CHAPTER 02 L. J. Gitman

1
CHAPTER 02 L. J. Gitman

• ANALYSIS
• OF
• FINANCIAL STATEMENTS

2
What is Financial Statements?

• 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) Income statements which presents the
  revenues and expenses and resulting net income or
  net loss for a specific period of time.
• For example

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ABC CorporationIncome Statementfor 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)

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What is Financial Statements?

• b) Balance Sheet A balance sheet reports the
  assets, liabilities, and owners equity at a
  specific date. Estimates the firms worth on a
  given date built in the accounting equation
• Assets Liabilities Owners Equity
• c) An owners Equity Statement Summarizes the
  changes in owners equity for a specific period
  of time.

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ABC CompanyBalance Sheetas of Dec. 31, 2008

• Assets Liabilities Stockholders 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

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ABC CompanyBalance Sheetas 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

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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 firms working capital over a
  period of time by listing the sources of funds
  and uses of these funds)
• e) Accounting Policies and Explanatory Notes.

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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 managements stewardship
  of the resources entrusted to it.

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Analysis Techniques

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

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Analysis Techniques

• Both techniques are based on
• 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.

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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.

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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.

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Ratio Analysis

• Interested Parties
• Management should be the most interested parties.
• Both present and prospective shareholders are
  interested.
• The firms creditors are also interested.
• Government and regulatory bodies.

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Types of Ratio

• Four types of ratios are used in analyzing
  the financial position of a company
• Liquidity ratios indicate the companys capacity
  to meet short-run obligations.
• Activity ratios indicate how effectively the
  company is using its assets.
• Leverage ratios indicate the companys capacity
  to meet its long term and short term debt
  obligations.
• Profitability ratios indicate the net returns on
  sales and assets.

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Ratio Analysis Analyzing Liquidity

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

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Ratio Analysis Analyzing Liquidity

• Interpretation
• The higher the ratio, more liquid the firm is.
  As a norm a CR of 2 is cited as acceptable. The
  companys 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.

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Ratio Analysis Analyzing Liquidity

• 2. Quick Ratio- Shows the extent to which the
  firms 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.

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Ratio Analysis Analyzing Activity

• Evaluate the firms overall performance and show
  how effectively it is putting its funds to work.
• Inventory Turnover Ratio Measures the activity,
  or liquidity, of a firms inventory.
• Inventory Turnover

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Ratio Analysis Analyzing Activity

• Average inventory for year
• 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.

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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

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Ratio Analysis Analyzing Activity

• It indicates the firms 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.

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Ratio Analysis Analyzing Activity

• 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.

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Ratio Analysis Analyzing Activity

• Total Assets Turnover- reflects how well the
  companys assets are being used to generate
  sales.
• Total Asset Turnover

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Ratio Analysis Analyzing Leverage

• Leverage Simply the degree of the firms
  borrowing or, the use of fixed costs in an
  attempt to increase (or lever up) profitability.
• Leverage ratio measure the extent of the firms
  total debt burden. They reflect the companys
  ability to meet its short-term and long-term debt
  obligations.

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Ratio Analysis Analyzing Leverage

• Leverage ratios are important to creditors, since
  they indicate whether or not the firms 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.

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Ratio Analysis Analyzing Leverage

• Debt to Total Assets Ratio Measures the
  proportion of total assets financed by the firms
  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. Macros debt ratio of 0.4 is
  satisfactory in that it is less than the
  acceptable level of 0.45 for the firm indicated.

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Ratio Analysis Analyzing Leverage

• 2. Time Interest Earned Ratio Measures the
  firms ability to make contractual interest
  payments.
• Times Interest Earned Ratio
• Between 3-5 is suggested. Higher the ratio,
  better it is for the firm. Macros times interest
  earned ratio of 8.55 times means that Macros
  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.

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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 firms good
  performance, poor ratio indicates here a basic
  failure that, if not corrected, would probably
  result in the firms 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.

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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-Profit Margin

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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-2.4
• Operating Profit Margin
• Net Profit Margin
• EPS

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Ratio Analysis Analyzing Profitability

• Return on Total Assets (ROA), also called the
  return on investment (ROA), measures the firms
  overall effectiveness in generating profits with
  its available assets.
• ROA

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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.
• ROA

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Categories of Financial Ratios

• Market Ratios measures a firms 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 firms earnings.
• P/E Ratio Market price per share/ EPS
• The higher the P/E ratio greater the investors
  confidence on the firms future performance.
• M/B (Market/Book Value) Ratio measures how much
  the investors are willing to pay for each dollar
  of the companys stock.
• M/B Ratio Market price per share/Book value per
  share
• Book Value per share Common stock equity/No. of
  common share outstanding

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Caution about Using Ratios

• 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.
• Ratios should be calculated during the same
  period of the year.
• Use only the audited financial statements.
• 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.

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Suggested Questions

• Define financial statement. What are their
  purposes.
• 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?
• Name the four different types of ratios. What
  does each of them indicate?
• What care should you take in using the financial
  ratios.