MODULE 10
ANALYSING FINANCIALS AT
BOARD LEVEL
ADB Private Sector Development Initiative
Corporate Governance Training
Solomon Islands
Originally by
Dr Judy Taylor
Acknowledgement
These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian Development Bank’s
Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical assistance facility co-financed by the
Asian Development Bank, Australian Aid and the New Zealand Aid Programme.
Outline of session
•
Role of Board and financial skills
•
•
•
•
•
Financial Literacy V Financial Expert
Use of subcommittees
Analysis of financial reports
• Analysis on internal reports
• Analysis on external financial reports
Horizontal, common-sizing and Ratio analysis
Red flags
Overview of financial governance
•
•
•
The board is responsible for the true and fair
financial reporting of their company (entity)
While the board delegates some of the oversight
tasks to committees, they retain ultimate
responsibility and authority
Board’s role is not to manage
•
•
But to ensure the organisation is being managed
When something goes wrong the board is
collectively accountable.
Overview of financial governance
•
•
To fulfill these responsibilities the Board needs to be financially
literate
Board must require high quality – SMART – reporting:
•
Specific reports,
•
Measurable,
•
Achievable,
•
Relevant,
•
Time bound
•
Monitor progress towards targets set in strategic and business plans.
•
Monitor and evaluate the CEO against KPI’s
Financial Literacy
Wikipedia:
Financial literacy is the ability to understand how
money works in the world: how someone manages to
earn or make it, how that person manages it, how
he/she invests it (turn it into more) and how that
person donates it to help others. More specifically, it
refers to the set of skills and knowledge that allows
an individual to make informed and effective
decisions with all of their financial resources
Financial Literacy
Australian Institute of Company Directors:1
•
The four pillars include a combination of skills,
background and experience that give Directors the
ability to perform
•
•
•
•
Formal legal and statutory requirements regarding the
financial requirements
Monitor the solvency of the company
Balance risk mitigation
Know when to call in experts
1. Dianne Hughes, Financial Fundamentals for Directors, Australian Institute of Company Directors, 2014
Financial Literacy
Contrasting a financial expert and financial literacy
• A financial expert can identify and choose the
correct accounting treatment and framework.
• A financial literate director is not expected to have
this level of knowledge. They would be satisfied
that the appropriate framework has been applied.
And when to call in experts to advise them.
• A board that does not possess both financial
experts and financially literate Directors suffers
severe consequences.
Overview of financial governance

The board manages using subcommittees.
Subcommittees allow2
More thorough research and consideration of
information
More time at the regular board meeting for
regular business.
Better dialogue between committee members and
staff and community members on the specific topic.
2. Dianne Hughes, Financial Fundamentals for Directors, Australian Institute of Company Directors, 2014
Overview of financial governance


The board sets up a financial, planning reporting
and budgeting committee
The Chief Financial Officer (CFO) then devolves
these duties into a number of separate areas which
ensures a system is in place to record, verify and
measure free of fraud (one model does not fit
every organization)
 Budgeting
and planning
 Day to day financial tasks
 Reporting
Financial Governance
ABoard of
Directors
Financial Planning,
Reporting and
budgeting
Human
Resources
subcommittee
Audit
compliance
and risk
management
Chief Financial
Officer
Budgeting
and
Planning
Receipts
Payments
Financial
Reporting
Overview of financial governance



The CFO implements a financial reporting system
that meets internal reporting requirements and
external reporting requirements.
The internal financial reporting should allow
analysis of the entity by directors to scrutinise the
financial security and probity of the organisation.
The external financial reporting should allow
directors to analyse their position and performance
across time and compared to their competitor's.
Financial budgeting


Module 8 looked at financial budgeting
The budget evolved from the Strategic plan.


The financial reporting should therefore be compared to the
targets and goals set in the Strategic Plan, the Corporate
Plan and Budgets
The Budget reporting will compare the actual expenditure to the
budgeted expenditure, this should be done on
 Reporting
basis (3 monthly, 6 monthly, annually)
 On a year to date basis
 An annual basis as well as a cash flow basis.

