CHAPTER 2: FINANCIAL STATEMENTS AND CORPORATE TAXES Description of Financial Statement Financial statements are prepared set of accounting reports that seek to provide information to its stakeholders about the previous business year’s financial performance and position. Three financial statements are annually prepared namely;  Statement of financial position (balance sheet)  Income statement (profit and loss account)  Cash flow statement (sources and uses of fund) 1Prepared by Alhaj Nuhu Abdulrahman

Description of Financial Statement The statement of financial position: A summary of book values of a firm’s assets and liabilities at a particular date. The assets represent uses of funds The liabilities represent sources of the funds. Components of assets  Current assets: cash, account receivable, inventory, etc  Fixed assets (tangible): buildings, equipment, vehicles, etc  Fixed assets (intangible): patent, skilled management, trained labour force, Components of liabilities  Current liabilities: accounts payable, accruals  Long term liabilities: long-term debts  Shareholders’ fund (equity): value of owners’ equity and retained earnings 2Prepared by Alhaj Nuhu Abdulrahman

Description of Financial Statement A summary of a firm’s financial performance over the previous business period usually a year. That is Net income or loss = total revenue – total expenses. The Cash flow Statement A summary of a firm’s sources and uses of cash from its operations, investment and financing activities, over a year. A firm’s net cash flows can be quite different from its net income The three components of cash flow statement:  i. Cash flow from operating activities  ii. Cash flow from investing activities  iii. Cash flow from financing activities 3Prepared by Alhaj Nuhu Abdulrahman

Uses of financial statement information Internal uses: management compensation, employee agitation for improved remuneration, evaluating strategic business units, comparison with previous years’ performance and future planning. External uses: information for short and long-term creditors, suppliers, rating agencies, current and potential investors, etc. Comparison with performance of competitors 4Prepared by Alhaj Nuhu Abdulrahman

Corporate Taxes Companies big and small pay tax on their net incomes at the end of the business year. Tax payable is calculated on marginal tax rates prescribed by a country’s tax code. Then average tax rate may be calculated. Marginal tax rate is the tax rate that the individual or company pays on each extra cedi of income. Average tax rate is the percentage of one’s income paid out as tax 5Prepared by Alhaj Nuhu Abdulrahman

Corporate Taxes For instance assume Ghana’s corporate tax code has the following structure: Taxable income (GH¢)Tax rates (%) , , , , , , , , Suppose a company has a taxable income of GH¢300,000. What will be the company’s total tax bill? What will be the company’s average tax rate? What will be its marginal tax rate? 6Prepared by Alhaj Nuhu Abdulrahman

Corporate Tax Solution: 0.15(GH¢50,000 - GH¢0) = GH¢7, (GH¢75,000 - GH¢50,000) = GH¢6, (GH¢100,000 - GH¢75,000) = GH¢8, (GH¢300,000 - GH¢100,000) = GH¢74,000 Total tax bill GH¢96,250 7Prepared by Alhaj Nuhu Abdulrahman

Corporate Tax (a) Tax bill = (0.15 x GH¢50,000) + (0.25 x GH¢25,000) + (0.34 x GH¢25,000) + (0.37 x GH¢200,000) = GH¢96,250 (b) Average tax rate = GH¢96,250/GH¢300,000 x 100= 32.08% (c) Marginal tax rate is 37%. This is because for every one more cedi of taxable income up to GH¢400,000 attracts a tax rate 37%. 8Prepared by Alhaj Nuhu Abdulrahman

Corporate Tax Because financial decisions usually involve new cash flows or change in existing ones, the marginal rate tells us the marginal effect of a decision on corporate tax bill. Financial managers therefore need to understand the tax consequences of investment and financing decisions. Three importance of tax in financial management:  Raising finance: debt financing attracts interest tax relief, while dividend payment on equity financing does not attract tax relief.  Investment in fixed assets: cost of acquiring certain types of fixed assets attracts a form of tax relief termed capital allowance. (e.g. depreciation)  Paying dividends: dividend payment attracts dividend tax. 9Prepared by Alhaj Nuhu Abdulrahman

