Financial Statements and ratio Analysis

It provides detailed information on the accounting policies, procedures, calculations, and transactions
underlying entries in the financial statements.

Key Parts of Financial Statements are-

 Income statement.

 Balance sheet.

 Statement of retained earnings.

 Statement of cash flows.

Income Statement:

Income statement provides a financial summary of the firm’s operating results during a specified
period. Most common are income statements covering a 1-year period ending at a specified date,
ordinarily December 31 of the calendar year.

Balance Sheet:

Balance sheet presents a summary statement of the firm’s financial position at a given point in time.
An important distinction is made between short-term and long-term assets and liabilities. Current
assets and current liabilities are short-term assets and liabilities. This means that they are expected to
be converted into cash (current assets) or paid (current liabilities) within 1 year or less.

Statement of Retained Earnings:

Statement of retained earnings reconciles the net income earned during a given year, and any cash
dividends paid, with the change in retained earnings between the start and the end of that year. An
abbreviated form of the statement of stockholders’ equity.

Statement of Cash Flows:

Statement of cash flows is a summary of the cash flows over the period of concern. The statement
provides insight into the firm’s operating, investment, and financing activities of cash flows and
reconciles them with changes in its cash and marketable securities during the period.

Types of Ratio Analysis

a) Compare with others or cross-sectional analysis

 Similar firms/Intra company

 Industry average

 Peer firms/Inter company

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Financial statements and Ratio Analysis
Comparisons are made by comparing similar ratios for firms within the same industry, or to an
industry average, as of some point of time. Time-series comparisons are made by comparing similar
ratios for a firm measured at various points of time.

b) Trend analysis or Time Series Analysis

Time series analysis evaluates performance over time, comparison of current to past
performance using ratios. It enables analyst to assess the firm’s progress. It can develop a
trend using multiyear comparisons.
c) Combined Analysis

 combination of Time Series Analysis and cross-sectional analysis

 The most informative analysis

 Helps to assess the trend in the behavior of the ratio in relation to the trend for the
industry.

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 competitor that it wishes to emulate.

 Ratio Analysis

Ratio Analysis:

Ratio Analysis involves methods of calculating and interpreting financial ratios to analyze and monitor
the firm’s performance.

Categories of Ratio Analysis:

 Liquidity Ratio

 Activity Ratio

 Debt /solvency Ratio

 Profitability Ratio

 Market Ratio.

Liquidity Ratios

Current Ratio:

The current ratio one of the most commonly cited financial ratios, measures the firm’s ability to meet
its short-term obligations.

Formula:

Current ratio = Current assets / Current Liabilities

Quick (Acid-Test) Ratio:

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Financial statements and Ratio Analysis
The quick (acid-test) ratio is similar to the current ratio except that it excludes inventory, which is
generally the least liquid current asset. The generally low liquidity of inventory results from two
primary factors: (1) many types of inventory cannot be easily sold because they are partially
completed items, special-purpose items, and the like; and (2) inventory is typically sold on credit,
which means that it becomes an account receivable before being converted into cash.

Formula:

Quick Ratio = Current Assets – Inventory /Current Liabilities

 Activity Ratio

Activity ratios:

Activity ratios measure the speed with which various accounts are converted into sales or cash-inflows
or outflows.

Inventory Turnover

Inventory turnover commonly measures the activity, or liquidity, of a firm’s inventory.

Formula:

Inventory turnover = Cost of goods sold / Inventory

 Activity Ratio

Average Collection Period:

The average collection period, or average age of accounts receivable, is useful in evaluating credit and
collection policies.

Formula:

Average collection period = Accounts receivable /average sales per day

= Accounts receivable /annual sales /365

Average Payment Period

The average payment period, or average age of accounts payable, is calculated in the same manner as
the average collection period.

Formula:

Average Payment period = Accounts payable / average purchase per day

= Accounts payable/annual purchase/365

 Activity Ratio

Total Asset Turnover:

The total asset turnover indicates the efficiency with which the firm uses its assets to generate sales.
Total asset turnover is calculated as follows:

Formula:

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Financial statements and Ratio Analysis
 Total assets turnover = Sales / total assets

 Debt/Solvency Ratio:

Debt ratio:

Debt ratio measures the proportion of total assets financed by the firm’s creditors. The higher this
ratio, the greater the amount of other people’s money being used to generate profits.

