Chapter 14

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CHAPTER 14

ACCOUNTING & FINANCIAL ANALYSIS

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LEARNING OBJECTIVES

1. Explain how firms use accounting.

2. Explain how to interpret financial statements.

3. Explain how to evaluate a firm’s financial condition.

Main ResourcesThe Importance

of Financial Statements

Income StatementBalance SheetRatio Analysis

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INTRODUCTION

Accounting is the summary of a company’s financial activities

The process of accounting ends with a set of financial statement

Financial statement provides detailed information about a company’s recent performance and its financial condition.

Managers use this information to evaluate the company’s strengths and weaknesses so that it can capitalize the strengths and make corrective actions if there are deficiencies.

This chapter focuses on how the accounting and the financial analysis functions can be used by companies to maximise its value




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THE IMPORTANCE OF ACCOUNTING

Accounting provides financial information of an organization.

The process starts with bookkeeping where daily or weekly transactions are recorded.

The end product of accounting cycle is the production of financial statements

The financial statements are important for: Reporting Decision making Controlling.




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REPORTING

Firms need to report all relevant financial activities accurately in accordance with “generally accepted accounting principles” (GAAP), Malaysia Accounting Standard Board (MASB) and International Accounting Standards (IAS).

The use of common set guidelines allows for more consistency in reporting practices among firms and consequently meaningful comparison can be made between firms.




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DECISION MAKING

Accounting data provides financial information to support decision making.

Eg: financial manager uses past data for budgeting decisions and anticipate future financing needs.

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CONTROLLING

Financial information helps managers to monitor and control the performance of individuals, departments and products.

This is done by evaluating and reviewing the financial statements.

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UNDERSTANDING FINANCIAL STATEMENTS Main components of financial statement

Income statement

Balance sheet Before analysing and interpreting the

financial statement, it is important to understand the information reported in both income statements and balance sheet.

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INCOME STATEMENT

Reports revenue, expenses and income or loss made during the accounting period which is usually one year. Net sales Cost of goods sold Gross profit

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INCOME STATEMENT

Operating expenses Interest expense Earning before interest and tax Net income

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BALANCE SHEET

Reports asset, liability and equity of firms. Assets = Liabilities + Owner’s Equity Assets

Current assets Fixed assets

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BALANCE SHEET

Liabilities Short term liabilities Long term liabilities

Owner’s equity

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RATIO ANALYSIS One of the tools that is used by financial managers

to assess the financial condition of the firm. It evaluates the relationship between financial

statement variables. It is used to compare current performance with past

performance to evaluate the impact of any financial decision implemented (internal analysis).

It is also used to compare the current performance within the industry to evaluate the standing of a particular firm to the ratios of industry average.

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RATIO ANALYSIS (cont.)

Ratio can be categorized into four main categories as follows: Liquidity Efficiency Financial leverage Profitability

The following is the financial statement of Kayu Kayan Bhd.

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Kayu Kayan BhdIncome Statement for the year ended 31 December

2007 RM

Net sales 700,000Cost of goods sold (500,000)Gross profit 200,000

Selling expenses 100,000General & administrative expenses 30,000Total operating expenses (130,000)Earning before interest & taxes (EBIT) 70,000

Interest expenses 10,000Earning before taxes 60,000

Income taxes (27%) 16,200Net income 43,800

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Kayu Kayan BhdBalance Sheet as at 31 December 2007

RM

Assets

Current assets:

Cash 17,000

Marketable securities 7,200

Accounts receivables 38,000

Inventory 93,000

Total current assets 155,200

Fixed Assets:

Net plant & equipment 290,000

Less: Accumulated depreciation 29,000

Net fixed asset 261,000

Total Assets 416,200

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Kayu Kayan BhdBalance Sheet as at 31 December 2007 (cont.) RM

Liabilities & Shareholders’ Equity

Current liabilities:

Accounts payable 55,000

Notes payable 13,000

Total current liabilities 68,000

Long-term debt 100,000

Owners’ equity:

Common stock 200,000

Retained earnings 48,200

Total owners’ equity 248,200

Total liabilities & owner’s equity 416,200

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Required Calculate all four categories of ratio (ie: liquidity,

efficiency, leverage and profitability). Evaluate the overall financial performance of Kayu

Kayan Bhd

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Liquidity Ratios

1. Current ratio

= current assets

current liabilities

= 155,200

68,000

= 2.28

Industry average = 3.00

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Liquidity Ratios

2. Quick ratio

= current assets - inventories

current liabilities= 155,200 – 93,000

68,000

= 0.91


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Efficiency Ratios

1. Inventory turnover

= cost of goods sold

inventory

= 500,000

93,000

= 5.37


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Efficiency Ratios2. Average collection period

= accounts receivable

daily credit sales

= 38,000

700,000/360 days

= 19.55 days

Industry average = 15 days

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Efficiency Ratios3. Fixed asset turnover

= Net sales

Fixed assets

= 700,000

261,000

= 2.68


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Efficiency Ratios4. Total assets turnover

= Net sales

Total assets

= 700,000

416,200

= 1.68


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Financial Leverage Ratios

1. Debt ratio

= total debt

total assets

= 168,000

416,200

= 0.40


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Financial Leverage Ratios

2. Times interest earned

= Earnings before interest & taxes (EBIT)

Annual interest expense

= 70,000

10,000

= 7 times

Industry average = 7.5 times

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Profitability Ratios

1. Net profit margin

= Net income x 100

Net sales

= 43,800 x 100

700,000

= 6.26%

Industry average = 7%

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2. Return on assets

= Net income x 100

Total assets

= 43,800 x 100

416,200

= 10%

Industry average = 10.5%

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3. Return on equity

= Net income x 100

Owners’ equity

= 43,800 x 100

248,200

= 18%

Industry average = 15%

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Summary Liquidity Ratios

Current ratio Quick ratio

Efficiency Ratios Inventory turnover Average collection period Fixed asset turnover Total assets turnover

Financial Leverage Ratios Debt ratio Times interest earned

Profitability Ratios Net profit margin Return on assets Return on equity

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LIMITATIONS OF RATIO ANALYSIS

Comparison with industry average is difficult for firms with various kind of industries.

Different operating and accounting practices among firms make comparison difficult.

Seasonal factors may distort ratios.

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SUMMARY

In this chapter we have:1. Discussed the importance of accounting and financial

statements to a company.

2. Discussed how to evaluate the performance of a firm using ratio analysis.

3. Discussed the limitations of ratio analysis

Chapter 14

Business

Transcript of Chapter 14