Understanding Financial

Statements Investor Perspective

P. S. M. Gunaratne PhD
Professor in Finance, Department of Finance
Faculty of Management & Finance, University of Colombo

Foundation Course
Colombo Stock Exchange Investor Education Programme

Introduction
Stock

Market is information driven

Economy-wide information
Industry/Sector specific information
Firm-specific information

Can alter the risk return

profile of the firm so
the value of the firm

Economy
Industry
Internal Env.
Firm
RISK
Return

Economy Wide Information

Affects

the entire market

GDP growth rate, Level of Employment,

Inflation, Exchange Rate, Interest rate
Peace war situation, regulatory
changes, etc.
The

level of sensitivity may vary

form firm to firm

Industry Specific Information

Affects

a particular sector /Industry

The

level of sensitivity may vary

form firm to firm

Some

economy-wide information
may affect particular sector/sectors

Be

careful! Sectors are not clearly

defined

Firm-Specific Information
Information

related to a particular firm and

affects only the particular firm.
Change of management, new investment plan,
different announcements by the firm, releasing
annual/financial reports, action taken against the
firm by regulators etc.

Some

information is frequent and regular

Releasing annual/financial reports, dividend

announcements

Some information is less frequent

Use of Information by Investors

Information is vital in valuing the stocks as

they alter risk-return profile of the underling
firms
In estimating value of stocks you need to
understand the changing risk return profile of
the firm with the new information
Value may compare with the current market
prices to decide whether stock is undervalued,
over valued or even fairly valued
Having followed the above steps, you can
decide whether to buy, hold or sell a particular
stock

Use of Information Cont..

In

making investment decisions you may

engage in different level of analysis
Industry level analysis
Industry

attractiveness

Firm level analysis

Firm

Attractiveness

Financial Statement as a Source of

Information

A regular flow of firm specific information come

through annual reports (quarterly reports) as
financial information
Investor can measure firm performance
through financial information
Basically risk-return characteristics of the firm
can be indentified through financial information
Financial information not only provides a
measure of past performance but also provides
a measure of its financial strength

Components of An Annual Report

The Business Review:

This summarizes a companys recent developments, trends and objectives.

This may be presented within chairmen/CEO review

The Financial Review /Financial Highlights: This presents a

companys business performance in Rupees

Financial Reports:

Income Statement

Balance Sheet

Cash Flow Statement

Statement of Change in Equity and Notes to Financial Statements

Independent Audit Report

Shareholder and Investor Information

Historical Summary Information

The Basis of Financial Statements

The resources controlled by a business are referred to as its

assets. For a new business, those assets originate from two
possible sources:
Investors who buy ownership in the business
Creditors who extend loans to the business

Those who contribute assets to a business have legal claims on

those assets. Since the total assets of the business are equal to
the sum of the assets contributed by investors and the assets
contributed by creditors, the following relationship holds and is
referred to as the accounting equation :
Assets
Resources

Liabilities + Owners' Equity

Claims on the Resources

The Basis of Financial Statements Cont..

Initially owners funds may use to start a business and

acquire different assets needed run the business. If no
borrowings are used equation could be simplified to:
Assets

Owners' Equity

Ex. Assume a group of people started a business by investing

100 million and acquired Land & Building worth of 60 Million
Assets: Rs. 100M = Owners' Equity 100M

The Balance Sheet of the Business is Based on the

Accounting Equation
The Balance Sheet
Assets: Land and Building
Cash
Total Assets

60,000,000
40,000,000
100,000,000

Owners Equity : Capital

Total Equity

100,000,000
100,000,000

The Basis of Financial Statements Cont.

Assume the same business borrowed Rs. Rs.50m from

a bank and bought a motor vehicle worth of Rs.55m.
Now the new equation for the business:
Assets: Rs. 150M = Liabilities 50 M + Owners' Equity 100M

The new Balance sheet

Balance Sheet
Assets:
Non Current Assets
Land and Building
Motor Vehicle
Current Assets
Total Assets

Cash

Owners Equity :
Equity
Liabilities :
Bank Loan
Total Equity and Liabilities

60,000,000
55,000,000
105,000,000
35,000,000
150,000,000
100,000,000
50,000,000
150,000,000

The Basis of Financial Statements Cont.

