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Introduction of Financial Statement

A financial statement (or financial report) is a formal record of the financial activities and
position of a business, person, or other entity. Financial statement analysis is a method or
process involving specific techniques for evaluating risks, performance, financial health, and
future prospects of an organization. It is the medium by which a company discloses information
concerning its financial performance. Followers of fundamental analysis use
the quantitative information gleaned from financial statements to make investment decisions. It
is used by a variety of stakeholders, such as credit and equity investors, the government, the
public, and decision-makers within the organization.A business financial statement shows the
sources of a company's revenue, how it spent its money, its assets and liabilities and how it
manages its cash flow. Financial statements are usually required by lenders when a business is
seeking a loan or as part of an annual statement released by a corporation at the conclusion of
the fiscal year.

Financial statements serve an important role in attracting potential investors and in


getting a new business off the ground. If you're trying to attract investors to help grow your
business, they'll likely want to view your financial statement to determine the financial
soundness of your operation. If you're looking to start a business, lenders will want to see a
business plan with projected financial statements.

Preparing the Financial Statements

Once the adjusting entries have been made or entered into a worksheet, the financial statements
can be prepared using information from the ledger accounts. Because some of the financial
statements use data from the other statements, the following is a logical order for their
preparation:

 Income statement
 Statement of retained earnings
 Balance sheet
 Cash flow statement
Income Statement

The income statement reports revenues, expenses, and the resulting net income. It is prepared
by transferring the following ledger account balances, taking into account any adjusting entries
that have been or will be made:

 Revenue
 Expenses
 Capital gains or losses

Statement of Retained Earnings

The retained earnings statement shows the retained earnings at the beginning and end of the
accounting period. It is prepared using the following information:

 Beginning retained earnings, obtained from the previous statement of retained earnings.
 Net income, obtained from the income statement
 Dividends paid during the accounting period

Balance Sheet

The balance sheet reports the assets, liabilities, and shareholder equity of the company. It is
constructed using the following information:

 Balances of all asset accounts such cash, accounts receivable, etc.


 Balances of all liability accounts such as accounts payable, notes, etc.
 Capital stock balance
 Retained earnings, obtained from the statement of retained earnings

Cash Flow Statement

The cash flow statement explains the reasons for changes in the cash balance, showing sources
and uses of cash in the operating, financing, and investing activities of the firm. Because the
cash flow statement is a cash-basis report, it cannot be derived directly from the ledger account
balances of an accrual accounting system
Case BackGround:

Silver River manufacturing organization is a large regional product of a farm and it is an


agribusiness supplier who relies on upon agriculturists for 45-50 percent of its aggregate deals.
In the decade before 2003, SRM had encountered high and moderately enduring development
in sales, resources and benefits however, Greg White the president of the SRM was worried
about the budgetary position of the association toward the end of 2003, the interest for new field
trailers in the citrus and vegetable commercial ventures began to tumble off and Marion Nation
National Bank likewise attempted to survey his credit installment framework. The retreat that
had been tormenting the country’s ranch economy and appalling stops for two straight winters
brought about high abbreviation of interest for woods retailer and citrus transport bearers: SRM
was not insusceptible to this. In spite of the fact that SRM had demonstrated high and relentless
development in deals, resources and benefits preceding 2003, on the other hand, towards the
end of 2003 the interest for new field trailers in citrus and vegetable commercial ventures began
for tumble off. SRM was likewise influenced by the retreat and on the highest point of this the
business went down steadily. Then again, his agrarian items were likewise influenced by the
terrible atmosphere.

In the decade before 2003, SRM had encounter high and moderately enduring development in
deals, resources and benefits. More than 85% of its sales come from the southeastern part of
US. Several major boat companies in Florida work closely with SRM in designing trailers for
their new offerings. The products manufactured by SRM are not subject to technological
obsolesces or to deterioration and in those instances where technology is to be considered, SRM
holds several patents with which it can partially offset some of the risk.

