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MODULE 2
Tab 2.1 Bartlett Co. Income Statements ($ 000) for the year ending Dec.31
2005
Sales revenue Less: Cost of goods sold Gross profits Less : Operating expenses Selling expenses General & admin expenses Lease expense Depreciation expense Total operating expense Operating profits Less: Interest expense Net profits before taxes Less: Taxes (rate = 29%) Net profits after taxes Less: Preference Dividends Earnings available for ordinary shareholders Earnings per share Dividends per share
2004
$3074 2088 _856 $100 $2567 1711
986
Tab 2.2
Assets Current assets Cash Marketable securities Accounts receivable Inventories Total current assets Non-current assets (at cost) Land & buildings Machinery & equipment Furniture & fixtures Vehicles Other (include financial leases) Total gross fixed assets (at cost) Less: Accumulated depreciation Net fixed assets Total assets
$288
2005
2004
Shareholders equity Preference shares cumulative 5%, $100, 2000 shares issued $200 Ordinary shares- Shares issued 2005: 76262 in 2004:76244 619 Retained earnings 1135 Total shareholders equity $1954 Total liabilities and shareholders equity $3597
Tab 2.3 Bartlett Company Statement of Cash flows ($000) for the year 31/12/05
Cash flows from Operating Activities Net profit after taxes Depreciation Increase in accounts receivable Decrease in inventories Increase in accounts payable Increase in accruals Cash provided by operating activities Cash flow from Investing activities Increase in gross non-current assets Change in business interests Cash provided by investing activities $231 239 (138)* 11 112 45 $500
(347) 0 (347)
Cash flow from Financing activities Decrease in notes payable ( 20) Increase in non-current debts 56 Changes in shareholders equity* 11 Dividends paid (108) Cash provided by financing activities Net increase in cash and marketable securities
Interested parties
The financial statements ratio analysis is of interest to shareholders, creditors, and the firm s management. i) Both present and prospective shareholders are interested in the firm s current and future level of risk and returns that directly affect the share price. ii) Creditors are interested in the short-term liquidity of the company and its ability in making the interest and principal payments. Their concern is also the firm s profitability, they want the business to be healthy and that will continue. iii) Management like shareholders, must be concerned with all aspects of the firm s financial situation. So they must operate in a manner that will result in financial ratios that will be considered favorable by both owners and creditors. They use ratios to monitor firm s performance from period to period.
Misleading Ratios Many people mistakenly believe that in the case of ratios for which higher values are preferred as long as the firm being analyzed has a value in excess of industry average, it can be viewed favorably. The bigger the better view can be misleading. Often a ratio that has a large but positive deviation from the norm can be indicative of problems. These may on more careful analysis be more severe than had the ratio been below the industry average.Refer example p47 ii) Time-series analysis This is applied when a financial analyst evaluates performance over time. Comparison of current with past performance, using ratio analysis, allows the firm to determine whether it is progressing as planned. Developing trends can be seen over multi-year comparisons.. As in cross-sectional analysis, any significant year to-year changes can be evaluated to assess whether there are any major problems.
Combined Analysis
The combined cross-sectional and time-series analysis are the most informative approach to ratio analysis. This permits assessment of the trend in behavior of the ratio in relation to the trend for the industry.
Cautions about using ratio analysis i) Ratios with large deviations from the norm only indicate symptoms of problem. Additional analysis needed to find out the causes of the problem. ii) A single ratio does not necessarily provide sufficient information from which to judge the overall performance of the firm. iii) The ratios compared should be calculated using the financial statements dated at the same point of time during the year, if not it may produce erroneous conclusions and decisions. iv) It is preferred to use audited financial statements for ratio analysis, if not they might not reflect the true financial situation.
v) The financial data compared should have developed in the same way. Use of different accounting treatment for inventory and depreciation can distort figures. vi) Results could be distorted by inflation, which cause the book values of inventory and depreciable assets to differ greatly from their true (replacement values).
1) Liquidity Ratios
The liquidity ratios are measured by its ability too satisfy its short term obligations as they come due. Liquidity refers to the solvency of the firm s overall financial position. These ratios are viewed as liquidity are the current ratio and the quick (acid-test) ratio. a) Current Ratio one of the most commonly cited financial ratios, measures the firm s ability to meet its short-term obligations and expressed as follows:
2. Activity Ratios
Activity ratios measure the speed with which various accounts are converted into sales or cash- inflows or outflows. Measures of liquidity are inadequate because differences in the composition of a firm s current assets and current liabilities can significantly affect its true liquidity. It is important to look beyond measures of overall liquidity to assess the activity of specific current accounts. A no. of ratios are available for measuring the activity of current accounts, inventory, accounts receivable and accounts payable. The efficiency with which total assets are used can also be assessed. The activity ratios involving the current accounts assume that their end-of period values are good approximations of the average account balance during the period, which is one year.
a) Inventory Turnover
This commonly measures the activity, or liquidity of a firm s inventory. It is calculated as follows : Inventory turnover = cost of goods sold inventory Applying this to Bartlett in 2005 = $2,088,000 = 7.2 $289,000 The resulting turnover is meaningful only if it is compared with that of other firm in the same industry, or the firm s past inventory turnover. Inventory turnover can easily be converted into an average age of inventory by dividing it into the no. of days. e.g. 360 days for a 12 month of 30 days. For Bartlett, this would be 50.0 days (360/7.2). This value can also be viewed as the average no. of days
3. Debt Ratios
The debt position of the firm indicates the amount of other people s money being used in attempting to generate profits. The financial analyst is most concerned with non-current debts, because these commit the firm to paying interest over the long term, as well as eventually repaying the principal borrowed. The claims of creditors must be satisfied prior to the distribution of earnings to shareholders. Shareholders pay special attention to the degree of indebtedness and ability to repay the debts. Lenders and Management are also concerned with the firm s indebtness. The more debt a firm uses in relation to its total assets, the greater its financial leverage. Financial leverage is the risk and return introduced through the use of fixed cost financing such as a debt.
i)
Debt ratio
The debt ratio measures the proportion of total assets financed by the firm s creditors. The higher this ratio, the greater the amount of other people s money being used in an attempt to generate Portfolio. The ratio is calculated : Debt ratio = Total liabilities Total assets Applying to Bartlett in 2005 is : $1,643,000 = 0.457 = 45.7% $3,597,000 This indicates that the company has financed 45.7 % of its assets with debt. The higher the ratio, the more financial leverage a firm has.