CHAPTER 2: FINANCIAL STATEMENTS AND CORPORATE TAXES Description of Financial Statement Financial statements are prepared set of accounting reports that

CHAPTER 2: FINANCIAL STATEMENTS AND CORPORATE TAXES

Description of Financial Statement

• Financial statements are prepared set of accounting reports that seek to

provide information to its stakeholders about the previous business year’s

financial performance and position.

• Three financial statements are annually prepared namely;

Statement of financial position (balance sheet)

Income statement (profit and loss account)

Cash flow statement (sources and uses of fund)

1Prepared by Alhaj Nuhu Abdulrahman


The statement of financial position:

• A summary of book values of a firm’s assets and liabilities at a particular date.

• The assets represent uses of funds

• The liabilities represent sources of the funds.

Components of assets Current assets: cash, account receivable, inventory, etc Fixed assets (tangible): buildings, equipment, vehicles, etc Fixed assets (intangible): patent, skilled management, trained labour force,

Components of liabilities Current liabilities: accounts payable, accruals Long term liabilities: long-term debts Shareholders’ fund (equity): value of owners’ equity and retained earnings



• A summary of a firm’s financial performance over the previous business

period usually a year.

• That is Net income or loss = total revenue – total expenses.

The Cash flow Statement

• A summary of a firm’s sources and uses of cash from its operations,

investment and financing activities, over a year.

• A firm’s net cash flows can be quite different from its net income

The three components of cash flow statement:

i. Cash flow from operating activities

ii. Cash flow from investing activities

iii. Cash flow from financing activities


Uses of financial statement information

• Internal uses: management compensation, employee agitation for improved

remuneration, evaluating strategic business units, comparison with

previous years’ performance and future planning.

• External uses: information for short and long-term creditors, suppliers,

rating agencies, current and potential investors, etc.

• Comparison with performance of competitors


Corporate Taxes

• Companies big and small pay tax on their net incomes at the end of the

business year.

• Tax payable is calculated on marginal tax rates prescribed by a country’s

tax code. Then average tax rate may be calculated.

• Marginal tax rate is the tax rate that the individual or company pays on

each extra cedi of income.

• Average tax rate is the percentage of one’s income paid out as tax


Corporate Taxes

• For instance assume Ghana’s corporate tax code has the following structure:

Taxable income (GH¢)Tax rates (%)

0 - 50,000 15

50,001 - 75,000 25

75,001 - 100,000 34

100,001 - 400,000 37

400,001 + 34

Suppose a company has a taxable income of GH¢300,000.

What will be the company’s total tax bill?

What will be the company’s average tax rate?

What will be its marginal tax rate?


Corporate TaxSolution:

0.15(GH¢50,000 - GH¢0) = GH¢7,500

0.25(GH¢75,000 - GH¢50,000) = GH¢6,250

0.34(GH¢100,000 - GH¢75,000) = GH¢8,500

0.37(GH¢300,000 - GH¢100,000) = GH¢74,000

Total tax bill GH¢96,250


Corporate Tax

(a) Tax bill = (0.15 x GH¢50,000) + (0.25 x GH¢25,000) +

(0.34 x GH¢25,000) + (0.37 x GH¢200,000) = GH¢96,250

(b) Average tax rate = GH¢96,250/GH¢300,000 x 100= 32.08%

(c) Marginal tax rate is 37%. This is because for every one more cedi of

taxable income up to GH¢400,000 attracts a tax rate 37%.


Corporate Tax

• Because financial decisions usually involve new cash flows or change in

existing ones, the marginal rate tells us the marginal effect of a decision on

corporate tax bill.

• Financial managers therefore need to understand the tax consequences of

investment and financing decisions.

• Three importance of tax in financial management: Raising finance: debt financing attracts interest tax relief, while dividend

payment on equity financing does not attract tax relief. Investment in fixed assets: cost of acquiring certain types of fixed assets

attracts a form of tax relief termed capital allowance. (e.g. depreciation) Paying dividends: dividend payment attracts dividend tax.


