An Introduction to Financial Analysis

 

Introduction

 

This book is designed to provide student with the knowledge and skills that enable them to analyze the financial statements of different businesses including banks. It starts with presenting the concept of financial reporting and explaining the main financial statements for general businesses and for banks. 

In chapter two students will learn about vertical and horizontal analyses of the main financial statements. Chapters three, four, five and six explain profitability, liquidity, solvency, and activity analyses. Chapter seven discusses integrated financial ratio analysis. Equity and credit analysis are described in chapter eight. Chapter nine talks about segment reporting. In chapter ten we explained the break even analysis. Chapter eleven elaborates the leverage analysis. The last chapter presents the prospective analysis and business failure.

All the chapters are supported with illustrative examples and exercises. It should be noted that some examples included real names of companies operating in Syria (Golden-Med Pharma, KINDA Pharma, and Karapeil). However, all the figures provided in examples and exercises related to these companies are hypothetical figures, and they are not representing real data by any means.

We hope that the book will achieve its intended purposes in providing simple and useful information in easy English language to our students.

Chapter One: An Introduction to Financial Analysis

 

1-1    Financial reporting and financial statements

Before starting our journey with financial analysis, it's beneficial to remember that accounting is seen as the language of business. It performs four main activities, which include, identifying, measuring, recording, and communicating the economic events of an organization to different parties, who have an interest in the organization. In this sense, accounting can be viewed as a financial information system that provides useful information to different parties interested in the business, to enable them making decisions. Figure (1-1) illustrates the different steps of accounting process.

In the first step of the accounting process, different economic events and transactions of the business are identified. Such transactions include the payment of the wages of employees in the company, the sale of its main goods or services etc.

After identifying economic events relevant to the business, these events and transactions are measured in monetary terms, and recorded in the accounting records. In the final step of the accounting process different transactions are processed and translated into accounting information that are communicated to different users, to allow them make informed decisions. 

This final step is a key part of financial reporting. Financial statements are the main source by which companies communicate information to different users. Understanding financial analysis requires an understanding of financial reporting and how to prepare the main financial statements and the purpose of each statement.

 
 1-1-1   Financial reporting.

 Users of financial statements include different parties inside and outside the organization. Examples of internal users include a company’s managers and employees. While external users of accounting information embrace: stockholders, bondholders, security analysts, suppliers, lending institutions, labor unions, regulatory authorities, and the general public.

These internal and external user groups need accounting information and reports to make different decisions concerning the business. For example, potential investors use the financial reports of a business to help them in deciding whether to buy its stocks. Suppliers use the financial reports to decide whether to sell their goods or services to a company on credit. 

Labor unions use the financial reports to help determine their demands when they negotiate for employees. Managers use financial information extracted from the financial reports to determine the company’s profitability.

Accordingly, financial reporting can be defined as "providing financial information about the reporting entity that is useful to existing and potential equity investors, lenders and other creditors in making their decisions about providing resources to the entity." (CARLON, 2016, p:13).

It should be noted that the International Accounting Standard Board (IASB), identified the objective of financial reporting as providing information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.

 In this sense financial reporting involves the disclosure of financial information to the various stakeholders about the financial performance and financial position of the organization over a specified period of time.

In case of listed companies the frequency of financial reporting is quarterly and annually. For financial information to be useful it should has two main characteristics.

The first qualitative characteristic of accounting information is Relevance, which is the capacity of information to affect users' decisions. This implies that timeliness is a desirable characteristic of accounting information. Interim (quarterly) financial reports are largely motivated by timeliness.

The second primary quality of accounting information is Reliability. For information to be reliable it must be verifiable, representationally faithful, and neutral. Verifiability means the information is confirmable. Representational faithfulness means the information reflects reality, and neutrality means it is truthful and unbiased. 

It should be noted that accounting information often demands a trade-off between relevance and reliability. Another question concerning financial reporting is about its content or main elements. The key elements of financial reporting include:

The financial statements – balance sheet, profit & loss account (or income statement), cash flow statement & statement of changes in owners' equity.

The notes to financial statements Quarterly & annual reports (interim reports) (in case of listed companies) Management Discussion and Analysis (In case of public companies) The importance of financial reporting cannot be over emphasized. It is required by each and every stakeholder for multiple reasons and purposes. The following points highlights why financial reporting framework is important: 

It helps an organization to comply with various statues and regulatory requirements. It facilitates statutory audit. The Statutory auditors are required to audit the financial statements of an organization to express their opinion. Financial Reports forms the backbone for financial planning, analysis, benchmarking and decision making.

Financial reporting helps organizations to raise capital both domestic as well as overseas. On the basis of financial, the public in large can analyze the performance of the organization as well as of its management. For the purpose of bidding, labor contract, government supplies etc., organizations are required to provide their financial reports and statements.

In sum the main objective of financial reporting is the dissemination of financial Statements that accurately measure the profitability and financial condition of a company. Before going further in exploring financial analysis and its objectives and importance, it is necessary to recall the main financial statements and the purpose of each statement.

1-1-1  A review of financial statements:

 As mentioned earlier financial statements are the outputs of accounting information system. They are means by which a business communicates information to its stakeholders. The key financial statements include : the income statement, the balance sheet (statement of financial position), the cash flow statement, and the statement of changes in owners' equity. In this section we will present each of these statements.

A.               The Income Statement:

The income statement of a firm shows its revenues and expenses over a specific period of time (usually one year). The income statement equation in its simplest form is:

                                          Revenues – Expenses = Net Income                             

 

 Revenues are the amounts reported from the sale of goods and services in the normal course of business. Expenses are the amounts incurred to generate revenue and include cost of goods sold, operating expenses, interest, and taxes. 

Expenses are grouped together by their nature or by function. According to the IASB, expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants.

The income statements can be presented in different ways. In its simple form it compares the firm's revenues with its expenses to get net income. In this case it is called single-step income statement. Another form to present the income statement is called multi-step income statement. In this form the income statement is prepared to show different levels of income (gross profit, operating income, income before tax, net income after tax …)

Under IFRS, the income statement can be combined with “other comprehensive income” and presented as a single statement of comprehensive income. Alternatively, the income statement and the statement of comprehensive income can be presented separately. Presentation is similar under U.S. GAAP.

Investors examine a firm’s income statement for valuation purposes while lenders examine the income statement for information about the firm’s ability to make the promised interest and principal payments on its debt.

Figure (2-1) shows multi-step income statement format:

 

Figure (2-1) multi-step income statement:

 

Revenue	XXX
Cost of goods sold	(XXX)
Gross profit	XXX
Selling, general, and administrative expenses	(XXX)
Depreciation expense	(XXX)
Operating profit	XXX
Interest expense	(XXX)
Income before tax	XXX
Provision for income taxes	(XXX)
Income from continuing operations	XXX
Earnings (losses) from discontinued operations, net of tax	XXX
Net income	XXX

 

It should be noted that the overall structure of an income statement for a bank doesn’t defer too much from a regular income statement. The top of the income statement is revenue and the bottom is net income. However, revenue is derived differently from that of regular companies. The income statement format for a bank will generally look as follows:

 

The income statement of (XY) bank for the year ended 31/12/2019

 

 

Revenue
Interest income
Interest expense
Net interest income
Non-interest income
Total revenue
provisions for loan losses
Non-interest expenses
Total Expenses
Income before interest and tax (EBIT)
Interest expense (on debts)
Income before tax (EBT)
Income tax expense
Net income

 

As can be seen from the bank income statement format, most of the bank’s revenue and expenses are related to interest. The bank receives interest income on the loans it issues, while it pays interest expense to the deposits used to fund the loans. Interest expense does not include interest expense from general debt. Non-interest income encompasses all the other business activities that a bank engages in. 

