HANDOUTS ON FUNDAMENTALS OF
2) Determine how much funding will
FINANCIAL MANAGEMENT 1
Chapter 6: Financial Statements
Analysis
(Reference: Van Horne and John M.
Wachowicz, Fundamentals of Financial
Management, 13th edition)
1) Introduction
a) To make rational decisions in
keeping with the objectives of the
firm, the financial manager must have
analytical tools.
b) The firm itself and outside
providers of capital creditors and
investors all undertake financial
statement analysis.
The type of analysis varies according
to the specific interests of the party
involved.
c) Trade creditors are primarily
interested in the liquidity of a firm.
Their claims are short term, and the
ability of the firm to pay these claims
quickly is best judged by an analysis
of the firms liquidity.
d) The claims of bondholders are long
term. They are more interested in the
cash-flow ability of the firm to service
debt over a long period of time. They
may evaluate this ability by analyzing
the capital structure of the firm, the
major sources and uses of funds, the
firms profitability over time, and
projections of future profitability.
e) Investors in a companys common
stock are principally concerned with
present and expected future earnings
as well as with the stability of these
earnings about a trend line. As a
result, investors usually focus on
analyzing profitability. They would
also be concerned with the firms
financial condition insofar as it affects
the ability of the firm to pay dividends
and avoid bankruptcy.
f) Internally, management also
employs financial analysis for the
purpose of internal control and to
better provide what capital suppliers
seek in financial condition and
performance from the firm.
2) Framework for financial analysis
a) Analysis of the funds needs of the
firm
a.1) Focus on the trend and seasonal
component of a firms fund
requirements.
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a.
be required in the future, and what
would be the nature of such needs,
including any seasonal component to
the needs.
b) Analysis of the financial condition
and profitability of the firm
b.1.) Analytical tools used to address
the first concern include sources and
uses of funds statements, statements
of cash flow, and cash budgets. Such
tools used to assess the financial
condition and performance of the firm
are financial ratios.
c) Analysis of the business risk of the
firm
c.1) Business risk relates to the risk
inherent in the operations of the firm.
Some companies are in highly volatile
lines of business and/or may be
operating close to their break-even
point.
c.2) Other companies are in very
stable lines of business and/or find
themselves operating far from their
break-even point.
3) All the three factors mentioned in
the framework should be considered
jointly and used in determining the
financial needs of the firm.
a) The greater the funds
requirements, the greater the total
financing that will be necessary.
b) The nature of the needs for funds
influences the type of financing that
should be used.
c) The firms level of business risk
also strongly affects the type of
financing that should be used.
c.1) The greater the business risk, the
less desirable debt financing usually
becomes relative to common stock
financing. In other words, equity
financing is safer in that there is no
contractual obligation to pay interest
and principal, as there is with debt.
c.2) A firm with a high degree of
business risk is generally ill advised to
take on considerable financial risk as
well.
d) The financial condition and
performance of the firm also influence
the type of financing that should be
used.
d.1) The greater the firms liquidity,
the stronger the overall financial
condition; and the greater the
profitability of the firm, the more risky
the type of financing that can be
incurred. That is, debt financing
becomes more attractive with
improvements in liquidity, financial
condition, and profitability.
PART 2:
Chapter 3: Financial Statements
(Reference: Brigham, Eugene,
Fundamentals of Financial
Management, 12th edition)
1) Introduction
The financial statements presented in
a typical
companys annual report look quite
official. They are signed by the firms
top executives and are certified by a
Big Four accounting firm, so one
would think that they must be
accurate. That may not be true,
though, for three reasons: legitimate
misjudgments in valuing assets and
measuring costs, flexible accounting
rules that result in differently reported
results for similar companies, and
outright cheating.
One blatant example of cheating
involved WorldCom, which reported
asset values that exceeded their true
value by about $11 billion. This led to
an understatement of costs and a
corresponding overstatement of
profits. Enron is another example.
That company overstated the value of
certain assets, reported those artificial
value increases as profits, and
transferred the assets to subsidiary
companies to hide the true facts.
Enrons and WorldComs investors
eventually learned what was
happening, the companies were
forced into bankruptcy, their top
executives went to jail, the accounting
firm that audited their books was
forced out of business, and millions of
investors lost billions of dollars. After
the Enron and WorldCom blowups,
Congress passed the Sarbanes-Oxley
Act (SOX), which required companies
to improve their internal auditing
standards and required the CEO and
CFO to certify that the financial
statements were properly prepared.
The SOX bill also created a new
watchdog organization to help make
sure that the outside accounting firms
were doing their job. From all
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indications, financial statements are
generally more accurate and clearer
than they were in the past. But the
world is dynamic, and a new
accounting problem surfaced in 2007.
Big banks, most notably Citigroup,
owned many risky but high-yielding
subprime mortgages. The banks
invented a complex legal procedure
that they called a structured
investment vehicle (SIV) to conceal
the fact that they held all of these
risky mortgages. They correctly feared
that people wouldnt want to do
business with a risky bank. But when
the subprime market fell apart in
2007, the banks had to acknowledge
their losses, which ran into many
billions of dollars. It turns out that the
banks had tried to avoid writing down
their mortgages; but a newly formed
organization set up by the Big Four
accounting firms, called the Center for
Audit Quality, took a hard line and
forced the writedowns. 2) Financial
Statements and Reports The annual
report is the most important report
that corporations issue to
stockholders, and it contains two
types of information.2 First, there is a
verbal section, often presented as a
letter from the chairperson, which
describes the firms operating results
during the past year and discusses
new developments that will affect
future operations. Second, the report
provides these four basic financial
statements:
1. The balance sheet, which shows
what assets the company owns and
who has claims on those assets as of
a given datefor example, December
31, 2008.
2. The income statement, which
shows the firms sales and costs (and
thus profits) during some past period
for example, 2008.
3. The statement of cash flows, which
shows how much cash the firm began
the year with, how much cash it
ended up with, and what it did to
increase or decrease its cash.
4. The statement of stockholders
equity, which shows the amount of
equity the stockholders had at the
start of the year, the items that
increased or decreased equity, and
the equity at the end of the year.
These statements are related to one
another; and taken together, they
provide an accounting picture of the
firms operations and financial
position. The quantitative and verbal
materials are equally important. The
firms financial statements report
what has actually happened to its
assets, earnings, and dividends over
the past few years, whereas
managements verbal statements
attempt to explain why things turned
out the way they did and what might
happen in the future.
Chapter 11: Understanding
Financial Statements
Chapter 12: Analysis of Financial
Statements
(Reference: Cabrera, Ma. Elenita
Balatbat, Financial Management
(Principles and Applications, vol. 1)
2015 edition)
1) Constraints on Relevant and
Reliable Information
a) Timeliness: In achieving a balance
between relevance and reliability, the
overriding consideration is how best to
satisfy the economic decision making
needs of users.
b) Balance between Benefit and Cost:
a pervasive constraint rather than a
qualitative characteristic. The
benefits derived from information
should exceed the cost of providing it.
The evaluation of benefits and costs
is, however, substantially
judgmental process.
c) Balance between qualitative
characteristics: Generally, the aim is
to achieve an appropriate balance
among the characteristics in order to
meet the objective of financial
statements. The relative importance
of the characteristics in different
cases is a matter of professional
judgment.
d) True Fair View or Fair Presentation:
Financial statements are frequently
described as showing a true and fair
view of the financial position,
performance and changes in financial
position of an enterprise. Although
this framework does not deal directly
with such concepts, the applications
of the principal qualitative
characteristics and of appropriate
accounting standards, normally results
in financial statements that convey
what is generally understood as a true
and fair view of such information.
