Chapter 1 - Financial statement analysis and ratios (fin.) Flashcards
stakeholders who benefit from financial statements
INTERNAL STAKEHOLDERS
owners, directors and managers - req fin statements to make bis decisions which affect continued ops
part of managers annual pres to shareholders
employees - need reports to make collective bargaining agreements with managements/unions/etc
can also use to make decisions e.g. promotions
EXTERNAL STAKEHOLDERS
- prospective investors - use statement to help make investment decisions
- analysts - to provide systematic analusis of performance and ratios, enhancing basis for investment decisions
- fin. institutions - use them to decide whether/terms of working cap/loans to finance expansion
-gov entities - to assess correct level of taxation to be paid by comp
-media - analysis, profiles on key staff etc
accounting standards
format of statements governed by law and underprinned by various acc standards
GAAP - generally accepted acc principles
- rules bases - rules and criteria
- guidelines to ensure uniformity and comparability of statements within a country
- US based
IFRS - international financial reporting standards
- set of international standards adopted by >140 jurisdictions
- principles based - good reporting and guidance
core accounting principles (11)
DAMGAMPEMC
- Dual Aspect concept
- Accounting entity concept
- Money Measurement concept
- Going concern concept
- Accruals concept
- Matching principle
- Prudence concept
- Economic entity concept
- Materiality concept
- True and fair concept
- Consistency and comparability concept
- dual aspect concept
fundamental convention - necessitates recognition of all aspects of a transaction
underlying basis for double entry acc system
replaced single entry (where only sales rev recognized not other side relating to receipt of cash)
aspects of transaction recognised under 2 main types
debit - portion that accounts for increase in assets/expenses and decrease in liabilities/equity/income
credit - portion that accounts for decrease in assets/expenses and increase in income/liabilities/equity
increase in assets must be offset bu increase in claims (liabilities or capital)
- money measurement concept
every recorded transaction is measures in monetary terms
- if not poss then not considered a material event and not recorded in comps accounting recs
- included instread in notes
- accounting entity concept
financial records prepared for distinct entity regarded as separate from individuals that own bis
- personal expenses of owners dont appear in income statement
-personal and bis assets/liabilities must be kept separate under this concept
bis entity distinct from owners
- going concern concept
assumption that bis will be in existence for forseeable future (UK = >12 months from date of statement authorisation)
legal req
assets recorded at lower of cost or book val
where comp is not a going concern - break up basis used and assets calc at net realisable val
auditors will need to issue opinion if they doubt validity of going concern statement
- Accruals concept
Incomes and expenses must be recognised when accrued regardless of when cash is paid
- so can be accounted for in one trading period even if cash is paid in another
income must be reported in period it is earned - not recieved
prepaid income must not be shown in period it is received, but in subsequent periods when service/obligation is performed
expenses record in period they are incurred not period they are paid
prepaid expenses not recorded in eriod paid but when services performed
Exception = CF statement whose main purpose is to present CF effects of transactions during period so accounts for movement of cash
ensures revenues and expenses are matched in acc period - similar to matching principle
- Matching principle/accruals based accounting
closely related to accruals concept (income/expenses recognized when accrued not when cash paid)
revs and related expenses must be matched and reported @ same time
expenses must be charged to income statement in acc period in which rev to which expenses relate in earned
- accrued expenses on income statement when incurred
- pre paid expenses deferred
- depreciation matches against economic benefit from asset over several acc periods
before this = expenses charged to income statement when paid meaning accrued expenses weren’t recognized and prepaid expenses were
matching - presents more balanced view of financial performance of comp - specifically due to depreciation
- Prudence
accounting should exhibit prudence and conservatism
- prevents eq being overvalued through overstatement of assets and income
- prevents liabilities from being understated
should not recognise an asset at value higher than could be recovered from its sale or use
inherent risk that assets are likely to be overstated and liabilities likely to be understated as company benefits through higher share price and cheaper sources of financing
- consistency and comparability concept
comp must use same acc method or principle throughout accounting period - allowing comparability
- should continue to use same assumptions such as depreciation yoy in same way
-if assumptions are altered - must explain
statements within industry must also be consistent
- Materiality concept
companies may ignore acc standards if net impact of doing so would have small impact on financial statements
- such that someone reading statement wouldnt be mislead
varies based on comp size
