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# Session 2 Analysing and interpreting accounting statements 1

2:1 Introduction In the first session we examined the financial statements that a business prepares. In this session, and the one that follows, we will consider the additional information about the health of the business that these statements can reveal. In this session our focus will be on ratio analysis. A ratio shows a relationship between two figures, such as, for example, a companys current assets and liabilities. Taken in isolation, a ratio tells us little, but when it is compared with, say, the same ratio for other businesses in the same business sector, it can reveal important information about the companys performance. Although ratios provide a quick and relatively straightforward way of examining the financial health of a business, there are some limitations to their use, and in this session we will examine these potential problems. Topics covered in this session Introducing ratio analysis hort!term solvency "ong!term solvency #inancial efficiency \$sing ratio analysis Resources you will need %yson &hapter '( 2:2 Introducing ratio analysis In the first session you saw that a companys financial statements are prepared along established lines, following recognised accounting conventions. This consistency of approach, although it is not perfect, allows us to interpret these statements in more depth. The main tool of interpretation is ratio analysis. A ratio is simply the relationship between one quantity and another. )e can, for example, look at the ratio between a companys net profit and sales, or the amount of capital it has borrowed in relation to its total capital. Any ratio taken in isolation is limited in what it can tell us. To be useful it needs to be compared with something else. )e can compare* actual performance with budgeted figures

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current performance with historical figures performance of a particular company with others in the same industry of a similar si+e. ,atios tend to focus on two broad areas* urvival ! This depends on solvency, the ability to pay debts when they fall due. If a company does not pay its creditors, then they may take legal remedies to force payment and this will probably impair the companys ability to survive.

#inancial efficiency ! This is the ma-or aid to investment decisions and usually involves a matching of profit against a variety of indicators. .xternal measures such as share valuations usually serve to make this area of analysis more ob-ective. Potential problems with ratio analysis )henever you are examining or preparing ratios, it is important to remember that some of the measures are percentages whilst others are simple index numbers. The task of interpreting accounting information is not always straightforward. Although financial statements are prepared following accounting rules, these rules can be applied in different ways. It is also important to bear in mind the audience for whom the analysis has been prepared. If the audience is external to the company, then the analysis will be dependent on published information, and will hence be as sound or unsound as that information itself. If the audience is internal, usually in order to make a decision of some kind, there will be vested interests, pre-udices, and the general politics of the company to take into account. &ertain empirical studies, such as /eaver 0'1223 4mi-ewki 0'1563 and Altman 0'1253 have indicated a strong correlation between weak key ratios and corporate collapse. These key ratios tend to be somewhat esoteric hybrids of the more common types. They usually focus on net current assets weaknesses, and the inability of earnings to cover long!term debt. 7owever nobody has yet demonstrated that corporate failure can be predicted by ratio analysis. This may be due to the following factors* ,atios show something is wrong or getting worse, they do not show terminality. Inflation. The accounting profession has been unable to persuade industry that an inflation accounting standard is desirable. 7ence different companies have pursued different policies, with the resulting disagreement over what 8real figures would reveal. 8&reative accounting can make results look better than they actually are by, for example, cutting expenditure on essential maintenance. These are measures designed to achieve short!term success but at the expense of long!term stability. The very existence of concepts and conventions does allow some flexibility of approach. Activity 2.1

"ook at the news story on :9'6 in %yson, and look at the questions on page 9;'. <ow read %yson :9'= ! 99( The next sections of this session take you through the essential ratios that you need in order to interpret a set of accounts. The relevant pages of the text book are identified for you, and you may find it helpful to read them as you learn about each ratio. 2:3 Survival short-term solvency There are two main types of ratios in this area* those indicating the imbalance between current assets and current liabilities, and those which indicate the rate at which short!term assets may be liquidated 0activity ratios3. The current ratio &urrent assets &urrent liabilities *'

9*' is often said to represent a decent degree of coverage, but the evidence is that the recession has caused this ratio to average at a much lower level than in the recent past, due to higher rates of corporate collapse and to increasing corporate efficiency 0destocking and quicker debt collection3. .fficient companies have always been able to operate at a lower current ratio than average. ,ead about the current ratio on pages 999!996 of %yson. The liquidity ratio &urrent assets ! stock *' &urrent liabilities This is also referred to as the 8acid test ratio or the 8quick assets ratio. The point of this ratio is that stocks may be difficult to liquidate 0turn into money3 so that it may be unreasonable to include them in a measure of liquidity. There is much evidence that this ratio has also reduced on average during recent years. A 8reasonable level does not exist and considerable discrepancies exist between different industries. #or example a shop which buys stocks on credit and which sells them very quickly will have a seemingly poor set of ratios. Activity ratios The next group of ratios look at the efficiency with which certain resources are managed. Average stock turnover Average stock x 62= &ost of sales The average stock figure can be calculated as an average of the opening and closing stock for a year or month. %ifferent industries will show wildly different characteristics in relation to stock turnover. #or example, a greengrocer would wish to

turn his stocks over on a daily basis, while a shipyard might only turn out one boat per year. Activity 2.2 Two businesses operate in the same industry. >ne has a stock turnover period that is higher than the industry average. The other has a stock turnover period that is lower than the industry average. ?ive three possible explanations for each businesss stock turnover period ratio. ollection o! de"ts %ebtors x 62= ales This refers to the average collection period in days in which debts are collected. This should be as short as possible for liquidity purposes, but about '.66 times the normal credit period is acceptable. redit taken &reditors x :urchases 62=

The slower debts are paid, the better, is the maxim here. 7owever, companies should beware the loss of goodwill and of potentially valuable discounts that can result from late payment. ,ead about the average settlement period for creditors on pages 9'1 and 99(. &omplete activity @.1. Other factors influencing short-term solvency i+e of operating costs can be significant and wages and salaries usually represent a hefty payment to be made on a regular basis. Analysis here would usually involve expressing each item of expense as a percentage of turnover. The lower this percentage is, the less of a drain on net current assets it will be. It is also clear that the lower it is the greater will profit be. /ank credit may be forthcoming and may enable companies to operate on a low current and liquidity ratio. olvency analysis from an external point of view is notoriously difficult, depending as it does on balance sheet figures which may be out of date, may also be sub-ect to seasonal factors, and which do not indicate the attitude of creditors and lenders who may show goodwill. &heck in %yson A :992!991 for activity 0efficiency3 ratios. 2:# Survival long-term solvency The next group of ratios examine how a company finances its operations.

\$earing ratio This may be expressed in a number of ways, all of which seek to demonstrate the relationship between ownersB capital and borrowed capital. The method below is popular* /orrowed capital x '(( Total capital Total capital would normal be shareholdersB funds plus borrowed capital. The larger the ratio becomes, the greater the dependence on outside borrowed capital. This means that more profit needs to be put aside to cover interest charges, and also that in years of small profit it is possible that the interest charges will not be covered at all. 87igh gearing should only be used when stable high profits are anticipated. Interest coverage ratio <et profit before interest and tax :eriodic interest charges *'

This measures the ability to service long term debt and should, of course, be as high as possible. <ow read pages 96'!969. 2:% &inancial e!!iciency ,atios in this area focus on a companys ability to generate income and profit. They are an aid to corporate and individual investment decisions. :roblems in interpreting these ratios usually involve comparability, in that profit can be before or after tax, or before or after interest charges. The important thing is to compare like with like. 'ro!ita"ility - return on capital employed ()* +, There are several ways of expressing return on capital employed, all of which are useful in different circumstances. <et profit0usually after tax3 x '(( hareholdersB funds The main use of this method is to investors who will be able to ascertain the after tax earnings, which they can compare with other firms. <et profit0before tax and interest3 ?ross assets x '((

This method of calculating return on capital employed gives a clearer picture to management. There are two reasons for this* Taxation falls irregularly and is based on fiscal principles, rather than accounting ones. =

/y focusing on the profit earned by all the assets possessed, no distortions occur due to a companyBs financial structure. In the first ,>&. ratio, a high figure may be earned by shareholders, simply because there are few of them, if most capital is borrowed. <ow read pages 996!992 in %yson Activity 2. ome businesses operate on a low net profit margin 0for example, a supermarket chain3. %oes this mean that the return on capital employed from the business will also be lowC *ther !orms o! !inancial e!!iciency )e will now consider other ratios that can be used to assess financial efficiency. The asset turnover ratio ales ?ross assets This ratio may be calculated for any asset or category of asset. The ratio reflects the use of the asset0s3 and hence of management efficiency. A good management team is looked upon as a prime component of future success. -et pro!it to sales <et profit x '(( ales This can be split into two further ratios* ?ross profit ales and >ther expenses ales

These ratios vary widely from industry to industry, with some companies going for low profit margins and high volume of sales and others going for high margins and lower volume. Accounting policies can make comparison between firms extremely difficult in the area of profitability. This is due to the problems with accounting methods, because not everybody values stock in the same way, or calculates depreciation in the same way. >ther problems can occur due to timing differences on asset acquisitions and the consequent effect of inflation. Share ratios This group of ratios is used by investors to help them assess the returns on their investments.

+arnings per share (+'S, <et profit after tax <umber of ordinary shares .: is significant for ordinary shareholders as it demonstrates their earnings and closely affects the share price. .ividend per share Total dividend <umber of ordinary shares Again, this affects the share price, but is of more use to investors looking for a quick profit rather than steady growth. <ote that dividend is payout, whilst earnings in .: represent payout plus retention. Dany other investment ratios exist, mostly creating relationships with share market prices. >bviously, these can only be used when a particular companyBs shares are traded, and are only applicable to public limited companies. 'rice-+arnings )atio ('+), tock Darket price per ordinary share .: This is the most commonly used investment ratio. It reflects the stock markets view of the shares. If the ratio is unusually high, it would reflect a level of confidence in the company over and above that suggested by the .: . There is a great deal of stock market theory concerning this issue, which is not within the remit of this module. ,ead pages 991 ! 96' Activity 2.! Identify and discuss three reasons why the :E. ratio of two businesses operating within the same industry may differ. The following activity provides more practice in interpreting financial statements and relating your analysis to business ob-ectives. If you are able to work with other students, complete the activity together, as a group. 2:/ Summary In this session you have calculated a range of ratios from financial statements and explored what they reveal about a companys health. The current ratio and acid test 0or liquidity3 ratio are useful for assessing a companys short!term prospects of survival, as are the various activity ratios. "ong!term solvency can be assessed by examining gearing and interest coverage ratios. Fou also used several ratios that look

at financial efficiency, including ,>&. and the asset turnover ratio. hare ratios, which are of particular interest to investors, include .: , %ividend per share and :.,. ,atios tell us little in isolation, but can be used to make comparisons between different companies in the same sector, or the same company at different times. They can also highlight characteristics of companies in different sectors. It is more useful to consider a range of ratios than to rely on a single point of comparison. There are certain problems in interpreting ratios, many of them related to the fact that companies do not always prepare their statements in exactly the same way, and that these differences in approach may not be immediately apparent. #inancial statements prepared for external audiences may not include all the information you would like to see, and the figures may not represent the current situation. It is also possible that 8creative accounting may show aspects of a business in a particularly favourable light. #inancial information prepared for internal consumption may also suffer from sub-ectivity, particularly if it has been assembled to support one side or another of an argument. There is some academic debate on whether it is possible to use ratio analysis to predict business failure. Try questions '(.; and '(.= on %yson pages 9;' ! 9;6 )e!erences Altman, ..I. 0'1253 8#inancial ratios, discriminant analysis and the prediction of corporate bankruptcy "ournal of #inance, eptember, pp. =51!2(1 /eaver, ).7. 0'1223 8#inancial ratios as predictors of failure, \$mpirical Research in Accounting% &elected studies, pp. @'!''' 4mif-ewski, D... 0'1563 8:redicting corporate bankruptcy* an empirical comparison of the extent of financial distress models, ,esearch :aper, tate \$niversity of <ew Fork #eedbac' on activity 2.2 Three possible reasons for a high stock 0inventories3 turnover period are* :oor stock controls, leading to excessive investment in stock. tock hoarding in anticipation of price rises or shortages. tock building in anticipation of increased future sales.

A low stock turnover period may be due to* Tight stock controls, thereby reducing excessive investment in stocks andEor the amount of obsolete and slow moving stocks.

An inability to finance the required amount of stock to meet sales demand. A difference in the mix of stocks carried by similar businesses 0for example, greater investment in perishable goods which are held for a short period only3. #eedbac' on activity 2. The fact that a business operates on a low profit margin indicates that a small percentage of profit is being produced for each G' of sales revenue generated. 7owever, this does not mean necessarily that the return on capital employed will be low as a result. If the business is able to generate a large amount of sales revenue during a period, the total profit may be very high even though the net profit per G' of sales revenue is low. If the net profit generated is high, this can lead, in turn, to a high return on capital employed, since it is the total net profit that is used as the numerator 0top part of the fraction3 in this ratio. Dany businesses 0including supermarkets3 pursue a strategy of 8low margin, high turnover. #eedbac' on activity 2.! The :E. ratio may vary between businesses within the same industry for the following reasons* Accounting conventions. %ifferences in the methods used to compute profit 0for example, stock valuation and depreciation3 can lead to different profit figures and, therefore, different :E. ratios. (ifferent prospects. >ne business may be regarded as having a much brighter future due to factors, such as, the quality of management, the quality of products, location and so on. This will affect the market price investors are prepared to pay for the share and, hence, the :E. ratio. (ifferent asset structure. The businesss underlying asset base may be much higher and this may affect the market price of the shares.