ACCOUNTING FOR MANAGEMENT DECISIONS

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ACCOUNTING FOR MANAGEMENT DECISIONS. WEEK 7 ANALYSIS AND INTERPRETATIION OF FINANCIAL STATEMENTS READING: TEXT CHAPTER 6. Learning Objectives. Define what a ratio is Identify the key aspects of financial performance and financial position that are evaluated by the use of ratios

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ACCOUNTING FOR MANAGEMENT DECISIONS

WEEK 7

ANALYSIS AND INTERPRETATIION OF FINANCIAL STATEMENTS

Learning Objectives
• Define what a ratio is
• Identify the key aspects of financial performance and financial position that are evaluated by the use of ratios
• Explain the terms profitability, efficiency, liquidity, gearing and investment
• Summarise the alternative bases of comparison for ratio analysis
• Present the ratio formulae for the basic ratios
• Calculate ratios to analyse the profitability, efficiency, liquidity, gearing and investment of a given entity’s financial statements over several periods
Learning Objectives cont’d
• Interpret basic ratios for profitability, efficiency, liquidity, gearing and investment
• Discuss the limitations of ratios as a tool of financial analysis
• Understand index or percentage analysis as an alternative to ratios
Financial Ratios

Learning Objective: Define what a ratio is

• Ratios provide a quick and simple means of examining the financial health of a business
• A ratio simply expresses the relationship between one figure appearing in the financial statements with another e.g. net profit in relation to capital employed
• Ratios are simple enough to calculate, and a good picture can be built up with just a few, however ratios can be difficult to interpret
• Can be expressed in various forms e.g. percentages, fractions, proportions depending on the need and use for the information
Financial Ratios cont’d

Learning Objective: Identify the key aspects of financial performance and financial position that are evaluated by the use of ratios

The key aspects of financial performance / position evaluated by the use of ratios are:

• Profitability
• Efficiency
• Liquidity
• Gearing
• Investment
Financial Ratio Classification

Learning Objective: Explain the terms profitability, efficiency, liquidity, gearing and investment

• Profitability - Measure of success in wealth creation
• Efficiency - Effectiveness of utilisation of resources
• Liquidity - The ability to meet short-term obligations
• Gearing - Measure of degree of risk to do with the amount of leverage used to finance the business
• Investment - Measure of the returns and performance of shares held by a business
The Need for Comparison

Learning Objective: Summarise the alternative bases of comparison for ratio analysis

Bases (benchmarks) that may be used as a basis of comparison for ratio analysis include:

• ‘Intertemporal’ - Based on past performance
• Budget - Based on planned performance
• Intra-industry - Based on comparison of performance with other firms in the same industry

A calculated ratio on its own does not say much about a business - it is only when it is compared with some form of ‘benchmark’ that the information can be interpreted and evaluated

The Key Steps in Financial Ratio Analysis

Step 1:

• Identify which key indicators and relationships require examination
• Identify who needs the information and why they need it

Step 2:

• Choose the most relevant set of ratios that will accomplish the desired purposes
• Calculate and record the results using the selected ratios

Step 3:

• Interpret and evaluate the results
Profitability ratios

Some profitability ratios include the following:

• Return on ordinary shareholders’ funds
• Return on total assets
• Return on capital employed
• Net profit margin
• Gross profit margin
The Ratios Calculated - Profitability Ratios

Return on shareholders funds (ROSF):

• Compares the amount of profit for the period available to the owners with the owners’ stake in the business
• Normally expressed as a percentage

Net profit after taxation and preference dividend (if any)

ROSF = x 100

Average ordinary share capital plus reserves

The Ratios Calculated - Profitability Ratios cont’d

Return on total assets (ROA):

• Compares the net profit generated by the business with the assets owned by the business
• Normally expressed as a percentage

Net profit before interest and taxation

ROA = x 100

Average total assets

The Ratios Calculated - Profitability Ratios cont’d

Return on capital employed(ROCE):

• Expresses the relationship between the net profit generated and the average long term capital invested
• Normally expressed as a percentage

Net profit before interest and taxation

ROCE= x 100

Share capital + long term loans

The Ratios Calculated - Profitability Ratios cont’d

Net profit margin:

• Relates the net profit for the period to the sales during that period
• Normally expressed as a percentage

Net profit before interest and taxation

Net profit margin = x 100

Sales

The Ratios Calculated - Profitability Ratios cont’d

Gross profit margin:

• Relates the gross profit of the business to the sales generated during the same period
• Gross profit represents the difference between sales and cost of sales
• Normally expressed as a percentage

Gross profit

Gross profit margin = x 100

Sales

Efficiency ratios

Efficiency ratios include the following:

• Average inventory turnover period
• Average settlement period for debtors
• Average settlement period for creditors
• Asset turnover period
The Ratios Calculated - Efficiency Ratios

Average inventory turnover period:

• Measures the average period inventory was held
• Normally expressed in terms of days
• Average inventory is the simple average of opening and closing inventory for the period

Average inventory held

Inventory turnover periods = x 365

Cost of sales

The Ratios Calculated - Efficiency Ratios cont’d

Average settlement period for accounts receivable (debtors):

• Calculates how long, on average credit customers take to pay amounts owed
• Normally expressed in terms of days

Average settlement period = x 365

Credit sales

The Ratios Calculated - Efficiency Ratios cont’d

Average settlement period for accounts payable (creditors):

• Calculates how long, on average the business takes to pay its creditors
• Normally expressed in terms of days

Average settlement period = x 365

Credit purchases

The Ratios Calculated - Efficiency Ratios cont’d

Asset turnover period:

• Examines how effectively the assets of the business are being employed in generating sales revenue
• Normally expressed in terms of days

