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Financial Management

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Financial Management ­ MGT201
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Lesson 03
ANALYSIS OF FINANCIAL STATEMENTS
Learning Objectives:
After going through this lecture, you would be able to have a better understanding of the following
concepts.
·  Analysis of Financial Statements
·  Key Financial Ratios
·  Limitation of Financial Statements Analysis
·  Market value added & Economic value added.
You have studied in previous lecture
·  Objective of Economics:
The objective of economics is profit maximization, however, for whom the profit is to be
maximized and for what duration may vary.
·  Objective of Financial Accounting (FA):
The objective of financial accounting is to record accurate, timely, consistent, and
generalized collection of financial data, consolidating the information and reporting it to the
management for decision-making. Nevertheless, the decision-makers use financial
management techniques for a useful interpretation of the consolidated financial data.
·  Objective of Financial Management (FM):
The  objective  of  financial  management  is  to  maximize  the  wealth  of  the
shareholders/owners. One way of increasing shareholders' wealth is by maximizing the
stock price. In financial management when we talk about the profit maximization, we
actually imply profit maximization for the shareholders of the company. We can simply
measure it from the share price of the company in the market.
Another way is to find the best investment and financing opportunities in order to maximize
the value of the company. As we will see in the later lectures, the two ways are closely
related to each other. Financial statements are used to assess the financial position as well as
performance of the company, so that the financing and investing decisions could be taken
accordingly.
Analysis of Financial Statements:
A company's financial statements need to be studied for signs of financial strengths and
weaknesses and then compared to (or benchmarked against) the industry. Before getting
into the details of the financial management techniques, we would briefly revise some of the
accounting concepts, which are going to help us in comprehending those analysis
techniques.
Basic Financial Statements:
There are four basic financial statements that are prepared by the financial accountants for the
use of the managers, creditors and investors of the company. These statements are
a. Balance Sheet
b. P/L or Income Statement
c. Cash Flow Statement
d. Statement of Retained Earnings (or Shareholders' Equity Statement)
The concepts that we are going to discuss here in reviewing financial accounting concepts are
Fundamental Accounting Equation and Double Entry Principle.
·  Assets +Expense = Liabilities + Shareholders' Equity + Revenue
(Note: Expense & Revenue are Temporary P/L accounts ­ the others are Permanent Balance Sheet
Accounts)
·  Left Hand Items increase when debited. Right Hand items increase when credited.
·  For every journal entry, the Sum of Debits = the Sum of Credits
Balance Sheet:
The following facts about balance sheet are also going to help us in understanding the
financial statements analysis process.
­  A balance sheet is a `static snapshot' at one point in time (therefore the consolidated
data available is vulnerable to inventory and cash swings, i.e., if the balance sheet of a
firm is showing low inventory and high cash position at the year ending when the
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Financial Management ­ MGT201
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balance sheet is prepared, the company may buy excessive inventory against cash the
very next day. The balance sheet prepared a day earlier would not report the new
transaction and the latest financial position of the company would not be known to the
analyst, unless the company updates him on that.)
­  Balance sheet items or accounts are `permanent accounts' that continue to accumulate
from one accounting cycle to the next.
­  Balance sheet items are recorded on historical cost basis, i.e., the balance sheet neglects
any increase in value of assets resulting from inflation and reports assets and liabilities
at their book value. It is a big limitation for financial analysts, since a useful analysis
could only be made by considering the assets and liabilities at their market value rather
than book value. Nevertheless, there are some approaches by which we can solve this
problem. Constant rupee approach is one such remedy.
­  Constant Rupee Approach: In constant rupee approach, two balance sheets of the same
company for different times are compared at a specific time and inflationary
adjustments are made.
·  Assets (Left Hand Side):
Having revised certain concepts and limitations of financial accounting process and
financial statements, we would now have a brief overview of the items that appear on the left-hand
side of the balance sheet, known as assets.
­  Assets are economic and business resources that are used in generating revenue for the
organization: They can be tangible (inventory) or intangible (patent, brand value,
license). Some assets are classified as current (cash, accounts receivable) and others are
fixed (machinery, land, and building). There are also long-term assets (property, loans
given) and contingent assets, the value of which can only be assessed in future (legal
claim pending, option).
­  Current Assets = Cash + Marketable Securities + Accounts Receivable + Pre-Paid
Expenses + Inventory
­  The accounts receivable aging schedule is a listing of the customers making up total
accounts receivable balance. Most businesses prepare an accounts receivable aging
schedule at the end of each month. Analyzing your accounts receivable aging schedule
may help you identify potential cash flow problems.