These may include credit card fees, underwriting fees, fees from overdrawn accounts, transaction fees, and any other non- interest income that a bank earns. Non-interest expenses are generally operational expenses and are essential to the day-to-day operation of a bank. They include salaries and bonuses to staff, marketing, and other administrative expenses.

B.               The Balance Sheet (statement of financial position):

While the income statement presents a picture of a firm’s economic activities over a period of time, its balance sheet is a snapshot of its financial and physical assets and its liabilities at a point in time. Just as with the income statement, understanding balance sheet accounts, how they are valued, and what they represent, is also crucial to the financial analysis of a firm.

The balance sheet (also known as the statement of financial position or statement of financial condition) reports the firm’s financial position at a point in time. The balance sheet consists of assets, liabilities, and equity.

Assets: Economic resources controlled by the business as a result of past transactions that are expected to generate future economic benefits.

Liabilities: Obligations resulted from past events that are expected to cause an outflow of economic resources.

Equity: The owners’ residual interest in the assets after deducting the liabilities. Equity is also referred to as stockholders’ equity, shareholders’ equity, or owners’ equity. Analysts sometimes refer to equity as “net assets.

The relationship among the main components of the balance sheet can be expressed using the accounting equation as flows: 

                                         Assets = Liabilities + Owner's equity                              

Figure (3-1) shows the format of the balance sheet:

 

 

Figure (3-1) the balance sheet format:

 

Current assets	XXX
Noncurrent assets	XXX
Total assets	XXX
Current liabilities	XXX
Noncurrent liabilities	XXX
Total liabilities	XXX
Equity	XXX
Total equity and liabilities	XXX

 The balance sheet format presented in figure (3-1) confirm with both IFRSs and U.S. GAAP that entail firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities.   This format is known as a classified balance sheet and is useful in evaluating liquidity.

Liquidity-based presentations, which are often used in the banking industry, present assets and liabilities in the order of liquidity.

To understand financial analysis techniques students should be familiar with the elements of the balance sheet. As can be seen from the balance sheet format presented above, assets and liabilities are categorized into main groups.

Current assets include cash and other assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater. The operating cycle is the

period of time it takes to produce or purchase inventory, sell the product, and collect the cash. Current assets are usually presented in the order of their liquidity, with cash being the most liquid. Current assets reveal information about the operating activities of the firm. They comprise elements such as cash and Cash equivalents, securities, trade receivables, inventories, and other current assets.

Current liabilities are obligations that will be satisfied within one year or one operating cycle, whichever is greater. More specifically, a liability that meets any of the following criteria is considered current:

-          Settlement is expected during the normal operating cycle.

-          Settlement is expected within one year.

-          Held primarily for trading purposes.

-          There is not an unconditional right to defer settlement for more than one year.

Current liabilities comprise elements such as accounts payable, notes payable and current portion of long-term debt, accrued liabilities (expense), and unearned revenue (deferred income).

Current assets minus current liabilities equals working capital. Insufficient working capital may indicate liquidity problems. Too much working capital may be an indication of inefficient use of assets. 

Noncurrent assets are economic resources that provide long-term future benefits to the business. They comprise all other assets that do not meet the definition of current assets because they will not be converted into cash or used up within one year or operating cycle. Noncurrent assets provide information about the firm’s investing activities, which form the foundation upon which the firm operates.

This group of assets contains several items such as property, plant, and equipment (tangible non-current assets including lands, buildings, machinery and equipment, furniture, and natural resources), investment property, and intangible assets.

Noncurrent liabilities obligations that do not meet the criteria of current liabilities. Noncurrent liabilities provide information about the firm’s long-term financing activities.

 

It should be noted that a bank has unique classes of balance sheet line items that other companies won’t. The typical structure of a balance sheet for a bank is shown below:

 

 

A bank balance sheet format
Assets
Property
Trading assets
Loans to customers
Deposits to the central bank
Total Assets
Equity and Liabilities
Liabilities
Loans from the central bank
Deposits from customers
Trading liabilities
Misc. debt
Equity
Common and preferred shares

Total Equity and Liabilities

As can be seen from the bank balance sheet format, loans to customers are classified as assets. This is because the bank expects to receive interest and principal repayments for loans in the future, and thus generate economic benefit from the loans.

Deposits from customers, on the other hand, are expected to be withdrawn by customers or also pay out interest payments, generating an economic outflow in the future. They are, therefore, classified as liabilities.

Deposits from a bank in a central bank are considered assets, similar to cash and equivalents for a regular company. This is because the bank can withdraw these deposits rather easily. It also expects to receive a small interest payment, using the central bank’s prime rate.

Loans from the central bank are considered liabilities, much like normal debt.

 

Banks may hold marketable securities or certain currencies for the purposes of trading. These will naturally be considered trading assets. They may have trading liabilities if the securities they purchase decline in value.

C.   The Cash flow statement: The third important financial statement is the cash flow statement. The income statement is based on the accrual basis, which in turn means that net income may not represent cash generated from operations. A company may generate positive and growing net income but may face insolvency because insufficient cash is being generated from operating activities. As a result preparing cash flow statement, using either the direct or indirect method, is very important in analyzing a firm’s activities and prospects.

The cash flow statement provides information about the following:

-            A company’s cash receipts and cash payments during an accounting period.

-            A company’s operating, investing, and financing activities.

 

-          The impact of accrual accounting transactions on cash flows.

-          The firm’s liquidity, solvency, and financial flexibility.

An analyst can use the cash flow statement of a business to determine whether:

-          Regular operations of the business generate enough cash to sustain the business.

-          Sufficient cash is generated to settle current obligations when they become due.

-          The business is likely to need more funding.

-          Unforeseen debts can be met.

-          A company can benefit of new business opportunities as they arise.

-          The impact of accrual accounting transactions on cash flows.

-          The firm’s liquidity, solvency, and financial flexibility.

An analyst can use the cash flow statement of a business to determine whether:

-          Regular operations of the business generate enough cash to sustain the business.

-          Sufficient cash is generated to settle current obligations when they become due.

-          The business is likely to need more funding.

-          Unforeseen debts can be met.

-          A company can benefit of new business opportunities as they arise.

Preparing the cash flow statement requires information about the income statement items and changes in balance sheet accounts.

Cash receipts and payments in the cash flow statement are classified into three main groups:

·      Cash flow from operating activities, sometimes referred to as “cash flow from operations” or “operating cash flow,” consists of the inflows and outflows of cash resulting from transactions that affect a company’s net income.

·      Cash flow from investing activities consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments.

Cash flow from financing activities (CFF) consists of the ·      inflows and outflows of cash resulting from transactions affecting a firm’s capital structure.

