Chapter-3

FIRM’S FINANCIAL OPERATION

 3.1. Financial Statement
• A financial Statement is a collection of monetary data and
information organized according to logical and consistent
accounting procedures.
• The main purpose is to convey an understanding of some
financial aspects of a business firm.
• It provides understanding of what happens to the firm’s money
as the firm pursues its business activities.
Uses of Financial Statement
• To present a historical record of the firm’s financial development
when fulfilled over a number of years.
• Used to forecast a course of action for the firm. Financial
statement is often prepared for a future period. It expresses the
financial manager’s estimate of the firm’s future performance.
• A means employed by firms to present their financial situations
to stockholders, creditors and the general public.
Major Forms of Financial Statements:
1. The Balance Sheet
2. The Income Statement ( Profit and loss statement)
3. A Flow of Funds Statement
 1. The Balance Sheet
 A balance sheet shows a company’s financial position as at a
point of time (usually the last date of the company’s fiscal year),
like a snap shot picture of the company’s financial situation at
that particular time point.
 There are three major items in a balance sheet: (1) Assets, (2)
Liabilities, and (3) Equity (or called Net Worth).
Balance sheet
 It shows the financial position of the firm at a moment of
reporting,
 It declares the assets, liabilities and equity for the firm at the
last day of the accounting period,
 It matches resources (assets) with sources (liabilities and
equity).
 ASSETS:
 Assets are classified into two categories: (1) Current Assets and
(2) Fixed Assets.
 They represent what a company owns, and are usually presented
at the top (first part) of a balance sheet.
 Current Assets of a construction company are usually cash,
accounts receivable, construction material inventory and so on
which have high liquidity (i.e. can be turned into cash easily).
 Fixed Assets of a construction company are usually property and
equipment, construction plant, trucks and so on which cannot be
readily turned into cash in a short time.
 Fixed Assets are also called Long-term Assets. When Current
Assets and Fixed Assets are added together, the sum is called
Total Assets.
 LIABILITIES
 When a construction company owes obligations to some third
parties, we call these obligations Liabilities. Liabilities are
usually presented at the middle part of a balance sheet.
 They are classified into (1) Current Liabilities and (2) Long-term
Liabilities.
 Current Liabilities of a construction company include bank
overdraft and short term bank loan, accounts payable to
subcontractors, suppliers and employers, rents, utilities and so
on. They are debts the company has to pay, say, within a year.
 Long-term Liabilities, however, are obligations with a period
more than one year, usually a few years or even longer.
 They often refer to long term bank loans or loans for mortgages
of equipment, building, land, or even cars/ trucks. These long-
term debts are usually repaid by installments.
 When Current Liabilities and Long- term Liabilities are added
together, the sum is called Total Liabilities.
 EQUITY
 Equity is the capital invested by the owner(s) of a company.
Because some construction companies are owned by
stockholders, so Equity is sometimes also referred to as
Stockholders’ Equity. Another name for it is ‘Net Worth’.
 Equity represents the Net Worth of the business, and can be
calculated by summing up the capital the owners have invested
and the profits that have been accumulated (after deducting all
the dividends paid so far to the owners) and retained up to the
present moment since the business began.
Assets 31/12/2012 31/12/2011
Current Assets
Cash 2,589,000 1,967,890
As at 5,767,000 5,403,670
Accounts receivable 1,641,750 1,350,918
Retention money 850,000 520,000
Material Inventory 547,250 450,306
Costs and estimated earnings in excess
of billings on work in progress 894,500 983,944
Prepaid expenses and others 12,289,500 10,676,728
Total Current Assets
Fixed assets 15,536,900 13,800,000
Property and equipment 2,680,040 2,039,480
Construction plant 2,070,000 1,812,000
Vehicles/Trucks 345,000 379,000
Furniture and fixtures 20,631,940 18,030,480
Total depreciable assets 12,529,373 11,158,000
Less accumulated depreciation 8,102,567 6,872,480
Net Fixed Assets 20,392,067 17,549,208
Total Assets
Liabilities
Current Liabilities 4,325,250 4,773,240
Accounts payable 1,586,037 1,475,918
Accrued expenses 647,250 491,973
Notes payable 919,380 756,514
Retention money payable 617,205 678,922
Billings in excess of costs and estimated 355,713 292,699
earnings on work in progress
Other current liabilities 8,450,835 8,469,266
Total Current Liabilities 3,528,557 3,695,267
Long-term Liabilities 10 11,979,392 12,164,533
Total Liabilities
 2. The Income Statement
 The income statement is a report of a firm’s activities during a
given accounting period.
 Firms often publish income statements showing the results of
each quarter and the full accounting year.
 It shows the revenues and expenses of the firm, the effect of
interest and taxes and the net income for the period. It may be
called as the profit-and-loss statement or the statement of
earnings.
 The balance sheet offers a view of the firm at a moment in time,
whereas the income statement summarizes the profitability of
operations over a period of time.
 It is an accounting device designated to show stockholders and
creditors whether the firm is making money. It can also be used
as a tool to identify the factors that affect the degree of
profitability.
It includes cost accounting of:
 Net sales or construction income or work execution in
monetary terms.
 Construction costs/ production costs/ that include the direct
costs,
 General and administration costs / overhead costs/
 Interest: the fixed charges paid by the firm on the money
that it borrows.
 Income Statement
Company-A 31/12/2012 31/12/2011
Revenue (A) 40,185,000 38,483,000
Materials (B) 13,000,000 12,500,000
Labour (C) 5,500,000 5,400,000
Subcontracts (D) 12,500,000 12,000,000
Other direct costs (E) 1,087,000 1,085,000
Total Cost of Revenue (F) (B+C+D+E) = 32,087,000 30,985,000
Gross Profit (G) (A-F) = 8,098,000 7,498,000
Operating Expenses (H) 2,036,500 1,943,500
Variable overhead (I) 3,358,500 2,979,500
Fixed overhead (J) (H+I) = 5,395,000 4,923,000
Total Operating Expenses (K) (G-J) = 2,703,000 2,575,000
Operating Profit (L) 30,000 -38,000
Miscellaneous income/expense (M) -5,500 4,000
Interest income (N) 19,000 12,900
Interest expense (O) -42,500 -41,000
Total Other Income/Expense (P) (L+M+N+O) = 1,000 -62,100
Net Profit before Tax (Q) (K+P) = 2,704,000 2,512,900
Tax Expense (25% tax rate) (R) 676,000 628,225

