Unit 3: Financial Statement Analysis

Financial Statement
Balance Sheet
Income Statement
Cash Flow Statement
Modifying Financial Data for Managerial Decisions
Net Cash Flows
Operating Assets and Operating Capital
Net Operating Profit
Free Cash Flows
Market Value Added and Economic Value Added
Financial Analysis
Types of Ratios
Du-Pont Identity
Use and Limitation of Ratio Analysis
Common Size Financial Statement
Financial Statements
Statement of information about assets, liabilities, revenues, expenses, and cash
flows during the specified period.
Popular financial statements are:
 Balance Sheet
 Income Statement
 Cash Flow Statement
Balance Sheet (Report of Condition)
 The balance sheet provides the pertinent information about the position of
banks. Such information is useful to regulator, stockholders, depositors, and
creditors to evaluate the bank performance.
Income Statement (Report of Income)
 The income statement provides the information about revenues, expenses, and
income over a designated period.
Cash Flow Statement
 Cash flow statement is concerned with the flow of cash in and out of the
business
 It shows how the changes in balance sheet accounts and income on the income
statement affect a company's cash position.
 Balance Sheet

B a la n c e S h e e t
As s e ts Li a bi litie s a n d Equ ity
Ca sh and m a r ket a ble xxxx Accou n t s pa ya ble xxxx
secu r it ies
Accou n t r eceiva bles xxxx Not es pa ya ble xxxx
In ven t or ies xxxx Accr u a ls xxxx
Ot h er cu r r en t a sset s xxxx Ot h er cu r r en t lia bilit ies xxxx
To ta l c u rre n t a s s e ts xxxx To ta l c u rre n t lia bilitie s xxxx
Net fixed a sset s xxxx Lon g t er m debt xxxx
To ta l lia bilitie s xxxx
P r efer r ed st ock xxxx
Com m on st ock xxxx
Ret a in ed ea r n in gs xxxx
To ta l e qu ity xxxx
To ta l a s s e ts xxxx To ta l lia bilitie s and xxxx
e qu i ty
Income Statement
Income Statement
Net sales xxxxxxx
(-) Operating costs (Variable and fixed costs) xxxxxxx
Earnings before interest, taxes, depreciation and amortization (EBITDA) xxxxxxx
(-) Depreciation and amortization xxxxxxx
Earnings before interest and taxes (EBIT) xxxxxxx
(-) Interest xxxxxxx
Earnings before taxes (EBT) xxxxxxx
(-) Taxes xxxxxx
Earnings before preferred dividend xxxxxxx
(-) Preferred dividend xxxxxxx
Earnings available to common stockholders (EATCSH) xxxxxxx
(-) Dividend to common stockholders xxxxxxx
Retained earnings / Addition to retained earnings xxxxxxx
Cash Flow Statement: Basic Facts

1.Incomes (sales revenue) Cash inflows xxxx

2.Expenses (purchase) Cash outflows (xxxx)

3.For any asset (such as receivable, inventory, fixed assets, except cash)
Decrease in assets (selling assets) Cash inflows xxxx
Increase in assets (purchasing assets) Cash outflows (xxxx)

4. For any liability (such as accounts payable, loans, equity, etc)

 Decrease in liability items Cash outflows (xxxx)
(paid / redemption)
 Increase in liability items Cash inflows xxxx
(issue / borrow)
A. Cost of goods sold = Purchase + Opening stock – closing stock
Note:
1.If you begin from cost of goods sold, no need to adjust closing
stock
2.If you begin from purchase, you have to adjust closing stock
3.It begins from either cost of goods sold or from purchase
B. Opening Fixed Account

Fixed Asset Account

Dr Cr
Amount, Rs Amount, Rs
To balance b/d xxxx By balance c/d xxxx
To profit xxxx By loss xxxx
To purchase of assets xxxx By depreciation for the year xxxx
By sales of plant xxxx
Cash Flow Statement Format (Direct Method)
Panel A: Cash flow from operating activities
1. Cash collection from customers and sales Amount, Rs Amount, Rs
Sales revenue xxxx
Discount allowed (xxxx)
Net sales xxxx
Increase in account receivable (xxxx)
Decrease in account receivable xxxx
Bad debt recovered xxxx
Bad debt written off (xxxx)
Increase in provision for bad debts xxxx
Decrease in provision for bad debts (xxxx) xxxx
2. Cash paid to creditors / suppliers
Cost of goods sold (xxxx)
Increase in closing inventory (xxxx)
Decrease in closing inventory xxxx
Increase in account payable xxxx
Decrease in account payable (xxxx) (xxxx)
3. Cash paid for interest and taxes
Interest expenses (xxxx)
Payment for taxes (xxxx) (xxxx)
Net cash flow from operating activities (1 + 2 + 3) = A xxxx
Panel B: Cash flow from investing activities Amount, Rs Amount, Rs
Purchase of fixed assets (land, building, plant,
(xxxx)
machinery, furniture, etc.)
Sale of fixed assets xxxx
Net cash flow from investing activities (B) xxxx