Average total assets employed

Average asset turnover period = x 365

Sales

Net profit before

interest and taxation

Sales

Multiplied by

Sales

Average total assets

Equals

Return on average

total assets

Figure 6.2

The main elements comprising the ROA ratio

The Relationship Between Profitability and Efficiency

The overall return on funds employed in the business will be determined both by the profitability of sales, and by efficiency in the use of assets

Liquidity ratios

Liquidity ratios include the following:

• Current ratio
• Acid test ratio
• Cash flow from operations ratio
The Ratios Calculated cont’d - Liquidity Ratios

Current ratio:

• Compares the business’s liquid assets with short-term liabilities (current liabilities)
• Expressed in terms of the number of times the current assets will cover the current liabilities

Current assets

Current ratio =

Current liabilities

The Ratios Calculated cont’d - Liquidity Ratios

Acid test (also known as the quick or liquid) ratio:

• Represents a more stringent test of liquidity than the current ratio
• Expressed in terms of the number of times the ‘liquid’ current assets will cover the current liabilities

Current assets (excluding inventory and prepayments)

Acid test ratio =

Current liabilities

The Ratios Calculated cont’d - Liquidity Ratios

Cash flows from operations ratio:

• Compares the operating cash flows with the current liabilities of the business
• Expressed in terms of the number of times the operating cash flows will cover the current liabilities

Operating cash flows

Cash flows from operations ratio =

Current liabilities

Financial Gearing (Leverage)

Financial Gearing: The existence of fixed payment bearing securities (e.g. loans) in the capital structure of a company

• The level of gearing, or the extent to which a business is financed by outside parties is an important factor in assessing risk
• Gearing may be used both to adequately finance the business, and to increase the returns to owners - provided that the returns generated from the borrowed funds exceed the interest cost of borrowing
Financial Gearing ratios

Financial gearing or leverage ratios include the following:

• Gearing ratio
• Interest cover ratio

Gearing ratio:

• Measures the contribution of long-term lenders to the long-term capital structure of the business
• Expressed in terms of a percentage

Long-term liabilities

Gearing ratio = x 100

Share capital + Reserves + Long-term liabilities

Interest cover ratio (times interest earned):

• Measures the amount of profit available to cover interest expense of the business
• Expressed in terms of the number of times the profit generated by the business will cover the interest expense of its gearing

Profit before interest and taxation

Interest cover ratio =

Interest expense

Investment ratios

Investment ratios include the following:

• Dividends per share
• Dividend payout ratio
• Dividend yield ratio
• Earnings per share
• Operating cash flow per share
• Price/earnings ratio
The Ratios Calculated cont’d - Investment Ratios

Dividends per share:

• Relates the dividends announced to the number of shares on issue of the business during a period
• Not a measure of total return of the business

Dividends announced during the period

Dividends per share =

Number of shares on issue during the period

The Ratios Calculated cont’d - Investment Ratios

Dividend payout ratio:

• Measures the proportion of earnings that a company pays out to shareholders in the form of dividends
• Expressed as a percentage

Dividends announced for the year

Dividend payout ratio = x 100

Earnings for the year available for dividends

The Ratios Calculated cont’d - Investment Ratios

Dividend yield ratio:

• Relates the cash return from a share to its current market value
• Expressed as a percentage

Dividends per share / (1 - t)

Dividend yield = x 100

Market value per share

The Ratios Calculated cont’d - Investment Ratios

Earnings per share:

• Relates the earnings generated by the company during a period to the number of shares on issue during the period
• Expressed as an amount

Earnings available to ordinary shareholders

Earnings per share =

Number of ordinary shares on issue

The Ratios Calculated cont’d - Investment Ratios

Operating cash flow per share:

• Relates the operating cash flow of the business during a period to the number of shares on issue during the period
• Expressed as an amount

Operating cash flows - Preference dividends

Operating cash flow per share =

Number of ordinary (equity) shares on issue

The Ratios Calculated cont’d - Investment Ratios

Price earnings ratio:

• Relates the market value of a share to the earnings per share
• Expressed in terms of the number of times the share price is greater than the current earnings per share

Market value per share

Price earnings ratio =

Earnings per share

Trend Analysis
• Trends may be identified by plotting key ratios on a graph, giving a visual representation of changes happening over time
• Intra-company trends may be compared against industry trends
• Key financial ratios are often published in companies annual reports as a way to help users to identify important trends
Ratios and Prediction Models
• Ratios are often used to help ‘predict the future’ however the choice of ratios and interpretation of results depend on the judgement of the analyst
• Researchers have developed ratio-based models which claim to predict future financial distress as well as vulnerability to takeover
• The future is likely to see further ratio-based prediction models developed to predict other aspects of financial performance
Limitations of Ratio Analysis

Learning Objective: Discuss the limitations of ratios as a tool of financial analysis

• The quality of the underlying financial statements determines the usefulness of the ratios derived from them
• Ratios only offer a restricted view of ‘relative’ performance and position - not the full picture
• No two businesses are identical and the greater their differences, the greater the limitations of ratio analysis as a basis for comparison
• Any ratios based upon balance sheet figures will not be representative of the whole period because the balance sheet is a snapshot of a moment in time
Index or Percentage Analysis

Learning Objective: Understand index or percentage analysis as an alternative to ratios

Index or Percentage analysis simply allows monetary figures to be replaced with an index or a percentage.

• There are three alternative index or percentage methods:
• The common size reports (also known as vertical analysis) – the key figure in the report, usually sales, becomes 100 and all other figures are expressed as a % of that figure
• Trend percentage – All figures in a base year are indexed as 100 and all subsequent years’ figures are expressed as a % of the base year figure
• Percentage change (also known as horizontal analysis) – the % change for the year is shown for each line item