Comprehensive Study Guide for Financial Performance, Analysis, and Business Finance

Measuring Financial Performance: Income Statements and Statements of Changes in Equity

• Purpose and Importance of Measuring Financial Performance

  • The statement of profit or loss reflects the accounting return for an entity over a specific period of time.

  • The Profit Formula: $\text{Profit} = \text{Income} - \text{Expenses}$.

  • While profit maximization is a common goal, entities increasingly focus on sustainable business practices, potentially making decisions beneficial for the environment or community over pure profit.

  • Triple Bottom Line Reporting: This refers to entities articulating and reporting on governance, environmental, and social policies alongside financial performance.

• Accounting Concepts for Financial Reporting

  • The Reporting Period: The specific period to which formal statements relate. For General Purpose Financial Statements (GPFS), the convention is a yearly reporting period.

  • Accrual Accounting: A system where transactions and events are recorded in the period they occur, rather than when cash is received or paid.

  • Accounting standards require GPFS to be prepared using accrual accounting.

  • Accrued Income: Income recognized without the receipt of cash (earned but not paid).

  • Accrued Expense: Expense recognized without the payment of cash (consumed or used but not paid, e.g., wage expense).

  • Accrual Adjustment Entries: Posted at the end of each period to ensure all items are recorded correctly:

  • Liability Recognition: Income received in advance (unearned) may have been recognized as a liability, but by period's end, a portion is earned as service is provided.

  • Asset Recognition: Prepaid expenses recognized as assets may be incurred by period's end as services are received.

  • Unrecognized Items: Ensuring recognition of items like depreciation, impairment loss, bad debt expense, cost of sales, wages, and rent.

• Cash Accounting vs. Accrual Accounting

  • Cash Accounting: Performance is the difference between cash received for income items and cash paid for expenses.

  • Income Received in Advance (Deferred Revenue): Cash is received but income is not yet earned; it must be recognized as a liability.

  • Prepaid Expenses: Expenses paid in advance (e.g., insurance); recorded as an expense only when consumed or used.

• Measuring and Accounting for Non-Current Assets

  • Depreciation: The allocation of the depreciable amount $\text{(Cost or Fair Value)} - \text{Residual Value}$ over the life of the asset.

  • All assets with limited useful lives must be depreciated; Land is a notable exception.

  • On the balance sheet, assets are carried at cost (or fair value) less Accumulated Depreciation (a contra-asset account).

  • Exceptions to Revaluation:

  • Goodwill: Cannot be revalued upwards and must be tested at least annually for impairment.

  • Identifiable Intangibles: Can be revalued upwards only if an active and liquid market exists.

  • Financial Instruments: Measured at fair value.

  • Agricultural Assets: Measured at value less costs to sell.

  • Recoverable Amount: The carrying amount of non-current assets at cost must not exceed the recoverable amount.

  • The recoverable amount is the highest of: (1) Expected fair value less costs to sell, and (2) Value in Use (Present value of expected future cash flows from use and disposal).

  • Impairment Loss: Recognized immediately when the carrying amount exceeds the recoverable amount.

  • Impairment Loss Formula: $\text{Impairment Loss} = \text{Carrying Amount} - \text{Recoverable Amount}$.

• Journal Entries and Detailed Examples

  • Depreciation (Amortisation):

  • Systematic allocation of cost; does not involve cash flows.

  • Entry: Dr Depreciation Expense / Cr Accumulated Depreciation.

  • Straight-Line Formula: $\text{Annual Depreciation Expense} = \frac{\text{Cost of Asset} - \text{Expected Residual Value}}{\text{Asset's Expected Useful Life}}$.

  • Example: Equipment purchased for $\$40,000$, useful life of $4$ years, residual value of $\$8,000$. Annual depreciation = $\frac{40,000 - 8,000}{4} = \$8,000$.

  • Impairment Loss:

  • Represents a loss in asset value during a period; no cash flow involved.