 

Figure (4-1) gives examples of cash flow items under each category:

 

Cash flows from operating activities
In cash flows	Out cash flows
Cash receipts from customers	Cash  payments  to   employees and suppliers

Interest and dividends received	Cash     payments    for     other expenses
Sale    proceeds   from    trading securities.	Cash payments for the purchase of trading securities.
	Interest payments
	Tax payments
Cash flows from investing activities
In cash flows	Out cash flows
Sale of non-current assets	Acquisition of non-current assets
Sale     of     debt    and    equity investments	Acquisition of debt and equity investments
Principal  received   form  loans made to others	loans made to others
Cash flows from financing activities
In cash flows	Out cash flows
Issuing shares	Reacquire shares
Issuing debts	Dividends payments
	Loan (debts) payments

 

There are two methods of presenting the cash flow statement: the direct method and the indirect method. Both methods allowed under U.S. GAAP and IFRS. The use of the direct method, however, is encouraged by both standard setters. Unfortunately, most firms use the indirect method. The difference between the two methods relates to the presentation of cash flows from operating activities. The presentation of cash flows from investing activities and financing activities is exactly the same under both methods.

Under the direct method cash flows from operating activities are calculated as shown in the following:

Operating Cash Flow – Direct Method For the year ended December 31

 

Cash collections from customers	Xxx
Cash paid to suppliers	(xxx)
Cash paid for operating expenses	(xxx)
Cash paid for interest	(xxx)
Cash paid for taxes	(xxx)
Net cash flows from Operating activities	Xxx

 

Under the indirect method, net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. These adjustments include eliminating noncash expenses (e.g., depreciation and amortization), non-operating items (e.g., gains and losses), and changes in balance sheet accounts resulting from accrual accounting events.

 

Operating Cash Flow – indirect Method For the year ended December 31

 

Net income

Xxx

Adjustments to reconcile net income to cash flow provided by operating activities:
Depreciation and amortization	Xxx
Deferred income taxes	Xxx
Increase  (deduct)  or   decrease  (add)     in   accounts	(xxx)

receivable
Increase (deduct) or decrease (add) in inventory	(xxx)
Decrease   (add)   or   Increase   (deduct)   in   prepaid expenses	Xxx
Increase  (add)  or  decrease  (deduct)     in   accounts payable	Xxx
Increase (add) or decrease (deduct)      in accrued liabilities	Xxx
Net cash flows from Operating activities	Xxx

 

It can be seen that under the indirect method, we start with the net income, the “bottom line” of the income statement. Under the direct method, the starting point is the top of the income statement, revenues, adjusted to show cash received from customers. Total cash flow from operating activities is exactly the same under both methods, only the presentation methods differ.

 

The main advantage of the direct method is that it shows the firm’s operating cash receipts and payments, while the indirect method only presents the net result of these receipts and payments. This information of past in cash flows and out cash flows is beneficial in predicting future operating cash flows. After calculating net cash flows from operating activities, using either direct or indirect methods, it becomes possible to prepare the cash flow statement. Figure (5-1) shows the format of cash flow statement:

Figure (5-1) cash flow statement format

 

Net cash flows from Operating activities	XXX
+ Net cash flows from investing activities	XXX
+ Net cash flows from financing activities	XXX
Net Change in cash balance during the period	XXXX
+ Beginning cash balance	XXX
= Closing balance of cash	XXXX

 

A.               Statement of Changes in owner’s Equity (or owner’s equity statement)

The last financial statement required by IFRSs is statement of changes in owner’s equity. This statement summarizes the changes in owner’s equity for a specific period of time. It starts with the beginning balance of owner’s equity, it then adds to this amount the net income for the period and new investments by the owner. After that owner’s drawings are deducted to get the closing balance of owner’s equity. 

This statement explains why the owner’s equity increased or decreased during the period. The statement of owner’s equity is usually prepared by referring to the balance sheet and income statement during a specific period of time. The income statement provides information about the net income or losses of the business, while the balance sheet will provide the information regarding the new  

Introduction

 

This book is designed to provide student with the knowledge and skills that enable them to analyze the financial statements of different businesses including banks. It starts with presenting the concept of financial reporting and explaining the main financial statements for general businesses and for banks. 

In chapter two students will learn about vertical and horizontal analyses of the main financial statements. Chapters three, four, five and six explain profitability, liquidity, solvency, and activity analyses. Chapter seven discusses integrated financial ratio analysis. Equity and credit analysis are described in chapter eight. Chapter nine talks about segment reporting. In chapter ten we explained the break even analysis. Chapter eleven elaborates the leverage analysis. The last chapter presents the prospective analysis and business failure.

All the chapters are supported with illustrative examples and exercises. It should be noted that some examples included real names of companies operating in Syria (Golden-Med Pharma, KINDA Pharma, and Karapeil). However, all the figures provided in examples and exercises related to these companies are hypothetical figures, and they are not representing real data by any means.

We hope that the book will achieve its intended purposes in providing simple and useful information in easy English language to our students.

Chapter One: An Introduction to Financial Analysis

 

1-1    Financial reporting and financial statements

Before starting our journey with financial analysis, it's beneficial to remember that accounting is seen as the language of business. It performs four main activities, which include, identifying, measuring, recording, and communicating the economic events of an organization to different parties, who have an interest in the organization. In this sense, accounting can be viewed as a financial information system that provides useful information to different parties interested in the business, to enable them making decisions. Figure (1-1) illustrates the different steps of accounting process.

In the first step of the accounting process, different economic events and transactions of the business are identified. Such transactions include the payment of the wages of employees in the company, the sale of its main goods or services etc.

After identifying economic events relevant to the business, these events and transactions are measured in monetary terms, and recorded in the accounting records. In the final step of the accounting process different transactions are processed and translated into accounting information that are communicated to different users, to allow them make informed decisions. 

This final step is a key part of financial reporting. Financial statements are the main source by which companies communicate information to different users. Understanding financial analysis requires an understanding of financial reporting and how to prepare the main financial statements and the purpose of each statement.

 
 1-1-1   Financial reporting.

 Users of financial statements include different parties inside and outside the organization. Examples of internal users include a company’s managers and employees. While external users of accounting information embrace: stockholders, bondholders, security analysts, suppliers, lending institutions, labor unions, regulatory authorities, and the general public.

These internal and external user groups need accounting information and reports to make different decisions concerning the business. For example, potential investors use the financial reports of a business to help them in deciding whether to buy its stocks. Suppliers use the financial reports to decide whether to sell their goods or services to a company on credit. 

Labor unions use the financial reports to help determine their demands when they negotiate for employees. Managers use financial information extracted from the financial reports to determine the company’s profitability.

Accordingly, financial reporting can be defined as "providing financial information about the reporting entity that is useful to existing and potential equity investors, lenders and other creditors in making their decisions about providing resources to the entity." (CARLON, 2016, p:13).

It should be noted that the International Accounting Standard Board (IASB), identified the objective of financial reporting as providing information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.

 In this sense financial reporting involves the disclosure of financial information to the various stakeholders about the financial performance and financial position of the organization over a specified period of time.

In case of listed companies the frequency of financial reporting is quarterly and annually. For financial information to be useful it should has two main characteristics.

