CHAPTER 2

Financial Analysis

Definitions and functions of financial statement

Financial ratios Basic sources and uses of funds

What is Financial Analysis?

Is a process of selecting, evaluating and interpreting the past financial data of a firm. It helps for making financial decision and can be used to assess the strength and weaknesses of management.

Financial Statements
Consists of:

Balance sheet,
Income Statement, Cash flows statement, Statement of retained earnings

Balance Sheet

Represent snapshot of firms financial position at specific point in time

Consist of : Assets (i.e. current and fixed) Liabilities (i.e. short and long term) Owners equity (i.e. common equity) Balance Sheet Equation Assets = Liabilities + Owners Equity

Format of Balance Sheet

Balance Sheet as at December 20XX
ASSETS Current Assets Marketable Securities Account Receivable Inventories Prepaid expenses Total Current Assets Fixed Assets Plant and Machinery Land and Buildings Total Fixed Assets LIABILITIES AND EQUITIES Current Liabilities Account Payable Notes Payable Accruals Total Current Liabilities

Long Term Debt Common Equity Common Stock Preferred Stock Retained Earnings TOTAL LIABILITIES AND EQUITY

TOTAL ASSETS

Balance Sheet (cont..)

Types of Assets

Cash (i.e. cash balance from cash transaction) Marketable securities (i.e. temporary investment) A/c receivables (i.e. debtors) Inventories (i.e. materials, WIP & unsold product) Prepaid (i.e. advance payment on expenses) Fixed assets (subjected to depreciation)

Balance Sheet (cont..)

Types of Liabilities & Equities

A/c payables (i.e. creditors) Notes payable (i.e. short term loan) Other payables (i.e. interest payment or income tax payable) Accrued expenses (i.e. unpaid expenses ) Capital stock (i.e. common or preferred stock) Retained earnings (i.e. reserved)

Income Statement

It summarize the firms revenue and expenses over an accounting period.

Operating activities Profit = Sales - Expenses

Income Statement (cont..)

Income Statement for the year ended December 20XX
Revenue/Net Sales less: COGS Gross Profit less: Operating Expenses Depreciation Operating Income/EBIT plus: other income less: Interest Earnings Before Taxes less: Corporate Taxes Net Income Dividend: Preferred Common Retained Earnings

Operating Activities

Financing Activities

Income Statement (cont..)

Items in income statement:

Sales/Revenue (i.e. cash & credit sales) COGS (i.e. cost to produce goods or services) Operating exp (i.e. marketing, administration etc) Interest (i.e. financing cost) Tax expenses (i.e. payment to govt) Net Income (i.e. to distribute to shareholders)

Statement of Retained Earnings

It shows the firms earnings that have not been distributed as dividends.
Statement of Retained Earnings for the year ended December 31, 20X2

Balanced of retained earnings, Dec 31, 20X1 add: Earning after tax 20X2 less: Dividend, 20X2 Balanced of retained earnings, Dec 31, 20X2

XXX XXX XXX XXXX

Cash Flow Statement

Summarizes the inflows and outflows of cash transactions for the year Divided into 4 categories:

C/flow from Operations C/flow from Investments C/flow from financings Reconciliation of cash

Financial Ratios

As an Analysis tools to interpret and evaluate firms performance Base on Financial Statement Users (i.e. Managers, investors, or interested parties ) Two ways to interpret: Trend analysis (i.e. vertical or time series) Comparative analysis (i.e. horizontal)

Financial Ratios (cont..)

5 categories of financial ratio

Liquidity ratios (i.e. how liquid the firms to meet short-term obligation) Activity ratios (i.e. to measure efficiency of assets to generate sales) Leverage ratios (i.e. how firms finance the its assets, to determine the capital structure) Profitability ratios (i.e. measure the efficiency of firms to generate profit) Market/Equity ratios (i.e. concern to shareholders)

Financial Ratios (cont..)

Liquidity Ratios Current Assets Current Ratio = Current Liabilities
Answer in X, higher ratio reflect the ability to pay its short term obligations on time

Quick Ratio =

Current Asset - Inventory Current Liabilities

Answer in X, higher ratio reflect the ability to pay its short term obligations without rely on inventories

Financial Ratios (cont..)

Liquidity Ratios Net Working = Capital CA - CL

Answer in $, higher (i.e. positive value), absolute measure in liquidity

Financial Ratios (cont..)

Activity Ratios Inventory COGS or Sales Inventory Turnover =
Answer in X, higher ratio reflect the effectiveness of inventory to generate sales

Average Collection Period =

A/c Receivables Daily Sales

Answer in Days, higher ratio indicates that firm has problem in collecting debt

Financial Ratios (cont..)

