How to InterpretFinancial Reports

Event 14

Deakin University CRICOS Provider Code: 00113B

14.1 Interpreting Financial Statements• Types of financial statements

• What may be hidden from view

• Assessing the health of a company – use of financial ratios

• Warning signs

2

14.2 The Three Financial StatementsStatement of Comprehensive Income,also known as:• Income statement;

• Profit and loss statement, or

• Statement of financial performance, or

• Statement of operations/earnings

Balance sheet, also known as:• Statement of financial position

Cash flow statement

3

14.3 Income Statement

Income statement (profit and loss)

Revenue (sales) – Expenses = Profit (earnings)

What do we want to see:a) Revenues greater than expenses

b) EBIT at least 3 times greater than Interest Expense

c) Consistently growing profits over time

4

14.4 Balance Sheet

Balance sheet Assets – Liabilities = EquityorAssets = Liabilities + EquityThis shows the resources controlled by the entity, and the claims on those resourcesWhat do we want to see:

a) High quality assets

b) Appropriate use of debt (in terms of sizeand maturity)

5

14.5 Cash Flow Statement

Cash flows are usually divided into three areas• Those from day to day operations

• Those used to invest in (or sell) long-term assets such as land and infrastructure

• Those used to finance the business (borrowings, repayments, and share issues)

What do we want to see:a) Positive cash flows from operations

b) Negative cash flows from investing (approx. level of depreciation)

c) Appropriate cash flows from financing (dividends not too high!!)

6

14.6 What Might be Hiddenfrom View• Acceptable alternatives in accounting

practices can create very different outcomes on the financial statements – interpretation requires some understanding of how to read the ‘Notes to the financial statements’

• Information about subsidiaries and associate companies may be left off the balance sheet

7

14.7 Financial Ratios

We use ratios to assess an organisation in the following areas:• Profitability & performance

• Efficiency

• Short-term liquidity

• Capital structure ratios & long-term solvency

• Share and dividend performance

8

14.8 Warning Signs

• Cash received (in cash flow statement) is lower than stated revenue (in the income statement)

• Assets that don’t earn profits are notgood assets

• Gearing ratio of higher than 60% is dangerous

• Current Ratio of less than 1 is worrying

• Accounts Receivable collection greater than60 days

9

14.9 Goodwill

• Tangible and intangible assets

• Synergies when companies combine assets

• Goodwill is the premium paid for the synergies an acquiring company expects to receive

• Recorded as a non-current asset

10

How to Assess Financial Ratios

Event 14

14.10 Financial Ratios

Profitability/Performance• Return on equity (ROE)

• Return on assets (ROA)

• Net profit margin (also called return on sales)

• Cash flow return on assets

Measures of return include: • Earnings before Interest & Tax (EBIT)

• Net Profit after Interest & Tax (Net Earnings)

12

14.11 Financial Ratios

Short-term Liquidity • Current ratio

• Quick asset ratio

• Cash flow adequacy

Long-term Solvency/Capital Structure• Debt-to-Assets

• Debt-to-Equity

• Times interest earned

13

14.12 Financial Ratios

Efficiency • Inventory turnover

• Inventory days on hand

• Accounts receivable (debtors) turnover

• Accounts receivable collection period

• Accounts payable (creditors) turnover

• Accounts payable collection period

14

14.13 Financial Ratios

Share & Dividend Performance • Price earnings ratio

• Earnings yield

• Earnings per share

• Dividend yield

• Dividend payout ratio

• Net asset backing

• Cash flow per share

15

14.14 BenchmarksROE (return on equity) Greater than ROA. High, but not too high

ROA (return on assets) Greater than Bank Deposit Rate

Net Profit margin Industry & Previous year comparisons

Current Ratio Good is 2:1 Bad is < 1:1

Quick Asset Ratio Good is 1.5:1 Bad is < 1:1

Debt to Assets < 60%. Any higher makes lenders wary.

Times Interest Earned Earnings should be 300% or 3x interest costs

Inventory Industry & previous year comparisons

Receivables Good is 30 days Bad is > 90 days

Earnings yield Bank deposit rate + a premium for risk

Price Earnings (P/E) Canadian Shares typically 12.0 - 15.0

Dividend yield Industry average

16