Toward the end of 2003, the demand for new field trailer in the citrus and vegetable industries
started to fall off. The recession that had been plaguing the nation’s farm economy and
disastrous freezes for two straight winters resulted in high curtailment of demand for grove
retailer and citrus transport carriers; SRM was not immune to this. Though SRM had shown
high and steady growth in sales, assets and profits prior to 2003, however, towards the end of
2003 the demand for new field trailers in citrus and vegetable industries started for fall off. In
order to sustain profits and superior market performance Mr. White aggressively reduced prices
to stimulate further sales. He had full confidence that national economic policies would revive
the ailing farm sector so; the downturn in demand would be short-term. Consequently,
production continued unabated and inventories started increasing. Mr. White’s next step was to
relax credit terms and standard to maintain preciously high growth and to reduce the ever
expanding inventory. This effort of Mr. White increased sales through the third quarter of 2005,
but inventories also increased steadily and particularly short-term credits and accounts
receivable grew up dramatically.

Hence, to finance these increase in assets, SRM turned to Marion Country National Bank,
(MCNB) for long term loan in 2004 and increase in its short term credit loan in both 2004 and
2005. MCNB had been a major banker of SRM for a long time. In the start, Lesa Nix, the vice-
president of MCNB, had handled the case of SRM. Later, she got promoted and was no longer
responsible for handling SRM’s account. However, as Mr. White was a close friend, she still
took keen interest on SRM. Even this was insufficient to cover the aggressive expansion on the
asset side. Consequently, Greg White who always made prompt payments, started to delay
payments. This resulted substantial increase in accounts payable and other short term loans.

Upon analyzing SRM’s financial conditions, Lesa Nix found that the bank’s computer analysis
system revealed a number of significant adverse trends and highlighted several potentially
serious problems. Its 2005 current, quick and debt ratios failed to meet the contractual limits of
2, 1.0 and 55percent respectively. Technically, the bank had a legal right to call for immediate
repayment of both long and short-term loans, and, if they were not repaid within ten days, could
force the company into bankruptcy.

Despite such adverse conditions Nix considered the company to have good long run prospects,
assuming, of course that management reacted immediately and appropriately to the current
situation. Hence, Nix looked upon the threat of accelerating the loan repayment primarily as a
means to get Greg White’s undivided attention and to force him to think about corrective
actions that must be taken at once to reverse the deterioration and to correct SRM’s near-term
problems. Even though she hoped to avoid calling the loans if at all possible because that action
would back SRM into a corner from which it might not be able to emerge intact, Nix realized
that the bank’s examiners, due to the recent spate of bank failures, were very sensitive to the
issue of problem loans. SRM’s Altman Z factor (2.88) for 2005 was below 2.99 which indicated
that SRM was likely to get bankrupt in two years. Because of this deficiency, MCNB was under
increased pressure from the regulators to reclassify SRM’s loan as ‘problem category’ and take
whatever steps needed to collect the money due and reduce the bank’s exposure as quickly as
practicable. In order to avoid reclassification, SRM required strong and convincing evidence to
prove that its problems were temporary in nature and it had good chance of reversing the trend.

The current financial problems were not the only problem Mr. White faced. He had recently
signed a contract for a plant expansion that would require another $6375000 of the capital
during the first quarter of 2006. He had planned to obtain this money by a short term loan from
MCNB to be repaid from the profit generated in the first quarter of 2006. He believed that new
facilities would enhance the production capabilities in a very lucrative area of custom horse van.

According to Mr. White’s analysis, the financial position of the company could improve
significantly over the next two years if the bank maintained or even extended the credit lines.
Once the new facility is added, the company would be able to increase output in rapidly
growing segments of market (horse van and home chain) and also reduce the dependency on
farm and light utility sales to 35% or less. He also projected that the sales growth would be 6%
and 9.5% in an average for 2006 and 2007 respectively, assuming there is no significant
improvement in either national or farm economy. He also assumed that SRM would change its
policy of aggressive marketing and sales promotion and return to full margin prices, standard
industry credit term and tighter credit standards. These changes would reduce cost of goods sold
to 82.5% in 2006 and 80% in 2007. Similarly administrative and selling expenses are likely to
decrease from 9% to 8% in 2006 and 7.5% in 2007. Also, the miscellaneous expense would
reduce to 1.75% and 1.25% of sales in 2006 and 2007 respectively.

