MODULE 10

ANALYSING FINANCIALS AT BOARD LEVEL

ADB Private Sector Development InitiativeCorporate Governance TrainingSolomon Islands

Originally byDr Judy Taylor

Acknowledgement

These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian Development Bank’s Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical assistance facility co-financed by the Asian Development Bank, Australian Aid and the New Zealand Aid Programme.

Outline of session• Role of Board and financial skills

• Financial Literacy V Financial Expert• Use of subcommittees• Analysis of financial reports

• Analysis on internal reports • Analysis on external financial reports

• Horizontal, common-sizing and Ratio analysis

• Red flags

Overview of financial governance

• The board is responsible for the true and fair financial reporting of their company (entity)

• While the board delegates some of the oversight tasks to committees, they retain ultimate responsibility and authority

• Board’s role is not to manage• But to ensure the organisation is being

managed• When something goes wrong the board

is collectively accountable.

Overview of financial governance

• To fulfill these responsibilities the Board needs to be financially literate

• Board must require high quality – SMART – reporting:• Specific reports, • Measurable, • Achievable, • Relevant, • Time bound

• Monitor progress towards targets set in strategic and business plans.

• Monitor and evaluate the CEO against KPI’s

Financial LiteracyWikipedia:Financial literacy is the ability to understand how money works in the world: how someone manages to earn or make it, how that person manages it, how he/she invests it (turn it into more) and how that person donates it to help others. More specifically, it refers to the set of skills and knowledge that allows an individual to make informed and effective decisions with all of their financial resources

Financial LiteracyAustralian Institute of Company Directors:1

• The four pillars include a combination of skills, background and experience that give Directors the ability to perform• Formal legal and statutory requirements regarding

the financial requirements• Monitor the solvency of the company• Balance risk mitigation• Know when to call in experts

1. Dianne Hughes, Financial Fundamentals for Directors, Australian Institute of Company Directors, 2014

Financial LiteracyContrasting a financial expert and financial literacy• A financial expert can identify and choose the

correct accounting treatment and framework.• A financial literate director is not expected to have

this level of knowledge. They would be satisfied that the appropriate framework has been applied. And when to call in experts to advise them.

• A board that does not possess both financial experts and financially literate Directors suffers severe consequences.

Overview of financial governance

The board manages using subcommittees. Subcommittees allow2

More thorough research and consideration of information

More time at the regular board meeting for regular business. 

Better dialogue between committee members and staff and community members on the specific topic.

2. Dianne Hughes, Financial Fundamentals for Directors, Australian Institute of Company Directors, 2014

Overview of financial governance The board sets up a financial, planning

reporting and budgeting committee The Chief Financial Officer (CFO) then devolves

these duties into a number of separate areas which ensures a system is in place to record, verify and measure free of fraud (one model does not fit every organization) Budgeting and planning Day to day financial tasks Reporting

Financial GovernanceA

subcommittee

Audit compliance and risk managem

ent

Human Resourc

es

Financial Planning,

Reporting and budgeting

Board of

Directors

Receipts Payment

sBudgetin

g and Planning

Financial Reportin

g

Chief Financial Officer

Overview of financial governance The CFO implements a financial

reporting system that meets internal reporting requirements and external reporting requirements.

The internal financial reporting should allow analysis of the entity by directors to scrutinise the financial security and probity of the organisation.

The external financial reporting should allow directors to analyse their position and performance across time and compared to their competitor's.

Financial budgeting Module 8 looked at financial budgeting The budget evolved from the Strategic plan.

The financial reporting should therefore be compared to the targets and goals set in the Strategic Plan, the Corporate Plan and Budgets

The Budget reporting will compare the actual expenditure to the budgeted expenditure, this should be done on

Reporting basis (3 monthly, 6 monthly, annually)On a year to date basisAn annual basis as well as a cash flow basis.

The report presented to the board will have already been vetted by the financial and internal audit subcommittees. While the internal audit will be concerned that the income and expenditure are recorded in the correct categories. The financial subcommittee will be concerned with the results.

