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Simon Fraser University
Business Administration
BUS 320
Amir Azaran

Chapter 3 Working with financial statement 3.1 Cash flow and financial statement: A closer look Cash is generated by selling a product, an asset, or a security. Selling a security involves either borrowing or selling an equity interest (i.e. shares of stock) in the firm. Source and uses of cash Source of cash: activities that generate cash Uses of cash: A firm’s activity in which cash is spent. An increase in a left-hand side (asset) account or a decrease in a left-hand side (liability or equity) account is a use of cash. Likewise, a decrease in an asset account or an increase in a liability (or equity) account is a source of cash. The net addition to cash is just the difference between sources and uses. The statement of cash flows Statement of cash flow is a firm’s financial statement that summarizes its sources and uses of cash over a specific period. We are trying to group all changes into three categories: operating activities, financing activities and investment activities. It might seem appropriate to express the change in cash on a per share basis, much as we did for net income. 3.2 Standardized financial statements Purpose: to compare companies to those of other, similar companies. One very common and useful way of doing this is to work with percentage instead of total dollars. Here’s two ways of standardizing financial statements. 1) Common-size statement A standardized financial statement presents all items in percentage terms. Balance sheets are shown as a percentage of asset and income statement as a percentage of sales. Common-size balance sheet The way is to express each item as a percentage of total assets. The total change has to be zero, since the beginning and ending numbers must add up to 100%. www.notesolution.com When we transform the number to percentage in balance sheet, it is relatively easy to read and compare. We can compare the increase or decrease of investment, current asset and so on based on their change in percentage, which is more obvious than numbers. Common-size income statements The way is to express each item as a percentage of total sales. Common-size income statements tell us what happens to each dollar in sales. The percentages are very useful in comparisons. Common-size statements of cash flow Each item can be expressed as a percentage of total sources or total uses. The results can then be interpreted as the percentage of total source of cash supplied or as the percentage of total uses of cash for a particular item. 2) Common-base-year financial statements: trend analysis It is a standardized financial statement presenting all items relative to a certain year amount. For example, a company’s inventory rose from 393 to 422. If we pick 2008 as our base year, then we would set inventory equal to 1 for that year. For 2009, we would calculate 422/393=1.07, which means 7 percent increase during the year. If we had multiple years, we would just divide each one by 393. Combined common-size and base-year analysis Reason: As total asset grow, most of other accounts grow as well. By first forming the common-size statements, we eliminate the effect of this overall growth. For example, a company’s accounts receivable were 165 or 4.9% of total asset in 2008. In 2009, they had risen to 188, which is 5.2% of total asset. If we do trend analysis in terms of dollars, the 2009 figure would be 188/165=1.14, a 14% increase in receivable. However, if we work with the common-size statements, the 2009 figure would be 5.2%/4.9%=1.06. This tells us that accounts receivable, as a percent of total asset, grew by 6%. Roughly speaking, what we see is that of the 14% total increase, about 8% (14%- 6%) is attributable simply to growth in total asset. 3.3 Ratio analysis. It is relationships determined from a firm’s financial information and used for comparison purposes. Using ratios eliminates the size problem since the size effectively divides out. We are then left with percentage, multiples, or time periods. For each of the ratios we discuss, several questions come to mind: www.notesolution.com 1. How is it computed? 2. What is it intended to measure, and why might we be interested? 3. What might a high or low value be telling us? How might such values be misleading? 4. How could this measure be improved? Financial ratios are traditional grouped into the following categories: 1. Short term solvency or liquidity ratios 2. Long-term solvency or financial leverage rations 3. Asset management or turnover ratios. 4. Profitability ratios 5. Market value ratios. Short term solvency or liquidity measures Short-term-solvency ratios are intended to provide information about a firm’s liquidity, and these ratios are sometime called liquidity measures. The primary concern is the firm’s ability to pay its bills over the short run without undue stress. Consequently, these ratios focus on current assets and current liabilities. Liquidity ratios are particularly interesting to short-term creditors. Why look at current assets and current liabilities: their book value and market value are likely to be similar; On the other hand, current assets and liabilities can and do change fairly rapidly, so today’s amounts may not be a reliable guide for the future. Current ratio (a measure of short-term liquidity) Current ratio= current asset/current liabilities To a creditor, particular a short-term creditor such as a supplier, the higher the current ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets. It is better that current ratio is more than 1, in this case, net working capital is positive and it indicates the firm is healthy. Note that a low current ratio may not be a bad sign for a company with large reverse of untapped borrowing power. The quick ratio www.notesolution.com Quick ratio= (current assets-inventory)/current liabilities Notice that using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. Other liquidity ratios A very short-term creditor might be interested in the cash ratio: N Cash ratio= cash+ cash equivalents/current liabilities N Net working capital to total assets= Net working capital/ total assets A relatively low value might indicate relatively low levels of liquidity. Imagine a firm a facing a strike and cash inflow are beginning to dry up. How long could the business keep running? One answer is given by interval measure. N Interval measure=current asset/average daily
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