Both Balance Sheet and Accounting Equation only shows

Assets, Liabilities and Owners Equity.
There are two other types of Accounts that do not directly
show in the Balance sheet; Revenues and Expenditures
Ex. Assume that the business we have so far considered
purchased goods (for sale) worth of Rs.150m from time to time
during the subsequent year and sold 80% of goods purchased
for Rs.175m and incurred various expenditures up to Rs. 18 m.
Interest paid for the loan Rs. 5 m. Repayment of loan Rs. 10m
Now we have to recognize the following expenditure and revenue
items
Expenditure:

Revenue :

Cost of sales (150m * 80%) = Rs.120 m

Other Expenditure
= Rs. 18 m
Interest paid
= Rs. 5 m
Sales
= Rs. 175m

All Income and Expenditure are recorded in the Income

Statement

The Basis of Financial Statements Cont.

Income Statement
Sales (Turnover)
Cost of Sales
Gross profit
Other Expenditure
Interest Paid
Net profit

175,000,000
(120,000,000)
55,000,000
(18,000,000)
(5,000,000)
32,000,000

Recognize that assets and liabilities possessed by the business

change with the above transactions
Also recognize that the unsold merchandising goods
(inventory) remaining at the end of the year is a Current Asset
By the amount of profit earned equity goes up

The Basis of Financial Statements Cont.

Balance Sheet
Assets:
Non Current Assets
Land and Building
Motor Vehicle
Current Assets
Cash
Inventory
Total Assets
Owners Equity :
Capital
Profit
Total Equity
Liabilities :
Bank Loan
Total Equity and Liabilities

60,000,000
55,000,000
115,000,000
27,000,000
30,000,000
57,000,000
172,000,000

100,000,000
32,000,000
132,000,000
40,000,000
172,000,000

Cash
Beg. Balance.
35M
+ Sales
175M
-Purchases (150M)
-Expenses
(18M)
-Loan Rep
(10M)
-Loan Interest (5M)
End Balance
27M
Inventory
20% of Purchases
150M * 20% = 30m
Loan
Beg. Balance.
50M
-Repayment (10M)
End Balance
40M

The Basis of Financial Statements Cont.

Cash Flow Statement

Cash flow from operating Activities
Net Profit
+Interest paid
Operating cash flow before working cap. adjust.
-Increase in inventories
Net cash flow from operations
Cash flow from Investment Activities
None
Cash flow from Financing Activities
Loan Interest
Loan Repayment
Net cash flow from financing activities
Change in Cash Balance
Cash at the beginning of the year
Cash at the end of the year

32,000,000
5,000,000
37,000,000
(30,000,000)
7,000,000

(5,000,000)
(10,000,000)
(15,000,000)
(8,000,000)
35,000,000
27,000,000

The Balance Sheet

The balance sheet portrays the financial position of

the company by showing what the company owns
and what it owes at the report date.
Accordingly it shows; Assets, Liabilities' and
Owners Equity
It is a snapshot, since it reports the companys
financial position at a specific point in time.

In the Blance Sheet Assets are classified into Fixed

(non Current ) and Current Assets
Liabilities are classified into long-term and current
liabilities

The balance sheet continues..

The Assets section includes all the goods and

property owned by the company, and uncollected
amounts due (receivables) to the company from
others. Assets are generally classified into Fixed
Assets and Current Assets
The Liabilities section includes all debts and
amounts owed (payables) to outside parties.
Liabilities are also classified into Long-term and
Current Liabilities
The Shareholders Equity section represents the
shareholders ownership interest in the company-what the companys assets would be worth after
all claims to other parties were paid.

