ENGINEERING ECONOMICS

Chapter Two
Understanding financial
statements & Ratio Analysis

BME/BAME III/II
 Course outline
Chapter: 2
Understanding financial statements (6 hours)
2.1 Fundamental equation and terminologies in accounting
2.2 Balance sheet
2.3 Income statement
2.4 Cash-flow statements
2.5 Financial ratios and analysis
The accounting system and flow of information
 Summary of major factors affecting stock prices

Antitrust Laws: Prevent

unfair competition
Financial Statements
• These are statements of financial information to the managers and the
shareholders.

– Income Statement (Profit and Loss Statement)

– Balance Sheet
– Cash Flow Statement

Financial Management is concerned with the investment , financing

and dividend decisions. FM deals with both raising of funds as well as utilization
of funds.
Financial Status for Business
Beginning of fiscal period

How much profit did the

company make during the Income Statement
fiscal period?

How much cash did the

company generate and Cash Flow Statement
spend during the period?

What is the company’s

financial position at Balance Sheet
the end of fiscal period?

End of fiscal period

Terminology
 Capital: The amount invested by the trader in his trade is called capital
• Net Worth : The value of total assets minus total liabilities or the value of the owners' claim on
the assets ( Owner’s equity= Assets- liabilities).
 Assets: The resources or property owned by the business organization to generate economic
benefit is known as assets.
 Fixed assets: Which can’t immediately be turned into cash, but are tangible items that a company
owns and uses to generate long-term income Land/Buildings/Plant/ Furniture/Vehicle
 Current assets: Which can be converted to cash within a year
Cash in hands, Bills receivable, prepaid expenses, stock in trade ( inventory), short term
investment, accrued income
 Liabilities: Liabilities are borrowed sums from the third parties to the business.
 Current liabilities: Repayable within one year
 Short term loan: 3month/6 month
 Sundry Creditors: Credit purchase of goods
 Bills payable: Debt to pay
 Bank Overdraft
 Outstanding expenses: Expenses incurred already but not yet paid are called outstanding expenses
Terminology
 Long term liabilities: Obligation or debts repayable for more than one accounting
periods e.g. debenture/Bond, Bank loan , Mortgage loan
 Intangible Assets:Cannot be touched/ not in physical form
(Patent/Goodwill/Copyright/ Trademark)
 Amortization: Amortization is a method of spreading an intangible asset's cost over the course
of its useful life. Intangible assets are non-physical assets that are essential to a company,
such as a trademark, patent, copyright, or franchise (License) agreement. Example: A company
may amortize a patent over 10 years, spreading the cost as an expense each year.
 Depreciation: Depreciation represents the decrease in an asset’s value. It’s a term commonly used
in accounting and shows how much of an asset’s value a business has used over a period of time.
 Equity: Equity, often called shareholders’ equity or owners’ equity on a balance sheet,
represents the amount of money that belongs to the owners of a business after all assets and
liabilities have been accounted for. Using the accounting equation, shareholder’s equity can be
found by subtracting total liabilities from total assets.
 Liquidity: Liquidity describes how quickly your assets can be converted into cash. Because
of that, cash is the most liquid asset. The least liquid assets are items like real estate or
land, because they can take weeks or months to sell.
Balance Sheet
A Balance Sheet is a financial statement that shows the financial position of a business at a
specific point in time (e.g., 32 Ashad 2083).
It is a statement of assets , liability and capital at specified date. It is prepared at a given
date (Point of time) to show financial position of a business concern. It shows composition
of fixed assets , investments , current assets & fictitious assets.
Importance / objectives of balance sheet

1. It reveals the financial position i.e. state of affairs of a business

2. It ascertained composition of assets and liabilities
3. It depicts the solvency i.e. debt paying capacity of the firms
4. It shows the position of proprietor’s capital (Assets- liabilities = owner’s capital)
5. Companies are legally required to prepare and present balance sheets.
Balance Sheet
• It gives snapshot summary of the firm's financial position at a
single point in time.
• The balance sheet shows the net worth of shareholders at a point in time,
whereas income statement measures changes in net worth.
• Liabilities indicate what money has been made available to the firm.
• Current Liabilities are the short -term debt obligations of a firm, with maturities of less
than one year.
• Fixed liabilities are firm's long-term finance such as long-term debts from banks
and the public.
• Assets show how the firm has used the money made available to it.
• Accruals are accrued wages , taxes or dividends, these are the items of expenses already
incurred but not paid.
• Income Tax – Annual expenses for profit
 Balance Sheet
• Fixed Assets are acquired for long-term uses in the firm such as plant, building,
land, and equipment.

