FIN 103 - III and IV. Financial Statements & Ratio Analysis

ATENEO – J.G.
SCHOOL OF MANAGEMENT FINANCE 103: PRINCIPLES OF FINANCE

Finance & Accounting Department III & IV – Financial Statements and Ratio Analysis
Instructor : Alice Ann M. Parlan, MBA, RFP SY 2017 – 2018 2nd Semester
FINANCIAL STATEMENTS & RATIO ANALYSIS

 Balance Sheet
 Income Statement
 Statement of Retained Earnings
 Statement of Cash Flows
 Accounting Income vs. Cash Flow
 Financial Ratio Analysis
 Du Pont System
 Market Value Added (MVA) and Economic Value Added (EVA)
 Effects of Improving Ratios
 Limitations of Ratio Analysis
 The Annual Report
The Annual Report is issued annually by a firm to its shareholders, which contains the management’s
analysis of the firm’s past operations and future prospects as well as the following basic financial
statements:
 Balance Sheet – provides a snapshot of a firm’s financial position at one point in time.
 Income Statement – summarizes a firm’s revenues and expenses over a given period of time;
also known as Profit and Loss (P&L) Statement
 Statement of Retained Earnings – shows how much of the firm’s earnings were retained, rather
than paid out as dividends
 Statement of Cash Flows – reports the impact of a firm’s activities on cash flows over a given
period of time.
 F/S: Balance Sheet

 Shows a firm’s assets, liabilities, and
shareholder’s equity, using the actual cost
of acquiring them, at a given point in time
 Accounting Book Value – value of an

asset as shown in the balance sheet; it
represents the historical cost of the asset
rather than current market value or
replacement cost
 Balance Sheet Equation :

Total Assets = Total Liabilities
+ Total Shareholder’s Equity
Total Resources of the Firm
= How it was financed by Debt or Capital
o Shows what assets the firm owns and who has claims on those assets as of a given date
Sources: Brigham and Houston: Essentials of Financial Management, 13th Ed., Cengage Learning Asia 2013; 1
Keown, Martin, Petty: Foundations of Finance, 7th Ed., Pearson Education, Inc. / Prentice Hall 2011
ATENEO – J.G. SCHOOL OF MANAGEMENT FINANCE 103: PRINCIPLES OF FINANCE
 Overview of Balance Sheet: TOTAL ASSETS
CURRENT ASSETS
1. Cash
2. Accounts Receivables (A/R)
3. Inventories
4. Other Current Assets
 Current Assets - called Gross Working Capital because these assets “turn over” (used &
replaced within a year)
 Cash - refers to Cash on hand, demand deposits, short-term marketable securities that
can be quickly converted into cash
 A/R - money owed by customers who purchased goods & services on credit
 Inventories - raw materials, work in progress, and finished goods held for eventual sale
 Other Current Assets - items such as prepaid expenses
LONG-TERM (FIXED) ASSETS

1. Net Property, Plant, and Equipment
2. Other Long-Term Assets
A. Land
B. Long-Term Investments
C. Intangible Assets – like Patents, Copyrights, Trademarks, Goodwill
 Depreciation Expense – a non-cash expense (found in Income Statement) to allocate the

cost of depreciable assets, such as machinery and equipment, over the asset’s expected
useful life
 Accumulated Depreciation – sum of all depreciation taken over the entire life of a
depreciable asset (found in Balance Sheet)
 Gross Fixed Assets – reflect the original cost of fixed assets
 Net Fixed Assets = Gross Fixed Assets minus Accumulated Depreciation taken over life
of the assets
 Overview of Balance Sheet: TOTAL LIABILITIES
CURRENT LIABILITIES
1. Accounts Payables (A/P)
2. Accrued Expenses
3. Short-Term Debt (Notes Payable)
4. Other Current Liabilities
 Current Liabilities (Short-Term Debt) - borrowed money that must be repaid within 12
months
 A/P or Trade Credit - the credit suppliers have extended when materials or inventories
were purchased and will be paid within 30, 60, and 90 days
 Accrued Expenses - unpaid short-term liabilities incurred during the firm’s operations
 Short-Term Notes - borrowings from banks or other FIs that are due and payable within
12 months
LONG-TERM LIABILITIES
1. Long-Term Loans
2. Corporate Bonds
3. Mortgages
 Long-Term Liabilities (L/T Debt) -borrowed money from banks or other financial
institutions that must be repaid longer than 12 months
 Corporate Bonds - borrowings of the firm through issuance of its own securities with
medium to long-term maturities
 Mortgages – loan to finance real estate where the lender has first claim on the property in
the event the borrower is unable to repay the loan
 Overview of Balance Sheet: SHAREHOLDERS’ EQUITY
SHAREHOLDERS’ EQUITY
1. Par Value of Common Stocks
2. Paid-In Capital
3. Retained Earnings
 Shareholders’ Equity – includes both preferred and common shareholders’ investment in

