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Analyzing Financial

Statements
MAF605
2.1.1 : Understanding Basic Financial Statement

› A company’s published annual report or financial statement


as consisting of certain pieces of important information
about the firm’s operations that are reported in the form of:
› The double entry system of accounting is produced
through the mathematical contents of these financial
statements is very straightforward and expressed a follows:
2.1.2 : Reporting the Value of a Balance Sheet Items

› In accounting statements, current (short term) refers to a period of up one


year.
› Long term refers to more than one year. Current assets are expected to
become cash within one year.
› On the other hand, current liabilities are usually mature or are expected to
be paid off cash within one year.
› A long term assets and long term liability have remaining maturities of more
the one year. Current assets and liabilities are usually arranged in
approximate order of remaining maturity, from shortest to longest. This
arrangement reflects the fact that, generally, the books values of the short-
remaining -maturity assets and liabilities tend to be closer to their current
market values than those that have long maturities. For example, the book
value of receivable may be fairly close to their market value. In contracts,
the current market value of net fixed assets can be very different from their
book values.
› Therefore, in reporting the dollar amounts of these values
various assets, the conventional practice is to report the
value the assets and liabilities on a historical cost basis.
Thus the balance sheet is NOT intended to present the
current market value of the company, but rather reports the
historical transactions recorded at their cost. Determining a
fair value of the business is different issue.
2.1.3 : The Balance Sheet
› The balance sheet reports the finical position of a company
at a particular point in time. The balance sheet shows the
assets of the company, which are the productive resource
used in its operations. The balance sheet also shows the
liabilities and stockholders’ equity of the company, which
are the total claims of creditors and owners against the
assets. Assets represent the resources owned by the firm,
whereas the liabilities and owner’s equity indicate how
those resources are financed.
› Assets and liabilities are both broken into short term and
long term parts and arranges in approximate order of more
or less than one year. The arrangement of the categories
tells us that, the assets fall into three parts:
2.1.4 : Income Statement
› The income statement reports the revenue, expenses, and
profit (or losses) a company over a specific interval of time,
typically a year or a quarter of a year. Net income,
sometimes referred to as profit, is the difference between
total revenue and total cost for that the operations. Figure
1.11 shows the income statement of XYZ. In this income
statement the gross profit is the net sales minus the cost of
goods sold, the cost of goods sold is the direct cost for the
material, labor, and other expenses directly associated with
the production of the goods or services sold by the
company.
2.1.5 : Sources and Uses of Cash
› The fundamental levels of firms do two different things.
They generate cash spent it.

Where did the money come from? To answer this, we need
to first identify those changes that used up cash (uses) and
those that brought cash in (sources).

Where did the money come from? To answer this, we need


to first identify those changes that used up cash (uses) and
those that brought cash in (sources).
2.1.6 : The Statement of Cash Flows
› The statements of such flows indicate how the cash position of
the company has changes during the period covered by the
income stamen. Thus, it complements the income statement
and the balance sheet. Changes in a company’s cash position
can be the result of any of the company’s many transactions.
The statement of cash flows breakdown the sources and uses
of cash into three components. These are cash flows from:

› Operating
› Investing
› Financing activities
2.1.7 : Cash Flows From Operating Activities
› The net income is taken from Kenanga income statement figure
1.15. To derive at the net income, various items are deducted from
sales, including some that are no cash expenses. Deprecation is
usually the largest of the conch’s items. Because these items are not
cash flows, they must be added back to determine cash flow.
Dividends are not subtracted from operating activities. Instead they
are a discretionary part of financing activities. The other items
represent changes in several working capital accounts, which are
part of operating activities. Decrease (increase) in assets (liability)
account are positive cash flows (inflow). The opposites are negatives
cash flows (outflows). One short-term liability, note payable, is
considered a financing activity and is not included in operating
activities.

› Investing activities flows include those connected with buying or


selling long term assets, acquiring other companies, and selling
subsidiaries.
› Financing activities cash flow include those connected with
selling or repurchasing common and preferred stock,
issuing or retiring long term debt, issuing and repaying
short-term notes, and paying dividends on common stock
or preferred stock. Net increase (decrease) in cash and
equivalents is the sum of the cash from the three section,
and operating cash flows. It is important to understand at
that such separations in the statement of cash flows are
somewhat arbitrary, particularly in the case of the first part
of the statement, which shows the cash flows from
operating activities. For, example dividends are include
with financing cash flows, whereas interest expense is
treated as an operating cash flows.
2.2 : Financial Ratios
› 2.2.1 : Short-Term Solvency, or Liquidity, Measures
› The objective of using a ratio analysis is simply to standardize
the information being analyzed so that comparisons can be
made between ratios of different firms or possibly the same firm
or different points in time.
› The ratios will give us two ways of making meaningful
comparison of a firm’s financial data. For example:
› we can examine the ratios across time or period that enables
us to identify any trends of the specific ratios chosen.
› we also can compare the firm’s ratios with those of other firms.
2.2.1 Short-Term Solvency, or Liquidity,
Measures

› Short-term solvency ratios are used for a firm liquidity


measure, and these ratios are sometimes called liquidity
measures. The primary concern is the firm’s ability to pay
its bills over the short term without having any financial
difficulty. Consequently, these ratios focus on current
assets and current liabilities. For obvious reason, liquidity
ratios are particularly interesting to short-term creditors.
Because financial managers are costly working with banks
and other short-term lenders, and understanding of these
ratios is important.
2.2.2 : Liquidity Ratios
› The most commonly used measure of overall liquidity is the
current ratio:
2.2.3 : Assets Turnover Ratios
› Assets turnover ratios are calculated to measure how
effectively a company manages it assets.

