Managing Finance for Leadership

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Financial Statements and
3 Financial Statement Analysis

By: Dr. Abebe Negesse

Oromia State University

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3.1. Financial Statements
 Financial statements (or financial reports)
are formal records of business financial
activities.
 These statements provide an overview of a
business profitability and financial condition
in both short and long term.
 Financial statements are summaries of the
operating, financing, and investment
activities of a business.

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 ... Financial Statements …
 Financial statements should provide information
useful to both investors and creditors in making
credit, investment, and other business decisions.
 And this usefulness means that investors and
creditors can use these statements to predict,
compare, and evaluate the amount, timing,
and uncertainty of potential cash flows.
 In other words, financial statements provide the
information needed to assess a company’s future
earnings and therefore the cash flows expected
to result from those earnings.
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 3.2. Objective of Financial Statements
 The objective of financial statements is to
provide information about the financial
strength, performance and changes in
financial position of an enterprise that is useful
to a wide range of users in making economic
decisions.
 Financial statements should be
understandable, reliable, relevant and
comparable.

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3.3. Types of Financial statements

 There are four basic financial statements:

 Balance sheet

 Income statement

 Statement of retained earnings

 Statement of cash flows

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3.3.1 Balance sheet
 also referred to as statement of financial
position or condition
 It is the financial statement showing a firm’s
accounting value on a particular date.
 It is a convenient means of organizing and
summarizing what a firm owns (its assets), what
a firm owes (its liabilities), and the difference
between the two (the firm’s equity) at a given
point in time.
 the left-hand side lists the assets of the firm, and
the right-hand side lists the liabilities and equity
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 Assets: The Left-Hand Side
 Assets are classified as either current or fixed.
 A fixed asset is one that has a relatively long life.
 A current asset has a life of less than one year.
This means that the asset will convert to cash
within 12 months.
 For example, inventory would normally be
purchased and sold within a year and is thus
classified as a current asset.
 Accounts receivable (money owed to the firm by
its customers) is also a current asset.
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 Liabilities and Owners’ Equity:
The Right-Hand Side
 The firm’s liabilities are the first thing listed on
the right-hand side of the balance sheet.
 These are classified as either current or long-
term.
 Current liabilities, like current assets, have a life
of less than one year (meaning they must be
paid within the year) and are listed before long-
term liabilities. Accounts payable (money the
firm owes to its suppliers) is one example of a
current liability.
 A debt that is not due in the coming year is
classified as a long-term liability. 3-8
 Liabilities and Owners’ Equity…
 The difference between the total value of the assets
and the total value of the liabilities is the
shareholders’ equity, also called common equity or
owners’ equity.
 This feature of the balance sheet is intended to
reflect the fact that, if the firm were to sell all of its
assets and use the money to pay off its debts, then
whatever residual value remained would belong to
the shareholders.
 So, the balance sheet “balances” because the
value of the left-hand side always equals the value
of the right-hand side.
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 Liabilities and Owners’ Equity…
 That is, the value of the firm’s assets is equal to the
sum of its liabilities and shareholders’ equity
Assets = Liabilities + Shareholders’ equity
 The structure of the assets for a particular firm
reflects managerial decisions about how much cash
and inventory to have and about credit policy, fixed
asset acquisition, and so on.
 The liabilities side of the balance sheet primarily
reflects managerial decisions about capital structure
and the use of short-term debt

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 Users of Balance sheet
 The balance sheet is potentially useful to many
different parties.
 A supplier might look at the size of accounts payable
to see how promptly the firm pays its bills.
 A potential creditor would examine the liquidity and
degree of financial leverage.
 Managers within the firm can track things like the
amount of cash and the amount of inventory that the
firm keeps on hand.
 Investors will frequently be interested in knowing the
profitability of the firm.

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 Users of Balance sheet…
 The fact that balance sheet assets are listed
at cost means that there is no necessary
connection between the total assets shown
and the value of the firm.
 Indeed, many of the most valuable assets that
a firm might have—good management, a good
reputation, talented employees—don’t appear
on the balance sheet at all.

