1. Topic 2
Analysis of financial statements and cash
flows

2. Learning Objectives
 Distinguish between balance sheet, income statements
and statement of cash flow.
 Indentify the items in those statements
 Explain the need of financial statements.
 Explain the usage of the ratios in financial statement
analysis.
 Calculate those ratios based on formulas given.
 Identify the limitations of ratio analysis.

3. Financial statements needs
 Financial statements users can be classified into 2
types:
• Internal users-persons employed by the firm
• External users-potential investors, the
Government, lenders, the public etc...
 Analyzing a firm’s financial statement can help
managers carry out three important tasks:
• Assess current performance through financial
statement analysis,
• Monitor and control operations, and
• Forecast future performance.

4. The Income Statement
 It is also known as Profit/Loss Statement
 It measures the results of firm’s operation over a
specific period.
 The bottom line of the income statement shows the
firm’s profit or loss for a period.
 Sales – Expenses = Profits
 Usefulness of income statement:
Evaluate the past performance of the firm.
Provide a basis for predicting future performance.

5. Income Statement Terms
 Revenue (Sales)
 Money derived from selling the company’s product or
service
 Cost of Goods Sold (COGS)
 The cost of producing or acquiring the goods or services
to be sold
 Operating Expenses
 Expenses related to marketing and distributing the
product or service and administering the business
 Financing Costs
 The interest paid to creditors
 Tax Expenses
 Amount of taxes owed, based upon taxable income

6. Figure 2-1

7. Figure 2-1 (cont.)

8. Table 2-2

9. 1. The Balance Sheet
 The balance sheet provides a snapshot of a firm’s
financial position at a particular date.
 It includes three main items: assets, liabilities and
equity.
 Assets (A) are resources owned by the firm
 Liabilities (L) and owner’s equity (E) indicate how
those resources are financed
 A = L + E
 The transactions in balance sheet are recorded
historically at cost price, so the book value of a firm
may be very different from its current market value.

10.  Current assets comprise assets that are relatively
liquid, or expected to be converted into cash within
12 months. Current assets typically include:
 Cash
 Marketable security–investment on short term financial
assets with high liquidity. Example: T-bill.
 Accounts Receivable (payments due from customers who
buy on credit)
 Inventory (raw materials, work in process, and finished
goods held for eventual sale)
 Other assets (ex.: Prepaid expenses are items paid for in
advance)
Balance Sheet Terms: Assets

11.  Fixed Assets – Include assets that will be used for
more than one year. Fixed assets typically include:
 Machinery and equipment
 Buildings
 Land
 Other Assets – Assets that are neither current
assets nor fixed assets. They may include long-term
investments and intangible assets such as patents,
copyrights, and goodwill.
Balance Sheet Terms: Assets

12.  Debt (Liabilities)
 Money that has been borrowed from a creditor
and must be repaid at some predetermined date.
 Debt could be current (must be repaid within
twelve months) or long-term (repayment time
exceeds one year).
Balance Sheet Terms: Liabilities

13.  Current Debt:
 Accounts payable (Credit extended by suppliers to a firm
when it purchases inventories)
 Accrued expenses (Short term liabilities incurred in the firm’s
operations but not yet paid for)
 Short-term notes (Borrowings from a bank or lending
institution due and payable within 12 months)
 Long-Term Debt
 Borrowings from banks and other sources for more than 1
year
Balance Sheet Terms: Liabilities

14.  Equity: Shareholder’s investment in the firm in the form of
preferred stock and common stock.
 Preferred stock: Preferred stockholders enjoy preference with
regard to payment of dividend and seniority at settlement of
bankruptcy claims.
 Retained Earnings: Cumulative total of all the net income over
the life of the firm, less common stock dividends that have been
paid out over the years.
 Paid in Capital: (money that a company gets from potential
investors in addition to the stated value of the stock).
Balance Sheet Terms: Equity

15. Balance Sheet
Assets Liabilities (Debt) & Equity
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses
Fixed Assets
Machinery & Equipment
Buildings and Land
Other Assets
Investments & patents
Current Liabilities
Accounts Payable
Accrued Expenses
Short-term notes
Long-Term Liabilities
Long-term notes
Mortgages
Equity
Preferred Stock
Common Stock (Par
value)
Paid in Capital
Retained Earnings

16. Balance Sheet

17. Cash Flows Statement
 Shows the changes of cash for the company in certain
period of time.
 Divided sources and uses of cash into three components:
Cash flow from operating activities
Cash flow from investment activities
Cash flow from financing activities
 Increasing (decreasing) of net cash is total cash flow from
operating, investing and financing activities. This changes
will be added with beginning balance to get ending cash
balance.

