chapter 11 analysis of financial statements

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 24

Chapter Chapter 1111

Analysis of Financial

Statements


• The income statement provides a financial summary

of a company’s operating results during a specified

period.

• Although they are prepared annually for reporting

purposes, they are generally computed monthly by

management and quarterly for tax purposes.

Financial Statements and ReportsThe Income Statement


Penny Ltd. Income StatementSales €80,000

Variable operating costs (60,000)

Fixed costs, excluding depreciation (12,000)

Depreciation ( 2,000)

EBIT = NOI 6,000

Interest ( 1,000)

Earnings before taxes (EBT) 5,000

Taxes (40%) ( 2,000)

Net income € 3,000

Dividends 2,000

Addition to retained earnings 1,000


• The balance sheet presents a summary of a firm’s

financial position at a given point in time.

• Assets indicate what the firm owns, equity represents

the owners’ investment, and liabilities indicate what

the firm has borrowed.

Financial Statements and Reports

The Balance Sheet


Penny Ltd. Balance Sheet

Current Current

Year Year

Cash & securities € 2,000 Accounts payable€ 4,000

Accounts receivable 6,000 Accruals 5,000

Inventory 7,000 Notes payable 1,000

Current assets 15,000 Current liabilities10,000

Net fixed assets 10,000 Long-term debt 6,000

Total assets €25,000 Total liabilities 16,000

Common stock 6,000

Retained earnings 3,000

Owners’ equity 9,000

Total liabilities & equity €25,000


Penny Ltd. Balance Sheet—Changes in Assets

Current Previous Year Year Change

Cash & securities € 2,000 €1,000Accounts receivable 6,000 5,000Inventory 7,000 8,000 Current assets 15,000 14,000Net fixed assets 10,000 9,000 Total assets €25,000 €23,000

1,000(1,000)

1,000

X

X

X

Fixed assets if no purchases or sales = €9,000 - €2,000 = €7,000Depreciation = €2,000Change in fixed assets = €10,000 - €7,000 = €3,000 Sources of Cash Uses of Cash

Asset Account Asset Account

Source Use


Penny Ltd. Balance Sheet—Changes in Liabilities and Equity

Current Previous Year Year

Accounts payable € 4,000€ 2,000Accruals 5,000 4,000Notes payable 1,000 2,000 Current liabilities 10,000 8,000Long-term debt 6,000 7,000 Total liabilities 16,000 15,000Common stock 6,000 6,000Retained earnings 3,000 2,000Owners’ equity 9,000 8,000 Total liabilities & equity €25,000€23,000

Change2,000(1,000)

(1,000)

1,000

Source Use

X

X

X

X

Sources of Cash Uses of Cash Liability/Equity Account Liability/Equity Account


• The statement of cash flows provides a summary of

the cash flows over the period of concern, typically the

year just ended.

• This statement not only provides insight into a

company’s investment, financing and operating

activities, but also ties together the income statement

and previous and current balance sheets.

Financial Statements and Reports

Statement of Cash Flows


Penny Ltd. Statement of Cash FlowsCash Flows from Operations:

Net income (NI) €3,000

Adjustments to NI

Depreciation 2,000 Inventory 1,000

Accounts payable 2,000

Accruals 1,000

Accounts receivable(1,000)Net CF from operations €8,000

Cash Flows from Long-Term Investing:Acquisition of assets (3,000)

Cash Flows from Financing Activities: Notes payable (1,000)

Long-term bonds (1,000)

Dividend payment (2,000)

Net CF from financing €(4,000)

Net Change in cash 1,000Cash at beginning of year 1,000Cash at end of year €2,000


• Notes to the financial statements provide detailed

information on the accounting policies, procedures,

calculations, and transactions underlying various

entries in the financial statements.

• Common issues include revenue recognition, income

taxes, breakdowns of fixed asset accounts, debt and

lease terms, and contingencies.

Notes to the Financial Statements


Financial Statements:Time Dimension

• Balance sheet—a “snapshot” of where the firm is at a specific point in time (stock statement).

• Income statement and statement of cash flows—shows the results of the firm’s activities over a period of time (flow statement).


Ratio (Financial Statement) Analysis

General categories of analysis:

• Liquidity

• Asset management

• Debt management

• Profitability

• Market value


Liquidity Ratios

• Help measure the liquidity position of the firm• Too little, or too much liquidity could be

considered a “bad sign”– too little liquidity—suggests the firm will have

problems paying its current obligations in the future– too much liquidity—might suggest the firm is not

investing its funds wisely

Provide an indication of how well the firm can meet its current obligations


Liquidity Ratios

Current ratio = total current assets

total current liabilities

Quick ratio = Total Current Assets - Inventory

total current liabilities


Asset Management Ratios

• Show how often the firm is “turning over” its assets to generate funds

• Generally, when assets are not turned over quickly enough, it is because sales have slowed or current assets, such as inventory and receivables, are too high

• If assets are turned over too quickly, it could mean that the firm is not producing enough

Provide an indication of how well the firm manages its assets (efficiency)


Asset Management RatiosInventory Turnover = Cost of Goods Sold

Inventory

DSO =Days Sales Outstanding = Receivables

Average sales per day

Fixed assets turnover ratio = Sales

Net fixed assets

Total Asset Turnover = Sales

Total Assets


Debt Management Ratios

• financial leverage refers to the use of debt

• leverage helps to magnify returns, on both the positive and the negative sides, because debt represents a fixed obligation

Indicate how the firm’s financial position is affected by the amount of debt it has


Debt Ratio = Total Liabilities/Total Assets

Debt Management RatiosDebt Management Ratios

Times Interest Earned = EBIT/Interest charges

Fixed charge coverage ratio = EBIT + Lease Pymts

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}


Profitability ratios

Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities.


Profitability RatiosProfitability Ratios

Profit Margin on Sales = Net Income/ Sales

Return on Total Assets = Net Income/ Total Assets

Return on Common Equity = Net Income available to common stockholders / Common equity


Market Value Ratios

Measures that consider the value of the firm’s stock in the financial markets—that is, how well investors perceive that the firm is creating value.


Market Value Ratios P/E = Market Price Per Share of Common Stock

Earnings Per Share

M/B = Market Price Per Share of Common Stock Book Value Per Share of Common Stock


Trend and Comparative Analyses

• Ratios should be evaluated• At a point in time in comparison to a norm,

such as an industry average, to determine the firm’s current financial position (comparative analysis).

• Over time to determine whether the firm’s current financial position is improving or deteriorating (trend analysis).


Using Financial Ratios

Types of Ratio Comparisons

chapter 11 analysis of financial statements

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