100k charged now or in 9 months (matching principle) immaterial to apple but material to Tala
- Economic entity concept
transactions of the comp must be kept separate from owners and other entities
- True and fair concept
Directors must only approve accounts that are true and fair view of assets, liabilities, financial position and profit and loss
- no statutory definition of true and fair
New regulator from 2019 - ARGA replaced FRC - accountable to parliament - can make direct changes to accounts rather than via courts
- directly regulates biggest audit firms
Construction of comp accounts
balance sheet - statement of fin. position
P&L - income statement
CF statement
statement of fin position/balance sheet composition
snapshot of financial position @ particular moment
split into 2 halves which must balance (assets-liabilities) = equity
Assets
CURRENT ASSETS
- cash
- trade receivables
-inventories/stocks
-prepayments
NON CURRENT ASSETS
-tangible
-intangible
-investment in financial assets
current vs non current assets
current = those that can be liquidated within a year
non current = longer term
CURRENT ASSETS
those purchased with intention of resale/cash conversion within 12 months
cash - cash balances at bank
trade receivables - amount owed by customers following sale on credit (recorded on income statement already - accruals concept) - aka debtors
inventories/stocks - finished goods or work in progress
prepayments - company prepaying an expense
NON CURRENT ASSETS
LT investments with useful life of >year
tangible non current - physical substance e.g land, buildings, plant and machinery
usually recognized initially @ acquisition cost and depreciation over time
intangible non current - non monetary without physical substance, e.g. brands, goodwill, trademarks, copyrights
Purchased goodwill = Price paid for company - Fair value of identifiable net assets
strict reqs for definition of intangible asset so some commercial brands not included as they dont meet accounting definition
NON CURRENT ASSETS
LT investments with useful life of >year
tangible non current - physical substance e.g land, buildings, plant and machinery
usually recognized initially @ acquisition cost and depreciation over time
intangible non current - non monetary without physical substance, e.g. brands, goodwill, trademarks, copyrights
Purchased goodwill = Price paid for company - Fair value of identifiable net assets
strict reqs for definition of intangible asset so some commercial brands not included as they dont meet accounting definition]
investment in financial assets - LT investments in fin. instruments e.g shares, bonds etx
recorded @ fair value
LIABILITIES
- provision
-contingent liability
effectively money owed to someone else. current = to be paid within a year, non current = to pe paid after a year
CURRENT
-overdrafts
-trade payables
- tax payable
-provisions
-accruals
NON- CURRENT
-loans
-bonds
-finance leases
provision - liability of uncertain timing/amount
contingent liability - possible liability depending on occurrence of another uncertain future event, or present obligation whose payment is unlikely/whole amount hard to measure
CURRENT LIABILITES
- overdrafts - ST debt with bank
- trade payables - ST debt when comp has bought something on credit
-tax payable
-provisions - liability of uncertain timing or amount.
-accruals - expenses incurred but not yet paid
NON CURRENT LIABILITIES
borrowing not repayable in next 12 months
-LT bank loans
-bonds
-finance leases
EQUITY
= shareholder’s funds, owners’ equity or capital
SHARE CAPITAL
- NV of ord and pref shares (may differ from authorized share capital as not all may be called up)
CAPITAL RESERVES
- cash on hand for future expenses or to offset losses
-share prem account - £ in here when shares issued above NV. not distributable as divi. can be converted into bonus issue
REVALUATION RESERVES
- arises from upward revaluation of non current assets
REV RESERVES/RETAINED EARNINGS
- accumulation of profits of lifetime of comp
- can be used for divi
NON CONTROLLING INTEREST
- arise when parent comp controls subsidiary but doesnt own all share capital
-eq attributable to remaining shareholders is here
EQUITY
= shareholder’s funds, owners’ equity or capital
SHARE CAPITAL
- NV of ord and pref shares (may differ from authorized share capital as not all may be called up)
CAPITAL RESERVES
- cash on hand for future expenses or to offset losses
-share prem account - £ in here when shares issued above NV. not distributable as divi. can be converted into bonus issue
REVALUATION RESERVES
- arises from upward revaluation of non current assets
REV RESERVES/RETAINED EARNINGS
- accumulation of profits of lifetime of comp
- can be used for divi
NON CONTROLLING INTEREST
- arise when parent comp controls subsidiary but doesnt own all share capital
-eq attributable to remaining shareholders is here
depreciation
method to allocate cost of tangible non current asset over its useful life
annual depreciation charge main in income statement to spread cost of asset over useful life - helping to match cost with rev it produces
doesnt apply to freehold land or non current assets - since they dont have limited economic life
- they are periodically revalued
annual depreciation charge calc by 1st subtracting estimated disposal val from cost = depreciable amount, then writing off over assets useful life. 2 methods
straight line depreciation
spreads depreciable amount over useful economic life equally/linearly
