Topic 2
Understanding Financial
Statement, Taxes, and
Cash Flows
1-1
Learning Goals & Objectives
1. Review the contents of the key financial statements
and the procedures for consolidating international
financial statements.
2. Understand who uses financial ratios and how.
3. Use financial ratios to analyze the liquidity level,
activity level, profitability, financial leverage, and
market value of a firm.
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Learning Objective
1
1-3
THREE Key Financial Statements:
Income Statement
The income statement (a.k.a statement of
profit/loss) provides a financial summary of a
company’s operating results during a specified
period.
It records ALL activities that bring Revenues and
Expenses to the reporting firm during the financial year.
Although they are prepared quarterly for reporting
purposes, they are generally computed monthly by
management and quarterly for tax purposes.
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THREE Key Financial Statements:
Income Statement (Cont’)
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THREE Key Financial Statements:
Balance Sheet
The balance sheet (also statement of financial
position) presents a summary of a firm’s financial
position at a given point in time.
The statement balances the firm’s assets (what it
owns) against its financing, which can be either
debt (what it owes) or equity (what was provided
by owners).
ALWAYS REMEMBER:
TOTAL ASSETS = TOTAL LIABILITIES + TOTAL EQUITY
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THREE Key Financial Statements:
Balance Sheet (Cont’)
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THREE Key Financial Statements:
Balance Sheet (Cont’)
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THREE Key Financial Statements:
Statement of Cash Flows
The statement of cash flows provides a summary
of the cash flows over the period of concern,
typically the year just ended.
Similar to Income Statement, but CF statement only
records CASH inflows and outflows
This statement not only provides insight into a
company’s investment, financing and operating
activities, but also ties together the income
statement and previous and current balance sheets.
1-9
THREE Key Financial Statements:
Statement of Cash Flows (Cont’)
Operating Activities
Cash generated from or used in the business operation,
normally Positive (inflow>outflow)
Investing Activities
Cash flow for long term investment, purchase or sale a
plant, etc.
Financing Activities
Cash flow from sales of new securities (stock/bond),
repurchase securities, payment of dividend, etc.
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THREE Key Financial Statements:
Statement of Cash Flows (Cont’)
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Learning Objective
2
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Using Financial Ratios:
Interested Parties
Ratio analysis involves methods of calculating and
interpreting financial ratios to assess a firm’s
financial condition and performance.
It is of interest to shareholders, creditors, and the
firm’s own management.
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Using Financial Ratios:
Interested Parties (Cont’)
Current and prospective shareholders are
interested in the firm’s current and future level of
risk and return, which directly affect share price.
Creditors are interested in the short-term liquidity
of the company and its ability to make interest and
principal payments.
Management is concerned with all aspects of the
firm’s financial situation, and it attempts to produce
financial ratios that will be considered favorable by
both owners and creditors.
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Using Financial Ratios:
Types of Ratio Comparisons
Cross-sectional analysis
Used to compare different firms/industries at the
same point in time
Industry comparative analysis
One specific type of cross sectional analysis. Used to
compare one firm’s financial performance to the
industry’s average performance
Benchmarking
A type of cross sectional analysis in which the firm’s ratio
values are compared to those of a key competitor or
group of competitors that it wishes
to emulate
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Using Financial Ratios:
Types of Ratio Comparisons (Cont’)
Trend or time-series analysis
Used to evaluate a firm’s performance over time
Combined Analysis
Combined analysis simply uses a combination of
both time series analysis and cross-sectional
analysis
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Using Financial Ratios:
Cautions about Using Ratio Analysis
Ratios must be considered together; a single ratio
by itself means relatively little.
Financial statements that are being compared
should be dated at the same point in time.
Use audited financial statements when possible.
The financial data being compared should have
been developed in the same way.
Be wary of inflation distortions.
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Learning Objective
3
1-18
Using Financial Ratios:
Class of Financial Ratios
Liquidity: Firm’s ability to meet its maturing
obligations
Efficiency/Asset Management/Activity: How efficient
a firm is using resources to generate sales
Financial Leverage Management: Indicate a firm’s
capacity to meet short & long term obligation
Profitability: The firm’s ability to generate profits on
sales, assets, stockholder’s investment
Market-Based: The market’s perceptions of a firm’s
performance and risk
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Liquidity Ratios:
Current Ratio
The current ratio measures the ability of the firm to meet its
short-term obligations.
A ratio of >1 shows liquidity. It shows that there is leeway in
the current assets available to pay for current liabilities.
A current ratio of 2 or more generally indicates a strong
financial condition.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐑𝐚𝐭𝐢𝐨 =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
E.g. the current ratio for Bartlett Company in 2006 is:
$1,223,000
= 1.97
$620,000
1-20
Liquidity Ratios:
Quick Ratio
The quick (acid-test) ratio excludes inventory, which is
generally the least liquid current asset.
Usually an acid test ratio of 1.0 or higher is considered
satisfactory by lenders and investors.
