Introduction - Employer Expectations Blueprint

Element #1: Teams

1)Understanding the Core Values and aligning to the core values are

very important for a successful career in any organisation. Core

Values determine the Organisation culture. Core values are the

values that one one uphold even at the cost of taking a financial hit.

The organisation will not compromise if core values are not

upholded. 2) Trust is the key factor in developing a healthy Team.

3) Trust is the foundation of the Team culture.

4) Without trusting relationships within the Teams, it may be

impossible to build a high-performance culture.

Element #2: Strategy

1) Strategy is the blue print that organisation will follow for

successful execution. It defines what products and services the

organisation will sell and or produce, to which demography and what

geographical locations it will serve.

2) Without Strategy organisation will waste its resources.

3) All the projects\programs and portfolios that the organisation

takes up must align to the organisational strategy.

4) To be successful it is essential that the organisation produces

products and services that are highly differentiated in the market to

gain competitive advantage over the competitors or it should aim to

be a cost leader example Reliance Jio in telecom segment.

5) Competitive advantage should be sustainable over a long period.

Element #3: Implementation

1) Best strategy can fail if not executed properly.

2) Communication is key to successful execution. Senior

management needs to spell out what is expected from the team in

unambiguous manner creating excitement in the organisation, the

teams need to understand their roles and responsibilities clearly.

Core values are clearly communicated to the teams.

3) Team and individual accountability

4) Understanding of financial management such as profit and loss,

cashflow, working capital, capital, collection, revenue etc.

5) Stay connected to the realities of the market.

6) Don't look for best run business, look for opportunity where you

can have maximum impact using your knowledge, experience and

skills.

Element #4: Capital

1) Understanding the cost of capital is very important.

2) Never invest your money without ensuring that the assets you

acquire can generate a return (profit) which is at least equal to the

cost of capital (interest and dividend)

3) Invest your money in a way that the assets will generate an inflow

of funds before the liabilities demand an outflow.

4) Understand your working capital cycle

5) Shorten the cash flow cycle time.

The System Of APEX Habits

1)Habits make us or destroy us, so it is essential that we choose our

habits wisely.
2) Understanding your priorities is very important.

3)Knowing your critical nos. such sales revenue and % profitability

to be achieved is very important and need to be reviewed on regular

basis. Asking yourself as to how you are doing w.r.t the goals you

have in front of you.

4) Having daily\weekly\monthly meetings.

5) Goals should be outside the comfort zone.

6) Team should be involved in creating goals so as to obtain buy in.

7) Goals should be SMART I.E. Specific, measurable, attainable,

relevant and time based.

8) Use 6 hat thinking while conducting meeting. discuss the

problems, discuss facts, discuss positives, creative idea, gut feeling.

Introduction To The Target Qualification System

1)S.T.A.R.S model, where S- startup, T-turnaround , A-accelerated

growth, R- realignment, S-sustaining success.

2) Ranking through Stars model: 1st rank Accelrated growth, 2nd

rank Re-alignment companies, 3rd rank startup companies, 4th rank

sustaing success companies 5th rank turn around companies.

3) Maximum impact can be created in turnaround company.

4)Keep STARS model in mind while targeting the companies.

5) Dont look for best run companies, look for companies where you

can create maximum impact

Part 1 - Salary Acceleration Formula

Part 2 - Salary Acceleration Formula

) Companies relate with you for their needs, not your needs.

2) creating a differentiated relationship

3) understand the N.E.E.D.S of the customer\employer. ie. new

emergencies and existing difficulties.

Understanding How Recruiters Work &

Connecting With Them

Introduction To The Insider Hacks Of The APEX

System
1) Without an authentic culture the time of A Players is wasted.
2) It is essential that we know the organisational culture before we join them.
3) Change the changeable
4) Remove yourself from unacceptable
5) Mastering the job search process is not an optional skill, its necessity.
6) Companies relate with you for their NEEDS not for your NEEDS
7) NEEDS -NEW EMERGENCIES AND EXISTING PROBLEMS TO BE SOLVED
8)STEEQ : SKILLS, TALENT, EDUCATION, EXPERIENCE, KNOWLEDGE ,
QUALITIES
9 ) My STEEQ should solve companies NEEDS where i get my WANTS (What
aspects are needed to be successful).

10) Your past salary has no bearing on your future income potential.
11) you should be able to give before you receive.
12) Early success or failure in a transition is the best indicator of your overall
success or failure.
13) At the early stage, relationships are more important than the outcome
14) When you solve your clients problem, you automatically solve your own
problem.

