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Chapter 1 - Auditing and the Public Accounting Profession

By Vincent Griffin,2014-05-15 15:45
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Chapter 1 - Auditing and the Public Accounting Profession

Chapter 9

    Analysis and Interpretation of Financial Reports

9.1 Users are interested in an entity’s future profitability, asset efficiency,

    liquidity and capital structure. Discuss the purpose of computing historical ratios.

Assessing the past profitability of the entity will shape an investor’s expectations as to

    the entity’s future profitability.

Decision-making tool for evaluating the historical health of an entity and predicting

    an entity’s future financial wellbeing.

9.9 Discuss 3 limitations of ratio analysis as a fundamental analysis tool

? Dependent on the quality of the entity’s financial reporting, disclosures and

    accounting policy choices

? Rely on asset, liability or equity numbers reported in the balance sheet - may not be

    representative of the financial position at other times of the year.

? Financial reports are historical statements reflecting past transactions.

9.10 You have identified 2 different entities operating in the same industry that

    have significantly different ROAs. Given that the entities have similar

    profitability ratios (for example, gross margin and net profit margin), what

    could account for the difference in their ROAs?

If two entities operating in the same industry have significant different ROAs, but the

    entities have similar profitability ratios (gross profit margin and/or profit margin), the

    different levels of investments in assets by the two entities could account for the

    difference in their ROAs.

Accounting: Business Reporting for Decision Making

    Birt et al

    Chapter 9

    E9.15 The following table reports various ratios for 2002 to 2006 for Qantas

    and Air New Zealand. Given that the companies operate in the same

    industry, what do the ratios suggest about the companies’ financing and

    investing activities?

Profitability

    Air NZ started off with losses in 2002 and then profitability keeps increasing up to 2004 before starts to decline

    Qantas’s EBIT margin was 5.53%, which continually increases, reaching a peak of 9.67% in 2004.

    The ROE of both Air NZ and Qantas exceed their respective ROA. Overall, Air NZ has a higher but more variable ROE and ROA relative to Qantas

Leverage

    Debt to equity ratio reveals that Qantas has a greater reliance on debt funding compared to Air NZ.

    Air NZ maintains its debt to equity ratio below 100%, which contributes to the decrease in ROE.

    As expected Qantas’ interest coverage ratio is generally lower than Air NZ.

Liquidity

    Higher gearing ratio for Qantas is also reflected in its low current ratio, however it may be an appropriate level for Qantas to operate.

    For Air NZ, its current ratios are above 1 throughout the years, but still below the desirable benchmark of 1.5.

Efficiency

    In terms of asset efficiency, both companies show a decrease in their days inventory and receivables indicating significant efficiency improvements placing less financial stress on the airway.

Performance

    Both companies’ PER has decreased over the period 2003 to 2005 but improved in 2006. In the last two years (2005 and 2006), Qantas’ PER is higher than Air NZ. This indicates that investors expect Qantas to generate higher earnings growth

     9.2

Accounting: Business Reporting for Decision Making

    Birt et al

    Chapter 9

P9.9 The proprietor of Kreamy Donuts has an appointment to see you next week

    to discuss plans to open another store in another suburb. To fund this expansion,

    the entity needs an injection of loan capital. Prior to the meeting, you have

    requested Kreamy Donuts financial reports. The following information was

    forthcoming.

Give the formula for, and calculate the following ratios for both years using

    year-end figures:

    i. current ratios

    Current ratio

    Current assets = Current liabilities

2008

    Current ratio

    60 000 = 15 000

    = 4 times

2007

    Current ratio

    56 000 = 25 000

    = 2.24 times

ii. acid test ratio

    Acid test ratio

    Current assets Inventory = Current liabilities

2008

    Acid test ratio

    60 000 12 000 = 15 000

    = 3.2 times

2007

    Acid test ratio

    56 000 16 000 = 25 000

    = 1.6 times

     9.3

Accounting: Business Reporting for Decision Making

    Birt et al

    Chapter 9

iii. days inventory

Inventory turnover (days)

    Average inventory 365 = × Cost of sales 1

2008

    Inventory turnover (days)

    12 000 365 = × 300 000 1 = 15 days

2007

    Inventory turnover (days)

    16 000 365 = × 360 000 1 = 16 days

iv. days debtors

Debtors turnover (days)

    Average trade debtors 365 = × Sales revenue 1

2008

    Debtors turnover (days)

    20 000 365 = × 480 000 1 = 15 days

2007

    Debtors turnover (days)

    22 000 365 = × 530 000 1 = 15 days

v. debt to equity

Debt to equity

    Total liabilities 100 = × Total equity 1

2008

    Debt to equity

    (15 000 + 50 000) 100 = × 165 000 1

    65 000 100 = ×

     9.4

Accounting: Business Reporting for Decision Making

    Birt et al

    Chapter 9

    165 000 1 = 39.39%

2007

    Debt to equity

    (25 000 + 50 000) 100 = × 183 000 1

    75 000 100 = × 183 000 1 = 40.98%

vi. profit margin

Profit margin

    Earnings before interest and tax (EBIT) 100 = × Sales revenue 1

2008

    Profit margin

    (94 000 + 6000) 100 = × 480 000 1

    100 000 100 = × 480 000 1 = 20.83%

2007

    Profit margin

    (71 000 + 4000) 100 = × 530 000 1

    75 000 100 = × 530 000 1 = 14.15%

vii. return on assets

Return on assets (ROA)

    Earnings before interest and tax (EBIT) 100 = × Average total assets 1

2008

    Return on assets (ROA)

    (94 000 + 6000) 100 = × 230 000 1

    100 000 100 = × 230 000 1 = 43.48%

     9.5

Accounting: Business Reporting for Decision Making

    Birt et al

    Chapter 9

2007

    Return on assets (ROA)

    71 000 + 4000 100 = × 258 000 1

    75 000 100 = × 258 000 1 = 29.07%

viii. return on equity

Return on equity (ROE)

    Net profit 100 = × Average equity 1

2008

    Return on equity (ROE)

    73 000 100 = × 165 000 1 = 44.24%

2007

    Return on equity (ROE)

    53 000 100 = × 183 000 1 = 28.96%

     9.6

Accounting: Business Reporting for Decision Making

    Birt et al

    Chapter 9

ANALYSIS

Nature of entity’s operations

Inventory levels would generally be low

    Majority of the sales would be cash

ROE has increased dramatically from 28.96% to 44.24%

To understand changes in the ROE, movements in the firm’s profitability (ROA) and

    asset efficiency (asset turnover) need to be considered

ROA has increased from 29.07% in 2003 to 43.48% in 2008

Underlying reason as to the firms profitability

Profit margin has improved from 14.15% in 2004 to 20.83% in 2008

Gross profit margin and the expense ratios have increased slightly indicating the

    improved profitability is associated with higher gross margins

Current asset management has not changed significantly

Reliance on external funding has remained consistent with approximately $0.40

    cents of debt employed for every $1 of equity to finance assets

Entity has spare capacity to absorb more debt if they open another restaurant

    Necessary to ensure that the business has the cash resources to service additional debt.

Current ratio of Kreamy Donuts has increased

High current ratio is not necessarily good, as it could be due to excess investments in

    unprofitable assets

    Acid test ratio of Kreamy Donuts has increased High current ratio is not necessarily good

ADDITIONAL INFORMATION REQUIRED

? Cash flow ratio

    ? Interest coverage

    ? Debt coverage ratio

LIMITATIONS OF RATIO ANALYSIS

? Quality of ratios calculated is dependent on quality of entity’s financial reporting.

    ? May not be representative of the financial position at other times of the year.

    ? Financial reports are historical statements reflecting past transactions.

     9.7

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