An investor should be wary if the quick ratio is below 0.5,
out of line with its industry, and/or showing a declining
trend.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
𝐐𝐮𝐢𝐜𝐤 𝐑𝐚𝐭𝐢𝐨 =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
E.g. the quick ratio for Bartlett Company in 2006 is:
$1,223,000 − $289,000
= 1.51
$620,000
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Efficiency/Activity Ratios:
Inventory Turnover
Inventory turnover indicates the rapidity at which
merchandise is being moved and the effect on the flow of
funds into the business.
Low figures indicate excessively high inventories. High
turnover compared to industry norms might reflect
insufficient merchandise to meet customer demand and
result in lost sales.
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 =
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
E.g. the inventory t/o for Bartlett Company in 2006 is:
$2,088,000
= 7.22
$289,000
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Efficiency/Activity Ratios:
Average Age of Inventory
The average age of inventory is the average number of days’
sales in inventory.
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
𝐀𝐯𝐞. 𝐀𝐠𝐞 𝐨𝐟 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 =
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝/𝟑𝟔𝟓
𝟑𝟔𝟓
𝐀𝐯𝐞. 𝐀𝐠𝐞 𝐨𝐟 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 =
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫
E.g. the AAI for Bartlett Company in 2006 is:
365
= 50.55 days
7.22
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Efficiency/Activity Ratios:
Accounts Receivable Turnover
Accounts receivable turnover determines the ability of the
business to collect debt from its customers. It shows the
number of account receivable turn in a year.
𝐒𝐚𝐥𝐞𝐬
𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 =
𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞
E.g. the accounts receivable turnover for Bartlett Company
in 2006 is:
$3,074,000
= 6.11
$503,000
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Efficiency/Activity Ratios:
Average Collection Period
The average collection period is the average number of days
a company needed to collect accounts receivable.
𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐂𝐨𝐥𝐥𝐞𝐜𝐭𝐢𝐨𝐧 𝐏𝐞𝐫𝐢𝐨𝐝 =
𝐒𝐚𝐥𝐞𝐬/𝟑𝟔𝟓
E.g. the average collection period for Bartlett Company in
2006 is:
$503,000
= 59.7 days
$3,074,000/365
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Efficiency/Activity Ratios:
Average Payment Period
The average payment period is the average number of days a
company takes to pay off credit purchases.
𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝑷𝒂𝒚𝒂𝒃𝒍𝒆
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐚𝐲𝐦𝐞𝐧𝐭 𝐏𝐞𝐫𝐢𝐨𝐝 =
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐒𝐚𝐥𝐞𝐬 ∗ /𝟑𝟔𝟓
E.g. the average payment period for Bartlett Company in
2006 is:
$382,000
= 66.8 days
$2,088,000/365
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Efficiency/Activity Ratios:
Total Assets Turnover
Total assets turnover indicates the efficiency with which the
firm uses its assets to generate sales.
𝐒𝐚𝐥𝐞𝐬
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 𝐓𝐮𝐫𝐧𝐨𝐯𝐞𝐫 =
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
E.g. the total assets turnover for Bartlett Company in 2006
is:
$3,074,000
= 0.85
$3,597,000
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Leverage Ratios:
Debt Ratio
The debt ratio measures the proportion of total assets
financed by the firm’s creditors.
𝐓𝐨𝐭𝐚𝐥 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
𝐃𝐞𝐛𝐭 𝐑𝐚𝐭𝐢𝐨 =
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
E.g. the debt ratio for Bartlett Company in 2006 is:
$1,643,000
= 0.457
$3,597,000
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Leverage Ratios:
Debt-to-Equity Ratio
The debt-to-equity ratio measures the relative proportion of
total liabilities and common stock equity used to finance the
firm’s total assets.
𝐓𝐨𝐭𝐚𝐥 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
𝐃/𝐄 𝐑𝐚𝐭𝐢𝐨 =
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 ′ 𝐄𝐪𝐮𝐢𝐭𝐲
E.g. the D/E ratio for Bartlett Company in 2006 is:
$1,643,000
= 0.841
$1,954,000
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Leverage Ratios:
Times Interest Earned Ratio
The times interest earned ratio measures the firm’s ability to
make contractual interest payments
Also known as interest coverage ratio.
It is quoted as a ratio and indicates how many times a
company can cover its interest charges on a pretax basis.
Failing to meet these obligations could force a company into
bankruptcy.
𝐄𝐁𝐈𝐓
𝐓𝐢𝐦𝐞𝐬 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐄𝐚𝐫𝐧𝐞𝐝 𝐑𝐚𝐭𝐢𝐨 =
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐄𝐱𝐩𝐞𝐧𝐬𝐞
E.g. the D/E ratio for Bartlett Company in 2006 is:
$418,000
= 4.49
$93,000
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Profitability Ratios:
Gross Profit Margin
Gross profit margin measures the percentage of each sales
dollar remaining after the firm has paid for its goods.
