Understanding Financial Statements. Elizabeth Rankin

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1 Understanding Financial Statements Elizabeth Rankin

2 Overview Accounting Concepts Principles Financial Statements Evaluating Performance Horizontal Analysis Vertical Analysis Ratio Analysis

3 Entity Concept Accounting draws a boundary around each organization to accounted for

4 Going Concern Concept Accountants assume the business will continue operating for the foreseeable future

5 Stable Monetary Unit Concept Accounting information is expressed primarily in monetary terms

6 Time period concept Ensures that accounting information is reported at regular intervals

7 Conservatism concept Accountants report items in the financial statements in a way that avoids overstating assets, owner s equity and revenues and avoids understating liabilities and expenses.

8 Materiality Concept Accountants perform strictly proper accounting only for items that are significant to the company s financial statements.

9 Reliability principle Accounting records and statements are based on the most reliable data available

10 Cost principle Assets and services, revenues and expenses are recorded at their actual historical cost.

11 Revenue Principle Tells accountants when to record revenue (only after it has been earned) and the amount of revenue to record (the cash value of what has been received).

12 Matching Principle Directs accountants to: 1. Identify all expenses incurred during the period 2. Measure the expenses, and 3. Match the expenses against the revenues earned during the period. The goal is to measure net cincome

13 Consistency Principle Businesses should use the same accounting methods from period to period

14 Disclosure Principle A company s financial statements should report enough information to outsiders to make informed decisions about the company.

15 Balance Sheet Now called Statement of Financial Position Assets = Liabilities + Owner s Equity at a point in time

16 Balance Sheet - continued Off Balance Sheet financing acquisition of assets or services with debt that is not reported on the balance sheet. Example an operating lease Much useful information is reported only in the notes, so initiated study them carefully.

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18 Income Statement Commonly called the Profit & Loss Statement. Now called the Statement of Financial Performance Revenues and gains - Expenses and losses = Net income or net loss for the period

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20 Statement of Cash Flows Cash receipts - Cash payments = Increase or Decrease in cash during the period, grouped under operating, investing and financing activities.

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22 Financial Statement Analysis Financial statement analysis focuses on the techniques used by internal manager and by analysts external to the organisation. A major source of their information is the annual report. In addition to the financial statements the annual report usually contain: 1. Notes to the financial statements 2. A summary of the accounting methods used 3. Managements discussion and analysis of the financial results 4. The auditor s report 5. Comparative financial data for a series of years

23 Objectives of Financial Statement Analysis Creditors are most concerned with assessing short-term liquidity and long term solvency. Short term liquidity is the organisation s ability to meet current payments as they come due. Long term solvency is the ability to generate enough cash to pay long term debts as they mature Investors are more concerned with profitability, dividends and future share prices.

24 Evaluating Performance The tools and techniques used to evaluate company performance can be divided into 3 broad categories: Horizontal analysis Vertical analysis Ratio analysis

25 Horizontal Analysis The study of percentage changes in comparative statements is called horizontal analysis. Horizontal analysis highlights changes in an item over time. Increase (Decrease) Change Percent Sales $ 1,208,899 $ 854,595 $ 354, % Net Income -$ 592,551 -$ 25,314 -$ 567, %

26 Horizontal Analysis - continued Trend Percentages are a form of horizontal analysis. Trends are important indicators of the director a business is heading. How have the sales changed over a 5 year period Net Sales $ 5,840,095 $ 5,110,420 $ 3,756,328 Employee expense $ 1,507,093 $ 1,663,254 $ 1,409,609 Net profit before tax -$ 391,564 $ 207,831 $ 240, Net Sales 155% 136% 100% Employee expense 107% 118% 100% Net profit before tax -163% 86% 100%

27 Vertical Analysis Vertical analysis reveals the relationship of each statement item to a specified base, which is the 100% figure. Every item of the financial statement is reported as a percentage of that base Amount Percent Amount Percent Revenues $ 5,840, % $ 5,110, % Employee expense $ 1,507, % $ 1,663, % Subcontractor expense $ 254, % $ 403, % Purchases $ 2,207, % $ 991, % Change in inventory -$ 26, % $ 16, % Consumables $ 332, % $ 460, % Marketing $ 103, % $ 77, % Fleet operation $ 85, % $ 152, % Occupancy costs $ 123, % $ 80, % Other expenses $ 1,385, % $ 807, % EBITDA -$ 132, % $ 456, % Depn & Amort $ 213, % $ 197, % Borrowing costs $ 45, % $ 51, % Profit before tax -$ 391, % $ 207, % Income tax $ 61, % $ 30, % Profit after tax -$ 452, % $ 177, %

