Analysis of organisations’ external reports Flashcards
1
Q
How do we do financial statement analysis
A
- Simple comparison
- Ratio analysis
- Trend analysis
- Comparison to benchmarks
2
Q
Accounting ratio categories
A
- Profitability ratios
- Efficiency ratios
- Capital structure ratios
- Liquidity ratios
- Market based ratios
3
Q
Profitability ratios
A
- Return on assets (ROA) • Return on equity (ROE)
- Profit margin
- Gross profit margin
4
Q
Return on assets
A
- Calculated as PROFIT ÷ TOTAL ASSETS × 100
- How much profit is being generated for every dollar of assets controlled by the organisation.
- Financial statement analysis should be undertaken with care.
5
Q
Return on owners equity
A
- Return on owners’ equity (ROE) = Profit ÷ average owner’s equity x 100
- Provides a measure of the profit being generated for each dollar of equity the owners have in the organisation.
- Generally, the larger the number the better and an improving trend across time is preferred.
6
Q
Profit Margin
A
- profit margin = profit ÷ sales x 100
- Provides an indication of the extent to which each dollar of sales contributes to profits.
- providing an indication of cost efficiency/control.
7
Q
Gross profit margin
A
- gross profit margin = (profit – cost of goods sold) ÷ sales x 100
- Gives an indication of pricing strategy (mark ups) which can be compared to similar organisations.
8
Q
Efficiency ratio
A
Inventory turnover
Debtors turnover
9
Q
Inventory turnover
A
- inventory turnover = cost of goods sold ÷ average inventory
- Provides an indication of how many times in the accounting period the organisation turned over (sold) its inventory.
- The higher the better.
10
Q
Debtors turnover
A
- debtors turnover = sales ÷ average accounts receivable
- Provides an indication of the number of times during the period that debtors turn over (pay)
- The higher the number the less the amount of cash tied up with debtors
11
Q
Capital structure ratios
A
- Debt to assets ratio
* Debt to equity ratio
12
Q
Debt to assets ratio
A
- Debt to assets ratio: Total liabilities ÷ total assets x 100 • Is a measure of the extent to which an organisation’s assets have been funded by lenders/creditors.
- All things being equal, the greater the percentage the greater the risk of an organisation.
13
Q
Debt to equity ratio
A
- debt to equity ratio = total liabilities ÷ total owners equity x 100
- Provides an indication of how much liabilities there are per dollar of equity.
- Shows the extent to which an organisation is dependent upon equity financing.
- All things being equal, the greater the relative level of debt financing the riskier the organisation.
- Organisations with high variability in cash flows will find it relatively risky to have higher levels of debt relative to equity.
14
Q
Liquidity ratios
A
Current ratio
Quick ratio
cash flows from operations to current liabilities
15
Q
Current ratio
A
- Current ratio = current assets ÷ current liabilities
- To assess whether an organisation will be able to pay its debts as and when they fall due.
- Benchmark : 1
16
Q
Quick ratio
A
• Quick ratio = (current asset – inventory) ÷ (current liabilities – bank overdraft) • Quick ratio (or acid-test) ratio is also used to assess the ability of an organisation to pay its debts as and when they are due.
17
Q
Market based ratios
A
Price earnings ratio
18
Q
Price earnings ratio
A
- price earnings ratio = market price per ordinary share ÷ earnings per share • Provides an indication of how many times earnings the market is prepared to pay for a share.
- A higher number relative to similar organisations indicates greater market acceptance of the organisation.
19
Q
Events occurring after the end of the reporting period
A
In respect of events that occur after the end of the reporting period, but before the financial statements have been authorised for issue, the organisation shall disclose in the notes to the financial statements: a. the nature of the event; and b. an estimate of its financial effect, or a statement that such an estimate cannot be made.
20
Q
Contingent liabilities
A
An obligation that is payable contingent upon a future event or an obligation that is not probable (in terms of resource outflows) or is not measurable with sufficient reliability. At the extreme, contingent liabilities can potential threaten the ongoing existence of an organisation.
