IA L34 1415 Ratio Analysis

8/10/2019 IA L34 1415 Ratio Analysis

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P14B28

International Accounting

Lecture 3 & 4

Financial Statement Analysis


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Group Assignment Membership Form

International Accounting

P14B28

Semester 1 2014/15Module Convenor: Rob Nieschwietz

Notes:

1. The Group Leader should submit the completed

membership form to the Faculty Office (AB 348) by 4pm

October 9th

, 2014.

2. The group leader will be responsible for submitting the

electronic copy of the completed assignment on Turnitin.

3. Group size: FIVE students

4. Please list the Group Leader first

5. Each group should submit only one completed form

6. List your Nottingham mail (no gmail or hotmail please!!)

Student Name Student ID Nottingham email ID Signature

1. @nottingham.edu.cn




Group

Leader


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Last lecturea recap:

3

Principal financial statements

Balance sheet, or statement of financialposition (SOFP)

Profit and loss (P/L), or Income statement (I/S), orStatement of financial performance (SOFP)

Cash flow statement or Statement of cashflow (SOCF)

Now lets have a look at the extracts from TedBaker Group Accounts 2011


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4

Leaning Objectives for Lecture 3&4

Explain and evaluate measures of a

companys performance ratio analysis

Critically apply ratio analysis, bearing inmind its strengths and limitations


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5

Why do we need ratios?

1. Comparisons between entitieswhich of

the following companies is the most

profitable?

Co. A Co. B

000 000

Profit 200 1,000Net assets 500 10,000

Return 40% 10%


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2. Comparisons over timehas there been an increase or

decrease in profitability from one year to the next?

Previous Current

year year

000 000Profit 900 1,000

Net assets 8,000 10,000

Return 11.25% 10%

In both cases a comparison of the absolute profits would give a misleading evaluation


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The Functions of Ratio Analysis

The main function of ratio analysis is to enableusers of published financial statements to evaluate

the financial performance and financial position of

the reporting entity for the purpose of makingeconomic decisions (buy/sell/hold decision for

example). This usually takes the form of:

1. Comparisons with other entities (inter-firm);

and/or

2. Comparisons over time (time series analysis).


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Warning!

Before you calculate ratios: Understand the industry, the economy, the

management, the governance, the products,the competitors, the value drivers (see nextslide), major risks (see later slide) etc.

Look for trends in the data

Look for keep performance indicators (KPIs)

including non financial data e.g. Sales persquare metre

Calculate percentage changes

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Value Drivers

Business Type Value Driver Example

Merchant Product / price differentials M&S plc

Service Exploit assets, e.g. knowledge KPMG

Manufacturing Transform bought-in goods and

services

Rolls Royce plc

Extractive Exploit natural resources BP

Banking Differentials in price of money HSBC


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Measuring Risk

Financial risk: the risk that a firm will have insufficient funds to payinterest or repay capital on its borrowing and hence default against itslenders.

Business risk: the risk of failure in the product or supply markets andhence a failure of its return-generating power; business risk also

includes risk brought about by technological change.

Regulatory risk: the risk that a firms products market or criticalsupply markets may be subjected to adverse regulation whichdiminishes its ability to earn revenue. The recognition in the 1980sthat asbestos was a principal cause of lung disease led to a ban on its

use as a building material; principal asbestos manufacturers wereforced out of business.

Market risk: the risk of variability in the firms share price and in theprice of its other traded financial securities.


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CORE ANALYSIS (Moon and Bates 1993)

Establishing and understanding the

context within which the firm hasbeen operating, externally and

internally.

Focuses on the financial statements

themselves (together with any other

available information), trends in

sales, profits, and asset and liability

movements.

Calculation of financial ratios.

Interpret the ratios calculated and

evaluate the performance of the firm.

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Context and Overview

What is the organisation? What does it do?Differentiated/customised products or commodities?How does it add value via its business processes?

What are its assets & liabilities?Capital intensity?

Intangibles?

How do its customers pay? Cash or credit?