  • Entry: Dr Impairment Loss / Cr Accumulated Impairment Loss.

  • Example: Equipment carrying amount is $\$32,000$ after year 1. Value in use is $\$30,000$, net selling price is $\$28,000$. Recoverable amount is $\$30,000$. Impairment loss = $\$32,000 - \$30,000 = \$2,000$.

  • Bad Debt Expense:

  • Accounts receivable that become uncollectable or are doubtful at period's end.

  • Entry (Unrecognized as doubtful): Dr Bad Debt Expense / Cr Accounts Receivable.

  • Entry (Doubtful Estimate): Dr Bad Debt Expense / Cr Allowance for Doubtful Debt (Contra-asset).

  • Example: Accounts receivable $\$35,000$ on June 1. Realized $\$1,000$ is uncollectable. June 30 estimate of $\$2,000$ doubtful. July 1 realized $\$500$ of the $\$2,000$ won't be collected.

  • Cost of Sales (COGS):

  • Formula: $\text{Cost of Sales} = \text{Inventory at beginning} + \text{Purchases} - \text{Inventory at end}$.

  • Gross Profit: $\text{Sales Revenue} - \text{COGS}$.

  • Example: Inventory July 1: $\$15,000$; Purchases: $\$10,000$; Final Stocktake: $\$2,000$. COGS = $\$15,000 + \$10,000 - \$2,000 = \$23,000$. With $\$30,000$ sales, Gross Profit = $\$7,000$.

  • Gain/Loss on Sale of Non-Current Assets:

  • Formula: $\text{Gain/Loss} = \text{Proceeds on Sale} - \text{Carrying Amount}$.

  • Example: Equipment purchased July 1, 2017 for $\$20,000$, 5-year life, no residual value. Sold Jan 1, 2019 for $\$19,000$. Accumulated depreciation at sale: $\frac{20,000 - 0}{5} \times 1.5 = \$6,000$. Carrying amount = $\$14,000$. Gain = $\$19,000 - \$14,000 = \$5,000$.

• Accounting Policies and Statement Formats

  • Quality of Earnings: Managers may use accounting discretion (Earnings Management) to portray desired profit levels, impacting contractual agreements and valuations.

  • Policy Choices: Depreciation method, inventory costing, asset valuation methods.

  • Accounting Estimates: Useful life, residual value, impairment, allowance for doubtful debts.

  • Statement of Profit or Loss: Must present revenue, cost of sales, financial costs, share of associate profits, tax expenses, and profit/loss from continuing/discontinuing operations.

  • Statement of Comprehensive Income: Includes all equity changes during a period except those from transactions with owners (e.g., dividends). It can be one statement or two.

  • Statement of Changes in Equity: Details equity changes from start to end of period, including profit, other comprehensive income, share issues/buy-backs, and dividends.

  • Closing Entries: Revenue/Expense accounts are closed to the Profit or Loss Summary account, with net profit/loss transferred to Retained Earnings.

Analysis and Interpretation of Financial Statements

• Nature and Purpose of Analysis

  • Assessing future financial health via past performance for valuation, debt repayment ability, going concern status, and competitive analysis.

  • Comparisons are essential: Against previous years, other figures in the same statement, and industry averages/competitors.

  • Tools: Reading strategies, management statements, ASX news releases, and industry context.

• Analytical Methods

  • Horizontal Analysis: Compares numbers across reporting periods to highlight change magnitude.

  • Dollar Change: $\text{Current Number} - \text{Previous Number}$.

  • Percentage Change: $\frac{\text{Current} - \text{Previous}}{\text{Previous}} \times 100$.

  • Trend Analysis: Predictive tool expressing items relative to a base year ($\text{Index} = 100$).

  • Vertical Analysis: Comparing items within the same statement (Common Size Statements). Revenue/Expenses expressed as % of Sales; Assets/Liabilities as % of Total Assets.

