MSO402: INTRODUCTION

TO FINANCIAL
MANAGEMENT

F I N A N C I A L A N A LY S I S
TECHNIQUES &
ACCOUNTING

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Financial Statements

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Financial Information of Business during a given period
Utilization of Funds
(i) Fixed Assets Arrangement of Funds
Land& Building, Plant &
Machinery, Equipment Owners’ Equity (+) Outsiders’
Equity (Liabilities)
(+)
(ii) Current Assets
Inventories + Receivables +
Debtors (Credit Sales) + Cash FAs convert CAs to generate Sales
Revenue during a period

At the end of the period:

CASH RM Inv
1) Compute the Income –
Income Statement
2) Financial status of the firm – Operating
Statement of changes in Cycle
Owners’ Equity & Debtors WIP Inv
Balance sheet
3) Cash flows during the
FIN Inv
period – Cash Flows
Statement
 Accounting representation of the firm
• Finance is primarily concerned with market values, but accounting data (or book
values) are often used in their place.
• Financial statement:
• Income statement: Income statement reports the firm’s revenues, costs and
profits over a particular period. It gives insights into the size and profitability
of the firm’s operations.

• Balance sheet: It gives the firm’s assets (liabilities and equity or what the firm’s
capital is invested in) and the claims against these assets.
• It gives insights into the resources the firms has at its disposal and the
firm’s financial structure.

• Statement of Changes in Equity explains the changes in equity including share

capital due to retained earnings & in some cases (for Sole Proprietorship firm)
due to Drawings also.

• Cash Flow Statement summarizes the cash inflows and outflows of the
enterprise resulting from its operating, investing and financing activities
during a period.

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 Major Account categories

Accounts are the categories into which the effects of

transactions are recorded & from which different financial
reports are created.

Income Operations
(Income
Statement)
Expenses

Assets
Financial
Liabilities Position
(Balance Sheet)
Owner’s Equity
Accrual Basis of Accounting
• Financial Accounts especially the Income Statement and Balance
Sheet are prepared using the Accrual Basis of Accounting.
• It relies on two concepts: Revenue Recognition and Matching
concepts.

• Accrual accounting measures the effects of transactions and

events in the periods when they occur. In contrast, cash-basis
accounting recognizes only cash receipts and disbursements.

• Example: recognition of interest expense or revenue (or wages,

salaries, or rent) at the end of a period even though the firm
makes no explicit cash transaction at that time.

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Accrual Basis of Accounting
• Adam-Art Supply recognizes for January 20XX, the entire Rs
1,40,000 of sales during January as revenue, even though it has
received Rs 1,14,000 in cash by the end of January. The firm
reasonably expects to collect the remaining accounts receivable of Rs
26,000 in Feb. The merchandise sold during Jan costs Rs 42,000. Of
the advance rental payments of Rs 14,000, only Rs 7,000 applies to
the costs of benefits consumed during Jan. Similarly for salaries, the
expense incurred is Rs 25,000.

• What would be income using both cash and accrual basis?

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Income Statement in Million (Rupees)
Revenue 100
Costs of goods sold 70
other costs 10
EBIT 20
Taxes 4
Interest expense 5
Earnings 11

Number of share 2 million@32

 Income Statement
Company Name
For the Time Period & Ending Date
• Net sales = Gross sales - (Returns and Allowances)
• Less, Cost of goods sold (COGS) = certain direct costs incurred for a
product, when is manufactured or sold (for Service firms, it is Cost of
Sales)
• Gross profit
• Less, Operating expenses = normal expenses other than
COGS(management salaries, advertising expenditures, repairs &
maintenance costs, research & development expenditures, lease
payments, and general & administrative expenses)
• Add, Non-Operating Incomes = (Income from investment made
outside the business)
• Operating profit
• Less, Depreciation & Interest expense
• Profit before taxes
• Less, Taxes
• Net income
Balance Sheet (annual average in millions)
Current Assets
Cash 2
Marketable securities 1
Receivables 3
Inventory 9
Total Current assets 15
Total long-term assets 175
Total assets 190

Current liabilities 5
Long-term debt 95
Total debt 100

Owner's Equity 90
Balance Sheet Relations

• Total Assets = NCA + CA •

• Net Current Asset = CA - CL •
• Net Assets = Net Fixed Assets + Net Current Assets •
• Capital employed is the sum of net worth or equity(E) and
borrowing/ debt(D) and it is equivalent of net assets:
• CE = Net worth + Borrowing = E + D CE = Net Assets

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Balance Sheet Examples

• Heckle Group began operations as an engineering consulting

firm, on June 1, 2018. On that date it issued 100,000 shares of
common stock for €920,000. During June, Heckle used
€600,000 of the proceeds to purchase office space and office
equipment. It acquired a patent for €120,000, agreeing to pay
the seller within 30 days. On June 30 Heckle signed a bank loan
for €400,000, bearing interest at 8% per year and payable in full
on June 30, 2021. Prepare, in good format, Heckle’s balance
sheet as of June 30, 2018.