Part 1: Jobs Communication Toolbox

Part 2: Jobs Communication Toolbox

Part 3: Jobs Communication Toolbox

1)First researched person is a key decision maker. it is essential that

a letter is sent prior to calling this person. He should be prepared to

have conversation with you. DON'T SURPRISE THEM.

2) You may have to leave a voice mail or may have to speak to

personal assistance, you may not get a second chance for first

impression.

3) Leave a clear and crisp message on answering machine.

4) while talking to the decision maker always reference the letter

you have sent. No scope of error while communicating with decision

maker.

5) You may have to call 5-6 times, dont lose hope.

6) Create a confident message.

Part 4: Jobs Communication Toolbox

Part 5: Jobs Communication Toolbox

Understanding The Anatomy Of An Interview &

Developing Your Game Plan
1)Preparation for the interview is very important.
2)Most people procrastinate job interview, which means its less competition
for us if we are prepared.
3) There are mainly 6 category of questions
a) Classic , such as "Tell me some thing about yourtself", "what are your
greatest strengths?" etc
b) Career goal : determine fit
c) Character related questions
d) Competency based questions
e) Creativity questions
f) Spin ball questions.

The purpose of financial ratio analysis is to 'unlock' a wide variety of information implicit
in the financial statements in order to meet the information requirements of a diverse
group
of potential users—principally managers and shareholders, but also creditors, investors,
employees, customers and other stakeholders. Financial ratios are data reduction
techniques that express items proportionately to others. As such, financial ratios are
relative and enable comparison of performance and financial position over time and with
other firms operating in the same industry. Credit rating firms rely on these ratios to
determine what rating to give a firm.
The mechanics of calculating financial ratios is only the first step in financial analysis.
The
next and more important step is to interpret the ratios calculated. The ratios may
indicate
the existence of financial problems within a business and can also be used as predictive
tools to provide some insight into the likely future performance and financial position of
an
organisation.
OBJECTIVES
On completion of this topic you should be able to:
􀂃􀀃 explain the key steps for decision making using financial statements analysis
􀂃􀀃 identify the main accounting/financial ratios used in analysing financial statements
􀂃􀀃 demonstrate how such ratios are calculated
􀂃􀀃 explain the value of using financial ratios to help analyse financial statements
􀂃􀀃 demonstrate an understanding of the limitations of ratio analysis.
REQUIRED READING
Peirson and Ramsay, Chapters 21 and 22
Reading 5.1 'Revealing ratios'
Reading 5.2 'Investment gymnastics'
Reading 5.3 'Problems in comparing financial performance across international
boundaries: a case study approach'
Reading 5.4 'Making sense of the finance page'
5.2
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNIT 101 FINANCIAL MANAGEMENT

WHAT ARE FINANCIAL RATIOS? WHY ARE

THEY USED? WHO USES THEM?
In this unit we have looked at the derivation and presentation of accounting information.
Accounting numbers by themselves in aggregate form may not clearly reveal how well a
firm is performing or its ability to continue and prosper. One solution to this is to express
the accounting numbers as ratios and then use them to interpret the information
contained
in financial statements. Numbers by themselves are meaningless, and the use of ratios is
designed to highlight the relationships between the individual items in an organisation's
financial accounts. For instance, if two firms operating an identical business earned the
same profit, this does not mean identical performance. We need to examine the profit
figure as a ratio by relating it to the investment base of each firm. For example, Digital
Ltd
and Cement Ltd are both suppliers of engineering software. Both companies reported a
profit of $2 500 000. Whilst they appear equal in terms of profit, Digital Ltd has $25 000
000 of assets and Cement Ltd has $10 000 000 of assets. If we combine the profit and
assets as a ratio, the return is 10% for Digital Ltd and 25% for Cement Ltd.
On this basis Cement Ltd has outperformed Digital Ltd and a valid comparison can be
made. Ratios therefore facilitate comparison between firms operating in the same
industry
and overcome differences that exist in the size of operations.
Financial ratios are figure relationships. A ratio is established by bringing together in a
logical relationship two figures or groups of figures, and expressing that relationship as a
ratio or percentage, whichever is appropriate. Ratio results may be expressed in different
ways. The most common are:
􀂃􀀃 as a ratio, such as 2:1
􀂃􀀃 as a percentage, such as 10%
􀂃􀀃 as a number, for instance 3 times or 30 days
􀂃􀀃 in a combination, such as 3 times 10%.
Ratios are well-known tools of financial analysis and interpretation, and constitute a
convenient method of relative measurement.
Financial ratios can be used by management and outside parties including shareholders
and
other stakeholders to make decisions in terms of their investment or financial
relationship
with a company or business. Financial analysis and interpretation enables better
decisionmaking
which is based on a number of steps including a definition of the problem,
identification of objectives, identification and analysis of available options and selection
of
the best option. The analysis should assist in:
􀂃􀀃 indicating where performance is deteriorating
􀂃􀀃 comparative analysis, indicating areas of operation where performance is below that
of
companies operating in the same area of business activity
􀂃􀀃 establishing the relationship between change in various areas of operation and
profitability and liquidity.
You should now read Peirson and Ramsay, Sections 21.1 to 21.3, pp. 754–757.
5.3
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNI T 1 0 1 F INANC IAL MANAGEMENT

