R-B-Ch.10 Points to Refresh

Major Financial Statements

Corporate shareholder annual and reports must include

Balance sheet
Income statement
Statement of cash flows

Reports filed with Securities and Exchange Commission (SEC)
10-K and 10-Q


Generally Accepted Accounting Principles (GAAP)

In USA formulated by the Financial Accounting Standards Board (FASB)
In India, Institute of Chartered Accountants.
Provides some choices of accounting principles
Financial statements footnotes must disclose which accounting principles are used by the firm


Balance Sheet

Shows resources (assets) of the firm and how it has financed these resources

Indicates current and fixed assets available at a point in time

Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity

Income Statement

Indicates the flow of sales, expenses, and earnings during a time period.

Statement of Cash Flows

Integrates the information on the balance sheet and income statement

Shows the effects on the firm’s cash flow of income flows and changes in various items on the balance sheet

It has three sections:

Cash Flow from Operating Activities – the sources and uses of cash that arise from the normal operations of a firm
Cash Flow from Investing activities – change in gross plant and equipment plus the change in the investment account
Cash Flow from Financing activities– financing sources minus financing uses

Alternative Measures of Cash Flow

While the cash flow statement and its format are of recent origin, investment community was using certain other concepts of cash flow earlier. Also some other concepts of cash flow are being used by analytical models and investors/analysts.

Traditional cash flow equals net income plus depreciation expense and deferred taxes

Free cash flow recognizes that some investing activities are critical to ongoing success of the firm. hence deducts the capital expenditure required to sustain the current operations from the cash flow.


Purpose of Financial Statement Analysis

Evaluate management performance in three areas by current investors and creditors:

Profitability
Efficiency of operations
Risk

Evaluate company performance in three areas by potential equity investors and lenders:
Profitability
Efficiency of operations
Risk


Information from the Financial Statements

One can the amount of sales in year, profit made in a year, the size of balance sheet, the amount debt carried etc. from a single balance sheet and profit and loss statement.

But ratios contain some more information. Some authors mention that they are more valuable than raw numbers.

Ratios provide meaningful relationships between individual values in the financial statements

Importance of Relative Financial Ratios

Compare to other entities
Examine a firm’s performance relative to:
-The aggregate economy
-Its industry or industries
-Its major competitors within the industry
-Its past performance (time-series analysis)

Five Categories of Financial Ratios

1. Internal liquidity (solvency)
2. Operating performance
a. Operating efficiency
b. Operating profitability
3. Risk analysis
a. Business risk
b. Financial risk
4. Growth analysis
5. External liquidity (marketability)


Common Size Statements

Normalize balance sheets and income statement items to allow easier comparison of different size firms
A common size balance sheet expresses accounts as a percentage of total assets
A common size income statement expresses all items as a percentage of sales

These statements very useful for forecasting future profit and loss account.

Evaluating Internal Liquidity

Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations
Current Ratio examines current assets and current liabilities
Quick Ratio adjusts current assets by removing less liquid assets
Cash Ratio is the most conservative liquidity ratio
Receivables turnover examines the quality of accounts receivable
Receivables turnover can be converted into an average collection period
Inventory turnover relates inventory to sales or cost of goods sold (CGS)
Average inventory processing time can be computed from Inventory turnover.
Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover

Evaluating Operating Performance

Ratios that measure how well management is operating a business
(1) Operating efficiency ratios
Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories
(2) Operating profitability ratios
Analyze profits as a percentage of sales and as a percentage of the assets and capital employed

Operating efficiency ratios

Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets).- Net sales/net total assets.
Net fixed asset turnover reflects utilization of fixed assets - net sales/net fixed assets

Operating profitability ratios

Gross profit margin measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold)