FINANCIAL STATEMENTS AND CORPORATE FINANCE

FIRMS DISCLOSURE OF FINANCIAL INFORMATION

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.

PREPARATION OF FINANCIAL STATEMENTS

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

TYPES OF FINANCIAL STATEMENTS

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.

Financial statements are analyzed using the ratios.

RATIO ANALYSIS

A ratio is simply a mathematical expression of an amount or amounts in terms of another or

others. A ratio may be expressed as a percentage, as a fraction, or a stated comparison between
two amounts. The computation of a ratio does not add any information not already existing in the
amount or amounts under study. A useful ratio may be computed only when a significant
relationship exists between two amounts. A ratio of two unrelated amounts is meaningless. It
should be re-emphasized that a ratio by itself is useless, unless compared with the same ratio
over a period of time and/or a similar ratio for a different company and the industry. Ratios focus
attention on relationships which are significant but the full interpretation of a ratio usually
requires, further investigation of the underlying data. Thus ratios are an aid to analysis and
interpretation and not a substitute for sound thinking.
These ratios act as a guide for decision making of the various potential and actual users of the
financial information.
These users include:
Shareholders- they have invested in the firm and are the owners. Shareholders are interested in
the profitability and survival of the firm. They are typically concerned with the allocation of
earnings for investment and the residual earnings which may be paid to them as dividends.

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;

(a) Current ratio = Current assets

Current liabilities

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.

(c) Cash ratio = Cash + Short term marketable securities

Current liabilities
This is a refinement of the quick ratio indicating the ability of the firm to meet its current
liabilities from its most liquid resources. Short term marketable securities include
commercial paper and treasury bills and other short term investments.

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.

Stock holding period = 360 Days x Average stock

Cost of sales
Indicates the number of days the stock was held in the warehouse before being sold.

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.

Debtors or average collection period = 360 Days

Debtor’s turnover
This refers to the credit period that was granted to the debtors on the period within which
they were to pay their dues to the firm.

Creditors/ accounts payable turnover = Annual credit purchases

Annual creditors
It indicates the number of times the firm bought goods on credit after paying its suppliers.
if its high then payment was made within a short period of time.

Creditors payment period = 360

Creditor’s turnover

= 360 x Average creditors

Annual credit purchases
This ratio indicates the credit period granted by suppliers.

(g) Total assets turnover = Annual sales

Total assets
This ratio indicates the amount of sales revenue generated from utilization of one shilling
of total assets.

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:

(a) Gross profit margin = Gross profit x 100

Sales
It indicates the efficiency with which management produces each unit of a product i.e. by
controlling the cost of sales.

(b) Net profit margin = Profit after tax x100

Sales
It indicates the ability of the firm to control financing expenses in particular interest
expense

(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.

(d) Return on investment/return on total assets = Net profit x 100

Total assets
This ratio indicates the return on profit from investment of one shilling in total assets
(e) Return on equity = net profit x 100
Equity
This ratio indicates the return of profitability on one shilling of equity capital contributed
by shareholders.

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.

Debt to total capital ratio = long term debt x 100

Total capital

Debt ratio = Total debt (current plus long term liabilities)

Total assets

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.

(e) Equity ratio = capital employed

Common equity capital
5. Investor ratios
They are also known as market or valuation ratios.

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.

(b) DPS = dividend paid

No. of ordinary shares issued
It indicates the cash dividend received for every share held by an investor. If all earning
attributable to ordinary shareholders were paid out as dividends then, EPS=DPS
(c) P/E ratio = MPS
EPS
The MPS is the price at which a new share can be bought. EPS is the annual income from
each share. Hence, P/E ratio indicates the number of years it will take to recover MPS
from the annual EPS of the firm. As will be observed in the earnings yield (EY) the price
earnings ratio is a reciprocal of EY.
Dividend payout ratio = DPS x 100
EPS
It represents the proportion of earnings that was paid out as dividend.
Retention ratio =1- dividend payout ratio (DPR)

Dividend yield = DPS x 100

MPS
(g) Earnings yield = EPS x100
MPS
It shows the investors total return on his investment.
(h) Dividend cover = EPS
DPS
It shows the number of times that the dividend can be paid from current year earnings.

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

Results of the same company over successive accounting periods

The comparison gives an idea of whether the company’s situation has improved; worsened or
stayed much the same.

Useful comparisons over time include

 The percentage growth in sales

 Increase or decrease in the debt ratio and the gearing ratio
 Changes in the current ratio, stock turnover period and debtors payment period
 Increase in EPS, the DPS and market price
The principal advantage of making comparisons over time is that they give some indication of
progress. However, there are some weaknesses in such comparisons

(a) The effect of inflation should be considered

(b) The progress a company has made needs to be set in the context of:

 What other companies have done

 Whether there have been any special environment or economic influences on the
companies performance

Comparisons between different companies in the same industry

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:

 Percentage rates of growth in sales and profits

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)

Comparisons between companies in different industries

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

 Long term debt to equity ratio 0.5:1

 Total assets turnover 2.5 times
 Average collection period 18 days
 Inventory turnover 9 Times
 Acid test ratio 1:1
 Gross profit margin 10%
Assume 360days in a year and that all sales are on credit basis
Required:
i. Long term debt
ii. Total liabilities and shareholder’s equity
iii. Cost of sales
iv. Inventory balance
v. Accounts receivable balance
vi. Cash balance
vii. Complete the statement of financial position of Mbuni Ltd for the year ended 31st
December 2020 using the results obtained in C(i) to C (iv) above

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

Balance sheet as at on 30th June

1996 1995
shs. 000 shs 000
Fixed Assets (net) 370 400
Current Assets
Stock 140 110
Debtors 80 60
Prepaid insurance 2 3
Cash at bank 13 -
Cash in hand 45 12
280 185
Less Current Liabilities
Creditors 20 66
Taxation 100 85
Dividends 90 68
Bank Overdraft - 41
210 260
Net current assets 70 (75)
440 325
Financed by:
Ordinary Shares 300 250

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

Profit and loss account

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

Balance sheet as at 30th April

2000 2001
Shs. Shs.
Fixed assets 10,050,000 11,350,000
Current Assets
Stock 1,500,000 2,450,000
Trade Debtors 1,200,000 3,800,000
Cash in hand 900,000 50,000
3,600,000 6,300,000
Less Current liabilities
Creditors 2,400,000 2,700,000

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:

1. Operating efficiency, which is measured by profit margin;

2. Asset use efficiency, which is measured by total asset turnover; and

3. Financial leverage, which is measured by the equity multiplier.

If the ROE is unsatisfactory, the DuPont identity helps analysts and management locate the part
of the business that is underperforming.

The formula for the DuPont identity is:

ROE = profit margin x asset turnover x equity multiplier

This formula, in turn, can be broken down further to:

Page 16 of 17
ROE = (net income / sales) x (revenue / total assets) x (total assets / shareholder equity)

DuPont Identity Example Calculation

Assume a company reports the following financial data for two years:

Year one net income = $180,000

Year one revenues = $300,000

Year one total assets = $500,000

Year one shareholder equity = $900,000

Year two net income = $170,000

Year two revenues = $327,000

Year two total assets = $545,000

Year two shareholder equity = $980,000

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:

ROE year x 60% x 56% = 20%

ROE year two = 52% x 60% x 56% = 17%

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