BACHELOR OF COMMERCE IN ACCOUNTING

MANAGEMENT ACCOUNTING FOR DECISION-MAKING

❑ SCOPE OF MANAGEMENT ACCOUNTING & FINANCE 3A

The MAF3A
FURTHER ASPECTS IN BUDGETING
module comprises
THE INVESTMENT DECISION 5 learning units
MANAGEMENT OF WORKING CAPITAL
ANALYSIS & INTERPRETATION OF FINANCIAL STATEMENTS
MANAGEMENT ACCOUNTING IN THE MODERN BUSINESS ENVIRONMENT
❑ RECAP OF PREVIOUS PRESENTATION
▪ The rise of 4IR: MI, AI, Robotics and the disruptions in operations.

▪ Value chain analysis: for improved organisational performance

▪ Material requirements planning (MRP-I), Manufacturing resource planning (MRP-II) and

Enterprise resource planning (ERP)

▪ Total quality management (TQM) and cost of quality

▪ Life cycle costing and product life cycle phases

▪ Business process re-engineering and contrasted it against TQM

▪ Benchmarking as an improvement tool.

❑ MANAGEMENT ACCOUNTING & FINANCE 3A LEVEL OUTCOMES
On successful completion of the module, you should be able to:

Outline the nature and Recognise the importance Prepare and analyse
purpose of a number of of the management of forecast statements/budgets
recent developments in working capital in a
management accounting business context
practice 2

1 3 5

Analyse financial statements Apply capital investment

and reports appraisal techniques for the
implementation of business
decisions
 UNIT 2:

ANALYSIS & INTERPRETATION OF FINANCIAL

STATEMENTS
❑ UNIT 2 LEVEL OUTCOMES
On successful completion of unit 2 of the module, you should be able to:

Develop annual financial statements and integrated reports

Discuss objectives and users of FSs analyses & Understand the limitations of accounting data

Apply techniques used in FSs analysis & Explain ratio analysis and how it is used to evaluate the
financial performance of a firm.
Execute and interpret Economic Value Added

Discuss business failure prediction models & Understand limitations of ratio analysis
❑ RECAP OF PREVIOUS PRESENTATION
▪ An explanation of the role played by value chain analysis in adding value to
an entity
▪ The roles that MRP-I, MRP-II, and ERP play in creating and enhancing
competitive advantage
▪ Total quality Management: An evaluation of all the aspects of an organization
that contribute to the production and delivery of a top-quality product or
service.
▪ Target costing and Life cycle costing of products and the implications for
product profitability
▪ Business Process Re-engineering (BPR), the fundamental elements that
make up BPR
▪ Benchmarking
▪ Examples
❑ TODAY’S PRESENTATION
▪ Introduction to the Analysis & Interpretation of FSs
▪ Developing annual financial statements and integrated reports;
▪ Objectives and users of FSs analyses;
▪ The limitations of accounting data;
▪ Interpretation of financial statements;
▪ Application of techniques used in FSs analysis;
▪ Accounting ratios: profitability, liquidity, efficiency, capital structure & investor;
▪ Utilizing ratio analysis to critically appraise a firm’s published FSs;
▪ Executing and interpreting Economic Value Added (EVA);
▪ ALTMAN’s business failure prediction model;
▪ Explain the limitations of ratio analysis;
▪ Practical examples;
▪ Summary
❑ INTRODUCTION TO FINANCIAL STATEMENTS ANALYSIS
▪ The analysis of an org’s FSs is almost as important as the preparation & presentation of
the FSs.

▪ Stakeholders: management, shareholders, prospective investors, financial institutions

and creditors, amongst others.

▪ Stakeholders are interested in the financial performance, the cash flow status and the
financial position of the organisation.

▪ The analysis of a firm’s FSs: 1 of the tools used to assess a firm’s financial
performance and financial position.

▪ The analysis of a firm’s FSs serves to identify areas where the organisation is excelling,
and areas where the organisation could do with some improvement (Skae 2017:275).
❑ ANNUAL FINANCIAL STATEMENTS & INTEGRATED REPORTS
▪ It is customary for the directors of a company to present comprehensive FSs to the
shareholders of said company at the company’s financial year-end, usually at the
company’s Annual General Meeting (AGM) (Correia 2019:5-3).

▪ FSs are supposed to present an objective, honest and complete representation of the
company’s operations for the past financial year, all in conformity with the International
Financial Reporting Standards (Skae 2017:275).

