1. How to Interpret Financial Reports Event 14 Deakin University CRICOS Provider Code: 00113B

2. 14.1 Interpreting Financial Statements Types of financial statements What may be hidden from view Assessing the health of a company – use of financial ratios Warning signs 2

3. 14.2 The Three Financial Statements Statement of Comprehensive Income, also known as: Income statement; Profit and loss statement, or Statement of financial performance, or Statement of operations/earnings Balance sheet, also known as: Statement of financial position Cash flow statement 3

4. 14.3 Income Statement Income statement (profit and loss) Revenue (sales) – Expenses = Profit (earnings) What do we want to see: a)Revenues greater than expenses b)EBIT at least 3 times greater than Interest Expense c)Consistently growing profits over time 4

5. 14.4 Balance Sheet Balance sheet Assets – Liabilities = Equity or Assets = Liabilities + Equity This shows the resources controlled by the entity, and the claims on those resources What do we want to see: a)High quality assets b)Appropriate use of debt (in terms of size and maturity) 5

6. 14.5 Cash Flow Statement Cash flows are usually divided into three areas Those from day to day operations Those used to invest in (or sell) long-term assets such as land and infrastructure Those used to finance the business (borrowings, repayments, and share issues) What do we want to see: a)Positive cash flows from operations b)Negative cash flows from investing (approx. level of depreciation) c)Appropriate cash flows from financing (dividends not too high!!) 6

7. 14.6 What Might be Hidden from View Acceptable alternatives in accounting practices can create very different outcomes on the financial statements – interpretation requires some understanding of how to read the ‘Notes to the financial statements’ Information about subsidiaries and associate companies may be left off the balance sheet 7

8. 14.7 Financial Ratios We use ratios to assess an organisation in the following areas: Profitability & performance Efficiency Short-term liquidity Capital structure ratios & long-term solvency Share and dividend performance 8

9. 14.8 Warning Signs Cash received (in cash flow statement) is lower than stated revenue (in the income statement) Assets that don’t earn profits are not good assets Gearing ratio of higher than 60% is dangerous Current Ratio of less than 1 is worrying Accounts Receivable collection greater than 60 days 9

10. 14.9 Goodwill Tangible and intangible assets Synergies when companies combine assets Goodwill is the premium paid for the synergies an acquiring company expects to receive Recorded as a non-current asset 10

11. How to Assess Financial Ratios Event 14

12. 14.10 Financial Ratios Profitability/Performance Return on equity (ROE) Return on assets (ROA) Net profit margin (also called return on sales) Cash flow return on assets Measures of return include: Earnings before Interest & Tax (EBIT) Net Profit after Interest & Tax (Net Earnings) 12

13. 14.11 Financial Ratios Short-term Liquidity Current ratio Quick asset ratio Cash flow adequacy Long-term Solvency/Capital Structure Debt-to-Assets Debt-to-Equity Times interest earned 13

14. 14.12 Financial Ratios Efficiency Inventory turnover Inventory days on hand Accounts receivable (debtors) turnover Accounts receivable collection period Accounts payable (creditors) turnover Accounts payable collection period 14

15. 14.13 Financial Ratios Share & Dividend Performance Price earnings ratio Earnings yield Earnings per share Dividend yield Dividend payout ratio Net asset backing Cash flow per share 15

16. 14.14 Benchmarks ROE (return on equity)Greater than ROA. High, but not too high ROA (return on assets)Greater than Bank Deposit Rate Net Profit marginIndustry & Previous year comparisons Current RatioGood is 2:1 Bad is < 1:1 Quick Asset RatioGood is 1.5:1 Bad is < 1:1 Debt to Assets< 60%. Any higher makes lenders wary. Times Interest EarnedEarnings should be 300% or 3x interest costs InventoryIndustry & previous year comparisons ReceivablesGood is 30 days Bad is > 90 days Earnings yieldBank deposit rate + a premium for risk Price Earnings (P/E)Canadian Shares typically 12.0 - 15.0 Dividend yieldIndustry average 16