BEYOND FINANCIAL STATEMENTS Prepared by: Rashied Small, Lucinda Smidt & Yaeesh Yassen National CPD Seminar September 2016 CPD SEminar - Beyond Financial Statements 1
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Statement of Financial Position What does the statement say? What does the statement does not say? Summary of assets and claims against those assets at a point in time Financial position with regards to its ability to meet current debt obligations Financial position with regards to its resources to carry on and sustain its operations. Book value of the business strength of the owner s claim against the resources Equity funding Debt funding Noncurrent assets Working capital Details of how the resources were used to generate revenue and profit Claims of creditors and owners against specific assets Misconception of capital under equity [investment vs cash] Market or current value of the business [book value] True economic benefits of assets [revenue earning capacity] CPD SEminar - Beyond Financial Statements 4
Statement of Financial Performance What does the statement say? What does the statement does not say? Primary (revenue) and secondary sources of income Indication of the nature of the core business activities Nature and magnitude of the costs to support operating activities Trading and operating performance of the business [measured by profit] Profits Finance costs Revenue Expenses Predict the future performance [revenue and expenses] Provide an exact measurement of net income for the reporting period True profit of the business - difference between the funds invested and its realizable amount on disposal Indicate the cash generated from operation [misconception that profit = cash] CPD SEminar - Beyond Financial Statements 5
Statement of Cash Flow What does the statement say? What does the statement does not say? Movement of cash and cash equivalents for the reporting period A positive cash flow is the ideal outcome cash in not always King Cash flow does not represent the profit [cash basis of reporting] Profits Finance costs Revenue Expenses Indication of the profit/loss realized Indication of the operating performance positive cash flow may be misinterpreted True causes of cash flows cash management decisions Actual cash flows include cash equivalents CPD SEminar - Beyond Financial Statements 6
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Red Flags in Financial Statements Rising debt equity ratio Consistently declining current ratio Declining interest cover ratio Continuous declining revenue trends RED FLAGS Rising receivable & inventory Unsteady cash flows CPD SEminar - Beyond Financial Statements 8
Business Analysis CPD SEminar - Beyond Financial Statements 9
Financial Analysis Process to evaluate financial position and performance using financial statements Profitability analysis Evaluate performance and return on investment Common techniques Risk analysis Evaluate creditworthiness and riskiness (business & financial risk) Cash flow analysis Evaluate sources and utilization of cash resources Ratio analysis Cash flow analysis CPD SEminar - Beyond Financial Statements 10
Ratio Analysis Ratios recognize the symbolic relationship of various items in the financial statements Ratios also allow for improved comparison through time or between organisations Ratio analysis is a suggestive indicator and does not provide conclusive evidence Effective financial analysis begins with analyzing the industry in which the entity operate and the entity s strategies to create a sustainable advantage CPD SEminar - Beyond Financial Statements 11
Limitations of Ratio Analysis Nature and structure of the organization cannot be explained by the numbers Benchmarking (average/moderate) does not reflect the goals of the organization Financial information may not reflect the true value inflationary conditions versus historical cost Seasonal fluctuations may distort the average results used in ratios Historical results versus market results distortion in comparison CPD SEminar - Beyond Financial Statements 12
Limitations of Ratio Analysis Estimations, professional judge and the offbalance sheet reporting may distort comparisons Accounting policies and practices differ from organisations Generalisation about the computation and interpretation of ratios Indepenedent view and interpretation of ratios may not provide a holistic view CPD SEminar - Beyond Financial Statements 13
Ratio Analysis Techniques Comparative analysis to reflect changes Horizontal analysis Trend analysis Comparative analysis over time base period Analysis of relationship for common activities Ratio analysis Vertical analysis Analysis of relationships between items CPD SEminar - Beyond Financial Statements 14
Ratio Analysis Key Areas CPD SEminar - Beyond Financial Statements 15
Profitability Analysis Profitability ratios measures the effectiveness of management in achieving operating goals as shown in relationship on revenue and investments. Common ratios: 1. Gross profit % 2. Operating profit % 3. Net profit % 4. Expenses % 5. Return on assets 6. Return on equity CPD SEminar - Beyond Financial Statements 16
Profitability Ratios Ratio Description Formula Interpretation Gross profit % Operating profit before depreciation % Operating profit % Return on sales Measure the trading performance and competitiveness of the business Return on sales before accounting for interest, tax and depreciation Operating return on sales from normal operations Shows the efficiency of management in cost control and management Gross profit/revenue x 100% Acceptable range 40% - 60% Indicate the safety margin before the business makes losses Indication of management s ability to convert sales into profits Expected to be stable and constant Increases are good Influenced by competition & costs EBITDA/Revenue x 100% Acceptable range 20% - 35% Expected to be stable and constant Increase significantly with scale Influenced by competition & costs Operating profit/revenue x 100% Acceptable range 10% - 30% Indication of operating efficiency and effectiveness Indication of the ability to add value through the operating process Increase significantly with scale Influenced by competition & costs CPD SEminar - Beyond Financial Statements 17