▪ All entities that subscribe to IFRSs are required to present 5 FSs that make up the ‘set
of annual financial statements’:
❑ ANNUAL FINANCIAL STATEMENTS & INTEGRATED REPORTS
▪ All entities that subscribe to IFRSs are required to present 5 FSs that make up the ‘set
of annual financial statements’:
✓ The statement of financial position (SOFP): financial position at a point in time
✓ The statement of comprehensive income (SOCI): financial performance
✓ The statement of changes in equity (SOCIE): changes in owner’s equity
✓ The statement of c ash flows (SOCF): movement of C&CEs
✓ The notes to the FSs comprising a summary of the significant accounting policies and
other explanatory information.
▪ The set of FSs listed above is not able to give a true picture of the business on its own.
▪ The FSs require indepth analysis & interpretation to unearth the true state of affairs and
reflection of the business.
▪ The type & extent of the analysis performed depends on the user, the user’s specific
needs & the information available to the user.
❑ PRIMARY USERS OF FINANCIAL STATEMENTS
▪ The objectives of FSA primarily dependent on the interests of the user of the FSs (Skae
et al., 2017:279):
▪ Shareholders: safety of their investment; profitability ratio: ROE, DPS; Leverage
▪ Creditors/Lenders: firms’ liquidity and solvency: the higher the liquidity, the higher the
ability of the firm to meet its obligations and vice versa.
▪ Management: whether annual targets have been met and what corrective actions might
be necessary. Profitability ratios are key.
▪ Employees/Unions: Job security and whether the earnings are high enough for
increased salaries and other benefits.
▪ Auditors: whether the FSs are a fair and unbiased representation of the entity, and that
they have been prepared in compliance with relevant International Financial Reporting
Standards (IFRS) and IAS statutes.
▪ Tax Authority (SARS): the tax payable by the firm
▪ User groups almost always use general purpose financial reports but their needs differ.
❑ ANALYSIS OF FINANCIAL STATEMENTS IN PRACTICE
▪ FSA is used to understand the current financial position of a company and its prospects
for the future (extrapolation).
▪ Finance professionals need to use their judgement and experience when they interpret
the results of financial statement analysis.
▪ It is not merely about calculating ratios and applying rules of thumb.
▪ The interpretation process is assisted by adopting an analytical framework, with the
following main components:
o identification of the user of the analysis
o understanding the nature of the business, industry and organisation
o identification of relevant sources of data for analysis
o numerical analysis of available data
o interpretation of the results of the analysis
o appreciating the limitations of the data and analysis
o communicating and reporting the analysis of the results and recommendations. Source:
❑ LIMITATIONS OF ACCOUNTING DATA
▪ FSA is only as reliable as the accounting data that forms the basis for these analyses. Therefore, if the
accounting data are erroneous, incomplete or biased, then the results of the FSA will be unreliable.

▪ Some of these limitations of accounting data as discussed by Correia (2019:5-12):

o Monetary expression: FSs contain purely historically financial information. Ratio analysis does not
take into consideration items which are of significant value to the org, but do not have a financial value.
o Simplification and summarization: Business transactions are complex in nature: amplified by
globalisation & technological advancements. Unfortunately, FSs, a simplified and summarized thus
dismissing the complexity and ambiguity of the operating environment.
o Flexible accounting policies: FSs are prepared in strict compliance with international accounting
standards and accounting policies. However, accounting policies differ.
o Inflation: The effect of inflation is not captured in FSs. Profits can easily be overstated, while losses are
understated.
o Market forces: FSs do not show the future market conditions to which the firm will be exposed. The
impact on the market share of the firm is uncertain.
❑ UNDERSTANDING THE BUSINESS AND INDUSTRY
▪ In order to interpret the calculations, it is important to understand the relationship
between the data and the underlying economics (and other reasons) for the company’s
current position.

▪ For example, the history, operating characteristics, management composition and

attitude to risks of the business will help to explain its current position and future
outlook.

▪ Comparisons of the results of the analysis against the industry can be very useful.

▪ Therefore, it is important to identify industry characteristics and to establish

benchmarks against which to compare position and performance.
❑ IDENTIFICATION OF DATA SOURCES FOR ANALYSIS
▪ A company’s annual report: The main source of financial and non-financial
information.
▪ The annual report provides:
o information that is required by law and by accounting standards.
o further voluntary disclosures that may be helpful.
▪ Other sources of information for analysis and interpretation include:
o interim announcements
o analyst/broker reports
o media announcements
o company web page
o specialist and industry groups
o corporate social responsibility reports.
❑ TECHNIQUES USED IN THE ANALYSIS OF FINANCIAL STATEMENTS
▪ Common techniques used in the analysis of a set of FSs include (1) the use of SOCFs,
(2) common-sized FSs & (3)ratio analysis.
▪ ‘Interpreting’ an analysis entails scrutinising for ‘trends’. ‘Trend analysis’ involves
comparing figures, ratios & percentages, regression:
✓ To prior years: The more prior years that you have at your disposal for the purpose of
comparison the better.
✓ To industry averages: This allows a user to an idea as to how the entity’s
performance compares with those of similar entities in the same industry.
✓ To accepted standards: Accepted standards should be considered as a guide only &
once again, the leading entity in an industry will seldom adhere to any so-called norms.
✓ To forecasts (past and future): internal users may compare, actual ratios to the
budgeted ratios over a certain period when planning budgets for the future. Variances
over the past need to be investigated & taken into account during the budgeting
process for the next period.
TECHNIQUES FOR FINANCIAL STATEMENTS ANALYSES
❑ TECHNIQUES USED IN THE ANALYSIS OF FINANCIAL STATEMENTS
▪ Common techniques used in the analysis of a set of FSs include (1) the use of SOCFs,
(2) common-sized FSs & (3)ratio analysis.
▪ ‘Interpreting’ an analysis entails scrutinising for ‘trends’. ‘Trend analysis’ involves
comparing figures, ratios & percentages, regression:
✓ To prior years: The more prior years that you have at your disposal for the purpose of
comparison the better.
✓ To industry averages: This allows a user to an idea as to how the entity’s
performance compares with those of similar entities in the same industry.
✓ To accepted standards: Accepted standards should be considered as a guide only &
once again, the leading entity in an industry will seldom adhere to any so-called norms.
✓ To forecasts (past and future): internal users may compare, actual ratios to the
budgeted ratios over a certain period when planning budgets for the future. Variances
over the past need to be investigated & taken into account during the budgeting
process for the next period.
❑ TECHNIQUES USED IN THE ANALYSIS OF FINANCIAL STATEMENTS
▪ Statement of Cash Flows:

✓ The SOCFs is one of the most important FSs to analyse as it reveals the cash flows.

✓ A company with cash flow challenges will not be able to repay creditors and other
short-term debts (such as overdrafts) and perhaps also the long-term debts as well.

✓ Persistent cash flow problems can ultimately lead to liquidity problems and finally
liquidation.
❑ TECHNIQUES USED IN THE ANALYSIS OF FINANCIAL STATEMENTS
▪ Common-sized Financial Statements

✓ This technique requires the FSs to be redrafted showing movements in either

currency or percentage terms.

✓ The common-size analysis is best performed if a bigger picture is the aim.

✓ ITR, comparisons should be made with other connected accounts, whether in the
SOCI or SOFP.

✓ Common-sizing analysis can be done as a horizontal or vertical analysis.

❑ TECHNIQUES USED IN THE ANALYSIS OF FINANCIAL STATEMENTS
▪ Common-sized Financial Statements
✓ Horizontal Analysis: the change from one year to the next within each line item in
the FSs is analysed on either a currency or percentage basis.
✓ Analysing the changes as a percentage is particularly useful when trying to identify
any unusual fluctuations.
✓ Large percentage fluctuations could be followed up for corrective action by
management or interpreted as best as is possible for the purpose of assessing risk.
✓ For an external auditor user, it acts as a useful tool in identifying accounts that appear
to include errors, fraud or misallocation, thus highlighting areas requiring further audit
procedures.
✓ Example: A material increase in the machinery account together with a similarly
material decrease in the repairs and maintenance account may indicate that
expenditure on repairs & maintenance has been erroneously debited to machinery (a
misallocation).
❑ TECHNIQUES USED IN THE ANALYSIS OF FINANCIAL STATEMENTS
▪ Common-sized Financial Statements

✓ Vertical Analysis: Involves comparing figures as a % of another figure (e.g.

wages as a % of revenue).

✓ Removes effects of inflation

✓ Enables easier comparison between large and small entities.

❑ TECHNIQUES USED IN THE ANALYSIS OF FINANCIAL STATEMENTS
▪ Ratio analysis in general:

▪ Ratio analysis is a very useful technique that analyses the FSs in a

way that provides us with information on the entity’s profitability, liquidity
and solvency.

▪ Unlike the common-sized FSs, the calculation and analysis of the ratios
involves an examination of the inter-relationship between various items
in the SOCI and or SOFP.
❑ CAUTION: PLEASE NOTE
▪ Ratio analysis is not merely about calculating correctly.
▪ The answers should be DENOTED correctly:
For example,
LIQUITY RATIOS (current & acid test ratios) should NOT be written as 2.52 X
but as 2.52:1✓
Inventory Turnover should NOT be written as, e.g. 3.75 X but as 3.75 times ✓
Gross Margin should NOT be written as, e.g. 27.5 X but as 27.5% ✓

▪ You should be able to calculate, interpret and provide meaningful

recommendations in ratio analysis.
ACCOUNTING STUDENTS FAIL EXAMS BECAUSE OF THESE!!!
❑ PROFITABILITY ANALYSIS
▪ PA involves calculating profitability by using line-items from the SOCI but it
also includes analysing the profitability in relation to items in the SOFP.

▪ Profitability ratios (Correia, 2019:5-21):

✓ Gross profit margin
✓ Net profit percentage
✓ Net operating profit margin
✓ Net profit margin
✓ Earnings before Interest, Depreciation & Amortisation (EBITDA) margin
✓ Return on owner’s equity (ROE)
✓ Return on assets (ROA): 3 FORMS: EBIT/TA; NOPAT/TA; PAT/TA
✓ Return on Capital Employed (ROCE)
❑ LIQUIDITY ANALYSIS:
▪ LA assesses an org’s ability to repay its debts in the short-term (1 year).
▪ These ratios focus on the current assets (CAs) & current liabilities (CLs).
▪ CAs can be converted into cash (liquidated) within 12 months of year-end &
CLs are debts that must be settled within 12 months of year-end.

▪ 2 liquidity ratios:

✓ Current ratio
✓ Acid-test ratio
❑ ASSET (RESOURCE) MANAGEMENT RATIOS:
▪ These ratios focus on how management manages the resources under their
control.
▪ 7 Resource management ratios:

✓ Debtors’ collection period

✓ Inventory turnover
✓ Creditors’ payment period
✓ Working Capital /Business cycle ratio
✓ Total Asset Turnover
✓ Fixed Assets Turnover
❑ SOLVENCY/STRUCTURE ANALYSIS:

▪ SA refers to an company’s ability to repay its debts in the long-term.