Formula:

Debt ratio = Total liabilities / Total assets

The times interest earned ratio:

Sometimes called the interest coverage ratio, measures the firm’s ability to make contractual interest
payments. The higher its value, the better able the firm is to fulfill its interest obligations.

Formula:

Times Interest earned ratio = earnings before interest and taxes / Interest

 Profitability Ratio:

 Gross Profit Margin:

The gross profit margin measures the percentage of each sales dollar remaining after the firm has paid
for its goods. The higher the gross profit margin, the better is its production activities.

Formula:

Gross profit margin = Sales – cost of goods sold / Sales

=Gross profit / Sales

Operating Profit Margin:

The operating 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.

Formula:

Operating profit margin = Operating Profits / Sales

Net Profit Margin:

The net profit margin measures the percentage of each sales dollar remaining after all costs and
expenses, including interest, taxes, and preferred stock dividends, have been deducted.

Formula:

Net profit margin = earnings available for common stockholders/ Sales

Earnings per Share (EPS):

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Financial statements and Ratio Analysis
The firm’s earnings per share (EPS) is generally of interest to present or prospective stockholders and
management. As we noted earlier, EPS represents the number of dollars earned during the period on
behalf of each outstanding share of common stock.

Formula:

Earnings per share = earnings available for common stockholders/ number of share of common stock
outstanding

Return on Total Assets (ROA):

The return on total assets (ROA) often called the return on investment (ROI), measures the overall
effectiveness of management in generating profits with its available assets.

Formula:

Return on total assets = earnings available for common stockholders / Total assets.

Return on Common Equity (ROE):

The return on common equity (ROE) measures the return earned on the common stockholders’
investment in the firm.

Formula:

Return on common equity = Earnings available for common stockholders / common stock equity

 Market Ratios:

Market ratios relate the firm’s market value, as measured by its current share price, to certain
accounting values.

Price/Earnings (P/E) Ratio:

The price/earnings (P/E) ratio is commonly used to assess the owners’ appraisal of share value. The
P/E ratio measures the amount that investors are willing to pay for each dollar of a firm’s earnings.

Formula:

Price/earnings(P/E) ratio = Market price per share of common stock/Earnings per share

 Market/Book (M/B) Ratio

The market/book (M/B) ratio provides an assessment of how investors view the firm’s performance. It
relates the market value of the firm’s shares to their book—strict accounting—value.

To calculate the firm’s M/B ratio, we first need to find the book value per share of common stock:

Formula:

 Book value per share of common stock = common stock equity / number of share of
common stock outstanding

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Financial statements and Ratio Analysis
  Market / Book(M/B) ratio = market price per share of common stock/ Book value per share
of common stock

P3–22 .Cross-sectional ratio analysis use the financial statements below and on page 106for
Fox Manufacturing Company for the year ended December 31, 2012, along with the industry
average ratios below:
Prepare and interpret a complete ratio analysis of the firm’s 2012 operations.
Summarize your findings and make recommendations.

Fox Manufacturing Company Income Statement for the Year Ended December 31, 2012

Sales revenue $600,000

Less: Cost of goods sold 460,000
Gross profits $140,000
Less: Operating expenses
General and administrative expenses $30,000
Depreciation expense 30,000
Total operating expense 60,000
Operating profits $ 80,000
Less: Interest expense 10,000
Net profits before taxes $ 70,000
Less: Taxes 27,100
Net profits after taxes (earnings available
for common stockholders) $ 42,900

Earnings per share (EPS) $2.15

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Financial statements and Ratio Analysis
Ratio Industry average, 2012

Current ratio 2.35

Quick ratio 0.87
Inventory turnover a 4.55
Average collection period 35.8 days
Total asset turnover 1.09
Debt ratio 0.300
Times interest earned ratio 12.3
Gross profit margin 0.202
Operating profit margin 0.135
Net profit margin 0.091
Return on total assets (ROA) 0.099
Return on common equity (ROE) 0.167

Earnings per share (EPS) $3.10

Fox Manufacturing Company

Balance Sheet
December 31, 2012

Cash $ 15,000
Marketable securities 7,200
Accounts receivable 34,100
Inventories 82,000
Total current assets $138,300
Net fixed assets 270,000
Total assets $408,300

