Interpretation of financial statements Flashcards
Users of financial statements what information needed?
Shareholders and potential investors:
- primarily concerned with receiving an adequate return on their investment, but it must at least provide security and liquidity
Suppliers and lenders:
- concerned with security of their debt or loan
Management:
- concerned with the trend and level of profits, since this is the main measure of their success
What are the other potential users include:
- bank managers
- financial institutions
- employees
- professional advisors to investors
- financial journalists and commentators
What we analyse if we want to know the performance?
- this looks largely at the statement of profit or loss and associated ratios
- profit margins, return on capital employed, net asset turnover
- looks at the results that the business has generated in the year
What we analyse if we to know the position?
- this looks at the statement of financial position and the associated ratios
- short-term liquidity, looking at working capital, long-term solvency, looking at levels of debt
What we analyse if we to know the investor?
- items that would specifically matter to investors
- share price, dividends and earnings
Gross profit margin
Gross profit/Sales revenue x 100%
What changes can influence gross profit margin?
- selling prices: increased competitions, entry into a new market
- sales mix: often deliberate (discontinuing some products
- purchase cost: including carriage inwards or discounts
- production cost - materials, labour or production overheads
What is the good way to analyse gross profit margin is to ask yourself?
Are there any reasons why the selling price has changed?
Are there any significant changes to the costs in the year?
Has there been any indication of a change in sales mix?
If gross profit has not increased in line with sales revenue what are the factors to make this discrepancies?
- increased ‘purchase’ costs
- inventory write offs
- other costs being allocated to cost of sales
Operating profit margin calculation?
Profit from operations/Sales revenue x 100%
What we need to consider if there are any changes in operating profit?
- changes in line with changes in gross profit margin?
- changes in line with changes in sales revenue?
- as many costs are fixed they need not necessarily increase/decrease proportionately with a change in revenue
- look at individual categories
What is important to consider when there are significant changes within operating expenses?
- are these due to one-off items such as redundancies
- are there likely to be ongoing future consequences
Calculation of ROCE?
Profit/Capital employed x 100%
How is the profit measured in ROCE?
- operating profit or
- the profit before interest and taxation
How is capital employed measured in ROCE?
- equity plus interest-bearing finance, i.e. the long term finance
- total assets less current liabilities
What ROCE for the current year should be compared to?
- the previous year ROCE
- the cost of borrowing
- other entities’ ROCE in the same industry
In comparison with a company that revalues their non-current assets how it will influence ROCE?
- it will make their ROCE lower than a company that does not revalue their assets
Calculation of ROE? Return on equity
Profit after tax/Equity x 100%
ROCE should be compared with?
- previous year figures - no changes in policies, if replacing non-current assets is that their value will decrease and ROCE will increase
- the company’s target ROCE
- the cost of borrowings
- other companies in same industry
Calculation for the net asset turnover
Sales revenue/ Capital employed
=times pa
What is the measure of management’s efficiency in generating revenue from the net assets at its disposal?
- the higher the asset turnover, the greater the efficiency
Other calculation for ROCE including ratios
Profit margin x Asset turnover
A trade-off may exist between margin and asset turnover
- low margin businesses (e.g. food retailers) usually have a high asset turnover
- capital-intensive manufacturing industries (e.g. electrical equipment manufacturers) usually have relatively low asset turnover but higher margins
Achieving same ROCE
- sell goods at a high profit margin with sales volume remaining low (designer shop)
- sell goods at a low profit margin with very high sales volume (e.g. discount clothes store)
What we using to analyse the position?
- short term liquidity
- long-term solvency
What are two ratios used to measure overall working capital?
- the current ratio
- the quick or acid test ratio
Current ratio calculation
Current assets/current liabilities : 1
What could cause higher or increasing figure of current ratio?
- high levels of inventory and receivables
- high cash levels which could be put to better use (e.g. investing in non-current assets)
What measures the current ratio?
- the adequacy of current assets to meet the company’s short-term liabilities
- it reflects whether the company is in a position to meet its liabilities as they fall due
Quick ratio/liquidity or acid ratio calculation
Current assets - Inventory/ Current liabilities : 1
Why is the quick ratio also known as the acid test ratio?
- because by eliminating inventory from current assets it provides the acid test of whether the company has sufficient liquid resources (receivables and cash) to settle its liabilities.
Looking at working capital what we need to have a look regarding cash?
- identify where any major cash inflows have come from in the year
- identify where the cash has been used in the year
Inventory turnover period calculation?
Inventory/ COS x365 days
Inventory turnover period calculation as a number of times per annum?
Cost of sales/ Inventory
= times pa
What indicate when an increasing number of days implies that inventory is turning over less quickly?