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 𝐒𝐚𝐥𝐞𝐬 − 𝐂𝐎𝐆𝐒
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 𝐌𝐚𝐫𝐠𝐢𝐧 = =
𝐒𝐚𝐥𝐞𝐬 𝐒𝐚𝐥𝐞𝐬
E.g. Bartlett Company’s gross profit margin in 2006 is:
$3,074,000 − $2,088,000
= 0.321
$3,074,000
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Profitability Ratios:
Operating Profit Margin
Gross profit margin measures the percentage of each sales
dollar remaining after all costs and expenses other than
interest, taxes, and preferred stock dividends are deducted.
𝐄𝐁𝐈𝐓
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐏𝐫𝐨𝐟𝐢𝐭 𝐌𝐚𝐫𝐠𝐢𝐧 =
𝐒𝐚𝐥𝐞𝐬
E.g. Bartlett Company’s operating profit margin in 2006 is:
$418,000
= 0.136
$3,074,000
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Profitability Ratios:
Net Profit Margin
Net profit margin indicates the level of profit from each
dollar of sales, and therefore measures the efficiency of the
operation.
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐌𝐚𝐫𝐠𝐢𝐧 =
𝐒𝐚𝐥𝐞𝐬
E.g. Bartlett Company’s net profit margin in 2006 is:
$221,000
= 0.072
$3,074,000
*Net profit = Earnings attributable to common shareholders
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Profitability Ratios:
Return on Total Assets
The return on total assets measures the overall effectiveness
of management in generating profits with its available
assets.
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭
𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐭𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 (𝐑𝐎𝐀) =
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
E.g. Bartlett Company’s ROA in 2006 is:
$221,000
= 0.061
$3,597,000
*Net profit = Earnings attributable to common shareholders
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Profitability Ratios:
Return on Equity
The return on equity measures the overall effectiveness of
management in generating profits with its available assets.
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭
𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐄𝐪𝐮𝐢𝐭𝐲 (𝐑𝐎𝐄) =
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬′ 𝐄𝐪𝐮𝐢𝐭𝐲
E.g. Bartlett Company’s ROA in 2006 is:
$221,000
= 0. 113
$1954,000
*Net profit = Earnings attributable to common shareholders
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Market Ratios:
Earnings per share
Earnings per share (EPS) represents the number of dollars
earned during the period on the behalf of each outstanding
share of common stock.
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭
𝐄𝐏𝐒 =
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐜𝐨𝐦𝐦𝐨𝐧 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠
E.g. Bartlett Company’s EPS in 2006 is:
$221,000
= $2.90
76,262
*Net profit = Earnings attributable to common shareholders
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Market Ratios:
Price/Earnings Ratio
The price/earnings (P/E) ratio measures the amount that
investors are willing to pay for each dollar of a firm’s
earnings.
𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝐏𝐫𝐢𝐜𝐞/𝐄𝐚𝐫𝐧𝐢𝐧𝐠 (𝐏/𝐄) =
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
E.g. If Bartlett Company’s common stock at the end of 2006
was selling at $32.25, using the EPS of $2.90, the P/E ratio at
year-end 2006 is:
$32.25
= 11.12
$2.90
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Market Ratios:
Market/Book Ratio
The market/book (M/B) ratio provides an assessment of
how investors view the firm’s performance.
𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝐌𝐚𝐫𝐤𝐞𝐭/𝐁𝐨𝐨𝐤 𝐫𝐚𝐭𝐢𝐨(𝐌/𝐁) =
𝐁𝐨𝐨𝐤 𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
Common stock equity
Book value per share =
Number of common share outstanding
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Market Ratios:
Market/Book Ratio (Cont’)
Substituting the appropriate values for Bartlett company
from its 2006 balance sheet, we get
$𝟏, 𝟗𝟓𝟒, 𝟎𝟎𝟎
𝐁𝐨𝐨𝐤 𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 = = $𝟐𝟓. 𝟔𝟐
𝟕𝟔, 𝟕𝟔𝟐
Using Bartlett company’s end of 2006 common stock price
of $32.25 and its $25.62 book value per share, we get
$𝟑𝟐. 𝟐𝟓
𝐌𝐚𝐫𝐤𝐞𝐭/𝐁𝐨𝐨𝐤 𝐫𝐚𝐭𝐢𝐨(𝐌/𝐁) = = 𝟏. 𝟐𝟔
$𝟐𝟓. 𝟔𝟐
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In Class Practice
AliGrandPa has the following information:
Sales RM 6,120,000
Net Profit Margin 11.00%
Current Liabilities RM 1,123,000
Current Ratio 1.25 times
Debt Ratio 55.00%
Return on Equity 19.50%
Find the fixed assets of AliGrandPa.
Answer: RM 6,268,044.87
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Learning Goals & Objectives
1. Review the contents of the key financial statements
and the procedures for consolidating international
financial statements.
2. Understand who uses financial ratios and how.
3. Use financial ratios to analyze the liquidity level,
activity level, profitability, financial leverage, and
market value of a firm.
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