The ratio measure the number of times the accounts receivable


balance and show how quickly the collection period for the company
during the year.

The day’s sale outstanding shows approximately how many days on average it takes to
collect the company’s account receivable. The day’s sale outstanding is also called the
average collection period.
2.2.4 : Leverage Ratios
2.2.5 : Coverage Ratios
2.2.6 : Profitability Ratios
2.2.7 : Market Value Ratios Measures
2.3.1 : The Dupont Analysis
Using the DuPont equation above allows management to see more
clearly what derives the return on equity and the interrelationships among
the net profit margin, the asset turnover, and the debt ratios.
Management is provided with a road map to follow in determine their
effectiveness in managing the firm’s resources to maximum the return
earned on the owner’s investment’s. In addition, the manager or owner
can determine why that particular retying egad earned.
2.3.2 : Limitations with Financial Statement and
Ratios Analysis
› The financial ratio have been proved and be used as a tool to evaluate company’s
financial positions, but anyone who works with these ratios ought to be aware of the
some limitation involved in their valuation. The following list includes of the more
important pitfalls that may be encountered in computing and interpreting financial
ratios.

› The different industry sometimes difficult to identify category to which a firm belongs,
especially when firm engages in various lines of business.
› The information of average industry are only approximation and are not scientifically
determined the ratios of all representative sample of the firms within the industry
› The different of accounting standard lead to different result of the ratio analysis.
› An industry may not provide a desirable target Ratios or norm of specific lines of
business. Generally, the information provides only as a guide to the financial positions
of the average firm in the industry.
› The different timing of fiscal year makes it difficult to compare the financial ratio,
especially for the firm that experience seasonality in their operation.
2.4.1 : Choosing Financial Ratios
› 2.4.2 : Discriminant Analysis and Credit Scoring
› It is important to know that financial ratios could be used as a
tool to assess the condition of a company. By using discriminant
analysis, you are able to predict significant events of the
company. The event such as probability of the company
bankruptcy and financial distress is possible by using the
discriminate statistical analysis. Discriminant analysis will
classify the company into one or more groups and produce the
classification results.
› Disriminat analysis model are also used for evaluaioting
commercial loan, consumer loans, and credit card applications.
Such models are often called credit scoring models. The basic
idea of credit scoring is to detect likelihood of default customer.
2.4.3 : Cross-Sectional Analysis
› Cross sectional analysis evaluates a company’s financial
ratio against industry average or average for a selected set
of comparable companies. The industry averages are
broken down into size of company and total sales. The
arrangement of the percentile such as the 25th percentile
belong to the smallest size, 50th to the medium size and
>75th to the larger size. Using this kind of information, a
company can compare itself to other companies of similar
size in the same industry.
2.4.4 : Time Series Analysis
› Changes in a company’s position such as liquidity, financial
leverage, asset turnover, or profitability ratios overt time
can be very meaningful. The changing trends in financial
ratios and companies information are resulting from
general economic condition, industry, specific managerial
decision, or simply something happen good or bad.
Therefore, time series over the period such 10 year period
of profitability ratio of a company could benefit the user in
making an investment decision.
› 1. Inflation and book values
› Chapter 1 emphasized accounting statement are historical
without taking into consideration several factors such inflation
that can distort the information recorded in the balance sheet.
Inflation can also distort a company’s reported earning through
the inventory method of the company. For example, LIFO (last
in first out) convention to overcome the earning, that will distort
its balance sheet by understating the inventory value.

› 2. International accounting
› Accounting standard are substantially different across
countries. As such, language and foreign currency conversion
also differences and need considerable effort to learn and
understand how those financial statements are different from
other countries.
› 3. Judgment, experience, and luck
› Making a right decision is not easy in a complex and dynamic
economic environment. Most decision involve some sorts of
trade-offs, frequently including the principle of high risk, high
return trade off. For example, a company can lower it shrikes by
using less debt, but that too will reduce the stockholders’
expectation return that require judgment and analysis.

› 4. The use of financial statement analysis
› There are two reasons why we should use financial statement
analysis. Firstly, it provides a structure for understanding the
dynamic of a company. The questions of how would some
event affect a company, whether the event significant or
insignificant could easily understand the importance of the new
information through understanding financial statement analysis.