ppt t/a carnegie et al;accounting financial and organisational decision making © mcgraw-hill...

12.1PPT t/a Carnegie et al;Accounting Financial and Organisational Decision Making© McGraw-Hill Australia Pty Ltd, 1999

ACCOUNTINGACCOUNTINGFinancial and Organisational Financial and Organisational

Decision MakingDecision Making

Chapter 12

Financial statement analysisSlides written and designed by

Tony Van Eekelen

12.2PPT t/a Carnegie et al; Accounting: Financial and Organisational Decision Making© McGraw-Hill Australia Pty Ltd, 1999

Chapter 12: Financial statement analysis

Learning ObjectivesLearning Objectives

• In this chapter you will be introduced to :

– the users of financial statement analysis and

how they use it

– a plan for financial statement analysis

– various techniques used for analysis

– the limitations of analysis using financial ratios



Learning ObjectivesLearning Objectives

– a range of financial ratios

– ratios for public sector

organisations

– the uses of ratio analysis



IntroductionIntroduction

• The financial statements of a firm are seen as a major source of information by many users for judging the risk and return elements of the entity.

• By using ratio analysis one can make more in depth decision regarding these elements.



Planned approach

Cross sectional Time series Common size

Ratio analysis

Techniques used

Users & uses of financial analysis



Limitations of ratios

Financial stability ratios

Per-share ratios

Efficiency Ratios

Ratios in public sector

Cash flows ratios

Uses of ratio analysis

Performanceratios



Users and uses of financial analysisUsers and uses of financial analysis

• Internal users– management

• for planning and control of the entity

• monitoring performance, diagnosing problems and revising plans

• External users– those making investment or lending decisions– those interest in the organisation’s performance



External usersExternal users• Two basic questions to be answered:

– How well has the entity performed?

– What is its present financial position?

• Other questions need to be asked to answer above?– What is the rate of return of shareholders’ funds? Or on total

assets?

– What is the short and long term trend?

– What can be done to improve it?

• Different users will have different criteria for evaluation.



A planned approach to financial analysisA planned approach to financial analysis• The following diagram (next slide) illustrates the process

by which one should approach financial analysis.• Stage 3 relates to the questions to be answered; such as

– How is the entity financed?

– How profitable is the entity and how is the profit earned?

– How efficient is the entity?

– How solvent is the entity?

– Is the performance satisfactory?

– How does the financial markets rate the entity’s securities?

– Are there any factors which may distort the interpretation?



A process for financial analysisA process for financial analysis

Identify the user/sof the information

Identify the decision/sto be made

Identify questions thatneed to be answeredto reach decisions

Interpret informationand significance compared with

a benchmark

Extract & supplementfinancial statement

information as required

Arrange information in a form suitable for analysis

Prepare a report answering questions posed

& making recommendations



Techniques usedTechniques used

• The most common is ratios.– Mainly to compare figures and to eliminate the

size factor

• The format can be expressed as– pure ratio– certain number of units– as a percentage - most common– as an index number



Techniques usedTechniques used

• Cross sectional analysis is to compare one organisation with another or the industry average.

• Common size financial statements are where the statement are converted to a % of one figure eg as a % of sales in the profit and loss

• Time series analysis is to calculate the ratios over a period of time and analysis the trends.



Ratio analysis of financial statementsRatio analysis of financial statements

• When conducting ratio analysis, ratios should be selected to answered the desired questions?

• The range of ratios can be divided into 5 groups:– performance or profitability

– operating efficiency

– financial stability

– cash flow ratios

– per share ratios



Limitations of ratio analysisLimitations of ratio analysis

• Three main limitations exist with ratio analysis:– timing problems

• reports are at a point in time.

• Window dressing - ie by engaging in activities to effect reports at year end.

• Time from end of period to publication of reports

• timing of future inflows and outflows are not reported



Limitations of ratio analysisLimitations of ratio analysis• The information base may cause problems

such as:– lack of disclosure generally

• minimum requires are set and lacks detail

– variation valuation methods• revaluation of assets on ad hoc basis

– variation in classification of information• using different accounting methods

– use of historical cost accounting information



Limitations of ratio analysisLimitations of ratio analysis

• End use– Ratios are based upon the past and may not be a

good indicator for the future.

– No standard of evaluation exists; what is a “good ratio”?

– Maybe receive conflicted results from ratios , thus making a overall conclusion difficult.



Performance ratiosPerformance ratios

• These ratios need to assess the profitability of the entity.

• Ratios included are:– gross profit margin – expenses ratio– net profit margin – asset turnover– quality of income ratio – return on assets– cash return on assets – return on equity– cash return to shareholders




• Gross profit margin

• Shows the relationship between mark up and sales; ie is the sales price high enough or is the cost price to high?

Sale

profit Gross margin profit Gross

Sale

profit Gross margin profit Gross




• Expenses ratio Monitoring expenses

• Net Profit Margin

– reflects the return on sales ignoring gearing and taxation

Sales

Expenses ratio Expenses

Sales

Expenses ratio Expenses

Sales

(bit)profit Net margin profit Net

Sales

(bit)profit Net margin profit Net




• Quality of income

– relationship between cash and profit

• Asset Turnover

• shows the sale generating ability of the assets

(at) Earnings

operations from flowcash index Quality

(at) Earnings

operations from flowcash index Quality

Assets Total

Salesover Asset turn

Assets Total

Salesover Asset turn




• Cash return on assets

– cash generating ability of assets to meet obligations

• Return on assets

– how profitable has the assets been?

assets Total

(bit) operations from flowsCash assetson return Cash

assets Total

(bit) operations from flowsCash assetson return Cash

assets totalAverage

(bit) EarningROA

assets totalAverage

(bit) EarningROA




• Dupont formula

• shows the break down of how the profit was made.

