Financial Statements

A Quick Overview

Kevalin Setthakorn, Ph.D.

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 Purpose of Financial Statements
Financial statements are:
“Structured representation of the financial position and financial performance
of an entity.”

Objective:
To provide information about:
– financial position,
– financial performance, and
– cash flows
of an entity that is useful to a wide range of users in making economic decisions.
 The Framework
• The International Financial Reporting Standards (IFRS), in
particular guidance on presentation and disclosure
• Local statutory requirements
– The Companies’ Ordinance, 1984, in particular the Fourth/ Fifth Schedule for
presentation purposes
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Directives of the regulatory bodies
Industry specific legislation
– Generally accepted accounting principles
 Components of Financial Statements

• General purpose financial statements comprise

of:
– Balance Sheet
– Profit and loss account
– Statement of changes in equity
– Cash flow statement
– Notes to the financial statements
 [Link] Balance Sheet

• The balance sheet shows a firm’s assets (what it

owns) and liabilities (what it owes)

• The difference between a firm’s assets and

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liabilities is the firm’s net worth

• For corporations, net worth is called

stockholder’s equity

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 A typical balance sheet
Assets Liabilities & Shareholder Equity

Current Assets: Current Liabilities:

Cash & short term securities Accounts payable
Accounts Receivable Short-term debt (due in one year)
Inventory Accrued expenses
Total Current Assets Total Current Liabilities

Fixed (long-term) assets: Long-term Liabilities

Property/plant/equipment Long-term debt
Investments Total Liabilities
Other assets
Shareholder Equity:
Common equity (paid in)
Retained earnings
Total Assets
Total liabilities & shareholder equity

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 Do financial analysts disagree with
balance sheet information?
• Main issue: Book values (The net asset value of a company, calculated by total
assets minus intangible assets (patents, goodwill) and liabilities) vs. market values

• Balance sheets omit some economically significant

assets called intangible assets, such as R&D

• Intangible assets, such as goodwill, are not reported at

market values (the excess of the purchase price of a company over its book value which
represents the value of goodwill as an intangible asset for accounting purposes)

• Some economically significant liabilities are also omitted,

e.g. pending lawsuits (In American law, a lawsuit is a civil action brought before a court in
which the party commencing the action)

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 2. Income Statement
• The income statement presents in a summary form the
profitability of a firm over an annual period

• The income statement presents information on

– Revenues (sales)
– Cost of goods sold
– Operating expenses
– Financing costs of doing business
– Tax expenses

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A typical income statement

Sales revenue
- Cost of goods sold
= Gross margin
- Operating expenses
= EBITDA (Earnings before interest, taxes and depreciation)
- Depreciation & Amortization
= EBIT (Operating income)
- Interest payment
= Taxable income
- Taxes
= Net Income

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 How is net income allocated?

• Dividends
• Change in retained earnings
• Earnings per share:
– Basic: Net income / shares of common stock
outstanding
– Diluted: Adjusts for stock options and convertible debt

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 Accounting vs. economic measures
of earnings
• Accounting definition of earnings ignores
unrealized gains or losses in market value of
assets and liabilities

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Accrual (make provision for (a charge) at the end of a financial period)
accounting recognizes revenues and expenses
in the period that they take place, which does
not necessarily match the cash flows of a firm

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 The firm’s expenses
• The firm’s expenses are separated into operating,
financing and capital
– Accounting depreciation does not attempt to measure
economic depreciation (loss in an asset’s value)
– Inconsistencies in the application of this categorization of
expenses (e.g., R&D is treated as an operating expense)

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 3. Statement of Cash Flows
• The statement of cash flows shows all the cash that
flows in and out of a firm during a specified period of time
• Note that income statements show revenues and
expenses
• Cash flow statements are useful because
– They show a firm’s cash position over time
– They avoid accounting judgments about revenues and expenses
found in income statements

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A typical cash flow statement
Cash flow from operations
Net income
+ Depreciation
- Increase in accounts receivable
- Increase in inventories
+ Increase in accounts payable
Total cash flow from operations

Cash flow from investing activities

- Investment in plant and equipment

Cash flow from financing activities

- Dividends paid
+ Increase in short-term debt
Change in cash and marketable securities

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 Financial Ratio Analysis: Evaluating
a firm’s performance
• Financial ratio analysis is a popular way of using
information from financial statements to evaluate
a firm’s performance

• Through the analysis of financial ratios, we can

easily identify the strengths and weaknesses of
a firm

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 How are financial ratios used?

