QUALITATIVE CHARACTERISTICS

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1 Ch 01 Accounting BBS Page 12 Tuesday, September 10, :26 AM Figure 1.5 Accounting assumptions and principles creditors might not know about this lawsuit. The full disclosure principle requires that all circumstances and events that would make a difference to financial statement users should be disclosed. If an important item cannot reasonably be reported directly in the financial statements, then it should be discussed in notes that accompany the statements. The accounting assumptions and principles are shown graphically in figure 1.5. Monetary assumption Accounting entity assumption Period assumption Measure of employee satisfaction Total number of employees Salaries paid Percentage of international employees Accounting records Salaries paid FORD CHRYSLER GMH Ford Toyota GMH 1998 Start of business QTR 1 J F QTR 2 MAM J QTR 3 QTR 4 J A SOND 2008 End of business Only those things that can be expressed in terms of money should be included in the accounting records. Going concern assumption Every entity can be separately identified and accounted for. Historical cost The economic life of a business can be divided into artificial time periods. Full disclosure principle Now Future Circumstances and events that make a difference to financial statement users should be disclosed. The business will continue in operation long enough to carry out its existing objectives. Assets should be recorded at cost. 12 Accounting: Building business skills QUALITATIVE CHARACTERISTICS Now let s turn our attention to the needs of external users of accounting information. Statement of Accounting Concepts (SAC) 2 identifies the objective of general-purpose financial reports as the provision of information useful for making and evaluating decisions about the allocation of scarce resources. But how is that objective best served? In what format should financial information be presented? How should assets, liabilities, revenues and expenses be measured? SAC 3 provides guidance on the qualitative characteristics that information contained in general-purpose financial reports should have in order to achieve the objective of providing useful information for decision making. The two main qualitative characteristics of information contained in general-purpose financial reports are relevance and reliability. All relevant and reliable financial information should be included, if it passes the materiality test. SAC 3 also states that general-purpose financial reports should be comparable and understandable. We will consider each of these characteristics in turn. Relevance Information of any sort is relevant if it would influence a decision. Accounting information is relevant if it would make a difference in a business decision. For example, when Colorado Group Ltd issues financial statements, the information in the statements is considered relevant because it provides a basis for forecasting future profits. Accounting information is also relevant to business decisions because it confirms or corrects previous expectations. Thus, Colorado Group Ltd s financial statements help predict future events and provide feedback about previous expectations for the financial health of the company.

2 Ch 01 Accounting BBS Page 13 Tuesday, September 10, :26 AM Reliability Reliability of information means that the information can be depended on. To be reliable, accounting information must be without undue error. Also, the information must be a faithful representation of what it purports to be. If a company s financial statements report sales of $20 million when it actually had sales of $10 billion, then the statements are not a faithful representation of the company s financial performance. Finally, accounting information must be unbiased it must not be selected, prepared or presented to favour one set of interested users over another. Materiality test The inclusion of all relevant and reliable information in financial reports is subject to a materiality test. Information is material if its omission or misstatement has the potential to adversely affect users decisions. Information that is immaterial does not need to be separately identified. However, this does not mean that we should not record immaterial transactions. For example, if Colorado Group Ltd sold a coathanger for $1 this would be considered immaterial; the sale would be recorded in the accounting records although it would not be separately identified in the financial statements. Being relevant, reliable and passing the materiality test is still not enough. SAC 3 identifies two other qualitative characteristics, comparability and understandability. Two constraints, timeliness and cost versus benefit, are also identified in SAC 3. Comparability Let s say that you and a friend kept track of your height each year as you were growing up. If you measured your height in feet and your friend measured hers in centimetres, it would be difficult to compare your heights. A conversion would be necessary. In accounting, comparability results when different companies use the same accounting principles. At one level, accounting standards are fairly comparable because they are based on certain qualitative characteristics, basic principles and assumptions. However, standards still allow for some variation in methods. For example, there are different ways to measure inventory. Often these different methods result in different amounts of net profit. To make comparison across companies easier, each company must disclose the accounting methods used. From the disclosures, the external user can determine whether the financial information is comparable and try to make adjustments. Unfortunately, converting the accounting numbers of companies that use different methods is not as easy as converting your height from feet to centimetres. One factor that can affect the ability to compare two companies is their choice of balance date. Most companies choose 30 June as their balance date, but other dates are also used. For example, look at Colorado Group Ltd s balance date. Retailers often use balance dates that coincide with the end of a week. However, this practice results in some years having 52 weeks whereas in other years (and for other companies) financial statements may be for a 53-week period. INTERNATIONAL NOTE Accounting standards differ between countries. This can complicate comparison of companies from different countries. Through the International Accounting Standards Board, standard setters around the world are working towards international harmonisation of accounting. Helpful hint An accounting time period that is 1 year long is called a financial year or a fiscal year. BUSINESS INSIGHT Management perspective Why do companies choose the particular year-ends that they do? For example, why doesn t every company use 30 June as the accounting year-end? Many companies choose to end their accounting year when inventory or operations are at a low. This is advantageous because compiling accounting information requires much time and effort by managers, so they would rather do it when they aren t as busy operating the business. Also, inventory is easier and less costly to count when it is low. Some companies whose year-ends differ from 30 June are Colorado Group Ltd, CSR Ltd and Freedom Group Ltd. Chapter 1: Introduction to financial statements 13

3 Ch 01 Accounting BBS Page 14 Tuesday, September 10, :26 AM INTERNATIONAL NOTE In the United States, the term consistency is used to refer to comparability of financial statements of the same entity over time. Figure 1.6 Qualitative characteristics of information in generalpurpose financial reports Users of accounting information also want to compare the same company s financial results over time. For example, to track Colorado Group Ltd s net profit over several years, you would need to know that the same principles have been used from year to year; otherwise, you might be comparing apples with oranges. Comparability is not satisfied unless a company uses the same accounting principles and methods from year to year. Thus, if a company selects one inventory accounting method in the first year of operations, it is expected to continue to use that same method in succeeding years. When financial information has been reported on a consistent basis, the financial statements permit meaningful analysis of trends within a company. A company can change to a new method of accounting if management can justify that the new method produces more meaningful financial information or if it is required by a change in accounting standards. In the year in which the change occurs, the change must be disclosed so that users of the statements are aware of the lack of consistency. Understandability Information contained in general-purpose financial reports should also be understandable. But whether information is understandable depends on the capabilities of the individual user. In maintaining this qualitative characteristic, preparers should be mindful of users of general-purpose financial reports who have the proficiency to comprehend the significance of accounting practices, i.e. users who understand the effect of alternative accounting methods on financial statements. It is not practical to require financial statements to be understandable to novices. Entities often need to report on complex transactions that cannot always be simplified to the extent that someone with no knowledge of accounting could understand them. Figure 1.6 summarises the qualitative characteristics identified in SAC 3 to make general-purpose financial reports serve their objective of providing information that is useful for decision making. These characteristics can involve some trade-offs. For example, information about future profits is very relevant. However, as we are unable to tell the future, such information lacks reliability. There is also some overlap between the qualitative characteristics identified in SAC 3 and the accounting assumptions and principles described in the preceding discussion. For example, the purpose of the full disclosure principle is that relevant information be provided. Tell me only what I need to know. I promise to tell the whole truth Now I get it! Apples Oranges BIG SHOT Which is better? Relevance 1. Provides a basis for predictions 2. Confirms or corrects previous expectations Reliability 1. Without undue error 2. Faithful representation 3. Unbiased Comparability 1. With different companies 2. With different years of the same company Understandability Able to be understood by proficient users The accounting assumptions and principles and the qualitative characteristics, together with accounting standards, are collectively referred to as Australian generally accepted accounting principles (GAAP). Australian GAAP are different from GAAP in other countries, such as the United States. The differences arise mainly in the detailed prescriptions of accounting standards. Every Australian accounting standard issued by the AASB includes a statement of conformity with New Zealand accounting standards and with international accounting standards. Any differences are specified in the statement of conformity. Australian GAAP are almost identical to New Zealand GAAP. (The differences between Australian GAAP and New Zealand GAAP in some accounting standards are covered in intermediate and advanced accounting courses.) 14 Accounting: Building business skills

