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Financial Statement Analysis

Lecture Outline

Ratio Analysis Advantages and limitations of ratio

analysis. Creative Accounting Motivations for Creative Accounting. Methods of Creative Accounting.

Types of Ratios

Profitability (Investors)– Designed to help a investors evaluate a

firms ability to control expenses and earn an adequate return.

Liquidity (Suppliers)– Enables the user to evaluate the ability of

an entity to repay its short term liabilities as they fall due.

Types of Ratios

Leverage (Lenders)– Measures the extent to which an entity

relies upon debt financing.

Profitability Ratios

Net Profit Ratio = OPAT

Sales

Net Profit = Operating profit after tax (OPAT)

Shows the amount of net profit earnt for every $1 of sales.

Profitability Ratios

If Net Profit ratio is increasing; Greater control of operating costs (ie

wages, rent, depreciation etc).

If Net Profit Ratio is decreasing; Operating costs are increasing without a

proportional increase in sales.

Net Profit Ratio

Company Net Profit Ratio

Woolworths/Foodland 2.1%

Telstra 18.1%

QANTAS 3.8%

Liquidity Ratio

Current Ratio = Current AssetsCurrent Liabilities

If < 1: Entity can’t meet obligations to creditors.

If too far > 1: Inefficient use of resources.

Average on the ASX (2003): 1.47: 1

Current Ratio

Company Current Ratio

Woolworths 0.84

Telstra 0.77

Rio Tinto 1.08

Leverage Ratio

Debt to Equity Ratio =Total Liabilities

Total Equity

Shows the financial structure of the firm. Average on ASX: 40%

Leverage Ratio

If the Debt to Equity ratio is increasing;– More of the firms operations are financed by debt

leading to:• Increased interest payments• Increased risk of failure

If the Debt to Equity ratio is decreasing;– Less of the firms operations are financed by debt

leading to:• Reduced interest payments• Lower risk of failure

Debt To Equity Ratio

Company Debt to Equity

Woolworths 29%

Telstra 97%

Rio Tinto 81%

Return on Assets

R.O.A = OPBT + Interest Expense

Average Total Assets

OPBT: Operating Profit before Tax

Measures managerial efficiency (ie more efficient managers will produce higher profits with the same bundle of assets).

Ratio Analysis - Usefulness

Quick to calculate and simple to interpret.

Brings figures down to a common scale.– Enables comparisons between entities of

different size.

Limitations

Ratios mean nothing on their own. To be useful a ratio must be compared with:– Ratios from a previous period– The same ratio from a different firm (within

the same industry)– An industry average or benchmark.

Ratios indicate that a problem exists but do not identify the problem itself.

Limitations

Ratios are based on information which is “out-of-date”.

Changes in accounting policy may effect the analysis.

Ratios are open to manipulation.

Breaking the Illusion

There is no such thing as a definitive profit figure.

Profit, within reason, is whatever you want it to be!!

Breaking the Illusion

Determination of profit is based on subjective decisions made by the preparer:

Example

1. Depreciation• Estimate useful life of the asset.• Estimate residual vale.

Creative AccountingDefined The process of manipulating accounting

numbers to convey an image desired by management. Varies between;

Window Dressing: • Adding polish to the financial statements to make

them look a little better.

ToDeception and Fraud

• Concealment of massive losses or debts.

Efficient Market Theory

Efficient Market Theory Manipulating profit figures does not fool

the market.– A company cannot increase its share price

simply by manipulating its profit figure.

Bonus Plan Hypothesis

If the market cannot be fooled then why do managers manipulate profit figures??

Research suggests the following possible reasons:

1.Bonus Plan Hypothesis2.Debt Covenant Hypothesis3.Political Cost Hypothesis

Bonus Plan Hypothesis

Managerial bonuses are often tied to the performance (profit) of the entity they manage.

In simple terms: The higher the profit, the higher the bonus

achieved by the manager.

Managers with bonus plans therefore have an incentive to maximise profits in order to maximise bonuses.

Debt Covenant Hypothesis

The existence of debt covenants constrains an entity’s ability to borrow funds.

A debt covenant restricts an entity’s ability to borrow more funds.– In very simple terms: A lender prevents an entity

from borrowing more money until they have paid back the lender.

Debt Covenant Hypothesis

Example: Debt Covenant

Debt to equity ratio must not exceed 70% .

Liabilities = 70,000

Equity = 100,000

What can an entity do if they have a debt to equity ratio of 70% but want to borrow more money??

Debt Covenant Hypothesis

To overcome this constraint: Manipulate numbers to increase profit by

$10,000. Equity rises by $10,000.

The entity can now borrow an additional $7,000.

77,000 x 100 110,000 1

= 70%

Political Cost Hypothesis

Relates to larger, more “politically visible” (ie wellknown) companies.

Hypothesises that when politically visible company’s make large profits it can lead to an increase in political costs.

Political Costs

Political Costs Include:– Greater taxation– Removal of subsidies– Greater regulation– Deregulation (ie less regulation)– Demand for higher wages by employees/unions– Demand for greater social expenditure– Demand for higher dividends by shareholders

Political Cost Hypothesis

In order to avoid or reduce political costs, politically visible entities have an incentive to manipulate their profits so that they appear lower than they would normally have been.