Unit 2 (a)

REVIEWING FINANCIAL
STATEMENTS

- Chapter 2
Introduction

• Annual report provides 4 basic financial

statements :
• Statement of Financial Position (Balance Sheet)
• Statement of Comprehensive Income (Income
Statement)
• Statement of Cash Flows
• Statement of Changes in Equities (Statement of
Retained Earnings)
• Financial statements give an accounting-
based picture of financial position of a firm.
Introduction (cont.)

• Accountants use financial statements

to show the picture of past financial
performance of a firm.
• Finance professionals use financial
statements to draw future inferences
about the firm.
Statement of Financial Position (Balance Sheet)

• Reports firm’s assets, liabilities and capital at a point in time.

Assets = Liabilities (Debts)+ Capital (Equity)

• Assets : shown in order of liquidity, divided into current assets

and non-current assets (fixed assets).

• Liabilities : shown in order of maturity, divided into current

liabilities and non-current liabilities (long-term debts or long-term
liabilities).

• Equity never matures, it also calls residual interests, divided into

ordinary shares capital (common stock), preference shares
capital (preferred stock) and reserves e.g. retained profits or
retained earnings, general reserve, revaluation reserve etc.
Table 2.1 Balance Sheet for DPH

Assets = Liabilities + Equity

Assets

• Current Assets
• Normally convert into cash within a year.
• Cash (and marketable securities)
• Accounts Receivable
• Inventory
Assets
• Non-current Assets (Fixed Assets)
• Useful life exceeding one year.
• Physical (tangible) assets (e.g. plant and
equipment, machinery, computers etc.)
• Non-physical (intangible) assets (e.g.
software, patents, trademarks, intellectual
properties etc.)
• Other immovable long-term assets (e.g.
fixtures and fittings etc.)
Liabilities

• Liabilities are loans to the firm

• Current Liabilities
• Obligations due within a year.
• Accruals (accrued wages and accrued taxes)
• Accounts Payable
• Notes Payable

• Non-current Liabilities (Long-term Debt or Long-

term Liabilities)
• Long-term loans and bonds have maturities greater
than one year.
Equity

• Firm’s Total Assets minus Total Liabilities.

• Types of Equity :
• Ordinary Shares (Common Stock)
• Fundamental ownership claim in public or private
company.
• Preference Shares (Preferred Stock)
• Hybrid security – characteristics of both long-term debt
and common stock.
• Retained Profits or Retained Earnings
• Cumulative earnings – reinvestments – dividend payments
Managing the Statement of Financial Position (Balance Sheet)

• Level of net working capital.

• Firm’s liquidity position.
• Method for financing firm’s assets.
• Debt Financing vs. Equity Financing.

• Difference between firm’s book value

and true market value.
Net Working Capital
Net Working Capital (Working Capital)
= Current assets - Current liabilities

• Net working capital : a measure of

firm’s ability to pay obligations.
• Healthy firms have positive net
working capital.
Liquidity

• Ability to convert assets into cash at

Fair Market Value (FMV).
• Current Assets -- most liquid
• Cash, marketable securities, accounts
receivable, and inventory.
• Inventory is the least liquid of current assets.

• Fixed Assets -- less liquid

Liquidity (cont.)

• Liquidity is a double-edged sword.

• Risk-Return trade-off.
• More liquidity means lower risk.
• firm can more easily pay obligations.

• But, liquid assets offer low returns. (e.g. cash

offers zero return)
• Fixed assets are illiquid but they help generate
revenue and profits.
Debt vs. Equity Financing (Capital Structure)
• Financial Leverage means using debt
financing to partially finance business
operations => Total Assets / Equity (i.e.
Equity Multiplier)
• Magnifies gains and losses.
• Debt holders -- fixed claim on firm’s cash flows (interest
paid on securities).
• Stockholders -- claim on remaining cash flow.

• Choice of firm’s capital structure represents

management’s preference on risk and return.
Book Value vs. Market Value
• Book Value (historical cost)
• Assets listed on balance sheet at purchase
price.
• Market Value
• Assets listed at value if sold in today’s market.
Statement of Comprehensive Income
(Income Statement)
• A record of a firm’s total earned
revenues and total incurred expenses
over a period of time.
• Income statement top line = revenues
• Expenses listed below revenues
• Bottom line = Revenues – Expenses = Net
Profits or Net Income
Basic Income Statement
Example : DPH Tree Farm Income Statement
Income/Firm Value Summary Below the Bottom Line
Income/Firm Value Summary Below the Bottom Line (cont.)
i.e. Total Assets – Total Liabilities – Preferred Stock
Statement of Cash Flows
• Financial statement that shows firm’s cash
flows over given period of time.
• includes only inflows and outflows of cash and
marketable securities.
• excludes transactions with no direct effect on cash
receipts and payments.
• Statement of Cash Flows - bottom line
• Reflects difference between cash sources and uses.
• Equals the change in cash on the firm’s balance
sheet.
Sources and Uses of Cash

