Analysis of organisations’ external reports

Question 1

How do we do financial statement analysis

Answer 1

•  Simple comparison
•  Ratio analysis
•  Trend analysis
•  Comparison to benchmarks

Question 2

Accounting ratio categories

Answer 2

•  Profitability ratios
•  Efficiency ratios
•  Capital structure ratios
•  Liquidity ratios
•  Market based ratios

Question 3

Profitability ratios

Answer 3

•   Return on assets (ROA) •  Return on equity (ROE)
•   Profit margin
•   Gross profit margin

Question 4

Return on assets

Answer 4

•  Calculated as PROFIT ÷ TOTAL ASSETS × 100
•  How much profit is being generated for every dollar of assets controlled by the organisation.
•  Financial statement analysis should be undertaken with care.

Question 5

Return on owners equity

Answer 5

•   Return on owners’ equity (ROE) = Profit ÷ average owner’s equity x 100
•   Provides a measure of the profit being generated for each dollar of equity the owners have in the organisation.
•   Generally, the larger the number the better and an improving trend across time is preferred.

Question 6

Profit Margin

Answer 6

•  profit margin = profit ÷ sales x 100
•  Provides an indication of the extent to which each dollar of sales contributes to profits.
•  providing an indication of cost efficiency/control.

Question 7

Gross profit margin

Answer 7

•  gross profit margin = (profit – cost of goods sold) ÷ sales x 100
•  Gives an indication of pricing strategy (mark ups) which can be compared to similar organisations.

Question 8

Efficiency ratio

Answer 8

Inventory turnover

Debtors turnover

Question 9

Inventory turnover

Answer 9

•  inventory turnover = cost of goods sold ÷ average inventory
•  Provides an indication of how many times in the accounting period the organisation turned over (sold) its inventory.
•  The higher the better.

Question 10

Debtors turnover

Answer 10

•   debtors turnover = sales ÷ average accounts receivable
•   Provides an indication of the number of times during the period that debtors turn over (pay)
•   The higher the number the less the amount of cash tied up with debtors

Question 11

Capital structure ratios

Answer 11

•   Debt to assets ratio

*   Debt to equity ratio

Question 12

Debt to assets ratio

Answer 12

•  Debt to assets ratio: Total liabilities ÷ total assets x 100 • Is a measure of the extent to which an organisation’s assets have been funded by lenders/creditors.
•  All things being equal, the greater the percentage the greater the risk of an organisation.

Question 13

Debt to equity ratio

Answer 13

•   debt to equity ratio = total liabilities ÷ total owners equity x 100
•   Provides an indication of how much liabilities there are per dollar of equity.
•   Shows the extent to which an organisation is dependent upon equity financing.
•   All things being equal, the greater the relative level of debt financing the riskier the organisation.
•   Organisations with high variability in cash flows will find it relatively risky to have higher levels of debt relative to equity.

Question 14

Liquidity ratios

Answer 14

Current ratio
Quick ratio
cash flows from operations to current liabilities

Question 15

Current ratio

Answer 15

•  Current ratio = current assets ÷ current liabilities
•  To assess whether an organisation will be able to pay its debts as and when they fall due.
•  Benchmark : 1

Question 16

Quick ratio

Answer 16

• Quick ratio = (current asset – inventory) ÷ (current liabilities – bank overdraft) • Quick ratio (or acid-test) ratio is also used to assess the ability of an organisation to pay its debts as and when they are due.

Question 17

Market based ratios

Answer 17

Price earnings ratio

Question 18

Price earnings ratio

Answer 18

•  price earnings ratio = market price per ordinary share ÷ earnings per share • Provides an indication of how many times earnings the market is prepared to pay for a share.
•  A higher number relative to similar organisations indicates greater market acceptance of the organisation.

Question 19

Events occurring after the end of the reporting period

Answer 19

In respect of events that occur after the end of the reporting period, but before the financial statements have been authorised for issue, the organisation shall disclose in the notes to the financial statements: a.  the nature of the event; and b.  an estimate of its financial effect, or a statement that such an estimate cannot be made.

Question 20

Contingent liabilities

Answer 20

An obligation that is payable contingent upon a future event or an obligation that is not probable (in terms of resource outflows) or is not measurable with sufficient reliability. At the extreme, contingent liabilities can potential threaten the ongoing existence of an organisation.

