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Chapter (2)

Chapter (2). Financial Statement and Analysis. The Stockholders’ Report & Understanding The Four Key Financial Statements. • The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP) .

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Chapter (2)

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  1. Chapter (2) Financial Statement and Analysis

  2. The Stockholders’ Report &Understanding The Four Key Financial Statements • The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP). • GAAP is authorized by the Financial Accounting Standards Board (FASB). It is an accounting profession’s rule-setting body. • The Sarbanes-Oxley Act of 2002, passed to eliminate the many disclosure and conflict of interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), which is a not-for-profit corporation that overseas auditors.

  3. The Stockholders’ Report • The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports. • Public corporations with more than $5 million in assets and more than 500 stockholders are required by the SEC (Securities & Exchange Commission – federal regulatory body governs sale & listing of securities) to provide their stockholders with an annual stockholders’ report (which summarizes & documents the firm’s financial activities during the past year).

  4. The Letter to Stockholders • is the primary communication from management, it discusses management philosophy, strategies, and actions and plans for the coming year.

  5. The Four Key Financial Statements: • The Income Statement • The Balance Sheet • Statement of Retained Earnings • Statement of Cash Flows

  6. The Income Statement * The income statement provides a financial summary of a company’s operating results during a specified period (fiscal year). • Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes * Look at table 2.1 (page 48)

  7. The Income Statement (cont.) • Operating Profit is often called Earnings Before Interest and Taxes (EBIT) • Net Profits = Earnings • Interest expense = Financial cost • Depreciation expense can be, and frequently is, included in manufacturing costs (cost of goods sold) to calculate gross profits. Depreciation is shown as an expense in this text to isolate its effect on cash flows.

  8. The Income Statement (cont.) • EPS (Earnings Per Share) represents the No. of dollars earned during the period on behalf of each outstanding share of common stock (earnings available for com. stocks / No. of shares of com. Stocks) • DPS (Dividend Per Share) represents the dollar amount of cash distributed during the period on behalf of each outstanding share of com. stock (actual cash distributed / No. of shares of com. Stocks)

  9. The Balance Sheet • The balance sheet presents a summary of a firm’s financial position at a given point in time. • Assets indicate what the firm owns, against financing (what it owes) or equity which represents the owners’ investment, and liabilities indicate what the firm has borrowed (debt).

  10. The Balance Sheet (cont.) • Current assets and current liabilities are short-term and expected to be converted into cash received (assets) or paid (liabilities) • All other assets and liabilities, along with stockholders’ equity, have an infinite life and considered long-term (fixed) • Marketable Securities are highly liquid short-term investments and viewed as a form of cash (near cash)

  11. The Balance Sheet (cont.) • Accounts receivable represent the total monies owed by the firm by its customers on credit sales made to them. • Inventories include raw materials and partially finished/finished goods. • Gross fixed assets is the original cost of all long-term assets owned by the firm • Net fixed assets is the difference between the gross fixed assets and accumulated depreciation • The net value of fixed assets called book value

  12. The Balance Sheet (cont.) • Accounts payables is amounts owed for credit purchases by the firm • Notes Payable is outstanding short-term loans (from commercial banks) • Accruals is amounts owed for services for which a bill may not be received (taxes due the gov. & wages due employees) • Long-term debt represents debt for which payment is not due in current year.

  13. The Balance Sheet (cont.) • Preferred stock entry shows the historical proceeds from the sale of preferred stock • The common stock entry is the par value of common stock • Paid-in-capital in excess of par is the amount of proceeds in excess of the par value received from the original sale of common stock. • The sum of the common stock & paid-in capital accounts divided by No. of shares outstanding represents the original price per share • Retained earnings (not cash) represent the cumulative total of all earnings, net of dividends, that have been retained & re-invested in the firm since its inception

  14. Statement of Retained Earnings • The statement of retained earnings reconciles the net income earned and any cash dividends paid during the year, with the change in retained earnings during the year

  15. Before going on • we should know what is Statement of Stockholders’ Equity It shows all equity account transactions that occurred during a given year

  16. Statement of Retained Earningsfor the Year Ended 31 December 2007 • Retained earnings balance (Jan 1, 2007) $1,012 • Plus: net profit after taxes (for 2007) $ 231 • Less: Cash dividends (paid during 2007) - Preferred stock ($10) - Common stock ($98) Total dividends paid ($ 108) - Retained earnings balance (Dec, 31 2007) $1,135 =====

  17. Statement of Cash Flows • 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

  18. Notes to the Financial Statements – FYI only • it provides detailed information on the accounting policies, procedures, calculations, and transactions underlying entries in the financial statements • In Practice box (page 53) discusses some common corporate accounting misdeeds and their potential impact on investors

  19. International Financial Statements • Current Rate (translation) Method is a technique under which all assets and liabilities are converted into dollar values using the exchange rate prevailing at the fiscal year ending date (the current rate) • Income statement items are treated similarly.

