Chapter 8: Accounting Analysis Flashcards
Accounting definition
Recording, measuring and reporting economic events or activities to interested parties in a usable form.
3 types of financial statement
- Statement of financial position/balance sheet
- Income statement
- Cashflow statement
- balance sheet and 3 main sections
Gives a snapshot of a company’s financial position at a given date, usuallly year end.
Has 3 main sections
1. assets (owned by company)
2. equity (amount shareholders have contributed and are due)
3. liabilities (amount the company owe)
Assets are listed on one side of the BS and equity and liabilities on the other. assets=equity+liabilities
– 2. Income statement
Summarises income or revenue earned and expenses. Tracks the trading activities over the accounting period.
Also called the P+L.
the relationship between the income statement and balance sheet by tracking the activity of the company throughout the whole year as income is earned etc and then it feeds into the BS at the end of the accounting period.
– 3. Cash flow statement - 3 types of cash activity
Identifies how much cash a company generated and spent over the accounting period. Splits the sources and uses of cash into 3 activities: operating, investing, financing activity.
5 elements of a financial statement
- Assets = items owned by the company (can usually yield economic benefit)
- Liabilities = money owed to others
- equity = amount invested by shareholders + unpaid dividends
- Reveneue = sales made by the company
- expenses = costs of doing business - rent, paying staff
Accounting regulations (ISSB + IASB)
Generally accepted accounting principles (GAAP)
* IFRS Foundation aims to harmonise GAAP gloablly
* Created 2 boards to set standards International accoutning standards Board (IASB) and international sustainability standards board (ISSB).
* ISSB - recent creation - set up for gloabl investment portfolios to meet ESG standards.
* IASB - Designed to set up gloabl standard accounting practices. Stdrds of IASB are set by IFRS
* The US uses it’s own US GAAP nationally that is based on IASB but not exact.
Group and company accounts and 2 issues when creating group accs
Group = AKA consolidated FSs - Includes accounts of the parent and all subsidiares rolled into 1 set of accs.
Company = entity level accs.
Issues with grouping accs
1. Goodwill = Assets and liabilities of SUBS are added to accs of the parent. This cancels out the cost of investment of the parent in the SUB. If cost of investment exceeded the value of assets of the SUB it is called goodwil and appears as an asset.
2. Non controlling interests = When a sub isn’t owned 100% by the UP, the shares that aren’t owned are called non controlling assets. NCAs are added onto the balance sheet despite not being owned by the UP as the BS measures all assets.
Non-current assets - how are they further categorised
Assets in long term and continuous use by the company. they are major investments that teh company hopes to make moeny from.
Catagorised into tangible and intangible assets
3 Types of non current asset - tangible etc
- tangible non current = physical assets like land, buildings. They are recorded initially at their actual cost but will need to be depreciated in following years accounts to make up for the economic gain it provides.
- Intangible non currentt = non physical but return econ benefit like intellectual property, computer software and purchased goodwill.
- non current investments = invested assets like equity, bonds, etc that will not be sold or mature in the next coming year. Recorded at cost in the FS minus impairment.
Current assets
Assets purchased with the intention of resale or conversion into cash within the next 12 months.
Include products ready to be sold, prepayments and cash balances.
Usually listed on the balance sheet in ascending order of liquidity.
Depreciation and amortisation - how are they recorded in the balance sheet
- Depreciation = applies to tangible non current that lose value over time as a result of use. For example farming equipment will be worth less afte 5 years of use.
- Amortisation = Intangible non current that lose value over time for example licenses.
- Recorded as expenses on the balance sheet as it infers the value is being used up.
Straight line depreciation calculation and meaning
(Cost - disposal value)
= ————————————–
Useful economic life in years.
Straight line depreciation is the most common depreciation calculation.
The expesnse is not linked to any cash expedniture so depreciation is entered as a non cash charge to reflect the fall in value.
The FS value of the asset is given by its cost-depreciation to date and is called net book value
4 types of equity
- Share capital = nominal value of equity and pref. share capital the company has issued.
- Capital reserves = revaluation reserves (increase in value of non current assets) and the share premium (when shares are issued above their nominal value) account. Cannot be issued as dividends
- Revenue reserves = accumilated profits of the company that haven’t been paid to shareholders.
- Non controlling interests = when a UP owns part of but not all of a subsidiary. The equity not owned by the UP is non controlling.
Equity = share capital + reserves
Current and non current liabilities
- Non current liabilities = money owed to another party that will not be paid in the next 12 months e.g. bond issues. Provisions also apply here (when there is an obligation to pay someone but the amount and when it is due hasn’t been established)
- Current liabilities = Money owed that is to be paid in the next 12 months. Amount owed to suppliers, trade payables etc.
THE INCOME STATEMENT - 10 components
- Revenue - all sales
- Cost of sales - productions costs, wages.
- Gross profit - total sales-the cost of sales
- Operating profit - gross profit-other operating expenses (marketing etc). Does not consider finance costs (interest) or tax.
- Finance costs/income - gains/losses from interest.
- Profit before tax -
- Tax
- Net income - tax and financing costs are deducted from profit. Helps calculate dividend
- Earnings per share (EPS) - shows profit after tax for shareholders per share.
- Dividends - profits that will be distributed to shareholders. Paid either in 1 go, half yearly, or quarterly.
Some flexibility on the format from IFRS
PBIT, EBIT, EBITDA
- PBIT = profit before interest and tax
- EBIT = Earning before interest and tax
- EBITDA = Earnings before interest tax depreciation or amortisation. Helps calculate a sustainable level of debt for a compamy.
Earnings per share calculation
Net income for fin year - dividends on preference shares
EPS = ——————————————————————————
Number of ordinary shares in issue
Capital and Revenue expedniture
- Capital expenditure = money spent to buy non current assets such as property. Shown on FS
- Revenue expenditure = moeny spent that immediately impacts the income statement like paying staff, rent etc.
CASH FLOW STATEMENT
Summary of all payments and receipts of cash trhoughout the year and shows how a company uses it’s cash
Cash flow statement contents and what governs them
IAS 7 accounting standard requires the below to be included
* Operating activities and net cash from operating activities - cash generating from business operations
* Investing activities and net cash used in InvAct - income from investment recieved in the form of cash over the year and cash used in buying/selling non current assets. Can include interest
* Financing activities and net cash generated from financing activities - cash spent on paying dividends, long term borrowing and cash from issuing shares-cash spent buying shares back/paying off debt. can include interest.
Differences of profit and cash
Profit is revenue driven and cash is recieved. THis means the 2 can be very different on the income statement. For examples if sales are recorded as a credit of cash and cash is not transfered immediately, the revenues will show however the cash will not match the revenues as it is still due.
profit is also based on expedniture incurrred and not cash paid out.
Free cash flow - ways to calculate
Cash that has been generated and has not been assigned a purpose (like operating cash). Can be derived from operating cashflow-mandatory cash expenditure to keep the biz running. Taken from the cashflow statement FCF is hard to achieve an exact figure for.
FCF is often calculated from the income statement. Takes net income and subtracts depreciation, amortisation and capital expenditure (cap expenditure idnicates cap spend requirement for the company). This is often considered a better way of calculating FCF as it removes inconsistencies from payments in advance or arrear.
Equity and enterprise cash flow
- Equity cash flow = free cash flow to the shareholders so will remove financing the cost to pay off lenders (due to debt being more senior than equity) but before any dividends are paid.
- Enterprise CF = cashflow before considering any financing costs like payments made to the financers of the firm in the form of shareholders or lenders (bond holders eg).
Contents of an annual report and accounts (for PTCs) - 6 points
- Strategic report - directors comment on the stratergy adopted and future plans
- Stakeholder review - way the company looks after shareholder interests
- Financial review - CFO outlines performance based on a variety of metrics.
- Governance report - outlines how the business operates responsibly and effectively. Has an audit committee report that are non-directors giving their overview.
- Directors renumeration - how well directors are paid.
- Financial statements including:
1. independant auditor’s report - external auditor attests that the accounts are accurate (qualified). If they say the FS isn’t done correctly/innacurate it is unqualified.
2. Accounts and notes - notes to analyse the performance of teh company and teh 3 financial statements previously mentioned.
3. Shareholder info - has previous dividends, share price, other useful info for current/future shreholders
Financial statement analysis using ratios - what they’re used for and their limitations - 3 of each
Ratios can be used for a number of reasons. They are useful for translating financial statement data into specfic measures. Their purpose is to:
* Assess business performance - by identifying relationships from data in the FS
* Summarise financial info into simple format
* Identify trends, strengths/weaknesses by comparing stats across industry averages and other competing firms.
Limitations:
* Not predicitive - are only based of historic data
* Use non-standard accounting/calculation methods from the GAAP making it hard to draw comparison
* Judgement is needed when performing ratio analysis - creating differences in results.
The use of historic data and it’s impact on share price
As data is historic, the relationship between accouting data and share prcie is unpredictable as the FS indicates past performance and will not necessarily indicate future performance.
Typically, the shareprice will only change if the data in the FS changes the investor’s opinion on the future of the firm.
Changes in share price can also be a result of earning being better/worse than expected.
Return and profitability ratios explaination - ROCE
Profitability ratios - % return a companny generates relative to it’s revenues. Links to profit margin (% of revenues a company earns after subtracting all costs).
Return on capital employed (ROCE) considered the best measure for overall mgmt performance in relation to capital paid into the business.
Measures profit as a % of invested (employed) capital as the employed capital is the money that should be used to generate profit.
Capital employed=equity+long term debt.
Also called return on shareholder’s assets (ROA).
Return on shareholder equity (ROE) is another performance measure for net income based on equity financing for the business.
Return on Capital Employed (ROCE) calculation.
ROCE=
Operating profit
——————————————— X100
Capital employed
Operating profit = profit before financing and tax (income statement)
Capital employed = total equity +total non current liabilities (balance sheet / sofp)
Return on Assets (ROA) formula
ROA
Operating profit
————————– X100
Total net assets
total net assets = non current+current assets - current liabilities
GIVES THE SAME RESULT AS ROCE
Return on shareholder equity (ROE)
ROE
Net income
—————————— X100
Shareholder equity
- Net income = at the bottom of income statement (all additions and subtractions made)
- Shareholder equity = total from the equity section on balance sheet/sofp
Profitability ratios - gross and operating profit margin
- Gross profit margin % = (gross profit / Revenues) X 100
- Operating profit margin % = (operating profit / Revenues) X100
Operating profit margin can also be used with the asset turnover ratio to provide a breakdown of the ROCE and ROA ratio.
Asset turnover - calc and how it is expressed
Asset turnover (number of times) = revenues/total net assets
Asset turnover takes annual revenues and divides it by total net assts of the business. It is expressed as number of times which is to reflect the amount of activity generated fron teh assets
The larger the asset turnover the more the company gets from the assets. If asset turnover is combinrf with the operating profit margin it = ROCE/ROA
Op profit margin x asset turnover = ROCE/ROA
Financial gearing ratios
Fin gearing = risk from a company’s debt
It analyses the proportion of debt financing a company has compared to equity = debt:equity ratio.
The higher the debt finance the higher the risk of the company not meeting it’s commitments because debt is more senior than equity and needs paying annually whereas equity and dividends don’t.
It can be a + as if the debt is fixed interest, whatever profit is made after interest is paid belongs to the equity holders.
The ratio can be innacurate as a company might hold lots of short term cash/investments to pay off the debt. Profit levels can also be used to assess the whether the debt is excessive (interest cover)
Debt to equity ratio
Debt:equity = Debt/Equity
Both debt and equity figures drawn from balance sheet. Non current liabilities are often considered debt.
Stated simply as debt to equity is 0.26 or as a percentage 26%.
Net debt to equity ratio
(Debt - cash and short term investments)
———————————.
Equity
net debt is simply the above that applies to the current assets on the balance sheet.
Interest cover
Operating profit
———————–.
Interest costs
Drawn from the income statement.
Liquidity ratios - current ratio - CURRENT A L
Current ratio
Current assets
————————- .
Current liabilities
The higher the result the better the company will be at meeting it’s ldue liabilities and continue to fund biz operations.
Quick ratio AKA acid test - minus Minecraft
Quick ratio
(current assets - inventory)
——————————–.