­  Inventory value (at any instant in time) is a very controversial figure which depends on
inventory valuation methodology (i.e. FIFO, LIFO, Average Cost) and Depreciation
Method (i.e. Straight Line, Double Declining, Accelerated). Companies have the
flexibility that they can use one methodology for preparing the financial statements &
the different methodology for tax purposes.
·  Liabilities (Right Hand Side):
The right hand side of the balance sheet represents liabilities.
­  Liabilities are sources which are use to acquire the resources or liabilities are
obligations of two types:
1) Obligations to outside creditors and
2) Obligations to shareholders known as Equity.
­  Liabilities can be short term debts, long term debt, equity, retained earnings, contingent,
unrealized gain on holding of marketable securities
­  Current Liabilities = Account Payables + Short Term Loans + Accrued Expenses
­  Net Working Capital = Current Assets ­ Current Liabilities
­  Total Equity = Common Equity + Paid In Capital + Retained Earnings (Retained
Earnings is NOT cash always)
­  Total Equity represents the residual excess value of Assets over Liabilities: Assets ­
Liabilities = Equity = Net Worth
­  Only cash account represents real cash which can be used to pay your bills!!
Profit & Loss account or Income Statement:
­  An income statement is a "flow statement" over a period of time matching the operating
cycle of the business, which reports the income of the firm.
­  Generally, Revenue ­ Expense = Income
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­
Right hand side receipts (revenues) are added. Left hand side payments (expenses) are
subtracted.
­
P/L Items or Accounts are `temporary' accounts that need to be closed at the end of the
accounting cycle.
­
Sales revenue ­ Cost of Goods Sold = Gross Profit (Revenue)
­
Cost of Goods Sold is a very controversial figure that varies depending on Inventory
Valuation Method (i.e., FIFO, LIFO, Average Cost) and Depreciation Method (Straight
Line, Double Declining, Accelerated). Depreciation is treated as an expense (although
it is non-cash)
­
Gross Revenue ­ Admin & Operating Expenses = Operating Revenue
­
Operating Revenue ­ Other Expenses + Other Revenue = EBIT
­
EBIT ­ Financial Charges & Interest = EBT Note: Leasing Treatment
­
EBT ­ Tax = Net Income
­
Net Income ­ Dividends = Retained Earnings
­
Net Income is NOT cash (it can't pay for bills)
P/L Statement of Company XYZ
Year Ending June 30th 2002)
(`000 Rs.)
(`000 Rs)
(`000 Rs)
Net Sales
1000
Cost of Goods Sold
(500)
Gross Profit
500
Administration Expenses
(200)
Depreciation Expense
(0)
Operating Profit
300
Other Expenses
(180)
Other Income (interest)
(0)
(180)
EBIT
120
Tax
(20)
Net Income
100
Cash Flow Statement:
A cash flow statement shows the cash position of the firm and the way cash has been
acquired or utilized in an accounting period.
A cash flow statement separates the activities of the firm into three categories, which are
operating activities, investing activities and financing activities.
·  Operating Cash Flow Statement can be obtained by using two approaches:
1) Direct
2) Indirect.
A cash flow statement can be derived from P/L or Income Statement and two consecutive year Balance
Sheets.
·  A cash flow statement is not prepared on accrual basis but rather on cash basis: Actual
cash receipts and cash payments.
·  The net income is obtained from the Income Statement of a period of time matching
the operating cycle of the business. Generally:
Revenue ­ Expense = Income
In order to arrive as the cash flows resulting from operating activities Increases in current assets
are cash payments (-), i.e., cash outflow
Increases in current liabilities are cash receipts (+), i.e., cash inflow
Right Hand Side Receipts are added.
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Left Hand Side payments are subtracted
Statement of Retained Earnings or Shareholders' Equity Statement
Total Equity = Common Par Stock Issued + Paid In Capital + Retained Earnings
(Retained Earnings is the cumulative income that is not given out as Dividend ­ it is NOT cash)
XYZ
Cash Flow Statement
(June 30th 2001 ­ June 30th 2002)
(`000 Rs)
(`000 Rs)
(`000 Rs)
Net Income
400
Add Depreciation Expense
100
Subtract Increase in Current Assets:
Increase in Cash
(400)
Increase in Inventory
(700)
(1100)
Add Increase in Current Liabilities:
Increase in A/c Payable
500
Cash Flow from Operations
(100)
Cash Flow from Investments
0
Cash Flow from Financing
500
Net Cash Flow from All Activities
400
Note 1:
Indirect Cash Flow Approach using Income Statement and two consecutive Balance
Sheets
Note 2:
Final Net Cash Flow from All Activities should match the difference in the difference in
the closing balances in the Balance Sheets from June 30th 2001 and June 30th 2002
Note 3:
Investments include all cash sale and purchases of non-current assets and marketable
securities
Note 4:
Financing includes all cash changes in loans, leasing, and equity etc.
SOME FINANCIAL RATIOS:
LIQUIDITY & SOLVENCY RATIOS:
Current Ratio: Current ratio is a ratio between current assets and liabilities, which tells that for every
dollar in current liabilities, how many current assets do the company possess. Since the current
liabilities are usually paid out of current assets, it makes sense to compare the two figures to assess the
liquidity of the firm. Liquidity implies the ease with which the current liabilities can be paid off.
Generally, the higher the ratio, the better it is considered, but too high a ratio may imply less productive
use of current assets. A ratio of two to one (2:1) is considered ideal.
= Current Assets / Current Liabilities
Quick/Acid Test ratio: Quick ratio is relatively a stringent measure of liquidity. The ratio is obtained
by subtracting inventory from current assets and dividing the result by current liabilities. Inventory is
the least liquid of all current assets. By subtracting inventory from current assets, we are actually
comparing more liquid assets with current liabilities. This ratio not only helps in gauging the solvency
of the company, it may also show if the inventories are piling up. A desirable quick ratio can range from
(0.8:1) to (1.5:1) depending on the nature of the business.
= (Current Assets ­ Inventory) / Current Liabilities
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Financial Management ­ MGT201
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Average Collection Period: Also known as Days Sales Outstanding, average collection period shows in
how many days the Accounts receivables of the company are converted into cash. Most of the
companies sell most of their products/services on credit basis, hence it is critical for the company to
know in how much time these receivables could be converted to cash in order to ensure liquidity at all
times. Average collection period is calculated using the following formula
= Average Accounts Receivable /(Annual Sales/360)
Note: Average collection period is usually expressed in terms of days. If you find a decimalized answer,
you should round it off to the next integer.
PROFITABILITY RATIOS:
The profitability ratios show the combine effects of liquidity, asset management, and debt
management on operating result.
Profit Margin (on sales): One of the most commonly used ratios is profit margin on sales. This ratio
tells the percentage of profit for every dollar of revenue earned. This ratio is usually expressed in terms
of percentage and the general rule is , the higher the ratio, the better it is. Most of the companies
compare this ratio to the previous years' ratios to assess if the company is better off.
= [Net Income / Sales] X 100
Return on Assets: Return on assets is another profitability ratio, which shows the profitability of the
company against each dollar invested in total assets. We can obtain this figure by simply by dividing the
net profit with total assets. Since the assets are economic resources that are used to earn profit, it is
logical to assess if the assets have been used efficiently enough to generate profits. This ratio is also
expressed in percentage terms.
= [Net Income / Total Assets] X 100
Return on equity:
Return on equity is of special interest to the shareholders, since equity
represents the owners' share in the business. Return on equity can be obtained by dividing the net
income with the total equity. This ratio shows that for each dollar in equity how much profit is
generated by the company.
= [Net Income/Common Equity]
ASSET MANAGEMENT RATIOS
These measures show how effectively the firm has been managing its assets.
Inventory Turnover:
Inventory turnover shows the number of times the inventories are replenished within one
accounting cycle. The ratio can be obtained by dividing the sales by inventory. While the quick ratio
measures the liquidity and points out the inventory piling problem, the inventory turnover confirms
whether or not the major portion of the current assets of the firm are tied up in inventory. This ratio is
also used in measuring the operating cycle and cash cycle of the firm. A higher turnover is desirable as
it reflects the liquidity of the inventories.
= Sales / inventories
Total Assets Turnover:
An effective use of total assets held by a company ensures greater
revenue to the firm. In order to measure how effectively a company has used its total assets to generate
revenues, we compute the total assets turnover ratios, dividing the sales by total assets.
= Sales / Total Assets
An increasing ratio over the years may show that with an addition of assets, the company has
been able to generate incremental sales in greater proportion.
DEBT (OR CAPITAL STRUCTURE) RATIOS:
Debt-Assets: A commonly used ratio to measure the capital structure of the firm is debt to assets ratio.
Capital structure refers to the financing mix (proportion of debt and equity) of a firm. The greater the
proportion of debt in the financing mix, the less willing creditors, and investors would be to provide
more finances to the company. In Pakistan, the debt to assets ratio is prescribed in prudential regulations
by the State Bank of Pakistan as a guideline for the banks (creditors). A ratio greater than 0.66 to 1 is
considered alarming for the providers of funds.