The report presented to the board will have already been vetted by
the financial and internal audit subcommittees. While the internal
audit will be concerned that the income and expenditure are
recorded in the correct categories. The financial subcommittee will
be concerned with the results.
Financial budgeting


Highlight variances and reasons for the variance where
the differences are material
But the board needs to understand
 why
there is a variation and whether it will continue –
 is
it due to a timing difference or a change in the
commercial environment –
 does
the budget need to be updated and profit figures
re-forecasted?
 do they have sufficient cash flow to meet obligations in
next operating period?
Financial reporting

Financial Committee has delegated responsibility
for the financial reporting
 they
will have overseen the implementation of systems
to ensure accuracy of reporting, free of fraud
 They will review the financial statements prior to
presentation to the board for acceptance
 They will report on any significant variations, significant,
unusual or large transactions, and changes in accounting
policies or procedures or treatment of accounts.
Financial Reporting
Specifically the committee will report at two levels

Report the internal performance of each major financial
control division
Profit and loss- actual v’s budgeted, YTD and same period last
year and reasons for variances, forecast for next three months
and YE
 Cash flow - actual v’s budgeted, YTD etc. as above
 Inventory or stock report
 Debtors report
 Creditors report
 Loan report
 Foreign currency report
 Capex report

Financial Reporting
 External
 Profit
financial statements 6 monthly and annually
and loss (financial performance)
 Balance sheet (financial position)
 Cash flow (where required)
 Statement of changes in equity (where required)
Financial Analysis
These reports will be reviewed by all the directors.
Financially literate boards need to understand the
financial reports and financial analysis, review them
and ask pertinent questions
Financial Analysis includes:
 Horizontal
- trending
 Vertical - common-sizing
 Ratio Analysis - 4 areas covered
 Red Flags
Horizontal analysis
Horizontal trend analysis takes a number of years of
financial statements,
it uses the first year as a base,
 calculates the dollar difference from the base year and
 converts this difference to a percentage
increase/decrease for each item for each of the years.

Vertical analysis
Common-sizing shows each item in each financial
report as a percentage of a base item.


balance sheet: all balance sheet items are shown as a
percentage of total assets.
income statement: all items are shown as a percentage
of sales
Common sizing allows more reliable comparison of
firms of different sizes because converting the
numbers to percentages removes differences caused
by size.
Balance sheet
Example of horizontal and common-sizing analysis.
Financial Reporting Horizontal
Common Sizing
2013
2014
2014
2013
2014
$
$
change
%
%
%
Cash at hand
5000
4000
(1000) -20
5
3.33
Accounts Receivable
2000
2500
25
2
2.1
Total assets
100000
120000
20000 20
100
2014
500
100
Balance sheet
Horizontal trends
cash at hand has decreased between 2013 and
2014 by 20%,
accounts receivable have increased by 25%,
total assets have only increased by 20%.
Our accounts receivable have increased by more than total
assets.
Commonsize Accounts (vertical )
cash at hand has decreased as a proportion of total
assets,
accounts receivable have increased.
Income statement Financial Reporting
2013
$
2014
Horizontal Trend
Horizontal Trend
2014
$
change
2014
%
Sales
50000
60000
10000
20
Cost of sales
25000
32000
7000
28
Gross profit
25000
28000
3000
12
Operating expenses
12000
14000
2000
17
EBITDA
13000
14000
1000
7.6
amortisation
2000
4000
2000
100
EBIT
11000
10000
(1000)
-9
Interest
1000
2000
1000
100
EBT
10000
8000
(2000)
-20
Tax
500
600
100
20
Income continuing
9500
7400
(2100)
-22
Depreciation &
operaions
Income statement
Note additional profit steps,
 gross
profit margin
 earnings before interest, tax, depreciation and
amortisation (EBITDA),
 earnings before interest and tax (EBIT) and
 earnings before tax, (EBT)
Income statement
Horizontal analysis



sales increased by 20% between 2013 and 2014, the
gross profit increased by only 12% and the
net income declined by 22%.
This tells us that costs of production have increased.
As we progress down the income statement the situation deteriorates.
Cost of sales increased by more than sales, our depreciation and amortisation have increased by
100%.
Reasons? Either1.the company has had to write down the value of an asset (written down as impaired
asset), or
2.they have purchased more assets.
If the reason is impairment then the news is not good but if it is a purchase of a new asset then
the assumption should be that it will be able to generate more income in next and subsequent
years.
Interest has also increased by 100%.
did the interest rate increase or did we borrow more?
maybe to buy more plant and equipment?
Income statement - Vertical analysis
Financial Reporting
Common Sizing
2013
2014
2013
2014
Sales
Cost of sales
$
50000
25000
$
60000
32000
%
100
50
%
100
53.3
Gross profit
Operating expenses
25000
12000
28000
14000
50
24
46.6
23.3
EBITDA
13000
14000
26
23.3
Depreciation &
amortisation 2000
EBIT
4000
11000
2000
10000
4
22
6.6
16.6
Interest
EBT
Tax
1000
10000
500
2000
8000
600
2
20
1
3.3
13.3
1
Income continuing
9500
7400
19
12.3
operaions
Income statement
Commonsize (vertical) analysis,