The first qualitative characteristic of accounting information is Relevance, which is the capacity of information to affect users' decisions. This implies that timeliness is a desirable characteristic of accounting information. Interim (quarterly) financial reports are largely motivated by timeliness.

The second primary quality of accounting information is Reliability. For information to be reliable it must be verifiable, representationally faithful, and neutral. Verifiability means the information is confirmable. Representational faithfulness means the information reflects reality, and neutrality means it is truthful and unbiased. 

It should be noted that accounting information often demands a trade-off between relevance and reliability. Another question concerning financial reporting is about its content or main elements. The key elements of financial reporting include:

The financial statements – balance sheet, profit & loss account (or income statement), cash flow statement & statement of changes in owners' equity.

The notes to financial statements Quarterly & annual reports (interim reports) (in case of listed companies) Management Discussion and Analysis (In case of public companies) The importance of financial reporting cannot be over emphasized. It is required by each and every stakeholder for multiple reasons and purposes. The following points highlights why financial reporting framework is important: 

It helps an organization to comply with various statues and regulatory requirements. It facilitates statutory audit. The Statutory auditors are required to audit the financial statements of an organization to express their opinion. Financial Reports forms the backbone for financial planning, analysis, benchmarking and decision making.

Financial reporting helps organizations to raise capital both domestic as well as overseas. On the basis of financial, the public in large can analyze the performance of the organization as well as of its management. For the purpose of bidding, labor contract, government supplies etc., organizations are required to provide their financial reports and statements.

In sum the main objective of financial reporting is the dissemination of financial Statements that accurately measure the profitability and financial condition of a company. Before going further in exploring financial analysis and its objectives and importance, it is necessary to recall the main financial statements and the purpose of each statement.

1-1-1  A review of financial statements:

 As mentioned earlier financial statements are the outputs of accounting information system. They are means by which a business communicates information to its stakeholders. The key financial statements include : the income statement, the balance sheet (statement of financial position), the cash flow statement, and the statement of changes in owners' equity. In this section we will present each of these statements.

A.               The Income Statement:

The income statement of a firm shows its revenues and expenses over a specific period of time (usually one year). The income statement equation in its simplest form is:

                                          Revenues – Expenses = Net Income                             

 

 Revenues are the amounts reported from the sale of goods and services in the normal course of business. Expenses are the amounts incurred to generate revenue and include cost of goods sold, operating expenses, interest, and taxes. 

Expenses are grouped together by their nature or by function. According to the IASB, expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants.

The income statements can be presented in different ways. In its simple form it compares the firm's revenues with its expenses to get net income. In this case it is called single-step income statement. Another form to present the income statement is called multi-step income statement. In this form the income statement is prepared to show different levels of income (gross profit, operating income, income before tax, net income after tax …)

Under IFRS, the income statement can be combined with “other comprehensive income” and presented as a single statement of comprehensive income. Alternatively, the income statement and the statement of comprehensive income can be presented separately. Presentation is similar under U.S. GAAP.

Investors examine a firm’s income statement for valuation purposes while lenders examine the income statement for information about the firm’s ability to make the promised interest and principal payments on its debt.

Figure (2-1) shows multi-step income statement format:

 

Figure (2-1) multi-step income statement:

 

Revenue	XXX
Cost of goods sold	(XXX)
Gross profit	XXX
Selling, general, and administrative expenses	(XXX)
Depreciation expense	(XXX)
Operating profit	XXX
Interest expense	(XXX)
Income before tax	XXX
Provision for income taxes	(XXX)
Income from continuing operations	XXX
Earnings (losses) from discontinued operations, net of tax	XXX
Net income	XXX

 

It should be noted that the overall structure of an income statement for a bank doesn’t defer too much from a regular income statement. The top of the income statement is revenue and the bottom is net income. However, revenue is derived differently from that of regular companies. The income statement format for a bank will generally look as follows:

 

The income statement of (XY) bank for the year ended 31/12/2019

 

 

Revenue
Interest income
Interest expense
Net interest income
Non-interest income
Total revenue
provisions for loan losses
Non-interest expenses
Total Expenses
Income before interest and tax (EBIT)
Interest expense (on debts)
Income before tax (EBT)
Income tax expense
Net income

 

As can be seen from the bank income statement format, most of the bank’s revenue and expenses are related to interest. The bank receives interest income on the loans it issues, while it pays interest expense to the deposits used to fund the loans. Interest expense does not include interest expense from general debt. Non-interest income encompasses all the other business activities that a bank engages in. 

These may include credit card fees, underwriting fees, fees from overdrawn accounts, transaction fees, and any other non- interest income that a bank earns. Non-interest expenses are generally operational expenses and are essential to the day-to-day operation of a bank. They include salaries and bonuses to staff, marketing, and other administrative expenses.

B.               The Balance Sheet (statement of financial position):

While the income statement presents a picture of a firm’s economic activities over a period of time, its balance sheet is a snapshot of its financial and physical assets and its liabilities at a point in time. Just as with the income statement, understanding balance sheet accounts, how they are valued, and what they represent, is also crucial to the financial analysis of a firm.

The balance sheet (also known as the statement of financial position or statement of financial condition) reports the firm’s financial position at a point in time. The balance sheet consists of assets, liabilities, and equity.

Assets: Economic resources controlled by the business as a result of past transactions that are expected to generate future economic benefits.

Liabilities: Obligations resulted from past events that are expected to cause an outflow of economic resources.

Equity: The owners’ residual interest in the assets after deducting the liabilities. Equity is also referred to as stockholders’ equity, shareholders’ equity, or owners’ equity. Analysts sometimes refer to equity as “net assets.

The relationship among the main components of the balance sheet can be expressed using the accounting equation as flows: 

                                         Assets = Liabilities + Owner's equity                              

Figure (3-1) shows the format of the balance sheet:

 

 

Figure (3-1) the balance sheet format:

 

Current assets	XXX
Noncurrent assets	XXX
Total assets	XXX
Current liabilities	XXX
Noncurrent liabilities	XXX
Total liabilities	XXX
Equity	XXX
Total equity and liabilities	XXX

 The balance sheet format presented in figure (3-1) confirm with both IFRSs and U.S. GAAP that entail firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities.   This format is known as a classified balance sheet and is useful in evaluating liquidity.

Liquidity-based presentations, which are often used in the banking industry, present assets and liabilities in the order of liquidity.

To understand financial analysis techniques students should be familiar with the elements of the balance sheet. As can be seen from the balance sheet format presented above, assets and liabilities are categorized into main groups.

Current assets include cash and other assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater. The operating cycle is the

period of time it takes to produce or purchase inventory, sell the product, and collect the cash. Current assets are usually presented in the order of their liquidity, with cash being the most liquid. Current assets reveal information about the operating activities of the firm. They comprise elements such as cash and Cash equivalents, securities, trade receivables, inventories, and other current assets.

Current liabilities are obligations that will be satisfied within one year or one operating cycle, whichever is greater. More specifically, a liability that meets any of the following criteria is considered current:

-          Settlement is expected during the normal operating cycle.

-          Settlement is expected within one year.

-          Held primarily for trading purposes.

-          There is not an unconditional right to defer settlement for more than one year.

