School of Accounting ACCT 1501: Accounting and Financial Management 1A

Week 10

Ratio Analysis - Basic

Student Handout Contents: 1. 2. 3. 4. Introduction Tutorial questions Week 11 Lecture examples Lecture slides

Lecturer: Mr. J. Knapp School of Accounting UNSW QUAD 3103

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

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

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 T&G

DQ14.4,14.5, 14.6, 14.9 P14.4, 14.11, 14.17

Tutorial Questions

T&G T&G T&G

DQ 14.1, 14.3 P14.6, 14.16 Case 14D

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 Woolworths = Earnings Before Interest and Tax Total Assets 2007 2006

Return on Assets

Return on Equity Woolworths

Operating Profit after Tax Shareholders Equity 2007 2006

Return on Equity

Profit Margin

Operating Profit after Tax Sales 2007 2006

Woolworths Profit Margin

Gross Margin

Gross Profit Sales 2007 2006

Woolworths Gross Margin

Activity/Turnover Ratios :
Total Asset Turnover = Sales Total Assets 2007 2006

Woolworths Total Asset Turnover

Inventory Turnover

COGS Average Inventory

Inventory= $1969.6 million in the 2005 Balance Sheet: Woolworths Inventory Turnover 2007 2006

Days in Inventory

Debtors Turnover

Credit Sales Average Trade Debtors

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

Days in Debtor

Liquidity Ratios :
Current Ratio Woolworths Current Ratio = 2007 Current Assets Current Liabilities 2006

Quick Ratio

Cash+Accounts Receivable+Short-term Investment

Current Liabilities

Woolworths Quick Ratio

2007

2006

Financial Structure Ratios :

Debt to Equity Ratio = Total Liabilities Total Shareholders' Equity 2007 2006

Woolworths Debt to Equity Ratio

Leverage Ratio

Total Assets Total Shareholders Equity

Woolworths Leverage Ratio

2007

2006

Accounting and Financial Management 1A

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.
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Week 10

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

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

Ratio analysis
Ratios can be grouped in many different ways e.g.,
Performance Activity

or turnover structure

Liquidity Financial

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

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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Performance ratios (examples)

Return on = Equity Operating Profit After Tax Shareholders Equity

Lecture Example

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

Return on Earnings Before Interest & Tax = Assets Total Assets
Woolworths Return on Assets 2007 =2111.3/14416.1 =14.65% 2006 =1722.2/13346.4 =12.90%

Owners are interested in expressing the profits of the firm as a rate of return on the amount of shareholders equity.

Return on = Equity
Woolworths Return on Equity

Operating Profit After Tax Shareholders Equity

2007 =1311.3/5514.7 =23.78% 2006 =1026.7/4257.6 =24.11%
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Performance ratios (examples)

Performance ratios (examples)

Profit Margin =

Operating Profit After Tax Sales Revenue

Gross Margin =

Gross Profit Sales Revenue

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

A discount retailer in a competitive market will have a low margin, and an upscale jeweller to have a _____ high margin. (please fill in the blanks using Low or _____ High)
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Gross Margin provides a further indication of the companys product pricing and product mix.
Remember: Gross profit= Sales revenue - COGS

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Lecture Example

-- Performance Ratio (cont.)

Profit Margin=
Woolworths Profit Margin

(please complete the blanks in lecture notes) Operating Profit After Tax Sales Revenue
2007 =1311.3/42477.1 =3.09% 2006 =1026.7/37734.2 =2.72%

Performance ratios (examples)

Earnings per share

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

Gross Margin=
Woolworths Gross Margin

Gross Profit Sales Revenue

2007 =10754/42477.1 =25.32% 2006 =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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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%.

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 Sales Total Assets

Inventory Turnover
Inventory = Turnover COGS Average Inventory

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

a measure of the number of times inventory is sold or used during the period the efficiency of inventory management
Days in = Inventory 365 Inventory Turnover

indication of operating efficiency.

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

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Debtors Turnover
Debtors = Credit Sales Turnover Average Trade Debtors This ratio indicates the efficiency of the company to collect the amount due from debtors. Days in 365 = Debtors Debtors Turnover The debtors turnover can be divided into 365 days in order to calculate the average number of days to collect accounts receivable.

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

Sales Total Assets

2007 =42477.1/14416.1 =2.95 2006 =37734.2/13346.4 =2.83

Inventory = Turnover
Woolworths Inventory Turnover Days in Inventory

COGS Average Inventory

2007 2006
=28388.7/0.5(2316.1+1969.6)

Inventory=$1969.6 million in the 2005 Balance Sheet

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.

=31832.8/0.5(2739.2+2316.1)

=12.59
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=13.25

=365/12.59 =28.99

=365/13.25 =27.55

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Lecture Example
-- Activity (Turnover) Ratios (please complete the blanks in lecture notes)
Debtors = Credit Sales Turnover Average Trade Debtors

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).

Assume that 2% of Woolworths sales in 2007 were on credit: Woolworths Debtors Turnover Days in Debtors 2007 =2%x 42477.1/0.5(95.7+85.1) =9.40 =365/9.40 =38.83

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Liquidity Ratios (Example)

Current = Ratio Current Assets Current Liabilities

Liquidity Ratios (Example)

Quick Ratio = also called the acid test
Cash+Accounts Receivable+Short-term Investment

Current Liabilities

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

Generally similar to Current Ratio, remove Inventory from the numerator

low ratio may indicate a problem in paying A ____ short term debts. high ratio may indicate the company may A too ____ not be efficiently using its current assets.
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particularly useful for companies that cannot convert inventory into cash quickly if necessary.

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Lecture Example
-- Liquidity Ratios (please complete the blanks in lecture notes)
Current = Ratio
Woolworths Current Ratio

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

Current Assets Current Liabilities

2007 2006 =4120.8/4874.3 =0.85

=4161.0/5502.8 =0.76

Quick Ratio =

Cash+Accounts Receivable+Short-term Investment

Current Liabilities
2007
=(798.8+484.7+41.4)/5502.8

Woolworths Quick Ratio =0.24

2006
=(525.9+1160.4+2.8)/4874.3

=0.35

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Financial Structure Ratios

Debt-to-Equity Ratio Debt-to-Assets Ratio Leverage Ratio = Total Liabilities Total Shareholders Equity Total Liabilities Total Assets Total Assets Total Shareholders Equity

Financial Structure Ratios

Debt-to-Equity Ratio = Total Liabilities Total Shareholders Equity

a measure of the proportion of borrowings to owners investment

Indicates

the companys policy regarding financing of its assets

debt >1, the assets are financed mostly with _______ Too high ratio is a warning about risk

do we need to calculate all these three ratios?

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Financial Structure Ratios

Debt-to-Assets Ratio = Total Liabilities Total Assets

Financial Structure Ratios

Leverage Ratio =
Total Assets Total Shareholders Equity

indicates the proportion of assets financed by liabilities.

The

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

The

high the ratio, the greater risk will be _____er associated with the firm's operation.

less higher the ratio, the ______is funded by more is funded by debt. equity; the ______

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Lecture Example
-- Financial Structure Ratios (please complete the blanks in lecture notes)
Debt-to-Equity Ratio
Woolworths Debt-to-Equity Ratio

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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Total Liabilities Total Shareholders Equity

2007 2006 =9088.8/4257.6 =2.13

=8901.4/5514.7 =1.61

Leverage Ratio
Woolworths

Total Assets Total Shareholders Equity

2007 =14416.1/5514.7 =2.61 2006 =13346.4/4257.6 =3.13

Leverage Ratio

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 = Operating Profit After Tax Sales Sales 2) Asset turnover = Total Assets 3) Leverage =
Total Assets Total Shareholders Equity

4) Return on equity = 1) x 2) x 3)
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Limitations of financial statement ratios

1. Ratios rely on past information.

Limitations of financial statement ratios (cont.)

3. Ratios are based on Year End Data.

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.

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).

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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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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Limitations of financial statement ratios (cont.)

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.

Limitations of financial statement ratios (cont.)

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

Sales Cost of Goods Sold

2007 Company A 500,000 100.0 384,000 76.8 Company B 300,000 100.0 217,800 72.6

2008 600,000 457,200 100.0 76.2

Sales Cost of Goods Sold

400,000 319,200

100.0 79.8

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Trend analysis
Evaluate changes in financial data over a period of time
Year-to-year

Trend analysis(Example)
2001 Sales COGS Gross Profit Expenses Net Profit 1,000,000 200,000 800,000 200,000 600,000 2002 2,000,000 800,000 1,200,000 600,000 600,000 percentage Change 100% 300% 50% 200% 0%
(2mil 1mil) 1 mil

change

Current year amount - Base year amount

or

(Current year amount Base year amount) Base year amount

2001 is base year

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Next lecture

Introduction to Management Accounting

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