Download 59400022 - Homework Minutes

Day 2
Financial Reporting & Forecasting
Review of Accounting
Financial Statements, Cash Flows & Taxes
Day 2 Outline
 Know the financial statements and where can be found
o
o
o
o
o
Income Statement
Price-earnings Ratio
Balance Sheet
Statement of Cash Flows
Tax-free Investments (Depreciation)
 Financial forecasting in a firm’s strategic growth
o Three financial statements
o Percent-of-sales method
o Methods to determine the amount of new funds required in
advance
o Factors that affect growth
Basic Financial Statements
(1) Income statement
The income statement measures the income generated
in the period and the resources used up in generating
that income [P&L]
(2) Balance Sheet & Statement of Retained earnings
The balance sheet shows the assets of a company
at a specific point in time, and how those assets
are funded
(3) Cash flow
The cash flow statement shows where cash comes from
during the period....and how it is spent
2. Sources of Information
• Annual reports
• Wall Street Journal
• Internet
–
–
–
–
NYSE (www.nyse.com)
Nasdaq (www.nasdaq.com)
Text (www.mhhe.com)
Company’s Site
• SEC
– EDGAR
– 10K & 10Q reports
Income Statement Multiple Step Structure
Sales – Cost of Goods Sold (COGS)
= Gross Profit (GP)
GP – Expenses = Earnings Before Interest and Taxes
(EBIT) or Operating Income (OI)
EBIT – Interest = Earnings Before Taxes (EBT)
EBT – Taxes = Earnings After Taxes (EAT) or Net Income
(NI)
Note:
NI in corporations is partially distributed to shareholders in the form of dividends and
remaining kept in corporations as reserve (Retained Earnings) for financing future
growth
Income Statement (cont’d)
Balance Sheet Items
• Liquidity: Asset accounts are listed in order of
liquidity
– Current assets
• Items that can be converted to cash within one year
– Marketable securities
• Temporary investments of excess cash
– Accounts receivable
• Allowance for bad debts to determine their anticipated
collection value
– Inventory
• Includes raw materials, goods in progress, or finished
goods
Balance Sheet Items (cont’d)
– Prepaid expenses
• Represent future expense items that are already paid for
– Investments
• Long-term commitment of funds (at least one year)
• Includes stocks, bonds, or investments in other
corporations
– Plant and equipment
• Carried at original cost minus accumulated depreciation
• Accumulated depreciation: Sum of past and present
depreciation charges on currently owned assets
Balance Sheet Items (cont’d)
– Total assets: Financed through liabilities or
stockholders’ equity
• Liabilities are financial obligations of the firm and move
from current liabilities (due within one year) to longerterm obligations
• Short-term obligations
– Accounts payable (amount owed on open account to suppliers)
– Notes payable (short-term signed obligations
– to the banker or other creditors)
– Accrued expense (payment not made for the obligation incurred on the
services received)
Stockholder’s Equity
• Represents total contribution and ownership
interest of preferred and common
stockholders
– Preferred stock
– Common stock
– Capital paid in excess of par
– Retained earnings
Statement of Financial Position (Balance
Sheet)
Statement of Retained Earnings (a short
supplement to the income statement)
• Indicates disposition of earnings with:
– any adjustments to previously reported income
– any restrictions on cash dividends
Sections of a Statement of Cash Flows
• Emphasizes critical nature of cash flow to the
operations of the firm
• Three primary sections of the statement of
cash flows:
– Cash flows from operating activities
– Cash flows from investing activities
– Cash flows from financing activities
• The results of three sections are added
together to compute the net increase or
decrease in cash flow
Concepts Behind the Statement of Cash
Flows
Overall Statement
Combining the Three Sections
Free Cash Flow
Free Cash Flow = Cash flow from operating activities
– Capital expenditures – Dividends
– Capital expenditures
• Maintain productive capacity of firm
– Dividends
• Maintain necessary payout on common stock and to
cover any preferred stock obligations
• Free cash flow is used for special financing
activities
– Example: leveraged buyouts
Connections among the Financial
Statements
The AKP SA example
 Earnings is the connecting element in Financial
Statements
 Cash flow items in the Income Statement and various
changes in cash items in the Balance Sheet are
constituent elements of a firm’s cash flow statement.
