The ability to comprehend, assess, interpret and criticise the financial statements and related information of different businesses is the quality above all others, which distinguishes the accountant from the bookkeeper. Complete mastery of accounts can be gained only as a result of wide experience, but whatever your personal circumstances, you can increase your understanding by careful and systematic reading of the financial columns of the daily press and by close attention to the professional journals.
Examination questions frequently call for appraisal of a specific document presented in the question, perhaps a balance sheet or income statement. Students often find such a problem difficult, not because they lack the necessary knowledge but because they are uncertain how to apply it. As a result, points are jotted down on the answer paper as they are thought of and such answers are naturally badly arranged and displayed and fail to exhibit any logical process of order and reasoning.
The object of this study unit is to show you the method which must underlie all good reports and appraisals, and the way in which they should be drafted.
Subject Matter for Analysis
Analysis of accounts usually means the analysis of balance sheets and trading and income statements (‘final accounts’) or their equivalent. Such accounts may be of two types:
- Published accounts, i.e. those prepared for the information of shareholders, etc.
- Internal accounts, i.e. those prepared for the information of the directors and management.
The second type, being the accounts upon which the policy of the concern is based, are usually in much greater detail than the first.
In either case, greater reliance can be placed on accounts which have been audited by a professional firm of standing than on any others; in particular, accounts drawn up by a trader himself are always open to question.
Analysis of accounts (meaning final accounts) does not, therefore, include any other accounts which may appear in the books. It is not an audit of the books or an investigation into the way in which the books have been kept. So long as the balance sheet and accounts are genuine, it does not matter whether the books have been well or badly kept.
Purpose of Analysis
The primary object of analysis of accounts is to provide information. Analysis which does not serve this purpose is useless.
The type of information to be provided depends on the nature and circumstances of the business and the terms of reference. By the latter we mean the specific instructions given by the person wanting the enquiry to the person making it. Of course, if the person making the enquiry is also the person who will make use of the information thus obtained, he will be aware of the particular points for which he is looking.
The position of the ultimate recipient of the information must be especially noted. Suppose you are asked by a debenture holder to comment on the balance sheet of a company in which he is interested. It should be a waste of time to report at length on any legal defects revealed in the balance sheet. You would naturally pay attention to points which particularly concern the debenture holder, e.g. the security for his loan to the company, and the extent to which his interest in the debentures is ‘covered’ by the annual profits.
This does not mean that legal defects should be ignored. It is very important that they should be mentioned (although briefly), for failure to comply with legal requirements may be indicative of more serious shortcomings, possibly detrimental to the security of the debenture holder.
This matter of approach is vital to the task of analysis. We shall now consider certain special matters in which various parties will be particularly interested. For the sake of illustration, we will deal with their positions in relation to the accounts for a limited company, but many of the points we are going to mention are relevant to the accounts of a sole trader or partnership.
These are interested in both the long- and short-term position of the company. In the long term they are interested in the company’s ability to repay the sums lent by them (assuming they are redeemable). They would look to see whether a sinking fund has been created, and for the realisable value of the assets which form security for their loans. The basis of valuation of assets would therefore be important, and whether the depreciation provision is adequate.
In the short term the debenture holder will consider the company’s ability to pay the loan interest and hence will examine the working capital (current assets less current liabilities).
As a general rule, a trade creditor will rely on trade references or personal knowledge when forming an opinion on the advisability of granting or extending credit to a company. He is not often concerned with the accounts, which he rarely sees, but if he does examine the accounts he will be as much concerned with existing liabilities as with assets. In particular, he will note the following:
- Working capital position or ability of company to pay debts when they fall due.
- Ease with which current assets can be converted into cash.
- Prior claims to company’s assets in the event of a liquidation, i.e. secured loans or overdrafts.
- Earnings record and expansion programme.
Before making a loan or granting an overdraft, the bank would consider:
- The nature and purpose of the loan.
- The duration of the loan (bankers prefer the short- or medium-term loan to those for longer periods).
- The arrangements for repayment.
- The prospects of repayment.
- Security and prior rights to the assets of the company on liquidation.
- Financial policies of the company, and calibre of management.
The average shareholder is interested in the future dividends he will receive. Future profits are of secondary importance, so long as they are adequate to provide the dividend.
