Financial Analysis and Reporting CHAPTER 1: Published Accounts Two Types of Accountants 1. There is the quiet introvert in a polyester suit but has so much knowledge in Financial Statement or FS 2. The other is a brash, smartly dressed “captain of industry”, capable of talking to different people. Financial Statement – written records that convey the business activities and the financial performance of a company. Financial Analysis and Reporting - This approach can be seen in practice because many companies pay their directors bonuses that are linked to profits, or they give them a stake in the company. 2. Monitoring the behaviour of Directors – this is where accounting statements come in. - if the shareholders have access to credible and informative financial statements, then they can review the directors’ performance. If the directors are not performing adequately, them they risk replacement. Example: the Enron illustrates one shortcoming of the monitoring approach. - Analysis – is the process of evaluating businesses, projects, budgets, and other finance related transactions to determine their performance and suitability. Reporting- is the process of documenting and communicating financial activities and performance over specific time periods, typically on a quarterly or yearly basis. Principals and Agents Agency Theory – branch of economics that is devoted to the behavioural implications of entrusting decisions to a third party. - Happens in large companies Shareholders – the principals - they invest by buying shares they cannot have a great deal of input into the process of running the company. Directors – their agents - must have freedom to make decisions on the running of the company. Act in the best interests of the shareholders, but it is easy to doubt whether they always will. Theft – simplest and most obvious form of abuse in the company. - - - The directors have control over the bookkeeping and accounting systems and they have to be responsible for the preparations of the financial statements that are used to monitor them. Even the Director’s statements are subject to an external audit, the auditors must be able to measure the FS against some benchmarks, otherwise they will be unable to form a meaningful view on the quality of the information that is being checked and reported on. The accounting rules that are described in this text are an important part of managing the relationship between principals and agents. For example: the directors could simply authorise excessive expenses claims for one another. Such behaviour would clearly be criminal, but it would be very difficult to detect Agency problem can be tackled by: 1. Trying to design reward packages – to motivate directors to act in the shareholder’s interest. History suggests: some directors are prepared to make their companies appear more profitable or more secure in order to retain their shareholder’d confidence. Accounting rules – designed to deal with specific areas where problems have risen. Standard-setters – they have design rules that deal with problem areas without alienating the companies whose accounts are going to be affected. - They also have retain the trust of the readers of financial statements, so the rules that are published must be logical and should lead to better accounts. Two Important Ratios: 1. Profitability is measured in terms of the return on capital employed ratio: Return on Capital Employed (ROCE) – financial ratio that can be used to assess a company’s profitability and capital efficiency. EBIT – Earning Before Interest and Tax Presentation of Financial Statement Shareholders - entitled to the profit International Accounting Standards 1 (IAS 1) – found the main rules relating to the format of a set of accounting statements Lenders – entitled to the interest Return on Capital Employed Formula Two statement that we will focus: ROCE = EBIT( Earnings before Interest and Tax Total Assets – total current liabilities ROCE = EBIT( Earnings before Interest and Tax Shareholder’s Equity + Long term liabilities 2. Gearing – one of the most important ratios for measuring risk: Gearing – the proportion of long term finance that comes from borrowing - A higher ratio implies an increased risk Heavy borrowing - means a higher annual interest, which means that there is a possibility that any downturn will leave a little or no profit left over for the shareholders. - Means that the company’s assets will have to be spread thinner if the company fails, so the lenders will have less chance of being paid in full from the proceeds of winding up the business. Gearing Ratio Formula Gearing = Long-term liabilities Shareholders’ equity + long term liabilities Gearing Ratio = Total debt Total Equity Gearing Ratio = EBIT(earnings before interest&tax Total Interest Gearing Ratio = Total debt Total Asset High Gearing Ratio vs Low Gearing Ratio High gearing ratio – exceeds 50% - Represent a highly geared or highly levered company Mid-level gearing ratio – between 25% and 50% - Known to be normal for well established companies Low gearing ratio – below 25% - Investors, lenders and any parties analyzing the financial documents would see a gearing ratio below 25% as very low risk. Statement of Financial Position - known as balance sheet - Includes ASSET, EQUITY, LIABILITIES - The format shows the company’s assets, broken down between non-current and current. Current Asset - a company's short-term assets; those that can be liquidated quickly and used for a company's immediate needs. -cash, cash equivalents, account receivable, stock inventory, marketable securities (bonds) Noncurrent assets - long-term and have a useful life of more than a year. - long-term investments, land, property, plant, and equipment (PP&E), and trademarks. - The second part of shows how those assets were financed in terms of equity and liabilities, with liabilities broken down between current and non-current. Current Liabilities - a company's short-term financial obligations that are due within one year or within a normal operating cycle. -short-term debt such as credit card, accounts payable Non-current liabilities - the debts a business owes, but isn't due to pay for at least 12 months. -notes payable, bonds payable, deferred income taxes Statement of Comprehensive Income – known as Income statement - Financial statement that summarizes both standard net income and other comprehensive income. - Sales, Expenses, Earnings Notes to the Accounts 3 Main Functions 1. Provide information in which FS have been prepared 2. Disclose information required by accountimg standards. 3. Provide information that is not presented elsewhere in the FS Preparing a Set of Financial Statements 1. Establish a clear objective 2. Identify the 1st step in solving the problem 3. Obtain the information required for that step 4. Repeat for each until the objective is achieved. Some Important Points About Preparing The Statements Two practical suggestions that can simply the process 1. Notes – part of financial statements and so they are cross referenced to the accounting statements themselves. 2. Workings – not part of the FS and they would not be shown to anybody - extremely important for examination purposes - should not be cross referenced to the statements because that might create impression for rough calculations. Work Neatly - Accounting is about communicating information to inform decisions. - Accounting Statements is intended to be read and understood. - Working should be on separate sheet and not scribbled - Bad habits are more difficult to overcome while under exam conditions - Better answers are generally better presented in addition to having the correct numbers. Bookkeeping – the process of recording the company’s financial transactions into organized accounts on a daily basis. Total Asset = liabilities + Equity - It should never be a coincidence that the balance sheet equation holds true. In practice, bookkeeping records are organized so that it must do so. - Every transaction or adjustment affects two items in the records Bookkeeping system – track of each individual asset, equity and liability balance. Each has its own record called an “account”. Assets – what a business owns, such as cash, accounts receivable, equipments, etc - DEBIT : increase CREDIT : decrease Expenses – the cost of consuming assets. They include rent, interest expense, etc. - DEBIT: increase CREDIT : decrease The owner’s equity – represents what the owner invest in the business - DEBIT : decrease CREDIT : increase Liabilities – claims against assets. These include accounts payable, wages payable, notes payable, etc - DEBIT : Decrease CREDIT: increase Revenue – cash generated from business activities such as sales, dividends, services, etc - DEBIT: Decrease CREDIT: Increase