• Was it that the assets did not generate sufficient sales or

• Was it that sales were generated but cost control as profit eroding?

overAsset turnmarginprofit Net ROA overAsset turnmarginprofit Net ROA




• Return on equity

– shows the return to shareholders funds

• Cash return to shareholders

– may indicate the likelihood of dividends

equityr shareholdeOrdinary

(at) Earningsequity on Return

equityr shareholdeOrdinary

(at) Earningsequity on Return

equityr Shareholde

operations from flowsCash rsshareholde return toCash

equityr Shareholde

operations from flowsCash rsshareholde return toCash



Operating efficiency ratiosOperating efficiency ratios

• These ratios indicate how management are utilising the assets and maximising returns

• Ratios included are:– inventory turnover– accounts receivable turnover– cash flows to sales– accounts payable turnover



Operating efficiency ratiosOperating efficiency ratios• Inventory turnover

– This ratio shows how quickly is the firm moving its inventory; ie converting to sales

– Gives the number of times per year the inventory turns over.

– Alternative measures is to convert into days; 365 divide by turnover.

inventory Average

sold goods ofCost turnover Inventory

inventory Average

sold goods ofCost turnover Inventory




• Accounts receivable turnover– how quickly the entity receives the cash from

credit sales;– again can be expressed as times per year or

number of days

– if high, may result in bad debts and cash shortagereceivable accounts gross Average

salescredit Gross turnover Receivable Acc.

receivable accounts gross Average

salescredit Gross turnover Receivable Acc.




• Cash flow to sales

• Accounts payable turnover– efficiency in paying creditors; discounts and

poor ratings

Sales

operations fromCash sales toflowCash

Sales

operations fromCash sales toflowCash

payable accounts gross Average

purchasescredit Gross turnover payable Accounts

payable accounts gross Average

purchasescredit Gross turnover payable Accounts



Financial stability ratiosFinancial stability ratios• What is the financial risk of the entity and is it able to

repay its debts?• Can be divided into short and long term ratios:• Short term

– current ratio – quick asset ratio – cash flow ratio

• Long term– debt to assets ratio– debt to equity ratio– times interest earned ratio– cash interest coverage– fixed charge coverage



Financial stability ratiosFinancial stability ratios

• All the short term ratios are trying to analysis the liquidity of the entity. Will there be sufficient fund to repay debts in the short term?

• Current ratio

– Rule of thumb is 2:1 but if too high then not efficient use of assets

sliabilitieCurrent

assetsCurrent ratioCurrent

sliabilitieCurrent

assetsCurrent ratioCurrent




• Quick asset ratio

– some assets maybe current but are not so liquid thus they are excluded from this ratio.

• Cash flow ratio

sliabilitieQuick

assetsQuick ratioasset Quick

sliabilitieQuick

assetsQuick ratioasset Quick

sliabilitieCurrent

operations from flowCash ratio flowCuash

sliabilitieCurrent

operations from flowCash ratio flowCuash




• Debt to total assets

– What is the financial risk of the entity?

– Measures leverage and if to high may cause bankruptcy

– Alternative measure:

assets Total

debt Total ratioasset Debt to

assets Total

debt Total ratioasset Debt to

equity Total

debt Total ratioequity Debt to

equity Total

debt Total ratioequity Debt to




• Times interest earned ratio– measures the safety margin of profit over

interest payments

– An alternative, as earnings is not all cash, then use Cash interest coverage

chargesInterest

(bit) Earnings ratio earnedinterest Times

chargesInterest

(bit) Earnings ratio earnedinterest Times

Interest

(bit) operations from flowCash coverageinterest Cash

Interest

(bit) operations from flowCash coverageinterest Cash



Per share ratiosPer share ratios

• There is a belief that the markets will price entities correctly, based upon available information. The following ratios show the markets evaluation of the entity.

• Can be divided into two areas:– Earning – Dividend




• Earnings ratios are as follows:

• Earnings per share

– shows the return per share to shareholders.

shares ofNumber

(ait) Earnings shareper Earnings

shares ofNumber

(ait) Earnings shareper Earnings




• Earnings Yield– is the rate of return based upon the current market price

– can be effected by the market volatility

• Price earnings ratio is an alternative to earning yield; and shows the number of years it will take for earnings to repay the market price.

shareper priceMarket

shareper EarningsYield Earnings shareper priceMarket

shareper EarningsYield Earnings

shareper Earnings

shareper priceMarket ratio earnings Price shareper Earnings

shareper priceMarket ratio earnings Price




• Dividends per share– refers to the amount of dividend received.

• Dividend Yield– return based upon current market price

shares ofNumber

Dividendshareper Dividends shares ofNumber

Dividendshareper Dividends

shareper priceMarket

shareper DividendYield Dividend shareper priceMarket

shareper DividendYield Dividend



Per share ratiosPer share ratios• Dividend pay out ratio

– how much of the earnings is being retained or paid out?

• Net tangible asset backing

– price per share relating to tangible assets

shareper Earning

shareper Dividendratiopayout Dividend shareper Earning

shareper Dividendratiopayout Dividend

sharesordinary of No.

assets tangibleTotalbackingasset leNet tangib sharesordinary of No.

assets tangibleTotalbackingasset leNet tangib



Uses of ratiosUses of ratios

• Other uses of financial ratios are:– as performance indicators– as predictors of financial distress– in making credit decisions

• Other techniques are – discriminant analysis– modelling– simulation

ppt t/a carnegie et al;accounting financial and organisational decision making © mcgraw-hill...

Documents

financial markets

limitations of analysis

present financial position

uses of ratio analysis

cross sectional analysis

loss time series analysis

depth decision

index number slide