BEYOND FINANCIAL STATEMENTS - SAIPA

BEYOND FINANCIAL STATEMENTS

Prepared by:

Rashied Small, Lucinda Smidt & Yaeesh Yassen

National CPD Seminar – September 2016

CPD SEminar - Beyond Financial Statements 1

Statement of Financial Position

Non-current assets

Working capital

Debt funding

Equity funding

What does the statement say?

• Summary of assets and claims against those assets at a point in time

• Financial position with regards to its ability to meet current debt obligations

• Financial position with regards to its resources to carry on and sustain its operations.

• Book value of the business –strength of the owner’s claim against the resources

What does the statement does not say?

• Details of how the resources were used to generate revenue and profit

• Claims of creditors and owners against specific assets

• Misconception of capital under equity [investment vs cash]

• Market or current value of the business [book value]

• True economic benefits of assets [revenue earning capacity]


Statement of Financial Performance

Revenue

ExpensesFinance

costs

Profits


• Primary (revenue) and secondary sources of income

• Indication of the nature of the core business activities

• Nature and magnitude of the costs to support operating activities

• Trading and operating performance of the business [measured by profit]


• Predict the future performance [revenue and expenses]

• Provide an exact measurement of net income for the reporting period

• True profit of the business -difference between the funds invested and its realizable amount on disposal

• Indicate the cash generated from operation [misconception that profit = cash]


Statement of Cash Flow

Revenue

ExpensesFinance

costs

Profits


• Movement of cash and cash equivalents for the reporting period

• A positive cash flow is the ideal outcome – cash in not always King

• Cash flow does not represent the profit [cash basis of reporting]


• Indication of the profit/loss realized

• Indication of the operating performance – positive cash flow may be misinterpreted

• True causes of cash flows – cash management decisions

• Actual cash flows – include cash equivalents


Red Flags in Financial Statements


RED FLAGS

Rising debt equity ratio

Declining interest

cover ratio

Unsteady cash flows

Rising receivable

& inventory

Continuous declining revenue trends

Consistently declining

current ratio

Business Analysis


Financial AnalysisProcess to evaluate financial position and performance

using financial statements

Profitability analysis – Evaluate performance andreturn on investment

Risk analysis – Evaluate creditworthiness and riskiness (business & financial risk)

Cash flow analysis – Evaluate sources and utilization of cash resources

Ratio analysisCash flow analysis

Common techniques


Ratio Analysis

• Ratios recognize the symbolic relationship of various items in the financial statements

• Ratios also allow for improved comparison through time or between organisations

• Ratio analysis is a suggestive indicator and does not provide conclusive evidence

• Effective financial analysis begins with analyzing the industry in which the entity operate and the entity’s strategies to create a sustainable advantage


Limitations of Ratio Analysis

• Nature and structure of the organization cannot be explained by the numbers

• Benchmarking (average/moderate) does not reflect the goals of the organization

• Financial information may not reflect the “true” value – inflationary conditions versus historical cost

• Seasonal fluctuations may distort the average results used in ratios

• Historical results versus market results –distortion in comparison


Limitations of Ratio Analysis

• Estimations, professional judge and the off-balance sheet reporting may distort comparisons

• Accounting policies and practices differ from organisations

• Generalisation about the computation and interpretation of ratios

• Indepenedent view and interpretation of ratios may not provide a holistic view


Ratio Analysis Techniques

• Analysis of relationships between items

• Analysis of relationship for common activities

• Comparative analysis over time – base period

• Comparative analysis to reflect changes

Horizontal analysis

Trend analysis

Vertical analysis

Ratio analysis


Ratio Analysis – Key Areas


Profitability Analysis

Profitability ratios measures the effectiveness of management in

achieving operating goals as shown in relationship on revenue and

investments.

Common ratios:1. Gross profit %2. Operating profit %3. Net profit %4. Expenses %5. Return on assets6. Return on equity


Profitability RatiosRatio Description Formula Interpretation

Gross profit % Return on salesMeasure the trading performance andcompetitiveness of the business

Gross profit/Revenue x 100%

• Acceptable range 40% - 60%• Indicate the safety margin before the

business makes losses• Indication of management’s ability to

convert sales into profits• Expected to be stable and constant• Increases are good• Influenced by competition & costs

Operating profit before depreciation %

Return on sales before accounting for interest, tax and depreciation

EBITDA/Revenue x 100% • Acceptable range 20% - 35%• Expected to be stable and constant• Increase significantly with scale• Influenced by competition & costs

Operating profit % Operating return on salesfrom normal operationsShows the efficiency of management in cost control and management