  20. Using Financial RatiosInterested Parties • Interested Parties need to have relative measures of the company’s operating efficiency. • Relative is the key word as the analysis of financial statement is based on the use of Ratios or Relative Values • The basic inputs to ratio analysis are the firm’s income statement and the balance sheet.

  21. Using Financial RatiosInterested Parties (cont.) • Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance. • It is of interest to shareholders, creditors, and the firm’s own management.

  22. Using Financial RatiosInterested Parties (cont.) • Shareholders are interested in the firm’s current and future level of risk and return as this affects the share price • Creditors are interested in liquidity of the firm and its ability to make interest & principal payments in addition to its profitability (i.e. healthy) • Management is concerned with all aspects and attempts to produce financial ratios favourable by both owners and creditors.

  23. Using Financial Ratios:Types of Ratio Comparisons • Cross-sectional analysis – Used to compare different firms at the same point in time • Trend or time-series analysis – Used to evaluate a firm’s performance over time

  24. Using Financial RatiosCross-Sectional Analysis • Analysts are interested in how well a firm has performed in relation to other firms in its industry ‘Benchmarking’ – this is one type! • Another type: Comparison to Industry Averages • Many mistakenly believe that as long as the firm being analyzed has a value “better than” the industry average, it can be viewed favourably. • However, this ‘better than average’ viewpoint can be misleading!

  25. Using Financial Ratios Cross-Sectional Analysis • Example: Inventory Turnover Ratio (P.55) • Higher values are preferred as it reflects the speed with which the firm moves its inventory from raw materials thru’ produc. into finished goods to the consumer • The Caldwell Manufacturing turnover was 14.8 better than the industry average (9.7) • High turnover means low levels of inventories in warehouse which hindered the firm’s ability to meet demand & resulted in lost sales

  26. Using Financial Ratios Time-Series Analysis • It evaluates performance over time • Developing trends can be seen by using multi-year comparisons. • Any changes may be symptomatic of major problems

  27. Using Financial RatiosCombined Analysis • The most informative approach to ratio analysis combines cross-sectional and time-series analyses. • It assess the trend in the behavior of the ratio in relation to the trend for the industry • Figure 2.1 (Page 57) depicts the average collection period ratio of Bartlett Company, over the years 2003-2006

  28. Using Financial RatiosCombined Analysis

  29. Using Financial RatiosCombined Analysis • The figure discloses: • Bartlett’s effectiveness in collecting its receivables is poor in comparison to the industry, and • Bartlett’s trend is towards longer collection periods Recommendation: Bartlett needs to shorten its collection period

  30. Using Financial RatiosCautions 4 Doing Ratio Analysis • Ratios that reveal large deviation from the NORM merely indicate symptoms of a problem. Add. analysis is needed to isolate the causes of the problem. Ratio Analysis directs attention to potential areas of concern; it does not provide conclusive evidence as to the existence of a problem. • Ratios must be considered together; a single ratio by itself means relatively little & cannot judge the overall performance • Financial statements that are being compared should be dated at the same point in time (e.g. seasonal impact) • Use audited financial statements when possible. • The financial data being compared should have been developed in the same way (e.g. depreciation & inventory). • Be wary of inflation distortions (older assets appear more efficient and profitable than new assets)

  31. Categories of Financial Ratios • 5 basic categories • Liquidity Ratios} • Activity Ratios} • Debt Ratios} (the 3 ratios measure risk) • Profitability Ratios (measure return) • Market Ratios (capture risk and return)

  32. Ratio Analysis • First: Liquidity Ratios: • The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come due. It refers to the solvency of the firm • These ratios provide signs of cash flow problems & impending business failure. • Two Basic measures of liquidity are: (1) Current Ratio (2) Quick (acid-test) Ratio

  33. Ratio Analysis Current Ratio = Current Assets = $1,223 = 1.97 Current Liabilities $620 Notes: • The higher the current ratio, the more liquid the firm is considered • A current ratio of 2.0 is occasionally cited as acceptable • But! A value’s acceptability depends on the industry in which the firm operates • Current ratio of 1.0 is acceptable for a public utility • Thus the rule is: The more predictable a firm’s cash flows, the lower the acceptable current ratio.

  34. Ratio Analysis • Quick Ratio = Current Assets – Inventory = $1,223 - $289 = 1.51 Current Liabilities $620 Notes: • It is similar to current ratio but it excludes the inventory, the least liquid current assets • Low liquidity of inventory results from (a) cannot be easily sold - partially completed (b) inventory sold on credit becomes account receivables before converted into cash • A quick ratio of 1.0 or greater is occasionally recommended but depends on the industry. • If inventory is easily to get liquid, the current ratio is preferred measure of overall liquidity.

