COMM1140: Financial Accounting/Management Financial Management is the process of planning, organising, controlling and monitoring financial resources with a view to achieve organisational goals and objectives. The primary objective of financial management is to maximise shareholder value through appropriate resources utilisation and decision making. Chapter 1: Introduction to financial accounting 1.1 Use and preparation of accounting • Financial accounting can be used by managers, investors, banker, financial analyst, etc. • Accounting is used for producing annual or monthly performance report. 1.2 Financial accounting • Accounting: is the process of identifying, measuring and communicating economic information to assist users to make decisions. • Accounting systems are often described as either: - Financial Accounting Systems: where periodic financial statements are provided to external decision-makers e.g., investors, creditors and customers. - Management Accounting System: Including information for planning and performance reports to mangers throughout the organisation; that is, internal decision-makers • Important definitions: - Financial Accounting measures a firm’s performance over time and their position at a point in time. - Financial Performance is the generation of new resources from day-to-day operations over a period of time. - Financial Position is the organisation’s set of financial resources and obligations at a point in time - Financial statements are the reports describing financial performance and financial position (e.g. balance sheet and income statement) - Notes are part of the statements, adding explanations to the numbers. • Good performance will lead to a healthy financial position - Company makes profità puts profit into resources - Healthy financial position à company can undertake activities à good performance • Management accounting helps more the managers and others in the firm. Overall, financial accounting and financial accounting exist to help internal and external personnel to make financial decisions. Internal= in the company External= outside the company 1.3 Who uses financial accounting information? Financial accounting helps internal and external users: - Stock market investors decide whether or not to lend - Banks and other lenders decide whether to buy, sell or hold shares of company - Managers run organisations on behalf of owners, members or citizen - Management by providing basic financial records for the purpose of day-today management, control, insurance and fraud prevention - Governments in monitoring the actions of organisations and in assessing taxes, such as income tax and the goods and service tax (GST) Possible users of the financial statements of a listed company are: - A company’s board of directors which managers the company on behalf of its shareholders. - Financial analyst for an investment banker must prepare reports on future earning and make recommending to buy or sell company shares. - A commercial Lending Officer needs to conduct regular reviews on company borrowing status. They must consider the company’s financial performance and position in order to approve the loan. - Sales manager of a supplier will need financial statements before signing contracts with distributors - Management and Unions need financial statements to see of companies can increase wages for workers 1.4 The people involved in financial accounting The main participants in the art of financial accounting are: • The information users (the decision-makers) • The information preparers, who put together the information together • The Auditors, who assist the users by enhancing the credibility’s of information Users(decision-makers) Users are people who make decisions based on the financial statements on behalf of the company. A user’s main demand is for the credible periodic reporting of an organisation’s financial position and performance: • Owners are individual business owners, e.g. proprietors, partners and other entrepreneurs, investors, etc • Potential owners are people who do not have a present funds invested but may be considered making an investment. • • • • • • • • • Creditors and Potential creditors are suppliers, banks, bondholders and others who have lent money to the organisation. Managers are those who run the organisation on behalf of the owner and need accounting reports for planning, controlling and organising activities. Employees and their union are interested in the organisations ability to pay wages, maintain employment level and give job security. Regulators and government bodies may use financial statements to evaluate whether the organisation is following various rules and agreements Financial and market analysts are people who study company’s performance in order to make recommendations about whether to invest in shares. Competitors may use financial statements to have a better understanding of their competitors operations and improve their own. Accounting researchers are people study and seek to improve accounting within firms. Customers may need financial statements to ensure security in the company. Miscellaneous 3rd party are people who may get access to an organisations financial statement and use the, in various ways. E.g. politicians, journalists. Etc Preparers (Decision Facilitators) Two main groups are responsible for the information in the financial statements: • Managers are responsible for running the firm and hence the accounting and controlling its financial affairs. • Accountants have the job of shaping the financial statement by applying the principles of accounting to the records. Auditors (credibility enhancers) Auditors report on the credibility and fairness of the financial statements on behalf of the owners and others. • There are external and internal auditors however firms often hire external auditors in order to keep a level of credibility. • External auditors cannot be a manager or an owner of the company. People and Ethics Ethical issues can arise in any area of accounting and can result in a lawsuit. 1.5 Accrual accounting Accrual Accounting includes the impact of transactions on the financial statement in the time period where revenue and expenses occur rather than when the cash is received or paid. • • Due to the modern-day using credit cards, etc, it takes a few days for the cash to appear in the bank and hence accrual accounting is preferred. Expenses include the cost of services and resources consumed in the process of generating revenue. - Wages, electricity, travel, rent, depreciation à depreciating is the decline in value an asset has over time. Accrual Accounting vs Cash accounting Cash Accounting only accounts for revenue and expense which cash is paid or received. Benefits of Accrual Accounting • It includes all assets and liabilities in the balance sheet to give a truer picture of the financial position • It includes all revenues and expenses regardless of whether cash has yet been received • Depreciation is included in accrual accounting, giving it a more accurate financial position Using Accrual Accounting to prepare financial statements In using accrual accounting it attempts to: • Include all cash receipts and payments that have already happened e.g. cash sales • Include future cash receipts • Measure the vale of incomplete transitions • Estimate figures when exact amounts are unknown • Make an economically meaningful overall assessment of problems • Estimate the consumption of an asset over time (depreciation) 1.6 The key financial statements Organisations are required to provide the following types of information which show: - financial position - financial performance - financial activities and investing activities. They must prepare: • Balance sheet à Financial Position • Income statement à Financial Performance • Cash flow statement • Notes Balance Sheet Balance Sheet shows an organisation’s resources (Assets) and claims on resources (liabilities & equity) at a particular point in time • The 3 main points is Assets, Liabilities and Shareholder’s Equity. π΄π π ππ‘π = πΏπππππππ‘πππ + πΈππ’ππ‘π¦ Assets • Are the current economic benefits that the organisation control and own from past transactions. They include: - Cash at bank accounts recorded deposits to and withdrawals from a bank Accounts receivable (also called debtors) represents amounts owing from customers for G+S Inventory generally Property, plant and equipment à land, buildings, vehicles, computer, furniture Liabilities • Are the future sacrifices of economic benefits that need to be made to others. They can be: - Loans, mortgages or amounts due to suppliers - Wages payable which is form worked done by employees, but they have not been paid. - Accounts Payable (often called trade creditors) is the amount owed to various suppliers for G+S - Provisions for Employee entitlements refers to things like holiday leave, sick leave, superannuation, etc Shareholders’ Equity • Is the excess of assets over liabilities. This includes - Share capital is the amount that owners have directly invested in the company - Retained profits represents the total profits that the company has retained in the business (not dividends) Income Statement (Profit and Loss Statement) Income Statement provides information on an organisations business operation to generate revenue over a period of time. It matches revenue earned and expenses incurred • If revenue is greater than expenses = net profit • If expense is greater than profit = net loss Cash Flow Statement Cash flow statement looks at all the inflow and outflow of cash over a period of time. It is usually split into 3 categories: • Operating Activities: Related to the provision of G+S • Investing activities: Related to the acquisition and disposal of certain noncurrent assets, including property, plant and equipment • Financing activities: relation to changing the size and composition of the financial structural of the entity, including equity and certain borrowings Note: consolidated financial statement Notes shows how an organisation is doing as a group and consolidate its accounts to provide a more accurate and fairer financial system. Financial statements that fact the holding company (parent company) subsidiaries into its aggregated accounting figure. • A subsider is a company controlled by parent company which has the power to govern the financial and operating policies. Relationships of the statements look at retained profits - Net profit increase retained profits 1.7 Demands on the quality of financial accounting information The statements need to be informative and fair 1.8 Financial statement assumptions The following concepts underline the practice and preparation of financial statements: • Accrual basis: Financial reports are prepared on the accrual bases of accounting • Going Concern: Statements are prepared on the premise that the company will continue operating • Accounting Entity: The company is a separate entity from its owners • Accounting Period: Life of a business needs to be divided into discrete periods to be evaluated • Monetary: accounting transactions need to be measure in 1 currency (usually the national currency) • Historical Cost: 1.9 Is accounting really important? Look back at who uses the statements. Chapter 2: Measuring and evaluating financial position and financial performance 2.1 Introduction to the balance sheet The Balance sheet (also known as the statement of financial position) shows a company’s financial position at a point in time. It includes: • Assets: cash, accounts receivable, inventory, equipment, land, buildings, etc • Liabilities: loans, wages, holiday leave, etc Current: 12 months and less • Equity: share capital, equity Non-Current: more than 12months 2.2 explanations of the three balance sheet categories: Assets, Liabilities and equity Assets Assets are resources controlled by the entity as a result of past events and from which future economic benefits are expected to accumulate to the entity. There is 3 characteristics: • Future economic benefit because assets are used to provide G+S in exchange for generating cash. • Controlled by the entity refers to an entity’s ability to control its assets in pursuing its objectives and regulating its access to others. • Occurrence of past transactions or other past events refers to transactions giving the entity control over the further economic benefits which have occurred. Liabilities Liabilities are present obligations which arise from past events which will be paid in an outflow of resources (assets). There is 2 characteristics: • Present obligation that involves a settlement in the future via a sacrifice of assets. • It must have adverse financial consequence for the entity, in that the entity is obliged to sacrifice economic benefits. Contingent Liabilities: refers to when a company doesn’t know whether or not they will take the liabilities E.g. Lawsuit Equity Equity is the owner’s interest in the organisation • Equity can be derived from the contributions the owners have made or accumulated from the profits which they have not claimed yet. (dividends) • Retained Profits: Represents past accrual profit which have not been distributed yet as dividends. • Share Capital: refers to money received from the distribution of shares. 2.3 Some preliminary analysis of the sound and light balance sheet • Debt to equity ratio = liabilities + equity • Current Ratio = current assets + Current liabilities • Quick ratio = (Current Assets – Inventory) + Current liabilities 2.4 A closer look at the balance sheet • It is a comparative BS: It shows last years and the current years. • CHEZ also has additional assets: à Investments (Short-term): could be shares which will be converted into cash in a year à Prepayments: refers to payments which were paid in advance but the benefit has not yet been received. à The property, plant and equipment: will be recorded as net due to depreciation Intangible assets: are non-current assets that have no physical substance e.g. copyrights, licences, trademarks, etc. • Chez includes additional liabilities: à Accrued expenses: which are expenses which have accrued over the year and have not been paid for yet à Provision or employees refers to holiday play, long-service leave, etc. 2.5 Maintaining the accounting equation • Financial accounting uses the double entry system, whereby if an asset goes up, a liability or equity would also go up, keeping it balance. • The amount could also go up and then go down in the same section. E.g. if a company buy $100,000 worth of inventory. Cash would go down, but inventory would go up. 2.6 Managers and balance sheet • Managers are in charge of putting the Balance Sheet together, which will show the firm’s financial position. • If a company has good financial position, it would be reflected in the retained profits as that is the net profit which wud be further distributed at a later date. 2.7 the Income Statement The income statements uses accrual accounting to describe the financial performance of company over a period of time. Net profit = revenue – expenses Revenues Revenues are increases in the company’s wealth from provisions of G+S • Cash payments • Credit payments • Payment in other form of wealth such as assets (forgiving debt) • If a company receives a dividend(investor) it would go in revenue Expenses Expenses are the decrease in a company’s wealth from generating revenue. • Includes COGS • Bills. Etc • Tax Profit Net profit is revenue – expense and all profits would go towards the shareholder. However, there was also be a net loss. The relationship of profit for the period to retained profits • Retained profits is the accumulation of the net profit minus the dividends declared. • An increase in net profit with increase retained profit and vice versa. 2.8 Connecting balance sheet and income statement The balance sheet shows all assets, liabilities and equity at a point in time and should show both the income statements at the beginning and end of period. • Revenue increase wealth à assets would increase and liabilities decrease and equity increases • Expense decreases wealth à decrease assets, increase liabilities ad decrease equity • A Net profit would increase assets, decrease liabilities and increase equity • A Net loss would decrease assets, increase liabilities and decrease equity. 2.9 A closer look at the income statement 2.10 Capital markets, managers and performance evaluation The net profit impacts on a great deal on the managers salaries, promotions, etc. It also depict the company’s shares and how it performed during the period of time Chapter 3: The double entry system 3.1 Transaction Analysis • Transactional analysis looks at understanding how any transaction o event affects a company’s financial statement. • Remember: π΄π π ππ‘π = πΏπππππππ‘πππ + πβπππβπππππ ! π πππ’ππ‘π¦ • After each transaction, the total assets mush equal total liabilities and equity. 3.2 transaction analysis extended Going one step further, we will expand the (RHS) liabilities and equity. • We start with the basic: Assets = liabilities + shareholder’s equity • Shareholder’s equity = share capital + retained profits Assets = Liabilities + share capital + retained profits • Retained profits = opening retained profits + net Profit – dividends Assets = Liabilities + Share Capital + opening retained profits + net profit dividends • Net profit = revenue – expense Assets = Liabilities + Share Capital + opening Retained Profits + revenue – Expenses – Dividends Reinforcing the relationship between 3 principal Financial Statements 3.3. Recording transactions; double-entry bookkeeping Double entry bookkeeping is when a transaction is recorded twice to ensure the balance sheet balances. • If an asset increase: - a liability of equity also increases - Another asset decreases Journal Entries Journal entries uses Debit (DR) and Credit (CR) instead of increase and decrease. • Increases: à Assets = liabilities + equity à Debits = Credits - Hence, increase in assets = Debit assets - Increase in Liabilities+ equity = Credit liabilities and equity • Decreases: à Assets = Liabilities + equity à Credits = Debits - Decrease in Assets = Credit assets - Decrease in liabilities and equity = debit liabilities and equity • • • For every transaction there will be a credit entry and a debit entry to balance it off Accounting’s way of recording transaction is called and entry’ and it follows the double entry system. The entries are transferred and summarised in accounts which is written as a numerical balance as a debit or credit. All accounts collected together gives us a ledge. 3.4 More about accounts Accounts is a record of the dollar amounts comprising a particular assets, liability, equity, revenue or expense. • The net effect of these accounts is a debit or credit and Is called the account balance. 3.5 More examples of how debits and credits work Look at textbook pg. 93 3.6 Debits and credits extended (looking at Revenue, Expense, Dividends, depreciation) • When looking at revenue and expense, remember that an increase in equity is a Credit and a decrease in shareholders equity is a debit. Revenues and Expenses • An increase in revenue à increases net profit à increases in retained profit à increase equity. - Hence increase in revenue = Credit revenue • An increase in expense à decreases net profit à decreases retained profit à decreases equity - Hence increase in expense = Debit expense Dividends and share issues • Declaring dividends à retained profits decrease à therefore it is a debit à however dividends is a distribution of retained profits not an expense. - Hence declaring dividends = Debit dividends declared • Issued share à increases share capital à increase in shareholder equity - Hence issued share = Credit share capital 3.7 Arranging accounts on the balance sheet Arranging accounts in the balance sheet tells other which categories these resources belong to: Current or non-current Bank Overdrafts It is when banks allow company’s to take out money from the bank even if they have $0 funds, hence giving them a loan. - It is a current liability 3.8 More journal entries Accumulated depreciation belongs in the non-current assets account and will be a credit (since it is a decrease). You record the amount lost Chapter 4: Record Keeping - Skip Chapter 5: Accrual Accounting Adjustments 5.1 Conceptual foundation of accrual accounting Accrual accounting is based on events, estimates and judgements that are important to the measurements of financial performance and position should be recognised by entries in the accounts regardless of whether or not they are yet to be or already have been realised by cash received or paid out. The objective is to recognise economic flows and cash flows à focus on revenue an expense recognition. • Revenue are inflows of economic resources from customers, earned through providing G+S (Earned revenue) • Expense are outflows of economic resources from business activities to generate revenue and serve customers. Any incurring expense if the cost of earning revenues. • Net Profit is the difference between revenues and expenses over a period of time. A conceptual system for accrual profit measurements Accrual accounting’s purposes to extend the measurement of financial performance and financial position by recognising phenomena before and affect cash flow. • We need to first recognise: - Revenue or expense at the same time as cash flow or outflow - Revenue or expense before cash inflow or outflow - Revenue or expense after cash inflow or outflow 5.2 Accrual Accounting Adjustments In order to implement accrual accounting system, some adjustments are required when revenues earned but not yet collected, expenses incurred but not yet paid, cash received from customer before related revenue has been earned and consumption of assets. • There are 4 main routine adjustments: - Prepayments - Unearned revenues - Accrual of unrecorded expenses - Accrual of unrecorded revenues Prepayments Prepayments are assets that arise because an expenditure has been made, but there is still value extending into the future. Firms/ individuals pay ahead • Usually are current assets (sometimes can be non-current) • It is NOT receivables (to be collected in cash) or inventory (to be sold for cash) • As the firm/customer is receiving the G+S the prepayment would go from an asset to an expense. • As customer/firm received G+S you would record the loss of asset and the gain of expense as the journal entry. Unearned revenues Unearned revenue refers to when cash has been received in advance but the G+S has not been provided. • Usually are current liabilities (can be non-current) • When receiving an unearned revenue, you would increase the cash and then put unearned revenue as a liability • When the customer is provided the G+S the unearned revenue goes down and sales revenue increases. Accrual of unrecorded expenses Accrued expenses are expenses that have been incurred during the current period but will not be paid until the following period. E.g. wages • Will be in liabilities • When an accrued expense has been paid it reduced the accrued expense (payable) and would increase in expenses. Accrual of unrecorded revenues Accrual of unrecorded revenues occurs when a service has been provided but cash will not be received until the following period (delay in payment) e.g. interest • Usually, a current asset • When incurring an accrual revenue, you would note it as an accrual revenue in current assets as well as an interest revenue (increase) 5.3 Multi – Column worksheets Multi-column worksheets are useful devices in preparing financial statements where there are many adjusting entries 5.4 The financial Period Financial statements all have a time dimension and balance sheets are prepared as at specific points in time and income statements cover specific period of time. 5.5 Contra Accounts Most balance sheets accounts can be considered to be a control account, meaning that the amount in the should be supported by, or reconcilable to lists or subsidiary ledgers, or some background data. • Controlled accounts refer to that the amount in the account should be traceable from somewhere else. A Contra Account allows us to recognise expenses and related values changed to assets without changing the control accounts. • It provides a bridge between accounting’s role in the internal control and in financial statement preparation. Accumulated depreciation Contra accounts are used to accumulate deprecation on fixed assets. E.g. building and equipment. • Usually accumulated depreciation would be a debit in the expense account and a credit in the contra asset account as accumulated depreciation. • E.g. equipment cost $500,000 and has a life of 5 rs, the annual depreciation is $100,000 5.6 Illustrative example Look at textbook pg198 à there is some practise. 5.7 Managers and accrual accounting assumptions Manager’s point of view on accrual accounting has several important implications: • It is a more inclusive way of measuring performance and position • Accrual accounting allows to show the attractiveness of the financial position, allowing to show off the manager’s position. Earnings management Earnings management is the use of accounting techniques to produce financial statements that present an overly positive view of a company’s business activities and financial position. • The financial statement can be manipulated and give an inaccurate picture of a company’s financial performance/financial position • Earning management happens when managers take advantage of how accounting rules are applied and create financial statements that “inflate” of “smooth” earnings (revenue or probability) • Hence when producing a financial statement, it must use the Framework Framework • The framework sets out the concepts that underline the preparation of financial reports for external users • The Framework includes: - Objective of financial reports - Assumptions underlying financial reports - Qualitative characteristics of financial information - Definition of elements of financial statements - Recognition and measurement of those elements Common approaches to manage earnings: • Improper recognition of revenue • Recording fictitious revenue • Channel stuffing • Improper management Estimates • Improper capitalization of expense • Improper expense recognition Motivations to manage earnings (revenue & profitability) • Market pressure to meet financial expectations • Bonus dependent on certain revenue or profitability • Stock options increases when profitability increases • Senior management pressuring individual manager to improve performance • Culture of company demand ‘high-growth’ Chapter 6: Financial reporting principles, accounting standards and auditing 6.1 Accounting regulation in Australia Credible financial reports is hard to achieve and hence governments implemented an effective regulations which accounting rules are based on. • The Corporate Law Economic Reform Program Act 1999 which came into effect on 1 January 2000 modifies the setting of accounting standards in Australia Australian securities and investments commission (ASIC) The Australian securities and investments commission (ASIC): is in charge with administrating and enforcing the corporations act 2001. It looks at: • Promoting honest and fairness in financial markets, products and services. • Monitors firms accounting standards and takes action when necessary • Oversight of the audit function, including registering auditor and enforcing auditor independence. ASIC regulated Australian companies, financial markets, financial service organisation and professionals who deal and advise in investments, superannuation, insurance, deposit-taking and credit. Its roles include: • The Consumer Credit Regulator: ASIC licenses and regulates how firms and consumers engage in consumer credit activities • The Market regulator: ASIC sees how effectively authorised financial markets are following regulations • The Financial service regulator: ASIC monitors financial services and make sure they operate efficiently, honestly and fairly Financial Reporting Council (FRC) The FRC is responsible for broadly overseeing the accounting and auditing standard-setting process in the private and public sectors • One of the key functions of the FRC is that they oversee the operation of the Australian Accounting Standards Board (AASB) • It also oversees the Auditing and Assurance Standards Board (AUASB) Australian Accounting Standards Board (AABS) The AASB Prepare, approves and issues accounting standards for the purpose of the Corporation act 2001 and for the public and non-profit sectors. Auditing and Assurance Standards Board (AUASB) AUASB is responsible for the development and maintained of auditing and assurance standards. 6.2 International financial reporting standards With more businesses outsources and entering foreign markets, the issue of adopting a single set of global accounting standards is a working progress. The benefit of adopting a single set of standards will be that it enables capital providers to assess and compare intercompany performance in a much more meaningful, effective and efficient way. 6.3 The importance of accounting standards and principles Read textbook for case study/examples 6.4 Accounting principles and the use of accounting information The accounting principles at as a structure to practise accounting and varies between entity’s • Accountants prepare the financial statements; auditors verify them and users interpret them • An accountings conceptual structure is the ‘general accepted accounting principle’ (GAAP)à these are rules, standards and usual practises that firms need to follow when preparing financial statements 6.5 Framework for the preparation and presentation of financial statements The framework issued by AASB sets out the concepts in preparing financial reports, including: • The objectives of financial reports • The assumptions underlying financial reports • The qualitative characteristics that determine the usefulness of financial reports • The definition of the elements from which financial reports are constructed: assets, liabilities, equity, income and expense • Recognition and measurement of the elements of financial statements The Objective of financial reports The objective of financial reports is to provide information about the financial position, financial performance and cash flows that is useful to user in making economic decisions. Elements of Financial Statements The key elements are: • Financial position