Topic 2: Analysis of Financial Statement

Question 1:
Discuss Two (2) benefits of ratio analysis to investors in evaluating financial position and operation of a company?

Qustion 2:
Last year 2007, Inspire Sdn Bhd had sales of RM300, 000 and a net income of RM20, 000 and its year-end assets were RM200, 000. The company's total debt to total asset ratio was 40%. _base_d on the Du Pont equation, Calculate the company's return on equity (ROE)

Format of the Statement of Cash Flows

The statement of cash flows has four distinct sections:

1. Cash involving operating activities
2. Cash involving investing activities
3. Cash involving financing activities
4. Supplemental information.

Assuming that the cash flow statement is being prepared using the indirect method (the method used by most companies) the differences in a company's balance sheet accounts will provide much of the needed information. For example, if the statement of cash flows is for the year 2007, the balance sheet accounts at December 31, 2007 will be compared to the balance sheet accounts at December 31, 2006. The changes—or differences—in these account balances will likely be entered in one of the sections of the statement of cash flows.

Shown below is each of the four sections of the statement of cash flows, followed by a list of those balance sheet accounts which affect it.


1. Cash Provided From or Used By Operating Activities

This section of the cash flow statement reports the company's net income and then converts it from the accrual basis to the cash basis by using the changes in the balances of current asset and current liability accounts, such as:

Accounts Receivable
Inventory
Supplies
Prepaid Insurance
Other Current Assets
Notes Payable (generally due within one year)
Accounts Payable
Wages Payable
Payroll Taxes Payable
Interest Payable
Income Taxes Payable
Unearned Revenues
Other Current Liabilities


In addition to using the changes in current assets and current liabilities, the operating activities section has adjustments for depreciation expense and for the gains and losses on the sale of long-term assets.


2. Cash Provided From or Used By Investing Activities

This section of the cash flow statement reports changes in the balances of long-term asset accounts, such as:

Long-term Investments
Land
Buildings
Equipment
Furniture & Fixtures
Vehicles


In short, investing activities involve the purchase and/or sale of long-term investments and property, plant, and equipment.


3. Cash Provided From or Used By Financing Activities

This section of the cash flow statement reports changes in balances of the long-term liability and stockholders' equity accounts, such as:

Notes Payable (generally due after one year)
Bonds Payable
Deferred Income Taxes
Preferred Stock
Paid-in Capital in Excess of Par-Preferred Stock
Common Stock
Paid-in Capital in Excess of Par-Common Stock
Paid-in Capital from Treasury Stock
Retained Earnings
Treasury Stock


In short, financing activities involve the issuance and/or the repurchase of a company's own bonds or stock. Dividend payments are also reported in this section.

Functionality:

Every investment decision affects the wealth of those who own the company. This is because the value of an asset is determined by expected future income streams and investments are undertaken now to generate income in the future. When you buy a share in a company you buy an asset and the value of that asset depends on the market view of the expected income stream likely to be generated by the company in the future. When the company undertakes an investment it changes the expected future income stream and hence changes its own value as an asset. Consequently the value of shares in the company will also change.

CONCEPT AND MEANING OF CORPORATE
POLICY
Corporate policy is the guide post to decision making. It helps in the managerial
thinking process and thus leads to the efficient and effective attainment of the
_object_ives of any organization.
Corporate policy has been defined as “Management’s expressed or implied intent to
govern action in the pursuit of the company’s _object_ives.” Corporate policy clarifies
the intention of management in dealing with the various problems faced. It gives the
managers a transparent guideline to take their decisions by being on the safe side.
Corporate policy helps the manager in identification of the solutions to the problem. It
provides the _frame_work in which he has to take the decisions. The distinct views
regarding policies can be categorized into the following three broad groups:
i) The first category holds the opinion that policy and strategy are synonymous.
Corporate policy has been defined by William Glueck as “Management policy is
long range planning. For all practical purposes, management policy, long range
planning and strategic management mean the same thing.” However, this view is
quite controversial as strategy and corporate policy do not mean the same thing.
Strategy includes awareness of the mission, purpose and _object_ives. It has been
defined as, “the determination of basic long term goals and _object_ives of an
enterprise, and the allocation of resources necessary to carry out these goals”,
while policies are statements or a commonly accepted understandings of decision
making and are thought oriented guidelines. Therefore, strategy and corporate
policy cannot be used interchangeably as there is a clear line of differentiation
between the two terms.
ii) The second group of experts view corporate policy as the process of
implementing strategy. In the words of Frank I. Paine and William Naumes,
“Policies guide and channel the implementation of strategy and prescribe how
processes within the organization will function and be administered. Thus the
term policy refers to organization procedures, practices and structures, concerned
with implementing and executing strategy.”
Supporting this view, Robert Mudric has defined corporate policy as “A policy
establishes guidelines and limits for discretionary action by individuals
responsible for implementing the overall plan.”
The view represents corporate policy to be
! Restrictive
! Laying stress only on the tactical side and ignoring the strategic dimension.
iii) The third view considers corporate policy to be decisions regarding the future of
an organization.
In this view, Robert J. Mockler defines corporate policy as, “Strategic
guidelines for action. They spell out what can and what cannot be done in all
areas of a company’s operation.”
According to the policy manual of General Electric Company, “Policy is
definition of common purpose for organization components of the company for
benefit of those responsible for implementation, exercise discretion and good
judgment in appraising and deciding among alternative courses of action.”
The views of different management scholars differ because of following reasons:
! There is no clear differentiation of policy from other elements of planning.
! There are different policies made at different levels of management for
directing executives.
32
Issues in Corporate
Management
! Corporate policy encompasses and relates to the entire process of planning.
Thus, corporate policy focusses on the guidelines used for decision making and
putting them into actions. It consists of principles along with rules of action that
provides for successful achievement of corporate _object_ives.