• Current Assets are cash, accounts receivables, and inventories of finished goods
and raw materials.
 Balance Sheet
• Depreciation is the allocation of cost of an asset to different time periods.
• Working Capital is composed of firm's current assets.
• Net Working Capital is the difference between current assets and current liabilities.

• Solvency: The ability of a business to meet its long-term obligations (debts and liabilities)
over a longer period.
Focus: Long-term financial stability and capacity to continue operations.

• Liquidity :The ability of a business to pay its short-term obligations (current liabilities) as
they become due, using its current assets (cash, inventory, receivables). Focus: Short-term
financial health and cash management.
Balance Sheet
Balance Sheet
Cash in hand
Cash in bank
Marketable securities
Accounts receivables
Prepaid expenses
Deposits

CURRENT
ASSETS
Finished Products
Work in progress
Raw materials
Other supplies

.
Balance Sheet
Section Sub-category Examples / Description
Cash, Accounts Receivable, Inventory,
Assets Current Assets
Prepaid Expenses

Property, Plant & Equipment , Intangible

Non-Current Assets
Assets (Patents, Goodwill), Investments

Accounts Payable, Short-term Loans,

Liabilities Current Liabilities
Accrued Expenses, Taxes Payable

Long-term Loans, Bonds Payable, Deferred

Non-Current Liabilities
Tax Liabilities, Lease Obligations

Common Stock, Retained Earnings,

Equity Shareholders' Equity
Additional Paid-in Capital, Treasury Stock

It follows the basic accounting equation:

Assets = Liabilities + Capital (Owner's Equity)
Types of Accruals
Balance Sheet
Type Meaning Example
Position
Salary payable,
Expenses incurred
Accrued Expenses Current Liabilities Rent outstanding,
but not paid
Interest due
Income earned but Interest receivable,
Accrued Income Current Assets
not received Rent receivable
Same as Accrued Taxes payable,
Accrued Liabilities Current Liabilities
Expenses Audit fees due

In accounting, Accruals refer to expenses that have been incurred (occurred) but not
yet paid, or income that has been earned but not yet received. These are recorded to
follow the Accrual Basis of Accounting.
Nepal Brick Factory
Balance Sheet for the year ended Ashad 31, 2081
Capital & Liability Assets
Accounts Payable 2000 Cash 1000
Notes Payable (ST) 400 Marketable securities 1000
Accrued wages 800 Accounts receivable 2400
Other accruals 800 Inventories 3600
Current liabilities 4000 Prepaid expenses 0
Long term debt 6000 Current Assets 8000
Preferred stock 0 Fixed Assets
Stockholder’s Equity Land 1000
Common stock (PAR 100) 2000 Building 5500
Additional Paid in capital 2000 M/C & Eqpt. 9500
Retained Earnings 6000 Other fixed assets 4000
Total Shareholder’s equity 10000 Total 20000
Accumulated Dep. 8000
Net Fixed assets 12000
Total Liabilities & equity 20000 Total Assets 20000
2.3 Income Statement

• The Second financial report is the income statement which

indicates whether the company is making or losing money during a stated
period, usually a year
• It shows the record of financial events between two points in time. It
has revenue from sales and expenses incurred during the period.
• Importance of Income Statement (P/L Statement)

 To reveals the profit and loss of certain period

 It shows the yearly sells and purchase
 To helps the calculate ratio of direct and indirect cost
 To help the comparison between incomes in topics wise
 To help to find out the profit or/loss
Income Statements (P/L statement)

• Expenditures are all cash outflows

– Expenses are only those expenditures that affect net worth of the shareholder’s of the
and appear in the income statement.
Receipts are all cash inflows.
Revenues are only those receipts that affect net worth and thus appear in the income
statement.

