Financial Management 1 BBPW 3103

Chapter 2 Analysis of Financial Statement

Introduction

Financial statement summarize all company assets, liability and equity Financial statement also used to make analysis and future planning For example : To make investment, purchase of assets, to increase sales etc.

Annual Report and Users of Financial Statement

Annual report

Summarize all financial statement such as balance sheet, income statement, cash flow etc. Also consist of chairman and directors message Show the profit and company performance

Annual Report and Users of Financial Statement (cont.)

User of Financial Statement

Internal : Manager and other officer that operate the company External : Person that not directly involve in operation such as shareholders, investor, creditors and so on

Income Statement

Prepare in 2 way

There are a few aspects in an income statement

Monthly : For the usage of the management to make decision Quarterly : Prepare for shareholders Yearly : Prepare to public information based on Company Act 1965 format

Sales figure Gross profit / gross loss Company expenses Net profit / net loss

Income Statement (cont.)

There are an example of Income Statement

Balance Sheet

Balance sheet summarise a few item as follow:

Assets : Current and long-term Liability : Current and long-term Shareholder Equity

Balance Sheet (cont.)

Balance Sheet (cont.)

Balance Sheet (cont.)

Assets can divided into 2 types that is current assets and long-term assets (fixed assets) Current assets

Are assets that can be converted into cash in the shortest period high liquidation There are a few components in currents assets : Cash, marketable securities, account receivable, inventory, prepaid expenses and accrued revenue

Balance Sheet (cont.)

Long-Term Assets

Are assets that are hold by the company more than one year low liquidation Component of long-term assets : Fixed assets, other long-term assets (investment, long-term receivable etc) and intangible assets (cannot seen in physically such as patent, franchise licences etc)

Balance Sheet (cont.)

Liabilities

Debt for the company that use to finance the operation There are 2 types of liabilities that is

Current liabilities : Short-term debt that mature less than one year such as Account Payable, Notes Payable and Tax Accrual Long-term liabilities : Long-term debt that mature more than one year such as Bonds, Long-Term Notes Payable and Lease.

Balance Sheet (cont.)

Shareholders Equity

Refer to the shareholder claim towards the assets Components of equity : Preference Share, Ordinary Share, Paid Up Capital Above Par Value and Retained Earning

Summary of basic accounting is Asset = Liability + Equity

Statement of Retained Earning

Showed how the retained earnings account adjusted between two dates of the balance sheet

Cash Flow Statement

Shows how the investment, operating and financing influence cash and marketable securities Cash flow statement can assist finance manager to

Evaluate company capability to generate positive cash flow in future Evaluate company capability to settle debts, pay dividents and provide loans

Cash Flow Statement (cont.)

Cash flow statement consist 3 main activities

Operating Activities : Activities that related to the company such as production of product, sales, services etc Investment Activities : Related with buying and selling of long-term assets such as purchase of fixed assets, selling investment, buying stocks etc Financing Activities : Activities that related in both current and long-term liabilities such as repayment loan, short-term and long-term loan etc

Preparing Cash Flow Statement

Step 1 : Classify the data into 3 components Operating activities, investment activities and financing activities Step 2 : Identify cash inflow (revenue) and cash outflow (payment) Step 3 : Prepare Cash Flow Statement format Step 4 : Record the data into Cash Flow Statement. Identify which item increase and decrease

Example of Cash Flow Statement for Company FAZ as at 31 December 2002

Differentiating Cash Resources and Usage

Cash Resources Decrease in asset Increase in liability Net profit Depreciation Sale of share

Cash Usage Increase in Asset Decrease in liability Bet loss Payment of dividends Share buyback

Decrease in asset : Company sole the assets and get cash Increase in asset : Company buy the assets and flow out the cash

Differentiating Cash Resources and Usage (cont.)

Increase in liability : Company make loan @ credit transaction and get cash Decrease in liability : Payment of company debt and flow out the cash Depreciation : One of non-cash expenses components in an income statement. Need to add back in preparing cash flow

Table below show changes in the balance sheet item of Company FAZ for year ended 31 December 2001 and 2002

Financial Ratio Analysis

Financial ratio is method to analyze company performance and financial status by comparing the ratio with the other company or with the industry There are 5 categories of financial ratio

Liquidity ratio : Refer to the company ability to fulfill its short-term maturity claims or obligation Asset management ratio : refer to the efficiency of the company to use its assets and how fast specific accounts can be converted into sales or cash

Financial Ratio Analysis (cont.)