  35. Ratio Analysis • Quick Ratio, sometimes, is defined as: = cash + market. securities + a/c receivables current liabilities

  36. Financial Ratio AnalysisIndustry Average Ratios (2003) for selected lines of business by SIC (Standard Industrial Classification)

  37. Ratio Analysis • Second: Activity Ratios: measure the speed with which various accounts are converted into sales or cash – inflows or outflows • Liquidity measures are inadequate because differences in the composition of a firm’s current assets/liabilities & would affect its ‘true’ liquidity • So we need to assess the activity (liquidity) of specific current accounts

  38. Ratio Analysis • Four Basic measures of Activity: (1) Inventory Turnover (2) Average Collection Period (a/c receivables) (3) Average Payment Period (a/c payables) (4) Total Asset Turnover

  39. Ratio Analysis • Inventory Turnover: measures the activity (or liquidity) of a firm’s inventory. Inventory turnover = Cost of goods sold Inventory Inventory turnover = $2,088,000 = 7.2 $289,000

  40. Ratio Analysis • An inventory turnover of 20.0 is acceptable for grocery store, whereas a common inventory turnover for an aircraft manufacturer is 4.0 • Inventory turnover can be converted into an average age of inventory • Average Age of Inventory = 365 Inventory Turnover • Inv Turnover = 365 = 50.7 (average No. of days’ sales) 7.2

  41. Ratio Analysis • Average Collection Period (or the average age of accounts receivable): • Sometimes called ‘Days’ Sales Outstanding – DSO’ It measures and evaluates the credit and collection policies.

  42. Ratio Analysis • Average Collection Period: = Accounts Receivables = A/C receivables Average Sales per day* Annual Sales 365 = $503,000 = $503,000 = 59.7 days $3,074,000 $8,422 365 * The formula as presented assumes, for simplicity, that all sales are made on a credit basis. If this is not the case, average credit sales per day should be substituted for average sales per day.

  43. Ratio Analysis • On the average, it takes 59.7 days to collect an account receivable • It is meaningful only in relation to the firm’s credit terms • If the firm extends 30-day credit terms to customers , ACP of 59.7 days indicates a poorly managed credit/collection Dept. • If it is 60-day credit terms, then 59.7-day ACP is quite acceptable

  44. Ratio Analysis • Average Payment Period (or average age of accounts payable): • = Accounts Payable = Accounts Payable Average purchase per day Annual purchase 365 Notes: • Annual purchases are not available in published financial statement • Therefore, purchases are estimated as a given percentage of cost of goods sold (assumed 70% of good sold) • Technically, annual credit purchases – rather than annual purchases (for simplicity) – should be used in calculating the ratio. But this refinement is ignored.

  45. Ratio Analysis • Average Payment Period: = $382,000 = $382,000 = 95.4 days 70% X $2,088,000 $4,004 365 • Again, the resulted figure should be read in line with the average credit terms extended to the firm by other firms/suppliers. • By 30-day credit terms, the firm considered a low credit rating • Prospective lenders & suppliers are interested in the firm’s bill-paying patterns.

  46. Ratio Analysis • Total Asset Turnover: indicates the efficiency with which the firm uses its assets to generate sales • Management is interested in this measure as it indicates whether the firm’s operation have been financially efficient. • = Sales = $3,074,000 = 0.85 Total assets $3,597,000 • The company’s turnover is 0.85 times per year • The higher a firm’s total asset turnover, the more efficiently its assets have been used.

  47. Ratio Analysis • Third: Debt Ratios: • The debt position points at the amount of other peoples’ money being used to generate profits • The more debt a firm has, the greater its risk of being unable to meet its contractual debt payments and becoming bankrupt. • Creditors, current and prospective shareholders, lenders, and management are also concerned about the firm indebtedness.

  48. Ratio Analysis • The more debt a firm uses in relation to its total assets , the greater its financial leverage • Financial Leverageis the magnification of risk and return introduced thru’ the use of fixed-cost financing (e.g. debt & preferred stocks) • & the more fixed-cost debt a firm uses, the greater will be its expected risk & return

  49. Ratio Analysis – Debt Ratios • The example in page 63, table 2.6 shows that with increased debt comes greater risk as well as higher potential return • Therefore, the greater the financial leverage, the greater the potential risk and return

  50. Ratio Analysis – Debt Ratios • There R 2 general types of debt measures: • the Degree of Indebtedness: measures the amount of debt relative to other significant balance sheet amounts (popular measure is Debt Ratio which measures the proportion of total assets financed by the firm’s creditors ) (2) the Ability to Service Debts: reflects a firm’s ability to make the payments required on a scheduled basis over the life of a debt. (Popular measure is Coverage Ratios)

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