we don’t see that sales have increased because
commonsizing uses sales as a base and this
number will always be 100%,

cost of sales has increased as a percentage of sales
and

gross margin has declined.
Directors would want to know why the gross profit margin has
declined
We can also see that depreciation has increased as we saw on
Horizontal, we also see that interest has increased. WHY?
Directors need to ask the ‘WHY’ question of management, and
not stop until they are satisfied with the response.
Ratio analysis
Provides a profile of a firm, to identify its economic
characteristics, competitive strategies, its unique
operation, and financial and investment characteristics
 Ratios for a single firm at a single point in time are
meaningless.
 Ratios for a single firm should be compared over
time, to identify trends.
 Ratios for a single firm should be compared with
ratios of firms operating in the same industry, either
directly or by use of industry
averages/benchmarks.
Ratios - limitations
ratios are only a tool and not the answer,
 ratios identify that a relationship has changed,
 not why it has changed.
Directors must know why!
1. should you be concerned?
2. is it only a timing difference?
Ratios are affected by differences in accounting methods
used by the company so care needs to be taken to use
consistent information, which may limit comparisons made
over time.

Comparing ratios across companies
Careful:
 different
textbooks use different formulas and also
 classify some of the ratios in different categories.
If you are comparing your company with another
company or published industry ratios, directors or their
delegates need to ensure that the same
 formula,
as well as
 accounting methods have been used –
if not the result will be meaningless.
Ratio analysis
Generally broken down into four areas of our business,

activity analysis,


liquidity analysis.


measure the company’s ability to meet its short-term obligations.
profitability analysis,


measure how efficiently a company performs day-to-day tasks, such
as the collection of receivables and management of inventory.
measure the company’s ability to generate profitable sales from its
resources, revenues and capital
solvency analysis and growth analysis,


measure a company’s ability to meet long-term obligations.
Subsets of these ratios are also known as “leverage” and “long-term
debt” ratios.
These areas are interrelated
Analyse the financial statements by assessing the major areas:
Activity analysis
Operational activity ratios include:
Inventory turnover
Receivables turnover
Payables turnover
Working capital turnover
Investment activity ratios include:
Fixed asset turnover
Total asset turnover
Liquidity analysis
Cash cycle day-counts include:
Days of sales in trade receivables
Days of supply in inventory
Days in accounts payable
Working capital ratios include:
Current ratio
Quick ratio
Cash ratio
Operational cash flow ratio
Defensive interval
6.
Solvency analysis
Debt ratios include:
Debt to total capital ratio
Debt to equity ratio
Other ratios include:
Capital expenditure ratio
CFO to debt ratio
Interest coverage ratios include:
Time interest earned ratio
Fixed charge coverage ratio
Time interest earned (cash basis) ratio
Fixed charge coverage (cash basis) ratio
Profitability analysis
Return on sales include:
Gross margin
Operating margin
EBITDA margin
EBIT margin
Pretax margin
Profit margin
Return on capital ratios include:
Return on assets (ROA)
Return on total capital (ROTC)
Return on equity (ROE)
Growth analysis
Retention rate
Dividend payout ratio
Sustainable growth rate
Other factors
Three-factor duPont model
Five-factor duPont model
Basic Earnings Per Share (EPS)
Diluted Earnings Per Share (EPS)
Adjustment for stock dividends and splits
Weighted average number of common
shares outstanding
Activity ratios
Operational




Inventory turnover (COGS/average inventory)
Receivables turnover (revenue/average receivables)
Payables turnover (purchases/average trade payables)
Working capital turnover (revenue/Average working capital)
Investment

Fixed asset turnover (revenue/average net fixed assets)

