2/2/2009. Financial statement EARNING POWER AND IRREGULAR ITEMS. EARNING POWER AND IRREGULAR ITEMS continued. Chapter 14

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1 Chapter 14 Financial statement analysis PowerPoint presentation by Anne Abraham University of Wollongong 2009 John Wiley & Sons Australia, Ltd EARNING POWER AND IRREGULAR ITEMS Earning power refers to profit adjusted for irregular items It is the most likely level of profit to be obtained in the future Four types of irregular items are reported: Errors Changes in accounting estimates Changes in accounting policies Discontinuing operations 2 EARNING POWER AND IRREGULAR ITEMS Entities must also disclose Revenues and expenses from ordinary activities that, because of their size, nature or incidence, are relevant to understanding financial performance e.g. major inventory write-downs and the cost of settling a legal dispute 3 1

2 Errors Prior period errors are errors made in a previous period that have resulted in the presentation of incorrect information in the financial statements In correcting the error, the entity must disclose The nature of the error The amount of correction for each financial statement line item affected The amount of correction at the beginning of the earliest prior period represented 4 Changes in accounting estimates A change in accounting estimates is a revision of estimates used in preparation of previous-period financial statements e.g. extension of estimated useful life or revision of estimated residual value of noncurrent assets The effect of the change must be disclosed within the notes to financial statements if it is material 5 Changes in accounting policies A change in accounting policy occurs when the policy used in the current year is different from the one used in the preceding year e.g. change in inventory costing methods, such as from FIFO to average cost Two types of changes: Changes in accounting standards Voluntary changes 6 2

3 Changes in accounting policies If material, must disclose in the notes: Nature of the change Reason(s) for the change Effect on current year profits Effect on each prior year profits presented Effect on all previous years not presented How change has been applied if retrospective application is not practicable 7 Discontinuing operations A dis operation is a component of an entity that is being disposed of or is classified as held for sale Carrying amounts of assets are measured at fair value less costs of disposal Results of discontinuing operations should be excluded when estimating future profits 8 Discontinuing operations AASB 5 and NZ IFRS5 require an entity to disclose on income statement as a single line item: Sum of after-tax profit or loss from dis operations After-tax gain or loss arising from restatement of assets of dis operations 9 3

4 Discontinuing operations Entities are also required to disclose (either on income statement or in notes): Revenue, expense and pre-tax profit or loss from discontinuing operations Gain or loss on measuring assets of dis operations at fair value and the associated tax effect Net cash flows from the operating, investing and financing activities of the dis operations 10 Discontinuing operations Other information that must be disclosed in the notes includes: Identification of discontinuing operations Business or geographic segment included Description of facts and circumstances of sale, or leading to expected disposal When discontinuance is expected to be completed 11 COMPARATIVE ANALYSIS Every item in financial reports represents something important It existed and was material at some time and in some quantity Its significance can be determined only in relation to something else: Single numbers on their own do not provide useful information 12 4

5 COMPARATIVE ANALYSIS Types of useful comparative information: Intra-entity basis Comparisons within a single entity (detects changes in financial relationships and trends) Industry averages Between entities in same industry (determines position relative to others) Inter-entity basis Between other entities (indicates competitive position) 13 COMPARATIVE ANALYSIS Basic comparative analysis techniques: Horizontal analysis Evaluates a series of financial data over time Vertical analysis Evaluates financial items in relation to a base amount Ratio analysis Evaluates a comprehensive range of financial relationships representing different aspects of an entity s activities 14 Horizontal analysis Used to evaluate a series of financial statement data over a period of time Analyses increases or decreases that have occurred from a particular base year Figures are stated as both dollar amounts and as percentages 15 5

6 Horizontal analysis Percentages removes the effect of size, so relative magnitude of change is revealed One year is selected as the base year and then increases or decreases are based on the formula: Change since = Current year amount Base-year amount base period Base-year amount 16 Vertical analysis Evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude Useful for comparing companies of different sizes Calculated percentages can also be tracked over time to determine patterns of change 17 RATIO ANALYSIS Ratio analysis can be used to make both: Intra-company comparisons Inter-entity comparisons 3 types of ratios: Liquidity Solvency Profitability 18 6

