Financial Statements PDF

FINANCIAL STATEMENTS AND STAKEHOLDERS => Financial statements are summaries of what a company does. They focus on the: 1. OPERATING activities 2. INVESTMENT activities 3. FINANCING activities Financial statements contain assumptions that affect how we use and interpret the financial dat...

FINANCIAL STATEMENTS AND STAKEHOLDERS => Financial statements are summaries of what a company does. They focus on the: 1. OPERATING activities 2. INVESTMENT activities 3. FINANCING activities Financial statements contain assumptions that affect how we use and interpret the financial data: 1. Transactions are recorded at historical cost = assets and liabilities are recorded at their original purchase price, rather than their current market value. This ensures consistency and reliability, though it may not reflect current economic value. 2. The statements are recorded for a predefined period of time = statements are prepared for specific periods (e.g., quarterly, annually) to provide a snapshot of the financial position and performance over time, facilitating periodic comparisons. 3. Statements are compliant with accrual accounting/matching principle = revenues and expenses are recognized when they are earned or incurred, not when cash is exchanged = transactions are recorded when they happen (eg: if a company delivers a service in December but doesn't receive payment until January, the revenue is recorded in December when the service was provided, not in January when the payment was received). This matching ensures that income is reported alongside the expenses that generated it, providing a more accurate picture of financial performance. 4. The business will continue as a going concern = the business will continue to operate for the foreseeable future and does not intend, nor is it forced, to liquidate or cease operations. 5. Statements are prepared assuming conservatism = statements aim to present a cautious view (=conservatism), where: - potential expenses and liabilities are recorded as soon as they are reasonably expected: if there is a chance the business might face a loss, it should be reported right away.  - revenues and gains are only recorded when they are assured or certain: the business should not record income until it is confident that it will receive it. This approach prevents the overstatement of financial health. The basic financial statements are: 1. BALANCE SHEET = report of what the company has (assets, debt, and equity) as of the end of the fiscal period 1. INCOME STATEMENT = report of what the company earned during the fiscal period 2. STATEMENT OF CASH FLOWS = report of the cash flows of the company over the fiscal period Balance sheets contain “stock quantities”; instead, income statements and cash flow statements contain “flows”: balance sheets are “pictures” of the company: informational only if compared with past ones = you can complete two balance sheets by analyzing the income statement and the cash flow statement produced in the time in between them: [BALANCE SHEET] = report of the assets, liabilities, and equity of a company at a point in time, generally at the end of a fiscal quarter or year: 1. ASSETS = resources of the business enterprise, which are comprised of current or long-lived assets 2. LIABILITIES = obligations of the business enterprise that must be repaid at a future point in time 3. EQUITY = ownership interest of the business enterprise - = ownership interest that the owners (or shareholders) have in a business, it represents the residual interest in the assets of the company after all liabilities have been deducted. ➔ The relation between assets, liabilities and equity is referred to as the ACCOUNTING IDENTITY => ASSETS = LIABILITIES + EQUITY - This identity holds at any moment during the firm’s life.  * balance sheet of a bank (financial company) is mirrored image of an industrial one (opposites) ASSETS LIABILITIES AND EQUITY Current Assets Current Liabilities 1. Cash 1. Accounts payable (unpaid bills to suppliers) 2. Marketable Securities 2. Accrued expenses (expenses recorded but not paid) 3. Accounts Receivable(customers’ 3. Current portion of Long-Term unpaid bills minus allowance for debt doubtful accounts) 4. Prepaid Expenses (expenses paid 4. Short-Term borrowing before the period of their use) 5. Inventories Long-Term Liabilities Fixed Assets Preferred Stocks 1. Plant, property, and equipment (at Equity their cost of acquisition minus accumulated depreciation) 2. Land 1. Stock value (par + additional paid-in capital) 3. Goodwill 2. Retained earnings [ASSETS] = anything that the company owns that has a VALUE Assets may have a physical in existence or not:  - Physical assets include inventory, office furniture, production equipment, etc - Intangible asset: they may be intangible, but they still contribute to the value