The Nature of Financial Statements - Example

Profitability measures Profitability measures Time and again, non-GAAP financial measures with respect to various companies are discussed. Most companies use both GAAP and non-GAAP financial measures in performance evaluation. These are also offered to investors to supplement the reported financial results. Most often than not, financial investors consider this information an additional insight into the company’s operating performance. Nonetheless, is always important to mention that non-GAAP financial measures should never been considered in isolation, superior or as substitutes to the GAAP based financial measures. Conventionally, non-GAAP financial measures exclude items from reported results primarily that are related to non-recurring restructuring and acquisition charges, non-recurring items related to spinoff, non-recurring gains/losses on sale of assets, and non-recurring tax items, in addition to amortization of intangible assets acquired. Typically, a look at company’s profitability starts with an income statement. An income statement is among the three major financial statements that enterprises prepare. It makes available a record of an entities revenues and expenses for a given duration and hence its serves as a basic measure of profitability (Carl, 2008). As a matter of fact, it often is referred to as a profit-and-loss statement. In general, an income statement can be defined as a scorecard that provides a summary of revenues and expenses incurred by a business enterprise for a specified duration. It is therefore an important tool that managers can use to aid their daily operations within a firm. Managers, in integrating non-GAAP financial reporting, look beyond the company’s earnings as displayed in the income statement. The document provides insightful information with respect to both GAAP and non-GAAP financial reporting. Additionally, by discussing profitability financial ratios, financial managers are able to establish the rate of return an enterprise is earning as well as how well the assets are managed. Additionally, the ratios allow managers to compare their entities performance to that of others within the industry. Such ratios include: gross profit margin, net profit margin and operating profits margin, among others (Carl, 2008). This paper discusses GAAP-based and non-GAAP based financial measures of profitability using a case study of EuroBank EFG. With a wide array of financing options, it is vital to critically evaluate a number of factors before conclusive deciding on the appropriate financing option. Factors necessary to make appropriate financing option decisions include (Christie, 2009, pp. 231): Capital requirement Funds urgency Costs associated with financing option The risks versus rewards Financing duration Business gearing ratio Business control Sample budget financial statements are attached in appendices. Calculating unit costs calls for a deeper understanding of the cost involved. A unit cost is calculated based on the total cost assigned to a production batch and the no of units in the batch. Total cost is calculated based on all the cost incurred to bring the produce to consumption. For instance, if the total cost of producing 500 units of beef burger is $400 and 300 units of hamburger is $500. Then the following is deduced. Total Units Total cost Unit cost Beef Burger 500 400 $1.25 Hamburger 300 500 $0.6 If the businesses pricing policy requires that selling price be set at $1.15 the unit cost, then beef burger will sell at $1.372 and hamburger at 0.69. Various tools are available for analysis of investments. The first toll commonly encountered in investment analysis is the Net Present Value. It illustrates the revenue/savings that will be gained from the investment, less associated costs. The future values are brought to the present using a compound interest known as the discounted rate. It is widely used due to its provision of a sense of direction as to how much the project will generate. Additionally, it represents a tool for making decisions regarding mutually exclusive projects (Parker, 2011, pp. 260). The internal rate of return is also widely used in investment analysis. It gives the measure and the ability of the investment to repay invested capital (Parker, 2011, pp. 263). Basically, it gauges the businesses’ internal merit. It provides the rate of money generation for the project. Other than the two, other methods employed include cost benefit analysis and gauging of the payback period. The benefit cost ratio is calculated by the equation below: The MCR is the maximum capitalization risk. The payback period on the other hand indicates the period it takes to recover an investment from the business. It however does not fully account for the time value of money. Financial statements are important tools that help various stakeholders to gain knowledge about the business (Helfert, 2001, pp. 48). Cash flow, balance sheet and profit and loss accounts offer crucial information which is used to calculate various ratios of importance to stakeholders. The cash flow statement is used to establish a firm’s liquidity; a balance sheet on the other hand gives a display of the businesses financial resources as well as obligations at any time while an income statement reflects the financial transaction of the business within a specified duration. The table below summarizes the functions of financial statements: Cash flow statement Provides information on businesses’ liquidity and solvency. Provides information relevant for evaluation of assets, liabilities and equity changes. Allows for comparison of performance of different businesses. Shows the amount, timing and future cash flow probabilities. Balance sheet It reflects the financial position of a business. It provides an overview of a company’s assets, liabilities and capital. Profit and loss account Indicates the businesses revenue. Indicates the costs and expenses charged on revenues. It shows the managers as well as investors whether the company lost cash during the period. Table 1: Purposes of financial statements (source: Parker, 2011, pp. 261). Different formats are often used in preparation of