Understanding Financial Statements Investor Perspective

P. S. M. Gunaratne PhD Professor in Finance, Department of Finance Faculty of Management & Finance, University of Colombo

Foundation Course Colombo Stock Exchange Investor Education Programme

Introduction
Stock

Market is information driven

Economy-wide information Industry/Sector specific information Firm-specific information

Can alter the risk return profile of the firm so the value of the firm

Economy Industry Internal Env.

Firm RISK Return

Economy Wide Information

Affects

the entire market

GDP growth rate, Level of Employment, Inflation, Exchange Rate, Interest rate Peace war situation, regulatory changes, etc.
The

level of sensitivity may vary form firm to firm

Industry Specific Information

Affects The

a particular sector /Industry

level of sensitivity may vary form firm to firm economy-wide information may affect particular sector/sectors careful! Sectors are not clearly defined

Some Be

Firm-Specific Information
Information

related to a particular firm and affects only the particular firm.

Change of management, new investment plan, different announcements by the firm, releasing annual/financial reports, action taken against the firm by regulators etc.

Some

information is frequent and regular

Releasing annual/financial reports, dividend announcements

Some information is less frequent

Use of Information by Investors

Information is vital in valuing the stocks as they alter risk-return profile of the underling firms In estimating value of stocks you need to understand the changing risk return profile of the firm with the new information Value may compare with the current market prices to decide whether stock is undervalued, over valued or even fairly valued Having followed the above steps, you can decide whether to buy, hold or sell a particular stock

Use of Information Cont..

In

making investment decisions you may engage in different level of analysis

Industry level analysis
Industry

attractiveness

Firm level analysis

Firm

Attractiveness

Financial Statement as a Source of Information

A regular flow of firm specific information come through annual reports (quarterly reports) as financial information Investor can measure firm performance through financial information Basically risk-return characteristics of the firm can be indentified through financial information Financial information not only provides a measure of past performance but also provides a measure of its financial strength

Components of An Annual Report

The Business Review:

This summarizes a companys recent developments, trends and objectives.

This may be presented within chairmen/CEO review

The Financial Review /Financial Highlights: This presents a

companys business performance in Rupees

Financial Reports:

Income Statement Balance Sheet Cash Flow Statement Statement of Change in Equity and Notes to Financial Statements

Independent Audit Report Shareholder and Investor Information Historical Summary Information

The Basis of Financial Statements

The resources controlled by a business are referred to as its assets. For a new business, those assets originate from two possible sources:
Investors who buy ownership in the business Creditors who extend loans to the business

Those who contribute assets to a business have legal claims on those assets. Since the total assets of the business are equal to the sum of the assets contributed by investors and the assets contributed by creditors, the following relationship holds and is referred to as the accounting equation : Assets Resources = Liabilities + Owners' Equity Claims on the Resources

The Basis of Financial Statements Cont..

Initially owners funds may use to start a business and acquire different assets needed run the business. If no borrowings are used equation could be simplified to: Assets = Owners' Equity
Ex. Assume a group of people started a business by investing 100 million and acquired Land & Building worth of 60 Million Assets: Rs. 100M = Owners' Equity 100M

The Balance Sheet of the Business is Based on the Accounting Equation

The Balance Sheet Assets: Land and Building Cash Total Assets Owners Equity : Capital Total Equity 60,000,000 40,000,000 100,000,000 100,000,000 100,000,000

The Basis of Financial Statements Cont.

Assume the same business borrowed Rs. Rs.50m from a bank and bought a motor vehicle worth of Rs.55m. Now the new equation for the business:
Assets: Rs. 150M = Liabilities 50 M + Owners' Equity 100M

The new Balance sheet

Balance Sheet
Assets: Non Current Assets Land and Building Motor Vehicle Current Assets Total Assets Cash

60,000,000 55,000,000 105,000,000 35,000,000 150,000,000 100,000,000 50,000,000 150,000,000

Owners Equity : Equity Liabilities : Bank Loan Total Equity and Liabilities

The Basis of Financial Statements Cont.

Both Balance Sheet and Accounting Equation only shows Assets, Liabilities and Owners Equity. There are two other types of Accounts that do not directly show in the Balance sheet; Revenues and Expenditures
Ex. Assume that the business we have so far considered purchased goods (for sale) worth of Rs.150m from time to time during the subsequent year and sold 80% of goods purchased for Rs.175m and incurred various expenditures up to Rs. 18 m. Interest paid for the loan Rs. 5 m. Repayment of loan Rs. 10m Now we have to recognize the following expenditure and revenue items Expenditure: Cost of sales (150m * 80%) = Rs.120 m Other Expenditure = Rs. 18 m Interest paid = Rs. 5 m Sales = Rs. 175m

Revenue :

All Income and Expenditure are recorded in the Income Statement

The Basis of Financial Statements Cont.

