Understanding Financial Statements

Understanding Financial Statements

CONTENT AREAS

  • What Are the Financial Statements?

  • What Is the Statement of Financial Position?

  • What Is the Statement of Comprehensive Income?

  • What Is the Statement of Changes in Equity?

  • What Is Financial Statement Analysis?

  • Appendix A: XYZ Inc. Financial Statements

LEARNING OBJECTIVES

  1. Statement of Financial Position: Describe the format and items, and explain classification of items.

  2. Statement of Comprehensive Income: Describe its structure.

  3. Statement of Changes in Equity: Describe its purpose and its links with the Statement of Financial Position and Statement of Comprehensive Income.

  4. Financial Ratios: Describe various liquidity, risk analysis, operating performance, and value ratios; evaluate company performance.

  5. Financial Analysis: Explain how to analyze a company’s financial statements using trend analysis and external comparisons.

KEY TERMS

  • Amortization

  • Assets

  • Audit

  • Auditor's report

  • Cash flow from operations/total debt ratio

  • Current assets

  • Current liabilities

  • Current ratio

  • Debt/equity ratio

  • Depreciation

  • Earnings per common share (EPS)

  • Equity

  • Financial statement analysis

  • Fixed assets

  • Gross profit

  • Gross profit margin ratio

  • Interest coverage ratio

  • Inventory turnover ratio

  • Liabilities

  • Liquidity ratio

  • Long-term liabilities

  • Market ratios

  • Net profit margin

  • Operating performance ratios

  • Price-earnings ratio (P/E)

  • Profit

  • Quick ratio

  • Ratio analysis

  • Retained earnings

  • Return on common equity (ROE)

  • Risk analysis ratios

  • Statement of changes in equity

  • Statement of comprehensive income

  • Statement of financial position

  • Trend ratios

  • Value ratios

  • Working capital

  • Working capital ratio

  • Yield

INTRODUCTION

  • This chapter addresses the fundamental analysis of a company, focusing on how mutual fund portfolio managers select securities.

  • The quote highlights the importance of assessing the company’s "true" value relative to market prices.

  • Earnings information forms the basis of stock valuation, where higher future earnings forecasts indicate undervalued shares, leading to price adjustments.

  • Types of information used to assess future earnings include company products, competition, management skills, and employee quality.

  • Financial statements summarize the company’s performance; mastering their analysis is crucial for mutual fund managers.

WHAT ARE THE FINANCIAL STATEMENTS?

  • Financial statements allow companies to report on their performance and are prepared under International Financial Reporting Standards (IFRS).

  • IFRS requires detailed disclosures to promote transparency for investors.

  • Four essential financial statements:     - Statement of Financial Position     - Statement of Comprehensive Income     - Statement of Changes in Equity     - Statement of Cash Flow

  • Focus will be on the first three statements in detail.

WHAT IS THE STATEMENT OF FINANCIAL POSITION?

  • Definition: The statement represents a company’s financial position at a specific date, typically the end of the fiscal year.

  • Key Features:     - Details what the company owns (assets) and owes (liabilities), plus shareholder equity.     - The fundamental accounting equation: Assets = Equity + Liabilities.     - Example from XYZ Inc.: Total assets of $520,000 consist of shareholders’ equity of $240,000 and liabilities of $280,000.

ASSETS

  • Classification:     - Current Assets: Expected to be converted to cash within one year.         - Examples for XYZ Inc.:             - Cash: $20,000             - Inventories: $60,000             - Trade Receivables: $40,000             - Total Current Assets: $120,000     - Fixed Assets: Expected to last longer than one year.         - Examples: Automobiles, factories, etc.         - XYZ Inc. fixed asset value: $400,000 (net plant and equipment, after depreciation).

LIABILITIES

  • Classification:     - Current Liabilities: Due within one year.         - For XYZ Inc.:             - Trade Payables: $20,000             - Notes Payable: $40,000             - Accrued Charges: $20,000             - Total Current Liabilities: $80,000     - Long-term Liabilities: Not typically paid within one year (e.g. debt).         - XYZ Inc. has long-term liabilities of $200,000.

SHAREHOLDERS’ EQUITY

  • Represents funds raised from shareholders and profits retained.     - Split between:         - Common Shares: $40,000         - Retained Earnings: $200,000     - Total Shareholders’ Equity for XYZ Inc.: $240,000.

WHAT IS THE STATEMENT OF COMPREHENSIVE INCOME?

  • Definition: Reflects revenues and expenses over a specific period, typically a year.

  • Structure:     - Sales Revenue: $1,000,000     - Less: Cost of Sales: $600,000 (includes costs of goods and labor).     - Resulting Gross Profit for XYZ: $400,000.

  • Expenses Recorded:     - General and Administrative: $200,000     - Selling Expense: $50,000     - Depreciation: $25,000     - Interest Expense: $20,000     - Taxes: $50,000     - Total Expenses: $345,000

  • Net Profit: $55,000 (     - Earnings per common share: $0.55

WHAT IS THE STATEMENT OF CHANGES IN EQUITY?

  • Links the Statement of Comprehensive Income and Statement of Financial Position regarding retained earnings.

  • Considers profitability retained in the business:     - Starting with retained earnings from previous year: $175,000.     - Plus: Current profit: $55,000.     - Less: Dividends paid: $30,000.     - Ending retained earnings: $200,000.

THE AUDITOR’S REPORT

  • Required by Canadian corporate law for companies to disclose their financial statements' fairness.

