CHAPTER 2: FINANCIAL STATEMENTS AND CORPORATE TAXES Description of Financial Statement Financial...
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Transcript of CHAPTER 2: FINANCIAL STATEMENTS AND CORPORATE TAXES Description of Financial Statement Financial...
CHAPTER 2: FINANCIAL STATEMENTS AND CORPORATE TAXES
Description of Financial Statement
• Financial statements are prepared set of accounting reports that seek to
provide information to its stakeholders about the previous business year’s
financial performance and position.
• Three financial statements are annually prepared namely;
Statement of financial position (balance sheet)
Income statement (profit and loss account)
Cash flow statement (sources and uses of fund)
1Prepared by Alhaj Nuhu Abdulrahman
Description of Financial Statement
The statement of financial position:
• A summary of book values of a firm’s assets and liabilities at a particular date.
• The assets represent uses of funds
• The liabilities represent sources of the funds.
Components of assets Current assets: cash, account receivable, inventory, etc Fixed assets (tangible): buildings, equipment, vehicles, etc Fixed assets (intangible): patent, skilled management, trained labour force,
Components of liabilities Current liabilities: accounts payable, accruals Long term liabilities: long-term debts Shareholders’ fund (equity): value of owners’ equity and retained earnings
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Description of Financial Statement
• A summary of a firm’s financial performance over the previous business
period usually a year.
• That is Net income or loss = total revenue – total expenses.
The Cash flow Statement
• A summary of a firm’s sources and uses of cash from its operations,
investment and financing activities, over a year.
• A firm’s net cash flows can be quite different from its net income
The three components of cash flow statement:
i. Cash flow from operating activities
ii. Cash flow from investing activities
iii. Cash flow from financing activities
3Prepared by Alhaj Nuhu Abdulrahman
Uses of financial statement information
• Internal uses: management compensation, employee agitation for improved
remuneration, evaluating strategic business units, comparison with
previous years’ performance and future planning.
• External uses: information for short and long-term creditors, suppliers,
rating agencies, current and potential investors, etc.
• Comparison with performance of competitors
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Corporate Taxes
• Companies big and small pay tax on their net incomes at the end of the
business year.
• Tax payable is calculated on marginal tax rates prescribed by a country’s
tax code. Then average tax rate may be calculated.
• Marginal tax rate is the tax rate that the individual or company pays on
each extra cedi of income.
• Average tax rate is the percentage of one’s income paid out as tax
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Corporate Taxes
• For instance assume Ghana’s corporate tax code has the following structure:
Taxable income (GH¢)Tax rates (%)
0 - 50,000 15
50,001 - 75,000 25
75,001 - 100,000 34
100,001 - 400,000 37
400,001 + 34
Suppose a company has a taxable income of GH¢300,000.
What will be the company’s total tax bill?
What will be the company’s average tax rate?
What will be its marginal tax rate?
6Prepared by Alhaj Nuhu Abdulrahman
Corporate TaxSolution:
0.15(GH¢50,000 - GH¢0) = GH¢7,500
0.25(GH¢75,000 - GH¢50,000) = GH¢6,250
0.34(GH¢100,000 - GH¢75,000) = GH¢8,500
0.37(GH¢300,000 - GH¢100,000) = GH¢74,000
Total tax bill GH¢96,250
7Prepared by Alhaj Nuhu Abdulrahman
Corporate Tax
(a) Tax bill = (0.15 x GH¢50,000) + (0.25 x GH¢25,000) +
(0.34 x GH¢25,000) + (0.37 x GH¢200,000) = GH¢96,250
(b) Average tax rate = GH¢96,250/GH¢300,000 x 100= 32.08%
(c) Marginal tax rate is 37%. This is because for every one more cedi of
taxable income up to GH¢400,000 attracts a tax rate 37%.
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Corporate Tax
• Because financial decisions usually involve new cash flows or change in
existing ones, the marginal rate tells us the marginal effect of a decision on
corporate tax bill.
• Financial managers therefore need to understand the tax consequences of
investment and financing decisions.