Revenue
Costs of Goods Sold
(COGS) Gross Profit
A l l Expenses
Net Income
Income Statements
Nepal Brick Factory for the year ending Ashad 31, 2081

Items Amount
Revenues 24000
Cost of good Sales 13600
Gross Income 10400
Marketing expenses 6000
General and administrative expenses 1200
Earning Before Dep., Interest & Taxes (EBDIT) 3200
Depreciation 1000
Net operating Income 2200
Other income 240
Earning Before Interest & taxes (EBIT) 2440
Interest expenses 440
Earning Before Taxes (EBT) 2000
Income Tax @40% 800
Net Income 1200
Balance Sheet & Income Statements
Aspect Income Statement Balance Sheet
Shows financial position at a
Purpose Shows profitability over a specific period
specific point in time
Performance (revenues, expenses, net
Covers Assets, Liabilities, and Equity
profit/loss)
Covers a period of time (e.g., month, Shows data at a single point in
Time Frame
quarter, 1 year) time (snapshot 2081/04/31)
Revenue, Cost of Goods Sold (COGS), Assets (Current & Non-current),
Key Components
Expenses, Net Income Liabilities, Equity
How much money was earned or lost What the company owns and owes
Focuses On
(Profit/loss) (Asset/Liability)
Equation Net Income = Revenue – Expenses Assets = Liabilities + Equity
Evaluate financial stability and
Helps Stakeholders Evaluate profitability and performance
liquidity
Financial Statement
Dynamic (changes over time) Static (status at a specific date)
Type
 2.4 Cash Flow Statement
A Cash Flow Statement is a financial report that shows the inflow and outflow of cash and
cash equivalents during a specific period (usually a month, quarter, or year). It shows where
the firm obtains cash and how it uses it.
It helps understand how a business is earning and spending its cash from operating,
investing, and financing activities.

• Sources of funds
– Increase in liabilities
– Increase net worth through retained earnings or capital contribution by the
shareholders
– Reduction in assets through sales of assets

• Uses of funds
– reduction in liabilities
– reduction in net worth through payment of dividends or losses
– increase in assets
Cash Flow Statement
• Cash flow from operating activities (Daily Business)
– Net profit (e.g., selling products or services).
– Depreciation
– Decrease in account receivables
– Increase in accounts payables
• Cash flow from investing activities (Asset buy/sell)
– Sales of fixed assets: land ,eqpt. (Cash Inflow)
– Investment in new fixed assets (Cash Outflow)
• Cash flow from financial activities (loan/capital)
– Increase in debt (cash inflow)
– Issuance of new shares (cash inflow)
– Dividend payment (cash outflow)
Cash Flow Statement
Objectives
• Analysis of cash position
• Short term cash planning and management
• Evaluation of liquidity (Current obligation)
• Analysis of cash flow from three different activities
• Comparison of operating performance (Past/Current)
• Helpful in estimating future cash flow (Dividend/Bonus)
• Helping in policy formulation.
• Useful for internal and external users such as managers, investors, creditors and other stakeholders

Depreciation
•Depreciation is not an actual cash outflow.
•It reduces net income in the income statement.
•But in the cash flow statement, it is added back to net income because no cash was actually spent.
Cash Flow Statements
Description Rs. Rs.
(A)Cash flow from operating activities 4000
Net Income 1200
Add amortization 1000
Due to change in working capital
Decrease in accounts receivable 600
Increase in inventories (600)
Increase in account payable 800
Increase in accrued wages 400
Increase in other accruals 600
(B) Cash Flow From investing activities (2000)
Increase in fixed assets (2000)
(c) Cash flow from financing activities (1000)
Cash Flow Statements
Description Rs.
Decrease in notes payables 0
Decrease in long term debt (600)
Payments of dividends (400)
Net change in cash (A+B+C) 1000
Add Opening cash balance 1000
Closing Cash balance 2000
2.5 Financial Ratio Analysis of Companies

 Financial ratio analysis is a scientific method used to evaluate the actual financial
condition and performance of a company. It helps determine how well a company is
performing and identifies its strengths and weaknesses.

