Next (final) week Revision class No new material Additional question 17 Revision Any questions about the course or exam preparation Remember you must achieve overall > 50% and for the exam at least 40% to pass the unit

Financial Statement Analysis

Lecture Outline Ratio Analysis Advantages and limitations of ratio analysis. Creative Accounting Motivations for Creative Accounting. Methods of Creative Accounting.

Types of Ratios Profitability (Investors) –Designed to help a investors evaluate a firms ability to control expenses and earn an adequate return. Liquidity (Suppliers) –Enables the user to evaluate the ability of an entity to repay its short term liabilities as they fall due.

Types of Ratios Leverage (Lenders) –Measures the extent to which an entity relies upon debt financing.

Profitability Ratios Net Profit Ratio= OPAT Sales Net Profit = Operating profit after tax (OPAT) Shows the amount of net profit earnt for every $1 of sales.

Profitability Ratios If Net Profit ratio is increasing; Greater control of operating costs (ie wages, rent, depreciation etc). If Net Profit Ratio is decreasing; Operating costs are increasing without a proportional increase in sales.

Net Profit Ratio CompanyNet Profit Ratio Woolworths/Foodland2.1% Telstra18.1% QANTAS3.8%

Liquidity Ratio Current Ratio= Current Assets Current Liabilities If < 1: Entity can’t meet obligations to creditors. If too far > 1: Inefficient use of resources. Average on the ASX (2003): 1.47: 1

Current Ratio CompanyCurrent Ratio Woolworths0.84 Telstra0.77 Rio Tinto1.08

Leverage Ratio Debt to Equity Ratio =Total Liabilities Total Equity Shows the financial structure of the firm. Average on ASX: 40%

Leverage Ratio If the Debt to Equity ratio is increasing; –More of the firms operations are financed by debt leading to: Increased interest payments Increased risk of failure If the Debt to Equity ratio is decreasing; –Less of the firms operations are financed by debt leading to: Reduced interest payments Lower risk of failure

Debt To Equity Ratio CompanyDebt to Equity Woolworths29% Telstra97% Rio Tinto81%

Return on Assets R.O.A =OPBT + Interest Expense Average Total Assets OPBT: Operating Profit before Tax Measures managerial efficiency (ie more efficient managers will produce higher profits with the same bundle of assets).

Ratio Analysis - Usefulness Quick to calculate and simple to interpret. Brings figures down to a common scale. –Enables comparisons between entities of different size.

Limitations Ratios mean nothing on their own. To be useful a ratio must be compared with: –Ratios from a previous period –The same ratio from a different firm (within the same industry) –An industry average or benchmark. Ratios indicate that a problem exists but do not identify the problem itself.

Limitations Ratios are based on information which is “out-of-date”. Changes in accounting policy may effect the analysis. Ratios are open to manipulation.

Breaking the Illusion There is no such thing as a definitive profit figure. Profit, within reason, is whatever you want it to be!!

Breaking the Illusion Determination of profit is based on subjective decisions made by the preparer: Example 1. Depreciation Estimate useful life of the asset. Estimate residual vale.

Creative Accounting Defined The process of manipulating accounting numbers to convey an image desired by management. Varies between; Window Dressing: Adding polish to the financial statements to make them look a little better. To Deception and Fraud Concealment of massive losses or debts.

Efficient Market Theory Manipulating profit figures does not fool the market. –A company cannot increase its share price simply by manipulating its profit figure.

Bonus Plan Hypothesis If the market cannot be fooled then why do managers manipulate profit figures?? Research suggests the following possible reasons: 1.Bonus Plan Hypothesis 2.Debt Covenant Hypothesis 3.Political Cost Hypothesis

Bonus Plan Hypothesis Managerial bonuses are often tied to the performance (profit) of the entity they manage. In simple terms: The higher the profit, the higher the bonus achieved by the manager. Managers with bonus plans therefore have an incentive to maximise profits in order to maximise bonuses.

Debt Covenant Hypothesis The existence of debt covenants constrains an entity’s ability to borrow funds. A debt covenant restricts an entity’s ability to borrow more funds. –In very simple terms: A lender prevents an entity from borrowing more money until they have paid back the lender.

Debt Covenant Hypothesis Example: Debt Covenant Debt to equity ratio must not exceed 70%. Liabilities = 70,000 Equity = 100,000 What can an entity do if they have a debt to equity ratio of 70% but want to borrow more money??

Debt Covenant Hypothesis To overcome this constraint: Manipulate numbers to increase profit by $10,000. Equity rises by $10,000. The entity can now borrow an additional $7, ,000 x ,000 1 = 70%

Political Cost Hypothesis Relates to larger, more “politically visible” (ie wellknown) companies. Hypothesises that when politically visible company’s make large profits it can lead to an increase in political costs.

Political Costs Political Costs Include: –Greater taxation –Removal of subsidies –Greater regulation –Deregulation (ie less regulation) –Demand for higher wages by employees/unions –Demand for greater social expenditure –Demand for higher dividends by shareholders

Political Cost Hypothesis In order to avoid or reduce political costs, politically visible entities have an incentive to manipulate their profits so that they appear lower than they would normally have been.