Panel C: Cash flow from financing activities xxxx ± xxxx

Issue of securities (short-term debt, shares, debentures,
xxxx
long-term debt, etc.)
Repayment or redemption of securities (xxxx)
Dividend payment (xxxx)
Net cash flow from financing activities (B) ± xxxx ± xxxx
Change in cash and equivalent (A + B + C) xxxx xxxx
Opening cash and equivalent xxxx
Closing cash and equivalent xxxx
Modifying Financial Data for Managerial Decisions
 The traditional financial statements are prepared as per regulatory
requirements by accountants.
 These financial statements are used by shareholders, managers, other
stakeholders
 These statements are modified to make more revealing and useful for
managers, security analysts, and other stakeholders.
 Modification of financial statements includes:
- Operating Assets and Operating Capital
- Net Cash Flow (NCF)
- Net Operating Profit after Taxes (NOPAT)
- Market Value Added (MVA)
- Economic Value Added (EVA)
- Free Cash Flow (FCF)
Operating Versus Non-Operating Assets
Operating Assets
 Assets necessary to operate business
 Operating assets are further divided into two categories: operating
current assets and long-term operating assets
1. Operating current Assets
 Operating current assets are the current assets that are used to support
operations normally, such as cash, inventory, and receivable
 However, it does not include short-term investment
 Operating current liabilities are the current liabilities that occur as
natural consequence of operations, such as account payable and
accruals
 Operating current liabilities do not include notes payable or any other
short-term debt that charge interest
2. Long-term operating assets
Long-term operating assets are long-term assets used to support
operations such as net plant and equipment
However, they do not include any long-term investment that pay
interest or dividend
Non-operating Assets
Non-operating assets refer to assets above the level of operating
requirement, such as short-term and long-term investment, land held by
company for future purpose, cash above the level of requirement
Total Operating Assets (or Capital)
Total operating assets (or capital) is the total amount of capital needed
to run the business
Total operating capital = Net operating working capital + Net fixed
assets
Net operating working capital (NOWC)
= Operating working capital (OWC) – Non-interest bearing current
liabilities
= (Cash + Account receivables + Inventories) – (Accounts payables +
Accruals)
Thus, NOWC is the operating capital financed by interest bearing
funds.
Operating working capital = All current assets used in operation of
business firms
Net Cash Flow (NCF)
The accounting profit (net income) of the firm cannot reflect the true
position of the firm as some of the expenses listed on income statement
are not paid in cash, for example depreciation, and some of the revenues
which are not collected are treated as revenues, for example account
receivable. The NCF considers these facts.

Net cash flow (NCF) = Net income – Non cash revenues

+ Non cash expenses
Net Profit after Taxes (NOPAT)
 Two identical firms with similar performance may have different
accounting profits because of different level of debt capital used.
 Thus, net income cannot be used to true evaluate the performance of a
firm operations or to measure the effectiveness of managers’ decision.
So, NOPAT is computed.
 NOPAT is profit calculated without considering the debt capital.
NOPAT = EBIT (1-t)
EBIT = Earning before interest and taxes
t = marginal taxes
Market Value Added (MVA)
 Market value added = Current market value of stock – Equity capital
supplied by shareholders
 Measures how well the firm is able to create the market value as
compare to equity investment initially.
 It measures the effects of managerial action since the very inception of
the firm.
Economic Value Added (EVA)
It measures the effects of manager’s effectiveness in a given year.
EVA = EBIT (1-t) – TOC x after-tax cost of capital

Emphasis on Free Cash Flow, FCF

 Free cash flow is the cash flow actually available for distribution to all
investors after the company has made all the investments in fixed
assets, new products, and working capital necessary for ongoing
operations.
FCF = NOPAT – Net investment in operating capital
Is negative free cash flow always bad? Answer is ‘not necessarily’.
 Negative FCF is serious if it is due to negative NOPAT and gives
signals that there is operating problems.
 But, highly growth firms experience heavy investment in operating
assets and nothing is wrong in the situation.
Interpretation of Financial Ratios
 Despite record profits, many firms have weak and inefficient areas
that still need to be addressed.

 One way to identify weaknesses and problem areas is by analyzing

financial statements, computing financial ratios.

1. Liquidity ratio
2. Asset management ratio
3. Debt management ratio
4. Profitability ratio
5. Market value ratio
1. Liquidity Ratio
It measures the ability of firm to pay immediately.
Current assets
1.1 Current ratio =
Current liabilities
Current assets = Cash, inventories, receivables, bank deposits, prepaid
expenses, marketable securities, etc.

Current liabilities = accounts payable, notes payable, accruals, etc.