Current liabilities comprise elements such as accounts payable, notes payable and current portion of long-term debt, accrued liabilities (expense), and unearned revenue (deferred income).

Current assets minus current liabilities equals working capital. Insufficient working capital may indicate liquidity problems. Too much working capital may be an indication of inefficient use of assets. 

Noncurrent assets are economic resources that provide long-term future benefits to the business. They comprise all other assets that do not meet the definition of current assets because they will not be converted into cash or used up within one year or operating cycle. Noncurrent assets provide information about the firm’s investing activities, which form the foundation upon which the firm operates.

This group of assets contains several items such as property, plant, and equipment (tangible non-current assets including lands, buildings, machinery and equipment, furniture, and natural resources), investment property, and intangible assets.

Noncurrent liabilities obligations that do not meet the criteria of current liabilities. Noncurrent liabilities provide information about the firm’s long-term financing activities.

 

It should be noted that a bank has unique classes of balance sheet line items that other companies won’t. The typical structure of a balance sheet for a bank is shown below:

 

 

A bank balance sheet format
Assets
Property
Trading assets
Loans to customers
Deposits to the central bank
Total Assets
Equity and Liabilities
Liabilities
Loans from the central bank
Deposits from customers
Trading liabilities
Misc. debt
Equity
Common and preferred shares

Total Equity and Liabilities

As can be seen from the bank balance sheet format, loans to customers are classified as assets. This is because the bank expects to receive interest and principal repayments for loans in the future, and thus generate economic benefit from the loans.

Deposits from customers, on the other hand, are expected to be withdrawn by customers or also pay out interest payments, generating an economic outflow in the future. They are, therefore, classified as liabilities.

Deposits from a bank in a central bank are considered assets, similar to cash and equivalents for a regular company. This is because the bank can withdraw these deposits rather easily. It also expects to receive a small interest payment, using the central bank’s prime rate.

Loans from the central bank are considered liabilities, much like normal debt.

 

Banks may hold marketable securities or certain currencies for the purposes of trading. These will naturally be considered trading assets. They may have trading liabilities if the securities they purchase decline in value.

C.   The Cash flow statement: The third important financial statement is the cash flow statement. The income statement is based on the accrual basis, which in turn means that net income may not represent cash generated from operations. A company may generate positive and growing net income but may face insolvency because insufficient cash is being generated from operating activities. As a result preparing cash flow statement, using either the direct or indirect method, is very important in analyzing a firm’s activities and prospects.

The cash flow statement provides information about the following:

-            A company’s cash receipts and cash payments during an accounting period.

-            A company’s operating, investing, and financing activities.

 

-          The impact of accrual accounting transactions on cash flows.

-          The firm’s liquidity, solvency, and financial flexibility.

An analyst can use the cash flow statement of a business to determine whether:

-          Regular operations of the business generate enough cash to sustain the business.

-          Sufficient cash is generated to settle current obligations when they become due.

-          The business is likely to need more funding.

-          Unforeseen debts can be met.

-          A company can benefit of new business opportunities as they arise.

-          The impact of accrual accounting transactions on cash flows.

-          The firm’s liquidity, solvency, and financial flexibility.

An analyst can use the cash flow statement of a business to determine whether:

-          Regular operations of the business generate enough cash to sustain the business.

-          Sufficient cash is generated to settle current obligations when they become due.

-          The business is likely to need more funding.

-          Unforeseen debts can be met.

-          A company can benefit of new business opportunities as they arise.

Preparing the cash flow statement requires information about the income statement items and changes in balance sheet accounts.

Cash receipts and payments in the cash flow statement are classified into three main groups:

·      Cash flow from operating activities, sometimes referred to as “cash flow from operations” or “operating cash flow,” consists of the inflows and outflows of cash resulting from transactions that affect a company’s net income.

·      Cash flow from investing activities consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments.

Cash flow from financing activities (CFF) consists of the ·      inflows and outflows of cash resulting from transactions affecting a firm’s capital structure.

 

Figure (4-1) gives examples of cash flow items under each category:

 

Cash flows from operating activities
In cash flows	Out cash flows
Cash receipts from customers	Cash  payments  to   employees and suppliers

Interest and dividends received	Cash     payments    for     other expenses
Sale    proceeds   from    trading securities.	Cash payments for the purchase of trading securities.
	Interest payments
	Tax payments
Cash flows from investing activities
In cash flows	Out cash flows
Sale of non-current assets	Acquisition of non-current assets
Sale     of     debt    and    equity investments	Acquisition of debt and equity investments
Principal  received   form  loans made to others	loans made to others
Cash flows from financing activities
In cash flows	Out cash flows
Issuing shares	Reacquire shares
Issuing debts	Dividends payments
	Loan (debts) payments

 

There are two methods of presenting the cash flow statement: the direct method and the indirect method. Both methods allowed under U.S. GAAP and IFRS. The use of the direct method, however, is encouraged by both standard setters. Unfortunately, most firms use the indirect method. The difference between the two methods relates to the presentation of cash flows from operating activities. The presentation of cash flows from investing activities and financing activities is exactly the same under both methods.

Under the direct method cash flows from operating activities are calculated as shown in the following:

Operating Cash Flow – Direct Method For the year ended December 31

 

Cash collections from customers	Xxx
Cash paid to suppliers	(xxx)
Cash paid for operating expenses	(xxx)
Cash paid for interest	(xxx)
Cash paid for taxes	(xxx)
Net cash flows from Operating activities	Xxx

 

Under the indirect method, net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. These adjustments include eliminating noncash expenses (e.g., depreciation and amortization), non-operating items (e.g., gains and losses), and changes in balance sheet accounts resulting from accrual accounting events.

 

Operating Cash Flow – indirect Method For the year ended December 31

 

Net income

Xxx

Adjustments to reconcile net income to cash flow provided by operating activities:
Depreciation and amortization	Xxx
Deferred income taxes	Xxx
Increase  (deduct)  or   decrease  (add)     in   accounts	(xxx)

receivable
Increase (deduct) or decrease (add) in inventory	(xxx)
Decrease   (add)   or   Increase   (deduct)   in   prepaid expenses	Xxx
Increase  (add)  or  decrease  (deduct)     in   accounts payable	Xxx
Increase (add) or decrease (deduct)      in accrued liabilities	Xxx
Net cash flows from Operating activities	Xxx

 

It can be seen that under the indirect method, we start with the net income, the “bottom line” of the income statement. Under the direct method, the starting point is the top of the income statement, revenues, adjusted to show cash received from customers. Total cash flow from operating activities is exactly the same under both methods, only the presentation methods differ.

 

The main advantage of the direct method is that it shows the firm’s operating cash receipts and payments, while the indirect method only presents the net result of these receipts and payments. This information of past in cash flows and out cash flows is beneficial in predicting future operating cash flows. After calculating net cash flows from operating activities, using either direct or indirect methods, it becomes possible to prepare the cash flow statement. Figure (5-1) shows the format of cash flow statement:

Figure (5-1) cash flow statement format

 

Net cash flows from Operating activities	XXX
+ Net cash flows from investing activities	XXX
+ Net cash flows from financing activities	XXX
Net Change in cash balance during the period	XXXX
+ Beginning cash balance	XXX
= Closing balance of cash	XXXX

 

A.               Statement of Changes in owner’s Equity (or owner’s equity statement)

The last financial statement required by IFRSs is statement of changes in owner’s equity. This statement summarizes the changes in owner’s equity for a specific period of time. It starts with the beginning balance of owner’s equity, it then adds to this amount the net income for the period and new investments by the owner. After that owner’s drawings are deducted to get the closing balance of owner’s equity. 

