Next (final) week

1. 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

2. Financial Statement Analysis

3. Lecture Outline • Ratio Analysis • Advantages and limitations of ratio analysis. • Creative Accounting • Motivations for Creative Accounting. • Methods of Creative Accounting.

4. 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.

5. Types of Ratios • Leverage (Lenders) • Measures the extent to which an entity relies upon debt financing.

6. 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.

7. 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.

8. Net Profit Ratio

9. 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

10. Current Ratio

11. Leverage Ratio Debt to Equity Ratio = Total Liabilities Total Equity • Shows the financial structure of the firm. • Average on ASX: 40%

12. 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

13. Debt To Equity Ratio

14. 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).

15. Ratio Analysis - Usefulness • Quick to calculate and simple to interpret. • Brings figures down to a common scale. • Enables comparisons between entities of different size.

16. 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.

17. Limitations • Ratios are based on information which is “out-of-date”. • Changes in accounting policy may effect the analysis. • Ratios are open to manipulation.

18. Breaking the Illusion • There is no such thing as a definitive profit figure. • Profit, within reason, is whatever you want it to be!!

19. Breaking the Illusion • Determination of profit is based on subjective decisions made by the preparer: Example • Depreciation • Estimate useful life of the asset. • Estimate residual vale.

20. 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. To Deception and Fraud • Concealment of massive losses or debts.

21. 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.

22. Bonus Plan Hypothesis • If the market cannot be fooled then why do managers manipulate profit figures?? • Research suggests the following possible reasons: • Bonus Plan Hypothesis • Debt Covenant Hypothesis • Political Cost Hypothesis

23. 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.

24. 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.

25. 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??

26. 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%

27. 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.

28. 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

29. 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.