Session 3

Managing Financial Health and

Performance
 Learning Objectives
1. Functions of the Financial Statements
2. Review of Financial Statements
3. Market Values vs Book Values
4. Accounting versus Economic Measures of Income
5. Returns to Shareholders versus returns on book
equity
6. Financial Ratio Analysis
7. Financial Planning Process
 Three Economic Functions of the Financial
Statements
1. Provide information to the owners and creditors
of the firm about the company's current status
and the past financial performance
2. Provide a convenient way for owners and
creditors to set performance targets and to
impose restrictions on the managers of the firm
3. Provide convenient templates for financial
planning
 2. Review of Financial Statements
• Balance sheet
• Income Statement
• The Cash Flow statement
 Balance sheet
• The firms balance sheet shows its assets(what it owns) and liabilities (what it owes)
at a point in time (e.g as on December 31 st/or any date which is considered the end
of financial year for the firm)
• The Difference between Assets and liabilities is called the Net worth (or
Stockholder’s Equity)
• The values of assets , liabilities and net worth carried on a published balance sheet
are measured at historical cost in accordance with generally accepted accounting
principles (GAAP)
• In Pakistan companies that wish to list their shares in PSEX and other companies as
well need to make their accounts according to the accounting standards and follow
the procedures of the SECP
• Current Assets are assets that can converted into cash within one year. They consist
of Cash, marketable securities, Inventories, account receivables
• Paid up capital is the amount raised by issuing the stock and the retained earnings is
the cumulative amount of past earnings that have been retained in the business
 Income Statement
• The income statement summarizes the profitability of
the firm over a period of time, usually a financial year
• Income (profit/earning) is the difference between
revenues and expenses
• Expenses are broken down in four major categories
– Cost of Goods sold
– General Administrative and selling expense
– Interest Expense
– Corporate income Taxes
 Statement of Cash Flows
• The statement of cash flows shows all the cash that flowed into and out of
the firm during a period of time
• It differs from income statement, which shows the firm’s revenues and
expenses
• The statement of cash flows is important for two main reasons
– It focusses attention on what is happening to the firm’s cash position over time
(whether its is building up or losing cash and the reasons for it)
– Unlike revenues and expenses that are recorded based upon accrual accounting
methods cash flow statements avoids managements judgements about issues such
regarding valuation of inventory and depreciation of tangible assets
• Cash flows are organized in three sections:
1. Cash flows from operations
2. Cash flows from investment activities
3. Cash flows from financing activities
 2.4 Notes to Financial Statements
Some specific items commonly found in the notes
are:
• An explanation of accounting methods used
• Greater details regarding certain assets or
liabilities
• Information regarding the equity structure of the
firm
• Documentation of changes in operations
• Off-balance sheet items
 3. Market values versus Book values
• Book values are the accounting values or values
mentioned of assets and liabilities in the
balance sheet.
• A company’s book value per share is the value
of its shareholder’s equity divided by the
number of common shares outstanding
• The Market price is the price of share at people
are willing to buy it e.g price quoted at stock
exchange
 3. Market values versus Book values
Why is the market price of a company’s stock different
from its book value?
• The book value doe not include all of a firm’s assets
and liabilities (e.g good will, reputation-intangible
assets)
• Assets and liabilities are recorded at historical cost
(original acquisition cost, rather than the current
market values)-
• ( accounting professionals are now moving to th
practice of Marking to market
 Accounting versus Economic Measures of
Income
• The accounting definition of income or earnings
or profits ignore unrealized gains or losses in
the market values of assets and liabilities.
• Such as the increase or decrease in the value
of shares of stocks or the value of your
property over the period.
• Economic calculation of profit, however, take
into account the unrealized gains and losses.
 Example
• If the net Wages over the year =$100,000
• Decline in the overall value of assets=$60,000
• Accountants will ignore the decline in the value of
assets because they are unrealized
• Economist, however will take into account the decline
in market value in calculating income because it affects
the expected consumption possibilities which become
$60,000 less than at the beginning of the year.
• Thus Economic profit/income will be $40,000
• Secondly, accounting income allows as an income deduction
the interest expense for the cost of borrowing funds, but not
a comparable deduction for the equity funds employed.
• Example: if a company earned $2million but used $50 million
in shareholders equity to finance the firms assets at an
appropriate cost of 10% then from an economic perspective
the firm incurred a loss of $3 million (2m-$50m*0.10=$3m)
• In this case although accounting profit is positive but the
firm is not covering its basic costs, including its cost of
capital.
 Measuring EVA
• Economic Value Added (EVA) is a method of measuring the economic
performance of a firm.
• EVA is the amount of earnings a company has after accounting for the
required capital costs.
• The idea behind this measurement is that a company increases in value
only if the return on its capital is greater than the opportunity cost of the
capital investment.
• EVA is one of the methods that firms are using to diagnose the health of
their firms
• This measure is very lear and can easily be generated
• It is either positive or negative, and is clearly based on standard
measurements and not hidden assumptions. That is the opportunity
costs and return on investment
 Financial Ratio Analysis
• Financial Ratios can be divided into 5 subsets
1. Liquidity Ratios
2. Profitability Ratios
3. Asset Turnover Ratios
4. Financial Leverage Ratios
5. Market Value Ratios
 Liquidity Ratios
• Measure the ability of the firm to meet its
short term obligations, or to pay its bills and
remain solvent
• The main ratios for measuring liquidity are:
1. The Current Ratio (CA/CL)
2. Quick Ratio(Cash +Marketable securities/CL)
 Profitability Ratios
• Profitability can be measured with respect to sales
(ROS), assets (ROA), or its equity (ROE)
• For return on sales and return on assets income is taken
as EBIT but for return on ROE it is taken as Net Income.
• Whenever a financial ratio contains an item from the
income statement, which cover period of time, and
another from the balance sheet, which is snapshot at a
point of time, the practice is to take the average of the
beginning and end of year balance sheet figures , and
use the average as the denominator
 Profitability Ratios
• Gross profit Margin=Gross profit/Sales
• ROS(Operating profit Margin)=EBIT/Sales
• ROA=EBIT/Avg Total Assets
• ROE=Net Income/Avg Shareholders Equity
 Asset Turnover Ratios
• Assess the firm’s ability to use its assets
productively in generating revenue
• Asset turnover is a broad measure, whereas
receivable turnover and inventory turover are
specific measures for particular asset
categories
– Asset Turnover=Sales/Average Total Assets
– Receivable Turnover=Sales/Average Receivables
– Inventory Turnover=CGS/Average Inventory
 Financial Leverage Ratios
• Highlight the capital structure of the firm, and
the extent to which it is burdened with debt
• The debt ratio measures the capital structure
• Debt Ratio=Total Debt/Total Assets
• The times interest earned measure indicates
the ability of the firm to cover its inteerst
payments
• Times interest earned=EBIT/Interest expense
 Market Value Ratios
• Market value ratios measure the relationship
between the accounting representation of the firm
and the market value of the firm. The two most
common ratios are:
• P/E Ratio=Price per share/EPS
• Market to book=Price per share/Book value per
share
• A ratio similar to Market to book ratio is the Tobin’s
q ratio (q)=Market value of assets/ Replacement cost
 When analyzing a firm’s financial ratios,
two things need to be established first
1. Whose perspective to adopt-shareholders,
creditors, or some other group of
stakeholders
2. What standard of comparison to use as a
benchmark
 Benchmarks can be of 3 types:
1. Financial ratios of other companies for the
same time period
2. Financial ratios of the company itself in
previous time periods
3. Information extracted from financial markets
such as asset prices or interest rates
 Concept check
• What are the 5 types of financial ratios used to
analyze a company’s performance?
 Common Size Analysis
• Vertical Analysis
• Horizontal Analysis
 The Relations among Ratios
• It is useful to decompose a firm’s ROA into the product
of two ratios as follows:
ROA=EBIT/SALES * SALES /ASSETS
=RETURN ON SALES*ASSET RNOVER
=ROS *ATO

