Nature and Scope of Financial Management Nature and Scope of Financial

Management

Topic 4
Interpretation Of
Financial Statement

Mr samson
Understanding the Basic Financial Statements

Financial Statements
Financial Statements are statements prepared by the
business firms or organizations to show the operating
results, financial position, and movement of cash of
the organization within a particular period of time.

Basic Financial Statements include

the following:-
Income Statement (Statement of Profit/Loss)
Statement of Financial Position or Balance Sheet
Statement of Cash flows

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Continues…

Income Statement
The Income Statement is a summary of incomes
earned and expenses incurred during a period with the
bottom line being the profit or loss realized.
The Income Statement also known as Profit or Loss
Statement, summarizes all financial activities during a
specific period of time, usually a year. It records the
income that was earned and expenses incurred during
the period, showing the profit earned or loss
incurred (difference between income & expenses).

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Continues ………..
The bottom line of an income statement is the net
income (net profit or surplus) or net loss (or deficit)
for the period.

Statement of Financial Position (SOFP)

The statement of financial position shows the
financial condition / position of an organization on a
specific date in regards to what it owns and what it
owes. Therefore, the main elements in a statement of
financial position are its assets, liabilities, and equity.
Continues……
Cash flow Statement
Cash flow statement is the logical statement which
shows where the cash resources came from, and where
they have gone to during the reporting period.
Cash inflows and outflows consist of both cash and cash
equivalents’.
Cash
Cash comprises cash on hand and demand deposits.
Cash Equivalent
Cash equivalent are short term, highly liquid investment
that are readily convertible to known amounts of cash and
which are subject to insignificant risk of changes in value.
Continues…..
These cash equivalents consist of the temporary
investments of cash not required at present by the
business, such as funds put on short-term deposit with
a bank.
Such investments must be readily convertible into
cash, or available as cash within three months. In
short, cash equivalents are held for the purpose of
meeting short-term cash commitments and not for
investment purposes.
Components of Financial Statements
Components of Financial Statements
Components f financial statements include assets,
liabilities, owners equity income and expenses
Assets
A present economic resource controlled by the entity as a
result of past events. An economic resource is a right that
has the potential to produce economic benefits.
It involves Currents Assets such as cash in hand, cash
at bank, Debtors, prepaid expenses, stock
Also Non current assets or Fixed assets which
include buildings, plant and equipment, motor vehicle,
land, long term investment etc.
Continues …..
Liabilities
A present obligation of the entity to transfer an
economic resource as a result of past events.
Liabilities involve Current Liabilities such as Bank
overdraft, Creditors or Account Payables, Outstanding
expenses, short term loans.
Non current liabilities include loans etc.
Owners’ Equity
Equity is the residual interest in, or remaining claims
against, the firm’s assets after deducting liabilities
(rights of the owners).
Continues …..
Equity is everything the entity owes to the owners/shareholders
including the initial capital contributed by the owners and the
profit generated by the business.

Income
Increases in assets or decreases in liabilities that result in
increases in equity, other than those relating to contributions from
holders of equity claims.
Expenses
Decreases in assets or increases in liabilities that result in
decreases in equity, other than those relating to distributions to
holders of equity claims.
Why Study Financial Statements
1. Assess current performance through financial
statement analysis
2. Monitor and control operations, and
 Both insiders (such as managers, board of
directors) and outsiders (such as suppliers,
creditors, investors) use the statements to monitor
and control the firm’s operations.
3. Forecast future performance.
 Financial planning models are typically built using
the financial statements
Continues …..
 Why Study Financial Statements
1. Assess current performance through financial
statement analysis
2. Monitor and control operations, and
 Both insiders (such as managers, board of
directors) and outsiders (such as suppliers,
creditors, investors) use the statements to monitor
and control the firm’s operations.
3. Forecast future performance.
 Financial planning models are typically built using
the financial statements
Sample for income statements.
From the following information you required to
prepare income statements
Sales………..500,000
Opening stock ……100,000
Purchases……200,000
Closing stock…..50,000
rent,……20,000
Insurance….50,000
Motor vehicle depreciation ….10,000
Continues….
Equation for balance sheet or statement of financial
position
Assets =liabilities + owners equity or
Owners equity= assets- liabilities
From the following information prepare statements of
financial position
Cash…..4525
Accounts receivable …..2040
Land……9755
Equipments ………6,500
Accounts payable…..9,800
Wages payable…..3765
Hamilton capita….9255
Users of financial statements information
Financial analysis can be undertaken by:
Trade Creditors
Trade creditors are interested in the firm’s ability to
meet their claims over a very short period of time. Their
analysis will therefore be confined to the evaluation of
the firm’s liquidity position.

