FINANCIAL

REPORTING &
ANALYSIS
PRIMER
FINANCIAL REPORTING ANALYSIS
Financial Reporting is the way companies show their financial performance to the
stakeholders. Financial Statements reflect the performance of a company during a period
for which the statements are prepared. There are 3 types of Financial Statements:
• Balance sheet
• Income Statement
• Cash Flow Statement

The balance sheet reports the firm’s financial position at a particular point in time. The
balance sheet consists of three elements:
• Assets: These are the resources that are controlled by the firm
• Liabilities: These are the obligations of the firm. The amounts that the firm owes
to lenders and other creditors.
• Owners’ equity: This is the residual interest in the net assets after deducting its
liabilities from its assets. It is also known as shareholder’s equity / shareholders’
funds.

Fundamental accounting equation:

Assets = Liabilities + Shareholders’ equity

The proportions of liabilities and equity used to finance a company are known as the
Company’s capital structure.

The income statement or the profit and loss statement reports the financial
performance of the firm over a period of time. The income statement includes:
• revenues,
• expenses,
• gains and losses.
Revenues are inflows generated from producing goods, rendering services, or other
activities that form the entity’s major operations.
Expenses are outflows generated due to producing goods or services that form the
entity’s major operations.

The Cash Flow Statement reports the company’s cash receipts and payments. These
cash flows are classified as follows:
• Operating cash flows include the cash effects of normal business transactions
• Investing cash flows result from the acquisition or sale of property, plant, and
equipment; securities; or investments.
• Financing cash flows result from issuance or repayment of the firm’s debt and
equity shares and dividend paid to shareholders.

Two Fundamental Characteristics of financial statements are:

• relevance
• fair representation
Relevance: Financial statements are relevant if the information can be used to take
decisions – evaluate the past or forecast the future. Also, financial statements should be
material to relevant.
Fair representation: Fair Financial Statements are complete, unbiased and free of any
error.
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The following four characteristics make the financial statements relevant and fair:
• Comparability
• Verifiability
• Timeliness
• Understandability

Some other Assumptions of Financial Statements:

• Fair Representation
• Going concern Basis
• Accrual basis of accounting
• Consistency between Periods
• Materiality

UNDERSTANDING THE BALANCE SHEET

The balance sheet reports the firm’s financial position at a point in time. It consists of
assets, liabilities, and shareholders’ equity.
Items recognised in a balance sheet have a probable future economic benefit and the
value or cost of it can be measured reliably.

Structure of a Balance sheet

• Current assets include cash and other assets that are likely to be used up in one
year or in one operating cycle. The operating cycle is the time it takes to produce
or purchase inventory, sell the product, and collect the cash.
Current Assets consist of:
➢ Cash and Cash Equivalents
➢ Marketable Securities
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 ➢ Accounts Receivables
➢ Inventories
➢ Other Current Assets

• Current liabilities are obligations to be paid off within one year or one operating
cycle. Current assets minus current liabilities equals working capital. Not having
enough working capital may indicate liquidity problems. However, having too much
working capital also indicates inefficient use of funds.
Current Liabilities consist of:
➢ Accounts Payable
➢ Notes Payable
➢ Current Portion of Long-Term Debt
➢ Accrued Liabilities
➢ Unearned Revenue

• Noncurrent assets are assets that will not be used in one year or in one operating
cycle. Noncurrent assets provide information about the firm’s investing activities.
Non-Current Assets include:
➢ Property, plant and equipment
➢ Investments
➢ Deferred Tax Assets
➢ Intangible Assets (e.g. Goodwill)

• Noncurrent liabilities are liabilities that do not meet the criteria of current
liabilities. Noncurrent liabilities provide information about the firm’s long-term
financing activities.
Non-Current Liabilities include:
➢ Long Term Debt
➢ Deferred Tax Liability

• Owners’ equity is the residual interest in the net assets after deducting its
liabilities from its assets. It is also known as shareholder’s equity / shareholders’
funds. Owners’ equity includes contributed capital, preferred stock, retained
earnings, non-controlling interest, and accumulated other comprehensive
income.

UNDERSTANDING THE INCOME STATEMENT

The income statement reports the revenues and expenses of the firm over a period of
time. It is also known as the profit and loss statement.

The income statement equation is:

Revenues − Expenses = net income
• Revenues are the amounts generated from the sale of goods and services in the
normal course of business.

• Expenses are the amounts incurred to generate revenue and include cost of
goods sold, operating expenses, interest, and taxes. Expenses are grouped
together by their nature or function.

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Gross profit is the amount that remains after subtracting the direct costs of producing a
product or service from revenue. Subtracting operating expenses, such as selling,
general, and administrative expenses, from gross profit results in operating profit or
operating income.

Revenue Recognition
Revenue is recognised when the performance obligations are satisfied.
The converged standards identify a five-step process for recognizing revenue:
1. Identify the contract with a customer.
2. Identify the separate or distinct performance obligations in the contract
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
Expense Recognition
Under the accrual method of accounting, expense recognition is based on the matching
principle whereby expenses to generate revenue are recognized in the same period as
the revenue. For example, if inventory is purchased during the fourth quarter of one year
and sold during the first quarter of the following year, the revenue and the expense (cost
of goods sold) are recognized in the first quarter, when the inventory is sold, not the period
in which the inventory was purchased.

Inventory Expense Recognition

Method Assumption COGS consists End Inventory
of consists of
FIFO First purchased First purchased Most recent
items are sold first purchases
LIFO Last purchased Last purchased Earliest purchases
items are sold first
Weighted Average Items sold are mix Average Cost of all Average Cost of all
of purchases items items

UNDERSTANDING CASH FLOW STATEMENT

The cash flow statement provides information on cash basis and beyond what is
available from the income statement, which is based on accrual accounting.

The cash flow statement provides the following:

• Information about a company’s cash receipts and cash payments
• Information about a company’s operating, investing, and financing activities.
• Information to assess the firm’s liquidity, solvency, and financial flexibility.

Cash flows to determine whether:

• Regular operations generate enough cash to sustain the business.
• Enough cash is generated to pay off existing debts as they mature.
• The firm is likely to need additional financing.
• Unexpected obligations can be met.
• The firm can take advantage of new business opportunities as they arise.
Types of Cash Flows:

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Operating Cash Flow
• Positive operating cash flow can be generated by the firm’s earnings-related
activities.
• However, positive operating cash flow can also be generated by decreasing
noncash working capital. But decreasing noncash working capital is not
sustainable.
• Operating Cash Flows also indicate the quality of earnings of a firm.

Investing Cash Flow

Increasing capital expenditures usually indicates growth. Generating operating cash
flow that exceeds capital expenditures is a desirable trait.

Financing Cash Flow

• The financing cash flows reveals information about whether the firm is generating
cash flow by issuing debt or equity.
• It also provides information whether firm is using cash to repay debt, reacquire
stock, or pay dividends.

RATIOS
Financial ratios can be classified as:
1. Activity ratios: This category includes asset utilization or turnover ratios. They
often give indications of how well a firm utilizes various assets
2. Liquidity ratios: It refers to the ability to pay short-term obligations as they come
due.
3. Solvency ratios: These provide information on the firm’s financial leverage and
ability to meet its longer-term obligations.
4. Profitability ratios: Profitability ratios provide information on how well the
company generates operating profits and net profits from its sales.
5. Valuation ratios: Ratios used in relative valuation of a company

ACTIVITY RATIOS
Activity ratios measure how efficiently the firm is managing its assets.

• Receivables Turnover Ratio

It is considered desirable to have a receivables turnover figure close to the industry

norm.

• Days of Sales Outstanding

These are the average number of days it takes for the company’s customers to pay their
bills:

It is considered desirable to have a collection period close to the industry norm.

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A collection period that is too high might mean that customers are too slow in paying their
bills, which also indicates that too much capital is tied up in assets. On the contrary, a
collection period that is too low might indicate that the firm’s credit policy is too rigorous,
which might also result in hampered sales.

• Inventory Turnover Ratio

It is a measure of a firm’s efficiency with respect to its processing and inventory
management

• Days of Inventory on Hand

As is the case with accounts receivable, it is considered desirable to have days of

inventory on hand close to the industry norm. A high processing period means that too
much capital is tied up in inventory and could also result in obsolete inventory. A low
processing period indicates that the firm has inadequate stock on hand, which could
impact sales.

• Payables Turnover Ratio

A measure of the use of trade credit by the firm

• Days of Payables

• Total Assets Turnover Ratio

This ratio tells us the effectiveness of firm’s use of its total assets to create revenue

The ratio varies as per industries. It is desirable to have the total asset turnover ratio close
to the industry norm. Low asset turnover ratios might mean that the company has too
much capital tied up in its asset base. A turnover ratio that is too high might imply that the
firm has too few assets for potential sales, or that the asset base is outdated.

• Fixed Asset Turnover

This ratio is specific to the utilization of fixed assets

It is desirable to have a fixed asset turnover ratio close to the industry norm.
Low fixed asset turnover might mean that the company has too much capital tied up in its
asset base or is using the assets inefficiently. A turnover ratio that is too high might imply
that the firm has obsolete equipment.

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 • Working Capital Turnover Ratio
This ratio helps us understand how effectively a company is using its working capital

Working capital is current assets minus current liabilities. This ratio gives us information
about the utilization of working capital in terms revenue value.

LIQUIDITY RATIOS
Liquidity ratios help determine the firm’s ability to pay its short-term liabilities.

• Current Ratio

The higher the current ratio, the more likely is the company will be able to pay its short-
term bills. A current ratio of less than one means that the company has negative working
capital and is probably facing a liquidity crisis.