THE CALCULATION OF FINANCIAL RATIOS

Financial ratios can be used to assess the various components of a business including its
liquidity, profitability, financial structure, management of assets, and attractiveness as
an
investment for shareholders. The formulae used to calculate the ratios to measure each
of
these aspects are contained in Appendix 21.1 on pages 800–801 of Peirson and Ramsay.
You should now read Peirson and Ramsay, Sections 21.5 and 21.6, pp. 761–776, Sections
22.2 to 22.4, pp. 804–817 and Appendix 21.1, pp. 800 – 801.
TRENDS IN FINANCIAL RATIOS
So far you have been shown how to calculate various ratios in isolation. You have also
seen what the results of such ratio calculations mean, that is, what their significance is.
However, ratios are best used when related to similar measurements made at other
times.
This means that we are interested in studying trends in single items or groups of items,
the
purpose being to discern the direction in which an enterprise is going. If an adverse trend
in any ratio is observed, corrective measures may be taken before the problem becomes
chronic and possibly incurable. Such analysis implies relatively frequent measurements,
so
that weaknesses can be detected early in their development and action taken to put
things in
order.
Care must be taken, however, to ensure that the time span of the measurements is
logical.
The same time span may not necessarily be appropriate for different kinds of ratios. In
fact, short-term comparisons of some ratios may be quite misleading because the
particular
message the ratio is expected to convey might not yet have become clear. However,
investment ratios, some long-term liquidity ratios and certain ratios calculated on a sales
or
volume base lend themselves to regular short-term study because of the sensitivity of
these
ratios to short-term changes.
There are some ratios for which the trend is observed over longer time spans; if it is
adverse, the message is dynamic and inescapable. For example, the debt ratio answers
the
vital question, 'Who owns the company?', and indicates if there is a trend towards
external
interests becoming more significant than those of internal owners that cannot long be
ignored without danger.
There are also dangers of misinterpreting favourable trends. Taking the current ratio as
an
example, a favourable upward trend may not necessarily indicate gathering strength.
The
current asset group may be built up with increased stock and increased debtors, both of
which are slowing down cash flows although contributing asset strength. If this asset
growth is financed by shareholders' funds or long-term debt, the current ratio looks
increasingly strong when in fact the firm is becoming over-invested and stagnant.
Liquidity is the keynote in working capital structure, and unless the ratio spells out
'liquidity' it says little that is really significant.
Some writers argue that, because ratios will vary according to a firm's environment, it is
wise to compare a firm to other firms in the same industry. If ratios of a firm are
distinctly
different from the industry norm, this suggests a need for further investigation. There is
considerable merit in this viewpoint. Nevertheless, there are some difficulties as well.
5.4
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNIT 101 FINANCIAL MANAGEMENT
The first problem is identifying what firms should be in an 'industry'. How widely or how
narrowly should a particular industry be defined?
An additional problem lies in diversification across industries. Where a firm carries on
operations in a number of different types of business, how do we determine its main
industry classification? Furthermore, the external analyst, despite the introduction of
AASB 1005: Segment Reporting will still find it difficult gain an informed view of the
different operations of a firm.
You should now read Peirson and Ramsay, Section 21.4, pp. 757–761.
THE PREDICTIVE ABILITY OF FINANCIAL
RATIOS
In the 1960s researchers applying different methodologies used financial ratios to predict
future events. The ability of financial ratios to predict corporate failure is important from
both the private and social points of view, since failure is obviously an indication of
resource misallocation. An early warning signal of probable failure will enable both
management and investors to take preventive measures and thereby improve both
private
and social resource allocation.
Beaver (1966) investigated the ability of financial ratios to predict failure of American
business firms. He examined 30 ratios of a paired sample of 79 failed and non-failed
firms
matched according to industry and asset size. These ratios were calculated over a five-
year
period for each firm. Beaver then compared the mean values of each of the ratios
between
the failed and non-failed firms. His analysis revealed that the failed firms' financial ratios
were not as good as those of the non-failed firms, and deteriorated over time as failure