of the company. Examples of intangible assets include a trademark or a patent. I. CURRENT ASSETS = MOST LIQUID assets of the company : assets that can be turned into cash in one operating cycle or one year, whichever is longer. ➔ They are used by the financial year’s end and new ones will be accumulated within the new fiscal year = they are TEMPORARY items which will be used SHORT TERM. 1. CASH, bills and currency: assets that are equivalent to cash (eg: bank account) = most liquid current asset 2. MARKETABLE SECURITIES = securities that can be readily sold (eg: short-term treasury bonds which you buy because you may have excess cash to invest) 3. ACCOUNTS RECEIVABLE = amounts due from customers arising from trade credit = customers’ unpaid bills minus allowance for doubtful accounts, will turn into cash soon 4. PREPAID EXPENSES = expenses paid before their period of use 5. INVENTORIES = material that will hopefully turn into cash soon, after undergoing the production cycle : investments in raw materials, work-in process, and finished goods for sale. * FIRM’S OPERATING CYCLE: 1. Invest cash in inventory: the business uses its cash to purchase inventory (goods or materials needed for sale). 2. Sell goods on credit: the inventory is sold to customers, but instead of receiving immediate payment, the sales are made on credit. This creates accounts receivable (customers owe the business money). 3. Collect payment on credit accounts: after a period, the business collects the money from the customers who bought on credit. This process converts accounts receivable back into cash. 4. Cash: The collected cash can now be reinvested into inventory, restarting the cycle.  II. FIXED ASSETS (or non-current assets) = CANNOT BE LIQUIDATED QUICKLY. ➔ they will stay with the company for a long time : they are LONG-TERM INVESTMENTS. They comprise both physical and nonphysical assets: - PHYSICAL assets, such as buildings and equipment, are reflected in the balance sheet as gross property, plant and equipment (PPE) and net PPE: 1. GROSS PPE (PLANT, PROPERTY AND EQUIPMENT) = total cost of investment in physical assets (= of acquiring physical assets, like land, machinery, buildings, etc.) 2. NET PPE = reflects the book value of these assets; after accounting for accumulated depreciation: NET PPE = difference between gross PPE (cost of acquisition of asset) and accumulated depreciation* (Value of PPE = its cost of acquisition - its accumulated depreciation) 3. LAND = It is classified as real property and is considered one of the most valuable assets a company can hold. Unlike other physical assets (like buildings or machinery), land is not depreciated: the value of land does not generally decrease over time, unless due to exceptional circumstances. Because land doesn’t lose value due to wear and tear or obsolescence, it remains recorded on the balance sheet at its cost of acquisition. * DEPRECIATION = GRADUAL ALLOCATION OF ASSET’S COST over its useful life (or economic life) = process of allocating the cost of a long-term asset over time, usually in a way that matches its usage or economic benefit. It is an “allocated expense” and not an actual cash outflow: it is a non-cash expense, meaning it reduces the company's reported income but does not involve an actual cash outflow. Depreciation allows companies to allocate the cost of a long-term asset over its useful life, which effectively lowers taxable income: this reduction in income leads to lower taxes. However, the rules for depreciation are largely determined by tax authorities, who decide what portion of an asset can be depreciated and for how long. Once a long-term asset is fully depreciated, it is no longer recorded on the balance sheet because its book value has been reduced to zero = no taxes are paid on it. However, the asset may still be in use within the company. There are three main forms of depreciation: I. Depreciation (for tangible assets like equipment and buildings) II. Depletion (for natural resources like oil or minerals) III. Amortization (for intangible assets like patents and copyrights) - INTANGIBLE = assets non-physical assets that do not have a physical presence but still hold value for a company, such as patents, trademarks, copyrights, and goodwill + Intangible assets may be AMORTIZED over some period, which is akin to depreciation:  1. GOODWILL = when a company acquires something (eg. another company) at a HIGHER PRICE THAN ITS BOOK-TO-MARKET VALUE, meaning for more than the fair value of the net assets of the acquired company. The excess amount paid is recorded as goodwill on the balance sheet. Goodwill = Purchase Price − Fair Value of Net Assets : difference between value of the asset you acquire and the book-value of it => potential future growth is intangible. [LIABILITIES] = are presented in order of their due date. I. CURRENT LIABILITIES = obligations due within one year or one operating cycle (whichever is longer). Current liabilities may consist of: 1. ACCOUNTS PAYABLE : company’s unpaid bills to suppliers for goods and services purchased on credit These may be recorded as a liability when the purchase is made, but the payment is often made at a later date, sometimes extending into the next fiscal year as debt. 2. ACCRUED EXPENSES = expenses that have been recorded but not yet paid. They represent obligations for expenses incurred in the current period, such as wages or taxes, that will be paid later. 