4 Ch 01 Accounting BBS Page 15 Tuesday, September 10, :26 AM CONSTRAINTS IN ACCOUNTING The characteristics we have discussed are intended to provide users of financial statements with the most useful information. Taken to the extreme, however, the pursuit of useful financial information could be far too costly to the company. Therefore, some constraints have been acknowledged in SAC 3 to ensure that GAAP are applied in a reasonable fashion, from the perspectives of both the company and the user. Constraints permit a company to modify generally accepted accounting principles (other than accounting standards) without jeopardising the usefulness of the reported information. The constraints are timeliness and costs versus benefits. These constraints are also very important considerations for standard setters. When setting the rules prescribed by accounting standards consistent with the qualitative characteristics identified in SAC 3, standard setters need to consider the amount of time and the costs required to prepare the information to be reported. These constraints are considered below. Timeliness Financial information may lose its relevance if it is not reported in a timely manner. For example, if we were to wait until we could determine whether each customer makes a warranty claim before reporting the profit on a sale, the financial statements would be delayed by years for some companies. Application of the timeliness constraint means that the preparer should not take so long to collect and prepare financial information that the reported information loses its relevance. Application of this principle may mean that some transactions and events are reported on before all the facts are known. Conversely, if we waited until all information were available, it may be too late for users who have to make decisions in the interim. Costs versus benefits An important consideration is the costs versus benefits of financial information. Preparers and standard setters seek to ascertain that the costs of preparing certain financial information are not greater than the benefits to be derived from using that information. Costs include collection, storage, retrieval, presentation, analysis and interpretation, potential loss of or reduction in competitive position, and the risk of misallocation of resources that could result from decisions if the information is unreliable. Benefits are the results of sound decisions made using the information contained in general-purpose financial reports. The costs and, to a greater extent, the benefits, of financial information are difficult to measure. Consequently, although this form of economic analysis of the provision of financial information is very important, it is unavoidably subjective. BEFORE YOU GO ON >> Review it 1. What are generally accepted accounting principles? 2. What is the basic objective of financial information? 3. Describe the assumptions and principles underlying financial statements. 4. Explain the two main qualitative characteristics of information in general-purpose financial reports. FINANCIAL STATEMENTS AND THE BASIC ACCOUNTING EQUATION Financial position, financial performance and cash flows are of interest to users of accounting information. For business purposes, it is customary to arrange this information in the format of three different financial statements, which form the backbone of financial accounting. To present a picture at a point in time of what your business controls (its LEARNING OBJECTIVE 5 Describe the three main financial statements and the basic accounting equation relating to the statement of financial position. Chapter 1: Introduction to financial statements 15

5 Ch 01 Accounting BBS Page 16 Tuesday, September 10, :26 AM INTERNATIONAL NOTE The statement of financial performance is referred to as the income statement in the United States. Sometimes this term is used by businesses operating in Australia. Helpful hint The heading of every statement of financial performance identifies the company, the type of statement and the time period covered by the statement. Usually another line is added to indicate the unit of measure; when it is used, this fourth line usually indicates that the data are presented in thousands or in millions. assets) and what it owes (its liabilities), you would prepare a balance sheet. Assets are formally defined in SAC 4 as future economic benefits controlled by the entity as a result of a past transaction or other past event. Liabilities are formally defined in SAC 4 as future sacrifices of economic benefits that the entity is currently obliged to make as a result of a past transaction or other past events. We will look at assets and liabilities in more detail in later chapters. As of 30 June 2001, when a balance sheet is prepared in accordance with accounting standards for external reporting, it is called a statement of financial position. Throughout this text we will use the term statement of financial position when referring to both the internal report (balance sheet) and the external report. Although their basic composition is the same, the statement of financial position and balance sheet are not usually identical. This is because the internal report (the balance sheet) typically shows more detail than the external statement of financial position. To show how successfully your business performed during a period of time, you would report its revenues and expenses in the profit and loss statement. When a profit and loss statement is prepared in accordance with accounting standards for external reporting, it is called the statement of financial performance. This title for the external financial statement was introduced in June Throughout this text we will use the term statement of financial performance when referring to both the internal report (profit and loss statement) and the external report. They are not usually identical because the internal report (the profit and loss statement) typically shows more detail than the external statement of financial performance. The presentation of the statement of financial performance will be covered in more detail in later chapters. Finally, of particular interest to you, your bankers and other creditors is the statement of cash flows to show where your business obtained cash during a period of time and how that cash was used. The statement of cash flows is considered in more detail in chapter 10. To introduce you to these statements, we have prepared the financial statements for a marketing agency, Wong Pty Ltd, in figure 1.7. Take some time now to look at their general form and categories in preparation for the more detailed discussion that follows. STATEMENT OF FINANCIAL PERFORMANCE The purpose of the profit and loss statement is to report the success or failure of the company s operations for a period of time. To indicate that Wong s statement reports the results of operations for a period of time, the statement is dated for the month ended 31 October The statement lists the company s revenues followed by its expenses. Finally, the net profit (or net loss) is determined by deducting expenses from revenues. This result is the famed bottom line often referred to in business. Why are financial statement users interested in the bottom line? Managers allocate resources based on their beliefs about the future performance of a company. If investors believe that Wong Pty Ltd will be even more successful in the future they may be willing to invest more capital. Investors are interested in a company s past net profit because it provides some information about future net profit. Similarly, creditors also use the profit and loss statement to predict the future. When a bank lends money to a company, it does so in the belief that it will be repaid in the future. If it didn t think it was going to be repaid, it wouldn t lend the money. Therefore, before making the loan the bank loan officer will use the profit and loss statement as a source of information to predict whether the company will be profitable enough to repay its loan. 16 Accounting: Building business skills

6 Ch 01 Accounting BBS Page 17 Tuesday, September 10, :26 AM Service revenues Expenses: Salaries expense Supplies expense Rent expense Insurance expense Interest expense Depreciation expense Profit before tax Tax expense WONG PTY LTD Statement of Financial Performance for the month ended 31 October 2003 $ $ Net profit after tax $ WONG PTY LTD Statement of Financial Position as at 31 October 2003 Assets Cash $ Accounts receivable 200 Advertising supplies Prepaid insurance 550 Office equipment Total assets $ Liabilities Accounts payable Interest payable Revenue received in advance Salaries payable Bank loan Total liabilities Owners equity Liabilities and owners equity $ $ Share capital Retained profits 31/10/ Total owners equity $ Calculation of retained profits Retained profits 1/10/03 Net profit after tax Less: Dividends $ 2860 (500) Retained profits 31/10/ Figure 1.7 Wong Pty Ltd s financial statements Helpful hint Note that final sums in the statements are doubleunderlined. Helpful hint The arrows in this illustration show interrelationships of the three financial statements. WONG PTY LTD Statement of Cash Flows for the month ended 31 October 2003 Cash flows from operating activities Cash receipts from operating activities Cash payments for operating activities Net cash provided by operating activities Cash flows from investing activities $ (5 500) Purchased office equipment (5 000) Net cash used by investing activities Cash flows from financing activities Issue of shares Proceeds from bank loan Payment of dividend (500) $ (5 000) Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period $ Chapter 1: Introduction to financial statements 17