• Three importance of tax in financial management: Raising finance: debt financing attracts interest tax relief, while dividend
payment on equity financing does not attract tax relief. Investment in fixed assets: cost of acquiring certain types of fixed assets
attracts a form of tax relief termed capital allowance. (e.g. depreciation) Paying dividends: dividend payment attracts dividend tax.
9Prepared by Alhaj Nuhu Abdulrahman
Corporate Tax
• Corporate financial managers should understand the effects of tax relief on incomes of both the company and its shareholders.
Illustration of tax relief
• Assume 2 firms; A and B both have earnings before taxes (EBIT) of GH¢1,000,000. Firm A however has GH¢40,000 interest on debts to pay. This reduces the company’s tax bill as illustrated:
Firm A Firm B
EBIT 1,000,000 1,000,000
Interest 40,000 0
Pretax income 960,000 1,000,000
Tax (35%) 336,000 350,000
Net income 624,000 650,000
10Prepared by Alhaj Nuhu Abdulrahman
Financial statements analysis
• Financial statements are the primary means of communicating financial information to users both within and outside the firm for decision making.
• One common use of financial statements is to compare those of a firm’s immediate past business period with the previous ones and those of other similar companies.
• Constraints faced by such comparisons include changes in size of the firm and differences in size with other firm types.
• To address these differences the financial statements are transformed into standardized financial statements.
Standardized Financial Statements
• All the items of the financial statements are presented in percentage terms called common-size statements.
• Each balance sheet item expressed as a percentage of total assets called common-size balance sheet
• Each income statement item expressed as a percentage of total sales called common-size income statement.
11Prepared by Alhaj Nuhu Abdulrahman
Financial statements analysis
• Illustration Azonto Corporation Balance Sheets for 2012 and 2013
2012 2013
Assets (GH¢) (GH¢)
Current assets
Cash 8,400 9,800
Accounts receivable 16,500 18,800
Inventory 39,300 42,200
Total current assets 64,200 70,800
Fixed assets
Net Premises & equipment 273,100 288,000
Total assets 337,300 358,800
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Financial statements analysis
Liabilities
Current liabilities
Accounts payable 31,200 34,400
Notes payable 23,100 19,600
Total current liabilities 54,300 54,000
Long-term debt 53,100 45,700
Owner’s Equity 50,000 55,000
Retained earnings 79,900 204,100
Total equity 229,900 259,100
Total liabilities 337,300 358,800
13Prepared by Alhaj Nuhu Abdulrahman
Financial statements analysis
• Azonto Corporation income statement for 2013
GH¢
Sales 231,100
Cost of goods sold 134,400
Depreciation 27,600
Earnings before interest and taxes 69,100
Interest 14,100
Income before tax 55,000
Tax (34%) 18,700
Net Income 36,300
Dividends 12,100
Retained earnings 24,200
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Financial statements analysis
Common-size balance sheet: each item is express as a percentage of total assets
Azonto Corporation Common-Size Balance Sheets for 2012 and 2013
2012 2013 Change
Assets (%) (%) (%)
Current assets
Cash 2.5 2.7 +0.2
Accounts receivable 4.9 5.2 +0.3
Inventory 11.7 11.8 +0.1
Total current assets 19.11 9.7 +0.6
Fixed assets
Net Premises & equipment 80.9 80.3 -0.6
Total assets 100 100 0.0
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Financial statements analysis
Liabilities
Current liabilities
Accounts payable 9.2 9.6 +0.4
Notes payable 6.8 5.5 -1.3
Total current liabilities 16.0 15.1 -0.9
Long-term debt 15.7 12.7 -3.0
Owner’s Equity 14.8 15.3 +0.5
Retained earnings 53.3 56.9 +3.6
Total equity 68.1 72.2 +4.1
Total liabilities 100 100 0.0
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Financial statements analysis
common-size income statement: each item expressed as percentage of total sales
Azonto Corporation Common-Size Income statement for 2013
(%)
Sales 100.0
Cost of goods sold 58.2
Depreciation 11.9
Earnings before interest and taxes 29.9
Interest 6.1
Income before tax 23.8
Tax (34%) 8.1
Net Income 15.7
Dividends 5.2
Retained earnings 10.5
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Financial statements analysis
Financial Ratio Analysis:
Financial ratios are quantitative tools for analyzing financial statements for purposes of
comparing firms’ performance, and for the same firm over the previous periods. They are
generally classified according to the activity or function to be evaluated as follows:
Liquidity ratios: They measure the firm’s ability to meet short-term obligations.
