FINALYS MODULE 1: FINANCIAL ANALYSIS Why are Financial Statements Important?

BASIC TERMS AND CONCEPTS

➢ Financial statements summarize and provide an
What are Financial Statements? overview of events relating to the functioning of
a firm.
➢ Financial statements are summaries of the ➢ Financial statement analysis helps identify:
operating(day-to-day), financing(loans), and o A firm’s strengths and;
investment (PPE) activities of a firm. o Weaknesses
➢ According to the Financial Accounting Standards (So that the management can take advantage of
Board (FASB), the financial statements of a firm a firm’s strengths and make plans to counter
should provide sufficient information that is useful weaknesses of the firm.
to: ➢ The strengths must be understood if they are
o Investors (provides equity and ownership) used to proper advantage and weaknesses must
and; be recognized if corrective action needs to be
o Creditors (provides debt/liability) taken.

in making their investment and credit decisions in Why is Financial Analysis Necessary?
an informed way.
(*some companies provide overstated financial Financial statement analysis provides answers to all of
statements to investors and creditors – proof of these questions:
profitability?) ➢ For example, are inventories adequate to
support the projected level of sales?
Additional Notes: ➢ Does the firm have too heavy an investment in
• The FS serves as a validation in revealing account receivable?
to us whether we have used the financial
➢ Does large account receivable reflect a tax
resources correctly in the past.
collection policy?
• Financial Analysis and Reporting also
serves as a key to corporate decision- ➢ To ensure efficient operations of a firm’s
making manufacturing facility, does the firm have too
• Financial Management career are fit to much or too little invested in plant and
any industry and company; and entails equipment?
acquiring key positions (e.g. CFA)
• Financial statements is not just about the What are the Different Financial Statements and
numbers; it is the story behind every Reports?
details/statements
• The Income Statement
What Rules and Standards govern the preparation of • The Balance Sheet
Financial Statements?
• The Statement of Retained Earnings
• The Statement of Cash Flows
➢ The financial statements are expected to be
prepared in accordance with a set of standards
A. The Income Statement
known as generally accepted accounting
• An income statement is a summary of the
principles (GAAP).
revenues and expenses of a business over a
period of time, usually either one month, three
(* PAFRS – Philippine Accounting Financial Reporting
months, or one year.
Standards; it follows the IFRS or the International Financial
• Summarizes the results of the firm’s operating and
Reporting Standards)
financing decisions during that time.
Additional Notes (Differences Between):
➢ The financial statements of publicly traded firms
• Sales (Merchandising) vs. Revenues
must be audited at least annually by (Service)
independent public accountants. (*Third party • COGS (Merchandising) vs. COS
auditing or cross-checking) (Service)
➢ The auditors are expected to attest to the fact • Admin Exp. (Internal) vs. General Exp.
that these financial statements of a firm have (Operating)
been prepared in accordance with GAAP. • Operating decisions of the company apply to the
production and marketing such as sales/revenues,
 cost of goods sold, administrative and general • Is the firm generating the cash needed to
expenses (advertising, office, salaries) purchase additional fixed assets for growth?
• Provides operating income/earning before • Is the growth so rapid that external financing is
interest and taxes (EBIT) required both to maintain operations and for
• Results of financing decisions are reflected in the investment in new fixed assets?
remainder of the income statement. • Does the firm have excess cash flows that can be
• When interest expenses and taxes are subtracted used to repay debt or to invest in new products?
from EBIT, the result is net income available to
shareholders. Ratio Analysis
• Net income does not necessarily equal actual
cash flow operations and financing. ➢ Financial statement report both on firm’s position
at a point in time and on its operations over
INCOME STATEMENT
some past period.
S Sales
(CGS) Cost of Goods Sold ➢ From management’s viewpoint, financial
GM Gross Margin/Profit? statement analysis is useful both as a way to:
(OE) Operational Expenses o Anticipate future conditions and;
EBIT Net Income from Operations o More important, as a starting point for
(IE) Interest Expense planning actions;
EBT Earnings Before Tax o That will influence the future course of
(IT) Income Tax
events or
NIAT Net Income After Tax
o To show whether a firm’s position has
been improving or deteriorating over
B. The Balance Sheet
time.