 Unlike the balance sheet and income statement, cash
flow statements are independent of accounting
methods
Taxes
• The one thing we can rely on with taxes is that they
are always changing
• Consequently, it is important to keep up with the
changing tax laws and to utilized specialists in the tax
area when making decisions where taxes are
involved.
• Marginal vs. average tax rates
– Marginal – the percentage paid on the next dollar
earned
– Average – the tax bill / taxable income
• Other taxes
Using Financial Ratios
•Calculating ratios is pointless unless they are
compared with some appropriate benchmarks.
•Remember; The use of ratios alone provide very little
information and may be misleading
•With that in mind, a firm’s performance needs to be
examined related to:
• The aggregate economy
• Its industry or industries
• Its major competitors within the industry
• Its own past performance (time-series analysis)
• Its own short & long term goals
Categories of Financial Ratios
•Despite the large number of ratios available, the most commonly used are
organized in six categories as follows:
•1) Liquidity Measurement Ratios
Current Ratio - Quick Ratio - Cash Ratio - Cash Conversion Cycle
•2) Profitability Indicator Ratios
Profit Margin Analysis - Effective Tax Rate - Return On Assets –
Return On Equity - Return On Capital Employed
•3) Debt Ratios
Overview Of Debt - Debt Ratio - Debt-Equity Ratio - Capitalization Ratio –
Interest Coverage Ratio - Cash Flow To Debt Ratio
•4) Operating Performance Ratios
Fixed-Asset Turnover - Sales/Revenue Per Employee - Operating Cycle
•5) Cash Flow Indicator Ratios
Operating Cash Flow/Sales Ratio - Free Cash Flow/Operating Cash Ratio –
Cash Flow Coverage Ratio - Dividend Payout Ratio
•6) Investment Valuation Ratios
Per Share Data - Price/Book Value Ratio - Price/Cash Flow Ratio –
Price/Earnings Ratio - Price/Earnings To Growth Ratio - Price/Sales Ratio - Dividend Yield Enterprise Value Multiple
The Quality of Financial Statements
• A basic assumption in Ratio Analysis is that: Financial
statements have build-in quality and they reflect reality.
• Recall: High-quality balance sheets must have
– Conservative use of debt
– Assets with market value greater than book
– No liabilities off the balance sheet
• High-quality income statements
– Reflect repeatable earnings
– Gains from nonrecurring items should be ignored
when examining earnings
– High-quality earnings result from the use of
conservative accounting principles that do not
overstate revenues or understate costs
The Financial Planning Concept
The concept
1.
Ability to plan ahead establishing performance targets, and
make necessary adjustments before actual events occur
2.
Financial Planning is a dynamic process considering Risktaking desires & Ability to hedge against them, following a
cycle of
•
•
•
making plans,
implementing them, and
revising them in the light of actual results.
3.
Financial Planning is a coherent process aligned with the
firm’s Strategic plans
4.
Financial Planning has always a well defined time horizon
5.
Forecasting the firm’s pro –forma statements (B/S, P/L, CF),
and estimating the implied need for external financing,
relying on historical data contained in the firm’s Financial
Statements
The Financial Planning Purpose
The purpose:
The primary purpose of financial planning is to determine:
1) whether the firm can realistically raise the necessary funds to
Finance its operating plans
Finance its major investment plans including working capital
and fixed assets
Finance acquisition plans and pay dividends
and
2) the sources of the funds required such as:
Retained Earnings
Borrowing
New equity
A combination of them
Constructing Pro Forma Statements
 Pro forma, or projected, financial statements enable a
firm to estimate its future level of receivables, inventory,
payables, as well as its anticipated profits and borrowing
requirements.
 These statements are often required by bankers and
other lenders as a guide for the future.