the firm
 Preferred Stockholders – stockholders that have claims on the firm’s income and assets
after creditors, but before common stockholders; Receives dividends that are fixed in
amount
 Common Stockholders – investors who own the firm’s common stocks; also known as
residual owners of the firm
 Common Stocks – the amount the firm receives after selling the stocks, which represent
ownership in a corporation
 Par Value – the arbitrary value a firm puts on each share of stock prior to its being offered
for sale
 (Additional) Paid-In Capital – the amount the firm receives from selling stock to investors
above par value
 Treasury Stock - firm’s stock that has been issued and the repurchased by the firm
 Retained Earnings – cumulative profits retained in business up to the date of the balance
sheet
 F/S: Income Statement
 Shows the firm’s sales and costs over a given time period
 Income Statement Equation :
Sales – Expenses = Profits
 Known also as Profit & Loss (P&L) Statement; indicates the amount of profits generated by a
firm, which is calculated on an accrual basis
 Accrual Basis Accounting – method of accounting whereby revenue is recorded when it is

earned, whether or not the revenue has been received in cash. Likewise, expenses are
recorded when they are incurred, even if the money has not actually been paid out
 Overview of Income Statement: GROSS PROFITS
SALES OR REVENUES
 Paid in Cash
 Paid thru Credit
 Sold on Installment
 Deferred Sales
Less:
COST OF GOODS SOLD (CGS)
Equals:
GROSS PROFITS
 Revenues - Total Sales Pesos equals Selling Price X Units Sold, whether sold in cash, thru
credit, on installment or deferred
 Cost of Goods Sold – the cost of producing or acquiring a product or service to be sold in the
ordinary course of business
 Gross Profits - Sales or Revenues minus Cost of Goods Sold
 Overview of Income Statement: OPERATING INCOME
GROSS PROFITS
Less:
OPERATING EXPENSES
 Marketing & Selling Expenses
 General & Administrative Expenses
Equals:
EARNINGS BEFORE INTEREST, TAXES DEPRECIATION & AMORTIZATION (EBITDA)
Less:
 Depreciation Expenses
 Amortization Expenses
Equals: OPERATING INCOME or OPERATING PROFITS (EBIT)
 Marketing & Selling Expenses – the (variable) cost of promoting and distributing the firm’s
products or services to customers
 General & Administrative Expenses – the firm’s overhead (fixed) expenses, such as salaries
and rent
 Depreciation Expense – a noncash expense to allocate the cost of depreciable assets, such
as plant & equipment, over the life of the asset
 Amortization Expense – a noncash expense to allocate the cost of the intangible assets, such
as copyrights, over the life of the asset
 Overview of Income Statement: TAXABLE INCOME
OPERATING INCOME or OPERATING PROFITS (EBIT)
Less:
FINANCING COST
 Interest Expenses
 Preferred Dividends
Equals:
TAXABLE INCOME (EBT)
 Operating Income or Operating Profits – also called earnings before interest & taxes (EBIT);
the result of management’s decisions relating only to the operations of the business
 Financing Cost – interest expenses resulting from the use of debt to finance operations and,
if the firm issued preferred stocks, includes also preferred dividends
 Taxable Income = Operating Income minus Financing Cost; also called earnings before taxes
(EBT)
 Overview of Income Statement: NET INCOME
TAXABLE INCOME (EBT)
Less:
INCOME TAX
Equals:
NET INCOME
 Taxable Income = Operating Income minus Financing Cost; also called earnings before taxes
(EBT)
 Income Tax – computed based on earnings before taxes (EBT) and the applicable tax rate for
the amount of income reported
 Net Income – earnings available to common stockholders, which represents income that may
be reinvested in the firm or distributed to its owners, provided that there is available cash to
do so
 Overview of Statement of Shareholders’ Equity (SE):
SE BALANCE, Previous Year
Add:
NET INCOME, Current Year
Less:
CASH / STOCK DIVIDENDS*
Add:
RETAINED EARNINGS
Equals:
SE BALANCE, Current Year
 SE = Par Value of Common Stocks + Paid-In Capital + Retained Earnings; shows how
much a firm’s equity changed during the year and why this change occurred
 Retained Earnings - cumulative profits retained in the firm up to the date of the balance
sheet; represents a “claim against assets”, which does not represent cash and are not
“available” for dividends or anything else; it may also be negative to show unrealized losses
like forex losses
 *Stock Dividend – distribution of shares of up to 25% of the number of shares outstanding,

issued on a pro rata basis to the current shareholders
 Other Financial Ratios: PER SHARE BASIS
NO. OF OUTSTANDING SHARES