Activity Ratios A/C Receivable = Turnover Sales A/C Receivable

Answer in X, higher ratio reflect the effectiveness in collecting receivables

Financial Ratios (cont..)

Activity Ratios Fixed Assets Sales = Fixed Assets Turnover
Answer in X, higher ratio reflect the effectiveness of fixed assets to generate sales

Total Assets Turnover

Sales Total Assets

Answer in X, higher ratio reflect the effectiveness of total assets to generate sales

Financial Ratios (cont..)

Leverage or Solvency Ratios Debt Total Debt = Total Assets Ratio
Answer in %, higher ratio reflect the higher amount of debt to finance assets

Debt to Equity

Total Debt Equity

Answer in %, higher ratio reflect the higher amount of debt (i.e. capital structure

Financial Ratios (cont..)

Leverage or Solvency Ratios Time Interest EBIT = Interest Earned
Answer in X, higher ratio indicates that firm can meet loan requirement and lower risk of default

Financial Ratios (cont..)

Profitability Ratios Gross Profit Gross Profit = Sales Margin
Answer in %, higher ratio indicates higher contribution margin

Operating Operating Profit (EBIT) = Sales Profit Margin

Answer in %, higher ratio indicates better productivity (i.e. operations)

Financial Ratios (cont..)

Profitability Ratios Net Profit Earnings After Tax = Sales Margin
Answer in %, higher ratio indicates better income to shareholders

Return On Assets

Earnings After Tax = Total Assets

Answer in %, higher ratio indicates higher return on firms investment

Financial Ratios (cont..)

Profitability Ratios Return On Equity = Earnings After Tax Total Equity

Answer in %, higher ratio indicates higher return to shareholders

Financial Ratios (cont..)

Market/Equity Ratios Earning Earnings After Tax = No. of common shares Per Share
Answer in $, higher ratio indicates better income per share

Price to Earnings

Market Price p/share = EPS

Answer in X, higher ratio indicates the firms market price is overvalued

Financial Ratio Analysis

Income Statement for the year ended December 31, 2003
Revenue/Net Sales less: COGS Gross Profit less: Operating Expenses Other operating expenses Operating Income(EBIT) plus: other income less: Interest Earnings Before Taxes less: Corporate Taxes (40%) Net Income less: Dividend- Preferred Common Retained Earnings RM'000 1500 450 1050 450 300 300 none 25 275 110 165 none 33 132

Financial Ratio Analysis (cont..)

Balance Sheet as at December 31, 2000 &2003
ASSETS Current Assets Cash Account Receivable Inventories Prepaid expenses Total Current Assets Fixed Assets Plant and Machinery Land and Buildings Total Fixed Assets 2003 12 44 82 8 146 LIABILITIES AND EQUITIES Current Liabilities Account Payable Notes Payable Accruals Total Current Liabilities 2003 38 35 6 79

Long Term Debt 170 450 620 Common Equity Common Stock Preferred Stock Retained Earnings

180

100 150 257

TOTAL ASSETS

766

TOTAL LIABILITIES AND EQUITY 766

Liquidity Ratios
Liquidity Ratios
1) Current ratio (times) Current Assets Current Liabilities 2) Quick ratio (times) Current Assets- Inventories Current Liabilities 3) Net working Capital Current Asset - Current Liablities 146 - 79 67.00 none 146 - 82 79 0.81 1.2X 146 79 1.85 2X 2003 Industry

Profitability Ratios
Profitability Ratios
1) Return on Equity (%) Earning after tax Common Equity 2) Return on Asset(%) Earnings after tax Total assets 3) Gross Profit Margin(%) Gross Profit Sales 4) Operating Margin(%) Operating Income Sales 5) Net Profit Margin(%) Net Profit Sales 165 1500 11.00 9% 300 1500 20.00 30% 1050 1500 70.00 65% 165 766 21.54 45% 165 507 32.54 32% 2003 Industry

Activity Ratios
Activity Ratio
1) Asset Turnover (times/yr) Sales Total Assets 2) A/c Receivables Turnover (times/yr) Sales A/c Receivables 3) Average Collection Period (days) A/c Receivables Daily Sales 4) Inventory Turnover (times/yr) COGS or Sales Inventory 5) Fixed Assets Turnover Sales Fixed Assets 1500 620 2.42 none 1500 82 18.29 20X 44 (1550/360) 10.22 6 days 1500 44 34.09 40X 1500 766 1.96 5X 2003 Industry

Leverage or Solvency Ratios

Leverage (Solvency) Ratio
1) Debt Ratio Total Debt Total Assets 2) Debt to Equity Total Debt Equity 3) Time Interest Earned (time) EBIT Interest 300 25 12.00 10X 259 507 51.08 50% 259 766 33.81 30% 2003 Industry

Advantages of Financial Ratios

Easy to calculate Allow comparison with industry average Can identify problem areas of a firm Can be used to evaluate a firms financial performance.