▪ The ratios deal with the total assets and total liabilities of the company.
▪ Solvency ratios give an estimate of the structural safety of the company.
▪ They focus on the ratio of internally sourced finance to externally sourced
finance.
▪ Solvency ratios: Debt Management ratios
✓ Debt ratio
✓ Debt equity ratio
✓ Interest Coverage ratio
 PROFITABILITY RATIOS
This set of ratios indicates the level of profitability from a management or
shareholders’ perspective
▪ Gross profit margin (GPM): indicates operational efficiency. Can fluctuate
for many reasons: Changes in mark-up; stock thefts; incorrect inventory
counts; inconsistent inventory valuation (%).

𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = × 100
𝑆𝑎𝑙𝑒𝑠

▪ Net profit percentage/margin (NPM): Profit after tax is used (%).

𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑁𝑃𝑀 = × 100
𝑆𝑎𝑙𝑒𝑠
▪ Return on owner’s equity (ROE): indicates return on ordinary
shareholders’ investment.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 & 𝑝𝑟𝑒𝑓. 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

𝑅𝑂𝐸 = × 100
𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑒𝑞𝑢𝑖𝑡𝑦

▪ Return on assets(ROA): indicates the effectiveness of management’s use

of the entity’s assets entrusted to them.

𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑅𝑂𝐴 = × 100
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
▪ Return on Capital Employed (ROCE): indicates return on capital invested.

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐶𝐸 = × 100
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠

𝑅𝑂𝐶𝐸 = 𝑆𝑎𝑙𝑒𝑠
× 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
× 100

𝑅𝑂𝐶𝐸 = Operating Margin x Asset turnover

Leverage Effect = ROCE - ROE

 LIQUIDITY RATIOS
This set of ratios indicate the ability of the company to repay its short-
term debts.
▪ Current ratio (CR): indicates the ability to repay the current liabilities out of
the current assets (X:1). Norm 2:1.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

▪ Acid-test ratio (ATR): stringent indicator of the ability to repay the current
liabilities out of the CAs excluding inventory (inventory may be a relatively
difficult current asset to convert into cash) (X:1). Norm 1:1.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠

𝐴𝑐𝑖𝑑 𝑡𝑒𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
 ASSET (RESOURCE) MANAGEMENT RATIOS
This set of ratios indicate management’s ability to derive value from the
firm’s resources.
▪ Inventory on hand (Days supply of inventory) (DSI): indicates how long
the balance of inventory on hand lasts; thus, highlights overinvestment /
underinvestment in inventory (days).

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐷𝑂𝐻 = × 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

▪ Inventory turnover: indicates how fast inventory is turned over (sold)

during the period (times).

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
▪ Debtors collection period (DCP): indicates the average period of time it
takes between the date of sale and the final receipt of cash (days).

𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐷𝐶𝑃 = × 365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
▪ Creditor payment period (CPP): indicates how long we take to pay
our trade creditors (days).

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝐶𝑃𝑃 = × 365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
▪ Business cycle days (BCD)/ Working Capital cycle: indicates how long
cash is tied up in the operating cycle & helps budget for cash requirements
needed to operate the business (days).
𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑐𝑦𝑐𝑙𝑒 = 𝐷𝑎𝑦𝑠 𝑆𝑢𝑝𝑝𝑙𝑦 𝑜𝑓 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑂𝐻 + 𝐷𝐶𝑃 − 𝐶𝑃𝑃
▪ Total Asset Turnover (TAT): indicates how efficient management is at generating sales
from assets (times).
𝑆𝑎𝑙𝑒𝑠
𝑇𝐴𝑇 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
▪ Fixed Asset Turnover (FAT): indicates how efficiently the company generates
revenues from its investments in fixed assets (that is property, plant and equipment).
(times).
𝑆𝑎𝑙𝑒𝑠
𝐹𝐴𝑇 =
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 (𝑃𝑃𝐸)
 SOLVENCY RATIOS (DEBT MANAGEMENT):
This set of ratios indicate the ability to meet long-term obligations.
▪ Debt ratio (DR): indicates how much of the asset base is financed by
external parties (indicates indebtedness) (%).

𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡𝑠
𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 = × 100
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
▪ Debt to Equity ratio (DE): indicates the proportion in which the company
is financed by shareholders’ equity versus external third-party capital (debt)
(%).
𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 = × 100
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
▪ Interest Coverage ratio (ICR): This ratio is similar to the debt equity ratio
except that it only includes interest-bearing debts. (times).

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
 MARKET RATIOS:
Market value ratios are used to evaluate the current share price of a traded shares.
These ratios are employed by current and potential investors to determine whether a
company's shares are over-priced or under-priced.
Market value ratios are not applied to the shares of privately-held entities, since there is no
accurate way to assign a market value to their shares.
▪ Price earnings ratio (PE): reflects how much investors are willing to pay
for every R1 of reported profits (reflects market confidence in future
performance of entity) (X:1)

𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑒𝑟 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒 (𝑎𝑡 𝑦𝑒𝑎𝑟 𝑒𝑛𝑑) 𝑀𝑃𝑃𝑆

𝑃𝐸 𝑟𝑎𝑡𝑖𝑜 = =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒𝑠 𝐸𝑃𝑆

▪ Earnings yield (EY): calculates the earnings as a percentage of market

value (%).