 A systems approach to develop pro forma statements
consists of:
• Constructing income statement based on sales
projections and the production plan
• Translating it into a cash budget
• Assimilating all materials into a pro forma balance
sheet
The Sales Forecast
• Very simple or very sophisticated forecasting
techniques may be used, including correlation
analyses, time series and trend analyses etc)
• Information for sales forecasts may come from
salesmen and related marketing functions, from
external specialists, from internally developed
models, industry trade groups etc
• Often times econometric applications are used in
conjunction with field information (sales composite
method)
Cash Budget
• Mandatory tool in short-term financial planning
– Helps to identify short-term needs timely enabling to take
precautions and exploit potential opportunities
• How it works
– Pro forma income statement must be translated into cash
inflows by defining sales and cash collections from all
activities of a firm
– Identify all cash outflows necessary to operations
– More precise time frames set to help anticipate patterns of
cash inflows and outflows (usually monthly intervals)
– Subtract cash outflows from cash inflows and determine
investing and financing needs in terms of amounts and time
Pro Forma Balance Sheet
• Represents the cumulative changes over time
– Important to examine the prior period’s balance
sheet
– Some accounts will remain unchanged, while
others will take new values
• Information is derived from the pro forma income
statement and cash budget
The Financial Planning Process
• The Percent-of-Sales Method is based on the
assumption that:
 Accounts on the balance sheet will maintain a given
percentage relationship to sales
 ST Notes payable, LT Loans, common stock, and
retained earnings do not maintain a direct relationship
with sales volume
Thus it is assumed that borrowing (short & long term),
and owner’s equity remain unchanged and only current
liabilities are affected (spontaneous liability accounts).
Regarding R/E they will change by the net Income less
dividend.
 Hence percentages are not computed
Illustrating the Financial Planning Process
Steps for constructing Pro-Forma Financial Statements
(The Percent-of-Sales Method)
(i) The Sales Forecast
• The starting point is collection of the historical sales data
contained in the firm’s Income Statements covering usually a time
horizon of ten years.
• Let’s assume that sales volume in BLUE MOUNTAIN SA for 2009 were $
2.290, the annual rate of growth between the years 2000 and 2009
was 8% and the assignment is to estimate 2010 sales volume based
on this percentage growth rate.
Applying this 8% growth rate to 2009 sales of $2.290 we
calculate the 2010 sale estimate to be ~$2.500, ($2.290 * 1.08)
The Financial Planning Process
ILLUSTRATION OF STEP (I)
BLUE MOUNTAIN SA
Income Statement
For the Year Ended Dec. 31, 2009 ($ 000's) & projected volume of 2010 sales
P/L Key Positions
2009
SALES
2.290,00
OPERATING EXPENSES
1,758,00
DEPRECIATION
200,00
OPERATING INCOME BEFORE TAX
332,00
TAXES @ 40%
133,00
NET INCOME AFTER TAX
199,00
DIVIDEND (Dividend Pay-out 30% - $59,70/139,30)
RETAINED EARNINGS
59,70
139,30
2009 %
+8%
2010
2,500,00
Illustrating the Financial Planning Process
Percent-of-Sales Method
(ii) The level of Expenses projected in support of forecasted sales volume
Express historical expense positions in the Income Statement
as a percentages to sales (same year)
Multiply percentages defined above with the new sales level
forecasted for constructing multiple step pro-forma income
statement
It is assumed
(1) no changes in operating strategies from previous periods
(2) selected accounts contain no fixed components (ie if sales
equal zero then selected accounts have zero balances-This
paradox is relaxed when regression analyses are used)
The Financial Planning Process
ILLUSTRATION OF STEP (II)
BLUE MOUNTAIN SA
Pro-Forma Income Statement
For the Year Ended Dec. 31, 2010 ($ 000's)
P/L Key Positions
2009
2009 %
2010
SALES
2.290,00
100,00%
2,500,00
OPERATING EXPENSES
1,758,00
76,70%
1.917,50
DEPRECIATION
200,00
8,8%
220,00
OPERATING INCOME BEFORE TAX
332,00
14,5%
362,50
TAXES @ 40%
133,00
-
145,00
NET INCOME AFTER TAX (NI)
199,00
8,7%
217,50
DIVIDEND (Dividend Pay-out 30% - $59,70/139,30)
RETAINED EARNINGS
59,70
65,25
139,30
152,25
Illustrating the Financial Planning Process
Percent-of-Sales Method
(iii) The level of asset required to support forecasted sales
Convert historical positions in the Balance Sheet (B/S) to
percentages by expressing all B/S accounts/positions as a
percentage of sales (same year)
Then Multiply the percentages defined above with the new sales
level forecasted for constructing the pro-forma Balance Sheet
Recall that percentages are not computed for ST Notes payable, LT
Loans, common stock, and retained earnings.
