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Part II Using Accounting Information for Decision-Making, Planning and Control Part II shows the reader how accounting information is used in decision-making, planning and control. The accounting tools and techniques are explained and illustrated by straightforward examples. Case studies, drawn mainly from real business examples, help draw out the concepts. Theory is integrated with the tools and techniques, and the use of quotations from the original sources should encourage readers to access the accounting academic literature that they may find of interest. Chapter 7 helps the reader to interpret the main financial statements. Chapters 8, 9 and 10 consider the accounting techniques that are of value in marketing, operations and human resource decisions respectively. Chapters 8, 9 and 10 do not take an approach to accounting that is common to other books. These chapters provide a practitioner- rather than an accounting-centred approach, demonstrating techniques that do not require any prior management accounting knowledge. The more traditional accounting focus is left to Chapter 11, by which time the reader should have little difficulty in understanding the more complex concepts. Chapter 12 focuses on strategic decisions such as capital investment and Chapter 13 on divisional performance measurement. Chapter 14 covers the subject of budgeting and Chapter 15 discusses budgetary control. 7 Interpreting Financial Statements and Alternative Theoretical Perspectives This chapter introduces the content of a company’s Annual Report and shows how ratio analysis can be used to interpret financial statements. This interpretation covers profitability, liquidity (cash flow), gearing (borrowings), activity/efficiency and shareholder return. A case study demonstrates how the use of ratios can look ‘behind the numbers’ contained in an Annual Report. The chapter concludes with several alternative theoretical frameworks on financial reporting. Interpreting financial statements Financial statements are an important part of a company’s Annual Report, which is required for all companies listed on the Stock Exchange. For companies not listed, the Companies Act requires the preparation of financial statements. The process of interpreting financial statements begins with a consideration of the wider context: economic conditions; changes in the industry (e.g. regulation, technology); and the competitive advantage (e.g. marketing, operations, distribution etc.) held by the business. Within this context, often gained through the financial press and trade periodicals, the Annual Report itself can be considered. The Annual Report for a listed company typically contains: 1 A financial summary – the key financial information. 2 The chairman’s or directors’ report. This provides a useful summary of the key factors affecting the company’s performance over the past year and its prospects for the future. It is important to read this information as it provides a background to the financial statements, in particular the company’s products and major market segments. It is important to ‘read between the lines’ in this report, since the intention of the Annual Report is to paint a ‘glossy’ picture of the business. However, as competitors will also read the Annual Report, the company takes care not to disclose more than is necessary. 3 The statutory reports (i.e. those required by the Companies Act) by the directors and auditors. These will help to identify any key issues that may be found in the accounts themselves. 84 ACCOUNTING FOR MANAGERS 4 The financial statements: Profit and Loss account, Balance Sheet and Cash Flow statement. The consolidated figures should be used, as these are the total figures for the group of companies that comprise the whole business. 5 Notes to the accounts, which provide detailed figures and explanations to the accounts. These often run to many pages. 6 A five-year summary of key financial information (a Stock Exchange Yellow Book requirement). The Accounting Standards Board recommends that listed companies include an operating and financial review that provides ‘a framework for the directors to discuss and analyse the business’s performance and the factors underlying its results and financial position, in order to assist users to assess for themselves the future potential of the business’ (quoted in Blake, 1997). The operating and financial review would replace much of the information contained in the chairman’s or directors’ reports (item 2 above). The Profit and Loss account, Balance Sheet and Cash Flow statement can be studied using ratios. Ratios are typically two numbers, with one being expressed as a percentage of the other. Ratio analysis can be used to help interpret trends in performance year on year and by benchmarking to industry averages or to the performance of individual competitors. Ratio analysis can be used to interpret performance against five criteria: ž ž ž ž ž the rate of profitability; liquidity, i.e. cash flow; gearing, i.e. the proportion of borrowings to shareholders’ investment; how efficiently assets are utilized; and the returns to shareholders. Ratio analysis There are different definitions that can be used for each ratio. However, it is important that whatever ratios are used, they are meaningful to the business and applied consistently. The most common ratios follow. The calculations refer to the example Profit and Loss account and Balance Sheet provided in Tables 6.1, 6.2 and 6.3 in Chapter 6. Ratios are nearly always expressed as a percentage (by multiplying the answer by 100). Profitability Return on (shareholders’) investment (ROI) 70 net profit after tax = 7% shareholders’ funds 1000 INTERPRETING FINANCIAL STATEMENTS 85 Return on capital employed (ROCE) 100 operating