  • Ratio Analysis: Dividing one item by another to create a relationship. Comparison benchmarks include arbitrary rules of thumb, time series, intra-industry, industry norms, and inter-industry.

• Key Financial Ratios

  • Profitability Ratios:

  • Return on Equity (ROE): $\frac{\text{Profit to Owners}}{\text{Average Equity}} \times 100$.

  • Return on Assets (ROA): $\frac{\text{Profit (Loss)}}{\text{Average Total Assets}} \times 100$.

  • Gross Profit Margin: $\frac{\text{Gross Profit}}{\text{Sales Revenue}} \times 100$.

  • Profit Margin: $\frac{\text{Profit (Loss)}}{\text{Sales Revenue}} \times 100$.

  • Asset Efficiency Ratios:

  • Asset Turnover: $\frac{\text{Sales Revenue}}{\text{Average Total Assets}}$ ($\text{times}$).

  • Days Inventory: $\frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365$ ($\text{days}$).

  • Days Debtors: $\frac{\text{Average Trade Debtors}}{\text{Sales Revenue}} \times 365$ ($\text{days}$).

  • Operating (Activity) Cycle: Sum of Days Inventory and Days Debtors.

  • Cash Cycle: Time between paying for inventory and receiving cash from sales.

  • Liquidity Ratios:

  • Current Ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$ ($\text{times}$).

  • Quick Ratio: $\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$ ($\text{times}$).

  • Cash Flow Ratio: $\frac{\text{Net Operating Cash Flows}}{\text{Current Liabilities}}$ ($\text{times}$).

  • Capital Structure and Servicing Ratios:

  • Debt to Equity: $\frac{\text{Total Liabilities}}{\text{Total Equity}} \times 100$.

  • Debt Ratio: $\frac{\text{Total Liabilities}}{\text{Total Assets}} \times 100$.

  • Equity Ratio: $\frac{\text{Total Equity}}{\text{Total Assets}} \times 100$.

  • Interest Coverage (Times Interest Earned): $\frac{\text{EBIT}}{\text{Net Finance Costs}}$ ($\text{times}$).

  • Debt Coverage Ratio: $\frac{\text{Non-Current Liabilities}}{\text{Net Operating Cash Flows}}$ ($\text{times}$).

  • Market Performance Ratios:

  • Earnings Per Share (EPS): $\frac{\text{Profit to Ordinary Shareholders}}{\text{Weighted Number of Ordinary Shares On Issue}}$.

  • Operating Cash Flow Per Share: $\frac{\text{Net Operating Cash Flow} - \text{Preference Dividends}}{\text{Weighted Number of Ordinary Shares On Issue}}$.

  • Dividends Per Share: $\frac{\text{Dividends Paid/Provided to Ordinary Shareholders}}{\text{Weighted Number of Ordinary Shares On Issue}}$.

• Limitations of Ratio Analysis

  • Changes in company structure across time.

  • Differing accounting methods between companies.

  • Different industry norms.

  • Need for non-financial information (e.g., environmental performance) for context.

Cash Flow Statements

• Definitions and Importance

  • Statement of Cash Flows (SCF): Reports cash inflows and outflows for a specific period.

  • Cash: Notes/coins and deposits at call.

  • Cash Equivalents: Highly liquid short-term investments (maturity $\le 3$ months) with minimal risk of value change; includes bank overdrafts.

  • Cash is essential for settling claims, meeting expenses, buying assets, and paying dividends. Business failure is often caused by cash shortages despite accounting profit.

• Purpose and Linkages

  • Ascertains cash generation and payment promptness. Prepared on a cash basis.

  • Reconciles movement in cash balance from opening to closing.

  • Explains the difference between net profit and net cash from operations.

• Classification of Cash Flows

  1. Operating Activities: Principal revenue-producing activities (Receipts from customers, payments to suppliers/employees, interest/tax).

  2. Investing Activities: Acquisition/disposal of long-term assets (PP&E, securities loans).

  3. Financing Activities: Changes in financial structure size/composition (debt borrowing/repayment, share issues/buy-backs, dividends).

• Preparation Methods

  • Direct Method: Reports major classes of gross cash receipts and payments using income statements and consecutive balance sheets.

  • Indirect Method: Reconciles operating profit to net cash by adjusting for non-cash items and accrual deferrals.

  • Adjustments: Increase in Current Asset ($-$), Decrease in Current Asset ($+$), Increase in Current Liability ($+$), Decrease in Current Liability ($-$).

• Advanced Cash Flow Analysis

  • Cash Adequacy Ratio: $\frac{\text{Cash from Operating Activities}}{\text{Capital Expenditure} + \text{Dividends Paid}}$.

  • Cash Flow to Sales Ratio: $\frac{\text{Cash from Operating Activities}}{\text{Net Sales}}$.

  • Free Cash Flow: $\text{Operating Cash Flow} - \text{Capital Investments for PPE to Maintain Operations}$.

Planning and Budgeting

• Strategic Planning vs. Budgeting

  • Strategic Planning: Long-term ($3-5$ years), senior management level, focuses on expansion, takeovers, and major development.

  • Budgets: Short-term (typically $1$ year), quantitative expression of plans, operationalizes strategic objectives.

• The Budgeting Process

  1. Consideration of past performance.

  2. Assessment of expected trading/operating conditions.

  3. Preparation of initial estimates.

  4. Feedback and adjustment from unit managers.

  5. Preparation of budgeted reports and sub-budgets.

  6. Monitoring actual performance against budget.

  7. Making adjustments during the period.

• Types of Budgets

  • Sales/Fees Budget: Sets expected activity levels.

  • Operating (Expenses) Budget: Departmental focus.

  • Production/Inventory Budget: Direct materials, labour, and overheads.

  • Purchases Budget: Inventory requirements based on sales.

  • Cash Budget: Expected future receipts and payments (ideally monthly).

  • Capital Budget: Long-term investment expenditure.

  • Program Budget: Focused on specific government/non-profit programs.

  • Master Budget: Set of interrelated operating and financial budgets.

• Variance Analysis

  • Variance: Difference between actual and budgeted results.

  • Favourable: Actual revenue > budget OR actual costs < budget.

  • Unfavourable: Actual revenue < budget OR actual costs > budget.

• Behavioural Aspects

  • Authoritarian Style: Top-down, targets set by senior management without unit manager input; can lead to unrealistic expectations.

  • Participative Style: Collaboration; can increase ownership but may result in targets being set too low.

  • Motivation: Targets should be challenging but attainable.

CVP Analysis, Cost Behaviour, and Relevant Costing

• Cost Behaviour Classification

  • Fixed Costs: Total stays same regardless of volume (e.g., rent, salaries). Per unit, fixed costs decrease as volume increases.

  • Variable Costs: Vary in total with volume; often linear (e.g., raw ingredients, fuel).

  • Mixed (Semi-Variable) Costs: Contain both fixed and variable components (e.g., electricity, mobile bills).

  • Stepped Costs: Fixed over a range but increase in discrete steps to allow higher output.

• Break-Even Point (BEP) Analysis

  • BEP occurs when $\text{Total Revenue} = \text{Total Costs}$.

  • Contribution Margin ($CM$): $\text{Revenue Per Unit} - \text{Variable Cost Per Unit}$.

  • Unit BEP Formula: $\text{BEP (Units)} = \frac{\text{Fixed Costs}}{\text{Contribution Margin Per Unit}}$.

  • Sales BEP Formula: $\text{BEP (\$)} = \frac{\text{Fixed Costs}}{\text{CM Ratio}}$ where $\text{CM Ratio} = \frac{\text{CM Per Unit}}{\text{Selling Price Per Unit}}$.

  • Target Profit Formula: $\text{Units Required} = \frac{\text{Fixed Costs} + \text{Desired Profit}}{\text{CM Per Unit}}$.