External environment PESTLE

SWOT

Corporate strategy

Critical success factors

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Financial ratio classification

Categories

Profitability

Efficiency

Liquidity

Financial gearing

Investment13


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PROFITABILITY

ROCE ROE

Capital turnover

Operating profitmargin

Gross profitmargin

Net profit margin

LIQUIDITY ANDEFFICIENCY

Acid test Current ratio

Inventoryholding period

Trade receivablecollection period

Trade payable

payment period

FINANCIALGEARING

Debt/equityratio

Interest cover

INVESTMENT

Dividend yield EPS

DPS

P/E ratio

MAIN RATIOS

Collis et al. (2012, p 216)


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Business

organisation

Competitors

Lenders

Managers

Owners Customers

Suppliers Investment

analysts

Community

representatives

Government

Employees

and their

representatives

Main users of financial information relating to a business

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Class ActivityIn pairs

How can ratios help users of accounts?

Select 3 user groups from the previous slide.

Think about what ratios they would be

particularly interested in and why.

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Profitability Ratios

Pr

Re ( ) 100%

PrRe ( ) 100%

-

Re

-

ofit for ordinary shareholders

turn on equity ROE Equity

Operating ofitturn on capital employed ROCE

Equity Non current Liabilities

venueCapital turnover

Equity Non current liabilities

Operating

arg 100%Re

arg 100%

Re

Operating profitprofit m invenue

Gross profitGross profit m in

venue

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Return on Equity (ROE)

Focuses on the profit generated on the investment of shareholders

funds Return is defined as the profit for ordinary shareholdersprofit after

interest and tax

Equity is the total equity

Benchmark?

PrRe ( ) 100%ofit for ordinary shareholdersturn on equity ROEEquity

2010 / 2011

17,280 100% 22.73%76,024

TB

ROE

2009 / 2010

13,527 100% 20.42%66,230

TB

ROE

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- ROE behavior is

dependent on both

earnings and the

asset base.

- Patterns tend tobe mean-reverting.

Extracts from Business Analysis and Valuation (Palepu et al. 2010. p278-279)19


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Effect of Gearing on ROE

100 E qu i t y 50 equ i t y 10 equ i t y

50 deb t 90 deb t

100,000 100,000 100,000

100,000 50,000 10,000

- 50,000 90,000

20,000 20,000 20,000

- 5,000 9,000

20,000 15,000 11,000

6,000 4,500 3,300

14,000 10,500 7,700

14% 21% 77%

Operating profit before I and T

Return on Equity

Profit after interest

Tax @ 30%

PAT

Interest @ 10% on debt

Capital employed

Equity

Debt

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Return on Capital Employed (ROCE)

ROCE measures the percentage return on the total investment of funds in thebusiness.

Capital employed include the shareholders fund and all sources of long-termfinance

ROE is a more modest return measure than ROCE

2010 / 2011

24,132100% 31.11%

77,571

TB

ROCE

2009 / 2010

19,782100% 29.29%

67,546

TB

ROCE

Pr

Re ( ) 100%-

Operating ofit

turn on capital employed ROCE Equity Non current Liabilities

Working 1 2010/2011 2009/2010

000 000Equity 76,024 66,230

Non-current liabilities 1,547 1,316

Capital employed 77,571 67,546

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Capital employed: Long-term Funding (SOFP)

ASSETS

Non-current

assets

Current assets

Currentliabilities

Long-termdebt

Shareholdersequity

CLAIMS

Long -

termfunding

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Capital Turnover

As high as possiblehigher level of turnover for lower level ofinvestment

2.42 times indicates that the capital have been turned-over 2.42times during the year. Or every 1 invested in the capital employedgenerates 2.42 of sales revenue.

2010 / 2011

187,7002.42

77,571

TB

Capital Turnover times

2009 / 2010

163,5862.42

67,546

TB

Capital Turnover times

Re

-

venueCapital turnover Equity Non current liabilities

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Operating Profit Margin

TB is making an operating profit of slightly over 12 on every 100 ofrevenue.

Improve the ratio by increasing selling price, if possible, or cutting costs.

ROCE = Capital Turnover x Operating Profit Margin

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arg 100%Re

Operating profit

Operating profit m in venue

2010 / 2011

24,132Operating Profit Margin 100% 12.86%

187,700

2009 / 2010

19,782Operating Profit Margin 100% 12.09%

163,586

TB

TB


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Gross Profit Margin

The relationship between production/purchasing costs and sales revenues. The

gross margin needs to be high enough to cover all other costs incurred by the

company.