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 3.4.2. The Income Statement
 An Income Statement, also called a Profit and Loss
Statement (P&L).
 It is a financial statement for companies that indicates
how Revenue (money received from the sale of
products and services, also known as the "top line")
is transformed into net income (the result after all
revenues and expenses have been accounted for,
also known as the "bottom line").
 The purpose of the income statement is to show
managers and investors whether the company made
or lost money during the period being reported.
 The income statement equation is:
Revenues - Expenses = Income 3-13
 3.5.3.Statement of Cash Flows

 The statement of cash flows is a summary over

a period of time of a firm’s cash flows from
operating, investment, and financing activities.
 By Analyzing these individual flows, current and
potential owners and creditors can examine such
aspects of the business as:
 The source of financing for business operations, whether
through internally generated funds or external sources of
funds.
 The ability of the company to meet debt obligations
(interest and principal payments).

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 3.5.3.Statement of Cash Flows …
 The ability of the company to finance expansion through
operating cash flow.
 The ability of the company to pay dividends to
shareholders.
 The flexibility the business has in financing its operations.
 The cash flow from operating activities is the most
complex of the three.
 Ideally, we could obtain it directly, by summing all
cash receipts (inflows) and disbursements
(outflows) for the periods covered by the statement.

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 3.5.3.Statement of Cash Flows …

 The cash flow from (used for) investing activities

includes cash flow due to investments in plant
assets, the disposal of plant assets, acquisitions of
other companies, and divestitures of subsidiaries.
 The cash flow from (used for) financing activities
includes cash flows due to the sale or repurchase of
common or preferred stock, the issuing or retirement
of long-term debt securities, and the payment of
common and preferred dividends.

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FINANCIAL STATEMENT
ANALYSIS

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 Meaning, Significance and Objectives of
Financial Analysis
 Financial analysis is one of the many tools useful
in valuation because it helps the financial analyst
gauge returns and risks.
 Financial analysis refers to analysis of financial
statements and it is a process of evaluating the
relationships among component parts of financial
statements.
 The focus of financial analysis is on key figure in the
financial statements and the significant relationships
that exist between them.

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 Meaning, Significance and Objectives of
Financial Analysis…

 The analysis of financial statements is designed to

reveal the relative strengths and weakness of a firm.
 Financial analysis helps users obtain a better
understanding of the firm’s financial conditions and
performance.
 It also helps users understand the numbers presented in
the financial statements and serve as a basis for financial
decisions.
 A financial ratio is a comparison between one bit of
financial information and another.
 Consider the ratio of current assets to current liabilities,
which we refer to as the current ratio.

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 APPROACHES OR TECHNIQUES OF
FINANCIAL ANALYSIS

The most frequently used techniques in analyzing financial

statements are:
i) Ratio Analysis – is a mathematical relationship
among money amounts in the financial statements.
ii) Cross-Sectional Analysis– involves the comparison
of different firms’ financial ratios at the same point in
time. Analysts are often interested in how well a firm
has performed in relation to other firms in its industry.
• Frequently, a firm will compare its ratio values to those
of a key competitor or group of competitors that it
wishes to emulate.
• This type of cross-sectional analysis, called
benchmarking, has become very popular. 3-20
 APPROACHES OR TECHNIQUES OF
FINANCIAL ANALYSIS

iii. Time-series analysis evaluates performance over

time. Comparison of current to past performance, using
ratios, enables analysts to assess the firm’s progress.
Developing trends can be seen by using multiyear
comparisons. Any significant year-to-year changes
may be symptomatic of a problem, especially if the
same trend is not an industry-wide phenomenon.
iv. Combined Analysis –The most informative approach
to ratio analysis combines cross-sectional and time-
series analyses. A combined view makes it possible to
assess the trend in the behavior of the ratio in relation
to the trend for the industry.

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 RATIO ANALYSIS
 Ratio analysis involves methods of calculating and
interpreting financial ratios to analyse and monitor the
firm’s performance.
 The basic inputs to ratio analysis are the firm’s income
statement and balance sheet.
 Ratio analysis is not merely the calculation of a given
ratio. More important is the interpretation of the ratio
value.
 A meaningful basis for comparison is needed to
answer such questions as “Is it too high or too low?” and
“Is it good or bad?”
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 CAUTIONS ABOUT USING RATIO ANALYSIS

 Before discussing specific ratios, we should consider the

following cautions about their use:
1. Ratios that reveal large deviations from the norm merely
indicate the possibility of a problem. Additional analysis
is typically needed to determine whether there is a
problem and to isolate the causes of the problem.
2. A single ratio does not generally provide sufficient
information from which to judge the overall performance
of the firm. However, if an analysis is concerned only
with certain specific aspects of a firm’s financial position,
one or two ratios may suffice.