  • Comprises four sections:     - Introductory section identifying covered financial statements.     - Management’s financial statement responsibilities.     - Auditor's responsibilities and methodology.     - Auditor’s opinion on fairness of statements per IFRS.

WHAT IS FINANCIAL STATEMENT ANALYSIS?

  • Fundamental for mutual fund managers; entails evaluating and interpreting financial statements.

RATIO ANALYSIS

  • Common tool in situating a company's financial health by determining relationships between quantities.     - Example: A company with $100,000 in current assets and $50,000 in current liabilities exhibits a 2:1 current ratio.

TYPES OF RATIOS

  • Liquidity Ratios: Assess the ability to meet short-term commitments.     - Common ratio: Current Ratio: Current Assets / Current Liabilities.

  • Risk Analysis Ratios: Determine how well a company handles debt obligations.     - Example: Debt/Equity Ratio.

  • Operating Performance Ratios: Evaluate managerial efficiency and resource use.     - Example: Return on Common Equity (ROE).

  • Value Ratios: Indicate share valuation based on company finances.     - Example: Price-Earnings Ratio (P/E).

LIQUIDITY RATIOS

  • Evaluate conversion of current assets to cash for meeting current liabilities:

  • WORKING CAPITAL RATIO OR CURRENT RATIO:     - Formula: racextCurrentAssetsextCurrentLiabilitiesrac{ ext{Current Assets}}{ ext{Current Liabilities}}     - XYZ’s current ratio: racextextdollar120,000extextdollar80,000=1.5:1rac{ ext{ extdollar}120,000}{ ext{ extdollar}80,000} = 1.5:1

  • QUICK RATIO (THE ACID TEST): Subtracts inventories from current assets:     - Formula: racextCurrentAssets−extInventoriesextCurrentLiabilitiesrac{ ext{Current Assets} - ext{Inventories}}{ ext{Current Liabilities}}     - XYZ’s quick ratio: rac120,000−60,00080,000=0.75:1rac{120,000 - 60,000}{80,000} = 0.75:1

RISK ANALYSIS RATIOS

  • Assess the weight of debt versus equity.

  • DEBT/EQUITY RATIO:     - Formula: racextTotalShort−andLong−TermDebtextTotalEquityrac{ ext{Total Short- and Long-Term Debt}}{ ext{Total Equity}}     - XYZ’s debt/equity ratio: rac40,000+200,000240,000=1:1rac{40,000 + 200,000}{240,000} = 1:1

CASH FLOW FROM OPERATIONS/TOTAL DEBT RATIO

  • Reflects ability to meet debt obligations:     - Here, cash flow from operations is defined as:       - Cash Flow From Operations = Profit + Non-Cash Deductions - Non-Cash Additions.     - XYZ’s ratio calculation: rac55,000+25,000240,000=0.33:1rac{55,000 + 25,000}{240,000} = 0.33:1

INTEREST COVERAGE RATIO

  • Indicates ability to cover interest expenses:     - Formula: racextEarningsBeforeInterestandTaxesextTotalInterestChargesrac{ ext{Earnings Before Interest and Taxes}}{ ext{Total Interest Charges}}     - XYZ’s coverage is rac(55,000+50,000+20,000)20,000=6.25exttimesrac{(55,000 + 50,000 + 20,000)}{20,000} = 6.25 ext{ times}

OPERATING PERFORMANCE RATIOS

  • Measure management's effectiveness with company resources:     - GROSS PROFIT MARGIN RATIO:         - Formula: racextGrossProfitextRevenuerac{ ext{Gross Profit}}{ ext{Revenue}}         - XYZ's ratio: rac400,0001,000,000=0.4ext(or40ext%)rac{400,000}{1,000,000} = 0.4 ext{ (or 40 ext{\%})}     - NET PROFIT MARGIN:         - Formula: racextNetProfitextRevenuerac{ ext{Net Profit}}{ ext{Revenue}}

VALUE RATIOS

  • Assess market perceptions of company shares by manipulating ratios available:     - EARNINGS PER COMMON SHARE (EPS):         - Formula: racextProfitextNumberofCommonSharesOutstandingrac{ ext{Profit}}{ ext{Number of Common Shares Outstanding}}     - XYZ’s EPS: rac55,000100,000=0.55rac{55,000}{100,000} = 0.55     - DIVIDEND YIELD: Annual dividends as a percentage of current market price:         - Formula: racextAnnualDividendperShareextCurrentMarketPricerac{ ext{Annual Dividend per Share}}{ ext{Current Market Price}}     - P/E RATIO:         - Formula: racextCurrentPriceofCommonShareextEarningsperSharerac{ ext{Current Price of Common Share}}{ ext{Earnings per Share}}         - Example for XYZ at ** ext{ extdollar}5**: rac50.55ightarrow9.1rac{5}{0.55} ightarrow 9.1

TREND AND EXTERNAL COMPARISONS

  • TREND ANALYSIS: Helps evaluate changes in financial performance over time; compare ratios year over year.

  • EXTERNAL COMPARISONS: Essential for contextualizing results; comparing similar firms aids in performance assessments.

SUMMARY OF KEY POINTS

  1. Statement of Financial Position: Shows the company's assets, liabilities, and equity.

  2. Statement of Comprehensive Income: Reflects total revenues and expenses over a designated timeframe.

  3. Statement of Changes in Equity: Highlights retained earnings development during the fiscal year.

  4. Financial Ratios: Include key liquidity, risk analysis, operating performance, and value ratios to assess company performance.

  5. Use trend and external comparisons for broader financial analysis.