Revised Chapter 2 Financial Statements and Corporate Finance
Revised Chapter 2 Financial Statements and Corporate Finance
Revised Chapter 2 Financial Statements and Corporate Finance
Financial statement disclosures provide internal and external business stakeholders with
additional information regarding a company’s financial operations. Small businesses do not
usually have significant disclosures for their financial statements. Larger business organizations
often use disclosures to provide additional information to lenders and investors. Disclosures can
be required by generally accepted accounting principles or voluntary per management decisions.
Accounting Changes
Companies must often alert business stakeholders regarding changes to accounting policies.
Inventory valuation, depreciation methods, application of GAAP(Generally Accepted
Accounting Principles) in similar accounting changes required disclosures. These disclosures
alert stakeholders to why financial information may suddenly look different on the company’s
financial statements. Disclosures may be simple statements regarding the change or provide a
lengthy explanation for the reason to change the company’s accounting policies and procedures.
Accounting Errors
Accounting errors usually require companies to inform stakeholders via a financial statement
disclosure. Errors can result from a variety of reasons. Transposing numbers, mathematical
computation, incorrect application of GAAP or failing to revalue assets using fair market value
are a few accounting errors. Companies may need to correct previous financial statements to
accurately reflect the company’s financial position for previous accounting periods. Significant
accounting errors can result in financial audits and possible bankruptcy by the company.
Reports about a company’s performance must be understandable and accurate. GAAP together
with international reporting standards provide a common set of rules and a standard format for
public companies to use when they prepare their reports.
This standardization also makes it easier to compare the financial results of different companies.
Investors need assurance that financial statements are prepared well
Financial statements provide a picture of the performance, financial position, and cash flows of a
business. These documents are used by the investment community, lenders, creditors, and
management to evaluate an entity. There are four main types of financial statements, which are
as follows:
Page 1 of 17
Income statement. This report reveals the financial performance of an organization for the
entire reporting period. It begins with sales, and then subtracts out all expenses incurred
during the period to arrive at a net profit or loss. An earnings per share figure may also be
added if the financial statements are being issued by a publicly-held company. This is
usually considered the most important financial statement, since it describes performance.
Balance sheet. This report shows the financial position of a business as of the report date
(so it covers a specific point in time). The information is aggregated into the general
classifications of assets, liabilities, and equity. Line items within the asset and liability
classification are presented in their order of liquidity, so that the most liquid items are
stated first. This is a key document, and so is included in most issuances of the financial
statements.
Statement of cash flows. This report reveals the cash inflows and outflows experienced by
an organization during the reporting period. These cash flows are broken down into three
classifications, which are operating activities, investing activities, and financing
activities. This document can be difficult to assemble, and so is more commonly issued
only to outside parties.
Statement of changes in equity . This report documents all changes in equity during the
reporting period. These changes include the issuance or purchase of shares, dividends
issued, and profits or losses. This document is not usually included when the financial
statements are issued internally, as the information in it is not overly useful to the
management team.
RATIO ANALYSIS
Page 2 of 17
lenders-lenders could be long-term or short-term lenders. They could be trade creditors, banks
or bondholders. They are interested in the liquidity of the firm which affects the perceived risk of
the firm.
Potential investors-an analysis of the firms profitability and risk would influence the decision
on whether to invest in a company’s stock or not they will make this decision by gauging the
expected return on their investment whether its in terms of a share price gain(capital gain) or
dividends.
The government-the government is mostly interested in a company’s tax liability. In the case of
government owned corporations, it will be concerned in the survival and the continued ability of
the company to provide the services it’s charged with providing especially for public utilities.
The company’s management-they are interested in the efficiency of the company in generating
profits. The company’s general performance is often regarded as a reflection of the
management’s effectiveness. The gearing ratios, profitability, liquidity and investor ratios are
important for decision making.
Competitors-they use financial statements for comparison to see their competitive strength.
Consumers and potential consumers-they are interested in the company’s ability to continue
providing for them the goods or services they require.
Hence the financial statement analysis serves to aid the above groups of people in decision
making.
