UNIT 13 FINANCIAL REPORTING UNIT CODE K5080526 CREDIT

UNIT 13: FINANCIAL REPORTING UNIT CODE: K/508/0526 CREDIT VALUE: 15

UNIT 13: FINANCIAL REPORTING § Learning Outcome 2: Interpret Financial Statements

THE BASIC SYLLABUS § 1. Analyse the context and purpose of financial reporting. § 2. Interpret Financial statements § 3. Evaluate financial reporting standards and theoretical models and concepts § 4. Evaluate international differences in financial reporting

LEARNING OUTCOMES §LO 2: Interpret Financial Statements § P 4: Calculate and present financial ratios for organisational performance and investment

OVERVIEW Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios.

LIQUIDITY RATIOS § Short-term Solvency Ratios attempt to measure the ability of a firm to meet its short-term financial obligations. In other words, these ratios seek to determine the ability of a firm to avoid financial distress in the short-run. The two most important Short-term Solvency Ratios are the Current Ratio and the Quick Ratio. (Note: the Quick Ratio is also known as the Acid. Test Ratio. )

LIQUIDITY RATIOS § Current Ratio § The Current Ratio is calculated by: Current Assets § Current Liabilities. § The current ratio compares liabilities that fall due within the year with cash balances, and assets that should turn into cash within the year. It assesses the company’s ability to meet its short-term liabilities.

LIQUIDITY RATIOS §Traditionally textbooks tell us that this ratio should exceed 2. 0: 1 for a company to be able to safely meet its liabilities. However, acceptable current ratios vary between industrial sectors, and many companies operate safely at below the 2: 1 level.

LIQUIDITY RATIOS § A very high current ratio is not necessarily good. It could indicate that a company is too liquid. Cash is often described as an ’idle asset‘ because it earns no return, and carrying too much cash is considered wasteful. A high ratio could also indicate that the company is not making sufficient use of cheap short-term finance.

LIQUIDITY RATIOS § Acid test § The acid test (or quick ratio) recognises that inventory often takes a long time to convert into cash. It therefore excludes inventory values from liquid assets. Traditionally textbooks tell us that this ratio should exceed 1: 1 but once again many successful companies operate below this level.

LIQUIDITY RATIOS §In practice a company’s current ratio and acid test should be considered alongside the company’s operating cashflow. A healthy cashflow will often compensate for weak liquidity ratios.

LIQUIDITY RATIOS § The acid test ratio formula: § Acid test (current assets – inventory) § Current liabilities

RETURN ON INVESTMENTS § Return on investment is a useful and simple measure of how effective a company generates profits from an investment. Many firms use ROI as a convenient tool to compare the benefit of an investment with the cost of the investment. If a company effectively utilizes an investment and produces gains, ROI will both be high. If a company ineffectively utilizes an investment and produces losses, ROI will be low.

RETURN ON INVESTMENTS § For investors, choosing a company with a good return on investment is important because a high ROI means that the firm is successful at using the investment to generate high returns. Investors will typically avoid an investment with a negative ROI, or if there are other investment opportunities with a positive ROI. Return on investment models are used often because the ROI ratio and inputs can be modified to fit different companies and financial situations.

RETURN ON INVESTMENTS § The return on investment ratio calculates the percentage return (profitability) on an investment. § Following is the ROI formula: § (Earnings from Investment – Cost of Investment) § Cost of Investment

RETURN ON INVESTMENTS § It should be noted that the definition and formula of return on investment can be modified to suit the circumstances -it all depends on what is included as returns and costs. For example to measure the profitability of a company the following formula can be used to calculate return on investment. § Net profit after interest and tax § Total Assets

RETURN ON INVESTMENTS § Return on capital employed (sometimes known as return on investment or ROI) measures the return that is being earned on the capital invested in the business. Operating profit (profit before interest) represents the profit available to pay interest to debt investors and dividends to shareholders. It is therefore compared with the long-term debt and equity capital invested in the business (non current liabilities + total equity).

RETURN ON INVESTMENTS § If we wished to calculate return on ordinary shareholders funds (the return to equity holders), we would use profit after interest and tax divided by total equity). A return on capital is necessary to reward investors for the risks they are taking by investing in the company. Generally, the higher the ROCE figure, the better it is for investors. It should be compared with returns on offer to investors on alternative investments of a similar risk.

RETURN ON INVESTMENTS § Generally, the higher the ROCE figure, the better it is for investors. It should be compared with returns on offer to investors on alternative investments of a similar risk. § The formula is: § Profit before interest and tax § capital employed x 100 § Capital employed is measured as equity, plus interest-bearing finance, i. e. non-current loans plus share capital and reserves.

CLASS QUIZ § Company A § $ § § § Fixed Assets Current Assets Stock Debtors Bank § § Less: Current Liabilities: Creditors § 30, 000 45, 000 15, 000 Capital Opening Capital Add Net Profit Less Drawings $ $ 70, 000 50, 000 9, 000 1, 000 90, 000 30, 000) 60, 000 (30, 000) 60, 000 100, 000 § § § $ 40, 000 Company B 80, 000 36, 000 116, 000 (16, 000) 100, 000 1. Required: Calculate the following for both companies: A. Current Ratio B. Acid Test Ratio 30, 000 100, 000 80, 000 36, 000 116, 000 (16, 000) 100, 000

Class Quiz § 2. ABC company has produced earnings of $50, 000 from an investment. The cost of the investment was $30, 000. § Calculate the Return on the Investment ratio. § 3. The average stockholders' equity and average capital employed of a company during the accounting year ended December 31, 20 X 2 were $348, 000 and $120, 000 respectively. The net profit during the period was $49, 000. Calculate return on capital employed of the company.

REFERENCES § Zenwealth. com. (2017). Ratio Analysis. [online] Available at: http: //www. zenwealth. com/Business. Finance. Online/RA/Ratio. Analysis. html [Accessed 30 Sep. 2017]. § http: //www. accaglobal. com, A. (2017). Ratio analysis | ACCA Qualification | Students | ACCA Global. [online] Accaglobal. com. Available at: http: //www. accaglobal. com/hk/en/student/exam-support-resources/fundamentalsexams-study-resources/f 2/technical-articles/ratio-analysis. html [Accessed 1 Oct. 2017]. § Wilkinson, J. (2017). Return on Investment (ROI) • The Strategic CFO. [online] Strategiccfo. com. Available at: https: //strategiccfo. com/return-investment-roi/ [Accessed 1 Oct. 2017].

REFERENCES § Liew, E. (2017). Frank Woods Business Accounting 1. [online] Academia. edu. Available at: https: //www. academia. edu/8752124/Frank_Woods_Business_Accounting_1 [Accessed 1 Oct. 2017]. § Readyratios. com. (2017). Return on Investment (ROI). [online] Available at: https: //www. readyratios. com/reference/profitability/return_on_investment_roi. html [Accessed 1 Oct. 2017]. § Kfknowledgebank. kaplan. co. uk. (2017). [online] Available at: http: //kfknowledgebank. kaplan. co. uk/KFKB/Wiki%20 Pages/Profitability%20 Analysis. aspx ? mode=none [Accessed 1 Oct. 2017]. § Accountingexplained. com. (2017). Return on Capital Employed (ROCE) Formula | Example | Analysis. [online] Available at: http: //accountingexplained. com/financial/ratios/return-on-capital-employed [Accessed 1 Oct. 2017].