21
Q
Remuneration policies
A
- This is a corporations law requirement within many countries.
- Managers in organisations typically receive bonuses (referred to commonly as ‘performance-based rewards’ or ‘at risk rewards’).
- The central idea behind such bonuses is that they motivate certain behaviours.
- The disclosures about bonuses inform the reader/analyst about certain priorities of the organisation and what types of performance the organisation appears particularly intent on improving.
- The information can also potentially help the reader/analyst identify risks and inconsistencies in the actions and rhetoric of an organisation.
22
Q
Why do organisations socially or environmentally report
A
- Much social and environmental disclosure appears to be motivated by profitability and survival considerations.
- We must not necessarily believe/trust everything we read
23
Q
how to know if an organisation is performing well socially or environmentally
A
- To understand whether an organisation is ‘performing well’ from a social or environmental perspective, we need to know something about the environment in which it is operating within.
- A well prepared social and environmental report will be clear about the context of the organisation. Interested stakeholders must also undertake their own research to understand organisational context and associated risks
24
Q
Independent review
A
- Managers might use various accounting techniques so as to project the best picture of the organisation.
- An independent expert review of a report will tend to add credibility and ‘value’ to the report.
- It is actually in the organisation’s interest to pay for the third party review.
25
So something to consider when reviewing the reports produced by organisations is
* who prepared the financial reports or the social and environmental reports?
* who reviewed/audited them?
* If the opinion provided was that the reports were poorly prepared perhaps breaching particular standards and guidelines then we might actually be wasting our time reviewing them.
* If the independent review was performed by individuals who have no clear expertise then its value would be questionable.
26
Conclusion
* ‘Accounts’ can take many forms and can address various aspects or organisational activities.
* The practice of ‘accounting’ can be extremely interesting and thought provoking.
* Accounting information provides us with power to make informed decisions.
27
Who would or should perform financial statement analysis
Requires some reasonable knowledge of financial accounting in terms of the current rules and conventions (and remember, accounting standards are frequently changing). People with limited financial accounting knowledge would be unwise to rely upon their own analysis of financial statements. •
28
Why would somebody do financial statement analysis?
There could be various reasons. People analysing the reports might be thinking of investing in an organisation, advising others about whether to invest, working for an organisation, loaning money to the organisation, selling goods on credit to the organisation, and so forth. For these various purposes they might want to know how efficiently the organisation is using its resources, how profitable the organisation is relative to other organisations, and the ability of the organisation to pay its debts as and when they fall due. FSA can provide such insights
29
Financial accounting numbers
Financial accounting numbers are everywhere and they are part of common communication. Financial accounting numbers are used in many agreements between an organisation and different stakeholders.
30
Stakeholder's interests in financial reports
Many stakeholders want information from annual reports, as their own wealth might be influenced by such numbers. For example: managers might be receiving bonuses tied to accounting profits; lenders might have negotiated debt to asset restrictions; employees want to know the security of their employment.
31
Financial accounting numbers create various social impacts
For example: if reported profits are falling then staff might be sacked so as to save on ‘expenses’; labour unions might use high reported profits as an excuse to call for increased wages.
32
Simple comparisson
A simple comparison of this year’s figure (perhaps particular expenses or revenues) with the previous year figure (sometimes referred to as horizontal analysis) – but we need to ensure there is nothing fundamentally different about the organisation from one year to the next (or that the accounting rules being used haven’t changed since last year in a way that might hamper our comparison)
33
Ratio analysis
Within ratio analysis, particular line items in financial statements are compared to other line items. It is used to evaluate various aspects of a company, for example its profitability, efficiency, liquidity, or solvency. We will consider a number of accounting ratios.
34
Trend analysis
Look at various financial indicators – perhaps ratios – over time to see if there is a pattern of improvement or deterioration.
35
Comparison to benchmarks
Different performance measures – which might be encapsulated in ratios - might be compared to other organisations to determine how the organisation is performing relative to others.
