MS4004: Statement

Analysis

Dr. K. D. N. Kumari
Financial Statement Analysis 1
Main objectives of a business
organization
Survival

Sales Revenue maximization

Profit

Growth

Increase the shareholders value

MS4004: Statement Analysis 2
Survival
• During early stage
of the business
• When trading
becomes difficult
• Threat of takeover

MS4004: Statement Analysis 3

• Three different ways of representing
the financial state of a company: Financial Status of
• Cash Management (can the
company meet its obligations?)
a company
• Profitability (Is it making money?) -
the income statement
• Assets versus Liabilities (what is the
value of the company? Who owns
what?) - the balance sheet
• Each one of these questions is
answered by the Financial
Statements.

Financial Statement Analysis

Introductio
n to
Financial
Statements

Financial Statement Analysis 5

Objectives
• At the end of this session, you should be able to:
 Explain the contents of the balance sheet.
 Describe the contents of the statement of profit and loss
 Derive the statement of cashflows from the balance sheet and the
statement of profit and loss.
 Distinguish between profit and cash flow.

Financial Statement Analysis 6

 The Big Three

Cash Flow Statements Income Statements Balance Sheets

These answer the important This is the financial sheet that tells How much debt do I have? How
managerial question “do I have you if your company is profitable or large are my assets? This sheet tells
enough cash to run my business” not. you the answer to these questions.
 Balance Sheet
• Financial statement showing a firm’s
accounting value on a particular date.
• It is a convenient means of organizing
and summarizing what a firm owns (its
assets), what a firm owes (its liabilities),
and the difference between the two (the
firm’s equity) at a given point in time.
• Assets are listed in order of decreasing
liquidity
• Ease of conversion to cash without
significant loss of value

Financial Statement Analysis 8

Balance Sheet
• As shown, the left side lists the assets of the firm, and the right side lists the
liabilities and equity.
Total value of liabilities and
Time value of Assets Net shareholder’s equity
working
capital Current Liabilities
Current Assets
Long-term dept

Fixed Assets
1. Tangible Fixed Assets Shareholder’s equity
2. Intangible Fixed Assets

Financial Statement Analysis 9

 The left side: Assets

Current asset Fixed asset :

• has a life of less than one year. • is one that has a relatively long life.
This means that the asset can be Fixed assets
convert to cash within 12 months. Tangible
Examples: assets are Tangible Intangible
physical
• Inventory: normally be purchased and
sold within a year . Vehicles
• Cash itself is a current asset.
• Accounts receivable (money owed to the Computer,
firm by its customers) are also current machineries
assets.
• Long term loans and advances: loans and
advances for a period of more than one
Financial Statement Analysis
year 10
Financial Statement Analysis 11
 The Right Side: LIABILITIES AND
OWNERS’ EQUITY
• The firm’s liabilities:
• These are classified as either current or long-term.
• Current liabilities, like current assets, have a life of less than one year (meaning
they must be paid within the year) and are listed before long-term liabilities.
• Example : Accounts payable (money the firm owes to its suppliers).

• Long-term liability : A debt that is not due in the coming year

• A loan that the firm will pay off in five years is one such long-term debt. Firms borrow in the
long term from a variety of sources. We will tend to use the terms bond and bondholders
generically to refer to long-term debt and long-term creditors, respectively.

Financial Statement Analysis 12

The Right Side: LIABILITIES AND
OWNERS’ EQUITY
• Shareholders’ equity (Owner’s equity)
 is the difference between the total value of the assets (current and
fixed) and the total value of the liabilities (current and long-term)
 Generally included : share capital
Reserves and Surplus
• The Balance Sheet Identity

Assets = Liabilities + Stockholder’s equity

Financial Statement Analysis 13
U.S. Corporation Balance Sheet
Table 1.1
Activity 01
Download an annual
report and select a
balance sheet. Then
convert it to a
simplified balance
sheet.

