Balance Sheet BFRS framework.

The final effects of every transaction of a business organization are classified under broad classes. Elements of financial statements are can be divided into two parts financial position in balance sheet and performance in the income statement. The change of economic benefits of an organization arises from the asset and liabilities increases and decreases. These are defined as income and expense. Financial statements work as a lens on business so that the users can understand how the business generates value through its operations.

Financial statements: Balance sheet

Balance sheet approach is adopted by BFRS framework. This treats the performance of the business as a mean of reconciliation of changes in financial position. The purpose of the financial statement is to provide the information about the financial position and performance of a business organization. Information is such that helps a wide range of users to make an economic decision. There are four main financial statements these are balance sheet, income statement, statement of cash flow and statement of changes in equity.

Income statement presents income and expenses of a business entity. Income represents the increase of future economic benefits. It is related to an increase in assets or a decrease in liabilities. A decrease in future economic benefit is presented by expenses which are related to a decrease in assets or increase in liabilities (Britton & Waterston, 2013). The financial position of a business organization is depicted through the balance sheet. It exhibits assets, liabilities, and equity of the stockholders. Assets are considered as investments expected to generate payoffs. Liabilities are the claim to payoffs by other outside claimants of business. Stockholder’s equity is the claim by the owners themselves. Assets and liabilities both are divided into current and long-term categories.

Current means the assets or liabilities have an impact on a single accounting period. The balance sheet can also be presented by an equation which is called balance sheet equation. The business organization has an identifiable operating cycle. The purpose of current assets or liabilities is trading. The characteristics of these items are that these are expected to realize within the single operating cycle (Green, 2013). Assets= Liabilities + Stockholder’s equity

This equation implies that assets will always be equal to a total of owner’s equity and liabilities. The balance sheet of an organization is presented here to understand it in a better way.

Problem 3-1: Working with a Balance sheet

Description

Amount

Amount

Assets

Cash

Accounts receivables

Inventories

Other current assets

Gross building and equipments

Accumulated depreciation

Net Fixed assets

Other Assets

Total assets

Liabilities

Notes payable

Accounts payable

Total current liabilities

Long term debt

Total liabilities

Stockholder’s Equity

Common Stock

Retained Earnings

Total equity

Total Liabilities and equity

75000

64050

60000

7500

1920,000

468000

206550

1452000

22500

15750

64050

1681050

79800

300000

379800

735000

566250

1301250

1681050

Net working capital    = Current Assets- Current Liabilities

                                    = 206550 – 79800 = 126750

Debt Ratio                  = Total Debt/ Total Assets

                                    = 379800/1681050= 0.22:1

The balance sheet is reformulated for valuing a business. But reformulation is a long and more technical process which is out of the scope of this essay. It discovers the firm’s ability to generate profit net operating assets and net financial obligation is calculated. Powers & Needles (2012) state a standard form of financial statements can’t be used for this. Net working capital can be referred as net operating assets. But the classification of items is redesigned to get net operating asset so both are not the same. Net working capital also gives the idea of income generating capability of the business.

The debt ratio is calculated to get the idea about the solvency of a firm. The more the debt ration the more the firm is insolvent. For this case, the firm has $100 assets against $22 debt. There is no ideal ratio. It depends on the size of the firm and the industry it belongs to.

Statement of Cash flow

Cash flow statement is an integral part of businesses financial statements. Useful information is provided through this statement. It is a way to provide information about the volume, timing, and certainty of future cash flows. It gives the liquidity and solvency information to the investors. The users can get an understanding of the ability of the firm to adapt to the changing circumstances by the timing of cash flows. There is an advantage of comparing the cash flow statements because they are not affected by the differing accounting policies.

Cash flow statement shows how the firm has generated and used cash during the period. There are three types of cash flows such as cash flows from operating activities, cash flows from investing activities and cash flows from financing activities (Suthan, 2007). The cash flows from operating activities are generated from sales and day to day business activities. Operating cash flows will be non-recurring and leads to the net profit or loss of the entity. They are related to the main revenue-producing activities of a business such as cash receipts from the sale of goods and services, receipt from fees, commissions, royalties, Cash payment to employees and to the supplier of goods and services etc.