Question 21

Remuneration policies

Answer 21

•   This is a corporations law requirement within many countries.
•   Managers in organisations typically receive bonuses (referred to commonly as ‘performance-based rewards’ or ‘at risk rewards’).
•   The central idea behind such bonuses is that they motivate certain behaviours.
•   The disclosures about bonuses inform the reader/analyst about certain priorities of the organisation and what types of performance the organisation appears particularly intent on improving.
•   The information can also potentially help the reader/analyst identify risks and inconsistencies in the actions and rhetoric of an organisation.

Question 22

Why do organisations socially or environmentally report

Answer 22

•  Much social and environmental disclosure appears to be motivated by profitability and survival considerations.
•  We must not necessarily believe/trust everything we read

Question 23

how to know if an organisation is performing well socially or environmentally

Answer 23

•  To understand whether an organisation is ‘performing well’ from a social or environmental perspective, we need to know something about the environment in which it is operating within.
•  A well prepared social and environmental report will be clear about the context of the organisation. Interested stakeholders must also undertake their own research to understand organisational context and associated risks

Question 24

Independent review

Answer 24

•  Managers might use various accounting techniques so as to project the best picture of the organisation.
•  An independent expert review of a report will tend to add credibility and ‘value’ to the report.
•  It is actually in the organisation’s interest to pay for the third party review.

Question 25

So something to consider when reviewing the reports produced by organisations is

Answer 25

•   who prepared the financial reports or the social and environmental reports?
•   who reviewed/audited them?
•   If the opinion provided was that the reports were poorly prepared perhaps breaching particular standards and guidelines then we might actually be wasting our time reviewing them.
•   If the independent review was performed by individuals who have no clear expertise then its value would be questionable.

Question 26

Conclusion

Answer 26

•  ‘Accounts’ can take many forms and can address various aspects or organisational activities.
•  The practice of ‘accounting’ can be extremely interesting and thought provoking.
•  Accounting information provides us with power to make informed decisions.

Question 27

Who would or should perform financial statement analysis

Answer 27

Requires some reasonable knowledge of financial accounting in terms of the current rules and conventions (and remember, accounting standards are frequently changing). People with limited financial accounting knowledge would be unwise to rely upon their own analysis of financial statements. •

Question 28

Why would somebody do financial statement analysis?

Answer 28

There could be various reasons. People analysing the reports might be thinking of investing in an organisation, advising others about whether to invest, working for an organisation, loaning money to the organisation, selling goods on credit to the organisation, and so forth. For these various purposes they might want to know how efficiently the organisation is using its resources, how profitable the organisation is relative to other organisations, and the ability of the organisation to pay its debts as and when they fall due. FSA can provide such insights

Question 29

Financial accounting numbers

Answer 29

Financial accounting numbers are everywhere and they are part of common communication. Financial accounting numbers are used in many agreements between an organisation and different stakeholders.

Question 30

Stakeholder’s interests in financial reports

Answer 30

Many stakeholders want information from annual reports, as their own wealth might be influenced by such numbers. For example: managers might be receiving bonuses tied to accounting profits; lenders might have negotiated debt to asset restrictions; employees want to know the security of their employment.

Question 31

Financial accounting numbers create various social impacts

Answer 31

For example: if reported profits are falling then staff might be sacked so as to save on ‘expenses’; labour unions might use high reported profits as an excuse to call for increased wages.

Question 32

Simple comparisson

Answer 32

A simple comparison of this year’s figure (perhaps particular expenses or revenues) with the previous year figure (sometimes referred to as horizontal analysis) – but we need to ensure there is nothing fundamentally different about the organisation from one year to the next (or that the accounting rules being used haven’t changed since last year in a way that might hamper our comparison)

Question 33

Ratio analysis

Answer 33

Within ratio analysis, particular line items in financial statements are compared to other line items. It is used to evaluate various aspects of a company, for example its profitability, efficiency, liquidity, or solvency. We will consider a number of accounting ratios.

Question 34

Trend analysis

Answer 34

Look at various financial indicators – perhaps ratios – over time to see if there is a pattern of improvement or deterioration.

Question 35

Comparison to benchmarks

Answer 35

Different performance measures – which might be encapsulated in ratios - might be compared to other organisations to determine how the organisation is performing relative to others.

