FIN 103 - III and IV. Financial Statements & Ratio Analysis

7/25/2019 FIN 103 - III and IV. Financial Statements & Ratio Analysis

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ATENEOJ.G. SCHOOL OF MANAGEMENT FINANCE 103: PRINCIPLES OF FINANCE

Finance & Accounting Department III & IV Financial Statements and Ratio AnalysisInstructor

: Alice Parlan SY 2016 2017 Intersession

Sources: Brigham and Houston: Essentials of Financial Management, 13thEd., Cengage Learning Asia 2013;

Keown, Martin, Petty: Foundations of Finance, 7th

Ed., Pearson Education, Inc. / Prentice Hall 20111

FINANCIAL STATEMENTS & RATIO ANALYSIS

Balance Sheet

Income Statement

Statement of Retained Earnings

Statement of Cash Flows

Accounting Income vs. Cash Flow

Financial Ratio Analysis

Du Pont System

Market Value Added (MVA) and Economic Value Added (EVA)

Effects of Improving Ratios

Limitations of Ratio Analysis

The Annual Report

The Annual Report is issued annually by a firm to its shareholders, which contains the managements

analysis of the firms past operations and future prospects as well as the following basic financial

statements:

Balance Sheetprovides a snapshot of a firms financial positionat one point in time.

Income Statement summarizes a firms revenues and expenses over a given period of time;

also known as Profit and Loss (P&L) Statement

Statement of Retained Earnings shows how much of the firmsearnings were retained, rather

than paid out as dividends

Statement of Cash Flows reports the impact of a firms activitieson cash flows over a given

period of time.

F/S: Balance Sheet

Shows a firms assets, liabilities, and

shareholdersequity, using the actual cost

of acquiring them, at a given point in time

Accounting Book Valuevalue of an

asset as shown in the balance sheet; it

represents the historical cost of the asset

rather than current market value or

replacement cost

Balance Sheet Equation :

Total Assets = Total Liabilities

+ Total Shareholders Equity

Total Resources of the Firm = How it was financed by Debt or Capital

o Shows what assets the firm owns and who has claims on those assets as of a given date


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Overview of Balance Sheet: TOTAL ASSETS

I. CURRENT ASSETS1. Cash2. Accounts Receivables (A/R)

3. Inventories4. Other Current Assets

Current Assets- called Gross Working Capital because these assets turn over (used &replaced within a year)

Cash - refers to Cash on hand, demand deposits, short-term marketable securities thatcan be quickly converted into cash

A/R - money owed by customers who purchased goods & services on credit

Inventories- raw materials, work in progress, and finished goods held for eventual sale

Other Current Assets- items such as prepaid expenses

II. LONG-TERM (FIXED) ASSETS1. Net Property, Plant, and Equipment2. Other Long-Term Assets

A. LandB. Long-Term InvestmentsC. Intangible Assetslike Patents, Copyrights, Trademarks, Goodwill

Depreciation Expensea non-cash expense (found in Income Statement) to allocate thecost of depreciable assets, such as machinery and equipmen t, over the assets expecteduseful life

Accumulated Depreciation sum of all depreciation taken over the entire life of adepreciable asset (found in Balance Sheet)

Gross Fixed Assetsreflect the original cost of fixed assets

Net Fixed Assets = Gross Fixed Assets minus Accumulated Depreciation taken over lifeof the assets

Overview of Balance Sheet: TOTAL LIABILITIES

I. CURRENT LIABILITIES

1. Accounts Payables (A/P)2. Accrued Expenses3. Short-Term Debt (Notes Payable)4. Other Current Liabilities

Current Liabilities (Short-Term Debt) - borrowed money that must be repaid within 12months


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A/P or Trade Credit - the credit suppliers have extended when materials or inventorieswere purchased and will be paid within 30, 60, and 90 days

Accrued Expenses- unpaid short-term liabilities incurred during the firms operations

Short-Term Notes- borrowings from banks or other FIs that are due and payable within12 months

II. LONG-TERM LIABILITIES1. Long-Term Loans2. Corporate Bonds3. Mortgages

Long-Term Liabilities (L/T Debt) -borrowed money from banks or other financialinstitutions that must be repaid longer than 12 months

Corporate Bonds - borrowings of the firm through issuance of its own securities withmedium to long-term maturities

Mortgagesloan to finance real estate where the lender has first claim on the property inthe event the borrower is unable to repay the loan

