MANAGERIAL FINANCE

MODULE 2

Financial Statements & Ratio Analysis

iii) Statement of Cash flows

It provides a summary of the cash flows over the period of concern, typically the year just ended. The statement provides insight into the firm s operating, investing and financing cash flows, and reconciles them with changes in its cash and marketable securities during the period of concern. Refer Table 2.3 Bartlett Co. s Cash Flow statements for the year ended 31 December 2005.

iv) Notes to the Financial Statements

They provide detailed information on the accounting policies, procedures, calculations and transactions underlying entries in the financial statements. Common issues include revenue recognition, income taxes, breakdown of non-current asset accounts, debt and lease terms, and contingencies.
* Professional securities analysts use the data in the statements and notes to develop estimates of the value of securities that the firm issues, and these estimates influence the actions of investors and firm s share value.

v) Consolidated international financial statements

The financial statements have been discussed was in only one currency. The issue of how to consolidate a Co. s foreign and domestic financial statements has bedeviled the accounting profession. The current policy mandates that companies translate their foreign-currency-denominated assets and liabilities into dollars, for consolidation with the parent company s financial statements. This is done by using a technique called the current rate (translation) method under which all the parent company s foreign currency-denominated assets and liabilities are converted into dollar values using the exchange rate prevailing at the financial year ending date.

Tab 2.1 Bartlett Co. Income Statements ($ 000) for the year ending Dec.31

2005
Sales revenue Less: Cost of goods sold Gross profits Less : Operating expenses Selling expenses General & admin expenses Lease expense Depreciation expense Total operating expense Operating profits Less: Interest expense Net profits before taxes Less: Taxes (rate = 29%) Net profits after taxes Less: Preference Dividends Earnings available for ordinary shareholders Earnings per share Dividends per share

2004
$3074 2088 _856 $100 $2567 1711

986

$108 187 35 223 553 303 91 212 64

194 35 239 568 418 93 325 94 231 10 221 $2.90 $1.29

148 10 138 $1.81 $0.75

Tab 2.2

Bartlett Company Balance Sheets ($ 000) as at 31 December 2005 2004

Assets Current assets Cash Marketable securities Accounts receivable Inventories Total current assets Non-current assets (at cost) Land & buildings Machinery & equipment Furniture & fixtures Vehicles Other (include financial leases) Total gross fixed assets (at cost) Less: Accumulated depreciation Net fixed assets Total assets

$363 68 503 289 $1223 51 365 300 $1004

$288

$2072 1866 358 275 98 $4669 2295 2374 $3597 =====

$1903 1693 316 314 96 $4322 2056 2266 $3270 =====

Liabilities and Shareholders Equity

Current liabilities Accounts payable Notes payable Accruals Total current liabilities Non-current debt (includes financial leases) * Total liabilities

2005

2004

$382 79 159 $620 $1023 $1643

$270 99 114 $483 $967 $1450

Shareholders equity Preference shares cumulative 5%, $100, 2000 shares issued $200 Ordinary shares- Shares issued 2005: 76262 in 2004:76244 619 Retained earnings 1135 Total shareholders equity $1954 Total liabilities and shareholders equity $3597

$200 608 1012 $1820 $3279

Tab 2.3 Bartlett Company Statement of Cash flows ($000) for the year 31/12/05
Cash flows from Operating Activities Net profit after taxes Depreciation Increase in accounts receivable Decrease in inventories Increase in accounts payable Increase in accruals Cash provided by operating activities Cash flow from Investing activities Increase in gross non-current assets Change in business interests Cash provided by investing activities $231 239 (138)* 11 112 45 $500

(347) 0 (347)

Cash flow from Financing activities Decrease in notes payable ( 20) Increase in non-current debts 56 Changes in shareholders equity* 11 Dividends paid (108) Cash provided by financing activities Net increase in cash and marketable securities

(61) $92 ====

Using financial ratios

The information contained in the financial statements is of major significance to shareholders, creditors, and managers all of whom need to have relative measures of company s operating efficiency and condition. Relative is the key word here, since analysis of financial statements is based on the knowledge and use of ratios or relative values. Ratio analysis involves the methods of calculating and interpreting financial ratios in order to assess the firm s performance and status. The inputs to ratio analysis are the firm s income statement and the balance sheet for the periods to be examined.

Interested parties
The financial statements ratio analysis is of interest to shareholders, creditors, and the firm s management. i) Both present and prospective shareholders are interested in the firm s current and future level of risk and returns that directly affect the share price. ii) Creditors are interested in the short-term liquidity of the company and its ability in making the interest and principal payments. Their concern is also the firm s profitability, they want the business to be healthy and that will continue. iii) Management like shareholders, must be concerned with all aspects of the firm s financial situation. So they must operate in a manner that will result in financial ratios that will be considered favorable by both owners and creditors. They use ratios to monitor firm s performance from period to period.

