chapter 14
DESCRIPTION
TRANSCRIPT
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CHAPTER 14
ACCOUNTING & FINANCIAL ANALYSIS
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LEARNING OBJECTIVES
1. Explain how firms use accounting.
2. Explain how to interpret financial statements.
3. Explain how to evaluate a firm’s financial condition.
Main ResourcesThe Importance
of Financial Statements
Income StatementBalance SheetRatio Analysis
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INTRODUCTION
Accounting is the summary of a company’s financial activities
The process of accounting ends with a set of financial statement
Financial statement provides detailed information about a company’s recent performance and its financial condition.
Managers use this information to evaluate the company’s strengths and weaknesses so that it can capitalize the strengths and make corrective actions if there are deficiencies.
This chapter focuses on how the accounting and the financial analysis functions can be used by companies to maximise its value
Main ResourcesThe Importance
of Financial Statements
Income StatementBalance SheetRatio Analysis
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THE IMPORTANCE OF ACCOUNTING
Accounting provides financial information of an organization.
The process starts with bookkeeping where daily or weekly transactions are recorded.
The end product of accounting cycle is the production of financial statements
The financial statements are important for: Reporting Decision making Controlling.
Main ResourcesThe Importance
of Financial Statements
Income StatementBalance SheetRatio Analysis
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REPORTING
Firms need to report all relevant financial activities accurately in accordance with “generally accepted accounting principles” (GAAP), Malaysia Accounting Standard Board (MASB) and International Accounting Standards (IAS).
The use of common set guidelines allows for more consistency in reporting practices among firms and consequently meaningful comparison can be made between firms.
Main ResourcesThe Importance
of Financial Statements
Income StatementBalance SheetRatio Analysis
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DECISION MAKING
Accounting data provides financial information to support decision making.
Eg: financial manager uses past data for budgeting decisions and anticipate future financing needs.
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CONTROLLING
Financial information helps managers to monitor and control the performance of individuals, departments and products.
This is done by evaluating and reviewing the financial statements.
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UNDERSTANDING FINANCIAL STATEMENTS Main components of financial statement
Income statement
Balance sheet Before analysing and interpreting the
financial statement, it is important to understand the information reported in both income statements and balance sheet.
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INCOME STATEMENT
Reports revenue, expenses and income or loss made during the accounting period which is usually one year. Net sales Cost of goods sold Gross profit
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INCOME STATEMENT
Operating expenses Interest expense Earning before interest and tax Net income
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BALANCE SHEET
Reports asset, liability and equity of firms. Assets = Liabilities + Owner’s Equity Assets
Current assets Fixed assets
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BALANCE SHEET
Liabilities Short term liabilities Long term liabilities
Owner’s equity
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RATIO ANALYSIS One of the tools that is used by financial managers
to assess the financial condition of the firm. It evaluates the relationship between financial
statement variables. It is used to compare current performance with past
performance to evaluate the impact of any financial decision implemented (internal analysis).
It is also used to compare the current performance within the industry to evaluate the standing of a particular firm to the ratios of industry average.
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RATIO ANALYSIS (cont.)
Ratio can be categorized into four main categories as follows: Liquidity Efficiency Financial leverage Profitability
The following is the financial statement of Kayu Kayan Bhd.
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Kayu Kayan BhdIncome Statement for the year ended 31 December
2007 RM
Net sales 700,000Cost of goods sold (500,000)Gross profit 200,000
Selling expenses 100,000General & administrative expenses 30,000Total operating expenses (130,000)Earning before interest & taxes (EBIT) 70,000
Interest expenses 10,000Earning before taxes 60,000
Income taxes (27%) 16,200Net income 43,800
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Kayu Kayan BhdBalance Sheet as at 31 December 2007
RM
Assets
Current assets:
Cash 17,000
Marketable securities 7,200
Accounts receivables 38,000
Inventory 93,000
Total current assets 155,200
Fixed Assets:
Net plant & equipment 290,000
Less: Accumulated depreciation 29,000
Net fixed asset 261,000
Total Assets 416,200
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Kayu Kayan BhdBalance Sheet as at 31 December 2007 (cont.) RM
Liabilities & Shareholders’ Equity
Current liabilities:
Accounts payable 55,000
Notes payable 13,000
Total current liabilities 68,000
Long-term debt 100,000
Owners’ equity:
Common stock 200,000
Retained earnings 48,200
Total owners’ equity 248,200
Total liabilities & owner’s equity 416,200
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Required Calculate all four categories of ratio (ie: liquidity,
efficiency, leverage and profitability). Evaluate the overall financial performance of Kayu
Kayan Bhd
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Liquidity Ratios
1. Current ratio
= current assets
current liabilities
= 155,200
68,000
= 2.28
Industry average = 3.00
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Liquidity Ratios
2. Quick ratio
= current assets - inventories
current liabilities= 155,200 – 93,000
68,000
= 0.91
Industry average = 1.50
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Efficiency Ratios
1. Inventory turnover
= cost of goods sold
inventory
= 500,000
93,000
= 5.37
Industry average = 6.50
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Efficiency Ratios2. Average collection period
= accounts receivable
daily credit sales
= 38,000
700,000/360 days
= 19.55 days
Industry average = 15 days
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Efficiency Ratios3. Fixed asset turnover
= Net sales
Fixed assets
= 700,000
261,000
= 2.68
Industry average = 2.8
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Efficiency Ratios4. Total assets turnover
= Net sales
Total assets
= 700,000
416,200
= 1.68
Industry average = 1.5
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Financial Leverage Ratios
1. Debt ratio
= total debt
total assets
= 168,000
416,200
= 0.40
Industry average = 0.30
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Financial Leverage Ratios
2. Times interest earned
= Earnings before interest & taxes (EBIT)
Annual interest expense
= 70,000
10,000
= 7 times
Industry average = 7.5 times
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Profitability Ratios
1. Net profit margin
= Net income x 100
Net sales
= 43,800 x 100
700,000
= 6.26%
Industry average = 7%
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Profitability Ratios
2. Return on assets
= Net income x 100
Total assets
= 43,800 x 100
416,200
= 10%
Industry average = 10.5%
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Profitability Ratios
3. Return on equity
= Net income x 100
Owners’ equity
= 43,800 x 100
248,200
= 18%
Industry average = 15%
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Summary Liquidity Ratios
Current ratio Quick ratio
Efficiency Ratios Inventory turnover Average collection period Fixed asset turnover Total assets turnover
Financial Leverage Ratios Debt ratio Times interest earned
Profitability Ratios Net profit margin Return on assets Return on equity
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LIMITATIONS OF RATIO ANALYSIS
Comparison with industry average is difficult for firms with various kind of industries.
Different operating and accounting practices among firms make comparison difficult.
Seasonal factors may distort ratios.
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SUMMARY
In this chapter we have:1. Discussed the importance of accounting and financial
statements to a company.
2. Discussed how to evaluate the performance of a firm using ratio analysis.
3. Discussed the limitations of ratio analysis