Financial Analysis
Chapte
r 2
LEARNING OBJECTIVES
2
An overview of the firm’s financial statements: income
statement, balance sheet, cash flow statement and statement
of shareholders’ equity.
Financial analysis: the common-size statements, ratio
analysis and tying the ratios together – the DuPont equation.
Benchmarking of performance: trend analysis, comparison to
industry average and peer group comparison; uses and
limitations of financial ratio analysis.
Financial Analysis
3
Financial analysis is the process of identifying the
financial strengths and weaknesses of the firm by
property establishing relationships between the
item of the balance sheet and the profit and loss
account.
USERS OF FINANCIAL ANALYSIS
4
Trade creditors
Suppliers of long-term debt
Investors
Management
Income Sttement
An income statement or profit and loss account
is one of the financial statements of a company
and shows the company's revenues and expenses
during a particular period.
It indicates how the revenues are transformed
into the net income or net profit.
Components of income statement
Revenue: The amount of money a business takes in during a reporting period
Expenses: The amount of money a business spends during a reporting period
Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever it is a business
sells
Gross profit: Total revenue less COGS
Operating income: Gross profit less operating expenses
Income before taxes: Operating income less non-operating expenses
Net income: Income before taxes less taxes
Earnings per share (EPS): Division of net income by the total number of outstanding shares
Depreciation: The extent to which assets (for example, aging equipment) have lost value over time
EBITDA: Earnings before interest, depreciation, taxes, and amortization
Format of Income Statement
Balance Sheet
The term balance sheet refers to a financial statement that reports a
company's assets, liabilities, and shareholder equity at a specific point in
time. Balance sheets provide the basis for computing rates of return for
investors and evaluating a company's capital structure.
In short, the balance sheet is a financial statement that provides a snapshot
of what a company owns and owes, as well as the amount invested by
shareholders. Balance sheets can be used with other important financial
statements to conduct fundamental analysis or calculate financial ratios.
Components of a Balance Sheet
Current Assets
Accounts within this segment are listed from top to bottom in order
of their liquidity. This is the ease with which they can be converted
into cash. They are divided into current assets, which can be
converted to cash in one year or less
Cash and cash equivalent
Accounts receivable
Inventory
Prepaid expenses
Long term assets
Long-term investments are securities that will not or cannot be
liquidated in the next year.
Fixed assets include land, machinery, equipment, buildings, and other
durable, generally capital-intensive assets.
Intangible assets include non-physical (but still valuable) assets such as
intellectual property and goodwill. These assets are generally only listed
on the balance sheet if they are acquired, rather than developed in-
house. Their value may thus be wildly understated (by not including a
globally recognized logo, for example) or just as wildly overstated.
Liabilities
A liabilityis any money that a company owes to outside parties,
from bills it has to pay to suppliers to interest on bonds issued to
creditors to rent, utilities and salaries.
Current liabilities are due within one year and are listed in order of
their due date.
Long-term liabilities, on the other hand, are due at any point after
one year.
Current liabilities
Current portion of long-term debt is the portion of a long-term debt due within the next 12 months. For
example, if a company has a 10 years left on a loan to pay for its warehouse, 1 year is a current liability and
9 years is a long-term liability.
Interest payable is accumulated interest owed, often due as part of a past-due obligation such as late
remittance on property taxes.
Wages payable is salaries, wages, and benefits to employees, often for the most recent pay period.
Customer prepayments is money received by a customer before the service has been provided or product
delivered. The company has an obligation to (a) provide that good or service or (b) return the customer's
money.
Dividends payable is dividends that have been authorized for payment but have not yet been issued.
Earned and unearned premiums is similar to prepayments in that a company has received money upfront,
has not yet executed on their portion of an agreement, and must return unearned cash if they fail to execute.
Accounts payable is often the most common current liability. Accounts payable is debt obligations on
invoices processed as part of the operation of a business that are often due within 30 days of receipt.
Long-term liabilities
Long-term debt includes any interest and principal on bonds issued
Pension fund liability refers to the money a company is required to pay
into its employees' retirement accounts
Deferred tax liability is the amount of taxes that accrued but will not
be paid for another year. Besides timing, this figure reconciles
differences between requirements for financial reporting and the way
tax is assessed, such as depreciation calculations.
Shareholder Equity
Shareholder equity is the money attributable to the owners of a business
or its shareholders. It is also known as net assets since it is equivalent to
the total assets of a company minus its liabilities or the debt it owes to
non-shareholders.
Retainedearnings are the net earnings a company either reinvests in the
business or uses to pay off debt. The remaining amount is distributed to
shareholders in the form of dividends.
Format of Balance sheet
Statement of Retained Earnings
A statement of retained earnings, sometimes called a statement of changes in equity,
shows the sum of the earnings that a company has accumulated and kept in the business
since it started operations.
A retained earnings ending balance for an accounting period is equal to the retained
earnings at the beginning of the period, plus net income earned during the period, minus
dividends issued to shareholders during the period.
In some cases, a company’s financial statements don’t include a separate statement of
retained earnings. In this event, the information is typically included in the income
statement or balance sheet, or as an addendum to one of those documents.
Format of Statement of Retained
Earnings
Particulars Amount Amount
(Rs.) (Rs.)
Opening balance of retained xxxxx
earnings
Add: Net income for the year xxxxx
Total distributable profit xxxxx
Less: Dividend paid to comon xxxxx
stockholders xxxxx xxxxx
Transfer to General researve
Closing balance of retained xxxxx
earnings
Cash Flow Statement
Cash flow statement is a statement which shows the source of cash inflow and uses
of cash out outflow of the business concern during a particular period of time.
It ithe statement, which involves only short term financial position of the business
concern.
This statement is designed to show how the firm’s operations have effected its cash
position by examining the investment(use of cash) and financing(source of cash) of
a firm.
So, cash flow statement is also known as use and source of cash statement.
Cash flow statement provides a summary of operating, investment and financing
cash flow and reconciles them with changes in cash and cash equivalants such as
marketable securities.
The statement divides the activities
into three groups:
Operating activities
Investing activities
Financing activities
Cash From Operating activities
The operating activities on the CFS include any sources and uses of
cash from business activities. In other words, it reflects how much cash
is generated from a company’s products or services.
These operating activities might include:
Receipts from sales of goods and services
Interest payments
Income tax payments
Payments made to suppliers of goods and services used in production
Salary and wage payments to employees
Rent payments
Any other type of operating expenses
Cash From Investing Activities
Investing activities include any sources and uses of cash from a
company’s investments.
Purchases or sales of assets,
loans made to vendors or received from customers, or
Any payments related to mergers and acquisitions (M&A) are included in
this category.
In short, changes in equipment, assets, or investments relate to cash from
investing.
Changes in cash from investing are usually considered cash-out items because cash is used to buy
new equipment, buildings, or short-term assets such as marketable securities. But when a company
divests an asset, the transaction is considered cash-in for calculating cash from investing.
Cash From Financing Activities
Cash from financing activities includes the sources of cash from
investors and banks, as well as the way cash is paid to shareholders.
This includes any dividends, payments for stock repurchases, and
repayment of debt principal (loans) that are made by the company.
Changes in cash from financing are cash-in when capital is raised and
cash-out when dividends are paid.
Thus, if a company issues a bond to the public, the company receives
cash financing. However, when interest is paid to bondholders, the
company is reducing its cash. And remember, although interest is a
cash-out expense, it is reported as an operating activity—not a
financing activity.
Format of Cash Flow Statement
Particulars Amount (million)
Operating activities
Net income before preferred dividend 117.5
Addition (Source of cash)
Depreciation and amortization 100
Increase in accouts payable 30
Increase in accrual 10
Subtraction (Use of cash)
Increase in accouts receivable (60)
increase in inventories (200)
Net cash flow provided by operating activities (2.5)
Long term investing activites
Cash used to purchase fixed assets (230)
Financing activities
Increase in notes payable 50
Increase in bonds 174
Payment of common and preferred divideds (61.5)
Net Cash Flow provided by financing activities (162.5)
Net changes in cash and cash equivalent (70)
Opening balance of cash and cash equivalent 80
Closing balance of cash and cash equivalent 10
Shareholders’ equity
Shareholder equity (SE) is a company's net worth and it is equal to the
total dollar amount that would be returned to the shareholders if the
company must be liquidated and all its debts are paid off. Thus,
shareholder equity is equal to a company's total assets minus its total
liabilities.
