Lecture 4 - Accounting interpretation and budgeting

8/7/2019 Lecture 4 - Accounting interpretation and budgeting

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Management forManagement forInformation SystemsInformation SystemsProfessionalsProfessionalsLecture 4: Accounting Interpretation and budgeting

ScheduleSchedule

Accounting ratios

Budgeting

An overview and summary of theaccounting information system

Martin Rafferty,r af fe rm@l sbu.a c.uk 2

Accounting ratiosAccounting ratios



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Covered to dateCovered to date

So far we have looked at three principaltypes of accounting information:

Cash flow analysis

Profit and loss accounts

Balance sheets

And we have, briefly looked at ways ofinterpreting them. Next we take a closer look


Overview of balance sheet ratiosOverview of balance sheet ratios

Most of the ratios we will look at are sourcedprimarily from the balance sheet. Because;

The balance sheet gives a better picture of thewhole business at a point in time than either theprofit and loss account or the cash flow analyses;which tend to look at only one aspect of thebusiness i.e. Profit/loss and cash positionrespectively

The balance sheet gives quantities (of assets,liabilities and capital) as stocks which can be readilycompared


Classes or types of ratioClasses or types of ratio

We will look at four types analysis by ratio primarilyfrom the balance sheet;

Liquidity

Solvency

Efficiency

Profitability (Source: www.businesslink.gov.uk)

We will also look at some other ratios which areuseful to bear in mind when evaluating companyperformance



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Liquidity ratiosLiquidity ratios

Current ratio - current assets divided by currentliabilities. This assesses whether the business hassufficient assets to cover liabilities. A ratio of twoshows there are twice as many current assets ascurrent liabilities

Quick or acid-test ratio - current assets (excludingstock) divided by current liabilities. A ratio of oneshows liquidity levels are high generallyinterpreted as an indication of solid financial health

Defensive interval - liquid assets divided by dailyoperating expenses. This measures how long yourbusiness could survive without cash coming in(uses data from profit and loss, as well as balancesheet)


Solvency ratiosSolvency ratios

Gearing is a sign of solvency. It is calculated by dividingmoney borrowed by the business by capi tal i.e. the ratio ofmoney sourced from borrowing to the money the ownersput in, the equation is:

Gearing = Borrowing/Capital*

The higher the gearing, the more vulnerable the company is toincreasing interest rates.

Lenders may refuse to offer further finance or make it moreexpensive at higher gearing levels. Higher gearing = higher risk, ingeneral.

High levels of gearing in the form of leverage have been acontributory factor in the recent financial crises and were a primecause in some business failures e.g. Northern Rock plc

*Other definitions are available


Efficiency ratiosEfficiency ratios

Debtors' turnover - average of credit sales divided by the averagelevel of debtors. This shows how long it takes to collect

payments. A low ratio may mean payment terms need tighteningup (takes data from P&L account and other sources)

Creditors' turnover - average cost of sales divided by the averageamount of credit that is taken from suppliers. This shows how

long your business takes to pay suppliers. Suppliers maywithdraw credit if you regularly pay late

Stock turnover - average cost of sales divided by the averagevalue of stock. This ratio indicates how long you hold stock beforeselling. A lower stock turnover may mean lower profits due to theholding of larger than necessary inventories



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Profitability ratioProfitability ratio

Return on capital employed (ROCE)indicates how much the business isearning per invested

Divide net profit before tax by the total valueof capital employed plus long term loans tocalculate the return on the money used in thebusiness is. This can then be compared withwhat the same amount of money (loans andshares) would have earned on deposit or insome other investment (Dunn (2010), p. 9)

Martin Rafferty,r af fe rm@l sbu.a c.uk 1 0

Other ratiosOther ratios

In addition to the ratios generated and usedwithin the business or when evaluating thebusiness by stakeholders (actual or potential)there are several other useful ratios that areprimarily used when comparing businessesagainst each other

These ratios can be useful to managers whofind their business to have surplus cash flowsor other funds not required on either a shortor long term basis for investment within thebusiness


Share price related ratiosShare price related ratios

Price earnings ratio

Net asset value

Dividend

Yield

Total return



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Price earnings (P/E) ratioPrice earnings (P/E) ratio

Price earnings ratio very similar to thereturn on capital employed ratio (ROCE) butcalculated by dividing the profit earned bythe business by the number of shares in

issue which gives the earnings per share(EPS) figure. This is then compared, as aratio, to the share price. In the case of theBarratt Developments plc example this is anegative value as they made a loss in the2009 financial year


Net asset value (NAV)Net asset value (NAV)

The net asset value of a company is the total assets less the totalliabilities. As a per share figure this total value is divided by thenumber of shares in issue to give an indication of what the shareswould be worth if the company were liquidated

When a companys share price is in excess of its net asset value it is tradingat a premium to NAV

When a companys share price is below the net asset value then it is tradingat a discount to NAV

One of the ways that management can use these figures is whenlooking at merger or acquisition targets. A company that istrading at a significant discount to NAV may be a good takeover(acquisition) opportunity if the true worth of that company canthen be realised by the management e.g. by selling off the assetsor by making them more productive


DividendDividend

The dividend is the amount of money paidout to shareholders and expressed as atotal in the company accounts and, in theUK, as pence per share

In the case of Barratt Developments theydid not pay a dividend in the year to June2009 in order to conserve cash



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YieldYield

The yield is very similar to the dividend andis the dividend expressed as a percentage ofthe share price. So a 10p per share dividendgives a yield of 5% on a 2 share price

The benefit of yield is that it produces a typeof interest rate produced as cash to theshareholders which can be directly comparedto other interest bearing assets e.g. cash inthe bank.