Net profit margin (%) = PAT/Revenue

arg 100%Re

Gross profitGross profit m invenue

2010 / 2011

115,777Gross Profit Margin 100% 61.68%187,700

2009 / 2010

99,927Gross Profit Margin 100% 61.09%

163,586

TB

TB

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Typical margin loss in different businesses

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Considerations when calculating

RETURN RATIOS

There are no standard formulae - What isappropriate in the particular circumstances?

1 Match asset base with relevant income2 Does the profit figuregross / net /operating - need adjustment?

3 Before or after tax ?

4 The averaging of balance sheet items5 The effect of gearing

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Class Activity - how choosing a different asset

(capital) base produces different rates of return?

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Preference sharesHave a fixed dividend.Must be paid before ordinary dividend for the year.Arrears must be paid before ordinary dividend (cumulative preference shares).Generally have priority on winding up.Do not have right to residual profits on winding up.

Not technically equity.


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Asset/Capital

base

Income

matched

Return

( )

a Equity (excl preference shares) 190,000 40,000 21.1

b Share capital plus loans 300,000 72,000 24.0

c Share capital + loans

investments

250,000 67,000 26.8

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Using average figures


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opening

capital

average

capital

closing

capital

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Using average figures

If we are making profits, equity is bigger at the end of the year than

the beginning. In fact, it is growing through the year.

If we are comparing income statement (period) figures with

balance sheet ones, it may be appropriate to use an average

balance sheet figure. Calculate the best average you can using

the information available.


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Liquidity and Efficiency Ratios

:

:

12 [ 365 ]

Liquidity

Current assetsCurrent ratio

Current liabilities

Current assets InventoriesAcid test

Current liabilities

Efficiency

InventoryInventory holding period months or days

Cost of sales

Trade receivable colle

12 [ 365 ]Re

12 [ 365 ]

Trade receivablesction period months or daysvenue

Trade payablesTrade payable payment period months or days

Cost of sales

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Liquidity and Efficiency

Liquidity ratios reflect the health or otherwise of the cash position ofthe business and its ability to meet its short-term obligations.

Efficiency ratios reflect how effectively business transactions are being

converted into cash.

What if a company have bad liquidity/efficiency ratios?

Their profit margins may be eroded by the financing costs of funding

overdue accounts

Cash flow shortfalls maybe put pressure on their ability to meet their

day-to-day obligations to pay employees, replenish stocks, etc

Limitations: Snapshot only, trend may be more important.

No standard ideal result, need comparisons.

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C t R ti d A id T t


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Current Ratio and Acid Test

Current ratio =2.14:1, ie. for every 1 of current liabilities there is 2.14 of currentassets with which to meet these commitments.

Usually current ratio should be larger than 1. The company should have enoughassets to cover its liabilities.

This ratio is unhelpful if inventory is not able to be sold quickly acid test

Current assetsCurrent ratio

Current liabilities

Current assets InventoriesAcid testCurrent liabilities

2010 / 2011

83,8002.14:1

39,186

83,800 42,4921.05:1

39,186

TB

Current ratio

Acid test

2009 / 2010

67,3872.36:1

28,59467,387 33,450

1.19:128,594

TB

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Current Ratio and Acid Test Acid test is also called Quick Ratio or Liquid Ratio

Limitations: this ratio assumed current assets are quickly turned into cashand current liabilities are quickly payable, which is not valid in real life.

Defensive interval shows how many days a company could survive at itspresent level of operating activity if no inflow of cash were received fromsales or other sources.

eg. TB 2009/10 Defensive interval = 79 days

Current assets InventoriesAcid test

Current liabilities

+ s - c

365

Quick assetsDefensive interval

Average daily cash from operations

Quick assets current assets inventory

opening debtors ales losing debtorsAverage daily cash from operation

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Efficiency


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Efficiency

2010/ 2011

42,49212 7.09

71,923

18,18212 1.16

187,700

18,88812 3.15

71,923

TB

Inventory holding period months

Trade receivables collection period months

Trade payables payment period months

2009/ 2010

33,45012 6.31

63,65914,436

12 1.06163,586

10,39212 1.96

63,659

TB

months

months

months

12 [ 365 ]

12 [ 365 ]

Re

12 [

InventoryInventory holding period months or days

Cost of sales

Trade receivablesTrade receivable collection period months or days

venueTrade payables

Trade payable payment period months or Cost of sales

365 ]days

Trade receivable collection period (debtor days) indicates the average time taken,in calendar months/days, to receive payment from credit customers.Trade payable payment period (creditor days) indicates the average time taken,in calendar days/months, to pay for suppliers received on credit.Management should take the maximum time allowed to pay trade creditors,whilst collecting payment from trade debtors as quickly as possible.