Financial budgeting Highlight variances and reasons for the variance

where the differences are material

But the board needs to understand why there is a variation and whether it will continue

– is it due to a timing difference or a change in the

commercial environment – does the budget need to be updated and profit

figures re-forecasted? do they have sufficient cash flow to meet obligations

in next operating period?

Financial reporting

Financial Committee has delegated responsibility for the financial reporting they will have overseen the implementation

of systems to ensure accuracy of reporting, free of fraud

They will review the financial statements prior to presentation to the board for acceptance

They will report on any significant variations, significant, unusual or large transactions, and changes in accounting policies or procedures or treatment of accounts.

Financial ReportingSpecifically the committee will report at two levels

Report the internal performance of each major financial control division Profit and loss- actual v’s budgeted, YTD and same

period last year and reasons for variances, forecast for next three months and YE

Cash flow - actual v’s budgeted, YTD etc. as above Inventory or stock report Debtors report Creditors report Loan report Foreign currency report Capex report

Financial Reporting External financial statements 6 monthly

and annually

Profit and loss (financial performance) Balance sheet (financial position) Cash flow (where required) Statement of changes in equity (where

required)

Financial AnalysisThese reports will be reviewed by all the directors. Financially literate boards need to understand the financial reports and financial analysis, review them and ask pertinent questionsFinancial Analysis includes:

Horizontal - trending Vertical - common-sizing Ratio Analysis - 4 areas covered Red Flags

Horizontal analysis

Horizontal trend analysis takes a number of years of financial statements,

it uses the first year as a base, calculates the dollar difference from the

base year and converts this difference to a percentage

increase/decrease for each item for each of the years.

Vertical analysisCommon-sizing shows each item in each financial report as a percentage of a base item.

balance sheet: all balance sheet items are shown as a percentage of total assets.

income statement: all items are shown as a percentage of sales

Common sizing allows more reliable comparison of firms of different sizes because converting the numbers to percentages removes differences caused by size.

Balance sheetExample of horizontal and common-sizing analysis.

Financial Reporting HorizontalCommon Sizing

2013 2014 2014 2014 2013 2014 $ $ change % % % Cash at hand 5000 4000 (1000) -20 5 3.33Accounts Receivable 2000 2500 500 25 2 2.1Total assets 100000 120000 20000 20 100 100 

Balance sheet Horizontal trends

cash at hand has decreased between 2013 and 2014 by 20%,

accounts receivable have increased by 25%, total assets have only increased by 20%.

Our accounts receivable have increased by more than total assets.Commonsize Accounts (vertical )

cash at hand has decreased as a proportion of total assets, accounts receivable have increased.

Income statement - Horizontal Trend

Financial Reporting Horizontal Trend

2013 2014 2014 2014 $ $ change %Sales 50000 60000 10000 20Cost of sales 25000 32000 7000 28 Gross profit 25000 28000 3000 12

Operating expenses 12000 14000 2000 17 EBITDA 13000 14000 1000 7.6Depreciation & amortisation 2000 4000 2000 100EBIT 11000 10000 (1000) -9Interest 1000 2000 1000 100 EBT 10000 8000 (2000) -20Tax 500 600 100 20 Income continuing 9500 7400 (2100) -22 operaions

Income statement Note additional profit steps,

gross profit margin earnings before interest, tax, depreciation

and amortisation (EBITDA), earnings before interest and tax (EBIT) and earnings before tax, (EBT)  

Income statementHorizontal analysis

sales increased by 20% between 2013 and 2014, the gross profit increased by only 12% and the net income declined by 22%.

This tells us that costs of production have increased. As we progress down the income statement the situation deteriorates. Cost of sales increased by more than sales, our depreciation and amortisation have increased by 100%. Reasons? Either- 1.the company has had to write down the value of an asset (written down as impaired asset), or2.they have purchased more assets. If the reason is impairment then the news is not good but if it is a purchase of a new asset then the assumption should be that it will be able to generate more income in next and subsequent years.Interest has also increased by 100%. did the interest rate increase or did we borrow more?maybe to buy more plant and equipment?

