Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia ACCOUNTING FOR MANAGEMENT DECISIONS WEEK 7 ANALYSIS AND INTERPRETATIION OF FINANCIAL STATEMENTS READING: TEXT CHAPTER 6
Jan 21, 2016
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
ACCOUNTING FOR MANAGEMENT DECISIONS
WEEK 7
ANALYSIS AND INTERPRETATIION OF FINANCIAL STATEMENTS
READING: TEXT CHAPTER 6
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Learning Objectives• Define what a ratio is• Identify the key aspects of financial performance and
financial position that are evaluated by the use of ratios
• Explain the terms profitability, efficiency, liquidity, gearing and investment
• Summarise the alternative bases of comparison for ratio analysis
• Present the ratio formulae for the basic ratios• Calculate ratios to analyse the profitability, efficiency,
liquidity, gearing and investment of a given entity’s financial statements over several periods
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Learning Objectives cont’d• Interpret basic ratios for profitability, efficiency,
liquidity, gearing and investment• Discuss the limitations of ratios as a tool of financial
analysis• Understand index or percentage analysis as an
alternative to ratios
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Financial RatiosLearning Objective: Define what a ratio is
• Ratios provide a quick and simple means of examining the financial health of a business
• A ratio simply expresses the relationship between one figure appearing in the financial statements with another e.g. net profit in relation to capital employed
• Ratios are simple enough to calculate, and a good picture can be built up with just a few, however ratios can be difficult to interpret
• Can be expressed in various forms e.g. percentages, fractions, proportions depending on the need and use for the information
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Financial Ratios cont’dLearning Objective: Identify the key aspects of financial performance and financial position that are evaluated by the use of ratios
The key aspects of financial performance / position evaluated by the use of ratios are:
• Profitability• Efficiency• Liquidity• Gearing• Investment
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Financial Ratio ClassificationLearning Objective: Explain the terms profitability, efficiency, liquidity, gearing and investment
• Profitability - Measure of success in wealth creation
• Efficiency - Effectiveness of utilisation of resources
• Liquidity - The ability to meet short-term obligations
• Gearing - Measure of degree of risk to do with the
amount of leverage used to finance the business
• Investment - Measure of the returns and
performance of shares held by a business
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Need for ComparisonLearning Objective: Summarise the alternative bases of comparison for ratio analysis
Bases (benchmarks) that may be used as a basis of comparison for ratio analysis include:• ‘Intertemporal’ - Based on past performance• Budget - Based on planned performance• Intra-industry - Based on comparison of
performance with other firms in the same industry
A calculated ratio on its own does not say much about a business - it is only when it is compared with some form of ‘benchmark’ that the information can be interpreted and evaluated
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Key Steps in Financial Ratio AnalysisStep 1:• Identify which key indicators and relationships require
examination
• Identify who needs the information and why they need it
Step 2:• Choose the most relevant set of ratios that will accomplish
the desired purposes
• Calculate and record the results using the selected ratios
Step 3:• Interpret and evaluate the results
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profitability ratios
Some profitability ratios include the following:
– Return on ordinary shareholders’ funds
– Return on total assets
– Return on capital employed
– Net profit margin
– Gross profit margin
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated - Profitability Ratios
Return on shareholders funds (ROSF): Compares the amount of profit for the period available to
the owners with the owners’ stake in the business Normally expressed as a percentage
Net profit after taxation and preference dividend (if any)
ROSF = x 100 Average ordinary share capital plus reserves
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated - Profitability Ratios cont’d
Return on total assets (ROA): Compares the net profit generated by the business with the
assets owned by the business Normally expressed as a percentage
Net profit before interest and taxation ROA = x 100
Average total assets
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated - Profitability Ratios cont’d
Return on capital employed(ROCE): Expresses the relationship between the
net profit generated and the average long term capital invested
Normally expressed as a percentage
Net profit before interest and taxation ROCE= x 100
Share capital + long term loans
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated - Profitability Ratios cont’d
Net profit margin: Relates the net profit for the period to the sales during that
period Normally expressed as a percentage
Net profit before interest and taxation Net profit margin = x 100
Sales
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The Ratios Calculated - Profitability Ratios cont’d
Gross profit margin: Relates the gross profit of the business to the sales
generated during the same period Gross profit represents the difference between sales and
cost of sales Normally expressed as a percentage
Gross profit Gross profit margin = x 100
Sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Efficiency ratios
Efficiency ratios include the following:
– Average inventory turnover period
– Average settlement period for debtors
– Average settlement period for creditors
– Asset turnover period
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated - Efficiency Ratios
Average inventory turnover period: Measures the average period inventory was held Normally expressed in terms of days Average inventory is the simple average of opening and
closing inventory for the period
Average inventory held Inventory turnover periods = x 365
Cost of sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated - Efficiency Ratios cont’d
Average settlement period for accounts receivable (debtors): Calculates how long, on average credit customers take to
pay amounts owed Normally expressed in terms of days
Average trade debtors Average settlement period = x 365
Credit sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated - Efficiency Ratios cont’d
Average settlement period for accounts payable (creditors): Calculates how long, on average the business takes to pay
its creditors Normally expressed in terms of days
Average trade creditors Average settlement period = x 365
Credit purchases
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The Ratios Calculated - Efficiency Ratios cont’d
Asset turnover period: Examines how effectively the assets of the business are
being employed in generating sales revenue Normally expressed in terms of days
Average total assets employed
Average asset turnover period = x 365 Sales
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Relationship Between Profitability and EfficiencyThe overall return on funds employed in the business will be determined both by the profitability of sales, and by efficiency in the use of assets
