The Reporting Environment

1
The Reporting Environment Accounts Analysis 1

• Week 4

2
Standard setting in UK
3
The Financial Reporting Council (FRC)

• The FRC is a unified, independent regulator with
  three key roles-
• Setting accounting and auditing standards
• Pro-actively enforcing and monitoring them
• Overseeing the self-regulatory professional
  bodies
• Established in 1990 to promote good financial
  reporting through its two subsidiaries
• Accounting Standards Board (ASB)
• Financial Reporting Review Panel (FRRP)
• The Council draws its members from across the
  financial, business and professional communities

4
Accounting Standards Board (ASB)

• The ASBs role is to issue Accounting Standards.
• It took over the task of setting accounting
  standards from the Accounting Standards Committee
  (ASC) in 1990.
• The ASB also collaborates with
• Accounting standard-setters from other countries
• International Accounting Standards Board (IASB)
• To influence the development of international
  standards
• To ensure that its standards are developed with
  due regard to international developments.
• The ASB has up to ten Board members, of whom two
  (the Chairman and the Technical Director) are
  full-time, and the remainder (accountants,
  industrialists and academics) are part-time

5
ASBs technical activities

• Development and review of accounting standards
• Issue of UITF Abstracts
• These are developed having regard to the ASB's
  Statement of Principles.
• Consultation process for developing new standard
• At least two formal consultation documents are
  published
• Discussion Paper, which sets out the issues and,
  if appropriate, proposed solutions.
• Followed by an exposure draft, designated a
  'Financial Reporting Exposure Draft' (FRED),
  which sets out the text of the proposed standard.

6
Statement of Principles

• An accounting standard-setter's conceptual
  framework or statement of principles describes
  the accounting model that it uses as the
  conceptual underpinning for its work.
• Such statements therefore typically describe the
  standard-setter's views on
• The activities that should be reported on in
  financial statements
• The aspects of those activities that should be
  highlighted
• The attributes that information needs to have if
  it is to be included in the financial statements
• How information should be presented in those
  financial statements
• The purpose of the Statement of Principles
• To provide conceptual input into the ASB's work
  on the development and review of accounting
  standards.
• The Statement is not, therefore, an accounting
  standard nor does it contain any requirements on
  how financial statements are to be prepared

7
Financial Reporting Review Panel (FRRP)

• The FRRP considers whether the annual accounts of
  public companies and large private companies
  comply with the requirements of the Companies Act
  1985 including applicable accounting standards.
• The Panel can ask directors to explain apparent
  departures from the accounting requirements
• If the Panel is not satisfied by the directors'
  explanations it aims to persuade them to adopt a
  more appropriate accounting treatment
• The directors may then voluntarily withdraw their
  accounts and replace them with revised accounts
  that correct the matters in error
• Depending on the circumstances, the Panel may
  accept another form of remedial action (eg.
  correction of the comparative figures in the next
  set of annual financial statements)
• Failing voluntary correction, the Panel can
  exercise its powers to secure the necessary
  revision of the original accounts through a court
  order
• The Panel maintains a legal costs fund of
  2million for this purpose

8
Urgent Issues Task Force (UITF)

• The main role of the UITF is to assist the ASB
  where unsatisfactory or conflicting
  interpretations have developed about a
  requirement of an accounting standard or the
  Companies Act
• The UITF seeks to arrive at a consensus on the
  accounting treatment that should be adopted in
  the context of the ASB's declared aim of relying
  on principles rather than detailed prescription
• UITF consensuses are published in the form of
  UITF Abstracts. Compliance with UITF Abstracts is
  necessary (other than in exceptional
  circumstances) in accounts that claim to give a
  true and fair view

9
UITF

• Commenced in 1991
• Many Abstracts have subsequently been
  incorporated into Financial Reporting Standards
• Latest Abstract was 15 December 2003
• Deal with particular areas which become relevant
  such as
• Accounting for operations in hyper-inflationary
  economies (issued in 1993 in response to trade
  with emerging economies of Eastern Europe)
• Recently
• Website development costs
• Barter transactions for advertising