7 Ch 01 Accounting BBS Page 18 Tuesday, September 10, :26 AM Note that the issue of shares and dividend distributions are not used in determining net profit. For example, $ of cash received from issuing new shares was not treated as revenue by Wong Pty Ltd, and dividends paid of $500 were not regarded as a business expense. DECISION TOOLKIT Decision checkpoints Info needed for decision Tool to use for decision How to evaluate results Are the business s operations profitable? Statement of financial performance The statement of financial performance reports on the success or failure of the business s operations by reporting its revenues and expenses. If the business s revenues exceed its expenses, it will report net profit; otherwise it will report a net loss. Each chapter presents useful information about how decision makers use financial statements. Decision toolkits summarise discussions of key decision-making contexts and techniques. STATEMENT OF FINANCIAL POSITION The statement of financial position reports assets and claims to those assets at a specific point in time. These claims are subdivided into two categories: claims of creditors and claims of owners. Claims of creditors are called liabilities. Claims of owners are called owners equity (or shareholders equity). This relationship is shown in equation form in figure 1.8. This equation is referred to as the basic accounting equation. Figure 1.8 Basic accounting equation Assets = Liabilities + Owners equity Helpful hint The heading of a statement of financial position must identify the entity, the type of statement and the date. Alternative terminology Other names for share capital are paid-up capital and contributed equity. INTERNATIONAL NOTE In the United States, it is common to prepare a separate statement reporting on the movement in retained profits, referred to as retained earnings, during the period. Assets must be in balance with the claims to the assets. As you can see from looking at Wong s statement of financial position in figure 1.7, assets are listed first, followed by liabilities and owners equity. Owners equity comprises two parts: (1) share capital and (2) retained profits and reserves. As noted earlier, share capital results when the company issues shares. Wong Pty Ltd has share capital of $ But where did that number for retained profits come from, and what does it mean? If Wong Pty Ltd is profitable, at the end of each period, usually a year, it must decide what portion of profits to pay to shareholders in dividends. In theory it could pay all of its current-period profits, but few companies choose to do this. Why? Because they want to retain part of the profits to allow for further expansion. High-growth companies, for example, often choose to pay no dividends. Retained profits is the net profit retained in the company. The amount of retained profits reported in the statement of financial position at the end of the period is the amount of retained profits at the beginning of the period, plus net profit after tax for the period, less any amount distributed as a dividend during the period. This may be reported on the statement of financial position. Alternatively, it may be shown as a separate note or at the end of the statement of financial performance. Companies can choose their own format for the presentation of internal financial statements. Reserves also form part of owners equity. Some reserves are accumulated profit and result from transferring amounts from retained profits to reserves. Other reserves result from the application of accounting standards involving asset revaluations and the translation of foreign currencies. Asset revaluations are dealt with in a later chapter; foreign currency translation is beyond the scope of this book. Wong Pty Ltd has no reserves. The owners equity of Wong Pty Ltd is $12 360, consisting of share capital of $ and retained profits of $ Accounting: Building business skills

8 Ch 01 Accounting BBS Page 19 Tuesday, September 10, :26 AM Creditors use the statement of financial position as another source of information to determine the likelihood that they will be repaid. They carefully evaluate the nature of a company s assets and liabilities. For example, does the company have assets that could easily be sold to repay its debts? Managers use the statement of financial position to determine whether inventory is adequate to support future sales and whether cash on hand is sufficient for immediate cash needs. Managers also look at the relationship between debt and owners equity to determine whether they have the best proportion of debt and equity financing. DECISION TOOLKIT Decision checkpoints Info needed for decision Tool to use for decision How to evaluate results Does the business rely mainly on debt or owners equity to finance its assets? Statement of financial position The statement of financial position reports the business s resources and claims to those resources. There are two types of claims: liabilities and owners (shareholders ) equity. Compare the amount of debt versus the amount of owners (shareholders ) equity to determine whether the business relies more on creditors or owners for its financing. STATEMENT OF CASH FLOWS The main purpose of a statement of cash flows is to provide financial information about the cash receipts and cash payments of a business for a specific period of time. To help investors, creditors and others in their analysis of a company s cash position, the statement of cash flows reports the cash effects of a company s (1) operating activities, (2) investing activities and (3) financing activities. In addition, the statement shows the net increase or decrease in cash during the period, and the cash amount at the end of the period. Users are interested in the statement of cash flows because they want to know what is happening to a company s most important resource. The statement of cash flows provides answers to these simple but important questions: Where did cash come from during the period? How was cash used during the period? What was the change in the cash balance during the period? The statement of cash flows for Wong, in figure 1.7, shows that cash increased by $ during the year. This resulted because operating activities (services to clients) increased cash by $5700, financing activities increased cash by $14 500, and investing activities used $5000 of cash for the purchase of equipment. Helpful hint The heading of a cash flow statement must identify the entity, the type of statement and the time period covered by the statement. DECISION TOOLKIT Decision checkpoints Info needed for decision Tool to use for decision How to evaluate results Does the business generate sufficient cash from operations to fund its investing activities? Statement of cash flows The statement of cash flows shows the amount of cash provided or used by operating activities, investing activities and financing activities. Compare the amount of cash provided by operating activities with the amount of cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash from financing activities. Chapter 1: Introduction to financial statements 19

9 Ch 01 Accounting BBS Page 20 Tuesday, September 10, :26 AM Helpful hint The percentage change in any amount from one year to the next is calculated as follows: Change during period 100 Previous value 1 Thus, the percentage change in profit is Change in profit 100 Previous year s profit 1 INTERRELATIONSHIPS OF STATEMENTS Because the results on some statements are used as inputs to other statements, the statements are interrelated. These interrelationships are evident in Wong s statements in figure The statement of financial position depends on the results of the statement of financial performance. Wong reported net profit of $2860 for the period. This amount is added to the beginning amount of retained profits as part of the process of determining ending retained profits. 2. The statement of cash flows and the statement of financial position are also interrelated. The statement of cash flows shows how the cash account changed during the period by showing the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the $ of cash at the end of the period. The ending amount of cash shown on the statement of cash flows is reflected in amounts reported on the statement of financial position. Study these interrelationships carefully. To prepare financial statements you must understand the sequence in which these amounts are determined, and how each statement affects the next. A quick look at Colorado Group Ltd s financial reports The same relationships that you observed among the internal financial statements of Wong Pty Ltd are evident in the 2002 financial statements of Colorado Group Ltd, which are presented in figures 1.9 to We have simplified the financial statements to assist your learning but they may look complicated to you anyway. Do not be alarmed by their seeming complexity. (If you could already read and understand them, there would be little reason to take this course.) By the end of the book, you ll have a great deal of experience in reading and understanding financial statements such as these. Colorado Group Ltd s actual financial statements are presented in appendix A at the back of the book. Before we dive in, we need to explain two points: 1. Colorado Group Ltd, like most companies, presents its financial statements for more than one year. Financial statements that report information for more than one period are called comparative statements. Comparative statements allow users to compare the financial position of the business at the end of an accounting period with that of previous periods. 2. Note that numbers are reported in thousands on Colorado Group Ltd s financial statements i.e. numbers are rounded to the nearest thousand. Thus, the company s net profit for 2002 was $ not $ Statement of financial performance Colorado Group Ltd s statement of financial performance is presented in figure 1.9. It reports total revenues in 2002 of $ It then subtracts three types of expenses cost of goods sold; selling, borrowing, and administrative expenses; and income tax expense to arrive at net profit of $ This is an 18.5% increase over profit for the previous year. (Remember, the figures quoted are in thousands.) Retained profits Colorado Group Ltd presented information about its retained profits in the statement of financial performance (then termed the profit and loss statement) in As a result of changes in accounting standards, this information is contained in the notes to the financial statements in The amount of $ reported as retained profits at 26 January 2002 reflects retained profits of $ at the beginning of the reporting period, plus $ profit for the year, less dividends of $ Accounting: Building business skills

10 Ch 01 Accounting BBS Page 21 Tuesday, September 10, :26 AM COLORADO GROUP LTD AND ITS CONTROLLED ENTITIES Statement of Financial Performance for the financial year ended 26 January 2002 (in thousands) Figure 1.9 Statement of financial performance for Colorado Group Ltd Revenue from sale of goods Dividends from subsidiaries Other revenues from ordinary activities Total revenue Cost of goods sold Selling expenses Borrowing costs Administration and other expenses Profit from ordinary activities before related income tax expense Income tax expense relating to ordinary activities Consolidated $ $ ( ) ( ) ( ) ( ) (1 750) (1 255) (27 120) (18 519) (7 571) (7 433) Profit from ordinary activities after related income tax expense $ $ Helpful hint The heading of every financial statement identifies the entity, the type of statement and the time period or date covered by the statement. Usually, another line is added to indicate the unit of measure; when it is used, this fourth line indicates that the data are presented in thousands or in millions. Statement of financial position As shown in its statement of financial position in figure 1.10 (p. 22), Colorado Group Ltd s assets include receivables, cash, inventories, and property, plant and equipment, plus other types of assets that we will discuss in later chapters, such as prepaid expenses. The company s total assets increased from $ on 27 January 2001 to $ on 26 January Its liabilities include accounts payable as well as interestbearing liabilities such as a bank loan. You can see that Colorado Group Ltd relies more on equity financing than on debt 53% of its assets are financed by owners equity. As you learn more about financial statements we will discuss how to interpret the relationships and changes in financial statement items. Statement of cash flows From the cash flow statement we can see that Colorado Group Ltd s cash increased by $ during the year ended 26 January The reasons for this increase can be determined by examining the statement of cash flows in figure 1.11 (p. 23). The company generated $ from its operating activities during the year. Its investing activities included capital expenditures (purchases of property, plant and equipment) as well as proceeds from the sale of non-current assets. The net effect of its investing activities was an outflow of cash of $ Its financing activities involved the payment of cash dividends. In all, the net effect of the cash generated from its operating activities, less the cash used in its investing and financing activities, was an increase in cash of $ Chapter 1: Introduction to financial statements 21

11 Ch 01 Accounting BBS Page 22 Tuesday, September 10, :26 AM Figure 1.10 Statement of financial position for Colorado Group Ltd COLORADO GROUP LTD AND ITS CONTROLLED ENTITIES Statement of Financial Position as at 26 January 2002 (in thousands) Current assets Cash assets Receivables Other financial assets (cash on short term deposit) Inventories Other Consolidated $ $ Total current assets Non-current assets Other financial assets Property, plant and equipment Intangible assets Deferred tax assets Other Total non-current assets Total assets Current liabilities Payables Interest-bearing liabilities Current tax liabilities Provisions Total current liabilities Non-current liabilities Interest-bearing liabilities Deferred tax liabilities Provisions Total non-current liabilities Total liabilities Net assets $ $ Equity Contributed equity Retained profits $ $ Total equity $ $ Other elements of an annual report Companies that are publicly traded must provide their shareholders with an annual report each year. The annual report always includes the financial statements introduced in this chapter. In addition, the annual report includes other important sources of information such as notes to the financial statements, the directors report and an independent auditor s report. If the concise form of financial reporting is used to report to shareholders, a general discussion and analysis section must be included. This is instead 22 Accounting: Building business skills

12 Ch 01 Accounting BBS Page 23 Tuesday, September 10, :26 AM of some of the notes to the financial statements which are included in the full financial report. No analysis of a company s financial situation and prospects is complete without a review of each of these items. COLORADO GROUP LTD AND ITS CONTROLLED ENTITIES Statement of Cash Flows for the financial year ended 26 January 2002 (in thousands) Figure 1.11 Statement of cash flows for Colorado Group Ltd Consolidated Cash flows from operating activities Cash receipts in the course of operations Cash payments in the course of operations Interest received Borrowing costs paid Income taxes paid $ ( ) 537 (1 750) (5 636) $ ( ) 530 (1 401) (892) Net cash provided by operating activities Cash flows from investing activities Payments for controlled entity (net of cash acquired on consolidation) Payment of dividends to former shareholders of Palmer Corporation Pty Ltd Payments for property, plant & equipment (6 728) (3 583) (7 461) (12 731) Proceeds on sale of non-current assets Net cash used in investing activities (17 314) (12 725) Cash flows from financing activities Proceeds from issue of shares Repayment of borrowings Proceeds from borrowings Dividends paid 479 (15 530) (6 830) (4 000) (3 400) Loan to controlled entities Net cash used in financing activities (8 081) (7 400) Net increase in cash held Cash at the beginning of the financial year Cash at the end of the financial year $ $ Notes to the financial statements Companies published financial statements are accompanied by explanatory notes and supporting schedules that form part of the statements. The notes to the financial statements clarify information presented in the financial statements, as well as expand on it where additional detail is needed. Information in the notes does not always have to be quantifiable (numeric). Examples of notes are descriptions of the accounting policies and methods used in preparing the statements, explanations of uncertainties and contingencies, and statistics and details too voluminous to be included in the statements. The notes are essential to understanding a company s operating performance and financial position. Figure 1.12 (p. 24) is an excerpt from the notes to Colorado Group Ltd s financial statements for It describes the methods the company uses to account for revenues. Chapter 1: Introduction to financial statements 23

13 Ch 01 Accounting BBS Page 24 Tuesday, September 10, :26 AM Figure 1.12 Excerpt from the notes to the financial statements of Colorado Group Ltd COLORADO GROUP LTD AND ITS CONTROLLED ENTITIES Notes to the Financial Statements (extract) for the financial year ended 26 January 2002 (D) REVENUE RECOGNITION Revenues are recognised at fair value of the consideration received net of the amount of goods and services tax (GST). Exchanges of goods or services of the same nature and value without any cash consideration are not recognised as revenues. Sale of goods Sales revenue comprises revenue earned (net of returns, discounts and allowances) from the provision of products to entities outside the consolidated entity. Sales revenue is recognised when the goods are provided, or set aside on the basis of a lay-by agreement. Management fee Services provided to wholly owned subsidiaries of the Company are recovered through the payment of management fees. Services provided include finance, real estate, information technology and human resources. Forfeited lay-bys Deposits and instalments paid for lay-bys that are subsequently forfeited are recognised as revenue after 2 months. Royalties The consolidated entity has contracted out the right to use various brand names. For the use of these brand names the consolidated entity receives royalty income. This income is recognised on receipt. Interest income Interest income is recognised as it accrues. Sale of non-current assets The gross proceeds from sales of non-current assets not originally purchased with the intention of resale are included as revenue of the consolidated entity. The profit or loss on disposal of assets is brought to account at the date an unconditional contract of sale is signed. The gain or loss on disposal is calculated as the difference between the carrying amount of the asset at the time of disposal and the net proceeds on disposal. Directors report The directors report section covers a number of issues which might affect the interpretation of the financial statements by users. The contents of the report in Australia are governed by the Corporations Act 2001 (ss ). Information required to be disclosed in the report helps shareholders assess the performance of the company and the directors. Among the things required to be included are a description of the business(es) undertaken by the company; details of dividends; a description of anything important that has happened after the financial statements were prepared (but before they were printed); and various information about directors, including how many directors meetings each one attended. Information that is already disclosed in the financial statements or notes to the financial statements doesn t need to be repeated in the directors report. In their report, directors will try to avoid disclosing things that might give competitors an advantage. Figure 1.13 presents a part of Colorado Group Ltd s directors report. 24 Accounting: Building business skills