à Assets, liabilities and equity • Financial performance à Income and expense Assets • Assets are resources controlled by the firm as a result from past events, and from which future economic benefits are expected to flow to the entity Asset recognition • Recognising the asset refers to the reporting of an item on the financial statements. • An asset should be recognised only when: - It is probably that it can gain future economic benefits’ - The cost of the item can be measured with reliability Liabilities • A liability is a present obligation of the entity arising from past events, the settlement of which is from an outflow of resources Liability recognition • There are 2 essential criteria in recognising a liability: - a sacrifice of economic benefits’ with an either in or outflow from the business • The item has a cost or value that can be measured reliably Equity • Equity is defined in the framework as the residual interest in the assets of an entity after deduction of its liabilities. Income • Income is defined in the Framework as an increase in economic benefits during the accounting period Expense • Expense is defined in the Framework as a decrease in economic benefits during the accounting period Measurement of the elements of financial statements The framework defines measurements as the process of determining the monetary amounts that the elements of the financial statements are to be recognised. • The framework sets out different measures bases: - History Cost: Assets/liabilities are recorded at the cash amount or equivalent, given that they are acquired at the time of their acquisition - Current Cost: Assets/liabilities are carried at the amount of cash or equivalent if it was acquired currently - Realisable (settlement) value: Assets/Liabilities are carried out at the amount of cash or equivalent that could currently be obtained by selling the asset in an orderly disposal. - Present Value: Assets/liabilities are carried at the present discounted value of the future net cash inflows. 6.6 Assets and Liabilities: Valuation and measurement There are 5 basic methods suggested for measuring(valuing) assets and Liabilities: • Historical Cost • Price-level-adjusted historical cost • Current or market value • Value in use (present value) • Liquidation value Historical Cost Historical cost (acquisition cost) values assets/liabilities at the amount paid or promised to be paid. • The ability to document the cost of an asset is the main reason why historical cost is the usual valuation method • Firms also rarely purchase assets or incur liabilities that are more than they are worth and hence uses historical cost • At the point of acquisition, historical cost = market value = value in use (present value) • Historical cost doesn’t include depreciation in assets and has criticism surrounding that Price-Level-adjusted historical cost This approach adjusts for changes in the value of purchasing power of the dollar rather than changes in the values of assets. • Looks as the comsumer index and inflation Current or Market Value (Value in exchange) This approach records the individual assets and liabilities at their current value and not the dollar itself. • It assumes that value is market-determined and that profit should be measured using changes over time in market value (depreciation) • Current value accounting can use input or output values: - Input market value (entry value) refers to the amount the asset cost to bring inot the firm - Output market value (exist value) refers to the amount an asset is worth if it was sold - Fair value is similar to market value except is does not require a market to exist. It is a hypothetical value which both parties agree on Value in use (present value) This approach considers that value flows from the way the company will use the asset to generate future cash flows • Value in use estimated by calculating the net present value of future cash inflows expected to be generated by assets or cash outflows expected • Present value is the future cash inflows minus lost future interest implied by waiting for the cash. Liquidation value Liquidation value is the output market value when a firm is going out of business. It is the value of when the business collects all its assets and turns it into cash to settle debts and sell out. 6.7 The Annual Report and Financial Statement • Accounting standards are require a complete set of financial statements with 5 components: A statement of financial position at the end of the period (balance sheet) • A statement of profit or loss and other comprehensive income (income statements) • A statement of changes In equity for the period • A statement of cash flows for the period • Notes to the financial statements, comprising a summary of significant accounting policies and other explanatory information Public companies and other firms include their set of financial statements in a much larger annual report, and contains: • Summary data on company performance • A letter to shareholders which highlights performance and future plans • An often-extensive chief executive officers report which describes economic and financial standpoint • For listed companies, a corporate government statement which include composition and membership of the board of directors • The financial statements • A director statements • An independent audit reports • Information on shareholders • Sustainability report • other voluntary information-à graphs, etc Full vs concise financial reports • Full set contains balance sheet, income statement, statement of change in equity, cash flow statement, notes to the financial statement, auditors report and board of directors’ declaration. • The concise statement are sent to all shareholder and only has relevant information for the shareholders 6.8 The External Auditor’s Report The auditor’s report is normally a routine statement by the auditors that provides an opinion on whether the financial statements present a true and fair view and are in accordance with accounting standards. • If an auditor denies the fairness of the statements, they have an adverse opinion • Assurance is an expression of a conclusion on a particular subject matter or information that is intended to increase the confidence of users • The auditor provides an opinion on whether the financial statements provide a true and fair view and whether they are in accordance with accounting standards External auditing refers to the evaluation of an organisation’s financial statements by an auditor who should be independent to the firm. The role has 2 fundamental parts: • To have an independent, unbiased and professional perspective • To render a competent opinion on whether the financial statements present a true and fair view • A typical Audit report includes: identify the company, the set if statements and their date • State that the directors are responsible for preparing the financial statement and for internal control of the firm • Include a statement that auditors are responsible • Include a statement by the auditor confirming they are independence • Include the matter that auditor’s judgment were the most significance in the audit • Present the auditors opinion that the statements are true and fair 6.9 The nature of a Profession and Professional Ethics For members of the professional accounting bodies there are ethical standards, including APES110 Code of Ethics for Professional Accountants. This code has 5 principles: • Integrity: an obligation to be straightforward and honest in relationships with firms • Objectivity: an obligation to not compromise their relationships with firms • Professional competence and due care: is the principle which: - To maintain professional knowledge and skill at the level required to ensure competent service - To act diligently in accordance with applicable technical and professional standards when providing service • Confidentiality: an obligation to refrain from: - Disclosing confidential information acquired through business relationship without proper authority from the client - Using confidential information acquired as a result of professional nd business relationships to their advantage • Professional behaviour: an obligation on accountants to comply with relevant laws and avoid actions that may discredit the accounting profession However, for professional accounting bodies (Auditors) they have various threats (independence): • Self-interest threats such as a financial interest in the client • Self-review threats such as auditing systems on report on those you are involved with • Advocacy threat such as promoting shares in a listed company when you are also the auditor of that company • Familiarity threats such as having a close relationship with director or client • Intimidation threats such as being threatened with dismissal or being pressured to reduce the extent of the work performed in order to reduce fees. 6.10 Capital Markets Summaries later 6.11 Contracts and Financial Accounting Information Look at textbook summries later 6.12 Manager and Financial Accounting standards Look at textbook and summaries later Chapter 7: Internal Control 7.1 Internal Control Internal control is the process of managing a business with conditions which increases efficiency and effectiveness of operation to reduce the risk of asset loss and help ensure reliabilities. • It is the process, effected by an entity board of directors, management and other personal, designed to provide reasonable assurance regarding the achievement of objective in the following categories: 1. effectiveness and efficiency of operations, including safeguarding assets again loss 2. Reliability of internal and external financial and non-financial reporting 3. Compliance with applicable laws and regulations • The chief executive officer (CEO) is responsible for internal control • All internal control have inherent limitations due to: - The limitations of human judgement (mistakes) - Managers can override effective internal control measures to cover up falls in profits, etc - Collusion between 2 or more individuals can prove to be ineffective • Internal control consists of the following 5 interrelate components: 1. Control environment: Incorporated all the written policies and procedures of the organisation as well as the unwritten practises. It provides discipline and structure, including integrity, ethical values, competence of employees, managements philosophy, etc 2. Risk Assessment: refers to identifying and analysing relevant risks that may adversely impact the achievement of the firms objectives 3. Control activities: refers to the polices and procedure that help ensure management directive are carried out and ensure that actions are taken to address risks to achieve the objectivises 4. Information and Communication: Information must be identified, captured and communicated to allow employees to work efficiently. Effective communication must also occur order for messages to be communicated clearly and have control implemented effectively. 