Cash flows from investing activities are the cash spent on acquiring assets less the cash received from selling assets. It will show the new investment in assets which will increase the future cash flows and income. Cash payments to acquire property plant and equipment, non-current assets, cash-receipt from the sale of property, plant, and equipment, cash payments to acquire debt and equity of other entities, interest, and dividends are examples of it (Suthan, 2007). 

Problem 3-2: Computing Cash flows

Description

Amount

Amount

Cash flows from operating activities

Net income

Adjustments

Depreciation

Increase in accounts receivables

Increase in inventories

Increase in Account payables

Net cash provided by operating activities

Cash flow from investing activities

Increase in net fixed assets

Cash flows from financing activities

Increase in Common stock

Dividends

Net cash provided by financing activities

Decrease in cash

Beginning cash

Ending Cash

36

(75)

(90)

75

99

(54)

(69)

60

(45)

45

(69)

15

(9)

60

51

Financing cash flows are the cash transactions associated with debt and equity claims. This works as an indicator which shows the future interest and dividend payments. Financing cash flows include cash proceeds from the share issue, payments to the owners who want to redeem shares, cash proceeds from loans, mortgages, bonds and other long-term borrowings, dividend payment etc.

Cash flow statement is necessary for liquidity analysis and financial planning. Liquidity analysis is involved with the risk of debt and cash required to settle the debt. Financial planning is used to manage treasure. The treasurer is concerned with the cash generation ability of the firm. The cash flow forecasting is possible by reformulating the cash flow statement but it is not the scope of this essay. Sometimes organizations may have the non-cash transactions such as acquiring of an entity by issuing shares. Such transactions should be disclosed.

Problem 3-3: Working with statement of cash flows

Description

Amount

Amount

Cash flows from operating activities

Net income

Adjustment:

Depreciation

Increase in accounts receivables

Increase in inventories

Increase in accounts payable

Net cash provided by operating activities

Cash flows from investing activities

Increase in plant and equipment

Cash flows from financing activities

Increase in notes payable

Increase in long-term debt

Issued new common stock

Dividends

Net increase in  cash

Beginning cash

Ending cash                             

322500

42500

(172500)

(17500)

107500

(135000)

107500

132500

62500

(72500)

282500

(135000)

230000

377500

625000

1002500

Ratio analysis is a tool to interpret the financial statements. It helps to understand the financial statements and gives the user a way to compare with other company’s financial statements. It is a simple way to measure the profitability, liquidity, efficiency and leverage of a company. It is a common type of comparison tool for the analysts. The analysts compare the ratios with other companies in a same industry or with the average ratio of the industry.

Problem 3-4: Ratio Analysis

Ratio analysis on Saudi Manufacturing Corporation is given here

   Current ratio = Current Asset ÷ Current liabilities

1.75:1

157500÷90000

   Debt ratio = Total debt ÷ Total assets

.5:1

180000÷360000

   Times interest earned = EBIT ÷ Interest expense

4.63:1

76500÷16515

   Average collection period = (A/R × Days) ÷ sales

91.25 days

(90000×365)÷360000

   Inventory turnover = Sales ÷(Inventory×365)

45 days

360000÷45000

   Fixed asset turnover = Sales ÷ Total fixed assets

1.77:1

360000÷202500

   Total asset turnover = Sales ÷ Total assets

1:1

360000÷360000

   Operating profit margin =  Op. Income ÷ Sales

21.25%

76500÷360000

   Operating return on assets = Op. Income ÷ Assets

21.25%

76500÷360000

   Return on equity = Net Income ÷ Owner’s Equity

20%

36000÷180000

Discussion on Ratio analysis

Current ratio: Current ratio is one of the most used ratios. It is used to measure the liquidity of a firm. Current ratio actually refers to the capability of a firm to pay its current obligations. In monetary terms, it expresses how much current assets a company holds against its current liabilities. Saudi Manufacturing Corporation has $157500 current assets against its $90000 current liabilities. The current ratio of this company refers that the company holds $1.75 current assets for every $1 current obligation.

Debt ratio: Debt ratio is a financial or leverage ratio. It measures leverage or financial risk of a firm. The higher the ratio is the greater the financial risk. The strength of bearing risk depends on the industry the company belongs to (Stickney, 1993). For example, Bank and other financial institutions have higher leverage than the typical manufacturing company. Saudi Manufacturing has $360000 total assets against its $180000 total liabilities. Ratio 2:1 refers to the company holds $2 assets for every $1 liabilities.