Income statement - Vertical analysis

Financial Reporting Common Sizing2013 2014 2013 2014

$ $ % %Sales 50000 60000 100 100Cost of sales 25000 32000 50 53.3Gross profit25000 28000 50 46.6Operating expenses 12000 14000 24 23.3EBITDA 13000 14000 26 23.3Depreciation & amortisation 2000 4000 2000 4 6.6EBIT 11000 10000 22 16.6Interest 1000 2000 2 3.3EBT10000 8000 20 13.3Tax 500 600 1 1Income continuing 9500 7400 19 12.3operaions

Income statementCommonsize (vertical) analysis, we don’t see that sales have increased because

commonsizing uses sales as a base and this number will always be 100%,

cost of sales has increased as a percentage of sales and gross margin has declined. Directors would want to know why the gross profit margin has declined We can also see that depreciation has increased as we saw on Horizontal, we also see that interest has increased. WHY? Directors need to ask the ‘WHY’ question of management, and not stop until they are satisfied with the response.

Ratio analysis Provides a profile of a firm, to identify its economic characteristics, competitive strategies, its unique operation, and financial and investment characteristics Ratios for a single firm at a single point in time

are meaningless. Ratios for a single firm should be compared

over time, to identify trends. Ratios for a single firm should be compared with

ratios of firms operating in the same industry, either directly or by use of industry averages/benchmarks.

Ratios - limitations ratios are only a tool and not the answer, ratios identify that a relationship has changed, not why it has changed.Directors must know why!

1. should you be concerned?2. is it only a timing difference?

Ratios are affected by differences in accounting methods used by the company so care needs to be taken to use consistent information, which may limit comparisons made over time.

Comparing ratios across companiesCareful:

different textbooks use different formulas and also classify some of the ratios in different categories.

If you are comparing your company with another company or published industry ratios, directors or their delegates need to ensure that the same

formula, as well as accounting methods have been used –

if not the result will be meaningless.

Ratio analysis Generally broken down into four areas of our business,

activity analysis, measure how efficiently a company performs day-to-day tasks,

such as the collection of receivables and management of inventory. liquidity analysis.

measure the company’s ability to meet its short-term obligations. profitability analysis,

measure the company’s ability to generate profitable sales from its resources, revenues and capital

solvency analysis and growth analysis, measure a company’s ability to meet long-term obligations. Subsets of these ratios are also known as “leverage” and “long-

term debt” ratios.These areas are interrelated

6.

Analyse the financial statements by assessing the major areas:

Activity analysis Operational activity ratios include: Inventory turnover Receivables turnover Payables turnover Working capital turnover Investment activity ratios include: Fixed asset turnover Total asset turnover

Solvency analysis Debt ratios include: Debt to total capital ratio Debt to equity ratio Other ratios include: Capital expenditure ratio CFO to debt ratio Interest coverage ratios include: Time interest earned ratio Fixed charge coverage ratio Time interest earned (cash basis) ratio Fixed charge coverage (cash basis) ratio

Growth analysis Retention rate Dividend payout ratio Sustainable growth rate

Liquidity analysis Cash cycle day-counts include: Days of sales in trade receivables Days of supply in inventory Days in accounts payable Working capital ratios include: Current ratio Quick ratio Cash ratio Operational cash flow ratio Defensive interval

Profitability analysis Return on sales include: Gross margin Operating margin EBITDA margin EBIT margin Pretax margin Profit margin Return on capital ratios include: Return on assets (ROA) Return on total capital (ROTC) Return on equity (ROE)

Other factors Three-factor duPont model Five-factor duPont model Basic Earnings Per Share (EPS) Diluted Earnings Per Share (EPS) Adjustment for stock dividends and splits Weighted average number of common shares outstanding

Activity ratios Operational

Inventory turnover (COGS/average inventory) Receivables turnover (revenue/average receivables) Payables turnover (purchases/average trade payables) Working capital turnover (revenue/Average working capital)

Investment Fixed asset turnover (revenue/average net fixed assets) Total asset turnover (revenue/average total assets

The higher activity ratios are, the more efficient the firm’s operations’ - relatively fewer assets are required to maintain a given level of operations. If activity ratios decline then the cash flow statement can be used to ascertain whether income has been too aggressively recognised

What activity ratios can tell youActivity ratios describe the relationship between a firm’s level of operations and the assets needed to sustain operating activities. If the strategic plan says the company will increase sales by 20% then accounts receivable turnover tell directors how much accounts receivable have to increase by to achieve this if the relationship is stable and linear.If our receivable turnover is 15 then we require $15 of revenue per dollar of accounts receivable, or for every $1 of revenue we generate $.06cents will be on credit.Gerald I White et al, The Analysis and Use of Financial Statements, (2003,Wiley), p 119.