Profitability Ratios Net profit % Ratio Description Formula Interpretation Expenses % of sales Operating performance as a return on sales Indicates the efficiency and cost management of the business Relationship of expenses on sales Net profit/revenue x 100% Expenses/Revenue x 100% Acceptable range 5% - 25% Indication of efficiency and overall profitability of the business Decrease significantly with debt financing Influenced by competition & costs Indication of operating efficiency and effectiveness of operations Indication of the effectiveness of management s cost performance Decrease significantly with scale CPD SEminar - Beyond Financial Statements 18
Profitability Ratios Ratio Description Formula Interpretation Return on assets Return on equity Measures the efficiency of utilizing the assets to generate profit Measures the efficiency with which the equity funds are utilized to generate profit Net profit/total assets x 100% Net profit/total equity x 100% Acceptable range 15% - 23% Indication of how efficiently management is utilizing its resources to generate profit Indication of the allocation of resources to value adding activities Indication of the effectiveness of managements investment decisions Acceptable range 8% - 15% Indication of the efficiency with which management utilizes the funds of equity holders to generate profit CPD SEminar - Beyond Financial Statements 19
Liquidity Ratios Liquidity measures ability of the organization to meet its short-term financial obligations when the are due ability to convert its shortterm assets into cash to meet obligations Common ratios: 1. Current ratio 2. Quick ratio 3. Cash ratio CPD SEminar - Beyond Financial Statements 20
Liquidity Ratio Current Ratio Ratio Description Formula Current ratio Measures the short-term financial risk and the ability of the organization to meet its short-term obligations Current assets : Current liabilities Interpretation Acceptable range 1:1 2:1 Indication of the security and cover provided to short-term creditors Indication of the sustainability of operating activities risk exposure Too low ratio increases the financial risk to short-term creditors Too high a ratio indicates that cash resources are tied up in unproductive assets CPD SEminar - Beyond Financial Statements 21
Liquidity Ratio Quick Ratio Ratio Description Formula Quick / acid test ratio Measures ability of the organization to easily converts its short-term associates to meet its short-term obligations (Current assets Inventory) : Current liabilities Interpretation Acceptable range 1:1 Indication of the immediate solvency of the organization to meets its short-term obligations High ratio provides the organization with safety margin to increase its short-term debt Ratio below 1:1 indicate the financial risk for creditors inability to meet its immediate short-term obligations CPD SEminar - Beyond Financial Statements 22
Liquidity Ratio Cash Ratio Ratio Description Formula Cash ratio Measures absolute liquidity of an organization cash available to meet obligations (Cash + cash equivalents) : Current liabilities Interpretation Acceptable range 0.5:1 Stringent indication of the liquidity of the organization alternative options to meet short-term obligations High ratio indicates poor resource allocation and management not utilizing cash resources efficiently CPD SEminar - Beyond Financial Statements 23
Liquidity Ratio Net Working Capital Ratio Ratio Description Formula Net working capital ratio Measures the management of operating liquidity cash resources available to fund operations (Current asset Current liabilities)/net Assets x 100% Interpretation Acceptable range must be positive Ratio below zero indicates that the organization the financial distress and business risk Indication of operating sustainability risk of asset stripping to sustain operations CPD SEminar - Beyond Financial Statements 24
Liquidity Ratio Defensive Interval Ratio Description Formula Defensive interval Measures the safety margin for the organization to funds its day-to-day operating costs Current assets/average daily operating cost Interpretation Acceptable range 30 to 90 days Indication of the ability to fund operating costs from internal resources Indication of the period the organization can rely on its resources to fund day-to-day costs Indication of operating risks ability to meet operating costs CPD SEminar - Beyond Financial Statements 25
Solvency Ratio Solvency measure the ability of the organization to meet its long-term obligations and sustain its activities to achieve its strategic goals Common ratios: 1. Debt ratio 2. Times interest earned ratio 3. Interest cover 4. Debt to equity ratio CPD SEminar - Beyond Financial Statements 26
Solvency Ratio Debt Ratio Ratio Description Debt ratio Measures the proportion utilization of debt financing by the organisation Formula Total Debt/Total Assets x 100% Interpretation Acceptable range 20% - 30% Indication of the dependency on debt financing by the organization - leverage (financial risk) Indication of the ability of the organization to provide security and cover for its debt providers Indication of the effectiveness of financial management and management of financial risk CPD SEminar - Beyond Financial Statements 27
Solvency Ratio Long-term Debt Ratio Ratio Description Formula Long-term debt ratio Measures the financial leverage of the organization utilization of long-term debt to fund the business Long-term debt/(equity + long term debt) x 100% Interpretation Acceptable range 20% - 30% Indication of the level of financial leverage of the organization Indication of financial risk the organization is exposed to CPD SEminar - Beyond Financial Statements 28