Total returnTotal return

Total return is a way of combining the yield andthe growth in share price to produce the totaltheoretical value that an investment in theshares of that company will or has produced oversome time period

The calculation can be complicated by, forexample;

Share issues (as in the case of Barratt Developmentsshare price since September 2009)

Tax due on income or capital gains...etc


Total shareholder returnTotal shareholder returnMartin Rafferty,r af fe rm@l sbu.a c.uk 1 8

Based on this graph was/is Barratt Developments a good investment?

Source: Barratt Developments plc, Annual Report and accounts June 2009


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BudgetingBudgeting


Budgeted AccountsBudgeted Accounts

COMMERCIAL SUCCESS = SURVIVAL +PROSPERITY

For SURVIVAL We need Adequate Cash Flow (fromour cash flow analysis lecture 2)

For PROSPERITY We must earn a Worthwhile Returnon Capital Employed (profit from our P&L accountlecture 3)

We can carry out both of these tasks forfuture time periods allowing us to budget forcontinued financial success


Budgeted AccountsBudgeted Accounts

The budget is;

A statement of management policy for a finitefuture period of time.

Translates policy into actions that achieve thepolicy.

Provides a standard of comparison with resultsactually achieved.

It is not (purely) an accounting statement



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Budgeting PhilosophyBudgeting Philosophy

Budgeting provides:

Delegation and Control

For success we need:

An understanding and acceptance of principle &involvement in the process - budgeting isparticipative and interactive the humanelement is paramount


Budgeting PhilosophyBudgeting Philosophy

Budgets are tomorrow's plans:

Not history plus 10% - they reflect newconditions not the inefficiencies of the past

Budgeting focuses attention on:

Future management action and policy theefficiency and success of management


BudgetingBudgeting is...is...

The process of - planning, monitoring andcontrol for; costs, expenses, and revenue

Normally annual - broken down into weeks ormonths - but can be longer

Usually expressed financially

Purpose: Increasing efficiency of: Money,Labour, Machinery



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Benefits of BudgetingBenefits of Budgeting

Translates policy into quantified action

Encourages delegation -Clear idea of what i s expected

Facilitates internal communication and co-ordination

Provides planning and control function

Help establish standards of performance. The budget is a performanceindicator

Forward planning focuses on operating problem early enough for action

Facilitates process of change

Budgets force managers to become better administrators


Budget PitfallsBudget Pitfalls

Cannot work without effective organisation -information systems

Will not solve problems of poor managementbut may help identify these

Imposed budgets cause frustration andresentment

Should only include controllable items


Budget PitfallsBudget Pitfalls

Avoid overlap between areas

Budget plans can become - Cumbersome -meaningless - Unduly expensive.

Can become inflexible - External factors change,Internal decisions get modified

New budgets should include re-examination ofstandards

Budgets growing from precedent (past practice)usually include undesirable expenditures.



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Steps of Budgetary ControlSteps of Budgetary Control

Sort out who is responsible for what

Identify policy objectives

Construct business plan

Co-ordinate departmental budgets and assign targets

Control performance against budget

Investigate variance and take controllingaction


Control And MonitoringControl And Monitoring

Does it need to be monitored?

Exception reporting

Make it predictive and easilyunderstandable display using Graphs,Histograms etc

Make it immediate: say within- 5 Workingdays


Principles Of ControlPrinciples Of Control

Major variances are usually confined to a few areas

Concentrate on the areas of greatest influence and control

Control is most effective at the action point

Provide responsible managers with the means to

achieve effective control

Adequate data

Appropriate authority and responsibility both arerequired together to be effective



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Management ControlManagement Control

Failure of Management Control usuallycaused by:

Lack of Clear Objectives

Lack of Energetic Leadership

Lack of Financial Knowledge

Poor delegation e.g. responsibility withoutauthority


Budgeting and annual reportsBudgeting and annual reports

There is frequently some budgetary dataincluded in annual reports in the form ofamounts of money set aside for e.g. baddebts which are expected but not yetknown (set against debtors)

However it is unlikely that any detailedbudgetary information will be included inthe annual report and accounts


Why not publish budgets?Why not publish budgets?

Detailed budgets may give competitors an insightinto the company management strategy e.g. if,in the case of a house builder, more (or less)money has been set aside for the acquisition ofland than in previous years for which the figuresare known

They are budgets and therefore based on

assumptions about future performance whichcould be misleading. Budgets are managementaccounts

Companies are not required to put theinformation in the annual report



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An overview and summary of theAn overview and summary of the

accounting information systemaccounting information system


Overview of connectionsOverview of connectionsMartin Rafferty,r af fe rm@l sbu.a c.uk 3 5

Benefits of accounting informationBenefits of accounting informationsystemssystems

For past periods the data is relativelystraightforward

Data is, often, easily accessible

Because of regulatory pressure it should be

easily comparable

Decisions can be made on a quantifiable(monetary) basis



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Confounding factorsConfounding factors

Invalid assumptions

Changes in external conditions

From the market

From the regulators

Competition

Creativity or outright dishonesty inpresentation


The tutorial is in room K507_8The tutorial is in room K507_8and is composed of assessment 1aand is composed of assessment 1a

which will commence at 4pmwhich will commence at 4pm dont be latedont be late


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Lecture 4 - Accounting interpretation and budgeting

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