Types of ratio comparisons

Ratio analysis does not involve the application of a formula o financial data in order to calculate a given ratio. More important is the interpretation of a ratio value, is it high or low, good or bad? 2 types of comparisons are made, cross-sectional and time-series. i) Cross sectional analysis It involves the comparison of different firm s financial ratios at the same point in time. Normally a business is interested to know how well it has performed in relation to its competitors. If they are companies, their reported financial status should be available for analysis. This type of cross-sectional analysis, is called bench marking . By comparing the firm s ratios to those of the benchmark Company, it can distinguish its areas in which it excels and areas which needs improvement. Another comparison is with industry averages, found in Market Comparative Analysis, e.g. Stock Exchange, Business Review, Financial Analysis Publication.

Misleading Ratios Many people mistakenly believe that in the case of ratios for which higher values are preferred as long as the firm being analyzed has a value in excess of industry average, it can be viewed favorably. The bigger the better view can be misleading. Often a ratio that has a large but positive deviation from the norm can be indicative of problems. These may on more careful analysis be more severe than had the ratio been below the industry average.Refer example p47 ii) Time-series analysis This is applied when a financial analyst evaluates performance over time. Comparison of current with past performance, using ratio analysis, allows the firm to determine whether it is progressing as planned. Developing trends can be seen over multi-year comparisons.. As in cross-sectional analysis, any significant year to-year changes can be evaluated to assess whether there are any major problems.

Combined Analysis

The combined cross-sectional and time-series analysis are the most informative approach to ratio analysis. This permits assessment of the trend in behavior of the ratio in relation to the trend for the industry.
Cautions about using ratio analysis i) Ratios with large deviations from the norm only indicate symptoms of problem. Additional analysis needed to find out the causes of the problem. ii) A single ratio does not necessarily provide sufficient information from which to judge the overall performance of the firm. iii) The ratios compared should be calculated using the financial statements dated at the same point of time during the year, if not it may produce erroneous conclusions and decisions. iv) It is preferred to use audited financial statements for ratio analysis, if not they might not reflect the true financial situation.

v) The financial data compared should have developed in the same way. Use of different accounting treatment for inventory and depreciation can distort figures. vi) Results could be distorted by inflation, which cause the book values of inventory and depreciable assets to differ greatly from their true (replacement values).

Categories of financial ratios

Financial ratios can be divided into five basic categories: i) Liquidity Ratios ) Measures ii) Activity Ratios ) iii) Debt Ratios ) Risk iv) Profitability Ratios ) Return v) Market Ratios ) Risk & Return

1) Liquidity Ratios
The liquidity ratios are measured by its ability too satisfy its short term obligations as they come due. Liquidity refers to the solvency of the firm s overall financial position. These ratios are viewed as liquidity are the current ratio and the quick (acid-test) ratio. a) Current Ratio one of the most commonly cited financial ratios, measures the firm s ability to meet its short-term obligations and expressed as follows:

Current Ratio = Current Assets Current Liabilities

The current ratio for Bartlett in 2005 is $1,223,000= 1.97 $ 620,000 A current ratio of 2 is acceptable, but the acceptability of the value depends on the industry in which a firm operates.

b) Quick-acid test ratio

The quick-acid test ratio is similar to current ratio, except that it excludes inventory, which is generally the least liquid current asset. The generally low liquidity of inventory results from primary factors 1) many types of inventory cannot be easily sold, 2) the items are sold on credit, and not easily converted into cash. The ratio is: Quick ratio = Current assets inventory Current Liabilities Quick ratio for Bartlett in 2005 is : $1,223,000 - $289,000 = 1.51 $620,000 * A Quick ratio of 1 or greater is occasionally recommended, but as with the current ratio, an acceptable value depends largely on the industry. Quick ratio provides a better measure of overall liquidity when a firm s inventory cannot be converted into cash easily.

