ACCOUNTING Financial and Organisational Decision Making Chapter 12 Financial statement analysis Slides written and designed by Tony Van Eekelen

Learning Objectives In this chapter you will be introduced to : the users of financial statement analysis and how they use it a plan for financial statement analysis various techniques used for analysis the limitations of analysis using financial ratios

Learning Objectives a range of financial ratios ratios for public sector organisations the uses of ratio analysis

Introduction The 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.

Users and uses of financial analysis Internal users management for planning and control of the entity monitoring performance, diagnosing problems and revising plans External users those making investment or lending decisions those interest in the organisation’s performance

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.

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 as How 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?

A process for financial analysis Identify the decision/s to be made Identify the user/s of the information Extract & supplement financial statement information as required Identify questions that need to be answered to reach decisions Interpret information and significance compared with a benchmark Arrange information in a form suitable for analysis Prepare a report answering questions posed & making recommendations

Techniques used The most common is ratios. Mainly to compare figures and to eliminate the size factor The format can be expressed as pure ratio certain number of units as a percentage - most common as an index number

Techniques used Cross 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 loss Time series analysis is to calculate the ratios over a period of time and analysis the trends.

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 profitability operating efficiency financial stability cash flow ratios per share ratios

Limitations of ratio analysis Three main limitations exist with ratio analysis: timing problems reports 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 reports timing of future inflows and outflows are not reported

Limitations of ratio analysis The information base may cause problems such as: lack of disclosure generally minimum requires are set and lacks detail variation valuation methods revaluation of assets on ad hoc basis variation in classification of information using different accounting methods use of historical cost accounting information

Limitations of ratio analysis End use Ratios 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.

Performance ratios These ratios need to assess the profitability of the entity. Ratios included are: gross profit margin – expenses ratio net profit margin – asset turnover quality of income ratio – return on assets cash return on assets – return on equity cash return to shareholders

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?

Performance ratios Expenses ratio Monitoring expenses Net Profit Margin reflects the return on sales ignoring gearing and taxation

Performance ratios Quality of income Asset Turnover relationship between cash and profit Asset Turnover shows the sale generating ability of the assets

Performance ratios Cash return on assets cash generating ability of assets to meet obligations Return on assets how profitable has the assets been?

Performance ratios Dupont formula shows the break down of how the profit was made. Was it that the assets did not generate sufficient sales or Was it that sales were generated but cost control as profit eroding?

Performance ratios Return on equity Cash return to shareholders shows the return to shareholders funds Cash return to shareholders may indicate the likelihood of dividends

Operating efficiency ratios These ratios indicate how management are utilising the assets and maximising returns Ratios included are: inventory turnover accounts receivable turnover cash flows to sales accounts payable turnover

Operating efficiency ratios Inventory turnover This ratio shows how quickly is the firm moving its inventory; ie converting to sales Gives the number of times per year the inventory turns over. Alternative measures is to convert into days; 365 divide by turnover.

Operating efficiency ratios Accounts receivable turnover how quickly the entity receives the cash from credit sales; again can be expressed as times per year or number of days if high, may result in bad debts and cash shortage

Operating efficiency ratios Cash flow to sales Accounts payable turnover efficiency in paying creditors; discounts and poor ratings

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 term current ratio – quick asset ratio – cash flow ratio Long term debt to assets ratio debt to equity ratio times interest earned ratio cash interest coverage fixed charge coverage

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 ratio Rule of thumb is 2:1 but if too high then not efficient use of assets

Financial stability ratios Quick asset ratio some assets maybe current but are not so liquid thus they are excluded from this ratio. Cash flow ratio

Financial stability ratios Debt to total assets What is the financial risk of the entity? Measures leverage and if to high may cause bankruptcy Alternative measure:

Financial stability ratios Times interest earned ratio measures the safety margin of profit over interest payments An alternative, as earnings is not all cash, then use Cash interest coverage

Per share ratios There 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: Earning Dividend

Per share ratios Earnings ratios are as follows: Earnings per share shows the return per share to shareholders.

Per share ratios Earnings Yield is the rate of return based upon the current market price can be effected by the market volatility Price earnings ratio is an alternative to earning yield; and shows the number of years it will take for earnings to repay the market price.

Per share ratios Dividends per share Dividend Yield refers to the amount of dividend received. Dividend Yield return based upon current market price

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 backing price per share relating to tangible assets

Uses of ratios Other uses of financial ratios are: as performance indicators as predictors of financial distress in making credit decisions Other techniques are discriminant analysis modelling simulation