It is assumed
The company operates in full capacity
The Financial Planning Process
ILLUSTRATION OF STEP (III)
BLUE MOUNTAIN SA
Pro-Forma Balance Sheet For the Year Ended Dec. 31, 2010 ($ 000's
Assets
Cash and Equivalents*
Accounts Receivable
Inventory
Prepaid Expenses
Total Current Assets
Net Fixed Assets
Total Assets
Liabilities and Owner's Equity
Accounts Payable**
Other Current Liabilities
Short-term Notes Payable
Total Current Liabilities
Long-term Debt
Total L.T Liabilities
Common Stock
Retained Earnings
Total Shareholder's Equity
Total Liabilities and Owner's Equity
2,009
186.00
198.00
250.00
20.00
654.00
2,340.00
102.50%
2,994.00
131.10%
2010
202.50
217.50
272.50
22.50
715.00
2,562.50
3,277.50
200.00
68.00
30.00
298.00
1,000.00
1,000.00
500.00
1,196.00
1,696.00
2,994.00
8.80%
3.00%
0.00%
11.80%
0.00%
0.00%
0.00%
n/a%
108.98%
105.99%
220.00
75.00
30.00
325.00
1,000.00
1,000.00
500.00
1,348.25
1,848.25
3,173.25
Example * 186/2,290=~8.1% & 2,500 X 8.1% = 202.50
Example ** 200/2,290=~8.8% & 2,500 X 8.8% = 220.0
2009%
8.10%
8.70%
10.90%
0.90%
28.60%
The Financial Planning Process
(iv)The external financing need for the firm’s operating activities
THE RULE
•IF ASSETS > LTL & EQTY = NEEDS EXTERNAL FINANCING (SHORTAGE IS COVERED BY
LOANS AND/OR NEW EQUITY)
•IF ASSETS < LTL & EQTY = NO NEED FOR EXTERNAL FINANCING. (SURPLUS IS ADDED
BACK TO CASH EQUIVALENTS)
Based on the findings in previous steps it seems that the
Additional external financing needs will total to $104,25T as
presented in the table below:
Selected key B/S & P/L positions ($000)
2009
2010
1) Total Assets
2.994,00
3.277,50
2) Total Liabilities & Owner’s Equity
2.994,00
3.173,25
External Financing Needs (EFN) (1-2)
104,25
The Financial Planning Process
Alternatively EFN can be estimated following a simple formula:
EFN = [(A/S*(ΔS)] – [L/S *(ΔS) + (M)*(St)*(1-D)]
Where:
1)
2)
3)
4)
5)
6)
Asset to Sales Historical Relationship (A/S )
Spontaneous Liabilities to Sales Historical Relationship (L/S)
Absolute change in Sales Volume (Forecast less historical) (ΔS)
Total Sales Volume Forecasted for the year (St)
Forecasted Profit Margin (M)
Forecasted Dividend Pay Out ratio (D)
OR
EFN = [(1,31*210)] – [(0,118*210) + (0,087)*(2.500,00)*(1-0,3)]and
EFN = $104,25
The Financial Planning Process
What to do next ?
Seek for the proper financing sources:
• To borrow from a bank or better off, negotiate trade terms to
extend credit from suppliers (‘free capital’)
• Alternatively consider leasing possibilities and/or equity financing
Asset Management
• Reduce investment in current and fixed assets
• Rationalize Receivables and Inventories (Decrease DSO and DIH)
Control growth rate
• Lower growth rates (say 5%) will require less asset investment
• Increase profit margin higher (say 12%) than the firm’s historical
margin
Growth and External Financing
• At low growth levels, internal financing (retained
earnings) may exceed the required investment in
assets
• As the growth rate increases, the internal financing
will not be enough and the firm will have to go to
the capital markets for money
• Examining the relationship between growth and
external financing required is a useful tool in longrange planning
The Internal Growth Rate
• The internal growth rate tells us how much the firm can grow
assets using retained earnings as the only source of financing.
