Financial Statement Analysis Part 1 Chapter-3. Financial Statement Analysis The art of transforming data from Financial Statements into information that

Financial Statement Financial Statement Analysis Part 1Analysis Part 1

Chapter-3

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.

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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.

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• 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.

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• Government: The financial statements of different

companies are also used by the government to analyze whether the tax paid by them is accurate .

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• Vendors: The vendors who extend credit to a

business require financial statements to assess the credit worthiness of the business.

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Financial Statements

Balance SheetBalance Sheet

A statement which show the financial position on a specific date of the firm that shows total assets = total liabilities + owners’ equity.

Income StatementIncome Statement A summary of a firm’s revenues and

expenses over a specified period, ending with net income or loss for the period.

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Alkozai Traders Balance Sheet (Asset Side)

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.

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.cc 394 Inventories 696 Prepaid Exp d d 5 Accum Tax Prepay 10 Current AssetsCurrent Assetsee $1195 $1195 Fixed Assets (@Cost)ff 1030 Less: Acc. Depr. gg (329) Net Fix. AssetsNet Fix. Assets $ $ 701 701 Investment, LT

50 Other Assets, LT 223 Total AssetsTotal Assets bb $2,169$2,169

Alkozai Traders Balance Sheet (thousands) Dec. 31, 2009Alkozai Traders Balance Sheet (thousands) Dec. 31, 2009a

Alkozai Traders Balance Sheet (Liability Side)

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.

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 cc 94 Accrued Taxes d d 16 Other Accrued Liab. d d 100 Current Liab.Current Liab. ee $ $ 500 500 Long-Term Debt f f

530 Shareholders’ Equity Com. Stock ($1 par) g g

200 Add Pd in Capital g g

729 Retained Earnings h h 210 Total Total EquityEquity $ $1,1391,139 Total Liab/EquityTotal Liab/Equitya,ba,b $2,169 $2,169

Alkozai Traders Balance Sheet (thousands) Dec. 31, 2009Alkozai Traders Balance Sheet (thousands) Dec. 31, 2009

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.

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.

External Comparison

• This involves comparing the ratios of one firm with those of similarsimilar firms or with industry averages.

OrOr• To compare the ratios of one firm with those of To compare the ratios of one firm with those of

similar firms or with industry averages at the similar firms or with industry averages at the same point in time is called External same point in time is called External Comparisons.Comparisons.

• SimilaritySimilarity is important as one should compare “apples to apples.”

• Example: to compare the ratios of MIHE and RIHE

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.

Types of Ratios

Balance Sheet Ratios (i) Liquidity Ratios (ii) Financial Leverage (Debt) RatiosIncome Statement Ratios (i) Coverage Ratios (ii) Activity Ratios (iii) Profitability Ratios (iv) Investment Ratios

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

Liquidity Ratio

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.

(i) Current Ratio(ii) Acid test (quick) Ratio


Liquidity Ratios

Liquidity Ratios

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.


Current Ratio

Liquidity Ratio

Liquidity Ratios Liquidity Ratios

Current RatioCurrent Ratio

Current AssetsCurrent AssetsCurrent LiabilitiesCurrent Liabilities

For Alkozai December 31, 2009

Current RatioCurrent Ratio

Current AssetsCurrent AssetsCurrent LiabilitiesCurrent Liabilities


If Current Assets = $1,195

and Current Liabilities = $500


Liquidity Ratios

$1,195$1,195$500$500

= 2.392.39

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.

Liquidity RatiosLiquidity 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.


Acid test (quick) Ratio

Liquidity RatiosLiquidity Ratios

Acid-Test (Quick)Acid-Test (Quick)

Current Assets - InvCurrent Assets - InvCurrent LiabilitiesCurrent Liabilities


Acid-Test (Quick)Acid-Test (Quick)

Current Assets - InvCurrent Assets - InvCurrent LiabilitiesCurrent Liabilities


If Current Assets = $1,195

and Current Liabilities = $500Inventory = $696


Liquidity Ratios

$1,195 - $696$1,195 - $696$500$500

= 1.001.00

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.

Financial Leverage (Debt) Ratios

Financial Leverage (Debt) Ratios

Shows the amount to which the firm is financed by debt.


Financial Leverage Ratios

Financial Leverage (Debt) RatiosFinancial Leverage (Debt) Ratios

(i) Debt-to-Equity(i) Debt-to-Equity(ii) Debt-to-Total-Assets(ii) Debt-to-Total-Assets


Financial Leverage 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.


Debt-to-EquityDebt-to-Equity

Financial Leverage RatiosFinancial Leverage Ratios


Total DebtTotal DebtShareholders’ EquityShareholders’ Equity

For Alkozai Trader December 31, 2009


Total DebtTotal DebtShareholders’ EquityShareholders’ Equity

For Alkozai Trader December 31, 2009If

Total Debt = 1030 and

Shareholder’s equity = 1139


Financial LeverageRatios

$1,030$1,030$1,139$1,139

= .90.90

Debt-to-Equity RatioDebt-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.


Shows the percentage of the firm’s assets that are supported by debt financing.

orIt is the relationship between borrower’s

fund (Debt) and total Assets.


Debt-to-Total-AssetsDebt-to-Total-Assets

Financial Leverage RatiosFinancial Leverage Ratios


Total DebtTotal DebtTotal AssetsTotal Assets

For Alkozai Traders December 31, 2009


Total DebtTotal DebtTotal AssetsTotal Assets

For Alkozai Traders December 31, 2009If

Total Debt = 1030And

Total assets = 2169


Financial LeverageRatios

$1,030$1,030$2,169$2,169

= .47.47

Debt-to-Total-Assets RatioDebt-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.

Documents

Financial Statement Analysis Part 1 Chapter-3. Financial Statement Analysis The art of transforming data from Financial Statements into information that