 Common Shares
 Preferred Shares
EARNINGS PER SHARE

= Net Income____________
No. of Outstanding Common Shares
DIVIDENDS PER SHARE

= Total Dividends Declared___
No. of Outstanding Shares
BOOK VALUE PER SHARE

= Common Equity ______
No. of Outstanding Common Shares
 Earnings per Share (EPS) – income on a per share basis
 Dividends per Share (DPS) – amount of dividends a firm pays for each share outstanding
 Book Value per Share (BVPS) – accounting value per share based on firm’s balance sheet
 Stock Price per Share – market value per share observed in the market place
 Other Financial Ratios: MORE LIQUIDITY RATIOS
AVE. COLLECTION PERIOD

= Accounts Receivable____
(Credit Sales / 365)
ACCOUNTS RECEIVABLES (A/R) TURNOVER RATIO

= Annual Credit Sales____
Accounts Receivables
INVENTORY TURNOVER
= Cost of Goods Sold___
Inventory
DAY SALES OUTSTANDING

= Receivables____
Annual Sales / 365
 Ave. Collection Period - how long the firm collects on its credit accounts & converts to cash
 A/R Turnover Ratio – expresses how often accounts receivable are “rolled over” during a
year
 Inventory Turnover – measures the number of times a firm’s inventories are sold and
replaced during the year (relative liquidity of the inventories)
 Day Sales Outstanding – indicates the average length of time the firm must wait after making
a sale before it receives cash
 Other Financial Ratios: OPERATING EFFICIENCY
BASIC EARNING POWER (BEP) RATIO or OPERATING RETURN ON ASSETS (OROA)

= EBIT_____
Total Assets
TOTAL ASSET TURNOVER

= Sales_____
Total Assets
FIXED ASSET TURNOVER

= Sales______
Net Fixed Assets
 Basic Earning Power (BEP) Ratio or OROA– indicates the ability of the firm’s assets to
generate operating income
 Total Asset Turnover – relates how well the firm is managing its assets to generate sales
(called asset efficiency)
 Fixed Asset Turnover – indicates how efficiently the firm is using its fixed assets
 Other Financial Ratios: FINANCING DECISION
TIMES INTEREST EARNED

= Operating Profits__
Interest Expense
DEBT / EQUITY RATIO

= Total Debt___
Total Equity
 Times Interest Earned – measures a firm’s ability to meet its interest payments from its
annual operating earnings
 Debt / Equity Ratio (D/E Ratio) – determines how much leverage the shareholders had in
magnifying expected earnings
 Other Financial Ratios: RETURN ON CAPITAL
RETURN ON EQUITY
= Net Income___
Common Equity
RETURN ON TOTAL ASSETS (ROA)

= Net Income____
Total Assets
 Return on Equity (ROE) – refers to accounting rate of return earned on the common
stockholders’ investment
 Return on Total Assets (ROA) – indicates the rate of return being earned on the firm’s assets
 Effects of Debt on ROA
Return on Assets
 To calculate return on assets, first find the profit margin by dividing net income by revenues.
Then, calculate asset turnover by dividing total revenues by total assets. Finally, multiply profit
margin by asset turnover to find ROA. These numbers can be found on the balance sheet and the
income statement.
Debt and ROA

 Increased debt has the potential to lower revenues as more money is spent servicing that debt.
If it is spent to increase production and production leads to significantly increased revenues,
increased debt may increase ROA.
 That depends on whether the debt burden is so costly it cuts into net income. If revenues rise as
a result of debt financing of production, but net income falls due to increased expense, ROA
declines.
 Effects of Debt on ROE
Return on Equity
 Return on equity is calculated by dividing annual earnings by average shareholder equity over the
year. Annual earnings are listed in a company's annual report. Shareholder equity is listed in the
balance sheet. In establishing a true picture of shareholder equity, check the company's quarterly
statements to see if shareholder equity has fluctuated during the year.
Debt and ROE

