FINANCIAL STATEMENT ANALYS LECTURE 1st

BY Farooq shah LECTURER at CECOS University

TOPIC 2: FINANCIAL STATEMENT ANALYSIS

Financial statement analysis (or financial analysis) the process of understanding the risk and profitability of a firm (business, sub-business or project) through analysis of reported financial information, particularly annual and quarterly reports. In this topic, we aim to: Develop an ability to read, understand and work with financial statements Use financial statement information to assess the performance of a company Introduce the use of financial modeling as a tool in corporate finance

TOPIC 1: THE IDEA OF THE CORPORATION

The topic is structured as follows:

The topic is structured as follows: 2.1 Accounting statements 2.1.1 Balance Sheet 2.1.2 Income Statement 2.2 Cash flow statement, Cash cycle 2.3 Financial Ratios

Introductory Comments

Sources of Information about a company Audited Annual Report Company Website Regulatory Bodies (SECP, Stock Exchange) Financial Press Industrial News Bulletins Analysts Reports/Websites

Introductory Comments

Audited Annual Report

Biggest/reliable source of publically available info Qualitative and Quantitative Information Contains Financial Statements

Introductory Comments
Overview if Financial Statements

The financial statements = financial representation of the business activity of the corporation.
Do not cover basic accounting in this course but essential to have an understanding of how financial statements work and to be able to use them for financial analysis. Financial statements prepared in accordance with Generally Accepted Accounting Principles reflected in Accounting Standards. Legal requirement for companies to use these standards in the preparation of accounts.

Overview of Financial Statements

. It is important to be aware of some of these: Historic Cost convention Going Concern assumption Consolidated Financial reports

Types of Financial Statements

The three basic financial statements which companies must prepare are:

1) The Balance Sheet: shows the cumulative value of various accounts since the beginning of the firm's business. These are described as the stock accounts. This is also called the Statement of Financial Position. 2) The Income Statement: shows the value of various transaction, or flow accounts, for the preceding period, usually a financial year. Also known as the Statement of Financial Activity.
3) The Cash Flow Statement: shows the movement (inflows, outflows) in cash account 4) Statement of Changes in Owners equity

Using Financial Statements

The many versions of profit Mostly used is Profit After Tax (PAT)/Net Profit/Net Income Other versions may also be used a) Contribution margin: is defined as Revenue minus Variable costs. This measures the contribution which an additional unit makes towards covering fixed costs. Used to estimate the breakeven level of sales volume;

b) Gross profit: Revenue less Cost of Goods Sold. Objective is to measure performance of manufacturing activity;

Using Financial Statements

c) EBITDA: Earnings before Interest, taxes depreciation and amortization. This adds back depreciation and amortization, to get closer to cash flow and to minimize the impact of different depreciation policies. d) EBIT: Earnings before Interest and taxes, which measures a business's income before it is divided among creditors, owners and tax payments. e) Net Profit: It represents profit available to shareholders after deducting all other claims on income, including taxes and interest expense.

Solution to review Problem 2.1

1) EBITDA = Total income from Operations + Depreciation = 1,650,000 + 300,000 = 1,950,000

Note 1: This is same as: Net Profit + Tax + Interest + Depreciation = 740,000+610,000+300,000+300,000 = 1,950,000 Note 2: Total income from Operations = EBIT
2) EBIT = Total income from Operations = 1,650,000 (no need to calculate) 3) NOPAT = Net Profit + Interest x (1-T) = 740,000 + 300,000 (1 0.45) = 740,000+ 165,000 = 905,000 OR NOPAT = EBIT * (1-T) = 1,650,000 x (1 0.45) = 905,000

Solution to review Problem 2.1

5) Net Operating Assets = Net Current + Net fixed + Net Other Assets = 4,500,000 + 4,000,000 + (-100,000) = 8,400,000 Note: 5.1) Net Current Assets (Net Working Capital) = CA CL (excluding Notes)* = 6,000,000 (3,000,000 1,500,000) = 4,500,000 * Excluded short term Notes from CL as it is not an operating current liability 5.2) Net Fixed Assets = Fixed Assets Accumulated Depreciation = 4,000,000 (As given in BS (no need to calculate) 5.3) Net Other Assets = Other Assets Other Liabilities = (Prepayments + Intangibles) Deferred Taxes = 400,000 + 100,000 600,000 = -100,000

Financial Statements Analysis

Who is Interested? Internal (Management) External (Shareholders, Creditors, Bankers, Suppliers, Customers, Regulators, Analysts) What are they trying to do?

To study relationship between variables (IS, BS, CF): change over time (trend analysis) comparison with other firms in industry (comparative ratio analysis)

Financial Statements Analysis

Why (Purpose)? To make certain decisions:

To determine relative strengths & weaknesses of a company; To evaluate past performance and map future plans; To estimate future Cash Flows & riskiness of those Cash Flows (for making investment and lending decisions); Keep an eye on the performance of the company to safeguard investment and take corrective action; To decide whether to keep doing business with the company

Financial Statements Analysis

Ratio Analysis A ratio is a relationship between two or more line items expressed in %age or number of times. (see following slides)

2.3 Financial Ratios

Financial ratios are an important tool for the financial analysts. By looking at relationships between variables we are able to: better assess the quality of results (by adjusting for size, currency etc.) examine trends over time and compare performance with other companies. Also important when developing financial forecasts, when need to understand relationships between certain variables, for example between sales and working capital. Different analysts use different ratios and, even for the same ratio, may use different definitions.