Overview of Balance Sheet: SHAREHOLDERS EQUITY

I. SHAREHOLDERS EQUITY1. Par Value of Common Stocks2. Paid-In Capital3. Retained Earnings

Shareholders Equityincludes both preferred and common shareholders investment in

the firm

Preferred Stockholders stockholders that have claims on the firms income and assetsafter creditors, but before common stockholders; Receives dividends that are fixed inamount

Common Stockholders investors who own the firms common stocks; also known asresidual owners of the firm

Common Stocks the amount the firm receives after selling the stocks, which representownership in a corporation

Par Valuethe arbitrary value a firm puts on each share of stock prior to its being offeredfor sale

(Additional) Paid-In Capitalthe amount the firm receives from selling stock to investorsabove par value

Treasury Stock - firms stock that has been issued and the repurchased by the firm

Retained Earningscumulative profits retained in business up to the date of the balancesheet


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F/S: Income Statement

Shows the firms sales and costs over a given time period

Income Statement Equation :

SalesExpenses = Profits

Known also as Profit & Loss (P&L) Statement; indicates the amount of profits generated by afirm, which is calculated on an accrual basis

Accrual Basis Accounting method of accounting whereby revenue is recorded when it isearned, whether or not the revenue has been received in cash. Likewise, expenses arerecorded when they are incurred, even if the money has not actually been paid out

Overview of Income Statement: GROSS PROFITS

SALES OR REVENUES Paid in Cash Paid thru Credit

Sold on Installment Deferred Sales

Less:COST OF GOODS SOLD (CGS)Equals:GROSS PROFITS

Revenues- Total Sales Pesos equals Selling Price X Units Sold, whether sold in cash, thrucredit, on installment or deferred

Cost of Goods Soldthe cost of producing or acquiring a product or service to be sold in theordinary course of business

Gross Profits - Sales or Revenues minus Cost of Goods Sold

Overview of Income Statement: OPERATING INCOME

GROSS PROFITS

Less:OPERATING EXPENSES Marketing & Selling Expenses General & Administrative Expenses

Equals:EARNINGS BEFORE INTEREST, TAXES DEPRECIATION & AMORTIZATION (EBITDA)

Less: Depreciation Expenses Amortization Expenses

Equals: OPERATING INCOME or OPERATING PROFITS (EBIT)


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Marketing & Selling Expenses the (variable) cost of promoting and distributing the firmsproducts or services to customers

General & Administrative Expensesthe firms overhead (fixed) expenses, such as salariesand rent

Depreciation Expensea noncash expense to allocate the cost of depreciable assets, suchas plant & equipment, over the life of the asset

Amortization Expensea noncash expense to allocate the cost of the intangible assets, suchas copyrights, over the life of the asset

Overview of Income Statement: TAXABLE INCOME

OPERATING INCOME or OPERATING PROFITS (EBIT)

Less:

FINANCING COST Interest Expenses Preferred Dividends

Equals:TAXABLE INCOME (EBT)

Operating Income or Operating Profits also called earnings before interest & taxes (EBIT);the result of managements decisions relating only to the operations of the business

Financing Costinterest expenses resulting from the use of debt to finance operations and,if the firm issued preferred stocks, includes also preferred dividends

Taxable Income = Operating Income minus Financing Cost; also called earnings before taxes(EBT)

Overview of Income Statement: NET INCOME

TAXABLE INCOME (EBT)

Less:INCOME TAX

Equals:NET INCOME

Taxable Income = Operating Income minus Financing Cost; also called earnings before taxes(EBT)

Income Taxcomputed based on earnings before taxes (EBT) and the applicable tax rate forthe amount of income reported


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Net Incomeearnings available to common stockholders, which represents income that maybe reinvested in the firm or distributed to its owners, provided that there is available cash todo so

Overview of Statement of Shareholders Equity (SE):

SE BALANCE, Previous Year

Add:NET INCOME, Current Year

Less:CASH / STOCK DIVIDENDS*

Add:RETAINED EARNINGS

Equals:SE BALANCE, Current Year

SE = Par Value of Common Stocks + Paid-In Capital + Retained Earnings; shows howmuch a firms equity changed during the yearand why this change occurred

Retained Earnings - cumulative profits retained in the firm up to the date of the balancesheet; represents a claim against assets, which does not represent cash and are notavailable for dividends or anything else; it may also be negative to show unrealized losseslike forex losses