It helps determine:
• How profitable the company is.
• Whether it can pay its short-term and long-term debts.
• How effectively it uses its assets and resources.
• Whether the company is financially stable and suitable for investment.

 A number of parties including creditors , potential suppliers , debenture holder, credit

institutions (banks), potential investors , employees , trade unions , customers,
taxation authorities and government have interest in the financial result of the company.
Use of Financial Ratio Analysis by Different Stakeholders

Stakeholder Purpose
Shareholders/Investors Concerned with future earnings and dividends
Creditors Evaluate repayment ability of its debts
Banks & Financial Institutions Decide whether to provide loans
Monitor performance and make strategic decisions,
Management/Engineer
future planning
Suppliers Assess short-term creditworthiness

Government Evaluate tax compliance and economic contribution

Employees Assess job security and company stability

Financial Ratio Analysis of Companies

In short financial ratios provide the following information:

1. How much profit is the business earning?

2. What percentage of sales is profit? (Profit Margin)
3. Can the company pay its expenses and meet its financial obligations on time?
4. How quickly do customers pay the money they owe to the company? (Debtors Collection)
5. How quickly does the company pay its suppliers? (Creditors Payment)
6. How many days of inventory (stock) does the company hold?
7. How effectively are the company's funds and assets being used?
8. What is the risk of the company failing to pay its debts or being liquidated?
9. Can the company comfortably repay its loans and other debts?
[Link] are the financial strengths and weaknesses of the company?

It gives the strength and weaknesses of the firm

Ratio Analysis
• In ratio analysis, we relate various items from the firm's financial statements to
each other with the aim of assessing and analyzing the firm's financial position.
• By comparing the financial ratios of the same company over different periods, or by
comparing with that of other companies in the industry, or the industry average, we can
compare the relative performance of the company.

• Common comparisons are:

1. Same company over several years.
2. An industry leader or "best practice."
3. Industry norms found in publications.
4. A self-developed set of comparable companies.
5. International variations on 2, 3, and 4.
6. Rules of "thumb."
Types of ratios used in evaluating a firm’s financial health
Liquidity Ratios
Liquidity ratios constitute the ratio analysis for the short term financial position of the firm. These ratios
refer to the ability of the firm to meet the short term obligations out of its short term resources. There
ratios help to decide the solvency of the firm (These ratios reflect a firm's short- term ability to pay its
debts)
1. Current ratio: Measures the ability of a company to pay current liabilities with current assets.
Current ratio = Current assets / Current liabilities
= 8000/4000= 2:1 Times (Standard 2:1) The performance of the company is sound.
2. Quick (Acid test) ratio: Measures the ability to pay short-term liabilities using the most liquid assets
(excluding inventory).
Quick (Acid test) ratio = (Current assets- Inventories) / Current liabilities
= (8000-3600)/4000=1.1:1 Times (Standard 1:1)
Acceptance i.e. inventory- less liquid upto 1:1 or 1:1.1 Insolvency Higher liquidity
ratios than comparables are subject to two interpretations dependent on context.
Higher liquidity may indicate better ability to pay short term debts
as they come due or alternatively may indicate inadequate controls over credit granting (forA/R)
or inventory buildup or no proper mgnt. of their funds.
Importance of Liquidity Ratios

• Assess short-term financial health.

• Show the ability to pay bills and creditors on time.
• Help banks and lenders evaluate creditworthiness.
• Assist management in controlling working capital.
• Reduce the risk of financial distress.
Debt Management / Leverage Ratios
Debt Management Ratios (also called leverage ratios) measure the extent to which a
company uses debt (borrowed funds) to finance its assets and operations.
These ratios indicate the company's long-term solvency and ability to meet its debt
obligations.

[Link] Ratio: Measures the percentage of total assets financed by debt.