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 Balance Sheet Examples
• Selected balance sheet amounts for Dragon Group International Limited, a
diversified electronics firm in Singapore, appears next, as of December 31,
2020, and December 31, 2019. Dragon Group International reports all
amounts in millions of Singapore dollars ($). Compute the missing amounts
for the two year.

2020 2019
Total Assets $199,824 ?
Noncurrent Liabilities 7,010 ?
Noncurrent Assets ? $ 17,368
Total Liabilities and Shareholders' Equity ? ?
Total Liabilities and Shareholders' Equity ? ?
Current Liabilities 139,941 126,853
Shareholders' Equity ? 53,721
Total Liabilities ? ?
Current Assets 170,879 170,234

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Income Statement Examples

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 Cash Flow Statement

• Comprising of cash flows from three specific activities & the statement is
prepared from the inputs received from Accrual basis accounting
statements (i.e. IS & BS)

1. Operating Activities
2. Investing Activities
3. Financing Activities

• In the Statement of Cash flow, the opening cash balance is

adjusted with the net flows from these three activities to identify
the closing cash balance (as reflected in the Balance Sheet).
Cash Flow Classification
Cash Flow Classification
Cash Flow Classification Example
 Identify the effect of each transaction on Cash Flow
Statement

• Amortization of a patent, treated as an expense, Rs 600.

• Acquisition of a factory site financed by issuing capital stock with a market value
of Rs 50,000 in exchange.
• Purchase of inventory on account for Rs12,500.
• Purchase of inventory for cash of Rs 6,000.
• Uninsured fire loss of merchandise inventory totaling Rs1,500.
• Collection of an account receivable totaling Rs1,450.
• Issue of bonds for Rs10,000 cash.
• Disposal of equipment for cash at its carrying value of Rs4,500 for Rs6,000.
Ratio Analysis

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Profitability Ratio
• Rate of return on assets (ROA)
• Rate of return on common shareholder’s equity (ROE)
• Earnings per share of common stock.
• Maruti Suzuki India Profit & Loss account, Maruti Suzuki India
Financial Statement & Accounts (moneycontrol.com)

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ROA
• It measures a firm’s performance in using assets to generate net income
independent of how the firm financed the acquisition of those assets.
• The calculation of ROA is as follows:
• ROA = (Operating Income – Income tax on interest expense) / Average Total
Assets
• ROA answers the question: how well has the firm done in conducting its
operations independent of financing costs.
• ROA has particular relevance to the lenders, or creditors, of a firm.
• Common shareholders find ROA useful in assessing financial leverage.

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Dis-aggregating ROA

ROA

Profit Margin for Asset Turnover

ROA Ratio

( (%))
= =

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 ROA
• Recent annual reports of CBRL Group (Cracker Barrel) and McDonalds Corporation
(McDonalds) reveal the following (amounts in millions).
Cracker Barrel ($) McDonalds ($)
Revenue 2,352 22,787
Interest Expense 59 417
Net Income 76 2,335
Average Total Assets 1,473 29,183

• Cracker Barrel operates a chain of restaurants featuring value-priced country meals.

Cracker Barrel owns all of its restaurants. McDonalds operates McDonalds, Boston
Market, and Chipotle Mexican Grill restaurants worldwide through both company owned
and franchised units. McDonalds owns the land and buildings of most of its franchised
restaurants and leases the space to the franchisees. The income tax rate is 35%.
a. Calculate the rate of return on assets for each company.
b. Disaggregate the rate of return on assets in part a into profit margin for ROA and total
assets turnover components.
c. Comment on the relative profitability of the two companies.

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ROE
• It measures a firm’s performance in using and financing assets to generate
earnings.
• The calculation of ROE is as follows:
• ROE = (Net Income - Dividends on Preferred Stock) / Average Equity
• This measure of profitability incorporates the results of operating, investing,
and financing decisions.