Equals
Multiplied by
Net profit beforeinterest and taxation
Sales
Sales Average total assets
Return on averagetotal assets
The main elements comprising the ROA ratio
Figure 6.2
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Liquidity ratios
Liquidity ratios include the following:
– Current ratio
– Acid test ratio
– Cash flow from operations ratio
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Liquidity Ratios
Current ratio: Compares the business’s liquid assets with short-term
liabilities (current liabilities) Expressed in terms of the number of times the current
assets will cover the current liabilities
Current assets Current ratio =
Current liabilities
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Liquidity Ratios
Acid test (also known as the quick or liquid) ratio: Represents a more stringent test of liquidity than the current
ratio Expressed in terms of the number of times the ‘liquid’ current
assets will cover the current liabilities
Current assets (excluding inventory and prepayments) Acid test ratio =
Current liabilities
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Liquidity Ratios
Cash flows from operations ratio: Compares the operating cash flows with the current
liabilities of the business Expressed in terms of the number of times the operating
cash flows will cover the current liabilities
Operating cash flows Cash flows from operations ratio =
Current liabilities
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Financial Gearing (Leverage)
Financial Gearing: The existence of fixed payment bearing securities (e.g. loans) in the capital structure of a company
• The level of gearing, or the extent to which a business is financed by outside parties is an important factor in assessing risk
• Gearing may be used both to adequately finance the business, and to increase the returns to owners - provided that the returns generated from the borrowed funds exceed the interest cost of borrowing
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Financial Gearing ratios
Financial gearing or leverage ratios include the following:
– Gearing ratio
– Interest cover ratio
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The Ratios Calculated cont’d - Financial Gearing (Leverage)
Gearing ratio: Measures the contribution of long-term lenders to the long-
term capital structure of the business Expressed in terms of a percentage
Long-term liabilities Gearing ratio = x 100
Share capital + Reserves + Long-term liabilities
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Financial Gearing (Leverage)
Interest cover ratio (times interest earned): Measures the amount of profit available to cover interest
expense of the business Expressed in terms of the number of times the profit
generated by the business will cover the interest expense of its gearing
Profit before interest and taxation Interest cover ratio =
Interest expense
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Investment ratios
Investment ratios include the following:
– Dividends per share
– Dividend payout ratio
– Dividend yield ratio
– Earnings per share
– Operating cash flow per share
– Price/earnings ratio
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Investment Ratios
Dividends per share: Relates the dividends announced to the number of shares
on issue of the business during a period Not a measure of total return of the business
Dividends announced during the period
Dividends per share = Number of shares on issue during the period
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Investment Ratios
Dividend payout ratio: Measures the proportion of earnings that a company pays
out to shareholders in the form of dividends Expressed as a percentage
Dividends announced for the yearDividend payout ratio = x 100
Earnings for the year available for dividends
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Investment Ratios
Dividend yield ratio: Relates the cash return from a share to its current market
value Expressed as a percentage
Dividends per share / (1 - t) Dividend yield = x 100
Market value per share
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Investment Ratios
Earnings per share: Relates the earnings generated by the company during a
period to the number of shares on issue during the period Expressed as an amount
Earnings available to ordinary shareholders
Earnings per share = Number of ordinary shares on issue
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The Ratios Calculated cont’d - Investment Ratios
Operating cash flow per share: Relates the operating cash flow of the business during a
period to the number of shares on issue during the period Expressed as an amount
Operating cash flows - Preference dividendsOperating cash flow per share =
Number of ordinary (equity) shares on issue
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
The Ratios Calculated cont’d - Investment Ratios
Price earnings ratio: Relates the market value of a share to the earnings per
share Expressed in terms of the number of times the share price
is greater than the current earnings per share
Market value per share Price earnings ratio =
Earnings per share
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Trend Analysis
• Trends may be identified by plotting key ratios on a graph, giving a visual representation of changes happening over time
• Intra-company trends may be compared against industry trends
• Key financial ratios are often published in companies annual reports as a way to help users to identify important trends
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Ratios and Prediction Models• Ratios are often used to help ‘predict the future’
however the choice of ratios and interpretation of results depend on the judgement of the analyst
• Researchers have developed ratio-based models which claim to predict future financial distress as well as vulnerability to takeover
• The future is likely to see further ratio-based prediction models developed to predict other aspects of financial performance
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Limitations of Ratio AnalysisLearning Objective: Discuss the limitations of ratios as a tool of financial analysis
• The quality of the underlying financial statements determines the usefulness of the ratios derived from them
• Ratios only offer a restricted view of ‘relative’ performance and position - not the full picture
• No two businesses are identical and the greater their differences, the greater the limitations of ratio analysis as a basis for comparison
• Any ratios based upon balance sheet figures will not be representative of the whole period because the balance sheet is a snapshot of a moment in time
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Index or Percentage AnalysisLearning Objective: Understand index or percentage analysis as an alternative to ratiosIndex or Percentage analysis simply allows monetary figures to be replaced with an index or a percentage.
• There are three alternative index or percentage
methods:
1. The common size reports (also known as vertical analysis)
– the key figure in the report, usually sales, becomes 100
and all other figures are expressed as a % of that figure
2. Trend percentage – All figures in a base year are indexed
as 100 and all subsequent years’ figures are expressed as a
% of the base year figure
3. Percentage change (also known as horizontal analysis) –
the % change for the year is shown for each line item