Understanding Accounts 3rd Ed.

Unit 2

The Open University

Publisher: The Open University, 2000, 123 pages

ISBN: 0-7492-9726-3

Keywords: Finance, MBA

Last modified: Jan. 25, 2014, 7:06 p.m.

Different people need annual reports: investors, lenders, managers, contributors, managers and employees. Their form vary from country to country with the two main categories being the Angle-American (giving a 'fair' view) and the Franco-German model (precedence of creditors' interests; profits entered when realized, losses/expenses immediately). Concerns about the accuracy of accounting statements have among others pushed new legislature like the Sarbanes-Oxley Act (passed July 2002), requiring CEOs and CFOs in the US to certify financial statements. It also addresses:

  • non-audit services of auditors (We'll say the report is great or we loose the 100 million consulting contract)
  • authority increase of audit committee
  • less loans to officers and directors
  • faster disclosure

Contents of the annual report

Compulsory section:

  • the directors' report (linked to corporate governance)
  • the auditors' report (appropriate accounting consistently applied and adequately disclosed, fair view, accounts prepared in accordance to relevant legislation; Franco-German model often does not require auditing as reports audited" by the tax authority)
  • the income statement (summary of productivity)
  • the balance sheet (summarises positions at the end of the financial year)
  • the cashflow statement (summary of sources of cash during year)
  • notes to the accounts

Voluntary sections

  • the chairman's statement
  • the chief executive's review
  • the operating and financial review (OFR)
  • the environmental report

Analysts put things into special spread sheets like the OUFS to look at several years of data in a standard way. Before you start, clarify your objective to analyse the right data, profit before tax if you lend money for example.

When you use ratios, consider the economy at the time and the industrial environment. There are four phases for ratios:

  • assessing operating efficiency
  • assessing financial structure
  • observe consequences of foregoing in profitability
  • evaluate cash flows

Three questions need to be asked:

  • Change in ratios, why
  • Compare ratios to similar companies
  • Do the ratios make sense

Consolidated group accounts

100% of shares: subsidiary wholly-owned
20-50%: related or associated company
<20%: trade investment

For subsidiaries: In general you build totals for the profit and loss and balance sheet, eliminating inter group transactions first. Take a good look at the goodwill in relation to the subsidiary. Goodwill is the premium the hodling company paid for the shares it owns over the book assets it acquired. If you paid $2000m to control 80% of a company with net assets of $1000m, you established a goodwill of $1200. This goodwill should be written off over its useful live. There is an example of a consolidated balance sheet on page 22ff.

With associated companies you consolidate net value of assets and portion of profits. Liabilities are not reflected in the balance sheet (example Enron). Trade investments are shown at cost price with only dividends shown as income in the PLS.

Analysis in Context

You need something to structure the segment of the market you are looking at. SWOT, STEEP and Porter's five forces are models to use here. You have three important numbers here:

  • sales show if their market share increases
  • return on capital if there is a competitive advantage
  • net operating margins show the competitive pressure

How you define the market will be critical to the evaluation, as always with STEEP, Porter's five forces of SWOT.

Operating Efficiency

Here the ratios come in. You are looking at the cycle of production, from Cash to (supply) raw materials, (production) work in progress, (demand) finished goods, (collection) trade receivables and back to cash.

Supply phase

(Remember, assets included in the balance sheet might not be those that are used in the income statement)

  • Raw material days = Raw material / (Cost of goods sold / 365)

Very useful if you look at different components of inventory seperately

  • Trade creditor days = Trade creditors x 365 / Cost of goods sold

This is about the payment terms that suppliers are granting.

Production phase

  • Work in progress days = Work in progress x 365 / Cost of goods sold

The small the more efficiently the raw materials are progressed.

  • Net property, plant and equipment turnover = Sales / Property, plant, equipment

Remember: Sales are in relation to current market values but assets might be included at a lower value as they are written off.

  • Plant life
    • Expected life = historic cost of plant and equipment / depreciation charge for year
    • Life used = Accumulated depreciation of plant and equipment / depreciation charge for year
    • Life remaining = Net book value of plant and equipment / depreciation charge for year

Remember: if fully written off the balance sheet does not show it, but it might still be used in the production cycle

Demand and collection phase

  • finished goods days = finished goods x 365 / cost of goods sold

If this rises, some sales that were expected might not have materialised or there is an upcoming promotion or ad campaign for which the company stocks up.

  • Receivable days = receivables x 365 / Sales

Net operating assets

Part of the funding comes from the cycle of production and via supplier's credit terms, which is very attractive. Minimum inventory holds down costs, then collect money quickly and pay suppliers late.

  • Net operating assets = accounts receivable + inventory + prepaid expenses - trade creditors - accrued expenses

Service organisations

also have a cycle of production in relation to Collection of cash, supply of raw materials and (demand) trade receivables. This means that these ratios are important here too. You might also want to look at things like occupancy rates for hotels for example.

Financial Structure

The main point here are liquidity (short-term) and solvency (long-term) ratios.

Management needs to make sure that there are good sources of finance, taking into account maturity, flexibility and stability while minimising costs. They need to keep a balance between dept and equity, where dept has certain clear rules to it like repayment times, first payment in case of liquidation,… and equity offers a higher return or rather has to due to the great risk it carriers for the providers of this finance.

Equity is therefore more expensive but it allows for more flexibility. Managers should match economic lives of assets with maturity of financing.

Liquidity

  • Current ratio = Current assets / current liabilities

This can be smaller than 1 in case the company is a going concern, meaning it can finance the liabilities through trading revenues.

  • Quick (acid test) ratio = Current assets - Inventory / Current liabilities

Uncertainty with the inventory is addressed here. It might not be worth anything and the liabilities must still be paid for.

  • working capital = current assets - current liabilities

again, looking at liquidity here. If the company is very trustworthy this can be a high minus though.

Solvency

The riskier the business, the greater the dependence on equity rather than dept. Shareholders can be thought as as an equity cushion. They provide money that will not have to paid back in liquidation. The liquidation process of assets must only stay above the book value of the assets minus the invested amount for all senior creditors to be paid. A company is worth $100m in total with $30m in equity. In liquidation the assets need to bring $70m not 100 for all senior creditors to be paid.

  • gearing = short- and long-term dept x 100 / equity

the more uncertainty about cash generated, the lowe this number should be, meaning the mor the company should rely on equity.

  • dept/equity ratio = short- and long-term dept / (short- and long-term dept + shareholders' equity)
  • net gearing % = (short- and long-term dept - cash and marketable securities x 100) / equity

This is done as marketable securities and cash are not really important in the cycle of production and can repay dept at once

  • leverage = long-term liabilities / equity

This presents a broader view beyond dept

  • leverage (tangible) = total liabilities / (equity - intangible assets)

you might also want to include contigent liabilities here, that just might occur in the future.

Capital employed = short-term dept + long-term dept + long-term liabilities + long-term provisions + shareholders' equity

When looking at dept you might also look at the average dept over several years to see if there is some seasonal pattern in interest expenses (Interest expense / average dept).

Profitability

Here we look at the income statment and profitability ratios. The income statments looks at the activities of a company on an accrual basis, meaing that revenues and expenses might appear in the income statement before the cash is collected.

  • Sales
  • - cost of goods sold
  • - selling and distribution expenses
  • - administration expenses
  • = Net operating profit
  • - interest expense
  • + interest income
  • + equity income
  • + dividend income
  • = Profit after financial items
  • +/- sundry income/expense
  • +/- gain/loss on sale of assets
  • +/- gain/loss on sale of investment
  • +/- exceptional income/expense
  • = Pre-tax profit
  • - Tax
  • = Net profit after tax
  • +/- Extraordinary income/expense
  • - minority interests
  • - dividends

In the Anglo-American the fair view is employed and the Franco-German model takes a very prudent view, including revenues only when they are realised and expenses as soon as anticipated. In the long run, the result in the same, but the short term my vary.

  • net operating profit = net operating profit / sales x 100

We can also look at:

  • cost of goods sold / sales x 100
  • and:

    • selling and distribution expenses / sales x 100
    • interest cover (times interest earned) = net operating profit / interest expense

    We also have some other relations

    • * pre-tax profit / sales x 100
    • * effective tax rate = taxes / pre-tax profit x 100

    Very low tax rate should make you wonder how they come about. In the Anglo-American model the published account are different from the tax accounts.