• A summary of the assets, liabilities and equity of
a business at a particular point in time, usually at ➢ Ratio analysis begins
the end of the firm’s fiscal year. o With the calculation of a set of financial
Ideal Ratio of: ratios
(40%) (60%) o Designed to show the relative strengths
Assets = Liabilities + Equity and;
o Weakness of a company as compared
(Resources of the business (Obligations of the business) (Ownership to
enterprise) left over
Residual) ▪ Other firms in the industry
Fixed Assets Long-term Common ▪ Leading firms in the industry
(Plant, Machinery, (Notes, bonds, & Capital stock ▪ The previous year of the same
Equipment & Buildings) Lease Obligation) outstanding; firm
Current Assets Current Liabilities Additional
➢ Ratio analysis helps to show whether the firm’s
(Cash, Marketable (Accounts Payable, paid-in
capital; position has been improving or deteriorating,
Securities, Account Wages and Salaries,
Receivable, Short-term loans, any Retained ➢ Ratio analysis can also help plan for the future.
Inventories) portion of long-term Earnings
indebtedness due in one Additional Notes:
(*Examples of year) (*Retained • Ratio analysis compares how much of your current
Marketable Securities – Earnings –
assets can pay your current liabilities.
stocks bought from (*Notes Payable – with are part of
the profit • The bigger the proportion of the gross margin,
other companies; Promissory note)
not the more profitable the company is, and the more
promissory notes;
treasury bills that are distributed they can pay their expenses.
convertible to cash) as • If the ratio analysis are positive, the more it is
dividends) easier to make decisions.
• Trend Analysis – Checks the pattern of your
ratio analysis
o Other firms in the industry –
(Comparative Analysis)
C. The Statement of Cash Flows o Comparison of the firm to other Leading
Firms – (Benchmarking)
The statement is designed to show how the firm’s o Comparison of the firm to the previous
operations have affected its cash position and to help year? – (Part of Trend Analysis)
answer questions such as these:
Types of Ratios o Interest on borrowing is a legal
➢ Liquidity Ratios liability of the firm
o Current Ratio – (derived by dividing your o Interest is to be paid out of
current assets to current liabilities) operating income
o Quick Ratio/Acid Test Ratio – (if sufficient, o Debt magnifies return and risk to
then liquid measured by: common stockholders
(Current Assets – Inventories) • Total Debt to Total Assets Ratio
Current Liabilities o Measures percentage of assets
(*Inventories are deducted because they are
being financed through
uncertain to sell?)
borrowings
o Too high a number means
➢ Asset Management Ratios (measures how efficient
and effective in managing assets)
increased risk of bankruptcy
o Inventory Turnover Ratio • Leverage
o Days Sales Outstanding o What percentage of total assets
o Fixed Assets Turnover Ratio are being financed through
o Total Assets Turnover Ratio equity (*Edited – “being financed
through liability)
Additional Notes:
➢ Debt Management Ratio
• Debt Management Ratio is all about
o Total Debt to Total Assets Ratio
liabilities and its relationship to other
o Times Interest Covered Ratio accounts.
• When you don’t have an operating income
➢ Profitability Ratios you can’t pay interest expense)
o Profit Margin on Sales • EBIT should always be positive
o Return on Assets
o Return on Equity D. Profitability Ratios
o Basic Earning Power Ratio • Net result of a number of policies and
decisions
A. Liquidity Ratio • Show the combined effect of liquidity,
• A liquid asset is one that can be easily asset management, and debt
converted into cash at a fair market management on operating results.
value. o Net Profit Margin on Sales
• Liquidity question deals with this ▪ Relates net income
question: available to common
o Will the firm be able to meet its stockholders to sales.
current obligations? o Basic Earning Power
• Two measures of liquidity ▪ Relates EBIT to Total
o Current Ratio Assets.
o Quick/Acid Test Ratio ▪ Useful for comparing
firms with different tax
B. Asset Management Ratios situations and different
• Asset management ratio measures how degrees of financial
effectively the firm is managing/using its leverage.
assets. o Return on Assets (ROA)
• Do we have too much investment in assets ▪ Relates net income
or too little investment in assets in view of available to common
current and projected sales levels? stockholder to total
• What happens if the firm has: assets.
o Too much investment in assets o Return on Common Equity (ROE)
o Too little investment in assets ▪ Relates net income
available to common
C. Debt Management Ratio stockholders to common
• Implications of use of borrowing stockholder’s equity.
o Creditors look to Stockholder’s o The higher the result, the more
equity as a safety margin profitable the business is.