3. CURRENT PORTION OF LONG-TERM DEBT = the part of long-term debt that is due for repayment within the current fiscal year. 4. SHORT-TERM BORROWING = loans that must be repaid by the end of the year (eg: short term bank loans). II. LONG-TERM LIABILITIES = obligations that are DUE BEYOND ONE YEAR. These represent debts or financial responsibilities the company must settle over a longer period. Different types of long-term liabilities include: 1. BONDS and LONG-TERM BANK LOANS = debt instruments issued or borrowed for a period longer than one year, with scheduled repayments. 2. CAPITAL LEASES = lease agreements where the lessee (the party renting the asset) assumes the risks and rewards of ownership, even though the lessee doesn't technically own the asset. These leases are treated as long-term debt on the balance sheet because the lessee effectively takes on the financial obligations associated with the asset, similar to owning it. 3. ASSET RETIREMENT LIABILITY = obligation to retire or decommission assets: the company is responsible for the future costs associated with decommissioning, dismantling, or cleaning up an asset at the end of its useful life, often due to regulatory requirements or contractual obligations.  4. DEFERRED TAXES = taxes are owed but payment is postponed, often due to differences between accounting income and taxable income (eg: depreciation methods) III. PREFERRED STOCKS = represents a class of ownership in a company that has a higher claim on the company’s assets and earnings than common stock. It is considered a hybrid instrument because it combines features of both debt and equity: preferred stockholders receive dividends before common stockholders and typically have a FIXED DIVIDEND RATE (which is why it is a liability). Preferred stock is recorded as part of equity on the company’s balance sheet, but due to its characteristics, it sometimes acts similarly to debt. IV. EQUITY = BOOK VALUE of OWNERSHIP OF A COMPANY = total own capital of the company, also LONG-TERM It is the value remaining after subtracting liabilities from assets and reflects the owners' share in the company. - Equity can grow through retained earnings or by issuing new shares. It is comprised of: 1. PAR VALUE = nominal value of a share of stock 2. ADDITIONAL PAID-IN CAPITAL (capital surplus) = amount paid by investors for the company’s stock that exceeds the par value. - for example: if the company issues a share with a par value of $1 but sells it for $10, the additional paid-in capital is $9 per share. 3. RETAINED EARNINGS = accumulation of net income that the company has retained (=invested) rather than distributed as dividends : retained earnings are reinvested in the business or used to pay down debt, they contribute to the growth of the company’s equity capital. *Capital of a company can grow if: - you issue new equity (new stock to new stockholders) - you retain and reinvest income made [NET WORKING CAPITAL] Net Working Capital (NWC) is a key measure of a company's short-term liquidity and its ability to meet its short-term obligations. Considering that: - current assets will turn into cash by end of year - current liabilities leave company the end of the year ➔ NET WORKING CAPITAL = total amount of CURRENT ASSETS - total amount of CURRENT OPERATING LIABILITIES - Current Operating Liabilities = Accounts Payable + Other Current Liabilities  = Those related to operations but excluding debt obligations A positive NWC indicates that the company has more current assets than current liabilities, which means the company is in a good position to cover its short-term debts and continue operations smoothly. Net Working Capital measures the company’s short-term investments or capital tied up in day-to-day operations: it's a sign of how much capital is invested in current assets, which are expected to be converted into cash within the year. NON-CASH WORKING CAPITAL refers to the same concept as working capital, but excluding cash and cash equivalents ➔ NON-CASH WORKING CAPITAL = NET WORKING CAPITAL - CASH The reason cash is excluded is that it is not used in day-to-day operations like other working capital items (e.g., receivables, inventory). Instead, non-cash working capital focuses on the operational assets