annual depreciation charge is a nonc ash entry on income statement to reflect estimated cost of resource sin period
on balance sheet = asset recorded at NBV
net book val = cost - accumulated depreciation
reducing balancing depreciation method
an accelerated depreciation method - s
depreciation calc @ fixed % of net book val - so higher depreciation costs in earlier years
may be more realistic as assets more effective when they are new
annual depreciation = depreciation rate x book val @ beginning of eyar
depreciate rate = %depreciation /year * 2
amortization
process of gradually writing off initial cost of an asset/loan - income statement/bal sheet not cash position
loan = spreading out loan payments over time
asset = spreading cost of intangible asset over its useful life (depreciation = for tangible)
writing down allowance
-cap allowance can be claimed when you buy assets to use in a bis - some/all of val can be deducted from pre tax profits
-e.g. patents, IP,copyright
purpose - tax relief for reduction in val of qualifying assets, allowing cost to be written off against taxable income of bis
availablee to; sole traders, self employed, or partnerships, comp and orgs liable to corp tax
what is income statement/ PL statement
sumarises income earned and expenditure incurred over acc period
function: to report profit/loss
order of income statement
IS: revenue
Revenu @ top of income statement
everything comp has sold, whether payment received or no
aka turnover, sales
IS: cost of sales
2nd line
rev - COGS = gross profit
includes raw mats, wages of staff making prods etc
costs to comp of generating the revenue
IS: gross profit
rev - COGS = gross profit
total sales - cost of the sales
reflects income prior to overhead expenses
Operating profit
= gross profit - op expenses - depreciation and amortisation
aka operating income aka PBIT/EBIT
op expenses - distro costs, admin expenses, marketing, rent etc
Net profit
bottom of income statement
all profit less all expenditures
= profit attributed to shareholders technically as all could be distributed as divi
numerator of EPS calc (EPS = net profit/no. of ord shares)
CF statement composition
OP ACTIVITIES
NET INCOME - start with this and reconcile to reflect net cash
+ depreciation/amortisation
+depreciation/amortisation (not cash)
+ loss from sales fixed assets (not cash)/ - gains
+ decrease in trade receivables/ - increase
+ decrease in inventory/ + increase
+ accounts payable / - accounts receivable
+ increase in accrued expenses/ - decrease
INVESTING ACTIVITIES
+ decrease in fixed assets, securities investments, non tangible current assets (sales)
- increase in fixed assets, securities investments, tangible non current assets (purchases)
FINANCING ACTIVITIES
+ increase in borrowing, increase in capital stock, increased interest received
- divi or interest payments, redeeming loans
Total FCF = total enterprise CF post reconciliation - divi - tax
gross profit margin (profitability)
both from income statement
gross profit = rev - COGS
- compare to last year comment on trend (where have rev/COGS moved?)
- higher = can spend higher proportion of income on other op expenses
GOOD : relationship between turnover and direct cost of providing product/service
BAD: may portray bis in too pos a light - ignores operating expenses which are v real
Breakeven point
denominator = contribution per unit because it contributes to meeting fixed costs
contribution margin = margin profit per unit sale
computed using contribution income statements which separate fixed and variable costs
Altman Z score
liquidity
determine prob of comp going into liquidation - analyses sales and gearing and distills to single score
only as good as sata that goes into it
cannot asses comp with little or no earnings (new)
highly sensitive to write offs in accounts which may falsely indictae bankruptcy
A - tests corporate distress
B - reflects extent of gearing
C - assesses ability to squeeze profits from assets
D - how much must MV fall by for liabilities to exceed assets
E- how efficiently assets used to generate sales
working capital/cash cycle
working cap = current assets - liabilities
= funding avail for conducting day to day bis
aka operational efficiency ratios
efficiency can be increased by
- minimising inventory elvels
- ensuring debtors pay quickly, delaying payments to creditors
comps should maintain at least an equal balance between coleection period and payment period for receivables and payables
considers velocity of CF within working cap cycle
payables payment period (Payables/COGS)
receivables payment period (Receivables/Revenue)
inventory holding days (COGS/INV)
debt to equity
gearing
debt includes liabilities with an interest bearing component (bot ST and LT)
trade payables, deferred income and divi payables generally excluded
sometimes pref shares included in equity
overdrafts included? case by case - ST anomaly or LT financing
generally >100% indicates comp would struggle to pay LT debt if loans called in
bis like utilities with steady earnings can tolerate a higher level than vol sectors e..g banking/tech - utility bis tend to be monopolies
net debt to equity
gearing
alt to debt to eq taking into account assets tha can be used to offset debt
(cash and ST investments from bal sheet )
interest cover
gearing
measures ability to pay ineterst out of op profits and other incomer receivables
higher = less risky
appropriate level varies sector to sector
key for lenders
restated vs diluted EPS
EPS will change is no. of outstanding shares changes