approached. Further investigation indicated that the best predictor of company failure
was
the cash flow-total debt ratio. This ratio misclassified only 13% of sample firms one year
before bankruptcy and 22% of the sample firms five years before bankruptcy.
Altman (1968) used multiple discriminant analysis to develop a model that could
discriminate between failed and non-failed American firms. His sample comprised 33
companies declared bankrupt over the period 1946–65 paired with a stratified sample of
33
manufacturing firms not declared bankrupt. From a list of 22 ratios Altman selected five
to
be included in the discriminant model. Those chosen were working capital to total assets,
retained earnings to total assets, earnings before interest and taxes to total assets,
market
value equity to book value of total debt, and sales to total assets. Altman tested the
accuracy of his model in predicting bankruptcy of the firms comprising his initial sample
and found that 95% of the sample were correctly classified as failing one year prior to
bankruptcy.
When the model was tested using a new sample of 25 bankrupt firms, Altman found that
the accuracy of the model one year prior to bankruptcy was 96%. He concluded that,
based
on the above results, the bankruptcy prediction model is an accurate forecaster of failure
up
to two years prior to bankruptcy and that the accuracy diminishes substantially as the
lead
time increases.
Since the pioneering studies were conducted, researchers across a number of countries
have
used univariate and multivariate financial ratio models to successfully predict financial
failure (Castagna and Matolcsy 1981; Lincoln 1984, 1996; Constable and Woodliff 1994).
5.5
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNI T 1 0 1 F INANC IAL MANAGEMENT
However, despite the many studies that have been carried out in this area, some
problems
still exist with this research.
1. One limitation of much of the published research is the retrospective or ex post nature
of the analysis. Usually the sample firms have all failed before the research is
performed, and if this research is to assist decision making it would be necessary to
make ex ante (prior) predictions about firms that are currently operating.
2. A major criticism of many studies is the failure to develop any theory of financial
failure that would specify the variables to be included in the discriminant function.
3. The methodologies chosen in some papers have important limitations that should be
considered in interpreting their results. For instance, the requirement that five years'
data be available on a firm omits from any study newly formed businesses where the
incidence of bankruptcy is high. Also, the use of the paired-sample design where
firms are matched on size and industry criteria precludes these variables as indicators
of failure. Yet both factors may have an impact on failure and therefore contain
relevant and important information.
4. Are financial ratios and prediction models sensitive to the use of alternative
accounting
methods? Which financial ratios are useful for bankruptcy prediction and are there
certain ratios that consistently show up in the discriminant studies? The studies
usually identify particularly significant ratios but there is no absolute test for the
importance of variables and the significance of particular variables.
5. A number of difficulties arising from the statistical assumptions made in using
multiple discriminant analysis have also been identified. These include the
assumptions of multivariate normality in the distribution of the sample groups; the
equality of the group dispersion (variance-covariance) matrices, addressing the
importance of the individual variables; reducing the number of variables that do not
significantly contribute to the overall discriminating model; the selection of prior
probabilities and costs of misclassification; and the classification error rates.
Furthermore, a model is only useful for predictive purposes if the underlying
relationships and parameters are stable over time.
You should now read Peirson and Ramsay, Section 21.7, pp. 776–778.
If you are interested in a more comprehensive analysis of financial ratios, refer to the
articles by Barnes (1987), Chen & Shimerda (1981), and Simnett & Trotman (1992) listed
in the 'References and further reading' section at the end of the topic.
LIMITATIONS OF RATIO ANALYSI S
Financial ratio analysis can assist in obtaining important information from financial
statements. We can, however, identify and explain five general limitations of ratio
analysis. They arise from:
􀂃􀀃 the use of conventional accounting information
􀂃􀀃 the variation in the classification of financial information
􀂃􀀃 the lack of specific information
􀂃􀀃 the timing of the information provided
􀂃􀀃 the lack of 'benchmark' ratios for evaluation purposes.
We will now discuss each of these limitations in turn.
5.6
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNIT 101 FINANCIAL MANAGEMENT