• Using the information from BLUE MOUNTAIN SA
ROA = $199 / $2,994= 0.066
Retention (D)=($199-$59) /$199 =0.70
Internal Growth Rate 
ROA  D
1 - ROA  D
[$199 / $2,994] *{[$ 199  $59] / $199}

{1  [$199 / $2,994] * [$199  $59] / $199}
[0.066 * 0.70] /{1  [0.066 * 0.70} 
0.0464 / 0.953  0.0487
 4.87%
Thus BLUE MOUNTAIN SA could grow at 4.87% relying solely on internally
generated funds without raising additional external capital. (increase in debt)
The Sustainable Growth Rate
• The sustainable growth rate tells us how much the firm can grow
by using internally generated funds and issuing debt to maintain
a constant debt ratio.
• Using the information from BLUE MOUNTAIN SA
ROE = $199 / ($1,196+$500)= 0.1173
Retention (D) =($199-$59) /$199 =0.70
ROE  D
1 - ROE  D
0.1173  0.70


{1  (0.1173  0.70)}
 0.0821 / 0.91789  0.08945
Sustainabl e Growth Rate 
 8.95%
The sustainable growth rate 8.95% for BLUE MOUNTAIN SA is substantially higher than
its internal growth rate. This is because we are allowing the company to issue debt as well
as use internal funds. (Note that no new equity is issued)
Determinants of Growth
• Profit margin – operating efficiency
• Total asset turnover – asset use efficiency
• Financial leverage – choice of optimal debt
ratio
• Dividend policy – choice of how much to pay
to shareholders versus reinvesting in the firm
It is important to note at this point that growth is not the goal of a firm in and of
itself. Growth is only important so long as it continues to maximize shareholder
value.
End of Day 2
Shokran”
Thank You
“
• DAY 2
Appendix A
The Financial Planning Process –
An illustration for constructing
Pro Forma Fin. Statements
Development of Pro Forma Statements
Pro Forma Income Statement
• Provides a projection on the anticipation of profits
over a subsequent period
• Four important steps include:
• Establishing a sales projection
• Determining production schedule and the associated use
of new material, direct labor, and overhead to arrive at
gross profit
• Computing other expenses
• Determining profit by completing actual pro forma
statement
The Sales Forecast
• Very simple or very sophisticated forecasting
techniques may be used, including correlation
analyses, time series and trend analyses etc)
• Information for sales forecasts may come from
salesmen and related marketing functions, from
external specialists, from internally developed
models, industry trade groups etc
• Often times econometric applications are used in
conjunction with field information (sales composite
method)
Establish a Sales Projection
• Let us assume Goldman Corporation has two primary
products: wheels and casters and projects the following
sales volumes and selling prices for the period in question
(6 months)
Table 4-1
Determine a Production Schedule and the
Gross Profit
• Number of units produced will depend on:
– Beginning inventory
– Sales projections
– Desired ending inventory
• To determine the production requirements:
Units
+ Projected sales
+ Desired ending inventory
– Beginning inventory
= Production requirements
Stock of Beginning Inventory
Suppose that Goldman Corporation has available in
stock (beginning inventory) with their corresponding
unit costs, the items shown in the Table below
Table 4-2
Production Requirements for Six Months
Suppose also that Goldman Corporation has estimated its
production requirements as shown in table below.
Table 4-3
New Unit Production Costs
• Assume further that due to price increases in raw material unit
costs to produce each unit is increased by $2 thus costing
Goldman Corporation $18/unit for wheels and $22/unit for
Casters as shown in the table below :
Table 4-4
Total Production Costs for the Period in
Question
Given the qty needed to be produced per product and the unit
cost per product, we can get the total cost estimates as given in
the table below:
Table 4-5
Cost of Goods Sold Estimates
 Costs associated with units sold during the time
period
 Assumptions for the illustration:
• Beginning inventory is assumed to be sold first
• First allocates the cost of current sales to beginning
inventory
• Then to goods manufactured during the period
Allocation of Manufacturing Cost and
Determination of Gross Profits
Table 4-6
Valuing Ending Inventory
Given the values of the beginning inventory, the total cost of
production for the period in question and the cost of sales for
same period, then we can get the value of the ending inventory
as shown in the table below.
