Four Key Questions when using Financial Information and Interpreting Accounting Ratios

There are many traps in using financial information and interpreting accounting ratios.

You are advised to approach the job with caution and always keep in mind four key questions:

1. Am I comparing like with like?
2. Is there an explanation?
3. What am I comparing it with?
4. Do I believe the figures?

1.  Am I comparing like with like?

Financial analysts pay great attention to the notes in accounts and to the stated accounting policies.

One of the reasons for this is that changes in accounting policies can affect the figures and hence the comparisons.

For example:

• Consider a company that writes off research and development costs as overheads as soon as they are incurred.
• Then suppose that it changes policy and decides to capitalize the research and development, holding it in the Balance Sheet as having a long-term value.
• A case can be made for either treatment but the change makes it difficult to compare ratios for different years.

2.  Is there an explanation?

Do not forget that there may be a special reason for an odd-looking ratio.

For example:

• Greetings card manufacturers commonly deliver Christmas cards  in August with an arrangement that payment is due on 1 January.
• The 30 June Balance Sheet may show that customers are taking an average of 55 days' credit.
• The 31 December Balance Sheet may show that customers are taking an average of 120 days' credit.
• This does not mean that the position has deteriorated dreadfully and the company is in trouble
• The change in the period of credit is an accepted feature of the trade and happens every year.
• It is of course important, particularly as extra working capital has to be found at the end of each year.

3.  What am I comparing it with?

A ratio by itself has only limited value.

It needs to be compared with something.

Useful comparisons may be with the company budget, last year's ratio, or competitors' ratios.

4.  Do I believe the figures?

You may be working with audited and published figures.

On the other hand, you may only have unchecked data rushed from the accountant's desk.

This sort of information may be more valuable because it is up to date.

But beware of errors.

Even if you are not a financial expert, if it feels wrong, perhaps it is wrong.

Basic financial statements (Profit and Loss Account)

The particulars of a regular company's Profit & Loss Account would look as follows:

Revenue - Sales value generated
Cost of Goods Sold - All costs related to the sale of the goods
Gross Profit - The excess of revenue over cost of goods sold (or likewise Gross Loss if otherwise)
Operating Expenses - All remaining expenses of the operations
EBITDA - Earnings before interest, taxes, depreciation & Amortisation
Depreciation - The decrease in the value of capital assets which are expensed off
EBIT - Earnings before interest and taxes
Interest - Interest cost of borrowings
Taxes - Taxes imposed on income
Net Profit - The final bottom line



Saturday December 11, 2010

Basic financial statements interpreted

By RAYMOND ROY TIRUCHELVAM


FOR a non-finance person, evaluating a company's financial can be daunting, let alone understanding it to form an opinion. The most basic form of financial statements comprises the Profit & Loss Account or sometimes referred to as Income Statement and the Balance Sheet.

Another two statements that make a complete financial information for reporting purposes comprise the Statement of Retained Earnings and Statement of Cash Flow.

The objective of a financial statement is to provide information about the financial position, performance and changes in the position of an enterprise.

The Balance Sheet represents the financial position or net worth of a business entity on a specified date. The presentation is based on a fundamental accounting equation of Assets = Liabilities + Shareholders Fund. The main categories of assets are usually listed first, usually in order of liquidity. Next follows liabilities, short and long term, which represent payables and borrowings held by the entity.

The difference between the assets and liabilities (Assets Liabilities = Shareholders Funds), is known as Shareholders Funds, or sometimes referred to as owner's equity, that entails the company's capital plus retained earnings. Borrowings (liability) or owner's money (owner's equity) are the two means used for financing an asset.

Mathematically, over a period of time, if the assets grow bigger than the liabilities, it would mean that the entity has made a profit (which represents the essence of the Profit & Loss Account); this is reflected via an increased asset base (taking shape in many forms from cash, inventories, accounts receivable, fixed assets or investments).

Reverting to the Balance Sheet equation, the Shareholders Fund will reflect the increment. Since the entity's capital remains constant (unless the new assets are caused by new share issues), the increment is credited to a special account called Retained Earnings, as the name denotes.

Next, the Profit & Loss Account represents summarised transactions of an entity's performance over a given period, showing its profitability (or losses). Acting as the management's scorecard, it identifies the revenues and expenses undertaken which results in either a profit or a loss, based on the fundamental accounting concept of: Revenue Expenses = Profit (or Loss if expenses exceed revenue).

This in return will drive the direction of the Shareholders Fund (in particular Retained Earnings sub-category), for good (profit) or for worse (loss).

The particulars of a regular company's Profit & Loss Account would look as in Table 1.

There is also a category of item to be on the lookout called Unusual Item, which represents non-recurring non-revenue based transaction undertaken by the entity that results in a profit or loss. Examples of MAS selling aircraft, discontinuing a business line, incurring losses from natural disaster, writing down of investment value, are a few, which should be evaluated separately from the results from operations.

Due to its importance, EPS or Earnings Per Share is also required to be disclosed at the end of the Profit & Loss account. It presents the earnings divided by the total ordinary shares outstanding.

This single measure differentiates the efficiency in the earnings between companies, and represents the most important criteria in determining the price of the entity's shares and is used as a component to derive the all important PE or Price to Earnings ratio.

A large Retained Earnings balance as compared to the total Shareholders Fund, will denote a profitable company (accumulation of profits over the years), and a negative Retained Earnings (or Retained Loss) reflects the opposite. In extreme cases, the Retained Loss (debit balance) can overtake the Share Capital (credit balance), thus resulting in a negative Shareholders Fund. One surely would not want to invest in such a company.

Some listed companies, when the Retained Earnings gets so large (coupled with other factors such as inability to pay out dividend), reward the shareholders via Bonus Issue exercise, whereby part of the retained earnings are converted into new shares, accruing to existing shareholders.

This not only represents a short cut of the dividend payout, but also a tax free option via capital returns.

Raymond Roy Tiruchelvam, who has problems reconciling his gross habits with his net income is a financial planner with SABIC Group of Companies.

http://biz.thestar.com.my/news/story.asp?file=/2010/12/11/business/7567075&sec=business

DIS Technology - Check List: What can we learn from this ugly saga?

As with Transmile, it is sad that the investors are again caught in such a fraud.  There must be heavy penalties for those involved, not least, to emphasize the seriousness of this matter and to deter future such happenings.

Could this fiasco, of false accounting, be predicted looking at the latest quarterly reported results?  Often the answer is NO, though it was obvious that the company's business was deteriorating and the balance sheet was not good quality. 

The revenues and earnings were manipulated in the accounting.  However, the cash flow statement would have indicated that not all is well with the company.  The CFO was strongly negative.

http://spreadsheets.google.com/pub?key=tZmdsnrXUbsFVCAmAaQRW4g&output=html

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Blogger Wisdom Wise has written a nice article on reading the annual report which I have copied and paste here:

Tuesday, March 09, 2010

Reading the Annual Report

When you look at a woman, which part of her anatomy do you look at first? Is it her face, her bosom or her bottom? It is all a matter of choice. It doesn't matter so long as you get to look at the whole picture. Now, when you look into an annual report, it is the same. Which statement do you prefer to see first. Is it the income statement, the cash flow statement or the balance sheet? Personally, I go straight for the balance sheet to find out what the company has and what it owes others. If I don't find things attractive there, I will just close the report, avoid the stock and move on.
The things that I pay attention in the balance sheet are: Paid-up capital, par value per share, retained earnings, current assets, and current liabilities. I pay special attention to its cash position and how much debt it has. If its debt is too high, when compared to its equity, I will normally lower the grading of the stock. Don't forget that all companies that folded are those with very high debt.
From the balance sheet, I go to the income statement , the cash flow statement, and then the CEO's statement, or Chairman's statement. If both are available, I'll read them both and also the notes in the annual report to ascertain that the company is not involved in any litigation. Lastly, I will go to the page that shows the names of the majority shareholders. A strong major shareholder is a advantage. Take the case of YTL Cement whose major shareholder is YTL Corp.
Things to consider when assessing a company are as follows: a) Calibre of management; b) Modal of business; c) Earnings per share; d) Dividend yield; e) Cash and debt position; f) Barrier of entry; and g) sustainability of profit.

Reading a Profit and Loss Account

Reading a Profit and Loss Account

A profit and loss (P&L) account is a statement of the income and expenditure of a business over the period stated, drawn up in order to ascertain how much profit the business made. 'Income" and "expenditure' here mean only those amounts directly attributable to earning the profit and thus would exclude capital expenditure, for example.

Importantly, the figures are adjusted to match the income and expenses to the time period in which they were incurred - not necessarily the same as that in which the cash changed hands.

What is a profit and loss account?

A profit and loss account is an accountant's view of the figures that show how much profit or loss a business has made over a period. To arrive at this, it is necessary to allocate the various elements of income and expenditure to the time period concerned, not on the basis of when cash was received or spent, but on when the income was earned or the liability to pay a supplier or employees was incurred. While capital expenditures are excluded, depreciation of property and equipment is included as a non-cash expense.

Thus if you sell goods on credit, you will be paid later but the sale takes place upon the contract to sell them. Equally if you buy goods and services on credit, the purchase takes palce when you contract to buy them, not when you actually settle the invoice.

What does a profit and loss account not show?

Most importantly, a P&L account is not an explanation of the cash coming into and going out of a business.

MAKING IT HAPPEN

The presence of stock and purchases indicates that the business is trading or manufacturing goods of some kind, rather than selling services.

Where a business holds stock, the purchases figure has to be adjusted for the opening and closing values in order to reach the right income and expenditure amounts for that period only. Goods for resale bought in the period may not have been used purely for that period but may be lying in stock at the end of it, ready for sale in the next. Similarly, goods used for resale in this period will consist parly of items already held in stock at the beginning of it. So take the amounts purchased, add the opening stock, and deduct the closing stock. The resulting adjusted purchase figure is known as 'cost of sales'.

In some businesses there may be other direct costs apart from purchases included in cost of sales. For example, a manufacturer may include some wages if they are of a direct nature (wages of employees directly involved in the manufacturing process, as distinct from office staff, say). Or a building contractor would include plant hire in direct costs, as well as purchses of materials.


How to interpret the figures

A lot of accounting analysis is valid only when comparing the figures, usually with similar figures for earlier periods, projected future figures, or other companies in the same business.

On its own, a P&L account tells you only a limited story, though there are some standalone facts that can be derived from it.

• Was this business successful in the period concerned?
• Was it able to make a profit, and not a loss?
• Was it able to pay dividends to shareholders out of that profit?

These are crucial pieces of information.

However, it is in comparisons that such figures start to have real meaning.

• The gross profit margin of X% was an important statistic in measuring business performance.
• The net profit margin before tax was Y%.
• You can calculate the net profit after tax (the bottom line).
• You could take the margin idea further and calculate the net profit after tax ratio to sales.
• Or you could calculate the ratio of any expense to sales. E.g. the wages to sales ratio.

If you then looked at similar margin figures for the preceding accounting period, you would learn something about this business.

Say the gross margin was 45% last year compared with 46% this year - there has been some improvement in the profit made before deducting overheads. But then suppose that the net profit margin of 8.8% this year was 9.8% last year. This would tell you that, despite improvement in profit at the gross level, the overheads have increased disproportionately. You could then check on the ratio of each item of the overheeads to sales to see where this arose and find out why. Advertising spending could have shot up, for example, or perhaps the company moved to new premises, incurring a higher rent. Maybe something could be tightened up.

Another commonly-used ratio

Another ratio often used in business analysis is return on capital employed. Here we combine the profit and loss account with the balance sheet by dividing the net profit (either before or after tax as required) by shareholders' funds. This tells you how much the company is making proportionate to money invested in it by the shareholders - a similar idea to how much you might get in interest on a bank deposit account. It's a useful way of comparing different companies in a particular industry, where the more efficient ones are likely to derive a higher return on capital employed.

COMMON MISTAKES

Assuming that the bottom line represents cash profit from trading

It does not! There are a few examples where this is the case: a simple cash trader might buy something for one price, then sell it for more; his profit then equals the increase in cash. But a business that buys and sells on credit, spends money on items that are held for the longer term, such as property or machinery, has tax to pay at a later date, and so on, will make a profit that is not represented by a mere increase in cash balances held. Indeed, the cash balance could quite easily decrease druing a period when a profit was made.


Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)