«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»
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
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.
For these ratios we need some additional information:
Number of shares issued 100,000 Market value of shares £2.50 Dividend per share
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.
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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 increasing rates of proﬁt on shareholders’ funds, capital employed and sales;
ž 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;
ž a level of debt commensurate with the business risk taken;
ž high efﬁciency as a result of maximizing sales from the business’s investments; and ž 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 89Liquidity 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.
ACCOUNTING FOR MANAGERSCase 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.
Ratios for gearing are shown in Table 7.6. These ratios reﬂect the reduction in long-term debt and the increase in shareholders’ funds. Although there has been an increase in interest expense, the increase in operating proﬁt has doubled the interest cover. Borrowings are one-third of capital employed, which is fairly conservative, while the interest cover provides good security for lenders.
The ratio for activity/efﬁciency is shown in Table 7.7. Despite a higher asset base, the 18.3% sales increase resulted in an improved efﬁciency ratio. As reﬂected in the acid test ratio (Table 7.5), working capital is affected signiﬁcantly by the low stock turn (3.6 means that on average books are held for 101 days before they are sold). It is also reﬂected in the average time it takes to pay creditors (over
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14,379 13,729 =22.0% =19.0% two months). However, the ratios show a slight improvement between 2000 and 2001 as current assets increased more than current liabilities, stock turn is higher and creditor payments quicker. Note that there are virtually no trade debtors as the bookshops are a retail business, consequently the debtor days measure is somewhat meaningless.
The shareholder return ratios are shown in Table 7.8. The increase in proﬁts between 2000 and 2001 resulted in increased earnings per share and a higher dividend payout in cash terms, although the percentage of proﬁts paid out in dividends reduced.
As was indicated earlier in this chapter, two years is too short a period to draw any meaningful conclusions and we would need to look at the ratios over ﬁve years
INTERPRETING FINANCIAL STATEMENTS 93
to identify any trends properly. Table 7.9 shows some of the information from the ﬁve-year summary of performance in Ottakar’s annual report. These ﬁgures show the sales growth over the ﬁve years much more clearly than do the two-year ratios, although the increase in proﬁts has been much lower. It also shows that the
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2000 year experienced a fall in proﬁts that was outside the trend. By calculating the ratios in Table 7.10 we can see this more clearly.
Although sales continue to increase, the rate of sales growth is slowing. The rate of gross proﬁt to sales is very steady (an indication of the margin allowed by book publishers), while operating proﬁts ﬂuctuated (probably a reﬂection of costs incurred in opening new bookshops, since location, in common with most retail businesses, is a key aspect of success). Ottakar’s annual report explains that the book market should experience an annual growth of 4–5%, but that the larger chains should gain market share at the expense of their weaker competitors.
It is important to remember that ratio analysis can be undertaken not only in relation to the manager’s own organization, but also in relation to the ﬁnancial statements of competitors, customers and suppliers. This is an aspect of strategic management accounting that was discussed in Chapter 4.
Alternative theoretical perspectives on ﬁnancial statements
Chapter 6 described the traditional theoretical perspective that has informed ﬁnancial statements, that is agency theory. We now consider some alternative perspectives: social and environmental reporting, intellectual capital and institutional theory. We also introduce creative accounting and ethics.
Social and environmental reporting
The concern with stakeholders rather than shareholders (introduced in Chapter 2) began in the 1970s and is generally associated with the publication in 1975 of The Corporate Report, a publication by the Accounting Standards Steering Committee.
Accounting academics began to question proﬁt as the sole measure of business
INTERPRETING FINANCIAL STATEMENTS 95performance and suggested a wider social responsibility for business and social accounting. Concepts of corporate social accounting and socially responsible accounting – most recently corporate social and environmental reporting (CSR) – attempt to highlight the impact of organizations on society.
Jones (1995) suggested three reasons for this:
1 A moral imperative that business organizations were insufﬁciently aware of the social consequences of their activities.
2 External pressure from government and pressure groups and the demand by some institutional investors for ethical investments. This was linked to the role of accounting in demonstrating how well organizations were fulﬁlling their social contract, the implied contract between an organization and society.
3 Internal change taking place within organizations as a result of education etc.
However, there has been little support for broader social accounting because accountants and managers have generally seen themselves as the agents of owners.
Social reporting could be seen as undermining the power of shareholders and the foundation of the capitalist economic system. There are also technical difﬁculties associated with social reporting, and a dominant belief among business leaders that government and not business had the responsibility to determine what was reported.