financial statements. However, the choice of format does not alter the ultimate results (Helfert, 2001, pp. 40). Businesses choose methods of representing financial statements based on its function or nature. However, preparations of such statements are guided by various global accounting standards e.g. IFRS, and GAAP. Different business types have different requirements and as such choose different formats. A sole trade for instance would prepare a simplified financial statement as compared to a public limited company. Some businesses prepare single step profit and loss account. These include classification of expenses depending on functionality and as such are deducted from total income in order to yield pre-tax income (Helfert, 2001, pp. 48). Other businesses adopt a multi step format whereby the cost of sales are deducted from sales to yield gross profit. Other income and expenses are then presented to yield pre-tax income. Unlike, the multi step format, single format does not classify costs as direct or indirect (Parker, 2011, pp. 260). While the single format provides low accounting information quality, the multi-step is rich in information. In preparation of balance sheets, some businesses match equity and liabilities to the businesses assets. Straight line balance sheets however allow for year by year comparison of the company’s assets and as such ability to access business performance from one year to another. 5.3 Analysis of projected financial statement Various ratios are useful in analysis of financial statement. These include: Current Ratio Current Ratio = Current Assets / Current Liabilities The current ratio measures the companys ability to repay the principal amounts of its liabilities. Current ratio Year Year Year Year 1 2 3 4 Current assets $206,020 $179,537 $229,435 $303,753   Current liabilities $2,100 $2,100 $2,100 $2,100 Current ratio 98.10 85.49 109.25 144.64 Quick Ratio Quick Ratio = (Current Assets - Inventory) / Current Liabilities The quick ratio shows whether a company can meet its liabilities from quickly-accessible assets. In practice, a quick ratio of 1.0 is normally considered adequate, with this caveat: the credit periods that the company offers its customers and those granted to the company by its creditor must be roughly equal (Warren, 2008, pp. 130). Quick ratio Year Year Year Year 1 2 3 4 Current Assets $206,020 $179,537 $229,435 $303,753 Inventory $25,000 $25,000 $25,000 $25,000 Current Assets Less Inventory $181,020 $154,537 $204,435 $278,753 Current liabilities $2,100 $2,100 $2,100 $2,100 Quick ratio 86.20 73.59 97.35 132.74 Gross Profit Margin The gross profit margin is a basic ratio that measures the added value that the market places on a companys non-manufacturing activities. Its formula is: Gross profit margin = (Sales - Cost of Goods Sold) / Sales The gross profit margin measures the amount that customers are willing to pay for a companys product, over and above the companys cost for that product. Gross Profit Margin Year Year Year Year 2003 2004 2005 2006 Sales $101,400 $103,428 $107,565 $114,019 Cost of sales $27,588 $28,139 $29,265 $31,021 Gross profit margin 72.8% 72.8% 72.8% 72.8% Net Profit Margin Net Profit Margin = Earnings after Taxes / Sales When net profit margin falls dramatically from the first to the fourth quarters, a principal culprit is cost of sales (Warren, 2008, pp. 129). Another place to look when you see a discrepancy between gross profit margin and net profit margin is operating expenses. When the two margins covary closely, it suggests that management is doing a good job of reducing expenses when sales fall, and increasing expenses when necessary to support production and sales in better times. Net Profit Margin Year Year Year Year 1 2 3 4 Net Income $73,813 $75,289 $78,300 $82,998 Sales $101,400 $103,428 $107,565 $114,019 Net profit margin 72.79% 72.79% 72.79% 72.79% Return on Assets Return on Assets = Net Income/ Total Assets This formula will return the percentage earnings for a company in terms of its total assets. The better the job that management does in managing its assets-the resources available to it-to bring about profits, the greater this percentage will be. Return on Assets Year Year Year Year 1 2 3 4 Net Income $73,813 $75,289 $78,300 $82,998 Total assets $123,300 $240,020 $207,417 $251,075 Return on assets 59.9% 31.4% 37.8% 33.1% Profitability ratios are important to prospective investors. It is important to note that dividend payouts are derived from profits. Additionally, company’s expansion largely relies on profitability and as such improvements in profit margin is important. On the other hand, liquidity ratios on the other hand mainly concerns creditors. These are not the focus of this paper. EuroBank EFG is part of the EFG Group, an international banking group which operates under a holding company known as European Financial Group EFG (Luxembourg) SA. EFG group is structured into two distinct sub-entities; each governed by an independent board of directors, management and sub-consolidated regulatory supervision (Eurobank EFG, 2010). The two entities are EFG International and Eurobank EFG. The current ratio compares a companys current assets (those that can be converted to cash during the current accounting period) to its current liabilities (those liabilities coming due during the same period). The usual formula is: Current Ratio = Current Assets / Current Liabilities The following table below shows the company’s current ratio. Table 2: Current Ratio Current ratio Year 2010 Year 2009 Year 2008 Current assets € 83,674.00 € 81,035.00 € 79,262.00 Current liabilities € 54,470.00 € 58,509.00 € 58,862.00 Current ratio 1.54 1.39 1.35 The current ratio measures the companys ability to repay the principal amounts of its liabilities. The current ratio is closely related to the concept of working capital. Working capital is the difference between current assets and current liabilities. The company’s current ratio is not very high though being greater than one indicates that the company is able to pay its debts on time. Additionally, noting that the value is not very high shows that the company is effectively utilizes its assets to generate income. Other than the