week 10 lecture notes (6 slides)

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School of Accounting

ACCT 1501: Accounting and Financial Management 1A

Week 10

Ratio Analysis - Basic

Student Handout

Contents:

1. Introduction 2. Tutorial questions Week 11 3. Lecture examples 4. Lecture slides

Lecturer:

Mr. J. Knapp

School of Accounting

UNSW

QUAD 3103

Blackboard: http://telt.unsw.edu.au

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1. Introduction

In this weeks lectures, you will learn to perform financial statement analysis, especially ratio

analysis, to assess the financial performance and viability of a company. By the end of this

week, you should be able to:

(1) locate the information in the financial reports that is needed calculate some basic

ratios reflecting a companys performance, activity, liquidity, and financial structure;

and

(2) interpret the ratios you have calculated to provide a financial commentary on the

company.

You should also be able to understand the limitations of ratio analysis, because we are reliant

on the historical information provided by the company and that the quality of this information

is very much affected by accounting measurement issues and accounting policy choices made

by management.

Learning objectives

At the end of this topic, you should be able to:

1. Explain the purpose of financial statement analysis

2. Identify types of ratios and their usefulness

3. Calculate and interpret the key financial ratios

4. Identify the limitations of ratio analysis

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Required readings Trotman & Gibbins Chapter 14: pages 615-631

Other References:

Deegan, Craig. 2007. Australian Financial Accounting, 5h Edition, North Ryde: McGraw Hill

Australian Pty Ltd

Carlon, S., Mladenovic, R., Loftus, J., Palm, C., Kimmel, P., Kieso, D. E., & Weygandt, J.J.,

2009, Accounting, building business skills, Milton, Qld: John Wiley & Sons (3rd

edition)

2. Tutorial Questions Week 11

Students should attempt these questions before the tutorial.

Preparation Questions

T&G DQ14.4,14.5, 14.6, 14.9

T&G P14.4, 14.11, 14.17

Tutorial Questions

T&G DQ 14.1, 14.3

T&G P14.6, 14.16

T&G Case 14D

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3. Lecture Examples (please bring your calculator to the

lecture.)

Use the Balance Sheets and Income Statements of Woolworths (Appendix 1 of

Trotman & Gibbons) to calculate the following ratios :

Performance Ratios :

Return on Assets

=

Earnings Before Interest and Tax

Total Assets

Woolworths 2007 2006

Return on Assets

Return on Equity

=

Operating Profit after Tax

Shareholders Equity


Return on Equity

Profit Margin = Operating Profit after Tax

Sales


Profit Margin

Gross Margin = Gross Profit

Sales


Gross Margin

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Activity/Turnover Ratios :

Total Asset Turnover = Sales

Total Assets


Total Asset Turnover

Inventory Turnover = COGS

Average Inventory

Inventory= $1969.6 million in the 2005 Balance Sheet:


Inventory Turnover

Days in Inventory

Debtors Turnover = Credit Sales

Average Trade Debtors

Assume that 2% of Woolworths sales in 2007 were on credit:

Woolworths 2007

Debtors Turnover

Days in Debtor

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Liquidity Ratios :

Current Ratio = Current Assets

Current Liabilities


Current Ratio

Quick Ratio = Cash+Accounts Receivable+Short-term Investment

Current Liabilities


Quick Ratio

Financial Structure Ratios :

Debt to Equity Ratio = Total Liabilities

Total Shareholders' Equity


Debt to Equity Ratio

Leverage Ratio = Total Assets

Total Shareholders Equity


Leverage Ratio

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Accounting and Financial

Management 1A

Week 10

Ratio Analysis

Prepared by: Dr. Wei Chen Presented by: Mr. J Knapp

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Lecture objectives

TC: Explain the purpose of financial statement analysis.

Identify types of ratios and their usefulness.

HOT: Calculate and interpret the key financial ratios.

Identify the limitations of ratio analysis.

Ratio analysis

Ratios can be calculated in different ways e.g.,

Return on Assets

= Net Profit After Tax

Total Assets

or

= Net Profit Before Tax

Total Assets

or

= Earnings Before Interest & Tax

Total Assets

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Ratio analysis

Ratios can be grouped in many different ways e.g.,

Performance

Activity or turnover

Liquidity

Financial structure

The list of potential ratios that may be calculated is endless.

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Performance ratios

Performance ratios aim to give the financial statement user some indication of the

companys record of generating profits and its potential for generating profits in the future.

Performance ratios: return on equity return on assets profit margin gross margin earnings per share cash flow to total assets price/earnings ratio dividend payout ratio.

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Performance ratios (examples)

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Return on Assets

Earnings Before Interest & Tax (EBIT) Total Assets

=

This ratio describes the rate of return management was able to earn on the assets that it had available

during the year.

An informed judgment about the firms profitability requires relating income from operations to the

assets used to generate that net profit.

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Owners are interested in expressing the profits of the firm as a rate of return on the

amount of shareholders equity.

