Download Investment Principles

Next (final) week
•Revision class
•No new material
•Additional question 17
•Revision
•Any questions about the course or exam
preparation
•Remember you must achieve overall > 50%
and for the exam at least 40% to pass the
unit
Financial Statement Analysis
Lecture Outline
Ratio Analysis
 Advantages and limitations of ratio
analysis.
 Creative Accounting
 Motivations for Creative Accounting.
 Methods of Creative Accounting.

Types of Ratios

Profitability (Investors)
– Designed to help a investors evaluate a
firms ability to control expenses and earn
an adequate return.

Liquidity (Suppliers)
– Enables the user to evaluate the ability of
an entity to repay its short term liabilities as
they fall due.
Types of Ratios

Leverage (Lenders)
– Measures the extent to which an entity
relies upon debt financing.
Profitability Ratios
Net Profit Ratio
=
OPAT
Sales
Net Profit = Operating profit after tax
(OPAT)
 Shows the amount of net profit earnt for
every $1 of sales.

Profitability Ratios
If Net Profit ratio is increasing;
 Greater control of operating costs (ie
wages, rent, depreciation etc).
If Net Profit Ratio is decreasing;
 Operating costs are increasing without a
proportional increase in sales.
Net Profit Ratio
Company
Woolworths/Foodland
Net Profit
Ratio
2.1%
Telstra
18.1%
QANTAS
3.8%
Liquidity Ratio
Current Ratio =
Current Assets
Current Liabilities
If < 1: Entity can’t meet obligations to creditors.
If too far > 1: Inefficient use of resources.
Average on the ASX (2003): 1.47: 1
Current Ratio
Company
Current Ratio
Woolworths
0.84
Telstra
0.77
Rio Tinto
1.08
Leverage Ratio
Debt to Equity Ratio =
Total Liabilities
Total Equity
Shows the financial structure of the firm.
 Average on ASX: 40%

Leverage Ratio
If the Debt to Equity ratio is increasing;
– More of the firms operations are financed by debt
leading to:
• Increased interest payments
• Increased risk of failure
If the Debt to Equity ratio is decreasing;
– Less of the firms operations are financed by debt
leading to:
• Reduced interest payments
• Lower risk of failure
Debt To Equity Ratio
Company
Debt to Equity
Woolworths
29%
Telstra
97%
Rio Tinto
81%
Return on Assets
R.O.A =
OPBT + Interest Expense
Average Total Assets
OPBT: Operating Profit before Tax

Measures managerial efficiency (ie more
efficient managers will produce higher profits
with the same bundle of assets).
Ratio Analysis - Usefulness

Quick to calculate and simple to
interpret.

Brings figures down to a common scale.
– Enables comparisons between entities of
different size.
Limitations

Ratios mean nothing on their own. To be
useful a ratio must be compared with:
– Ratios from a previous period
– The same ratio from a different firm (within
the same industry)
– An industry average or benchmark.

Ratios indicate that a problem exists but do
not identify the problem itself.
Limitations

Ratios are based on information which
is “out-of-date”.

Changes in accounting policy may
effect the analysis.

Ratios are open to manipulation.
Breaking the Illusion

There is no such thing as a definitive
profit figure.

Profit, within reason, is whatever you
want it to be!!
Breaking the Illusion

Determination of profit is based on
subjective decisions made by the
preparer:
Example
1. Depreciation
• Estimate useful life of the asset.
• Estimate residual vale.
Creative Accounting
Defined

The process of manipulating accounting
numbers to convey an image desired by
management. Varies between;
Window Dressing:
• Adding polish to the financial statements to
make them look a little better.
To
Deception and Fraud
• Concealment of massive losses or debts.
Efficient Market Theory
Efficient Market Theory
 Manipulating profit figures does not fool
the market.
– A company cannot increase its share price
simply by manipulating its profit figure.
Bonus Plan Hypothesis

If the market cannot be fooled then why
do managers manipulate profit
figures??

Research suggests the following
possible reasons:
1.Bonus Plan Hypothesis
2.Debt Covenant Hypothesis
3.Political Cost Hypothesis
Bonus Plan Hypothesis

Managerial bonuses are often tied to the
performance (profit) of the entity they
manage.
In simple terms:
 The higher the profit, the higher the bonus
achieved by the manager.

Managers with bonus plans therefore have an
incentive to maximise profits in order to
maximise bonuses.
Debt Covenant Hypothesis

The existence of debt covenants constrains
an entity’s ability to borrow funds.

A debt covenant restricts an entity’s ability to
borrow more funds.
– In very simple terms: A lender prevents an entity
from borrowing more money until they have paid
back the lender.
Debt Covenant Hypothesis
Example: Debt Covenant
Debt to equity ratio must not exceed 70% .
Liabilities = 70,000
Equity = 100,000

What can an entity do if they have a debt to
equity ratio of 70% but want to borrow more
money??
Debt Covenant Hypothesis
To overcome this constraint:
 Manipulate numbers to increase profit by
$10,000. Equity rises by $10,000.

The entity can now borrow an additional
$7,000.
77,000 x 100
110,000
1
= 70%
Political Cost Hypothesis

Relates to larger, more “politically
visible” (ie wellknown) companies.

Hypothesises that when politically
visible company’s make large profits it
can lead to an increase in political
costs.
Political Costs
Political Costs Include:
–
–
–
–
–
–
–
Greater taxation
Removal of subsidies
Greater regulation
Deregulation (ie less regulation)
Demand for higher wages by employees/unions
Demand for greater social expenditure
Demand for higher dividends by shareholders
Political Cost Hypothesis

In order to avoid or reduce political
costs, politically visible entities have an
incentive to manipulate their profits so
that they appear lower than they would
normally have been.