Activity ratios: They measure the effectiveness of utilizing operational assets.
Leverage or Financial Gearing ratios: They measure the extent to which the firm is financed
with debts. That is the ratio debt to equity in the firm’s capital structure
Profitability ratios: They measure the efficiency or profitability of the firm.
Investment or shareholders’ ratios: They indicate how well a company has performing in
terms of share market value and other related items like dividends.
18Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis:
Madina Corporation Statement of Financial Position as at 31st December 2012
Assets GH¢’000 GH¢’000
Cash 50
Marketable Securities 150
Receivable (debtors) 200
Inventories (Stocks) 300
Total Current Assets 700
Plant and Equipment 1,876
Less depreciation 500
Net Plant equipment 1,376
Total Assets 2,076
19Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
Liabilities GH¢’000 GH¢’000
Accounts payable (Creditors) 60
Notes payable (at 10%) 100
Accruals 10
Provision for tax 130
Total Current Liabilities 300
Bond (at 8%) 500
Debentures (at 10%) 200
Ordinary Shares 600
Retained earnings 476
Total Equity 1,076
Total Liabilities 2,076
The market price per share was GH¢5.25
Shares outstanding 200,000
20Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
Madina Corporation Income Statement for the year ended December 31st2012GH¢’000 GH¢’000
Sales 3,000Cost of goods sold 2,555Gross profit 445Less operating expenses:
Selling 22General & administrative 40Payment on Office building 28Total operating expenses 90Gross operating profit 355
Less Depreciation 100Net Operating profit 255Income from other services 15Earning Before Interest and Taxes (EBIT) 270
21Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
Less interest on notes payable 10
Interest on Bonds 40
Interest on Debentures 20
Total interest expense 70
Net income before taxes 200
Less Corporate tax (40%) 80
Net income after Corporate tax 120
Dividend declared and paid 90
22Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio AnalysisLiquidity Ratios: (Short term solvency measures)
• Current ratio = = = 2.33
• Quick (Acid-test) ratio = = = 1.33 times
• Cash ratio = = = 0.67 times
Short-term creditors are interested in these ratio because they indicate the ability of
firm to pay.
Asset Management or Turnover ratios: they indicate the rate at which goods are
Converted or turnover into sales. That is how efficiently and intensively a firm uses its
assets to generate sales.
• Inventory (stock) Turnover Ratio = = = 8.52 times
23Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio AnalysisIf inventory is turned over 8.52 times in a year, we can determine how long it took to
turn it over on average.
• Inventory turnover in days = = = 42.8 days
OR
• Inventory turnover in days = = = 42.9 days
• Receivables Turnover Ratio = = = 15 times
• Days’ sales in receivables or Average Collection Period (ACP) = = 24.33 days . The shorter the collection period the better.
• Total assets turnover = = = 1.45 times
This implies for every GH¢1 asset, GH¢1.45 sales is generated.
• Fixed Assets Turnover = = = 2.18 times
This implies for every GH¢1 of fixed asset, GH¢2.18 sales is generated.
24Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
Leverage or gearing ratios (long-term solvency measures)
• Gearing ratios indicate the firm’s ability to meet its long-term financial obligations to
creditors. They also indicate the proportion of debt in a firm’s capital structure.
• Different methods of calculating leverage ratios exist.
• Total Debts ratio: This ratio can be defined in several different ways, the easiest of
which is this: = = 48.17%
• That implies the company is financed with 48.17% debt. By extension every GH¢1.00 in
assets is financed with GH¢0.4817 debt and GH¢0.5183 equity
• Total Debt/Equity ratio = = 0.93 times
or = 0.93 times
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Financial Ratio Analysis
Total Asset/equity ratio or Equity Multiplier = = = 1.93 times
or = 1.93 times
Long-term Debt ratio = =
= 0.39 times
Interest coverage ratio = = = 3.86 times
The lower the interest-cover ratio, the greater is the risk of default in interest payment.
Cash Coverage ratio = = = 5.29 times
This is used as a measure of cash flow available to meet financial obligations.
26Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
PROFITABILITY RATIOS: These ratios measure the effectiveness of a business in
generating profits. Varieties of profitability ratios exist and the following are probably
the best known and the most widely used.
• Net income margin ratio (NIM) = = 4%
It implies Gp4 is generated for every GH¢1.00 of sales.
• Return on Assets (ROA) = 5.78%
It means about Gp58 profit is generated per every GH¢1 of assets.
• Return on Equity (ROE) = 11.15%
For every cedi in equity about Gp11 is generated.
27Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
• INVESTMENT RATIOS: These ratios measure variety of returns on equity
investment for publicly traded companies. And are computed for informed equity
investment decisions like buying more shares or holding on or selling out. Data for
their computation are in part market information not necessarily contained in
financial statements, thus also called market value ratios.
• Earnings per Share (EPS) = GH¢0.60/share
• Dividend per Share (DPS) = GH¢0.45/share
• Dividend payout ratio (DPR): This ratio reveals the percentage (%) or proportion of
net earnings declared as dividend. DPR = = 75%
• Dividend Cover (DC): This ratio indicates how many times dividend can be paid
out of current Net profit. = 1.3 times
28Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis• Earnings yield (EY): This measure the Percentage of EPS on Market price per Share (MPS):
= 11.43%
• Dividend Yield (DY): This shows the percentage of DPS in relation to MPS
= 8.57%
• Price/ Earnings Ratio (P/E): It is used by security analysts to assess the future market
performance of a company. It measures how much investors are willing to pay per cedi of
earnings. = = 8.75 times
• Market/Book ratio: It compares the market value of the firm to it investment cost. A value less
than 1 could mean the firm has not been successful in generating value for its shareholders.
Book value per share is total equity divided by number of shares outstanding .
Market/Book ratio = = = = 0.96 times
29Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
Exercise:
• ABC Company distributed GH¢90,000 of its net income as dividend this year which
represented 60% dividend payout ratio.
i) What was the company’s net income?
ii) What was the retention ratio?
iii) How much was the retained income?
30Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
Exercise:
• ABC Company distributed GH¢90,000 of its net income as dividend this year which
represented 60% dividend payout ratio.
i) What was the company’s net income?
ii) What was the retention ratio?
iii) How much was the retained income?
Solution:
i) Payout ratio x net income = GH¢90,000
60% x net income = GH¢90,000
Net income =
Net income = GH¢150,000
31Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
• ii) Retention ratio = 100% - payout ratio
= 100% - 60% = 40%
• iii) Retained income = retention ratio x net income
= 40% x GH¢150,000 = GH¢60,000
32Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis
The DuPont Identity
• The fact that the ROE (11.15%) is higher than ROA (5.78%) calculated above
reflects the use of more debt financing or financial leverage by the company.
The ROE equation is however further decomposed into three ratio components to
determine the causes of the level of ROE or any changes in it. The decomposition
was developed and used by an American company called DuPont, thus generally
referred to as The DuPont Identity. ROE is decomposed into the following three
determinants:
1. Profit Margin:- the company’s pricing strategy and ability to control costs.
2. Asset Turnover:- measures the intensity with which a company utilizes its assets.
3. Gearing:- Financing with debt instead of equity can increase ROE but also increase
the risk that a decrease in turnover may make it difficult for the company to meet
its debt obligations
33Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis: The DuPont Identity
• ROE = (Net Profit Margin) x (Total Asset Turnover) x (Equity Multiplier)
= x x
= x x
= 0.04 x 1.45 x 1.93 = 0.11194 or 11.94%
34Prepared by Alhaj Nuhu Abdulrahman
Financial Ratio Analysis: The DuPont Identity
Steps to increase the ROE ratio level:
• First to improve the profit margin the firm must be efficient in its operation by
keeping operating costs down.
• Second to generate more sales operational assets must used more intensely which
improves the asset turnover.
• Third is the use of more debt financing thereby using less equity financing, which
improves the equity multiplier. Often, only one or a combination of two of the three
strategies may be appropriate. For instance, a company that has reached the limits
of what lenders are willing to lend to it cannot use gearing to improve the ROE.
35Prepared by Alhaj Nuhu Abdulrahman