ACCA F3. Provided by Academy of Professional Accounting (APA) Financial Accounting (FA) 财务会计第二十九讲. ACCA Lecturer: Rachel XU

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1 Professional Accounting Education Provided by Academy of Professional Accounting (APA) ACCA F3 Financial Accounting (FA) 财务会计第二十九讲 ACCA Lecturer: Rachel XU ACCAspace 中国 ACCA 特许公认会计师教育平台 Copyright ACCAspace.com

2 Part H: Interpretation of Financial Statements Interpretation of financial statements 2

3 H1-H3: Interpretation of Financial Statements Information required by users The broad categories of ratios Profitability and return Liquidity, gearing/leverage and working capital Interpreting information Limitation of ratio analysis 3

4 Information Required by Users Users of financial statements can gain a better understanding of the significance of the information in financial statements by comparing it with other relevant information. Comparison may be made with: Previous financial periods Similar businesses Industry averages There are a number of users of a company s financial statements. Each user has differing needs. In the exam, you may need to interpret financial statements or ratios for a particular user so it is important to understand the key concerns each type of user will have 4

5 Information Required by Users How do the following users of financial statements benefit from ratio analysis? a) Employees b) Government c) Potential investor d) Lenders and suppliers e) Customers f) Shareholders 5

6 Information Required by Users Financial analysis Trend analysis Changes in the nature of the business Unrealistic depreciation rates under historical cost accounting The changing value of the currency unit being reported Changes in accounting policies Comparisons across companies Different degrees of diversification Different production and purchasing policies Different financing policies (e.g., leasing as opposed to buying) Different accounting policies Different effects of government incentives 6

7 The Broad Categories of Ratios Categories of ratio Profitability and return Long term solvency and stability Liquidity Efficiency Ratios do not give us much information when taken in isolation. In order for them to be useful, we need to have something to compare them to such as previous periods, similar businesses or industry averages. 7

8 Profitability and Return Gross profit margin = Gross profit / Revenue The gross profit margin measures how well a company is running its core operations. The gross profit percentage should be similar from year to year for the same company. A significant change may be due to: A change is sales price A change in product mix An incorrect inventory valuation (will affect 2 years) A change in cost of sales due to efficiency or price movements 8

9 Profitability and Return Operating profit margin = PBIT / Revenue X 100% Profit before interest taxation (PBIT) is used because it avoids distortion when comparisons are made between two different companies where one is heavily financed by means of loans, and the other is financed entirely by ordinary share capital. 9

10 Profitability and Return Operating profit margin cont d The extra consideration for the operating margin over the gross margin is how well the company is controlling its overheads. A significant change (especially a fall) may be due to: The reasons for the movement in the gross profit margin as stated above Changes in control over administration and distribution costs One off expenses, e.g., advertising 10

11 Profitability and Return Return on capital employed = PBIT / (Equity + NCL) X 100% Note that Equity + NCL = total assets less current liabilities Return on capital employed measures how efficiently a company uses its capital to generate profits. A potential investor or lender should compare the return to a target return or a return on other investments/loans. Careful consideration of the industry is required as ROCE for a manufacturing company is likely to be lower than that of a services company as a manufacturing company has higher assets (e.g., fatories, plant & machinery, 3 types of inventories raw material, work in progress, finished goods.) 11

12 Profitability and Return Return on capital employed cont d Other reasons for a significant change may include: New assets acquired during the year which are not yet running at capacity Assets aging Revaluations 12

13 Profitability and Return Return on equity = Profit after tax and preference dividend / equity shareholders funds X 100% Whilst the return on capital employed looks at the overall return on the long-term sources of finance, return on equity focuses on the return for the ordinary shareholders. Reasons for changes in the ROE will be similar to the ROCE with the extra consideration of changes in interest paid and gearing. This is because ROE uses profit after tax whereas ROCE uses PBIT. 13