Analysis and use of ratiosIf the Accounts receivable turnover ratio declines from 15 to 7.6 sales on credit per dollar of sales have increased.

Director must know why - why did the ratio change? In order to answer that question it is necessary to go back to our formula. Revenue/average accounts receivable.

Analysis and use of ratiosIn year 2 the change in receivable turnover from 15 down to 7.6 could be because

both revenue and accounts receivable increased, revenue remained the same but accounts receivable

increased, or revenue declined but accounts receivable increased.

Ratios are only a tool they are not the answer, without knowing the reason you don’t know anything.3.(Sales increased by 5000 and Accounts receivable (3260-680=2580)

Liquidity ratios Liquidity analysis analyses whether the firm has sufficient

resources to meet their short term liquidity requirements. Cash cycle day-counts include (or net operating cycle)

Days of sales in trade receivables (365/receivable turnover) Days of supply in inventory (365/inventory turnover) Days in accounts payable (365/payable turnover) Cash conversion cycle (receivable + inventory – number of days of

payables) Working capital ratios include

Current ratio (current assets/current liabilities) Quick ratio (Cash+ short-term marketable

investments+receivables/CL) Cash ratio (Cash+ short-term marketable securities/CL) Operational cash flow ratio

Defensive interval (Cash + short-term marketable/daily cash expenditures)

Liquidity ratios Divide 365/activity ratios we convert activity into liquidity measures.

receivable turnover ratio of year 1: 15 - 365/15 = 24.33 days to collect receivables year 2: 7.6 - 365/7.6 = 48 days to collect receivables

Directors would need to evaluate this change.What are normal terms for collection in this industry? What does the internal operating manual specify for giving and collectingCredit.

Is normal terms 15, 30 or 45 days?If 45 days is the norm then the directors were fortunate that they had rapid collection policies in year1. However to push for payment earlier than the industry norm can push clients away. So the new result depending upon the reason, may be permanent. If the norm is 30 why have management allowed collection to slow down?

Operating cycleBy converting all the activity ratios into days outstanding ratios, directors can begin to calculate their operating cycle.

“The operating cycle is the sum of the days it takes for a firm to sell its inventory plus the number of days it takes to convert the resulting receivables into cash. The cash cycle is the number of days in the operating cycle less the number of days credit the firm obtains by deferring payment on its payables. The shorter the cycle the more efficient the firm’s operations.”

If receivables=48; inventory=24 operating cycle =24+48=72If payables outstanding= 35 Cash cycle = 24+48-35 = 37

24 days you are holding inventory48 days customers are using your money35 days you are using your suppliers money

Gerald I White et al, The Analysis and Use of Financial Statements, (2003,Wiley), p 124

Cash flow / operating cycle

http://jasoncracecpa.com/blog/2015/10/shorter-cash-flow-cycle-stronger-business/

Working capital The working capital ratios use increasingly narrow definitions of current assets divided by total current liabilities to measure the firms’ ability to meet their current liabilities. Working capital is defined as current assets less current liabilities. They are assets and liabilities that are liquid and fall due within one year.

Working capital The current ratio is the broadest working capital ratio that uses all current assets divided by all current liabilities. This ratio should have a value greater than 1, and should be between 1.5 and 3. A value less than 1 means the company does not enough liquid assets to pay its current liabilities. A value greater than 3 means they have $3 of current assets for every $1 of current liabilities. If the value is too high the company has idle funds that could be used for investment or given back to the owners – dividends.

Defensive interval Measures how many days a firm can survive given its liquid cash and obligations assuming no further inflows of cash. Defensive interval = (Cash + short-term marketable securities/daily cash expenditures)

If the defensive interval is 50 then this means the company can survive 50 days. The larger the number the more liquid the company is.

Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 329

Solvency Analysis Solvency ratios analyse the underlying

capital structure of the company to evaluate and identify any long term risks in meeting their long term obligations.