28 Vertical Analysis - continued The percentages shown in the example before can be presented as a separate statement that only reports percentages (no dollar amounts). Such a statement is called a common size statement Percent Percent Revenues 100.0% 100.0% Employee expense 25.8% 32.5% Subcontractor expense 4.4% 7.9% Purchases 37.8% 19.4% Change in inventory -0.5% 0.3% Consumables 5.7% 9.0% Marketing 1.8% 1.5% Fleet operation 1.5% 3.0% Occupancy costs 2.1% 1.6% Other expenses 23.7% 15.8% EBITDA -2.3% 8.9% Depn & Amort 3.7% 3.9% Borrowing costs 0.8% 1.0% Profit before tax -6.7% 4.1% Income tax 1.0% 0.6%

29 Ratio Analysis An important part of financial analysis is the calculation and interpretation of ratios. A ratio expresses the relationship of one number to another number.

30 Ratio Analysis - continued Ratios can be classified as follows: 1. Ratios that measure the company s ability to pay current liabilities 2. Ratios that measure the company s ability to sell inventory and collect receivables 3. Ratios that measure the company s ability to pay short-term and long-term debt 4. Ratios that measure the company s profitability 5. Ratios used to analyze the company s shares as an investment.

31 Working Capital Working capital = current assets current liabilities Working capital is widely used to measure a business s ability to meet its short-term obligations with its current assets. Two decision making tools based on working capital data re current ratio and the acid test ratio =

32 Current Ratio The current ratio measures the company s ability to pay current liabilities with current assets. Current ratio = current assets current liabilities Current assets consist of cash, short term investments, net receivables, inventory and prepaid expenses. Current liabilities include accounts payable, bank overdraft, unearned revenues and all types of accrued liabilities =

33 Acid test ratio The acid test ratio or quick ratio tells us whether the company could pay all its current liabilities if they came due immediately. Quick ratio = cash + net receivables + investments current liabilities Inventory and prepaid expenses are not included because they are the least liquid of the current assets = =

34 Inventory turnover ratio cost of goods sold average inventory Indicated the saleability of inventory the number of times a company sells it average inventory level during a year Inventory turnover rates vary widely with the nature of the business = = ( )/

35 Accounts Receivable Turnover Ratio Measures a company s ability to collect cash from credit customers. Ratio indicates how many times during the year the average level of receivables is turned into cash. = net credit sales average net accounts receivable = = ( )/

36 Day s sales in receivables Indicates how many days sales are in receivables = average net accounts receivable (net sales divided by 365) ( )/2 = = /

37 Debt ratio The ratio of total liabilities to total assets Indicates the proportion of the company s assets it has financed with debt. = total liabilities total assets =

38 Times interest earned ratio Or interest coverage ratio Relates income to interest expense Measures the number of times that operating income can cover interest expense Income from operations = income before tax plus interest expense = Income from operations Interest expense =

39 Return on net sales ratio Calculates the percentage of each sales dollar earned as net income Companies strive for a high rate of return. = net income net sales =

40 Return on Assets The rate of return on total assets measures a company s success in using its assets to earn income for the persons who are financing the business. measure of profitability. Rate of Return Net Interest on total =income + expense assets Average total assets What is a good rate of return on total assets? There is no single answer to this question because rates of return vary widely by industry = = ( )/

41 Return on Equity Shows the relationship between net income and average ordinary equity. Rate of return Net income Pref Div on equity = Avg ordinary equity Return on equity should exceed return on assets. Interest expense should always be lower than the amount the earned from investments = = ( )/

42 Earnings per share Most widely quoted of all financial statistics EPS is the amount of net income per ordinary share = net income preference shares number of issued ordinary shares =

43 Price/Earnings ratio Ratio of the market price of an ordinary share to the company s earnings per share Otherwise knows as the P/E ratio The higher a share s P/E ratio the high its downside risk the risk that the share s market price will fall. = market price of ordinary share Earnings per share

44 Dividend yield Ratio of dividends per share to the market price per share Measures the percentage of a share s market value that is returned annually as dividends

45 Book value per share Indicates the recorded accounting amount of each share It bears no relationship to the market value Value investors use this ratio as contrasted to growth investors who focus on trends in a company s net income =

46 Limitations of Financial Analysis Business decisions are made in a world of uncertainty It s a bit like the thermometer a reading of 39ºC indicates that something is wrong with the patient, but the temperature alone does not indicate what the problem is or how to cure it. Only by analyzing the individual items that make up the ratio can you determine how to solve the problem.