USE OF CONVENTIONAL ACCOUNTING INFORMATION

The first limitation of ratio analysis is that it is based upon conventional accounting
information. Under conventional accounting procedures it is possible to produce many
different statements of financial performance (profit and loss statements) and
statements of
financial position (balance sheets) for the same firm. Yet ratio analysis uses figures from
such financial statements to examine a firm's performance over time and to compare the
firm's performance with that of other firms. Thus the value of ratio analysis largely
depends upon whether the firms examined have used the same accounting procedures
over
the relevant period. Although the Australian professional accounting bodies do require
disclosure of accounting policies, both the number of policies disclosed and the detail
given leaves much to be desired.
VARIATION IN CLASSIFICATION OF FINANCIAL INFORMATION
A second limitation concerns the classification of accounting information (into current
assets, non-current assets, current liabilities, and so on). When ratios are calculated for a
firm, it is often necessary to compare one group of expenses, assets or liabilities with
another. Therefore to make valid inter-firm ratio comparisons the system of classification
in the statements of financial position (balance sheets) and statements of financial
performance (profit and loss statements) must be identical. Unfortunately, this does not
occur in practice.
LACK OF SPECIFIC INFORMATION
A third general problem results from a lack of detailed accounting information. For
example, the calculation of the stock turnover of a firm requires knowledge of a firm's
cost
of goods sold and average stock, but it is difficult to obtain the amount for cost of goods
sold from a typical published report. That information is generally not publicly available.
Companies generally supply the minimum information required by the Corporations Law,
though if firms wish to be listed on the stock exchange, any additional information
required
for listing will also be provided. The first item often shown in published statements of
financial performance (profit and loss statements) is operating profit. Companies are
required by the Corporations Law to show some expenses, such as interest and
depreciation, but these are normally shown in the notes to the accounts and not in the
statement of financial performance (profit and loss statement) proper. Consequently, the
silence of financial statements in certain areas undermines the overall value of ratio
analysis.
TIMING OF INFORMATION
A fourth limitation arises from the timing of financial reports. Annual reports of years
ended 30 June are normally published between September and the end of the calendar
year.
Imagine a situation where financial ratio analysis of a firm is required in August. The
information that is used may be up to 14 months old and the financial characteristics of a
firm may have changed markedly during that period. Admittedly, firms that are listed on
the stock exchange are required to publish half-yearly reports. However, a typical
halfyearly
report gives limited information.
5.7
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNI T 1 0 1 F INANC IAL MANAGEMENT
The fact that the financial circumstances of a firm may change quite drastically before
the
production and publication of the financial reports poses two major problems for the
financial analyst.
􀂃􀀃 First, if the financial circumstances change for the worse, any ratio analysis based on
financial reports when produced will fail to take account of the newly emerging
adverse trends.
􀂃􀀃 Second, if the financial circumstances change for the better, any ratio analysis, again
based on the originally produced reports, may detect problems that no longer exist.
That is, any weaknesses exposed may have been solved by the time they become
apparent to the analyst.
LACK OF 'BENCHMARK' RATIOS FOR EVALUATION PURPOSES
A fifth limitation of ratio analysis is that because the trading circumstances of firms differ,
it is not generally possible to provide a benchmark or norm ratio to which the ratio of the
firm being evaluated can be compared. Industry averages are just that, an average of all
firms in the industry, and this average figure may not be an optimal ratio.
FUNDAMENTAL ANALYSIS
Some of the ratios we have discussed are also used to conduct what is known as
fundamental analysis, to value a share and compare this to the market value to
determine
whether the share should be purchased or sold. Proponents of this method believe the
value of a share is derived from the underlying factors such as earnings per share and
other
company attributes, industry and country economic factors as well as international
markets.
Those who use fundamental analysis believe they can identify companies which are
under
or over valued in the share market and that their strategy will enable them to earn a
better
return than the market. However, those who believe the share market is efficient would
reject this view.
You should now read Peirson and Ramsay, Sections 22.5 and 22.6, pp. 818–828.
LIMITATIONS OF SPECIFIC RATIOS
We will now discuss some limitations applying to some of the ratios discussed earlier.
CURRENT RATIO
The current ratio compares a firm's stock of current assets to its stock of current
liabilities
and has traditionally been one of the principal ratios used in analysing the liquidity of a
firm. The higher the amount of current assets in relation to current liabilities, the greater
the assurance that the firm will be able to meet its current liabilities. The higher the
current
ratio, the better the liquidity of the particular firm. In other words, the current ratio is
supposed to give an indication of the firm's margin of safety. If problems such as strikes
or
power failures interfere with the firm's cash flow, the margin of safety will, it is hoped,
act
as a buffer until the problems are overcome.
5.8
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNIT 101 FINANCIAL MANAGEMENT
The major deficiency of the current ratio is that it is based upon a liquidation concept. It
assumes basically that if the firm is liquidated, the current assets can be sold and the
proceeds used to pay the current liabilities. This is a heroic assumption for a number of
reasons. On liquidation, current assets are not sold off to pay for current liabilities;
rather,
the proceeds of all assets, both current and fixed, are used to pay off creditors in the
order
specified by law. The funds gained by the sale of current assets are not earmarked