Past dividends provide the basis on which future dividends may be estimated, just as past profits afford a similar indication as to future profits. Estimates may, however, be upset because of radical changes in the nature of trade, production methods, general economic conditions, etc.
If the shares are listed on a stock exchange, it will be found that the market price varies more or less directly with the dividends declared. It is generally accepted that a company ought not to pay out more than two-thirds of its distributable profits each year in the form of dividend.
Cover is a vital factor in respect of any shares carrying fixed dividend rights, e.g. preference shares. The coefficient of cover is determined by dividing the annual dividend into the amount of the annual profits.
With redeemable shares, attention will be paid to the ability of the company to redeem on the due dates. There may be a sinking fund created for this purpose.
Overall, the shareholder would be concerned with whether the company still provides the best home for his investment or whether his money would be better utilised elsewhere.
Directors and Management
These are interested in the actual results, to enable them to:
- Compare with competitors.
- Compare with budgeted or expected results.
- See whether capital has been utilised in the best way and profits maximised.
Potential Takeover Bidders
In a takeover situation, the buying company may see hidden potential in another company in the form of under-valued assets or under-utilised funds. It may therefore be able to make a successful offer to the shareholders, who may not be aware of their company’s real value. Potential takeover bidders would consider:
- Current value of assets as opposed to book values.
- The asset-stripping potential, i.e. can the assets be sold off for a profit and the company liquidated rather than bought as a going concern for continuation in the future?
- The effect of the directors’ financial and dividend policies in fostering shareholders’ loyalties (e.g. is there ill feeling and aggravation at the annual general meeting?).
Control of all costs, direct and indirect, is essential if profit is to be maximised. In a broad and general fashion, excluding the advanced techniques of budgetary control and cost accounting, it is possible to watch total costs of each type, and to take action to reduce them when necessary.
This may be done by comparing manufacturing costs, administration costs, and selling and distribution costs with profit (gross or net) or with sales. The broad headings, manufacturing costs, etc. can, of course, be usefully analysed into their constituent parts and similar comparison made with profit or sales. The trend of the ratio – whether there has been an increase or decrease in costs as compared with profit or sales – is the significant factor.
Net Income Related to Capital Employed
This is widely used but unfortunately the formula for capital employed is not widely agreed. The ratio is used because it attempts to relate income generated to the resources employed.
The meaning of capital employed can be approached from two angles – the finance and the asset approaches.
- Finance Method
Income is related to total funds invested in the business and this involves taking the total of all shareholders’ (proprietors’ if sole trader or partnership) funds plus future and current liabilities as shown in the balance sheet.
- Assets Method
Income is related to assets employed, being fixed assets and current assets as shown in the balance sheet. Thus the values placed on non-current and current assets will reflect directly on this ratio. To capitalise brands, for example, is thought to strengthen a balance sheet. But you can also appreciate what it does to the return on capital employed, with the increase in assets it provides.
We are really talking about the same figure, as a balance sheet must balance. The difference between the two will concern the assets or funds to be counted. Are all funds/assets included in the figure for capital employed, whether employed during the year or not? Is working capital to be counted, or only fixed capital?
There is no easy answer to these questions and again the wisest approach will be one of caution. Generally, however, total funds or total assets will be favoured since investors expect all resources to be used. In any case, all resources have an opportunity cost, i.e. alternative uses.
Net Income Related to Shareholders’ Funds
This may be useful in showing how efficiently a particular section of company capital is being used and what is said here in connection with shareholders’ funds could equally apply to other types of funds, loan capital, etc.
Various Expenses Related to Turnover
Using this ratio, wages, departmental expenses, selling expenses can all be related to sales. Comparisons can be made over periods of time and at the same time within the firm.
Value Added Per Employee
This is the amount added to the cost of materials consumed to cover labour charges, expenses and gross profit, divided by the number of employees. Thus a guide is obtained to the output per employee.
Sales Per Employee
This is obtained by dividing the value of sales for a period by the average number of persons employed during that period. Expressed on its own it is of relative insignificance, but it is normally used in comparison with previous periods.
Times Covered for Interest and Dividends
This may be used to show how many times over a company could pay the demands on it in terms of interest and/or dividends. Alternatively it can show how far income would have to fall before dividend/interest was put at risk. It is calculated by the formula:
Net Trading Income
Rate of Interest x Loans, etc.
