Presentation on theme: "ACCOUNTING Financial and Organisational Decision Making"— Presentation transcript:
1 ACCOUNTING Financial and Organisational Decision Making Chapter 12Financial statement analysisSlides written and designed byTony Van Eekelen
2 Learning Objectives In this chapter you will be introduced to : the users of financial statement analysis and how they use ita plan for financial statement analysisvarious techniques used for analysisthe limitations of analysis using financial ratios
3 Learning Objectives a range of financial ratios ratios for public sector organisationsthe uses of ratio analysis
4 IntroductionThe financial statements of a firm are seen as a major source of information by many users for judging the risk and return elements of the entity.By using ratio analysis one can make more in depth decision regarding these elements.
7 Users and uses of financial analysis Internal usersmanagementfor planning and control of the entitymonitoring performance, diagnosing problems and revising plansExternal usersthose making investment or lending decisionsthose interest in the organisation’s performance
8 External users Two basic questions to be answered: How well has the entity performed?What is its present financial position?Other questions need to be asked to answer above?What is the rate of return of shareholders’ funds? Or on total assets?What is the short and long term trend?What can be done to improve it?Different users will have different criteria for evaluation.
9 A planned approach to financial analysis The following diagram (next slide) illustrates the process by which one should approach financial analysis.Stage 3 relates to the questions to be answered; such asHow is the entity financed?How profitable is the entity and how is the profit earned?How efficient is the entity?How solvent is the entity?Is the performance satisfactory?How does the financial markets rate the entity’s securities?Are there any factors which may distort the interpretation?
10 A process for financial analysis Identify the decision/sto be madeIdentify the user/sof the informationExtract & supplementfinancial statementinformation as requiredIdentify questions thatneed to be answeredto reach decisionsInterpret informationand significance compared witha benchmarkArrange information in aform suitable for analysisPrepare a report answeringquestions posed& making recommendations
11 Techniques used The most common is ratios. Mainly to compare figures and to eliminate the size factorThe format can be expressed aspure ratiocertain number of unitsas a percentage - most commonas an index number
12 Techniques usedCross sectional analysis is to compare one organisation with another or the industry average.Common size financial statements are where the statement are converted to a % of one figure eg as a % of sales in the profit and lossTime series analysis is to calculate the ratios over a period of time and analysis the trends.
13 Ratio analysis of financial statements When conducting ratio analysis, ratios should be selected to answered the desired questions?The range of ratios can be divided into 5 groups:performance or profitabilityoperating efficiencyfinancial stabilitycash flow ratiosper share ratios
14 Limitations of ratio analysis Three main limitations exist with ratio analysis:timing problemsreports are at a point in time.Window dressing - ie by engaging in activities to effect reports at year end.Time from end of period to publication of reportstiming of future inflows and outflows are not reported
15 Limitations of ratio analysis The information base may cause problems such as:lack of disclosure generallyminimum requires are set and lacks detailvariation valuation methodsrevaluation of assets on ad hoc basisvariation in classification of informationusing different accounting methodsuse of historical cost accounting information
16 Limitations of ratio analysis End useRatios are based upon the past and may not be a good indicator for the future.No standard of evaluation exists; what is a “good ratio”?Maybe receive conflicted results from ratios , thus making a overall conclusion difficult.
17 Performance ratiosThese ratios need to assess the profitability of the entity.Ratios included are:gross profit margin – expenses rationet profit margin – asset turnoverquality of income ratio – return on assetscash return on assets – return on equitycash return to shareholders
18 Performance ratios Gross profit margin Shows the relationship between mark up and sales; ie is the sales price high enough or is the cost price to high?
19 Performance ratios Expenses ratio Monitoring expenses Net Profit Marginreflects the return on sales ignoring gearing and taxation
20 Performance ratios Quality of income Asset Turnover relationship between cash and profitAsset Turnovershows the sale generating ability of the assets
21 Performance ratios Cash return on assets cash generating ability of assets to meet obligationsReturn on assetshow profitable has the assets been?
22 Performance ratios Dupont formula shows the break down of how the profit was made.Was it that the assets did not generate sufficient sales orWas it that sales were generated but cost control as profit eroding?
23 Performance ratios Return on equity Cash return to shareholders shows the return to shareholders fundsCash return to shareholdersmay indicate the likelihood of dividends
24 Operating efficiency ratios These ratios indicate how management are utilising the assets and maximising returnsRatios included are:inventory turnoveraccounts receivable turnovercash flows to salesaccounts payable turnover
25 Operating efficiency ratios Inventory turnoverThis ratio shows how quickly is the firm moving its inventory; ie converting to salesGives the number of times per year the inventory turns over.Alternative measures is to convert into days; 365 divide by turnover.
26 Operating efficiency ratios Accounts receivable turnoverhow quickly the entity receives the cash from credit sales;again can be expressed as times per year or number of daysif high, may result in bad debts and cash shortage
27 Operating efficiency ratios Cash flow to salesAccounts payable turnoverefficiency in paying creditors; discounts and poor ratings
28 Financial stability ratios What is the financial risk of the entity and is it able to repay its debts?Can be divided into short and long term ratios:Short termcurrent ratio – quick asset ratio – cash flow ratioLong termdebt to assets ratiodebt to equity ratiotimes interest earned ratiocash interest coveragefixed charge coverage
29 Financial stability ratios All the short term ratios are trying to analysis the liquidity of the entity. Will there be sufficient fund to repay debts in the short term?Current ratioRule of thumb is 2:1 but if too high then not efficient use of assets
30 Financial stability ratios Quick asset ratiosome assets maybe current but are not so liquid thus they are excluded from this ratio.Cash flow ratio
31 Financial stability ratios Debt to total assetsWhat is the financial risk of the entity?Measures leverage and if to high may cause bankruptcyAlternative measure:
32 Financial stability ratios Times interest earned ratiomeasures the safety margin of profit over interest paymentsAn alternative, as earnings is not all cash, then use Cash interest coverage
33 Per share ratiosThere is a belief that the markets will price entities correctly, based upon available information. The following ratios show the markets evaluation of the entity.Can be divided into two areas:EarningDividend
34 Per share ratios Earnings ratios are as follows: Earnings per share shows the return per share to shareholders.
35 Per share ratios Earnings Yield is the rate of return based upon the current market pricecan be effected by the market volatilityPrice earnings ratio is an alternative to earning yield; and shows the number of years it will take for earnings to repay the market price.
36 Per share ratios Dividends per share Dividend Yield refers to the amount of dividend received.Dividend Yieldreturn based upon current market price
37 Per share ratios Dividend pay out ratio Net tangible asset backing how much of the earnings is being retained or paid out?Net tangible asset backingprice per share relating to tangible assets
38 Uses of ratios Other uses of financial ratios are: as performance indicatorsas predictors of financial distressin making credit decisionsOther techniques arediscriminant analysismodellingsimulation