especially to pay current liabilities.
Further, the financial statements have been prepared on the assumption that the firm is
capable of operating into the foreseeable future. Assets have been valued on an ongoing
concern basis, not on liquidation values. Inventory, for example, should be valued at the
lower of cost or market value. In a liquidation however, inventory may not realise either
cost or normal market value. The current ratio is based on the assumption of a static
situation. The concern should be with the firm's dynamic environment. It is preferable to
analyse a firm's ability to generate funds in the future out of existing current assets to
pay
current liabilities.
Window dressing the current ratio
A firm might wish to manipulate its current ratio because a poor current ratio could affect
its ability to raise additional loan funds from other financial institutions. A firm can do this
in a number of ways. It can adjust its current asset and current liability classifications. For
example, a property developer might regard an office block as a current asset. The
inclusion of an office block within current assets would naturally have a marked effect on
a
current ratio.
A current ratio may also be 'improved' by reducing current assets and current liabilities
by
the same dollar amount. Imagine a firm has current assets of $400 000 and current
liabilities of $200 000. The current ratio is therefore 2:1. Suppose $100 000 of cash is
used to pay off liabilities. Current assets will now be $300 000 and current liabilities
$100 000; the current ratio will be improved from 2:1 to 3:1.
A current ratio can also be improved at balance date by judicious timing in borrowing
funds. Imagine a firm with current assets of $200 000 and current liabilities of $100 000.
If that firm negotiated a long-term loan for capital investment of $100 000 towards the
end
of the financial year but retained the loan as cash at balance date, its current ratio would
improve from 2:1 to 3:1. Current liabilities would not alter as the loan would be regarded
as long term.
Current ratio norm
What should a firm's current ratio be? A number of texts suggest that the current ratio
should be a particular value; but it is foolhardy to advocate that the current ratio should
be
a given value for all firms, regardless of business circumstances. Take a supermarket as
an
illustration. It orders goods; the goods are received; the goods are sold and turned into
cash; payment is made to the supplier. Think of this in terms of days. Assume a
supermarket is able to convert its stock, on average, into cash in 14 days. Payment to
suppliers may not have to be made for 30 days. Suppliers normally finance a
supermarket
through trade credit. It would thus be expected that a supermarket would have a
relatively
high level of current liabilities and hence a typical supermarket's current ratio would be
lower than that of most other firms.
5.9
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNI T 1 0 1 F INANC IAL MANAGEMENT
On the other hand, the current ratio of a major manufacturer such as Pacific Dunlop
would
be different. It must purchase raw materials, convert the materials into product, hold the
product as inventory, and finally receive cash for the product's sale. Pacific Dunlop's
operating cycle is therefore much longer than that of many firms. (The operating cycle is
the time that elapses between the first outlays on manufacturing inputs and the receipt
of
cash from the sale of finished products.) Such firms at any time must hold a large stock
of
raw materials, semi-finished goods and finished goods. Wages paid to employees in the
processing of materials will be capitalised and included in the valuation of inventory.
Similar comments apply also to the quick asset ratio.
INVENTORY (STOCK) TURNOVER
The calculation of the inventory or stock turnover ratio requires the use of cost of goods
sold as the numerator. As mentioned earlier, cost of goods sold is not commonly
available
from published reports. Therefore the external analyst is often forced to use sales
instead
of cost of goods sold. This is unfortunate, because sales is always greater than cost of
goods sold by the amount of gross profit. Therefore a firm's stock turnover will obviously
be higher if sales, rather than cost of goods sold, is used in its calculation. This may not
be
a problem if the firm's average gross margin is constant over time, but should the gross
margin alter, an obvious bias is introduced.
In a sense, gross profit margin and the stock turnover ratio logically interrelate with one
another. Once the gross profit margin has been correctly set by a firm, the next step is to
ensure that stock is turned over as rapidly as possible. So, as well as the gross profit
margin, it is necessary to know the stock turnover for each sales line. The average stock
turnover of the firm as a whole is important, but it depends upon turnover of individual
lines. An adequate stock turnover on one line will affect the stock turnover as a whole. An
external analyst cannot monitor the turnover of each single line. An internal analyst,
however, can.
The important point is that the level of stock held should be adequate to meet
requirements
of the sales and production departments. At the same time excessive levels of stock
should
not be held as the money invested in this way is not earning any return.
ACCOUNTS RECEIVABLE (DEBTORS) TURNOVER
The accounts receivable or debtors turnover ratio is calculated by dividing average
debtors
by the net credit sales x 365 days. The purpose of the ratio is to give an appreciation of
how quickly receivables have been collected during the period. The external analyst
cannot find separate information on annual credit sales in published reports, but is forced
to
use total sales instead of credit sales. In this case, it is hoped that the ratio between cash
and credit sales will be exactly the same in each year. This may not be the case.
Once the debtors turnover ratio is calculated it should be compared to a firm's
established
terms of credit. In other words, if a firm has a policy that receivables should be paid in
30 days, the debtors turnover ratio should be 12. If the debtors turnover ratio is higher
than
the terms of credit, it will bear investigation. Where a firm has distinctly different types of
credit sales, such as 7-day and 90-day accounts, it is advisable for the internal analyst to
calculate separate debtors turnover ratios for each type of credit sale.
5.10
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNIT 101 FINANCIAL MANAGEMENT