• The decomposition of ROA into ROS and ATO highlights

the fact that firms in different industries can have vastly
different ROS and turnover ratios yet the same return on
assets
• Example: A super market chain and a utility company
 The Effect of Financial Leverage
• Financial leverage simply means the use of borrowed
money
• the shareholder of the firm use financial leverage in order
to boost their ROE, but in doing so they increase the
sensitivity of ROE (NI/SE) to fluctuations in the firm’s
underlying operating profitability as measured by its
ROA(EBIT/A)-A use of financial leverage increases both its
financial as well as operational risk
• An increase in a firm’s financial leverage will increase its
ROE if and only if its ROA exceeds the interest rate on the
borrowed funds
 Limitations of Ratio Analysis
• The basic problem is there is no absolute standard by
which to judge whether the ratios are too high or too
low
• Ratios are comprised of accounting numbers, often
calculated in arbitrary ways
• It is difficult to define a set of comparable firms
because firms even in same industry are often quite
different
• Financial ratio analysis provides a rough guide and
should not be used in isolation for decision making
3.8:Constructing a Financial Planning Model

• Financial Plans are usually embodies in

quantitative models derived in whole or in part
from a firm’s financial statements
• A simplest approach is the percent of sales
method
• Where sale is forecasted for the next year and
assumption is made that most of the items on the
income statement and balance sheet will maintain
the same ratio to sales as in the previous year.
3.10:Working Capital Management
• The difference between Current Assets and Current
Liabilities is called Working Capital.
• In most business cash must be paid out to cover
expenses( raw material etc)before any cash is
collected from the sale .
• If a firm’s need for working capital is permanent
rather than seasonal, it usually seeks long-term
financing for it.
• Seasonal financing are met through short term
financing arrangements, such as loans from banks
 3.11: Liquidity and Cash Budgeting
• A firm that is profitable in the long run can experience serious
difficulties and even fail if it runs out of cash or credit in the short
run
• Liquidity means that one has the means to make immediate
payment for some purchase or to settle a debt that has come due.
• Illiquidity is a situation in which one has sufficient wealth to aford
the purchase or to settle the debt, but one does not have the
means to pay immediately.
• To avoid the difficulties caused by illiquidity, firms need to forecast
their cash outflows and inflows carefully.
• A plan that shows the forecasts is called a cash budget
 Concept check
• Why is liquidity important for a firm?
• Cash management is important because even
a profitable firm can get into financial distress
or even go bankrupt it becomes illiquid