    • * net profit after tax / sales x 100

    Tells us what of sales is left over to give to shareholders. For dividends, we look at:

  • payout ratio = dividends / net profit after tax x 100
  • One should also be aware of core (resulting in NOP) and non-core earnings.

    Market-Related Ratios

    • earnings per share = net profit after tax / average numbers of shares issued
    • price / earnings ratio = markte price of share / earnings per share

    You can also look at the prospective ratio by taking expected earnings per share into account instead.

    Book value shows the historic cost or current market value of assets.

    • price/book = market share price / shareholders' equity per share
    • price/book = market capitalisation / sharehoders' equity

    You can also take a look at other indicators sometimes called output-related performance indicators (ORPIs) but these are complex to define in a meaningful way, can deliver very high information on a companies performance though.

    Inappropriate ORPIs can lead to (Peter Smith, 1993)

    • Tunnel vision
    • Sub-optimisation
    • Myopia
    • Convergence
    • Ossification
    • Gaming
    • Misrepresentation

    Ratio Analysis

    This part covers core ratios, of which two kinds exist.

    Dupont Pyramid

    Return on Capital Employes = Asset utilisation x Return on sales
    Net operating profit / Capital employed = Sales / capital employe x Net operating profit / Sales

    This does not consider the financial performance of the company, and for this we need to look at the

    Core Ratios

    Return on equity = Operating efficiency x Financial structure x Profitability
    Return on equity = Asset turnover x Asset leverage x Return on sales
    NPAT / Equity = Sales / Total assets x Total assets / Equity x NPAT / Sales

    Having looked at these, you can continue by looking into more detail, but these give a good overview. To interpret the core ratios, you need to keep the sector and the economy in mind.

    The level of asset turnover is related to the amount of technology used in the sector. The asset leverage should be inversely related to the volatility of cash flows, as said before. Profitability needs to be looked at with the help of Porter's five forces model.

    Cash Flows

    For a company to survive, the cash flow from operations needs to be enough to cover all financial needs in the medium/long term. The cash flow statement shows the uses and sources of cash during a financial period. If it is not published, it can be calculated from the other statements.

    The calculation of a cash flow statment serves three purposes:

    • finding the sources and uses of cash
    • separating core operations and unusual events
    • comparing cash generation with cash need

    There are several fields needed in a cash flow statement. These are calculated as follows.

    To start with, we can look at the operating profit, which already has depreciation deducted though, which is a non-cash charge. Therefor we do:

    Net operating profit + Depreciation = EBITDA (Earnings before interest, taxes, depreciation and amortisation). If there are other non-cash charges, you need to add them back in too. The good thing with EBITDA is, that it kind of looks at the core business, factoring out the other stuff, which are more political items than business ones.

    If trade receivables from the beginning of the period to the end have shrunk, this is an additional source of cash as the company must have collected some of the previous year's receivables and all of this years. Similarly an increase in an operating liability presents a source of cash. In short:

    • Increase in asset = decrease in liability = cash inflow
    • Decrease in asset = increase in liability = cash outflow

    Adjusting EBITDA with these working capital items, gives the Operating Cash Flow (OCF). This is the cash generated by the operating activities of a company before any financing and long-term investment decisions.

    The next item is tax payment, which is often done a lot later than the fiscal year tax payment that is included in the income statement. We start by calculating the corporation tax payable at the start plus during the reporting period, substracting the amount payable at the end of the period. This is the corporation tax paid during the period. You then do the same with the deferred tax payable and prepayments.

    The next item is relating to dept, and normally interest and lease expenses can be taken from the income statement. In the previous year balance sheet you can normally find a "current portion of long-term dept", which is the amount that the company would have needed to repay this year.

    This brings us to the discretionary cash flow, which is the cash flow available after current operations and metting obligatory payments. The come some things the company can do.

    First up on the list are dividends, where you again use those payable at the start of the period, plus declared during the period and still payable at the end.

    With the rest of the money the company can choose to do many things. Buy property, plant or aqeuipment for example. To find out what they spent here, you take: PPE at the start of the period + depreciation - PPE at the end of the period + revaluation + foreign exchange gain or losses on PPE + capitalised interest + book value of items sold or bought = expenditure on PPE.