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Return on Equity

Operating Profit After Tax Shareholders Equity

=

Lecture Example -- Performance Ratios (please complete the blanks in lecture notes)

Return on Assets

Earnings Before Interest & Tax Total Assets

=

Return on Equity

Operating Profit After Tax Shareholders Equity

=


Return on Assets


Return on Equity

=2111.3/14416.1 =14.65%

=1722.2/13346.4 =12.90%

=1311.3/5514.7 =23.78%

=1026.7/4257.6 =24.11%

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Profit margin gives some indication of pricing strategy or competition intensity.

A discount retailer in a competitive market will have a

_____ margin, and an upscale jeweller to have a

_____ margin. (please fill in the blanks using Low or High)

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Profit Margin Operating Profit After Tax

Sales Revenue =

low

high


Gross Margin provides a further indication of the companys product pricing and product mix.

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Gross Margin Gross Profit

Sales Revenue =

Remember: Gross profit= Sales revenue - COGS

Lecture Example -- Performance Ratio (cont.) (please complete the blanks in lecture notes)

Profit Margin Operating Profit After Tax Sales Revenue

=

Gross Margin Gross Profit Sales Revenue

=


Profit Margin


Gross Margin

=1311.3/42477.1 =3.09%

=10754/42477.1 =25.32%

=1026.7/37734.2 =2.72%

=9444.6/37734.2 =25.03%

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EPS relates earnings attributable to ordinary shares to the number of ordinary shares issued.

E.g. Woolworths

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Earnings per share

Net operating profit Dividends on preferred shares Weighted average number of ordinary shares outstanding

=

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Performance ratios

These ratios should exceed zero (a positive return).

You would prefer their values to be as high as possible.

Values of these ratios generally range between 5% and 20%.

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Activity (Turnover) ratios

Activity ratios aim to give the financial statement users some indication of the

companys operations in certain areas.

Activity ratios: Total Asset Turnover

Inventory Turnover

Debtors Turnover

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Total Asset Turnover

Assets Turnover reflects a companys ability to use its assets to generate sales.

An indication of operating efficiency.

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Assets Turnover

Sales Total Assets

=

Inventory Turnover

a measure of the number of times inventory is sold or used during the period

the efficiency of inventory management

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Inventory Turnover

COGS Average Inventory

=

Days in Inventory

365 Inventory Turnover

=

a measure of how long, in days, inventory is held on average.

Debtors Turnover

This ratio indicates the efficiency of the company to collect the amount due from debtors.

The debtors turnover can be divided into 365 days in order to calculate the average number of days to collect accounts

receivable.

Too high a figure may indicate a problem with the granting of credit

and/or collection policies.

Too low a figure may indicate that the credit granting and/or

collection policies are too strict (by, for example, industry

standards) and sales are being lost.

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Debtors Turnover

Credit Sales Average Trade Debtors

=

Days in Debtors

365 Debtors Turnover

=

Lecture Example -- Activity (Turnover) Ratios (please complete the blanks in lecture notes)


Assets Turnover

Assets Turnover

Sales Total Assets

=

Inventory Turnover

COGS Average Inventory

=

Inventory=$1969.6 million in the 2005 Balance Sheet


Inventory Turnover

Days in Inventory

=42477.1/14416.1 =2.95

=31832.8/0.5(2739.2+2316.1)

=12.59

=37734.2/13346.4 =2.83

=28388.7/0.5(2316.1+1969.6)

=13.25

=365/12.59 =28.99 =365/13.25 =27.55 18

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Lecture Example -- Activity (Turnover) Ratios (please complete the blanks in lecture notes)

Assume that 2% of Woolworths sales in 2007 were on credit:

Woolworths 2007

Debtors Turnover

Days in Debtors

Debtors Turnover

Credit Sales Average Trade Debtors

=

=2%x 42477.1/0.5(95.7+85.1) =9.40

=365/9.40 =38.83

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Liquidity ratios

Liquidity ratios aimed at giving the financial statement user some indication of the

companys ability to pay its short term debts as they fall due.

Liquidity ratios:

- Current Ratio

- Quick Ratio

Remember, a company may be forced into liquidation if it cant pay its short term debts (even though it might be profitable in the long term). 20

Liquidity Ratios (Example)

This ratio measures the ability of the company to pay current debts as they become due.

A ____ ratio may indicate a problem in paying

short term debts.

A too ____ ratio may indicate the company may

not be efficiently using its current assets.

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Current Ratio

Current Assets Current Liabilities

=

low

high

Liquidity Ratios (Example)

Generally similar to Current Ratio, remove Inventory from the numerator

particularly useful for companies that cannot convert

inventory into cash quickly if necessary.