The Income Statement

The Income Statement can be thought of more

like a motion picture, since it reports on how a
company performed during the period(s) and
shows whether that companys operations have
resulted in a profit or loss.
It compares periodic expenses with the periodic
revenues and it shows the estimated tax for
the period (only in companies)
It estimates the profit or loss for the period
under consideration

Statement of Cash Flows

The statement of cash flows reports on the
companys cash movements during the period
separating them meaningfully into operating,
investing and financing activities.
Can identify sources and uses of cash
Show the relation between profit or Loss and
cash flows

The Footnotes

The footnotes provide more detailed

information about the financial statements.

Audit Report

There are two kinds of auditing, namely internal and

external (independent) auditing.
Internal auditing focuses on the audit of an entitys
operational effectiveness and control. (by internal auditors)
On the other hand, an external or independent audit
focuses on the assessment of the fairness of an entitys
financial statements (by independent auditors)
Audit report is expression of an opinion whether an entity has
prepared financial statements fairly in all material respects in
accordance with the financial reporting standards.
To support the audit, the auditor must perform procedures to
obtain audit evidence about the amounts and disclosures in the
financial statements. He also tests the entitys internal control and
policies that are relevant to the entitys preparation and fair
presentation of financial statements.
It helps the credibility of the reported financial statements because
of the independence and impartiality which are the qualities of
external auditors.

Financial Statement Analysis

Purpose
Different groups of Financial statement users with different
information needs

Focus will be on needs of equity investors and suppliers of credit

Differing the levels of technical expertise

Focus on tools used by a sophisticated user

Primary questions relate to company performance

and financial strength, but user emphasis may differ

Investment analysts are primarily interested in financial

statements as a predictor of future performance
Lenders will primarily focus on the financial strength (default
risk)

Each question is the sum of different issues

Financial Statement Analysis

Simple Analysis
You can just go through figures and compare them
with previous years figures analyze the difference.
You my use percentage changes year to year profit
growth is 38% etc.
You can compare them with other firm s well
Sometimes this kind of analysis is misleading

Ex. You dont know whether you get enough return for your
investment

Ratio Analysis

Ratios helps us to understand certain phenomenon in a

more meaningful and useful manner. Its a way of
analyzing and presenting information so that user could
benefit more.

Ratios are used in much of our daily life too

Automobiles How many kilometers per liter
Cricketer Average ODI score

Ratios are helpful to judge comparative performance

Financial ratios are used to weigh and evaluate the
operating performance of the firm.

If a firm earn Rs. 500,000 profit from Rs. 5,000,000 of sales (10
percent profit margin) that might be quite satisfactory where as
Rs. 50,000 earnings on 5,000,000 (1 percent margin) could be
disappointing

Constructed ratios can be compared with the industry as

well as well as with the own past records or budgeted
figures.
Reasons for deviations and variations should be further
studied Ratios show the symptom not the cause

Classification of Ratios

Profitability Ratios

Assets Utilization

Current Ratio
Quick Ratio

Debt utilization ratio

Receivable turnover
Average collection period
Inventory turnover
Fixed assets turnover
Total assets turnover

Liquidity Ratios

Profit margin
Return on assets (investment)
Return on equity

Debt to total assets

Time interest earned
Fixed charge coverage

Market Value Ratio

Earnings Per Share

P/E ratio
Market to book Ratio

Classification of Ratios cont

1. Profitability Ratios:
to measure the ability of the firm to earn an adequate return on sales,
total assets or invested capital
2. Assets Utilization Ratios:
Speed at which the firm is turning over accounts receivable,
inventory and how productive the fixed assets are in terms sales
generations
3. Liquidity Ratios:
Firms ability to pay off short-term obligations
4. Debt Utilization Ratios:
the overall debt position of the firm is evaluated in the light of its
assets base and earning power
5. Market value Ratio
Can be computed only for publicly traded stocks.
*The user of the financial statement will attach different degrees of importance to the
four categories of ratios.
potential investor or share holder profitability
banker or trade creditor liquidity and debt utilization

1. Profitability Ratios:
Gross profit Margin
= (Gross Profit/Sales) x 100--- (1,000,000/4,000,000)X100=25%
May depend on the nature of the industry, type of product, level
of competition sales policy and strategies, image of the firm and
the brand.