Corporate Tax

• Corporate financial managers should understand the effects of tax relief on incomes of both the company and its shareholders.

Illustration of tax relief

• Assume 2 firms; A and B both have earnings before taxes (EBIT) of GH¢1,000,000. Firm A however has GH¢40,000 interest on debts to pay. This reduces the company’s tax bill as illustrated:

Firm A Firm B

EBIT 1,000,000 1,000,000

Interest 40,000 0

Pretax income 960,000 1,000,000

Tax (35%) 336,000 350,000

Net income 624,000 650,000


Financial statements analysis

• Financial statements are the primary means of communicating financial information to users both within and outside the firm for decision making.

• One common use of financial statements is to compare those of a firm’s immediate past business period with the previous ones and those of other similar companies.

• Constraints faced by such comparisons include changes in size of the firm and differences in size with other firm types.

• To address these differences the financial statements are transformed into standardized financial statements.

Standardized Financial Statements

• All the items of the financial statements are presented in percentage terms called common-size statements.

• Each balance sheet item expressed as a percentage of total assets called common-size balance sheet

• Each income statement item expressed as a percentage of total sales called common-size income statement.



• Illustration Azonto Corporation Balance Sheets for 2012 and 2013

2012 2013

Assets (GH¢) (GH¢)

Current assets

Cash 8,400 9,800

Accounts receivable 16,500 18,800

Inventory 39,300 42,200

Total current assets 64,200 70,800

Fixed assets

Net Premises & equipment 273,100 288,000

Total assets 337,300 358,800



Liabilities

Current liabilities

Accounts payable 31,200 34,400

Notes payable 23,100 19,600

Total current liabilities 54,300 54,000

Long-term debt 53,100 45,700

Owner’s Equity 50,000 55,000

Retained earnings 79,900 204,100

Total equity 229,900 259,100

Total liabilities 337,300 358,800



• Azonto Corporation income statement for 2013

GH¢

Sales 231,100

Cost of goods sold 134,400

Depreciation 27,600

Earnings before interest and taxes 69,100

Interest 14,100

Income before tax 55,000

Tax (34%) 18,700

Net Income 36,300

Dividends 12,100

Retained earnings 24,200



Common-size balance sheet: each item is express as a percentage of total assets

Azonto Corporation Common-Size Balance Sheets for 2012 and 2013

2012 2013 Change

Assets (%) (%) (%)

Current assets

Cash 2.5 2.7 +0.2

Accounts receivable 4.9 5.2 +0.3

Inventory 11.7 11.8 +0.1

Total current assets 19.11 9.7 +0.6

Fixed assets

Net Premises & equipment 80.9 80.3 -0.6

Total assets 100 100 0.0



Liabilities

Current liabilities

Accounts payable 9.2 9.6 +0.4

Notes payable 6.8 5.5 -1.3

Total current liabilities 16.0 15.1 -0.9

Long-term debt 15.7 12.7 -3.0

Owner’s Equity 14.8 15.3 +0.5

Retained earnings 53.3 56.9 +3.6

Total equity 68.1 72.2 +4.1

Total liabilities 100 100 0.0



common-size income statement: each item expressed as percentage of total sales

Azonto Corporation Common-Size Income statement for 2013

(%)

Sales 100.0

Cost of goods sold 58.2

Depreciation 11.9

Earnings before interest and taxes 29.9

Interest 6.1

Income before tax 23.8

Tax (34%) 8.1

Net Income 15.7

Dividends 5.2

Retained earnings 10.5



Financial Ratio Analysis:

Financial ratios are quantitative tools for analyzing financial statements for purposes of

comparing firms’ performance, and for the same firm over the previous periods. They are

generally classified according to the activity or function to be evaluated as follows:

Liquidity ratios: They measure the firm’s ability to meet short-term obligations.

Activity ratios: They measure the effectiveness of utilizing operational assets.

Leverage or Financial Gearing ratios: They measure the extent to which the firm is financed

with debts. That is the ratio debt to equity in the firm’s capital structure

Profitability ratios: They measure the efficiency or profitability of the firm.