10
Ratio Analysis

• Ratios are
• Mathematical formulae that simplify financial
  information for the non-financial specialist
  whose responsibility is to understand, analyse,
  and act upon reported financial information
• Advantages of ratios
• Trends
• Comparison
• Extrapolation

11
Groups of Ratios

• Different Classes of ratios are available for
  different classes of user
• Profitability
• Efficiency
• Liquidity
• Gearing
• Investor ratios

12
Liquidity Ratios

• Current ratio
• Current assets
• Current liabilities
• Means There are sufficient current assets to
  cover current Liabilities as they fall due
• Acid test ratio
• Current assets (less stock)
• Current liabilities
• Means Coverage of current liabilities by
  liquid
• assets
• Ratios are often expressed as percentages
• Liquidity ratios usually are not

13
2001 liquidity ratios for Somerfield

• Current ratio
• 576.4 1 0.88
• 651.6
• Quick (acid test) ratio
• 576.4 329.9 1 0.38
• 651.6
• In short for every 1 of current liabilities
  (bills to be paid) Somerfield has 88p of assets
  to pay them with!
• As stock takes a while to convert to cash
• If we ignore that then Somerfield has only 38p of
  liquid assets to pay every 1 of short term
  liabilities.
• Is this desperate?

14
Tesco 2003
15
Tesco 2003 liquidity ratios

• Current ratio
• 2440 1 0.45
• 5372
• Quick (acid test) ratio
• 2440 1140 1 0.24
• 5372

16
Avon Rubber plc 2003
17
Avon Rubber liquidity ratios 2003

• Current ratio
• 84578 1 1.05
• 80292
• Quick (acid test) ratio
• 84578 20611 1 0.80
• 80292

18
Conclusions

• Somerfield not that bad
• Industry type is important average ratios
  will vary depending on the type of business
• The size of a business is made irrelevant as we
  are not interested in total figures in the
  accounts but the relationship between one part of
  the accounts and another
• The numbers on the face of the accounts can tell
  us some things but
• We need techniques to supplement this information
• Think who are these accounts aimed at?

19
Conclusions

• These ratios would be important to
• Suppliers can they pay me?
• Lenders can they pay interest? Why do they
  want a loan?
• Employees is my job safe?
• Competitors benchmarks and comparisons

20
Do ratios give you the full story?

• Well, no but they provide another dimension.
• Also its how you INTERPRET them.
• Levels of interpretation (from essay experience)
• (1) Calculated ratios
• (2) 1 and said this is good/bad
• (3) 1 2 and compared over time or to
  competitor/industry average
• (4) All the above and provided explanation of
  WHY changes have occurred

21
Level 4 example general

• Gross Profit Margin
• Gross profit X 100
• Sales
• Means Difference between sales and cost of
  sales and therefore profitability in buying or
  producing and selling goods.
• There are a range of potential reasons why the
  gross profit margin might change.

22
Level 4 example specific

• Changes in ratios could point to all sorts of
  things going on under the surface
• Chaimans statement
• Executives reviews
• Notes to the accounts
• Can all provide a source of information to help
  interpret the results of ratios
• Hence ratio analysis
• Financial press and the internet can also provide
  up to date information to support analysis

23
Stock turnover period

• Cost of sales n times per year
• Average stock held (or closing stock)
• Means Number of times stock is turned over
  each year
• Whats Hot The shorter time, the better.
• Means less funds being tied up in stock.
• Note often the average stock is not used but
  simply the stock figure in the balance sheet

24
Somerfield Stock Cost of Sales

• Stock in Balance Sheet
• 2000 372.6
• 2001 329.9
• Cost of Sales from PL
• 2000 5415.5
• 2001 4523.5

25
Applying the ratios

• 2001
• 4523.5 13.7 times in the year
• 329.9
• 2000
• 5415.5 14.5 times in the year
• 372.6

26
Diagnosis

• Clearly deteriorating
• Why?
• Is management aware?
• Are they doing anything about it?

27
Prognosis

• Stock availability
• When basic items are not available on the
  shelves, it is frustrating for any shopper. For
  Kwik Saves target market, who keep relatively
  small stocks at home, it is particularly
  frustrating and encourages them to shop
  elsewhere. We have sharply increased the
  availability of everyday and promotional items
  through improvements in distribution and stores
  internal replenishment procedures.
• During October, we reappraised the frozen food
  lines that we stock, simplifying the offer to
  ensure high availability and good presentation
  for the most popular products. This worked well,
  and we are now applying the same principles
  elsewhere in the store making ranges simpler
  and more disciplined while still providing the
  choice that todays consumers require.
• We are also increasing the focus on brands,
  taking Kwik Save back to its roots by offering
  the biggest brands at lowest prices.
• To give customers a lower-cost choice we have
  been offering Somerfield own-label products, but
  this has confused many customers. We are phasing
  this policy out, replacing all Somerfield lines
  with value alternatives by this Autumn.

28
Prognosis

• Investing behind the scenes
• We are investing in our IT and distribution
  systems to achieve higher availability and
  service to stores at lower cost.
• Our IT strategy is to simplify and clarify our
  systems focusing investment initially on
  updating our distribution and Kwik Save store
  systems. By June this year, all Kwik Save units
  were linked into our store IT system.
• During the year we opened a completely rebuilt
  and enlarged distribution depot near York. The
  depot is over 500,000 sq ft in size and handles
  ambient, chilled and frozen products. It is
  operated by an outsourced logistics specialist.
  The new year will see the increasing use of
  multi-temperature vehicles, significantly
  increasing both depot and store productivity. In
  the South West we outsourced some of our
  logistics operations, ensuring that staff
  transferred to the outsourcing organisations on
  equivalent terms.

29
Did it work?

• Calculating ratios for the next 2 years
• 2002 report 13.9 times per year
• 2003 report 15.6 times per year

30
None the wiser, but better informed

• Well thats great Im glad I came along.
• Most text books give you formulae for ratios,
  right?
• So all I need is a list of formulae (like the one
  helpfully attached to the handout), a balance
  sheet and a PL account and away I go?
• Not quite

31
Some terms in the text books arent found in
published accounts

• Book - Sales
• Accounts - Turnover or sometimes retailers use
  sales to mean turnover including VAT, then show
  turnover. You want turnover.
• Book - Credit sales/credit purchases
• Accounts - Not reported use turnover or
  purchases
• Hang about, I cant find purchases
• True, it might not be there, use cost of
  sales??!!
• Hang about, I cant find cost of sales either
• Look in the notes.
• Against almost every line in BS and PL there is
  a note number.
• Always look to the notes for more explanation
• Eg
• In BS creditors you will need trade creditors
  which is just one class of creditors
• The detail will be in the notes

32
Profitability Ratios

• Return on Capital Employed (ROCE)
• Net profit before interest and tax X 100
• Share capital reserves long term loans
• A ratio that indicates the efficiency and
  profitability of a company's capital
  investments.
• ROCE should always be higher than the rate that
  the company borrows at, otherwise any increase in
  borrowings will reduce shareholders' earnings

33
Net Profit Margin

• Net profit before interest and tax X 100
• Sales
• Relationship between turnover and controllable
  profit. How are management controlling business
  expenses?

34
Efficiency Ratios

• Average settlement period for debtors
• Trade debtors X 365
• Credit sales
• Means How quickly an average debtor takes to
  pay. Shown in days.
• The quicker debtors pay up the better.
• Normal terms .v. actuality

35
Efficiency Ratios

• Average settlement period for creditors
• Trade creditors X 365
• Credit purchases
• Means How long, on average, it takes a business
  to pay its trade creditors in days
• Deferring paying creditors is free credit

36
Gearing (leverage) Ratios

• Gearing ratio
• Long term liabilities X 100
• Share capital reserves long term liabilities
• Means contribution of long-term lenders to the
  long-term capital structure

37
A risky business

• Borrowing is a risk because
• interest has to be paid whether the investment is
  a success or not.
• Even if a company is making a loss it still has
  to pay interest
• Borrowing is thus a risk
• The more of their capital that is borrowed
• The bigger the risk.
• The higher the gearing ratio, the bigger the
  proportion of the companies money that is
  borrowed and therefore the bigger the risk.
• A company with a high gearing ratio is in a very
  dangerous situation if interest rates are going
  up.
• Their interest payable bill will be rising fast,
  with no corresponding increase in sales revenue.
• The first thing to suffer is therefore profit

38
Gearing Ratios

• Interest Cover
• Profit before interest and tax
• Interest payable
• Means Amount of profit available to cover
  interest payments
• Whats Hot the higher, the more funds
  available to meet interest payments.
• So long term lenders more secure

39
Investor Ratios

• Dividends per share
• Dividends announced during period
• Number of shares in issue
• Means cash return an investor can expect
  from shares held in a company
• Tip Frequently shown in notes to accounts

40
Investor Ratios

• Dividend payout ratio
• Dividends announced for the year X 100
• Earnings for the year available for dividends
• Means Proportion of earnings paid out to
  shareholders as dividends

41
Investor Ratios

• Earnings per Share (EPS)
• Earnings available to ordinary shareholders
• Number of ordinary shares in issue
• The earnings of a company is its profit, and so
  if we change the wording of earnings per share to
  profit per share the meaning should become a lot
  clearer.
• It is literally the amount of profit that has on
  average been earned by each share.

42
FRS 14

• FRS 14 requires that EPS is shown as a footnote
  to the profit and loss account of a quoted
  company.
• FRS 14 defines EPS as Basic earnings per share
  should be calculated by dividing the net profit
  or loss for the period attributable to ordinary
  shareholders by the weighted average number of
  shares outstanding during the period.
• The trend of EPS is a better indicator of
  progress than the trend in profit. In order to
  maintain EPS at the same level after a share
  issue a company must deploy the proceeds of the
  issue at least as profitably as the original
  capital

43
Investor Ratios

• Price/Earnings ratio (P/E ratio)
• Market value of shares
• EPS
• Means compares market value of the share with
  its earnings.
• Whats Hot A high figure shows the
  markets confidence in the future
  earnings potential of the company.
• The higher the confidence, the more investors
  will be prepared to pay for shares in relation to
  the current earnings level.

44
Can we predict potential bankruptcy?

• Edward Altman (1968 1981)
• Calculation of Z-Score
• Historic Basis
• Key ratios weightings Z-Score
• Note use as part of an evaluation

45
Altmans Z-Score
46
The Interpretation of Z Score

• Z-SCORE ABOVE 3.0
• The company is safe based on these financial
  figures only.
• Z-SCORE BETWEEN 2.7 and 2.99
• Grey area/ Zone of ignorance.
• This zone is an area where one should exercise
  caution.
• Z-SCORE BETWEEN 1.8 and 2.7
• Grey area/ Zone of ignorance.
• Good chances of the company going bankrupt within
  2 years of operations from the date of financial
  figures given.
• Z-SCORE BELOW 1.80
• Probability of financial embarrassment is very
  high.

47
Worked Example Somerfield 2001

• Return on Assets
• 11.6/1509.3 0.0077X3.3 0.0254
• Sales to Total Assets
• 4612.5/1509.3 3.0561X0.999 3.0530
• Equity to Debt
• 1509.3/800 1.8866 X 0.6 1.1317
• Working Capital to Total Assets
• (75.2)/1509.3 (0.0498) X 1.2
  (0.0598)
• Retained Earning to Total Assets
• 548.9/1509.3 0.3637 X 1.4 0.5092
• Total of Weighted Scores 4.6595