18. Cash inflows and outflows

19. Figure 2-2

20. Table 2-4

21. Uses of Financial Ratios:
Within the Firm
 Identify deficiencies in a firm’s performance
and take corrective action.
 Evaluate employee performance and
determine incentive compensation.
 Compare the financial performance of
different divisions within the firm.

22. Uses of Financial Ratios:
Outside the Firm
Financial ratios are used by:
 Lenders in deciding whether or not to make a loan to
a company.
 Credit-rating agencies in determining a firm’s credit
worthiness.
 Investors (shareholders and bondholders) in deciding
whether or not to invest in a company.
 Major suppliers in deciding to whether or not to grant
credit terms to a company.

23. Trend analysis
Compare the current ratios with ratios in previous year. It
covers some time period so the analyst can see the
achievement flow for the company in longer period.
Comparison analysis
Compare the company’s ratios with ratios of other
equivalent companies. If there is industry ratios, it can be
used as a guide to evaluate the position of the company in
the industry.
Benchmarking
Compare the company’s financial position with other
competitors.
Types of Analysis

24. 2. Measuring Key Financial
Relationships: Five Key Questions
1. How liquid is the firm? (Liquidity)
2. Is management generating adequate operating
profits on the firm’s assets?(Profitability)
3. Is management providing a good return on the
capital provided by the shareholders? (Asset
Management)
4. How is the firm financing its assets? (Leverage)
5. Is the management team creating shareholder
value? (Market-Value)

25.  Liquidity is measured by two approaches:
1. Comparing the firm’s current assets and current liabilities
2. Examining the firm’s ability to convert accounts receivables
and inventory into cash on a timely basis
 Working Capital uses to measure the ability of a business
to pay it short term debt by current assets and shows the
amount of leaved current assets after current liabilities has
been paid.
Formula: Working capital = Current assets – current liabilities
Larger the net working capital, better the firm’s ability to
repay its debt.
Net working capital can be positive or zero or negative. It is
1. Liquidity ratios

26.  Current ratio compares a firm’s current assets to its
current liabilities.
Formula:
Current ratio = Current assets/Current liabilities = x Times
 The higher of this ratio means the business financial is
better where it has enough liquid asset of its operation.
Liquidity ratios (cont…)

27.  Quick ratio compares cash and current assets (minus
inventory) that can be converted into cash during the year
with the liabilities that should be paid within the year.
Formula:
Quick Ratio = Current Assets – inventory / Current liabilities = x Times
 This ratio is more stringent measure of liquidity than the
current ratio in that it excludes inventories and other current
assets (those that are least liquid) from current assets.
 The higher the answer, shows the business has enough quick
assets to pay its short term debt immediately.
Liquidity ratios (cont…)

28. 2. Asset management ratios
 Is management generating adequate operating profits
on the firm’s assets?
 It use to identify the efficiency and effectiveness of the
firm in managing its assets.
 The firm should make basic decision about total
investment in account receivable, inventory and fixed
assets.

29. Asset management ratios (cont…)
 Average Collection Period (ACP) determines the average
days for the firm to collect its account receivable from
customers in certain period.
 How long does it take to collect the firm’s receivables?
Formula:
ACP = Accounts receivable/(Annual credit sales/365)= Days
= Accounts receivable/(Daily credit sales)= Days
 Comparison of this ratio with credit period will measure the
efficiency of the firm to collect its debt.

30.  Account Receivable Turnover determines the ability of the
business to collect debt from its customers. It shows the
number of account receivable turn in a year. A turn covers
the starting period of account receivable until the due of the
account.
Formula
Account Receivable Turnover =
Credit Sales/Accounts receivable = Times
 Higher account receivable turnover is better because it
shows the business can collect its debt immediately and has
a few bad debt.
Asset management ratios (cont…)

31.  Inventory Turnover measures the number of times a firm’s
inventories are sold and replaced during the year.
Formula:
 Inventory Turnover = Cost of goods sold/Inventory = Times
 The higher turnover means the firm in better position
because it shows the quick inventory movement. Inventory
can be sold quickly and replace back immediately. It also
can reduce the number of cash in term of inventory. It also
prevent the bad inventory.
Asset management ratios (cont…)