5. Monitoring: internal control systems need to be monitored to assess the quality of the systems performance over time. It can be trough ongoing monitoring activities or separate evaluations or a combination of the 2. Control Activities Some examples of internal control: • Top level reviews: managers carry out reviews of actual performance which assess which objectives are achieved • Information processing: controls are used to check accuracy, completeness and correct authorisation of transactions • Separate record keeping: When handling assets have 2 different people record in different processes so that there is security • Physically protect sensitive assets: sensitive assets like cash, inventory, etc should be lock in a safe place like the bank or a safe. 7.2 Internal Control of Cash Cash is the assets that is usually most susceptible to theft because of its liquid and anonymous nature. • A common control is to have a locked-in sales register or carefully controlled records • The access key to the register is kept by 1 person who balances cash to sales records and will be recorded on tape. The person who counts the cash in the till should cross check with the sales proceeds and makes sure it all matches • However with more E-commerce and card transactions, there has been a less use in cash • Another control is to have multi-copied, prenumbers sales invoice so that t can cross checked against accounts receivable records. 7.3 Bank Reconciliations Bank reconciliations is the process based on the cash account and the bank statement which is received monthly Bank Statements vs Cash accounts Businesses and individuals receive bank statement for every bank account they maintain which details all their transactions • However due to the timing difference when bank statements are released, there could be certain items not recorded • There could also be errors between banks statements and company’s accounting records and must be corrected immediately The reconciliation process Reconciliation refers to the process which isolate items that cause a huge difference between the depositors record and the bank statement • A common reconciliation from is determining the amount of cash a company controls and the reports on its end-of-period balance sheet • If the balances don’t agree and the reconciling items are deemed correct, there is a good chance that a record-keeping error has been made • Reconciliation contain adjustments to both the ending cash balance and balance sheet as there needs to be adjusting journal entries on the statements -Cash receipts journal (CRJ) 7.4 Performing a bank Reconciliation from information in cash journals list all payments received The following steps need to be taken to complete a bank reconciliation -Cash payments journal statement: (CPJ) records all cheques 1. Go through last months reconciliation statement and tick off issued and direct payments any outstanding amounts that are on this month’s statement 2. See what remains unticked and they should be in the CRJ and CPJ (tock them after entering them in the right category) 3. Total the CPJ and CRJ and post to bank ledger 4. Prepare. Bank reconciliation statement form 7.5 Petty Cash Petty cash is another form of control for cash were a fund is established for use in making small payments, especially those that are impractical or uneconomical for cheque • A petty cash fund is made through cashing a cheque drawn from the firm’s account and then controlled by an individual known as a fund custodian Making Disbursements from the fund As payments are made from the fund, the custodian makes a from known as a petty cash voucher which shows the amount and the purpose Replenishing the fund The petty cash fund is replenished when the fund is low Errors in the petty cash fund Sometimes the errors are from the custodian and hence need to be fixed immediately as it is a shortage on cash 7.6 Disclosure of internal control in annual reports Companies which are on the ASX must now include a section in their annual report on corporate governance, and may include: • The board of directors has responsibility for the internal control system • The role of the audit committee in the evaluation of internal control is noted • Operating budgets are used to monitor performance • Internal audits are an important part of the interna control system • Controls are important in certain key areas including treasury • There are clearly defined guidelines for capital investment 7.7 Managers and Internal Control Internal control is the responsibility of management and are fundamental to the accurate recording of transactions and reliable financial reports • A system of internal control should minimise and detect errors and irregularities • No internal control system can completely eliminate all errors and irregularities due to human error • Although control measure do decrease error and irregularities it also costs a lot to manage and implement and becomes a matter of judgement on the part if management as it estimates the potential losses from errors but also adds additional costs. Chapter 14: The Statement of Cash Flows 14.1 Purpose of Cash flow analysis The performance of a firm in generating wealth through accrual profit as well as the inflows and outflows of cash, hence the cash flow looks at how much cash is available and where additional cash will come from. • Looks at how well they manage cash • Cash flow statement uses CASH ACCOUNTING The purpose of Cash flow analysis is: • To produce a measure of performance that is based on day-to-day cash flow, including the business activities, making it more accurate • It provides details on a firms cash movements • It also informs users the businesses cash position • To incorporate other non-operating cash inflows and outflows, such as investments, allowing a complete description of how the firm’s cash was managed during the period. 14.2 Overview of the statement of Cash flows Classification of cash flow transactions For firm which are profit seeking, they would divide their cash flow transaction into 3 sections: • Operating Activities: are activities that produce main revenue • Investing Activities: are activities that relate to the acquisition and disposal of noncurrent assets, including property, equipment, etc à Long term assets • Financing Activities: are activities that relate to equity capital and borrowing Format of the Statement of Cash Flows The cash flow statements has a standard format and variations may be a sign of problems Some important features of the format is: • The statement of cash flow covers the same period as the income statement • Cash includes some equivalents like, bank deposits and certificates. • The international financial reporting standards allow alternative classification on the format like including interest paid • It can also have negative bank balances (overdrafts) from management activities • The cash flow statement has rules to ensure tat it focuses on cash as it records when cash has been moved • Deriving the cash flow from day-to-day operations is one of the main reasons of having cash flow analysis. • It takes ways accrual accounting’s many adjustments to emphasises on the statement of cash flows through starting with net profit and then remove the effects of accounts receivable, accounts payable, depreciation and then accruals Direct vs Indirect method of reporting cash flow from operations Cash flow from operations can be reported using direct or indirect method. • Direct method reports gross cash inflows and gross cash outflows • The information needed for a direct method can be obtained from: - Using the accounting system, which records inflows and outflows of cash - Adjusting sales, cost of sales and other profit and loss items • The direct method provides more useful information for estimating future cash flows that the indirect method which only shows net amount of cash flows The indirect methods uses the accrual-based profit figure in order to get the cash flow: • Adjustments to remove accruals for non-cash expense/revenues from noncurrent asset (depreciation) • Adjustments to remove accruals for uncollected revenue, revenues received in advance, prepaid expenses and unpaid expense, represented by a change in non-cash working capital 14.3 Preparation using the Direct Method When using the direct method, you need to calculate cash receipts from customers, payments to suppliers and employees, and other expense/revenue. Then the cash flows from investments and financing are then calculated Cash flows from operating activities To determine the cash flows from operation using the direct methods you need to convert the accrual-based figures to a cash basis for each item. Information can be derived from income statement and balance sheet. • Receipts from customers • Interest and dividends received • Payments to suppliers and employees • Interest paid • Income tax paid Cash receipts from customers Cash receipts are not the same a sales as some account receivable will not be paid by the year-end, hence cash received from customers will be less than sales if accounts receivable increases. In order to get cash received you need to sales figure from the income statement and the open and closing balances of accounts receivable. • Think of debits and credits in the accounts receivable, sales and cash Hence