profit before interest and tax = 7.7% shareholders’ funds + long-term debt 1,000 + 300 Operating profit/sales operating profit before interest and tax 100 = 5% sales 2,000 Gross profit/sales gross profit 500 = 25% sales 2,000 Each of the profitability ratios provides a different method of interpreting profitability. Satisfactory business performance requires an adequate return on shareholders’ funds and total capital employed in the business (the total of the investment by shareholders and lenders). Profit must also be achieved as a percentage of sales, which must itself grow year on year. The operating profit and gross profit margins emphasize different elements of business performance. Liquidity Working capital current assets 500 = 143% current liabilities 350 Acid test (or quick ratio) current assets − inventory 500 − 200 = 86% current liabilities 350 A business that has an acid test of less than 100% may experience difficulty in paying its debts as they fall due. On the other hand, a company with too high a working capital ratio may not be utilizing its assets effectively. Gearing Gearing ratio 300 long-term debt = 23.1% shareholders’ funds + long-term debt 1,000 + 300 86 ACCOUNTING FOR MANAGERS Table 7.1 Risk and return – effect of different debt/equity mix 100% equity 50% equity 50% debt 10% equity 90% debt Capital employed 100,000 100,000 100,000 Equity Debt 100,000 0 50,000 50,000 10,000 90,000 Operating profit before interest and tax Interest at 10% on debt 20,000 0 20,000 5,000 20,000 9,000 Profit after interest Tax at 30% 20,000 6,000 15,000 4,500 11,000 3,300 Profit after tax 14,000 10,500 7,700 14% 21% 77% Return on investment Interest cover profit before interest and tax 100 = 6.25 times interest payable 16 The higher the gearing, the higher the risk of repaying debt and interest. The lower the interest cover, the more pressure there is on profits to fund interest charges. However, because external funds are being used, the rate of profit earned by shareholders is higher where external funds are used. The relationship between risk and return is an important feature of interpreting business performance. Consider the example in Table 7.1 of risk and return for a business whose capital employed is derived from different mixes of debt and equity. While in the above example the return on capital employed is a constant 20% (an operating profit of £20,000 on capital employed of £100,000), the return on shareholders’ funds increases as debt replaces equity. This improvement to the return to shareholders carries a risk, which increases as the proportion of profits taken by the interest charge increases (and is reflected in the interest cover ratio). If profits turn down, there are substantially more risks carried by the highly geared business. Activity/efficiency Asset turnover 2,000 sales = 121% total assets 1,150 + 500 INTERPRETING FINANCIAL STATEMENTS 87 This is a measure of how efficiently assets are utilized to generate sales. Investment in assets has as its principal purpose the generation of sales. Three other efficiency ratios are those concerning debtors’ collections, stock turnover and creditors’ payments, which were covered in Chapter 6. Shareholder return For these ratios we need some additional information: Number of shares issued Market value of shares 100,000 £2.50 Dividend per share dividends paid 30,000 = £0.30 per share number of shares 100,000 Dividend payout ratio dividends paid 30,000 = 43% profit after tax 70,000 Dividend yield dividends paid per share 0.30 = 12% market value per share 2.50 Earnings per share 70,000 profit after tax = £0.70 per share number of shares 100,000 Price/earnings (P/E) ratio market value per share 2.50 = 3.57 times earnings per share 0.70 The shareholder ratios are measures of returns to shareholders on their investment in the business. The dividend and earnings ratios reflect the annual return to shareholders, while the P/E ratio measures the number of years over which the investment in shares will be recovered through earnings. 88 ACCOUNTING FOR MANAGERS Interpreting financial information using ratios The interpretation of any ratio depends on the industry. In particular, the ratio needs to be interpreted as a trend over time, or by comparison to industry averages of competitor ratios. These comparisons help determine whether performance is improving and where improvement may be necessary. Based on the understanding of the business context and competitive conditions, and the information provided by ratio analysis, users of financial statements can make judgements about the pattern of past performance and prospects for a company and its financial strength. Broadly speaking, businesses seek: ž ž ž ž ž increasing rates of profit on shareholders’ funds, capital employed and sales; adequate liquidity (a ratio of current assets to liabilities of not less than 100%) to ensure that debts can be paid as they fall due, but not an excessive rate to suggest that funds are inefficiently used; a level of debt commensurate with the business risk taken; high efficiency as a result of maximizing sales from the business’s investments; and a satisfactory return on the investment made by shareholders. When considering the movement in a ratio over two or more years, it is important to look at possible causes for the movement. These can be gained by understanding that either the numerator (top number in the ratio) or denominator (bottom number in the ratio) or both can influence the change. Some of the possible explanations behind changes in ratios are described below. Profitability Improvements in the returns on shareholders’ funds (ROI) and capital employed (ROCE) may either be because profits have increased and/or because the capital used to generate those profits has altered. When businesses are taken over by others, one