Managing Financial and Human Resources

1 HR 7003-Managing Financial and Human Resources for Sustainable Business Success

Topic Overview 10: Financial Performance

Contents:

1. Introduction

2. Income statement

3. Analysis and interpretation of the annual report

4. Profitability analysis

5. Solidity and solvency

6. Liquidity

By the end of this week, you will be able to:

• Understand what the main components of the Income statement are

• Analyze the information provided in the Annual Reports

• Perform ratio analysis

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1. Introduction

As we have discussed in week 1, the companies have assets that are used to produce profits, which

is the target. The purpose of all corporations (excluding the non-profit organizations and

corporations) is to generate profits, while in the cases where that can not be achieved and there is

no profitability, there is neither reason for existence.

The companies operate to have income/revenue/sales higher than their costs. In the current week

we will discuss how the performance of a company is measured how that information, combined

with the previous week’s topic could be combined by the stakeholders in the process of decision

making.

Horngren et al. (2002) introduces the discussion of income measuring by discussing the two most

popular method:

• Accrual basis: The impact of transactions is recognized in the financial statements in the

accounting period that the revenues and costs have occurred.

• Cash basis: The revenues and costs are recognized when the company receives or pays

cash.

In addition it is highlighted that for the recognition of revenues, two criteria must be met:

✓ The revenues must be earned: That is when the goods or services are delivered.

✓ The revenues must be realized: Cash are received or other claims to cash are received in

exchange for the goods or services delivered.

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2. Income statement

Before going to the Income Statement discussion the following relationship should be

understanded:

Assets = Liabilities + Equity

Assets = Liabilities + Paid Capital + Retained Earnings

Assets = Liabilities + Paid Capital + Cumulative Revenues – Cumulative Expenses

The difference between Revenues and Expenses are the amount for which the shareholders wealth

will increase! The income statement summarizes the results of a firm’s operations for a period of

time, which is simply the difference mentioned above – the profit.

Horngren et al. (2002) use the following simple example to introduce how the income statement

works:

Sales 160,000

Expenses

Cost of goods sold 100,000

Rent 2,000

Depreciation 100

Total expenses (102,100)

Net Income 57,900

As it is obvious, the above simple example uses only 3 types of expenses:

• Cost of goods sold

• Rent

• Depreciation

The purpose of the above example is to understand how that statement works and how to relate

that information with the information coming from the statement of financial position, in order to

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be able to analyze the financial performance of a company. The purpose is not to prepare that

statement, that is an accounting activity, useful, but not in the aims of the current week’s material.

A more complicated example follows , where several other expenses are used:

• Selling, general and administrative expenses

• Interest expense

• Provision for income taxes

In addition, the steps for arriving from Sales (Revenues) to the final Net Income are presented.

Example: The Income Statement of Altron for the year ended January 3, 1998

Altron Incorporated

Income Statement

For the Year Ended January 3, 1998

Net sales $ 172,428

Cost of sales (134,373)

Gross profit 38,055

Selling, general and administrative expenses (14,844)

Income from operations 23,211

Other income 1,503

Interest expense (31)

Income before provision for income taxes 24,683

Provision for income taxes (10,016)

Net income 14,667

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The above graph, extracted from Mongiello (2009) represents very well the relationship between

the income statement’s outcome (PROFT/LOSS) and the balance sheet. It can be observed as the

allocation of the wealth, originated by the operating and financial income, to the company’s

shareholders. The providers of equity capital are compensated for their investment to buy the

firm’s stock.

The below, is a graphical representation of Mongiello (2009), which describes how the wealth

produced in the financial year by the company, is allocated to the several stakeholders:

o Employees

o Consultants

o Lenders

o Government

o Shareholders

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In addition, we can see how the company has been funded by its suppliers of money:

o Clients-Consumers

o Borrowers

o Shareholders (not presented here, but the do provide money by purchasing capital)

3. Analysis and interpretation of the annual report

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Mongiello (2009) explains that there both positive and negative aspects regarding the increased

volume of information available for the investors. As more information can be extracted from the

financial statements, which can ease the insight in the performance and situation of the entity, the

risk and uncertainty regarding a company’s performance are minimized. However, the very nature

of this information, incentives and gives the option to the management team to steer the attention

of the information users to specific results and figures. That could result in biased conclusions and

judgements regarding how the firm has performed and which is its financial condition. An example

of that according to Mongiello (2009) is the when an increase in turnover is highlighted, whilst its

negative effects on the profitability are not mentioned.

Ratio analysis

Alexander and Nobes (2004) explains that a number, in isolation, is not a very helpful piece of

information. For example, ‘sales last year were 20 million Norwegian krone’; what information

does this give? Without knowledge of the exchange rate between the home currency and

Norwegian krone, no comparison with home sales is possible. Without knowledge of the size of

the Norwegian market for the products concerned, and without knowledge of the structure of that

market in terms of size and number of competitors, no comparison with the general situation in

Norway is possible. Without knowledge of sales figures for earlier years, and of the assets available

and the expenses consumed to create those sales, no appraisal of progress, effectiveness or

efficiency is possible.

Comparison is the key. A ratio is potentially a very powerful tool, but it is also a very simple one.

