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Understanding Financial Statements (Contd)
Understanding Financial Statements (Contd)
Understanding Financial Statements (Contd)
Statements (contd)
1. Understanding Balance Sheet
2. Use of Ratio Analysis to analyse
financial statements
Long-Term Assets
Long Term Assets are those tangible assets
with a useful life greater than one year.
Generally, fixed assets refer to items such as
equipment, buildings, production plants and
property. On the balance sheet, these are
valued at their cost. Depreciation is subtracted
from all except land. Fixed assets are very
important to a company because they
represent long-term illiquid investments that a
company expects will help it generate profits.
Concept of Depreciation
Depreciation is the process of
allocating the original purchase price of
a fixed asset over the course of its
useful life. It appears in the balance
sheet as a deduction from the original
value of the fixed assets and is also
shown in the income statement as an
expense.
Current Liabilities
Current liabilities are those obligations
that are usually paid within the year,
such as accounts payable, interest on
long-term debts, taxes payable, and
dividends payable. Because current
liabilities are usually paid with current
assets, as an investor it is important to
examine the degree to which current
assets exceed current liabilities.
Examples of Liabilities
Accounts payable are debts owed to
suppliers for the purchase of goods and
services on an open account. Almost all firms
buy some or all of their goods on account.
Long-term debt is a liability of a period
greater than one year. It usually refers to
loans a company takes out. These debts are
often paid in installments. If this is the case,
the portion to be paid off in the current year is
considered a current liability.
Shareholders Equity
Shareholders' equity is the value of a
business to its owners after all of its
obligations have been met. This net worth
belongs to the owners. Shareholders' equity
generally reflects the amount of capital the
owners invested plus any profits that the
company generates that are subsequently
reinvested in the company. This reinvested
income is called retained earnings.
Ratio Analysis
There are broadly three types of ratios:
Liquidity Ratios;
Leverage Ratios; and
Profitability Ratios
Liquidity Ratios
Current Ratio
Current Ratio =
Current Assets / Current Liabilities
While there is no fixed norm, a
benchmark norm is 1.5:1; i.e., current
assets should be 1.5 times that of
current liabilities. Comparison with the
industry average also gives useful
information.
Working Capital
Working Capital is simply the amount that
current assets exceed current liabilities. Here
it is in the form of the equation:
Working Capital = Current Assets - Current
Liabilities
The higher the amount, the greater is the
security to the investors that the firm will be
able to meet its financial obligations. Many
times, a company does not have enough
liquidity. This is often the cause of being over
leveraged.
Leverage Ratios
Leverage is a ratio that measures a
company's capital structure. In other words, it
measures how a company finances its
assets. Does it rely strictly on equity? Or,
does it use a combination of equity and debt?
The answers to these questions are of great
importance when assessing the firms ability
to raise more debt as well as its tendency to
go into bankruptcy. Leverage is calculated as:
Long-term Debt / Total Equity
Turnover Ratios
Turnover ratios are essentially asset
management ratios which measure how
effectively the firm is managing its assets.
The more important ratios are:
Inventory Turnover Ratio
Receivables Turnover Ratio
Limitations (contd)
Many firms would like to compare themselves
with industry leaders rather than industry
averages.
The true values of assets in the balance sheet
may be markedly different from the recorded
figures of cost due to inflation, etc. Hence,
comparative analysis should be conducted for
firms of the same age. Analysis of one firm over
different time periods must e done with care (time
series analysis).
Limitations (contd)
Firms may employ different accounting
practices. This will distort the results unless
suitable adjustments made.
Firms may employ window-dressing
techniques to make their financial
statements look better.