Total asset turnover (revenue/average total assets
The higher activity ratios are, the more efficient the firm’s operations’ relatively fewer assets are required to maintain a given level of operations. If
activity ratios decline then the cash flow statement can be used to ascertain
whether income has been too aggressively recognised
What activity ratios can tell you
Activity ratios describe the relationship between a firm’s
level of operations and the assets needed to sustain
operating activities.
If the strategic plan says the company will increase sales
by 20% then accounts receivable turnover tell directors
how much accounts receivable have to increase by to
achieve this if the relationship is stable and linear.
If our receivable turnover is 15 then we require $15 of
revenue per dollar of accounts receivable, or for every
$1 of revenue we generate $.06cents will be on credit.
Gerald I White et al, The Analysis and Use of Financial Statements, (2003,Wiley), p 119.
Analysis and use of ratios
If the Accounts receivable turnover ratio declines from
15 to 7.6 sales on credit per dollar of sales have
increased.
Director must know why - why did the ratio change?
In order to answer that question it is necessary to go
back to our formula. Revenue/average accounts
receivable.
Analysis and use of ratios
In year 2 the change in receivable turnover from 15 down to 7.6
could be because



both revenue and accounts receivable increased,
revenue remained the same but accounts receivable increased,
or
revenue declined but accounts receivable increased.
Ratios are only a tool they are not the answer, without knowing
the reason you don’t know anything.
3.(Sales increased by 5000 and Accounts receivable (3260-680=2580)
Liquidity ratios


Liquidity analysis analyses whether the firm has sufficient resources
to meet their short term liquidity requirements.
Cash cycle day-counts include (or net operating cycle)





Working capital ratios include





Days of sales in trade receivables (365/receivable turnover)
Days of supply in inventory (365/inventory turnover)
Days in accounts payable (365/payable turnover)
Cash conversion cycle (receivable + inventory – number of days of
payables)
Current ratio (current assets/current liabilities)
Quick ratio (Cash+ short-term marketable investments+receivables/CL)
Cash ratio (Cash+ short-term marketable securities/CL)
Operational cash flow ratio
Defensive interval (Cash + short-term marketable/daily cash
expenditures)
Liquidity ratios
Divide 365/activity ratios
we convert activity into liquidity measures.

receivable turnover ratio of


year 1: 15 - 365/15 = 24.33 days to collect receivables
year 2: 7.6 - 365/7.6 = 48 days to collect receivables
Directors would need to evaluate this change.
What are normal terms for collection in this industry?
What does the internal operating manual specify for giving and collecting
Credit.
Is normal terms 15, 30 or 45 days?
If 45 days is the norm then the directors were fortunate that they had
rapid collection policies in year1. However to push for payment earlier
than the industry norm can push clients away. So the new result
depending upon the reason, may be permanent. If the norm is 30 why
have management allowed collection to slow down?
Operating cycle
By converting all the activity ratios into days outstanding ratios,
directors can begin to calculate their operating cycle.
“The operating cycle is the sum of the days it takes for a firm to sell its inventory
plus the number of days it takes to convert the resulting receivables into cash.
The cash cycle is the number of days in the operating cycle less the number of
days credit the firm obtains by deferring payment on its payables. The shorter
the cycle the more efficient the firm’s operations.”
If receivables=48; inventory=24 operating cycle =24+48=72
If payables outstanding= 35 Cash cycle = 24+48-35 = 37
24 days you are holding inventory
48 days customers are using your money
35 days you are using your suppliers money
Gerald I White et al, The Analysis and Use of Financial Statements, (2003,Wiley), p 124
Cash flow / operating cycle
http://jasoncracecpa.com/blog/2015/10/shorter-cash-flow-cycle-stronger-business/
Working capital
The working capital ratios use increasingly narrow
definitions of current assets divided by total current
liabilities to measure the firms’ ability to meet their
current liabilities.
Working capital is defined as current assets less
current liabilities. They are assets and liabilities that
are liquid and fall due within one year.
Working capital
The current ratio is the broadest working capital ratio that
uses all current assets divided by all current liabilities.
This ratio should have a value greater than 1, and should
be between 1.5 and 3.
A value less than 1 means the company does not enough
liquid assets to pay its current liabilities.
A value greater than 3 means they have $3 of current
assets for every $1 of current liabilities. If the value is too
high the company has idle funds that could be used for
investment or given back to the owners – dividends.
Defensive interval
Measures how many days a firm can survive given its
liquid cash and obligations assuming no further inflows of
cash.
Defensive interval = (Cash + short-term marketable
securities/daily cash expenditures)
If the defensive interval is 50 then this means the company
can survive 50 days. The larger the number the more
liquid the company is.
Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 329
Solvency Analysis