Table 4-7
Other Expense Items
Suppose also that Goldman Corporation has estimated its other
expenses to be; $12,000 for SG&A, $1,500 for Interest expenses,
Corporate taxes are at 20%, dividend pay out approximately 3%,
then the pro-forma income statement will be structured as follows:
 Subtracted from gross profits the General and
administrative expenses to arrive at EBIT
 Subtracted from EBIT the interest expenses
to arrive at EBT
 Subtracted from EBT the income taxes to arrive at EAT
 Subtracted from EAT the dividend pay out of 3%
to arrive at Retained Earnings
Pro Forma Income Statement
Using the information gathered so far, the pro-forma Income
statement will be as follows:
Table 4-8
Cash Budget
• Mandatory tool in short-term financial planning
– Helps to identify short-term needs timely enabling to take
precautions and exploit potential opportunities
• How it works
– Pro forma income statement must be translated into cash
inflows by defining sales and cash collections from all
activities of a firm
– Identify all cash outflows necessary to operations
– More precise time frames set to help anticipate patterns of
cash inflows and outflows (usually monthly intervals)
– Subtract cash outflows from cash inflows and determine
investing and financing needs in terms of amounts and time
Monthly Sales Pattern & Cash Receipts
Sales Pattern Suppose that Goldman Corporation’s SALES in December
were $12,000 and based on the sales trends of the past has estimated its
sales pattern for the first half of the year as shown in table below.
Table 4-9
Cash Receipts: Suppose also that a careful analysis of past sales and
collection records show that 20% of the monthly sales is collected within same
month and the remaining80% in the following month as shown in the table
below
Table 4-10
Avg Monthly production Costs Pattern & Cash
Payments
Suppose that Goldman Corporation’s Material Purchases in
December were $4,500 and material, labor and overhead costs are
incurred on an equal monthly basis over the projected six-month
period as shown in table below. Note also that Payment for
material is made the following month in full after purchases have
been made, whereas Labor & Overhead costs are paid in same
month.
Table 4-12
Summary of All Monthly Cash Payments
Suppose also that a careful analysis of past performance in expenditure records show that
Disbursements for general and administrative expenses ($12,000) are equally distributed
over the six month period, Interest payments ($1,500) are due in June, dividends pay
($1,500) are due in June every year and taxes are paid quarterly in two equal installments.
Also $8,000 in Feb plus $10,000 in June to be expensed for new equipment
Table 4-13
Cash Budget
Monthly Ending Cash Flow
• Difference between monthly receipts and payments
is the net cash flow for the month
– Allows the firm to anticipate the need for funding at the
end of each month
Table 4-14
Pro Forma Balance Sheet
• Represents the cumulative changes over time
– Important to examine the prior period’s balance
sheet
– Some accounts will remain unchanged, while
others will take new values
• Information is derived from the pro forma income
statement and cash budget
Development of a
Pro Forma Balance Sheet
“Prior” Balance Sheet for the year ended
DECEMBER 31, 2010
Table 4-16
Pro Forma Balance Sheet
Table 4-17
Explanations of Pro Forma Balance Sheet










Cash ( $5,000 )—Assume minimum cash balance as shown in “prior’ B/S.
Marketable securities ( $3,200 )—remains unchanged from prior
period’s value in Table 4–16
Accounts receivable ( $16,000 )—based on June sales of $20,000 in
Table 4–10 (80% of current month sales become accounts receivables)
Inventory ( $6,200 )—ending inventory as shown in Table 4–7.