 Increased debt increases the leverage factor in a company. During normal or boom times,
leverage results in exponential profit returns. During recessions, leverage can result in
exponential losses, as well.
 A large debt burden carries risk because of the reaction of leverage to the prevailing economic
conditions. Increased debt favors ROE during boom times, but hurts ROE during recessions.
 Problems with ROE
 ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole
measure of performance:
 ROE does not consider risk
 ROE does not consider the amount of capital invested
 Might encourage managers to make investment decisions that do not benefit shareholders
 ROE focuses only on return. A better measure is one that considers both risk and return.
 The DuPont Equation
 A formula that shows the relationship among asset management, debt management, and
profitability ratios:
ROE = Net Income X Sales X Total Assets_____

Sales Total Assets Total Common Equity
 Profit Margin - Expense Control; tells the firm how much it earns on sales, which determines
its command on premium price and holding down of costs
 Total Assets Turnover - Asset Utilization; tells the firm how many times the profit margin is
earned each year for each pesos of sales and how many times its assets turned over each
year
 Equity Multiplier – Debt Utilization; the adjustment factor
 Profits and cash flows are not the same thing!
 Two Ways to Measure a Firm’s Cash Flows:
 Free Cash Flows – the amount of cash available from operations after the firm pays for the
investments it has made in operating working capital and fixed assets. This cash is available
for distribution to firm’s creditors and owners.
 Statement of Cash Flows – focuses on identifying the sources and uses of cash that explain
the change in the firm’s cash balance reported in the balance sheet
 Potential Uses of Freed Up Cash
 Expand business
 Reduce debt
 Repurchase stock
 All these actions would likely improve the stock price
 Three Key Activities that Explain Cash Inflows & Cash Outflows of the Firm:
1. Generating Cash Flows from Day-to-Day Operations - how much cash is coming from the
normal course of operating a business, starting with :
- purchasing inventories on credit
- selling on credit
- paying for the inventories
- collection on sales made on credit
2. Investing in Fixed Assets & Other Long-Term Investments - when a firm purchases or
sells fixed assets, like equipment or building, there can be a significant cash inflows and
outflows
3. Financing the Business - cash inflows & outflows occur from:

- borrowing and repaying S/T and L/T Debt
- paying dividends to the shareholders
- issuing new equity stocks or repurchasing stocks from shareholders
Overall Statement of Cash Flows:
 Converting a Firm’s Income Statement from an Accrual Basis to Cash Basis in Two (2)
Steps:
1. Add Back depreciation to net income since depreciation is not a cash expense
2. And Subtract the following:

- any uncollected sales (or total sales minus increases in accounts receivables)
- cash payments for inventories (or increases in inventories minus increases in
accounts payables)
 Valuation of Free Cash Flows
 Economic Value Added (EVA)
 A financial performance that measures a firm’s economic profit, which assigns:

 cost to the equity capital (the opportunity cost of funds provided by the shareholders)
 interest cost on the firm’s debt
 Economic Value Added Equation:
EVA = Operating Return - Cost of x Total

on Assets All Capital Assets
= Php Amount (if positive, then there is added economic value)
 Value created by management is determined by the amount the firm earns on its invested capital
relative to the cost of both equity and debt funds, and the amount of capital invested in the firm
(which are the total assets)
 Computing for Economic Profit:
 Market Value Added (MVA)
MVA = Market value __ Equity capital

of equity supplied
 Market Value Ratios:
PRICE / EARNINGS RATIO

= Market Price per Share__
Earnings per Share
PRICE / BOOK RATIO

= Market Price per Share___
Equity Book Value per Share
 Price/Earnings Ratio (P/E Ratio) – the price the market places on Php 1 of the firm’s reported
earnings
 Price / Book Ratio (P/BV Ratio) – If > I, then investors believe that the firm is more valuable
than the amount shareholders have invested in it
 Analyzing Market Value Ratios
 Price-Earnings Ratio (P/E) : How much investors are willing to pay for $1 of earnings?
 Price-Cash Flow Ratio (P/CF): How much investors are willing to pay for $1 of cash flow?
 Price-Book Value Ratio (M/B): How much investors are willing to pay for $1 of book value
equity?
 For each ratio, the higher the number, the better.
 P/E and M/B are high, if ROE is high and risk is low.
 Trend Analysis and Benchmarking
 Used to estimate the likelihood of improvement or

deterioration in financial condition
 Trend Analysis - analyzes a firm’s financial ratios

over time
 Benchmarking - comparing with the industry’s

average can help determine how the firm is faring
with other companies
 Potential Problems and Limitations of Financial Ratio Analysis
 Comparison with industry averages is difficult for a conglomerate firm that operates in many
different divisions
 “Average” performance is not necessarily good, perhaps the firm should aim higher
 Seasonal factors can distort ratios
 “Window dressing” techniques can make statements and ratios look better
 Different operating and accounting practices can distort comparisons.
 Sometimes it is hard to tell if a ratio is “good” or “bad”.
 Difficult to tell whether a company is, on balance, in strong or weak position.
 Interplay among Balance Sheet, Income Statement, and Statement of Cash Flows
 SUMMARY: Five Major Categories of Financial Ratios