2) Linkage of Financial Statements
a) The four financial statements are
linked with each other and linked
across time.
b) The statement of financial position
and statement of comprehensive
income are linked via retained
earnings. Retained earnings are
updated each period and reflect
cumulative income that has not yet
been distributed to shareholders.
c) There is an order to financial
statements preparation:
(c.1) A company prepares its income
statement using the statement of
comprehensive income accounts. It
then uses the net income number and
dividend information to update the
retained earnings account.
(c.2) It prepares the statement of
financial position using the updated
retained earnings account along with
the remaining statement of financial
position accounts from the trial
balance.
(c.3) It prepares the statement of
shareholders equity.
(c.4) It prepares the statement of
cash flows using information from the
cash accounts and other sources.
3. Financial statement analysis the
process of extracting information from
a financial statements to better
understand a companys current and
future performance and financial
condition. It involves
Comparing the firms
performance to that of other
firms in the same industry, and
Evaluating trends in the firms
financial position over time.
The primary goal of financial
management is to maximize
shareholders wealth. Accounting
data influence stock prices and such
data can be used to see why a
company is performing the way it is
and where it is heading.
4. Analyzing the broader business
environment
a) Life cycle
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a.1) At what stage in its life is this
company? Is it a startup, experiencing
growing pains?
a.2) Is it strong and mature, reaping
the benefits of competitive
advantages?
a.3) Is it nearing the end of its life,
trying to milk what it can from
stagnant product lines?
b) Outputs
b.1) What products does it sell?
b.2) Are its products new, established
or dated?
c) Buyers
c.1) Who are its buyers?
c.2) Are buyers in good financial
condition?
c.3) Do buyers have substantial
purchasing power?
c.4) Can the seller dictate sales terms
to buyers?
d) Inputs
d.1) Who are its suppliers?
d.2) Are there many supply sources?
d.3) Does the company depend on a
few supply sources with potential for
high input costs?
e) Competition
e.1) In what kind of markets does it
operate?
e.2) Are markets open? Is the market
competitive?
e.3) Does the company have
competitive advantages?
e.4) Can it protect itself from new
entrants? At what cost?
e.5) How must it compete to survive?
f) Financing
f.1) Must it seek financing from public
markets? Is it going public?
f.2) Is it seeking to use its stock to
acquire another company?
f.3) Is it in danger of defaulting on
debt covenants?
f.4) Are there incentives to tell an
overly optimistic story to attract lower
cost financing or to avoid default on
debt?
g) Labor
g.1) Who are its managers+ What
are their backgrounds? Can they be
trusted? Are they competent?
g.2) What is the state of employee
relations? Is labor unionized?
h) Governance
h.1) How effective is its corporate
governance? Does it have strong and
independent board of directors?
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h.2) Does a strong audit committee of
the board exist, and is it populated
with outsiders?
h.3) Does management have a large
portion of its wealth tied to the
companys stock?
i) Risk
i.1) Is it subject to lawsuits from
competitors or shareholders?
i.2) Is it under investigation by
regulators?
i.3) Has it changed auditors? If so,
why?
i.4) Are its auditors independent?
i.5) Does it face environmental and/or
political risks?
5. Limitations of Financial Statements
Analysis
a) Information derived by the analysis
are not absolute measures of
performance in any and all of the
areas of business operations. They
are only indicators of degrees of
profitability and financial strength of
the firm.
b) Limitations inherent in the
accounting data the analyst works
with. These are brought about by
among others: (1) variation and lack
of consistency in the application of
accounting principles, policies and
procedures; (2) too-condensed
presentation of data; and (3) failure to
reflect change in purchasing power.
c) Limitations of the performance
measures or tools and techniques
used in the analysis. Quantitative
measurements are not absolute
measures but should be interpreted
relative to the nature of the business
and in the light of past, current and
future operations. Timing of
transactions and the use of averages
can also affect the results obtained in
applying the techniques in financial
analysis.
d) Analysts should be alert to the
potential for management to influence
the outcome of financial statements in
order to appeal to creditors, investors
and others.