Use of financial ratios
1. for evaluating the ability of the firm to meet its short term financial obligation as and
when they fall due
2. To interpret the performance of the firm over the period covered by the financial
statements.
3. For comparison of the performance of the firm this can be done in the following ways
(a) Cross sectional analysis-the performance of the firm in question is compared with
that of individual competitive firms in the same industry.
(b) Trend/time series analysis-the firm’s performance is evaluated over time.
4. For predicting future performance of the firm.
5. To establish the efficiency of assets utilization to generate sales revenue
6. To establish the extent which the assets of the firm has been financed by fixed charge
capital.
Limitations of financial ratios
1. Ratios are computed at a specific point in time.
Page 3 of 17
2. Ratios ignore the effect of inflation in performance which is a vital part in the daily
business management
3. The comparison between firms is often done even for firms with differences in size and
technology
4. Ratio analysis engages the use of historical data contained in financial statements which
may be irrelevant in decision making.
5. The different accounting policies applied by firms in similar industries say in
depreciation calculation is a hindrance to comparison.
Types of ratios
Ratios are broadly classified into 5 categories
Liquidity ratios
Efficiency/turnover ratios
Profitability ratios
Gearing ratios
Investor ratios
1. Liquidity ratios
Liquidity refers to an enterprise's ability to meet its short-term obligations as and when
they fall due. Liquidity ratios are used to assess the adequacy of a firm’s working capital.
Shortfalls in working capital may lead to inability to pay bills and disruptions in
operations, which may be the forerunner to bankruptcy. They are also known as working
capital ratios. They are;
This ratio indicates the number of times the current liabilities can be paid from current
assets before these assets are exhausted. It is recommended that the ratio be at least 2.0
i.e. the current assets must be at least twice as high as current liabilities.
Page 4 of 17
(b) Quick/acid test ratio = Current assets- Stock
Current liabilities
It is a more refined ratio than the current ratio in which the stocks are excluded as they
may not be easily converted to cash. The ratio indicates the firm’s ability to pay the
current liabilities from the more liquid assets of the firm.
2. Turnover ratios
They are also known as efficiency or activity ratios. They indicate the efficiency with
which the firm has utilized the assets or resources to generate sales revenue/turnover.
Activity ratios can be categorized into two groups: The first group measures the activity
of the most important current accounts, which include inventory, accounts receivable, and
accounts payable1. The second group measures the efficiency of utilization of total assets
and fixed assets.
Stock/inventory turnover = Cost of sales
Average stock
It indicates the number of times the stock was turned into sales in the year. The higher the
ratio, the better the firm and the higher the sales. A low stock turnover ratio indicates that
the stock levels are either very high or they are slow moving this leads to a reduction in
the firms profitability.
Note: the average stock is the average of the opening and closing stock.
Page 5 of 17
Debtors turnover = Annual credit sales
Average debtor
This ratio indicates the number of times debtors come to buy on credit after paying their
dues to the firm. If the rate is high the better the firm as it means they bought many times
hence meaning they paid within a shorter time. The average debtor is the average of the
opening and closing debtor balances. If no opening debtors are given use the closing
debtors to represent average debtors.
Page 6 of 17
Profitability ratios
Profitability ratios evaluate the firm’s earnings with respect to a given level of sales, a
certain level of assets, the owner’s investment, or share value. Evaluating the future
profitability potential of the firm is crucial since in the long run, the firm has to operate
profitably in order to survive. The ratios are of importance to long term creditors,
shareholders, suppliers, employee’s and their representative groups. All these parties are
interested in the financial soundness of an enterprise. The ratios commonly used to
measure profitability include:
(c) Operating profit margin = Operating profit/earning before interest and tax x 100
Sales
This ratio indicates the firm’s ability to control its operating expenses such as electricity,
rent, rates and other costs.
Page 7 of 17
Return on capital employed (ROCE) = net profit x 100
Net assets (capital employed)
4. Gearing/ leverage ratios
These ratios are used as a measure of the extent to which the company is financed by
borrowed and owners’ funds.
Debt to equity ratio = long term debt x 100
Common equity capital
Long term debt is sometimes referred to as fixed charge capital.
This ratio indicates the proportion of total assets that has been financed using long term
and current liabilities.