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Financial statements and Ratio Analysis
Liabilities and Stockholders’ Equity

Accounts payable $57,000

Notes payable 13,000
Accruals 5,000
Total current liabilities $ 75,000
Long-term debt $150,000
Common stock equity (20,000 shares
outstanding) $110,200
Retained earnings 73,100
Total stockholders’ equity $183,300
Total liabilities and stockholders’ equity $408,300

SOLUTIONS: 22
Liquidity Ratio
 Current Ratio= Current Asset ÷ Current Liabilities
= 138300÷75000
= 1.844
=1.85:1
Current Ratio used to measure short term paying debt ability which is within 90 days. Here
Industry Average is 2.35% that is higher than this company.
 Quick ratio= (Current assets - Inventories) ÷ current liabilities
=(138300 – 82000)/75000
=0.75
Acid test ratio measures immediate short-term liquidity. Here, company’s ratio is lower than
industry average.

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Financial statements and Ratio Analysis
Activity Ratio
 Inventory turnover = Cost of goods sold÷ Average Inventory
= 460,000 ÷ 82,000
= 5.60 times
Inventory turnover measures liquidity of inventory. Here inventory turnover higher than
market average. That means it utilize its inventory better.
Average collection period = Account receivable/annual sales/365
= 34100/600000/365
= 20.75 Days

Profitability Ratio
 Gross Profit Margin = Gross profit / Sales

= 140000/600000

= .2333

= 23.33%

 Operating Margin = Operating Profit / Sales

= 80000/600000

= .1333

= 13.33%

 Net Profit Margin = Net income ÷ Net sales

= 42900 ÷ 600000
= .0715
=7.15%
Profit margin measure income generate by each dollar of sales. Here gross & operating profit
margins are more or less better but net margin has got less than industry average. It means
firm’s operating activities is satisfactory but net margin has gone down due to it’s financial
leverage cost.

 Asset turnover = Net sales ÷ Total assets

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Financial statements and Ratio Analysis
= 600000 ÷408300
=1.47 times
Asset turnover measure how efficiently assets are used to generate sales. Here asset turnover is
higher than market average.
 Return on assets (ROA) = Net profit ÷ Total asset

= 42900 / 408300

= .1050

 Return on Equity (ROE) = Net profit ÷ Stockholders Equity

= 42900 / 183300

= .2340

Here, return on both assets & equity is higher than the industry average.

 Earning per Share (EPS) = Net profit ÷ No. of Common Stock

= 42900 / 20000

= 2.145 Tk.

Here, Earning per share is much lower than the industry average.

Solvency Ratio
 Debt to total asset ratio=Total debt/Total asset

=225000/408300
=.55
=55%
Debt ratio measure percentage of total asset provided by creditors. Here, firm has gone
through more debt finance as compared to market average.
 Times interest earned= EBIT/ interest expense

=80000/10000
=8 times
Times interest earned measures the ability to meet interest payment as they come due. Here,
firm’s ability is bellow than market average.

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Financial statements and Ratio Analysis
Recommendation:
Here, we may conclude that company is running its operation efficiently though having some
liquidity shortage as compared to industry standard. But firm should not go for further debt
financing since it has put a negative impact on net margin which in turn resulting in lower
earnings per share (EPS). This might lower the confidence in the minds of investing people.
P-3.23: Financial statement analysis the financial statements of Zach Industries for the year
ended December 31, 2012, as follows.

Zach Industries Income Statement

For the Year Ended December 31, 2012

Zach Sales revenue $160,000

Assets Less: Cost of goods sold 106,000

Gross profits $ 54,000

Cash $ 500
Less:
Marketable Operating expenses
securities 1,000
AccountsSelling
receivable
expense $ 25,000
16,000
Inventories 45,500
General and administrative expenses 10,000
Total current assets $ 72,000
Land Lease expense 1,000
$ 26,000
Buildings and equipment
Depreciation expense 90,000
10,000
Less: Accumulated depreciation 38,000
Total operating expense $ 37,000
Net fixed assets $ 78,000
Operating profits
Total assets $ $150,000
17,000

Less: Interest expense 6,100

Net profits before taxes $ 10,900

Liabilities and Stockholders’ Equity
Less: Taxes 4,360
Accounts payable $ 22,000
Net profits after taxes $ 6,540
Notes payable 47,000
Total current liabilities $ 69,000
Long-term debt 22,950
Common stock 31,500
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Financial statements and Ratio Analysis
Retained earnings 26,550
Total liabilities and stockholders’ equity $150,000
 Industries Balance Sheet December 31, 2012

The firm’s 3,000 outstanding shares of common stock closed 2012 at a price of $25 per
share.