Solvency Ratio Debt to Equity Ratio Ratio Description Debt to equity ratio Measures financial gearing of the organization relationship between debt versus equity funding Formula Total debt/total equity x 100% Interpretation Acceptable range 50% Indication of the capital structure of the organization long-term financial structure High ratio indicates that the organization has a high debt leverage high financial risk Indication of financing the growth of the organisation CPD SEminar - Beyond Financial Statements 29
Solvency Ratio Interest Cover Ratio Ratio Description Formula Interest cover ratio Measures the ability of the organization to pay its debt servicing costs from operations number of time interest is covered Operating profit/ Interest paid Interpretation Acceptable range 6 7 times Indication of the level of risk the organization has in meet is debt financing costs A low ratio indicates that the organization is burdened with a high level of debt financing Too high a ratio may indicate low debt leverage or efficient and profitable operations CPD SEminar - Beyond Financial Statements 30
Efficiency Ratios Efficiency ratios measure the effective management and allocation of resources to the operating goals of the organization. Common ratios: 1. Asset turnover ratio 2. Inventory turnover ratio 3. Debtors turnover ratio 4. Creditors turnover ratio CPD SEminar - Beyond Financial Statements 31
Efficiency Ratio Asset Turnover Ratio Description Formula Asset turnover ratio Measures the ability of the organization to convert its investments in assets into revenue utilize the resources to generate revenue Revenue/Total non-current assets Interpretation Indication of the utilization of the resources as a revenue driver Indication of the effective management decisions for investments in resources to generate revenue As low ratio indicates that management have investment in ineffective resources or unproductive resources A low ratio indicates that the organization has too low and investment in resources to support potential sales CPD SEminar - Beyond Financial Statements 32
Efficiency Ratio Inventory Turnover Ratio Description Formula Inventory turnover ratio Measures the ability of the organization to convert its into revenue number of times the entire inventory is sold during the period Average inventory/revenue Interpretation Indication of the efficiency with which inventory is converted into sales Low ratio may indicate a risk of holding low level of inventory resulting a potential loss of sales High ratio may indicate a difficulty in the organization selling its inventory resulting over stocking or a decline in the market for the goods CPD SEminar - Beyond Financial Statements 33
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Cash flow Analysis Cash flow ratios measures the effectiveness of management of cash resources in achieving strategic goals without increasing the risks to the organisation. Common ratios: 1. Operating cash flow ratio 2. Operating cash margin 3. Cash debt cover ratio 4. Cash interest cover ratio 5. Cash return on assets 6. Cash re-investment ratio CPD SEminar - Beyond Financial Statements 35
Operating Cash Flow Ratio Ratio Description Operating cash flow ratio Measures the gap between the time the goods are acquired from suppliers and the time it takes to collect cash from customers Ratios Inventory holding period Debtors collection period Creditors repayment period Interpretation Indication of the ability of the organization to funds its sales/operating activities from internal sources Indication of the organization s dependency on short-term debt financing (bridging finance) CPD SEminar - Beyond Financial Statements 36
Inventory Holding Period Ratio Ratio Description Formula Inventory holding period ratio Measures the time period its takes the organization to sell its goods from the date of purchase shelf-life (Average inventory/cost of sales) x Annual working days Interpretation Acceptable range 20-46 days A high ratio indicates an over investment in inventory, inventory build up or holding of slow moving goods A low ratio indicates a high level of sales activity but may not reflect a high profit as profit may be sacrificed for increased sales A high ratio may indicate a low investment in inventory resulting in loss of potential revenue CPD SEminar - Beyond Financial Statements 37
Debtors Collection Period Ratio Ratio Description Formula Debtors collection period ratio Measures the time period its takes the organization to collect the cash from customers from the date of sale (Average debtors/credit sales) x Annual working days Interpretation Acceptable range 30-60 days Indication of the liquidity of the trade receivables Indication of the credit management of the organization measured in comparison to credit policy A low ratio indicates an efficient sale cycle A high ratio may indicate a significant investment in debtors or create of revenue through credit CPD SEminar - Beyond Financial Statements 38
Creditors Repayment Period Ratio Ratio Description Formula Debtors collection period ratio Measures the time period its takes the organization to pay creditors from the date of purchases (Average creditors/credit purchases) x Annual working days Interpretation Acceptable range 30-60 days A high ratio may indicate liquidity problems inability to meet obligations when due A high ratio may indicate a low financial or creditworthiness risk Must be viewed in conjunction with the debtors collection ratio and liquidity ratios High ratio indicates the utilization of interest-free debt to funds operations CPD SEminar - Beyond Financial Statements 39