14
 Net Working Capital (NWC)
Net Working Capital ( NWC) = Current Asset ( CA ) − Current Liability ( CL)
• The difference between a firm’s current assets and its current liabilities is
called net working capital.
• NWC is positive when current assets exceed current liabilities.
• Based on the definitions of current assets and current liabilities, this means the cash
that will become available over the next 12 months exceeds the cash that must be
paid over the same period.
• For this reason, net working capital is usually positive in a healthy firm.
• in a healthy company.

Financial Statement Analysis 15

Building the Balance Sheet
• Example: A firm has,
• Current assets of $100 Total assets = $100 + 500 =$600
• Net fixed assets of $500 Total liabilities = $70 + 200 =$270
• Short-term debt of $70 Shareholders’ equity = $600 – 270 =$330
• Long-term debt of $200.
• What is shareholders’ equity?
• What does the balance sheet look like?
• What is net working capital?

Financial Statement Analysis 16

Building the Balance Sheet

• Example: A firm has,

• Current assets of $100
• Net fixed assets of $500
• Short-term debt of $70
• Long-term debt of $200.

Financial Statement Analysis 17

• The balance sheet would look like this:

• Net working capital

Financial Statement Analysis 18

• The assets on the balance sheet are listed in order of the length of time it
takes for them to convert to cash in the normal course of business.
• Similarly, the liabilities are listed in the order in which they would
normally be paid.
• The structure of the assets for a particular firm reflects,
• the line of business the firm is in
• Managerial decisions about how much cash and inventory to have
• Managerial decisions about credit policy, fixed asset acquisition, and so on.
• The liabilities side of the balance sheet primarily reflects
• managerial decisions about capital structure and the use of short-term debt.

Financial Statement Analysis 19

Analysis of Balance Sheet

• There are three particularly important things to keep in mind when

examining a balance sheet:
• Liquidity
• Debt versus equity
• Accounting (Book) value versus Economic(Market) value.

Financial Statement Analysis 20

Liquidity
• Liquidity refers to the speed and ease with which an asset can be
converted to cash.
• Gold is a relatively liquid asset; real estate is not.
• Liquidity has two dimensions: ease of conversion of cash versus loss of
value.
• A highly liquid asset is therefore one that can be quickly sold without
significant loss of value.
• An illiquid asset is one that cannot be quickly converted to cash without
a substantial price reduction.

Financial Statement Analysis 21

• Assets are normally listed on the balance sheet in order of decreasing
liquidity, meaning that the most liquid assets are listed first.
• Current assets: are relatively liquid and include cash and assets we expect
to convert to cash over the next 12 months.
• Fixed assets: are, for the most part, relatively illiquid.
• These consist of tangible assets : buildings and equipment that don’t convert to cash
at all in normal business activity (they are, of course, used in the business to
generate cash).
• Intangible assets: a trademark, have no physical existence but can be very valuable.
Like tangible fixed assets, they won’t ordinarily convert to cash and are generally
considered illiquid.

Financial Statement Analysis 22

Debt versus Equity
• Shareholders’ equity is defined as this residual portion.
Shareholders’ equity = Assets – Liabilities
• The use of debt in a firm’s capital structure is called financial
leverage.
• The more debt a firm has (as a percentage of assets), the greater is
its degree of financial leverage.
We will discuss this in detail at Return on equity later

Financial Statement Analysis 23

 Book value VS Market value
• The balance sheet provides the book value of the assets,
liabilities, and equity.
• Market value is the price at which the assets, liabilities, or
equity can be bought or sold.
• Market value and book value are often very different.
• Which is more important to the decision-making process?