Times interest earned: Time interest earned ratio is a leverage ratio which measures the current interest payment capability of the organization. It implies how many times it can pay its interest payments by its net operating income. Saudi Manufacturing Corporation has $76515 net operating income and its interest expense is $16515. The ratio 4.63:1 refers that the company is able to pay interest payment 4.63 times in a single accounting period.

Average collection period: Average collection period is an efficiency ratio which assesses the company’s ability to recover its accounts receivables. Average collection period measures the time a firm needs to recover its payment from its accounts receivables. It is measured in the number of days. Saudi Manufacturing Corporation has 91.25 days which means it takes almost 91 days to recover its accounts receivables.

Inventory turnover: Inventory turnover is also an efficiency ratio. It measures how many times a firm has been able to turn its inventory into sales. The more the inventory turnover the more the firm is efficient in turning inventory into sales. Inventor turnover can be expressed in the number of days. Saudi Manufacturing Corporation has 45 days or 8.11 times in a year inventory turnover. It refers that the company takes 45 days to turn its inventory into sales or it can turn inventory into sales 8 times in a year.

Fixed asset turnover: Fixed asset turnover is an efficiency ratio which measures the operating efficiency of a firm. It is measured by dividing sales by fixed assets. It means the capability of the firm to produce sales from fixed assets. A firm which has higher fixed asset turnover means the higher efficiency of using its fixed investments. Fixed assets turnover of Saudi Manufacturing Corporation is 1.77:1. It refers that the corporation is able to produce $1.77 sales from $1 fixed assets.

Total assets turnover: Like fixed asset turnover total assets turnover measures the efficiency of the firm in terms of using its totals assets. The firm measures how much sales are produced by its total assets. Saudi Manufacturing Corporation has 1:1 total assets turnover. It means that the firm is able to produce $1 sales from its $1 total assets.

Operating profit margin: Operating profit margin is a very useful profitability ratio which measures the operating profitability of a firm. Net operating income before interest and tax is divided by total sales to find operating profit margin. It is expressed in percentage and it shows how much operating profit a firm can produce by its $100 sales. Saudi Manufacturing Company has 21.25% operating profit margin. It means the firm is able to earn $21.25 operating profit from $100 sales.

Return on assets: Return on assets is a profitability ratio which measures how much return a firm is able to generate from its assets. Net operating income is measured against total assets. Saudi manufacturing company has 21.25% returns on operating asset. It means the firm generates $21.25 return on $100 sales. Return on equity: Return on equity measures the return to the stockholders of the company. Net income is measured against the common stock of the firm. Unlike the operating profit margin and return on assets, return on equity is measured by net income. Saudi manufacturing company has 20% return on equity which means the company is able to earn $20 on its $100 common stock.

Problem 3-5: Market value ratios

We know that, Price to Earnings ratio           = Price per share ÷ Earning per share

                                                            18.69   = Price per share ÷ 2.65

                                                            49.53 = Price per share

Price to equity book value ratio         = 49.53 ÷ 12.67

                                                            = 3.91

Earnings per share measure how much a firm is able to generate earnings for each of its shares. Price to Earnings ratio measures how much an investor is willing to pay against a firm’s EPS. Price to book value is the measure which means how much price the firm has in its written value against EPS (Green, 2013).

Problem 3-6: Ratio Computation

Current ratio

1.24:1

Acid-test ratio

0.85:1

Times interest earned

8.13 times

Inventory turnover

86.90 days

Total asset turnover

0.4

Operating profit margin

31%

Days in receivables

52.14 days

Operating return on assets

12.4%

Debt ratio

0.52:1

Fixed asset turnover

0.4%

Return on equity

16.30%

References

Britton, A., & Waterston, C. (2013). Financial accounting. Harlow: Financial Times Prentice Hall.

Green, J. (2013). Financial Statement Analysis and Equity Valuation. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2271238

Powers, M., & Needles, B. (2012). Financial accounting. [Mason]: South-Western, Cengage Learning.

Stickney, C. (1993). Financial statement analysis. Fort Worth: Harcourt Brace Jovanovich Publishers.

Suthan, A. (2007). Fundamental of Financial Statement Analysis. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.1588981