Financial analysis

and REPORTING
BY: PROF JENNELYN G MERCADO
 RIGHTS OF STOCKHOLDERS
• Too receive dividends in proportion to his
ownership
• To hold or sell his stock certificates
• To share in Liquidation
• To purchase a pro rata portion of any new
stock issus
• To inspect the firms books and records
STOCK CERTIFICATE
 Two kinds of stocks
•COMMON STOCK
•PREFERRED STOCK
 ABC COMPANY INCOME STATEMENT
SALES $100,000
less: Sales Ret. & Allowances 5,000
Net Sales $ 95,000
Less: Cost of Goods Sold 45,000
Gross Profit $ 50,000
Less: Operating Expenses
Gen & Admin Exp $20,000
Interest Exp. 5,000
Depreciation 5,000
Total $ 30,000
Net Profit Before Taxes $ 20,000
Less: Taxes(50%) 10,000
Net Profit After Taxes $ 10,0000
Double declining balance method is a
form of an accelerated depreciation
method in which the asset value is
depreciated at twice the rate it is done
in the straight-line method. Since the
depreciation is done at a faster rate (twice
to be precise) of the straight-
line method it is called accelerated
depreciation.
However, accelerated depreciation does
not mean that the depreciation
expense will also be higher. The asset will
depreciate by the same amount however
it will be expensed higher in early years of
its useful life while the depreciation
expense will be lower in the later years of
as compared to the straight line method of
depreciation.
How to Calculate Double Declining Balance Depreciation
Following are the Steps involved in the calculation of
depreciation expense using Double declining method.
1.Determine the initial cost of the asset at the time of
purchasing.
2.Determine the salvage value of the asset i.e. the value at
which the asset can be sold or disposed of after its useful life
is over.
3.Determine the useful or functional life of the asset
4.Calculate depreciation rate i.e. 1/useful life
5.Multiply the beginning period book value by twice the
depreciation rate to find the depreciation expense
6.Deduct the depreciation expense from the beginning value
to calculate the ending period value
7.Repeat the above steps till the salvage value is reached
Double Declining Method Example
Suppose a business has bought a machine
for $ 100,000. They have estimated the
useful life of the machine to be 8 years with
a salvage value of $ 11,000.
Now, as per the straight-line method of depreciation:

•Cost of the asset = $ 100,000

•Salvage Value = $ 11,000
•The useful life of the asset = 8 years
•Depreciation rate = 1/useful life *100 = (1/8) * 100 = 12.5%

Double-declining balance formula = 2 X Cost of the asset X

Depreciation rate
Here, it will be 2 x 12.5% = 25%

•Year 1 Depreciation = $100000 X 25% = $25,000

•Year 2 Depreciation = $75,000 x 25% = $18,750
Depreciation account of the balance sheet will look
like below over the 8 years of the machine’s life:
A firm has earned $50,000 after tax in the
current year. A depreciation charge of
$130,000 was deducted along with $5,000
for amortization of organizational expenses.
How large a cash flow was generated by
the firm’s current operation? Why might this
cash flow exceeds the firm’s after-tax
profits?
The Dayton Company has after-tax profits of
$130,000. In calculating these profits, the firm
deducted depreciation on two assets- A and B.
Asset A was purchased three years ago for $80,000
and is being depreciated by the straight-line
Method over a five –year period. Asset B was
purchased four years ago for $200,000 and is being
depreciated using the Double-Declining Balance
Method over a six year period. What is the firm’s
Cash flow for the current year?
 SUM-OF-THE-YEARS’ DIGITS METHOD
The sum of years' digits method is a
form of accelerated depreciation that
is based on the assumption that the
productivity of the asset decreases
with the passage of time.
 Use the following formula to calculate it:

Applicable percentage = Number of years of estimated life

remaining at the beginning of the year
SYD

SYD = n ( n + 1)
2
 Example of Sum of the Years' Digits
Depreciation
•ABC Company purchases a
machine for $100,000. It has an
estimated salvage value of
$10,000 and a useful life of five
years. The sum of the years' digits
depreciation calculation is:
Which method of Depreciation is Best?

•The Straight Line MEthod

 INTEREST AND DIVIDENDS

Interest – Is shown as an expense on the income

statement and represents payments made by the
firm to creditor for money lent.