Limitations of analysis may be
overcome to some extent by finding
appropriate benchmarks used by most
analysts such as the performance of
comparable components and the
average performance of several
companies in the same industry.
6. Financial Ratio Analysis
a) Financial ratio is a comparison in
fraction, proportion, decimal or
percentage of two significant figures
taken from financial statements.
b) It expresses the direct relationship
between two or more quantities in the
statement of financial position and
statement of comprehensive income
of a business firm.
c) The ratios are categorized as
follows:
c.1) Liquidity ratios give us an idea
of the firms ability to pay off debts
that are maturing within a year or
within the next operating cycle.
These ratios are necessary if the firm
is to continue operating.
c.2) Asset management ratios give
us an idea of how efficiently the firm is
using its assets. Good asset
management ratios are necessary for
the firm to keep its costs low and thus,
its net income high.
c.3) Debt management ratios tell us
how the firm has financed its assets
as well as the firms ability to repay its
long-term debt. These indicate how
risky the firm is and how much of its
operating income must be paid to
bondholders rather than stockholders.
c.4) Profitability ratios give us an
idea of how profitability the firm is
operating and utilizing its assets.
These ratios, combine the asset and
debt management categories and
show their effects on return on equity.
c.5) Market book ratios - these ratios
which consider the stock price, give us
an idea of what investors think about
the firm and its future prospects.
These tell us what investors think
about the company and its prospects.
7. Summary of most commonly used
ratios: their formulas and basic
significance
a) Ratios used to evaluate short-term
financial position (short-term solvency
and liquidity)
a.1) Current ratio primary test of
solvency to meet current obligations
from current assets as a going
concern; measure of adequacy of
working capital.
Current ratio = total current
assets/
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total current
liabilities
a.2) Acid-test ratio or quick ratio a
more severe test of immediate
solvency; test of ability to meet
demands from current assets.
Acid test ratio or quick ratio =
total quick assets / total current
liabilities
Total quick assets: cash +
marketable securities + accounts
receivable
a.3) Working Capital to total assets
indicates relative liquidity of total
assets and distribution of resources
employed.
Working capital to total assets
=
Working Capital / Total Assets
Working capital = current assets
current
Liabilities
b) Ratios used to evaluate asset
liquidity and management efficiency
b.1) Trade receivable turn-over
velocity of collection of trade accounts
and notes; test of efficiency of
collection.
Trade receivable turn-over = net
credit sales /
Average trade receivable (net)
b.1b) Average collection period or
number of days sales uncollected
evaluates the liquidity of accounts
receivable and the firms credit
policies.
Average collection period or
number of days sales uncollected
= 360 days / receivable turnover
or accounts receivable / net
sales/360
b.2) Inventory turnover measures
efficiency of the firm in managing and
selling inventories
Finishes goods inventory = Cost
of goods sold / average finished
goods inventory
c) Ratios used to evaluate long-term
financial position or stability/leverage
c.1) Debt ratio shows proportion of
all assets that are financed with debt.
Debt ratio = total liabilities / total
assets
c.2) Equity ratio indicates proportion
of assets provided by owners.
Reflects financial strength and caution
to creditors.
Equity ratio = total equity / total
assets
c.3) Debt to equity ratio measures
debt relative to amounts of resources
provided by owners.
Debt to equity ratio = total
liabilities / total equity
c.4) Fixed assets to long-term
liabilities reflects extent of
investment in long-term assets
financed from long-term debt.
Fixed assets to long-term
liabilities = fixed assets (net) /
total long-term liabilities
d) Ratios used to measure
profitability and returns to investors
d.1) Gross profit margin measures
profit generated after consideration of
cost of products sold.
Gross profit margin = gross
profit / net sales
d.2) Operating profit margin
measures profit generated after
consideration of operating costs.
Operating profit margin =
operating profit / net sales
d.3) Net profit margin (rate of return
on net sales measures profit
generated after consideration of all
expenses and revenues
Net profit margin = net profit /
net sales