Regarding the financial data provided in the case and the projected income statement and
balance sheet, we have to analyze whether SRM is eligible to obtain the bank loan. Now, the
question is whether the bank should extend the existing short and long-term loans or should
rather demand immediate repayment of both existing loans. Also we have to propose
alternatives available to SRM if the bank were to decide to withdraw the entire line of credit and
to demand immediate repayment of the two existing loans.
Sources & uses:

Statement of Changes in Financial Position year ended Dec 31(Thousands of Dollars)


Particulars 2004 2005
Sources of funds
Net income after taxes 6987 831
Depreciation 1823 2244
Funds from operations 8810 3075
Long-term loan 3506 -
Net decrease in working capital
Total sources 12316 3075
Application of funds
Mortgage change 293 287
Fixed assets change 2574 3051
Dividend on stock 1747 208
Net increase in working capital 7702 (471)
Total uses 12316 3075
Analysis of change in working capital
Increase (decrease) in current assets
Cash Change (1260) (107)
AR Change 1501 11985
INV change 15505 14992
CA change 15745 26870

Increase (decrease) in current liabilities


AP change 2104 14446
NP change 4116 10441
ACC change 1823 2454
CL change 8043 27341
Net increase (decrease) in working capital 7702 (471)

Comparing the Statement of changes of Financial Position of 2004 and 2005, net changes after
taxes in 2005 is decreased by $6156000 along with Funds from operations by $5735000 and
there is no long term loan taken in the year 2005. A total source in year 2004 is $12316000 and
in the year 2005 is $ 3075000.
Application of funds been decreased in year 2005 comparing to year 2004 is
decreased by $9241000; there is no significant change in the 2005. Mortgage change amount in
2005 is $600(decrease), Fixed Assets is change by $477000, dividend on stock is changed by
$1539000.
Ratio Analysis:

Financial ratio analysis is performed by comparing two items in the financial statements. The
resulting ratio can be interpreted in a way that is not possible when interpreting the items
separately. In short, we are analyzing interrelationships.
Financial ratios can be classified into ratios that measure: profitability, liquidity, management
efficiency, leverage, and valuation & growth.

Liquidity ratios:

These ratios show the cash levels of a company and the ability to turn other assets into cash to
pay off liabilities and other current obligations.

a) Current Ratio: Current Assets / Current Liabilities

Evaluate the ability of a company to pay short-term obligations using current assets. Such as
(cash, marketable securities, current receivables, inventory, and prepayments).

b) Acid Test Ratio = Quick Assets / Current Liabilities

Also known as "quick ratio", it measures the ability of a company to pay short-term obligations
using the more liquid types of current assets or "quick assets" (cash, marketable securities, and
current receivables)

Leverage ratios:

Companies rely on a mixture of owners' equity and debt to finance their operations. A leverage
ratio is any one of several financial measurements that look at how much capital comes in the
form of debt (loans), or assesses the ability of a company to meet financial obligations.

a) Debt Ratio =Total Liabilities / Total Assets

Measure the portion of company assets that is financed by debt (obligations to third parties).
Debt ratio can also be computed using the formula: 1 minus Equity Ratio.
b) Times Interest Earned = EBIT / Interest Expense

Measures the number of times interest expense is converted to income, and if the company can
pay its interest expense using the profits generated. EBIT is earnings before interest and taxes.