This can be applied to preference shares, loan stock and debentures.
Current assets are compared with current liabilities. Generally speaking, the larger the former in relation to the latter the more financially stable is the business. As a very general rule, total current assets should be at least twice total current liabilities.
The length of time an asset is held or a liability is outstanding determines the category into which it falls, i.e. whether current or non-current. If an asset is to be held for up to a year, not longer, or a liability is to be paid off within a year, then one is a current asset and the other a current liability. Non-current assets or ‘non-current” liabilities, e.g. loan capital, are of a permanent nature.
This ratio can also be referred to as the working capital ratio.
- The type of trade carried on by the business. In particular, trade fluctuations, owing to seasonality of sales of the product and the like, are extremely important. If the selling season is a number of months away, the inventory carried may build up considerably (giving a larger total of current assets) and yet, for all practical purposes, from the point of view of liquid resources the position will have deteriorated.
- Having regard to what is stated in (i), you will see that it is not the total ratio which is of importance but rather the composition of the total assets and total liabilities. Referring to the figures in the example, we may ask:
- Is the inventory composed mainly of raw materials or finished goods? Is the inventory slow moving? The aim should be to predetermine a desirable relationship between the different types of inventory and follow it as closely as possible.
- Will the receivables pay promptly?
- How quickly must the trade payables be paid off?
- Will the bank extend the overdraft or is there a danger of it being called in?
The real question is the rate at which money will be received into the business as compared with the rate of payments to cover current liabilities. There is nothing static about a business but, unfortunately, this is often the erroneous impression gathered from accounting ratios. A clear understanding of the underlying implications is essential if ratios are to be a useful tool of management.
From what we have said, it should be clear that ‘2 to 1’ is only an approximate guide. At times a lower or higher ratio may be regarded as normal, e.g. a 5 to 1 ratio may be present at certain times of the year and be quite acceptable.
Once an ideal ratio for the business has been established, the most important point, from a financial point of view, is to ascertain whether there is a rise or fall, for, generally speaking, the former may be regarded as a favourable trend and the latter an unfavourable one. Again, no hard and fast rule is possible for much depends upon the circumstances.
- Working Capital and the Current Ratio
The working capital is the excess of current assets over current liabilities. There is therefore a direct connection between working capital and the current ratio. If working capital is inadequate, so that the business is unable to pay its way, it will, if the worst comes to the worst, have to close down. This state of affairs usually arises from overtrading, i.e. having a volume of turnover which, with available working capital, is far too large. Typical steps leading to over-trading are:
- Large quantities of materials are purchased.
- Extra workers and staff are employed to deal with the additional production and sales.
- There is a rise in all other operating costs.
Next, after a time, the length of which depends upon the production and sales cycles, extra revenue from sales is received. Often a number of months will have elapsed before this extra cash is received. There has, however, been immediate payment of wages and salaries and only a limited period of credit will normally be allowed by payables. Possibly a bank overdraft will be obtained to accommodate immediate needs. If not, or when the limit of the overdraft is reached, an anxious creditor may apply for a petition, and the business may then be forced into bankruptcy or liquidation.
Even if a business does manage to survive, it will not, for a considerable period, be able to take advantage of a new market, the development of new ideas or a similar project. There is thus a second danger of being forced out of business, this being brought about by the competition of more progressive rival concerns.
In the circumstances outlined, only the availability of cash can avert the dangers. This is thus of the greatest possible importance to any business; without cash it is unlikely to survive. Stocks form part of the working capital and these, in the short term, are of limited value. It may be possible to attract cash customers by giving a discount, but this will mean that less profit is earned.
Because of the importance of paying payables promptly, it is advisable to fix a period of time within which accounts have to be settled. Following normal commercial practice, this may be taken as one month. If the business cannot meet its obligations within each month, then that is a danger sign, which indicates that prompt remedial action should be taken. The next ratio greatly assists in maintaining adequate cash or near cash resources.
Liquidity Ratio (Acid Test or Quick Ratio)
The liquidity ratio is the relationship which exists between liquid assets (cash and good receivables) and liquid liabilities (trade payables). Any inventory, work-in-progress or other current assets which are not cash or near cash do not enter into the comparison. There is thus a direct measure of solvency.
