Professional Documents
Culture Documents
Accounting Analysis PDF
Accounting Analysis PDF
Analysis
TABLE OF CONTENTS
9.1 Purpose of Financial Statements..................... 164 9.3.2 Format and Terminology ................................... 172
9.2 Balance Sheet........................................... 164 9.3.3 Capital and Revenue Expenditure ...................... 174
9.2.1 Introduction ...................................................... 164 9.4 Cash Flow Statement ................................... 175
9.2.2 Accounting Equation ......................................... 164 9.4.1 Introduction....................................................... 175
9.2.3 Format............................................................... 166 9.4.2 Scope ................................................................ 175
9.2.4 Fixed Assets ...................................................... 166 9.4.3 Cash Definition .................................................. 176
9.2.5 Current Assets................................................... 168 9.4.4 Format and Terminology ................................... 176
9.2.6 Current Liabilities .............................................. 168 9.5 Analysis of Accounts.................................... 177
9.2.7 Accruals and Prepayments................................ 168 9.5.1 Introduction....................................................... 177
9.2.8 Capital Employed............................................... 169 9.5.2 Profitability Ratios............................................. 178
9.2.9 Long-Term Liabilities ........................................ 169 9.5.3 Liquidity Ratios ................................................. 179
9.2.10 Provisions for Liabilities and Charges ............. 169 9.5.4 Financial Gearing Ratios .................................... 180
9.2.11 Called-Up Share Capital................................... 169 9.5.5 Investors Ratios ............................................... 182
9.2.12 Share Premium Account Reserve.................... 169 9.5.6 Shareholder Value Added (SVA)........................ 185
9.2.13 Revaluation Reserve........................................ 171 9.5.7 Enterprise Value to EBITDA ............................... 186
9.2.14 Other Reserves................................................ 171
9.2.15 Profit and Loss Account Reserve .................... 171
9.2.16 Minority Interests ............................................ 171
9.3 Profit and Loss Account Statement .................. 172
9.3.1 Introduction ...................................................... 172
159
9 Accounting Analysis
160
9 Accounting Analysis
Learning Objectives
Company Profit and Loss Accounts
Know the purpose of profit and loss accounts and their basic contents.
161
9 Accounting Analysis
Capital reserves.
Goodwill.
Share capital.
Share premium account.
Understand the following.
Fixed assets.
Intangible assets.
Current liabilities.
Current assets.
Capital employed (Total assets Current liabilities).
Net asset values.
Assets less preference capital less liabilities divided by the number of shares.
Valuation, historical cost and depreciation.
May be tested by simple calculations.
Effect of stock splits.
Problems of fluctuating values.
Effect of economic cycles.
FRS 1.
What is a cash flow statement?
When is it required?
Why is it required?
Covers the period of the balance sheet.
Taxation.
Capital expenditure.
Financing.
Acquisitions and disposals.
Equity dividends paid.
Return on investment and servicing of finance.
Management of liquid resources.
162
9 Accounting Analysis
Ratios
Understand the purpose of ratio analysis, its uses and limitations.
163
9 Accounting Analysis
The format usually adopted by UK companies presents this equation vertically with net assets above
shareholders funds. In outline, a UK balance sheet appears as follows.
Balance Sheet Outline
000
Assets 400
Liabilities (150)
Net Assets 250
Shareholders Funds
Share capital 100 Source of funds
Reserves 150 from shareholders
250
As we can see, the accounting equation holds the balance sheet balances.
164
9 Accounting Analysis
1. Assets
These represent resources owned or controlled by the company and available for its use, such as stocks
of goods for sale or production equipment. These can be sub-categorised under two headings, Fixed
Assets and Current Assets.
Fixed Assets
Assets acquired for continued use in the business to earn profit, not for resale. Examples of such items
would include office and production buildings and equipment. Clearly these are intended for long-term
use, not simply to be sold on at a profit.
Current Assets
Assets acquired for conversion to cash during the ordinary course of business. Examples of such assets
would include stocks of goods available for sale to customers, or customers account balances which will
be settled for cash. By convention, assets which are to be converted into cash within 12 months are
deemed to be current.
2. Liabilities
Liabilities represent amounts owed by the company to outside suppliers and lenders. These too are
sub-categorised as
Creditors: amounts falling due within one year. These are also known as current liabilities.
Creditors: amounts falling due after more than one year. These are also known as long-term
liabilities.
The purpose of the above classification is to provide a clear indication of the timescales for settlement.
3. Share Capital
This is money invested in the company by shareholders, i.e. money subscribed for shares.
4. Reserves
These generally represent profits earned and retained by the company since it began trading, though there
may be other types of reserves as we will see later.
This is only a broad outline and in reality the balance sheet will contain much more detail. You are required
to know this full detail for the exam.
165
9 Accounting Analysis
9.2.3 Format
The general format for a balance sheet is prescribed in the Companies Acts and can be illustrated by the
following example.
2003 2002
Section
000 000
Fixed assets 9.2.4
Intangible 877 662
Tangible 19,798 19,854
Investments 37 39
20,712 20,555
Current assets 9.2.5
Stock 19,420 19,101
Debtors 27,882 35,980
Investments 1,487 2,116
Cash 3,923 4,804
52,712 62,001
Current liabilities 9.2.6 (48,817) (45,218)
Net current assets 3,895 16,783
Total assets less current liabilities 9.2.8 24,607 37,338
Long-term liabilities 9.2.9 (3,695) (18,553)
Provisions for liabilities and charges 9.2.10 (1,484) (2,193)
Net Assets 19,428 16,592
Capital and reserves
Called-up share capital 9.2.11 1,743 1,725
Share premium account reserve 9.2.12 2,237 2,182
Revaluation reserve 9.2.13 4,687 3,806
Other reserves 9.2.14 1,204 1,204
Profit and loss account reserve 9.2.15 8,557 6,875
Total shareholders funds 18,428 15,792
Minority interests 9.2.16 1,000 800
19,428 16,592
You will notice that the balance sheet is shown for both this year end (31 December 2003) and the
previous year end (31 December 2002) for comparison purposes. The section numbers referred to above
(known as Notes to the Accounts) would normally provide further detailed analysis, but in this table they
are being used to provide additional explanations of the terminology.
166
9 Accounting Analysis
The Companies Act requires that all fixed assets that have limited useful economic lives must be
depreciated, but what is depreciation?
Example
A company buys some production machinery at a cost of 60,000. It expects, from previous experience,
that it will last five years, after which time it will be sold for 5,000. It will therefore cost the company
55,000 (60,000 cost less 5,000 expected sale proceeds) to use the equipment over these five years.
Applying the matching concept, this 55,000 cost should be spread over the five years, i.e. a depreciation
expense of 11,000 charged against the profit each year.
Depreciation is the method by which the cost of using the asset is matched against its related benefit.
On the balance sheet fixed assets are usually stated at net book value (NBV), i.e. cost less the
accumulated depreciation provision. Thus, at the end of each of the next five years the fixed asset will be
valued in the balance sheet as follows.
As we can see, the balance sheet net book value of the equipment falls by 11,000 each year (as the
amount is charged as an expense depreciation), until in Year 5 it has dropped to the estimated sales
proceeds of 5,000.
Depreciation is an example of the accounting principle known as accrual or matching. Note that the
depreciation charge in the profit and loss account, of 11,000 each year, is just an accounting entry and
does not appear in the cash flow statement.
167
9 Accounting Analysis
Investments
These represent long-term ownership of shares in other companies and are usually reported in the balance
sheet at historical cost. Additional reporting regulations apply to significant levels of shareholdings that
have caused the investments to be classified as either a subsidiary (50%+) or an associate (20%-50%).
Accruals
An accrual is an amount due in respect of goods and services used during the year but not yet invoiced.
Since the amount is owed even though it has not yet been invoiced for, it has to be shown as part of the
liabilities. Accruals are therefore shown as part of current liabilities.
168
9 Accounting Analysis
Prepayments
Prepayments are amounts paid before the balance sheet date which relate to the period after that date.
Since we have paid the money over but not yet received the benefit due from the expenditure, we still have
an asset at the balance sheet date. Prepayments are therefore shown as part of debtors, within current
assets.
169
9 Accounting Analysis
Example
A company could raise 20,000 by issuing 5,000 new 1 ordinary shares at an issue price of 4 each. This
results in a premium of 3 per share (issue price of 4, less nominal value of 1).
Under the Companies Act, the company must record the issue of these shares by increasing the called-up
share capital by only the nominal value of the shares issued, i.e. 5,000. The premium of 15,000 must
be added to the share premium account reserve. The impact on the accounting equation is
000
Impact on Net Assets
Cash +20
+20
Impact on Shareholders Funds
Share capital +5
Share premium account reserve +15
+20
Having been created, the share premium account reserve can only subsequently be reduced in five
circumstances without a courts permission.
1. To issue bonus shares. Bonus shares are issued by a company when it feels that the share price
has gone too high. A bonus issue, like a rights issue, is made to the existing shareholders and
gives them a number of free shares proportionate to their existing holding.
For example, a 1 for 2 bonus issue, with the cash bonus share price at 9, would give the owner of
two shares one new share.
The impact on the share price is as follows.
Existing holding 2 shares @ 9 = 18
Bonus shares 1 share @ free = 0
Final holding 3 shares = 18
or 6 per share
In terms of the balance sheet, the effect is
* Any surplus over the value of the share premium would have to go to other reserves. Note that it is not just
the share premium account reserve that can be used to finance a bonus issue any reserve will do.
2. To write off preliminary expenses of forming a company.
3. To write off expenses of issue of shares or debentures.
4. To charge the premium on repayment on debentures.
5. To charge the discount on issue of debentures.
The share premium account reserve can never be reduced to pay dividends to the shareholders, as
it is one of the companys non-distributable reserves.
170
9 Accounting Analysis
171
9 Accounting Analysis
However, it only owns 80% of ABC Ltds net assets, with the other 20% being owned by the minority
interest. XYZ plc recognises this fact by analysing the total shareholder financing into two separate
entities group shareholders funds and minority interest. The minority interest shows how much of the
net assets belong to the minority shareholders in ABC Ltd.
XYZ plc Group Profit and Loss Account for the Year Ended 31 December 2003
2003 2002
Notes
000 000
Turnover 135,761 141,013
Cost of sales (85,604) (91,011)
Gross profit 50,157 50,002
Distribution costs (22,961) (21,636)
Administrative expenses (19,620) (16,752)
Other operating income 100 200
Operating profit 7,676 11,814
Exceptional items (270) (1,296)
7,406 10,518
Income from fixed asset investments 100 100
Interest receivable and similar income 30 161
Interest payable and similar charges (3,176) (3,521)
Profit on ordinary activities before taxation 4,360 7,258
Tax on profit on ordinary activities (1,104) (2,000)
Profit on ordinary activities after taxation 3,256 5,258
Minority interests (60) (20)
Extraordinary items
Profit/(loss) for the financial year 3,196 5,238
Dividends paid and proposed (2,064) (6,527)
Retained profit/(loss) for the financial year 1,132 (1,289)
Earnings per ordinary share 5.08p 9.06p
172
9 Accounting Analysis
Terminology
In accordance with the accruals or matching principle, income and expenses are recognised in the profit
and loss account statement when earned regardless of when paid. Any difference between the recognition
of these items and the corresponding cash flow will be reflected in a balance sheet debtor or creditor.
1 Turnover
The turnover or sales figure represents the total value of goods or services provided to customers during
the accounting period whether they have been paid for or not, in accordance with the accruals principle.
2 Cost of Sales
The cost of sales represents the total cost to the business of buying or making the actual items sold.
3 Gross Profit
Gross profit is the difference between the value of the sales and the value of the cost of goods sold. One
measure frequently used in determining the performance of the business is to consider its gross profit
margin, which can be calculated as follows.
Gross profit
Formula to Learn: Gross profit margin = 100%
Turnover
Clearly, the higher the margin for a particular level of operations, the higher the profit. However, this does
not mean that low margins result in low profits. A number of businesses generate very healthy profits
through selling very large numbers of items (achieving correspondingly large turnover) at low margins.
5 Exceptional Items
Exceptional items are unusually large items of income or expense arising during the year. They are
separately classified as exceptional items to highlight their one-off nature. An exceptional item
Is material.
Derives from events or transactions that fall within the ordinary activities of the business.
Needs to be separately disclosed by virtue of its size or incidence if the financial statements are to
give a true and fair view.
6 Interest Payable
In common with most other business expenses, any interest payable goes to reduce the companys profit
before tax and hence taxable profit by the gross amount payable. For example, if a company has in issue
100,000 of 10% loan stock, then the interest charge in its accounts each year will be 10,000.
173
9 Accounting Analysis
8 Minority Interests
Minority interests arise in a similar way as in the balance sheet. Where XYZ plc owns 80% of ABC Ltd, it
will include all of ABC Ltds profit after tax in its own consolidated accounts on the basis that it controls all
of ABC Ltds operations. However, it does not own all of that profit, with 20% belonging to the minority
interests. The 20% of ABC Ltds profit after tax that belongs to the minority interests is deducted from the
profit after tax, leaving the amount of profit attributable to the shareholders in XYZ plc.
9 Extraordinary Item
An extraordinary item is a large one-off item, similar to an exceptional item, that requires separate
disclosure in order to ensure that the truth in the accounts (the trends, ratios, etc.) is not distorted. An
extraordinary item
Is material.
Possesses a high degree of abnormality which arises from events or transactions that fall outside
the ordinary activities of the business.
Is not expected to recur.
Note that this definition is exceedingly restrictive and it is highly unusual that a profit and loss account
statement will have an extraordinary item shown. For that reason our illustrative accounts have shown the
positioning of the item in the accounts but given a nil amount. In such a case, a company would dispense
with the line altogether.
Tax is payable on extraordinary items. The figure that would be shown on the face of the profit and loss
account would be a net of tax figure.
Dividends
These represent the cash dividends paid out or proposed to be paid out to shareholders net of starting rate
income tax.
Most of the time companies pay out dividends which are less than their profits after tax, i.e. the dividend is
being paid from this years profits and is said to be covered. However, it is not essential for a dividend to
be covered. It may be financed from previously retained profits which, as we have seen, are accumulated
in the balance sheet profit and loss account reserve balance. XYZ plcs dividend for 2002 is uncovered in
our example.
In most cases, UK companies pay dividends in two stages.
Interim dividend paid this is paid out during the year based on the half years performance.
Final dividend proposed this is paid to shareholders following the approval of the year end
accounts at the AGM.
174
9 Accounting Analysis
Revenue Expenditure
Revenue expenditure is expenditure incurred in
Acquiring assets to be sold for conversion into cash, e.g. stock.
Manufacturing, selling, distributing goods, e.g. wages.
Day-to-day administrative expenses, e.g. electricity, telephone.
Maintenance of fixed assets, e.g. repairs.
Revenue expenditure is charged directly against profits for the period to which it relates.
9.4.2 Scope
FRS 1 applies to all financial statements intended to give a true and fair view, excluding
Small companies where a small company is defined as one which fulfils two of the following three
criteria.
Turnover Not more than 5.6m
Total Assets Not more than 2.8m
Employees Not more than 50
Subsidiaries of parents, where 90% or more of the voting rights are controlled within the group,
who file publicly available versions of their consolidated financial statements.
Mutual life assurance companies.
Pension Funds.
Open-ended investment funds.
175
9 Accounting Analysis
Disclosure
The cash flow statement must show a total for each class.
Note that the cash flow does not include depreciation as that is an accounting entry in the profit and loss
account.
The cash flow statement must cover the period between the companys balance sheet dates, i.e. the same
period as the profit and loss account.
176
9 Accounting Analysis
Format
The illustration below shows how a cash flow statement should appear in the account of XYZ plc.
XYZ plc Group Cash Flow Statement for the Year Ended 31 December 2003
2003 2002
000 000
Net cash inflow from operating activities 15,844 11,766
Returns on investments and servicing of finance
Interest received 113 261
Dividends received/(paid) 0 1,021
Interest paid (3,021) (3,521)
(2,908) (2,239)
Taxation (589) (3,110)
Capital expenditure
Payments to acquire intangible assets (289) (662)
Payments to acquire tangible assets (2,258) (3,750)
Receipts from sales of tangible fixed assets 645 2,235
(1,902) (2,177)
Acquisitions and disposals
Purchase of subsidiary undertakings (9,847) (10,089)
177
9 Accounting Analysis
The financial statements are primarily prepared for company shareholders. However, they may have
several other users, such as the Board, suppliers, competitors and employees. Each of these groups will
use the accounts to provide an indication of the
Returns they are receiving.
Risks they are facing.
A number of fairly standard ratios have been developed to assist with this process, and these can be
grouped under four headings.
Profitability Ratios
Ratios that assess the trading or operating performance of the company, i.e. levels of trading profits
generated, and the productivity of trading assets.
Liquidity Ratios
Ratios that assess the risk that the company may be unable to pay its creditors as they fall due with cash
and assets generated from trading.
Investors Ratios
Ratios that assess the returns to the providers of finance, who may be either shareholders or lenders.
Ratios are rarely useful when viewed in isolation. However, they can be used to assess a company by
comparison to sector averages, market averages or other similar companies. A companys progress can
also be measured by comparing ratios with past in-house figures (for internal assessment) or previous
published accounts to give a picture of year-on-year performance.
However, as there are no official rules concerning ratio calculation, there is a risk that, if two ratios from
different sources are being compared, slightly different calculation methods may have been used, giving
rise to some distortion in the comparison. Also, changes in accounting policies and restatement of prior
year figures may lead to changes in ratios, which are not necessarily indicative of underlying performance.
Throughout our review of ratios, we will draw examples from the balance sheet and profit and loss
account data for Illustration plc, which can be found at the end of this chapter.
Basic Calculation
The return on capital employed is calculated as follows.
Profit
This profit figure can be viewed as operating profit, i.e. the profits that management have generated from
the resources they have available. It is specifically before interest payable since this will clearly be
dependent on the financing of the business the larger the loan, the larger the interest payable.
178
9 Accounting Analysis
In the examination, you may be given the profit before tax figure and the interest payable and be asked to
calculate operating profit, as follows.
Profit before tax 3,673
Add back interest payable 2,811
Operating profit 6,484
Capital Employed
Capital employed could be viewed from the financing side as
6,484
ROCE = 100%
37,486
ROCE = 17.3%
Current Ratio
This ratio is calculated from using the companys year-end position. The ratio calculates whether assets
recoverable within one year are sufficient to cover liabilities falling due within that year.
Current assets
Formula to Learn: Current ratio =
Current liabilities
57,653
Current ratio =
43,666
179
9 Accounting Analysis
57,653 19,420
Quick ratio =
43,666
38,233
Quick ratio =
43,666
Basic Calculation
This is a relationship that shareholders would consider as a measure of the risk to their dividends.
Considerations
We consider only interest-bearing debt since this is what is causing the risk to profit before tax, hence
ultimately the profits after tax and amounts available for payment as dividends to our shareholders.
2,372 + 2,073
Debt to equity = 100%
33,041
4,445
Debt to equity = 100%
33,041
180
9 Accounting Analysis
Considerations
We should consider the ability of the company to use the cash it has available to repay debt.
2,519
Net debt to equity = 100%
33,041
Basic Calculation
This ratio considers gearing from the viewpoint of the profit and loss account statement and measures the
capacity of the firm to meet its interest obligations.
Considerations
The interest cover provides a measure of the ability of the company to pay the fixed interest on borrowings
from profits for the year. Clearly, the higher the level of interest cover, the less risk there is to either
shareholders or lenders. However, there is no optimal level.
181
9 Accounting Analysis
2,301,000
EPS =
18,762,000 shares
EPS = 12.3p
Fully Diluted Earnings Per Share
The objective of the fully diluted earnings per share figure is to warn shareholders of the companys
possible future deterioration in the earnings per share figure, as a result of an obligation to issue new
shares. There are a number of reasons why earnings could be diluted in the future.
Convertible loan stock in issue.
Convertible preference shares in issue.
Options issued by and exercisable on the company.
Warrants in issue.
Each of these circumstances may result in more shares being issued in future years. These would be taken
into account when calculating the fully diluted earnings per share.
Fully diluted earnings per share is calculated on the basis that conversion of the debentures/preference
shares or the exercise of warrants/options has already occurred. The impact of the notional conversion/
exercise on earnings per share is calculated, and the result is fully diluted earnings per share.
182
9 Accounting Analysis
Considerations
The P/E ratio expresses the number of years earnings represented by the current market price.
If we take our current share price as 2.20 and our EPS figure as 12.3p, the P/E ratio is
220p
Price/Earnings =
12.3p
6.42p
Dividend yield = 100%
220p
183
9 Accounting Analysis
Dividend Cover
Dividend cover is used to assess the likelihood of the existing dividend being maintained. The dividend
cover is calculated as follows.
12.3p
Dividend cover =
6.42p
Basic Ratio
The net asset value or net asset value per share is calculated as follows.
33,041
Net asset value =
18,762
= 1.76
Considerations
Net assets attributable to ordinary shareholders should exclude the book value of any preference share
capital the company has in issue.
The net asset value could show an unrealistic figure if a strict policy of historical cost accounting has
been applied. The shareholders may be more interested in asset values if the company adopts a
revaluation policy.
Net asset value will also be reduced proportionately if the company performs a stock split or capitalisation
issue, as the number of shares will increase with no corresponding change in net assets.
184
9 Accounting Analysis
Definition
SVA is defined as
Formula to Learn: SVA = Net operating profit after tax - Cost of capital
Cost of Capital
Formula to Learn: Cost of capital = Value of the capital invested Weighted average cost of capital
That is, the after-tax cost to the company of servicing its finance based on the required returns of equity
and debt investors and the market values of these sources of finance.
If the SVA is a positive value, then value is being added by the management of the company.
Although you are required to understand the basic details of SVA, you will not be asked to calculate this
ratio in your exam.
185
9 Accounting Analysis
Enterprise value
Formula to Learn: EV to EBITDA =
EBITDA
Enterprise Value
Enterprise value is the total value of all the ordinary shareholders equity, preference shares and net debt.
Formula to Learn:
Enterprise value = Market value of ordinary shares + Market value of preference shares + Market value of debt
- Cash and investments
186
9 Accounting Analysis
Illustration Plc
187
9 Accounting Analysis
188