• Quick Ratio
This is a more stringent measure of liquidity

The higher the quick ratio, the more likely it is that the company will be able to pay its
short-term bills.

• Cash ratio
This is the most conservative liquidity measure

The higher the cash ratio, the more likely it is that the company will be able to pay its
short-term bills.

• Cash Conversion Cycle

The cash conversion cycle is the length of time it takes to turn the firm’s cash investment
in inventory to turn back into cash. The cash conversion cycle is computed from days
sales outstanding, days of inventory on hand, and number of days of payables:

High cash conversion cycles are considered undesirable. A conversion cycle that is too
high implies that the company has an excessive amount of capital investment blocked in
the sales process.

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SOLVENCY RATIOS
Solvency ratios measure a firm’s financial leverage and ability to meet its long-term
obligations. Solvency ratios include various debt ratios that are based on the balance
sheet and coverage ratios that are based on the income statement.

• Debt to Equity Ratio

A measure of the firm’s use of fixed-cost financing sources

Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a
source of financing.

• Debt to Capital Ratio

Capital equals all short-term and long-term debt plus preferred stock and equity.
Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a
source of financing.

• Debt to Asset Ratio

Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a
source of financing.

• Leverage Ratio

Greater use of debt financing increases financial leverage and, typically, risk to equity
holders and bondholders as well.

• Interest Coverage Ratio

This ratio helps determine the firm’s ability to repay its debt obligations.

The lower this ratio, the more likely it is that the firm will have difficulty meeting its debt
payments.

• Debt to EBITDA Ratio

Another ratio that reflects a firm’s ability to meet its debt obligations is the debt-to-EBITDA
ratio:

• Fixed Charge Ratio

This ratio determines the company’s ability to meet its obligations

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Fixed charge coverage is more meaningful measure for companies that lease a large
portion of their assets, e.g. airlines

PROFITABILITY RATIOS
Profitability ratios measure the overall performance of the firm relative to revenues,
assets, equity, and capital.

• Net Profit Margin

It is a matter of concern if this ratio is too low.

• Gross Profit Margin

The gross profit margin is the ratio of gross profit (sales less cost of goods sold) to
sales

It is a matter of concern if this ratio is too low.

• Operating Profit Margin

• Pretax Margin Ratio

The pretax margin is calculated as:

• Return on Assets Ratio

Return on assets (ROA) is an indicator of how profitable a company is relative to its total
assets. ROA is best used when comparing similar companies or by comparing a company
to its own previous performance.

• Operating Return on Assets

• Return on Total Capital

Total capital includes short- and long-term debt, preferred equity, and common equity. It
is a matter of concern if this ratio is too low.

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 • Return on Equity
The return on equity is the ratio of net income to average total equity

Return on equity (ROE) measures a corporation's profitability in relation to stockholders’

equity. Whether an ROE is considered satisfactory will depend on what is normal for the
industry or company peers. A good rule of thumb is to target an ROE that is equal to or
just above the average for the peer group.

A similar ratio to the return on equity is the return on common equity

DUPONT ANALYSIS
The return on common equity is often more thoroughly analysed using the DuPont
Decomposition.
The DuPont analysis is an approach that can be used to analyse return on equity (ROE).
It breaks down ROE into a function of different ratios.
There are two variants of the DuPont system: The original three-part approach and the
extended five-part system.

For the original approach, start with ROE defined as:

We can expand this further:

The first term is still the profit margin, the second term is now asset turnover, and the third
term is a financial leverage ratio

This is the original DuPont equation. It is arguably the most important equation in ratio
analysis, since it breaks down a very important ratio (ROE) into three key components.

The extended (5-way) DuPont equation takes the net profit margin and breaks it down
further.

Note that the first term in the 5-part DuPont equation, net profit margin, has been
decomposed into three terms:

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An investor can use analysis like this to compare the operational efficiency of two similar
firms. Managers can use DuPont analysis to identify strengths or weaknesses that should
be addressed.
This allows an investor to determine what financial activities are contributing the most to
the changes in ROE.

Net Profit Margin

The net profit margin is the ratio of bottom line profits compared to total revenue or total
sales. The profit margin can be improved if costs for the owner were reduced or if prices
were raised, which can have a large impact on ROE.

Asset Turnover Ratio

The asset turnover ratio measures how efficiently a company uses its assets to generate
revenue. The ratio can be helpful when comparing two companies that are very similar.
Because average assets include components like inventory, changes in this ratio can
signal that sales are slowing down or speeding up earlier than it would show up in other
financial measures. If a company's asset turnover rises, its ROE will improve.

Financial Leverage
Financial leverage, or the equity multiplier, is an indirect analysis of a company's use of
debt to finance its assets. If the company borrows more to purchase assets, the ratio will
continue to rise. However, using too much debt in order to increase the financial leverage
ratio—and therefore increase ROE—can create disproportionate risks.

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