Cash Received Cash Paid

Cash Outflow from

Cash Inflow from Operations
Operations

Cash
Cash Outflows
Inflows
Sources and Uses of Cash
• Statement of Cash Flows reflects :
• Operating Activities
• Investing Activities
• Financing Activities
• Net Change in Cash and Cash Equivalents
(e.g.Marketable Securities etc.)
Cash Flows from Operating Activities
• Represents items directly associated
with producing and selling the firm’s
products.
Cash Flows from Investing Activities
• Represents cash flows associated with
buying or selling fixed or other long-
term assets.
• Reflects the firm’s investment in fixed
assets.
Cash Flows from Financing Activities
• Cash flows from debt and equity
financing transactions. Examples :
• Issuing short- or long-term debt
• Issuing stock
• Using cash to pay dividends
• Using cash to pay off debt
• Using cash to buy back stock
Net Change in Cash and Cash Equivalents (e.g.
short-term deposits, marketable securities etc.)

• Statement of Cash Flows bottom line :

• Total of cash flows from operating, investing,
and financing activities.
• Reconciles to the net change in cash and cash
equivalents (e.g. marketable securities) on the
statement of financial position (balance sheet)
over the period.
Example : DPH Tree Farm Statement of Cash Flows
Free Cash Flow of a Firm
• Operating Cash Flow (OCF)
• Generated from operations after necessary operating
expenses and taxes are paid.
• = EBIT-tax+DA(depr.&amort.)
• = Net Operating Profit after Taxes (NOPAT)+DA
(depr.&amort.)
• = EBITDA-tax
• Net profit firm earns after taxes but before financing costs.

• Investment in Operating Capital (IOC)

• Includes fixed assets, current assets, and spontaneous current
liabilities i.e. reinvestment of cash in the firm
Free Cash Flow (cont.)

-
Free Cash Flow (cont.)
• Firms with positive Free Cash Flow
(FCF) have funds available for
distribution to investors and lenders.
• Potential negative FCF implications for
firms :
• Experiencing operating or managerial problems.
• Investing heavily in operating capital to support
growth.
• Note: FCF might be negative while OCF is positive
Statement of Changes in Equities
(Statement of Retained Earnings)
• Shows detailed changes in retained
earnings during the reporting period.
• Reconciles net income and dividends
paid with changes in retained earnings
from one period to the next.
Cautions in Interpreting Financial Statements
• Preparation of financial statements are required to
comply with accounting standards such as IFRS in
Hong Kong and GAAP in US.
• Firms may explore possibilities of loop holes in these
accounting standards and to do some “earnings
management” e.g.:
• “Smooth” earnings
• Use different depreciation methods

• Sarbanes-Oxley Act in US passed in 2002 tried to fix

some of the loop holes to prevent earnings
management.
• Prevents deceptive accounting and management practices
Unit 2 (b)
ANALYZING FINANCIAL
STATEMENTS

- Chapter 3
Introduction
• Uses of Financial Statements
• Analyze firm performance.
• Develop plans to improve performance.

• (A) Ratio Analysis

• Calculating and analysing financial ratios to assess firm’s
performance and to identify actions that could improve firm
performance.
• Ratio Analysis are used to :

• compare to the same firm over time. (Trend Analysis)

• compare to competitors.

• (B) Comparison using Standardized Financial

Statements
(A) Five Groups of Financial Ratios

• 1) Liquidity
• 2) Asset Management
• 3) Debt Management
• 4) Profitability
• 5) Market Value / Investment
1) Liquidity Ratios
• Relationship between firm’s current
assets and current liabilities.
• Common liquidity ratios :
• Current ratio
• Quick (or Acid-Test) ratio
• Cash ratio
Current Ratio
• Broadest liquidity measure.
• Measures current assets available to
pay current liabilities.
Quick Ratio
• Excludes inventory (which is usually
not very liquid) in the numerator.
• Measures a firm’s ability to pay short-
term obligations without inventory
sales.
Cash Ratio
• Measures ability of the firm to pay
short-term obligations only with
available cash and marketable
securities.
2) Asset Management Ratios (Efficiency Ratios)

• Measure efficiency of firm’s asset use.

• Inventory
• Accounts Receivable / Debtors
• Accounts Payable / Creditors
• Total Assets, Fixed Assets and Working
Capital
Inventory Management
• Inventory Turnover Ratio
• Dollar of sales produced per dollar of inventory.
• Often uses cost of goods sold instead of sales
because inventory is listed on the balance sheet at
cost.