Solvency ratios are categorised as either debt or coverage ratios.

Debt ratios use balance sheet values whereas coverage ratios use income statement values.

Solvency Analysis Debt ratiosDebt-to-assets ratio (Total debt/Total assets)Debt-to-capital ratio (Total debt /Total debt+ Total shareholders’ equity) Debt-to-equity ratio (Total debt /Total shareholders’ equity)Financial leverage ratio (Average total assets/ Average total equity)Coverage ratiosInterest coverage (EBIT /Interest payments)Fixed charge coverage (EBIT+ lease payments/Interest payments + lease payments)

Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 33

Solvency - Debt ratios Measure debt relative to assets, capital or equity.

Debt to assets measures the amount of assets financed by debt. A ratio of .3 means 30% of assets are financed by debt. The higher the debt to asset ratio, the greater the debt and thus the greater the risk of insolvency The debt to capital ratio measures the debt as a proportion of debt plus shareholders equity. Debt to equity a narrower measure of solvency uses debt to shareholders equity. A higher proportion of debt relative to equity increases the riskiness of the firm.

Solvency - Debt ratios Financial leverage ratio or leverage ratio, If leverage is 4 then for every $4 of average total assets, the company has $1 of average equity.

If assets are not being funded by equity then they must be funded by debt or other liabilities, thus the higher the leverage ratio the greater the debt burden and the greater the solvency risk they face.

Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 334

Solvency - Coverage ratiosMeasure the firm’s ability to meet its interest obligations.

Interest coverage ratio (or times interest earned ratio) measures how many times EBIT can cover the interest payments. The higher the ratio the greater is the firm’s ability to meet its interest obligations. Interpretation of this ratio. Coverage may improve even if debt increases if interest rates decline temporarily (and debt is floating rate debt) or EBIT improves. However the long term solvency situation may have deteriorated. Fixed charge coverage adds lease payments, other fixed obligations to both EBIT and interest payments. The higher the ratio, the greater the ability of the company to meet its debt and fixed charge obligations.

Gerald I White et al, The Analysis and Use of Financial Statements, (2003,Wiley), p 131Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 334

Profitability Analysis Measures the return using both income statement subtotals and balance sheet aggregates. It then focuses on the growth of the company by a three-step process that results in a sustainable measure of growth.  

Profitability Analysis Return on sales include

Gross margin (Gross profit/sales)Operating margin (operating income/sales)EBIT margin (EBIT/sales)Pretax margin (EBT/sales)Profit margin (net incomes/sales)Contribution margin (sales-variable costs/sales)

Return on capital ratios includeReturn on Assets (EBIT/assest) or ((EBIT/sales)*(sales/asssest))Return on total capital (ROTC)Return on equity (ROE) 

Growth analysis ratios includeRetention rate Dividend payout ratioSustainable growth rate

Profitability ratios Measure the firm’s ability to generate profits.

The higher the profitability ratios the greater return a company is able to generate on sales and/or its capital. The measures of profitability using sales as a percentage of income statement subtotals were already discussed under common-sizing.

Profitability ratios To reiterate, gross profit margin

identifies the profit from production and identifies what remains to cover obligations

such as operational and fixed costs as well as creditors and provide a return to the owners of the company. As we progress down the profitability ratios more of this gross margin is used up until we arrive at net profit margin- revenue less all expenses (including recurring and non-recurring components).

Profitability ratios The reporting of profitability ratios using this tiered

income statement is also useful because it allows your company to compare itself to other companies at different stages.

For instance: This allows comparison even if they have significantly different amounts of plant and equipment because EBITDA ignores the impact of depreciation and amortisation as well as interest and tax.

It also facilitates the comparison with companies with significantly different debt structures because EBIT ignores interest and taxation. 

Profitability ratios The return on capital ratios use balance sheet items to assess profitability. Return on assets (ROA) measures the net return per dollar of assets.

Return on equity (ROE) is one the most quoted ratios.

