Project Cost Management

PCM518
UNIT 1.1

Financial Statement Analysis

Introduction
 A financial report (also referred to as financial statement or finance report) is a management tool
used to communicate key financial information to both internal and external stakeholders.
 Financial reporting is intended to provide information useful in making business and economic
decisions.
 Users of financial statements include internal and external stakeholder groups e.g. the company’s
managers, stockholders, bondholders, security analysts, suppliers, lending institutions, employees,
labour unions, regulatory authorities, and the general public.
 Various stakeholders use the financial reports to make decisions; e.g.
◦ Evaluate your decision to invest in the entity’s shares on the basis of the information obtained
from the financial reports
◦ Suppliers use the financial reports to decide whether to sell merchandise to a company on credit.
◦ Labour unions use the financial reports to help determine their demands when they negotiate for
employees.
◦ Management& shareholders could use the financial reports to determine the company’s
profitability and to predict future performance.
The objective of financial reporting
 Most organizations prepare and present their financial reports according to the International
Financial Reporting Standards (‘the IFRS Standards’).
 These standards are developed and approved by the International Accounting Standards Board and
are based on the Conceptual Framework for Financial Reporting (‘the IFRS Framework’).
 The IFRS Framework sets out the basic concepts that are incorporated during the
preparation and presentation of an entity’s financial reports.
 The IRFS frameworks identifies the primary objective of financial reporting, users of
financial reporting, and defines the type and the nature of the information that should be
provided to them.
 According to the IFRS Framework,
◦ the objective of financial statements is “to provide information about an entity’s assets,
liabilities, equity, income and expenses that is useful to financial statements users in assessing the
prospects for future net cash inflows to the entity and in assessing management’s stewardship of
the entity’s resources”.
 Stewardship: the conducting, supervising, or managing of financial resources.
Who are the users of financial reporting?
 External capital providers - assist them in their decisions about where to allocate capital,
- making informed decisions when participating in voting on
important corporate actions.
- Assists them in evaluating management performance and in
deciding whether some form of intervention is required to
address areas of concern.
 Existing shareholders: entity’s existing and potential equity investors, lenders &other creditors.
 Investors are interested in an entity’s ability to generate net cash inflows, and the
market’s perception of the entity’s ability to generate net cash inflows, since this
perception will influence its share price and consequently their dividend payments.
 Net cash inflow is the sum over a period of time of the total cash received (inflow) from
sales and loans less the total amount of money spent (outflow).
 Lenders and other creditors are also interested in an entity’s ability to generate net
cash inflows, since these cash inflows are required to make interest payments and finance
the repayments of the capital they provided to the entity.
 South African Revenue Service (SARS) requires entities to provide annual financial
statements in order to calculate entity’s tax.
 Entity’s management uses the financial statements, along with other tools, to
determine if its objectives have been achieved, and for planning and control purposes.
Statement of financial position
 A statement of financial position is organised into two sections, distinguishing between its assets
and its equity and liabilities.
◦ Assets are what a business owns

 Non current assets:

 long-term investments that are not easily converted to cash or are not expected to become
cash within an accounting year.
 Tangible: Property/ real estate, plant and equipment
 Intangible assets: intellectual property, such as trademarks, patents, and copyrights.
 Natural resources: assets that occur naturally, and they are derived from the earth, e.g.
timber, fossil fuels, oil fields, and minerals.
 Current Assets:
 Assets that can be quickly converted into cash, within one year. And they are commonly used
to measure the liquidity of a company.
 Cash, accounts receivable and inventory, short-term investments.
• Liabilities are what a business owes.
◦ Assets minus liabilities equals equity; also known as “capital” , or an entity’s net worth.
◦ There are two types of liabilities:
• Current liabilities need to be paid back within a year and include credit lines, loans, salaries
and accounts payable.
o Examples: Accounts payable (unpaid bills to the company’s vendors); interest payable (Interest
expenses that have already occurred but have not been paid); Income taxes payable; bank
account overdrafts; accrued expenses (expenses that have been incurred but no supporting
documentation/ invoice received yet)
o Many company expenses are current liabilities.
• Long-term liabilities can be paid back after a year and include mortgages and bonds
o Bonds payable are recorded when a company issues bonds to generate cash.
• Equity: Companies can issue new shares by selling them to investors in exchange for cash and then
use the proceeds to fund their business, grow operations, hire more people etc.
• Each share of the same class has the exact same rights and privileges as all other shares of the same
class. This is part of the term’s meaning – equity meaning “equal”.
• Equity is the actual value of funds that owners of the entity invest in the business.
 A statement of financial position is, therefore, a summary of the capital that was obtained by the
entity over a certain period of time& a breakdown of how this capital was deployed in the entity.
Major elements of a statement of financial position
Example of statement of financial position
Statement of profit and loss
 A profit and loss statement (P&L), or income statement or statement of operations, is a financial report that
provides a summary of a company’s revenues, expenses, and profits/losses over a given period of time; (usually
one year).
 The categories that can be found on the P&L include:
◦ Revenue (or Sales): amount includes all income received for products or services rendered by the entity
during the financial year.
◦ Cost of Goods Sold (or Cost of Sales): includes the cost of raw materials, electricity and other consumables
used in production process
◦ The investment income section includes all income generated by the financial assets of the entity
◦ Finance cost is the interest that the entity has paid on debt financing.
◦ Ordinary dividends: total amount that is paid to the ordinary shareholders in the form of their dividends
◦ The retained earnings are the portion of the profit that was not paid out as dividends to shareholders, but
that was reinvested in the entity
◦ Selling, General & Administrative Expenses
◦ Marketing and Advertising
◦ Technology/Research & Development
◦ Interest Expense
◦ Taxes
◦ Net Income
Example
Statement of cash flows
 The cash flow statement is concerned with the flow of cash in and out/ how the entity generates
and utilizes cash of the business.
 A distinction is made between the cash results of operating, investing and financing activities in the
statement of cash flows.
 Cash generated from the normal operating activities: Operating activities include the
production, sales, and delivery of the company’s product as well as collecting payments from its
customers. This could include purchasing raw materials, building inventory, advertising, and
shipping the product.

