Financial Statement Analysis Part 1

1. Financial Statement Analysis Part 1 Chapter-3

2. Financial Statement Analysis • The art of transforming data from Financial Statements into information that is useful for informed decision making is called Financial Statement Analysis. • The firm itself and outside providers of capital (creditors and investors) all undertake financial statement analysis.

3. External Uses of Financial Statement • Investors: The external users of financial statements are basically the investors who use the financial statements to evaluate the financial strength of a company. This would help them to make logical investment decisions.

4. External Uses of Financial Statement • Financial Institutions: The users of financial statements are also the different financial institutions like banks and other lending institutions who decide whether to help the company with capital.

5. External Uses of Financial Statement • Government: The financial statements of different companies are also used by the government to analyze whether the tax paid by them is accurate .

6. External Uses of Financial Statement • Vendors: The vendors who extend credit to a business require financial statements to assess the credit worthiness of the business.

7. Financial Statements Balance Sheet A statement which show the financial position on a specific date of the firm that shows total assets = total liabilities + owners’ equity. Income Statement A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period.

8. Alkozai Traders Balance Sheet (Asset Side) a. How the firm stands on a specific date. b. What AL owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. Cash and C.E. $ 90 Acct. Rec.c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10Current Assetse $1195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223Total Assets b $2,169 Alkozai Traders Balance Sheet (thousands) Dec. 31, 2009a

9. Alkozai Traders Balance Sheet (Liability Side) a. Assets = Liabilities + Equity. b. What AL owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. Notes Payable $ 290 Acct. Payable c 94 Accrued Taxes d 16 Other Accrued Liab. d100Current Liab.e$ 500 Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g 200Add Pd in Capital g 729 Retained Earnings h210 Total Equity $1,139 Total Liab/Equitya,b $2,169 Alkozai Traders Balance Sheet (thousands) Dec. 31, 2009

10. Cross Sectional Financial Statement Studies A level is needed by which to judge a company’s performance. This level can be obtained by comparing companies with in the same industries with other companies. This is known as a cross-sectional study.

11. Time Series Financial Statement Studies To compare the accounts of one company with its own previous years. Possible to see if a company is improving in certain areas or not. This is known as a Time series study.

12. External Comparison This involves comparing the ratios of one firm with those of similar firms or with industry averages. Or To compare the ratios of one firm with those of similar firms or with industry averages at the same point in time is called External Comparisons. Similarity is important as one should compare “apples to apples.” Example: to compare the ratios of MIHE and RIHE

13. How a Ratio is expressed? • As Percentage: such as 25% or 50%. For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales. • As Proportion: The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. • As Pure Number /Times: The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

14. Types of Ratios Balance Sheet Ratios (i) Liquidity Ratios (ii) Financial Leverage (Debt) Ratios Income Statement Ratios (i) Coverage Ratios (ii) Activity Ratios (iii) Profitability Ratios (iv) Investment Ratios

15. Liquidity Ratio Ratio’s that measure a firm’s ability to meet short term obligations. Or It shows that Can we make required payments? Balance Sheet Ratios Liquidity Ratios

16. Liquidity Ratios • Liquidity ratios are used to measure a firm ability to meet short term obligations. • They compare short term obligations with short term (or current) resources available to meet these obligations.

17. Liquidity Ratios • Current Ratio • Acid test (quick) Ratio Balance Sheet Ratios Liquidity Ratios

18. Liquidity Ratio Shows a firm’s ability to cover its current liabilities with its current assets. Or It is the relationship between the current assets and current liabilities of a firm. Balance Sheet Ratios Current Ratio

19. Liquidity Ratios Current Ratio Current Assets Current Liabilities For AlkozaiDecember 31, 2009 If Current Assets = $1,195 and Current Liabilities = $500 Balance Sheet Ratios Liquidity Ratios $1,195 $500 = 2.39

20. Current Ratio • Looks at the ratio between Current Assets and Current Liabilities • A ratio of 2.39 would mean the firm has $2.39 of current assets to cover every $1 in current liabilities • Too high – Might suggest that too much of its assets are tied up in unproductive activities – too much stock, for example? • Too low - risk of not being able to pay Current liabilities.

21. Liquidity Ratios Shows a firm’s ability to meet current liabilities with its most liquid assets. Or It is the ratio between Quick Current Assets and Current Liabilities. Balance Sheet Ratios Acid test (quick) Ratio

22. Liquidity Ratios Acid-Test (Quick) Current Assets - Inv Current Liabilities For AlkozaiDecember 31, 2009 If Current Assets = $1,195 and Current Liabilities = $500 Inventory = $696 Balance Sheet Ratios Liquidity Ratios $1,195 - $696 $500 = 1.00

23. Acid Test (quick) Ratio • The Inventory takes to much time to convert into cash, so a more realistic ratio is to ignore Inventory. • A ratio of 1 would means that the firm has $1 of cash to cover every $1 in current liabilities. • Again if it is too high means that the business is very liquid, may be able to use the cash for other activities to increase performance. • If it is too low then the business may face problems in payment of current liabilities.

24. Financial Leverage (Debt) Ratios Shows the amount to which the firm is financed by debt. Balance Sheet Ratios Financial Leverage Ratios

25. Financial Leverage (Debt) Ratios (i) Debt-to-Equity (ii) Debt-to-Total-Assets Balance Sheet Ratios Financial Leverage Ratios

26. Financial Leverage (Debt) Ratios It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity). The Debt to Equity ratio is computed by simply dividing the total debt of the firm by its share holder’s equity. Balance Sheet Ratios Debt-to-Equity

27. Financial Leverage Ratios Debt-to-Equity Total Debt Shareholders’ Equity For Alkozai TraderDecember 31, 2009 If Total Debt = 1030 and Shareholder’s equity = 1139 Balance Sheet Ratios Financial Leverage Ratios $1,030 $1,139 = .90

28. Debt-to-Equity Ratio The ratio 0.90 tells us that creditors are providing 90 cents of financing for each $1 being provided by shareholder’s.

29. Financial Leverage (Debt) Ratios Shows the percentage of the firm’s assets that are supported by debt financing. or It is the relationship between borrower’s fund (Debt) and total Assets. Balance Sheet Ratios Debt-to-Total-Assets

30. Financial Leverage Ratios Debt-to-Total-Assets Total Debt Total Assets For Alkozai TradersDecember 31, 2009 If Total Debt = 1030 And Total assets = 2169 Balance Sheet Ratios Financial Leverage Ratios $1,030 $2,169 = .47

31. Debt-to-Total-Assets Ratio This ratio highlights the relative importance of debt financing to the firm by showing the percentage of the firm’s assets that is supported by debt financing. The 0.47 ratio shows that 47 percent of the firm assets are financed by debt and remaining 53 percent of the finance comes from the owner side.