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 CAUTIONS ABOUT USING RATIO ANALYSIS…

3. The ratios being compared should be calculated using

financial statements dated at the same point in time
during the year. If they are not, the effects of seasonality
may produce erroneous conclusions and decisions.
4. It is preferable to use audited financial statements for
ratio analysis. If they have not been audited, the data in
them may not reflect the firm’s true financial condition.
5. The financial data being compared should have been
developed in the same way. The use of differing
accounting treatments—especially relative to inventory
and depreciation—can distort the results of ratio
comparisons, regardless of whether cross-sectional or
time-series analysis is used. 3-24
Types of Financial Ratios

1) Liquidity Ratio
2)Asset Management

3)Leverage Ratio

4)Profitability Ratio

5)Market Value Ratio

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 1) Liquidity Ratios (LR)
 Liquidity ratios measure the ability of a firm to
meet its immediate obligations and reflect the
short – term financial strength or solvency of a
firm.
 liquidity ratios measure a firm’s ability to pay its
current liabilities as they mature by using current
assets.
 There are two commonly used liquidity ratios: the
current ratio and the quick ratio.

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 Cont’d…
i) Current ratio(CR) – measures the ability of a
firm to satisfy or cover the claims of short-term
creditors by using only current assets. This ratio
relates current assets to current liabilities
Current ratio = Current assets
Current liabilities
 Relatively high current ratio is interpreted as an
indication that the firm is liquid and in good
position to meet its current obligations.

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 Cont’d…
 A reasonably higher current ratio as compared to
other firms in the same industry indicates higher
liquidity position.
 A very high current ratio, however, may
indicate excessive inventories and accounts
receivable, or a firm is not making full use of its
current borrowing capacity.

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 Cont’d…
ii) Quick ratio (Acid – test ratio) (QR): measures the
short-term liquidity by removing the least liquid current
.
assets such as inventories. Inventories are removed
because they are not readily or easily convertible into cash.
Quick ratio = Current assets – Inventory
Current liabilities
 Like the current ratio, the quick ratio reflects the firm’s
ability to pay its short-term obligations, and the higher the
quick ratio the more liquid the firm’s position.
 But the quick ratio is more detailed and penetrating
test of a firm’s liquidity position as it considers only the
quick asset. 3-29
 2. Asset Management Ratios
 Also known as Activity Ratios
 indicate how much a firm has invested in a
particular type of asset (or group of assets)
relative to the revenue the asset is producing.
 measure the degree of efficiency a firm
displays in using its assets.
 Generally, high turnover ratios are associated
with good asset management and low turnover
ratios with poor asset management.
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 Cont’d…
Activity ratios include:
i. Accounts Receivable turnover (ART)
ii. Inventory turnover (ITO)
iii. Fixed assets turnover (FAT)
iv. Total assets turnover(TAT)

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 Accounts Receivable turnover (ART)
 measures how efficiently a firm’s accounts
receivable is being managed.
 It indicates how many times or how rapidly
accounts receivable are converted into cash
during a year.
Accounts receivable turnover = Net sales
Accounts receivable

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Accounts Receivable turnover (ART) …
 A ratio substantially lower than the industry
average may suggest that a firm has more
liberal credit policy, more restrictive cash
discount offers, poor credit selection or
inadequate cash collection efforts.
 In computing the accounts receivable turnover

ratio, only credit sales should be used in the

numerator.

