Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 1 Accounting For Management Decisions WEEK 7 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS READING: TEXT CH 6

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 2 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 3 Learning Objectives cont’d Interpret Interpret basic ratios for profitability, efficiency, liquidity, gearing and investment limitations analysis Discuss the limitations of ratios as a tool of financial analysis alternative Understand index or percentage analysis as an alternative to ratios

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 4 Financial Ratios Learning Objective: Define what a ratio is examining financial health Ratios provide a quick and simple means of examining the financial health of a business relationshipone another A ratio simply expresses the relationship between one figure appearing in the financial statements with another eg net profit in relation to capital employed simple difficult 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 various Can be expressed in various forms eg percentages, fractions, proportions, depending on the need and use for the information

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 5 Financial Ratios cont’d Learning Objective: Identify the key aspects of financial performance and financial position that are evaluated by the use of ratios key 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 6 Financial Ratio Classification Learning Objective: Explain the terms profitability, efficiency, liquidity, gearing and investment Profitability Profitability - Measure of success in wealth creation Efficiency Efficiency - Effectiveness of utilisation of resources Liquidity Liquidity - The ability to meet short-term obligations Gearing Gearing - Measure of degree of risk to do with the amount of leverage used to finance the business Investment Investment - Measure of the returns and performance of shares held by a business

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 7 The Need for Comparison Learning Objective: Summarise the alternative bases of comparison for ratio analysis benchmarks Bases (benchmarks) that may be used as a basis of comparison for ratio analysis include: past ‘Intertemporal’ - Based on past performance planned Budget - Based on planned performance comparison Intra-industry - Based on comparison of performance with other firms in the same industry own compared interpretedevaluated 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 8 The Key Steps in Financial Ratio Analysis Step 1: keyrelationships examination Identify which key indicators and relationships require examination who Identify who needs the information and why they need it Step 2: relevant Choose the most relevant set of ratios that will accomplish the desired purposes Calculaterecord Calculate and record the results using the selected ratios Step 3: Interpretevaluate Interpret and evaluate the results

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 9 Profitability ratios Some profitability ratios include the following: ordinary shareholders –Return on ordinary shareholders funds total assets –Return on total assets capital employed –Return on capital employed –Net profit –Net profit margin –Gross profit –Gross profit margin

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 10 The Ratios Calculated - Profitability Ratios ROSF Return on shareholders funds (ROSF): profit to the ownersowners’ stake  Compares the amount of profit for the period available to the owners with the owners’ stake in the business percentage  Normally expressed as a percentage ROSF = NP after taxation & preference div (if any) x 100 Average ord share capital plus reserves

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 11 The Ratios Calculated - Profitability Ratios cont’d ROA Return on total assets (ROA): net profit assetsCompares the net profit generated by the business with the assets owned by the business percentageNormally expressed as a percentage ROA = NP before interest & taxation x 100 Average total assets

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 12 The Ratios Calculated - Profitability Ratios cont’d ROCE Return on capital employed (ROCE): net profitaverage long term capitalExpresses the relationship between the net profit generated and the average long term capital invested percentageNormally expressed as a percentage ROCE = NP before interest and taxation x 100 (Share capital + long term loans)

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 13 The Ratios Calculated - Profitability Ratios cont’d Net profit Net profit margin: net profit sales  Relates the net profit for the period to the sales during that period percentage  Normally expressed as a percentage NP = N P before interest and taxation x 100 margin Sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 14 The Ratios Calculated - Profitability Ratios cont’d Gross profit Gross profit margin: gross profitsales  Relates the gross profit of the business to the sales generated during the same period differencesales and COS  Gross profit represents the difference between sales and COS percentage  Normally expressed as a percentage GP Gross profit ( GP ) margin = Gross profit x 100 Sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 15 Efficiency ratios Efficiency 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 16 The Ratios Calculated - Efficiency Ratios Average inventory turnover period Average inventory turnover period: averageperiodheld  Measures the average period inventory was held expresseddays  Normally expressed in terms of days averageopening closing  Average inventory is the simple average of opening and closing inventory for the period Inventory Average inventory held x 365 turnover = Cost of sales period

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 17 The Ratios Calculated - Efficiency Ratios cont’d accounts receivable/debtors Average settlement period for accounts receivable/debtors how longCalculates an average of how long credit customers take to pay amounts owed daysNormally expressed in terms of days Average = Average trade debtors x 365 settlement period Credit sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 18 The Ratios Calculated - Efficiency Ratios cont’d accounts payable/creditors Average settlement period for accounts payable/creditors: how long pay  Calculates how long, on average the business takes to pay its creditors days  Normally expressed in terms of days Average Average trade creditors x 365 settlement = Credit purchases period

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 19 The Ratios Calculated - Efficiency Ratios cont’d Asset turnover period: effectively sales revenueExamines how effectively the assets of the business are being employed in generating sales revenue daysNormally expressed in terms of days Average asset = Average total assets employed x 365 turnover period Sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 20 The Relationship Between Profitability and Efficiency bothprofitabilitysales 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 Equals Multiplied by Net profit before interest and taxation Sales Average total assets Return on average total assets The main elements comprising the ROA ratio Figure 6.2