14 Ch 01 Accounting BBS Page 25 Tuesday, September 10, :26 AM COLORADO GROUP LTD AND ITS CONTROLLED ENTITIES Directors Report (extract) Consolidated result The net profit after tax of the consolidated entity for the financial year was $17.1 million. This represents a $2.6 million (+ 18.5%) improvement on the 2001 result of $14.5 million. Review of operations The consolidated revenue for the year was $381.9 million (2001: $325.4 million) and the consolidated net profit after tax was $17.1 million (2001: $14.5 million). Further discussion of this year s results are set out elsewhere in this Annual Report. Dividends The final dividend determined by the Directors, in respect of the year ended 26 January 2002, to be paid 19 April 2002, is an ordinary dividend of 7.0 cents per share, fully franked at 30% ($6.0 million). An interim ordinary dividend of 2.0 cents per share fully franked at 30% ($1.7 million) was paid on 2 November State of affairs The significant change in the state of affairs of the consolidated entity that occurred during the financial year under review was the acquisition of the wholesale and retail business Palmer Corporation Pty Ltd (formerly Palmer Corporation Limited) in March Details of the transaction are provided in Note 23 to the financial statements. Significant events after balance date As disclosed in Note 29 to the financial statements, the Company has, since the end of the financial year, purchased the key assets of Diana Ferrari Pty Ltd, including well known womens footwear labels Diana Ferrari and DF Supersoft. Diana Ferrari Pty Ltd was primarily involved in wholesaling and retailing of footwear. Other than discussed above, there has not arisen in the interval between the end of the financial year and the date of this report any item, transaction or event of a material and unusual nature likely, in the opinion of the Directors of the Company, to affect significantly the operations of the consolidated entity, the results of those operations, or the state of affairs of the consolidated entity, in future financial years. Figure 1.13 Excerpts from the directors report for Colorado Group Ltd Auditor s report Another important source of information is the auditor s report. An auditor is an accountant who conducts an independent examination of the accounting data presented by a company. Only accountants who meet certain criteria, such as chartered accountants and certified practising accountants (CPAs), may perform audits. If the auditor is satisfied that the financial statements present fairly the financial position, results of operations and cash flows in accordance with generally accepted accounting principles, then an unqualified opinion is expressed. If the auditor expresses anything other than an unqualified opinion, then the financial statements should be used only with caution. That is, without an unqualified opinion, we cannot have complete confidence that the financial statements give an accurate picture of the company s financial health. Figure 1.14 (p. 26) is the auditor s report from Colorado Group Ltd s 2002 annual report. The company received an unqualified opinion from its auditor, KPMG. Chapter 1: Introduction to financial statements 25

15 Ch 01 Accounting BBS Page 26 Tuesday, September 10, :26 AM Figure 1.14 Auditor s report on the financial statements of Colorado Group Ltd Independent Audit Report To the members of Colorado Group Ltd Scope We have audited the financial report of COLORADO group ltd for the financial year ended 26 January 2002, consisting of the statements of financial performance, statements of financial position, statements of cash flows, accompanying notes (1 to 29), and the Directors declaration set out on pages 30 to 59. The financial report includes the consolidated financial statements of the consolidated entity, comprising the Company and the entities it controlled at the end of the year or from time to time during the financial year. The Company s Directors are responsible for the financial report. We have conducted an independent audit of this financial report in order to express an opinion on it to the members of the Company. Our audit has been conducted in accordance with Australian Auditing Standards to provide reasonable assurance whether the financial report is free of material misstatement. Our procedures included examination, on a test basis, of evidence supporting the amounts and other disclosures in the financial report, and the evaluation of accounting policies and significant accounting estimates. These procedures have been undertaken to form an opinion whether, in all material respects, the financial report is presented fairly in accordance with Accounting Standards and other mandatory professional reporting requirements and statutory requirements in Australia so as to present a view which is consistent with our understanding of the Company s and the consolidated entity s financial position, and performance as represented by the results of their operations and their cash flows. An audit opinion expressed in this report has been formed on the above basis. Audit opinion In our opinion, the financial report of COLORADO group ltd is in accordance with: (a) the Corporations Act 2001, including: (i) giving a true and fair view of the Company s and consolidated entity s financial position as at 26 January 2002 and of their performance for the year ended on that date; and (ii) complying with Accounting Standards and the Corporations Regulations 2001; and (b) other mandatory professional reporting requirements. BEFORE YOU GO ON Review it questions marked with this Colorado Group Ltd icon require that you use the company s 2002 annual report at the back of the book. >> Review it 1. What questions might each of the following decision makers ask that could be answered by financial information: manager, creditor, and bank manager? 2. What are the content and purpose of each statement: statement of financial performance, statement of financial position, and statement of cash flows? 3. The accounting equation is: Assets = Liabilities + Owners equity. Replacing words in the equation with dollar amounts, what is Colorado Group Ltd s accounting equation at 26 January 2002? (Hint: Use figure 1.10 or the company s annual report in appendix A.) (The answer to this question is on p. 64.) 4. Why are notes to the financial statements necessary? What kinds of items are included in these notes? 5. What is the purpose of the directors report in the annual report? 6. What is the purpose of the auditor s report? >> Do it Deanna s Dog Parlour Pty Ltd began operations on 1 July The following information is available for Deanna s Dog Parlour on 30 June 2003: service revenue $17 000; accounts 26 Accounting: Building business skills

16 Ch 01 Accounting BBS Page 27 Tuesday, September 10, :26 AM receivable $4000; accounts payable $2000; building rental expense $9000; notes payable $5000; share capital $10 000; retained profits?; equipment $16 000; insurance expense $1000; supplies (asset) $1800; supplies expense $200; cash $2000; dividends $0. Prepare a statement of financial performance and a statement of financial position using this information. Reasoning: A statement of financial performance reports the success or failure of a company s operations for a period of time. A statement of financial position presents the assets, liabilities and owners equity of a company at a specific point in time. Solution: Revenues Service revenue Expenses: Rent expense Insurance expense Supplies expense DEANNA S DOG PARLOUR PTY LTD Statement of Financial Performance for the year ended 30 June 2003 $ $ Total expenses Net profit $ DEANNA S DOG PARLOUR PTY LTD Statement of Financial Position as at 30 June 2003 Assets Cash $ Accounts receivable Supplies Equipment Total assets $ Liabilities Accounts payable Notes payable Total liabilities Shareholders equity Share capital Liabilities and shareholders equity $ $ Retained profits Total shareholders equity Total liabilities and shareholders equity $ THE CLASSIFIED STATEMENT OF FINANCIAL POSITION As explained previously, the statement of financial position shows a snapshot of a company s financial position at a point in time. To improve users understanding of a company s financial position, companies group similar assets and similar liabilities together. This is useful because it tells you that items within a group have similar LEARNING OBJECTIVE 6 Identify the sections of a classified statement of financial position Chapter 1: Introduction to financial statements 27

17 Ch 01 Accounting BBS Page 28 Tuesday, September 10, :26 AM economic characteristics. Australian accounting standard AASB 1040 prescribes minimum disclosures on the face of a classified statement of financial position. These are listed in figure Figure 1.15 Minimum disclosures on the statement of financial position Assets Cash assets Receivables Inventories Investments in associates and joint venture entities Other financial assets Property, plant and equipment Tax assets Intangible assets Liabilities Payables Interest-bearing liabilities Tax liabilities Provisions Equity Contributed equity (capital) Reserves Retained profits or accumulated losses Companies may choose to report more classifications. For example, David Jones Ltd separately identified prepayments as an asset on the face of its 2001 statement of financial position. More classifications of assets are typically used for internal reports. The standard also requires that the assets and liabilities be categorised as current and non-current, unless categorisation by liquidity provides more relevant information. Almost all companies, other than financial institutions and insurance companies, choose the current/non-current categories for presentation of the statement of financial position. Although not as informative as liquidity categories, the current/non-current categories provide a crude measure of (1) whether the company has enough assets to pay its debts as they come due and (2) the claims of short-term and long-term creditors on the company s total assets. Current and non-current categories are used extensively for internal and external reporting. These categories can be seen in the statement of financial position included in Colorado Group Ltd s 2002 annual report at the back of this book. Each of the categories is explained below. CURRENT ASSETS Current assets are assets that are expected to be converted to cash or used in the business within 1 year or the operating cycle. The operating cycle is the average time taken to acquire goods and services and convert them to cash in producing revenues. Colorado Group Ltd reported current assets of $ For most businesses the cut-off for classification as current assets is 1 year from the balance date. For example, accounts receivable are included in current assets because they will be converted to cash through collection within 1 year. Supplies are current assets because we expect that they will be used in the business within 1 year. However, some businesses use a longer period as the cut-off if their operating cycle is longer than 1 year. BUSINESS INSIGHT Management perspective Some companies use a period longer than 1 year to classify assets and liabilities as current because they have an operating cycle longer than 1 year. The operating cycle of a company is the average time that it takes to go from cash to cash in producing revenues. For example, if your business sells TVs, your operating cycle would be the average length of time it would take for you to purchase your inventory, sell it on account, and then collect cash from your customers. For most businesses this cycle takes less than a year, so they use a 1-year cut-off. But for some businesses, such as vineyards or aeroplane manufacturers, this period may be longer than a year. Except where noted, we will assume that 1 year is used to determine whether an asset or liability is current or non-current. 28 Accounting: Building business skills