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 Dis-aggregating ROE

ROE

Profit Margin for Asset Turnover Leverage Ratio

ROE Ratio

= =
=

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EPS
• Earnings per share equals net income attributable to common stock divided by the average
number of common shares outstanding during the period.
• Basic EPS
• Diluted EPS: Convertible bonds and convertible preferred stock permit their holders to
exchange these securities directly for shares of common stock. When holders convert their
securities or when employees exercise their options, the firm will issue additional shares of
common stock.
• Criticism: Two firms with the same earnings and earnings per share will differ in profitability if
one of the firms requires more assets to generate those earnings than does the other firm.
• Variant is the Price/ Earnings ratio.

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Analysis of Risk

• Various factors affect the risk of business firms:

• Economy-wide Factors
• Industry-wide Factors
• Firm-specific Factors
Analysts assessing risk generally focus on the relative liquidity of a firm. Liquid resources
provide a firm with financial flexibility. Assessing liquidity requires a time horizon and
consider 3 questions:
• Does a firm have sufficient cash to repay a loan due tomorrow?
• Will the firm have sufficient cash to repay the same loan due in six months?
• Will the firm have sufficient cash to repay the same loan due in five years?

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Measures of Short-term Liquidity Risk
• Current Ratio = CA/ CL
• Quick Ratio = (CA- Inventory – Prepaid Expenses)/ CL
• Working capital turnover ratios.
Days inventory held = 365/ Inventory Turnover Ratio
Days accounts receivable outstanding = 365/Accounts Receivable Turnover Ratio
Days accounts payable outstanding =365/ Accounts Payable Turnover Ratio

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Measures of Long-term Liquidity Risk
Debt Ratio
Liabilities to Assets Ratio = Total Liabilities/Total Assets
Long-Term Debt Ratio = Long-Term Debt/Total Assets
Debt-Equity Ratio = Long-Term Debt/Shareholders’ Equity
• Interest Coverage Ratio = income before interest and income tax expenses/ interest
expense.

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Question
• Analyse the profitability
position of the companies. Use
the dis-aggregated analysis to Ratios Company A Company B
emphasize on the differences ROA (%) 9.7 9.68
that you encounter between
ROE(%) 13.28 14.61
the companies.
Current Ratio 0.58 2.47
• The two companies are Maruti
Debt to Equity 0.02 0.19
Suzuki and Wipro. Which of the
Ratio
companies corresponds to A
and B? What is the reason for Asset Turnover 1.49 0.7
your conclusions? Ratio
Inventory 11.94 0.00
Turnover Ratio
Price/BV 4.05 2.58
Asset/ Equity 1.37 1.51

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 Question
• The current year gross profit of X Ltd. is Rs.8,00,000. This is one-
fourth of the year’s sales. Out of total sales, three-fourth is on credit.

• The inventory turnover is 10 times and the average collection period

is 15 days (assume 360 days a year).

• Total assets turnover is 4 times & the long-term debt to equity is

50%. Shareholder’s equity is Rs.4,00,000. The current ratio is 2:1.

• Find out: (i) Debtors, (ii) long-term debt, (iii) cash-in-hand, (iv)
creditors, (v) closing stock, (vi) fixed assets. Also prepare the balance
sheet of X ltd. for the current year.

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• Calculate the following ratios
1. Current ratio
2. Quick ratio
3. Cash ratio
4. Asset turnover ratio
5. Inventory turnover ratio
6. Debt/asset ratio
7. Equity multiplier
8. Times-Interest-Earned Ratio
9. Net profit margin
10. ROE
11.Earning Yields
12. PE ratio
• Current ratio = currents assets /current liabilities
• Measures short-term debt paying ability

• Quick ratio = (cash + marketable securities + receivables)/current

liabilities
• A refined measure of the short-term debt-paying ability of the firm.
• Measures short-term solvency

• Cash ratio = (cash + market securities)/current liabilities

• This ratio shows the company's ability to repay its short-term debt.

• Asset turnover ratio: Revenue/assets

• This ratio shows how efficiently a company can use its assets to
generate sales.
• Inventory turnover ratio= cost of goods sold/inventory
• Evaluation of efficiency in producing and selling goods and
adequacy of controls on inventory holding.

• Debt to asset ratio = total debt/total assets

• Depicts extent of total debt financing in business.