Operating profit/Revenue x 100%

• Acceptable range 10% - 30%• Indication of operating efficiency and

effectiveness• Indication of the ability to “add

value” through the operating process• Increase significantly with scale• Influenced by competition & costs



Net profit % Operating performance asa return on salesIndicates the efficiency and cost management of the business

Net profit/Revenue x 100%

• Acceptable range 5% - 25%• Indication of efficiency and overall

profitability of the business• Decrease significantly with debt

financing• Influenced by competition & costs

Expenses % of sales Relationship of expenses on sales

Expenses/Revenue x 100%

• Indication of operating efficiency and effectiveness of operations

• Indication of the effectiveness of management’s cost performance

• Decrease significantly with scale



Return on assets Measures the efficiency of utilizing the assets to generate profit

Net profit/Total assets x 100%

• Acceptable range 15% - 23%• Indication of how efficiently

management is utilizing its resources to generate profit

• Indication of the allocation of resources to value adding activities

• Indication of the effectiveness of managements investment decisions

Return on equity Measures the efficiency with which the equity funds are utilized to generate profit

Net profit/Total equity x 100%

• Acceptable range 8% - 15% • Indication of the efficiency with

which management utilizes the funds of equity holders to generate profit


Liquidity Ratios


Liquidity measures ability of the organization to meet its short-term financial obligations when the are due – ability to convert its short-

term assets into cash to meet obligations

Common ratios:1. Current ratio2. Quick ratio3. Cash ratio

Liquidity Ratio – Current Ratio


Ratio Current ratio

Description Measures the short-term financial risk and the ability of the organization to meet its short-term obligations

Formula Current assets : Current liabilities

Interpretation • Acceptable range 1:1 – 2:1• Indication of the security and cover

provided to short-term creditors• Indication of the sustainability of

operating activities – risk exposure• Too low ratio increases the financial risk

to short-term creditors• Too high a ratio indicates that cash

resources are tied up in unproductive assets

Liquidity Ratio – Quick Ratio


Ratio Quick / acid test ratio

Description Measures ability of the organization to easily converts its short-term associates to meet its short-term obligations

Formula (Current assets – Inventory) : Current liabilities

Interpretation • Acceptable range 1:1• Indication of the immediate solvency of the

organization to meets its short-term obligations

• High ratio provides the organization with safety margin to increase its short-term debt

• Ratio below 1:1 indicate the financial risk for creditors – inability to meet its immediate short-term obligations

Liquidity Ratio – Cash Ratio


Ratio Cash ratio

Description Measures absolute liquidity of an organization – cash available to meet obligations

Formula (Cash + cash equivalents) : Current liabilities

Interpretation • Acceptable range 0.5:1• Stringent indication of the liquidity of the

organization – alternative options to meet short-term obligations

• High ratio indicates poor resource allocation and management – not utilizing cash resources efficiently

Liquidity Ratio – Net Working Capital Ratio


Ratio Net working capital ratio

Description Measures the management of operating liquidity – cash resources available to fund operations

Formula (Current asset – Current liabilities)/Net Assets x 100%

Interpretation • Acceptable range must be positive• Ratio below zero indicates that the

organization the financial distress and business risk

• Indication of operating sustainability – risk of asset stripping to sustain operations

Liquidity Ratio – Defensive Interval


Ratio Defensive interval

Description Measures the safety margin for the organization to funds its day-to-day operating costs

Formula Current assets/Average daily operating cost

Interpretation • Acceptable range 30 to 90 days• Indication of the ability to fund operating

costs from internal resources• Indication of the period the organization

can rely on its resources to fund day-to-day costs

• Indication of operating risks – ability to meet operating costs

Solvency Ratio


Solvency measure the ability of the organization to meet its long-term

obligations and sustain its activities to achieve its strategic goals

Common ratios:1. Debt ratio2. Times interest earned ratio3. Interest cover4. Debt to equity ratio

Solvency Ratio – Debt Ratio


Ratio Debt ratio

Description Measures the proportion utilization of debt financing by the organisation

Formula Total Debt/Total Assets x 100%

Interpretation • Acceptable range 20% - 30%• Indication of the dependency on debt

financing by the organization - leverage (financial risk)

• Indication of the ability of the organization to provide security and cover for its debt providers

• Indication of the effectiveness of financial management and management of financial risk

Solvency Ratio – Long-term Debt Ratio


Ratio Long-term debt ratio

Description Measures the financial leverage of the organization – utilization of long-term debt to fund the business