Corporate Tax Corporate financial managers should understand the effects of tax relief on incomes of both the company and its shareholders. Illustration of tax relief Assume 2 firms; A and B both have earnings before taxes (EBIT) of GH¢1,000,000. Firm A however has GH¢40,000 interest on debts to pay. This reduces the company’s tax bill as illustrated: Firm A Firm B EBIT 1,000,000 1,000,000 Interest 40,000 0 Pretax income 960,000 1,000,000 Tax (35%) 336, ,000 Net income 624, ,000 10Prepared by Alhaj Nuhu Abdulrahman

Financial statements analysis Financial statements are the primary means of communicating financial information to users both within and outside the firm for decision making. One common use of financial statements is to compare those of a firm’s immediate past business period with the previous ones and those of other similar companies. Constraints faced by such comparisons include changes in size of the firm and differences in size with other firm types. To address these differences the financial statements are transformed into standardized financial statements. Standardized Financial Statements All the items of the financial statements are presented in percentage terms called common-size statements. Each balance sheet item expressed as a percentage of total assets called common-size balance sheet Each income statement item expressed as a percentage of total sales called common-size income statement. 11Prepared by Alhaj Nuhu Abdulrahman

Financial statements analysis Illustration Azonto Corporation Balance Sheets for 2012 and Assets (GH¢) (GH¢) Current assets Cash 8,400 9,800 Accounts receivable 16,500 18,800 Inventory 39,300 42,200 Total current assets 64,200 70,800 Fixed assets Net Premises & equipment 273, ,000 Total assets 337, ,800 12Prepared by Alhaj Nuhu Abdulrahman

Financial statements analysis Liabilities Current liabilities Accounts payable 31,200 34,400 Notes payable 23,100 19,600 Total current liabilities 54,300 54,000 Long-term debt 53,100 45,700 Owner’s Equity 50,000 55,000 Retained earnings 79, ,100 Total equity 229, ,100 Total liabilities 337, ,800 13Prepared by Alhaj Nuhu Abdulrahman

Financial statements analysis Azonto Corporation income statement for 2013 GH¢ Sales 231,100 Cost of goods sold 134,400 Depreciation 27,600 Earnings before interest and taxes 69,100 Interest 14,100 Income before tax 55,000 Tax (34%) 18,700 Net Income 36,300 Dividends 12,100 Retained earnings 24,200 14Prepared by Alhaj Nuhu Abdulrahman

Financial statements analysis Common-size balance sheet: each item is express as a percentage of total assets Azonto Corporation Common-Size Balance Sheets for 2012 and Change Assets (%) (%) (%) Current assets Cash Accounts receivable Inventory Total current assets Fixed assets Net Premises & equipment Total assets Prepared by Alhaj Nuhu Abdulrahman

Financial statements analysis Liabilities Current liabilities Accounts payable Notes payable Total current liabilities Long-term debt Owner’s Equity Retained earnings Total equity Total liabilities Prepared by Alhaj Nuhu Abdulrahman

Financial statements analysis common-size income statement: each item expressed as percentage of total sales Azonto Corporation Common-Size Income statement for 2013 (%) Sales Cost of goods sold 58.2 Depreciation 11.9 Earnings before interest and taxes 29.9 Interest 6.1 Income before tax 23.8 Tax (34%) 8.1 Net Income 15.7 Dividends 5.2 Retained earnings Prepared by Alhaj Nuhu Abdulrahman