A ratio is one number divided by another. If the total Norwegian market for the product is 400

million Norwegian krone, then the ratio of sales by the company mentioned above to its total home

market is 20 : 400 (or 1 : 20 or 5 per cent).”

For the rest of the current week’s material, the ratios discussed by Mongiello (2009) will be

analyzed in order to prepare you understand how the Financial Performance Analysis is performed.

Lee et al. report evidence that managers of Korean firms use almost all income statement variables

to influence earnings numbers (i.e. revenues and selling, general & administrative expenses to

report small positive earnings from operations) verifying the importance of income statement in

the decision making process of financial information’s users.

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4. Profitability analysis

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As we have already discussed, making profits is the key target of companies, to be profitable and

maximize the wealth of the owners in the medium and long term. We use the profitability ratios to

investigate if that aim has been achieved, from the owners’ point of view. The return for their

investment is calculated by dividing the net profit by the equity.

ROE = net profit / equity.

A more detailed aspect of the profitability of the entity explores the amount of wealth that the

entity has created by using the resources made available for its operations. equity and long-term

liabilities are the capital employed by the company to produce profits, through the use of the assets

purchased.

Hence, the formula for capital employed is:

Capital employed = equity + long term liabilities

Seen from a different point of view (refer to the accounting equation explained in chapter 3), this

formula is also:

Capital employed = total assets – current liabilities

Hence the formula for Return on Capital Employed is:

ROCE = operating profit / capital employed.

Whether you decide to use operating profit including exceptional events or you prefer to stick with

the underline performance, i.e. the performance that does not consider the exceptional events and

the discontinued activities, depends on the aim of your analysis; are you investigating the

performance of a specific period of time, or are you trying to understand the potential of the entity

in its core operations?

Formally, this is done by calculating respectively Return on Sales and Asset TurnOver:

ROS = operating profit / sales

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ATO = sales / capital employed

The obvious relationship ROS X ATO = ROCE is quite meaningful.

Mongiello (2009) explains that the profitability of the main operations is achieved through the

combination of the pace of the turnover of the capital and margins.

The interpretation of the ratios above depends on the nature of a company’s operations and

strategy. If it aims to sell at low prices and high volume, this analysis is expected to result in high

ATO and low ROS. However, the per unit margin of the product is minimized.

5. Solidity and solvency

The relationship between long term liabilities and equity is called Gearing and is measured by the

following formula:

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Gearing = long term liabilities / equity

It can be argued that the higher the gearing, the better it is for the shareholder due to the multiplier

effect on the profitability. However, in the determination of the capital structure, the companies

cannot ignore the fact that the high gearing increases the risk of the entity, as there is a commitment

to higher debt, both principal and interest. The best balance must be found in terms of the optimal

capital structure, while the literature of that specific topic is very long with both positive and

negative empirical evidence.

In the above decision, the average gearing of the competitors and the average in the industry must

be taken into consideration. However, a key indicator could also be the ratio called ‘interest cover’.

It shows how many times the operating profit is larger than the interest, which is the cost of

financing the entity. It is calculated by the following formula:

Interest cover = operating profit / finance costs

The ‘net finance cost’, i.e. finance cost after deducting finance income or the ‘finance cost’ could

be used in the above ratio. That depends on the nature of the firm as whether the finance income

is integral part of the normal financing activity of the entity or derives from an exceptional event.

6. Liquidity

Another effect of the combination of profitability, gearing and management of cash flows is the

status of the entity’s liquidity, which describes whether a company has enough current assets to

meet its current liabilities.

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The decision whether an entity is assumed liquid or illiquid can be attempted by using several

ratios: current and quick ratios, which compare the amount of current assets to the amount of

current liabilities. In addition the debtors’, creditors’ and inventory’s days, which measure the

average time it takes for the cash flows to enter or leave the entity.

The formulae are as follows:

Current ratio = current assets / current liabilities

Quick ratio = (current assets – inventory) / current liabilities

Debtors’ days = (trade debtors / sales) X 365

Creditors’ days = (trade creditors / purchases) X 365

Inventory’s days = (inventory / cost of sales) X 365

There are several inconsistencies and limitations in the ratios mentioned above. Mongiello (2009)

lists the following:

(i) they refer to trade creditors and debtors, whilst we are interested in the whole of the

cash flows, but this makes the results more reliable and meaningful;

(ii) purchases are normally not given in the account, hence they must be constructed

starting from cost of sales and adjusting for amortization, depreciation and variation of

inventories;

(iii) they should refer to more representative values of the debtors, creditors and inventory

than the closing ones, e.g. annual averages.

The following Mongiello’s (2009) figure presents graphically the relationship between the

debtors’, creditors’ and inventory’s days, and the stages from purchase to monetary cycle.

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To conclude and summarize all the material covered during the Topic Overview 2, you need to

check and study the extra material uploaded in the VLE “Exercises on Ratios”.

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References

Alexander, D., & Nobes, C., 2004. Financial accounting: an international introduction. Pearson

Education.

Alexander, J., 2018. Financial planning & analysis and performance management. John Wiley &

Sons.

Lee, B.B., Shin, H., Vetter, W. and Kim, D.W., 2017. Management of income statement variables

to report small positive earnings numbers. Asian Review of Accounting, 25(1), pp. 58-84.

Mongiello, M., 2009. International Financial Reporting. BookBoon.