Net Profit after Tax (S) (Q-R) = 2,028,000 1,884,675

Table-3.2
 Income Statement

Company-B 30/10/2014 30/10/2015

Revenue 300,000 600,000

Cost of Goods Sold 60,000 150,000

Gross Profit 240,000 450,000

Selling, General, Administrative 30,000 40,000

Research & Development 25,000 25,000

Other operating Expense 10,000 15,000

Operating Income 175,000 370,000

Interest Expense 15,000 15,000

Earnings before tax(EBT) 160,000 355,000

Taxes 32,000 60,000

Net Income 128,000 295,000

Table – 3.3
Net Income = Total Revenue – Cost of goods sold – operating
Expenses – Interest Expenses – Taxes

Revenue: sales generated by the company and its business

operations.
Cost of goods sold: costs related to producing goods or services.
Operating expenses: other costs required to run the day-to-day
business. e.g. Include selling, general & administrative costs,
research & development costs, and other operating expenses.
Interest Expenses: Interest payments due to for any outstanding
company debt.
Taxes: Relevant corporate tax applicable to the company.
 3. Flow-Of-Funds Statement
 This statement shows the movement of funds into the firm’s
current asset accounts from external sources such as
stockholders, creditors and customers.
 It also shows the movement of funds to meet the firm’s
obligation, or pay dividends. The movements are shown for a
specific period, normally the same time period as the firm’s
income statement.
 The difference between sources and uses is shown as an increase
or decrease in net working capital.
 The pool is a measure of net working capital. If the firm has more
funds coming in than going out, net working capital increases.
 Sales of Fixed Sales of Debts Funds from
Assets stock Operations