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐸𝑌 = × 100
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑒𝑟 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒
▪ Dividend yield (DY): calculates the dividends as a percentage of each R1
invested. A high DY may be indicative of either a relatively high payout or a
share price that is very low (poor market sentiments) (%)

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒

𝐷𝑖𝑣 𝑦𝑖𝑒𝑙𝑑 = × 100
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝑒𝑛𝑑 𝑜𝑓 𝑦𝑒𝑎𝑟)

▪ Market to book value ratio (MBVR): compares the value placed on a business
by accounting records (in FSs) to the market value (based on expectation of future
performance). It suggests how much investors are paying against each rand of BV in
the SOFP and it tries to establish a relationship between the book values expressed in
the balance sheet and the actual market price of the stock (times).
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑒𝑟 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒
𝑀𝐵𝑉𝑅 =
𝑁𝑒𝑡 𝑎𝑠𝑠𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
ECONOMIC VALUE ADDED (EVA)
❑ ECONOMIC VALUE ADDED (EVA)
❖ Traditional financial performance measures:
▪ Traditional/classic financial performance measures such as Net operating profit after tax
(NOPAT); Earnings before interest, tax, amortization, and depreciation (EBITDA) only
consider the costs of lenders’ capital in calculating companies’ overall profitability.
▪ They overlook shareholders’ investment as a source of financing to obtain return.
❖ Economic value added (EVA):
▪ EVA is an analytical tool developed by Stern and Stewart (1982) after years of research.
▪ EVA is a contemporary measure of financial performance that shows the economic
profit available to SHAREHOLDERS (Zenzerovi´c 2023).
▪ EVA assesses a firm's ability to generate value beyond its cost of capital.
▪ EVA is calculated by subtracting the total cost of capital from the net operating profit
after taxes (NOPAT). A positive EVA indicates that a firm is creating value for its
shareholders, while a negative EVA suggests value destruction.
❑ COMPARING TRADITIONAL PERFORMANCE MEASURES & EVA
❑ ECONOMIC VALUE ADDED (EVA) AS PERFORMANCE METRIC

▪ The purpose of EVA is to evaluate economic profit rather than accounting profit by
including opportunity cost (i.e., the cost of capital) in the analysis.

▪ The implementation of a proper EVA-based performance measurement system can

generate reliable information to facilitate decision-making processes which will, in turn,
rapidly grow shareholder wealth.

▪ Strategic decisions based on EVA-founded performance metrics facilitates faster growth

of the firm, which is always good news to shareholders.

▪ EVA represents a measure of the Rand surplus value created by an investment or a

portfolio of investments.
.
❑ ECONOMIC VALUE ADDED (EVA) AS PERFORMANCE METRIC
▪ By deducting the cost of capital & the cost of debt from total income, EVA is used to
evaluate the true economic profit of firms (Skae et al., 2017:311).
▪ EVA is calculated as follows:
EVA = Net Operating Profit Less Adjusted Taxes – [Capital invested x Cost of Capital]
EVA = NOPAT – (CI x WACC)

Alternatively,
EVA = (ROI − WACC) × CI
✓ Where: Capital employed = Total Assets – Non-interest bearing liabilities.
✓ Cost of capital is the Weighted Average Cost of Capital (WACC)
✓ ROI = return on capital invested
✓ CI = capital invested = sum of capital and reserves and financial liabilities
✓ WACC = [E/(E+D) × Re] + [D/(E+D) × Rd × (1 − Tax)]
❑ ECONOMIC VALUE ADDED (EVA): APPLICATION:
You are a performance management expert at GFW Ltd and the CEO has tasked you with
aiding her on the following improvement programme:

Economic value added (EVA)

