GBS 520 :FINANCIAL AND MANAGEMENT ACCOUNTING

Analysis & Interpretation of Financial Statements FINANCIAL AND MANAGEMENT ACCOUNTING UNIT 5 Analysis & Interpretation of Financial Statements

Unit Objectives interpret financial statements for a wide range of organizations.

Financial Statement Analysis Financial Statement Analysis will help business owners and other interested people to analyse the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival.

Financial Statement Analysis Purpose: To use financial statements to evaluate an organisation’s Financial performance Financial position. To have a means of comparative analysis across time in terms of: Intracompany basis (within the company itself) Intercompany basis (between companies) Industry Averages (against that particular industry’s averages) To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making.

Financial Statement Analysis Financial statement analysis involves analysing the information provided in the financial statements to: Provide information about the organisation’s: Past performance Present condition Future performance Assess the organisation’s: Earnings in terms of power, persistence, quality and growth Solvency Provides information on business survival

Business Survival There are two key factors for business survival: Profitability Solvency Profitability is important - the business should generate revenue (income) in excess of the expenses incurred in operating that business. The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations.

Effective Financial Statement Analysis Effective Finstats Analysis Internal factors External factors Strategy, Objectives, Industry Factors Macro factors - economy Broader Picture of the Company

Effective Financial Statement Analysis To perform an effective financial statement analysis, you need to be aware of the organisation’s: business strategy objectives annual report and other documents like articles about the organisation in newspapers and business reviews. These are called individual organisational factors.

Effective Financial Statement Analysis Requires that you: Understand the nature of the industry in which the organisation works. This is an industry factor. Understand that the overall state of the economy may also have an impact on the performance of the organisation. → Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing and is likely to perform in the future.

Tools of Financial Statement Analysis: The commonly used tools for financial statement analysis are: Financial Ratio Analysis Comparative financial statements analysis: Horizontal analysis/Trend analysis Vertical analysis/Common size analysis/ Component Percentages

Financial Ratio Analysis Ratio analysis - tool for measuring a firm’s: liquidity, profitability, reliance on debt financing, as well as the effectiveness of management’s resource utilization/efficiency ratios.

Financial Ratio Analysis Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements. Ratio analysis also expresses relationships between different financial statements. Financial Ratios can be classified into 5 main categories:

Financial Ratio Analysis .

Ratio Analysis Formulae The Major ratios and how they are calculated as shown in the following table covering:

Financial Ratios Analysis

Liquidity or Short-Term Solvency ratios Short-term funds management Working capital management is important as it signals the firm’s ability to meet short term debt obligations. To evaluate an organization’s or project’s ability to pay short term debts as they fall due current assets are compared to current liabilities in order to give the current ratio.

Liquidity or Short-Term Solvency ratios Current Ratio = Current Assets Current Liabilities Measures of short-term solvency i.e immediate ability of a firm to pay its current debts as they come due. Current ratio is particularly important to a company thinking of borrowing money or getting credit to use. Potential creditors use this ratio to measure a company’s liquidity or ability to pay off short-term debts. Compare against the industry The ideal benchmark for the current ratio is K2:K1 where there are two kwacha of current assets (CA) to cover K1 of current liabilities (CL). 2:1 indicate the level of safety in the ability to cover unforeseen cash needs from current assets. The acceptable benchmark is K1: K1 but a ratio below K1CA:K1CL represents liquidity riskiness as there is insufficient current assets to cover K1 of current liabilities.

Liquidity or Short-Term Solvency ratios Quick Ratio or Acid Test= This is a more rigorous test than CR. This ratio only considers cash and Accounts Receivable. A quick ratio less than 1 implies dependency on inventory o liquidate short-term debt. Stocks are deducted since they are typically the least liquid of a firm’s current assets When is the company solvent? When the Quick ratio is 1.0 or greater. Which liquidity ratio is more accurate, the current ratio or the quick ratio? The quick ratio, since it excludes stocks, the least liquid asset, and the asset on which losses are most likely to occur in the event of liquidation.

Profitability Ratios In the long run liquidity and solvency are meaningless if the organization is not profitable. Profitability is imperative for survival and prosperity. Profitability refers to the ability to earn more income than expenses. A profitable entity covers its expenses and earns extra income over and above its expenses.