(d) Times interest earned ratio = Profit before interest and tax
Interest charges
The interest coverage ratio shows the number of times that interest can be paid from the
firm’s earnings.
Page 8 of 17
EPS = Profit after interest, tax and preferred dividend
No. of ordinary shares issued
This ratio indicates the earnings power of the firm i.e. how much earnings or profits are
attributed to every share held by an investor. The higher the ratio, the better the firm.
Page 9 of 17
Comparisons of accounting figures
Useful information is obtained from ratio analysis largely by means of comparisons. The
comparisons that might be made include:
(a) Between the company’s results in the most recent year and its results in previous years
(b) Between the company’s results and the results of other companies in the same industry
(c) Between the company’s results and the results of other companies in other industries
The comparison gives an idea of whether the company’s situation has improved; worsened or
stayed much the same.
(b) The progress a company has made needs to be set in the context of:
This is a way of assessing which companies are outperforming others. The comparisons can help
investors to rank the companies in order of desirability as investments, and judge relative share
prices or future prospects. It is important to make these comparisons with caution: a large
company and a small company in the same industry might be expected to show different results
not just in terms of size, but in terms of:
Page 10 of 17
Percentages of profits re-invested (dividend cover will be higher in a company that needs to
retain profits to finance investment and growth)
Fixed assets (large companies are more likely to have freehold property in their balance
sheets)
An investor ought to be aware of how companies in one industry compare with other industries.
USES/APPLICATIONS OF RATIOS
Ratios are used in the following ways by managers in various firms
i. Evaluating the efficiency of the assets utilization to generate sales revenue i.e. turnover
ratio
ii. Evaluating the ability of the firm to meet its short term financial obligation as and when
they fall due (liquidity ratios)
iii. To carry out industrial analysis i.e. compare the firms performance with the average
industrial performance of the firm with that of the individual competitors in the same
industry.
iv. For cross sectional analysis i.e. compare the performance of the firm with that of the
individual competitors in the same industry.
v. For trend/time series analysis i.e. Evaluate the performance of the firm over time
vi. To establish the extent which the assets of the firm has been financed by fixed charge
capital i.e. use of the gearing ratio
vii. To predict the bankruptcy of the firm i.e. use of selected ratios to determine the overall
ratio usually called the Z-score. The Z-score when compared with a pre-determined
acceptable Z-score will indicate the probability of the bankruptcy of the firm in future.
Page 11 of 17
QUESTION 1
The following data was extracted from the financial statements of Mbuni Ltd for the year ended
31st December 2020
Shs. ‘000’ Shs ‘000’
Non Current Assets:
Plant and Equipment ?
Current assets
Stock ?
Cash ?
Accounts Receivables ?
Total current assets ??
Total Assets ??
Financed by:
Notes payable 100,000
Long term debt ?
Ordinary share capital 100,000
Retained earnings 100,000
Total equity and Liabilities ??
Additional information
Page 12 of 17
QUESTION 2
The following financial statements were prepared from the books of Ration Ltd.