Solvency ratios analyse the underlying capital
structure of the company to evaluate and identify
any long term risks in meeting their long term
obligations.
Solvency ratios are categorised as either debt or
coverage ratios.
Debt ratios use balance sheet values whereas
coverage ratios use income statement values.
Solvency Analysis
Debt ratios
Debt-to-assets ratio (Total debt/Total assets)
Debt-to-capital ratio (Total debt /Total debt+ Total shareholders’
equity)
Debt-to-equity ratio (Total debt /Total shareholders’ equity)
Financial leverage ratio (Average total assets/ Average total equity)
Coverage ratios
Interest coverage (EBIT /Interest payments)
Fixed charge coverage (EBIT+ lease payments/Interest payments +
lease payments)
Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 33
Solvency - Debt ratios
Measure debt relative to assets, capital or equity.
Debt to assets measures the amount of assets financed by
debt. A ratio of .3 means 30% of assets are financed by
debt. The higher the debt to asset ratio, the greater the
debt and thus the greater the risk of insolvency
The debt to capital ratio measures the debt as a
proportion of debt plus shareholders equity.
Debt to equity a narrower measure of solvency uses debt
to shareholders equity. A higher proportion of debt
relative to equity increases the riskiness of the firm.
Solvency - Debt ratios
Financial leverage ratio or leverage ratio,
If leverage is 4 then for every $4 of average total
assets, the company has $1 of average equity.
If assets are not being funded by equity then they
must be funded by debt or other liabilities, thus the
higher the leverage ratio the greater the debt burden
and the greater the solvency risk they face.
Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 334
Solvency - Coverage ratios
Measure the firm’s ability to meet its interest obligations.
Interest coverage ratio (or times interest earned ratio) measures how
many times EBIT can cover the interest payments. The higher the ratio
the greater is the firm’s ability to meet its interest obligations.
Interpretation of this ratio. Coverage may improve even if debt
increases if interest rates decline temporarily (and debt is floating rate
debt) or EBIT improves. However the long term solvency situation may
have deteriorated.
Fixed charge coverage adds lease payments, other fixed obligations
to both EBIT and interest payments. The higher the ratio, the greater the
ability of the company to meet its debt and fixed charge obligations.
Gerald I White et al, The Analysis and Use of Financial Statements, (2003,Wiley), p 131
Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 334
Profitability Analysis
Measures the return using both income statement
subtotals and balance sheet aggregates. It then
focuses on the growth of the company by a three-step
process that results in a sustainable measure of
growth.
Profitability Analysis
Return on sales include
Gross margin (Gross profit/sales)
Operating margin (operating income/sales)
EBIT margin (EBIT/sales)
Pretax margin (EBT/sales)
Profit margin (net incomes/sales)
Contribution margin (sales-variable costs/sales)
Return on capital ratios include
Return on Assets (EBIT/assest) or ((EBIT/sales)*(sales/asssest))
Return on total capital (ROTC)
Return on equity (ROE)
Growth analysis ratios include
Retention rate
Dividend payout ratio
Sustainable growth rate
Profitability ratios
Measure the firm’s ability to generate profits.
The higher the profitability ratios the greater
return a company is able to generate on sales
and/or its capital.
The measures of profitability using sales as a
percentage of income statement subtotals were
already discussed under common-sizing.
Profitability ratios
To reiterate, gross profit margin
identifies the profit from production and
identifies what remains to cover obligations such as
operational and fixed costs as well as creditors and
provide a return to the owners of the company.
As we progress down the profitability ratios more of this gross
margin is used up until we arrive at net profit margin- revenue
less all expenses (including recurring and non-recurring
components).
Profitability ratios



The reporting of profitability ratios using this tiered
income statement is also useful because it allows your
company to compare itself to other companies at
different stages.
For instance: This allows comparison even if they have
significantly different amounts of plant and equipment
because EBITDA ignores the impact of depreciation and
amortisation as well as interest and tax.
It also facilitates the comparison with companies with
significantly different debt structures because EBIT
ignores interest and taxation.
Profitability ratios
The return on capital ratios use balance sheet items to assess
profitability.
Return on assets (ROA) measures the net return per dollar of assets.
Return on equity (ROE) is one the most quoted ratios.
It measures the return on the equity invested in the firm. If the firm
cannot generate a greater return on the equity I can invest somewhere
else, the company should not have my investment.
By extension if they do not earn a return on retained earnings greater
than that outside the firm, they should return the earnings via dividends
to the owners
David Hey-Cunningham, Financial Statements Demystified, (4th Edition Allen and Unwin), p 246
ROE