Debt ratio = Total Debt / TotalAssets =10000/20000=1:2=50%
(Standard 1:2) The firm has financed about half of its assets by borrowing.
Satisfactory

[Link] to equity ratio : Measures the proportion of debt and owner's equity used to finance
the business.
Debt to equity ratio = Total Liabilities / Owners' Equity=10000/10000=1:1
=100% (standard 1:1) satisfactory
5. Interest Coverage Ratio : Measures the company's ability to pay interest on its loans.
or, Times interest earned = EBIT / Interest Expense=2440/440=5.55 Times
• (Standard is 6 times)
• Low than standard it means timely interest pay capacity of company is low

• Higher ratio = Better ability to pay interest.

• Lower ratio = Greater risk of default.

• The higher any debt ratio is the greater the company's risk as fixed interest expenses are
increasing. Thus, higher debt ratios than comparables may indicate more risk than
comparables. However, if the company is well managed, this risk may be offset with higher
returns to shareholders. Leverage means using borrowed money (debt) to run or grow a
business in addition to your own money, simply:

• If a company uses more loans, it has high leverage.

• If a company uses less loans and more own money, it has low leverage.
Debt Management / Leverage Ratio

• The higher any debt ratio is the greater the company's risk as fixed interest expenses
are increasing. Thus, higher debt ratios than comparable may indicate more risk than
comparable. However, if the company is well managed, this risk may be offset with higher
returns to shareholders.

• Leverage means using borrowed money (debt) to run or grow a business in addition to
your own money, simply:

 If a company uses more loans, it has high leverage.

 If a company uses less loans and more own money, it has low leverage.
Debt Management / Leverage Ratio
Importance of Leverage Ratios:
• Evaluate long-term financial stability.
• Measure dependence on borrowed funds.
• Assess the company's ability to repay loans.
• Help banks and investors assess financial risk.
• Support financing and investment decisions.
Debt management (leverage) ratios help the following answer:
• How much debt does the company use?
• Is the company financially risky?
• Can the company repay its long-term loans?
• Can it pay interest on borrowed money?
• Is the company relying more on debt or owner's equity?
Asset Management/ Activity Ratios
Asset Management Ratios, also called Activity Ratios, measure how efficiently a company
uses its assets to generate sales and income. They show how well the management is using
resources like inventory, receivables, and total assets.

6. Inventory Turnover Ratio

Measures how many times inventory is sold and replaced during a period.
Inventory Turnover Ratio = Total Revenue (Sales)/ Inventory
=24000/3600=6.67:1 Times
Standards 5:1
Any turnover ratio: Normally higher than the comparable ratios are good.
Number of times the inventory is turned over during the year
365/6.67= 55 days average ( time taken to purchase raw material about 55 days)
Meaning:
High ratio-fast selling, efficient inventory management
Low ratio -slow-moving stock
Asset Management/ Activity Ratios
7. Asset Turnover Ratio: Measures how efficiently total assets generate sales.
Or, Total Asset Turnover Ratio= Total revenue/Total assets
• =24000/20000=1.2:1 Times
• Standard 1.5 times (Poor performance of the company)
• Meaning:
• Higher ratio - Better use of assets
• Lower ratio - Inefficient use of assets
8. Day’s Sales Outstanding (DSO) Ratio or Day’s Receivables
= Accounts receivables / Average Days Sales
• Average days sales = Total Revenue / 360
=2400/(24000/360)=36 Days
• Standard = 30 Days
• Poor collection of accounts receivable.
9. Fixed assets turnover ratio = Total Revenues/Fixed assets
=24000/12000=2:1 Times
Standard 2:1, Satisfactory
Number of times the average fixed assets are turned over during the year.

Asset management ratios answer:

 How fast is inventory sold?

 How quickly do customers pay?
 How efficiently are assets used?
 How effectively is accounts receivable used?

.
 Profitability Ratios
Profitability ratios are financial ratios that measure a company’s ability to generate profit
from its sales, assets, or shareholders’ investment.
They show how efficiently a business is earning profit.