It is advantageous to keep this ratio in balance, as during the normal course of business events revenue from receivables will usually be required to pay payables. This helps to maintain stocks at a stable level and profits earned can be used to increase liquid resources.
If the liabilities are to be met, the ratio must clearly be at least 1 to 1, i.e. liquid assets must be equal to payables. Any falling short indicates that additional cash has to be obtained. The trend of the ratio will be a very helpful guide, for under stable trading conditions it should remain steady, without appreciable movement either way. A sharp fall in the liquid assets available without a similar fall in payables will show that immediate action is necessary.
Ratio of Current to Non-Current Assets
Current assets are compared with non-current assets and the ratio established. Owing to differences in types of business, and conditions under which they operate, it is virtually impossible to state a desirable ratio which can be applied generally. For the individual business it should be possible to establish the ideal ratio. Comparing ratios within an industry will usually show that the stronger businesses have the larger proportion of current assets. There is nothing to be gained by comparing ratios for concerns in different industries.
We’ve already explained the term ‘current assets’. Non-current assets are properties, machines, equipment and other possessions held in the business permanently for the purpose of earning profit. Examples are land and buildings, plant and machinery, office furniture and machinery, motor vehicles and loose tools. The significant fact to remember is that these assets are not held in the normal course of business, but are retained so that materials may be converted to finished goods and the latter then sold.
Ratio of Shareholders’ to Payables’ Equity
Liabilities in a company balance sheet can be divided into two parts:
- Capital, reserves and undistributed profits owned by the shareholders (the net worth of the business)
- Sums due to payables and lenders of loan capital (payables’ equity)
The two are compared to give the ratio of shareholders’ to payables’ equity. A strong business will have the largest proportion of its total liabilities composed of the net worth. Weaker concerns are those which are dependent upon payables and thus any adverse interference from them may lead to serious consequences. The strong company is fully ruled by shareholders without interference from payables.
LIMITATIONS OF RATIO ANALYSIS
It must be emphasised that accounting ratios are only a means to an end, and not an end in themselves. By comparing the relationship between figures, only trends or significant features are highlighted. The real art in interpreting accounts lies in defining the reason for the features and fluctuations. In order to do this effectively, the interested party may need further information and a deeper insight into the business’s affairs. The following points should also be borne in mind:
- The date to which the accounts are drawn up. Accurate information can only be obtained from up-to-date figures. Seasonal trends should not be forgotten, as at the end of the peak season the business presents the best picture of its affairs.
- The position as shown by the balance sheet. The arrangement of certain matters can be misleading and present a more favourable position, i.e. making the effort to collect debts just before the year-end in order to show more cash and lower receivables than is usual; ordering goods to be delivered just after the year-end so that stocks and payables can be kept as low as possible.
- Management interim accounts should be examined wherever possible to obtain a clearer idea of trends.
- Comparison with similar businesses should also be made.
OTHER MEASURES OF BUSINESS OPERATIONS
The ratios we have outlined are the more common measures of company performance. Attention should, however, be paid to the gearing of the company, i.e. the capital structure and the way the company finances its assets. The word ‘capital’ here is used in a wider sense than share capital.
The lenders of funds to the company fall into two groups:
- Least Risk
- Debenture holders (who have first claim on money from a company in the event of a winding-up)
- Payables (who are unsecured but can sue for their debts)
- Most Risk
Ordinary shareholders, who are only repaid in the event of a liquidation, when the leastrisk group has been fully repaid.
Gearing is the relationship of ordinary shareholders’ funds (sometimes called equity interest) to preference shares and debentures (called fixed-return capital).
If a company is low-geared it means that the proportion of preference shares and debentures is low compared with ordinary shares. Hence the preference shareholders and debenture holders have greater security for payment of dividends/loan interest and the ordinary shareholders are not liable to such violent changes in return on their investment, as there is less to pay before they receive their entitlement.
High gearing, on the other hand, means a high proportion of preference shareholders and debenture holders to ordinary shareholders. Here there is greater risk for the ordinary shareholders as a greater proportion of the profits is to be paid out to a fixed return capital, before they receive their entitlement.