Use the preceding financial statements to complete the following table. Assume the industry
averages given in the table are applicable for both 2011 and 2012

Ratio Industry average Actual 2011 Actual 2012

Current ratio 1.80 1.84 ______

Quick ratio 0.70 0.78 ______
Inventory turnover 2.50 2.59 ______
Average collection period 37.5 days 36.5 days ______
Debt ratio 65% 67% ______
Times interest earned ratio 3.8 4.0 ______
Gross profit margin 38% 40% ______
Net profit margin 3.5% 3.6% ______
Return on total assets 4.0% 4.0% ______
Return on common equity 9.5% 8.0% ______
Market/book ratio 1.1 1.2 ______
Based on a 365-day year and on end-of-year figures.
Analyze Zach Industries’ financial condition as it is related to (1) liquidity (2) activity, (3)
debt, (4) profitability, and (5) market. Summarize the company’s overall financial condition.

SOLUTIONS: 23
Liquidity Ratio
 Current ratio = current assets/ current liability

= 72000/69000
= 1.04: 1

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Financial statements and Ratio Analysis
Current ratio for 2015 is 1.04 which is much lower than previous year (1.84) and also lower
than the industry average. (1.8).
 Quick ratio =current assets – Inventory / current liability

= 72000 – 45500/69000
= 26500/69000
= .38:1
Quick ratio is .38 for 2015 which is also lower than previous year and not up to the industry
average level.

Activity Ratio
 Inventory turnover=Cost of goods sold /Inventory

= 106000/45500
= 2.33 times
Activity analysis inventory provides the inventory turnover and average collection period.
Here inventory turnover of Zach industry is 2.33 times which shows that it sold its goods lesser
times than both industry average and previous year’s turnover.

 Average collection period = account receivable/Annual sales/365 days

=25000/160000/365 days
= 25000/438
= 57 days
Average collection period for 2015 is 57 days which means it takes more time to collect
money as compared to both industry average days and previous year`s collection period.

Debt ratio:
 Debt Ratio = Total liability/Total assets

= 69000+22950/150000
= 91950/150000
= .69:1
Debt of Zach industry implies about its debt finance percentage and interest expense coverage
ratio.
Debt ratio for 2015 is 69% which is higher than industry average and previous year`s debts. It
means company has finance most of its assets by taking loan.
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Financial statements and Ratio Analysis
  Times interest earned ratio = Earnings before interest tax/Interest expenses

= 17000/6100
=2.79 times
Times interest earned ability of Zach industry has gone down to 2.79 times as compared to the
times of both 2014 and industry standard.

Profitability Ratio:
 GP margin = Gross profit/ Sales

= 54000/160000
= 33.75%
This ratio says about company`s performance in terms of its net income and gross margin.
Moreover it tells also about how it has earned using its assets and financing through common
shares.

 Net profit margin = Net income/Sales

= 6540/160000
= 4.08%
Here, company’s performance seems to be better off as compared to net margin of industry
average, although gross profit is lesser than industry average.
 Return on total asset = Earning available common stock/ Total asset

= 6540/ 150000
= 4.36%

 Return on equity (ROE) = Earnings available for common stock/ owner`s equity

= 6540/31500+26550
= 6540/58050
= 11.26%
On the other hand, both current year’s return on assets and return on equity is higher than its
standard.

Market Ratio:

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Financial statements and Ratio Analysis
  Book value per share = Common stock equity/No. of common stock

= 58050/3000 stock
= 19.35
This ratio implies to what extent company has been successful in creating value of its
shareholder.

 Market/ book ratio = Market price per share/Book value per share

= 25/ 19.3
= 1.29
Here, Zach industry has made greater value 1.29 as compared to its previous year`s value and
its industry standard value.
Finally we may conclude that Zach industry had a better operating performance during 2012
that facilitates the company to create a higher market price of shares. But company’s risk has
increased in terms of its liquidity to pay off its liabilities since it has financed most of its assets
through debt leverage.