Profitability Ratios 3 elements of the profitability analysis: Analysing sales and trading margin focus on gross profit Analysing on the control of expenses focus on net profit Assessing the return on assets and return on equity Focus of ROE/ROA/ROCE

Profitability Ratios Gross Profit % = Gross Profit * 100 Sales Gross Profit Margin (GPM) % = Gross Profit * 100 Cost of sales Can compute other ratios before gross margins to see contributions to sales E.g. Other expenses against sales

Gross Profitability analysis Two main factors determine gross profitabilty/ margins: Competition – as the level of competition intensifies, more substitutes become available, which limits a company’s ability to raise prices and pass along price increases to customers. Product mix – if the proportion of lower price, higher volume products increases relative to that of higher priced, lower volume products, then gross profit Kwachas may stay the same, but gross profit margin declines.

Profitability Ratios Net Profit % = Net Profit before tax *100 Sales It incorporates all expenses associated with ordinary business (excluding tax) thus a measure of the overall operating efficiency of the firm. It is important to analyze the ratio over-time. A decline in the ratio over-time may indicate a margin squeeze suggesting that productivity improvements may need to be initiated.

Profitability Ratios Return on Assets = Net Profit * 100 Average Total Assets This ratio shows how much money the company earned on each Kwacha it invested in assets. It is a measure of overall company earning power or profitability. The higher the ratio the greater the return on assets.

Profitability Ratios Return on Equity (ROE)= Net Profit *100 Average Total Equity This ratio indicates the amount of net earnings resulting from investments in equity. Shareholders are particularly interested in this ratio, because it shows them how much they are earning on their investments. Measures overall efficiency of firm in managing its total investments in assets and in generating a return to shareholders. ROE allows you to gauge whether the company is value creator or cash is being created from existing assets.

ROE Analysis Structure

Asset Management/Efficiency measures Asset Turnover measures relate to the productivity of company assets. Such measures seek to answer the question about the amount of capital being utilised to generate a specific sales volume. This shows that K1 of the assets is generating only K?? of sales. As asset turnover increases, there is greater cash inflow from sales as lower level assets generate more sales.

Asset Management/Activity Ratios The Asset turnover= This ratio represents the efficiency of asset usage to generate sales revenue. Measures management’s ability to generate revenues from investments in assets. Generally the higher this ratios: The smaller the investment being used to generate sales, thus the more profitable the company Indicates the firm has less money tied up in assets for each Kwacha of sales A declining ratio may indicate that firm has over-invested in assets

Asset Management/Activity Ratios Debtors Turnover- is ratio that measures the times trade receivables turnover during the year. The higher the debtor turnover ratio the shorter the time between sales and cash collection. It is best compared to industry in order to determine if the company should improve their collection rate. Lower ratio can be an indication of systematic problems within the company.

Asset Management or Activity Ratios Creditor Turnover- measures the rate at which a company pays off its creditors. The higher the creditor turnover ratio the shorter the time between credit purchases and payment to creditors. CT is best compared to industry. Lower ratio can be an indication that the company is facing liquidity problem or the company has changed its policy of payment to creditors.

Asset Management or Activity Ratios Stock Turnover- measures the no of times times trade inventory is turned over to sales during the year. The higher the stock turnover ratio the shorter the time between sales and selling inventory. ST is best compared to industry. The faster the inventory turns the more efficiently the company manages their stocks.

Asset Management or Activity Ratios Net working Capital Turnover= Sales Current Assets-Current Liabilities Shows how efficient WC is employed i.e measure how efficient the business is using its available assets. WCT measures the amount of net revenue generated per monetary unit of WC. It varies from industry to industry. Best to compare WCT to industry average.

Leverage or Gearing Gearing measures the % of capital employed that is financed by debt. The higher the gearing ratio, the higher the dependency on borrowing and the higher the level of financial risk due to the increased volatility of profits. The lower the gearing ratio, the higher dependency on equity financing.

Leverage or Gearing Ratios Debt/Total Assets ratio = Debt *100 Total Assets Debt to Equity ratio = Debt *100 Total Equity Times Interest Earned = Earnings before Interest and Tax Interest Measures extent to which operating income can decline before the firm is unable to meet its annual interest costs. TIE determines how many times during the year the company has earned the annual interest costs associated with servicing its debts. The TIE ratio is used by bankers to assess a firm’s ability to pay their liabilities. Normally a banker will be looking for a TIE ratio to be 2 or greater.