14 Profitability and Return Learning example Given below are extracts from a company s statement of financial position and statement of profit or loss. SOFP $ SOPL $ Share capital 120,000 Operating profit 24,000 Share premium 30,000 Finance cost 2,000 Retained earnings 70,000 Income tax 6,000 Non-current liabilities 50,000 Current liabilities 20,000 What is the return on capital employed and return on equity? 14

15 Profitability and Return Analysing ROCE in more detail Return on capital employed is a useful primary ratio in analysing profitability and efficiency together. However, to sub-analyse ROCE, two secondary ratios can be used to consider profitability and efficiency separately: Profitability operating profit margin Efficiency asset turnover ratio This is because when the operating profit margin is multiplied by the asset turnover ratio; this results in the ROCE ratio: Operating profit margin x Asset turnover ratio = Return on capital employed PBIT Revenue Revenue Total assets current liabilities = * or total equity + noncurrent liabilities PBIT Total assets current liabilities 15

16 Profitability and Return Asset turnover ratio = revenue / (total assets current liabilities) This ratio measures the efficiency of the use of net assets in generating revenue. Ideally the ratio should be increasing, but we need to be careful when making assessments based on this ratio, because the company could have bought lots of assets late in the year and they simply have not had much time to start generating revenue. It this is the case, the ratio will almost certainly fall, but this is not a reflection on the ability of the assets to generate revenue, it is simply a timing issue. 16

17 Liquidity Gearing/Leverage and Working Capital Long-term solvency: debt and gearing ratios Debt ratio = Total debts / Total assets There is no absolute guide to the maximum safe debt ratio, but as a very general guide, you might regard 50% as a safe limit to debt. In practice, many companies operate successfully with a higher debt ratio than this, but 50% is nonetheless a helpful benchmark. In addition, if the debt ratio is over 50% and getting worse, the company s debt position will be worth looking at more carefully. 17

18 Gearing / leverage ratio Gearing = Total long term debts / (shareholders equity + total long term debt) X 100% There is no absolute limit to what a gearing ratio ought to be. A more than 50% is said to be highly geared. Many companies are highly geared, but if a highly geared company raises its level of gearing even more, it is likely to have problems borrowing in the future. However, it could lower its gearing by boosting its shareholders capital, either with retained profits or by a new share issue. Liquidity Gearing/Leverage and Working Capital 18

19 Liquidity Gearing/Leverage and Working Capital Gearing / leverage ratio cont d Gearing is concerned with the long-term financial stability of the company. It is looking at how much the company is financed by debt. Debt is cheaper than equity as interest is tax deductible but the higher the gearing ratio, the less secure the financing of the company will be and possibly the company s future. Leverage is the term used to describe the converse of gearing, i.e., the proportion of total assets financed by equity, and which may be called the equity to assets ratio. It is calculated as follows. Leverage = Shareholder s equity / (Shareholders equity plus total long term debt) X 100% 19

20 Liquidity Gearing/Leverage and Working Capital Learning example Purple Co. has the following amounts on its statement of financial position at the year-end. Tangible non-current assets 133,750 Intangible assets 15,800 Inventory 27,400 Receivables 17,430 Cash at bank and in hand 3,200 Bank overdraft 1,500 Trade payables 34,340 Five year bank loan 50,000 Provisions 5,700 What is Purple Co. s debt ratio? A. 18.1% B. 45.9% C. 46.3% D. 74.6% 20 $

21 Liquidity Gearing/Leverage and Working Capital Interest cover = Profit before interest and tax / Interest charges The interest cover ratio considers the number of times a company could pay its interest payments using its profit form operations. The main concern is the risks not being able to settle the debt as it falls due. 21

22 Liquidity Liquidity measures the availability of a company s cash to pay its short term debts. Current ratio (working capital ratio) = Current assets / Current liabilities Liquidity Gearing/Leverage and Working Capital This ratio measures a company s ability to pay its current liabilities out of its current assets. Working capital (current assets current liabilities) is needed by all companies in order to finance day-to-day trading activities. Sufficient working capital enables a company to: Hold adequate inventories Allow a measure of credit to its customers Pay its suppliers on the due date 22

23 Liquidity Gearing/Leverage and Working Capital A company should not operate at a level that is too low as they will not have sufficient assets to cover their debts as they fall due. However, a company should not operate at a level that is too high as this may suggest that the company has too much inventory, receivables or cash. The specific industry the company operates in should also be taken into account as for example, a supermarket holds relatively low levels of inventories as then are perishable, few receivables as customers generally pay in cash and high payables as supermarkets typically have superior bargaining power to their smaller suppliers. 23

24 Liquidity Gearing/Leverage and Working Capital Quick ratio (acid test) = Current assets less inventory / current liabilities This is similar to the current ratio except that it omits the inventories figure from current assets. This is because inventories are the least liquid current asset that a company has, as it has to be sold, turned into receivables and then the cash has to be collected. A ratio of less than 1:1 could indicate that the company would have difficulty paying its debts as they fall due. 24

25 Liquidity Gearing/Leverage and Working Capital Efficiency Efficiency measures how well the company uses its assets to generate profit, revenue and cash. Ratios Inventory turnover period (days) = Inventories / Cost of sales X 365 days 25

26 Liquidity Gearing/Leverage and Working Capital This ratio measures the number of days inventories are held by a company on average. This figure will depend on the type of goods sold by the company. A company selling fresh fruit and vegetables should have a low inventory holding periods as these goods will quickly become inedible. A manufacturer of aged wine will be default have very long inventory holding periods. It is important for a company to keep its inventory days as low as possible, subject of course to being able to meet its customers demands. A significant change may be due to: A change in type of inventory held Improved or worsened inventory controls Changes in the popularity of certain inventory items 26

27 Liquidity Gearing/Leverage and Working Capital Receivables collection period (days) = Trade receivables / Revenue X 365 days This ratio shows, on average how long it takes for the trade receivables to settle their account with the company. The average credit term granted to customers should be taken into account as well as the efficiency of the credit control function within the company. A significant change maybe due to: Increased / decreased credit terms offered to customers Change in the mix between cash and credit transactions Better / worse credit control 27

28 Payables payment period (days) = Trade payables / Cost of sales X 365 days Liquidity Gearing/Leverage and Working Capital This ratio is measuring the time it takes the company to settle its trade payables balances. Trade payables provide the company with a valuable source of short term finance, but delaying payment for too long a period of time can cause operational problems as suppliers may stop providing goods and services until payment is received. A significant change may be due to: Increased / decreased credit terms from suppliers Increase / decrease in cash Better / worse management of the payables ledger 28

29 Liquidity Gearing/Leverage and Working Capital Working capital cycle Inventory days + receivables days payable days 29

30 Liquidity Gearing/Leverage and Working Capital The working capital cycle has to be financed as cash has not yet been received from the sale of goods before the supplier has to be paid. The longer the cycle, the more financing is required and the higher the risk of bankruptcy. This is why it is good to have short inventory days and receivables collection periods, and longer payables payment periods. However, this must be weighed up with the fact that a company must not run a risk of stockouts (if inventory days are too low) or customer and supplier dissatisfaction by insisting on short and long payment periods respectively. 30

31 Liquidity Gearing/Leverage and Working Capital Learning example Given below are extracts from a company s financial statement. 20x8 ($ 000) 20x7 ($ 000) Revenue Cost of sales Inventory Receivables Calculate the inventory turnover period and receivables days and comment upon your findings. 31

32 Liquidity Gearing/Leverage and Working Capital Learning example Steve s working capital ratios are as follows: Which of the following statements is correct? A. The cash operating cycle has lengthened in 20x2. B. Steve has taken advantage of early settlement discounts offered by suppliers in 20x2. 20x1 C. Steve is taking longer to sell his inventory in 20x2. 20x2 Quick ratio Payables days Receivables days Inventory turnover D. Steve has offered early settlement discounts to customers in 20x2. 32