• Days’ Sales in Inventory Ratio

• Measures the average number of days inventory is
held before final product is sold.
Accounts Receivable Management
• Average Collection Period (ACP) Ratio
• Measures number of days accounts receivable are
held until cash is collected from the sale.

• Accounts Receivable Turnover Ratio

• Measures dollars of sales produced per dollar of
accounts receivable.
Accounts Payable Management
• Average Payment Period (APP) Ratio
• Measures the number of days accounts payable
held before extending cash to pay for raw materials

Or Credit
purchases

• Accounts Payable Turnover Ratio

• Measures dollar of COGS per dollar of accounts
payable.
Or Credit
purchases
Total Asset Management
• Total Asset Turnover Ratio
• Measures dollars of sales produced per dollar of
total assets.

• Capital Intensity Ratio

• Measures dollars of total assets needed to
produce a dollar of sales.
Fixed Asset and Working Capital Management
• Fixed Asset Turnover Ratio
• Measures dollars of sales produced per dollar of
net fixed assets.

(after depr.)

• Sales to Working Capital Ratio

• Measures dollar of sales produced per dollar of
working capital. (Current Assets – Current
Liabilities)
3) Debt Management Ratios (Solvency Ratios)

• Two Major Types :

• Measure debt amount.
• Measure firm’s ability to repay debt in the firm.
Debt vs. Equity Financing
• Three Measures :
• Debt Ratio
• Debt-to-Equity Ratio
• Equity Multiplier Ratio

• Debt Ratio
• Measures percentage of total assets financed
with debt.
Debt vs. Equity Financing
• Debt-to-Equity Ratio
• Measures dollars of debt financing for every
dollar of equity financing.

• Equity Multiplier Ratio => measure financial leverage

• Measures the dollars of assets on balance sheet
for every dollar of equity financing.
Coverage Ratios
• Times Interest Earned Ratio
• Measures operating earnings dollars available to
meet interest obligations.
i.e. Operating income

• Cash Coverage Ratio

• Measures operating cash available to meet
interest and other fixed charges, and indicates if
debt burden is too large.
i.e. EBITDA

i.e. Borrowing costs e.g.

interests, fees etc.
4) Profitability Ratios
• Show the combined effect of liquidity,
asset management and debt
management on firm’s operating
results.
• Closely monitored by investors since
stock prices react very quickly to
unexpected changes in these ratios.
Profit Margin & Return on Assets (ROA)
• Percent of sales left after all firm expenses are paid.

Net

• Measures overall return on firm’s assets inclusive of

leverage and taxes.
Return on Equity (ROE)
• Measures return on common
stockholders’ investment.
• Affected by net income and amount of
financial leverage.
• High ROE is usually a positive sign,
unless driven by excessively high
leverage.
Dividend Payout Ratio
• Measures fraction of earnings paid out
to common stockholders as dividends.
5) Market Value Ratios (Investment Ratios)

• Market prices of publicly-traded firms

incorporate risk.
• Market values reflect what investors
think of the company’s future
performance and risk.
Price-Earnings Ratio
• Best known and most often quoted
figure.
• Measures price investors will pay per dollar of
earnings.
• High PE ratio usually indicates projected
growth.
• Drives stock classification as growth or value.
DuPont Analysis
• Uses both Balance Sheet and Income Statements.
• Breaks ROA and ROE into components to explain why
the ratios are low or high.
• ROA = Net Profit/Total Assets
• = Net Profit/Sales x Sales/Total Assets
• = Net Profit Margin x Total Asset Turnover
• ROE = Net Profit/Equity
• = (Net Profit/Sales x Sales/Total Assets) x
Total Assets/Equity
• = (Net Profit Margin x Total Asset Turnover) x
Equity Multiplier
• = ROA x Equity Multiplier
 Du Pont Analysis

Net Income Sales Assets

Return on equity = ¾¾¾¾¾¾ ¾¾¾¾ ¾¾¾¾¾¾¾¾¾
Sales Asset Shareholder’s
Equity

Net Total Equity

Profit Asset Multiplier
Margin Turnover
(Profitability) (Efficiency) (Leverage)
DuPont Analysis
(B) Standardized Financial Statements
Common-Size Financial Statements :
• They are used to compare financial
statements of different company size, or of
the same company over time.
• By expressing the items in proportion to
some size-related measure, standardized
financial statements can be created,
revealing trends and providing insight into
how the different companies compare.
• Balance sheet items – expressed as a percentage of
total assets.
(B) Standardized Financial Statements
(B) Standardized Financial Statements
Standardized financial statements are useful
for :
- Comparing financial information year-to-
year.
Time Series Analysis or Trend
Analysis
- Comparing companies of different sizes,
particularly within the same industry.
Cross-Sectional Analysis
End of Unit 2