Lecture - 1 - Analysis of Financial Statements

8/6/2019 Lecture - 1 - Analysis of Financial Statements

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FADM 2

CA.N.Nabeel Ahmed


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Relevance of Accounting Numbersy It helps in determining value ofthe Firm

y It helps in predicting bankruptcy ofthe Firm

y It helps in taking managerial decisionsy Pricing

y Make or buy

y Close or continue

y Analyze financial statements


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Financial Statement Analysis -

Usersy The users of financial reports can broadly be

categorised as:y resource providers

e.g., creditors, lenders, shareholders, employees

y recipients of goods and servicesi.e., customers, debtors

y parties performing an overview or regulatory function

e.g., tax office, corporate regulator, statistical bureausy internal managementto assist in their decision making

duties


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NATURE AND PURPOSE OF

FINANCIAL ANALYSISy Financial analysis involves expressing the reported numbers in relative

terms (percentages, ratios, comparison)

y Highlights the strengths and weaknesses of firms

y By evaluating an entitys financial past, users are in a better position toform an opinion as to the entitys future financial health

y Uses reported financial numbers to form opinions aboutthe entitysfinancial performance.


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ANALYTICAL METHODS

y It is essential in financial analysis to compare figures with:

y the equivalent figures from previous years

y

other figures in the financial statements (competitors)

y Analytical methods include

y (A) Horizontal analysis

y

(B)Vert

ical analysisy (C)Ratio analysis

y (D)Trend analysis

y (E) Benchmarks


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(A) Horizontal analysisy Compares reported numbers in different reporting periods

to highlightmagnitude and significance of changes

y

Dollar change is calculated by:

y Percentage change is calculated by:

(Current Year Number Previous Year number

) * 100Previous Year Number

Accounting number in current reporting period()Accounting number in previous reporting period


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Example: Comparative Balance SheetDecember 31, 2009, and 2010

2010 2009 Amount Percent

Assets

Cash $1,200 $2,350 $(1,150) -48.90%

Accounts receivable 6,000 4,000 2000 50%

Inventory 8,000 10,000 -2000 -20.00%

Prepaid Expenses 300 120 180 150.00%

Land 4,000 4,000 0 0%

Building 12,000 8,500 3,500 41.20%

----------- ----------- ----------

Total assets 31,500 28,970 2,530 8.70%

====== ====== ====== ======

Liabilities and Stockholders' Equity

Accounts payables $5,800 $4,000 1800 45%

Accrued payables 900 400 500 125%Loan 300 600 -300 -50%

Bank Over Draft 7,500 8,000 -500 -6.30%

Total paid in capital 9,000 9,000 0 0%

Retained earnings 8,000 6,970 1,030 14.80%

---------- ---------- ---------- ---------

Total liabilities and

stockholders' equity $31,500 $28,970 $2,530 8.70%===== ====== ====== ======


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ContyA horizontal analysis can be for

y Income Statement

y Balance Sheet

y Cash Flow statement

y Easyto identify which reported numbers have gone upor gone down in the period.

y Acts as a base for auditors to have enquiries on anysignificant changes in the period


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2. Vertical analysisy Involves comparing the items in a financial statementto an

anchor item in the same financial statement:

INCOME STATEMENT

y

Revenue and expense items are expressed as a percentage ofsales or revenue

BALANCE SHEET

y A, L and Equity items are expressed as a percentage oftotalassets

y When expressed this way, the financial statements are oftenreferred to as common size statements


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Company A

Particulars Amount %

Revenue 200,000 100

Cost of sales 50000 25

Gross profit 150000 75

Other income 10000 5

Sales and marketing -20000 -10

Occupancy -5000 -2.5

Admin expenses -15000 -7.5

Finance Cost -25000 -12.5

Profit 95000 47.5


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Common Size Analysis

Company A Company B

Particulars Amount % Amounts %

Revenue 200,000 100 1,000,000 100

Cost of sales 50,000 25 400,000 40

Gross profit 150,000 75 600,000 60

Other income 10,000 5 50,000 5

Sales and marketing (20,000) -10 (150,000) -15

Occupancy (5,000) -2.5 (80,000) -8

Admin expenses (15,000) -7.5 (35,000) -3.5

Finance Cost (25,000) -12.5 (60,000) -6

Profit 95,000 47.5 325,000 32.5


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Ratio analysisy Ratio analysis is a 3-step process

1. Calculate a meaningful ratio by expressing $ amt of an

item by $ amoun

tof ano

ther i

tem

2. Compare the ratio with a benchmark

3. Interpretthe ratio, seek to explain why it differsy from previous years

y from comparative entities or

y from industry averages


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Ratio Analysis(1)Liquidity

(2)Turnover Ratios

(3)Profitability(4)Capital Structure

(5)Market Performance


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1) LIQUIDITY ANALYSISy The survival ofthe entity depends on its abilityto pay

its debts when they fall due (its liquidity)

yAn entity must have sufficientworking capital tosatisfy its short-term requirements and obligations

y But excess working capital is undesirable because thefunds could be invested in other assets that wouldgenerate higher returns.