and liabilities that are tied to business activities. [MARKET-TO-BOOK RATIO] 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑀𝑎𝑟𝑘𝑒𝑡 − 𝑡𝑜 − 𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 - BOOK VALUE = value of the company according to its balance sheet: ➔ 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠’ 𝐸𝑞𝑢𝑖𝑡𝑦​ - TOTAL SHAREHOLDERS EQUITY is found on the company's balance sheet and represents the net value of the company (total assets minus total liabilities). - MARKET VALUE = value of the company according to the market: ➔ 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 × 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠 Example of Balance Sheet: [INCOME STATEMENT] = summary of company’s OPERATING PERFORMANCE OVER A PERIOD OF TIME (usually a quarter or a year) = it shows how a company's revenue is transformed into net income, detailing whether the company is generating profits or incurring losses over time. It shows dynamics of company's capital over time, growing or decreasing due to whether or not profit was made. - did the company make money? is it profitable or not? and if so, though which means does it gain/lose its money? The cost of sales, also referred to as the cost of goods sold, (COGS) is deducted from revenues, giving a gross profit. General operating expenses (SG&A) are related to the support of the general operations of the company, and include salaries, marketing costs, and R&D. Depreciation Is the amortized cost of physical assets. From Operating Income, we deduct interest expense and add any interest income. 1. REVENUES (= sales) - COST OF GOODS SOLD (COGS) - COGS = purchases in year t – final inventory in year t + initial inventory in year t = GROSS PROFIT (= first margin) 2. GROSS PROFIT – SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (SG&A) - SG&A are the operating expenses that are not directly tied to production but are necessary for running the business : SG&A = sales commission + advertising and promotion + overhead, such as rent or utilities, + payroll = EBITDA : Earnings Before Interest, Taxes, Depreciation and Amortization (D&A) 3. EBITDA – D&A : Earnings Before Interest and Taxes – Depreciation & Amortization  - D&A are non-cash expenses that account for the gradual allocation of the cost of long-term tangible (depreciation) and intangible (amortization) assets over their useful life. = EBIT (Earnings Before Interest and Taxes) = (NET) OPERATING INCOME 4. EBIT + INTEREST INCOME – INTEREST EXPENSE - Interest income = revenue generated from interest on investments or loans made by the company. - Interest expenses = costs incurred from borrowing (e.g., loans or bonds). If it says “interest income (expense)” the (number) = interest expense = EBT (Earnings Before Taxes) 5. EBT – TAXES on EBT - Effective TAX RATE = (TAXES on ebt) / EBT = COMPANY’S NET INCOME - net income = company’s final profit or loss of the company after all revenues, costs, and expenses have been accounted for. It is the most crucial indicator of a company’s overall profitability. Example of Income Statement: + EARNINGS PER SHARE = measures the portion of a company's profit (=net income) allocated to each outstanding share of common stock: 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 ➔ 𝐸𝑃𝑆 = 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 - If there are preferred dividends the formula is: 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝐸𝑃𝑆 = 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 [STATEMENT OF CASH FLOWS] = summary of a COMPANY’S CASH FLOWS (inflows and outflows) over a specific period. Unlike the Income Statement, which includes both cash and non-cash items, the statement of cash flows focuses only on actual cash transactions (dynamics of cash within the company). It provides a clearer picture of a company’s liquidity and cash management. Sections of this statement are: I. CASH FLOW from OPERATIONS (OCF) = cash flows from DAY-TO-DAY OPERATIONS : cash generated or used by the company in its core business operations during the period. It is basically net income adjusted for non-cash expenditures (like depreciation and amortization) and changes in working capital accounts (such as accounts receivable or inventory). OCFs show how much cash the company has generated through its primary operations, which is important for assessing whether the company can sustain its operations without relying on external financing. ➔ OCF = Net Income + Non-Cash Expenditures (=D&A) - Changes in Non-Cash Working Capital Accounts + Interest Income (Expense) - Non-Cash Expenditures = D&A (depreciation and amortization) II. CASH FLOW from INVESTING (ICF) = cash flows related to the ACQUISITION OR SALE OF LONG-TERM ASSETS, such as PPE and other assets (eg: securities or acquisitions of other companies) + PROCEEDS FROM THE SALE OF ASSETS = AMOUNT THE COMPANY INVESTED (generated by OCFs) ICFs reflect the company’s strategy for growth and expansion through investments and are often linked to the company’s ability to generate cash from operations to fund these activities. ➔ ICF = (-) CAPEX = - CAPEX = the money company spends to buy, maintain, or improve its Long-Term Assets, such as buildings, vehicles, equipment, or land = Change in Long-Term Assets + D&A III. CASH FLOW from FINANCING ACTIVITIES (FCF) = cash flows from activities related to the company’s CAPITAL STRUCTURE and SOURCES OF CAPITAL FUNDS: this includes activities like issuing or repurchasing stock, borrowing or repaying debt, and paying dividends. FCFs show HOW the company RAISES FUNDS (through debt or equity) and how it RETURNS CAPITAL to SHAREHOLDERS (eg: through dividends or stock buybacks) - = financing cash flows are used to repay a debt* ➔ FCF = Change in Financial Debt - Interest Income (Expense) - Dividend + New Equity Issued (if any) + LT Deferred Taxes - LT Deferred Taxes = company owes tax office money - negative if no debt has been repaid but only issued (look at change in LT debt) ➔ If Change in Equity = (Net Income - Dividend) : NO NEW EQUITY was issued If Change in Equity > (Net Income - Dividend) : NEW EQUITY WAS ISSUED ù + NEW EQUITY = Change in Equity - (Net Income - Dividend) + Net Income - Dividend = AMOUNT REINVESTED —-- ➔ OFC + IFC + FCF = CHANGE IN CRO (= Cash Receivables Outstanding = Change in Cash)  Change in Cash Receivables Outstanding refers to the variation in the amount of money a company is owed from customers (accounts receivable) over a specific period. Essentially, it reflects how much more or less the company is waiting to collect from its customers at the end of the period compared to the beginning. If the company has more accounts receivable (= if the change in CRO is positive), it could indicate that the company made more sales on credit than it collected in cash. —-- Dynamic of Cash Flows MAKE MONEY with operating (OCF) => INVEST with investing (ICF) => REPAY DEBT with financial (FCF) 1. OPERATING cash flows (OCFs) come first, generated by the company’s regular business activities. 2. The cash from operations is used to INVEST in assets and expand the business (ICFs). 3. Any remaining cash may be used for FINANCING ACTIVITIES (FCFs), such as repaying debt, buying back shares, or paying dividends. 4. If there is any excess cash left, it is added to the company’s CASH BALANCE on the balance sheet, which impacts the company’s overall liquidity and financial position. Example of Cash Flows Statement [FINANCIAL ANALYSIS] = interpretation of financial data to EVALUATE the operating and financial PERFORMANCE of a COMPANY. ➔ It consists mainly of RATIO ANALYSIS: a FINANCIAL RATIO is a comparison between one item of financial information and another. Financial ratios evaluate the main aspects of operating performance and financial condition: 1. LIQUIDITY 2. FINANCIAL LEVERAGE 3. PROFITABILITY I. LIQUIDITY RATIOS Liquidity = ability of a company to MEET its SHORT-TERM OBLIGATIONS using assets that are readily converted into cash. One of the most common liquidity ratios: 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 ➔ 𝐶𝑈𝑅𝑅𝐸𝑁𝑇 𝑅𝐴𝑇𝐼𝑂 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 - a current ratio below 1 would indicate that the firm has more obligations coming due in the next year than assets it can expect to turn to cash The QUICK or ACID TEST RATIO is a variant of the current ratio: it distinguishes current assets that can be converted quickly into cash (cash, marketable securities) from those that cannot (inventory, accounts receivable). 𝐶𝑎𝑠ℎ + 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 ➔ 𝑄𝑈𝐼𝐶𝐾 𝑅𝐴𝑇𝐼𝑂 1 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 ➔ 𝑄𝑈𝐼𝐶𝐾 𝑅𝐴𝑇𝐼𝑂 2 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 [LIQUIDITY AND OPERATING CYCLE] ➔ OPERATING CYCLE = duration from the time cash is invested in goods and services to the time that investment produces cash = total time it takes to convert raw materials or inventory into cash. We have: 1. ACCOUNT RECEIVABLES TURNOVER = measures how efficiently a company collects its receivables, indicating the speed at which it converts credit sales into cash. 𝑆𝑎𝑙𝑒𝑠 ➔ 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 2. INVENTORY TURNOVER = indicates how quickly a company sells and replaces its inventory. It reflects the efficiency of inventory management. 