Financial reports and ratios
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Financial reports and ratios

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A presentation which focuses on the analysis and interpretation of financial reports.

A presentation which focuses on the analysis and interpretation of financial reports.

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Financial reports and ratios Financial reports and ratios Presentation Transcript

  • Financial Reports and Ratios Analytical Techniques
    • Analytical Techniques permit businesses to study end of period reports in order to base decisions for the future. Techniques may include:
    • Ratio analysis
    • Vertical and horizontal analysis
    • Trend analysis
  • Ratio Analysis
    • Valuable tool for interpreting financial ratios
    • Efficient way to express relationship of one number to another
    • 3 areas of analysis:
      • Profitability
      • Financial stability
      • Management effectiveness
  • Vertical Analysis
    • Analysis of items or a group of items in the same financial period.
      • Eg comparison of Net Sales to Expense groups
  • Horizontal Analysis
    • Analysis of items or a group of items across consecutive accounting periods.
      • Eg comparison of Sales in ’07 to ‘08
  • Trend Analysis
    • Analysis of items across at least three consecutive accounting periods.
      • Eg Sales are progressively increasing over the five year period.
  • RATIOS
    • Presented as % or as ratios
    • Assist in:
      • decision making
      • Interpreting financial reports
      • Assessment of enterprise ’s:
        • Profitability
        • Stability
        • Effectiveness
  • Ratios
  • Profitability
    • Profitability is the ability to earn income within the present financial structure of an enterprise.
    • Profitability Ratios
    • Gross profit ratio
    • Net profit ratio
    • Ratio of expenses to sales
    • Return on equity ratio
    • Return on total assets ratio
  • Gross Profit Ratio
    • Indicates the ability of a trading enterprise to generate gross profit from sales.
    • Compare result to industry benchmarks to determine suitability of business performance
    • Result indicates:
    • for every $ of sales – number of cents retained as gross profit
    • how effective business is in passing on increases in COGS to customers
    • High result may indicate:
    • ability of business to cover all costs
    • capacity to earn acceptable net profit and return to owner
    • Low result may indicate inability to:
    • meet further costs
    • return satisfactory net profit
    • return satisfactory rate to owner
  • Recommendations
    • Improve sales
    • Ascertain:
      • stock levels - should be high enough to meet demand
      • appropriateness of stock to appeal to market
      • demand for stock held
      • Appropriateness of selling price
    • Conduct market research/analysis to assist with the above.
    • Institute policy to minimise COGS
    • Investigate alternative suppliers selling similar quality products for less
    • Take advantage of discounts offered to lower costs
  • Net Profit Ratio
    • Indicates the ability of a trading enterprise to generate a return on the owner ’s investment.
    • Compare result to industry benchmarks to determine suitability of business performance
    • Result indicates:
    • for every $ of sales – number of cents retained as net profit
    • how effective business is in minimising expenses
    • poor GP ratio will impact on NP ratio
    • High result may indicate:
    • High operating revenue
    • Low operating expenses
    • Low result may indicate:
    • inappropriate pricing policy
    • inadequate stock
    • inappropriate stock
    • expenses too high
  • Recommendations
    • Improve sales
    • as per Gross Profit recommendations
    • Minimise expenses
    • Set budgets for departments
    • Investigate alternative suppliers to lower costs
    • As per Gross Profit recommendations
  • Expense Groups to Sales Indicates the amount of the sales dollars needed to cover expenses. Compare result to industry benchmarks to determine suitability of business performance.
    • High result may indicate:
    • weak control over expenses in proportion to the sales
    • Low result may indicate:
    • tight control over the expenses in proportion to the sales
  • Recommendations Investigate unusually high or low expense items to ensure errors have not been made in recording. Increase net profit while retaining expense levels at current level. Decrease expenses while retaining or improving sales.
  • Rate of Return on Equity Ratio Indicates the return to the owner on the amount invested in the business Aim for a return of, around, 14% which allows funding for future growth and a return on investment.
    • High result may indicate:
    • efficient operation
    • business may be under-capitalised (owner has not contributed equity to the optimum level)
      • Under-capitalisation can be identified when NP ratio is close to or under industry benchmark yet ROE is well above industry benchmark
    • Low result may indicate:
    • owner ’s money may perform better invested elsewhere
    • business may be over-capitalised (if owner has invested over the optimum sum into the business)
      • Can be identified when NP ratio is close to industry benchmark yet the ROE result is well below industry benchmark
    • management may take little risk therefore business is cautiously run
    • inefficient management making poor decisions, lack of foresight.
  • Recommendations
    • Improve net profit result using previous recommendations.
    • Check level of capitalisation to ensure appropriateness for industry.
      • If under-capitalised owner should consider investing further funds into the business.
      • If over-capitalised owner should consider investing excess funds into alternative investments.
  • Rate of Return on Total Assets Ratio
    • Indicates the ability of the enterprise to generate profits using its assets.
    • Compare result to industry benchmarks to determine suitability of business performance.