Market Test Ratios Based on the share market's perception of the company. Price/Earnings ratio The higher the ratio, the higher the perceived quality of the earnings by the share market. Dividend yield = Gross Dividend Per Share Market Price per Share

Market Test Ratios Earnings per share = Net Profit after tax Number of issued ordinary shares Dividends per share = Dividends Dividend payout ratio = Dividends per share *100 Earnings per share Price Earnings ratio = Market price per share Earnings yield = Net Profit after tax - preferred Dividend Market Price per Share

Illustration: Financial statement analysis The following are the financial statements of Zitandizane Ltd. The Company is a diversified enterprise with its main interests in the manufacture and retail of plastic products. The financial statements of Zitandizane Ltd need to be analysed. An investor is considering purchasing shares in the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the company’s performance and position

Zitandizane Ltd Statement of Financial Performance for year ended 31 March

Zitandizane Ltd Statement of Financial Position as at 31 March

Zitandizane Ltd Statement of Cash Flows for the year ended 31 March

Additional information: Credit purchases for the year 2011 were K2,142,800. General prospects for the major industries in which Zitandizane is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for plastic remaining strong. Benchmarks: There are no exact benchmarks for Zitandizane Ltd because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2011. Gross profit margin 25% Net profit margin 7% Inventory turnover 6 times Debt/equity ratio 0.6 : 1 Return on Assets 12% Return on Equity 20%

Illustration: Financial statement analysis REQUIRED Using ratios critically evaluate the financial performance of the company. Write a report on the company’s performance and position

Liquidity or Solvency Ratios 2010 2011

Asset Management/Activity Ratios 2010 2011

Asset Turnover 2010 2011

Asset Management or Activity Ratios Trade Creditor Days= Trade Creditors X 365 Credit Purchases This ratio shows the number of days’ credit is taken from suppliers. 2010 2011

Asset Management or Activity Ratios Average Collection Period = Average accounts Receivable * 365 Average net credit sales measures the length of time it takes to convert average sales into cash. A long average collection requires a higher investment in accounts receivable, thus less cash available to cover cash outflows 2010 2011

Profitability Ratios Industry GPM=25% NPM=7%

Financial Structure or Capitalisation Ratios Debt/Equity 2010 2011

Profitability ratios: Relevant ratios Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2010 and 2011 year end figures were used and this is a slight variation to the formulas provided. Profitability ratios: Benchmarks 2010 2011 Gross Profit Margin Industry 25% 22% 22.7% Net Profit Margin 7% 7.1% 6.1% Return on Assets 12% 15.6% 15.5% Return on Equity 20% 32% 26%

Asset Management ratios: Benchmarks 2010 2011 Inventory Turnover Industry 6 % 5.8 times 5.58 times Asset Turnover Not given 2.2 2.53

Credit purchases not available Liquidity ratios: Benchmarks 2010 2011 Current Ratio Ideal standard 2:1 Acceptable standard 1:1 1.78:1 1.70:1 Quick Ratio 0.85:1 0.69:1 Days Payable Standard 30 days Credit purchases not available 49.19 days

Financial Structure ratios: Benchmarks 2010 2011 Debt/Equity Industry 0.6:1 Standard benchmark 1:1 1.05: 1 0.67:1 TIE Standard benchmark: Between 3 and 5. Below 3 risky. Above 5 very favourable 10.14 times 39.74 times

Report For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the company’s performance and position is also important to get a better picture of how well the company is actually doing. ROE in 2011 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates. ROE has decreased by 4% but the company’s ROE at 26% is still better than the industry average of 20% Riskiness of business is being reduced by the significant repayment of loan in 2011.

Profitability Asset Management The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average. Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%. The horizontal analysis information show that Sales have increased by 20%. However operating costs have increased by 34%. Asset Management IT has gone down slightly from 5.8 to 5.58 times. IT is still close to the industry benchmark of 6 times. AT has increased showing more sales being generated from asset usage

Liquidity Current ratios of 1.78:1 (2010) and 1.70: 1 are at above acceptable levels but below ideal level. Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2011 (0.69:1). Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2011). Days Payable is a concern as there may be poor debt payment management.

Financial Structure Although slightly higher than D/E industry benchmark (0.67:1), business has become less risky due to the significant repayment of loan in 2011. TIE is extremely good for the business at 39.74 times (well above 5 the standard benchmark).

Recommendation Given: the strong forecast for the industry (ie general prospects looking good and world demand for plastic products remaining strong), the sales growth in this business, acceptable ratios as they are quite close to the industry averages, good cash flows from operating activities and favourable ROE, although it has decreased, it is still better than the industry average ROE. => it is recommended that the investor purchase shares in the Zitandizane Ltd company.