- lack of demand for the goods
- poor inventory control
- an increase in costs (storage, obsolescence, insurance, damage)
What is the calculation of receivables collection period?
Trade receivables/Credit sales x 365 days
Increasing accounts receivables is bad sign what could be reasons?
- lack of proper credit control
- a deliberate policy to attract more trade
- a major new customer being allowed different terms
The receivables days ratio can be distorted by:
- using year-end figures which do not represent average receivables
- factoring of accounts receivables which results in very low trade receivables
- sales on unusually long credit terms to some customers
Payables payment period calculation
Trade payables/ credit purchases x 365 days
What we compare with payables payment period?
- a long credit period may be good as it represents a source o free finance
- a long credit period may indicate that the company is unable to pay more quickly because of liquidity problems
What if credit is long? payables payment period
- the company may develop a poor reputation as a slow payer and may not be able to find new suppliers
- existing suppliers may decide to discontinue supplies
- the company may be losing out on worthwhile prompt payment discount
What is the calculation for working capital cycle (cash cycle)?
Inventory turnover period (days) + receivables collection period - payables payment period
What the working capital shows?
- the average length of time between paying production costs and receiving cash returns from inventory
The main point to consider when assessing the loner-term financial position are:
- gearing
- overtrading
What gearing ratios indicate?
- degree of risk attached to the company and
- the sensitivity of earnings and dividends to changes in profitability and activity level
What indicates highly geared businesses?
- a large proportion of fixed-return capital is used
- there is a greater risk of insolvency
- returns to shareholders will grow proportionately more if profits are growing
What indicates low-geared businesses?
- provide scope to increase borrowings when potentially profitable projects are available
- can usually borrow more easily
What two fundamental characteristics must have to use gearing successfully?
- relatively stable profits
- suitable assets for security
What are two methods commonly used to express gearings?
- debt/equity ratio
- percentage of capital employed represented by borrowings
Calculation of deb/equity ratio
Loans + Preference share capital/ Ordinary share capital + Reserves + Non-controlling interest
Calculation of capital employed represented by borrowings
Loans + Preference share capital/ Ordinary share capital + Reserves + Non-controlling interest + Loans + Preference share capital
Calculation for interest cover?
Profit before interest and tax/ Interest payable
Interest cover indicates the ability of a company to pay interest out of profits:
- low interest cover indicates to shareholders that their dividends are at risk
- the company may have difficulty financing its debts if its profits fall
- interest cover of less than two is usually considered unsatisfactory
When overtrading arises?
- where a company expands its sales revenue rapidly without securing adequate long-term capital for its needs
What are the symptoms of overtrading?
- inventory increasing, possibly more than proportionately to revenue
- receivables increasing, possibly more than proportionately to revenue
- cash and liquid assets declining
- trade payables increasing rapidly
P/E ratio - Price/Earnings
Current share price/ Latest EPS
- represents the market’s view of the future prospects of the share
- high P/E suggests that high growth is expected
What means higher P/E ratio and Lower P/E ratio?
Higher P/E ratio:
- the faster the growth the market is expecting in the company’s future EPS
Lower P/E ratio:
- the lower the expected future growth
Calculation of Dividend yield
Dividend per share/ Current share price
- the lower the dividend yield, the more the market is expecting future growth in the dividend and vice versa
Calculation of Dividend cover
Profit after tax/ Dividends
- this is the relationship between available profits and the dividends payable out of the profits
- the higher the dividend cover, the more likely it is that the current dividend level can be sustained in the future
What ratios can help with?
- to assist analysis
- they help to focus attention systematically on important areas and summarise information in an understandable form
- they assist in identifying trends and relationships
Disadvantages of ratios?
- they ignore future action by management
- they can be manipulated by window dressing or creative accounting
- they may be distorted by differences in accounting policies
What is Creative accounting?
- refers to the accounting practices that are designed to mislead the view that the user of financial statements has on an entity’s underlying economic performance
- used to increase profits, inflate asset values or understate liabilities
What is Window dressing?
- is a method of carrying out transactions in order to distort the position shown by the financial statements and generally improve the position shown by them
Examples of window dressing
- a company might chase receivables more quickly at the year end to improve their bank balance
- a company may change its depreciation estimate i.e. by increasing the expected useful life of an asset, the depreciation charge will be smaller resulting in increased profits
- an existing loan may be repaid immediately before the year end and then taken out again in the next financial year
How can we achieve value for money in not-for-profit and public sector organisations?
Effectiveness
- success in achieving its objectives
Efficiency
- how well its resources are used
Economy
- keeping cost of inputs low