Limitations of Financial Ratios

Does not provide useful information. Can be easily misinterpreted. Many firms window dress their financial statement to make them look better for credit analysis.

Sources and Uses of Funds

Is a Statement of changes in financial position (i.e. assets, equity & liabilities) Summarized all the new or additional Sources and Uses for investment purpose Questions:

Where did firms get its funds during the year? What did the firm do with available funds? How does operations affect firms assets and liabilities?

Sources and Uses of Funds

Funds Flow Statement

Combine changes in B/Sheet with other relevant financial figures (i.e. income statement) Funds inflow Sources Funds outflow Uses
Total Sources of Funds = Total Uses of Funds

Funds Flow Statement (cont..)

How to Identify Sources and Uses of Funds?

Sources of Funds

Uses Of Funds

Decrease in Asset Increase in Liability & Equity EAT/Net profit Depreciation

Increase in Asset Decrease in Liability &Equity Net loss from operations Dividend

Sources & Uses of Funds involve in Operations

Mekar Inc Bhd Balance Sheet as at 31 December 20X1 and 20X2 (RM'000) 20X1 20X2 Current Assets Cash 28 97 Marketable Securities 42 10 Account Receivable 93 128 Inventories 65 85 Total Current Assets 228 320 Fixed Assets Gross Fixed Assets less: depreciation Total Fixed Assets TOTAL ASSETS Current Liabilities Account Payable Notes Payable Accrued Expenses Total Current Liabilites Long Term Debt Common Equity Common Stock Paid in capital Retained Earnings TOTAL LIABILITIES AND EQUITY

887 226 661 889

1020 285 735 1,055

To Analyze the Balance Sheet, Two BS is required

64 20 95 179 297

95 87 75 257 318

140 108 165 889

160 120 200 1,055

Analyze Income Statement

Mekar Inc Bhd Income statement for the year ended 31 December 20X2 (RM'000) 20X2 Revenue/Net Sales 960 less: COGS 624 Gross Profit 336 less: Operating Expenses 167 Depreciation 19 Operating Income/EBIT 150 less: Interest Expenses 30 Earnings Before Taxes 120 less: Corporate Taxes 48 Net Income 72 less: Dividend 37 Retained Earnings 35

Dividend is Transferred to the Fund Flow Statement

BUT If there is no IS Div = EAT- (RE1+RE0)

Mekar Inc Bhd Analysis for Funds Flow Statement for the year ended 31 Dec 20X2 (RM'000) 20X1 20X2 X2-X1 S/U Current Assets Cash 28 97 69 U Marketable Securities 42 10 -32 S Account Receivable 93 128 35 U Inventories 65 85 20 U Total Current Assets 228 320 Fixed Assets Gross Fixed Assets less: depreciation Total Fixed Assets TOTAL ASSETS Current Liabilities Account Payable Notes Payable Accrued Expenses Total Current Liabilites Long Term Debt Common Equity Common Stock Paid in capital Retained Earnings TOTAL LIABILITIES AND EQUITY

887 226 661 889

1020 285 735 1,055

133 59

U S

64 20 95 179 297

95 87 75 257 318

31 67 -20

S S U

All the items in BS need to be subtracted, X2-X1 And then transfer To Funds Flow Statement Except Retained Earnings

21

140 108 165 889

160 120 200 1,055

20 12 35

S S NA

Mekar Inc Bhd Funds Flow Statement for the year ended 31 Dec 20X2 (RM'000) Sources of Funds Funds from operations EAT 72 a Depreciation 19 Total Funds from operations 91 Proceeds from the sale of: New long-term debt New common stock New paid in capital Total sources from long term funds Proceeds from changes of WC Sale in short-term securities Increase in acc payables Increase in notes payables Total sources from short-term funds Total sources of funds Uses of Funds Long-term uses of funds Net capital expenditureb Dividend Total uses of long-term funds Changes in WC Increase in cash Increase Account Receivable Increase in Inventories Decrease in misc liabilities Total uses of short-term funds

Depreciation: Extract from IS or (Take the difference in BS)

21 20 12 53

32 31 67 130 274

Parenthesis If there is no IS available

93 37 130

Net Capex: Net FA1 Net FA0+ Dep or (Gross FA1 Gross FA0 )

69 35 20 20 144