The CEO wants your views on the use of EVA as the key performance metric at GFW Ltd.
You have been supplied with the current EVA calculation (Appendix 1) but there is some
doubt about whether the junior management accountant who has done this work was
sufficiently trained in the method. Therefore, the CEO requires you to evaluate its accuracy
and the assumptions which form part of the calculation and advise her on your results,
providing calculations as needed.
❑ ECONOMIC VALUE ADDED (EVA): APPLICATION:
❑ ECONOMIC VALUE ADDED (EVA)
▪ When calculating EVA:
1. Start with “Operating profit” as first line item
2. Second step: “Add back” the following:
✓ Non-cash expenses are correctly added back to profit as such costs are treated as unacceptable
accounting adjustments on a cash-based view.
✓ Marketing activities for long-term benefit are correctly added back as they generate future value for the
business and so the prior year expenditure is also added in to capital employed.
✓ R&D expenditure should be treated the same way the long-term marketing spending (note that there
was no R&D expenditure in the prior year).
3. Third step: “Less” the following:
▪ The tax cost should be the amount paid adjusted for lost tax on interest and not the adjusted amount
of tax charged in the accounts.
▪ Please note the following:
✓ The WACC should be based on the post-tax cost of debt.
✓ The capital employed figure should be based on the year start figure.
❑ ECONOMIC VALUE ADDED (EVA): CORRECT CALCULATION:
$m
Operating profit 551·4
Add back
Non-cash expenses 15·1
Marketing capitalised 23·1
Research and development (R&D) 10·0
Less
Tax paid (130·0)
Lost tax relief on interest (30% x R81.6m) (24·5)
NOPAT 445·1
Capital employed
At 20X5 year start 2 282·0
Marketing spend capitalised from YE 30 June 20X4 23·1
Adjusted capital employed at 20X5 year start 2 305·1
WACC = (1/2 x 16%) + (1/2 x 6·8% x (1 – 30%)) = 10·38%
EVA = NOPAT – (WACC x Capital employed) = 445.1 –(10.38%x2305.1) = R205.83
❑ EVA: INTERPRETATIONS & ASSUMPTIONS:
▪ The EVA indicates a positive position for the company as it adds to shareholder wealth.
▪ The following assumptions in the calculation require comment:
o There is an implicit assumption that accounting depreciation (included in operating
profit) is equivalent to economic depreciation (which should be used for EVA
calculations). This is questionable generally, although there is no information to allow a
more accurate calculation.
o Take note that marketing expenditure is capitalised. In general, marketing expenses that
are expected to generate long-term benefits (such as significant advertising campaigns,
branding investments, or customer acquisition costs), may be capitalized as intangible
assets on the balance sheet. This is done if these expenses are expected to create
future economic benefits that will extend beyond the current accounting period.
o Note also that no amortisation needs to be charged on the R&D costs since the
product has not yet launched. This is in line with the accounting treatment of such items
o The R&D investments are treated as operating expenses and not as capital invested, they should be
excluded from the capital employed portion of the EVA formula. (See Intangible Assets!!)
❑ ECONOMIC VALUE ADDED: EXAMPLE 2: PAST QUESTION JAN24
Use the information provided below to answer the following question.

INFORMATION
Fogram Limited (FL) has reported operating profits of R40 million. This was after charging
R12 million for the development and launch costs of a new product that is expected to
generate profits for 5 years. Taxation is paid at the rate of 30% of the operating profit.
FL has a risk-adjusted weighted average cost of capital of 15% per annum and is paying
interest at 10% per annum on a substantial long-term loan. FL's non-current asset value is
R50 million, and the net current assets have a value of R20 million. The replacement cost of
the non-current assets is estimated to be R80 million.

REQUIRED:
Calculate the FL's Economic Value Added (EVA) for the period.
❑ ECONOMIC VALUE ADDED: EXAMPLE 2: PAST QUESTION JAN24
SOLUTION
EVA and related measures attempt to improve on traditional accounting measures of
performance by measuring the economic profit of an enterprise.
EVA is calculated as follows:
EVA = After-tax operating profit less the cost of the capital employed to produce the profit.
EVA = (ROIC – WACC) x IC = NOPAT – WACC x IC
where
ROIC = Return on invested capital
WACC = Weighted Average Cost of Capital
IC = Invested Capital (at the beginning of the year)
❑ ECONOMIC VALUE ADDED: EXAMPLE 2: PAST QUESTION JAN24
1. Calculation of NOPAT: R million
Operating profit 40.00
Add back development costs 12.00✓
Adjusted Operating profit 52.00
Less one year’s amortisation of development costs (R12 million/5) (2.40)✓
Net Operating profit before tax 49.60✓
Taxation at 30% of net operating profit before tax (30% x 49.6) (14.88)✓
NOPAT 34.72✓
2. Calculation of economic value of net assets:
Replacement cost of net assets (R20 million + R80 million) 100✓
Add back investment in new product for future benefit (R12 m – R2.4 m) 9.6✓
Economic value of net assets 109.60✓
3. Calculation of EVA:
Economic Value Added = NOPAT - WACC x IC = R34.72m - 15%xR109.60m 18.28✓✓
ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL
❑ ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL
▪ Altman’s Z-score model is considered an effective method of predicting the state of
financial distress of any org by using multiple balance sheet values & corporate
income.

▪ Altman developed the formula for predicting bankruptcy around the time of the Great
Depression, when orgs experienced a sharp rise in incidences of default.

▪ The Z-score model predicts the probability that a company would collapse in the next 2
years.

▪ The model proved to be an accurate method for predicting bankruptcy on several

occasions. According to studies, the model showed an accuracy of 72% in predicting
bankruptcy 2 years before it occurred.
❑ ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL

▪ The Altman’s Z-score formula is written as follows:

ζ = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:
Zeta (ζ) is the Altman’s Z-score
A is the Working Capital/Total Assets ratio
B is the Retained Earnings Reserve/Total Assets ratio
C is the Earnings Before Interest and Tax/Total Assets ratio
D is the Market Value of Equity/Total Long-Term Liabilities ratio
E is the Total Sales/Total Assets ratio
❑ ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL
❑ INTERPRETING THE ALTMAN’S Z-SCORE
▪ The lower the Z-score, the higher the odds that a company is heading for bankruptcy.
▪ A Z-score ≤ 1.8 means that the org has a high probability of going bankrupt.
▪ A score ≥ 3 means that the company is in a safe zone and is unlikely to file for
bankruptcy.
▪ A score between 1.8 and 3 means that the company is in a grey area & with a moderate
chance of filing for bankruptcy. E.g., The org will probably be bankrupt within 2 years

