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© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 1

CHAPTER 5

Interpreting Financial
Reports and
Alternative Perspectives

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 2
Learning Objectives
 What information is typically disclosed in a public
company’s annual report?
 What is the Management’s Discussion and Analysis
(MD&A) and what information is normally disclosed in an
MD&A?
 How are a company’s profitability, liquidity, leveraging,
activity/efficiency, and shareholder return calculated and
then analyzed?
 What is meant by intellectual capital and institutional
theory, and how can these two perspectives be used as
alternatives to financial reporting.
 How can corporate social and environmental reporting be
used to supplement financial reporting?
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 3
Annual Reports
 Financial summary
 Main advisers
 Reports of the chairman/president/chief executive officer,
directors, and/or chief financial officer
 Statutory reports (required by Companies Act) of
directors
 Audit report
 Financial reports
 Statement of comprehensive income, Statement of financial
position, and Statement of cash flows
 Notes to financial reports
 Five year summary of key financial information

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 4
Management’s Discussion
and Analysis (MD&A)
 The nature of the business
 Management’s objectives and its strategies for
meeting those objectives
 The entity’s most significant resources, risks,
and relationships
 The results of operations and prospects
 The critical performance measures and
indicators that management uses to evaluate the
entity’s performance against stated objectives
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 5
Ratio Analysis
 Two numbers, usually with one expressed
as a percentage of the other
 Ratios help interpret trends and
benchmark to industry averages or
competitors
 Different definitions for these ratios.
Important to apply consistently

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 6
Ratio Analysis
Ratio analysis five criteria:
1. The rate of profitability
2. Liquidity (cash flow)
3. Leveraging
 the proportion of borrowings to shareholders’
investment
4. How efficiently assets are utilized
5. The return to shareholders

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 7
Ratios
 Leveraging
 Profitability  Degree of operating leverage
 Return on (shareholders’) (Gearing ratio)
investment (ROI)
 Return on capital employed  Interest cover ratio
(ROCE)  Risk/ return relationship
 Operating margin
(Operating profit/sales)  Activity/Efficiency
 Gross Margin  Asset turnover
(Gross profit/sales)
 Operating expenses/sales
 Shareholder Return
 Sales growth  Dividend per share
 Liquidity  Dividend payout ratio
 Working capital ratio  Dividend yield
 Acid test (or quick ratio)  Price/Earnings (P/E) ratio

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 8
Statement of Comprehensive Income
Sales 2,000,000
Less: cost of sales 1,500,000
Gross profit 500,000
Less: selling, administration & finance 400,000
expenses
Operating profit before interest and tax 100,000
Less: interest 16,000
Profit before tax 84,000
Less: income tax 14,000
Profit after tax 70,000
Less: dividend 30,000
Retained profit 40,000

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 9
Statement of Financial Position

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 10
Profitability Ratios
RETURN ON (SHAREHOLDERS’) INVESTMENT (ROI)
Net profit after tax 70
= = 7%
Shareholders’ funds 1,000

RETURN ON CAPITAL EMPLOYED (ROCE)


Operating Profit before interest and taxes 100
= = 7.7%
Shareholders equity + Long term debt 1,000 + 300

OPERATING MARGIN (OR OPERATING PROFIT/SALES)


Operating Profit before interest and taxes 100
= = 5%
Sales 2,000

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 11
Profitability Ratios
GROSS MARGIN (OR GROSS PROFIT/SALES)
Gross profit 500
= = 25%
Sales 2,000

OPERATING EXPENSES/SALES
Operating expenses 400
= = 20%
Sales 2,000
SALES GROWTH
Sales in Year 2 - Sales in Year 1 2,000 – 1,800
= = 11.1%
Sales in Year 1 1,800

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 12
Liquidity Ratios
Working capital ratio
Current assets 500
= = 143%
Current liabilities 350

Acid test (or quick ratio)


Current assets – inventory 500 – 200
= = 86%
Current liabilities 350

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 13
Leveraging
DEGREE OF OPERATING LEVERAGE OR GEARING RATIO
Long-term debt 300
= = 23.1%
Shareholders’ equity + Long-term debt 1,000 + 300

INTEREST COVER RATIO


Profit before interest and taxes = 100
= 6.25 times
Interest payable 16

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 14
Risk and Return

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 15
Activity/Efficiency
Asset turnover
Sales 2,000
= = 121%
Total assets 1,150 + 500

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 16
Working Capital
 The difference between current assets and
current liabilities
 Money tied up in receivables and inventory
puts pressure on the firm either to reduce
the level of that investment or to seek
additional borrowings
 Alternatively, cash surpluses can be
invested to generate additional income
through interest earned

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 17
Working Capital Cycle

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 18
Managing Working Capital
 Receivables, through effective credit approval,
invoicing, and collection activity
 Inventory, through effective ordering, storage,
and identification of inventory
 Payables, by negotiation of trade terms and
through taking advantage of prompt-payment
discounts
 Cash, by effective forecasting, short-term
borrowing, and/or investment of surplus cash
where possible

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 19
Managing Accounts Receivable
Days’ sales outstanding
If the business has sales of $2 million and accounts
receivables of $300,000
Average daily sales = $2,000,000/365 = $5,479

54.75 average
Accounts receivables 300,000
= = days’ sales
Average daily sales 5,479 outstanding

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 20
Managing Inventory
Inventory Turnover
Cost of sales $1,500,000
Inventory $200,000

Inventory Turnover:
7.5 times per year
Cost of sales 1,500,000
= = or every
Inventory 200,000 49 days (365/7.5)

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 21
Managing Accounts Payable
Days’ purchases outstanding
Cost of sales $1,500,000
Accounts payable $300,000
Average daily purchases = $1,500,000/$300,000 = $4,110

Accounts payable 1,500,000 73 average days


= = purchases
Average daily purchases 300,000 outstanding

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 22
Shareholder Return
 Additional information
 Number of shares issued 100,000
 Market value of shares $ 2.50

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 23
Shareholder Return Ratios
Dividend per share
Dividends paid 30,000
= = $0.30 per share
Number of shares 100,000

Dividend payout ratio


Dividends paid 30,000
= = 43%
Profit after tax 70,000

Dividend yield
Dividends paid per share 0.30
= = 12%
Market value per share 2.50

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 24
Shareholder Return Ratios
Earnings per share
Profit after taxes 70,000
= = $0.70 per share
Number of shares 100,000

Price/Earnings (P/E) ratio


Market value per share 2.50
= = 3.57 times
Earnings per share 0.70

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 25
Interpreting Ratios

 Trend over time


 Comparison to industry averages or
competitor ratios or predetermined targets.
 Both the numerator and denominator
affect the ratio

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 26
Interpreting Ratios
 Increasing rates of profit on shareholders’ equity, capital
employed, and sales
 Adequate liquidity (a ratio of current assets to liabilities
of not less than 100%) to ensure that debts can be paid
as they fall due, but not an excessive rate to suggest that
funds are inefficiently used
 A level of debt commensurate with the business risk
taken
 High efficiency as a result of maximizing sales from the
business’s investments
 A satisfactory return on the investment made by
shareholders

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 27
Interpreting Ratios
 Profitability
 Increased profits
 Reducing costs
 Maintain profits while reducing assets and
repaying debt
 Sales growth may result in a higher profit but
not necessarily in a higher rate of profit as a
percentage of sales
 Improved rate of gross profit may be the result
of higher selling prices, lower cost of sales or
changes in product mix
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 28
Interpreting Ratios
 Liquidity
 Improvements are the result of changing the
balance between current assets and current
liabilities
 May be improved by long-term borrowing
 Repaying long-term debt will reduce liquidity

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 29
Interpreting Ratios
 Leveraging
 Affected by more shares being issued, new
borrowings or repayment of debt
 Higher profits or lower debt will improve
interest cover
 Activity/efficiency
 Improved due to increase in sales or
reduction in assets. Efficient collection of
debtors and management of inventory.

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 30
Interpreting Ratios
 Shareholder return
 Paying higher dividends may lead to
borrowings for capital investment, but lower
dividends are not favoured by investors
 Share price is a result of market expectations
about the company’s future
 An increase in the number of shares will also
affect these ratios.

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 31
Alternative Theoretical
Perspectives on Financial Reports
 Intellectual capital
 ‘the hidden dynamic factors that underlie the visible
company’ Edvinsson & Malone
 human (developing and leveraging individual knowledge and
skills)
 organizational (internal structures, systems and procedures)
 customer (loyalty, brand, image, etc.)
 Institutional theory
 ‘Organizations compete not just for resources and
customers, but for political power and institutional legitimacy,
for social as well as economic fitness’ DiMaggio & Powell
 Legitimation
 Isomorphism
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 32
Corporate Social and
Environmental Reporting
 Stakeholder theory
 Impact of organizations on society
 Managers see themselves as agents of
owners with primary duty of directors being to
shareholders
 Sustainability

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 33
Corporate Social and
Environmental Reporting
Corporate social accounting and socially responsible
accounting
1. A moral imperative that business organizations were
insufficiently aware of the social consequences of their activities.
2. External pressure from government and pressure groups, and
the demand by some institutional investors for ethical investments.
This was linked to the role of accounting in demonstrating how well
organizations were fulfilling their social contract , the implied
contract between an organization and society.
3. Change taking place within organizations as a result of such
factors as education and professionalization.

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© 2013 John Wiley & Sons, Ltd, Accounting for
Managers, 1Ce, Ch 5
Sustainability and the “Triple
Bottom Line”
 Sustainability
 Meeting the needs of the present without
compromising the ability of future generations to
meet their own needs (e.g. global warming)
 Triple Bottom Line
 describes new types of markets and innovative
business approaches that are needed to achieve
success
 Economic
 Environmental
 Social
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 35
Global Reporting Initiative (GRI)
 Voluntary standards for reporting on
economic, environmental, social, and
governance dimensions of their activities,
products, and services
 Describe factors about the health of the
business and its stakeholder relationships
 How the business impacts on society
 Measures of performance not just
management process

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 36
Conclusion
 Annual Report
 Management’s Discussion and Analysis (MD&A)
 Use of ratios (profitability, liquidity, leveraging,
activity/efficiency, and shareholder return) to
interpret financial information
 Intellectual capital and institutional theory
 Corporate social and environmental reporting

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 5 37