Financial statements analysis Financial Ratio Analysis: Financial ratios are quantitative tools for analyzing financial statements for purposes of comparing firms’ performance, and for the same firm over the previous periods. They are generally classified according to the activity or function to be evaluated as follows: Liquidity ratios: They measure the firm’s ability to meet short-term obligations. Activity ratios: They measure the effectiveness of utilizing operational assets. Leverage or Financial Gearing ratios: They measure the extent to which the firm is financed with debts. That is the ratio debt to equity in the firm’s capital structure Profitability ratios: They measure the efficiency or profitability of the firm. Investment or shareholders’ ratios: They indicate how well a company has performing in terms of share market value and other related items like dividends. 18Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis: Madina Corporation Statement of Financial Position as at 31 st December 2012 Assets GH¢’000 GH¢’000 Cash 50 Marketable Securities 150 Receivable (debtors) 200 Inventories (Stocks) 300 Total Current Assets 700 Plant and Equipment 1,876 Less depreciation 500 Net Plant equipment 1,376 Total Assets 2,076 19Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Liabilities GH¢’000 GH¢’000 Accounts payable (Creditors) 60 Notes payable (at 10%) 100 Accruals 10 Provision for tax 130 Total Current Liabilities 300 Bond (at 8%) 500 Debentures (at 10%) 200 Ordinary Shares 600 Retained earnings 476 Total Equity 1,076 Total Liabilities 2,076 The market price per share was GH¢5.25 Shares outstanding 200,000 20Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Madina Corporation Income Statement for the year ended December 31 st 2012GH¢’000 Sales 3,000 Cost of goods sold 2,555 Gross profit 445 Less operating expenses: Selling 22 General & administrative 40 Payment on Office building 28 Total operating expenses 90 Gross operating profit 355 Less Depreciation 100 Net Operating profit 255 Income from other services 15 Earning Before Interest and Taxes (EBIT) Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Less interest on notes payable 10 Interest on Bonds 40 Interest on Debentures 20 Total interest expense 70 Net income before taxes 200 Less Corporate tax (40%) 80 Net income after Corporate tax 120 Dividend declared and paid 90 22Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Liquidity Ratios: (Short term solvency measures) Current ratio = = = 2.33 Quick (Acid-test) ratio = = = 1.33 times Cash ratio = = = 0.67 times Short-term creditors are interested in these ratio because they indicate the ability of firm to pay. Asset Management or Turnover ratios : they indicate the rate at which goods are Converted or turnover into sales. That is how efficiently and intensively a firm uses its assets to generate sales. Inventory (stock) Turnover Ratio = = = 8.52 times 23Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis If inventory is turned over 8.52 times in a year, we can determine how long it took to turn it over on average. Inventory turnover in days = = = 42.8 days OR Inventory turnover in days = = = 42.9 days Receivables Turnover Ratio = = = 15 times Days’ sales in receivables or Average Collection Period (ACP ) = = days. The shorter the collection period the better. Total assets turnover = = = 1.45 times This implies for every GH¢1 asset, GH¢1.45 sales is generated. Fixed Assets Turnover = = = 2.18 times This implies for every GH¢1 of fixed asset, GH¢2.18 sales is generated. 24Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Leverage or gearing ratios (long-term solvency measures) Gearing ratios indicate the firm’s ability to meet its long-term financial obligations to creditors. They also indicate the proportion of debt in a firm’s capital structure. Different methods of calculating leverage ratios exist. Total Debts ratio: This ratio can be defined in several different ways, the easiest of which is this: = = 48.17% That implies the company is financed with 48.17% debt. By extension every GH¢1.00 in assets is financed with GH¢ debt and GH¢ equity Total Debt/Equity ratio = = 0.93 times or = 0.93 times 25Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Total Asset/equity ratio or Equity Multiplier = = = 1.93 times or = 1.93 times Long-term Debt ratio = = = 0.39 times Interest coverage ratio = = = 3.86 times The lower the interest-cover ratio, the greater is the risk of default in interest payment. Cash Coverage ratio = = = 5.29 times This is used as a measure of cash flow available to meet financial obligations. 26Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis PROFITABILITY RATIOS: These ratios measure the effectiveness of a business in generating profits. Varieties of profitability ratios exist and the following are probably the best known and the most widely used. Net income margin ratio (NIM) = = 4% It implies Gp4 is generated for every GH¢1.00 of sales. Return on Assets (ROA) = 5.78% It means about Gp58 profit is generated per every GH¢1 of assets. Return on Equity (ROE) = 11.15% For every cedi in equity about Gp11 is generated. 27Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis INVESTMENT RATIOS: These ratios measure variety of returns on equity investment for publicly traded companies. And are computed for informed equity investment decisions like buying more shares or holding on or selling out. Data for their computation are in part market information not necessarily contained in financial statements, thus also called market value ratios. Earnings per Share (EPS) = GH¢0.60/share Dividend per Share (DPS) = GH¢0.45/share Dividend payout ratio (DPR): This ratio reveals the percentage (%) or proportion of net earnings declared as dividend. DPR = = 75% Dividend Cover (DC): This ratio indicates how many times dividend can be paid out of current Net profit. = 1.3 times 28Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Earnings yield (EY): This measure the Percentage of EPS on Market price per Share (MPS): = 11.43% Dividend Yield (DY): This shows the percentage of DPS in relation to MPS = 8.57% Price/ Earnings Ratio (P/E): It is used by security analysts to assess the future market performance of a company. It measures how much investors are willing to pay per cedi of earnings. = = 8.75 times Market/Book ratio: It compares the market value of the firm to it investment cost. A value less than 1 could mean the firm has not been successful in generating value for its shareholders. Book value per share is total equity divided by number of shares outstanding. Market/Book ratio = = = = 0.96 times 29Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Exercise: ABC Company distributed GH¢90,000 of its net income as dividend this year which represented 60% dividend payout ratio. i) What was the company’s net income? ii) What was the retention ratio? iii) How much was the retained income? 30Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis Exercise: ABC Company distributed GH¢90,000 of its net income as dividend this year which represented 60% dividend payout ratio. i) What was the company’s net income? ii) What was the retention ratio? iii) How much was the retained income? Solution: i) Payout ratio x net income = GH¢90,000 60% x net income = GH¢90,000 Net income = Net income = GH¢150,000 31Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis ii) Retention ratio = 100% - payout ratio = 100% - 60% = 40% iii) Retained income = retention ratio x net income = 40% x GH¢150,000 = GH¢60,000 32Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis The DuPont Identity The fact that the ROE (11.15%) is higher than ROA (5.78%) calculated above reflects the use of more debt financing or financial leverage by the company. The ROE equation is however further decomposed into three ratio components to determine the causes of the level of ROE or any changes in it. The decomposition was developed and used by an American company called DuPont, thus generally referred to as The DuPont Identity. ROE is decomposed into the following three determinants: 1. Profit Margin:- the company’s pricing strategy and ability to control costs. 2. Asset Turnover:- measures the intensity with which a company utilizes its assets. 3. Gearing:- Financing with debt instead of equity can increase ROE but also increase the risk that a decrease in turnover may make it difficult for the company to meet its debt obligations 33Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis: The DuPont Identity ROE = (Net Profit Margin) x (Total Asset Turnover) x (Equity Multiplier) = x x = x x = 0.04 x 1.45 x 1.93 = or 11.94% 34Prepared by Alhaj Nuhu Abdulrahman

Financial Ratio Analysis: The DuPont Identity Steps to increase the ROE ratio level: First to improve the profit margin the firm must be efficient in its operation by keeping operating costs down. Second to generate more sales operational assets must used more intensely which improves the asset turnover. Third is the use of more debt financing thereby using less equity financing, which improves the equity multiplier. Often, only one or a combination of two of the three strategies may be appropriate. For instance, a company that has reached the limits of what lenders are willing to lend to it cannot use gearing to improve the ROE. 35Prepared by Alhaj Nuhu Abdulrahman