Accounting For Managers

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1 Accounting For Managers Professor ZHOU Ning SCHOOL OF ECONOMICS AND MANAGEMENT BEIHANG UNIVERSITY

2 Chapter 13 Financial Statement Analysis

3 The objectives of Chapter 13 Business objectives Overall measures Profitability ratios Investment utilization ratios Financial condition ratios Dividend policy Growth measures Making comparisons 13-3

4 Relationship to previous material Focus has been: What goes into 3 basic financial statements Income Statement, Balance sheet, Statement of Cash Flows. Now focus is: How statements are analyzed by management, investors, and creditors. 13-4

5 Objective of a Business Create value for its shareholders while maintaining a sound financial position. Return on investment. Sound financial position. Other important objectives include: Employee satisfaction. Social responsibility. Ethical considerations. 13-5

6 Overview GAAP does not define ratios. Multiple equally valid approaches to ratios and analysis. Managers (e.g. division manager, sales manager) should be measured to items that they control. Investors and top management are most interested in overall performance or broadest measures of performance. Understanding less broad measures of performance may give additional insight into overall performance 13-6

7 Structure of the analysis From broadest to more specific levels. Principal value of financial analysis: Suggests questions not answers. Ratio comparisons start with supposition that all other things are equal (they rarely are). 13-7

8 Categories of ratios which measure: Overall performance. Profitability. Investment utilization. Financial condition. Dividend policy. 13-8

9 Making comparisons Finding the appropriate standard is difficult. A high ratio (e.g. current ratio, ROI) may be good or bad. It can t be viewed in isolation. Is a high CR good or bad? Is a high ROI always good? Values of ratios compared across time longitudinal analysis, or trend analysis. 13-9

10 Overall Measures (1) Possible definitions of investment: assets, owners equity, invested capital. Possible definitions of return: net income, net income -preferred dividends, net income + interest expense (1-tax rate). Use income generated from pool of funds before considering cost of funds in pool

11 Overall Measures (2) Tangible assets How well management is using a pool of capital. Before considering financing decisions. Some analysts ignore interest adjustment. Measures how an enterprise uses its funds. May be used to evaluate individual business units in a large company when managers do not influence financing decision (i.e. how assets are financed)

12 (3) Overall Measures Or, Common shareholders equity = total shareholders equity - preferred stock. Reflects return on funds invested by shareholders. Of interest to current and prospective shareholders

13 Overall Measures (4) Invested capital = permanent capital = capital employed = long-term liabilities + shareholders equity = working capital + non-current assets. Return on funds entrusted to the firm for relatively long time

14 Variations Average or weighted average investment is more representative (e.g. (beginning + ending) 2). Tangible assets instead of total assets. To determine tax rate, can use total tax rate or tax rate excluding deferred taxes

15 Relationship of ROE to Profit Margin, Asset TO & Leverage ROE can be viewed as: Pretax profitx margin percentage * Asset Turnover ratio * Financial leverage ratio * Tax retention rate. ROE = (Pretax profit/sales revenue) * (sales revenues / total assets) * (Total assets/shareholders equity) * (1- Tax rate) How do we improve ROE? 13-15

16 Relationship of ROE to Profit Margin, Asset TO & Leverage F company BS F company IS F company CF 13-16

17 Illustration 13-1 factors affecting return in investment *numbers based on 2006 data in F company 13-17

18 (5) Overall Measures Market price per share/eps Market price is not controlled by company; reflects all information available to the market. Reflects how investors judge future performance or prospects of the company. Commonly compared to other companies in same industry

19 Profitability measures Common size financial statements = Vertical analysis: (1) Express each item on the income statement as a percentage of net sales. (2) a measure of overall profitability 13-19

20 (3) Profitability measures Class discussion: Company ABC has an EPS of $5 per share, Company XYZ has an EPS of $10 per share. Is one a better company or investment than the other? Is one more profitable than the other? 13-20

21 Investment utilization measures How well are assets managed. Profitability measures focus on Income Statement. Investment utilization measures involve balance sheet and income statement amounts

22 Investment utilization measures Investment turnover (1) (2) (3) 13-22

23 Investment utilization measures Capital intensity: less encompassing than investment turnover. (4) 13-23

24 Investment utilization measures Working capital measurers (5) Cash expenses = total expenses - depreciation - other non-cash expenses (6) 13-24

25 Investment utilization measures Working capital measurers (7) (8) 13-25

26 Investment utilization measures Working capital measurers (9) (10) Working capital= current assets-current liabilities 13-26

Investment utilization measures Working capital measurers Cash conversion cycle: Receivables conversion period (i.e. days receivables) + inventory conversion period (i.e. days inventory) - payment deferral period (i.

27 Investment utilization measures Working capital measurers Cash conversion cycle: Receivables conversion period (i.e. days receivables) + inventory conversion period (i.e. days inventory) - payment deferral period (i.e. days payables) = operating cycle - payment deferral period. A measure of liquidity. Indicates time interval for which additional short-term financing might be needed to support a spurt in sales

28 Financial condition ratios (1) Liquidity. Solvency

29 Liquidity Ability to meet current obligations. Tests for size and relationship between current liabilities and current assets. Liquidity measures: (2) (3) Monetary current assets = current assets - inventory - prepaid assets

30 Solvency Ability to meet interest costs and repayment schedules associated with long-term debt. Solvency measures (4) (5) (6) Total invested capital = long-term debt + shareholders equity 13-30

31 Solvency Measures (Continued) (7) (8) 13-31

32 Dividend policy (1) (2) Provides info on how growth is financed. Less dividends paid means more earnings are retained to fund growth

33 Dividend yield vs. interest yield on bonds Not a valid comparison. Investor s return on bonds kept to maturity: Interest (adjusted for amortization of premium/discount). Investor s return on common stock: Dividends + change in share price. Function of expected future earnings. Earnings reinvested in business

34 Growth measures Key accounting items for which growth is computed: sales, net income, earnings per share. Items Average yeras growth 2006 = 2005 ( growth 2004 per 2003 year 2002 for 2001 n years)/n Net sales $6,295 $6,191 $5,787 $5,181 $4,652 $4,349 Year-to-year basis 1.68% 6.98% 11.70% 11.37% 6.97% Average growth rate 7.74% Compound growth rate = based on present value concepts. May be misleading due to abnormally high or low beginning or ending year

35 Implied growth rate Estimates potential to grow its sales and profits without an injection of new capital (1) (2) 13-35

36 Bases for comparison Experience. A feel for what is right or reasonable. Budget. A target developed within the company. Factors to be considered: How carefully was budget constructed? What circumstances are different now? Historical standards. Prior period s results adjusted for changes in accounting methods. External benchmarks. Competitor, industry average

37 Comments on Ratio Analysis Helps paint a picture. Try to overcome tendency to look at numbers rather than underlying reasons. Starting point; identifies questions not answers

38 Summary of Ratio 13-38

39 Summary of Ratio 13-39

40 Summary of Ratio 13-40

41 Summary of Chapter 13 Business objectives Overall measures Profitability ratios Investment utilization ratios Financial condition ratios Dividend policy Growth measures Making comparisons 13-41

42 Assignments of Chapter 13 Problem 13-1~13-7 Case

43 Thank you 13-43

WEEK 10 Analysis of Financial Statements

WEEK 10 Analysis of Financial Statements Learning Objectives 1. Organize a systematic financial statements analysis using common-size financial statements and ratio analysis. 2. Recognize the potential