Ratio Analysis

Analyst and other stakeholders of company are interested with qualitative information from financial statements by examining relationsip between items on the statements and identifying trends in these relationships.

There are major types of ratios in analysis:

1. Liquidity ratios: Measures of the company’s short term ability to pay its maturing obligations. Consists of : Current ratio, quick or acid-test ratio, current cash coverage ratio.

2. Activity ratios: Measures of how effectively the company uses its assets. Consists of : receiveables turnover, inventory turnover, asset turnover.

3. Profitability ratios: Measures of the degree of success/failures of a given company or division for a given period of time. Consists of : profit margin on sales, rate of return on assets, rate of return on common stock equity, earning per share, price-earnings ratio, payout ratio.

4. Coverage ratios: Measures of degree of protection for long-term creditors and investors. Consists of : debt to total assets, times interest earned, cast debt coverage ratio, book value per share, free cash flow.

Balance Sheet and Statement of Cash Flows

The knowledge of accounting is very important as investor and internal manager to measure health of a business. The most important is the ability to understand financial statements.  Financial statements consists of balance sheet, income statement, cash flow statement, and retained earning statement. In this post, I will share more about balance sheet and statement of cash flows.

Balance Sheet

Balance sheet provides information on assets, liabilities and shareholders’ equity. As the result, balance sheet provides a basis for calculating rates of retur and evaluating capital structure of the company. Analysts use information in balance sheet to assess company’s risk and future cash flows. Analysts use balance sheet to asses company’s liquidity, solvency, and financial flexibility.

Liquidity is the amount of time that is expected to elapse until an asset is realized or converted into cash or until a liability has to be paid. Creditors is interested with short-term liquidity to see whether the company able to pay its short-term debts. Solvency refers to the ability of a company to pay its debts as they mature. Ratio debts to assets should be lower to get higher solvency. Both liquidity and solvency will affects financial flexibility, which measures the ability of company to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.

Eventhough, balance sheet also has its limitations. First, most assets and liabilities and reported at historical cost. Therefore, sometimes balance sheet is criticized for not report fair value. Second, companies use judgement and estimates to determine many items reported in balance sheet. For example, good will and brand recognitions may be judged differently from various companies. Third, balance sheet ignore some items that cannot be record objectively. For example, knowledge and skill of employees cannot be put into balance sheet. Many items also reported in an “off balance sheet” manner, like third party’s assets under managements in bank industry.

Balance sheet accounts has three general classes of items :

1. Assets: Probable future economics benefits controlled by company as result of past transactions or events. Assets may consist of current assets (cash, cash equivalents, and inventory), long term investments, PPE(Property, Plant and Equipment), intangible assets, and other assets.

2. Liabilities: Probable future sacrifices of economics benefits arising from present obligation of company to transfer assets or provide services to other party in the future as result of past transaction or events. Liabilities may consist current liabilities and long term debt.

3. Equity: Residual interest in the assets of company that remains after diducting its liabilities. In a company, equity is also the ownership interest. Equity may consist capital stock, additional paid-in capital and retained earnings.

Statement of Cash flows

Cash flow statement is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities.

Operating activities involve the cash effects of transaction that enter into the determination of net income. Investing activities includes the making or collecting loans and acquiring or disposing of investments (both debt and equity) and PPE. Financing activities includes liability and owners’ equity items, such as obtaining share from owners or providing them return of their investments and borrowing money from creditors and repaying the amounts borrowed.

The basic format of cash flow statement :

Cash flows from operating activities      xxx

Cash flows from investing activities       xxx

Cash flows from financing activities       xxx

Net increase (decrease) in cash            xxx

Cash at the beginning of year               xxx

Cash at the end of year                      $XXX

Income Statements : Dell’s accounting case

Financial statements  consists of balance sheet, income statement, cash flow statement, and retained earning statement. In this post, I will share more about income statement and retained earnings.

Income statement is useful for evaluating past performance, provide basis for future predictions, and help assess the risk or uncertainty of achieving future cash flow.

Eventhough, income statement also has its limitations. First, companies ignores items that they cannot measure reliably, such as unrealized gains or losses in some investments and brand recognitions, customer loyalty, etc. Second, numbers in income statements are affected by accounting method, e.g. depreciation rate. Third, income measurement involves judgement, e.g. bad debt rate, useful life of assets. Stakeholders has to understand this limitation to use it accordingly.

There are some case in these days that many companies do “earning management”, which planning timing of revenues, expenses, gains, and loses to smooth out bumps in earnings. This is happened currently with Dell company. For years, Dell is well known as expert in squeezing efficiency out of its supply chain and drive  down cost. In July 2010, Security Exchange Commission (SEC) found out that Dell had manipulated its accounting over an extend  period to project financial results. On July 22, Dell aggreed to pay 100 million dollars penalty to settle allegations by SEC. 

