atrill, mclaney, harvey, jenner: accounting 4e © 2008 pearson education australia 1 accounting for...

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia

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Accounting For Management Decisions

WEEK 7

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

READING: TEXT CH 6


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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


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Learning Objectives cont’d

• InterpretInterpret basic ratios for profitability, efficiency, liquidity, gearing and investment

• Discuss the limitationslimitations of ratios as a tool of financial analysisanalysis

• Understand index or percentage analysis as an alternativealternative to ratios


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Financial Ratios

Learning Objective: Define what a ratio isLearning Objective: Define what a ratio is

• Ratios provide a quick and simple means of examiningexamining the financial healthfinancial health of a business• A ratio simply expresses the relationshiprelationship between oneone

figure appearing in the financial statements with anotheranother eg net profit in relation to capital employed• Ratios are simplesimple enough to calculate, and a good

picture can be built up with just a few, however, ratios can be difficultdifficult to interpret• Can be expressed in variousvarious forms eg percentages,

fractions, proportions, depending on the need and use for the information


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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 keykey aspects of financial performance/position evaluated by the use of ratiosratios are:

• Profitability• Efficiency• Liquidity• Gearing• Investment


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Financial Ratio Classification

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

• ProfitabilityProfitability - Measure of success in wealth creation

• EfficiencyEfficiency - Effectiveness of utilisation of resources

• LiquidityLiquidity - The ability to meet short-term obligations

• GearingGearing - Measure of degree of risk to do with the

amount of leverage used to finance the business

• InvestmentInvestment - Measure of the returns and

performance of shares held by a business


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The Need for Comparison

Learning Objective: Summarise the alternative bases of Learning Objective: Summarise the alternative bases of comparison for ratio analysiscomparison for ratio analysisBases (benchmarksbenchmarks) that may be used as a basis of comparison for ratio analysis include:• ‘Intertemporal’ - Based on pastpast performance• Budget - Based on plannedplanned performance• Intra-industry - Based on comparisoncomparison of

performance with other firms in the same industry

A calculated ratio on its ownown does not say much about a business - it is only when it is comparedcompared with some form of ‘benchmark’ that the information can be interpretedinterpreted and evaluatedevaluated


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The Key Steps in Financial Ratio Analysis

Step 1:•Identify which keykey indicators and relationshipsrelationships require examinationexamination•Identify whowho needs the information and why they need it

Step 2:•Choose the most relevantrelevant set of ratios that will accomplish the desired purposes•CalculateCalculate and recordrecord the results using the selected ratios

Step 3:•InterpretInterpret and evaluateevaluate the results


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Profitability ratios

Some profitability ratios include the following:– Return on ordinary shareholdersordinary shareholders funds– Return on total assetstotal assets– Return on capital employedcapital employed– Net profitNet profit margin– Gross profitGross profit margin


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The Ratios Calculated - Profitability Ratios

Return on shareholders funds (ROSFROSF): Compares the amount of profitprofit for the period

available to the ownersto the owners with the owners’ owners’ stakestake in the business

Normally expressed as a percentagepercentage

ROSF = NP after taxation & preference div (if any) x 100 Average ord share capital plus reserves


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The Ratios Calculated - Profitability Ratios cont’d

Return on total assets (ROAROA): •Compares the net profitnet profit generated by the business with the assetsassets owned by the business

•Normally expressed as a percentagepercentage

ROA = NP before interest & taxation x 100Average total assets


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Return on capital employed (ROCEROCE): • Expresses the relationship between the net net

profitprofit generated and the average long term average long term capitalcapital invested

• Normally expressed as a percentagepercentage

ROCE = NP before interest and taxation x 100 (Share capital + long term loans)


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Net profitNet profit margin: Relates the net profitnet profit for the period to the

salessales during that period Normally expressed as a percentagepercentage

NP = NP before interest and taxation x 100margin Sales


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Gross profitGross profit margin: Relates the gross profitgross profit of the business to the salessales

generated during the same period Gross profit represents the differencedifference between sales sales

and COSand COS Normally expressed as a percentagepercentage

Gross profit (GPGP) margin = Gross profit x 100 Sales


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Efficiency ratios

EfficiencyEfficiency ratios include the following:

– Average inventory turnover period

– Average settlement period for debtors

– Average settlement period for creditors

– Asset turnover period


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The Ratios Calculated - Efficiency Ratios

Average inventory turnover periodAverage inventory turnover period: Measures the averageaverage periodperiod inventory was heldheld Normally expressedexpressed in terms of daysdays Average inventory is the simple averageaverage of openingopening

and closingclosing inventory for the period

Inventory Average inventory held x 365turnover = Cost of sales period


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The Ratios Calculated - Efficiency Ratios cont’d

Average settlement period for accounts receivable/debtorsaccounts receivable/debtors • Calculates an average of how longhow long credit customers take

to pay amounts owed• Normally expressed in terms of daysdays

Average = Average trade debtors x 365 settlement period Credit sales


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Average settlement period for accounts payable/creditorsaccounts payable/creditors: Calculates how longhow long, on average the business takes to

paypay its creditors Normally expressed in terms of daysdays

Average Average trade creditors x 365settlement = Credit purchases period


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Asset turnover period:Asset turnover period: • Examines how effectivelyeffectively the assets of the business

are being employed in generating sales revenuesales revenue• Normally expressed in terms of daysdays

Average asset = Average total assets employed x 365turnover period Sales


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The Relationship Between Profitability and Efficiency

The overall return on funds employed in the business will be determined bothboth by the profitabilityprofitability of salessales, and by efficiencyefficiency in the use of assets

Equals

Multiplied by

Net profit beforeinterest and taxation

Sales

Sales Average total assets

Return on averagetotal assets

The main elements comprising the ROA ratio

Figure 6.2


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Liquidity ratios

Liquidity ratios include the following:

– Current ratio

– Acid test ratio

– Cash flow from operations ratio


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The Ratios Calculated - Liquidity Ratios

Current ratio:Current ratio: Compares the business’s liquid assetsliquid assets with its

short-term liabilities (currentcurrent liabilities) Expressed in terms of the number of timesnumber of times the

current assets will covercover the current liabilities

Current ratio = Current assets (CA) Current liabilities (CL)


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The Ratios Calculated - Liquidity Ratios cont’d

Acid testAcid test (also known as the quick/liquid ratioquick/liquid ratio): Represents a more stringentstringent test of liquidityliquidity than

the currentcurrent ratio Expressed in terms of the number of times the liquidliquid

current assets will covercover the currentcurrent liabilities

Acid test = CA (excl. inventory & prepayments) CL


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The Ratios Calculated - Liquidity Ratios cont’d

Cash flows from operations ratio:Cash flows from operations ratio: • Compares the operating cash flowsoperating cash flows with the

current liabilitiescurrent liabilities of the business• Expressed in terms of the number of timesnumber of times the

operating cash flows will covercover the currentcurrent liabilities

Cash flows from = Operating cash flows operations ratio CL


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Financial Gearing (Leverage)

Financial GearingFinancial Gearing: The existence of fixed fixed paymentpayment bearing securities (eg loans) in the capital structure of a company

• The levellevel of gearing, or the extentextent to which a business is financed by outside partiesoutside parties is an important factor in assessing riskassessing risk

• Gearing may be used both to adequately financefinance the business, and to increaseincrease the returnsreturns to owners - provided that the returnsreturns generated from the borrowed funds exceedexceed the interestinterest cost of borrowing


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Financial Gearing ratios

Financial gearing or leverage ratios include the following:

– Gearing ratio

– Interest cover ratio


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The Ratios Calculated - Financial Gearing (Leverage) cont’d

Gearing ratio:Gearing ratio: • Measures the contribution of long-term lenderslong-term lenders to the

long-term capital structurelong-term capital structure of the business• Expressed in terms of a percentagepercentage

Gearing ratio = Long-term liabilities x 100

Share capital + Reserves + L/term liab


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The Ratios Calculated - Financial Gearing (Leverage) cont’d