 The cash from investing activities indicates how much cash is generated or spent on the
investment in additional fixed assets or investments: Investing activities are purchases or sales
of assets (land, building, equipment, marketable securities, etc.), loans made to suppliers or
received from customers, and payments related to mergers and acquisitions.

 Cash from financing activities, indicates the cash flow generated by changes in the capital
components of the entity: Financing activities include the inflow of cash from investors, such as
banks and shareholders and the outflow of cash to shareholders as dividends as the company
generates income.
Example
KEY CONCEPTS
UNIT 1. 2

Ratio Analysis
Financial ratio analysis
 Ratio analysis is the process of combining two or more line items by a mathematical operation and
analyzing the results
 In order to analyse the financial performance and position of an entity, we often use the information
provided in the financial statements to calculate financial ratios.
 Financial ratio analysis is the technique of comparing the relationship (or ratio) between two or
more items of financial data from a company's financial statements.
 It is mainly used as a way of making fair comparisons across time and between different companies
or industries.

Requirements for financial ratios

 First requirement is that the comparison being made be meaningful: meaning provide valuable
information to the users of the financial statements.
 The second requirement for financial ratios is that the value of the ratio be a true indication of the
financial performance of the entity and only the relevant amounts be included during the
calculation of the ratio.
 The third requirement for ratios is that their values be comparable over a period of time as
well as between different industries and entities. This means that the ratio should be
calculated in a consistent manner.
Norms of comparison
 The financial information is converted into ratios in order to provide a basis for comparison.
 Ratios are calculated for categories such as liquidity, asset management, debt management,
profitability, and market value.
 They are used to study changes in a company's operations over time.
 Ratios for a particular company are also compared with those for the industry as a whole or with
those for a specific competitor or group of competitors.
 The purpose is to identify and then analyse deviations from industry averages. These figures are
published by industry groups, banks, and trade associations for use as benchmarks.
Types of ratios
1. Profitability ratios: refers to the efficiency with which an entity utilises its capital to generate
revenue;

◦ Return on assets : Measures your ability to turn assets into profit.

 This is a very useful measure of comparison within an industry. A low ratio compared to
industry may mean that your competitors have found a way to operate more efficiently.
◦ Return on Equity: Rate of return on investment by preference shareholders. Are you making
enough profit to compensate for the risk of being in business? (preference shareholders definition
can be stated as the owners of stock who have priority on a company's assets)
 How does this return compare to less risky investments like bonds?
◦ Return on ordinary shareholders’ equity: focuses only on that portion of the entity’s equity
that is provided by the ordinary shareholders.
 The value of this ratio is slightly lower than the ROSE ratio, indicating that the ordinary
shareholders realised a lower return than the preference shareholders. As
2. Liquidity ratios: look at the availability of cash for operations.
◦ Current Ratio: Measures your ability to meet short term obligations with short term assets. a
useful indicator of cash flow in the near future.
 A ratio less that 1 may indicate liquidity issues.
 A very high current ratio may mean there is excess cash that should possibly be invested
elsewhere in the business or that there is too much inventory.
 Most believe that a ratio between 1.2 and 2.0 is sufficient.
◦ Quick ratio: also referred to as the acid-test ratio) also emphasises the entity’s current liabilities.
 Unlike the current ratio, however, not all current assets are included in the calculation of the
quick ratio.
◦ Cash ratio: cash ratio, the focus is solely on the cash and cash equivalents available
3. Profit margin ratios: measures the ability of a company to generate profits. These ratios are of
interest to investors who would like to invest in the most profitable companies around.
◦ Gross profit margin: the portion of the entity’s revenue that is realised as profit after the cost of
sales has been subtracted.
◦ Operating profit margin: the percentage of the revenue that is realised as profit after provision has
been made for all the normal operating expenses.
◦ Earnings before interest and tax margin: provides an indication of the profit generated by an
entity’s operating and investment activities, excluding any finance cost that resulted from its financing
activities.
 In comparison to the operating profit margin, this ratio therefore considers the profit generated by
the entity’s total assets, and not only the assets that are utilised for operating activities.
◦ Net profit margin: The net profit (NP) margin indicates how much of the initial revenue is left after
tax is paid.
4.Turnover ratios of various capital investments: The asset turnover ratio measures the efficiency of
a company's assets in generating revenue or sales.
◦ The turnover time of trade receivables : shows the average time that it takes to convert an
investment in TR into revenue.
 This represents the average collection period of the trade receivables (that is, how long the
customers who purchase items on credit take on average to settle their accounts).
◦ Inventory turnover time: calculates the average time it takes to convert an investment in
inventory into revenue.
◦ Trade payables turnover time: used to quantify the rate at which a company pays off its
suppliers.
◦ Cash conversion cycle: used as an indication of the length of time that elapses from when cash
is spent on purchasing inventory until the cash is received back from creditor customers.
5. Solvency ratios: Solvency refers to an entity’s ability to cover its obligations when it closes down
its operating activities.
◦ Comparing an entity’s total assets and total debt capital is, therefore, of great importance.
◦ Debt-to-assets ratio: is the relationship between the debt capital and the total assets provides an
indication of the portion of the total capital requirement that is financed by means of debt capital. The
higher the value of this ratio, the weaker the business’s solvency position.
◦ Debt-to-equity ratio : The debt-to-equity ratio is another way of assessing an entity’s solvency. This
ratio compares the amount of debt capital with the equity capital. ( equity represents the amount of
money that would be returned to a company's shareholders if all of the assets were liquidated and all of the
company's debt was paid off in the case of liquidation)
◦ Financial leverage ratio: show how much of an organization's capital comes from debt — a solid
indication of whether a business can make good on its financial obligations.
 A higher financial leverage ratio indicates that a company is using debt to finance its assets and
operations — often a sign of a business that could be a risky bet for potential investors.
◦ Finance cost average: indicates if sufficient profits are available to pay the finance cost on its debt
capital.
◦ Preference dividend coverage ratio: allows us to see if sufficient profits are available to pay the
preference dividends
DuPont analysis
 A convenient way of combining the information contained in the various return ratios is to conduct a
DuPont analysis.
 DuPont analysis also enables an analyst to understand what effect changes in the components of the
ratios have on the overall return generated by the entity.
Using Du Pont Analysis: Example
 An investor is interested in two similar companies within the same industry.The investor wants to use the DuPont analysis method to compare each
company's strengths and areas of opportunity and help them decide which company is the better investment option.They begin by gathering the following
financial information about each company:
1. Investor uses each company's net income and revenue to calculate their net profit margins:
Company one's net profit margin= R2,000 / R8,000 = 0.25
Company two's net profit margin= R2,500 / R20,000 = 0.125
2. The investor uses each company's revenue and average assets to calculate their total asset turnover:
Company one's total asset turnover= R8,000 / R5,000 = 1.6
Company two's total asset turnover= R20,000 / R8,000 = 2.5
3. The investor uses each company's average assets and average equity to calculate their equity multiplier:
Company one's equity multiplier= R5,000 / R2,000 = 2.5*
Company two's equity multiplier= R8,000 / R1,000 = 8*
4. Finally, the investor uses the figures from each of their previous calculations to calculate each company's return on equity ROE
using the DuPont analysis formula:
Company one's DuPont analysis ROE= 0.25 x 1.6 x 2.5 = 1
Company two's DuPont analysis ROE= 0.125 x 2.5 x 8 = 2.5
Using the DuPont analysis model allows the investor to see that although company two has a higher return on equity ratio than
company one, a large portion of company two's ROE results from its equity multiplier.The investor can also see that a large portion of
company one's ROE ratio results from its 25% net profit margin. Because of this information, the investor invests with company one.