    Cash proceeds must be added to the cash flow. Next up are investments. Here you look for any changes, excluding changes in valuation or exchange rates. Also take into account any provisions or other out of the ordinary items that might become due soon (or later) to not be surprised later.

    Then you look at how the company financed it's cash shortfalls, with equity, long-term or short-term dept.

    When forecasting you should take into account three different cash flows:

    • Operating free cash flow: this is after taxes
    • Free cash flow: after additional interest
    • Residual free cash flow: after dividends

    If there isn't enough information available, you take Operating Profit and substract taxation to get NOPAT, which is also used a lot in replacement of free operating cash flow.

    Cash Flow Ratios

    These are used to look at the ratios between cash inflows and obligations. (NOPAT / interest paid) shows how well the interest payment was covered. You can then also add in other stuff lke current portion of long-term dept and leases (CPLTD&L) and/or dividends. It really depends on what you want to calculate.

    This synopsis is licensed under a Creative Commons License from the OUBS Blog.

    1. Introduction
      • 1.1 Introduction to the Block
      • 1.2 Introduction to the Unit
        • Outline of Unit 2
        • Aims and objectives of the unit
    2. Why Annual Reports?
      • 2.1 Who Needs the Annual Report?
      • 2.2 Which Annual Reports?
      • 2.3 What Terminology?
      • 2.4 Contents of the Annual Report
        • Compulsory Sections
        • Voluntary Sections
        • The directors' report
        • The auditors' report
        • The Financial statements and related notes
      • 2.5 Who is the Analyst?
      • 2.6 Using Ratios
    3. Analysis in Context
      • 3.1 The Porter ‘Five Forces’ Model
        • The threat of new entrants
        • The bargaining power of customers
        • The bargaining power of suppliers
        • The threat of substitute products or services
        • Jockeying for position
      • 3.2 Competitive Strategy
      • 3.3 The Porter Model Applied — Two Examples
    4. Operating Efficiency
      • 4.1 The Cycle of Production
      • 4.2 The Supply Phase
        • Raw material days
        • Trade creditors days
      • 4.3 The Production Phase
        • Work in progress days
        • Accrued expenses days
        • Net property, plant and equipment turnover
        • Plant life
      • 4.4 The Demand and Collection Phases
        • Finished goods days
        • Receivable days
      • 4.5 Net Operating Assets
      • 4.6 Service Organisations
    5. Financial Structure
      • 5.1 Sources of Finance
      • 5.2 Liquidity
        • Current ratio
        • Quick (acid test) ratio
        • Working capital
      • 5.3 Solvency
        • Gearing
        • Debt/Equity ratio
        • Net gearing
        • Leverage ratios
        • Capital employed
        • Seasonal debt
    6. Profitability
      • 6.1 The Income Statement
      • 6.2 Profitability Ratios
        • Net operating profit
        • Interest cover
        • Pre-tax profit
        • Net profit after tax
      • 6.3 Core v. Non-Core Earnings
      • 6.4 Market-Related Ratios
        • Earnings per share
        • Price/book ratio
      • 6.5 Other Output-Related Performance Indicators
    7. Ratio Analysis
      • 7.1 The Core Ratios
      • 7.2 Interpreting the Core Ratios
      • 7.3 Interpreting the Core Ratios — An Illustration
    8. Cash Flow
      • 8.1 Calculating the OUFS Derived Cash Flow
        • Operating profit
      • 8.2 Adjustments for Forecasting
      • 8.3 Cash Flow Ratios
      • 8.4 Interpreting the Cash Flow — An Example
    • Appendix 1: Blank OUFS
    • Appendix 2: Blue Circle OUFS
    • Appendix 3: Blue Circle Industries plc 1997 OUFS Spreading Notes
    • Appendix 4: Porter Checklist
      • Threat of new entrants
      • Bargaining power of customers
      • Bargaining power of suppliers
      • Threat of substitute products or services
      • Jockeying among current contestants
    • Appendix 5: Albert Fisher OUFS
    • Appendix 6: Blue Circle Derived Cash Flow

    Reviews

    Understanding Accounts

    Reviewed by Roland Buresund

    Decent ****** (6 out of 10)

    Last modified: May 21, 2007, 2:51 a.m.

    MBA material, what do you expect?

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