Financial Statement Analysis 24

Statement of Profit and Loss

Financial Statement Analysis 25

Statement of Profit and Loss/ Income Statement
• An income statement will contain the following basic elements:
1.Revenues(Sales)
2.Expenses
 Cost of goods sold, Interest expenses, SGA (selling, general and
administrative) expense, depreciation expense, Income tax expense
3.Profits
 Gross profit, net operating income (also known as EBIT), earnings before
taxes (EBT), and net income (Profit after tax)
• The net change in owners’ equity during an accounting period,
called as profit after tax.
• 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥=𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠−𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Financial Statement Analysis 26
• The first thing reported on an income statement would usually be revenue
and expenses from the firm’s principal operations.
• Subsequent parts include, among other things: financing expenses such as
interest paid.
• Taxes paid are reported separately.
• The last item is net income (the so-called bottom line).

Financial Statement Analysis 27

 Elements of an Income Statement
• Revenue • Operating expenses
• Sales is the earnings from the sale of goods or • Overhead or cost incurred in operating a business:
the performance of service Selling expenses, General and Administrative expenses,
• Sales return and allowances is the refunds or Depreciation expense
adjustments for unsatisfactory merchandise or • Operating Profit =Gross Profit-Operating expenses
service
• Other Income
• Expenses
• Earnings before Interest and tax(EBIT)= Operating profit
• Cost of goods sold
+other income
• Cost to the business for merchandise or
goods sold • Interest Expense
• Calculated as beginning inventory + • Earnings before taxes (EBT)= (EBIT)- Interest Expense
purchases – ending inventory = cost of
• Taxes (Income Taxes)
goods sold
• Gross profit on sales • Net income (EAT)= Earnings before taxes (EBT)- Taxes
• The difference between the net sales and the
cost of goods sold

EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes
Example: Global Petroleum Corporation Income Statement
 What is the bottom line of the Global
Petroleum’s corporation in year 2007?

 What can the firm do with the net

income?

 What are the elements available in this

Income Statement other than to discussed
elements?

Retained earnings

𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠= 𝑁𝑒𝑡𝑖𝑛𝑐𝑜𝑚𝑒− 𝐶𝑎𝑠h 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

The difference between net income and cash
dividends, is the addition of retained earnings for
the year.

This amount is added to the cumulative retained earnings

account on the balance sheet
29
 Calculating Earnings and Dividends per Share
• Net income is often expressed on a per-share basis and called earnings per share (EPS).
• If Global Petroleum’s corporation had 179 million common shares outstanding at the end of 2007. Based on the income statement , what was EPS? What were
dividends per share?
•
Total Common shares =179 millions
Net income = $949 millions
Preferred stock dividend= $3 millions
Earning for common stockholders=$ 949millons- $3 millions=$946 millions
• EPS= $ 946 million /179million= $5.29per share
• Dividend per share is the total amount of declared dividends for every share of common stock issued. Dividend per share can be calculated using the following
formula:

Total Common shares =200 millions

Total dividends for common stocks= $345 millions
Dividends per share = $345 million/200 million = $1.93 per share

Financial Statement Analysis 30

Statement of Cash Flow

Financial Statement Analysis 31

 Cash Flow Statements
• A report of all a firm’s transactions that involve cash
• The key elements are revenues (money flowing in) and expenses (money
flowing out).
• Cash flow statements compare the sum of the revenues to the sum of the
expenses on a regular time basis – usually monthly.
 What are Revenues?
• Sales
• Interest from firm’s investments (e.g., a company savings account)
• Royalty and Licensing payments for appropriate use of firm’s intellectual
property

Another source of cash inflow, but not a revenue is the cash the firm
receives from borrowing money.
 What are Expenses?