accounts receivable can be expressed as: opening balances A/R + credit sales – cash received from customers = closing balance A/R or Cash received from customers = credit sales + opening balances A/R– closing balance A/R Cash Paid to Suppliers To calculate the cash paid to suppliers you need to calculate the amount of purchased (inventory) and the COGS in calculating net profit Hence payment to suppliers are: Payment to supplier = purchases + opening accounts payable – closing accounts payable Purchases = COGS + closing inventory – opening inventory Payments to other suppliers for service, and to employees Under accrual accounting, payments for expenses like, wage, interest, insurance, tax, etc are all listed in the income statement. However insurance is usually prepaid and would affect the cash flow. Wages: Interest: Tax: Cash Flows from Investing activities To calculate cash inflows and outflows in investing activities yon ed to look at changes n the noncurrent assets to give details on the sale of any assets during the year. When there are changes in noncurrent assets it could be an acquisition, disposal, asset revaluation. • Purchases/sales of property and equipment • Purchases/sales of equity investments • Purchases/sales of businesses • Collection/provisions of loans to other enterprises Cash flows from Financing activities To calculate the cash flow of Financing activities you need to examine the noncurrent liabilities and shareholder’s equity account • Borrowing/repaying debt • Issuing shares/buying back shares • Paying dividends 14.35 analyse and interpret changes in cash flows through Cash flow ratios (additional from lecture) Cash flow ratio are related to liquidity and have 2 categories: • Cash sufficiency ratio: examines whether the company can generate sufficient cash to meet its financial obligations • Cash efficiency ratio: Examine how well the company generates cash. Cash sufficiency ratio • Helps users interpret whether a company can generate sufficient cash to meet its financial obligations. Ratios are: - Current liability coverage ratio - Long term debt coverage ratio - Interest coverage - Dividend coverage - Cash generating power Current liability coverage ratio This ratio demonstrates the ability for operations to generate cash to cover short term debts πππ‘ πππ β ππππ ππππππ‘πππ πππ‘ππ£ππ‘πππ πΆπ’πππππ‘ ππππππππ‘π¦ πππ£πππππ πππ‘ππ = ππ’πππππ‘ ππ’ππππππ‘πππ • If ratio is less than 1, business is not generating enough cash to pay labilities Long term debt coverage ratio Assess whether a company could repay its long-term debt with annual cash flow from operations πππ‘ πβππ ππππ ππππππ‘πππ πππ‘ππ£ππ‘πππ πΏπππ − π‘πππ ππππ‘ πππ£πππππ πππ‘ππ = ππππ π‘πππ ππππ‘ • If ratio is more than 1 it reflect a firms ability to pay its debts Interest coverage Helps understand how easily a company can cover its interest payments with cash flows πππ‘ πππ β ππππ ππππππ‘πππ πππ‘ππ£ππ‘πππ πΌππ‘ππππ π‘ πππ£πππππ πππ‘ππ = πΌππ‘ππππ π‘ ππ₯ππππ ππ • A higher ratio is better as it shows a company can cover their interest expense Dividends coverage Helps understand how easily a company can cover its dividends payments with cash πππ‘ πππ β ππππ ππππππ‘πππ πππ‘ππ£ππ‘πππ πππ£πππππ πππ£πππππ πππ‘ππ = πππ£ππππππ ππππππππ • A higher ratio is better Cash generating power ratio Measures the company’s ability to generate cash from operations activities only πππ‘ πππ β ππππ ππππππ‘πππ πππ‘ππ£ππ‘πππ πΆππ β πππππππ‘πππ πππ€ππ πππ‘ππ = πππ‘ πππππππ π ππ πππ β(ππππ ππ. πππ. &πππ£. πππ‘ππ£. ) Cash Efficiency Ratio Hels users determine how efficient a company is at generating cash • Asset’s efficiency • Cash flow to sales • Days in receivables (covered last week) • Days in inventory (covered last week) Asset’s efficiency Similar to ROA, but uses cash flow from operations instead of net income. It shows how well a company uses its assets to generate cash flow πππ‘ πππ β ππππ ππππππ‘πππ πππ‘ππ£ππ‘πππ π΄π π ππ‘ πππππππππ¦ = π‘ππ‘ππ ππ π ππ‘π • Its best to look at historical trends or compare with competitors Cash flow to sales Also called operating cash flow rate and assess how many dollars of cash is generated for every dollar of sales πππ‘ πππ β ππππ ππππππ‘πππ πππ‘ππ£ππ‘πππ πΆππ β ππππ€ π‘π π ππππ = πππππ πππ£πππ’π • Its best to look at historical trends or compare with competitors 14.355 Working capital management (WCM) WCM is defined as a business strategy designed to ensure a company uses its current assets and liabilities effectively • It is crucial to ensure a company maintains sufficient cash flow to meet its short-term operating costs and obligations • WCM is inked to generating posiive cash flows from operating activities • Investors may look at working capital to assess their efficiency and effectiveness of management. πππ‘ πππππππ πππππ‘ππ = ππ’πππππ‘ ππ π ππ‘π − ππ’πππππ‘ ππππππππ‘πππ • If working capital is too low it suggests a company may not be able to pay its financial obligations and lead to bankruptcy • If working capital is too high I may suggest the company invests excessively in cash and liquid assets and is a poor use of resources. Cash Conversion Cycle (CCC) Cash conversion cycle measure how long cash is within the company as well as how many days it takes for a company to convert investments and other resource into cash flows from sales However there is ways to improve CCC: • Reduce days in inventory • Reduce debtors days • Increase accounts payable days 14.4 Interpreting a statement of cash flows (direct method) From the cash flow statement, you can derive: • Cash held remained fairly constant, reducing from $326.2 mill o $319.1 mill • Cash flow from operations fell from $173 mil to $116.9 mil. But receipts from customer increased, payment to suppliers and employees also increased. • There were large cash flows for investing activities • Only a small portion of the investing activities was funded by cash from operations • There was a substantial increase in financing inflows as a result of thr issue of shares and new borrowings • Under financing activities, some borrowings were repaid ($233.5 mil) and dividends of $75.9 mil were paid, but there was also a borrowing of $695.7 mil and cash received from issued shares. 14.5 Preparation using the indirect method The indirect methods is only different to the direct method in reporting the cash flow from operations as it starts with operating profits, then makes adjustments to this figure from noncash items to arrive at cash flow from operating activities. • There are 2 types of non-cash items from operating activities: - Depreciation, losses and gains - Credit and accrual transactions from profit • For depreciation, losses and other expense which don’t affect cash, it is added onto operating profit • Non-cash revenues are deducted from operating profit • When adjusting working capital: - Deduct from operating profit increases in working capital assets (debtors, inventory and prepayments) - Deduct from operating profit decreases in working capital liabilities (accounts payable and accruals) - Add to operating profit decreases in working capital assets - Add to operating profit increases in working capital liabilities 14.6 Interpreting a statement of cash flows (indirect method) You can assume from the indirect method of cash flow statement: • The company’s cash from operations is very large in relation to its other cash flows, allowing the firm to finance most of it activities from generating cash. • The company doesn’t keep much cash on hand in comparison to their cash inflow. • Changes are suggested in the firms relationships with its customers and suppliers and accounts receivable increase over 20X7 and 20X8 but decrease in 20X9. Inventories rose in 20X9 and accounts payable were paid off faster à reducing cash from operation by more than $100 mil • Company had more noncurrent assets in 20X9 which cost $268 mil in 20X9 which helped generate cash from operations • Acquisition helped the company keep its assets renewed so they don’t lose value • The company did not pay much in dividents • Net total cash flows was small compared to operations, investing and financing flows 14.7 Cash flow and the manager Managers are responsible for managing cash so bills can be paid on time, excess borrowing and interest cost can be avoided and the company’s liquidity and solvency can be protected. • They need to effectively employ and use cash, so it doesn’t just sit there • The cash flow statement provides a measure managerial performance in managing cash and reflect their efforts. Chapter 15: Financial Statement Analysis 15.1 Investment and relative Return Investments are made to earn a return and the amount earned would be relative to how much you invest à more invested = more return • It can be determined by: π ππ‘π’ππ π ππππ‘ππ£π πππ‘π’ππ (πππ‘ππ’π ππ πππ£ππ π‘ππππ‘) = πΌππ£ππ π‘ππππ‘ Most of financial statement analysis is based on ratios such as ROI. You should remember: • The purpose of a ratio is to produce a scale-free, relative measure o a company that can be used to compare with other companies. ROI cancels out how large companies will have larger numbers so that big and small companies can be compared • The ratio will be unreliable unless us numerator is appropriate, meaning the numerator must be calculated properly. Numerator can be: net profit, earnnin before tax or cash flow • These also apply for the denominator of the ratio and the denominator can be: Assets, gross assets and shareholder’s equity. 15.2 Introduction to financial statement analysis The purpose of financial statement analysis is to evaluate the firm’s financial performance and financial position through their financial statements Financial evaluation is not just calculation Financial evaluation also includes making a judgement based on the calculations through having a deep understanding of the body and knowledge of the company • Financial accounting information is viewed as a part of a network of information to illustrate the company, it is not a stand-alone item Preparation for intelligent analysis When decoding a financial statement, you must know what the you are looking for or else you will fail in analysing it. • A large factor of analysing is the ratio as it indicates the firms accounting policies over a period of time and can be compared to other firms. • In order to do a useful financial statesment analysis, you should: 1. Learn about the organisation, its objectives and its plans as information on the written down will not be enough to fully grasp the whole understanding of the company’s financial stand-point. 