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 21 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 22 The Ratios Calculated - Liquidity Ratios Current ratio: liquid assets current  Compares the business’s liquid assets with its short-term liabilities (current liabilities) number of times cover  Expressed in terms of the number of times the current assets will cover the current liabilities Current ratio = Current assets (CA) Current liabilities (CL)

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 23 The Ratios Calculated - Liquidity Ratios cont’d Acid testquick/liquid ratio Acid test (also known as the quick/liquid ratio): stringentliquidity current  Represents a more stringent test of liquidity than the current ratio liquid covercurrent  Expressed in terms of the number of times the liquid current assets will cover the current liabilities Acid test = CA (excl. inventory & prepayments) CL

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 24 The Ratios Calculated - Liquidity Ratios cont’d Cash flows from operations ratio: operating cash flows current liabilitiesCompares the operating cash flows with the current liabilities of the business number of times covercurrentExpressed in terms of the number of times the operating cash flows will cover the current liabilities Cash flows from = Operating cash flows operations ratio CL

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 25 Financial Gearing (Leverage) Financial Gearingfixed payment Financial Gearing: The existence of fixed payment bearing securities (eg loans) in the capital structure of a company levelextent outside parties assessing risk The level of gearing, or the extent to which a business is financed by outside parties is an important factor in assessing risk financeincrease returnsreturns exceed interest 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 26 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 27 The Ratios Calculated - Financial Gearing (Leverage) cont’d Gearing ratio: long-term lenders long-term capital structureMeasures the contribution of long-term lenders to the long-term capital structure of the business percentageExpressed in terms of a percentage Gearing ratio = Long-term liabilities x 100 Share capital + Reserves + L/term liab

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 28 The Ratios Calculated - Financial Gearing (Leverage) cont’d Interest cover ratio (times interest earned): amount of profitavailablecover interest expenseMeasures the amount of profit available to cover interest expense of the business number of times coverinterest expense of its gearingExpressed 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 29 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 30 The Ratios Calculated - Investment Ratios cont’d Dividends per share: dividends announced number of shares on issueRelates the dividends announced to the number of shares on issue of the business during a period NotNot a measure of total return of the business Dividends = Dividends announced during period per share No. of shares on issue during period

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 31 The Ratios Calculated - Investment Ratios cont’d Dividend payout ratio: proportion of earnings pays out dividendsMeasures the proportion of earnings that a company pays out to shareholders in the form of dividends percentageExpressed as a percentage Dividend = Dividends announced for the year x 100 payout ratio Earnings for year available for dividends

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 32 The Ratios Calculated - Investment Ratios cont’d Dividend yield ratio: cash return current market valueRelates the cash return from a share to its current market value percentageExpressed as a percentage Dividend yield = Dividends per share/(1 - t) x 100 Market value per share company tax rate where: t = company tax rate

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 33 The Ratios Calculated - Investment Ratios cont’d Earnings per share: earnings number of shares on issueRelates the earnings generated by the company during a period to the number of shares on issue during the period amountExpressed as an amount Earnings per share = Earnings available to ord. s/holders Number of ordinary shares on issue

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 34 The Ratios Calculated - Investment Ratios cont’d Operating cash flow per share: operating cash flow number shares on issueRelates the operating cash flow of the business during a period to the number of shares on issue during the period amountExpressed as an amount Operating cash = Operating cash flows - Pref dividends flow per share Number of ord. shares on issue

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 35 The Ratios Calculated - Investment Ratios cont’d Price earnings ratio: market value earnings  Relates the market value of a share to the earnings per share times greatercurrent  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 36 Trend Analysis Trends Trends may be identified by plotting key ratios on a graph, giving a visual representation of changes happening over time compared industry Intra-company trends may be compared against industry trends Keyratios annual identify 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 37 Ratios and Prediction Models Ratiospredict the future judgement 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 predictfinancial distress Researchers have developed ratio-based models which claim to predict future financial distress as well as vulnerability to takeover further other 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 38 Limitations of Ratio Analysis Learning Objective: Discuss the limitations of ratios as a tool of financial analysis quality usefulness The quality of the underlying financial statements determines the usefulness of the ratios derived from them Ratiosrestrictedrelative Ratios only offer a restricted view of relative performance and position - not the full picture differenceslimitations No two businesses are identical and the greater their differences, the greater the limitations of ratio analysis as a basis for comparison balance sheet not 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 39 Index or Percentage Analysis Learning Objective: Understand index or percentage analysis as an alternative to ratios Index/Percentage replaced Index/Percentage analysis simply allows monetary figures to be replaced with an index or a percentage. There are 3 alternative index/percentage methods: 1.T common size reports sales that figure. 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 percentage of that figure.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 40 Index or Percentage Analysis cont’d 2.Trend %All indexed base 2.Trend % – 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.% changehorizontal change 3.% change (also known as horizontal analysis) – the % change for the year is shown for each line item