There are two types of expenses:

FIXED COSTS
and
VARIABLE COSTS
 Fixed Costs
Things that do not depend on number of units produced.
• Rent payments
• Salaried employees
• Capital Investments and (some) maintenance
• Utilities (phone, water, electric, etc)
• Insurance
• Taxes (on property, plant, and equipment)
• Advertising (*)
Variable Costs
Things that depend on the number of units produced (e.g. royalties paid)
• Materials Cost
• Supplies
• Production Wages
• Outside / Contracted labor
• Advertising (*)
• Sales Commissions / Distribution Costs
• Equipment Maintenance
 Accounting Profit vs. Cash Flow
• Accounting Profit based on accrual principle and
matching principle.
• Profit and Cash Flow are not the same thing

• Finance emphasizes the importance of timing

of cash flow matters.
• “You can’t deposit net income, only cash”
• Accrual accounting may obscure timing.
37
 Example
• In period 1, a firm produces goods that cost 150,000;in period 2 it sells the
goods for 200000 on credit; in period 3 it collects receivables. The profit and
cash flow for the three periods are shown below:

Period 1 Period 2 Period 3

1. Sales 0 200,000 0
2. Change in accounts receivable 0 200,000 (200,000)
3. Cost of goods sold 0 150,000 0
4. Change in inventories 150,000 (150,000) 0
5. Profit 1-3 0 50000 0
6. Cash inflow 1-2 0 0 200,000
7. Cash outflow 3+4 150,000 0 0
8. Net cash flow6-7 (150,000) 0 200,000

𝑃𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡
𝐶𝑎𝑠 h𝐶𝑎𝑠 =
𝑖𝑛𝑓 h𝑙𝑜𝑤𝑆𝑎𝑙𝑒𝑠
𝐹𝑙𝑜𝑤= Cost−
𝐶𝑎𝑠
=𝑆𝑎𝑙𝑒𝑠 𝐶𝑜𝑠𝑡 𝑜𝑓
h 𝑖𝑛𝑓𝑙𝑜𝑤−
−
of 𝐴𝑐𝑐𝑜𝑢𝑛𝑡
Goods 𝐶𝑎𝑠𝐺𝑜𝑜𝑑𝑠
h 𝑜𝑢𝑡𝑓𝑙𝑜𝑤
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
Financial Statement Analysis 38
Net Cash Flow
• When look at the statement of profit and loss, the emphasis was on profit
after tax( also known as bottom line).
• In finance, however the focus is on cash flow.
• The firms’ cash flow generally differs from its profit after tax because some
of the revenues/expenses shown on its statement of profit and loss may not
have been received / paid in cash during the year.
• The relationship between net cash flow and profit after tax is ,

Financial Statement Analysis 39

 • Non-Cash Revenue : accrued income that has not yet been received cash.
• Non-Cash Expense : Depreciation
• In practice, analysts generally define the net cash flow as:
𝑁𝑒𝑡 𝐶𝑎𝑠h 𝐹𝑙𝑜𝑤= 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛+ 𝐴𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛
• However, note that the above expression will not reflect net cash flow
accurately if there are significant noncash items beyond depreciation and
amortization.

Financial Statement Analysis 40

 Statement of Cash Flow
• From a financial point of view, a firm basically generates cash and spends cash,
• The activities which generate Cash are called Sources of Cash
• Examples : issues securities, raises bank loan, sells a product, disposes an asset
• The activities that absorb cash are called Uses of Cash
• Examples : redeems securities, pay interest and dividends, purchases materials, acquires an asset.
Sources of Cash Uses of Cash
Decrease in any asset(other than to cash) Increase in any asset(Other Than to Cash)

Increase in any liability Decrease in any liability

Net profit after tax Net Loss
Depreciation and other none-cash charges Dividends paid
Sale of Stock Repurchase or retirement of Stock

• Cash Flow: Inflows and outflows of cash and cash equivalents

• Cash Balance: Cash on hand and demand deposits (cash balance on the balance sheet)
Financial Statement Analysis 41
ExampleFirm A Ballance Sheet for Financial Years 2010 and 2011
2011 2010 Increase Decrease
Equity and Liabilities
Shareholders' Funds 500 450
share capital(Per value $10) 100 100 - -
Reserves and surplus 400 350 50 -
Non-current Liabilities 300 270
Long-term borrowings 200 180 20 -
Differed tax Liabilities 50 45 5 -
Long term provisions 50 45 5 -
Current Liabilities 200 180
Short-term borrowings 40 30 10 -
Trade paybles 120 110 10 -
other current labilities 30 30 - -
short-term provisions 10 10 - -

