Financial Management

1. Financial Management Understanding Financial Statements Analysis of Financial Statements Introduction to Financial Management

2. Understanding Financial Statements Objective of this section is; To get an understanding about the Financial Statements • Income Statement (Earnings Statement) • Balance Sheet • Statement of Changes in Equity • Statement of Cash Flows • Accounting Policies & Notes

3. Uses of financial statements? • allow user to assess: • financial position of the company • success of its operations • policies and strategies of management • insight into future performance • Financial statements are “history” BUT they can help project the future

4. Accounting Period • Although the firm’s life is continuous (going concern), financial data is presented for arbitrary time periods - year, quarter, etc. • Leads to make adjustments and estimates Ex. Accruals, depreciations.

5. Income Statement • For a given Period (Ex. Year, semi annual etc.) • Realization Principle • Matching Concept • Accrual Vs. Cash

6. Income Statement cont…) Ex. Revenue *** Cost of sales (**) Gross profit *** Other income ** Distribution Cost (**) Admin. Expenses (**) Other (**) Operating Costs (**) Operating Profit *** Finance Cost (**) Profit before tax *** Tax (**) PAT *** Extraordinary Items (**) NPAT ***

7. Issues of the Income Statement • Accrual basis • Estimates, Ex. depreciation provision for bad debts) • Cash flow Vs. Income statement. • Opportunity cost is not considered.

8. Balance Sheet A “statement of financial condition” On a particular date (a “snapshot”) Assets = Liabilities + Equities

9. Balance Sheet cont… Ex. Assets Note Rs. Non Current Assets Property, Plant equipment (*) *** Investments (*) *** Intangible Assets (*) *** Current Assets Inventories (*) *** Debtors (*) *** Cash & Bank (*) *** Total Assets *** Capital & Liabilities Share Capital (*) *** Reserves (*) *** Accumulated Profits (*) *** Non- current Liabilities Debentures (*) *** Current Liabilities Creditors (*) *** Bank OD (*) *** Capitol and Liabilities ***

10. Issues of the Balance Sheet • Historical cost Tangible (ex. Fixed assets) Intangible (ex. TM, Goodwill) • Estimates (ex. depreciation) • Non-Comparability (ex. Assets acquired at different time periods)

11. Statement of Equity • Documents changes in balance sheet equity accounts from one accounting period to the next • Provides an important link between the balance sheet and the income statement

12. Cash Flow Statement • A positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash • Only source in financial statement to learn about the generation of cash from operations is the statement of cash flows”

13. Components of Cash Flow Statement • OPERATING ACTIVITIES • INVESTING ACTIVITIES • FINANCING ACTIVITIES • Which do you think is most important in assessing the firm’s prospects? Why? • Defining these activities may help answer the question...

14. The most important component of a cash flow • All sources and uses of cash represent important information • But, only cash flows from operating activities represent cash generated internally • In order to SURVIVE, a firm needs to generate positive cash flows internally, i.e. from “what it does for a living”...

15. Notes • Are an INTEGRAL part of the statements • Provide summary of accounting policies • Present detail about particular accounts (e.g. inventory, investments, etc.) • Include other information (e.g. leasing arrangements, pending legal proceedings, income taxes, etc.)

16. Profitable, yet in Trouble? • A firm is defined as “profitable if it has a positive net income • A positive net income results from accrual-based revenues exceeding accrual-based expenses • A firm may have a positive net income, but this does not guarantee that the firm has the CASH to meet its obligations! • However, the idea is that, financial statements will be much more of a map

17. Analysis of Financial Statements The objective is to understand; • How financial statement analysis helps to assess the firm’s health. • The basic tools of financial statement analysis (e.g. trend, cross-sectional, and ratio analysis)

18. Basic Tools • Common size financial statements • Financial ratio analysis • Trend analysis • Cross-sectional analysis

19. Common Size Statements • Common size income statement • expresses each income statement category as a percentage of net sales • Common size balance sheet • expresses each item on balance sheet as a percentage of total assets • Both statements facilitate structural analysis of the firm