Working-Capital Pool

(All current accounts)

Marketable Securities Cash Inventory Accounts Receivables

Purchase fixed Pay Dividends Retire debt Tax, Interest

assets

Fig. 3.4: Sources and uses of funds and the working capital pool.
 Sample on Flow-Of-Funds

1988 1987

Source of funds
Net Income from operations Birr 148,262 Birr 127,065
Noncash expenses 107,296 92,297
Total funds from operations 255,558 219,362
Proceeds from long-term borrowing 92,621 41,831
Sales of property 6,101 1,499
Sales of common stock 2,112 1,804

Total sources of Funds Birr 356,392 Birr 264,497

Application of funds
Expenditures for property and equipment Birr 234,511 Birr 174,408
Miscellaneous investments 4,728 3,215
Payments of cash dividends 50,924 48,107
Funds held for plant construction 975 45,378

Total application of funds Birr 291,138 Birr 271,108

Increase (decrease) in net worki

ng capital Birr 65,254 Birr (6,611)

Table- 3.5
 3.2. Financial Analysis
• In financial statement analysis, Financial Ratios help a lot in
indicating the financial health of a construction company.
• The financial ratios relevant to the construction industry can be
classified into five categories. They are (1) Profitability Ratios, (2)
Liquidity Ratios, (3) Working Capital Ratios, (4) Capital Structure
Ratios, and (5) Activity Ratios.
• Five Categories of Financial Ratios
• In this section, we have to refer to Tables 3.1 and 3.2 explanation
of the financial ratios below will be based on these two tables –
Income Statement and Balance Sheet above.
1. Profitability Ratios
 Profitability ratios measure the construction company’s ability to
earn profit from its operation. The three most commonly used
profitability ratios are:
A) Gross Profit Margin Ratio
 This ratio shows the margin left after meeting production costs.
 It measures the efficiency of production and pricing.

Gross Profit Margin Ratio= Gross profit / Revenue

= 8,098,000 / 40,185,000 =
20.15%
(The goal for profit margin ratio is 25% minimum.
 B) Net Profit Margin Ratio
• Net Profit Margin Ratio= Net profit before tax / Revenue
= 2,704,000 / 40,185,000 = 6.73%
• (The goal for net profit margin ratio is 5% minimum)