Assets
Non-current Assets 600 550
Fixed asset 500 450 50 -
Non-current investments 50 40 10 -
Long -term loans and advances 50 60 - 10
Current Assets 400 350
Current investments 20 20 - -
Inventories 160 140 20 -
Trade receivables 140 120 20 -
Cash and cash equivalents 60 50 10 -
Short-term loans and advances 20 20 - -

Financial Statement Analysis 42

According to the balance sheet we can summarize the sources and uses of
cash.
Sources Users

Increase in reserves and surplus 50 Increase in fixed assets 50

Increase in non-current
Increase in long-term borrowings 20 investments 10
Increase in deferred tax liabilities 5 Increase in inventories 20
Increase in long-term provisions 5
Increase in short-term borrowings 10
Increase in trade payables 10 Increase in trade receivables 20
Decrease in long-term loans and
advances 10
Total sources 110 Total uses 100

Net addition to cash 10

Note that the addition to cash is $10 million and it tallies with the $10 million change shown on the balance
sheet.
Financial Statement Analysis
43
Three Sections of the Statement of Cash
Flows:
Financial Activities

Operation Activities
Investing Activities

Cash Flow Statement

Financial Statement Analysis 44

 Cash Flow Classifications
 1. Operating Cash Flow
 Cash flows from Operating activities
 Cash Flow from Operations typically includes the
cash flows associated with sales, purchases, and
other expenses. Profit P
 The direct and indirect presentation of operating Depreciation D
cash flow: Amortization A
Impairment expense I
 Direct Presentation: Operating cash flows are
Change in working capital ΔWC
presented as a list of cash flows; cash in from
Change in provisions ΔP
sales, cash out for capital expenditures, etc.
Interest Tax (I)
 Indirect Presentation: Operating cash flows Tax (T)
are presented as a reconciliation from profit Operating cash flow OCF
to cash flow:

Financial Statement Analysis 45

2. Investing Cash Flow
• Cash flow from investing activities is a section of the cash flow statement that
shows the cash generated or spent relating to investment activities.
• Investing activities include purchases of physical assets, investments in
securities, or the sale of securities or assets.
• Negative cash flow from investing activities might not be a bad sign if
management is investing in the long-term health of the company.

Financial Statement Analysis 46

3. Financing Cash Flow
• Cash flow from financing activities is a section of a company’s cash flow statement, which shows the net flows of
cash that are used to fund the company.
• Financing activities include transactions involving debt, equity, and dividends.
• Debt and equity financing are reflected in the cash flow from financing section, which varies with the different
capital structures, dividend policies, or debt terms that companies may have.
• Formula and Calculation for Financial Cash Flow
• Investors and analyst will use the following formula and calculation to determine if a business is on sound
financial footing.
• CFF = CED − (CD + RP)
• where: CFF=Cash flow from Finance
• CED = Cash in flows from issuing equity or debt
• CD = Cash paid as dividends and RP = Repurchase of debt and equity​

47
Statement of Cash Flows
Example

Financial Statement Analysis 48

 Income
Statement Balance Sheet Cash Flow
Time Period of time A point in time Period of time

Purpose Profitability Financial position Cash movements

Measures Revenue, expenses, Assets, liabilities, Increases and decreases

profitability shareholders' equity in cash

MS4004: Statement Analysis 49

 Review Quiz
• Johnny’s Car Repair Shop started the year with total assets of $60,000 and
total liabilities of $40,000. During the year the business recorded $100,000
in car repair revenues, $55,000 in expenses, and dividends of $10,000.
• Q1. The net income reported by Johnny’s Car Repair Shop for the year was
a. $35,000.
b. $45,000.
c. $20,000.
d. $90,000.
e. none of the options listed

Financial Statement Analysis 50