36
Comparison to benchmarks warning
But be careful when comparing financial accounting numbers with similar organisations. Different organisations in different industries are subject to different risks and therefore simply comparing their profitability might not be appropriate. Also, we must consider size (for example, is it sensible to compare the performance of Coles with that of a corner store?) and geographical location (for example, different countries can pose different risks and different costs of operation making comparison problematic).
37
Accounting policies
Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements • Whilst often very difficult to understand (even for experienced accountants), the first notes that accompany financial statements generally are the ‘accounting policy notes’. An entity shall disclose its significant accounting policies comprising: of the measurement basis (or bases) used in preparing the financial statements; and the other accounting policies used that are relevant to an understanding of the financial statements.
38
Profitability ratios
Looks at the ability of an organisation to make a profit (but remember, here we are looking at organisations that are established to make profits. Such analysis might not be relevant for not-for-profit entities). Determined by comparing profits against bases such as sales, assets or owners’ equity.
39
Efficiency ratios
Provides insight into how an organisation is managing its assets and liabilities.
40
Capital structure ratios
Provides an insight into how the organisation is being funded (from owners or through debt) and therefore provides some indicator of risk.
41
Liquidity ratios
Provides insights into the ability of an organisation to pay its debts as and when they fall due.
42
Market based ratios
Provides an insight into how the market values an organisation
43
ROE considerations
The ROE provides a measure of the profit being generated – which ultimately might go to owners in the form of dividends – for each dollar of equity the owners have in the organisation. Provides a basis for investors to compare to other investment opportunities – The rate of return certainly should be higher than low risk returns, such as returns on bank deposits. There is no absolute ‘right’ percentage. There is a need to compare with benchmarks.
44
Inventory turnover considerations
A lower inventory turnover is a potential sign of inefficiency and also exposes the organisation to various risks, such as risk of spoilage or obsolescence. – But again remember this tends to be industry specific. A retailer of expensive luxury cars would be expected to have a lower inventory turnover that a fruit and vegetable shop. • A higher inventory turnover is reflective of greater efficiency in both purchasing and sales activities and potentially the need for less cash for acquiring inventory.
45
Cash flows from operations to current liabilities
* Cash flows from operations to current liabilities = cash flows from operating activities ÷ current liabilities
* In Module 3 we discussed the statement of cash flows and noted that one classification of cash flows was cash flows from operating activities (the other classifications being cash flows from financing activities and cash flows from investing activities).
* This measure provides an indication of the ability of an organisation to cover its financial obligations as a result of its operating activities, rather than having a reliance on cash flows from financing or investing.
* Generally, the bigger this ratio is, the better
46
Price earnings ratio considerations
A higher number relative to similar organisations indicates greater market acceptance of the organisation. The market might believe that the organisation has relatively lower risk and/or it has good growth prospects – so a higher number seems a good thing. • But ……sometimes these numbers can get very high to the point they seem to defy explanation and are potentially indicative of an ‘overheated market’.
47
Notes
The three specific topics we can consider are: – Notes about events occurring after the end of the reporting period. – Notes about contingent liabilities. – Notes about how senior managers/executives are being paid – what type of incentives are there? •
48
Is total assets (balance sheet) a true measure of assets
. As we should also appreciate, ‘total assets’ does not include many valuable assets. For example, most internally generated intangible assets – which might have great value – are not recognised within financial accounting (because the accounting standards prohibit their recognition), and hence do not appear on the balance sheet. Analysts need to remember this. Also, many other key resources of the organisation – such as its labour force, key intellectual capital, valuable customer and supplier networks and so forth are not reported on the balance sheet.
49
As such, and given the voluntary nature of the reporting, when reviewing a sustainability report it is important to firstly try to understand:
– Why management has prepared the report (motivation)?
– Why they have decided to disclose the particular social and environmental information that they have disclosed?
– What stakeholders does it seem to be directed towards?