(What questions do they answer?)
 Liquidity: Can the firm meet the required payments as they fall due?
These ratios give an idea of the firm’s ability to pay off debts that are maturing within a year.
 Asset Management: Does the firm manage its assets efficiently to generate enough sales?
These ratios give an idea of how efficiently the firm is using its assets.
 Debt Management: Does the firm finance its assets with the right mix of debt and equity?
These ratios give an idea of how the firm has financed its assets as well as the firm’s ability to
repay its long-term debt.
 Profitability: Are the Firm's managers providing good returns on shareholders' capital? Do sales
prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?
These ratios give an idea of how profitably the firm is operating and utilizing its assets.
 Market Value: Are the Firm's managers creating shareholders' value? Do investors like what
they see as reflected in P/E and M/B ratios? These ratios give an idea of what investors think
about the firm and its future prospects based on its stock price.

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FIN 103 - III and IV. Financial Statements &amp; Ratio Analysis

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ATENEO – J.G.

SCHOOL OF MANAGEMENT FINANCE 103: PRINCIPLES OF FINANCE

FINANCIAL STATEMENTS & RATIO ANALYSIS

 The Annual Report

 F/S: Balance Sheet

 Accounting Book Value – value of an

 Balance Sheet Equation :

 Overview of Balance Sheet: TOTAL ASSETS

 Other Current Assets - items such as prepaid expenses

LONG-TERM (FIXED) ASSETS

 Depreciation Expense – a non-cash expense (found in Income Statement) to allocate the

 Gross Fixed Assets – reflect the original cost of fixed assets

 Overview of Balance Sheet: TOTAL LIABILITIES

 Overview of Balance Sheet: SHAREHOLDERS’ EQUITY

 Shareholders’ Equity – includes both preferred and common shareholders’ investment in

 F/S: Income Statement

 Income Statement Equation :

Sales – Expenses = Profits

 Accrual Basis Accounting – method of accounting whereby revenue is recorded when it is

 Overview of Income Statement: GROSS PROFITS

 Gross Profits - Sales or Revenues minus Cost of Goods Sold

 Overview of Income Statement: OPERATING INCOME

Equals: OPERATING INCOME or OPERATING PROFITS (EBIT)

 Overview of Income Statement: TAXABLE INCOME

OPERATING INCOME or OPERATING PROFITS (EBIT)

 Overview of Income Statement: NET INCOME

TAXABLE INCOME (EBT)

 Overview of Statement of Shareholders’ Equity (SE):

SE BALANCE, Previous Year

 *Stock Dividend – distribution of shares of up to 25% of the number of shares outstanding,

 Other Financial Ratios: PER SHARE BASIS

NO. OF OUTSTANDING SHARES

EARNINGS PER SHARE

DIVIDENDS PER SHARE

BOOK VALUE PER SHARE

 Earnings per Share (EPS) – income on a per share basis

 Other Financial Ratios: MORE LIQUIDITY RATIOS

AVE. COLLECTION PERIOD

ACCOUNTS RECEIVABLES (A/R) TURNOVER RATIO

DAY SALES OUTSTANDING

 Other Financial Ratios: OPERATING EFFICIENCY

BASIC EARNING POWER (BEP) RATIO or OPERATING RETURN ON ASSETS (OROA)

TOTAL ASSET TURNOVER

FIXED ASSET TURNOVER

 Other Financial Ratios: FINANCING DECISION

TIMES INTEREST EARNED

DEBT / EQUITY RATIO

 Other Financial Ratios: RETURN ON CAPITAL

RETURN ON TOTAL ASSETS (ROA)

 Effects of Debt on ROA

Debt and ROA

 Effects of Debt on ROE

Debt and ROE

 Problems with ROE

 The DuPont Equation

ROE = Net Income X Sales X Total Assets_____

 Equity Multiplier – Debt Utilization; the adjustment factor

 Statement of Cash Flows

 Profits and cash flows are not the same thing!

 Two Ways to Measure a Firm’s Cash Flows:

 Potential Uses of Freed Up Cash

 All these actions would likely improve the stock price

 Statement of Cash Flows

3. Financing the Business - cash inflows & outflows occur from:

FIN 103 - III and IV. Financial Statements & Ratio Analysis

FIN 103 - III and IV. Financial Statements & Ratio Analysis