P3–24:Integrative—Complete ratio analysis given the following financial

statements(following and on page 109), historical ratios, and industry averages, calculate
Sterling Company’s financial ratios for the most recent year. (Assume a 365-day year.

Sterling Company Income Statement for the Year Ended December 31, 2012

$10,000,00
Sales revenue 0
Less: Cost of goods sold 7,500,000
Gross profits $ 2,500,000
Less: Operating expenses
Selling expense $300,000
General and administrative expenses 650,000
Lease expense 50,000
Depreciation expense 200,000
Total operating expense $ 1,200,000
Operating profits $ 1,300,00

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Financial statements and Ratio Analysis
 0
Less: Interest expense 200,000
1,100,00
Net profits before taxes $ 0
Less: Taxes (rate = 40%) 440,000
Net profits after taxes $ 660,000
Less: Preferred stock dividends 50,000
Earnings available for common stockholders $ 610,000

Earnings per share (EPS) $3.05

Sterling Company Balance Sheet December 31, 2012

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Financial statements and Ratio Analysis
 Assets

Cash $ 200,000
Marketable securities 50,000
Accounts receivable 800,000
Inventories 950,000
Total current assets $ 2,000,000

Gross fixed assets (at cost) 12,000,000

Less: Accumulated depreciation 3,000,000

Net fixed assets $ 9,000,000

Other assets 1,000,000
Total assets $12,000,000

Liabilities and Stockholders’ Equity

Accounts payable $ 900,000
Notes payable 200,000
Accruals 100,000
Total current liabilities $ 1,200,000
Long-term debt (includes
$ 3,000,000
financial leases)
Preferred stock (25,000 shares,
$2 dividend) $ 1,000,000

Common stock (200,000

shares at $3 par) 600,000

Paid-in capital in excess of

par value 5,200,000
Retained earnings 1,000,000 17 | P a g e
Financial statements and Ratio Analysis
Total stockholders’ equity $ 7,800,000
Total liabilities and
 Thefirm has an 8-year financial lease requiring annual beginning-of-year payments of $50,000.
Five years of the lease have yet to run. Annual credit purchases of $6,200,000 were made during
the year.
The annual principal payment on the long-term debt is $100,000.

On December 31, 2012, the firm’s common stock closed at $39.50 per share

Historical and Industry Average Ratios for Sterling Company

Industry
average,
Ratio Actual 2010 Actual 2011 2012

Current ratio 1.40 1.55 1.85

Quick ratio 1.00 0.92 1.05
Inventory turnover 9.52 9.21 8.60

Average collection period 45.6 days 36.9 days 35.5 days

Average payment period 59.3 days 61.6 days 46.4 days
Total asset turnover 0.74 0.80 0.74
Debt ratio 0.20 0.20 0.30
Times interest earned ratio 8.2 7.3 8.0
Fixed-payment coverage ratio 4.5 4.2 4.2
Gross profit margin 0.30 0.27 0.25
Operating profit margin 0.12 0.12 0.10
Net profit margin 0.062 0.062 0.053
Return on total assets (ROA) 0.045 0.050 0.040
Return on common equity (ROE) 0.061 0.067 0.066
Earnings per share (EPS) $1.75 $2.20 $1.50
Price/earnings (P/E) ratio 12.0 10.5 11.2
Market/book (M/B) ratio 1.20 1.05 1.10
Analyze its overall financial situation from both a cross-sectional and a time-series viewpoint.
Break your analysis of the firm’s liquidity, activity, debt, profitability, and market ratio.
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Financial statements and Ratio Analysis
SOLUTIONS:24
Liquidity Ratio
 Current ratio = current assets/ current liability

=2000000/1200000

=1.67: 1

This ratio is lower than industry average but higher than previous year’s ratio.

 Quick ratio =current assets – Inventory / current liability

=2000000 – 950000/1200000

=.875: 1

This ratio is lower than previous year’s ratio and industry average.

Activity Ratio
 Inventory turnover=Cost of goods sold /Inventory

= 7500000/950000

= 7.89 times

Turnover of goods sold is lesser times than industry average and previous year’s times.

 Average collection period = account receivable/Annual sales/365 days

=800000/10000000/365 days

= 29.2 days

Average collection period is better off as compared to industry and previous year’s
collection period.