Suppliers of Long Term Debts

Are concerned with the firm’s long term solvency and
survival. They analyze the firm’s profitability over time;
the firm’s ability to generate cash to be able to pay
interest and repay principal and the relationship between
various sources of funds (capital structure relationship).
Continues……..
Investors.
Investors are most concerned about the firm earnings.
They concentrate on the past and future profitability
and also on the firm’s capital structure.

Management
Management are interested in every aspect of
financial analysis. It is their overall responsibility to
see that the resources of the firm are used in more
effective and efficient manner, and that the firm’s
financial condition is sound.
Tools for financial analysis
There are several techniques for financial statements
analysis, they include the following:-
Ratio analysis
Vertical analysis
Horizontal analysis
Industry comparison
Trend analysis
In this course we will concentrate much on ratio
analysis
Ratio analysis
Ratio analysis is a powerful tool for financial analysis. A
ratio is defined as “the indicated quotient of two
mathematical expressions” or as “the relationship between
two or more things”.
In financial analysis, a financial ratio is a relationship
between two accounting numbers. Ratios help to make a
qualitative judgment about the firm’s financial performance.
Generally ratios facilitate comparison of:
 One company over time (Time Series Analysis)
 One company versus other companies (Inter- firms
Analysis
 One company versus industry averages(Industry
Analysis)
Types of Ratios and their Interpretations
Several ratios, calculated from accounting data, may be
grouped into various classes, according to the financial
activity or function to be evaluated. In the view of the
requirements by the various users of ratio, they may be
classified in the following categories
Liquidity ratios
Profitability Ratios
Current ratio
Working Capital Efficiency Ratios
Leverage/ gearing ratio
Market share valuation ratio
Working capital cycle (cash operating cycle) etc.
Types of ratio analysis continue…..
1. Liquidity ratio
Liquidity ratios measure a firm’s ability to meet its
current obligations. It shows how solvent is a
business. It involves current ratio and Quick ratio
2. Current Ratio
Current ratio helps decide whether the current assets
will be able to generate sufficient cash to pay off the
current liabilities as and when they fall due. Looks at
the ratio between Current Assets and Current
Liabilities
Current ratio =Total current assets/ total current
liabilities.
Continues
Ideal level – 2 : 1
A ratio of 5 : 1 would imply the firm has Tsh.5 of
assets to cover every Tsh.1 in liabilities.
A ratio of 0.75 : 1 would suggest the firm has only 75
cents in assets available to cover every Tsh. 1 it owes.
Too high – Might suggest that too much of its assets
are tied up in unproductive activities – too much
stock, for example.
Too low - risk of not being able to pay your debts
Continues….
3. Quick Ratio
Also referred to as the ‘Acid test ratio’
Acid test ratio = Quick Assets / Current liabilities
 Quick Assets = (Current assets – stock)
1.5:1 seen as ideal
The omission of stock gives an indication of the cash
the firm has in relation to its liabilities (what it owes)
A ratio of 3:1 therefore would suggest the firm has 3
times as much cash as it owes – very healthy!
A ratio of 0.5:1 would suggest the firm has twice as
many liabilities as it has cash to pay for those
liabilities. This might put the firm under pressure but is
not in itself the end of the world!
Continues….
4. Profitability ratio.
Profitability measures look at how much profit the
firm generates from sales or from its capital assets.
These ratios analyze the profitability of the company.
Ratios in this category include the following:-
(a) Gross Profit Margin