18 Ch 01 Accounting BBS Page 29 Tuesday, September 10, :26 AM Common types of current assets are (1) cash, (2) marketable securities, such as shares held as a short-term investment, (3) receivables (notes receivable, accounts receivable and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Figure 1.16 shows the current assets reported in the 2001 financial statements of David Jones Ltd. DAVID JONES LTD Statement of Financial Position (partial) (in thousands) Figure 1.16 Current assets section Current assets Cash assets $ Receivables Inventories Prepayments Total current assets $ A company s current assets are important in assessing its short-term debt-paying ability, as explained later in the chapter. NON-CURRENT ASSETS Non-current assets are assets that are not expected to be consumed or sold within 1 year or the operating cycle. They encompass a diverse range of assets. The most common types of non-current assets include receivables that are due more than 1 year from the date of the statement of financial position; investments; property, plant and equipment; and intangible assets. Figure 1.17 shows the non-current assets reported in the 2001 financial statements of David Jones Ltd. DAVID JONES LTD Statement of Financial Position (partial) (in thousands) Figure 1.17 Non-current assets section Non-current assets Property, plant and equipment $ Intangibles Deferred tax assets Other assets Total non-current assets $ Property, plant and equipment Property, plant and equipment are assets with relatively long useful lives that are used in operating the business. This category includes land, buildings, machinery and equipment, delivery equipment, and furniture. David Jones Ltd reported property, plant and equipment of $ in its statement of financial position shown in figure Depreciation is the practice of allocating the cost of assets to a number of periods, rather than simply expensing the full purchase price of the asset in the year of purchase. Assets that the company depreciates should be reported on the statement of financial position at cost less accumulated depreciation. For example, Colorado Group Ltd reported property, plant and equipment accumulated depreciation of $ in the notes to the financial statements. The accumulated depreciation is the total amount of depreciation to date over the life of the asset. Intangible assets Many companies have non-financial assets that have no physical substance yet often are very valuable. These assets are referred to as intangible assets. They include patents, copyrights and trademarks or trade names that give the company exclusive right of use Alternative terminology Property, plant and equipment are sometimes called fixed assets. Chapter 1: Introduction to financial statements 29

19 Ch 01 Accounting BBS Page 30 Tuesday, September 10, :26 AM for a specified period of time. David Jones Ltd reported intangible assets of $ , as shown in figure CURRENT LIABILITIES In the liabilities section of the statement, the first grouping is current liabilities. Current liabilities are obligations that are to be paid within the coming year. Common examples are accounts payable, wages payable, bank loans payable, interest payable, taxes payable, and current maturities of long-term obligations (payments to be made within the next year on long-term obligations). Within the current liabilities section of the statement of financial position, payables are usually listed first, followed by interest-bearing liabilities, tax liabilities and provisions. The current liabilities section adapted from the 2001 statement of financial position published by David Jones Ltd is shown in figure Figure 1.18 Current liabilities section DAVID JONES LTD Statement of Financial Position (partial) (in thousands) Current liabilities Payables $ Interest-bearing liabilities 359 Tax liabilities Other provisions Total current liabilities $ NON-CURRENT LIABILITIES Obligations expected to be paid after 1 year are classified as non-current liabilities. Liabilities in this category include debentures payable, mortgages payable, unsecured notes payable and lease liabilities. Many companies report long-term debt maturing after 1 year as a single amount in the statement of financial position and show the details of the debt in notes to the financial statements. Others list the various types of long-term liabilities. In its statement of financial position, David Jones Ltd reported non-current liabilities as shown in figure Figure 1.19 Non-current liabilities section DAVID JONES LTD Statement of Financial Position (partial) (in thousands) Non-current liabilities Interest-bearing liabilities $ Deferred tax liabilities 288 Other provisions Total non-current liabilities $ Accounting: Building business skills BEFORE YOU GO ON >> Review it 1. What are the major sections in a classified statement of financial position? 2. What is the difference between current assets and non-current assets? 3. What was Colorado Group Ltd s largest type of current asset at 26 January 2002? (The answer to this question is on p. 64.) >> Do it The following information relates to Hoffman Ltd s statement of financial position at 30 June All receivables are due within 30 days.

20 Ch 01 Accounting BBS Page 31 Tuesday, September 10, :26 AM Prepare the assets section of Hoffman Ltd s statement of financial position. Reasoning: Current assets are cash and other resources that are reasonably expected to be consumed in 1 year. Accumulated depreciation should be subtracted from property, plant and equipment to determine net property, plant and equipment. Solution: Current assets Cash Accounts receivable Inventory Short-term investments Total current assets Property, plant and equipment Less: Accumulated depreciation Short-term investments $2 300 Cash 800 Property, plant and equipment Inventory Accumulated depreciation Accounts receivable HOFFMAN LTD Statement of Financial Position (partial) as at 30 June 2003 Assets $ $ Total assets $ ANALYSING FINANCIAL STATEMENTS So far, we have introduced the three main financial statements and discussed how these statements provide information about a company s performance and financial position. Now it is time to extend this discussion by showing you specific tools that can be used to analyse financial statements to make a more meaningful evaluation of a company. The analysis of financial statements is covered in more detail in chapter 11. LEARNING OBJECTIVE 7 Calculate ratios for analysing a company s profitability, liquidity and solvency. RATIO ANALYSIS Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. The relationship is expressed in terms of a percentage, a rate, or a simple proportion. To illustrate, in 2001 Fantastic Furniture Holdings Ltd had current assets of $ and current liabilities of $ The relationship between these accounts is determined by dividing current assets by current liabilities, to get The alternative means of expression are: Percentage: Current assets are 173% of current liabilities. Rate: Current assets are 1.73 times as great as current liabilities. Proportion: The relationship of current assets to liabilities is 1.73:1. For analysis of the main financial statements, ratios can be classified as shown in figure 1.20 (p. 32). Chapter 1: Introduction to financial statements 31

21 Ch 01 Accounting BBS Page 32 Tuesday, September 10, :26 AM Figure 1.20 Financial ratio classifications Liquidity ratios Measures of short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash Profitability ratios Revenues Expenses = Net profit Measures of the operating success of a company for a given period of time Founded in 1892 XYZ Ltd Solvency ratios Measures of the ability of the company to survive over a long period of time Ratios can provide clues to underlying conditions that may not be apparent from inspection of the individual components of a particular ratio. However, a single ratio by itself is not very meaningful. Accordingly, in this and the following chapters we will use: 1. Intracompany comparisons covering 2 years for the same company. 2. Intercompany comparisons based on comparisons with a competitor in the same industry. PROFITABILITY Fantastic Furniture Holdings Ltd tries to generate a profit for its shareholders by selling furniture. The statement of financial performance reports how successful it is at generating a profit from its sales and other revenue. The statement reports the revenue for the period and the expenses incurred during the period. Fantastic Furniture s statement of financial performance for the year ended 30 June 2001 is provided in figure Figure 1.21 Fantastic Furniture Holdings Ltd s statement of financial performance FANTASTIC FURNITURE HOLDINGS LTD Statement of Financial Performance (partial) for the year ended 30 June 2001 Revenue from ordinary activities Expenses from ordinary activities Borrowing costs Operating profit before income tax Income tax expense attributable to operating profit Consolidated $ $ ( ) ( ) (75 425) (71 082) $ ( ) ( ) Profit from ordinary activities after related income tax expense $ $ From this statement we can see that Fantastic Furniture s revenue increased significantly during the year from $ in 2000 to $ in In order to increase net profit, the company needs its revenue to increase more than its expenses. However, this was not the case for Fantastic Furniture. Its expenses increased by almost as much as its revenue, resulting in stable profit for the 2 years. 32 Accounting: Building business skills

