Lecture notes made throughout the first semester of financial management 314. All classes attended so no gaps in the notes. Used these notes for finals and achieved a mark of +80%.
Summary: Ratio Analysis - Corporate Finance [EMNF2724]
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Financial Management 314 (202151047314)
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Financial Management 314
Component 1
Accounting Classification of Financial Statements
Learning Outcomes for Component 1
Reorganize financial items into the standardized format of the three major financial
statements
Illustrate the relationship between the elements of the different financial
statements. This is done by doing ratio analysis.
Evaluate the company’s return on equity (ROE) by means of a detailed DuPont
analysis
o Calculate the components of ROE
o Identify specific aspects of financial performance that contribute towards
ROE
o Assess the impact that operating investing and financing decisions will have
on ROE
Chapter 2: Financial Statements
One of the key features of financial statements is that they need to be comparable. The
statements of companies may not be that comparable as a result of different accounting
standards that are employed by the people who draft those statements. Since 2005, South
Africa companies have adopted international financial reporting standards (IFRS). This
means that trying to compare account records from before and after 2005 may be
problematic because there are different accounting standards being used. Another
important thing to note is that IFRS is only a guideline, which means it is not an exact
instruction or rule – it is open to interpretation. So, 2 companies can report on the same
item in their published financial statements, but due to the possibility that the guideline
may have been interpreted differently, it may look very different in the published financial
statements. There is also the possibility, especially with multinational firms, where there
might be different standards all together. This would be, for instance, a company in America
using US GAAP, and a company in South Africa using IFRS.
The solution to this is to standardize published financial statements to simplify this. This
makes it possible for us to make comparisons between not only companies, but also over
time. If we know that there is a standard format of financial statements, it’s easy to stay
consistent in the calculation of financial ratios. This also makes comparing companies in
different sectors easily comparable – e.g., a financial institution and a shop.
When looking at financial statements, there are 3 main reports that we draft/use:
Income statement/statement of profit and loss: Income is what we generate by
producing items and selling them or delivering a service. From this we deduct
expenses, taxes, and all costs that we incur in the generation of that income and
, what is left is the profit for the year. This profit/loss will either increase or decrease
the retained earning reserve that is shown in the statement of financial position.
Statement of financial position/balance sheet: The one side consists of assets – non-
current and current assets. Assets are basically those items that we invested our
capital in, which we use to generate income. On the other side, we find the sources
of finance. That gives us our capital structure and how we have financed our assets.
These financing sources (equity and liabilities) must equal the total assets in order
for the balance sheet to balance. These sources of financing on the equity side can
be broken up into ordinary shares, reserves (e.g., retained earnings), preference
shares and non-controlling interest. On the debt side, we find current and non-
current liabilities.
Statement of cash flow: the reasoning behind a cash flow statement is to record the
movement in cash that was generated or applied during the year. In order to do this,
we state what cash balances we had available at the beginning of the year. This
balance will then increase or decrease during the year due to activities by the
company. The cash balance at the end of the year is then reached. It is the
movement during the year that we want to try and breakdown even more in order
to report on that in the financial statement. This movement is broken down into
cash from operating activities, cash from investing activities and cash from financing
activities. Here, it is indicated whether it was an inflow of cash or an outflow of cash.
This gives an idea of how cash was generated and applied during the financial year.
With these financial statements, it is important to understand the relationship between the
different elements that form part of each statement. In other words, what are the assets in
terms of the sources of financing, what is the capital structure, the debt, etc.
It is also important to be able to identify all these items that are included within these
elements. Make use of the document that defines all the terminology in this module.
If there is a movement in the general reserve (a distributable reserve) it is accounted for in
the statement of profit and loss).
*Illustrate the relationships between the elements of the different financial statements and
how they work together - everything is integrated. One decision has an effect on the rest of
the business.
Evaluate the company’s return on equity by means of DuPont analysis
Calculate components of ROE
Identify specific aspects of financial performance that contributes to roe
Assess the impact that operating investing and financing decisions will have of ROE
DuPont Analysis
This is a model or tool used to basically an indicator of internal efficiency. It provides a
breakdown of the components that contribute to the ROE of a company and we need to do
this in order to evaluate changes in the ration. It gives us more information if we can
compare these values over time for the same company. We can see where the changes in
the values indicate a problem. We can also compare these values across different firms to
see where value is created.
, It is important to show all equations and calculations clearly and calculations should not be
rounded off. The calculations this year are more simplified compared to that of second year.
Only final answers should be rounded off to 2 decimal places, unless otherwise specified.
Indicate the correct unit of measurement (%, R, time etc.). Average values are not used in
this module.
The leverage factor is an indicator of the amount of debt used to finance _____. It gives us a
decimal value/factor that indicates how much of our total assets are financed by debt. The
higher the value, the more debt in the capital structure, and the lower the solvency.
Solvency is the ability to repay debts.
Total asset turnover is an indicator of efficiency – how well are management utilizing the
assets we have. This is once again a factor. The higher the value, the more effective we are
at utilizing our assets.
Finance cost burden is finance cost tax over EBIT.
Tax burden is profit after tax divided by profit before tax.
In 2016 there was a trigger mistake and entered the selling price as 21c per share instead of
R21 per share. This had a massive effect on the company share price. The resultant trades
because of this were not enough to make a trade cancellation so the company had to carry
that loss. The market price tanked. This is why it is important to do
Tax rates for this module if not otherwise specified.
Corporate tax rate: 28%
Capital gains inclusion rate: 80%
VAT: 15%
SELF STUDY
The following definitions and calculations of the ratios that are included as a part of a
detailed DuPont analysis
Starting from profitability ratio
These ratios are very important and should become a part of you.
H/W: DuPont Difficult LTD, Problem 1, problem 2
Debt solvency relationship: solvency is a concept, and the concept is explained as the ability
of a company to pay back all debts (long term and short term). Solvency refers to the
amount of debt in the capital structure. If over time you see debt levels increased, that
means solvency decreases. The ability to pay back decreases. The higher the debt, the
higher the risk and the lower the chance that you will be able to pay back the debt. It is
possible that as equity increases, debt may also increase.
Return of assets is how much profit is generated by the utilization of total assets. It is
profitability and efficiency.
Component 2
We are interested in how well the management is performing. In this component we shift
focus from a financial side to a managerial side.
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