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Quick Ratio

Cash+Accounts Receivable+Short-term Investment Current Liabilities

=

also called the acid test

Lecture Example -- Liquidity Ratios (please complete the blanks in lecture notes)


Current Ratio


Quick Ratio

Current Ratio

Current Assets Current Liabilities

=

Quick Ratio

Cash+Accounts Receivable+Short-term Investment Current Liabilities

=

=4161.0/5502.8 =0.76

=(798.8+484.7+41.4)/5502.8

=0.24

=4120.8/4874.3 =0.85

=(525.9+1160.4+2.8)/4874.3

=0.35

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Financial structure ratios

Financial structure ratios measure the ability of the company to continue operations in the

long term.

Financial structure ratios: Debt/equity ratio

Debt/assets ratio Leverage ratio

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Financial Structure Ratios

Debt-to-Equity Ratio

Total Liabilities Total Shareholders Equity

=

Leverage Ratio

Total Assets Total Shareholders Equity

=

Debt-to-Assets Ratio

Total Liabilities Total Assets

=

do we need to calculate all these three ratios?

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a measure of the proportion of borrowings to owners investment

Indicates the companys policy regarding financing of its assets

>1, the assets are financed mostly with _______

Too high ratio is a warning about risk

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=

debt


indicates the proportion of assets financed by liabilities.

The _____er the ratio, the greater risk will be

associated with the firm's operation.

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Debt-to-Assets Ratio

Total Liabilities Total Assets

=

high


a measure of how much of assets is financed by equity.

The higher the ratio, the ______is funded by

equity; the ______ is funded by debt.

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Leverage Ratio

Total Assets Total Shareholders Equity =

less

more

Lecture Example -- Financial Structure Ratios (please complete the blanks in lecture notes)


Leverage Ratio





=

Leverage Ratio

Total Assets Total Shareholders Equity =

=8901.4/5514.7 =1.61

=9088.8/4257.6 =2.13

=14416.1/5514.7 =2.61

=13346.4/4257.6 =3.13

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Ratio analysis -- summary

The calculation of a ratio simply involves dividing the dollar amount of one item with

the dollar amount of another.

Only some relationships will, however, be meaningful.

Determine which ratios will be useful to the specific analysis.

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Relationship between ratios

Many ratios are related, and any analysis will benefit from an understanding of these

relationships.

For example:

Activity (turnover) ratios are related to liquidity ratios.

Performance ratios are related to financing ratios.

Performance ratios are related to activity (turnover) ratios.

And so on.

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Du Pont Analysis

1) Profit margin =

2) Asset turnover =

3) Leverage =

4) Return on equity = 1) x 2) x 3)

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Operating Profit After Tax Sales

Sales Total Assets

Total Assets Total Shareholders Equity

Limitations of financial statement ratios

1. Ratios rely on past information. The usefulness of ratios is based upon the belief that past

relationships are useful in forecasting future performance.

However, numerous factors may mean that past

relationships do not continue into the future.

2. Ratios rely on historical cost financial statements. Failure to adjust for inflation or market values results in

current dollar amounts often being compared to past

dollar amounts. For example, current dollar profits with

historical dollar assets.

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Limitations of financial statement ratios (cont.)

3. Ratios are based on Year End Data. Year end data may not be reflective of the typical

situation of the company. Furthermore, management

may attempt to improve certain ratios by, for example,

using cash to pay off short term borrowings (improves

the current ratio).

4. Not all required information will be disclosed. For example, many foreign companies will not disclose

cost of goods sold, making the calculation of inventory

turnover difficult.

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5. The Balance Sheet, Income Statement and Cash Flow Statement may not provide all the information.

The general purpose financial statements may be

subject to subsequent modification, qualification or

additional clarification. To reduce the impact of

this problem, financial statement users should

also examine the information contained in the

directors report, audit report, and other

information sources.

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6. It may not be possible to compare between different entities.

Different accounting methods, size, geographical

operations, etc. may make it difficult to find an appropriate

benchmark against which to compare the ratios

calculated.

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Common size financial statements

The preparation of common size financial statements involves the presentation of all

balance sheet items as a percentage of total

assets and profit and loss items as a percentage

of total sales.

Common size financial statements attempt to factor out the size of the company.

This assists in comparing companies and analysing trends for a single company.

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Illustration of Common Size

Financial Statements

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2007 2008

Company A

Sales 500,000 100.0 600,000 100.0

Cost of Goods Sold 384,000 76.8 457,200 76.2

Company B

Sales 300,000 100.0 400,000 100.0

Cost of Goods Sold 217,800 72.6 319,200 79.8

Trend analysis

Evaluate changes in financial data over a

period of time

Year-to-year change

or

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Current year amount - Base year amount

(Current year amount Base year amount) Base year amount

2001 2002 Change

Sales 1,000,000 2,000,000

COGS 200,000 800,000

Gross Profit 800,000 1,200,000

Expenses 200,000 600,000

Net Profit 600,000 600,000

2001 is

base year

(2mil 1mil)

1 mil

100%

300%

50%

200%

0%

Trend analysis(Example)

percentage

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