1. Chapter  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 1 ANALYSIS & INTERPRETATION OF FINANCIAL REPORTS LEARNING OUTCOME:  TO ANALYSE AND INTERPRET FINANCIAL REPORTS AND RELATED INFORMATION IN ORDER TO PROVIDE ADVICE TO MANAGEMENT 2

2.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 2 KEY TERMS  accounts receivable turnover ratio  budget  equity ratio  gross profit ratio  inventory turnover ratio  net profit ratio  quick asset ratio

3.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 3 KEY TERMS  ratios  return on equity ratio  return on asset ratio  Statement of Financial Performance  Statement of Financial Position  variance  working capital ratio

4.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 4 CLASSIFICATION OF STATEMENT OF FINANCIAL PERFORMANCE 1.COST OF GOODS SOLD xOPENING INVENTORIES xPLUS: PURCHASES xOTHER TRADING EXPENSES xLESS: CLOSING INVENTORIES 2.OTHER INCOME 3.SELLING EXPENSES 4.ADMINISTRATION EXPENSES 5.FINANCE EXPENSES 6.OTHER OPERATING EXPENSES

5.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 5 CLASSIFICATION OF STATEMENT OF FINANCIAL POSITION 1.CURRENT ASSETS 2.CURRENT LIABILITIES 3.WORKING CAPITAL 4.NON-CURRENT ASSETS xTANGIBLE xINTANGIBLE xINVESTMENTS 5.NON-CURRENT LIABILITIES 6.OWNER’S EQUITY xCAPITAL xDRAWINGS xNET PROFIT/LOSS

6.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 6 BUDGETS budget  A budget is a plan of expected future action expressed in monetary terms variance  A variance is the difference between an actual result and a budget result  Use: review of Statements of Financial Performance and Position xactual results are compared to the expected results xvariances are analyses xexplanations for these variances are given

7.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 7 ADVANTAGES OF BUDGETING  Compare the results of various items with previous years’ results  Set future budgets  Review variations from budgets and determine reasons  Take remedial action for future periods  Make decisions re: future expansion  Establish future marketing and selling practices  Ascertain the reliability of budget forecasts

8.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 8 RATIOS Ratios Ratios are tools that enable management to:  Measure and compare information within a business over several periods  Compare similar businesses in the same industry

9.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 9 Sources of information Information used in ratios comes from:  Statement of Financial Position xCurrent ratio xLiquid or quick asset ratio xDebt to equity ratio  Statement of Financial Performance xGross profit ratio xNet profit ratio  Both Statement of Financial Position and Performance xAccounts receivable turnover

10.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 10 TYPES OF RATIOS: PROFITABILITY

11.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 11 TYPES OF RATIOS: PROFITABILITY

12.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 12 TYPES OF RATIOS: FINANCIAL STABILITY

13.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 13 TYPES OF RATIOS: EFFICIENCY  Inventory efficiency ratios

14.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 14 TYPES OF RATIOS: EFFICIENCY  Accounts receivable

15.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 15 TYPES OF RATIOS: OTHER RATIOS

16.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 16 INTERPRETATION OF RATIOS  Profitability ratios  Financial stability ratios  Ratios of efficiency

17.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 17 INTERPRETATION OF RATIOS PROFITABILITY RATIOS Gross profit ratio  Shows the return on net sales prior to adding revenue or deducting expenses ÙReasons gross profit ratio increases: xselling prices increase and purchase price remains unchanged xopening inventory undervalued xclosing inventory overvalued xpurchase bought at lower price

18.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 18 INTERPRETATION OF RATIOS PROFITABILITY RATIOS Gross profit ratio ÙReasons gross profit ratio decreases: xdiscounts given on sales products xclosing inventory undervalued xobsolete or damaged stock written off xpurchases bought at higher price but sales values not adjusted

19.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 19 INTERPRETATION OF RATIOS PROFITABILITY RATIOS Net profit ratio  Shows the amount earned by normal activities after accounting for other revenue and expenses ÙMeasures operation efficiency ÙReasons net profit ratio increases: xexpenses decrease xoperating revenue increases xfixed costs spread over higher sales revenue

20.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 20 INTERPRETATION OF RATIOS PROFITABILITY RATIOS Net profit ratio ÙReasons net profit ratio decreases: xexpenses increase at higher rate than COGS xother operating revenue sources decline ÙTo arrest declining net profit margins: xinvestigate business selling plans and techniques xincrease effective promotion and advertising xencourage areas of operating revenue xreview alternative and cheaper interest rates xreview all expenses

21.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 21 INTERPRETATION OF RATIOS PROFITABILITY RATIOS Return on equity ratio  Shows the return on every dollar invested in the business Return on assets  Indicates the earning capacity of the business ÙMeasures efficiency of business asset usage

22.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 22 INTERPRETATION OF RATIOS FINANCIAL STABILITY RATIOS Working capital ratio  Test of business solvency, to see if it can meet short-term debts from its current assets ÙShows amount of dollars to cover every dollar of liabilities ÙThe higher the ratio, the better the position of the business

23.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 23 INTERPRETATION OF RATIOS FINANCIAL STABILITY RATIOS Working capital ratio cont... ÙAcceptable ratio must be well above 1:1 ÙUnacceptable ratio must be below 0.7:1 xMay require injection of capital ÙAbove 4:1 xInventory investment to high xCash at bank may need to be invested short term for higher return

24.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 24 INTERPRETATION OF RATIOS FINANCIAL STABILITY RATIOS Quick asset ratio  Only the liquid business items that easily convert to cash are used ÙInventories and prepayments are excluded from current assets and the bank overdraft from current liabilities ÙRatio well above 1:1 is acceptable

25.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 25 INTERPRETATION OF RATIOS FINANCIAL STABILITY RATIOS Equity ratio  Shows relationship of owner’s equity invested in business to the total assets of the business ÙIt is the degree to which the business relies on owner capital ÙThe higher the ratio, the lower the need for externally borrowed funds ÙHigh equity ratio = long-term financial stability

26.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 26 INTERPRETATION OF RATIOS RATIOS OF EFFICIENCY Inventory turnover times  Means the number of times that inventories turn over per year Inventory turnover in days ÙLow turnover rate indicates inventory levels are too high ÙProduct demand may have slowed

27.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 27 INTERPRETATION OF RATIOS RATIOS OF EFFICIENCY Accounts receivable turnover  Measures the efficiency of management in collecting the debts of the business ÙThe shorter the period of collection, the greater the cash flow of the business ÙLong collection periods may lead to bad debt

28.  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Applications for Financial Accounting by David Willis, slides prepared by Kaye Watson 28 LIMITATIONS OF RATIOS  Ratio analysis and interpretation can be influenced by factors such as: Ùpoor or inadequate accounting methods Ùincomplete financial reports Ùchanges in accounting methods Ùexistence of unusual items during a financial year e.g. losses by fire Ùmanagement changes Ùchanges to the economy, such as an industry recession