Income Statement
Sales (Turnover) Cost of Sales Gross profit Other Expenditure Interest Paid Net profit 175,000,000 (120,000,000) 55,000,000 (18,000,000) (5,000,000) 32,000,000

Recognize that assets and liabilities possessed by the business change with the above transactions Also recognize that the unsold merchandising goods (inventory) remaining at the end of the year is a Current Asset By the amount of profit earned equity goes up

The Basis of Financial Statements Cont.

Balance Sheet Assets: Non Current Assets Land and Building Motor Vehicle Current Assets Cash Inventory Total Assets Owners Equity : Capital Profit Total Equity Liabilities : Bank Loan Total Equity and Liabilities
Cash Beg. Balance. 35M + Sales 175M -Purchases (150M) -Expenses (18M) -Loan Rep (10M) -Loan Interest (5M) End Balance 27M Inventory 20% of Purchases 150M * 20% = 30m Loan Beg. Balance. 50M -Repayment (10M) End Balance 40M

60,000,000 55,000,000 115,000,000 27,000,000 30,000,000 57,000,000 172,000,000

100,000,000 32,000,000 132,000,000 40,000,000 172,000,000

The Basis of Financial Statements Cont.

Cash Flow Statement

Cash flow from operating Activities Net Profit +Interest paid Operating cash flow before working cap. adjust. -Increase in inventories Net cash flow from operations Cash flow from Investment Activities None Cash flow from Financing Activities Loan Interest Loan Repayment Net cash flow from financing activities Change in Cash Balance Cash at the beginning of the year Cash at the end of the year 32,000,000 5,000,000 37,000,000 (30,000,000) 7,000,000

(5,000,000) (10,000,000) (15,000,000) (8,000,000) 35,000,000 27,000,000

The Balance Sheet

The balance sheet portrays the financial position of the company by showing what the company owns and what it owes at the report date. Accordingly it shows; Assets, Liabilities' and Owners Equity It is a snapshot, since it reports the companys financial position at a specific point in time.

In the Blance Sheet Assets are classified into Fixed (non Current ) and Current Assets Liabilities are classified into long-term and current liabilities

The balance sheet continues..

The Assets section includes all the goods and property owned by the company, and uncollected amounts due (receivables) to the company from others. Assets are generally classified into Fixed Assets and Current Assets The Liabilities section includes all debts and amounts owed (payables) to outside parties. Liabilities are also classified into Long-term and Current Liabilities The Shareholders Equity section represents the shareholders ownership interest in the company-what the companys assets would be worth after all claims to other parties were paid.

The Income Statement

The Income Statement can be thought of more like a motion picture, since it reports on how a company performed during the period(s) and shows whether that companys operations have resulted in a profit or loss. It compares periodic expenses with the periodic revenues and it shows the estimated tax for the period (only in companies) It estimates the profit or loss for the period under consideration

Statement of Cash Flows

The statement of cash flows reports on the companys cash movements during the period separating them meaningfully into operating, investing and financing activities. Can identify sources and uses of cash Show the relation between profit or Loss and cash flows

The Footnotes

The footnotes provide more detailed information about the financial statements.

Audit Report

There are two kinds of auditing, namely internal and external (independent) auditing. Internal auditing focuses on the audit of an entitys operational effectiveness and control. (by internal auditors) On the other hand, an external or independent audit focuses on the assessment of the fairness of an entitys financial statements (by independent auditors)
Audit report is expression of an opinion whether an entity has prepared financial statements fairly in all material respects in accordance with the financial reporting standards. To support the audit, the auditor must perform procedures to obtain audit evidence about the amounts and disclosures in the financial statements. He also tests the entitys internal control and policies that are relevant to the entitys preparation and fair presentation of financial statements. It helps the credibility of the reported financial statements because of the independence and impartiality which are the qualities of external auditors.

Financial Statement Analysis

Purpose
Different groups of Financial statement users with different information needs

Focus will be on needs of equity investors and suppliers of credit

Differing the levels of technical expertise

Focus on tools used by a sophisticated user

Primary questions relate to company performance and financial strength, but user emphasis may differ

Investment analysts are primarily interested in financial statements as a predictor of future performance Lenders will primarily focus on the financial strength (default risk)

Each question is the sum of different issues

Financial Statement Analysis

Simple Analysis
You can just go through figures and compare them with previous years figures analyze the difference. You my use percentage changes year to year profit growth is 38% etc. You can compare them with other firm s well Sometimes this kind of analysis is misleading

Ex. You dont know whether you get enough return for your investment

Ratio Analysis

Ratios helps us to understand certain phenomenon in a more meaningful and useful manner. Its a way of analyzing and presenting information so that user could benefit more.

Ratios are used in much of our daily life too

Automobiles How many kilometers per liter Cricketer Average ODI score

Ratios are helpful to judge comparative performance Financial ratios are used to weigh and evaluate the operating performance of the firm.

If a firm earn Rs. 500,000 profit from Rs. 5,000,000 of sales (10 percent profit margin) that might be quite satisfactory where as Rs. 50,000 earnings on 5,000,000 (1 percent margin) could be disappointing

Constructed ratios can be compared with the industry as well as well as with the own past records or budgeted figures. Reasons for deviations and variations should be further studied Ratios show the symptom not the cause

Classification of Ratios

Profitability Ratios

Profit margin Return on assets (investment) Return on equity Receivable turnover Average collection period Inventory turnover Fixed assets turnover Total assets turnover Current Ratio Quick Ratio Debt to total assets Time interest earned Fixed charge coverage Earnings Per Share P/E ratio Market to book Ratio

Assets Utilization

Liquidity Ratios

Debt utilization ratio

Market Value Ratio

Classification of Ratios cont

1. Profitability Ratios: to measure the ability of the firm to earn an adequate return on sales, total assets or invested capital 2. Assets Utilization Ratios: Speed at which the firm is turning over accounts receivable, inventory and how productive the fixed assets are in terms sales generations 3. Liquidity Ratios: Firms ability to pay off short-term obligations 4. Debt Utilization Ratios: the overall debt position of the firm is evaluated in the light of its assets base and earning power
5. Market value Ratio Can be computed only for publicly traded stocks. *The user of the financial statement will attach different degrees of importance to the four categories of ratios. potential investor or share holder profitability banker or trade creditor liquidity and debt utilization

1. Profitability Ratios:
Gross profit Margin
= (Gross Profit/Sales) x 100--- (1,000,000/4,000,000)X100=25% May depend on the nature of the industry, type of product, level of competition sales policy and strategies, image of the firm and the brand.

Net profit Margin

= (Net Income/Sales ) x 100--(200,000/4,000,000)X100 =25% May depend on all the factors mentioned under the gross profit margin and the level of other expenses (Overheads). Variations should be studied, Sometimes changes might be due the changing policies. However, total profitability of the firm is not only depend upon profit margin (how much you earn from each rupee of sales) but also your assets turnover ( how much sales you generate per each a rupee of assets)

1. Profitability Ratios:
Return on Total Assets (investment)
= (Net Income + Interest payment /Total Assets) X 100 = (200,000+40,000 / 1,600,000) x 100 Net income = After tax profit + Interest Total Assets = Owners fund and debt

= 15%

Return on Equity
=(Net Income/Total Equity ) X100 = (200,000/ 1,000,000) X 100 = 20%

Net Income = After tax profit * Above rations depend on both profit margins and assets turnover you can find whether you are getting required rate of return for your investment

2. Assets Utilization (Management) Ratios (Turnover Measures)

1.Receivable Turnover: Sales (Credit)/ Accounts Receivables -- 4,000,000/350,000 = 11.4 times 2. Average collection period: (Days sales in receivable) Accounts Receivable /*Average daily credit sales = 350,000/10,959=32Days * Average daily Credit sales = Credit sales/365 3. Inventory Turnover Sales/Inventory = 4,000,0000/370,000 = 10.8 times * better to use average inventory 4. Average Inventory Period (Days Sales in Inventory) Inventory/Average daily sales = 370,000/10,959= 33.8 days 365 days/inventory turnover = 365/10.8 = 33.8 days. 5. Fixed Assets Turnover Sales/Fixed Assets = 4,000,000/800,000 = 5 6. Total Assets Turnover Sales/Total Assets = 4,000,000/1,600,000= 2.5

How efficiently assets are being utilized

Liquidity Ratios (short term solvency)

1 Current Ratio
=Current Assets/Current Liabilities = 800,000/300,000 = 2.67 or (1 : 2.67)

2. Quick Ratio (Acid Test Ratio)

=(Current Assets Inventory)/Current Liabilities =430,000/300,000 = 1.43 or (1: 1.43)

3 Cash Ratio =Cash/Current Liabilities

= 30,000/300,000 = 0.1 or (1 : 0.1)

4. Net Working Capital to Total Assets

= Net working capital/ Total Assets = 500,000/1,600,000 = 0.3125 or 31.25%

4. Debt Utilization Ratios

1. Debt to Total Assets
(Total Debt/Total Assets) X100 = (600,000/1,600,000)X100 = 37.5%

*Total debt = (total Assets Equity)

2. Debt Equity Ratio

(Total Debt/Total Equity)100100 = (600,000/1,000,000)X100= 60%

3. Equity Multiplier
Total Assets/Total Equity = 1,600,000/1,000,000 = 1.6 times

4. Times Interest Earned (Interest Coverage)

Earnings before interest and taxes (EBIT)/Interest = 550,000/50,000= 11

5. Fixed Charge Coverage

Earnings before fixed charges and taxes/Fixed Charges =600,000/100,000 = 6 Firms ability to meet all fixed charges (ex. Lease payment)

5. Market Value Ratios

1. Earnings Per Share (EPS) Net Income/No. of Shares outstanding* = 200,000/40,000 = 5 * 40,000 shares outstanding 2. Price Earnings Ratio, P/E Ratio Price per share*/earnings per share = 20/5 = 4 times * Market price of the share Rs. 20 3. Market to Book Ratio Market Value per Share / Book Value per Share = 20/10 = 2 times

Other than the above three major ratios, shareholders may be interested in such ratios as Dividend Per share , Dividend cover, Net Assets per share etc.