Trading Profit and Loss Account for the year ending 30th June 1996
Shs.000 Shs. 000
Sales: Cash 400
Credit 1000 1400
Less: Cost of sales
Opening stock 110
Purchases (all on credit) 800
910
Less closing stock 140 770
630
Less:Expenses 420
210
Less: Estimated corporation tax 100
110
Less: proposed dividends 90
20
Add: balance brought forward 70
90
Page 13 of 17
Profit and loss account 90 70
390 320
10% Debentures 50 5
440 325
Required
1. Calculate the following ratios for the year ended 30th June 1996
i. Gross profit margin
ii. Net profit margin
iii. Stock turnover
iv. Return on capital employed
v. Average collection period (in days)
vi. Creditors turnover
vii. Fixed Asset turn over
2. Calculate for the year ended 30th June 1995 and 1996:
i. Current Ratio
ii. Quick Ratio
3. Name two limitations of ratio analysis
QUESTION 3
Balance Sheet
2002 2001
Assets Shs. ‘000’ Shs. ‘000’
Investments at cost 10,400 16,000
Land 8,800 12,600
Plant and Machinery at cost 2,000 2,200
Buildings at cost 10,000 18,000
Stock 11,000 13,000
Debtors 8,000 10,000
Bank 200 -
50,400 71,800
Liabilities and Capital
Ordinary shares of Shs. 20 each 8,000 10,000
Share Premium 2,600 2,800
Revaluation reserve - 4,000
Profit and Loss account 9,000 5,000
10%Debentures 16,000 30,000
Accumulated Depreciation:
Plant and machinery 800 1,000
Building 2,000 2,200
Creditors 8,000 12,000
Proposed dividends 4,000 4,000
Bank - 800
50400 71,800
Page 14 of 17
Sales 40,000 40,000
Cost of Goods sold 20,000 24,000
Gross profit 20,000 16,000
Expenses (including interest) 12,000 12,000
Net profit 8,000 4,000
Dividends 4,000 4,000
Retained profit for the year 4,000 -
b/f 5,000 5,000
c/f 9,000 5,000
REQUIRED
For each of the two years calculate the following ratios:
i. Gross profit percentage
ii. Debtors collection period
iii. Creditors turn over
iv. Current ratio
v. Acid test ratio
vi. Dividend cover
QUESTION Four
The following information has been extracted from the books of whales Limited
Profit and Loss for the year ended 30th April 2000 and 2001
2000 2001
Shs. Shs.
Sales(All credit) 7,650,000 11,500,000
Less Cost of Sales 5,800,000 9,430,000
Gross profit 1,850,000 2,070,000
Less expenses:
Miscellaneous expenses 150,000 170,000
Loan interest 50,000 350,000
Taxation 600,000 550,000
Dividend paid (all on ordinary shares)300,000 300,000
(1,100,000) (1,370,000)
Net Profit 750,000 700,000
Page 15 of 17
1,200,000 3,600,000
11,250,000 14,950,000
Financed By:
Ordinary share capital 5,900,000 5,900,000
Loans (Long term) 350,000 3,350,000
Profit and Loss Account 5,000,000 5,700,000
11,250,000 14,950,000
The following additional information is available:
During the year30th April 2001, the company tried to stimulate sales by reducing
the selling price of its products and by offering more generous credit terms to
customers
Required:
1. Calculate the following accounting ratios for the two years 2000 and 2001:
i. Profit to sales
ii. Return on Capital employed
iii. Gearing ratio
iv. Acid Test Ratio
v. Debtors collection period
vi. Stock turnover
2. From the information above, comment on the company’s results for the year
ended 30th April 2001 under the heads of ‘profitability’ , ‘Liquidity’,
‘efficiency’ and the ‘shareholders interest’
The DuPont Identity
The DuPont identity is an expression that shows a company's return on equity (ROE). It is
represented as a product of three other ratios: the profit margin, the total asset turnover and the
equity multiplier.
The DuPont identity, commonly known as DuPont analysis, comes from the DuPont
Corporation, which began using the idea in the 1920s. DuPont identity tells us that ROE is
affected by three things:
If the ROE is unsatisfactory, the DuPont identity helps analysts and management locate the part
of the business that is underperforming.
Page 16 of 17
ROE = (net income / sales) x (revenue / total assets) x (total assets / shareholder equity)
Assume a company reports the following financial data for two years:
Using the DuPont identity, the ROE for each year is:
ROE year / $300,000) x ($300,000 / $500,000) x ($500,000 / $900,000) = 20%
ROE year two = ($170,000 / $327,000) x ($327,000 / $545,000) x ($545,000 / $980,000) = 17%
With a slight amount of rounding, the above two ROE calculations break down to:
You can clearly see that the ROE declined in year two. During the year, net income, revenues,
total assets and shareholder equity all changed in value. By using the DuPont identity, analysts or
managers can break down the cause of this decline. Here they see the equity multipler and total
asset turnover remained exactly constant over year two. This leaves only the profit margin as the
cause of the lower ROE. Seeing that the profit margin dropped from 60 percent to 52 percent,
while revenues actually increased in year two, indicates that there are issues with the way the
company handled its expenses and costs throughout the year. Managers can then use these
insights to improve the following year.
Page 17 of 17