2 cash flow and financial statement analysis

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my-business-economics-and-financial.html

Cash Flow and Financial Statement Analysis-FSA

A summary of a firm’s payments during a period of time. This statement reports cash inflows and outflows based on the firm’s

operating activities,

investing activities, and

financing activities

Cash flow from operating activities

Inflows Outflows

From sales of goods or services From interest and dividend income

To pay suppliers for inventory To pay employees for services To pay lenders (interest) To pay government for taxes To pay other suppliers for other operating expenses

Cash flow from investing activities

Shows impact of buying and selling fixed assets and debt or equity securities of other entities.

Inflows Outflows

From sale of fixed assets From sale of debt or equity securities (other than common equity) of other entities

To acquire fixed assets To purchase debt or equity securities (other than common equity) of other entities

Equity security: Equity securities are shares of stock held by investors as reported on a company's balance sheet. A company issues equity securities as a means to raise capital in the financial markets for a major event, such as an expansion or merger or for product development. By purchasing equity, shareholders are obtaining a partial ownership stake in that company. Equity issuance is an alternative to issuing bonds, which are a form of debt, in the public markets.

Common Stock: Common stock is ownership in a company, just the basic stock that we are used to trading. Companies sell common stock through public offerings, and it is traded among investors on the secondary market. Those who hold the stock hope to earn dividends from their share of company profits. However, many profitable companies do not pay dividends, and never have any intentions of doing so (i.e. Microsoft). The obvious risk with common stock is that the price may fall. Unlike some other investment vehicles, investors cannot lose more than their initial investment.

Preferred Stock: Like common stock, preferred stock is sold by companies and is then traded among investors on the secondary market. Preferred stock is less risky than common stock,


therefore investors can expect less reward. In many ways, preferred stock works like bonds. While bonds guarantee regular interest payments, preferred stock guarantees regular dividend payments for a specified time. Preferred stock price is less volatile than common, and virtually eliminates the possibility of large capital gains. The bottom line is that preferred stock is less risky than common stock. It is designed to provide an income generating opportunity for investors while raising capital for the underlying company.

Common Equity: A measure of equity, which only takes into account the common stockholders, and disregards the preferred stockholders. It is equal to shareholders' equity minus preferred equity.

Preferred Equity: A measure of equity, which only takes into account the preferred stockholders, and disregards the common stockholders. It is equal to shareholders' equity minus common equity.

Cash flow from financing activities

Shows influence of all cash transactions with shareholders and the borrowing and repaying transactions with lenders.

Inflows Outflows

From borrowing From the sale of the firm’s own equity securities

To repay amounts borrowed To repurchase the firm’s own equity securities To pay shareholders dividends

Indirect Method or Reconciliation Method:

Indirect method is the most widely used method for the calculation of net cash flow from operating activities. Under this method, net cash provided or used by operating activities is determined by adding back or deducting from net income those items that do not effect on cash. The following are the common types of adjustments that are made to net income to arrive at net cash flow from operating activities.

Adjustments Needed to Determine Net Cash Flow from Operating Activities Using Indirect Method

Note: Direct and indirect methods are different only to the extent of the calculation of cash flows from operating activities; cash flows from investing and financing activities are calculated in the same manner.


Example:

Cash flow from operating activities:

Net income

117000

Adjustments to reconcile net income to net cash used/provided by operating by activities:

Depreciation expenses 14,800

Amortization of trade mark 2,400

Amortization of bond premium (1,000)

Equity in earnings of Porter Co. (3,500)

Gain on condemnation of land (8,000)

Loss on sale of equipment 1,500

Increase in deferred tax liabilities 3,000

Increase in accounts receivable (net) (53,000)

Increase in inventories (152,000)

Decrease in prepaid expenses 500

Increase in accounts payable 1,000

Increase in accrued liabilities 4,000

Decrease in income tax payable (13,000) 203,500

Net cash used by operating activities

(86,500)

Direct Method or Income Statement Method:

Under the direct method the statement of cash flows reports net cash flow from operating activities as major classes of operating cash receipts (e.g., cash collected from customers and cash received from interest and dividends) and cash disbursements (e.g., cash paid to suppliers for goods, to employees for services, to creditors for interest, and to government authorities for taxes).

The direct method is explained on cash flow statement direct method page. This method is illustrated here in more detail to help you understand the difference between accrual based income and net cash flow from operating activities and to illustrate the data needed to apply the direct method.


Suppose a company, which began business on January 1, 2005, has the following balance sheet information:

December 31

2005 2004

Cash $159,000 0

Accounts receivable 15,000 0

Inventory 160,000 0

Prepaid expenses 8,000 0

Property, plant, and equipment (net) 90,000 0

Accounts payable 60,000 0

Accrued expenses payable 20,000 0

Company's December 31, 2005, income statement and additional information are:

Revenues from sales $780,000

Cost of goods sold 450,000

Gross profit 330,000

Operating expenses $160,000

Depreciation 10,000 170,000

Income before income taxes 160,000

Income tax expenses 48,000

Net income $112,000

Additional Information: (a). Dividends of $70,000 were declared and paid in cash. (b). the accounts payable increase resulted from the purchases of merchandise. (c). Prepaid expenses and accrued expenses payable relate to operating expenses.