It measures the return on the equity invested in the firm. If the firm cannot generate a greater return on the equity I can invest somewhere else, the company should not have my investment. By extension if they do not earn a return on retained earnings greater than that outside the firm, they should return the earnings via dividends to the owners

David Hey-Cunningham, Financial Statements Demystified, (4th Edition Allen and Unwin), p 246

ROE Directors should be aware that all ROEs are

not the same, and that a ROE that appears stable across 5 years may not be stable.

Different factors may have resulted in a similar but misleading outcome. DuPont is a measure that breaks down the ROE into a five step process to better understand why the ROE changes and identify what generates the ROE.

DuPont analysis of ROE by management provides useful information to Directors

Cash flow analysis Analysis of the cash flow statement should be done in steps.Step 1.

• Identify major sources of Cash flow • Is CFO positive?

• Evaluate sufficiency of Cash flow.• Is CFO sufficient to fund capital requirements?• Is funding of capital from CFF?

Step 2. • Examine major determinants of Cash Flow

• Indirect method shows where cash is being used• Compare Net Income with Cash Flow • How consistent are CFO

Step 3• CFI

• examine each line itemStep 4

• CFF• Examine each line item

Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 278

Cash flow ratiosOnce an understanding of the sources and determinants of cash flow are understood ratio analysis can be undertaken. The Profitability ratios look for cash flow performance while the Solvency ratios look for cash flow coverage.

Profitability ratios Cash flow to revenue (CFO/Net revenue)Cash return on assets (CFO /Average total Assets)Cash return on equity (CFO / Average shareholders’ equity) Cash to income (CFO / Operating income) Cash flow per share ((CFO – Preferred dividends)/number of shares o/s)

Cash flow to revenue identifies the CFO generated per dollar of revenue. Cash return on assets measures CFO per dollar invested in average total assets, it shows how hard or efficiently our asset are able to generate CFO. Cash return on equity measures the return per dollar of equity, for every equity dollar invested by owners generate $X of CFO. Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 288

Coverage ratio

Debt coverage (CFO/total debt)Interest coverage (CFO +Interest paid+ Taxes paid) / Interest paid)Reinvestment (CFO / Cash paid for long-term assets)Debt payment (CFO / Cash paid for long-term debt repayment)Dividend payment (CFO / Dividends paid) Investing and financing (CFO / Cash outflows for investing and financing activities)

Interest coverage (Time interest earned) (cash basis) ratioThomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 288

Coverage ratioThe coverage ratios measure the sufficiency of cash flows to meet individual requirement such as,

capital requirements in total, interest payments on debt, the ability to acquire more assets and thus growability to pay dividends.

Investing and financing ratios measure the total of these commitments -the ability to acquire assets, pay debts, and make distributions to owners. It is a tighter measure of CFO. 

Ratio analysis When reviewing financial reports and

ratios directors must know why the ratio has

changed – the numerator or the denominator

Directors must know whether the change they see is temporary or permanent. Is it due to timing issues or fundamental change in the business environment?

Directors need to know whether to take action to reverse the change in ratio.

Red flags Companies, even those that comply with IFRS have discretion over the timing and recording of:

Purchases of assetsPurchase versus lease of assetsSale or disposal of assets Recording of losses’Recording of profitsClassifying the investment in other securities as trading, available for sale or held to maturityDepreciation, rate useful life and salvage valueLeases and off balance sheet transactionsRecognition of extraordinary eventsWriting down inventoryEstimating account receivable delinquency

Red FlagsA Red flag requires the director’s attention.

The following introduces some of the red flags that directors should seek answers to if they are present in financial reporting.1.Where there is a substantial improvement in reported net income but not the same proportional improvement in cash flow from operations in the period.2. Individual final quarter adjustments that are unusually large3. Inventory or accounts receivable that are unusually high relative to sales,4. Unexpected large asset write offs.5. Significant proportion of inventory measured at net realisable value.6. Are there any intangible assets? Should they be amortised or tested for impairment?7. Are cash flow receipts from customers less than cash flow payments to suppliers8. Is the net CFO negative or less than net profit after tax?

Group activity 2

Using the attached income statement and balance sheet1. Convert both statements to a common size

statement2. Analyse the statements using vertical analysis3. Using both statements complete horizontal

analyses4. Do the required ratio calculations. What do

they tell you?5. Analyse the accounts6. Are there any red flags?