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Financial Statements and
Analysis
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Understanding Financial
Statements
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The Annual Report
Income statement (Profit and Loss Account)A statement that summarizes a firms revenues,expenses , and profit or loss over a given period oftime.
Balance sheetA statement that provides a snapshot of a firmsfinancial position at one point in time, detailing thefirms assets, liabilities, and owners equity.
Statement of cash flowsA statement that provides a summary of the cashflows of a firm over a given period of time.
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SALES
- EXPENSES= PROFIT
Income Statement
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SALES
- EXPENSES= PROFIT
Income Statement
Revenue
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Income Statement
SALES
- EXPENSES= PROFIT
Cost of Goods Sold
Operating Expenses
(marketing, administrative)Financing Costs
Taxes
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SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING PROFIT (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
Income Statement
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SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME(EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
Income Statement
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SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating ExpensesOPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLETO COMMON STOCKHOLDERS
Income Statement
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Balance Sheet
Consists of:
1. Assets
2. Financing:Liabilities (Debt)
Equity
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Assets
Current Assets: assets that are relatively liquid,and are expected to be converted to cash within ayear. Cash, marketable securities, accounts receivable, inventories,
prepaid expenses.
Fixed Assets: asset with long-term use or value
-machinery and equipment, buildings, and land.
Other Assets: any asset that is not a current assetor fixed asset. Intangible assets, such as patents and copyrights.
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FinancingDebt Capital: financing provided by a
creditor.Short-term debt: borrowed money thatmust be repaid within the next 12 months.
Accounts payable, other payables such asinterest or taxes payable, accrued expenses,short-term notes.
Long-term debt: loans from banks orother sources that lend money for longerthan 12 months.
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Financing
Equity Capital: shareholders investment in thefirm.
Preferred Stock: holders receive fixeddividends, have higher priority than common
stockholders in event of liquidation of thefirm.
Common Stock: holders are residual owners
of the firm. They receive whatever is left aftercreditors and preferred stockholders are paid.
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Common or Owners Equity
Capital
Refers to equity excluding preferred stock
Owners equity components are:
1. Common stock
2. Paid-in capital additional money paid directlyto a firm by its owner
3. Share premiumdifference between market
price and par value when new stock are issued4. Retained earnings net profits that are
retained by a firm for its use rather than paid asdividends
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Balance SheetAssets Liabilities (Debt) & Equity
Current Assets
Cash
Marketable Securities
Accounts Receivable
InventoriesPrepaid Expenses
Fixed Assets
Machinery &
Equipment
Buildings and Land
Other Assets
Investments & patents
Current LiabilitiesAccounts PayableAccrued ExpensesShort-term notes
Long-TermLiabilities
Long-term notesMortgages
EquityPreferred StockCommon StockPaid in CapitalRetained Earnings
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Cash Flow Statement
Shows how funds are generated and used during a certainperiod. (Refer to Figure 3.1 on page 109) Provides answers to questions such as:
- Why was money borrowed during the period?- Why did firm issue additional shares?- What was done to firm's net profits?- How did firm retire long-term debt?- How did firm finance additional plants & equipments?
Provides insight into companys investment, financing &operating activities and reconciles them with changes in itscash and marketable securities during the period.
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Cash Flow Statement
Cash flows from Operations Net cash flows from operations after taxesand interest expenses
Cash Flows from InvestingIncludes acquisition of real assets (capital
expenditures) and disposal and purchase of
financial assets.
Cash flows from Financing Net cash flow from the issue and repurchaseof equity, from the issue & repayment ofdebt and after dividend payments
= Net Change in Cash Balance
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*Note: Net increase (decrease) in cash + MS should be equal
to difference between cash & MS on the balance sheet at thebeginning and end of year.
Total Operating CF + Total Investment CF+ Total Financing CF = Net change in
Cash & MS*
Cash Flow Statement
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Cash Flow Statement
Basic Inflows (Sources) and Outflows (Uses) of cash
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Inflows (Sources) Outflows (Uses)
Decrease in any asset Increase in any asset
Increase in any liability Decrease in any liability
Net profits after taxes Net loss
Depreciation & noncash charges Dividends paid
Sale of stock Repurchase or retirement ofstock
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Financial Analysis
Process of analyzing financial statementsto enable managers to evaluateperformance & whether objectives are
being met or not.Enables weaknesses & strengths to beidentified.
