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Module 6ModuleModuleModule 666 Interpretation of Financial StatementsStatements Omar ElKheshen – kheshen@gmail.com 1
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Learning Objectives By the end of this module you should understand: 1. The need for ratio analysis of external financial statements 2. The strengths and weaknesses of ratio analysis 3. The major ratios commonly used: liquidity ratios, profitability ratios, capital structure ratios, and efficiency ratios 4.4. How to expand the external analysis to an integrated chart analysis focusing onHow to expand the external analysis to an integrated chart analysis focusing on return on investment 5. The basic stock market ratios Omar ElKheshen – kheshen@gmail.com 2
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Agenda 6.1 Introduction 6.2 Ratio Analysis 6.3 Group 1: Liquidity Ratios 6.4 Group 2: Profitability Ratios 6.5 Group 3: Capital Structure Ratios 66..66 GroupGroup 44: Efficiency Ratios: Efficiency Ratios 6.7 Other Possible Ratios 6.8 Window Dressing 6.9 Putting it all Together: The Dupont Chart 6.10 A One Hundred Per Cent Statement 6.11 Basic Stock Market Ratios Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 3
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In chapter 1, we saw how this course is designed to cover both accounting functions – financial and managerial Financial Accounting Management (Reporting) Accounting Compiling accounting information Predicting future prices and costs of into financial statements showing the daily operations overalloverall picture of the firmpicture of the firm Important for managers and Important for managers to plan and shareholders in taking decisions and control the day to-day activities of the assessing company’s performance business The first 7 modules of this course address financial accounting for managers; the following 9 modules address management accounting for decision making Omar ElKheshen – kheshen@gmail.com 4
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So far we’ve covered the meaning and the basic construction of the principal financial statements prepared by a company Module 2 Module 3 Module 4 Module 5 Profit and loss Balance Statement of Financial reporting account sheet cash flow framework From the The perspective of a manager who must understand what accounting numbers tell him Omar ElKheshen – kheshen@gmail.com 5
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This module completes that broad picture as it helps managers interpret accounting information Financial interpretation allow managers: 1 Inter-period Compare the performance of the company this Comparison period with last 2 Inter-firm Compare the performance of the company with Comparison that of its competitors 33 Comparison against Compare the performance of the company with Set ExpectationsSet Expectations what the directors expectedwhat the directors expected 4 Weaknesses Detect areas of weaknesses to direct managerial Uncovering efforts towards Interpreting financial statements is the logical extension to constructing and reading them Omar ElKheshen – kheshen@gmail.com 6
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Absolute figures as reported in financial statements do not tell very much; unlike ratios that allow companies to gauge their performance against benchmarks Percentages & Ratios e.g. Industrial statistics issued by “clearing houses” Permit Easy comparison between different corporate entitiesentities Divisions within the Companies within the Companies within the company same group same industrial sector Average industrial figures are usually a reasonable guide to management as to how their companies have performed over the accounting period Omar ElKheshen – kheshen@gmail.com 7
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A word of warning about ratios Ratios can suppress poor absolute figures Example A company could report a 300% growth impression of success and progress A competitor using the same amount of capital and labor inputs are enjoying sales of €1,000 Using average figures should be used for ratios rather than yearUsing average figures should be used for ratios rather than year--end figuresend figures No two companies measure these ratios in the same way A company must apply its definitions consistently for all accounting periods It’s better to draw conclusions from the ratios’ trend rather than one year’s numbers Consolidated financial statements should be used wherever possible Omar ElKheshen – kheshen@gmail.com 8
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Agenda 6.1 Introduction 6.2 Ratio Analysis 6.3 Group 1: Liquidity Ratios 6.4 Group 2: Profitability Ratios 6.5 Group 3: Capital Structure Ratios 66..66 GroupGroup 44: Efficiency Ratios: Efficiency Ratios 6.7 Other Possible Ratios 6.8 Window Dressing 6.9 Putting it all Together: The Dupont Chart 6.10 A One Hundred Per Cent Statement 6.11 Basic Stock Market Ratios Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 9
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We will conduct our ratio analysis on MBA’s industrial operations figures since these are the most significant contributor to the overall results MBA Group Income Statement The authors have created their own ‘industrial averages’ from data collated from each of the sectors in which MBA is active Omar ElKheshen – kheshen@gmail.com 10
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Financial ratios enable managers to reduce the amount of data to a workable form and to make it more meaningful Financial Ratios Relationship between two quantities on a company’s financial statements, derived by dividing one quantity by another Profitability Capital Efficiency Liquidity Ratios Structure Ratios Ratios Ratios Measure aMeasure a MeasureMeasure Examine theExamine the Indicate howIndicate how company’s management’s asset structure effectively a ability to meet overall of the company company has its maturing effectiveness Analyze the been managing short-term extent to which its assets obligations the company relies on debt Managers must learn which ratios are appropriate, however they seldom provide conclusive answers, they just lead you into asking the right questions Omar ElKheshen – kheshen@gmail.com 11