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Efficiency

Usually we will use average inventory to calculate the

inventory turnover. But if a figure for opening stock is notprovided, we can use closing stock as a proxy.

Caveat: No standard periodinventory levels will varydepending on the business activities and the time of year.Again, trends are more helpful than snapshot

Ideally we should use purchases to calculate Trade PayablesPayment Period, but if the figure for purchase is not available,

we could also use cost of sales

If a breakdown of debtors/creditors is not given, it is likely

that the figures are in the notes to the accounts.

sin

2

opening inventory clo g inventoryAverage inventory

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Operating Cash Cycle/Cash Operating Cycle

The time between buying inventory and receiving cash from customers.

Typical operating cycle for a retailer

A longer operating cash cycle means more money is tied up in working capital. A

shorter operating cycle is therefore preferable.

OCC Average inventory holding period

Average trade receivable collection period

Average payable payment period

OCC

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Gearing Ratios

/ 100%

cov 100%

Non current liabilities

Debt equity ratio Equity

Operating profitInterest er

Interest payable

Generally concerned with the relationship between debt and equity capital,the financial structure of an organization.

Used by investors and lenders to assess financial risk when a business has an

obligation to service and repay long-term debts.

The higher the gearing, the higher the risk that the business will be unable to

pay the interest on its loans or make repayment in times of economicrecession.

On the other hand, the higher the gearing, the higher the returns to

shareholders will be in strong economic conditions.

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Gearing Ratio

These ratios describe the relative proportions of debt and equity used tofinance a business.

Interest cover calculates the number of times the interest payable iscovered by profits available for such payments and assesses the relativesafety of interest payments.

2010 / 2011

1,547/ 2.03%76,024

24,132cov 371.26

65

TB

Debt equity ratio

Interest er times

2009 / 2010

1,316/ 1.99%

66,230

19,782cov 133.66

148

TB

Debt equity ratio

Interest er times

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Investment Ratios

Pr

Pr / ( )

DividendsDividend per shareNumber of ordinary share

Dividend per shareDividend yield

Average share price

ofit for ordinary shareholdersEarnings per share Number of ordinary share

Share priceice earnings ratio PE

Earni

ngs per share

Investment ratios generally indicate the extent to which the business isundertaking capital expenditure to ensure its survival, and stability and itsability to sustain current revenues and generate future increased revenues. It is also used by investors, analysts and financial journalists to evaluate theshareholders return and aid investment decisions.

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Dividend per share and Dividend yield


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Dividend per share and Dividend yield

Dividend per share (Dividend net) is the total amount declared as dividendsper each ordinary share in issue.

Dividend yield shows how much a company pays out in dividends each year

relative to its share price

If average share price is not available, you can also use the FYE date shareprice.

If two companies both pay annual dividends of 1 per share, but company Ais trading at 20 while company B is trading at 40, then A has a dividendyield of 5% while B is only yielding 2.5%. Thus, assuming all other factors areequivalent, which stock would an investor prefer?

DividendsDividend per share

Number of ordinary share

Dividend per shareDividend yield

Average share price

2010/ 2011

8,574100 20.52

41,786

20.524.65%441.40

TB

Dividend per share pence

pDividend yield p

2009 / 2010

7,138100 17.15

41,623

17.15

3.91%439.10

TB

pence

p

p

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Earnings per share (EPS) and P/E ratio


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Earnings per share (EPS) and P/E ratio

EPS measures the total return per share of earnings available toshareholders.

P/E ratio reflects the stock markets view on how long the current level ofEPS will be sustained. OR how many years it would take to recover themarket price paid for the shares out of the earnings. The higher the P/E ratiothe better, as it reflects the stock markets confidence in the companysfinancial prospects.

Dividend cover = EPS / DPS - It shows the number of times the profitsattributable to equity shareholders cover the dividends payable for the

period.