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Liquidity Ratiosy A group of ratios which helps to analyze the ability of the

company to pay off its short term liabilities.

y It Analyses the Current assets and Current Liabilities.y Ability to meet short term liability

y If CA > CL Shows that liquidity position is good

y Also throws a light on financing of Assets

y If CA>CLy Part ofCurrent assets are financed by Long term sources

y If CA


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a. Current Ratioy Current ratio

y Current ratio (or working capital ratio) indicates $ of

current

asset

s per $ of current

liabilit

ies.

y We need to know :-

y Composition ofthe ratio

y Interpretation ofthe ratio

Current assets =x times

Current liabilities

Current ratio

an arbitrary ruleofthumb is that itshould be around

1.5 : 1


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Exampley If Current ratio = 2:1

yWhat do you infer from it?y Current ratios is twice Current liability

y Current ratio is positive

y Can we say whether Current ratio is favorable orunfavorable?

y Unless Compared, cannot be interpreted.


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Lets compare

A B C

CR 4:1 3:1 1:1

Recall :-

- Composition of CA and CL

Is it necessary for accounting policies to be same for each of the

three companies?

-Stock (FIFO , WA)

-Accounts Receivable ( Difference in Provision for Bad debts)


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Limitations of Current RatioyFocus on Quantity rather than Quality

yCurrent Ratio is subjectto accountingassumptions:y Stock valuation,

y Provision for Doubtful debts

ySowindow dressing is possible .


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Address the limitations of Window

Dressing

y (a) Current Ratio = CA / CL

y (b) Liquid Ratio

y = (CA- Stock) / CL

y (c )Absolute Cash ratioy = (CA Stock Debtors) / CL


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2)Turnover Ratios

a. Debtors Days ( Accounts Receivable Days)

y Days debtors ratio indicates average period oftime itt

akest

o collect

t

he money from it

st

rade relat

ed account

sreceivable.

y In other words, No. Of days of sales, remaining as adebtor.

Average Debtors = x days

Sales revenue Per day

Days debtors


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Exampley Sales Revenue per year = 7200

yAverage Debtors = 500

y Sales per day = 7200/365 = $20 per day

y Debtors days = 500/20 = 25 days

y DD : Is 25 days a good indication of Debtors days?

y Cannot conclude unless compared with Creditor days orcompanys policy for collection of Debtors


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No stringent Nr & Dr for Debtors

Days

Average Debtors =x days

Sales revenue Per day

Days debtors

Average Debtors =x days

Credit Sales revenue Per day

Days debtors


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Which company is doing better?A B

Debtor Days 50 150

Creditor Days 25 175

Credit policy for both company = 75 days!

Is it bad to have HUGE DEBTORS?

Ageing Analysis shows quantum ofgood quality Debtors!


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b. Creditor Daysy Creditor days, shows the number of days purchases

which is standing as creditor.

Average Creditors =x days

Purchases per day

Creditors Days


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c.Inventory Daysy Days inventory ratio indicates the average period oftime

ittakes to sell inventory .

y In other words, Number of days of sales in Inventory.

Average Inventory =x days

Cost of goods sold per day

Days inventory

Cost of goods sold = Sales - Profit


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Putting it Together.

y Debtors Days + Inventory Days Creditors Days = Working capital Days

CurrentAssets

CurrentLiabilities

Cash Conversion Cycle

The cash conversion cycle attempts to measure theamount oftime each net input dollar is tied up in theproduction and sales process before it is converted intocash through sales to customers.


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Example5. The following ratios have been calculated for Interport Pty LLc, a manufacturing

company.

2010 2009

Current Ratio------------- 2.5:1 1.3:1

Quick asset ratio--------- 1.3:1 0.7:1

Inventory Days----------- 130 90

Debtor Days-------------- 62 45

Creditor Days------------- 44 43

Profit Margin------------- 5% 7%

Comment on

Liquidity

Management Efficiency

Profitability


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Summarizing Liquidity RatioLiquidity

Ratios

CurrentRatio

LiquidRatio

AbsoluteCash Ratio

Turn overRatios

DaysDebtors

CreditorDays

InventoryDays

Documents

Lecture - 1 - Analysis of Financial Statements