Goals of the firms:

I. Profit Maximization

II. Maximization of the Shareholders Wealth


I. Profit Maximization:

Profit maximization stresses the efficient use of capital resources, but it is not specific(or ignore) with respect to the time _frame_ over which the profits are to be measured.

In short- term executives may used different assets to sell-off and turn the cash to increase liquidity on corporate balance sheets and than could easily increase profits. But this short run profit taking strategy is not in the best long-term _object_ive and interest of the owners of the public corporation.

In microeconomics, profit maximization functions largely as a theoretical goal, with economist using different models, charts and tables to prove the case that in free market economy firms behave rationally if they increase or maximize profit _base_d on information.

In this world of economics two(2) distinctive elements of business are ignored:

1. uncertainty 2. timing


In reality, different investment projects differ a great deal with respect to risk characteristics, and to ignore these differences in the practice of corporate financing can result in poor management decisions.

In business life there is a very definite relationship between risk and expected return - that is,

private investors demand a higher expected return for taking on the investment projects additional risk.

To ignore this relationship leads to improper decision making to allocate the capital which could lead to long-term conflict between existing investors and management.

II. Maximization of Shareholders Wealth

means maximization of the market value of the existing shareholders common stock price – because the effects of all financial decisions are included.

I. Private Investors react to poor investment or dividend decisions by selling stocks and causing the total market value of the public shares to fall.

II. Investors can react to good decisions by pushing
up the price of stocks and create wealth for the
shareholder.

If the owners of the corporation are to _base_ financial decisions on a single goal, that goal must be precise, not allow for misinterpretation, and deal with all the complexities of the real business world, including but not limited to:


1. legal issues
2. environmental standards
3. ethical and cultural considerations
4. international dimensions
5. labor demand and rights
6. tax


The market price of the public corporation reflects the value of the public corporations seen by its owners (investors = shareholders = equity holders) and takes into account the complexity and complications of
the real-business risks.

The unifying _object_ive in corporate finance is to maximize the share value of the public firm.

Investment projects, financing structure and dividend decisions must be directed by management toward share value maximization _object_ive.

The _object_ive is narrowed from maximizing firm value to maximizing stockholder value or stockholder wealth.

How do we measure stockholder wealth?


1. In a publicly traded company, the stock price is an observable and real measure of stockholder wealth


2. The _object_ive of maximizing stockholder wealth can be narrowed to maximizing stock price


3. The stock price possess unique value of measuring stockholder wealth at any time, not limited to corporate annual report or financial reports.

Why private investors focuses on Stock Price Maximization:

1. The stock prices are the most observable of all measures
that can be used to judge the performance of the publicly
traded corporation.

2. The stock price, in a market with rational investors,
reflects the long-term effects of the firm’s decisions

3. The stock price is a real measure of stockholders wealth,
since the stockholders can sell stock and receive the price
now.



Two mechanisms designed to provide power to stockholders:


I. The Annual Meeting, where the shareholders of publicly
traded firms are called to gather once every year at annual
meeting and decide directly on selection of the board of
directors

The shareholders who cannot attend the meeting can still exercise their voting power by filling out a proxy.

A Proxy enables shareholders to vote in absentia for boards of directors and resolution that will coming to a vote at the shareholders meeting.

II. The Boards of Directors is the body that oversees the management of a public corporation.

The Board of Directors as elected representatives of the shareholders, the directors are obligated to ensure that managers are looking out for stockholders interests.

They have the power to change the top management of the firm and have a substantial influence on how the corporation is run and how the dividends are distributed.

source: www.ibp.uw.edu.pl