Investment or shareholders’ ratios: They indicate how well a company has performing in

terms of share market value and other related items like dividends.


Financial Ratio Analysis:

Madina Corporation Statement of Financial Position as at 31st December 2012

Assets GH¢’000 GH¢’000

Cash 50

Marketable Securities 150

Receivable (debtors) 200

Inventories (Stocks) 300

Total Current Assets 700

Plant and Equipment 1,876

Less depreciation 500

Net Plant equipment 1,376

Total Assets 2,076


Financial Ratio Analysis

Liabilities GH¢’000 GH¢’000

Accounts payable (Creditors) 60

Notes payable (at 10%) 100

Accruals 10

Provision for tax 130

Total Current Liabilities 300

Bond (at 8%) 500

Debentures (at 10%) 200

Ordinary Shares 600

Retained earnings 476

Total Equity 1,076

Total Liabilities 2,076

The market price per share was GH¢5.25

Shares outstanding 200,000



Madina Corporation Income Statement for the year ended December 31st2012GH¢’000 GH¢’000

Sales 3,000Cost of goods sold 2,555Gross profit 445Less operating expenses:

Selling 22General & administrative 40Payment on Office building 28Total operating expenses 90Gross operating profit 355

Less Depreciation 100Net Operating profit 255Income from other services 15Earning Before Interest and Taxes (EBIT) 270



Less interest on notes payable 10

Interest on Bonds 40

Interest on Debentures 20

Total interest expense 70

Net income before taxes 200

Less Corporate tax (40%) 80

Net income after Corporate tax 120

Dividend declared and paid 90


Financial Ratio AnalysisLiquidity Ratios: (Short term solvency measures)

• Current ratio = = = 2.33

• Quick (Acid-test) ratio = = = 1.33 times

• Cash ratio = = = 0.67 times

Short-term creditors are interested in these ratio because they indicate the ability of

firm to pay.

Asset Management or Turnover ratios: they indicate the rate at which goods are

Converted or turnover into sales. That is how efficiently and intensively a firm uses its

assets to generate sales.

• Inventory (stock) Turnover Ratio = = = 8.52 times


Financial Ratio AnalysisIf inventory is turned over 8.52 times in a year, we can determine how long it took to

turn it over on average.

• Inventory turnover in days = = = 42.8 days

OR

• Inventory turnover in days = = = 42.9 days

• Receivables Turnover Ratio = = = 15 times

• Days’ sales in receivables or Average Collection Period (ACP) = = 24.33 days . The shorter the collection period the better.

• Total assets turnover = = = 1.45 times

This implies for every GH¢1 asset, GH¢1.45 sales is generated.

• Fixed Assets Turnover = = = 2.18 times

This implies for every GH¢1 of fixed asset, GH¢2.18 sales is generated.



Leverage or gearing ratios (long-term solvency measures)

• Gearing ratios indicate the firm’s ability to meet its long-term financial obligations to

creditors. They also indicate the proportion of debt in a firm’s capital structure.

• Different methods of calculating leverage ratios exist.

• Total Debts ratio: This ratio can be defined in several different ways, the easiest of

which is this: = = 48.17%

• That implies the company is financed with 48.17% debt. By extension every GH¢1.00 in

assets is financed with GH¢0.4817 debt and GH¢0.5183 equity

• Total Debt/Equity ratio = = 0.93 times

or = 0.93 times



Total Asset/equity ratio or Equity Multiplier = = = 1.93 times

or = 1.93 times

Long-term Debt ratio = =

= 0.39 times

Interest coverage ratio = = = 3.86 times

The lower the interest-cover ratio, the greater is the risk of default in interest payment.

Cash Coverage ratio = = = 5.29 times

This is used as a measure of cash flow available to meet financial obligations.



PROFITABILITY RATIOS: These ratios measure the effectiveness of a business in

generating profits. Varieties of profitability ratios exist and the following are probably

the best known and the most widely used.