Leverage ratio : Refer to the level of debt usage and ability to fulfill its financial claims such as interest claims Profitability ratio : Refer to the effectiveness in generating return from investment and sales Market value ratio : Refer to the company ability to create market value in excess its investment costs.

Financial Ratio Analysis (cont.)

Finance manager have to consider following issues before preparing ratio analysis

A few types of ratio must be done to before the decision made Need to make comparisons with other company in the same industry or with industry Use the financial statement that have been audited Use the same method to evaluate items in the financial statement that will be compared

Financial Ratio Analysis (cont.)

Liquidity Ratio

Net Working Capital : The different between total current assets and total current liabilities. The higher NWC, the better for the company NWC = Current Asset Current Liability NWC for Company ABC is = RM122,300 RM62,000 = RM60,300 NWC Industry : RM42,700 The NWC for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Liquidity Ratio (cont.)

Current Ratio : Measures the company ability to fulfill its short-term loans using current assets. The higher ratio is better for the company CR = Current Asset Current Liability CR Company ABC is = RM122,300 RM62,000 = 1.97 times CR Industry : 2.05 times The CR for industry is better than Company ABC

Financial Ratio Analysis (cont.)

Liquidity Ratio (cont.)

Quick Ratio : Measure the company ability to pay its short-term debts quickly (didnt include inventory and prepayment). The higher ratio is better for the company QR = (Current Asset Inventory Prepayments) Current Liability QR for Company ABC is = (RM122,300 RM28,900) RM62,000 = 1.51 times QR industry : 1.43 times The QR for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Assets Management Ratio

Account Receivable Turnover: Measure the company ability to collect debts from customer. The higher ratio is better to the company ART = Credit Sales Account Receivable ART for Company ABC is = RM307,400 RM50,300 = 6.11 times ART Industry : 8.24 times The ART for industry is better than Company ABC

Financial Ratio Analysis (cont.)

Assets Management Ratio (cont.)

Average Collection Period : Showed the average days taken by company to collect the account receivable. The low days taken is better for the company ACP = 360 ART ACP for Company ABC is = 360 days 6.11 times = 58.92 days ACP Industry : 44.3 days The ACP for industry is better than Company ABC

Financial Ratio Analysis (cont.)

Assets Management Ratio (cont.)

Inventory Turnover : Measure the efficiency of inventory management. The higher IT is better to the company IT = Cost of Goods Sold Inventory IT for Company ABC is = RM208,800 RM28,900 = 7.22 times IT Industry : 6.6 times The IT for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Assets Management Ratio (cont.)

Average Inventory Sales Period : Show the number of days taken to make one round of inventory sales. The low of the ratio is better to the company AISP : 360 IT AISP for Company ABC is = 360 7.22 times = 49.86 days AISP Industry : 55.30 days The AISP for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Assets Management Ratio (cont.)

Fixed Assets Turnover : Show the company efficiency in using fixed assets to generate sales. The higher the ratio is better to the company FAT = Sales Net Fixed Assets FAT for Company ABC is = RM307,400 RM237,400 = 1.29 times FAT Industry : 1.35 times The FAT for industry is better than Company ABC

Financial Ratio Analysis (cont.)

Assets Management Ratio (cont.)

Total Assets Turnover : Measure company efficiency in using all assets to generate sales. The higher the ratio is better to the company. TAT = Sales Total Assets TAT for Company ABC is = RM307,400 RM359,700 = 0.85 times TAT Industry : 0.75 times The TAT for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Leverage Ratio

Debt Ratio : Measure the percentage of total assets are financed by debt. The lower the ratio is better to company DR = (Total Liability Total Assets) x 100 DR for Company ABC is = (RM164,300 RM359,700) x 100 = 45.7% DR Industry : 40.0% The DR for industry is better than Company ABC

Financial Ratio Analysis (cont.)

Leverage Ratio (cont.)

Debt-Equity Ratio : Measure the total long-term debts for each ringgit of equity. The lower the ratio is better to the company DER = (Long-Term Liability Equity) x 100 DER for Company ABC is = (RM102,300 RM195,400) x 100 = 52.4% DER Industry : 50.0% The DER for industry is better than Company ABC

Financial Ratio Analysis (cont.)

Leverage Ratio (cont.)

Equity Multiplier : Show the asset ownership for each ringgit of equity. The higher the ratio is better to the company EM = 1 (1 Debt Ratio) EM for Company ABC is = 1 (1 45.7%) = 1.84 times EM Industry : 1.67 times The EM for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Leverage Ratio (cont.)