There are two key factors for business survival:

Profitability is important if the business is to generate revenue (income) in excess of the expenses incurred in operating that business.

The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations.

Financial Statements

A financial statement is a complication of data, which is logically and consistently organized according to the accounting principles.

Its purpose is to convey an understanding of some financial aspects of a business firm.

Financial statements are the major means through which firms present their financial situation to stockbrokers, creditors and the general public.

The majority of firms include extensive financial statements in their annual reports, which are distributed widely.

Who analyzes financial statements?

Internal users (i.e. management)

External users (i.e. Investors, creditors, regulatory agencies, stock market analysts and auditors)

Internal users use it for planning, evaluating and controlling company operations.

External users use it for assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management.

Effective Financial Statement Analysis

To perform an effective financial statement analysis, you need to be aware of,

individual organisational factors, o business strategy o objectives o Annual report and other documents like articles about the organization in

newspapers and business reviews.

External factors, o Understand the nature of the industry in which the organisation works. This is

an industry factor. o Understand that the overall state of the economy may also have an impact on

the performance of the organisation.


Principal Tools of Analysis

Financial Ratio Analysis

Comparative financial statements analysis: o Horizontal analysis/Trend analysis o Vertical analysis/Common size analysis/ Component Percentages

Ratio Analysis

Computation is simple but interpretation is difficult. Usefulness of ratios depends on their intelligence and skillful interpretation. Helps in valuing firms quantitatively.

Working capital = Current assets – current liabilities

Profitability Ratios Liquidity or Short-Term Solvency ratios Asset Management or Activity Ratios Financial Structure or Capitalisation Ratios Market Test Ratios

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Liquidity Ratios

Liquidity implies a firm’s ability to pay its debts in the short run. Short-term liquidity involves the relationship between current assets and current liabilities. If a firm has sufficient net working capital (excess of current assets over current liabilities), it is

assumed to have enough liquidity. Current Ratio:

Ideally, this has to be around two, but it usually depends on the industry we are talking. If it is less than 1 it simply means that the company is in a great risk. If it is 1 it is again at some risk if debtors do not pay their part in the correct date. If it is above 2 that simply means there are too many current assets and the company may not be efficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management.

Quick Ratio (Acid test)

Ideal value for this is 1. In finance, the “Acid-test” or quick ratio or liquid ratio measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. A company with a Quick Ratio of less than 1 cannot currently pay back its current liabilities. Note that Inventory is excluded from the sum of assets financially.

Financial Structure or Capitalisation Ratios

𝐷𝑒𝑏𝑡/𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =𝐷𝑒𝑏𝑡

𝐸𝑞𝑢𝑖𝑡𝑦

𝐷𝑒𝑏𝑡/𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑟𝑎𝑡𝑖𝑜 =𝐷𝑒𝑏𝑡

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 ∗ 100

𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =𝐸𝑞𝑢𝑖𝑡𝑦

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠∗ 100

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CLsliabilitiecurren

CAassetscurrentratiocurrent

CL

sInventorieassetscurrentratioQuick

sLiabilitieCurrent

assetsQuickratioQuick

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𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short-term loan etc.

Each of these ratios gives valuable information about the company. As example Debt/Equity ratio, measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.

Asset Management or Activity Ratios

Measures the speed at which inventory is converted to sales and/or Debtors converted to cash. Asset Management Ratios attempt to measure the firm's success in managing its assets to generate sales. For example, these ratios can provide insight into the success of the firm's credit policy and inventory management. These ratios are also known as Activity or Turnover Ratios.

Normally there is a defined average collection period for the company by rules. We will compare realized average collection period with that. If the average collection period is 30 days and the realized average collection period is 60 days. It will say few things about the company collection.

Collection job is poor (debt collector & collection) Difficulties in obtaining prompt payments Customers face financial problems

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NOTE: Here you can also use the ‘inventory instead’ of ‘average inventory’, but we have to mention that in the calculation.

Measures how fast the inventory moving through the firm and generating sales. This is important because of two reasons. We have to make sure that we do not run out stock due to low inventory. Moreover, in the same time we have to make sure that we avoid excessive carrying charge because of high inventory.

Profitability/Efficiency Ratios

Measure the efficiency of the firm’s activities and its ability to generate profits (profit per unit sold).

Gross profit (Also called "gross margin" and "gross income”): A company's revenue minus its cost of goods sold. Gross profit is a company's residual profit after selling a product or service and deducting the cost associated with its production and sale. To calculate gross profit: examine the income statement, take the revenue and subtract the cost of goods sold.