Plant and equipment ( $27,740+ $18,000) $45,740
Accounts payable ( $5,732 )—based on June purchases in Table 4–13
Notes payable ( $5,884 )—the amount that must be borrowed to
maintain the cash balance of $5,000, as shown in Table 4–15
Long-term debt ( $15,000 )—remains unchanged from prior period’s
value in Table 4–16
Common stock ( $10,500 )—remains unchanged from prior period’s
value in Table 4–16
Retained earnings ( $39,024 )—initial value plus pro forma income
($20,500 + $18,524)
Analysis of Pro Forma Statement
The growth of $25,640
Total assets (June 30, 2011)……$76,140
Total assets (Dec 31, 2010)…….$50,500
Increase………………………………..$25,640
Was financed by:
• accounts payable = $1,232 ($5732 – $4500)
• notes payable, and profit = $5,884 ($5884 - $0), and
• as reflected by the increase in retained earnings $18,524
The Rule determining the external financing needs (EFN)
IF ASSETS > LIABILITIES & EQUITY = NEEDS EXTERNAL FINANCING
IF ASSETS < LIABILITIES & EQUITY = NO NEED FOR EXTERNAL
FINANCING & THE SURPLUS IS ADDED BACK TO CASH EQUIVALENTS
BACK-UP NOTES
69
BACK-UP NOTES - 1
• Rules for Ratio interpretation
• There can be an enormous large number of financial ratios, but knowing a
few empirical rules can assist to remember the way of their calculation,
and to interpret their meaning better. Basically each ratios name symbolizes
and reveals the way to be calculated and the purpose it serves.
• For example:
– Ratios expressed as ‘margin’ imply that a B/S or P/L position needs to
be divided by sales
– Ratios expressed as ‘turnover’ imply that sales volume (or a variation
of sales) needs to be divided by a B/S or P/L position.
– Ratios expressed ‘return on’ imply that net income (or a variation of
net income) needs to be divided by a B/S or P/L position.
70
BACK-UP NOTES - 2
• Use of Ratios in Constructing Fin. Statements
• When sales volume and cash on hand can be determined with relative
accuracy and pre-defined ratios on historical data are available, then the
construction of both B/S & P/L can be accomplished
• For example:
• Given: Sales Volume $1.440 & Cash on Hand $40 and tax rate at 40%
• Accompanied by: 1) DSO = 25 days
2) Gross Margin = 45%
•
3) INVTURN = 12 times 4) ROA = 12%
•
5) Quick Ratio = 2 times 6) TIE = 6 times
•
7) Debt to Assets = 60% 8) Net Margin = 5%
THEN
continue
71
BACK-UP NOTES - 2
Use of Ratios in Constructing Fin. Statements (cont’d)
P/L
1.Net Income after tax (NIAT) = Sales*Net Margin =
OR NIAT $72
2.Net Income before tax (NIBT) = NIAT /(1-Tax Rate) =
OR NIBT $120
3.Cost of Sales (COPS) = Sales-(Gross Margin*Sales)=
OR COPS = $792
4.Interest expense (I) = TIE*I = EBIT & NIBT + I = EBIT = $120 = 4I= OR I=$30
5.EBIT= NIBT + I =
OR EBIT = $150
6.Operating Expenses (OE) = Sales – COPS – EBIT=
OR OE = $498
BACK-UP NOTES - 2
• Use of Ratios in Constructing Fin. Statements
(cont’d)
P/L 200X1
SALES $ 1’440
COPS
792
OE
498
EBIT
$150
I
30
NIBT
$120
TAX
48
NIAT
$72
BACK-UP NOTES - 2
Use of Ratios in Constructing Fin. Statements (cont’d)
B/S
•
•
•
•
•
•
•
•
Total Assets = NIAT/ROA =
Accounts Receivable = DSO*Sales per Day =
Inventory = Sales/INVTURN =
Current Liabilities = Cash + A/R/Quick Ratio =
Long term Liabilities = Total Assets* Debt to Assets ratio =
Owner’s Equity = Total Assets – Total Debt =
Fixed Assets = Total Assets – Current Assets =
Long Term Debt = Total LT Liabilities – Current Liabilities =
OR $600
OR $100
OR $120
OR $70
OR $360
OR $240
OR $340
OR $290
BACK-UP NOTES - 2
• Use of Ratios in Constructing Fin. Statements (cont’d)
B/S200X1
ASSETS
Cash & Equivalent $4O
A/R
100
Inventory
120
Net F/A
340
Total Assets
$600
LIABILITIES & EQUITY
Current Liabilities $70
LT Debt
290
Equities
240
Total Liab. & Equity $600
End