• Equity multiplier = Assets/Equity

• It measures financial leverage.
• Companies finance their operations with equity or debt, so a high
equity multiplier indicates that a larger portion of asset financing
is attributed to debt.
• Times-interest-earned (TIE) ratio = EBIT/(Interest Expense)
• company's ability to meet its debt obligations.
• The interest expense includes the total interest payable on bonds
and other contractual debt.
• TIE indicates how many times a company can cover its interest
charges on a pre-tax earnings basis.

• Net profit margin = Earnings/Revenue

• It shows how much of each dollar collected by a company as
revenue translates into profit.
• RoE = Total Earnings/Total equity
• Return on equity measures a corporation's profitability by
revealing how much profit a company generates with the money
shareholders have invested.

• Earning yield = earnings per share/price per share

• The earnings yield (which is the inverse of the P/E ratio) shows
the percentage of each dollar invested in the stock that was
earned by the company.

• Price-Earnings Ratio (P/E Ratio) = price per share/earnings per share

• It shows the rupee amount an investor can expect to invest in a
company in order to receive one rupee of that company’s
earnings.
• Current ratio = currents/current liabilities = 15/5=3
• Quick ratio = (cash + marketable securities + receivables)/current
liabilities =6/5=1.2
• Cash ratio = (cash + market securities)/current
liabilities=3/5=0.6
• Asset turnover ratio: Revenue/assets=100/190=0.53
• Inventory turnover ratio= cost of goods
sold/inventory=70/9=7.78
• Debt to asset ratio = total debt/total assets = 100/190 = 0.53
• Equity multiplier = Assets/Equity = 190/90=2.11
• Times-interest-earned ratio = EBIT/(Interest Expense) = 20/5=4
• Net profit margin = Earnings/Revenue = 11/100=0.11
• RoE = Total Earnings/Total equity = 11/90=0.12
• Earning yield = earnings per share/price per share
=(11/2)/32=0.17
• P/E ratio = price per share/earnings per share = 32/(11/2)=5.82
• In the corporate finance, we analyse four types of ratios
• Liquidity Ratios: They measure the firm’s ability to meet current
obligations.

• Leverage Ratios: These ratios show the proportion of debt and

equity in financing the firm’s assets.

• Activity Ratios: They reflect the firm’s efficiency in utilising the

assets.

• Profitability Ratios: These ratios measure overall performance and

effectiveness of the firm.
• Liquidity Ratios:
• Current Ratio
• Quick Ratio
• Cash ratio
• Leverage ratio
1. Debt-Equity Ratio
• Total debt/total equity or total long-term debt/net worth
• Net worth = Equity share capital + preference share capital +
reserves and surpluses

2. Debt-Equity Ratio
• Total debt ratio: Total debt/ total assets

= Long-term debts + Current liabilities/Total debts + Net worth

3. Interest Coverage ratio: The interest coverage ratio is used to test

the firm’s debt-servicing capacity.
Interest coverage = EBDIT/Interest
The higher the IC ratio, better it is both for the firm and lenders.
• Activity Ratios
• Inventory turnover ratio is also known as stock turnover ratio
• Inventory Turnover Ratio = Cost of goods sold/Average inventory at
cost
• Average inventory = Opening stock + closing stock/2
• Costs of goods sold: Opening stock + Purchases – Closing stock
= Net Sales – Gross profit

• A higher ratio is an indication that the firm is moving the stocks

better so profitability, in such a situation, would be more.
• Days of Inventory holdings:
• Number of days of inventory holdings = 360/Inventory turnover ratio

• Total Assets Turnover Ratio

• Sales/ total assets
The idea is that if the firm manages the assets more efficiently, sales would be more
and equally profits would be up
• Profitability ratios:
• Gross Profit Ratio = Sales-cost of goods sold*100/sales
• Gross profit*100/Sales

• Net Profit Ratio = [Profit after tax/Sales]*100

• Net profit is obtained, after deducting operating expenses,
interest and taxes from gross profit

• Operating Expenses Ratios: To identify the cause of fall or rise in

net profit, each operating expense ratio is to be calculated
• Operating expense ratio = Operating expense/Sales
• Return on Total Assets: EBIT/Total Assets

• Return on Equity = Profit after tax – Preference dividend/Equity

shareholders funds

• Earnings per Share = Net profit after tax preference

dividend/Number of equity shares outstanding

• Price Earnings Ratio = Market price per equity share/Earnings

per equity share