  • Margin of Safety: Difference between break-even volume and actual output.

• Operating Gearing (Leverage)

  • High proportion of fixed costs relative to variable costs indicates high operating gearing.

  • More risky because profit fluctuates significantly with small changes in sales.

• Relevant Information for Decision Making

  • Relevant Costs/Income: Differ among alternatives; must be future-oriented.

  • Incremental Costs/Income: Additional amounts resulting from a choice.

  • Opportunity Cost: Benefits forgone by selecting the next best alternative.

  • Avoidable vs. Unavoidable Costs: Avoidable costs are relevant to outsourcing decisions; unavoidable costs are irrelevant.

• Specific Decision Scenarios

  • Special Orders: One-time offers. Accept if \text{Incremental Revenue} > \text{Incremental Costs}. Consider Spare Capacity (amount of capacity available to increase output).

  • Example: Laptop cost $\$1,620$ (VC), Price $\$2,400$. UniThink offers $\$1,800$ for $500$ units. If capacity exists, incremental profit is $(\$1,800 - \$1,620) \times 500 = \$90,000$. Accept.

  • Make or Buy: Compare avoidable internal costs to external purchase price.

  • Scarce Resources: If machines/labour are limited, maximize the contribution margin per unit of the constrained resource.

Capital Investment

• Nature of Investment Decisions

  • Large resource amounts, long timeframes, huge cash outlays, difficult to reverse.

  • Uncertainty: Unmeasurable variation. Risk: Measurable variation.

• Appraisal Methods

  1. Accounting Rate of Return (ARR): $\frac{\text{Average Profit}}{\text{Average Investment}}$. Simple but ignores time value of money (TVM) and cash importance.

  2. Payback Period (PP): Time to recoup initial outlay. Ignores cash flows after payback and TVM.

  3. Net Present Value (NPV): Sum of PVs of inflows minus PV of outflows.

  • Formula: $PV = \frac{FV}{(1+r)^n}$.

  • Decision Rule: Accept if NPV > 0.

  • Discount Rate Factors: Inflation, Risk, Opportunity Cost.

  1. Internal Rate of Return (IRR): The rate where $NPV = 0$. Accept if IRR > \text{Required Rate of Return}. May conflict with NPV for project ranking.

Financing the Business

• Net Working Capital Management

  • $\text{Net Working Capital} = \text{Current Assets} - \text{Current Liabilities}$.

  • Hedging Principle: Matching funding maturity with cash flow use.

  • Permanent Assets: Financed by permanent (>1 year) and spontaneous (unplanned) sources.

  • Temporary Assets: Financed by temporary sources.

• Managing Liquidity Components

  • Cash: Trade-off between risk (insolvency) and return (opportunity cost of holding cash).

  • Accounts Receivable: Balancing increased sales vs. costs of bad debts and administration.

  • Average Collection Period (ACP): Increasing ACP indicates lenient credit or inefficient collections.

  • Inventory: Balancing profit from sales vs. storage/theft/obsolescence costs.

  • Just in Time (JIT): Reducing funds tied up by ordering only when needed.

• Sources of Finance

  • Short-Term: Trade credit, overdrafts, Bank Accepted Bills (BABs), Promissory Notes (PNs), Factoring (selling debtors), and Floor Plan Finance.

  • Long-Term Debt: Fixed/Variable-rate loans, Leases (Novated, Finance, Operating), Hire-purchase, Corporate Bonds (unsecured), and Debentures (secured).

  • Equity:

  • Ordinary Shares: Dividends, no fixed maturity, ranked last in winding up.

  • Preference Shares: Hybrid, fixed dividends, no voting rights, ranked ahead of ordinary shares.

  • Rights Issue: New shares for existing owners (Renounceable or Non-renounceable).

  • Hybrids: Convertible Notes (debt converting to equity) and Convertible Preference Shares.

  • International: Direct Equity Investment (significant influence) vs. Portfolio Investment (no control).