▪ INVESTORS: Investors use Altman’s Z-score to make a decision on whether to buy or

sell a firm’s stock, depending on the assessed financial strength. If a firm shows a Z-
score closer to 3, investors may consider purchasing the company’s stock since there is
minimal risk of the business going bankrupt in the next 2 years.
▪ If a firm shows a Z-score closer to 1.8, the investors may consider selling the stock to
avoid losing their investments since the score implies a high probability of going
bankrupt.
❑ LIMITATIONS OF ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL
▪ There are good reasons to always question the applicability of the Z-Score model to a particular
business context (e.g., the insolvency of a foreign competitor of Firm X does not mean that Firm X is
likely to fail: the fundamentals of the markets are different !!!).
▪ The Z-Score model identifies financial ratios which may significantly differ in value between surviving
and failing companies.
▪ It is important that the firm being analysed is similar to those used to build the model for the results to
be relevant.
▪ The Altman Z-score was originally developed in the late 1960s and was based on data from US
companies, primarily in the manufacturing sector.
▪ There are 3 reasons to question the applicability of such data to Firm X in a different market:
✓ The world economy has changed significantly since Altman’s original work. The data for this model is
now nearly 50 years old.
✓ The economy of the USA may not reflect the market in which Firm X (the firm being analysed) works.
✓ Firm X operates in a mining sector, which is not like general manufacturing, for example, it is highly
capital intensive with long periods of no revenue generation.
▪ As for the Z-score, Firm X is not likely to be appropriately modelled by such data.
❑ ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL: EXAMPLE
Study carefully the following company information and answer the following question:

COMPANY INFORMATION
Frontier Mining (Frontier) is a mineral ore mining business in the country of Mozambique. It owns and
operates four mines. A mine takes on average two years to develop before it can produce ore and the
revenue from the mine is split (25:75) between selling the ore under fixed price contracts over five years
and selling on the spot market. The bulk of the business’s production is exported. A mine has an average
working life of about 20 years before all the profitable ore is extracted. It then takes a year to
decommission the site and return the land to a useable form for agriculture or other developments.

Required:
Explain the potential effects of a mine’s lifecycle on Frontier’s Z-score and the company’s probability of
failure.
❑ ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL: EXPLANATION:
The lifecycle issues for Frontier relate to the long timescale (23 years) for development and use of a mine
and the uneven cash flows over this lifecycle. The initial development phase of two years will require large
capital investments with no revenue being generated. There is then a 20-year revenue-generating phase
followed by a final year of decommissioning costs with no revenue.
This will impact on the Z-score by making the score very volatile as the mines go through the 3 phases of
their lives.
– During the development phase, total assets are growing while revenue is zero. This will mean that the
E variable will be zero and the A and C variables will be falling, thus lowering the score.
– During the working phase of the mine, the total assets will be static or falling (depending on the
accounting for reserves) while the revenue is high.
– During the decommissioning phase, the assets will be falling and again there will be no revenue, so a
low Z-score could be expected.
In conclusion, the fact that Frontier has only 4 mines will mean that the phase of any one mine will have
a significant impact on the score. If two mines are in development at the same time, then there is likely to
be a large effect in lowering the Z-score. It will be the scale of the financial resources which Frontier can
call on over the life of the mines which will dictate its survival.
❑ ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL: EXPLANATION:
The lifecycle issues for Frontier relate to the long timescale (23 years) for development and use of a mine
and the uneven cash flows over this lifecycle. The initial development phase of two years will require large
capital investments with no revenue being generated. There is then a 20-year revenue-generating phase
followed by a final year of decommissioning costs with no revenue.
This will impact on the Z-score by making the score very volatile as the mines go through the 3 phases of
their lives.
– During the development phase, total assets are growing while revenue is zero. This will mean that the
E variable will be zero and the A and C variables will be falling, thus lowering the score.
– During the working phase of the mine, the total assets will be static or falling (depending on the
accounting for reserves) while the revenue is high.
– During the decommissioning phase, the assets will be falling and again there will be no revenue, so a
low Z-score could be expected.
In conclusion, the fact that Frontier has only 4 mines will mean that the phase of any one mine will have
a significant impact on the score. If two mines are in development at the same time, then there is likely to
be a large effect in lowering the Z-score. It will be the scale of the financial resources which Frontier can
call on over the life of the mines which will dictate its survival.
❑ ALTMAN’S Z-SCORE FAILURE PREDICTION MODEL: EXAMPLE
You are the management accountant at HGF Resources, and you have just determined that the
company’s Altman’s Z-score is 1.93.

Given this information, which of the following represents the best action to be taken by HGF
Resources?

