assets may differ from their true values due to inflation.Results such as the book value of inventory and depreciable assets may differ from their true values due to inflation.

Suggested Questions Define financial statement. What are their purposes.Define financial statement. What are their purposes. Compare and contrast between time series and cross-sectional analysis of financial statement.Compare and contrast between time series and cross-sectional analysis of financial statement. State the parties interested in using the financial statement. Which ratios are the greatest concern for the creditors? Why? State the parties interested in using the financial statement. Which ratios are the greatest concern for the creditors? Why? Name the four different types of ratios. What does each of them indicate?Name the four different types of ratios. What does each of them indicate? What care should you take in using the financial ratios.What care should you take in using the financial ratios.