Managerial Finance- Module 2.1

8/3/2019 Managerial Finance- Module 2.1

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MANAGERIAL FINANCE

MODULE 2

Financial Statements & Ratio

Analysis


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iii) Statement of Cash flowsIt provides a summary of the cash flows over the period of concern,

typically the year just ended. The statement provides insight into the

firms operating, investing and financing cash flows, and reconcilesthem 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 StatementsThey 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 andlease terms, and contingencies.

* Professional securities analysts use the data in the statements and notes to developestimates of the value of securities that the firm issues, and these estimatesinfluence the actions of investors and firms share value.


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v) Consolidated international financial statementsThe 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, forconsolidation with the parent companys financial statements.

This is done by using a technique called the current rate

(translation) method under which all the parent companys

foreign currency-denominated assets and liabilities areconverted into dollar values using the exchange rate prevailing at

the financial year ending date.


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

2005 2004

Sales revenue $3074 $2567

Less: Cost of goods sold 2088 1711

Gross profits 986 _856

Less : Operating expenses

Selling expenses $100 $108

General & admin expenses 194 187

Lease expense 35 35

Depreciation expense 239 223Total operating expense 568 553

Operating profits 418 303

Less: Interest expense 93 91

Net profits before taxes 325 212

Less: Taxes (rate = 29%) 94 64

Net profits after taxes 231 148

Less: Preference Dividends 10 10

Earnings available for ordinary shareholders 221 138

Earnings per share $2.90 $1.81

Dividends per share $1.29 $0.75


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Tab 2.2 Bartlett Company Balance Sheets ($ 000) as at 31 December

2005 2004

Assets

Current assets

Cash $363 $288Marketable securities 68 51

Accounts receivable 503 365

Inventories 289 300

Total current assets $1223 $1004

Non-current assets (at cost)

Land & buildings $2072 $1903

Machinery & equipment 1866 1693

Furniture & fixtures 358 316

Vehicles 275 314

Other (include financial leases) 98 96

Total gross fixed assets (at cost) $4669 $4322

Less: Accumulated depreciation 2295 2056

Net fixed assets 2374 2266

Total assets $3597 $3270

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Liabilities and Shareholders Equity 2005 2004

Current liabilities

Accounts payable $382 $270

Notes payable 79 99Accruals 159 114

Total current liabilities $620 $483

Non-current debt (includes financial leases) * $1023 $967

Total liabilities $1643 $1450

Shareholders equity

Preference shares cumulative 5%, $100, 2000 shares

issued $200 $200

Ordinary shares- Shares

issued 2005: 76262 in 2004:76244 619 608

Retained earnings 1135 1012

Total shareholders equity $1954 $1820

Total liabilities and shareholders equity $3597 $3279


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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 $231

Depreciation 239

Increase in accounts receivable (138)*

Decrease in inventories 11

Increase in accounts payable 112

Increase in accruals 45

Cash provided by operating activities $500

Cash flow from Investing activities

Increase in gross non-current assets (347)

Change in business interests 0

Cash provided by investing activities (347)

Cash flow from Financing activities

Decrease in notes payable ( 20)

Increase in non-current debts 56Changes in shareholders equity* 11

Dividends paid (108)

Cash provided by financing activities (61)

Net increase in cash and marketable securities $92

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Using financial ratiosThe information contained in the financial statements is of major

significance to shareholders, creditors, and managers all of whom

need to have relative measures of companys operating efficiency

and condition.

Relative is the key word here, since analysis of financial

statements is based on the knowledge and use ofratios

orrelative values.

Ratio analysis involves the methods of calculating and interpreting

financial ratios in order to assess the firms performance andstatus.

The inputs to ratio analysis are the firms income statement and

the balance sheet for the periods to be examined.


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Interested partiesThe financial statements ratio analysis is of interest to

shareholders, creditors, and the firms management.

i) Both present and prospective shareholders are interested in the

firms 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 companyand its ability in making the interest and principal payments. Their

concern is also the firms profitability, they want the business to be

healthy and that will continue.

iii) Management like shareholders, must be concerned with all

aspects of the firms 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 monitorfirms erformance from eriod to eriod.


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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 firms financial ratios at thesame 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 benchmarking. By comparing the firms 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.


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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.


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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 financialstatements 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.


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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 ratiosFinancial 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


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1) Liquidity RatiosThe liquidity ratios are measured by its ability too satisfy its short

term obligations as they come due. Liquidity refers to the solvency

of the firms overall financial position. These ratios are viewed asliquidity are the current ratio and the quick (acid-test) ratio.

a) Current Ratio one of the most commonly cited financial

ratios, measures the firms 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 of2 is acceptable, but the acceptability of the value

depends on the industry in which a firm operates.


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b) Quick-acid test ratioThe 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 inventoryCurrent Liabilities

Quick ratio for Bartlett in 2005 is : $1,223,000 - $289,000 = 1.51

$620,000

* A Quick ratio of1 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 firms inventory cannot be converted into casheasil .


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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 firms 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.


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a) Inventory TurnoverThis commonly measures the activity, or liquidity of a

firms inventory. It is calculated as follows :

Inventory turnover = cost of goods soldinventory

Applying this to Bartlett in 2005 = $2,088,000 = 7.2

$289,000

The resulting turnover is meaningful only if it iscompared with that of other firm in the same industry, or

the firms 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 of30 days. For Bartlett, this would be 50.0 days

(360/7.2). This value can also be viewed as the average no. of

days


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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 accountsreceivable 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 firms credit terms. If for

instance Bartlett extends 30-day credit terms to customers, an averagecollection period of58.9 days indicate a poorly managed credit.


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c) Average Payment PeriodThe 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 Bartletts 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


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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 Bartletts 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 firms total assets turnover, the more

efficient the its assets have been used.

This is important to the management as it indicates whether the

firms operations are financially efficient.


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3. Debt Ratios

The debt position of the firm indicates the amount of other

peoples 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 firms 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.


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i) Debt ratio

The debt ratio measures the proportion of total assets financed by

the firms creditors. The higher this ratio, the greater the amount of

other peoples 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 assetswith debt. The higher the ratio, the more financial leverage a firm

has.


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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.


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iii) Fixed-payment coverage ratioThe fixed-payment coverage ratio measures the firms 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 payts + {(principle payt + preference dividends) x| 1/(1-T)|}Where T is the corporate tax rate applicable to the firms 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.

Managerial Finance- Module 2.1

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