Dividends – Represent the distribution of earnings

to the owners or stockholders of a corporation and
are not tax deductible
Sales
- Cost of Goods Sold
Gross Profit
-Expenses other than Interest
Operating Profit
-Interest Expense
Net Profit Before Taxes
-Taxes
Net Profit After Taxes
-Preferred Dividends
Earnings Available to Common Stockholders
-Common Stock Dividends
Retained Earnings
 CORPORATE TAXES
Normal /Operating Income
-- A corporation is Taxed at a rate of 22 percent on the first
$25,000 and 48 % on earnings above $25,000.
Example:
JAM’s Advertising has before-tax earnings of $60,000.
The Tax on these earnings can be found by taking .22 ($25,000)
+ .48 ($60,000-$25,000), which equals $5,500+$16,800 =
$22,300.
The firm’s total taxes on its before-tax earnings are
therefore $22, 300.
Average Tax Rates – found by dividing its taxes by its
taxable income.

Marginal Tax Rates - This represents the rate at which

additional income is taxed.
In the preceding example, JAM’s Adv. Had taxable
income of $60,000 and its total taxes were $22,300. Had
the firm’s earnings been $70,000, the marginal tax rate
on the additional $10,000 of income would have been
48%.
 CAPITAL GAINS
If a firm sells certain capital assets which it held for a period greater than
six months for more than the asset’s initial purchase price, the difference
between the sale price and the purchase price is called Capital Gain.

• The tax code provides a tax rate of 30 percent or the normal tax rate,
whichever is lower, on capital gains.

• When a firm sells an asset for more than its book value but less than its
initial price, the gain is taxed as normal income. The 30 percent tax
applies only to gains above the initial purchase price for the assets held
for six months or longer.
 Example:
• The Commodore Company has operating
earnings of $100,000 and has just sold for
$40,000 a machine initially purchased one
year ago for $36,000. The machine was being
depreciated by the straight line method over
a four-year period and had no salvage value.
Calculate the firm’s total tax liability from
both its operating income and the sale of
machine.
 ANALYZING FINANCIAL
STATEMENTS
*LEARNING GOALS*
 Review the contents of the Stockholders’ report and the
procedures for consolidating international financial statements.
Understand who uses financial ratios and how.
Use ratios to analyze a firm’s liquidity and activity.
Discuss the relationship between debt and financial leverage
and the ratios used to analyze the firm’s debt.
Use ratios to analyze a firm’s profitability and its market value.
The Four Key Financial Statements

 INCOME STATEMENTS
BALANCE SHEET
STATEMENT OF STOCKHOLDERS’ EQUITY
STATEMENT OF CASH FLOWS
 INCOME STATEMENT
Provides a financial summary of the firm’s
operating results during a specified period.
 BALANCE SHEET
Summary stamen of the firm’s financial position at a
given point in time.
 CURRENT ASSETS – short-term assets
expected to be converted into cash within 1 year or
less.
 CURRENT LIABILITIES – short-term liabilities,
expected to be paid within 1 year or less.
 LONG-TERM DEBTS – Debts for which
payment is not due in the current year.
 PAID-IN CAPITAL IN EXCESS OF PAR- the
amount of proceeds in excess of par value
received from the original sale of common
stock
 RETAINED EARNINGS – the cumulative total
of all earnings, net of dividends that have been
retained and reinvested in the firm since its
inception.
The Key Components of the Balance Sheet can be shown as:

CURRENT LIABILITIES
CURRENT ASSETS
LONG-TERM DEBT

STOCKHOLDERS’ EQUITY
FIXED ASSETS
Or

TOTAL TOTAL LIABILITIES

= AND
ASSETS
STOCKHOLDERS’
EQUITY
 STATEMENT OF STOCKHOLDERS’
EQUITY
Shows all equity account transactions that occurred during a
given year.
It also represents the residual value of assets minus the
liabilities

 The statement of Retained Earnings- is an

abbreviated form of the statement of stockholders’
Equity.
 STATEMENT OF CASH FLOWS
Provides a summary of the firm’s operating,
investment, and financing cash flows and
reconciles them with the changes in its cash and
marketable securities during the period.
 RATIO ANALYSIS

Involves methods of calculating and interpreting

financial ratios to analyze and monitor the firm’s
performance.
 TYPES OF RATIO COMPARISONS
 Cross Sectional Analysis
- Involves the comparison of different firms financial
ratios at the same point in time.