way of improving ROI or ROCE is to increase profits by reducing costs (often as a result of economies of scale), but another is to maintain profits while reducing assets and repaying debt. Improvements in operating profitability as a proportion of sales (PBIT or EBIT) are the result of profitability growing at a faster rate than sales growth, a result either of a higher gross margin or lower expenses. Note that sales growth may result in a higher profit but not necessarily in a higher rate of profit as a percentage of sales. Improvement in the rate of gross profit may be the result of higher selling prices, lower cost of sales, or changes in the mix of product/services sold or different market segments in which they are sold, which may reflect differential profitability. Naturally, the opposite explanations hold true for deterioration in profitability. INTERPRETING FINANCIAL STATEMENTS 89 Liquidity Improvements in the working capital and acid test ratios are the result of changing the balance between current assets and current liabilities. As the working capital cycle in Figure 6.1 showed, money changes form between debtors, stock, bank and creditors. Borrowing over the long term in order to fund current assets will improve this ratio, as will profits that generate cash flow. By contrast, using liquid funds to repay long-term loans or incurring losses will reduce the working capital used to repay creditors. Gearing The gearing ratio reflects the balance between long-term debt and shareholders’ equity. It changes as a result of changes in either shareholders’ funds (more shares may be issued), raising new borrowings or repayments of debt. As debt increases in proportion to shareholders’ funds, the gearing ratio will increase. Interest cover may increase as a result of higher profits or lower borrowings (and reduce as a result of lower profits or higher borrowings), but even with constant borrowings changes in the interest rate paid will also influence this ratio. Activity/efficiency Asset turnover improves either because sales increase or the total assets used reduce, a similar situation to that described above for ROCE. The efficiency with which debtors are collected, inventory is managed and creditors paid is also an important measure. Shareholder return Decisions made by directors influence both the dividend per share and the dividend payout ratio. Dividends are a decision made by directors on the basis of the proportion of profits they want to distribute and the capital needed to be retained in the business to fund growth. Often, shareholder value considerations will dictate the level of dividends, which businesses do not like to reduce on a per share basis. This is sometimes at the cost of retaining fewer profits and then having to borrow additional funds to support growth strategies. However, the number of shares issued also affects this ratio, as share issues will result in a lower dividend per share unless the total dividend is increased. As companies have little influence over their share price, which is a result of market expectations as much as past performance, dividend yield, while influenced by the dividend paid per share, is more readily influenced by changes in the market price of the shares. Earnings per share is influenced, as for profitability, by the profit but also (like dividends) by the number of shares issued. As for the dividend yield, the price/earnings (P/E) ratio is often more a result of changes in the share price than in the profits reflected in the earnings per share. Explanations for changes in ratios are illustrated in the following case study. 90 ACCOUNTING FOR MANAGERS Case study: Ottakar’s – interpreting financial statements Ottakar’s has 74 bookshops and 900 employees. It is the second largest specialist bookseller in the UK after Waterstone’s. The information in Tables 7.2 and 7.3 has been extracted from the company’s annual report. The number of shares issued was 20,121,000 in 2001 and 20,082,000 in 2000. Ratios for profitability are shown in Table 7.4. There was a strong sales growth between 2000 and 2001. Despite this growth, the gross margin remained constant and operating profit to sales increased. This is because the proportion of sales consumed by overheads (selling, distribution and administration costs) reduced from 36.6% [(22,707 + 3,986)/72,922] to 34.8% [(26,219 + 3,797)/86,287]. Operating profit more than doubled (from £1,678 to £3,516) and profit after tax increased from £463 to £1,792 (all figures are in £’000). As shareholders’ funds increased by only 10% and capital employed by only 6%, the return on both measures of investment showed a strong improvement. Ratios for liquidity are shown in Table 7.5. While the working capital ratio is healthy, indicating that the company has adequate funds to pay its debts, the acid test reveals that after deducting inventory, the company has only about 22% of assets to cover its current liabilities. This means that it is dependent on sales of books in stock to pay suppliers for those books. The efficiency measures (see below) support this. Table 7.2 Ottakar’s Profit and Loss account in £’000 2001 2000 Turnover Cost of sales 86,287 −52,755 72,922 −44,551 Gross profit Selling and distribution costs Administration expenses 33,532 −26,219 −3,797 28,371 −22,707 −3,968 Operating profit Profit/(loss) on disposal of fixed assets 3,516 4 1,678 −336 Profit before interest and taxation Other interest receivable and similar income Interest payable and similar charges 3,520 3 −727 1,342 2 −562 Profit on ordinary activities before taxation Taxation on profit on ordinary activities 2,796 −1,004 782 −319 Profit for the financial period Dividend and appropriations 1,792 −503 463 −302 Retained profit for the period for equity shareholders 1,289 161 Earnings per share 8.91p 2.31p