Directors should be aware that all ROEs are not the
same, and that a ROE that appears stable across 5
years may not be stable.
Different factors may have resulted in a similar but
misleading outcome. DuPont is a measure that
breaks down the ROE into a five step process to
better understand why the ROE changes and
identify what generates the ROE.
DuPont analysis of ROE by management provides
useful information to Directors
Cash flow analysis
Analysis of the cash flow statement should be done in steps.
Step 1.
•
Identify major sources of Cash flow
•
•
Is CFO positive?
Evaluate sufficiency of Cash flow.
•
•
Is CFO sufficient to fund capital requirements?
Is funding of capital from CFF?
Step 2.
•
Examine major determinants of Cash Flow
•
•
•
Indirect method shows where cash is being used
Compare Net Income with Cash Flow
How consistent are CFO
Step 3
•
CFI
•
examine each line item
Step 4
•
CFF
•
Examine each line item
Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 278
Cash flow ratios
Once an understanding of the sources and
determinants of cash flow are understood ratio
analysis can be undertaken.
The Profitability ratios look for cash flow
performance while the Solvency ratios look for cash
flow coverage.
Profitability ratios
Cash flow to revenue (CFO/Net revenue)
Cash return on assets (CFO /Average total Assets)
Cash return on equity (CFO / Average shareholders’ equity)
Cash to income (CFO / Operating income)
Cash flow per share ((CFO – Preferred dividends)/number of shares o/s)
Cash flow to revenue identifies the CFO generated per dollar of revenue.
Cash return on assets measures CFO per dollar invested in average total
assets, it shows how hard or efficiently our asset are able to generate CFO.
Cash return on equity measures the return per dollar of equity, for every
equity dollar invested by owners generate $X of CFO.
Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 288
Coverage ratio
Debt coverage (CFO/total debt)
Interest coverage (CFO +Interest paid+ Taxes paid) / Interest paid)
Reinvestment
(CFO / Cash paid for long-term assets)
Debt payment (CFO / Cash paid for long-term debt repayment)
Dividend payment (CFO / Dividends paid)
Investing and financing (CFO / Cash outflows for investing and
financing activities)
Interest coverage (Time interest earned) (cash basis) ratio
Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 288
Coverage ratio
The coverage ratios measure the sufficiency of cash flows
to meet individual requirement such as,
capital requirements in total,
interest payments on debt,
the ability to acquire more assets and thus grow
ability to pay dividends.
Investing and financing ratios measure the total of these
commitments -the ability to acquire assets, pay debts,
and make distributions to owners. It is a tighter measure of
CFO.
Ratio analysis

When reviewing financial reports and ratios
directors must know why the ratio has changed – the
numerator or the denominator
 Directors must know whether the change they see is
temporary or permanent. Is it due to timing issues or
fundamental change in the business environment?
 Directors need to know whether to take action to
reverse the change in ratio.

Red flags
Companies, even those that comply with IFRS have discretion
over the timing and recording of:
Purchases of assets
Purchase versus lease of assets
Sale or disposal of assets
Recording of losses’
Recording of profits
Classifying the investment in other securities as trading, available for sale
or held to maturity
Depreciation, rate useful life and salvage value
Leases and off balance sheet transactions
Recognition of extraordinary events
Writing down inventory
Estimating account receivable delinquency
Red Flags
A Red flag requires the director’s attention.
The following introduces some of the red flags that directors should seek answers
to if they are present in financial reporting.
1.Where there is a substantial improvement in reported net income but not the
same proportional improvement in cash flow from operations in the period.
2. Individual final quarter adjustments that are unusually large
3. Inventory or accounts receivable that are unusually high relative to sales,
4. Unexpected large asset write offs.
5. Significant proportion of inventory measured at net realisable value.
6. Are there any intangible assets? Should they be amortised or tested for
impairment?
7. Are cash flow receipts from customers less than cash flow payments to suppliers
8. Is the net CFO negative or less than net profit after tax?
Group activity 2
Using the attached income statement and balance sheet
1. Convert both statements to a common size statement
2. Analyse the statements using vertical analysis
3. Using both statements complete horizontal analyses
4. Do the required ratio calculations. What do they tell
you?
5. Analyse the accounts
6. Are there any red flags?