 Average payment period = Accounts payable/average purchase/365 days

= 900000/6200000/365 days
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Financial statements and Ratio Analysis
 = 52.98 days

Average payment period is higher than industry average and lower than previous year’s
payment period.

 Total assets turnover = Sales/total assets

= 10000000/12000000

= .83

Company made a higher sales using it’s assts as compared to industry and previous year’s
turnover.

Debt ratio
 Debt Ratio = Total liability/Total assets

= 4200000/12000000

= .35

This ratio has increased comparing it’s industry average and previous year’s position. It
means company resorts to more debt finance.

 Times interest earned ratio = Earnings before interest tax/Interest expenses

= 1300000/200000

= 6.5 times

This times is lower than industry standard and previous year’s coverage ability. It means
company is losing the ability to pay off it’s fixed cost financing expenses.

N. B. Fixed payment coverage ratio is not figured out here.

Profitability ratio:
 Gross Profit margin = Gross profit/ Sales

=2500000/10000000

= .25

This ratio shows that company’s gross margin is more or less satisfactory.

 Operating margin = operating profit/ Sales

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Financial statements and Ratio Analysis
 = 1300000/10000000

= .13

Here, company’s operating margin is showing the uptrend & higher the standard.

 Net profit margin = Net income/Sales

= 610000/10000000

= .061

Net margin is much better than industry standard & having a bit negative trend.

 Return on total asset = Earning available common stock/ Total asset

= 610000/12000000

= .05

This ratio says that company has earned better using it’s total assets in relation to industry
average & trend remains up to the mark.

 Return on equity (ROE) = Earnings available for common stock/ owner`s equity

= 610000/6800000

= .089

This ratio shows that company has earned much better using share finance as compared to
industry average & It’s business trend.

 Earnings per share (EPS) = Earnings available for common stockholders/ number
of share of common stock outstanding

= 610000/200000

= 3.05 Tk.

Company’s earning per share is much higher than industry average & previous year’s earning
which means it will create a bullish image in the minds of investing public.

Market ratio
 Price / Earnings Ratio (P/E)= Market price per share of common stock/Earnings
per share

=39.5/3.05

= 12.95 times
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Financial statements and Ratio Analysis
Here, P/E ratio is better off to the market standard meaning that investors are optimistic about
the future of the company.

 Market/ book ratio = Market price per share/Book value per share

= 39.5/34

= 1.16

 Book value per share = Common stock equity/No. of common stock

= 6800000/200000 shares

= 34 Tk

Her, M/B ratio shows that company has made a positive value of shares which is higher than
standard in relation to it’s market share price.

Conclusion:
Finally it can be said that the liquidity condition of this company is not that much satisfactory
because it has less amount of cash or cash equivalents to meet its current obligations
according to the industry standard.
Moreover, from the activities point of view company has not performed that much well in
terms of its inventory turnover and collection period though it has higher asset turnover`
If we say about profitability company has a greater return over its turnover and also having
satisfactory return using its assets that resulted in higher EPS.
From the market point of view company has made better image since it has higher P/E ratio
and M/B Ratio.
Now we may conclude that though company has performed well in the market with a bullish
image for the investors but its risk has a bit increased to pay off its current obligations .

Review Question 3-1: What roles do GAAP, the FASB and PCAOB play in the financial
reporting activities of public company?

Answer: Every corporation has many and varied uses for the standardized record and reports
of its financial activities. Periodically report must be prepared for regulators, creditors, owners
and management. GAAP, known as generally accepted accounting principles, is the guidelines
used to prepare and maintain financial record and reports.

FASB or financial Accounting Standard Board is a rule –setting body that authorizes this
accounting practice and procedures followed by the corporation.
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Financial statements and Ratio Analysis
PCAOB, Public company Accounting Oversight board is a non- profit corporation that
oversees auditors of public corporations. The PCAOB is charged with protecting the interest of
investors and furthering the public interest in the preparation of informative, fair and
independent audit reports. This organization put an effort to eliminate the many disclosure and
Conflict Of Interest Problem of Corporation and plays a role for the accuracy of the audited
financial statements of public companies.

Question 3-2: Describe the purpose of each of the four major financial
statements.