𝐶𝑂𝐺𝑆 ➔ 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 These ratios can be interpreted as measuring the SPEED with which the firm turns accounts receivable into cash or inventory into sales. These ratios are often expressed in terms of the NUMBER OF DAYS OUTSTANDING to reflect how many days it takes, on average, to complete a transaction cycle: 1. DAYS RECEIVABLE OUTSTANDING = measures the number of days, on average, it takes for a company to collect payment after a sale 365 ➔ 𝐷𝑎𝑦𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 2. DAYS INVENTORY HELD = how long, on average, inventory is held before being sold. 365 ➔ 𝐷𝑎𝑦𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐻𝑒𝑙𝑑 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 => OPERATING CYCLE = DAY SALES IN INVENTORY (how long inventory is held) + DAY SALES OUTSTANDING (how long it takes to collect receivables) - shorter operating cycle means that a company can recover its cash more quickly, which is beneficial for liquidity. [ACCOUNTS PAYABLES CYCLE] The company can also measure how efficiently it handles its payables using similar ratios that show how long it takes the company to pay its suppliers. These ratios can be computed for accounts payable, relative to purchases: 1. ACCOUNT PAYABLES TURNOVER = measures how quickly a company pays its suppliers. 𝐶𝑂𝐺𝑆 ➔ 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 2. DAYS PAYABLES OUTSTANDING = number of days, on average, it takes for the company to pay its suppliers after purchasing goods or services 365 ➔ 𝐷𝑎𝑦𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 II. LEVERAGE RATIOS => Leverage = the PROPORTION of INVESTED CAPITAL FINANCED WITH DEBT. - It gives an indication of how much of the company’s investments are funded by borrowing as opposed to equity financing. 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑒𝑏𝑡 ➔ DEBT-TO-CAPITAL RATIO => 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 - invested capital includes both equity and debt, representing the total capital used to finance the company’s operations It can also be expressed as: 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑒𝑏𝑡 ➔ DEBT-TO-EQUITY RATIO => 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 * FINANCIAL DEBT is equal to = Notes Payable/ST Debt + Current Maturities of ST Debt + LT Debt - compares debt to equity and is useful for understanding the level of debt relative to the company’s own capital 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑒𝑏𝑡 Using MARKET VALUE we would have : 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 The INTEREST COVERAGE RATIO or TIE (= TIMES INTEREST EARNED) measures a company's ability to MEET its INTEREST OBLIGATIONS on OUTSTANDING DEBT = it indicates number of times the company’s EBIT (earnings before interest and taxes) can cover debt financing expenses. It is a measure of a company’s ability to handle financial burdens 𝐸𝐵𝐼𝑇 ➔ 𝑇𝐼𝐸 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 III. PROFITABILITY RATIOS => Profitability ratios help assess a company’s ability to GENERATE EARNINGS relative to its sales, equity, or invested capital: information provided in a firm’s accounts can be combined to evaluate its financial performance. 1. RETURN ON EQUITY (ROE) = expresses profitability of the firm’s EQUITY CAPITAL : measures the profitability of a company in relation to shareholders' equity, indicating how well a company is using its equity capital to generate profit. 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 ➔ 𝑅𝑂𝐸 = 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦(𝑡−1) 2. RETURN ON ASSETS (ROA) or RETURN ON INVESTED CAPITAL = expresses profitability of the firm’s TOTAL INVESTED CAPITAL : measures the profitability of a company relative to its total assets, indicating how efficiently it is using its assets to generate earnings. 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 ➔ 𝑅𝑂𝐴 = 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑎𝑡 𝑡−1) - Net Operating Profit = EBIT - TOTAL INVESTED CAPITAL= Shareholders Equity + Financial Debt + LT Deferred Taxes (at t-1) => ROE > ROA ALWAYS. ROE and ROA are typically calculated using average values or beginning-of-period figures for assets or invested capital. This helps in aligning the income (e.g., EBIT) generated throughout the current year with the capital base that was available at the start of that period. The LEVERAGE IDENTITY connects ROE, ROA, and leverage to demonstrate the IMPACT OF DEBT ON PROFITABILITY : it shows how leveraging debt can increase ROE by amplifying the returns from assets, assuming the company is generating a higher return on its assets than the cost of its debt (ROD) 𝐷 ➔ 𝑅𝑂𝐸 = 𝑅𝑂𝐴 + [(𝑅𝑂𝐴 − 𝑅𝑂𝐷) 𝐸 ] × (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) - ROD = return on debt  - D/E = debt-to-equity ratio - Tax Rate = corporate tax rate. 3. RETURN ON SALES (ROS) = expresses the profitability of the firm’s REVENUES. ROS is the firm's operating profit margin: it represents the profit produced per dollar of revenues. 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 ➔ 𝑅𝑂𝑆 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 - (Net) Operating Profit = EBIT - Revenues = total sales Example(s) of Financial ratios