The Dell case is about income statement. Prior to 2007, Dell had cooperated with Intel by exclusivity payments. Intel paid some amounts to Dell to use its chip exclusively in Dell’s computer. The amounts of payment reached 76% or Dell quarterly operating income in first quarter 2007.

In 2007, Dell decided to use AMD’s processors in its product, which is in competition with Intel’s processors. This made Intel stopped its exclusivity payments. After Intel cut its payments, Dell again misled investor my not disclosing the true reason behind company’s decreased profitability. Dell said that the main reason was too aggressive pricing in the face of slowing demand and component cost declined less than expected.

 

In multiple step of Income Statements, there should be a separation between operating income and non-operating income. In Dell case, operating income should come from selling computers and non-operating income should come from other than this activity, for example exclusivity payments from Intel. Failed to report this separation will mislead investor as we see from this case.

Therefore, income statement components include :

1. Operating sections

• Sales and revenue sections
• Cost of Good Sold (COGS)
• Selling expenses
• Admin & General expenses

2. Non-Operating sections

• Other revenue and gains, such as rental fee and dividents from investing in other company.
• Other expenses and losses, such as interest from payable

3. Income Tax

4. Discontinued operations

5. Extraordinary items

6. Earning per share (EPS)

 

In description above, companies have to report separately irregular items in componenents of income on income statements.  These irregular items includes discontinued operations, extraordinary items, unusual gains and losses, changes in accounting principles, changes in estimates, and correction of errors. Each of these irregular items has different reporting method we have to understand.

Earning per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. Many beginner investors only see this number to decide their investment plan, which make the risk even higher. Therefore, accounting rule concluded that companies must disclose earnings per share on the face of income statement to lower this risk. Usually, we can see EPS in lower line of income statement.

Retained earning is the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Retained earning statement reports this portion, separated from other part of financial statements.

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Fail to report income statement accordingly will mislead stakeholders, such as managers, investors, and customers. As the result we can see from Dell’s case, the company has to pay $100 millions and Mr. Michael Dell as CEO has to pay $4 million.

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• Dell’s Sordid Intel Past [Dell] (gizmodo.com)

Accounting Cycle

The understanding of  accounting cycle is a very basic. So here it is the cycle :

0. Identifying and recording transactions and other events

Determine what to record, either internal events like paying salaries or using raw material nor external events like sales transaction or buy from supplier.

1. Journalizing

Put transactions or other events in the journal. The simplest form is general journal that chronologically list transactions or other events, expressed in debits and credits to accounts.

2. Posting

Transfer journal to ledger accounts, such as cash account, common stock account, notes payable account. Each account will be recorded from the information get from the journal. Accounts will get three column form of account, consists of account name, debit, credit, and balance.

3. Trial balance preparation

Trial balance lists accounts and their balance at a given time. Usually, company prepares a trial balance at the end of an accounting period. Trial balance consists account names, debit, and credit. In the debit column, there are accounts of assets, such as cash, account recievable, inventory, and some fix assets. In the credit column, there are accounts of liabilities and equities, such as note payable, common stocks, and dividend. Sum of debit and credit value should be balance to each other.

4. Adjusting entries

Companies adjust entries in trial balance at the end of accounting period to ensure revenue recognition and matching principle. Adjusting entries make it possible to report balance sheet the appropriate assets, liabilities, and equity at the statement date. And also, income statement the proper revenues and expenses for the accounting period.

Companies usually adjust entries on defferal (prepaid expenses and unearned revenues) and accruals (accrued revenues and accrued expense).

5. Adjusted trial balance

After trial balance adjusted, companies prepare aonter trial balance from its ledger accounts, which called adjusted trial balance. It consists already additional adjusting factor, such as depreciation, prepaid insurance expense, accrued salary expense.

6. Financial statement preparation

Company can prepare financial statements directly form adjusted trial balance. Financial statements  consists of balance sheet, income statement, cashflow statement, and retained earning statement.

7. Closing

Closing process zeroes the balance of nominal (temporary) accounts, such as revenue and expense account balance (which reported in income statement). Companies transfer all of the revenue and expense to a clearing or suspense account called income summary, which matches revenue and expense.

8. Post closing trial balance

Post closing trial balance consists only real acounts, such as assets, liabilities, and equity.

9. Reversing Entries

After closing, companies may reverse some of the adjusting entries before start next period of accounting period. These are called reversing entries.

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Source: Keiso, D., 2010. “Intermediate Accounting 13th ed”. John Willey & Sons (Asia) Pte. Ltd.