Quick assets
1.2 Quick ratio = Current liabilities

Quick assets = total current assets – Inventories

1.3 Net working capital to total asset ratio
Net working capital
= Total assets
Cash + Marketable securities
1.2 Cash ratio = Current liabilities

Net working capital = Total current assets – Total current liabilities

2. Assets Management Ratios
It measures how effectively the firm is utilizing its available
assets to generate sales.
Co s t o f g o o d s s o ld
2.1 (a ) In v e n to ry tu rn o v e r ra tio =
Av e ra g e in v e n to ry
If cost of goods sold is not given, we use sales instead of cost of
goods sold as:
S a le s
2.1 (b) In v e n to ry tu rn o v e r ra ti o =
Av e ra g e in v e n to ry
Cost of goods sold = Purchase + Opening stock – Closing stock
(Op e n in g s to c k + Clo s in g s to c k )
Av e ra g e in v e n to ry =
2
2.2 Re c e iv a ble tu rn o v e r ra tio
An n u a l c re d it s a le s
=
Av e ra g e a c c o u n t re c e iv a ble s
Measures how many times average account receivables turns
into sales.
2. Assets Management Ratios continue . . .
Re c e iv a ble s
2.4 D a y s s a le s o u ts ta n d in g =
Av e ra g e s a le s p e r d a y
An n u a l s a le s
Av e ra g e s a le s p e r d a y =
360-d a y s
S a le s
2.5 F ix e d a s s e ts tu rn o v e r ra tio =
N e t fix e d a s s e ts
S a le s
2.6 To ta l a s s e ts tu rn o v e r ra tio =
To ta l a s s e ts
3. Debt Management Ratios
To ta l d e bt
3.1 D e bt a s s e t ra tio =
To ta l a s s e ts
To ta l d e bt
3.2 D e bt to e qu ity ra tio =
To ta l e qu ity
Lo n g -te rm d e bt
3.3 Lo n g -te rm d e bt t o to ta l a s s e ts ra tio =
To ta l a s s e ts
3. Debt Management Ratios continue . . .
EB IT
3.4 In te re s t c o v e ra g e ra tio =
In te re s t p a y m e n ts
EB IT+ D e p re c ia tio n
3.5 Ca s h c o v e ra g e ra tio =
In te re s t p a y m e n ts

4. Profitability Ratios
N e t in c o m e
4.1 N e t p ro fit m a rg in =
S a le s
Gro s s p ro fit
4.2 Gro s s p ro fit m a rg in =
S a le s
Op e ra tin g p ro fit
4.3 Op e ra tin g p ro fit ra tio =
S a le s
EB IT
4.4 B a s ic e a rn in g p o w e r ra tio =
To ta l a s s e ts
N e t in c o m e
4.5 Re tu rn o n a s s e ts =
To ta l a s s e ts
N e t in c o m e
4.6 Re tu rn o n e qu ity =
To ta l e qu i ty
5. Market Value Ratios
Ma rk e t p ric e p e r s h a re
5.1 P ric e e a rn in g ra tio =
Ea rn in g p e r s h a re
Ma rk e t p ric e p e r s h a re
5.2 Ma rk e t to bo o k v a lu e ra tio =
B o o k v a lu e p e r s h a re
D iv id e n d s
5.3 D iv id e n d p a y o u t ra tio =
N e t in c o m e
Re ta in e d e a rn in g s
5.4 Re te n tio n (p lo w b a c k ) ra tio = 1- P a y o u t ra tio =
N e t in c o m e
Problem No.1

Morang Brick Company has Rs.13,13,500 in current assets and

Rs.5,25,000 in current liabilities. Its initial inventory level is
Rs.3,75,000 and it will raise funds as additional notes payable
and use hem to increase inventory. How much can company’s
short term debt (notes payable) increase without violating a
current ratio of 2 to 1? What will be the firm’s quick ratio after
the company has raised the maximum amount of short-term
funds? (Ans. Increase in notes payable = Rs.2,63,500; Quick
Ratio = 1.19x; 2056 (F), 2058)
Problem No.1
Janakpur Cigarette Ltd. has current assets of Rs.1 million and
current liabilities of Rs. 6,00,000.
i. What is the company’s current ratio?
ii. What would be its current ratio if each of the following
occurred , holding all other things constant?
a. A machine costing Rs.100,000 is paid for with cash.
b. Inventories of Rs.120,000 are purchased and financed with
trade credit.
c. Accounts payable of Rs.50,000 are paid off with cash.
d. Accounts receivable of Rs.75,000 are collected.
e. Long-term debt of Rs.200,000 is raised for investment in
inventories Rs.100,000 and to pay down short-term
borrowings Rs.100,000.
(Ans. i. 1.7 ii. 1.5 iii. 1.5 iv. 1.73 v. 1.7 vi. 2.2)
Problem No. 3

Wolken Corporation has Rs.5,00,000 of debt outstanding, and it pays an interest rate
of 10 percent annually. Wolken’s annual sales are Rs.2 million; its average tax rate
is 20 percent; and its net profit margin on sales is 5 percent. If the company does
not maintain a TIE ratio of at least 5 times its bank will refuse renew the loan, and
bankruptcy will result. What is Wolken’s TIE ratio? (Ans. 3.5x)