Answer:

Income Statement:

Income statement provides a financial summary of the firm’s operating results during a
specified period. Most common are income statements covering a 1-year period ending at a
specified date, ordinarily December 31 of the calendar year.

Income statements show the revenue earned during a reporting period. Included in this report
are the expenses and cost of creating the revenue. Once the expenses and costs are removed
from the total revenue, the bottom line of the report reveals whether or not the company lost
money or made money. This report is sometimes referred to as the profit and loss statement.
Another feature of the income statement is the EPS, or earnings per share. This reveals what a
shareholder would receive if you were being paid dividends per each share owned.

Balance Sheet:

Balance sheet presents a summary statement of the firm’s financial position at a given point in
time. An important distinction is made between short-term and long-term assets and liabilities.
Current assets and current liabilities are short-term assets and liabilities. This means that they
are expected to be converted into cash (current assets) or paid (current liabilities) within 1 year
or less.

The balance sheet's purpose is to show the assets of the company. Balance sheets are based on
a fix point called a reporting period—a day, a month, a quarter, a year. A quick glance at a
balance sheet will show you what the company owns and how much it owes. Balance sheets

23 | P a g e
Financial statements and Ratio Analysis
include assets (property, cash, anything owned of value), liabilities (debt owed) and
shareholder's equity.

Statement of Retained Earnings:

Statement of retained earnings reconciles the net income earned during a given year, and any
cash dividends paid, with the change in retained earnings between the start and the end of that
year. Statement of retained earnings is an abbreviated form of the statement of stockholder
equity.

Once liabilities and assets are known and a balance sheet is created, it is known whether or not
the shareholders have a positive or negative equity. From the equity is taken retained earnings.
Retained earnings are broken down and explained in the statement of retained earnings. This
statement reveals what the company keeps and does not distribute to the owners and how that
amount changes over the reporting period. Losses are called accumulated losses, retained
losses or accumulated deficit.

Statement of Cash Flows:

Statement of cash flows is a summary of the cash flows over the period of concern. The
statement provides insight into the firm’s operating, investment, and financing cash flows and
reconciles them with changes in its cash and marketable securities during the period.

Cash on hand is important because it supports the daily activities of a business. There must be
enough cash on hand to pay expenses and buy assets as needed. Cash flow statements

Track the inflow and outflow of cash. They reveal whether or not cash was generated by the
business. The data for a cash flow statement comes from an income statement and the balance
sheet. The cash flow statement reveals net decreases or increases of cash for the reporting
period.

Question 3- 6: What is the difference between cross sectional and time series
ratio analysis? What is benchmarking?

Answer: Cross sectional analysis involves the comparison of different firm’s financial ratios
at the same point in time.

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Time series analysis evaluates performance over time, comparison of current to past
performance using ratios. It enables analyst to assess the firm’s progress. It can develop a trend
using multiyear comparisons.

Frequently, a firm may compare its ratio values with those of a key competitors or group of
competitors that it wishes to emulate. This type of cross sectional analysis called
benchmarking.

Question 3- 12: What is financial leverage?

Answer: The debt position of a firm indicates the amount of other people’s money being
used to generate profit. Creditor’s claims must be met before the earnings can be distributed to
shareholders. In general the more debt a firm uses in relation to its assets, the greater its
financial leverage. The higher the financial leverage the greater will be its risk and return.
Financial leverage is the magnification of risk and return through the use of fixed cost
financing, such as debt and preferred stock.

More specifically financial leverage is the use of borrowed money to increase production
volume and thus sales and earnings. It is measure as the ratio of total debt to total asset. The
greater the financial leverage.

Since interest is a fixed cost(which can be written off against revenue) a loan allows an
organization to generate more earnings without a corresponding increase in the equity capital
requiring increased dividend payments (which cannot be written off against the earnings).
However, while high leverage may be beneficial in boom periods, it may cause serious cash
flow problems in recessionary periods because there might not be enough sales revenue to
cover the interest payments.

Question 3-16: Which measure of profitability is probably of greatest

interest to the investing public? Why?

Answer: The firms earning per share (EPS) is generally of interest to present or prospective
shareholders and management. EPS represents the money earned during the period on behalf of
each outstanding share of common stock. This measure of profitability is considered an
important indicator of corporate success. That is why EPS is closely watched by the investing
public.

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