2. Obtain a clear understanding of the decision or evaluation to which the analysis will contribute to (external people) 3. Calculate the ratio, trends and other figure that apply to your specific problem 4. Find whatever comparative information which provides a frame for your analysis. 5. Focus on the analytical results that are more significant to the decision-maker’s circumstances 15.3 Common Size statements You can also use Common size statements to calculate the approx. size of the company through calculating all balance sheet figures as % of total assets and all income statements as % of total revenue. You can only compare firms if they have similar sizes 15.4 Woolworths Limited: An Example Company Look at textbook pg 565 15.5 Financial Statement Ratio Analysis Ratios are quick method of breaking the information in the financial statements down into a form that allows for comparability with other companies and with the financial performance of the company over a number of years There are different types of ratios to use: • Profitability ratio • Activity ratio • Liquidity ratio • Financial structure ratios There will be specific ratios under these ratios Profitability ratios • Looks at how well they generate earnings compared to expenses • They should be positive and be between 5%-20% Return on Equity (ROE) • Return on equity is calculated as operating profit after tax divided by total shareholders’ equity ππππππ‘πππ ππππππ‘ πππ‘ππ π‘ππ₯ π ππΈ = πβπππβπππππ ! π πππ’ππ‘π¦ • ROE indicates how much return the company is generating on the accumulated shareholders’ investment Return of Assets (ROA) • ROA determines the return they earn on the assets under their control. Assessing the effectiveness of asset utilization. ππππππ‘πππ ππππππ‘ πππ‘ππ π‘ππ₯ π ππ΄ = π‘ππ‘ππ ππ π ππ‘π Profit margin • Profit margin indicates the percentage of sales revenue that ends up as profit, so it is the average profit on each dollar of sales πππ΄π ππππππ‘ ππππππ = Operating profit after tax (OPAT) πππππ Gross Margin • Also known as gross profit ratio shows the company’s product pricing and product mix. Looks at their sales revenue retained after incurring the direct cost (COGS) (πππππ − πΆππΊπ) πΊπππ π ππππππ = πππππ Dividends which guarantees a return but have no say in the Earnings per share (EPS) company • This shows how much an investor would earn per share πππ΄π − ππππππππππ π βπππ π·ππ£ππππππ πΈππππππ πππ π βπππ = π€πππβπ‘ππ ππ£πππππ ππ’ππππ ππ ππππππππ¦ π βππππ ππ π π’ππ Price-to-Earnings ratio (PE) • PE looks at accounting earnings and market price of the share ππππππ‘ πππππ πππ π βπππ ππΈ = πΈπππππππ πππ π βπππ Dividend Payout ratio • This shows the portion of earnings paid to shareholders πππ£ππππππ ππππππππ π·ππ£ππππ πππ¦ππ’π‘ πππ‘ππ = πΈππ Activity (turnover) Ratio • Look at how well they convert assets/liabilities into cash Total assets turnover • Shows how much sales volume is associated with a dollar of assets π ππππ π‘ππ‘ππ ππ π ππ‘ π‘π’ππππ£ππ = ππ π ππ‘π Inventory turnover • It shows the efficiency of inventory management as the number of times inventory is sold during the year πΆππΊπ πΌππ£πππ‘πππ¦ ππ’ππππ£ππ = πππ£πππ‘πππ¦ Days in Inventory • How long, in days, inventory is held on average 365 π·ππ¦π ππ πΌππ£πππ‘πππ¦ = πΌππ£πππ‘πππ¦ ππ’ππππ£ππ Debtors Turnovers • It shows how many days it takes, on average, to collect a day’s sales revenue on credit. ππππππ‘ π ππππ π·πππ‘πππ π‘π’ππ ππ£ππ = π‘ππππ ππππ‘πππ (πππππ’ππ‘π ππππππ£ππππ) Days in Debtors • Average number of days to collect accounts receivable 365 π·ππ¦π ππ π·πππ‘πππ = π·πππ‘πππ ππ’ππππ£ππ Liquidity Ratio • Looks at their ability to pay financial obligations Current ratio • It indicated whether the company has enough short-term assets to cover its short-term debts ππ’πππππ‘ ππ π ππ‘π πΆπ’πππππ‘ πππ‘ππ = πΆπ’πππππ‘ ππππππππ‘πππ Quick Ratio/Acid Test • Indicates whether current liabilities could be paid without having to sell the inventory πΆπ’πππππ‘ ππ π ππ π‘ − πΌππ£πππ‘πππ¦ ππ’πππ πππ‘ππ = πΆπ’πππππ‘ πΏπππππππ‘πππ Interest Coverage Ratio • Indicates the degree to which financial commitments are covered by the company’s ability to generate profit and cash flow πΈππππππ ππππππ πππ‘πππ π‘ πππ π‘ππ₯ πΌππ‘ππππ π‘ πΆππ£πππππ πππ‘ππ = πππ‘ πππ‘ππππ π‘ πΈπ₯ππππ π Financial Structure (solvency) ratio • Looks at their ability to pay non-current liabilities when they fall due and how they operate Debt-to-equity ratio • Indicates the company’s policy regarding financing of its assets - Ratio with more than 1 = financing assets with more debt - Ratio with less than 1 = financing assets with equity π‘ππ‘ππ ππππππππ‘πππ π·πππ‘ − π‘π − πππ’ππ‘π¦ πππ‘ππ = π‘ππ‘ππ π βπππβππππππ ! πππ’ππ‘π¦ Debt-to-asset ratio • Indicated the portion of assets financed by liabilities π‘ππ‘ππ πΏπππππππ‘πππ π·πππ‘ − π‘π − π΄π π ππ‘π π ππ‘ππ = π‘ππ‘ππ πΏπππππππ‘πππ + πβπππβππππππ πππ’ππ‘π¦ Leverage ratio • Indicates how much of its assets is financed by equity π‘ππ‘ππ ππππππππ‘πππ + π βπππβπππππππ πππ’ππ‘π¦ πΏππ£πππππ π ππ‘ππ = π βπππβπππππ πΈππ’ππ‘π¦ 15.6 Integrative ratio analysis The DuPont system of ratio analysis will link the ratios together. It is useful to analyse the drivers of ROE and allow users to focus on the key metrics of financial performance individually to identifying strengths and weaknesses • DuPont is the concept of borrowing money to then invest it in order to get a return, this is leverage. • If the interest expense is less than the return, the profit after tax goes up - The more borrowed the higher the ROE 15.65 Limitations of Ratio Analysis Ratios need to be considered in the context of: • Industry averages • Past records • Business strategy • General market conditions • ‘abnormal’ situation - Hence it doesn’t paint an accurate picture of the company as well doesn’t consider 1 off factors in the market (covid) Its number are all based on: • Past, historical information • Year-end information • Different companies use different measurements • Not all information recognised on the B/S and I/S - Hence, the information doesn’t portray accurate ratios as well as makes it difficult to compare firms The information can also be: • Misleading • Manipulated to paint the firm in a better light - Making the ratios unreliable 15.7 Financial Statement ratio analysis Example Read textbook Pg. 579 15.8 ‘What if’ Effect on Ratio Read Textbook Pg. 590 (just examples) 15.9 Measuring a Manager’s Performance Financial Statements doesn’t measure a manager’s performance without sensitive and informed interpretation as the only way you can ‘measure’ a managers performance is how well they have prepared the financial statements as well as how well the company is doing…ish Finance What is Finance? • Finance studies the activities which look at management of capital and investment • The 2 main section of finance are: - Corporate/Business Finance: the view of the firm/management à Which project to invest in? How to finance operations? How to pay out earnings? - Investment/Asset price: the view of the investor à what are the assets/securities worth? How risky are they? How to form portfolios? Difference between Accounting and Finance Accounting: • Accounting measure realised oncome and cash flow over a period and construct the balance sheet at a particular point in time • Goals: - Communicate accounting information in a standard way - Reduce information asymmetry between firm insiders and outsiders • Target Audience: - Internal management/financial controlling/capital budgeting - Tax Authorities & regulators - Other stakeholder: employees, customers & suppliers, wider community - Shareholder & creditors (existing and potential) - Financial & credit analysts, who in turn provide information to investors Finance: • Finance is concerned with the value or price of companies/assets/mew projects. Price in finance is always forward-looking (based on expectation about future cash flows and risks) and provides tools to forecast and estimate both • Goals: - Valuation: what is the asset worth today? - Pricing: what should the asset’s price be today? • Target audience: - Internal: capital budgeting process – management makes investment decisions into new projects bask on internal forecasts - External: Investors decide whether to buy or sell the assets of the company and at what price Asset: Accounting Assets are all the things that represent what the firm is using its funds which will hopefully provide cash Finance In finance, assets has 2 sides. The owner enjoys the claims/ownership of the cash flow, however the part which provided the assets to the owner will see it as a liability as they need to pay for those cash flow to the owner Value and Price Asset Pricing Taking the investors POV, there is 2 key question in finance to ask, • What is an asset worth? ß T his talks about the value of the asset • How much should I pay for it? ß This talk about the price of it “Price is what you pay, value is what you get.” – Warren Buffett Estimating Value Investors and analysts use techniques to formulate the value or future price of shares of companies. • Fundamental analysis (FA): is the collection and processing of relevant information available in the public sphere to estimate intrinsic value. There are 2 way: - Top-down FA: “big picture” approach considers macro factors to forecast economy-wide or industry-specific cash flows. E.g. interest rates, economic growth, consumer spending, etc - Bottom-up FA: Firm specific approach considers micro-factors to focus on future cash flows of individual firms. Looking at the small things in the firm that might affect future cash flows. E.g. accounting ratios which assess a company’s capital, liquidity, debt, etc • Technical Analysis (TA): Aims to explain and forecast share price movement based on past price behaviours (history). It assumes