• Net income margin ratio (NIM) = = 4%

It implies Gp4 is generated for every GH¢1.00 of sales.

• Return on Assets (ROA) = 5.78%

It means about Gp58 profit is generated per every GH¢1 of assets.

• Return on Equity (ROE) = 11.15%

For every cedi in equity about Gp11 is generated.



• INVESTMENT RATIOS: These ratios measure variety of returns on equity

investment for publicly traded companies. And are computed for informed equity

investment decisions like buying more shares or holding on or selling out. Data for

their computation are in part market information not necessarily contained in

financial statements, thus also called market value ratios.

• Earnings per Share (EPS) = GH¢0.60/share

• Dividend per Share (DPS) = GH¢0.45/share

• Dividend payout ratio (DPR): This ratio reveals the percentage (%) or proportion of

net earnings declared as dividend. DPR = = 75%

• Dividend Cover (DC): This ratio indicates how many times dividend can be paid

out of current Net profit. = 1.3 times


Financial Ratio Analysis• Earnings yield (EY): This measure the Percentage of EPS on Market price per Share (MPS):

= 11.43%

• Dividend Yield (DY): This shows the percentage of DPS in relation to MPS

= 8.57%

• Price/ Earnings Ratio (P/E): It is used by security analysts to assess the future market

performance of a company. It measures how much investors are willing to pay per cedi of

earnings. = = 8.75 times

• Market/Book ratio: It compares the market value of the firm to it investment cost. A value less

than 1 could mean the firm has not been successful in generating value for its shareholders.

Book value per share is total equity divided by number of shares outstanding .

Market/Book ratio = = = = 0.96 times



Exercise:

• ABC Company distributed GH¢90,000 of its net income as dividend this year which

represented 60% dividend payout ratio.

i) What was the company’s net income?

ii) What was the retention ratio?

iii) How much was the retained income?



Exercise:

• ABC Company distributed GH¢90,000 of its net income as dividend this year which

represented 60% dividend payout ratio.

i) What was the company’s net income?

ii) What was the retention ratio?

iii) How much was the retained income?

Solution:

i) Payout ratio x net income = GH¢90,000

60% x net income = GH¢90,000

Net income =

Net income = GH¢150,000



• ii) Retention ratio = 100% - payout ratio

= 100% - 60% = 40%

• iii) Retained income = retention ratio x net income

= 40% x GH¢150,000 = GH¢60,000



The DuPont Identity

• The fact that the ROE (11.15%) is higher than ROA (5.78%) calculated above

reflects the use of more debt financing or financial leverage by the company.

The ROE equation is however further decomposed into three ratio components to

determine the causes of the level of ROE or any changes in it. The decomposition

was developed and used by an American company called DuPont, thus generally

referred to as The DuPont Identity. ROE is decomposed into the following three

determinants:

1. Profit Margin:- the company’s pricing strategy and ability to control costs.

2. Asset Turnover:- measures the intensity with which a company utilizes its assets.

3. Gearing:- Financing with debt instead of equity can increase ROE but also increase

the risk that a decrease in turnover may make it difficult for the company to meet

its debt obligations


Financial Ratio Analysis: The DuPont Identity

• ROE = (Net Profit Margin) x (Total Asset Turnover) x (Equity Multiplier)

= x x

= x x

= 0.04 x 1.45 x 1.93 = 0.11194 or 11.94%


Financial Ratio Analysis: The DuPont Identity

Steps to increase the ROE ratio level:

• First to improve the profit margin the firm must be efficient in its operation by

keeping operating costs down.

• Second to generate more sales operational assets must used more intensely which

improves the asset turnover.

• Third is the use of more debt financing thereby using less equity financing, which

improves the equity multiplier. Often, only one or a combination of two of the three

strategies may be appropriate. For instance, a company that has reached the limits

of what lenders are willing to lend to it cannot use gearing to improve the ROE.


Documents

CHAPTER 2: FINANCIAL STATEMENTS AND CORPORATE TAXES Description of Financial Statement Financial statements are prepared set of accounting reports that