(b) Operating Profit Margin

(c) Net Profit Margin

(d) Return on Capital Employed (ROCE)

(e) Return on Assets (ROA)

5. Working Capital Efficiency Ratios
This set of ratios help us analyze how efficiently the
assets of a company are being used in generating
revenue. These ratios include the following:-
Asset Turnover
Inventory Turnover
Receivable Days
Payable Days
Working Capital Cycle
6. leverage/ gearing ratio
Capital Gearing Ratio
This ratio is important measure of the company’s risk
and stability because it expresses the relationship
between a company’s borrowings and its own funds.
It is calculated as:
 = (Total long term debts/ Shareholders’ fund) x 100
Total long term debts includes all items that have to
be classified as debts according to the requirement of
IAS 32 and IFRS 9. Debts include long term
borrowings, debentures, and redeemable preference
shares.
 7. Market share Valuation Ratios
Valuation ratios generally rely on a company’s current
share price and reveal whether the stock is an
attractive investment option at the time. You can also
call these ratios are market ratios as they examine a
company’s attractiveness in the stock market.

Some of market share valuation ratios include.

• Price of earning ratio
• Price/cash flow ratio
• Peg ratio
• Price to sales ratio.
8. Working capital cycle
Working Capital Cycle
The working capital cycle is the approximately
number of days it takes to purchase the inventory, sell
the inventory, and receive cash.
Cash, inventories, receivables, and payables
comprise the working capital cycle.
Inventory is purchased by cash or on credit. Credit
purchase give raise to payables. Inventories are sold
for cash or on credit. Credit sales give rise to
receivables. When receivables pay, a company gets
cash to pay its payables and so the cycle continues.
Working capital cycle Continues…
Working Capital Cycle
The working capital cycle can be converted
into number of days by using the receivable
days and payables day’s ratios as follows:
Working Capital cycle =
Inventory turnover days + Receivable days –
Payable days
limitations of ratios.
Ratio analysis is a widely used technique to evaluate
the financial position and performance of the firm.
But there are certain problems in using ratios.
(i) Ratios are based only on the information which has
been recorded in the financial statements.
(ii) Financial statements themselves are subject to
several limitations. For example, non-financial
changes though important for the business are not
relevant by the financial statements.
(iii) Personal judgment plays a great part in determining
the figures for financial statements.
Factors which distort ratios, leading to
unreliable conclusions
(i) standards of Comparisons
No fixed standard can be laid down for ideal ratios.
There are no well accepted standards or rule of thumb
for all ratios which can be accepted as norm. It
renders interpretation of the ratios difficult.
(ii) Price Level
A change in a price level can affect the validity of
ratios calculated for different time periods. In such a
case the ratio analysis may not clearly indicate the
trend in solvency and profitability of the company.
Factors which distort ratios, leading to
unreliable conclusions continues…..
(iii) Changing Situations
Ratios are useful in judging the efficiency of the
business only when they are compared with past
results of the business.
However, such a comparison only provide glimpse of
the past performance and forecasts for future may not
prove correct since several other factors like market
conditions, management policies, etc. may affect the
future operations
Factors which distort ratios, leading to
unreliable conclusions continues…..
(iv) Company Differences
Not only industries differ in their nature, but also the
firms of the similar business widely differ in their size
and accounting procedures etc.
It makes comparison of ratios difficult and
misleading.