10. Net Profit Margin on sales :Measures final profit after all expenses.
Net Profit Margin on sales = Net income /Net Sales
= 1200/24000=5 % of sales as profit Standard 8% so poor
performance

Meaning:
• Shows overall profitability of business.
• Higher percentage : Better financial performance.
 Profitability Ratios
11. Return on equity ROE or (Return on Investment) :
Measures return earned on owner’s/shareholders’ investment.

Return on equity ROE (Return on Investment)

= Net income /Owners' Equity =1200x100/10000=12%

Standard =15%, Low performance of company

Meaning:
• Shows profitability for owners/shareholders.
• Higher ROE : Better return to investors.
 Profitability Ratios

12. Return on total Assets (ROA)= Net income/Total assets

• =1200x100/20000=6%
• Standard = 9%, Poor performance of the company

• Profitability ratios answer:

• Is the business making enough profit?
• How much profit is earned from sales?
• How efficiently are assets used to earn profit?
• What return do shareholders get?
• How much profit is earned per share? EPS=Net Income/Nos. of share
Market Value analysis
Market value analysis focuses on the value of a company in the stock market, not just its
accounting profits. It helps understand whether a company is overvalued or undervalued.
13. Price/Earnings (P/E) ratio
= Market Price Per Share (MPS) / Earnings per share (EPS)
=200/60=3.33Times (Standard: Less than 15 is acceptable) ( Assume that market
price per share is Rs. 200)
EPS = Net Income/ No. of share outstanding=1200/20=60
This ratio shows how much investors wiling to pay for per rupee of reported profits. The PE
ratios are higher for firms with strong growth prospects , other things being equal.
It is a very controversial ratio not easily subject to interpretation.
Research shown that of all ratios, P/E is most context specific in its interpretation. For
example, a high P/E has been cited as being an indication of a highly risky stock.
Meaning:
High P/E → strong investor confidence or overvaluation.
Low P/E → undervaluation or low growth expectations.
14. Market-to-Book Ratio : Compares market value with book value of shares.

Market Value/ Book Value ratio =MVS/BVS

= Market value per share/ Book Value per share
=200/500 = 0.40 times
Book Value per share= Book Equity/ No. of shares =10000/20= Rs. 500
The market price of the company is assumed to be Rs. 200. If the industry average ratio of MV/BV
is 1.5 , the ratio 0.4 calculated above is less than the industry average. Thus investors are
willing to pay less for a rupee of company’s share than for one of an average company in an
industry.
Meaning:
High ratio : Strong market perception of company value.
Low ratio : Weak investor confidence.
Importance of Market Value Analysis
• Helps investors decide whether to buy or sell shares.
• Shows market perception of company performance.
• Indicates growth potential of a company.
• Helps compare companies in the stock market.
• Useful for valuation during mergers or acquisitions.
 Home Assignment for Chapter Two

1. Why do business firm use ratio analysis? Define the different ratios with formula.
2. Compare profit and loss statement and cash flow statement with relevant examples you
know.
3. Which ratios would you compute if you are asked to measure how
effectively a firm is managing its assets? Explain these ratios.
4. What is balance sheet? What purpose does it serve?
5. What is income statements ? What purpose does it serve?
6. You are looking to purchase stock of a company base on the following ratios calculated.
Discuss three ratios and justify whether you should buy it or not. (i) Debt ratio ii) P/E ratio
iii) Profit margin iv) Total assets turnover.
Q.7 Find the different ratios and analyze the company performance, the rough data are given
below: (Assume suitable data if necessary)

Company Data Standard Ratio

EBIT 2700 Current ratio 2:1
Total assets 28000 Quick ratio 1:1
Fixed assets 8000 Debt ratio 50%
Accounts Receivables 2800 Debt to equity 100%
Total Revenue 32000 Time interest earned ratio 7 Times
Interest payments 300 Asset Turnover 1.5 Time
Market price of Share 265 Day's receivable 30 days
Nos. of Share Outstanding 100 Net profit margin 15%
Net Income 2200 ROA 10%
Inventory 3500 ROE 8%
Current assets 20000 P/E ratio 6 Times
Current liabilities 8000 Market Value/Book Value 1.5 Times
Long term debt 12000