current ratio, quick ratio is also an important to tool in financial statement analysis. Quick ratio is a variant of the current ratio. It takes into account the fact that inventory, while it is a current asset, is not as liquid as cash or accounts receivable. Cash is completely liquid; accounts receivable can normally be converted to cash fairly quickly, by pressing for collection from the customer. But inventory cannot be converted to cash except by selling it. The quick ratio determines the relationship between quickly accessible current assets and current liabilities: Quick Ratio = (Current Assets - Inventory) / Current Liabilities The table below shows the company’s quick ratio for the three years being assessed. Table 3: Quick ratio Quick ratio Year 2010 Year 2009 Year 2008 Current Assets € 83,674.00 € 81,035.00 € 79,262.00 Inventory € 5,389.00 € 7,667.00 € 8,565.00 Current Assets Less Inventory $78,285 $73,368 $70,697 Current liabilities € 54,470.00 € 58,509.00 € 58,862.00 Quick ratio 1.44 1.25 1.20 The quick ratio shows whether a company can meet its liabilities from quickly-accessible assets. In practice, a quick ratio of 1.0 is normally considered adequate, with this caveat: the credit periods that the company offers its customers and those granted to the company by its creditor must be roughly equal. The results obtained over the three years all give a value greater than one with 2010 recording the highest value. This is in essence means that the company has increased capability to pay off its debts. The net interest margin narrows the focus to profitability in addition highlighting the company’s sales efforts. It also reflects the company’s ability to keep its operating expensive low in relation to sale. This ratio is determined by the formula: Net Interest Margin = Earnings after Taxes / Sales The company records a net interest decline in 2010 to 2.6% from 2.8% in 2009 and 3.2% in 2008. However, despite the decline, the level remains relatively stable more so considering that the effects of economic recession are just withering away. Effective use of profits to generate profits is an important responsibility the company’s management. Return on Assets (ROA) clearly evaluates how well this responsibility is being exercised. The ratio is obtained by the following formula: Return on Assets = Net Income/ Total Assets The formula will return the percentage earnings for a company in terms of its total assets. The better the job that management does in managing its assets-the resources available to it-to bring about profits, the greater this percentage will be. The company’s ROA has recorded significant decline across the three years evaluated as shown by the graph below: Figure 1: ROA trends The decline is mainly attributed to the decline of operations in Greece. However, the positive value indicates that the company is still able to generate profits from its resources. Return on equity (ROE) also acts as a measure of the company’s profitability. It is calculated as shown: Return on Equity = Net Income / Stockholders Equity A comparison of return on equity to return on assets helps in establishing how the company obtains funds for its assets’ acquisition. Assets are acquired through two major sources: creditors (through borrowing) and stockholders (through retained earnings and capital contributions). Collectively, the retained earnings and capital contributions constitute the companys equity. When the value of the companys assets exceeds the value of its equity, you can expect that some form of financial leverage makes up the difference: i.e., debt financing. Return on equity for the firm, just like ROA has declined across the years evaluated. This is shown by the figure below: Figure 2: ROE trends To establish how the company funds its operations a comparison of the two is done as shown in the chart below: Figure 3: Comparison of ROE to ROA From the graph, it can be deduced that in year 2008 and 2009, the company funded some portion of its operations through borrowing. However, in 2010 borrowing to fund operations is not recorded as shown by the lesser value of ROE compared to ROA. An interesting phenomenon to mention is the fact that in 2010, ROE value is negative indicated to some extent that not all assets are effectively utilized to generate profit to the company. This is a measure of the amount of banks capital as a percentage of the risk weighted credit exposures. Minimum capital adequacy ratios indicate that the depositors are protected and the financial system is stable and efficient. Eurobank’s capital adequacy ratio has been on a consistent rise over the last three years. It is vital to note that both total tier I ratio and total capital adequacy ratios are above the recommended minimal limits of 4% and 8% respectively. As earlier mentioned, the non-GAAP financial measures are not considered in isolation, or as substitute for comparable GAAP measures. They have limitations due to fact that their preparation is not in line GAAP and hence not comparable to similarly titled measures of competitors or other corporations due to potential differences in calculation methods and exclude items. These limitations are bridged by using the non-GAAP financial measures as supplements to GAAP measures and offering reconciliations of non-GAAP and comparable GAAP financial measures. References Carl, W. (2008). Survey of Accounting. Cincinnati: South-Western College Publication. pp. 128–132. Erich, H. (2001). "The Nature of Financial Statements: The Income Statement". Financial Analysis - Tools and Techniques - A Guide for Managers. London: McGraw-Hill, p. 40. Eurobank EFG. (2010). Financial statements year 2009. Retrieved on 02/07/2011 from Eurobank EFG. (2010). Financial statements year 2010. Retrieved on 02/07/2011 from http://www.eurobank.gr/Uploads/pdf/Eurobank%20FIN%20AR%202010%20en.pdf Helfert, E. A. (2001). The Nature of Financial Statements: The Income Statement". Financial Analysis: Tools and Techniques. London: McGraw-Hill. Parker, R. H. (2011). Estimating financial distress with a dynamic model: evidence from family owned enterprises in a small open economy. Journal of Multinational Financial Management, 21(3), 245-261. Read More