(v) Ratios alone are not Adequate

Ratios are not only indicators, they cannot be taken
as final regarding good or bad financial position of
the business. Other things have also to be seen.
Factors which distort ratios, leading to
unreliable conclusions continues…..
(vi)Limited use of Single Ratios
A single ratio, usually, does not convey much of a
sense. To make a better interpretation, a number of
ratios have to be calculated which is likely to confuse
the analyst than help him in making any good
decision.
Quality of assets is not reflected in the ratios.
Corporate evaluation using Financial Ratios
Illustration
Mambo Ltd is a diversified enterprise with its
main
interests in the manufacture and retail of
plastic products.
An investor is considering purchasing shares in
need to be analysed.
the company. The Relevant ratiosstatements
financial need to be
selected
of and Ltd
Mambo calculated and a report needs to be
written for the investor. The report should
evaluate the company’s performance and position.
In your report, you should state the possible reasons for
and significance of any changes in the ratios shown by your
calculations.
The following are its financial statements for the year
2006.
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 Mambo Ltd
Statement of Financial Position as at 31 March
2005 2006
Tsh.000 Tsh.000 Tsh.000 Tsh.000
Current Assets
Bank 33.5 41.0
Accounts receivable 240.8 210.2
Inventory 300.0 370.8
Total current Assets 574.3 622.0
Non-current assets
Fixtures & fittings (net) 64.6 63.2
Land & buildings (net) 381.2 376.2
445.8 439.4
Total assets 1,020.1 1,061.4

Current Liabilities
Accounts payable 261.6 288.8
Income tax 60.2 76.0
Total Current Liabilities 321.8 364.8
Non-current liabilities
Loan 200.0 60.0

Shareholders Funds
Paid-up ordinary capital 300.0 334.1
Retained profit 198.3 302.5
498.3 636.6
Total liabilities & equity 1,020.1 1,061.4
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 Mambo Ltd
Statement of Financial Performance for year ended 31 March

2005 2006
Tsh.000 Tsh.000 Tsh.000 Tsh.000
Sales 2,240.8 2,681.2
Less Cost of goods sold 1,745.4 2,072.0
Gross profit 495.4 609.2
Wages & salaries 185.8 275.6
Rates 12.2 12.4
Heat & light 8.4 13.6
Insurance 4.6 7.0
Interest expense 24.0 6.2
Postage & telephone 9.0 16.4
Depreciation -
Buildings 5.0 5.0
Fixtures & fittings 27.0 276.0 32.8 369.0

Net profit before tax 219.4 240.2

Less Income tax 60.2 76.0
Net profit after tax 159.2 164.2

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 Mambo Ltd
Statement of Cash Flows for the year ended 31 March
2005 2006
Tsh.000 Tsh.000 Tsh.000 Tsh.000
Cash flow from operations
Receipts from customers 2,281 2,711.8
Payments to suppliers & employees (2,050) (2,460.4)
Interest paid (24) (6.2)
Tax paid (46.4) (60.2)
Net cash flow from operating activities 160.6 185
Investing activities
Purchase of non-current assets (121.2) (31.4)
Net cash used in investing activities (121.2) (31.4)
Financing activities
Dividends paid (32.0) (40.2)
Issue of ordinary shares 20.0 34.1
Repayment of loan capital -__ (140.0)
Net cash outflow from financing activities (12) (146.1)
Increase in cash & cash equivalents 27.4 7.5

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Additional information:
Credit purchases for the year 2006 were Tsh.2,142,800.
General prospects for the major industries in which Mambo
Ltd. is involved look good with a forecast glut of oil set to
reduce the cost of production and world demand for
plastic remaining strong.
Benchmarks:
There are no exact benchmarks for Mambo Ltd because it
is a diversified company. The following are average
indicators that relate to the plastic retailing and
manufacturing industries for the year 2006.
 Gross profit margin 25%
 Net profit margin 7%
 Inventory turnover 6 times
 Capital gearing ratio 60%
 Return on Assets 12%
 Return on Capital Employed 20%
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 Thank you
God bless you all