This statement explains why the owner’s equity increased or decreased during the period. The statement of owner’s equity is usually prepared by referring to the balance sheet and income statement during a specific period of time. The income statement provides information about the net income or losses of the business, while the balance sheet will provide the information regarding the new  

Introduction

 

This book is designed to provide student with the knowledge and skills that enable them to analyze the financial statements of different businesses including banks. It starts with presenting the concept of financial reporting and explaining the main financial statements for general businesses and for banks. 

In chapter two students will learn about vertical and horizontal analyses of the main financial statements. Chapters three, four, five and six explain profitability, liquidity, solvency, and activity analyses. Chapter seven discusses integrated financial ratio analysis. Equity and credit analysis are described in chapter eight. Chapter nine talks about segment reporting. In chapter ten we explained the break even analysis. Chapter eleven elaborates the leverage analysis. The last chapter presents the prospective analysis and business failure.

All the chapters are supported with illustrative examples and exercises. It should be noted that some examples included real names of companies operating in Syria (Golden-Med Pharma, KINDA Pharma, and Karapeil). However, all the figures provided in examples and exercises related to these companies are hypothetical figures, and they are not representing real data by any means.

We hope that the book will achieve its intended purposes in providing simple and useful information in easy English language to our students.

Chapter One: An Introduction to Financial Analysis

 

1-1    Financial reporting and financial statements

Before starting our journey with financial analysis, it's beneficial to remember that accounting is seen as the language of business. It performs four main activities, which include, identifying, measuring, recording, and communicating the economic events of an organization to different parties, who have an interest in the organization. In this sense, accounting can be viewed as a financial information system that provides useful information to different parties interested in the business, to enable them making decisions. Figure (1-1) illustrates the different steps of accounting process.

In the first step of the accounting process, different economic events and transactions of the business are identified. Such transactions include the payment of the wages of employees in the company, the sale of its main goods or services etc.

After identifying economic events relevant to the business, these events and transactions are measured in monetary terms, and recorded in the accounting records. In the final step of the accounting process different transactions are processed and translated into accounting information that are communicated to different users, to allow them make informed decisions. 

This final step is a key part of financial reporting. Financial statements are the main source by which companies communicate information to different users. Understanding financial analysis requires an understanding of financial reporting and how to prepare the main financial statements and the purpose of each statement.

 
 1-1-1   Financial reporting.

 Users of financial statements include different parties inside and outside the organization. Examples of internal users include a company’s managers and employees. While external users of accounting information embrace: stockholders, bondholders, security analysts, suppliers, lending institutions, labor unions, regulatory authorities, and the general public.

These internal and external user groups need accounting information and reports to make different decisions concerning the business. For example, potential investors use the financial reports of a business to help them in deciding whether to buy its stocks. Suppliers use the financial reports to decide whether to sell their goods or services to a company on credit. 

Labor unions use the financial reports to help determine their demands when they negotiate for employees. Managers use financial information extracted from the financial reports to determine the company’s profitability.

Accordingly, financial reporting can be defined as "providing financial information about the reporting entity that is useful to existing and potential equity investors, lenders and other creditors in making their decisions about providing resources to the entity." (CARLON, 2016, p:13).

It should be noted that the International Accounting Standard Board (IASB), identified the objective of financial reporting as providing information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.

 In this sense financial reporting involves the disclosure of financial information to the various stakeholders about the financial performance and financial position of the organization over a specified period of time.

In case of listed companies the frequency of financial reporting is quarterly and annually. For financial information to be useful it should has two main characteristics.

The first qualitative characteristic of accounting information is Relevance, which is the capacity of information to affect users' decisions. This implies that timeliness is a desirable characteristic of accounting information. Interim (quarterly) financial reports are largely motivated by timeliness.

The second primary quality of accounting information is Reliability. For information to be reliable it must be verifiable, representationally faithful, and neutral. Verifiability means the information is confirmable. Representational faithfulness means the information reflects reality, and neutrality means it is truthful and unbiased. 

It should be noted that accounting information often demands a trade-off between relevance and reliability. Another question concerning financial reporting is about its content or main elements. The key elements of financial reporting include:

The financial statements – balance sheet, profit & loss account (or income statement), cash flow statement & statement of changes in owners' equity.

The notes to financial statements Quarterly & annual reports (interim reports) (in case of listed companies) Management Discussion and Analysis (In case of public companies) The importance of financial reporting cannot be over emphasized. It is required by each and every stakeholder for multiple reasons and purposes. The following points highlights why financial reporting framework is important: 

It helps an organization to comply with various statues and regulatory requirements. It facilitates statutory audit. The Statutory auditors are required to audit the financial statements of an organization to express their opinion. Financial Reports forms the backbone for financial planning, analysis, benchmarking and decision making.

Financial reporting helps organizations to raise capital both domestic as well as overseas. On the basis of financial, the public in large can analyze the performance of the organization as well as of its management. For the purpose of bidding, labor contract, government supplies etc., organizations are required to provide their financial reports and statements.

In sum the main objective of financial reporting is the dissemination of financial Statements that accurately measure the profitability and financial condition of a company. Before going further in exploring financial analysis and its objectives and importance, it is necessary to recall the main financial statements and the purpose of each statement.

1-1-1  A review of financial statements:

 As mentioned earlier financial statements are the outputs of accounting information system. They are means by which a business communicates information to its stakeholders. The key financial statements include : the income statement, the balance sheet (statement of financial position), the cash flow statement, and the statement of changes in owners' equity. In this section we will present each of these statements.

A.               The Income Statement:

The income statement of a firm shows its revenues and expenses over a specific period of time (usually one year). The income statement equation in its simplest form is:

                                          Revenues – Expenses = Net Income                             

 

 Revenues are the amounts reported from the sale of goods and services in the normal course of business. Expenses are the amounts incurred to generate revenue and include cost of goods sold, operating expenses, interest, and taxes. 

Expenses are grouped together by their nature or by function. According to the IASB, expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants.

The income statements can be presented in different ways. In its simple form it compares the firm's revenues with its expenses to get net income. In this case it is called single-step income statement. Another form to present the income statement is called multi-step income statement. In this form the income statement is prepared to show different levels of income (gross profit, operating income, income before tax, net income after tax …)

Under IFRS, the income statement can be combined with “other comprehensive income” and presented as a single statement of comprehensive income. Alternatively, the income statement and the statement of comprehensive income can be presented separately. Presentation is similar under U.S. GAAP.

Investors examine a firm’s income statement for valuation purposes while lenders examine the income statement for information about the firm’s ability to make the promised interest and principal payments on its debt.