Operating Cash Flow Ratio Ratio Description Formula Operating cash flow ratio Measures the ability of the organization to pay its short-term obligations from cash generated from operations Cash from operations/current liabilities Interpretation Acceptable range 1:1 Indication of the organization s ability to meet its short-term obligation from cash generated from operations A ratio of less than 1:1 indicates a financial risk as the organization cannot pay its short-term obligations from internal cash generated A high ratio indicates that the organization generates sufficient to funds expansions and replacement of assets CPD SEminar - Beyond Financial Statements 40
Operating Cash Margin Ratio Ratio Description Operating cash flow ratio Measures the ability of the organization to convert sales into cash Formula Cash from operations/revenue x 100% Interpretation Acceptable range 10% - 15% Indication of the organization s ability to convert is sales into cash to finance its obligations Indication of the organization risk to service its investors from operations pay taxes. Dividends and interest Indication of the cash efficiency and performance of the operating activities of the organisation CPD SEminar - Beyond Financial Statements 41
Cash Debt Cover Ratio Ratio Description Formula Operating cash solvency ratio Measures the ability of the organization to pay all its obligations from the cash generated from operations Cash from operations/total liabilities Interpretation Acceptable range 1:1 Indication of the organization s ability to meet its short-term obligation from cash generated from operations A ratio of less than 1:1 indicates a financial risk as the organization cannot pay its short-term obligations from internal cash generated A high ratio indicates that the organization generates sufficient to funds expansions and replacement of assets CPD SEminar - Beyond Financial Statements 42
Cash Interest Cover Ratio Ratio Description Formula Operating cash solvency ratio Measures the ability of the organization to pay debts service costs from the cash generated from operations (Cash from operations + Interest paid + Tax paid)/interest paid Interpretation Acceptable range 6 8 times Indication of the ability of the organization to pay service costs from the cash generated from operations A ratio less than zero indicates that the organization cannot pay its interest costs from operations increase the financial risk to the business CPD SEminar - Beyond Financial Statements 43
Cash Return on Assets Ratio Ratio Description Cash return on asset ratio Measures the ability of the organization to generate cash from the ulisation of its resources Formula Cash from operations/total assets x 10% Interpretation Acceptable range 20% - 35% Indication of the efficiency of management to utilise its resources to generate cash Indication of management s efficiency in allocating resources to cash and value creation activities Indication of the effective allocation of resources to develop and maintain the competitive advantage of the organisation CPD SEminar - Beyond Financial Statements 44
Cash Re-investment Ratio Ratio Description Formula Cash re-investment ratio Measures the ability of the organization to generate cash from the acquire resources for expansions and replacement purposes Cash from operations/acquisition of noncurrent assets Interpretation Acceptable range 20% - 35% Indication of the efficiency of management to plan to have sufficient cash to replace and acquire assets A low ratio indicates that the organization is dependent of external funding to sustain its activities to achieve its goals A high ratio indicates that management has planned adequately for sustain operating activities CPD SEminar - Beyond Financial Statements 45
Financial Stability Ratios Financial stability ratios measures the ability of the organization to meet its long-term obligations while at the same time having sufficient resources available to sustain its operations. Common ratios: 1. And solvency ratios 2. Debt to equity ratio 3. Working capital to asset ratio 4. Debt to equity ratio 5. Free cash flow ratio CPD SEminar - Beyond Financial Statements 46
Financial Stability Ratio Free Cash flow Ratio Description Formula Free cash flow ratio Measures the ability of the organization to generate cash from operations which exceed its capital expenditure requirements Operating cash flow Capital expenditure Interpretation Indication of the organization to generate organic growth (internal growth) Indication of the organization to generate sufficient cash to pay returns to equity investors Indication of the organization to maintain its competitive advantage Indication of the organization financial flexibility for growth and expansion CPD SEminar - Beyond Financial Statements 47
Financial Stability Ratio Working Capital to Assets Ratio Description Working capital to total assets ratio Measures the liquidity of the organization in terms of its ability to easily convert its assets in cash to meet financial obligations Formula Working capital/total assets x 100% Interpretation Indication of the organization liquidity to meet its obligations and sustain its operations without causing financial distress Indication of the level of resources required to meet its day-to-day operating obligations A high ratio may indicate that management is not using its resources efficiently cash resources are tied up in working capital CPD SEminar - Beyond Financial Statements 48
Looking Beyond the Numbers Questions to ask Revenue = Single customer Revenue = Single product Revenue = Geographical markets Supply chain = Single supplier Competition = Competitive advantage Future potential = Research & Development Environment = Regulations CPD SEminar - Beyond Financial Statements 49
Summary CPD SEminar - Beyond Financial Statements 50
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