2. Activity Ratios
Activity ratios measure the speed with which various accounts are converted into sales or cash- inflows or outflows. Measures of liquidity are inadequate because differences in the composition of a firm s current assets and current liabilities can significantly affect its true liquidity. It is important to look beyond measures of overall liquidity to assess the activity of specific current accounts. A no. of ratios are available for measuring the activity of current accounts, inventory, accounts receivable and accounts payable. The efficiency with which total assets are used can also be assessed. The activity ratios involving the current accounts assume that their end-of period values are good approximations of the average account balance during the period, which is one year.

a) Inventory Turnover
This commonly measures the activity, or liquidity of a firm s inventory. It is calculated as follows : Inventory turnover = cost of goods sold inventory Applying this to Bartlett in 2005 = $2,088,000 = 7.2 $289,000 The resulting turnover is meaningful only if it is compared with that of other firm in the same industry, or the firm s past inventory turnover. Inventory turnover can easily be converted into an average age of inventory by dividing it into the no. of days. e.g. 360 days for a 12 month of 30 days. For Bartlett, this would be 50.0 days (360/7.2). This value can also be viewed as the average no. of days

b) Average Collection Period

The average collection period, or average age of accounts receivable, is useful in evaluating credit and collection policies. It is derived by dividing the average daily sales into the accounts receivable balance: Average collection period = accounts receivable average sales per day = accounts receivabl (average sales) /360 Applying this for Bartlett in 2005 it is = $503,000 = 58.9 days ($3,074,000)/360 * This is meaningful only in relation to the firm s credit terms. If for instance Bartlett extends 30-day credit terms to customers, an average collection period of 58.9 days indicate a poorly managed credit.

c) Average Payment Period

The average payment period, or average age of accounts payable, is calculated in the same manner as the average collection period. Average payment period = accounts payable average purchase per day = accounts payable (annual purchases / 360) *To find the annual purchases is difficult, as value is not given in the published financial statements. Purchases are estimated at a percentage of cost of goods sold. If Bartlett s purchases equals to 70% of its cost of goods sold in 2005: Average payment period = $382,000 $2,088,000 x 70% 360 = $382,000 $4,060 = 94.1 days

d) Total Assets Turnover

Total assets turnover indicates the efficiency with which the firm uses all its assets to generate sales. Total assets turnover is Calculated as: Total assets turnover = Sales Total assets The value of Bartlett s total assets turnover in 2005 is: $3,074,000 = 0.85 $3,597,000 The company therefore turns its assets over 0.85 times a year. Generally the higher a firm s total assets turnover, the more efficient the its assets have been used. This is important to the management as it indicates whether the firm s operations are financially efficient.

3. Debt Ratios
The debt position of the firm indicates the amount of other people s money being used in attempting to generate profits. The financial analyst is most concerned with non-current debts, because these commit the firm to paying interest over the long term, as well as eventually repaying the principal borrowed. The claims of creditors must be satisfied prior to the distribution of earnings to shareholders. Shareholders pay special attention to the degree of indebtedness and ability to repay the debts. Lenders and Management are also concerned with the firm s indebtness. The more debt a firm uses in relation to its total assets, the greater its financial leverage. Financial leverage is the risk and return introduced through the use of fixed cost financing such as a debt.

i)

Debt ratio

The debt ratio measures the proportion of total assets financed by the firm s creditors. The higher this ratio, the greater the amount of other people s money being used in an attempt to generate Portfolio. The ratio is calculated : Debt ratio = Total liabilities Total assets Applying to Bartlett in 2005 is : $1,643,000 = 0.457 = 45.7% $3,597,000 This indicates that the company has financed 45.7 % of its assets with debt. The higher the ratio, the more financial leverage a firm has.

ii) Times interest earned ratio

The times interest earned ratio measures the ability to make contractual interest payments. The higher the value of this ratio, the better able the firm is to fulfil its interest obligations. Times interest earned is calculated as follows: Times interest earned = earnings before interest and taxes interest The figure for earnings before interest and taxes is the same as the figure for operating profits shown in the income statement. Applying this ratio to Bartlett in 2005 : Times interest earned = $418,000 = 4.5 $93,000 The times interest earned ratio for Bartlett seems acceptable. A value of at least 3.0 5.0 is suggested.

iii) Fixed-payment coverage ratio

The fixed-payment coverage ratio measures the firm s ability to meet all fixed-payment obligations, such as loan interest and principal, lease payments and preference dividends. As it is true for the times interest earned ratio, the higher this value, the better. The formula is : Fixed payment coverage ratio = earnings before interest and taxes + lease payments Interest + lease pay ts + {(principle pay t + preference dividends) x| 1/(1-T)|} Where T is the corporate tax rate applicable to the firm s income. The term 1/(1-T) is included to adjust the after-tax principal and preference dividend payments back to a before-tax equivalent consistent with the before-tax values of all other firms. Applying this to Bartlett in 2005:

Fixed payment coverage ratio = $418,000 + $35,000

$93,000 + $35,000 + {(79,000 + $10,000) x |1/(1- 0.29)|} = $453,000/ $242,000 = 1.9 As the earnings available are nearly twice as large as its fixed-payment obligations, the firm appears to safely meet its fixed payment.