1. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 1

2. CHAPTER 5 Interpreting Financial Reports and Alternative Perspectives © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 2

3. Learning Objectives What information is typically disclosed in a public company’s annual report? What is the Management’s Discussion and Analysis (MD&A) and what information is normally disclosed in an MD&A? How are a company’s profitability, liquidity, leveraging, activity/efficiency, and shareholder return calculated and then analyzed? What is meant by intellectual capital and institutional theory, and how can these two perspectives be used as alternatives to financial reporting. How can corporate social and environmental reporting be used to supplement financial reporting? © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 3

4. Annual Reports Financial summary Main advisers Reports of the chairman/president/chief executive officer, directors, and/or chief financial officer Statutory reports (required by Companies Act) of directors Audit report Financial reports  Statement of comprehensive income, Statement of financial position, and Statement of cash flows Notes to financial reports Five year summary of key financial information © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 4

5. Management’s Discussion and Analysis (MD&A) The nature of the business Management’s objectives and its strategies for meeting those objectives The entity’s most significant resources, risks, and relationships The results of operations and prospects The critical performance measures and indicators that management uses to evaluate the entity’s performance against stated objectives © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 5

6. Ratio Analysis Two numbers, usually with one expressed as a percentage of the other Ratios help interpret trends and benchmark to industry averages or competitors Different definitions for these ratios. Important to apply consistently © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 6

7. Ratio Analysis Ratio analysis five criteria: 1. The rate of profitability 2. Liquidity (cash flow) 3. Leveraging  the proportion of borrowings to shareholders’ investment 4. How efficiently assets are utilized 5. The return to shareholders © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 7

8. 8 Ratios Profitability  Return on (shareholders’) investment (ROI)  Return on capital employed (ROCE)  Operating margin (Operating profit/sales)  Gross Margin (Gross profit/sales)  Operating expenses/sales  Sales growth Liquidity  Working capital ratio  Acid test (or quick ratio) Leveraging  Degree of operating leverage (Gearing ratio)  Interest cover ratio  Risk/ return relationship Activity/Efficiency  Asset turnover Shareholder Return  Dividend per share  Dividend payout ratio  Dividend yield  Price/Earnings (P/E) ratio

9. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 9 Statement of Comprehensive Income

10. Statement of Financial Position © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 10

11. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 11 Profitability Ratios RETURN ON (SHAREHOLDERS’) INVESTMENT (ROI) Net profit after tax70 Shareholders’ funds 1,000 RETURN ON CAPITAL EMPLOYED (ROCE) Operating Profit before interest and taxes100 Shareholders equity + Long term debt 1,000 + 300 OPERATING MARGIN (OR OPERATING PROFIT/SALES) Operating Profit before interest and taxes 100 Sales 2,000 = 7% = = 7.7%= == 5%

12. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 12 Profitability Ratios GROSS MARGIN (OR GROSS PROFIT/SALES) Gross profit 500 Sales2,000 OPERATING EXPENSES/SALES Operating expenses 400 Sales 2,000 SALES GROWTH Sales in Year 2 - Sales in Year 1 2,000 – 1,800 Sales in Year 1 1,800 = = 25% == 20% = = 11.1%

13. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 13 Liquidity Ratios Working capital ratio Current assets 500 Current liabilities 350 Acid test (or quick ratio) Current assets – inventory 500 – 200 Current liabilities 350 = = 143% = 86% =

14. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 14 Leveraging DEGREE OF OPERATING LEVERAGE OR GEARING RATIO Long-term debt 300 Shareholders’ equity + Long-term debt 1,000 + 300 INTEREST COVER RATIO Profit before interest and taxes 100 Interest payable 16 = 23.1% = = 6.25 times =

15. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 15 Risk and Return

16. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 16 Activity/Efficiency Asset turnover Sales 2,000 Total assets 1,150 + 500 = = 121%

17. Working Capital The difference between current assets and current liabilities Money tied up in receivables and inventory puts pressure on the firm either to reduce the level of that investment or to seek additional borrowings Alternatively, cash surpluses can be invested to generate additional income through interest earned © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 17

18. Working Capital Cycle © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 18

19. Managing Working Capital Receivables, through effective credit approval, invoicing, and collection activity Inventory, through effective ordering, storage, and identification of inventory Payables, by negotiation of trade terms and through taking advantage of prompt-payment discounts Cash, by effective forecasting, short-term borrowing, and/or investment of surplus cash where possible © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 19

20. Managing Accounts Receivable Days’ sales outstanding If the business has sales of $2 million and accounts receivables of $300,000 Average daily sales = $2,000,000/365 = $5,479 Accounts receivables300,000 Average daily sales 5,479 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 20 = 54.75 average days’ sales outstanding =

