Chapter 7
Interpreting Financial Statements
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
1
Overview
•
•
•
•
Annual Reports
Ratio analysis
Interpreting financial statements
Alternative theoretical perspectives
– Intellectual capital
– Institutional theory
• Corporate social and environmental reporting
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
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The Annual Report
• The chairman’s, directors’ and/or chief financial
officer’s report
• Operating and Financial Review (OFR)
• Statutory reports by directors and auditors:
summary of financial performance, major
policies, strategies and activities, details about
the board of directors, and statements about
corporate governance and internal control and
the responsibility of the board for the financial
statements
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The Annual Report
• Auditors report
– an opinion as to whether the financial statements
give a true and fair view and are compliant with
the Companies Act and IFRS
• Financial statements
• Notes to the financial statements
• 5 year Summary of key financial information
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Context of financial statements
• Annual Report and company website as ‘public
relations’
• Library databases (eg Factiva)
• Industry publications, trade associations and
exhibitions
• Market research, consulting firms, stock market
analysts
• Personal experience
 What is happening in the company’s market? Is
customer demand changing? What technological and
regulatory changes are affecting it? Who are the major
competitors?
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Accounting for Managers, 4th edition,
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Ratios
• Two numbers, with one expressed as a ratio
(or percentage) to the other,
– from Income Statement, and/or Statement of
Financial Position
•
•
•
•
Trend over time
Benchmarking to industry, competitors etc.
Comparison to target or expectation
Note: different definitions of ratios exist – it is
essential to be consistent
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Ratio analysis
• Profitability
• Liquidity, i.e. cash flow
• Gearing, i.e. the proportion
of borrowings to
shareholders investment
• Efficiency of use of assets
• Shareholder returns
 Trends
 Benchmarking
 increasing rates of profit on
shareholders’ funds, capital
and sales
 adequate liquidity to ensure
debts can be paid, but not
such that funds are
inefficiently used
 debt commensurate with
the business risk taken
 efficiency through using
investments to maximise
sales
 a satisfactory return on the
investment made by
shareholders
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
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Ratios
• Profitability
– Return on
(shareholders’)
investment (ROI)
– Return on capital
employed (ROCE)
– Operating profit/sales
– Gross profit/sales
– Overhead/sales
• Liquidity
– Working capital
– Acid test (or quick ratio)
• Gearing
– Gearing ratio
– Interest cover
 Risk/ return relationship
• Activity/efficiency
– Asset turnover
– Debtors, creditors &
stock
• Shareholder return
– Dividends and earnings
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Income Statement
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Statement of Financial Position
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Profitability ratios (x 100 for %)
ROI:
Net profit after tax
Shareholders’ funds
70
= 7%
1000
Operating profit/sales:
Profit before interest & tax
Sales
100
= 5%
2000
ROCE:
Profit before interest & tax
S’holders funds + LT Debt
100
= 7.7%
1000 + 300
Gross profit/sales:
Gross profit
Sales
500
2000
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
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= 25%
11
Profitability ratios
Overhead/sales:
Overhead
Sales
400
= 20%
2000
Sales growth:
Gross profit
Sales
2000-1800 =
2000
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11.1%
12
Liquidity ratios (x 100 for %)
Working capital:
Current assets
Current liabilities
50
350
= 143%
Acid test (quick):
Current assets – inventory
Current liabilities
500 – 200
350
= 86%
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
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Gearing ratios
Gearing:
LT Debt
S’holders’ funds + LT Debt
300
1000 + 300
= 23.1%
Interest cover:
Profit before interest & tax
Interest payable
100
16
= 6.25 times
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Risk & return
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Activity/efficiency ratios
Asset turnover:
Sales
Total assets
2000
1150 + 500
= 121%
© 2012 John Wiley & Sons, Ltd,
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Working capital
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Managing working capital
• Managing receivables through effective credit
approval, invoicing and collection activity;
• Managing inventory through effective ordering,
storage and identification of stock;
• Managing payables by negotiation of trade terms
and through taking advantage of settlement
discounts; and
• Managing cash by effective forecasting, shortterm borrowing and/or investment of surplus
cash where possible.
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Managing Receivables & Inventory
Days’ sales outstanding (DSO):
Sales £2 million
Debtors £300,000
Average daily sales:
£2 million/365 = £5,479
DSO:
Debtors
Average daily sales
= £300,000/£5,479 = 54.75
Stock Turns:
Cost of sales £1.5 million
Inventory £200,000
Turns = Cost of sales (CoGS)/Invent.
= £1,500,000/200,000 = 7.5 Turns
per year, or every 49 Days in Inv.
DiI = 365/7.5. Note also that
Inventory = CoGS/Turns, where
Turns ≡ Days in Year/DiI or DiY/DiI
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Accounting for Managers, 4th edition,
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Managing Payables
Days’ purchases outstanding
(DPO):
Cost of Sales £1.5 million
Payables £300,000
Average daily purchases:
£1.5 million/365 = £4,110
DPO:
Payables
Average daily purchases
= £300,000/£4,110 = 73
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Accounting for Managers, 4th edition,
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Effect on ratios of changes in working
capital
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Shareholder return ratios – 1
Dividend per share:
Dividend paid
No. of shares
30,000 = £0.30
100,000
Dividend payout ratio:
Dividends paid
Profit after tax
30,000 = 43%
70,000
Dividend yield:
Dividends per share
Market value per share
0.30
= 12%
2.50
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Accounting for Managers, 4th edition,
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Shareholder return ratios – 2
Earnings per share:
Profit after tax
No. of shares
70,000
100,000
= £0.70
Price/Earnings (P/E):
Market value per share
Earnings per share
2.50
0.70
= 3.57 times
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
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© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
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The ideal ratios?
• Increasing rates of profit on shareholders’ funds, capital
employed and sales, and sales growth;
• 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;
• Level of debt commensurate with the business risk taken;
• High efficiency as a result of maximizing sales from the
business’s investments in assets (non-current & current);
• A satisfactory return on the investment made by
shareholders.
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
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Interpreting ratios - 1
•
•
•
•
Trend over time
Comparison to benchmark
Comparison to target or expectation
Both the numerator and denominator affect
the ratio
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Accounting for Managers, 4th edition,
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Interpreting ratios - 2
• Profitability
– Increased profits (more sales, higher margins,
lower costs) or lower capital
– Higher profit (in £s) is not the same as a higher
rate of profit (the % to sales)
– Improved rate of gross profit may be the result of
higher selling prices, lower cost of sales or
changes in product mix (or any combination of
these)
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
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Interpreting ratios - 3
• 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
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
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Interpreting ratios - 4
• Gearing
– Affected by more shares being issued, new
borrowings or repayment of debt
– Higher profits will improve interest cover
• Activity/efficiency
– Improved due to increase in sales or reduction in
assets. Efficient collection of debtors and
management of inventory.
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
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Interpreting ratios - 5
• Shareholder returns
– 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.
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Accounting for Managers, 4th edition,
9781119979678
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Using the Statement of Cash Flows
• To help inform the interpretation of ratios
– Changes in profitability, affected by changes in working
capital, are revealed in the operating cash flow
– Cash flow from investing would show the purchase of new
non-current assets or business acquisitions (including
goodwill), and proceeds of sale of any surplus non-current
assets
– Cash flow from financing would reveal borrowings or
repayments of debt, equity raised from shareholders or
payments for share buybacks, as well as the payment of
dividends
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Accounting for Managers, 4th edition,
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Limitations of ratio analysis
• Financial Statements
– contain estimates involving subjectivity and there is
discretion in how accounting principles and standards are
applied
– are backwards looking, showing historical costs without
recognising inflation
• The ratios should be interpreted along with
economic, industry and competitive conditions, and
the company’s unique situation
• Ratios can only be interpreted based on trends,
benchmarks and targets
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
32
Alternative theoretical perspectives on
financial statements
• Intellectual capital
• Institutional theory
– ‘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); and
– customer (loyalty, brand,
image, etc.).
– ‘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
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
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Corporate Social Responsibility (CSR)
• Stakeholders or shareholders?
• Sustainability: economic, social,
environmental (‘triple bottom line’)
• Global Reporting Initiative
– economic, environment, human rights, labour,
product responsibility and society
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
34
Key points
• Reading Annual Reports and understanding the
broader business context
• Using ratio analysis to interpret financial
statements
• Using the Statement of Cash Flows
• Managing working capital
• Alternative theoretical perspectives: Intellectual
capital & Institutional theory
• Corporate social and environmental reporting
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
35