DEBT
The debt ratio measures the use made of interest bearing outside sources of finance and
is
used to gauge the financial risk of the firm.
Financial leverage or gearing refers to the degree to which a firm has depended on debt
to
finance its assets. The higher the proportion financed out of debt, the higher the financial
risk of the organisation is supposed to be. A number of ratios can be used to gauge the
degree of a firm's financial leverage or gearing but the main ratio used is either the debt
to
assets ratio or the debt–ratio.
The ideal size of a firm's leverage ratios depends upon the type of industry and the
extent
of the firm's profit fluctuations. Some firms such as finance companies must, because of
the nature of their business, have high leverage ratios. Those of others such as heavy
manufacturers would be more moderate. A firm's profit fluctuation is also a factor in
determining the optimum leverage ratios. A firm with a highly fluctuating profit pattern
may find these fluctuations are becoming more marked because of high leverage. If a
firm
can earn more from borrowed funds than the after-tax cost of debt, profit will be
increased
through using debt finance. Alternatively, if a firm earns less on borrowed funds than the
after-tax cost of debt, profit will be lower than it would otherwise have been.
TIMES INTEREST EARNED (INTEREST COVER)
Interest cover is calculated by dividing earnings before interest and taxes by interest.
The
idea behind the ratio is that it will calculate the number of times interest is covered by
the
earnings. In other words, if the ratio is 5:1, it means that the earnings can cover the
interest
paid five times. If the ratio is only 1:1, all the earnings before interest and taxes are
absorbed by payment of interest. In theory, the higher the times interest cover, the less
the
financial risk of the company.
Again, there are difficulties with the use of this ratio. If a firm is paying interest, it must
pay it in cash. Earnings before interest and taxes are not calculated on a cash basis but
on
an accrual basis. This ratio is therefore comparing an item based on a cash concept to an
item based on an accrual concept.
EARNINGS PER SHARE
Earnings per share is calculated by dividing earnings, after tax and the payment of
preference dividends, by the number of ordinary shares on issue. This ratio is widely
used
as a measure of a firm's operating performance. As such it has a number of limitations.
First, the ratio depends again on the definition of reported earnings. Judgment needs to
be
exercised in the inclusion or exclusion of extraordinary items. The value derived also
depends upon the number of shares issued and can be subject to fluctuations because of
new shares, bonus issues and other share capital charges.
Some of the ratios we have examined are of considerable value to investors. Reading 5.1
'Revealing ratios' and Reading 5.2 'Investment gymnastics' provide a review of some of
these ratios from an investment perspective.
5.11
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNI T 1 0 1 F INANC IAL MANAGEMENT