Current liabilities
Inventory is removed from the current assets as it is hard to value and is not always highly liquid.
A score of more than 1 means a company will have sufficient short term assets to meet short term liabilities.
Investor ratios - Earning per share
EPS
Net profit/loss (for ordinary shareholders)
———————————–.
Avrg. no. of ordinary shares outstanding in a period
IAS 33 defines the calculation as the above and it is widely used in investing.
net profit/loss = net profit on income statement-dividends on pref shares.
* EPS shows how much profit that was made in the year can be paid to shareholders as dividend.
* Helps in calculating the price/earing ratio
* propective EPS is the speculative EPS for the future. Historic EPS is the factual past EPS.
Earnings per share for preference shares
To adjust the calc for pref shares the below is the formula.
Net income for fin year - dividends on pref shares
———————————————-.
no. ordinary shares in issue.
Non controlling assets must also be taken into account and removed for group accounts.
Diluted earnings per share - what std requires its disclosure
Creates a future EPS figure to take into account events that could/have already happened.
Convertible shares would dilute the EPS considerably if exercised and convertible shares are not considered in the normal EPS. More shares = lower EPS value. A diluted EPS is required for companies with high volumes of convertible shares in issue.
IAS 33 requires it’s disclosure
Price/earning ratio (PE ratio)
PE ratio
Current market price per share
———————————.
Earnings per share
Quoted in the number of years of dividend payments required to achieve the current share price.
Trailing PE
AKA PE trailing 12 months (ttm) or last twelve months (ltm).
Looks back on old data from the past year as per the PE calculation. Can be updated at quarterly intervals.
Forward PE
Aka estimated PE.
based on an estimated net earnings over the next 12 months. These estimates are typically the mean from the estimates generated by a group of analysts. Called consensus estimate.
Companies with losses or estimated losses have an undefined PE ratio.
In terms of economic uncertainity this figure is less useful as the environment can change so easily.
Uses of the PE ratio
- Evaluate a company’s stock price compared to it’s earnings
- Can compare the PE ratio of 2 companies to see which one has better returns
- Evaluate whether the market is priced over/under/equal to expected.
- Compare industries for their growth/returns potential
- Can be considered alongisde IRs - low short term IR and infaltion means a typically higher PE ration.
- Compare an indiviudal company’s PE to a whole stock market’s PE so assess returns.
Enterprise value (EV) to EBIT AND EV CALC
EV/EBIT
EV=mkt cap + all debt + non controlling assets + pref shares - all cash/cash equivalents. Considered as the cost of buying the whole business
Comparison of ev/ebit to p/e. =
PE assesses expesiveness of a company’s shares only. EV/EBIT looks at the whole company.
The lower the EV/EBIT the cheaper the company
Enterprise value to EBITDA
EV/EBITDA
Also used to assess cheapness of a business.
EBITDA = non GAAP measure of (simply) operating cashflow as ‘DA’ aren’t cash flow linked. it often leaves out the working capital cash which is significant so must be used with caution.
Gross dividend yield
gross div yeild expresses total dividends per share paid over the last year as a %of current share price.
Gross div yeild
Dividend
—————– X100
Current share price
Can indicate that the share price is low compared to the dicidend it can return
LOW div yield shows mkt confidence in teh company’s ability to increase dividends over time.
Gross dividend cover - calculation
Assess how well a firm can cover it’s dividend payout with the profits that it made = how easy is it for the company to pay dividends.
Also shows the proportion of profits reinvested in the company. (if div cover is 2X then 50% of profits were paid to shareholders and 50% were reinvested)
IF it is less than 1 = uncovered dividend - the profits weren’t enough to cover the dividend.
Div cover
EPS
——————-.
Dividends per share
Done
Capital reserves include what:
Revaluation reserves and the share premium account and revenue reserves
Equity comprises of
Equity = share capital + reserves +capital reserves
Reserves = revenue and capital
Capital reserves = revaluation reserve and share premium
Where are dividends show in a separate statement
Statement of changes in equity. Also shows share capital reserve, capital reserve, revenue reserve
Methods of measuring hearing
Debt to equity
Net debt to equity
Interest cover
