1 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, Chapter 7 Interpreting Financial Statements

Overview Annual Reports Ratio analysis Interpreting financial statements Alternative theoretical perspectives – Intellectual capital – Institutional theory Corporate social and environmental reporting 2 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

The Annual Report The chairman’s, directors’ and/or chief financial officer’s report Operating and Financial Review (OFR) Statutory reports by directors and auditors: summary of financial performance, major policies, strategies and activities, details about the board of directors, and statements about corporate governance and internal control and the responsibility of the board for the financial statements 3 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

The Annual Report Auditors report – an opinion as to whether the financial statements give a true and fair view and are compliant with the Companies Act and IFRS Financial statements Notes to the financial statements 5 year Summary of key financial information 4 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Context of financial statements Annual Report and company website as ‘public relations’ Library databases (eg Factiva) Industry publications, trade associations and exhibitions Market research, consulting firms, stock market analysts Personal experience  What is happening in the company’s market? Is customer demand changing? What technological and regulatory changes are affecting it? Who are the major competitors? 5 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Ratios Two numbers, with one expressed as a ratio (or percentage) to the other, – from Income Statement, and/or Statement of Financial Position Trend over time Benchmarking to industry, competitors etc. Comparison to target or expectation Note: different definitions of ratios exist – it is essential to be consistent 6 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Ratio analysis Profitability Liquidity, i.e. cash flow Gearing, i.e. the proportion of borrowings to shareholders investment Efficiency of use of assets Shareholder returns  Trends  Benchmarking increasing rates of profit on shareholders’ funds, capital and sales adequate liquidity to ensure debts can be paid, but not such that funds are inefficiently used debt commensurate with the business risk taken efficiency through using investments to maximise sales a satisfactory return on the investment made by shareholders 7 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Ratios Profitability – Return on (shareholders’) investment (ROI) – Return on capital employed (ROCE) – Operating profit/sales – Gross profit/sales – Overhead/sales Liquidity – Working capital – Acid test (or quick ratio) Gearing – Gearing ratio – Interest cover  Risk/ return relationship Activity/efficiency – Asset turnover – Debtors, creditors & stock Shareholder return – Dividends and earnings 8 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Income Statement 9 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Statement of Financial Position 10 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Profitability ratios (x 100 for %) ROI: Net profit after tax Shareholders’ funds 70= 7% 1000 ROCE: Profit before interest & tax S’holders funds + LT Debt 100= 7.7% Operating profit/sales: Profit before interest & tax Sales 100= 5% 2000 Gross profit/sales: Gross profit Sales 500= 25% © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Profitability ratios Overhead/sales: Overhead Sales 400= 20% 2000 Sales growth: Gross profit Sales = 11.1% © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Liquidity ratios (x 100 for %) Working capital: Current assets Current liabilities = 143% Acid test (quick): Current assets – inventory Current liabilities 500 – = 86% 13 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Gearing ratios Gearing: LT Debt S’holders’ funds + LT Debt = 23.1% Interest cover: Profit before interest & tax Interest payable = 6.25 times 14 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Risk & return 15 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Activity/efficiency ratios Asset turnover: Sales Total assets = 121% 16 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Working capital 17 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Managing working capital Managing receivables through effective credit approval, invoicing and collection activity; Managing inventory through effective ordering, storage and identification of stock; Managing payables by negotiation of trade terms and through taking advantage of settlement discounts; and Managing cash by effective forecasting, short- term borrowing and/or investment of surplus cash where possible. 18 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Managing Receivables & Inventory Days’ sales outstanding (DSO): Sales £2 million Debtors £300,000 Average daily sales: £2 million/365 = £5,479 DSO: Debtors Average daily sales = £300,000/£5,479 = Stock Turns: Cost of sales £1.5 million Inventory £200,000 Turns = Cost of sales (CoGS)/Invent. = £1,500,000/200,000 = 7.5 Turns per year, or every 49 Days in Inv. DiI = 365/7.5. Note also that Inventory = CoGS/Turns, where Turns ≡ Days in Year/DiI or DiY/DiI 19 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Managing Payables Days’ purchases outstanding (DPO): Cost of Sales £1.5 million Payables £300,000 Average daily purchases: £1.5 million/365 = £4,110 DPO: Payables Average daily purchases = £300,000/£4,110 = © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Effect on ratios of changes in working capital 21 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Shareholder return ratios – 1 Dividend per share: Dividend paid No. of shares 30,000= £ ,000 Dividend payout ratio: Dividends paid Profit after tax 30,000= 43% 70,000 Dividend yield: Dividends per share Market value per share 0.30= 12% © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Shareholder return ratios – 2 Earnings per share: Profit after tax No. of shares 70, ,000 = £0.70 Price/Earnings (P/E): Market value per share Earnings per share = 3.57 times 23 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

24 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

The ideal ratios? Increasing rates of profit on shareholders’ funds, capital employed and sales, and sales growth; 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; Level of debt commensurate with the business risk taken; High efficiency as a result of maximizing sales from the business’s investments in assets (non-current & current); A satisfactory return on the investment made by shareholders. 25 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Interpreting ratios - 1 Trend over time Comparison to benchmark Comparison to target or expectation Both the numerator and denominator affect the ratio 26 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Interpreting ratios - 2 Profitability – Increased profits (more sales, higher margins, lower costs) or lower capital – Higher profit (in £s) is not the same as a higher rate of profit (the % to sales) – Improved rate of gross profit may be the result of higher selling prices, lower cost of sales or changes in product mix (or any combination of these) 27 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Interpreting ratios - 3 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 28 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Interpreting ratios - 4 Gearing – Affected by more shares being issued, new borrowings or repayment of debt – Higher profits will improve interest cover Activity/efficiency – Improved due to increase in sales or reduction in assets. Efficient collection of debtors and management of inventory. 29 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Interpreting ratios - 5 Shareholder returns – 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. 30 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Using the Statement of Cash Flows To help inform the interpretation of ratios – Changes in profitability, affected by changes in working capital, are revealed in the operating cash flow – Cash flow from investing would show the purchase of new non-current assets or business acquisitions (including goodwill), and proceeds of sale of any surplus non-current assets – Cash flow from financing would reveal borrowings or repayments of debt, equity raised from shareholders or payments for share buybacks, as well as the payment of dividends 31 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Limitations of ratio analysis Financial Statements – contain estimates involving subjectivity and there is discretion in how accounting principles and standards are applied – are backwards looking, showing historical costs without recognising inflation The ratios should be interpreted along with economic, industry and competitive conditions, and the company’s unique situation Ratios can only be interpreted based on trends, benchmarks and targets 32 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Alternative theoretical perspectives on financial statements Intellectual capital – ‘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); and – 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’ DiMaggio & Powell DiMaggio & Powell – Legitimation – Isomorphism 33 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Corporate Social Responsibility (CSR) Stakeholders or shareholders? Sustainability: economic, social, environmental (‘triple bottom line’) Global Reporting Initiative – economic, environment, human rights, labour, product responsibility and society 34 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Key points Reading Annual Reports and understanding the broader business context Using ratio analysis to interpret financial statements Using the Statement of Cash Flows Managing working capital Alternative theoretical perspectives: Intellectual capital & Institutional theory Corporate social and environmental reporting 35 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,