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Agenda 6.1 Introduction 6.2 Ratio Analysis 6.3 Group 1: Liquidity Ratios 6.4 Group 2: Profitability Ratios 6.5 Group 3: Capital Structure Ratios 66..66 GroupGroup 44: Efficiency Ratios: Efficiency Ratios 6.7 Other Possible Ratios 6.8 Window Dressing 6.9 Putting it all Together: The Dupont Chart 6.10 A One Hundred Per Cent Statement 6.11 Basic Stock Market Ratios Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 12
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Managers’ first concern is liquidity, they ask "Is the company able to meet its short-term maturing obligations?" Current Ratio Quick Ratio (Acid Test) Current Assets Current Assets - Inventory Current Liabilities Current Liabilities A company is in a good position: Widely accepted rule of thumb of 1 times: If current assets exceed current liabilitiesIf current assets exceed current liabilities The company has enough to pay itsThe company has enough to pay its by a comfortable margin obligations, no matter how bad its inventories are performing MBA = 16,924 = 3.62 times MBA = 16,924 − 6,458 = 2.24 times (3,070 + 1,606) (3,070 + 1,606) Industry sector = 2.58 times Industry sector = 1.27 times Healthy Position Healthy Position Omar ElKheshen – kheshen@gmail.com 13
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It is wrongly perceived as a rule of thumb that a 2 times current ratio indicates a sound financial situation Wrong Perceptions A company can pay its bills A ratio of less than 2 times because it has a current ratio indicates that a company cannot greater than 2 times. pay its bills Example A company has the following:A company has the following: Current assets of €4,000 (cash €2,000 + inventory €2,000) Current liabilities of €2,500 (all creditors) Therefore current ratio = 1.6 times Next accounting period: Paid off current liabilities of €2,000 in cash Therefore current ratio =4 times (Inventory €2,000/ Creditors €500) Since nothing is known about the marketability of inventory it might be that the liquidity position of 1.6 times is healthier than 4 times in this example. Omar ElKheshen – kheshen@gmail.com 14
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Agenda 6.1 Introduction 6.2 Ratio Analysis 6.3 Group 1: Liquidity Ratios 6.4 Group 2: Profitability Ratios 6.5 Group 3: Capital Structure Ratios 66..66 GroupGroup 44: Efficiency Ratios: Efficiency Ratios 6.7 Other Possible Ratios 6.8 Window Dressing 6.9 Putting it all Together: The Dupont Chart 6.10 A One Hundred Per Cent Statement 6.11 Basic Stock Market Ratios Review Questions Case Studies Omar ElKheshen – kheshen@gmail.com 15
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If liquidity is management’s first concern for short-term survival, then profitability gives them an insight into long-term survival Profitability Ratios Gross Profit Profit Return Return on Return on Return on Margin Margin on Total Specific Capital Owner’s Assets Assets Employed Equity Profitability ratios give some answers as to how effective this managerial action has been Omar ElKheshen – kheshen@gmail.com 16
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If liquidity is management’s first concern for short-term survival, then profitability gives them an insight into long-term survival Profitability Ratios 1 Gross Profit Profit Return Return on Return on Return on Margin Margin on Total Specific Capital Owner’s Assets Assets Employed Equity Gross profitGross profit Revenues MBA = 8,787 × 100 = 20.12% 43,662 Industry sector = 14.61% Well above the industry average Omar ElKheshen – kheshen@gmail.com 17
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If liquidity is management’s first concern for short-term survival, then profitability gives them an insight into long-term survival Profitability Ratios 2 Gross Profit Profit Return Return on Return on Return on Margin Margin on Total Specific Capital Owner’s Assets Assets Employed Equity Alternatively could Profit from ordinary activities before taxation use profit after tax Revenues MBA = 3,185 × 100 = 7.29% 43,662 Industry sector = 6.98% Indicates that MBA’s Still above the industrial average but not by as much overhead structure is as its gross profit margin is heavier than its competitors Omar ElKheshen – kheshen@gmail.com 18
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If liquidity is management’s first concern for short-term survival, then profitability gives them an insight into long-term survival Profitability Ratios 3 Gross Profit Profit Return Return on Return on Return on Margin Margin on Total Specific Capital Owner’s Assets Assets Employed Equity Profit from ordinary activities before taxation Total assets MBA = 3,185 × 100 = 9.75% 32,653 Industry sector = 7.91% This advantage could be caused by MBA’s assets MBA is in a good position as it is ‘working its assets’ being older (worth less) harder than its competitors than their competitors’ assets Omar ElKheshen – kheshen@gmail.com 19
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If liquidity is management’s first concern for short-term survival, then profitability gives them an insight into long-term survival Profitability Ratios 4 Gross Profit Profit Return Return on Return on Return on Margin Margin on Total Specific Capital Owner’s Assets Assets Employed Equity Profit from ordinary activities before taxation Inventory MBA = 3,185 × 100 = 49.32% 6,458 Industry sector = 60.08% MBA’s performance An industry which records a return of under 100% is suggests that it is carrying one that requires a relatively heavy inventory level more inventory than its A service firm like a solicitor records above 100% competitors Omar ElKheshen – kheshen@gmail.com 20
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