Formula Long-term debt/(Equity + long term debt) x 100%

Interpretation • Acceptable range 20% - 30%• Indication of the level of financial leverage

of the organization• Indication of financial risk the organization

is exposed to

Solvency Ratio – Debt to Equity Ratio


Ratio Debt to equity ratio

Description Measures financial gearing of the organization – relationship between debt versus equity funding

Formula Total debt/Total equity x 100%

Interpretation • Acceptable range 50%• Indication of the capital structure of the

organization – long-term financial structure• High ratio indicates that the organization

has a high debt leverage – high financial risk

• Indication of financing the growth of the organisation

Solvency Ratio – Interest Cover Ratio


Ratio Interest cover ratio

Description Measures the ability of the organization to pay its debt servicing costs from operations –number of time interest is covered

Formula Operating profit/ Interest paid

Interpretation • Acceptable range 6 – 7 times• Indication of the level of risk the

organization has in meet is debt financing costs

• A low ratio indicates that the organization is burdened with a high level of debt financing

• Too high a ratio may indicate low debt leverage or efficient and profitable operations

Efficiency Ratios


Efficiency ratios measure the effective management and

allocation of resources to the operating goals of the organization.

Common ratios:1. Asset turnover ratio2. Inventory turnover ratio3. Debtors turnover ratio4. Creditors turnover ratio

Efficiency Ratio – Asset Turnover


Ratio Asset turnover ratio

Description Measures the ability of the organization to convert its investments in assets into revenue – utilize the resources to generate revenue

Formula Revenue/Total non-current assets

Interpretation • Indication of the utilization of the resources as a revenue driver

• Indication of the effective management decisions for investments in resources to generate revenue

• As low ratio indicates that management have investment in ineffective resources or unproductive resources

• A low ratio indicates that the organization has too low and investment in resources to support potential sales

Efficiency Ratio – Inventory Turnover


Ratio Inventory turnover ratio

Description Measures the ability of the organization to convert its into revenue – number of times the entire inventory is sold during the period

Formula Average inventory/Revenue

Interpretation • Indication of the efficiency with which inventory is converted into sales

• Low ratio may indicate a risk of holding low level of inventory resulting a potential loss of sales

• High ratio may indicate a difficulty in the organization selling its inventory – resulting over stocking or a decline in the market for the goods

Cash flow Analysis


Cash flow ratios measures the effectiveness of management of

cash resources in achieving strategic goals without increasing the risks to

the organisation.

Common ratios:1. Operating cash flow ratio2. Operating cash margin3. Cash debt cover ratio4. Cash interest cover ratio5. Cash return on assets6. Cash re-investment ratio

Operating Cash Flow Ratio


Ratio Operating cash flow ratio

Description Measures the gap between the time the goods are acquired from suppliers and the time it takes to collect cash from customers

Ratios • Inventory holding period• Debtors’ collection period• Creditors repayment period

Interpretation • Indication of the ability of the organization to funds its sales/operating activities from internal sources

• Indication of the organization’s dependency on short-term debt financing (bridging finance)

Inventory Holding Period Ratio


Ratio Inventory holding period ratio

Description Measures the time period its takes the organization to sell its goods from the date of purchase – shelf-life

Formula (Average inventory/Cost of sales) x Annual working days

Interpretation • Acceptable range 20 - 46 days• A high ratio indicates an over investment in

inventory, inventory build up or holding of slow moving goods

• A low ratio indicates a high level of sales activity but may not reflect a high profit as profit may be sacrificed for increased sales

• A high ratio may indicate a low investment in inventory resulting in loss of potential revenue

Debtors’ Collection Period Ratio


Ratio Debtors’ collection period ratio

Description Measures the time period its takes the organization to collect the cash from customers from the date of sale

Formula (Average debtors/Credit sales) x Annual working days

Interpretation • Acceptable range 30 - 60 days• Indication of the liquidity of the trade

receivables• Indication of the credit management of the

organization – measured in comparison to credit policy

• A low ratio indicates an efficient sale cycle • A high ratio may indicate a significant

investment in debtors or create of revenue through credit

Creditors’ Repayment Period Ratio


Ratio Debtors’ collection period ratio

Description Measures the time period its takes the organization to pay creditors from the date of purchases

Formula (Average creditors/Credit purchases) x Annual working days

Interpretation • Acceptable range 30 - 60 days• A high ratio may indicate liquidity problems

– inability to meet obligations when due• A high ratio may indicate a low financial or

creditworthiness risk• Must be viewed in conjunction with the

debtors’ collection ratio and liquidity ratios• High ratio indicates the utilization of

interest-free debt to funds operations

Operating Cash Flow Ratio



Description Measures the ability of the organization to pay its short-term obligations from cash generated from operations