22 Ch 01 Accounting BBS Page 33 Tuesday, September 10, :26 AM To evaluate the profitability of Fantastic Furniture, we will use ratio analysis. Profitability ratios measure the operating success of a company for a given period of time. We will look at two examples of profitability ratios: return on assets and profit margin. Return on assets An overall measure of profitability is the return on assets ratio. This ratio is calculated by dividing net profit by average assets. (Average assets are commonly calculated by adding the beginning and ending values of assets and dividing by 2.) The return on assets ratio indicates the amount of net profit generated by each dollar invested in assets. Thus, the higher the return on assets, the more profitable the company. The 2001 statement of financial performance for Fantastic Furniture was presented in figure The 2001 and 2000 return on assets ratios of Fantastic Furniture and Freedom Group (a company operating in the same industry) are presented in figure Return on assets ratio = Net profit Average total assets Figure 1.22 Return on assets ratio Fantastic Furniture ($ in thousands) $4025 = 21.3% $4018 = 32.1% ($ $16 044)/2* ($ $9026)/2* Freedom Group 3.5%** 1.8% * Amounts used to calculate average assets are taken from the statement of financial position (figure 1.24). Total assets in 1999 were $ Also note that amounts in the ratio calculations have been rounded to the nearest thousand. ** Freedom Group s 2001 financial statements are for a 9-month period. We can evaluate Fantastic Furniture s 2000 and 2001 return on assets ratios in a number of ways. First we can compare the ratio across time. That is, did its performance improve? The decrease from 32.1% in 2000 to 21.3% in 2001 suggests decline in profitability. The ratio tells us that in 2000 Fantastic Furniture generated 32 cents on every dollar invested in assets, and in 2001 it generated 21 cents on every dollar invested in assets. Then we can compare the ratios with those of another operator in the industry, Freedom Group. In both years Fantastic Furniture s return on assets ratio was substantially better than that of Freedom Group. Thus, based on the return on assets ratio, Fantastic Furniture s profitability appears stronger than Freedom Group s. However, Fantastic Furniture s profitability has declined, whereas Freedom Group s has improved. Profit margin The profit margin ratio measures the percentage of each dollar of sales that results in net profit. It is calculated by dividing net profit by net sales (revenue) for the period. Businesses with high turnover, such as supermarkets and grocers (Coles or Woolworths) and discount stores (Big W or Chickenfeed) generally experience low profit margins. Low-turnover businesses, such as jewellery stores (Tiffany s) or submarine manufacturers (Australian Defence Industries), usually have high profit margins. Profit margins for Fantastic Furniture and Freedom Group are shown in figure 1.23 (p. 34). Note that the figure for sales revenue used in the calculation of the profit margin ratio is not the same as total revenue reported in the statement of financial performance. This is because total revenue includes revenue other than sales. Chapter 1: Introduction to financial statements 33

23 Ch 01 Accounting BBS Page 34 Tuesday, September 10, :26 AM Figure 1.23 Profit margin ratio Profit margin ratio = Net profit Net sales Fantastic Furniture ($ in thousands) $4025 = 5.8% $4018 = 7.0% $ $ Freedom Group 2.3% 0.8% DECISION TOOLKIT Fantastic Furniture s profit margin declined from 7.0% in 2000 to 5.8% in This means that in 2000 the company generated 7 cents on each dollar of sales, and in 2001 it generated 5.8 cents on each dollar of sales. But how does Fantastic Furniture compare with its competitors? Its profit margin ratio was higher than Freedom Group s in both years, even though Freedom Group s profit margin improved in In subsequent chapters you will learn more about evaluating a company s profitability. Decision checkpoints Info needed for decision Tool to use for decision How to evaluate results Is the company using its assets effectively? Net profit and average assets Return on assets ratio = Net profit Average total assets Higher value suggests favourable efficiency (use of assets). Is the company maintaining an adequate margin between sales and expenses? Net profit and net sales Profit margin ratio = Net profit Net sales Higher value suggests favourable return on each dollar of sales BEFORE YOU GO ON >> Review it 1. What are the three ways that ratios can be expressed? 2. What is the purpose of profitability ratios? Explain the return on assets ratio and the profit margin ratio. LIQUIDITY You can learn a lot about a company s financial health by also evaluating the relationship between its various assets and liabilities. However, any analysis of liquidity is incomplete without looking at cash flows. First we will look at some ratios that use numbers from the statement of financial position. This will be followed by cash flow analysis. Suppose you are a banker considering lending money to Fantastic Furniture, or you are a computer manufacturer interested in selling it computers. You would be concerned about Fantastic Furniture s liquidity its ability to pay obligations that are expected to become due within the next year or operating cycle. You would look closely at the relationship of its current assets to current liabilities. 34 Accounting: Building business skills

24 Ch 01 Accounting BBS Page 35 Tuesday, September 10, :26 AM Current assets Cash Receivables Inventories Other FANTASTIC FURNITURE HOLDINGS LTD Statement of Financial Position (partial) as at 30 June 2001 Consolidated $ $ Total current assets $ Non-current assets Receivables Property, plant and equipment Intangibles Deferred tax assets Other Total non-current assets Total assets Current liabilities Payables Interest-bearing liabilities Current tax liabilities Provisions Total current liabilities Non-current liabilities Provisions Total non-current liabilities Total liabilities Net assets $ $ Figure 1.24 Statement of financial position for Fantastic Furniture Holdings Ltd Shareholders equity Share capital Retained profits $ $ Total shareholders equity $ $ Working capital One measure of liquidity is working capital, which is the difference between the amounts of current assets and current liabilities: Working capital = Current assets Current liabilities When working capital is positive, there is greater likelihood that the company will pay its liabilities. When the reverse is true, short-term creditors may not be paid, and the company may ultimately be forced into liquidation. Fantastic Furniture had working capital in 2001 of $ ($ $ ). Chapter 1: Introduction to financial statements 35