Net profit Margin

= (Net Income/Sales ) x 100--(200,000/4,000,000)X100 =25%
May depend on all the factors mentioned under the gross profit
margin and the level of other expenses (Overheads).
Variations should be studied, Sometimes changes might be due the
changing policies.
However, total profitability of the firm is not only depend upon
profit margin (how much you earn from each rupee of sales) but
also your assets turnover ( how much sales you generate per
each a rupee of assets)

1. Profitability Ratios:
Return on Total Assets (investment)
= (Net Income + Interest payment /Total Assets) X 100
= (200,000+40,000 / 1,600,000) x 100

= 15%

Net income = After tax profit + Interest

Total Assets = Owners fund and debt

Return on Equity
=(Net Income/Total Equity ) X100
= (200,000/ 1,000,000) X 100

= 20%

Net Income = After tax profit

* Above rations depend on both profit margins and assets
turnover you can find whether you are getting required rate of
return for your investment

2. Assets Utilization (Management) Ratios

(Turnover Measures)

How efficiently assets are being utilized

1.Receivable Turnover:
Sales (Credit)/ Accounts Receivables -- 4,000,000/350,000 = 11.4 times
2. Average collection period: (Days sales in receivable)
Accounts Receivable /*Average daily credit sales = 350,000/10,959=32Days
* Average daily Credit sales = Credit sales/365
3. Inventory Turnover
Sales/Inventory = 4,000,0000/370,000 = 10.8 times
* better to use average inventory
4. Average Inventory Period (Days Sales in Inventory)
Inventory/Average daily sales = 370,000/10,959= 33.8 days
365 days/inventory turnover = 365/10.8 = 33.8 days.
5. Fixed Assets Turnover
Sales/Fixed Assets = 4,000,000/800,000 = 5
6. Total Assets Turnover
Sales/Total Assets = 4,000,000/1,600,000= 2.5

Liquidity Ratios (short term solvency)

1 Current Ratio
=Current Assets/Current Liabilities
= 800,000/300,000 = 2.67 or (1 : 2.67)

2. Quick Ratio (Acid Test Ratio)

=(Current Assets Inventory)/Current Liabilities
=430,000/300,000 = 1.43 or (1: 1.43)

3 Cash Ratio
=Cash/Current Liabilities
= 30,000/300,000 = 0.1 or (1 : 0.1)

4. Net Working Capital to Total Assets

= Net working capital/ Total Assets
= 500,000/1,600,000 = 0.3125 or 31.25%

4. Debt Utilization Ratios

1. Debt to Total Assets
(Total Debt/Total Assets) X100 = (600,000/1,600,000)X100 = 37.5%

*Total debt = (total Assets Equity)

2. Debt Equity Ratio

(Total Debt/Total Equity)100100 = (600,000/1,000,000)X100= 60%

3. Equity Multiplier
Total Assets/Total Equity = 1,600,000/1,000,000 = 1.6 times

4. Times Interest Earned (Interest Coverage)

Earnings before interest and taxes (EBIT)/Interest =
550,000/50,000= 11

5. Fixed Charge Coverage

Earnings before fixed charges and taxes/Fixed Charges
=600,000/100,000 = 6
Firms ability to meet all fixed charges (ex. Lease payment)

5. Market Value Ratios

1. Earnings Per Share (EPS)
Net Income/No. of Shares outstanding* = 200,000/40,000 = 5
* 40,000 shares outstanding
2. Price Earnings Ratio, P/E Ratio
Price per share*/earnings per share = 20/5 = 4 times
* Market price of the share Rs. 20
3. Market to Book Ratio
Market Value per Share / Book Value per Share = 20/10 = 2 times

Other than the above three major ratios, shareholders may be

interested in such ratios as Dividend Per share , Dividend cover,
Net Assets per share etc.