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Summary Intermediate Finance and Accounting (1CK40) - ALL lectures and ALL reading material
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1CK40 Summary 2022Cash flow statements and financial ratios
The major financial statement
• Income statement: identifying the amount of wealth generated (profit and loss account)
o Measures flow of wealth during a particular period
• Statement of financial position: accumulated wealth and the form it does take (balance sheet)
o Is concerned with the financial position at a particular moment in time (snapshots)
• Statement of cash flows: summarizes all in- and outflows of cash during a particular period, and
categorizes them into:
o Cash flows from operating activities
o Cash flows from investing activities
o Cash flows from financing activities
Statement of financial position at the start of the accounting period → income statement & cash flow
statement → statement of financial position at the end of the accounting period
What is cash and why is cash so important?
• Cash: Notes and coins in hand and deposits in banks and similar institutions that are accessible to the
business on demand
• Cash equivalents: short-term liquid investment that can be readily convertible to known amounts of
cash and are subject to an insignificant risk of change of value
Cash is important, since it allows a business to buy new assets or enables a business to pay its
employees, and bills.
Moreover, it connects statements of financial position with each other
Layout of cash flow statement
• Cash flows from operating activities: arise from
normal day-to-day trading activities, after taking
account of the tax paid and financing costs related to
these activities (profit – (inventory end of day –
inventory start of day))
o Direct method: involves an analysis of all cash
receipts and payments related to operation for a
given period
o Indirect method: starts with profit and then uses
information form the income statement and
statement of financial position to identify cash
flows of a particular period
▪ Always check for differences in inventory, trade
receivables, and trade payables (profit +
decrease inventory – increase trade
receivables)
1
, ▪ Adds back depreciation to (income) profit (profit – increase inventory + increase trade payable
+ depreciation)
▪ Also checks for interest expenses as interest receivable and interest payable
▪ Checks for taxation expenses (amounts that should be paid) Taxation paid = taxation start
period (balance sheet) + taxation expense – taxation end period (balance sheet
▪ Subtracts dividend paid from (income) profit
o Summary indirect method:
• Cash flows from investing activities: arise from acquiring and selling non-current assets and cash
inflows that arise from financial investments (loans and shares)
o Also, salvage value of an old machine, interest from loans, and dividends received from shares that
are held in other businesses
• Cash flows from financing activities: relating to the long-term financing of the business
o Also, in- and outflow for the raise and redemption of long-term borrowings
2
,Net increase of decrease in cash and cash equivalents
Final total cash flow statement = (cash + cash equivalent) end period – (cash + cash equivalent) start
period
For the analysis and interpretation of the three statements, one can make use of so-called financial
ratios
• Examine various aspects of financial health of a company and as such can assist in highlighting the
strengths and weakens of a business
• It should be used in comparison with past ratios, ratios from similar types of businesses or planned
ratios
•
Profitability ratios
Return on ordinary shareholders’ funds:
𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 (𝑙𝑒𝑠𝑠 𝑎𝑛𝑦 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑)
𝑅𝑂𝑆𝐹 = ∗ 100%
𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠
• The higher, the better
• Averages are used
Return of capital employed: compares the amount of profit for the period available to owners with their
average investment in the business during the same period
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐶𝐸 = ∗ 100%
𝑆ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 + 𝑁𝑜𝑛𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑅𝑂𝐶𝐸 = ∗
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
• Preferably, ROCE is above the rate that businesses pay for borrowed funds
• Whenever possible, one should average components that are measured at specific moments in time
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = ∗ 100%
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
• Factors such as degree of competition, type of customer, economic climate, and industry
characteristics will influence this ratio
• Excellent ratio for comparing operational performance
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = ∗ 100%
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
Efficiency ratios
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 ℎ𝑒𝑙𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 ′ 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 = ∗ 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
• Businesses prefer a short inventories turnover period to a long one, because holding inventories has
costs
3
, 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑓𝑜𝑟 𝑡𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 = ∗ 365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
• Lower is preferred
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑓𝑜𝑟 𝑡𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 = ∗ 365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
• Higher is preferred, but too high risks loss of goodwill of suppliers
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑡𝑜 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝑟𝑎𝑡𝑖𝑜 =
𝑆ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 + 𝑁𝑜𝑛𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• A higher ratio tends to suggest that assets are being used more productively in the generation of
revenue. However, a very high ratio may suggest that the business is ‘overtrading’ on its assets
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑝𝑒𝑟 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠
• A higher ratio implies that they are deploying their staff efficiently
Liquidity ratios
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• A higher ratio is better
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠)
𝐴𝑐𝑖𝑑 𝑡𝑒𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• Useful because for many businesses, inventories cannot be converted into cash quickly
• Minimum level: 1.0. However, for many highly successful companies, it is not unusual for the acid test
ratio to be below 1.0 without causing liquidity problems
𝐶𝑎𝑠ℎ 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑒𝑑 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑛𝑔 𝑜𝑏𝑙𝑖𝑔𝑎𝑡𝑖𝑜𝑛𝑠 𝑟𝑎𝑡𝑖𝑜
𝐶𝑎𝑠ℎ 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑒𝑑 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• The higher the ratio, the better the liquidity of the business
Financial gearing ratios
Financial gearing occurs when a business is financed, at least in part, by borrowing rather than by
owners’ equity
• Involves taking a commitment to pay interest charges and to make capital repayments
• Done because of insufficient funds or to increase the returns to owners
• Effects:
o Returns to shareholders become more sensitive to changes in operating profits
o A change in operating profits will lead to a proportionately greater change in the ROSF ratio
𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚 (𝑛𝑜𝑛𝑐𝑢𝑟𝑟𝑒𝑛𝑡) 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐺𝑒𝑎𝑟𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜 = ∗ 100%
𝑆ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠 + 𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚 (𝑛𝑜𝑛𝑐𝑢𝑟𝑟𝑒𝑛𝑡) 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• Measures the contribution of long-term lenders to the long-term capital structure of a business.
(>50% is considered high)
4
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