*Stock Dividend distribution of shares of up to 25% of the number of shares outstanding,issued on a pro rata basis to the current shareholders


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Other Financial Ratios: PER SHARE BASIS

NO. OF OUTSTANDING SHARES

Common Shares

Preferred Shares

EARNINGS PER SHARE= Net Income____________

No. of Outstanding Common Shares

DIVIDENDS PER SHARE= Total Dividends Declared___

No. of Outstanding Shares

BOOK VALUE PER SHARE= Common Equity ______

No. of Outstanding Common Shares

Earnings per Share (EPS) income on a per share basis

Dividends per Share (DPS) amount of dividends a firm pays for each share outstanding

Book Value per Share (BVPS) accounting value per share based on firms balance sheet

Stock Price per Sharemarket value per share observed in the market place

Other Financial Ratios: MORE LIQUIDITY RATIOS

AVE. COLLECTION PERIOD

= Accounts Receivable____(Credit Sales / 365)

ACCOUNTS RECEIVABLES (A/R) TURNOVER RATIO= Annual Credit Sales____

Accounts Receivables

INVENTORY TURNOVER= Cost of Goods Sold___

Inventory

DAY SALES OUTSTANDING= Receivables____

Annual Sales / 365

Ave. Collection Period - how long the firm collects on its credit accounts & converts to cash

A/R Turnover Ratio expresses how often accounts receivable are rolled over during ayear

Inventory Turnover measures the number of times a firms inventories are sold andreplaced during the year (relative liquidity of the inventories)


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Day Sales Outstandingindicates the average length of time the firm must wait after makinga sale before it receives cash

Other Financial Ratios: OPERATING EFFICIENCY

BASIC EARNING POWER (BEP) RATIO or OPERATING RETURN ON ASSETS (OROA)= EBIT_____

Total Assets

TOTAL ASSET TURNOVER= Sales_____

Total Assets

FIXED ASSET TURNOVER= Sales______

Net Fixed Assets

Basic Earning Power (BEP) Ratio or OROA indicates the ability of the firms assets togenerate operating income

Total Asset Turnover relates how well the firm is managing its assets to generate sales(called asset efficiency)

Fixed Asset Turnoverindicates how efficiently the firm is using its fixed assets

Other Financial Ratios: FINANCING DECISION

TIMES INTEREST EARNED= Operating Profits__

Interest Expense

DEBT / EQUITY RATIO= Total Debt___

Total Equity

Times Interest Earned measures a firms ability to meet its interest payments from itsannual operating earnings

Debt / Equity Ratio (D/E Ratio) determines how much leverage the shareholders had inmagnifying expected earnings

Other Financial Ratios: RETURN ON CAPITAL

RETURN ON EQUITY= Net Income___

Common Equity

RETURN ON TOTAL ASSETS (ROA)= Net Income____

Total Assets


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Return on Equity (ROE) refers to accounting rate of return earned on the commonstockholders investment

Return on Total Assets (ROA)indicates the rate of return being earned on the firms assets

Effects of Debt on ROA and ROE

ROA is lowered by debt:Interest lowers Net Income, which also lowers ROA = NI/Assets

Use of debt also lowers equity:Hence, debt could raise ROE = NI/Equity

Problems with ROE

ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole

measure of performance: ROE does not consider risk ROE does not consider the amount of capital invested Might encourage managers to make investment decisions that do not benefit shareholders

ROE focuses only on return. A better measure is one that considers both risk and return.

The DuPont Equation

A formula that shows the relationship among asset management, debt management, andprofitability ratios:

ROE = Net Income X Sales X Total Assets_____

Sales Total Assets Total Common Equity

Profit Margin - ExpenseControl; tells the firm howmuch it earns on sales,which determines itscommand on premium priceand holding down of costs

Total Assets Turnover -Asset Utilization; tells thefirm how many times theprofit margin is earned eachyear for each pesos of salesand how many times itsassets turned over eachyear

Equity Multiplier DebtUtilization; the adjustmentfactor


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Profits and cash flows are not the same thing!

Two Ways to Measure a Firms Cash Flows:

Free Cash Flows the amount of cash available from operations after the firm pays forthe investments it has made in operating working capital and fixed assets. This cash isavailable for distribution to firms creditors and owners.