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ii) Inventory turnover (ITO)–

 measures how many times per year the

inventory level is sold (turned over).
Inventory turnover = Cost of good sold
Inventory

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 Iii) Fixed assets turnover (FAT)

– measures how efficiently a firm uses it fixed assets. It

shows how many birr’s of sales are generated from
one birr of fixed assets.
Fixed assets turnover = Net sales___
Net fixed assets
 A fixed assets turnover ratio substantially lower than
other similar firms indicates underutilization of fixed
assets, i.e., idle capacity, excessive investment in
fixed assets, or low sales levels.
 This suggests to the firm possibility of increasing
outputs without additional investment in fixed assets.
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 IV)Total assets turnover (TAT)

– indicates the amount of net sales generated from each

birr of total tangible assets. It is a measure of the firm’s
management efficiency in managing its assets.
Total assets turnover = Net Sales
Total assets
 A high total assets turnover is supposed to indicate
efficient asset management, and low turnover indicates
a firm is not generating a sufficient level of sales in
relation to its investment in assets.

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 3) Leverage Ratios

 Also known as Financial Leverage

Management Ratio(FLMR)
 Leverage ratios are also called debt management
or utilization ratios.
 They measure the extent to which a firm is
financed with debt, or the firm’s ability to generate
sufficient income to meet its debt obligations.

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 i) Debt to total assets (Debt) Ratio

– measures the percentage of total funds provided by

debt.
Debt ratio = Total liabilities
Total assets
 A high debt ratio implies that a firm has liberally

used debt sources to finance its assets.

 Conversely, a low ratio implies the firm has

funded its assets mainly with equity sources.

 Debt ratio reflects the capital structure of a firm.

 The higher the debt ratio, the more the firm’s

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financial risk.
 ii)Debt Equity Ratio(DER)
 The Debt-equity ratio indicates the relationship
between the total debts funds provided by
creditor and those provided by the owners of the
firm.
 This ratio reflects the relative claim of creditors
and shareholders against the assets of the
firm. It is computed as:
Debt- Equity Ratio=Total liability
Total equity

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 iii) Times – interest earned

 measures a firm’s ability to pay its interest

obligations.
Times interest earned = EBIT
Interest expense
 The times interest earned ratio implicitly assumes a
firm’s operating income (EBIT) is available to meet
its interest obligations.
 However, earnings before interest and taxes are an
income concept and not a direct measure of cash.
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 4) Profitability Ratios
 These ratios measure the earning power of a firm
with respect to given level of sales, total assets,
and owner’s equity.
 The following ratios are among the many measures
of a firm’s profitability.
I ) Profit Margin – shows the percentage of each birr
of net sales remaining after deducting all expenses.
Profit margin = Net income
Net Sales

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 ii) Return on investment (total assets)

– measures how profitably a firm has used its investment in

total assets.
Return on investment = Net income after tax
Total assets
 Generally, a high return on investment is sought by firms.

 This can be achieved by increasing sales levels,

increasing sales relative to costs, reducing costs

relative to sales, or efficiently utilizing assets.

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 iii) Return on equity

– indicates the rate of return earned by a firm’s

stockholders on investments made by themselves.
Return on equity = Net income after tax__
Stockholders’ equity
OR
Return on equity = Return on investment
1 – Debt ratio
• A high return on equity may indicate that a firm is more
risky due to higher debt balance. On the contrary, a low ratio
may indicate greater owner’s capital contribution as compared to
debt contribution.
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 5) Marketability Ratios

 Marketability ratios are used primarily for

investment decisions and long range planning.
They include:
I ) Earnings per share (EPS) – expresses the
profits earned on each share of a firm’s common
stock outstanding. It does not reflect how much is
paid as dividends.
Earnings per share = Net income – Preferred stock dividend
Number of common shares
outstanding
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 ii) Dividends Per Share (DPS)

– represents the amount of cash dividends a firm

paid on each share of its common stock
outstanding.
DPS = Total cash dividends on common shares
Number of common shares outstanding

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 COMPARING FINANCIAL RATIOS
 To address whether a given ratio is high or low, good or
bad, a meaningful basis is needed for comparison. Two
types of ratio comparisons can be made.
I ) Cross – sectional analysis – is the comparison of a
firm’s ratios to those other firms in the same industry at the
same point in time. Here, the firm is interested in how well
it has performed in relation to other firms. Generally, cross
– sectional analysis is preformed based on industry
averages of different financial ratios.
ii) Time – series analysis – is an evaluation of a firm’s
financial ratios over time. The purpose is to determine
whether the firm is progressing or deteriorating. 3-46
Questions or Comments

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