Financial Statement Analysis
1. How in your FSA subject do you view the income statements, including cash flow statements and the balance sheet in determining the profitability of a company?
1.1 Income Statement
Income statement or profit or loss statement is basically a financial statement of an organization for a specific time period that measures the financial performance which shows the revenues and the business expenses through operating and non operating activities (Berends, 2010). This statement also shows the net profit or loss incurred by the company over a specific time period. There are two main portions in an income statement, income portion deals with operating items and this portion is used to analyze by the investors to disclose the information about sales/ revenues and incurred expenses through business operations (Black, 2011).
Assets = Liabilities + Owner’s equity
The other portion is non-operating that contains the information about revenues and expenses that does not generated by the business to perform business regular operations (Bragg, 2013). This statement is used to assess organizational profitability by deducting the expenses from the generated revenue over a specific time period (Boone, 2013). If net income positive this means profit otherwise is loss.
1.2 Balance Sheet
Balance sheet is the financial statement that summarizes the organizational assets, owner’s equity and its liabilities over a specific time period (Brealey and Stewart, 2011). The main purpose of balance sheet is to have an idea about the financial condition of an organization that shows the own and owes of organization. It helps the businessmen to understand the strengths and capabilities of organization (Brendy, 2012).
Total Assets = Current assets + Other Assets + fixed Assets
Liabilities = Current Liabilities + Long term Liabilities
Net Worth = Assets – Liabilities – Book Value
Retained Earnings = Earnings retained for business opportunities/ investments
1.3 Cash Flow Statement
Cash flow statement contains about 17 items listed in the specific order they need to appear, cash flow statement is prepared monthly for the first year, quarterly in 2nd year and annually for 3rd year of business (Broadbent and Cullen, 2012). Cash shows the cash in hand, sales shows the income from sale paid for cash receive able means income from collection on cash owed to the business resulting in sales, other incomes means liquidation of asset, income from any investment and loan interest that has been extended (Dayanada, 2012). Total income in cash flow statement shows the total money (sales + receivables + other income). Merchandise or material is raw material used by the company to manufacture products, when raw material comes in, cash goes out. The labour required to manufacture product is called direct labour, expenses required incurred for business operations called overhead (Drury, 2012). Under marketing the expenses, commissions and direct costs related with marketing and sales departments are considered. Research and development are expenses for R & D operations. Some expenses called general and administration expenses incurred during the general administrative operations of business. Information about the paid taxes, except payroll are also treated as expenses in cash flow statement (Dyson, 2013). Capital shows the investment amount need to create income, loan payments are the payments use to reduce long term liabilities, material cost plus direct labour, marketing sales, research and developments, taxes, loan payments, capital and overhead expenses shows the total expenses (Fridson, et al., 2013). Whereas the cumulative cash flow is calculated by subtracting previous cash flow from current cash flow (Gartner, et al., 2013).
2. Importance and role in determining profitability of a company
The financial statements provide the information to the creditors and investors to evaluate an organizational financial strengths and performance. Manager, creditors and investors need published financial information of an organization to make measurements and making analysis (Berends, 2010). The financial conditions of an organization are of important and major concerns to creditors and investors, as well as financial managers also need this information for making financial decisions and to know financial condition of company. Balance sheet shows the liabilities, assets and owner’s equity, it does not contains the information about business operations and changes occurred during the specific period to run business and final results, so the creditors, investors and financial manager need income statement to know the profit and loss, and cash flow to evaluate the cash flow in and out of company account to carried out business operations (Boone, 2013). Through income statement past and current incomes can be compare that shows the performance of an organization. A retained earning is part of equity is of important for the creditors and investors to understand the strengths and performance of an organization because if there is an increase in retained earning it means that a steady growth in organizational shareholder’s equity (Black, 2011).
3. Explain 5 ratios clearly
3.1 Profitability ratio
Financial ratios are used to measure the business abilities to generate revenue as compared to it expenses and other costs incurred in a specific time period (Bragg, 2013). Higher values of these ratios as compared to organizational competitors show that organization is doing well business. These ratios assess the ability of organization to earn profit, sales revenue and cash flow (Brealey and Stewart, 2011). The creditors and investors and business owner also need these ratios to make investment decision for future or to understand the business performance in past period. The most important ratios are return on capital employed (ROCE), gross profit margin, net profit margin and cash return on capital invested (CROCI) (Brendy, 2012). ROCE indicate how well an organization is using capital to generate returns and money for its shareholders is indicated by return on investment. Higher values means organization is executing operations in well manner to earn profit (Broadbent and Cullen, 2012).
3.2 Debt ratio
This is another financial ratio that is used by the creditors, investors and business owner to measure the degree of consumer’s leverage (Drury, 2012). This is ratio of total debt to total assets, and is expressed in percentage. Higher this ratio indicates that the risk associated with this company is high lower value of this ratio indicate low risk (Dayanada, 2012).
3.3 Liquidity ratio,
Liquidity ratio basically indicates the organizational ability to repay short term to the creditors to reduce short term liabilities (Dyson, 2013). Liquidity ratio can be calculated by following formula
Liquidity Ratio = Liquid Assets / Short term Liabilities
If the value of the liquidity ratio is greater than 1 then it means that fully covered. High ratio indicate low risk of default, low ratio indicates higher risk of default (Fridson, et al., 2013).
3.4 Turnover ratio,
Turnover ratio indicate the number of times (frequency, repetition) of organization inventory replaced during a specific time schedule (Gartner, et al., 2013). Turnover ratio can be calculated as cost of goods/products/ services sold divided by average inventory over a specific time period. High value result indicates that organization is producing and selling products/ services quickly (Berends, 2010).
3.5 Employee ratio
This ratio indicates an important ratio of organization between sales and number of employees (Boone, 2013). Higher value of this ratio means more productivity of organization higher value indicates more revenue generated by an employee (Black, 2011).
4. References and Bibliography
Black, G. (2011) Introduction to Accounting and Finance, 4th ed. England: Pearson Education Ltd.
Bragg, S. (2013) Cost reduction Analysis: Tools and Strategies, 4th ed. London: John Wiley & Sons
Brealey, A. and Stewart, (2011) Capital Investment and Valuation, 4th ed.London: Mc-Graw Hill Publishers
Brendy, M. (2012) Accounting and Finance, 8th ed. Oxford: Cengage Learning
Broadbent, and Cullen, J. (2012) Managing Financial Resources, 8th ed. UK: Butterworth-Heinemann
Dayanada, D. (2012) Capital Budgeting, 6th ed. Cambridge: Cambridge University Press
Drury, C. (2012) Management and Cost Accounting, 10th ed. England: South-Western Cengage Learning
Dyson, J.D. (2013) Accounting for Non-Accounting Students, 10th ed. England: Pearson Education Ltd
Fridson, Martin, and Alvarez, (2013) Financial Statement Analysis: A Practitioner’s Guide, 6th ed. UK: John Wiley & Sons
Gartner, William, and Bellamy, (2013) Enterprise, 5th ed. London: South-Western Cengage Learning