Interest Coverage Ratio : Used to decide the number of times the company can repay all its interest expenses with the current income. ICR = Profit Before Interest & Tax Interest Expenses ICR for Company ABC is = RM41,800 RM9,300 = 4.49 times ICR Industry : 4.30 times The ICR for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Profitability Ratio

Gross Profit Margin : Measure the profit for each ringgit of sales that can be used to pay sales and admin expenses. The higher the ratio is better to the company GPM = (Gross Profit Sales) x 100 GPM for Company ABC is = (RM98,600 RM307,400) x 100 = 32.1% GPM Industry : 30.0% The GPM for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Profitability Ratio (cont.)

Net Profit Margin : Measure the company ability to generate net profit from each ringgit sales after deducting all expenses. The higher the ratio is better to company NPM = (Net Profit Sales) x 100 NPM for Company ABC is = (RM23,100 RM307,400) x 100 = 7.5% NPM Industry : 6.4% The NPM for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Profitability Ratio (cont.)

Operating Profit Margin : Measure operation efficiency in reducing cost and increasing return before interest and tax. The higher the ratio is better to the company OPM = (Operating Profit Sales) x 100 OPM for Company ABC is = (RM41,800 RM307,400) x 100 = 13.6% OPM Industry : 10.0% The OPM for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Profitability Ratio (cont.)

Return On Asset : Measure company effectiveness in using its assets to generate profit. The higher the ratio is better to the company ROA = (Net Profit Total Asset) x 100 ROA for Company ABC is = (RM23,100 RM359,700) x 100 = 6.42% ROA Industry : 4.80% The ROA for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Profitability Ratio (cont.)

Return On Equity : Measure company efficiency to generate profit for its ordinary share. ROE = (Net Profit Equity) x 100 ROE for Company ABC is = (RM23,100 RM195,400) x 100 = 11.8% ROE Industry : 8.0% The ROE for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Profitability Ratio (cont.)

Earning Per Share : Measure net profit generated from each ordinary share. The higher the ratio is better to shareholders EPS = Profit Available to Ordinary S/H Number of Ordinary Share Issued EPS for Company ABC is = RM22,100 76,262 units = RM0.29 EPS Industry : RM0.26 The EPS for shareholders Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Market Value Ratio

Price Earning Ratio : Shows the total ringgit that investor willing to pay for each ringgit of profit reported by the company. The higher the ratio, the higher confidence of the investor towards the company future PER = Market Price Per Share EPS PER for Company ABC is = RM3.23 RM0.29 = 11.1 times PER Industry : 1.25 times The PER for Company ABC is better compare to industry

Financial Ratio Analysis (cont.)

Market Value Ratio (cont.)

Dividend Yield Ratio : Measure the rate of dividend return received from a share investment DYR = (Dividend Per Share Market Price Per Share) x 100 DVR for Company ABC is = (RM0.15 RM3.23) x 100 = 4.6%

Conducting a Complete Ratio Analysis

There are 2 methods to conduct ratio analysis

DuPont Analysis : Looks at the main section that contribute to the company financial performance Summary of Financial Ratio Analysis : Looks at all Financial aspects

DuPont Analysis

Used to evaluate financial status that combines income statement and balance sheet to measure company probability Step 1 : Analyze ROA ROA = Net Profit Margin x Total Asset Turnover = (Profit After Tax Sales) x (Sales Total Assets) = 7.5% x 0.85 times = 6.4%

DuPont Analysis (cont.)

In DuPont analysis, Net Profit Margin used to measure the profitability of sales and Total Assets Turnover used to measure company efficiency in using assets to generate sales In this analysis, company can evaluate two different components that is the profit on sales and efficiency in asset management

DuPont Analysis (cont.)

Step 2 : Analyze ROE ROE = ROA x Equity Multiplier = (Profit After Tax Total Asset) x (Total Assets Total Equity) = 6.4% x 1.84 times = 11.8% The value is same that calculate before

DuPont Analysis (cont.)

By using DuPont Analysis, finance manager can evaluate 3 different components

Profit on sales Efficiency of assets management Effect of using debts in funding assets

Summarizing All Financial Ratio

Used 5 categories of ratio to evaluate company performance that is

Liquidity ratio Asset management ratio Leverage ratio Profitability ratio Market value ratio

Weaknesses In Financial Ratio

The accuracy of the financial ratio depends on the accuracy of the data found in the financial statement By using the financial ratio for industrial comparison purposes, the users must take into consideration that the industry ratio is only rough estimate Financial ratio is relative measurement and does not show the actual size of the firm Financial ratio id used to measure the status of the firm but it can not show the issue that had caused the situation