Interest cover ratio (times interest earned):Interest cover ratio (times interest earned): • Measures the amount of profitamount of profit availableavailable to covercover

interest expenseinterest expense of the business• Expressed in terms of the number of timesnumber of times the profit

generated by the business will covercover the interest interest expense of its gearingexpense of its gearing

Interest cover ratio = Profit before interest and taxationInterest expense


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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


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The Ratios Calculated - Investment Ratios cont’d

Dividends per share: • Relates the dividends announceddividends announced to the

number of shares on issuenumber of shares on issue of the business during a period

• NotNot a measure of total return of the business

Dividends = Dividends announced during periodper share No. of shares on issue during period


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Dividend payout ratio:Dividend payout ratio: • Measures the proportion of earningsproportion of earnings that a company pays outpays out to shareholders in the form of dividendsdividends

• Expressed as a percentagepercentage

Dividend = Dividends announced for the year x 100 payout ratio Earnings for year available for dividends


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Dividend yield ratio:Dividend yield ratio: • Relates the cash returncash return from a share to its current market valuecurrent market value

• Expressed as a percentagepercentage

Dividend yield = Dividends per share/(1 - t) x 100Market value per share

where: t = company tax ratecompany tax rate


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Earnings per share:Earnings per share: • Relates the earningsearnings generated by the company during a period to the number of number of shares on issueshares on issue during the period

• Expressed as an amountamount

Earnings per share = Earnings available to ord. s/holders Number of ordinary shares on issue


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Operating cash flow per share:Operating cash flow per share: • Relates the operating cash flowoperating cash flow of the business during a period to the numbernumber of shares on issueshares on issue during the period

• Expressed as an amountamount

Operating cash = Operating cash flows - Pref dividends flow per share Number of ord. shares on issue


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Price earningsPrice earnings ratio: ratio: Relates the market valuemarket value of a share to the

earningsearnings per share Expressed in terms of the number of timestimes

the share price is greatergreater than the currentcurrent earnings per share

Price earnings ratio = Market value per share Earnings per share


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Trend Analysis

• TrendsTrends may be identified by plotting key ratios on a graph, giving a visual representation of changes happening over time• Intra-company trends may be comparedcompared

against industryindustry trends• KeyKey financial ratiosratios are often published in

companies annualannual reports as a way to help users to identifyidentify important trends


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Ratios and Prediction Models

• RatiosRatios are often used to help predict the futurepredict the future however the choice of ratios and interpretation of results depend on the judgementjudgement of the analyst• Researchers have developed ratio-based models

which claim to predictpredict future financial distressfinancial distress as well as vulnerability to takeover• The future is likely to see furtherfurther ratio-based

prediction models developed to predict otherother aspects of financial performance


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Limitations of Ratio AnalysisLearning Objective: Discuss the limitations of ratios as a Learning Objective: Discuss the limitations of ratios as a tool of financial analysistool of financial analysis

• The qualityquality of the underlying financial statements determines the usefulnessusefulness of the ratios derived from them

• RatiosRatios only offer a restrictedrestricted view of relativerelative performance and position - not the full picture

• No two businesses are identical and the greater their differencesdifferences, the greater the limitationslimitations of ratio analysis as a basis for comparison

• Any ratios based upon balance sheetbalance sheet figures will notnot be representative of the whole period because the balance sheet is a snapshot of a moment in time.


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Index or Percentage AnalysisLearning Objective: Understand index or percentage Learning Objective: Understand index or percentage analysis as an alternative to ratiosanalysis as an alternative to ratios

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

There are 3 alternative index/percentage methods:1.1. TThe common size reportscommon size reports (also known as vertical

analysis) – the key figure in the report, usually salessales becomes 100 and all other figures are expressed as a percentage of that figure. that figure.


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Index or Percentage Analysis cont’d

2.2. Trend %Trend % – All All figures in a base year are indexedindexed as 100 and all subsequent years figures are expressed as a % of the base base year figure.

3.3. % change% change (also known as horizontalhorizontal analysis) – the % change change for the year is shown for each line item

atrill, mclaney, harvey, jenner: accounting 4e © 2008 pearson education australia 1 accounting for...

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