20. Ratio Analysis A ratio measures the relationship between two or more variables. Motivation for use of ratios • Gives a summary statistic • Helps to identify benchmarks • Standardizes financial statements • Easy to measure relationships • Easy to make comparisons

21. Ratio Analysis cont… • Profitability ratios • Liquidity ratios • Debt ratios • Asset activity ratios • Market value ratios Five Categories of Ratios

22. Ratio Analysis cont… Profit Vs. Profitability Profitability ratios measure the overall effectiveness of the firm’s management. • There are two profitability ratios • Profit on Sales • Profit on Investment Profitability Ratios

23. Profitability Ratios

24. Profitability Ratios cont… Profit Margin Profit margin ratio measures a firm's ability to control its expenses relative to its sales. Gross Profit Sales Gross Profit Margin = How effective is the firm in generating revenue in excess of its cost of goods sold?

25. Balance Sheet Beta Company Ltd. Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities Rs.230 Current Assets Rs.1,230 Bonds Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Income Statement Beta Company Ltd. Gross Profit = Margin Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Net Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 Gross Profit Sales 575 1,450 Gross Profit Margin = = 39.7%

26. Profitability Ratios cont… Operating profit margin Operating Income Sales Operating Profit Margin = How effective is the firm in keeping costs of production low?

27. Balance Sheet Beta Company Ltd. Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable Rs.115 Inventories 625 Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Cap.l in Excess of Par Rs.600 Total Assets Rs.2,530 Retained Earnings Rs.800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Income Statement Beta Company Ltd. Operating Profit = Margin Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 Operating Income Sales 330 1,450 Oper. Profit Margin = = 22.8%

28. Profitability Ratios cont… Net Profit Margin Net Income Sales Net Profit Margin = How much net profit is being generated from sales?

29. Balance Sheet Beta Company Ltd Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable Rs.115 Inventories 625 Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Cap.l in Excess of Par Rs.600 Total Assets Rs.2,530 Retained Earnings Rs.800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Income Statement Beta Company Ltd Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 Net Profit = Margin Net Income Sales 162 1,450 Net Profit Margin = = 11.2%

30. Profitability Ratios cont… Return On Assets Net Income Total Assets Return on Assets = • How effectively is the firm generating net income from its assets ? • ROA does not consider leverage

31. Balance Sheet Beta Company Ltd Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable Rs.115 Inventories 625 Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Cap.l in Excess of Par Rs.600 Retained Earnings Rs.800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Total Assets Rs.2,530 Income Statement Beta Company Ltd Net Income Total Assets Return on Assets Sales Rs.1,450 Cost of Goods Sold Rs.875 Gross Profit Rs.575 Operating Expenses Rs. 45 Depreciation Rs. 200 Operating Income Rs.330 Interest Expense Rs. 60 Income Before Taxes Rs.270 Taxes (40) Rs.108 Net Income Rs.162 Dividends Paid Rs.100 Addition to Retained Earnings Rs.62 = 162 2,530 ROA = = 6.4%

32. Profitability Ratios cont… Return On Equity Net Income Common Equity Return on Equity = How well is the firm generating return to its equity providers?

33. Balance Sheet Beta Company Ltd Assets Liabilities Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable Rs.115 Inventories 625 Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Cap.l in Excess of Par Rs.600 Retained Earnings Rs.800 Total Liabilities and Owners Equity Rs.2,530 Total Assets Rs.2,530 Total Owners’ Equity Rs.1,700 Income Statement Beta Company Ltd Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 Net Income Common Equity Return on Equity = 162 1,700 ROE = = 9.53%

34. Liquidity Ratios Measure the ability of the firm to meet its short-term financial obligations.

35. Liquidity Ratios Measure the ability of the firm to meet its short-term financial obligations. Current Assets Current Liabilities Current Ratio = Are there sufficient current assets to pay off current liabilities? What is the cushion of safety?