21. Managing Inventory Inventory Turnover Cost of sales $1,500,000 Inventory $200,000 Inventory Turnover: Cost of sales 1,500,000 Inventory 200,000 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 21 = = 7.5 times per year or every 49 days (365/7.5)

22. Managing Accounts Payable Days’ purchases outstanding Cost of sales $1,500,000 Accounts payable $300,000 Average daily purchases = $1,500,000/$300,000 = $4,110 Accounts payable 1,500,000 Average daily purchases 300,000 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 22 = = 73 average days purchases outstanding

23. Shareholder Return Additional information  Number of shares issued100,000  Market value of shares $ 2.50 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 23

24. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 24 Shareholder Return Ratios Dividend per share Dividends paid 30,000 Number of shares 100,000 Dividend payout ratio Dividends paid30,000 Profit after tax 70,000 Dividend yield Dividends paid per share 0.30 Market value per share 2.50 = = $0.30 per share == 43% = = 12%

25. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 25 Shareholder Return Ratios Earnings per share Profit after taxes 70,000 Number of shares 100,000 Price/Earnings (P/E) ratio Market value per share 2.50 Earnings per share 0.70 == $0.70 per share = = 3.57 times

26. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 26 Interpreting Ratios Trend over time Comparison to industry averages or competitor ratios or predetermined targets. Both the numerator and denominator affect the ratio

27. Interpreting Ratios Increasing rates of profit on shareholders’ equity, capital employed, and sales Adequate liquidity (a ratio of current assets to liabilities of not less than 100%) to ensure that debts can be paid as they fall due, but not an excessive rate to suggest that funds are inefficiently used A level of debt commensurate with the business risk taken High efficiency as a result of maximizing sales from the business’s investments A satisfactory return on the investment made by shareholders © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 27

28. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 28 Interpreting Ratios Profitability  Increased profits  Reducing costs  Maintain profits while reducing assets and repaying debt  Sales growth may result in a higher profit but not necessarily in a higher rate of profit as a percentage of sales  Improved rate of gross profit may be the result of higher selling prices, lower cost of sales or changes in product mix

29. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 29 Interpreting Ratios Liquidity  Improvements are the result of changing the balance between current assets and current liabilities  May be improved by long-term borrowing  Repaying long-term debt will reduce liquidity

30. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 30 Interpreting Ratios Leveraging  Affected by more shares being issued, new borrowings or repayment of debt  Higher profits or lower debt will improve interest cover Activity/efficiency  Improved due to increase in sales or reduction in assets. Efficient collection of debtors and management of inventory.

31. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 31 Interpreting Ratios Shareholder return  Paying higher dividends may lead to borrowings for capital investment, but lower dividends are not favoured by investors  Share price is a result of market expectations about the company’s future  An increase in the number of shares will also affect these ratios.

32. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 32 Alternative Theoretical Perspectives on Financial Reports Intellectual capital  ‘the hidden dynamic factors that underlie the visible company’  ‘the hidden dynamic factors that underlie the visible company’ Edvinsson & Malone  human (developing and leveraging individual knowledge and skills)  organizational (internal structures, systems and procedures)  customer (loyalty, brand, image, etc.) Institutional theory  ‘Organizations compete not just for resources and customers, but for political power and institutional legitimacy, for social as well as economic fitness’  ‘Organizations compete not just for resources and customers, but for political power and institutional legitimacy, for social as well as economic fitness’ DiMaggio & Powell  Legitimation  Isomorphism

33. Corporate Social and Environmental Reporting Stakeholder theory Impact of organizations on society Managers see themselves as agents of owners with primary duty of directors being to shareholders Sustainability © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 33

34. Corporate Social and Environmental Reporting Corporate social accounting and socially responsible accounting 1. A moral imperative that business organizations were insufficiently aware of the social consequences of their activities. 2. External pressure from government and pressure groups, and the demand by some institutional investors for ethical investments. This was linked to the role of accounting in demonstrating how well organizations were fulfilling their social contract, the implied contract between an organization and society. 3. Change taking place within organizations as a result of such factors as education and professionalization. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 34

35. Sustainability and the “Triple Bottom Line” Sustainability  Meeting the needs of the present without compromising the ability of future generations to meet their own needs (e.g. global warming) Triple Bottom Line  describes new types of markets and innovative business approaches that are needed to achieve success  Economic  Environmental  Social © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 35

36. Global Reporting Initiative (GRI) Voluntary standards for reporting on economic, environmental, social, and governance dimensions of their activities, products, and services  Describe factors about the health of the business and its stakeholder relationships  How the business impacts on society  Measures of performance not just management process © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 36

37. Conclusion Annual Report Management’s Discussion and Analysis (MD&A) Use of ratios (profitability, liquidity, leveraging, activity/efficiency, and shareholder return) to interpret financial information Intellectual capital and institutional theory Corporate social and environmental reporting © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 37