Question

FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION

The following information has been extracted from the financial statements and notes of Brown Ltd.

	2014	2013
Revenue	$ 870 000	$ 862 500
Interest expense	34 500	39 750
Income tax expense	66 900	39 750
Profit	78 750	84 150
Dividends	42 000	42 000
Total assets	810 000	832 500
Total debt	429 750	458 250
Share capital	258 000	243 000
Retained earnings	122 250	131 250

Required:

1. Using the above information, discuss the profitability and financial stability of Brown Ltd in 2014 and 2013.
2. Nick, a financial analyst with an established brokerage firm says: “The critical number I look for at any company is operating cash flow. If cash flow is less than earnings, I consider a company a poor performer and a poor investment prospect.”

Briefly discuss whether you do or you do not agree with this comment. Explain why or why not.

Answer 1

1) Discussion on profitability and financial stability -

Profitability can be expressed /measured using few key ratios -

a) Net profit/margin ratio = (Net profit/Revenue)*100

For 2014 = (78750/870000)*100 = 9.05% For 2013 = (84150/862500)*100 = 9.75%

Overall there is a reduction in profit margin from 2013 to 2014 from 9.75 to 9.05% which is a negative sign

b) Return on assets ratio (ROA) = (Net profit/Assets)*100

For 2014 = (78750/810 000)*100 = 9.72% For 2013 = (84150/832 500)*100 = 10.10%

Overall there is a reduction in return from assets from 10.10 to 9.72% which is a negative sign

2) Financial stability = the most important components of stability is solvency

a) Debt to equity ratio is a good indicator of solvency. A decrease in DE ratio over time indicates better stability

Debt to equity ratio = Debt/(capital+retained earnings)

For 2014 = 429750/( 258 000+ 122 250) = 1.130 For 2013 = 458 250/(243 000+131 250) = 1.224

Overall there is a reduction in debt to equity ratio from 2013 to 2014 which indicates good stability

3) To get an understanding of the financial analyst - let us look at the difference between operating cash flow and net income/earnings.

operating cash flow basically is your total cash in flow (in hand) is derived by

= Net income after tax +/- changes in working capital

So operating cash flow gives the profit by way of cash method than accural method (GAAP based) of accounting. Accrual method may give profits which are not yet received in the form of cash but accrued.

The biggest advantages of operating cash flow is that you

A) cannot easily manipulate cash flow where as you can manipulate the net income under accrual method of accounting

B) Ultimately cash is king in any business. Stable flow of cash is the deciding factor of health of a business.

Hence Agree with the statement because cash flow is a better indicator than net income