ASSESSMENT OF RATIO ANALYSIS

We can conclude that in any ratio analysis it is wise not to rely upon one or two ratios. It
is
not possible, for instance, to conclude that because the current ratio is 3:1, there are no
liquidity problems. It would, for example, be necessary to consider the stock turnover
ratio, debtors turnover, and quick asset ratio. Therefore it is advisable to interrelate
ratios
to obtain a clearer picture. If there is a substantial discrepancy between the quick ratio
and
the current ratio, this is probably because of inventory. To check on this it is necessary to
examine the stock turnover ratio.
It is also necessary to understand the implications of the different ratios and how they
relate
to one another. If a firm has a healthy gross profit margin but low overall profitability,
this
should be investigated. Is the gross profit margin so high that the firm is pricing itself out
of the market? If that is not the case, the expenses of the firm should be examined. Is
advertising too high? Or is it so low that sales are not being achieved? What about wages
and salaries?
That is not to say that it is necessary to calculate as many ratios as possible. It is easy to
confuse effort with intelligent analysis. The point is to understand the ratios and to know
how to manipulate them to obtain valid information.
Care must be taken in doing ratio analysis of companies domiciled in other countries as
their cultural and national attributes may mean different accounting practices. This
aspect
is considered in Reading 5.3 'Problems in comparing financial performance across
international boundaries: a case study approach'. However, the move toward adoption of
international accounting standards may mean this is less of an issue in the future.
􀂃 􀀃A C T I V I T Y 5 . 1
Read Reading 5.4 'Making sense of the finance page'.
Which financial ratios does your organisation employ? Compare these with the
ratios used by others in your study group.
5.12
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNIT 101 FINANCIAL MANAGEMENT

REVIEW QUESTIONS
These review questions have been selected from the questions and problems at the end
of
the appropriate chapters of the prescribed textbook
Peirson and Ramsay, Chapter 21.
5.1 Question 1 (p. 781)
According to the conceptual framework for general purpose financial
reporting, who are the primary users of financial statement information and
what are their information needs?
5.2 Question 9 (p. 781)
Interpretation is arguably the most difficult phase of financial statement
analysis. Explain how the shortcomings of historical cost accounting data
accentuate the problems of interpreting financial statement data.
5.3 Question 16 (p. 781)
'Statements of financial position ratios such as current and quick asset ratios
are unsatisfactory for evaluating solvency.' Do you agree? Give reasons.
5.4 Question 22 (p. 781)
The lack of timeliness of published accounting data is a major weakness of
financial statement analysis. Discuss this issue with reference to the
evaluation of solvency.
5.5 Problem 1 (p. 783)
Interpreting statement of financial position ratios.
(See Peirson and Ramsay, p. 783 for details)
5.6 Problem 2 (p. 784)
Interpreting statement of financial position and cash cycle ratios.
(See Peirson and Ramsay, p. 784 for details)
5.7 Problem 3 (p. 784)
Calculation and interpretation of ratios of short-term financial position.
(See Peirson and Ramsay, p. 784 for details)
Peirson and Ramsay, Chapter 22.
5.8 Problem 1 (p. 832)
Cross-sectional analysis of management's operating performance.
(See Peirson and Ramsay, p. 832 for details)
5.9 Problem 7 (p. 835)
Time-series analysis of profitability.
(See Peirson and Ramsay, p. 835 for details)
5.10 Problem 11 (p. 836)
Cross-sectional application of fundamental analysis.
(See Peirson and Ramsay, p. 836 for details)
5.13
TOPIC 5
THE
INTERPRETATION
OF FINANCIAL
STATEMENTS
UNI T 1 0 1 F INANC IAL MANAGEMENT

SUMMARY
This topic concludes our consideration of financial accounting. We have now completed
the financial accounting cycle. In Topic 2 we introduced the accounting concepts that
help
us determine which data we need to capture. This data is then fed into an accounting
system or process that summarises the data. Topic 3 outlined how this data is reported
in
financial statements, and Topic 4 provided a particular emphasis on the financial
reporting
of companies. In Topic 5 the cycle is now complete as we attempt to use the information
provided in financial reports to analyse the performance of the firm. Nonetheless, it is
important to remain mindful of the concepts, processes and reporting procedures that
give
rise to the information upon which our