36. Balance Sheet Beta Company Ltd Assets Liabilities Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities Rs. 230 Current Assets Rs.1,230 Long-term DebtRs. 600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Current Assets Current Liabilities Current Ratio = 1,230 230 Current Ratio = = 5.35

37. Liquidity Ratios cont… Quick/Acid-test ratio Current Assets - Inventory Current Liabilities Acid-Test Ratio = What happens to the firm’s ability to repay current liabilities after what is usually the least liquid of the current assets is subtracted?

38. Balance Sheet Beta Company Ltd Assets Liabilities Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities Rs. 230 Current Assets Rs.1,230 Long-term Debt Rs. 600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Current Assets - Inventory Current Liabilities Acid-Test Ratio = 1,230 -625 230 = 2.63 Acid-Test Ratio=

39. Debt Ratios Measure the relative size of the firm’s debt and the firm’s ability to pay off the debt.

40. Debt Ratios Measure the relative size of the firm’s debt and the firm’s ability to pay off the debt. Total Debt Total Assets Debt Ratio = • What proportion of firm’s assets are financed with debt?

41. Balance Sheet Beta Company Ltd Assets Liabilities Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 8 00 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Income Statement Beta Company Ltd Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 Total Debt Total Assets Debt Ratio = 230 + 600 2,530 Debt Ratio = = 33%

42. Debt Ratios cont… Debt To Equity Ratio Debt to Equity Ratio Total Debt Common Equity = What is the proportion of debt relative to equity financing for the firm?

43. Balance Sheet Beta Company Ltd Assets Liabilities Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Income Statement Beta Company Ltd Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 Debt to Equity Ratio Total Debt Common Equity = 230 + 600 1,700 D/E = = 48.8%

44. Debt Ratios cont… Times Interest Earned ratio Operating Income Interest Expense Times Interest Earned Ratio = • What is the firm’s ability to repay interest payments from their income?

45. Times Interest = Earned Ratio Operating Income Interest Expense Balance Sheet Beta Company Ltd Assets Liabilities Cash Rs.175Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530Retained Earnings 800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Income Statement Beta Company Ltd Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 330 60 = 5.5 TIE Ratio =

46. Asset Activity Ratios

47. Asset Activity Ratios Help to assess how effectively the firm is using assets to generate sales. Accounts Receivable Avg. Daily Credit Sales Average Collection Period = How long does it take for the firm to collect its credit sales from customers?

48. Average Collection = Period Accounts Receivable Avg. Daily Credit Sales Balance Sheet Beta Company Ltd Assets Liabilities Additional Info: We assume all sales are credit sales. Cash Rs.175 Accounts PayableRs.115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities Rs.230 Current Assets Rs.1,230 BondsRs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Income Statement Beta Company Ltd Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 430 1,450/365 ACP = = 108.24 days Days in a year

49. Asset Activity Ratios cont… Inventory Turnover ratio Sales Inventory Inventory Turnover Ratio = How many times the inventory is translated into sales?

50. Inventory Turnover = Ratio Sales Inventory Balance Sheet Beta Company Ltd Assets Liabilities Cash Rs.175 Accounts Payable Rs.115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities Rs.230 Current Assets Rs.1,230 Long-term Debt Rs.600 Plant & Equipment Rs.2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock Rs.300 Net Fixed Assets Rs.1,300 Capital in Excess of Par 600 Total Assets Rs.2,530 Retained Earnings 800 Total Owners’ Equity Rs.1,700 Total Liabilities and Owners Equity Rs.2,530 Income Statement Beta Company Ltd Sales Rs.1,450 Cost of Goods Sold 875 Gross Profit Rs.575 Operating Expenses 45 Depreciation 200 Operating Income Rs.330 Interest Expense 60 Income Before Taxes Rs.270 Taxes (40%) 108 Net Income Rs.162 Dividends Paid 100 Addition to Retained Earnings Rs.62 1450 625 Inventory Turnover = = 2.3