Net profit (Also called net income or net earnings): Often referred to as the bottom line, net profit is calculated by subtracting a company's total expenses from total revenue, thus showing what the company has earned (or lost) in a given period of time (usually one year).

Profits generated are compared with the amount invested by owners and creditors. It is required to generate adequate profits per unit asset otherwise; assets are misused

or under-utilized.

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profitNetinmprofitNet

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assetsAverage

SalesratioturnoverAsset

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𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑃𝑜𝑤𝑒𝑟 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑏𝑒𝑓𝑜𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑛𝑡 𝑐𝑕𝑎𝑟𝑔𝑒𝑠 𝑎𝑛𝑑 𝑡𝑎𝑥𝑖𝑠𝑎𝑡𝑖𝑜𝑛

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Earning Power Measures the operating business performance, this is not affected by interest charges and taxation.

Return on equity is an important profit indicator for shareholders.

Market Test Ratios

Market test ratios will help the stockholders to analyze their present and future investment in the firm.

Compare the investment value with factors such as debt, dividends, earnings etc.

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒 =𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑠𝑠𝑢𝑒𝑑 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠𝑕𝑎𝑟𝑒𝑠

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒 =𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑠𝑠𝑢𝑒𝑑 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠𝑕𝑎𝑟𝑒𝑠

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒 ∗ 100

𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜 =𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒

Du Pont Analysis

Analyze return ratios in terms of profit margin and turnover ratios.

DuPont analysis tells us that ROE is affected by three things:

Operating efficiency, which is measured by profit margin Asset use efficiency, which is measured by total asset turnover Financial leverage, which is measured by the equity multiplier

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incomeNetequityonturn

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ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity) les

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡𝑠

𝑠𝑎𝑙𝑒𝑠 ∗

𝑆𝑎𝑙𝑒𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑠𝑠𝑒𝑡𝑠 ∗

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑠𝑠𝑒𝑡𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐸𝑞𝑢𝑖𝑡𝑦

Issues in FSA

Comparability between periods. The company preparing the financial statements may have changed the accounts in which it stores financial information, so that results may differ from period to period. For example, an expense may appear in the cost of goods sold in one period, and in administrative expenses in another period.

Comparability between companies. An analyst frequently compares the financial ratios of different companies in order to see how they match up against each other. However, each company may aggregate financial information differently, so that the results of their ratios are not really comparable. This can lead an analyst to draw incorrect conclusions about the results of a company in comparison to its competitors.

Operational information. Financial analysis only reviews a company's financial information, not its operational information, so you cannot see a variety of key indicators of future performance,


such as the size of the order backlog, or changes in warranty claims. Thus, financial analysis only presents part of the total picture.

Interpretation of results - Variability in interpretations

Correlation among ratios - Degree of correlation

Development of benchmarks

o Many firms operate in different industries.

o Proportions of operation

Window dressing

o Shows a better picture than what actually exists

o Makes no sense in analyzing

NOTE: Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future. Financial statement analysis might look good but other factors that can cause an organisation to collapse.

Common size Income statement

Common size income statement is an income statement in which each account is expressed as a percentage of the value of sales. This type of financial statement can be used to allow for easy analysis between companies or between time periods of a company.

“Common size income statement” analysis allows an analyst to determine how the various components of the income statement affect a company's profit.


Common size Balance sheet

Common size Balance sheet is a company balance sheet that displays all items as percentages of a common base figure. This type of financial statement can be used to allow for easy analysis between companies or between time periods of a company.

In the normal balance sheet, account values are expressed in dollar terms, while in the common size one, each value is listed as a percentage of total assets. This is also done for liabilities, where each liability account is a percentage of total liabilities.

◦ Important analysis for comparative purposes “Over time” and For “different sized enterprises“

Horizontal Analysis

Horizontal analysis is the comparison of historical financial information over a series of reporting periods, or of the ratios derived from this financial information. The analysis is most commonly a simple grouping of information that is sorted by period, but the numbers in each succeeding period can also be expressed as a percentage of the amount in the baseline year, with the baseline amount being listed as 100%.

Read more at: http://www.accountingtools.com/horizontal-analysis

Horizontal Analysis of the Income Statement

Horizontal analysis of the income statement is usually in a two-year format, such as the one shown below, with a variance also shown that states the difference between the two years for each line item. An alternative format is to simply add as many years as will fit on the page, without showing a variance, so that you can see general changes by account over multiple years. A third format is to include a vertical analysis of each year in the report, so that each year shows expenses as a percentage of the total revenue in that year.

http://www.accountingtools.com/horizontal-analysis


It should be possible to calculate the ratios when the FSs are given. Here is an example of doing that.

Financial%20statement%20analysis.pdf

2 cash flow and financial statement analysis

Economy & Finance

full note set

higher debt gearing

net cash flow

net income

cash flow

income statement

preferred stock

secondary market