A. HGF Resources should pursue aggressive debt restructuring to improve its balance sheet and reduce
financial leverage.
B. HGF Resources should institute anti-takeover measures to forestall immediate acquisition by its
competitors.
C. HGF Resources should change from technology-intensive production to labour-intensive production to
reduce capital expenditures.
D. HGF Resources should implement cost-cutting measures, focusing on reducing operating expenses
and improving cash flow to enhance its financial stability.
DUPONT ANALYSIS
❑ DU PONT ANALYSIS:ROE
▪ ROE measures the return a company generates on its equity capital.
▪ To understand what drives a company’s ROE, the Du Pont analysis decomposes the
ROE into the three main constituents ratios (granular).

▪ Decomposition of ROE is sometimes referred to as DuPont analysis because it was

developed originally at that company.

▪ The 3 drivers or 3 CHAINS of ROE to be investigated separately and then in total.

▪ Du Pont Analysis investigates all 3 chains: A Chain is as strong as its weakest link

▪ Each of these component ratios is an indicator of a distinct aspect of a company’s

performance that affects ROE, the decomposition allows us to evaluate how these
different aspects of performance affected the company’s profitability (ROE).
DUPONT ANALYSIS: ROE
❑ DU PONT ANALYSIS: ROE
▪ The three main drivers or chain are:
✓ Return on total assets (Total asset turnover (TAT)): Indicator of efficiency
✓ Profit margin (PM): Indicator of profitability
✓ The equity multiplier (EM): Financial leverage: Indicator of solvency

▪ A firm’s ROE is a function of its net profit margin, its efficiency, and its leverage.

▪ DuPont analysis allows the decomposition of ROE into its 3 drivers in order to
investigate them separately and total.

▪ ROE is a function of a company’s ROA and its use of financial leverage: ROE can be
improved by improving ROA or making more effective use of leverage.
❑ DU PONT ANALYSIS (Correia, 2019:5-27)
❑ DU PONT ANALYSIS: Structured Analysis TechniqueROE

𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕
𝑹𝑶𝑬 =
𝑻𝒐𝒕𝒂𝒍 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝑬𝒒𝒖𝒊𝒕𝒚

= 𝑹𝑶𝑨 × 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆

= 𝑨𝒔𝒔𝒆𝒕 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 × 𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 × 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆

𝑺𝒂𝒍𝒆𝒔 𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

= × ×
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑺𝒂𝒍𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓 𝒆𝒒𝒖𝒊𝒕𝒚
❑ DU PONT ANALYSIS: BENEFITS
▪ Decomposing ROE involves expressing it as a product of its component ratios.
▪ Each of the 3 component ratios is an indicator of a distinct aspect of a company’s
performance that affects ROE, the decomposition allows us to evaluate how these
different aspects of performance affected the company’s profitability (ROE).

▪ DuPont analysis provides a quick snapshot of the overall performance of a firm in three
of the four critical areas of ratio analysis, profitability, operating efficiency and leverage.

▪ By identifying strengths and/or weaknesses in ALL of the three areas, the DuPont
analysis enables the analyst to quickly focus his or her detailed study on a particular
spot, making the subsequent inquiry both easier and more meaningful.
▪ The DuPont analysis draws from the broadest values on the SOFP & SOCI.
❑ DU PONT ANALYSIS: SHORTCOMINGS
▪ It is not a replacement for detailed, comprehensive FS analysis.

▪ The DuPont decomposition does not readily identify a number of problems.

▪ E.g., an average outcome for net profitability may mask the existence of a low gross
margin combined with an abnormally high operating margin.

▪ Which will require a detailed of the 2 measures for the true performance of the firm

▪ Du Pont analysis uses accounting numbers which are not reliable

▪ It does not include the cost of capital in the analysis.

❑ DU PONT ANALYSIS: EXAMPLE
DXT Enterprises experienced the following year-on-year changes:
Net Profit Margin: Increased 30%
Total Asset turnover: Increased 45%
Total Assets: Decreased 12%
Total equity: Increased 40%
Using DuPont analysis, determine the year-on-year change in DXT’s return on equity.
A. Increased 103.0%.
B. Increased 63.0%.
C. Increased 12.5%.
D. Increased 18.5% X

ROE = (Net Profit Margin)x(Total Asset turnover)x(Financial Leverage)

ROE = (Net Profit Margin)x(Total Asset turnover) x(Total Assets/Total Shareholders’ Equity)
ROE = (100%+30%)x(100%+45%)x((100% -12%)/(100%+40%)) =1.185-1 = 18.5%
❑ LIMITATIONS OF RATIO ANALYSIS
▪ Limitations of Ratio Analysis included (Skae 2017:320):
✓ Ratio analysis is unreliable when comparing entities operating in several different
industries.
✓ Sometimes an entity may be so far ahead of others in the industry, or it may have such
a stranglehold on the market that it would be unrealistic to compare the entity’s ratios
with the industry average. Outliers.
✓ The lack of consideration of the negative impact that inflation might have on figures in
the financial statements.
✓ Different (subjective use of) accounting policies by different entities makes ratio
analysis between firms even more unreliable.
✓ Often analyst dependent: Different analysts tend to have different opinion. Ratios can
be subjective, informed by the analyst’s bias.
✓ Entities can use creative accounting to manipulate their FSs at the end of the financial
year (Steinhoff!!!).