32.  Fixed Asset Turnover indicates how efficiently the firm is
using its fixed assets.
Formula:
Fixed Asset Turnover = Sales/Total fixed assets = Times
 The higher this ratio is better because it shows the
effectiveness of the firm to produce sales from its fixed
assets. This ratio shows the sales generated from every
dollar of fixed asset.
Asset management ratios (cont…)

33.  Total Asset Turnover shows the assts efficiency based on
the relation between firm’s sales and the total assets.
Formula:
Total Asset Turnover = Sales/Total Assets = Times
 The higher of this ratio is better because it shows the
effectiveness of the firm in managing its assets. It means
how much of sales can be generated from every dollar of
asset.
Asset management ratios (cont…)

34. 3. Profitability Ratio
 Gross Profit Margin measures of the gross profit earned
on sales. The gross profit margin considers the firm's cost
of goods sold, but does not include other costs.
Formula:
Gross profit margin= Gross profit/Sales = %
 The higher of this ratio is better because it means efficient
purchase management and related cost with purchases is
reduced.

35. Profitability Ratio (cont….)
 Net profit margin determines profit earns from every dollar
of sales after all expenses, including cost of good sold,
sales expenses, general and admin cost, depreciation,
interest and tax completely paid.
Formula:
Net profit margin= Net Income/Sales = %
 The higher of this ratio is better because it shows the
reducing in expenses or cost in producing sales.

36. Profitability Ratio (cont….)
 Return On Equity (ROE) measures the profits earned for
each dollar invested in the firm's stock
Formula:
ROA= Net income/Common Equity= Times
Higher ratio is favored because the firm can generate better
return to the owner of the firm.
 Return On Asset (ROA) determines the effectiveness of
management in using their asset to generate income.
Formula:
ROA= Net income/Total Assets = Times
The higher of this ratio is better because it show the firm is
more effective in using their assets.

37. 4. Leverage Ratio
 Does the firm finance its assets by debt or equity or both?
 Leverage ratio shows the ability of the firm to fulfill its
responsibility or obligation to their debtors.
 This ratio determine the effectiveness of management in using
and managing capital.
 Debt Ratio indicates the percentage of the firm’s assets that
are financed by debt (implying that the balance is financed by
equity).
Formula:
Debt Ratio = Total debt/Total assets = %
The lower of this ratio means more coverage earn by debtors
if the firm bankrupt.

38. Leverage Ratios (cont..)
 Debt to Equity Ratio measure the percentage of liability
covers by equity.
Formula:
Debt to Equity (DOE)= Total debts/Total equity= %
The lower of this ratio is better because it shows the firm is
able to add its debt/liability if it needs to do so.
 Times Interest Earned indicates the amount of operating
income available to service interest payments.
Formula:
Times Interest Earned = Operating profit (EBIT)/Interest= Times
The higher of this ratio is better because it shows the firm is
able to pay the interest expenses.

39.  Is the management team of the firm creating shareholder
value?
 Earning Per Share (EPS) represents the portion of a
firm's earnings, that is allocated to each share of common
stock.
Formula:
EPS = Net income/number of shares
 The higher the earnings per share, the higher each share
should be worth.
5. Market Value Ratios

40. Market Value Ratios (cont….)
 Price/Earnings Ratio Indicates how much investors
are willing to pay for $1 of reported earnings.
Formula:
P/E = Price per share/Earnings per share= Times
 A high P/E ratio is better because it shows that
investors are anticipating higher growth in the future.

41.  Market-to-Book Ratio measures how much a company
worth at present, in comparison with the amount of capital
invested by current and past shareholders into it. It shows
firm's success in creating value for its stockholders.
 Indicates the investor’s assessment of the firm.
 Formula:
Market-to-Book Ratio = market value per share/ book value per
share
Where: Book value per share= Equity/number of shares
 The higher of this ratio is better because the investors believe the
firm is more valuable than what they originally paid for the stock.
Market Value Ratios (cont….)

42. 3. The Limitations of
Financial Ratio Analysis
 It is sometimes difficult to identify industry categories
or comparable peers.
 The published peer group or industry averages are
only approximations.
 Industry averages may not provide a desirable target
ratio.
 Accounting practices differ widely among firms.
 A high or low ratio does not automatically lead to a
specific conclusion.
 Seasons may bias the numbers in the financial
statements.