markets are divan by mass psychology and slow incorporation of information. It uses: - Trend lines and support & resistance lines - Moving averages (M A) - Continuation and reversal patterns Looking at FA, is mainly looks at value however because value and price is closely related it can overlap. There is 2 techniques in FA: • Absolute valuation technique: Very bottom-up: forecast/model individual cash flows of the firm into the future and derive today’s intrinsic value while accounting for risk - Dividend discount models (DDM) - Discounted cash flow models (DCF) • Relative valuation techniques: current value/price companies by comparing them to other companies based on accounting information, especially financial ratios - Comparable company analysis: compare a target firm to a set of similar firms using ‘multiples’ - Precedent analysis: In mergers, price target firms based on recent transactions - Quantitative strategies that use financial ratios to form portfolios in hope of outperforming the market. Share valuation using Multiples Share valuation using multiples looks at techniques which estimate firm and share value that relies on comparing the valuation of a target firm in relation with a ‘peer’ company. There are 2 important measure of a firm value: • Market Capitalisation (market value of equity): - The number of shares outstanding x share price • Enterprise value (EV) - Market value of equity + market value of debt – cash - Market value of equity + Net Debt Performance measures Equity – based performance metrics such as: • Net income or earning (per share): Bottom-line for shareholders after al accounting deductions and taxes • Levered cash flow or free cash flow to equity (FCFE): a cash-flow based measure of what is left for shareholder from operating profits after ‘paying bill’s Company/enterprise – based metrics such as: • EBITDA: “earning before everything” in particular debt service • Unlevered cash flow of free cash flow to the firms (FCFF): A cash-flow based measure of what us left for shareholder & debtholders from operating profits after paying most bill except financing, e.g. adding back D&A, deducting capes and taxes (But not interest) Common valuation metrics These following ratios look at how much a company needs to pay per unit of performance and is the company expense relative to the earning or is it more or less • The price – earnings (P/E) Ratio: - Share price divide by earning per share OR Market cap divide by earning per share - Can be based on trailing (last year) or forward earnings (this year) - Looks at how many time earnings am I paying for my share • EV/EBITDA - Enterprise value divide by ‘earnings before everything” - Very commonly used in M&A (mergers & Acquisition) context - Looks at valuing the total company • Price/sales ratio: - Market capitalisations divide by total revenue/sales - Often used for firms with negative earnings (same purpose as P/E) - Sales less volatile than earning but can still be manipulated - Sales do not mean earnings • Price/Book - Market cap divide by book value of equity - Used in financial firms because it look at financial assets Reciprocals of multiples are called yields Analysts and investors can talk in term of yields instead of multiples, mostly for the dividend yield which expresses the dividend relative to share price (%) Comparable company Analysis (CCA) Comparable company analysis (comps) values a target firm using valuation multiples of comparable/peer firms • Peer firms: firms that are similar along crucial and relevant dimensions • Multiples: a ratio of firm value relative to some performance metric of the firm (e.g. earnings, cash flow, etc) • Key Assumptions: holding other things constant, similar performance characteristics should be worth the same, or should ‘trade for the same multiple’ • Downside: remember CCA is a relative evaluation approach, average valuation change with the state of the market, if market goes down, multiples as well How does it happen: Step 1: Find a number of peers, comparable companies with similar characterises Step 2: Collect data on several valuation metrics and cleanse them of one-off effects Step 3 Apply peer valuation metrics to target Who uses multiples? • Equity analyses use it in their research reports when formulating price targets for listed firms • Private equity investors when considering taking private to public firm • Investment bankers when helping firms to sell divisions to interested parties or advising on take-over of other firms • Buy-side investors are heavy users of multiples Limitation of Multiples • When valuing a firm using multiples, there is no clear guidance about how to adjust for difference in expect future growth rates, risks or difference in accounting policies • For some companies, especially young companies without any history of earnings/dividend and wild swings in accounting performance, there is a lack of suitable metrics • What if different valuation metrics provide very different answer? • Comps only provide information about the value of a firm relative to other firms in the comparison set, - Using multiples will not determine the entire industry Pro Forma Cash flow analysis Pro forma financial statement are financial reports derived under assumptions and hypothetical condition for the future, focusing on income statement and cash flows projections. They are used if: • Analysis is interested in either future dividends actually paid to shareholder or socalled free cash flow to equity (FCFE) that could be paid out to shareholder • Private equity firms are interested in free cash flow to the firm (FCFF) which measures money available to be paid out to both creditors and shareholders • Management will want to estimate the incremental (after-tax) cash flow (ICF) from a new project - So what is left to the firm if the project goes ahead and all bills are paid Capital budgeting & incremental cash flow Capital budget is a list of all projects a company has committed to undertaking during the next period. It is the internal analysis by managers on: • How a potential project will affect earnings and cash flows • Whether to accept or reject it. Cash flow types and timing Incremental cash flow Incremental cash flow is the cash flows (budget) that a company needs when taking on a new project Incremental Cash flow = NOPAT + Depreciation – change in net working capital – net capital spending + terminal cash flows - NOPAT = EBIT x 1-tax - EBIT = revenue – cost – depreciation Makes sure to include the following: • Opportunity cost: cost of lost options/alternative users. Use high alternative value in calculations • Side effects: benefits or costs to other operations of the firm as a consequence of the project • Changes in net working capital • Taxes are real cash flows, despite being based on accounting profits Changes in net working capital For the purpose of incremental project cash flow, considering: • Cash: Is additional cash required to sustain turnover? • Accounts receivable: are A/R going up due to the project • Accounts Payable: Are A/P going up as a consequence of the project? • Inventory: will additional inventory be held? βπππΆ = βπΆππ β βπππ + βπ΄/π − βπ΄/π + βπΌππ£πππ‘πππ¦ Net Capital Spending Net capital spending (NCS) = new purchases for fixed assets minus proceeds from the sale of fixed assets. Usually occurs: • New machinery bought for the project (capitalised/depreciated) • Major upgrade/repairs (capitalised/depreciated) • Maintenance/minor repairs (not capitalised) • New machine replacing an existing machine which is sold (sale may have tax) Depreciation Mainly there are 2 options: • Prime cost (straight-line) method - Annual D = (initial cost – salvage)/number of years - Most assets are depreciated straight-line to zero for tax purposes • Accelerated options: diminishing value method - Multiply percentage by the written down value at the beginning of the year - In final year, full depreciation to 0 After – Tax Salvage • At the end of its useful life a piece of machinery may be sold if the salvage value is different from the book value of an asset (there would be a tax effect) - Salvage Value = pre-tax cash proceeds from the sale - Book value = initial cost – accumulated depreciation - Tax liability = (salvage value – book value) x tax rate Free Cash Flow Analysts, financial manager and investor tend to ignore net oncome and look more on the measures of ‘actual cash flow’. There are 2 main types: • Free cash flow to the firm (FCFF): also called cash flow from assets (CFA) considers operating cash flows from the core operating business of the firm • Free cash flow to equity (FCFE): Cash available to shareholder to either reinvest or pay out. Close to FCFF, but also considering effects of interest payments Free Cash Flow to the Firm FFCF is very similar to how we compute the incremental cash flow from a project. Think of the entire firm as ‘the project’ πΉπΆπΉπΉ = ππππ΄π + π·ππππππππ‘πππ − βπππ‘ π€ππππππ πππππ‘ππ − πππ‘ πππππ‘ππ π πππππππ Free cash flow to Equity FCFE explicitly accounts for the effect of debt and focuses on what is left over for shareholder only. FCFE= NOPAT + Depreciation - βnet working capital – net capital spending – interest x (1tax) + net debt issued OR FCFE= Net income + D&A - βNWC – net capital spending + net debt issuance Cash flow yields for valuation Value-oriented investors like valuation metrics based around cash flow. We can define these as yields. There is one firm-level measure and one equity-based measure: • FCFF yield = FCFF/EV - FCFF multiples = EV/FCFF • FCFE yield = FCFE/MV equity - FCFE Multiple = MV Equity/FCFE Responsible Financial Management Corporate social responsibility Corporate social responsibility represents a broad concept that refer to the responsibility for all companies to integrate social and environment matters in their business operations • As companies operate in society they need to satisfy both shareholders and stakeholders (employees, customers, supplier, society) The legal responsibility directors observe through company law The Fundamental tax principle and their link to financial management The different forms and components of non-financial reporting