Asset Management Ratios:

Asset management (turnover) ratios compare the assets of a company to its sales revenue.
Asset management ratios indicate how successfully a company is utilizing its assets to generate
revenues. Analysis of asset management ratios tells how efficiently and effectively a company
is using its assets in the generation of revenues.

a) Inventory Turnover (cost) = COGS / Average Inventory

Represents the number of times inventory is sold and replaced. Take note that some authors use
Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is
efficient in managing its inventories

b) Inventory Turnover (selling) = Sales / Average Inventory

Represents the number of times inventory is sold and replaced. Take note that some authors use
Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is
efficient in managing its inventories

c) Fixed Asset turnover = Sales/Fixed Assets

The fixed-asset turnover ratio is, in general, used by analysts to measure operating
performance. It is a ratio of net sales to fixed assets. This ratio specifically measures how able a
company is to generate net sales from fixed-asset investments

d) Total Asset Turnover = Sales / Total Assets

Measure overall efficiency of a company in generating sales using its assets, the formula is
similar to ROA, except that net sales is used instead of net income

e) Average collection period = Receivables/Sales per day


An average collection period shows the average number of days necessary to convert
business receivables into cash.

Profitability Ratios:

A profitability ratio is a measure of profitability, which is a way to measure a company's


performance. Profitability is simply the capacity to make a profit, and a profit is what is left
over from income earned after you have deducted all costs and expenses related to earning the
income.

a) Gross Profit Rate/Margin = Gross Profit / Net Sales

Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales
minus sales returns, discounts, and allowances) minus cost of sales.

b) Return on Sales/Profit Margin = Net Income / Net Sales

Also known as "net profit margin" or "net profit rate", it measures the percentage of income
derived from dollar sales. Generally, the higher the ROS the better.

c) Return on Assets = Net Income / Average Total Assets

In financial analysis, it is the measure of the return on investment. ROA is used in evaluating
management's efficiency in using assets to generate income.

d) Return on Stockholders' Equity = Net Income / Average Stockholders' Equity

Measures the percentage of income derived for every dollar of owners' equity.

Altman Z Factor:
The Altman Z Score model, defined as a financial model to predict the likelihood of bankruptcy
in a company, was created by Edward I. Altman. Altman was a professor at the Leonard N.
Stern School of Business of New York University. His aim at predicting bankruptcy began
around the time of the great depression, in response to a sharp rise in the incidence of default.

Z= 0.012X1+0.014x2+0.033x3+0.006x4+0.999x5
Ratio Analysis:

Financial ratio analysis is performed by comparing two items in the financial statements. The
resulting ratio can be interpreted in a way that is not possible when interpreting the items
separately. In short, we are analyzing interrelationships.
Financial ratios can be classified into ratios that measure: profitability, liquidity, management
efficiency, leverage, and valuation & growth.

Liquidity ratios:

These ratios show the cash levels of a company and the ability to turn other assets into cash to
pay off liabilities and other current obligations.

c) Current Ratio: Current Assets / Current Liabilities

Evaluate the ability of a company to pay short-term obligations using current assets. Such as
(cash, marketable securities, current receivables, inventory, and prepayments).

d) Acid Test Ratio = Quick Assets / Current Liabilities

Also known as "quick ratio", it measures the ability of a company to pay short-term obligations
using the more liquid types of current assets or "quick assets" (cash, marketable securities, and
current receivables)

Leverage ratios:

Companies rely on a mixture of owners' equity and debt to finance their operations. A leverage
ratio is any one of several financial measurements that look at how much capital comes in the
form of debt (loans), or assesses the ability of a company to meet financial obligations.

c) Debt Ratio =Total Liabilities / Total Assets

Measure the portion of company assets that is financed by debt (obligations to third parties).
Debt ratio can also be computed using the formula: 1 minus Equity Ratio.
d) Times Interest Earned = EBIT / Interest Expense

Measures the number of times interest expense is converted to income, and if the company can
pay its interest expense using the profits generated. EBIT is earnings before interest and taxes.

Asset Management Ratios:

Asset management (turnover) ratios compare the assets of a company to its sales revenue.
Asset management ratios indicate how successfully a company is utilizing its assets to generate
revenues. Analysis of asset management ratios tells how efficiently and effectively a company
is using its assets in the generation of revenues.

f) Inventory Turnover (cost) = COGS / Average Inventory

Represents the number of times inventory is sold and replaced. Take note that some authors use
Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is
efficient in managing its inventories

g) Inventory Turnover (selling) = Sales / Average Inventory

Represents the number of times inventory is sold and replaced. Take note that some authors use
Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is
efficient in managing its inventories

h) Fixed Asset turnover = Sales/Fixed Assets

The fixed-asset turnover ratio is, in general, used by analysts to measure operating
performance. It is a ratio of net sales to fixed assets. This ratio specifically measures how able a
company is to generate net sales from fixed-asset investments

i) Total Asset Turnover = Sales / Total Assets

Measure overall efficiency of a company in generating sales using its assets, the formula is
similar to ROA, except that net sales is used instead of net income

j) Average collection period = Receivables/Sales per day


An average collection period shows the average number of days necessary to convert
business receivables into cash.

Profitability Ratios:

A profitability ratio is a measure of profitability, which is a way to measure a company's


performance. Profitability is simply the capacity to make a profit, and a profit is what is left
over from income earned after you have deducted all costs and expenses related to earning the
income.

e) Gross Profit Rate/Margin = Gross Profit / Net Sales

Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales
minus sales returns, discounts, and allowances) minus cost of sales.

f) Return on Sales/Profit Margin = Net Income / Net Sales

Also known as "net profit margin" or "net profit rate", it measures the percentage of income
derived from dollar sales. Generally, the higher the ROS the better.

g) Return on Assets = Net Income / Average Total Assets

In financial analysis, it is the measure of the return on investment. ROA is used in evaluating
management's efficiency in using assets to generate income.

h) Return on Stockholders' Equity = Net Income / Average Stockholders' Equity

Measures the percentage of income derived for every dollar of owners' equity.

Altman Z Factor:
The Altman Z Score model, defined as a financial model to predict the likelihood of bankruptcy
in a company, was created by Edward I. Altman. Altman was a professor at the Leonard N.
Stern School of Business of New York University. His aim at predicting bankruptcy began
around the time of the great depression, in response to a sharp rise in the incidence of default.

Z= 0.012X1+0.014x2+0.033x3+0.006x4+0.999x5
Silver River Manufacturing Company
Du Pont System:
Particular ROE = NPM × TAT × EM
s
ROE = Net Income × Sales × Total Assets
Sales Total Assets Total Equity
2003 28.26 = 5.50 × 3.06 × 1.6796
2004 16.68 = 3.44 × 2.60 × 1.8634
2005 1.96 = 0.38 × 2.04 × 2.4873
Industry 17.50 = 2.90 × 3.00 × 2.00
Average

For 2003

X1= Working capital / Total assets

=30565 / 61539 = 0.497

X2 = Retained earnings / Total assets

=11041/ 61539 = 0.179

X3 = EBIT / Total assets

= 21251 / 61539 = 0.345

X4 = Market value of equity / Book value of total debt

= 68481.58 / 24901 = 2.750

X5 = Sales / Total assets

= 188097 / 61539 = 3.057

Z = 0.012x1 + 0.014x2 + 0.033x3 + 0.006x4 + 0.999x5

= 3.09
For 2004

X1= Working capital / Total assets

=38266 / 78034 = 0.490

X2 = Retained earnings / Total assets

= 16282 / 78034 = 0.209

X3 = EBIT / Total assets

= 15364 / 78034 = 0.197

X4 = Market value of equity / Book value of total debt

= 37405.54 / 36516 = 1.024

X5 = Sales / Total assets

= 203124 / 78034 = 2.603

Z = 0.012x1 + 0.014x2 + 0.033x3 + 0.006x4 + 0.999x5

= 2.622

For 2005

X1= Working capital / Total assets

=37795 / 105711 = 0.358

X2 = Retained earnings / Total assets

= 16904 / 105711 = 0.159

X3 = EBIT / Total assets

= 4888 / 105711 = 0.046

X4 = Market value of equity / Book value of total debt

= 3852.82 / 63211 = 0.061


X5 = Sales / Total assets

= 215305 / 105711 = 2.037

Z = 0.012x1 + 0.014x2 + 0.033x3 + 0.006x4 + 0.999x5

= 2.043