Question 36

Comparison to benchmarks warning

Answer 36

But be careful when comparing financial accounting numbers with similar organisations. Different organisations in different industries are subject to different risks and therefore simply comparing their profitability might not be appropriate. Also, we must consider size (for example, is it sensible to compare the performance of Coles with that of a corner store?) and geographical location (for example, different countries can pose different risks and different costs of operation making comparison problematic).

Question 37

Accounting policies

Answer 37

Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements • Whilst often very difficult to understand (even for experienced accountants), the first notes that accompany financial statements generally are the ‘accounting policy notes’. An entity shall disclose its significant accounting policies comprising: of the measurement basis (or bases) used in preparing the financial statements; and the other accounting policies used that are relevant to an understanding of the financial statements.

Question 38

Profitability ratios

Answer 38

Looks at the ability of an organisation to make a profit (but remember, here we are looking at organisations that are established to make profits. Such analysis might not be relevant for not-for-profit entities). Determined by comparing profits against bases such as sales, assets or owners’ equity.

Question 39

Efficiency ratios

Answer 39

Provides insight into how an organisation is managing its assets and liabilities.

Question 40

Capital structure ratios

Answer 40

Provides an insight into how the organisation is being funded (from owners or through debt) and therefore provides some indicator of risk.

Question 41

Liquidity ratios

Answer 41

Provides insights into the ability of an organisation to pay its debts as and when they fall due.

Question 42

Market based ratios

Answer 42

Provides an insight into how the market values an organisation

Question 43

ROE considerations

Answer 43

The ROE provides a measure of the profit being generated – which ultimately might go to owners in the form of dividends – for each dollar of equity the owners have in the organisation. Provides a basis for investors to compare to other investment opportunities – The rate of return certainly should be higher than low risk returns, such as returns on bank deposits. There is no absolute ‘right’ percentage. There is a need to compare with benchmarks.

Question 44

Inventory turnover considerations

Answer 44

A lower inventory turnover is a potential sign of inefficiency and also exposes the organisation to various risks, such as risk of spoilage or obsolescence. – But again remember this tends to be industry specific. A retailer of expensive luxury cars would be expected to have a lower inventory turnover that a fruit and vegetable shop. • A higher inventory turnover is reflective of greater efficiency in both purchasing and sales activities and potentially the need for less cash for acquiring inventory.

Question 45

Cash flows from operations to current liabilities

Answer 45

• Cash flows from operations to current liabilities = cash flows from operating activities ÷ current liabilities
• In Module 3 we discussed the statement of cash flows and noted that one classification of cash flows was cash flows from operating activities (the other classifications being cash flows from financing activities and cash flows from investing activities).
• This measure provides an indication of the ability of an organisation to cover its financial obligations as a result of its operating activities, rather than having a reliance on cash flows from financing or investing.
• Generally, the bigger this ratio is, the better

Question 46

Price earnings ratio considerations

Answer 46

A higher number relative to similar organisations indicates greater market acceptance of the organisation. The market might believe that the organisation has relatively lower risk and/or it has good growth prospects – so a higher number seems a good thing. • But ……sometimes these numbers can get very high to the point they seem to defy explanation and are potentially indicative of an ‘overheated market’.

Question 47

Notes

Answer 47

The three specific topics we can consider are: – Notes about events occurring after the end of the reporting period. – Notes about contingent liabilities. – Notes about how senior managers/executives are being paid – what type of incentives are there? •

Question 48

Is total assets (balance sheet) a true measure of assets

Answer 48

. As we should also appreciate, ‘total assets’ does not include many valuable assets. For example, most internally generated intangible assets – which might have great value – are not recognised within financial accounting (because the accounting standards prohibit their recognition), and hence do not appear on the balance sheet. Analysts need to remember this. Also, many other key resources of the organisation – such as its labour force, key intellectual capital, valuable customer and supplier networks and so forth are not reported on the balance sheet.

Question 49

As such, and given the voluntary nature of the reporting, when reviewing a sustainability report it is important to firstly try to understand:

Answer 49

– Why management has prepared the report (motivation)?
– Why they have decided to disclose the particular social and environmental information that they have disclosed?
– What stakeholders does it seem to be directed towards?