Statement of Cash Flows focuses on identifying the sources and uses of cash thatexplain the change in the firms cash balance reported in the balance sheet

Potential Uses of Freed Up Cash

Expand business

Reduce debt Repurchase stock

All these actions would likely improve the stock price


Three Key Activities that Explain Cash Inflows & Cash Outflows of the Firm:

1. Generating Cash Flows from Day-to-Day Operations - how much cash is coming from thenormal course of operating a business, starting with :

- purchasing inventories on credit- selling on credit- paying for the inventories- collection on sales made on credit


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2. Investing in Fixed Assets & Other Long-Term Investments - when a firm purchases orsells fixed assets, like equipment or building, there can be a significant cash inflows andoutflows

3. Financing the Business - cash inflows & outflows occur from:- borrowing and repaying S/T and L/T Debt- paying dividends to the shareholders- issuing new equity stocks or repurchasing stocks from shareholders


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Overall Statement of Cash Flows:

Converting a Firms Income Statement from anAccrual Basis to CashBasis in Two (2) Steps:

1. Add Back depreciation to net income since depreciation is not a cash expense

2. And Subtract the following:- any uncollected sales (or total sales minus increases in accounts receivables)- cash payments for inventories (or increases in inventories minus increases in

accounts payables)


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Economic Value Added (EVA)

A financial performance that measures a firms economic profit, which assigns: cost to the equity capital (the opportunity cost of funds provided by the shareholders) interest cost on the firms debt

Economic Value Added Equation:

EVA = Operating Return - Cost of x Totalon Assets All Capital Assets

= Php Amount (if positive, then there is added economic value)

Value created by management is determined by the amount the firm earns on its invested capitalrelative to the cost of both equity and debt funds, and the amount of capital invested in the firm(which are the total assets)

Computing for Economic Profit:

Market Value Added (MVA)

MVA = Market value __ Equity capitalof equity supplied

Market Value Ratios:

PRICE / EARNINGS RATIO= Market Price per Share__

Earnings per Share

PRICE / BOOK RATIO= Market Price per Share___

Equity Book Value per Share


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Price/Earnings Ratio (P/E Ratio)the price the market places on Php 1 of the firms reportedearnings

Price / Book Ratio (P/BV Ratio)If > I, then investors believe that the firm is more valuable

than the amount shareholders have invested in it

Analyzing Market Value Ratios

Price-Earnings Ratio (P/E): How much investors are willing to pay for $1 of earnings?

Price-Cash Flow Ratio (P/CF): How much investors are willing to pay for $1 of cash flow?

Price-Book Value Ratio (M/B): How much investors are willing to pay for $1 of book valueequity?

For each ratio, the higher the number, the better.

P/E and M/Bare high if ROEis high and risk is low.

Trend Analysis and Benchmarking

Used to estimate the likelihood of improvement ordeterioration in financial condition

Trend Analysis - analyzes a firms financial ratios overtime

Benchmarking- comparing with the industrys average

can help determine how the firm is faring with othercompanies

Potential Problems and Limitations of Financial Ratio Analysis

Comparison with industry averages is difficult for a conglomerate firm that operates in manydifferent divisions

Average performance is not necessarily good, perhaps the firm should aim higher

Seasonal factors can distort ratios

Window dressing techniques can make statements and ratios look better

Different operating and accounting practices can distort comparisons.

Sometimes it is hard to tell if a ratio is good or bad.

Difficult to tell whether a company is, on balance, in strong or weak position.


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K M ti P tt F d ti f Fi 7th

Ed P Ed ti I / P ti H ll 201118

SUMMARY: Five Major Categories of Financial Ratios(What questions do they answer?)

Liquidity: Can the firm meet the required payments as they fall due?These ratios give an idea of the firms ability to pay off debts that are maturing within a year.

Asset Management: Does the firm manage its assets efficiently to generate enough sales?These ratios give an idea of how efficiently the firm is using its assets.

Debt Management: Does the firm finance its assets with the right mix of debt and equity?These ratios give an idea of how the firm has financed its assets as well as the firms ability torepay its long-term debt.

Profitability: Are the Firm's managers providing good returns on shareholders' capital? Do salesprices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?These ratios give an idea of how profitably the firm is operating and utilizing its assets.

Market Value: Are the Firm's managers creating shareholders' value? Do investors like what

they see as reflected in P/E and M/B ratios? These ratios give an idea of what investors thinkabout the firm and its future prospects based on its stock price.

FIN 103 - III and IV. Financial Statements & Ratio Analysis

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Transcript of FIN 103 - III and IV. Financial Statements & Ratio Analysis