2010/ 2011

17,280100 20.52

41,786441.40

/ 10.6741.35

TB

Earnings per share pence

pP E years

p

2009 / 2010

13,527100 32.50

41,623439.10

13.5132.50

TB

pence

pyears

p

Pr

Pr / ( )

ofit for ordinary shareholdersEarnings per share

Number of ordinary share

Share priceice earnings ratio PEEarnings per share

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Average dividend yield ratios for businesses


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Average dividend yield ratios for businesses

in a range of industries

0

1

2

6

5

4

3

Oilan

dgas

Constructio

nand

mat

erials

Chem

icals

Indu

strial

engine

ering

Pharmaceutical

sand

biotechn

ology

Tob

acco

Foodand

Drug

ret

ailers

Electricity

Lifeinsur

ance/

assu

rance

Media

Travelandle

isure

Beve

rages

4.304.25

2.18

2.81

4.45

4.14

2.19

2.65

2.96

5.22

2.62

4.23

3.12

Averagefor

allSE

listedbusinesses

%

Constructed from data appearing in Th eFinanc ial Times, 3/4 April 2010

44

Average price/earnings ratios for businesses


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Average price/earnings ratios for businesses

in a range of industries

0

5.0

25.0

20.0

15.0

10.0

Oiland

gas

Construction

andmate

rials

Chemicals

Industrial

engineering

Pharmaceuticals

and

Biotechno

logy

Tobacco

FoodandDrug

reta

ilers

Electricity

Lifeinsura

nce/

assurance

M

edia

Travelandleisure

Beverages

14.10

12.77

28. 79

15.58

12.31

19.07

15.11

17.34 17.17 17.20

21.78

11.31

30.0

17.73

Averagefora

llSE

listedbusinesses

tim

es

Constructed from data appearing in Th eFinancial Times, 3/4 April 2010

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ff f G i S


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Effect of Gearing on EPS

Year 1 2 3 4 5 Capital employed

k k k k k k

Operating profit 200 300 200 40 200 Shareholders funds 1000

Interest 0 0 0 0 0 Loans 0

200 300 200 40 200 Capital employed 1000

EPS 0.20 0.30 0.20 0.04 0.20 Capital gearing 0%

Year 1 2 3 4 5 Capital employed

k k k k k k

Operating profit 200 300 200 40 200 Shareholders funds 500

Interest 50 50 50 50 50 Loans 500

150 250 150 -10 150 Capital employed 1000

EPS 0.30 0.50 0.30 -0.02 0.30 Capital gearing 100%

Company B

Company A

Company B

Company A

Assume 1 shares in issue

Two companies, identical operating profit and capital employed

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-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

EPS

Year

Company A

Company B

Effect of Gearing on EPS

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Limitations of ratio analysis

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Data unavailable or unsynchronised Non-standardised accounting

Do not take account of non-financial factors May be misleading Summarised data, limited segmental analysis

Conclusion: Ratio analysis can only support decisions and

encourage further enquiry.

It is important to note that ratios are not standardbut can be calculated in different ways.

Consistency and interpretation are what matters!


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Read Moon & Bates 1993

Obtain Annual Report for your chosen company

Undertake qualitative analysis on nature of

business/strategy etc and decide what impactthis might have on the results you will get from

your ratio analysis

Data source

Financial statements

Datastream (Electronic database in school)

Tips for your group project 1

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Use the best available information, which may not beideal informationthat we have seen with averagingbalance sheet values, applies to other informationavailable to us. eg. Debtor collection period relate to creditsales. Cash sales

produce no debtors! You might have to assume there are nocash sales.

So ratios and averages are simplifications, intended togive a broad view.

If other credit balances are long term items, we couldtreat them as part of capital for the purposes of ratioanalysis.

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The simplified balance sheets from the examplesshow basic categories.

Published accounts often show other items, whichmay be difficult to interpret, even with the help ofthe notes.

Such items may include various provisions,including provisions relating to pensions, ordeferred tax assets and liabilities.

Judgement is needed to decide what to include inratio analysis.

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PRACTICE QUESTIONS on Ratio Analysis

in Collis et al. (2nd)

P236 Q1 Q3 Q4

Solutions to practice questions can be

downloaded from Moodle

Documents

IA L34 1415 Ratio Analysis