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Intro to Financial Management of the Organisation

Week 4More Ratios & Expanding the

Annual Report

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Groups of Ratios

Different Classes of ratios are available for different classes of user

Profitability Efficiency Liquidity Gearing Investor ratios

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Profitability Ratios Return on Capital Employed (ROCE)Net profit before interest and tax X 100

Share capital + reserves + long term loans

A ratio that indicates the efficiency and profitability of a company's capital investments.

ROCE should always be higher than the rate that the company borrows at, otherwise any increase in borrowings will reduce shareholders' earnings

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Net Profit Margin

Net profit before interest and tax X 100

Sales Relationship between turnover

and “controllable” profit. How are management controlling business expenses?

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Efficiency Ratios Average settlement period for

debtors Trade debtors X 365 Credit sales Means : How quickly an average

debtor takes to pay. Shown in days. The quicker debtors pay up the

better. Normal terms .v. actuality

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Efficiency Ratios

Average settlement period for creditors

Trade creditors X 365 Credit purchases

Means : How long, on average, it takes a business to pay its trade creditors in days

Deferring paying creditors is free credit

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Gearing (leverage) Ratios

Gearing ratio Long term liabilities X 100 Share capital + reserves +

long term liabilities Means :contribution of long-

term lenders to the long-term capital structure

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A risky business Borrowing is a risk because… Interest has to be paid whether the investment is a

success or not. Even if a company is making a loss it still has to pay

interest Borrowing is thus a risk The more of their capital that is borrowed The bigger the risk.

The higher the gearing ratio, the bigger the proportion of the companies money that is borrowed and therefore the bigger the risk.

A company with a high gearing ratio is in a very dangerous situation if interest rates are going up.

Their interest payable bill will be rising with no corresponding increase in sales revenue.

The first thing to suffer is profit

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Gearing Ratios Interest Cover Profit before interest and tax Interest payable Means : Amount of profit available

to cover interest payments

What’s Hot : the higher, the more funds available to meet interest payments.

So long term lenders more secure

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Investor Ratios

Dividends per share Dividends announced during

period Number of shares in issue Means :cash return an investor

can expect from shares held in a company

Tip: Frequently shown in notes to accounts

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Investor Ratios

Dividend payout ratio Dividends announced for the year

X 100 Earnings for the year available for

dividends

Means :Proportion of earnings paid out to shareholders as dividends

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Investor Ratios Earnings per Share (EPS) Earnings available to ordinary shareholders Number of ordinary shares in issue

The earnings of a company is its profit, and so if we change the wording of earnings per share to profit per share the meaning should become a lot clearer.

It is literally the amount of profit that has on average been earned by each share.

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FRS 14 – Earnings per Share

FRS 14 requires that EPS is shown as a footnote to the profit and loss account of a quoted company.

FRS 14 defines EPS as: “Basic earnings per share should be calculated by dividing the net profit or loss for the period attributable to ordinary shareholders by the weighted average number of shares outstanding during the period.”

The trend of EPS is a better indicator of progress than the trend in profit. In order to maintain EPS at the same level after a share issue a company must deploy the proceeds of the issue at least as profitably as the original capital

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Investor Ratios Price/Earnings ratio (P/E ratio) Market value of shares EPS Means : compares market value of the

share with its earnings. What’s Hot : A high figure shows the

market’s confidence in the future earnings potential of the company.

The higher the confidence, the more investors will be prepared to pay for shares in relation to the current earnings level.

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Price/Earnings ratio (P/E ratio)

Recognised by many investors as the KEY investor ratio

Capital Radio plc Example 2000 EPS = 26.3p Market Price of Ordinary Shares at Balance

Sheet date = £14.38 2001 EPS = 23.8p Market Price of Ordinary Shares at Balance

Sheet date = £5.20

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Capital Radio plc P/E Ratio

2000 14.38 / 0.263 = 54.7 times

2001 5.20 / 0.238 = 21.8 times

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What do the Directors say? 1

The Chief Executive (upbeat)

This year has been challenging for Capital Radio, as the media industry faced difficult trading conditions resulting from the economic slowdown.

Our revenues came under pressure as advertising demand fell, requiring us to take a prudent look at the management of our cost base.

Though the current market conditions may prevail for some time our strong radio brands, healthy balance sheet and focused management team will ensure we weather the downturn.

We are confident of the long-term prospects for radio advertising and retain our belief in the importance of aggressively expanding our national presence.

Pass the Bucket… Cool people Hot ideas Real insight

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What do the Directors say? 2

Finance Director Total revenue of £123.2 million was down 1% on the

previous year (down 6% on a like for like basis).

Underlying Group profit before tax was £30.1million, down 27%, in line with the guidance we gave at the end of September.

The tax charge on our underlying profitability for the year was 28.5% (2000: 26.3%).

Our underlying earnings per share were down 33% at 26.3p. Our underlying earnings per share has declined due to a combination of the difficult trading conditions and the planned short-term dilution caused by the acquisitions of Century Radio and Beat.

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What do the Directors say? 2a

Revenue from our established stations was £106.8 million, down 9%, which resulted in the operating profit from our established stations being down 16% at £39.6 million.