SE is a number that stock investors and analysts look at when they're
evaluating a company's overall financial health. It helps them to judge
the quality of the company's financial ratios, providing them with the
tools to make better investment decisions.
Shareholders' equity section of
balance sheet
Financial analysis
Standards of Comparison
28
Time series analysis
Inter-firm analysis
Industry analysis
Proforma financial statement analysis
NATURE OF RATIO ANALYSIS
29
A financial ratio is a relationship between two
accounting numbers.
Ratios help to make a qualitative judgement about the
firm’s financial performance.
Types of Financial Ratios
30
Liquidity ratios
Leverage ratios
Activity ratios
Profitability ratios
LIQUIDITY RATIOS
31
Liquidity ratios measure a firm’s ability to meet
its current obligations.
Current assets
Current ratio =
Current liabilities
Current assets – Inventories
Quick ratio =
Current liabilities
Cash + Marketable securities
Cash ratio =
Current liabilities
Cont…
32
LEVERAGE RATIOS
33
To judge the long-term financial position of the firm, financial leverage, or capital
structure ratios are calculated.
These ratios indicate mix of funds provided by owners and lenders.
Cont…
34
Cont…
35
ACTIVITY RATIOS
36
Activity ratios are employed to evaluate the efficiency with which the firm
manages and utilizes its assets.
These ratios are also called turnover ratios because they indicate the
speed with which assets are being converted or turned over into sales.
Activity ratios, thus, involve a relationship between sales and assets.
Inventory Turnover and
37
Debtors Turnover
Assets Turnover Ratios
38
PROFITABILITY RATIOS
39
The profitability ratios are calculated to measure the operating
efficiency of the company.
Generally, two major types of profitability ratios are calculated:
1. profitability in relation to sales
2. profitability in relation to investment.
Cont…
40
Cont…
41
Cont…
42
Cont…
43
Cont…
44
EVALUATION OF A FIRM’S
EARNING
45
POWER:
DUPONT ANALYSIS
RONA (or ROCE) is the measure of the firm’s operating
performance. It indicates the firm’s earning power.
RONA can be computed as follows:
A firm can convert its RONA into an impressive ROE
through financial efficiency.
COMPARATIVE
46
STATEMENTS ANALYSIS
A simple method of tracing periodic changes in the financial
performance of a company is to prepare comparative statements.
Comparative financial statements will contain items at least for two
periods.
Changes—increases and decreases—in income statement and balance
sheet over a period can be shown in two ways:
(1) aggregate changes and
(2) proportional changes.
TREND ANALYSIS
47
In financial analysis the direction of changes over a period of years
is of crucial importance.
Time series or trend analysis of ratios indicates the direction of
change.
This kind of analysis is particularly applicable to the items of profit
and loss account.
Cont…
48
Fortrend analysis, the use of index numbers is generally advocated.
The procedure followed is to assign the number 100 to items of the
base year and to calculate percentage changes in each items of other
years in relation to the base year. This procedure may be called as
“trend-percentage method.”
Example: Hindustan
49
Manufacturing Company
INTER-FIRM ANALYSIS
50
The analysis of the financial performance of all firms in an industry
and their comparison at a given point of time is referred to the cross-
section analysis or the inter-firm analysis.
To ascertain the relative financial standing of a firm, its financial ratios
are compared either with its immediate competitors or with the
industry average.
Example: Construction industry:
Inter-firm Comparison Market
51
Share
52
UTILITY AND LIMITATIONS
OF RATIO ANALYSIS
UTILITY OF RATIO ANALYSIS
53
the ability of the firm to meet its current obligations;
the extent to which the firm has used its long-term
solvency by borrowing funds;
the efficiency with which the firm is utilizing its assets
in generating sales revenue
the overall operating efficiency and performance of the
firm.
Diagnostic Role of Ratios
54
Profitabilityanalysis
Assets utilization
Liquidity analysis
Strategic Analysis
CAUTIONS IN USING RATIO
55
ANALYSIS
Standards for comparison
Company differences
Price level changes
Different definitions of variables
Changing situations
Historical data