Indicates how a firm has performed &likely to perform in the future
Tool for analysis - financial ratios
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Ratios- an attempt to standardize financial information tofacilitate meaningful comparisons
ratios answer questions concerning well-being of a firm:
has the firm been able to meet its debt obligations?
is management making enough profits from firms
assets?
how does management finance its investment?
are owners getting enough returns on theirinvestment?
ratios are of interest to shareholders, creditors and firms
own management
Financial ratios
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comparing ratios of a single firm in
a single year against the
benchmark (industry average) for
the same year.
Types of comparison
Cross-sectionalanalysis
comparing ratios of a single firm
over a period of time, usually 5years
Trend or
Time-Series analysis
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Cautions when doing ratioanalysis
ratios must be considered together, a single ratio byitself means relatively little.
financial statements being compared should be
dated at the same point in time.
use audited financial statements when possible
financial data being compared should have beendeveloped in the same way.
be wary of inflation especially when comparing oldfirms and new firms.
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Limitations of Ratio Analysis
Ratios are not useful for analyzing operations of acompany involved in various industrial sectors
Seasonal factors may distort ratios and thus fail toprovide a true picture of firms condition
Different operating policies and accountingpractices can distort comparison betweencompanies
Ratio analysis has to be comprehensive (not just asingle ratio) in order to reflect true performance ofa company
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Categories of Financial Ratios
1. Liquidity Ratios
2. Efficiency/Activity Ratios
3. Leverage/Debt Ratios4. Profitability Ratios
5. Market Ratios
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1. Liquidity Ratios
Measure solvency of firms overall
financial position
Measure ability to meet short-termobligations on time
Higher liquidity ratios are better for theyindicate that firm has a margin of safety
after fulfilling its short-term obligations
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1. Liquidity Ratios
Current ratio = Current assets
Current liabilities
Quick or Acid-test ratio = Current assets - Inventories
Current liabilities
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2. Efficiency/Activity ratios
Measure the speed with which specificcurrent accounts are converted into salesor cash (inflows and outflows)
Due to liquidity ratios are inadequate toassess the activity of specific currentaccounts due to different composition of
the accountsAlso important to look beyond liquidity ofassets to assess their activity
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Inventory turnover = Cost of Goods SoldInventory
* Measures activity or liquidity of firms inventory
Ave. Collection Period = Acc. Receivables x 365
Annual Credit Sales
* Measures amount of time needed to collect accounts receivable
Ave. Payment Period = Accounts Payable x 365Annual Credit Purchases
* Measures amount of time needed to pay accounts payable
Total Assets Turnover = SalesTotal Assets
* Measures firms efficiency of using its assets to generate sales
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3. Leverage Ratios
Measure amount of debt a firm uses togenerate profits
Higher debt means higher financialleverage and thus greater potential riskand return to the firm
Also measure ability to service debts
(payment of the fixed charges)
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Debt ratio = Total LiabilitiesTotal Assets
Measures proportion of total assets financed by creditors
Debt-Equity ratio = Long-term debtOwners equity
* Indicates relationship between funds provided by long-term creditors versus those provided by owners
Times Interest Earned = EBIT / Interest expenseMeasures ability to meet contractual interest payments
Fixed Payment Coverage Ratio (FPCR)FPCR=
EBIT + Lease pmtsInt. + Lease pmts + {(Pcipal pmts + PS div.) x [1/(1-T)]}
* Measures ability to meetall fixed payment obligations
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4. Profitability Ratios
Measure ability to generate profits withrespect to sales, assets or owners funds
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Gross profit margin = Gross profits
Sales* profits after payment of raw material costs
Operating profit margin = Operating Profits
Sales* profits after all operating costs and expenses arededucted
Net profit margin = Net profitsSales
* profits after deducting all operating costs, expenses,interest and taxes
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Return on Total Assets (ROA) = Net profitsTotal assets
* Measures managements effectiveness in generating
profits with available assets
Return on Common Equity (ROE) = Net profits
Common equity
* Measures return earned on owners investment
Earnings per Share (EPS)EPS = Earnings Available to Common Holders
Unit of common shares outstanding* Amount of profits earned for every unit of shares ofcommon stock outstanding and not amount of profitsactually obtained or distributed to stockholders
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5. Market Ratios
Relate a firms market value to certain
accounting values
Measure how well investors in themarketplace feel the firm is doing in termsof risk and return
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Price/Earnings (P/E) Ratio = Market price per share
EPS
* Amount investors are willing to pay for every dollar of companys
earnings
* Used to assess investors confidence in a company
Can be used as basis for share valuation; higher ratio greaterconfidence on the firm
Market/Book (M/B) Ratio = Market price per shareBook value per share
* Provides an assessment of how investors view the firms performance* It relates the market value of firms shares to their book value
Enable comparison made with other firms.
Market/Book (M/B) Ratio = Market price per shareBook value per share