• Calculating financial ratios allows us to

– Examine the firm’s performance through time (e.g.
last five years) and identify trends
– Compare the firm’s performance with other
comparable firms (peer group) and identify the firm’s
competitive advantage
– Some financial ratios (e.g. price-earnings ratio,
market-to-book ratio) are useful in valuation analysis,
such as valuing private firms

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 Classification of financial ratios

• Profitability ratios
• Liquidity ratios
• Efficiency ratios
• Financial leverage ratios
• Market value ratios
• Payout policy ratios

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 Profitability Ratios
• After-tax operating margin: Measures the firm’s effectiveness in
generating profits from operations

(EBIT – taxes)/Sales

• Return on assets: Measures the firm’s operating effectiveness in

generating profits from its assets

(EBIT – taxes)/Average Assets

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 Profitability Ratios
• Return on equity: Measures the firm’s profitability from the
perspective of the equity investor

Net Income/Stockholder’s Equity

• Return on capital: Measures the firm’s effectiveness in generating

profits from the capital invested in the firm

(EBIT – taxes)/(BV Debt + BV Equity)

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 Liquidity Ratios
• Current ratio: Compares current assets (cash, inventory, accounts
receivable) to current liabilities (obligations due within one year)

Current Assets/Current Liabilities

• Quick or Acid Test ratio: Variant of current ratio that distinguishes

current assets that can be converted quickly into cash (cash,
marketable securities) from those that cannot (inventory, accounts
receivable)

(Cash + Marketable Securities)/Current Liabilities

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 Efficiency Ratios
(Asset Management Ratios)
• Asset Turnover ratio: Indicates how efficiently the firm is using its
assets to generate sales

Sales/Average Total Assets

• Accounts Receivable Turnover ratio: Indicates how rapidly the firm is

collecting its credit, measured by how many times accounts
receivable are rolled over during a year

Sales/Average Accounts Receivable

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 Efficiency Ratios
• Inventory Turnover ratio: Indicates the relative liquidity of inventories,
measured by how many times the firm’s inventories are replaced
during a year

Cost of Goods Sold/Average Inventory

• Days Receivable Outstanding, Days Inventory Held:

365/Receivable Turnover

365/Inventory Turnover

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 Financial Leverage Ratios
• Times Interest Earned Ratio (Interest Coverage Ratio): Measures
the firm’s capacity to meet interest payments from pre-debt, pre-tax
earnings

EBIT/Interest Expenses

• Debt Capitalization ratio: Measures how much debt a firm is using as

a proportion of its total capital (total value of debt plus equity)

Debt/(Debt + Equity)

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 Financial Leverage Ratios
• Debt to Equity Ratio: Measures debt as a proportion of the firm’s
equity

Debt/Equity

• The above two ratios can also be calculated by using only long-term
debt

• Moreover, these ratios must be calculated using market instead of

book values for debt and equity. Market-based debt ratios give a
better indication of a firm’s ability to borrow

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 Market Value Ratios
• Price to Earnings ratio (P/E) and Market to Book ratio: Measure the
relation between the accounting measures (value) of the firm and its
market value

Price per Share/Earnings per Share

Price per Share/Book Value per Share

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 Payout Policy Ratios
• Dividend Payout ratio: It relates dividends paid to the earnings of the
firm

Dividends/Earnings

• Dividend Yield ratio: It relates the dividend paid to the price of the
stock

Annual Dividends per Share/Price per Share

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 The DuPont Analysis
• A useful way to understand the sources that drive a firm’s
ROA and ROE

• We can disaggregate ROA as follows:

ROA = (Net Profit Margin) × (Total Asset Turnover)

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 The DuPont Analysis
• Asset turnover and net profit margin (return on sales) drive ROA

• If a firm can reduce working capital without hurting its competitiveness,

then asset turnover ↑ and ROA ↑

• If a firm cuts back capital expenditures, then, in the short run, ROA ↑
because asset turnover ↑ (due to total assets ↓) and return on sales ↑ (the
latter because future depreciation ↓ and, thus, net income ↑)

• But, this strategy, will probably hurt the firm’s competitiveness and, thus,
ROA in the long run

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 The DuPont Analysis
• Moreover, we can disaggregate ROE as follows:

ROE = (ROA) ÷ (1 – Debt Ratio)

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As we see, ROE can increase through an increase in
ROA or the Debt Ratio

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 The DuPont Analysis
• Financial analysts value more a firm that increases its
ROE through higher ROA

• A firm that increases ROE by taking on more debt

also increases the probability of being in financial
distress (bankruptcy)

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 Capital Budgeting Techniques
tools used in financial decision-making to evaluate whether a
project, investment, or business expansion is financially worthwhile.

“Is this project worth the money, time, and risk?”

• Weighted Cost of Capital (WACC)

• Payback Period (Year)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)

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 WACC
• Weighted Average Cost of Capital
• The average return that a company must pay to its
investors (equity and debt)

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 Example of WACC
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 Payback Period
• The time it takes to recover the initial investment
A shorter period = quicker return of money

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 Net Present Value (NPV)
The total value created by a project in today’s money.
If NPV > 0, the project adds value

• Often the discount rate = WACC (Weighted Average Cost of Capital),

because WACC reflects the minimum return required by both debt holders
and shareholders.
• Sometimes, for very risky projects, companies use a higher discount rate
to be more conservative.
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 Internal Rate of Return (IRR)
The rate of return the project is expected to generate
If IRR > WACC, the project is attractive

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 NPV shows how much value in dollars.
IRR shows how high the return in %.

How they connect:

• If NPV is positive, then IRR will be greater than the discount rate
• If NPV is zero, IRR will be exactly equal to the discount rate
• If NPV is negative, IRR will be less than the discount rate

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