    • High result may indicate:
    • efficient use of assets
    • wise decisions made regarding asset acquisition
    • Low result may indicate:
    • inefficient use of assets
    • inappropriate levels/types of assets leading to poor performance
    • high purchase price for assets
  • Recommendations Increase net profit. Decrease average total assets – ensure optimum level of assets retained. Carefully consider potential of assets prior to acquisition.
  • Financial Stability Financial Stability indicates the short-term liquidity and long-term solvency of an enterprise.
    • Financial Stability Ratios
    • Current Ratio
    • Quick Ratio (Acid Test)
    • Equity Ratio
    • Debt Ratio
  • Current Ratio Measures the ability of the enterprise to meet its short-term financial obligations; that is, commitments due in the current financial year. Ideal result = 2:1; for every $1 of CL (short-term financial obligations) business carries $2 CA to cover.
    • High result indicates:
    • assurance that obligations can be met
    • if too high (3:1+) may indicate ‘idle funds’. Funds better invested in higher interest bearing assets.
    • Low result may indicate:
    • inability to meet obligations
  • Recommendations Pay off bank overdrafts as soon as possible. Investigate alternative suppliers (accounts payable) to lower cost of stock. Invest ‘idle funds’ in areas likely to attract a higher return.
  • Quick Ratio Indicates the entity ’s ability to meet its immediate financial obligations such as accounts payable from its immediately accessible or quickly converted assets such as cash and accounts receivable. Does not include inventories and prepayments because they are difficult to convert to cash in the short term. Bank overdrafts are usually not due in the next accounting period, therefore; not included. Ideal result = 1:1; for every $1 of CL (immediate financial obligations, not including bank overdraft) business has $1 CA (not including stock/prepaids) to cover.
    • High result indicates:
    • High degree of assurance that immediate debts can be paid
    • Excessive levels of quick assets held eg cash
    • Low result may indicate:
    • inability to meet immediate debts
    • Business is relying on turnover of stock to meet obligations
  • Recommendations Consider level of accounts payable Ensure cash flow is optimal – accounts receivable pay on time. Maintaining adequate levels of cash rather than excessive (better invested in higher returning applications)
  • Equity Ratio Indicates the extent to which the owner has financed the business ’s assets as opposed to using alternative source of finance – borrowings (debt). Mirror of Debt Ratio – both ratios should equal 100%. A = L + Oe Ideal is 50% - that is business assets are half funded by equity and half by debt. Finance companies will “move in” when ratio reaches 70:30 debt to equity.
    • High result indicates:
    • Most funds provided by owner to finance business
    • Low result may indicate:
    • Most funds provided by borrowings to finance business
  • Recommendations Heavy dependence on equity indicates business is not highly geared. (Gearing refers to level of debt). In times of low interest rates on money market and if business is performing well owner should invest further in business. Decrease debt through repayment to achieve 50:50 balance of debt/equity. Minimise need to carry hold/own large assets.
  • Debt Ratio Indicates the way in which business is financed and extent of borrowing in relation to assets.
    • High result indicates:
    • Most funds provided by borrowings to finance business
    • Low result may indicate:
    • Most funds provided by owner to finance business
  • Recommendations Heavy dependence on debt indicates business is highly geared. Places high burden on business to meet repayments. Repay as soon as possible. Carefully consider any further investment in future beyond the 50:50 balance of debt/equity.
  • Effectiveness of Management Policies Management effectiveness is a measurement of how successfully managers have been in directing and maintaining the set policies of an enterprise.
    • Management Effectiveness Ratios
    • Turnover of Accounts Receivable
    • Turnover of Inventories
  • Turnover of Accounts Receivable Ratio Measures the efficiency of the business in managing its accounts receivable. Business operations are dependant upon the collection of this debt. Cash flow into the buisness is required to maintain operations eg pay wages, bills etc.
    • High result indicates:
    • Inefficient Collection Policy – should state collection rate between 20-40 days – if number of days too high strong possibility of high bad debts figure.
    • Poor cash flow
    • Loose credit policy
    • Low result may indicate:
    • Effective credit policy, efficient collection of Accounts Receivable
  • Recommendations
    • Tighten credit policy and communicate to debtors. All business offering credit should establish a credit policy.
      • Policy conditions include:
        • Repayment time (usually 30 days)
        • Discounts offered for prompt payment
        • Interest to be charged on overdue account
        • Method to determine credit worthiness of applicant.
      • Business should issue monthly statements which serve as a reminder
    • Factor Accounts Receivable – debts are sold to financial institute for 90-85% of value.
      • Attractive option because it offers immediate cash flow
      • Saves the business the cost of phone calls, reminders legal action etc.
  • Turnover of Inventories Ratio Measures how efficiently the inventory of the business is being managed. Comparison against industry averages will indicate acceptable turnover.
    • High result indicates:
    • Slow-moving inventory
    • Large holding of inventory ready for sale
    • Low result may indicate:
    • Fast-moving inventory
    • Shortage of inventory available for sale
  • Recommendations Stock at appropriate levels – JIT Investigate methods of lowering COGS. Target customers more effectively – marketing.