25 Ch 01 Accounting BBS Page 36 Tuesday, September 10, :26 AM Current ratio Liquidity ratios measure the short-term ability of the entity to pay its maturing obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio, which is calculated by dividing current assets by current liabilities. The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios. The 2001 and 2000 current ratios for Fantastic Furniture and Freedom Group are shown in figure Figure 1.25 Current ratio Current ratio = Current assets Current liabilities Fantastic Furniture ($ in thousands) $ = 1.73:1 $ = 1.92:1 $8997 $6478 Freedom Group 1.51:1 1.43:1 What does the ratio actually mean? Fantastic Furniture s 2001 current ratio of 1.73:1 means that for every dollar of current liabilities, it has $1.73 of current assets. Fantastic Furniture s current ratio has decreased in However, when compared with Freedom Group s current ratio of 1.51:1, Fantastic Furniture appears to have more liquidity. The current ratio is only one measure of liquidity. It does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose whether a portion of the current assets is tied up in slow-moving inventory. The composition of the assets matters because a dollar of cash is more readily available to pay the bills than is a dollar of inventory. For example, suppose a company s cash balance declined while its inventory increased substantially. If inventory increased because the company is having difficulty selling its products, then the current ratio might not fully reflect the reduction in the company s liquidity. In a later chapter you will learn how to analyse the liquidity of certain assets using turnover ratios. Using the statement of cash flows The statement of cash flows provides financial information about the sources and uses of a company s cash. Investors, creditors, and others want to know what is happening to a company s most liquid resource its cash. In fact, it is often said that cash is king because if a company can t generate cash, it won t survive. To aid in the analysis of cash, the statement of cash flows reports the cash effects of (1) a company s operating activities, (2) its investing activities, and (3) its financing activities. Sources of cash matter. For example, you would feel much better about a company s health if you knew that its cash was generated from the operations of the business rather than borrowed. The statement of cash flows for Fantastic Furniture for the year ended 30 June 2001 is provided in figure In the long term, it is generally desirable that a company can generate enough cash from its operating activities to pay dividends and finance its investing needs. This needs to be assessed over a number of years because the timing of major capital investment expenditures and, to a lesser extent, cash paid for operating activities can cause considerable variation in the relationship between operating and investing cash flows from year to year. For example, consider investing cash flows of Fantastic Furniture. Cash 36 Accounting: Building business skills

26 Ch 01 Accounting BBS Page 37 Tuesday, September 10, :26 AM used by operating activities for 2001 was $ , compared with $ cash generated by operating activities in Much of the negative net operating cash flows reflects the purchase of inventory. Net cash spent on investments in 2001 was $ compared with $ in In order to finance its dividends, loan repayments and investing activities, in 2000 Fantastic Furniture had to supplement its internally generated cash with cash from outside sources, by issuing new shares and by borrowing. FANTASTIC FURNITURE HOLDINGS LTD Statement of Cash Flows (partial) for the year ended 30 June Figure 1.26 Statement of cash flows for Fantastic Furniture Holdings Ltd Cash flows from operating activities Cash receipts Cash payments to suppliers and employees Interest received Interest paid Income tax paid Consolidated $ ( ) (60 301) ( ) $ ( ) ( ) ( ) Net cash provided by (used in) operating activities ( ) Cash flows from investing activities Proceeds from sale of plant and equipment Payments for acquisitions of plant and equipment Payments for goodwill ( ) ( ) ( ) Loans repaid by controlled entities Loans to controlled entities Net cash provided by (to) investing activities ( ) ( ) Cash flows from financing activities Proceeds from issue of shares Proceeds from borrowings Repayments of borrowings Dividends paid (22 118) ( ) ( ) ( ) Share issue costs ( Net cash provided by (to) financing activities ( ) ( ) Net increase (decrease) in cash held ( ) Cash at the beginning of the financial year Cash at the end of the financial year $ ( ) $ Earlier we introduced you to the current ratio. The statement of cash flows can also be used to calculate additional measures of liquidity. The current cash debt coverage ratio is a measure of liquidity that is calculated as cash provided by operating activities divided by average current liabilities. It indicates the company s ability to generate sufficient cash to meet its short-term needs. In general, a value below 0.40 times is considered cause for additional investigation of a company s liquidity. Figure 1.27 (p. 38) shows the current cash debt coverage ratio for Fantastic Furniture for 2000 and Freedom Group for 2000 and As Fantastic Furniture has negative cash from operating activities for 2001, the ratio is not calculated for that year. Chapter 1: Introduction to financial statements 37

27 Ch 01 Accounting BBS Page 38 Tuesday, September 10, :26 AM Figure 1.27 Current cash debt coverage ratio Current cash debt coverage ratio = Cash provided by operations Average current liabilities Fantastic Furniture ($ in thousands) Not calculated $2836 = 0.51 times ($ $4643)/2* Freedom Group 0.25 times** times * Amounts used to calculate average current liabilities are taken from the statement of financial position (figure 1.24). Current liabilities at year-end 1999 were $ Also note that amounts in the ratio calculations have been rounded to the nearest thousand. ** Freedom Group s 2001 financial statements were for a 9-month period. DECISION TOOLKIT We can use these measures to supplement the analysis using the statement of financial position. Fantastic Furniture s current cash debt coverage ratio of 0.51 in 2000 exceeded the recommended minimum level of 0.40, suggesting that its liquidity was adequate. But this changed dramatically in On the other hand, Freedom Group s value of 0.25 is less than the recommended level. Recall, however, that Freedom Group s 2001 current cash debt coverage ratio was based on only 9 months of cash flows. The ratios indicate that monitoring of liquidity for both companies is warranted. Decision checkpoints Info needed for decision Tool to use for decision How to evaluate results Can the company meet its short-term obligations? Can the company meet its short-term obligations? Current assets and current liabilities Current liabilities and cash provided by operating activities Current assets Current ratio = Current liabilities Cash provided Current cash by operations debt coverage = ratio Average current liabilities Higher ratio suggests favourable liquidity. A higher value indicates liquidity. Helpful hint Some users evaluate solvency using a ratio of liabilities divided by shareholders equity. The higher this ratio, the lower a company s solvency. SOLVENCY Now suppose that instead of being a short-term creditor, you are interested in either buying Fantastic Furniture s shares or extending the company a long-term loan. Longterm creditors and shareholders are interested in a company s long-term solvency its ability to pay interest as it comes due and to repay the debt at maturity. Solvency ratios measure the ability of the business to survive over a long period of time. The debt to total assets ratio is one source of information about long-term debt-paying ability. Cash flow ratios, such as the cash debt coverage ratio, are also useful tools of analysis. Debt to total assets ratio The debt to total assets ratio measures the percentage of assets financed by creditors rather than shareholders. Debt financing is more risky than equity financing because debt must be repaid at specific points in time, whether the company is performing well or not. Thus, the higher the percentage of debt financing, the riskier the company. 38 Accounting: Building business skills

28 Ch 01 Accounting BBS Page 39 Tuesday, September 10, :26 AM The debt to total assets ratio is calculated by dividing total debt (both current and non-current liabilities) by total assets. The higher the percentage of total liabilities (debt) to total assets, the greater the risk that the company may be unable to pay its debts as they come due. The ratios of debt to total assets for Fantastic Furniture and Freedom Group for 2000 and 2001 are presented in figure Debt to total assets ratio = Total liabilities Total assets Figure 1.28 Debt to total assets ratio Fantastic Furniture ($ in thousands) $9323 = 43% $6822 = 43% $ $ Freedom Group 39% 44% The 2001 ratio of 43% means that 43 cents of every dollar invested in assets by Fantastic Furniture has been provided by its creditors. The higher the ratio, the lower the equity buffer available to creditors if the company becomes insolvent. Thus, from the creditors point of view, a high ratio of debt to total assets is undesirable. Fantastic Furniture s solvency appears lower than that of Freedom Group in However, both companies have low debt ratios. BUSINESS INSIGHT Investor perspective Debt financing differs greatly across industries and companies. Here are some debt to total assets ratios for selected companies: Colorado Group Ltd (2001) Harvey Norman David Jones OPSM Protector Air New Zealand Fletcher Challenge Forests Total debt to total assets as a percentage 40% 53% 41% 31% 94% 32% The adequacy of this ratio is often judged in the light of the company s profits and cash flows. Generally, companies with relatively stable profit can support higher debt to total assets ratios than can cyclical companies with widely fluctuating profits, such as many high-tech companies. The cash debt coverage ratio is a measure of solvency that is calculated as cash provided by operating activities divided by average total liabilities. It indicates the company s ability to generate sufficient cash to meet its long-term needs. Figure 1.29 (p. 40) presents the cash debt coverage ratio for Fantastic Furniture for 2000 and for Freedom Group for 2000 and The ratio is not calculated for Fantastic Furniture for 2001 because its net cash flows from operations were negative. A general rule of thumb is that a ratio below 0.20 times is considered cause for additional investigation. Chapter 1: Introduction to financial statements 39