7 Liquidity ratios Liquidity ratios measure the short-term ability of an entity to pay its debts and meet unexpected needs for cash Important to bankers, suppliers and other short-term term creditors 1. Current ratio Indicates short term debt paying ratio current assets current liabilities 19 Liquidity ratios 2. Quick ratio Measure of an entity s immediate short-term liquidity Often called the acid test ratio Excludes inventory and prepaid assets which are the least liquid current assets cash + marketable securities + net receivables current liabilities 20 Liquidity ratios 3. Current cash debt coverage Reflects the whole period not just a single point in time Does not just use year end balances Combines cash and accrual figures net cash provided by operating activities average current liabilities 21 7

8 Liquidity ratios 4. Receivables turnover Indicates the effectiveness of credit collection policies Measures the number of times trade receivables are converted into cash during the period net credit sales average net trade receivables 22 Liquidity ratios 5. Average collection period Converts receivables turnover figure into a measure of days for receivables collection 365 days receivables turnover 23 Liquidity ratios 6. Inventory turnover Reflects the effectiveness of inventory management cost of goods sold average inventory 24 8

9 Liquidity ratios 7. Average days in inventory Converts inventory turnover into a measure of days for inventory to be sold. 365 days inventory turnover 25 Solvency ratios Solvency ratios measure the ability of an entity to survive over a long period of time Important to long-term creditors and shareholders 8. Debt to total assets ratio Indicates degree of leverage (percent of total assets funded through debt) total liabilities total assets 26 Solvency ratios 9. Times interest earned Indicates entity s ability to sustain debt by measuring its ability meet interest payments as they become due Measures the number of times interest obligations can be covered by operating profit profit before income tax + interest expense interest expense 27 9

10 Solvency ratios 10. Cash debt coverage Indicates entity s ability to repay liabilities from cash generated from operating activities, without having to liquidate assets used in operations Reflects the whole period, not just a single point in time net cash provided by operating activities average total liabilities 28 Solvency ratios 11. Free cash flow Indicates entity s ability to pay dividends or expand operations Provides an estimation of discretionary cash Combines cash and accrual figures net cash provided by operating activities capital expenditures 29 measure the profit or operating success of an entity for a given period of time Size of entity s profit affects its: Ability to obtain debt and equity financing i Liquidity position Ability to grow Profitability is often regarded as the ultimate test of management s operating effectiveness 30 10

11 Relationships among profitability measures Return on ordinary shareholders equity ratio Indicates earnings per dollar invested by the owners Affected by: Return on assets ratio (ratio 13) Degree of leverage profits available to ordinary shareholders average ordinary shareholders equity Return on assets Measures overall profitability with respect to investment in assets Affected by: Degree of leverage (interest expense) Profit margins Asset base profit average total assets 33 11

12 14. Profit margin Measures percentage of each dollar of sales that results in profit High volume firms (e.g. supermarkets) generally experience low profit margins Low volume firms (e.g. white goods) have high profit margins profit net sales 34 Profitability Ratios (cont d) 15. Asset turnover Measures how efficiently assets are used to generate sales net sales average total assets 35 Profitability Ratios (cont d) Relationship between profitability ratios:. Return on assets = profit margin x asset turnover = net profit x net sales net sales average total assets 36 12

13 16. Gross profit rate Indicates entity s ability to maintain an adequate selling price above its costs Ratio declines as industry becomes more competitive gross profit sales Operating expenses to sales ratio Measures costs incurred to support each dollar of sales operating expenses net sales Cash return on sales ratio Similar to net profit ratio Uses cash numerator instead of accrual profit net cash provided by operating activities net sales 39 13

14 19. Earnings per share (EPS) Measures profit earned on each ordinary share Reporting of EPS is regulated by AASB 133 profit available to ordinary shareholders weighted average no. of ordinary shares Price-earnings ratio Measures ratio of market price of each ordinary share to earnings per share Reflects investors assessments of an entity s future earnings share price earnings per share Cash dividend payout rate Measures the percentage of profit distributed in the form of cash dividends Entities with high growth rates generally have low payout ratios because they reinvest most of their profit in the firm cash dividends profit 42 14

15 LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS 1. Estimates Financial statements contain many estimates e.g. - allowance for doubtful debts - depreciation expense - costs of warranties If estimates are inaccurate, the financial ratios and percentages will also be inaccurate 43 LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS 2. Cost Many items are carried at historic cost. This does not account for price-level changes 3. Alternative accounting methods Differences in accounting policies for the similar financial activities are often allowed e.g. methods of depreciation 44 LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS 4. Atypical data Some end-of-period data may not represent normal business conditions 5. Diversification Diversification within entities limits usefulness of financial statement analysis Segment data may provide more relevant and comparable information 45 15

16 Decision Toolkit Luxury Loft Ltd Work through on your own and check your results with the suggested solution provided