Formula Cash from operations/Current liabilities

Interpretation • Acceptable range 1:1• Indication of the organization’s ability to

meet its short-term obligation from cash generated from operations

• A ratio of less than 1:1 indicates a financial risk as the organization cannot pay its short-term obligations from internal cash generated

• A high ratio indicates that the organization generates sufficient to funds expansions and replacement of assets

Operating Cash Margin Ratio



Description Measures the ability of the organization to convert sales into cash

Formula Cash from operations/Revenue x 100%

Interpretation • Acceptable range 10% - 15%• Indication of the organization’s ability to

convert is sales into cash to finance its obligations

• Indication of the organization risk to service its investors from operations – pay taxes. Dividends and interest

• Indication of the “cash” efficiency and performance of the operating activities of the organisation

Cash Debt Cover Ratio


Ratio Operating cash solvency ratio

Description Measures the ability of the organization to pay all its obligations from the cash generated from operations

Formula Cash from operations/Total liabilities

Interpretation • Acceptable range 1:1• Indication of the organization’s ability to

meet its short-term obligation from cash generated from operations

• A ratio of less than 1:1 indicates a financial risk as the organization cannot pay its short-term obligations from internal cash generated

• A high ratio indicates that the organization generates sufficient to funds expansions and replacement of assets

Cash Interest Cover Ratio


Ratio Operating cash solvency ratio

Description Measures the ability of the organization to pay debts service costs from the cash generated from operations

Formula (Cash from operations + Interest paid + Tax paid)/Interest paid

Interpretation • Acceptable range 6 – 8 times• Indication of the ability of the organization

to pay service costs from the cash generated from operations

• A ratio less than zero indicates that the organization cannot pay its interest costs from operations – increase the financial risk to the business

Cash Return on Assets Ratio


Ratio Cash return on asset ratio

Description Measures the ability of the organization to generate cash from the ulisation of its resources

Formula Cash from operations/Total assets x 10%

Interpretation • Acceptable range 20% - 35%• Indication of the efficiency of management

to utilise its resources to generate cash• Indication of management’s efficiency in

allocating resources to cash and value creation activities

• Indication of the effective allocation of resources to develop and maintain the competitive advantage of the organisation

Cash Re-investment Ratio


Ratio Cash re-investment ratio

Description Measures the ability of the organization to generate cash from the acquire resources for expansions and replacement purposes

Formula Cash from operations/Acquisition of non-current assets

Interpretation • Acceptable range 20% - 35%• Indication of the efficiency of management

to plan to have sufficient cash to replace and acquire assets

• A low ratio indicates that the organization is dependent of external funding to sustain its activities to achieve its goals

• A high ratio indicates that management has planned adequately for sustain operating activities

Financial Stability Ratios


Financial stability ratios measures the ability of the organization to

meet its long-term obligations while at the same time having sufficient resources available to sustain its

operations.

Common ratios:1. And solvency ratios2. Debt to equity ratio3. Working capital to asset ratio4. Debt to equity ratio5. Free cash flow ratio

Financial Stability Ratio – Free Cash flow


Ratio Free cash flow ratio

Description Measures the ability of the organization to generate cash from operations which exceed its capital expenditure requirements

Formula Operating cash flow – Capital expenditure

Interpretation • Indication of the organization to generate organic growth (internal growth)

• Indication of the organization to generate sufficient cash to pay returns to equity investors

• Indication of the organization to maintain its competitive advantage

• Indication of the organization financial flexibility for growth and expansion

Financial Stability Ratio – Working Capital to Assets


Ratio Working capital to total assets ratio

Description Measures the liquidity of the organization in terms of its ability to easily convert its assets in cash to meet financial obligations

Formula Working capital/Total assets x 100%

Interpretation • Indication of the organization liquidity to meet its obligations and sustain its operations without causing financial distress

• Indication of the level of resources required to meet its day-to-day operating obligations

• A high ratio may indicate that management is not using its resources efficiently – cash resources are tied up in working capital

Looking Beyond the Numbers


Questions to ask

• Revenue = Single customer

• Revenue = Single product

• Revenue = Geographical markets

• Supply chain = Single supplier

• Competition = Competitive advantage

• Future potential = Research & Development

• Environment = Regulations

Summary


BEYOND FINANCIAL STATEMENTS - SAIPA

Documents

Transcript of BEYOND FINANCIAL STATEMENTS - SAIPA