Development stations losses were £3.0 million compared to a £1.9 million charge in the previous financial year

But.. With the interim dividend of 6.0p per share, our total dividend per share for the year is unchanged at 18.5p.

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Benjamin Graham’s Analysis

P/E Ratios are a measure of stock market performance

Calculated US average ratios for the periods 1871-1970 Lowest = 9.5 (1941-50) Highest was 18.1 (1961-63)

Compared these calculations to the rates available on high-class bonds

(A P/E ratio of 20 = an earnings yield of 5%

Eg 100 / PE ratio = Earnings Yield)

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Can we predict potential bankruptcy?

Edward Altman (1968 & 1981) Calculation of Z-Score Historic Basis Key ratios + weightings = Z-

Score

Note: use as part of an evaluation

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Altman’s Z-ScoreRATIO FORMULA WEIGHT

FACTOR

Return on Total Assets

Earnings Before Interest and Taxes----------------------------------Total Assets

x. 3.3

Sales to Total Assets

Net Sales----------------------------------Total Assets

x 0.999

Equity to Debt Market Value of Equity----------------------------------Total Liabilities

x 0.6

Working Capital to Total Assets

Working Capital----------------------------------Total Assets

x 1.2

Retained Earnings to Total Assets

Retained Earnings----------------------------------Total Assets

x1.4

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The Interpretation of Z Score: Z-SCORE ABOVE 3.0 The company is safe based on these financial figures

only.

Z-SCORE BETWEEN 2.7 and 2.99 Grey area/ Zone of ignorance. This zone is an area where one should exercise caution.

Z-SCORE BETWEEN 1.8 and 2.7 Grey area/ Zone of ignorance. Good chances of the company going bankrupt within 2

years of operations from the date of financial figures given.

Z-SCORE BELOW 1.80 Probability of financial embarrassment is very high.

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Worked Example – Somerfield 2001

Return on Assets 11.6/1509.3 = 0.0077X3.3 = 0.0254 Sales to Total Assets 4612.5/1509.3 – 3.0561X0.999 = 3.0530 Equity to Debt 1509.3/800 = 1.8866 X 0.6 = 1.1317 Working Capital to Total Assets (75.2)/1509.3 = (0.0498) X 1.2 = (0.0598) Retained Earning to Total Assets 548.9/1509.3 = 0.3637 X 1.4 = 0.5092 Total of Weighted Scores = 4.6595

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Expanding the Annual Report Inflation Adjustments Is it an issue? Current Cost Accounting Adjustment of profit by

replacement costs of stocks/fixed assets

Current Purchasing Power Adjustment of profit by an index

(usually Retail Price Index)

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Value Added Statements

Alternative Method of Stating the Profit & Loss Account

Shows “Value Created” rather then profit made

Capital Radio Example

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Environmental Accounting Companies have a responsibility

for the damage that they (may) cause to the environment

The (potential) effects depend on the type of company

Companies should deal with this in the accounts In the annual report

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Why? Whether for moral, economic,

legal or pragmatic reasons, every organisation is having to make an increasingly explicit assessment of its environmental and social impact and to attempt to re-position itself as the terms of the social contract between business and society come under increasing scrutiny.

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Should accounts & reports deal with these issues?

Pragmatic – accounting Provision for the costs of remedying

past contamination should be recognised when an entity is legally or constructively obliged to rectify the damage

Abandonment costs - full provision for the total costs should be made when the environmental damage is inflicted.

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Should accounts & reports deal with these issues?

Moral Responsibility There is no FRS that deals with

Environmental Reports Individual accounting bodies and

environmental groups have provided guidance

Environmental Report can appear In annual report or As distinct report circulated with

annual report

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Suggested Contents CEO statement Organisational profile Key environmental impacts Environmental policy statements Management system and procedures Performance and compliance Targets and achievements Independent verification statement

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Objective should be… The provision of information about the

environmental impact and operational performance of an entity that is useful to relevant stakeholders in assessing their relationship with the reporting entity

It should be transparent information on the company’s policies and successes

Which means….

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Concern for the planet…(or profits?)

Benefits from this greater transparency may include:

an increase in the number of customers who consider, respect or share the same values

being placed on ‘preferred suppliers’ lists of companies that consider environmental responsibility upstream to their own operations

stronger relationships with stakeholders by involving them in the reporting process and

general public approval, thus lowering reputational risk.

ACCA Singapore advice publication

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Examples – the pathetic..

African Gold plc No policy Firestone Diamonds plc A detailed environmental

management programme report covering rehabilitation of both historical and planned mining operations has been completed and submitted to the Department of Minerals & Energy for approval.

Why? RSA legislation.

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Examples – and the top notch

EMI

The Body Shop

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Crawling on the bandwagon?

Yearly percentage of companies producing a corporate environmental report

1993 13% 1996 17% 1999 24% 2002 28%

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The Audit Problem Auditors have no guidelines on

auditing the Environmental Report Social Audit Ltd – hidden agenda Role Conflict – auditors as employees

of shareholders/stewardship of funds

Do we need audit guidelines? Do we need environmental reports? Should they be highlighted as simply

public relations?