Tools of Financial Statement Analysis: Comparative financial statements analysis: Horizontal analysis/Trend analysis Vertical analysis/Common size analysis/ Component Percentages

Horizontal analysis/Trend analysis Trend percentage Line-by-line item analysis Items are expressed as a percentage of a base year This is a time series analysis For example, a line item could look at increase in sales turnover over a period of 5 years to identify what the growth in sales is over this period.

Vertical analysis/Common size analysis/ Component Percentages All items are expressed as a percentage of a common base item within a financial statement e.g. Financial Performance – sales is the base e.g. Financial Position – total assets is the base Important analysis for comparative purposes Over time and For different sized enterprises

Tools of Financial Statement Analysis: Horizontal analysis/Trend analysis Analyse the performance trend Changes in key ratios Changes in absolute figures Usually year on year May take a three or five year review May be Presented in graphical or narrative form Challenges: Comparability Changes in accounting policies

Tools of Financial Statement Analysis: Horizontal analysis/Trend analysis Example

Trend Analysis Company X PLC Statement of comprehensive Income For the year ended 31st December 2012 Amounts in Zambian Kwacha 5 Year Summary 2012 2011 2010 2009 2008 Turnover 88,000,111 66,960,300 58,800,234 37,000,111 28,150,500 Gross Profit 14,090,000 10,059,500 6,632,618 2,799,320 1,400,986 Profit for the period 9,152,400 6,400,389 8,000,345 1,900,456 3,245,675 Total non-current assets 34,540,456 20,134,576 14,000,235 16,014,234 10,450,987 Total current Assets 55,678,987 30,000,123 33,908,768 32,098,768 25,487,650 Total assets 90,219,443 50,134,699 47,909,003 48,113,002 35,938,637 Share capital and reserves 43,000,345 33,847,945 27,447,556 19,447,211 17,546,755 Total current liabilities 19,034,576 11,908,790 15,890,765 14,888,776 13,000,456 Total long term liabilities 28,184,522 4,377,964 4,570,682 13,777,015 6,789,108 Total capital and liabilities 37,336,319

Trend analysis Trend analysis - annual changes 2012 2011 2010 2009 Turnover 31% 14% 59% Gross Profit 40% 52% 137% 100% Profit for the period 43% -20% 321% -41% Total non-current assets 72% 44% -13% 53% Total current Assets 86% -12% 6% 26% Total assets 80% 5% 0% 34% Share capital and reserves 27% 23% 41% 11% Total current liabilities 60% -25% 7% 15% Total long term liabilities 544% -4% -67% 103% Total capital and liabilities 29%

Trend analysis

Tools of Financial Statement Analysis: Vertical analysis/Common size analysis/ Component Percentages Compares all figures as a percentage of a common measure Usually turnover or total assets

Tools of Financial Statement Analysis: Vertical analysis/Common size analysis/ Component Percentages Example

Common Size analysis Company X PLC Statement of comprehensive Income   Statement of comprehensive Income For the year ended 31st December 2012 Common Size analysis All amounts in Zambian Kwacha 2012 2011 % revenue Revenue 87,012,634 75,000,123 100% Cost of sales 46,543,794 35,726,692 53% 48% Gross Profit 40,468,840 39,273,431 47% 52% Administration expenses 11,482,165 10,168,351 13% 14% Operating Expenses 15,407,316 12,039,527 18% 16% Total expenses 26,889,481 22,207,878 31% 30% Operating profit 13,579,359 17,065,553 23% Other income 331,173 1,793,308 0% 2% Profit before tax 13,910,532 18,858,861 25% Income tax expense 4,941,772 3,905,930 6% 5% Profit for the period 8,968,760 14,952,931 10% 20%

Limitations of Financial Statement Analysis We must be careful with financial statement analysis. Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future. Based on historical data Absolute size of a ratio is meaningless unless used in relative way – prior year/industry/trend analysis Intercompany comparisons limited to how similar the companies are Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse Need to consider a holistic view rather than just ratios but other factors such as strategy/objectives/etc.

Summary End of Unit 5 Marks end of the Financial Accounting part of the course Next – management accounting

Case study Download the latest annual report of your company or for AEL (listed on LUSE) Using ratio analysis analyse the company performance and provide detailed comments. Assignment 3 – Group work