Figure (2-1) shows multi-step income statement format:

 

Figure (2-1) multi-step income statement:

 

Revenue	XXX
Cost of goods sold	(XXX)
Gross profit	XXX
Selling, general, and administrative expenses	(XXX)
Depreciation expense	(XXX)
Operating profit	XXX
Interest expense	(XXX)
Income before tax	XXX
Provision for income taxes	(XXX)
Income from continuing operations	XXX
Earnings (losses) from discontinued operations, net of tax	XXX
Net income	XXX

 

It should be noted that the overall structure of an income statement for a bank doesn’t defer too much from a regular income statement. The top of the income statement is revenue and the bottom is net income. However, revenue is derived differently from that of regular companies. The income statement format for a bank will generally look as follows:

 

The income statement of (XY) bank for the year ended 31/12/2019

 

 

Revenue
Interest income
Interest expense
Net interest income
Non-interest income
Total revenue
provisions for loan losses
Non-interest expenses
Total Expenses
Income before interest and tax (EBIT)
Interest expense (on debts)
Income before tax (EBT)
Income tax expense
Net income

 

As can be seen from the bank income statement format, most of the bank’s revenue and expenses are related to interest. The bank receives interest income on the loans it issues, while it pays interest expense to the deposits used to fund the loans. Interest expense does not include interest expense from general debt. Non-interest income encompasses all the other business activities that a bank engages in. 

These may include credit card fees, underwriting fees, fees from overdrawn accounts, transaction fees, and any other non- interest income that a bank earns. Non-interest expenses are generally operational expenses and are essential to the day-to-day operation of a bank. They include salaries and bonuses to staff, marketing, and other administrative expenses.

B.               The Balance Sheet (statement of financial position):

While the income statement presents a picture of a firm’s economic activities over a period of time, its balance sheet is a snapshot of its financial and physical assets and its liabilities at a point in time. Just as with the income statement, understanding balance sheet accounts, how they are valued, and what they represent, is also crucial to the financial analysis of a firm.

The balance sheet (also known as the statement of financial position or statement of financial condition) reports the firm’s financial position at a point in time. The balance sheet consists of assets, liabilities, and equity.

Assets: Economic resources controlled by the business as a result of past transactions that are expected to generate future economic benefits.

Liabilities: Obligations resulted from past events that are expected to cause an outflow of economic resources.

Equity: The owners’ residual interest in the assets after deducting the liabilities. Equity is also referred to as stockholders’ equity, shareholders’ equity, or owners’ equity. Analysts sometimes refer to equity as “net assets.

The relationship among the main components of the balance sheet can be expressed using the accounting equation as flows: 

                                         Assets = Liabilities + Owner's equity                              

Figure (3-1) shows the format of the balance sheet:

 

 

Figure (3-1) the balance sheet format:

 

Current assets	XXX
Noncurrent assets	XXX
Total assets	XXX
Current liabilities	XXX
Noncurrent liabilities	XXX
Total liabilities	XXX
Equity	XXX
Total equity and liabilities	XXX

 The balance sheet format presented in figure (3-1) confirm with both IFRSs and U.S. GAAP that entail firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities.   This format is known as a classified balance sheet and is useful in evaluating liquidity.

Liquidity-based presentations, which are often used in the banking industry, present assets and liabilities in the order of liquidity.

To understand financial analysis techniques students should be familiar with the elements of the balance sheet. As can be seen from the balance sheet format presented above, assets and liabilities are categorized into main groups.

Current assets include cash and other assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater. The operating cycle is the

period of time it takes to produce or purchase inventory, sell the product, and collect the cash. Current assets are usually presented in the order of their liquidity, with cash being the most liquid. Current assets reveal information about the operating activities of the firm. They comprise elements such as cash and Cash equivalents, securities, trade receivables, inventories, and other current assets.

Current liabilities are obligations that will be satisfied within one year or one operating cycle, whichever is greater. More specifically, a liability that meets any of the following criteria is considered current:

-          Settlement is expected during the normal operating cycle.

-          Settlement is expected within one year.

-          Held primarily for trading purposes.

-          There is not an unconditional right to defer settlement for more than one year.

Current liabilities comprise elements such as accounts payable, notes payable and current portion of long-term debt, accrued liabilities (expense), and unearned revenue (deferred income).

Current assets minus current liabilities equals working capital. Insufficient working capital may indicate liquidity problems. Too much working capital may be an indication of inefficient use of assets. 

Noncurrent assets are economic resources that provide long-term future benefits to the business. They comprise all other assets that do not meet the definition of current assets because they will not be converted into cash or used up within one year or operating cycle. Noncurrent assets provide information about the firm’s investing activities, which form the foundation upon which the firm operates.

This group of assets contains several items such as property, plant, and equipment (tangible non-current assets including lands, buildings, machinery and equipment, furniture, and natural resources), investment property, and intangible assets.

Noncurrent liabilities obligations that do not meet the criteria of current liabilities. Noncurrent liabilities provide information about the firm’s long-term financing activities.

 

It should be noted that a bank has unique classes of balance sheet line items that other companies won’t. The typical structure of a balance sheet for a bank is shown below:

 

 

A bank balance sheet format
Assets
Property
Trading assets
Loans to customers
Deposits to the central bank
Total Assets
Equity and Liabilities
Liabilities
Loans from the central bank
Deposits from customers
Trading liabilities
Misc. debt
Equity
Common and preferred shares

Total Equity and Liabilities

As can be seen from the bank balance sheet format, loans to customers are classified as assets. This is because the bank expects to receive interest and principal repayments for loans in the future, and thus generate economic benefit from the loans.

Deposits from customers, on the other hand, are expected to be withdrawn by customers or also pay out interest payments, generating an economic outflow in the future. They are, therefore, classified as liabilities.

Deposits from a bank in a central bank are considered assets, similar to cash and equivalents for a regular company. This is because the bank can withdraw these deposits rather easily. It also expects to receive a small interest payment, using the central bank’s prime rate.

Loans from the central bank are considered liabilities, much like normal debt.

 

Banks may hold marketable securities or certain currencies for the purposes of trading. These will naturally be considered trading assets. They may have trading liabilities if the securities they purchase decline in value.

C.   The Cash flow statement: The third important financial statement is the cash flow statement. The income statement is based on the accrual basis, which in turn means that net income may not represent cash generated from operations. A company may generate positive and growing net income but may face insolvency because insufficient cash is being generated from operating activities. As a result preparing cash flow statement, using either the direct or indirect method, is very important in analyzing a firm’s activities and prospects.

The cash flow statement provides information about the following:

-            A company’s cash receipts and cash payments during an accounting period.

-            A company’s operating, investing, and financing activities.

 

-          The impact of accrual accounting transactions on cash flows.

-          The firm’s liquidity, solvency, and financial flexibility.

An analyst can use the cash flow statement of a business to determine whether:

-          Regular operations of the business generate enough cash to sustain the business.

-          Sufficient cash is generated to settle current obligations when they become due.

-          The business is likely to need more funding.

-          Unforeseen debts can be met.

-          A company can benefit of new business opportunities as they arise.

-          The impact of accrual accounting transactions on cash flows.

-          The firm’s liquidity, solvency, and financial flexibility.

An analyst can use the cash flow statement of a business to determine whether:

-          Regular operations of the business generate enough cash to sustain the business.

-          Sufficient cash is generated to settle current obligations when they become due.

-          The business is likely to need more funding.

-          Unforeseen debts can be met.

-          A company can benefit of new business opportunities as they arise.

Preparing the cash flow statement requires information about the income statement items and changes in balance sheet accounts.

Cash receipts and payments in the cash flow statement are classified into three main groups:

·      Cash flow from operating activities, sometimes referred to as “cash flow from operations” or “operating cash flow,” consists of the inflows and outflows of cash resulting from transactions that affect a company’s net income.

·      Cash flow from investing activities consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments.

Cash flow from financing activities (CFF) consists of the ·      inflows and outflows of cash resulting from transactions affecting a firm’s capital structure.

 

Figure (4-1) gives examples of cash flow items under each category:

 

Cash flows from operating activities
In cash flows	Out cash flows
Cash receipts from customers	Cash  payments  to   employees and suppliers

Interest and dividends received	Cash     payments    for     other expenses
Sale    proceeds   from    trading securities.	Cash payments for the purchase of trading securities.
	Interest payments
	Tax payments
Cash flows from investing activities
In cash flows	Out cash flows
Sale of non-current assets	Acquisition of non-current assets
Sale     of     debt    and    equity investments	Acquisition of debt and equity investments
Principal  received   form  loans made to others	loans made to others
Cash flows from financing activities
In cash flows	Out cash flows
Issuing shares	Reacquire shares
Issuing debts	Dividends payments
	Loan (debts) payments

 

There are two methods of presenting the cash flow statement: the direct method and the indirect method. Both methods allowed under U.S. GAAP and IFRS. The use of the direct method, however, is encouraged by both standard setters. Unfortunately, most firms use the indirect method. The difference between the two methods relates to the presentation of cash flows from operating activities. The presentation of cash flows from investing activities and financing activities is exactly the same under both methods.

Under the direct method cash flows from operating activities are calculated as shown in the following:

Operating Cash Flow – Direct Method For the year ended December 31

 

Cash collections from customers	Xxx
Cash paid to suppliers	(xxx)
Cash paid for operating expenses	(xxx)
Cash paid for interest	(xxx)
Cash paid for taxes	(xxx)
Net cash flows from Operating activities	Xxx

 

Under the indirect method, net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. These adjustments include eliminating noncash expenses (e.g., depreciation and amortization), non-operating items (e.g., gains and losses), and changes in balance sheet accounts resulting from accrual accounting events.

 

Operating Cash Flow – indirect Method For the year ended December 31

 

Net income

Xxx

Adjustments to reconcile net income to cash flow provided by operating activities:
Depreciation and amortization	Xxx
Deferred income taxes	Xxx
Increase  (deduct)  or   decrease  (add)     in   accounts	(xxx)

receivable
Increase (deduct) or decrease (add) in inventory	(xxx)
Decrease   (add)   or   Increase   (deduct)   in   prepaid expenses	Xxx
Increase  (add)  or  decrease  (deduct)     in   accounts payable	Xxx
Increase (add) or decrease (deduct)      in accrued liabilities	Xxx
Net cash flows from Operating activities	Xxx

 

It can be seen that under the indirect method, we start with the net income, the “bottom line” of the income statement. Under the direct method, the starting point is the top of the income statement, revenues, adjusted to show cash received from customers. Total cash flow from operating activities is exactly the same under both methods, only the presentation methods differ.

 

The main advantage of the direct method is that it shows the firm’s operating cash receipts and payments, while the indirect method only presents the net result of these receipts and payments. This information of past in cash flows and out cash flows is beneficial in predicting future operating cash flows. After calculating net cash flows from operating activities, using either direct or indirect methods, it becomes possible to prepare the cash flow statement. Figure (5-1) shows the format of cash flow statement:

Figure (5-1) cash flow statement format

 

Net cash flows from Operating activities	XXX
+ Net cash flows from investing activities	XXX
+ Net cash flows from financing activities	XXX
Net Change in cash balance during the period	XXXX
+ Beginning cash balance	XXX
= Closing balance of cash	XXXX

 

A.               Statement of Changes in owner’s Equity (or owner’s equity statement)

The last financial statement required by IFRSs is statement of changes in owner’s equity. This statement summarizes the changes in owner’s equity for a specific period of time. It starts with the beginning balance of owner’s equity, it then adds to this amount the net income for the period and new investments by the owner. After that owner’s drawings are deducted to get the closing balance of owner’s equity. 

This statement explains why the owner’s equity increased or decreased during the period. The statement of owner’s equity is usually prepared by referring to the balance sheet and income statement during a specific period of time. The income statement provides information about the net income or losses of the business, while the balance sheet will provide the information regarding the new  contributions (investments) and drawings by the owner.

Figure (6-1) presents the format of statement owner’s equity.

Figure (6-1) format of statement of owner’s equity.

 

Owner’s capital at the beginning of the period	XXX
Add:
Net income	XXX
Owner’s new investments	XXX
Less:
Owner’s drawings	XXX
Net loss	XXX
= Closing balance of owner’s equity	XXXX

 

 

1-1    The concept of financial analysis

Financial statement analysis is seen as an essential and important part of the broader field of business analysis. Business analysis is the process of evaluating a company’s economic prospects and risks. This includes analyzing a company’s business environment, its strategies, and its financial position and performance. Financial statement analysis is the application of analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business analysis.

Financial analysis uses the information in a company’s financial statements, together with other relevant information, to make economic decisions. It can be useful in assessing a company’s performance and trends in that performance. Essentially, an analyst translates data into financial metrics that assist in decision making. He seeks to answer such questions as: How successfully has the firm performed, relative to its own past performance and relative to its competitors? How is the firm likely to perform in the future? Based on expectations about future performance, what is the value of this company or the securities it issues?

A primary source of data is a company’s annual report, including the financial statements and notes, and management commentary (operating and financial review or management’s discussion and analysis).

It should be noted that financial statements are the primary source of information for financial analysis. This means that the quality of financial analysis depends on the reliability of financial statements.

 

1-2   The objectives of financial analysis

The major objective of financial statement analysis is to provide decision makers information about a business for use in decision-making. Users of financial statement information are the decision makers concerned with evaluating the economic situation of the firm and predicting its future course.

Financial statement analysis can be used by the different users and decision makers to achieve the following objectives:

Assessment of past performance and current position:

A business previous performance is often a good indicator of its future performance. Consequently, an investor or creditor is interested in the trend of past sales, expenses, net income, cash flows and return on investment. These trends provide a means for judging management’s past performance and are probable indicators of future performance.

 

Similarly, analyzing current position indicates where the business stands today. For example, the current position analysis will show the types of assets owned by a business and the different liabilities it owes. It, additionally, indicates what the cash position is, how much debt the company has in relation to equity and how reasonable the inventories and receivables are.

Prediction of net income and growth prospects:

The financial statement analysis helps in predicting the earning prospects and growth rates in the earnings which are used by investors while comparing investment alternatives and other users interested in judging the earning potential of the business. Investors also consider the risk or uncertainty associated with the expected return. With the help of financial analysis, assessment and prediction of the bankruptcy and probability of business failure can be done.

Loan decision by financial institutions and banks: Financial analysis helps the financial institutions and banks to decide whether a loan can be given to the company or not. It assists them in identifying the credit risk, deciding the terms and conditions of a loan if sanctioned, interest rate, maturity date etc.