L5b - Financial Statement Analysis

Question 1

Review of Financial Statements?

Answer 1

• Show financial performance and business activities
• Financial statements are used by both insiders (such as managers, board of directors) and outsiders (such as suppliers, creditors) to monitor and control the firm’s operations to ensure that their interests are being served.
• For example, a creditor may analyze a firm’s financial statements to decide whether or not to renew the company’s loan.
  
  • banks provide two types of loans: credit lines (like credit cards) and term loans
    
    • Need to meet certain financial covenants for credit lines like a minimum level of cashflow
• A very common method of understanding the financial performance and health of a firm is to undertake a financial ratio analysis. The sources of these ratios are financial statements.
• Using financial statements managers are able to carry out three important tasks:
  
  • 1. Assess current performance through financial statement analysis,
       * leverage, costs of sales xxx
  • 2. Monitor and control operations, and
  • 3. Forecast future performance

Question 2

What are the three important Accounting Statements?

Answer 2

• The Statement of Financial Position (balance sheet)
• THe income statement (profit and loss sheet)
• The Cashflow statement

Question 3

What does a Balance sheet look like and what is the point of one?

Answer 3

The balance sheet provides a snapshot of the firm’s financial position (accounting value) on a specific date.

• It states what the firm owns (assets on the left) and how it is financed (liabilities and shareholders’ equity on the right). (What are the firm’s assets and how are they funded?).
• The accounting definition that underlies the statement of financial position and describes the relationship is:

Total Assets = Total Liabilities + Total Shareholder’s Equity

Question 4

How are Total Assets, liability and equity defined?

Answer 4

• if current assets > current liabilities
  
  • roughly you can say the firm has the ability to pay back its short term debts
• if current ratio = (CA/CL) is too high
  
  • Not using companies’ assets efficient to generate a high return from investing them in cash-yielding projects

Question 5

How is Liquidity defined and how does it related to the balance sheet?

Answer 5

• Liquidity refers to the ease and quickness with which assets can be converted to cash.
• Current assets are the most liquid and include cash and assets that will be turned into cash within a year.
• Non-current assets are the least liquid kind of assets. Non-current assets do not convert to cash from normal business activity, and they are not usually used to pay expenses such as payroll. They can be tangible (e.g., property, plant and equipment) and/or intangible (e.g., value of patent).
• The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations (less financial distress). However, liquid assets have lower rates of return than non-current asse

Question 6

How are debt and equity-related to the balance sheet?

Answer 6

• Payment: Payment for debt holders is generally fixed (in the form of interest); Payment for equity holders (dividends) is not fixed nor guaranteed. •
• Seniority: Debt holders are paid before equity holders. Debt holders can force the firm into a bankruptcy.
• Maturity: Debt matures after a fixed period while equity securities do not mature.

Question 7

How are things valued on a balance sheet?

Answer 7

• Value versus cost:
  
  • The accounting value of a firm’s assets is frequently referred to as the book value of the assets.
• International Financial Reporting Standards (IFRS) value assets at theoretically true market or fair values. Market or fair value is the price at which willing buyers and sellers would trade the assets.

Question 8

What is an Income Statement?

Answer 8

• The income statement measures performance over a specific period. (How has the firm performed over the previous period?).
• An income statement measures the amount of profits generated by a firm over a given time period (usually a year or a quarter).
• An income statement is also called a profit and loss statement. It is an important statement for existing and potential shareholders.
• Income statement can be expressed as follows:
  
  • Revenues (or Sales) – Expenses = Profits

Question 9

What is the make-up of an Income Statement?

Answer 9

Question 10

When analysing an income statement, what should financial managers keep in mind?

Answer 10

• Non-cash expenses includeS Amortisation:
  
  • Amortisation refers to the routine decline in value of an intangible asset over time. It is also used to describe the repayment of a loan or finance agreement over a period of time.

Question 11

What is the difference between the Average and Marginal Tax rates?

Answer 11

• Average tax rate is the tax bill divided by your taxable income. That is, the percentage of your income that goes to pay taxes.
  
  • For instance, assume a company has a taxable income of £400,000 and a tax bill of £90,000, then its average tax rate is 90,000/400,000 = 22.5 per cent.
• Marginal tax rate is the tax (%) you pay if you earn one more unit of currency.
  
  • If the tax rate for the first £200,000 is 20% and extra earnings above £200,000 are charged 25%, then marginal tax rate is 25%.

Question 12

What is the purpose of a cash flow statement?

Answer 12

• • The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash.
  
  • (Where has the cash come from and what has the firm spent?)

Change in Cash balance for 2010 = Ending Cash Balance for 2010 - Ending Cash Balance for 2009

• • Cash flow analysis involves understanding the use and source of cash for the companies.

Decrease in Short-Term deposits ==> because I’m investing less its less money going out the account

Question 13

What is the traditional format of a Cashflow statement?

Answer 13

• • The format for a traditional cash flow statement is as follows:
• Beginning Cash Balance:
  
  • Plus: Cash Flow from Operating Activities (CFO)
  • Plus: Cash Flow from Investing Activities (CFI)
  • Plus: Cash Flow from Financing Activities (CFF)
• Equals: Ending Cash Balance NCF ≡ CFO + CFI + CFF

Question 14

What are the different types of Cashflows?

Answer 14

• CF from operating activities represent the cash flow generated by company’s business activities, including sales of goods and services.
• CF from investing activities is the cash flows that arise out of the purchase and sale of long-term assets (non-current assets) such as plant and equipment. The net change in cash flow from investing activities equals the acquisition of non-current assets plus any security investments minus the sales of non-current assets.
• CF from financing activities represent cash flows of the firm from financing purposes such as issue of new shares, buying back its own shares, increasing or decreasing borrowing, payment of dividends.

Question 15

What is Ratio Analysis?

Answer 15

• Standardize the financial statements to compare the companies with different sizes or currencies. One way to standardize is converting monetary amounts into percentages (e.g., divide each item in balance sheet by total asset, divide each item in income statement by total revenues). The resulting financial statements are called common-size statements.
• Another way to standardize is calculating and comparing financial ratios. Ratio analysis gives insight into a company’s performance and financial

Question 16

What short-term solvency or liquidity ratios are there?

Answer 16

Question 17

What are the Long-term solvency or financial leverage ratios?

Answer 17

Question 18

What are the Asset Management or turnover ratios?

Answer 18

Question 19

What are the Profitability ratios?

Answer 19

Question 20

What are the market value measure ratios?

Answer 20