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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
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Financial Statement Analysis
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Lecture Outline
Ratio Analysis Advantages and limitations of ratio
analysis. Creative Accounting Motivations for Creative Accounting. Methods of Creative Accounting.
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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.
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Types of Ratios
Leverage (Lenders)– Measures the extent to which an entity
relies upon debt financing.
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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.
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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.
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Net Profit Ratio
Company Net Profit Ratio
Woolworths/Foodland 2.1%
Telstra 18.1%
QANTAS 3.8%
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Liquidity Ratio
Current Ratio = Current AssetsCurrent 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
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Current Ratio
Company Current Ratio
Woolworths 0.84
Telstra 0.77
Rio Tinto 1.08
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Leverage Ratio
Debt to Equity Ratio =Total Liabilities
Total Equity
Shows the financial structure of the firm. Average on ASX: 40%
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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
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Debt To Equity Ratio
Company Debt to Equity
Woolworths 29%
Telstra 97%
Rio Tinto 81%
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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).
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Ratio Analysis - Usefulness
Quick to calculate and simple to interpret.
Brings figures down to a common scale.– Enables comparisons between entities of
different size.
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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.
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Limitations
Ratios are based on information which is “out-of-date”.
Changes in accounting policy may effect the analysis.
Ratios are open to manipulation.
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Breaking the Illusion
There is no such thing as a definitive profit figure.
Profit, within reason, is whatever you want it to be!!
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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.
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Creative AccountingDefined 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.
ToDeception and Fraud
• Concealment of massive losses or debts.
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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.
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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 Hypothesis2.Debt Covenant Hypothesis3.Political Cost Hypothesis
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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.
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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.
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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??
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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%
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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.
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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
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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.