33 Learning example Interpreting Information Two companies Binky and Smokey trade in the same market. Their financial statements for the year ended 31 October 20x6 are summarised below: SOPL FOR THE YEAR ENDED 31 OCTOBER 20X6 Binky Smokey $ 000 $ 000 $ 000 $ 000 Sales revenue Cost of sales (155) (151) Gross profit Expenses Administrative Selling and distribution Depreciation 9 12 Loan note interest (68) (107) Net profit

34 SOFP AT 31 OCTOBER 20x6 Binky Smokey Assets $ 000 $ 000 $ 000 $ 000 Non-current assets At cost Accumulated depreciation (75) (96) Current assets Inventory Receivables Bank Equity and liabilities Share capital and reserves Share capital Retained earnings % Loan note Current liabilities Total equity and liabilities

35 Interpreting Information Learning example Required a) Calculate the following ratios for Binky and Smokey: (state the formulae used for calculating the ratios) Profitability ratios: Gross profit percentage; Net profit percentage; Asset turnover ratio Liquidity ratios: Current ratio; Quick ratio (acid test ratio); Receivables collection period b) Compare and comment on the performance of the companies as indicated by the ratios you have calculated in part (a). (9 marks) 35

36 Interpreting Information Solution The gross profit percentage is high for both companies. Smokey, which has higher sales figure in absolute terms, also has a higher gross profit percentage. It is possible that its marginally greater sales volume enables it to take advantage of discounts. As the two companies operate in the same market, it is possibly geographical location that makes the difference in the profit margin Smokey can make. The picture is different when it comes to net profit percentage. At 21.5%, that of Binky is significantly higher than that of Smokey (15.4%). The main reason for this is that expenses in all categories are higher for Smokey. In addition, Smokey is paying loan interest, while Binky does not have any loans. 36

37 Interpreting Information Solution The asset turnover ratios show that Binky is making more efficient use of assets than Smokey, as it is generating proportionally more sales from the assets. As discussed below, the inefficiency of Smokey may be partly because working capital is tied up in inventory. The current ratios of both companies are greater than one, with Smokey having the edge slightly. These ratios indicate that the companies have sufficient current assets to meet their current liabilities. 37

38 Interpreting Information Solution However, the quick ratios are more worrying. Both companies have quick ratios of less than one, indicating potential liquidity problems. In the case of Smokey, the quick ratio is very low at 0.3:1. Much of Smokey Ltd. s working capital is tied up in inventory, and the high inventory level suggests that inventory is not selling. Smokey, with its low cash balance and lack of liquidity, may have problems paying debts as they fall due. 38

39 Interpreting Information Solution The receivables collection period is high for both companies, but for Smokey, at 89.8 days it is considerably higher than that of Binky, which has 59.1 days. Smokey Ltd. Needs to pay attention to credit control. The longer a debt remains unpaid, the less likely it is to be paid. In conclusion, although Smokey has a higher profit margin, it has liquidity problems, is less efficient and has ineffective credit control. Binky is therefore a better investment prospect. 39

40 Limitation of Ratio Analysis Information problems The base information is often out of date, so timeliness of information leads to problems of interpretation. Historical cost information may not be the most appropriate information for the decision for which the analysis is being undertaken. Information in published accounts is generally summerised information and detailed information may be needed. Analysis of accounting information only identifies symptoms not causes and thus is of limited use. 40

41 Limitation of Ratio Analysis Comparison problems: trend analysis Effects of price changes make comparisons difficult unless adjustments are made. Impacts of changes in technology on the price of assets, the likely return and the future markets. Impacts of a changing environment on the results reflected in the accounting information. Potential effects of changes in accounting policies on the reported results. Problems associated with establishing a normal base year to compare other years with. 41

42 Limitation of Ratio Analysis Comparison problems: across companies Selection of industry norms and the usefulness of norms based on averages. Different firms having different financial and business risk profiles and the impact on analysis. Different firms using different accounting policies. Impacts of the size of the business and its comparators on risks, structure and returns. Impacts of different environments on results, e.g., different countries or home-based versus multinational firms. 42

43 Summary 43

44 Professional Accounting Education Provided by Academy of Professional Accounting (APA)