= Total Debt / Total Assets
Debt-Equity: Another commonly used ratio, debt to equity, explicitly shows the proportion to debt to
equity. A ratio of 60 to 40 is used for new projects, i.e., for a project it is permitted to raise its finances
60 percent from the debt and 40 percent from equity. Debt to equity is computed by the following
formula.
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= Total Debt / Total Equity
Times-Interest-Earned: Times-interest-earned reflects the ability of a company to pay its financial
charges (interest). This ratio is obtained by dividing the operating profit by the interest charges.
Conceptually, the interest charges are to be paid from the earnings before interest and taxes. A ratio of 4
to 1 shows that the company covers the interest charges 4 times, which is generally considered
satisfactory by the management, however, a ratio higher than that, may be more desirable. A high time-
interest-earned ratio is a good sign, especially for the creditors.
= EBIT / Interest Charges
Market Value Ratios:
Market value ratios relate the firm's stock price to its earnings & book value per share. These
ratios give management an indication of what equity investors think of the company's past performance
& future prospects
Price Earning Ratio:
It shows how much investors are willing to pay per rupee of reported profits. This ratio reflects
the optimism, or lack thereof, investors have about the future performance of the company.
= Market Price per share / *Earnings per share
Market /Book Ratio:
Market to book ratio gives an indication how equity investors regard the company's value. This
ratio is also used in case of mergers, acquisition or in the event of bankruptcy of the firm.
= Market Price per share / Book Value per share
*Earning Per Share (EPS):
= Net Income / Average Number of Common Shares Outstanding
Ratios help us to compare different businesses in the same industry and of a similar size.
Limitations of Financial Statement Analysis:
Despite the fact that ratios are a useful analysis tool, there are certain limitations, which are
important for an analyst to understand before applying this tool, in order to make his analysis more
meaningful.
·  FSA is generally an outdated (because of Historical Cost Basis) post-mortem of what has
already happened. It is simply a common starting point for comparison. Use Constant Rupee /
Dollar analysis to account for inflation.
·  FSA is limited by the fact that financial statements are "window dressed" by creative
accountants. Window dressing refers to the understatement or overstatement of financial facts.
·  Different companies use different accounting standards for Inventory, Depreciation, etc.
therefore comparing their financial ratios can be misleading
·  FSA just presents a few static snapshots of a business' financial health but not the complete
moving picture.
·  It's difficult to say based on Financial Ratios whether a company is healthy or not because that
depends on the size and nature of the business.
Difference in Focus:
Financial Statements are prepared by financial accountants with a certain perspective,
however the financial managers--the end users of these financial statements, have a different focus to
draw meaningful conclusions out of these statements. These differences are listed below
·  Financial Accounting (FA) Focus:
·  Use Historical Value (assets are booked at original purchase price)
·  Follow Accrual Principle (calculate Net Income based on accrued expense and accrued
revenue)
·  How to most logically, clearly, and completely represent the financial data.
·  Financial Management (FM) Focus:
·  Use Market Value (assets are valued at current market price)
·  Follow Incremental Cash Flows because an Asset's (and a Company's) Value is
determined by the cash flows that it generates.
·  How to pick the best assets and liabilities portfolios in order to maximize shareholder
wealth.
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FM Measures of Financial Health:
The financial management measures that are used for assessing the financial health of a company
primarily focus on the basic objective of financial management, i.e., to increase the wealth of the
shareholders. Given below are the two important measures of financial health.
M.V.A (Market Value Added):
Market Value Added is a measure of wealth added to the amount of equity capital provided by
the shareholders. It can be determined by the following equation
MVA (Rupees) = Market Value of Equity ­ Book Value of Equity Capital
Following are the characteristics of MVA
·  It is a cumulative measure, i.e., it is measured from the inception of the company to
date. Market Value is based on market price of shares.
·  It shows how much more (or less) value the management has succeeded in adding (or
reducing) to the company in the eyes of the general public / market.
·  It is used for incentive compensation packages for CEO's and higher level
management.
·  E.V.A (Economic Value Added):
Economic Value Added, on the other hand, focuses on the managerial effectiveness in a
given year. It can be obtained by subtracting the cost of total capital from the operating profits of a
company
EVA (Rupees) = EBIT (or Operating Profit) ­ Cost of Total Capital
EVA has the following characteristics
·  It is measured for any one year.
·  It is relatively difficult to calculate because Operating Profit depends on
Depreciation Method, Inventory Valuation, and Leasing Treatment, etc. Also, a
combined Cost of Total Capital (Debt and Equity) is difficult to compute.
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios