MANAGERIAL FINANCE

Chapter Two
Financial Statements and Cash Flow Analysis

Financial statements provide useful information about a company’s financial position on

financing and investing activities at a point in time and summarize operating activities for a
period of time. The financial statements are very useful to users as they can help them make
better economic decisions. In Malaysia, it is a requirement for public listed companies in the
official list of Bursa Malaysia to draw up financial statements. The Companies Act 1965 also
states that all companies registered under the Registrar of Companies (ROC) are required to
draw up annual financial statements. These financial statements must be prepared according
to accounting standards set by the Malaysian Accounting Standards Board (MASB). In
general, financial statements consists of Balance Sheet, Income Statement and Statement of
Cash Flow.

2.1 The Balance Sheet

Balance sheet is a snapshot of the firm’s assets, liabilities and equities. It records the book
value of all the firm’s assets, liabilities and equities as at the end of certain period, accumulated
ever since the firm’s inception. For example, a firm was founded ten years ago with a
beginning total assets of RM1 million. Over the years, new assets were acquired and some
assets were disposed. As at the end of last year, the total assets figure was RM10 million,
indicating that as of point of time, the total assets value is RM10 million. The value reported
is the book or purchase value of the items. Assets are lumped in one side (left-hand side) while
liabilities together with owner’s equity (or shareholder’s equity) are on the other side (right-
hand side). This relationship is represented in the following equation known as the balance
sheet identity:

Assets = Liabilities + Shareholders’ equity (owner’s equity)

The owner’s equity measures the ‘net worth’ of the firm, what is left of the assets after
deducting all the liabilities. It is therefore can be represented as follows:

Owner’s equity = Assets – Liabilities

The asset section is normally divided into the current assets and non-current assets section (also
called fixed assets). It is called current asset because the items are generally more liquid than
the items in the non-current assets section. Liquidity can be defined as the measure of how
quickly an asset can be converted into cash, without significantly losing its market value.
Among the items in the current asset section are: cash and cash equivalents, accounts
receivables and inventory. In the non-current asset section, the common items are property,
plant and equipment, intangible assets, investment properties and investments in subsidiaries.
For current liabilities, the common items are: accounts payables, short-term loans and current
tax liabilities. In the non-current liabilities section, the common items are: long-term
borrowings and deferred tax liabilities. Finally, in the shareholders’ equity section, the
common items are: share capital, reserves, retained earnings and minority interests. A basic
balance sheet would be as follows.

ABC Berhad
Balance Sheet
As at 31 December 2014

ASSET LIABILITIES
Current Assets Current Liabilities
Non-current Assets Non-current Liabilities
Total Assets Total Liabilities
Shareholders’ Equity
Total Liabilities & Shareholders’ Equity

However, in practice, there are various formats of how balance sheets are constructed. There
are cases where the items are arranged in such a way that the least liquid items are at the top.
In some cases, it is called the statements of financial position, instead of balance sheet. The
following is an example of a balance sheet of a Malaysian public-listed company, KFC
Holdings (Malaysia) Berhad for the year ended 2010.
Balance sheet is a useful tool that financial managers use and refer to in making certain
financial decisions. For example, balance sheet is referred to in measuring the degree of
financial leverage in a firm. Financial leverage is the use of debt in a firm’s capital structure.
The more debt a firm has the greater its degree of financial leverage. However, the balance
sheet items are based on book values or accounting values (historical costs) instead of the
market values. In practice, the market value is more useful and more accurate particularly
when it involves valuation of firm’s assets and liabilities.

2.2 The Income Statement

The income statement or also commonly called the profit and loss (P&L) statement is a measure
of the firm’s performance over some period of time. If balance sheet is like a snap shot, income
statement is like a video recording. It records firm’s performance over certain period, for
example a year, half a year or a quarter. The basic format of an income statement consists of
the sales or revenue minus the expenses, giving us the profit (or loss). Similar to the balance
sheet, there are various formats used to construct the income statement. The following is an
example of a typical format of an income statement.

Income Statement (Example 1)

Sales (Revenue or Turnover)

- Cost of goods sold
- Depreciation
= Earnings before interest and taxes (EBIT)
- Interest paid
= Taxable income (Profit before tax)
- Taxes
= Net profit (Net income or net earnings)

Income Statement (Example 2)

SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS

The following is an example of an income statement of KFC Holdings (Malaysia) Berhad, for
the year ended 2010.
2.3 Statement of retained earnings

Statement of retained earnings is a statement which reports how net income and dividends
affect a firm’s financial position during the stipulated period.
For example, let’s say the beginning balance of retained earnings for a firm in 2013 is
RM1,320. During the year, the net income reported is RM412 and the dividends paid are
RM103. Therefore, the ending balance of the retained earnings for year 2013 can be calculated
as follows.

Beginning balance, retained earnings, 2004 $1,320

+ Net Income $412
- Dividends $103
Ending balance, retained earnings, 2005 $1,629

The following is the statement of retained earnings of KFC Holdings (Malaysia) Berhad for
the year 2010. Notice that the name used is statement of changes in equity.

2.4 The Accounting Statement of Cash Flows

The final accounting statement is the accounting statement of cash flows or simply the cash
flow statement. It records the changes in the sources and uses of funds or cash in the firm
during the period and it uses both the balance sheet and income statement items. Basically, a
statement of cash flow is divided into three sections – cash flow from operating activities, cash
flow from financing activities and cash flow from investing activities. An increase in an asset
item indicates a cash outflow, while a decrease shows a cash inflow because a decrease
indicates an asset is being disposed. On the other hand, an increase in a liabilities item indicates
a cash inflow, vice-versa.

The following is an example of a typical statement of cash flow for a firm. For the cash flow
from operating activities, the section starts with net profits after taxes which is added with the
depreciation. Depreciation is added back because it is actually a non-cash item and therefore
no cash out flow had actually taken place.

The following is a section of a statement of cash flow (cash flows from operating activities) for
KFC Holdings (Malaysia) Berhad for the year 2010.
2.5 Financial Cash Flow

In addition to the accounting statement of cash flows, there is a financial cash flow statement,
which is a simplified version of the accounting statement of cash flow. It builds on the balance
sheet identity: Assets = Liabilities + Shareholders’ Equity. The financial cash flow identity is
then built as:
Cash flow from assets = cash flow to creditors + cash flow to shareholders
The identity is based on the premise that assets of a business should generate cash flow which
is then used to pay creditors in the form of interests or retirement of debt; and also shareholders
in the form of dividends or share repurchase. In other words, we can say that the cash flow to
creditors and shareholders are funded by the cash flow generated from assets.

However, there are cases whereby a firm records negative net cash flow from assets and
positive cash flow to creditors and also cash flow to shareholders. Here, the equation becomes:

Cash flow to assets = cash flow from creditors + cash flow from shareholders

In this case, we can say that cash flow paid to assets are funded by the cash flow from creditors
and shareholders. A firm may purchase a huge amount of assets and at the same time take up
large amount of borrowings and/or issue new shares to the shareholders.

Cash Flow from Assets

Cash flow from assets involves three main components as follows.

1. Operating cash flow – cash flow that results from firm’s day-to-day activities of
producing and selling.

2. Capital spending – net spending on fixed assets such as machineries and equipment.

3. Change in net working capital – net change in current assets relative to current
liabilities.

Basically, the operating cash flow (OCF) is revenue minus costs. Here, we do not include
depreciation because it is a non-cash item. We also do not include interest because it is a
financing expense, not operating expense. We include taxes because they are paid in cash.
Generally, the operating cash flow (OCF) equation is as follows.

OCF = EBIT + Depreciation - Taxes

The following are the balance sheet and income statement of a corporation used as examples
to build the financial cash flow.
 M CORPORATION
2004 & 2005 Balance Sheets ($ in millions)

2004 2005
Assets
Current Assets
Cash 104 160
Accounts receivable 455 688
Inventory 553 555
Total 1,112 1,403
Fixed assets
Net plant & equipment 1,644 1,709
Total assets 2,756 3,112

Liabilities & Owners’ Equity

Current liabilities
Accounts payable 232 266
Notes payable 196 123
Total 428 389
Long-term debt 408 454
Owner’s equity
Common stock & paid-in surplus 600 640
Retained earnings 1,320 1,629
Total 1,920 2,269
Total liabilities & owner’s equity 2,756 3,112

M. CORPORATION
2005 Income Statement
($ in millions)

Sales 1,509
Cost of goods sold 750
Depreciation 65
Earnings before interest & taxes 694
Interest paid 70
Taxable income 624
Taxes 212
Net income 412
Dividends 103
Addition to retained earnings 309
For the firm, the operating cash flow is as follows.

Operating Cash Flow

Earnings before interest & taxes (EBIT) $694
+ Depreciation 65
- Taxes 212
Operating cash flow 547

For the capital spending, it is cash spent on fixed asset minus cash received from sale of fixed
assets (if any). At end of 2005, net fixed assets = $1,709. At end of 2004, it was $1,644. So,
$1,709 - $1,604 = $65. However, during the year, the company wrote off (depreciated) $65 of
fixed assets (refer to income statement). So, during the year 2005 the company has spent $1,709
- $1,644 + $65 = $130 on fixed assets.

Ending net fixed assets $1,709

- Beginning net fixed assets 1,644
+ Depreciation 65
Net capital spending 130

Another name of capital spending is capital expenditure (CAPEX)

For the change in net working capital (NWC), we need to calculate the difference between
the current assets and current liabilities in the current year first, then for the previous year and
calculate the difference. Referring to balance sheet, in 2005, current assets = $1,403, in 2004
current assets = $1,112. So during the year, the company invested $291 in current assets.
Meanwhile, current liabilities were $428 in 2004 & $389 in 2005.

So, NWC in 2005 = $1,403 - $389 = $1,014; NWC in 2004 = $1,112 - $428 = $684

Ending NWC $1,014

- Beginning NWC 684
Change in NWC $ 330

Therefore, the cash flow from assets is as follows.

Operating cash flow $547

- Net capital spending 130
- Change in NWC 330
Cash flow from assets $ 87

Based on cash flow identity earlier, CF from assets = CF to creditors + CF to shareholders.

CF from assets sometimes are denoted as “free” cash flow (FCF)
The cash flow to creditors is basically equals to the total interest paid to creditors minus net
new borrowing (if any). Referring to income statement, the company paid $70 in interest to
creditors. In the balance sheet, we see that long-term debt increased by $46 ($454 - $408). So
the company paid out $70 in interest, but borrowed an additional amount of $46. Therefore,
we have the following.

Interest paid -$70

+ Net new borrowing 46
Cash flow to creditors - $24

Cash flow to creditors is also called cash flow to bondholders.

The cash flow to shareholders is basically equals to the total dividends paid minus the net
new equity raised. Referring to the income statement, dividend paid to shareholders is $103.
Common stock & paid-in surplus account increased by $40, so this shows that net new equity
raised is $40. Therefore, the cash flow to the shareholders is as follows.

Dividends paid -$103

+ Net new equity raised 40
Cash flow to shareholders - $63

Putting it all together, we have the following.

Cash flow from assets =$87

Cash flow to creditors = $24
Cash flow to shareholders = $63

$87 = $24 + $63

CASH FLOW FROM ASSETS = CASH FLOW TO CREDITORS + CASH FLOW TO

SHAREHOLDERS

2.6 Sources and uses of funds

In addition to the financial cash flow that we constructed above, we can also develop a
statement of sources and uses of funds for the items in the balance sheet. In principle, the net
movement of funds (cash) with regards to the balance sheet items provide the figure for the
cash balance in the current assets section of the balance sheet. The sources of cash and uses of
cash activities are as follows.
  Sources of cash
- Decrease in asset
- Increase in liabilities & shareholder’s equity

 Uses of cash
- Increase in asset
- Decrease in liabilities & shareholder’s equity

2.7 Financial Ratio Analysis

Financial ratios help us to analyze the financial performance of a company and understand
the business in a more systematic manner. The financial ratios are categorized into the
following:
• Short-term solvency, or liquidity, ratios.
• Long-term solvency, or financial leverage, ratios.
• Asset management, or turnover, ratios.
• Profitability ratios.
• Market value ratios.

The following are balance sheet and income statement for a company.
Additional Information:
Stock Price per share is $88 and Number of shares outstanding is 33 million shares

LIQUIDITY RATIOS

1. Current Ratio = Current Assets/Current Liabilities

= $708/$540 = 1.31 times

The firm is able to cover current liabilities with its current assets by a factor of 1.3 to 1. The
ratio should be compared to the industry—it’s possible that this industry has a substantial
amount of cash flow and that they can meet their current liabilities out of cash flow instead of
relying solely on the liquidation of current assets that are on the books.

2. Quick Ratio = (Current Assets – Inventories)/Current Liabilities

= ($708-$422)/$540 = 0.53 times

The quick ratio is quite a bit lower than the current ratio, so inventory seems to be an
important component of current assets.

3. Cash Ratio = Cash/Current Liabilities

= $98/$540 = 0.18 times

This company carries a low cash balance. This may be an indication that it is aggressively
investing in assets that will provide higher returns. We need to make sure that we have enough
cash to meet our obligations, but too much cash reduces the return earned by the company.

LEVERAGE RATIOS

1. Total Debt Ratio = (Total Assets – Total Equity/Total Assets

= ($3,588-$2,591)/$3,588 = 0.28 times

The firm finances approximately 28 percent of its assets with debt.

2. Debt to Equity Ratio = Total Debt/Total Equity

= $997/2,591 =0.38 times

3. Equity Multiplier = Total Assets/Total Equity = 1 + TD/TE = 1.38 times

COVERAGE RATIOS

1. Times Interest Earned Ratio = EBIT/Interest

= $600/$141 = 4.26 times

2. Cash Coverage = (EBIT + Depreciation & amortization)/Interest

= ($600 + $276)/$141 = 6.22 times

Remember that depreciation (and amortization) is a noncash deduction. A better indication of
a firm’s ability to meet interest payments may be to add back the depreciation and
amortization to get an estimate of cash flow before taxes.

INVENTORY RATIOS

1. Inventory Turnover = Cost of Goods Sold/Inventory

= $1,435/$422 = 3.40 times

2. Day’s Sales in Inventory = 365 days/Inventory Turnover

= 365/3.40 = 104.37 days

Inventory turnover can be computed using either ending inventory or average inventory when
you have both beginning and ending figures. It is important to be consistent with whatever
benchmark you are using to analyze the company’s strengths or weaknesses.

It is also important to consider seasonality in sales. If the balance sheet is prepared at a time
when there is a large inventory build-up to meet seasonal demand, then the inventory turnover
will be understated and you might believe that the company is not performing as well as it is.
On the other hand, if the balance sheet is prepared when inventory has been drawn down due
to seasonal sales, then the inventory turnover would be overstated and the company may appear
to be doing better than it really is. Averages using annual data may not fix this problem. If a
company has seasonal sales, you may want to look at quarterly averages to get a better
indication of turnover.

RECEIVABLES RATIOS

1. Receivables Turnover = Sales/Accounts Receivable

= $2,311/$188 = 12.29 times

2. Day’s Sales in Receivables = 365 days/Receivables Turnover

= 365/12.29 = 29.69 days

Technically, the sales figure should be credit sales. This is often difficult to determine from
the income statements provided in annual reports. If you use total sales instead of credit sales,
you will overstate your turnover level. You need to recognize this bias when credit sales are
unavailable, particularly if a large portion of the sales are cash sales.
As with inventory turnover, you can use either ending receivables or an average of beginning
and ending.

You also run into the same seasonal issues as discussed with inventory.
Probably the best benchmark for days’ sales in receivables is the company’s credit terms. If
the company offers a discount (1/10 net 30), then you would like to see days’ sales in
receivables less than 30. If the company does not offer a discount (net 30), then you would
like to see days’ sales in receivables close to the net terms. If days’ sales in receivables is
substantially larger than the net terms, then you first need to look for biases, such as
seasonality in sales. If this does not provide an explanation for the difference, then the
company may need to take another look at its credit policy (who it grants credit to and its
collection procedures).

3. Total Asset Turnover = Sales/Total Assets

= $2,311/$3,588 = 0.64 times

Having a TAT of less than one is not a problem for most firms. Fixed assets are expensive
and are meant to provide sales over a long period of time. This is why the matching principle
indicates that they should be depreciated instead of immediately expensed.

PROFITABILITY RATIOS

1. Gross Profit Margin = Gross Profit/Sales

= $876/$2,311 = 37.9%

2. Net Profit Margin = Net Profit/Sales

= $363/$2,311 = 15.69%

3. Return on Assets = Net Profit/Total Assets

= $363/$3,588 = 10.11%

4. Return on Equity = Net Profit/Total Equity

= $363/$2,591 = 13.99%

Note that the ROA and ROE are returns on accounting numbers. As such, they are not directly
comparable with returns found in the marketplace. ROA is sometimes referred to as ROI (return
on investment). As with many of the ratios, there are variations in how they can be computed.
The most important thing is to make sure that you are computing them the same way as the
benchmark you are using.
ROE will always be higher than ROA as long as the firm has debt (and ROA is positive). The
greater the leverage, the larger the difference will be. ROE is often used as a measure of how
well management is attaining the goal of owner wealth maximization.

MARKET VALUE RATIOS

1. Price-Earnings Ratio = Price per share/Earnings per share

= $88/$10.99 = 8.01 times

 2. Market-to-Book Ratio = Market value per share/Book value per share

= $88/($2,591/33) = 1.12 times

3. Market capitalization = price per share x number of shares outstanding

= $88 x 33 million = $2,904 million

4. Enterprise Value (EV) = Market capitalization + Market value of interest-bearing debt
– Cash

= $2,904 +($196 + $457) - $98 = $3,459 million

5. EV Multiple = EV/EBITDA

= $3,459/$876 = 3.95 times

Financial ratios are more useful when they are compared with other benchmarks such as
industry averages or other comparable companies. It is also advisable to make trend analysis
in order to compare to historical performance.