C) Return on Equity Ratio

Return on Equity Ratio= Net profit before tax / Owners’ equity
= 2,704,000 / 8,412,675
= 32.14%
(The return on equity ratio should be between 15% and 40%)
2. Liquidity Ratios
• Liquidity ratios indicate the construction company’s ability to
pay its obligations as they come due. The three most common
liquidity ratios used are shown below.
A) Current Ratio
• Current Ratio used to ability of a firm to meet its obligation in
short-run.
• Current assets get converted into cash in the operating cycle of
the firm and provide the funds needed to pay current
liabilities.
• As a general rule a 1.5 to 2.0 ratio is considered acceptable
Current Ratio = Current assets / Current liabilities
= 12,289,500 / 8,450,835 = 1.45
(The current ratio should be higher than 1.3 for a financially
healthy construction company)
 B) Acid Test Ratio
• A more strict measure of liquidity than the current ratio.
• Inventories are least liquid of current assets. It requires a two-
step process in order to be converted into cash.
• The acid test is so named because it shows the ability of a firm
to pay its obligation without relying on the sale and collection
of its inventories.
• A 1/1 quick ratio has traditionally been deemed adequate for
most firms.
Acid Test Ratio (or Quick Ratio) = (Cash + Accounts receivables) /
Current liabilities
= (2,589,000 + 5,767,000) / 8,450,835
= 0.99
• (The acid test ratio or quick ratio should be higher than 1.1 for
a construction company)
 C) Current Assets to Total Assets Ratio
Current Assets to Total Assets Ratio = Current assets / Total Assets
= 12,289,500 / 20,392,067
= 60.27%
(The current assets to total assets ratio should be between 60%
and 80%)
 3. Working Capital Ratios
These ratios measure how well the construction company is utilizing
its working capital. The three most commonly used working capital
ratios are shown below.
A) Working Capital Turnover
Working Capital Turnover = Revenue / Working capital
= 40,185,000 / (12,289,500 – 8,450,835) = 10.47 times
(The working capital turnover should be between 8 and 12 times per
year)
B) Net Profit to Working Capital Ratio
Net Profit to Working Capital Ratio =
Net profit before tax /Working capital
= 2,704,000 / (12,289,500 – 8,450,835) = 70.44%
(The net profit to working capital ratio should be between 40% and
60%)
 C) Degree of Fixed Asset Newness
Degree of Fixed Asset Newness = Net depreciable fixed assets / Total
depreciable fixed assets
= 8,102,567 / 20,631,940 = 39.27%
(The degree of fixed asset newness should be between 40% and
60%)
4. Capital Structure Ratios
 Capital structure ratios indicate the ability of the construction
company to manage liabilities. These ratios also indicate the
approach that the company prefers to finance its operation. The
two major capital structure ratios are:
A) Debt to Equity Ratio
Debt to Equity Ratio = Total liabilities / Owners’ equity
= 11,979,392 / 8,412,675 = 1.42
(The debt to equity ratio should be lower than 2.5)
 B) Leverage
Leverage= Total assets / Owners’ equity
= 20,392,067 / 8,412,675 = 2.42 OR
Leverage = Total assets / Owners’ equity
= (Total liabilities + Owners’ equity) / Owners’ equity
= (Total liabilities / Owners equity) + 1
= Debt to Equity Ratio + 1
= 1.42 + 1
= 2.42
(The leverage should be lower than 3.5. Some construction
companies prefer to use leverage of 3.5 or close to it but some
conservative ones prefer to use a lower leverage. This relates to, of
course, the use of a higher or lower debt to equity ratio by the
company.)
5. Activity Ratios
 Activity ratios indicate whether or not the construction company
is using its assets effectively, and if yes, how effective they are.
There are quite a number of activity ratios, and the seven
commonly used ones are shown below.
A) Average Age of Material Inventory
Average Age of Material Inventory = (Material inventory / Materials
cost) × 365 days
= (850,000 / 13,000,000) × 365 = 23.87 days
(The average age of material inventory should be shorter than 30
days)
B) Average Age of Under Billings
Average Age of Under Billings = (Under billings / Revenue) × 365 d
= (547,250 / 40,185,000) × 365 = 4.97 days
(The average age of under billings should be the shorter the better)
 C) Average Age of Accounts Receivable
Average Age of Accounts Receivable = (Accounts receivable /
Revenue) × 365 d
= (5,767,000 / 40,185,000) × 365 = 52.38 days
(The average age of accounts receivable should be shorter than 45 days)
D) Cash Conversion Period
Cash Conversion Period = Average age of material inventory +
Average age of under billings + Average age of accounts receivable
= 23.87 + 4.97 + 52.38 = 81.22 days
(The cash conversion period should be shorter than 75 days)
E) Average Age of Accounts Payable
Average Age of Accounts Payable = [Accounts payable / (Materials +
Subcontracts)] × 365 d
= [4,325,250 / (13,000,000 + 12,500,000)] × 365
= 61.91 days
(The average age of accounts payable should be shorter than 45 days)
 F) Average Age of Over Billings
Average Age of Over Billings = (Over billings / Revenue) × 365 d
= (617,205 / 40,185,0 2 gl00) × 365 = 5.61 days
(Usually there is no guideline on average age of over billings)
G) Cash Demand Period
Cash Demand Period = Cash conversion period – Average age of
accounts payable– Average age of over-billings
= 81.22 – 61.91 – 5.61 = 13.70 days
(The cash demand period should be shorter than 30 days)
THANKS