Time –Series Analysis

- evaluation of the firm’s financial performance over
time using financial ratio analysis.
 Combined Analysis
- The most informative approach to ratio
analysis. Makes it possible to assess the trend in
the behavior of the ratio in relation to the trend
for the industry.
 CAUTIONS ABOUT USING RATIO ANALYSIS
oRatios that reveal large deviations from the norm merely indicate symptoms
of a problem.
oA single ratio does not generally provide sufficient information from which to
judge the overall performance of the firm.
oThe ratios being compared should be calculated using financial statements
dated at the same point in time during the year.
oIt is preferable to use audited financial statements for ratio analysis.
oThe financial data being compared should have been developed in the same
way.
oResults can be distorted by INFLATION, which can cause the BV of inventory
and depreciable assets to differ greatly from its replacement values.
FINANCIAL RATIOS
LIQUIDITY
ACTIVITY
DEBT
PROFITABILITY
MARKET RATOS
 LIQUIDITY RATIOS
It measures the firm’s ability to satisfy its short-term obligations as they
become due.
CURRENT RATIO= Current Assets
Current Liabilities

QUICK RATIO = Current Assets-Inventory

Current Liabilities

STRICT RATIO = Current Assets – Accounts Receivables

Current Liabilities
 ACTIVITY RATIOS
Measures the speed with which various accounts are converted into sales
or cash.
INVENTORY TURNOVER = Cost of Goods Sold
Inventory

Average Age of Inventory = 365 days

Inv, Turnover

A/R TURNOVER = Sales / Accounts Receivables

Average Age of A/R = 365 days

A/R Turnover
ACCOUNTS PAYABLE TURNOVER = Cost of Goods Sold
Accts Payable

Average Age of Accts Payable = 365 days

A/P Turnover

TOTAL ASSET TURNOVER = Sales/Total Assets

a. Find the average quarterly inventory and use it to calculate
the firm’s inventory turnover and the average age of
inventory.
b. Assuming that the company is in an industry with an
average inventory turnover of 2.0, how would you evaluate
the activity of Wilkins’ inventory?
 DEBT RATIO
DEBT position of the firm indicates the amount of other
people’s money being used to generate profits.
The more debt the firm has, the greater its risk of being
unable to meet its contractual debt payments.

FINANCIAL LEVERAGE - is the magnification of risk and

return through the use of fixed-cost financing, such as
debt and preferred stock.
 Example:
Patty Akers is in the process of incorporating her new
business. After much analysis she determined that an
initial investment of $50,000, $20,000 in current assets
and $30,000 in fixed assets– is necessary. These funds can
be obtained in either of two ways. The first is the no-debt
plan, under which she would invest the full $50,000
without borrowing. The other alternative, the debt plan,
involves investing $25,000 and borrowing balance of
$25,000 at 12% annual interest. Regardless of which
alternative she chooses, Patty expects sale to average
$30,000 costs and operating expenses to average $18,000
and earnings to be taxed at a 40% rate.
The example demonstrates that
with increased debt comes
greater risk as well as higher
potential return.
 DEBT RATIO

Measures the proportion of total assets financed by the firm’s creditors.

Debt Ratio = Total Liabilities / Total Assets

Times Interest Earned Ratio = Earnings before Interest And Taxes
Interest
Fixed-Payment Coverage Ratio = Earnings Before interest and Taxes + Lease Payments

Interest+Lease Payments +{(Principal Payment+P/S Div) x [1/(1-T)]}

 PROFITABILITY RATIO

Common-Size Income statement – A popular tool for evaluating

profitability in relation to sale. Each item on this statement is expressed
as a percentage of sales.

Gross Profit Margin = Sales-Cost of Goods Sold/ Sales

Operating Profit Margin = Operating Profits/ Sales

Net Profit Margin = Earnings available to Common Stockholders

sales
EPS = NPAT- Preferred Stock Dividends
No. of Shares of C/S Outstanding

Return on Total Assets (ROA) = EACSH/ Total Assets

Return on Common Equity (ROE) = EACSH/ CS Equity

 MARKET RATIO

PRICE EARNING RATIO = Market Price per share of C/S

Earnings per Share
MARKET/BOOK (M/B) RATIO = Common Stock Equity
No. of Shrs of C/S Outstanding