Transcript Slide 1

ACCOUNTING FOR
MANAGEMENT DECISIONS
WEEK 7
ANALYSIS AND INTERPRETATIION OF
FINANCIAL STATEMENTS
READING: TEXT CHAPTER 6
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
ROA =
Net profit before interest and taxation
Average total assets
x 100
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
ROCE=
Net profit before interest and taxation
x 100
Share capital + long term loans
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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 margin =
Net profit before interest and taxation
x 100
Sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Efficiency ratios
Efficiency ratios include the following:
– Average inventory turnover period
– Average settlement period for debtors
– Average settlement period for creditors
– Asset turnover period
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Inventory turnover periods =
Average inventory held
x 365
Cost of sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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 =
Average trade debtors
Credit sales
x 365
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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 =
Average trade creditors
x 365
Credit purchases
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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 asset turnover period =
Average total assets employed
x 365
Sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Liquidity ratios
Liquidity ratios include the following:
– Current ratio
– Acid test ratio
– Cash flow from operations ratio
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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 ratio =
Current assets
Current liabilities
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Financial Gearing ratios
Financial gearing or leverage ratios
include the following:
– Gearing ratio
– Interest cover ratio
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d Financial Gearing (Leverage)
Gearing ratio:
 Measures the contribution of long-term lenders to the longterm capital structure of the business
 Expressed in terms of a percentage
Long-term liabilities
Gearing ratio =
x 100
Share capital + Reserves + Long-term liabilities
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d Financial Gearing (Leverage)
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
Interest cover ratio =
Profit before interest and taxation
Interest expense
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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 per share =
Dividends announced during the period
Number of shares on issue during the period
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Dividend yield =
Dividends per share / (1 - t)
x 100
Market value per share
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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 flow per share =
Operating cash flows - Preference dividends
Number of ordinary (equity) shares on issue
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Price earnings ratio =
Market value per share
Earnings per share
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
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:
1.
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
2.
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
3.
Percentage change (also known as horizontal analysis) –
the % change for the year is shown for each line item
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia